Prop. Regs, on sales-based royalties and vendor allowances.

• Author: Weber, Neal A.

On December 16, 2010, the IRS issued much-anticipated proposed regulations on the capitalization and allocation of sales-based royalties, and on adjustments to the cost of merchandise inventory for sales-based vendor allowances (REG-149335-08). Whether sales-based royalties are properly treated as a selling expense or an inventoriable cost has been a controversial issue that the IRS and Treasury have been working on as part of their combined Priority Guidance Plan.

The proposed regulations generally require taxpayers to treat sales-based royalties as capitalized production costs that may be recovered immediately through cost of goods sold. With respect to sales-based vendor allowances, the proposed regulations follow a field directive (LMSB-04-0910-026) recently issued by the Large Business & International (LB&I) Division, advising that under Sec. 471, sales-based vendor allowances (SBVAs) should be treated as purchase price adjustments to inventory, not income. Consistent with the directive, the proposed regulations provide that taxpayers should treat SBVAs as purchase price adjustments. However, the regulations clarify that such adjustments are to be made to the cost of merchandise sold, or deemed sold, under the taxpayer's cost flow assumption using reasoning similar to that applied to capitalizable sales-based royalties (Prop. Regs. Sees. 1.263A - l(e) (3)(ii)(U) and 1.263A - 3(e)). The proposed regulations also revise the simplified production and resale methods and address how these items affect the retail inventory method under Regs. Sec. 1.471-8, as discussed below.

Sales-Based Royalties

Sec. 263A and its accompanying regulations require taxpayers to capitalize the direct and indirect costs allocable to property produced or acquired for resale. These costs must be capitalized without regard to when they are incurred (i.e., regardless of whether incurred before, during, or after the production period) (Regs. Sec. 1.263A - 2(a)(3)). Moreover, indirect costs are allocable to property that the taxpayer has produced or acquired for resale when the costs directly benefit, or are directly incurred because of, production or resale activities (Regs. Sec. 1.263A - l(e) (3)(i)). The regulations provide a detailed, nonexclusive list of indirect costs that may be capitalizable. Licensing and franchising costs are included in this list. Specifically, Regs. Sec. 1.263A - l(e)(3)(ii)(U) provides that

[l]icensing and franchise costs include fees 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. These costs include the otherwise...