                          108 T.C. No. 3



                   UNITED STATES TAX COURT



INTERNATIONAL MULTIFOODS CORPORATION AND AFFILIATED COMPANIES,
  Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent



   Docket No. 11643-92.                    Filed January 29, 1997.


        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
                               - 2 -

     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.



     David R. Brennan, John K. Steffen, Susan B. Grupe, and

Nathan P. Zietlow, for petitioner.

     Jack Forsberg, for respondent.



     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
                              - 3 -

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

     1
      At trial, the parties addressed an additional issue:
whether the loss realized by petitioner on the sale of the stock
of Paty S.A.-Produtos Alimenticios, Ltda. (the Paty stock loss
issue), constitutes a foreign source loss for purposes of
computing petitioner's foreign tax credit limitation under sec.
904(a). On July 8, 1996, the Internal Revenue Service issued
proposed regulations involving the allocation of losses realized
                                                   (continued...)
                               - 4 -

     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

     1
      (...continued)
on the disposition of stock. Under the regulations, petitioner
would be able to elect retroactively to source its Paty stock
loss in the United States. See sec. 1.865-2(a)(1), (e)(2)(i),
Proposed Income Tax Regs., 61 Fed. Reg. 35696, 35698-35699 (July
8, 1996). On July 19, 1996, respondent filed a motion to sever
the Paty stock loss issue and hold it in abeyance pending the
filing of a status report by respondent in February 1997
regarding the finalization of the relevant regulations.
Respondent's motion to sever issue will be granted.
                                   - 5 -

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              2
                                       Bujana

    Nov. 16, 1981    Philippines     Naque Franchising Co.       49

    Mar. 16, 1984    Taiwan          Continental Foods            6

    May 19, 1978     Thailand        Thai Franchising Co.        21


     2
      Although styled a Technical Cooperation Agreement,
petitioner's agreement in Taiwan was, in all material respects,
the same as its franchise agreements.
                                 - 6 -

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:



     3
      The agreements provided for the payment of royalties equal
to the following percentages of the franchisees' gross sales:



         Agreement                       Royalty Percentage

         Indonesia                            3.90
         The Philippines                      3.50
         Taiwan (as amended)                  3.50
         Thailand (as amended)                3.35

     4
      The franchise agreements for the Philippines and Thailand
had 20-year terms, while the agreement for Indonesia had an
initial term of 20 years with an option for the franchisee to
extend the agreement for additional 20-year periods. The
agreement for Taiwan, as amended, provided for a term of 20 years
with an option for the franchisee to extend the agreement for one
additional 20-year period.
                              - 7 -


     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


     5
      Subject to certain limitations, the franchise agreements
permitted franchisees to subfranchise Mister Donut shops within
the respective franchisee's territory.
     6
      Hereinafter, "territory" is a reference to one of the 11
operating and nonoperating countries.
                                 - 8 -

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
                               - 9 -

programs, which consisted of a basic 4-week class plus a 2-week

supplemental class for international franchisees.7

     In addition, when franchisees opened their initial Mister

Donut shops, petitioner provided them with the assistance of two

Mister Donut employees for a 3-week period to work with the

shop's manager and to assist in the training of the bakers and

sales personnel.   Petitioner also provided its franchisees with

manuals, which covered all aspects of managing and operating a

Mister Donut franchise, such as operating and production

procedures, baked goods, training, equipment, advertising, repair

and maintenance, sanitation, and special programs.   The franchise

agreements contained strict confidentiality provisions and

provided that the Mister Donut manuals remained the property of

petitioner and were to be returned to it upon termination of the

franchise agreement.

     In order to ensure that the distinguishing characteristics

of the Mister Donut System were uniformly maintained, petitioner

established standards for furnishings, equipment, finished

product mixes, and supplies,8 which the franchisees were required

     7
      International franchisees could send additional employees
for training each year.
     8
      Petitioner had entered into supplier agreements with
manufacturers outside the United States, licensing them to
produce bakery mixes, fillings, and other products to its
specifications for sale to Mister Donut franchisees and
subfranchisees. These agreements obligated suppliers to meet
petitioner's quality standards, prohibited suppliers from selling
                                                   (continued...)
                               - 10 -

to meet.    The agreements also required that franchisees operate

their shops in accordance with petitioner's standards of quality,

preparation, appearance, cleanliness, and service.

Petitioner's Sale of Its Asian and Pacific Mister Donut
Operations to Duskin


     Duskin is a Japanese corporation which markets a variety of

goods and services, primarily through franchise operations.     On

November 19, 1983, petitioner and Duskin entered into an

agreement for the sale of petitioner's assets, rights, and

interests in Mister Donut in Japan (the Japan Agreement).    The

Japan Agreement also included a covenant by petitioner not to

compete in the donut business in Japan for a period of 20 years,

as well as a covenant by Duskin not to conduct any business

similar to the Mister Donut business anywhere outside Japan for a

period of 10 years.

     By the end of 1986, petitioner had decided to sell its food

distribution and franchise business.    Petitioner was having

difficulty providing adequate service to its Mister Donut

operations in Asia and the Pacific.     Duskin was seeking to expand

into new territories as it had nearly saturated the Japanese

market.    Given its organization, financing, and experience,


     8
      (...continued)
Mister Donut products to anyone other than Mister Donut
franchisees or subfranchisees, and imposed strict confidentiality
requirements on the suppliers to prevent the disclosure of
petitioner's formulas and trade secrets.
                              - 11 -

Duskin appeared the logical buyer for petitioner's franchisor's

interest in Mister Donut in Asia and the Pacific.

