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As the World Churns: Avoiding Tax Planning Disaster by Avoiding Anti-Churning Rules

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Most large merger and acquisition (M&A) transactions are actually negotiated three times: the first time by the clients, the second time by the corporate attorneys, and the third time by the tax attorneys.

The Tax GuyThis reflects the fact that M&A negotiations follow a natural progression from the broadly general to the highly particular, and that different levels of knowledge and legal expertise are needed at each stopping point along the path.

At the outset, the business people must first decide whether the acquisition transaction makes business sense, and this is a broad inquiry with a strong financial emphasis. If the deal gets a green light from the business people, the corporate attorneys then try to translate the proposed acquisition transaction into a legally binding set of agreements.

This process usually involves taking a proposed term sheet (sometimes literally written up on a cocktail napkin, but in all events characterized by a series of specific and often detailed agreements on certain issues, accompanied by often gaping chasms of missing information in other areas) and translating these relatively simplistic “terms” into a detailed set of contractual covenants.

The tax attorneys are then called upon (often belatedly, and sometimes at the very last possible minute) to “vet” the transaction for tax problems and to propose adjustments that will help the parties achieve the desired business objectives. Tax attorneys can often add specific value at this point by proposing ways to cut tax costs, but perhaps their greater service at this juncture is to spot lurking tax catastrophes not visible to the ordinary human eye. For example, one of the esoteric or complex tax “mistakes” that a tax attorney might catch is if an acquisition transaction runs afoul of so-called anti-churning rules under Code § 197.

The History of Code § 197-Rules on Depreciating Goodwill

To understand how and why the “anti-churning” rules can be a trap for the unwary, one must start with the history and purpose of Code § 197. That Code section was adopted in 1993, after a long and acrimonious history of litigation between the IRS and taxpayers over the proper tax treatment of goodwill, going-concern value, and certain other intangible assets acquired in connection with the purchase of a business.

Basically, before August 10, 1993 (the enactment date of Code § 197), the IRS had historically taken the position that the goodwill of a business was not an amortizable asset because that goodwill could exist for an indefinite (and potentially infinite) period of time, and thus the useful life could not be estimated with reasonable certainty.

Taxpayers, however, took the position that goodwill is always an ephemeral asset that dissipates (often rapidly) in value unless it is constantly maintained with additional spending, and accordingly taxpayers sought to depreciate or amortize goodwill over a realistic time period. The conflict between taxpayers and the IRS over this issue was massive and enduring: It was the tax-law equivalent of the One Hundred Years War.

In 1993, Congress decided to bring peace to this area by enacting Code § 197. Under Code § 197, the cost of acquiring any” amortizable section 197 intangible,” including goodwill, is capitalized and amortized ratably over a 15-year period. As a practical matter, this rule allows the acquirer of a business to amortize goodwill and a variety of other common business intangibles over the quasi-reasonable period of 15 years, while at the same time eliminating all variance among the various types of intangible assets, and thus eliminating most opportunities to “play games” through favorable allocations of purchase price. After all, if every asset is amortizable over the same 15-year period, then allocation of purchase price among intangible assets becomes a moot point.


Joe Darby, a tax law expert, is also the author of Practical Guide to Mergers, Acquisitions and Business Sales, 2nd Edition, published by The National Underwriter Company, a division of ALM Media. ThinkAdvisor readers can get this resource at a 10% discount. Go there now.


The Anti-Churning Limitation

Congress recognized, however, that this “new” rule allowing 15-year amortization of goodwill was a major change in the existing law, and could easily tempt taxpayers who acquired intangible assets under the old law (i.e., when goodwill could not be amortized) to create a nominal or paper sale transaction with themselves and thus come within the new provisions of Code § 197.

This type of sell-to-yourself arrangement is called a “churning” transaction. In a classic churning transaction, the shareholders of Company A might set up as an alter ego Company B, and then sell A’s assets to B (i.e., to themselves) in a taxable transaction that might in fact produce little or no gain (especially if the existing goodwill had been previously purchased by B, and therefore had a high but non-amortizable tax basis). If not blocked by the anti-churning rules, this type of churning transaction could be used to convert non-amortizable tax basis into amortizable tax basis.

To illustrate the issue with a specific example, assume Company A had bought the business assets of another (unrelated) company in 1992 for $5 million, $4 million of which was allocated to goodwill and $1 million of which was allocated to other assets (e.g., tangible assets or real estate). If Company A subsequently sold in 2007 (i.e., after August 10, 1993) the same business assets at cost (i.e., $5 million) to related Company B (owned by the same shareholders that owned Company A) Company A would recognize some gain (because the tangible assets or real property had been subject to amortization/ depreciation, and thus the sale would trigger recapture income under Code § 1245 or unrecaptured Code § 1250 gain).

