[Federal Register Volume 79, Number 8 (Monday, January 13, 2014)]
[Rules and Regulations]
[Pages 2094-2098]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-00327]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9652]
RIN 1545-BI57


Sales-Based Royalties and Vendor Allowances

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
capitalization and allocation of royalties that are incurred only upon 
the sale of property produced or property acquired for resale (sales-
based royalties). This document also contains final regulations 
relating to adjusting inventory costs for a type of an allowance, 
discount, or price rebate earned on the sale of merchandise (sales-
based vendor chargebacks). These regulations modify the simplified 
production method and the simplified resale method of allocating 
capitalized costs between ending inventory and cost of goods sold. 
These regulations affect taxpayers that incur capitalizable sales-based 
royalties or earn sales-based vendor chargebacks.

DATES: 
    Effective date: These regulations are effective on January 13, 
2014.
    Comment date: Comments will be accepted until April 14, 2014.
    Applicability date: For dates of applicability, see Sec. Sec.  
1.263A-1(l),

[[Page 2095]]

1.263A-2(f), 1.263A-3(f), and 1.471-3(g).

ADDRESSES: Written (including electronic) comments should be submitted 
to Internal Revenue Service, CC:PA:LPD:PR (REG-149338-08), Room 5203, 
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044, or electronically to www.regulations.gov (IRS 
REG-149338-08). Alternatively, comments may be hand-delivered Monday 
through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR 
(REG-149338-08), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue NW., Washington, DC. All comments will be available 
for public inspection and copying.

FOR FURTHER INFORMATION CONTACT: John Roman Faron, (202) 317-6950 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains final regulations that amend the Income Tax 
Regulations (26 CFR part 1) relating to the allocation under section 
263A of the Internal Revenue Code (Code) of certain sales-based 
royalties and relating to the determination of cost of merchandise in 
inventory under section 471 when a taxpayer earns a type of sales-based 
vendor allowance. On December 17, 2010, a notice of proposed rulemaking 
(REG-149335-08) was published in the Federal Register (75 FR 78940). 
Written comments responding to the notice of proposed rulemaking were 
received. The comments are available for public inspection at 
www.regulations.gov or on request. A public hearing was requested and 
held on April 13, 2011. After consideration of all the comments, the 
proposed regulations are adopted as revised by this Treasury decision. 
The comments are discussed in the preamble.

Summary of Comments and Explanation of Provisions

Sales-Based Royalties

    The proposed regulations clarified that sales-based royalties, like 
other royalties, may be capitalizable to property a taxpayer produces 
or acquires for resale. Royalty costs are capitalizable when they are 
incurred in securing the contractual right to use a trademark, 
corporate plan, manufacturing procedure, special recipe, or other 
similar right associated with property produced or property acquired 
for resale. Sales-based royalty costs are royalties that are incurred 
only upon the sale of property produced or acquired for resale.
    The proposed regulations provided that sales-based royalties 
required to be capitalized must be allocated only to property that has 
been sold or, for inventory property, deemed to be sold under the 
taxpayer's inventory cost flow assumption. In response to concerns that 
the requirement to allocate sales-based royalties only to cost of goods 
sold would unduly burden taxpayers using simplified allocation methods, 
the final regulations provide that the allocation of sales-based 
royalties to property sold is optional rather than mandatory. 
Therefore, the final regulations permit taxpayers to either allocate 
sales-based royalties entirely to property sold and include those costs 
in cost of goods sold or to allocate sales-based royalties between cost 
of goods sold and ending inventory using a facts-and-circumstances cost 
allocation method described in Sec.  1.263A-1(f) or a simplified method 
provided in Sec.  1.263A-2(b) (the simplified production method) or 
Sec.  1.263A-3(d) (the simplified resale method). The final regulations 
also clarify that sales-based royalties that a taxpayer allocates 
entirely to inventory property sold are included in cost of goods sold 
and may not be included in determining the cost of goods on hand at the 
end of the taxable year regardless of the taxpayer's cost flow 
assumption.
    A commentator suggested that the final regulations acknowledge that 
a sales-based royalty payable by a reseller of inventory to its 
supplier is a direct acquisition cost under section 471 and included in 
cost of goods sold when the inventory item is sold. The final 
regulations do not adopt this comment because whether a cost is a 
royalty described in Sec.  1.263A-1(e)(3)(ii)(U) or is a contingent 
acquisition cost is beyond the scope of these regulations.