     On January 31, 1989, following 2 years of negotiations,

petitioner and Duskin entered into an agreement for the sale of

petitioner's entire interest in Mister Donut in designated Asian

and Pacific nations for $2,050,000.    Pursuant to the agreement,

petitioner sold its existing franchise agreements, trademarks,

Mister Donut System, and goodwill for each of the operating

countries, and its trademarks9 and Mister Donut System in the

nonoperating countries.   Joseph Dubanoski, formerly a division

vice president with petitioner whose primary responsibilities

involved the development and implementation of international

franchises, determined petitioner's sale price.   In arriving at

this amount, Mr. Dubanoski considered:   (1) The royalty income

generated in the operating countries; (2) the growth potential in

the operating countries; (3) the development potential in the

nonoperating countries; and (4) the value of the trademarks in

the operating and nonoperating countries.

     Although nothing in the franchise agreements required

petitioner to obtain the consent of the franchisees before

assigning its rights as franchisor, Duskin expressed concern that

franchisees might be unwilling to work with a Japanese company.


     9
      Included within the transfer of the Mister Donut trademarks
were trademark applications which petitioner had filed and which
presumably were pending as of the date of the purchase agreement.
                              - 12 -

Therefore, the purchase agreement required petitioner to obtain

an agreement from each franchisee consenting to the assignment of

petitioner's franchisor's interest to Duskin.   Duskin also

expressed concern as to whether petitioner would be able to

obtain the requisite approvals and consents and complete the acts

necessary to transfer the trademarks and franchise agreements.

Consequently, petitioner included two provisions in the purchase

agreement which provided for a refund to Duskin of a portion of

the sale price in the event petitioner was unable to transfer all

or some of the franchise agreements and trademarks.

     Article V, paragraph 3(a), of the purchase agreement listed

various documents that petitioner was to deliver to Duskin to

establish that the transfer of the Mister Donut trademarks for

the nonoperating countries had been perfected.10   Article V,

paragraph 4, provided that in the event petitioner was unable to

deliver the requisite documents, petitioner would refund $615,000

of the purchase price to Duskin, and Duskin would reconvey the

trademarks and Mister Donut System for the nonoperating

countries.


     10
      In addition to the trademarks and Mister Donut System,
petitioner was responsible for delivering the following
documents: (1) Certified resolutions from petitioner's board of
directors authorizing performance on the purchase agreement; (2)
an opinion letter from counsel for petitioner stating that the
purchase agreement was valid and enforceable; and (3) an opinion
letter from the law firm of Baker & McKenzie confirming that
petitioner's title in the trademarks in the nonoperating
countries had been transferred to Duskin.
                              - 13 -

     In addition, article VII, paragraph 1, listed various

consents, approvals, assignments, and other documents that

petitioner was required to deliver to Duskin with respect to the

transfer of the trademarks, franchise agreements, and supplier

agreements for the operating countries.    Article VII, paragraph

2, provided that a portion of the purchase price would be

refunded if petitioner was unable to deliver the requisite

documents for one or more of the operating countries.    The

amount of the refund was dependent upon the number of operating

countries with respect to which petitioner was unable to deliver

all necessary documents:


No. of Operating Countries
With Respect to Which Post-
Closing Assignments and
Consents Are not Delivered             Purchase Price Adjustment

         4                             $700,000 or $500,000 and
                                         Hawaii license
         3                             $400,000 or $200,000 and
                                         Hawaii license
         2                             $150,000 or $50,000 and
                                         Hawaii license
         1                             Hawaii license


     1
       "Hawaii license" is a reference to a provision in the
purchase agreement that permitted Duskin to opt for a perpetual,
prepaid license to use the Mister Donut trademark in Hawaii in
exchange for a reduction in the amount of cash to be refunded
from petitioner.


Petitioner satisfied all the terms in the purchase agreement, and

no price adjustments were made.
                             - 14 -

     The purchase agreement also contained a covenant by

petitioner not to compete in the operating and nonoperating

countries for a period of 20 years.   Article XIV, paragraph 1, of

the agreement stated:


          MDAI [Mister Donut] covenants and agrees with
     Duskin that, for a period of twenty (20) years
     commencing on the Post-Closing Date, MDAI will not,
     either directly or indirectly:

     (a) carry on in any of the Non-Operating Countries or
     in any of the Duskin Operating Countries any business
     similar to the Mister Donut shop business being sold
     and transferred by MDAI to Duskin on the Post-Closing
     Date;

     (b) otherwise sell doughnuts in any of the Non-
     Operating Countries or any of the Duskin Operating
     Countries; or

     (c) disclose all or any part of the Mister Donut System
     or any of the bakery mix formulae, with or without the
     payment of consideration, to any person for use in any
     of the Non-Operating Countries or the Duskin Operating
     Countries. * * *


The agreement similarly contained a covenant by Duskin not to

compete in any business similar to the Mister Donut business in

the United States, Canada, and 38 European, Mideastern,

Caribbean, and Latin American countries for a period of 5 years.

The countries included in the Duskin covenant were nations where

petitioner had Mister Donut franchise operations or registered

trademarks.11

     11
      The purchase agreement also amended Duskin's covenant not
to compete contained in the Japan Agreement to conform with
                                                   (continued...)
                                - 15 -


Petitioner's Allocation and Reporting of the Proceeds From the
Sale


     Duane A. Suess and John D. Schaefer were employees in

petitioner's tax department and were involved in the sale of the

Mister Donut franchise business in Asia and the Pacific.     Messrs.

Suess and Schaefer reviewed all drafts of the purchase agreement.

