Transcript Is Available of IRS Hearing on Accounting Regs

"TAXABLE YEAR OF INCOME INCLUSION UNDER AN ACCRUAL METHOD OF ACCOUNTING; AND ADVANCED PAYMENTS FOR GOODS, SERVICES, AND OTHER ITEMS"

[REG-104554-18 and REG-104870-18]

UNITED STATES DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE

PUBLIC HEARING ON PROPOSED REGULATIONS

Washington, D.C.

Tuesday, December 10, 2019

PARTICIPANTS:

For IRS:

CHARLES W. GORHAM
Special Counsel
(Income Tax and Accounting)

KARLA M. MEOLA
Special Counsel
(Income Tax and Accounting)

PETER E. FORD
Senior Counsel
(Income Tax and Accounting)

For U.S. Department of Treasury:

ELLEN MARTIN
Attorney-Advisor
Office of Tax Policy

WENDY FRIESE
Attorney
Office of Tax Policy

Speaker:

LES SCHNEIDER
Ivins, Phillips, & Barker

MICHAEL SOLOMON
M.F. Solomon Tax Consulting, LLC

* * * * *

PROCEEDINGS

(10: 04 a.m.)

MR. GORHAM: Thank you for coming. We appreciate you showing up. This is the public hearing for two related proposed regulations that were published on September 9, 2019. One of them is REG-104870-18, titled Taxable Year of Income Inclusion Under an Accrual Method of Accounting, which deals with income recognition timing rules, under section 451B, and the other one is REG-104554-18, titled Advanced Payment for Goods, Services, and Other Items, which deals with advanced payment rules, under section 451C.

I want to introduce the panel members. My name is Charlie Gorham. I'm Special Counsel at the Office of Chief Counsel for Income Tax and Accounting. To my immediate left is Karla Meola. She's a Special Counsel in the Office of the Associate Chief Counsel Income Tax and Accounting. To her left is Peter Ford. He's a Senior Counsel in the Office of the Associate Chief Counsel Income Tax and Accounting. To his left is Ellen Martin. She's a Tax Policy Advisor for the Office of Tax Policy at Treasury, and, to her left, is Wendy Friese, a Tax Policy Advisor for the Office of Tax Policy at Treasury.

Our schedule today includes two speakers, and the list of speakers has been handed out. Each speaker will have 10 minutes to present their remarks. There is a timer that is on the podium. It used to have lights that blinked at two minutes, but they don't work anymore, so, but it does show the actual time that's left. So, when your 10 minutes are over, you'll — the clock will be at zero, and, after that, we'll ask that you stop speaking, and we'll start asking questions, and, so, we don't anticipate the hearing lasting long, since there's only two people, but if you do need to leave, or go to the restroom during the hearing, you know, please, make sure that you have an escort. They're located over here, near the exit, and, as always, we ask that everyone, please, be courteous to our speakers and vice versa. So, let's move forward with our first speaker, Les Schneider, from Ivins, Phillips, & Barker.

MR. SCHNEIDER: Thank you for the opportunity to testify today. My name is Les Schneider. I am a partner with the Washington, D.C. law firm of Ivins, Phillips, & Barker, and I'm joined here, today, by my partner, Pat Smith, who may assist me in responding to any questions that you may have. The clients, on his behalf, I'm testifying, are subject to the new financial accounting requirement in ASE606, three-part revenue from certain types of production contracts, using it over time, or a percentage of completion method, which I'll refer to, shorthand, as the Book PCM Method.

My testimony focuses on four main topics: first, the need for taxpayers, in that position, to be permitted to use their Book PCM Method for tax purposes; second, the effect of the realization requirement on the application of section 451B to incomplete production contracts reported on the Book PCM Method, for financial reporting purposes; three, the ability of taxpayers to offset their cost of goods sold against any revenue that is accelerated, by means of the application, as either section 451B or section 451C; and four, the need to broaden the category of goods eligible for the exception in proposed regulations, under section 451C, to certain so-called specified goods.

So, let me turn to the first subject, the need for a Book PCM Method, for tax purposes. While the overall actual goal of section 451B is to require greater conformity between tax and financial conformity, with respect to the time for reporting gross income, from revenue producing transactions, the earlier of section 451B would actually produce the greatest non-conformity between tax and financial reporting, is in the case of transactions that have to be reported on a PCM Method for financial reporting purposes, but for which the taxpayer must use an accrual delivery method for tax purposes. Our firm's written comments explain the various ways in which that non-conforming treatment will impose severe administrative hardships on taxpayers complying with those rules. We don't have time to go into those in my affirmative remarks today.

I submit that the only feasible solution in this type of situation is to give the taxpayers the option of following the Book PCM Method of accounting for tax purposes. Our firm's written comments explain, in considerable detail, how such a Book PCM option might operate, and I'd be pleased to respond to any questions that you might have in that regard. Let me assure you that the suggestion to remit a Book PCM option is motivated, exclusively, by the desire of companies to avoid the considerable complexity that would otherwise result if taxpayers were required to use completely different methods of accounting for tax and financial reporting purposes, for what might be hundreds or thousands of different contracts.

Taxpayers' good faith motivation for suggesting a Book PCM option is demonstrated by the fact that, even if the Treasury and the IRS were to conclude that the realization requirement has not been satisfied in the case of incomplete contracts for the production and sale of goods, which is the next subject, time for tax — that, in that case, taxpayers would nevertheless use and elect the Book PCM option. Many of those clients would do that, even though that would result in the reporting of more income than under an non-realization conclusion. As noted in the preamble to the proposed regulations, you might think that an alternative way to solve this problem, and the administrative problems, would be to expand the definition of a long-term contract, and let more people use the PCM Method, under section 460.

Our firm written comments explain why that alternative is significantly more complicated than a Book PCM option, without producing any greater accuracy in the measurement of income. The potential differences in the contract price on the revenue side, and the treatment of Schedule M adjustments, on the cost side, are not likely to produce a significant difference in the timing of income recognition for tax and financial reporting purposes. In contrast, the trade-off in administrative complexity will be significant, if section 460 must be applied, instead of a Book PCM option.

The second topic is the application of the realization requirement, the incomplete production contracts. Tying it to the related subject of realization, a legitimate question is posed whether section 451B should even apply to the types of contracts in which a Book PCM option is being proposed. As everyone knows, existing law treats the sale of property as incomplete, prior to the completion of the production of the property and its delivery to the customer. In other words, prior to completion and delivery of the property, there has not yet been a realization of that, with respect to the sale of the property for tax purposes.