Sales-Based Vendor Allowances in General

    The proposed regulations provided that the amount of an allowance, 
discount, or price rebate that a taxpayer earns by selling specific 
merchandise is a reduction in the cost of the merchandise sold or 
deemed sold under a taxpayer's cost flow assumption. The preamble to 
the proposed regulations referred to this type of allowance as a sales-
based vendor allowance. The proposed regulations required that these 
allowances reduce cost of goods sold and not reduce ending inventory 
cost or value of goods on hand at the end of the taxable year.
    A commentator disagreed with the requirement in the proposed 
regulations that the vendor allowances described in the proposed 
regulations always must reduce cost of goods sold. The commentator 
disputed that a vendor allowance should reduce cost of goods sold 
merely because the allowance is dependent on a sale of merchandise. 
Citing Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707 (1956), the 
commentator suggested that sales-based vendor allowances that are the 
subject of an advance agreement between the vendor and the purchaser at 
the time the merchandise is purchased must be netted against the 
original cost of the merchandise and applied to ending inventory or 
cost of goods sold depending on the taxpayer's inventory cost flow 
assumption. Accordingly, the commentator suggested that the regulations 
be revised to provide that a sales-based vendor allowance may properly 
reduce the value of goods on hand at the end of the taxable year.
    The final regulations reflect the commentator's suggestion that a 
vendor allowance does not reduce the cost of goods sold merely because 
the allowance is dependent on a sale of merchandise. The proposed 
regulations were overbroad because they required taxpayers to allocate 
to cost of goods sold all allowances that arise from selling 
merchandise. For example, if, after selling a certain number of units, 
a taxpayer earns a discount off each unit purchased during the taxable 
year, the allowance properly may be allocable to both the cost of units 
that remains in ending inventory and the cost of units included in cost 
of goods sold during the year. Similarly, a sales-volume allowance that 
provides only a reduction in the cost of any purchases made by a 
taxpayer in the next taxable year properly reduces the cost of the 
units of the product purchased in the next year. As the preceding two 
examples illustrate, the proposed regulations were overbroad in that 
they could be interpreted to require these allowances to reduce cost of 
goods sold solely because they arose as a result of selling 
merchandise. The extent to which a vendor allowance is properly 
allocable to the cost of goods in ending inventory or the cost of goods 
sold depends on all facts and circumstances, including the terms and 
conditions of the agreement between the vendor and the taxpayer. See 
Pittsburgh Milk Co. v. Commissioner. As described later in this 
preamble, the final regulations more clearly identify a type of sales-
based vendor allowance that, to clearly reflect income, must reduce the 
cost of goods sold.
    The commentator also asserted that Rev. Rul. 2001-8 (2001-1 CB 
726), see

[[Page 2096]]

Sec.  601.601(d)(2), and earlier rulings support the proposition that 
sales-based vendor allowances are an adjustment to the cost of 
merchandise physically removed from inventory. Although allowances, 
discounts, and price rebates properly are treated as adjustments to the 
price of merchandise, the final regulations do not adopt the 
commentator's rationale for determining whether these adjustments 
properly reduce ending inventory or cost of goods sold. Rev. Rul. 2001-
8 does not establish a general principle that sales-based vendor 
allowances reduce the invoice cost of merchandise physically sold. Rev. 
Rul. 2001-8 addresses a unique cost adjustment (floor stocks payments) 
that relates to goods physically on hand on a particular date and 
should not be applied beyond its specific facts.

Sales-Based Vendor Chargebacks

    In response to comments that the proposed regulations were 
overbroad, the Treasury and IRS are considering alternatives to a broad 
definition of sales-based vendor allowances. The final regulations, 
however, specifically identify one type of sales-based vendor allowance 
(sales-based vendor chargebacks) that, to clearly reflect income, 
reduces cost of goods sold and does not reduce the cost of goods on 
hand at the end of the taxable year. Therefore, the final regulations 
apply the rule articulated in the notice of proposed rulemaking to 
sales-based vendor chargebacks. A sales-based vendor chargeback is 
defined as 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. Sales-based vendor chargebacks protect a taxpayer from 
realizing a loss or a reduced profit on the sale of specific 
merchandise when the taxpayer is obligated by contract with the vendor 
of the merchandise to resell the merchandise at a specific price (in 
some cases below the taxpayer's cost). Under the terms and conditions 
of the agreement between the vendor and the taxpayer and the economics 
of the transaction, it is inappropriate to treat the allowance as an 
adjustment to the cost of goods in ending inventory. A sales-based 
vendor chargeback properly reduces only cost of goods sold because it 
arises from and relates only to merchandise sold. Thus, it reduces the 
invoice cost of the merchandise sold and clearly reflects income only 
if it reduces cost of goods sold.

