filed: September 12, 1991; As Amended October 15, 1991.
On Appeal From The United States District Court For The District of New Jersey; D.C. Civ. No. 88-4846.
Becker and Hutchinson, Circuit Judges, and D. Brooks Smith, District Judge.*fn*
This appeal by the United States from an adverse judgment of the district court in a tax refund case raises important questions concerning a taxpayer's ability to depreciate acquired intangible assets. Taxpayer/appellee Newark Morning Ledger Co. ("Morning Ledger") acquired a corporation, which itself had previously acquired the assets of eight Michigan newspapers by means of an I.R.C. §§ 332, 334(b)(2) liquidation, and which had attempted to depreciate some $67 million of the purchase price as allocated to a category denominated "paid subscribers." This amount reflected an estimate by financial and statistical experts of the present value of the future profits to be derived from the 460,000 at-will subscribers acquired in the liquidation. The Internal Revenue Service ("the Service") disallowed the depreciation deductions on the ground that Morning Ledger's predecessor could not, by sophisticated and accurate expert analysis, convert into a depreciable asset what was quintessentially goodwill -- i.e., the value of the expectation of continued patronage. The tax was paid, the refund suit ensued, and, after a bench trial, the district court entered judgment for Morning Ledger. For the reasons that follow, we will reverse.
I. FACTS AND PROCEDURAL HISTORY
Over a period of several months in 1976, the Herald Company ("Herald") purchased, through private sales and a public tender offer, all the outstanding stock of Booth Newspapers, Inc. ("Booth"), a Michigan corporation which published daily and Sunday newspapers in eight Michigan communities with a total at-will subscription of approximately 460,000.*fn1 In 1977, Herald liquidated the Booth stock, received all the latter's assets, and continued publishing the eight newspapers under the same names. In 1987, Herald was merged into appellee Morning Ledger, a New Jersey corporation, effectively making the operations of Herald and Booth unincorporated divisions of Morning Ledger.
Herald's 1977 liquidation of the stock of Booth was carried out pursuant to sections 332 and 334(b)(2) of the Internal Revenue Code. These sections required Herald's $328,173,154 adjusted tax basis in Booth's stock to be allocated among the various depreciable and non-depreciable assets of Booth distributed to Herald in the liquidation in accordance with the respective fair market values of the assets. Herald allocated $234,063,002 of this amount to various financial assets (cash, securities, including the stock of Parade, and accounts and notes receivable); and to tangible assets (land, improvements to land, buildings, production and office equipment, furniture, fixtures, vehicles, computer hardware and software). Herald allocated the remaining $94,110,152 to three intangible assets -- $26,337,152 to goodwill and going-concern value combined, and $67,773,000 to a category Herald denominated as "paid subscribers." The amount earmarked as paid subscribers represented Morning Ledger's estimate of the future profits to be derived from the 460,000 at-will subscribers acquired from Booth, all or most of whom were expected to continue to subscribe to the various newspapers after the change in control.
Beginning with its 1977 tax return, Herald claimed depreciation deductions for various assets acquired in the liquidation of Booth. Consistent with applicable regulations, discussed infra, Herald did not attempt to claim depreciation deductions for goodwill or going concern value. On its 1977 through 1980 returns, however, Herald claimed as depreciation deductions a portion of the $67,773,000 amount allocated to paid subscribers. The Service disallowed these deductions on the ground that the amount allocated to paid subscribers should have been included in the amount allocated to non-depreciable goodwill. The Service therefore determined that Herald owed additional taxes and interest for each of the applicable years, which Herald paid in full.
Morning Ledger, as successor to Herald, filed a timely claim for refund with the Service in 1988. After the Service failed to act upon the claim within the six month period prescribed by I.R.C. § 6532(a), Morning Ledger filed the instant action, in the district court for the District of New Jersey, to recover federal income taxes and interest erroneously assessed and collected.