The conference report — by the Blue Book, issued by the Joint Committee, states, very clearly, that section 451B was not intended by Congress to override the realization requirement in the tax law. Unfortunately, this issue is not addressed, directly, in the proposed regulations. However, the proposed regulations, certainly, leave the reader with the impression that the Treasury and IRS assume that section 451B applies to production contracts accounted for on a Book PCM Method for financial reporting purposes.

At this point, you might pause and justifiably ask why are we proposing a Book PCM option, if we don't really believe that 451B is even applicable in these situations, where a taxpayer might use the Book PCM Method for tax purposes, and I said — as I said before, the answer is that, even in the face of favorable conclusion, that the realization requirement is not satisfied in these situations. Many of our clients would still choose to use a Book PCM option for tax purposes and pay more tax, in order to avoid the administrative complexity of having to deal with Schedule M adjustments, on hundreds or thousands of separate contracts.

Okay, third topic — cost of goods sold offset. Turning to the subject of a cost of goods sold offset, if a taxpayer using the Book PCM Method for financial reporting purposes were required, for tax purposes, to accelerate the reporting of revenue for tax purposes, but were not given an offset for the related cost of goods sold, that result would resolve in a tax burden that many taxpayers could not easily handle. Accordingly, in our written comments, we addressed, at length, the importance of, as well as the legal requirement that taxpayers be permitted to offset cost of goods sold, but against any revenue that has to be accelerated, under either Sections 451B or 51C. In our view, the justifications against the cost of goods sold offset, offered in the preamble to the proposed regulations, are not persuasive.

In addition, it would be ironic for a provision in the tax law that was designed to promote greater conformity between tax and financial reporting for revenue to (inaudible) a gross mismatch between tax and financial reporting for cost of goods sold, that relates to that revenue. The financial accounting profession would never have adopted a principle dictating accelerated reporting of revenue, if a consequence of an acceleration would be to report revenue at a different time than on the related amount of cost of goods sold, is re-permitted against the offset against that accelerated revenue. Likewise, in the case of 451C, recognition of an advanced payment in income for tax purposes, prior to the actual sale of the goods, has long been recognized as involving the net amount of the gross income (inaudible) payment, where sales of goods are involved.

Going all the way back through the original caseload dealing with advanced payments, from the sale of goods, it has never been the Treasury, this intent, to tax the gross (inaudible) payment. This conclusion is evidenced in the doctrine that emerged from the Hagan advertising line of cases, and the last subject, exception from section 451C for specified goods. As we state in our written comments, we commend the Treasury and the IRS's efforts to recognize the need for an exception from the strict one-year deferral period permitted under section 451C.

However, we submit that this exception is designed too narrowly, and does not apply to taxpayers that are no less deserving of relief than taxpayers that fit within the eligibility requirement in the proposed regulations. In particular, there's no reasonable justification for limiting the relief afforded by the specified good exception in the proposed regulations, just the taxpayers with contracts that contain precise contractual delivery dates. There are many situations where the precise delivery date of the goods is not known at the outset of the contract, but there is not the slightest uncertainty that the goods will eventually be provided by the taxpayer. We think those taxpayers are deserving of this type of specified goods exception. Likewise, there's no signed policy justification, if we're limiting the exception for specified goods to contracts accounted for on a point in time method for financial reporting purposes. Contracts that must be accounted for on the (inaudible) PCM Method are just as deserving for relief from the one-year deferral invitation.

Okay. Thank you for the opportunity to testify today, and I'm available, along with Pat, here, to answer any questions that you may have, either about our testimony, or the extensive written comments that we provided previously.

MR. GORHAM: Yes. Thank you, Les. We really appreciate all your comments. We do have some questions.

MR. SCHNEIDER: Okay.

MR. GORHAM: So, my first question is that you were involved in the drafting of the conference report, right?

MR. SCHNEIDER: Yes.

MR. GORHAM: And were you involved in the drafting of the Blue Book?

MR. SCHNEIDER: No.

MR. GORHAM: So, could you expound on the discussions that you had with the drafters, regarding the scope of the provision and working on the conference report?

MR. SCHNEIDER: With respect to the realization concept?

MR. GORHAM: Right, with respect to the realization concept, and there have been some arguments that, maybe, it's only meant to apply to two sets of things, unbilled receivables for services and credit card fees. Could you just expound on that a little bit?

MR. SCHNEIDER: Well, I — our discussion, with respect to the Joint Committee on that realization issue, was really focused almost on an issue that we're not addressing here at all, which is whether there, in fact, is an exception for realization. I guess we were, at first, since there's nothing in the legislative history about that, at least up to that point, were concerned that some of our financial accounting clients, not ones that we're testifying on today, were concerned that they are — like, for hedge funds, we have to mark the market, all of their investments for tax purposes, because that's the method they used for financial reporting, and, so, when we talked to the Joint Committee, they said, oh, no, no, we really intended these rules not to change the realization requirement, and we said, well, you know, there's a host of ready — readily, you know, available kinds of treatments, where you have an exception for the realization requirement for financial reporting, under ASE606, but there's no comparable rule for tax purposes, like mark the market for a financial reporting company, sell versus lease, undistributed earnings from a subsidiary.

Those are all examples where there hasn't been a realization, but, you know, you might worry that the way the statute is drafted, section 451B, would apply to those kinds of things, and, I guess, the Joint Committee, at that point, said we never meant, or we didn't that Congress meant for the statute to apply to those situations, where there wasn't a realization event, and, so, you know, would you help in the drafting of a footnote that addresses those types of situations? We never really, at that point, discussed unbilled receivables. We didn't discuss, you know, executory production contracts. So, our interaction with the Joint Committee, at that point in time, didn't delve into any of the issues we're testifying about today.

MR. GORHAM: So, with regard to realization, and I will ask Mr. Solomon this question as well, it seems like —

MR. SCHNEIDER: Right.

MR. GORHAM: — you disagree with him on what realization is. Is that a fair —

MR. SCHNEIDER: Well, well, that may be too broad a description of our differences, I guess.

MR. GORHAM: Okay.

