The U.S. Court of Appeals for the Second Circuit held that a company’s royalty payments for the right to use certain trademarks could be currently deducted, reversing a Tax Court decision. Since the royalty payments were calculated using a percentage of sales, the Second Circuit held, the royalty cost was incurred only if inventory was sold; therefore capitalization of the cost was not required under the uniform capitalization (UNICAP) rules of IRC § 263A.
Congress passed section 263A to establish a single, comprehensive set of rules for the treatment of costs of producing, acquiring and holding inventory. Treas. Reg. § 1.263A-1(e)(3)(i) requires the capitalization of “all indirect costs properly allocable to property produced or property acquired for resale” and defines costs properly allocable to property as those “that directly benefit or are incurred by reason of the performance of production or resale activities.” The Treasury regulations provide a nonexhaustive list of indirect costs that must be capitalized and a list of costs (such as marketing, selling, advertising and distribution costs) that can be currently deducted. Under Treas. Reg. § 1.263A-1(e)(3)(ii)(U), the former include licensing and franchise costs including “fees incurred in securing the contractual right to use a trademark … associated with property produced or property acquired for resale.”
Robinson Knife Manufacturing Co. manufactured kitchen utensils that it sold under the Pyrex and Oneida names using trademark rights purchased from Corning Inc. and Oneida Ltd. Under the agreements, Robinson paid Corning and Oneida a percentage of the wholesale price of any utensils sold. The company deducted royalty payments totaling $3,925,667 on its 2003 and 2004 tax returns. The IRS determined that $412,713 of the royalty costs should have been capitalized as part of inventory and assessed deficiencies for both years. Robinson sought relief from the Tax Court. The court, however, held that the costs were properly allocable to the utensils, since “the royalties directly benefited and/or were incurred by reason of [Robinson’s] production activities.” Robinson appealed to the Second Circuit.
The Second Circuit, citing Treas. Reg. § 1.263A-1(e)(3)(ii)(U), rejected Robinson’s arguments that any trademark royalty payments are deductible marketing, selling, advertising and distribution costs or that its payments were not included in the costs described in the regulation. However, the court did agree with Robinson that its royalty payments were not allocable to inventory and therefore could be deducted. Even though the licensing agreements were necessary for Robinson to produce the utensils under the brand names, Robinson had no royalty cost if no inventory was sold. Therefore, the costs were not allocable to inventory because they were not incurred because of production activities, nor did they directly benefit production. The court stated the Tax Court’s analysis was flawed, since it asked whether the licensing agreements were incurred because of production or benefited production rather than asking the same question about the royalty costs. Also, since Treas. Reg. § 1.263A-2(a)(2)(ii)(A)(1) permits the current deduction of royalty payments for each copy of a book that is sold, the court stated the “the uniform capitalization rules would not be very uniform if they were to treat books and spatulas differently.”
Robinson Knife Manufacturing Co. Inc. v. Commissioner , docket no. 09-1496-ag (2nd Cir., 3/19/2010), rev’g, TC Memo 2009-9
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.
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