Royalty Issues – The case of Robinson Knife Manufacturing Co. Inc. & Subsidiaries v. Commissioner

In an ongoing court battle related to capitalizing royalties, strike one up for the side of the taxpayer. On March 19, 2010, the U.S. Court of Appeals, Second Circuit overturned a January 2009 ruling by the United States Tax Court. This decision relates to the interpretation of the tax treatment of royalty payments under trademark licensing agreements.

In Robinson Knife Manufacturing Co. Inc. v. Commissioner, (T.C. Memo. 2009-9), the taxpayer was actively engaged in the business of designing, manufacturing, marketing, and selling kitchen products to large retailers, such as Target, Sears, and Wal-Mart. Robinson also maintains licensing agreements with other companies for the right to use trademarks on 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 those kitchen tools sold.

During 2003 and 2004, the taxable years originally challenged by the IRS, Robinson had licensing agreements with Corning Inc. and Oneida Ltd. Robinson incurred and paid trademark royalties of about $2 million each year. Robinson deducted the royalty payments as ordinary and necessary business expenses. Upon examination, the IRS determined that Robinson must capitalize the royalties pursuant to Section 263A of the code.

The capitalization rules basically require that certain costs incurred to produce property considered inventory in the hands of the taxpayer be included in inventory costs. These costs must be capitalized and cannot be currently deductible for tax return purposes. The Internal Revenue Code provides a list of costs which may be considered allocable to production and thus required to be capitalized. Included in this list are licensing costs incurred in securing the right to use a trademark.

Some costs, considered indirect costs, are excluded from the capitalization requirement, such as marketing, selling, advertising, and distribution costs. As part of its marketing decisions as it related to these trademark items, Robinson did not advertize or market its own products, but relied on the trademarked products to entice customers.

The IRS contended that the royalties constituted a capitalized cost and the Tax Court, in 2009, agreed with the agency. The Court stated that the license agreements gave Robinson the right to manufacture branded kitchen tools and could not do so without those agreements. Robinson argued that the royalties constituted a marketing expense that should be exempt from capitalization. However, initially, the Tax Court prevailed.

Fast forward to 2010 as the case is presented to the Appellate Court, which held that taxpayers subject to Section 263A may deduct royalty payments that are calculated as a percentage of sales and are incurred only upon the sale of inventory and not when it is produced or manufactured. The Robinson royalties were paid based solely on sales, not production. The taxpayer used the trademarks on its product packaging for sales based on the goodwill and brand loyalty already established by such trademarks.

On March 19, 2010, the U.S. Court of Appeals, Second Circuit overturned the Tax Court ruling on the basis that the Commissioner and the U.S. Tax Court were misinterpreting the facts, and confusing license agreements with royalty costs. Robinson used the trademarks to market their products since customers would choose the products displaying the trademark names over the generic products. The royalties therefore were not used in the production or manufacturing of the product but in the sale of the product. Furthermore, Robinson did not pay the royalty as the product was made but only as the product was sold. Based upon these facts, the royalty costs would be fully deductible as incurred since none of the royalty was at all related to any product remaining in inventory.

What does this mean for taxpayers going forward? There is room for interpretation on whether or not royalty costs are to be expensed or capitalized. This case shows that the purpose and intent surrounding the payment of royalties in relation to production activities is a key factor in determining their tax treatment. Royalties paid simply to use a brand name and which aren’t paid until the product is sold represent an operating expense. On the other hand, royalties paid to develop inventory would be capitalized since the absence of these types of royalties would be detrimental to the production of the product.

Should you have any questions on how this case may affect your business or which costs to capitalize, please contact your MarcumRachlin Tax Professional.