MR. SCHNEIDER: I think we both believe that there's, obviously, a realization exception, in section 451B. The question is to what does the realization concept apply, and I think — we think it, surely, applies to the sale of goods, and, particularly, executory production contracts. So, I think the place where we may be diverged, somewhat, is on the treatment of the realization concept that is — applies to services. In the thought that we said of in the abstract, don't think that the realization concept applies there. It's more about we have trouble seeing how the realization concept yields a different answer than the Old Events Test, when you apply it for services.

It just seems like the concepts are sort of used interchangeably there. I mean, we're — I am not aware of any case or ruling that was decided in the services area on the grounds that there hasn't been a realization. They always seem to decide the issue on the basis of whether the Old Events Test is satisfied, and, so, since section 451B is designed to modify the Old Events Test, I guess, we have trouble seeing how it doesn't apply to service contracts, all kinds of service contracts.

MR. GORHAM: So, in other words, it seems like you're saying that realization, for you, is more a 1001 concept. Is that fair?

MR. SCHNEIDER: Yes, yes.

MR. GORHAM: Okay. Could you explain what you think the interaction is between 1001 and 451?

MR. SCHNEIDER: I'm not sure that there is a tremendous amount of interaction. I mean, I think, with respect — well, I shouldn't say that, but, with respect for the sale of goods, I think, you know, 1001, clearly, applies. It applies more clearly to incidental sales and not inventory sales, but, you know, there's Section 1013, and there are interactions in the area of condemnation, insurance recoveries that have evolved, inventories.

So, while you don't normally see 1001 cited in connection with sales of inventory, there's clearly an interaction within the statute and regulations, and, so, we think, you know, they probably do apply jointly. I think the place where 451 steps in is, if you're on the Cash Method of accounting, you might have a realization at a different time than you have it on the Accrual Method. So, there is an overlay in 1001, with respect to your method of accounting. So, I think, in that sense, they do interact, but I think we, you know, specifically, with respect to the sale of property, at least, you know, we think that there does need to be a realization, and, you know, you tend not to see so much section 451 cited, with regard to the timing, as much as 1001 seems to control, in those situations. Pat, do you have any —

MR. SMITH: No, I don't —

MR. GORHAM: So, I mean, you brought up the idea of the Cash Method. So, are you saying that you think that realization, on some level, is tied to your method of accounting?

MR. SCHNEIDER: Well, I think you do get a different answer, you know, depending on whether you're on the Cash on the Accrual Methods, I mean.

MR. GORHAM: Right.

MR. SCHNEIDER: You know, the amount realized is different. You know, it's the face amount for an accrual basis taxpayer. It's the fair market value of the obligation for the cash basis taxpayer, and then there's the doctrine of cash equivalency, you know? So, you don't have income, if what you receive is just a promise to pay on the Cash Method, whereas, in Accrual Method, taxpayer has income in that situation. So, I — clearly, the method of accounting interacts with 1001.

MR. GORHAM: So, there were a few items that you did not comment on, in the reg, and, so, I just want to see if you have any thoughts —

MR. SCHNEIDER: Okay.

MR. GORHAM: — and, so, one of them was do you think that we need any special rules to address the applicability of the rule to foreign persons?

MR. SCHNEIDER: You got any thoughts on that? I —

MR. SMITH: We haven't given any —

MR. SCHNEIDER: We really haven't thought about that, and I —

MR. GORHAM: Okay.

MR. SCHNEIDER: — I don't know that you'd — whether you do or you don't, I would say.

MR. GORHAM: And one of the questions that we asked, in the proposed regs, was, you know, about how do we deal with things, like escalating rent agreements, where, you know, the AFS and income inclusion, you know, exceeds the amount of the rent received for a particular year. How do you think we should address that issue?

MR. SCHNEIDER: I think it would be preferable if you treated it like 467, and just carved it out as a special method of accounting. I think it would be easier, and I think it — maybe, it's consistent with the policy on contingencies.

MR. GORHAM: Do you not think that there could be any similarities drawn between the escalating rent agreements and the issue of the trailing commissions that's been brought up numerous times?

MR. SCHNEIDER: I don't know. I'm not sure that there is a — necessarily a connection, there. Yeah, I haven't thought about that, but —

MR. GORHAM: How would you treat the trailing commissions?

MR. SCHNEIDER: Why, I mean, they clearly are — you know, in a sense, there are a reduction in revenue, but, on the other hand, it probably is a Section, you know, a 162 expense, and, so, I'd — and I think, maybe, the question is separate, and that the answer has to be decided separately.

MR. GORHAM: Are there any special methods of accounting that you think we did not include, and it's a non-exhaustive list, but —

MR. SCHNEIDER: Right.

MR. GORHAM: — are there any that you think we could include, that — or are you happy with the list?

MR. SCHNEIDER: Yeah, not enough that we've thought about them. I think we're happy with the list —

MR. GORHAM: Okay.

MR. SCHNEIDER: — other than adding a Book PCM Method.

MR. GORHAM: Well, I know Ellen has a question on that, so.

MR. SCHNEIDER: Okay.

MS. MARTIN: Yeah. So, actually, Les, just — I don't know if you can turn it on. Okay. I — is that better?

MR. GORHAM: That's fine.

MS. MARTIN: Okay. So, yeah, I just wanted to ask a clarifying question on your suggestion for the Book PCM Method, and, going back to your comment letter, I appreciate the work that went into that, but, as I've read it a couple times, I sort of — I just want to clarify how that — how you see that working with sort of Book Tax differences. I mean, I think what you're suggesting, perhaps, is that the only Book — the only part you would follow a Book on is in determining the completion factor.

MR. SCHNEIDER: That's correct.

MS. MARTIN: The PCM (inaudible) does follow tax —

MR. SCHNEIDER: Correct.

MS. MARTIN: — principles for your cost deductions, other than 263A and 471.

MR. SCHNEIDER: Exactly. Yes.

MS. MARTIN: So, for example, like, Book Tax depreciation, deductions, you would still deduct your tax depreciation, just using Book in the completion factor.

MR. SCHNEIDER: Correct. So, it would still be deductible. I mean, what makes it easy is that you would be deducting it at the same time. It's just a question almost of below the line, or below the line, as to whether it would be in the completion factor, in computing gross income, or it would be deductible, separate from the completion factor. I mean, you can even state it's still an above the line deduction, but it wouldn't affect the completion factor.

