Editor: Greg A. Fairbanks, J.D., LL.M.
In September 2019, Treasury and the IRS released Prop. Regs. Sec. 1.451-8 (REG-104554-18), which provides rules for the deferral of advance payments for goods, services, and certain other items under Sec. 451(c). These proposed regulations are largely based on the guidance relating to the deferral of advance payments issued in Rev. Proc. 2004-34. This includes (1) retaining the types of revenues eligible for deferral; (2) allowing taxpayers without an applicable financial statement (AFS) to defer advance payments as long as certain conditions are met; (3) requiring taxpayers to accelerate deferred revenue in certain situations; and (4) retaining the favorable provisions for certain short tax years.
The proposed regulations also contain significant differences from Rev. Proc. 2004-34, including (1) examples showing that advance payments for loyalty or rewards points, discount vouchers, airline miles, and other similar arrangements that are treated as separate performance obligations may be eligible for deferral treatment; and (2) an exclusion of advance payments for "specified goods" if the payment is received at least two years before the contracted delivery date.
Prop. Regs. Sec. 1.451-8 also refers to the recently released proposed Regs. Sec. 1.451-3 issued under Sec. 451(b) for many of the definitional items such as the definition of AFS, performance obligation, revenue, and transaction price.
In general, Sec. 451 provides that the amount of any item of gross income is included in gross income for the tax year in which the taxpayer receives it, unless, under the method of accounting used in computing taxable income, the amount is to be properly accounted for as of a different period.
Generally, accrual-method taxpayers recognize income when all the events occur that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. This is known as the all-events test (see Regs. Sec. 1.451-1). All of the events that fix the right to receive income occur when (1) payment is due; (2) payment is made; or (3) the required performance takes place, whichever happens earliest (see, e.g., Rev. Rul. 2003-10).
Sec. 451(c) as amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, provides a general rule requiring accrual-method taxpayers to take advance payments into income in the tax year of receipt (the full-inclusion method). Sec. 451(c), as amended, also provides accrual-method taxpayers with an election to defer the inclusion of income from certain advance payments for goods, services, and other specified items to the subsequent tax year of receipt if that income is also deferred for AFS purposes. The TCJA generally codified the existing deferral method for certain advance payments as provided in Rev. Proc. 2004-34. Prop. Regs. Sec. 1.451-8 is intended to describe and clarify the requirements of Sec. 451(c).
New deferral regulations
Similar to Rev. Proc. 2004-34, under the proposed regulations, an advance payment is a payment received by the taxpayer in which (1) taking the full amount of the payment into income in the year of receipt is a permissible method of accounting; (2) a portion of the payment is included in revenue by the taxpayer in an AFS for a subsequent year; and (3) the payment must be for certain types of revenue (see Prop. Regs. Sec. 1.451-8(b)(1)).
The types of revenue qualifying for deferral are payments for goods, services, the use of intellectual property, software, gift cards, certain subscriptions, certain warranty contracts, memberships, payments for the use of property if the occupancy or use is ancillary to the provision of services, and reward and loyalty programs.
The proposed regulations also contain examples showing that advance payments for loyalty or rewards points, discount vouchers, airline miles, and other similar arrangements that are treated as separate performance obligations may be eligible for deferral treatment. This is welcome news for taxpayers in the retail and transportation industries. The addition of these examples is the result of the different treatment of these items for financial statement purposes under the new accounting standard for revenue recognition (e.g., FASB Accounting Standards Codification Topic 606, Revenue From Contracts With Customers). Under the new standard, many taxpayers now treat these items as future revenue rather than as an item of an accrued expense, thus bringing these items within the purview of Prop. Regs. Sec. 1.451-8. Taxpayers should look for similar changes that are made as a result of the new standard.
The proposed regulations also provide a list of items excluded from the definition of advance payment that is similar to Rev. Proc. 2004-34. These items include rent, insurance premiums, payments with respect to financial instruments, payments relating to certain warranty or guaranty contracts, payments subject to Sec. 871(a), 881, 1441, or 1442, and certain payments in property to which Sec. 83 applies (see Prop. Regs. Sec. 1.451-8(b)(1)(ii)).
The proposed regulations contain an additional exclusion for payments received more than one tax year before the tax year of the contractual delivery date for a specified good. A specified good is a good for which (1) the taxpayer does not have the particular good or a substantially similar good on hand at the end of the year in which the advance payment is received; and (2) the taxpayer recognizes all of the revenue from the sale of the good in its AFS in the year of delivery (see Prop. Regs. Sec. 1.451-8(b)(9)). Originally, this provision was thought to be fairly limited to the aerospace and defense industries. However, it appears this provision may apply to a variety of taxpayers.
It should also be noted that the advance payment provisions appear to be operable at the gross receipts level. The preamble to the proposed regulations points out that there is no corresponding offset for the cost of goods sold. As a result, taxpayers may find they will recognize income in one year but are unable to recognize a corresponding offset for the cost of goods sold until a subsequent tax year.
