1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 09-1496-ag Robinson Knife Mfg. Co. v. Comm’r UNITED STATES COURT OF APPEALS FOR THE SECOND CIRCUIT

____________________________________ August Term, 2009 (Argued: December 16, 2009 Decided: March 19, 2010) Docket No. 09-1496-ag

____________________________________ ROBINSON KNIFE MANUFACTURING CO MPANY, INC. AND SUBSIDIARY, Petitioner-Appellant ,

v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. *

____________________________________ Before: CALABRESI, CABRANES, and PARKER, Circuit Judges.

____________________________________ Appeal from a judgment of the United Stat es Tax Court holding that, pursuant to 26 U.S.C. § 263A and the corresponding Treasury regulations, Petitioner- Appellant could not immediately deduct its sales-based trademark r oyalty payments, but was instead required to capitalize such costs. We REVERSE the decision below. ROBERT J. LANE, JR., Hodgs on Russ LLP, Buffalo, N.Y., for Petitioner-Appellant.

* The Clerk of the Court is directed to amend the official caption as set forth above.JOHN A. DUDEC K, JR. (Richard Farber, on the brief ) for John A. DiCicco, Acting Assistant Attorney General, Tax Division, U.S. Department of Justice, Washington, D.C., for RespondentAppellee. 1 2 3 4 5 6 7 8 9 10

11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 ____________________________________

CALABRESI, Circuit Judge : Petitioner-Appellant Robinson Knife Manufact uring Company (“Robinson”) sells kitchen tools labeled with trademarks licensed from thir d parties to whom Robinson pays royalties. In Robinson’s income tax returns for its taxa ble years ending March 1, 2003, and February 28, 2004, Robinson deducted these royalty payments as ordinary and necessary business expenses under 26 U.S.C. § 162. The Commissioner disagreed and issued a notice of deficiency stating that, under 26 U.S.C. § 263A, the royalties are re quired to be capitaliz ed and made part of Robinson’s inventory costs. The Tax Court, T.C. Memo 2009-9, 2009 Tax Ct. Memo LEXIS 10, upheld the Commissioner. Robinson appeals. We hold that where, as he re, a producer’s royalty payments (1) are calculated as a percentage of sa les revenue from inventory and (2) are incurred only upon the sale of that inventory, they are imme diately deductible as a matter of law because they are not “properly allocable to property produced” within the meaning of 26 C.F.R. § 1.263A-1(e). We therefore REVERSE the decision below. Facts I. Robinson Knife Robinson is a corporation whose business is the design, manufacture and marketing of kitchen tools such as spoons, soup ladles, spatulas , potato peelers, and co oking thermometers. In the process by which Robinson typically turns an idea into a saleable finished product, someone

2at Robinson com es up with an idea for a produc t. Robinson then decides which brand name would be best for that product, and if Robinson does not already have a licensing agreement that would permit it to use that trademark on the prop osed product, it tries to negotiate one. Once Robinson has a licensing agreement in hand, it hires an industrial designer to design the product, and the trademark licensor is consulted “to make su re that they agree that [the designer’s plans] are appropriate for the brand th at’s involved.” Robinson next contracts out the manufacturing, usually to firms in China or Taiwan, and the products are shipped to Robinson in the United States. With the products in hand, Robinson mark ets them under the previously selected brand name to customers, who are generally large retailers such as Wal-Mart or Target. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 Robinson’s products are functiona lly the same as its competitors’, so it largely relies on trademarks and design to differentia te its products. One particular subset of those trademarks is at issue here: famous trademarks licensed by Robinson from third parties who own the trademarks. 1 Often Robinson makes and sells, at the same time, products th at are identical, but only some of which bear the relevant tradem arks, while others do not. Robinson does not advertise the Robinson name or feature it prominently on its products’ packaging. During the taxable years at issue, Robinson used, inter alia , two well-known licensed trademarks: Pyrex, which is owned by Corning, Inc., and Oneida, which is owned by Oneida Ltd. The owners of these two trademarks have for many years conducted substantial and continuous advertising and mark eting activities to develop tr ademark awareness and goodwill. As a result, it is much easier for Robinson to place a Pyrex or Oneida prod uct at a major retailer than it is to place an otherwise identical house-brand product.

1 Robinson also makes and sells some products labeled with “house” trademarks owned by Robinson, as well as store-brand products for sale to particular retail stor e chains that own these store brands.

