Rev. Rul. 81-55

1981-1 C.B. 52, 1981-8 I.R.B. 6.

                       Internal Revenue Service
                                 Revenue Ruling

     INDUSTRIAL DEVELOPMENT BONDS; EXEMPT SMALL ISSUE; PURCHASE OF COVENANT

                                 NOT TO COMPETE

                          Published: February 23, 1981

26 CFR 1.103-10: Exemption for certain small issues of industrial development bonds

(Also Section 61; 1.61-7.)

  Industrial development bonds; exempt small issue; purchase of covenant not to compete.  The purchase with the proceeds of industrial development bonds of a covenant not to compete that is limited to a definite time period is an acquisition of property that qualifies under section 103(b)(6)(A) of the Code. If a nonexempt person purchases such a covenant with its own funds together with facilities it will use in connection with its existing facilities in the same city that were financed the previous year by industrial development bonds, the purchase is a capital expenditure within the meaning of section 103(b)(6)(D).

ISSUES

  (1) Is the payment for a covenant not to compete an acquisition of property that qualifies under section 103(b)(6)(A) of the Internal Revenue Code?

  (2) Is the payment for a covenant not to compete a capital expenditure within the meaning of section 103(b)(6)(D) of the Code for purposes of determining if the exempt small issue limitation of $10,000,000 has been exceeded?

FACTS

  Situation 1. City M, an incorporated municipality, proposes to issue industrial development bonds in the amount of $1,000,000 and to loan the bond proceeds to X, a nonexempt person, for the acquisition of the assets of an established and active business enterprise.  The business assets to be acquired consist of land, buildings, and equipment valued at $800,000. In addition, X will acquire a covenant not to compete valued at $200,000.

  The covenant not to compete to be acquired by X will be negotiated at arms- length and will be limited to a definite period and to the geographical area of M.  The covenant will provide that after the sale of the assets the seller will, for the duration of the covenant, refrain from participating in any business similar to the one conducted by X and refrain from selling products that directly or indirectly compete with those of X.

  M proposes to treat the bonds as an exempt small issue of $1,000,000 or less under section 103(b)(6)(A) of the Code.  The bonds will not be arbitrage bonds within the meaning of section 103(c)(2).

  Situation 2. In 1979, city O, an incorporated municipality, issued industrial development bonds in the amount of $7,500,000 and loaned the bond proceeds to Y, a nonexempt person, for the acquisition of manufacturing facilities located in Q.  Q made the election provided in section 103(b)(6)(D) of the Code to treat the bonds as an exempt small issue of $10,000,000 or less.  On the date the bonds were issued there were no prior outstanding small issues and no capital expenditures had been made that were required to be taken into account in determining whether the aggregate face amount of the bonds exceeded $10,000,000.  The bonds are not arbitrage bonds within the meaning of section 103(c)(2).

  On October 1, 1980, Y used its own funds and acquired an active business enterprise located in O for a purchase price of $2,800,000 consisting of land, buildings, and equipment valued at $2,500,000 together with a covenant not to compete valued at $300,000.  The newly acquired facilities are operated in connection with Y's regular activities in O.

  The covenant not to compete acquired by Y was negotiated at arms-length and is limited to a definite period and to the geographical area of O.  The covenant provides that the seller will, for the duration of the covenant, refrain from participating in any business similar to the one conducted by Y and refrain from selling products that directly or indirectly compete with those of Y.

LAW AND ANALYSIS

  Section 103(a)(1) of the Code provides that gross income does not include interest on the obligations of a state or political subdivision of a state.

  Section 103(b)(1) of the Code provides that, except as otherwise provided in section 103(b), any industrial development bond shall be treated as an obligation that is not described in section 103(a)(1).

  Section 103(b)(6)(A) of the Code provides that section 103(b)(1) shall not apply to any obligation issued as part of an issue the

aggregate authorized face amount of which is $1,000,000 or less and substantially all of the proceeds of which are to be used for the acquisition of land or property of a character subject to the allowance for depreciation, or to redeem part or all of a prior issue that was issued for such purposes.

  Section 103(b)(6)(D) of the Code provides that, at the election of the issuer, section 103(b)(1) shall not apply to obligations issued in an aggregate face amount of $10,000,000 or less and substantially all of the proceeds of which are to be used for the acquisition of land or property of a character subject to the allowance for depreciation.  For purposes of determining the aggregate face amount of such bond issue, there must be taken into account the face amount of the bonds to be issued, the outstanding face amount of any prior exempt small issues, and the aggregate amount of capital expenditures with respect to certain facilities.

