Amortization of intangibles: is a mergers and acquisitions boom imminent?by Willens, Robert
As a result of The Omnibus Budget Reconciliation Act of 1993, acquired intangibles may now be amortized over a 15-year period. Wall Street expects this to lead to a boom in merger and acquisition activity. The author explains the new rules and respectfully disagrees with the rest of Wall Street.
Over the past several months the question of whether acquired intangible assets can be amortized for tax purposes has been debated in the popular press, in boardrooms throughout the country, in the Supreme Court and, most importantly, in the halls of Congress. In April, the Supreme Court handed down its decision in the Newark Morning Ledger case. In an issue of whether acquired newspaper-subscriber lists could be amortized, the Court ruled customer-based intangibles were eligible for amortization by taxpayers able to prove such intangibles possessed ascertainable value and a limited useful life which could be estimated with reasonable accuracy. This was true, moreover, regardless of how much the asset appeared to reflect the expectancy of continued customer patronage. Nevertheless, the decision left a bad taste in the mouths of many observers. The Supreme Court admonished that, although customer based intangibles were not per se goodwill, the burden of proof needed to sustain the assertion that ascertainable values and limited useful lives in fact exist will be high and, in many cases, insurmountable. Adding fuel to this debate at this time was the uncertain status of the so- called Rostenkowski initiative to enact legislation that would standardize the amortization of intangibles. Mr. Rostenkowski's approach was to expand the list of amortizable items, but, at the same time, to introduce an elongated amortization period that would insure the revenue impact of the proposal would be neutral or, in light of the decision in Newark Morning Ledger, mildly positive.
Enter IRC Section 197
Much of this uncertainty was settled by the passage of the Omnibus Budget Reconciliation Act of 1993 ("the Act"). This legislation allows amortization with respect to intangibles that are denominated, for tax purposes, as Sec. 197 intangibles. These intangibles must be acquired (or treated as acquired pursuant to a Sec. 338 election) and held in connection with the conduct of a trade or business or an activity engaged in for the production of income. The Act provides the basis of the intangibles will be amortized ratably over a 15-year period that begins with the month the intangible is acquired. In no event, however, will Sec. 197 encompass intangibles created by the taxpayer. This exclusion, of course, is hardly damaging since the legislation does not overturn the widely-held view (bolstered by the IRS in Rev. Rul. 92-80 where it held advertising expenses are deductible) that the costs of creating intangibles are generally ordinary and necessary business expenses deductible under Sec. 162(a).
The list of Sec. 197 intangibles includes goodwill, which is the value attributable to the expectancy of continued patronage and going concern value, defined as the additional element of value that attaches to property by reason of its existence as an integral part of a going concern. Sec. 197 intangibles also include a concept known as assembled work force that pertains, generally, to the composition of the work force and/or the terms and condition of employment. Under prior law, as illustrated by the decision in Ithaca Industries, assembled work force was regarded as a self-regenerating asset that could not be amortized because it did not waste. The list also includes an item identified as information base that is more generally known as customer lists, subscriber lists, insurance expirations, client files, and lists of advertisers. It also encompasses know-how in the form of patents, copyrights, formulas or processes, and customer-based intangibles, defined for this purpose as the value resulting from the future provision of goods or services to customers in the ordinary course of business. Examples of customer-based intangibles would include mortgage- servicing contracts, investment management contracts, and deposit base in the case of financial institution acquisitions. Also included are supplier based intangibles, the value resulting from the future acquisition of goods or services pursuant to relationships with suppliers, including favorable shelf or display space, credit ratings, or supply contracts. The list also includes licenses or rights granted by a governmental unit, including such rights granted for an indefinite period. This term can be illustrated by items such as airport slots, airline routes, and broadcasting licenses. Sec. 197 intangibles also include covenants not to compete, or similar arrangements, provided they are entered into in connection with the acquisition of an interest in a business. In addition, the term includes franchises, trademarks, or trade names. However, the Act specifically provides the present law treatment of contingent payments is slated to continue. Such present law permits a deduction for payments contingent on productivity, provided the contingent amounts are paid as part of a series of payments payable at least annually throughout the term of the agreement, so long as the payments are substantially equal in amount or payable under a fixed formula.
