Not All Royalty Costs Are Capitalized

In a case decided this month, Robinson Knife sees a tax court ruling reversed in its favor.

Robinson Knife Manufacturing Co. is a corporation in the business of designing, manufacturing, and marketing kitchen tools. During the years at issue, Robinson used two well-known licensed trademarks: Pyrex and Oneida. The agreements gave Robinson the exclusive right to manufacture, distribute, and sell certain kitchen tools using the licensed brand names. In return, the company 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 deducted the payments as ordinary and necessary business expenses under Section
162(a) of the Internal Revenue Code. The Internal Revenue Service determined that, under Section 263A, the royalty payments must be capitalized. The U.S. Tax Court found in favor of the IRS; however, the Second Circuit Court of Appeals reversed the tax court’s holding and ruled in favor of Robinson.1

Section 263A states the following about real or tangible personal property produced by the taxpayer: both the “direct costs” of the property and the property’s proper share of “indirect costs” — part or all of which are allocable to such property — are included in inventory costs if it is inventory in the hands of the taxpayer.

Regarding the Robinson case, the IRS did not claim that the royalty payments were direct costs. (Note that indirect costs are properly allocable to property produced when the costs directly benefit or are incurred by reason of the performance of production activities.2)

According to Robinson, its royalty payments are marketing, selling, advertising, or distribution costs; this variety of costs is deductible. But the tax court disagreed: it contended that the regulations specifically list fees incurred in securing the contractual right to use a trademark as an example of indirect costs that must be capitalized to the extent they are properly allocable to property produced. The court noted that if we were to accept Robinson’s view, we would effectively write the word “trademark” out of the regulation.

WillensFinal“The court observed that in this case, royalties like Robinson’s do not directly benefit and are not incurred by reason of the performance of production activities.” — Robert Willens

In reaching that conclusion, the court observed that in this case, royalties like Robinson’s do not directly benefit and are not incurred by reason of the performance of production activities. It is clear that Robinson could have manufactured the products, and did, without paying the royalty costs. Robinson could have manufactured the same quantity and type of kitchen tools and owed no royalties, so long as none of that inventory was ever sold bearing the licensed trademarks.

The circuit court held that it is the costs, not the contracts pursuant to which those costs are paid, that must be a “but for” cause of the taxpayer’s production activities in order for the costs to be properly allocable to those activities and subject to the capitalization requirement.3

In other words, had Robinson’s licensing agreements provided for nonsale-based royalties, such as manufacturing-based or minimum royalties, capitalization would have been required. Here, however, Robinson’s royalties were sales-based. They were calculated as a percentage of net sales and were incurred only upon the sale of those kitchen tools. They are, therefore, immediately deductible.

Thus, in the circuit court’s view, royalty payments that are calculated as a percentage of sales revenue from certain inventory, and incurred only upon the sale of such inventory, are not required to be capitalized.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

Footnotes
1 See Robinson Knife Manufacturing Co., Inc. v. Commissioner, _F.3d_ (2nd Cir. 2010).
2 See Reg. Sec. 1.263A-1(e)(3)(i).
3 The tax court stated that “without the licensing agreements, the taxpayer could not have manufactured branded kitchen tools.” The Second Circuit agreed with Robinson that the tax court’s reasoning confused the license agreements with the royalty costs.

 

 

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