Last week, a tax court upheld the government’s notion that some royalties must be capitalized.

Specifically, in Robinson Knife Manufacturing Co. Inc. v. Commissioner, T.C. Memo. 2009-9, the taxpayer was actively engaged in the business of designing, developing, manufacturing, marketing, and selling kitchen “tools.” Robinson sells its kitchen tools to large retailers, such as Target, Sears, and Wal-Mart, in both the U.S. and Canada. Some of the products it produces and sells are under its own brand names, which include America Cooks and Chip Clip.

However, Robinson also is involved in licensing agreements with big brand name companies for the right to use the well-known trademarks to label some kitchen tools that it produces and sells. In return for use of the trademarks, Robinson paid royalties based upon a percentage of net sales of the kitchen tools bearing the marks.

Further, Robinson made a marketing decision not to advertise its own branded kitchen tools in magazines, newspapers, broadcast media, direct mailings, or billboards. Instead, it relied on the reputation of the better-known trademarks to entice customers “at the point of sale.”

During the taxable years at issue, Robinson had licensing agreements for the use of trademarks from both Corning Inc. and Oneida Ltd. Both licensing agreements embodied certain terms and conditions of “quality control” over the branded kitchen tools. For the relevant taxable years, Robinson incurred and paid trademark royalties to Corning and Oneida for $2,184,252 and $1,741,415, respectively. Under the tax code’s Section 162(a), Robinson deducted the royalty payments as ordinary and necessary business expenses. The IRS by contrast, determined that Robinson must capitalize the royalties under Section 263A of the code.

The Production Process

The capitalization rules of Section 263A require that a taxpayer’s direct costs and some indirect costs of producing property considered inventory in the hands of the taxpayer be included in inventory costs. As a result, these costs must be capitalized under the tax code direct costs include direct labor costs and materials costs; indirect costs encompass all costs that are not direct costs.

The regulations provide a non-exclusive list of indirect costs that must be capitalized to the extent the costs are “properly allocable” to producing property. Included in this list are “licensing costs incurred in securing the contractual right to use a trademark or other similar rights associated with producing property.” So according to tax regulations1, fees incurred in securing the contractual right to use a trademark are examples of indirect costs that must be capitalized — at least to the extent they are properly allocable to producing property.

However, some indirect costs are expressly excluded from the capitalization requirement, such as marketing, selling, advertising, and distribution costs. Into which category did Robinson’s royalties fall? The IRS contended that the royalties constituted indirect costs and the court agreed with the agency.

Indeed, regulations required that licensing costs be capitalized to the extent they were properly allocable to producing property. And based on the tax rules, indirect costs were properly allocable to producing property when the costs directly benefited or were incurred by reason of the performance of production activities. (See Reg. Sec. 1.263A-1(e)(3)(i).)

Consider that in this case, the license agreements gave Robinson the right to manufacture branded kitchen tools — and without those agreements Robinson could not have legally manufactured them. Following that logic, the court concluded that acquiring the right to use the trademarks was “part of Robinson’s production process.” As a result, the royalties paid “directly benefited” Robinson’s production activities and/or were incurred “by reason of” the company producing the branded kitchen tools. Therefore, the royalties were indirect costs that certainly were properly allocable to the branded kitchen tools that Robinson produced.

Marketing Expenses

Robinson argued, futilely, that the royalties constituted “marketing expenses” that are exempt from capitalization. In this regard, Robinson mistakenly relied on Revenue Ruling 2000-4, 2000-1 C.B. 331, in which the IRS determined that indirect costs incurred to obtain, maintain, and renew “ISO 9000” certification, were not subject to capitalization. Those costs, the ruling notes, were “in connection with a quality control policy” and such costs are specifically exempted from the capitalization rules.

In the Robinson case, however, the royalties were not related to a quality control policy but, rather were license costs for the right to use the trademarks in connection with production of its own kitchen tools. In this regard, the IRS asserted, and the court wholeheartedly agreed, that there is, for capitalization purposes, a crucial, yet subtle, distinction between costs “incurred for marketing” and costs “incurred to produce a more marketable product.”

In the end, the royalties paid by Robinson Knife fell squarely within the latter categorization and, to the company’s dismay, these costs were required to be capitalized.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

Footnotes

1Regulation Section 1.263A-1(e)(3)(ii)(U).