Final regulations issued on sales-based royalties and vendor allowances
TAX ALERT |
On Jan. 13, 2014, the IRS issued final regulations (TD 9652) relating to the treatment of sales-based royalties under section 263A and sales-based vendor allowances and chargebacks under section 471. These regulations modify and finalize the proposed regulations that the IRS issued on Dec. 17, 2010, and adopt many of the considerations that commentators raised during the public hearing in April 2011. Two new examples were added to further clarify the new concepts defined in the regulations. On May 6, 2014, the IRS issued Rev. Proc. 2014-33, providing guidance on how to apply accounting method changes to each of the concepts covered in the final regulations.
Sales-based royalties are costs that taxpayers incur in securing a contractual right to use trademark, corporate plan, manufacturing procedure, special recipe, or other similar rights associated with property produced or property acquired for resale. These royalties are generally contingent and due upon the sale of the related property. While sales-based royalties are capital in nature, there was little IRS published guidance prior to the issuance of the final regulations on how to allocate these costs to cost of goods sold (COGS) or ending inventory.
The final regulations continue to permit taxpayers to allocate sales-based royalties either (1) to property sold (including the sales-based royalties in COGS), or (2) between COGS and ending inventory based on facts and circumstances. The regulations permit the use of one of the following pre-existing allocation methods: 1) cost allocation method;1 2) simplified production method; 2 or 3) simplified resale method.3 Taxpayers allocating 100 percent of sales-based royalties to inventory sold may not include these royalties in determining ending inventory. Rather, taxpayers would include these costs in current-year COGS. The preamble to the final regulations states that the determination of whether a cost is a royalty cost4 or a contingent acquisition cost falls outside the scope of these specific regulations.
A taxpayer that wishes to make any one of the following changes to its method of accounting for sales-based royalties may do so via new automatic accounting method change number 201:5
- From not capitalizing sales-based royalties to capitalizing these costs and allocating them entirely to COGS under the taxpayer's method of accounting
- From not capitalizing sales-based royalties to capitalizing these costs and allocating them to inventory property under the taxpayer's method of accounting
- From capitalizing sales-based royalties and allocating these costs to inventory property to allocating them entirely to COGS
- From capitalizing sales-based royalties and allocating these costs entirely to COGS to allocating them to inventory property
However, a taxpayer that wants to change its accounting method to capitalize sales-based royalties and allocate them to inventory property using an "other reasonable method"6 may not do so under this automatic accounting method change. Furthermore, if a taxpayer uses a simplified method to determine costs allocable to inventory property, the taxpayer must remove sales-based royalties from the formulas used to calculate ending inventory in the same manner in which the amounts were originally included in the formulas. Additionally, taxpayers using a simplified method with a historic absorption ratio election must revise all previous and current historic absorption ratios. In order to avoid duplication or omission of items when the accounting method is changed, these revised ratios must be used to revalue beginning inventory and are subject to the taxpayer's full section 481(a) adjustment.
The IRS' transition guidance provides a waiver of the scope limitations for taxpayers filing the automatic accounting method change in the first or second tax years that end on or after Jan. 13, 2014. In order to ease the administrative burden of filing multiple accounting method changes, taxpayers may file a single Form 3115 if concurrent automatic method changes under section 263A are being filed.
Sales-based vendor allowances
Sales-based vendor allowances are allowances, discounts or price rebates that a reseller receives, earns or otherwise becomes entitled to based on the resale of a vendor's merchandise to a third party. These are facts and circumstances driven determinations and usually result in either the reduction of cost of goods in ending inventory or COGS. Aside from specifically identified sales-based vendor chargebacks (as discussed later), the final regulations do not discuss the treatment of other types of sales-based vendor allowances. The IRS and Treasury Department are seeking further comments from industry in order to craft additional guidance on defining specific sales-based vendor allowances and creating objective rules for the allocation of such allowances to the purchase price of goods, ending inventory or COGS.
Sales-based vendor chargebacks
The new regulations define a sales-based vendor chargeback as a specific sales-based vendor allowance that is "an allowance, discount, or price rebate that a taxpayer becomes unconditionally entitled to by selling a vendor's merchandise to specific customers identified by the vendor at a price determined by the vendor."7 In order to clearly reflect income, sales-based vendor chargebacks reduce COGS but do not reduce the cost of goods included in ending inventory.
The regulations provide an example of a wholesaler of pharmaceuticals and a manufacturing company. In the example, the wholesaler purchases drugs from the manufacturer for $10x per unit. The manufacturer has agreements with certain customers that entitle the customers to purchase drugs from the wholesaler for only $6x per unit. These agreements provide a price rebate to the wholesaler for the $4x difference, which can be rebated to the wholesaler, credited towards the wholesaler's invoice from the purchase of drugs from the manufacturer, or credited towards future purchases from the manufacturer. Since this price rebate falls under the new definition of a sales-based vendor chargeback, regardless of the choice that the wholesaler makes (rebate, invoice credit or future credit), the wholesaler will decrease its COGS and will not reduce the ending inventory.8
Taxpayers that use a simplified method to allocate additional section 263A costs to ending inventory and wish to no longer include cost adjustments for sales-based vendor chargebacks in such formulas may do so under new automatic accounting method change number 202. Similar to the sales-based royalty changes, the same limitations apply to taxpayers that use simplified methods to determine additional section 263A costs or simplified methods with historic absorption ratios.
Taxpayers that wish to treat sales-based vendor chargebacks as a reduction in COGS may change their accounting method via new automatic change number 203. The same scope limitations that are waived for sales-based royalties also apply to both sales-based vendor chargeback changes. Concurrent UNICAP method changes are allowed for both chargeback changes, similar to the sales-based royalty method change.
Taxpayers engaged in manufacturing that have agreements with other companies to license products or to receive chargebacks based on existing sales agreements could be affected by these new regulations. These regulations provide an opportunity for taxpayers to review existing agreements, and taxpayers should consider the implications of the new regulations while drafting future agreements in order to insure the desired tax treatment of the transaction. Taxpayers wishing to adopt the new accounting methods described in the final regulations may do so via any one of three new automatic accounting method changes, with the scope limitations waived for the first or second tax years ending on or after Jan. 13. 2014. Also, taxpayers with pending requests for non-automatic method changes (filed prior to May 6, 2014) may now request automatic consent under the new regulations.
1 Under Reg. section 1.263A-1(f).
2 Under Reg. section 1.263A-2(b).
3 Under Reg. section 1.263A-3(d).
4 Under Reg. section 1.263A-1(e)(3)(ii)(U).
5 See Rev. Proc. 2011-14, APPENDIX section 11.11, as modified by Rev. Proc. 2014-33.
6 See Reg. section 1.263A-1(f)(4).
7 See Reg. section 1.471-3(e)(1)(i).
8 See Reg. section 1.471-3(e)(1)(ii).