Menu
Tax Notes logo

Settlement Recommended For Franchise Transfer Amortization Issues


FSA 1993-1073

DATED
DOCUMENT ATTRIBUTES
Citations: FSA 1993-1073

 

INTERNAL REVENUE SERVICE

 

MEMORANDUM

 

CC:FS:* * *

 

* * *

 

 

date: * * *

 

 

to: Regional Counsel, * * *

 

Attn:* * *

 

Special Trial Attorney

 

 

from: Assistant Chief Counsel (Field Service) CC:FS

 

 

subject: * * *

 

sections 1253, 167

 

 

[1] This is in response to your memorandum of * * * requesting field service advice with respect to the above-named taxpayer.

 

[2] ISSUES

 

 

(1) Whether I.R.C. section 1253(d) is applicable to the portion of a lump sum paid to acquire two television stations which is allocable to the stations' network affiliation contracts, and if so, how should the amount so allocable be determined. 1253-0000

(2) Whether the amount allocated to "customer lists" can be amortized under section 167 and, if so, whether the petitioner should be limited to amortization of the replacement cost or the informational value of the lists. 0167-1300

(3) Whether the petitioner can amortize the value of employment contracts, which it computed by reference to the avoided costs of hiring and training the employees, over the average remaining term of the contracts. 0167-1300

 

[3] CONCLUSIONS

 

 

(1) We recommend that Regional Counsel consider settling the section 1253 issue in view of the litigation hazards presented by the Tax Court's decision in Tele-Communications, Inc. & Subsidiaries v. Commissioner, 95 T.C. 495 (1990), appeal docketed, No. 91-9010 (10th Cir. June 3, 1991) (hereinafter TCI).

(2) Customer lists acquired by the petitioners in this transaction cannot be amortized under section 167, and the Service should raise the replacement cost or the informational value of the lists only as an alternative argument if the petitioners prevail on their argument that the customer lists are assets separate and distinct from goodwill.

(3) The avoided cost of hiring and training employees under employment contracts is not the proper method for determining the amortization of employment contracts, and we question whether these employment contracts are amortizable under section 167. However, the litigating hazards and the expert witness fee costs to challenge this issue should be taken into account in any potential settlement negotiations on this issue.

 

FACTS

 

 

[4] On * * * purchased all of the stock of * * * from * * * for $* * * owned and operated television stations in * * * and * * * both of which had network affiliation agreement with * * * has been a * * * affiliate since * * * The affiliation agreements essentially grant * * * a right of first refusal to broadcast * * * programs in the * * * and * * * markets. In addition, * * * is entitled to receive network compensation payments from * * * Both the * * * and the * * * markets had independent stations that could have been substituted as the * * * affiliate.

[5] Petitioners made a section 338 election pursuant to the purchase agreement. On the resulting one-day return, petitioner made the following relevant allocations:

 Network Affiliation                $ * * *

 

 FCC License                          * * *

 

 Customer List                        * * *

 

 Employment Contracts                 * * *

 

 Goodwill and Going Concern Value     * * *

 

 

[6] On * * * the appraisal firm of * * * rendered an opinion concerning the fair market value of the acquired assets as of * * * determined that the above listed assets had the following values:

 Network Affiliation                $ * * *

 

 FCC License                          * * *

 

 Customer List                        * * *

 

 Employment Contracts                 * * *

 

 Goodwill and Going Concern Value     * * *

 

 

[7] * * * continued its operations as a subsidiary of * * * and filed consolidated returns with * * * for the * * * and * * * tax years. Petitioner claimed amortization deductions with respect to the customer lists, film contracts, film library, computer software, and employment contracts. Petitioners initially treated the network affiliation agreements as nonamortizable. Thereafter, petitioners filed a claim for refund in which they characterized the network agreements as franchises amortizable over a ten-year period under section 1253(d)(2). The Service denied the refund claims and issued a notice of deficiency in which it disallowed amortization deductions claimed for the customer lists and employment contracts.

