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FRANCHISES,
INTANGIBLE GEORGE
CAPITAL,
AND ASSETS**
MUNDSTOCK*
OMPLEXITY and confusion in the C incora,w-tax arise.-when t4x--consequences depend upon distinctions that cannot be made. The rules applicable to intangible capital are a perfect example. Much depends on whether intangible value is considered to be attributable to someihing viewed as an asset; yet, the notion of an asset lacks sulticient substance to support the weight placed upon it.' In general, when a distinction does not work, it is best to replace the distinction with one that does. Unfortunately, this does not seem possible with intangible capital. There is no ready substitute for the asset notion. The beat that can be done is to take some weight off it. This article explores this thesis by focussing on the treatment of intangible capital involved in franchising. Franchising is illustrative because its popularity as a form of business organization is attributable, at least in part, to its utility for exploiting intangible capital. The Franchisor Franchisors have a wide variety of intangible capital: trademarks, trade names, service marks, copyrights, patents, unpatented technology, know-how, business systems, goodwill, going concern value, human capital, and the like. This intangible capital provides returns in the form of amounts realized for sales of franchises to franchisees and in the form of royalties from franchisees under franchise agreements. A franchisor also might receive hidden returns on intangible capital through mark-ups in the prices charged to franchisees for real estate, goods, and services and through kickbacks from third party suppliers to franchisees.' All of these forms of income attributable to intangible fUll.3 capital are taxed in A franchisor incurs substantial expenditures related to its intangible capital: *University of Miatni School of Law, Coral Gables, FL 33124.
expenditures on advertising, R&D, recqib@Wt, tt -pning, and the like. usiness expenditures generalij are '@de@iu@tible unless they are so related to an asset that the expenditures must be capitalized to that asset. A franchisor's expenditures related to its intangible capital generally are not considered to be related to an asset. The uniform capitalization rules enacted in 1986 do not apply with regard to intangibles. Thus, most business expenditures related to intangible capital are deductible. Some such expenditures are not deductible, however. For example, legal fees related to trademarks, service marks, and trade narnes-both fees related to their acquisition and the costs of lawsuits in their defense-are sufficiently connected to these assets to be capitalized. These capitalized amounts usually result in little tax benefit, as the underlying assets are not depreciable.' The law views depreciation, in general, as an allowance for the wasting of an asset. If one thinks about intangible value as if it were a tangible object, its wasting is problematic. Thus, the law sets a very high standard for depreciability: an intangible asset must have a reasonably determinable fixed life. Trademarks, trade names, and service marks rarely satisfy this requirement because of their renewability. Similarly, when a franchisor purchases a trademark or the like, it must capitalize the purchase price as the cost of an asset (that probably is not depreciable). This patchwork regime is troubling.r' Most of a franchisor's cost-expenditures on advertising, R&D, and the like-receive unjustifiably favorable treatment: immediate deductibility. These costs increase the value of the business and relate to future earnings, just like the costs of tangible assets, and yet are not capitalized and depreciated, like the parallel costs of tangible assets. In contrast, some of a franchisor's costs-such as legal fees related to trademarks, costs of purchased 299
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trade names, and the like; costs that are economically indistinguishable from deductible expenditures-receive unjustifiably unfavorable treatment: effectively no deduction. It is important to note that most of these problems arise from trying to treat intangible value as if it were a tangible asset. Advertising expenditures do not resemble asset costs and are deductible. Legal fees related to trademarks look like legal fees related to assets and therefore are capitalized. Trade names do not waste like tangible assets and therefore generally are not depreciable. One class of expenditures of franchisors is not controlled by the asset notion: startup expenditures. Even though not connected with an asset, these expenditures are capitalized and depreciable over 60 months. A non-asset oriented rule that applies only to start-up expenditures presents problems, however. Identical expenditures of similar businesses are treated differently depending upon whether the incurring business is viewed as being in a start-up phase. The Franchisee The asset notion also contributes to problems in the treatment of franchisees. A franchisee's royalty payments are