     The first draft, which was dated January 20, 1988, and

prepared by Bruce M. Bakerman of petitioner's legal department,

contained a provision allocating the purchase price between the

existing franchises, goodwill, trademarks, and pending trademark

applications.   The actual percentage to be allocated to these

assets was left blank.   Mr. Suess reviewed this draft and

handwrote the following on the document:


          Approve subject to:

          1) Review of foreign tax consequences associated
     with each country covered by the agreement;

          2) Review of foreign source income rules to
     determine best way to maximize foreign source income.
     Initial review indicates goodwill and noncompete
     covenants may give rise to such income.

          3) Allocation of proceeds will be critical aspects
     of 1 & 2 above, therefore flexibility in this area
     should be a major negotiating point.

     11
      (...continued)
Duskin's covenant under the purchase agreement. As a result,
Duskin was no longer precluded from competing in the donut
business outside Japan; rather, Duskin could compete anywhere in
the world outside of 41 enumerated countries, none of which were
located in Asia.
                                   - 16 -


        In a memorandum dated May 24, 1988, from Michael S. Munro to

Paul Quinn, Mr. Munro recommended that the purchase agreement

should not contain an allocation of the sale price.12       In

response to this suggestion, petitioner's legal department

removed the allocation from the subsequent draft dated May 25,

1988.        However, in a memorandum dated May 27, 1988, Mr. Schaefer

expressed concern regarding the absence of such an allocation:


     The lack of any purchase price allocation in the
     Agreement is not particularly helpful from a U.S. tax
     viewpoint. However, the fact that the purchaser is a
     Japanese entity and the current lack of distinction in
     the amount of tax on capital gains and ordinary income
     minimizes this concern.

     It could be advantageous to have a portion of the
     purchase price allocated to "goodwill" in the four Far
     East countries where Mister Donut already has
     franchisees.

     My main concern, though, is with uncertain tax
     consequences surrounding the transfer of trademarks in
     the Peoples Republic of China, Taiwan, Indonesia,
     Malaysia, Singapore, and Hong Kong. It is possible
     that the trademark transfers could generate a tax in
     these countries. Therefore, if amounts are to be
     allocated to the trademarks associated with these
     countries, the purchase price allocated to them should
     be as little as possible. If this is not practical as
     negotiations continue, I would appreciate it if you
     could keep me advised so that I can get some outside
     professional help with respect to the tax consequences
     of the trademark sale in these countries.




        12
      Mr. Munro was an assistant to Mr. Quinn, petitioner's
group vice president for international affairs.
                              - 17 -

     In a memorandum dated September 8, 1988, Mr. Suess provided

draft language for a provision allocating the purchase price

between goodwill, trademarks, and petitioner's covenant not to

compete.   In his memorandum, Mr. Suess stated:


          In negotiating the allocation it is important to
     note that the amounts allocated to goodwill and the
     noncompete covenant, to the extent upheld upon IRS
     audit, will be tax-free to Multifoods. The amount
     allocated to the trademarks and pending trademark
     applications will be subject to a tax of approximately
     38% in the U.S. and potentially additional taxes in the
     countries in which such trademarks are registered.
     Therefore, to the extent that we can maximize the
     allocation to the goodwill and non-compete covenant, we
     will maximize Multifoods' after-tax gain on the sale.

           You requested that I advise you of the potential
     tax consequences to Duskin of the purchase price
     allocation. As previously discussed, both goodwill and
     trademarks are generally amortizable for tax purposes
     in Japan. Non-compete covenants are also generally
     amortizable for tax purposes in Japan. Therefore, it
     is possible that Duskin may be indifferent to the
     specific amounts allocated to each type of asset.
     * * *



     On or about January 27, 1989, petitioner obtained a draft of

an appraisal from the Valuation Engineering Associates Division

of Touche Ross (Touche Ross), allocating the sale price among the

assets to be sold.   Duskin was not involved in the selection of

Touche Ross, nor did it indicate to petitioner its preferred

allocation.

     On January 31, 1989, Touche Ross submitted its final report,

which stated:
                             - 18 -

          Based on our limited review of information
     provided to us, we allocated the $2,050,000 purchase,
     as follows:

     Trademarks              $120,000           6%
     Non-competition          820,000          40%
     Goodwill               1,110,000          54%

     Total                 $2,050,000         100%


Article IV, paragraph 3, of the purchase agreement contained the

same allocation.

     In reporting its foreign and domestic source income for its

taxable year ended February 28, 1989, petitioner followed the

allocation contained in article IV of the purchase agreement.

After allocating its selling expenses among the goodwill and

trademarks sold to Duskin, petitioner reported $1,016,64313 of

foreign source income from the sale of goodwill, $820,000 of

foreign source income from the covenant not to compete, and

$109,907 of U.S. source income from the sale of the trademarks.

Petitioner did not allocate any of its selling expenses to the

sale of the covenant not to compete.


                             OPINION


     We must determine what portion, if any, of the gain on

petitioner's sale of its Asian and Pacific Mister Donut

operations constitutes foreign source income for purposes of

     13
      The parties have stipulated that petitioner should have
allocated selling expenses of $97,398 to goodwill, which would
have produced income in the amount of $1,012,602.
                                - 19 -

computing petitioner's foreign tax credit limitation under

section 904(a).

       We begin with the sourcing of income rules under section

865.    Section 865(a)(1) provides that income from the sale of

personal property by a U.S. resident14 is generally sourced in

the United States.     Section 865(d) provides that in the case of

any sale of an intangible, the general rule applies only to the

extent that the payments in consideration of such sale are not

contingent on the productivity, use, or disposition of the

intangible.     Sec. 865(d)(1)(A).   Section 865(d)(2) defines

"intangible" to mean any patent, copyright, secret process or

formula, goodwill, trademark, trade brand, franchise, or other

like property.     Section 865(d)(3) carves out a special sourcing

rule for goodwill.     Payments received in consideration of the

sale of goodwill are treated as received from sources in the

country in which the goodwill was generated.

