Sales-Based Royalties and Vendor Allowances

By Robert Ford, CPA, and John Suttora, CPA, Washington, DC

Editor: Mary Van Leuven, J.D., LL.M.

Tax Accounting

In December 2010, Treasury proposed new regulations (REG-149335-08) that address two issues regarding the computation of inventory values. The first relates to the capitalization and allocation of royalties incurred only upon the sale of property produced or property acquired for resale (sales-based royalties). The second issue concerns the adjustment of the cost of merchandise inventory for an allowance, discount, or price rebate based on merchandise sales (sales-based vendor allowances).

Sales-Based Royalties in the Prop. Regs.

As evidenced by recent litigation and technical memorandums, the capitalization of sales-based royalties into inventory under the uniform capitalization rules of Sec. 263A and the related regulations (UNICAP rules) has created contention between taxpayers and the IRS. If enacted, recently proposed regulations would help alleviate the disagreement as to the capitalization of sales-based royalties when using a simplified method. With regard to sales-based royalties, the proposed rules specifically address the Second Circuit’s decision in Robinson Knife Mfg. Co., 600 F.3d 121 (2d Cir. 2010), nonacq., AOD 2011-01 (2/8/11).

Under the simplified methods found in the UNICAP rules, a ratio multiplied by ending inventory value determines the amount of costs requiring capitalization to inventory for tax purposes, if any, in addition to any costs already capitalized on a taxpayer’s financial statements. The ratio for the simplified production method is (1) the total additional Sec. 263A costs incurred during the year to (2) total Sec. 471 costs incurred during the year. Thus, any amounts capitalized as additional Sec. 263A costs such as sales-based royalties, in part, become capitalized to ending inventory under those simplified methods, even though the sales-based royalties are not incurred until the goods are sold.

Prior to the proposed regulations, the IRS challenged taxpayers that excluded sales-based royalties from additional Sec. 263A costs and therefore from capitalization under Sec. 263A. The Second Circuit, however, decided for the taxpayer in Robinson Knife, allowing exclusion of sales-based royalties from capitalization. The language in the proposed regulations requires capitalization of the sales-based royalties but allocates those costs only to inventory that is already sold. Because cost of goods sold already includes the basis of such inventory, taxpayers effectively deduct those costs as sales are made.


Matters regarding the capitalization of royalties first came to light in 2001 when the Tax Court decided Plastic Engineering & Tech. Servs., Inc., T.C. Memo. 2001-324. In Plastic Engineering, the court dealt with applying the simplified production method under the UNICAP rules to capitalize a royalty for the use of a patented plastic manufacturing system called a hot manifold assembly. The amount of the royalty was a percentage of the sales of the plastic products manufactured through the patented system. The taxpayer expensed these royalties currently. The court held, however, that Regs. Sec. 1.263A-1(e)(3)(ii)(U) requires capitalization of the royalties as license and franchise costs. The licensed patent was a critical component of Plastic Engineering’s manufacturing system because it enabled the taxpayer to manufacture the end products.

In 2006, the royalty issue resurfaced with the issuance of Technical Advice Memorandum 200630019. In this memorandum, the IRS analyzed the tax consequences of capitalizing royalties when the taxpayer used a facts-and-circumstances approach instead of a simplified method to capitalize costs under the UNICAP rules. This taxpayer’s royalty payments were for the use of a license and were determined based on the number of units sold. The license granted a U.S. corporation the rights to use its foreign parent’s intellectual property, including design patents, trademarks, service marks, copyrights, and know-how in its manufacturing process. The taxpayer did not capitalize any sales-based royalty costs incurred, but instead deducted them currently.

The IRS found that the royalty costs were capitalizable under the UNICAP rules as license and franchise costs because the costs directly benefited the taxpayer’s production activities. However, it also used a facts-and-circumstances approach and found that the costs were not necessarily allocable to ending inventory because of their relation to goods already sold. The IRS pointed out that the regulations allow a taxpayer using a facts-and-circumstances approach to apply different allocation methods to different types of costs.

The Tax Court also addressed the issue of sales-based royalties in Robinson Knife Mfg. Co., T.C. Memo. 2009-9, which held in favor of the government. In that case, the taxpayer engaged in the business of designing, developing, manufacturing, marketing, and selling kitchen tools and gadgets and paid licensors royalties based on a percentage of sales for the rights to use certain trademarks on its products. For tax purposes, the taxpayer treated the royalty payments as costs not required to be capitalized, after making the determination that the royalties were in the nature of marketing, selling, and advertising costs.

The Tax Court held that the taxpayer was required to capitalize the royalty costs when using the simplified production method as licensing and franchise costs to ending inventory in accordance with Regs. Sec. 1.263A-1(e)(3)(ii)(U). In making this determination, the court found that production activities benefited from the royalties as Robinson Knife could not have legally manufactured the products without the payments. Further, the licensors of the trademarks were heavily involved in the development of the products and required an approval for a product’s design prior to using a trademark on a product. The licensors could also inspect and approve the products after manufacturing was complete.

