tax neutrality and the tax treatment of purchased...

TAX NEUTRALITY AND THE TAX TREATMENTOF PURCHASED INTANGIBLES**

JANE G. GRAVELLE*ANDJACKTAYLOR*

ABSTRACT chased intangibles should not be based on

Numerous IRSItaxpayer disputes about their useful lives. Indeed, for a given

the amortization periods for purchased in- holding period and a given rate of growth

tangibles have led to proposals for legis- of the firm, tax rates would be equated

lation to establish statutory amortization across. intangible assets only if a common

periods. Should Congress decide to legis- amortization period is used. That a single

late in this area, this economic analysis amortization period would be neutral

suggests that the simplest alternative-a across purchased intangibles of different

single period for all purchased inta. durability is a surprising result, but it

ngl- follows from allowing the cost of createdbles-is also correct to provide equal treat- intangibles to be expensed.ment for different types of intangibles.The next section of this paper reviews

the types of intangible assets and the con-

REPRESENTATIVE Dan Rosten- troversy over the tax treatment of pur-kowski introduced his H. R. 3035 on chased intangibles. The following section

July 25, 1991, which would provide a 14- reviews what may be called the "conven-year amortization period for most pur- tional wisdorn!'-that recovery periods forchased intangible assets, including good- purchased intangibles should be based onwill and going-concem value. The 14-year useful life. The final section discusses theperiod was selected to avoid negative rev- economic analysis of investment, takingenue consequences. The Rostenkowski bill into account both created and purchasedgenerally has been favorably received by intangibles. Technical details of tax ratethe tax community, because it would sim- calculations are included in an appendix.plify a contentious area of the tax law, andit has been endorsed by the Treasury De-partment. One criticism of the bill was that The Controversy Over Purchaseda 14-year period is too long for short-lived Intangible Assetspurchased intangibles such as software.

The current tax treatment of purchasedOn August 12, 1991, the General Ac-intangibles has resulted in a considerablecounting Office (GAO) released a reportcontroversy. The general rule is that awhich suggested that Congress should al-purchased intangible asset may be depre-low the amortization of all purchased in-ciated or amortized for tax purposes if ittangible assets including goodwill, overcan be established that the asset has a de-specific statutory cost recovery periods. The terminable cost and a limited, deterirnin-GAO report analogized the cost recoveryable life. "Goodwill" and "going concernof purchased intangibles to the cost re-value," however, are said never to havecovery of tangible depreciable assets.these characteristics and therefore neverPurchased intangibles that decline into be depreciable.' Since deducting costsvalue rapidly should b@ written off over aby depreciation gives a lower present valueshort amortization period, while pur-of taxes over the life of an investment thanchased intangibles that decline in valuededucting them only when the asset is sold,slowly should be written off over a longerthere is an obvious incentive for taxpay-period.ers to establish values and limited livesThis paper considers the appropriate tax for purchased intangible assets. This be-treatment of purchased intangibles. Wecomes a particular issue when purchasingconclude that write-off periods for pur-a complete business, where all of the pur-

*Congressional Research Service, Washington, DC chase price not allocable to the business's20540. tangible assets must be allocated to in-

77

78 NATIONAL TAX JOURNAL [Vol. XLV

tangible assets or to "goodwill." ("Good- tence of a separate asset with a determin-will" means, in accounting jargon, the able value and a limited life.value of a business operation over and It is instructive to consider just whyabove the value assigned to the business's these assets have economic value. An in-financial assets, physical assets, and intangible asset such as knowledge or a re-tangible assets that can be distinguished lationship with clients might have valuefrom goodwill.) over and above the name-recognition or

Some intangible assets have long been "goodwill" value of a business for two rea-identified in law or regulations and have sons. One is that building such knowl-established rules. Patents, for example, are edge or such relationships usually in-granted for 17 years, so this is the max- volves costs (for example, training classes,imum useful life. (Taxpayers are allowed development costs, advertising, joiningto prove a shorter life if they can.) Copy- professional associations or country clubs,rights also have legally-established lives, buying lunches). The other is that even ifbut they are quite long (the author's life little or no outlays are involved, it mayplus 50 years in most cases), so economic still take some time to develop the knowl-lives would usually have to be established edge or form the necessary relationships,by "facts and circumstances" for amorti- so that the value of a purchased customerzation purposes. Trademarks, franchises, base or existing pool of knowledge at leastand the like are given special rules under will equal the present value of the extraInternal Revenue Code section 1253 for income it will bring in. The purchaser ofcertain types of economic interests, but a going concern is frequently willing tootherwise are considered to have indefi- pay extra to avoid these outlays and op-nite lives and not amortizable .2 Con- portunity costs.tracts, leases, and similar instruments To illustrate how a customer base, forwith legally-limited lives are also trou- example, can be valuable even if it costsble-free, since they could probably be am- nothing to establish, imagine a profes-ortized without opposition from the Inter- sional office whose business associationsnal Revenue Service (IRS) if they can be grew simply by word-of-mouth, as physi-properly valued. Likewise, assets for which cians'were once reputed to do. If one hadthere are separate markets or that are a chance to buy this practice as a goingpurchased by themselves, such as soft- concern, netting a steady income, insteadware and subscription lists, are often easy of starting from nothing and building upto value and noncontroversial. one's income over several years, what

