Amortizing intangibles - a break-even analysis.
In Newark Morning Ledger Co. v. United States (no. 91-1135 [U.S. April 20, 1003] rev'g and rem'g 945 F.2d 555 [3rd Cir. 1991]), the U.S. Supreme Court held a taxpayer must satisfy the "substantial burden" of proving an asset had an accurately determinable value to sustain amortization deductions. Disputes have arisen in the past over both the value and amortizability of intangibles and significant public and private resources have been devoted to related litigation. To simplify the treatment of acquired intangible assets and prevent future disputes, OBRA allows amortization deductions for most intangible assets.
The new law is effective for intangible assets acquired after August 10, 1993. However, taxpayers may elect to apply it to intangibles acquired between July 25, 1991, and the effective date (the election period) or apply prior law. Such an election applies to all a taxpayer's transactions in this period and may not be selectively made for one transaction but not another.
OBRA allows amortization deductions for most intangibles, determined by ratably amortizing an asset's adjusted basis over a 15-year period beginning with the month it was acquired.
Amortizable intangible assets-- referred to in the act as section 197 intangibles--include customer-based intangibles, supplier-based intangibles, books and records, patents, proprietary technology, copyrights, licenses, trademarks and trade names, franchise values, noncompetition agreements and goodwill-going concern values.
Excluded are financial and land interests, computer software (if readily available for purchase by the general public without substantial modifications and not acquired as part of a trade or business), certain interests or rights acquired separately (such as an interest in a patent not acquired as part of a trade or business), interests under leases or debt instruments, sports franchises, mortgage-servicing rights and certain transaction costs.
RESOLVING OLD DISPUTES
Many disputes over acquisitions before July 26, 1991, have not been settled; they are not covered under OBRA. However, the Internal Revenue Service recently announced an initiative to settle many of these cases (except those involving transactions made during the election period).
The settlement offer will reduce taxpayers' basis in amortizable intangible assets by the greater of 15% or a 50% cost-recovery adjustment. It is based on the premise taxpayers should, on a present value basis, recover no more than 50% of an intangible asset's total basis (including goodwill) through amortization. This adjustment is calculated using tables prepared by the IRS and included in the settlement announcement news release.
Taxpayers evaluating whether to settle should consider a number of factors, including the dollar amount of compromise required, the taxpayer's perception of the risk of litigation, the expected legal costs and assessed penalties and interest.
FINDING THE BREAK-EVEN POINT
For taxpayers that completed acquisitions during the election period, deciding to use the prior treatment and accept the associated risks or simply to adopt the new treatment is based on similar factors. A break-even analysis can be performed that considers each alternative's benefits and risks. Four primary variables affect the analysis.
Percentage amortizable. The percentage of total intangible assets that have been or will be amortized under the old law is a critical variable. It can range from 0% to 100%. Because it is beneficial for taxpayers to maximize the percentage of total intangible assets amortizable for tax purposes, it is common to see allocations attributing 80% to 100% of total intangible value to amortizable intangible assets. The higher the percentage, the more attractive the old treatment will be, all other factors being equal.
Probability of successful amortization. Taxpayers should consider how likely it is the IRS will allow previous amortization deductions. As noted earlier, the tax treatment of intangibles was changed to end disputes over use of the previous method. If the old method is applied to election-period acquisitions, an assumption must be made about the risk of the disputed deductions. Legal, accounting and appraisal service costs may be required to support the deductions and some or all of them might be disallowed. The disallowance risk is based on how well a taxpayer meets the Newark Morning Ledger substantial-burden test.
Weighted-average amortizable life. The weighted-average life of amortizable assets for which deductions could be taken under the previous law is critical to the break-even analysis. Average life historically was determined by contract, by statute or by statistical analysis. The lives of some assets, such as bank depositors, can be as short as 3 to 5 years, while most patents have finite lives determined legally to be 17 years beginning with the issuance date. Because intangible assets with shorter average lives have shorter amortization periods--accelerating receipt of tax benefits--the treatment under the old law is more attractive.
