IRS releases safe harbor procedures for economic performance on ratable service contracts

Tax Hot Topics: Economic performance on ratable service contractsThe IRS recently released Rev. Proc. 2015-39, which provides a safe harbor under which a taxpayer using an accrual method of accounting may treat economic performance as occurring on a ratable basis for service contracts that are within the scope of the revenue procedure.

A service contract is within the scope of the revenue procedure if (1) the contract provides for similar services to be supplied on a regular basis, such as daily, weekly or monthly; (2) each occurrence of the service provides independent value, such that the benefits of receiving each occurrence of the service is not dependent on the receipt of any previous or subsequent occurrence of the service; and (3) the term of the contract does not exceed 12 months. (Contract renewals are not included.)

If a contract meets all these requirements, it is considered a ratable service contract for which economic performance occurs ratably over the contract. For contracts that include services that meet these requirements and services that do not, the services must be separately priced for taxpayers to apply the safe harbor to the services that meet the requirements.

This safe harbor allows taxpayers to apply the 3 ½ month rule or the recurring item exception to ratable service contracts for the portion of the contracts for which economic performance occurs during the required time period, even though the entire contract may extend beyond the required time period for either of these exceptions. The 3 ½ month rule, in Treas. Reg. Sec. 1.461-4(d)(6)(iii), allows a taxpayer to treat economic performance as occurring for service liabilities as the taxpayer makes payment to the person providing the service if the taxpayer can reasonably expect the person to provide service within 3 ½ months of the payment date.   

Prior to the issuance of this revenue procedure., the Tax Court, in Caltex Oil Venture v. Commissioner, 138 T.C. 18 (2012), construed the 3 ½ month rule to mean that all services under a contract must be provided in order for the 3 ½ month rule to apply. Thus, it was unclear whether the IRS would take the position that this exception could be used in relation to contracts that extended beyond 3 ½ months because not all the services under the contract had been provided. The revenue procedure provides several examples illustrating that for ratable service contracts meeting the requirements described above, the 3 ½ month rule is applicable to the 3 ½ month portion of such contracts.   

Similarly, the recurring item exception, as defined in Treas. Reg. Sec. 1.461-5, could be applied to the shorter of 8 ½ months of the contract or the amount of the services provided by the time the return is filed, provided that all other requirements of the recurring item exception are met. However, taxpayers that want to apply the recurring item exception should be aware that this safe harbor for ratable service contracts does not overturn the IRS position in Rev. Rul. 2012-1 regarding the interpretation of “not material” and “better matching” under the recurring item exception. Under Treas. Reg. §1.461-5(b), the recurring item exception applies only if the amount of the liability is not material or the accrual of the liability for the earlier tax year results in a better matching of the liability with the income to which it relates. In Rev. Rul. 2012-1, the IRS states that because the contracts at issue in the ruling (a contract that likely would be a ratable service contract) accrued the liability over more than one year for financial statement purposes under GAAP, the contracts did not meet either the “not material” or the “better matching” requirements, and thus were not allowed to use the recurring item exception.   

Taxpayers wishing to change their method to conform to the new safe harbor may do so under the automatic method change procedures. The eligibility requirement in Rev. Proc. 2015-13, limiting the ability of taxpayers to file an automatic method change for the same item within five years, is waived for the taxpayer’s first, second or third taxable year ending on or after July 30, 2015.

While the safe harbor is currently limited to contracts described above, the IRS has requested comments regarding when economic performance occurs for liabilities arising from service contracts that have deliverable-type services that are not completed on a periodic basis, that have multiple services not separately priced or for ratable service contracts with a term of longer than one year.

Sharon Kay
+1 202 861 4140

Ellen Martin
+1 202 521 1558

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.