Taxpayers in recent years have in- would the customer base be worth? Itscreasingly gone beyond these established value would be the difference between in-boundaries, however, and have attempted come with and without this client base,to allocate portions of the purchase price over the time it took to establish it. Theof newly-acquired businesses to such value of the purchased base,' therefore,things as the business's technological and would equal the discounted value of thefirm-specific knowledge and its relation- extra income.ship with its customers, markets, or em- In the situation envisioned here, thereployees ("core deposits" of banks, "client is no contract with each customer guar-base" of professional offices, "insurance-in- anteeing or anticipating future paymentsforce" of insurance companies, customer from that customer. If that were the case,lists or "market share" in general, trained each contract would be an asset with aworkforce, and the like). These assets determinable value and (presumably) a setshare the characteristic that their value life (the length of the contract). The valueis intimately related to the continued op- discussed above arises because it is knowneration of the business. Although the IRS (or believed) that, in the course of a year,has usually argued that these "assets" are some of the customers will make enoughindistinguishable from goodwill, some payments to produce the expected in-courts have allowed taxpayers to make the come, although which customers exactlydistinction and thus establish the exis- is not known. In actual sales, such values

No. 11 TAXATION OF PURCHASED INTANGIBLES 79

are often established by statistical anal- tion of the purchased general knowledge)yses of customer turnover rates, the busi- would normally be developed in the busi-ness's records of average gross per cus- ness and its costs deducted as current ex-tomer, and the like. Thus, it is obviously penses. The latter, if purchased as a partnot the individual customers who are the of the purchase of an ongoing business,assets being purchased here, as would be would most likely be treated as nonde-the case with explicit contracts; the asset preciable "goodwill" by IRS.being purchased is the mass asset con- Administrative simplicity is a principalsisting of the entire customer base. reason for interest in legislative reform of

In this case, where no direct outlays are the tax treatment of purchased intangi-required, the value of this base is main- bles. A recent study of the General Ac-tained, because customers who disappear counting Office (GAO)3 surveyed some of(through death or relocation) would be the disputes and conflicts that have ari-automatically replaced by the same word- sen. These administrative issues were alsoof-mouth process that created the busi- reviewed in a recent pamphlet publishedness initially. Thus, even though the ex- by the Joint Committee on Taxation.'isting customers disappear, the customer Some of the administrative issues have tobase does not. In this case, the purchased do with disputes over whether part of theintangible, like goodwill, is not a depre- purchase price reflected goodwill itself orciating asset. other amortizable assets. Others have to

Of course, in many cases there are di- do with practical problems in valuing as-rect costs in establishing and maintain- sets and establishing a useful life. Theing a customer base, such as advertising. GAO recommended defining various typesIn this case, the asset does depreciate; at of intangible assets and assigning themthe same time, the costs of maintaining it useful lives, based largely on the notionare expensed. As will be shown subse- that this treatment would match incomequently, this expensing of costs of main- and expense more closely and GAO's con-taining (or increasing) the value of an in- clusion that such a treatment would betangible is central to the issue of the feasible. Other groups testifying at hear-neutral treatment of purchased intangi- ings of the Ways and Means Committeebles. on October 2, 1991, including the Trea-

It is also obvious that these assets are sury Department and the American Barnot likely to have much value apart from Association, recommended a single am-their connection to an ongoing business. ortization period for all purchased intan-Customers and suppliers make their own gible assets. These recommendations werechoices about whom to do business with, made largely on the grounds of adminis-influenced by the business's reputation, trative simplicity.location, personalities, waiting rooms, and The single amortization period, regard-many other factors that are not easily less of its length, would probably be thetransferred from one business to another. simplest approach to the treatment ofAt the very least, it is unlikely that the purchased intangibles. Unlike the GAOvalue of the assets would be the same if suggestion, there would be much less ofsold separately from the business. an incentive to allocate intangible assets

Knowledge or technology as a source of to particular types and thus less contro-value seems simpler but is made compli- versy, since these assets are very difficultcated by the tax structure. Knowledge or to value.technology useful to any similar business There was also some discussion about(a computer program, for example) has a the tax treatment of intangibles pur-market value apart from the business in chased separately. It would be simpler towhich it is used, but technology useful only include all intangibles; however, it wouldin a specific firm does not. The one would also be possible to apply a general rule tonormally be purchased on the open mar- intangibles purchased with the sale of aket and its cost amortized; the other (which business while allowing other treatmentmight be merely a specialized modifica- for intangibles purchased separately. The


