Field Guidance on the Planning & Examination of Sales-Based Royalty Payments and Sales-Based Vendor Allowances
March 1, 2011
LB&I Control No: LB&I-4-0211-002
Impacted IRM 4.51.2
DIRECTORS, FIELD OPERATIONS
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PRE-FILING AND TECHNICAL GUIDANCE
|FROM:||Sergio Arellano, Industry Director Retailers, Food, Pharmaceuticals & Healthcare|
|SUBJECT:||Field Guidance on the Planning & Examination of Sales-Based Royalty Payments and Sales-Based Vendor Allowances|
This memorandum provides guidelines for the efficient use of audit time and resources devoted to the examination of payers of sales-based royalties and payees of sales-based vendor allowances. This memorandum does not address issues relating to the examination of other parties to these transactions.
This LB&I Directive is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.
Royalties are costs incurred by taxpayers to secure contractual rights to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property the taxpayer produces or acquires for resale. Sales-based royalties become due only upon the sale of property. Like other royalties, sales-based royalties that are incurred by reason of or that benefit production or resale activities must be capitalized under Section 263A. Taxpayers who use the simplified production method or simplified resale method allocate sales-based royalties, like other costs, between ending inventory and cost of goods sold.
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. Reseller taxpayers generally treat sales-based vendor allowances as a reduction in cost, part of which reduces the cost of goods in ending inventory under the simplified resale method.
The taxpayer in Robinson Knife Manufacturing Company, Inc. v. Commissioner, 600 F.3rd 121 (2d Cir. 2010), rev’g T.C. Memo 2009-9, treated sales-based royalty costs as deductible sales expenses rather than production costs. The Service determined that the royalties were production costs that Robinson must capitalize to inventory under § 263A. The Tax Court held that the royalties were production costs because they directly benefited and were incurred by reason of production. The Court of Appeals, however, held that the royalties were not production costs required to be capitalized under the Section 263A regulations. Rather, the royalty costs were incurred by reason of the sale of Robinson’s product and were deductible under Section 162.
The Service has issued an Action On Decision (AOD 2011-01) that nonacquiesces to the Robinson Knife decision. The AOD concludes that the court confused the timing of the sales-based royalty payments with the purpose of the payments, and failed to recognize that Robinson had to manufacture the items to sell them. The AOD agrees with the Tax Court that the royalty expenses were production costs that must be capitalized under section 263A.
Proposed regulations under section 263A, published at 75 F.R. 78940 (December 17, 2010), clarify that sales-based royalties generally are a production cost, despite the fact that the cost is not incurred until property is sold. However, because sales-based royalties are incurred only when property is sold, the proposed regulations provide that sales-based royalties are allocable only to the property sold and are not allocated to ending inventory under the simplified production method and simplified resale method formulas.
The proposed regulations also clarify that sales-based vendor allowances are a reduction in costs and not an increase in gross receipts. However, like sales-based royalties, sales-based vendor allowances properly are allocated to property sold during the taxable year and do not reduce costs in ending inventory under the simplified resale method.
The proposed regulations, although not effective until finalized, represent the government position on the proper accounting treatment of these amounts.
Planning and Examination Guidance
Pending publication of final regulations, agents should not expend further resources challenging a taxpayer’s accounting for sales-based royalties as described in the
proposed regulations or under a method that reaches a similar result.
Sales-Based Vendor Allowances:
Pending publication of final regulations, agents should not challenge taxpayers’ use of a method of accounting for sales-based vendor allowances that is consistent with either (1) the proposed regulations, or (2) the current regulations that allocate a portion of vendor allowances to ending inventory under the simplified resale method.
If you have any questions, please contact the pharmaceutical and biotech technical advisors or the retail technical advisors.
|cc:||Commissioner and Deputy Commissioner, LB&I
Deputy Commissioner, Operations
Division Counsel, LB&I