A. AFS Deferral Method

Consistent with section 451(c)(1)(A), these proposed regulations provide that an accrual method taxpayer with an AFS includes an advance payment in gross income in the taxable year of receipt unless the taxpayer uses the deferral method in section 451(c)(1)(B) and proposed §1.451-8(c) (AFS deferral method). A taxpayer using the AFS deferral method must have an AFS, as described in section 451(b)(1)(A)(i) or (ii). These proposed regulations define the term AFS by reference to the definition of that term in proposed §1.451-3(c)(1) (REG-104870-18). Under the AFS deferral method, a taxpayer with an AFS that receives an advance payment must include: (i) The advance payment in income in the taxable year of receipt, to the extent that it is included in revenue in its AFS, and (ii) the remaining amount of the advance payment in income in the next taxable year. The AFS deferral method provided in these proposed regulations closely follows the deferral method of Revenue Procedure 2004-34, as modified by Revenue Procedure 2011-14 (2011-4 IRB 330), and as modified and clarified by Revenue Procedure 2011-18 (2011-5 IRB 443), and Revenue Procedure 2013-29 (2013-33 IRB 141) (Revenue Procedure deferral method). Because new section 451(c)(1)(B) was intended to generally codify the Revenue Procedure deferral method, the Treasury Department and the IRS believe that rules similar to the Revenue Procedure deferral method are necessary and appropriate for the proper application of section 451(c). See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.).

B. Non-AFS Deferral Method

Section 451(c)(4)(A) generally defines an advance payment as any payment the full inclusion of which in gross income of the taxpayer for the year of receipt is a permissible method of accounting, any portion of which is included in revenue by the taxpayer in an AFS, and which is for goods, services, or other items identified by the Secretary. One commenter noted that the financial statement requirement within the definition of an advance payment means that the rule in Revenue Procedure 2004-34 that depended on determining when the advance payment was earned was not within the statutory text of section 451(c). The Treasury Department and the IRS have concluded that section 451(c) does not prohibit a deferral method that is otherwise permissible under Revenue Procedure 2004-34. See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.). See also, Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) at 170-171 (Dec. 20, 2018). Revenue Procedure 2004-34 permitted non-AFS taxpayers to use the Revenue Procedure deferral method based on when the income is earned (earned standard). See section 5.02(3)(b) of Revenue Procedure 2004-34. The Revenue Procedure deferral method using the earned standard is a permissible method of accounting for non-AFS taxpayers and, therefore, these proposed regulations also provide a similar deferral method for non-AFS taxpayers in proposed §1.451-8(d) (non-AFS deferral method). Under the non-AFS deferral method, an accrual method taxpayer without an AFS that receives an advance payment must include: (i) The advance payment in income in the taxable year of receipt, to the extent that it is earned, and (ii) the remaining amount of the advance payment in income in the next taxable year.

A. In general

Section 451(c)(4)(A) generally defines advance payment as any payment (i) the full inclusion of which in gross income of the taxpayer for the taxable year of receipt is a permissible method of accounting, (ii) any portion of which is included in revenue by the taxpayer in an AFS (or such other financial statement as the Secretary may specify) for a subsequent taxable year, and (iii) which is for goods, services, or such other items as may be identified by the Secretary.

Proposed §1.451-8(b)(1)(i) clarifies that the definition of advance payment under the AFS and non-AFS deferral methods is consistent with the definition of advance payment in Revenue Procedure 2004-34, which section 451(c) was meant to codify. See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.). The Treasury Department and the IRS believe this definition of advance payment: (1) is consistent with section 451(c), (2) minimizes additional tax compliance burden and cost, (3) provides clarity to taxpayers, and (4) uses rules which are familiar to both taxpayers and the IRS.

Two commenters suggested that airline miles be explicitly included in the list of items for which an advance payment may be received. The commenters suggested that airline miles are a unique type of item, generally redeemed for air travel and non-travel rewards. The Treasury Department and the IRS decline to specifically include airline miles in the definition of advance payment because the use of the deferral method under these proposed regulations, to the extent airline miles are redeemable for goods or services, is already permissible. Therefore, these proposed regulations include examples to illustrate that, to the extent certain reward points are treated as separate performance obligations, they may be eligible for the deferral methods provided under these proposed regulations.

Another commenter suggested that progress payments with respect to the sale of an interest in real property should be included in the definition of an advance payment. Revenue Procedure 2004-34 was intended to provide a simplified and consistent deferral period for the sale of goods, services, and other items. However, the definition of advance payment in Revenue Procedure 2004-34 does not include prepayments for interests in real property. These proposed regulations generally provide the same types of items in the definition of advance payment to those items provided in Revenue Procedure 2004-34. However, the Treasury Department and IRS will consider any comments received in determining whether it is appropriate to include additional types of items in the definition of advance payment.

B. Items Excluded from the Definition of an Advance Payment

Section 451(c)(4)(B) provides that certain items, except as otherwise provided by the Secretary, are to be excluded from the definition of an advance payment. Pursuant to section 451(c)(4)(B), the term advance payment does not include rent; insurance premiums governed by subchapter L; payments with respect to financial instruments; payments with respect to certain warranty or guaranty contracts; payments subject to section 871(a), 881, 1441, or 1442; payments in property to which section 83 applies; and other payments identified by the Secretary.

Several commenters requested that certain payments for certain types of goods be excluded from the definition of an advance payment under section 451(c)(4)(B). A commenter requested that certain pre-delivery payments for the sale of high-value customer-configured equipment that will be delivered to customers at reasonably certain times not be included in the definition of advance payment. Another commenter requested that an exclusion be provided for goods for which (i) a taxpayer receives a payment in a taxable year with respect to a contract for the sale of goods not properly includible in such taxpayer’s finished goods inventory, and (ii) on the last day of such taxable year the taxpayer does not have on hand (or available to it in such year through its normal source of supply) goods of a substantially similar kind and in a sufficient quantity to satisfy the contract during such contract year. This commenter suggested a narrowing of this exclusion could be done according to whether a good is commercially significant or of high-value. A commercially significant good has a useful life equal to or in excess of 10 years and it is developed, marketed, and sold to customers in the aerospace industry. Generally these goods require a significant amount of capital to produce and may require considerable time from development to delivery. Generally, for financial statement purposes, such manufacturers recognize revenue related to these goods when the product is completed and delivered to the customer and title and risk of loss have transferred to the customer.

Proposed §1.451-8(b)(1)(ii) provides a list of items excluded from the definition of advance payment that is similar to Revenue Procedure 2004-34. An additional exclusion is provided for payments received in a taxable year earlier than the taxable year immediately preceding the taxable year of the contractual delivery date for a specified good, as defined in §1.451-8(b)(9). In response to the comments received, the Treasury Department and IRS have determined that an exclusion is appropriate for certain goods for which a taxpayer requires a customer to make an upfront payment under the contract if (i) the contracted delivery month and year of the good occurs at least two taxable years after an upfront payment, (ii) the taxpayer does not have the good or a substantially similar good on hand at the end of the year the upfront payment is received, and (iii) the taxpayer recognizes all of the revenue from the sale of the good in its AFS in the year of delivery.

The Treasury Department and the IRS have employed the authority granted to the Secretary in section 451(c)(4)(B)(vii) to exclude certain payments, in a limited manner, that would otherwise constitute advance payments within the meaning of section 451(c)(4)(A), in response to the proposals described in comments already received. In order to fully consider other such potential exclusions, detailed comments that specifically address the following issues are requested:

Section 451(c)(3) provides that the deferral method does not apply to an advance payment received by the taxpayer during a taxable year if such taxpayer ceases to exist during (or with the close of) the taxable year. In contrast, Revenue Procedure 2004-34 provides more detailed acceleration rules.

The Treasury Department and the IRS have determined that rules similar to the acceleration rules provided in Revenue Procedure 2004-34 are appropriate for the proper application of the AFS and non-AFS deferral methods. The continued use of the deferral method for an advance payment is not appropriate and should be limited in certain situations, such as when the taxpayer ceases to exist, or when their obligation regarding the advance payment is satisfied or otherwise ends. Accordingly, proposed §1.451-8(c)(2) and (d)(6) provide rules to ensure the acceleration of an advance payment when a taxpayer either dies or ceases to exist, or when a taxpayer’s obligation regarding an advance payment is satisfied or otherwise ends, except in certain circumstances. Consistent with Revenue Procedure 2004-34, the acceleration rules do not apply to a taxpayer that engages in a transaction to which section 381 applies or certain transactions in which section 351 applies in the taxable year in which an advance payment is received.

Section 451(c) does not specifically address whether the deferral method may be used when an amount is earned in the taxable year, but deferred for AFS purposes. The deferral method under section 451(c) is an exception to the requirement to include an amount in income when it is received but is not an exception to the requirement to include an amount in income when it is earned under the all events test. Accordingly, consistent with Revenue Procedure 2004-34, these proposed regulations permit deferral of advance payments received to the extent, in the year of receipt, the amount is not included in revenue in the taxpayer’s AFS, and is not otherwise earned in the taxable year of receipt. The amounts not included in gross income in the year of receipt must be included in gross income in the next taxable year.

Section 451(c) does not address the treatment of financial statement adjustments that cause amounts to not be included in income.

Proposed §1.451-8(c)(3) and (d)(7) provide that a taxpayer that defers inclusion of all or a portion of an advance payment must include the remainder of the advance payment in gross income in the subsequent year, notwithstanding any write-down or adjustment for financial accounting purposes. This provision is consistent with a plain reading of section 451(c)(1)(B) and the rule in proposed §1.451-3(j), which require that an item of income treated as deferred revenue in a taxpayer’s AFS in one year and charged, in whole or part, to a capital account in a subsequent year, is included in revenue in the subsequent year.

A financial accounting adjustment may occur after certain equity acquisitions. For example, after certain equity acquisitions, the acquiring entity may write-down or adjust the target’s deferred revenue in the subsequent year under purchase accounting rules. Some taxpayers have asserted that a write-down or adjustment for financial accounting purposes results in a permanent exclusion of income for federal income tax purposes. Proposed §1.451-8(c)(3) and (d)(7) provide clarification for instances in which a taxpayer defers inclusion of an advance payment and is subsequently acquired in certain equity acquisitions. The Treasury Department and the IRS believe that financial statement write-downs or adjustments to deferred revenue should not be taken into account for federal income tax purposes when determining the proper amount to be included in income under the deferral method. This clarification ensures that a financial statement write-down or adjustment to deferred revenue does not result in a permanent exclusion of income for federal income tax purposes.

Section 451(c) does not provide rules relating to the treatment of short taxable years. Proposed §1.451-8(c)(4) and (d)(8) use the short taxable year rules of Revenue Procedure 2004-34 for the AFS and non-AFS deferral methods because a rule for short taxable years is necessary to properly implement the deferral method provided in section 451(c)(1)(B).

Sections 451(b) and (c)(4)(D) require that taxpayers with contracts that contain multiple performance obligations must allocate transaction price, and therefore defer (or accelerate) income inclusion, consistent with the transaction price allocation used for AFS purposes. Proposed §1.451-3(c)(3) (REG-104870-18) defines the term performance obligation to mean a promise in a contract with a customer to transfer to the customer either a good or service (or a bundle of goods or services) that is distinct, or a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. Proposed §1.451-8(b)(4) defines the term performance obligation by cross-reference to proposed §1.451-3(c)(3) for purposes of the allocation rule provided in section 451(c)(4)(D).

