The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, fundamentally changed how accrual-method taxpayers determine when to recognize income for federal tax purposes. Although it has received little attention compared with other elements of the TCJA, the amendments to Sec. 451 potentially affect a broader cross section of taxpayers than almost any other change made by the TCJA.
The impact of these amendments is amplified by the potential interaction with recently revised financial accounting standards applicable to revenue from customer contracts. First, Sec. 451 will require tax departments to be vigilant for situations in which the new financial accounting standards accelerate the recognition of revenue for book purposes, because that acceleration might translate directly into accelerated income recognition for federal tax purposes as well.
Second, revised Sec. 451 binds tax more closely to the new financial accounting standards in the case of customer contracts having multiple "performance obligations." For federal tax purposes, taxpayers now must allocate the contract's "transaction price" among each performance obligation in the same way it is allocated for financial accounting purposes. Each of these terms is taken directly from the new financial accounting standards, underscoring the new relationship between tax and books.
New Sec. 451
Accrual-method taxpayers are well-acquainted with the general requirement to recognize income in the tax year in which all the events have occurred that fix the right to receive an item of income and the amount of that income can be determined with reasonable accuracy. The "all-events test" has been a bedrock of federal tax accounting for decades.
An equally well-established principle is that financial accounting and tax accounting have fundamentally different purposes, and, as a result, how a taxpayer treats an item of income or expense for financial accounting purposes generally does not determine how that item may be treated for federal tax purposes. Although many taxpayers try to align their financial and tax accounting methods as closely as possible to avoid book-tax differences, the core differences between financial and tax accounting have not always permitted those two methods to align.
The TCJA fundamentally alters the relationship between financial and tax accounting. Sec. 451(b) effectively imposes a (one-way) book-tax conformity rule for recognizing income for tax purposes. Under the new rule, an accrual-method taxpayer may not treat the all-events test as being met for any item of gross income (or portion thereof) any later than when that item is taken into account as revenue in either an applicable financial statement (AFS) or another financial statement that Treasury and the IRS identify as applying for this purpose. This conformity requirement does not apply to taxpayers that do not have an AFS, or to any item of gross income in connection with a mortgage servicing contract.
Sec. 451(b)(3) defines an AFS as (1) a financial statement certified as being prepared in accordance with U.S. GAAP for certain purposes (such as an SEC Form 10-K, or certain audited statements that the taxpayer uses for credit purposes, reports to shareholders, and specific other uses); (2) if the taxpayer has no AFS under (1), a financial statement prepared using International Financial Reporting Standards (IFRS) and filed with certain foreign government entities; or (3) if the taxpayer has no AFS under either (1) or (2), a financial statement filed by the taxpayer with any other regulatory or governmental body specified by the IRS and Treasury.
Importantly, this new conformity requirement does not apply to income items for which the taxpayer is using another "special method of accounting" provided in the Code, such as the installment method of Sec. 453 or the long-term contract method of Sec. 460. It appears, however, that this new statutory requirement will invalidate nonstatutory accounting methods that potentially conflict with it, such as the deferral rules for certain sales of goods heretofore permitted by Regs. Sec. 1.451-5.
Taxpayers may continue to use the more limited one-year deferral permitted by Rev. Proc. 2004-34, however, for advance payments received in connection with the future provision of goods, services, and other specific transactions. In fact, the TCJA incorporates the deferral method of Rev. Proc. 2004-34 directly into the Code as new Sec. 451(c). Although the statutory language of Sec. 451(c) does not mirror the language of the existing revenue procedure verbatim, there is no indication in either the legislative text or the accompanying legislative history that Congress intended to preempt — or narrow the application of — the existing deferral method of Rev. Proc. 2004-34. As such, companies currently using the deferral method described in the revenue procedure should not be required to request IRS consent to continue doing so.
FASB ASC Topic 606: Potential acceleration of book revenue
FASB Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers (Topic 606), and IFRS 15, Revenue From Contracts With Customers, have changed the financial accounting treatment of revenue from customer contracts for taxpayers using either U.S. GAAP or IFRS. A detailed description of the new financial accounting standard is beyond the scope of this discussion. In general, however, the new standard requires taxpayers to exercise judgment to determine the amount of revenue to which they expect to be entitled under a customer contract, and to recognize that revenue for book purposes either at a point in time or over time, depending on the nature of the "performance obligations" within that contract.
At the risk of significantly understating its complexity, FASB Accounting Standards Codification Topic 606 generally moves the financial accounting standard for recognizing customer revenue further away from the traditional all-events test applied to that item for tax purposes. In some cases, Topic 606 will require recognizing revenue sooner for book purposes than may have been the case under previous financial accounting rules — and sometimes sooner than would have been required by applying the Code's all-events test. As a result, because Topic 606 may require accelerating the recognition of certain items of revenue for financial accounting purposes, and because new Sec. 451(b) requires accelerating the recognition of income for tax purposes to match the timing of that item for book purposes, Topic 606 may now accelerate the recognition of tax income even if there otherwise is no linkage between the company's financial and tax methods of accounting for that item, and even if the traditional all-events test would not yet have been satisfied.
Prior to the enactment of new Sec. 451(b), some tax departments had assessed the potential tax impact of Topic 606 and concluded that there would be little or no impact upon their company's tax methods or tax positions. For many companies for which "tax does not follow book," this may well have been accurate at the time of those initial reviews. Now, however, because Sec. 451(b) requires accelerating tax income to match book revenue regardless of whether there is otherwise any linkage between the company's tax and book methods, a second look may be in order. Indeed, well-advised tax departments will ensure an open line of communication with their financial accounting colleagues to identify not only current items of income that may be affected for tax purposes but also future adjustments in financial accounting treatment that may automatically change the company's tax positions (with or without the tax department's knowledge).
Potentially affected companies also should keep in mind that changing the timing of an item of income (i.e., the year in which that item is recognized for tax purposes) generally will be a change in method of accounting requiring IRS consent. The legislative history of this provision makes clear that the consent requirement applies to changes resulting from the revisions to Sec. 451. To date, the IRS has not issued guidance regarding the procedures for making any such required method changes or whether those changes will be eligible for automatic consent.
Many other issues could arise
This discussion touches at the highest level on only a single topic arising from a change in one of the fundamental provisions of federal tax accounting. The other issues are legion and include how the rules apply to original issue discount and other debt instruments; how to align accelerating income from the sale of goods with the corollary cost recovery rules unaffected by the amendments to Sec. 451; precisely how Rev. Proc. 2004-34 aligns with the now-codified version of its "deferral method"; and how to apply the new rules mandating book-tax consistency in allocating customer revenue among multiple performance obligations, another new linkage between tax and Topic 606. This last issue is potentially far-reaching, particularly if state governments adopt the same allocation/characterization requirement for performance obligations for direct and indirect tax purposes.
Even though to date it has not received the same level of scrutiny as have many of the other TCJA amendments to the Code, this revision to a bedrock component of the federal tax accounting rules — particularly when viewed in the context of an equally paradigmatic shift in financial accounting for book purposes — will have broad and long-lasting repercussions upon the federal tax landscape.
These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.