CHAPTER 6
Deferred Tax Consequences of Goodwill and Intangible Assets

A. Introduction

This book primarily discusses the accounting requirements for goodwill and other intangible assets. However, goodwill and other intangible assets also have tax consequences. These tax consequences will affect either (or both of) (1) deferred tax consequences or (2) the amount of actual tax paid.

This chapter covers two intertwined subjects. First, it covers deferred tax consequences reported in financial statements concerning goodwill and other intangibles. Deferred tax consequences arise from the difference between the accounting treatment of an asset or liability and the tax treatment. Under U.S. GAAP, goodwill cannot be amortized.1 In contrast, goodwill under prescribed circumstances may be amortized and deducted in determining income tax liability.2 This difference between the accounting and tax treatments can give rise to deferred tax consequences.3

Second, this chapter covers the treatment of goodwill and other intangible assets on income tax returns. Section 197 specifies what an amortizable intangible asset is and what it is not. It is specific about the amortization of goodwill and all other intangible assets—amortize all of them over 15 years, with no exceptions. It is also an evolving area of the Internal Revenue Code, as can be seen by the change in handling professional sports franchises.4 For a more detailed analysis of I.R.C. § 197, see Nellen, 533-3rd T.M., Amortization of Intangibles (U.S. Income Series).

B. Deferred Tax Consequences

In a business combination, the acquirer applies the principles of ASC 740-10 (former FAS 109) to any temporary differences, carryforwards, or income tax uncertainties inherited from the acquiree.5 Moreover, because the assets and liabilities are marked up to their fair value, the differences between their preacquisition carrying values and their preacquisition tax bases will require an adjustment to the deferred taxes account to reflect the new carrying values. Further, for tax purposes the amortization of goodwill and certain other intangible assets is “over a fifteen-year period, beginning with the month in which the intangibles are acquired.”6

Deferred income taxes are not recognized for any portion of goodwill for which amortization is not deductible for income tax purposes, which is the case in some jurisdictions but not for U.S. federal income tax purposes. ASC 350 does not affect the requirements in ASC 740 for recognition of deferred income taxes related to goodwill and intangible assets.7

An acquirer must recognize a deferred tax asset or liability for the acquiree's temporary differences and carryforwards, except for differences relating to the following: (1) the portion of goodwill for which amortization is not deductible for tax purposes, (2) unallocated negative goodwill, (3) leveraged leases, and (4) acquired Opinion 23 differences.9

Former FAS 109 noted that amortization of goodwill is deductible for tax purposes in some tax jurisdictions, thus giving rise to deferred taxes.10 In these jurisdictions, “the reported amount of goodwill and the tax basis of goodwill are each separated into two components as of the combination date for purposes of deferred tax calculations.”11

ASC 805–740 lists some special rules for the determination of deferred taxes in the case of goodwill. Specifically, the Codification subtopic separates the difference between the reported amount of goodwill and the tax basis of goodwill into two components. The first component equals the lesser of (1) goodwill for financial reporting and (2) tax-deductible goodwill.12 The second component of goodwill equals the excess of book goodwill over tax goodwill, or tax goodwill over book goodwill.13

Any difference that arises between the reported amount of goodwill and the tax basis in the first component is a temporary difference for which a deferred tax liability or asset is recognized.14 The second component does not give rise to any deferred taxes.15

If the second component is an excess of tax-deductible goodwill over reported goodwill, “the tax benefit for that excess is a temporary difference” and the acquirer recognizes a deferred tax asset under ASC 740-10 (former FAS 109).16 However, if the reported amount of goodwill exceeds the tax-deductible amount of goodwill, the excess does not result in a deferred tax liability.

C. Amortization of Goodwill and Certain Other Intangibles under I.R.C. § 197

Before the enactment of I.R.C. § 197, taxpayers and the IRS differed over the legitimacy of amortization deductions for intangibles such as customer lists, covenants not to compete, goodwill, and going-concern value. Taxpayers tried to establish that certain intangibles had a determinable cost basis separate and distinct from goodwill and going-concern value and a limited useful life, the length of which could be determined with reasonable accuracy. Taxpayers sought to amortize these costs (i.e., deduct them in equal amounts over the asset's identified useful life). The IRS attempted to refute these contentions by arguing (among other things) that the intangibles were indistinguishable from goodwill and going-concern value.18

Many businesses showed great creativity in identifying intangible assets for tax purposes. Deductions were taken for items such as customer lists, pizza recipes, a company's shrinking market, and a business's nonunion status. In 1993 Congress decided that legislation was needed to clarify the categories of amortizable intangible assets, and as a result enacted I.R.C. § 197.19 Section 197 requires amortization of certain specified intangible assets, including goodwill and going-concern value, over 15 years. Amortization under this Code section is mandatory, not elective, reflecting Congress's desire to bring certainty to this area of the tax law.

