[JOINT COMMITTEE PRINT] DESCRIPTION OF PROPOSALS RELATING TO THE FEDERAL INCOME TAX TREATMENT OF CERTAIN INTANGIBLE PROPERTY AND (H.R. 3035, H.R. 1456, H.R. 563) Scheduled for Hearings BEFORE THE COMMITTEE ON WAYS AND MEANS ON OCTOBER 2 and 29, 1991 Prepared by the Staff OF the JOINT COMMITTEE ON TAXATION SEPTEMBER 30, 1991 U.S. GOVERNMENT PRINTING OFFICE WASHINGTON 1991 : JOINT COMMITTEE ON TAXATION 102d Congress, 1st Session HOUSE SENATE DAN ROSTENKOWSKI, Illinois LLOYD BENTSEN, Texas Chairman Vice Chairman SAM GIBBONS, Florida DANIEL PATRICK MOYNIHAN, New York J.J. PICKLE, Texas MAX BAUCUS, Montana BILL ARCHER, Texas BOB PACKWOOD, Oregon GUYVANDERJAGT,Michigan ROBERT DOLE, Kansas HarryL.Gutman,ChiefofStaff CONTENTS Page NTRODUCTION 1 I. Summary 3 II. Background and Present Law 5 II. Description of Proposals 19 A. H.R. 3035 (Chairman Rostenkowski) 19 B. H.R. 1456 (Mr. Vander Jagt, Mr. Anthony, Mrs. Kennelly) 28 C. H.R. 563 (Mr. Donnelly) 29 V. Issues Regarding the Federal Income Tax Treatment OF Intangible Assets 30 A. Treatment ofIntangible Assets in General 30 B. Treatment ofGoodwill and Going Concern Value. 31 C. Determination of the Amortization Period and Method for Intangible Assets 33 D. Effective Dates ofthe Bills 35 (lU) INTRODUCTION The House Committee on Ways and Means has scheduled public hearings on October 2 and 29, 1991, on proposals relating to the Federal income tax treatment of certain intangible property. This pamphlet,^ prepared by the staff of the Joint Committee on Tax- ation, provides a description of present-law tax rules and the three bills listed for the hearing (H.R. 3035, H.R. 1456, and H.R. 563), and a discussion of issues related to the Federal income tax treatment ofintangible property and to these bills. Part I of the pamphlet is a summary of present law and the three bills listed for the hearing. Part II provides a more detailed description of the present-law tax rules relating to intangible assets and background on such tax rules and related executive and judi- cial interpretations. Part III provides a more detailed description of the three bills: H.R. 3035 (introduced by Chairman Rostenkowski); H.R. 1456 (introduced by Mr. Vander Jagt, Mr. Anthony, and Mrs. Kennelly); and H.R. 563 (introduced by Mr. Donnelly). Part IV pro- vides a discussion of issues related to the Federal income tax treat- ment of intangible assets and the three bills. 'This pamphlet may be cited as follows: Joint Committee on Taxation, Description ofPropos- als Relating to the Federal Income Tax Treatment ofCertain Intangible Property (H.R. J0J5, H.R. U56: andH.R. 56.JI(JCS-14-91),September30, 1991. (1) SUMMARY I. Present law In determining taxable income for Federal income tax purposes, taxpayers are allowed depreciation deductions for the exhaustion, wear and tear, and obsolescence of property that is used in a trade or business or that is held for the production of income. Under Treasury Department regulations, no depreciation deductions are allowed with respect to intangible property unless the intangible property has a limited useful life that may be determined with rea- sonable accuracy. In addition, under the same Treasury Depart- ment regulations, no depreciation deductions are allowed with re- spect to goodwill or going concern value. Numerous court decisions and Internal Revenue Service pro- nouncements have addressed whether depreciation deductions are allowed with respect to intangible property. In general, a taxpayer must establish that the intangible property is distinguishable from goodwill or going concern value and that the intangible property has a limited useful life that is determinable with reasonable accu- racy. Because this is essentially a factual determination, different results have often been reached in different cases with respect to the same or similar types of intangible property. H.R. 3035 (Chairman Rostenkowski) H.R. 3035 would allow an amortization deduction with respect to goodwill, going concern value, and certain other intangible proper- ty that is acquired by a taxpayer and that is held by the taxpayer in connection with the conduct of a trade or business or an activity engaged in for the production of income. The amount of the deduc- tion would be determined by amortizing the adjusted basis of the intangible ratably over a 14-year period. H.R. 3035 generally would apply to specifically defined intangible property whether acquired as part of the acquisition of a trade or business or as a single pre-existing asset. The bill would