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New TAM highlights issues in like-kind exchanges involving intangibles.

When corporations are considering the disposition of business assets, one of the issues that frequently arises is whether a like-kind exchange under section 1031 of the Internal Revenue Code might be available to defer gain recognition. Many businesses will have significant intangible assets, leading to an inquiry about how these intangible assets will be treated in a like-kind exchange.

In a recent technical advice memorandum (TAM 200602034), the Internal Revenue Service provided restrictive guidance on this topic. The IRS basically took the position that most intangibles do not qualify for like-kind exchange treatment. The IRS also looked at the section 1031 replacement property identification requirements in this TAM, and applied them rigorously to the taxpayer's disadvantage. At the bottom line, this TAM sends a clear message that the IRS will permit taxpayers to take advantage of tax deferral only if the requirements of section 1031 are specifically satisfied.

Facts

TAM 200602034 involved a parent corporation and several of its subsidiaries that apparently filed a consolidated return. The companies engaged in four transactions in one taxable year involving the transfer and acquisition of tangible and intangible business assets. The taxpayer claimed that all of gain on the sales and purchases were subject to deferral under section 1031.

In the first transaction, on Date 1 the taxpayer transferred the tangible and intangible assets pertaining to the business of Corporation 1 to Buyer 1. Corporation 1 was involved in the research, design, and manufacture of Product 1 in the United States and around the world, and Corporation 1 had facilities located in three states and one foreign country. The intangible assets transferred in this first transaction consisted of (1) patents, (2) trademarks (including design marks) and trade names, (3) designs and drawings, (4) software, and (5) trade secrets and know how.

In the second transaction, on Date 2 the taxpayer transferred substantially all of the assets of five subsidiaries (collectively, Corporations 2) to Buyer 2; Buyer 2 acquired certain other assets as well. Corporations 2, which were engaged in business in three states, designed, manufactured, marketed, and tested Product 2, which was used in certain types of industrial operations. The intangible assets transferred to Buyer 2 were divided into the same broad categories as related to the transfer to Buyer 1.

On the same date as the second transaction, the tax-payer acquired from Seller i the assets and business operations of Seller 1, a firm engaged in the research, design, manufacture, and marketing of Product X in the United States. Seller 1 had facilities in three states. The intangible assets acquired from Seller I were divided into four categories: (1) trademarks and trade names, (2) designs and drawings, (3) software and (4) trade secrets and know how.

On Date 3, the taxpayer acquired the assets of Seller 2. Seller 2's products and manufacturing operations were split into two divisions. One division was a leading producer of Product Xl, with manufacturing plants in foreign countries. The other division was a leading producer of Product X2, with facilities in the US and a foreign country. Seller 2 had a reputation for innovative engineering and manufacturing skills and was regarded as the industry's technological leader. The intangible assets acquired from Seller 2 included (1) patents, (2) designs and drawings, (3) software, and (4) trade secrets and know how.

The taxpayer claimed like-kind exchange treatment of the disposition of certain of the intangibles pertaining to Corporation 1 and Corporations 2 as well as the related acquisition of the intangible assets from Seller 1 and Seller 2. With respect to the assets sold by Corporation 1, the taxpayer claimed that the acquisition from Seller 1 of (1) trade makes and trade names and (2) trade secrets and know how qualified under section 1031. With respect to Corporations 2, the taxpayer claimed that the acquisition from Seller 1 of four types of intangible assets qualified under section 1031: (1) trademarks and trade names, (2) designs and drawings, (3) trade secrets and know how, and (4) software. The taxpayer also claimed that Corporations 2 were entitled to like-kind exchange treatment with respect to their acquisition from Seller 2 of (1) patents, (2) designs and drawings, (3) trade secrets and know how, and (4) software. The taxpayer did not claim like-kind exchange treatment with respect to any of the tangible assets involved in these transactions.

