Final regulations help taxpayers compute revenue

The final revenue recognition regulations (TD 9941) under Section 451 both provide guidance to accrual-method taxpayers required to accelerate income under the new rules and also give taxpayers opportunities to defer the recognition of revenue under a variety of circumstances. The regulations are required to be implemented for the first tax year beginning on or after Jan. 1, 2021, but taxpayers may implement these regulations early and avail themselves of their benefits early. The IRS recently released procedures for changing methods of accounting to comply with the final rules, and they must be applied for all Forms 3115 filed on or after Aug. 12, 2021.

The Tax Cuts and Jobs Act (TCJA), in conjunction with the recent adoption of ASC 606, Revenue from Contracts with Customers, often changes the timing of income inclusion for accrual method taxpayers with applicable financial statements (AFS).¹ Practitioners, through numerous comment letters and informal discussions, requested relief from some of the scenarios in the proposed regulations that result in accelerated taxable income. The final regulations provide some of the requested relief, along with increased clarity around the revenue required to be accelerated for tax purposes, sought by taxpayers.

Two of the most significant opportunities contained in the final regulations relate to contractual enforceable right provisions and optional cost offsets. Under the enforceable right rules, taxpayers may exclude from income amounts to which the taxpayer does not have an enforceable right to recover if the taxpayer’s customer terminates the contract to which the income relates on the last day of the taxable year. Additionally, pursuant to the cost offset method, taxpayers may reduce income attributable to the future sale of inventory that is otherwise required to be accelerated under the AFS income inclusion rule discussed below.

Background

The adoption of ASC 606 can change the timing of revenue recognition for contracts with customers as the requirements for revenue recognition under ASC 606 are different from the recognition requirements under previous GAAP.

Under Section 451(a) and Treas. Reg. Sec. 1.451-1(a), gross income generally includes any amount received in a tax year, unless such amount is properly accounted for in a different period under the taxpayer’s method of accounting.

Prior to the TCJA’s enactment, accrual-method taxpayers recognized revenue in the taxable year in which (1) all the events have occurred that fix the right to receive income, and (2) the income could be determined with reasonable accuracy (the “all-events test”). Further, a fixed right to receive income under the all-events test was generally satisfied upon the earliest date when such income was earned, due, or received by the taxpayer.

The TCJA added a new Section 451(b) that requires taxpayers to follow the all-events test as long as they recognize income no later than when it is recognized in their AFS (the “income inclusion rule”). This new rule may accelerate income to a year earlier than it would have been recognized under the all-events test for many taxpayers with AFS.

The TCJA also created new Section 451(c), which codified and modified guidance (Rev. Proc. 2004-34) giving taxpayers the option to include advance payments in income in the year of receipt or defer a portion for eligible items to the subsequent year.

The final regulations under Section 451 are generally applicable to tax years beginning on or after Jan. 1, 2021, however, taxpayers may choose to apply the final regulations to a tax year beginning after Dec. 31, 2017, provided they are applied in their entirety and in a consistent manner to such tax year and all subsequent taxable years. However, taxpayers are generally not allowed to include a method change on an amended return. As discussed later, the current method change procedures do not provide taxpayers with the ability to apply the final regulations to any tax year that has already been filed, for example, by allowing method changes on amended returns.

While the TCJA effectively provides that a taxpayer’s satisfaction of the all-events test may be accelerated via the income inclusion rule, it should be noted that such rule does not apply to taxpayers without an AFS. Further, under statutory exceptions, the income inclusion rule does not apply to an item of gross income earned in connection with a mortgage servicing contract or any item of gross income subject to a special method of accounting (as discussed below).

Treas. Reg. Sec. 1.451-3

Treas. Reg. Sec. 1.451-3 provides guidance for taxpayers complying with the new provisions contained in Section 451(b). Although the regulation provides much in the way of direction, perhaps the most significant areas addressed relate to (i) required and optional adjustments to AFS revenue for purposes of applying the income inclusion rule and (ii) the allocation of the transaction price to revenue streams containing multiple performance obligations.

AFS revenue and related adjustments

Section 451(b) generally requires that the all-events test be considered satisfied no later than when an item of income is reflected as revenue in a taxpayer’s AFS. The statute applies the acceleration rule to each item of “gross income”; however, the regulations apply the acceleration rule to gross receipts and do not allow an acceleration of any related cost of goods sold. As such, understanding the revenue reflected in an AFS becomes extremely important for purposes of applying Section 451(b). The regulations go into a great deal of detail in defining an AFS and the related revenue adjustments that can or must be made for tax purposes.

