BUSINESS PURCHASE PRICE ALLOCABLE TO FRANCHISE MAY BE AMORTIZED, EVEN THOUGH TRANSFEROR TREATS THE TRANSACTION AS SALE OF A CAPITAL ASSET.

Rev. Rul. 88-24

ISSUE

If a taxpayer purchases all of the assets of a franchisee's business, including the franchise rights, for a fixed sum and the original franchisor retains a significant power, right, or continuing interest with respect to the franchise, is the taxpayer entitled, pursuant to section 1253(d)(2) of the Internal Revenue Code, to amortize the portion of the purchase price allocable to the franchise?

FACTS

In 1967, Z transferred a franchise to Y. The franchise agreement gave Y the exclusive right to package, distribute, and sell products bearing the Z trade names and trademarks within a certain geographic area. Pursuant to the franchise agreement, Y was required to follow specific formulas in the production process, to maintain adequate productive capacity, to meet various quality control standards, and to promote the sale and distribution of the Z products. The agreement stated that Y's rights under the franchise agreement could not be transferred without the prior written consent of Z. The agreement contained no restrictions on the duration of the franchise granted to Y, provided Y complies with the provisions of the agreement. The agreement is a "franchise" as defined in section 1253(b)(1) of the Code. The franchise is also a "capital asset" in Y's hands, within the meaning of section 1221 of the Code.

In 1987, Y sold its business to X for 200,000x dollars. Among the assets transferred to X were Y's rights under the franchise agreement with Z. X can establish under section 1060 of the Code that 10,000x dollars of the total 200,000x purchase price was paid for the franchise rights, that 100,000x dollars was paid for the tangible assets, and that the remaining 90,000x dollars represented the going concern value and goodwill of the business. X, Y, and Z are unrelated parties. Prior to the sale, Z consented to the transfer of the franchise rights to X and confirmed that the franchise agreement remained in full force and effect after the sale. Although Y did not retain any interest in the franchise, X is subject to the same restrictions and conditions imposed by Z in the franchise agreement issued to Y. X did not pay any amount to Z on the transfer of the franchise.

On its federal income tax return for the 1987 calendar year, X claimed a deduction of 1,000x dollars (1/10 of the 10,000x dollars paid to Y for the franchise rights) under section 1253(d)(2)(A) of the Code.

LAW AND ANALYSIS

Section 1253(a) of the Code states that a transfer of a franchise, trademarked, or trade name shall not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark, or trade name.

Section 1253(b)(1) of the Code states that the term "franchise" includes an agreement which gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specific area.

Section 1253(b)(2) of the Code states that the term "significant power, right, or continuing interest" includes, but is not limited to, the following rights with respect to the interest transferred:

(A) A right to disapprove any assignment of such interest, or part thereof.

(B) A right to terminate at will.

(C) A right to prescribe the standards of quality of products used or sold, or of services furnished, and of the equipment and facilities used to promote such product or services.

(D) A right to require that the transferee sell or advertise products or services of the transferor.

(E) A right to require that the transferee purchase substantially all supplies and equipment from the transferor.

(F) A right to payments contingent on the productivity, use, or disposition of the subject matter of the interest transferred if such payments constitute a substantial element under the transfer agreement.

Section 1253(d)(2)(A) of the Code states that if a transfer of a franchise, trademark, or trade name is not (by reason of the application of subsection (a)) treated as a sale or exchange of a capital asset, then any noncontingent payment which is made in discharge of a principal sum agreed upon in the transfer agreement shall be allowed as a deduction (in the case of a single payment made in discharge of such principal sum) ratably over the period beginning with the tax year in which the payment is made and ending with the ninth succeeding tax year or ending with the last tax year beginning in the period of the transfer agreement, whichever period is shorter.

In the present situation, Y did not retain any significant power, right, or continuing interest with respect to the transferred franchise. The franchise was a capital asset in Y's hands. As to Y, therefore, the transaction was a sale of a capital asset.

X, however, acquired the franchise subject to the rights and powers imposed by Z in the original franchise agreement between Z and Y. These retained rights and powers constitute significant powers, rights, and continuing interests under section 1253(b)(2) of the Code. If X had acquired the franchise directly from Z, X would have been entitled under section 1253(d)(2) to amortize the cost of the franchise over a period of 10 years. The question presented, therefore, is whether X is to be denied the benefits of amortization because the franchise was acquired from the prior franchisee rather than from the franchisor.

Section 1253 of the Code does not address specifically the problem of a transfer of a franchise from a prior franchisee to a subsequent franchisee. It can be argued, however, that a literal reading of the statute precludes the subsequent franchisee from obtaining the benefits of amortization under section 1253(d)(2), which applies only if section 1253(a) causes the transfer to be treated other than as a sale or exchange of a capital asset. When, as in the present situation, the prior franchisee retains no significant power, right, or continuing interest, the transaction can be viewed as such a sale or exchange.

Although the above argument is consistent with the express language of the statute, it ignores the congressional intent that a taxpayer should be entitled to amortize its cost under section 1253(d)(2) of the Code if it obtains a franchise subject to a significant power, right, or continuing interest. The tax treatment afforded the purchaser should not turn upon whether the franchise was obtained from the franchisor or from a prior franchisee.

In addition, although the consideration for the franchise in the present case was paid to the prior franchisee, the franchisor was a party to the transaction because the franchisor's consent was required to effect the transfer. The franchise rights run from the franchisor to the new franchisee, and the franchisor retains a significant power right, or continuing interest. Thus, from the standpoint of the new franchisee, both the prior franchisee and the franchisor are transferors and the transfer is subject to the type of restrictions, that, under section 1253(a) of the Code, normally prevent the transaction from being considered a sale or exchange of a capital asset.

HOLDING

X is entitled, under section 1253(d)(2) of the Code, to amortize the portion of the purchase price attributable to its acquisition of Y's franchise rights.

This holding is limited to amounts properly allocable to the franchise rights acquired. The Internal Revenue Service will scrutinize closely transactions of this type to ensure a proper allocation of the purchase price among the franchise, goodwill, and other assets.

DRAFTING INFORMATION

The principal author of this revenue ruling is Mr. William E. Blanchard of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Blanchard on (202) 377-9589 (not a toll-free call).