On December 21, 2020, the Treasury and IRS issued final Regulations under Section 451 to determine the tax year in which an amount must be reported as gross income on tax returns. The ordinances implement changes to the Tax Reduction and Employment Act 2017 (TCJA) to Section 451 to:
(i) require accrual taxpayers to show an amount as gross income for tax purposes no later than the tax year in which the amount is shown as revenue in their “Applicable Financial Statements” (AFS) – that is, typically “AFS Inclusion “Of Section 451 (b); and
(ii) allow accrual taxpayers to defer tax reporting for certain “prepayments” of income for one year, unless the amounts are shown as revenue on the taxpayer’s AFS for the taxable year of receipt – that is, the deferred prepayment “in Section 451 (c).
The regulations provide much-needed clarity on some of the issues raised in the proposed regulations on each of these regulations and will have an impact on taxpayers in a wide variety of industries. In addition, the regulations contain a number of specific rules, restrictions and exemptions, some of which are relevant to taxpayers in certain industries. Therefore, every taxpayer should carefully review the rules.
Section 451 (b) – The AFS Inclusion Rule
An open issue that the ordinances attempt to clarify is the extent to which the AFS inclusion rule requires the recording of income items that the tax law would otherwise not have considered realized in the tax year. In the conference report annexed to the TCJA, Congress stated that unrealized income should not be included in the AFS inclusion rule. How exactly this concept would work in many cases, however, was unclear. Realization is a tax term that is commonly used to refer to property sales, but typically not used for certain types of income such as royalties and indemnities.
The IRS and the Treasury Department declined comments from the commentators to define the term “realization” in the regulations. Rather, the ordinances generally provide that amounts shown as income in a taxpayer’s AFS for the year must be included in gross income for tax purposes that year. However, to bring the general rule in line with the realization requirement and to enforce the declaration of Congress in the conference report, the regulations generally require taxpayers to reduce AFS revenue by amounts based on the provisions of the applicable treaty (including lump-sum damage provisions) and federal, state, local or international law (including fair principles), the taxpayer would not have had the right to reclaim if the customer had terminated the contract on the last day of the tax year. For example, AFS revenues that are subject to a precedent that has not occurred by the end of the tax year will be “withdrawn” if the taxpayer is not entitled to statutory revenues due to the precedent or in equity at the end of the year. This may include, for example, an investment banker’s fee contractually contingent on a merger or acquisition that is ongoing by the end of the year. Determining amounts that a taxpayer could not get back by law or in equity (e.g. according to a quantum meruit theory) can be difficult, burdensome and uncertain for some taxpayers, as the application of this exclusion may be a detailed factual and requires legal analysis. Accordingly, the regulations provide for this rule to be optional. The “AFS Alternative Income Method” allows taxpayers to bypass this rule. In many cases, for the sake of simplicity, the compromise is that the taxpayer shows more gross income than would otherwise be required. However, if the taxpayer chooses the AFS alternate income method, they must do so for any items of income that would be subject to the AFS inclusion rule related to a particular trade or business.
The ordinances provide that the AFS inclusion rule does not change the treatment of a transaction or the character of an item for federal income tax purposes. For example, the fact that the taxpayer’s AFS treats a transaction as a sale (as opposed to a lease) and thus reflects all revenue upfront does not mean that the transaction is treated as a sale for tax purposes per se. If the transaction is a tax lease, it will continue to be treated as a lease for tax purposes. Similarly, the ordinances provide that a contribution, capital repayment, or amount the taxpayer receives as conduction on another person does not constitute gross income for federal income tax purposes, even if treated as a source of income by a taxpayer’s AFS. The IRS can, of course, always point to inconsistent accounting / tax treatment as evidence of a taxpayer contesting the tax characterization of a transaction, but the AFS inclusion rule does not affect the question. The regulations do not provide for a circumvention of this rule and these amounts may require adjustments to the book tax.
Another important problem resolved by the regulations is that costs generally cannot be accelerated to offset revenue that is accelerated under the AFS inclusion rule. For example, the preamble to the regulation expressly provides that credit card companies cannot reduce the amount of exchange fees that would otherwise have to be reported under the AFS inclusion rule by the amount of discounts, reward points, bonus miles or other incentives (if these amounts are reached at the end of the Tax year have not yet fulfilled the time rules of § 461), even if these items reduce the income in the taxpayer’s annual financial statements. Similarly, pharmaceutical manufacturers that reduce their financial report revenue by the amount of any discounts or chargebacks they are likely to pay in connection with that revenue in the coming years must include those amounts back on their tax returns under the AFS inclusion rule. In addition, taxpayers are required to count back any amounts that were excluded from the revenue generated in the financial statements because the amounts were deemed to be uncollectible.
However, the Regulations allow a taxpayer who is required to expedite the reporting of income from the sale of inventories under the AFS Inclusion Rule in order to reduce the amount of inclusion of income by the cost of goods related to the inventory to which the Acceleration has resulted in income (the “AFS reimbursement method”). The costs must still be incurred during the tax year according to the normal rules of Sections 461 and the inventory and UNICAP rules, ie they cannot be projections of the costs that will be incurred in the future. As a result, most taxpayers cannot simply follow the books to determine the reasonable cost of this method. As with the alternative AFS income method, the AFS cost compensation method can also be selected. A taxpayer can choose not to use it if, for example, the method would be too burdensome. As with the AFS Alternative Income Method, the AFS Cost Offsetting Method, if used, must be used for any revenue that is eligible for the method in a trade or business.
Section 451 (c) – The Advance Payment Deferment Rule
The Regulations clarify that when determining the extent to which an advance payment is not included in AFS Revenue for the year of receipt, the taxpayer shall adjust AFS Revenue in accordance with the provisions of the Regulations for the AFS Inclusion Rule got to. For example, if a taxpayer reduces revenue in their financial statements for expected discounts, refunds, chargebacks, or bad debts, the taxpayer must add those items to AFS revenue for both the purposes of the AFS inclusion rule and to determine the amount of the advance payment that cannot be deferred under the prepayment deferral rule. In accordance with previous IRS administrative guidelines and proposed regulations, the regulations provide that any prepayment amount not included in gross income in the year of receipt must be included in gross income in accordance with the rule for deferring prepayments in the following tax year.
The Regulations generally do not provide for offsetting AFS revenues against an advance payment in the tax year of receipt by the amount of the expected costs associated with such revenues. However, in accordance with the provisions of the AFS Inclusion Rule of the Regulation, the Regulation’s Advance Payment Delay provisions allow taxpayers to adjust the amount of an advance payment related to the sale of inventory recognized in AFS revenue to the cost of the goods related with reducing the inventory item that leads to prepayment. Similar rules apply to determining these costs. However, no offset is allowed for prepayments for the sale of gift cards or customer reward points. As with the AFS cost offsetting method applicable for the purposes of the AFS inclusion rule, the cost offsetting method provided with respect to the prepayment deferral rule is an elective accounting method that, when used by the taxpayer, is an elective accounting method for all Advance payments used must be received from a taxpayer in connection with a trade or business selling inventory.