Expect Increased IRS Scrutiny of Royalty Costs

Tax Controversy Alert
01.15.09

In Robinson Knife Manufacturing Company, Inc. v. Commissioner, T.C. Memo 2009-9 (January 14, 2009), the United States Tax Court broadly interpreted the circumstances under which a royalty paid in connection with the production and sale of merchandise must be capitalized under IRC § 263A as an indirect production cost rather than currently deducted as a marketing expense. In essence, the Tax Court suggested a “but for” analysis in determining whether a royalty is incurred “by reason of” the taxpayer’s production activities. This case is likely to further embolden the IRS in challenging the tax treatment of royalty costs.

In Robinson Knife, the taxpayer designed and manufactured a wide variety of kitchen implements. Some of the kitchen implements were sold under trade names owned by the taxpayer, while others reflected trade names licensed from third parties. Although not reflected in the opinion, the underlying briefs reveal that the trademarks licensed from third parties were not an integral part of the products’ design or functionality, but instead were a function of how and to whom the company intended to market the finished goods.

The Tax Court disregarded (and did not even mention) this aspect of the licensing agreements. Instead, the court focused on the fact that the taxpayer negotiated and used the licenses prior to rather than following the manufacture of the goods, and the fact that the licensors retained various rights designed to protect the goodwill associated with the trademarks. Viewing the facts in this manner, the court reasoned that had the taxpayer not acquired the right to use the trademarks, it would not have been entitled to manufacture the kitchen implements bearing the chosen logos, and as such, the royalty made production of the merchandise possible. From this, the court concluded that the royalties either directly benefited or were incurred by reason of the taxpayer’s production activities. In other words, “but for” the royalty, there would have been no production, and as a result the royalty must be capitalized as an indirect production cost under IRC § 263A.

Because Robinson Knife employed a simplified method to allocate other production costs, the court concluded that the IRS properly required the company to allocate the capitalized royalty costs using the same simplified method. The court had no occasion to address whether and the extent to which a taxpayer instead using a facts and circumstances method of accounting for production costs may allocate a properly capitalized royalty to the year’s cost of goods sold. On appropriate facts, such a fact-based allocation to cost of goods sold will result in the proper matching of the royalty cost to the goods to which it relates.

The Tax Court’s decision in Robinson Knife is likely to embolden IRS examination teams’ current practice of challenging the tax treatment of a wide range of royalties. Taxpayers should expect the IRS to scrutinize the treatment of any royalty that is not capitalized into ending inventory, unless the payment clearly relates only to the use of intellectual property after the conclusion of the production process.

Further, where the IRS challenges the taxpayer’s current treatment of royalty costs, the examination team is likely to assert that the taxpayer is using an incorrect method of accounting and that the IRS is entitled to place the taxpayer on a new accounting method of the IRS’s choosing. In many cases, the IRS attempts to require the taxpayer to begin using a simplified method for purposes of allocating production costs, including royalties. The end result of the IRS’s overall approach is to capitalize excessive production costs, including royalties, and to overstate the taxpayer’s taxable income.

The Treasury Department and the IRS National Office currently are developing administrative guidance regarding the treatment of royalties similar to those at issue in Robinson Knife. Miller & Chevalier has provided the government with extensive comments regarding the proper tax treatment of royalty expenses (2008 TNT 120-26; copy available from Miller & Chevalier) and will continue doing so. Depending on the ultimate outcome of this guidance project, however, particularly in light of Robinson Knife, taxpayers should expect the IRS to continue scrutinizing the current deductibility of nearly all royalty expenses.

For more information, please contact any of the following lawyers:

Patricia Sweeney, psweeney@milchev.com, 202-626-5926

Dwight Mersereau

James Atkinson

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