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Washington Tax Alert March 23, 2011 (sales-based royalties incurred by resellers)

Washington Tax Alert from Don Barnes, dbarnes@washingtontaxlaw.com
March 23, 2011

These comments are submitted in response to a Notice of Proposed Rule-Making relating to the treatment of certain sales-based royalties, fees and payments under IRC § 263A (collectively referred to hereinafter as "sales-based royalties"). The proposed regulations were issued on December 16, 2010, and comments were requested by March 17, 2011. We respectfully request that you consider these comments, even though they are being submitted after the deadline for comments.

The proposed regulations have been an item on the Treasury/IRS Priority Guidance Plan for several years. The 2009-2010 Priority Guidance Plan referred to the item as "Guidance under section 263A regarding the treatment of post-production costs, such as sales-based royalties." (italics added.)

The current 2010-2011 Priority Guidance Plan, which was issued on December 7, 2010, shortly before issuance of the proposed regulations, described the guidance as "Regulations under § 263A regarding the treatment of sales-based costs, such as sales-based royalties."

The proposed regulations do not explain this change in scope of the guidance, but the proposed regulations by their terms apply to fees, payments, and royalties incurred by a taxpayer upon the sale of property produced or acquired for resale. See Prop. Reg. § 1.263A-1(e)(3)(ii)(U). We commend Treasury and the Service for expanding the scope of the guidance to include both producers of property and resellers of property. The current regulations are applicable to both producers and resellers, and it makes sense that any revised regulation should address both producers and resellers of property.

The proposed regulations do not, however, address the fact that sales-based royalties incurred by a reseller of property may be a direct acquisition cost under IRC § 471 rather than an indirect additional IRC § 263A cost. Literally, the proposed regulations are limited to sales-based royalties that are indirect costs. See Prop. Reg. § 1.263A-1(e)(3)(ii)(U)(2) ("and the cost is required to be capitalized under this paragraph (e)(3)").

However, the subtlety of this language has resulted in some uncertainty among examining agents and Appeals officers. In the interest of clarity and efficiency and to avoid any conflict with other regulations, we recommend that the proposed regulations acknowledge that a sales-based royalty payable by a reseller of inventory to its supplier is an additional direct acquisition cost under IRC § 471, and included in cost of goods when the inventory item is sold under the reseller's cost flow assumption.

Consider the following example. Taxpayer purchases all the assets comprising a business, including substantial inventory, from Seller. The purchase can be an asset acquisition or a stock acquisition with an IRC § 338(g) or IRC § 338(h)(10) election. Taxpayer and Seller agree on a fixed purchase price of $95x, but because of uncertainties regarding the value of the inventory, the parties agree that if Taxpayer is able to resell the acquired inventory at a certain price, Taxpayer will pay Seller an additional $5x.

When and if Taxpayer resells the purchased inventory at the agreed upon price, Taxpayer will incur an additional $5x which will be included in the purchase price (or deemed purchase price in the event of a stock acquisition with IRC § 338 election) and allocated among the assets purchased under the residual method. See Treas. Reg. §§ 1.1060-1, 1.338-6 and 1.338-7. Treas. Reg. § 1.338-7(b) provides that if the amount allocated to a given asset is different from the original amount allocated to it, "the difference is added to or subtracted from the original allocation to the asset, as appropriate."

If the additional $5x is allocated to inventory under the residual method, Treas. Reg. § 1.338-7(d)(1) provides that "the increased amount otherwise allocable to such asset is taken into account under general principles of tax law that apply when part of the cost of asset not previously taken into account in basis is paid or incurred after the asset has been disposed of, depreciated, amortized, or depleted."

These rules are directed to determining the acquisition cost of assets and the tax treatment of contingent consideration where the contingent consideration is incurred after the assets are acquired. These contingent acquisition costs are not indirect costs or additional IRC § 263A costs.

The same tax results should apply if a taxpayer makes an isolated purchase of inventory which is not part of an applicable asset acquisition. Any sales-based royalty payable by the taxpayer to the supplier of inventory should be added to the taxpayer's IRC § 471 cost of the inventory, and immediately deducted as cost of goods sold.

In the interest of clarity and to be consistent with other regulations, we think the proposed regulations under IRC § 263A should acknowledge that sales-based royalties incurred by a reseller of property to its suppliers are an additional direct acquisition cost of the property, and included in cost of goods sold when incurred under general tax principles.

We would be happy to discuss these comments with you or others at Treasury or the Service. Thank you for your consideration.