Opinion ID: 357
Heading Depth: 2
Heading Rank: 3

Heading: Deductibility of the Royalty Payments

Text: Robinson presents three arguments that the royalty payments are not required to be capitalized under § 263A: (1) that the royalty payments are deductible as marketing, selling, advertising, [or] distribution costs, 26 C.F.R. § 1.263A-1(e)(3)(iii)(A); (2) that royalty payments which are not incurred in securing the contractual 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 allocable 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 intellectual property royalties under the uniform capitalization regulations. Apart from the decision below, the only other case concerning these issues is another Tax Court memorandum decision. See Plastic Eng'g & Tech. Servs., Inc. v. Comm'r, T.C. Memo. 2001-324, 2001 Tax Ct. Memo LEXIS 360. 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 required to be capitalized under the § 263A regulations.
According to Robinson, its royalty payments are marketing, selling, advertising, [or] distribution costs. Although Robinson is correct that marketing, selling, 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 trademark 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 trademarks 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 property produced or property acquired for resale, id. § 1.263A-1(e)(3)(ii). If we were to accept 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 marketing, selling, advertising, and distribution costs. This Court has not decided on the proper level of deference owed to revenue rulings after United States v. Mead Corp., 533 U.S. 218, 121 S.Ct. 2164, 150 L.Ed.2d 292 (2001). See Reimels v. Comm'r, 436 F.3d 344, 347 n. 2 (2d Cir. 2006). We need not do so here, for the ruling does not help Robinson no matter how much deference we accord to it. In the revenue ruling, a taxpayer was permitted to deduct the costs of obtaining ISO 9000 certification, which differentiated it from non-certified competitors and allowed it to do businesses with customers who required certification. The IRS determined that ISO 9000 certification, like advertising 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 capitalized. Since trademarks instead are on the capitalization list, the revenue ruling is wholly distinguishable. 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 contracts 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 regardless of the number of trademarked items manufactured or sold) would be immediately deductible. So would a manufacturing-based royalty paid whenever the manufacturer produced an inventory item bearing the licensed trademark-and this would be so even if the trademarked items were not sold until a later taxable year. But the point of § 263A and its regulations is precisely to make sure that trademark royalties are not deducted during a taxable year which precedes 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, acquiring, or carrying property to be deducted currently, rather than capitalized into the basis of the property and recovered when the property is sold or as it is used by the taxpayer. This [would] produce[ ] a mismatching of expenses and the related income and an unwarranted deferral of taxes. S.Rep. No. 99-313, at 140; accord T.D. 8482, 1993-2 C.B. at 78. For these reasons, we reject the contention that all trademark royalties are immediately deductible.
Robinson next argues that its royalty payments 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 trademark, 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 payments are not described in § 1.263A-1(e)(3)(ii)(U), that description does not include all costs, or even all trademark costs, that must be capitalized. The costs incurred by Robinson are still indirect costs, and they are, therefore, required to be capitalized to the extent they are properly allocable to property produced. As § 1.263A-1(e)(3)(i) explains, [i]ndirect costs 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 that 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) requires capitalization only of lump-sum minimum royalties. Assuming, contrary to what we have said above, that costs not described in subclause (U) are necessarily deductible, then any manufacturing-based royalty would be deductible. But it would be contrary to the purpose of § 263A to permit taxpayers to manufacture inventory and deduct royalties immediately, even if that inventory were not sold or otherwise disposed of until a later taxable year.
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]