At last week’s ABA May Tax Meeting, government attorneys from both the Internal Revenue Service National Office Income Tax & Accounting division (IT&A) and the Department of the Treasury provided updates to taxpayers and practitioners on the status of guidance projects, and offered clarification regarding certain recent legislative proposals. IT&A leadership acknowledged that while during the onboarding of a new administration the guidance process tends to slow, the Biden Administration came in quickly with experienced leadership, ready to work and “firing on all cylinders.” This alert walks through several of the tax accounting and federal updates the government attorneys provided, insight with respect to future pieces of guidance and legislative proposals, and what taxpayers should anticipate in coming months.
Overview of recent guidance published and current projects
Since 2018, the government has been busy analyzing and developing guidance for various tax provisions from the Tax Cuts and Jobs Act (TCJA). According to the latest IRS Priority Guidance Plan (PGP), TCJA guidance spanned 58 regulation packages, 42 revenue procedures, 59 Notices, and a number of other pieces of guidance, whether in the form of FAQs, new forms, or publications. Government panelists indicated there has been “no rest for the weary,” as historically the IT&A division may have averaged 3-4 significant pieces of published guidance annually, but since last October, they have published that same amount of guidance on a monthly basis.
Taxpayers and practitioners certainly appreciate the significant effort required to release so much guidance, but supplemental guidance would be appreciated. IT&A leadership confirmed that the division is working on procedural guidance to assist taxpayers in the implementation of the new Code Sections 451(b) and (c). In addition to this revenue recognition guidance, the government also confirmed guidance is currently being developed with respect to opportunity zones and certain small business taxpayer provisions. It was also helpful to be reminded that in many instances requisite forms, publications and instructions take more time to develop than certain published guidance, and with so many new provisions added by the TCJA, there has been no shortage of such documentation as well.
It is important to note, while the aforementioned guidance projects are currently being addressed with release dates in the near future, government representatives did not hesitate to remind attendees of the 800-pound gorilla in the room, the proposed legislation packages which, if enacted, would require the government’s immediate attention—likely delaying pending publication projects. It will be interesting to see the government progress this summer as such proposals move toward enactment.
Clarification of the New Section 162(f) Establishment Requirement
The TCJA amended Section 162(f) to limit a taxpayers’ ability to deduct fines and settlements paid at the behest of or to a government entity. However, the amendments do include an exception for amounts paid as restitution or remediation or to come into compliance with the law. The exception has two requirements: (1) the payments must be identified as restitution, remediation, or paid for coming into compliance with any law that was violated (the Identification Requirement);1 and, (2) taxpayers must establish that purpose for the payments (the Establishment Requirement).2 Although final regulations were released in January and resolved many issues with the amended statute,3 there are nonetheless a number of unanswered questions regarding the implementation of Section 162(f) and the new Section 6050X, which warrant additional guidance. Unfortunately, government representatives indicated they are not currently working on any guidance with respect to these sections. The government did indicate they would welcome and entertain any private letter ruling request, including, for example, expanding the non-exhaustive list in the regulations of the types of documentation that can be used by a taxpayer to satisfy the Establishment Requirement.
While not currently working on any guidance under Section 162(f), government representatives did clarify language in the final regulations with respect to the new Establishment Requirement. The final regulations provide, that “the establishment requirement is met if the taxpayer, using documentary evidence, proves the taxpayer's legal obligation, pursuant to the order or agreement, to pay the amount identified as restitution, remediation, or to come into compliance with a law; the amount paid or incurred; the date the amount was paid or incurred; and that, based on the origin of the liability and the nature and purpose of the amount paid or incurred, the amount the taxpayer paid or incurred was for restitution or remediation, or to come into compliance with any law.”4 The regulation then specifies that “a taxpayer will not meet the establishment requirement if the taxpayer fails to prove that the taxpayer paid or incurred the amount identified as restitution, remediation, or to come into compliance with a law; the amount paid; the date the amount was paid or incurred; or that the amount the taxpayer paid or incurred was for the nature and purpose identified in the order or agreement.”5 Many practitioners and taxpayers merely viewed the subsequent sentence as clarifying the initially stated rule, but earlier this year, a government representative commented that the Establishment Requirement is actually a two-part rule. More specifically, under the first prong, the Establishment Requirement is satisfied if the taxpayer, using documentary evidence, proves the legal obligation, the amount, and the date paid or accrued, and proves that the nature and purpose of the payment was for restitution, remediation, or coming into compliance with the law. Under the second prong — phrased in the negative — though, the Establishment Requirement is not satisfied if the taxpayer fails to provide those elements. At the May ABA meeting, it was clarified that a settlement agreement could satisfy the first part of the Establishment Requirement, but fail the second part by calling for a compensatory payment when the statute underlying the government’s claim doesn’t allow for that remedy. It is important to note, while there are two parts to the Establishment Requirement and that both must be satisfied, there are likely only rare situations in which a taxpayer will satisfy the positive requirement without also satisfying the negative requirement.
