Second Circuit Court of Appeals Reverses Tax Court and Permits Expensing of Royalty Payments Incurred on Sales of Inventory
In Robinson Knife Manufacturing Company and Subsidiary v. Commissioner, __F.3d__(3/19/2010), the Second Circuit, as set forth in the opinion of Judge Calabresi, held that the petitioner-appellant should be allowed to deduct sales-based trademark royalty payments instead of being required to capitalize such costs as was the decision of the Tax Court below, T.C. Memo 2009-9 and the government’s position throughout. See 26 USC §263A. The taxpayer had deducted the royalties under §162(a) as ordinary and necessary business expenses. The Second Circuit held that where a producer's royalty payments (1) are calculated as a percentage of sales revenue from inventory and (2) are incurred only upon the sale of that inventory, they are immediately deductible as a matter of law because they are not "properly allocable to property produced" per Treas. Reg. § 1.263A-1(e).
In comments cited in the tax press, a representative of the Treasury Office of Tax Legislative Counsel, acknowledged that it has two concerns with the holding in Robinson Knife which it intends to address in regulations on pre-production period costs. The first is that even though Treasury received a number of comments requesting that sales-based costs be deductible, the final §263A regulations only provided for the exclusion for commissions to authors. In contrast, the Second Circuit accepted the argument that sales based royalties were deductible and read into the regulations what the Treasury intentionally omitted in finalizing the regulations. The second concern involves separating the cost from the underlying right received. The Second Circuit merely looked at the cost, i.e., if the cost is triggered at sale, it’s not capitalizable.
A Closer Look At Robinson Knife.
The taxpayer, Robinson Knife, designs, manufactures and markets kitchen tools and in designing a product selects a brand name which it may own or if not, enter into a licensing agreement. The products in issue here were sold with licensing rights to the brand name owned by third parties. In this case the licensed trademarks were “Pyrex” and “Oneida”. The agreements gave Robinson the exclusive right to manufacture, distribute, and sell certain types of kitchen tools using the licensed brand names. In return, Robinson agreed to pay each trademark owner a percentage of the net wholesale billing price of the kitchen tools sold under that owner's trademark. No minimum or lump-sum royalty payment was required, nor did royalties for any kitchen tools accrue at any time before the tools were sold. Thus, Robinson could design and manufacture as many Pyrex or Oneida kitchen tools as it wanted without paying any royalties unless and until Robinson actually sold the products. For the years in issue, 2003 and 2004, Robinson paid royalties to the owners of the trademarks of close to $4M. Upon review of the tax returns, the IRS proposed an assessment in income tax on the basis that the licensing payments must be charged to capital and deducted over time in accordance with its method of inventory accounting. See Treas. Reg. §1.263A-1(c)(4). See also INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 83-84 (1992). The Tax Court agreed with the Service and held that under the regulations to §263A, the royalty payments directly benefited Robinson's production activities and/or were incurred by reason of those activities. It also held that the royalties were not "marketing" costs exempt from § 263A capitalization under those regulations. The Second Circuit addressed the issue on appeal as one of “law” and not as a mixed question of law and fact.
After reviewing the legislative history to §263A, enacted in 1986, the Court noted that the statute, in particular §263A(b)(1), requires that for tangible personal property produced by the taxpayer, both "the direct costs of such property, and . . . such property's proper share of those indirect costs (including taxes) part or all of which are allocable to such property," shall be included in inventory costs if it is inventory in the hands of the taxpayer. In this case while Robinson does not manufacture kitchen tools itself, i.e., such manufacturing takes place in China and Taiwan it still "produces" the kitchen tools within the statutory definition of that term. See § 263A(g)(2). Under the regulations to §263A, the so-called INDOPCO regulations, taxpayers “must capitalize all direct costs and certain indirect costs properly allocable to property produced. . . ." Treas. Reg.§ 1.263A-1(e)(1). Direct costs consist primarily of materials and labor, which the parties agreed would not apply to the royalty payments As to indirect costs, the regulation states the following:
“Indirect costs are defined as all costs other than direct material costs and direct labor costs (in the case of property produced). . . . Taxpayers subject to section 263A must capitalize all 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. Indirect costs may be allocable to . . . other activities that are not subject to section 263A. Taxpayers subject to section 263A must make a reasonable allocation of indirect costs between production . . . and other activities.” Treas. Reg.§ 1.263A-1(e)(3)(i).
Paragraphs (ii) and (iii) of the regulation provides "[e]xamples of indirect costs required to be capitalized," and "[i]ndirect costs not capitalized," respectively. One of the items on the list is:
“(U) Licensing and franchise costs. Licensing 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. . . . 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.” Treas. Reg. § 1.263A-1(e)(3)(ii)(U). However, the regulation provides that selling and distribution costs, such as costs involved in “marketing, selling, advertising, and distributing” inventory property are not required to be capitalized. Treas. Reg. § 1.263A-1(e)(3)(iii)(A). This process involves allocating certain costs or expenses that must be capitalized and those that can be expensed. There are several methods provided under the regulations. See, e.g., Treas. Reg. §1.263A-1(f) (“facts and circumstances method”); Treas. Reg. §1.263A-2(b)(“simplified production method” which allocates a pool of costs between ending inventory and cost of goods sold). The simplified production method, the Court noted, is administratively cheaper but can yield distortion of income unfavorable to the taxpayer because it can force the taxpayer to allocate costs to ending (i.e., ongoing) inventory when a more accurate method would have permitted much quicker cost recovery by allocating most or all of those same costs to inventory that was sold. Robinson elected the simplified production method.
The opinion noted that were the allocation methods to work “perfectly” no case would have been required to be litigated here and every dollar paid by Robison for sales-based royalties would be matched with those items actually sold. In such instance the royalties should be expensed or its cost recovered immediately and not capitalized. Under the Service’s approach, a substantial portion of the royalties would be allocated to ending inventory to be recovered against taxable income in a later year.
Robinson argued for immediate expensing on three grounds: (1) as "marketing, selling, advertising, [or] distribution costs," Treas. Reg. § 1.263A-1(e)(3)(iii)(A); (2) payments are not "incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced," and, as such are always deductible perTreas. Reg. § 1.263A-1(e)(3)(ii)(U); or, (3) the payments were not "properly allocable to property produced," Treas. Reg. § 1.263A-1(e)(3)(i).
Aware that it was the first appellate court to address the issue of royalties under the INDOPCO regulations, it rejected Robinson’s first two arguments as involving circumstances well beyond the facts of the case, but agreed on the third ground, that the royalty payments which are (1) calculated as a percentage of sales revenue from certain inventory, and (2) incurred only upon sale of such inventory, are not required to be capitalized under the § 263A regulations.