Proposed §1.451-8(b)(7) defines the term transaction price by cross-reference to proposed §1.451-3(c)(6). Proposed §1.451-3(c)(6) defines the term transaction price to mean the gross amount of consideration to which a taxpayer expects to be entitled for AFS purposes in exchange for transferring promised goods, services, or other property, including amounts referred to in proposed §1.451-3(i). However, the term transaction price does not include certain items, such as amounts collected on behalf of third parties that are not otherwise income to the taxpayer, increases for consideration to which a taxpayer’s entitlement is contingent on the occurrence or nonoccurrence of a future event, and reductions for amounts subject to section 461. Proposed §1.451-3(c)(6)(ii) presumes that an amount included in the transaction price for AFS purposes is not contingent unless, upon examination of all of the facts and circumstances existing at the end of the taxable year, it can be established to the satisfaction of the Commissioner that the amount is contingent on the occurrence or nonoccurrence of a future event. Proposed §1.451-3(c)(6)(ii) also provides that certain amounts included in transaction price for AFS purposes, however, will not be treated as contingent on the occurrence or nonoccurrence of a future event.

Comments are requested on allocation of the transaction price (i) to performance obligations that are not contractually based, (ii) for arrangements that include both income subject to section 451 and long-term contracts subject to section 460, and (iii) when the income realization event for federal income tax purposes differs from the income realization event for AFS purposes.

For non-AFS taxpayers, there is a continued need to provide an allocation method consistent with the objective criteria standard in Revenue Procedure 2004-34 because such taxpayers do not have an AFS and cannot use the transaction price allocation used for AFS purposes, as provided in section 451(b)(4). Therefore, proposed §1.451-8(d)(5) permits a non-AFS taxpayer to allocate the revenue of multiple obligations in a single contract based on how such obligations are separately priced or on any method that may be provided in guidance published in the IRB.

Several commenters discussed the need for a regulatory exception to the existing statutory and regulatory timing rules that apply to liabilities (for example, deductions and offsets for rebates, refunds, and cost of goods sold (COGS) prior to when the liability for such items is incurred under section 461) when advance payments are required to be included in income under section 451(c) prior to the completion of the sale of goods or provision of services (accelerated cost offset). The commenters argued that not providing an accelerated cost offset in the regulations would cause a mismatch of income and expenses and result in the taxation of gross receipts.

An allowance to account for future cost of goods sold, for future estimated costs, or other cost offset is inconsistent with sections 461(h) and, 471, 263A, and the accompanying regulations. Moreover, section 13221 does not change the timing rules provided in sections 461, 471, 263A and elsewhere that apply to liabilities. Section 13221 changes the timing of income for advance payments for goods and generally codifies Revenue Procedure 2004-34. See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.). Revenue Procedure 2004-34 does not include an accelerated cost offset when amounts are included in income prior to the sale of goods or provision of services.

The Conference Report also indicates that section 13221 of the Act is “intended to override any deferral method provided by Treasury Regulation §1.451-5 for advance payments received for goods.” H.R. Rep. No. 115-466, at 429 n 880 (2017) (Conf. Rep.). Section 1.451-5 includes a deferral method that allows an accelerated cost offset when certain amounts are included in income prior to the sale of goods. See §1.451-5(c). Section 451(c) does not provide a cost offset, and the Conference Report does not provide any indication that Congress intended to preserve the cost offset rules permitted under §1.451-5. See also, Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) at 156-157 and 164-165 (December 20, 2018). Final regulations were published in the Federal Register (84 FR 33691) on July 15, 2019, that withdraw §1.451-5, consistent with the Act.

The Treasury Department and the IRS believe that Congress intentionally simplified the rules for advance payments by limiting the deferral of advance payments for taxpayers with an AFS to a prescribed statutory method that: (1) does not include an accelerated cost offset, (2) is consistent with Revenue Procedure 2004-34, and (3) overrides §1.451-5. See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.). Accordingly, the Treasury Department and the IRS decline to provide an accelerated cost offset in these proposed regulations. The Treasury Department and the IRS do not agree with the contention that changes to the timing of income under section 451 without an accelerated cost offset cause a taxation of gross receipts. Section 451(c) and these proposed regulations merely change the timing of income recognition, do not preclude any associated reduction or deduction for properly incurred liabilities, and are consistent with existing statutory and regulatory timing requirements that apply to liabilities.

Several commenters proposed a cost offset mechanism for manufacturers of certain property and taxpayers with inventoriable goods in order to ensure matching of income and the associated expenses. Commenters made the following suggestions to alleviate the potential mismatch of the acceleration of income recognition with different timing rules for associated costs: (i) permitting a taxpayer that uses a percentage of completion method for AFS purposes (book PCM), but not subject to section 460, to elect to use their AFS method for tax purposes; (ii) permitting a taxpayer that uses book PCM, but not subject to section 460, to elect to apply section 460 for federal income tax purposes; (iii) expanding the recurring item exception in section 461(h)(3) to permit a taxpayer to offset the portion of the advance payment included in income for the taxable year by the cost of goods sold related to this payment if the goods are completed and shipped to the customer within 8 ½ months of the end of the taxable year that the advance payment is included in income; or (iv) providing a cost offset for taxpayers that can demonstrate at the time of the purchase agreement that a net operating loss will remain unused for the 5-year period after the taxable year the advance payment is received.

The Treasury Department and the IRS continue to consider whether any such exceptions are an appropriate use of the Secretary’s authority under section 461(h) or 460. To facilitate further consideration of such potential exceptions, detailed comments that specifically address the following issues are requested:

Section 451(c)(2) provides that a taxpayer may elect deferral treatment of an advance payment governed by section 451(c), and such election shall be made at such time and manner and with respect to such categories of advance payments as specified by the Secretary. Section 451(c)(2)(B) provides that the deferral method is treated as a method of accounting and the election is effective for taxable years with respect to which it is first made and for all subsequent taxable years, unless the taxpayer secures the consent of the Secretary to change to a different method of accounting.

The use of the AFS or non-AFS deferral method is the adoption of, or a change in, a method of accounting under section 446. A taxpayer may change its method of accounting to use the deferral methods only with the consent of the Commissioner as required under section 446(e) and the corresponding regulations. The Treasury Department and the IRS intend to issue future guidance that will provide the procedures by which a taxpayer may change its method of accounting to use one of the deferral methods described in these proposed regulations. However, until further guidance for the treatment of advance payments is applicable, a taxpayer may continue to rely on Revenue Procedure 2004-34, as described in Notice 2018-35.

Executive Orders 13771, 13563, and 12866 direct agencies to assess costs and benefits of available regulatory alternatives and, if regulation is necessary, to select regulatory approaches that maximize net benefits, including potential economic, environmental, public health and safety effects, distributive impacts, and equity. Executive Order 13563 emphasizes the importance of quantifying both costs and benefits, reducing costs, harmonizing rules, and promoting flexibility. The Executive Order 13771 designation for any final rule resulting from these proposed regulations will be informed by comments received. The preliminary Executive Order 13771 designation for this proposed rule is regulatory.

The proposed regulations have been designated by the Office of Information and Regulatory Affairs (OIRA) as subject to review under Executive Order 12866 pursuant to the Memorandum of Agreement (MOA, April 11, 2018) between the Treasury Department and the Office of Management and Budget regarding review of tax regulations. The Office of Information and Regulatory Affairs has designated these proposed regulations as significant under section 1(b) of the MOA. Accordingly, OMB has reviewed these proposed regulations.

1.Background

Under section 451(a) of the Internal Revenue Code, income is “recognized” (that is, included in gross income for tax purposes) in the year in which it is received by the taxpayer, unless it is properly accounted for in a different period under the taxpayer’s method of accounting. Because of this latter condition, the tax treatment of certain forms of income depends on the method of accounting a taxpayer is using. For taxpayers using the accrual method of accounting, income is generally recognized in the year in which all events have occurred that fix the right to receive that income and when the amount of income can be determined with reasonable accuracy (the “all events test”). Receipt of payment by the business satisfies the all events test. However, recognition of certain payments for goods or services not yet provided may be deferred to the year following receipt of payment, to the extent that recognition is also deferred for on the taxpayer’s Applicable Financial Statement (AFS). Such payments are referred to as “advance payments.”

Prior to the December 22, 2017, enactment of, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” Public Law 115-97, 131 Stat. 2054 (2017), commonly referred to as the Tax Cuts and Jobs Act (TCJA), taxpayers were generally permitted to defer the tax on these advance payments; in other words, advance payments could be recognized in a later taxable year. Section 451(c), added by the TCJA, allows accrual-method taxpayers to elect to recognize as income only a portion of such an advance payment in the taxable year in which it is received, and then recognize the remainder in the following taxable year. Section 451(c) essentially codifies the deferral method of accounting for advance payments that was permitted in Revenue Procedure 2004-34. (Joint Committee on Taxation, General Explanation of Public Law 115-97, (Washington, U.S. Government Publishing Office, December 2018), at 167.) New section 451(c), the subject of the proposed regulations, deals with issues around how these advance payments are defined and the timing in which they need to be recognized in the business’s income tax.

These proposed regulations provide certainty and clarity to taxpayers affected by statutory changes introduced in section 451(c). The Treasury Department and IRS have received questions and comments regarding the meaning of various provisions in section 451(c) and issues not explicitly addressed in the statute. The Treasury Department and the IRS have determined that such comments warrant the issuance of further guidance.

The proposed regulations provide guidance regarding the new section 451(c). The subsequent economic analysis covers proposed regulations to: (1) Describe and clarify the deferral rules for advance payments for taxpayers without an Applicable Financial Statement (AFS); (2) provide acceleration rules for taxpayers that cease to exist; (3) clarify the treatment of financial statement adjustments for taxpayers that have deferred advance payments; (4) provide rules relating to the treatment of short taxable years for taxpayers deferring advance payments; and (5) define and clarify the treatment of performance obligations.

A. Baseline

The Treasury Department and the IRS have assessed the benefits and costs of the proposed regulations relative to a no-action baseline reflecting anticipated Federal income tax-related behavior in the absence of these proposed regulations. The following largely qualitative analysis describes the anticipated economic effects of the proposed regulation relative to this baseline.

B. Summary of Economic Effects

The proposed regulations provide certainty and consistency in the application of section 451(c) by providing definitions and clarifications regarding the statute’s terms and rules. An economically efficient tax system generally aims to treat income and expense derived from similar economic decisions consistently across taxpayers and across activities in order to reduce incentives for businesses to make choices based on tax rather than market incentives. In the absence of the guidance provided in these proposed regulations, the chances that different taxpayers might interpret the statute differently is exacerbated. For example, two similarly situated taxpayers might interpret the statutory provisions pertaining to the definition of advanced payments differently, with one taxpayer pursuing a project that another comparable taxpayer might decline because of a different interpretation of how the income may be treated under section 451(c). If this second taxpayer’s activity is more profitable, an economic loss arises. An economic loss might also arise if all taxpayers have identical interpretations under the baseline of the tax treatment of particular income streams but are more conservative (or less conservative) regarding the interpretation than Congress intended for these income streams. In this case, guidance provides value by bringing economic decisions closer in line with the intents and purposes of the statute.

Because the proposed regulations clarify the tax treatment of certain income streams, there is the possibility that investments or other business decisions may change as a result of these regulations. The Treasury Department and the IRS have not made projections of the change in investment patterns that might arise due to the discretionary aspects of the proposed regulations. The Treasury Department and the IRS have also not made projections of any change in compliance costs arising from the proposed regulations, relative to the baseline. The Treasury Department project that changes in investment patterns and compliance costs relative to the baseline may generally be small because the proposed regulations affect a relatively small number of entities and because they largely mirror the rules of Rev. Proc. 2004-34.

