Copyright (c) 1992 Tax Analysts
Tax Notes
AUGUST 3, 1992
LENGTH: 12147 words
DEPARTMENT: Special Reports (SPR)
CITE: 56 Tax Notes 629
HEADLINE: 56 Tax Notes 629 - THE MASS ASSET RULE REFLECTS INCOME AND AMORTIZATION DOES NOT.
AUTHOR: Johnson, Calvin H.
Tax Analysts
SUMMARY:
Calvin H. Johnson is a Centennial Professor of Law, University of Texas Law School. Professor Johnson has no financial interest in the outcome of Newark Morning Ledger v. United States directly or through clients. Professor Johnson is the author of 'The Expenditures Incurred by the Target Corporation in an Acquisitive Reorganization are Dividends to the Shareholders: (Pssst, Don't Tell the Supreme Court),' 52 Tax Notes 463 (1991) (cited favorably by the Supreme Court, Indopco, Inc. v. Commissioner, 60 USLW 4173, 4174 n.4 (1992), for the need for a strong law of capitalization) and of 'Brief for Amicus Curiae, Taxation With Representation, Thor Power Tool Co. v. Commissioner' (1978) (arguing for the government on the grounds ultimately adopted by the Court that tax need not follow GAAP accounting). The author thanks Professor Wayne Barnett for helpful comments and John Jacks and Russell O'Keefe for invaluable research assistance.
Professor Johnson argues that the Supreme Court should decide Newark Morning Ledger v. United States this term to prohibit the amortization of customer base and similar intangibles. Johnson believes that a customer base is like a leaky bucket of water. Individual customers may trickle out, but customers added to the bucket keep the water level at or above the original level. A well- maintained customer base can be expected to remain intact or expand so long as the business survives, and the customer base here was expanding and not exhausting. When replenishment or replacement of customers is accomplished with deducted expenses, Johnson argues, the mass asset rule, which denies amortization of acquisition costs, clearly reflects income. In his view, amortization does not reflect income, and it reduces the effective rate of tax materially below the statutory tax rate. There is no case, Johnson contends, for reducing the tax rate on corporate acquisitions below the general statutory level. Finally, Johnson argues that treating customer base and similar intangibles as amortizable has led to 'goose stuffing,' that is, abusive overvaluation of the nongoodwill intangibles. He thinks that the taxpayer in Newark Morning Ledger has grossly overvalued the
TEXT:
In its next term in Newark Morning Ledger v. United States, /1/ the Supreme Court must decide whether the acquisition cost of a customer-base intangible may be amortized as individual customers leave and are replaced. Newark Morning Ledger is the successor to a corporation that purchased a chain of Michigan newspapers for $328 million. /2/ The taxpayer allocated $71 million of that cost to existing subscribers to the various newspapers in the chain and amortized the $71 million over the period of time that the existing subscribers could be expected to remain. The district court agreed with the taxpayer, but the Third Circuit held that the intangible was indistinguishable from goodwill and was not amortizable. The Supreme Court took certiorari because of a conflict among the circuits and because it affects billions of dollars of tax revenue. /3/
This report argues that the customer base and similar intangibles are not amortizable. To identify income and reduce it by tax at statutory tax rates, it is necessary that capital be preserved. Costs that are not lost but continue to be investments generating income need to be kept in adjusted basis and not deducted. The mass asset rule, which denies amortization, clearly reflects the investor's income from the acquisitions. By contrast, amortization of the customer base reduces the effective tax rate on the acquirer's investment, typically to about a third of the normal statutory tax rate. /4/
Amortization would amount to a rather dramatic subsidy for corporate acquisitions. In 1986 through 1991, there were a trillion dollars of corporate acquisitions. /5/ According to a sample taken by the General Accounting Office (GAO), acquiring corporations allocated 10 percent of the total cost of acquisitions to customer- or supply-base intangibles. /6/ Corporate acquisitions thus generate $7.8 billion of customer and supply-base intangibles a year. /7/ In the GAO sample, taxpayers claimed a useful life for the intangibles of 8.8 years. Allowing the $7.8 billion investment to be amortized over 8.8 years, when the investment is in fact preserved, would cost the government revenue of $1.66 billion annually. /8/ Congress has shown considerable hostility to corporate acquisitions in recent years in its tax legislation. There is no responsible case for cutting the effective tax rate on acquisitions to a third of the statutory rate nor for devoting $1 2/3 billion in revenue annually by what is basically just an accounting misdescription of the acquisition costs.
This special report first explains the logic of economic depreciation and effective tax rate analysis. It shows why the mass asset rule, which denies amortization of acquisition costs, reflects income and why amortization reduces effective tax rates below the statutory norm. It then explains why generally accepted accounting principles (GAAP) (i.e., nontax financial accounting required for SEC reporting purposes) does not help the tax analysis. GAAP required amortization of goodwill and other intangibles to curb corporate takeovers and it is ironic therefore to cite GAAP treatment so as to subsidize takeovers. The memorandum shows, finally, that the attempt to distinguish customer or supply-base intangibles from nonamortizable goodwill leads to abuses. In this case, for instance, the taxpayer has grossly overvalued the intangible, by an order of 1431 times, with the help of four testifying experts.
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I. THE BURNING BUSH; IDENTIFYING
TRUE INCOME
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The purpose of tax accounting is to identify the taxpayer's income from its investments. Congress has provided that if the taxpayer's method of accounting does not clearly reflect income, taxable income shall be computed in accordance with a method that does clearly reflect income, as determined by the Secretary of the Treasury or his delegate. /9/ The statute, the Court has said, 'reflects an attempt to measure economic income -- not an effort to use the tax law to serve ancillary purposes.' /10/ The Court has, in recent years, consistently thrown out the doctrinal barriers that would impede good tax accounting. /11/ The jurisprudence defining good tax accounting is extensive, and the courts have developed an expertise commensurate with their responsibilities.
In an income tax, investments are made and continued with 'hard money,' that is, post-tax, undeducted amounts. An employee, for instance, deposits only after-tax wages in his saving account and the deposits remain nondeductible so long as they remain in the account and continue to be investments. Within an income tax, the ability to make or continue investments with pretax, deducted, 'soft money' amounts, is a very special privilege. /12/ Deducting investments that still have continuing value reduces the effective rate of tax on the investment to below the congressionally provided statutory tax rate. /13/ At the extreme, deducting investments simultaneous with the investing means that tax does not reduce the investor's return at all so that there is then a zero effective tax rate. /14/ Under 'Samuelson' or economic depreciation, we can identify and tax the real return from an investment only if the remaining investment is continued as undeducted 'hard money' adjusted basis.
Economic depreciation is glorious stuff. Economic depreciation makes the real or effective rate of tax equal to the statutory tax rate that Congress said it intended to apply. Making the effective tax rate equal the statutory tax rate makes the tax system neutral between investments that are subject to an income tax and neutral between taxpayers in different tax brackets. It is because of the logic of economic depreciation that customer-base intangibles are not amortizable.
A. The Glory of the Mass Asset Rule
1. The rationale for the mass asset rule. In Newark Morning Ledger, the taxpayer is a successor to a newspaper that acquired a chain of Michigan newspapers. The taxpayer allocated $71 million of the overall $328 million cost of the acquisition to 460,000 existing subscribers to various newspapers in the chain. Individual subscribers eventually drop off the list as individuals die, move away or just lose interest in the newspaper. Taxpayer's experts determined that in high turnover towns like Ann Arbor, Michigan, any subscriber could be expected to stay on for just over 14.7 years. In low turnover towns like Bay City, Michigan, a subscriber could be expected to stay on for 23 years. The taxpayer amortized the $71 million cost it allocated to the subscribers as a whole over the expected remaining duration of a subscriber.
While individual subscribers in fact dropped off the list, they were replaced by new subscribers. The number of subscribers increased overall and subscription prices went up. Viewed as a whole, the subscriber base did not exhaust or depreciate. The revenues from subscriptions as a whole did not decline or give any indication of ending so long as the newspaper continued publishing. In general, every business firm's customer base survives, so long as the business survives. If we view the customer base as a whole as like a savings account generating interest return, the account still generated interest and it is still an investment so long as the enterprise continues.
