On September 5, 2019, the Treasury Department and the IRS released proposed regulations that would affect when taxpayers report their gross income amounts. In general, section 451 sets out the rules regarding when (i.e., the tax year) should be reported as gross income on the taxpayer's return. The Tax Cuts and Jobs Act, or TCJA, amended section 451 in two ways for liability-based taxpayers:
To require them to report a sum as gross income for tax purposes no later than the time the amount is reflected as income in the "Applicable Financial Statement" (AFS) and
To allow you to defer your tax return for certain "prepayments" of income for one year.
The regulation clarifies some issues related to the TCJA amendments but leaves many others unresolved. The Treasury and IRS have called on the public to comment on many of these outstanding issues.
Section 451 (b) - AFS Rule
The TCJA amended section 451 (b) to change the taxpayer method's employment in the "all events" test to align tax accounting with financial accounting. Based on this test, an item of income is included in gross income for tax purposes when all the events leading to the right to receive the item occur. The value of the item can be determined with reasonable accuracy. Before the TCJA, the test for all events was considered satisfactory when:
Income is earned through performance,
Payment is due, or
Payment is made.
Under Section 451 (b), as amended by the TCJA, even if an amount does not meet any of these three conditions, it should be deferred to gross income for tax purposes to the extent that it is reflected in the taxpayer's VFA for that year in particular. According to the regulation, unbilled credits cannot be deferred for tax purposes until all services have been provided under the contract (as in the previous law) if and to the extent that the taxpayer declares the credits as the taxpayer's AFS in the previous year.
The regulation would specify that the AFS rule does not change the fiscal nature, even if it differs from the AFS nature. For instance, if a transaction is treated as a tax lease but as an AFS sale, the character will still be a tax lease. The regulation would also clarify that the AFS rule has no impact on amounts that:
Depend on the occurrence or non-occurrence of a future event (for example, anticipated income and yearly renewal fees for contracts of 'insurance),
Collected on behalf of third a party (e.g., sales tax),
Payments deemed to be deposited or made per general principles of taxation,
The result of marking, but not for taxes,
Regulated by a non-recognition provision, such as Articles 332, 337, 351, 368, 355 or 72l, or
Governed by a particular accounting method, such as the rate method or the tax method percentage of completion. This is the case even though these amounts are treated as income in the taxpayer's VFA.
By law, the regulations will specify that for certain "specific expenses" related to debt securities, including expenses for credit card delays, expenses for cash advances, and foreign exchange fees, the modified test for all the events of section 451 (b), including the AFS rule, supersedes the initial emission reduction (OID) rules of sections 1271 to 1275. Therefore, a taxpayer must include these specified taxes in gross income from the tax year of receipt, if included in AFS income for the receipt. However, the OID rules would have allowed the taxpayer to include them in his gross income in one or more subsequent years. However, the regulation would not apply to all event testing for overriding the OID rules on any other item, such as points, treated as a reduction or adjustment of a debt instrument's yield for reporting purposes. Also, the AFS rule does not preclude applying the market reduction rules set out in section 1276.
Section 451 (c) - Prepayments
The TCJA amended section 451 (c) to state that a contributor to the accrual accounting method may elect to defer the filing of a "prepayment" for goods, services, or anything else to the plans of the Treasury for the following year received to the extent that the taxpayer does not include the income advance in AFS for the year of receipt ("deferral method").
The regulation would extend the types of payments eligible for the deferral method beyond those for goods and services to include all items considered "advance payments," which provides for a similar deferral method under the previous law, i.e., payments:
For computer software
For occupancy or use of the ancillary property for services
For subscriptions, if not listed in section 455.
For subscriptions, if not listed in section 456.
For the use of intellectual property
Relating to certain warranties or warranty arrangements.
For example, according to the rules, payments in advance payments for the use of intangibles would continue to be deferred. Likewise, all items which cannot be carried over per would remain ineligible under regulations, including rent, insurance, and payments under financial instruments.
Additionally, the regulation excludes prepayments for goods from the definition of prepayments if the taxpayer:
Requires a customer to make an early payment at least two tax years before the contractual delivery date goods,
You do not have the good or a substantially similar good on hand (or available from normal sources of supply) at the end of the year in which the prepayment is received and
Confirm all proceeds from the sale of the asset to AFS in the year the goods are delivered to the customer. This exclusion from the definition of prepayment may allow a taxpayer to defer the prepayment by several years (that is, in addition to a deferral other than one year) if the taxpayer determines that the payment deferred is allowed (e.g., with case law).
This proposed exception is important to many taxpayers who enter into contracts to sell goods well in advance of expected delivery.
The regulation would address certain issues that are not addressed in Rev. Proc. 2004-34. For example, it specifies that the taxpayer cannot defer the recognition of a payment that has been reserved in the year in which it is received per the applicable tax principles, even if the payment has not yet been declared as income in the taxpayer's AFS.
The regulation also specifies that the taxpayer who postponed the introduction of all or part of an advance must include the residual advance in the following year; it is understood that the advance may be reduced or an adjustment for financial accounting purposes.
Several other rules of Rev. Proc. 2004-34 are incorporated into the regulation, including:
A deferral regime for taxpayers without AFS.
Rules for short tax years.
Elimination of deferral in certain situations if the taxpayer ceases to exist or the obligation associated with the advance is rejected.
Effective Dates
In general, it is proposed that the regulations on the application of the AFS rule and the treatment of installments apply to taxation years on or after the date of publication of the final regulation. However, a taxpayer can invoke the settlement (in addition to the proposed rules on specific quotas for debt securities) during years beginning after December 31, 2017, provided that the taxpayer applies all the rules contained in the regulation and the enforcement of regulations regularly to all income items (except for income related to specific taxes related to debt instruments). Instead, the effective date of the proposed rules on specified rates would be postponed until the taxpayer's first fiscal year begins one year after the date of publication of the final regulation. Despite the delay in the effective date of the regulation for specific rates related to debt securities, a taxpayer can claim the regulation for the specified rates for fiscal years on or after December 31, 2018. The taxpayer applies all the rules contained therein of the regulations.
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