Treasury Department, for example, sug- treatment of purchased intangibles be-gested that software purchased under a come that a number of bills were intro-nonexclusive license (e.g., commercial duced in Congress in 1991 to provide somesoftware purchased for use in a firm as legislated bounds on the treatment of theseopposed to a software firm purchasing an types of assets. H.R. 3035, introduced byexclusive right) should be treated sepa- Ways and Means Committee Chairmanrately. The American Bar Association Rostenkowski, would provide a flat 14-yearsuggested that separately purchased in- amortization period for all purchased in-tangibles be excluded from the general tangibles. H.R. 1456, introduced by Rep-coverage of a single amortization sched- resentatives Vander Jagt, Anthony, andule, with appropriate safeguards to pre- Kennelly, would allow amortization of in-vent abuse .5 tangibles where a limited useful life can

No tax treatment will completely elim- be determined. H.R. 563, introduced byinate disputes about valuation. For ex- Representative Donnelly, would disallowample, in any sale of a business there will deductions for most intangibles alto-be an incentive to allocate value to those gether. Another approach discussed dur-assets which are more generously treated ing hearings conducted by the Ways and(such as equipment and amortizable in- Means Committee in October of 1991 wastangibles) and less to those assets which the provision of industry specific guide-are less generously treated (such as land). lines. The 14-year amortization period,In general, however, the valuation prob- with an exception of off-the-shelf soft-lems are probably much greater between ware, was included in the recent tax billdifferent types of intangible assets versus passed by the House on February 27, 1992the division between tangible and intan- (H.R. 4287).gible assets. Hence, the most important The conceptual problems that have madesimplifying approach would be to have a the administration of and compliance withsingle amortization period for all intan- the tax rules for intangible assets such agibles including goodwill. nightmare seem to relate primarily to as-

The American Institute of Certified sets sold as a part of or in connection withPublic Accountants (AICPA) has recom- the sale of an ongoing business operation.mended in testimony at the hearings that The remainder of this analysis is devoteddifferent amortization periods be pro- primarily to a discussion of these types ofvided for different industries. While this assets. Assets that are readily market-approach would not be as simple as a uni- able or that are created and sold sepa-form treatment of intangibles, it would rately do not necessarily involve the sameprobably be simpler than an asset by as- issues. Thus, this analysis does not applyset treatment. to intangibles which are created in order

The depreciation rules (and controver- to be sold, such6as movies and some com-

sies) generally apply to purchased intan- puter software.gible assets, not to self-proclueed ones. Thecosts of creating "goodwill," customer re-

Tax Accounting For Cost Recovery:lationships, and other such assets are A Conventional Viewmostly deductible current expenses suchas advertising, salaries, and other ordi- It is a well-established principle that thenary business expenses. In current tax law, proper measurement of economic incomethese expenses are deductible in the year requires the accounting for changes in theincurred, not matched with the income value of assets. If an Asset declines in valuethey produce. (This is not the case with because it is being wom out or used up,production by companies in the business the decline in value would reduce income,of creating intangible assets, such as soft- and deductions for depreciation or amor-ware producers or film makers; their costs tization should be allowed. There is con-are always capitalized and deducted only siderable literature on the role played bywhen the products are sold or used.) depreciation in measuring income prop-

So severe have controversies over the erly. Examples among a broad literature

No. 1] TAXATION OF PURCHASED INTANGIBLES 81

which relates primarily to depreciable as- across industries or categories of assets andsets include Gravelle (1982), Auerbach that consideration be given to having dif-(1983), Jorgenson and Sullivan (1981), and ferent amortization periods.Fullerton, Henderson, and Mackie (1987).Attention to the treatment of created in-

Neutrality, Efficiency, And Thetangible assets either conceptually or em-Treatment Of Purchased Intangiblespirically has been quite limited (see Ful-

lerton and Lyon (1988) and Mundstock While there is a growing agreement that(1990)). The role played by the tax treat- some legislative intervention is needed toment of used assets has been the subject deal with the current chaos in the indus-of relatively limited research, and has try, the economic issues associated withprimarily focused on single sales of real the treatment of purchased intangiblesestate as in Hendershott and Ling (1984) have been largely misunderstood. Theand Gravelle (1987). central flaw in the current reasoning that

