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Second Circuit Reverses Tax Court on Deductibility of Sales-Based Royalties

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April 08, 2010

The Second Circuit Court of Appeals has reversed the Tax Court's holding (TC Memo 2009-9) in Robinson Knife Manufacturing Co. v. Commissioner (No. 09-1496) on the deductibility of sales-based royalties under Section 263A.

The Tax Court had held that a taxpayer manufacturing kitchen tools was required to capitalize, under Section 263A, certain sales-based royalties that it paid for use of licensed trademarks. The Second Circuit instead held that sales-based royalty payments (i.e., royalty payments triggered by the sale of merchandise as opposed to the production of merchandise) are deductible because they are not indirect production costs under Section 263A.

The taxpayer used the simplified production method to allocate inventoriable costs between cost of goods sold and ending inventory. After designing certain kitchen tools, the taxpayer entered into contracts with companies owning well respected, trademarked brand names. The contracts allowed the taxpayer to use certain trademarks on products designed by the taxpayer. The contracts were entered into prior to production commencing. Under the contracts, royalties were incurred only when products were sold, not at the time products were produced. The taxpayer did not capitalize the royalty costs under Section 263A, but deducted them instead.

When the issue was litigated at the Tax Court, the IRS claimed that the royalty costs were indirect production costs, arguing that the taxpayer could not have legally manufactured the products with the trademark but for the agreement. Treasury Reg. Sec. 1.263A-1(e)(3) describes indirect production costs as those costs that directly benefit production or are incurred by reason of the performance of production. Treas. Reg. Sec. 1.263A-1(e)(3)(ii)(U) includes licensing and franchising costs in the non-exclusive list of indirect costs that must be capitalized to the extent they relate to the production process. The taxpayer argued that its royalty costs were not licensing and franchising costs as described in that regulation section, but were marketing expenses exempt from capitalization under Treas. Reg. Sec. 1.263A-1(e)(3)(iii)(A).

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The Tax Court rejected the taxpayer's argument and said that the taxpayer's royalty costs were licensing and franchising costs as described in the regulations. Further, the Tax Court stated that acquiring the right to use the trademarks related to the taxpayer's production process. Consequently, the royalties paid directly benefited petitioner's production activities and/or were incurred by reason of petitioner's production of the licensed products and were therefore indirect costs properly allocable to the licensed products produced by the taxpayer.

The taxpayer also argued that, even if the royalty costs were indirect production costs, such costs should not be associated with ending inventory because the costs were incurred only in connection with sold items. However, because the taxpayer used the simplified production method described in Treas. Reg. Sec. 1.263A-2(b) to allocate other additional Section 263A costs, the Tax Court agreed with the IRS that the taxpayer was required to use the simplified production method for all direct and indirect costs subject to Section 263A, including the subject royalty costs. The court acknowledged that because the simplified production method is intended to ease the administrative burdens of Section 263A, by its nature it may result in an allocation that is not as precise as other specific cost allocation methods. Therefore, the Tax Court rejected the taxpayer's claim that including these costs in the simplified production method distorted income because, in fact, these costs were attributable to items that were no longer in ending inventory (sold items).

On appeal to the Second Circuit, the taxpayer argued that: (1) the royalty payments were deductible as marketing, selling, advertising or distribution costs; (2) the royalty payments that 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" are always deductible; and (3) the royalty payments at issue were not "properly allocable to property produced." The Second Circuit rejected the taxpayer's first two arguments, but accepted the taxpayer's third argument.

Addressing the taxpayer's third argument (i.e., that the costs were not properly allocable to property produced), the Second Circuit stated that the Tax Court opinion confuses the "license agreements" with the "royalty costs." Specifically, the Second Circuit stated that while the Tax Court asked whether the license agreement benefitted production, it did not ask whether the "royalty costs" directly benefitted or were incurred by reason of the production process. The Second Circuit stated that royalties like those in the Robinson Knife case do not "directly benefit," and are not incurred by reason of, the performance of production activities. The Second Circuit stated that while the Tax Court was correct that the taxpayer could not have produced the products without the license agreements, it was clear that the taxpayer could have produced products without incurring a royalty. Therefore, the royalty costs did not directly benefit production and were not incurred by reason of the production process.

In support of its conclusion, the Second Circuit cited to the regulatory and legislative history, as well as Treas. Reg. Sec. 1.263A-2(a)(2)(ii)(A)(1), which distinguishes between personal property and intangible property. That regulation section makes the point that the cost of producing and developing books does not include commissions for sales of books that have already taken place. The Second Circuit stated that "it would similarly be 'inappropriate' for a kitchen tool manufacturer to capitalize trademark royalties where such royalties are based only on those kitchen tools that have been sold by the manufacturer, and not on any kitchen tools that are still on hand."

Accordingly, the Second Circuit held that the taxpayer may deduct royalty payments that: (1) are calculated as a percentage of sales revenue from certain inventory and (2) are incurred only upon the sale of such inventory.

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