Editor: Christine M. Turgeon, CPA
Treasury recently issued final regulations under Sec. 451(c) relating to when an accrual-method taxpayer should include certain advance payments in gross receipts. While Sec. 451(a) generally provides that items of income ought to be included upon receipt, an exception in Sec. 451(c)(1)(B) allows the deferral of such income to a subsequent tax year.
Merger-and-acquisition (M&A) stock transactions frequently are structured in a manner that closes the corporate target's tax year, which may accelerate previously deferred revenue. Because of this, Sec. 451(c) should be considered when structuring such M&A transactions — including special rules relating to short tax years of 92 days or less.
This item discusses these matters.
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, amended Sec. 451(c) to align with Rev. Proc. 2004-34, which generally had governed the U.S. tax treatment of certain advance payments for over a decade prior to the TCJA's enactment. Sec. 451(c)(1)(A) provides the general rule requiring an accrual-method taxpayer to include an advance payment in gross income in the tax year of receipt. However, Sec. 451(c)(1)(B) permits a taxpayer to elect to include any portion of the advance payment in gross income in the tax year following the year of receipt, to the extent such income is not included in revenue in the taxpayer's "applicable financial statement" (AFS) in the year of receipt.
Previously, Regs. Sec. 1.451-5 had allowed taxpayers to defer income recognition for advance payments for goods until the tax year in which they were properly included in income under the taxpayer's method of accounting, which in certain circumstances allowed a multiyear deferral. Proposed regulations under Sec. 451(c) that were issued in 2019 were finalized on Jan. 6, 2021 (T.D. 9941), and are effective for tax years beginning on or after Jan. 1, 2021.
Eligibility requirements to elect deferral method of advance payments
Sec. 451(c)(1)(B) provides for limited deferral, notwithstanding receipt of a payment, where the taxpayer (1) receives an advance payment for goods, services, or certain other items; (2) computes its taxable income under an accrual method of accounting; and (3) for financial reporting purposes, reports such advance payment in a year subsequent to the year of receipt.
Sec. 451(c)(2) provides that a taxpayer must make an election as prescribed by Treasury to use the deferral method for advance payments. Sec. 451(c)(2)(B) states that such an election shall be effective for the tax year in which it is first made and for all subsequent tax years. Regs. Sec. 1.451-8(g)(1) states that a taxpayer may make an initial election by filing a federal income tax return reflecting the deferral method in computing its taxable income. However, if the application of the deferral method under Sec. 451(c)(1)(B) results in the taxpayer changing its established method of accounting, procedures under Regs. Sec. 1.451-8(g)(2) apply.
Sec. 451(c)(4)(A) defines the term "advance payment" as any payment (1) for which the full inclusion of the payment into gross income at the time of receipt would be permissible; (2) any portion of which is included in revenue in a financial statement for a subsequent tax year; and (3) that is for goods, services, or other such items as described in Regs. Sec. 1.451-8(a)(1)(i)(C) (e.g., use of intellectual property or an eligible gift card sale). Sec. 451(c)(4)(B) and the regulations thereunder exclude certain payments from the definition of "advance payment," such as payments with respect to financial instruments.
Regs. Sec. 1.451-8(c)(4) provides that certain events cause the acceleration of previously deferred revenue in gross income for the tax year, including a short tax year, if applicable (the acceleration rule). These events include when the taxpayer ceases to exist (other than from a transaction to which Sec. 381 applies) or when the taxpayer's obligation is satisfied or otherwise ends (other than from a Sec. 351 transaction among members of the same consolidated tax group that involves the transfer of substantially all of the assets of a trade or business, including advance payments).
However, Regs. Sec. 1.451-8(c)(6) provides that if the taxpayer's next succeeding tax year is a short tax year (and not by reason of Regs. Sec. 1.451-8(c)(4)) that consists of 92 days or less, the taxpayer must include the portion of the advance payment not included in the tax year of receipt in gross income for the short tax year to the extent taken into account as AFS revenue as of the end of such tax year (the short-tax-year rule). Further, any amount of the advance payment not included in gross income in (1) the tax year of receipt or (2) the short tax year must be included in gross income for the tax year immediately following the short tax year. Accordingly, the short-tax-year rule essentially provides an exception to the acceleration rule.
