To Capitalize or to Expense: How Sec. 263A Treats Royalties

By John Suttora, CPA, and Damon Bender, J.D., LL.M., Washington, DC

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

The tax treatment of royalty payments—to capitalize or to expense—depends on the terms of the royalty agreements and, in some situations, the Sec. 263A uniform capitalization rules. This item reviews certain authorities on the treatment of royalty payments, including the Tax Court’s recent decision in Robinson Knife Manufacturing Co.


Regardless of the industry, manufacturers frequently enter into licensing agreements with third parties to obtain various rights for the production, sale, marketing, and distribution of goods. Whether it is a drug manufacturer licensing the rights to a patented compound or a producer of retail goods obtaining the right to use another company’s trademark, licensing agreements appear to be standard in the world of production. What does not appear to be standard is the tax treatment of royalty payments made under the licensing agreements for purposes of Sec. 263A.


The Sec. 263A uniform capitalization (UNICAP) rules require that all direct costs and certain indirect costs allocable to certain property be either (1) included in inventory costs or (2) capitalized, if the property is not inventory. Regs. Sec. 1.263A-1(e)(1) requires taxpayers subject to Sec. 263A to capitalize all direct costs and certain indirect costs properly allocable to property produced or property acquired for resale. Direct costs include direct material costs and direct labor costs for a producer and acquisition costs for a reseller (see Regs. Sec. 1.263A-1(e)(2)).

Taxpayers must capitalize indirect costs to the extent they are properly allocable to property produced or property acquired for resale. Regs. Sec. 1.263A1(e)(3)(i) defines indirect costs as all costs other than direct material costs and direct labor costs (in the case of property produced) or acquisition costs (in the case of property acquired for resale). Indirect costs are properly allocable to property produced or property acquired for resale when the costs directly benefit or are incurred due to the performance of production or resale activities. Indirect costs may be allocable to both production and resale activities as well as to other activities not subject to Sec. 263A.

In the case of royalty expenses, tax treatment has been dependent on the nature and terms of the royalty paid as well as the method used to allocate the Sec. 263A costs. For example, if the taxpayer determines that the royalty payment is related solely to the right to sell, market, and distribute a particular product, the royalty payment would be excluded from capitalization under Regs. Secs. 1.263A1(e)(3)(iii)(A), (4)(ii)(B), and/or (4)(iv)(N). These Treasury regulations allow a deduction for costs relating to selling, marketing, and distribution.

However, if the taxpayer determines that the royalty expense paid either directly benefits or was incurred because of production-related activities, such payment would be capitalized under Regs. Sec. 1.263A-1(e)(3)(ii)(U). This Treasury regulation characterizes licensing and franchise costs as indirect costs that are capitalized to inventory.

Many taxpayers allocate royalty expenses between deductible and capitalizable indirect costs. Such allocation is specifically permitted (and required) by Regs. Sec. 1.263A-1(c)(1).

Plastics Engineering

The IRS has disputed a taxpayer’s allocation of royalty expenses between deductible and capitalizable indirect costs under Sec. 263A-1(c)(1) in several situations. Most notable is the Tax Court’s decision in Plastics Engineering & Technical Services, T.C. Memo. 2001-324. The sole issue for determination by the Tax Court in this case was whether Sec. 263A required a taxpayer who used the simplified production method (see Regs. Sec. 1.263A-2(b)) to capitalize certain royalties it paid as the exclusive licensee of a patent.

The taxpayer entered into a licensing agreement with a related third party whereby the taxpayer was granted an exclusive and nontransferable license to manufacture and sell products that make use of a certain production process that was the subject of the third party’s patent. In exchange for this license, the taxpayer agreed to pay a contingent royalty equal to 10% of the net sales price of all products manufactured through use of the patented technology.

The Tax Court agreed with the IRS and rejected the taxpayer’s argument that the contingent royalty took the cost out of the realm of Regs. Sec. 1.263A-1(e)(3)(ii)(U). It held that because the royalty payment was for the right to use a certain production process, that payment was indeed an includible indirect cost under Regs. Sec. 1.263A-1(e)(3)(ii)(U) and was required to be capitalized to inventory and relieved through cost of goods sold. Further, due to the mechanics of the simplified production method used by the taxpayer, these royalty costs were allocated to ending inventory even though the costs were not incurred until the goods were sold.

Letter Ruling 200630019

The IRS followed the Plastics Engineering decision in Letter Ruling 200630019, which it issued on March 31, 2006. The taxpayer in the letter ruling owned nearly all the stock of a subsidiary. The subsidiary acquired the right to manufacture goods for sale to the taxpayer. The royalties paid were based on the rights described in an agreement between the taxpayer and the subsidiary; however, the amount of royalty was calculated based on the number of products sold to the taxpayer each month. The subsidiary did not include any portion of the royalty expense as an indirect cost allocable to inventory.

Citing Plastics Engineering, the IRS ruled that the royalties paid by the subsidiary for the rights under the licensing agreement constituted licensing and franchise costs within the scope of Regs. Sec. 1.263A-1(e)(3)(ii)(U). Further, the IRS ruled that the rights acquired directly benefited the subsidiary’s production activities, and as such the royalties were indirect costs properly allocable to property produced that must be capitalized under Sec. 263A. However, in this instance the taxpayer used a facts-and-circumstances approach to allocate costs to ending inventory. Under this method, the royalty costs would not be allocated to ending inventory because they were not incurred until the goods were sold. Due to insufficient facts, the IRS could not rule on whether such a facts-and-circumstances method was appropriate.

Industry Directive

Seeing a trend of inconsistent treatment by both taxpayers and IRS exam personnel, on May 7, 2007, the IRS issued an industry directive that elevated treatment of royalties (among other costs) to a Tier II issue. Tier II issues are defined in Internal Revenue Manual Section as those that involve areas of potential high noncompliance and/or significant risk to the Large and Mid-Size Business Division or a particular industry. They include emerging issues where the law is fairly well established, but there is need for further development, clarification, direction, and guidance on the IRS position.

Although the directive deals specifically with the pharmaceuticals industry, its scope is applicable to other industries as well. The directive clearly identifies the issue of whether or not royalties paid by a taxpayer represent a capital expenditure under Sec. 263A.

In issuing the directive, the IRS intended to provide a uniform format and approach for examiners to evaluate potential compliance risk related to the treatment of royalties (among other costs) under Sec. 263A, to outline the issue management and oversight process that had been established, and to introduce an initial set of audit guidelines. The overall effect of the directive was to increase the level of scrutiny for taxpayers subject to Sec. 263A that incur royalty expenses.

Robinson Knife

Following the issuance of the directive, recent guidance relating to the treatment of royalties under Sec. 263A can be found in the Tax Court’s decision in Robinson Knife Manufacturing Co., T.C. Memo. 2009-9. Like Plastics Engineering, the issue before the Tax Court in Robinson Knife was whether a taxpayer using the simplified production method was required to capitalize royalties incurred in connection with certain trademark licensing agreements under Sec. 263A.

The taxpayer was engaged in the business of designing, developing, manufacturing, marketing, and selling kitchen tools and gadgets. The taxpayer entered into two separate licensing agreements for the right to use trademarks in connection with kitchen tools it produces and sells. In return for the rights granted, the taxpayer agreed to pay a royalty in an amount equal to 8% of the net wholesale selling price of the kitchen tools sold under one licensing agreement and to pay an amount equal to 11% of net sales up to $1 million and 8% on net sales exceeding $1 million under the other licensing agreement.

For tax purposes, the taxpayer treated the royalty payments associated with both licensing agreements as excludible costs, which are not required to be capitalized, after making the determination that the royalties were in the nature of marketing, selling, and advertising costs that were not subject to capitalization. However, the Tax Court reached the opposite conclusion because the taxpayer could not have legally manufactured the products without the rights it was granted under the licensing agreements. As such, the Tax Court held that the royalty expenses were includible indirect costs under Regs. Sec. 1.263A-1(e)(3)(ii)(U). Further, as in the case of Plastics Engineering, due to the mechanics of the simplified production method, the Tax Court held that the taxpayer should allocate the royalty costs to ending inventory even though the taxpayer did not incur the costs until the goods were sold.

Because the royalty payments in question were for the right both to manufacture and to distribute and sell, it is interesting that an allocation was not made between those capitalizable and noncapitalizable elements. Perhaps the result would be different in cases in which the royalty was strictly for the right to distribute and sell a product.


Although the language contained in the Treasury regulations supporting Sec. 263A is relatively clear as to the tax treatment of licensing costs and royalties, royalty agreements can be highly factual in nature, and the actual tax treatment will depend on the nature and terms of the costs incurred and the methodology used to allocate those costs. Regs. Sec. 1.263A-1(e)(3)(ii)(U) should be carefully considered, and a separate analysis should be conducted to determine the nature and terms of the royalty paid and how such costs should be allocated to ending inventory.


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

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

This article represents the views of the author or authors only, and does not necessarily rep-resent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

© 2009 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.

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

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