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In Revenue Ruling 2007-37, the Internal Revenue Service concluded that the cancellation of a distribution agreement will, in certain circumstances, constitute a sale or exchange of property and any gain realized by the distributor should be treated as a capital gain for federal income purposes. This ruling affirms the interplay of various sections of the Internal Revenue Code that produce this favorable tax result. For most individuals, classifying income as a capital gain rather than ordinary income will be beneficial. First, most capital gains are taxed at a maximum tax rate of 15 percent (as opposed to a maximum individual tax rate of 35 percent for ordinary income). Second, in most transactions resulting in the recognition of capital gains, a taxpayer is allowed to offset the amount of any gain with the taxpayer’s basis in the asset being sold. In Revenue Ruling 2007-37, a taxpayer owned an automobile distributorship. As part of this business, the taxpayer was party to a distribution agreement with an automobile manufacturer that entitled the taxpayer to sell the manufacturer’s automobiles within a prescribed geographic area. The taxpayer paid the manufacturer a fixed sum for the distributorship, and the taxpayer was also required to make a substantial capital investment in its distributorship by maintaining an inventory of the manufacturer’s automobiles. The ruling primarily focuses on the appropriate tax treatment of the payment received by the taxpayer from the automobile manufacturer in cancellation of the distribution agreement, arising from the manufacturer’s decision to discontinue the production of the automobiles which were the subject of the agreement. To be eligible for capital gain treatment, a payment must arise from the sale or exchange of either a capital asset or “Section 1231 property.” Section 1221 defines a capital asset as property owned by a taxpayer, whether or not it is connected with the taxpayer’s trade or business. However, property used in a taxpayer’s trade or business and of a character that is subject to the allowance for depreciation (under Section 167) is not a capital asset. “Section 1231 property” is defined in Section 1231 as property that is used in the taxpayer’s trade or business, is held for more than one year and is property of a character subject to the allowance for depreciation. If a taxpayer has a net gain for a taxable year from sales or exchanges of Section 1231 property, each gain is treated as a long-term capital gain. If a net loss results, such loss is treated as not arising from the sale or exchange of a capital asset. Generally, the result of the operation of Section 1231 in a taxable year is to give the taxpayer the benefit of long-term capital gains treatment on net gains and ordinary loss treatment on net losses. In analyzing whether the payment received by the taxpayer in Revenue Ruling 2007-37 should be taxed as a capital gain, the IRS focused on the two critical elements necessary for capital gain treatment: • Did the transaction involve the sale or exchange of property? • Was the property a capital asset or Section 1231 property? With respect to the first issue concerning a sale or exchange, Section 1241 provides a clear statutory answer. Under Section 1241, proceeds received by a distributor from the cancellation of a distribution agreement, where the distributor has made a substantial investment of capital in the distributorship, are considered as amounts received from the sale or exchange of the agreement. In the regulations promulgated under Section 1241, the term “cancellation” means a termination of the contractual rights of a distributor with respect to a particular distributorship, other than by the expiration of the agreement in accordance with its terms. Moreover, the regulations provide that Section 1241 applies to distribution agreements only if they are for the sale or servicing of tangible goods. It does not apply to agreements for the sale of intangible property or for rendering personal services. With respect to the requirement that Section 1241 only applies to a distribution agreement if the distributor has made a substantial investment of capital in the distributorship, the regulations provide that such a capital investment must be reflected in physical assets such as inventories of tangible goods, equipment, machinery, storage facilities or similar property. The regulations provide an example of a distribution agreement that does not qualify for sale or exchange treatment under Section 1241 where a distributor of food products merely solicited orders from customers and had the manufacturer ship the orders directly to the customers without the requirement that the distributor maintain any inventory, warehouse facilities or delivery fleet. Based upon the facts presented in Revenue Ruling 2007-37 (i.e., the taxpayer’s investment in an inventory of the manufacturer’s automobiles), the IRS correctly concluded that, by the application of Section 1241, the cancellation of the distribution agreement should be treated as a sale or exchange. Accordingly, the IRS next was required to focus on whether the distribution agreement constituted either a capital asset or Section 1231 property. Under Code Section 197(f)(7), property that is an “amortizable Section 197 intangible” is treated as property of a character subject to the allowance for depreciation. An amortizable Section 197 intangible includes any franchise, trademark, or trade name acquired by the taxpayer on or after the effective date of Section 197 (in general, August 11, 1993). The term “franchise” is defined to include an agreement that gives the right to sell goods within a specified area. Therefore, most distribution agreements will also constitute a “franchise” for purposes of Section 197. The IRS concluded in Revenue Ruling 2007-37 that since the distribution agreement in question was an amortizable Section 197 intangible, the agreement did not qualify as a capital asset under Section 1221 since it is property of a character subject to an allowance for depreciation. However, as an amortizable Section 197 intangible used in connection with a trade or business and held for more than one year, the agreement constituted Section 1231 property and the proceeds received upon its termination should be taxed as a capital gain (subject to possible recapture under Section 1245). Although the distribution agreement in question in the Ruling was entered into after the effective date of Section 197, the Ruling also addressed the appropriate tax treatment of cancellation payments received on account of distribution agreements entered into prior to the effective date of Section 197. In this regard, the IRS concluded that most distributorships acquired on or after Jan. 1, 1970 (the effective date of Code Section 1253), and before the effective date of Section 197 will be treated as Section 1231 property since Section 1253, prior to the enactment of Section 197 in 1993, allowed for the amortization of franchises in a manner similar to the amortization of intangible property allowed under Section 197. With respect to a distribution agreement entered into before Jan. 1, 1970 (the effective date of Section 1253), there was no statutory provision allowing for the amortization of such agreements and, therefore, such agreements do not constitute property of a character subject to the allowance for depreciation and do not qualify as Section 1231 property. However, because such agreements are not amortizable, such agreements constitute a capital asset under Section 1221, also resulting in capital gain treatment upon their cancellation. Although Revenue Ruling 2007-37 does not break any new ground, it does offer a broad review of the various provisions of the code that, together, allow for capital gain treatment of proceeds received upon the cancellation of a distribution agreement (where there has been a substantial investment of capital in the distributorship by the distributor). Mark L. Silow is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.

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