A customer base is like a leaky bucket that is constantly being refilled. Water trickles out in drops. But, if new water is constantly added to the bucket, the water level remains constant or even rises. Given a water level that is not dropping, no deduction should be allowed for depreciation or amortization. Capital should be preserved if the investment is in fact intact. We can reach that correct result by looking to the water level in the bucket as a whole: there is no drop in the water level here. Or we can reach the same result by looking to the net of offsetting effects: both old drops are leaking and new drops are being added. The investor as a matter of economics has no net loss. So long as the water level is maintained with expensed costs, the taxpayer has neither a proper reduction in his capital or tax basis nor a deduction for loss of basis.
The costs of replacing or replenishing customers on the subscriber list are expensed when made. Replenishment and replacement costs themselves have value long into the future for so long as the new customers last. They might be identified as capital investments at least in theory. But, there really is no feasible way to determine what proportion of the costs serve the future nor to match them against any future revenue. The primary way to replace or replenish newspaper subscribers is to run a good daily newspaper. In general, customers come because of reputation or word of mouth about the quality of the business. Thus, replenishment occurs largely automatically just because the business is paying its current business expenses. Some large scale advertising or circulation campaign expenditures might be specially identified as being long- term investments in part. But, the identification of the investments to future returns would be sloppy at best. Existing law eliminates the problems by treating advertising and circulation expenditures as current expenses, whatever their status as capital expenditures in theory, /15/ and there has never been any practical suggestion that some of the costs of operating the newspaper might be capitalized.
When customers are replaced or replenished and the costs of replenishment are deducted when made, the proper accounting for the customer base for tax purposes is the mass asset rule. Under the mass asset rule of accounting, a taxpayer's cost of acquiring a subscription base or similar intangible is to allow deduction of the costs of replenishing or replacing the base, but to capitalize the initial cost of the base without amortization. The mass asset rule would not allow the taxpayer to amortize the acquisition cost of the customer base so long as the customer base continues.
Under the mass
asset rule, the courts look at the taxpayer's capital or basis in the customer
base as a whole:
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[A] purchased . . . customer list is
an indivisible
business property with an indefinite,
nondepreciable life.... It
is subject to temporary attrition as well
as expansion through
departure of some customers, acquisition
of others, and increase
or decrease in the requirement of
individual customers. A normal
turnover of customers represents merely
the ebb and flow of a
continuing property status in this
species, and does not within
ordinary limits give rise to the right to
deduct for tax
purposes the loss of individual
customers. The whole is equal to
the sum of its fluctuating parts at any
given time, but each
individual part enjoys no separate
capital standing independent
of the whole, for its disappearance
affect but does not
interrupt or destroy the continued
existence of the whole. /16/
Similarly,
The gradual replacement of old
patrons with new ones is not
to be regarded as the exchange of old
capital assets for new and
different ones, but rather as the process
of keeping a
continually existing capital asset
intact. /17/
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Under the mass asset rule, the newspaper in Newark Morning Ledger acquired not 460,000 separate little capital assets, that were lost and deductible as subscribers dropped off, but rather a single capital asset, a customer base, which continued intact.
Even if we view the taxpayer's capital as separate subscribers, the taxpayer has no loss of capital on net. Any losses the taxpayer has, looking only at the asset customer by customer, are fully replenished or offset as a matter of economics by gains when new customers come in. The mass asset rule can be understood as the sum of two simplifying assumptions. The capital nature of costs to replace new subscribers is ignored and the loss of old subscribers is ignored as well. /18/ Both sides of the trade-off are terrific ideas. We avoid the unfathomable morass of trying to determine how current expenditures benefit future periods and we avoid the silly quagmire of trying to distinguish customer base from nondepreciable goodwill. /19/ The sum of the offsetting errors reaches the right result, which is that the taxpayer's capital is not dropping. When any losses are replenished, in any event, the investor has not lost any capital as a matter of economics and has nothing lost which to deduct.
The mass asset
rule is a living tree. Its roots go back to the first case on subscriptions
lists, reported in the first report of the predecessor to the Tax Court. /20/
The Tax Court has recently extended the mass asset rule to make 'assembled work
force' a nondepreciable asset indistinguishable from goodwill:
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While the assembled work force might
be subject to
temporary attrition as well as expansion
through departure of
some employees and the hiring of others,
it would not be
depleted due to the passage of time or as
a result of use. The
turnover rate of employees represents
merely the ebb and flow of
a continuing work force. An employee's
leaving does not
interrupt or destroy the continuing
existence of the whole. To
the extent the leaving of any employee
reduces the value of the
assembled work force as a whole this
value would be restored by
the hiring of a new employee. /21/
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2. The mass asset rule under effective-tax-rate analysis. When replenishment or replacement of the customer base is expensed when made, the mass asset rule clearly reflects income and depreciation does not. The mass asset rule is 'economic depreciation,' that is, it is the kind of depreciation which identifies economic income and reduces that income by the statutory tax rates. Economic depreciation can be computed by calculus for any assumed or modeled stream of revenue from subscribers. When replenishment of the subscribers is accomplished by tax deductible payments and the revenue stream continues, the economic depreciation needed to reach the statutory tax rate is zero. The depreciation that might be allowed for subscribers who leave is completely offset by the deduction for the costs of the subscribers who replace them. 'When replenishment and replacement is considered for intangibles, it simply converts, in mathematical terms, every intangible asset into a non-depreciating asset.' /22/ Thus, it does not matter mathematically whether existing subscribers stay on for three years or for 14 or 23 years or for 100 years as a matter of fact. When replenishment is expensed, mathematically depreciation drops out of the formula.
Assume, to take a very simplified example, that revenue from customers is $200x per year. Assume that the expenses of getting and keeping customers -- e.g., the costs of running a good newspaper and the costs of advertising and circulation drives -- are $190x, so that the net income from the customers is $10x. Assume that the $10x income goes on indefinitely. /23/ Assume the investor demands 10- percent return, so that the investor would pay $100x for the customer base. /24/ The appropriate way for the acquirer to account for its income from its $100x investment is to depreciate none of its initial $100x acquisition cost. When the replenishment costs are deducted when made but none of the acquisition costs are deducted, that will leave $10x as the taxable income. Imposing tax on the income at 34 percent applied to corporations -- without allowing any reduction of taxable income for depreciation of the purchase price -- will reduce the income to $6.6x after tax. The after-tax income will thus be 6.6 percent of the initial cost, which is the right level implied by a 34-percent tax on 10-percent income. /25/ All investors will find their 10-percent pretax income reduced by their statutory tax rate and none will be preferred or discriminated against by the tax. /26/ With that level of tax, all investors will be indifferent between an investment in a savings account paying 10-percent interest and this business that generates 10-percent interest. Tax will not tilt a level playing field.
By contrast,
allowing amortization of the $100x cost of the customer base understates income
and makes the real or effective rate of tax too low. The effective tax rate
shows how much taxes reduce the taxpayer's income in fact. The effective tax
rate is the difference between the pretax return from the investment and the
posttax return from the investment. /27/ The following Chart 1, which assumes
10-percent pretax discount rates, shows how much below the 34-percent statutory
tax rate the taxpayer's effective tax rate is (vertical axis), assuming that the
taxpayer's cost may be amortized over various numbers of years (horizontal
axis):28
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[CHART 1, 'EFFECTIVE TAX RATE FOR MASS
ASSET FOR VARIOUS
AMORTIZATION PERIODS (34% STATUTORY TAX
RATE, 10% PRETAX
RETURN),' OMITTED]
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Chart 1 starts with an effective tax rate of zero for the cases in which the cost of the intangible is deducted immediately: With expensing immediately, taxes do not reduce the taxpayer's rate of return. /29/ The graph then shows, for example, that a 10-year amortization period yields effective tax rates that are 15 percent for corporate taxpayers who are to pay 34- percent tax rates on their investments. /30/ As amortization periods grow longer, the effective rate rises toward the statutory 34-percent rate, but it is only with infinite lives (that is, no depreciation deductions), that the effective rate will equal the statutory tax rate.
