Issues in the Deductibility of Trade Promotion Expenditures

By Larry Maples

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Co-op Advertising

Co-op advertising agreements are usually included on the reseller’s order form when goods are purchased from the manufacturer. The agreement may specify such details as the design of the ads, where the ads may appear, and dates by which the ads must appear. After the reseller performs the required advertising, it is normally required to submit documentation, such as invoices and copies of ads, to demonstrate compliance. Upon receipt of this documentation, the manufacturer will either reimburse the seller or reduce the sales price on purchases to the reseller. If the claim form and documentation are submitted in the year in which the advertising services are performed, the manufacturer deducts its costs in that year; however, the timing of the deduction has been an issue when a claim was submitted in the year after the services were performed.

The question is whether the filing of the claim form or the performance of the advertising services is the act that fixes the fact of the liability under the all-events test [IRC section 461(h) and Treasury Regulations section 1.461-1(a)(2)(i)]. The conflict within the IRS on this issue has its source in the Supreme Court’s General Dynamics decision, which held that the all-events test was not met for a self-insurer’s liability for medical services until the taxpayer’s employee submitted a claim form, even if the medical service had already been provided (481 U.S. 239). In a series of contradictory technical advice memoranda (TAM), the IRS both applied and distinguished the General Dynamics rule to cooperative advertising allowances (see TAM 9204003, 9320001, and 9343006). Finally, in Revenue Ruling 98-39, the IRS held that a manufacturer may accrue a deduction for cooperative advertising before the filing of a proof-of-performance claim. This ruling should help determine whether the timing of the claim form is crucial. The only remaining hurdle in establishing a deduction is to show that services were rendered.

Slotting and Stock-lifting Fees

For decades, supermarkets and other retail outlets have been charging slotting fees for shelf space for new products. The manufacturer pays a fee to the retailer for the privilege of “slotting” its products in the retailer’s warehouse and ultimately on its retail shelves. These fees are also known as new-product-introduction or product-placement fees and represent a significant portion of large grocery chains’ profits. Slotting is the method many manufacturers use to introduce products on a continual basis, because many supermarket or drugstore products have a short lifespan.

This continual process of introducing new products would seem to be a good argument for the current deduction of these fees. In some cases the benefit period may extend beyond one year, but the IRS has not required capitalization of advertising, which commonly has benefits that extend beyond a year (Revenue Ruling 92-80, 1992-2, C.B.57). The analogy with advertising is appropriate because slotting can be viewed as a replacement for, or at least a complement to, advertising.

Although Treasury Regulations section 1.263(a)(4) signals a retreat from the “future benefit” test, certain contract rights can, in certain circumstances, be considered a separate and distinct intangible required to be capitalized. The regulations do not give an example of slotting fees per se, but Treasury Regulations section 1.263(a)-4(1), Example 8, contains an interesting example of “stock-lifting,” a close cousin to slotting.

In the example, a wholesale distributor of automobile replacement parts made an offer to a retail store to replace its existing inventory with its own brand and to give the store credit for the cost of the inventory replaced. The IRS concludes that capitalization is not required as long as the store is not obligated to continue stocking the new brand. But if the store were obligated to purchase all of its inventory from this wholesale distributor for an extended period (e.g., three years), the distributor should capitalize the amount of the credit given as an inducement for this arrangement.

In practice, the tactic of stock-lifting or buying a competitor’s products right off the shelves of a potential customer is usually a more discrete event than slotting, which normally entails payments on a continual basis to introduce new product after new product. This might be why the regulation’s writer used stock-lifting to illustrate trade channel costs that should be capitalized. But because the regulations give no example of slotting, it is possible that the IRS might require capitalization of slotting arrangements that create an obligation to provide space for a particular product over a longer timeframe.

Distribution Channel Costs

Prior to the release of these regulations, IRS pronouncements indicated that the cost of developing and upgrading distribution channels should be capitalized. In Letter Ruling 9331001, a wholesaler of fragrances, cosmetics, clothing, and accessories expanded into the retail market by opening a chain of boutiques. The IRS viewed the opening of the first boutique as the start of a new business and the opening of the subsequent boutiques as an expansion of the business. The preparatory costs had to be capitalized, and only those costs connected to the first boutique were amortizable as start-up costs under IRC section 195. In Field Service Advice (FSA) 199309282, a taxpayer reimbursed an independent marketer for expenditures designed to upgrade the taxpayer’s image and appearance standards. The IRS said such reimbursements should be capitalized even if the same costs would have been deductible if incurred by the independent marketer. Some costs, such as equipment, are routinely capitalized, but some of the reimbursement was for advertising, which normally would be deducted. The IRS’s rationale for capitalizing advertising in this situation was that the reimbursements were contingent on an extension of the marketing contract. The IRS viewed the contract as a “significant future benefit” under the rationale of Indopco [503 U.S. 79 (1992)].

Because the regulations signal the IRS’s retreat from a strict application of the “significant future benefit” test back toward the pre-Indopco “separate and distinct” test, the Briarcliff Candy [73-1USTC 9288 (CA-2, 1973)] case should receive renewed attention from taxpayers. In that case, a candy manufacturer incurred costs to develop a new distribution channel. The Second Circuit allowed a deduction for the costs to develop the channel under the rationale that “no separate and distinct asset” had been created. The Supreme Court’s rejection of this test in Indopco put Briarcliff in limbo, but the new regulations may put new life in this key pro-taxpayer case, allowing a deduction for developing a new distribution channel.

Note that even though the change in the regulations opens the possibility of deducting some expansion costs, capitalization will still be required if the expansion uses newly established subsidiaries. The Tax Court has held that if there are legitimate business reasons for accomplishing the expansion via a new subsidiary, the taxpayer must accept all of the consequences of that decision. One consequence is that the subsidiary must treat the costs of creating the subsidiary as capitalized start-up costs (TC Memo 1992-221).

The new distribution channel of choice for many businesses is the Internet. To the extent that online development costs are allocable to software development, the rules for software recovery would apply. But the recovery of costs that are not allocable to software is less clear. Under the IRS approach on channel-of-distribution costs prior to the issuance of the new regulations, one could expect to capitalize the costs. However, the IRS’s decision to back off from the “significant future benefit” test may create an opportunity to deduct nonsoftware costs.