AFS revenue

The final regulations define AFS and provide ordering rules that require a taxpayer to use the financial statement with the highest priority. Such financial statements include GAAP and IFRS statements included in a Form 10-K filed with the SEC or foreign equivalent, a GAAP or IFRS audited financial statement used for credit, reporting or non-tax purposes, or other statements (other than a tax return) filed with a federal, state, or foreign governmental agency.

AFS revenue includes all items of revenue, but not net of any related costs, reported in the taxpayer’s AFS. However, such revenue is not limited solely to amounts included in the income statement. Other revenue items may be captured elsewhere in the AFS (e.g., in retained earnings and other comprehensive income), and must be included in AFS revenue.

Enforceable right to recover

Section 61(a) provides a statutory definition of gross income that includes income realized in any form—whether money, property, or services. The regulations under Section 61 provide that taxpayers should look to Section 451 for the general rules as to when an item is included in gross income (i.e., the taxable year).

This statutory construction was acknowledged in footnote 872 to the Joint Explanatory Statement of the Committee of Conference, which provided that new Section 451(b) “does not revise the rules associated with when an item is realized for Federal income tax purposes and, accordingly, does not require the recognition of income in situations where the Federal income tax realization event has not yet occurred.”² The Conference Report, which summarized current law, further emphasized the importance of first ascertaining whether a taxpayer was in receipt of an item of gross income before turning to Section 451 to determine the timing of when that item is included in gross income. Thus, Section 451(b) is inapplicable in situations where realization has not occurred.

Treasury declined to provide a definition for the term “realization” in the final regulations, but instead offered that the concept of realization is a factual determination that has different meanings in different contexts. The preamble did indicate, however, that the government believes “it is reasonable to conclude that Congress intended a different concept of realization that would give full effect to the statute.” Therefore, taxpayers should be mindful of their particular facts and circumstances to determine if a realization event has occurred prior to the application of Section 451(b).

Although Treasury did not define “realization,” the final regulations did offer the concept of an “enforceable right,” which may be viewed as a subset of “realization.” The final regulations provide that in determining when an item of gross income is “taken into account as AFS revenue,” AFS revenue is reduced by amounts that the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable year. The determination of whether the taxpayer has an enforceable right is governed by the contract and applicable federal, state or international law.

The application of the enforceable right provision is highly factual in nature. As such, taxpayers should possess a thorough understanding of the facts surrounding a transaction as well as how federal, state, or international law is applied to the contractual terms of that transaction. Accordingly, an enforceable right analysis can prove burdensome and time-consuming for taxpayers.

In light of the potential complexities involved in performing an enforceable right analysis, Treasury provided taxpayers with the ability to simplify the analysis by way of the “Alternative AFS Revenue Method.” Under the Alternative AFS Revenue Method, a taxpayer does not reduce AFS revenue by amounts that the taxpayer lacks an enforceable right to recover. Rather, the taxpayer generally reports income in an amount equal to that reported on the AFS. The result is a potential acceleration of revenue recognition in exchange for a reduction in contract analysis.

The Alternative AFS Revenue Method is a method of accounting and must be applied to all items of gross income in the trade or business that are subject to the AFS Income Inclusion Rule. Both the general rule and the alternative rule are methods of accounting that must be applied consistently and cannot be changed without consent of the Commissioner.

Additional adjustments to AFS income

The final regulations provide the following mandatory adjustments to AFS revenue to determine when an item of gross income is “taken into account as AFS revenue” for purposes of the AFS Income Inclusion Rule and Alternative AFS Revenue Method:

AFS revenue must be increased by any book reductions attributable to cost of goods sold (COGS) and liabilities required to be accounted for under other provisions such as Section 461—including rebates, refunds, chargebacks, allowances, and rewards.

AFS revenue must be increased for any reduction for amounts anticipated to be in dispute or uncollectable (but see Rev. Rul. 2003-10).

AFS revenue must be decreased by amounts attributable to book increases in the transaction price resulting from a significant financing component.

Cost offset to AFS revenue

Under ASC 606, when certain criteria for revenue recognition are met, revenue for the production of goods is recognized over time instead of at a point in time. When those criteria are met, an entity will recognize revenue and the related production costs over time as the entity produces the goods, which results in revenue (and costs) being recognized earlier than under previous GAAP. Under the prior financial statement guidance revenue and the related production costs for the goods would not be recognized until the goods had been delivered to the customer.