MS. MARTIN: Yeah, almost — is that step —

MR. SCHNEIDER: Yeah.

MS. MARTIN: Would that still provide the — I mean, I — I'm assuming yes, because you've thought this through, that that still provides the administrative convenient — I mean, it's still easier, even though you would have to not just completely follow Book for your deductions, as well —

MR. SCHNEIDER: Yes.Yeah.

MS. MARTIN: — but you still have to go back in and adjust your costs.

MR. SCHNEIDER: It — no, absolutely —

MS. MARTIN: Okay.

MR. SCHNEIDER: — and I, you know, I was thinking, somewhere, too, about, on the cost side, I don't know that we explained this in complete detail enough, on our comments, but what distinguishes the people that are on the Book PCM Method, compared to other manufacturers is that most manufacturers have an inventory that consists, mostly, of raw materials and finished goods.

Their work in process is usually tiny because the production period is just a few hours or a day or two, and, so, if you were to dig inside their inventory questing system, they have elaborate rules to track the cost of the raw materials and the finished goods, but they, generally, treat the work in process as one, big, undifferentiated lump sum, and they just simply know that, since they're only selling finished goods, once the work in process is made into finished goods, they go out the door. That inventory turns over.

Here, you have an entire set of industries, where their whole inventory, almost, is work in process, and, so, just think about what kind of a questing method you'd need to track a Schedule M adjustment, let's say, on employee benefits, to the direct labor employees that work on thousands of different contracts during the course of the year. When you don't calculate the schedule adjustment till the end of the year, when you compare the total Book labor cost with the total tax labor cost, only, now, you have to allocate it back to all the individual contracts, and you have to allocate it to the individual items.

I mean, they don't even have an inventory costing system, today, that would tell you that, for the 10,000 different widgets, some assemblies, parts, and partially completed finished goods, what's the unit cost of each of those things, but 263A sort of forces you to use that kind of a method for your 471 costs. Whereas, their 471 method, before they want to run this Book PCM Method, it was just a lump sum. They have no idea what the inventory cost of any one part of any one contract is, and, so, you, now, go to the Book PCM Method for Book purposes, and you, now, all of a sudden, have no section 471 costs, no Book Inventory Method. How in the world are those companies going to be able to figure out, let alone on a basic cost, let alone their Schedule M adjustments? What part of each cost goes with each widget and each contract, across thousands of contracts? I mean, it's just, I mean, impossible administrative problem to apply inventory cost accounting in that kind of a setting.

MR. FORD: Can I just jump in here?

MR. GORHAM: Yes.

MR. FORD: So, are you suggesting that tax — some taxpayers are not on an activity—based costing model, which kind of lays out what their specific costs are, per process, within sort of total inventory?

MR. SCHNEIDER: Yes. I would say none of the companies, in these industries, that are affected by Book PCM, are on activity—based costing. They're not building up a standard cost for the product, at this raw material stage, then at the next stage, and the next stage, and the next stage. They're just linking all the costs together on the contract, which is Book cost, not Schedule M adjustments, and allocating it, in total, to the contract, today, even before 451B. So, I mean, you really — there's no way they could do an inventory costing system now, when you take away even what little Book Inventory Costing Method they have, and say, well, for Books, everything's just deductible, as they incur it. So, what's their tax unit cost of any widget? They have no idea.

MS. MARTIN: So, this is an existing issue, then?

MR. SCHNEIDER: Well, it's not an issue because no one's ever — you know, they're not on (inaudible) they're — the inventory turns over only when the goods, finished goods, are sold. So, there's a massive lump work in process. See, it's an ending inventory, until the proper period, when it's made into a finished product, and it goes out the door, and, so, it's being deducted at the right time. It's an ending inventory, at the right time. It's just not being allocated piece by piece, across every item in the inventory, even today, but it'll be even more difficult, if they go to Book PCM, and everything just becomes deductible on the Books. Then, they don't even have the deferred amount of cost, in total.

MS. MARTIN: Okay. Thank you. I — actually, I have another question on the specified —

MR. SCHNEIDER: Yes.

MS. MARTIN: — your fourth item on the broadening the exception for specified goods. You sort of mentioned that you think we should, you know, that the, I guess, the restriction on the delivery date in the contract and the Book Method is too limiting for other taxpayers. I mean, without those in there, what restrictions, if any, would you consider, and how would you — do you have any suggestions on how you would broaden that form?

MR. SCHNEIDER: What do you say, the time limit, you know, for the length of the contract, what do you think? Yeah.

MR. SMITH: Well, I think we'd, you know, tried to get into that in our comment letter, that is, you know, just to say that the facts and circumstances have to indicate that the performance will, in fact, occur. It's just that it's not possible to determine at the time the contract is entered into, precisely, when each unit will be completed. I think, you know, that just seems like a really arbitrary and unreasonable requirement because it's so, so limited. You know, the — most taxpayers, at least the taxpayers that we're representing, simply can't determine that. They're not in the kind of business, you know, like an aircraft manufacturer, where they have these elaborate, precise schedules. It's just not common at all.

MS. MARTIN: So, I guess, would you see it applying to all goods, or, I mean, I — that's sort of where I'm getting at, is where do you draw the line, or do you?

MR. SMITH: Well, no, what I said — I mean, it —

MS. MARTIN: Just — just facts and circumstances?

MR. SMITH: You know, in facts and circumstances, tests saying, you know, is it reasonably predictable that the required performance will, in fact, occur, as opposed to, you know, the situations in the Supreme Court cases, where they were concerned, well, the customer may not want this. I mean, these, the customers we're talking about definitely want it. It's just that it can't be determined with as much precision as in the aircraft manufacturer's situation, precisely when the performance will occur.

MR. SCHNEIDER: Well, and, perhaps, though, you know, a restriction, like the deferral period, would be at least two years, some time, and you're already covered for one year, under the existing reg. So, you know, maybe a minimum deferral period, like that, would be fine, I think. I mean, I think, as you saw, you know, yesterday, in the meeting we had on the cemetery industry, it could be deferral periods of 10, 15, or 20 years —

MS. MARTIN: Right.

MR. SCHNEIDER: — on certain kinds of goods, and, you know, having to pick up the income on day one, and the expense, 20 years later, is a hardship.

