Amortization of intangibles under sections 167 and 197.

On September 29, 1997, Tax Executives Institute submitted the following comments to the Internal Revenue Service on proposed regulations under sections 167 and 197 of the Internal Revenue Code, relating to the amortization of certain intangible property. The Institute's comments were developed under the joint aegis of its Federal and International Tax Committees whose chairs are, respectively, David L. Klausman of Intel Corporation and Joseph S. Tann, Jr of Ameritech Corporation. The following TEI members also contributed to the development of the submission: David L. Bernard of Kimberly-Clark Corporation, Philip G. Cohen of Unilever United States Inc., and Judith E. Plump of Cosmair Inc.

The U.S. Department of the Treasury and the Internal Revenue Service have issued proposed regulations under sections 167 and 197 of the Internal Revenue Code, relating to the amortization of certain intangible property. The proposed regulations were published in the FEDERAL REGISTER on January 16. 1997 (62 Fed. Reg. 2336), and in the INTERNAL REVENUE BULLETIN on March 31, 1997 (1997-13 I.R.B. 12).(1) A public hearing was held on the regulations on May 15, 1997.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 5,000 members represent nearly 2,800 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and that taxpayers can comply with in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under sections 167 and 197 of the Internal Revenue Code, relating to the amortization of certain intangible property.

Prop. Reg. [sections] 1.197-2: Amortization of Goodwill and Other Intangibles

Sections 167(f) and 197 of the Internal Revenue Code provide comprehensive rules for the depreciation and amortization of many intangible assets. Section 197(a) permits an amortization deduction with respect to the capitalized costs of a "section 197 intangible" that is acquired by the taxpayer and held in connection with the conduct of a trade or business or for the production of income. The amount of the deduction is determined by amortizing the adjusted basis of the intangible ratably over a 15-year period. Section 197(g) of the Code grants authority to the Secretary of the Treasury to prescribe appropriate regulations.

Section 197 was added to the Code by the Omnibus Budget Reconciliation Act of 1993 and affects taxpayers that acquired intangible property after August 10, 1993, or made a retroactive election to apply the 1993 law to intangibles acquired after July 25, 1991. A "section 197 intangible" -- which includes goodwill, going concern value, workforce in place, information base, know-how, customer-and supplier-based intangibles, governmental licenses and permits, covenants not to compete and other similar arrangements, franchises, trademarks, trade names, and contracts for the use of the foregoing assets -- is defined in Prop. Reg. [sections] 1.197-2(b).

TEI is concerned about the application of the regulations, especially in the international area. We believe that the proposed definition of section 197 intangible property is so broad that it reaches many ordinary, intercompany royalty payments that are deductible under section 162 of the Code, and that, we submit, Congress did not intend to affect by enacting section 197. The regulations should be clarified to ensure the continued deductibility of these items.

A. Application to License Agreements. Prop. Reg. [sections] 1.197-2(b)(11) defines a section 197 intangible as including "any right under a license, contract, or other arrangement providing for the use of' a section 197 intangible. Subparagraph (b)(5) further defines "know-how, etc." as including any "patent, copyright, formula, process, design, pattern, know-how, format, package design, computer software...or interest in film...." Under Prop. Reg. [sections] 1.197-24)(3)(i)(A), in the case of a license, permit, or contract for the use of a section 197 intangible, the amount chargeable to the capital account (and thus amortized over 15 years) includes

all amounts required to be paid

pursuant to the agreement or

right, whether or not

any amount would be deductible under

section 162 if the agreement or right

were not a section 197 intangible.

Although an exception from the general rules is provided for separately purchased contract rights that are limited in amount or have a fixed duration of less than 15 years, the definition of a "trade or business" is expansive.(2) Prop. Reg. [sections] 1.1972(e)(3) provides that "the acquisition of a franchise, trademark, or trade name constitutes the acquisition of a trade or business" unless "its value is nominal or the taxpayer irrevocably disposes of it immediately after its acquisition." "Nominal" is not defined in the regulations.

