Rev. Rul. 87-63

1987-2 C.B. 210, 1987-29 I.R.B. 8.

FRANCHISES; LICENSE AGREEMENTS; DEDUCTIONS

Published: July 20, 1987

Section 1253.-Transfers of Franchises, Trademarks, and Trade Names

(Also Sections 162, 461; 26 CFR 1.162-1, 1.162-11, 1.461-1.)

  Franchises; license agreements; deductions. A license agreement to receive computerized commodity trading suggestions does not constitute a franchise under section 1253 of the Code and payments by the licensee must be deducted ratably over the term of the agreement.

ISSUE

  If a taxpayer enters into a 12-year license agreement under which the taxpayer is authorized to receive trading suggestions for commodities traded on major commodities exchanges, may the taxpayer deduct fees paid to the licensor in the year the taxpayer pays the fees?

FACTS

  X corporation develops computer programs designed to aid in the prediction of commodity price trends. X inputs current commodity trading data into a central computer. Licensees can then access the computer's trading suggestions (trading signals) and use the information for investment advisory purposes.

  In 1983, LP, a limited partnership engaged in the business of commodity trading and commodity investment advising, entered into a 12-year license agreement with X, under which LP was licensed to receive trading signals for up to 26 different commodities traded on major commodities exchanges. LP uses the accrual method of accounting to compute income for federal tax purposes.

  For each commodity for which LP elected to receive trading signals, X was to be paid a 900x dollar fee, of which 225x dollars was in cash and the remainder in the form of a 12-year full recourse promissory note, requiring equal quarterly payments. LP was also required to pay X in cash each year additional fees based upon performance and the total amount of customers' funds under LP's management during that year.

  X claims that its relationship with LP is that of franchisor- franchisee and is controlled for tax purposes by section 1253 of the Internal Revenue Code. X therefore contends that the fees paid to license the trading signals constitute contingent fees under section 1253(d)(1). This contention is based on characterizing the total payments under the agreement as payments that are contingent on the number of commodities (which could vary from 1-26) for which LP elects to receive trading signals. X contends as well that the fees based on performance and the amount of customers' funds under management also constitute contingent fees, as defined in section 1253(d)(1).

  X plays no part in the management or operation of LP's business, and LP acquired no rights to the name, trademarks, or logos of X. X has no control over the manner in which LP utilizes the trading signals.

  For the tax year 1983, LP had a cash outlay, exclusive of business formation costs, of 225x dollars for each commodity for which it elected to receive trading signals. For that tax year, LP claimed a deduction for the entire 900x dollar cost for each commodity for which LP elected to receive trading signals.

LAW AND ANALYSIS

  Section 162(a) of the code provides that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.

  Section 1253(b) of the code states that the term franchise includes 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.

  Section 1253(d)(1) of the Code states that amounts paid or incurred during the tax year on account of a transfer, sale, or other disposition of a franchise, which are contingent on the productivity, use, or disposition of the franchise, shall be allowed as a deduction under section 162(a).

  The legislative history of section 1253 of the Code shows that Congress did not intend section 1253 to control transactions like the one between LP and X. As indicated by the Senate Finance Committee report, this section was intended to apply to systems of distribution generally characterized by many or all of the traditional indicia of franchise arrangements. These include the continued use by the franchisee of the franchisor's trade name and trademarks, quality controls by the franchisor's, management and operational guidance, and common advertising and promotion by the franchisor, within a specified area. See S. Rep. No. 91-552, 91st Cong., 1st Sess. 207-211 (1969), 1969-3 C.B. 423, 554- 557. X and LP are totally independent entities and are not part of a common system of distribution, promotion, or management. LP does no distribute, sell, or provide to its customers the information provided to LP by X. LP is merely a licensee of information compiled and provided by X, and not a franchisee. Therefore, the provisions of section 1253 are inapplicable to this situation.

  The fees paid by LP to X for receipt of the trading signals are ordinary and necessary business expenses deductible by LP over the duration of the franchise agreement, as provided by section 162(a) of the Code. Section 1.162-1(a) of the Income Tax Regulations provides that among the items included in business expenses is rental for the use of business property. Section 1.162-11(a) provides that if a leasehold is acquired for business purposes for a specific sum, the purchaser may take as a deduction an aliquot share of the cost of the leasehold each year during the term of the leasehold.

  Rev. Rul. 74-358, 1974-2 C.B. 43, concerns amounts paid for contracts that permit a television station to exhibit films an unlimited number of times during a limited period of time. The ruling holds that section 1.162-11(a) of the regulations applies to payments for these contracts, whether the contracts are licenses or leases.

  In the present situation, LP has contracted to receive and use the signals chosen an unlimited number of times during the 12-year term of the agreement. Therefore, like the contracts in Rev. Rul. 74-358 described above, the license fees paid by LP are governed by the provisions of section 1.162-1(a) of the regulations. LP is entitled to deduct a ratable portion of the fees for the signals each year. In addition, LP is entitled to deduct in the years in which they are incurred the fees based on performance and the amount of funds under management.

  Even if the arrangements between X and LP were to be construed as a franchise with contingent fees that are subject to the provisions of section 1253(d)(1) of the Code, the timing for the deduction of the fees under section 162(a) would be subject to the provisions of section 461(a) and section 1.461- 1(a)(2) of the regulations. See Rev. Rul. 81-262, 1981-2 C.B. 164.

  After July 18, 1984, the timing of deductions taken by a taxpayer in LP's situation is determined by section 461(h) of the Code. Section 461(h) provides that in determining whether an amount has been incurred with respect to any time, the all events test shall not be treated as met any earlier than when economic performance occurs. Section 461(h)(2)(A)(i) provides that if the liability of the taxpayer arises out of services to the taxpayer by another person, economic performance occurs as that other person provides the services. Since the payments to X constitute rental payments under section 1.162-11(a) of the regulations, performance corresponds to the rental period covered by the fees paid or incurred. Thus, application of section 461(h) provides the result described above regardless of whether the contractual relationship between X and LP is governed by section 1253. LP could still deduct a ratable portion of the 900x dollar fee for each year of the agreement. Moreover, section 461(h) would not preclude the deduction of any other fees that are otherwise deductible and that are allocable to the performance of X in a given year.

HOLDING

  The licensing agreement between LP and X does not constitute a franchise under section 1253 of the Code. Thus, the fees payable by LP to X pursuant to the licensing agreement are not contingent payments under section 1253(d)(1). The fees for the trading signals are for the unlimited access to the computer information for a limited period of time and, therefore, are deductible ratably over that period of time in accordance with the provisions of section 1.162- 11(a) of the regulations. The fees that are contingent on the performance of the commodities and on the amount of customer's funds under management may be deducted in whole in the year in which they are incurred.

Rev. Rul. 87-63, 1987-2 C.B. 210, 1987-29 I.R.B. 8