rr-07-37.pdf

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Part I
Section 1221.-- Capital Asset Defined

26 CFR 1.1221-1: Meaning of terms.
(Also '' 197, 1231, 1241, 1245, 1253; 1.1241-1.)

Rev. Rul. 2007-37

ISSUE
1. Is the cancellation of a distributor agreement between a manufacturer and a
distributor of the manufacturer=s products a sale or exchange of property?
2. Is any resulting gain to the distributor capital gain or treated as capital gain?
FACTS
X manufactures automobile N. X sells N through a network of automobile
distributors with which X enters into distributor agreements. The distributor agreements
generally provide that a distributor may sell N within a prescribed geographic area and
may renew the agreement as long as the distributor performs according to the
agreement.
In 1994, A entered into a distributor agreement with X to sell N. The amount of
A=s payment to X for the agreement is not contingent on the productivity, use, or
disposition of the right to sell N, but rather is a fixed sum. Since then, A has been
continuously engaged in the trade or business of selling N. A makes a substantial

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capital investment in its distributorship as reflected in the cost of its N inventory.
X plans to discontinue production of N in 2007, and offers payments to
distributors to cancel their N distributor agreements. In 2007, A accepts X=s payment
of $40x in cancellation of its N distributor agreement with X. A=s basis in the distributor
agreement is $10x. A has no section 1231 losses.
LAW
Section 1241 of the Internal Revenue Code provides that amounts received by a
distributor of goods for the cancellation of a distributor agreement in which the
distributor has a substantial capital investment are amounts received in exchange for
the agreement. Section 1.1241-1(b) of the Income Tax Regulations defines
Acancellation@ of a distributor agreement as a termination of all 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.
Section 1.1241-1(c) provides that ' 1241 applies to a distributor agreement only
if (i) it is for marketing or marketing and servicing of goods, (ii) the distributor has made
a substantial capital investment in the distributorship, and (iii) the capital investment is
reflected in physical assets such as inventories of tangible goods, equipment,
machinery, storage facilities, or similar property.
Section 1221 defines "capital asset" as property held by the 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 provided in ' 167 is not a capital asset. Section 1221(a)(2).

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Under ' 1231, gain from the sale or exchange of property that is not a capital
asset may be treated as capital gain if the property is used in the trade or business, is
held for more than one year, and is property of a character subject to the allowance for
depreciation under ' 167. If a taxpayer has a net gain for a taxable year from sales or
exchanges of property used in the trade or business as defined in ' 1231(b) (as well as
from certain involuntary conversions of property), each gain or loss from such sales or
exchanges is treated under § 1231(a)(1) as a long-term capital gain or loss. If a net
loss results, each gain or loss is treated under § 1231(a)(2) as not arising from the sale
or exchange of a capital asset. Generally, the result of the operation of ' 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. However, ' 1231(c) provides that
the net section 1231 gain for any taxable year is treated as ordinary income to the
extent of the taxpayer=s non-recaptured net section 1231 losses for the five most recent
preceding taxable years.
Since section 1231 gain includes gain from the sale or exchange of property of a
character subject to an allowance for depreciation under § 167, section 1231 gain may
be subject to recapture under ' 1245. Section 1245 provides for recapture of
depreciation and amortization if the property sold or exchanged is section 1245
property. Section 1245 property includes any personal property, including intangible
personal property, of a character subject to the allowance for depreciation under ' 167.
See ' 1245(a)(3)(A) and ' 1.1245-3(b)(2).
Franchises subject to ' 197