Discount rate. The discount rate used to determine the present value of each scenario's deductions is important--the present value of future amortization tax benefits must be compared so timing differences between the alternative treatments are considered. While the same discount rate should be used for both tax treatments, the rate selected has an impact on the conclusion.
Assuming all other variables are equal, selecting a lower discount rate makes the weighted-average amortizable life less important because future tax benefits are not reduced as much in discounting to present value. Conversely, higher rates tend to amplify the importance of tax benefits' timing because future tax benefits are discounted more severely.
MAKING THE COMPARISON
A differential discounted cash flow analysis can be used to compare the old and new tax treatments. Future amortization tax benefits of intangible assets are projected for both and the present value is calculated. Given any set of specific assumptions, it is possible to determine which treatment yields the greater present values of tax benefits on an expected-value basis.
For each combination of values for the probability of successful amortization (from 100% to 50%, in 10% increments) and weighted-average amortizable life (between 1 and 15 years), the percent of intangibles amortizable is interpolated so the present values of amortization tax benefits under both treatments are equal. The variables represent a break-even or indifference point between tax methods. After each break-even point is calculated, a graph of the percent amortizable and average amortizable life for each point is generated for each probability factor, yielding five separate curves. Amortization under each scenario is calculated using the straightline method; the discount rate is kept constant at 15%.
The results are shown in the exhibit on page 32 and can be used to determine which alternative is more desirable based on a taxpayer's values for each variable. If the old law is more beneficial, the point of intersection of the percent of amortizable intangibles and a particular acquisition's weighted-average amortizable life will be above the selected probability factors' curve. (The higher above the curve, the more beneficial the old treatment is.)
To use the exhibit, select the appropriate probability factor and find its curve. Then, locate the point on the graph indicated by the taxpayer's percentage of amortizable intangible assets and average amortizable life. If that point is above the selected probability factor curve, the old treatment is better. If it is below the line, the new treatment is more favorable.
The graph shows that the present value of amortizing 80% of total intangible assets over 7 years with an 80% probability of success approximately equals the present value of the new treatment (amortizing 100% of total intangible assets over 15 years with 100% probability of success). Accordingly, if the 80% probability curve is selected and an acquisition is made in which 82% of total intangible assets are amortizable and the weighted-average amortization life is 5 years, the graph shows it is more beneficial to use the old treatment.
The exhibit also can be used to indicate a break-even risk factor given known values for the percent of amortizable intangibles and the weighted-average amortizable life. If 80% of the total intangible asset value is amortizable over three years, the implied break-even probability of success will be 65%. In this example, a taxpayer should elect the old treatment if the probability of success is greater than 65%.
As the exhibit shows, a net present value calculation can establish which treatment is more beneficial based on the above factors. While it must be modified to consider more complicated amortization methods, professional fees or other factors, the exhibit should help CPAs determine the appropriate course of action based on each taxpayer's circumstances.
* THE OMNIBUS Budget Reconciliation Act of 1993 offers taxpayers an option for amortizing intangible assets acquired between July 25, 1991, and August 10, 1993 (the election period). The assets can be amortized using the old or the new law-- whichever yields greater tax savings.
* FOR ASSETS ACQUIRED before July 26, 1991, the Internal Revenue Services is willing to settle disputed cases.
* TAXPAYERS CAN PREPARE a break-even analysis to assess the benefits and risks of each alterative. Determining which option is better depends on how much is amortizable, the probability the IRS will approve amortizations under the old method, the period over which the asset can be amortized and the discount rate.
* GIVEN SPECIFIC assumptions, a graph helps taxpayers determine which treatment yields the greater present value of tax benefits.
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|Author:||Fuller, David N.|
|Publication:||Journal of Accountancy|
|Date:||Jun 1, 1994|
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