[8] Petitioners have filed Tax Court petitions in which they argue that the network affiliation agreements are amortizable under section 1253(d)(2). Petitioners are currently seeking leave to amend their petitions to claim section 1253(d) amortization for the FCC licenses, and to argue that any overallocation to intangibles in issue should be attributed to the FCC licenses.

 

DISCUSSION

 

 

Network Affiliation Contracts

[9] Section 1253(a) provides that a transfer of a franchise, trademark 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(d)(2) provides, generally, that the transferee of a franchise can amortize the cost of the franchise over ten years if the transfer is not treated as a sale or exchange of a capital asset under section 1253(a).

[10] Section 1253(b)(1) defines the term "franchise" to include "an agreement which gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area." Section 1253(b)(2) provides 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) The right to disapprove any assignment of such interest, or any part thereof;

(B) The right to terminate the interest at will;

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

(D) The right to require that the transferee sell or advertise only products or services of the transferor;

(E) The right to require that the transferee purchase substantially all of his or her supplies and equipment from the transferor; or

(F) The 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.

 

[11] Section 1253 does not specifically address whether a subsequent transferee of a franchise can amortize the portion of the purchase price allocable to the franchise under section 1253(d). In fact, a literal reading of the statute would preclude a subsequent franchisee from obtaining the benefits of amortization under section 1253(d)(2). However, in Rev. Rul. 88-24, 1988-1 C.B. 306, the Service elected to extend the benefit of the section 1253 ten-year amortization period to a third-party transfer. Specifically, the ruling provides that the franchisor is deemed to participate in the transfer of its franchise by a franchisee to a new franchisee. Thus, the new franchisee is permitted to amortize the cost of the franchise if the franchisor continues to retain a significant power, right, or continuing interest over the franchise.

[12] In TCI, the Tax Court held that a cable television franchise was a "franchise" within the meaning of section 1253, and allowed the taxpayer to amortize over a ten-year period the costs of the cable television franchises it had purchased from former cable operators. The court stated that the term franchise for section 1253 purposes, includes (1) an agreement (2) which gives one of the parties the right to distribute, sell, or provide goods, services, or facilities (3) within a specified area. Id. at 509.

[13] The Service argued in TCI that an examination of the legislative history indicated that section 1253 was enacted in response to a line of cases commonly referred to as the "Dairy Queen" cases /1/, and was intended to apply only to private franchises, not public franchises. The court concluded that because the statute was not ambiguous on its face, an examination of the legislative history was inappropriate under basic principles of statutory construction. Id. at 506-10. Moreover, the court noted that the legislative history did not even support the Service's position that section 1253 was applicable only to private franchises. Id. at 511.

[14] In the instant case, a strong argument can be made that the network affiliation agreements constituted franchises for section 1253 purposes because such agreements gave * * * the right to distribute its programs, and more importantly its advertisements, to the * * * and the * * * markets. It is important to note that a reversal by the Tenth Circuit in TCI will not likely further the Service's position in the instant case because here we are dealing with private, as opposed to public, franchises.

[15] If petitioners are successful in arguing that the network affiliation agreements constitute franchises within the meaning of section 1253(b)(1), amortization will be allowed only if the transfer of the franchise was not a sale or exchange of a capital asset as provided in section 1253(a). Accordingly, there must be a showing that * * * retained a significant power, right, or continuing interest with respect to the subject matter of the franchise.

[16] Although we have not had the benefit of reviewing the network affiliation agreements, it is our understanding that a national network can exert significant power over a local broadcast station. At the very least, a court would probably conclude that a network possesses a continuing interest in a local affiliate. As a general matter, we understand that a local network affiliate is likely to be more profitable than an unaffiliated local broadcast station. We further understand that it is not an uncommon practice within the industry for a network to consider terminating its affiliation with a local station for numerous reasons, including: (1) repeated refusals on the part of the local station to broadcast network programming, (2) a decrease in the quality of the station's original programming and news department, or (3) a reduction in the quality of the local station's transmissions. A national network will more readily terminate its affiliation with a local station if an unaffiliated station exists in the same market. In this case, an unaffiliated station existed in each of the * * * and the * * * markets. Thus, a convincing argument could be made that * * * retained significant control over the local broadcast stations. Regional Counsel should review the network affiliation agreements in light of the section 1253(b)(2) factors listed above to determine whether * * * did in fact retain a significant power, right, or continuing interest with respect to the * * * affiliates.

