Rev. Rul. 88-24

1988-1 C.B. 306, 1988-15 I.R.B. 6.

                       Internal Revenue Service

                                 Revenue Ruling

                      FRANCHISES; AMORTIZATION DEDUCTIONS

                           Published: April 11, 1988

SECTION 1253. - TRANSFERS OF FRANCHISES, TRADEMARKS, AND TRADE NAMES

  Franchises; amortization deductions. If a franchise is transferred by a franchisee, then the transferee of the franchise may amortize the acquisition cost allocable to the franchise rights under section 1253(d)(2) of the Code.

  A franchisor transferred to a franchisee the exclusive right to package, distribute, and sell the franchisor's products within a certain geographic area. The franchisee was required under the transfer agreement to follow specific formulas with respect to the franchisor's products and to meet various quality control standards. The franchisee's rights under the franchise agreement could not be transferred without the franchisor's prior written consent. The franchise was a capital asset in the franchisee's hands.

  The franchisee sold its business - including all of the franchise rights - to an unrelated party for $200,000. The new franchisee can establish that $10,000 of the purchase price was paid for the franchise rights, $100,000 was paid for tangible assets, and $90,000 was paid for goodwill. The franchisor had agreed to the sale and kept the new franchisee under the same restrictions as the original franchisee. On its Federal income tax return for the year in which the purchase took place, the new franchisee claimed an amortization deduction of $1,000 under section 1253(d)(2).

  ISSUE. At issue is whether the new franchisee may amortize the cost of the franchise rights under section 1253(d)(2)), where the original franchisor retains a significant power, right, or continuing interest in the franchise, even though the sale of the franchise rights was a sale of a capital asset as to the initial franchisee who sold the rights.

  HOLDING. The Service has held that the new franchisee may amortize the acquisition cost allocable to the franchise rights under section 1253(d)(2).

  ANALYSIS. The underlying issue presented to the Service was which factor should control the new franchisee's treatment of the franchise rights: (1) the fact the new franchisee's acquisition from the first franchisee was a sale of a capital asset as to the first franchisee or (2) the fact that, had the new franchisee acquired the franchise rights directly from the franchisor, it would have been entitled under section 1253(d)(2) to amortize the cost of the franchise over a period of 10 years. The Service concluded that, while the former theory may have theoretical support, congressional intent indicates that 'a taxpayer should be entitled to amortize its cost under section 1253(d)(2) of the Code if it obtains a franchise subject to a significant power, right, or continuing interest. The tax treatment afforded the purchaser,' the Service continued, 'should not turn upon whether the franchise was obtained from the franchisor or from a prior franchisee.'

                                     ISSUE

  If a taxpayer purchases all of the assets of a franchisee's business, including the franchise rights, for a fixed sum and the original franchisor retains a significant power, right, or continuing interest with respect to the franchise, is the taxpayer entitled, pursuant to section 1253(d)(2) of the Internal Revenue Code, to amortize the portion of the purchase price allocable to the franchise?

                                     FACTS

  In 1967, Z transferred a franchise to Y. The franchise agreement gave Y the exclusive right to package, distribute, and sell products bearing the Z trade names and trademarks within a certain geographic area. Pursuant to the franchise agreement, Y was required to follow specific formulas in the production process, to maintain adequate productive capacity, to meet various quality control standards, and to promote the sale and distribution of the Z products. The agreement stated that Y's rights under the franchise agreement could not be transferred without the prior written consent of Z. The agreement contained no restrictions on the duration of the franchise granted to Y, provided Y complies with the provisions of the agreement. The agreement is a 'franchise' as defined in section 1253(b)(1) of the Code. The franchise is also a 'capital asset' in Y's hands, within the meaning of section 1221 of the Code.

  In 1987, Y sold its business to X for 200,000x dollars. Among the assets transferred to X were Y's rights under the franchise agreement with Z. X can establish under section 1060 of the Code that 10,000x dollars of the total 200,000x purchase price was paid for the franchise rights, that 100,000x dollars was paid for the tangible assets, and that the remaining 90,000x dollars represented the going concern value and goodwill of the business. X, Y, and Z are unrelated parties. Prior to the sale, Z consented to the transfer of the franchise rights to X and confirmed that the franchise agreement remained in full force and effect after the sale. Although Y did not retain any interest in the franchise, X is subject to the same restrictions and conditions imposed by Z in the franchise agreement issued to Y. X did not pay any amount to Z on the transfer of the franchise.

