                       T.C. Memo. 2001-324



                     UNITED STATES TAX COURT



   PLASTIC ENGINEERING & TECHNICAL SERVICES, INC., Petitioner
                               v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 10157-99.                  Filed December 28, 2001.


     Charles E. Turnbull and Frank E. Henke, for petitioner.

     John W. Stevens, for respondent.


                       MEMORANDUM OPINION



     GOLDBERG, Special Trial Judge:     Respondent determined a

deficiency in petitioner’s Federal income tax in the amount of

$9,170 for the taxable year 1995.   Unless otherwise indicated,

section references are to the Internal Revenue Code in effect for

the year in issue, and all Rule references are to the Tax Court

Rules of Practice and Procedure.
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       The sole issue in this case is whether petitioner is

required under section 263A, to capitalize certain royalties paid

as the exclusive licensee of a patented “hot manifold assembly

system”.

       This case was submitted fully stipulated pursuant to Rule

122.    The stipulation of facts and the attached exhibits are

incorporated herein by this reference.    At the time the petition

was filed, petitioner’s principal place of business was Auburn

Hills, Michigan.

       Petitioner is a Michigan corporation licensed by the State

and engaged in the business of manufacturing and engineering of

products and services in the fields of industrial chemicals,

plastics, materials, and synthetics.    The sole shareholder and

president of petitioner is Patrick A. Tooman (Mr. Tooman).

Petitioner was incorporated on June 21, 1984.    Mr. Tooman

developed a hot manifold assembly system which was patented under

the United States Letters Patent No. 4,964,795 (the patent),

dated October 23, 1990.    The patent, as described in the

abstract, is “a manifold assembly system of the type used for

conveying plastic injecting molding material from a central

injection point or sprue to a number of mold cavities or to

multiple points”.

       On June 10, 1993, petitioner and Mr. Tooman entered into an

agreement entitled Amended and Restated License Agreement (the
                                - 3 -

agreement), effective as of December 10, 1992.    The agreement set

the amount to be paid for past and future use of the patent in

petitioner’s assembly system.   Under the agreement, petitioner

has the exclusive and nontransferable license and right to

manufacture and sell the assembly system covered by the patent

from December 10, 1992, until December 31, 2004.    Termination of

the agreement may occur upon 10 days’ written notice by either

party or default.   The agreement defines the licensee as

petitioner and the licensor as Mr. Tooman.    Amounts paid by

petitioner to Mr. Tooman for future use of the patent are

referred to as royalties.

     The patent is and has been utilized as a critical component

of petitioner’s assembly systems since 1984.    Royalties are equal

to 10 percent of the net sales price of all plastic molded

products manufactured through the use of the patented assembly

system, also known as the “end product(s)”.    End products are

considered sold at such time as an invoice covering the end

products is delivered to a customer of the petitioner, or if not

invoiced, at the time that such products are shipped, delivered,

or otherwise made available to the customer.    All royalty

payments were paid to Mr. Tooman on a quarterly basis, pursuant

to the agreement.

     Petitioner timely filed its U.S. Corporation Income Tax

Return, Form 1120, for taxable year 1995, and utilized the
                               - 4 -

accrual method of accounting for the year in issue.   Petitioner

incurred $999,151 for the exclusive and nontransferable right to

use the patent.   Petitioner did not allocate any of the $999,151

paid under the agreement to the goods it produced, including

inventory remaining at the end of the year.   Rather, petitioner

deducted the entire $999,151 as “Other Deductions” on line 26 of

its 1995 Federal income tax return as an ordinary and necessary

business expense pursuant to section 162 or, alternatively, as a

depreciation deduction under section 167.   Petitioner used a

simplified production method to calculate inventory costs during

the 1995 taxable year, allocating $510,124 in administrative,

service, and support department costs to production under section

263A.   In allocating section 263A costs to inventory, petitioner

used an absorption ratio calculated by dividing section 263A

costs by the costs of production other than section 263A costs.

     In a notice of deficiency, respondent determined that

petitioner failed to include or allocate the $999,151 in

royalties to production pursuant to section 263A.   Specifically,

based on petitioner’s allocation formula, which is not in

dispute, respondent determined that $26,971 of the $999,151 was

allocable to the ending inventory and was required to be

capitalized and included in petitioner’s cost of inventory.

Accordingly, respondent determined a deficiency of $9,170 for the

1995 taxable year.
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     Deductions are a matter of legislative grace, and taxpayers

bear the burden of proving the entitlement to any deduction

claimed.   INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992);

New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

Section 162(a) allows a deduction for a taxpayer’s “ordinary and

necessary” business expenses paid or incurred during the taxable

year.   However, deductions allowed under section 162(a) are also

“subject to the exceptions provided in part IX (sec. 261 and

following, relating to items not deductible).”     Sec. 161.

     The uniform capitalization rules of section 263A(a)(1)

require that all direct costs and certain indirect costs

allocable to certain property be included in inventory, or

capitalized if such property is not inventory.     Taxpayers subject

to section 263A must capitalize all direct costs and certain

indirect costs properly allocable to property produced or

property acquired for resale.   Sec. 1.263A-1(e)(1), Income Tax

Regs.   “Direct costs”, as they are relevant to “producers”,

include “direct material costs and direct labor costs.”     Sec.

