Court Rules Sales-Based Royalty Payments Are Not Capitalizable into Ending Inventory 

The Second Circuit reversed the Tax Court, allowing a manufacturer to deduct royalty payments calculated as a percentage of sales revenue at the time of the sales, rather than requiring the manufacturer to capitalize the royalty payments as part of its ending inventory costs.

 

Background

Robinson Knife manufactures kitchen products.  In the year at issue, Robinson licensed from Pyrex and Oneida the right to design and manufacture products under the well-known brand names.  The licensing agreement between Robinson and the third parties required a royalty based upon the number of units sold.

 

In addition, the agreement included a quality control provision requiring Robinson to obtain the trademark owner’s approval for product design, packaging and promotional materials before selling a branded product.  Quality control provisions are included in most trademark licensing agreements.

 

The regulations under §263A state that a taxpayer “must capitalize all direct costs and certain indirect costs properly allocable to property produced…. Indirect costs are properly allocable to property produced … when the costs directly benefit or are incurred by reason of the performance of production … activities.” 26 C.F.R. § 1.263A-1.

 

Tax Court Decision

The government argued that the royalty payments must be capitalized into inventory because the royalties directly benefited Robinson’s production activities or were incurred by reason of those activities.  The Tax Court agreed finding that the quality control provisions from the trademark licensing agreements made “obtaining approval from the licensors to use the Pyrex and Oneida trademarks on new kitchen tools . . . an integral part of developing and producing the Pyrex- and Oneida-branded kitchen tools.” The Tax Court concluded that “acquiring the right to use the Pyrex and Oneida trademarks was part of petitioner’s production process.”  Therefore, the Tax Court determined, the cost must be capitalized into inventory under §263A using Robinson’s simplified production method.

 

Second Circuit Decision

The Second Circuit reversed the ruling, finding that the Tax Court confused royalties from the licensing agreements with the agreements themselves. The Court focused on the royalty payments being calculated on items SOLD and not PRODUCED, as Robinson could have produced the kitchen tools without paying any royalties.  Presumably, if the royalty payments were instead based on units produced, capitalization would have been required.

 

Treasury Position

The IRS has not announced whether it will follow the appeals court decision or appeal it.  We expect that the IRS will provide guidance on this issue.  Given the IRS’s position and the reversal by the appeals court, taxpayers who pay sales-based royalties should consult with their tax advisor on the tax treatment of such payments.
This article was adapted, with permission, from "What's News in Tax," a biweekly publication of KPMG's Washington National Tax.

 

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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.