A toy designer/marketer has its toys manufactured overseas by contractors using its own molds, dies, patents, and trademarks. Usually the company buys the finished toys from the contractor and resells them to customers itself. But for large customers with their own import capabilities, the company instead directs the contractor to sell and ship DIRECTLY to the customer at a price the company sets -- and the contractor remits to the company the difference between what the customer paid and what the company would have paid. What kind of receipt is that markup for Article 9-A allocation purposes -- a sale, a royalty, a commission, or something else?

Plain-English summary

Buddy L Corporation designed its own toys, owned the patents and trademarks for them, and had them manufactured by contractors in the Far East using molds and dies Buddy L supplied. The contractors were responsible only for sourcing raw materials and physically producing toys exactly to Buddy L's specified quantity, timing, and style. Buddy L's normal business model was to buy the finished toys from the contractor and resell them itself to customers.

But for its largest customers -- those with their own foreign-commerce/import capabilities -- Buddy L used a different arrangement, driven by financing considerations: the customer dealt DIRECTLY with the contractor, with the contractor selling and shipping the goods straight to the customer. Even so, Buddy L still controlled the transaction completely -- it dictated the price the contractor charged the customer, and the sale happened only at Buddy L's direction. The contractor then remitted to Buddy L the excess of what the customer actually paid over the (lower) price Buddy L would otherwise have charged the contractor for the same goods. Tellingly, if the goods turned out to be defective, it was Buddy L -- not the contractor -- that took the merchandise back and absorbed the loss, even though legal title had passed directly from contractor to customer.

The question was how to classify Buddy L's receipts from this indirect-sale arrangement for Article 9-A receipts-factor allocation purposes. The Department held these receipts didn't fit neatly into any single existing category. They couldn't be ordinary sales receipts, because it was the CONTRACTOR, not Buddy L, that transferred both title and possession to the customer. They resembled ROYALTIES, because the contractor was using Buddy L's patents, trademarks, molds, and dies to produce and sell the product. They also resembled COMMISSIONS, because they were, in substance, payments from a seller (the contractor, acting at Buddy L's direction) to the party (Buddy L) that arranged the sale. The Department's solution: treat the receipts as a hybrid, apportioning them between the royalty and commission categories, with each portion allocated under its own respective rule.

What this means for you

Receipts from indirect, contractor-mediated sales arrangements may not fit cleanly into "sales" categories

If your business structures sales through a contract manufacturer selling directly to your customer at your direction -- especially where your IP, tooling, and pricing control are involved but you never take title -- don't assume the resulting markup is ordinary sales income; it may need to be analyzed and apportioned as a royalty/commission hybrid instead.

Retaining risk (like defect liability) even without taking title can support a "not merely a sale" characterization

The fact that Buddy L, not the contractor, absorbed defective-goods losses helped establish that Buddy L remained economically involved in the transaction in a way that went beyond a pure sales relationship -- worth documenting if you're in a similar indirect-sale structure.

When a receipt has features of multiple categories, expect an apportionment rather than an all-or-nothing answer

Rather than forcing Buddy L's hybrid receipts into either the royalty or commission bucket exclusively, the Department directed a proportional split -- a useful precedent if your own receipts genuinely blend characteristics of more than one Article 9-A category.

Common questions

Q: If a contract manufacturer sells and ships directly to my customer at my direction, are my markup receipts treated as ordinary sales income?
A: Not under this ruling -- because title and possession pass from the contractor (not you) to the customer, the receipts are better characterized as a royalty/commission hybrid rather than sales receipts.

Q: Do I need to pick either "royalty" or "commission" for these receipts, or can they be split?
A: This ruling directs an apportionment between the two categories, with each portion allocated under its own applicable rule -- not an all-or-nothing choice.

Citations and references

Statutes and guidance:

• Article 9-A of the Tax Law (Franchise Tax on Business Corporations)

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_1981.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/h81_19c.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-H-81(19)C
Corporation Tax
March 24, 1981

STATE OF NEW YORK
STATE TAX COMMISSION
ADVISORY OPINION

PETITION NO. C801006B

On October 6, 1980, a Petition for Advisory Opinion was received from Buddy
L Corporation, 200 Fifth Avenue, New York, New York 10010.
The issue raised is the nature and proper method of allocation of certain
receipts received by Petitioner, under the circumstances described below, for
purposes of the Franchise Tax on Business Corporations imposed under Article 9-A
of the Tax Law.
Petitioner is in the business of manufacturing and selling toys. It designs
its own toys and has the appropriate molds and dies manufactured for it.
Petitioner owns patents and trademarks for its toys, in various countries. The
toys are manufactured for Petitioner by contractors in the Far East. Petitioner
supplies its molds and dies to the contractors, which are responsible for
obtaining raw materials and producing the toys. The toys are manufactured only
in accordance with the order of Petitioner, which thus controls the quantity,
timing and styles manufactured. Petitioner's usual method of operation is to
obtain toys from the contractors for an agreed upon price and then to sell the
toys directly to customers. However, in the case of large-scale customers having
foreign commerce capabilities the customer is permitted to deal directly with the
contractor. In such cases the customer, rather than Petitioner, bears the burden
of financing the sale and, indeed, Petitioner asserts that this alternate sales
method is dictated by financing considerations. In such instances the price
charged by the contractor to the customer is dictated by Petitioner, and the sale
is made to the customer only at the direction of Petitioner. Title to the product
passes directly from the contractor to the customer. However, where the goods
prove to be defective it is Petitioner, and not the contractor, which takes the
merchandise back and incurs the loss. The excess of the price paid by the
customer to the contractor over the price payable by Petitioner to the contractor
for the same product is remitted by the contractor to Petitioner. It is the
nature of this income which is at issue herein.
Receipts from the transactions described by Petitioner do not clearly and
unmistakably lie within the ambit of any of the categories employed under the
Franchise Tax on Business Corporations. These transactions constitute a route,
albeit a circuitous one, whereby Petitioner effectuates its business purpose of
selling its product. However, Petitioner's receipts cannot properly be
denominated receipts from sales inasmuch as it is the contractor and not
Petitioner which transfers both title and possession from itself to the customer.
The receipts in question bear certain of the characteristics of royalty payments.
Thus, the contractor is permitted to use Petitioner's patents and copyrights, in
addition to its dies and molds, in order to produce and sell a product. However,
the receipts also resemble commissions, in that they constitute payments made by
a seller to a party which arranged for the sales of such seller. In effect, then,
the receipts in question constitute a hybrid, composed of royalties and
commissions. Accordingly, such receipts should be appropriately apportioned
between the two and each portion treated, for purposes of allocation, pursuant
to such apportionment.
DATED: March 24, 1981

JAMES H. TULLY., COMMISSIONER
TP-8 (4/80)

s/LOUIS ETLINGER
Deputy Director
Technical Services Bureau

LOUIS M. JACOBSON, DEPUTY COMMISSIONER
FRANK J. PUCCIA, DIRECTOR