Trademark taxation: what's in a name?

• Author: Harrison, Jack F.

Trademark Taxation: What's in a Name?

1. INTRODUCTION

   What's in a name? The question might sound like a cliche, but in view of evolutionary changes in the consumer sector of many world economies, well recognized trademarks and trade names can become unrecorded assets of substantial value to both domestic and multinational entities (MNEs). This general increase in the value of marketing intangibles has not escaped the watchful eyes of Congress and the Treasury Department as evidenced by recent changes to the Internal Revenue Code. (1)

   Tax executives are now faced with the challenge of evaluating not only the tax effect of economic assets reflected in financial statements and tax returns, but also the tax attributes associated with unrecorded intangible assets. In this regard, the tax executive must be sensitive to the tax ramifications of what marketing executives strive to do: enhance customer recognition of a product or service. The costs associated with a portion of this recognition process and the related tax pitfalls and opportunities presented by the repeal of section 177 and application of sections 367, 482, 861, and 904 are the subjects of this article. (*1)

2. DEFINITIONS

   Treasury Regulations Sections 1.1253-2(b) and (c) and case law (2) provide the following generally accepted definitions:

   Trademark: "Any word, name, symbol, or device, or any combination thereof, adopted and used bya manufacturer or merchant to identify his goods and distinguish them from those manufactured or sold by others."

   Trade name: "Any name used by a manufacturer or merchant to identify or designate a particular trade or business or the name or title lawfully adopted and used by a person or organization engaged in a trade or business."

   As a matter of practice, a trademark is generally identified with a perticular product being sold as contrasted with a trade name which is generally identified with the entity performing the selling activity. Exhibit I illustrates the differences between trademarks, trade names, and other intangibles not addressed herein. For purpose of this article, trademarke and trade names are discussed inclusively as trademarks.

3. REPEAL OF SECTION 177

   The repeal of section 177, generally effective for costs incurred after December 31, 1986, is one of the quieter tax law changes made by the Tax Reform Act of 1986. (3) Prior to repeal, section 177 permitted an elective amortization deduction of not less than 60 months for certain trademark and trade name expenses which otherwise would have constituted capital expenditures pursuant to section 263. The repeal of section 177 effectively requires taxpayers to capitalize all costs directly connected with the acquisition, protection, expansion, registration, or defense of a trademark or trade name with an indeterminate useful life.

   In addition to non-deductibility on an entity's tax return, capitalized trademark costs may meet the "permanent difference" criteria of A.P.B. No. 11 (4) while creating a long-term temporary difference which may necessitate a "tax planning" strategy for purposes of F.A.S. No. 96. (5) Therefore, the tax executive should endeavor to accurately identify, distinguish, and minimize capitalizable costs associated with indefinite life trademarks.

   Important to the process of identification of capitalizable trademark expenses is cooperation of internal and external legal counsel. Outside counsel should be made aware of the associated issue and requested to provide the entity with appropriately detailed billing statements. Similarly, internal legal counsel should be educated in the area, with time and applied assets being identified and allocated accordingly. Careful instructions should be provided to identify only costs associated with "arbitrary" and "suggestive" trademarks for which protection is afforded and therefore a capital asset created. Other trademarks with little or no protection such as "descriptive" or "generic" trademarks should be excluded from review owing to the lack of asset value.

   The compliance tracking process should involve use of a set of criteria for distinguishing costs associated with the protection of the trademark capital asset from costs associated with protection of the associated income. Such a distinction was made by the Tax Court in J.R. Wood & Sons, Inc., (6) which provided that the costs associated with the protection of trademark income were deductible as ordinary and necessary business expenses.

   In addition to proper segregation of costs, careful consideration should be given to allocation of domestically incurred trademark expenses to any dirsctly benefitted foreign affiliates. Although the allocated expense will not be allowed as a deduction for earnings and profits computation purposes, (7) any allowable foreign tax deduction will reduce the trademark's after-tax cost. Further, such an allocation might contribute to a marketing intangible "cost-sharing" arrangement (discussed below).

   Consideration should also be given to identifying the trademark component as a separate section 1060 Class III asset in a taxable asset purchase involving a trademark. (8) Basis may be recovered pursuant to section 165 upon any future loss, abandonment, or discontinuance of the trademark. (9) Impairment of a trademark through an objective action such as an infringement injunction will generally be easier to support upon audit than the subjective loss of goodwill.

   Exhibit II sets forth a trademark capitalization worksheet, which can be utilized in identifying and quantifying trademark costs potentially subject to capitalization. The checklist may be helpful in identifying some of the more important tax issues affecting an MNE's valuable trademark.

4. SECTION 482

   1. GENERAL

      The Tax Reform Act of 1986 amended section 482 to provide that if intangible property is transferred or licensed to a related party, the income from such transfer or license must be "commensurate with the income attributable to the intangible." (10) The definition of intangible property for purposes of this provision is contained in section 936(h)(3)(B), and includes (1) patents, (2) copyrights, (3) know-how, (4) trademarks, (5) franchises, and (6) customer lists.

      The General Explanation of the Tax Reform Act of 1986, prepared by the staff of the Joint Committee on Taxation (hereinafter cited as the "General Explanation), (11) states that "the bill does not intend to mandate the use of the contract manufacturer or cost-plus method of allocating income or any other particular method." (12) Despite this disclaimer of mandatory use of the cost-plus method, contract manufacturing and contract marketing appear to be precisely the positions underlying the super royalty provision. Some taxpayers feel that the Internal Revenue Service has legislatively succeeded in advancing the contract manufacturing position, which had generally proved to be an unsuccessful litigating position for the IRS. (13) The General Explanation goes on to say that "functional analysis" will be looked to more than comparables and that "... the profit or income stream generated by or associated with intangible property is to be given primary weight." (14)

      One issue of immediate concern arises in a practical application of the amendment's effective date. The super royalty amendment applies to taxable years beginning after December 31, 1986, but only with respect to trademark transfer or licenses granted after November 16, 1985 (or before such date with respect to property not in existence or owned by the taxpayer on such...