Exceptions Will Be Governed by Present Law
There are numerous exceptions to the term Sec. 197 intangibles and these items will be amortizable or nonamortizable according to the dictates of present law including, most notably, the findings of the Newark Morning Ledger case. Among the exceptions are an interest in a corporation, partnership, trust or estate, an interest under a financial contract, as well as an interest in land. Also excluded is computer software readily available for purchase by the general public that has not been substantially modified and is subject to a non-exclusive license--so- called off-the-shelf software. Computer software is also exempted when the software is not acquired in a transaction involving the acquisition of assets which constitute a business or a substantial portion of a business.
For this purpose, the principles of Sec. 1060 are scheduled to play a major role. A group of assets will constitute a business if the assets are of such a character that goodwill could properly attach thereto. Moreover, the acquisition of a franchise, trademark, or tradename is always regarded as the acquisition of a business. With respect to computer software exempted from Sec. 197 status, the Act specifically provides depreciation is determined by amortizing the basis of the exempted software ratably over a 36-month period. Additional exemptions include interests not acquired in a transaction involving the acquisition of a business including interest in a film, recording, video, book or similar property, rights to receive tangible property or services under a contract, and an interest in a patent or copyright. Also excluded is an interest as a lessor or lessee under an existing lease of tangible property as well as an interest under any indebtedness, provided the debt was in existence on the date the interest was acquired. The Act specifically excludes franchises to engage in a professional sport, as well as any item acquired in connection with such a franchise. It also excludes fees for professional services and all transaction costs incurred by parties to a transaction with respect to which any portion of the gain is not recognized under Part III (Corporate Organizations and Reorganizations) of Subchapter C. This latter exception is designed to bolster the Supreme Court's decision in Indopco, which concluded that such expenses are not currently deductible and because they produce benefits extending beyond the close of the year in which incurred, must be capitalized. The specific prohibition included in the Act is designed to insure that such capitalized expenditures cannot be amortized either. A final exception (for which the IRS is directed to establish regulations) relates to rights received under a contract, or granted by a government, and not acquired in a transaction involving the acquisition of a business. In cases where the rights have a fixed duration of less than 15 years or, alternatively, are fixed as to amount and the cost is properly recovered under a method similar to the units of production method, the amortization period provided under general principles of tax law, rather than 15-year amortization, will be available.
Finally, the Act carves out from Sec. 197 status purchased mortgage servicing rights not acquired in a business acquisition. In cases where such rights are carved out, the depreciation deduction allowed is determined using the straight line method over a nine-year period. Although Sec. 197 is generally designed to apply to property acquired after the date of enactment of the legislation (August 10, 1993), there will be an election to apply the provisions to all property acquired subsequent to July 25, 1991. This election will also affect all property acquired (since July 25, 1991) by parties related to the taxpayer at any time between August 2, 1993, and the date of the election. Sec. 197 intangibles will be regarded, for tax purposes, as property of a character subject to the allowance for depreciation. This means generally that such items are not eligible for capital asset treatment and, when such an intangible is disposed of at a gain, such gain will be considered ordinary income in an amount not exceeding the prior amortization deductions claimed. Finally, when a Sec. 197 intangible is disposed of and, after the disposition, other Sec. 197 intangibles acquired in the same transaction or series of related transactions are retained, no loss will be recognized with respect to the disposition. The basis of the remaining Sec. 197 intangibles acquired in the transaction will instead be increased by the amount of the loss not recognized on the disposition. In the same vein, the Act expressly provides that a covenant not to compete cannot be considered disposed of, or worthless, until the disposition or worthlessness of all interests in the business acquired in connection with such covenant.
