To print this article, all you need is to be registered or login on Mondaq.com.
INTRODUCTION
A sale of a business to a buyer often involves an element of
goodwill, a term that can have different meanings in different
contexts, depending on whether the term relates to (i) purchase
price allocations for financial statement purposes or income tax
purposes or (ii) attempting to compute the source of income for
foreign tax credit purposes. Compounding the definitional
inconsistency, the meaning of the term has changed over time.
The Merriam-Webster Dictionary defines goodwill in a
non-business context as “a kind, helpful, or friendly feeling
or attitude.” In a business context, the term is given various
definitions, including
- the amount of value that a company’s good reputation adds
to its overall value, - the favor or advantage that a business has acquired especially
through its brands and its good reputation, - the value of projected earnings increases of a business
especially as part of its purchase price, or - the excess of the purchase price of a company over its book
value which represents the value of goodwill as an intangible asset
for accounting purposes.
This article examines the evolution of the international tax
consequences of controlled and uncontrolled sales of goodwill by a
U.S. corporation, and begins with a 1989 sale of a regional donut
shop franchise business operated outside the U.S. to an
uncontrolled Japanese buyer.
THE INTERNATIONAL MULTIFOODS CORPORATION CASE
Taxpayer’s Franchising Business
International Multifoods Corporation v.
Commr.1 is a case that involves a U.S. corporation
(“U.S. Co”) that operated a donut store franchising
business. It perfected a system that utilized franchisees to
prepare and merchandise distinctive donuts, pastries, and other
food products. The franchise agreements refer to this system as the
“Mister Donut System,” which entailed a unique and
readily recognizable design, color scheme and layout for the
premises wherein such business is conducted and for its
furnishings, signs, emblems, trade names, trademarks, certification
marks, and service marks.
U.S. Co typically granted franchisees the right to open a fixed
number of Mister Donut shops pursuant to established terms and
conditions and at locations approved by U.S. Co. The franchise
agreements provided that U.S. Co would not open or authorize others
to open any Mister Donut shops in the franchisee’s territory
until the franchise agreement expired or was terminated, or unless
the franchisee did not meet its development schedule by failing to
open the requisite number of Mister Donut shops by the agreed-upon
date. In the event the franchisee failed to open the agreed-upon
number of shops, it lost its exclusive rights in the territory and
could not open any additional Mister Donut shops.
Franchisees were entitled to use the building design, layout,
signs, emblems, and color scheme relating to the Mister Donut
System, along with petitioner’s copyrights, trade names, trade
secrets, know-how, and preparation and merchandising methods, as
well as any other valuable and confidential information. However,
U.S. Co retained exclusive ownership of its current and future
trademarks, as well as any additional materials that constituted an
element of the Mister Donut System. Use of these assets was
prohibited after the termination of the franchise agreement.
Sale of Franchising Business
In early 1989, U.S. Co sold its Asian and Pacific Mister Donut
franchising business to a Japanese purchaser for $2.05 million.
Pursuant to the agreement, U.S. Co transferred its franchise
agreements, trademarks, Mister Donut System, and goodwill for each
of the Asian and Pacific countries in which U.S. Co had existing
franchise agreements, as well as its trademarks and Mister Donut
System for those Asian and Pacific countries in which it had
registered trademarks but did not have franchise agreements. From
the viewpoint of U.S. Co, the agreed price for the transaction took
into account (i) the royalty income generated in the operating
countries, (ii) the growth potential in the operating countries,
(iii) the development potential in the nonoperating countries, and
(iv) the value of the trademarks in the operating and nonoperating
countries.
As a condition of the contract, U.S. Co agreed to a noncompete
covenant for 20 years covering all countries in which franchising
arrangements were in place or where trademarks were registered
within the territory, but franchises did not exist. As a condition
to full payment, U.S. Co needed to obtain consents of all
franchisees.
Goodwill Reported as a Separate Asset from Trademarks
and Systems
At the suggestion of U.S. Co’s tax department, the asset
purchase agreement did not allocate the purchase price to the
assets sold. The ostensible reason given in a memorandum was
concern that certain countries within the territory might consider
imposing withholding taxes on the amounts allocated to local
trademarks. Although not in the memorandum, the advice reflected
divergent tax treatment for the source of gains when computing the
foreign tax credit limitation of a U.S. taxpayer under the rules of
U.S. tax law.
