Despite turning 25 years old this year, the section 197 anti-churning rules, which deny certain amortization deductions, remain a trap for the unwary. We were reminded of that, as was the taxpayer at issue, in IRS Field Attorney Advice (FAA) 20181701F. Taxpayers should take note and carefully consider application of the anti-churning rules any time they are involved in business asset acquisitions or similar transactions involving related parties or a continuing interest by historic owners.
The FAA addressed the section 197 anti-churning rules in the context of a domestic parent’s acquisition of a brand it purchased from a foreign subsidiary. The legal analysis turned on the application of section 1253 to the payment from the domestic parent to the foreign subsidiary, which governed the asset’s amortizability outside of section 197 and is beyond the scope of this analysis.
Section 197 in general
Section 197 governs amortization deductions for many types of intangible assets. Congress enacted section 197 in 1993 after a history of litigation between the IRS and taxpayers over the proper tax treatment of goodwill, going-concern value, and certain other intangible assets acquired in connection with the purchase of a business. Before the enactment of section 197, goodwill and going concern value were generally treated as nonamortizable intangible assets. As a result, the portion of the purchase price of a business allocated to those assets could be used only to offset gain recognized on a future sale of the assets of the business. Because of the less-than-optimal tax treatment of those intangibles, purchasers of businesses were often tempted to assign a proportionately greater amount of the purchase price of a business to depreciable tangible and amortizable intangible assets than to goodwill or going concern value. Section 197 generally grants a 15-year amortizable life to goodwill and intangible assets acquired after its enactment.
The antichurning provisions disallow amortization deductions for certain intangibles.11 Assets subject to the antichurning provisions include goodwill and similar intangible assets held by the seller that were not amortizable prior to the enactment of section 197 and that were acquired from a related person (as defined in sections 267(b) and 707(b), except substituting "more than 20 percent" for "more than 50 percent") who continues to use the intangible. The relationship is tested immediately before and after the sale of the intangible and applies regardless of whether or not the common owners recognize taxable income or gain in connection with the transaction.
The anti-churning rules generally apply only to assets held by the taxpayer or a related party during the period beginning July 25, 1991 and ending Aug. 10, 1993. Unfortunately the anti-churning rules apply to all value of the ‘churned intangible’ and not just the value as of Aug. 10, 1993. It is not enough to document that there was minimal value as of 1993, rather taxpayers have the unenviable task of establishing that no goodwill or similar intangible existed.
Example: If on Aug. 10, 1993 Taxpayer A owned $100 of goodwill and on July 1, 2018 (when the goodwill is worth $150 million) enters into a transaction subject to the anti-churning provisions, the entire $150 million is subject to the anti-churning provisions despite the facts that only $100 existed on Aug. 10, 1993.
If a taxpayer finds themselves in this position, amortization may still be available, as the anti-churning provisions apply only to goodwill and similar intangible assets held by the seller that were not amortizable prior to the enactment of section 197. If the taxpayer can identify assets that would have been amortizable pre-section 197, such assets are not subject to the antichurning rules.
To establish that an intangible asset would have been amortizable pre-section 197, the taxpayer must show that the asset has both a readily ascertainable value separate and distinct from goodwill and a useful life. This is the same analysis performed by the taxpayer in Letter Ruling 201016053. A similar analysis was performed in CCA 200911006, addressing the segregation of intangibles for purposes of the section 1031 like-kind exchange rules. While neither the letter ruling nor the CCA directly addresses the antichurning provisions, they nonetheless indicate the IRS' acceptance of separate identification of intangibles apart from goodwill. However, it is the taxpayer's burden of establishing that the intangible asset in question has both a readily ascertainable value separate and distinct from goodwill, and a useful life.
In addition to identifying intangibles separate from goodwill, transaction structuring alternatives exist that could alleviate anti-churning concerns. In order to effectively structure a solution, however anti-churning issues must be timely identified and addressed.
As FAA 20181701F shows, the anti-churning provisions of section 197 remain a trap for the unwary. Taxpayers entering into related party merger and acquisition (M&A) transactions involving the purchase and sale of intangibles should carefully consider these rules. Further, where an M&A transaction involves a continuing interest by the prior owners of the business, as is common in private equity M&A, the anti-churning rules often must be dealt with. In these transactions, tax deductions for intangible asset amortization are often important; where they are, the anti-churning provisions should be considered. As discussed above, there are potential solutions to the issue if it is identified early.
Read more on the identification of intangible assets separate and apart from goodwill: Separately identifiable intangible assets: Tax opportunities and traps