PLR 1317003: Termination payment must be capitalized and may be recovered under section 167

Plain-English summary

The IRS considered the tax treatment of a payment made to terminate two franchise agreements. It ruled that the payment had to be capitalized as a newly created intangible under the regulations for terminating certain exclusive-rights agreements. The taxpayer could not use the franchise's remaining 15-year section 197 life as the recovery period. Instead, recovery could be available under section 167 if the useful life was limited and reasonably estimable, or under the regulatory safe harbor if it was not. The ruling did not decide several other issues, including the value and useful life of the intangibles.

Ruling snapshot

• Question: How should a payment to terminate franchise agreements be capitalized and recovered?
• Outcome: Mixed, the payment must be capitalized, but the requested section 197 recovery period was not allowed.
• Key authorities: IRC §§ 167, 197, 263(a), and 1253; Treas. Reg. §§ 1.167(a)-3 and 1.263(a)-4(d)(7).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201317003 Third Party Communication: None
Release Date: 4/26/2013 Date of Communication: Not Applicable
Index Number: 263.00-00, 167.00-00,
197.00-00 Person To Contact:
----------------, ID No. ------------------
--------------------------- Telephone Number:
---------------------------------------- ----------------------
-------------------------------------------------- Refer Reply To:
-------------------------- CC:ITA:B06
---------------------------- PLR-132688-12
Date:
January 24, 2013

In Re: Request for Rulings under §§ 167, 197 and 263(a).

Taxpayer = --------------------------------------------------
--------------------------

Parent = --------------

Predecessor = ----------------------------------------

Franchisee = --------------------------------

Party 1 = -----------------------------------------------------------------------

                                         -------------------

Termination Payment = ------------------------------

Process = ------------------------------------------------------------------------

Technology 1 = ------------------------------------------------------------------------

                                          -----------------------------------------------------------------------
                                         --------------------------------------

Technology 2 = ---------------------------------------

Product 1 = -----------------------------------------------------------------------

PLR-132688-12 2

                                         -------------------

Product 2 = ---------------------------------------------------------------
-------------

Industry = ------------------------------------------------------------------------

State 1 = --------------

State 2 = ------------------------------

State 3 = ------------------------

Date 1 = -------------------

Date 2 = --------------------------

Date 3 = ----------------------------

Date 4 = ------------------------

Date 5 = -------------------

Date 6 = ----------------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

A = ----

B = ----

Dear -----------------:

This letter is in response to your letter dated Date 1, and subsequent correspondence,
submitted on behalf of Taxpayer, requesting a letter ruling on whether Taxpayer must
capitalize a termination payment made by Taxpayer to Franchisee pursuant to
§ 1.263(a)-4(d)(7) of the Income Tax Regulations and whether Taxpayer’s termination
payment is properly amortizable over the duration of the franchisee’s original useful life
PLR-132688-12 3

of the intangible asset using the remaining portion of the 15 year statutory life
established under § 197 of the Internal Revenue Code.

                                      FACTS

Taxpayer represents that the facts are as follows:

Taxpayer is a U.S. corporation, organized and existing under the laws of State 1 and
having its principal office in State 2, and is a subsidiary of Parent. Taxpayer is a global
leader in Process for Industry. Taxpayer developed certain technology capabilities for
use in Industry, including Technology 1. Prior to entering into the agreements described
below, Taxpayer primarily operated in State 3 and did not have the capacity to operate
effectively in other areas.

On Date 2, Taxpayer entered into a franchise agreement with Predecessor, the
predecessor in interest to Franchisee, whereby Predecessor acquired exclusive rights
constituting a franchise as defined in § 1253(b)(1) to distribute, sell, or provide goods,
services, or facilities worldwide in connection with Product 1. This agreement was
perpetual and would not be terminated except upon certain events. Taxpayer and
Franchisee amended the agreement on different occasions to change certain terms.