3In all resp ects relevant to this case, the Py rex and Oneida licensing agreements were the same. The agreements gave Robinson the exclus ive right to manufacture, distribute, and sell certain types of kitchen tools using the licensed br and names. In return, Robinson agreed to pay each trademark owner a percentage of the net w holesale billing price of the kitchen tools sold under that owner’s trademark. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 2 Robinson was not required to make any minimum or lump-sum royalty payment, nor did royalties for any kitchen tools accrue at any time before the tools were sold. Thus, Robinson could desi gn and manufacture as many Pyrex or Oneida kitchen tools as it wanted without paying any royalties unless and until Robinson actually sold the products. 3 Robinson did sell a significant volume of Pyrex- and Oneida-branded products, and during the taxable years at issue it pa id royalties both to Corni ng and to Oneida, of $2,184,252 and $1,741,415, respectively. II. The Tax Controversy On Robinson’s Forms 1120, U.S. Corporati on Income Tax Return, for taxable years ending March 1, 2003, and February 28, 2004, R obinson deducted the above-mentioned payments to Corning and Oneida as ordinary a nd necessary business expenses under 26 U.S.C. § 162. The IRS determined instead that under 26 U.S.C. § 263A and the accompanying Treasury Regulations the royalty payments, rather than being immediately deductible, must be added to Robinson’s capital and deducted only over time, in line with complex accoun ting principles. As

2 The percentage in the Pyrex agreement wa s 8%. The Oneida agreement provided that Robinson would pay 11% on net sales up to $1 million, and then 8% on net sales above $1 million. A later Oneida agreement changed the 8% to 9% before the end of the taxable period at issue. 3 Robinson also agreed to contra ctual provisions designed to prot ect the value of the licensed trademarks, as is typical in tr ademark licensing agreements. Before selling a branded product, Robinson had to get the trademark owner’s appr oval of the product’s design, its packaging, and any promotional materials. Robinson further agr eed not to engage in conduct that would damage the goodwill or value of the licensed trademarks.

41 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 a result, the IRS denied the deduction and i ssued a notice of deficiency to Robinson. Robinson petitioned the Tax Court for a rede te rmination of the de ficiency. Robinson there argued, as it does here, that the royalty payments were not required to be capitalized under the § 263A regulations. The Tax C ourt rejected Robinson’s arguments . It held that, within the meaning of the Treasury Regulations, the royalt ies directly benefite d Robinson’s production activities and/or were incu rred by reason of those activ ities. It also held that the royalties were not “marketing” costs exempt from § 263A cap italization under those regulations. Robinson timely appealed to this Court.

Discussion I. Standard of Review We review the Tax Court’s legal conclusions de novo and its factual findings for clear

error. Wright v. Comm’r , 571 F.3d 215, 219 (2d Cir. 2009). The pa rties dispute the standard of review applicable to mixed questions of law and fact de cided by the Tax Court. The Commissioner notes that we have thrice held that clear error revi ew applies to such Tax Court decisions. Id. ; Merrill Lynch & Co. v. Comm’r , 386 F.3d 464, 469 (2d Cir. 2004); Bausch & Lomb Inc. v. Comm’r , 933 F.2d 1084, 1088 (2d Cir. 1991). Ye t Robinson points out that we apply de novo review to mixed questions decided by a district court after a bench trial. See, e.g. , Starbucks Corp. v. Wolfe’s Borough Coffee, Inc. , 588 F.3d 97, 105 (2d Cir. 2009); Design Strategy, Inc. v. Davis , 469 F.3d 284, 300 (2d Cir. 2006); Phansalkar v. Andersen Weinroth & Co. , 344 F.3d 184, 199 (2d Cir. 2003). And the releva nt statute commands us to review Tax Court decisions “in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury.” 26 U.S.C. § 7482(a)(1). We need not resolve this apparent

5inconsistency here. In our view , the case presents a pure question of law—the interpretation of a Treasury Regulation—and we therefore apply de novo review. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 4 II. Legal Framework A. Capitalization and Deduction The income tax law distinguishes between bus iness expenses and cap ital expenditures. Under 26 U.S.C. § 162(a), taxpayers may deduct “a ll the ordinary and necessary expenses paid or incurred during the taxable ye ar in carrying on any trade or business.” By contrast, under 26 U.S.C. § 263(a)(1), no immediate deduction is allo wed for capital expenditures, which are “[a]ny amount paid out for new buildings or for perm anent improvements or betterments made to increase the value of any property or estate.” As the Supreme C ourt has explained in the leading case on this distinction, immediate de duction of a cost is more favorab le to the taxpayer than is capitalization: The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer's cost recovery: While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertai ned, is deducted upon dissolution of the enterprise. INDOPCO, Inc. v. Comm’r , 503 U.S. 79, 83-84 (1992). The significance of the distinction is only sli ghtly different where, as here, the expense would be capitalized to inventory. For invent ory—especially inventory held for sale—the taxpayer usually does not have to rely on deprecia tion or wait for dissolution of the enterprise in order to obtain cost recovery. Instead, the taxpayer has to fo llow complex inventory accounting rules in order to get de ductions over time. See 26 C.F.R. § 1.263A-1(c)(4) (“Costs that are

4 We note, however, that Wright , Merrill Lynch , and Bausch & Lomb do not cite the abovementioned statute, and their application of clear error review to mixed que stions does appear to be in tension with the statute’s text.

