September 10, 2003

The Honorable Mark W. Everson

Commissioner

Internal Revenue Service

Room 3000 IR

1111 Constitution Avenue, N.W.

Washington, D.C. 20224

Attn:   CC:PA:T:CRU (ITA)

Re: Notice 2002–79, on Including Advance Payments and Advance Rentals in Gross Income

Dear Commissioner Everson:

The American Institute of Certified Public Accountants offers the enclosed comments on the revenue procedure proposed in Notice 2002–79 and the proposed changes to reg. section 1.61–8(b). These comments were developed by members of our Tax Accounting Technical Resource Panel and approved by the Tax Executive Committee.

We would be pleased to offer further assistance or discuss these comments with you or a member of your staff at any time. If you have any questions, please contact either: Robert Kilinskis, Chair of the Tax Accounting Technical Resource Panel, at (312) 242–9855; or George White, AICPA Technical Manager, at (202) 434-9268.

Sincerely,

Robert A. Zarzar

Chair, Tax Executive Committee

Enclosures

cc:    

Helen M. Hubbard, Tax Legislative Counsel

          Sharon Kay, Tax Specialist

          Robert M. Brown, Associate Chief Counsel (IT&A)

           AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on the Proposed Revenue Procedure and Proposed Regulations

on

Including Advance Payments and Advance Rentals in Gross Income

September 10, 2003

Developed by the

Advance Payments Task Force

Robert Kilinskis, Chair

Jay Kalis

Jane Rohrs

Leslie Schneider

Cristy Turgeon

George White, AICPA Technical Manager

A.        Accounting for Cost of Goods Sold

Notice 2002–79, 2002–50 I.R.B. 964 (the Notice), requests comments regarding the treatment of cost of goods sold in deferring advance payments from the sale of goods. The proposed revenue procedure provides that advance payments received for the sale of goods, which are not otherwise deferred pursuant to reg. section 1.451-5(b)(1)(ii), should be taken into income for federal income tax purposes in the taxable year of receipt to the extent they are included in gross receipts for financial reporting purposes for that year. Any remaining amount must be included in gross income for the next succeeding taxable year. The proposed revenue procedure should also make provision for the treatment of the related cost of goods sold.

Gross income, as defined under section 61, includes "gains derived from dealings in property." See also reg. section 1.61-3(a) ("gross income means the total sales, less the cost of goods sold"). Accordingly, it is the gain resulting from the sale of property as opposed to gross receipts that are subject to tax. By requiring recipients of advance payments for mixed or non-service contracts to recognize income without a corresponding offset for the related costs and expenditures, the proposed revenue procedure in effect requires taxation of gross receipts. If taxpayers are required to include such gross receipts in income, then they should be allowed to offset the relevant cost of goods sold.

One alternative for the treatment of cost of goods sold, associated with advance payments for sales of goods that must be recognized prior to the completed sale of the goods, would be to treat the advance payment as a reduction in the cost of related items held in inventory to the extent of the taxpayer's basis in such inventory, applying the economic performance rules to determine that basis. To the extent the advance payment exceeds the basis of the inventory, the excess would be currently taxable with no basis offset. This approach is used in reg. section 1.1001-1(c)(1), for amounts received by a taxpayer in connection with property that is not yet sold, such as a deposit on a pending real estate sale or the receipt of fire insurance proceeds that do not exceed the cost of the property damaged by fire. Under this approach, the income inclusion for an advance payment could not create a loss by accelerating a larger cost of goods sold deduction.

A second alternative would be to take into account a proportionate amount of cost of goods sold related to the advance payments that are accrued prior to the delivery of the goods. For example, the amount of costs that may offset the inclusion of gross receipts from advance payments would equal the amount of advance payments included in income multiplied by the that year's ratio of total costs capitalized under section 263A relating to goods purchased or produced over gross receipts from the sale of goods.

This ratio would be computed for the trade or business that includes the advance payments in income. Any difference between the amount of costs included under this method and the actual costs of goods would be deducted from (or included in) income in the year the goods are sold, as determined under the taxpayer's method of accounting (e.g., as determined under reg. section 1.446–1(c)(1)(ii)(C)).

We recommend conforming reg. section 1.451–5 to the approach taken in the proposed revenue procedure for taking cost of goods sold into account with respect to advance payments. Considerable uncertainty exists about how to compute cost of goods sold under the regulations, and the approach adopted by the proposed revenue procedure would create clarity and consistency among the deferral provisions.

B.                 Allocations Between Deferral Provisions

The Notice requests comments regarding a taxpayer's ability to allocate advance payments between the deferral provisions of reg. section 1.451–5 and the proposed revenue procedure. The proposed revenue procedure defines an advance payment, in part, as a payment solely for "the sale of goods (other than for sales of goods for which the taxpayer uses a deferral method provided in reg. section 1.451–5(b)(1)(ii))." Notice 2002–79, section 4.01(4)(b).

As proposed, the definition of advance payment permits taxpayers to choose between the deferral provisions in reg. section 1.451–5 and those in the proposed revenue procedure. This choice creates uncertainty about the scope of the proposed revenue procedure. We suggest that the definition of advance payments in the proposed revenue procedure be limited to payments for the sale of goods for which the taxpayer cannot apply a deferral method provided in reg. section 1.451–5(b)(1)(ii). In other words, where applicable, reg. section 1.451–5 should be the exclusive provision to defer advance payments from the sale of goods. The proposed revenue procedure would apply, for example, in the context of non-allocable advance payments received under a computer software maintenance agreement that obligates the recipient to provide product updates as well as support services (including support unrelated to the product updates). The mutually exclusive nature of this definition would reduce confusion about whether a taxpayer should apply the deferral provisions in the regulations or those in the proposed revenue procedure.

Even with mutually exclusive scopes with respect to sales of goods, potential overlaps of the deferral provisions would exist with respect to advance payments for services. Reg. section 1.451–5 encompasses advance payments for "an obligation to perform services that are to be performed as an integral part" of the sale of goods. Without further clarification about what constitutes services integral to a sale of goods, a taxpayer cannot determine whether the deferral provisions of the regulations would apply to an advance payment for such services or the proposed revenue procedure would apply to the payment after allocating the payment between the deferral provisions. We recommend, therefore, clarifying what services are integral to a sale of goods in the regulations to eliminate confusion about whether an allocation under the deferral provisions is required at all.

C.        Acceleration of Advance Payment Inclusion

The Notice requests comments regarding the need to accelerate inclusion for nontaxable transfers of advance payments, such as transfers under sections 351 and 721. The proposed revenue procedure requires that a taxpayer include in gross income: (1) all advance payments if, during that year, the taxpayer either dies or ceases to exist in a transaction other than one to which section 381(a) applies or (2) advance payments if, and to the extent that, the taxpayer's obligation to provide the item or items for which the advance payment was received ends in that year.

The acceleration provision of the proposed revenue procedure reflects two basic principles: (1) a transferee is a separate taxpayer that, outside a section 381(a) context, may use methods of accounting for advance payments associated with a trade or business that differ from those used by the transferor and (2) a transferor might shift income to the transferee if the transfer does not trigger income inclusion. Because the transferor in a section 351 or 721 transaction represents a different taxpayer than the corporation or partnership, we understand that acceleration for section 351 and 721 transfers might be appropriate in some situations to acknowledge that the transferee may adopt its own accounting method for advance payments and to avoid the possible shifting of income to the transferee. In some contexts, however, acceleration has not been required for those transfers, such a transfer of accounts receivable to a new transferee corporation for which bad debts deductions had been accrued in Rev. Rul. 78–280, 1978–2 C.B. 139 (permitting a transferor to exclude a bad debt reserve from income in a section 351 transfer and following Nash v. United States, 398 U.S. 1 (1970), which reached the same result in a section 721 transfer) and a mid-contract change in taxpayer for long-term contract methods of accounting under reg. section 1.460–4(k)(6) (adopting a step-in-the-shoes approach for section 351 transfers).

