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Clarification Requested on Advance Payments Guidance

JUN. 21, 2018

Clarification Requested on Advance Payments Guidance

DATED JUN. 21, 2018
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June 21, 2018

Mr. David Kautter
Assistant Secretary for Tax Policy
Office of Tax Policy,
US Department of Treasury
1500 Pennsylvania Ave NW
Washington, DC 20220

cc:
Mr. Scott Dinwiddie
Associate Chief Counsel (IT&A)
Internal Revenue Service

Mr. John P. Moriarty
Deputy Associate Chief Counsel (IT&A)
Internal Revenue Service

Mr. Peter E. Ford
General Attorney, IT&A Branch 2
Internal Revenue Service

Mr. Thomas West
Tax Legislative Counsel, Office of Tax Policy
US Department of Treasury

Mr. Christopher Call
Attorney Advisor
US Department of Treasury

Ms. Ellen Martin
Tax Policy Advisor
US Department of Treasury

Re: Notice 2018-35 — Transitional Guidance for Advance payments Under Section 451(c)

Dear Sir:

We are writing on behalf of a client which respectfully requests guidance on various issues regarding the new Internal Revenue Code Sections 451(b) and 451(c). The client needs clarity regarding the application of these code sections in order to comply with their fiscal year 2019 tax reporting obligations and to make informed decisions regarding estimated tax payments, cash flow and other planning matters.

Specifically, our client respectfully requests the following guidance:

1. Advance payments for software be identified by the Secretary as advance payments eligible for deferral pursuant to Section 451(c)(4)(A)(ii).

2. Any changes required to be made to comply with Section 451(c) be made under the automatic consent provisions, with the terms and conditions generally included in Rev. Proc. 2015-13 and a scope waiver for changes filed within the prior five years.

3. Clarification that the filing of an application for a change in accounting method, in a taxpayer's ASC 606 adoption year, is treated as occurring prior to such adoption.

4. Administrative relief providing for a 6-year Section 481 adjustment with respect to adjustments required to comply with the provisions of Section 451(b).

Our client appreciates your consideration of these comments and respectfully requests the opportunity to meet with you in person to further discuss the details relating to the issues created by the adoption of ASC 606 in conjunction with tax reform. Please feel free to contact me at (202) 327-6684 or Don Reiris at (732) 516-4522 with any questions or concerns.

Sincerely,

Alison Jones
Principal
Ernst & Young LLP
1101 New York Ave., NW
Washington, DC 20005

Background

Taxpayer is a US-based global software company with $4 billion in annual revenue, derived primarily from multi-year licensing of its software. Taxpayer's fiscal year ends March 31st.

US GAAP Revenue Recognition

ASC 605

Taxpayer historically recognized software revenue over each software license term on a ratable basis. Advance payments were recorded as deferred revenue. Example — Consider a five year license sold for $500. The license period runs from April 1st, 2017 through March 31, 2022. Five equal payments of $100 are due and paid each March 31st beginning in 2017. Revenue of $100 is recognized each year beginning in FY 2018.

 

3/31/17

FY 2018

FY 2019

FY 2020

FY 2021

FY 2022

Payment (Cash)

$100

$100

$100

$100

$100

 

Book Revenue

$0

$100

$100

$100

$100

$100

ASC 606

Taxpayer adopted ASC 606 in FY 2019 (April 1, 2018 – March 31, 2019). Under this model, certain contract revenue is recognized upon contract inception. Accordingly, amounts previously deferred for US GAAP under the ratable model, as well as amounts contracted but not yet due or invoiced, will be recorded to retained earnings upon the adoption of ASC 606. Example — Using the facts outlined above, revenue of $400 will be recorded to retained earnings on April 1, 2018. No further revenue will be recognized with respect to this contract.

 

3/31/17

FY 2018

FY 2019

FY 2020

FY 2021

FY 2022

Payment (Cash)

$100

$100

$100

$100

$100

 

Book Revenue

$0

$100

 

 

 

 

Retained Earnings

 

 

$400

 

 

 

US Income Tax Recognition

Pre-TCJA

The Taxpayer recognizes revenue under the deferral method provided for in Revenue Procedure 2004-34, which permits for a limited one year deferral of advance payments. Example — Under the facts outlined above, each $100 payment will be recognized in the year subsequent to the year of receipt.

