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Texas Law Professor Believes IRS Can Settle Intangible Cases.

FEB. 1, 1994

Texas Law Professor Believes IRS Can Settle Intangible Cases.

DATED FEB. 1, 1994
DOCUMENT ATTRIBUTES
  • Authors
    Johnson, Calvin H.
  • Institutional Authors
    Johnson, Calvin H.
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    intangibles, amortization
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 94-1334
  • Tax Analysts Electronic Citation
    94 TNT 23-105
====== SUMMARY ======

Calvin H. Johnson, professor of law at the University of Texas, believes that the Service can settle the approximately 1,500 amortization of intangible cases on favorable terms. In a letter to David L. Jordan, acting IRS chief counsel, Professor Johnson states that the opportunity to settle cases involving publicly held companies is particularly strong because of SEC accounting rules.

According to Johnson, the financial accounting rules treat tax savings as arising when expenses are recorded, without regard to when the taxes are actually due and payable. If the intangible is not amortizable for tax purposes, however, the company is not credited with the savings on its financial statements.

Johnson recommends that the Service offer to allow companies with pending cases to amortize their intangibles, but to allow the amortization over very long periods (85-99 years and never less than 40 years). Such a long term amortization, he says, would result in a relatively small amount of revenue lost for the Service. However, allowing the companies to claim the credit for financial statement purposes provides an incentive to publicly held companies to settle because it will immediately increase the amount of reported earnings.

====== FULL TEXT ======

February 1, 1994

The Honorable David L. Jordon

 

Acting Chief Counsel

 

Internal Revenue Service

 

Room 3026 IRS Building

 

1111 Constitution Avenue, NW

 

Washington, DC 20224

BY FAX: (202) 622-6513. Follow up by 2 Day Mail.

Re: Settling pre-section 197 Newark Morning Ledger issues with

 

long life amortization.

Dear Mr. Jordon:

The IRS has the opportunity to achieve favorable settlements of the open Newark Morning Ledger cases because of an anomaly in GAAP computation of tax expense. Accounting Standards, required for publicly held companies, put a premium on the amortizability of intangibles for tax purposes, but they then treat long and short amortization periods as having the same effect. The IRS should accordingly offer to allow amortization of intangibles at issue -- so that the takeover companies can report tax savings of 34% of their amortization expenses on their nontax financial statements. The IRS should, however, also offer only very long amortization periods (85- 99 year and never less than 40 years) -- so that the accounting will approximate the companies' true economic position and so that the IRS retains most of the economic value of the tax deductions. The long periods will have no adverse impact on the companies; reported earnings.

We talked at the Houston ABA Tax Section meeting and I promised to send you an explanation of my suggestion.

SETTLEMENT BETWEEN A ROCK AND A HARD PLACE. The IRS has an open inventory of $4.9 billion of tax deficiencies involving the amortization of intangibles arising in years before the effective date of section 197. The IRS is under intense pressure to settle those cases without any loss of revenue. The Committee Reports under section 197 jaw boned the IRS, "in the strongest possible language" to settle the open cases, but Committees also refused to grant section 197 tax relief retroactively because that would require confessing significant revenue losses that the country can afford in these times of extraordinary deficits. The IRS needs to be stingy in settlements because Congress' actions speak louder than its words and because the IRS has a duty to support the integrity of the revenue estimating process. Still, the language of the Committee reports puts pressure on the IRS to settle.

A FASB-GIVEN OPPORTUNITY. There is an especially large window for settlements with publicly held companies, under terms favorable to the IRS, because of accounting standards that must be used for SEC purposes. GAAP makes it important for a publicly traded company to achieve tax amortization for its intangibles, but it is blind, once amortization is allowed, as to whether the amortization period is long or short.

For financial purposes, an acquired intangible must be amortized over a period not greater than 40 years and 40 years is the most commonly used amortization period. Financial Accounting Standards in general treat the tax expense as arising when GAAP income is reported and treat tax savings as arising when GAAP expenses are recorded, without regard to when the taxes are actually due and payable to the government. If the intangible is amortizable at all for tax purposes, GAP will credit the reporting company for tax savings at 34% of the amortization expense. The standards are blind to the time value of money. Tax savings that come faster than 40 years arising from the amortization expenses are nonetheless credited only when the nontax amortization expense accrues and tax savings that come slower than 40 years are nonetheless credited as if they had already been paid. Actual payments and savings of tax change the deferred tax account, which is a quasi-liability listed on the right side of the balance sheet, but actual payments and savings do not affect either reported earnings or net worth.

For financial purposes, however, if the intangible is not amortization at all for tax purposes, the tax savings that might arise from use of the acquirer's basis in the intangible is ignored. The difference between GAAP treatment, requiring amortization, and a tax treatment denying amortization is a "permanent difference" and no tax savings may be credited to the firm. Goodwill, amortizable for accounting but not for tax under presection 197 law, has no tax savings associated with it. The firm gets credit for the tax savings at 34% of intangible amortization expense only if the intangible is amortizable for tax and it will need to fight for that tax savings on its reported earnings with special intensity.

