International Multifoods Corp. v. Commissioner

*26 RUWE, Judge: *6 Respondent determined deficiencies in petitioner's Federal income taxes as follows:

Taxable Year Ended	Deficiency
Feb. 28, 1987	$ 2,962,380
Feb. 29, 1988	3,592,402

*7 Petitioner paid these deficiencies following receipt of its notice of deficiency and then filed a petition with this Court claiming an overpayment of income tax for each year. On December 6, 1993, petitioner filed a motion for leave to amend petition in order to claim an increased overpayment of income tax for its taxable year ended February 28, 1987, resulting from, among other things, an alleged foreign tax credit carryback from its taxable year ended February 28, 1989, in the amount of $ 952,015. On January 28, 1994, this Court granted petitioner's motion in part and allowed petitioner to claim an increased overpayment of income tax resulting from the alleged foreign tax credit carryback from its 1989 taxable year.

Allowance of this foreign tax credit carryback depends upon our resolution of the issue we confront today. We must decide what portion, if any, of the gain realized by petitioner on the sale of Asian and Pacific operations of Mister Donut of America, Inc. (Mister Donut), petitioner's wholly owned subsidiary, to Duskin Co. (Duskin) on January 31, 1989, constitutes foreign source income for purposes of computing petitioner's foreign tax credit limitation pursuant to *8 section 904(a). ¹

*9 *27 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the taxable years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. At the time its petition was filed, petitioner maintained its principal place of business in Minneapolis, Minnesota.

Petitioner is a Delaware corporation which filed consolidated Federal income tax returns for itself and its affiliated subsidiaries for the relevant taxable years. During these years, petitioner and its subsidiaries were involved primarily in the manufacture, processing, and distribution of food products.

Mister Donut franchised Mister Donut pastry shops in the United States and abroad. As of January 1989, there were approximately 500 Mister Donut shops in the United States, 78 shops in Asia and the Pacific, and approximately 35 to 40 shops in Europe, the Middle East, and Latin America. Mister Donut joined in the filing of petitioner's consolidated returns. Hereinafter, we will generally refer to Mister Donut's transactions as petitioner's, since Mister Donut was petitioner's wholly owned*10 subsidiary.

Petitioner's Asian and Pacific Mister Donut Operations

As of January 1989, petitioner had registered Mister Donut trademarks in the following countries: Indonesia, the Philippines, Taiwan, Thailand, Australia, the People's Republic of China, Hong Kong, Malaysia, New Zealand, Singapore, and South Korea.

Petitioner, as franchisor, had entered into Mister Donut franchise agreements in Indonesia, the Philippines, Thailand, and Taiwan ² (the operating countries). The franchise agreements in effect on January 31, 1989, were as follows: *28

Date of
Initial			No. of Mister
Agreement	Territory	Franchisee	Donut Shops
Apr. 30, 1987	Indonesia	PT Naga Puspita	2
		Bujana
Nov. 16, 1981	Philippines	Naque Franchising Co.	49
Mar. 16, 1984	Taiwan	Continental Foods	6
May 19, 1978	Thailand	Thai Franchising Co.	21

These agreements contained substantially similar requirements except for provisions dealing with franchise fees, royalties, ³ development schedules, and the length of the agreement. ⁴ As of January 31, 1989, petitioner did not have franchise agreements in any of the other countries in which it had registered trademarks; i.e., Australia, Hong Kong, Malaysia, *11 New Zealand, the People's Republic of China, Singapore, and South Korea (the nonoperating countries).

Mister Donut had perfected a system that utilized franchisees to prepare and merchandise distinctive quality*12 doughnuts, pastries, and other food products. The franchise agreements refer to this system as the "Mister Donut System", which is described as:

the name "Mister Donut", a unique and readily recognizable design, color scheme and layout for the premises wherein such business is conducted (herein called a "Mister Donut Shop") and for its furnishings, signs, emblems, trade names, trademarks, certification marks and service marks * * *, all of which may be changed, improved and further developed from time to time * * *

The Mister Donut System also included methods of preparation, serving and merchandising doughnuts, pastries, and other food products, and the use of specially prepared doughnut, pastry, and other food product mixes as may be changed, improved, and disclosed to persons franchised by petitioner to operate a Mister Donut shop.

