Prop. Regs. on Sales-Based Royalties and Vendor Allowances

By Roger Wilkins, CPA, MST, and Natalie Tucker, CPA, MTA,

Editor: Neal A. Weber, CPA

Tax Accounting

On December 16, 2010, the IRS issued much-anticipated proposed regulations on the capitalization and allocation of sales-based royalties, and on adjustments to the cost of merchandise inventory for sales-based vendor allowances (REG-149335-08). Whether sales-based royalties are properly treated as a selling expense or an inventoriable cost has been a controversial issue that the IRS and Treasury have been working on as part of their combined Priority Guidance Plan.

The proposed regulations generally require taxpayers to treat sales-based royalties as capitalized production costs that may be recovered immediately through cost of goods sold. With respect to sales-based vendor allowances, the proposed regulations follow a field directive (LMSB-04-0910-026) recently issued by the Large Business & International (LB&I) Division, advising that under Sec. 471, sales-based vendor allowances (SBVAs) should be treated as purchase price adjustments to inventory, not income. Consistent with the directive, the proposed regulations provide that taxpayers should treat SBVAs as purchase price adjustments. However, the regulations clarify that such adjustments are to be made to the cost of merchandise sold, or deemed sold, under the taxpayer’s cost flow assumption using reasoning similar to that applied to capitalizable sales-based royalties (Prop. Regs. Secs. 1.263A-1(e)(3)(ii)(U) and 1.263A-3(e)). The proposed regulations also revise the simplified production and resale methods and address how these items affect the retail inventory method under Regs. Sec. 1.471-8, as discussed below.

Sales-Based Royalties

Sec. 263A and its accompanying regulations require taxpayers to capitalize the direct and indirect costs allocable to property produced or acquired for resale. These costs must be capitalized without regard to when they are incurred (i.e., regardless of whether incurred before, during, or after the production period) (Regs. Sec. 1.263A-2(a)(3)). Moreover, indirect costs are allocable to property that the taxpayer has produced or acquired for resale when the costs directly benefit, or are directly incurred because of, production or resale activities (Regs. Sec. 1.263A-1(e)(3)(i)). The regulations provide a detailed, nonexclusive list of indirect costs that may be capitalizable. Licensing and franchising costs are included in this list. Specifically, Regs. Sec. 1.263A-1(e)(3)(ii)(U) provides that

[l]icensing and franchise costs include fees incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced or property acquired for resale. These costs include the otherwise deductible portion (e.g., amortization) of the initial fees incurred to obtain the license or franchise and any minimum annual payments and royalties that are incurred by a licensee or a franchisee. [Regs. Sec. 1.263A-1(e)(3)(ii)(U)]

However, taxpayers may deduct “marketing, selling, advertising, and distribution costs” (Regs. Sec. 1.263A-1(e)(3)(iii)(A)).

In Robinson Knife Mfg. Co., T.C. Memo. 2009-9, the Tax Court agreed with the IRS in holding that the taxpayer’s royalty payments to a third party for the use of a patent, which gave the taxpayer the right to manufacture the third party’s branded kitchen tools, were capitalizable to inventory. The court found that the patents directly benefited the taxpayer’s production activities and that, without the right to use those patents, the taxpayer would not have been allowed to manufacture the goods.

On appeal, the Second Circuit reversed, holding that the taxpayer could deduct “royalty payments that are (1) calculated as a percentage of sales revenue from certain inventory, and (2) incurred only upon sale of such inventory” (Robinson Knife Mfg. Co., 600 F.3d 121 (2d Cir. 2010), nonacq., AOD 2011-01 (2/8/11)). The court reasoned that although the license agreements were required for the taxpayer to legally manufacture the products, production activities could have been (and were, in fact) performed without payment of the royalty costs. Citing language from Regs. Sec. 1.263A-1(e)(3)(i), the court concluded that the royalties do not “directly benefit” and were not “incurred by reason of the performance of production . . . activities.” It is important to note, however, that the Second Circuit rejected the taxpayer’s argument that all royalty payments may be immediately deductible. Rather, the court noted that lump-sum minimum royalty payments (i.e., those of a specified amount that do not vary with the number of trademarked items manufactured or sold) should be reasonably allocated between ending inventory and cost of goods sold.

In the preamble to the proposed regulations, the IRS notes that the Second Circuit in Robinson Knife “misconstrued the nature of costs required to be capitalized.” The preamble points out that royalties are the costs associated with the right to use intellectual property. “If the use of those rights directly benefits or is incurred by reason of production activities, then the cost of securing those rights do as well” (REG-149335-08). Therefore, Prop. Regs. Sec. 1.263A-1(e)(3)(i)(A) clarifies that “indirect costs may directly benefit or be incurred by reason of the performance of production or resale activities even if the costs are calculated as a percentage of sales revenue from inventory or are incurred only upon the sale of inventory.”

The proposed regulations provide that otherwise capitalizable sales-based royalties are properly allocable to inventory sold during the year (Prop. Regs. Sec. 1.263A-1(e)(3)(ii)(U)(2)). The result of the proposed regulations is to allow a current deduction for sales-based royalties as an additional cost of merchandise sold during the year. This is a similar result to that in Robinson Knife, in which the court held that the costs were not capitalizable, but clarifies that sales-based royalties are incurred by reason of production or resale activities and are therefore capitalizable licensing and franchise costs under Regs. Sec. 1.263A-1(e)(3)(ii)(U).