On Date 3, Taxpayer entered into a separate franchise agreement with Franchisee
whereby Franchisee acquired exclusive rights constituting a franchise as defined in
§ 1253(b)(1) to distribute, sell, or provide goods, services, or facilities worldwide in
connection with Product 2. This agreement was for a term of A years, thereafter
perpetually renewable in 1 year increments provided that Taxpayer and Franchisee
agreed in writing to an extension not less than B days before the end of the term.
Additionally, this agreement could be terminated by Taxpayer or Franchisee upon
certain events, or unilaterally by Taxpayer with written notice to Franchisee upon certain
other events. Taxpayer and Franchisee amended and restated the agreement to
change certain terms.

In Year 3, Taxpayer’s management determined that Taxpayer could increase profits by
removing Franchisee from the distribution channel and either selling directly to end-
users, or by seeking a partnership with another company.

On Date 4, Taxpayer and Franchisee mutually agreed to terminate their existing
contractual relationship. In accordance with the termination agreement, Taxpayer was
required to pay the Termination Payment for, among other reasons, the termination of
all contractual agreements previously entered into by Taxpayer and Franchisee.
Taxpayer’s ruling request relates only to the portion of the Termination Payment that is
allocable to the termination of the agreements entered into on Dates 2 and 3.
Taxpayer’s ruling request does not relate to the portion of the Termination Payment that
is allocable to other items such as the purchase of tangible assets or any non-compete
PLR-132688-12 4

agreement. Also, Taxpayer did not as a result of the termination agreement, pay for the
acquisition of assets constituting a trade or business or substantial portion thereof.

                              RULINGS REQUESTED

Taxpayer requests that the Internal Revenue Service issue the following rulings:

1. The portion of the Termination Payment made by Taxpayer to Franchisee that is
   allocable to the termination of the agreement entered into on Date 2, is properly
   amortizable over the duration of Franchisee’s original useful life of the intangible asset
   (using the statutory life of 15 years under § 197) when said intangible asset was created
   in Year 1. Thus, because that useful life has elapsed under statute, the Termination
   Payment, although capital under § 1.263(a)-4(d)(7), should be fully amortized in the
   period in which it was made.

2. The portion of the Termination Payment made by Taxpayer to Franchisee that is
   allocable to the termination of the agreement entered into on Date 3, is properly
   amortizable over the duration of Franchisee’s original useful life of the intangible asset
   (using the statutory life of 15 years under § 197) when said intangible asset was created
   in Year 2. Thus, Taxpayer is entitled to amortize the portion of the Termination
   Payment allocable to the agreement entered into on Date 3, ratably over the period
   beginning with Date 5, through the calendar tax year ended Date 6.

                              LAW AND ANALYSIS
   

Section 263(a) provides generally that no deduction is allowed for any amount paid out
for new buildings or for permanent improvements or betterments made to increase the
value of any property or estate or any amount expended in restoring property or in
making good the exhaustion thereof for which an allowance is or has been made.

Section 1.263(a)-4 provides rules for applying § 263 to amounts paid to acquire or
create intangibles. Section 1.263(a)-4(b)(1) provides that except as otherwise provided
in § 1.263(a)-4, a taxpayer must capitalize an amount paid to: (i) acquire an intangible
(see § 1.263(a)-4(c)); (ii) create an intangible described in § 1.263(a)-4(d); (iii) create or
enhance a separate and distinct intangible asset within the meaning of § 1.263(a)-
4(b)(3); (iv) create or enhance a future benefit identified in the Federal Register or the
Internal Revenue Bulletin as an intangible for which capitalization is required; and (v)
facilitate (as defined in § 1.263(a)-4(e)(1)) the acquisition or creation of an intangible.

Section 1.263(a)-4(c)(1) provides, in part, that a taxpayer must capitalize an amount
paid to another party to acquire any intangible from that party in a purchase or similar
transaction. Specifically, § 1.263(a)-4(c)(1)(viii) provides that a taxpayer must capitalize
amounts paid to another party to acquire a franchise, trademark or trade name (as
defined in § 1.197-2(b)(10)).
PLR-132688-12 5

Section 1.263(a)-4(d)(1) provides a general rule that a taxpayer must capitalize
amounts paid to create an intangible described in § 1.263(a)-4(d). See also § 1.263(a)-
4(b)(1)(ii).

