Practitioner Seeks to Eliminate Ambiguity in Tax Accounting Regs

October 29, 2019

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220

The Honorable Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Ave, NW
Washington, DC 20224

Re: Comments on REG-104870-18

Dear Assistant Secretary Kautter and Chief Counsel Desmond:

I want to thank you both, and also thank Jeffrey Van Hove and the rest of your teams from Treasury and the Internal Revenue Service for giving me the opportunity to discuss the guidance (REG-104870-18) published in the Federal Register on Monday, September 9, 2019 addressing section 451(b) of the Internal Revenue Code (“Code”). As I outlined at our meeting, there are several provisions in the proposed regulation that present significant concerns to a number of the public companies that I represent and to me (as a practitioner in this tax accounting discipline for over 40 years and as an Adjunct Professor of Income Tax Accounting at the Georgetown University Law Center for many years in the 1980 to 2000 time period). This letter provides my written comments on Prop. Reg. §1.451-3, and also includes a red-lined markup (Exhibit A attached hereto) of the Treasury's proposed regulation §1.451-3 that offers revisions to the proposed regulation to clear up certain troubling language and ambiguities that are found in REG-104870-18 as currently proposed.

Section 451(b) was added to the Code by Section 13221 of An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018 (referred to generally as the Tax Cuts and Jobs Act of 2017 (“TCJA”)). This provision, simply stated, provides that the all events test with respect to any item of gross income (or portion thereof) is not treated as met any later than when the item (or portion thereof) is included in revenue for financial reporting purposes on an applicable financial statement (“AFS”). Congress made it clear in three important ways that the newly enacted section 451(b) only applies to an item of income that has been realized for Federal income tax purposes:

1. Congress' statutory language provides that the provision applies to items of “gross income”: “the all events test with respect to any item of gross income (or portion thereof) shall not be treated as met any later than when such item (or portion thereof) is taken into account as revenue” in an applicable financial statement or other financial statements as specified by the Secretary. Section 451(b)(1)(A). The Code defines “gross income” under section 61, and the Senate Report accompanying the 1954 enactment of section 61 states, “This definition is based upon the sixteenth amendment and the word 'income' is used as in section 22(a) [of the 1939 Code] in its constitutional sense.” S. Rept. 1622 (1954). In the constitutional sense, amounts must be realized before they can be recognized as income for tax purposes. “[I]t is a long-standing principle that no loss (or gain) may be 'recognized' for tax purposes unless it is first 'realized.' 26 U.S.C. § 1001(a); Treas. Reg. § 1.1001-1(a); Eisner v. Macomber, 252 U.S. 189 (1920); Helvering v. Bruun, 309 U.S. 461 (1940); Commissioner of Internal Revenue v. Glenshaw Glass Co., 348 U.S. 426 (1955).” First Federal Sav. & Loan Ass'n of Temple v. United States, 694 F. Supp. 230, 239 (W.D. Texas 1988). Consequently, the statutory language of section 451(b)(1)(A) expresses Congressional intent that the provision only applies to income that has been realized, and, thus, the income recognition rule of section 451(b) has no impact on amounts that have not yet been realized for tax purposes.

2. When Congress has addressed realization and has chosen to deviate from the clear realization principles under section 61 and section 1001, it has done so expressly in an unambiguous manner. For example, Congress specified that certain financial instruments are treated as sold at the end of the year under section 1256(a) or 1259(a), and, as a result of this rule, effectively chose to treat the gain or loss on these instruments as constructively realized at the end of each taxable year. In the case of Section 13221 of the TCJA, Congress did not state an intention to change in any way the tax law on realization. In fact, in the Conference Report to the TCJA, Congress expressly states the contrary: “The provision does not revise the rules associated with when an item of income is realized for Federal income tax purposes and, accordingly, does not require the recognition of income in situations where the Federal income tax realization event has not yet occurred.” Conference Report, p. 275, fn. 872.