Sales-Based Vendor Allowances Other Than Chargebacks

    The final regulations reserve rules for the treatment of other 
sales-based vendor allowances. Given the factual nature of particular 
vendor allowance arrangements between sellers and purchasers of 
merchandise, the IRS and Treasury Department request comments regarding 
additional guidance defining or describing particular sales-based 
vendor allowances and on objective rules for allocating such allowances 
to the purchase price of goods acquired in the future, ending 
inventory, or cost of goods sold.

Effective/Applicability Date

    These regulations apply for taxable years ending on or after 
January 13, 2014.

Special Analyses

    This Treasury decision is not a significant regulatory action as 
defined in Executive Order 12866, as supplemented by Executive Order 
13563. Therefore, a regulatory assessment is not required. Section 
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does 
not apply to these regulations, and because the regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Code, the notice of proposed rulemaking that 
preceded these final regulations was submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business. No comments were received from the Small Business 
Administration.

Drafting Information

    The principal author of these regulations is John Roman Faron of 
the Office of the Associate Chief Counsel (Income Tax and Accounting). 
However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *

    Section 1.263A-1 also issued under 26 U.S.C. 263A.
    Section 1.263A-2 also issued under 26 U.S.C. 263A.
    Section 1.263A-3 also issued under 26 U.S.C. 263A. * * *
    Section 1.471-3 also issued under 26 U.S.C. 471. * * *


0
Par. 2. Section 1.263A-0 Table of Contents is amended by adding new 
entries for Sec. Sec.  1.263A-1(c)(5), (k), and (l); 1.263A-
2(b)(3)(ii)(C), (e), and (f); 1.263A-3(d)(3)(i)(C)(3) and (f); and 
revising the entry for Sec.  1.263A-1(e)(3)(ii) to read as follows:


Sec.  1.263A-0  Outline of regulations under section 263A.

* * * * *


Sec.  1.263A-1  Uniform Capitalization of Costs.

* * * * *
    (c) * * *
    (5) Costs allocable only to property sold.
* * * * *
    (e) * * *
    (3) * * *
    (ii) Examples of indirect costs required to be capitalized.
* * * * *
    (k) Change in method of accounting.
    (1) In general.
    (2) Scope limitations.
    (3) Audit protection.
    (4) Section 481(a) adjustment.
    (5) Time for requesting change.
    (l) Effective/applicability date.


Sec.  1.263A-2  Rules Relating to Property Produced by the Taxpayer.

* * * * *
    (b) * * *
    (3) * * *
    (ii) * * *
    (C) Costs allocable only to property sold.
* * * * *
    (e) Change in method of accounting.
    (1) In general.
    (2) Scope limitations.
    (3) Audit protection.
    (4) Section 481(a) adjustment.
    (5) Time for requesting change.
    (f) Effective/applicability date.


Sec.  1.263A-3  Rules Relating to Property Acquired for Resale.

* * * * *
    (d) * * *
    (3) * * *
    (i) * * *
    (C) * * *
    (3) Costs allocable only to property sold.
* * * * *
    (f) Effective/applicability date.
* * * * *

[[Page 2097]]


0
Par. 3. Section 1.263A-1 is amended by:
0
1. Adding a paragraph (c)(5).
0
2. Revising paragraph (e)(3)(i) and paragraph (e)(3)(ii) introductory 
text.
0
3. Redesignating paragraph (e)(3)(ii)(U) as paragraph (e)(3)(ii)(U)(1), 
revising the second sentence of newly-designated paragraph 
(e)(3)(ii)(U)(1), and adding a sentence to the end of newly-designated 
paragraph (e)(3)(ii)(U)(1).
0
4. Adding paragraph (e)(3)(ii)(U)(2).
0
5. Revising paragraph (l).
    The additions and revisions read as follows:


Sec.  1.263A-1  Uniform capitalization of costs.

