Source: https://www.federalregister.gov/documents/2010/12/17/2010-31597/sales-based-royalties-and-vendor-allowances
Timestamp: 2018-04-19 22:22:48
Document Index: 736658536

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Federal Register :: Sales-Based Royalties and Vendor Allowances
A Proposed Rule by the Internal Revenue Service on 12/17/2010
78940-78944 (5 pages)
https://www.federalregister.gov/d/2010-31597 https://www.federalregister.gov/d/2010-31597
Send submissions to: CC:PA:LPD:PR (REG-149335-08), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-149335-08), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers may submit comments electronically via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG-149335-08).
This document also contains proposed amendments to 26 CFR part 1 relating to the determination of cost of goods in inventory under section 471 when a taxpayer receives a sales-based vendor allowance. Sales-based vendor allowances are allowances, discounts, or price rebates that a reseller receives, earns, or otherwise becomes entitled to based on the resale of a vendor's merchandise to a third party.
Section 1.263A-1(f) provides various “facts-and-circumstances” cost allocation methods that taxpayers may use to allocate direct and indirect costs Start Printed Page 78941to units of property produced or acquired for resale. The facts-and-circumstances methods allocate costs based on a relationship between the costs incurred and the units of property produced or acquired for resale.
In lieu of a facts-and-circumstances allocation method, taxpayers may use the simplified methods provided in § 1.263A-2(b) (the simplified production method) or § 1.263A-3(d) (the simplified resale method) to allocate costs to eligible property produced or eligible property acquired for resale. The simplified methods differ from facts-and-circumstances methods in that they allocate a pool of capitalizable costs (additional section 263A costs) between ending inventory and cost of goods sold using a defined ratio rather than allocating specific costs to particular goods. Additional section 263A costs are defined in § 1.263A-1(d)(3) as the costs, other than interest, that were not capitalized under the taxpayer's method of accounting immediately prior to the effective date of section 263A, but that are required to be capitalized under section 263A. Under the simplified methods, taxpayers allocate additional section 263A costs between ending inventory and cost of goods sold using a formula that includes all additional section 263A costs incurred during the taxable year (including capitalizable sales-based royalties, if any).
Section 1.471-2(c) permits merchants and manufacturers to value inventories at either (1) cost, or (2) cost or market, whichever is lower. Under § 1.471-3(b), the cost of merchandise purchased by taxpayers in general is the invoice price less trade or other discounts.
Section 1.471-8 allows a retail merchant to use the retail inventory method to arrive at an approximate cost of goods in ending inventory. This cost is determined by multiplying the aggregate selling prices of the goods in ending inventory by the ratio of (1) the cost of the goods in beginning inventory plus the cost of goods purchased during the year, to (2) the retail selling prices of the goods in beginning inventory plus the retail selling prices of inventory purchased during the year, with proper adjustments to the selling prices for mark-ups and mark-downs. However, retail selling prices are not adjusted for temporary mark-downs. Rev. Rul. 79-115 (1979-1 CB 185), see § 601.601(d)(2).
In Robinson Knife, the Court of Appeals for the Second Circuit held that royalties for the right to use certain trademarks in manufacturing kitchen tools were not allocable to the property produced 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 court stated that the royalty costs were not incurred by reason of and did not directly benefit the performance of production activities, and therefore were not capitalizable under the section 263A regulations. The court reasoned that, although the licensing agreements may have directly benefited or been incurred by reason of production activities, the regulations did not require the capitalization of the royalty costs because the costs themselves did not directly benefit and were not incurred by reason of the performance of production activities.
The proposed regulations are consistent with the court's conclusion that, because of their relationship to sales, sales-based royalties inherently should not be capitalized to ending inventory. Because sales-based royalties are not incurred (within the meaning of section 461) until a unit of property is sold, sales-based royalties are more directly related to units of property sold during the taxable year than to unsold units. Therefore, the proposed regulations provide that capitalizable sales-based royalties are properly allocable to units of property produced or acquired for resale that are sold, or deemed sold, during the taxable year.
However, Robinson Knife misconstrued the nature of costs required to be capitalized. Royalties are the costs associated with the right to use intellectual property such as copyrighted works or patented inventions. If the use of those rights directly benefits or is incurred by reason of production activities, then the cost of securing those rights do as well. The fact that the amount of sales-based royalties is determined by reference to the number of units of property a taxpayer sells or is calculated as a percentage of revenue from the sale of inventory affects when a taxpayer incurs (within the meaning of section 461) that amount, but does not change an otherwise capitalizable production or resale cost into a non-capitalizable cost. Therefore, the proposed regulations also clarify 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. Sales-based royalties, like other costs that directly benefit or are incurred by reason of production or resale activities, are capitalizable licensing and franchise costs within the meaning of § 1.263A-1(e)(3)(ii)(U).
Under § 1.471-3(b), the cost of merchandise a taxpayer purchases generally is the invoice price less trade or other discounts. A sales-based vendor allowance is an allowance, discount, or price rebate a taxpayer earns as a result of selling a vendor's merchandise, typically at a temporarily reduced price. The taxpayer's right to receive the sales-based vendor allowance depends on actual sales of the vendor's products. The amount received directly relates to the specific merchandise the taxpayer sells and properly is treated as a reduction in the cost of that merchandise. Therefore, the proposed regulations clarify that a sales-based vendor allowance is an adjustment to the cost of the merchandise sold or deemed sold under the taxpayer's cost flow assumption.