We believe that the advance payment context is similar to those described above and suggest exempting certain transfers under sections 351 and 721 from the acceleration provision. We recommend an exception that would apply to section 351 transfers where substantially all of the assets of a trade or business, including the advance payments, are transferred to another entity; the transferee uses the Deferral Method after the transfer with respect to the transferred advance payments; and the transferee is a member of the same consolidated group as the transferor. This exception would resemble the acceleration exception with respect to section 481(a) adjustments for transfers under section 351 within a consolidated group. Rev. Proc. 2002–9 and Rev. Proc. 97–27 provide that the acceleration of a section 481(a) adjustment is not required if one member of a consolidated group transfers substantially all of the assets of the trade or business, which gave rise to the adjustment, to a member of the same group in a section 351 transfer and if the transferee member adopts and uses the same method of accounting as the transferor member. When the acceleration exception applies, the transferee continues to take the section 481(a) adjustment into income over the same adjustment period started by the transferor member.

We also recommend a comparable exception that would apply to section 721 transfers of substantially all of the assets of a trade or business to a partnership if the partnership uses the Deferral Method after the transfer and income attributable to the transferred advance payments is allocated to the contributing partner. We contemplate that this exception would resemble the special rules proposed under section 460 for mid-contract changes in taxpayer by imposing a step-in-the-shoes requirement with respect to the accounting method used after the transfer and by applying section 704(c) principles to prevent the shifting of pre-contribution income to other partners. See Notice 2002–37, 2002–23 I.R.B. 1095. By preserving both the relevant taxpayer and the use of the Deferral Method with respect to a trade or business, our recommendations for section 351 and 721 transfers would avoid the need for accelerated inclusion of advance payments.

Our suggested exemptions for certain section 351 and section 721 transfers would remain subject to the financial reporting limitations, which may limit the situations where the exemptions would apply. The proposed revenue procedure could contain an anti-abuse provision if those exemptions were perceived to create opportunities to circumvent the acceleration provision; however, we believe the requirement to transfer substantially all of the assets of a trade or business would adequately restrict the exemptions to transfers that accord with the purpose of the acceleration provision.

D.        Short Taxable Years

The Notice requests comments regarding the treatment of short taxable years resulting from section 381(a) transactions (as determined under section 381(b)). The proposed revenue procedure requires that a taxpayer using the Deferral Method include advance payments in gross income in the next succeeding taxable year following the year of receipt to the extent the advance payments were not already included in income.

Short taxable years created perceived inequities under Rev. Proc. 71–21, 1971–2 C.B. 549, which permitted deferral only if the services would be rendered by the end of the next succeeding taxable year. For example, if either the taxable year of receipt or the succeeding taxable year was shortened, a taxpayer might be unable to render the services within the shortened period that included the year of receipt and the succeeding year, and therefore, the taxpayer could not defer inclusion of an advance payment. Similarly, a taxpayer's successive short taxable years, such as two three-month taxable years, would have prevented the deferral of advance payments for services that would be rendered within a 12-month period. The inherent limitations of Rev. Proc. 71–21 arguably favored taxpayers that might have longer deferral periods, for example, a taxpayer that would render services within an 18–month period during two consecutive taxable years, over taxpayers with successive short taxable years that received advance payments for services to be rendered within a 12–month period.

We believe the proposed revenue procedure partially alleviates the perceived inequities by permitting deferrals for advance payments even if the income is not earned by the end of the next succeeding taxable year. This change, however, more directly resolves the controversies that arise in determining whether a series of agreements or renewal agreements fall within the scope of Rev. Proc. 71–21 by ignoring when income is earned. With respect to short taxable years, the change eliminates the issue that services might not be rendered by the end of the succeeding taxable year. Because the change has not addressed the relative duration of the deferral period, special consideration is needed for short taxable years.

Because the Deferral Method is intended to achieve a limited deferral period, we believe it is appropriate to disregard year-ends in certain circumstances to establish a deferral period approximately equal to the period that would have applied in the absence of the short period. Therefore, we suggest providing a minimum fixed deferral period that approximates the intended one-year deferral of the proposed revenue procedure. In particular, we suggest modifying the last sentence of section 5.02(1) to read: "The remaining amount of the advance payment must be included in gross income no later than the later of 12 months from the date of receipt or the end of the next succeeding taxable year."

Alternatively, we suggest that a short tax year be disregarded if the short year results from a change in tax year under section 442 or from a closing of the year as a result of entering into a section 381(a) transaction, joining or leaving a consolidated group under reg. section 1.1502–76, or electing or terminating S corporation status. In each of these cases the taxpayer continues to exist after the transaction or change in taxable year or is treated as a successor in interest to such taxpayer.

