Royalty Payments Not Subject to Capitalization Under Sec. 263A

A recent Second Circuit decision provides a potential opportunity for taxpayers that will incur royalty payments to structure the agreements in such a manner that they can immediately deduct royalty costs instead of capitalizing them under the uniform capitalization rules of Sec. 263A. In Robinson Knife Manufacturing Co., No. 09-1496-ag (2d Cir. 3/19/10), the court ruled that a taxpayer involved in manufacturing could currently deduct trademark licensing royalty payments if the payments were calculated as a percentage of sales revenue from certain inventory and were incurred upon the sale of that inventory. The court’s interpretation of Sec. 263A and the regulations thereunder may give taxpayers an opportunity to structure licensing and franchise agreements in such a way that they may deduct royalties paid under such agreements currently instead of capitalizing them to inventory.

Costs Allocable to Inventory

Sec. 263A provides that in the case of property that is inventory in the hands of a taxpayer, certain direct and indirect costs otherwise deductible by the taxpayer must be capitalized as inventory costs. The taxpayer generally recovers the capitalized costs as it sells the inventory. Sec. 263A applies to property produced by the taxpayer or property acquired for resale.

Sec. 263A provides that inventory costs include direct material and direct labor costs as well as an allocation of indirect costs. The regulations define indirect costs as all costs other than direct material and direct labor costs or acquisition costs that directly benefit or are incurred by reason of the performance of production activities. When indirect costs are also allocable to other activities not subject to Sec. 263A, the taxpayer must make a reasonable allocation of indirect costs between production and other activities.

The regulations list examples of indirect costs that are inventoriable to the extent they are properly allocable to produced property or property acquired for resale. Allocable indirect costs include certain taxes, depreciation, and environmental remediation costs, among other costs. Also listed are licensing and franchise costs, as discussed below. Taxpayers must analyze their costs to determine whether the costs directly benefit, or are incurred by reason of, a production activity. The regulations also specifically provide that certain costs, including marketing, selling, advertising, and distribution expenses, are not subject to capitalization and are therefore currently deductible.

Licensing, Franchise, and Royalty Costs

Indirect costs, such as licensing, franchise, and royalty payments, may relate to both inventory and noninventory operations; as such, they must be analyzed to determine whether the costs relate to inventory operations. The regulations specify that allocable indirect costs include licensing and franchise fees incurred to secure the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced or acquired for resale. Such costs include the otherwise deductible portion of the initial fees incurred to obtain the license or franchise agreement, generally recovered through amortization. In addition, allocable costs include any minimum annual payments and royalties that are incurred by a licensee or franchise to the extent related to production activities (Regs. Sec. 1.263A-1(e)(3)(ii)(U)).

Before the Second Circuit addressed the issue in Robinson Knife, there was very little guidance on the treatment of royalties paid pursuant to license and franchise agreements under Sec. 263A. The only prior published opinion was a Tax Court decision that ruled against the taxpayer (Plastic Engineering & Tech. Servs., Inc., T.C. Memo. 2001-324). In Plastic Engineering, the Tax Court addressed whether the taxpayer was required to capitalize certain royalties paid as the exclusive licensee of a patented hot manifold assembly system, with royalties equal to 10% of the net sales price of all plastic molded products manufactured through the use of the patented assembly system. The Tax Court ruled that the royalty payment at issue related to a manufacturing procedure and that royalty payments made for a patented manufacturing process are inventoriable costs under Sec. 263A even through the royalty was contingent upon the selling of the goods. The taxpayer argued that the regulations under Sec. 263A covered only “minimum” royalties and not contingent royalty payments. However, the Tax Court ruled that the taxpayer’s argument was flawed and that the regulations clearly addressed indirect licensing and franchise costs as allocable costs, and the regulation’s reference to minimum annual royalties was only an example of such costs.

Relying on Plastic Engineering, the IRS reached a similar conclusion in Technical Advice Memorandum 200630019. In that ruling, the IRS held that a subsidiary must capitalize royalty payments to its parent for the right to use certain intellectual property necessary to conduct production activities.

Robinson Knife: Royalty Costs Deductible Under Trademark Licensing Agreements

The Tax Court in Robinson Knife followed a similar pattern. Robinson Knife is a corporation engaged in the business of designing, developing, manufacturing, marketing, and selling kitchen tools, which it markets and sells to large retailers. Because many kitchen tools have similar characteristics, Robinson Knife often enters into trademark licensing agreements with well-known names in order to differentiate its product (if in name only) from other products on the market.

Robinson Knife’s general production process is as follows. Robinson Knife develops an idea for a new product. It then decides which trademark, if any, would be the most appropriate to couple with the idea and designs a new tool. After Robinson Knife has both the design and the trademark license approval, it contracts with a third party to manufacture the product. Robinson Knife may also produce an identical product that does not bear the licensed trademark.

For products with a licensed trademark, the packaging either identifies only the licensed trademark or, if Robinson Knife’s name is also on the package, the licensed trademark is more prominently displayed. Robinson Knife often relies on the reputation of the licensed trademark to differentiate the product at the point of sale.

The case involved two licensing agreements that were identical in all pertinent terms. Under these agreements, Robinson Knife had the exclusive right to manufacture, distribute, and sell certain types of kitchen tools using the licensed brand names. Robinson Knife was required to pay to the trademark owner a percentage of the net wholesale billing price of the kitchen products bearing the trademark. Robinson Knife did not have any obligation to make a royalty payment until a kitchen product was sold and was not required to make any minimum or lump-sum royalty payment. Under this arrangement, Robinson Knife would not owe any royalties if it did not sell the trademarked products it produced.

Robinson Knife, which was an accrual-method taxpayer, sold some of the products bearing the trademark and paid the resulting trademark royalties. It deducted the royalties incurred and paid as ordinary and necessary business expenditures. The IRS determined after examination that the company should have capitalized the payments under Sec. 263A.

The Tax Court ruled against the taxpayer, holding that the royalty payments are indirect costs that were required to be capitalized under Regs. Sec. 1.263A-1(e)(3)(ii)(U). The court found that Robinson Knife incurred the royalty costs “by reason of the production activities” because “without the license agreements, [Robinson Knife] could not have legally manufactured” the kitchen products. In addition, the Tax Court noted that the marketing benefit generated by the trademarks (i.e., brand recognition at the point of sale) did not alter the fact that the royalty fees permitted Robinson Knife to use the trademark during the production process. Finally, the court cited Plastic Engineering for the proposition that the fact that the royalty payments were tied to actual sales was not a determining factor.

Robinson Knife made three alternative arguments on appeal to the Second Circuit:

• The royalty payments are deductible under Regs. Sec. 1.263A-1(e)(3)(iii)(A) as advertising or marketing expenses;
• Royalty payments that are not incurred in securing the contractual right to use the trademark are always deductible; and
• The royalty payments at issue were not “properly allocable to the property produced.”

The Second Circuit held for Robinson Knife based on the third argument. Specifically, the court held that royalty payments that are calculated based on a percentage of sales revenue from certain inventory and that are incurred only upon the sale of such inventory are not required to be capitalized under the Sec. 263A regulations. The Second Circuit dismissed Robinson Knife’s first two arguments as being overbroad; taken to a logical conclusion, each would require the court to rule that all trademark royalties were exempt from capitalization, which the court felt was incorrect.

In reaching its conclusion, the Second Circuit found that the Tax Court had asked the wrong question required by the regulations: The court had asked whether Robinson Knife’s license agreements directly benefited the production process when it should have asked whether the royalty payment costs directly benefited the production process. The regulations require capitalization if the costs directly benefit or are incurred by reason of the production process. As such, according to the Second Circuit, if the Tax Court had asked the right question, it would have found that the royalty payments had nothing to do with the production process. Robinson Knife could have, and did, manufacture the products without having to pay any royalty payments. The payments became due only when the company sold the products. “[I]t is the costs, and not the contracts pursuant to which those costs are paid, that must be a but-for cause of the taxpayer’s production activities in order for the costs to be properly allocable to those activities and subject to the capitalization requirement.”

The Second Circuit also made an analogy to regulatory and legislative history regarding the sales of books; this history directly addressed payments due upon sale. Regs. Sec. 1.263-2(a)(2)(ii)(A)(1) notes that the costs that must be capitalized for developing and producing books do not include “commissions for sales of books that have already taken place.” Because the royalty payments at issue were also sales based and incurred only on the sale of the product, Robinson Knife similarly was not required to capitalize the payments. The court noted, however, that it was possible that a future taxpayer could draft a royalty agreement that in form met the requirements set forth (i.e., based on sales and incurred upon sale) but in economic reality related to products not yet sold; that was not the case here.

The Second Circuit did not directly address Plastic Engineering and simply mentioned it in passing as the only other case it had found that discussed whether royalty payment costs are capitalizable under Sec. 263A. Assuming that Plastic Engineering remains good law in some or all jurisdictions, a distinguishing factor would be that the rights at issue in Plastic Engineering actually permitted the taxpayer to conduct the manufacturing process (i.e., in a but-for case, the production process itself could not have occurred without the royalty agreement). In Robinson Knife, the rights were not associated with the actual ability to conduct the production process.

Planning Considerations

The Second Circuit’s holding provides planning opportunities for taxpayers entering into royalty payment agreements. Provided that the economics make sense and that the taxpayer has not previously adopted a method of accounting that capitalizes the sales-based royalty payments, taxpayers may be able to structure the agreements in such a way that royalties paid under the agreements may be currently deducted instead of capitalized to inventory. The taxpayer making the royalty payments should avoid agreements to make two types of payments:

• Lump-sum minimum royalty payments based on a specified payment that does not vary regardless of the number of trademarked items manufactured or sold; and
• Manufacturing-based royalties paid whenever the manufacturer produces an inventory item bearing the licensed trademark.

Instead, the taxpayer making the royalty payment would prefer an agreement to make royalty payments that are sales based and that do not directly benefit and are not incurred by reason of the performance of production activities. The taxpayer’s royalty payments should be calculated as a percentage of sales revenue and should be incurred only upon sale of that inventory. In addition, the royalty payments should be based on products sold in the current period and not on products to be sold in the future. Taxpayers who have already adopted a method of accounting that capitalizes sales-based royalty payments should analyze whether there are opportunities for filing for a change in accounting method.

The Second Circuit’s opinion appears to stand for the broad proposition that any sales-based royalty payments that the taxpayer incurs only at the point of sale are not subject to capitalization. Assuming that this holding is adopted by other jurisdictions and by the IRS (the IRS has not yet announced its plans after the opinion), an unanswered question is whether royalty payments such as those in Plastic Engineering would also be deductible. That is to say, would royalty payments that are based on sales and incurred only at the point of sale but that are also related to rights that are fundamentally necessary to conduct the production process be deductible? It is unclear whether the Second Circuit has implicitly added a third requirement for deductibility—i.e., that the right granted by the agreement not be necessary to conduct the production process itself. In Robinson Knife, the taxpayer could have produced the exact knife though without the licensed trademark. In Plastic Engineering, the taxpayer could not have conducted the manufacturing without the licensed right.

Conclusion

Taxpayers may have the opportunity to structure licensing and royalty agreements so that they can deduct royalty payments as ordinary and necessary business expenses. These types of payments can be substantial for taxpayers that produce inventory or acquire inventory for resale. Taxpayers and their advisers should analyze the specific facts applicable to their businesses and agreements and determine whether they can make an argument for currently deducting royalty payments that are not associated with the production process.

Editor: Frank J. O’Connell Jr., CPA, Esq.

EditorNotes

Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.

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