The economic consequences of these proposed regulations depend in part on their interaction with other sections of the Code, including section 460, which governs when costs can be recovered under the percentage of completion method, and section 461(h), which governs when costs incurred by a taxpayer satisfy the all events test, including a requirement for economic performance, and are thereby allowed as deductions for Federal income tax purposes. The economic analysis of the final regulations under section 451(c) may address the economic effects of regulatory guidance, if any, under sections 460 and 461(h) or other sections of the Code that interact with section 451(c), that is issued between the proposed and final regulations.

The Treasury Department and the IRS project that approximately 15,000 business entities may be affected by these regulations.

The Treasury Department and the IRS solicit comments on this conclusion and particularly solicit comments that provide data, evidence, or models that would enhance the rigor by which the non-revenue economic effects might be estimated for the final regulations.

C. Economic Analysis of Specific Provisions

The Treasury Department and the IRS solicit comments on the economics of each of the items discussed subsequently and of any other items of the proposed regulations not discussed in this section. The Treasury Department and the IRS particularly solicit comments that provide data, other evidence, or models that could enhance the rigor of the process by which provisions might be developed for the final regulations.

i. Deferral Methods under section 451(c)

The statute prescribes a particular deferral method for accrual-method taxpayers that have an AFS (AFS taxpayers) but does not explicitly describe a deferral method to be used by taxpayers that do not have an AFS (non-AFS taxpayers). To remedy this gap, the proposed regulations describe and clarify that a method similar to the deferral method available to non-AFS taxpayers under Revenue Procedure 2004-34 will be available to non-AFS taxpayers.

The Treasury Department and the IRS considered and rejected a narrow interpretation of section 451(c) that would have precluded non-AFS taxpayers from using a deferral method similar to that provided in Revenue Procedure 2004-34. Section 451(c) does not explicitly prohibit the use of such a method by non-AFS taxpayers, and the Treasury Department and IRS continue to have authority under the Code to prescribe a deferral method for such taxpayers. Precluding non-AFS taxpayers from using a deferral method similar to that of AFS taxpayers would treat AFS and non-AFS taxpayers quite differently regarding business decisions they might make that are otherwise similar. Such treatment would result in a less economically efficient tax system, which generally treats similar economic decisions similarly.

The Treasury Department and the IRS solicit comments on this decision on the treatment of deferral by non-AFS taxpayers and particularly solicit comments that provide data, other evidence, or models that could enhance the rigor by which the final regulations over non-AFS deferral might be developed.

ii. Advance Payment Acceleration Provisions

If a taxpayer ceases to exist by the close of a taxable year in which an advance payment has been received and deferred, then issues may arise as to when or whether the remaining amount of the payment will be recognized as taxable income because there may not be a succeeding taxable year in which such income can be recognized.

Under the statute, if the taxpayer dies or ceases to exist by the close of the taxable year in which the advance payment was received, any remaining untaxed amounts of advance payments must be included in income in the year they were received. The proposed regulations extend this payment “acceleration” rule to situations in which a performance obligation is satisfied or otherwise ends in the taxable year of receipt or in a succeeding short taxable year, a treatment that is consistent with a similar rule in Revenue Procedure 2004-34.

The Treasury Department and the IRS considered not modifying or expanding the acceleration rule contained in section 451(c), but rejected this alternative because of the remaining amount may never be picked up into income risking a permanent exclusion of the amount from taxable income. The possibility of a permanent exclusion of income provides incentives for taxpayers to structure payments in ways that avoid tax liability, thus reducing Federal tax revenue without providing an accompanying general economic benefit. The proposed regulations treat the expanded set of accelerated transactions consistently with similar types of transactions based on the timing and structure of the payments involved.

The Treasury Department and the IRS solicit comments on the proposed regulation’s treatment of acceleration and particularly solicit comments that provide data, other evidence, or models that would enhance the rigor by which the treatment of acceleration might be developed for the final regulations.

iii. Advance Payments and Financial Statement Adjustments

Under the statute, if a taxpayer counts an advance payment as an item of deferred revenue, under certain conditions (for example, certain acquisitions of one corporation by another), the taxpayer may be required by its system of accounting to adjust that item on the balance sheet in a subsequent year. The item would then not be included in current earnings or AFS revenues. In this case, taxpayers might argue that they can exclude the amount deferred from taxable income because it is never “earned” nor included in revenue under their AFS. If this argument is upheld, taxpayers could convert an income “deferral” amount into an income “exemption” amount. To address this issue and avoid this possibility, the proposed regulations specify that such financial statement adjustments are to be treated as “revenue.”

The Treasury Department and the IRS considered not providing clarity on the treatment of financial statement write-downs, but rejected that approach, because it would have risked an inappropriate permanent exclusion of income. The possibility of a permanent exclusion of income provides incentives for taxpayers to structure payments in ways that avoid tax liability, thus reducing Federal tax revenue without providing an accompanying general economic benefit.

The Treasury Department and the IRS solicit comments on these proposed regulations and particularly solicits comments that provide data, other evidence, and models that would enhance the rigor by which the final regulations dealing with financial statement adjustments might be developed.

iv. Short Taxable Years and the 92-Day Rule

Section 451(c) does not provide a rule relating to the treatment of short taxable years. In the absence of such a rule, it will be unclear to taxpayers how they should implement the deferral method provided in section 451(c) in the case of a short taxable year. To address this issue, the proposed regulations provide rules relating to the treatment of short taxable years for advance payments that are generally consistent with Revenue Procedure 2004-34. The Treasury Department and the IRS considered and rejected not providing short taxable year rules because such a decision would have created significant confusion among taxpayers, increased administrative costs for the IRS, and increased compliance costs for taxpayers.

The Treasury Department and the IRS solicit comments on these proposed regulations and particularly solicit comments that would provide data, other evidence, and models that would enhance the rigor by the treatment of short taxable years might be developed for the final regulations.

v. Performance Obligations for Non-AFS Taxpayers

A performance obligation is a contractual arrangement with a customer to provide a good, service or a series of goods or services that are basically the same and have a routine pattern of transfer. The statute requires that taxpayers with contracts that include multiple performance obligations to allocate the transaction price to each performance obligation in the same manner that revenue is allocated in the taxpayer’s AFS. The statute does not, however, specify the allocation rules to be used by non-AFS taxpayers.

To address this issue, the proposed regulations provide allocation rules for non-AFS taxpayers consistent with a similar rule in Revenue Procedure 2004-34. That rule specifies that the transaction price be allocated in a manner that is based on payments the taxpayer regularly receives for an item or items it regularly sells or provides separately. The Treasury Department and the IRS considered not providing allocation rules for non-AFS taxpayers but rejected such an approach because it would have treated similarly situated taxpayers quite differently, and would have led to increased administrative costs for the IRS and increased compliance costs for taxpayers. While the allocation rules for AFS taxpayers and non-AFS taxpayers under the proposed regulations do differ, the chosen solution provides a rule upon which non-AFS taxpayers can rely, while minimizing the differences between AFS and non-AFS taxpayers in this regard within the constraints imposed by the statute.

The Treasury Department and the IRS solicit comments on these proposed regulations and particularly solicit comments that would provide data, other evidence, and models that would enhance the rigor by which final regulations affecting the treatment of performance obligations taxable for non-AFS taxpayers might be developed for the final regulations.

These proposed regulations do not impose any additional information collection requirements in the form of reporting, recordkeeping requirements or third-party disclosure requirements related to tax compliance. However, because the deferral methods described in proposed §§1.451-8(c) and (d) are methods of accounting, a portion of affected taxpayers would be required to request the consent of the Commissioner for a change in their method of accounting under section 446(e) and the accompanying regulations. The IRS expects that these taxpayers will request this consent by filing Form 3115, Application for Change in Accounting Method (Parts I, II, IV and Schedule B). Filing of Form 3115 and statements attached thereto (for taxpayers who are required to do so or who elect to do so as a result of the proposed regulations) is the sole collection of information requirement imposed by the statute and the proposed regulations. See subsequent paragraphs for a description of taxpayers who would be required to change the method of accounting under the statute and the proposed regulations.

For purposes of the Paperwork Reduction Act, the reporting burden associated with the collection of information with respect to section 451(c) will be reflected in the Paperwork Reduction Act submissions for IRS Form 3115 (OMB control numbers 1545-0074 for individual filers, 1545-0123 for business filers, and 1545-2070 for all other types of filers). The IRS may provide streamlined method change procedures which could permit the filing of a statement in lieu of filing a Form 3115, or, in certain cases, no notification (see, for example, the revenue procedure accompanying these proposed regulations).

The Treasury Department and the IRS anticipate that these proposed regulations would require an accrual method taxpayer that receives an advance payment and chooses to make an election to use the deferral method described in proposed §1.451-8(c) or (d) to file a Form 3115 to change the method of accounting to comply with these proposed regulations. See proposed §1.451-8(e). The Treasury Department and IRS estimate that 20,000-40,000 taxpayers will be required to file a Form 3115 in order to change to the deferral method described in proposed §1.451-8(c).¹ The Treasury Department and the IRS anticipate a certain number of accrual method taxpayers without an AFS that receive advance payments may choose to use the non-AFS deferral method described in proposed §1.451-8(d). The Treasury Department and IRS plan to provide streamlined procedures for taxpayers to change to the methods of accounting described in proposed §1.451-8(c) and (d). See the revenue procedure accompanying these proposed regulations.

For a taxpayer with an AFS that uses the deferral method in proposed §1.451-8(c), a change in the taxpayer’s revenue recognition policies for financial accounting purposes requires the taxpayer to seek the consent of the Commissioner under section 446(e) to use the method for federal income tax purposes. See proposed §1.451-8(e). It is anticipated that the reporting burden associated with the collection of information for a statement in lieu of the Form 3115 would be reflected in the Paperwork Reduction Act Submission associated with Revenue Procedure 2018-31, 2018-22 IRB 637 (or successor) (OMB control number 1545-1551). See the revenue procedure accompanying these proposed regulations.

In 2018, the IRS released and invited comment on a draft of Form 3115 in order to give members of the public the opportunity to benefit from certain specific provisions made to the Code. The IRS received no comments on the forms during the comment period. Consequently, the IRS made the forms available in January 2019 for use by the public. The IRS notes that Form 3115 applies to changes of accounting methods generally and is therefore broader than section 451(c).

The current status of the Paperwork Reduction Act submissions related to the information collections in the proposed regulations is provided in the accompanying table. The overall burden estimates provided for the OMB control numbers below are aggregate amounts that relate to the entire package of forms associated with the applicable OMB control number and will in the future include, but not isolate, the estimated burden of the tax forms that will be created or revised as a result of the information collections in the proposed regulations. These numbers are therefore unrelated to the future calculations needed to assess the burden imposed by the proposed regulations. These burdens have been reported for other regulations that rely on the same OMB control numbers to conduct information collections under the Paperwork Reduction Act, and the Treasury Department and the IRS urge readers to recognize that these numbers are duplicates and to guard against overcounting the burden that the regulations that cite these OMB control numbers impose. No burden estimates specific to the forms affected by the proposed regulations are currently available. The Treasury Department and the IRS have not estimated the burden, including that of any new information collections, related to the requirements under the proposed regulations. For the OMB control numbers discussed above, the Treasury Department and the IRS estimate PRA burdens on a taxpayer-type basis rather than a provision-specific basis. Those estimates capture both changes made by the Act and those that arise out of discretionary authority exercised in the proposed regulations (when final) and other regulations that affect the compliance burden for that form.

The Treasury Department and the IRS request comments on all aspects of information collection burdens related to the proposed regulations, including estimates for how much time it would take to comply with the paperwork burdens described above for each relevant form and ways for the IRS to minimize the paperwork burden. In addition, when available, drafts of IRS forms are posted for comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.htm. IRS forms are available at https://www.irs.gov/forms-instructions. Forms will not be finalized until after they have been approved by OMB under the PRA.