The treatment of tangible assets under purchased intangibles should be amor-the income tax has evolved into some fairly tized based on their useful lives is thefixed principles. Tangible assets that do failure to recognize that the treatment ofnot lose value through use (or which may used assets cannot be divorced from theactually appreciate in value over time), treatment of new assets in assessing eco-such as land, are always capitalized and non-iic efficiency and tax neutrality, as boththe capitalized costs are not deducted un- practices act together to determine incen-til and unless the asset is sold or ex- tives and disincentives to invest and trade.changed. Structures and equipment are Specifically, this analysis concludes thatallocated to categories and assigned de- tax neutrality and economic efficiency dopreciable lives and patterns; the present not require that separate amortizationsystem, dating from the Tax Reform Act periods be ascribed to purchased intan-of 1986, attempts to approximate the value gibles depending on their degree of wast-of economic depreciation, at least overall, ing away.' Moreover, it is not clear thatfor structures and equipment. Currently, allowing any amortization period at all forused tangible assets are allowed the same purchased intangibles is desirable on ef-depreciation methods as new ones. ficiency grounds. The simple reason is that

Intangible assets which decline in value the principal requirement for tax neu-should, by analogy, be subject to similar trality-the capitalization of created in-treatment. Created intangibles, which tangibles-has not been met. Created in-arise from expenditures such as advertis- tangibles, whether generated throughing and training, are, however, allowed to worker training, labor inputs, or adver-be expensed. This tax treatment of cre- tising, are expensed. Although @here mayated intangibles is largely due to admin- be legitimate tax policy reasons for notistrative considerations, since it would be capitalizing these assets (the obvious con-difficult in practice to identify those costs straint being measurement of the costs),which are creating an intangible. the fact that they are expensed is crucial

The argument that purchased intangi- to the issue of economic efficiency. If ourbles should be amortized based on their framework of analysis is constrained byuseful life is based on a similar analogy, the expensing of created intangible as-and it is the gist of the GAO's argument. sets, there is no reason to vary the am-Even those who considered a single amortization period with durability of a pur-ortization period desirable on administra- chased asset.tive grounds generally did do so even To explain this issue, it is perhaps firstthough they believe that not varying the important to note that there are actuallyamortization treatment is distortionary or two different emciency issues associatedinequitable .7 The American Bar Associa- with the tax treatment of assets. The firsttion, for example, suggested that the has to do with the incentives to allocateTreasury Department might study resources to different types of invest-whether useful lives vary significantly ments. Barring spill-over effects, alloca-


tive efficiency is reached when all assets gibles are treated more generously thanare subject to the same effective tax rates. other assets in all of the cases studied. Forit is this type of issue that suggests that example, if assets are sold every 10 years,the cost of longer-lived assets, such as the effective tax rate for structures is 43.4buildings, be deducted over long periods percent and the effective tax rate forof time and that the cost of shorter-lived equipment is 30.2 percent, but the effec-assets, such as machinery and equip- tive tax rate for intangibles, even with noment, be deducted over shorter periods of amortization of purchased intangibles, istime. taxed at rates ranging from 6.9 percent to

The second efficiency issue has to do 26.5 percent.with the effect of the tax system on the The lock-in effect (the additional taxselling of assets. When an asset is sold, which occurs because of sale of assets)the taxpayer is subject to capital gains varies across asset types. Not surpris-taxes, which in general means that tax ingly, it is less serious for equipment,burdens rise when assets are expected to where depreciation in the hands of thebe sold. This treatment has two effects. purchaser offsets much of the capital gainsFirst, it may affect the allocative effi- tax. For example, the 30.2 percent tax rateciency issue if taxpayers expect, at the time for equipment assuming assets are soldthey make an investment, that the asset every 10 years is only slightly higher thanwill be sold at some future date. Secondly, the tax rate assuming assets are neverit creates a lock-in effect, discouraging sold. Moreover, for those intangibles whichbusinesses from being sold. do not depreciate or depreciate slowly and

To illustrate these effects, Table 1 pre- which cannot be deducted by the pur-sents calculations of the effective tax rate chaser, the change in tax liability due tofor different types of assets, including in- selling assets is larger than for tangibletangibles, land, equipment, and struc- assets. For example, assuming no eco-tures. Tax rates are calculated assuming nomic depreciation and no deduction forthe assets are sold every 10. years, every purchased intangibles, the tax rate is 26.520 years, every 30 years, or not at all. percent if assets are sold every 10 yearsWhen assets are sold, the calculations take as compared to zero if assets are never sold.into account the successive series of cap- It may be a somewhat unexpected re-ital gains taxes which are paid at each sult to find that intangibles with rapidround, as well as the treatment of the as- depreciation rates are not heavily af-set for depreciation and amortization pur- fected by sale, given the general notionposes in the hands of the purchaser. We that assets should have lives associatedconsider intangible assets which depre- with their durability. The reason for thisciate at different rates, and also examine is that the original asset has depreciatedtwo cases. In one case the purchased in- in value so much that the capital gainstangible cannot be deducted at all, but tax on sale is relatively small, comparedrather reduces the capital gain on a fu- to the original investment in the asset. Inture sale. In the other case, purchased in- this case of a single asset sale, providingtangibles are amortized over a 10-year more generous treatment to assets whichperiod, a period which was simply chosen depreciate rapidly would be targeting thosefor illustrative purposes. (The mathemat- assets whose tax burdens are least af-ical analysis underlying these effective tax fected by the sale in the first place.rates is presented in the appendix.) It may be argued, however, that the

