Royalty payments not subject to capitalization under Sec. 263A.

• Author: O'Connell, Frank J., Jr.

A recent Second Circuit decision provides a potential opportunity for taxpayers that will incur royalty payments to structure the agreements in such a manner that they can immediately deduct royalty costs instead of capitalizing them under the uniform capitalization rules of Sec. 263A. In Robinson Knife Manufacturing Co., No. 09-1496-ag (2d Cir. 3/19/10), the court ruled that a taxpayer involved in manufacturing could currently deduct trademark licensing royalty payments if the payments were calculated as a percentage of sales revenue from certain inventory and were incurred upon the sale of that inventory. The court's interpretation of Sec. 263A and the regulations thereunder may give taxpayers an opportunity to structure licensing and franchise agreements in such a way that they may deduct royalties paid under such agreements currently instead of capitalizing them to inventory.

Costs Allocable to Inventory

Sec. 263A provides that in the case of property that is inventory in the hands of a taxpayer, certain direct and indirect costs otherwise deductible by the taxpayer must be capitalized as inventory costs. The taxpayer generally recovers the capitalized costs as it sells the inventory. Sec. 263A applies to property produced by the taxpayer or property acquired for resale.

Sec. 263A provides that inventory costs include direct material and direct labor costs as well as an allocation of indirect costs. The regulations define indirect costs as all costs other than direct material and direct labor costs or acquisition costs that directly benefit or are incurred by reason of the performance of production activities. When indirect costs are also allocable to other activities not subject to Sec. 263A, the taxpayer must make a reasonable allocation of indirect costs between production and other activities.

The regulations list examples of indirect costs that are inventoriable to the extent they are properly allocable to produced property or property acquired for resale. Allocable indirect costs include certain taxes, depreciation, and environmental remediation costs, among other costs. Also listed are licensing and franchise costs, as discussed below. Taxpayers must analyze their costs to determine whether the costs directly benefit, or are incurred by reason of, a production activity. The regulations also specifically provide that certain costs, including marketing, selling, advertising, and distribution expenses, are not subject to capitalization and are therefore currently deductible.

Licensing, Franchise, and Royalty Costs

Indirect costs, such as licensing, franchise, and royalty payments, may relate to both inventory and noninventory operations; as such, they must be analyzed to determine whether the costs relate to inventory operations. The regulations specify that allocable indirect costs include licensing and franchise fees incurred to secure the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced or acquired for resale. Such costs include the otherwise deductible portion of the initial fees incurred to obtain the license or...