T.C. Memo. 2001-324
UNITED STATES TAX COURT
PLASTIC ENGINEERING & TECHNICAL SERVICES, INC., Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 10157-99. Filed December 28, 2001.
Charles E. Turnbull and Frank E. Henke, for petitioner.
John W. Stevens, for respondent.
MEMORANDUM OPINION
GOLDBERG, Special Trial Judge: Respondent determined a
deficiency in petitioner’s Federal income tax in the amount of
$9,170 for the taxable year 1995. Unless otherwise indicated,
section references are to the Internal Revenue Code in effect for
the year in issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
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The sole issue in this case is whether petitioner is
required under section 263A, to capitalize certain royalties paid
as the exclusive licensee of a patented “hot manifold assembly
system”.
This case was submitted fully stipulated pursuant to Rule
122. The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time the petition
was filed, petitioner’s principal place of business was Auburn
Hills, Michigan.
Petitioner is a Michigan corporation licensed by the State
and engaged in the business of manufacturing and engineering of
products and services in the fields of industrial chemicals,
plastics, materials, and synthetics. The sole shareholder and
president of petitioner is Patrick A. Tooman (Mr. Tooman).
Petitioner was incorporated on June 21, 1984. Mr. Tooman
developed a hot manifold assembly system which was patented under
the United States Letters Patent No. 4,964,795 (the patent),
dated October 23, 1990. The patent, as described in the
abstract, is “a manifold assembly system of the type used for
conveying plastic injecting molding material from a central
injection point or sprue to a number of mold cavities or to
multiple points”.
On June 10, 1993, petitioner and Mr. Tooman entered into an
agreement entitled Amended and Restated License Agreement (the
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agreement), effective as of December 10, 1992. The agreement set
the amount to be paid for past and future use of the patent in
petitioner’s assembly system. Under the agreement, petitioner
has the exclusive and nontransferable license and right to
manufacture and sell the assembly system covered by the patent
from December 10, 1992, until December 31, 2004. Termination of
the agreement may occur upon 10 days’ written notice by either
party or default. The agreement defines the licensee as
petitioner and the licensor as Mr. Tooman. Amounts paid by
petitioner to Mr. Tooman for future use of the patent are
referred to as royalties.
The patent is and has been utilized as a critical component
of petitioner’s assembly systems since 1984. Royalties are equal
to 10 percent of the net sales price of all plastic molded
products manufactured through the use of the patented assembly
system, also known as the “end product(s)”. End products are
considered sold at such time as an invoice covering the end
products is delivered to a customer of the petitioner, or if not
invoiced, at the time that such products are shipped, delivered,
or otherwise made available to the customer. All royalty
payments were paid to Mr. Tooman on a quarterly basis, pursuant
to the agreement.
Petitioner timely filed its U.S. Corporation Income Tax
Return, Form 1120, for taxable year 1995, and utilized the
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accrual method of accounting for the year in issue. Petitioner
incurred $999,151 for the exclusive and nontransferable right to
use the patent. Petitioner did not allocate any of the $999,151
paid under the agreement to the goods it produced, including
inventory remaining at the end of the year. Rather, petitioner
deducted the entire $999,151 as “Other Deductions” on line 26 of
its 1995 Federal income tax return as an ordinary and necessary
business expense pursuant to section 162 or, alternatively, as a
depreciation deduction under section 167. Petitioner used a
simplified production method to calculate inventory costs during
the 1995 taxable year, allocating $510,124 in administrative,
service, and support department costs to production under section
263A. In allocating section 263A costs to inventory, petitioner
used an absorption ratio calculated by dividing section 263A
costs by the costs of production other than section 263A costs.
In a notice of deficiency, respondent determined that
petitioner failed to include or allocate the $999,151 in
royalties to production pursuant to section 263A. Specifically,
based on petitioner’s allocation formula, which is not in
dispute, respondent determined that $26,971 of the $999,151 was
allocable to the ending inventory and was required to be
capitalized and included in petitioner’s cost of inventory.
Accordingly, respondent determined a deficiency of $9,170 for the
1995 taxable year.
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Deductions are a matter of legislative grace, and taxpayers
bear the burden of proving the entitlement to any deduction
claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992);
New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
Section 162(a) allows a deduction for a taxpayer’s “ordinary and
necessary” business expenses paid or incurred during the taxable
year. However, deductions allowed under section 162(a) are also
“subject to the exceptions provided in part IX (sec. 261 and
following, relating to items not deductible).” Sec. 161.
The uniform capitalization rules of section 263A(a)(1)
require that all direct costs and certain indirect costs
allocable to certain property be included in inventory, or
capitalized if such property is not inventory. Taxpayers subject
to section 263A must capitalize all direct costs and certain
indirect costs properly allocable to property produced or
property acquired for resale. Sec. 1.263A-1(e)(1), Income Tax
Regs. “Direct costs”, as they are relevant to “producers”,
include “direct material costs and direct labor costs.” Sec.
1.263A-1(e)(2)(i), Income Tax Regs. “Direct material costs”
include the costs of those materials that become an integral part
of specific property produced and those materials that are
consumed in the ordinary course of production and that can be
identified or associated with particular units or groups of units
of property produced. Sec. 1.263A-1(e)(2)(i)(A), Income Tax
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Regs.
