Robinson Knife Mfg. Co., Inc. v. C.I.R., 2010 WL 986532 (2d Cir. 2010)

There was a rather fetching decision issued by the Second Circuit (Cabranes, Parker, Calabresi writing) on Friday. The Circuit reversed a decision by the Tax Court that would have essentially eliminated the ability of corporations to deduct royalty payments for trademark licenses.

The tax code differentiates between ordinary and necessary business expenses and capital expenditures. Business expenses can be deducted during the taxable year; capital expenditures must be amortized over time. It’s often financially advantageous for a company to be able to immediately deduct a given expense.

Trademarks raise perhaps the most complex intellectual property taxation issues. Royalties that are paid on the number of sales of a product, or contingent serial payments made by a licensee, are generally immediately deductible if they satisfy three requirements: (1) payments by the transferee must be contingent on the productivity, use, or disposition of the trademark; (2) payments must be paid not less frequently than annually during the entire term of the agreement, including renewals; and (3) payments must be substantially equal in amount or paid under a fixed formula. 26 U.S.C. 1253 (“Transfers of franchises, trademarks and trade names.”)

Robinson Knife was a major manufacturer of kitchen products. In the year at issue, Robinson licensed, inter alia, Pyrex and Oneida, two widely-known kitchen trademarks for it’s ware. The agreement entered into between Robinson and its licensors did not include a lump-sum or a minimum production limit — Robinson was free to use the trademarks on as many or few tools as it wanted, provided that it paid a royalty fee when a kitchen item was sold. And Robinson sold a lot.

The licensing agreement between Robinson and the third-parties included a quality control provision. The provision stated that Robinson must obtain a trademark owner’s approval for product design, packaging and promotional materials before selling a branded product. Quality control provisions, of some type, are included as a matter of course in almost all trademark licensing agreements.

Treasury regulations state that taxpayers “must capitalize [amortize] all direct costs and certain indirect costs properly allocable to property produced…. Indirect costs are properly allocable to property produced … when the costs directly benefit or are incurred by reason of the performance of production … activities.” 26 C.F.R. § 1.263A-1.

The I.R.S. contended that the royalty payments must be amortized because the royalties directly benefited Robinson’s production activities or were incurred by reason of those activities.  The Tax Court agreed finding that the QC provisions from the trademark licensing agreements made “obtaining approval from the licensors to use the Pyrex and Oneida trademarks on new kitchen tools . . . an integral part of developing and producing the Pyrex- and Oneida-branded kitchen tools.” The Tax Court concluded that “acquiring the right to use the Pyrex and Oneida trademarks was part of petitioner’s production process. Consequently, the royalties paid to Corning and Oneida directly benefited petitioner’s production activities and/or were incurred by reason of petitioner’s producing the Pyrex- and Oneida-branded kitchen tools and [were] therefore indirect costs properly allocable to the Pyrex-and Oneida-branded kitchen tools petitioner produced.”

The Second Circuit reversed, finding that the Tax Court confused royalties from the licensing agreements with the agreements themselves. The royalty costs, according to the Second Circuit, were not “directly . . . incurred by reason of the performance of the production . . . activities.” Wrote the Second Circuit:

The Tax Court is clearly right that “without the license agreements, petitioner could not have legally manufactured” the Pyrex and Oneida kitchen tools, Robinson, 2009 Tax Ct. Memo LEXIS 10, at * 16. It is equally clear, however, that Robinson could have manufactured the products, and did, without paying the royalty costs. None of the product approval terms of the license agreements referenced by the Tax Court relates to Robinson’s obligation to pay the royalty costs. Robinson could have manufactured exactly the same quantity and type of kitchen tools-that is, it could have “perform[ed]” its “production … activities” in exactly the same way it did-and, so long as none of this inventory was ever sold bearing the licensed trademarks, Robinson would have owed no royalties whatever. Robinson’s royalties, therefore, were not “incurred by reason of” production activities, and did not “directly benefit” such activities. In other words, while we may agree with the Tax Court’s implicit conclusion that “directly benefit or are incurred by reason of” boils down to a but-for causation test, we hold that under the plain text of the regulation it is the costs, and not the contracts pursuant to which those costs are paid, that must be a but-for cause of the taxpayer’s production activities in order for the costs to be properly allocable to those activities and subject to the capitalization requirement.