United States: Final Regulations Released Revising The Tax Treatment Of Sales-Based Royalties And Vendor Allowances

Last Updated: April 1 2014
Article by Ellen McElroy

In December 2010, the IRS and Treasury proposed regulations that required the allocation of sales-based royalties and vendor allowances exclusively to property that has been sold (or for inventory property, deemed sold under the taxpayer's cost flow assumptions), rather than allowing the costs to be allocated between cost of goods sold and ending inventory.1 This approach fails to address whether particular payments (royalties or vendor allowances) were due as a result of actual sales or an acquisition of goods, or whether the sale evidenced the amount of, or timing of, payment for an obligation/incentive.

The IRS and Treasury recently released final regulations under Sections 263A and 471 regarding the allocation of sales-based royalties and sales-based vendor allowances.2 The final regulations modify the proposed regulations and allow various allocation approaches for sales-based royalties and provide specific allocation rules for sale-based vendor chargebacks.

By allowing various approaches for sales-based royalties, the IRS acknowledges the range of taxpayers and methods of reporting such payments. The changes result in more accurate cost allocations and streamline the approach used by taxpayers, especially taxpayers using a simplified method under Section 263A. Clarifying the treatment of sales-based vendor chargebacks, the IRS recognizes that it may be appropriate to treat these payments as a reduction to the cost of inventory on hand at year-end. Further, while the final regulations were pending, the IRS issued a field directive directing agents not to challenge a taxpayer's position related to either sales-based royalties or sales-based vendor allowances.3 As a result of the final guidance, the IRS will likely update the directive to reflect the final regulations, which may result in enhanced scrutiny of these issues for taxpayers under examination.

Sales-Based Royalty Payments

Sales-based royalty costs are defined as fees, payments, or royalties that are paid with the sale of property.4 Section 263A requires the capitalization of royalty costs made 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.5 The proposed regulations provided that sales-based royalty costs were capitalized, and that such royalties were allocable exclusively to property that has already been sold.6

The Preamble to the proposed regulations referenced Robinson Knife Manufacturing Co. v. Commissioner, 7 in which the Second Circuit Court of Appeals found that royalties paid for the right to use certain trademarks in manufacturing was not allocable to the property produced but treated as an otherwise deductible selling expense. The court determined that because the taxpayer's royalty payments were calculated as a percentage of net sales and were incurred only on the sale of the product, the royalty costs were not capitalizable under the Section 263A regulations. Although the decision was acknowledged, the Preamble clarified that the IRS and Treasury determined that the Second Circuit "misconstrued" the nature of costs required to be capitalized. As such, the proposed regulations explained that royalties are "costs" associated with the right to use intellectual property, such as copyrighted works or patented inventions. Accordingly, the proposed regulations conclude that sales-based royalties that directly benefit or are incurred by reason of production or resale activities are capitalizable licensing and franchise costs within the meaning of Treas. Reg. 1.263A-1(e)(3)(ii)(U). When the rules were finalized, rather than revising its position to conform to the court's analysis in Robinson Knife, the regulations instead focused on the disparate treatment arising for taxpayers under the proposed regulations. Concerns had been raised that the requirement to allocate sales-based royalties only to cost of goods sold would unduly burden taxpayers using simplified allocation methods for purposes of Section 263A. 8 Consequently, the final regulations provide that the "allocation of sales-based royalties to property sold is optional rather than mandatory."9

By loosening the allocation requirements, a taxpayer may either allocate sales-based royalties entirely to cost of goods sold or these amounts may be allocated between cost of goods sold and ending inventory using a facts-and-circumstances cost allocation method (described in Treas. Reg. §1.263A-1(f)) or a simplified method provided in Treas. Reg.§1.263A-2(b) (the simplified production method) or Treas. Reg. §1.263A-3(d) (the simplified resale method).

The final regulations further clarify that sales-based royalties allocated exclusively to inventory property sold are included in cost of goods sold and may not be included in determining the cost of goods on hand at the end of the tax year, regardless of the taxpayer's cost flow assumption. In other words, the regulations ensure similar results regardless of whether the rules are being applied by FIFO or LIFO taxpayers.

Sales-Based Vendor Allowances

The 2010 proposed regulations also addressed sales-based vendor allowances, which are defined as an allowance, discount or price rebate that a taxpayer earns as a result of selling a vendor's merchandise.10 Under the proposed regulations, these amounts are essentially included in gross income immediately.11 The proposed regulations specified that sales-based vendor allowances were allocable to the units of property sold (or deemed sold under the taxpayer's cost flow assumption) and not included in determining the inventory cost or value of goods on hand at the end of the tax year under any inventory method.12

The Preamble to the final regulations explains that the revisions were included as a response to comments regarding the proposed regulations. The Preamble makes clear that the IRS and Treasury considered various alternative approaches for sales-based vendor allowances. Ultimately, the final regulations reserve treatment for all allowances other than sales-based vendor chargebacks. Vendor chargebacks are defined as an allowance, discount, or price rebate that a taxpayer becomes unconditionally entitled to by selling a vendor's merchandise to specific customers identified by the vendor at a price determined by the vendor.13 The final regulations reserve the treatment of all other sales-based vendor allowances. Comments have been requested so that they can address a range of vendor allowances.

Pepper Perspective

The final regulations highlight the importance of reviewing sales-based arrangements. In response to these regulations, royalty payment arrangements should be reviewed to evaluate and consider whether royalty payments are properly characterized as sales-based royalty payments. Because the final regulations provide flexibility in how these amounts are allocated, companies should consider whether they benefit from allocating costs exclusively to cost of goods sold or between cost of goods sold and ending inventory. If one approach is more beneficial, then changes should be considered either in business practices or by making an accounting method change.

Similarly, with sales-based vendor allowances, it is important to review these arrangements to determine whether arrangements qualify for the favorable treatment available for sales-based vendor chargebacks. Because treatment is less clear for other arrangements, companies should ensure that sales-based arrangements are properly treated as chargebacks to take advantage of the treatment allowed under the regulations.

Footnotes

1. On December 17, 2010, a Notice of Proposed Rulemaking (REG-149335-08) was published, Fed. Reg. Vol. 76, No. 195, p. 62327.

2. T.D. 9652 (January 10, 2014).

3. See IRS, Field Guidance on the Planning & Examination of Sales-Based Royalty Payments and Sales-Based Vendor Allowances, LB&I-04-0211-002 (March 1, 2011).

4. "Royalty costs are capitalizable when they are 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. Sales-based royalty costs are royalties that are incurred only upon the sale of property produced or acquired for resale." Preamble to T.D. 9652 (January 13, 2014).

5. Id.

6. Supra, n.1.

7. 2009 T.C. Memo ¶2009-009; rev'd in 600 F.3d 121, (2d Cir. 2010).

8. Taxpayers using one of the methods for purposes of Section 263A were required to make additional allocations to comply with the proposed regulations. Under the final regulations, these allocations can be made directly under the simplified approach.

9. Preamble to T.D. 9652 (January 10, 2014).

10. The proposed regulations required sales-based vendor allowances, which are rebates or discounts from a vendor as a result of selling the vendor's merchandise, to be taken into account as an adjustment to the cost of goods sold.

11. Supra, n.1.

12. See Prop. Reg. § 1.263A-1(c)(5).

13. Treas. Reg. §1.471-3(e)(1)(i).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Ellen McElroy
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions