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Change in Contracts Triggers Payment of Taxes on Previously Deferred Revenue


1/2/13

Synopsis:

In a recent IRS Chief Counsel Memorandum, the IRS held that a taxpayer’s (“Taxpayer’s”) previously deferred revenues from advance payments received under “take or pay” contract provisions became taxable in the year that these contract provisions were eliminated. The IRS reasoned that the Taxpayer was no longer liable for delivery of the goods. The IRS also indicated that, even if the liability to ship against the “take or pay” payments received continued to exist, it believed the Taxpayer would have been incorrectly applying the method prescribed in the regulations for accounting for advance payments. Furthermore, the IRS also indicated that the Taxpayer, in effect, changed accounting methods without IRS permission.

Issue:

In this case, Taxpayer was a manufacturer who negotiated long-term contracts with its customers who were willing to make initial advance payments (IAPs) on a “take or pay basis” to assure supplies in times of high demand. In practice, the Taxpayer deferred recognition of the IAPs and included them in income ratably over the term of each agreement beyond the end of the year after the receipt, generally the maximum deferral permitted by IRS regulations for advance payments on goods. Five years after the long-term contracts with IAPs were negotiated, the market for Taxpayer’s products changed and it renegotiated several contracts to retain the business. As part of the contract renegotiations, Taxpayer charged a “deferral fee” in lieu of an IAP, or partially refunded the IAP. The Taxpayer then stopped applying the IAP on a ratable basis and did not report the IAP in income for two taxable years.

The IRS Chief Counsel’s views summarized in the first paragraph above highlight the importance of considering the income tax impact of changes to contracts and business models. The consequences, including potential penalties, of triggering for income tax purposes the reporting of previously deferred income are self-evident. However, changes in contracts may also call for a change in the method of accounting for the income or expense under the contracts. In this case, once the Taxpayer reported the income from the IAPs differently for two or more consecutive tax years, the Taxpayer effectively changed accounting methods. Accounting method changes often require explicit IRS permission and, at a minimum, a special form (Form 3115) with significant information to be attached to the taxpayer’s return, even when going from an unacceptable method to an acceptable one. If a taxpayer fails to obtain permission from the IRS to change its accounting method for an income or expense or for its overall method (e.g., cash vs. accrual) before the IRS begins an audit of the taxpayer, it will generally be up to the IRS as to when and whether to make the change. For example, where the unfavorable taxable income impact of a change would normally be spread over the subsequent three years according to the regulations, if the taxpayer fails to properly obtain permission, the IRS could include the entire unfavorable impact all in one tax year.

What Does CohnReznick Think?
Given the pace of change in today’s business world, it is not unusual for companies, particularly in rapid changing sectors, such as technology, media, and biotechnology, to adjust by changing their business models and related customer and vendor contracts. So, changes in how to account for and when to recognize revenues and expenses, for both financial reporting and income tax purposes, are usually in order. Oftentimes, the answer will differ between financial and tax reporting and the required changes could be overlooked putting the taxpayer at the IRS’ mercy for the tax treatment.

To learn more about CohnReznick’s Federal Tax Services, please visit our webpage.


Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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