PLR 1322020: IRS allows current treatment for payments under a product-distribution agreement

Plain-English summary

The IRS ruled that a distributor does not have to capitalize specified payments made to a supplier under an agreement to distribute and sell a product. The agreement included payments tied to sales, targets, services, and other contractual terms, as well as proposed amendments. The IRS concluded that section 1253 did not require capitalization of the identified payments on the facts presented. The ruling depended on the agreement and representations described in the letter, and the IRS expressed no opinion on other tax consequences.

Ruling snapshot

• Question: Must the distributor capitalize the specified payments it makes to the supplier under the distribution agreement?
• Outcome: Approved
• Key authorities: IRC §§ 1253 and 162; IRC § 6110(k)(3).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201322020 Third Party Communication: None
Release Date: 5/31/2013 Date of Communication: Not Applicable
Index Number: 1253.00-00
Person To Contact:
-------------------------------------------------------- ----------------------------- -----------------
------------------------------------- Telephone Number:
------------------------------ ---------------------
Refer Reply To:
----------------------------------- CC:ITA:B02
PLR-137756-12
Date:
February 28, 2013

              TY: -------

Legend

Taxpayer = -----------------------------------------------------------------------------------------------------

Supplier = ------------------------------------------------------------------------------
Company A = ---------
Company B = -----------
Products = ------------
Product A = --------------------------------------
Agreement = ---------------------------------------------------------------------------------------------------

Type X = --------------

Amendment A = ----------------------------------------------------------------------------------------------
Amendment B = ----------------------------------------------------------------------------------------------
Period A = ----------
Period B = ----------

K = --
M = ------
P = --------------
Q = --------------
R = ------
S = ------
T = ------
U = -----------
V = ------
W = -----------
X = ------
PLR-137756-12 2

Y = ------
Z = --------------

Date 1 = ----------------------
Date 2 = ----------------
Date 3 = ----------------
Date 4 = ----------------------
Date 5 = ----------------
Date 6 = -------------------
Date 7 = ----------------
Date 8 = -------------------

Type A Payment = -------------------------------------------------------------
Type B Payment = ----------------------------------------------------------------------------
Type C Payment = ----------------------------------------------------------------
Type D Payment = -------------------------------------------------------------------------------------------
Type E Payment = -------------------------------------------------------------------------------------------

Type F Payment = -------------------------------------------------------------------------------------------

Type G Payment = -------------------------------------------------------------------------------------------

Type H Payment = -------------------------------------------------------------------------------------------

Type J Payment = ------------------------------------------------

Dear -----------------

This responds to your request of August 29, 2012 for a private letter ruling concerning
the proper treatment under § 1253 of the Internal Revenue Code of certain payments by
Taxpayer.

FACTS:

Taxpayer is in the business of distributing Products and similar products from a wide
variety of suppliers through a specific group of retailers under contract to Taxpayer from
time to time (“Retailers”). Supplier supplies Product A, which is one of the “Products”
that is distributed by Taxpayer.

Taxpayer and Supplier entered into the Agreement dated as of Date 1. Under the
Agreement, Supplier authorizes Taxpayer to offer, sell, and distribute Product A through
PLR-137756-12 3

Retailers for a term of Period B. The Agreement provides Taxpayer with a limited
license to use Supplier’s marks in connection with the sale of Product A.

As of Date 4, the terms of the Agreement provided as follows: The total purchase price
of Product A paid by the customer consists of the Type H Payment and Type J
Payment. The Type J Payment is remitted from Taxpayer to Supplier. Supplier pays
Taxpayer the Type A Payment, which is equal to K percent of the Type J payment from
each unit of Product A sold by Retailers. The Agreement sets forth a negotiated stated
target number of units to be sold for each year (the “Stated Target”). The Stated Target
increases each year over the term of the Agreement. Taxpayer is required to pay
Supplier a Type B Payment for each year, which is a per unit payment of $X for each
unit of Product A sold by Retailers over the Stated Target for a given year. Taxpayer is
also required to pay Supplier a Type C Payment for each year, which is a fixed annual
amount corresponding to $Y times the Stated Target for that year. If, in any given year,
the total Type J Payments for Product A sold through Retailers does not exceed $Z
(the “Minimum Annual Sales Target”), Taxpayer is required to pay Supplier the Type D
Payment, which is a fixed amount of $W . Taxpayer is required to pay Supplier the Type E
Payment, which is a per unit payment of $V for each unit of Product A sold. The Type H
Payment, reduced by the Type E Payment and the Type B Payment, is retained by
Taxpayer and the Retailers (the “Taxpayer Retained Amount”). Amendment A made
certain changes to the Agreement, including adding the Type A Payment, the Type C
Payments and the Type D Payment, and extending the term of the Agreement to
Date 6.