Section 197 requires the amortization of purchased (not created) goodwill and other intangibles.20 The amount of the deduction is determined by amortizing an intangible's adjusted basis ratably over the 15-year period beginning with the month that the taxpayer acquired the intangible.21 There is no alternative minimum tax adjustment for the depreciation of any of these intangibles, including goodwill.

The 15-year period begins on the first day of the month the intangible property was acquired.22

In the case of contingent amounts that become fixed before the expiration of the 15-year amortization period, the taxpayer must add the incremental amount to the current basis and amortize the aggregate basis over the remainder of the 15 years.

If a taxpayer disposes of any amortizable § 197 intangible that was acquired in a transaction (or a series of related transactions) where other amortizable § 197 intangibles were acquired in the same transaction or transactions, then no loss is recognized. Instead, the adjusted basis of the remaining amortizable § 197 intangibles is increased by the amount of the disallowed loss.24 A loss can be recognized where a § 197 intangible is disposed of and was not acquired with other § 197 intangibles.25

The term amortizable § 197 intangible means any § 197 intangible:

  1. Acquired by the taxpayer after the date of the enactment of § 197 (Aug. 10, 1993), and
  2. Held in connection with the conduct of a trade or business or an activity described in § 212.26

1. Intangible Assets

Section 197 intangible assets include the following:

a. Goodwill and Going-Concern Value

Goodwill is the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.27 Going-concern value is the additional value of a trade or business attached to property because the property is an integral part of an ongoing business activity. It includes value based on the ability of a business to continue to function and generate income even though there is a change in ownership (but does not include any other § 197 intangible). It also includes value attributable to the immediate use of an acquired trade or business.

A company must test goodwill annually for impairment, but goodwill is not likely to be impaired early in the post-acquisition period.29 For that reason, the tax treatment of goodwill and going-concern value and the accounting treatment will likely differ until both the accounting impairment and tax amortization indicate that the value of goodwill is zero.30

In the case of an asset acquisition (or a qualified stock purchase under §338) of a trade or business, both the buyer and seller must use the residual (allocation) method to allocate the purchase price to each asset transferred.31 This method determines the seller's gain or loss from the transfer of each asset of the target company, including the value of goodwill and going-concern value as well as the purchaser's basis in the assets (assuming a taxable sale).

Treas. Reg. § 1.1060-1T(c) applies the residual allocation rules of Treas. Regs. §§ 1.338-6 and -7. These regulations divide assets into seven categories as follows:

  • Class I—Cash and cash equivalents (e.g., bank accounts)
  • Class II—Actively traded personal property, certificates of deposit, and foreign currency
  • Class III—Assets the taxpayer marks to market at least annually and debt instruments, including accounts receivable (other than contingent debt or convertible debt)
  • Class IV—Inventory
  • Class V—All assets other than Class I, II, III, IV, VI, and VII assets
  • Class VI—§ 197 intangibles except goodwill and going-concern value
  • Class VII—Goodwill and going-concern value32

A company must first allocate the purchase price to the Class I assets on a dollar-for-dollar basis. Next, the allocation goes to the Class II assets, followed by the Class III, IV, and V assets, limited to their fair market value. After that, the allocation goes to any Class VI assets, except goodwill and going-concern. Finally, any amount left over, the residual, is allocated to goodwill and going-concern value.33 The seller and purchaser can agree in writing as to the allocation of consideration or value to the assets transferred. However, the IRS has the right to challenge the allocation values included in the agreement.34

Generally, the tax residual method and the accounting residual method will reach the same result provided a company does not use a going-concern account or similar account for tax purposes.

b. Workforce in Place

Workforce in place is an intangible asset that refers to the composition of a workforce (for example, its experience, education, or training). It also includes the terms and conditions of employment, whether contractual or otherwise, and any other value placed on employees or any of their attributes. For example, a taxpayer must amortize the portion of the purchase price of a business that is attributable to the existence of a highly skilled workforce. Also, the cost of acquiring an existing employment contract or relationship with employees or consultants must be amortized.35

Both accounting standards and the tax code require use of the residual allocation method. If a workforce in place § 197 intangible asset is identified, it will result in a difference in the amount of goodwill for accounting and tax purposes Also, if a company purchases a stand-alone workforce to supplement an existing workforce, it can add the amount it paid to the original amount recognized for the workforce.

c. Information Base

Information base includes business books and records, operating systems, customer or prospective customer lists, technical manuals, training manuals or programs, data files, accounting or inventory control systems, customer lists, subscription lists, insurance expirations, patient or client files, lists of newspaper, magazine, radio, and television advertisers, and any other information base.37

d. Knowhow, etc.