not change the Federal income tax treatment of self-created intangible proper- ty, such as goodwill that is created through advertising or other similar expenditures. H.R. 3035 would apply to property acquired after the date of en- actment. H.R. 1456 (Mr. VanderJagt, Mr. Anthony, and Mrs. Kennelly) H.R. 1456, the "Intangibles Amortization Clarification Act of 1991," would amend section 167 of the Internal Revenue Code to provide that the value of customer based, market share, and any similar intangible items are amortizable over their useful life if the taxpayer can demonstrate through any reasonable method that (1) the intangible items have an ascertainable value that is separate (3) and distinct from other assets (including goodwill and going con- cern value), if any, acquired as part of the same transaction, and (2) the intangible items have a limited useful life, the length of which can be reasonably estimated. In addition, H.R. 1456 would grant the Treasury Department the authority to promulgate regulations establishing safe harbor recov- ery periods that are consistent with industry practice and experi- ence for specific types of customer based, market share, and any similar intangible items, and regulations concerning the manner in which such intangible items may be valued separately and distinct- ly from other assets (including goodwill and going concern value). H.R. 1456 would apply to all open taxable years (i.e., all taxable years for which the statute oflimitations has not expired). H.R. 563 (Mr. Donnelly) H.R. 563 would amend section 167 of the Internal Revenue Code to provide that in determining whether an income tax deduction is allowed for any amount that is paid or incurred to acquire custom- er base, market share, or any similar intangible item, the amount is to be treated as paid or incurred for intangible property with an indeterminate useful life. Consequently, no depreciation or amorti- zation deduction would be allowed under the bill for the cost of ac- quiring customer base, market share, or other similar intangible property. H.R. 563 would apply to acquisitions that occur after the date of enactment. BACKGROUND AND PRESENT LAW 11. In general Under section 167 of the Internal Revenue Code, taxpayers are allowed depreciation deductions for the exhaustion, wear and tear, and obsolescence of property that is used in a trade or business or that is held for the production of income. Under Treasury Depart- ment regulations, no depreciation deductions are allowed with re- spect to intangible property unless the intangible property has a limited useful life that may be determined with reasonable accura- cy.^ In addition, under the same Treasury Department regulations, no depreciation deductions are allowed with respect to goodwill. Thus, in order for depreciation or amortization ^ deductions to be allowed for Federal income tax purposes with respect to intangible property, a taxpayer generally must establish that the property is distinguishable from goodwill and that the property has a limited useful life that is determinable with reasonable accuracy. Numer- ous court decisions and Internal Revenue Service pronouncements have addressed whether these requirements have been satisfied with respect to different types of intangible property. The determi- nation whether depreciation deductions are allowed with respect to intangible property is dependent on all the facts and circum- stances. In certain situations, however, the Internal Revenue Serv- ice and some courts have suggested that certain results should be considered a matter of law. Often, different results have been reached in different cases with respect to the same or similar types ofintangible property. Issues regarding the amortization of intangible assets frequently arise in the context of the acquisition of a business enterprise. If the price paid to acquire a trade or business exceeds the value of the tangible assets of the trade or business, the purchaser general- ly must allocate such excess either to (1) goodwill or going concern value, which are not depreciable or amortizable for Federal income tax purposes, or (2) other intangible assets, which may be deprecia- ble or amortizable for Federal income tax purposes.