Opinion ID: 357
Heading Depth: 3
Heading Rank: 3

Heading: Properly Allocable to Property Produced

Text: Robinson's third argument is that the Tax Court's view that Robinson's royalties were properly allocable to property produced was based on an erroneous interpretation 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 legally manufactured them. In addition to securing the licenses for the trademarks, obtaining approval from the licensors to use the Pyrex and Oneida trademarks on new kitchen tools was also an integral part of developing and producing the Pyrex- and Oneida-branded kitchen tools. For example, the industrial designers that petitioner hired conferred with the licensors to ensure that the new kitchen tools were appropriate for a particular trademark. After the new kitchen tools were manufactured, 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 part of petitioner's production process. Consequently, the royalties paid to Corning and Oneida directly benefited petitioner's production activities and/or were incurred by reason of petitioner's producing the Pyrex- and Oneida-branded kitchen tools and are therefore indirect costs properly allocable to the Pyrex- and Oneida-branded kitchen tools petitioner produced. Robinson, 2009 WL 89206, at , 2009 Tax Ct. Memo LEXIS 10, at -. But, as Robinson points out, the Tax Court's reasoning confuses the license agreements with the royalty costs. The Treasury regulations provide that [i]ndirect 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) (emphasis added). The Tax Court did not ask whether the royalty costs directly benefit[ed] or [were] incurred by reason of the performance of production ... activities. Instead, the Tax Court asked whether the license agreements did so. But that is not what the 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 ... activities. 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 WL 89206, at , 2009 Tax Ct. Memo LEXIS 10, at  16. It is equally clear, however, that Robinson could have manufactured the products, and did, without paying the royalty costs. None of the product approval terms of the license agreements referenced by the Tax Court relates to Robinson's obligation to pay the royalty costs. Robinson could have manufactured exactly the same quantity and type of kitchen toolsthat is, it could have perform[ed] its production... activities in exactly the same way it didand, so long as none of this inventory was ever sold bearing the licensed trademarks, Robinson would have owed no royalties whatever. Robinson's royalties, therefore, were not incurred by reason of production activities, and did not directly benefit such activities. In other words, while we may agree with the Tax Court's implicit conclusion that directly benefit 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 activities in order for the costs to be properly allocable to those activities and subject to the capitalization requirement. Our interpretation of § 1.263A-1 (e)(3)(i) is corroborated by the 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 property (for which production costs must be capitalized) and intangible property (to which § 263A generally does not apply) states: [T]he costs of producing and developing books include prepublication expenditures incurred by publishers, including payments made to authors ( other than commissions for sales of books that have already taken place ), as well as costs incurred by publishers in writing, editing, compiling, illustrating, designing, and developing the books. Id. (emphasis added). [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 receives 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 Court and the Commissioner in this case would give rise to exactly the problem Congress crafted § 263A to fix, for then the treatment of indirect costs [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 nature of the underlying property 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 treat books and spatulas differently. Moreover, the Treasury's reasoning in adding the parenthetical about commissions for sales of books that have already taken place to the final version of 26 C.F.R. § 1.263A-2(a)(2)(ii)(A)(1) is also applicable here. The 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 publishers of similar properties) to be capitalized under section 263A. Under the regulations, prepublication expenditures include payments made to authors of literary works. Commentators have inquired as to whether 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 would be inappropriate for a publisher to capitalize commissions where such commissions related only to books that had been sold by the publishers, and not to any books (or copyrights pertaining to such books) that were still on hand. In response to these comments, forthcoming regulations will not require the capitalization of payments made to authors where such payments are commissions for sales of books that have already taken 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 future sales occur. Moreover, payments made to authors of literary 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 preceding 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 inappropriate for a kitchen-tool manufacturer to capitalize trademark royalties where such royalties are based only on those kitchen tools that have been sold by the manufacturer, and not on any kitchen tools that are still on hand. Although the 1988 Notice does not explicitly state the reason why capitalization should not be required for commissions for sales of books that have already taken place, the distinction drawn by the IRS is guided by the principles underlying inventory accounting. The purpose of inventory accounting isas we have previously saidto reflect income 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 royalty only for kitchen tools that have already been sold, it is necessarily true that the royalty costs and the income from sale of the inventory items are incurred simultaneously. [9] The Commissioner's position in the case before us would, instead, distort Robinson's income by denying it deductions until some subsequent year, potentially long after the inventory items to which those deductions should attach have been sold. Had Robinson's licensing agreements provided for non-sales-based royalties, such as manufacturing-based or minimum royalties, then under the reasoning of Notice 88-86 capitalization would be required. And this, too, follows from inventory accounting principles. Suppose SpoonCo, another kitchen tool manufacturer, 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 for 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, because otherwise SpoonCo would be getting its deduction in the year before it got the corresponding income. In the instant case, however, the record is clear that Robinson's royalties were sales-based. They were calculated as a percentage of net sales of kitchen tools, and they were incurred only upon the sale of those kitchen tools. [10] They are therefore immediately deductible. [11]