Firm Seeks Changes to Specified Goods Rule in Tax Accounting Regs

November 7, 2019

Mr. David Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

Mr. Jeffrey Van Hove
Senior Advisor for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

Mr. Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Mr. Michael Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: Proposed Regulations Regarding Advance Payments for Goods, Services, and Other Items (REG-104554-18)

Dear Sirs:

On September 9, 2019, the United States Department of the Treasury ("Treasury") and the Internal Revenue Service (the "Service") published proposed regulations in the Federal Register (the "Proposed Regulations")¹ with respect to advance payments as described in Section 451(c) of the Code.² We appreciate that Treasury and the Service included an exclusion for "specified goods"³ from the definition of an "advance payment" in Section 451(c)(4)(A) of the Proposed Regulations⁴ (the "Specified Goods Rule") because we believe that this exclusion recognizes the existence of certain contracts where taxpayers enter into contracts with their customers for long-lived products with integral services and receive advance payments for those contracts. We believe that the Specified Goods Rule seeks to implement Congress' intent to provide for book-tax conformity with respect to those specific fact patterns. However, as discussed further below, as currently drafted, the Specified Goods Rule does not cover all the fact patterns that we understand that Treasury and the Service intended to include within the scope of that Rule. Accordingly, this comment letter contains suggestions to revise the Specified Goods Rule to address those fact patterns that we believe were inadvertently excluded from the Proposed Regulations. To the extent that we have other comments relating to the Proposed Regulations, those comments will be addressed separately.

Factual Overview

In a comment letter that we provided to you on October 26, 2018, we described facts relating to X, a calendar year accrual method taxpayer. This letter further supplements and clarifies the facts provided in our October 26, 2018 letter. X is a deconsolidated entity that, for business reasons related to product development in its industry, has a single, limited-life business line. X manufactures a long-lived product("Product") that it sells to Customer 1 for inclusion in a manufactured good that Customer 1 sells to Customer 2. In addition, X enters into a long-term maintenance agreement with Customer 2. Under this agreement, X receives upfront payments from Customer 2 for the sale of replacement components in connection with the Product, as well as related integral services associated with the Product, including installation and maintenance. In a typical example of a long-term maintenance contract, X receives payments from Customer 2 in years 1 through 10 and incurs costs in years 5 through 15 for providing replacement components and related integral services. X does not service and replace components in Product on a particular date identified in the long-term maintenance agreement; instead, Product is serviced and parts are replaced based on facts and circumstances described in the agreement between X and Customer 2 (generally, when objective factors relating to the use of Product are met). X's business line has a limited life due to, among other reasons, technological changes. As a result, X will cease selling Product and entering into long-term maintenance agreements at a future date, and X will be liquidated. For purposes of this example, X will liquidate in year 15.

Previously, for both financial accounting and tax purposes,⁵ X recognized income as costs were incurred and, therefore, revenue and costs were "matched." X's financial accounting treatment has not changed. Under a narrow interpretation of Section 451(c), as amended by the Tax Cuts and Jobs Act("TCJA"),⁶ X may now have to recognize income for tax purposes in years 1 through 10 and X may not be able to recognize its cost of goods sold ("COGS") until those costs are incurred in years 5 through 15. As described above, due to the specific nature of X's facts (namely, that X will be liquidated at the end of Product's life cycle), a narrow interpretation of Section 451(c) will result in a mismatch of revenues and COGS, leading to net operating losses ("NOLs") generated in later years when X has little (and, eventually, no) income received to offset its costs. Because taxpayers are no longer permitted to carry back their NOLs due to changes made by the TCJA, X will have a permanent loss in the later years of its limited life.

To address this potential inequity and ensure that both the matching principle and book-tax conformity are satisfied, our October 26, 2018 letter recommended that Treasury issue guidance allowing taxpayers to offset an advance payment included in income in a taxable year by a proportionate amount of the estimated costs attributable to the goods sold under the agreement for which such advance payments are received. Our letter included proposed regulatory language for your consideration. Our proposed regulatory language was not adopted in the Proposed Regulations, and Treasury and the IRS did not permit taxpayers to offset advance payments by an estimated COGS amount. We understand that Treasury and the IRS continue to consider whether cost acceleration may be appropriate in certain circumstances.

