Goodwill Hunting Gone Bad: Tax Law's Outmoded Treatment of Goodwill

• Publication year: 2021
• Citation: Vol. 96

96 Nebraska L. Rev. 883. Goodwill Hunting Gone Bad: Tax Law's Outmoded Treatment of Goodwill

Goodwill Hunting Gone Bad: Tax Law's Outmoded Treatment of Goodwill

Mitchell L. Engler(fn*)

TABLE OF CONTENTS

I. Introduction .......................................... 884

II. Governmental Goodwill Hunting Before 1993 .......... 887
A. General Description of Pre-1993 Dynamic and § 197 .............................................. 887
B. Two Illustrative Examples ......................... 890
1. Example 1: Former Baseball Commissioner Bud Selig's Tax Case ............................... 890
2. Example 2: Sale of Bud's Bar and Grill .......... 891
C. Summary ......................................... 892

III. Goodwill Hunting Gone Bad: Taxpayers Now Hunt . . . . 893
A. Goodwill Hunting on Transfers to Foreign Subsidiaries ....................................... 893
B. Goodwill Hunting for Foreign Tax Credits ......... 895
1. Example 1A: Bud Selig's Tax Case ............. 899
2. Example 2A: Bud's London Bar and Grill ........ 901
C. Seller's Goodwill Incentives for Capital Gains ...... 904
1. Contingent "Earn Outs" ........................ 904
a. Example 1B: Bud Selig's Tax Case ......... 905
b. Example 2B: Sale of Bud's Bar and Grill ..... 906
2. Fixed-Consideration Incentives ................. 907

IV. Responses to Goodwill Hunting Gone Bad ............. 908
A. Replace Goodwill Sourcing Exception with Foreign Taxation .......................................... 909
1. Underlying Goals of § 865(d)(2) and (d)(3)...... 909
2. Goodwill as a Poor Proxy for Real Goal ......... 911

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3. Substitute Actual Taxation and Link to Treaty Rules .......................................... 912
B. Franchise Attack Gone Bad: Drop Trademarks from § 1253 ............................................ 914
1. Congressional Motivation: Split-Interest Franchises .................................... 915
2. Inconsistency and Practical Allocation Issues . . . 916
3. Subsequent Changes Leave One-Sided Punitive Regime ........................................ 917
4. Discontinuities in Trademark Litigation ........ 919
5. Summary ...................................... 921
C. Business Sale Override of §§ 1221(a)(3) and 1235 . . 921

V. Conclusion ............................................ 922

I. INTRODUCTION

Prior to 1993, the tax rules motivated the Internal Revenue Service (IRS) to "hunt for goodwill." Due to the lack of depreciation deductions for goodwill,(fn1) business buyers typically allocated minimal purchase price to this asset.(fn2) Buyers instead apportioned their costs to depreciable assets like customer lists.(fn3) The IRS typically reallocated significant amounts back to nondepreciable goodwill.(fn4) In response to all the difficult litigation,(fn5) Congress enacted § 197 in 1993. This section provides business buyers the same fifteen-year depreciation recovery on goodwill, customer lists, trademarks, patents, copyrights, and many other intangible assets. By equalizing the treatment of

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goodwill and other related intangibles, Congress effectively circumvented the IRS's unsatisfying hunt for goodwill.(fn6)

In an interesting reversal, recent regulations publicized how taxpayers now seek goodwill. Prior to the recent regulatory and Tax Code changes, international tax rules incentivized taxpayers to inflate goodwill on transfers to their foreign subsidiaries.(fn7) This flowed from a goodwill exception to the regular gain-recognition rules on such transfers.(fn8) Recent regulations targeted this particular loophole, explaining why the tax law should not differentiate between goodwill and other closely related intangibles.(fn9) But while the recent tax bill shuts down this specific goodwill pursuit, meaningful goodwill-hunting mischief remains fully intact in several other significant areas.

For instance, a less publicized case involved a taxpayer's sale of its international operations to an unrelated buyer.(fn10) The seller claimed a hefty goodwill allocation to boost its foreign tax credit allowance. Different income sourcing rules for goodwill and related assets encouraged this taxpayer attempt.(fn11) And since this involves the sale of assets to a third party, the recent change to subsidiary transfers does not impact this goodwill incentive.