Impact on Mergers and Acquisitions
In light of the enactment of this legislation, Wall Street has been rife with fortune tellers reporting that a marked increase in mergers and acquisitions activity is inevitable. While we believe M&A activity may be aided and abetted by the ability to amortize intangibles, we also believe the intangibles legislation will not unleash a torrent of such activity, because the intangibles provision does not carry with it a reinstatement of the General Utilities doctrine. This doctrine, finally repealed in TRA 86, generally allowed assets to pass out of corporate solution without the imposition of taxes. Because such an asset movement is essential to obtaining an amortizable basis for intangibles and the demise of General Utilities renders such a movement taxable, it seems clear the intangibles proposals will have a relatively minor impact on the magnitude of M&A activity.
In cases where the stock of a corporation is acquired in a transaction meeting the definition of a "qualified stock purchase," (a purchase, or series of purchases within a 12-month period, of an amount of stock sufficient to render the target an affiliate of the acquirer), the asset movement needed to invoke the intangibles legislation is triggered by the acquirer's decision to execute a Sec. 338 election. This decision, however, is fraught with peril and, such election will generally be made in limited instances where special factors (such as net-operating-loss carryovers) are present:
Acquisition of a Parent. The most conspicuous benefits, and problems, arising from this legislation are found in this situation. Making a regular 338 election in these circumstances results in an acquisition regarded as an asset purchase. The upside is the buyer can step up the basis of the target's assets to an amount equal to the purchase price of the stock, plus target's liabilities assumed, including tax liabilities arising from the deemed sale that results from the election. The downside is the target is treated as if it had sold all its assets at fair value in a fully taxable transaction, as of the close of the acquisition date. Absent a target NOL to shelter the gain from the deemed sale, Sec. 338 elections have rarely have been made since the General Utilities doctrine was repealed. However, with the passage of the intangibles legislation, Sec. 338 elections may make sense in cases where a target has a high basis in its assets consisting largely of previously nonamortizable intangibles.
Acquisition of a Subsidiary. In this situation, the buyer and the seller must jointly execute an election under Sec. 338(h)(10), which will permit the acquisition of the stock of the subsidiary to be regarded, for tax purposes, as an asset transaction. The transaction is treated as if the subsidiary member of the affiliated group that files a consolidated tax return had, while still a member of such group, sold all its assets (to a Newco deemed created by the buyer) and, immediately thereafter, distributed the proceeds in a liquidation to which Sec. 332(a) applies.
The seller will only agree to such an election if the tax on an asset deal does not differ materially from that which would be imposed on a stock sale. This determination hinges on the target's inside and outside basis: Inside basis is the subsidiary's basis in its assets; outside basis refers to the selling parent's tax basis in the subsidiary's stock. If the seller's basis in the subsidiary's stock (outside basis) is materially greater than the subsidiary's inside asset basis, the seller will be reluctant to agree to a Sec. 338(h)(10) election unless the buyer offers to increase the purchase price in an amount sufficient to cover the additional tax cost associated with selling lower basis assets. However, the buyer will only entertain this notion if the present value of the tax savings from the basis step-up and consequent amortization and depreciation deductions does not fall below this incremental amount that it must pay to the seller. This amount is influenced by the amount of the purchase price which is assigned to intangible assets which can be amortized. The legislation allows both sides of the acquisition process to comfortably work with the same set of figures with regard to the amortization of intangibles. However the legislation will have its most significant effect in transactions where inside and outside basis are synchronized.
Acquisition of a Division. This is the most straightforward type of acquisition transaction. There is no question of inside/outside basis or NOLs. All such deals are unquestionably asset transactions; no elections of any kind are required. Under old law, the buyer of the division could only be certain of amortizing those intangibles that had an ascertainable value and a limited, determinable useful life. The effect of the new legislation on this situation is to allow the amortization of all or substantially all the purchase price of the acquisition.