3. Section 451 of the Code has consistently been interpreted by the Treasury, the IRS and the judiciary as addressing income recognition for income that has been realized under section 61 and its predecessor provisions. As stated by the Supreme Court in Helvering v. Horst, 311 U.S. 112, 115 (1940), there is no realization of income for a taxpayer before “the last step is taken by which he obtains the fruition of the economic gain, which has already accrued to him.”¹ See also 1 Bittker Federal Taxation of Income, Estates, and Gifts, para. 5.1 (1981) (The increase or decrease in a taxpayer's net worth (i.e. the value of his assets) will not be accounted for (“realized” as a practical matter) until there is some event that freezes or fixes the gain with sufficient certainty so that it is proper to tax it.). Income, once realized, is generally recognized under section 451 unless subject to a specific non-recognition provision in the Code. Had Congress intended to change the rules on realization rather than recognition, it would not have placed the TCJA change in a section of the Code that has clearly only applied to recognition. “Congress normally can be presumed to have had knowledge of the interpretation given to the incorporated law, at least insofar as it affects the new statute.” Lorillard v. Pons, 434 U.S. 575, 581 (1978).

The preamble to the proposed regulation expressly states the above-quoted rule in Footnote 872 of the Conference Report that the newly enacted section 451(b) provision does not revise the rules associated with when an item of income is realized for Federal income tax purposes. Unfortunately, despite the direct indications of Congressional intent in the three numbered paragraphs above and the express statement in the preamble to the proposed regulation that there must be realization before recognition, the proposed regulation: (i) contains a specific provision (Prop. Reg. §1.451-3(c)(6)(ii)) that undermines the realization requirement as a pre-condition to the recognition rule of section 451(b); (ii) sets out examples that fail to adequately limit the application of section 451(b) to realized amounts; and (iii) introduces further ambiguity rather than clarification by including in the preamble the statement that “the proposed regulations provide that the AFS inclusion rule applies to unbilled receivables included in revenue for AFS purposes related to both services and goods” without limiting this statement to unbilled amounts that have been realized for Federal income tax purposes.

A. Issue #1 — Prop. Reg. §1.451-3(c)(6)(ii).

The troubling provision in the proposed regulation is the following language in Prop. Reg. §1.451-3(c)(6)(ii) which defines the AFS transaction price that is to be included on a taxpayer's Federal income tax return as not including:

Increases in consideration to which a taxpayer's entitlement is contingent on the occurrence or nonoccurrence of a future event (for example, bonuses contingent on performance and insurance contract commissions contingent on renewal) for the period in which the amount is contingent. Amounts included in the transaction price for AFS purposes are presumed to not be contingent on the occurrence or nonoccurrence of a future event, unless, upon examination of all the facts and circumstances existing at the end of the taxable year, it can be established to the satisfaction of the Commissioner that the amount is contingent on the occurrence or nonoccurrence of a future event. An amount included in the transaction price for AFS purposes that is actually or constructively received, that is due and payable, or for which the taxpayer has an enforceable right to payment for performance completed to date, however, will not be treated as contingent on the occurrence or nonoccurrence of a future event[.]

This language presents three distinct inconsistencies with the concept of realization.

1. First, the above exclusion language in the proposed regulation is limited to “[i]ncreases in consideration to which a taxpayer's entitlement is contingent on the occurrence or nonoccurrence of a future event.” Under the precedents that address when realization occurs for Federal income tax purposes (see the cases cited in the footnotes 699 - 704 of the General Explanation Of Public Law 115-97 (JCS-1-18), “Blue Book”), there is no realization for tax purposes if the entitlement to payment of the consideration (base consideration and/or incremental consideration) is conditioned on the taxpayer's satisfaction of non-ministerial performance obligations before obtaining an unconditional right to payment. The inclusion of the words “[i]ncreases in consideration” conflicts with the established principle that all consideration which is contingent on the occurrence or nonoccurrence of a future event (and not just increases in consideration) are not realized until the taxpayer has a fixed and unconditional right to payment. For example, in Commissioner v. Indianapolis Power & Light Company, 493 U.S. 203 (1990), the Supreme Court applied the realization rule when it decided that the taxpayer's receipt of customer deposits was not realized income at the time of receipt. Id. at 212. The Court explained, “The key is whether the taxpayer has some guarantee that he will be allowed to keep the money.” Id. at 210. In other words, the key to identifying realization of income for tax purposes is looking to the taxpayer's entitlement to payment. This same application of realization to all consideration and not just to increases in consideration is found in Rev. Rul. 79-195, 1979-1 C.B. 177, where the IRS itself held that “income is realized by the School as each lesson is completed by the student.” See also Decision, Inc. v. Commissioner, 47 T.C. 58 (1966), acq. 1967-2 C.B. 2.