[17] It is significant to note that even if the Service is successful in arguing that the network affiliation agreements are not franchises within the meaning of section 1253, such victory may be limited. As noted above, petitioners are currently seeking leave to amend the Tax Court petition to claim section 1253(d) amortization for the FCC licenses and to argue that any overallocation to intangibles in issue should be attributed to such licenses. Petitioners will likely rely on TCI as support for the proposition that FCC licenses, like cable television franchises, are the type of public franchises which qualify for the section 1253 ten-year amortization period. Although the Tax Court has not decided Jefferson Pilot, which deals with the amortization of FCC licenses, we anticipate that petitioners will be able to make a strong argument that FCC licenses qualify for section 1253(d) amortization, even if network affiliation agreements do not.

[18] We also note that recent amendments to section 1253 will reduce the revenue drain and administrative burdens resulting from a short amortization period. In 1989, Congress amended section 1253(d)(2), effective for transfers occurring after October 2, 1989, by limiting its application to franchises with a purchase price of $100,000 or less. Amounts in excess of $100,000 can be amortized only over a minimum of 25 years, if the taxpayer elects. Omnibus Reconciliation Act of 1989, Pub. L. No. 101-239, section 7622 (as codified at sections 1253(d)(2)(B) and (d)(3)).

[19] In light of the foregoing, we recommend that Regional Counsel pursue settlement negotiations concerning the amortization of network affiliation agreements under section 1253.

Customer Lists

[20] * * * sold advertising time to both local and national advertisers. Sales to local advertisers were handled by account executives employed by and working at the stations. National sales were made by a rep firm which sold available time on * * * stations in return for a commission.

[21] * * * included both national and local customers in the customer list assets. The acquisition date value of the stations' advertisers or customers was estimated by * * * using a discounted cash flow approach. * * * concluded that the value of the lists was equal to the present value of projected future net revenues from the sales of advertising to advertisers or customers existing in * * * Additionally, the * * * report indicates that the portion of the network affiliation contract value which is attributable to existing advertiser revenues was subtracted from the value determined for the customer lists to avoid double-counting. The lives of the customer lists were estimated by reference to historical rates at which advertiser relationships were terminated. Although the petitioners allege that the customer lists had information value, the customer lists were clearly valued using an income method.

[22] Treas. Reg. section 1.167(a)-3 provides, in part, that an intangible asset may be subject of a depreciation allowance if the asset is of use in the business for only a limited period, the length of which can be estimated with reasonable accuracy. No allowance will be permitted merely because in the unsupported opinion of the taxpayer, the intangible asset has a limited useful life. No deduction for depreciation is allowable with respect to goodwill.

[23] In general, we agree with your statement that where an ongoing business is acquired with the expectation of continued patronage of the seller's customers such that the purchaser merely steps into the shoes of the seller, the two-prong attack announced in Houston Chronicle Publishing Co. v. United States, 481 F.2d 1240 (5th Cir. 1973), cert. denied, 414 U.S. 1129 (1974) and followed in Rev. Rul. 74-456 cannot be met because the customer based intangible is either goodwill or is inextricable from goodwill.

[24] In Newark Morning Ledger Co. v. United States, 945 F.2d 555, 566, (2d Cir. 1991), petition for cert. filed, No. 91-1135 (U.S. Jan. 13, 1992), the Third Circuit stated that the Service has more accurately characterized the prevailing case law with respect to the acquisition of an ongoing business and adopted the test set out in Houston Chronicle and Rev. Rul. 74-456. The Third Circuit further stated:

 

As the cases discussed supra demonstrate, the depreciability of customer lists, while no longer per se forbidden under the mass asset rule, still is limited to a narrow set of circumstances. Customer lists are generally not depreciable when acquired in conjunction with the sale of the underlying business as a going concern. In the context of the sale of a going concern, it is simply often too difficult for the taxpayer and the court to separate the value of the list qua list from the goodwill value of the customer relationships/structure.

