American Bar Association. Section of Taxation. Tax Accounting Committee. January 29, Accounting for Ratable and Non-Ratable Service Contracts

Transcription

1 American Bar Association Section of Taxation Tax Accounting Committee January 29, 2016 Accounting for Ratable and Non-Ratable Service Contracts Moderator: Les Schneider, Partner, Ivins, Phillips & Barker, Washington, D.C. Panelists: Jane Rohrs, Deloitte Tax LLP, Washington, D.C. John Moriarty, Acting Associate Chief Counsel, Income Tax & Accounting, Internal Revenue Service Thomas Moffitt, Branch Chief, Branch 2, Income Tax & Accounting, Internal Revenue Service 1

2 I. Legal Background A. Principles for Revenue Recognition 1. From the viewpoint of a service provider, revenue accrues at the earlier of: (1) when an amount is due; (2) when an amount is received; or (3) performance occurs. Schlude v. Commissioner, 372 U.S. 128 (1963); Rev. Rul , C.B Except in instances where the performance called for by the contract is divisible, the performance standard in the three-part test for revenue recognition does not occur until performance is completed. Decision, Inc. v. Commissioner, 47 T.C. 58 (1966), acq C.B If a contract is not divisible, the IRS has ruled that unbilled revenue associated with part performance of a result-oriented contract need not be recognized as revenue by the service provider, notwithstanding that such revenue might be recognized as revenue for GAAP purposes. PLR In Rev. Rul , C.B. 177, the IRS addressed the issue of the timing of revenue recognition in the context of a divisible contract. In this ruling, a correspondence school using the accrual method of accounting provided courses to students that were completed over a 36-month period. In lieu of paying for the courses upon matriculation, students executed a promissory note requiring them to pay the tuition within 9 months following graduation. The notes provided that if a student terminated a course before its completion, the student s tuition charge was limited to an amount based on the number of lessons received in comparison to the total number of lessons required to complete the course. Based on those facts, the IRS ruled that the contract was divisible, with performance occurring as each lesson was rendered. Accordingly, the IRS ruled that the correspondence school was required to recognize revenue before a student graduated and even before a student completed a particular course. Instead, the IRS ruled that the amount of revenue that is required to be recognized is based on the part of the tuition that was attributable to the lessons that had already been rendered to a student. 5. Query whether the standard for divisibility of a contract is the same under contract law and the tax law. According to contract law, under 2

3 the Second Restatement of Contracts, a contract is treated as divisible only if it can be shown that the parties would have agreed to an allocation of the contract price commensurate with the portion of the services that are performed, even if the balance of the work required by the contract is never completed. 6. Amounts received in advance of the performance of services may be eligible for a one-year deferral under Rev. Proc , I.R.B Where performance is based on the completion of the services in a result-oriented contract, it is unclear whether progress billings reflecting partial performance could be treated as advance payments that may be deferred for tax purposes, pursuant to Rev. Proc , because the payments precede the completion of performance. Even if deferral is potentially permissible, will a taxpayer in that situation be able to satisfy the financial conformity requirement for deferral? B. Principles for Expense Deductibility 1. From the viewpoint of the recipient of the services, expenses accrue upon the earlier of: a. When the amount is due and payable and the economic performance requirement is satisfied; or b. When the all-events test (which includes the economic performance requirement), is satisfied. Section 461(h) and Rev. Rul , I.R.B c. Since an obligation to pay an expense may be fixed by the receipt of an invoice from a service provider or by the terms of the engagement, apart from economic performance, the expense might be deductible prior to the completion of the services, even though the services are not divisible. d. In the case of an obligation to pay for the receipt of services, economic performance occurs as the services are received. 3