The Second Circuit, however, overturned the Tax Court’s decision in favor of the taxpayer. It found the relevant facts to be that the royalties were (1) calculated as a percentage of sales revenue of the trademarked products and (2) incurred only upon the sale of the inventory and not on the basis of production. The Second Circuit held that the plain text of Regs. Sec. 1.263A-1(e)(3)(i) required capitalization of costs and not the contracts under which the costs were paid, benefiting the production process. This rationale would not necessarily extend to minimum royalties or royalties that are production based.

The proposed regulations arrive at the same conclusion as the Second Circuit’s Robinson Knife decision but use a different approach. The preamble to the proposed regulations states:

The proposed regulations achieve a similar result to that in Robinson Knife, but rather than determining that sales-based royalty costs are inherently non-capitalizable, the proposed regulations provide that otherwise capitalizable sales-based royalty costs are properly allocable to property sold during the taxable year.

As opposed to the view of the Second Circuit that sales-based royalties do not benefit the production process, the proposed regulations require capitalization of the sales-based royalties but allocate those costs to inventory that is already sold. Because cost of goods sold already includes the basis of the inventory, expense of the capitalized royalties essentially occurs as taxpayers make any payments.

It is of interest that on February 8, 2011, the IRS issued an action on decision concerning the decision in Robinson Knife (AOD 2011-01), stating that it will not follow the Second Circuit’s decision that sales-based royalty payments are deductible expenses, except in cases litigated in the Second Circuit. Given the proposed regulations, presumably the IRS agrees with the conclusion in Robinson Knife but not necessarily with the rationale behind the decision.

Note that even though Treasury has not yet finalized the proposed regulations, taxpayers can apply methodologies similar to those described for sales-based royalties, according to a recent release from the IRS. Subsequent to the issuance of the proposed regulations, on March 1, 2011, the IRS’s Large Business and International Division (LB&I) issued a field directive (LB&I 4-0211-002) discussing the application of the proposed regulations to taxpayers incurring sales-based royalties. In the directive, the LB&I instructs field agents not to challenge taxpayers that follow a methodology similar to those described in the proposed regulations.

Sales-Based Vendor Allowances in the Prop. Regs.

The proposed regulations also adjust the rules related to the treatment of sales-based vendor allowances for taxpayers using the retail inventory method. Under that method, the cost of inventory is determined by multiplying the aggregate selling prices of the goods in ending inventory by a ratio or cost compliment. The ratio is (1) the total cost of goods in beginning inventory plus purchases of goods during the year to (2) the retail selling prices of the goods in beginning inventory plus the retail selling prices of inventory purchased during the year, with proper adjustments to the selling prices for markups and markdowns.

Prior to the issuance of the proposed regulations, the LB&I issued a field directive (LMSB-04-0910-026) discussing the treatment of sales-based vendor allowances as well as margin protection payments under Sec. 471. The directive advises the field to treat sales-based vendor allowances as a purchase price adjustment and not as an income adjustment for the purposes of Sec. 471.

The directive states that some taxpayers using the retail inventory method currently reduce the numerator of the cost compliment for any margin protection payments received. The LB&I instructs the field not to expend resources pursuing any adjustments created by this treatment of margin protection payments. The directive also seems to imply that pursuit by the field for the treatment of sales-based vendor allowances reducing the numerator is not necessary.

The preamble to the proposed regulations indicates that sales-based vendor allowances are properly allocable to property sold during the tax year. However, the proposed regulations do not specifically modify the retail inventory method under Regs. Sec. 1.471-8. Instead, the regulations modify the definition of “inventories at cost” under Regs. Sec. 1.471-3. Thus, under the proposed regulations, the amount of an allowance, discount, or price rebate that a taxpayer earns by selling specific merchandise is a reduction to the cost of merchandise sold or deemed sold under the inventory cost flow assumption that the taxpayer uses to identify the costs in ending inventory. This amount decreases the cost of goods sold and does not reduce the inventory cost or value of goods on hand at the end of the tax year.

Accordingly, it remains to be seen how the proposed regulations might affect the guidance issued in field directive LMSB-04-0910-026 described above. Note also that in the same directive discussing sales-based royalties (LB&I 4-0211-002), the IRS instructs its field agents not to challenge taxpayers applying a methodology similar to those described in either the current or the proposed regulations regarding sales-based vendor allowances.


If finalized as written, the proposed regulations would allocate sales-based royalties and vendor allowances to property sold during the tax year. The preamble indicates that the intention of the proposed regulations is that neither sales-based royalties nor sales-based vendor allowances should adjust the value of ending inventories. The IRS will not challenge taxpayers applying methodologies similar to those described in the proposed regulations, as evidenced in LB&I 4-0211-002. Until the proposed regulations are finalized, however, taxpayers are left with the existing guidance as described above, including the related field directives addressing the treatment of both sales-based royalties and vendor allowances, as well as AOD 2011-01 concerning the treatment of sales-based royalties afforded by Robinson Knife.


Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.

For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

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