2. Second, the statement that “[a]n amount included in the transaction price for AFS purposes . . . for which the taxpayer has an enforceable right to payment for performance completed to date, however, will not be treated as contingent on the occurrence or nonoccurrence of a future event” is ambiguous as best and likely to engender significant controversy with the Examination Division of the IRS. Tax law fixes realization when there is a fixed and unconditional right to payment. Rather than use the accepted tax language for realization (i.e., an unconditional right to payment), the proposed regulation provision adopts the term “enforceable right to payment” which is a term that is taken from the financial statement rules in ASC 606-10-25-29 (“An entity shall consider the terms of the contract, as well as any laws that apply to the contract, when evaluating whether it has an enforceable right to payment for performance completed to date in accordance with paragraph 606-10-25-27(c). The right to payment for performance completed to date does not need to be for a fixed amount.” (Emphasis supplied)). ASC 606-10-55-12 provides that an “entity's right to payment for performance completed to date need not be a present unconditional right to payment. In many cases, an entity will have an unconditional right to payment only at an agreed-upon milestone or upon complete satisfaction of the performance obligation.” The final regulation, if it is relying on the “enforceable right to payment” rule in ASC 606, or if the IRS Examination Division so interprets the provision to track to these rules, will result in any such regulation effectively overwriting the realization requirement that has historically controlled realization for tax purposes by requiring a fixed, unconditional right to payment before there is realization. Had Congress intended for the financial statement rule to become operative for tax realization purposes, it would have so stated. “Congress . . . does not alter the fundamental details of a regulatory scheme in vague terms or ancillary provisions — it does not . . . hide elephants in mouseholes.” Whitman v. American Trucking Ass'ns, Inc., 531 U.S. 457, 468 (2001).

3. Third, the proposed regulation's introduction of a rebuttable presumption (“Amounts included in the transaction price for AFS purposes are presumed to not be contingent on the occurrence or nonoccurrence of a future event, unless, upon examination of all the facts and circumstances existing at the end of the taxable year, it can be established to the satisfaction of the Commissioner that the amount is contingent on the occurrence or nonoccurrence of a future event.”) changes the taxpayer's administrative burden of proving realization and, importantly, is inconsistent with Congress' express language in section 451(b) restricting the application of the provision to items of “gross income”. It further directly contradicts the direct statement of Congressional intent that section 451(b) “does not revise the rules associated with when an item is realized for Federal income tax purposes. . . .” Conf. Rep. at 428, fn. 872. In proving realization under pre-TCJA law, taxpayers, while having the commonly accepted burden of proof in tax cases, did not have to satisfy the higher standard of disproving the rebuttable presumption in a manner that was satisfactory to the Commissioner. The proposed regulation, by this alteration of the specific burden of proof with respect to the application of section 451(b) to taxpayers with an AFS, ignores the express statement of Congress that section 451(b) is not intended to revise the rules associated when an item is realized.

B. Issue #2 — Prop. Reg. §1.451-3(m).

The examples in the proposed regulation fail to adequately demonstrate how the AFS inclusion rule only applies to amounts realized for Federal income tax purposes. These examples do not provide sufficient guidance for taxpayers that have an enforceable right to payment under the financial statement rules governing their AFS but do not have a fixed and unconditional right to payment that is a pre-condition to tax realization. Exhibit A that is attached to this letter modifies certain of the examples to make this distinction clear and adds two additional examples to further illustrate how the tax realization and the AFS inclusion rules intersect.

C. Issue #3 — Preamble statement that the proposed regulations provide that the AFS inclusion rule applies to unbilled receivables included in revenue for AFS purposes related to both services and goods.