4 e Where an event other than payment of the expense is required in order to satisfy economic performance, payment may precede economic performance by up to 3 ½ months for purposes of satisfying the economic performance requirement. f. An amount may be deducted in the taxable year preceding the satisfaction of the economic performance requirement where economic performance occurs within 8 ½ months of the succeeding taxable year and the matching requirement is satisfied. g. An expense may satisfy the all-events test and the economic performance requirement, but that doesn t necessarily mean that the expense is currently deductible because the expense might be a prepaid expense that must be capitalized under the 12-month rule in the Treas. Reg (a)-4(f). 2. In Caltex Oil Venture v. Commissioner, 138 T.C. 18 (2012), the Tax Court ruled that in the case of an obligation to pay for a non-divisible service, economic performance for purposes of the 3 ½ month rule (and presumably the 8 ½ month rule, in the case of the recurring item exception) was not satisfied until the performance of the services was completed. Moreover, the court held that the performance of the services had to be completed within the relevant 3 ½ or 8 ½ month period in order for the expense to be deductible in the preceding taxable year. 3. In an attempt to provide relief to taxpayers from this decision, in Rev. Proc , I.R.B. 1008, the IRS announced a safe harbor that applies in the case of divisible, repetitive types of services. In that case, the IRS ruled that economic performance may be treated as occurring ratably over the term of the contract (referred to as a ratable service contract ). a, Illustrations of ratable service contracts are maintenance contracts, janitorial service contracts, etc. b. In contrast, contracts for result oriented services are not eligible for this treatment. 4

5 II. Resolving the issues using three examples A. Example One - Result-oriented contract with no progress billings A taxpayer that uses the accrual method of accounting is engaged in the business of providing consulting services to clients. The taxpayer orders a piece of machinery from a manufacturer. The taxpayer is responsible for arranging and paying for the delivery of the machinery. The taxpayer contracts with a trucking company on December 27, 2015 to ship the machinery to the taxpayer s place of business for a fixed price of $1,000. Assume that the trucking company also uses the accrual method of accounting. The transport of the machinery commences on December 28, 2015, and arrives at the taxpayer s place of business on January 5, On January 10, 2016, the trucking company issues an invoice for $1,000 for transporting the machinery and the taxpayer pays the invoice on January 30, For financial reporting purposes, the trucking company recognizes a ratable portion of the revenue based on the distance that the freight travelled towards its destination by year end. It is unclear whether this financial reporting result will change in 2018, with the adoption of the new FASB 606 on revenue recognition. 1. In what taxable year must the trucking company report the $1,000 as revenue for tax purposes? a. To determine when the performance requirement is satisfied, the taxpayer must determine whether the contract for delivery services is divisible. b. Since partial delivery of the machinery does not provide any value to the taxpayer, the contract appears to be a non-divisible result-oriented contract, so that the performance requirement is not satisfied until the machinery arrives at the taxpayer s place of business. c. Accordingly, none of the events in the three-part test for revenue recognition occurs until 2016, so revenue is not recognized until

6 d. Query: If payment on this contract were due in advance, would the prepayment be eligible for deferral until 2016? 2. In what taxable year may the taxpayer deduct the $1,000 shipping expense? a. Since the contract is not divisible for tax purposes, the performance test is not satisfied until completion of delivery. b. Since both delivery and billing occur in 2016, the taxpayer may not deduct the delivery expense until c. Query: If payment were required in advance, could the expense be deducted in 2015? d. In that case, the all-events test would be satisfied in 2015 and the economic performance requirement would be satisfied within 3 ½ months of the date of prepayment. e. Moreover, prepayment in that circumstance would not violate the 12 month rule in Treas. Reg (a)-4(f). f. Discussion of issues. B. Example Two - Result-oriented contract with progress billings A taxpayer that uses the accrual method of accounting is engaged in the business of performing advertising services for clients. The taxpayer becomes embroiled in a lawsuit with a client and retains the services of a law firm to handle the litigation. Assume that the law firm also uses the accrual method of accounting. The terms of the engagement are that the law firm will handle the litigation at the rate of $1,000/hour plus out-of-pocket expenses. The engagement commences on November 2, On December 10, 2015, the law firm issues an invoice for work performed on the engagement during the month of November in the amount of $50,000, and the invoice is paid by the taxpayer on January 10, On January 10, 2016, the law firm issues an invoice for work performed during the month of December in the amount of $40,000 and the invoice is paid by the taxpayer on February 15, Over the course of the next three years, the law firm performs additional work and issues numerous monthly invoices for its work. Assume that the litigation is concluded in