Richard M. Lipton is a partner in the Chicago office of Baker & McKenzie LLP. A graduate of Amherst College and the University of Chicago Law School, he is former chair of the American Bar Association's Section of Taxation and a fellow and officer of the American College of Tax Counsel. He is a frequent participant in educational programs sponsored by Tax Executives Institute and other organizations, and has published numerous articles in The Tax Executive and elsewhere.

Applicable Law

Section 1031(a)(1) generally provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. Under Treas. Reg. [section] 1.1031(a)-1(b), the words "like kind" refer to the nature and character of the property and not to its grade or quality and, further, that an exchange of one kind or class of property for a different kind or class is not a like-kind exchange.

Under Treas. Reg. [section] 1.1031(a)-2(a), personal properties of a like class are considered to be of "like kind" for purposes of section 1031. In determining whether exchange properties are of a like kind, no inference is to be drawn from the fact that the properties are not of a like class. Furthermore, Treas. Reg. [section] 1.1031(a)-2(b) provides that depreciable tangible personal properties are of a like class if they are either within the same General Asset Class (as defined in Treas. Reg. [section] 1.1031(a)-2(b)(2)) or within the same Product Class (as defined in Treas. Reg. [section] 1.1031(a)-2(b)(3)).

Under Treas. Reg. [section] 1.1031(a)-2(b)(1), a single property may not be classified within more than one General Asset Class or within more than one Product Class. Treas. Reg. [section] 1.1031(a)-2(b)(2) generally provides that property within a General Asset Class consists of depreciable tangible personal property described in one of certain asset classes in Rev. Proc. 87-56, 1987-2 CB 674. For example, generally speaking, all office furniture (and related fixtures and equipment) are within the same General Asset Class (e.g., desks, files, safes, and other furniture and equipment that are not structural components of a building). Under Treas. Reg. [section] 1.1031(a)-2(b)(3), property within a Product Class consists of depreciable tangible personal property that is described in a six-digit Product Class determined under the North American Industry Classification System (NAICS), subject to certain exceptions.

Treas. Reg. [section] 1.1031(a)-2(c)(1) provides that an exchange of intangible personal property qualifies for non-recognition under section 1031 only if the exchanged intangible properties are of a like kind. No like classes are provided for intangible properties. Whether intangible personal property is of a like kind to other intangible personal property generally depends on (i) the nature or character of the rights involved (e.g., a patent or a copyright) and (ii) the nature or character of the underlying property to which the intangible personal property relates. Under Treas. Reg. [section] 1.1031(a)-2(c)(2), the goodwill and going concern value of a business is not of a like kind to the goodwill and going concern value of another business.

Two examples are provided in the regulations concerning exchanges of intangibles. In Treas. Reg. [section] 1.1031(a)-2(c)(3), Example 1, Taxpayer K exchanges a copyright on a novel for a copyright on a different novel; these properties were of a like kind. In contrast, in Example 2, Taxpayer J exchange a copyright on a novel for a copyright on a song, and the properties exchanged were deemed not of a like kind. Thus, both the nature or character of the rights involved and the nature or character of the underlying property are taken into account.

Application to this Exchange

The issue before the IRS in TAM 200602034 was how these rules apply in the case of a multi-company, multi-asset exchange. The IRS has long rejected the notion that taxpayers may treat the multiple assets of a business as a single property for like-kind exchange purposes. Rather, the determination whether (or the extent to which) section 1031 applies to an exchange of the assets of one business for the assets of another business requires an analysis of the underlying assets exchanged. See, e.g., Rev. Rul. 89-121, 1989-2 C.B. 203, and Rev. Rul. 55-79, 1955-1 C.B. 370. The asset-by-asset analysis is required to verify that the properties exchanged are of like kind.