It is hereby certified that these proposed regulations will not have a significant economic impact on a substantial number of small entities within the meaning of section 601(6) of the Regulatory Flexibility Act (5 U.S.C. chapter 6).

The Treasury Department and the IRS have estimated the number of business entities that may be affected by the statute and these proposed regulations. The statute and proposed regulations affect only those business entities that use an accrual method of accounting.

Regarding the accrual method of accounting, the Treasury Department and the IRS estimate that approximately 9 percent of business entities with gross receipts of $25 million or less used an accrual method of accounting in taxable year 2016. Furthermore, section 13102 of TCJA modified section 448 to expand the number of taxpayers eligible to use the cash method. In general, C corporations and partnerships with a C corporation partner are now permitted to use the cash receipts and disbursements method of accounting if average annual gross receipts are $25 million or less (up from $5 million or less in 2016). The Treasury Department and the IRS project that in future years, the number of entities with gross receipts not greater than $25 million that will be using the accrual method will be less than 9 percent of all entities with gross receipts not greater than $25 million.

Source: Statistics of Income data. Cash accounting includes cash, other, and unknown.

Regarding the applicable financial statement, the Treasury Department and the IRS estimate that 235,000 – 250,000 entities with gross receipts of $25 million or less had an audited income statement in taxable year 2016. This is an upper bound estimate of entities that may be affected by these proposed regulations because small entities are less likely to have a financial statement that falls within the definition of AFS in proposed §1.451-3(c)(1) (which generally refers to certified audited financial statements in accordance with GAAP or IFRS). An AFS is generally a financial statement that is certified as being prepared in accordance with GAAP or IFRS that is issued for credit purposes, reporting to shareholders, or other non-tax purpose. The smaller the entity, the less likely that it will engage a CPA firm to audit their financial statements. An AFS does not include financial statements that have only been compiled or reviewed by a CPA firm, which are more affordable for small entities, as these types of statements are not certified as prepared in accordance with GAAP or IFRS.

Affected taxpayers would be required to file Form 3115. As an indicator of whether a taxpayer is likely to have to file a Form 3115, the Treasury Department and the IRS estimated the number of businesses that used the accrual method of accounting, had a financial statement, and indicated they had unearned or deferred income. Approximately 15,000 businesses with gross receipts of $25 million or less fit this category. This is an upper bound estimate of the number of taxpayers relying of Revenue Procedure 2004-34 that will need to file a Form 3115 since some reporting of unearned or deferred income may just have deferral for financial reporting and not tax reporting reasons.

These proposed rules will not have a significant economic impact on small entities affected because the costs to comply with these proposed regulations are not significant. An entity is required to file a Form 3115 (Parts I, II, IV and Schedule B) to change its method of accounting in order to use the deferral method described in proposed §1.451-8(c) or (d). The Treasury Department and IRS plan to provide streamlined procedures for taxpayers to change to the methods of accounting described in proposed §1.451-8(c)1 and (d). See the revenue procedure accompanying these proposed regulations. As noted in this revenue procedure, the estimated cumulative annual reporting and/or recordkeeping burden for the statutory method changes described under OMB control number 1545-1551, before publication of the revenue procedure, is 27,336 respondents, and a total annual reporting and/or recordkeeping burden of 30,580 hours. The estimated annual burden per respondent/recordkeeper under OMB control number 1545-1551 before publication of this revenue procedure varies from 1/6 hour to 8½ hours, depending on individual circumstances, with an estimated average of 1¼ hours. The estimated cumulative annual reporting and/or recordkeeping burden for the method changes described under OMB control number 1545-1551 after that revenue procedure is accounted for is 27,346 respondents, and a total annual reporting and/or recordkeeping burden is 31,479 hours, leaving the average reporting and recordkeeping burden essentially unchanged. These burdens are essentially unaffected by these proposed regulations.

Notwithstanding this certification that the proposed rule would not have a significant economic impact on a substantial number of small entities, the Treasury Department and the IRS invite comments from the public about the impact of this proposed rule on small entities.

Pursuant to section 7805(f), these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Section 202 of the Unfunded Mandates Reform Act of 1995 requires that agencies assess anticipated costs and benefits and take certain other actions before issuing a final rule that includes any Federal mandate that may result in expenditures in any one year by a state, local, or tribal government, in the aggregate, or by the private sector, of $100 million in 1995 dollars, updated annually for inflation. In 2018, that threshold is approximately $150 million. This rule does not include any Federal mandate that may result in expenditures by state, local, or tribal governments, or by the private sector in excess of that threshold.

Executive Order 13132 (entitled “Federalism”) prohibits an agency from publishing any rule that has federalism implications if the rule either imposes substantial, direct compliance costs on state and local governments, and is not required by statute, or preempts state law, unless the agency meets the consultation and funding requirements of section 6 of the Executive Order. This rule does not have federalism implications and does not impose substantial direct compliance costs on state and local governments or preempt state law within the meaning of the Executive Order.

Section 451(b)(1) generally provides that, for an accrual method taxpayer with an AFS or other specified financial statement, the all events test with respect to any item of gross income, or portion thereof, is not treated as met any later than when such item, or portion thereof, has been taken into account as revenue in an AFS or other specified financial statement (the AFS income inclusion rule). The AFS income inclusion rule generally increases financial accounting and tax accounting conformity. On May 28, 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly announced new financial accounting standards for revenue recognition, titled “Revenue from Contracts with Customers (Topic 606).” See ASC Topic 606 and IASB International Financial Reporting Standard (IFRS) 15 (New Standards). Under the New Standards, items of income may be included as revenue in an AFS earlier than they would have been included in income under the all events test prior to the Act.

A. Taxpayers Subject to the AFS Income Inclusion Rule

The proposed regulations clarify how the AFS income inclusion rule applies to accrual method taxpayers with an AFS. Some taxpayers use an accrual method of accounting for all applicable items of income (overall accrual method taxpayers) and others use an accrual method of accounting for only some items of income. Both types of taxpayers (collectively, accrual method taxpayers) compute taxable income, at least in part, under an accrual method. Accordingly, proposed §1.451-3(b) provides that the AFS income inclusion rule generally applies to accrual method taxpayers with an AFS when the timing of income inclusion for one or more items of income is determined using the all events test.

The proposed regulations do not include special rules regarding the applicability of the AFS income inclusion rule to foreign persons. The Treasury Department and the IRS are aware that applying the AFS income inclusion rule to a controlled foreign corporation (CFC) may create mismatches between the CFC’s taxable income for U.S. Federal and foreign tax purposes. As a result, certain taxpayers may lose the ability to credit foreign taxes imposed on a CFC’s income, particularly where such taxes relate to amounts includible in gross income under section 951A and are therefore ineligible to be carried back or forward under section 904(c). Comments are requested regarding whether special rules are needed to address the applicability of the AFS income inclusion rule to foreign persons, including whether and how the rules for determining the taxable income of a CFC can be adjusted to better align the U.S. Federal and foreign income tax bases.

B. Exceptions to the AFS Income Inclusion Rule

Proposed §1.451-3(d) clarifies that the AFS income inclusion rule applies only to taxpayers that have one or more AFS covering the entire taxable year. This approach is consistent with the exception in section 451(b)(1)(B)(i), which provides that the AFS income inclusion rule does not apply to taxpayers without an AFS for a taxable year. In addition, some accrual method taxpayers may have an AFS in one taxable year and no AFS in another taxable year. To address this situation, the proposed regulations provide that the AFS income inclusion rule applies on a year-by-year basis and, therefore, an accrual method taxpayer with an AFS in one taxable year that does not have an AFS in another taxable year must apply the AFS income inclusion rule in the taxable year that it has an AFS, and does not apply the rule in the taxable year in which it does not have an AFS.

Consistent with section 451(b)(1)(B)(ii), proposed §1.451-3(d) also provides that the AFS income inclusion rule does not apply to items of income in connection with a mortgage servicing contract. A letter addressed to the Treasury Department indicated that it is unclear whether this exclusion can be applied to income relating to interest rate lock commitments (IRLCs) entered into by mortgage lenders. The proposed regulations do not address this issue because section 475 generally would require mortgage lenders to include income relating to IRLCs in taxable income in accordance with the mark-to-market method of accounting. As a result, a mortgage lender generally would not apply section 451(b) to determine when income relating to IRLCs is includible in income.

C. Transactions Treated Differently for Federal Income Tax and AFS Purposes

Except as provided in proposed §1.451-3(e), proposed §1.451-3(e) clarifies that the AFS income inclusion rule does not change the treatment of a transaction for Federal income tax purposes. The treatment of a transaction or event in a taxable year may be different for Federal income tax and AFS purposes. For example, a rental agreement that is treated as a lease for Federal income tax purposes may be treated as a sale or financing for AFS purposes, or vice versa. Similarly, a transaction that is deemed to occur (for example, under a mark-to-market method) for AFS purposes may not be deemed to occur for Federal income tax purposes. The AFS income inclusion rule generally was not intended to require taxpayers to recharacterize a transaction for Federal income tax purposes to conform to the characterization of the transaction in the taxpayer’s AFS. As stated in the Conference Report, “The provision does not revise the rules associated with when an item is realized for Federal income tax purposes and, accordingly, does not require the recognition of income in situations where the Federal income tax realization event has not yet occurred.” H.R. Rep. No. 115-466, at 428 fn. 872 (2017) (Conf. Rep.).

However, as also stated in the Conference Report, the AFS income inclusion rule was intended to include unbilled receivables for partially performed services:

“Under the provision, an accrual method taxpayer with an applicable financial statement will include an item in income under section 451 upon the earlier of when the all events test is met or when the taxpayer includes such item in revenue in an applicable financial statement. For example, under the provision, any unbilled receivables for partially performed services must be recognized to the extent the amounts are taken into income for financial statement purposes.”

H.R. Rep. No. 115-466, at 428 fn. 874 (2017) (Conf. Rep.). Commenters suggested that the intent to include unbilled receivables conflicts with the intent to not change the treatment of a transaction to match the taxpayer’s AFS treatment. The Treasury Department and the IRS do not agree. In applying the AFS income inclusion rule to unbilled receivables, a taxpayer is not changing the treatment of the transaction when it includes in income amounts included in its AFS. Moreover, these proposed regulations also apply to unbilled receivables for the sale of goods because there is no distinction in section 451(b) between unbilled receivables for services and unbilled receivables for the sale of goods, and service providers and sellers of goods that are including unbilled receivables in revenue for AFS purposes should be treated similarly for Federal income tax purposes under section 451(b). Accordingly, the proposed regulations provide that the AFS inclusion rule applies to unbilled receivables included in revenue for AFS purposes related to both services and goods.

Commenters raised concerns about the interaction between sections 61 and 461 with the AFS income inclusion rule. For AFS purposes, taxpayers may be required to include variable consideration when determining the transaction price of a contract. Under the New Standards, variable consideration includes items such as discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, and other similar items. Variable consideration may also include promised consideration that taxpayers are not yet entitled to under the contract because it is contingent on the occurrence or nonoccurrence of a future event. For Federal income tax purposes, these items of variable consideration may be contingent future income under section 61 or liabilities subject to section 461. Section 451(b) could be read to accelerate the timing of contingent future income and liabilities to match their inclusion in revenue for AFS purposes. However, section 451(b) was intended to change only the timing of income to ensure that those items of income are not included later than when they are included for AFS purposes. See H.R. Rep. No. 115-466, at 428 fn. 874 (2017) (Conf. Rep.) and Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) at 166 (Dec. 20, 2018). Accordingly, proposed §1.451-3(c)(6) provides that the transaction price that is used to determine whether an amount has been included in revenue does not include items to which a taxpayer’s entitlement is contingent on the occurrence or nonoccurrence of a future event, reductions for amounts subject to section 461 (including allowances, adjustments, rebates, chargebacks, refunds, rewards, and amounts included in the cost of goods sold), and amounts collected for third parties. However, in order to reduce compliance burden and prevent abuse and undue administrative burden, proposed §1.451-3(c)(6) presumes that an amount included in the transaction price for AFS purposes is not contingent future income unless, upon examination of all of the facts and circumstances existing at the end of the taxable year, it can be established to the satisfaction of the Commissioner that the amount is contingent on the occurrence or nonoccurrence of a future event.