*29 Petitioner granted franchisees the right to open a fixed number of Mister Donut shops pursuant to established terms and conditions and at locations approved by petitioner. ⁵ The franchise agreements provided that petitioner would not open or authorize others to open any Mister Donut shops in the franchisee's territory ⁶ until the franchise*13 agreement expired or was terminated, or unless the franchisee did not meet its development schedule by failing to open the requisite number of Mister Donut shops by the agreed-upon date. In the event the franchisee failed to open the agreed-upon number of shops, it lost its exclusive rights in the territory and could not open any additional Mister Donut shops. Petitioner could then operate, or authorize others to operate, Mister Donut shops in the territory, so long as the newly opened shops were not within a certain proximity of the franchisee's already existing shops.

Franchisees were entitled to use the building design, layout, signs, emblems, and color scheme relating to the Mister Donut System, along with petitioner's copyrights, trade names, trade*14 secrets, know-how, and preparation and merchandising methods, as well as any other valuable and confidential information. However, petitioner retained exclusive ownership of its current and future trademarks, as well as any additional materials that constituted an element of the Mister Donut System. Use of these assets was prohibited after the termination of the franchise agreement.

The franchise agreements obligated petitioner to provide training at petitioner's training facility in Saint Paul, Minnesota, for employees of the franchisees. Instructional programs covered every aspect involved in the operation of a Mister Donut franchise, including production procedures and techniques, personnel matters, accounting, promotion, and maintenance. Petitioner required its new international franchisees to send a minimum of two employees to the training programs, which consisted of a basic 4-week class plus a 2-week supplemental class for international franchisees. ⁷

*15 *30 In addition, when franchisees opened their initial Mister Donut shops, petitioner provided them with the assistance of two Mister Donut employees for a 3-week period to work with the shop's manager and to assist in the training of the bakers and sales personnel. Petitioner also provided its franchisees with manuals, which covered all aspects of managing and operating a Mister Donut franchise, such as operating and production procedures, baked goods, training, equipment, advertising, repair and maintenance, sanitation, and special programs. The franchise agreements contained strict confidentiality provisions and provided that the Mister Donut manuals remained the property of petitioner and were to be returned to it upon termination of the franchise agreement.

In order to ensure that the distinguishing characteristics of the Mister Donut System were uniformly maintained, petitioner established standards for furnishings, equipment, finished product mixes, and supplies, ⁸ which the franchisees were required to meet. The agreements also required that franchisees operate their shops in accordance with petitioner's standards of quality, preparation, appearance, cleanliness, and service. *16

Petitioner's Sale of Its Asian and Pacific Mister Donut Operations to Duskin

Duskin is a Japanese corporation which markets a variety of goods and services, primarily through franchise operations. On November 19, 1983, petitioner and Duskin entered into an agreement for the sale of petitioner's assets, rights, and interests in Mister Donut in Japan (the Japan Agreement). The Japan Agreement also included a covenant by petitioner not to compete*17 in the donut business in Japan for a period of 20 years, as well as a covenant by Duskin not to conduct any business similar to the Mister Donut business anywhere outside Japan for a period of 10 years.

*31 By the end of 1986, petitioner had decided to sell its food distribution and franchise business. Petitioner was having difficulty providing adequate service to its Mister Donut operations in Asia and the Pacific. Duskin was seeking to expand into new territories as it had nearly saturated the Japanese market. Given its organization, financing, and experience, Duskin appeared the logical buyer for petitioner's franchisor's interest in Mister Donut in Asia and the Pacific.

On January 31, 1989, following 2 years of negotiations, petitioner and Duskin entered into an agreement for the sale of petitioner's entire interest in Mister Donut in designated Asian and Pacific nations for $ 2,050,000. Pursuant to the agreement, petitioner sold its existing franchise agreements, trademarks, Mister Donut System, and goodwill for each of the operating countries, and its trademarks ⁹ and Mister Donut System in the nonoperating countries. Joseph Dubanoski, formerly a division vice president with *18 petitioner whose primary responsibilities involved the development and implementation of international franchises, determined petitioner's sale price. In arriving at this amount, Mr. Dubanoski considered: (1) The royalty income generated in the operating countries; (2) the growth potential in the operating countries; (3) the development potential in the nonoperating countries; and (4) the value of the trademarks in the operating and nonoperating countries.

Although nothing in the franchise agreements required petitioner to obtain the consent of the franchisees before assigning its rights as franchisor, Duskin expressed concern that franchisees might be unwilling to work with a Japanese company. Therefore, the purchase agreement required petitioner to obtain an agreement from each franchisee consenting to the assignment of petitioner's*19 franchisor's interest to Duskin. Duskin also expressed concern as to whether petitioner would be able to obtain the requisite approvals and consents and complete the acts necessary to transfer the trademarks and franchise agreements. Consequently, petitioner included two provisions in the purchase agreement which provided for a refund to Duskin of a portion of the sale *32 price in the event petitioner was unable to transfer all or some of the franchise agreements and trademarks.