Additional cryptocurrency guidance on the horizon
With the cryptocurrency market surging, the diversification of the market expanding, and even Commissioner Rettig highlighting the role of cryptocurrency reporting in the approximate $1 trillion tax gap, it was relieving to hear that, unlike hopeful guidance under Section 162(f), the government is actually currently working on cryptocurrency guidance. Although reticent to describe specifically what type of guidance nor the specific subject, the government did indicate that guidance was actively being reviewed. An outstanding project on the PGP calls for guidance under Section 6045 with respect to information reporting of virtual currency, but it would certainly be helpful for the government to release more comprehensive guidance that addresses the multitude of transactions that cryptocurrencies implicate, as well as guidance for issuers of such currency. After taxpayers and practitioners were forced to sit with the initial Notice 2014-216 for nearly five years before receiving Rev. Rul. 2019-24,7 addressing the treatment of cryptocurrency received subsequent to hard forks, the government has already this year released a clarifying ILM that specifically addresses the receipt of Bitcoin Cash by holders of Bitcoin subsequent the 2017 Bitcoin hard fork.8 As the government reiterated though, such guidance may not be relied on as precedent by other taxpayers; thus, reinforcing the need for more substantive cryptocurrency guidance to be released, and quickly, by the government.
A Primer on Section 165(i) and its application to losses suffered attributable to the COVID-19 pandemic
With few items more relevant than the application of Section 165(i) to losses attributable to the COVID-19 pandemic, practitioners and government attorneys provided an overview of the technical requirements of Sections 165(a), 165(i), and analytical approaches to resolve certain Section 165(i) issues. In order to qualify for Section 165(i) treatment, which affords taxpayers the ability to treat disaster losses as occurring, and therefore deductible, in the tax year immediately prior to the disaster year, a loss must first qualify under Section 165(a), which allows a deduction for any loss sustained during the tax year that is not compensated for by insurance or otherwise. To the extent a loss qualifies under Section 165(a) and occurred in the United States, since the COVID-19 pandemic is a federal declared disaster and the entire United States is thus a federally-declared disaster areas, the key hiccup in application of Section 165(i) is demonstrating a loss is “attributable to” COVID-19. The government acknowledged that the term “attributable-to” is not generally defined in the Code for regulations, but nonetheless critical for establishing entitlement to the loss. There was an indication that the government is considering guidance under Section 165(i) although they did not offer specifics about the content or timing of guidance. The one question raised by the government was how such losses could be substantiated. Thus, to the extent that such a loss is claimed, a taxpayer must carefully craft both support for and substantiation of, a loss under Section 165(i).
Requests for additional implementation guidance as well as procedural guidance under Section 451
Under the TCJA, Section 451(b) was added to the Code generally modifying the historic All Events Test for income recognition providing that income must be recognized no later than when such amounts are taken into account for financial accounting purposes. While final regulations were released in December 2020, which addressed a number of issues under the standard for income recognition,9 many taxpayers continue to struggle with the challenge of implementing the new rules.
There was a review of the AFS Income Inclusion Rule that begins with financial accounting determinations and then makes a series of adjustments to determine the amounts of income required to be recognized for tax purposes.10 The Enforceable Rights Standard, which requires a hypothetical evaluation of amounts that would be due if a customer were to terminate a contract at year-end is an important element of the AFS Income Inclusion Rule.11 Although taxpayers can always recognize income in full, the Enforceable Right Standard may affect income recognition for cash and volume discounts, preferred customer discounts, refunds that are pending, and license revenue. The discussion at the ABA meeting highlighted the complications of these rules, making clear that taxpayers have to consider federal, state, and local law for purposes of determining revenue recognition.
