Firm Elaborates on Its Proposed Elective Accounting Method

January 27, 2020

Courier's Desk
Commissioner of Internal Revenue
Internal Revenue Service
Attn: CC:PA:LPD:PR (REG-104870-18 and REG-104554-18)
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: Supplemental Comments with respect to Proposed Regulations under Sections 451(b) and (c)
REG-104870-18 and REG-104554-18

Dear Sir:

On November 8, 2019, we submitted comments on the proposed regulations under section 451(b) and section 451(c), and we testified at the public hearing that was held with respect to these proposed regulations on December 10, 2019. During the public hearing, we received a number of questions from the government panelists. In addition, after the public hearing, we engaged in follow-up discussions regarding our original comments and our testimony with the staffs of the Treasury Department and Internal Revenue Service National Office.

Pursuant to those discussions, we are submitting this additional comment letter to supplement our views on several of the subjects that were discussed both during and after the public hearing. First, as part of our efforts to encourage the Treasury and IRS to make available an optional Book PCM Method for taxpayers that use an over-time method of accounting to recognize revenue for financial reporting purposes, we have enclosed a draft revenue procedure containing suggested language for an optional Book PCM Method for tax purposes with respect to section 451(b) and section 451(c) of the Internal Revenue Code.

This draft revenue procedure provides additional detail regarding our proposal for an optional Book PCM Method and addresses a number of issues that have been raised by representatives of the Treasury and the IRS about this proposal. We received a number of followup questions from the IRS about the interaction between the treatment of Schedule M adjustments and sections 263A and 471. The draft revenue procedure explains how Schedule M adjustments would be handled and how the Book PCM Method interacts with sections 471 and 263A. In general, Schedule M adjustments that reflect differences in either the types or amounts of costs taken into account in computing the percentage of the work that is completed during a particular taxable year are taken into account for tax purposes. However, they are taken into account as additions to or reductions in gross income for tax purposes, separate and apart from the calculation of the amounts of contract revenue and contract costs that are recognized under the Book PCM Method.

We also received several follow-up questions from the IRS about the application of sections 263A and 471 if a taxpayer elects the Book PCM method. As noted in the draft revenue procedure that is enclosed, sections 263 A and 471 are not taken into account in the Schedule M adjustments that are made for taxpayers using the Book PCM Method for two reasons. First, as in the case of the percentage-of-completion method under section 460, under the Book PCM Method, all contract-related costs are treated as reductions in taxable income in the taxable year in which the costs are incurred. Accordingly, no Schedule M adjustments for the application of sections 263A and 471 are necessary. Second, the main purpose of the Book PCM Method is to eliminate the administrative complexities that would result if a taxpayer were required to change to a percentage-of-completion method of revenue recognition for AFS purposes, but were required to remain on an accrual delivery method with respect to the treatment of costs for tax purposes that required the application of sections 263A and 471.

We also received follow-up questions about whether the non-application of sections 263A and 471 to taxpayers using the Book PCM Method would have the effect of eliminating those sections from the Code. In our experience, no more than five percent of the taxpayers that are engaged in production activities are required to use an over-time method of revenue recognition for AFS purposes so as to be eligible for the Book PCM Method for tax purposes. Accordingly, the vast majority of taxpayers, including many taxpayers electing the Book PCM Method that also have standardized products that would still be accounted for on an accrual delivery method, would continue to apply sections 263A and 471 to their production costs not accounted for under the Book PCM Method. The Book PCM Method simply deals with the most extreme situations under ASC 606, where the new AFS reporting rules would otherwise require taxpayers to use completely different methods of accounting for AFS and tax purposes.

In addition to a draft revenue procedure, we have also enclosed suggested draft language for possible inclusion in the preamble to the final regulations under section 451(b) and section 451(c), explaining the decision to permit a Book PCM Method option.

