On September 5, 2019, the Internal Revenue Service (Service) and the Department of Treasury (Treasury) issued proposed regulations for Section 451(c) of the Internal Revenue Code (Code).1 Section 451(c) was added to the Code with the enactment of the Tax Cuts and Jobs Act (enacted as “An Act to provide for reconciliation under titles II and V of the concurrent resolution on the budget for fiscal year 2018”) (TCJA) on December 22, 2017. Consistent with the directive in the statute and legislative history, the proposed regulations continue to codify the advance payments guidance previously provided in Rev. Proc. 2004-34, allowing for up to a one-year deferral for advance payments received for goods and services to the extent such amounts are deferred for financial accounting purposes.
In addition to largely conforming with Rev. Proc. 2004-34, the proposed regulations reflect the Service and Treasury’s consideration of comments submitted by taxpayers. While the proposed regulations favorably exclude certain upfront payments received by taxpayers in connection with goods that require considerable time to develop and deliver from the definition of advance payments, the proposed regulations fail to provide the accelerated cost offset that many taxpayers had requested. With the changes made to section 451(b) and the general acceleration of income recognition, the ability to defer income under section 451(c) is more beneficial than ever though; particularly, with the repeal of Treas. Reg. 1.451-5, section 451(c) and the proposed regulations provide the only real option for income deferral in the Code.
Although generally adopting the guidance previously provided in Rev. Proc. 2004-34, it is important for taxpayers to thoroughly review the proposed regulations to ensure they properly evaluate and implement the new rules, as many aspects of the previous rules have been revised, including the requirement to file a method change if seeking to comply with the proposed regulations. For more information on the requirement to file a method change, please see the ES alert on Rev. Proc. 2019-37, the Service’s concurrently-released guidance that provides detail regarding such change.
Background
Before this statutory change, taxpayers using an accrual method of accounting applied the All Events Test to determine the timing of both revenue and expenses. Under the All Events Test, revenue for the sale of goods or services was recognized upon the earlier of when the revenue was: (1) received; (2) due and payable; or (3) earned through the required performance.2 With respect to advance payments (e.g., payments received in one tax year for goods or services to be provided in a later year), a trilogy of US Supreme Court cases between 1957 and 1963 established the general rule for income recognition for prepayments, that income should be recognized no later than upon receipt.3 Subsequent to the trilogy, courts held that taxpayers could defer income beyond the year of receipt.4 In response to these developments, in the early 1970s, administrative guidance was issued providing an exception to this general rule, which allowed taxpayers to defer income recognition for advance payments on a limited basis, generally no longer than when the advance payments were recognized for financial accounting purposes.5 Subsequent guidance also allowing a deferral for advance payments was issued, including Treas. Reg. § 1.451-5 (allowing advance payments deferral for the sale of goods and long-term contracts until such goods are provided to a customer); and Rev. Proc. 2004-34 (establishing the Deferral Method, which allowed deferral of advance payments for both goods and services for up to one year if such income is also deferred for financial statement purposes).6 When these administrative exceptions were released, significant and often multi-year income deferral was available for financial accounting purposes. To minimize this disparity, the Service and Treasury allowed a similar deferral of income recognition for tax purposes.
More recently, in 2014, FASB issued new revenue recognition standards for financial accounting purposes (i.e., ASC 606).7 Under ASC 606, which was required to be adopted by public companies in 2018 and private companies in 2019, revenue recognition standards were modified to focus on the satisfaction of various performance obligations within a contract and recognition of a proportionate amount of the overall transaction price upon the satisfaction of each performance obligation. In many circumstances, ASC 606 requires revenue recognition for financial accounting purposes in years earlier than under the previous standards, and some taxpayers found the new standard created complexity with matching income recognition for book and tax purposes.
With the TCJA, the historic rules of income recognition for tax purposes have been significantly modified. Section 451(b) was revised to provide that for accrual method taxpayers, the All Events Test for any item of income is satisfied no later than when such income is recognized for financial accounting purposes. Additionally, section 451(c) was added to the Code and allows a taxpayer to elect to defer the recognition of advance payments to the taxable year following the taxable year of receipt to the extent such income is deferred for financial accounting purposes, except any portion of such payment which is required under section 451(b) to be included in gross income in the taxable year in which the payment is received.
Section 451(c) essentially codified the Deferral Method under Rev. Proc. 2004-34, under which an advance payment may be deferred to the subsequent tax year to the extent recognized for financial accounting purposes for that taxable year, i.e., a one-year deferral.
As a new Code section, taxpayers and practitioners eagerly awaited additional guidance regarding section 451(c). Although the Service issued interim guidance with Notice 2018-35, the guidance was limited, primarily accepting the status quo while the government was drafting regulatory guidance. The Notice allowed taxpayers to continue relying on Rev. Proc. 2004-34 for the treatment of advance payments.8
Interest in regulations under section 451(c) was further heightened when the Service withdrew long-standing regulations, Treas. Reg. 1.451-5.9 These earlier regulations allowed taxpayers to defer income recognition for advance payments until the payments were recognized in gross receipts under the taxpayer’s financial accounting method, often for more than one taxable year.
Proposed regulations
With the release of these proposed regulations, the Service and Treasury have addressed certain open questions. Further, the guidance is particularly timely as many calendar-year companies are finalizing 2018 filing positions.
- Proposed regulations allow continued use of the Deferral Method
First and foremost, for a taxpayer with an Applicable Financial Statement (an “AFS”) (generally, an audited financial statement or a financial statement used for banking or for other regulatory purposes), the proposed regulations note that section 451(c) was intended to codify Rev. Proc. 2004-34 and the Deferral Method that allows qualifying taxpayers to defer certain income from advance payments for one tax year. For non-AFS taxpayers, a similar deferral method is available under proposed Treas. Reg. §1.451-8(d), relying on the “earned” standard. A taxpayer without an AFS must include income in the year of receipt to the extent that it is earned in that year, any remaining income may be deferred to the subsequent tax year.
| Eversheds Sutherland observation: While it is not surprising the proposed regulations confirm that section 451(c) was intended to codify the Deferral Method provided in Rev. Proc. 2004-34, the use of the AFS or non-AFS deferral method provided in the proposed regulations is considered the adoption of, or change in, a method of accounting. Therefore, to the extent a taxpayer uses one of these methods, a change in method of accounting and Form 3115 may be required to properly implement the proposed regulations. |
- Beyond Deferral Method, proposed regulations largely conform to Rev. Proc. 2004-34
As evidenced in the legislative history to section 451(c), the proposed regulations widely conform to many of the more detailed provisions of Rev. Proc. 2004-34.10 Proposed Treas. Reg. §1.451-8(b)(1)(i) confirms the definition of an advance payment under the proposed regulations that is consistent with the definition of an advance payment in Rev. Proc. 2004-34, including a similar list of items that are included in, as well as items that are excluded from, the definition of an advance payment. Specifically, an advance payment includes a payment for: services; the sale of goods; the use, including by license or lease, of intellectual property, including copyrights, patents, trademarks, and similar intangible rights; the occupancy or use of property if such is ancillary to the provision of services; the sale, lease, or license of computer software; guaranty or warranty contracts ancillary to any of the aforementioned; subscriptions in tangible or intangible format; memberships in an organization; an eligible gift card sale; and any other payment specified by the Service. Excluded from the definition of an advance payment is: rent; insurance premiums; payments with respect to financial instruments, including purported prepayments of interest; and, payments received in a taxable year earlier than the taxable year immediately preceding the taxable year of the contractual delivery date for a specified good. It is important to note, the list of excluded items was expanded by the proposed regulations, as discussed below.
Beyond the consistent application of the Deferral Method for taxpayers with AFS, the earned standard deferral method for non-AFS taxpayers, and the definition of advance payments, the proposed regulations also generally conform to Rev. Proc. 2004-34 in the following instances:
- Generally, adoption of the acceleration rules provided in Rev. Proc. 2004-34 regarding taxpayers ceasing to exist, or participating in transactions to which sections 351 or 381 apply; and
- Use of the short taxable years rules of Rev. Proc. 2004-34 for both AFS and non-AFS deferral methods.
| Eversheds Sutherland observation: As indicated by the proposed regulations, with respect to certain instances, i.e., acceleration of income when a taxpayer ceases to exist, when a taxpayer’s obligation regarding an advance payment is satisfied or otherwise ends, or a taxpayer has a short taxable year, the proposed regulations fully adopt the rules provided in Rev. Proc. 2004-34. Thus, to the extent a taxpayer encounters one of these situations, in addition to the proposed regulations, Rev. Proc. 2004-34 and authorities interpreting the revenue procedure may be useful to ensure a taxpayer does not run afoul of the new rules. |
- Proposed regulations fail to provide accelerated cost offset
Taxpayers and practitioners had requested that the regulations include a cost of goods sold (COGS) offset to the recognition of advance payments under section 451(c). While the statutory language of section 451(c) arguably supports such an offset11 and the economic performance requirement of section 461(h) does not prevent one,12 the Service and Treasury determined that an allowance for future COGS or future estimated costs was inconsistent with sections 461(h), 471, 263A, and the accompanying regulations.