In discussing the impact of the new Enforceable Right standard in the context of leases and licenses, the government indicated the standard was intended to resolve uncertainties with respect to certain situations involving variable consideration, but practitioners identified a number of issues that remain outstanding. Ranging from the consideration of liquidated damages provisions to certain leases with defined periods of time where the lease cannot be canceled, government representatives reiterated that any analysis under Section 451(b) begins with financial reporting income recognition. In fact, the government indicated that enforceable rights shouldn’t be viewed as different or distinct from the AFS Income Inclusion Rule, rather intended to illustrate the consequences stemming from a hypothetical situation in which a lease terminated at the end of a specific year; in situations where an enforceable right, termination payment or liquidated damages exceed the amount of income that would be included under the AFS Income Inclusion Rule, the AFS Income Inclusion Rule serves as a ceiling to the amount of income required to be recognized under Section 451. Additionally, the government resolved a lingering question regarding why different treatment was provided for significant financing components, which the final regulations provide an exception to the AFS Income Inclusion Rule. Government representatives indicated the exception was provided to address situations where book grosses up a contract price above what would otherwise be includable int taxable income; the rule, rather, requires inclusion of an amount only which the lessor is entitled.
Additionally, the AFS Income Inclusion Rule allows a limited offset method for the cost of goods in process. While the final regulations provide this limited cost offset accounting method for items of unsold inventory produced during the year “cost of goods progress offset.”12 Unfortunately, however, the method requires that the cost of offset muse be applied separately for each item of inventory, that is—it must be determined on an item-by-item basis, rather than relying on a more administrable contract-by-contract basis.13
The government acknowledged that a less detailed approach was not offered due to concerns that taxpayers should not be allowed to use an approach different from its existing inventory methods (e.g., its identification method (FIFO/LIFO) and its valuation method (cost, market, lower of cost or market.) With the final regulations, the government sought to allow taxpayers to reduce income recognition requirements, and thus, allowed a cost offset, applying an approach that was thought to apply the taxpayer’s actual methodologies. The government acknowledged the complications of requiring allocations to the item level but had no immediate resolution for simplifying this complicated approach. A more simplified approach was thought to provide less precise results for taxpayers. In response, practitioners offered a solution that has been widely recommend since the release of the final regulations, to provide taxpayers with a safe harbor to use their book percentage of completion method (PCM) for tax purposes. A book percentage of completion safe harbor would allow estimated revenue with a cost offset based on the percentage of contract completion. As such, determinations occur in aggregate rather than at the item level. Interestingly, an example was discussed that demonstrated both the cost offset method and book PCM reached the same result, despite the former requiring an additional 14 different steps to reach the final result. Although sympathetic that taxpayers find the final Section 451(b) regulations challenging to apply, the government reiterated that the cost offset method is optional and that taxpayers don’t have to adopt such a method, full income recognition is always available. It will be interesting to see which of these, if any, taxpayer recommendations are incorporated into the pending procedural guidance the government indicated would be released in the near future.
There was also discussion of advance payment issues implicated by the new Section 451(c). As a result of cancellations and delays arising as a result of the COVID-19 pandemic, there was a question about whether additional deferrals might be made available under the CARES Act. The government indicated that the CARES Act authority likely did not extend to items controlled by the statute and they are not inclined to allow an extension of income deferral under Section 451(c). There was a question about whether certain relevant judicial exceptions continue to apply subsequent to Section 451(c), but the government representatives indicated here was no change to the government’s views on such authorities as stated in the AOD for such cases.
Finally, the government addressed the status of procedural guidance that is effective for tax years beginning on or after January 1, 2021. The guidance is expected to address when and whether accounting method changes are necessary as the rules are implemented. It is expected that there will be a waiver of scope restrictions fand audit protection will be made available.
