Slotting fees: should they be expensed or capitalized?

The preferred tax treatment of slotting fees paid by manufacturers to retailers in the food industry has yet to be formally provided by statute or IRS pronouncement. Because the benefit period related to the fees may extend beyond one year, the question of whether the payments constitute a currently deductible expense rather than one that should be capitalized is of concern to taxpayers. This is particularly true in light of the Supreme Court's INDOPCO, Inc. decision.

Slotting Fees

Slotting fees are food industry manufacturers' payments to retailers to induce a retailer to shelve the product. The use of these fees is found throughout the food retailing industry and is considered standard practice. In addition, the practice is spreading to other retail industries (such as bookstores). Another related practice is that of "staying fees," payments made in subsequent periods so that the retailer continues to shelve a manufacturer's products. The practice is often subject to criticism, due to inconsistent payment amounts and the camouflage surrounding these transactions.

There is currently a great deal of debate surrounding both the origin and continuing purpose of slotting fees. The primary problem with any objective study of the economic issues surrounding slotting fees is the inconsistency in amount and clandestine nature of the payments. Manufacturers blame the fees on the consolidating retail food market. They argue that retailers now possess the power to force manufacturers to pay these fees so that retailers' products can be made available to consumers. The retailers claim, however, that manufacturers willingly pay the fees.

Applicable Tax Law

In general, Sec. 162 and the related regulations allow a deduction for ordinary and necessary business expenses incurred by a taxpayer. Sec. 263 provides that taxpayers are not currently allowed to deduct amounts paid that permanently improve or increase the value of an asset. In other words, typically those expenditures that result in a benefit (asset) which has value over multiple tax periods are to be capitalized and their costs allocated over multiple tax periods.

In INDOPCO, Inc., 503 US 79 (1992), the Supreme Court held that "deductions are exceptions to the norm of capitalization, and are allowed only if there is clear provision for them in the Code and the taxpayer has met the burden of showing a right to the deduction." The Court further detailed the requirements:

the creation of a separate and distinct asset may well be a sufficient but not a necessary condition to classification as a capital expenditure .... Nor does Lincoln Savings prohibit reliance on future benefit as a means of distinguishing an ordinary business expense from a capital expenditure. Although the mere presence of an incidental future benefit ... may not warrant capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization.

This finding appears to make a strong statement that to the extent payment of fees provides a long-term benefit, it is likely to require capitalization.

The results of INDOPCO have, therefore, brought concern to taxpayers whose business practice requires the payment of fees such as slotting fees, While the specifics of INDOPCO relate to investment banking fees and other expenses incurred as part of an acquisition of a subsidiary, the implications of the ruling may be construed to apply to slotting fees.

The Service has provided detailed guidance on a few specific issues in light of INDOPCO, such as incidental repair costs and severance payments. In Rev. Rul. 94-12, the IRS stated that INDOPCO did not affect the deductibility of incidental repair costs: "With respect to expenditures that produce benefits both in the current year and in future years, the determination of whether such expenditures must be capitalized requires a careful examination of the facts." It held that, in the case of incidental repairs, the costs were generally deductible even though there may be some future benefit. Rev. Rul. 9477 used the same argument in determining that severance payments made in regard to downsizing may produce future cost benefits, because they related primarily to services that had already been provided. As such, they were properly a current deduction rather than a cost to be capitalized.

The American Bar Association Section of Taxation Committee on Tax Accounting issued a report on issues raised by INDOPCO. This report noted a proposed Coordinated Issue Paper (ISP) on slotting fees that concluded that such fees should be capitalized. However, there has been no follow-up ISP to this proposal. Likewise, the IRS issued Notice 96-7 to obtain public comment on how it should address issues on the deductibility of various expenditures as a result of INDOPCO; the deadline for comments was May 6, 1996. The authors are not aware of any subsequent rulings by the Service on slotting fee treatment.

It is interesting to consider the treatment of advertising expenditures. It is quite common for advertising expenditures to provide benefits such as customer goodwill for a period of time greater than one year. Yet, as long as the payments are reasonable in amount and are shown to have a business purpose, they have been allowed as currently deductible expenses. In fact, advertising expenditures are specifically excluded from inventoriable costs under Sec. 263A's uniform capitalization rule. If the arguments that slotting fees are in a sense a replacement of advertising expenditures are correct, it would appear logical to treat them the same, regardless of the future benefit the fees provide.

Recommended Treatment

It is apparent that ethical and economic concerns regarding slotting fees exist. Given that neither the Federal Trade Commission nor the Federal courts have formally taken action against the use of slotting fees, these issues will continue to exist. While this ambiguity is likely to prevent the IRS from structuring slotting fees treatment to obtain an economic policy objective, their treatment remains an important compliance issue that should be addressed. The Service should issue a revenue ruling on the treatment of slotting fees in light of INDOPCO, as it has done for incidental repair costs and severance payments. The IRS should also, within this ruling, take the position that taxpayers may deduct fees for which there is an uncertain benefit in the current period as they do with advertising expenditures. Until the IRS issues such specific guidance, taxpayers should carefully document the details of their fee arrangements with retailers. Specifically, taxpayers should be as exact as possible regarding the period for which the fees provide benefit. To the extent that fees clearly represent "staying fees" paid each year to maintain the products or are paid in lieu of other types of advertising, this should be documented to help provide evidence that supports a current deduction. Because of the lack of specific guidance, it is believed that taxpayers will be able to protect themselves by currently expensing slotting fees that guarantee shelf space for only the first year after payment of the fee. To the extent that a fee agreement provides benefits for multiple years, the conservative taxpayer will want to allocate the fees over the number of years benefitted by the fee arrangements; concerned taxpayers may also wish to request a letter ruling.

Conclusion

While the tax community and economists continue to debate the economic and ethical considerations of slotting fees, the Service should provide guidance on the proper tax treatment of these fees to taxpayers currently forced by industry practice to pay them. This is particularly true in light of INDOPCO.

Until the IRS provides exact guidance, taxpayers should carefully document the fee agreement details and the time periods for which they expect to receive benefits from fees. This will allow careful review of, and provide evidence on, the facts and circumstances of specific fee arrangements. These facts and circumstances may then be used to appropriately determine whether current deduction of the expense or capitalization treatment is warranted.