not viewed as costs of assets and are deductible (subject to accounting limitations). Contingent payments for a franchise based on use, sales, and the like are viewed as royalty-like and generally also are so deductible. In order that franchisees not deduct contingent payments prior to the year to which they relate, a new rule was enacted in 1989 that limits the deduction to payments determined by a qualifying fixed formula.' All other payments related to the acquisition of a franchise are treated as nondeductible costs of an asset. These capitalized costs of a franchise are deprec* 4 *, -Ay@x 25 -ye4aWO yi in the case of a fixed price 017@,00@o o; less). In the unusual en@mmtance that the life of the franchise is determinable, depreciation over this life is allowed. Again, the asset notion motivates a troubling bright line with considerable tax
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significance. Some payments for the use of a franchisor's intangible capital are viewed as being unlike payments to acquire an asset and are immediately deductible, while other payments for the same use receive radically less favorable treatment. Accounting concerns motivate a line between innnediately deductible fixed-formula contingent payments and capitalized, 25-year depreciable, fluctuating-formula contingent payments. In addition, the start-up rules apply to franchisees, with the same untoward effects discussed above with regard to franchisors. Further difficulty is presented if a franchisee purchases its franchise from a prior franchisee. The total pruchase price must be allocated among the acquired assets, including the transferred franchise, up to their values, with any excess treated as nondepreciable goodwill or going concern value. The franchise might have value because the transferred franchise agreement provides for below-market royalties or the like (compared to what the franchisor could get from a new franchisee)' or because the transfer avoids a lump silm payment to the franchisor. The franchise also might have value because it gives access to an attractive and developed market . It is hard to distinguish this potential source of value from goodwill. At least one court, however, has allowed a purchaser franchisee to allocate a goodwilllike amount to a depreciable public franchise on the theory that such a franchisee cannot have goodwill. Payments to a prior franchisee for the franchise are subject to the same treatment as such payments to a franchisor, as discussed above. Once more, current law draws objectionable, arbitrary, lines. Expenditures of a purchaser franchisee have differing tax treatments depending upon whether they are allocated (a)to the sometime depreciable franchise agreement, (b) to nondeW-ilL.- v prqgiab lea* -concern value, or (c) to some depreciable intangible. The law requires a refined dissection of purchased intangible capital for which there is little economic basis. Additionally, current law, in effect, creates an extra tax when a franchisee sells
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GEORGE MUNDSTOCK
its franchise to a purchaser franchisee. This can be seen by comparing the treatment of the sale of a business consisting of depreciable tangible assets with the treatment of the sale of a franchise. When a depreciable tangible asset is sold, there should be relatiygjy-little- ini@rease in the tax on the income- generated by tfiii asset. Consider the sale of an asset that has been subject to perfect economic depreciation. The asset's adjusted basis to the seller exactly equals the asset's value. A fair market value price results in no gain to the seller. The buyer's depreciable basis is the same as the seller's prior to sale. Thus, sale of the asset effects no change in its taxation. If depreciation has been accelerated, the seller pays some tax, but this tax is partially offset, in present value terms, by increased buyer depreciation. When a franchise is sold, the present value of taxes on the income generated by the transferred business increases considerably. The seller probably has expensed its costs in developing its non-asset intangible capital, so that the entire portion of the sale price allocated to this intangible capital is taxable. The purchaser is allowed little or no depreciation of the same amounts. Consequently, in contrast to the sale of a business consisting primarily of depreciable tangible assets, the sale of a franchise effects a greater, "extra," tax. GeneraHzation and Conceptualization The discussion thus far has focussed on the taxation of franchising. In analyses of tax policy issues, in order that all similar activities be taken into account, it generally is best to consider problems at as high a level of generality as is realistic. The rules applicable to franchising are not materially different from the rules applicable to other activities involving substantial intangible capital. The next section of this paper demonstrates that broadbased reforrn of the taxation of intangible capital is realistic. It makes sense, therefore, to generalize the analysis above into a broad critique of the current taxation of intangible capital (capitalization, depre-