In addition, section 451(b) was intended to accelerate income inclusion when (i) the taxpayer’s customer controls the asset that is created or enhanced, or (ii) the taxpayer has a right to partial payment, even when a contract requires delivery, acceptance, and title transfer before a taxpayer can bill its customer. See Examples 2 and 4 of the Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) at 162-163 (Dec. 20, 2018). Accordingly, proposed §1.451-3(c)(6)(ii) provides that an amount included in the transaction price for AFS purposes may not be treated as contingent on the occurrence or nonoccurrence of a future event if the taxpayer has been paid or has an equitable, contractual, or other right to partial payment for performance completed to date. Additionally, proposed §1.451-3(c)(6)(iii) provides that transaction price may not be reduced for amounts subject to section 461, including, in the case of credit card transactions, reward amounts.

Comments are requested on the interaction among sections 61, 461, and 451(b), and specific situations in which future contingent income and liabilities might be included in revenue for AFS purposes. Comments are requested, for example, on the applicability of the proposed rules to escalating rental agreements not subject to section 467, where amounts included in revenue in an AFS as rent for one year of a multi-year rental agreement exceed actual rent received for that year. Specifically, does the excess of the amount included in revenue as rent over the amount of actual rent in a particular year represent a contingency or merely an allocation of the overall transaction price? Comments are requested on the extent to which certain contract terms might affect the result. Comments also are requested on the proposed presumption that the AFS income inclusion rule should apply when an item is included in revenue in an AFS and what a taxpayer should be required to demonstrate in order to successfully rebut the presumption. Finally, comments are requested on how reassessments of variable consideration after the taxable year of the commencement of the contract should be treated for Federal income tax purposes.

D. Interaction with Exclusion Provisions and Effect on Non-Recognition Transactions

Commenters noted that the AFS income inclusion rule may appear to overturn numerous exclusion provisions and adversely affect the treatment of non-recognition transactions in the Code. For example, the AFS income inclusion rule could be read to apply to a transaction that is treated as a sale of property with profit or loss for AFS purposes but that is treated as a reorganization under section 368 for Federal income tax purposes. The proposed regulations clarify that the AFS income inclusion rule does not change the applicability of any exclusion provision, or the treatment of non-recognition transactions, in the Code, the Income Tax Regulations, or other guidance published in the Internal Revenue Bulletin, consistent with Congressional intent that the provision does not revise the rules associated with the time at which an item is realized for Federal income tax purposes. H.R. Rep. No. 115-466, at 428 fn. 872 (2017) (Conf. Rep.) and Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) at 166 (Dec. 20, 2018).

E. Special Methods of Accounting

Section 451(b)(2) provides that the AFS income inclusion rule does not apply to any item of gross income for which the taxpayer uses a special method of accounting provided under any provision of Chapter 1, other than any provision of part V of subchapter P. Commenters raised questions about the interaction between the AFS income inclusion rule and special methods of accounting. In response, proposed §1.451-3(b) amplifies the meaning of the term “special method of accounting” and, except as provided in proposed §1.451-3(b), provides that the AFS income inclusion rule does not apply to any item of income, or portion of an item of income, when the timing of income inclusion is determined under a required or permitted special method of accounting used for Federal income tax purposes. The proposed regulations also clarify that when a taxpayer uses a special method of accounting, the special method of accounting determines the timing of the income inclusion. The proposed regulations provide a non-exclusive list of examples of special methods of accounting. In addition, the proposed regulations make clear that because the AFS income inclusion rule affects the time at which the all events test is met, the rule applies only to items of income that are subject to the all events test. For a discussion of special methods of accounting under the provisions of part V of subchapter P (relating to income from certain debt instruments), see section 7 of this preamble.

Section 451(b) does not address how to apply the AFS income inclusion rule and all events test to a multi-year contract. Proposed §1.451-3(k) provides that a taxpayer with a multi-year contract applies the all events test by applying a cumulative approach reflecting amounts previously included under section 451 rather than an annualized approach.

An annualized approach would look at payments received in each taxable year in isolation and compare the amounts included in the taxpayer’s AFS and under the all events test to determine whether an amount should be included for Federal income tax purposes. This approach would generally result in an overall acceleration of income relative to income included in revenue for AFS purposes, could cause amounts to be included for Federal income tax purposes earlier than under a contract’s terms, and could result in double counting of income. Section 451(b)(1) does not require this treatment.

A cumulative approach better reflects the economic reality of a multi-year transaction. Accordingly, the proposed regulations require taxpayers to take into account the cumulative amounts previously included in prior taxable years in determining a given contract year’s income inclusions under section 451(b)(1). Comments are requested regarding the treatment of multi-year contracts under the AFS income inclusion rule.

The proposed regulations describe and clarify the definition of AFS under section 451(b)(3). Section 451(b)(3) generally defines AFS to mean financial statements prepared according to generally accepted accounting principles (GAAP financial statements), certain financial statements prepared according to international financial reporting standards (IFRS financial statements), and financial statements filed with certain regulatory or government bodies. Section 451(b)(1)(A)(ii) provides the Secretary with authority to specify other financial statements for purposes of section 451(b)(1).

The list of financial statements qualifying as an AFS under section 451(b)(3) is similar, but not identical, to the list of financial statements in Revenue Procedure 2004-34 (2004-1 CB 991). The general priority for identifying the AFS in section 451(b)(3)(A) through (C) is similar to the priority provided in Revenue Procedure 2004-34. Certain financial statements that have traditionally been treated as AFS under Revenue Procedure 2004-34, such as IFRS financial statements used for (1) credit purposes, (2) reporting to shareholders, partners, or other proprietors or to beneficiaries, and (3) any other substantial nontax purposes, are not expressly included in section 451(b)(3). However, the legislative history indicates that Congress intended for Revenue Procedure 2004-34 to be followed. See H.R. Rep. No. 115-466, at 429 (2017) (Conf. Rep.). Accordingly, proposed §1.451-3(c)(1) is generally consistent with the list of AFS from Revenue Procedure 2004-34.

The proposed regulations also clarify the financial statements filed with certain regulatory or government bodies that qualify as an AFS under section 451(b)(3)(C), which is similar to section 4.06(3) of Revenue Procedure 2004-34. The proposed regulations clarify that financial statements that are filed with a state government or state agency, or a self-regulatory organization, also qualify as an AFS under section 451(b)(3)(C). For example, the Financial Industry Regulatory Authority and state agencies that regulate insurance companies or public utilities are agencies requiring reports that qualify as an AFS.

Proposed §1.451-3(h) addresses various issues relating to how financial results are reported for certain taxpayers. These proposed regulations propose rules consistent with the rules provided in §1.56-1 because Congress indicated a desire for rules similar to those found in Revenue Procedure 2004-34 and the rules in Revenue Procedure 2004-34 follow certain rules in §1.56-1. See IRS Announcement 2004-48 (2004-22 IRB 998).

Section 451(b)(5) and proposed §1.451-3(h)(1), (2), and (3) provide that, for purposes of the general rule in section 451(b)(1), if the financial results of a taxpayer are reported on the AFS, as defined in section 451(b)(3), for a group of entities, such statement shall be treated as the AFS of the taxpayer. When a consolidated or combined AFS or other financial statement lists items separately for each member taxpayer, the amount of revenue attributable to a particular taxpayer is determined based on its respective separately stated item. If the amounts are aggregated, however, the taxpayer must rely on the source documents that were used to create the group’s AFS to determine its percentage of each aggregated item reported on the consolidated or combined AFS. The source documents should be used to determine the taxpayer’s respective share of revenue on the AFS, so as to properly reflect the correct amount of gross income under section 451(b).

Proposed §1.451-3(h)(4) provides guidance for taxpayers with a financial reporting period that is different than the taxpayer’s taxable year. The proposed regulations provide that the taxpayer must use one of three permissible methods in order to determine whether an item of income has been included in revenue on an AFS. Under one method a taxpayer uses the accounting principles used to create its AFS to determine the items of income to be reported in revenue as if its financial reporting period coincided with its taxable year. Under the second method a taxpayer makes a reasonable estimate of revenue for the pro rata portion of the taxable year for which the financial statement year and taxable year do not align. Under the third method, if a taxpayer’s financial accounting year ends five or more months after the end of its taxable year, the taxpayer computes revenue based on the revenue reported on the AFS for the financial accounting year ending within its taxable year.

Proposed §1.451-3(h)(5) provides guidance on a restatement of a taxpayer’s financial statements. The rules generally provide that the taxpayer must determine the reason for the restatement of the AFS. For example, if a taxpayer restates revenue on an AFS and such restatement changes the time at which an item of income or a portion thereof is taken into account as revenue on the AFS, the change constitutes a change in method of accounting under section 446. This rule is consistent with current practice regarding the determination of a change in method of accounting.

The regulations under section 6001 require a taxpayer to keep books and records sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown in an income tax return, which includes the identification of items includible in gross income under section 451. This requirement includes any books and records sufficient to establish a taxpayer’s calculation of income when its financial results are included in an AFS of a group of entities.

Proposed §1.451-3(c)(4) defines the term revenue for purposes of section 451(b)(1) broadly to include all items of income under section 61 (gains, profits, and income for Federal income tax purposes). This definition is consistent with the current application of the all events test under §1.451-1(a) and ensures greater financial accounting and tax accounting conformity.

One commenter discussed the effect of the New Standards on sections 451(b) and (c). The commenter noted that, under the New Standards, certain revenue may be included earlier than under section 451 prior to amendment by the Act. The commenter also noted that an amount booked to retained earnings should be treated as revenue for purposes of section 451(b) even though that amount may not be shown as book revenue for financial accounting purposes. A narrow reading of the term revenue could result in items of income that are taken into account on an AFS and that otherwise would be required to be included in gross income escaping section 451(b) altogether. For example, taxpayers may include items, or portions of items, in other comprehensive income on an AFS that are excluded from the revenue line(s) on the AFS. Accordingly, a broad reading of revenue ensures that the correct amount of income that is taken into account in an AFS is subject to section 451(b).

Multiple commenters proposed allowing a cost offset when income is included under the AFS income inclusion rule. For example, one commenter suggested that, in determining the amount of income to include under section 451(b), taxpayers selling goods should reduce AFS revenue by the cost of goods sold associated with a sale that does not presently reduce AFS revenue. The commenter acknowledged that costs are not taken into account for Federal income tax purposes until the all events test is satisfied, which includes the economic performance rules under section 461. Because of the resulting inconsistency with sections 461 and 471, these regulations do not follow the commenter’s suggestion that a cost offset or cost of goods sold reduction should apply without regard to the economic performance rules of section 461 and inventory accounting rules of section 471.

Congress has addressed various cost recovery mechanisms in the past. In 1955, Congress repealed the reserve method for estimated expenses under section 462 of the Code. See An Act to Repeal Sections 452 and 462 of the Internal Revenue Code of 1954, Public Law No. 84-74, section 1(b) (1955). Section 462 of the Code was a companion to section 452, which allowed taxpayers to report certain types of prepaid income over time. In the Senate Report discussing the repeal of sections 452 and 462, Congress noted that “the problem presented by section 462 is that of the timing of deductions when a taxpayer changes accounting methods.” S. Rep. 84-372, at 4 (1955). The Senate noted that taxpayers would be entitled to the deductions even without section 462. In addition, section 462 increased the possibility of distortions of income because expenses were being deducted when the amount had not yet been incurred.