This language set out in the preamble (“Accordingly, the proposed regulations provide that the AFS inclusion rule applies to unbilled receivables included in revenue for AFS purposes related to both services and goods.”) is creating significant financial statement and tax reporting uncertainty. The uncertainty that drives the preamble language arises in how to square the statement in Footnote 874 of the Conference Report (which notes an intention to apply the AFS inclusion rule to unbilled receivables for partially performed services) with the explicit language of section 451(b) that it only applies to items of “gross income” (i.e., realized consideration) and Footnote 872 in the Conference Report which states Congress' intention not to revise the rules on realization. The proposed regulation does not adequately address how the statutory text and Footnote 872 are to be reconciled with Footnote 874. Importantly, the regulation needs to clearly state that any portion of unbilled receivables (whether for partially performed services and goods) that has not been realized for federal income tax purposes but has been included in revenue for AFS purposes is not subject to section 451(b)'s AFS inclusion rule. The rule suggested in the proposed regulation that all unbilled receivables for both partially completed goods and services contracts are reportable for tax purposes under section 451(b) (whether realized or not) ignores two very important points.

1. First, as explained in significant detail above, realization requires a taxpayer to not only render performance but also to satisfy milestones and/or complete separate performance obligations to give a taxpayer the fixed and unconditional right to payment. Partially completed contracts for the sale of goods or the performance of services on which no current fixed and unconditional right to payment exists are not subject to the AFS inclusion rule because there is no realization until payment is fixed. In situations where the revenue recognition rules for financial statements are based on a factual determination that a reporting entity has a fixed and unconditional right to payment, then applying the AFS inclusion rule seems to foster compliance by bringing book and tax into conformity where both the AFS reporting rules and the tax realization rules are based on the same or substantially similar factual determinations.² Compliance will be fostered by forcing taxpayers to be consistent with the AFS if the factual base on which income is reported for financial statement and tax purposes is the same, i.e., a fixed and unconditional right to payment.

2. The second point of reference for reconciling the statutory text and the two Conference Report footnotes is that the financial reporting rules require certain taxpayers to report for AFS purposes over time as work on contracts for the sale of goods or the performance of services progresses. See e.g., ASC 606-10-25-27 through ASC 606-10-25-29. In most cases, over time reporting bears no relationship to when income is realized for tax purposes, because as explained previously, an enforceable right to payment which is the governing revenue recognition standard under ASC 606, particularly in the case of over time reporting on a cost-to-cost basis, will generate unbilled receivables on the financial statement for amounts to which the taxpayer has no unconditional right to payment until satisfaction of an agreed-upon milestone or upon complete satisfaction of a performance obligation. Imposing an AFS inclusion rule for amounts that bear no relationship to facts that demonstrate a fixed and unconditional right to payment is directly contrary to Congress' stated position that the realization rules are not to be revised by section 451(b).

As a final comment relating to over time reporting under ASC 606, I point out that the uncertainty engendered by the interaction of ASC 606 and section 451(b) is creating a significant financial statement reporting problem that needs immediate clarification. The public reporting entities that I represent, and their outside accounting firms, cannot agree on how section 451(b) applies to entities whose income is to be reported over time under ASC 606 but have not yet realized for tax purposes the income associated with unbilled receivables on the AFS. The accounting firms as well as the taxpayers need the final regulations to directly address how realization limits the AFS inclusion rule so that the financial statements that must reflect both set of rules (ASC 606 in financial statement income reporting and section 451(b) in correctly reflecting the public entity's tax provision) can correctly present financial statement income, including the effect in any such AFS of the tax liability properly reportable on the Federal income tax return.

* * *

Thank you for providing me with the opportunity to provide comments on REG-104870-18. While I do not, at this time, request an opportunity to present these comments at a public hearing, I am able, if necessary, to discuss these points with your respective offices further. I hope that these comments and the attached markup of the regulations that are consistent with the comments made herein can be helpful to you and your staff in reaching decisions on the final content of the subject regulation.

Respectfully yours,

Michael F. Solomon
MF SOLOMON TAX CONSULTING, LLC
Rancho Santa Fe, CA

Cc:
Jeffrey Van Hove, Senior Advisor, U.S. Treasury (Office of Tax Policy)
Ellen Martin, Attorney-Advisor, U.S. Treasury (Office of Tax Policy)
Charles Culmer, Senior Technician Reviewer, IRS Office of Chief Counsel
Charles Gorham, Special Counsel, IRS Office of Chief Counsel