61 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 capitalized under sec tion 263A are recovered through deprec iation, am ortization, cost of goods sold, or by an adjustment to basis at the time th e property is used, sold, placed in service, or otherwise disposed of by the taxpayer.”). These rules are designed to achieve a result that is as similar as possible to what woul d happen if it were administrativel y feasible to keep track of each individual inventory item, so that whenever an item were sold its cost basis would be known, and the taxpayer would pay income tax on th e gain (or deduct the lo ss) from the sale of that inventory item. In other words, “costs of merchandise and produced goods are capitalized and held in abeyance until they can be matche d against sales revenues.” Bittker & Lokken, Federal Taxation of Income, Estates and Gifts ¶ 105.8.1 (2009); see also 26 U.S.C. § 471(a) (giving the Secretary authority to prescribe inve ntory accounting rules to “clearly reflect[] . . . income”); INDOPCO , 503 U.S. at 84 (“[T]he Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributab le, thereby resulting in a more accurate calculation of net income for tax purposes.”). With ideal matching, a taxpayer would be perm itted to deduct the costs of producing an inventory item no earlier, and no la ter, than the taxable year in which that particular inventory item is sold. Unfortunately, when a company has, say, 100,000 identical spatulas on hand at any given time and it is constantly creating and sellin g such spatulas (along with any number of other products), perfect matching may be difficult and the costs of producing an inventory item are sometimes recovered earlier or later than they ou ght to be. A distortion of income results. B. Section 263A As part of the most recent major revisions to the Internal Revenue Code, Congress, in the Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085, enacted 26 U.S.C. § 263A to address what it perceived as two significant prob lems concerning the expense/capital expenditure

71 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 boundary with respect to inventory: First, the ex isting rules may allow costs th at are in reality co sts of producing, acquiring, or carrying property to be deduc ted currently, rather than capitalized into the basis of the property and recovere d when the property is sold or as it is used by the taxpayer. This produces a mi smatching of expenses and the related income and an unwarranted deferral of taxes. Second, different capitalization rules may apply under present law depending on the nature of the property and its intended use. These differences may cr eate distortions in the allocation of economic resources and the manner in which certain economic activity is organized. . . . [I]n order to more accurately reflect income and make the income tax system more neutral, a single, comprehensive set of rules should govern the capitalization of costs of producing, acquiring, and holding property . . . . S. Rep. No. 99-313, at 140 (1986), reprinted in 1986-3 C.B. (Vol. 3) 1, 140; see also Suzy’s Zoo v. Comm’r , 273 F.3d 875, 879 (9th Cir. 2001) (“The legisl ative history of § 263A indicates that Congress intended a single comprehensive set of rules to govern determination of whether costs should be capitalized, from the moment of ac quisition through producti on and disposition of property.”). The statute provides that, in the case of “[ r]eal or tangible pers onal property produced by the taxpayer,” 26 U.S.C. § 263A(b)(1), both “the direct costs of such property, and . . . such property’s proper share of those indi rect costs (including taxes) part or all of which are allocable to such property,” id. § 263A(a)(2), shall be included in i nventory costs if it is inventory in the hands of the taxpayer, id. § 263A(a)(1)(A). Where, as here , a taxpayer does not manufacture kitchen tools itself, but instead contracts the ma nufacturing out, it sti ll “produces” the kitchen tools within the statutory definition of that term. Id. § 263A(g)(2). C. The § 263A Regulations Treasury is authorized to make regulations to carry out the purposes of § 263A. Id. § 263A(i). And, several years after the statute’s enactm ent, Treasury issued final § 263A regulations, T.D. 8482, 1993-2 C.B. 77. The preamb le to the 1993 final regulations contains an

8explanation of the purpose of § 263A and of the regulations that is substantially identical to the

statem ent found in the legislative history. See id. at 78. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 5 Two parts of these uniform capitalization regulations are cent ral in this case. The first is the determination of whether a particular cost must be capita lized; the second explains how, on ce a cost is capitalized, it is allocated to particular units of inventory. 1. Whether To Capitalize Under the regulations, “[t]axpayers subject to section 263A must capitalize all direct costs and certain indirect costs properly allocab le to property produced . . . .” 26 C.F.R. § 1.263A-1(e)(1). Direct costs consist primarily of materials and labor, id. § 1.263A-1(e)(2), and the Commissioner does not claim that Robinson’s royalty payments are direct costs. As to indirect costs, the regula tion states the following: Indirect costs are defined as all costs other th an direct material costs and direct labor costs (in the case of property produced) . . . . Taxpa yers subject to section 263A must capitalize all indirect co sts properly allocable to property produced . . . . Indirect costs are properly allocable to property produced . . . when the costs directly benefit or are incu rred by reason of the performance of production . . . activities. Indirect costs ma y be allocable to . . . other activities that are not subject to section 263A. Ta xpayers subject to section 263A must make a reasonable allocation of indirect costs between production . . . and other activities. Id. § 1.263A-1(e)(3)(i). Paragraphs (ii) and (iii) c ontain lists of “[e]xamples of indirect costs required to be capitalized,” and “[i]ndirect cost s not capitalized,” respectively. Id. § 1.263A-1(e)(3). Paragraph (ii) states that the it ems on its list “are examples of indirect costs that must be capitalized to the extent they are prop erly allocable to property produced.” Id. § 1.263A1(e)(3)(ii). One of the items on the list is:

5 The preamble to the original 1987 te mporary regulations does the same. See T.D. 8131, 1987-1 C.B. 98, 98-99.

91 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 (U) Licens ing and franchise costs. Licen sing and franchise costs include fees incurred in securing the contractual ri ght to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced . . . . These costs incl ude the otherwise de ductible portion (e.g., amortization) of the initial fees incurred to obtain the license or franchise and any minimum annual payments and royalties that are incurred by a licensee or a franchisee. Id. § 1.263A-1(e)(3)(ii)(U). Conversely, paragraph (i ii) states that the items on its list “are not required to be capitalized under section 263A.” Id. § 1.263A-1(e)(3)(iii). Th e first item on that list is: “(A) Selling and distribut ion costs. These costs are ma rketing, selling, advertising, and distribution costs.” Id. § 1.263A-1(e)(3)(iii)(A). 2. How To Allocate Although the dispute in this case is about whether Robinson’s royalties must be capitalized and not about how they must be allo cated, some discussion of the relevant allocation methods is necessary to an understanding of w hy the parties care whet her Robinson’s royalties are deducted or capitalized. The regulations pr ovide for two methods of allocating costs to inventory. The first is the “facts and circumstances” method, see 26 C.F.R. § 1.263A-1(f), which most taxpayers use. This method acknowledges that it is often impossible to tell the cost of a particular item sold, and so it uses one of se veral complicated and administratively expensive processes to approximate that cost and allocate it to particular goods. See id. ; see also Leslie J. Schneider, Federal Income Taxation of Inventor ies § 5.01[1], [6][d] (201 0) (noting that the various forms of the facts-and-circumstances me thod are expensive to administer because they differ from financial accounting ru les and the pre-§ 263A rules). The other method, the “simplified produc tion method,” was created to help manufacturers who, in 1986, would have had to make substantial modifications to their cost accounting methods in order to comply with the new § 263A. See W. Eugene Seago, Inventory

10Tax Accounting and Unifor m Capitalization § 2: 47 (2009). Such companies were given the option of grandfathering themselves out of the facts and circumstances method and thereby avoiding the associated admini strative costs. The simplifie d production method, using a ratio found in the regulations, allocate s a pool of costs between endi ng inventory and cost of goods sold. See 26 C.F.R. § 1.263A-2(b). The simplif ied production method is administratively cheaper than the facts and circumstances method, but it may result in distortions of income unfavorable to the taxpayer becau se it can force the taxpayer to allocate costs to ending ( i.e. , ongoing) inventory when a more accurate method would have permitted much quicker cost recovery by allocating most or all of thos e same costs to inventory that was sold. 1 2 3 4 5 6 7 8 9 10 11 12 13 6 Robinson elected the simplified production method. If the allocation methods in the regulations wo rked perfectly, this case would never have been litigated. Under a perfect allocation sy stem, every cent Robinson paid in sales-based royalties would be allocated to exactly those inventory items whose sale triggered Robinson’s

6 As one treatise explains: Although the simplified production method doe s reduce the difficulty and expense that otherwise would result from determ ining inventoriable costs under Section 263A, it is not clear whether a taxpayer actually benefits by employing the simplified procedure. It is clear that accounting costs are reduced, but application of the method may result in an increase in the amount of inventoriable costs as compared to what the increase would be under a more pr ecise computation. Because the increase to ending inventory is based on the ratio of additional Section 263A costs incurred during the y ear to Section 471 costs incurred during that year, for some businesses a significant portion of the additional Section 263A costs would not be associated with goods in ending inventory if precise computations were made. For example, additional Section 263A costs incurred during the year may be 10 percent of to tal Section 471 costs incurred during the year. Yet, the nature of th e additional Section 263A cost s may be attributable to producing only a very small portion of items actually in ending inventory. Thus, these additional costs might have only a s light impact on ending inventory under a precise computation. However, under the simplified production method, 10 percent of these additional Section 263A costs will be allocated to ending inventory. Stephen F. Gertzman, Federal Tax Accounting ¶ 6.07[4][a] (2009).

11obligation to pay. Because it is the sale of kitchen tools that triggers Robinson’s obligation to pay royalties, all Robinson’s roya lties would be allocate d to those inventory items that are sold, at the same time as, and therefore during the same taxable year as, the royalties are incurred. The result would be that Robins on would recover the cost of the royalties immediately—just as it would if, as Robinson claims, the royalties were de ductible rather than subj ect to capitalization. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 In reality, the allocation methods do not work perfectly. And Robinson, presumably to save administrative costs, elec ted the least accurate of the permissible methods. A significant amount of money, therefore, ride s on whether Robinson can deduct its royalty payments. If Robinson cannot deduct the payments immediately, then a substantial por tion of them will be allocated to ending inventory, and Robinson will have to wait until a later taxable year to recover those costs. III. Deductibility of the Royalty Payments Robinson presents three arguments that th e royalty payments are not required to be capitalized under § 263A: (1) that the royalty payments ar e deductible as “marketing, selling, advertising, [or] distribution cost s,” 26 C.F.R. § 1.263A-1(e)(3)(iii )(A); (2) that royalty payments which are not “incurred in securing the contract ual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced,” id. § 1.263A-1(e)(3)(ii)(U), are always deductible; and (3 ) that the royalty payments were not “properly allocabl e to property produced,” id. § 1.263A-1(e)(3)(i). 7 All of these arguments present questions of first impression. We are the first court of appeals to address the treatment of intellectua l property royalties under the uniform capitalization regulations. Apart from the decision below, the only other case c oncerning these issues is another Tax Court