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Under ' 197(f)(7), property that is an Aamortizable section 197 intangible@ is
treated as property of a character subject to the allowance for depreciation under ' 167.
An Aamortizable section 197 intangible@ is any section 197 intangible that is acquired
by the taxpayer on or after the effective date of ' 197 (in general, August 11, 1993; or
July 26, 1991, if there is a valid retroactive election under ' 1.197-1T) and is held in
connection with the conduct of a trade or business. Section 197(c)(1) and '
13261(g)(2) of Pub. L. No. 103-66. Under ' 197(d)(1)(F), a Asection 197 intangible@
includes any franchise, trademark, or trade name. Section 197(f)(4) defines the term
Afranchise@ by reference to ' 1253(b)(1), which provides that a franchise includes an
agreement that gives the right to sell goods within a specified area.
Since an amortizable section 197 intangible, including a franchise, is property of
a character subject to an allowance for depreciation under § 167, it is not a capital asset
for purposes of ' 1221. However, if an amortizable section 197 intangible is used in a
trade or business and held for more than one year, gain or loss on its sale or exchange
generally qualifies as a section 1231 gain or loss. Similarly, an amortizable section 197
intangible is section 1245 property and any section 1231 gain from the sale or exchange
of an amortizable section 197 intangible may be subject to recapture under ' 1245.
Franchises acquired on or after January 1, 1970, and before the effective date of ' 197

Whether a franchise acquired on or after January 1, 1970 (the effective date of
' 1253), and before the effective date of ' 197, is a capital asset under § 1221 or
section 1231(b) property depends on whether the franchise is amortizable under ' 1253
and whether, because of such amortization, it is property of a character subject to the

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allowance for depreciation under ' 167. For this purpose, the relevant provisions of '
1253 are those in effect before its amendment in 1993, and references to ' 1253 in this
section of this revenue ruling are to the provisions in effect before its 1993 amendment.
In general, intangible assets acquired before the effective date of ' 197 could be
amortized only if they had a limited useful life, the length of which could be estimated
with reasonable accuracy. Section 1.167(a)-3. Although franchises in many cases
have indefinite useful lives, ' 1253 allowed the cost of franchises in which the transferor
retained any significant power, right, or continuing interest to be either deducted in the
taxable year paid or amortized over a specified period of time. Section 1253(d)(1),
which was not affected by the 1993 amendment, provides that a purchaser of a
franchise may deduct certain contingent payments under ' 162(a). Section 1253(d)(2)
provided that payments not deductible under ' 1253(d)(1) were recoverable over a
period of time that depended on whether the payments were made in a lump sum, in
approximately equal installments over a specified period, or under another payment
arrangement. For transfers after October 2, 1989, ' 1253(d)(2) did not apply if the
transfer of the franchise involved principal payments in excess of $100,000, but the
taxpayer could elect under ' 1253(d)(3) to recover the cost of the franchise ratably over
a 25-year period beginning with the taxable year of the transfer. Thus, although ' 1253
did not explicitly provide that a franchise was treated as property of a character subject
to the allowance for depreciation, it permitted acquisition costs to be amortized as if the
franchise had a limited useful life.
Property amortizable under provisions of the Code other than § 167 has been

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held to be Aproperty of a character which is subject to the allowance for depreciation
under ' 167" and ' 1231(b) property. See Tom F. Baker v. Commissioner, 38 T.C. 9
(1962); McEnery v. Commissioner, T.C. Memo. 1967-213. AIt has long been
established that an amortizable item is >of a character subject to depreciation= as
required under ' 1231(b).@ Estate of Shea v. Commissioner, 57 T.C. 15, 23 (1971),
acq
. 1973-2 C.B. 3. Therefore, property that was amortizable under § 1253 is properly
treated as property of a character subject to the allowance for depreciation under § 167
and as section 1231(b) property rather than a capital asset.
The amortizable character of franchises transferred during the period between
1969 and the effective date of § 197 also determines their proper treatment for
purposes of § 1245. For transfers after October 2, 1989, § 1245(a)(2)(C) provided that
deductions allowable under § 1253(d)(2) or (d)(3) were treated as deductions for
amortization for purposes of § 1245, and § 1245(a)(3) provided that property subject to
the allowance for amortization in § 1253(d)(2) or (d)(3) was section 1245 property. The
legislative history relating to the 1989 amendments of section 1245 and 1253 stated that
no inference was intended as to the recapture requirements of prior law. As noted
above, however, under the prior law the cost of a franchise was amortizable under §
1253(d)(2), including in cases in which the principal payments exceeded $100,000. As
is the case for purposes of § 1231, any franchise the cost of which was amortized under
§ 1245(d)(2) is properly treated for purposes of § 1245 as property of a character
subject to the allowance for depreciation under § 167. Accordingly, such a franchise is
section 1245 property.