To support their decision not to include an accelerated cost offset, the Service highlights that section 451(c) changes only the timing rules of income inclusion, not liabilities; and because section 451(c) generally codified Rev. Proc. 2004-34, and Rev. Proc. 2004-34 does not include an accelerated cost offset; then no offset was included.
Further, the Service failed to see in the legislative history “any indication that Congress intended to preserve the cost offset rules permitted under Treas. Reg. §1.451-5.” Before its repeal,13 Treas. Reg. §1.451-5 allowed an extended deferral and also permitted a cost offset when advance payments were recognized,14 following tax decisions preceding the regulations that allowed for such offset.15 One rationale for the extended deferral and companion offset was the matching principle, (that income and related expenses should be taken into account in the same year to clearly reflect income). By allowing income deferral until the goods are provided to customers, the income deferral coupled with cost offset meant that Treas. Reg. §1.451-5 allowed a matching of income attributable to the sale of goods with costs of producing such goods.
Unfortunately, the Service and Treasury decided to narrowly interpret the legislative history of section 451(c) to support their determination that the proposed regulations should not include an accelerated cost offset. The Service and Treasury welcome comments with respect to whether there should be any exceptions to the rules to alleviate the potential mismatch of the acceleration of income recognition with different timing rules for associated costs.
| Eversheds Sutherland observation: While it is discouraging that the Service failed to include any cost offset in the proposed regulations, the preamble indicates that the government remains willing to consider an offset. With a goal of releasing as much TCJA guidance as quickly as possible, further considering this alternative may have involved more protracted determinations implicating other Code sections, i.e., §§461, 471 and 263A. Taxpayers should consider providing comments to advocate for more favorable treatment to demonstrate the actual mismatching of income and expense that results from requiring the acceleration of income without a comparable accelerated cost offset. Specifically, the Service notes that a cost offset mechanism was of particular importance for manufacturers of certain property and taxpayers with inventoriable goods to ensure matching of income and expenses. While the Service did not adopt the comments provided by such taxpayers, the indication of continued consideration suggests that comments addressing why an exception to use the book percentage-of-completion (PCM) method or an expanded definition of “unique item” for section 460 purposes are important. |
- Proposed regulations clarify the meaning of advance payments
The proposed regulations clarify that the definition of advance payment under the AFS and non-AFS deferral methods is consistent with the definition of advance payment provided in Rev. Proc. 2004-34.16 In the preamble to the proposed regulations, two requests were referenced, which sought to include in the definition of advance payments airline miles and progress payments with respect to the sale of an interest in real property. While airline miles were not explicitly referenced because the use of the Deferral Method to the extent airline miles are redeemable for goods or services is already permissible, progress payments related to the sale of an interest in real property were not included because the existing rules do not include prepayments for interests in real property. Nonetheless, the preamble indicated that the government will consider comment regarding additional types of items to include in the definition of advance payments.
Proposed Treas. Reg. §1.451-8(b)(1)(ii), further provides a list of items excluded from the definition of advance payments that is similar to Rev. Proc. 2004-34.17 One significant exclusion was added to the proposed regulations. In response to comments received from the aerospace and defense industries, which highlighted the potential impact of advance payments received in connection with “commercially significant” or “high-value” goods that take a significant amount of time to produce. For these items, the proposed regulations include an exclusion for certain goods for which customers make upfront payments under the contract, delivery of the good occurs at least two taxable years after such upfront payment, the taxpayer doesn’t have the goods on hand at the end of the year of the upfront payment, and the taxpayer does not recognize revenue from the sale of the good in its AFS until the year of delivery. When the exclusion was requested, an argument was made that consistent with caselaw, payment is associated with a later perfomance event, and thus for purposes of the All Events Test, the income would be properly recognized when the performance occurs rather than upon receipt. Consequently, the request was sought, and the government allowed, a longer deferral period than generally available for advance payments. It is appreciated that the proposed regulations support a longer deferral consistent with the economics of a unique transaction. Although the government seems to have granted the requested exclusion from the advance payments provisions, ambiguity remains about when income should be recognized. Further, it is appreciated that this single situation warrants a longer deferral, and it is hoped that when these rules are finalized additional circumstances warranting longer deferral will be recognized.
