By James L. Atkinson & Dwight N. Mersereau, Miller & Chevalier Chartered
The IRS has issued proposed regulations (REG-149335-08) affecting taxpayers required to pay “sales-based royalties” upon the sale of inventory. The guidance, issued in the form of proposed regulations under the “uniform capitalization rules” of section 263A, largely is taxpayer favorable and may confer substantial tax benefits on affected companies. The proposed rules affect how quickly a taxpayer may recover royalty costs that become due only upon the sale of the inventory to which they relate.
For example, a sales-based royalty would include a royalty owed to a third party for the taxpayer’s incorporation of a trademark into items manufactured by the taxpayer, so long as the royalty becomes due and payable only with respect to the units sold to third-parties. The Second Circuit Court of Appeals recently held that such royalties are more akin to selling expenses than to production costs and are beyond the capitalization requirement of section 263A (Robinson Knife Mfg. Co. v. Commissioner, 300 F.3d 121, 2d Cir. 2010).
The proposed regulations adhere to the IRS’s disagreement with Robinson Knife’s conclusion that certain sales-based royalties are currently deductible selling expenses. Instead, the proposed regulations would require anyone selling inventory items to capitalize royalties having a sufficient nexus to the taxpayer’s production activities, even if those royalties are incurred only upon the sales of inventory (suggesting without stating that some sales-based royalties may in fact remain outside the scope of section 263A).
Additionally, the regulations would allow taxpayers to recover capitalized sales-based royalties entirely in the year incurred by treating them as allocable to items sold during the year and includible in the year’s cost of goods sold. Previously, some IRS examination teams had taken the position that some portion of the sales-based royalty is allocable to items remaining in ending inventory, precluding the taxpayer from recovering the entire royalty in the year incurred.
As a practical matter, treating the entire royalty as a cost of goods sold places the taxpayer in a similar position as if the costs were currently deductible. The proposed regulations allow the IRS to adhere to its view that such royalties must be treated as production costs while acceding to the Second Circuit’s view that where the royalty relates to an item that is sold during the year, the cost can be recovered immediately.
The distinction between Robinson Knife and the proposed regulations lies in how the royalty is recovered rather than in when. For many taxpayers, this distinction does not affect the bottom-line tax result. However, there may be unfavorable, collateral consequences for others.
If finalized, the proposed regulations may allow taxpayers paying sales-based royalties to recover those costs more quickly than their current tax accounting method allows. The extent of the potential tax benefit will depend largely on the taxpayer’s current tax accounting treatment of sales-based royalties and the magnitude of those costs. The benefit will be available regardless whether the taxpayer uses a “simplified method” in applying the uniform capitalization rules.
Taxpayers incurring sales-based royalties will have an opportunity to request a change in accounting method to conform their present treatment of those costs to the treatment proposed by the regulations. Many taxpayers currently capitalizing sales-based royalties will obtain an immediate tax benefit as a result of the accounting method change. Even taxpayers already deducting royalties can obtain a benefit from changing to the method described in the proposed regulations. By properly changing their method of accounting, they will obtain “audit protection” for prior years. The IRS generally requires taxpayers to wait for proposed regulations to be finalized before implementing associated accounting method changes.
Finally, the proposed regulations are likely to end disputes immediately with IRS examination teams as to the proper treatment of sales-based royalties. While this has been a frequent audit issue for manufacturers in recent years, the proposed regulations clearly signal the view of the National Office and of Treasury regarding the appropriate application of section 263A to these costs.