The district court conducted a bench trial at which Morning Ledger argued that, under the relevant regulations and case law, discussed infra, in order to depreciate the paid subscribers as an intangible asset, it need only prove that the 460,000 at-will subscriber relationships acquired from Booth: (1) had limited useful lives that could be estimated with reasonable accuracy; and (2) also had ascertainable values separate and distinct from goodwill. Under Morning Ledger's interpretation of these requirements, depreciation deductions were available provided it could satisfy the essentially statistical and factual burden of demonstrating that the subscriber relationships had limited useful lives and that they had ascertainable values.
To this end, Morning Ledger presented the testimony of financial and statistical experts who explained that, based on historical and demographic data, and taking due consideration of actuarial factors such as death, relocation, changing life-styles and tastes, and competition from other media sources, they had arrived at reasonable estimates of how long the average at-will subscriber existing in 1977 would continue to subscribe to the various newspapers. These estimates ranged from a low of 14.7 years for subscribers to the Ann Arbor News to a high of 23.4 years for subscribers to the Bay City Times.
These experts further testified that, from among the market, cost, and income approaches to valuing the existing subscriber relationships in 1977, the income approach provided the only appropriate methodology. Employing this approach, the experts testified that they first calculated the present value of the gross revenue stream that would be generated by these subscribers over their estimated useful lives. From this amount, they subtracted the projected costs of collecting that subscription revenue. The experts opined that the resultant net revenue stream, estimated by one expert as $67,773,000 and by another as $60,470,000, represented a reasonable estimate of the value of the intangible asset designated as paid subscribers.
For the most part, the Service did not contest Morning Ledger's expert evidence. Indeed, the Service stipulated to Morning Ledger's estimates of the useful lives of the subscription relationships. It did contest Morning Ledger's reliance on the income method of valuation, arguing that, assuming that the asset was depreciable at all, the cost method was the only appropriate method, and that the cost of generating 460,000 subscribers through a subscription drive was on the order of only $3 million. The Service refused, however, despite the district court's entreaties, to present expert evidence to refute Morning Ledger's estimates of the value of the subscriber relationships under the income method.*fn2
The crux of the Service's case, rather, was that Morning Ledger had misinterpreted the applicable law and that all its sophisticated financial and statistical evidence was therefore irrelevant to the fundamental legal hurdle which it could not overcome. That hurdle, in the Service's submission, is that governing law requires a taxpayer to do more than demonstrate a reasonable estimate of useful life and an ascertainable value in order to depreciate a purchased intangible asset; in addition, the taxpayer is required to demonstrate that the asset is not goodwill. In the Service's view, the future stream of revenues expected to be generated by the existing 460,000 at-will subscribers is the very essence of the goodwill value of the newspapers and, as such, is not depreciable.
The district court rejected the Service's argument, holding, in effect, that any asset for which a useful life could be demonstrated and a value ascertained was, by definition, not goodwill. Having reached this conclusion, and having no expert evidence before it but that of Morning Ledger, the court held that Morning Ledger was entitled to depreciate the paid subscribers account over its estimated useful lifetime based on a total value of $67,773,000, which amount the court allocated to the various daily and Sunday newspapers. The court ordered the parties to calculate, and the government to repay, all taxes erroneously paid by Morning Ledger and applicable interest thereon.
The Service timely appealed from the final judgment of the district court. We thus have jurisdiction pursuant to 28 U.S.C. § 1291. Determining whether a taxpayer has satisfied the requirements for depreciating an intangible asset is generally a factual question. See Manhattan Co. of Virginia, Inc. v. Commissioner, 50 T.C. 78, 92-93 (1968). Hence, we review the district court's factual findings for clear error. Of course, to the extent that the district court misinterpreted or misconstrued the governing law, our review is plenary.
A. The Regulations, The Nature of Goodwill, and the Contentions of the Parties
I.R.C. § 167(a) allows as a depreciation deduction a reasonable allowance for exhaustion, wear and tear, and obsolescence of property, both tangible and intangible, used in a trade or business. Treasury Regulation 1.167(a)-3 elaborates on the depreciation of intangibles as follows:
If an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy, such an intangible asset may be the subject of a depreciation allowance. Examples are patents and copyrights. An intangible asset, the useful life of which is not limited, is not subject to the allowance for depreciation. No allowance will be permitted merely because, in the unsupported opinion of the ...