Another category of § 197 intangible asset includes any patent, copyright, formula, process, design, pattern, knowhow, package design, formats, and other similar item. This category also includes (1) computer software not publicly available and acquired as part of the acquisition of a trade or business, and (2) interests in films, sound recordings, videotapes, books, and similar property acquired as part of the purchase of a trade or business.38

e. Customer-Based Intangibles

A customer-based intangible asset includes any composition of market, market share, and any other value resulting from the future provision of goods or services because of relationships with customers in the ordinary course of business. For example, a company must amortize the part of the purchase price of a business that is for the existence of the following intangibles:

  1. A customer base
  2. A circulation base
  3. An undeveloped market or market growth
  4. Insurance in force
  5. A mortgage-servicing contract
  6. An investment management contract
  7. Any other relationship with customers involving the future provision of goods or services (however, accounts receivables or other similar rights are not § 197 intangibles).39

f. Supplier-Based Intangibles

Supplier-based intangibles include any value resulting from future acquisitions of goods and services pursuant to relationships (contractual or otherwise) in the ordinary course of business with suppliers of goods or services to be used or sold by the taxpayer.40 Any portion of the purchase price of a trade or business attributable to a favorable contract with distributors (such as favorable shelf or display space at a retail outlet) or other favorable supply contracts must be amortized over 15 years in accordance with § 197. However, contracts acquired separately from the acquisition of the trade or business are not § 197 intangibles and are amortized over the term of the contract, rather than over 15 years.41 Since many supply contracts will have a useful life shorter than 15 years, it may prove advantageous to acquire the contracts separately from the acquisition of the trade or business.

g. Government-Granted Licenses, Permits, and Other Rights

Licenses, permits, and other rights granted by a government unit include, for example, the capitalized costs of acquiring a liquor license, a taxicab medallion, airport slots, a regulated airline route, or a television or radio broadcasting license.42

Excluded from this category are interests in land (e.g., timber rights, grazing rights, riparian rights, air rights, zoning variance),43 interests under a lease of tangible property,44 certain rights to receive tangible property or services,45 and certain other rights acquired in the ordinary course of a trade or business.46

h. Covenant Not to Compete

Section 197 intangibles include any covenant not to compete (or similar arrangement) entered into in connection with the acquisition of a direct or indirect interest in a trade or business, or a substantial portion of a trade or business.47 An indirect interest in a trade or business includes an interest in a partnership or a corporation engaged in the trade or business. An arrangement that requires the former owner to perform services (or to provide property or the use of property) is not similar to a covenant not to compete to the extent that the amount paid under the arrangement represents reasonable compensation for those services or for that property or its use.48

i. Franchise, Trademark, and Trade Name

A franchise, trademark, or trade name is also classified as §197 intangible.49 A franchise includes any agreement that provides a party to the agreement with the right to distribute, sell, or provide goods, services, or facilities, within a specified area. A trademark includes any word, name, symbol, or device or any combination of these items, adopted and used to identify goods or services and distinguish them from those provided by others. A trade name includes any name used to identify or designate a particular trade or business. It also includes the name or title used by a person or organization engaged in a trade or business.50 A taxpayer generally must amortize its franchise, trademark, and trade name purchase or renewal costs over 15 years. However, under I.R.C. § 1253(d)(1), contingent payments made by the transferee of a franchise, trademark, or trade name are currently deductible provided they are: (1) contingent on the productivity, use, or disposition of the franchise, trademark, or trade name; and (2) paid not less frequently than annually during the entire term of the agreement, including renewals, either substantially in equal amounts or paid under a fixed formula.51

Trademarks and trade names often have indeterminate useful lives. For accounting purposes, businesses normally do not amortize trademarks or trade names, but they are subject to impairment testing. Amortizing trademarks and trade names over a 15-year period for tax purposes is often an advantage to the business.

j. Professional Sports Franchise

For acquisitions occurring after October 22, 2004, a franchise engaged in professional sports and any intangible assets acquired in connection with acquiring the franchise (including player contracts) is a § 197 intangible amortizable over a 15-year period.53

k. Contract for the Use of, or a Term Interest in, a § 197 Intangible Arrangement Providing for the Use of Any § 197 Intangible