By comparing across assets, one can see single asset comparison in Table 1 is nothow different types of assets are treated representative of the characteristics of anby the tax law. This is the efficiency issue ongoing business. In an ongoing business,which is normally concerned with the set- the value of assets, either tangible or in-ting of depreciation rates. By comparing tangible, does not deteriorate over time;across sales periods, one can see the extra rather these assets are replaced. An on-tax which arises due to sales of assets. going business must add new capital in-

As the results in Table 1 show, intan- vestment as well as continue to engage in

No. 11 TAXATIONOF PURCHASEDINTANGIBLES 83

TABLE IEFFECTIVE TAX RATES FOR ASSETS, BY TYPE AND HOLDING PERIOD

Number of Years Held Before Sale

NeverAs,,(,t LTe 10 20 30 Sold

Intangibles (No Deduction for Purchased Intangibles)

8 = .00 26.5 14.9 8.5 0.08 = .05 21.4 8.6 3.3 0.08 = .15 12.8 2.2 0.3 0.08 = .25 6.9 0.5 0.0 0.0

Intangibles (Ten Year Amortization for Purchased Intangibles)

6 = .00 18.7 8.0 4.1 0.08 = .05 14.8 4.5 1.5 0.08 = .15 8,5 1.1 0.1 0.08 = .25 4.5 0.2 0.0 0.0

Land 51.5 43.8 36.6 34.0

Structures 43.4 40.3 37.7 35.5

Equipment 30.2 27.6 27.3 27.2

Source: Authors' calculations. The symbol 8 refers to the rate of economicdepreciation of intangibles. Calculations are based on formulas presented in theappendix, for single asset sales. The inflation rate is set at 4 percent, the realafter tax rate of return at 5 percent, and the statutory tax rate at 34 percent.Structures are assumed to depreciate at a three percent rate, and equipment isassumed to depreciate at a 15 percent rate. Equipment is assumed to fall intothe five year depreciation class.

activities which will maintain intangible equipment when assets are sold, becauseassets. the calculations account for recent vin-

Accordingly, in Table 2 the effective tax tages of replacement investment which arerates are calculated for an asset with the held for a short period of time and whichassumption of replacement investment. are not fully depreciated. To illustrate, forThese effective tax rates require that one equipment the tax burden rises from 27.2take into account the tax treatment of all percent assuming assets are never sold toof the generations of replacement invest- 42.6 percent assuming sale every 10 yearsment as well as the original investment. if reinvestment is assumed, as in Table 2.As a result, the tax burdens are larger for Without reinvestment (Table 1), the ratedepreciable assets such as structures and rises from 27.2 percent to 30.2 percent.


TABLE 2EFFECTIVE TAX RATES BY TYPE OF ASSET AND HOLDING PERIOD, ASSUMING

REINVESTMENT TO MAINTAIN ASSET VALUE

Number of Years Held Before Sale

NeverAsset Type 10 20 30 Sold

Intangibles (No Deduction for Purchased Intangibles)

8 = .00 26.5 14.9 8.5 0.08 = .05 26.5 14.9 8.5 0.08 = .15 26.5 14.9 8.5 0.08 = .25 26.5 14.9 8.5 0.0

Intangibles (Ten Year Amortization for Purchased Intangibles)

a = .00 18.7 8.0 4.1 0.08 = .05 18.7 8.0 4.1 0.06 = .15 18.7 8.0 4.1 0.08 = .25 18.7 8.0 4.1 0.0

Land 51.5 43.8 39.6 34.0

Structures 49.2 42.3 38.5 35.5

Equipment 42.6 34.1 30.8 27.2

Source: Authors' calculations. These calculations are based on the investmentformula with replacement in the Appendix, equation (10).

When reinvestment is considered for for all intangible assets results in equalintangibles, it simply converts, in math- treatment of all intangibles. Providingematical terms, every intangible asset into differential treatment would favor short-a non-depreciating asset. As shown in Ta- lived intangibles, not make the treatmentble 2, all intangibles are subject to the neutral.same tax rate, regardless of the deprecia- This conclusion that neutrality acrosstion rate. Each new increment of replace- different types of intangibles leads to ament investment is expensed. The flow of common amortization period does not de-net income becomes identical for both pend on the narrow assumption that theshort-lived and long-lived intangibles.9 Or, asset is simply maintained. This conclu-another way to put it is that an intangi- sion would also hold if assets of the firmble which depreciates rapidly is automat- were allowed to grow (or decline) as longically given beneficial treatment via the as the growth rate is the same for all firmsexpensing of replacement investment. (i.e. unrelated to the durability of the par-Providing a fixed treatment-whether it ticular intangible asset)." While the lev-is no write-off or a fixed write-off period- els of tax rates would differ, they would