1.   Goodwill


       Petitioner allocated $1,110,000 of the sale price to

goodwill.     On brief, petitioner maintains that the franchisor's

interest it conveyed to Duskin consisted exclusively of

intangible assets in the nature of goodwill; i.e., franchises,

trademarks, and the Mister Donut System.      Petitioner contends


       14
      Sec. 865(g)(1)(A)(ii) defines "United States resident" to
include a domestic corporation. See sec. 7701(a)(30).
                              - 20 -

that the income attributable to the sale of this goodwill

constitutes foreign source income pursuant to section

865(d)(3).15

     This argument mistakes goodwill for the intangible assets

which embody it.   Goodwill represents an expectancy that "old

customers will resort to the old place" of business.      Houston

Chronicle Publishing Co. v. United States, 481 F.2d 1240, 1247

(5th Cir. 1973); Canterbury v. Commissioner, 99 T.C. 223, 247

(1992).   The essence of goodwill exists in a preexisting business

relationship founded upon a continuous course of dealing that can

be expected to continue indefinitely.    Canterbury v.

Commissioner, supra at 247; Computing & Software, Inc. v.

Commissioner, 64 T.C. 223, 233 (1975).   The Supreme Court has

explained that "The value of every intangible asset is related,

to a greater or lesser degree, to the expectation that customers

will continue their patronage [i.e., to goodwill]."      Newark

Morning Ledger Co. v. United States, 507 U.S. 546, 556 (1993).

An asset does not constitute goodwill, however, simply because it

contributes to this expectancy of continued patronage.

     Section 865(d)(1) provides that income from the sale of an

intangible asset by a U.S. resident will generally be sourced in

the United States.   Section 865(d)(2) defines "intangible" to

     15
      On brief, petitioner appears to concede that no goodwill
existed with respect to its trademarks in the nonoperating
countries, since it had no franchises in those countries or
customers who could "return" to Mister Donut stores.
                                 - 21 -

include, among other things, secret processes or formulas,

goodwill, trademarks, and franchises.     Section 865(d)(3) then

provides a special rule for goodwill, sourcing it in the country

in which it was generated.

     Petitioner's argument equates goodwill with the other assets

listed in the definition of "intangible" in section 865(d)(2).

This Court has recognized that intangible assets such as

trademarks and franchises are "inextricably related" to goodwill.

Canterbury v. Commissioner, supra at 249-251; see also Philip

Morris, Inc. v. Commissioner, 96 T.C. 606, 634 (1991), affd.

without published opinion 970 F.2d 897 (2d Cir. 1992).     However,

we believe that Congress' enumeration of goodwill in section

865(d)(2) as a separate intangible asset necessarily indicates

that the special sourcing rule contained in section 865(d)(3) is

applicable only where goodwill is separate from the other

intangible assets that are specifically listed in section

865(d)(2).     If the sourcing provision contained in section

865(d)(3) also extended to the goodwill element embodied in the

other intangible assets enumerated in section 865(d)(2), the

exception would swallow the rule.     Such an interpretation would

nullify the general rule that income from the sale of an

intangible asset by a U.S. resident is to be sourced in the

United States.16     See Torres v. McDermott Inc., 12 F.3d 521, 526

     16
          Indeed, in the purchase agreement, petitioner failed to
                                                       (continued...)
                              - 22 -

(5th Cir. 1994); Israel-British Bank (London), Ltd. v. FDIC, 536

F.2d 509, 512-513 (2d Cir. 1976); Edward B. Marks Music Corp. v.

Colorado Magnetics, Inc., 497 F.2d 285, 288 (10th Cir. 1974).17

     Respondent contends that, although not denominated as such,

what Duskin acquired from petitioner was a territorial franchise

for the operating and nonoperating countries.     Petitioner, on the

other hand, argues that it did not sell Duskin a franchise, but,

rather, the entire Mister Donut franchising business in Asia and

the Pacific.   Petitioner maintains that the sale of a franchise

requires the franchisor to retain an interest in the business and

that petitioner failed to retain the requisite interest in this

case following the sale to Duskin.     Petitioner contends that

section 1253(a) and our opinion in Jefferson-Pilot Corp. v.

Commissioner, 98 T.C. 435 (1992), affd. 995 F.2d 530 (4th Cir.

1993), support its interpretation of "franchise".

     Although section 865 does not provide a definition of

franchise, section 1253(b)(1) defines it for purposes of section

     16
      (...continued)
allocate any portion of the sale price to the franchise
agreements. Instead, petitioner allocated $1,930,000 to goodwill
and the covenant not to compete and later reported this amount as
foreign source income on its 1989 Federal income tax return.
Petitioner allocated the remaining $120,000 of the sale price to
the trademarks and reported this amount as U.S. source income on
its 1989 return.
     17
      In Edward B. Marks Music Corp. v. Colorado Magnetics,
Inc., 497 F.2d 285, 288 (10th Cir. 1974), the court stated that
"it is the general rule that a proviso should be strictly
construed to the end that an exception does not devour the
general policy which a law may embody."
                               - 23 -

1253(a) to include "an agreement which gives one of the parties

to the agreement the right to distribute, sell, or provide goods,

services, or facilities, within a specified area."    We have found

this definition to be consistent with the common understanding of

the term.    Jefferson-Pilot Corp. v. Commissioner, supra at 440-

441.    When Congress uses a term that has accumulated a settled

meaning under equity or the common law, courts must infer that

Congress intended to incorporate the established meaning of the

term, unless the statute otherwise dictates.    NLRB v. Amax Coal

Co., 453 U.S. 322, 329 (1981); see also Jefferson-Pilot Corp. v.

