Int'l Multifoods Corp. v. Comm'r of Internal Revenue, 11643-92.

• Decision Date: 29 January 1997
• Docket Number: No. 11643-92.,11643-92.
• Citation: 108 T.C. No. 3,108 T.C. 25
• Parties: INTERNATIONAL MULTIFOODS CORPORATION and Affiliated Companies, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

108 T.C. 25
108 T.C. No. 3

INTERNATIONAL MULTIFOODS CORPORATION and Affiliated Companies, Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 11643-92.

United States Tax Court.

Jan. 29, 1997.

David R. Brennan, John K. Steffen, Susan B. Grupe, and Nathan P. Zietlow, Minneapolis, MN, for petitioner.

Jack Forsberg, St. Paul, MN, for respondent.

P was in the business of franchising the right to operate Mister Donut shops in the United States and abroad. On Jan. 31, 1989, P sold its Asian and Pacific Mister Donut business operations for $2,050,000. Pursuant to the agreement, P transferred its franchise agreements, trademarks, Mister Donut System, and goodwill for each of the Asian and Pacific countries in which P 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. In the purchase agreement, P allocated $1,930,000 of the sale price to goodwill and a covenant not to compete. On its 1989 Federal income tax return, P reported the income allocated to these assets as foreign source income for purposes of computing P's foreign tax credit limitation under sec. 904(a), I.R.C. R determined that the goodwill and covenant not to compete were inherent in P's franchisor's interest. R further determined that the sale of P's franchisor's interest produced U.S. source income under sec. 865(d)(1), I.R.C.

Held: The goodwill inherent in the Mister Donut business in Asia and the Pacific was embodied in, and inseverable from, P's franchisor's interest and trademarks that were conveyed to D. The income attributable to the sale of P's franchisor's interest and trademarks constitutes U.S. source income under sec. 865(d)(1), I.R.C.

Held, further: P's covenant not to compete, which prohibited P from carrying on any business similar to Mister Donut or disclosing any part of the Mister Donut System in specified Asian and Pacific countries, possessed independent economic significance and is severable from P's franchisor's interest and trademarks.

Held, further: P has not shown that more than $300,000 of the sale price should be allocated to the covenant not to compete. R concedes that any amount allocated to the covenant constitutes foreign source income.

Held, further: A pro rata portion of P's selling expenses must be allocated to the sale of the covenant not to compete. Sec. 862(b), I.R.C.

RUWE, Judge:

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 ¦
                +-------------------------------+
                

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 section 904(a).¹

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 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 Taiwan² (the operating countries). The franchise agreements in effect on January 31, 1989, were as follows:

+--------------------------------------------------------------+
                ¦Date of ¦ ¦ ¦ ¦
                +-------------+-----------+----------------------+-------------¦
                ¦Initial ¦ ¦ ¦No. of Mister¦
                +-------------+-----------+----------------------+-------------¦
                ¦Agreement ¦Territory ¦Franchisee ¦Donut Shops ¦
                +-------------+-----------+----------------------+-------------¦
                ¦Apr. 30, 1987¦Indonesia ¦PT Naga Puspita Bujana¦2 ¦
                +-------------+-----------+----------------------+-------------¦
                ¦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, 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 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.

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 territory⁶ 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. 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 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...