 

3/31/17

FY 2018

FY 2019

FY 2020

FY 2021

FY 2022

Payment (Cash)

$100

$100

$100

$100

$100

 

Tax Revenue

$0

$100

$100

$100

$100

$100

Post-TCJA

Section 451(b) requires taxpayers to recognize income under the earlier of (i) the all events test or (ii) when such income is recognized in the taxpayer's financial statements. Section 451(c) codified and modified Rev. Proc. 2004-34 (and defines eligible advance payments as those for goods, services or other items to be specified by the Secretary). Example — Under the facts outlined above, all previously unrecognized revenue will be recognized in FY 2019 because:

  • Section 451(c)

    • Unless included among the “other items to be specified by the Secretary,” software is no longer an item eligible for deferral and/or

    • After the adoption of ASC 606, no advance payment would exist subsequent to the book adjustment to retained earnings (thus, no opportunity for deferral is available)

  • Section 451(b) — to the extent deferral under Section 451(c) is unavailable, Section 451(b) requires recognition as the all events test is satisfied at this point in time.

 

3/31/17

FY 2018

FY 2019

FY 2020

FY 2021

FY 2022

Payment (Cash)

$100

$100

$100

$100

$100

 

Tax Revenue

$0

$100

$400

 

 

 

Issues

Advance Payments — Section 451(c)

  • Advance payments received relating to software are not explicitly listed as an item eligible for deferral under Section 451(c). The Taxpayer respectfully requests that such advance payments for software be identified by the Secretary as advance payments pursuant to Section 451(c)(4)(A)(ii).

  • Taxpayer respectfully requests that changes required to be made to comply with Section 451(c) be made under the automatic consent provisions, with the terms and conditions generally included in Rev. Proc. 2015-13 and a scope waiver for changes filed within the prior five years.

  • Assuming the Taxpayer is required to file a change in method of accounting (Form 3115) to adopt the new 451 provisions, a question arises as to the sequence of events:

    • ASC 606 adoption

      ASC 606 provides that an entity shall apply [the new rules] for annual reporting periods beginning after December 15, 2017.

      Additionally, a cumulative adjustment to opening retained earnings, to reconcile the prior book revenue recognition methodology to the new methodology, is required by ASC 606.

    • Adoption of Sections 451(b) and/or (c)

      Rev. Proc. 2015-13 provides that the “year of change” is the taxable year for which a change in method of accounting is effective (Section 3, Paragraph 19). For an automatic change, the year of change is the taxable year designated on the Form 3115. For a non-automatic change, the year of change is the taxable year for which the taxpayer timely filed a Form 3115. The § 481(a) adjustment is computed as of the beginning of the year of change (Section 3, Paragraph 15) which, under Richardson T.C. Memo 1996-106, is the first day of the year of change.

      Specifically, the Taxpayer would greatly appreciate further clarity regarding which of the items should be considered to occur first. The sequence determines the tax implications

    • If the adoption of the Section 451 statutory rules is deemed to occur first, then the Taxpayer would generally compute a Section 481(a) adjustment to ensure no duplications or omissions. The resulting positive Section 481(a) adjustment would then be recognized over a four year period under the provisions of Rev. Proc. 2015-13 ($100 in FYs 2019 through 2022 in the preceding example).

 

3/31/17

FY 2018

FY 2019

FY 2020

FY 2021

FY 2022

Payment (Cash)

$100

$100

$100

$100

$100

 

Tax Revenue

$0

$100

 

 

 

 

481(a)

 

 

$100

$100

$100

$100

  • If ASC 606 is deemed to occur first, no advance payment will exist at the beginning of the tax year pursuant to the definition of an advance payment provided in Section 451(c)(4)(A)(ii). Therefore, all previously deferred revenue ($400 in the preceding example) must be recognized in the year of ASC 606 adoption (FY 2019 in the preceding example).