Commissioner, supra at 442 n.8.    Since we find no indication that

Congress intended "franchise" to carry a different meaning in the

context of section 865, we adopt this definition for purposes of

this section.

       Pursuant to section 1253(a), the transfer of a franchise,

trademark, or trade name shall not be treated as the sale or

exchange of a capital asset if the transferor retains a

significant power, right, or continuing interest with respect to

the subject matter of the franchise, trademark, or trade name.

Prior to its amendment in the Omnibus Budget Reconciliation Act

of 1993 (OBRA), Pub. L. 103-66, sec. 13261(c), 107 Stat. 312,

539,18 section 1253(d)(2)(A) provided that if a transfer of a

       18
      Congress amended sec. 1253(d) by replacing pars. (2), (3),
(4), and (5) with the following:

                                                     (continued...)
                              - 24 -

franchise, trademark, or trade name is not treated as the sale or

exchange of a capital asset, then any single payment in discharge

of a principal sum agreed upon in the transfer agreement shall be

deducted ratably by the payor over a period of 10 years or the

period of the transfer agreement, whichever is shorter.

     In Jefferson-Pilot, the taxpayer's subsidiary purchased

three radio stations, and the taxpayer sought a deduction under

section 1253(d)(2) for a portion of the purchase price, which it

claimed was attributable to Federal Communications Commission

(FCC) broadcast licenses transferred pursuant to the sale.    We

concluded that the FCC licenses constituted franchises under

section 1253, and a ratable portion of the purchase price

attributable to the licenses was deductible under section

1253(d)(2).   We found that the FCC had retained the right to

disapprove of any assignment of the licenses, as well as the

right to prescribe standards of quality for broadcasting services


     18
      (...continued)
        (2) Other payments.--Any amount paid or incurred on
     account of a transfer, sale, or other disposition of a
     franchise, trademark, or trade name to which paragraph
     (1) [sec. 1253(d)(1)] does not apply shall be treated
     as an amount chargeable to capital account.

        (3) Renewals, etc.--For purposes of determining the
     term of a transfer agreement under this section, there
     shall be taken into account all renewal options (and
     any other period for which the parties reasonably
     expect the agreement to be renewed).

Omnibus Budget Reconciliation Act of 1993, Pub. L. 103-66, sec.
13261(c), 107 Stat. 312, 539.
                             - 25 -

and for the equipment used to broadcast.   Jefferson-Pilot Corp.

v. Commissioner, supra at 447.

     Neither the language of section 1253(a) nor our opinion in

Jefferson-Pilot supports petitioner's position.   Section 1253(a)

provides that the transfer of a franchise will not be treated as

the sale or exchange of a capital asset so long as the transferor

retains a significant power, right, or continuing interest with

respect to the subject matter of the franchise.   The necessary

implication is that a franchise can be transferred without the

retention by the transferor of any significant degree of control.

In such a case, the transfer will be treated as the sale or

exchange of a capital asset, and the transferee will not be

permitted to amortize any portion of the purchase price.   See

sec. 1253(d)(2) (prior to amendment by OBRA sec. 13261(c)).

Indeed, if petitioner's argument were correct, section 1253(a)

would have been altogether unnecessary, as the sale of a

franchise would only occur where the transferor retained a

significant interest in the franchise.   However, as we explained

in Jefferson-Pilot Corp. v. Commissioner, 98 T.C. at 441-442 n.7:



     Sec[tion] 1253 requires a two-step analysis. First, we
     must determine if the interest transferred was a
     "franchise" as defined in sec[tion] 1253(b)(1); then we
     determine whether a significant power was retained.
     Limiting the definition of "franchise" based on
     inferences from the retained powers requirement begs
                              - 26 -

     the question of whether the interest transferred is a
     "franchise" in the first place. [Citation omitted.19]


     Petitioner's sale of its Mister Donut operations to Duskin

constituted the sale of a "franchise" for purposes of section

865(d)(2).   Petitioner transferred to Duskin its existing

franchise agreements, trademarks, and Mister Donut System in each

of the operating countries, as well as its trademarks and Mister

Donut System in the nonoperating countries.   Petitioner's Mister

Donut operation utilized franchisees to prepare and merchandise

distinctive quality doughnuts.    This system included methods of

preparation, serving, and merchandising doughnuts.    In the

purchase agreement, petitioner not only sold Duskin petitioner's

rights as franchisor in the existing franchise agreements in the

operating countries, but also all its rights to exclusive use in

the designated Asian and Pacific territories of its secret

formulas, processes, trademarks, and supplier agreements; i.e.,

its entire Mister Donut System.   Duskin received petitioner's

existing rights as franchisor, as well as the right to enter

franchise agreements in the nonoperating countries.

     Respondent argues that any goodwill associated with the

Asian and Pacific franchise business was part of, and inseverable


     19
      Petitioner transferred its interest in Mister Donut in
certain designated Asian and Pacific countries only. As of Jan.
31, 1989, petitioner presumably had retained its rights to the
Mister Donut System everywhere other than the 11 operating and
nonoperating countries and Japan.
                               - 27 -

from, the franchisor's rights and trademarks acquired by Duskin.

Respondent maintains that any gain attributable to the sale of

franchises or the trademarks produces U.S. source income, as

section 865 generally sources income in the residence of the

seller.   See sec. 865(a),(d)(1).

     While there are no cases on point under section 865, case

law interpreting other provisions of the Code supports

respondent's position.   In Canterbury v. Commissioner, 99 T.C.

