United States: Purchase Price Allocation Rules: Sections 1060, 338, And 197

Last Updated: February 13 2004
Article by Mark J. Silverman

Originally published June, 2003. To read this article in full, please go to the bottom of this page.

PART ONE: INTRODUCTION

I. INTRODUCTION

A. One of the most publicized and long-awaited business provisions contained in the Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, 107 Stat. 312 (1993) (the "1993 Act") was section 197 of the Internal Revenue Code of 1986 (the "Code"), which governs the tax treatment of acquired intangible assets.

B. However, section 197 cannot be analyzed in isolation. Since it comes into play whenever there is an allocation of consideration to an amortizable section 197 intangible, a basic understanding of the allocation rules of sections 1060 and 338(h)(10) is critical.

C. Thus, PART ONE of this Outline summarizes the allocation provisions of sections 1060 and 338(h)(10). PART TWO of this Outline contains introductory material relating to section 197, describes the statutory regime and the regulations, and illustrates through examples the application of section 197 in various acquisition transactions.

II. SECTION 1060: SPECIAL ALLOCATION RULES FOR CERTAIN ASSET ACQUISITIONS

A. The Need For Allocation

  1. The purchase and sale of an ongoing business involves, of course, the purchase and sale of numerous separate items, often including intangibles such as goodwill and/or the agreement of the seller not to compete with the purchaser for a period of time.
  2. Historically, goodwill was treated as a nondepreciable, capital asset. A seller often has no basis in any goodwill associated with its business.
  3. In contrast, tangible assets (other than land and inventory) generally consist of depreciable property described in section 1231.
  4. Amounts received in exchange for a covenant not to compete were typically amortizable by the purchaser over the period for which the covenant ran, and were ordinary income to the seller to the full extent of the payments.

B. Competing Interests

  1. Prior to the Tax Reform Act of 1986 (the "1986 Act"), purchasers and sellers generally had competing interests with regard to the allocation of consideration in the sale of a business.
  2. A purchaser generally wished to allocate as much consideration as possible to assets with short depreciable or amortizable lives. Accordingly, given a choice between allocating consideration to goodwill or to a covenant not to compete, the purchaser would generally prefer an allocation to the covenant.
  3. In contrast, the seller wished to take advantage of lower capital gains rates. Thus, the seller would generally prefer allocations to goodwill, a capital asset, to allocations to a covenant not to compete, which gives rise to ordinary income.
  4. To the extent that any of the transferred assets had comparatively short depreciable lives, the parties might be able to agree on an allocation of additional purchase price to such assets. However, such an allocation could possibly increase recapture income under section 1245 and thus result in ordinary income which the seller would seek to avoid.

C. Litigation Over Purchase Price Allocations

  1. Prior to the enactment of section 1060 as part of the 1986 Act, taxpayers and the government had frequently skirmished over purchase price allocations.
  2. a. Selling taxpayers sought to disregard allocations made to covenants not to compete, and purchasing taxpayers sought to allocate additional amounts to such covenants and away from goodwill.

    b. In cases where the contract of purchase and sale was silent as to the allocation of purchase price, it was possible for the parties to "whipsaw" the government by taking positions inconsistent with each other, but without invoking any elevated burden of proof in the courts.

  3. Courts were, in general, reluctant to allow taxpayers to disregard the allocations made in a contract of purchase and sale.

a. Most courts required a taxpayer to provide "strong proof" of the parties' intent of a different allocation than the one contained in the contract in order to disregard the written terms. See, e.g., Kreider v. Commissioner, 762 F.2d 580 (7th Cir. 1985).

b. Some courts went further and adopted a test whereby the taxpayer could disregard allocations in the contract of purchase and sale only by adducing proof which would be admissible under state law to alter the construction of the contract or to show its unenforceability because of mistake, undue influence, fraud, duress, etc. Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967).

c. Substantial litigation also ensued where the contracts were silent as to the allocation of purchase price among the tangible and intangible assets transferred.

(1) Taxpayers often attempted to use the "second tier allocation" method, while the government would usually argue for the "residual method." See, e.g., Barnes Group Inc. v. United States, 697 F. Supp. 591 (D. Conn. 1988); Banc One Corp. v. Commissioner, 84 T.C. 476 (1985) (second tier allocation method rejected in favor of the residual method). But see, Rev. Rul. 77-456, 1977-2 C.B. 102 (second tier allocation method used for additional basis attributable to transaction costs).

(a) Under the second tier allocation method, any consideration in excess of the appraised fair market value of all acquired assets, including goodwill, is allocated among the assets (other than cash) in proportion to such appraised fair market value.