The Internal Revenue Code (the Code) likewise incentivizes business sellers to allocate more towards goodwill in order to maximize income taxed at favorable capital gains rates. For instance, § 1253 denies the lower capital gains rates to contingent payments for trademarks (and franchises) but not for goodwill and other intangibles. In addition, even fixed-payment sales can trigger goodwill-hunting opportunities due to specialized capital gains rules applicable solely to select types of intellectual property (i.e., copyrights and patents).(fn12)

These varying capital gains rules for business sellers ignore the lessons of the recent regulations and § 197. This Article thus proposes several corrections to the ongoing goodwill difficulties. As developed in the roadmap below, the foreign sourcing of intangibles gains should be keyed to the foreign taxation of such gains rather than the presence of

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goodwill. Next, § 1253 should eliminate trademarks from its coverage. Third, similar to the § 197 rules for buyers, uniform capital gains rules should apply to business sellers regardless of the nature of the intangible assets.

This Article proceeds as follows: Part II chronicles how the government's goodwill-hunting efforts prior to 1993 culminated in the enactment of § 197. In addition to providing useful background information, this Part also presents two illustrative examples based on former Baseball Commissioner Bud Selig's actual tax case.

Part III then further utilizes these examples to illustrate the bountiful goodwill-hunting opportunities for taxpayers. As discussed above, this role reversal flows from the differential tax-favored treatment of goodwill in the subsidiary transfer, foreign tax credit, and capital gains areas.

After Part III's exposition of current law's problematic areas, Part IV presents incisive solutions for each area.(fn13) Section IV.A first addresses the goodwill sourcing problem under current § 865. Goodwill currently operates as a poor proxy for the ultimate target: foreign taxation of the intangibles gain. In addition to the valuation difficulties highlighted above, goodwill does not accurately capture the desired foreign taxation even in theory.(fn14) Fortunately, an existing treaty-sourcing provision provides the pathway for reform: link the taxpayer-desired foreign sourcing to the actual foreign taxation of the intangibles gain.(fn15) Drawing upon this proven approach should counteract the usual status quo bias against untested reforms.(fn16)

Section IV.B next tackles the problematic inclusion of trademarks in § 1253 (along with franchises).(fn17) This encourages taxpayers to allocate contingent payments away from trademarks and towards goodwill. Section 1253 should be scaled back to apply only to franchises for several reasons. As a starting point, the legislative history reflects congressional concern primarily over franchises, with trademarks added more as an afterthought. In addition, trademarks raise real prac-

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tical issues avoided in the franchise context. For instance, franchises typically subsume all the business goodwill, thereby minimizing the problematic allocation issues.(fn18)

Finally, section IV.C addresses the other relevant capital gains provisions for business sellers. In particular, § 1235 facilitates capital gains for certain patents, while § 1221(a)(3) denies capital gains for certain copyrights. Interestingly, this mixture of favorable and undesired rules presents the inverse sellers' side to the buyers' difficulties prior to § 197. Such recognition suggests the comparable fix here: application of standardized rules to all transferred intangibles upon the sale of a business.(fn19)

II. GOVERNMENT GOODWILL HUNTING BEFORE 1993

As background, this Part explores the government's goodwill-hunting quest prior to the 1993 adoption of § 197. Taxpayers generally minimized goodwill allocations on business acquisitions prior to 1993 in order to increase their depreciation deductions. By providing the same fifteen-year depreciation period for all covered intangibles, the 1993 enactment of § 197 alleviated pressure on goodwill allocations. After section II.A expands upon this general description, section II.B provides two illustrative examples.

A. General Description of Pre-1993 Dynamic and § 197

When a taxpayer purchases a business, the taxpayer must allocate the purchase price among all the acquired assets.(fn20) This allows separate determinations of depreciation for each acquired asset as well as any gain (or loss) on the subsequent sale of any acquired asset. From an incentives standpoint, buyers generally prefer to allocate more purchase price to depreciable assets, especially ones with relatively

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short depreciation periods.(fn21) This allows faster depreciation deductions, which reduces the reportable income (and tax payments) in the short term. Such quicker cost recovery generally benefits taxpayers under time-value-of-money principles. As evidenced by the short example right below, earlier tax savings benefit taxpayers through reducing their interest expense in the interim period.(fn22)

Assume that Bob Buyer pays tax at a constant 50% rate each year and buys a $1,000,000 asset. With a five-year depreciation period, Bob will save $100,000 tax in each of the next five years.(fn23) A longer ten-year period reduces Bob's annual tax savings to just $50,000.(fn24) In this case, Bob would recoup the initial annual $50,000 shortfall through an additional $50,000 savings in years six...