No. 11 TAXATION OF PURCHASED INTANGIBLES 85

still be uniform across different types of is considered superior on administrativeintangibles. and simplicity grounds, it is also com-

To restate this point in another way: pletely consistent with tax neutrality-athere is no reason from an efficiency rare case where economic neutrality andstandpoint to provide amortization lives administrative simplicity point to the samefor purchased intangible assets which vary solution.by the durability of the asset. First, for asingle asset sale, the tax burden imposed

ENDNOTESat sale is relatively unimportant for ashort-lived asset because the asset's value **The views in this paper do not necessarily reflecthas fallen so much and the capital gains the views of the Congressional Research Service of thetax is extremely small relative to the Library of Congress. We thank two anonymous ref-

erees for suggestions, and we especially thank Emiloriginal investment. For the more real S.ley for his valuable comments and discussions.istic case of an ongoing business, while the 'U.S. Congress, Joint Committee on Taxation, De-value of the intangible asset may deteri- scription of Proposals Relating to the Federal Incomeorate, the expensing of replacement in- Tax Treatment of Certain Intangible Property. JCS-

14-91, September 30, 1991. U.S. Gov. Print. Off.,vestment by the purchaser automatically Washington: 1991. P. 5.provides an offsetting benefit for shorter- 2 lbid, p. 11.lived intangibles, so that all intangible 3 United States General Accounting Office, Issuesassets are treated the same only if the and Policy Proposals Regarding Tax Treatment of In-

tangible Assets, Report GAO/GGD-91-88, Augusttreatment of purchased intangibles does 1991.not vary with the expected life. 'Joint Committee on Taxation, Description of Pro-

Of course, these issues do not confront posals Relating to the Federal Income Tax Treatmentdirectly the question of whether it is de- of Certain Intangible Property.

'That is- firms could attempt to complete a salesirable to provide no deduction, expen- through s;le of the firm and separate sale of certainsing, or some intermediate amortization assets, so rules would have to be put in place to pre-value. In general, however, it does not ap- vent use of this mechanism.pear that a strong efficiency case can be 6The analysis which follows depends on the original

creation and maintenance of the intangible by the firmmade for providing write-offs for pur- through expenditures which are expensed. Thus, it doeschased intangibles. While providing Such not apply, for example, to customer lists which area benefit could reduce the barriers to sale, purchased periodically from another party and which

may customarily be amortized. If a firm has such anit increases the beneficial treatment of existing customer list, there is a case for amortizingintangibles relative to other assets. the cost associated with this list, although the desir-Therefore, there is both an efficiency gain ability of doing so must be considered in light of theand an efficiency loss to allowing write- administrative costs. A similar treatment applies tooffs of purchased intangibles. The reve- other goods, such as software, which are purchased

from another party. There are also examples of in-nue used to finance such a benefit could tangible assets which do not strictly fit into theprobably be used more effectively to pro- framework discussed in this analysis. For example, ifvide relief for tangible assets, where an a firm has a building which ir, leased with specificefficiency gain is much more likely. rents which are above the market value, the value of

this lease may be argued to be amortizable. The valueMoreover, it seems likely that the bar- of such a lease is, however, in the nature of a wind-riers to sale are less severe in the case of fall, so that the treatment of such an asset will notintangible assets, which cannot generally affect investment decisions; rather, the tax treatment

will be capitalized in the purchased price.be sold as separate assets from the busi- 7 An exception was testimony from the Congres-ness itself It seems unlikely that the de- ,ional Research Service (CRS). This testimony wascision to sell an ongoing business is So based on a CRS report by Gravelle and Taylor (1991).highly responsive to tax considerations. 'There is occasionally confusion about whether equalLock-in effects are probably more serious tax treatment refers to efficiency issues or equity or

fairness, rather than efficiency. There is little reasonfor other types of assets than intangibles. to see differences in tax rates across asset types as a

