The amortization of purchased intangible assets.

• Author: Wertlieb, Mark
• Position: Newark Morning Ledger Co.

Author's note: The authors gratefully acknowledge the assistance of Jamie B. Fowler, CPA, Senior Manager, KPMG Peat Marwick, New York, N.Y., in the completion of this article.

On Apr. 20, 1993, the U.S. Supreme Court released its anxiously awaited decision in the Newark Morning Ledger Co.(1) case on the amortization of purchased intangible assets. Holding 5-to-4 for the taxpayer, the Supreme Court held that a taxpayer that proves its acquired intangible assets have both an ascertainable value and a limited useful life, the duration of which can be ascertained with reasonable accuracy, may depreciate those assets over that useful life.

The Court rejected a long-argued IRS position that some assets are, as a matter of law, inseparable from goodwill and thus not subject to amortization.(2) The Court held that the issue is one of fact and that "[t]he significant question for purposes of depreciation is not whether the asset falls within the core of the concept of goodwill'. . . but whether the asset is capable of being valued and whether that value diminishes over time."(3)

This article will analyze the Supreme Court's decision in light of the lower courts' holdings; examine the questions still unanswered by the decision; look to its implications; discuss applicable strategies and new legislation; analyze the industry implications; and point out planning opportunities.

Statutory and Regulatory History

The lack of consistency in the statutory and regulatory interpretations by the courts, in, e.g., Houston Chronicle Publishing Co.,(4) Donrey, Inc.,(5) Citizens and Southern Corporation and Subsidiaries(6) and Colorado National Bankshares, Inc., and Subsidiaries,(7) had created much uncertainty and provided little guidance for the taxpayer before the Supreme Court's decision in Newark Morning Ledger.

Sec. 167(a) allows "as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)--(1) of property used in the trade or business, or (2) of property held for the production of income." Under Regs. Sec. 1.167(a)-3, the depreciation deduction for an intangible asset, which is less susceptible to obvious signs of "exhaustion, wear and tear," is allowed only if the life of the intangible asset is known to be limited from experience or other factors and can be estimated with reasonable accuracy. Unfortunately, the regulation does not provide a definition of intangible property; however, two examples of intangibles, patents and copyrights, are given.(8)

Goodwill is not defined by statute. Numerous definitions, from "the avoidance of start-up costs" to "continued patronage," can be found in a swollen body of case law.(9) Furthermore, no depreciation deduction is currently allowed for goodwill since it lacks an ascertainable useful life.(10) Theoretically, the existence of goodwill continues as long as the related business continues.(11)

Under the "indivisible-asset" or "mass-asset" theory, the courts had ruled in numerous cases that customer-based intangibles are an inseparable part of a nondepreciable asset body called goodwill. Under this theory, goodwill is categorized as a self-regenerating asset in that the expiring components (customers) are replaced so that the value of the asset remains relatively constant over time. Even if the value of goodwill fluctuates, there is no way to measure its useful life since goodwill cannot be separated into distinctive elements or assets, each having its own depreciable useful life.(12) Other courts (see discussion below) have ruled that certain customer-based intangibles can be valued and assigned a useful life. Such a determination is factual and the taxpayer bears the burden of establishing the right to claim the deduction.

Court Interpretations

The courts have struggled with the definition of what constitutes an amortizable intangible asset. Before the Houston Chronicle decision, courts often swayed toward the idea that intangible assets could not be separated from goodwill and therefore could not be depreciated.(13) In Houston Chronicle, the taxpayer had acquired all of the assets of a competing newspaper, including all of its subscription lists. A valuation study established the value of the subscription lists by reference to an estimate of the number of subscribers that would have become Houston Chronicle subscribers on the closing of the former paper multiplied by the average cost of obtaining a new subscriber, i.e., the cost approach. Based on experience, the taxpayer used a useful life of five years for depreciation purposes. The Service argued that the lists were not amortizable as a matter of law, and that the "mass-asset" theory applied to deny the depreciation deduction. The Fifth Circuit rejected the argument that all subscription lists are inextricably linked with goodwill, and held that the taxpayer had met its burden of proof in determining the separate value of the lists and their useful lives.

Soon after the Fifth Circuit's decision in Houston Chronicle, the IRS announced its official position on the depreciation of intangible assets in Rev. Rul. 74-456.(14) In that ruling, the Service concluded that the determination that customer-based intangibles are indistinguishable from goodwill is factual, rather than a matter of law. As such, the burden is on the taxpayer to establish that the intangible asset has a value separate and distinct from goodwill and a limited useful life that can be ascertained with reasonable accuracy.

Donrey represented another taxpayer victory involving the depreciation of newspaper subscription lists. In that case, it was held that newspaper subscription lists were depreciable in the context of a purchase of an ongoing newspaper. The value of those lists was determined by reference to the "advertising revenue enhancement" attributable to the subscribers, i.e., the additional revenue derived from advertisers. A jury found that the paid subscription lists in question had a value separate from goodwill. An assigned depreciable life of 23 years was determined based on an analysis completed by a market research and consulting firm that serviced the newspaper industry. The Eighth Circuit agreed that the taxpayer had met its dual burden of proof; the lists had an ascertainable value separate and distinct from goodwill, and a limited useful life that could be reasonably estimated.

The concepts in these cases in the publication subscription area are equally applicable in the banking area. Both Citizens and Southern Corp. and Colorado National Bankshares serve as examples of taxpayer victories in the allowance of depreciation of bank intangibles, i.e., core deposits. "Core deposit base" is a term used in the banking industry to represent the "present value of the future stream of income to be derived from employing the purchased core deposits of a bank."(15)

In Citizens and Southern Corp., the taxpayer had acquired nine banks and sought to depreciate the banks' deposit base. It valued these intangibles by comparing the acquisition costs of the core deposits with the alternative cost of borrowing funds to run its business. The taxpayer argued that core deposits were a low-cost source of funds that contributed to the profitability of a commercial bank. The Tax Court decided that studies done by the taxpayer, which estimated the percentage of accounts that would close over a given period of time, established the estimated useful life of the deposits. Thus, the Tax Court concluded that the deposit base was not a self-regenerating asset, and that it had a value separate and distinct from goodwill.

In Colorado National Bankshares, the Tax Court and the Tenth Circuit agreed with the taxpayer's contention that core deposits were separate and distinct assets, and not merely portions of the goodwill associated with preexisting customer relationships. The Tax Court recognized that the Financial Accounting Standards Board, the Securities and Exchange Commission and the Office of the Comptroller of the Currency require that core deposits be recorded as an asset separate and distinct from goodwill for financial statement purposes. The Tax Court also found that the fact that new accounts would be opened as old accounts were closed did not make the deposit base self-regenerating.

The Tax Court has consistently held that core deposits are not goodwill, and that...