- Section 865(a)(1) of the Internal Revenue Code then in effect
(“Code”) provided that income from the sale of personal
property by a U.S. resident is generally sourced in the U.S. - Code §865(d)(1)(A) provided that in the case of any sale
of an intangible, the general rule would apply only to the extent
that the payments in consideration of such sale were not contingent
on the productivity, use, or disposition of the intangible. - Code §865(d)(2) defined “intangible” to mean any
patent, copyright, secret process or formula, goodwill, trademark,
trade brand, franchise, or other like property. - Code §865(d)(3) carved out a special sourcing rule for
goodwill. Payments received in consideration of the sale of
goodwill are treated as received from sources in the country in
which the goodwill was generated.
Consistent with the foregoing tax rules controlling the source
of income, the tax department of U.S. Co ultimately advised that
amounts allocated to goodwill and the noncompete provision would
produce foreign source income for U.S. Co that in theory could
release unused foreign tax credits from earlier years. The effect
would be that no U.S. cash tax would be paid with regard to those
items and previously unused foreign tax credits would be used,
thereby producing a benefit.
Based on a purchase price allocation report prepared by a major
accounting firm for use by U.S. Co, $1.93 million of the sale price
was allocated to goodwill and a covenant not to compete. On its
1989 Federal income tax return, U.S. Co reported the income
allocated to those assets as foreign source income for purposes of
computing the foreign tax credit limitation under Code
§904(a).
Challenge to Separate Asset Called Goodwill
The I.R.S. examined the tax returns for the years involved and
disallowed the company’s application of Code §865(d)(3).
It contended that U.S. Co sold a global franchise to the purchaser
and that all the value was in the trademarks and the Mister. Donut
System, and treated the gain as being derived from U.S. sources.
The unused foreign tax credits from prior years no longer produced
a cash tax benefit.
The company filed a petition to the Tax Court challenging the
deficiency asserted by the I.R.S. based on the fact that the
goodwill in issue was attributable to the foreign trademarks used
in the foreign markets in which the company conducted its
franchising business. The court agreed with the I.R.S. According to
the court, U.S. Co was mistaken when it attempted to separate
goodwill from the assets in which the goodwill was embodied.
Goodwill represents an expectancy that old customers will resort to
the old place of business.2 The essence of goodwill
exists in a preexisting business relationship founded upon a
continuous course of dealing that can be expected to continue
indefinitely.3 The value of every intangible asset is
related, to a greater or lesser degree, to the expectation that
customers will continue their patronage.4 An asset does
not constitute goodwill, however, simply because it contributes to
this expectancy of continued patronage.
The court agreed with the I.R.S. that the purchaser acquired a
franchise from U.S. Co to operate, relying on the definition found
in Code §1253(a). Under that provision, a 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 specified area. That was the essence of U.S.
Co’s agreement with the purchaser. It then concluded that
the goodwill associated with the franchise business was part of,
and inseverable from, the franchisor’s rights and trademarks
acquired by the purchaser.
While there are no cases on point under section 865, case law
interpreting other provisions of the Code supports respondent’s
position. In Canterbury v. Commissioner, 99 T.C. 223
(1992), we considered whether the excess of a franchisee’s
purchase price of an existing McDonald’s franchise over the
value of the franchise’s tangible assets was allocable to the
franchise or to goodwill for purposes of amortization pursuant to
section 1253(d)(2)(A). We recognized that McDonald’s franchises
encompass attributes that have traditionally been viewed as
goodwill. The issue, therefore, was whether these attributes were
embodied in the McDonald’s franchise, trademarks, and trade
name, which would make their cost amortizable pursuant to section
1253(d)(2)(A), or whether the franchisee acquired intangible
assets, such as goodwill, which were not encompassed by, or
otherwise attributable to, the franchise and which were
nonamortizable.
