57 Tax Notes 691

Tax Notes

NOVEMBER 2, 1992

LENGTH: 1554 words

DEPARTMENT: Letters to the Editor (LTE)

CITE: 57 Tax Notes 691

HEADLINE: 57 Tax Notes 691 - NEWARK MORNING LEDGER: INTANGIBLES ARE NOT AMORTIZABLE.

AUTHOR: Johnson, Calvin H.

TEXT: 26 OCT 92

To the Editor:

This fall the Supreme Court will hear Newark Morning Ledger v. United States to decide whether customer lists and similar intangibles are amortizable assets. In 'The Mass Asset Rule Reflects Income and Amortization Does Not,' 56 Tax Notes 629 (August 3, 1992), I argued that the government has a winning case on the merits because amortization misdescribes the taxpayer's economic income. By letter published in Tax Notes (Oct. 19, 1992, p. 427), Reuven Avi-Yonah of the Milbank, Tweed firm in New York made three comments responding to my article. This letter is my response to his comments.

In my original article, I argued that amortization of the customer lists would be a low-rate tax subsidy to corporate takeovers. The taxpayer's investment in customer lists in Newark was not being exhausted. While individual customers were leaving the purchased newspapers, they were constantly replaced with new customers. In an income tax, a taxpayer's economic income can be accurately described, I argued, only by an accurate description of the taxpayer's capital base. Given that the capital base was not shrinking as a whole and that replenishment of individual customers was accomplished with tax-deducted moneys, I argued, only the 'mass asset' rule, which denies amortization, clearly reflects income and describes the taxpayer in a fair and neutral manner.

In his first comment, Mr. Avi-Yonah argued that I did not think that the mass asset rule is better per se, but only that it was necessary for administrative reasons, namely, the difficulty of proving that the capital base shrinks as a systematic matter and the difficulty of identifying capitalizable costs of replacement. He argued that we should solve the second difficulty by adopting appropriate rules for capitalization of advertising costs, similar to the interest capitalization rules, but that we also should allow amortization f the capital base where the taxpayer can prove that individual customers are leaving.

I do not think it wrong to describe Newark Morning Ledger's economic situation as requiring capitalization. The problem is not primarily one of advertising, however, because the primary way that newspapers replenish lost customers is by publishing a good newspaper. When a customer moves away, for instance, the new occupant of the house sees the quality of the paper and replaces the old occupant on the subscriber list. Or customers buy an issue on the newsstand and become regular customers because of the quality of the paper. If you will allow me to use taxpayer's (quite dubious) figures allocating costs to customers, a new subscriber is worth $71 million/460,000 or $154 dollars. Every time a new subscriber shows up, that means $154 of the newspaper's operating cost has not expired by year end, but has value beyond the year. Under the capitalization route, we should then capitalize $154 of the taxpayer's newspaper costs so that the taxpayer's basis accounts continue to describe the taxpayer's true investment. Since the customer base in Newark Morning Ledger was in fact expanding -- rather than contracting as amortization implies -- the capitalization remedy is more draconian for the taxpayer than is the mass asset rule, which merely denies amortization. For litigation purposes, however, a taxpayer representative would not be free to suggest the capitalization remedy because it is not jurisdictionally before the Court.

But I seem to be missing something in Mr. Avi-Yonah's argument, because I do not follow why he thinks that capitalization is an exclusive remedy blocking other pathways to truth. We must take as a given that Newark Morning Ledger did not in fact capitalize nor offer to capitalize $154 per new subscriber. Replenishment of customers in fact occurred in the case with expensed, 'soft-money' amounts. Once that is the scope condition, then amortization or depreciation drops out of the algebraic formulas that make effective tax rate equal to the statutory rate. Given the expensing of the replenishment costs, amortization does not reflect income, within the requirement in section 446(b) that a taxpayer's accounting clearly reflect income. The taxpayer's investment is not shrinking and has not in fact been lost; accounting that claims it has shrunk misdescribes the taxpayer. There are two perfectly fine alternative ways to describe a customer base that is not shrinking: (1) add to basis the new customers who are preventing the taxpayer from losing its capital (capitalize); (2) deny depreciation because the taxpayer's customer base is in fact not depreciating (mass asset rule). Either remedy is available. It would be bad accounting, per se, to allow amortization because neither remedy is applied.

