The IRS recently released final regulations (T.D. 9652) under Sections 263A and 471 regarding the allocation of sales-based royalties and sales-based vendor allowances. The final regulations modify and replace proposed regulations were issued in December 2010.
Sales-based royalties are royalty costs incurred only upon the sale of property produced or acquired for resale. Royalty costs can be capitalized under Section 263A when they are incurred, in order to secure the contractual right to use a trademark, a corporate plan, a manufacturing procedure, a special recipe or another similar right associated with the production of property or the acquisition of property for resale.
The proposed regulations required sales-based royalties to be allocated to cost of goods sold. Under the final regulations, taxpayers can allocate sales-based royalties entirely to cost of goods sold (and therefore not capitalized to ending inventory) or between cost of goods sold and ending inventory using a facts-and-circumstances cost allocation method. The proposed and final regulations follow the decision in Robinson Knife Manufacturing v. Comm'r (No. 09-1496), in which the Second Circuit reversed a Tax Court decision and allowed a taxpayer to deduct sales-based royalties rather than treat them as costs that could be allocated to ending inventory under Section 263A.
The proposed regulations also defined sales-based vendor allowances very broadly, as the amount of an allowance, a discount or a price rebate that a taxpayer earns by selling specific merchandise. All sales-based vendor allowances were to be treated as a reduction of the cost of goods sold or deemed sold under the taxpayer's cost flow assumption. Upon receiving numerous comments, the IRS conceded that the definition of sales-based vendor allowances was too broad, and it modified the regulations. In the final regulations, only sales-based vendor chargebacks are required to be treated as a reduction of cost of goods sold. Sales-based vendor chargebacks are defined as an allowance, a discount or a price rebate to which a taxpayer becomes unconditionally entitled by selling a vendor's merchandise to specific customers identified by that vendor at a price determined by the vendor.
The final regulations reserve rules for the treatment of any other type of sales-based vendor allowance. Taxpayers with other types of vendor allowances will have to consider all of the facts and circumstances in determining an allocation method until further guidance is issued.
The IRS issued a field directive (LB&I-04-0211-002) in March 2011 directing agents not to challenge a taxpayer's position related to either sales-based royalties or sales-based vendor allowances. The IRS will likely update this directive in light of the final regulations being issued, especially because the final regulations do not address the treatment of all types of sales-based vendor allowances.
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