Sales-Based Vendor Allowances

Trade discounts are adjustments to the purchase price of the merchandise purchased. They may include volume discounts, allowances for overcharges, price concessions, vendor penalties, price protections, spoilage allowances, markdown money for damaged goods, or other rebates. Under Regs. Sec. 1.471-3(b), taxpayers must deduct trade discounts from the invoice price of the purchased merchandise. Despite the requirement of the regulation to reduce invoice price by the amount of trade discounts, taxpayers often inventory their purchased merchandise at its gross purchase price and then report the trade discount as income when it is earned. This is usually the result of following book accounting for the item (which is often to report the trade discounts as income).

A controversial issue in this area has been whether taxpayers should treat rebates or discounts tied to selling prices as income or as reductions to the cost of the goods. As previously noted, LB&I recently issued a directive advising that SBVAs constitute purchase price adjustments, not income adjustments, for purposes of Sec. 471. SBVAs are allowances, discounts, or price rebates that a vendor pays to resellers to sell its products to customers at a reduced price. SBVAs are not based on the number of units the reseller purchases, but rather on how many units the reseller sells. The directive appears to leave open the possibility of deferring income by applying the SBVAs to inventory. The proposed regulations agree with the conclusion in the directive that taxpayers should treat SBVAs as a reduction in the cost of merchandise purchased. However, Prop. Regs. Sec. 1.471-3(e) clarifies that

the amount of an allowance, discount, or price rebate a taxpayer earns by selling specific merchandise is a reduction in the cost (as determined under paragraph (a), (b), or (d) of this section) of the merchandise sold or deemed to be sold under the inventory cost flow assumption (such as first-in, first-out; last-in, first-out; or a specific-goods method) the taxpayer uses to identify the costs in ending inventory.

Similar to sales-based royalties, this produces the same result as including the SBVAs in income but as an adjustment to the cost of merchandise sold rather than as an item of gross income.

Simplified Production and Simplified Resale Methods

The simplified production and resale methods both involve determining the amount of additional Sec. 263A costs capitalized into inventory by computing an “absorption ratio.” The absorption ratio is not computed exactly the same under both methods; however, the numerator generally contains the amount of additional Sec. 263A costs incurred during the year, and the denominator includes Sec. 471 costs incurred during the year. The simplified service cost method with the production cost allocation ratio is a submethod of the simplified production method. It calculates capitalizable mixed service costs by multiplying them by the ratio of production costs to total costs.

As a result of requiring taxpayers to allocate sales-based royalties and SBVAs to property that has been sold or deemed sold, the proposed regulations require taxpayers using either the simplified production or simplified resale method to remove capitalizable sales-based royalties and SBVAs from the absorption ratio and the Sec. 471 costs included in ending inventory (see Prop. Regs. Secs. 1.263A-2(b)(3)(ii)(C) and 1.263A-3(d)(3)(i)(C)(3)). However, taxpayers must continue to include capitalizable sales-based royalties in both the numerator and denominator of the production cost allocation ratio for purposes of determining capitalized mixed service costs under the simplified service cost method.

Retail Inventory Method

Under the retail inventory method, ending inventory is computed by applying a cost complement ratio to the retail selling price of goods on hand at the end of the year. The ratio is determined by taking the purchase price of beginning inventory and current-year purchases over the retail selling price of the same merchandise. The LB&I directive points out that taxpayers may be reducing the cost of purchases by vendor allowances while not making a corresponding adjustment to the retail sales price for such items. The proposed regulations do not specifically amend Regs. Sec. 1.471-8; however, Prop. Regs. Secs. 1.263-1 and 1.471-3 preclude a taxpayer from including sales-based royalties or SBVAs in the cost of merchandise purchased for purposes of computing the cost complement ratio.

Recent Developments

On February 8, 2011, the IRS announced in AOD 2011-01 that it “will not follow the Second Circuit’s holding that sales-based royalty payments are deductible expenses except in litigating cases appealable to the Second Circuit.” In disagreeing with the Second Circuit’s decision in Robinson Knife, the IRS stated in AOD 2011-01 that it believes

the court confused the timing with the purpose of the payments. Robinson incurred the royalty expenses to first produce then sell the trade-marked items. Like all manufacturers, Robinson had to manufacture the tools to sell them. We think that the Tax Court correctly held that Robinson incurred the royalty expenses “by reason of” its production activities, and the royalty payments were production costs within the meaning of §1.263A-1(e)(3)(i).

AOD 2011-01 clearly supports the position set forth by the proposed regulations, which requires treating sales-based royalties as production costs required to be capitalized under Sec. 263A that are allocated to inventory sold during the year (i.e., as costs of goods sold).


The proposed regulations will apply to tax years ending on or after the date the regulations are published as final. Until the regulations are finalized, taxpayers under exam that are currently treating sales-based vendor allowances as purchase price adjustments may use the LB&I directive to protest a proposed method change. Taxpayers outside the Second Circuit that are currently deducting sales-based royalties may want to consider changing to the method described in the proposed regulations in order to obtain audit protection for prior years. Taxpayers currently allocating sales-based royalties between inventory on hand at the end of the year and merchandise sold should also consider changing their method of accounting to take advantage of a more favorable treatment. Currently, it appears as though this change would generally constitute an advance consent request under Rev. Proc. 97-27. However, it is anticipated that when finalized, the regulations will provide specific transition rules consistent with the current procedures for Sec. 263A method changes.


Neal Weber is managing director-in-charge, Washington National Tax, with RSM McGladrey, Inc., in Washington, DC.

For additional information about these items, contact Mr. Weber at (202) 370-8213 or

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

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