Even in those cases where customer lists have been deemed depreciable, the value assigned to the lists has been limited to the cost of generating a like list of potential customers. As a general matter, the courts have not permitted customer lists to be valued as the stream of income to be generated over their remaining years of patronage. We agree. . . . The fact is that, when employed in the context of the sale of an ongoing concern, the income approach to valuing a list of customers inherently includes much or all of the value of the expectancy that those customers will continue their patronage - i.e., the goodwill of the acquired concern.

 

[25] You ask whether the National Office wants to litigate a case which is appealable to the * * * Circuit. In general, we hope that the Supreme Court will grant the petition for writ of certiorari in Newark Morning Ledger, and resolve the controversy concerning the proper test. The Service believes that the proper test was set out in Houston Chronicle, while taxpayers and the Tax Court have adopted the residuary test, i.e., any intangible asset possessing a determinable life and an ascertainable value, is, by definition, not goodwill. See Citizens & Southern Corp. v. Commissioner, 91 T.C. 463 (1988), aff'd, 919 F.2d 1492 (11th Cir. 1990); and Colorado National Bankshares v. Commissioner, T.C. Memo. 1990-495, appeal docketed, No. 90-9019, (10th Cir. Sep. 27, 1991).

[26] We believe that the * * * Circuit should be a favorable circuit to the Service on this matter, and we are aware of no reason why this issue should not be litigated in the * * * Circuit. If the Supreme Court does not grant certiorari in Newark Morning Ledger, we would welcome the opportunity to litigate this matter in the * * * Circuit in the hope of establishing further favorable appellate precedent. However, this desire should not be interpreted as infringing on your discretion to settle this matter or this case.

[27] In Panichi v. United States, 834 F.2d 300 (2d Cir. 1987)., the Second Circuit upheld a district court ruling that a taxpayer who purchased a list of customers from a trash collection business was entitled to depreciate the value of the list. The taxpayer acquired only a small fraction of the seller's customer route stops and some equipment, and the remainder of the route stops were sold to other buyers. The seller retained its trade name for its ongoing business.

[28] We believe that the * * * Circuit may be amenable to the argument that the factual issue in customer list cases is whether "stepping into the shoes of the seller" occurred. Panichi, id. at 301, cites the test as set out in Rev. Rul. 74-456 and in Houston Chronicle. In Newark Morning Ledger, the Third Circuit stated concerning Panichi:

 

[the * * * Circuit] was careful to note that the list was depreciable because the taxpayer had not acquired it as part of a going concern. Thus, there was no possibility that the value of the list reflected the value of the seller's goodwill.

 

[29] There is also support in other * * * Circuit decisions. In Imperial News Co., Inc. v. United States, 576 F. Supp. 865 (E.D.N.Y. 1983), aff'd without published opinion, 742 F.2d 1434 (2d Cir. 1984), the taxpayer claimed depreciation deductions for intangible assets acquired by its purchase of a magazine distributor. The district court denied the depreciation deduction for the right to distribute magazines because the noncontract "right" was nothing more than the customer structure of the acquired business. "The taxpayer here purchased nothing more than 'the ability to avoid start-up costs by stepping into the seller's shoes,' replacing the seller as the local distributor with whom the national distributors were likely to deal." 576 F. Supp. at 868.