Deferral method for taxpayers without an AFS
The TCJA initially limited the deferral method to those taxpayers with an AFS (see Sec. 451(c)(4)(A)(ii)). However, similar to the provisions of Rev. Proc. 2004-34, the proposed regulations allow taxpayers that do not have an AFS to use the deferral method based on when income is earned by applying the earned standard. Under the non-AFS deferral method, accrual-method taxpayers without an AFS that receive advance payments must include the advance payment in income in the tax year of receipt, to the extent that it is earned. The remaining amount of the advance payment is taken into income in the next succeeding tax year.
Under the proposed regulations, payment is earned when the all-events test is met, without regard to when the amount is received. Taxpayers that are unable to determine the extent to which a payment is earned in the tax year of receipt may do so based on (1) a statistical basis if adequate data is available; (2) a straight-line ratable basis over the term of the agreement for advance payments received under a fixed-term agreement if it is reasonable to believe the payments will be received ratably; or (3) any other basis that results in a clear reflection of income (in the opinion of the IRS) (see Prop. Regs. Sec. 1.451-8(d)(4)).
Other special rules
If the payment relates to multiple items within a contract, the payment must be allocated to the various items based on objective criteria (see Prop. Regs. Sec. 1.451-8(d)(5)). This is similar to the requirement in Rev. Proc. 2004-34. However, it should be easier now to satisfy the objective criteria standard given the provision to align the timing of income with the taxpayer's multiple performance obligations used for financial statement purposes (see Sec. 451(c)(4)(D)).
The proposed regulations retain the favorable rules provided by Rev. Proc. 2004-34 for certain short tax years. In general, if a taxpayer is using the deferral method and has a short tax year consisting of 92 days or less in the year after it receives an advance payment, the taxpayer will not be required to take the remaining portion of the deferred revenue into income for the short tax year. Rather, the taxpayer will include the portion of the advance payment in income only to the extent it is included in revenue in an AFS (or earned for taxpayers that do not have an AFS) (see Prop. Regs. Secs. 1.451-8(c)(4) and (d)(8)). The special short-tax-year rule does not apply for taxpayers that die or cease to exist in a transaction other than a transaction to which Sec. 381(a) applies.
The proposed regulations adopt the more detailed provisions of Rev. Proc. 2004-34 in determining whether the recognition of advance payments must be accelerated. Under the proposed regulations, taxpayers are required to take into income the amount of any advance payments that have not been previously recognized in the tax year in which the taxpayer either dies or ceases to exist in a transaction, other than a transaction to which Sec. 381(a) applies. Likewise, if the taxpayer's obligation with respect to the advance payments is satisfied or otherwise ends, the related income must be taken into income. There are certain exceptions to the general rule. If the obligation ends because the taxpayer entered into a Sec. 381 transaction, the acceleration rule does not apply. In addition, if the taxpayer's obligation ends because the taxpayer entered into a Sec. 351 transaction where substantially all the assets were transferred to another member of the same consolidated group, the acceleration rule does not apply as long as the transferee adopts and uses the deferral method.
Taxpayers were hoping the proposed regulations would provide more clarity as to when a taxpayer's obligation is satisfied or otherwise ends. As an example, a manufacturer may complete a sale of merchandise with its customers but remain obligated to accept returned and recalled merchandise, service warranties, handle complaints from customers and inquiries from governmental agencies, or provide rebates for the merchandise. Thus, it remains unclear whether the taxpayer's obligation ends upon the sale of merchandise or at some other point in time.
As noted earlier, Prop. Regs. Sec. 1.451-8 relies heavily on the concurrently issued Prop. Regs. Sec. 1.451-3 for many of its definitions. For example, in using the deferral method, the transaction price must be allocated using the provisions of Prop. Regs. Sec. 1.451-3(g). Regs. Sec. 1.451-3 also contains definitions for "applicable financial statement" (Prop. Regs. Sec. 1.451-3(c)(1)); "performance obligation" (Prop. Regs. Sec. 1.451-3(c)(3)); "revenue" (Prop. Regs. Sec. 1.451-3(c)(4)); and "transaction price" (Prop. Regs. Sec. 1.451-3(c)(6)).
Opportunities to apply the proposed rules
The proposed regulations apply for tax years beginning after the date they are published in the Federal Register as final regulations. However, taxpayers may rely on the proposed regulations for tax years beginning after Dec. 31, 2017, provided they apply all the rules contained in those proposed regulations.
The long-awaited proposed regulations under Sec. 451(c) generally codify the special rules for advance payments under Rev. Proc. 2004-34, provide clarifying examples for certain advance payments treated as separate performance obligations, provide an exclusion for advance payments for specified goods, and align many definitional items with the proposed regulations under Sec. 451(b). However, some questions remain unanswered. Until final regulations are issued under Sec. 451(c), taxpayers with advance payments may continue to rely on Rev. Proc. 2004-34 by applying transition guidance under Notice 2018-35 or choose to adopt Prop. Regs. Sec. 1.451-8 for tax years beginning after Dec. 31, 2017. Taxpayers may wish to review their treatment of advance payments for opportunities to apply the new proposed regulations. In particular, taxpayers adopting the Topic 606 revenue recognition standard that begin treating certain advance payments such as loyalty or rewards points, discounts vouchers, airline miles, and other similar arrangements as separate performance obligations may have a new opportunity to defer revenue for advance payments.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Contributors are members of or associated with Grant Thornton LLP.