MR. SMITH: And, on the revenue side, on the financial accounting revenue side, again, you know, the requirement that the revenue has to be reported for financial accounting purposes, when the goods are delivered, again, that's just not representative of the kinds of business operations of the taxpayers that we're representing because there is, you know, as Les has discussed, at length, for financial accounting purposes, they run on PCM. So, I, you know, just saying that the revenue has to be reported for tax purposes at the same time that it's reported for financial accounting purposes seems, to us, to be a more reasonable aspect of that requirement.

MR. SCHNEIDER: I mean, there'd still be a conformity requirement for those people. So, if they picked up the revenue on their books, through Book PCM, they — obviously, the advanced payment wouldn't be an advanced payment, and it wouldn't be deferrable.

MS. MARTIN: Right.

MR. FORD: So, are there any of your recommendations that are more appropriate for sub regulatory guidance?

MR. SCHNEIDER: Well, I think the Book PCM Method — I don't know that we would see that as being something you would put into the regulations. I mean, it's —

MR. FORD: Well, you know, I guess, that we —

MR. SCHNEIDER: — it's sort of a safe harbor.

MR. FORD: — we would hope there might be some reference to it, you know, to —

MR. SCHNEIDER: In the preamble, but —

MR. FORD: The details would — could well be put forth in the revenue procedure.

MR. SCHNEIDER: You know, because, again, I mean, it's not — the method is not being proposed as a matter of law. We're not saying — under existing law, we're entitled to that, under 451. So, I think it's probably a special method of accounting, like the type you've issued in (inaudible) to other industries, over the years.

MS. FRIESE: So, if you think we just allow for a Book PCM, then some of the other, like, relief, if you will, that's been suggested, do you think that that would solve some of the other issues?

MR. SCHNEIDER: Well, it does, not for everybody, but it does. I mean, I'd —

MR. SMITH: It solves the cost offset issue, basically.

MR. SCHNEIDER: Or, at least, for people that would be on Book PCM —

MR. SMITH: Yeah.

MR. SCHNEIDER: — yeah, I mean, like, for example, yesterday, we talked about the cemetery industry. They're not on Books PCM, and it doesn't solve their problem, but it solves, certainly, solves all the people that are on Book PCM. I mean, in a sense, you are giving them a cost offset for a Book PCM.

MS. FRIESE: Right.

MR. GORHAM: All right. Do you have anything, anything, any recommendations for anyone who's not on Book PCM?

MR. SCHNEIDER: Well, I — we — I think, in our written comments, we talked about the contingent revenue provision in the regulations. We thought that it leaves a very ambiguous impression, as to what the standard of proof is. We don't really understand why you need a presumption, and what we really think is you wanted to give people the option to ignore the contingencies because our clients would just as soon pay tax on the higher amount of the contract price, if that's being recognized as the contract price, for Book purposes, to avoid a Schedule M adjustment. So, I mean, that —

MR. SMITH: Well, really, to avoid having to go through on a contract —

MR. SCHNEIDER: By contract.

MR. SMITH: — by contract basis, and analyze every single one of, you know, hundreds or thousands of contracts. I mean, they just don't want to have to do that.

MR. SCHNEIDER: Right. Well, you know, with the existing language saying, well, you know, you have to — there's a presumption that it's not contingent, and you also satisfy it to the, you know, convince the Commissioner that — of the reasonableness of it. I mean, that sort of makes it sound like it's not a 51-49 case, but, you know, maybe, if the agents are 30 percent there, it's reasonable. So, they're not there. Their position is not going to be overturned. I — it just doesn't seem like there's going to be big abuse in that area, and, in particularly, we think a lot of clients would want to ignore the ability to reduce the contract rights, in any event, just to avoid administrative complexity. So, I — we think, you know, just an ordinary — there, just a basic burden of proof rule is enough, in that area.

MR. GORHAM: All right.Thank you.

MR. SCHNEIDER: Okay.

MR. GORHAM: We appreciate your comments. Thank you.

MR. SCHNEIDER: Thank you.

MR. GORHAM: Our next speaker is Michael Solomon, from M.F. Solomon Tax Consulting, LLC.

MR. SOLOMON: Okay. Is this camera good?

SPEAKER: Yeah. I'm going to —

MR. SOLOMON: Okay.

SPEAKER: — I'm going to start it. I have to start it.

MR. SOLOMON: Ready to go.

SPEAKER: Okay.

MR. SOLOMON: Good morning. My name's Michael Solomon. These hearings may not be as exciting as the ones down the street, in the matter of impeachment of the President, but the rules we are discussing, today, are likely to be in place long after this President, and the following Presidents, have come and gone. So, it's my hope that, on the basis of the comments that you've heard, today, from Les, and from me, and from those that have been provided in writing, that we can find the right answers to these important tax accounting questions. My goal, in speaking, today, is to identify certain ambiguities and inconsistent provisions in the regs, so that those of us who work with these rules every day, in the trenches, can help companies avoid costly audit controversies and allow their financial statements, which is really important, to correctly measure tax liabilities and not have significant reserves.

I want to focus on a few basic concerns. The first concern is that the proposed regulations do not provide adequate guidance relating to the requirement that income must first be realized before it can be recognized. I mean, you heard Les address this, too, and it's clearly something, and I know we discussed this directly, and have been in lots of comments. We need to have a better answer on that. The concern is exacerbated by a lack of guidance on the proper treatment of unbilled receivables, reported on a taxpayer's applicable financial statements that result from overtime reporting. I — under AOC606, and Les mentioned that, as well.

The second concern that I will address is the provision in the proposed regulation that creates a rebuttable presumption, as to realization, in cases where income is reported on an applicable financial statement, and the third element of these comments concerns ambiguities in the examples, and their failure to properly distinguish when income is realized and when it must be recognized, under section 451B.

If Congress had intended that the TCJA Amendment, section 451B, was require — would require the tax reporting of income to fully conform to the reporting of all income on a taxpayer's financial statement, it would have said that. Instead, it made it clear, in the Conference Report, in Footnote H72, that 451B's conformity provision can only apply to amounts that have been realized as income for tax purposes. I address this realization prerequisite in my written comments, and I'm not going to repeat what I said previously.

However, I would like to directly state that the Courts, and this really goes to your question, Charlie, to Les, that the Supreme Court and the IRS, itself, have consistently held that realization is a precondition to both contracts for the sale of goods and for the performance of services. Income related to both goods and services need to be realized before it can be taxed. Any suggestion to the contrary seems, to me, to be incorrect.