223 (1992), we considered whether the excess of a franchisee's

purchase price of an existing McDonald's franchise over the value

of the franchise's tangible assets was allocable to the franchise

or to goodwill for purposes of amortization pursuant to section

1253(d)(2)(A).    We recognized that McDonald's franchises

encompass attributes that have traditionally been viewed as

goodwill.   The issue, therefore, was whether these attributes

were embodied in the McDonald's franchise, trademarks, and trade

name, which would make their cost amortizable pursuant to section

1253(d)(2)(A), or whether the franchisee acquired intangible

assets, such as goodwill, which were not encompassed by, or

otherwise attributable to, the franchise and which were

nonamortizable.

     We found that the expectancy of continued patronage which

McDonald's enjoys "is created by and flows from the

implementation of the McDonald's system and association with the
                                - 28 -

McDonald's name and trademark."    Id. at 248 (fn. ref. omitted).

In addition, we stated:


     The right to use the McDonald's system, trade name, and
     trademarks is the essence of the McDonald's franchise.
     * * * Respondent did not identify, and we cannot
     discern, any quantifiable goodwill that is not
     attributable to the franchise. We find that
     petitioners acquired no goodwill that was separate and
     apart from the goodwill inherent in the McDonald's
     franchise.

     [T]he franchise acts as the repository for goodwill
     * * * [Id. at 249; fn. ref. omitted; emphasis added.]


We concluded that the goodwill produced by the McDonald's system

was embodied in, and inseverable from, the McDonald's franchise

that the taxpayer received.20

     Similarly, in Montgomery Coca-Cola Bottling Co. v. United

States, 222 Ct. Cl. 356, 381-382, 615 F.2d 1318, 1331-1332

(1980), the Court of Claims, in valuing a Coca-Cola franchise,

explained:


     Defendant's expert has testified that there is no
     goodwill in a Coca-Cola bottling operation. Anything
     resembling goodwill attaches solely to the national
     company and the name of the product * * *. Customers
     buy Coca-Cola because of * * * the product, not because
     of who bottles it. Since goodwill is considered to be
     the value of the habit of customers to return to
     purchase a product at the same location, the absence of
     the product would destroy the value of the habit; and
     since only one entity has the perpetual right to
     distribute Coca-Cola in a territory, the value of

     20
      Although Canterbury v. Commissioner, 99 T.C. 223 (1992),
involved a sale by a franchisee, we find its analysis of this
issue applicable to the instant case as well.
                               - 29 -

       goodwill, and the franchise are so interrelated as to
       be indistinguishable, all the value should then be
       assigned to the franchise. * * * [Emphasis added; fn.
       ref. omitted.]


       In Zorniger v. Commissioner, 62 T.C. 435 (1974), we

addressed the issue of whether the taxpayer's shares of stock in

a Chevrolet dealership possessed goodwill that should have been

reflected in the valuation of the stock for purposes of the gift

tax.    We held that no goodwill existed in the stock, since the

dealership agreement required Chevrolet's prior approval of any

transfer of the taxpayer's interest therein.    Id. at 444-445.    We

relied principally on our decision in Akers v. Commissioner, 6

T.C. 693, 700 (1946), where we determined that no goodwill

existed in a General Motors' dealership upon liquidation, as the

taxpayer had a nontransferable, personal services contract, which

could have been divested from the taxpayer under circumstances

outside his control.    In Zorniger v. Commissioner, supra at 444-

445 (quoting Akers v. Commissioner, supra at 700), we stated:


       "The franchises were not assignable and by their terms
       were made personal contracts between the parties. Such
       good will or going-concern value as the corporation
       might have created during its existence was subject at
       all times to be divested by termination of the
       franchises without action by the corporation. * * *

       The good will, if any, continued to be embodied in the
       franchises and they, under the circumstances, were not
       property subject to transfer or other disposition by
       the corporation." [Citation omitted.]
                              - 30 -

     It is also well established that trademarks embody goodwill.

Renziehausen v. Lucas, 280 U.S. 387, 388 (1930); Stokely USA,

Inc. v. Commissioner, 100 T.C. 439, 447 (1993); Canterbury v.

Commissioner, supra at 252; Philip Morris Inc. v. Commissioner,

96 T.C. at 636.   Consumers associate the Mister Donut trademark

with their pleasurable experience at Mister Donut shops.     As a

result, goodwill is also embodied in the trademarks, which Duskin

acquired and which cause customers to return to Mister Donut

shops in the future and patronize them.

     Petitioner's business in the operating countries was

conducted by granting Mister Donut franchises.   Under the

purchase agreement, Duskin received petitioner's rights as

franchisor under the existing franchise agreements in the

operating countries.   The franchisees in the operating countries

possessed the exclusive right to open stores pursuant to

established conditions and at locations approved by the

franchisor.   In order to ensure that the distinguishing

characteristics of Mister Donut were uniformly maintained, the

franchise agreements had established standards for furnishings,

equipment, product mixes, and supplies, which the franchisees

were required to meet.   The franchise agreements also required

that franchisees operate their shops in accordance with uniform

standards of quality, preparation, appearance, cleanliness, and

service.   The agreements provided that the franchisor could not

open, or authorize others to open, any Mister Donut shops in the
                              - 31 -

franchisee's country 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.

     Mister Donut's success resulted from the Mister Donut System

and the high standards for quality and service, which the

franchisees were required to meet.     See supra p. 9.    Although

these characteristics produced goodwill in the operating

countries, that goodwill was embodied in the franchises and

trademarks conveyed to Duskin.

     Petitioner also transferred its Mister Donut System and

trademarks for each of the nonoperating countries.       Duskin

received the right to exploit--either by entering franchise

agreements in these territories or by opening shops itself--the

Mister Donut System along with the accompanying trademarks,

formulas, and other intangible assets.    In the nonoperating

countries, there were no Mister Donut shops for customers to

patronize at the time the purchase agreement was executed.

Goodwill is founded upon a continuous course of dealing that can

be expected to continue indefinitely.     Canterbury v.

