Firm Seeks to Reduce Complexity for Advance Payment Treatment

October 29, 2018

Courier's Desk
Commissioner of Internal Revenue
Internal Revenue Service
Attn: CC:PA:LPD:PR
1111 Constitution Avenue, NW
Washington, D.C. 20224

Dear Sir:

On May 14, 2018, we submitted a comment letter on behalf of our clients in response to the request for comments in Notice 2018-35. Among other subjects, that comment letter discussed our recommendation that taxpayers that are required to use the percentage-of-completion method for financial reporting purposes under ASC 606 should be permitted to also use the percentage-of-completion method for tax purposes, even though the contracts involved do not satisfy the definition of a long-term contract in section 460(f). In this comment letter, we provide a discussion of the policy reasons why the use of such an optional percentage-of-completion method should be permitted for tax purposes, as well as a discussion of several issues that arise in connection with allowing such a method to be used for tax purposes and draft language for the proposed regulations authorizing the use of such an optional method.

In addition, we submitted a supplemental comment letter on June 14, 2018. That comment letter discussed the legal support in the statute and the Conference Report for the conclusion that taxpayers that produce goods for customers, and that are subject to either section 451(b) or section 451(c) or both, are required to measure the amount of gross income that is required to be recognized for tax purposes by reason of either of these provisions by offsetting against the amount of gross receipts under either section 451(b) or section 451(c) the amount of costs that relate to those gross receipts. In this follow-up to those comments, we provide additional support for this conclusion, as well as providing draft language for the proposed regulations that would implement this conclusion, and we address some of the issues that arise in connection with such a cost offset.

I. Background

The Tax Cuts and Jobs Act (“TCJA”) added to the Internal Revenue Code (“Code”) a new section 451(b), which provides that in computing a taxpayer's income under the accrual method, the all-events test with respect to any item of gross income (or portion thereof) shall be treated as met no later than when such item (or portion thereof) is taken into account as revenue in the taxpayer's applicable financial statements. In addition, the TCJA also added new section 451(c), which permits a limited one-year deferral for advance payments provided the advance payment is also deferred for financial reporting purposes. Both of these provisions are effective for taxable years beginning after December 31, 2017.

In a development that was unrelated to the new tax law provisions, in 2014, the Financial Accounting Standards Board (“FASB”), in conjunction with the International Accounting Standards Board (“IASB”), issued new financial accounting rules, which revised the financial reporting rules with respect to the timing of revenue recognition. These new rules were contained in Accounting Standards Update No. 2014-09 (May 2014), ASU No. 2014-09, which added a new subdivision to the FASB's Accounting Standards Codification (“ASC”). This new subdivision is Topic 606 in the ASC, Revenue from Contracts with Customers. This new subdivision in the ASC is generally referred to as ASC 606, and that term will be used in this discussion. ASC 606 took effect for public companies on January 1, 2018.

In general, ASC 606 does not significantly change the timing of the recognition of revenue for financial reporting purposes for most types of transactions involving the production and/or sale of goods. In particular, in the case of the production and/or sale of goods for specific customers, under most circumstances, revenue is likely to continue to be recognized at the point in time when the goods are shipped or delivered to a customer. This corresponds with the time when the revenue is typically recognized by a taxpayer for tax purposes. Accordingly, under these circumstances, new section 451(b) is unlikely to have a significant effect on the time for reporting income for tax purposes.

However, in the case of certain types of transactions, ASC 606 imposes a new standard for revenue recognition for financial reporting purposes that represents a significant departure from past practice. The types of transactions that are most significantly affected by ASC 606 involve an entity that has a contract with a customer to produce goods for the customer that meets one of the three conditions described below.

In those circumstances, the entity is required to recognize the income from the contract for financial reporting purposes over time as the entity performs the work under the contract using a book percentage-of-completion method, rather than at the single point in time when the goods are shipped or delivered to the customer. The three conditions that require this type of reporting are:

ASC 606, ¶ 606-10-25-27.

Financial accountants have generally interpreted the foregoing conditions as being satisfied in the case of a contract calling for goods to be produced to the specifications of a customer and where the goods would generally not be saleable to other customers. In such circumstances a percentage-of-completion type of method (referred to herein as a “book PCM method”) is required to be used for financial reporting purposes, even though this method is not required or permitted to be used for tax purposes because the contract does not meet the definition of a long-term contract in section 460(f) of the Code.

This set of circumstances poses considerable complexities with respect to the application of both section 451(b) and section 451(c) of the Code. For example, issues arise with respect to the application of the financial conformity rules relating to the deferral of advance payments in a case where a taxpayers financial accounting method does not specifically account for advance payments received under such a contract, as is the case with the percentage-of-completion method. In addition, the potential for mismatching of revenue and expenses is particularly acute in circumstances where a taxpayer uses a book PCM method for financial reporting purposes, but the taxpayer uses an accrual-shipments method or a units-of-delivery method for tax purposes.

As noted earlier, this comment letter addresses the concept of providing taxpayers with the ability to elect to use their book PCM method for tax purposes as a way of avoiding the complexities that would result from being required to use two entirely separate and very different methods of accounting for book and tax purposes.

In addition, neither section 451(b) nor section 451(c) deals explicitly with the issue of whether, or how, costs of performance are taken into account in applying these provisions. More specifically, these provisions do not explicitly address the issue of whether, when sales revenue is reported for tax purposes sooner than it would otherwise be reported for tax purposes as a result of applying either section 451(b) or section 451(c), the amount of sales revenue that is accelerated is offset by the amount of costs that are properly associated with that amount of sales revenue.

Thus, one of the most significant issues that is raised by section 451(b) and section 451(c) is whether such a cost offset is required. As noted earlier, we addressed this issue in our comment letter dated June 14, 2018, and we address this subject in greater detail in this comment letter as well, in addition to providing specific proposed language to address this issue in the regulations.

II. Allowance of an optional book percentage-of-completion method

A. Description of proposal

In light of the complexities mentioned above and the potential for mismatching of revenue and expenses, we recommend that consideration be given in any proposed regulations that are issued under section 451(b) and section 451(c) to permitting a taxpayer that uses a book PCM method for financial reporting purposes for a contract involving the production and/or sale of goods and related services that are integral to the production and/or sale of the goods,¹ but for which the taxpayer uses the accrual-shipments method or the units-of-delivery method for tax purposes, to instead elect to use the taxpayer's book PCM method for tax purposes for the contract, even though the contract would not otherwise be subject to section 460 of the Code. Under this elective method for tax purposes, a taxpayer would calculate each year's total gross receipts with respect to a contract for which an election is made in the same way the taxpayer reports income for financial reporting purposes, namely, by computing the ratio of the total costs incurred to date on the contract to the total estimated costs to complete the contract.

The resulting percentage of the contract that is considered complete as of the end of each taxable year would be multiplied by the total expected contract price to establish the cumulative portion of the total contract revenue that must be recognized. The total expected contract price is determined by taking into account both the fixed portion of the contract price and any additional revenue from the contract that is contingent on future events, but that the taxpayer reasonably expects to earn.

The cumulative amount of revenue required to be recognized on the contract as of the end of the current taxable year would be compared with the cumulative revenue recognized in prior taxable years, and the difference would be recognized as revenue in the current taxable year. Any costs incurred during the taxable year incident to the performance of the contract would be treated as an offset to the contract revenue as the costs are incurred to determine the amount of gross income on the contract that is recognized in that taxable year.

The proposed method would be elective, but if the election is made, the taxpayer's book PCM method would be required to be used for tax purposes for all the contracts in the taxpayer's trade or business that are accounted for under the PCM method for financial reporting purposes pursuit to ASC 606, regardless of whether the contracts were entered into prior to or after the effective date of section 451(b) and section 451(c). The election would be treated as a change in method of accounting and would be made by filing a Form 3115 under the automatic consent procedures in Rev. Proc. 2018-31, 2018-22 IRB 637, for the first taxable year to which section 451(b) and section 451(c) would otherwise apply. The accounting method change would result in a section 481(a) adjustment that would be taken into account by the taxpayer in accordance with the provisions in Rev. Proc. 2018-31.

The election would be binding on the taxpayer for all contracts in the trade or business to which the election applies that are eligible for the election. As discussed below, this aspect of the proposed election is intended to achieve the goal of simplification that is the principal rationale for the proposed election. Moreover, this aspect of the proposed election is also consistent with the general principle that accounting methods ordinarily apply separately to each separate trade or business that is operated by a taxpayer. To revoke the election, the taxpayer would be required to file a non-automatic accounting method change request and obtain the consent of the Commissioner to change to a different method of accounting.

If the election to use the book PCM method for tax purposes is made, the amount of gross income from any contract to which the election applies that is reported for tax purposes for a particular taxable year would be equal to the amount of gross income reported for that contract for financial reporting purposes for that year. As a result, this reporting would be consistent with the requirements of section 451(b), and accordingly section 451(b) would not require any additional gross income acceleration beyond the acceleration that results from the taxpayer's use of the book PCM method for tax purposes.

In addition, the election to use the book PCM method for tax purposes would also be consistent with the provisions in section 451(c) with respect to any contract to which the election was applicable, so that any progress payments received with respect to such a contract would be taken into account only for purposes of determining the total expected contract price, and as a result section 451(c) would not require any additional gross income acceleration with respect to the contract.

B. Suggested regulatory language

Set forth below is suggested regulatory language to implement this proposal.

(h) Optional method for certain taxpayers.

C. Discussion of issues addressed by proposal

1. Allowance of a book PCM option for tax purposes is consistent with the policy objectives in TCJA

One of the principal goals of Congress in enacting the amendments to section 451 in the TCJA was to encourage a more efficient income tax regime that reduces the disparities between net income that is reported for financial accounting purposes and taxable income that is reported for tax purposes. More specifically, the amendments to section 451 were designed to provide a more accurate picture of a taxpayer's taxable income by conforming the measurement of taxable income with the measurement of net income as it is reported to shareholders and the SEC.

Since ASC 606 had been issued in 2014, although it was not immediately effective, the enactment by Congress of the amendments to section 451 in the TCJA in December of 2017 was unquestionably intended to conform the revenue recognition rules in section 451 to those in ASC 606. Since, under ASC 606, many contracts for the production and/or sale of goods that had not previously been required to be accounted for using the percentage-of-completion method for financial reporting purposes would now be required to be accounted for using this method, the enactment of these amendments had the effect of promoting conformity between the tax rules for revenue recognition and the accelerated reporting of gross income under these new financial reporting rules.

Moreover, Congress's desire to conform the tax rules for revenue recognition to the new financial reporting rules in ASC 606 is further demonstrated by the provision in section 451(b)(4) (and the parallel provision in section 451(c)(4)(D)), which provides that in the case of a contract containing multiple performance obligations, the allocation of the total transaction price among the multiple performance obligations is to be made in the same way the allocation is made for purposes of reporting revenue in the taxpayer's applicable financial statements. Not only does this allocation rule parallel a specific rule in ASC 606, but the use of the term “performance obligation” likewise parallels the terminology in ASC 606. The term “performance obligation” was not a term that had previously been commonly used in the tax law. In conclusion, permitting a taxpayer's book PCM method to be used for tax purposes is entirely consistent with Congress' goals in enacting section 451(b) and section 451(c).

In contrast, compelling a taxpayer that is required to use a percentage-of-completion method for financial reporting purposes to continue to use the accrual-shipments method or the units-of-delivery method for tax purposes conflicts with that goal. Denying taxpayers that are required to use a percentage-of-completion method for financial reporting purposes the ability to use that same method for tax purposes would create even greater differences between tax and financial reporting than existed before the enactment of section 451(b) and section 451(c) and the adoption of ASC 606. Accordingly, since ASC 606 will prevent certain contracts for the production and/or sale of goods from being reported on the accrual-shipments method or the units-of-delivery method for financial reporting purposes, permitting such contracts to be accounted for on the same method for tax and financial reporting purposes will promote the goal of conformity between those methods.

Moreover, from the point of view of record-keeping, since costs that are accounted for on a book PCM method for financial reporting purposes would be treated as reducing net income for financial reporting purposes at the time the costs are incurred, a taxpayer's book accounting system would not ordinarily retain the costing information that would be necessary to compute the deferred costs that remain in a taxpayer's inventory for tax purposes under an accrual-shipments method or a units-of delivery method. Requiring non-conforming reporting for tax and financial reporting purposes will impose significant record-keeping burdens on taxpayers.

