Tax Treatment of Sales-Based Royalties and Sales-Based Vendor Allowances

        On December 17, 2010, the Internal Revenue Service issued long-awaited proposed regulations dealing with the inventory treatment of sales-based royalties.  These proposed regulations provide that a taxpayer who incurs royalties for the use of know-how or production processes in circumstances where such royalties are dependent on the sale of products produced with such know-how may deduct these royalties as part of the cost of goods sold, rather than being required to capitalize any portion of the royalties to ending inventory, regardless of the taxpayer’s UNICAP allocation method (i.e, facts-and circumstances allocation method or simplified production or resale method) and regardless of the taxpayer’s inventory identification method (i.e, FIFO or LIFO).  This very favorable conclusion was not unexpected in light of the recent Second Circuit decision in Robinson Knife Manufacturing Co., Inc. v. Commissioner, 600 F.3d 121 (2d Cir. 2010). 

         However, in a surprising development, the Service paired the inventory treatment of sales-based royalties with the inventory treatment of sales-based vendor allowances.  As a result, the proposed regulations take the position that a taxpayer may not reduce the cost of its ending inventory by any rebates or trade or other types of discounts or chargebacks, if such rebates or discounts are earned upon the sale of goods.  This latter holding is completely contrary to past IRS practice and precedents and we expect to file comments strongly protesting this conclusion.

         Finally, it should be noted that the proposed regulations are prospective and would apply to taxable years ending on or after the date the proposed regulations are adopted in final form.  The proposed regulations do not indicate how the IRS will treat pending cases.  In addition, the proposed regulations do not contain any transition rules for their implementation, once final regulations are adopted, although a section 481(a) adjustment would normally be required in these circumstances.  Treas. Reg. § 1.263A-7.

         If you are affected by these new proposed regulations and have any questions about their application, please contact us.