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ciation, and taxation of disposititon). The problems with a narrow approach can be seen in two recent proposals. One proposal would disallow or defer some advertising deductions. 8 This disallowance would cause taxpayers (i) to label pro. motional activities as other than adverto -F@stAemure tlie@ir protisin@g@"a'na - (ii) -'@ motional activities in order that any associated expenditures not be subject to the unfavorable advertising rules. Another proposal would disallow depreciation of all purchased customer- or market-related intangibles.' This disallowance would reduce the problems arising from the current varying treatments of different types of purchased customer- or market-related intangibles, but would exacerbate the problems from (a) the inconsistent treatment of self-developed and purchased customer- or market-related intangibles and (b) the line between purchased customer- or market-related intangibles and similar intangibles, such as a purchased favorable supply contract. Only comprehensive reform avoids the difficulties inherent in piecemeal reform. It is possible to generalize even further. For example, my analysis, by showing that our income taxes do not work with regard to business intangible capital, makes a case for a consumption-type business taxsay, expensing of all expenditures. Similarly, my analysis can suggest that the best income tax on business (at least business conducted in corporate form) is not the current regime (which measures taxable income, not by valuing accretions to wealth, but by using cash flows-gross income less expenses-to approximate economic income), but rather a true accretion regime where business ownership interests (stock, in the case of a corporation) are marked to market. In other words, since capitalization of expenditures to assets is the fundamental mechanism used by our non-accretion income taxes to identify and value taxable accretions to wealth,'o my analysis that rules based on the asset notion cannot work with intangible capital can cause one to conclude that we should abandon the current regime, Such a very generalized approach is
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particularly attractive to one looking for perfect rules. There does not appear to be a perfect way to tax business intangible capital under a non-accretion income tax. Thus, any criticism of the taxation of intangible capital is implicitly a criticism of our non-accretion taxes. Reform of the current system seems futile. I do not find this very generalized approach attractive. Generalization makes sense only when it is realistic. Moving to expensingil or marking to market does not seem realistic, while, as discussed below, broad-based reform of intangible capital does. My analysis should not be carried to its logical conclusion. Refusing to fully generalize from my analysis does mean abandoning perfect solutions. Perfect solutions to tax problems are rarely available, however. For example, two rules closely related to those considered here are imperfect. Current tax depreciation of tangible assets is a crude approximation of economic depreciation. Similarly, the rules that distinguish between a deductible repair and a capitalized improvement do not come close to those under a perfect income tax." An imperfect rule is acceptable when a perfect rule does not exist and alternate imperfect rules work even less well. The question is whether any improvement is possible. The current rules for the taxation of business intangible capital are seriously defective. Most troublingly, businesses that use self-developed intangible capital are allowed to expense their investments (consumption tax type treatment), while other capital-intensive businesses are subject to capitalization and depreciation (income tax treatment).13 As intangible capital becomes more and more important to business, these defects will become increasingly significant. An admirable desire for perfection should not cause one to ignore real and growing problems. Any4mlopfact@-roforni4hat-eflkot"m-improvement merits serious consideration. An Imperfect Proposal The discussion above concludes that the defects in current law are attributable to
