The IRS recently held that a manufacturer did not have to capitalize, but instead could deduct, construction support payments that it made to its dedicated retailers. From a retailer’s point of view, this means that payments of this type cost the manufacturer less after tax and, as a result, should encourage such payments to be made.
In Chief Counsel Advice 201405014 (Sept. 12, 2013, released Jan. 31, 2014), a manufacturer provided construction support payments to its dedicated retailers to enable them to “incorporate seven critical image elements” into their stores. The retailers had to continue to sell the manufacturer’s products and maintain the store design for at least 15 years; otherwise, the construction support payments had to be returned to the manufacturer.
The IRS had to determine whether the manufacturer received a continuing benefit in exchange for the construction support payment of a type that would require capitalization and amortization under the applicable regulations. The IRS found that the manufacturer obtained intangible rights to require the retailers to conform to the design concepts. However, reviewing the situations in which capitalization would be required one by one, the IRS found that none of them applied:
- The manufacturer’s rights did not create a separate and distinct asset, because the rights had no value apart from the promotion of its product line. Thus, they were like advertising expenses that may be deducted.
- The rights did not create a financial interest (such as a forward contract or option), because, although the retailers were required to sell the manufacturer’s products, they did not have to buy any specific quantity.
- The rights were not a right to provide services that was required to be capitalized under the regulations, again because the retailers did not have to buy any specific quantity.
- Finally, the payments did not create a right in real property of a type contemplated by the regulations, because the improvements were “cosmetic” and not to remain affixed for an indefinite period of time.
The Chief Counsel Advice does not discuss the tax implications of the construction support payments to the retailers, other than to say that “[s]ome renovation may be required, and the retailers may be required to capitalize some of these costs as purchases of or improvements to tangible property.” Unspoken is the possibility that the IRS would require the construction support payment to be treated as income to the retailer when received. See, e.g., John B. White, Inc. v. Commissioner, 55 T.C. 729 (1971), aff’d per curiam, 458 F.2d 989 (3d Cir. 1972) (incentive payment by car manufacturer to dealer to move to a better neighborhood must be included in dealer’s income). See also Internal Revenue Manual § 188.8.131.52.6.2(4) (07-23-2009) (“Whereas retailers generally take the position that these [merchandise display] allowances reduce the bases of the acquired assets, the IRS takes the position that these allowances represent gross income.”) and id. § 184.108.40.206.6.6 (07-23-2009) (“Some retailers receive up-front cash payments from vendors in exchange for a commitment to purchase a targeted volume over a period of time or to remain a customer for a specified period of time…. Retailers may … take the position that the up-front payments are in the nature of loans or deposits from the vendors that must be repaid if the terms of the agreement are not met and, thus, do not constitute gross income upon receipt. Conversely, the IRS has taken the position that the cash payments represent gross income as payment for the exclusive right to supply the retailer with goods of a specific type. The IRS also has taken the position that since the retailer alone controls whether or not the prerequisite purchases are made, the payments are an accession to wealth, clearly realized, and over which the taxpayer has complete dominion and control [and thus must be included in income].”) Internal Revenue Code § 110, which excludes from income certain tenant improvement payments received by a retailer from a lessor under a short-term lease, would apparently not prevent this result, because the payment is received from the manufacturer, not the lessor.
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