Section 1.263(a)-4(d)(7)(i) provides that a taxpayer must capitalize amounts paid to
another party to terminate certain agreements: (A) a lease of real or tangible personal
property between the taxpayer and that party; (B) an agreement that grants that party
the exclusive right to acquire or use the taxpayer's property or services to conduct the
taxpayer's business; or (C) an agreement that prohibits the taxpayer from competing
with that party or from acquiring property or services from a competitor of that party.
In this case, Taxpayer terminated its two franchise agreements with Franchisee.
Because the original agreements granted Franchisee exclusive rights to use Taxpayer’s
property to conduct Taxpayer’s business, the Termination Payment made by Taxpayer
to Franchisee created new intangible assets under § 1.263(a)-4(d)(7)(i)(B). An issue,
however, remains as to whether it could also be construed that Taxpayer acquired one
or more franchises under § 1.263(a)-4(c)(1)(viii). Because of the different treatment of
the two types of intangibles generally, and the application of different rules (e.g., the 12-
month rule does not apply to acquired intangibles, etc) it is necessary to assign a
particular expenditure into one of the categories in § 1.263(a)-4.

Section 1.263(a)-4(d)(7) uses explicit language to describe the types of transactions for
its application. In this case, Taxpayer’s contract terminations clearly fall under those
described in § 1.263(a)-4(d)(7)(i)(B). See also § 1.263(a)-4(d)(7)(iii), Examples 1 and 2.
While § 1253(b)(1) defines the term “franchise” as an agreement which gives one of the
parties to the agreement the right to distribute, sell, or provide goods, services, or
facilities, within a specified area, the termination agreement did not create a new
agreement to acquire a franchise under § 1253(b)(1) in this respect. The legal effect of
the agreement to terminate the relationship between Taxpayer and Franchisee was to
extinguish agreements giving one party the exclusive right to distribute product in a
specified territory.

Accordingly, the Termination Payment made by Taxpayer is required to be capitalized
as created intangible assets under § 1.263(a)-4(d)(7)(i)(B) and not as acquired
intangible assets under § 1.263(a)-4(c)(1)(viii). The remaining question is whether
Taxpayer may recover the Termination Payment under § 167 or § 197.

Section 167(a) provides that there shall be allowed as a depreciation deduction a
reasonable allowance for the exhaustion, wear and tear, and obsolescence of property
used in the taxpayer's trade or business.

Section 1.167(a)-3(a) provides in pertinent part that if an intangible is known from
experience or other factors to be of use in the business or in the production of income
for only a limited period, the length of which can be estimated with reasonable accuracy,
PLR-132688-12 6

such an intangible asset may be the subject of a depreciation allowance. Section
1.167(a)-3(a) further provides that no allowance will be permitted merely because, in the
unsupported opinion of the taxpayer, the intangible asset has a limited useful life.
Section 1.167(a)-3(b) provides a 15-year useful life safe harbor for certain intangible
assets with indeterminable useful lives, beginning on the first day of the month in which
the intangible is placed into service.

The Tax Court in Rodeway Inns of America v. Commissioner, 63 T.C. 414 (1974) held
that a taxpayer’s payment to terminate the exclusive right that the taxpayer had
previously granted to another person to develop the taxpayer’s motel chain in four
states was depreciable under § 167 over the remaining useful life of the original
agreement. The capital expenditure is properly amortizable over the remaining useful
life of the original agreement because it is made to obtain the asset held by another
person, that is, an asset limited by the terms of the original agreement. See Rodeway,
63 T.C. at 421-22. While the terms of the territorial agreement in Rodeway provided for
its continuance for as long as 24 years and 22 months after the date on which it was
cancelled, the Court determined that the agreement’s remaining useful life was 5 years,
because all desirable locations for motels would be taken within that time. Id. at 422-23.

Section 197(a) provides that a taxpayer shall be entitled to an amortization deduction
with respect to any amortizable § 197 intangible. Section 197(b) provides that no other
depreciation or amortization deduction shall be allowable with respect to any
amortizable § 197 intangible. The amount of the deduction under § 197 is determined
by amortizing the adjusted basis of such intangible ratably over the 15-year period
beginning with the month in which the intangible was acquired.