Second, there was considerable discussion at the public hearing regarding the scope of the exception that is provided in the proposed regulations for so-called “specified goods.” Set forth below are some additional comments and suggestions regarding the parameters of the exception from section 451(c) for “specified goods.” In our original comment letter dated November 8, 2019, we made two suggestions with respect to the exception from advance payment treatment in the proposed regulations under section 451(c) for payments relating to “specified goods.” First, we contended that the requirement for eligibility for this exception that the delivery date for the goods must be specified in the contract was overly restrictive. Second, we contended that the requirement that all the revenue related to the goods must be reported in the taxpayer's applicable financial statement (“AFS”) when the goods were completed and delivered was also overly restrictive. We have the following additional comments with respect to these two suggestions.

With respect to the requirement for contractually specified delivery dates, we noted in our original comment letter that in the Supreme Court trilogy of cases dealing with the tax treatment of advance payments for services, in each of the three cases, in rejecting the taxpayer's deferral method of accounting for these payments, the Court had expressed concern that the services to which the advance payments related might never in fact be performed, and that this possibility undercut the propriety and accuracy of the taxpayer's deferral method. We also noted that some of the Court of Appeals decisions following the Supreme Court trilogy that permitted deferral of advance payments took into account this consideration by permitting deferral in a situation where there was a contractually fixed date or dates on which performance was to occur.

Nevertheless, not all of the cases where deferral of advance payments was permitted involved such precisely fixed performance dates. Instead, in some cases where deferral was permitted, the court's decision was based on facts and circumstances that provided comparable assurance that the performance to which the payments related would in fact take place, notwithstanding the absence of fixed delivery dates in the contract.

Thus, while contractually fixed precise dates for performance represent one factor that can overcome the concern that the performance to which the advance payments relate might never in fact occur, we previously suggested that there are other types of circumstances where it is no less certain that the performance will in fact occur. Accordingly, we proposed that the requirement of contractually fixed delivery dates should be relaxed so that, in the alternative, if, based on all the facts and circumstances, it is reasonably certain that the goods to which the payment relates wilt in fact be delivered, this would be an alternative way of providing the necessary certainty that the performance will in fact occur.

One situation where there might be heightened concern that the recipient of advance payments might never be called on to perform the required delivery of the goods is in a case where the customer is an individual, rather than a business. In this regard, each of the three cases making up the Supreme Court's advance payment trilogy involved situations where the customers who made the payments were individuals rather than businesses. Two of the cases involved automobile clubs where the payments at issue were annual dues covering potential future roadside assistance services to the individuals making the payments, and the third case involved payments by individuals for dance lessons to be provided to the individuals in the future.

While the Supreme Court decisions did not explicitly refer to the fact that the customers in these cases were individuals, nevertheless, it seems indisputable that this fact played a part in the Court's analysis in reaching the conclusion that there was a significant possibility that customers who are individuals, rather than businesses, might fail to call on the taxpayers in the three cases to provide the services to which the customers were contractually entitled. In other areas of the tax law, it is well-established that the fact that individuals may not claim benefits to which they are contractually entitled is a relevant consideration in determining the proper tax treatment of the claims.

For example, in United States v. General Dynamics Corp., 481 US 239 (1987), the Supreme Court held that an employer who maintained a medical expense reimbursement plan for employees was not entitled to deduct an estimate of the employees' claimed medical expenses prior to the time when employees actually filed a claim for reimbursement. The Court explained its reasoning in part as follows:

Some covered individuals, through oversight, procrastination, confusion over the coverage provided, or fear of disclosure to the employer of the extent or nature of the services received, might not file claims for reimbursement to which they are plainly entitled. Such filing is not a mere technicality. It is crucial to the establishment of liability on the part of the taxpayer.

Id. at 244.

In contrast, if an employer maintains a medical benefits plan in which claims are submitted to the employer by the businesses that provide medical services to employees, rather than by the employees themselves, the employer is permitted to claim a deduction based on the time when the services are provided rather than when the claims are submitted. See Rev. Proc. 2019-43, section 20.01(1)(a)(1)(A) and (B). This distinction reflects the understanding that the uncertainties with regard to employees claiming benefits to which they are contractually entitled do not exist in the case of businesses claiming benefits to which they are contractually entitled.