Article V, paragraph 3(a), of the purchase agreement listed various documents that petitioner was to deliver to Duskin to establish that the transfer of the Mister Donut trademarks for the nonoperating countries had been perfected. ¹⁰ Article V, paragraph 4, provided that in the event petitioner was unable to deliver the requisite documents, petitioner would refund $ 615,000 of the purchase price to Duskin, and Duskin would reconvey the trademarks and Mister Donut System for the nonoperating countries.

*20 In addition, article VII, paragraph 1, listed various consents, approvals, assignments, and other documents that petitioner was required to deliver to Duskin with respect to the transfer of the trademarks, franchise agreements, and supplier agreements for the operating countries. Article VII, paragraph 2, provided that a portion of the purchase price would be refunded if petitioner was unable to deliver the requisite documents for one or more of the operating countries. The amount of the refund was dependent upon the number of operating countries with respect to which petitioner was unable to deliver all necessary documents:

No. of Operating Countries
With Respect to Which Post-
Closing Assignments and
Consents Are not Delivered	Purchase Price Adjustment
4	$ 700,000 or $ 500,000 and
	Hawaii license1
3	$ 400,000 or $ 200,000 and
	Hawaii license
2	$ 150,000 or $ 50,000 and
	Hawaii license
1	Hawaii license

*21 Petitioner satisfied all the terms in the purchase agreement, and no price adjustments were made.

*33 The purchase agreement also contained a covenant by petitioner not to compete in the operating and nonoperating countries for a period of 20 years. Article XIV, paragraph 1, of the agreement stated:

MDAI [Mister Donut] covenants and agrees with Duskin that, for a period of twenty (20) years commencing on the Post-Closing Date, MDAI will not, either directly or indirectly:

(a) carry on in any of the Non-Operating Countries or in any of the Duskin Operating Countries any business similar to the Mister Donut shop business being sold and transferred by MDAI to Duskin on the Post-Closing Date;

(b) otherwise sell doughnuts in any of the Non-Operating Countries or any of the Duskin Operating Countries; or

(c) disclose all or any part of the Mister Donut System or any of the bakery mix formulae, with or without the payment of consideration, to any person for use in any of the Non-Operating Countries or the Duskin Operating Countries. * * *

The agreement similarly contained a covenant by Duskin not to compete in any business similar to the Mister Donut business in the United*22 States, Canada, and 38 European, Mideastern, Caribbean, and Latin American countries for a period of 5 years. The countries included in the Duskin covenant were nations where petitioner had Mister Donut franchise operations or registered trademarks. ¹¹

Petitioner's Allocation and Reporting of the Proceeds From the Sale

Duane A. Suess and John D. Schaefer were employees in petitioner's tax department and were involved in the sale of the Mister Donut franchise business in Asia and the Pacific. Messrs. Suess and Schaefer reviewed all drafts of the purchase agreement.

The first draft, which was dated January 20, 1988, and prepared*23 by Bruce M. Bakerman of petitioner's legal department, contained a provision allocating the purchase price between the existing franchises, goodwill, trademarks, and pending trademark applications. The actual percentage to be *34 allocated to these assets was left blank. Mr. Suess reviewed this draft and handwrote the following on the document:

Approve subject to:

1) Review of foreign tax consequences associated with each country covered by the agreement;

2) Review of foreign source income rules to determine best way to maximize foreign source income. Initial review indicates goodwill and noncompete covenants may give rise to such income.

3) Allocation of proceeds will be critical aspects of 1 & 2 above, therefore flexibility in this area should be a major negotiating point.

In a memorandum dated May 24, 1988, from Michael S. Munro to Paul Quinn, Mr. Munro recommended that the purchase agreement should not contain an allocation of the sale price. ¹² In response to this suggestion, petitioner's legal department removed the allocation from the subsequent draft dated May 25, 1988. However, in a memorandum dated May 27, 1988, Mr. Schaefer expressed concern regarding the absence*24 of such an allocation:

The lack of any purchase price allocation in the Agreement is not particularly helpful from a U.S. tax viewpoint. However, the fact that the purchaser is a Japanese entity and the current lack of distinction in the amount of tax on capital gains and ordinary income minimizes this concern.

It could be advantageous to have a portion of the purchase price allocated to "goodwill" in the four Far East countries where Mister Donut already has franchisees.