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Therefore, a distributor agreement acquired after 1969 and before the effective
date of ' 197, for a fixed payment, including a fixed sum payable in a series of
approximately equal payments, is amortizable under § 1253 and is treated as property
of a character subject to the allowance for depreciation in ' 167. Because it is property
of a character subject to the allowance for depreciation, it is not a capital asset, but gain
from the sale or exchange of such property may be treated as capital gain under § 1231
and may be subject to recapture under ' 1245.
Franchises acquired before January 1, 1970

A distributor agreement entered into before January 1, 1970 (the effective date of
' 1253), is not amortizable, is not property of a character subject to the allowance for
depreciation in ' 167, and is a capital asset under ' 1221. See Rev. Rul. 55-374, 1955-
1 C.B. 370; Rev. Rul. 88-24, 1988-1 C.B. 306.
ANALYSIS
In the present case, A=s distributor agreement with X is for the marketing of
goods, and A has made a substantial investment of capital in the distributorship as
reflected in A=s inventory value. The cancellation did not occur by reason of the
expiration of the agreement in accordance with its terms and the cancellation terminates
all of A=s rights to sell product N. Therefore, ' 1241 applies to the cancellation of the
agreement and X=s payment to A in cancellation of A=s distributor agreement is treated
as an amount received in exchange for the agreement.
A=s distributor agreement gives A the right to sell N within a specific geographic
area. Therefore, the agreement is a franchise under ' 1253(b)(1). A entered into the

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distributor agreement after August 10, 1993, and holds it in connection with the conduct
of a trade or business. Thus, the distributor agreement is an Aamortizable section 197
intangible@ and property of a character subject to the allowance for depreciation
provided in ' 167, and is not a capital asset. A=s gain of $30x from the payment for the
cancellation of the distributor agreement qualifies under ' 1231 as long-term capital
gain, subject to recapture under ' 1245 and recharacterization under ' 1231(c).
If A had entered into the distributor agreement with X after 1969, but before the
effective date of ' 197, gain from the cancellation of the agreement would similarly
qualify for ' 1231 treatment. Because A paid X a fixed amount for the distributor
agreement, the agreement would be amortizable under ' 1253, and as a result would
be property of a character that is subject to an allowance for depreciation under ' 167.
The $30x gain from the cancellation would be treated as long-term capital gain under '
1231, subject to any applicable recapture under ' 1245 and recharacterization under '
1231(c).
If A had entered into the distributor agreement with X before 1970, the
agreement would be a capital asset and the $30x gain from the cancellation would be
capital gain.
HOLDING
1. The cancellation of a distributor agreement between a manufacturer and a
distributor of the manufacturer=s products is a sale or exchange of property if the
distributor has made a substantial capital investment in the distributorship and the
investment is reflected in physical assets.

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2. Any resulting gain to the distributor is capital gain if the agreement is a capital
asset. The gain is section 1231 gain and may be treated as capital if the agreement is
property of a character subject to the allowance for depreciation under § 167. For this
purpose, property is treated as being of such a character if it is amortizable under § 197
or § 1253. The section 1231 gain may be subject to recapture under ' 1245.
DRAFTING INFORMATION
The principal author of this revenue ruling is Maxine Woo-Garcia of the Office of
Associate Chief Counsel (Income Tax & Accounting). For further information regarding
this revenue ruling, contact Ms. Woo-Garcia on (202) 622-7900 (not a toll-free call).