Finally, in any case where a contract that is reported under a book PCM method for financial reporting purposes calls for progress payments during the performance of the contract, accounting for those progress payments on an accrual-shipments method or units-of-delivery method for tax purposes will introduce extreme administrative complexity with respect to the application of section 451(c). In contrast, under the percentage-of-completion method, the receipt of progress payments plays no role in the calculation of income from a contract except with respect to the determination of the total contract price.

Accordingly, it is unclear how the financial conformity requirement in section 451(c) could even be applied for tax purposes where progress payments are received during the performance of a production and/or sale contract that is accounted for on a percentage-of-completion method for financial reporting purposes. Thus, permitting a taxpayer's book PCM method to be used for tax purposes, so that section 451(c) would not require any additional income acceleration beyond the income acceleration that occurs under the book PCM method itself, would avoid all the complex issues that would otherwise arise with respect to the application of the financial conformity rule in section 451(c). These considerations strongly support the option of permitting an elective book PCM method for tax purposes.

2. Use of a book PCM method versus the tax PCM method in section 460

The first issue that is addressed by this proposal is whether a taxpayer using a book PCM method for financial reporting purposes pursuant to the principles in ASC 606 for contracts to produce goods (and related integral services) for customers, but using the accrual-shipments method or units-of-delivery method for these contracts for tax purposes, should be permitted to use that same book PCM method for tax purposes, or whether instead the taxpayer should be permitted for tax purposes to use the percentage-of-completion method as provided in section 460. There are several reasons why this proposal adopts the approach of permitting the use of the taxpayer's book PCM method for tax purposes.

First, from the point of view of statutory authority, section 460 applies to any contract that meets the definition of a long-term contract under section 460(f) of the Code. This section does not contemplate the possibility that taxpayers might electively use the percentage-of-completion method for contracts that are not long-term contracts as they are defined in section 460(f).

Moreover, since the use of the PCM method for tax purposes is mandatory in the case of any contract that meets the definition of a long-term contract, expanding the definition of “unique items” to cover the types of contracts for which the book PCM method is required for financial reporting purposes under ASC 606 would not permit the electivity that is an important element of this proposal. In addition, while the definition of “unique items” might be expanded to encompass many of the situations for which the book PCM method is required, there is no assurance that the definition could be expanded in a way that would perfectly match the situations covered by ASC 606.

In contrast, section 446(a) provides that, as a general rule, a taxpayer is required to use the same method of accounting for tax purposes that is used by the taxpayer in keeping its books. Moreover, section 446(b) confers on the IRS broad authority to require a taxpayer to use a different method of accounting for tax purposes than the method used for financial reporting purposes, if the method of accounting used by a taxpayer for financial reporting purposes fails to clearly reflect the taxpayer's income for tax purposes. Under these provisions, we believe the IRS has greater latitude to permit the use of a new method of accounting for tax purposes, a book PCM method, rather than to permit the use of the percentage-of-completion method described in Treas. Reg. § 1.460-4 to account for contracts that do not fall within the current definition of a long-term contract.

Second, from the point of view of administrability, permitting a taxpayer to follow its book PCM method for tax purposes would be a far simpler approach for taxpayers to apply and for the IRS to audit than would be the case if the percentage-of-completion method prescribed in Treas. Reg. § 1.460-4 were permitted to be used for tax purposes on an elective basis for contracts that would not otherwise be considered long-term contracts. While the basic operation of book PCM and section 460 are similar in terms of measuring progress toward completion based on the proportion of costs incurred to total expected contract costs, nevertheless, there are also numerous differences between the percentage-of-completion method that is prescribed for tax purposes under section 460 and the book PCM method under ASC 606 that would need to be addressed from the point of view of record-keeping, if a taxpayer could not simply follow its book PCM method for tax purposes.

For example, special rules are provided in the section 460 regulations to determine when a contract is considered complete for tax purposes. No such rules apply for financial reporting purposes. Second, the section 460 regulations contain special rules for determining when progress towards completion of a contract begins, whereas no such rules apply for financial reporting purposes. Third, detailed rules apply for tax purposes to determine what costs to include in the estimated costs to complete a contract. These rules are inapplicable for financial reporting purposes. Fourth, the section 460 regulations contain detailed rules for determining whether a single long-term contract is severed into two or more separate agreements or whether two or more separate agreements should be aggregated into a single long-term contract. These severing and aggregating rules are not necessarily the same as the rules that apply for financial reporting purposes. Finally, special look-back rules apply for tax purposes to reconcile a taxpayer's estimate of the costs to complete a contract with the actual costs incurred. These special rules apply for tax purposes after a long-term contract has been completed. However, these rules are inapplicable for financial reporting purposes.

In light of the foregoing disparities between the percentage-of-completion method that is applied for financial reporting purposes and the percentage-of-completion method that is required under section 460, it would be much easier for taxpayers to use their book PCM method for tax purposes instead of a section 460 PCM method. If the goal of allowing some form of percentage-of-completion method to be used for tax purposes in a case where a taxpayer accounts for a contract for financial reporting purposes under a book PCM method is to achieve simplification for both taxpayers and the IRS, it would be inconsistent with that goal to require different percentage-of-completion methods to be used for tax and financial reporting purposes.

In addition, from the point of view of taxpayers' record-keeping, it would be much simpler if taxpayers could account for contracts reported on a book PCM method for financial reporting purposes to use that same method for tax purposes. If taxpayers were instead required under this option to use a tax version of the percentage-of-completion method, taxpayers would be required to maintain significant records that would not otherwise be necessary to track progress towards completion on a book basis.

Moreover, there is no suggestion that the special rules for measuring progress towards completion in the income tax regulations are appreciably biased in the direction of reporting revenue sooner or later for tax purposes than under a book PCM method. Accordingly, there would not be any built-in biases in favor of taxpayers if a book PCM option were allowed, as opposed to permitting the percentage-of-completion method as prescribed in Treas. Reg. § 1.460-4(b) to be used for tax purposes for contracts not otherwise satisfying the definition of a long-term contract in section 460(f).

For these reasons, the proposal adopts the approach of permitting the use of a book PCM option for tax purposes, rather than requiring taxpayers to follow the percentage-of-completion method described in Treas. Reg. § 1.460-4(b) if they wish to elect PCM for contracts that would not otherwise be considered long-term contracts.

3. Scope of election

Another issue that is addressed in this proposal is the scope of the proposed election to use a book PCM method for tax purposes. The proposal adopts the approach of requiring a taxpayer that chooses to use its book PCM method for tax purposes to apply that method to all contracts within a trade or business that are reported on the book PCM method for financial reporting purposes but that are reported for tax purposes on the accrual-shipments method or the units-of-delivery method. This exclusivity approach serves three main purposes.

First, this approach is most consistent with advancing the goal of making accounting methods with respect to revenue recognition more administrable. If a taxpayer were permitted to use its book PCM method for tax purposes for only those contracts that the taxpayer desired, while permitting the taxpayer to continue using the accrual-shipments method or the units-of-delivery method for other contracts reported on the book PCM method for financial reporting purposes, the resulting hybrid approach would not promote the goal of simplification. In fact, that type of hybrid approach would introduce additional complexity into the tax system.

Second, in light of the compelling benefits of administrability from using a taxpayer's book PCM method for tax purposes, the only conceivable justification for a taxpayer making selective use of the book PCM option would be in order to take advantage of that method when that method produces a more favorable tax result than the accrual-shipments method or units-of-delivery method, but instead use the accrual-shipments method or the units-of-delivery method when that method produces a more favorable tax result than the book PCM method. To make the book PCM option fair to both the IRS and taxpayers, we believe the choice between a book PCM method and the accrual-shipments method or the units-of-delivery method should be based on considerations of administrability alone and should not be based on which method produces a more favorable tax result.

Finally, making the election to use the book PCM method apply to all contracts in the same trade or business operated by a taxpayer for which the PCM method is used for book purposes is consistent with the normal principle that methods of accounting ordinarily apply to an entire trade or business. For the foregoing reasons, the proposal adopts an all-or-nothing approach with respect to the book PCM option for each trade or business of a taxpayer.

4. Method of election and binding effect of election

The proposal also deals with the issue of how to elect the book PCM method, regardless of whether the contracts that are subject to the election were entered into prior to, or after, the effective date of section 451(b) and section 451(c). The proposal treats the adoption of the book PCM method for tax purposes as a change in method of accounting requiring the consent of the Commissioner.

Thus, taxpayers adopting the book PCM option would be required to file a Form 3115 for the first taxable year to which taxpayers seek to apply the book PCM option for tax purposes. The accounting method change would be eligible for the automatic consent procedures in Rev. Proc. 2018-31, 2018-22 I.R.B. 637. Any section 481(a) adjustment that results from such an accounting method change would be taken into account in accordance with the provisions in Rev. Proc. 2018-31.

5. Coordination with section 451(b) and section 451(c)

As discussed above, a taxpayer electing to use its book PCM method for tax purposes would not be subject to any additional gross income acceleration as a result of the application of the provisions of either section 451(b) or section 451(c). Under a book PCM election, since income with respect to the contracts covered by the election would be reported for tax purposes at the same time the income is reported in the taxpayer's financial statements, section 451(b) would not require any additional gross income acceleration with respect to these contracts beyond the gross income acceleration that results from application of the book PCM method.

Moreover, the allowance of the use of a book PCM method for tax purposes avoids the issue discussed in the other main part of these comments, which is whether a taxpayer using the accrual-shipments method or the units-of-delivery method of accounting for tax purposes is entitled to an offset for its actual and estimated cost of goods sold that are allocable to any revenue that is accelerated by reason of the operation of either section 451(b) or section 451(c). The percentage-of-completion method has its own rules for the treatment of the costs of performing a contract that is accounted for on the percentage-of-completion method, and those rules uniformly treat the costs of performance as a reduction in taxable income in the taxable year the costs are incurred, regardless of when the property is completed and delivered to the customer.

Thus, costs are never taken into account under the percentage-of-completion method before the costs are incurred (except, of course, for purposes of estimating the total costs to be incurred under the contract for purposes of measuring progress toward completion). Accordingly, the offset issue for cost of goods sold is avoided if the percentage-of-completion method is used for tax purposes.

With respect to the application of section 451(c), the operation of that provision in a case where a taxpayer uses the percentage-of-completion method for financial reporting purposes but uses the accrual-shipments method or the units-of-delivery method for tax purposes introduces a number of complexities with respect to the application of the financial conformity requirement in section 451(c)(4)(A)(ii). The reason the application of the financial conformity requirement poses complex problems in a case where a taxpayer uses the percentage-of-completion method for financial reporting purposes is that under the percentage-of-completion method, the timing of the receipt of advance payments does not affect the timing of reporting the taxpayer's gross income.

Accordingly, difficult issues are posed with respect to the application of the financial conformity requirement in section 451(c)(4)(A)(ii) if a taxpayer is required to use the percentage-of-completion method for financial reporting purposes, but continues to use an accrual-shipments method or units-of-delivery method for tax purposes. These issues did not exist prior to the enactment of section 451(c).

These difficult issues would be avoided if a taxpayer is permitted to elect to use its book PCM method for tax purposes. Under the proposal, section 451(c) would not result in any additional gross income acceleration to a taxpayer that elects to use its book PCM method for tax purposes beyond the gross income acceleration that results from application of the book PCM method, since the receipt of advance payments does not affect the operation of the book PCM method.

In conclusion, we submit that there are numerous sound policy reasons why a taxpayer should be permitted to use its book PCM method for tax purposes in appropriate circumstances.

III. Cost offset against section 451(b) inclusions in gross receipts

A. Description of proposal

In applying section 451(b), any amount of sales revenue or gross receipts that is required to be accelerated for tax purposes by reason of the application of section 451(b) would be offset by the amount of costs properly associated with that amount of sales revenue or gross receipts. The cost offset would include both costs that have already been incurred at the time of the required inclusion in sales revenue or gross receipts and costs that have not yet been incurred at that time but that are expected to be incurred in the future. The amount of costs properly associated with the inclusion in sales revenue or gross receipts would be determined on a pro rata basis in proportion to the ratio of the inclusion in sales revenue or gross receipts to the total expected contract price.