Thirty years later, Congress repealed the use of the reserve method for determining losses from bad debts under section 166 in the Tax Reform Act of 1986. In repealing the reserve method, Congress noted that this method was inconsistent with the rules for other deductions under the all events test and could result in deductions being allowed for Federal income tax purposes for losses that may never occur. S. Rep. No. 99-313, at 155 (1986). Moreover, “if a deduction is allowed prior to the taxable year in which the loss occurs, the value of the deduction to the taxpayer will be overstated.” S. Rep. No. 99-313, at 155 (1986).

These proposed regulations do not allow a cost offset provision because similar potential distortions of income could result. An allowance to account for future cost of goods sold, for future estimated costs, or other cost offsets also is inconsistent with sections 461 (in particular section 461(h)), 263A, and 471, and the regulations under those sections. In addition, these proposed regulations do not allow a cost offset provision because there is nothing in the statute or legislative history that indicates that in amending section 451 Congress intended to change sections 461, 263A or 471, and the regulations under those sections. See also, General Explanation of Public Law 115-97 (JCS-1-18) at 150-151, and 164-165 (Dec. 20, 2018).

Nevertheless, the Treasury Department and the IRS continue to consider whether any exceptions are an appropriate use of the Secretary’s authority under section 461(h) or 460. To facilitate further consideration of any potential exceptions, detailed comments that specifically address the following issues are requested:

The proposed regulations describe and clarify the allocation of transaction price under section 451(b)(4). Section 451(b)(4) provides that, in the case of a contract with multiple performance obligations, the allocation of the transaction price to each performance obligation shall be equal to the amount allocated to each performance obligation for purposes of including such item in revenue in the AFS of the taxpayer. Consistent with the definition of performance obligation found in the New Standards, proposed §1.451-3(c)(3) defines “performance obligation” to mean a promise in a contract with a customer to transfer to the customer either a good or service (or a bundle of goods or services) that is distinct, or a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. See ASC Topic 606 and IFRS 15.

Comments are requested on allocation of the transaction price (i) to performance obligations that are not contractually based, (ii) for arrangements that include both income subject to section 451 and long-term contracts subject to section 460, and (iii) when the income realization event for Federal income tax purposes differs from the income realization event for AFS purposes.

Commenters proposed allowing taxpayers that include items of income as revenue in an AFS over a period of time under the New Standards (AFS over-time method) to follow that method for Federal income tax purposes. Allowing taxpayers to follow their AFS over-time method for Federal income tax purposes would potentially defer income beyond what is permitted under section 451(b), section 451(c), and the all events test. The AFS income inclusion rule operates only to accelerate income inclusion; the AFS income inclusion rule can never cause income inclusion to occur later than when the all events test is satisfied. Allowing taxpayers to follow their AFS over-time method for Federal income tax purposes may also affect the treatment of costs in a manner that is inconsistent with sections 461 and 471. However, the Treasury Department and the IRS continue to study the commenters’ proposal and request additional comments on this issue. Specifically, additional comments are requested regarding: the size of taxpayers likely to be affected; the industries likely to be affected; the number of taxpayers likely to be affected; the compliance burden and administrative complexity likely to be avoided; and the degree to which an over-time method under the New Standards accelerates or defers income relative to the all events test and the AFS income inclusion rule.

A. Credit Card Fees and Other Fees

The Treasury Department and the IRS have treated certain credit card fees associated with pools of credit card receivables as creating or increasing original issue discount (OID) on those pools. See Revenue Procedure 2004-33 (2004-1 CB 989) (the IRS will not challenge the treatment of late fees as creating or increasing OID); Revenue Procedure 2005-47 (2005-2 CB 269) (the IRS will not challenge the treatment of cash advance fees as creating or increasing OID); Revenue Procedure 2013-26 (2013-22 IRB 1160) (safe harbor method of accounting for OID on a pool of credit card receivables for purposes of section 1272(a)(6)); and Chief Counsel Notice CC-2010-018 (Sept. 27, 2010) (as a result of the Tax Court’s decision in Capital One Financial Corp. and Subsidiaries v. Commissioner, 133 T.C. 136 (2009), the IRS will no longer challenge or litigate the issue of whether interchange fee income creates or increases OID).

With the enactment of section 451(b), however, Congress expressed its intention to overturn the tax treatment of those credit card fees as OID, including the use of the OID timing rules, and subject them to the all events test. The Conference Report to the Act states, “[section 451(b)] directs accrual method taxpayers with an applicable financial statement to apply the income recognition rules under section 451 before applying the special rules under part V of subchapter P ...” (which includes the OID rules). H.R. Rep. No. 115-466, at 428 (2017) (Conf. Rep.). In particular, the legislative history describes the treatment of credit card late fees, credit card cash advance fees, and interchange fees as creating or increasing OID for Federal tax purposes and lists these fees as examples of amounts to which section 451(b), as amended, would apply. Id. at 427, 429. These three credit card fees are not generally treated as discount for AFS purposes.

Congress clearly expressed its intention to overturn the tax treatment of credit card late fees, cash advance fees, and interchange fees (specified credit card fees) and to subject these fees to the all events test as modified by section 451(b). Id. at 429. The legislative history quoted in the preceding paragraph further suggests that Congress intended that other fees associated with a lending transaction that might otherwise be accounted for in calculating OID are to be subjected to the AFS income inclusion rule before the application of the OID rules. Based on the legislative history, however, taxpayers have stated that section 451(b) was not intended to affect the application of the general OID timing rules to OID other than with respect to items not treated as discount for financial reporting purposes, such as the specified credit card fees. Id. at 427-429. Moreover, taxpayers have stated that the application of section 451(b) to OID other than items not treated as discount for financial reporting purposes would result in significant administrative burden and very little additional tax revenue. The Treasury Department and the IRS agree with commenters on this issue. Therefore, in the absence of a clear indication in the legislative history that Congress intended for section 451(b) to override the general timing rules for OID, and in order to reduce administrative burden, the proposed section 451(b) regulations would not apply to determine the time at which OID generally is includible in income. See §1.451-3(c)(5)(ix) of the proposed regulations.

The proposed regulations contain two provisions that implement Congressional intent regarding the treatment of fees, including the specified credit card fees. First, under proposed §1.451-3(i), if a fee is not treated by a taxpayer as discount or as an adjustment to the yield of a debt instrument over the life of the instrument (such as points) in its AFS and the fee otherwise would be treated as creating or increasing OID for Federal income tax purposes (specified fee), then the rules in the proposed regulations under section 451(b) apply before the rules in sections 1271 through 1275 and the regulations thereunder. For example, proposed §1.451-3(i) applies to the specified credit card fees. Second, proposed §1.1275-2(l) includes a proposed amendment to the final regulations under section 1275 to clarify that an item of income that is subject to the timing rules in the proposed regulations under section 451(b) (such as the specified credit card fees) is not taken into account in determining the amount of OID (if any) on the debt instrument. Removing specified fees and specified credit card fees from the calculation of OID will permit taxpayers to apply only the rules of section 451(b) to these fees, without also having to apply the rules relevant to OID. In addition, the Treasury Department and the IRS propose to obsolete Revenue Procedure 2004-33, Revenue Procedure 2005-47, Revenue Procedure 2013-26, and Chief Counsel Notice CC-2010-018. The Treasury Department and the IRS request comments on the proposed obsolescence of these documents.

B. Market Discount

Taxpayers requested guidance as to whether market discount is includible in income under section 451(b). The Treasury Department and the IRS previously announced that proposed regulations would provide that accrued market discount is not includible in income under section 451(b). Notice 2018-80 (2018-42 IRB 609), issued September 27, 2018.

A bond is generally treated as having market discount when the principal amount of the bond exceeds the holder’s basis immediately after it was acquired by the holder. Under section 1276(a), market discount is includible in income only upon disposition of a market discount bond at a gain or the receipt of a partial principal payment, unless the holder of the bond elects otherwise. In each case, the market discount inclusion is limited to accrued market discount as defined in section 1276(b). In general, the timing rules for income inclusion in section 1276 are a codification of the pre-1984 timing rules for market discount and confirm that the all events test generally does not determine when accrued market discount is includible in income. The proposed regulations therefore include the market discount rules on the list of special methods of accounting to which section 451(b) does not apply.

Executive Orders 13771, 13563, and 12866 direct agencies to assess costs and benefits of available regulatory alternatives and, if regulation is necessary, to select regulatory approaches that maximize net benefits, including potential economic, environmental, public health and safety effects, distributive impacts, and equity. Executive Order 13563 emphasizes the importance of quantifying both costs and benefits, reducing costs, harmonizing rules, and promoting flexibility. The Executive Order 13771 designation for any final rule resulting from the proposed regulation will be informed by comments received. The preliminary Executive Order 13771 designation for this proposed rule is regulatory.

The proposed regulation has been designated by the Office of Information and Regulatory Affairs (OIRA) as subject to review under Executive Order 12866 pursuant to the Memorandum of Agreement (MOA, April 11, 2018) between the Treasury Department and the Office of Management and Budget regarding review of tax regulations. The Office of Information and Regulatory Affairs has designated these proposed regulations as significant under section 1(b) of the MOA. Accordingly, these proposed regulations have been reviewed by OIRA.

1. Background

In plain language, section 451 of the Internal Revenue Code (the “Code”) and the proposed regulations deal with differences between when income is recognized for Federal tax purposes and when it is recognized on businesses’ financial accounting statements. The recently enacted section 451(b) more closely aligns the timing rules of the tax system with general financial accounting standards.

Under section 451(a) of the Code, any item of gross income is required to be included as income by the taxpayer (“recognized“) when it is received by the taxpayer unless, under the taxpayer’s method of accounting, the income is properly accounted for in a different period. For this purpose, businesses and individuals are generally required to use the accounting method that is used regularly to keep their financial records. This may be a cash receipts and disbursements accounting method, under which income is recognized when payment is actually or constructively received, or it may be an accounting system based on income and expense accrual principles. Certain corporations and some partnerships are required to use an accrual method, and generally taxpayers employing inventories in their trade or business must use an accrual method with regard to purchases and sales of inventory.

Current regulations require taxpayers using an accrual accounting method to report income in the taxable year in which all events that fix the right to receive such income have occurred, provided the amount can be determined with reasonable accuracy. Under IRS guidance, this “all events test” is met upon the earliest of when (i) payment is earned through performance by the taxpayer (e.g., provision of the contracted goods or services), (ii) payment is due to the taxpayer, or (iii) payment is received by the taxpayer.

In contrast, U.S. generally accepted accounting principles (“GAAP”) and international financial reporting standards (“IFRS”), having different purposes from tax law, may often dictate alternative rules as regards the timing of revenue recognition. Differences between these financial accounting standards and the Code in the timing of revenue recognition may arise for a number of reasons. For example, under certain circumstances, financial accounting rules may require revenue to be recognized when the costs of providing goods or services pursuant to a contract are incurred, while the all events test may not be satisfied until the contract obligation is fulfilled. If meeting the taxpayer’s performance obligation occurs over more than a single accounting period, then this timing pattern can result in a disparity between the year in which the associated revenue is booked for financial accounting purposes and the year in which the associated taxable gross income is recognized.

Congress enacted new section 451(b) in part because conformity in the timing of income recognition between the accrual system of accounting and the tax system (“book-tax conformity”) will generally “promote simplification and reduced compliance costs.” See Senate Budget Explanation of the Bill (2017-11-20) at p. 161.