We found that the expectancy of continued patronage which
McDonald’s enjoys “is created by and flows from the
implementation of the McDonald’s system and association with
the McDonald’s name and trademark.” Id. at 248 (fn. ref.
omitted).
Because no portion of U.S. Co’s gain from the sale of its
Mister Donut franchise business was attributable to a separate
asset called “goodwill,” the entire gain produced
domestic source income for a U.S. corporate tax resident.
Previously unused foreign tax credits were not available to offset
U.S. tax on any portion of the U.S. Co’s gain.
Legacy of Court’s Decision
International Multifoods reinforced a long line of
thought that goodwill is generally inseparable from trademarks and
other marketing intangibles. It did not provide a promising path
forward for other taxpayers that might want to allocate amounts
toward goodwill, and thereby change the source of the income. The
court defined goodwill as the “expectancy of continued
patronage.”5 Less established companies naturally
have less of a track record that might draw customers back in.
Trademarks and other forms of branding may have a bigger role in
attracting repeat customers. In other words, business goodwill
might be more tied to other intangibles and less able to stand on
its own.
Such reasoning seemed particularly relevant to Mister Donut. All
its Asia-Pacific franchises were fairly new. In several countries
for which Mister Donut sold franchise rights, Mister Donut owned
registered trademarks in jurisdictions where operations were not
yet carried on. Whatever goodwill it had in such countries could
only be attributed to its franchise system. But dominance of
franchise rights value is equally true for more established
companies. The court relied on older cases involving franchises by
more familiar names, such as McDonald’s and Coca-Cola, that
similarly held goodwill to be inseparable from the companies’
franchises. The message of International Multifoods was
that for most businesses, new and old, separating goodwill from
other intangibles is a difficult task.
UNCONTROLLED SALES: DEVELOPMENTS AND RULEMAKING
The I.R.S. applied this logic in the context of like-kind
exchanges. In Technical Advice Memorandum (“T.A.M.”)
200602034, the I.R.S. held that trademarks are part of goodwill,
going concern value, or both. As goodwill and going concern are
unique to each business, trademarks were unique to each business,
as well. Consequently, an exchange of trademarks could not qualify
for nonrecognition as a like-kind exchange within the meaning of
Code §1031.
Three years later, the I.R.S. explicitly rescinded T.A.M.
200602034 with Chief Counsel Advice (“C.C.A.”) 200911006,
which concluded that trademarks and similar assets can qualify for
favorable like-kind exchange tax treatment. The conclusion reached
in C.C.A. 200911006 provided support for the possibility of
separating goodwill from marketing-based intangibles. The I.R.S.
stated:
Upon further consideration, the Office of Associate Chief
Counsel (Income Tax & Accounting) has concluded that the
analysis of Newark Morning Ledger Co. applies in determining
whether intangibles constitute goodwill or going concern value
within the meaning of §1.1031(a)-2(c)(2). Accordingly,
intangibles such as trademarks, trade names, mastheads, and
customer-based intangibles that can be separately described and
valued apart from goodwill qualify as like-kind property under
§1031. In our opinion, except in rare and unusual situations,
intangibles such as trademarks, trade names, mastheads, and
customer-based intangibles can be separately described and valued
apart from goodwill.
The I.R.S.’s volte-face was driven by Newark
Morning Ledger, a Supreme Court case that preceded
International Multifoods.6 In Newark
Morning Ledger, a newspaper wanted to take deductions related
to its amortization of its “paid subscribers.” The I.R.S.
argued that the asset was too connected to goodwill, which was not
amortizable.7 The Supreme Court focused on whether paid
subscribers should be an amortizable asset, but in deciding in
favor of the newspaper, it rejected the I.R.S.’s argument that
goodwill could not be distinguished from paid subscribers.
Yet, Newark Morning Ledger covered fairly narrow
grounds and focused on a specific type of intangible asset. Nothing
in the case necessarily contradicted the long-standing idea that
marketing-based intangibles like trademarks are inseparable from
goodwill. International Multifoods mentioned the case but
was not bound by it. And the Supreme Court even warned other
taxpayers that the burden of splitting goodwill from other
intangibles would still be “too great to bear” in most
cases.