7 Notably, Robinson does not challenge the validit y of the applicable Treasury regulations. Robinson only disputes the Commissioner’s and th e Tax Court’s interpre tations of them.

12m emorandum decision. See Plastic Eng’g & Tech. Servs., Inc. v. Comm’r , T.C. Memo. 2001- 324, 2001 Tax Ct. Memo LEXIS 360. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 We reject Robinson’s first two arguments as addressing situations that go far beyond the case presented here, but we are persuaded that the third argument is correct. We conclude that royalty payments which are (1) calculated as a percentage of sales revenue from certain inventory, and (2) incurred only upon sale of such inventory, are not requi red to be capitalized under the § 263A regulations. A. Marketing, Selling, Advertising, and Distribution Costs According to Robinson, its royalty payments are “marketing, selling, advertising, [or] distribution costs.” Although Robinson is correc t that “marketing, selli ng, advertising, and distribution costs” are deductible , 26 C.F.R. § 1.263A-1(e)(3)(iii) (A), we are not persuaded by Robinson’s two arguments that all tradem ark royalty payments are such costs. First, Robinson emphasizes that its object in licensing the trademarks is to entice customers to buy products that are otherwise identical to Robinson’ s competitors’ products. But Robinson’s argument proves too much. All trad emarks may serve that purpose. And the regulations specifically list “fees incurred in securing the contractual right to use a trademark ,” id. § 1.263A-1(e)(3)(ii)(U) (emphasis added), as an “example[] of indirect costs that must be capitalized to the extent they are properly allocable to propert y produced or property acquired for resale,” id. § 1.263A-1(e)(3)(ii). If we were to ac cept Robinson’s view, we would effectively read the word “trademark” out of the relevant regulation. Second, Robinson argues that Rev. Rul. 2000-4, 2000-1 C.B. 331, compels the conclusion that trademark royalties are “marketin g, selling, advertising, and distribution costs.” This Court has not decided on the proper level of deference owed to revenue rulings after United

13States v. Mead Corp. , 533 U.S. 218 (2001). See Reimels v. C omm’r , 436 F.3d 344, 347 n.2 (2d Cir. 2006). We need not do so here, for the ru ling does not help Robinson no matter how much deference we accord to it. In the revenue ruli ng, a taxpayer was permitted to deduct the costs of obtaining ISO 9000 certification, which differentia ted it from non-certified competitors and allowed it to do businesses with customers who required certification. The IRS determined that ISO 9000 certification, like a dvertising or training expenses, “ does not result in future benefits that are more than incidental.” Rev. Rul. 2000-4, 2000-1 C.B. at 331. But, in contrast to trademarks, there is nothing in the 26 C.F.R. § 1.263A-1(e)(3)(ii) list that suggests that fees for certifications such as ISO 9000 must ever be cap italized. Since trademarks instead are on the capitalization list, the revenue ruling is wholly distinguishable. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 Moreover, Robinson’s argument is at odds with the intent of both § 263A and the regulations. If all trademark royalties were “marketing, selling, advertising, [or] distribution costs,” then they would be deductible regardless of the terms of the c ontracts under which they were paid. As a result, a lump-sum minimum royalty payment ( i.e. , a royalty payment of a specified amount which does not vary regard less of the number of trademarked items manufactured or sold) would be immediately deductible. So would a manufacturing-based royalty paid whenever the ma nufacturer produced an invent ory item bearing the licensed trademark—and this would be so even if the tradem arked items were not sold until a later taxable year. But the point of § 263A a nd its regulations is precisely to make sure that trademark royalties are not deducted duri ng a taxable year which preced es the year in which the corresponding trademarked items are sold. To hold otherwise would be to “allow costs that are in reality costs of producing, acqui ring, or carrying property to be deducted currently, rather than capitalized into the basis of the property and recovered when the prope rty is sold or as it is used

