Opinion ID: 3014809
Heading Depth: 3
Heading Rank: 3

Heading: The goodwill adjustment

Text: The Tax Court also rejected McCarthy’s reinsurance model on the grounds that McCarthy made only “some type of vague expense adjustment” to account for intangibles such as goodwill that were associated with the 376 terminated contracts. 122 T.C. at 250-51. A larger adjustment for the intangibles, which the Commissioner believes is justified, would lead to a smaller tax deduction. McCarthy subtracted some $300 million from his total valuation of all of Capital’s contracts, to account for the value added by Capital’s name, reputation, and other goodwill factors, as well as by its workforce and provider network. These factors made up a part of the value of Capital’s contracts, but were not lost when those contracts were lost; therefore, Capital did not—and could not—claim them as part of its deduction. The dispute here is over the method of calculating this goodwill adjustment. McCarthy used a rental charge, whereby he valued these intangibles based on what it would cost Capital to rent them in a market transaction. The Commissioner argued, and the Tax Court agreed, that this was improper. Instead, the Tax Court found that McCarthy should have deducted a “capital charge” from the value of the contracts, based on a valuation of the intangible factors that takes into account the market rate of return on those factors. Although the Commissioner has not attempted to calculate what such a charge would look like, we assume that it would lead to a greater offset for these intangibles, and so to a smaller tax deduction. Capital argues, however, that McCarthy’s method, which used a rental charge rather than a capital charge, was proper and indeed standard. The Tax Court found that McCarthy’s explanation for not taking a capital charge for the related intangibles was “not credible.” Id. at 251. Capital claims that this contradicted the “undisputed testimony of all the experts,” which was that rental charges are normally used in insurance valuation, and that McCarthy’s use of them was proper. The Commissioner responds that McCarthy’s charge for the related intangibles was based on their cost to Capital rather than their market value, and that this method of deducting the other intangibles overstated the value of the lost contracts. Capital’s characterization of the record appears to be 26 mistaken. The Commissioner’s witnesses did not concede that McCarthy’s approach was correct, although neither did they claim that it was professionally untenable. They did argue for an alternative method, which presumably would have given a different, and greater, value to Capital’s goodwill. Given the dispute in the record between well-qualified experts, and the Tax Court’s greater familiarity with the issue, we cannot conclude that the Tax Court’s finding here was clearly erroneous. Indeed, this finding seem s conceptually correct—Capital’s goodwill factors should be subtracted at their value, not their cost—although Capital argues that McCarthy’s rental charge was meant to estimate value and not cost. We thus accept the Tax Court’s conclusion that McCarthy should have used a capital charge, rather than a rental charge, to extract goodwill from his valuation of the contracts. But, as explained above, see supra Part IV.B, Capital does not lose its entire deduction merely because the Commissioner has found some flaws in its method. On the remand that our other holdings require, the Commissioner will have the opportunity to explain what McCarthy should have done differently in this regard, relying on specific calculations of cash flows rather than on generic names like “capital charge” versus “rental charge.” The Commissioner will also be able to propose an alternate valuation for the $300 million goodwill adjustment. Capital, meanwhile, will have another opportunity to demonstrate to what extent McCarthy’s method captures the factors raised by the Commissioner. Ultimately, the Tax Court must determine what goodwill adjustment is appropriate, using either McCarthy’s rental charge, a capital charge proposed by the Commissioner on remand, or some other adjustment taking into account the arguments of both sides. In sum, the mere fact that McCarthy’s charge is flawed does not mean that the Tax Court may reject Capital’s entire valuation.