Many businesses, including both manufacturers and distributors, offer up-front incentive payments to customers in exchange for the customers’ commitment to purchase the manufacturer or distributor’s products. In a recent private letter ruling (PLR), the IRS concluded that certain types of incentive payments are required to be capitalized while other types of incentive payments may be currently deducted when paid.
In PLR 201032025, the IRS reviewed incentive payments made with respect to three different categories of supply agreements utilized by a manufacturer. Under all three categories, the manufacturer is obligated to supply designated products on an as-needed basis, upon the demands of customers, and customers are generally obligated to purchase 100 percent of their requirements for the designated products from the manufacturer. Also, under all three categories, the purchase price for a product is adjusted periodically, usually annually, on the basis of the cost of the underlying raw materials of the product, subject to appropriate volume discounts.
The differences among the three categories of supply agreements can be summarized as follows:
• Category One supply agreements do not contain a minimum purchase requirement and do not require the customer to retain the manufacturer as its supplier for products not specifically designated in the supply agreement.
• Category Two supply agreements also do not contain a minimum purchase requirement, but do require the customer to retain the taxpayer as its supplier for products not specifically designated in the supply agreement should the need for such products arise. In addition, customers subject to Category Two supply agreements may be under the obligation to use the manufacturer as their supplier if the customer replaces products designated in the agreement with another type of product, replaces the products designated in the agreement with a product that incorporates new technologies or acquires a new business line that uses products offered by the taxpayer. In addition, under certain Category Two supply agreements, the manufacturer is entitled to recover from the customer a portion of its investment in manufacturing technology purchased from third parties during the course of the agreement if the agreement is terminated early.
• Category Three supply agreements contain a minimum purchase requirement that the customer must pay to the manufacturer regardless of whether the customer purchases any products from the manufacturer.
In order to entice customers to enter into any of the three categories of supply agreements or to extend the term of a previously executed supply agreement, the manufacturer offers incentive payments or signing bonuses to its customers. These payments are one-time, up-front and non-refundable, and are payable within a short period of time following the execution of a supply agreement. The amounts of the incentive payments vary by customer and are usually based upon the anticipated volume of products the manufacturer expects to be purchased by the customer.
Generally, taxpayers desire to currently deduct all business related payments in the year paid or accrued pursuant to Section 162 of the Internal Revenue Code, which provides for the deductibility of ordinary and necessary business expenses. However, Code Section 263(a) generally prohibits deductions for capital expenditures and requires that such expenditures be added to the tax basis of the tangible or intangible “asset” created by the expenditure and amortized over the life of the asset.
The issue examined in PLR 201032025 is whether the incentive payments made under the three categories of supply agreements constitute amounts paid to acquire or create an intangible asset, the cost of which must be capitalized pursuant to Code Section 263(a).
The IRS concluded that the manufacturer neither acquired nor created any intangible property rights under Category One or Category Two supply agreements because customers are not required under either category of agreement to purchase any specific amount of product during the term of a supply agreement and the price of the product is not fixed at the time customers execute the supply agreement. Rather, the activation of the Category One and Category Two supply agreements is contingent upon a customer’s request for the product, which may never occur. Therefore, the manufacturer has acquired no “rights” that could be considered to be an intangible asset.
However, the IRS concluded differently with respect to incentive payments made pursuant to Category Three supply agreements, which do impose a minimum purchase obligation on the customer. Specifically, the IRS cited Treasury Regulation § 1.263(a)-4(d)(6), which provides that a taxpayer must capitalize amounts paid to another party if the taxpayer has the right to provide or to receive services or the right to be compensated for services regardless of whether the taxpayer provides such services. In the case of Category Three supply agreements, the IRS noted that because customers are obligated to purchase a minimum amount of product, such obligation confers a right upon the manufacturer equivalent to the right to either provide services or to be paid for services regardless of whether services are rendered as described in Treas. Reg. § 1.263(a)-4(d)(6).
In the ruling, the IRS also concluded that the amounts the manufacturer may recover from its customers for investment in machinery and equipment under a Category Two supply agreement did not equate to the right to provide or receive services or the right to be compensated for services, and, therefore, does not serve to create an intangible asset subject to capitalization.
Although not entirely relevant to the facts in PLR 201032025, the regulations do specifically address another type of customer incentive payment. The regulations specifically provide that an incentive payment payable by a manufacturer to a customer upon the customer’s achievement of a minimum purchase amount is not subject to capitalization because the arrangement does not provide the manufacturer with the right or obligation to provide property (Treas. Reg. §1.263(a)-4(d)(2)(vi)(Ex. 6)). This result is consistent with the IRS position in PLR 201032025.
PLR 201032025 provides relatively clear guidance as to when incentive payments must be capitalized rather then currently deducted. The critical distinction among the three categories of supply agreements reviewed was the minimum purchase obligation imposed under Category Three supply agreements which, in effect, guaranteed the manufacturer a minimum level of sales. In essence, this right has an intrinsic value that constitutes an intangible property interest. The exclusivity rights granted to the manufacturer under Category One and Category Two supply agreements were not deemed sufficient to create an intangible property right that would require capitalization for any incentive payments made pursuant to those agreements. •
MARK L. SILOW is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.