Section 451(b) applies only to taxpayers that use the accrual method and have an Applicable Financial Statement (“AFS”). In plain language, an AFS is a financial statement certified as having been prepared under GAAP or IFRS. All publicly traded U.S. corporations possess an AFS, as do many privately held corporations and partnerships, which may have such certified accounting statements for credit purposes or for shareholder or partner reporting purposes. The income recognition rules for accrual-method taxpayers without an AFS and cash-method taxpayers are not altered by the enactment of section 451(b) or by the proposed regulations. The Treasury Department and the IRS project that there were approximately 3.1 million tax-reporting entities in taxable year 2016 that used an accrual method of accounting. They further project that fewer than 10 percent of these, or approximately 296,000 entities had an AFS, and thus could have been affected by section 451(b) and the proposed regulations had these been in effect in taxable year 2016.

For these taxpayers, Section 451(b) modifies the all-events test by stating that the test is not met for any item of income any later than when it is taken into account as revenue in an AFS or other designated financial statement (the “AFS income inclusion rule”). Thus, this new rule requires taxpayers to recognize income upon the earlier of when the all-events test is met or when the taxpayer includes the amount in revenue (broadly defined) in its AFS (“AFS income inclusion rule”). The AFS income inclusion rule operates only in one direction — to accelerate in time the recognition of gross income for tax purposes. This acceleration occurs in situations where income has been recognized for financial accounting purposes before the all events test has been satisfied.

2. Need for the proposed regulations

The proposed regulations deliver certainty and clarity to taxpayers affected by the Act’s introduction of the new section 451(b) and allow them to comply with the new statutory provision with a higher level of confidence.

The Treasury Department and IRS published a Notice in April 2018, requesting public comments regarding the application of the AFS income inclusion rule, the meaning of various concepts and terms used in section 451(b), and other implementation issues not explicitly addressed in the statute. As explained earlier in this Preamble, the proposed regulations address the comments and questions subsequently raised by the public.

3. Overview of the proposed regulations

The proposed regulations include applicability and definitional guidance regarding section 451(b). Specifically, the proposed regulations: (1) clarify how the AFS inclusion rule applies to multi-year contracts; (2) describe and clarify the definition of an AFS for a group of entities; (3) define the meaning of the term revenue in an AFS; (4) define a transaction price and clarify how that price is to be allocated to separate performance obligations in a contract with multiple obligations; and (5) describe and clarify rules for transactions involving certain debt instruments.

4. Economic analysis

A. Baseline

The Treasury Department and the IRS have assessed the benefits and costs of the proposed regulations relative to a no-action baseline reflecting anticipated Federal income tax-related behavior in the absence of these proposed regulations.

B. Summary of Economic Effects

The proposed regulations provide increased certainty, clarity, and consistency in the application of section 451(b) by providing definitions and clarifications regarding the statute’s terms and rules. In the absence of such guidance, the chances that different taxpayers would interpret the statute differently would be exacerbated. Similarly situated taxpayers might interpret the statutory provisions pertaining to the recognition of income differently, with one taxpayer pursuing a project that another comparable taxpayer might decline to make because of different interpretations of how the income would be treated under section 451(b). If this second taxpayer’s activity were more profitable, an economic loss arises. Even in situations where taxpayers would generally adopt similar interpretations of the Code under the baseline, the lack of guidance increases opportunities for that interpretation to differ from what Congress intended. In this case, guidance provides value by bringing economic decisions closer in line with Congressional intent. In the context of economic activity by businesses that are subject to section 451(b) or that interact with such businesses, the proposed regulations thus help to ensure that similar economic activities, representing similar timing of income, are taxed similarly, thereby improving U.S. economic performance.

The Treasury Department and the IRS have not undertaken quantitative estimates of these possible efficiency gains because any such quantitative estimates would be highly uncertain. For example, the proposed regulations include provisions to clarify how income should be included from multi-year contracts. The Treasury Department and the IRS do not have readily available data or models to determine how businesses might apply the AFS inclusion rule to multi-year contracts in the absence of the proposed regulations or under alternative regulatory approaches. Furthermore, even in the event that most businesses could be presumed to adopt a particular treatment under the baseline, the Treasury Department and the IRS further do not have readily available data or models of the volume or pattern of their multi-year contract payments and they thus cannot project with any degree of precision the differences in tax treatment taxpayers would experience between the proposed regulations and the baseline or alternative regulatory approaches. Such differences are a key component of the marginal effective tax rate that these contracts would experience, which in turn would determine how economic activity would be affected by the proposed regulations relative to the baseline or alternative regulatory approaches.

The Treasury Department and the IRS further project that issuance of the proposed regulations will reduce compliance and enforcement costs relative to the baseline because the enhanced certainty and clarity they provide should make it easier for businesses to calculate their tax liability relative to the baseline. Greater efficiencies should also result from the promulgation of the proposed regulations, relative to the baseline, by reducing taxpayer disputes with the IRS that otherwise would have to be dealt with through sub-regulatory guidance or resolved through increased litigation. By providing greater certainty of how the law will be applied, the Treasury Department and the IRS project that the proposed regulations will reduce these implementation costs. The Treasury Department and the IRS have not made a quantitative estimate of the reduction in compliance and enforcement costs resulting from the proposed regulations. They have not made such an estimate in part because models of compliance cost are not currently available to provide a reasonably precise estimate of compliance costs in the absence of the proposed regulations.

With these limitations in mind, part II.4.C of this Special Analyses section explains the rationale behind the approaches taken by the proposed regulations and qualitatively evaluates the alternatives considered.

The Treasury Department and the IRS solicit comments on the economic effects of the proposed regulations.

C. Economic Effects of Specific Provisions

The proposed regulations embody certain regulatory decisions that reflect the regulatory discretion of the Treasury Department and the IRS. These decisions specify more fully how the AFS income inclusion rule is to be implemented.

The Treasury Department and IRS solicit comments on the economics of each of the items discussed below and of any other items of the proposed regulations not discussed in this section. The Treasury Department and the IRS particularly solicit comments that provide data, other evidence, or models that could enhance the rigor of the process by which the final regulations might be developed.

i. Application of the AFS Income Inclusion Rule to Multi-year Contracts

The proposed regulations clarify how section 451(b) applies to multi-year contracts. The Treasury Department and the IRS considered two alternative approaches for such contracts: (i) an annualized approach and (ii) a cumulative approach. Under an annualized approach, for each year under the contract a taxpayer would compare the income included as revenue in its AFS for that year and the gross income recognized under the all events test for that same year to determine its gross income inclusion, with the proviso that the total amount of gross income recognized under the contract is not to exceed the total contract price. In contrast, under a cumulative approach, in each year a taxpayer would compare the cumulative amount of revenue included in its AFS up to and including that year with the cumulative amount of gross income recognized under the all events test up to and including that year.

Example 4 of the proposed regulations, the summary table of which is reproduced in the first three rows of the following table, shows the treatment of gross income under a cumulative approach. The fourth row in this table shows the treatment of gross income under the annualized approach.

An annualized approach could accelerate the recognition of taxable income to a greater degree than what is reflected in revenue for AFS purposes. In this example, such an approach would ignore in 2019 the fact that cumulative AFS revenue of $50x had been recognized as taxable gross income in 2018. Accordingly, the annualized approach would require that an additional $25x of income be recognized in 2019, since a payment of that amount was received in that year. In effect, an annualized approach would accelerate the recognition of $25x from 2021 to 2019 relative to gross income recognition under the cumulative AFS income inclusion rule.

The Treasury Department and IRS concluded that the extent of acceleration of income that may occur when using an annualized approach would be excessive relative to the cumulative approach when considered against the intents and purposes of the statute. The proposed regulations therefore adopt the cumulative approach.

ii. Applicable Financial Statement covering a group of entities

The proposed regulations provide rules for taxpayers whose financial results are included on an AFS covering a group of entities. These rules specify that, if a taxpayer’s financial results are reported on the AFS for a group of entities, the taxpayer’s AFS is the group’s AFS. However, if the taxpayer also reports financial results on a separate AFS that is of equal or higher priority, then the separate AFS is the taxpayer’s AFS. The rules also specify how a taxpayer using a group AFS is to determine the amount of revenue allocated to the taxpayer. The Treasury Department and the IRS considered as an alternative not providing substantive rules on how taxpayers should apply the AFS income inclusion rule when their financial results are included in an AFS for a group of entities. This alternative was rejected because it would have increased compliance burdens and potentially led to similarly situated taxpayers applying the AFS income inclusion rule differently.

The Code does not specify how the AFS income inclusion rule is to function whenever the AFS accounting period and the taxable year do not coincide. The proposed regulations do not adopt a single, one-size-fits-all approach, but rather provide taxpayers three separate options for addressing this situation. A change from one option to another, however, would be considered a change in method of accounting requiring the permission of the IRS. By providing taxpayers with several options, the proposed regulations will minimize taxpayer compliance costs when dealing with non-congruent tax and financial accounting periods relative to an alternative approach of specifying a single option, with no significant revenue implications or effects on economic decisions.

iii. Revenue in an AFS

The proposed regulations describe and clarify the definition of revenue to broadly include all items of income under section 61. Because this definition of revenue is based on tax principles, there may be items of revenue included in this definition that adjust retained earnings on financial statements but are not reflected in the revenue line on such financial statements. The Treasury Department and the IRS considered and rejected a narrower definition of revenue or a definition that was tied to the AFS definition of revenue. The definition of revenue advanced in the proposed regulations is consistent with the current application of the all events test under §1.451-1(a) and ensures that all financial statement items are taken into account for tax purposes. In contrast, a narrow definition of revenue would allow, or even encourage, taxpayers to avoid the AFS income inclusion rule by not classifying an item as revenue on their financial statement.

iv. Allocation of Transaction Price

Section 451(b)(4) specifies that, in the case of a contract which contains multiple performance obligations, the allocation of the transaction price to each obligation is determined using the allocation used in the AFS. The Code, however, does not define either transaction price or performance obligation, thus the proposed regulation defines these terms. The proposed regulations clarify that a transaction price does not include amounts collected on behalf of third parties. Transaction price also does not include amounts that are contingent on the occurrence or non-occurrence of a future event. Without these exclusions, section 451(b) could be used to override other provisions of the Code concerning the definition of what constitutes gross income. This result would be at odds with the purpose of section 451, which is not to determine the existence or the amount of gross income, but rather to determine the timing of its recognition. Consequently, alternatives to these rules were not considered here.

Amounts included in the transaction price for an AFS are presumed to be not contingent, unless the taxpayer demonstrates otherwise. The Treasury Department and the IRS project that this rule will lead to reduced compliance burden for taxpayers, and reduced administrative costs for taxpayers and IRS and should lead to fewer taxpayer disputes on this issue relative to an alternative presumption regarding possible contingent amounts.

v. Rules for certain debt instruments

Section 451(b)(2) states that the AFS inclusion rule does not apply to items of gross income for which a taxpayer uses a special method of accounting provided under the Code. However, the Code does not apply this exception to special accounting rules that apply to original issue discount (“OID”), market discount, and certain other items with respect to debt instruments under part V of Subchapter P of the Code.

The proposed regulations implement this provision regarding special methods of accounting, and clarify the effect of section 451(b) on the excepted Subchapter P rules.