Certain “indirect costs” must also be capitalized to the
extent they are properly allocable to property produced.
“Indirect costs” are defined as all costs allocable to property
produced or acquired for resale by the taxpayer other than direct
material costs and direct labor costs (in the case of property
produced). Sec. 1.263A-1(e)(3), Income Tax Regs. Indirect costs
are properly allocable to property produced when the costs
directly benefit or are incurred by reason of the performance of
production activities. Id. Royalty payments are specifically
identified as an indirect cost that must be capitalized. Section
1.263A-1(e)(3)(ii)(U), Income Tax Regs., states as follows:
Licensing and franchise costs. Licensing and franchise
costs include fees 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. These costs include the otherwise
deductible portion (e.g., amortization) of the initial
fees incurred to obtain the license or franchise and
any minimum annual payments and royalties that are
incurred by a licensee or a franchisee.
Section 1.263A-1(e)(3)(ii), Income Tax Regs., provides a
nonexclusive list of examples of certain indirect costs that must
be capitalized.
Respondent contends that the royalty payments incurred by
petitioner are subject to the capitalization rules of section
263A, and further that the payments must be deducted over time
through petitioner’s cost of goods sold.
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Petitioner contends that it was not required to capitalize
royalty payments to Mr. Tooman pursuant to section 263A because
the payments were “contingent royalties” rather than “minimum
royalties”. Petitioner defines contingent royalties as royalty
payments derived from a percentage of petitioner’s net sales of
products manufactured through the patent process. Petitioner’s
argument is based on the construction, and effectively the
interpretation, of the last sentence of section 1.263A-
1(e)(3)(ii)(U), Income Tax Regs., shown above. Petitioner
construes the last sentence of section 1.263A-1(e)(3)(ii)(U),
Income Tax Regs., so that the word “minimum” modifies the nouns
“payments” and “royalties”. We disagree.
Petitioner was in the business of manufacturing products in
the fields of industrial chemicals, plastics, materials, and
synthetics. Petitioner acquired the exclusive right to produce
certain end products as licensee, and through the use, of the
manufacturing process protected under Mr. Tooman’s patent. The
patent was “a manifold assembly system of the type used for
conveying plastic injecting molding material from a central
injection point or sprue to a number of mold cavities or to
multiple points”, thus enabling petitioner to create the end
products. The regulations of section 263A clearly state that
“licensing and franchise costs * * * incurred in securing the * *
* manufacturing procedure, special recipe, or other similar right
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associated with property produced”, including “any minimum annual
payments and royalties ... incurred by a licensee”, are indirect
costs that must be capitalized in ending inventory. Sec. 1.263A-
1(e)(3)(ii)(U), Income Tax Regs.
Petitioner reads “minimum annual payments and royalties” in
a vacuum. This phrase merely gives examples of “licensing and
franchise costs” that are classified as indirect costs. The
distinction petitioner wishes this Court to make between the
phrase “minimum royalties” and “contingent royalties” is
illogical in light of the objectives of the statute and
regulations. As previously stated, under the statute and
regulations, indirect costs, that is costs other than direct
material costs and direct labor costs or acquisition costs, must
be capitalized if properly allocable to property produced. Sec.
1.263A-1(e)(3)(i), Income Tax Regs. Further, the regulations
give as an example of an indirect cost required to be
capitalized, licensing and franchise costs. Sec. 1.263A-
1(e)(3)(ii)(U), Income Tax Regs. The language found in the
regulations speaks directly to petitioner’s license of the
patented manufacturing process and the royalties incurred in
securing that license.
Petitioner relies on a number of cases in its brief that
“widely recognize” “minimum royalties”; however, the cases bear
no relevance to the issue of capitalization under section 263A,
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and have no persuasive value to petitioner’s case.1
Accordingly, we find that the royalty payments incurred by
petitioner in 1995 are indirect costs to the production of the
end products, and, as such, the royalty payments are subject to
the capitalization rules of section 263A.
We have considered all of the other arguments made by
petitioner, and, to the extent we have not addressed them,
conclude they are without merit.
To reflect the foregoing,
Decision will be entered
for respondent.
1
We note that Wood v. United States, 377 F.2d 300 (5th Cir.
1967), and J. Strickland & Co. v. United States, 352 F.2d 1016
(6th Cir. 1965), were decided approximately 20 years before
Congress enacted sec. 263A in the Tax Reform Act of 1986, Pub. L.
99-514, sec. 803, 100 Stat. 2350. Petitioner also cited the
following cases which concerned the research and experimental
expenditures deduction under sec. 174 and years in issue from
1976 through 1984: Harris v. Commissioner, T.C. Memo. 1990-80
(tax years 1979-1982), affd. 16 F.3d 75 (5th Cir. 1994); Estate
of Cook v. Commissioner, T.C. Memo. 1993-581 (tax years 1976-
1982); Research Two Ltd. Pship. v. Commissioner, T.C. Memo. 2000-
259 (tax years 1982-84).