We can also find the effective tax rate for amortization periods in this case. Ann Arbor customers in this case were amortized over 14.7 years, and for that amortization period, the effective rate is 17.4 percent. /31/ The tax rate for the Bay City customers, amortized over 23 years, is at 22 percent and not so low, but it is still very much lower than the 34-percent tax rate that section 11 says Congress intended for corporate investments.
Calculations of
effective rates depend in part on what discount rate is used, and Chart 1 uses
a 10-percent discount rate that assumes some risk. Different discount rates
affect the results a little bit. For instance, corporate investors normally
subject to 34- percent tax can expect only 6.6-percent returns from their fully
taxed investments and they will bid up the price of tax-preferred investments
such as amortizable customer lists. There is a feedback under which the rise in
price drops the pretax return, which in turn drops the effective tax rate.
Chart 2 assumes that after-tax rates of return reach an equilibrium return of
6.6 percent for 34-percent bracket investors:
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[CHART 2, 'EFFECTIVE TAX RATES WITH
AMORTIZATION 10% DISCOUNT
RATE AND EQUILIBRIUM RATE COMPARED,'
OMITTED]
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As Chart 2 shows, the range of discount rates does not matter much here, although effective rate calculations do drop some with the lower 'equilibrium' discount rates.
We can figure out the average impact of amortization as well. According to the GAO, the average life claimed for customer-base intangibles in their sample was 8.8 years. /32/ With 8.8-year amortization, a 34-percent statutory tax rate and a 6.6-percent 'equilibrium' discount rate, the effective tax rate under taxpayer claims averages 11.78 percent. /33/ In sum, allowing amortization of mass assets will drop the effective tax rate to about a third of the 34-percent statutory tax rate that Congress has said was intended.
3. The scope of the mass asset rule.
a. Capitalized replacement. Not all intangibles are appropriately treated under the mass asset rule. The identifying hallmark for the rule is that replenishment occurs with tax- deductible expenditures. If the replacement or replenishment is capitalized and separately depreciated over the period for which it is valuable, then depreciation of the initial acquisition costs does not drop out of the equations for economic depreciation. The initial acquisition cost would then appropriately be deducted as the taxpayer loses its initial capital. Thus, for example, computer software purchased from a vendor is a capital expenditure and it can not be replaced or replenished with tax deductible money. The initial cost of the computer software is thus appropriately deducted as it ceases to be an investment.
Some assets are
specially treated and are in fact amortizable even though replenishment is
expensed. Congress in its sovereign power can mandate bad accounting and low
effective tax rates and Congress has in the past allowed both amortization and
expensing of the replenishment. Before 1986, for example, then section 177 of
the code enabled taxpayers to amortize basis in trademarks or trade names over
a five-year amortization period. The rationale was to give small companies the
tax benefits enjoyed by large companies, who paid for the costs of establishing
trademarks with in-house counsel and in practice deducted all of the costs as
current business expenses. /34/ In 1986 Congress repealed the five-year
amortization saying,
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The possibility that some taxpayers
may fail accurately to
compute nondeductible expenses [is not
adequate] justification
for permitting rapid amortization.
Furthermore to the extent
such mischaracterization
occurs, a five-year amortization
provision only partially
alleviates any unfairness. /35/
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The old section 177 rule for amortization was also repealed because 'there is no basis for a presumption that a trademark or trade name will decline in value' and that a tax subsidy was not appropriate because no case had been made that 'investment in trademarks and trade names produces special social benefits that market forces might inadequately reflect.' /36/ Thus Congress can enact a subsidy by allowing amortization and also expensing of the replacement, as shown by the enactment of old section 177. But, the courts should not on their own initiative allow a subsidy by allowing both expensing and amortization, as shown by the repeal of old section 177.
b. Expectation of systematic decline. The formulas for effective tax rates also do not require that basis be kept constant if the taxpayer's investment or capital is in fact declining. Zero depreciation clearly reflects income only if the customer base is not declining. If the revenues have a finite life, for example, some depreciation deductions should be allowed. If we assume a pattern with constant 'annuity' return, economic depreciation is equal to present value of the most remote annual return, so that if the annuity would go on for some years the economic depreciation will be quite small. /37/ Economic depreciation would also allow the taxpayer a deduction if a fraction of its customer base shrinks. If customer base drops in half, for example, (subscription rates remaining the same), the taxpayer's capital has dropped in half as well, and it would be appropriate to allow deduction of half of basis. If we assume that the taxpayer will expect a return that is just equal to the going interest rate, adjusted for risk, economic depreciation will always make the adjusted basis for customer base equal to the (internal, transaction cost free) fair market value of the base. /38/ Thus, if the customer base declines in value, the adjusted basis computed under economic depreciation declines as well. If the investor abandons the business or customers go away, the remaining basis needs to be deducted.
The mass asset
rule as a legal doctrine allows the taxpayer to deduct its cost if its capital
in fact disappears. If the investor leaves the business, the customers go away
and the purchase price for the base is deductible. /39/ Furthermore, a loss is
allowed if the base is partially worthless:
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[A] going concern can dispose of its
business in a
particular area . . . along with the
incident goodwill without
abandoning its entire business. /40/
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But the needs of administrability restrict deduction of some losses that would be allowed as a matter of effective tax rate theory. Our tax system is based on realized gains or losses. The taxpayer does not expect its investment to decline. A well-maintained customer base will retain its value so long as the firm remains in business. There is no basis for assuming that customer base will decline. Departures from the expectation of indefinite life are then treated as mere market fluctuations, ignored until a realization event. Increases in value of the capital and decreases in value of the capital are not taken into account until they are 'realized.'
The mass asset
rule, under a realized income tax, allow deduction of basis only if some
identifiable segment of overall capital is demonstrably lost:
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It is only when all or a
substantial, identifiable,
vendible portion of the list of customers
is terminated
permanently, either through extraneous
causes or the sudden and
involuntary inability of the owner to
serve them, that a tax
loss may be claimed and then only where
the loss may be
adequately measured. /41/
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It might be possible to amend current law to loosen up realization doctrine some to allow losses that have occurred in the value of customer base, although the losses are not realized. Good economic depreciation theory would allow losses for declines in value. But, under the same theory, the taxpayer should 'recoup' the asset, that is, reverse the loss deductions by having taxable income, if customer base should revive. Under the same theory, the taxpayer should also have taxable income and expanded basis if the customer base expands beyond the initial acquisition cost. If the customer base should triple in our example, the taxpayer should have $300x capitalized basis and taxable income of $200x to get there. The measurement of the loss under the mass asset rule, in any event, depends upon the taxpayer's capital -- that is, his entire customer base -- and not upon loss or replenishment of any one customer in the base. Taxpayer here has seen its customer base expand, not contract. Looking to the value of capital to determine basis, ignoring realization, would be adverse to the taxpayer's interest here.
B. GAAP Income
Since 1970, nontax financial statements prepared for SEC reporting purposes to conform to GAAP must amortize the costs of acquired intangibles, including goodwill, over a period of not more than 40 years. /42/ Most companies use the maximum 40-year period in their published financial statement. /43/ Prior to 1970, GAAP provided that indefinite-life intangibles were not amortized unless there was an event that 'indicates a loss or a limitation on the useful life of the intangible.' /44/ The idea for mandatory amortization over some arbitrary period came from the staff of the SEC and the purpose of the staff proposal was to curb accounting incentives for corporate takeovers that did not make economic sense. /45/ For tax purposes, however, the motives are flipped because it is amortization that gives an incentive to corporate takeovers, whereas the old pre-1970 GAAP rule of nonamortization would do better to curb uneconomic corporate takeovers.
GAAP accounting does not reflect economic income on this issue. A 40-year amortization period for an infinite life asset yields a 25- percent effective tax rate for a taxpayer subject to statutory tax rates of 34 percent. /46/ Amortization over periods of less than 40 years reduces the effective rate even further. A 40-year amortization period comes closer to the congressionally intended statutory tax rate than do shorter periods. But, amortization is still not an appropriate economic norm to guide the tax system.
