59 Tax Notes 285

Tax Notes

APRIL 12, 1993

LENGTH: 1775 words

DEPARTMENT: Current and Quotable (CQT)

CITE: 59 Tax Notes 285

HEADLINE: 59 Tax Notes 285 - AMORTIZATION OF INTANGIBLES: IMPACT OF SELLER TAX.

AUTHOR: Johnson, Calvin H.

SUMMARY:

The following letter was sent to Hank Gutman, Chief of Staff of the Joint Committee on Taxation, by Professor Calvin Johnson,

TEXT:

Proponents of a short, 14- or 16-year amortization period for intangibles acquired with a business are arguing that the short tax life is needed to offset the effects of General Utilities repeal on the seller of a business. This letter rebuts the argument: Even looking at the buyer and seller in combination, short-life amortization would undertax corporate acquisitions and therefore encourage them.

Proponent's Case

Under the General Utilities rule in effect before 1986, a selling corporation avoided tax on gain on sale of its business. The buyer nonetheless got a higher tax basis in the assets. The tax treatment of the parties in combination was a negative tax that added money to the sale transaction. With the repeal of the General Utilities rule in 1986, however, corporate sellers must now recognize capital gain in a taxable purchase. Moreover, interest was imposed on the tax-deferral benefits of the installment method and corporate capital gains rates were raised to par with ordinary rates. Tax can sometimes still add money to a sale transaction (e.g., a sale by a loss corporation to a taxable corporation), but less often.

Proponents of short-life amortization of intangibles are arguing that the net tax collected on taxable sales after 1986 discourages sales. The tax, it is said, locks in capital in the hands of entrenched and inefficient management that pays higher-than-market wages. Reducing the tax burden on the sale, it argued, would allow taxable acquisitions justified by other considerations to go forward. Even after short-life amortization is adopted, there will still be a net toll charge or penalty on taxable sales, it is argued, because the seller's tax is immediate, whereas the buyer's tax savings would be spread over the 14 or 16 years.

Rebuttal

Enactment of short-life amortization of intangibles would in fact make corporate acquisitions preferentially taxed investments, even when buyers and sellers are viewed in combination. The preferential tax treatment would tilt the level playing field to favor more acquisitions. On the seller's side, the tax on business sales tends to be lower, not higher than the tax paid by the other side of a typical investment. On the buyer's side, 14- or 16-year amortization materially understates income, reducing the effective tax rate to about a third of normal corporate rates. Finally, resurrection of the General Utilities rule, if it is to be done at all, should be done only directly by tax relief on the seller's side.

1. Tax on the Seller. Repeal of the General Utilities rule just brought corporate acquisitions into the real tax world that alternative investments have faced for years. When a corporation makes any investment, someone on the other side must pay tax. Assume, for instance, that a corporation is deciding whether (1) to build new plant or equipment or (2) to buy out some competitor. Tax will affect alternative (1) because builders must pay immediate tax on the value they add. Salaries and product profits are taxed immediately. If some of the costs paid to the builders are not tax to the builder because of the builder's expenses, that just means that the recipient of the expenses must pay the tax. The General Utilities argument proponents are making pretends that seller tax is a phenomenon only of (2), buying of another business, and ignores the tax paid by the other side in (1), or other alternative investments.

More generally, it is a norm of an income tax that tax is imposed when investments are made. The tax on sellers of a business is not some strange penalty that needs to be offset, but rather a normal feature of the income tax for all corporate expenditures.

The seller-side toll charge on acquisitions is ordinarily less than the tax toll charge on new production. The corporate seller of a business can use its preexisting basis to offset its tax, whereas builders of a new plant and equipment (and their expense recipients) have no preexisting basis for the added value they provide. Installment sales are available, to a limited degree, for business acquisitions but not for new production. The corporate acquirer could distribute its money, instead of buying out a business, but then shareholders would pay dividend (double) tax, without benefit of basis, on the distribution. Seller-side tax is commonly avoided, moreover, because the seller is from a tax-loss industry and will bear no tax on the sale. Provider-side tax treatment thus favors corporate acquisitions. If anything, corporate acquisitions should thus bear a compensating penalty on the buyer's side.

Zero tax on sellers is also available even after 1986 by way of tax-free acquisitive reorganizations. If taxes are a toll charge, we nevertheless have a shun-toll road for corporate acquisitions so we need worry too much that the toll charge is too high. But in a reorganization, the buyer must carry over the seller's old basis and that is what buyers want to avoid.

