The Tax Cuts and Jobs Act of 2017 introduced amendments to income inclusion and advanced payments deferral rules for U.S. federal tax purposes by adding Sections 451(b) and 451(c) to the Internal Revenue Code. Due to the limited initial and interim guidance provided, myriad questions arose about the changes, leaving many taxpayers anxiously awaiting clarification.
The long-anticipated proposed guidance was finally released earlier this month, on September 5. The guidance appears in Treasury Regulation Section 1.451-3 (for Section 451(b)) and Regulation Section 1.451-8 (for Section 451(c)).
The proposed changes to Section 451(b) address income inclusion and “affect taxpayers that use an accrual method of accounting and have an applicable financial statement,” or AFS. The proposed changes to Section 451(c) provide a deferral method of accounting for “taxpayers that use an accrual method of accounting and receive advance payments.”
Critically, the newly proposed regulations may be relied on as guidance until final regulations are enacted.
Changes to Section 451(b)
The proposed Treas. Reg. Section 1.451-3 provides that an accrual-basis taxpayer with an applicable financial statement cannot recognize income later than it is recognized for financial accounting purposes on an AFS. This is known as the AFS income inclusion rule, which generally increases book and tax conformity. Under the new regulation, income may be included as revenue for tax purposes earlier than it would have been included under the longstanding “all-events” test, provided certain conditions are met.
Revenue is broadly defined under the proposed regulation as “all transaction price amounts included in gross income under Section 61.” A transaction price is “the gross amount of consideration to which a taxpayer expects to be entitled for AFS purposes in exchange for transferring promised goods, services or other property,” not including:
- Amounts collected on behalf of third parties (such as sales taxes)
- Certain contingent considerations (such as performance bonuses)
- Reductions for amounts subject to Section 461 (such as rebates and refunds) and amounts included in cost of goods sold (COGS). Note that there is no COGS offset available under the proposed regulation, which had been widely requested by taxpayers.
The AFS income inclusion rule applies only to taxpayers with at least one AFS that covers the entire taxable year. Since some accrual method taxpayers may have an AFS in one taxable year and not in another, the proposed regulation provides that the AFS income inclusion rule applies on a year-by-year basis. In addition, the rule does not apply to income items in connection with a mortgage servicing contract.
The proposed regulation also clarifies that the AFS income inclusion rule doesn’t change the treatment of a transaction for federal income tax purposes and that the treatment “may be different for federal income tax and AFS purposes.” For example, the AFS inclusion rule does not recharacterize the treatment of Sections 336(e) or 338(h)(10) transactions for federal income tax purposes.
Under the proposed regulation, a taxpayer’s AFS must be determined by using a priority rule. Below is the list of financial statement types, in descending order of priority:
- GAAP statements (such as a Form 10-K)
- IFRS statements (such as a statement filed by the taxpayer with an agency of a foreign government)
- Other statements (such as a statement filed with a U.S. state agency that regulates insurance companies)
It’s important to note that Section 451(b) is a revenue acceleration provision, not a revenue deferral provision. Financial accounting and tax to some extent will now walk hand in hand. As a result, income that is accelerated for financial accounting purposes under the new rules may be accelerated for tax purposes as well. This is especially noteworthy in light of FASB Accounting Standards Codification (ASC) Topic 606, which requires taxpayers to recognize certain revenue items sooner for book purposes.
Changes to Section 451(c)
As a general rule, an accrual method taxpayer who receives advance payments should include those payment amounts in income in the taxable year of receipt. The proposed Treas. Reg. 1.451-8 allows accrual method taxpayers, however, to defer advance-payment income to the taxable year after the year of receipt, provided the income is also deferred on the applicable financial statement.
It’s important to note that even taxpayers without an AFS can take advantage of deferral provisions under the proposed regulation. It is allowable to use other measures to calculate the amount eligible for income deferral, such as a straight-line ratable basis or a statistical basis.
One-year tax deferral has long been guided by Revenue Procedure 2004-34, now codified as Section 451(c). The proposed regulation is similar to Revenue Procedure 2004-34, but there are differences. The proposed legislation introduces an additional exclusion for specified goods (such as rent and insurance premiums), while the remaining exclusions from advance payments mirror those in Revenue Procedure 2004-34. In addition, the proposed regulation defines “advance payment” and “performance obligations,” outlines advance payment acceleration provisions and clarifies rules related to short taxable years.
The IRS made proposed regulations 1.451-3 and 1.451-8 available for public comments when it published them on September 5. Under a best-case scenario, the final regulations will be enacted in 2021.
In the meantime, taxpayers have a choice. They may rely on the proposed regulations for tax years beginning after December 31, 2017. Alternately, they may rely on existing regulations until the final regulations are published in the Federal Register. Given that certain related IRS 2018 tax deadlines are approaching fast — for example, the extended deadline for Form 1120 for corporations is October 15 — many companies must work quickly to determine which option is more favourable. It’s important to note that this is an all-or-nothing reliance. Thus, Section 451(b) is applied to all income items (other than specified fees), while Section 451(c) is applied in total to all advance payments during the taxable year.
Hanna Mialik, Senior Associate, Corporate and International Tax Advisory, contributed to this article.
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