GAAP accounting
also does not provide a norm to guide the tax system because of the very
different functions of GAAP and tax accounting. The job of the SEC is to
prevent overstatement of income, that is, to control management and prevent
management from ignoring economic losses. /47/ The regulatory problem for tax
is to control management understatement of income, as amortization would do
here. GAAP accounting, consistently, is conservative in ways that are
inappropriate for the tax system. As the Supreme Court said in Thor Power Tool
Co. v. Commissioner, /48/
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Consistent with its goals and
responsibilities, financial
accounting has as its foundation the
principle of conservatism,
with its corollary that 'possible errors
in measurement [should]
be in the direction of understatement
rather than overstatement
of net income and net assets.' In view of
the Treasury's
markedly different goals and
responsibilities, understatement of
income is not destined to be a guiding
light. /49/
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Tax accounting is too important to be left to the accountants.
GAAP accounting, finally, has in recent years shown no loyalty to maintaining assets on the balance sheet which accurately reflect the investment of the firm. Under GAAP, the income statement is considered to be more important than the balance sheet. /50/ Goodwill is deemed to be of no importance as an asset on the balance sheet because accountants view intangibles with suspicion and because they compute value primarily by finding the present value of reported income. /51/ To identify taxable income as a matter of economics, however, it is necessary to identify the investment as well as the income. In an income tax, investments are made and continued with 'hard' undeducted amounts. /52/ It is possible to identify and tax the income from investments, at statutory tax rates, only by keeping adjusted basis up to the amount of the taxpayer's real investment. Thus, GAAP's lack of effort to make the balance sheet reflect the real investment in the firm means that it cannot here lead the tax system.
C. Amortization Does Not Reflect Income
By count of the cases, the majority rule is that no amortization or depreciation is allowed for customer- or supply-base intangibles. /53/ But there is a competing line of cases, a 'minority strand,' /54/ that allows customer base to be depreciated as individual customers leave the list, even though there is no shrinkage of the customer base as a whole. Under that competing line, the taxpayer must only show sophisticated proof that the individual subscribers are identifiable apart from goodwill as a whole. /55/ The taxpayer in Newark Morning Ledger hired four sophisticated experts who were able to convince the trial court that sufficient proof had been offered to justify amortization, subscriber by subscriber. /56/ The Third Circuit reversed the trial court, finding that the customer base is embedded in and part of nondepreciable goodwill as a matter of law, notwithstanding the taxpayer's proof of the separate value of the subscriber base. /57/ It is the Third Circuit's decision, in favor of the government, which the Supreme Court took certiorari on.
Amortization of the acquisition cost of customer base as individual customers leave does not reflect income, even when the taxpayer can prove a segregated value for the customer base apart from goodwill. As noted, when the taxpayer is replenishing customers with tax-deductible expenditures and when the customer base as a whole is not declining, amortization does not identify the taxpayer's pretax return nor reduce it by the statutory tax rates. With an amortization period of 14.7 years used for the Ann Arbor subscribers, the effective tax rate on the purchase of the customer list became 17.4 percent. /58/ With an amortization period of 23 years used for Bay City subscribers, the effective tax rate is 19.7 percent. /59/ For both cases the statutory rate is supposed to be a 34-percent tax rate.
There is no viable justification for a preferential rate on corporate acquisitions while other investments are subject to 34- percent statutory rates. Congress has in recent years shown considerable hostility to corporate acquisitions and it has been willing to impose significant tax 'impediments' on corporate acquisitions. /60/ But the argument here is not for a penalty on corporate acquisitions, but rather for a level playing field in which tax on corporate acquisitions is brought up to the statutory norm. Reduction of the effective tax rate on acquisitions of customer intangibles, by allowing amortization of the costs, would change from Congress' traditional body-English spin against acquisition investments to a kick in the pants in favor of acquisition investments.
There are advocates of a consumption tax, which is a zero tax rate on all investment returns, and they have argued for a low tax on anything including acquisition of intangibles. /61/ Congress has, however, directed the courts toward a comprehensive income tax, from whatever source derived. /62/ A major purpose of advocates of consumption tax, moreover, is to create tax neutrality between investments, /63/ and neutrality is not served by having a preferentially low or zero tax within what is generally a comprehensive tax on investment income at statutory rates.
Some economists have worried that a full tax rate on acquired intangibles will freeze sales of intangibles. Expenditures that build customer base internally are expensed for tax purposes, even if they are really capital investments economically. As noted, the ability to make investments with tax-deductible 'soft money' is equivalent under ordinary circumstances to a zero tax on investment returns. /64/ That means that there is a discrimination between internally created customer base, taxed at zero tax rates, and acquired customer base, which should be taxed at statutory rates. Some economists have worried about the discrimination and its effects in suppressing acquisitions. /65/ But the phenomenon is the same for unrealized appreciation, for instance, on raw land. Capital that is unrealized appreciation is not taxed, but sale of land is taxed and land must be acquired with 'hard-money' capitalized after-tax capital. A court cannot allow the purchase price of land to be deducted or amortized to catch up with unrealized appreciation. /66/ Within what is generally an income tax, Congress should not use soft money investing in other cases as a justification to lower or forgo tax on sold capital. /67/
If we extend the rationale of the minority strand to all investments, anything is a depreciable asset. Take a look at crop land. The minority strand that allows customer base to be amortized as customers leave looks at each customer as a separate capital asset. The minority strand, moreover, ignores the replacement customers that in fact leave the investor whole. Apply that rationale to land. The land can be looked at as just the summation of a series of individual harvests. We could allocate the cost of the land as a whole among the harvests and allow the taxpayer to deduct the allocated cost at the end of the year after each harvest goes by. Land then would be depreciable and it would be depreciable under an accelerated depreciation schedule which is faster than straight line. /68/ In fact, the only reason that the taxpayer in Newark Morning Ledger did not take an accelerated schedule was because the taxpayer was not aggressive enough or didn't think of it. /69/ As a matter of economics, land is not depreciable. After each harvest goes by, the infinite stream of harvests yet to come is closer and leaves the owner with the same indefinite stream of harvests and without any economic loss. /70/ Land is a 'mass asset' of harvests under current law which holds its value although individual harvests have passed. Under current law, land is nondepreciable and rents are income in full, without offset for depreciation. /71/
Same thing with a savings account. As a matter of economics and common sense, a savings account is capital that remains intact as capital so long as the money is not withdrawn. But, under the minority strand, we will need to look at savings accounts, interest withdrawal by interest withdrawal and allocate basis -- the cash amount initially deposited -- among the interest payments withdrawn. Thus the withdrawal of interest would be the occasion to depreciate the initial and still intact deposit. Same thing with corporate stock. Each dividend distribution would be the occasion for the use of the taxpayers' initial cost of the corporate stock. (Cf. contra, the statute, IRC section 301(c), wherein Congress would disallow use of the shareholder's basis if the corporation had earnings and profits.) It is a weird concept of income, inconsistent with our common sense notions of income. It treats amounts as recovery of capital when the capital has in fact not been lost. But, if one insists on looking at capital customer by customer, harvest by harvest or dividend by dividend, the minority strand mandates rapid depreciation. /72/
As a matter of economics, the mass asset rule does have limitations to its scope. If the customer base could be presumed to shrink as a systematic matter or the replenishment of the base were capitalized, then the acquisition cost would appropriately be amortizable. But economic depreciation and effective rate analysis places limits and distinctions on the mass asset rule that are different from the distinction drawn by the minority strand. The minority strand looks at the asset in subdivided pieces and ignores the replacement of the pieces, provided that the taxpayer has sophisticated proof that the customer base varies from goodwill.