Because of the breadth of these definitions, many annual royalty payments under a trademark or patent license are not currently deductible.(3) As drafted, the proposed regulations affect U.S.-based multinational corporations with respect to licenses to foreign subsidiaries where earnings and profit calculations are relevant, as well as foreign-owned multinational corporations that grant licenses to U.S. subsidiaries and joint ventures. TEI submits that denying current deductions for contingent royalty payments in these circumstances is contrary to the legislative history of section 197.

When section 197 was enacted in 1993, Congress clearly intended that amounts deductible under prior, law remain deductible under the new provision:

Except in the case of

amounts paid or incurred

under certain covenants not to

compete (or under certain other

arrangements that have the same

effect as covenants not to

compete) and certain amounts

paid or incurred on account of the

transfer of a franchise, trademark,

or trade name, the bill generally

does not apply to any amount that

is otherwise currently deductible

(i.e., not capitalized) under

present law.

H.R. Rep. No. 103-213, 103d Cong., 1st Sess. 673 (1993) (Statement of Managers) (emphasis added). For more than five decades, the courts have held that licensing arrangements providing for contingent annual payments have been currently deductible. See, e.g., Associated Patentees v. Commissioner, 4 T.C. 979 (1945), acq., 1959-2 C.B. 3 (providing for the current deductibility of contingent payments in the context of a sale). Current deductibility is also the proper tax and financial accounting result since the licensee can avoid payment of the royalty by not using the intangible during the year; this payment is thus not a benefit that extends beyond the end of the year. In other words, requiring capitalization in these circumstances would distort the measurement of income.

Even with respect to fixed royalties, the proposed regulations may produce anomalous results. Consider, for example, a licensing agreement with a three-year term that is automatically renewed on a year-to-year basis unless one party terminates the agreement in writing. Under Prop. Reg. [sections] 1.197-2(f)(3)(B)(ii), the royalty for each successive one-year term must be amortized over a 15-year period. If the licensing arrangement is between a U.S. parent and a foreign subsidiary (which is common because of section 367(d)), the subsidiary's earnings and profits will be overstated. Similarly, a licensing arrangement between two foreign subsidiaries will distort one subsidiary's earnings. We submit that this makes no sense from either a tax policy or economic standpoint.

The broad definitions in the proposed regulations could also adversely affect licensing agreements between domestic affiliates where state law parallels the federal rules. In these circumstances, the licensor will include royalty payments in income currently, while the licensee amortizes the payment over 15 years. Although the consolidated return rules will ameliorate the mismatch of income and expense for federal purposes, the net income of the licensee could clearly be overstated for state tax purposes.

For the foregoing reasons, TEI recommends that Prop. Reg. [sections] 1.1972(f)(3) be deleted from the final regulations.

B. Application to Non-Exclusive Licenses. TEI also recommends that nonexclusive licenses be excluded from the definition of a section 197 intangible. Transfer of these licenses do not constitute a true sale of a trade or business; they merely permit more than one entity to use the technology. Such licensing transactions should not be treated as sales under the final regulations.

C. Application to the Acquisition of Limited Rights. Prop. Reg. [sections] 1. 1972(e)(3)(i) provides generally that the acquisition of a franchise, trademark, or trade name constitutes the acquisition of all or a substantial portion of a trade or business.(4) TEI is concerned that the regulations could be construed to include the acquisition of limited rights to a franchise, trademark, or trade name. If so, certain payments relating to the franchise, trademark, or trade name acquisition would be deductible under section 1253(d),(5) but amounts relating to the patents, know-how, or similar intangibles acquired in connection with those rights would be amortizable under section 197. This makes little sense. TEI recommends that the final regulations provide that if payments relating to the acquisition of a franchise, trademark, or trade name are deductible under section 1253(d), then the existence of that franchise, trademark, or trade name will not, by itself, result in the acquisition being treated as the purchase of a trade or business.

