The Value of the Tax Certificate Policy

© 1998 by Kofi Asiedu Ofori and Mark Lloyd

Abstract
     Tax certificates are an example of successful incentive regulation. Prior to its repeal in 1995, Section 1071 of the Internal Revenue Code permitted the tax-free sale or exchange of media properties to effectuate policies of the Federal Communications Commission. Enacted by Congress in 1943, this provision was originally used in transactions involving non-minorities to reduce ownership concentration in the radio and television sectors. In 1978, the policy was expanded to promote goals favoring diversity of viewpoint by means of increased minority ownership. This paper provides an overview of the historical value of tax certificates as incentive regulation. It also discusses the importance of tax certificates in the context of ownership opportunities for minorities and concentration of ownership in the radio industry.

     Keywords: media ownership concentration, minority ownership, incentive regulation, diversity of viewpoint, tax certificates.

Acknowledgments

     This paper would not have been possible without the interest and support of Eli Naom, Allen Hammond, and Caterina Alvarez who worked tirelessly to organize a conference on New Approaches to Minority Media Ownership hosted by the Columbia Institute for Tele-Information, Columbia University.

     The authors would also like to acknowledge the important contribution of David Lowenstein for assisting with data analysis.

The Civil Rights Forum

     The Civil Rights Forum is a Washington-based nonprofit organization dedicated to promoting civil rights principles and advocacy to the implementation of the 1996 Telecommunications Act, and to reframe the discussion over the role of media in our society around the needs of communities and the rights of citizens. Visit our web site: Civil Rights Forum

Table of Contents

I. Tax Certificates as Incentive Regulation.

II. The Economic Value to Private Parties (Investors, Buyers & Sellers)

III. Ownership Size in Relation to Station Performance

IV. Quantifying the Public Interest Cost of Deregulation

V. The Cost of Tax Certificates Compared with Other Non-gain Recognition Provisions of the Internal Revenue Code

VI. The Value of Tax Certificates in the Present Marketplace

APPENDIX

A. Section 1071 of the Internal Revenue Code
B. Examples of Tax Certificate Letters Unrelated to Minority Ownership

Summary
     This paper discusses a range of economic, First Amendment and regulatory values that are associated with the tax certificate policy. Perhaps most central to the idea of tax certificates is that it can be used as a regulatory tool to achieve the related goals of economic competition and diversity of viewpoint.
     As a regulatory tool tax certificates have value as a means of encouraging industry behavior through the use of tax incentives. The authors of this paper firmly believe that the trend towards ownership concentration in the radio market encumbers the time-honored goals of economic competition and viewpoint diversity. The adoption of new multiple and duopoly ownership limits along with the re-enactment of the tax certificate policy would greatly serve to alleviate this problem. Minority tax certificates in conjunction with ownership limits would serve to encourage the sale of stations that are grandfathered under the new ownership caps. Precedent for the use of Section 1071 in this manner can be found in past instances when tax certificates were used as an incentive to gain compliance with Commission multiple ownership rules.

     The economic benefits of tax certificates enure to private parties and the general public as well. As more competitors acquire stations there are more services with competing views and opinions for the public to choose from. The fact that tax certificates are an election, not a requirement, makes the policy consistent with the philosophy of placing reliance upon marketplace forces.

     The ability of minorities to acquire 364 cable TV, television and radio licenses through the use of tax certificates and to increase their broadcast holdings from 40 in 1978 to 350 in 1995 demonstrates the effectiveness of tax certificates. Present day marketplace circumstances, however, present challenges. Competing tax-free methods of selling stations detract from the attractiveness of tax certificates as an option for sellers. Moreover, soaring station prices make it uneconomical to own stations in the major markets except for broadcasters that already own three or more stations in the local market.

     A market analysis based upon the Herfindahl-Hisschman Index indicates that as of 1997 all radio markets warrant scrutiny under Department of Justice merger guidelines. Secondly, the trend over time is towards less competition. Under such market conditions government intervention in the form of common ownership limits and tax certificates is warranted. Only in this manner can competition and diversity of viewpoint be promoted.

     A comparison of the gross revenues of stations based upon the number of stations owned nationwide and locally by the parent company demonstrates that superior station performance can be linked with the acquisition of additional stations. For example, mean station revenue increased from 1 million to nearly 5 million dollars as ownership by the parent company increased from 1 to 3 stations to 69 to 182 stations. A similar pattern was found for local ownership. The competitive advantages enjoyed by the large broadcasters enable them to devote greater streams of revenue to station salaries, program production and sales promotion. If small and minority broadcasters are to remain competitive in the present radio marketplace, there must be regulatory intervention that will afford them the ability to acquire additional stations. Such intervention should take the form of common ownership limits and re-enactment of the tax certificate policy.

