Goodwill And Mister Donut ' A Going Concern?

• Published date: 01 February 2022
• Subject Matter: Corporate/Commercial Law, Intellectual Property, Tax, Trademark, Corporate Tax, Franchising, Withholding Tax
• Law Firm: Ruchelman PLLC
• Author: Mr Michael Peggs and Wooyoung Lee

INTRODUCTION

A sale of a business to a buyer often involves an element of goodwill, a term that can have different meanings in different contexts, depending on whether the term relates to (i) purchase price allocations for financial statement purposes or income tax purposes or (ii) attempting to compute the source of income for foreign tax credit purposes. Compounding the definitional inconsistency, the meaning of the term has changed over time.

The Merriam-Webster Dictionary defines goodwill in a non-business context as "a kind, helpful, or friendly feeling or attitude." In a business context, the term is given various definitions, including

• the amount of value that a company's good reputation adds to its overall value,
  
  
• the favor or advantage that a business has acquired especially through its brands and its good reputation,
  
  
• the value of projected earnings increases of a business especially as part of its purchase price, or
  
  
• the excess of the purchase price of a company over its book value which represents the value of goodwill as an intangible asset for accounting purposes.

This article examines the evolution of the international tax consequences of controlled and uncontrolled sales of goodwill by a U.S. corporation, and begins with a 1989 sale of a regional donut shop franchise business operated outside the U.S. to an uncontrolled Japanese buyer.

THE INTERNATIONAL MULTIFOODS CORPORATION CASE

Taxpayer's Franchising Business

International Multifoods Corporation v. Commr.¹ is a case that involves a U.S. corporation ("U.S. Co") that operated a donut store franchising business. It perfected a system that utilized franchisees to prepare and merchandise distinctive donuts, pastries, and other food products. The franchise agreements refer to this system as the "Mister Donut System," which entailed a unique and readily recognizable design, color scheme and layout for the premises wherein such business is conducted and for its furnishings, signs, emblems, trade names, trademarks, certification marks, and service marks.

U.S. Co typically granted franchisees the right to open a fixed number of Mister Donut shops pursuant to established terms and conditions and at locations approved by U.S. Co. The franchise agreements provided that U.S. Co would not open or authorize others to open any Mister Donut shops in the franchisee's territory until the franchise 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.

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 secrets, know-how, and preparation and merchandising methods, as well as any other valuable and confidential information. However, U.S. Co 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.

Sale of Franchising Business

In early 1989, U.S. Co sold its Asian and Pacific Mister Donut franchising business to a Japanese purchaser for $2.05 million. Pursuant to the agreement, U.S. Co transferred its franchise agreements, trademarks, Mister Donut System, and goodwill for each of the Asian and Pacific countries in which U.S. Co had existing franchise agreements, as well as its trademarks and Mister Donut System for those Asian and Pacific countries in which it had registered trademarks but did not have franchise agreements. From the viewpoint of U.S. Co, the agreed price for the transaction took into account (i) the royalty income generated in the operating countries, (ii) the growth potential in the operating countries, (iii) the development potential in the nonoperating countries, and (iv) the value of the trademarks in the operating and nonoperating countries.

As a condition of the contract, U.S. Co agreed to a noncompete covenant for 20 years covering all countries in which franchising arrangements were in place or where trademarks were registered within the territory, but franchises did not exist. As a condition to full payment, U.S. Co needed to obtain consents of all franchisees.

Goodwill Reported as a Separate Asset from Trademarks and Systems

At the suggestion of U.S. Co's tax department, the asset purchase agreement did not allocate the purchase price to the assets sold. The ostensible reason given in a memorandum was concern that certain countries within the territory might consider imposing withholding taxes on the amounts allocated to local trademarks. Although not in the memorandum, the advice reflected divergent tax treatment for the source of gains when computing the foreign tax credit limitation of a U.S. taxpayer under the rules of U.S. tax law.

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