M&A may be exciting (or at least as exciting as tax law gets), but the bread and butter of corporate tax practice is in reducing current year taxable income and the best way to do that is to ensure that costs paid in the year don’t have to be capitalized. Significant help is provided for writing off royalty expenses by a new case of first impression under Treas.
Robinson Knife Manufacturing Co. v. CIR, 105 AFTR 2d 2010-XXXX (2d Cir. 2010), allowed the immediate deduction of license royalty payments as they accrued on the sale of the licensed inventory, rather than requiring the royalties to be capitalized into inventory. The decision rejected the Service’s deficiency assessments, which would have shifted about 10 percent of the royalty payments into ending inventory for this FIFO taxpayer.
The key to obtaining the current deductions were the facts that:
- The license agreements made the royalties payable only upon the taxpayer’s withdrawal of the licensed products from inventory for sale, not upon their manufacture and
- The royalties were a percentage of the sale price.
Robinson contracted for the manufacture (usually outside the U.S.) of products such as knives and obtained trademark licenses (such as from Oneida and Pyrex) to allow it to have the licensors’ trademarks stamped on the knives. 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. Robinson was not required to make any minimum or lump-sum royalty payment, 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.
The percentage in the Pyrex agreement was eight percent (later changed to nine percent). The Oneida agreement provided that Robinson would pay 11 percent on net sales up to $1 million and then eight percent on net sales above $1 million. Robinson also agreed to contractual provisions that were designed to protect the value of the licensed trademarks, as is typical in trademark-licensing agreements. Before selling a branded product, Robinson had to get the trademark owner's approval of the product's design, its packaging and any promotional materials. Robinson further agreed not to engage in conduct that would damage the goodwill or value of the licensed trademarks.
The issue was whether Robinson could deduct the royalties when they accrued upon sale of inventory or had to capitalize the royalties into inventory. The Service claimed that Reg. 1.263A-1(e)(2) required capitalization of the royalties as “indirect costs” that “directly benefit or are incurred by reason of the performance of production ... activities.” Robinson used the FIFO inventory method and generally capitalized its production costs under the “simplified production method.” Reg. 1.263A-2(b).
However, Robinson did not apply the simplified production method to its royalties, but instead deducted them as paid. The Service determined a deficiency, asserting that the simplified production method must be applied to the royalties and, as a result, ending inventory for 2003 and 2004 should have reflected about 10 percent of the royalty costs that Robinson deducted. Robinson disagreed and petitioned the Tax Court. The Tax Court agreed with the Service that the costs had to be capitalized under the simplified production method. Robinson appealed.
Analysis on Appeal
The Court of Appeals saw the issue as whether the royalty payments were related to the making of the products. The court ruled they were not and so the payments did not have to be capitalized.
First, however, the Court of Appeals rejected the taxpayer’s arguments that the royalties were selling or marketing expenses that did not have to be capitalized into inventory and also rejected the argument that they were not incurred in securing the trademark right, which they clearly were. But the Court agreed with the taxpayer on its third argument: that the royalties did not come within the requirement of Reg. 1.263A-1(e)(2) that the payments be “properly allocable to property produced.” The opinion stated:
The Treasury regulations provide that “[i]ndirect costs are properly allocable to property produced ... when the costs directly benefit or are incurred by reason of the performance of production ... activities.” 26 C.F.R. § 1.263A-1(e)(3)(i) (emphasis added). The Tax Court did not ask whether the royalty costs “directly benefit[ed] or [were] incurred by reason of the performance of production ... activities.” Instead, the Tax Court asked whether the license agreements did so. But that is not what the regulation's language (and sensible intent) goes to.
This issue is on the Treasury’s 2009-2010 business plan as “Guidance under § 263A regarding the treatment of post-productions costs such as sales based royalties.” The opinion’s last footnote pointedly tells the Treasury that if it wants to change the law it must change the regulation, at least in the Second Circuit.
Trademark licensing agreements of the sort at issue in the Robinson case are very common. However, the particular terms describing when payments are due vary widely:
- Licensees who have been capitalizing such royalties should examine their agreements to determine whether the royalties can be expensed
- Licensees who have the flexibility to revise their royalty agreements to meet the standards of the Robinson test should do so.
- Licensors should be cooperative in providing such royalty agreements, because tax savings to the licensees can benefit the licensors.
|Rate this article 5 (excellent) to 1 (poor). Send your responses here
John Baron, JD, is the lead partner of the Charlotte office’s Tax Group and partner-in-charge of the Charlotte office, Alston & Bird LLP, Charlotte. Clay Littlefield, JD, is a partner with Alston & Bird LLP, Charlotte. 704 444-1440. Littlefield previously served in the Financial Institutions and Products Division of IRS Chief Counsel. Both Baron and Littlefield are attorneys in the Federal Tax Group.