The IRS and the courts have also held that even small differences between similar properties may be relevant in determining whether two properties are of like kind, particularly in the area of personal property. For example, in Rev. Rul. 79-143, 1979-1 C.B. 264, the IRS held that U.S. $20 gold coins, which are numismatic-type coins, are not like kind to South African Krugerrand gold coins, which are bullion-type coins, whereas in Rev. Rul. 76-214, 1976-1 C.B. 218, the IRS concluded that Mexican 50-peso gold coins and Austrian 100-corona gold coins were of like kind because they were official government restrikes and non-currency, bullion-type coins. A similar result was reached in California Federal Life Insurance Co. v. Commissioner, 680 F.2d 85 (9th Cir. 1982), affg 76 T.C. 107 (1981), in which U.S. Double Eagle $20 gold coins and Swiss francs were held to be property of "like kind" because the former were numismatic-type coins whereas the latter were simply currency. (1) Furthermore, the IRS takes the position that in the case of exchanges of intangible property, the standard for determining if intangible property is of like kind to other intangible property is, if anything, more rigorous than the standard for matching tangible personal property. Although like classes are provided for tangible personal property, there are no classes for intangible personal property. Rather, a two-pronged analysis is required under Treas. Reg. [section] 1.1031(a)-2(c) which requires a matching of both (i) the nature or character of the rights involved, and (ii) the nature or character of the underlying property to which the intangible personal property relates. The General Asset Classes under Treas. Reg. [section] 1.1031(a)-2(b)(2) and the Product Classes under Treas. Reg. [section] 1.1031(a)-2(b)(3) are taken into account for purposes of determining whether the underlying property is of like kind, but even if this test is satisfied, the nature and character of the rights involved must also be considered. For example, in the case of patents, the regulations provide expressly that even if the nature and character of the rights under one patent are the same as the nature and character of the rights under another patent, (2) the nature of the underlying property also must be considered under the General Asset Classes and the Product Classes in order to determine if there has been an exchange of patents qualifying under section 1031.

In TAM 200602034, the taxpayer argued that patents should not be grouped on the basis of the underlying property but rather on the basis of four broad classes of underlying property: (1) process, (2) machine, (3) manufacture, and (4) composition of matter, which are the categories used in the U.S. patent law for classifying intellectual property that may be patented. (3) Thus, a machine patent would be of like kind to any other machine patent, and a process patent would be of like kind to any other process patent, etc. The IRS specifically rejected this argument on the grounds that there is no authority to support the taxpayer's position. Instead, the IRS reaffirmed its view that the underlying property must be either in the same General Asset Class or the same Product Class to qualify for a like-kind exchange.

Likewise, the taxpayer argued that any trademark, trade name, or design mark serves the same marketing function, which is to identify the "source of origin." Thus, the taxpayer contended that all marks and trade names should be treated as of like kind because they enjoy essentially the same legal protections. The IRS bluntly rejected this contention. According to the IRS, trademarks and trade names are a component of a larger asset, which is either goodwill or going concern value or both. The IRS emphasized that a trademark is generally viewed as a device used by a merchant to identify its goods or services and to distinguish them from others, while a trade name is a name, word or phrase employed by one engaged in business as a means of identifying its products, business or services, and of establishing good will. (4) The IRS viewed trademarks and trade names as assets that are tied to the expectancy of continued customer patronage and the ability of a business to continue functioning or generating income without interruption, which are inherent in the goodwill and going concern value or any business. As previously explained, under Treas. Reg. [section] 1.1031(a)-2(c)(2), goodwill and going concern value never qualifies for a like-kind exchange.

The IRS also referred to the large volume of litigation concerning the infringement of registered marks and trade names, which is generally based on the premise that each trademark or trade name is unique and of importance to the promotion of the goods, services, or enterprises represented. The IRS viewed it as "disingenuous" for anyone to assert that all trademarks and trade names are alike. Instead, the IRS viewed them as so closely related to (if not a part of) the goodwill and going concern value of a business that they should not be treated as property eligible for a like-kind exchange.