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the asset notion. Under these circumstances, it makes sense to look for possible reforms by viewing intangible capital as disembodied value rather than as a collection of assets. The issue then presented is how to identify and tax this disembodied value. Under our non-accretion income taxes, value generally is identified and taxed by capitalizing expenditures (deferring expenses). The key to taxing intangible capital, therefore, is to identify the connection between value and expenditures. In a sense, all business expenditures are associated with value. Businesses expect to get their money's worth from any expenditure. An expenditure on a tangible asset is associated with the valuable asset. A true current expense is associated with a valuable increase in current revenues. An expenditure not related to an asset or to an increase in current revenues should relate to future revenues (or future cost savings) and therefore should be associated with a current increase in the value of the business that is not represented by a traditional asset. Consequently, any expenditure not related to an asset or to current revenues must relate to intangible capital. One might be troubled by this idea that businesses always get their money's worth from expenditures. Businesses do make mistakes. Nevertheless, this money's worth notion underlies current law's realization requirement. Assets sometimes are not worth what they cost, but no loss is allowed until realized by disposition. Businesses do not always get value for the broad range of indirect expenditures now subject to the uniform capitalization rules. The money's worth notion is generally consistent with current law. The fundamental question, therefore, is how to distinguish non-asset intangible capital expenditures, on the one hand, from asset-related expenditures and true current%mpwmes,- on the other. FbrpfaVftes of this exercise, it seems reasonable to assume that current law does an adequate job of identifying asset-related expenditures. Having thus distinguished assetrelated expenditures from non-asset expenditures, the hard issue becomes how
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GEORGE MUNDSTOCK
to bifurcate non-asset expenditures; i.e., how to tell true current expenses from nonasset intangible capital expenditures ("expenses" that relate to the future). The money's worth notion suggests that when a business increases its non-asset expend or yVM;'thtrbdglness expects either (i) increased current revenues or (ii) increased future revenues (or decreased future expenses); i.e., intangible capital. Increased non-asset expenditures of any sort not associated with increased current revenues relate to intangible capital. Having identified expenditures related to intangible capital, it is necessary to determine how to depreciate them. Depreciation of tangible assets approximates the assets' decline in value. An asset loses value when the asset's future utility declines, presumably as a result of the receipt of current benefits. 14 Tangible asset depreciation therefore roughly follows the receipt of current benefits. A parallel rule for intangible capital expenditures would provide for deductions at the time of the associated increase in revenues (or decrease in expenses). Increased non-asset expenditures not associated with increased current revenues should be deductible only to the extent of increased revenues (or decreased expenses) in later years. One further refinement is helpful. Under current law, depreciation allocable to manufacturing inventory or to producing property to be used by the taxpayer must be capitalized as an indirect cost of the inventory or self-produced property. The value lost by the depreciating asset does not relate to current revenues but to an increase in the value of the manufactured inventory or self-produced asset. Depreciation is viewed like a current expenditure in manufacturing or production. Parallel rules should apply to non-asset intangible capital. The deferral of increased non-asset expenditures not associated with increased current revenues should also apply to deemed expenditures in the form of depreciation. These ideas can be hewn into a practical proposal: When current-law deductible expenses (of any sort, including de-
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preciation) exceed the average of such expenses for the three prior years, the excess would be deductible only to the extent that current revenues exceed the av15 erage of the three prior years'revenues. Under the analysis above, these incrda'ge& 4@kl)eftgi6s'-r6rate either to increased current revenues or to the future. Thus, the proposal provides that increased current expenses are immediately deductible only if there are increased current revenues. If not, the increased expenses are deferred." These deferred expenses would be deductible in later years. The proposal provides depreciation that is similar to income-forecast depreciation. Deferred expenses from one year would be treated as current expenses in the following year. If revenues increase (or then current expenses decrease) in the subsequent year, the deferred expenses would be deductible then. Again, any deferred expenses would carry forward, effecting an indefinite carry forward. In this fashion, the proposal would achieve the basic goal that increased current expenses be deferred until revenues increase (or expenses decrease). This ad hoc depreciation obviously would be considerably slower than economic depreciation in many cases. Any resulting harsh effectr, could be softened by allowing a deduction for some portion, say 20 percent, of any expenses otherwise deferred. In other words, each year increased expenses would be deductible up to the sum of (a) increased revenues plus (b) 20 percent of the amount by which increased expenses exceed increased revenues. This would assure that taxpayers do no worse than 20 percent annual declining balance depreciation. Rules would be provided for controlled groups, short years, mergers, new businesses and investments, and the like. The start-up rules would be repealed. Under the proposal, in a taxable asset acquisition, the balance of the seller's nondeducted deferred expenses would be treated as an asset with a value equal to the amount of the balance. This amount would be tax-free to the seller (since the basis of the deemed asset would equal its