The choice
between the majority rule, which makes customer base a nondepreciable mass
asset, and the minority strand, amortization, has a clear right answer. This is
not an issue to be decided by the ordinary legal process of analogy and
distinction. The majority rule is right because it reflects income and the
minority strand is wrong because it does not. Economic depreciation and the
logic of effective tax rate analysis is the 'burning bush' through which
speaketh the Word of the Lord. /73/ The resolution resides in the Calculus. As
Alexander Pope said about the founder of the Calculus,
________________________________________________________________________________
Nature and Nature's Laws lay hid
in Night
God said, Let Newton be, and all
was light. /74/
________________________________________________________________________________
________________________________________________________________________________
II. 'SOPHISTICATED
PROOF' LEADS TO
GROSS OVERVALUATION
________________________________________________________________________________
As a matter of economics and theory, customer basis is indistinguishable from goodwill. Goodwill is nondepreciable /75/ and under the mass asset rule, customer base is nondepreciable as well. But the minority strand has given corporate acquirers a reasonable basis upon which to claim amortization on their tax returns and taxpayers have responded by allocating their purchase price away from nonamortizable goodwill and to intangible assets with a short claimed life instead. The game is coloquially called 'pigeon hole stuffing' or 'goose stuffing.' Every category that might have a short life is valued as highly as the market can bear and when that intangible is full another one is invented. /76/ On their tax returns, the game has meant that taxpayers have large extinguished goodwill. In the GAO sample, 75 percent of the costs of corporate acquisitions in excess of specific assets were allocated to amortizable intangibles and 25 percent of the costs are left as goodwill. /77/ There is no adverse party to these valuations -- the seller does not care /78/ -- so that valuation is a private matter between taxpayer and its appraiser. Pigeon hole or goose stuffing often amounts to fraud or gross overvaluation, as illustrated by this case.
The minority strand allows amortization of customer base if the taxpayer presents sophisticated proof that the intangible is separable from goodwill. Here, the taxpayer presented four sophisticated experts who managed to convince the district court that the intangibles were severable from goodwill and that the taxpayer had paid $71 million dollars for the customers. The taxpayer's experts ran circles around a not-very-well-represented government. But, in the end, the system of sophisticated proof came up with an indefensible principle that computed the net present value of gross receipts, ignoring all the costs of running a newspaper that it would take to keep the receipts coming. In the end, the $71 million is on the order of 1431 times the true fair market value of the base. Section 6662(h) imposes a 40-percent penalty on 'gross valuation misstatements,' defined as overvaluations of over four times the value finally determined. The taxpayer's valuation is four to five times larger than a gross valuation overstatement.
Taxpayer's experts determined the value of the customer base by determining a present value for the revenues from the subscribers, less only the modest cost of collection. An investor pays only for income, net of costs, and does not pay for revenue that the investor must lose to expenses. Taxpayer claimed that the net present value of revenues is a respected valuation technique. It is the net present value of net income after subtraction of all costs that is the legitimate theory; net present value of revenues is nonsense.
For newspapers, there is a not unsubtle difference between revenues and net income. In 1991 the newspaper industry reported net profit margins of 3.3 percent and since 1988, profit margins have varied from 3.3 to 7.8 percent. /79/ On the basis of those figures, an investor buying into the newspaper industry can thus expect net or income to be between 3.2 and 7.2 percent of the revenues. /80/ On the basis of most recent past experience, revenues would be between 14 and 31 times the net income from the newspaper business that a real investor would pay for. /81/ Newspapers are fun to own and operate. They provide a voice and influence, so that the profit from the newspaper industry tends to be extraordinarily low. In recent years, the newspaper industry has been very weak because the industry as a whole has declined relative to newer media.
The taxpayer's valuation method allocates all of the cost of running a newspaper away from the subscriber revenue and onto the other sources of newspaper revenue, that is, advertising and newsstand sales. There is no merit to the allocation. In the newspaper business, readers are sought so as to generate advertising revenue. More readers automatically justify higher charges to advertisers. Reader revenue and advertising revenue go together like love and marriage, and there is no feasible basis upon which to separate the two for the purpose of allocating the cost of running the newspaper. The dollars from readers and from advertisers are all fungible and equally valuable. In absence of any other rational basis, the costs of running the newspaper have to be allocated pro rata to the overall profit margins and that means that income is 14 to 31 times less than taxpayer claimed. The IRS at trial offered proof that it was possible to reproduce the 340,000 subscribers by expenditures, for instance, for advertising and circulation drives of $3 million. One might wonder still why any buyer would pay more for a customer base than the cost of achieving the base by some other means. The $3 million cost of reproducing the base is of the value determined by looking at revenue and it is thus within the reasonable range of what a real net present value of net income would be.
Subscribers are not free, as taxpayer's allocation method claims. You have to provide them a newspaper to get them to pay their subscription bills, and newspapers are expensive operations. The marginal cost of a newspaper goes up as readers go up. You have to pay for newsprint, for instance, and the marginal cost of newsprint alone commonly exceeds the subscriber fee. Moreover, the syndicated columnists and comics charge more in steps as readership goes up. Finally, you have to cover a town of 50 subscribers with one reporter (part time); if readership goes up you can hire another reporter or two. The marginal costs of a newspaper go up as subscribers go up. It is only by running a newspaper that you get the subscriber revenue. The costs cause the income.
If there is any departure from overall profit margins to determine the cost of subscription agreements, it is clear that the subscriptions need to bear more of the costs, not less. Newspapers traditionally sell the newspapers at a loss to attract readers which in turn attract advertisers. /82/ Certainly, the costs of running the newspaper have to be absorbed somewhere. If your customers do not cover your costs, the tooth fairy will not. Taxpayer's method of allocation ignored all the newspaper costs of getting the subscriber revenue. The taxpayer has indulged in some goose stuffing, grossly overvaluing the asset claimed to be depreciable so as to avoid costs being allocated to nondepreciable goodwill. It is now time to cook the goose.
The taxpayer added insult to injury by adding a final $3 million dollars of overvaluation under a method of allocation sometimes called 'second tier' allocations. The theory of 'second tier' allocation was that taxpayers overpaid for all the assets and that the overpayment must be allocated among the parts according to the relative fair market value of the parts. Thus the taxpayer's [gross over-] valuation of the subscriber list was $68 million, but the taxpayer raised its basis in the list to $71 million by allocating $3 million of its 'overpayment' to the list. /83/
In the Tax Reform Act of 1986, Congress banned the 'second tier' allocation method and mandated the 'residual method of allocation.' /84/ Even before 1986, the weight of authority was running strongly in favor of the residual method. /85/ The residual method treats the purchase price for the newspaper chain that is greater than the value of any specific assets as goodwill.
The 'second tier' allocation method of accounting fails to reflect income here and the residual method clearly reflects income. The taxpayer did not pay more for the subscribers than they were worth. No rational corporation, such as the taxpayer, overpays for assets when bargaining at arm's length. Fair market value is by definition what is paid for the property at arm's length. What has happened here is that the taxpayer has allocated to specific assets, claimed to be depreciable, amounts that are in fact costs of purchasing the whole business in excess of specific assets, that is, costs of going concern or additional goodwill, which are nondepreciable. Every viable business has a going-concern value in excess of the value of its specific assets. Every business is a network that reproduces itself and grows and processes supplies or services to make revenue. The value of the minerals in a human being is only 75 cents. Similarly, the value of a business as a going concern is usually far more that the sum of the value of the separate assets. The taxpayer has shown no evidence that it paid more for individual parts than they are worth. /86/ The extra payment taxpayer made, over the sum of the parts, was goodwill or going-concern value, which is not depreciable.
The taxpayer's allocations show the folly of trying to distinguish intangibles such as customer base from nondepreciable goodwill. In good theory, there is no distinction between the tax treatment of goodwill and that of mass assets such as customer base. Both are nondepreciable. So the 'sophisticated' proof by taxpayer's four experts went to prove a distinction that does not exist in good theory. Our system is basically a self-assessing system and less than one percent of tax returns are audited. It cannot handle sophisticated proofs that lead to abuses like this. If such gross overvaluations are presented to the Supreme Court by serious professionals, then the valuations proving severability from goodwill as claimed on a tax return are limited only by the clear blue sky.
________________________________________________________________________________
III.