B. Suggested regulatory language

(b) Treatment of cost of goods sold. —

(1) If as a result of the application of § 451(b), an amount of sales revenue relating to an agreement with a customer for the production and/or sale of goods (including related services that are integral to the production and/or sale of the goods) is required to be included in a taxpayer's gross receipts in an earlier taxable year than the taxable year when the amount of sales revenue would otherwise be included in the taxpayer's gross receipts under the taxpayer's regular accrual method of accounting (such as the accrual-shipments method or the units-of-delivery method), but for the application of § 451(b), the taxpayer must reduce such amount of sales revenue by the actual and estimated cost of goods sold allocable to such amount of sales revenue (as determined in paragraph (b)(2)) in order to determine the amount of gross income that is taken into account in computing the taxpayer's gross income by reason of the application of § 451(b).

(2) Determination of the amount of cost of goods sold that is properly allocable to an amount of sales revenue. In order to determine the amount of cost of goods sold that is properly allocable to an amount of sales revenue under paragraph (1), the taxpayer must apply the following steps:

(i) Compute the total estimated cost of goods sold with respect to the contract in respect of which § 451(b) applies.

(ii) Determine the total contract price with respect to the contract in subdivision (i).

(iii) Divide the total estimated cost of goods sold in subdivision (i) by the total contract price in subdivision (ii) to compute the expected cost of goods sold percentage with respect to the contract.

(iv) Multiply the expected cost of goods sold percentage computed in subdivision (iii) by the amount of sales revenue that is included in the taxpayer's gross receipts for the taxable year in subsection (b)(1) to determine the portion of the total estimated cost of goods sold in subdivision (i) that is treated as a reduction from the taxpayer's gross receipts in computing the effect on the taxpayer's gross income by reason of the application of § 451(b) to the contract in subdivision (i).

(v) For purposes of subdivision (i), the taxpayer's total estimated cost of goods sold with respect to a contract is determined in accordance with the principles in § 1.61-3(a).

(3) Reconciliation at the time of related subsequent events. To the extent an amount of sales revenue and an amount of cost of goods sold (resulting in an amount of gross income) are taken into account in a particular taxable year under § 451(b), such amounts shall not be taken into account again in any later taxable year, such as in the taxable year when the taxpayer receives a payment on the contract or when the goods that are the subject of the contract are delivered to the customer.

C. Discussion of issues related to proposal

1. Legal basis for allowing a cost offset under section 451(b)

a. The reference in section 451(b)(1)(A) to “any item of gross income” as the amount that is subject to acceleration based on the financial accounting treatment of the item supports allowing a cost offset under section 451(b).

The use of the phrase “any item of gross income” in the statement of the income acceleration rule in section 451(b)(1)(A) is the consideration that provides the strongest support for the conclusion that a cost offset for cost of goods sold should be permitted under section 451(b) in the case of income derived from the sale of goods, since in such a case it is clear that the total amount of the “item of gross income” from the sale is the total amount of sales revenue on the sale less the amount of cost of goods sold that is associated with the sale. “Gross income” is a technical term and concept in the tax law that has a very clearly defined meaning, particularly in the case of gross income from the sale of goods.

The income acceleration rule in section 451(b)(1)(A) provides that for a taxpayer using the accrual method of accounting, “the all events test with respect to any item of gross income (or portion thereof) shall . . . be treated as met [no] later than when such item (or portion thereof) is taken into account as revenue” for financial accounting purposes (emphasis added). Thus, section 451(b) is applicable to “any item of gross income (or portion thereof)” that is included in revenue for financial accounting purposes.

In the case of a sale of goods, Treas. Reg. § 1.61-3(a) makes clear that the amount of “gross income” on the sale is the amount of sales revenue on the sale less the amount of cost of goods sold that is associated with the sale:

In a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold. . . . Gross income is determined . . . without subtraction of selling expenses, losses or other items not ordinarily used in computing costs of goods sold. . . . The cost of goods sold should be determined in accordance with the method of accounting consistently used by the taxpayer.

The detail that is provided in this section of the regulations regarding items that are not included in cost of goods sold (“selling expenses, losses or other items not ordinarily used in computing costs of goods sold”), together with the statement that “cost of goods sold should be determined in accordance with the method of accounting consistently used by the taxpayer,” confirm that the concept of cost of goods sold generally has a well understood meaning for purposes of determining the amount of gross income from a sale of goods. Case law follows this concept that in the case of a sale of goods, the amount of gross income from the sale is the amount of sales revenue from the sale less the amount of cost of goods sold that is associated with the sale. See, e.g., Max Sobel Wholesale Liquors v. Commissioner, 630 F.2d 670, 671 (9th Cir. 1980) (“[T]ax law distinguishes between exclusions from gross income ('above the line' items) and deductions from gross income ('below the line' items). 'Gross income,' I.R.C. § 61, is determined by subtracting all 'above the line' items from gross receipts. See Reg. § 1.61-3(a).”) (citations omitted).

Thus, in the case of a sale of goods, when section 451(b)(1)(A) refers to “any item of gross income,” it is very clear that the income amount to which section 451(b)(1)(A) refers is the selling price of the goods less the cost of goods sold associated with the sale. It would not be consistent with the use of the phrase “any item of gross income” in section 451(b)(1)(A) to conclude that the amount by which a taxpayer's taxable income is increased by reason of the application of section 451(b) is, for example, the total amount of sales revenue on a sale, since that amount does not reflect the offset for cost of goods sold that is clearly a necessary element in the determination of the amount of gross income from a sale of goods.

The type of factual situation involving a contract for the production and/or sale of goods² where section 451(b) will have its most significant effects is where the contract is required to be accounted for using the percentage-of-completion method for financial reporting purposes under ASC 606 but where the units of delivery method is used for tax purposes. In this type of factual situation, the fact that the income acceleration under section 451(b) occurs as a result of the use of the percentage-of-completion method for financial accounting purposes, so that only a portion of the total gross income on a particular contract, or even on a particular unit, is reported in a particular year, should not affect the conclusion that a cost offset should be allowed against the amount of gross receipts or sales revenue that is accelerated under section 451(b), since the income acceleration rule in section 451(b)(1)(A) refers not only to “any item of gross income” but also to a “portion thereof”

When the percentage-of-completion method is used, the amount of gross income that is reported each year is based on the portion of the total contract price that is reported for that year, less the amount of costs relating to the contract that are incurred that year. The difference between these two amounts for any year clearly represents the “portion” of the total amount of gross income on the contract that is reported that year, and this “portion” clearly comes within the terms of section 451(b)(1)(A) as representing a “portion” of the total “item of gross income” consisting of the total gross income on the contract as a whole.

It has been suggested that the reference in section 451(b)(1)(A) to a “portion” of an “item of gross income” might be interpreted as applying to the amount of gross receipts that is associated with the particular item of gross income, but without the associated cost of goods sold amount being taken into account as an offset to the gross receipts amount. We submit that this interpretation of the reference to a “portion” of an “item of gross income” in section 451(b)(1)(A) would not be reasonable.

The word “portion” means a part of a whole amount that is less than the entirety of the whole amount. However, the amount of gross receipts that is associated with an item of gross income in the case of a sale of goods is not less than the whole amount of the item of gross income but is instead larger than the whole amount of the item of gross income. For example, if an item of gross income from the sale of goods has an amount of gross receipts of $100X associated with it, and the associated cost of goods sold amount is $60X, the amount of the item of gross income is $40X, equal to the $100X amount of gross receipts less the $60X cost of goods sold amount. In this example, the gross receipts amount of $100X is clearly not a portion of the $40X amount of the item of gross income, since the gross receipts amount is necessarily larger than the associated amount of the item of gross income.

An additional reason why a cost offset should be allowed under these circumstances for purposes of section 451(b) is the fact that financial reporting under the percentage-of-completion method pursuant to ASC 606 reflects a cost offset for the costs of performing the contract. Although section 451(b) does not explicitly refer to the treatment of costs for financial accounting purposes, nevertheless, the general thrust of section 451(b) in requiring income acceleration for tax purposes to reflect financial accounting income reporting supports the notion that the treatment of costs for tax purposes should be parallel to the treatment of costs for financial reporting as well.

The effect on the amount of net income that is reported for financial accounting purposes under ASC 606 when the percentage-of-completion method is used is limited to the difference between the portion of the total contract price that is reported in a particular year and the amount of costs relating to the contract that are incurred that year. As a result, the general policy of financial conformity that is reflected in section 451(b) should be satisfied if the effect on taxable income of applying section 451(b) is the same as the effect of the particular contract on the amount of net income that is reported for financial accounting purposes, which will be the case only if a cost offset is permitted.

b. The economic performance requirement does not provide a basis for denying a cost offset under section 451(b).

The IRS might argue that the acceleration of an offset for the cost of performance prior to the transfer of the completed goods to a customer is prohibited by the economic performance requirement in section 461(h). The IRS might argue that in the case of a contract obligating a taxpayer to produce property and deliver the completed property to the customer, section 461(h)(2)(B) requires that the property be provided to the customer in order to satisfy the economic performance requirement.

However, the regulations under section 461(h) provide that delivery of the property to the customer is not necessary for the economic performance requirement to be satisfied. Instead, Treas. Reg. § 1.461-4(d)(4)(i) provides that if a taxpayer's liability requires the taxpayer to provide property to another person, economic performance occurs as the taxpayer incurs costs in satisfying the obligation. Thus, with respect to costs of performance that have already been incurred, transfer of the goods to the customer is not necessary to satisfy the economic performance requirement.

The issue of the inclusion in the cost offset of expected future costs, as opposed to costs that have already been incurred, does not arise under section 451(b) in the type of factual situation on which this comment letter is focused. As discussed previously, the factual situation in which section 451(b) will have its most significant effects in connection with contracts for the production and/or sale of goods involves contracts that have previously (before 2018) been accounted for both for financial accounting purposes and for tax purposes using a units-of-delivery method of accounting, but where ASC 606 will now require that income be reported for financial accounting purposes based on the work that has been performed on units that have not yet been delivered under a percentage-of-completion method of reporting. Under that method, the measurement of progress towards completion is based on the amount of costs that have been incurred in proportion to the expected total contract costs.

In this type of situation, the application of section 451(b) will require the acceleration of income recognition for tax purposes based on the income that is recognized for financial reporting purposes under ASC 606. In this type of factual situation, the issue of a cost offset for expected future costs does not arise, since the financial accounting income that is recognized under ASC 606 under the percentage-of-completion method is based exclusively on costs that have actually been incurred through the end of the reporting period. Nevertheless, we believe it is appropriate to discuss the propriety of a cost offset for expected future costs under section 451(b) because of the possibility that there could be other types of factual situations where the cost offset issue could arise under section 451(b) with respect to expected future costs, and because we believe the resolution of the issue of the treatment of expected future costs under section 451(b) is relevant to the resolution of the issue of the treatment of expected future costs under section 451(c).

The type of situation where the issue of a cost offset for expected future costs could in fact arise under section 451(b) would involve a contract for the production and/or sale of goods where ASC 606 does not require the use of the percentage-of-completion method, but where ASC 606 instead requires the recognition of income on the contract for financial reporting purposes at a single point in time that is earlier than the point in time when the income on the contract is recognized for tax purposes, and where, at the point in time when the income is recognized for financial reporting purposes under ASC 606, there are some costs that are required to complete work on the contract that have not yet been incurred. Accordingly, the inclusion in the cost offset under section 451(b) of costs that have not yet been incurred is addressed in a later subsection of this comment letter, including the applicability of the economic performance requirement in the case of such costs.

c. A comparison between section 451(b) and the corresponding provision of the Camp tax reform proposal supports allowing a cost offset under section 451(b).

It has been suggested that sections 451(b) and 451(c) as enacted by the TCJA should be interpreted by reference to the corresponding provisions in the 2014 Camp tax reform proposal from which these provisions were derived. The corresponding provisions in the Camp proposal were included in section 3303 of that proposal. As explained below, the wording of the Camp proposal was less supportive of the notion of a cost offset than is the language that was actually used in section 451(b), and the contrast between the wording of the Camp proposal and the text of section 451(b) as enacted by the TCJA provides further support for the conclusion that a cost offset should be allowed under section 451(b).