The efficiency analysis suggests that matter of equity, because taxpayers can acbust theirchoice of a single amortization period does behavior to adapt to tax burdens. In that adjustmentnot result in distortions in the tax treat- process, after-tax rates of return tend to be equated

and pre-tax returns diverge. Thus, from an economicment of different types of intangible as- perspective, the notion of horizontal equity or fair-sets. Thus, if a single amortization period ness across taxpayers is not a particularly relevant


issue To the extent that taxes on capital fall in gen- Jorgenson, Dale W. and Martin A. Sullivan. Inflationeral on high income individuals, the amortization pe- and Capital Recovery in the United States. In De.riod or the ability to amortize at all may be relevant preciation, Inflation, and the Taxation of Income fromin that more generous treatment makes the tax sys- Capital. Ed. Charles R. Hulten, Washington, D.C.:tem slightly less progressive. There is also an inevi- The Urban Institute Press, 1981, pp. 171-236.table redistributional effect any time the tax law Mundstock, George, "Franchises, Intangible Capital,changes. Individuals who have existing assets expect and Assets," National Tax Journal, 43 (Septemberthe purchase price to be affected by the tax treatment 1990): 299-305.of the purchaser. Thus, allowing more generous treat- Taylor, Jack. Amortization of Customer-Based Intan-ment would provide a windfall gain for these individ- gibles: An Economic Perspective. Congressional Re-uals and allowing less generous treatment would research Service Report 91-218 E, March 6, 1991.sult in a windfall loss. These consequences are U.S. Congress. Joint Committee on Taxation. De-inevitable, and occur with any type of tax change. By scription of Proposals Relating to the Federal In-historical comparison with other tax law changes, come Tax Treatment of Certain Intangible Prop.windfall gains and losses from restructuring the am- erty. JCS-14-91, September 30, 1991. U.S. Gov.ortization of intangibles would appear modest. Print. Off., Washington: 1991 P 5

'This point was made in a Congressional Research United States General Accounting Office, Issues andService report on customer-based intangibles (see Policy Proposals Regarding Tax Treatment of In-Taylor (1991)). A related point is made in the discus- tangible Assets, Report GAO/GGD-91-88, Au.sion of this issue by the Joint Committee on Taxation, gust 1991.Description of Proposals Relating to the Federal In-come Tax Treatment of Certain Intangible Property. Appendix: Deriving Effecldve Tax

lothis argument assumes no relationship betweengrowth rate of capital and the durability of the in- Ratestangible. The argument can be made that the optimal To measure the effective tax rate on a newpath of the capital stock would be to grow at a slower investment we solve for c, the marginal prod-rate as the expected sale period approaches, and the uct of capital, which will equate the expendi-tax burdens associated with sale grow, but this opti- ture on an asset to the present value of the netmal path is not related to the durability of the asset.It is possible, however, that it is easier to achieve this returns. We consider first the case of a singleoptimal growth path with assets that depreciate more asset, and then the case of an asset with re-rapidly, particularly for small firms. Such an argu- placement investment. The standard form forment would argue for a longer write-off period for as- this solution is:sets that depreciate more rapidly, not a shorter one.

1 f

T

c(l - u)e-Ir,lltdt + UZREFERENCES

0

Auerbach, Alan. "Corporate Taxation in the United + (SPT1(1 - us) + ugb)eStates." Brookings Papers on Economic Activity,1983, 2: 451-505. where c is the marginal product of capital, u is

Fullerton, Don, Yolanda K. Henderson and James the tax rate, r is the real discount rate, 8 is theMackie. "Investment Allocation and Growth Under rate of economic depreciation, z is the presentthe Tax Reform Act of 1986," in Compendium of Tax value of depreciation deductions, T is the hold-Research, 1987, Office of Tax Analysis, Treasury ing period, SPT, is the sales price at the timeDepartment, U S Government Printing Office,Washington D.C. of sale, us is the capital gains tax rate, B is the

Fullerton, Don and Andrew B. Lyon. "Tax Neutrality ratio of the undepreciated basis to the originaland Intangible Capital" in Tax Policy and the Econ- sales price, and u is the inflation rate. Theomy, Ed. Lawrence Summers, National Bureau of marginal product of capital is the sum of theEconomic Research, Cambridge: The MIT Press, real pre-tax rate of return and the rate of eco-1988, pp. 63-88. nomic depreciation. The first teryn on the right

Gravelle, Jane G. "Effects of the 1981 Depreciation hand side represents the stream of outputRevisions on the Taxation of Income From Business (marginal product) from the investment. ThisCapital." National Tax Journal 35 (March 1982):1-20. stream of output depreciates at rate 8 and is

-. "Tax Policy and Rental Housing: An Eco- discounted at rate r. The second term on thenomic Analysis." Congressional Research Service, right hand side is the present value of depre-Library of Congress, Report No. 87-536-E, June ciation, and the last term is the present value25, 1987. of the after tax proceeds of the sale of the asset.

Gravelle, Jane G. and Jack Taylor. "Taxing Intan- This equation does not account for depreciationgibles: An Economic Analysis." Congressional Re- recapture which is not relevant under the as-search Service, Library of Congress, Report 91-55 E, sumption that the capital gains tax and theOctober 25, 1991.