Most publicly traded companies must treat their reported GAAP earnings as true yardsticks, with regard to the economics of the transaction. As an economic matter, long amortization periods are more valuable to the IRS than short periods are (and on the other side long amortization periods are less valuable to the taxpaying companies), but the economic difference does not show up in reported earnings. Because of the time value of money, revenue lose over a 99 year amortization purposes hurts the IRS and the federal deficit less than the same 34% revenue lost over 3 or 2 years or less. Publicly traded companies, however, ordinarily use GAAP earnings as the definitive yardsticks, ignoring the economics, because reported earnings strongly affect stock market prices. For many executives, their bonuses and stock options are also tied to reported earnings. For companies facing a threat of a hostile take-over or are near the "coverage" requirements in their debenture indentures or loan renewal contacts, reported earnings are a life and death matter.

Public traded companies are thus in a position to make major concessions on amortization periods, as long as they can achieve amortization as a matter of principle. Conversely, they will get no credit in reported earnings for negotiating short amortization periods on their nontax income statements once they have achieved tax amortization. The IRS can satisfy the perceived needs of publicly traded companies, while retaining the real, discounted present vale of the tax revenues, by offering to allow amortization for the border-line intangibles but only over very, very long 85-99 year terms.

THE IRS IS SERVED BY JUSTICE. The economically correct amortization periods to cover all intangibles pre-section 197 are also very long. For many of the intangibles now at issue, it is possible to clearly reflect income of the acquiring company only by using the mass asset rule for acquired intangibles. Under the mass asset rule, the taxpayer's basis in acquired intangibles is not amortized because replacements are deducted immediately. If a paperboy delivers the paper to the same porch each day, for instance, the newspaper company does not lose any of its capital just because the subscriber in the house changes identity. To treat the newspaper as losing capital as customers turn over is like fliping [sic] coins 100 times but counting the tails but not the heads. The newspaper's capital (basis) accounts can be made to describe the acquirer's true investment only if the basis in customers is kept in tact when the customer base remains the same or grows. In Newark Morning Ledger, the Supreme Court did not apply the mass asset rule to customer base. For that reason the Court's decision is an embarrassment to the law and it needs to be narrowly construed.

The government briefs before the Supreme Court did not argue the mass asset rule in Newark Morning Ledger, but Court cited the mass asset rule favorably, citing Ithaca Industries. The Court said that Ithaca Industries applied to self-regenerating assets. As a matter of economics, a self-regenerating asset properly subject to the mass asset rule is one in which replacements are deducted as ordinary and necessary business expenses. /1/ Mass asset rules are those assets that are renewed, not through investments treated as capital expenditures by tax accounting, but automatically in the ordinary course of the trade or business by expenditures treated as mere current expenses by tax accounting.

If we assume that mass asset rule applies widely to the current controversies, then the weighted average amortization life becomes extraordinarily long. According to my figures, compiled using the date compiled and reported by the GAO, an average amortization period of 83-110 years, applied to all intangibles would properly weight the mass assets and the intangibles at issue with truly short economic lives. IRS offers to settle intangibles issues by offering 99 amortization lives to all intangibles would work justice and truly describe the acquiring taxpayers.

GAAP requires intangibles to be written off over 40 years for nontax accounting, but GAAP's 40 year standard was written to be too short as a matter of economics. The standards board was attempting to DISCOURAGE takeover activity by adopting a standard that was shorter than real economic declines, so as to increase reported losses. Applying that same GAAP intent to tax implies tax lives should be LONGER than real economic lives. Longer than economic lives, on average, are satisfied only by greater than 100 year amortization periods. In any event, the GAAP period 40 years is the minimum amortization period that the IRS should accept; GAAP earnings gives no credit for anything shorter.

NINETY-NINE/FORTY OR FIGHT. With only 1500 cases in total, the IRS can afford to litigate all of the open cases. The money at issue, $4.9 billion, is material well worth fighting over. Congress was unwilling to give away that money in its revenue estimates, notwithstanding the jawing in the Committee Reports. The IRS is capable of winning some big cases, distinguishing Newark Morning Ledger and even confining it to its facts. I would recommend offering ready amortization for border line intangibles, but then insisting upon lives of between 40 and 99 years to settle the life for all the intangibles.

Please call on me if I can provide any further aid or information on this issue.

Sincerely yours,

Calvin H. Johnson

 

Andrews & Kurth Centennial

 

Professor of Law

FOOTNOTE

/1/ Jane Gravelle and Jack Taylor (Congressional Research Service of Library of Congress), Tax Neutrality and the Tax Treatment of Purchased Intangibles, 40 Nat. TaxJ. 77, 84 (1992); Calvin Johnson, The Mass Asset Rule Reflects Income and Amortization Does Not, 56 Tax Notes 629, 634 (1992).

END OF FOOTNOTE

DOCUMENT ATTRIBUTES
  • Authors
    Johnson, Calvin H.
  • Institutional Authors
    Johnson, Calvin H.
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    intangibles, amortization
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 94-1334
  • Tax Analysts Electronic Citation
    94 TNT 23-105
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