With respect to the provision in the Camp proposal that corresponded to section 451(b) as enacted by the TCJA, the provision in the Camp proposal stated that for a taxpayer using the accrual method of accounting, “the amount of any portion of any item of income shall be included in gross income not later than the taxable year with respect to which such amount is taken into account in income” for financial accounting purposes. While this provision was unquestionably similar to section 451(b) as enacted by the TCJA, nevertheless, there are also notable differences between the two provisions.

The most significant difference between the wording of the two provisions relating to the argument that a cost offset should be allowed under section 451(b) is that while section 451(b) as enacted uses the term “any item of gross income,” in contrast, the corresponding provision in the Camp proposal used the term “any item of income.” The change from “any item of income” to “any item of gross income” makes clear that the use of the phrase “any item of gross income” in section 451(b) as enacted represented a conscious and deliberate decision on the part of the drafters of section 451(b) to measure the effect on taxable income with reference to the definition of gross income in the tax law. As discussed above, in the case of a sale of goods, it is clear that the “item of gross income” is the amount of sales revenue on the sale less the amount of cost of goods sold associated with the sale.

Other differences between section 451(b) as enacted and the corresponding provision of the Camp proposal likewise make clear that section 451(b) as enacted by the TCJA was not simply copied from the Camp proposal. For example, section 451(b) phrases its operative rule in terms of the time when the all events test is satisfied, but the corresponding provision in the Camp proposal made no reference to the all events test.

Section 451(b) as enacted states the test based on the financial accounting effect in terms of financial accounting “revenue,” which clearly contrasts with the use of the term “item of gross income” to refer to the taxable income effect. In contrast, the corresponding provision in the Camp proposal stated the test based on the financial accounting effect in terms of financial accounting “income,” which was the same term that was used to describe the taxable income effect.

The use of different terms in section 451(b) to refer to the effect on taxable income and the effect on financial accounting net income, in contrast to the use of the same term for both effects in the Camp proposal, supports the conclusion discussed above that of the language in section 451(b) was intended to clarify the Camp proposal to insure that an offset for cost of goods sold would be allowed. Accordingly, since the terminology in section 451(b) is much more consistent with the interpretation that a cost of goods sold offset is permitted in apply section 451(b), the language in section 451(b) clearly supports the conclusion that the phrase “item of gross income” should be given the precise technical meaning this phrase has in the tax law, a meaning that unquestionably incorporates the inclusion of a cost offset in the case of an “item of gross income” from the sale of goods.

d. Relationship between cost offset issue and elective use of book PCM

In the preceding major section of this comment letter, we recommended that the IRS and Treasury permit taxpayers to elect for tax purposes to use their book PCM method for any contracts that are subject to the PCM method for book purposes but not for tax purposes. However, if the IRS and Treasury make the decision to permit taxpayers to elect to use the book PCM method for tax purposes, we do not believe the IRS and Treasury should view that decision as eliminating the need for confirming the existence of a cost offset under section 451(b) and section 451(c), in the event a taxpayer chooses not to take advantage of this elective use of book PCM, or in the event the book PCM election is not available in the particular circumstances of the taxpayer. As discussed in detail below, we believe that providing a cost offset under both provisions represents the clearly correct legal answer.

Moreover, while this comment letter focuses on the type of situation where ASC 606requires use of the PCM method for book purposes, but where the taxpayer uses the accrual-shipments method or the units-of-delivery method for tax purposes, that type of situation is not the only type of situation that is affected by section 451(b). Instead, section 451(b) also applies in the case of a contract for the production and/or sale of goods where ASC 606 does not require the use of the percentage-of-completion method, but where ASC 606 instead requires the recognition of income on the contract for financial reporting purposes at a single point in time that is earlier than the point in time when the income on the contract is recognized for tax purposes.

For example, that type of situation might exist where a taxpayer produces and completes goods under a contract with a customer but does not deliver the goods to the customer immediately after the goods are completed. Under ASC 606 the taxpayer might be required to recognize the sales revenue for financial reporting purposes at the time the goods were completed. However, for tax purposes, the sale of the goods might not be recognized until the goods are delivered in the subsequent taxable year.

Under section 451(b), in the absence of a cost offset in these circumstances, the taxpayer would be required to recognize as sales revenue for tax purposes the entire sales price of the goods, but would not have the benefit of a cost of goods sold offset until the subsequent taxable year. Elective use of book PCM would not be available in this type of situation, since the taxpayer would not be using PCM for book purposes under ASC 606, so a taxpayer in this position could not avoid the adverse effects of being denied a cost offset under section 451(b) through the use of elective book PCM. Accordingly, a book PCM election does not resolve all the potential mismatches of revenue and cost of goods sold if a cost offset is not permitted under section 451(b).

For the foregoing reasons, we do not believe the IRS and Treasury should deny a cost offset on the grounds that taxpayers can avoid this adverse result by electing to use book PCM for tax purposes.

2. Should the cost offset under section 451(h) include expected future costs?

Another issue addressed by the proposal is whether the amount of costs that are allowed as an offset under section 451(b) should be limited to costs that have already been incurred at the time section 451(b) affects taxable income, or instead whether all expected future costs relating to the total amount of sales revenue or gross receipts that is accelerated under section 451(b) should be taken into account. The proposal adopts the approach of permitting a cost of goods sold offset for both actual costs that have already been incurred and estimated future costs that will ultimately be included in cost of goods sold.

The proposal adopts this approach because the true ultimate amount of gross income on the transaction will necessarily reflect all future costs that are properly associated with the relevant amount of sales revenue. Failure to reflect future costs in the cost offset under section 451(b) will not give a correct and accurate amount for the “item of gross income” to which section 451(b) applies.

One potential objection to this conclusion might be that, as noted above, costs are not ordinarily taken into account for federal income tax purposes until they are considered incurred within the meaning of the all-events test, including the application of the economic performance requirement. Costs that are expected to be incurred in the future clearly do not satisfy the economic performance requirement, so that allowing a cost offset for costs in this category might potentially be viewed as being inconsistent with the economic performance requirement. However, there are several reasons why this possible objection is not valid.

First, the amount of expected future costs that are taken into account as part of the cost offset in this context are solely for purposes of determining the amount of gross income that is accelerated under section 451(b). The only reason it is necessary to determine the amount of expected future costs is because of the acceleration of income that is required under section 451(b). In light of this circumstance, permitting a cost offset that includes costs that are expected to be incurred in the future should not be viewed as being inconsistent with the economic performance requirement.

Instead, in a case where it is known that it will be necessary to incur some amount of costs in the future in order to complete production and/or sale of the goods that are responsible for the amount of sales revenue or gross receipts that is being accelerated into income under section 451(b), it is very likely that if the taxpayer were not permitted to take into account an estimate of the amount of future costs that it will be necessary to incur to complete production and/or sale of the goods and thereby have the right to the sales revenue or gross receipts, the result of the denial of the ability to take these costs into account would be that the amount of supposed gross income that would be included in taxable income for the year in which section 451(b) had an effect would exceed the total gross income on the transaction as a whole. Correspondingly, for the year in which these costs were ultimately incurred, the taxpayer would report a loss in connection with this transaction. This pattern of reporting would clearly not represent an accurate picture of the gross income from the transaction.

Second, even if the economic performance requirement were viewed as being overridden by taking into account estimated future costs in determining the amount of gross income that is accelerated based on applying section 451(b), nevertheless, it is clear that section 451(b) was intended to override the all-events test with respect to the reporting of an “item of gross income.” As a result, it is appropriate that the all-events test should be overridden under section 451(b) not only with respect to the reporting of the sales revenue component of an “item of gross income” but also with respect to the cost offset component of that same “item of gross income.” If the IRS and Treasury were to adopt a rule under section 451(b) that resulted in inconsistent treatment as between the sales revenue component of an item of gross income and the cost offset component of that same item of gross income, and thus resulted in a failure to match the appropriate amount of costs with the amount of sales revenue that is required to be accelerated under section 451(b), such an unjustifiable internal inconsistency would be subject to challenge as being a violation of the arbitrary and capricious standard under the Administrative Procedure Act. See, e.g., Business Roundtable v. SEC, 647 F.3d 1144, 1153 (D.C. Cir. 2011).

3. Method for allocating cost offset amounts to sales revenue inclusions under section 451(b)

Another issue that is addressed by the proposal to permit a cost offset for both costs that have already been incurred and the estimated amount of costs that will be incurred in the future against any income inclusions that are required under section 451(b) in the case of contracts for the production and/or sale of goods is the issue of how the total estimated cost for the contract as a whole should be allocated among multiple income inclusions under section 451(b) in connection with a particular contract for the production and/or sale of goods.

We believe the most appropriate approach for the allocation of the total estimated amount of cost of goods sold on a contract to which section 451(b) applies should be based on a pro rata allocation of the total estimated amount of cost of goods sold in proportion to the total expected contract price. Thus, the taxpayer should determine the ratio of the total amount of estimated cost of goods sold on the contract and calculate the ratio of that amount to the total expected contract price. The taxpayer should then multiply this ratio by the amount of any portion of the contract price that is required to be included in the taxpayer's gross receipts for a particular taxable year under section 451(b) in order to determine the amount of cost of goods sold to treat as a reduction to that portion of the contract price for purposes of determining the amount of gross income on the contract that is required to be taken into account for that taxable year pursuant to section 451(b).

IV. Cost offset against section 451(c) inclusions in gross receipts

A. Description of proposal

In applying section 451(c), any amount of sales revenue or gross receipts that is required to be accelerated for tax purposes by reason of the application of section 451(c) would be offset by the amount of costs properly associated with that amount of sales revenue or gross receipts. The cost offset would include both costs that have already been incurred at the time of the required inclusion in sales revenue or gross receipts and costs that have not yet been incurred at that time but that are expected to be incurred in the future. The amount of costs properly associated with the inclusion in sales revenue or gross receipts would be determined on a pro rata basis in proportion to the ratio of the inclusion in sales revenue or gross receipts to the total expected contract price.

B. Suggested regulatory language

(b) Treatment of cost of goods sold.

(1) If as a result of the application of § 451(c), an amount of sales revenue relating to an agreement with a customer for the production and/or sale of goods (including related services that are integral to the production and/or sale of the goods) is required to be included in a taxpayer's gross receipts in an earlier taxable year than the taxable year when the amount of sales revenue would otherwise be included in the taxpayer's gross receipts under the taxpayer's regular accrual method of accounting (such as the accrual-shipments method or the units-of-delivery method), but for the application of § 451(c), the taxpayer must reduce such amount of sales revenue by the actual and estimated cost of goods sold allocable to such amount of sales revenue (as determined in paragraph (b)(2)) in order to determine the amount of gross income that is taken into account in computing the taxpayer's gross income by reason of the application of § 451(c).

(2) Determination of the amount of cost of goods sold that is properly allocable to an amount of sales revenue. In order to determine the amount of cost of goods sold that is properly allocable to an amount of sales revenue under paragraph (1), the taxpayer must apply the following steps:

(i) Compute the total estimated cost of goods sold with respect to the contract in respect of which § 451(c) applies.

(ii) Determine the total contract price with respect to the contract in subdivision (i).

(iii) Divide the total estimated cost of goods sold in subdivision (i) by the total contract price in subdivision (ii) to compute the expected cost of goods sold percentage with respect to the contract.

(iv) Multiply the expected cost of goods sold percentage computed in subdivision (iii) by the amount of sales revenue that is included in the taxpayer's gross receipts for the taxable year in subsection (b)(1) to determine the portion of the total estimated cost of goods sold in subdivision (i) that is treated as a reduction from the taxpayer's gross receipts in computing the effect on the taxpayer's gross income by reason of the application of § 451(c) to the contract in subdivision (i).

(ii) For purposes of subdivision (i)(a) of subparagraph (2)(i), the taxpayer's total estimated cost of goods sold with respect to a contract is determined in accordance with the principles in § 1.61-3(a).

C. Discussion of issues related to proposal

1. Legal basis for allowing a cost offset under section 451(c)

a. The use of the phrase “item of gross income” in the definition of “receipt” in section 451(c) supports the allowance of a cost offset under section 451(c).

