IRS Won't Acquiesce In 2nd Circuit Decision Allowing Deduction For Trademark Licensing Costs

AOD 2011-001, 02/09/2011

IRS has issued an action on decision (AOD) announcing its nonacquiescence with the Second Circuit's decision in Robinson Knife Manufacturing Co. & Subs. v. Comm., (CA 2 3/19/2010) 105 AFTR 2d 2010-1467. This case allowed a kitchen tool manufacturing company to currently deduct the sales-based royalties it paid under trademark licensing agreements. IRS determined that the Second Circuit “confused the timing with the purpose of the payments,” and that the payments were production costs under Reg. §1.263A-1(e)(3)(i) incurred in connection with the items' manufacture and were thus appropriately capitalized and allocated to inventory.

Background. Under the Code Sec. 263A capitalization rules, a taxpayer must include in inventory costs its direct costs (and some indirect costs) of producing property that is inventory in its hands. Direct costs include direct labor costs and material costs, e.g., the costs of the materials that become an integral part of specific property produced and the materials that are consumed in the production process and that can be identified or associated with particular units of property produced. (Reg. §1.263A-1(e)(2)(i)(A)) Indirect costs include all costs other than direct costs. Only some indirect costs are required to be capitalized. (Reg. §1.263A-1(e)(3)(i))

Licensing costs incurred in securing the contractual right to use a trademark or other similar right associated with property produced are indirect costs that must be capitalized (to the extent the costs are properly allocable to property produced). (Reg. §1.263A-1(e)(3)(ii)) On the other hand, marketing, selling, advertising, and distribution costs are indirect costs that are specifically excluded from the Code Sec. 263A capitalization rules. (Reg. §1.263A-1(e)(3)(iii))

Facts. Robinson Knife Manufacturing Co. (Robinson) is engaged in designing, developing, manufacturing, marketing, and selling kitchen tools and gadgets used in food preparation and service (kitchen tools). It markets and sells the kitchen tools to large retailers in the U.S. and Canada, including Wal-Mart and Sears. As part of its operations, it enters into licensing agreements for the right to use well-known trademarks in connection with some of the kitchen tools it produces and sells. In return, it generally pays the trademark licensors royalties based on a percentage of net sales of the kitchen tools bearing the licensors' trademarks (sales-based royalties).

During 2003 and 2004, Robinson had licensing agreements for the use of trademarks from Corning, Inc. (for the Pyrex brand) and Oneida, Ltd. It produced and sold kitchen tools using trademarks owned by them, and deducted the royalty payments as ordinary and necessary business expenses on its tax returns. On audit, IRS determined that the royalties had to be capitalized under Code Sec. 263A and allocated to its inventory.

Tax Court sided with IRS. The Tax Court concluded that Robinson's acquisition of the right to use the Pyrex and Oneida trademarks was part of its production process, and that the royalties paid to Corning and Oneida directly benefited its production activities and/or were incurred by reason of its producing the trademarked kitchen tools. The license agreements gave Robinson the right to manufacture the Pyrex- and Oneida-branded kitchen tools, without which it couldn't have legally manufactured them, and the royalties were thus indirect costs properly allocable to the Pyrex- and Oneida-branded kitchen tools that Robinson produced. In so holding, it rejected Robinson's argument that the royalties paid to Corning and Oneida were deductible marketing expenses that were exempt from the capitalization rules. (Robinson Knife Manufacturing Co., Inc., TC Memo 2009-9)

Second Circuit reversed. On appeal, the Second Circuit found that the Tax Court's reasoning confused the license agreements with the royalty costs. It determined that Robinson's royalties were not “incurred by reason of,” and didn't directly benefit, its production activities. Looking to the plain text of Reg. §1.263A-1(e)(3)(i), the Court found that it is the actual costs of producing and developing an item, and not the contracts pursuant to which those costs are paid, that are subject to the capitalization requirement. The Second Circuit stressed that Robinson's royalties were sales-based—calculated as a percentage of net sales of kitchen tools and incurred only upon the sale of those kitchen tools—and as such were immediately deductible. (Robinson Knife Manufacturing Co. & Subs. v. Comm., (CA 2 3/19/2010) 105 AFTR 2d 2010-1467)

Issuance of proposed regs. On Dec. 17, 2010, in response to the Second Circuit's decision, IRS issued proposed regs stating that sales-based royalties are production costs required to be capitalized under Code Sec. 263A and allocated to inventory sold during the taxable year. (Prop Reg §1.263A-1(c)(5)) IRS stated that the Second Circuit “misconstrued the nature of costs required to be capitalized,” noting that the fact that the amount of sales-based royalties is determined by reference to the number of units sold affects only the timing of when that amount is incurred, but does not change an otherwise capitalizable production cost into a non-capitalizable cost. The proposed regs further clarified that an indirect cost may directly benefit, or be incurred by reason of, the performance of production or resale activities, even if the costs are incurred only upon the sale of inventory. (Prop Reg §1.263A-1(e)(3)(i))

IRS nonacquiesces. In the AOD, IRS stated that it disagreed with the Second Circuit's reasoning and that it wouldn't follow the Courts holding, except in cases appealable to the Second Circuit (i.e., those in New York, Connecticut, and Vermont).It opined that the Second Circuit confused the timing with the purpose of the payments, reasoning that Robinson incurred the royalty expenses first to produce the trademarked items, then to sell them. In the end, IRS agreed with the Tax Court that Robinson incurred the royalty expenses “by reason of” its production activities, so the royalty payments were “production costs” under Reg. §1.263A-1(e)(3)(i) and not currently deductible expenses under Code Sec. 162.

Observation: In Mayo Foundation for Medical Education and Research, et al. v. U.S. (S Ct 1/11/2011) 107 AFTR 2d 2011-341, the Supreme Court stated that interpretive IRS regs are entitled to heightened Chevron deference. Thus, the outcome of this issue might be resolved upon finalization of the proposed regs.

References: For the uniform capitalization rules, see FTC 2d/FIN ¶G-5450; United States Tax Reporter ¶263A4; TaxDesk ¶456,000; TG ¶16100.