My main concern, though, is with uncertain tax consequences surrounding the transfer of trademarks in the Peoples Republic of China, Taiwan, Indonesia, Malaysia, Singapore, and Hong Kong. It is possible that the trademark transfers could generate a tax in these countries. Therefore, if amounts are to be allocated to the trademarks associated with these countries, the purchase price allocated to them should be as little as possible. If this is not practical as negotiations continue, I would appreciate it if you could keep me advised so that I can get some outside professional help with respect to the tax consequences of the trademark sale in these countries.

*25 In a memorandum dated September 8, 1988, Mr. Suess provided draft language for a provision allocating the purchase price between goodwill, trademarks, and petitioner's *35 covenant not to compete. In his memorandum, Mr. Suess stated:

In negotiating the allocation it is important to note that the amounts allocated to goodwill and the noncompete covenant, to the extent upheld upon IRS audit, will be tax-free to Multifoods. The amount allocated to the trademarks and pending trademark applications will be subject to a tax of approximately 38% in the U.S. and potentially additional taxes in the countries in which such trademarks are registered. Therefore, to the extent that we can maximize the allocation to the goodwill and non-compete covenant, we will maximize Multifoods' after-tax gain on the sale.

You requested that I advise you of the potential tax consequences to Duskin of the purchase price allocation. As previously discussed, both goodwill and trademarks are generally amortizable for tax purposes in Japan. Non-compete covenants are also generally amortizable for tax purposes in Japan. Therefore, it is possible that Duskin may be indifferent to the specific amounts allocated to*26 each type of asset. * * *

On or about January 27, 1989, petitioner obtained a draft of an appraisal from the Valuation Engineering Associates Division of Touche Ross (Touche Ross), allocating the sale price among the assets to be sold. Duskin was not involved in the selection of Touche Ross, nor did it indicate to petitioner its preferred allocation.

On January 31, 1989, Touche Ross submitted its final report, which stated:

Based on our limited review of information provided to us, we allocated the $ 2,050,000 purchase, as follows:

Trademarks	$ 120,000	6%
Non-competition	820,000	40%
Goodwill	1,110,000	54%
Total	$ 2,050,000	100%

Article IV, paragraph 3, of the purchase agreement contained the same allocation.

In reporting its foreign and domestic source income for its taxable year ended February 28, 1989, petitioner followed the allocation contained in article IV of the purchase agreement. After allocating its selling expenses among the goodwill and trademarks sold to Duskin, petitioner reported $ 1,016,643 ¹³*36 of foreign source income from the sale of goodwill, $ 820,000 of foreign source income from the covenant not to compete, and $ 109,907 of U.S.*27 source income from the sale of the trademarks. Petitioner did not allocate any of its selling expenses to the sale of the covenant not to compete.

OPINION

We must determine what portion, if any, of the gain on petitioner's sale of its Asian and Pacific Mister Donut operations constitutes foreign source income for purposes of computing petitioner's foreign tax credit limitation under section 904(a).

We begin with the sourcing of income rules under section 865. Section 865(a) (1) provides that income from the sale of personal property by a U.S. resident ¹⁴ is generally sourced in the United States. Section 865(d) provides that in the case of any sale of an intangible, the general rule applies only to the extent that the payments in consideration of such sale are not contingent on the productivity, use, or disposition of the intangible. Sec. *28 865(d)(1)(A). Section 865(d)(2) defines "intangible" to mean any patent, copyright, secret process or formula, goodwill, trademark, trade brand, franchise, or other like property. Section 865(d) (3) carves out a special sourcing rule for goodwill. Payments received in consideration of the sale of goodwill are treated as received from sources in the country in which the goodwill was generated.

1. Goodwill

Petitioner allocated $ 1,110,000 of the sale price to goodwill. On brief, petitioner maintains that the franchisor's interest it conveyed to Duskin consisted exclusively of intangible assets in the nature of goodwill; i.e., franchises, trademarks, and the Mister Donut System. Petitioner contends that the income attributable to the sale of this goodwill constitutes foreign source income pursuant to section 865(d) (3). ¹⁵

*29 This argument mistakes goodwill for the intangible assets which embody it. Goodwill represents an expectancy that "old *37 customers will resort to the old place" of business. Houston Chronicle Publishing Co. v. United States, 481 F.2d 1240, 1247 (5th Cir. 1973); Canterbury v. Commissioner, 99 T.C. 223, 247 (1992). The essence of goodwill exists in a preexisting business relationship founded upon a continuous course of dealing that can be expected to continue indefinitely. Canterbury v. Commissioner, supra at 247; Computing & Software, Inc. v. Commissioner, 64 T.C. 223, 233 (1975). The Supreme Court has explained that "The value of every intangible asset is related, to a greater or lesser degree, to the expectation that customers will continue their patronage [i.e., to goodwill]." Newark Morning Ledger Co. v. United States, 507 U.S. 546, 556 (1993). An asset does not constitute goodwill, however, simply because it contributes to this expectancy of continued patronage.