CONCLUSION
________________________________________________________________________________
To clearly reflect income from a corporate acquisition, the costs of acquiring customer base and similar intangibles are not amortizable. Under the mass asset rule, the costs of replenishing or maintaining a customer base are deducted when incurred, but the costs of acquiring the customers in a corporate acquisition are preserved in capital and neither deducted nor depreciated. The mass asset rule accurately reflects income. When replenishment or replacement of customers is made with tax-deducted amounts, depreciation drops out of the formulas for effective tax rate. Customer base is like a leaky bucket; so long as water dripping into a bucket maintains the water level, the taxpayer has not lost his investment. Customer base is indistinguishable in theory from goodwill. Both are nondepreciable assets. Taxpayer allocations here abusively overvalue the customer base because it was claimed to be depreciable. The allocations overstuff the depreciable assets by 14-31 times so as to avoid allocation of the costs to nondepreciable goodwill.
Allowing customer base to be amortized reduces the effective tax rate on the acquirer's investment materially below the statutory rate normally applied to corporations. There is no responsible case to be made for reducing the effective tax rate on the acquisition below normal rates. Allowing amortization would lose revenue, on the order of $1 billion a year, just because of an accounting misdescription.
________________________________________________________________________________
FOOTNOTES
________________________________________________________________________________
/1/ 736 F.Supp. 176 (D. N.J. 1990) rev'd 945 F.2d 555 (3d Cir. 1991) cert. granted 60 U.S.L.W. 3687 (April 7, 1992).
/2/ For purposes of this paper, the term 'taxpayer' will refer to both to the Herald Corporation, the acquiring corporation that did the initial allocations, and to its successor, Newark Morning Ledger, the surviving corporation into which Herald merged. Newark Morning Ledger is now claiming the benefit of the amortization and is the petitioner and appellant in the litigation.
/3/ Petitioner's Brief on Writ of Certiorari, Newark Morning Ledger Co. v. United States at 26 (January 13, 1992) (Robert H. Bork, first signatory)
/4/ See infra note 33 and accompanying text (effective tax rate for average life claimed by taxpayers is 11.78 percent, where the statutory tax rate is 34 percent.)
/5/ According to Merrill-Lynch, Business Brokerage and Valuation Division, there were $986 billion of mergers and acquisitions in 1986-1991, for an average of $164 billion a year. (Press releases of 1/21/92, 1/24/91, 1/22/90, 2/8/88). Of those, 46 percent or $164 billion were cash acquisitions; 54 percent were acquisitions with stock or with a mixture of stock and cash.
/6/ According to the GAO, taxpayers allocated 23 percent of the cost of corporate acquisitions to intangibles other than goodwill and 45 percent of that to customer or supply base intangibles. U.S. General Accounting Office, Tax Policy: Issues and Policy Proposals Regarding Tax Treatment of Intangible Assets 24 (Aug 1991). Twenty- three percent of 45 percent is 10.35 percent. The GAO data is from a sample of taxpayer claims in the IRS appeals office and there is no way to tell if the sample is more or less aggressive than taxpayers in general. Taxpayers in IRS Examinations and in Litigation, however, are slightly more aggressive than those in Appeals, judging from useful-life claims. Id. at 25, Table 3.4.
/7/ 10.23 percent of $75.5 billion is $7.8 billion. The $7.8 billion figure is likely to be conservative because some intangible acquisition costs will arise in the 54 percent of acquisitions involving some stock.
/8/ $7.8 billion of new intangibles per year, deducted from the 34-percent corporate rate and amortized over 8.8 years yields an annual deduction of $7.8 bil. X 34 percent X 1/8.8 or $302 million a year. The present value of an 8.8-year, $302 million annuity is $1.66 billion. The discount rate used here is the government's pretax cost of borrowing at 7.7 percent. (Applicable long term federal tax rate is 7.73 percent for July 1992. Rev. Rul. 92-50, IR 92-70 (June 18, 1992). The discount rate used is a bit high because the government should collect some tax on interest, offsetting its pretax interest costs. A lower discount rate would raise the present value estimates of the annual impact of customer-base intangibles.
/9/ IRC section 446(b)
/10/ Portland Golf Club v. Commissioner, 497 U.S. 154, 182 (1990)
/11/ Indopco, Inc. v. Commissioner, 112 S. Ct. 1039 (1992) (no 'separate and distinct asset' needed to capitalize an investment expenditure); Hillsboro National Bank Co. v. United States, 460 U.S. 370, 392 (1983) (O'Connor, J.) (no 'recovery' needed for the tax benefit rule to reverse a prior, now inappropriate deduction into income); Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979) (Nontax 'GAAP' accounting did not prevent adoption of sound rule to prevent abusive inventory write-downs).
/12/ Johnson, 'Soft Money Investing Under the Income Tax,' 1989 Ill. L. Rev. 1019, 1039-1053 (1990).
/13/ The basic equations are Samuelson's and they are a worthy part of the reason for his Nobel Prize in economics. Samuelson, 'Tax Deductibility of Economic Depreciation to Insure Invariant Valuations,' 72 J. Pol. Econ. 604 (1964), is the pioneering article. See also Warren, 'Accelerated Capital Recovery, Debt, and Tax Arbitrage,' 38 Tax Law. 549 (1985); Johnson, 'Soft Money Investing Under the Income Tax,' 1989 Ill. L. Rev. 1019, 1039-1053 (1990); Gann, 'Neutral Taxation of Capital Income: An Achievable Goal?' 48 Law & Contemp. Probs. 77, 108-13 (1985) for lawyer's explanations of economic depreciation.
/14/ Cary Brown, 'Business-Income Taxation and Investment Incentives,' in Income, Employment and Public Policy: Essays in Honor of Alvin H. Hanson 300 (1948) (Hence 'Cary Brown thesis'). Good explanations of the thesis and its scope include Dep't of the Treasury, Blueprints for Basic Tax Reform 12324 (1977); Andrews, 'A Consumption-Type or Cash Flow Personal Income Tax,' 87 Harv. L. Rev. 1113, 112328 (1974); Surrey, 'The Tax Reform Act of 1969 -- Tax Deferral and Tax Shelters,' 12 B.C. Indus. & Com. L. Rev. 307 (1971).
/15/ See, e.g., 1 Bittker and Lokken, Federal Taxation of Income, Estates and Gifts para. 20.4.5 (advertising), para. 26.4.6 (circulation expenses) (2d ed. 1989). Sponsors of what is now IRC section 173 (allowing immediate deduction of expenditures to increase circulations) argued that they allowed the expensing of the costs to eliminate problems. 96 Cong. Rec. 13276, 15586 (1950) See Florida Publishing Co. v. Commissioner, 64 T.C. 269, 277 (1975) aff'd. by unpublished opinion (5th Cir. 1977) (explaining legislative history of IRC section 173).
/16/ Golden State Towel and Linen Service, Ltd. v. United States, 373 F.2d 938, 944 (Ct. Cl. 1967)
/17/ Boe v. Commissioner, 307 F.2d 339, 343 (9th Cir. 1962)
/18/ William Popkin, Introduction to Federal Income Taxation 416-417 (1987) articulates the nonamortizable nature of intangibles in terms of the trade-off of treatment of acquisition and replacement costs.
/19/ See Rev. Rul. 74-456, 1974-2 C.B. 65 (customer base can be segregated from goodwill only in very unusual cases).
/20/ Danville Press, Inc. v. Commissioner, 1 B.T.A. 1171 (1925) (no deduction allowed upon fluctuation of the customer list).
/21/ Ithaca Industry Inc. v. Commissioner, 97 T.C. 253, 267 (1991). Moreover the Tax Court said, 'employment relationship [with each employee] will terminate at the latest upon the death of the employee . . . ,' but that this does not mean the assembled work force as a whole had a limited life, because 'each employee is not a separate asset independent of the whole.'
/22/ Jane Gravelle and Jack Taylor (Congressional Research Service of Library of Congress), 'Tax Neutrality and the Tax Treatment of Purchased Intangibles,' 40 Nat. Tax J. 77, 84 (March 1992)
/23/ The assumption that revenue goes on indefinitely does not mean that the revenue must be infinite because the value of distant amounts is not material. For instance, the sum of all the cash received after 25 years from an annuity is under 10 cents: At 10- percent discount rates, 90.8 percent of the value of an annuity is reflected by the first 25-years' worth of payments. Thus the fact that all business will die eventually does not materially undercut the simplifying assumption that the revenue is infinite.
