TAM 200630019, a technical advice memorandum released in 2006, may support an argument that production-related royalties that are contingent on sales may be excluded from ending inventory. Specifically, the TAM appears to indicate that production costs, including contingent royalties that are factually related to items sold, may be allocated to cost of sales if the taxpayer uses a facts-and-circumstances method (as opposed to a simplified method) to allocate additional Section 263A costs. The TAM provides that a cost allocated entirely to cost of goods sold, and thus recognised currently, still constitutes “capitalisation” for purposes of Section 263A.
Facts of the TAM
A foreign parent corporation (parent) granted an indirectly owned US subsidiary (subsidiary) an indivisible, non-transferable, and non-exclusive right to manufacture, produce, and assemble products and related parts in the United States under a license agreement. The agreement required the subsidiary to pay a royalty to the parent on the number of units sold by the subsidiary during each calendar month. The subsidiary used the intellectual rights and technical information granted by the agreement to produce certain products and parts, including those that remained on hand at the end of each tax year at issue.
The subsidiary used a “facts-and-circumstances” method under Reg. Sec. 1.263A-1(f)(2) as its method of capitalising Section 263A costs. Under its facts-and-circumstances method, the subsidiary used an equivalent unit of production (EUP) method to allocate additional Section 263A costs to units produced, including units in ending inventory. The subsidiary excluded the royalty expense from its EUP method and instead “deducted” all the royalty fees paid during the four years under audit. In years one and two, the subsidiary deducted the royalties paid as “other deductions” on line 26 of Form 1120. In years three and four, the royalties paid were reported as “other costs” on Schedule A, Costs of goods sold.
IRS analysis
The Internal Revenue Service (IRS) first analysed whether the subsidiary was required to capitalise the royalties under Section 263A, and concluded that the royalties were licensing and franchise costs that were required to be capitalised (Reg. Sec. 1.263A-1(e)(3)(ii)(U)). The IRS also cited Plastic Engineering & Technical Services, Inc, (T.C. Memo. 2001-324) to support its conclusion that the royalties were required to be capitalised. In that case, the Tax Court required a taxpayer that used the simplified production method to capitalise contingent royalties where the rights granted under the royalty agreement directly benefited the taxpayer's production activities.
The IRS then considered whether the subsidiary's method of accounting for the royalty expenses treated the expenses as a production cost or as a period expense. In analysing this issue, the TAM states, “a taxpayer including a cost in inventory is capitalising that cost even if the cost is allocated entirely to cost of goods sold.” Accordingly, the TAM recognises that a taxpayer using a facts-and-circumstances allocation method can fully allocate a production cost to cost of goods sold, assuming that the allocation meets the reasonableness standard under Reg. Sec. 1.263A-1(f)(4). However, the IRS argued that while it is possible to have a reasonable capitalisation method that allocates the entire amount of a cost to cost of goods sold, capitalisation in the vast majority of cases involves the allocation of some portion of the cost to items in ending inventory.
The IRS next determined that the subsidiary's treatment of the royalty expense was not consistent with the manner in which capitalisation of an item most commonly operates, but was consistent with the manner in which the deduction of an item as a period expense commonly operates. Accordingly, the IRS concluded that the subsidiary treated the royalties as a period expense and that the treatment was improper.
Observation: It appears that the IRS based this conclusion on the subsidiary's treatment of the royalties as a period expense in years one and two and as not includible in its EUP calculation in any year. Consequently, a taxpayer attempting to allocate contingent royalties entirely to cost of goods sold should be careful that its presentation is consistent with a capitalisation method.
Observation: The TAM clearly states that the allocation of production costs entirely to cost of goods sold constitutes a method of capitalisation under Section 263A. However, because the IRS based its decision on the subsidiary's presentation, it did not analyse whether the allocation of contingent royalties entirely to cost of goods sold in this case would have been reasonable.
As indicated above, the facts of the TAM state “the intellectual property rights and technical information were used by subsidiary in all units and parts produced, including those that remained on hand at the end of each of the taxable years at issue.” By including this statement in the facts, the IRS may be implying that the allocation of royalties entirely to cost of goods sold in this instance would have been unreasonable because the rights granted under the agreement were used in the production of the goods in ending inventory. If the IRS were to pursue this argument, most contingent royalties related to production know-how would be allocable to goods in ending inventory according to the IRS. On the other hand, if the IRS ultimately agrees with the contention that contingent royalties cannot factually relate to goods in ending inventory because the royalty does not accrue until the point of sale, contingent royalties would be deductible under a facts-and-circumstances method.
After reaching the conclusion that the subsidiary's treatment of royalties was improper, the IRS determined it was moot whether the subsidiary's change in treatment of the royalty from a deduction in years one and two and as cost of goods sold in years three and four was a change in method of accounting.
Observation: It could be argued that a change in the characterisation of royalty expense from a deduction to cost of goods sold is not a change in method of accounting because the change is in presentation only and does not affect the timing of the recognition of the royalty expense. However, it also could be argued that this change in characterisation could only result from a change in the treatment of the royalty expense from a deduction to either a Section 471 cost or a Section 263A cost that is allocated entirely to cost of goods sold. According to the IRS, the change in the identification of Section 471 and Section 263A costs is a change in method of accounting that requires IRS advance consent, unless the taxpayer is making the change in conjunction with a change to a Section 263A allocation method specifically described in the regulations. Consequently, taxpayers should be aware that merely making re-class entries for royalties on their tax return without a related method change may not be sufficient to support the argument that they are using a capitalisation method to account for the royalties.
Next, the IRS attempted to evaluate the reasonableness of the subsidiary's EUP method. The subsidiary did not allocate any additional Section 263A costs to its in-transit raw materials on the basis that the indirect costs allocable to in-transit raw materials already were included in the cost of such materials for financial reporting purposes. The National Office did not have sufficient information to determine whether such costs indeed were already allocated. Moreover, the National Office stated it lacked sufficient information to evaluate the similarity of the units produced and the rate at which costs were incurred in order to determine whether the EUP method was reasonable. Finally, the National Office indicated that the IRS could mandate the use of any reasonable method, including the simplified production method, if the subsidiary used an improper method of capitalising costs under Section 263A.
Conclusion
While the overall conclusion was not favourable for taxpayers, the TAM provides favourable recognition that the allocation of production costs entirely to cost of goods sold constitutes a method of capitalisation under Section 263A. As a result, the TAM presents an opportunity for taxpayers that use (or change to) a facts-and-circumstances method to allocate certain additional Section 263A costs to cost of goods sold. Specifically, royalties that are contingent on sales arguably may be allocated to cost of goods sold to the extent the royalty agreement is carefully drafted to support this argument. In addition, taxpayers that are not using a simplified production method should examine other existing costs that may qualify to be allocated entirely to cost of goods sold.
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