7 For financial reporting purposes, assume that the law firm recognizes revenue as it bills its clients. For financial reporting purposes, the advertising company deducts its legal fees as the legal work is performed, confirmed by the subsequent receipt of a bill from the law firm. 1. In what taxable year must the law firm report the various fees as revenue for tax purposes? a. Is the litigation engagement divisible? What factors are relevant in making this determination for tax purposes? b. The engagement is clearly result oriented, but monthly progress billings are contemplated based on hourly work, so does this arrangement convert an otherwise non-divisible services contract into a divisible contract? c. The three-part test for revenue recognition is satisfied in 2015 for the services that are performed in November and December of d. The bill for November was sent to the client in 2015, so the only basis for deferral of revenue by the law firm would be the application of Rev. Proc Does this transaction qualify for deferral? e. However, the law firm s billing for December was not sent until Does this delay revenue recognition until 2016 even apart from Rev. Proc , or does the law firm s work in November and December of 2015 trigger revenue recognition in 2015, regardless of the time of billing? f. Can the law firm argue that the amount of revenue recognition with respect to December was not known in 2015 because the bill was not prepared and issued to the client until 2016? g. Could Rev. Proc apply to the December accrual of revenue? h. How would the answers change if instead of billing by the hour, each bill was a fixed predetermined amount that did not 7

8 necessarily correspond with the amount of legal work performed for that billing period? 2. In what taxable year may the taxpayer deduct the $50,000 fee, the $40,000 fee and any remaining fees payable over the next three years? a. Without regard to whether the legal services are divisible, the recipient of the services receives a bill for the November services in 2015, so that the amount owed is known and due and payable in b. What about the December services? c. Since no amount is due and payable in 2015 with respect to December s services, is the performance requirement satisfied in 2015? d. Do the progress billings convert, a result-oriented contract into a divisible contract? e. Could the lack of a bill in 2015 for December s services be overcome by the client calling the law firm and asking the amount of the bill? f. Would the prepaid expense rules in Treas. Reg (a)-4(f) pose a problem for current deductibility because the prepayment would precede the completion of the litigation by more than one year? g. If the law firm were using the cash method of accounting, the advertising firm could not deduct bills received prior to yearend that were not paid within 2 ½ months of the end of the year in which the bill was received because of section 404(a)(5). 8

9 C. Example Three - Ratable services contract A taxpayer that uses the accrual method of accounting is engaged in the business of producing widgets for customers. The taxpayer enters into a twoyear contract with a janitorial services company to clean the taxpayer s factory at the close of business every evening. The contract amount is fixed at $120,000 per year, and the taxpayer is billed monthly by the janitorial services company at the rate of $10,000/mos. Assume that the janitorial services company also uses the accrual method of accounting. The contract starts on December 1, 2015, and the taxpayer receives the first $10,000 invoice for December s cleaning services in January of The invoice is paid on January 20, In what taxable year must the janitorial services company include the December charge in revenue for tax purposes? a. This type of contract would probably be regarded as a divisible contract for tax purposes. b. However, would the contract be regarded as divisible under contract law? What factors would be determinative on divisibility? Is it necessary for tax purposes to determine what price the parties would have agreed to if the parties entered into two separate one-year contracts? c. Assuming the contract is divisible, performance would precede billing, so the $10,000 bill for December should be recognized as revenue in d. The delay in billing should not defer revenue recognition until In what taxable year may the taxpayer deduct (or include in inventoriable costs) the December charge for cleaning services that is received and paid in January, a. In this case, performance for December should be completed in December, so the janitorial expense should be deductible and then includible in inventoriable costs in

10 b. The failure of the taxpayer to receive a bill for December s janitorial services until January of 2016 should not delay the taxpayer s deduction because the amount owed is fixed and known to the taxpayer at the end of III. Open Discussion and Questions 10