/24/ If an investor has alternative investments that give return rate 'd,' the investor will pay for an infinite stream of annual income 'A.' With A at $10x and d at 10 percent, is $100x.
/25/ The Internal Rate of Return from an investment is the after-discount rate (after tax interest or 'i' here) that will make the present value of the returns equal to the present value of the costs. For this investment, i is the rate that satisfies the following equation, where 't' is the tax rate imposed on annual net income (A) from the investment:
[FORMULA OMITTED]
The first term on the right side of the equation represents the $100x outlay for the investment and is derived by calculus (series analysis) from an assumed infinite stream of amounts A. The second term represents the discounted present value of all the amounts A of taxable income per year, discounted at an (unknown) after-tax discount rate. The final term represents tax at tax rate t on those As. Note that no depreciation of purchase price * is allowed in the equation to compute taxable income A. The point of the exercise is to find the rate i that will make the present value of returns equal present value of costs, and that will tell us what the real return rate is from the investment after tax.
* [CHARACTER NOT REPRODUCIBLE]
Solving (1) for i,
(2) i = (1-t) (d), proving that under the assumptions, the regime without depreciation reduces the pretax return d by tax rate t.
/26/ The formulas in supra note 25 work for any tax rate t.
/27/ The effective tax rate is the difference between pretax compound return from the gain property and post-tax compound return from the property, divided by the pretax return, that is,
________________________________________________________________________________
(d-i)/d ,
________________________________________________________________________________
where 'd' is the pretax annual return from the investment and 'i' is the after tax annual return from the investment. Bradford & Stuart, 'Issues in the Measurement and Interpretation of Effective Tax Rates,' 39 Nat'l. Tax J. 307, 308 (1986); Fullerton, 'Which Effective Tax Rate?' 37 Nat'l. Tax J. 23, 27 (1986).
/28/ The post-tax internal return,'i,' from the investment is the rate that will solve the following equation:
[FORMULA OMITTED]
The first three terms on the right of the equation represent the purchase price, the present value of the pretax income, and the present value tax on income, as explained supra note 25. The final term represents the present value of amortization of purchase price, *, over period n. Only * of * may be deducted per year and that deduction saves tax at rate t (34 percent here). The bracketed term is the standard formula for the present value of an annuity of tax savings * for n years. The formula cannot be solved by algebra; it takes trial and error attempts (done by computer nowadays) to find the right i. Once i, the after-tax rate, is found, the effective tax rate is the difference between pretax and posttax divided by pretax (supra, note 27).
* [CHARACTERS NOT REPRODUCIBLE]
/29/ This is just the 'Cary Brown thesis,' see supra note 14.
/30/ IRC section 11 provides for a 34-percent rate for corporations with taxable income of over $75,000.
/31/ Assuming a pretax return (d) of 10 percent and amortization period n of 14.7, the posttax return that makes the net present value of the investment equal to zero (i in the formula in supra note 28) is 8.26 percent for an effective tax rate of 17.4 percent of the pretax return.
/32/ U.S. General Accounting Office, supra note 6, at 25 Table 3.4
/33/ Assuming a posttax return (i) of 6.6 percent and amortization period n of 8.8, the pretax return that makes the net present value of the investment equal to zero (d in the formula in supra note 28) is 7.48 percent for an effective tax rate (i.e., (di)/i) of 11.78 percent of the pretax return.
/34/ S. Rep. No. 1941, 84th Cong., 2d Sess., 1956-2 C.B. 1227, 1232.
/35/ Staff of the Joint Comm. on Tax., General Explanation of the Tax Reform Act of 1986 at 143 (Comm. Print 1987)
/36/ Id.
/37/ See, e.g. Johnson, supra note 12 at 1042-1050 for the logic. The economic depreciation for an annuity is like repayments of principal on a house mortgage and principal repayments can be a very small percentage. If customer base is to continue as a constant annuity for 50 years, the depreciation in the first year is less than 8/10ths of 1 percent of the annual revenue, using 10-percent discount rate.
/38/ Fellows, 'A Comprehensive Attack on Tax Deferral,' 88 Mich. L. Rev. 722, 730 (1990).
/39/ McCrory Corp. v. United States, 651 F.2d 828, 833-834 (2d Cir. 1981) (basis allocated to goodwill can be deducted when acquired businesses were abandoned); Misegades v. Commissioner, 53 T.C. 477, 486 (1969) (goodwill of purchased solo law practice may be deducted upon retirement or death of the lawyer).
/40/ Skilken v. Commissioner, 420 F.2d. 266, 269 (6th Cir. 1969); Metropolitan Laundry Co. v. United States, 100 F. Supp. 803, 806 (D. Calif. 1951).
/41/ Golden State Towel and Linen Service, Ltd. v. United States, 373 F.2d 938, 944 (Ct. Cl. 1967)
/42/ AICPA Accounting Principles Board, Opinion No. 17, Intangible Assets para. 9 (1970).
/43/ AICPA, Accounting Trends and Techniques 174 (45th ed. 1991) (In a sample of SEC reporting companies, half (195/ 399) reported using lives of 40 years and another 21 percent reported using lives 'not to exceed 40 years.' 6.8 percent reported lives of 2030 years; four percent reported lives of 1020 years. The remaining 22 percent reported 'other' or amortization over the legal or estimated life.)
/44/ AICPA, Accounting Research Bulletin No. 43, ch. 5, para. 9 (1953)
/45/ However, Budge (SEC Commissioner), 'Accounting Questions in Corporate Acquisitions,' Security Market Agencies, Hearings Before the Subcomm. on Commerce & Finance, H. Interstate & Foreign Commerce Comm., 91st Cong., 1st Sess. at 18 (Feb. 25, 1969) APB Opinion No. 17 was proposed and considered in tandem with APB Opinion No. 16, which severely limited use of the advantageous 'pooling' method for accounting for corporate acquisitions. The SEC staff in Opinion No. 17 wanted a 33-year life for amortization, the AICPA on behalf of clients wanted a 50-year life and the 40-year life chosen in Opinion No. 17 is an arbitrary compromise, about midway between the two. See also infra note 47 (SEC staff had informal practice of demanding amortization in years before Opinion No. 17).
/46/ Assuming a posttax return (i) of 6.6 percent and assuming amortization period n is 40 years, the formula, in supra note 28, generates an effective tax rate of 25.1 percent.
/47/ See, e.g., Rappaport, SEC Accounting Practice and Procedure 335, 710 (3d ed. 1972). (SEC had for a number of years before Opinion No. 17 taken the informal position that intangibles had to be written off, because intangible assets sometimes masked deteriorating profits.)
/48/ 439 U.S. 522 (1979).
/49/ Id. at 542.
/50/ See, e.g., AICPA, Accounting Principles Board Statement No. 4 para. 12 (1970) (income statement is most important statement provided by financial accounting); Stephen Gilman, 'Accounting Concepts of Profit' ch. 3 (1939).
/51/ Homer Kripke, 'A Good Look at Goodwill in Corporate Acquisitions,' Banking L. J. 10351036 (Dec. 1961).
/52/ Johnson, 'Soft Money Investing,' supra note 12, at 1019.
/53/ The IRS has won 83 out of 123 litigated cases. New York State Bar Association Tax Section, 'Report on Proposed Legislation on Amortizable Intangibles (H.R. 3035),' 52 Tax Notes 943, 946 (1991). The report argues that the statistic is misleading primarily because since Houston Chronicle (1973), the outcome 'has rested to a large degree on the sophistication of the taxpayer's proof.' For a criticism of resting the outcome on 'the sophistication of the proof' see text accompanying infra notes 7686. Other collections of cases consistently report that the government wins most of the cases. 'Annotation: Subscription, Mailing, and Customer Lists, Acquired by Taxpayer, as Amortizable Intangible Capital Assets Under 26 USCS section 167(a),' 24 ALR Fed 754 (1975); 23A Mertens, Law of Federal Income Taxation sections 23A.132133 (1990).