Prop. Reg. [sections] 1.197-2(h)(6)(ii): The Anti-Churning Rule

Section 197(f)(A) of the Code contains an anti-churning rule to prevent taxpayers from amortizing section 197 intangibles acquired before the effective date of the statute (i.e., August 10, 1993). H.R. Rep. No. 103-111, 103d Cong., 1st Sess. 691 (1993) (House Report). Thus, the term "amortizable section 197 intangible" does not include any section 197 intangible for which depreciation or amortization would not have been allowed but for this section and that is acquired by the taxpayer if (i) the intangible was held or used at any time between July 25, 1991, and August 10, 1993, by the taxpayer or a related party, (ii) the intangible was acquired from a person who held the intangible during this transition period and, as part of the transaction, the user does not change, or (iii) the taxpayer grants the right to use such intangible to a person (or person related to such person) who held or used the intangible during the transition period. Section 197(f)(9)(C) provides that parties are related if G) the related person owns more than 20 percent of the value of stock or capital or profits interest, or (ii) the parties are engaged in the same trade or business under common control. A person is treated as related if such relationship exists immediately before or after the acquisition of the intangible.

In respect of the anti-churning rule, Prop. Reg. [sections] 1.197-2(h)(6(ii) provides --

A person is treated as related

to another person if the

relationship exists --

(A) In the case of a

single transaction,

immediately before

or immediately after

the acquisition of

the intangible involved; or

(B) In the case of a

series of related

transactions, at any

time during the period

beginning immediately before the

earliest acquisition

and ending immediately

after the last

acquisition of any

intangible acquired

in a series of transactions.

TEI is concerned that the proposed regulations may have ramifications for purposes of a "busted section 351" transaction.(6) This transaction may typically be described, as follows:

Parent transfers stock of Target

to Newco in exchange for

Newco common stock. Under

a binding agreement made

prior to the transfer, Parent

immediately transfers more

than 80 percent of Newco

stock to underwriters who

sell the stock to the public in

a firm-commitment underwriting.

A joint election is

made under section

338(h)(10) by Parent and

Newco to treat the transaction

as a deemed asset acquisition.

In the foregoing example, Newco's acquisition of Target's intangible assets would be subject to amortization under section 197's 15-year rule. Under the proposed regulations, however, the momentary stock ownership of Newco by Parent may create a related-party status between Parent and Newco; the intangible assets would thus fail to qualify for amortization under section 197. TEI submits that this result is contrary to the legislative history of section 197 and established case law and rulings and, moreover, ignores the economic substance of the transaction.

The House report on section 197 provides, as follows:

It is anticipated that in the

case of a transaction to which

section 338 of the Code applies,

the corporation that is

treated as selling its assets

will not be considered related

to the corporation that is

treated as purchasing the

assets if at least 80 percent

of the stock of the corporation

that is treated as selling

its assets is acquired by purchase

after July 25, 1991.

H.R. Rep. No. 103-111 at 780 n.157. See also S. Print No. 36, 103d Cong., 1st Sess. 423 n.34 (1993) (Senate Report). Although this passage technically addresses only the relationship between the new and old targets, we submit the same rationale should obtain for the relationship between Parent and Newco.

Under section 338(a), the target corporation is treated as having sold all of its assets at the close of the acquisition date at fair market value in a single transaction, and is treated as a new corporation that purchased all its assets on the date after the acquisition date. For purposes of these rules, the wholly transitory ownership of Newco stock by Parent is ignored. See Private Letter Ruling 9142013 (July 17, 1991) ("Parent is not a person from whom the ownership of stock would, under section 318 of the Code, be attributed to Buyer within the meaning of section 338(h)(3)(A)(iii)."); Private Letter Ruling 9541039 (July 20, 1995) (the acquisition by a new corporation of all the stock of another subsidiary of the new corporation's parent, and the deemed acquisition of the acquired corporation's affiliates, will each qualify under section 338). See also Treas. Reg. [sections] 1.338-2(d) ("[N]ew target is treated as a new corporation that is unrelated to old target for purposes of subtitle A of the Internal Revenue Code. Thus, in the section 338(a)(1) deemed sale, new target is treated as purchasing assets from an unrelated person and ... is not considered related to old target for purposes of section 168."). Thus, the proposed regulations conflict with the consistent treatment of the transaction under section 338.