As a preliminary to addressing the issue of the legal basis for allowing a cost offset for purposes of section 451(c), it is first necessary to describe briefly the basic operative rules under section 451(c), which are more complex than the operative rule in section 451(b). The general rule in section 451(c)(1)(A) is that “[a] taxpayer which computes taxable income under the accrual method of accounting, and receives any advance payment during the taxable year, shall . . . include such advance payment in gross income for such taxable year.” However, section 451(c)(1)(B) permits such a taxpayer to elect an alternative method of accounting for advance payments.

Under this alternative elective method of accounting for advance payments, any advance payment that is subject to this alternative elective method must be subdivided into two components. First, “to the extent that any portion of such advance payment is required under subsection (b) [section 451(b)] to be included in gross income in the taxable year in which such advance payment is received,” as a result of the inclusion of this portion of the advance payment in revenue for financial reporting purposes, this portion of the advance payment must be reported for tax purposes at the same time it is reported for financial accounting purposes, in accordance with the requirements of section 451(b). Section 451(c)(1)(B)(i).

Second, to the extent that any portion of the advance payment is not required to be included in gross income in the year the advance payment is received under section 451(b), the taxpayer must “include the remaining portion of such advance payment in gross income in the taxable year following the taxable year in which such payment is received.” Section 451(c)(1)(B)(ii). The term “advance payment” is defined in section 451(c)(4), and this definition is primarily based on whether any portion of the payment is included in revenue by the taxpayer for financial reporting purposes in a taxable year subsequent to the year in which the payment is received. Section 451(c)(4)(A)(ii). The discussion in this section will assume that the taxpayer has made the election to use the alternative method of accounting for advance payments that is provided in section 451(c)(1)(B).

Turning now to the issue of the legal basis for allowing a cost offset for purposes of section 451(c), with respect to any portion of a particular advance payment that is required to be included in gross income in the year the payment is received in accordance with section 451(b), the previous analysis of the cost offset issue under section 451(b) remains applicable, in light of the cross-reference in section 451(c) to the income inclusion required under section 451(b). Thus, it is only necessary to address the cost offset issue under section 451(c) with respect to whatever portion of the advance payment is subject to elective deferral to the year following the year in which the advance payment is received.

As in the case of the cost offset issue under section 451(b), the cost offset issue under section 451(c) relates not only to costs that have already been incurred at the time of the required income inclusion under section 451(c), but also to amounts of expected future costs that it will be necessary for the taxpayer to incur in order to complete production and/or sale of the goods³ to which the advance payments relate. In the case of advance payments that are subject to section 451(c), in contrast to the situation under section 451(b), the cost of goods sold amounts that are likely to be relevant are less likely to include costs that have already been incurred at the time of the required income inclusion but instead are more likely to be amounts of expected future costs that have not yet been incurred at the time of the section 451(c) inclusion.

In particular, with respect to any portion of an advance payment that is not required to be included in gross receipts in the year the payment is received under section 451(b), but is instead eligible to be deferred to the following year, the cost offset issue relates only to costs that have not yet been incurred at the time the advance payment is received, since costs that have already been incurred at that time will have been taken into account under section 451(b) in those situations where book PCM is required to be used for financial reporting purposes, since costs that have already been incurred will be taken into account under book PCM and thus will be reflected under section 451(b).

As discussed above with respect to the legal basis supporting a cost offset under section 451(b), in the case of a sale of goods, the most significant element in that legal basis is the fact that the acceleration rule in section 451(b) refers to “any item of gross income” as the amount that is subject to accelerated income inclusion. Like section 451(b), section 451(c) also refers to an “item of gross income.” The reference to an “item of gross income” in section 451(c) occurs in the definition of “receipt” in section 451(c)(4)(C): “For purposes of this subsection, an item of gross income is received by the taxpayer if it is actually or constructively received, or if it is due and payable to the taxpayer.” (Emphasis added.)

As with the use of the term “item of gross income” in section 451(b), the use of this same term in section 451(c) likewise necessarily carries with it the implication that in the case of a sale of goods, the cost of the goods that are sold must be taken into account in determining the amount of the “item of gross income.” In this regard, as is the case under section 451(b), the term “item of gross income” is much more precise and specific than a mere general reference to “gross income” or “income” or “inclusion in gross income” or “inclusion in income.”

The use of the term “item of gross income” in section 451(c)(4)(C) was clearly not a casual choice of words. As discussed earlier in connection with section 451(b), the phrase “item of gross income” instead is a very technical and precise phrase that cannot be viewed as having been accidental. Thus, in applying the various rules in section 451(c), the operative amount in all of the rules should be viewed as being “an item of gross income.”

As discussed in connection with section 451(b), in the case of a sale of goods, it is clear that the amount of the “item of gross income” that is associated with such a sale is the total sales revenue or gross receipts on the sale reduced by the total amount of cost of goods sold associated with the sale. Thus, where a particular advance payment is subject to the elective deferral method under section 451(c), and where some portion of the advance payment is eligible for deferral to the taxable year following the year in which the advance payment is received, the amount of gross income that should be recognized in that following taxable year under section 451(c) is the total portion of the contract price that was received as an advance payment, and that was eligible for deferral, reduced by the amount of cost of goods sold that is properly associated with that deferred amount of contract price.

Failure to take into account the amount of cost of goods sold in determining the amount by which the taxpayer's taxable income is increased under section 451(c) would result in an increase in taxable income by an amount that is larger than the amount of gross income properly associated with the amount of the advance payment or portion of the advance payment that is subject to accelerated income inclusion under section 451(c). As discussed above, in the case of advance payments, this cost of goods sold amount is likely to consist of amounts of expected future costs that have not yet been incurred at the time of the section 451(c) inclusion rather than costs that have already been incurred at that time.

b. The economic performance requirement does not provide a basis for denying a cost offset under section 451(c).

As discussed in connection with the cost offset for expected future costs under section 451(b), the IRS might argue that allowing a cost offset under section 451(c) for expected future costs would violate the economic performance requirement. However, as discussed in connection with the cost offset issue under section 451(b), the effect of allowing a cost offset against the amount of any portion of the contract price that is required to be accelerated under either section 451(b) or section 451(c) is not to accelerate a deduction, but instead the effect of the cost offset is merely to determine the proper amount of the item of gross income that is required to be accelerated. This is not the type of effect that the economic performance requirement was intended to prevent.

Moreover, similar to what is the case under section 451(b), the requirement under section 451(c) to include an amount in income at the time an advance payment is received (subject to elective one-year deferral) is itself a departure from the normal operation of the accrual method. Under the normal operation of the accrual method, in the case of a sale of goods, the amount of gross income that is associated with any particular unit under a multi-unit contract is not recognized until the particular unit is either shipped or delivered to the customer, depending on whether the taxpayer uses the accrual-shipments method or the units-of-delivery method.

Since the effect of section 451(c) is clearly to depart from that normal operation of the accrual method with respect to the time of reporting the portion of the contract price that is associated with the particular unit, it is also clearly appropriate to depart from the normal operation of the accrual method with respect to the cost offset element of the amount of gross income that is associated with the particular unit. In addition, as will be discussed in detail in a later subsection, the allowance of a cost offset for expected future costs under the rules relating to advance payments in connection with the sale of goods that was permitted under Treas. Reg. § 1.451-5 prior to the enactment of section 451(c) was clearly not viewed by the IRS and Treasury as representing a violation of the economic performance requirement, since the two provisions coexisted for over 33 years. As will be discussed later in connection with the discussion of Treas. Reg. § 1.451-5, the rationale that was relied on for the conclusion that the cost offset under Treas. Reg. § 1.451-5 was not inconsistent with the economic performance requirement should be equally applicable under section 451(c).

Finally, as is the case under section 451(b), denying taxpayers the ability to claim a cost offset under section 451(c) for expected future costs would ordinarily have the effect that the taxpayer would be required to report an amount of gross income at the time of each advance payment income inclusion that would exceed the total amount of gross income on the entire contract that was associated with the portion of the total contract price being reported under section 451(c) at that time. Correspondingly, if the taxpayer were denied a cost offset against the advance payment for the related amount of estimated fixture costs, the consequence would be that at the later time when the estimated future costs were actually incurred, the taxpayer would ordinarily be required to report those costs as losses, with no associated revenue.

As in the case of section 451(b), this pattern of reporting would not reflect the reality of the overall amount of gross income realized by the taxpayer on the contract as a whole. Moreover, in some cases, because of new limitations with respect to the use of net operating losses, the tax benefit of the later costs would be permanently lost, where the entity performing the contract has no revenue from other sources against which the costs could be deducted.

c. In light of the extremely close relationship between section 451(b) and section 451(c), if a cost offset is allowed for purposes of section 451(b), then a cost offset should also be allowed for purposes of section 451(c).

Even if it is accepted that the use of the term “any item of gross income” in the operative rule in section 451(b), together with the other considerations that have been discussed, lead to the conclusion that a cost offset against any income acceleration under section 451(b) should be permitted for purposes of determining the amount of the gross income acceleration under section 451(b), nevertheless, it might be objected that the same result does not necessarily follow in the case of income accelerations under section 451(c), because of the fact that, in contrast to the situation with respect to section 451(b), the term “an item of gross income” in section 451(c) does not appear in the operative rules in section 451(c), but instead only in the portion of section 451(c) that provides a definition of the term “receipt” or “received.”

However, the reason why this objection is incorrect is that the operative rules in section 451(c), in contrast to the operative rule in section 451(b), relate to the treatment of “advance payments,” rather than to the “item of gross income” that is associated with the advance payments. Thus, the operative rules in section 451(c) must necessarily relate to the treatment of advance payments, rather than to the “item of gross income” that is associated with those advance payments.

It is clear that the amount of any advance payment, or any portion of an advance payment, that may be subject to section 451(c) will necessarily be larger than the amount of the item of gross income that is associated with the advance payment or the relevant portion of the advance payment. Moreover, as will be discussed below in later subsections, the fact that the use of term “an item of gross income” in the definition of the term “receipt” in section 451(c) represents a clear change from both the provisions of Rev. Proc. 2004-34 and the provision of the Camp tax reform proposal that corresponded to section 451(c) confirms that the use of this term “an item of gross income” in section 451(c) represents a deliberate and conscious decision that should be given its full effect.

In addition, if it is accepted that a cost offset should be permitted under section 451(b) that encompasses not only the amount of the costs that have actually been incurred at the time of the income inclusion that is required under section 451(b), but also the estimated amount of the costs that the taxpayer will be required to incur in the future to satisfy its obligations relating to the income inclusion, one consequence of this conclusion is that the very close relationship between section 451(b) and section 451(c) provides additional support for the conclusion that a cost offset that is parallel to the cost offset permitted under section 451(b) should also be permitted under section 451(c).

The close relationship between section 451(b) and section 451(c) is shown by the fact that both section 451(b) and section 451(c) were enacted by the same section, section 13221, of the TCJA, and by the fact that no other provisions were contained in this section of the TCJA. This close relationship is also shown by the fact that both section 451(b) and section 451(c) provide special rules for accrual method taxpayers that accelerate the time of income recognition in comparison to the time when income would otherwise be recognized under the accrual method. Moreover, both provisions are discussed together in the same section of the Conference Report. In addition, the operation of both provisions depends in part on the treatment of the relevant items for financial reporting purposes.

The closest connection between the operation of section 451(b) and the operation of section 451(c) is the rule in section 451(c) that under the elective deferral method that is provided by section 451(c)(1)(B), a taxpayer must report any portion of an advance payment in accordance with the requirements in section 451(b) to the extent section 451(b) requires that portion of the advance payment to be included in gross income in the year the payment is received. In light of this close coordination and interrelationship between the operation of section 451(b) and the operation of section 451(c), if it is accepted that a cost offset is permitted under section 451(b), it would clearly make no sense to deny a cost offset for purposes of section 451(c).

d. Relationship between a cost offset under section 451(c) and prior law

One additional objection that might be made to the proposition that an offset to advance payments inclusion for the estimated future cost of goods sold of the goods to which the advance payments relate is permissible is that this result goes further than under the law prior to the enactment of section 451(b) and section 451(c). The IRS might contend that prior to the enactment of section 451(b) and section 451(c), the only situation where an offset for cost of goods sold was permitted was in a case where substantial advance payments were received.