[30] In Thrifticheck Service Corporation v. Commissioner, 287 F.2d 1 (2d Cir. 1961), the taxpayer purchased the assets of a check service company that was being liquidated, and the taxpayer claimed a depreciation deduction for the customer contracts with banks. Each contract contained a provision for a premature cancellation and for automatic renewal. The Second Circuit recognized that a purchaser of renewable business contract buys not only the immediately available benefits of the going business, but also the intangible value of expected future business. The Second Circuit concluded that the purchase price included amounts paid for the likelihood that new contracts would be made with the same buyer. Accordingly, the taxpayer was denied the depreciation deduction. Thrifticheck was cited by the Second Circuit in Panichi and the district court in Imperial News Co.

[31] You also ask whether the Service should argue that the cost approach is the only acceptable method for valuing a customer list. Customer based intangibles such as customer lists are intangible assets which are closely associated with continuing the customer relationships developed by the acquired business. When a customer based intangible is acquired as part of an ongoing business, characteristics such as no change in name, location or personnel, such that the taxpayer could be seen as stepping into the shoes of the seller and expecting continued patronage by the existing group of customers, have led to the conclusion that the customer based intangible is either goodwill, or is inextricable from goodwill. Thus, our primary argument should be that no amortizable asset separate from goodwill or going concern value exists. However, the cost approach can be raised as an alternative argument if the petitioners have shown that their case meets the exception to the general rule and that the asset in question does not possess the characteristics of goodwill.

Employment Contracts

[32] The employment contracts were valued using a "cost avoidance" approach. The * * * report asserts that * * * maintains employment contracts with key on-air personnel to insure their continued service. The two stations had twenty-two employment contracts. * * * reconstructed the time and expense in assembling a news team. The factors taken into account were the amount of time and money expended by * * * to recruit, hire, train and promote reporters. * * * estimated that the amount expended in recruiting, hiring, training, and promoting the reporters was $* * * for * * * and $* * * for * * * These amounts were multiplied by the average remaining useful life on the contracts, two years for * * * and three years for * * * A total value of $* * * was determined for the employment contracts.

[33] The average useful life of an employment contract was determined to be * * * years because the contracts had an average * * * year remaining term. The taxpayer considered only the value of the contracts based on their actual remaining average life of * * * years; thus, although the contracts were renewed in many cases, the taxpayer did not consider the possibility of renewals.

[34] The Service has not articulated a position concerning whether employment contracts may be amortized and concerning the proper method for valuing and lifing employment contracts. In general, employment contracts, i.e., the value of future services of employees under the employment contracts, in limited circumstances can be amortizable assets. However, the valuation method used by the taxpayer must be closely scrutinized to ascertain whether goodwill or going concern value characteristics were utilized.

[35] The employment contract is an asset to the taxpayer, but the payments under the employment contract itself represent a liability to the taxpayer. The purchase price of the employment contract, to the extent of the payments under the contract, will be recoverable as a section 162 deduction over the life of the employment contract. Thus, it is the "premium" paid for the "favorableness" of the employment contract that is the asset that may be amortized.

[36] For example, assume that A executes an employment contract with Target Company in 1988 that provides that A will be paid 10x in 1988, 12x in 1989, 14x in 1990, and 16x in 1991. If Acquiring Company buys Target Company in 1990, and A's employment value is 17x in 1990 and 18x in 1991, then Acquiring Company has a favorable employment contract, which may be amortizable. However, if A's employment value in 1990 and 1991 is 14x, then Acquiring Company does not have a favorable employment contract. Thus, there is no asset to amortize.

[37] We are unaware of any case that has taken this approach with respect to amortization of employment contracts, but we think that it is analogous to amortization of favorable leaseholds. In order to support a separate allocation for a favorable leasehold, the taxpayer must demonstrate (1) that its leasehold had excess value over contract rent, for which it paid a premium, and (2) that none of the premium claimed was paid for goodwill or other nonamortizable asset. See Winn-Dixie Montgomery. Inc. v. United States, 444 F.2d 677, 683 (5th Cir. 1971).