This category includes any right (including a term interest whether outright or in trust) under a license, contract, or other arrangement for the use of a § 197 intangible.54 The classification as a § 197 intangible will generally not apply for payments under such a contract or term interest that was not acquired as part of the acquisition of a trade or business.55

2. Excluded Items: Items That Are Not Intangibles

Amortization under § 197 is not available for the cost of acquiring an interest in a corporation, partnership, trust, or estate, regardless of whether these are regularly traded interests on an established market.

a. Interests in a Corporation, Partnership, Trust, or Estate

Amortization under § 197 is not available for the cost of acquiring stock, partnership interests, or interests in a trust or estate, even if these are regularly traded interests on an established market.56

b. Interests under Certain Financial Contracts

Amortization under § 197 is not available for an interest under an existing futures contract, foreign currency contract, interest rate swap, notional principal contract, or similar financial contract. The status of these financial contracts for § 197 purposes does not depend on whether the interest is regularly traded on an established market.57

c. Interests in Land

Amortization under § 197 is not available for an interest in land, which includes a fee interest, life estate, remainder, easement, mineral right, timber right, grazing right, riparian right, air right, zoning variance, and any other similar right.58

d. Certain Computer Software

Amortization under § 197 is not available for computer software. This exclusion applies to any interest in computer software that is (or has been) readily available to the public on similar terms, is subject to a nonexclusive license, and has not been substantially modified.59 In addition, an interest in computer software that is not acquired as part of the purchase of a trade or business is also excluded as a § 197 intangible.60

Additional intangible assets that are not § 197 intangibles include:

  1. Certain interests in films, sound recordings, videotapes, books, or other similar property that are not acquired as part of the purchase of a trade or business61
  2. Certain rights to receive tangible property or services62
  3. Certain interests in patents or copyrights63
  4. Interests under leases of tangible property64
  5. Interests in indebtedness65
  6. Mortgage servicing rights66
  7. Certain transaction costs (fees for professional services)67

3. IFRS

Most deferred tax liabilities and deferred tax assets arise where income or expense is included in accounting profit in one period, but is included in taxable profit (tax loss) in a different period. The resulting deferred tax is recognized in profit or loss. An example occurs when costs of intangible assets have been capitalized in accordance with IAS 38 and are being amortized in profit or loss, but were deducted for tax purposes when they were incurred.68

IFRS permits or requires certain assets to be carried at fair value or to be revalued (see, for example, IAS 16 Property, Plant and Equipment, IAS 38 Intangible Assets, IAS 40 Investment Property and IFRS 9 Financial Instruments). In some jurisdictions, the revaluation or other restatement of an asset to fair value affects taxable profit (tax loss) for the current period. As a result, the tax base of the asset is adjusted and no temporary difference arises. In other jurisdictions, the revaluation or restatement of an asset does not affect taxable profit in the period of the revaluation or restatement and, consequently, the tax base of the asset is not adjusted. Nevertheless, the future recovery of the carrying amount will result in a taxable flow of economic benefits to the entity and the amount that will be deductible for tax purposes will differ from the amount of those economic benefits. The difference between the carrying amount of a revalued asset and its tax base is a temporary difference and gives rise to a deferred tax liability or asset.69

Goodwill arising in a business combination is measured as the excess of (a) over (b) below:

  1. The aggregate of:
    1. The consideration transferred measured in accordance with IFRS 3, which generally requires acquisition-date fair value;
    2. The amount of any non-controlling interest in the acquiree recognized in accordance with IFRS 3; and
    3. In a business combination achieved in stages, the acquisition-date fair value of the acquirer's previously held equity interest in the acquiree.
  2. The net of the acquisition-date amounts of the identifiable assets acquired and liabilities assumed measured in accordance with IFRS 3.70

Many taxation authorities do not allow reductions in the carrying amount of goodwill as a deductible expense in determining taxable profit. Moreover, in such jurisdictions, the cost of goodwill is often not deductible when a subsidiary disposes of its underlying business. In such jurisdictions, goodwill has a tax base of nil. Any difference between the carrying amount of goodwill and its tax base of nil is a taxable temporary difference. However, this Standard does not permit the recognition of the resulting deferred tax liability because goodwill is measured as a residual and the recognition of the deferred tax liability would increase the carrying amount of goodwill.71

Subsequent reductions in a deferred tax liability that is unrecognized because it arises from the initial recognition of goodwill are also regarded as arising from the initial recognition of goodwill and are therefore not recognized.72 Deferred tax liabilities for taxable temporary differences relating to goodwill are, however, recognized to the extent they do not arise from the initial recognition of goodwill.73

Notes

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