A conservative reading of C.C.A. 20091106 is that it applies
only to like-kind exchanges. The case also lacked a franchise,
which was an important factor in International Multifoods.
There are ways to distinguish C.C.A. 20091106 from
International Multifoods. For a franchisee, goodwill is
embedded in the trademark, the brand advertising, the layout of the
premises, and the sale of a standardized product.
Is one franchisee’s Mister Donut donut different from
another franchisee’s Mister Donut donut? Yet, the comment that
goodwill can usually be split from trademarks and other intangibles
is generally stated. Whether by accident or by design, the I.R.S.
has cast doubt on the relevance of International
Multifoods, at least within the newspaper industry.
Status of the Statutes
Other changes have followed this trend. Valuation of goodwill
was important in the context of Code §367, which requires gain
recognition for transfers of certain property to foreign
corporations, with Code §367(d) covering intangible property.
Goodwill was originally not included in Code §367(d), because
it was already located outside the U.S. This created an incentive
to allocate sums to goodwill, since it could escape recognition
treatment. The Tax Cuts and Job Acts of 2017 (“T.C.J.A.”)
added goodwill to Code §367(d), removing one need to value
goodwill separately from other intangibles.8 The
preamble to the Code §367 regulations suggest that the I.R.S.
wanted to reduce the number of difficult goodwill valuation
fights.
But it would be hasty to conclude that International
Multifoods is of no relevance. The impetus behind the case
– the favorable sourcing rule for goodwill in Code
§865(d)(3) that can be used to access unused foreign tax
credits – still exists. C.C.A. 20091106 might have given
fresh vigor to taxpayers hoping to take advantage of this rule.
International Multifoods may have drawn some helpful
lines for taxpayers looking to fiddle with goodwill allocation. The
court found that the existence of a franchise system subsumed all
the goodwill in Mister Donut’s franchising business. Mister
Donut not only allowed the purchaser the use of its franchise
system but dumped all its rights in Asia-Pacific into the
agreement:
Petitioner not only sold [the purchaser] petitioner’s rights
as franchisor in the existing franchise agreements in the operating
countries, but also all its rights to exclusive use in the
designated Asian and Pacific territories of its secret formulas,
processes, trademarks, and supplier agreements; i.e., its
entire Mister Donut System.
This was backed up by the existence of noncompete covenants that
prevented the parties from operating in each other’s region.
Taxpayers looking to benefit from a favorable goodwill allocation
might be advised to move away from using franchises. Given
opportunities for intangible allocation arbitrage still exist,
these are still useful lessons.
CONTROLLED SALES OF GOODWILL
International Multifoods was a case about an
uncontrolled sale of goodwill. Is the decision relevant for
controlled sales of goodwill? At the time of International
Multifoods, goodwill was not defined as an intangible asset
under Code §367(d), but was defined under Code
§936(h)(3)(B)(vi) as any similar item, which has substantial
value independent of the services of any individual.
Following the International Multifoods decision in1997,
goodwill became a definitional component of all other intangible
property under Code §936(h)(3)(B)(i)-(v), namely:
(i) patent, invention, formula, process, design, pattern, or
know-how,
(ii) copyright, literary, musical, or artistic composition,
(iii) trademark, trade name, or brand name,
(iv) franchise, license, or contract,
(v) method, program, system, procedure, campaign, survey, study,
forecast, estimate, customer list, or technical data.
At that time, the definition of an intangible asset under Treas.
Reg §1.482-4 referenced Code §367(d), which in turn
referenced Code §936(h)(3)(B).9 Controlled
transactions that were nonrecognition transactions under Code
§351 or §361 often relied on the active-trade-or-business
exemption under Code §367(a)(3) to conclude a transfer of
goodwill by the U.S. transferor without the recognition of any gain
for the transferred goodwill asset. Other sale transactions
involving a buyer that planned to use the transferred goodwill to
earn income other than active business income relied on an accurate
estimation or valuation of the arm’s length consideration
payable to the seller.
