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Third Circuit addresses burden of proof in valuing intangibles.

In Capital Blue Cross, 3d Cir., 12/5/05, rev'g in part and remd'g 122 TC 224 (2004), the Third Circuit held that the Tax Court erred in assigning a zero basis in hundreds of terminated insurance contracts issued by Capital Blue Cross (Capital).The appellate court concluded that minor flaws in a taxpayer's valuation were insufficient to reject the valuation completely.

Valuing Intangibles

Although this case arose because of facts related to the 1986 statutory transition of Blue Cross Blue Shield (BCBS) organizations from tax free to taxable, the decision has consequences beyond such entities and their insurance contracts. The Third Circuit's discussion applies more broadly, to the valuation of intangible assets in general and the taxpayer's burden of proving valuation. The court addresses the issue in light of Newark Morning Ledger Co., 507 US 546 (1993), in which the Supreme Court allowed depreciation deductions for a newspaper company's paid subscriber base.

This item discusses the facts of Capital Blue Cross and the decision's significance as to the broader valuation issue. Accordingly, the facts discussed are only those needed for a full understanding of that issue.


BCBS organizations were not subject to Federal income tax until 1987. The Tax Reform Act of 1986, Section 1012, eliminated their tax exemption and provided that such organizations could take a stepped-up basis in their assets based on each asset's fair market value (FMV) on Jan. 1,1987 (the fresh-start basis rule).

On that date, Capital had more than 23,000 group health insurance contracts outstanding, covering more than 12,000 insured groups. The contracts automatically renewed on a month-to-month or annual basis, unless cancelled. At that time, Capital was the leading health insurance provider in its geographical area; alternatives to BCBS (such as health maintenance and other organizations) were not yet widespread, but were developing in importance.

Capital did not apply the fresh-start basis rule to its insurance contracts in 1987. In 1995, however, it obtained a valuation of the contracts it had as of Jan. 1, 1987, and on its 1994 tax return claimed a $2.6 million loss deduction under Sec. 165 for group contracts cancelled in 1994. Capital also filed amended returns for 1991-1993, claiming loss deductions for the contracts cancelled during those years.

The IRS disallowed the claimed deductions in full, determining that Capital failed to establish that it incurred any loss and that the contracts were components of indivisible intangible assets. The Tax Court found several flaws in Capital's valuation, discounted the taxpayer's expert testimony and concluded that the contracts had a zero basis.

Third Circuit's Opinion

Mass asset rule: The court first addressed the Service's determination that the contracts constituted a single, indivisible mass asset for which no loss was allowable. Citing Newark Morning Ledger, the court explained that the mass asset rule "prohibits the depreciation of certain customer-based intangibles because they constitute self-regenerating assets that may change but never waste." It added that the rule "also prevents taxpayers from deducting the loss of individual components of the mass"

Given that the Supreme Court allowed a depreciation deduction for the newspaper subscription lists in Newark Morning Ledger, the Third Circuit questioned the continuing validity of the mass asset rule, writing that "if the subscription lists ... were not a mass asset, it is arguably difficult to see what would be." In any event, the court concluded that Capital's group contracts were distinct, not components of a larger indivisible asset.

Burden of proof: In Tax Court, the taxpayer bears the burden of proof, but Capital argued that that court should have shifted the burden to the ILLS, in part because the deficiency nonce "was arbitrary for finding no value." (On appeal, the Service's experts agreed that the contracts had some value.) In essence, Capital was asking the court to accept its valuation in the absence of any valuation evidence offered by the Service. The Third Circuit rejected that contention, holding that the Tax Court is not required to choose between the parties' valuations, or to accept the taxpayer's valuation if the IRS's valuation is unreasonable; rather, the court must make an independent determination.

As for intangible assets, the Third Circuit noted that taxpayers carry a heavy burden of proving that a particular asset can be valued and has a limited useful life; see Newark Morning Ledger. But the court found tension between the heavy burden imposed by Newark Morning Ledger and the rule (previously mentioned) allowing the Tax Court to determine FMV when neither the taxpayer's nor the Service's valuation is convincing.

The court reconciled that tension by concluding that "the taxpayer always bears the burden of proving that his lost intangible assets are susceptible of separate valuation." However, it continued, "[o]nce a court is satisfied that the intangible assets may be valued separately, its obligation is to find the correct value. Where the Commissioner refuses to submit any valuation, or where his valuation is arbitrary, the court will essentially be forced to start from the taxpayer's valuation." (Emphasis in original.) Importantly for Capital, the court added, "it will not, in our view, be reasonable for a court to reject the taxpayer's valuation out of hand simply because the Commissioner has identified minor flaws in the valuation."

Separate yet aggregate: The court added that although Capital must prove that each of the cancelled contracts had some individual value, it does not lose its deduction if it fails to convince the court of each contract's exact separate value; the court may accept an aggregate deduction. If the court can calculate the aggregate value of a group of contracts, it concluded, "the taxpayer has satisfied its burden under Newark Morning Ledger."


The Third Circuit went on to address the Tax Court's perceived flaws in Capital's valuation and rejected some of the lower court's findings. In line with its conclusion on aggregate value, the Third Circuit found nothing inherently wrong with the taxpayer's use of a "reinsurance" model to value the contracts as if they had been sold together in a block. The court noted a valid dispute over Capital's adjustment for goodwill, but rejected as erroneous the Tax Court's conclusion that Capital failed to establish a "lapse rate" for its contracts (i.e., the probability that each group's contract would lapse in any given year).

The appellate court then remanded the case back to the Tax Court to find the correct valuation. Finding it "clear" that Capital had some basis in the cancelled contracts, the Third Circuit stated that the IRS would do well to quantify its objections to Capital's valuation; otherwise, "it would seem that the Tax Court will have little choice but to grant Capital its claimed deduction."

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Article Details
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Author:Magin, Elizabeth
Publication:The Tax Adviser
Date:Mar 1, 2006
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