Thus, in light of this recognized distinction in the tax law between the tax treatment of claims by individuals and claims by businesses, as part of our recommendation for expanding the requirement in the specified goods exception for contractually specified delivery dates to encompass other types of situations where, based on all the facts and circumstances, it is reasonably certain that the goods to which the payments relate will in fact be provided, we would recommend providing specifically that one of the relevant facts and circumstances is whether the taxpayer's customers are businesses or instead are individuals; and in the case of individuals, whether there are significant potential non-business reasons why the customer might never call upon the recipient of the customer's advance payments to provide the customer with the goods to which the advance payments relate. The General Dynamics case offers an illustration of a situation where such non-business factors suggest that it might be in the individual's interest to decline to request the requisite performance.

We would also point out that the specified goods exception is only applicable in cases where advance payments are received for the future delivery of goods, in contrast to the situation in the Supreme Court trilogy. In our view it seems far less likely that a customer would decline to accept goods the customer had ordered and paid for in whole or in part than in the types of situations involved in the Supreme Court trilogy. In the case of contracts for the production and sale of goods, the risk that the customer will not want goods for which the customer has made advance payments seems very small.

With respect to the second suggestion in our original comment letter dated November 8, 2019, relating to the taxpayer's accounting method in its AFS, we noted in that comment letter that conditioning eligibility for the specified goods exception on the requirement that the revenue on the goods to which the payments relate must be reported in its entirety in the taxpayer's AFS at the time the goods are completed and delivered was also overly restrictive. We suggested that instead the requirement be relaxed so that it would be satisfied so long as the revenue is reported for tax purposes no later than the time when the revenue is reported in the taxpayer's AFS.

Our reason for making this recommendation was that under ASC 606, many taxpayers are required to report revenue with respect to the production of goods for customers as the work on the goods is performed, rather than when the goods are completed and delivered. As we noted in our original comment letter, we could discern no policy reason why taxpayers in this situation should be denied the benefit of the specified goods exception.

However, as we noted in our original comment letter, if the decision is made to adopt our recommendation for an elective Book PCM Method, taxpayers making that election would not need to take advantage of the specified goods exception, because, under the elective Book PCM Method, section 451(c) would have no application to contracts that are accounted for under this method. If our recommendation for an elective Book PCM Method is adopted, the Treasury and the IRS might decide that the availability of this election is sufficient to deal with the issue discussed above, and that it is not necessary to expand the requirement relating to the time when revenue is reported in the taxpayer's AFS.

Finally, in discussions with Treasury and IRS representatives at the hearing and after the hearing, there seemed to be a concern on the part of these representatives that expanding the requirement for contractually specified delivery dates in the manner described above would have the effect that the specified goods exception would apply to virtually all advance payments for goods to be delivered in the future. In response to that concern, we would suggest consideration of the possibility of limiting the expansion of the specified goods exception to situations where the anticipated duration of the contract calling for advance payments is at least 24 months. We believe that the greater the length of time between the receipt of the advance payment and the time for performance of work under the contract, the greater the possibility of a mismatch of income and expense and a distortion of the measurement of income. By limiting eligibility for the specified goods exception to situations where the anticipated duration of the contract is at least 24 months, the exception would be narrowed considerably and its application would be confined to the most extreme situations where a mismatch between revenue and costs may occur.

We have also enclosed for your consideration draft language for possible inclusion in the preamble to the final regulations under section 451(c) explaining the decision to expand the scope of the exception from section 451(c) for so-called “specified goods.”'

If you have any questions about our suggestions or would like to discuss them further with us, please contact either of the undersigned at (202) 393-7600.

Leslie J. Schnejder

Patrick J. Smith

Ivins Philips Barker Chartered
Washington, DC

Enclosures

Cc:
Krishna Vallabhaneni, Tax Legislative Counsel, U.S. Treasury Dept.
Brett York, Acting Deputy Tax Legislative Counsel, U.S. Treasury Dept.
Wendy Friese, Office of Tax Legislative Counsel, U.S. Treasury Dept.
John Moriarty, Associate Chief Counsel (IT&A), IRS
Charles Gorham, Special Counsel, Office of Associate Chief Counsel (IT&A), IRS
Peter Ford, Senior Counsel, Br. 2, Office of Associate Chief Counsel (IT&A), IRS