Planning for changes to research and experimental expenditures under Section 174
The government suggested that guidance is being considered to address expected changes to Section 174(a) for tax years beginning after 12/31/21. As a reminder, the TCJA amended Section 174 eliminating immediate expensing of Section 174 expenses, requiring R&E expenditures to be capitalized and amortized ratably over 5 years for R&E conducted in the US (15 years, if outside the US), and deeming software development costs to be Section 174 expenses (rather than treated differently under Rev. Proc. 2000-50). The government is considering changes to the Section 174 regulations, whether to eliminate the election under Section 59(e) that allows 10-year amortization for research and experimental costs, as well as changes to Rev. Proc. 2000-50, which allows an immediate deduction for software development costs. Thus, the government is evaluating how such costs would be defined. Since Rev. Proc. 69-21 was issued,14 the IRS has taken the position that software development costs so closely resemble research and experimental expenditures as to warrant deduction treatment.
In addition to the substantive questions that will be addressed, the government is also evaluating procedural guidance required as a result of the statutory changes under TCJA. The statute provides that this change is an automatic change initiated by the taxpayer with no Section 481(a) adjustment. The government is considering whether a Form 3115 is required and whether an optional Section 481(a) adjustment may be available.
Because Congress is currently considering whether to continue the immediate deduction for research and experimental expenditure, this substantive and procedural guidance may ultimately be unnecessary. It will be very interesting to see how this situation unfolds.
Real-time review of new CFC accounting method change guidance dropped mid-meeting
To no one’s surprise, the government also released Rev. Proc. 2021-26 in the middle of the meeting last week, providing guidance with respect to accounting method changes made on behalf of CFCs.15 Specifically, the guidance temporarily expands the availability of automatic consent for a CFC to change its method of accounting for depreciation to the alternative depreciation system (ADS) under Section 168(g) in order to ease the burden on a CFC to conform its income and E&P computation with its qualified business asset investment (QBAI) computation. Rev. Proc. 2021-26 also provides the terms and conditions for such accounting method changes to ensure that Section 481(a) adjustments are properly included in computations of tested income and tested loss, and clarifying certain aspects of the 150% rule that limits audit protection for CFCs. The government indicated the intent of the guidance was to, in the spirit of the preamble to the final GILTI regulations,16 provide for certain depreciation changes that weren’t available automatically to be automatic, while concurrently updating certain procedural rules applicable to CFCs in Rev. Proc. 2015-1317 to the extent possible. Helpfully, the government clarified that duplicate copies of Forms 3115 filed on behalf of CFCs for certain depreciation method changes filed under Section 6.01 of Rev. Proc. 2019-4318 are unaffected by the guidance, but on a going forward basis, all depreciation changes filed on behalf of CFCs should be filed under Rev. Proc. 2021-26, and the new Section 6.22 of Rev. Proc. 2019-43. Although the former provides a less administratively burdensome rule by allowing the aggregation of adjustments, the government did not extend the same aggregation option to this CFC change indicating that a CFC is already required to calculate any Section 481(a) adjustment on an asset-by-asset basis, and, thus, the government concluded that this approach would not impose an additional burden beyond Form 3115 disclosures. Lastly, while clarifying the application of the 150% rule, the government indicated they did not further address certain audit protection or Exam rules as these issues remain under consideration.
1 I.R.C. §162(f)(2)(A)(ii).
2 I.R.C. §162(f)(2)(A)(i).
4 Treas. Reg. §1.162-21(b)(3)(i).
6 2014-16 I.R.B. 938 (03/25/14).
7 2019-44 I.R.B. 1004 (10/09/19).
8 ILM 202114020 (04/09/21).
10 Treas. Reg. §1.451-3(b)(1).
11 Treas. Reg. §1.451-3(b)(2)(i)(B).
12 Treas. Reg. §1.451-3(c)(2).
13 Treas. Reg. §1.451-3(c)(4).
14 1969-2 C.B. 303, amplified by Rev. Proc. 97-50, 1997-2 C>B. 525, and superseded by Rev. Proc. 2000-50, 2000-2 C.B. 601.
15 2021-22 I.R.B. (05/11/21).
17 2015-5 I.R.B. 419 (01/16/15).
18 2019-48 I.R.B. 1107 (11/08/19).