EXCHANGE OF RIGHTS TO MANUFACTURE AND/OR DISTRIBUTE PRODUCTS WAS LIKE-KIND EXCHANGE

In a private letter ruling, IRS has held that a taxpayer’s exchange of certain manufacturing and/or distribution rights with respect to a given group of products, for other manufacturing and/or distribution rights with respect to that same group of products, was a like-kind exchange with no recognition of gain or loss.

Background. Code Sec. 1031(a)(1) provides generally that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of a like kind which is to be held either for productive use in a trade or business or for investment.

Reg. § 1.1031(a)-1(b) provides that, as used in Code Sec. 1031(a), the words “like kind” have reference to the nature or character of the property and not to its grade or quality, and that an exchange of one kind or class of property for a different kind or class is not a like-kind exchange.

Reg. § 1.1031(a)-2(c)(1) provides that an exchange of intangible personal property qualifies for nonrecognition of gain or loss under Code Sec. 1031 only if the exchanged intangible properties are of a like kind. No like classes are provided for intangible properties. Whether intangible personal property is of a like kind to other intangible personal property generally depends on (i) the nature or character of the rights involved (e.g., a patent or a copyright) and (ii) the nature or character of the underlying property to which the intangible personal property relates.

Facts. Taxpayer entered into two types of agreements: the Single Activity Agreements and the Dual Activity Agreements.

Under the Single Activity Agreements, Taxpayer has rights to distribute BB, a group of Products of various different brand names, appearances, ingredients, packaging, manufacturing processes, and marketing strategies, within Territory 1 or Territory 2.

Under the Dual Activity Agreements, Taxpayer has rights to manufacture and distribute AA, a group of Products of various different brand names, appearances, ingredients, packaging, and marketing strategies, that are different from BB. Products are nondepreciable tangible personal property. The Dual Activity Agreements grant Taxpayer the right to manufacture and distribute AA within Territory 1 or Territory 2.

The length of the term, the renewable periods, and the geographical territories covered for the rights vary among the agreements within the Dual Activity Agreements and the Single Activity Agreements. In addition, the conditions imposed in connection with the manufacturing and distribution rights such as marketing, quality control, and inventory maintenance also vary among the agreements.

Another party, Exchanger, entered into two types of agreements: the Replacement Dual Activity Agreements and the Replacement Single Activity Agreements. These agreements have the same set of counter parties as Taxpayer’s agreements. The Replacement Single Activity Agreements grant Exchanger the right to distribute BB within Territory 3, Territory 4, or Territory 5. The Replacement Dual Activity Agreements grant Exchanger the right to manufacture and distribute AA within Territory 3, Territory 4, or Territory 5. The length of the term, the renewable periods, and the geographical territories covered for the rights vary among the agreements within the Replacement Dual Activity Agreements and the Replacement Single Activity Agreements. In addition, the obligations imposed in connection with the distribution rights such as marketing, quality control, and inventory maintenance also vary among the agreements.

For economic and historical reasons, manufacturers of AA have long acted as distributors of AA. The inclusion of both business activities in the Dual Activity Agreements and Replacement Dual Activity Agreements reflects the underlying economics and longstanding historical relationship between the two. Manufacturing and distribution of AA is frequently best performed by a single entity as part of an integrated business process.

Taxpayer enters into two exchanges with Exchanger. In the first exchange, Taxpayer will simultaneously exchange its Single Activity Agreements with Exchanger’s Replacement Single Activity Agreements. In the second exchange, Taxpayer will simultaneously exchange its Dual Activity Agreements for Exchanger’s Replacement Dual Activity Agreements.

The rights under the Dual Activity Agreements and the Single Activity Agreements are held by Taxpayer for productive use in a trade or business. The rights under the Replacement Dual Activity Agreements and the Replacement Single Activity Agreements will be held by Taxpayer for productive use in a trade or business. The proportionate values of the manufacturing and distribution rights are roughly similar across both the Dual Activity Agreements and the Replacement Dual Activity Agreements.