Pursuant to the AFS income inclusion rule, tax recognition of this production income is accelerated such that tax revenue recognition will match book revenue recognition. However, the related COGS may not be accelerated for tax purposes under the principles contained in Sections 446, 461, 471, and 263A. As a result, there can be a mismatch of revenue and COGS for tax purposes. In response to taxpayer concerns over this potential mismatch, Treasury provided the cost offset method in the final regulations.

The final regulations do not provide an accelerated deduction under the provisions of Sections 461, 471, and 263A when goods are produced over a period of time and an amount is accelerated into income under the AFS Income Inclusion Rule. Instead, the final regulations allow a taxpayer to reduce a portion of the revenue it would otherwise be required to include under the AFS Income Inclusion Rule by a new safe harbor referred to as the “cost of goods in progress offset.” The safe harbor option only applies to sale of items of inventory and does not include costs associated with other revenue streams (e.g., accelerated deductions related to rewards programs). This optional safe harbor reduction is referred to in the final regulations as an “AFS cost-offset method” and is discussed in further detail below.

The AFS cost offset method does not modify the rules for determining when costs are allocated to and included in inventory under Sections 461, 471, and 263A. Therefore, the AFS cost-offset method applies only to reduce the amount of income included under the AFS income inclusion rule. Costs allocated to inventory will continue to be recovered through COGS in the year they are treated as sold in accordance with the taxpayer’s inventory cost flow assumption.

Under the AFS cost-offset method, a taxpayer may reduce gross income includible for a year prior to the year in which ownership of inventory transfers to the customer by reducing the amount of revenue it would otherwise be required to include under the AFS income inclusion rule by the “cost of goods in progress offset.”

The cost of goods in progress offset for each item of inventory in the taxable year is calculated as (1) the cost of goods incurred through the last day of the taxable year, (2) reduced by the cumulative cost of goods in progress offset amounts attributable to the item of inventory that were taken into account in prior taxable years, if any. The cost of goods in progress amount is determined for each item of inventory by applying the taxpayer’s methods of accounting used for federal income tax purposes, including Sections 263A and 471. However, the cost of goods in progress offset cannot reduce the AFS inventory inclusion amount for the item of inventory below zero.

A taxpayer that defers revenue prior to the sale under the AFS cost-offset method will generally include that revenue in the tax year in which ownership of the item of inventory is transferred to the customer.

Exclusions from the AFS Inclusion Rule

Pursuant to Teas. Reg. Sec. 1.451-3(b)(3), the following items are excluded from application of the AFS income inclusion rule:

• Items of gross income utilizing a special method of accounting to determine timing
• Items of gross income incurred in connection with a mortgage servicing contract
  
• Any taxable year that is not covered entirely by one or more AFS
  

A special method of accounting under Treas. Reg. Sec. 1.451-3 is defined as a method of accounting either expressly permitted or required under the Code, regulations, or other published guidance that includes items of gross income in a taxable year not determined by the all-events test. Some examples of special methods of accounting include installment sales under Section 453, long-term contracts under Section 460, short-term obligations under Sections 1281 through 1283, and the mark-to-market method under Section 475.

Allocation of transaction price

A performance obligation is defined by the final regulations as a promise in a contract with a customer to transfer to the customer a distinct good, service, or right (or combination thereof). The regulations further provide that separate performance obligations are identified by applying the accounting standards the taxpayer uses to prepare its AFS.

As an example, consider a contract for the sale of a widget. Under the terms of the contract the purchaser receives a widget, a warranty, and technical support. It is possible that the widget, the warranty, and the technical support may all be considered separate performance obligations within the contract (i.e., a single contract with multiple performance obligations).

Treas. Reg. Secs. 1.451-3(d) and 1.451-8(c)(8) create a conformity requirement with respect to contracts containing multiple performance obligations. Under this rule, if the taxpayer must allocate a contract’s transaction price among multiple performance obligations for financial statement purposes, the taxpayer must also make the same allocation among the same performance obligations for tax purposes.

Mandating the same allocations of transaction price to performance obligations for tax purposes promotes accuracy in matching the book inclusions for specific items of revenue with the corresponding gross income required to be analyzed for tax. However, it should be noted that this matching does not require a recharacterization of a transaction for tax purposes (e.g., a tax sale will not be treated as a lease solely due to financial statement treatment of the transaction as a lease).

The final regulations also clarify that each separate performance obligation for financial reporting purposes yields an item of gross income for tax purposes that must be accounted for separately under the AFS Income Inclusion Rule. However, there may be single performance obligations for financial reporting purposes that yield multiple items of gross income for tax purposes.