  On its federal income tax return for the 1987 calendar year, X claimed a deduction of 1,000x dollars (1/10 of the 10,000x dollars paid to Y for the franchise rights) under section 1253(d)(2)(A) of the Code.

                                LAW AND ANALYSIS

  Section 1253(a) of the Code states that a transfer of a franchise, trademarked, or trade name shall not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark, or trade name.

  Section 1253(b)(1) 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 specific area.

  Section 1253(b)(2) of the Code states that the term 'significant power, right, or continuing interest' includes, but is not limited to, the following rights with respect to the interest transferred:

    (A) A right to disapprove any assignment of such interest, or part thereof.

    (B) A right to terminate at will.

    (C) A right to prescribe the standards of quality of products used or sold, or of services furnished, and of the equipment and facilities used to promote such product or services.

    (D) A right to require that the transferee sell or advertise products or services of the transferor.

    (E) A right to require that the transferee purchase substantially all supplies and equipment from the transferor.

    (F) A right to payments contingent on the productivity, use, or disposition of the subject matter of the interest transferred if such payments constitute a substantial element under the transfer agreement.

  Section 1253(d)(2)(A) of the Code states that if a transfer of a franchise, trademark, or trade name is not (by reason of the application of subsection (a)) treated as a sale or exchange of a capital asset, then any noncontingent payment which is made in discharge of a principal sum agreed upon in the transfer agreement shall be allowed as a deduction (in the case of a single payment made in discharge of such principal sum) ratably over the period beginning with the tax year in which the payment is made and ending with the ninth succeeding tax year or ending with the last tax year beginning in the period of the transfer agreement, whichever period is shorter.

  In the present situation, Y did not retain any significant power, right, or continuing interest with respect to the transferred franchise. The franchise was a capital asset in Y's hands. As to Y, therefore, the transaction was a sale of a capital asset.

  X, however, acquired the franchise subject to the rights and powers imposed by Z in the original franchise agreement between Z and Y. These retained rights and powers constitute significant powers, rights, and continuing interests under section 1253(b)(2) of the Code. If X had acquired the franchise directly from Z, X would have been entitled under section 1253(d)(2) to amortize the cost of the franchise over a period of 10 years. The question presented, therefore, is whether X is to be denied the benefits of amortization because the franchise was acquired from the prior franchisee rather than from the franchisor.

  Section 1253 of the Code does not address specifically the problem of a transfer of a franchise from a prior franchisee to a subsequent franchisee. It can be argued, however, that a literal reading of the statute precludes the subsequent franchisee from obtaining the benefits of amortization under section 1253(d)(2), which applies only if section 1253(a) causes the transfer to be treated other than as a sale or exchange of a capital asset. When, as in the present situation, the prior franchisee retains no significant power, right, or continuing interest, the transaction can be viewed as such a sale or exchange.

  Although the above argument is consistent with the express language of the statute, it ignores the congressional intent that a taxpayer should be entitled to amortize its cost under section 1253(d)(2) of the Code if it obtains a franchise subject to a significant power, right, or continuing interest. The tax treatment afforded the purchaser should not turn upon whether the franchise was obtained from the franchisor or from a prior franchisee.

  In addition, although the consideration for the franchise in the present case was paid to the prior franchisee, the franchisor was a party to the transaction because the franchisor's consent was required to effect the transfer. The franchise rights run from the franchisor to the new franchisee, and the franchisor retains a significant power right, or continuing interest. Thus, from the standpoint of the new franchisee, both the prior franchisee and the franchisor are transferors and the transfer is subject to the type of restrictions, that, under section 1253(a) of the Code, normally prevent the transaction from being considered a sale or exchange of a capital asset.

                                    HOLDING

  X is entitled, under section 1253(d)(2) of the Code, to amortize the portion of the purchase price attributable to its acquisition of Y's franchise rights.

  This holding is limited to amounts properly allocable to the franchise rights acquired. The Internal Revenue Service will scrutinize closely transactions of this type to ensure a proper allocation of the purchase price among the franchise, goodwill, and other assets.

                              DRAFTING INFORMATION

  The principal author of this revenue ruling is Mr. William E. Blanchard of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Blanchard on (202) 377-9589 (not a toll-free call).

Rev. Rul. 88-24, 1988-1 C.B. 306, 1988-15 I.R.B. 6.