(b) Under the residual method, any consideration in excess of the fair market value of separately identifiable assets is allocated solely to goodwill.

(2) The second tier allocation method generally made it easier to allocate less consideration to goodwill and more to depreciable or amortizable assets.

D. The 1986 Act

  1. Congress believed in 1986 that the government lacked sufficient resources to challenge effectively cases in which the parties misstated the value of assets when making allocations in connection with the sale of a business. H.R. Conf. Rep. No. 99-841, pt. II, at 208 (1986).
  2. a. Note that as part of the 1986 Act, the differential between capital gains rates and ordinary income rates was eliminated, so that the parties would no longer have substantial competing interests in making purchase price allocations.

    b. The purchaser would continue to benefit from allocations to depreciable and/or amortizable property, and the seller would have no incentive to resist such allocations.

  3. Congress decided to adopt the residual method already provided for in regulations under section 338, in order to ensure that the value of the business in excess of the value of tangible assets was allocated to goodwill or some similar intangible, rather than to tangible assets with short depreciable lives. Adopting this method also equalized the treatment of asset acquisitions and qualified stock purchases under section 338.

E. Summary of Section 1060

  1. Section 1060 applies to any "applicable asset acquisition." Section 1060(a).

a. An applicable asset acquisition is any transfer of assets constituting a trade or business if the purchaser's basis in the acquired assets is determined wholly by reference to the consideration paid for such assets. Section 1060(c).

b. Regulations broadly define "assets constituting a trade or business" as consisting of any group of assets (i) the use of which would constitute an active trade or business for purposes of section 355, or (ii) to which goodwill or going concern value could under any circumstances attach. Treas. Reg. § 1.1060-1(b)(2)(i).

(1) Concurrent with the enactment of section 197 (discussed in greater detail below), references to "goodwill or going concern value" that were contained in section 1060(b) and (d) were changed to "section 197 intangibles."

(2) QUERY: To what extent will this change be incorporated in the section 1060 regulations pertaining to the definition of "assets constituting a trade or business?" Because the definition of a section 197 intangible is significantly broader than goodwill and going concern value, this change could greatly expand the scope of section 1060.

c. Determination of whether goodwill or going concern value could attach: The Temporary and Final Regulations Effective for Asset Acquisitions on or After January 6, 2000.

(1) Temporary regulations providing rules for determining whether goodwill or going concern value can attach to a group of assets under section 1060 were released on January 5, 2000, effective for asset acquisitions on or after January 6, 2000. These regulations were finalized on February 13, 2001 without substantial modification and are effective for asset acquisitions on or after March 16, 2001.

(2) NOTE: Because the language of the final regulations generally mirrors that of the temporary regulations, unless otherwise noted, all references below to the final regulations, effective for asset acquisitions on or after March 16, 2001, include references to the temporary regulations, effective for asset acquisitions on or after January 6, 2000 and before March 16, 2001.

(3) Under the final regulations, goodwill is defined as "the value of a trade or business attributable to the expectancy of continued customer patronage." Treas. Reg. § 1.1060- 1(b)(2)(ii). Going concern value is defined as "the additional value that attaches to property because of its existence as an integral part of an ongoing business activity." Id.

(4) In determining whether goodwill or going concern value could attach, all facts and circumstances are taken into account. Treas. Reg. § 1.1060-1(b)(2)(iii). Factors to be considered include:

(a) The presence of any intangible asset, provided the transfer of solely such intangible asset would not constitute a trade or business;

(b) The existence of an excess of the total consideration over the aggregate book value of the tangible and intangible assets purchased (other than goodwill and going concern value) as shown on the books of the purchaser; and

(c) Related transactions, including lease agreements, licenses and other similar arrangements between the purchaser and seller in connection with the transfer.

(5) In listing these factors, the final regulations differ from the old temporary regulations in two respects:

(a) The old temporary regulations did not include the first factor (i.e., the presence of an intangible asset); and

(b) The old temporary regulations included covenants not to compete, employment contracts, and management contracts within related transactions. See Temp. Treas. Reg. § 1.1060-1T(b)(2) (effective prior to January 6, 2000).

(6) QUERY: Does the removal of covenants not to compete, employment contracts, and management contracts from related transactions indicate that such agreements are not factors to be considered in determining whether goodwill or going concern value could attach? Presumably, under the first factor of the final regulations, covenants not to compete should be considered intangible assets, the transfer of which would not be a trade or business in the absence of other assets. Either way, the new regulations provide that a covenant not to compete entered into in connection with an applicable asset acquisition is treated as an asset transferred as part of a trade or business. Treas. Reg. § 1.1060-1(b)(7). Thus, a covenant not to compete must be included in the asset pool when applying the residual method.