However, absent the anti-churning rules, Company B now would have $5 million of tax basis in depreciable or amortizable assets, which would almost certainly be viewed as a favorable tax arbitrage, i.e., applying the post-1993 amortization rules under Code§ 197 to the full $5 million worth pre-1993 assets.

A savvy tax observer might feel constrained to point out that the anti-churning rules are “preventing” an abuse that was always far less likely to occur than Congress may have imagined. In fact, a pretty good argument can be made that these rules create a complex and burdensome trap for the unwary in order to solve a relatively minor problem-but that is another story. The point of this article is that these anti-churning rules exist and need to be carefully understood and addressed in any acquisition transaction that involves a significant purchase of pre-1993 intangible assets.

Technical Review of the Anti-Churning Rules

Section 197(f)(9) contains the anti-churning rules, and provides that the term “amortizable § 197 intangible” shall not include goodwill, going concern value, or any other intangible asset for which depreciation or amortization would not have been allowable but for the enactment of § 197, if (1) such intangible asset is acquired by the taxpayer after August 10, 1993 and (2) such intangible was held or used at any time on or after July 25, 1991, and on or before August 10, 1993, by the taxpayer or a related person. Thus, the anti-churning rules apply to goodwill, going concern value, or certain other intangibles transferred after August 10, 1993, but only if the taxpayer or a related person held or used such assets at any time from July 25, 1991 to August 10, 1993.


Joe Darby, a tax law expert, is also the author of Practical Guide to Mergers, Acquisitions and Business Sales, 2nd Edition, published by The National Underwriter Company, a division of ALM Media. ThinkAdvisor readers can get this resource at a 10% discount. Go there now.


“Related Party” Is Very Broadly Defined

The key issue in the anti-churning rules is the relatively low threshold for determining related-party status. Section 197(f)(9)(C)(i) indicates that a person (called the “related person”) is related to another person if the related person bears a relationship to such person described in § 267(b) or § 707(b)(1), with “20 percent” substituted for “50 percent.” Thus, the anti-churning rules apply a remarkably low 20 percent threshold as the determination of related-party status.

The times at which the participants in a transaction are tested for related-party status under these provisions is a particularly important-and dangerous-element of the anti -churning rules. Section 197(f)(9)(C)(ii) specifies the time for making this related-person determination, and states that” A person shall be treated as related to another person if such relationship exists immediately before or immediately after the acquisition of the intangible involved.” [Emphasis added.] T

he regulations provide additional guidance regarding the application of these tests. First, where there is a series of related transactions, the test is applied immediately before the earliest of such transaction or immediately after the last such transaction. See Reg. § 1.197-2(h)(6)(ii). There is a variety of transactional paths where, because of the testing both before and after the transaction, a seemingly benign transaction between unrelated parties can be picked up by these rules.

When the Anti-Churning Rules Produce Stomach-Churning Surprises

The situation where the anti-churning rules are most likely to deliver an unexpected and nasty surprise is when an existing company (with goodwill dating back to before 1993) wishes to sell its assets to a buyout group that is comprised of outside investors and/or lenders plus the existing management-the classic management leveraged buyout or LBO.

On a positive note, it is clear that the anti-churning rules apply only if the target, or person related to the target, held the intangible in question on or before August 10, 1993, the enactment date of Code § 197.

A Churn for the Worse

The good news is that the anti-churning rules “only” apply to goodwill, going concern value, and certain other intangibles, like trade names and trademarks, that were not amortizable prior to the enactment of Code § 197. The bad news is that these types of assets have large and ever-increasing value in the modern economy.

Ironically, as the value of goodwill and similar assets grows ever larger, and as the amounts at stake under the anti-churning rules grow correspondingly substantial, it means that the exact types of disputes that Code § 197 was intended to eliminate-litigation over whether items such as customer-lists or workforce in place had an ascertain-able useful life prior to the August 10, 1993, enactment date-will become increasingly important and increasingly likely to be litigated once again. After all, if you can prove that an asset would have been amortizable under pre-Code § 197 law, then you are out from under the anti-churning rules.

There is, in short, an ironic and soap-opera quality to the fact that the anti-churning rules will tend to undermine the exact purposes–i.e., ending litigation over whether myriad complex intangible assets has ascertainable useful lives–for which Code § 197 was enacted.

There is, of course, an irresistible name for this soap opera: As the World Churns.


Joe Darby, a tax law expert, is also the author of Practical Guide to Mergers, Acquisitions and Business Sales, 2nd Edition, published by The National Underwriter Company, a division of ALM Media. ThinkAdvisor readers can get this resource at a 10% discount. Go there now.


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