E.         Using Statistical Sampling to Track Advance Payments

The Notice requests comments regarding the use of statistical methodologies for tracing advance payments if a taxpayer cannot determine the extent to which particular advance payments received in a given taxable year are actually included in gross receipts for financial reporting purposes in that year. The proposed revenue procedure requires that a taxpayer, using the Deferral Method, have a methodology in place for determining that advance payments are included in gross income by the end of the next succeeding taxable year. If advance payments for goods or services are not traced, a taxpayer may use the same methodology that it uses for financial reporting purposes provided that the methodology provides a basis for determining how much of the current year's advance payments are included in gross receipts for financial reporting purposes for the current year and ensuring that the portion of advance payment that is not included in gross income in the year of receipt is included in the next succeeding taxable year.

We believe that the proposed revenue procedure should specifically state that ratable inclusion of advance payments is a method of accounting that clearly reflects income. Furthermore, if a taxpayer is unable to determine the advance payments actually included in gross receipts for financial reporting purposes, the proposed revenue procedure should allow the use of statistical sampling to determine such amounts. See e.g., section 3.06 of Rev. Proc. 71-21, 1971-2 C.B. 549 (permitting the use of statistical sampling for contingent services).

Statistical sampling is an appropriate methodology to use when a facts and circumstances determination is needed for a population that is too large to review in its entirety, and there is a need to examine detail that is not captured in existing summary records. The IRS has issued a Director's memorandum that documents guidelines for its audit teams to use when taxpayers have used statistical sampling in the filing of a return. We suggest that the statistical sampling provisions that are provided in the proposed revenue procedure be consistent with those guidelines. See Keith M. Jones, Field Directive on the Use of Estimates from Probability Samples (Mar. 14, 2002).

F.         Other Issues

1.       Payments With Respect to Financial Instruments

The proposed revenue procedure excludes payments with respect to financial instruments (for example, debt instruments, deposits, letters of credit, notional principal contracts, options, forwards, futures, foreign currency contracts, credit card agreements, financial derivatives, etc.), including purported prepayments of interest, from the definition of advance payments. This provision presumes that annual fees received with respect to credit and charge card agreements are not of a nature eligible for deferral under the proposed revenue procedure. To the extent these fees are determined to be consideration for the use of money, the original issue discount (OID) rules should apply to allow deferral of the fees. However, if the treatment of these fees is not otherwise accounted for by a specific financial regulation or guidance, we suggest that the proposed revenue procedure govern their treatment for federal income tax purposes.

If card agreement annual fees are not subject to the OID rules and are not governed by the proposed revenue procedure, it appears that the taxpayer has no other option but to include such fees in taxable income when they are received without regard to their treatment for financial statement purposes. Requiring current inclusion of card agreement annual fees for tax purposes appears inconsistent with the proposed revenue procedure's stated intent of reducing the administrative and tax compliance burdens on taxpayers and minimizing disputes between the Internal Revenue Service and taxpayers regarding advance payments. See Barnett Banks of Florida Inc., et al. v. Commissioner, 106 T.C. 103 (1996), Signet Banking Corp. v. Commissioner, 106 T.C. 117 (1996), aff'd, 118 F.3d 239 (4th Cir. 1997), and American Express vs. United States, 47 Fed. Cl. 127 (2000). Consequently, the AICPA recommends that the final revenue procedure allow deferral for annual fees received in advance with respect to card agreements to the extent it is determined they are not subject to the OID rules.

2.       Advance Rentals

The proposed revenue procedure should treat rental payments for the use of tangible property in the same manner as rental payments for the use of intangible property. Proposed regulations under section 61 would modify the requirement that a taxpayer include advance rentals in income in the year of receipt, except as provided in section 467, to the extent that the Service publishes guidance authorizing deferral. The proposed revenue procedure would authorize use of the Deferral Method with respect to rental payments for intellectual property but would deny use of that method for rental payments for tangible property (other than for the use or occupancy of tangible property ancillary to the provision of services). We have not identified any reason for distinguishing between rental payments based on the tangible or intangible character of the property to which the payments relate. Moreover, section 467, which requires the deferred recognition of advance payments for the use of tangible property, suggests that rental payments for the use of tangible property are properly recognized over the rental period rather than upon receipt. Therefore, we recommend that the proposed revenue procedure permit taxpayers to use the Deferral Method with respect to all advance rentals regardless of whether those payments relate to tangible or intangible property.

