In December 2010, the IRS and Treasury proposed regulations that required the allocation of sales-based royalties and vendor allowances exclusively to property that has been sold (or for inventory property, deemed sold under the taxpayer’s cost flow assumptions), rather than allowing the costs to be allocated between cost of goods sold and ending inventory.1 This approach fails to address whether particular payments (royalties or vendor allowances) were due as a result of actual sales or an acquisition of goods, or whether the sale evidenced the amount of, or timing of, payment for an obligation/incentive.
The IRS and Treasury recently released final regulations under Sections 263A and 471 regarding the allocation of sales-based royalties and sales-based vendor allowances.2 The final regulations modify the proposed regulations and allow various allocation approaches for sales-based royalties and provide specific allocation rules for sale-based vendor chargebacks.
By allowing various approaches for sales-based royalties, the IRS acknowledges the range of taxpayers and methods of reporting such payments. The changes result in more accurate cost allocations and streamline the approach used by taxpayers, especially taxpayers using a simplified method under Section 263A. Clarifying the treatment of sales-based vendor chargebacks, the IRS recognizes that it may be appropriate to treat these payments as a reduction to the cost of inventory on hand at year-end. Further, while the final regulations were pending, the IRS issued a field directive directing agents not to challenge a taxpayer’s position related to either sales-based royalties or sales-based vendor allowances.3 As a result of the final guidance, the IRS will likely update the directive to reflect the final regulations, which may result in enhanced scrutiny of these issues for taxpayers under examination.
Sales-Based Royalty Payments
Sales-based royalty costs are defined as fees, payments, or royalties that are paid with the sale of property.4 Section 263A requires the capitalization of royalty costs made to secure the contractual right to use a trademark, a corporate plan, a manufacturing procedure, a special recipe or another similar right associated with the production of property or the acquisition of property for resale.5 The proposed regulations provided that sales-based royalty costs were capitalized, and that such royalties were allocable exclusively to property that has already been sold.6
The Preamble to the proposed regulations referenced Robinson Knife Manufacturing Co. v. Commissioner,7 in which the Second Circuit Court of Appeals found that royalties paid for the right to use certain trademarks in manufacturing was not allocable to the property produced but treated as an otherwise deductible selling expense. The court determined that because the taxpayer’s royalty payments were calculated as a percentage of net sales and were incurred only on the sale of the product, the royalty costs were not capitalizable under the Section 263A regulations. Although the decision was acknowledged, the Preamble clarified that the IRS and Treasury determined that the Second Circuit “misconstrued” the nature of costs required to be capitalized. As such, the proposed regulations explained that royalties are “costs” associated with the right to use intellectual property, such as copyrighted works or patented inventions. Accordingly, the proposed regulations conclude that 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 Treas. Reg. 1.263A-1(e)(3)(ii)(U). When the rules were finalized, rather than revising its position to conform to the court’s analysis in Robinson Knife, the regulations instead focused on the disparate treatment arising for taxpayers under the proposed regulations. Concerns had been raised that the requirement to allocate sales-based royalties only to cost of goods sold would unduly burden taxpayers using simplified allocation methods for purposes of Section 263A.8 Consequently, the final regulations provide that the “allocation of sales-based royalties to property sold is optional rather than mandatory.”9
By loosening the allocation requirements, a taxpayer may either allocate sales-based royalties entirely to cost of goods sold or these amounts may be allocated between cost of goods sold and ending inventory using a facts-and-circumstances cost allocation method (described in Treas. Reg. §1.263A-1(f)) or a simplified method provided in Treas. Reg.§1.263A-2(b) (the simplified production method) or Treas. Reg. §1.263A-3(d) (the simplified resale method).
The final regulations further clarify that sales-based royalties allocated exclusively 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. In other words, the regulations ensure similar results regardless of whether the rules are being applied by FIFO or LIFO taxpayers.
Sales-Based Vendor Allowances
The 2010 proposed regulations also addressed sales-based vendor allowances, which are defined as an allowance, discount or price rebate that a taxpayer earns as a result of selling a vendor’s merchandise.10 Under the proposed regulations, these amounts are essentially included in gross income immediately.11 The proposed regulations specified that sales-based vendor allowances were allocable to the units of property sold (or deemed sold under the taxpayer’s cost flow assumption) and not included in determining the inventory cost or value of goods on hand at the end of the tax year under any inventory method.12
The Preamble to the final regulations explains that the revisions were included as a response to comments regarding the proposed regulations. The Preamble makes clear that the IRS and Treasury considered various alternative approaches for sales-based vendor allowances. Ultimately, the final regulations reserve treatment for all allowances other than sales-based vendor chargebacks. Vendor chargebacks are defined as an allowance, discount, or price rebate that a taxpayer becomes unconditionally entitled to by selling a vendor’s merchandise to specific customers identified by the vendor at a price determined by the vendor.13 The final regulations reserve the treatment of all other sales-based vendor allowances. Comments have been requested so that they can address a range of vendor allowances.
The final regulations highlight the importance of reviewing sales-based arrangements. In response to these regulations, royalty payment arrangements should be reviewed to evaluate and consider whether royalty payments are properly characterized as sales-based royalty payments. Because the final regulations provide flexibility in how these amounts are allocated, companies should consider whether they benefit from allocating costs exclusively to cost of goods sold or between cost of goods sold and ending inventory. If one approach is more beneficial, then changes should be considered either in business practices or by making an accounting method change.
Similarly, with sales-based vendor allowances, it is important to review these arrangements to determine whether arrangements qualify for the favorable treatment available for sales-based vendor chargebacks. Because treatment is less clear for other arrangements, companies should ensure that sales-based arrangements are properly treated as chargebacks to take advantage of the treatment allowed under the regulations.
1 On December 17, 2010, a Notice of Proposed Rulemaking (REG-149335-08) was published, Fed. Reg. Vol. 76, No. 195, p. 62327.
2 T.D. 9652 (January 10, 2014).
3 See IRS, Field Guidance on the Planning & Examination of Sales-Based Royalty Payments and Sales-Based Vendor Allowances, LB&I-04-0211-002 (March 1, 2011).
4 “Royalty costs are capitalizable when they are incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced or property acquired for Resale. Sales-based royalty costs are royalties that are incurred only upon the sale of property produced or acquired for resale.” Preamble to T.D. 9652 (January 13, 2014).
6 Supra, n.1.
7 2009 T.C. Memo ¶2009-009; rev’d in 600 F.3d 121, (2d Cir. 2010).
8 Taxpayers using one of the methods for purposes of Section 263A were required to make additional allocations to comply with the proposed regulations. Under the final regulations, these allocations can be made directly under the simplified approach.
9 Preamble to T.D. 9652 (January 10, 2014).
10 The proposed regulations required sales-based vendor allowances, which are rebates or discounts from a vendor as a result of selling the vendor’s merchandise, to be taken into account as an adjustment to the cost of goods sold.
11 Supra, n.1.
12 See Prop. Reg. § 1.263A-1(c)(5).
13 Treas. Reg. §1.471-3(e)(1)(i).