2. If section 1060 applies to a transaction, the "consideration received" for the acquired assets must be allocated among the assets in accordance with regulations under section 338(b)(5). Section 1060(a). See also Treas. Reg. § 1.1060-1(c)(2).

a. The regulations require that the consideration be allocated among the assets under the "residual method."

b. On August 4, 1999, the Internal Revenue Service ("Service") issued proposed regulations under section 338. On January 6, 2000, the Service issued temporary regulations that mirrored the proposed regulations. These temporary regulations were finalized with minor modification on February 13, 2001 and are effective for deemed and actual asset acquisitions on or after March 16, 2001. The temporary and final regulations include seven asset classes, defined as follows:

(1) Class I assets consist of cash and general deposit accounts.

(2) Class II assets consist of certificates of deposits, U.S. government securities, readily marketable stock and securities, and foreign currency.

(a) Under the final regulations, Class II assets do not include stock of target affiliates, whether or not of a class that is actively traded, other than actively traded stock defined in section 1504(a)(4).

(b) NOTE: The temporary regulations permitted stock of target affiliates to qualify as Class II assets. (c) Therefore, Class II assets include stock of target affiliates for asset acquisitions occurring on or after January 6, 2000 and before March 16, 2001, but do not include stock of target affiliates for asset acquisitions occurring on or after March 16, 2001.

(3) Class III assets consist of accounts receivable, mortgages, and credit card receivables from customers which arise in the ordinary course of business.

(4) Class IV assets consist of stock in trade of the taxpayer or other property of a kind which would be included in the inventory of the taxpayer, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business.

(5) Class V assets consist of all assets other than Class I, II, III, IV, VI, VII assets.

(6) Class VI assets consist of all section 197 intangibles, as defined by section 197, except goodwill and going concern value.

(7) Class VII assets consist of goodwill and going concern value (whether or not the goodwill or going concern value qualifies as a section 197 intangible). Treas. Reg. § 1.338- 6(b).

(8) These regulations are generally effective for allocation of consideration in asset acquisitions on or after January 6, 2000.

c. Prior to January 6, 2000, consideration was allocated first to "Class I assets," next to "Class II assets" up to their fair market value (and in proportion to their fair market value, if the total consideration is less than their fair market value), then to "Class III assets" up to their fair market value (and in proportion to their fair market value, if the total consideration is less than their fair market value), then to "Class IV assets" up to their fair market value (and in proportion to their fair market value, if the total consideration is less than their fair market value), and finally to "Class V assets." Temp. Treas. Reg. § 1.338(b)-2T(b)(2) (effective prior to January 6, 2000); Temp. Treas. Reg. § 1.1060-1T(d)(2) (effective prior to January 6, 2000). See T.D. 8711 (Jan. 16, 1997) (adding a new "Class V").

(1) These five asset classes were as follows:

(a) Class I assets consist of cash and demand deposits.

(b) Class II assets consist of certificates of deposits, U.S. government securities, readily marketable stock and securities, and foreign currency.

(c) Class III assets consist of tangible and intangible assets other than those described in Classes I, II, IV, and V.

(d) Class IV assets consist of all section 197 intangibles (whether amortizable or not), "except those in the nature of goodwill and going concern value."

(e) Class V assets consist of section 197 intangibles in the nature of goodwill and going concern value. See T.D. 8711 (Jan. 16, 1997). The sum of the amounts allocated to Classes IV and V are reported in the aggregate on Form 8594. See Appendix A; see also T.D. 8711 (Jan. 16, 1997), amending Temp. Treas. Reg. § 1.1060-1T(h)(3).

(2) On January 16, 1997, the Service issued T.D. 8711, which amended Temp. Treas. Reg. §§ 1.1060-1T(d)(2) and 1.338(b)-2T(b) to provide for the five asset classes above.

(a) Prior to the amendment, there was no Class V asset category, and Class IV consisted of intangible assets "in the nature of goodwill and going concern value."

(b) The amendment is effective for applicable asset acquisitions under section 1060 completed on or after February 14, 1997 (and for acquisition dates, as defined in section 338(h)(2), on or after the same date).