Hendershott, Patric H. and David C. Ling. "Trading regular tax rate are the same. To solve thisand the Tax Shelter Value of Depreciable Real Es- equation for c, the marginal product, or usertate." National Tax Journal, 37 (June 1984): 213- cost, of capital, we must obtain a value for the224. sales price at time 1:

No. 11 TAXATIONOF PURCHASEDINTANGIBLES 87

T investment. In this case the price of an assetSPT, = e@,_8,T

f@

(C(l _ U)e-(@@S)tdt)+ uzSPT, at time Tl will be:

+ (SPT2(l - u.) + ug BSPTI)E (2) SPT@ U)

(7)ue

Note that the sales price at time Tl dependsin turn on the sales price for the next sale at It is the differential in the tax treatment oftime T2. The product is larger with inflation new and used assets that affects purchase price.and smaller with depreciation, and tax depre- The absence of expensing causes the purchaseciation and basis depend on the sales price at price to fall by u percent, but this is offset bytime Tl: the recovery of basis when the next sale occurs.

T If purchased intangibles were eligible forSPIM= e(.--5)2T (c(l - u)e-Ir"'dt) + uzSPT, amortization or depreciation over a period of

fo time, the cost of capital would be smaller andlr+.)T

the sales price larger. For example, the cost of+ (SPm(l - u,,) + ug BSPT2)e- (3) capital would now become:

The equation for the sales price at time T2 (I - U,,) - (@+8yrlooks exactly the same as the price at time T2 (r -+-6) 1 -(r+nYr)

e-except that the product has grown further with (1 - uz - UgBe-inflation and depreciation, and depreciation and cbasis are multiplied by the sales price at time

(8)T2, and sales price depends on the sales priceat time T3. The sales price would also be affected as wellBy continual substitution we can obtain an by the more beneficial tax treatment of pur-equation for the value of the marginal product chased assets:or user cost, c:

(r + 8)(1 - uz - u@Be-"'+@)T)1 -ug)

e-(r+6)T

(I - uz - u,,Be-(r+.)T

(I - u)(1- e-(r+B)T)(4)

One can also see that the sales price for aused asset will be the cost of a new asset, aftercorrections for depreciation and inflation. That e (.-8)T(l - u)

is:SPT, = - (9)(1 - uz - uBe-(r,wyr),

SPTI = e(.-B)T. (5) Note that if used assets were expensed thesales price would be similar to that of assets

In the case of intangibles, these relation- other than intangibles, since there would be noships are affected by the differential treatment difference in the treatment of new and pur-of newly-created intangibles and purchased in- chased assets.tangibles. Consider the common case where Once the cost of capital is found, the effectivecosts to create the intangibles are expensed tax rate can be calculated by subtracting thewhile costs of acquiring intangibles are not de- depreciation rate from the cost of capital to ob-ducted until recovered as basis on subsequent tain the real pre-tax rate of return. The differ-sale. The first round of investment would in- ence between the pre-tax rate of return and thevolve setting z to I and B to 0; in subsequent after-tax rate of return (r), divided by the pre-sales z would be set to zero and B to 1. The tax rat, of return, yields the effective tax rate.equation for the cost of capital would be: Now consider an investment assuming that

(1T) any depreciation in the asset is offset by re-

e placement investment. In this case, out of the- uge -(-@IT) cash flow from the investment (c), reinvest-

Ce-(r+b)T)

(6) ment in the amount of 8 is set aside. We mustallow for tax depreciation on this asset as well.In addition, because the asset does not decline

The price of a used asset will also be affected in value, the value of the product does not de-by the differences in tax treatment from a new cline in value.


T mulas are very complicated and are not pre-1(c(l - u) - 8 + uBz(t))e-dt sented here).

The case of an intangible asset is, however,much more straightforward. Since new incre-ments to investment are expensed, the value

+ uz + (SPT,(l - u,,) - uB)e (10) of z(t) is always 1. In addition, since c is equalto the pre-tax return plus the depreciation rate,all of the terms involving 8 in equation (10)

In equation (10), z(t) refers to the present cancel out. Every intangible asset looks iden-value of tax depreciation per dollar of invest- tical regardless of the rate at which it depre-ment made at time t. B represents the aggre- ciates; no depreciation term appears in the costgate undepreciated basis of both initial and re- of capital formula at all. The effective tax rateplacement investment. In the case of a tangible is det6rmined solely by the frequency of the saleasset, like equipment, the measurement of the of the business and is completely unaffected byaggregate basis and of the present value of de- the depreciation rate.preciation is very complex. For example, if the These results also hold true if the firm's as-holding period is 10 years and depreciation is sets are allowed to grow. There will be an ad-over a five-year period, the initial investment ditional negative cash flow from reinvestmentplus the first five years of replacement invest- for growth, with a concurrent tax deduction;ment will be fully depreciated, and the re- moreover, the discount factor will be the ratemaining five years partially depreciated. Basis of return minus the growth rate. But the de-will remain for some portion of the last five preciation terms will still disappear from theyears of replacement investment. (These for- equation.

tax neutrality and the tax treatment of purchased...

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