United States

Tax regulations provide cash flow opportunities for auto suppliers


Royalties are costs that a taxpayer incurs in securing a contractual right to use a trademark, corporate plan, manufacturing procedure or other similar rights associated with property produced or acquired for resale. This is a common expense incurred by tier-one and tier-two suppliers associated with the use of intellectual property, including blue-sky research and development activities, existing customer relationships, trademarks, and/or proprietary manufacturing processes typically licensed by the parent corporation (or other related party).

These royalties are generally contingent and due upon the sale of the related property, and are based on a percentage of associated revenue or similar calculation (i.e., a sales-based royalty). Even though these expenses cannot be avoided, final regulations issued by the Treasury Department and the IRS provide an opportunity for taxpayers to potentially reduce income tax liability (and thus increase available cash flows).

Historically, the IRS has taken the stance that royalties associated with the production and sale of tangible personal property were subject to capitalization and, as such, a portion of these expenses must be allocated to ending inventory via application of the uniform capitalization rules of Sec. 263A. This treatment had been questioned by taxpayers, but the IRS had been successful in defending this requirement until the Second Circuit Court of Appeals' decision in Robinson Knife (600 F.3d 121 (2010)) ruled that Sec. 263A does not require the capitalization of sales-based royalties.

In response to the Robinson Knife decision, the Treasury and the IRS released final regulations which still dictate that sales-based royalties may be capitalized indirect costs under Sec. 263A, but that the costs are allocable only to property that has been sold, thereby resulting in immediate recognition of such costs.

The takeaway on sales-based royalties

Automotive manufacturers and suppliers generally treat royalties as a period cost for financial statement reporting, but capitalize a portion of these expenses as ending inventory for tax-reporting purposes. The final regulations now provide taxpayers with the ability to follow their financial accounting methods regarding sales-based royalties, and to claim an immediate deduction for both GAAP and tax purposes.

Taxpayers should re-evaluate their current treatment of sales-based royalties (and similar costs) to determine if there are any opportunities to change their Sec. 263A methods to achieve a more tax-efficient result, reduce current income tax liabilities and increase cash flow.

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