The proposed regulations implement this provision by providing a non-exhaustive list of special methods of accounting, and by clarifying how section 451(b) applies to certain credit card receivables. The proposed regulations specifically except from section 451(b) the timing rules for accrued market discount on bonds and the general OID timing rules, as well as the timing rules for OID determined with respect to special debt instruments (contingent payment and variable rate debt instruments, certain hedged debt instruments, and inflation-indexed debt instruments). Nevertheless, following the legislative history of the Act (see Conference Report, p. 276), the proposed regulations provide that credit card late fees, credit card cash advance fees, and interchange fees are subject to the AFS income inclusion rule. The proposed regulations further specify that if these credit card fees are subject to a taxpayer’s AFS, they are not to be taken into account in determining whether a debt instrument associated with them has OID. Existing rules continue to apply to these items for taxpayers not possessing an AFS. The Treasury Department and the IRS expect that this treatment will provide a straightforward application of section 451(b) consistent with Congressional intent without unnecessarily complicating OID calculations and adding to taxpayer compliance burdens.

The Treasury Department and the IRS considered and rejected a broader application of the AFS income inclusion rule to include all amounts determined under the OID and market discount accounting methods, even in cases where the items are treated as discount or as an adjustment to the yield of a debt instrument over the life of the instrument in its AFS for financial reporting purposes. The proposed regulations do not subject these amounts to the AFS income inclusion rule because these special accounting methods do not generally rely on the all events test to determine the timing of income inclusion and these current special accounting methods provide workable income-recognition timing rules that appropriately measure income. The Treasury Department and the IRS expect that subjecting these items to the AFS income inclusion rule of section 451(b) would disrupt and complicate current tax accounting practices with no general economic benefit.

These proposed regulations do not impose any additional information collection requirements in the form of reporting, recordkeeping requirements or third-party disclosure requirements. However, because section 451(b) and the proposed regulations provide methods of accounting affecting the timing of income inclusion, the consent of the Commissioner under section 446(e) is required before using such method. The IRS expects that these taxpayers will request this consent by filing Form 3115, Application for Change in Accounting Method. Filing of Form 3115 (for taxpayers who are required to do so or who elect certain methods of accounting described in the proposed regulations) is the sole collection of information requirement imposed by the statute and the proposed regulations. See subsequent paragraphs for a description of taxpayers who would be required to change the method of accounting under the statute and the proposed regulations.

For purposes of the Paperwork Reduction Act, the reporting burden associated with these collections of information will be reflected in the IRS Form 3115 Paperwork Reduction Act Submissions (OMB control number 1545-0074 for individual income tax returns; OMB control number 1545-0123 for business taxpayers). On December 17, 2018, the Treasury Department and the IRS published Revenue Procedure 2018-60, 2018-51 IRB 1045, which provides procedures for taxpayers to make a change in method of accounting to comply with section 451(b)(1)(A) and/or (b)(4). Taxpayers are able to request these section 451 changes using reduced filing requirements, such as by filing a short Form 3115, or for certain taxpayers, by using a streamlined method change procedure that involves not filing a Form 3115. See also the revenue procedure accompanying these regulations for similar simplified method change procedures to make a change in method of accounting to comply with these proposed regulations.

In 2018, the IRS released and invited comment on a draft of Form 3115 in order to give members of the public the opportunity to benefit from certain specific provisions made to the Code. The IRS received no comments on the forms during the comment period. Consequently, the IRS made the forms available in January 2019 for use by the public. The IRS notes that Form 3115 applies to changes of accounting methods generally and is therefore broader than section 451(b).

Additionally, proposed §1.451-3(h) provides additional methods of accounting that require a taxpayer to request consent of the Commissioner under section 446(e) before using such method. Under proposed §1.451-3(h)(4)(iii), for a taxpayer with a financial accounting year that is different from its tax accounting year, a change in the method by which the taxpayer computes its revenue is a change in method of accounting. Under proposed §1.451-3(h)(5), a restatement of an AFS that changes the timing of which an item of income, or portion thereof, is taken into account in revenue on the AFS is also a change in method of accounting. The Treasury Department and the IRS expect that taxpayers will request this consent by filing Form 3115.

For a taxpayer with an AFS required to comply with section 451(b) and/or proposed §1.451-3, a change in the taxpayer’s revenue recognition policies for financial accounting purposes requires the taxpayer to seek the consent of the Commissioner under section 446(e) to use the method for Federal income tax purposes. See proposed §1.451-3(l). The reporting burden associated with the collection of information for a statement in lieu of the Form 3115 will be reflected in the Paperwork Reduction Act Submission associated with Revenue Procedure 2018-31, 2018-22 IRB 637 (or successor) (OMB control number 1545-1551). See the revenue procedure accompanying these proposed regulations.

The current status of the Paperwork Reduction Act submissions that will be revised as a result of the information collections in the proposed regulations is provided in the accompanying table. As described above, the reporting burdens associated with the information collections in the proposed regulations are included in the aggregated burden estimates for OMB control numbers 1545-0074 (in the case of individual filers of Form 3115), 1545-0123 (in the case of business filers of Form 3115), and 1545-1551 (in the case of filers subject to Revenue Procedure 2018-31). The overall burden estimates associated with the OMB control numbers below are aggregate amounts that relate to the entire package of forms associated with the applicable OMB control number and will in the future include, but not isolate, the estimated burden of the tax forms that will be created or revised as a result of the information collections in the proposed regulations. These numbers are therefore unrelated to the future calculations needed to assess the burden imposed by the proposed regulations. These burdens have been reported for other income tax regulations that rely on the same information collections and the Treasury Department and the IRS urge readers to recognize that these numbers are duplicates and to guard against overcounting the burdens imposed by tax provisions prior to the Act. No burden estimates specific to the forms affected by the proposed regulations are currently available. The Treasury Department and the IRS have not estimated the burden, including that of any new information collections, related to the requirements under the proposed regulations. For the OMB control numbers discussed in the preceding paragraphs, the Treasury Department and the IRS estimate PRA burdens on a taxpayer-type basis rather than a provision-specific basis. Those estimates capture both changes made by the Act and those that arise out of discretionary authority exercised in the proposed regulations (when final) and other regulations that affect the compliance burden for that form.

The Treasury Department and IRS request comment on all aspects of information collection burdens related to the proposed regulations, including estimates for how much time it would take to comply with the paperwork burdens described above for each relevant form and ways for the IRS to minimize the paperwork burden. In addition, when available, drafts of IRS forms are posted for comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.htm. IRS forms are available at https://www.irs.gov/forms-instructions. Forms will not be finalized until after they have been approved by OMB under the PRA.

D. Regulatory Flexibility Act

It is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities within the meaning of section 601(6) of the Regulatory Flexibility Act (5 U.S.C. chapter 6).

New section 451(b) of the Act requires that an item of income be included in gross income for tax purposes no later than when the item is counted as revenue in an applicable financial statement. This typically moves the recognition of income forward by a year or two compared to previous law. These proposed regulations provide general guidance on the rule, including the scope of the rule, exceptions to the rule, definitions of key terms, and examples demonstrating applicability of the rule.

The Treasury Department and the IRS have estimated the number of small business entities that may be affected by the statute and these proposed regulations. The statute and proposed regulations affect only those business entities that (i) use an accrual method of accounting, and (ii) have an applicable financial statement.

Regarding an accrual method of accounting, many small business entities use the cash receipts and disbursements method of accounting (cash method), as opposed to an accrual method, and thus are not subject to this provision. The percent of returns that use an accrual method of accounting, by entity types and for entities with gross receipts not greater than $25 million, are shown in the accompanying table.

The Treasury Department and the IRS next examined the second condition, that only entities with an Applicable Financial Statement (“AFS”) are affected by the statute and the proposed regulations. The Treasury Department and the IRS do not have readily available data to measure the prevalence of entities with an AFS. However, Schedule M-3, which is used to reconcile an entity’s net income or loss for tax purposes with its book income or loss, reports whether an entity has a certified audited income statement. Unfortunately for the current exercise, the Schedule M-3 is required to be filed only by entities possessing at least $10 million of assets. Nevertheless, it is this population that is far more likely to possess an AFS. Furthermore, data are currently available only for electronic filers.

For taxable year 2016, approximately 87 percent of accrual-method entities filing Forms 1120, 1120-S, and 1065 with gross receipts of $25 million or less were filers of electronic tax forms. About 11 percent, or 265,000 of these returns, included a Schedule M-3. About 40 percent of the returns with Schedule M-3, or 106,000, indicated they had a certified audited income statement.² Based on the assumption that filers of paper tax forms have the same incidence as electronic filers and that entities that do not file a Schedule M-3 generally do not have an AFS, then the Treasury Department and the IRS estimate that roughly 122,000 (=106,000/0.87) entities with gross receipts of $25 million or less are accrual-method entities that have an AFS. If 5 percent of entities that do not file a Schedule M-3 also have an AFS then approximately 247,000 entities with gross receipts of $25 million or less are potentially affected by the proposed regulations. These estimates of affected filing entities are reproduced in the following table.

This rule would not have a significant economic impact on small entities affected. The costs to comply with these proposed regulations are not significant. Taxpayers needing to make method changes pursuant to section 451(b) or the proposed regulations will be required to file a Form 3115. The Treasury Department and the IRS have provided streamlined procedures for certain taxpayers to change their method of accounting to comply with section 451(b), and plan to provide streamlined procedures for taxpayers to change to the methods of accounting described in these proposed regulations. See Revenue Procedure 2018-60, and the revenue procedure accompanying these regulations. Under the streamlined procedures, certain taxpayers would either complete only a portion of the Form 3115 or would not complete the Form 3115 at all to comply with section 451(b). The streamlined method change procedures are available to taxpayers (other than a tax shelter) who satisfy the gross receipts test under section 448(c) and for taxpayers making such a method change which results in a zero section 481(a) adjustment. (For tax years beginning in 2018, an entity satisfied the gross receipts test if its average annual gross receipts was $25 million or less. For tax years beginning in 2019, this threshold increased to $26 million or less.) In addition, the Treasury Department and the IRS plan to issue a streamlined procedure, using a short Form 3115, for taxpayers using a section 451(b) method who have a change in their AFS for revenue recognition that requires a method change for tax purposes. See the revenue procedure accompanying these regulations.

As noted in the revenue procedure accompanying these regulations, the estimated cumulative annual reporting and/or recordkeeping burden for the statutory method changes described under OMB control number 1545-1551, before publication of the revenue procedure, is 27,336 respondents, and a total annual reporting and/or recordkeeping burden of 30,580 hours. The estimated annual burden per respondent/recordkeeper under OMB control number 1545-1551 before publication of this revenue procedure varies from 1/6 hour to 8½ hours, depending on individual circumstances, with an estimated average of 1¼ hours. The estimated cumulative annual reporting and/or recordkeeping burden for the method changes described under OMB control number 1545-1551 after that revenue procedure is accounted for is 27,346 respondents, and a total annual reporting and/or recordkeeping burden is 31,479 hours, leaving the average reporting and recordkeeping burden essentially unchanged. These burdens are essentially unaffected by these proposed regulations.

Notwithstanding this certification, the Treasury Department and the IRS invite comments from the public about the impact of this proposed rule on small entities.

Pursuant to section 7805(f), these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Section 202 of the Unfunded Mandates Reform Act of 1995 requires that agencies assess anticipated costs and benefits and take certain other actions before issuing a final rule that includes any Federal mandate that may result in expenditures in any one year by a state, local, or tribal government, in the aggregate, or by the private sector, of $100 million in 1995 dollars, updated annually for inflation. In 2018, that threshold is approximately $150 million. This rule does not include any Federal mandate that may result in expenditures by state, local, or tribal governments, or by the private sector in excess of that threshold.

Executive Order 13132 (entitled “Federalism”) prohibits an agency from publishing any rule that has federalism implications if the rule either imposes substantial, direct compliance costs on state and local governments, and is not required by statute, or preempts state law, unless the agency meets the consultation and funding requirements of section 6 of the Executive Order. This rule does not have federalism implications and does not impose substantial direct compliance costs on state and local governments or preempt state law within the meaning of the Executive Order.