Commissioner, 99 T.C. at 247; see also Computing & Software, Inc.

v. Commissioner, 64 T.C. at 233.     Goodwill is the expectancy of

continued patronage.   Houston Chronicle Publishing Co. v. United

States, 481 F.2d at 1247.   Petitioner concedes on brief that
                                - 32 -

     in the operating countries where the franchises had
     been developed, the value to Duskin was in obtaining
     the assets which comprised the goodwill. In contrast,
     there was no value, or negligible value, in the
     trademarks or trade names in the non-operating
     countries. * * * Thus, in the non-operating countries
     where the franchises had not been developed, any value
     acquired by Duskin was merely for the right to do so.
     [Emphasis added.]


Petitioner has failed to establish that it transferred any

goodwill in the nonoperating countries other than what might have

been embodied in its trademarks.

      We find that petitioner did not establish that it

transferred any goodwill separate and apart from the goodwill

inherent in the franchisor's interest and trademarks that

petitioner conveyed to Duskin.    Pursuant to section 865(d)(1),

income attributable to the sale of a franchise or a trademark is

sourced in the residence of the seller.    The income petitioner

received upon the sale of these assets must, therefore, be

sourced in the United States.


2.   Covenant Not To Compete


      The only remaining asset transferred to Duskin that could

produce foreign source income is petitioner's covenant not to

compete.   Respondent concedes that any amount allocated to the

covenant constitutes foreign source income to petitioner.

      Respondent argues that the covenant (like goodwill) was

inseverable from the franchisor's interest that petitioner
                               - 33 -

conveyed to Duskin.   Respondent alleges that the franchise rights

Duskin acquired provided it with the exclusive right to use the

know-how, trade secrets, trademarks, and other components of the

Mister Donut System in the operating and nonoperating countries.

Any competition or disclosure of the Mister Donut System by

petitioner in these countries, respondent contends, would have

deprived Duskin of the beneficial enjoyment of the rights it had

acquired.   Thus, respondent maintains that petitioner's covenant

should be viewed as an inseverable element of the franchisor's

interest acquired by Duskin.   We disagree.

     The covenant granted Duskin benefits in addition to those

necessarily conveyed by petitioner's transfer of its franchisor's

interests and trademarks.   The covenant prohibited petitioner

from conducting any business similar to the Mister Donut business

in the operating or nonoperating countries or from otherwise

selling doughnuts in any of these countries.   Since petitioner

possessed expertise, knowledge, and contacts regarding the donut

business, it was reasonable for Duskin to preclude petitioner

from reentering the donut business in Asia and the Pacific under

a different name.   We conclude that the covenant not to compete

possessed independent economic significance, as it did more than

simply preclude petitioner from depriving Duskin of rights which

it had acquired in purchasing petitioner's franchise rights and

trademarks.   As we stated in Horton v. Commissioner, 13 T.C. 143,

147 (1949) (Court reviewed):
                              - 34 -


          It is well settled that if, in an agreement of the
     kind which we have here, the covenant not to compete
     can be segregated in order to be assured that a
     separate item has actually been dealt with, then so
     much as is paid for the covenant not to compete is
     ordinary income and not income from the sale of a
     capital asset. * * *

See also General Ins. Agency, Inc. v. Commissioner, 401 F.2d 324,

329-330 (4th Cir. 1968), affg. T.C. Memo. 1967-143.

     It is necessary, therefore, to determine what portion of the

$2,050,000 sale price must be allocated to the covenant not to

compete.   Petitioner bears the burden of proof.   Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933); Peterson Mach.

Tool, Inc. v. Commissioner, 79 T.C. 72, 81 (1982), affd. without

published opinion 54 AFTR 2d 84-5407, 84-2 USTC par. 9885 (10th

Cir. 1984).

     Petitioner urges us to uphold the allocation in the purchase

agreement of $820,000.   Petitioner relies upon case law

indicating that an allocation in a purchase agreement to a

covenant not to compete will be respected for Federal income tax

purposes if it was the intent of the parties to make such an

allocation and the covenant possessed independent economic

significance.   See, e.g., Major v. Commissioner, 76 T.C. 239, 246

(1981).

     We decline to place reliance upon the allocation contained

in the purchase agreement.   The cases upholding the contracting

parties' allocation of a specific amount to a covenant not to
                              - 35 -

compete are premised upon the assumption that the competing tax

interests of the parties will ensure that the allocation is the

result of arm's-length bargaining.     Where the assumption is

unwarranted, there is no reason to be bound to the allocation in

the contract.   See, e.g., Patterson v. Commissioner, 810 F.2d

562, 570 (6th Cir. 1987), affg. T.C. Memo. 1985-53; Schulz v.

Commissioner, 294 F.2d 52, 55 (9th Cir. 1961), affg. 34 T.C. 235

(1960); Lemery v. Commissioner, 52 T.C. 367, 375-376 (1969),

affd. per curiam 451 F.2d 173 (9th Cir. 1971).     In the instant

case, Mr. Suess' memorandum of September 8, 1988, indicates that

the interests of Duskin and petitioner were apparently not

adverse as to the allocation of the sale price.     No

representatives from Duskin testified at trial regarding whether

Duskin considered the allocation important, and, given Mr. Suess'

statements, we suspect that Duskin was unconcerned.      Petitioner,

on the other hand, was certainly cognizant of the potential tax

consequences of the allocation, because of the obvious impact on

the calculation of petitioner's foreign tax credit, as well as

the possibility that the transfer of petitioner's trademarks to

Duskin would generate a tax in several Asian and Pacific nations.

