Final Regulations for Sales-Based Royalties and Sales-Based Vendor Allowances

By John Suttora, CPA, and Mathew McNeil, CPA, Washington; and Matt Borrack, CPA, Tampa, Fla.

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

Tax Accounting

Treasury and the IRS in January issued final regulations (T.D. 9652) under Secs. 263A and 471 addressing the capitalization and allocation of certain sales-based royalties and adjustments to inventory for certain sales-based vendor allowances. The final regulations adopt, with changes, proposed regulations issued in 2010 and are effective Jan. 13, 2014.

Sales-Based Royalties

The capitalization of sales-based royalties to inventory under the uniform capitalization rules of Sec. 263A has been a source of contention between taxpayers and the IRS since the early 2000s. In late 2010, in an effort to alleviate this disagreement, the government issued proposed regulations (REG-149335-08) clarifying that sales-based royalties capitalizable to property produced or acquired for resale are allocable only to property that a taxpayer has sold. The final regulations retain this approach, but they allow the allocation of sales-based royalties to sold property to be optional rather than mandatory, addressing concerns that a requirement to allocate sales-based royalties only to sold property could unduly burden taxpayers using simplified allocation methods under Sec. 263A.


Royalties are costs incurred to secure contractual rights to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property the taxpayer produces or acquires for resale. Sales-based royalties are those that become due only upon the sale of property.

Though matters regarding the capitalization of sales-based royalties first surfaced in 2001 (see Plastic Engineering & Tech. Services, Inc. , T.C. Memo. 2001-324), the 2010 proposed regulations specifically addressed the Second Circuit's decision in Robinson Knife Manufacturing Co., Inc. , 600 F.3d 121 (2d Cir. 2010). In the latter case, licensing agreements required the taxpayer to pay royalties based on a percentage of sales for the right to use certain trademarks on its products. The Second Circuit held that although the licensing agreements may have directly benefited or been incurred by reason of production activities, the regulations did not require the capitalization of the royalty costs in that instance because the costs were not incurred by reason of the performance of production activities but rather by the sale of merchandise generating the royalties.

The 2010 proposed regulations arrived at the same conclusion as the Second Circuit in Robinson Knife but used a different approach. The preamble 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 required capitalization of the sales-based royalties—but only to property that has been sold or, for inventory property, deemed to have been sold under the taxpayer's inventory cost flow assumption.

The final regulations made this allocation optional. Therefore, the final regulations permit taxpayers either to 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 or one of the simplified methods described in Regs. Sec. 1.263A-2(b) or 1.263A-3(d).

Sales-Based Vendor Allowances

A sales-based vendor allowance is an allowance, discount, or price rebate a taxpayer earns as a result of selling a vendor's merchandise, typically at a temporarily reduced price. The taxpayer's right to receive the sales-based vendor allowance depends on actual sales of the vendor's products. In general, Regs. Sec. 1.471-3(b) calculates the cost of merchandise a taxpayer purchases to be the invoice price less trade or other discounts. Under existing law, and depending on its method of accounting, a taxpayer might allocate certain sales-based vendor allowances that are earned upon the sale of inventory to the taxpayer's inventory on hand at the end of the year.

In also addressing the treatment of sales-based vendor allowances, the proposed regulations provided that amounts received in the form of sales-based vendor allowances would be treated as directly relating to the specific merchandise that the taxpayer sold and accounted for as a reduction in the cost of merchandise sold or deemed sold under a taxpayer's cost flow assumption and not included in determining the inventory cost or value of goods on hand at the end of the tax year under any method.

As explained in the preamble to the final regulations, the proposed regulations were determined to be overbroad because they required taxpayers to allocate all sales-based vendor allowances to cost of goods sold and not to goods remaining in ending inventory, regardless of whether this treatment was consistent with the economic reality of the underlying vendor allowance agreement. For example, if, after selling a certain number of units, a taxpayer earns a discount off each unit purchased during the tax year, the allowance may be properly allocable to both the cost of units remaining in ending inventory and the cost of units included in cost of goods sold during the year. Similarly, a sales-volume allowance that provides only a reduction in the cost of any purchases made by a taxpayer in the next tax year properly reduces the cost of the units of the product purchased in the next year. Given the factual nature of each vendor allowance arrangement, the government declined to create a universal rule covering all forms of vendor allowances. Rather, it specifically identified one type of sales-based vendor allowance (sales-based vendor chargebacks) that, to clearly reflect income, reduces the cost of goods sold and does not reduce the cost of goods on hand at the end of the tax year.

Unde r the final regulations, 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. Given this specific definition, the final regulations likely affect a smaller population of taxpayers than if they had applied to all sales-based vendor allowances.

The final regulations reserve rules for the treatment of sales-based vendor allowances other than the sales-based vendor chargebacks. The IRS requested comments regarding additional guidance defining or describing particular sales-based vendor allowances and on objective rules for allocating such allowances to the purchase price of goods acquired in the future, ending inventory, or cost of goods sold.


Taxpayers with existing license and vendor allowance agreements should review these agreements. Taxpayers should also analyze present methods of capitalizing sales-based royalties and sales-based vendor allowances under Secs. 263A and 471, to determine whether a change in method of accounting is needed to correct an impermissible treatment or to take advantage of a more favorable treatment. It is expected that the IRS will issue a revenue procedure with transition guidance providing procedures to make an automatic change in a method of accounting. Until that guidance is issued, any changes would need to be made in accordance with the provisions of Rev. Proc. 97-27 and Rev. Proc. 2011-14, depending on a taxpayer's particular facts and circumstances.


Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington.

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. The information contained in this item 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. This item represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.

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