/54/ Newark Morning Ledger Co. v. United States, 945 F.2d at 565
/55/ See, e.g., Citizens & Southern Corp. v. Commissioner, 91 T.C. 463 (1988) aff'd, 919 F.2d 1492 (11th Cir. 1990) (per curiam) (amortization of depositors); Donrey Inc v. United States, 809 F.2d 534 (8th Cir. 1987); Houston Chronicle v. United States, 481 F. 2d 1240 (5th Cir. 1973) cert. denied 414 U.S. 1129 (1974). But see Rev. Rul. 74-456, 1974-2 C.B. 65 (customer base may be segregated from goodwill only in very unusual cases).
/56/ 734 F.Supp. 176, 179-183.
/57/ Newark Morning Ledger Co. v. United States, 945 F.2d 555 (3d Cir. 1991).
/58/ See text accompanying supra note 31.
/59/ See text accompanying supra note 31.
/60/ Congress has enacted at least five major tax penalties on corporate acquisitions in recent years: (1) IRC section 5881 (anti- 'greenmail' provisions), added in 1987, imposes a 50-percent penalty that prevents a corporate raider from making his profit by selling back a fractional interest in the target corporation to the target. See Ginsburg & Levin, 4 Mergers, Acquisitions and Leveraged Buyouts para. 1317 (1991). (2) IRC section 163(e) (5)&(i), added in 1989, defers and then disallows accrued but unpaid interest in leveraged buyouts if the interest rate is above threshold rates. (See Sheppard, 'Conference Committee Goes After the Junk Bond Junkies,' 45 Tax Notes 1042 (Nov. 27, 1989). (3) IRC sections 280G, 4999 (anti-golden parachute provisions), added in 1984, penalize management that pays itself a large severance pay that might induce it to go along with an acquisition. (4) IRC section 172(b) (1) (E)&(h) prevents interest incurred in a leveraged buyout from providing Net Operating Loss carrybacks, and (5) IRC section 279 (acquisition indebtedness) is a holdover from a prior generation (enacted in 1969), but it still prevents the deduction of interest incurred to acquire another corporation.
The IRS has shown itself to be quite partial to the defense in corporate takeovers by allowing potential targets to issue 'poison pills' without tax. Poison pills are bargain stock options issued to existing shareholders, contingent on a take-over threat, which dilute the raider's interest. Rev. Rul. 90-11, 1990-1 C.B. 10. Lowering the tax rate on corporate acquisitions would be partial to the offense
/61/ See, e.g., Ture and Bonilla (IRET), 'Testimony and Statement, Unofficial Transcript of Ways and Means Committee Hearing on Intangible Bill,' 91 TNT 226-46 (Lexis electronic edition November 4, 1991). See also Durst, 'The Depreciation Debate: Have Bulow and Summers Suggested a Viable Compromise?' 30 Tax Notes 259, 259 (1986) (consumption tax advocates believe that tax at any rate on investment income is too high.)
/62/ Commissioner v. Glenshaw Glass, 348 U.S. 426, 429 (1955)
/63/ See, e.g., Hall & Jorgenson, 'Application of the Theory of Optimal Capital Accumulation' in Tax Incentives and Capital Spending (G. Fromm, ed. 1971) (zero effective tax on investment return is neutral if pretax interest rates are fixed).
/64/ See text accompanying supra note 14.
/65/ Jane Gravelle and Jack Taylor (Congressional Research Service of Library of Congress), 'Tax Neutrality and the Tax Treatment of Purchased Intangibles,' 40 Nat. Tax J. 77 (March 1992)
/66/ Cf. Merchants' Loan & Trust Co. v. Smietanka, 255 U.S. 509 (1921) (appreciation is not 'capital' constitutionally immune from an 'income' tax when the appreciated asset is in fact sold).
/67/ Cf. Staff of the Joint Comm. on Tax., General Explanation of the Tax Reform Act of 1986 at 143 (Comm. Print 1987) quoted in text accompanying, supra, notes 35 & 36. (Other taxpayers' preferences do not justify amortization.)
/68/ Douglas Kahn, Letter to the Editor, 53 Tax Notes 858 (1991); Douglas Kahn, 'Accelerated Depreciation -- Tax Expenditure or Proper Allowance for Measuring Net Income?,' 78 Mich. L. Rev. 1 (1979), criticized by Calvin Johnson, 'Kahn Depreciation and the Mintax Baseline in Accounting for Government Cost,' 53 Tax Notes 1523 (1991) (method reduces effective tax rate and discriminates among tax brackets); Boris Bittker and Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, 1992 supplement para. 23.6.6 (method creates exceedingly low income in early years and too-high income in later years).
/69/ Michael Schler, Letter to the Editor, 'The Case (Law) for Accelerated Depreciation,' 53 Tax Notes 1430 (1991) (accelerated depreciation is bad policy but it has substantial authority in the case law) citing Citizens and Southern Corp. v. Commissioner, 91 T.C. 463 (198-) aff'd. 919 F.2d 1492 (11th Cir. 1990) (per curiam).
/70/ See Walter Blum, 'Amortization of a Retained Terminable Interest After Transfer of a Remainder,' 62 Taxes 211 (1984).
/71/ Commissioner v. Gillette Motor Transport, 364 U.S. 130 (1960) (payment for lease was rent, not sale of underlying property); Hort v. Commissioner, 313 U.S. 28 (1941) (tenant's payment for cancellation of lease was rent to landlord and not recovery of capital); Reggio v. United States, 151 F. Supp. 740 (Ct. Cl. 1957) (payment in lieu of interest was not recovery of capital). See J. Dodge, The Logic of Tax 252-257 (1989).
/72/ Michael Schler, Letter to the Editor, 'The Case (Law) for Accelerated Depreciation,' 53 Tax Notes 1430 (1991).
/73/ Exodus 3:2
/74/ Alexander Pope, Epitaph intended for Sir Isaac Newton.
/75/ Treas. Reg. section 1.167(a)-3(1960). The regulations have expressly denied depreciation of goodwill since 1927. TD 4055, VI-2 C.B. 63 (1927).
/76/ Compare Braitman, 'Individual and Partnership Tax Shelters: Preopening Expense,' 37 N.Y.U. Tax Inst. ch. 11 (1978) (tax promoter in nonadversarial allocations created 25 different names for tax expensed fees) with General Accounting Office, supra note 6, at 41- 43, Appx. I (listing different names for short-term intangibles claimed by taxpayers).
/77/ Id. at 24 ( of purchase price in sample was allocated to amortizable intangibles and <$Esize 7 7/23 of purchase price was allocated to goodwill.
/78/ Prior to the 1986 amendments to IRC section 336, sellers recognized no gain when buyers made IRC section 338 elections, as here. After 1986, the seller recognizes gain but it matters very little whether the gain is capital or ordinary or whether the seller is considered to have sold long-life or short-life assets.
/79/ 47 Value Line Investment Survey No. 38, at 1806 (June 5, 1992)
/80/ Profit margins are conventionally stated as profit as a percentage of costs. The formula to convert the statement to a percentage of revenue is:
Profit/Revenue = profit margin/
(profit margin + 100 percent).
The 100 percent in the formula represents the costs. Profit margin plus 100 percent represents costs plus profit margin or revenue.
/81/ Revenue at 100 percent is percent or 14 times larger than a 7.2 percent profit. Revenue is 1/3.3 percent or 31 times larger than a 3.3-percent profit.
/82/ John Morton, 'Why a Coke Costs More than a Newspaper,' 12 Washington J. Rev. 46 (Nov. 1990) (Publishers have priced their newspapers lower than Coca-Cola to generate advertising revenue); Cole & Rechtin, 'Hard Times at the Times, Says Internal Memo,' 12 Los Angeles Bus. J. 1 (Oct. 22, 1990) (The 25 cents readers pay for a Times is less than the cost of the paper in it, let alone salaries).
/83/ 734 F.Supp. at 183184.
/84/ Tax Reform Act of 1986, Pub. L. No. 99-514 section 641 adding IRC section 1060.
/85/ See Staff of the Joint Committee on Tax, General Explanation of the Tax Reform Act of 1986 at 357 (Comm. Print 1987)
/86/ Bank One Corporation v. Commissioner, 84 T.C. 476.476, 502503 (1985).
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