The final regulations provide that if a contract with a customer includes items of gross income subject to a special method of accounting (e.g., long term contracts under Section 460) and other items of gross income, the transaction price is first allocated to items of gross income subject to a special method of accounting, with the residual amount allocated to the other items of gross income. Prior to such allocation, AFS adjustments (as detailed in the “Additional adjustments to AFS income” sub-section above) must be evaluated and implemented.

Advance payments

Prior to the release of Treas. Reg. Sec. 1.451-8, Rev. Proc. 2004-34 provided guidance for accrual taxpayers that received certain advance payments for the provision of goods, services, or other specified items. This revenue procedure provided accrual method taxpayers with the option to either include advance payments in income in the year of receipt (the “full inclusion method”) or to defer a portion of the advance payments to the subsequent year for eligible items (the “deferral method”).

The TCJA provided taxpayers with Section 451(c), which is essentially a codified and modified version of Rev. Proc. 2004-34. Pursuant to Section 451(c)(4), an advance payment is defined as a payment that (i) may permissibly be included in income on the year of receipt, (ii) a portion of the payment is included in AFS revenue in a year subsequent to the year of receipt, and (iii) the payment is for goods, services or other specified items. Such advance payments may be accounted for either under the full inclusion method or the deferral method.

Notice 2018-35 allowed taxpayers to continue to rely on Rev. Proc. 2004-34 until further guidance was issued. As such, taxpayers had the ability to defer recognition of advance payments under both Section 451(c) and Rev. Proc. 2004-34. The final regulations obsolete Rev. Proc. 2004-34 and Notice 2018-35 for tax years beginning on or after Jan. 1, 2021.

Treas. Reg. Sec. 1.451-5, prior to its revocation, previously allowed accrual method taxpayers to defer the inclusion of income for advance payments for goods for periods in excess of those permitted under Rev. Proc. 2004-34. However, Treas. Reg. Sec. 1.451-5 was not included in the final regulations and those deferral provisions are, accordingly, no longer applicable.³

Treas. Reg. Sec. 1.451-8

Treas. Reg. Sec. 1.451-8 codifies and modifies Rev. Proc. 2004-34 such that certain advance payments are eligible for the deferral method of accounting. To qualify as an advance payment, the payment must be eligible to be included in income in the year of receipt and all or a portion of the payment must be reflected in the taxpayer’s AFS in a year subsequent to the year of receipt. The regulation broadens the list provided in the statute to include payments for items such as goods, services, the use of intellectual property, computer software, eligible gift cards, certain warranty contracts, subscriptions, memberships and the occupancy or use of property ancillary to the provision of services.

Similar to Treas. Reg. Sec. 1.451-3, the final regulations state that if a taxpayer allocates a contract’s transaction price among multiple performance obligations for financial statement purposes, the taxpayer must also make the same allocation among the same performance obligations for tax purposes. Pursuant to this rule, each performance obligation, or item for tax purposes, may be eligible to use the deferral method of accounting as described in Treas. Reg. Sec. 1.451-8. Accordingly, taxpayers may need to perform additional analysis to determine the proper treatment of items for which an advance payment is received.

The deferral method is not limited to taxpayers with AFS. Similar to Rev. Proc. 2004-34, the final regulation provides a deferral method for taxpayers without AFS (the non-AFS deferral method). Taxpayers using the non-AFS deferral method include advance payments in revenue in the year of receipt, to the extent the payment is earned (which is different from the deferral method that requires inclusion to the extent included in a taxpayer’s AFS), and the remainder is included in the subsequent period. Without the regulations, taxpayers that don’t have AFS were at risk of not being allowed to use the deferral method for advance payments for tax years beginning on or after Jan. 1, 2021, because Rev. Proc. 2004-34 was obsoleted as of that date and Section 451(c) only allows taxpayers with AFS to use the deferral method.

Specified goods

The proposed regulations excluded specified goods from the definition of “advance payments.” The regulations provided that the definition of an advance payment generally does not include a payment received in a tax year which precedes the contractual delivery date for a specified good by two or more years. A “specified good” is defined as a good for which (i) the taxpayer does not have available, in the year the advance payment is received, goods of a substantially similar kind and in a sufficient quality to satisfy the contract and (ii) all the revenue from the sale of the good is recognized in AFS in the year of delivery. Thus, advance payments for specified goods were required to be analyzed under Treas. Reg. Sec. 1.451-3.

The final regulations generally retain the specified good exception contained in the proposed regulations, thereby requiring analysis under Treas. Reg. Section 1.451-3. However, under the final regulations, taxpayers have the option to treat an otherwise qualifying payment for a specified good as an advance payment and apply the deferral provisions of Treas. Reg. Sec. 1.451-8.