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Amortizing franchises under new Sec. 197.

The new Sec. 197 rules for amortizing intangible assets will significantly affect traditional tax strategies for the purchase and sale of business organizations. It is also important for tax practitioners to be aware of the far-reaching effects of Sec. 197 on transfers of intangibles in situations not involving sales of businesses. Transactions potentially affected by these new rules include transfers of trademarks and tradenames, franchises, licenses, permits and many other contractual business arrangements.

Fifteen-year life now

applies to franchises

Prior to the Revenue Reconciliation Act of 1993 (RRA), deductions for amounts paid to acquire franchises, trademarks and tradenames were governed by Sec. 1253(d). The term "franchise" was broadly defined to include any agreement granting a right to distribute, sell or provide goods, services or facilities within a specified area (Sec. 1253(b)(1)). Sec. 1253(d) generally permitted lump-sum payments made to acquire a franchise, trademark or tradename to be amortized over a 10-year period, provided the amount paid did not exceed $100,000. (The 10-year amortization period is also applicable to all transfers made before Oct. 3, 1989, rcgardless of the amount.) If the amount paid exceeded $100,000, a taxpayer could generally elect to amortize the payment over a 25-year period (Sec. 1253(d)(2)(B) and (d)(3)(B), prior to amendment).

Although Sec. 1253(d)(1) continues to govern deductions for periodic payments contingent on the productivity, use or disposition of a franchise, trademark or tradename, the amortization provisions for lump-sum and other nonperiodic payments are now governed exclusively by new Sec. 197(a). This new provision prescribes straight-line amortization over a 15-year period beginning with the month in which the intangible is acquired, regardless of the amount involved or the period for which the franchise is granted. The new rules generally apply to intangibles acquired after Aug. 10, 1993, although a taxpayer may elect to apply these rules to any applicable intangible acquired after July 25, 1991.

Under pre-RRA law, there was some question as to whether Sec. 1253 applied to governmental licenses and permits. In two recent cases, the IRS unsuccessfully challenged the applicability of Sec. 1253 to cable television franchises granted by local communities, and to radio broadcast licenses granted by the FCC (Tele-Communications, Inc., 95 TC 495 (1990), and Jefferson-Pilot Corp., 98 TC 435 (1992), aff'd, 4th Cir., 1993). Sec. 197 eliminates this controversy (at least for rights acquired after Aug. 10, 1993) by specifically including licenses, permits and other rights granted by governmental units and agencies in the definition of a "Section 197 intangible" (Sec. 197(d)(1)D)).

Fifteen-year rule has

limited exclusions

Certain "self-created" intangible assets are excluded from the 15-year amortization rule, if the intangible is not created in connection with the acquisition of assets that constitute a trade or business or a substantial portion thereof. However, Sec. 197(c)(2) makes this exclusion inapplicable to franchises, trademarks and tradenames, governmental licenses and noncompetition agreements. Sec. 197(e) contains several additional exclusions from the term "Section 197 intangible," one of which is for contractual and certain other rights not acquired as part of an acquisition of assets that constitute a trade or business or a substantial portion thereof. Under this exclusion, patents, copyrights and interests in films, books and similar property are removed from the 15-year amortization provisions of Sec. 197, but only if such rights are acquired separately from the acquisition of a trade or business (Sec. 197(e)(4)).

Sec. 197(e)(4)(D) further excludes certain "separately acquired" rights under contracts, including rights granted by governmental units or agencies, from the 15-year amortization rule if the rights have a fixed duration of less than 15 years, or would normally be amortizable in accordance with the unit-of-production or similar method. This exclusion applies, however, only "to the extent provided in regulations." According to the Conference Report, franchises, trademarks and tradenames may never come within this particular exclusion, since any acquisition of such rights is considered to constitute the acquisition of a trade or business or a "substantial portion" of a trade or business. The committee report does not indicate whether governmental licenses and permits should be treated as "franchises" for purposes of this presumption. This may revive the controversy regarding whether the term "franchise" includes governmental as well as commercial contractual agreements.

Whatever its impact on franchises and governmental licenses, however, Sec. 197(e)(4)(D) is clearly of significance to other contractual business agreements not falling within the broad definition of "franchises." The committee reports indicate that amortization of such rights should be permitted over the actual term of the agreement, or over some other readily identifiable amortization period pursuant to regulations prescribed by the Treasury. The reports suggest that regulations should address the effect of renewal options when determining whether rights are fixed in duration or amount. Other facts and circumstances, such as actual custom or practice regarding renewals and the expectancy of renewals, should also be considered. Until guidance is provided on these issues, it appears that the amortization of all contractual rights will be subject to the general 15-year rule of Sec. 197(a) However, if a contractual right is clearly limited in duration, a taxpayer may be able to use an amortization period of less than 15 years on the basis of the committee report language, although the statutory language suggests that this provision is not self-implementing.

While not specifically addressed by the statutory provisions, the committee reports make it clear that the unamortized basis of a separately acquired Sec. 197 intangible may generally be deducted as a loss in the year of disposition or abandonment. This rule mitigates the rather harsh application of the general 15-year life to contractual rights that have an actual duration of less than 15 years. However, this relief provision is inapplicable to the disposition of a Sec. 197 intangible acquired in connection with one or more other Sec. 197 intangible assets that continue to be owned by the taxpayer subsequent to the disposition of the particular intangible in question (Sec. 197(f)(1)).

Dispositions of franchises

also affected by Sec. 197

The RRA also provides new certainty for several issues related to the disposition of contractual rights and agreements and similar intangibles, at least for those acquired after Aug. 10, 1993. Sec. 197(f)(7) provides that an intangible asset amortizable under Sec. 197 is to be treated as property of a character subject to the allowance for depreciation provided in Sec. 167. This provision, together with a new cross-reference inserted in Sec. 1245(a)(3), makes it clear that amortization deductions are subject to recapture as ordinary income on the disposition of a Sec. 197 intangible. On the other hand, any gain in excess of the potential recapture amount should clearly qualify for capital gain treatment under Sec. 1231, which applies to depreciable business assets held for more than one year prior to sale. Although not specifically stated in the statute, this result seems clearly dictated by the statutory scheme, and is confirmed by the committee explanations regarding the disposition of Sec. 197 intangibles.

These are only a few of the significant changes and issues arising under new Sec. 197. It will be important for practitioners to be aware of the potential application of this provision to many common business agreements, even when such agreements are not related to the purchase of a business.
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Author:Addison, Emerson J., Jr.
Publication:The Tax Adviser
Date:Dec 1, 1993
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