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sale price) and subject to depreciation under the new rules to the buyer. Thus, a buyer would step into its seller's shoes with respect to the seller's nondeducted balance of expenses deferred under the new rules. The question arises as to how the special rules for franchising would be modified under this regime. A franchisor's expenditures for advertising, R&D, 17 and the like would be subject to the new rules. A franchisee also would be subject to the new rules. It should be possible to repeal the 1989 rules that capitalize and 25-year depreciate fluctuating-formula contingent franchise payments, as the proposal should do a better job of effecting the matching and similar accounting policies underlying the 1989 rules. This would achieve a nice simplification and improvement. The rules applicable to a franchise pur_ chased from a prior franchisee also could be streamlined. Most simply, amounts that otherwise would be nondepreciable or subject to 10- or 25-year depreciation could be treated like purchased goodwill and recovered under the new depreciation rule. This rule also could apply to a franchisee that purchases a franchise from the franchisor for a lump sum. In both cases, the law would be simplified and the economic problems inherent in arbitrary lines would be reduced. I have explored the problems with the proposal elsewhere."' To summarize, i the proposal is not perfect, its economic effects are problematic. For example, current law's expensing of expenditures associated with self-developed intangible capital is neutral between types of selfdeveloped intangible capital (assuming that all tax savings also is expensed). The proposal is neutral only if it provides perfect economic depreciation, which seems unlikely. Consequently, the proposal probably increases a distortion between tppes -of int *W 'ble -4*@19 -In the abstract, it is not possible to decide whether this additional distortion is worse than the distortions reduced by the proposal. A quantitative analysis is required. The proposal presents numerous such difricult, "second best," problems, which are beyond the scope of this article. Thus, I
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cannot recommend the proposal's adoption at this time. The purpose of the proposal is merely to illustrate that comprehensive non-assset oriented rules that reduce the problems in current law might be workable. My intuition is that the proposal would effect a considerable improvement over current law. Under the proposal, intangible capital would be treated more like tangibles. The proposal would eliminate the difference between start-up and other businesses. Any extra tax on dispositions of businesses with intangible capital would be reduced. Finally, by dealing with intangibles comprehensively, the proposal would permit simplification and other improvements in other rules. Conclusion:
Law and Confusion
As a lawyer, I am trained to respect legal concepts. Nevertheless, my basic analysis of the taxation of business intangible capital is to reject the legal concept, the asset notion, underlying the current regime. The asset notion is inapt, because much intangible capital is not represented by anything traditionally viewed as an asset. Policymakers must stop being confused by this legal concept. ENDNOTES **The author would like to thank Thomas Barthold, Kenneth M. Casebftr, Andrew B. Lyon, and Pamela j. pecarich for their help with this article. 'This article's general analysis of the taxation of intangible capita is drawn from Mundstwk (1987). Most importantly, this articleassumes what I documented in the earlier aracle, that there is evidence that many currently deductible business expensea are associated with an increase in intangible capital. The sigraficance of this is explored finther in Fullerton and Lyon (1988). In the interests of reducing the number of notes, there are no further citations to my earlier article for its basic analysis. 2For a general discussion of franchising, see Brown (1989). $nr a basic discussion of tht-Imtim of hvmchismg, see Davidson (1989) and Senate Committee on Finalce (1989), pp. 158-61. No further citations for current law are made. One can criticize current law for not treating certain ftanchisor sales of franchises as sales of assets, so that some basis recovery is allowed. Since the generai basis recovery problem is discussed later, this narrow problem is not considered further.
