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IRS: Minimum Royalties for Licensed Patents Must Be Capitalized


6/19/13

Synopsis:
 
In recent field attorney advice, the IRS concluded that minimum royalties paid for use of licensed patents that are not based on sales of products produced must be capitalized to the taxpayer’s ending inventory under the rules of IRC Section 263A.
 
Issue:
 
The taxpayer developed, manufactured, marketed, and sold a product. In order to use patented technology required for the manufacturing process, the taxpayer entered into a licensing agreement with the patent holder. The agreement provided the patent holder with two forms of royalty compensation: the Earned Royalty and the Minimum Royalty. The Earned Royalty was calculated using a specified amount per unit of product sold or leased. The Minimum Royalty was a fixed annual payment to the patent holder due at the same time every year. The agreement stipulated that, if the taxpayer made any Earned Royalty payment in a given year, it would be credited against the Minimum Royalty payment due.
 
In the tax years analyzed in the field advice (20124401F), the Earned Royalty always exceeded the Minimum Royalty due. Therefore, the taxpayer argued to the IRS that no Minimum Royalty was actually paid and took a deduction for the full amount of royalties paid to the patent holder as cost of goods sold. The IRS disagreed, arguing that the Minimum Royalty amount must be capitalized to the taxpayer’s ending inventory under the rules of Section 263A. The field advice memorandum concurred with the IRS.
 
Section 263A requires the capitalization of direct and indirect costs that are properly allocable to tangible personal property produced by a taxpayer. Indirect costs – costs incurred to produce property other than direct material and labor costs – are properly allocable to the property when the costs directly benefit, or are incurred by reason of, the production. The regulations that accompany Section 263A specifically list licensing and franchise costs, including minimum annual payments and royalties, as indirect costs that must be capitalized.
 
Under a proposed regulation, royalty costs that are incurred based only on the sale of property produced are allocable only to goods that are sold, thus flowing through the cost of goods sold for that year. The Earned Royalty payments in excess of the Minimum Royalty are based on the number of units sold or leased and are due only when the transactions occur. Excess Earned Royalty payments are treated as sales-based royalties under the proposed regulation rules. The IRS has instructed revenue agents not to challenge this sales-based royalty treatment if taxpayers account for the payments under the rules of the proposed regulations.
 
The taxpayer argued that because the Earned Royalty payments for the years in question exceeded the Minimum Royalty due, there was no Minimum Royalty payment actually due in those years. The IRS disagreed. Under the license agreement, the Minimum Royalty was due and payable every year, regardless of units sold or leased. Because of this, the taxpayer’s liability for the Minimum Royalty exists whether or not there is sufficient Earned Royalty liability to credit the amount due to zero. Thus, the Minimum Royalty must be capitalized.
 
To learn more about CohnReznick’s Tax Specialty Services, visit our webpage.


Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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