The term “section 197 intangible” is defined in § 197(d) and the regulations thereunder.
Intangible assets not described in § 197(d) or the regulations thereunder may not be
amortized under § 197. Further, § 197(c)(2) provides that the term “amortizable section
197 intangible” does not include any § 197 intangible that is not described in
§ 197(d)(1)(D), (E), or (F), and that is created by the taxpayer, unless the intangible is
created in connection with a transaction (or series of related transactions) involving the
acquisition of assets constituting a trade or business or substantial portion thereof.
Section 1.197-2(d)(2)(ii) states, in part, that a § 197 intangible is created by the taxpayer
to the extent the taxpayer makes payments or otherwise incurs costs for its creation,
production, development, or improvement.

Taxpayer represents that it did not acquire assets constituting the acquisition of a trade
or business or a substantial portion thereof. We note, however, that Taxpayer did not
provide a list of the intangible assets, or interest therein, acquired or reacquired by
Taxpayer upon entering into the termination agreement despite our request that
Taxpayer provide such list. Consequently we cannot determine whether Taxpayer
acquired or reacquired any § 197 intangibles that constitute the acquisition of a trade or
PLR-132688-12 7

business or a substantial portion thereof, e.g. any trademarks. Therefore, Taxpayer
must depreciate the Termination Payment, if at all, under § 167.

The Service will ordinarily not rule on the useful life of assets for purposes of § 167.
See section 4.01(12) of Rev. Proc. 2013-3, 2013-1 IRB 113, 119. Nonetheless, we note
that the Termination Payment is allocable, in part, to a perpetual agreement. If the
useful life of the intangible asset created upon the termination of the perpetual
agreement cannot be estimated with reasonable accuracy, Taxpayer may avail itself of
the safe harbor in § 1.167(a)-3(b). However, despite Taxpayer’s arguments to the
contrary, Taxpayer may not use Franchisee’s remaining statutory life of either franchise
under § 197. Section 197 does not establish a useful life for purposes of the
depreciation deduction under § 167(a).

                                 CONCLUSION

Based solely on the facts and representations submitted and the relevant law and
analysis as set forth above, we conclude that the Termination Payment (1) is
capitalizable under § 1.263(a)-4(d)(7)(i)(B) and (2) is not properly amortizable over the
duration of Franchisee’s original useful life of the intangible assets (using the statutory
life of 15 years under § 197) when said intangible assets were created. We conclude
that the Termination Payment may be recovered under § 167(a) if Taxpayer knows from
experience or other factors that the intangibles assets are of use in the business or in
the production of income for only a limited period, the length of which can be estimated
with reasonable accuracy or, if not, under § 1.167(a)-3(b).

We understand that Taxpayer already took the position that they requested in this letter
ruling on their originally filed Year 3 federal tax return. Accordingly, Taxpayer should
assess whether it needs to amend its Year 3 federal tax return to become compliant
with the conclusions in this letter ruling. If Taxpayer determines that it must amend its
Year 3 federal tax return, it should attach a copy of this letter ruling with its amended
return.

Except as set forth above, we express no opinion concerning the Federal income tax
consequences of the facts described above under any other provisions of the Code.
Specifically, no opinion is expressed or implied on (i) whether the intangibles have
reasonably ascertainable value and a limited useful life; (ii) whether the portion of the
Termination Payment that that Taxpayer allocated to the termination of the agreements
entered into on Dates 2 and 3 is correct; (iii) whether any agreements not referenced
above affect the proper characterization of the transactions for federal tax purposes;
and (iv) whether Taxpayer acquired any § 197 intangibles.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.
PLR-132688-12 8

In accordance with the power of attorney, we are sending copies of this letter to
Taxpayer's authorized representative. We are also sending a copy of this letter to the
appropriate operating division director.

                                 Sincerely,

                                 Patrick M. Clinton

                                 Patrick M. Clinton
                                 Assistant to the Branch Chief, Branch 7
                                 (Income Tax & Accounting)

Enclosures (2):
copy of this letter
copy for section 6110 purposes