Federal Court Of Appeal Confirms Tax Deductibility Of Oversight Expenses In M&A Transactions

On June 25, 2018, the Federal Court of Appeal upheld the 2016 decision of the Tax Court of Canada in Rio Tinto Alcan Inc. v. The Queen1 that investment banking and professional advisory fees incurred by a corporation in order to obtain advice for the board of directors "in their discharge of oversight responsibilities" are fully deductible. This is an important decision for widely-held corporations for two reasons: (1) it confirms the tax treatment of often significant expenses; and (2) it is judicial recognition of the fact that board members are increasingly expected to understand management's proposals and to seek independent professional advice to guide their decision-making process, rather than simply acquiescing to these proposals without further scrutiny.

Background In 2002, the taxpayer, Rio Tinto Alcan Inc. ("Rio Tinto"), was considering the possibility of acquiring Pechiney S.A. ("Pechiney"), a French public company. Rio Tinto retained the investment banks Morgan Stanley & Co. Incorporated ("Morgan Stanley") and Lazard Frères & Co. LLC ("Lazard Frères") to assist in assessing a potential transaction, and specifically, to analyze and prepare financial models of the possible transaction. Morgan Stanley and Lazard Frères each conducted an independent analysis of various strategies and alternatives for a potential transaction and made a number of presentations to the board of directors of Rio Tinto. In addition, Morgan Stanley and Lazard Frères each provided advice with respect to a related spin-off of certain assets to satisfy conditions imposed by competition authorities with respect to the Pechiney transaction.

In connection with these transactions, Rio Tinto incurred approximately $100 million in transaction expenses, including investment banking, legal, and professional advisory fees. Rio Tinto deducted the expenses in the taxation years in which they were incurred, pursuant to section 9 of the Income Tax Act2 (the "Tax Act"). The Canada Revenue Agency ("CRA") disallowed the deductions pursuant to paragraph 18(1)(b) of the Tax Act on the basis that the fees were incurred on account of capital.

The Tax Court of Canada Judgment The Tax Court of Canada (the "TCC") rejected the CRA's long-held view that expenses incurred in the context of an M&A transaction are of a capital nature, and thus are not deductible. Instead, they noted a distinction between "oversight expenses", which are current expenses that were incurred by the board of...