Both of the exchanges were exchanges of like-kind property. IRS determined that both of the exchanges are exchanges of like-kind property only.

The Agreements are intangible property that grant rights related to the manufacturing and/or distribution of BB or AA. Because, in both exchanges, Taxpayer and Exchanger will simultaneously exchange the Agreements, the only issue is whether the exchanged Agreements are of a like kind. That determination depends on (i) the nature or character of the rights involved and (ii) the nature or character of the underlying property to which the agreements relate. (Reg. § 1.1031(a)-2(c)(1))

The exchanged Single Activity Agreements. The Single Activity Agreements and the Replacement Single Activity Agreements are both in the nature of BB distribution agreements. Distribution of BB is a single business activity. The terms of the agreements are substantially similar, and any difference among them is a difference in grade or quality.

Accordingly, the nature or character of the Single Activity Agreements and the Replacement Single Activity Agreements are of a like kind.

The second requirement for the Agreements to be of a like kind is that the underlying property subject to the Single Activity Agreements and Replacement Single Activity Agreements must itself be of a like kind. The underlying property to which the intangible rights relate is BB, a group of Products that are distributed in a largely similar manner. BB includes Products with different brand names, appearances, ingredients, packaging, manufacturing processes, and marketing strategies. Nevertheless, all of BB are distributed in a substantially similar manner to a largely common set of customers who resell them to end customers who, in turn, use each of the Products of BB for a substantially similar purpose. Any differences among BB that are relevant to distribution are differences in grade or quality, and not differences in nature or character.

Accordingly, the underlying property subject to the Single Activity Agreements and the Replacement Single Activity Agreements is of a like kind.

The exchanged Dual Activity Agreements. The Dual Activity Agreements and the Replacement Dual Activity Agreements are both in the nature of AA manufacturing and distribution agreements. Manufacturing and distribution are two distinct business activities and the rights to each would not, absent some close connection between these activities, be of a like kind.

IRS, however, noted the economic and historic connections between manufacturing and distributing AA. In addition, manufacturing rights and distribution rights granted under the agreements can only be exercised in conjunction with each other under the agreements. The proportionate values of the manufacturing rights and the distribution rights are roughly the same across all of the Dual Activity Agreements and Replacement Dual Activity Agreements. Accordingly, while manufacturing and distribution are business activities of a different nature or character, the close economic and unique historical connection between the manufacturing and the distribution of AA demands that they be treated as two aspects of a single business activity where the rights to manufacturing and distribution are contained within the same integrated agreement.

The terms of the agreements are substantially similar in granting rights to manufacture and distribute AA. Each agreement grants rights related to a single business activity, the integrated manufacturing and distribution of AA. The differences in the length of the term, renewable periods, geographical territories covered, quality control provisions, marketing activity obligations, etc. vary among the Dual Activity Agreements and the Replacement Dual Activity Agreements. These differences, however, are insubstantial, relating as they do to the grade or quality of the rights rather than to their nature or character.

Consequently, the nature or character of the manufacturing and distribution rights in the Dual Activity Agreements and Replacement Dual Activity Agreements are of a like kind.

The second requirement for the agreements to be of a like kind is that the underlying property subject to the Dual Activity Agreements and the Replacement Dual Activity Agreements must itself be of a like kind. The underlying property to which the intangible rights to manufacture and distribute relate is AA, a group of Products that share substantially similar manufacturing and distribution processes. AA includes Products with different brand names, appearances, ingredients, packaging, and marketing strategies. Nevertheless, all of AA are manufactured using a substantially similar process in facilities of a common design, and they are distributed in a substantially similar manner to a largely common set of customers who resell them to end customers who, in turn, use each of the Products of AA for a substantially similar purpose. Any differences among AA that are relevant to manufacturing or distribution are differences in grade or quality, and not differences in nature or character.

Accordingly, under the second prong of the test in § 1.1031(a)-2(c), the underlying property to which the tangible rights granted by the Dual Activity Agreements and the Replacement Dual Activity Agreements relate is of a like kind.

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