Sales-based royalties and vendor allowances.

• Author: Van Leuven, Mary

In December 2010, Treasury proposed new regulations (REG-149335-08) that address two issues regarding the computation of inventory values. The first relates to the capitalization and allocation of royalties incurred only upon the sale of property produced or property acquired for resale (sales-based royalties). The second issue concerns the adjustment of the cost of merchandise inventory for an allowance, discount, or price rebate based on merchandise sales (sales-based vendor allowances).

Sales-Based Royalties in the Prop. Regs.

As evidenced by recent litigation and technical memorandums, the capitalization of sales-based royalties into inventory under the uniform capitalization rules of Sec. 263A and the related regulations (UNICAP rules) has created contention between taxpayers and the IRS. If enacted, recently proposed regulations would help alleviate the disagreement as to the capitalization of sales-based royalties when using a simplified method. With regard to sales-based royalties, the proposed rules specifically address the Second Circuit's decision in Robinson Knife Mfg. Co., 600 F.3d 121 (2d Cir. 2010), nonacq., AOD 2011-01 (2/8/11).

Under the simplified methods found in the UNICAP rules, a ratio multiplied by ending inventory value determines the amount of costs requiring capitalization to inventory for tax purposes, if any, in addition to any costs already capitalized on a taxpayer's financial statements. The ratio for the simplified production method is (1) the total additional Sec. 263A costs incurred during the year to (2) total Sec. 471 costs incurred during the year. Thus, any amounts capitalized as additional Sec. 263A costs such as sales-based royalties, in part, become capitalized to ending inventory under those simplified methods, even though the sales-based royalties are not incurred until the goods are sold.

Prior to the proposed regulations, the IRS challenged taxpayers that excluded sales-based royalties from additional Sec. 263A costs and therefore from capitalization under Sec. 263A. The Second Circuit, however, decided for the taxpayer in Robinson Knife, allowing exclusion of sales-based royalties from capitalization. The language in the proposed regulations requires capitalization of the sales-based royalties but allocates those costs only to inventory that is already sold. Because cost of goods sold already includes the basis of such inventory, taxpayers effectively deduct those costs as sales are made.

Background

Matters regarding the capitalization of royalties first came to light in 2001 when the Tax Court decided Plastic Engineering & Tech...