On Sept. 6, the IRS and the U.S. Department of the Treasury released the much-anticipated revenue recognition proposed regulations under IRC Sections 451(b) and 451(c), which were enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA). In addition to the proposed regulations, the IRS and Treasury issued Revenue Procedure 2019-37, which provides rules for an automatic method change to adopt the proposed regulations.
The proposed regulations define several terms relevant to the new revenue recognition rules under IRC Section 451(b). The term “revenue” is defined broadly as all transaction price amounts includable in gross income under Section 61 and includes revenue reported in other comprehensive income. The term “transaction price” is defined as the gross amount of consideration to which a taxpayer expects to be entitled, except that it does not include amounts collected on behalf of third parties, consideration contingent on the occurrence or nonoccurrence of a future event, or reductions for accrued expenses under Section 461 or costs of goods sold under Section 471. Determining whether revenue is contingent for tax purposes could create differences between tax reporting and financial reporting, but such differences must be supported in order to overcome the rebuttable presumption that tax reporting and financial reporting should be consistent.
The revenue recognition rules under IRC Section 451(b) do not apply in the case of a special method of accounting. Under the proposed regulations, a special method of accounting includes, but is not limited to, the crop method under Sections 61 and 162, a method provided under Sections 453 through 460, hedging transactions under regulation Section 1.446-4, rents accounted for under Section 467, items marked-to-market under Section 475, certain original issue discount transactions, and intercompany accounting under Sections 1502 and 1503.
The proposed regulations also provide that certain transactions retain their current treatment for federal income tax purposes even if that treatment is different for AFS purposes. The transactions affected include, but are not limited to, a lease or license treated as an operating arrangement for tax purposes but as a sale for AFS purposes or vice versa, transactions where items are marked-to-market for AFS purposes but no disposition has occurred for tax purposes, and nonrecognition transactions where no gain or loss is recognized for tax purposes.
The proposed regulations generally follow Revenue Procedure 2004-34, which describes which payments are considered to be advance payments and which are not. The list of services for which an advance payment may be made includes the sale of goods, the license of intellectual property, and the sale of computer software. Payments for rents, insurance, and financial instruments are not covered by the advance payment rules.
The proposed regulations also allow non-AFS taxpayers to use the deferral method. Additionally, the proposed regulations provide that advance payments are included in income when earned under the all-events test under regulation Section 1.451-1(a). Taxpayers may use statistical basis to determine when the advance payments are earned if adequate information is available or may treat the advance payments as if they are earned on a straight-line basis.
The proposed regulations include examples illustrating how the advance payment rules apply to loyalty and airline rewards programs. These rules use the performance obligations for financial statement purposes to determine the proper allocation of income to the respective reward program.
Regulation Sections 1.451-3 and 1.451-8 are proposed to be effective for tax years beginning after the regulations are published in the Federal Register, but taxpayers may rely on the rules in the proposed regulations for tax years beginning on or after Jan. 1, 2018, provided they apply the rules consistently to all income. As noted earlier, Revenue Procedure 2019-37 allows taxpayers to file Form 3115, “Application for Change in Accounting Method,” under the automatic method change rules in order to adopt the proposed regulations.
The new regulations likely will affect most accrual basis taxpayers that have an AFS or that defer income consistent with their financial reporting. Taxpayers should evaluate the impact that these proposed regulations might have on revenue recognition to assess if a method change would be beneficial or required.
Proposed regulation 1.451-3: Tax revenue recognition tied to book
The rules under Section 451(b) generally apply to accrual basis taxpayers that have an applicable financial statement (AFS) and that are required to recognize income no later than when that revenue is recognized in their AFS. As defined by the proposed regulations, an AFS is a financial statement that is certified as prepared in conformity with U.S. GAAP or International Financial Reporting Standards (generally an audited financial statement). Financial statements provided to federal or state regulatory agencies also are treated as AFSs under the proposed regulations.The proposed regulations define several terms relevant to the new revenue recognition rules under IRC Section 451(b). The term “revenue” is defined broadly as all transaction price amounts includable in gross income under Section 61 and includes revenue reported in other comprehensive income. The term “transaction price” is defined as the gross amount of consideration to which a taxpayer expects to be entitled, except that it does not include amounts collected on behalf of third parties, consideration contingent on the occurrence or nonoccurrence of a future event, or reductions for accrued expenses under Section 461 or costs of goods sold under Section 471. Determining whether revenue is contingent for tax purposes could create differences between tax reporting and financial reporting, but such differences must be supported in order to overcome the rebuttable presumption that tax reporting and financial reporting should be consistent.
The revenue recognition rules under IRC Section 451(b) do not apply in the case of a special method of accounting. Under the proposed regulations, a special method of accounting includes, but is not limited to, the crop method under Sections 61 and 162, a method provided under Sections 453 through 460, hedging transactions under regulation Section 1.446-4, rents accounted for under Section 467, items marked-to-market under Section 475, certain original issue discount transactions, and intercompany accounting under Sections 1502 and 1503.
The proposed regulations also provide that certain transactions retain their current treatment for federal income tax purposes even if that treatment is different for AFS purposes. The transactions affected include, but are not limited to, a lease or license treated as an operating arrangement for tax purposes but as a sale for AFS purposes or vice versa, transactions where items are marked-to-market for AFS purposes but no disposition has occurred for tax purposes, and nonrecognition transactions where no gain or loss is recognized for tax purposes.
Proposed regulations under Section 1.451-8: Timing of income in the case of advance payment
The rules under Section 451(c) generally apply to accrual basis taxpayers that receive advance payments and allow income recognition under either the full inclusion method or the deferral method. Generally, taxpayers that adopt the deferral method must include in income advance payments that are included in the AFS or determined to be earned by the taxpayer if they do not have an AFS. Under the deferral method, income can be deferred only until the tax year following the year of receipt.The proposed regulations generally follow Revenue Procedure 2004-34, which describes which payments are considered to be advance payments and which are not. The list of services for which an advance payment may be made includes the sale of goods, the license of intellectual property, and the sale of computer software. Payments for rents, insurance, and financial instruments are not covered by the advance payment rules.
The proposed regulations also allow non-AFS taxpayers to use the deferral method. Additionally, the proposed regulations provide that advance payments are included in income when earned under the all-events test under regulation Section 1.451-1(a). Taxpayers may use statistical basis to determine when the advance payments are earned if adequate information is available or may treat the advance payments as if they are earned on a straight-line basis.
The proposed regulations include examples illustrating how the advance payment rules apply to loyalty and airline rewards programs. These rules use the performance obligations for financial statement purposes to determine the proper allocation of income to the respective reward program.
Conclusion
The proposed regulations implement the TCJA changes to timing for income recognition, but they do not include a cost offset for accrued expenses or inventory. However, the preamble to the proposed regulations under 1.451-3 provides that Treasury and the IRS still are considering whether a book percentage of completion method approach might be used to accommodate better matching of income and expenses.Regulation Sections 1.451-3 and 1.451-8 are proposed to be effective for tax years beginning after the regulations are published in the Federal Register, but taxpayers may rely on the rules in the proposed regulations for tax years beginning on or after Jan. 1, 2018, provided they apply the rules consistently to all income. As noted earlier, Revenue Procedure 2019-37 allows taxpayers to file Form 3115, “Application for Change in Accounting Method,” under the automatic method change rules in order to adopt the proposed regulations.
The new regulations likely will affect most accrual basis taxpayers that have an AFS or that defer income consistent with their financial reporting. Taxpayers should evaluate the impact that these proposed regulations might have on revenue recognition to assess if a method change would be beneficial or required.