     Petitioner's expert witness, Robert F. Reilly,21 valued the




     21
      Mr. Reilly was the director of the Valuation Engineering
Associates Division of Touche Ross when Touche Ross prepared the
allocation that petitioner used in its purchase agreement with
Duskin.
                                 - 36 -

covenant at $620,000,22 almost $200,000 less than the amount

allocated by petitioner in the purchase agreement with Duskin.

Although expert opinions can assist the Court in evaluating a

claim, we are not bound by the opinion of any expert and may

reach a decision based on our own analysis of all the evidence in

the record.     Helvering v. National Grocery Co., 304 U.S. 282, 295

(1938); Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir.

1976), affg. T.C. Memo. 1974-285.

     Mr. Reilly computed the value of the covenant not to compete

under the comparative business valuation method and a discounted

net cash-flow analysis.     Utilizing this comparative approach, Mr.

Reilly computed Mister Donut's discounted net cash-flow under two

scenarios.     Scenario 1 assumed that the covenant was in place,

and petitioner could not reenter the Asian and Pacific donut

market.     Scenario 2 assumed that the purchaser did not receive a

covenant, and petitioner would reenter the market and compete.

Mr. Reilly attributed the difference in the sum of Mister Donut's

discounted net cash-flows under these two scenarios to the


     22
          Mr. Reilly's report contained the following allocation:

             Asset                         Fair Market Value

     Non-compete agreement                      $620,000
     Trade secrets and know-how                   50,000
     Trademarks and trade names                  370,000
     Existing franchise agreements               200,000
     Goodwill                                    810,000

      Total                                    2,050,000
                              - 37 -

covenant not to compete.   Mr. Reilly then added the income tax

benefits of amortization over the covenant's estimated

enforceable period of 5 years to determine the portion of the

$2,050,000 sale price to be allocated to the covenant.

     Mr. Reilly performed these calculations twice, once assuming

the most likely competition scenario from petitioner in the event

it reentered the Asian and Pacific market, and a second time

assuming the worst case competition scenario from petitioner.23

Mr. Reilly estimated the values of the covenant under the most

likely competition scenario and the worst case competition

scenario at $620,000 and $630,000, respectively.   He then

reconciled these differences and arrived at a final value of

$620,000.

     We find two difficulties with Mr. Reilly's report and his

calculations.   First, we are unsure whether Mr. Reilly's

calculations and valuation of the covenant not to compete

erroneously assumed that petitioner could reenter these Asian and

Pacific markets again as "Mister Donut", despite the fact that

petitioner had conveyed its existing franchise agreements,

trademarks, and Mister Donut System to Duskin in the purchase

agreement.   For instance, Mr. Reilly testified at trial that "The



     23
      Under the worst case of competition from petitioner, Mr.
Reilly projected that petitioner's reentry into the Asian and
Pacific market would be so competitive that the purchaser of
petitioner's Mister Donut franchise business would be unable to
open new franchises after 1 year.
                              - 38 -

value of the [Duskin's] business would be reduced by $620,000,

due to the most likely competition from Mister Donut."    But

petitioner had already transferred its rights to Mister Donut in

the operating and nonoperating countries.    Assuming no covenant

existed, and petitioner had chosen to reenter the donut market in

these territories, it would have had to do so under a different

name.24

     Second, Mr. Reilly computed the value of the covenant not to

compete under both the most likely and the worst cases of

competition without factoring in the likelihood of petitioner's

competition into his calculations.     Although Mr. Reilly's report

stated that there existed a less-than-50-percent chance of

petitioner's reentering the Asian and Pacific market for such

franchise operations, his calculations ignored the fact that

competition was unlikely even without a covenant.

     Based on our review of the record, we conclude that $300,000

of the sale price should be allocated to the covenant not to

compete.   Respondent concedes that the amount allocable to the


     24
      In response to respondent's pretrial inquiry, petitioner
stated that future competition from petitioner could reduce the
net income of a buyer of Mister Donut's Asian and Pacific
franchise operations by 40-45 percent. Petitioner attributed
this reduction to the following: (1) Formulas for the bakery
mixes, 10 percent; (2) ability to control suppliers, 30 percent;
and (3) knowledge of the business and donut market, 5 percent.
However, only the impact of the third factor, which petitioner
determined would reduce a buyer's net income by only 5 percent,
would presumably be attributable to the covenant not to compete,
as the supplier contracts and trade secrets were assets sold to
Duskin.
                               - 39 -

covenant not to compete constitutes foreign source income for

purposes of computing petitioner's foreign tax credit limitation

pursuant to section 904(a).

     Finally, petitioner incurred $107,491 of expenses in

connection with the sale to Duskin but did not allocate any

portion of the expenses to the sale of the covenant not to

compete.   At trial, Mr. Schaefer testified that "It was my

conclusion that we were selling assets, trademarks, good will,

and selling expenses should be allocated to those * * * assets

being sold.   The covenant not to compete is--I equate to kind of

a performance contract.   We weren't selling anything; therefore,

selling expenses should not be allocated to it."   On brief,

respondent argues that to the extent a portion of the sale price

is allocated to the covenant and treated as foreign source

income, a pro rata share of the selling expenses must necessarily

be allocated to the covenant, thus reducing petitioner's foreign

source income.   See sec. 862(b).

     Section 1.861-8(b)(1), Income Tax Regs., provides that

deductions are allocated to the class of gross income to which

they are definitely related.   Section 1.861-8(b)(2), Income Tax

Regs., provides that a deduction is "definitely related" to a

class of gross income "if it is incurred as a result of, or

incident to, an activity or in connection with property from

which such class of gross income is derived."   Accordingly, we
                             - 40 -

hold that a pro rata portion of the selling expenses must be

allocated to petitioner's sale of the covenant not to compete.


                                        An appropriate order will

                                   be issued.