Moreover, the proposed regulations are at odds with the established interpretation of the control requirement under section 351(a). Under the step-transaction doctrine, the momentary ownership of a new entity by a parent company is disregarded for purposes of the reorganization provisions. McDonald's Restaurants of Illinois v. Commissioner, 688 F.2d 520 (7th Cir. 1982) (stock of Newco sold to the underwriters disregarded in determining whether Parent maintains a sufficient continuity of interest in Newco under section 351); Yoc Heating Corp. v. Commissioner, 61 T.C. 168 (1973) (steps were treated as an integrated transaction; Newco's acquisition of assets was by purchase). See also Rev. Rul. 54-96, 1954-4 C.B. 111 ("The two steps of the transaction [a transfer of assets to Newco and an immediate exchange of Newco stock for 20 percent voting stock of another corporation] were part of a prearranged integrated plan, and may not be considered independently of each other for Federal tax purposes.").(7)

Finally, TEI submits that the regulations should be revised because, as proposed, they do not accord with the economics of the transaction. The purpose of the anti-churning rule is to prevent taxpayers from applying the amortization provisions to intangible assets acquired prior to the date of enactment. The transaction described above effectively constitutes a sale of corporate stock to the general public. In these circumstances, there is no abuse of the section 197 rules.

For the foregoing reasons, the anti-churning rule should be clarified to provide that no "tainting" relationship exists between the acquiring person and the seller of the target stock.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the international aspects of the proposed regulations under sections 167 and 197 of the Code, relating to the amortization of certain intangible property. If you have any questions, please do not hesitate to call Joseph S. Tann, Jr., chair of TEI's International Tax Committee, at [phone], David L. Klausman, chair of TEI's Federal Tax Committee, at [phone], or Mary L. Fahey of the Institute's professional staff at [phone].

(1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions of the proposed regulations are cited as "Prop. Reg. [sections]." References to page numbers are to the proposed regulations (and preamble) as published in the INTERNAL REVENUE BULLETIN.

(2) An exception also exists under Prop. Reg. [sections] 1.197-2(e)((3)(ii)(A) for certain trademarks or trade names included in computer software or in an interest in a film, sound recording, video tape, book, or similar property.

(3) Under Prop. Reg. [sections] 1.197-2(c)(13)(i)(C), a limited exception exists for contracts that have a fixed duration or amount. It is often difficult for related parties to prove that contracts have a fixed duration. Moreover, section 482 of the Code requires transfers of intangibles to be "commensurate with income." Thus, many cross-border licensing agreements provide for contingent payments. For this reason, in the international area, the scope of this exception is limited.

(4) Exceptions are provided in Prop. Reg. [sections] 1.197-2(e)(3)(ii) for a trademark or trade name used in a computer software and other film or recording property, and for values that are nominal.

(5) Section 1253(d) permits a deduction for amounts paid on account of the transfer, sale, or other disposition of a franchise, trademark, or trade name where the amount (i) is contingent on the productivity, use, or disposition of the franchise, trademark, or trade name, and (ii) is part of a series of substantially equal payments paid at least annually.

(6) Section 351 (a) of the Code generally permits the tax-free transfer of property to a corporation in exchange for stock in the transferee corporation. If the section does not apply, the transfer is treated as a sale of property and the gain, if any, is taxed under section 1001(c).

(7) Rulings in other areas similarly support disregarding momentary ownership for attribution purposes. Rev. Rul. 72-320, 1972-1 C.B. 270 (momentary ownership of stock of controlled corporations disregarded for S corporation determination); Rev. Rul. 70-391, 1970-2 C.B. 3 (acquired company held not related to acquirer for purpose of anti-churning rules on the investment tax credit); Rev. Rul. 57-53, 1957-1 C.B. 291 (one-month ownership disregarded in determining membership in buyer's consolidated group); Technical Advice Memorandum 8837003 Way 31, 1988) (target not considered affiliated with parent under consolidated return regulations).