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The discussion herein does not consider which income associated with intangible capital should be subject to any preferential treatment for capital gain, as the purposes underlying any such preference are too murky. 'Ms article treats amortization as a form of depreciation. 'This article's sole concern is that the tax system not inadverteatly dgmions Thus, the article is agnostic on the social desirability of franchising and of the underlying businesses. 6Senate Committee on Finance (1989), p. 159-60. 7It might be possible to depreciate this value attributable to below-market royalties and the like over the period for below-market royalties. This is a very limited opportunity for depreciation, since very few transferred franchise agreements provide below-market royalties and the like, as royalty rates usually are a fixed percentage of use, gross income, and the like, which percentage does not change from fi-anchisee to franchisee. Davidson argues that a taxpayer should be allowed to bifurcate value attributable to the firanchise agreement between the initial and renewal periocla and depreciate the value attributable to the initial period. He does not articulate a valuation methodology. His discussion suggests that he would depreciate all value attributable to the initial period and not just any value &om below-market royalties and the like. If so, it is hard to see how or why his amount is or should be depreciable. For example, under his approach, one also should treat ownership of land as consisting of a series of successive ownership periods, each of which is depreciable, which is absurd. Compare Mundstock (1990), pp. 738-39, with Davidson (1989), pp. 1055-60. ee, for example, Fullerton and Lyon (1988), p. 83. ost conspicuously, see House Committee on Ways and Menn (1987), pp. 1058-61. "Under a non-accretion income tax, a receipt generally is taxed. Thus, if the expenditure of that receipt is capitalized, the net effect is that the capitalized amount-the deemed accretion to wealth-is taxed. "I find expensing objectionable per se, as well. 12of course, these rules also are badly in need of reform and are not particularly good precedent for anything. 13 See Kaplow (1988), pp. 301-302. "Obviously an asset also can lose value because of unexpected obsoleseense and other unexpected market effects. These changes in value generally are ignored under current law until a realization event. '5Mundstock (1987), pp. 1237-63. The discussion
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here ignores inteml See Mundstock (1987), pp. 1185, fh. 20 16Any deferred amount is not taken into account for purposes of determining averages in future year. This corrects an error on page 1240 of Mun&tock (1987). '7The current preference for A&D could be retained if desired for non-tax reasom"Mundstock (1987), pp. 1247-51, 1253-54. '!4#AgX@Lyon call@d thip W w,,Y,4t4jAuQu. For- another example, Seymour Fiekowsky has suggested to me, if I understand lum, that non-asset intangible capital generally is more risky fl= tangibles, so that, taking risk into account, expensing is needed to maintain neutrality. REFERENCES Brown, Harold, Franchising: Realities and Remedies (New York: Law Journal Semiuars-Press, Rev. Ed. 1989). Davidson, Daniel M. "The Amortization of Franchises: Back to the Future?," Taxes, Vol. 67, No. 12 (December, 1989), pp. 1043-60. Fullerton, Don, and Andrew B. Lyon, "Tax Neutrality and Intangible Capital," in Lawrence H. Summen, editor, Tax Policy @t@ The Economy, Vol. 2 (Cambridge, Mass.: The MIT Press, 1988), pp. 6388. House Committee on Ways and Means, "Report to Accompany the Recommendations of the Committee on Ways and Means," in House of Representatives, House Report (Budget Committee) No. 100491 (Washington, D.C.: U.S. Government Printing Office, October 27, 1987), pp. 1025-632. Kaplow, Louis, "Comments on William D. Andrews and David F. Bradford, 'Savings Incentives in a Hybrid Income Tax,"' in Henry J. Aaron, Harvey Galper, and Joseph A. Pechman, editors, Uneasy Compromise: Problems of a Hybrid Income-Consumption Tax (Washington, D.C.: The Brookings Institution, 1988), pp. 300-308. Mundstock, George, "Taxation of Business Intangible Capital," University of Pennsylvania Law Review, Vol. 135, No. 5 (June, 1987), pp. 1179-263. Munclstock, George, "Eleventh Circuit Affirms Accelerated Depreciation of Land?," Tax Notes, Vol. 47, No. 6 (May 7, 1990), pp. 737-39. Senate Committee on Finance, Revenue Reconciliation Act of 1989: Explanation of Provisions Approved by the Committee on October 3, 1989 (Washington, D.C.: U.S. Government Printing Office, October 12, 1989).
