By James Atkinson at The Tax Adviser on June 1, 2018
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, fundamentally changed how accrual-method taxpayers determine when to recognize income for federal tax purposes. Although it has received little attention compared with other elements of the TCJA, the amendments to Sec. 451 potentially affect a broader cross section of taxpayers than almost any other change made by the TCJA.
The impact of these amendments is amplified by the potential interaction with recently revised financial accounting standards applicable to revenue from customer contracts. First, Sec. 451 will require tax departments to be vigilant for situations in which the new financial accounting standards accelerate the recognition of revenue for book purposes, because that acceleration might translate directly into accelerated income recognition for federal tax purposes as well.
Second, revised Sec. 451 binds tax more closely to the new financial accounting standards in the case of customer contracts having multiple "performance obligations." For federal tax purposes, taxpayers now must allocate the contract's "transaction price" among each performance obligation in the same way it is allocated for financial accounting purposes. Each of these terms is taken directly from the new financial accounting standards, underscoring the new relationship between tax and books.
New Sec. 451
Accrual-method taxpayers are well-acquainted with the general requirement to recognize income in the tax year in which all the events have occurred that fix the right to receive an item of income and the amount of that income can be determined with reasonable accuracy. The "all-events test" has been a bedrock of federal tax accounting for decades.
An equally well-established principle is that financial accounting and tax accounting have fundamentally different purposes, and, as a result, how a taxpayer treats an item of income or expense for financial accounting purposes generally does not determine how that item may be treated for federal tax purposes. Although many taxpayers try to align their financial and tax accounting methods as closely as possible to avoid book-tax differences, the core differences between financial and tax accounting have not always permitted those two methods to align.
The TCJA fundamentally alters the relationship between financial and tax accounting. Sec. 451(b) effectively imposes a (one-way) book-tax conformity rule for recognizing income for tax purposes. Under the new rule, an accrual-methodtaxpayer may not treat the all-events test as being met for any item of gross income (or portion thereof) any later than when that item is taken into account as revenue in either an applicable financial statement (AFS) or another financial statement that Treasury and the IRS identify as applying for this purpose. This conformity requirement does not apply to taxpayers that do not have an AFS, or to any item of gross income in connection with a mortgage servicing contract.
Sec. 451(b)(3) defines an AFS as (1) a financial statement certified as being prepared in accordance with U.S. GAAP for certain purposes (such as an SEC Form 10-K, or certain audited statements that the taxpayer uses for credit purposes, reports to shareholders, and specific other uses); (2) if the taxpayer has no AFS under (1), a financial statement prepared using International Financial Reporting Standards (IFRS) and filed with certain foreign government entities; or (3) if the taxpayer has no AFS under either (1) or (2), a financial statement filed by the taxpayer with any other regulatory or governmental body specified by the IRS and Treasury.
Importantly, this new conformity requirement does not apply to income items for which the taxpayer is using another "special method of accounting" provided in the Code, such as the installment method of Sec. 453 or the long-term contract method of Sec. 460. It appears, however, that this new statutory requirement will invalidate nonstatutory accounting methods that potentially conflict with it, such as the deferral rules for certain sales of goods heretofore permitted by Regs. Sec. 1.451-5.
Taxpayers may continue to use the more limited one-year deferral permitted by Rev. Proc. 2004-34, however, for advance payments received in connection with the future provision of goods, services, and other specific transactions. In fact, the TCJA incorporates the deferral method of Rev. Proc. 2004-34 directly into the Code as new Sec. 451(c). Although the statutory language of Sec. 451(c) does not mirror the language of the existing revenue procedure verbatim, there is no indication in either the legislative text or the accompanying legislative history that Congress intended to preempt — or narrow the application of — the existing deferral method of Rev. Proc. 2004-34. As such, companies currently using the deferral method described in the revenue procedure should not be required to request IRS consent to continue doing so.