The federal Second Circuit Court of Appeals has ruled that trademark licensees can in certain circumstances immediately deduct royalty payments as current expenses, rather than capitalizing and deducting them over time.
Overruling both the IRS and the United States Tax Court, the Second Circuit ruled in Robinson Knife Manufacturing Company, Inc. vs. IRS that where the royalty payments: 1) are calculated as a percentage of sales revenue from inventory, and 2) are incurred only upon the sale of that inventory, such payments are immediately deductible.
Robinson Knife designs, manufactures, and markets kitchen tools such as spoons, soup ladles, spatulas, and cooking thermometers, and sells them to retail customers such as Wal-Mart and Target. Sometimes it sells the products under the store brand. In this case, Robinson Knife sold the goods under the Pyrex and Oneida trademarks, which it licensed from Corning and Oneida respectively. Both license agreements required payment of royalties as a percentage of sales revenue only on sale to the retailers, with no royalty advance payments or minimum guaranteed royalties.
IRS rules under Section 263A of the Internal Revenue Code require the capitalization of, “all direct costs and certain indirect costs properly allocable to property produced,” and include, “licensing and franchise costs” as examples of indirect costs, “that must be capitalized to the extent they are properly allocable to property produced.” Examples of indirect costs not allocable to property produced include, “marketing, selling, advertising, and distribution costs.”
Robinson Knife argued that because the famous trademarks were intended to boost sales of their products, the royalties were in the nature of advertising expenses and thus currently deductible. It was overruled by both the IRS and the Tax Court, which ruled that the royalty expenses must be capitalized under complex inventory accounting rules and deducted over time.
But the Second Circuit ultimately agreed with Robinson Knife, on the grounds that the obligation to pay royalties was not incurred unless and until a sale was made, thus royalties were not incurred by reason of production activities, and did not directly benefit such activities.
This is an important victory for licensees, but its scope is unclear. It remains to be seen whether: 1) the IRS follows this ruling outside of the Second Circuit (New York, Connecticut, and Vermont); and 2) it applies as well to royalties paid on copyright, patent, and other intellectual property licenses. Logically it should, because the ruling was based on the timing of the royalty payments, not on the nature of the intellectual property.
Takeaway: trademark licensees based in New York, Connecticut, or Vermont that pay royalties as a percentage of sales revenue of goods only upon sale of those goods can immediately deduct the royalties as current expenses. It remains to be seen whether the IRS allows analogous treatment for licensees based in other states, as well as licensees of patents, copyrights, and other intellectual property.