  Section 103(b)(6)(G) of the Code and section 1.103-10(b)(2)(i)(b) of the Income Tax Regulations provide that the loss of the tax exemption for interest on an exempt small issue of governmental obligations shall begin on the date of the capital expenditure that causes the obligations to exceed the exempt small issue limitation.

  The 'substantially all' test in section 103(b)(6)(A) of the Code will be satisfied if 90 percent or more of the proceeds of an exempt small issue are used for the acquisition, construction, reconstruction or improvement of land or property of a character subject to the allowance for depreciation under section 167. Sections 1.103-8(a)(1)(i) and 1.103-10(b)(1)(ii) of the regulations.

  Section 1.103-10(b)(2)(ii) of the regulations provides that an expenditure  (regardless of how paid, whether in cash, notes, or stock in a taxable or nontaxable transaction) is a section 103(c)(6)(D) (redesignated as section 103(b)(6)(D)) capital expenditure if:

    (a)  The capital expenditure was financed other than out of the proceeds of issues taken into account.

    (b)  The capital expenditures were paid or incurred during the 6-year period that begin 3 years before the date of issuance of the issue and ends 3 years after such date.

    (c)  The principal user of the facility in connection with which the property resulting from the capital expenditures is used and the principal user of the facility financed by the proceeds of the issue in question is the same person or are two or more related persons.

    (d)  Both facilities referred to in (c) were located in the same incorporated municipality or in the same county (outside of the incorporated municipality in such county), and

    (e)  The capital expenditures were properly chargeable to the capital account of any person or state or local governmental unit (whether or not such person is the principal user of the facility or a related person).

  Section 1.167(a)-3 of the regulations provides that if an intangible asset 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, such an intangible asset may be the subject of a depreciation allowance.

  Rev. Rul. 68-636, 1968-2 C.B. 92, concludes, in part, that a covenant not to compete that is separate from goodwill and has a limited useful life is an intangible depreciable asset.

  Situation 1. In order to qualify as an exempt small issue of $1,000,000 or less under section 103(b)(6)(A) of the Code, substantially all (90 percent or more) of the bond proceeds must be used for the acquisition of land or depreciable property.  The covenant not to compete to be acquired by X is separate from goodwill and will have a limited useful life. Therefore, the covenant is an intangible asset subject to the allowance for depreciation as provided in section 1.167(a)-3 of the regulations. Also see Rev. Rul. 68-636.

  Situation 2. Y's purchase of the business enterprise for $2,800,000 included Y's payment for $300,000 for the covenant not to compete.  The covenant not to compete was (1) financed other than out of bond proceeds, (2) paid for during the 3-year period following the issuance of the bonds, (3) used by Y in connection with Y's facility financed by bonds issued by O, (4) attributable to a business enterprise located in the same incorporated municipality as the facility financed by bond proceeds, and (5) chargeable to the capital account of Y.  Thus, the purchase of the covenant not to compete satisfies the requirements set forth in section 1.103-10(b)(2)(ii) of the regulations.

HOLDINGS

  Situation 1. The purchase of the covenant not to compete by X will be an acquisition of property that qualifies under section 103(b)(6)(A) of the Code. Because substantially all (90 percent or more) of M's bond proceeds will be used for land or property subject to the allowance for depreciation, the bonds will qualify as an exempt small issue of $1,000,000 or less under section 103(b)(6)(A) and the interest on the bonds will be excludable from gross income under section 103(a)(1).

  Situation 2. The purchase of the covenant not to compete by Y is a capital expenditure within the meaning of section 103(b)(6)(D) of the Code and section 1.103-10(b)(2)(ii) of the regulations.  Because the aggregate face amount of the bonds ($7,500,000 plus $2,800,000 equals $10,300,000) exceeded the $10,000,000 limitation for an exempt small issue, the exception provisions of section 103(b)(6)(D) do not apply and the interest on the bonds is not excludable from gross income under section 103(a)(1) beginning on October 1, 1980, the date of the capital expenditure.

Rev. Rul. 81-55, 1981-1 C.B. 52, 1981-8 I.R.B. 6.