Mr. Avi-Yonah argues, in his second comment, that the Houston Chronicle case so revolutionized the law that prior cases denying amortization are now dead. The IRS has won 83 of the 123 decided cases, on Mr. Avi-Yonah's count, but he argues that the trend of the law since Houston Chronicle favors mortization. Mr. Avi-Yonah also argues that the mass asset rule, whatever its theoretical advantages, has long been dead and that it is too late to revive it.

Mr. Avi-Yonah assumes that Houston Chronicle, which allowed amortization of separately purchased customer lists, is a beacon principle, a growing, rightly decided, strong case. But Houston Chronicle is bad accounting and wrongly decided, at least if it is applied to allow amortization in cases like Newark Morning Ledger where the customer base is concededly not shrinking. A wrongly decided case has no penumbra or influence beyond its decision on the case. The Houston Chronicle court did not hear nor address the arguments about effective tax rates and replenishment of the base with tax deductible amounts that rebut its decision, and, accordingly, the case is not a very strong precedent even should its facts arise again. It would be acceptable craftsmanship for the Supreme Court to distinguish Houston Chronicle, rather than take it on directly. In Houston Chronicle the taxpayer bought the customer list of a defunct newspaper and that is different from the living, growing customer base that Newark Morning Ledger bought. Newark was not losing its capital, whereas, just maybe, Houston Chronicle was. But I would expect that Houston Chronicle as a principle will wither and die, once the Supreme Court gets Newark right.

Mr. Avi-Yonah's obituary for the mass asset rule also is premature. In Ithaca Industries v. Commissioner, 97 T.C. 253, 267 (1991), decided too recently to be included in the inventory of amortization cases that Mr. Avi-Yonah cites, the Tax Court adopted the mass asset rule to deny amortization of purchased employee base. There is no principled distinction between Ithaca's employee base and Newark's customer base. The mass asset rule is strong, clean-living doctrine that decided Ithaca and governs in Newark and will allow the Supreme Court to describe the taxpayer's true economic position.

Mr. Avi-Yonah, in his third comment, argued that a decision in favor of the government in Newark Morning Ledger will make it too expensive to adopt legislation giving 16-year lives for both goodwill and intangibles, citing Peter Cobb of the Joint Committee on taxation.

Mr. Cobb is right that the country cannot afford amortization once Newark Morning Ledger is decided for the government. The revenue estimates for 16-year amortization assumed that taxpayers would win in Newark Morning Ledger and all of the similar cases of mass If the government wins, we cannot afford the revenue loss. But of course, the country cannot afford amortization any more this year than next year on the merits. It is only that revenue estimating has scored it wrong.

Sixteen-year amortization for goodwill and other intangibles reduces the tax rate of investments in corporate takeovers in half (with a percent or two variation that depends on the discount rate). If 16-year amortization is adopted, we will see the era of $1 real estate and gargantuan goodwill as the costs of corporate takeovers are allocated, in a game called pigeonhole stuffing, to assets with a favorabl tax rate. GAAP accounting adopted mandatory 40-year amortization to discourage corporate takeovers. Thus, it is bitterly ironic that GAAP accounting is being used to support preferential tax rates for corporate takeovers. Uniform and universal application of the mass asset rule gives far more promise of solving the quagmire of the pigeonhole stuffing game by applying rules that make the tax accounting conform to the economics of the transactions. The economy is reaching for a $400-billion-per year deficit. I do not see that anyone has tried to justify the preferential tax on corporate takeovers. We do not need to spend revenue on a subsidizing tax rate for corporate takeovers.

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Sincerely yours,

Calvin H. Johnson

Centennial Professor of Law

University of Texas

October 26, 1992

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