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Eversheds Sutherland observation: The preamble to the proposed regulations noted that the government was willing to consider other examples of items that could be excluded from the definition of advance payments and requested comments regarding whether:
- The authority granted to the Secretary to exclude certain payments from the definition of an advance payment under section 451(c) also permits an exception for those payments from the rules regarding the All Events Test under section 451(b);
- What significance should the time it takes to manufacture or create an item of property, or its useful life, be given in determining whether a pre-delivery payment for such item of property should be included in income as an advance payment;
- The Secretary has the authority to issue rules that change the timing of deductions or provide a safe harbor allowing specified categories of taxpayers to use methods of accounting for recognizing income other than section 451;
- Could the Secretary require that a taxpayer use an alternative method of accounting as a condition for excluding a type of payment from the definition of advance payment;
- Could the Secretary impose a time limit on exclusions from the definition of advance payment, e.g., exclusions limited to a certain number of years after which all remaining amounts of income must be recognized;
- Could the Secretary allow deferral of income in an amount equal to the estimated future performance costs while requiring current recognition of estimated profits not in excess of the amounts of advance payments, and if so, could such rules account for the time value of money for any variance in estimated costs of profits; and
- Would it be inappropriate to reduce the amount a C corporation would be permitted to defer for a given taxable year under the potential exclusion by an amount equal to the excess of distributions the C corporation made to its shareholders with respect to its stock, over the C corporation’s taxable income for that taxable year?
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- Proposed regulations interaction with financial statement adjustments
Although not addressed by the statute itself, the treatment of financial statement adjustments that cause amounts to be excluded from income is addressed in the proposed regulations. Notwithstanding any write-down or adjustment for financial accounting purposes, proposed Treas. Reg. §§1.451-8(c)(3) and (d)(7) provide that a taxpayer that defers inclusion of all or part of an advance payment must include the remainder of the advance payment in gross income in the subsequent year. In connection with such financial statement adjustments, many commenters were concerned that a write-down or adjustment for financial accounting purposes could result in the permanent exclusion of income for federal income tax purposes. In response to these concerns, proposed Treas. Reg. §§1.451-8(c)(3) and (d)(7) clarify the treatment of such write-downs in connection with certain equity transactions. Specifically, the Service provides that financial statement write-downs or adjustments to deferred revenue should not be taken into account for federal income tax purposes when determining the proper amount to be included in income under the deferral method.
| Eversheds Sutherland observation: The clarification provided by the Service and Treasury in proposed Treas. Reg. §§ 1.451-8(c)(3) and (d)(7) will be helpful to several taxpayers that routinely complete transactions and experience write-downs or adjustments to deferred revenue for financial accounting purposes. In such instances, it will be important for taxpayers to ensure that for federal income tax purposes, such write-downs should not be taken into account when determining the proper amount to be included in income under the deferral method. This clarification in the proposed regulations is not only consistent with the statute but also ensures there is no permanent exclusion of income for tax purposes. |
- Proposed regulations address allocation of transaction price among performance obligations in a contract, presuming no contingent amounts ncluded in transaction price
Sections 451(b) and (c)(4)(D) require taxpayers with contracts that contain multiple performance obligations to allocate the transaction price, and, therefore, defer or accelerate income inclusion, consistent with the taxpayer’s treatment for financial accounting purposes. Generally, the proposed regulations for advance payments, proposed Treas. Reg. §1.451-8, define the terms “performance obligation” and transaction price” by cross-referencing their definitions in the proposed regulations under section 451(b), proposed Treas. Reg. §1.451-3. Specifically, proposed Treas. Reg. §1.451-3(c)(6) defines the term transaction price to mean the gross amount of consideration to which a taxpayer expects to be entitled for AFS purposes in exchange for transferring promised goods, services, or other property; the term does not include certain items, such as amounts collected on behalf of third parties, increases for consideration to which a taxpayer’s entitlement is contingent on the occurrence or nonoccurrence of a future event, and reductions for amounts subject to section 461.
Proposed Treas. Reg. §1.451-3(c)(6)(ii) presumes that an amount included in the transaction price for financial accounting purposes is not contingent unless, upon examination of all the facts and circumstances, it can be established to the satisfaction of the Service that the amount is contingent on the occurrence or nonoccurrence of a future event. Thus, while the Service acknowledges that within a transaction price, certain amounts very well may be contingent on a future event, the proposed regulations presume all amounts of the price are not contingent unless determined otherwise. It will be interesting moving forward to see how this presumption impacts taxpayers’ allocation of transaction price amongst the performance obligations of a contract, and how, from a practical perspective, this presumption is rebutted when it would appear contingent future income is more common than the Service may have anticipated.