However, prior to the enactment of section 451(b) and section 451(c), the only situation where a taxpayer was required to include advance payments for the sale of goods in gross income earlier than the time when the goods were delivered was under the special rule in Treas. Reg. § 1.451-5(c) relating to substantial advance payments for inventoriable goods, namely, where the amount of advance payments that were received exceeded the estimated cost of the goods to which the advance payments related. In that case, the deferral of the advance payments was limited to two taxable years beyond the year in which the advance payments were received. In contrast, in all other circumstances, a taxpayer was eligible under Treas. Reg. § 1.451-5(b) to defer the advance payments until the time when the goods were delivered, since that was the time when the gross income would be reported for financial reporting purposes.

Section 451(c) changes that result for the first time and requires revenue recognition in the taxable year immediately subsequent to the year of receipt in the case of advance payments for the sale of goods, notwithstanding a longer deferral period in the taxpayer's financial statements. As a result, the effect of section 451(c) is to accelerate gross income in comparison to the prior rules, but section 451(c) does not have the effect of either increasing or reducing gross income in comparison to the prior rules. Thus, the reason the proposal goes further than prior law is simply that the income acceleration rules in section 451(c) themselves go further than the income acceleration rule under prior law in Treas. Reg. § 1.451-5.

Finally, with respect to the case law relating to advance payments, while the Supreme Court decided a series of three cases in which taxpayers using the accrual method of accounting were required to include the full amounts of advance payments in gross income at the time the advance payments were received, see Schlude v. Commissioner, 372 U.S. 128 (1963); American Automobile Association v. United States, 367 U.S. 687 (1961); and Automobile Club of Michigan v. Commissioner, 353 U. S. 180 (1957), nevertheless, all three of these cases involved advance payments for services to be performed in the future, rather than advance payments for goods to be provided in the future. It is clear that in the case of services, in contrast to the situation with respect to the sale of goods, the amount of the gross income from such services is not reduced by the costs of providing the services. Moreover, in Schlude, for example, the Court relied in part on the fact that “the advance payments related to services which were to be performed only upon customers' demands without relation to fixed dates in the future,” and that the customers “could simply allow their rights under the contracts to lapse,” without receiving any services in exchange for the advance payments. 372 U.S. at 135.

With respect to case law dealing with advance payments relating to the sale of goods, in Consolidated-Hammer Dry Plate & Film Company v. Commissioner, 317 F.2d 829 (7th Cir. 1963), the Seventh Circuit held that partial payments prior to delivery and acceptance of goods being produced by the taxpayer for the federal government were not taxable to the taxpayer until the delivery and acceptance of the goods, relying on the rationale that the payments were in the nature of financing for the production of the goods. Id. at 832.

However, in Hagen Advertising Displays, Inc. v. Commissioner, 407 F.2d 1105 (6th Cir. 1969), the Sixth Circuit held that to the extent a manufacturer of advertising signs received advance payments for signs to be delivered in the future, “at least a portion of the advance payments constituted gross income in the year of their receipt, even though petitioner is an accrual-basis taxpayer.” Id. at 1109. On the issue of “what portion of the advance payments must be included in gross income in the year of receipt,” id. at 1110, the court recognized that to determine the proper amount of gross income to be recognized, it would be necessary and appropriate for the taxpayer to reduce the total amount of the advance payments received by the Cost of the signs that would be delivered in exchange for those advance payments, since the court agreed with the taxpayer's contention that “inclusion of the entire amount of the advances, without an allowance for related costs of goods sold, would constitute taxation of the return of capital.” Id.

However, since “[t]axpayer has made no attempt to estimate the cost of goods sold of the signs for which advances were received,” and “[s]ince it is clear that taxpayer, not the Commissioner, must bear the burden of reporting in the proper tax year amounts which it claims are costs of goods sold, taxpayer cannot complain in this petition for review of the consequences of its failure to do so.” It is notable that Hagen was decided six years after the last of the three Supreme Court decisions on the taxation of advance payments, and that Hagen relied on those decisions in rejecting the taxpayer's attempt to defer the advance payments. Thus, Hagen provides strong support for the conclusion that when a taxpayer is required to include an advance payment relating to the sale of goods in determining taxable income prior to the delivery of the goods, the taxpayer should be permitted to take the estimated future cost of those goods into account in determining the amount of the required gross income inclusion relating to the advance payment.

e. The allowance of a cost offset in Treas. Reg. § 1.451-5 supports the allowance of a cost offset under section 451(c).

It is also extremely relevant to the issue of whether a cost offset should be allowed under section 451(c) that the provision of the regulations dealing with the deferral of advance payments relating to the sale of goods that was in effect before the enactment of section 451(c), namely, Treas. Reg. § 1.451-5, clearly provided for an offset against advance payments for the cost of the goods to which the advance payments related for cases where income recognition relating to the advance payments was required at a time before the time when the goods to which the advance payments related were provided to the customer. These regulations were issued in response to court decisions, such as those that were discussed in the preceding subsection of this comment letter, in which the tax treatment of advance payments for the future performance of services or the future sale of goods was addressed.

The background for these regulations also includes the fact that, in September of 1969, President Nixon appointed a task force, the President's Task Force on Business Taxation, which issued a report in September of 1970 making recommendations for changes in several areas. One of these recommendations was that there should be an increased conformity between tax and financial accounting. See, e.g., John S. Nolan, The Merit in Conformity of Tax to Financial Accounting, Taxes, December, 1972, at 761. The treatment of advance payments was one area where the tax and financial accounting treatments had begun to diverge as a result of the court decisions in this area.

As a result, regulations were issued under section 451 that were designed to permit taxpayers to defer for tax purposes the reporting of advance payments for the sale of goods to be delivered in a later taxable year until the taxable year in which the goods were delivered to the customer. However, because this policy was intended to be consistent with the call for greater conformity between tax and financial reporting mentioned above, the approach the IRS and Treasury adopted to implement this deferral policy was conditioned on financial conformity in the treatment of the advance payments.

Thus, the general rule in Treas. Reg. § 1.451-5(b)(1)(ii), which permitted taxpayers using an accrual method of accounting that received advance payments for the sale of goods in a later taxable year than the year in which the advance payments were received to defer the reporting of the advance payments for tax purposes to the year in which the amounts would be properly accruable for tax purposes, which would ordinarily have been the year in which the goods to which the advance payments related were delivered to the customer, conditioned the availability of this tax deferral on the requirement that the advance payments must not be included in gross receipts for tax purposes any later than the year in which the advance payments were included in gross receipts for financial reporting purposes. Since generally accepted accounting principles at that time required advance payments to be deferred for financial reporting purposes until the goods to which the advance payments related were delivered to the intended customer, the practical effect of this general rule in the regulations was to permit tax deferral until the goods were delivered to the customer.

However, the IRS and Treasury also concluded that, in a situation where a taxpayer received advance payments that exceeded the expected cost of the goods to be delivered in a future taxable year, so that the taxpayer was assured, at the time it received the advance payments, that it would earn a profit on the sale of the goods, there should be a time limit on the length of the deferral period before the assured profit was recognized in gross income. The approach the IRS and Treasury adopted to implement this policy was reflected in Treas. Reg. § 1.451-5(c), which provided special rules for the treatment of advance payments that related to goods that were included in the taxpayer's inventory.

Under these rules, if a taxpayer received advance payments that exceeded the cost of the goods to which the advance payments related (referred to in the regulations as “substantial advance payments”), the taxpayer was only able to defer the reporting of the advance payments for tax purposes to the second taxable year following the taxable year in which the substantial advance payments were received. However, to be consistent with the policy that only the expected amount of profit on the sale, rather than the total amount of the advance payment, would be included in the taxpayer's gross income at the end of the two-year deferral period, Treas. Reg. § 1.451-5(c)(1)(ii) provided that in cases where a taxpayer was required to accelerate the recognition of substantial advance payments relating to the sale of inventoriable goods, compared to the time when the goods were delivered to the customer, the taxpayer was also required to take into account a cost offset against the advance payments at the time the advance payments were recognized for tax purposes:

[T]he taxpayer must take into account in such taxable year the costs and expenditures included in inventory at the end of such year with respect to such goods (or substantially similar goods) on hand or, if no such goods are on hand by the last day of such . . . taxable year, the estimated cost of goods necessary to satisfy the agreement.

This provision in Treas. Reg. § 1.451-5(c)(1)(ii) is obviously highly relevant to the issue of whether a similar cost offset is appropriate under section 451(c). In this regard it is particularly notable that this cost offset under Treas. Reg. § 1.451-5(c)(1)(ii) was not limited to costs that had already been incurred at the time the advance payments were required to be recognized for tax purposes, but also included estimated future costs in those cases where the costs related to the advance payments had not yet been incurred at that time. The proposed version of Treas. Reg. § 1.451-5 was issued on August 7, 1970, Accounting for Advance Payments, 35 Fed. Reg. 12612 (August 1, 1970), only a little more than a year after the Sixth Circuit's Hagen decision, which was discussed in the preceding subsection of this comment letter.

This cost offset provision in Treas. Reg. § 1.451-5(c)(1)(ii) undoubtedly reflected the discussion in the Sixth Circuit's Hagen decision to the effect that when taxpayers are required to recognize advance payments for the sale of goods for tax purposes prior to the time when the taxpayer delivers the goods to the customer, the taxpayer should be permitted to claim an offset against the amount of the advance payments for the estimated cost of the goods to which the advance payments relate. Thus, the cost offset provision in Treas. Reg. § 1.451-5(c)(1)(ii) did not represent administrative generosity to taxpayers on the part of the IRS and Treasury, but instead simply represented an acknowledgment and recognition by the IRS and Treasury of what was required in order to avoid taxing the taxpayer on a return of capital, as discussed in the Hagen case. Accordingly, the cost offset provision in Treas. Reg. § 1.451-5(c)(1)(ii) provides strong support for the position that a similar cost offset, encompassing not only costs already incurred but also estimated future costs, should also be permitted under section 451(c).

In response to the foregoing argument, as noted earlier, the IRS and Treasury may contend that permitting a cost offset for estimated future costs would violate the economic performance requirement under the all-events test as it relates to deductions, costs, and liabilities. However, we believe the IRS and Treasury both explicitly and implicitly rejected that position by reason of the fact that the IRS and Treasury continued to permit an offset for estimated future costs under Treas. Reg. § 1.451-5(c)(1)(ii) (prior to the enactment of section 451(b) and section 451(c)), notwithstanding the enactment of the economic performance requirement in 1984.

Subsequent to the enactment of section 461(h), the terms of Treas. Reg. § 1.451-5(c)(1)(ii) were never modified as a result of the enactment of the economic performance requirement in section 461(h) in 1984. Treas. Reg. § 1.451-5 was originally issued in final form in 1971, T.D. 7103, Accounting for Advance Payments, 36 Fed. Reg. 5495 (March 24, 1971), and, as noted above, the provision concerning the inclusion of a cost offset for estimated future costs was contained in the original 1971 version of this regulation.

After section 461(h) was enacted in 1984, Treas. Reg. § 1.451-5 was allowed to remain in effect for over 33 years, until the enactment of section 451(c) in December of 2017, with no change to the provision permitting a cost offset for estimated future costs, even though Treas. Reg. § 1.451-5 was amended twice during the period of time after the enactment of section 461(h) in other ways. T.D. 8067, Accounting for Long-Term Contracts, 51 Fed. Reg. 376 (Jan. 6, 1986); T.D. 8929, Accounting for Long-Term Contracts, 66 Fed. Reg. 2219 (Jan. 11, 2001). Moreover, when proposed regulations under section 461(h) were issued in 1990, IA-258-84, Economic Performance Requirement, 55 Fed. Reg. 23235 (June 7, 1990), followed by final regulations on this subject in 1992, T.D. 8408, Economic Performance Requirement, 57 Fed. Reg. 12411 (April 10, 1992), there was no reference in the preambles to either the proposed regulations or the final regulations to any perceived need to make any change to Treas. Reg. § 1.451-5 to take account of the enactment of the economic performance requirement.

In addition, one of the provisions that was added to the regulations under section 461 as part of the changes that were made to the regulations relating to section 461(h) can be read as encompassing the inclusion of estimated future costs in the cost offset under Treas. Reg. § 1.451-5. That provision is Treas. Reg. § 1.461-1(a)(2)(iii)(C), in a subsection of the regulations headed “Alternative timing rules,” which reads as follows:

Section 461 and the regulations thereunder do not apply to any amount allowable under a provision of the Code as a deduction for a reserve for estimated expenses.

