Tax News Highlights: Participation Payments to Manufacturer Currently Deductible

| 12/4/2014

IRS private letter ruling (PLR) 201447004 issued Nov. 21, 2014, holds that component manufacturers may be able to take a deduction for payments for marketing and product development expenses made as part of a product development agreement with another manufacturer.

Taxpayers are required to capitalize payments made to create a separate and distinct intangible asset or other future benefit, to create or acquire an intangible asset, and to facilitate the creation or acquisition of an intangible asset. In the situation addressed in the PLR, the taxpayer entered into an agreement with another manufacturer to develop a component that would become part of a new product. Among other terms, the taxpayer agreed to:

  • Design, manufacture, certify, test, and supply the component as an exclusive supplier to the manufacturer
  • Absorb all nonrecurring costs incurred during the development process
  • Make contribution payments toward the manufacturer’s development and marketing costs of the end product

The component manufacturer in the PLR was not guaranteed any component sales or a fixed selling price for the components as part of the agreement but did have certain remedies if the manufacturer did not comply with its exclusivity obligations or canceled the product prior to production.

The IRS holds that in this circumstance, the taxpayer was not required to capitalize the participation payments. There are three factual aspects of the contract that are important to note in the ruling:

  1. The IRS notes that there was no creation of a separate intangible asset because there was nothing the taxpayer could sell. If the agreement had been established as a forward purchase or similar option contract, there might have been a different result.
  2. There was no capitalizable asset because the taxpayer did not receive any rights to guaranteed sales or a fixed purchase price from the manufacturer. An amount paid to another party with the mere hope of continuing or maintaining a business relationship is not a capitalizable intangible asset.
  3. IRS regulations do not require capitalization of an exclusivity agreement related to the sale of tangible property. An agreement providing a taxpayer the right to use tangible or intangible property (such as a lease) or an agreement providing the taxpayer the right to provide or receive services, however, would be capitalizable.

A PLR is nonbinding advice provided relevant to a specific taxpayer’s situation and may be relied upon only by the taxpayer for which it is requested. However, a PLR is useful in determining the position of the IRS and can be relied on for purposes of penalty relief. Any taxpayer following the guidance in PLR 201447004 should also carefully review its fact pattern in light of the IRS ruling.

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