3.       Definition of Services

We suggest that the proposed revenue procedure explicitly define the term "services." The Notice acknowledged that considerable controversy exists about whether a particular advance payment is for services and therefore qualifies under Rev. Proc. 71–21 for deferral. The proposed revenue procedure seeks to minimize that controversy by expanding the scope of the deferral provisions to amounts received for services, non-services, and mixed services/non-services. We agree that the expanded scope will reduce controversies; however, we are concerned that the term "services" remains undefined in the proposed revenue procedure. Unless an advance payment fits within the added non-service categories, a taxpayer still must determine if it received an advance payment for services. The uncertainty as to what constitutes a "service" is the basis of the litigation in Barnett and Signet, as described above. The definition of "service" is also the basis of the Service's denial of the American Express accounting method change, which led to litigation concerning the Service's discretion in administering its procedural guidance. The proposed revenue procedure has identified but not addressed this issue. Therefore, we recommend that the proposed revenue procedure define the term "services."

Alternatively, we suggest expanding the scope of the revenue procedure to include all advance payments unless otherwise excluded under section 4.02. The task of defining services might prove burdensome, and an exclusionary approach might provide a more administrable solution to resolving these controversies. As such, the proposed revenue procedure could explicitly address those situations where deferral is not considered appropriate rather than relying on an undefined term to limit the scope of applicability.

4.       Additional Examples

The AICPA suggests the following additional examples be included in the proposed revenue procedure to reflect a wider range of the guidance that has been released by the Service:

a.  To clarify the scope of the proposed revenue procedure, we request that the Service's position regarding contracts whose services are provided by authorized representatives of the taxpayer be illustrated by inserting "or an authorized representative" to section 5.03 Example (4), so that it will read:

 

(4) On July 1, 2003, C, in the business of selling and repairing television sets, receives an advance payment for a 2-year contract under which C, or an authorized representative, agrees to repair or replace certain parts in the customer's television set if those parts fail to function properly. For financial reporting purposes, C includes 1/4 of the payment in gross receipts for 2003, 1/2 of the payment in gross receipts for 2004, and 1/4 of the payment in gross receipts for 2005. C uses the Deferral Method. For federal income tax purposes, C must include 1/4 of the payment in gross income for 2003 and the remaining 3/4 of the payment in gross income for 2004.

 

b. The Service has denied deferral treatment under Rev. Proc. 71-21 for advance payments received for multiple year service contracts. In PLR 199944040 (June 21, 1999), the Service ruled that an insurance company could not use Rev. Proc. 71-21 to defer payments received for processing claims under an agreement with a seven-year term because the services required by the agreement as it existed at the end of the taxable year could not be performed before the end of the next succeeding taxable year. It was the Service's position that to qualify for such deferral treatment all of the services, and not merely the services that relate to any particular payment under the agreement, had to be completed before the end of the next succeeding taxable year.

The advance payments received under the contract at issue in the letter ruling would qualify for treatment under the Deferral Method. Accordingly, we suggest that the proposed revenue procedure provide the following example:

A, a calendar year insurance agency, is in the business of negotiating, placing, and servicing insurance coverage and administering claims. On December 31, 2002, A enters into a contract to provide claims administration services for a four-year period beginning January 1, 2003, or until closure of the claims, whichever comes first. The contract further provides that A will be paid fees for each of the four policy years by the day preceding each policy year (e.g., by December 31, 2002 for the 2003 policy year). For financial reporting purposes, A includes the first payment in income for 2003; the second payment in income for 2004; the third payment in income for 2005; and the fourth payment in income for 2006. A uses the Deferral Method. Under section 4 of the revenue procedure, each installment payment constitutes an advance payment. For federal income tax purposes, A must include the first payment in income for 2003; the second payment in income for 2004; the third payment in income for 2005; and the fourth payment in income for 2006.