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Firm Addresses Specified Goods Rule in Advance Payments Regs

NOV. 8, 2019

Firm Addresses Specified Goods Rule in Advance Payments Regs

DATED NOV. 8, 2019
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November 8, 2019

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

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

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

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

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

Dear Sirs:

On September 9, 2019, the United States Department of the Treasury ("Treasury") and the Internal Revenue Service (the "Service") published proposed regulations in the Federal Register (the "Proposed Regulations")1 with respect to advance payments as described in Section 451(c) of the Code.2 We commend Treasury and the Service for excluding certain payments for a specified good3 from the definition of "advance payment"4 in the Proposed Regulations (the "Specified Goods Rule").5 This provision appropriately ensures that income attributable to these payments is clearly reflected subsequent to the amendments to Section 451(c) made in P.L. 115-97 (the "Act").6

In the preamble, Treasury and the Service requested comments on certain aspects of the Proposed Regulations. Baker &McKenzie submits this letter in response to the request for comments. Although we believe that the Proposed Regulations, as currently drafted, allow a taxpayer to include a payment subject to the Specified Goods Rule in income for tax purposes when such payment is recorded as revenue in the taxpayer's applicable financial statement, we respectfully request that Treasury clarify our understanding in the final regulations.

Our comments in this letter are limited to the timing of income recognition for payments attributable to specified goods. While we will have other comments with respect to Section 451, those matters are beyond the scope of this letter and will be addressed separately.

I. Interaction Between Advance Payment Deferral and the Specified Goods Rule

The Proposed Regulations appropriately implement Congress's goal of achieving book-tax conformity.7 In the context of a specified good, we understand that certain payments may be treated as advance payments, as to which an election can be made to include the amount in income the year after receipt, whereas other payments are required to be included in income in the year of delivery under the Specified Goods Rule, such that all payments are recognized in the taxable year of delivery of the good.

In other words, there are two categories of payments that taxpayers may receive with respect to a specified good:(i) payments that are received two years or more before the delivery date and (ii) payments that are received in the year before delivery. Under the Proposed Regulations, payments in the first category qualify for the specified goods exclusion in Prop. Treas. Reg. § 1.451-8(b)(1)(ii)(H), but payments in the second category do not fit within that exclusion. As a result, we read the Proposed Regulations to provide that payments in the second category are treated as "advance payments" under the general rule described in Prop. Treas. Reg. § 1.451-8(a) and that taxpayers with an applicable financial statement may apply the deferral rule described in Prop. Treas. Reg. § 1.451-8(c). Based on our understanding of the Proposed Regulations, regardless of when a taxpayer receives a payment for a specified good, through the combination of the Specified Goods Rule and Prop. Treas. Reg. § 1.451-8(c), a taxpayer selling a specified good recognizes all payments attributable to such good in the year of delivery.

As an example of our understanding of these rules, assume the following: (i) a manufacturer, X,sells a specified good to a customer for $1,000;(ii)the contract evidencing the sale stipulates the specified good will be delivered in five years (i.e., the contractual delivery date is in Year 5); (iii) X receives $100 under the contract at the time of its signing (Year 0);(iv) X receives $200 under the contract in Year 3;(v) X receives $300 under the contract in Year 4; and (vi) X, at the time of delivery in Year 5, receives the balance of the purchase price, $400. Under the Proposed Regulations, the payments received in Year 0($100) and Year 3 ($200) will be subject to the Specified Goods Rule and taken into income at delivery, and the payment received in Year 4($300)will be an advance payment deferrable for one year under Prop. Treas. Reg. § 1.451-8(c). Thus, in Year 5, X will recognize all payments received under the contract as income, which is the same year that it will recognize all such payments as revenue on its applicable financial statement.

II. Recommendation in Response to Request for Comments

In the preamble, Treasury stated that the "deferral method under section 451(c) is an exception to the requirement to include an amount in income when it is received." If a taxpayer is availing itself of the Specified Goods Rule, then any payments covered by the rule should be outside the ambit of Section 451(c). Neither the preamble nor the Proposed Regulations explicitly provide when payments subject to the Specified Goods Rule are includable in income.

Since the Proposed Regulations do not identify the Specified Goods Rule as a special method of accounting, such payments may arguably be subject to Section 451(b). In order to avoid potential future controversies between the Service and taxpayers, we respectfully request that Treasury clarify that the Specified Goods Rule constitutes a special method of accounting when promulgating final regulations and that, pursuant to that special method of accounting, payments subject to the Specified Goods Rule are included in income for tax purposes when they are included in revenue on an applicable financial statement.8 This recommendation is based on the same policy reasons that justified promulgation of the Specified Goods Rule in the first instance: clear reflection of income and matching principles.

In contrast, and in response to some of the questions specifically raised in the preamble to the Proposed Regulations, we do not believe it would be necessary or appropriate for Treasury to exercise its regulatory authority to: (i) impose conditions unrelated to an accrual method of accounting with respect to an exclusion; (ii) impose a time limit on an exclusion; (iii) allow deferral of income in an amount equal to the estimated future performance while requiring current recognition of estimated profits not in excess of the amounts of advance payments; or (iv) reduce the amount a C corporation would be permitted to defer for a given taxable year by an amount equal to the excess of distributions the C corporation made to its shareholders with respect to its stock, over the C corporation's taxable income for that taxable year.

Any of the above described restrictions could defeat the purpose of the Specified Goods Rule by creating a mismatch between gross receipts and associated expenses. In addition, any of the above described restrictions would lead to administrative complexities, create traps for the unwary, and unnecessarily implicate other provisions of the Code.

We appreciate your consideration of our request and attention to this mailer and would be pleased to continue a dialogue with you. If you would like to discuss these matters further, please contact Anne Batter at(202) 835-6171 or Jeff Maydew at(312) 861-2560.

Respectfully submitted,

Baker &McKenzie LLP
Washington, DC

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

FOOTNOTES

1Advance Payments for Goods, Services, and Other Items, Notice of Proposed Rulemaking, 84 Fed. Reg. 47175, REG-104554-18.

2Unless otherwise noted, all "Code" and "Section" references are to the United States Internal Revenue Code of 1986, as amended, and all "Tress. Reg. §" references are to the Treasury Regulations promulgated thereunder.

3Prop. Treas. Reg. § 1.451-8(b)(9).

4As that term is defined in Section 451(c)(4)(A).

5Prop. Tress. Reg. § 1.451-8(b)(1)(ii)(H).

6We thank Treasury and the Service for their thoughtful consideration of our comments submitted in response to Notice 2018-35. See Comment Letter, Baker &McKenzie LLP, Application of Section 451(c) to the Aerospace Industry (March 6, 2019); Comment Letter, Baker &McKenzie LLP, Re: Request for Comments on Deferral of Advance Payments in Response to Notice 2018-35 (May 18, 2018).

7See H.R. Conf. Rep. No. 115-466, at 276 n.874 (2017)("Conference Report") (referring to Section 451(6), as amended by the Act, as the "financial statement conformity requirement added to section 451").

8Treasury can identify the Specified Goods Rule as a special method of accounting in Prop. Tress. Reg. § 1.451-3(c)(5), in which case it would be excepted from Section 451(b)(1) by Section 451(b)(2). By making this clarification in the final regulations, Treasury would be exercising its grant of regulatory authority under Sections 451(c)(4)(B)(vii) and 7805.

END FOOTNOTES

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