^ ^Treas. Reg. sec. 1.167(a)-3providesthat: Ifan intangible asset is known from experience or other factors to be of use in the business or in the production ofincome for only a limited period, the length ofwhich can beestimated with reasonable accuracy, suchan intangible asset may be thesubject ofa depreciation allowance. Examples are patents and copyrights. An intangible asset, the useful life ofwhich is not limited, is not subject to the allowance for depreciation. No allowance will be permitted merely because, in the unsupported opinion ofthe tax- payer, the intangible asset has a limited useful life. No deduction for depreciation is allowablewith respecttogoodwill. ^The deductions allowed for the exhaustion, wear and tear, and obsolescence of intangible property that is used in a trade or business or that is held for the production of income are often referredtoasamortizationdeductions. *Seesection 1060oftheCodeand the regulationsthereunderwhich providerulesfortheallo- cationofthepurchasepriceamongassetsinthecaseofcertain acquisitionsoccurringafterMay 6, 1986. (5) 6 The following discussion illustrates some of the issues and incon- sistencies that arise under present law. Treatment ofcertain customer-based intangibles Taxpayers that have acquired a trade or business have often allo- cated a portion of the purchase price to customer lists, subscription lists, client records, and other similar intangible assets that repre- sent the customer base of the trade or business. A recurring issue for Federal income tax purposes has been whether a value and life for such intangible assets can be identified that is separate and dis- tinct from goodwill, which generally has been defined as "the ex- pectancy that old customers will resort to the old place" ^ or "the expectancy ofcontinued patronage, for whatever reason." ^ In a number of cases decided prior to 1973, the courts generally held that customer lists and other similar customer-based intangi- bles are "related to" or "in the nature of goodwill and, conse- quently, no depreciation or amortization deductions are allowed with respect to such assets. In many of these cases, the Internal Revenue Service successfully argued that such customer-based in- tangibles are "mass assets," the value of which may fluctuate as particular customers are lost and others replace them. These mass assets were considered to provide an inexhaustible benefit and have an indefinite useful life. For example, in Golden State Towel and Linen Service, Ltd. v. United States,"^ the Court of Claims denied a depreciation or loss deduction with respect to a customer list that was acquired in con- nection with the purchase of the assets of a linen business. The court held that a terminable-at-will customer list is an indivisible asset that is indistinguishable from goodwill. The court found that while the list is subject to temporary attrition as well as expansion due to the departure of old customers and the addition of new cus- tomers, no deduction is allowed for Federal income tax purposes for the normal turnover ofcustomers.® In 1973, however, the Fifth Circuit Court of Appeals in Houston Chronicle Publishing Company v. United States ^ held that the "mass asset" theory does not preclude depreciation or amortization deductions with respect to customer-based intangibles. In Houston Chronicle the taxpayer acquired lists of newspaper subscribers in connection with the acquisition of the tangible assets of a newspa- per publishing company. The newspaper of the acquired publishing company was not published after the acquisition. The court held 5Commissionerv. Killian,314F.2d852,855(5thCir. 1963). «Boe V. Commissioner, 307 F.2d339, 343(9thCir. 1962). See, also, NewarkMorningLedgerCo. V. UnitedStates, No. 90-5637(3rdCir. 1991). '373F.2d938(Ct. CI. 1967). *See, also, Danville Press, Inc. v. Commissioner, 1 B.T.A. 1171 (1925) (no depreciation deduc- tions allowed with respect to newspaper subscribers); Boe v. Commissioner, 35 T.C. 720 (1961), aff'd307 F.2d339(9thCir. 1962)(nodepreciationorlossdeductionsallowedwithrespecttomed- ical service contracts); Westinghouse Broadcasting Co. v. Commissioner, 36 T.C. 912 (1961) (no depreciation deductions allowed with respect to spot advertising contracts); Scalish v. Commis- sioner,21 T.C.M. 260(1962)(nodepreciationdeductionsallowed with respecttocigarettevending amlalcohwiendewliotchatrieosnpelecatsetso);inTshuormasncev.eCxopmimraitsisoinosn);era,n5d0MTa.Cr.sh24&7 (M1c96L8e)n(nnaon.depInrce.civa.tiCoonmmdiesdsuicotnieorn,s 51 T.C. 56 (1968), aff'd 420 F.2d 667 (3rd Cir. 1970) (same). But, see, Seaboard Finance Co. v. Commissioner, 367 F.2d 646 (9th Cir. 1966) (depreciation deductions allowed with respect to fa- vorableloancontracts). 3481 F.2d 1240(5thCir. 1973),cert, denied,414 U.S. 1129(1974).