There is no discussion of this provision in either the preamble to the proposed section 461(h) regulations or the preamble to the final section 461(h) regulations. Moreover, a Checkpoint search in IRS Rulings and Releases using both the citation for this provision and the text of the provision produces no relevant documents with respect to this provision. Nevertheless, based on the text of this provision, it would appear that this provision should apply to the inclusion of estimated future costs in the cost offset under Treas. Reg. § 1.451-5.

The reference in this provision in Treas. Reg. § 1.461-1(a)(2)(iii)(C) to “any amount allowable under a provision of the Code” should encompass an amount that is allowable pursuant to a regulation that is issued under a provision of the Code, and Treas. Reg. § 1.451-5 is unquestionably a regulation issued under section 451 of the Code. In addition, the reference in this provision in Treas. Reg. § 1.461-1(a)(2)(iii)(C) to “a deduction for a reserve for estimated expenses” should encompass the allowance of a cost offset for estimated future costs under Treas. Reg. § 1.451-5.

In addition, in accounting method changes, private letter rulings, and field service advices issued subsequent to the enactment of section 461(h), the IRS has continued to either reference or specifically permit the allowance of an offset for the estimated cost of goods sold of goods in respect of which a substantial advance payment has been received by a taxpayer. See, e.g., FSA 1847 (Jul. 12, 1996); FSA 2306 (Mar. 25, 1998); PLR 9231002.

Thus, the potential IRS argument that permitting a cost offset under section 451(c) for estimated future costs would violate the economic performance requirement is clearly refuted by the continued allowance of a cost offset for estimated future costs under Treas. Reg. § 1.451-5 despite the enactment of the economic performance requirement.

Consequently, since it was clear that a cost offset encompassing both actual costs and expected future costs was permitted under Treas. Reg. § 1.451-5(c)(1)(ii) with respect to advance payments relating to the sale of goods prior to the enactment of section 451(c), and since that provision reflected an acceptance by the IRS and Treasury of the judicial position on the need for a cost offset that was expressed in the Sixth Circuit's Hagen decision, it is reasonable to conclude that a cost offset under section 451(c) encompassing both actual costs and expected future costs survives in the case of advance payments relating to the sale of goods.

However, as discussed earlier, because of the effect of section 451(b), the cost offset under section 451(c) will ordinarily consist only of expected future costs, and will not include any costs that have already been incurred. In contrast, the cost offset under Treas. Reg. § 1.451-5 included both expected future costs and costs that had already been incurred, because of the absence of any rule comparable to section 451(b) under prior law.

The conclusion that the allowance of a cost offset under Treas. Reg. § 1.451-5 supports the allowance of a cost offset under section 451(c) is not affected by the recent announcement proposing the withdrawal of Treas. Reg. § 1.451-5. Since that regulation is now superseded by section 451(c), there is no continuing need for those regulations. However, that proposed withdrawal in no way invalidates the analysis that the presence of a cost offset in Treas. Reg. § 1.451-5 supports the propriety of permitting a cost of goods sold offset against any income inclusions that result from taxing advance payments prior to the completion and delivery of the goods to which the advance payments relate.

Moreover, as will be discussed in subsequent subsections of this comment letter, there is nothing in the text or legislative history of section 451(c) that suggests that there was any intention to overrule the understanding under prior law that any rule that requires the reporting for tax purposes of advance payments relating to the sale of goods prior to the time when the goods are delivered to the customer should be accompanied by a cost offset against the advance payments for the estimated future costs that the taxpayer will be required to incur with respect to the goods to which the advance payments relate. Moreover, as discussed in the preceding subsection, the use of the phrase “item of gross income” in section 451(c) to refer to the effect on taxable income of the operation of section 451(c) makes clear that retention of the cost offset for purposes of section 451(c) was in fact very much intended.

f. The lack of a cost offset for advance payments for sales of goods in Rev. Proc. 2004-34 does not support denying a cost offset under section 451(c).

In response to the foregoing argument that one reason a cost offset should be permitted under section 451(c) in the case of advance payments relating to the sale of goods is because a cost offset was permitted under Treas. Reg. § 1.451-5(c)(1)(ii), it might be argued that since Rev. Proc. 2004-34, in contrast to Treas. Reg. § 1.451-5, did not provide for any cost offset against advance payments, even in cases where taxpayers used Rev. Proc. 2004-34, rather than Treas. Reg. § 1.451-5, with respect to advance payments relating to the sale of goods, as a result, no cost offset was intended in section 451(c). This argument would also rely on the fact that the Conference Report discussion relating to section 451(c) specifically referred to an intention to codify Rev. Proc. 2004-34 in section 451(c). This reference to Rev. Proc. 2004-34 in the Conference Report will be discussed in more detail in the next subsection.

Rev. Proc. 2004-34 was a successor to Rev. Proc. 70-21 and Rev. Proc. 71-21, which were issued during the same time period as Treas. Reg. § 1.451-5. Rev. Proc. 70-21 and Rev. Proc. 71-21 provided a limited one-year deferral period for advance payments relating to the performance of services. These revenue procedures did not provide any cost offset with respect to this category of advance payments. When Rev. Proc. 2004-34 was issued as a replacement for Rev. Proc. 71-21, the scope of the revenue procedure was expanded to include advance payments with respect to the sale of goods, but Rev. Proc. 2004-34 did not provide any cost offset in the case of advance payments for the sale of goods.

However, Announcement 2004-48, which was issued at the same time as Rev. Proc. 2004-34 to explain some of the decisions that were reflected in Rev. Proc. 2004-34, included a discussion of the reasons why the decision had been made not to permit a cost offset in the case of advance payments for the sale of goods under Rev. Proc. 2004-34. This discussion included the following:

The final revenue procedure is designed to simplify the various issues that have arisen under Rev. Proc. 71-21. After careful consideration, the Service has determined that a special COGS rule is inconsistent with that simplification. Taxpayers that receive advance payments for goods and qualify to use the deferral method in § 1.451-5 may use that method, including the rule for COGS included in the regulation.

(Emphasis added.)

This passage from Announcement 2004-48 made clear that the decision not to permit a cost offset under Rev. Proc. 2004-48 in connection with advance payments relating to the sale of goods was based on the rationale that permitting a cost offset in those circumstances would be inconsistent with the simplification Rev. Proc. 2004-34 was intended to achieve, and also made clear that a cost offset remained available under Treas. Reg. § 1.451-5. Thus, the lack of any cost offset provision in Rev. Proc. 2004-34 was based solely on administrative considerations relating to the desire for simplification and therefore should not be viewed as support for denying a cost offset under section 451(c) in the case of advance payments relating to the sale of goods.

Moreover, this affirmative reference to the continued availability of a cost offset under Treas. Reg. § 1.451-5 provides further confirmation that the economic performance requirement did not present any obstacle to that cost offset, in light of the fact that Rev. Proc. 2004-34 was issued 20 years after the enactment of section 461(h). The reason why the reference to Rev. Proc. 2004-34 in the Conference Report should likewise not be viewed as supporting that position is discussed below.

In addition, it was not happenstance that Treas. Reg. § 1.451-5 was issued in the form of a regulation, whereas Rev. Proc. 70-21, Rev. Proc. 71-21, and Rev. Proc. 2004-34 were all issued as revenue procedures. The different forms these guidance documents took reflected differences in the legal status of the positions reflected in these documents.

Rev. Proc. 70-21, Rev. Proc. 71-21, and Rev. Proc. 2004-34 all provided favorable treatment to taxpayers in circumstances where the IRS and Treasury believed they were not legally obligated to provide favorable treatment, namely, advance payments for the performance of services. In contrast, Treas. Reg. § 1.451-5 was viewed by the IRS and Treasury as providing definitive and legally correct resolutions of issues on which there were somewhat conflicting results in case law. In light of the difference in legal status as between Treas. Reg. § 1.451-5 and the revenue procedures on advance payments, it is particularly clear that the absence of a cost offset in Rev. Proc. 2004-34 for advance payments relating to the sale of goods should not be viewed as representing the correct or definitive resolution of the issue of whether a cost offset is appropriate, and the allowance of a cost offset under Treas. Reg. § 1.451-5 should instead be viewed as having authoritative weight.

g. Statements in the Conference Report on section 451(c) do not support denying a cost offset in the case of advance payments relating to the sale of goods.

The section of the Conference Report on the TCJA dealing with section 451(c) includes the following statement regarding the relationship between section 451(c) and Rev. Proc. 2004-34:

The provision . . . codifies the current deferral method of accounting for advance payments for goods, services, and other specified items provided by the IRS under Revenue Procedure 2004-34.

If the foregoing statement were read in isolation, this statement might be viewed as suggesting that section 451(c) was intended to be identical in every aspect of its operation to Rev. Proc. 2004-34, and, under this interpretation, for example, the denial of a cost offset in the case of advance payments for the sale of goods would be carried over from Rev. Proc. 2004-34 to section 451(c). However, the statement in the Conference Report quoted above is followed immediately by an additional statement that makes clear that the first statement was not intended to imply the wholesale importation of the rules in Rev. Proc. 2004-34:

That is, the provision allows accrual method taxpayers to elect to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income also is deferred for financial statement purposes.

The foregoing statement makes clear that it was only limited aspects of the rules in Rev. Proc. 2004-34 that were codified in section 451(c), namely, the one-year deferral period provided in Rev. Proc. 2004-34, and the requirement that amounts must be deferred for financial reporting purposes in order to be eligible for deferral for tax purposes under section 451(c). This second sentence in the Conference Report does not suggest that these two aspects of Rev. Proc. 2004-34 are merely examples of aspects of Rev. Proc. 2004-34 that were codified in section 451(c) but rather that these two aspects of Rev. Proc. 2004-34 represent the totality of the rules in Rev. Proc. 2004-34 that were codified in section 451(c).

The words “That is” with which this second sentence begins clearly indicate that what follows is simply a different way of saying what was said in the first sentence. The words “That is” are not the sort of words that would be used if what followed these words represented merely examples of what was meant by the preceding sentence. If that had been the intention, the sentence would have begun with the words “For example,” rather than the words “That is.”

Moreover, it seems clear that other aspects of Rev. Proc. 2004-34 were not intended to be carried over into section 451(c), such as the rule in Rev. Proc. 2004-34 that taxpayers with financial statements other than applicable financial statement would determine the portion of an advance payment to report for tax purposes in the year the advance payment was received based on the portion of the advance payment that was earned in that year, rather than making this determination based on the portion of the advance payment that was reported as income for financial reporting purposes in that year. There is nothing in section 451(c) that suggests this aspect of Rev. Proc. 2004-34 would carry over to section 451(c). Instead, section 451(c) clearly provides that the same rules that apply in the case of applicable financial statements will also apply to other financial statements, to the extent the IRS and Treasury exercise their authority to include other financial statements for purposes of section 451(b) and section 451(c).

An additional extremely important aspect of the second statement relating to section 451(c) quoted above from the Conference Report is the way this statement describes the amounts that are eligible for deferral under section 451(c): “defer the inclusion of income associated with certain advance payments.” (Emphasis added.) It is extremely significant that this statement does not refer to deferring the inclusion of the total amount of advance payments, but instead refers to deferring the inclusion of “income associated with certain advance payments.” (Emphasis added.)

Thus, the amount that is deferred under section 451(c) is not the total amount of the advance payment but rather the amount of income associated with the advance payment. This aspect of this statement is consistent with the fact, noted earlier, that the definition of “receipt” in section 451(c) refers to the time when an item of gross income is received, not the time when an advance payment is received.

Moreover, a footnote to the second statement in the Conference Report quoted above reads as follows: “Thus, the provision is intended to override any deferral method provided by Treasury Regulation section 1.451-5 for advance payments received for goods.” This footnote is entirely consistent with the conclusion that the intended codification of Rev. Proc. 2004-34 was limited to the one-year deferral period and the financial conformity requirement in Rev. Proc. 2004-34, since Treas. Reg. § 1.451-5 provided a much more generous deferral period than Rev. Proc. 2004-34. In addition, as will be discussed below, there was a similar but not identical footnote in the Joint Committee explanation of the provision in the 2014 Camp tax reform proposal that corresponded to section 451(c), but the differences between the two footnotes provide support for the conclusion that the intended codification of Rev. Proc. 2004-34 in section 451(c) did not encompass the denial of a cost offset.