Request for Changes to the Specified Goods Rule in the Proposed Regulations

Although we disagree with Treasury and the IRS's conclusion in the Preamble to the Proposed Regulations that "changes to the timing of income under section 451 without an accelerated cost offset [do not] cause a taxation of gross receipts," we do not believe that COGS acceleration is the only way to address the fact pattern described above and implement Congressional intent. In fact, our October 26, 2018 letter noted that another option available to Treasury and IRS to address the fact pattern above was for Treasury to exercise its grant of regulatory authority in Section 451(c)(4)(B)(vii) to exclude "any other payment" from the definition of "advance payment." Treasury clearly exercised this authority when it provided the Specified Goods Rule in the Proposed Regulations.

Based on the description of the Specified Goods Rule in the Preamble, we believe that Treasury and IRS intended to include the fact pattern described above within the scope of the Specified Goods Rule. However, as currently drafted, this fact pattern appears to have been inadvertently excluded. We recommend that, in promulgating final regulations, Treasury and IRS make the targeted changes to the Proposed Regulations that we identify below to clearly provide that the fact pattern described in this letter is included within the scope of the Specified Goods Rule. Specifically, we recommend that the Proposed Regulations should be revised as follows(changes to the Proposed Regulations appear in bold):

Prop. Treas. Reg. Sec. 1.451-8(b)(1)(ii)(H): Payments (or portions thereof) received in a taxable year earlier than the taxable year immediately preceding the taxable year of the contractual delivery date for a specified good.

Prop. Treas. Reg. Sec. 1.451-8(b)(8): Contractual delivery date. Contractual delivery date means the month and year of delivery listed in the written contract to the transaction or the reasonably determined date of delivery based on all the facts and circumstances as provided in the contract.

Prop. Treas. Reg. Sec. 1.451-8(b)(9): Specified good. A specified good means a good and integral services furnished with respect to such good for which:

(i) During the taxable year a payment is received, the taxpayer does not have on hand (or available to it in such year through its normal source of supply) goods of a substantially similar kind and in a sufficient quantity to satisfy the contract to transfer the good to the customer; and

(ii) All the revenue from the sale of the good is recognized in the taxpayer's AFS no later than in the year of delivery.

Alternative Recommendation

If Treasury and the IRS do not adopt our proposed changes to the language of the Specified Goods Rule, as stated above, we request that Treasury and the IRS add an additional exclusion to the list of items excluded from the definition of an advance payment in Prop. Treas. Reg. Sec. 1.451-8(b)(1)(ii). This proposed exclusion would read as follows:

(I) Advance payments which, based on all factual material available at the time a contract or purchase agreement is entered into, the taxpayer reasonably estimates that it will have a net operating loss that remains unused for the 5-year period after the year the advance payments received are included in the taxpayer's taxable income.

As we have previously noted, this alternative would ensure that both the matching principle and Congress' goal of promoting book-tax conformity are met. Our October 26, 2018 letter describes, in detail, the authority and policy reasons supporting this alternative.

Conclusion

We appreciate your consideration of our recommendations and would be pleased to continue a dialogue with you. If you would like to discuss these matters further, please contact Alexandra Minkovich at(202) 452-7015.

Respectfully submitted,

Baker &McKenzie LLP
Washington, DC

cc:
Krishna Vallabhaneni, Tax Legislative Counsel, U.S. Treasury
Hannah Hawkins, Deputy Tax Legislative Counsel, U.S. Treasury
Ellen Martin, Tax Policy Advisor, U.S. Treasury
John Moriarty, Associate Chief Counsel, Income Tax &Accounting
Peter E. Ford, Senior Counsel, Income Tax & Accounting