Either Taxpayer or Supplier may terminate the Agreement upon material breach,
insolvency or bankruptcy of the other party, or, under certain circumstances, if a party
ceases offering Products or Product A. If the Agreement is terminated before the end of
its term, Taxpayer is obligated to pay only the Type C Payments that have accrued up
to the date of termination. Additionally, if the Agreement is terminated, the obligation to
pay the Type D Payment in the year of termination or any future year terminates.

Subsequent to Date 4, Taxpayer and Supplier entered into Amendment B, which makes
certain changes to the Agreement, including (a) the Type C Payments for the period
from Date 3 through Date 7 are reduced by $U per year; (b) beginning Date 7, the Type C
Payments are eliminated; (c) Beginning Date 7, the Type B Payment is reduced from $X
per unit sold of Product A to $T per unit sold, and applies to every unit sold (i.e. the Type B
Payment will no longer apply only to sales in excess of the Stated Target); (d) beginning
Date 7, the Type E Payment is eliminated; (e) Taxpayer shall retain the Type F Payment,
which is an additional $R to $S per unit of Product A sold; (f) beginning Date 5, Supplier
will pay to Taxpayer the Type G Payment, which is based on the total Type J Payments
for Product A sold through Retailers for a given year ($R per unit for total Type J Payments
between $P and $Q, and $M per unit for total Type J Payments above $Q; (g) beginning
Date 7, the Type A Payment is eliminated; and (h) the term of the Agreement is extended
to Date 8. In addition, Taxpayer and Supplier
PLR-137756-12 4

are considering an amendment to make certain additional changes to the Agreement,
including clarifying the specific amount of the Type F Payment between $R and $S for
particular Product A sales and that the Type D Payment will not apply to contract years
beginning after Date 6.

All of the payments by Taxpayer to Supplier that are described in this FACTS section
are made no less frequently than annually.

The Taxpayer makes the following representations:

1. The Agreement is not a sale or license, except to the extent that Supplier grants to
   Taxpayer and the Retailers a limited license to use Supplier’s marks in connection with
   the sale of Product A.
2. Under the Agreement, Supplier is hiring Taxpayer to promote, sell, and distribute
   Product A.
3. The Type H Payment is determined by Taxpayer based on a recommendation by
   Supplier.
4. The Type C Payments, the Type D Payments, Type B Payments, and the Type E
   Payments, and the Type J Payments are the only amounts that are or will be paid or
   remitted by Taxpayer to Supplier for the sale of Product A.
5. The division of revenue between Taxpayer and the Retailers from the sale of
   Product A is the result of an arm’s length negotiation and is comparable to the division
   of revenue between Taxpayer and Retailers of products similar to Product A.
6. The Type C Payments and Type D Payments were intended by the parties to the
   Agreement to encourage Taxpayer’s continued promotion of Product A.
7. The Type B Payments were intended by the parties to the Agreement to provide
   Supplier with a share of the revenue from the sale of each unit of Product A over the
   Stated Target.
8. The Type A Payments, together with the Taxpayer Retained Amount, were intended by
   the parties to the Agreement to compensate Taxpayer for providing certain services
   relating to Product A under the Agreement in a manner that encourages Taxpayer’s
   continued promotion of Product A.
9. The Type E Payments were intended by the parties to the Agreement as an offset,
   to the Taxpayer Retained Amount and to compensate Supplier for certain expenses
   relating to Product A.
10. At the time Taxpayer agreed to the Type C Payments and Type D Payments,
    Taxpayer expected both the Stated Target and Minimum Annual Sales Target to be
    exceeded.
11. Taxpayer uses Supplier’s marks solely on the packaging of Product A, in the area
    where Product A is displayed for sale and in marketing materials related to Product A.