(c) The effective date provisions of T.D. 8711 also provide that a taxpayer may elect which rules to apply to transactions entered into prior to February 14, 1997. For acquisition dates prior to February 14, 1997, if section 197 applies to any asset acquired, the taxpayer may consistently (in all transactions in which adjusted grossed-up basis ("AGUB"), aggregate deemed sales price ("ADSP"), modified aggregate deemed sales price ("MADSP"), or consideration must be allocated under section 338 or 1060): (i) apply the new rules; (ii) apply the rules in effect prior to the issuance T.D. 8711; or (iii) apply the rules in effect prior to the issuance of T.D. 8711, but treat all section 197 intangibles as Class IV assets.

(d) QUERY: If a taxpayer must apply one of these three options "consistently," can the taxpayer choose to apply the new rules for a transaction with an acquisition date prior to February 14, 1997, if such taxpayer had already applied the rules prior to the issuance of T.D. 8711 to an earlier transaction?

i) For example, assume that Taxpayer enters into two transactions, one in 1994 and one in 1996. Taxpayer applied the rules in effect prior to the issuance of T.D. 8711 to the 1994 transaction on its 1994 tax returns.

ii) Under the effective date provisions, it seems that Taxpayer will not be allowed to elect to use the new rules for the 1996 transaction, unless Taxpayer amends its 1994 returns and applies the new rules to the 1994 transaction.

d. NOTE: As stated above, the statutory language refers to the consideration received. The old section 1060 regulations provided, "The purchaser’s consideration is the cost of the assets acquired in the applicable asset acquisition. The seller’s consideration is the amount realized from the applicable asset acquisition under section 1001(b)." Temp. Treas. Reg. § 1.1060-1T(c)(1) (effective prior to January 6, 2000). The final section 1060 regulations slightly amended the definition of consideration to provide, "The seller’s consideration is the amount, in the aggregate, realized from selling the assets in the applicable asset acquisition under section 1001(b). The purchaser’s consideration is the amount, in the aggregate, of its cost of purchasing the assets in the applicable asset acquisition that is properly taken into account in basis." Treas. Reg. § 1.1060- 1(c)(1).

(1) The regulation appears to be at odds with section 1060(a), which implies that a single amount is to be used for purposes of determining both the transferee's basis and the transferor's gain on the sale.

(2) As illustrated in the examples in this Outline, this distinction raises a number of questions with respect to (i) the treatment of acquisition costs, and (ii) bargain purchase acquisitions.

(3) With respect to acquisition costs, on December 19, 2002, the Service issued a Notice of Proposed Rulemaking, Reg. 125638-1 (December 19, 2002), proposing regulations (the "Proposed section 263(a) Regulations") that provide rules for determining the extent to which taxpayers must capitalize costs incurred (i) to acquire, create, or enhance intangible assets, (ii) to facilitate the acquisition, creation, or enhancement of intangible assets, and (iii) to facilitate certain restructurings, reorganizations, and transactions involving the acquisition of capital, including a stock issuance, borrowing, or recapitalization. Prop. Treas. Reg. § 1.263(a)-4.

(a) While providing some guidance regarding the treatment of acquisition costs in applicable asset acquisitions, these regulations fall short of clarifying the issue.

(b) The Proposed section 263(a) regulations are discussed in detail in Example 4 (below).

III. SECTION 338 - TREATING A STOCK PURCHASE AS AN ASSET ACQUISITION

Overview

  1. If a purchasing corporation acquires 80 percent or more of the stock of the target corporation in a qualified stock purchase ("QSP"), a section 338 election may be made to treat the stock purchase as an asset purchase. Such election must be made within eight and one-half months after the month in which the acquisition date occurs.
  2. Absent such an election, the purchasing corporation will ordinarily take a carryover basis in the target's assets.
  3. If the target corporation was a member of an affiliated group prior to the QSP, the parties may elect under section 338(h)(10) to treat the asset purchase as occurring while target is still a member of such group.
  4. Except as otherwise noted, in all discussions of section 338 contained in this Outline, P will represent the purchasing corporation, T will represent the target corporation, and, unless otherwise indicated, it should be assumed that P acquires 100 percent of the stock of T by purchase on the acquisition date.

Purchase Price In Deemed Sale Transaction

In the case of a section 338(h)(10) transaction, T's basis in its assets following the transaction is its "adjusted grossed-up basis" ("AGUB") determined pursuant to Treas. Reg. § 1.338(h)(10)-1(d)(2) (effective for deemed asset acquisitions on or after March 16, 2001). See Temp. Treas. Reg. § 1.338(h)(10)-1T(d)(2) (effective for deemed asset acquisitions on or after January 6, 2000 and before March 16, 2001). See Treas. Reg. § 1.338(h)(10)-1(e)(5) (effective for deemed assets acquisitions prior to January 6, 2000).

