A new IRS legal advice memorandum addresses a fact pattern that may become more common in the wake of Tax Reform—sale of intangible property from a controlled foreign corporation to its United States parent—and highlights the potential application of Code § 1253 to change the tax results of such a transaction. As illustrated by the Legal Advice Memorandum (LAFA or Memo), the intersection between § 1253’s amortization rules, the normal rules for amortizing Code § 197 intangibles, and related implications for recognition of capital gain or loss are complex. Although § 1253 is primarily thought of in the context of retail restaurant franchises, its application to other transfers of intangibles should not be overlooked.
The Memo deals with a series of unrelated transfers of intangible property within a multinational group, specifically marketing intangibles which the document refers to simply as Brand 1 and Brand 2. The U.S. Parent company had, prior to 1993, developed Brand 1. Thus, it was a pre-1993 intangible subject to “anti-churning rules” under § 197 that result in frozen basis following a related party transfer. On Date 1, Domestic Parent sold Brand 1 to its Foreign Subsidiary, in a transfer potentially subject to anti-churning rules under § 197.
On Date 2, Brand 1 was subdivided into Brand 2 and Brand 3. Foreign Subsidiary then transferred rights to Brand 2 back to the U.S. Parent, while retaining Brand 3. The time period between Date 1 and Date 2 is unstated, but presumably these were separate transactions.
In return for transferring rights to Brand 2, Foreign Subsidiary received a lump sum payment from Domestic Parent. The parties executed an agreement governing their rights and obligations with respect to Brand 2 and Brand 3. As summarized later in the analysis section of the LAFA, Foreign Subsidiary and Parent had certain shared quality control rights with respect to Brands 1 and 2, including use of the Brand in a dignified manner in accordance with good trademark practices, use of the Brand in a manner that does not harm the value of the Brand or its related goodwill, and using the Brand in connection with high quality goods and services. The Memo describes the quality control obligations as “reciprocal,” so Foreign Subsidiary presumably had similar quality control obligations to U.S. Parent in its use of the Brand. Further, the Foreign Subsidiary had the right to consent to any assignment of Brand 2 by U.S. Parent; U.S. Parent could also block Foreign Subsidiary’s assignment of Brand 3.
At issue in the case was whether U.S. Parent could amortize the lump sum payment it made to Foreign Subsidiary for the Brand, or whether this payment resulted in frozen basis that was non-amortizable under the so-called “anti-churning rules.” As noted above, Brand 2 was held by the taxpayer prior to 1993, so that its sale to a related party would generally be subject to the anti-churning rules. At times it has been argued that an intangible in existence on 1993, but substantially different or more valuable today should be bifurcated between its pre-1993 and post-1993 elements, with only the pre-1993 elements being subject to the anti-churning rule. A bifurcation argument was not addressed in the Memo.
Furthermore, deductions allowable under § 1253 are explicitly treated as deductions for amortization for purposes of § 197. See § 197(f)(9). The taxpayer and the IRS both seem to have assumed that § 197 would apply absent the anti-churning rules.
Importantly, one exception to the anti-churning rules is for intangible property that would have been amortizable prior to the enactment of § 197. See § 197(f)(9)(A). The current version of § 1253 treats lump sum payments as chargeable to the capital account (see § 1253(d)(2)), so that the taxpayer would rely on § 197 or other applicable law for amortization. Also note that § 1253(d)(1) specifically authorizes a current deduction for payments contingent on use of the franchise IP by the transferee.
Under the pre-1993 version of § 1253, however, deductions were allowed ratably over 25 years for lump payments made in connection with the acquisition of a Franchise as to which the Franchisor retained significant rights or powers. Thus, if the Foreign Subsidiary retained significant powers or rights over Brand 2, the lump sum payment would have been amortizable under the law prior to the enactment of § 197. This would, in turn, have permitted Domestic Parent to avoid the anti-churning rule’s bar on amortization of its lump sum payment under § 197(a).
Thus, the key issue was whether Foreign Subsidiary retained “significant” powers, rights or interest in Brand 2 within the meaning of § 1253(b). As discussed in the § 1253 case law, such as the 1993 Tax Court case Stokely USA v. Commissioner, § 1253(b) was enacted to bring order to the chaos of the Dairy Queen line of cases in distinguishing between sales and licenses of Franchise IP. Under § 1253(b), six enumerated rights are deemed to be per se significant, and result in license treatment. Other rights may be significant depending on the facts and circumstances, as noted in the Stokely decision. Relevant to the LAFA, the Foreign Subsidiary apparently had held back two rights that are per se significant under § 1253(b): rights to prescribe quality control standards for products used and sold and rights to disapprove any assignment of an interest in the Brand.
As noted above, Domestic Parent and Foreign Subsidiary entered into mutual control obligations to use the Brand only in high quality goods and services, use the Brand in a manner that protected its goodwill and value, etc. It is not stated in LAFA what the consequences were for breach of this obligation, or what remedies Foreign Subsidiary could use to enforce its rights. The IRS, however, emphasized that §1253(b)(2)(C) refers to a right to “prescribe” quality control standards. Prescription according to the IRS needed to be a one-way street. The parties’ mutual rights to require each other to maintain high quality standards were not sufficient to cause Foreign Subsidiary to retain significant rights in Brand 2.
The IRS also dismissed the agreement’s apparent requirement that Foreign Subsidiary consent to any assignment of Brand 2 by Domestic Parent because Domestic Parent had similar consent rights over Foreign Subsidiary’s transfer of Brand 3. Again, the mutual control by the parties over each other’s actions was not seen as giving each party a significant retained interest in the Brand.
In short, the IRS concluded that neither of the Foreign Subsidiary’s retained rights was a significant power, right or interest because both parties had mutual rights and obligations. Accordingly, the Foreign Subsidiary did not retain significant rights and the Domestic Parent’s purchase price was not amortizable under § 197.
In the LAFA, the IRS seems to have envisioned § 1253(b) as limited to a classic franchisor-franchisee relationship, where the Franchisor dictates the terms. However, in so doing, the LAFA arguably relies on the same facts and circumstances analysis that § 1253 was intended to override with bright line rules.
Whatever the merits of the IRS and Taxpayer’s respective positions in the LAFA itself, the case nonetheless illustrates the potential role of § 1253 in planning for the proper characterization of IP transfers. While most thought of in the context of classic “franchises,” such as Dairy Queen, § 1253 by its terms also applies to transfers of trademarks and trade names and any “agreement [granting] the right to distribute goods, services or facilities” within a specified area. In one other recent Chief Counsel advice, the IRS argued that § 1253 should apply to a pharmaceutical commercialization agreement.
In the case of a taxpayer selling pre-1993 IP, treatment of a franchise may provide an avenue, with proper planning, to avoid creating “frozen basis” under the anti-churning rules. Conversely, on a sale of trademarks or marketing IP for which a U.S. taxpayer desires capital gains, § 1253 could have the undesirable effect of causing the transfer to result in ordinary income or of causing the IP to become amortizable in the transferee’s hands so that the gain becomes subject to § 1239. Given its potentially broad application, § 1253 should not be overlooked, as one of the many issues that may arise in transferring IP within a related party group.