Therefore, the clear starting point, for me, in analyzing how to implement the statute, and I hope that it's the same for the drafters of the regs, is that section 451B does not require tax reporting to mirror financial statement reporting. Rather, it seems to me that it should serve a more limited goal of using the income reported on an applicable financial statement, to help indicate, first, whether Book income has been realized for tax, and, second, to ensure that realized income should be recognized for tax no later than when such amounts are reported on the financial statement.

The regulations do address realization and recognition, in general terms, but leave many ambiguities, and contain many inconsistencies that will lead to confusion and inefficiencies in application. How should Treasury carry out the Congressional Mandate, and use the financial statement to do — help determine both when income is realized and when should it be recognized? I would like to suggest that there are two separate paradigms, situations, that the regulations need to separate, and then appropriately address.

The first paradigm is where payment has already been made to the taxpayer, or the taxpayer has an unconditional right to the payment. The second paradigm, however, is where the taxpayer has not yet been paid, and has no unconditional right to payment. Each paradigm requires different answers, under section 451B. They can't be lumped together because the question of tax realization differs dramatically in both of these cases.

So, let's look at the first paradigm, how section 451B should apply to amounts that have already been paid or unconditionally due. Well, the normal tax rules, in the case of amounts have been paid or due, hold the realization as met on payment, or, in the case of an accrual basis taxpayer, when amounts are unconditionally due to be paid, if earlier than payment. Recognition usually happens contemporaneously with realization, but may be deferred under provisions, such as the Advanced Payment Rules, Installment Sale Recording, or Reorganization Rules.

Section 451B applies, in this paradigm, to ensure that a taxpayer cannot defer reporting income that has been realized to a later year because of deferred billing or the failure to properly sever individual performance obligations under a contract that each have separate billing entitlements. The regulations under 451B should make it clear that if the financial statement rules use payment or an unconditional right to payment as the reason for Book inclusion, then tax should conform.

The second paradigm case presents the most important reason that I am here today. The regulations need to better address how to treat amounts that are reported as Book income, but are included on an applicable financial statement as unbilled receivables because the taxpayer has not yet been paid and does not yet have a right to invoice the customer for the Book income amount. Congress wanted to address these unbilled receivables in Footnote H74, but said it didn't intend to override the prerequisite of realization in Footnote H72. What is missing, in the regs — helpful guidance is to when an unbilled amount is not yet realized, and, thus, is not yet subject to section 451-B. The proposed rate suggests that income is realized that the taxpayer has an enforceable right to payment. I have struggled to find a tax case that defines what an enforceable right to payment is in the context of helping define realization or recognition. What I have found are dozens of tax cases decided over nearly a hundred years of tax guidance which states that income is not realized until the taxpayer has an unconditional right to the income.

Do enforceable and unconditional mean the same thing? Can the regulations make that clear? If the meaning is the same, then perhaps there is no ambiguity here. However, as I pointed out in my comments filed in October, the term "enforceable right to payment" appears to be taken from AFC 606. These rules specifically state that when evaluating whether a taxpayer has an enforceable right to payment, the right to payment need not be a present unconditional right to payment. How should taxpayers in the IRS audit teams decide which meaning to use and will this ambiguity serve to accentuate, rather than ameliorate controversy and compliance costs? I hope that since Congress did not intend to alter the rules regarding realization, the terms and the regulations will be clarified to be consistent with the long series of cases and rulings that have addressed this realization concept and require an unconditional right to payment.

My primary concern with the proper taxation with the unbilled amounts is that no attempt is made in these proposed regs to distinguish the tax rules under 451-B that should apply when the financial statements report income, at a point and time reporting basis, as compared to when they require overtime reporting. Each of these 2 financial statement rules are based on financial statements that are materially different in answering whether the book income reported in each method has been realized.

If regulations are true to the Congressional mandate, that income must first be realized before it can be recognized. The first question that much be asked is whether each of these 2 separate income reporting rules include unbilled amounts and book income on a standard that needs tax realization. When one reviews these newly adopted rules, they appear to be diametrically different in their relation to tax realization. Point in time reporting closely tracks what we would think as realization. You basically pay tax when you have delivered something, when you've performed or when you basically have completeD a separate performance obligation. Overtime reporting, however, is PCM. It's the equivalent to what 460 requires. At time during the performance of a contract subject to overtime reporting and prior to the completion, there is no unconditional right to income, only an anticipated right. I think that the Code with the IRS has made it clear that you can't use PSM unless you basically own a 460 contract. I think that the overtime reporting is effectively the antithesis of realization when you compare to what the tax rules say.

So, my basic point, I guess, with respect to unbilled receivables is, I think that an unbilled receivable, under the book over time reporting method essentially is the same as when I've got a lease or a sale for book and for tax. It's a completely different method. It has no relation to realization. I think that the carve out ought to be the same as we've carved out leases and sales and different transactions in this context.

I think I've run over my time and I will stop. I have a few other points to make, but maybe if you have questions, I'll address them there.

MR. GORHAM: Thank you so much for your comments. We really appreciate it. We do have some questions. I think Les mentioned that it may be despite what your comments and his comments seem to say, that maybe you did disagree as much on what realization really is. I mean, he is saying you actually agreed.

MR. SOLOMON: Yeah. Les and I basically agree. Most of the cases that deal with services deal with it in the context of has it satisfied the all events test. Have you been paid? Is it a payment? Is it something that basically should be triggered? However, if you look at the cases, and I think I cited those in my supplemental comments that I submitted to you, there are several Supreme Court cases dealing with services that basically say we can't tax until you have a right to the income, until you effectively have earned that income. I think I cited clearly there's a statement to that effect in Schutte, Indianapolis Power which is a service provider case. The Court focused exactly on that point, and how there really wasn't an entitlement to income. It was basically a deposit or an amount that wasn't yet a payment. I think you have a number of Supreme Court cases that address that and I don't think Les and I probably differ much on that issue.

MR. GORHAM: Okay. So, to be clear, I mean if we were to adopt your definition of realization. I mean, you think it would apply to both the provision of services and the sale of goods.

MR. SOLOMON: Clearly, it definitely applies to both. Realization does.

MR. GORHAM: In your submission, your submission ties realization to these words, a fixed and unconditional rate to the income — that's right. Right?

MR. SOLOMON: Right.