 

3/31/17

FY 2018

FY 2019

FY 2020

FY 2021

FY 2022

Payment (Cash)

$100

$100

$100

$100

$100

 

Tax Revenue

$0

$100

 

 

 

 

481(a)

 

 

$400

 

 

 

The first scenario deeming the application of the tax statutory rules to occur first appears to be the better interpretation. Current guidance provides that a taxpayer's restatement of its AFS for financial accounting presentation does not affect the propriety of the taxpayer's method of accounting for advance payments in the prior taxable years(s) (See, Rev. Proc. 2017-30; Section 16.10(1)(a)(ii)). Applying similar analysis, a company's implementation of ASC 606 that results in a cumulative effect adjustment (i.e. an adjustment to effectively restate prior financial statements) should not change the propriety of the taxpayer's method of accounting. Therefore, the adoption of ASC 606 (and related cumulative effect adjustment to retained earnings) should not impact a taxpayer's ability to make an accounting method change to comply with Section 451(c).

Furthermore, the statutory and procedural rules generally governing a change in accounting method are instructive. Under these rules, the taxpayer is generally required to apply the new method of accounting as of the tax year of change, and compute a Section 481(a) adjustment to assure that there are no duplications or omissions of income. The Section 481(a) adjustment is then computed as of the beginning of the tax year of change (i.e. the first day of the taxable year). For purposes of administrative ease, this computation is best calculated by focusing on the difference between the taxpayer's current and proposed methods of accounting. Otherwise the computation can easily become overly burdensome when taxpayers are required to consider the restatements of financial statement balances which may include or exclude amounts that should or should not be considered for tax purposes (e.g., amounts previously recognized for tax purposes and not for book purposes).

  • As partially illustrated above, significant uncertainty exists relative to the computation of taxable income for FY2019. Furthermore, the Taxpayer's ability to protectively overpay its anticipated liability when it files an extension (and/or estimated payment, as appropriate) is impacted by the cash flow concerns previously discussed, as well as the Taxpayer's understanding that the IRS intends to initially apply such overpayments to any outstanding § 965 liabilities. Due to these concerns, the Taxpayer respectfully requests relief from interest and penalties associated with quarterly estimated tax payments/extension payments.

Immediate Full Contract Revenue Inclusion — Section 451(b)

US GAAP and Tax Revenue Recognition

In addition to the issues described above surrounding the initial adoption of Sections 451(b) and (c), additional concerns arise subsequent to the Taxpayers adoption of ASC 606. Assume the Taxpayer enters into the contract described above subsequent to the effective date of ASC 606. The previous facts with revised dates are as follows: Taxpayer enters into a five year license for $500. The license period runs from April 1st, 2020 through March 31, 2024.

Five equal payments of $100 are due and paid each April 1st beginning in 2020. For financial statement purposes, revenue is recognized at a point in time, specifically at contract inception

 

FY 2020

FY 2021

FY 2022

FY 2023

FY 2024

Payment (Cash)

$100

$100

$100

$100

$100

Book Revenue

$500

 

 

 

 

Tax Revenue

$500

 

 

 

 

Tax Liability

$105*

 

 

 

 

* $5 in excess of cash received

Issues

Section 451(b) requires taxpayers to recognize revenue no later than when recognized for financial statement purposes. Accordingly, in situations like the one described above (which is common for the Taxpayer as well as taxpayers in other industries), the tax liability for FY20 exceeds the cash received by the Taxpayer in FY20. This result creates tremendous cash flow concerns as the Taxpayer not only needs to satisfy its tax liability, but also needs to fund its ordinary operating expenses.

Assuming that there is a realization event pursuant to the terms of the contract, the acceleration of revenue recognition appears mandated by Section 451(b). Specific relief generally requires a change in the statutory language (e.g., the relief provided to the mortgage servicing industry under Section 451(b)(1)(B)(ii) which addresses this specific issue for one particular industry). Such modifications to the statute are generally beyond the IRS and Treasury's scope of authority.

  • However, there are some avenues of administrative relief that would be greatly appreciated as taxpayers work to transition to the new tax rules and attempt to manage the significant shift in taxable income recognition. Consider Section 13321(e)(2) of the TCJA which provides special rules for original issue discount impacted by new Section 451. Under such rules, a 6-year Section 481(a) spread period is provided. The Taxpayer respectfully requests the IRS and Treasury use their administrative authority for implementing accounting method changes to provide a similar 6-year Section 481(a) spread. This would greatly ease the aforementioned cash flow concerns and better allow similarly situated taxpayers to manage the significant acceleration of tax revenue.

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