I. Tax Certificates as Incentive Regulation.

     Any discussion of the value of tax certificates must begin with a description of its original intent. Adopted by Congress in 1943, the tax certificate policy was designed to avoid hardship on the part of broadcasters whose ownership size or network operations conflicted with national policies favoring competition and diversity of viewpoint. Ironically, its repeal in 1995 has been attributed to a transaction that would have advanced those very same goals by enabling an African-American to acquire the vast cable TV properties of Viacom.

     Circa 1941; the Federal Communications Commission, not even a decade old, decided, with the help of the U.S. Supreme Court in 1943, that it was a bad idea for the Radio Corporation of America (RCA) to operate two radio networks. The concern was grounded in two related concepts firmly rooted in those progressive values which dominated our public policies around the time of the Great Depression. Those two concepts, well articulated by the Supreme Court on many occasions, are the evils of monopoly or conversely the importance of fair competition, and the First Amendment virtues of diverse communications sources. The impetus for tax certificates was the need to contend with ownership trends in the broadcast industry that were incompatible with the public interest values of competition and diversity.

     In 1939, the Commission commenced an investigation into the monopolistic practices of powerful radio networks. The findings of the Chain Broadcasting report are reminiscent of conditions in today's marketplace.

     The record evidences a definite trend towards concentration of ownership of radio stations...Eighty-seven of [the radio owners] received in 1938 approximately 52 percent of the total business of all commercial broadcasting stations. To the extent that the ownership and control of radio-broadcast station falls into fewer and fewer hands, whether they be network organizations or other private interests, the free distribution of ideas and information, upon which our democracy depends is threatened.

     As a result of the Chain Broadcasting report, the FCC effectively forced David Sarnoff, President of RCA, to divest his "blue network". The property was sold to Edward J. Noble, the Lifesaver king, and eventually became the American Broadcasting Company (ABC). The 1941 FCC Commissioners and their colleagues in Congress may have been Roosevelt Progressives, but they were not unmindful of the harm this new policy would cause the powerful, and newly minted, "General Sarnoff". There was a need to soften the blow of the divestiture requirements imposed by Chain Broadcasting. Tax certificates, therefore, were devised to permit the General and other media monopolists to defer any capital gains on the "involuntary" sale of their properties.

     During the ensuing years, tax certificates were used very effectively to encourage compliance with FCC policies that placed limits on the common ownership of radio and television stations. Beginning with the sale of the "blue network" to ABC, an estimated 177 tax certificates were issued to ease the impact of divestitures required by such policies. None of these transactions involved racial or ethnic minorities.

     Initially, tax certificates were used in conjunction with forced divestitures. Subsequently, the policy was used as an incentive for voluntary divestitures. The latter rewarded owners for divesting properties that were grandfathered under Commission rules prohibiting the same-market common ownership of TV and radio stations and the cross-ownership of broadcast and newspaper operations. Appendix B contains four examples of tax certificates that fit within this category.

     Out of concern for the inadequate representation of the views of minorities, the Commission began, in 1978, issuing tax certificates to increase minority ownership. Since its inception, however, the overarching goal of tax certificates has been to promote competition and diversity of expression.

     Circa 1998; the conditions of today's radio marketplace resemble those of 1941 and present an opportunity to employ incentive regulation to advance the policies of competition and diversity.

     Following the passage of the Telecommunications Act of 1996, there has been an unprecedented decline in the number of radio owners. Seven hundred fewer companies now own this mainstay of American broadcasting. By eliminating FCC policy that placed limits on common ownership, Congress has effectively reduced competition and the diversity of expression.

     Figure 1 shows that the top 50 radio firms collectively owned approximately 800 stations in 1996. One year after passage of the Telecommunications Act, the top ten firms owned 800 stations. Two years after the Act, the number stations owned by the ten largest firms exceeded 1,300. The tremendous growth in national ownership consolidation has been paralleled by reduced numbers of competitors in the local markets. In a study of market ownership trends the Commission noted that the declining number of radio owners "is not simply the result of consolidation in a few large or small markets," but is rather part of a pattern that exists across all market sizes (see Figure 2).

     Market consolidation is a fait accompli that cannot be reversed by reliance upon marketplace forces. Radio deregulation has come at the cost of a tremendous reduction in the amount of competition in the marketplace. Market entry by small and minority competitors has been stifled by soaring station prices. Under present marketplace circumstances regulatory intervention in the form of ownership limits and tax incentives is warranted.

