Wrestling Control from the UNICAP Regulations: The Irrelevance of Quality Control in Determining Capitalizable Trademark Royalties

Abstract

Taxpayers generally must capitalize direct and indirect costs attributable to their production of inventory. Due to uncertainty about whether this requirement applies to sales-based trademark royalties, the regulations now clarify that these royalties are indeed capitalizable as indirect production costs. However, the regulations also let taxpayers allocate these sales-based costs entirely to cost of goods sold. So, to the relief of taxpayers, the regulations have the practical effect of permitting immediate cost recovery—similar to a business expense deduction—for sales-based royalties.This Article questions the rationale for treating trademark royalties as capitalizable indirect costs. It argues that the regulations inappropriately rely on a licensor’s retention of control over product quality to link a licensed mark with inventory production and hence treat the associated royalties as production costs. The Article finds such reliance inappropriate because every valid trademark license involves a retention of control and the significance of control has diminished in modern trademark law and licensing practices. The Article further explains how this focus on control inadvertently makes all trademark royalties (including minimum and upfront royalties) capitalizable as indirect costs and therefore potentially allocable to ending inventory.Finally, the Article describes how the unique nature of trademarks complicates efforts to classify many royalties as capitalizable indirect costs. By stressing the actual use of a mark rather than licensing terms, the Article proposes that the regulations illustrate capitalizable indirect costs more narrowly by referencing royalties paid to license trademarked product designs. But the Article also contends that the regulations could appropriately treat trademark royalties as direct costs where, as happens with increasing frequency, a licensed mark becomes an integral part of the goods being produced.