Sales-based royalties and sales-based vendor allowances are properly allocable to property sold during the taxable year. Therefore, it is inappropriate to treat sales-based royalties and sales-based vendor allowances as adjustments to the cost of goods in ending inventory. The proposed regulations provide that sales-based royalties and sales-based vendor allowances are allocable to the units of property sold or deemed sold under the taxpayer's cost flow assumption and are Start Printed Page 78942not included in determining the inventory cost or value of goods on hand at the end of the taxable year under any inventory method.
Because the proposed regulations expressly allocate sales-based royalties and sales-based vendor allowances to property that has been sold or deemed sold, the proposed regulations revise the simplified production and simplified resale methods to remove costs such as capitalizable sales-based royalties and cost reductions such as sales-based vendor allowances, which are properly allocable to property that has been sold, from the formulas used to allocate additional section 263A costs to ending inventory. Taxpayers must continue to include capitalizable sales-based royalty costs in both the numerator and denominator of the production cost allocation ratio under § 1.263A-1(h)(5) for purposes of determining capitalized mixed service costs under the simplified service cost method.
The proposed regulations do not modify the retail inventory method under § 1.471-8 specifically. Section 1.471-3 and section 263A determine the cost of purchases for purposes of the retail inventory method, and the proposed regulations under §§ 1.263A-1 and 1.471-3 preclude a taxpayer from including sales-based royalties and sales-based vendor allowances in the cost of goods in the fraction used to determine the value of ending inventory under § 1.471-8. Similarly, if the selling price markdown in a sales-based vendor allowance arrangement is temporary, the retail selling price component of the fraction is not adjusted.
Par. 2. Section 1.263A-0 is amended by adding new entries for §§ 1.263A-1(c)(5), 1.263A-1(k), 1.263A-1(l), 1.263A-2(b)(3)(ii)(C), 1.263A-2(e), 1.263A-2(f), 1.263A-3(d)(3)(i)(C)(3), and 1.263A-3(f) and revising the entry for §§ 1.263A-1(e)(3)(ii) in the table of contents to read as follows:
(5) Costs allocable only to sold property. Any cost that is required Start Printed Page 78943under this section, § 1.263A-2, or § 1.263A-3, to be allocated only to property sold, or deemed to be sold under the inventory cost flow assumption (such as first-in, first-out, last-in, first-out, or a specific-goods method) the taxpayer uses to identify the costs in ending inventory, must be included in cost of goods sold and is not included in determining the inventory cost or value of goods on hand at the end of the taxable year.
(C) Costs allocable only to sold property. Additional section 263A costs incurred during the taxable year, as defined in paragraph (b)(3)(ii)(A)(1) of this section, section 471 costs incurred during the taxable year, as defined in paragraph (b)(3)(ii)(A)(2) of this section, and section 471 costs remaining on hand at year end, as defined in paragraph (b)(3)(ii)(B) of this section, do not include costs specifically described in § 1.263A-1(e)(3)(ii) or cost reductions described in § 1.471-3(e) as properly allocable only to property that has been sold or, for inventory property, deemed to be sold under the inventory cost flow assumption (such as first-in, first-out; last-in, first-out; or a specific-goods method) a taxpayer uses to identify the costs in ending inventory.
(4) Additional section 263A costs incurred during the test period, as defined in paragraph (b)(4)(ii)(A)(2) of this section and section 471 costs incurred during the test period, as defined in paragraph (b)(4)(ii)(A)(3) of this section, do not include costs specifically described in § 1.263A-1(e)(3)(ii) or cost reductions described in § 1.471-3(e) as properly allocable only to property that has been sold or, for inventory property, deemed to be sold under the inventory cost flow assumption (such as first-in, first-out; last-in, first-out; or a specific-goods method) a taxpayer uses to identify the costs in ending inventory.
Par. 5. In § 1.263A-3, paragraphs (d)(3)(i)(C)(3), (d)(3)(i)(D)(3), (d)(3)(i)(E)(3), and (f) are added to read as follows:
(3) Costs allocable only to sold property. Section 471 costs remaining on hand at year end, as defined in paragraph (d)(3)(i)(C)(2) of this section, do not include costs that are specifically described in § 1.263A-1(e)(3)(ii) or cost reductions described in § 1.471-3(e) as properly allocable only to property that has been sold or, for inventory property, deemed to be sold under the inventory cost flow assumption (such as first-in, first-out; last-in, first-out; or a specific-goods method) a taxpayer uses to identify the costs in ending inventory.
(D) * * *Start Printed Page 78944
(3) Current year's storage and handling costs, beginning inventory, and current year's purchases, as defined in paragraph (d)(3)(i)(D)(2) of this section, do not include costs that are specifically described in § 1.263A-1(e)(3)(ii) or cost reductions described in § 1.471-3(e) as properly allocable only to property that has been sold or, for inventory property, deemed to be sold under the inventory cost flow assumption (such as first-in, first-out; last-in, first-out; or a specific-goods method) a taxpayer uses to identify the costs in ending inventory.
(3) Current year's purchasing costs and current year's purchases, as defined in paragraph (d)(3)(i)(E)(2) of this section, do not include costs that are specifically described in § 1.263A-1(e)(3)(ii) or cost reductions described in § 1.471-3(e) as properly allocable only to property that has been sold or, for inventory property, deemed to be sold under the inventory cost flow assumption (such as first-in, first-out; last-in, first-out; or a specific-goods method) a taxpayer uses to identify the costs in ending inventory.
[FR Doc. 2010-31597 Filed 12-16-10; 8:45 am]