     Regulations adopted during the 1940s may provide a model for using tax certificates to restore competition and diversity in today's marketplace. Specifically, Congress should establish limits on the common ownership of radio stations. For the purpose of the local market caps, the Herfindahl-Hisschman Index can be used as an objective standard for determining whether a merger or acquisition conflicts with the public interest.

     Secondly, Congress should reestablish the tax certificate policy. In conjunction with a FCC policy favoring minority ownership, tax certificates can be used to encourage owners of stations that are grandfathered under new ownership caps to sell them to minorities. The ability of incentive regulation to influence industry behavior is evidenced by the estimated 536 instances in which owners elected tax-free treatment in the past.

     Considerable discussion has centered around whether Congress should adopt a minority or a small business tax certificate policy. However, Section 1071 of the Internal Revenue Code, when in effect, never defined a class of qualified buyers. As previously explained, the purpose of Section 1071 was to influence industry compliance with ownership policies by means of incentive regulation. Increased minority ownership was one of several "ownership policies" that the FCC successfully administered under the rubric of Section 1071. Therefore, Congress need only enact what it repealed—a tax certificate policy with "competition and diversity" as the operative terms.

     The real question is whether minority ownership regulations under legislation similar to Section 1071 can withstand heightened judicial scrutiny of affirmative action programs. The authors of this paper maintain that pro-minority ownership regulations supported by strong evidence that they advance the goal of diversity of expression can withstand the standard handed down by the U.S. Supreme Court in Adarand. The latter did not overrule language in Metro Broadcasting that said it is a permissible objective of affirmative action to promote the diversification of broadcast licenses. Research on the nexus between minority ownership and viewpoint diversity is presently being conducted by the University of Santa Clara School of Law on behalf of the FCC's Office on Communications Business Opportunities.

II. The Economic Value to Private Parties (Investors, Buyers & Sellers)

     Section 1071 essentially permits favorable tax treatment by permitting the deferral of otherwise taxable gain realized from the sale of media property. In order for a taxpayer to receive such treatment there must be a sale or exchange of property that the Commission deems to be "necessary or appropriate to effectuate a change in a policy of, or the adoption of a new policy by, the Commission with respect to the ownership and control of radio broadcasting stations." Over the years the provision has been extended to include the sale of television and cable TV properties.

     Much attention has focused on the benefits enjoyed by minorities under this provision. While tax certificates have greatly leveraged the bargaining power of minorities seeking to acquire a station, the direct tax benefit is conferred upon the companies that sell stations.

     Since its inception 1943, tax certificates have enabled sellers to select one of three approaches to structure a tax-free transaction. A seller who would otherwise pay taxes on the gain realized from the sale of a media property may elect to have the transaction treated as an involuntary conversion under Section 1033 of the Internal Revenue Code. The latter provision permits gain to be taxed only to the extent that the proceeds from transaction exceed the cost of replacement media property. In effect, the seller does not have to pay taxes as long as they reinvest the proceeds from a sale in replacement property. Section 1033 generously permits replacement property to be acquired prior to the sale of the property for which the tax certificate is issued, provided the replacement property is still owned by the seller on the date when the tax certificate property was sold.

     The second tax-free option permitted sellers to use the gain to reduce their basis in other depreciable property. Such property is defined as property "remaining in the hands of the taxpayer" immediately after the tax certificate transaction or acquired within the same taxable year. Therefore, the taxpayer's basis in assets, such at other media property, can be used to reduce tax liability.

     A third approach was to combine the features of first two options. A tax payer may defer a portion of the gain through the acquisition of replacement property and another portion by reducing the basis of depreciable property.

     In a market where station prices are appreciating at a very fast rate the non-gain recognition features of Section 1071 provided strong incentives for owners to sell; and in the case of minority tax certificates, to sell to a specific class of buyers. Over more than 40 years, station owners were granted an estimated 536 tax certificates.

     In 1982, the Commission modified its the tax certificate regulations to encourage venture capital investment in minority businesses. The goal was to encourage start-up investment in minority-controlled entities and to contribute to the stabilization of their operations. Under the 1982 Minority Tax Certificate Policy, tax certificates were issued to investors who purchased initial shares in minority-controlled broadcast entities or who purchased shares within one year after the issuance of the broadcast license. When these investors sold their shares any gain on the sale was deferred under the provisions of Section 1071.