Valuation issues or issues with the application of a selected
transfer pricing method dominated definitional issues in the
context of a controlled transaction where the foreign
acquirer’s intent was the generation of passive income. Here,
the cost approach to valuation likely would not have captured the
dynamic effect of continued business patronage at the heart of
goodwill value. The income approach that used a limited useful life
or a steeply declining royalty rate over time may not have captured
the momentum effect of goodwill in future sales or margins. Among
the key assumptions that required robust support were (i) customer
retention and (ii) an understanding of the way in which a retained
customer base grows and contributes to sales and margins. Required
forecasting assumptions may have influenced intangible asset value
in transactions at that time.
Where the acquirer of goodwill planned to earn passive income,
cost-sharing arrangements were adopted as replacements for actual
transfers, especially as large tech companies began expansion
outside the U.S. after the 1990’s. One-time or lump-sum sales
of goodwill therefore gave way to buy-in payments, known currently
as platform contribution transaction payments, followed by
cost-sharing payments between the participants over the term of a
cost-sharing agreement.
Following the decision in International Multifoods, the citation
trail is almost nonexistent in the context of controlled goodwill
sales and its influence diminishes much the same way as
uncontrolled goodwill sales.
2017 T.C.J.A.
Treasury clarified the valuation or quantification issue by
codifying the requirement for aggregate valuation of intangible
property transferred in foreign controlled transactions as part of
the 2017 T.C.J.A.10 At the same time, the definition of
an intangible asset under Code §936 was replaced by an
expanded definition under new Code §367(d)(4) that explicitly
includes (i) goodwill, going concern value, or workforce in place
(including its composition and terms and conditions (contractual or
otherwise) of its employment) and (ii) any other item, the value or
potential value of which is not attributable to tangible property
or the services of any individual.
Goodwill and Chapter VI of the 2017 OECD
Guidelines
In the 2017 edition of the O.E.C.D. Guidelines,11
goodwill is handled not as a separate intangible asset but rather
as a component of value of other intangible assets in the context
of a controlled sale or other transfer. As such, it is consistent
with the Tax Court’s decision in International
Multifoods. Going concern value is accorded the same
treatment.12 The I.R.S. view of goodwill as part of an
aggregate intangible asset transfer is therefore currently
consistent with the controlled transaction treatment of goodwill by
other O.E.C.D. member state treaty partners.
CONCLUSION
Has the precedential value of Mister Donut gone
stale?
The general approach of International Multifoods to
foreign goodwill sales in the controlled transaction context
remains very much in line with current law and is broadly
consistent with multilateral guidance when Competent Authority is
asked to address intangible property transactions with treaty
partners.
In a unilateral context, the well-established theory behind
International Multifoods is of uncertain status. The
I.R.S.’s comments in C.C.A. 200911006 make it unclear whether
the I.R.S. has fundamentally shifted its thinking or whether those
remarks were intended to apply only in specific contexts. Either
way, International Multifoods still matters. The taxpayer
was unsuccessful, but it might only have provided an example of how
not to play games with goodwill.
Footnotes
1. 108 T.C. 25 (1997).
2. Houston Chronicle Publishing Co. v.
U.S., 481 F.2d 1240, 1247 (5th Cir. 1973); Canterbury v.
Commr, 99 T.C. 223, 247 (1992).
3. Canterbury v. Commr., supra; Computing &
Software. Inc. v. Commr., 64 T.C. 223, 233 (1975).
4. Newark Morning Ledger Co. v. U.S., 507
U.S. 546, 556. (1993).
5. Citing Houston Chronicle Publishing Co.,
481 F.2d 1240. (1973).
6. 507 U.S. 546 (1993).
7. This is no longer an issue due to Code §197
allowing for amortization of goodwill.
8. See “Controlled Sales of Goodwill,”
below, for further discussion of this change.
9. As mentioned below in connection with the 2017
T.C.J.A., the list in Code §936(h)(3)(B) has been moved to
Code §367(d)(4). In addition, two new categories of intangible
property have been added.
10. Dec. 22, 2017, 131 Stat. 2219, Pub. L.
115-141.
11. O.E.C.D. (2017), O.E.C.D. Transfer Pricing
Guidelines for Multinational Enterprises and Tax Administrations
2017, O.E.C.D. Publishing, Paris.
12. Id. paragraph 6.28.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.