MR. GORHAM: So, there is some concern that that language is essentially the old all events test, which I think you just said, that you thought that's how it would apply for services. Right? What do you think is actually covered by the statute then?

MR. SOLOMON: Well, the statute covers a lot of things, as I said. There has been a lot of ambiguity over the years as to whether an amount has been realized in the context of a service taxpayer. Do I wait until the end of a contract until I have an entitlement to bill? If I have 10 separate performance obligations, does each one basically give me a fixed right to an amount of income, even though I can't bill for it later?

There's all kinds of situation that we come across where taxpayers haven't answered that question as to when does a fixed right to income come up in a service contract. As I said in my comments just now, you can use this 451-B Rule, this financial conformity rule, to say if my books report something, I have to show — it's kind of like your rebuttable presumption test. I have to show that this is not yet been realized. What bothers me, however, is that we can't use a realization tests in a book income type of situation where we report over time that has no standard of realization. So, as I said, it should be excluding taxpayers that report under booked PSM from the operation of 451-B. It shouldn't apply to them, because it's the same as if they were reporting as a lease for tax and a sale for books. There's no consistency in that set of transactions in that way. I think that it's a mistake to try to bootstrap on those taxpayers these rules. You might be able to bootstrap it in the point of time situation, but not the over time reporting situation. It just doesn't fit.

MS. MARTIN: Just to follow on that a little bit, just so I can try to understand, if you would just apply it to point in time for services is what we're talking about right now. Right? That's kind of the question.

MR. SOLOMON: I don't think there's a distinction again between services and sale of goods contracts because the same issue is there. There is no realization in over time reporting. It doesn't put — you don't have a realization concept when the books put up an amount of income that's based on the amount of costs I've incurred toward some completion in the future. So, it applies to both.

MS. MARTIN: So, my question is, in the context of services, is there generally a difference between taxpayers who are using point in time for AFS and when they would recognize the revenue under the all events test?

MR. SOLOMON: I think there's a difference for sure that you have a taxpayer that's got a point in time basis which basically says when I complete my whatever the service is, I'm basically have to, I don't know, go out and provide a certain kind of service to some military base, and when I complete it, I'm entitled to a hundred dollars. That's a lot different from somebody who has to provide some kind of service that's a service that also has no entitlement to payment until it's completed, but they have to, as each dollar is incurred on that, the fact that ASC-606 says you have to report an assumed profit margin on that dollar, even though you may never get the dollar, even though it may never be reimbursed to you or paid to you. That's where I have the problem and I don't think it's limited to services or goods or where it's over time. When it's point in time, I think you have the IRS rulings and you have the case law that says if you sever an individual service aspect and it's a separate performance obligation and you report that separate performance obligation at point in time, you should pay tax on that, at that point, because both realization and recognition occurred simultaneously.

MS. FRIESE: As Les pointed out, as part of the history of what did he want to be, it was part of the CAMP proposal and that was meant to address the unbilled receivable for non-dividable services. Would you say that your interpretation of the realization concept then would override the intent of what you want the original CAMP proposal?

MR. SOLOMON: I mean the Kent proposal, there are several CAMP proposals all over this stuff. I don't think that it necessarily said that it was going to apply and make book text conformity required in this particular situation. As I remember, and I don't have all of that in front me right now. It didn't necessarily address the question of whether it could replace the realization with this. It did say that they were intending to do that. I think that Congress clearly said that they intended to do something with unbilled receivables in Footnote H-74, but I also think — this is my whole problem here — is the regs don't tell us how to first decide whether there's realization and then to apply this unbilled receivable situation in the context of realized amounts. I added some examples to what I submitted to you to try to help differentiate that. Clearly the examples that are in there currently, basically all refer back, not to realization, but to whether an amount is included in an AFS. Even in the contingent example, number ten, as I remember where you're talking about the contingent right to certain future amounts that depend on whether somebody then exercises the contingency. Even then, they don't say that the reason is not income up front. It's not because of the realization. They say it's not there because it's contingent under to be and you can prove the rebuttable presumption against that, rather than just deal with it directly and say it's not realized. It doesn't say that. It just refers back to the regs. I think it's this kind of confusion and I understand you are struggling with this, but we're going to have to defend all of this stuff with audits and the same thing with this rebuttable presumption. It's going to change you guys have had this type of rule in effect forever. Most taxpayers that I represent that are reporting or have to report under over time reporting for books, have reported over time reporting for book forever. This is not new. ROC-606 may be new, but the percentage of completion for book reporting has always been there for these large taxpayers. We've had Schedule M's for 50 years dealing with this. The IRS has basically decided this is when you pay tax on this income, even though your books have said it's paid later. To all of a sudden, have a C change that says it's rebuttable presumption and the rules are to be different, and we're moving this — we've been through this for 50 years. If we're not changing realization, all these public companies that have been reporting forever on this, why should they have to redo everything that they've done. I think the over time reporting piece of these book rules need to be taken out, deal with point in time, deal with what is basically, I think what CAMP was clearly intending to look at, which are separate performance obligations or deferred billing when you've earned the money. All of those things seem right for an unbilled amount, but not to try to superimpose on tope of the rest of this, you know, some notion where you have somehow required to report over time for books, that that should also measure realization. It doesn't.

MR. FORD: So, you would say that for U.S. tax purposes, the use of an enforceable right doesn't equal realization, for tax purposes?

MR. SOLOMON: It depends on how you would define, the enforceable right. If it basically is defined as the way AOC-606 defines it, absolutely it doesn't meet the realization standard. It is specific in the depths of the AOC-606 reporting rules and I set that out in my comments to you, that it says it doesn't have to be unconditional.

MR. GORHAM: Enforceable right is used in the blue book; right?

MR. SOLOMON: It's used in the blue book, yes.

MR. GORHAM: So, you would ask us to disregard the blue book? The examples, at least, just to clarify.

MR. SOLOMON: To be fair, I think that when the blue book was written, I don't think the definition was maybe as well defined to the drafters of the blue book as they should have as they looked. But they did specifically say, as noted by Les and by all of our comments, that Footnote 72 says that we are not overriding realization. So, if enforceable right means realization, then it should apply, but if it doesn't mean realization, then it can't in the context over time, then it shouldn't apply.

MR. FORD: So, just to clarify, if enforceable right meaning tax purposes, clearly you would be offended?