     The value of tax certificates to minorities was that it enhanced their bargaining power when seeking to acquire a station. In a limited number of instances, sellers lowered the station price by an amount equal to their capital gains tax savings. In such instances minorities were able to acquire stations at a lower price than non-minorities. It should be noted, however, that the non-gain recognition treatment of Section 1071 was an option for the seller; they were not required to sell to minorities at a lower price. In many instances countervailing considerations influenced sellers not to elect Section 1071 treatment (see Section VII, infra).

     Figure 3 demonstrates that tax certificates greatly served to increase the number of stations owned by minorities.

     Prior to the FCC's adoption of the minority tax certificate policy in 1978 there were only 40 stations owned by minorities. By 1995, that number increased to 350. During the 17 intervening years 364 tax certificates were issued for transactions involving sales to minorities; 290 radio, 43 TV and 31 cable TV . Figure 3 indicates the number of annual television and radio sales to minorities that involved the use of tax certificates.

III. Ownership Size in Relation to Station Performance

     In 1996, Congress eliminated limits on the number of radio stations that a single company could own on a nationwide basis. Broadcasters were also permitted to own a greater number of stations in the local markets; up to 8 stations could be owned by a single company in the major markets.

     An estimated 11 billion dollars worth of mergers and acquisitions took place within the first six months after passage of the Telecommunications Act as large group owners took advantage of ownership deregulation. Station prices soared as high as 20 times cash flow in the major markets as market consolidators rushed to acquire new stations. Minorities were generally not party to these transactions, except as sellers. The number of African-American owned radio stations declined by 26, and overall minority ownership of TV and radio declined from 350 to 322 during 1996.

     The passage of the Telecommunications Act in 1996 and repeal of the tax certificate policy the year before combined to hinder the ability of minorities to take advantage of ownership deregulation and expand their operations. In the absence of tax certificates minorities were unable to negotiate for new stations and to compete with the capital resources of the large group owners. Large group owners, on the other hand, quickly moved to consolidate market share (see Figures 1,2, & 6).

     In order to demonstrate the importance of large operations in the new marketplace and thus the need for tax certificates, the Civil Rights Forum compared station performance with ownership size. The results indicate that growth in the number of stations is accompanied by an overall increase in station performance.

     The analysis examined a sampling of 3,502 radio stations. The stations were divided into quartiles based upon the number of stations owned by the parent company in the local and national markets. For the national market the quartiles were 1 to 3, 4 to 13, 14 - 68, and 69 - 182 stations. The quartiles for the local markets were 1 to 2, 3, 4 to 5, and 5 to 10 stations. Figures 4 and 5 provide data on the performance of stations based upon the ownership quartile of the parent company. The means of the following variables were used to measure station performance: station revenues, local cume share, market revenue share, and power ratio.

     Figure 4 indicates that the most significant change in station performance associated with change in company size was station revenue. Mean station revenue increased from 1.006 to 4.965 million dollars as the quartile of national ownership increased from 1 to 3 stations to 69 to 182 stations. There were also significant increases in market revenue share (5.45 % to 8.4%) and local cume share (5.43% to 7.37%). There was no appreciable change in power ratio (1.02% too 1.09%).

     An examination of local ownership indicates that, with the exception of station revenue, there is less dramatic change in station performance. As the quartile for local station ownership increased from 1 to 2 stations to 5 to 10 stations, mean power ratio remained unchanged, and there was a decrease in the variables market revenue share and local cume share. Mean station revenue, however, increased from 1.7 million dollars to 4.8 million dollars (see Figure 5).

     The fact that companies with more stations generate higher station revenues despite no corresponding change in local cume share and other performance variables suggests a linkage between large company size and increased ability to obtain purchases and/or higher prices from advertisers. Further investigation is warranted to determine whether large firms condition the purchase of commercial time on one station upon the purchase of time on other stations that they own. Another area of inquiry is to determine whether large firms leverage their control of market share to raise advertising prices.

     The present analysis demonstrates that the acquisition of stations has been accompanied by an appreciable increase in station revenues. It is also implies that small firms are at a competitive disadvantage. Stations with large parent companies have greater revenue streams with which to hire the best on-air talent, to invest in program production and to spend on sales promotion. These competitive advantages ultimately work to the disadvantage of small and minority firms. If minorities and small firms are to remain competitive in the present radio marketplace, there must be regulatory intervention that will afford them the ability to acquire additional stations. Such regulatory intervention should take the form of limits on common ownership and re-enactment of the tax certificate policy.

IV. Quantifying the Public Interest Cost of Deregulation

     A standard measure of economic concentration is the Herfindahl-Hisschman Index ("HH Index"). The HH Index provides a convenient method for quantifying reduced competition that may be associated with ownership deregulation and repeal of the tax certificate policy.