12. Taxpayer sells products that compete with Product A in the same places and in the
    same manner as Product A; provided, however, that a Retailer may display Product A
    on a stand-alone basis for a limited period of time as part of a special marketing
    program.
    PLR-137756-12 5

13. Taxpayer is the exclusive distributor of Product A only with respect to the Retailers
    with certain exceptions, including that Supplier was permitted to sell Product A through
    only Taxpayer, Company A, or Company B with respect to a Type X version of Product A
    during a period of Period A following Date 2.

14. Except to the extent that Taxpayer agrees to distribute Product A in accordance with
    the Agreement, Supplier does not participate in, or have control over, Taxpayer’s
    business.

LAW AND ANALYSIS:

Section 1253(a) of the Code provides as a general rule that a transfer of a franchise,
trademark, or trade name shall not be treated as a sale or exchange of a capital asset if
the transferor retains any significant power, right, or continuing interest with respect to
the subject matter of the franchise, trademark, or trade name.

Section 1253(b)(1) provides that the term “franchise” includes an agreement which
gives one of the parties to the agreement the right to distribute, sell, or provide goods,
services, or facilities, within a specified area.

Section 1253(b)(2) provides that the term “significant power, right, or continuing interest”
includes, but is not limited to, the following rights with respect to the interest transferred:
(A) A right to disapprove any assignment of such interest, or any part thereof.
(B) A right to terminate at will.
(C) A right to prescribe the standards of quality of products used or sold, or of
services furnished, and of the equipment and facilities used to promote such
products or services.
(D) A right to require that the transferee sell or advertise only products or
services of the transferor.
(E) A right to require that the transferee purchase substantially all of his supplies
and equipment from the transferor.
(F) A right to payments contingent on the productivity, use, or disposition of the
subject matter of the interest transferred, if such payments constitute a
substantial element under the transfer agreement.

Section 1253(c) of the Code provides that amounts received or accrued on account of a
transfer, sale, or other disposition of a franchise, trademark, or trade name which are
contingent on the productivity, use, or disposition of the franchise, trademark, or trade
name transferred shall be treated as amounts received or accrued from the sale or
other disposition of property which is not a capital asset.

Section 1253(d)(1)(A) provides that, in general, any amount described in
§ 1253(d)(1)(B) which is paid during the taxable year on account of a transfer, sale, or
other disposition of a franchise, trademark, or trade name shall be allowed as a
deduction under § 162(a) of the Code (relating to trade or business expenses).
PLR-137756-12 6

Section 1253(d)(1)(B) provides that an amount is described in § 1253(d)(1)(B) if it
(i) is contingent on the productivity, use, or disposition of the franchise,
trademark, or trade name,
and (ii) is paid as part or a series of payments
(I) which are payable not less frequently than annually throughout the
entire term of the transfer agreement, and
(II) which are substantially equal in amount (or payable under a fixed
formula).

Section 1253(d)(2) provides that any amount paid or incurred on account of a transfer,
sale, or other disposition of a franchise, trademark, or trade name to which § 1253(d)(1)
does not apply shall be treated as an amount chargeable to capital account.

The Tax Reform Act of 1969, P.L 91-172, added § 1253 to the Code. According to the
Senate Committee Report, S. Rep. No. 91-552, “The committee amendments also
provide that the term ‘franchise‘ includes an agreement which gives one of the parties to
the agreement the right to distribute, sell, or provide goods, services, or facilities, within a
specified area. This would include distributorships or other similar exclusive-type
contract arrangements to operate or conduct a trade or business within a specified area,
such as a geographical area to which the business activity of the transferee is limited by
the agreement.” The Report also states that

   If the transfer agreement includes significant conditions or restrictions which are
   subject to the transferor’s approval on a continuing basis, this power to exercise

PLR-137756-12 7

   continuing, active, operational control over the transferee’s business activities is
   to be considered as a retention by the transferor of a significant power, right, or
   continuing interest. Moreover, if the transferor’s conduct constitutes participation
   in the commercial or economic activities of the transferee’s business, then this
   also is to be regarded as a retention of a significant power, right, or continuing
   interest.

Based on the facts presented, we hold that § 1253 does not require the taxpayer to
capitalize the payments by Taxpayer to Supplier that are specifically mentioned above
in the FACTS section. If the taxpayer makes the additional amendments to the
Agreement that are specifically discussed above in the FACTS section, this holding will
continue to be valid.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                   Sincerely,



                                   Thomas D. Moffitt
                                   Branch Chief, Branch 2
                                   (Income Tax & Accounting)

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