MR. GORHAM: If enforceable right meets realization. Requirements for tax, then I would be fine for using that term, as long as you define what we mean by an enforceable right for payment is realized to know. I would be very happy with that.

MR GORHAM: How would you define fixed and unconditional right to payment?

MR. SOLOMON: I would refer back to about the 12 that I cited for you in my comments, and that is it is something that the taxpayer last act necessarily to say "Pay Me", not that I can send a bill out today, but the obligor under those comments can't say, "I don't want to pay you because you haven't performed or you haven't completed your performance. By the way, Les had hacked and he was able to answer questions. I don't have anybody here to help me. I may have to ask for assistance at some point.

MR. GORHAM: So, we'll move on from realization, unless anyone else has another question about that. In your submission, you did not discuss any cost offsets like Les had some suggestions. Some he liked, some he didn't. Did you have any other comment on anything that he mentioned? It sounds like you would agree to a book PCM, cost offset mechanism.

MR. SOLOMON: I guess I did say in my supplemental comments that I believe that if you are all overtime reporting to give taxpayers the opportunity to elect that, to better match income and expense, it makes sense to me, we shouldn't, necessarily have the tax law, have this wide disparity of when to come and went expenses reported. I feel that's right and I think I said in my comments and Les reiterated the same thing. I don't think it's a regulation point because it doesn't really relate to the statute but you guys should provide a notice to that effect. I mean you did those things, package design. You did it. There are many times where you've done these things and I think it would be useful in here. I also think, and one thing Les didn't say, but I'll try to help him out a little bit, where you have these wide disparities in when an amount is basically received and while you have to perform, the tax code has basically not done a good job in dealing with that. I think if you go back to cases like Mini Aircraft and Ford and say that where you have these wide disparities in timing, that the courts don't want to have this wide mismatch. So, I just think that in a way, where things happen in close point in time, you shouldn't be concerned. But where it's wide disparities, we should be concerned. Another last point on this whole area is it's all timing anyway; right? This is timing. So, this is really, if everything happens year in and year out on the same basis, it's a one time issue because if I accelerate income, don't accelerate income this year. By next year I'm picking up the benefit or getting the cost of what it is now. So, to try to write a rule, is basically kind of distorting what has been the historic set of rules for realization and everything else, to have a one-time pickup in income from the standpoint of the government. You are not supposed to be concerned with timing anyway. It doesn't make a lot of sense. I am a purist in this regard; right? I'm retired now. I don't teach anymore, but yet, I feel strongly about these things. As I said, these rules are going to be around forever. I don't want to have a rule that comes in that doesn't make too good of sense to me.

MR. GORHAM: So, I'll ask you some of the same questions that I asked Les. We did ask for comments on various issues in the NPRM. I'll fire up with you. Do you think we need any special rules to address the applicability of the rule to foreign persons?

MR. SOLOMON: You know, I haven't focused on that as much, but clearly, there seems to me to be some sense of if what we're dealing with are general concepts like realization and recognition and we've got 964 out there that basically tells us that we've got to use U.S. principles, I think there should be some indication as to how foreign persons should be treated under these rules, either carved out or kept in, but absent that, then there's going to be enough ambiguity that people aren't going to really understand what they should do. So, it does seem to me that it does — we get a lot of questions often as to what do our foreign subsidiaries do. I think it would be appropriate to help them.

MR. GORHAM: One of the other things that we asked about is about escalating rent agreements where he AFS and incoming collusion exceeds the amount of rent received for a particular year. How do you think we should treat that, based on your comments?

MR. SOLOMON: I don't think I have a comment on tht, because I don't quite understand the question. Maybe if you can repeat the question a little bit slower —

MR. GORHAM: Sure. If it would be a long term rental agreement and the rent escalates over time, but you're going to get fixed amount every single year and you've included maybe — say, it's a 10 year rental agreement, and you include all 10 years in your AFS revenue in year 1, or somehow up front.

MR. SOLOMON: Well, I think Les's point was to go back to 471 and see how that rent ought to be reported, I do think that poses an interesting question because is that a question that really — I think we know from the standpoint of tax that where I've rented something, it's kind of like interest; right? I'm getting the benefit of something over time. It's hard for me to understand why the financial statements allow somebody to pick that up. I think it goes back to the question of why the financial statement is doing that. A lot of the tax rule is —

MS. MARTIN: I think the more common fact pattern from an adjustment is that they would spread it over the 10-year period, so you would have more in it than you would actually receive in the rental agreement, because their rents were escalating over time. So it's not necessarily going to pick up in year 1. It's just that the book spreads it evenly.

MR. SOLOMON: Again, I think that's a harder question because it goes to whether there is really a disproportionate amount attributable to these periods. I think that's a facts and circumstances test and I think that's what I would be looking to. If there's a reason for that, I mean, is that something that ought to be a trigger. As I said, the question of whether there is realization is a factual question. Somebody has to answer that. If it's been done forever, that it hasn't been realized and the books are reporting it the same, then there should be a better eye on that, but if there is a factual reason why there should be realization and this triggers the inquiry, somebody has to defend that.

MR. GORHAM: I'm assuming you would have the same answer for the trailing commissions issue.

MR. SOLOMON: Yes.

MR. GORHAM: Then I think the last question that I asked Les was are there any special methods of accounting that you think we should include in the non-excessive list that would be helpful.

MR. SOLOMON: Well, one of the things I identified, at least in thinking of this, and I don't know how this comes down, but you talked about special methods of accounting, but one of the things you find in the tax law, is that when you receive payment, not only do you have income, but if that payment is a deposit, is a loan, is an option payment or is something else, it's not going to be reported for tax. So, I guess the question is, is that the type of — not mischaracterization, but difference in characterization that is the same thing as a lease or a sale or is the same thing as a market to market versus something else? Do your books report that amount as an income amount but tax is calling it one of these other things? That's the things that I've seen in the last couple of months that people have asked me. I don't think there's an answer in that reg on that. So, I don't know whether that's a different method of accounting that you're asking for, but it's clearly when a payment is not realized for tax.

MR. GORHAM: Thank you. Thank you for your comments.

MR. SOLOMON: Thank you very much.

MR. GORHAM: This concludes the hearing. I want to thank our speakers and everyone who attended today. We appreciate your time. Thanks.

(Whereupon, at 11: 06 a.m., the HEARING was adjourned.)