Long-Awaited Proposed Income Recognition Rules Provide Answers, But Some Questions Remain

Proposed regulations implementing Sec. 451(b) require taxpayers on the accrual method of accounting to recognize income for tax purposes no later than for book purposes. The intended effect of the proposed rule is to accelerate in time the recognition of gross income for tax purposes. Proposed regulations implementing Sec. 451(c) clarify the deferral rules for advance payments for accrual method taxpayers. While the proposed regulations are not effective until finalized, taxpayers are permitted to rely upon them for 2018, and they offer clarity as well as new alternatives for taxpayers to consider.

Treasury and IRS released long-awaited proposed rules that would implement changes enacted under the Tax Cuts and Jobs Act (TCJA) to income recognition rules under Sec. 451(b) and (c). The Sec. 451(b) proposed regulations require taxpayers using the accrual method of accounting to recognize income for tax purposes no later than when such income is included in revenue for book purposes. The Sec. 451(c) proposed regulations codified the one-year deferral method under Rev. Proc. 2004-34 and repealed methods that permitted a longer deferral. Rev. Proc. 2019-37 provides additional procedures to make changes in methods of accounting to conform to the proposed regulations. The guidance addresses many of the open questions surrounding the implementation of Sec. 451(b) and (c).

The proposed regulations would be effective when final regulations are published. However, taxpayers can rely on the proposed regulations for taxable years beginning after December 31, 2017. The guidance comes at a time when many taxpayers are filing automatic accounting method changes to implement new GAAP revenue recognition standards under ASC 606, Revenue from Contracts with Customers. The proposed regulations offer some additional alternatives, but in most cases do not affect the changes being made to implement ASC 606 for tax purposes.

Income Acceleration Rule

The proposed regulations implement the income inclusion rule under Sec. 451(b), which requires taxpayers to recognize income upon the earlier of when the all-events test is met or when the taxpayer includes the amount in revenue in its Applicable Financial Statement (AFS). Some highlights of the proposed regulations are listed below.

• AFS is broadly defined for purposes of determining whether the provision applies. An AFS includes not only a certified audited statement under GAAP or IFRS, but any other financial statement (audited or unaudited) that is filed with a federal or state government, agency, or regulatory organization.
• The treatment of a transaction for federal income tax purposes is not recharacterized for purposes of the provision, even if the AFS treats the transaction differently, such as in the case of lease vs. financing treatment, or mark-to-market accounting, in an AFS. Although the provision does not change the timing for when a realization event occurs for federal income tax purposes, the proposed regulations confirm that the rule applies to unbilled receivables for partially performed services and unbilled receivables for the sale of goods. Thus, there is no exception for unbilled receivables under the theory that no realization event had occurred, as some commentators had hoped. However, accrued market discount is not subject to the rule because there is no realization event, consistent with the policy Treasury and IRS announced in Notice 2018-80.
• A nonexclusive list of special accounting methods to which the rule does not apply was provided, such as installment sales under Sec. 453, long-term contracts subject to Sec. 460, leases subject to Sec. 467, mark-to-market accounting under Sec. 475, certain transactions under Sec. 988, etc. The guidance clarifies that when a taxpayer uses a special method, that method, rather than Sec. 451(b) determines the timing of the income inclusion.
• The rule does not apply to items for which a taxpayer’s entitlement is contingent on the occurrence or nonoccurrence of a future event (i.e., variable consideration). Under a rebuttable presumption, amounts included in the AFS are assumed not to be contingent, unless the taxpayer can establish otherwise.
• Reductions to revenue for amounts subject to Sec. 461 (including allowances, adjustments, rebates, chargebacks, refunds, rewards and amounts included in the cost of goods sold) that may be treated as negative variable consideration for an AFS do not reduce AFS revenue earned for purposes of the rule.
• A cumulative approach applies for purposes of determining the amount of revenue a taxpayer has included in its AFS for multi-year contracts.
• Those who hoped the proposed regulations might provide relief in the form of cost offsets for situations where revenue is included in the AFS, as well as an offsetting accrual for future costs, were disappointed. The guidance provides no relief to take cost offsets into account, but instead requests comments, leaving hopes alive that relief may be provided in future guidance.

Deferral Rules for Advance Payments

The proposed regulations under Sec. 451(c) clarify the deferral rules for advance payments received for goods and services. Some highlights of the proposed regulations are listed below.

• While Sec. 451(c) is only applicable to taxpayers with an AFS, the proposed regulation provides guidance for taxpayers to allow the method to be applied to taxpayers without an AFS. Thus, taxpayers who were eligible for the deferral method under Rev. Proc. 2004-34 continue to be eligible under Sec. 451(c).
• The list of items excluded from the one-year deferral rule under the proposed rules generally is consistent with the exclusions set forth in Rev. Proc. 2004-34. However, an additional exception is provided for payments received from the sale of specified goods where payment is received at least two tax years prior to the tax year of the contractual delivery date and revenue is recognized upon delivery for AFS purposes. This exception may permit a longer deferral than would be available under Sec. 451(c) for payments received for specified goods.
• The proposed regulations clarify that the deferral method is generally allowed for rewards programs or loyalty points to the extent the taxpayer treats the rewards as a separate performance obligation in its AFS. However, this treatment is not allowed for rewards provided by credit card issuers with respect to credit card purchases.
• Income acceleration rules for taxpayers that cease to exist, rules for short tax years, and purchase price accounting adjustments involving a write-down of deferred revenue are consistent with existing guidance under Rev. Proc. 2004-34.

The Takeaway

The regulations are effective when finalized, which should not occur until 2020 at the earliest. In the meantime, the proposed regulations answer many questions regarding the direction in which the final regulations are headed and provide some new alternatives for taxpayers to consider. Automatic accounting method changes are available to implement the proposed regulations for taxpayers who choose to rely on them for 2018. As a result, it is important to discuss with your tax advisor how the new income recognition rules apply to your business.