141 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 by the taxpayer. This [would] produce[] a m ismat ching of expenses and the related income and an unwarranted deferral of ta xes.” S. Rep. No. 99-313, at 140; accord T.D. 8482, 1993-2 C.B. at 78. For these reasons, we re ject the contention that all trademark royalties are immediately deductible. B. Incurred in Securing the Contractual Right Robinson next argues that its royalty paym ents are deductible because they are not described in § 1.263A-1(e)(3)(ii)(U) , that is, because they are not “incurred in securing the contractual right to use a tradem ark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced.” But Robinson’s conclusion does not follow from its premise. Assuming arguendo that Robinson’s royalty paymen ts are not described in § 1.263A-1(e)(3)(ii)(U), that “d escription” does not include all costs, or even all trademark costs, that must be capitalized. The costs incurre d by Robinson are still indirect costs, and they are, therefore, required to be capitalized to th e extent they are properl y allocable to property produced. As § 1.263A-1(e)(3)(i) explains , “[i]ndirect cost s are defined as all costs other than direct material costs and direct labor costs (in the case of property produced).” (emphasis added). The royalties are costs. They are not direct costs. Hence, they are indirect costs, and such costs are not exempt from the capitalization requirement merely because they are absent from the list of “examples of indirect costs th at must be capitalized to the extent they are properly allocable to property produced” found in § 1.263A-1(e)(3)(ii). Robinson’s second argument, like its first, moreover, is too broad. According to Robinson, the above-cited language in § 1.263A-1(e)(3)(ii)(U) requi res capitalization only of lump-sum minimum royalties. A ssuming, contrary to what we ha ve said above, that costs not described in subclause (U) ar e necessarily deductible, then any manufacturing-based royalty

151 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 would be deductible. But it would be contrary to the purpose of § 263A t o permit taxpayers to manufacture inventory and deduct ro yalties immediately, even if that inventory were not sold or otherwise disposed of until a later taxable year. C. Properly Allocable to Property Produced Robinson’s third argument is that the Tax C ourt’s view that Robinson’s royalties were “properly allocable to property produced” was ba sed on an erroneous inte rpretation of 26 C.F.R. § 1.263A-1(e)(3)(i). We agree. The Tax Court stated: The Corning and Oneida license agreements gave petitioner the right to manufacture the Pyrex- and Oneida-branded kitchen tools, and without the license agreements, petitioner could not have lega lly manufactured them. In addition to securing the licenses for the trademarks, obtaining approval from the licensors to use the Pyrex and Oneida trademarks on ne w kitchen tools was also an integral part of developing and producing the Pyre x- and Oneida-branded kitchen tools. For example, the industrial designers th at petitioner hired conferred with the licensors to ensure that the new kitchen tools were appropriat e for a particular trademark. After the new kitchen tools were manufact ured, Corning and Oneida had the right to inspect and approve the finished kitchen tools before petitioner marketed and sold them to customers. We conclude that acquiring the right to use the Pyrex and Oneida trademarks was pa rt of petitioner's production process. Consequently, the royalties paid to Co rning and Oneida directly benefited petitioner's production activit ies and/or were incurred by reason of petitioner's producing the Pyrex- and Oneida-branded ki tchen tools and are therefore indirect costs properly allocable to the Pyrex- a nd Oneida-branded kitc hen tools petitioner produced. Robinson , 2009 Tax Ct. Memo LEXIS 10, at *16-*17. But, as Robinson points out, the Ta x Court’s reasoning confuses the license agreements with the royalty costs . The Treasury regulations provide that “[i]ndir ect costs are properly allocable to property produced . . . when the costs directly benefit or are incurred by reason of the performance of production . . . activities.” 26 C.F.R. § 1.263A-1(e)(3)(i) (em phasis added). The Tax Court did not ask whether the royalty costs “directly benefit[ed] or [were] incurred by

161 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 reason of the perform ance of pr oduction . . . activities.” Instead, the Tax Court asked whether the license agreements did so. But that is not what th e regulation’s language (and sensible intent) goes to. Royalties like Robinson’s in this case do not “directly benefit,” and are not “incurred by reason of[,] the performance of production . . . ac tivities.” The Tax Court is clearly right that “without the license agreements, petitioner could not have legally manufactured” the Pyrex and Oneida kitchen tools, Robinson , 2009 Tax Ct. Memo LEXIS 10, at *16. It is equally clear, however, that Robinson could ha ve manufactured the products , and did, without paying the royalty costs . None of the product appr oval terms of the license ag reements referenced by the Tax Court relates to Robinson’s obligation to pay the royalty costs. Robinson could have manufactured exactly the same quantity and t ype of kitchen tools—that is, it could have “perform[ed]” its “production . . . activities” in exactly the same wa y it did—and, so long as none of this inventory was ever sold bearing the licensed tradem arks, Robinson would have owed no royalties whatever. Robinson’s royaltie s, therefore, were not “incurred by reason of” production activities, and did not “dir ectly benefit” such activities. In other words, while we may agree with the Tax Court’s implicit conclu sion that “directly bene fit or are incurred by reason of” boils down to a but-for causation test, we hold that under the plain text of the regulation it is the costs, and not the contracts pursuant to which those costs are paid, that must be a but-for cause of the taxpayer’s production ac tivities in order for the costs to be properly allocable to those activities and subj ect to the capitalization requirement. Our interpretation of § 1.263A-1 (e)(3)(i) is corroborated by th e regulatory and legislative history, as well as by a related regulation. 26 C. F.R. § 1.263A-2(a)(2)(ii)(A)(1), a regulation that distinguishes between tangible personal pr operty (for which production costs must be