The IRS then turned to the unregistered intellectual property which was exchanged. The taxpayer claimed that this property should be grouped into three broad categories: (1) designs and drawings (2) trade secrets and secret know how, and (3) software. These rights are generally protected under the Uniform Trade Secrets Act and the common law. (5) There is no limit to the number or variety of forms of proprietary information that may be protected as trade secrets under this body of law. (6)

The IRS concluded that in light of the commonality of the legal protections afforded to unregistered intangible property, proprietary information satisfy the first prong of the test in Treas. Reg. [section] 1.1031(a)-2(c)(1) for being of like kind, i.e., the intangible property itself is of the same nature and character. The issue, however, was whether the underlying property was of the same nature and character. The taxpayer focused on the categories used in the Uniform Trade Secrets Act, which addresses formulas, patterns, compilations, programs, devices, methods, techniques, or processes. The IRS viewed these categories as being similar to those of process, manufacture, machines, and composition of matter which had been raised by the taxpayer in conjunction with determining whether patents are of like kind, and the IRS rejected this argument for the same reasons. According to the IRS, the unregistered intellectual property exchanged by the taxpayer could not be treated as of like kind unless the specific underlying properties to which the unregistered intangibles relate are within the same General Asset Class or the same Product Class.

Another issue that arose in TAM 200602034 involved the treatment of foreign intangibles. Section 1031(h)(2)(A) provides that personal property used predominantly within the U.S. and personal property used predominantly outside the US are not property of like kind. Under section 1031(h)(2)(B), this determination is made, with respect to the relinquished property, by looking at its predominant use in the two-year period ending on the date of the relinquishment and, in the case of the replacement property, by reference to the two-year period beginning on the date of its acquisition.

The taxpayer had exchanged part of the intangibles of a company based in the United States for the intangibles of a company based outside the United States. The tax-payer contended that intangible property is not capable of being used predominantly in one location, whether inside or outside of the United States. The IRS rejected this contention--it believed that the situs of predominant use of the intangible property could be determined. Moreover, because the plain language of section 1031(h)(2) applied to personal property, the IRS believed that a determination of predominant use is required.

For purposes of determining the predominant use of property, the taxpayer attempted to draw analogies to the rules under section 1033 of the Code (for which a "functional" test has been established) and also the income sourcing rules for personal property sales under section 865(a). The IRS rejected these arguments and focused, instead, on the plain meaning of the word "use" in section 1031(h)(2). According to the IRS, the location of the use of an intangible asset can be determined by where the property is licensed to be enjoyed. Since the intangibles were licensed to be used for production at a plant located outside of the United States, the IRS concluded that the intangibles were being used predominantly outside of the United States for purposes of section 1031(h)(2) and, hence, could not be treated as of like kind with intangibles used within the United States.

Identification

The other major issue addressed in TAM 200602034 involved the sufficiency of the replacement property identification made by the taxpayer. With respect to the sale by Corporation 1, the taxpayer had identified the intangible assets of seven companies as prospective replacement property for the intangible assets which were sold, and these identified intangibles had a value well in excess of 200 percent of the value of the relinquished property. Furthermore, the assets actually acquired by Corporation 1 had a value that was significantly less than 95 percent of the total value of the identified potential replacement property. Similarly, with respect to the sale by Corporation 2, the taxpayer identified the intangible assets of 19 more companies that had a value in excess of 200 percent of the value of the relinquished assets, and the total value of the acquired property was less than 95 percent of the value of the potential replacement property that had been timely identified by the taxpayer.

As is well known by most tax practitioners, section 1031(a)(3)(A) provides that any property received by the taxpayer is treated as property that is not like-kind property if such property is not identified as property to be received in the exchange on or before the day that is 45 days after the date on which the taxpayer transfers the relinquished property (the so-called identification period), and the taxpayer must acquire the replacement property within 180 days of the date of transfer of the relinquished property (the so-called replacement period). Under Treas. Reg. [section] 1.1031(k)-1(c), any replacement property that is received by the taxpayer before the end of the identification period is treated as having been timely identified. Otherwise, replacement property is identified before the end of the identification period only if the requirements of Treas. Reg. [section] 1.1031(k)-1(c)(2)-(6) are satisfied. Treas. Reg. [section] 1.1031(k)-1(c)(2) requires that the replacement property must be identified in writing before the end of the identification period, and Treas. Reg. [section] 1.1031(k)-1(c)(3) provides that replacement property must be unambiguously described. Under Treas. Reg. [section] 1.1031(k)-1(c)(4)(i), the maximum number of replacement properties that a taxpayer is permitted to identify is:

(a) three properties, without regard to the fair market values of those properties (the "3-property rule"); or (b) any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer (the "200-percent rule").

Under Treas. Reg. [section] 1.1031(k)-1(c)(4)(ii), if, as of the end of the identification period, the taxpayer has identified more properties as replacement property than permitted under the 3-property rule and the 200-percent rule, the taxpayer is treated as if no replacement property has been identified. This "disallowance" does not apply, however, with respect to (1) any replacement property received by the taxpayer before the end of the identification period and (2) with respect to any property received before the end of the 180-day replacement period as long as the taxpayer received before the end of the replacement period at least 95 percent of the aggregate fair market value of all identified replacement properties (the "95-percent rule").

In this case, the taxpayer identified intangible assets as replacement property using the broad categories previously discussed. This identification was viewed by the IRS as having violated the 3-property rule and the 200-percent rule. Moreover, because each identification only included the name of the seller, as well as a very general description of the intangible assets ("Intellectual Property, including but not limited to patents, trademarks, copyrights, software, know-how, designs and other intellectual property assets as may be owned, licensed by or leased by the seller"), even if the 3-property or the 200-percent rule had been satisfied, these identifications did not satisfy the "specificity" requirements of Treas. [section] Reg. 1.1031(k)-1(c)(3). Furthermore, because the value of the acquired intangible property was less than 95 percent of the value of all identified intangibles, the 95-percent rule was not satisfied either. Thus, only the replacement property that was acquired within the identification period was timely identified. All other replacement property was deemed not to be of like kind, without regard to its nature or character.

Conclusion

In TAM 200602034, the IRS adopted a very hard-line approach with respect to exchanges of intangibles and the identification requirements under section 1031. It remains to be seen whether the courts will agree with the IRS's position (particularly with respect to its position that trademarks and trade names are part of the goodwill of a company rather than separable intangible assets). TAM 200602034 serves, however, as a stark reminder to tax practitioners that the form and requirements for a like-kind exchange must be followed meticulously. This issue is magnified by the narrow definition of "like kind" for exchanges of personal property.

(1) The IRS views its strict approach to like-kind personal property determinations as supported by Congress, which provided in section 1031(e) that livestock of different sexes is not of a like kind.

(2) See S. Rep. No. 91-552, 91st Cong., 1st Sess. 102 (1969). Treas. Reg. [section] 1.1031(a)-2(c)(1).

(3) 35 U.S.C. [section] 101.

(4) Citing R. Schechter & J. Thomas, Intellectual Property: The Law of Copyrights, Patents and Trademarks 539 (2003), and Ballantine's Law Dictionary 1289 (3rd ed. 1969).

(5) Unregistered intellectual property is generally protected if (1) secrecy is maintained through the reasonable diligence of the holder of the information and (2) commercial value is derived from this information not being generally known.

(6) Federal law lists numerous types of unregistered intangible properties within the meaning of the term "trade secrets," including financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devises, formulas, designs, prototypes, methods, techniques, processes, procedures, programs, or codes, whether tangible or intangible, and whether stored, compiled or memorialized physically, electronically, graphically, photographically, or in writing. 18 U.S.C. [section] 1839(3).
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Title Annotation:technical advice memorandum
Author:Lipton, Richard M.
Publication:Tax Executive
Date:Mar 1, 2006
Words:4028
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