The IRS issued final regulations on sales-based royalties and vendor allowance rules under Sec. 263A and Sec. 471 (T.D. 9652). The rules, which adopt the proposed regulations (REG-149335-08) issued in 2011 with some changes in response to comments, apply to tax years ending on or after Jan. 13, 2014.
The sales-based royalty rules relate to the capitalization and allocation of royalties incurred upon the sale of property produced or property acquired for resale. Sales-based vendor allowances are the adjustments to the cost of merchandise inventory for an allowance, discount, or price rebate based on merchandise sales.
The proposed regulations were issued in response to ongoing litigation over whether sales-based royalties were required to be capitalized under Sec. 263A. Rather than determining that sales-based royalty costs are inherently noncapitalizable, the proposed regulations provided that otherwise capitalizable sales-based royalty costs are properly allocable to property sold during the tax year. The proposed regulations allocated 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.
In response to comments that the requirement to allocate sales-based royalties only to cost of goods sold would burden taxpayers using simplified allocation methods, the final regulations make this method optional, instead of mandatory. Therefore, the final regulations permit taxpayers to either allocate sales-based royalties entirely to property sold and include those costs in cost of goods sold or to allocate sales-based royalties between cost of goods sold and ending inventory using a facts-and-circumstances cost-allocation method described in Regs. Sec. 1.263A-1(f) or a simplified method.
The proposed regulations required that these sales-based allowances reduce cost of goods sold and not reduce ending inventory cost or value of goods on hand at the end of the tax year. A commenter disputed that a vendor allowance should reduce cost of goods sold merely because the allowance is dependent on a sale of merchandise. The IRS stated in the final regulations’ preamble that it agreed with the commenter and that the proposed regulations were overbroad because they required taxpayers to allocate to cost of goods sold all allowances that arise from selling merchandise. For example, the IRS noted it would not be appropriate to apply the rule in a situation where a taxpayer received an increased allowance from a vendor after selling a certain number of units.
The IRS noted in the preamble that it is considering alternatives to a broad definition of sales-based vendor allowances. The final regulations, however, specifically identify one type of sales-based vendor allowance (sales-based vendor chargebacks) that, to clearly reflect income, reduces cost of goods sold and does not reduce the cost of goods on hand at the end of the tax year. Therefore, the final regulations apply the rule articulated in the proposed regulations to sales-based vendor chargebacks. A sales-based vendor chargeback is defined as an allowance, discount, or price rebate that a taxpayer becomes unconditionally entitled to by selling a vendor’s merchandise to specific customers identified by the vendor at a price determined by the vendor.