IRS Issues Proposed Regulations on the Treatment of Sales-Based Royalties

Pharmaceutical companies commonly pay royalties related to the right to make, use, and/or sell products based on patented biological or chemical know-how, where the amount of the royalty payment is based on a percentage of the revenue from the sale of products and is incurred only when the products are sold.

On December 17, 2010, the IRS issued proposed regulations (REG-149335-08) that agree with the result (but not the reasoning) of the Second Circuit Court of Appeal’s decision in Robinson Knife Mfg. Co. Inc. V. C.I.R. In Robinson Knife, the Second Circuit held that section 263A does not require the capitalization of sales-based royalty costs. As a result, according to the Second Circuit, sales-based royalties (i.e., royalties that are calculated as a percentage of sales revenue from inventory, and incurred only upon sale of that inventory) are treated as deductible costs for purposes of section 263A, rather than indirect costs subject to capitalization in part to ending inventory. In contrast, the proposed regulations provide that sales-based royalties are capitalizable indirect costs under section 263A, but that these costs are allocable only to property that has been sold. Please see here for additional information on the proposed regulations.