     An analysis performed by the FCC demonstrates that as of November 1997 all radio markets are in the zone above 1800 that "warrant scrutiny" under Department of Justice guidelines (see Figure 6). Figure 6 also demonstrates that all markets experienced a decline in the amount of competition during the eight month period between March and November 1997. As more revenues became concentrated in the hands of fewer owners, fewer dollars became available for the remaining competitors.

     The analysis suggests that it can be shown, quantitatively, that competition has decreased as a result of changes in ownership policy (i.e. ownership deregulation and the repeal of tax certificates). The authors of this paper recommend using the HH Index as quantitative tool to measure the cost to the public interest of deregulatory actions taken by Congress. Conversely, the Index can be used as yardstick to measure the benefits of polices that promote competition and diversity.

V. The Cost of Tax Certificates Compared with Other Non-gain Recognition Provisions of the Internal Revenue Code

     Concern was expressed during the 1995 Senate hearings on tax certificates about loss tax revenues. Tax certificates were perceived by some members of Congress as an unjustifiable subsidy for big business.

     It seems to me when we are cutting all of these Federal programs, as I said earlier, we should take a careful look. Even though I sympathize with the goals, I cannot sympathize with somebody walking off with a half a billion dollars in the transaction.

     Senator Dole (R-KS) appears to have overlooked the cost to the public interest, in terms of reduced competition, that can be associated with the repeal of tax certificates (Section IV, supra). Moreover, the cost to taxpayers for the tax certificate program is significantly less than other non-gain recognition provisions of the Internal Revenue Code. According to the Joint Committee on Taxation, the cost to taxpayers for tax deferrals under Section 1071 averaged 140 million dollars annually between 1990 and 1994 compared to 500 million dollars annually for other provisions that permit the deferral of gain on like-kind exchanges.

VI. The Value of Tax Certificates in the Present Marketplace

     The tax certificate is valuable to a minority buyer to the extent that the seller's capital gains savings exceeds the difference in purchase price offered by the minority and non-minority buyers. There are, however, alternative methods of selling communications properties tax-free. Stock-for-stock swops and tax-free exchanges are two examples. During the 1995 Senate hearing on tax certificates, ex-FCC Commissioner Tyrone Brown provided seven examples of tax-free sales of cable TV systems that did not involve tax certificates. Station trades (or station-swops) are another common example tax-free transactions.

     The variety of tax-free alternatives compete with the attractiveness of electing tax certificate treatment. Further, if the tax rate for capital gains, presently 20 percent, were to decline, the incentive for electing tax certificates will also decline. For this reason, policy-decision makers should consider offering tax credits to enhance the incentive to sell to minorities.

     In the radio marketplace, however, even tax credits may be ineffective. The unprecedented high level of station prices in the major markets are only economical for broadcasters who are established market consolidators—broadcaster who already own three to four stations in a market and are willing to pay a premium to increase their market share. By imposing limits on multiple and duopoly ownership, Congress and the Commission can indirectly affect station prices. under such a scenario, tax certificates can play an important role by encouraging the sale of stations that are grandfathered by new ownership limits. Competition and diversity within the ownership structure of the radio industry can thus be invigorated.

APPENDIX

Sec. 1071. Gain from sale or exchange to effectuate policies of F.C.C.

(a) Nonrecognition of gain or loss

     If the sale or exchange of property (including stock in a corporation) is certified by the Federal Communications Commission to be necessary or appropriate to effectuate a change in a policy of, or the adoption of a new policy by, the Commission with respect to the ownership and control of radio broadcasting stations, such sale or exchange shall, if the taxpayer so elects, be treated as an involuntary conversion of such property within the meaning of section 1033. For purposes of such section as made applicable by the provisions of this section, stock of a corporation operating a radio broadcasting station, whether or not representing control of such corporation, shall be treated as property similar or related in service or use to the property so converted. The part of the gain, if any, on such sale or exchange to which section 1033 is not applied shall nevertheless not be recognized, if the taxpayer so elects, to the extent that it is applied to reduce the basis for determining gain or loss on sale or exchange of property, of a character subject to the allowance for depreciation under section 167, remaining in the hands of the taxpayer immediately after the sale or exchange, or acquired in the same taxable year. The manner and amount of such reduction shall be determined under regulations prescribed by the Secretary. Any election made by the taxpayer under this section shall be made by a statement to that effect in his return for the taxable year in which the sale or exchange takes place, and such election shall be binding for the taxable year and all subsequent taxable years.
(b) Basis
     For basis of property acquired on a sale or exchange treated as an involuntary conversion under subsection (a), see section 1033(b).