As noted above, because merger-and-acquisition (M&A) stock transactions frequently are structured in a manner that closes the corporate target's tax year, a potential impact of a transaction may be to accelerate the recognition of deferred revenue. For example, if a corporate taxpayer has $100 of deferred revenue for tax purposes as of the end of year 1, and that taxpayer is sold to a corporate buyer on June 30 of year 2 in a transaction that terminates the taxpayer's tax year as of closing, the full $100 will be recognized in the short pre-close tax year, assuming no revenue is recognized in the AFS in year 1. By contrast, if the short pre-close tax year consists of 92 days or less, the corporate target only includes deferred revenue in that short pre-close tax year to the extent it includes such revenue in an AFS. Additionally, any amount of the advance payment not included in (1) the tax year of receipt and (2) the short tax year must be included in gross income for the tax year immediately following the short tax year (i.e., the short post-close tax year).
Note that the rule also applies if the short tax year is a post-close tax year. For example, assume that on May 1, 2021, B, an accrual-method calendar-year corporate taxpayer, received $100 as an advance payment for a contract to be performed in 2021, 2022, and 2023. On Oct. 31, 2021, C, an unrelated corporation that files its federal income tax return on a calendar-year basis and that is a member of a consolidated group, acquired all the stock of B, and B joined C's consolidated group. Before the stock acquisition, for 2021, B included $40 of the advance payment in AFS revenue and reported $60 as a deferred revenue liability.
For federal income tax purposes, B must take $40 of the advance payment into income in its short tax year ending Oct. 31, 2021. B's subsequent tax year, the short tax year ending Dec. 31, 2021, is a tax year that is 92 days or less. Therefore, B generally will include the portion of the advance payment not included in the tax year of receipt in gross income for this short tax year, to the extent it is taken into account as AFS revenue (see Regs. Sec. 1.451-8(c)(6)(iii), Example 2). Note that, to the extent the deferred revenue recognized in the Nov. 1, 2021, to Dec. 31, 2021, period in B's AFS is less than $60, the short post-close tax year results in an effective deferral of a portion of deferred revenue into 2022 for tax purposes (i.e., absent the short-tax-year rule, B would have recognized the full $60 in the post-close tax year).
M&A transaction considerations
The short-tax-year rule is nonelective. It is important to remember the rule whenever there is an accrual-method corporate target with significant deferred revenue and the acquisition structure results in closing the corporate target's tax year (e.g., the target joins a U.S. tax consolidation with the buyer corporation). This short-tax-year rule can produce materially different tax results when the timing of the transaction closing results in the application (or nonapplication) of the rule. This impact, in turn, can have purchase price consequences if, for example, the seller indemnifies the buyer for pre-closing income taxes and/or the purchase price is reduced by indebtedness that includes pre-closing income tax liabilities.
The short-tax-year rule also should be considered in the context of how deferred revenue is taxed in corporate M&A stock transactions as a general matter. While a detailed examination of such treatment is beyond the scope of this discussion, it is worth noting that the quantification of the tax liability associated with deferred revenue presents a number of practical issues. For example, in order to quantify the tax impact of the buyer's taking on deferred revenue, the parties should separate out AFS deferred revenue relating to contracts written in the tax year preceding the tax year of the transaction from deferred revenue relating to contracts written in older years as well as deferred revenue relating to contracts written in the short pre-close tax period.
Further, in quantifying the net income tax liability in respect of deferred revenue that may be inherited by the buyer, it would be necessary to bifurcate the remaining cost-of-performance liability, which generally would continue to be deductible post-closing in the context of a corporate target, from the profit margin, which may result in net taxable income to the buyer. It is also helpful to consider the tax implications of deferred revenue in conjunction with how deferred revenue is being treated in the transaction for nontax purposes — for example, is the entire amount of deferred revenue on the AFS being treated as indebtedness reducing purchase price?
Considering deferred advance payments
Accrual-method taxpayers generally are allowed to defer inclusion of a portion of advance payments for tax purposes to one tax year subsequent to the receipt of such payments (assuming they do so for financial reporting purposes and elect to do so for tax purposes). Within these deferral rules are exceptions commonly triggered as a result of a stock acquisition of a corporate target, including an acquisition that results in a short tax year. Tax advisers should be mindful of the impact of the transaction on previously deferred advance payments, including the potential application of the nonelective short-tax-year rule if closing may occur within 92 days of the end of the target's tax year.
Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.
For additional information about these items, contact Ms. Turgeon at 973-202-6615 or firstname.lastname@example.org.
Contributors are members of or associated with PricewaterhouseCoopers LLP.