To capitalize or to expense: how sec. 263A treats royalties.

• Author: Suttora, John

The tax treatment of royalty payments--to capitalize or to expense--depends on the terms of the royalty agreements and, in some situations, the Sec. 263A uniform

capitalization rules. This item reviews certain authorities on the treatment of royalty payments, including the Tax Court's recent decision in Robinson Knife Manufacturing Co.

Overview

Regardless of the industry, manufacturers frequently enter into licensing agreements with third parties to obtain various rights for the production, sale, marketing, and distribution of goods. Whether it is a drug manufacturer licensing the rights to a patented compound or a producer of retail goods obtaining the right to use another company's trademark, licensing agreements appear to be standard in the world of production. What does not appear to be standard is the tax treatment of royalty payments made under the licensing agreements for purposes of Sec. 263A.

UNICAP Rules

The Sec. 263A uniform capitalization (UNICAP) rules require that all direct costs and certain indirect costs allocable to certain property be either (1) included in inventory costs or (2) capitalized, if the property is not inventory. Regs. Sec. 1.263A-1(e)(1) requires taxpayers subject to Sec. 263A to capitalize all direct costs and certain indirect costs properly allocable to property produced or property acquired for resale. Direct costs include direct material costs and direct labor costs for a producer and acquisition costs for a reseller (see Regs. Sec. 1.263A-1(e)(2)).

Taxpayers must capitalize indirect costs to the extent they are properly allocable to property produced or property acquired for resale. Regs. Sec. 1.263A-1(e)(3)(i) defines indirect costs as all costs other than direct material costs and direct labor costs (in the case of property produced) or acquisition costs (in the case of property acquired for resale). Indirect costs are properly allocable to property produced or property acquired for resale when the costs directly benefit or are incurred due to the performance of production or resale activities. Indirect costs may be allocable to both production and resale activities as well as to other activities not subject to Sec. 263A.

In the case of royalty expenses, tax treatment has been dependent on the nature and terms of the royalty paid as well as the method used to allocate the Sec. 263A costs. For example, if the taxpayer determines that the royalty payment is related solely to the right to sell, market...