Trademark licensees, and likely copyright and patent licensees, can now take comfort in deducting royalty payments as a current expense in light of a recent federal appeals court decision. In Robinson Knife Manufacturing Co., Inc. v. Commissioner (March 19, 2010), the U.S. Court of Appeals for the Second Circuit ruled that royalties paid for the use of licensed trademarks are immediately deductible by the taxpayer as ordinary and necessary business expenses. The Second Circuit reversed a Tax Court ruling that a taxpayer-licensee must capitalize (i.e., include in costs of inventory) sales-based royalties, which would have resulted in higher income tax liability to the taxpayer. Under the facts of the case, capitalization would have increased the company's taxable income for the years in question, while a deduction would have reduced the company's tax liability for the same period.
Robinson Knife designs and manufactures kitchen tools. Robinson develops concepts for new items and then seeks out licensing deals from third party brand owners best suited for each product. Under the licensing arrangements, Robinson arranges to manufacture and market the products under a third party brand name to customers such as Wal-Mart or Target. Because Robinson's products are functionally similar to its competitors' products, it largely relies on trademarks and designs to market its products.
During the taxable years at issue in the case, Robinson licensed the famous marks Pyrex and Oneida. The license agreements gave Robinson the exclusive right to manufacture and sell certain types of kitchen tools using the licensed names. In return, Robinson agreed to pay each trademark owner a percentage of the net wholesale billing price of the kitchen tools sold under that owner's trademark. Robinson was not required to make any minimum or lump-sum royalty payment, nor did royalties for any kitchen tools accrue at any time before the tools were sold. Thus, Robinson could design and manufacture as many Pyrex or Oneida kitchen tools as it wanted to keep in inventory, without paying any royalties until they actually sold the products.
Robinson deducted paid royalties as ordinary and necessary business expenses. The IRS determined, however, that such payments, rather than being immediately deductible, must be capitalized and deducted over time in line with complex accounting principles. As a result, the IRS denied the deduction and issued a notice of deficiency to Robinson. Robinson petitioned the Tax Court, which ruled in favor of the IRS. Robinson then appealed to the Second Circuit.
The Arguments and Second Circuit Ruling
Two of the taxpayer's three arguments were rejected by the Court. Robinson's first argument was that royalties are deductible because they are akin to "marketing, selling or distribution costs" under Section 263A of the Internal Revenue Code. The Court rejected this argument because such a sweeping interpretation conflicts with other sections of the Code and IRS regulations, and certain types of royalties associated with inventory do have to be capitalized.
Robinson's second argument was that royalty payments were not "incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe or other similar right associated with property produced" under Section 263A. The Court rejected this argument because such a narrow interpretation of the statute would limit such costs to payments like closing costs, legal fees and up-front payments and administrative fees paid as an inducement to obtain a license agreement.
But the Court ruled in Robinson's favor on its third argument that under Section 263A, such payments were not "properly allocable to property produced" under that Section. The Court held that the royalty payments at issue were deductible in the year paid and that a taxpayer-licensee may immediately deduct the cost of paid royalties as a matter of law, provided the licensee:
- calculates royalties as a percentage of sales revenue from inventory; and
- incurs royalty liability only upon the sale of that inventory.
Because Robinson's license agreements with Pyrex and Oneida met these tests, the Court ruled that Robinson was allowed to deduct the payments. Because the court held that royalties meeting these two criteria are deductible as a matter of law, the reasons for making the royalty payments need not be examined.
Why This Decision is Important to You
The IRS has not announced whether it will follow Robinson Knife or instead continue to maintain the position that royalty payments should be capitalized.
Although the decision addresses only trademark license royalties, we believe it is also applicable to royalties paid under copyright and patent licenses. The Second Circuit itself noted it was the "first court of appeals to address the treatment of intellectual property royalties under the uniform capitalization regulations." The Robinson Knife decision should therefore apply to all royalties paid under any intellectual property licenses, as long as the Second Circuit's criteria are met.
If you include sales-based royalties in ending inventory costs, you must continue to follow your established method of accounting unless you receive consent from the IRS to change to a different method. You can request consent by filing a Form 3115 under the procedures delineated in Rev. Proc. 97-27, although consent is at the IRS's discretion.
If you currently deduct sales-based royalties and are under examination by the IRS, you should consider the costs and benefits of protesting an IRS proposed change in method of accounting. You should be mindful that the Robinson Knife decision weakens the IRS's position that royalty payments must be capitalized.