The final regulations [PDF 214 KB] adopt changes to the simplified production method and the simplified resale method of allocating capitalized costs between ending inventory and cost of goods sold as proposed in a December 2010 issuance of proposed regulations. The final regulations include modifications made in response to comments to the proposed regulations.
The final regulations also request comments concerning the treatment of sales-based vendor allowances that are other than chargebacks (described below).
The December 2010 proposed regulations clarified that sales-based royalties—like other royalties—may be “capitalizable” to property a taxpayer produces or acquires for resale, but the proposed regulations also provided that sales-based royalties required to be capitalized are allocable only to property that a taxpayer has sold.
In the preamble to the proposed regulations, the IRS and Treasury examined the decision of the Second Circuit in Robinson Knife Manufacturing Co. v. Commissioner (royalties for right to use certain trademarks in manufacturing kitchen tools not allocable to the property produced because the taxpayer’s royalty payments were calculated as a percentage of net sales and were incurred only on the sale of the product; thus, royalty costs not capitalizable under the section 263A regulations).
The IRS and Treasury found that the Second Circuit in Robinson Knife had “misconstrued” the nature of costs required to be capitalized, and the December 2010 proposed regulations explained that royalties are the “costs” associated with the right to use intellectual property—such as copyrighted works or patented inventions.
Accordingly, sales-based royalties that directly benefit or are incurred by reason of production or resale activities are capitalizable licensing and franchise costs within the meaning of Reg. section 1.263A-1(e)(3)(ii)(U).
Concerning a sales-based vendor allowance—defined as an allowance, discount or price rebate that a taxpayer earns as a result of selling a vendor’s merchandise (typically at a temporarily reduced price)—the December 2010 proposed regulations were issued to clarify that a sales-based vendor allowance is an adjustment to the cost of the merchandise sold or deemed sold under the taxpayer’s cost flow assumption.
Finally, the proposed regulations provided that sales-based royalties and sales-based vendor allowances are allocable to the units of property sold—or deemed sold under the taxpayer’s cost flow assumption—and are not included in determining the inventory cost or value of goods on hand at the end of the tax year under any inventory method.
Because the proposed regulations expressly allocated sales-based royalties and sales-based vendor allowances to property that has been sold or deemed sold, they revised the simplified production and simplified resale methods to remove costs (such as capitalizable sales-based royalties) and cost reductions (such as sales-based vendor allowances) which had been properly allocable to property that has been sold, from the formulas used to allocate additional section 263A costs to ending inventory.
Read TaxNewsFlash-United States [PDF 40 KB] for an initial description of the proposed regulations.
As explained in the preamble to the final regulations, the changes concerning sales-based royalties adopted in the final regulations include the following amendments in response to comments made to the proposed regulations.
- Because of concerns that the requirement to allocate sales-based royalties only to cost of goods sold could unduly burden taxpayers using simplified allocation methods, the final regulations provide that the allocation of sales-based royalties to property sold is optional rather than mandatory.
- The final regulations accordingly permit taxpayers either (1) to allocate sales-based royalties entirely to property sold and include those costs in cost of goods sold or (2) to allocate sales-based royalties between cost of goods sold and ending inventory using a facts-and-circumstances cost allocation method (described in Reg. section 1.263A-1(f)) or a simplified method provided in Reg. section 1.263A-2(b) (the simplified production method) or Reg. section 1.263A-3(d) (the simplified resale method).
- The final regulations clarify that sales-based royalties that a taxpayer allocates entirely to inventory property sold are included in cost of goods sold and may not be included in determining the cost of goods on hand at the end of the tax year regardless of the taxpayer’s cost flow assumption.
The changes made in response to comments concerning sales-based vendor allowance provisions include the following:
- In response to a suggestion that the regulations be revised to provide that a sales-based vendor allowance may properly reduce the value of goods on hand at the end of the tax year, the final regulations provide that a vendor allowance does not reduce the cost of goods sold merely because the allowance is dependent on a sale of merchandise. The preamble to the final regulations states that the proposed regulations “were overbroad” because they required taxpayers to allocate to cost of goods sold all allowances that arise from selling merchandise.
- The final regulations narrow the definition of a sales-based vendor allowance that is allocated entirely to cost of goods sold.
Sales-based vendor chargebacks
In response to comments that the proposed regulations were overbroad, the IRS and Treasury announced they considered alternatives to a broad definition of sales-based vendor allowances.
The final regulations specifically identify one type of sales-based vendor allowance—sales-based vendor chargebacks—that, in order clearly to reflect income, reduces cost of goods sold and does not reduce the cost of goods on hand at the end of the tax year. Therefore, the final regulations apply the rule articulated in the proposed regulation for sales-based vendor chargebacks.
However, with respect to sales-based vendor allowances that are other than chargebacks, the final regulations reserve rules for the treatment of such other sales-based vendor allowances. Instead, the IRS and Treasury are requesting 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. Comments are due 90 days after the proposed regulations are published in the Federal Register on Monday, January 13, 2014.
The final regulations apply for tax years ending on or after January 13, 2014