17capitalized) and intang ib le property (to which § 263A genera lly does not apply) states: “[T]he costs of producing and developing books incl ude prepublication expenditures incurred by publishers, including payments made to authors ( other than commissions fo r sales of books that have already taken place ), as well as costs incurred by pub lishers in writing, editing, compiling, illustrating, designing, and developing the books.” Id. (emphasis added). 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 8 As a result, if a publishing company enters into an agreement with an author whereby royalties (or some portion thereof) are paid for each copy of the book that is sold, and are not due to the author unless and until such sales occur, those royalties are not to be capitalized. By contrast, if the author is paid a royalty for every book that is printed, or receiv es a lump-sum royalty, then capitalization is required. It would be contrary to the purpose of § 263A and the regulations if commissions for sales of books that have already taken place were treated differently from similar royalties for sales of other types of goods. The position taken by the Tax Cour t and the Commissioner in this case would give rise to exactly the problem Congress crafted § 263A to fix, for then “the treatment of indirect co sts [would] vary depending on the type of property produced.” S. Rep. No. 99-313, at 133. The preamble to the uniform capitalization regulations confirms that capitalization ought not to “depend[] on the natu re of the underlying prop erty and its intended use,” as it did under the pre-§ 263A laws. T.D. 8482, 1993-2 C.B. at 78. And, the uniform capitalization rules would not be very uniform if they were to tr eat books and spatulas differently.

8 As discussed below, the regulat ory history explains that “commi ssions for sales of books that have already taken place” refers to commissions for books that, having already been sold, do not remain on hand for future sale.

181 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 Moreover, the Treasury’s reasoning in addi ng the parenthetical about “commissions for sales of boo ks that have already taken pl ace” to the final versi on of 26 C.F.R. § 1.263A2(a)(2)(ii)(A)(1) is also applicable here. Th e parenthetical was absent from the temporary regulations, but in a 1988 Notice the IRS stated the following: Section 1.263A-1T(a)(5)(iii) of the regulations requires the prepublication expenditures of books publishers (and publis hers of similar properties) to be capitalized under secti on 263A. Under the regulations, prepublication expenditures include payments made to authors of literary works. Commentators have inquired as to wh ether this requirement to capitalize payments made to authors would apply to commissions or royalties that were paid to authors where such commissions were based on contemporaneous sales of the books. Commentators have noted that it woul d be inappropriate for a publisher to capitalize commissions where such commi ssions related only to books that had been sold by the publishers, and not to any books (or copyr ights pertaining to such books) that were still on hand. In response to these comments, forthc oming regulations will not require the capitalization of payments made to authors where such payments are commissions for sales of books that have already take n place. If, in contrast, payments are made to authors as pre-paid commissions for future sales of books, such payments shall be capitalized and deducted by the publisher as such fu ture sales occur. Moreover, payments made to authors of li terary works that pertain to the use, by the publisher, of the author's rights in the literary works, and that are not based on particular sales of the books, shall be capitalized and amortized as prepublication expenditures under section 167 of the Code . In determining whether payments made to authors are described in the pr eceding sentence, the substance of the transaction, and not its form, shall control. I.R.S. Notice 88-86, 1988-2 C.B. 401, 409. It would similarly be “inappr opriate” for a kitchentool manufacturer to capitalize trademark royalties where such royalties are based only on those kitchen tools that have been so ld by the manufacturer, and not on any kitchen tools that are still on hand. Although the 1988 Notice does not e xplicitly state the reason why capitalization should not be required for “comm issions for sales of books that have alre ady taken place,” the distinction drawn by the IRS is guided by the principles underlying inventory accounting. The

19purpose of inventory accounting is—as we have pr eviously said—to refl ect incom e clearly, by matching income with the costs of producing that income in the same taxable year. See Part II.A, supra . When a publisher incurs the obligation to pay a commission only for books that have already been sold, or when Robinson incurs the obligation to pay a ro yalty only for kitchen tools that have already been sol d, it is necessarily true that the royalty costs and the income from sale of the inventory items are incurred simultaneously. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 9 The Commissioner’s position in the case before us would, instead, distort Robinson’s income by de nying it deductions until some subsequent year, potentially long after the i nventory items to which those deductions should attach have been sold. Had Robinson’s licensing agreements provide d for non-sales-based royalties, such as manufacturing-based or mini mum royalties, then under the reasoning of Notice 88-86 capitalization would be required. And this, too, follows from i nventory accounting principles. Suppose SpoonCo, another kitchen tool manufacture r, has a licensing agreement with Corning under which royalties are paid for each Pyrex spoon manufactured . SpoonCo makes 500 Pyrex spoons in Year 1, and pays Corning a royalty fo r all 500, as is required by their agreement. SpoonCo doesn’t sell any of the spoons until Year 2, when it sells all 500. SpoonCo should have to wait until Year 2 to take the deduction, be cause otherwise SpoonCo would be getting its deduction in the year before it got the corresponding income.