2. Amortization Understates Buyer's Income. The proposed amortization of intangibles over a short 14- or 16-year tax life would generate a tax advantage on the buyer's side. As a matter of economics, most of the premium value for a business is in nondepreciating intangible assets. An ongoing business is more valuable than its parts can be sold for because the business is a living organism that replaces its parts. A corporation acquiring an ongoing business acquires a base of existing customers, suppliers, depositors, employees and etc. Individual components, such as individual customers, do leave. But the acquiring corporation does not lose any of its capital investments as individual customers turn over because the customers are replaced in the ordinary course of the business. Where the mass asset such as a customer base remains in fact or grows as a whole, accurate accounting would preserve the acquirer's capital and deny amortization of acquirer's basis.

Replacement of customers, moreover, is accomplished by immediate expenses. Giving both amortization of the costs of departing customers and expensing of the costs of the replacement would generate basis accounts that are lower than the buyer's real investment.

When an investor's basis is allowed to drop below the value of its investment, that means in turn that the effective tax imposed on the investment drops below the statutory tax rate that Congress has mandated when it focused on rates. Allowing nondepreciable assets to be written off over 14 years reduces the effective tax rate on the acquisitions to about one-third of the statutory 34 percent tax rate. /1/ Given that accelerated depreciation and inflation just about offset each other, 34 percent is the effective tax rate most corporations face as well. Imposing a normal tax rate on most corporate investments, but only one-third of the normal rate on acquisitions tilts the level playing field in favor of acquisitions over alternative investments.

The short, 14- or 16-year tax life would apply not only to nondepreciating intangibles like customer or supplier base, but also to intangibles like covenants not to compete or franchises that in fact have fixed lives. The proposal is intended as a revenue-neutral compromise to forestall expensive litigation over what in fact is the expected economic life of acquired intangibles.

The short 14- or 16-year lives, however, are revenue neutral only under the erroneous assumption that mass asset intangibles like customer base are properly depreciated (over a life of approximately nine years). If we move to the correct assumption that the mass assets are not depreciating, then it is possible to reach revenue neutrality only by using an 83-year tax life for all intangibles. A short, 14-year life is one-sixth of the revenue neutral life leading to annual amortization deductions that are six times too large.

Proponents also argue for short lives so that the effective tax rates on acquired intangibles will approach the effective tax rates on self-constructed intangibles base. The costs of constructing new mass assets, such as customer base, are deducted immediately because the tax law has not identified an investment in the ordinary expenses that attract new customers, suppliers, or employees. Under what is sometimes called the Cary Brown thesis, the ability to make investments with immediately-expensed, pretax 'soft money' is a privilege that is ordinarily at least as valuable as not paying any tax on the subsequent income from the investment. The effective tax rate on the self-construction of intangibles is thus zero.

Corporate acquisitions are real investments, however, and the income tax generally imposes real tax (not zero effective rate tax) on investments. The only reason we allow expensing for self-creation of intangibles is because the law has trouble identifying the investment in acquiring new customers. It is quite something to go from expensing where the tax law cannot find any investment to expensing where the expenditure is a clear investment. Zero rates on investment income might be fine under a consumption tax, but they are distorting and discriminating under a tax system that tries to be a comprehensive income tax.

3. Repeal of General Utilities Repeal. Finally, if proponents of short life amortization are seeking to resurrect the General Utilities rule, so that corporate sellers of business can avoid tax on the sale, then the tax advantages should be given directly to the sellers. Some sellers already pay no tax on sale because, for instance, of preexisting net operating losses. It would be a mistake to add on preferential amortization lives, where the seller already has achieved the intended tax exemption for the sale.

Sellers, moreover, cannot be expected to capture all of the value of tax benefits given to buyers on the other side of a transaction. The bidders competing for acquisitions pay tax at varying effective tax rates, depending on the industry and the net operating losses that are available. The optimal acquirer for nontax purposes may not be the acquiring corporation with the most tax to save. Market prices capture the buyer's tax benefit, moreover, only if the markets have not already been swamped by other available tax loopholes. If repeal of seller tax is the goal, in sum, it would be more effective to resurrect General Utilities directly by repealing seller tax, rather than to hide the effect with buyer-side loopholes.

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FOOTNOTE

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/1/ See Johnson, 'The Mass Asset Rule Reflects Income and Amortization Does Not,' Tax Notes, Aug. 3, 1992, p. 629.

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