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Taxpayers Expect Hangover From Contract Characterization Fights

Posted on Sep. 24, 2019

Contract provisions for things like candy, beer, and drugs with the same economic results can receive different tax treatments under the recent tax accounting proposed regs, depending on specific formulation.

The recent section 451(b) revenue recognition proposed regs (REG-104870-18) acknowledge taxpayer concerns by excluding contingent consideration from that provision’s income acceleration rule but don’t extend the corresponding treatment to contingent liabilities.

Carol Conjura of KPMG LLP told Tax Notes that this misalignment could elevate form over substance in many contract provisions. That in turn would generate lots of costly tax controversy, she said, including for manufacturers of products that go stale.

On September 5 the IRS and Treasury released two long-awaited sets of proposed regs governing the Tax Cuts and Jobs Act’s provisions regarding revenue recognition, section 451(b), and advance payments, section 451(c). Section 451(b) requires taxpayers on the accrual method of accounting who have applicable financial statements to recognize income no later for tax purposes than for book purposes.

The proposed regs exclude payments contingent on some future event from the transaction price used in determining whether some payments will be accelerated by section 451(b). The exclusion operates with a presumption that follows a taxpayer’s applicable financial statement, but it allows a taxpayer to prove that a payment included in such a statement was actually contingent.

However, taxpayers aren’t allowed to reduce the transaction price based on liabilities subject to section 461’s economic performance requirement.

Conjura said the different treatment between contingent liabilities and revenues could lead to tax controversy on whether particular contract provisions are conditions precedent or subsequent. Taxpayers subject to section 451(b) will have to closely examine their contracts to sort out which provisions involve contingent income not subject to acceleration and which are contingent liabilities they have to wait to deduct.

Shelf Life

The problem comes from financial standards making less of the difference between the types of conditions than the tax law, according to Conjura. In some cases, the proposed section 451(b) regs could actually accelerate more income than the financial accounting standards would, she said.

On the one hand, a taxpayer selling a product or service could offer a volume rebate based on a business threshold, something the proposed regs would likely treat as a contingent future liability, Conjura said. Conversely, the taxpayer could reach the same economic effect by rewriting the contract to start with the discounted price and having an add-on charge in case the customer doesn’t reach the threshold and receive a different tax treatment, she said.

In the first case, the taxpayer would include more income for tax than for book under the proposed regs, and in the second case it would include less, according to Conjura.

That sort of form-over-substance issue could also appear in staleness provisions for things like candy or beer, Conjura said. A contract could be written as the manufacturer taking back unsold product — the contingent liability treatment — or with an upfront discount the customer would have to repay if it sells the whole shipment — the contingent income treatment, she said.

Conjura gave an example of a candy company selling to a retailer in which the retailer buys 100 boxes of candy for $10 each and agrees to refund the price of any product unsold by the expiration date. The manufacturer estimates that 20 boxes will remain unsold, she added.

However the contract is phrased, the financial statement would include $800 of revenue after the $200 expected reduction is subtracted from the $1,000 maximum value, Conjura said. Under the contract as stated, the manufacturer would have $1,000 of income and later deduct $200 under the proposed regs, she said.

“If the manufacturer changed the agreement to charge $8 per box, with a contingent amount due of $2 per box if more than 80 are sold before the state d date, then the applicable financial statement recognizes the same $800, but now tax can recognize the same $800 because the $200 is [the] contingent additional transaction price,” Conjura said.

Example 7 in the proposed regs involves pharmaceutical contract chargebacks and sets up the same dichotomy. In that example, the taxpayer manufacturer pays its wholesaler a chargeback for resales to qualifying customers. The example concludes that those anticipated chargebacks don’t reduce the taxpayer’s income, although the contract could just as easily start with a base rate reflecting the chargeback and rise for resales to nonqualified customers to fit the contingent income provision.

Section 451(b) should treat the revenue line on a taxpayer’s applicable financial statement as a ceiling on its income acceleration, Conjura said. Breaking the items up shouldn’t result in more income acceleration, she said.

Financial accounting rules don’t distinguish between the types of contingencies, Conjura said, but the proposed tax rules require dissecting each adjustment for analysis under sections 451 and 461, and it isn’t always clear which situation the facts fit.

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