9 Since Robinson is an accrual- method taxpayer, the “all events” test found elsewhere in the Treasury regulations prohibits Robinson from de ducting (or capitalizing) its royalty payments before the corresponding k itchen tools are sold. See 26 C.F.R. § 1.461-1(a)(2)(i) (“Under an accrual method of accounting, a liabili ty . . . is incurred, and genera lly is taken into account for Federal income tax purposes, in th e taxable year in which all the events have occurred that establish the fact of the liabil ity, the amount of the lia bility can be determ ined with reasonable accuracy, and economic performance has occurred with respect to the liability.”). Taxpayers are generally required to use the accrual method for inventory. See 26 U.S.C. § 471; 26 C.F.R. § 1.471-1.

20In the instan t case, however, the record is clear that Robinson’s royalties were salesbased. They were calculated as a percentage of ne t sales of kitchen tools, and they were incurred only upon the sale of those kitchen tools. 1 2 3 10 They are therefor e immediately deductible. 11

10 The language of Notice 88-86 reflects a justified concern about the possib ility of abuse. We agree with the IRS that “the s ubstance of the trans action, and not its form, shall control,” 1988-2 C.B. at 409, in determining whether royalty paym ents are deductible. The two requirements we have set forth—that the royalties must be calculat ed based on sales, and th at the royalties must be incurred only upon those sales—should prevent mo st abusive deductions in this context. For example, “payments . . . made to authors as pr e-paid commissions for future sales of books,” id. , would be incurred before the sales took place. Si milarly, if a manufacturer entered an agreement whereby no royalties were to be paid unless at least one unit of licensed-trademark inventory were sold, but the amount of royalties would then be a specified lump sum, this agreement would fail the requirement that the roya lties be calculated based on sales. We do not, however, rule out the possibility that, in a future case, a taxpayer might structure a licensing transaction in such a way that it formally meets our two requirements, while in economic substance the royalties are for inventory items that have not yet been sol d. Under those circumst ances, deduction should not be permitted. But there is no suggestion that Robinson’s royalty payments are, in economic substance, anything other than tr ue sales-based royalties. 11 One might consider whether some level of de ference ought to be given to the Commissioner’s interpretation of the Trea sury’s own regulations. See Auer v. Robbins , 519 U.S. 452, 461 (1997) (holding that an agency’s inte rpretation of its own regulations is “controlling unless plainly erroneous or inconsistent with the regulation” (internal quotation marks omitted)); Bowles v. Seminole Rock & Sand Co. , 325 U.S. 410, 414 (1945) (same). But we need not decide whether Auer deference applies here or in tax cases gene rally, for at least two reasons. First, the Commissioner has not argued Auer deference, so any such argument is forfeited. See Norton v. Sam’s Club , 145 F.3d 114, 117 (2d Cir. 1998). Second, and mo re important, even if we were to apply Auer , we would not reach a different result. The Commissioner’s reading of the regulation is contrary to the plain meaning of its text. In this respect, we note that the Commissioner’s brief is not the only agency interpreta tion of the regulation before us; we also have the preamble, the related regulation concerning c opyright royalties paid by boo k publishers, and Notice 88-86. Thus, unlike Auer , there are abundant “reason[s] to su spect that the inte rpretation [in the agency’s brief] does not reflect the agency's fair and considered judgment on the matter in question,” 519 U.S. at 462. Cf. Pierre v. Comm’r , 133 T.C. ___, ___ , 2009 U.S. Tax Ct. LEXIS 21, at *34-*36 (2009) (Cohen, J., concurring) (similarly rejecting Auer deference to the Commissioner’s litigating position). The Treasury has for the past two-and-one-hal f years indicated that it intends to issue “[g]uidance under § 263A regarding the treatment of post-production costs, such as sales-based royalties.” See I.R.S. 2009-2010 Priority Guidance Plan (Nov. 24, 2009); I.R.S. 2008-2009 Priority Guidance Plan (Sept. 10, 2008); I.R. S. 2007-2008 Priority Guidance Plan (Aug. 13, 2007). Because we are interpreting the § 263A re gulations and not § 263A itself, the Treasury remains free to issue guidance contrary to our ho lding in the form of new regulations or of amendments to existing regulations. Such regulat ions would, of course, be subject to judicial

2122 1 2 3 4 5 IV. Conclusion For these reasons, we hold that taxpayers su bject to 26 U.S.C. § 263A may deduct royalty payments that are (1) calculated as a percentage of sales revenue from certain inventory, and (2) incurred only upon sale of such inventory. A ccordingly, we REVERSE the judgment of the Tax Court and REMAND with instructions to enter judgment for Robinson.

review to determine whether they conform to the underlying statute. Cf. Gen. Elec. Co. v. Comm’r , 245 F.3d 149, 154 n.8 (2d Cir. 2001) (noting that the appropriate deference standard for Treasury Regulations is “ar guably unsettled” in this Circuit). In any even t, under the regulations as they now stand, sales-based royalties are deduc tible provided that they satisfy the requirements set forth in this opinion.