* * * * *
    (c) * * *
    (5) Costs allocable to property sold. A cost that is allocated 
under this section, Sec.  1.263A-2, or Sec.  1.263A-3 entirely to 
property sold must be included in cost of goods sold and may not be 
included in determining the cost of goods on hand at the end of the 
taxable year.
* * * * *
    (e) * * *
    (3) * * *
    (i) In general. (A) Indirect costs are defined as all costs other 
than direct material costs and direct labor costs (in the case of 
property produced) or acquisition costs (in the case of property 
acquired for resale). Taxpayers subject to section 263A must capitalize 
all indirect costs properly allocable to property produced or property 
acquired for resale. Indirect costs are properly allocable to property 
produced or property acquired for resale when the costs directly 
benefit or are incurred by reason of the performance of production or 
resale activities. Indirect costs may directly benefit or be incurred 
by reason of the performance of production or resale activities even if 
the costs are calculated as a percentage of revenue or gross profit 
from the sale of inventory, are determined by reference to the number 
of units of property sold, or are incurred only upon the sale of 
inventory. Indirect costs may be allocable to both production and 
resale activities, as well as to other activities that are not subject 
to section 263A. Taxpayers must make a reasonable allocation of 
indirect costs between production, resale, and other activities.
    (B) Example. The following example illustrates the provisions of 
this paragraph (e)(3)(i):

    Example.  (i) Taxpayer A manufactures tablecloths and other 
linens. A enters into a licensing agreement with Company L under 
which A may label its tablecloths with L's trademark if the 
tablecloths meet certain specified quality standards. In exchange 
for its right to use L's trademark, the licensing agreement requires 
A to pay L a royalty of $X for each tablecloth carrying L's 
trademark that A sells. The licensing agreement does not require A 
to pay L any minimum or lump-sum royalties.
    (ii) The licensing agreement provides A with the right to use 
L's intellectual property, a trademark. The licensing agreement also 
requires A to conduct its production activities according to certain 
standards as a condition of exercising that right. Thus, A's right 
to use L's trademark under the licensing agreement is directly 
related to A's production of tablecloths. The royalties the 
licensing agreement requires A to pay for using L's trademark are 
the costs A incurs in exchange for these rights. Therefore, although 
A incurs royalty costs only when A sells a tablecloth carrying L's 
trademark, the royalty costs directly benefit production activities 
and are incurred by reason of production activities within the 
meaning of paragraph (e)(3)(i)(A) of this section.

    (ii) Examples of indirect costs required to be capitalized. The 
following are examples of indirect costs that must be capitalized to 
the extent they are properly allocable to property produced or property 
acquired for resale:
* * * * *
    (U) Licensing and franchise costs. (1) * * * These costs include 
the otherwise deductible portion (such as amortization) of the initial 
fees incurred to obtain the license or franchise and any minimum annual 
payments and any royalties that are incurred by a licensee or a 
franchisee. These costs also include fees, payments, and royalties 
otherwise described in this paragraph (e)(3)(ii)(U) that a taxpayer 
incurs (within the meaning of section 461) only upon the sale of 
property produced or acquired for resale.
    (2) If a taxpayer incurs (within the meaning of section 461) a fee, 
payment, or royalty described in this paragraph (e)(3)(ii)(U) only upon 
the sale of property produced or acquired for resale and the cost is 
required to be capitalized under this paragraph (e)(3), the taxpayer 
may properly allocate the cost entirely to property produced or 
acquired for resale by the taxpayer that has been sold.
* * * * *
    (l) Effective/applicability date. (1) Paragraphs (h)(2)(i)(D), (k), 
and (l) of this section apply for taxable years ending on or after 
August 2, 2005.
    (2) Paragraphs (c)(5), (e)(3)(i), and (e)(3)(ii)(U) of this section 
apply for taxable years ending on or after January 13, 2014.
0
Par. 4. Section 1.263A-2 is amended by adding paragraphs (b)(3)(ii)(C) 
and (b)(4)(ii)(A)(4) and revising paragraph (f) to read as follows:


Sec.  1.263A-2  Rules relating to property produced by the taxpayer.

* * * * *
    (b) * * *
    (3) * * *
    (ii) * * *
    (C) Costs allocated to property sold. Additional section 263A costs 
incurred during the taxable year, as defined in paragraph 
(b)(3)(ii)(A)(1) of this section, section 471 costs incurred during the 
taxable year, as defined in paragraph (b)(3)(ii)(A)(2) of this section, 
and section 471 costs remaining on hand at year end, as defined in 
paragraph (b)(3)(ii)(B) of this section, do not include costs described 
in Sec.  1.263A-1(e)(3)(ii) or cost reductions described in Sec.  
1.471-3(e) that a taxpayer properly allocates entirely to property that 
has been sold.
* * * * *
    (4) * * *
    (ii) * * *
    (A) * * *
    (4) Additional section 263A costs incurred during the test period, 
as defined in paragraph (b)(4)(ii)(A)(2) of this section, and section 
471 costs incurred during the test period, as defined in paragraph 
(b)(4)(ii)(A)(3) of this section, do not include costs specifically 
described in Sec.  1.263A-1(e)(3)(ii) or cost reductions described in 
Sec.  1.471-3(e) that a taxpayer properly allocates entirely to 
property that has been sold.
* * * * *
    (f) Effective/applicability date. (1) Paragraphs (b)(2)(i)(D), (e), 
and (f) of this section apply for taxable years ending on or after 
August 2, 2005.
    (2) Paragraphs (b)(3)(ii)(C) and (b)(4)(ii)(A)(4) of this section 
apply for taxable years ending on or after January 13, 2014.