[38] In Forman Inc. v. United States, (D. Md. 1989), 89-1 USTC paragraph 9165, the taxpayer claimed a depreciation deduction for a "favorable" union contract. We recognize that the facts in that case are not the same as the facts in your case. However, in denying the taxpayer's deduction, we note that the district court stated that one of the factors it considered was that the purchase price was apparently set before the negotiations with the union over this contract even began. With respect to the factor, we question whether the taxpayer in the instant case can establish that it was aware of the alleged favorableness of the employment contracts in question and establish that it paid a premium for those contracts.

[39] * * * determined that the value of the contracts was due to the avoided costs of hiring and training the employees under contract. We do not believe that this is the proper method for valuing an employment contract. If the employment contract does not have the favorableness aspect discussed above, then the avoided cost argument in an employment contract situation is not meaningfully different from an avoided cost argument in an assembled work force situation. See Ithaca Industries, Inc. v. Commissioner, 97 T.C. 253 (1991).

[40] If an employment contract does have the favorableness aspect discussed above, we do not believe that the avoided cost approach is the correct method to value the contract. Rather, the valuation should be based on the favorableness of each employment contract over the remaining life of the contract.

[41] We recognize that there are hazards to litigating this issue. In KFOX, Inc. v. United States, 510 F.2d 1365 (Ct. Cl. 1975), the Claims Court held that the disc jockeys' and radio station manager's contracts were independent assets severable from that of the station's goodwill for tax purposes, and that such contracts were amortizable over the contract life which was to be measured by contract terms plus single renewal option. In that case, the taxpayer, who wanted to purchase KFOX radio station, insisted that the current owners negotiate and execute contracts with five workers previously not working under any service contract. The taxpayer determined that the employees were responsible for additional revenues for adding sponsors and saved salaries because the manager did the work of four employees. The taxpayer adopted these figures as his tax basis in the employment contracts and amortized these assets over the useful life of the contracts. The government presented no evidence in opposition to that of the taxpayer, but relied on the legal position that the contracts were inseverable from goodwill and as such were nondeductible.

[42] KFOX is a litigation hazard. However, the case was poorly reasoned, and, in part, has been rejected by the Second Circuit. See Barnes Group Inc. v. United States, 697 F. Supp. 591 (D. Conn. 1988), vacated and remanded, 872 F.2d 528 (2d Cir. 1989), 724 F. Supp. 37 (D. Conn. 1989), aff'd, 902 F.2d 1114 (2d Cir. 1990). In Barnes Group, the Second Circuit held that the taxpayer was not entitled to amortization deductions for certain employment contracts, including covenants not to compete. The Second Circuit found that the contracts for the key employees were contingent on the sale of the acquired corporations to the taxpayer. Thus, the court found that the contracts were not ever assets of the acquired companies, and that they were, in effect, negotiated by the taxpayer.

[43] Further, the Service is not aware of the fair market value of the employees in question on the date of the acquisition. Thus, without hiring an expert and incurring substantial expenses, it may be difficult to challenge the taxpayer's allocation. Thus, while we believe that the cost avoidance method of valuing the employment contracts is improper, the hazards inherent in KFOX and the costs of hiring an expert should be taken into account in evaluating possible settlement of this issue.

[44] This document may include confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the Internal Revenue Service, including the taxpayer involved, and its use within the Service should be limited to those with a need to review the document in relation to the subject matter or case discussed herein. This document also is tax information of the instant taxpayer which is subject to section 6103.

[45] If you have any questions concerning this field service advice, please contact * * * at FTS * * * with respect to Issue 1 or * * * at FTS * * * with respect to Issue 2 and Issue 3.

By: Daniel J. Wiles

 

Field Service Division

 

FOOTNOTE

 

 

1 Both the House and Senate reports discuss and cite the Dairy Queen cases. H. Rep. No. 413, 91st Cong., 1st Sess., 1, 160-163, 1969 3 C.B. 200, 300-301; S. Rep. No. 552, 91st Cong., 1st Sess., 1, 205-209, 1969-3 C.B. 423, 554-555. All of the Dairy Queen cases involved the transfer of private business franchises.

 

END OF FOOTNOTE
DOCUMENT ATTRIBUTES
Copy RID