| Eversheds Sutherland observation: The statutory changes reflect a general effort by the Service and Treasury to conform the income recognition rules for tax purposes with the revenue recognition rules under ASC 606. While the allocation of transaction price among performance obligations in a contract mimics the treatment called for in the new revenue recognition standards, concerning future contingent income, the Service’s decision to presume amounts included in the transaction price are not contingent imposes a challenge on taxpayers that possess such income. Taxpayers with such income should fully evaluate how this presumption could impact income recognition for tax purposes, and ensure the inclusion of any future contingent income is fully substantiated to rebut the presumption created with the proposed regulations. |
- Proposed regulations indicate that adoption or changing to deferral provided under Section 451(c) is a change in method of accounting
Consistent with the statutory language in section 451(c)(2)(B) which provides that the deferral method is treated as a method of accounting, the preamble to the proposed regulations explicitly states that “the use of the AFS or non-AFS deferral method is the adoption of, or a change in, a method of accounting under section 446.” Accordingly, taxpayers seeking to use the AFS deferral method must obtain the consent of the Commissioner.
| Eversheds Sutherland observation: Commentators were uncertain as to whether following the deferral method provided under section 451(c) would require a change in method of accounting. Fortunately, the preamble to the proposed regulations explicitly indicates that the use or adoption of the AFS (or non-AFS) deferral method under the proposed regulations is a change in method of accounting, which requires the consent of the Commissioner. As discussed in the ES alert on Rev. Proc. 2019-37, the Service nearly concurrently released guidance providing an automatic method for taxpayers seeking to comply with the new proposed regulations under section 451(c). Please see that alert for additional analysis of the method changes available. |
If you have any questions about this legal alert, please feel free to contact any of the attorneys listed under 'Related People/Contributors' or the Eversheds Sutherland attorney with whom you regularly work.
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1 REG-1045540-18 (09/05/2019).
2 Treas. Reg. § 1.451-1(a).
3 Schlude v. Comm’r, 372 US 128 (1963), American Auto. Ass’n v. Comm’r, 367 US 687 (1961), Automobile Club of Mich. v. Comm’r, 353 US 180 (1957).
4 See, e.g., Artnell v. Commissioner, 400 F.2d 981 (7th Cir. 1968) (finding that income attributable to season ticket sales and associated fees could be deferred until games were actually played).
5 See, e.g., Rev. Proc. 71-21, 1971-2 C.B. 549 (1971).
6 Treas. Reg. § 1.451-5 (advance payments for the sale of goods and long-term contracts; Rev. Proc. 2004-34, 2004-22 I.R.B, 991. Rev. Proc. 2004-34 was a modification and expansion of the deferral provisions originating in Rev. Proc. 71-21, 1971-2 C.B. 549.
7 See FASB Update No. 2015-14; FASB Update No. 2016-8, “Revenue from Contracts with Customers” (Topic 606).
8 The Notice stated that the Service and Treasury intended to issue guidance under section 451(c), but until that guidance was published, taxpayers could continue to rely on Rev. Proc. 2004-34 with respect to the treatment of advance payments. The Notice stated that during this period before guidance is issued, the Service would not challenge a taxpayer’s use of Rev. Proc. 2004-34 to satisfy the requirements of section 451, although the Service would continue to require taxpayers, on examination, to verify that they were properly applying Rev. Proc. 2004-34.
9 T.D. 9870 (07/15/2019).
10 H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.).
11 See section 451(c)(4)(C), which refers to an “item of gross income” in the definition of “receipt,” with an “item of gross income” for tax purposes being defined, under Treas. Reg. §1.61-3(a) as the sale of revenue minus the cost of goods sold.
12 Because a cost offset is not a deduction, rather a determination of the proper amount of gross income to be recognized, economic performance should not prevent a cost offset under section 451(c), as it didn’t under the repealed Treas. Reg. §1.451-5(c).
13 See T.D. 9870 (07/15/2019).
14 Treas. Reg. §1.451-5(c) allowed a cost offset when advance payments were likely to be included in income for tax purposes prior to when the goods were sold; furthermore, allowing a cost offset to take into account both the actual and estimated cost of goods sold.
15 See Consolidated-Hammer Dry Plate & Film Company v. Commissioner, 317 F.2d 829 (7th Cir. 1963), in which the court held that advance payments from the sale of goods were proceeds of a loan and not income; Hagen Advertising Displays, Inc. v. Commissioner, 407 F.2d 1105 (6th Cir. 1969), in which the court held that advance payments for sale of goods were taxable as income, but that taxpayer should be permitted to offset the income with cost of goods sold related to such advance payments.
16 Proposed Treas. Reg. §1.451-8(b)(1)(i)(C), supra note 10.
17 Proposed Treas. Reg. §1.451-8(b)(1)(ii), supra note 10.
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