Tax Accounting
The Office of Chief Counsel advised that a taxpayer was not properly using the method of accounting for advance payments in Regs. Sec. 1.451-5 for certain payments the taxpayer received pursuant to long-term agreements for the sale of goods.
Background
Taxpayer A manufactures Product C for use in various industries. When the demand for C grew rapidly in previous years, A developed a business model to exploit the increased demand and insulate itself from dramatic decreases in future demand or new competition that might affect prices. A therefore negotiated long-term supply contracts with some of its customers that would ensure steady demand to justify a substantial increase in production. These supply contracts were take or pay, in that the customer agreed to pay for a certain quantity of C, whether or not it actually took delivery. In return, A agreed to stand ready to deliver the specified quantity of C at specified times at set prices. Each customer also agreed to pay A nonrefundable advance payments.
Terms of original contracts: A entered into long-term contracts with various customers beginning in year 1. The contracts specified minimum yearly quantities that the customer would purchase, and A would deliver, at fixed prices over a term of years. The majority of the contracts were for the same term of years. All of the original contracts had a take-or-pay feature and an initial, nonrefundable advance payment (IAP). The contracts specified that the IAP is to be applied to purchases ratably over the contract period on a per-unit basis.
For book and tax purposes, A recognized income from the sale of goods as the goods were shipped and recognized income from long-term contracts at the average price over the term of each contract. For tax purposes, A adopted the method in Regs. Sec. 1.451-5, under which A included advance payments in income in the tax year in which they are recognized for book purposes. Therefore, because A recognized long-term contract income at the average contract price for book purposes, it deferred initial recognition of the IAP and included the IAP in income ratably over the term of each agreement. For book and tax purposes, A recorded the IAP in a deferred revenue liability account and recorded an additional deferral for each sale based on a difference between the average contract price and the actual amount stated on the sales invoice.
Terms of modified contracts: In year 5 of the contracts, the market for C changed, and A’s long-term supply contracts were then charging customers more than the customers would otherwise pay on the open market. A therefore decided to negotiate contract modifications or cancel contracts with customers on a case-by-case basis.
For contracts it did not cancel, A negotiated new prices, new quantities, or both, based on market prices and the customer’s need for C. A also agreed to modify some of the other provisions of the contracts, including a change in the length of the contract term, a charge of a “deferral fee” in lieu of the customer’s required purchase, or a partial refund of the IAP. The most important modification in A’s practice was that it no longer applied the IAP ratably. Beginning in year 5 and continuing through year 6, A did not report the IAP in income based on units sold for the majority of its contracts, in essence deferring the IAP indefinitely for many of its long-term contracts.
For one particular long-term contract, A and its customer agreed that the customer was not obligated to purchase any C in one particular calendar quarter. In return for A’s agreement to not enforce the take-or-pay feature of the original agreement, the customer agreed to pay a “deferral fee” and to take delivery of the originally specified quantity of C in a later year.
Because A was not shipping any C for the deferral period, it did not recognize any portion of the IAP for that contract for that period and, in addition, it recognized as current taxable income only one-half of the deferral fee. A classified the other half of the deferral fee as a liability, and it would not recognize it until it knew whether the customer would purchase C in the next calendar quarter.
The Office of Chief Counsel’s Advice
The IRS audit team examining A’s returns sought advice from the Office of Chief Counsel (OCC) on whether A was properly using the method of accounting in Regs. Sec. 1.451-5 for advance payments received pursuant to its contracts for the sale of C. The OCC advised that it was not using the method correctly. According to the OCC, A’s actions showed that its liability under these contracts had ended, and it was required to immediately recognize as income all advance payments received in prior years under Regs. Sec. 1.451-5(f). In the alternative, the OCC advised that the audit team could argue that A had changed its method of accounting.
End of the liability under the contracts: As the OCC explained, under Regs. Sec. 1.451-5(f), if a taxpayer has adopted a method of accounting under which it defers the inclusion of advance payments in income, and the taxpayer’s liability under the agreement otherwise ends, all advance payments received under that agreement, and that the taxpayer has deferred, must be included in gross income in the year the taxpayer’s liability ended.
A’s original contracts deferred the inclusion of advance payments in income. After the contracts were modified, A continued to defer IAPs and did not immediately recognize all the IAPs it had deferred. To determine if A improperly was using the accounting method under Regs. Sec. 1.451-5, the OCC found that it was necessary to determine whether the modifications to the original contracts were significant enough that A’s liability under those contracts “otherwise ended.”
The OCC found that Regs. Sec. 1.451-5 gives no guidance on when a taxpayer’s liability under a long-term contract ends that applied to A’s scenario. Consequently, it was necessary to look to contract law of A’s state of residence, Michigan, to determine when a liability ends. After surveying Michigan case law, the OCC concluded that the liability under a contract would end when the parties to the contract deliberately abandoned their future obligations under the contract.
The OCC found that the facts of each contract it examined showed that A and its customers abandoned the original long-term supply agreements with the subsequent amendments. Although the original agreements allowed mutually agreed modifications, the substance of each of the modifications was that they created new agreements. The subsequent amendments substituted new price, quantity, and performance terms that were so different from the original that they rendered the original a nullity. Because the liability under the original contracts ended, and A did not immediately recognize the deferred IAPs in income, the OCC concluded that A was not properly using the accounting method in Regs. Sec. 1.451-5.
Change in method of accounting: The OCC further advised that even if A’s liability under the contracts did not end, its method of accounting for the advance payments no longer was consistent with Regs. Sec. 1.451-5, and it recommended that in the alternative the audit team propose that A had improperly changed its method of accounting for advance payments. A received IAPs, applied them to shipments in the early years of each agreement, and then stopped doing so, even as it continued to ship goods under those contracts. The OCC stated that A’s failure to recognize any IAP when it shipped goods was an accounting method change because A had changed the time when it recognized the IAP as taxable income. According to the OCC, this change was not a mere change in fact, because none of the underlying facts had changed; A received IAPs in earlier years and had changed only how it recognized those advance payments.
Reflections
Diamonds may be forever, but, as the OCC points out, deferral is not. Whether or not the OCC’s analysis of Michigan contract law is entirely sound, the magnitude of the changes the taxpayer made to the agreements in question does suggest that the liabilities under the agreements ended for purposes of Regs. Sec. 1.451-5 at the time the taxpayer and its customers modified them.
Field Attorney Advice 20134801F (11/29/13)