1.263A-1(e)(2)(i), Income Tax Regs.     “Direct material costs”

include the costs of those materials that become an integral part

of specific property produced and those materials that are

consumed in the ordinary course of production and that can be

identified or associated with particular units or groups of units

of property produced.   Sec. 1.263A-1(e)(2)(i)(A), Income Tax
                                - 6 -

Regs.

     Certain “indirect costs” must also be capitalized to the

extent they are properly allocable to property produced.

“Indirect costs” are defined as all costs allocable to property

produced or acquired for resale by the taxpayer other than direct

material costs and direct labor costs (in the case of property

produced).   Sec. 1.263A-1(e)(3), Income Tax Regs.   Indirect costs

are properly allocable to property produced when the costs

directly benefit or are incurred by reason of the performance of

production activities.   Id.   Royalty payments are specifically

identified as an indirect cost that must be capitalized.   Section

1.263A-1(e)(3)(ii)(U), Income Tax Regs., states as follows:

     Licensing and franchise costs. Licensing and franchise
     costs include fees incurred in securing the contractual
     right to use a trademark, corporate plan, manufacturing
     procedure, special recipe, or other similar right
     associated with property produced or property acquired
     for resale. These costs include the otherwise
     deductible portion (e.g., amortization) of the initial
     fees incurred to obtain the license or franchise and
     any minimum annual payments and royalties that are
     incurred by a licensee or a franchisee.

Section 1.263A-1(e)(3)(ii), Income Tax Regs., provides a

nonexclusive list of examples of certain indirect costs that must

be capitalized.

     Respondent contends that the royalty payments incurred by

petitioner are subject to the capitalization rules of section

263A, and further that the payments must be deducted over time

through petitioner’s cost of goods sold.
                               - 7 -

     Petitioner contends that it was not required to capitalize

royalty payments to Mr. Tooman pursuant to section 263A because

the payments were “contingent royalties” rather than “minimum

royalties”.   Petitioner defines contingent royalties as royalty

payments derived from a percentage of petitioner’s net sales of

products manufactured through the patent process.   Petitioner’s

argument is based on the construction, and effectively the

interpretation, of the last sentence of section 1.263A-

1(e)(3)(ii)(U), Income Tax Regs., shown above.   Petitioner

construes the last sentence of section 1.263A-1(e)(3)(ii)(U),

Income Tax Regs., so that the word “minimum” modifies the nouns

“payments” and “royalties”.   We disagree.

     Petitioner was in the business of manufacturing products in

the fields of industrial chemicals, plastics, materials, and

synthetics.   Petitioner acquired the exclusive right to produce

certain end products as licensee, and through the use, of the

manufacturing process protected under Mr. Tooman’s patent.    The

patent was “a manifold assembly system of the type used for

conveying plastic injecting molding material from a central

injection point or sprue to a number of mold cavities or to

multiple points”, thus enabling petitioner to create the end

products.   The regulations of section 263A clearly state that

“licensing and franchise costs * * * incurred in securing the * *

* manufacturing procedure, special recipe, or other similar right
                               - 8 -

associated with property produced”, including “any minimum annual

payments and royalties ... incurred by a licensee”, are indirect

costs that must be capitalized in ending inventory.    Sec. 1.263A-

1(e)(3)(ii)(U), Income Tax Regs.

     Petitioner reads “minimum annual payments and royalties” in

a vacuum.   This phrase merely gives examples of “licensing and

franchise costs” that are classified as indirect costs.    The

distinction petitioner wishes this Court to make between the

phrase “minimum royalties” and “contingent royalties” is

illogical in light of the objectives of the statute and

regulations.   As previously stated, under the statute and

regulations, indirect costs, that is costs other than direct

material costs and direct labor costs or acquisition costs, must

be capitalized if properly allocable to property produced.     Sec.

1.263A-1(e)(3)(i), Income Tax Regs.    Further, the regulations

give as an example of an indirect cost required to be

capitalized, licensing and franchise costs.    Sec. 1.263A-

1(e)(3)(ii)(U), Income Tax Regs.   The language found in the

regulations speaks directly to petitioner’s license of the

patented manufacturing process and the royalties incurred in

securing that license.

     Petitioner relies on a number of cases in its brief that

“widely recognize” “minimum royalties”; however, the cases bear

no relevance to the issue of capitalization under section 263A,
                                 - 9 -

and have no persuasive value to petitioner’s case.1

     Accordingly, we find that the royalty payments incurred by

petitioner in 1995 are indirect costs to the production of the

end products, and, as such, the royalty payments are subject to

the capitalization rules of section 263A.

     We have considered all of the other arguments made by

petitioner, and, to the extent we have not addressed them,

conclude they are without merit.

     To reflect the foregoing,

                                              Decision will be entered

                                         for respondent.




1
     We note that Wood v. United States, 377 F.2d 300 (5th Cir.
1967), and J. Strickland & Co. v. United States, 352 F.2d 1016
(6th Cir. 1965), were decided approximately 20 years before
Congress enacted sec. 263A in the Tax Reform Act of 1986, Pub. L.
99-514, sec. 803, 100 Stat. 2350. Petitioner also cited the
following cases which concerned the research and experimental
expenditures deduction under sec. 174 and years in issue from
1976 through 1984: Harris v. Commissioner, T.C. Memo. 1990-80
(tax years 1979-1982), affd. 16 F.3d 75 (5th Cir. 1994); Estate
of Cook v. Commissioner, T.C. Memo. 1993-581 (tax years 1976-
1982); Research Two Ltd. Pship. v. Commissioner, T.C. Memo. 2000-
259 (tax years 1982-84).