To reiterate, we feel this provision is important, but not nearly as comprehensive as the financial press would lead one to believe. To benefit from the provisions of Sec. 197, the acquisition from which the intangibles arise must be structured as an asset acquisition for tax purposes. Since many acquirers of stock will not make the 338 election, the purchase accounting goodwill necessitated by the application of APB 16 will not, inevitably, translate into "tax goodwill" to which Sec. 197 pertains. While most acquisitions of subsidiaries or divisions of corporations can be so structured, with consequent benefits, it is rare for the acquisition of an entire company to be structured in a manner that would benefit from these provisions. The repeal of the General Utilities doctrine, that culminated with TRA 86, makes it generally prohibitive to format the acquisition of an entire company as an asset acquisition in light of the up front tax cost imposed on this privilege. Therefore, this provision will have its greatest impact on transactions involving sales of portions of a corporation, as opposed to cases where the entire corporation is acquired by another corporation.
ILLUSTRATING THE CONCEPTS OF SEC. 197
For Sec. 197 of the Revenue Reconciliations Act of 1993 to operate, an acquisition must be actually structured as 1) an asset acquisition or 2) an acquisition of stock treated (pursuant to an election) as an asset acquisition. These principles can be best illustrated using three alternative scenarios:
1. Acquisition of a Division. Assume Corp. X conducts a business in divisional format that possesses the following assets:
In this situation, a buyer would purchase the division for $4,400 ($4,000 in cash and $400 in assumed liabilities) and be certain of obtaining amortization of the portion of the purchase price ($3,000) allocated to intangibles. Such amortization will generate (at a 35% tax rate) tax savings of $1,050. In contrast to current law, where the ability to amortize was problematic, these tax savings might be "shared" with the seller leading to increased realizations.
2. Acquisition of a Subsidiary. For a subsidiary acquisition to fit our asset acquisition model, the buyer and seller must execute an election under Sec. 338(h)(10), which permits an acquisition of stock of a subsidiary to be regarded, for tax purposes, as an asset transaction. A seller will be amenable to such an election if the tax on an asset deal does not differ materially from that which would be imposed on a stock sale. This, in turn, depends on the relationship between inside and outside basis. Outside basis is the seller's tax basis in the subsidiary's stock whereas inside basis refers to the latter's basis in its assets.
In our model, our division, if incorporated, would possess an inside basis of $1,200. If, however, the seller had a $1,500 outside basis with respect to the subsidiary's stock, it would be unwilling to join in an "(h)(10)" election unless it was compensated for the additional tax cost associated with selling lower basis assets. This necessity for compensation reduces the buyer's tax windfall and, as a result, impedes a transaction. Thus, subsidiary deals operate most efficiently where inside and outside basis are synchronized.
3. Acquisition of a parent. It is in this context that the problems (and opportunities) are most noticeable. For a parent acquisition to be regarded as an asset deal, the buyer must execute a "regular" Sec. 338 election. As a result of this election, the target is treated as if it sold all its assets at fair value, in a fully taxable transaction, as of the close of the acquisition date. The buyer, in turn, is treated, in effect, as if it purchased those same assets for an amount equal to the purchase price of the stock plus target's liabilities assumed, including tax liabilities resulting from the deemed sale. Accordingly, absent a target net operating loss (NOL) available to shelter the gain from the deemed sale, Sec. 338 elections are rarely made since the 1986 repeal of the ameliorative General Utilities doctrine.
Nevertheless, with the current legislation, Sec. 338 elections will be made in cases where a target has a high basis in its assets consisting in large part of pre-legislation nonamortizable intangibles. Thus, in our model, assume a parent with a $2,000 basis in intangibles worth $3,000. Such basis is not eligible to be amortized because the intangibles were acquired in an acquisition occurring prior to the effectiveness of the intangibles legislation.
In this case, a Sec. 338 election triggers a taxable gain of $1,200 ($200 with respect to fixed assets and $1,000 with respect to intangibles) and yields a tax cost of $420 ($1,200 x 35%). However, the buyer gains an extra $3,620 in amortization deductions ($4,820 - target's $1,200 asset basis). These deductions create (on an undiscounted basis) $1,267 in tax savings, more than justifying the Sec. 338 election.
Robert Willens, CPA, is managing director in the Investment Banking Division of Lehman Brothers, Inc. Prior to joining Lehman Brothers, Mr. Willens was a partner of KPMG Peat Marwick.
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