1. Temporary Regulations (Effective for Deemed Assets Acquisitions on or after January 6, 2000 and before March 16, 2001) and Final Regulations (Effective for Deemed Asset Acquisitions on or after March 16, 2001)

a. AGUB defined

Under the temporary and final regulations, AGUB is the sum of

  1. P’s grossed-up basis in recently purchased T stock
  2. P's basis in nonrecently purchased T stock; and
  3. New T's liabilities. Treas. Reg. § 1.338-5(b)(1).;

b. Grossed-up basis in recently purchased T stock

P’s grossed-up basis in recently purchased T stock equals

(1) P’s basis in recently purchased T stock at the beginning of the day after the acquisition date determined without regard to the acquisition costs;

(2) multiplied by a fraction, the numerator of which is 100 percent minus the percentage of T stock (by value, determined on the acquisition date) attributable to P’s nonrecently purchased T stock, and the denominator of which is the percentage of T stock (by value, determined on the acquisition date) attributable to P’s recently purchased T stock;

(3) plus the acquisition costs P incurred in connection with its purchase of the recently purchased stock that are capitalized in the basis of such stock (e.g., brokerage commissions and any similar costs incurred by P to acquire the stock). Treas. Reg. § 1.338-5(c).

(a) NOTE: On December 19, 2002, the Service issued a Notice of Proposed Rulemaking, Reg. 125638-1 (December 19, 2002), proposing regulations that provide rules for determining the extent to which taxpayers must capitalize transaction costs incurred with respect to the acquisition, creation, and enhancement of intangible assets. These proposed regulations are discussed in greater in Example 4 (below).

c. Basis in nonrecently purchased stock

(1) In the absence of a gain recognition election, P retains its basis in the nonrecently purchased T stock. Treas. Reg. § 1.338-5(d)(1).

(2) If a gain recognition election is made, P is treated as having sold its nonrecently purchased T stock for the basis amount (described below), and its basis on the acquisition date in nonrecently purchased T stock is the basis amount (described below). Treas. Reg. § 1.338-5(d)(3)(i).

(3) Basis amount: The basis amount is P’s basis in recently purchased T stock at the beginning of the day after the acquisition date determined without regard to the acquisition costs multiplied by a fraction the numerator of which is the percentage of T stock (by value, determined on the acquisition date) attributable to P’s nonrecently purchased T stock and the denominator of which is 100 percent minus the numerator amount. Treas. Reg. § 1.338- 5(d)(3)(ii).

d. Liabilities

(1) The liabilities of old T are the liabilities of T that are properly taken into account in amount realized under general principles of tax law that would apply if old target had sold its assets to an unrelated person for consideration that included the discharge of liabilities. Such liabilities may include liabilities for the tax consequences resulting from the deemed sale. The liabilities of old T are measured as of the beginning of the day after the acquisition date. Treas. Reg. § 1.338-4T(d)(1).

(2) NOTE: The definition of liabilities in the final regulations, effective for deemed asset acquisitions on or after March 16, 2001, differs from the definition of liabilities in the temporary regulations, effective for deemed assets acquisitions on or after January 6, 2000 but before March 16, 2001, in two respects:

(a) The temporary regulations provide that the liabilities of old T are the liabilities of T (and the liabilities to which T’s assets are subject) as of the beginning of the day after the acquisition date. The purpose for the language change in the final regulations was to simplify the discussion of liabilities and to clarify that the treatment of tax liability is to be determined under general principals of taxation. See Preamble to T.D. 8940 (Feb. 12, 2001).

(b) The final regulations make reference to Treas. Reg. § 1.338-1(d), which applies a next day rule to section 338 transactions. Commentators believed that under the language of the temporary regulations a purchaser acquiring stock of a subsidiary member in a consolidated group could, after acquiring the target stock, cause the target to sell all of its assets to another person later on the closing date and make a unilateral section 338(g) election causing the results of the sale to fall onto the selling consolidated group’s return. See Preamble to T.D. 8940 (Feb. 12, 2001). The next day rule is intended to ensure that all tax liability stemming from a post acquisition sale of acquired assets falls on the acquiring corporation by providing that the target and all persons related thereto must treat a post acquisition sale of assets as occurring at the beginning of the day following the transaction and after the deemed purchase of new target. See Treas. Reg. § 1.338-1(d).

e. Allocation

AGUB is allocated among T’s assets pursuant to the residual method under Treas. Reg. § 1.338-6 and –7. See Treas. Reg. § 1.338(h)(10)-1(d)(2).

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The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

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