In this regard, it is significant that this footnote in the Conference Report referring to Treas. Reg. § 1.451-5 was appended to the second sentence in the Conference Report relating to Rev. Proc. 2004-34, rather than to the first sentence. That is, the footnote is appended to the sentence in the Conference Report that explains the meaning of the description of section 451(c) as representing a “codification” of Rev. Proc. 2004-34 as consisting of the one-year deferral period and the financial conformity requirement. As a result, the meaning of this footnote is that the one-year deferral period in section 451(c) overrules the more generous deferral period that was provided by Treas. Reg. § 1.451-5.

Finally, based on case law in the Supreme Court and in the courts of appeals, it would be improper to give any weight to this statement in the Conference Report to the effect that section 451(c) “codifies the current law deferral method of accounting for advance payments . . . under Revenue Procedure 2004-34” on any point relating to the provisions in Rev. Proc. 2004-34 that is not tied to specific language in section 451(c) itself In Shannon v. United States, 512 U.S. 573 (1994), the Supreme Court made clear that it is improper for a court to give any weight to statements in legislative history that do not relate to specific statutory language:

We are not aware of any case, however (and Shannon does not bring one to our attention), in which we have given authoritative weight to a single passage of legislative history that is in no way anchored in the text of the statute. On its face, the passage Shannon identifies does not purport to explain or interpret any provision of the IDRA.

Id. at 583. On this principle, the Court endorsed a statement by the D.C, Circuit;

We agree with the District of Columbia Circuit that “courts have no authority to enforce [a] principle] gleaned solely from legislative history that has no statutory reference point.” International Brotherhood of Elec. Workers, Local Union No. 474, AFL-CIO v. NLRB, 814 F.2d 697, 712 (1987) (emphasis deleted). We thus conclude that there is no support in the Act for the instruction Shannon seeks.

Id. at 583-84.

The Ninth Circuit, for example, relying on Shannon, has applied this principle in the following terms:

. . . . The case law of the Supreme Court and our court establishes that legislative history, untethered to text in an enacted statute, has no compulsive legal effect. . . .

. . . . The Supreme Court thus made clear that principles in legislative history that have no statutory reference point and do not purport to explain any part of an enacted law do not carry the force of law. As such, they do not bind anyone — administrative agencies included.

Northwest Environmental Defense Center v. Bonneville Power Administration, 477 F.3d 668, 682-83 (9th Cir. 2007).

Applying this principle in the present case, the text of section 451(c) does not itself make any reference to Rev. Proc. 2004-34. To the extent that the specific provisions of section 451(c) parallel the specific provisions of Rev. Proc. 2004-34, namely, the one-year deferral period and the financial conformity principle, the statements in the Conference Report relating to Rev. Proc. 2004-34 may have some relevance in interpreting these specific provisions in section 451(c). However, it would be contrary to the principle expressed by the Supreme Court in Shannon and by the D.C. Circuit and the Ninth Circuit in the cases cited above to rely on any of the provisions in Rev. Proc. 2004-34 that do not have specific parallel provisions in section 451(c) for purposes of interpreting other aspects of section 451(c). Thus, for example, it would be improper to rely on the lack of a cost offset under Rev. Proc. 2004-34 in the case of advance payments for the sale of goods to conclude that section 451(c) should be interpreted in a way that does not provide a cost offset for this category of advance payments, especially in the face of the specific reference in section 451(c) to an “item of gross income” and the fact that a cost offset is necessary in order to determine the proper amount of an “item of gross income” in the case of sales of goods.

The foregoing analysis is equally applicable with respect to the footnote in the Conference Report that refers to Treas. Reg. § 1.451-5. The statutory text of section 451(c) itself says nothing about a repeal or overruling of Treas. Reg. § 1.451-5. Accordingly, reading the footnote as having any implications about any issues on which the provisions of section 451(c) are not explicitly inconsistent with the provisions of Treas. Reg. § 1.451-5 would represent giving inappropriate weight to the footnote in violation of the principle expressed in the cases discussed above.

h. The contrast between the definition of “receipt” in section 451(c) and the definition of “received” in Rev. Proc. 2004-34 provides further support for the conclusion that section 451(c) was not intended to codify every aspect of Rev. Proc. 2004-34.

In further support of the conclusion that section 451(c) was not intended to codify all aspects of Rev. Proc. 2004-34, it is notable that the definition of “receipt” in section 451(c) differs in one significant respect from the definition of “received” in Rev. Proc. 2004-34. As noted earlier, section 451(c)(4)(C) defines “receipt” as follows: “For purposes of this subsection, an item of gross income is received by the taxpayer if it is actually or constructively received, or if it is due and payable to the taxpayer.” (Emphasis added.)

As noted earlier, it is significant that this definition of “receipt” defines receipt in terms of the time when item of gross income is received by the taxpayer.” (Emphasis added.) In contrast, section 4.04 of Rev. Proc. 2004-34 defined “received” as follows: "Income is 'received' by the taxpayer if it is actually or constructively received, or if it is due and payable to the taxpayer.” (Emphasis added.)

Thus, the definition of “received” in Rev. Proc. 2004-34 used the very general term “income” to refer to the amount that was received, whereas the definition of “receipt” in section 451(c) uses the much more precise and specific term “an item of gross income” to refer to the amount that is received. This contrast between the definition of “receipt” in section 451(c) and the definition of “received” in Rev. Proc. 2004-34 makes clear that it was a very conscious and deliberate choice to use the precise and technical phrase “an item of gross income” in the definition of “receipt” in section 451(c), rather than the much more general term “income” that had been used in the definition of “received” in Rev. Proc. 2004-34. Thus, the use of the phrase “an item of gross income” in the definition of “receipt” in section 451(c) should be given effect, and giving effect to the use of this term requires allowing a cost offset in determining the amount of gross income that is deferred under section 451(c).

i. A comparison between section 451(c) and the corresponding provision of the Camp tax reform proposal supports the allowance of a cost offset under section 451(c).

As is the case with respect to section 451(b) and the corresponding provision in the Camp proposal, while section 451(c) as enacted by the TCJA is unquestionably very similar to the corresponding provision in the Camp proposal, nevertheless, the two provisions are not identical. By far the most significant difference between the two provisions is the fact that the provision in the Camp proposal that corresponded to section 451(c) did not include any provision corresponding to the definition of “receipt” in section 451(c).

As discussed above, it is the use of the phrase “item of gross income” in the definition of “receipt” in section 451(c) that provides the clearest evidence that section 451(c) was intended to incorporate a cost offset concept. The fact that the inclusion of this definition of “receipt” in section 451(c) represented an entirely new addition that was not present in the corresponding provision of the Camp proposal provides very strong evidence that the addition of this definition with its use of the term “item of gross income” represented a very conscious and deliberate choice on the part of the drafters of section 451(c), and this conscious and deliberate choice should be given full effect by giving effect to the cost offset concept that is clearly incorporated in the use of the phrase “item of gross income.”

Finally, even though the provision in the Camp proposal that corresponded to section 451(c) did not include any provision corresponding to the definition of “receipt” in section 451(c), nevertheless, the Joint Committee explanation of this provision in the Camp proposal included two sentences that were identical to the two sentences in the Conference Report relating to section 451(c) that have been discussed above. As discussed above, these two sentences make clear not only that the “codification” of Rev. Proc. 2004-34 was limited to the one-year deferral period and the financial conformity requirement, but also that the amount that is subject to elective deferral is not the full amount of the advance payment but rather the “income associated” with the advance payment. Thus, as discussed above with respect to the two sentences in the Conference Report, the corresponding two sentences in the Joint Committee explanation of the Camp proposal provide strong support for the inclusion of a cost offset concept in the advance payment provision.

Finally, as noted above, there was a footnote to the second sentence in the Joint Committee explanation that was similar, but not identical, to the footnote in the Conference Report on the TCJA that was discussed above. The footnote in the Joint Committee explanation read as follows: “Thus, the proposal is intended to override the exception in Treasury Regulation section 1.451-5(c) for inventoriable goods.” As discussed above, the corresponding footnote in the Conference Report on the TCJA reads as follows: “Thus, the provision is intended to override any deferral method provided by Treasury Regulation section 1.451-5 for advance payments received for goods.”

The fact that the footnote in the Joint Committee explanation referred to Treas. Reg. § 1.451-5(c) and the “exception . . . for inventoriable goods” in that subsection could be viewed as indicating an intention in the Camp proposal to override the cost offset provision that was included in that subsection of the regulation. However, the fact that the corresponding footnote in the TCJA Conference Report was modified in comparison to the footnote in the Joint Committee explanation to refer instead to the entirety of Treas. Reg. § 1.451-5, rather than to the subsection of that regulation dealing with the special rule for inventoriable goods, as the Joint Committee explanation did, provides strong evidence that there was a conscious decision on the part of the drafters of section 451(c) to eliminate the implication that the cost offset provision in the regulation was being overridden in section 451(c).

2. Method of allocating cost offset amounts to advance payment inclusions under section 451(c)

As in the case of section 451(b), based on the conclusion that a cost offset for both costs that have already been incurred and the estimated amount of costs that will be incurred in the future should be permitted against any advance payment inclusions that are required under section 451(c) in the case of advance payments relating to the production and/or sale of goods, the proposal deals with the issue of how the total estimated cost for the contract as a whole should be allocated among multiple payments to be received in connection with a particular contract for the production and/or sale of goods.

A preliminary issue in addressing this cost allocation issue is how to determine the treatment of a payment that is received during the course of performance of a contract after there have been one or more required income inclusions under section 451(b). In such a situation, we believe that the payment should be allocated first to the amount of the portion or portions of the contract price that have previously been required to be included in the taxpayer's gross receipts and should be treated as a payment of these amounts to the extent of the lesser of these amounts or the amount of the payment.

If the amount of the payment is less than the amount of the total portions of the contract price that have previously been required to be included in the taxpayer's gross receipts under section 451(b), the consequence under section 451(c) is that no portion of the payment is subject to section 451(c). In contrast, if the amount of the payment exceeds the amount of the total portions of the contract price that have previously been required to be included in the taxpayer's gross receipts under section 451(b), the consequence under section 451(c) is that only the excess of the amount of the payment over the amount of these previous inclusions under section 451(b) is treated as an advance payment that is subject to section 451(c).

For example, if a taxpayer is required to report a portion of the contract price equal to $10X under section 451(b) in year one and reports $2X as gross income under section 451(b) in year one based on a cost of goods sold offset of $8X against that $10X contract price inclusion, and the taxpayer then receives a payment of $12X in year two, the first $10X of that payment is treated as a payment of the $10X portion of the contract price that was required to be reported under section 451(b) in year one, and only the $2X amount of the excess of the $12X payment over the $10X prior contract price inclusion is treated as an advance payment that is subject to section 451(c) in year two.

Turning then to the issue of how to allocate cost of goods sold amounts among advance payments that are subject to section 451(c), as in the case of section 451(b), we believe the most appropriate approach for the allocation of the total estimated amount of cost of goods sold on a contract to which section 451(c) applies should be based on a pro rata allocation of the total estimated amount of cost of goods sold in proportion to the total expected contract price. Thus, the taxpayer should determine the ratio of the total amount of estimated cost of goods sold on the contract and calculate the ratio of that amount to the total expected contract price. The taxpayer should then multiply this ratio by the amount of any portion of the contract price that is required to be included in the taxpayer's gross receipts for a particular taxable year under section 451(c) in order to determine the amount of cost of goods sold to treat as a reduction to that portion of the contract price for purposes of determining the amount of gross income on the contract that is required to be taken into account for that taxable year pursuant to section 451(c).

* * * * *

If, after reviewing these comments, you have any questions, or would like to discuss any of the issues in more detail, please feel free to contact the undersigned at (202) 393-7600.

Respectfully submitted,

Leslie J. Schneider

Patrick J. Smith

Ivins, Phillips & Barker
Washington, DC

cc:
Department of the Treasury
1500 Pennsylvania Ave., N.W.
Washington, D.C. 20220

Internal Revenue Service
1111 Constitution Ave., N.W.
Washington, D.C. 20224