Section 865(d) (1) provides that income from the sale of an intangible*30 asset by a U.S. resident will generally be sourced in the United States. Section 865(d) (2) defines "intangible" to include, among other things, secret processes or formulas, goodwill, trademarks, and franchises. Section 865(d) (3) then provides a special rule for goodwill, sourcing it in the country in which it was generated.

Petitioner's argument equates goodwill with the other assets listed in the definition of "intangible" in section 865(d) (2). This Court has recognized that intangible assets such as trademarks and franchises are "inextricably related" to goodwill. Canterbury v. Commissioner, supra at 249-251; see also Philip Morris, Inc. v. Commissioner, 96 T.C. 606, 634 (1991), affd. without published opinion 970 F.2d 897 (2d Cir. 1992). However, we believe that Congress' enumeration of goodwill in section 865(d) (2) as a separate intangible asset necessarily indicates that the special sourcing rule contained in 865(d)(3) is applicable only where goodwill is separate from the other intangible assets that are specifically listed in section 865(d)(2). If the sourcing provision contained *31 in section 865(d)(3) also extended to the goodwill element embodied in the other intangible assets enumerated in section 865(d)(2), the exception would swallow the rule. Such an interpretation would nullify the general rule that income from the sale of an intangible asset by a U.S. resident is to *38 be sourced in the United States. ¹⁶*32 See Torres v. McDermott Inc., 12 F.3d 521, 526 (5th Cir. 1994); Israel-British Bank (London), Ltd. v. FDIC, 536 F.2d 509, 512-513 (2d Cir. 1976); Edward B. Marks Music Corp. v. Colorado Magnetics, Inc., 497 F.2d 285, 288 (10th Cir. 1974). ¹⁷

Respondent contends that, although not denominated as such, what Duskin acquired from petitioner was a territorial franchise for the operating and nonoperating countries. Petitioner, on the other hand, argues that it did not sell Duskin a franchise, but, rather, the entire Mister Donut franchising business in Asia and the Pacific. Petitioner maintains that the sale of a franchise requires the franchisor to retain an interest in the business and that petitioner failed to retain the requisite interest in this case following the sale to Duskin. Petitioner contends that section 1253(a) and our opinion in Jefferson-Pilot Corp. v. Commissioner, 98 T.C. 435 (1992), affd. 995 F.2d 530 (4th Cir. 1993), support its interpretation of "franchise".

*33 Although section 865 does not provide a definition of franchise, section 1253(b) (1) defines it for purposes of section 1253(a) to include "an agreement which gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area." We have found this definition to be consistent with the common understanding of the term. Jefferson-Pilot Corp. v. Commissioner, supra at 440-441. When Congress uses a term that has accumulated a settled meaning under equity or the common law, courts must infer that Congress intended to incorporate the established meaning of the term, unless the statute otherwise dictates. NLRB v. Amax Coal Co., 453 U.S. 322, 329 (1981); see also Jefferson-Pilot Corp. v. Commissioner, supra at 442 n.8. Since we find no indication that Congress intended "franchise" to carry a different meaning in the context of section 865, we adopt this definition for purposes of this section.

*39 Pursuant to section 1253(a), the transfer of a franchise, trademark, or trade name shall not be treated as the sale or exchange of a capital*34 asset if the transferor retains a significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark, or trade name. Prior to its amendment in the Omnibus Budget Reconciliation Act of 1993 (OBRA), Pub. L. 103-66, sec. 13261(c), 107 Stat. 312, 539, ¹⁸ section 1253(d)(2)(A) provided that if a transfer of a franchise, trademark, or trade name is not treated as the sale or exchange of a capital asset, then any single payment in discharge of a principal sum agreed upon in the transfer agreement shall be deducted ratably by the payor over a period of 10 years or the period of the transfer agreement, whichever is shorter.

*35 In Jefferson-Pilot, the taxpayer's subsidiary purchased three radio stations, and the taxpayer sought a deduction under section 1253(d) (2) for a portion of the purchase price, which it claimed was attributable to Federal Communica