0
Par. 5. In Sec.  1.263A-3, paragraphs (d)(3)(i)(C)(3), (d)(3)(i)(D)(3), 
(d)(3)(i)(E)(3), and (f) are added to read as follows:


Sec.  1.263A-3  Rules relating to property acquired for resale.

* * * * *
    (d) * * *
    (3) * * *
    (i) * * *
    (C) * * *
    (3) Costs allocable to property sold. Section 471 costs remaining 
on hand at year end, as defined in paragraph (d)(3)(i)(C)(2) of this 
section, do not include costs that are specifically described in Sec.  
1.263A-1(e)(3)(ii) or cost reductions described in Sec.  1.471-3(e) 
that a taxpayer properly allocates entirely to property that has been 
sold.
    (D) * * *

[[Page 2098]]

    (3) Current year's storage and handling costs, beginning inventory, 
and current year's purchases, as defined in paragraph (d)(3)(i)(D)(2) 
of this section, do not include costs that are specifically described 
in Sec.  1.263A-1(e)(3)(ii) or cost reductions described in Sec.  
1.471-3(e) that a taxpayer properly allocates entirely to property that 
has been sold.
    (E) * * *
    (3) Current year's purchasing costs and current year's purchases, 
as defined in paragraph (d)(3)(i)(E)(2) of this section, do not include 
costs that are specifically described in Sec.  1.263A-1(e)(3)(ii) or 
cost reductions described in Sec.  1.471-3(e) that a taxpayer properly 
allocates entirely to property that has been sold.
* * * * *
    (f) Effective/applicability date. Paragraphs (d)(3)(i)(C)(3), 
(d)(3)(i)(D)(3), and (d)(3)(i)(E)(3) of this section apply for taxable 
years ending on or after January 13, 2014.

0
Par. 6. Section 1.471-3 is amended by:
0
1. Adding paragraphs (e) and (g).
0
2. Designating the undesignated text following paragraph (d) as 
paragraph (f).
    The additions read as follows:


Sec.  1.471-3  Inventories at cost.

* * * * *
    (e) Sales-based vendor allowances--(1) Treatment of sales-based 
vendor chargebacks--(i) In general. A sales-based vendor chargeback 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. A sales-based vendor chargeback decreases cost of goods 
sold and does not reduce the cost of goods on hand at the end of the 
taxable year.
    (ii) Example. The following example illustrates the provisions of 
this paragraph (e)(1).

    Example.  (i) W is a wholesaler of pharmaceuticals. W purchases 
Drug X from the manufacturer, M, for $10x per unit. M has agreements 
with specific customers that allow those customers to acquire Drug X 
from M's wholesalers for $6x per unit. Under an agreement between W 
and M, W is required to sell Drug X to specific customers at the 
prices M has negotiated with such customers ($6x per unit) and, in 
exchange, M agrees to provide a price rebate to W equal to the 
difference between W's cost for Drug X and the price W is required 
to charge specific customers under the agreement (a difference of 
$4x per unit). W sells Drug X to specific customer Y for $6x. Under 
the agreement between W and M, the price rebate can be paid to W, 
credited against M's invoice to W for W's purchase of Drug X, or it 
can be credited to W's future purchases of drugs from M.
    (ii) Under the terms of the agreement, W is unconditionally 
entitled to the price rebate of Drug X when it sells Drug X to 
specific customer Y, a specifically identified customer of M. The 
price rebate received by W for the sale of Drug X to Y is a sales-
based vendor chargeback. Therefore, the amount of the sales-based 
vendor charge back, $4x per unit for Drug X, whether paid to W, 
credited against M's invoice to W for W's purchase of Drug X or 
credited against a future purchase, decreases cost of goods sold and 
does not reduce the cost of Drug X on hand at the end of the taxable 
year.

    (2) Treatment of other sales-based vendor allowances. [Reserved]
* * * * *
    (g) Effective/applicability date. Paragraph (f) of this section 
applies to taxable years ending on or after January 13, 2014.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
    Approved: December 13, 2013.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2014-00327 Filed 1-10-14; 8:45 am]
BILLING CODE 4830-01-P