Advance Payments for Goods, Services, and Other Items

 
CONTENT
Federal Register, Volume 84 Issue 174 (Monday, September 9, 2019)
[Federal Register Volume 84, Number 174 (Monday, September 9, 2019)]
[Proposed Rules]
[Pages 47175-47191]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-19197]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-104554-18]
RIN 1545-B078
Advance Payments for Goods, Services, and Other Items
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking.
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SUMMARY: This document contains proposed regulations regarding the
timing of income inclusion under section 451 of the Internal Revenue
Code (Code) of advance payments for goods, services, and certain other
items. The proposed regulations reflect changes made by the Tax Cuts
and Jobs Act. These proposed regulations affect taxpayers that use an
accrual method of accounting and receive advance payments.
DATES: Written or electronic comments or a request for a public hearing
must be received by November 8, 2019.
ADDRESSES: Submit electronic submissions via the Federal eRulemaking
Portal at www.regulations.gov (indicate IRS and REG-104554-18) by
following the online instructions for submitting comments. Once
submitted to the Federal eRulemaking Portal, comments cannot be edited
or withdrawn. The Department of the Treasury (Treasury Department) and
the IRS will publish for public availability any comment received to
its public docket, whether submitted electronically or in hard copy.
Send hard copy submissions to Internal Revenue Service, CC:PA:LPD:PR
(REG-104554-18), Room 5205, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to Courier's Desk,
Internal Revenue Service,
[[Page 47176]]
CC:PA:LPD:PR (REG-104554-18), 1111 Constitution Avenue NW, Washington,
DC 20224.
FOR FURTHER INFORMATION CONTACT: Concerning this proposed regulation,
Peter E. Ford, (202) 317-7003; concerning submission of comments or a
request for a public hearing, Regina L. Johnson, (202) 317-6901 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
    This document contains proposed amendments to 26 CFR part 1 under
section 451(c). On December 22, 2017, section 451(c) was amended by
section 13221 of the Tax Cuts and Jobs Act, Public Law 115-97 (131
Stat. 2054) (the Act), to provide that a taxpayer using an accrual
method of accounting (accrual method taxpayer) with an applicable
financial statement (AFS) may use the deferral method of accounting
provided in section 451(c) for advance payments. These proposed
regulations also provide a deferral method of accounting for taxpayers
that do not have an AFS. Unless otherwise indicated, all references to
section 451(c) in this preamble are to section 451(c), as amended by
the Act.
    In general, section 451 provides that the amount of any item of
gross income is included in gross income for the taxable year in which
it is received by the taxpayer, unless, under the method of accounting
used in computing taxable income, the amount is to be properly
accounted for as of a different period. Under Sec.  1.451-1, accrual
method taxpayers generally include items of income in gross income in
the taxable year when all the events occur that fix the right to
receive the income and the amount of the income can be determined with
reasonable accuracy (the all events test). All the events that fix the
right to receive income occur when (1) the required performance takes
place, (2) payment is due, or (3) payment is made, whichever happens
first. See Revenue Ruling 2003-10 (2003-1 CB 288); Revenue Ruling 84-31
(1984-1 CB 127); Revenue Ruling 80-308 (1980-2 CB 162). Section 451(c)
requires an accrual method taxpayer who receives an advance payment to
include the amount thereof in income in the taxable year of receipt.
Section 451(c) also generally codifies the current deferral method of
accounting for certain advance payments for goods, services, and other
specified items provided by the IRS under Revenue Procedure 2004-34
(2004-22 IRB 991) by allowing accrual method taxpayers to elect to
defer the inclusion of income associated with certain advance payments
to the taxable year following the taxable year of receipt if such
income also is deferred for AFS purposes.
    On April 12, 2018, the Treasury Department and the IRS issued
Notice 2018-35 (2018-18 IRB 520) requesting, in part, comments on
future guidance under section 451(c). The record of public comments
received in response to Notice 2018-35 may be requested by sending an
email to [email protected]. This document provides
guidance on the application of section 451(c), taking into account
comments that were received regarding section 451(c). The application
of section 451(c) is addressed in separate guidance published in the
same issue of the Federal Register as these proposed regulations.
Explanation of Provisions
    These proposed regulations describe and clarify the statutory
requirements of section 451(c) by providing new Sec.  1.451-8.
1. Deferral Methods Under Sec.  1.451-8
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
Sec.  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 Sec.  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 Sec.  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.
2. Definition of Advance Payment
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)
[[Page 47177]]
for a subsequent taxable year, and (iii) which is for goods, services,
or such other items as may be identified by the Secretary.
    Proposed Sec.  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 Sec.  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 Sec.  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:
    1. Does the authority granted to the Secretary by section
451(c)(4)(B)(vii) to exclude certain payments from the definition of an
advance payment under section 451(c) also permit an exception for those
payments from the rules regarding the all events test under section
451(b)?
    2. What significance, if any, should the time it takes to
manufacture or create an item of property, or such item of property's
useful life, be given in determining whether a pre-delivery payment for
such item of property should be included in income as an advance
payment?
    3. Does the authority granted to the Secretary by section
451(c)(4)(B)(vii) authorize rules that change the timing of deductions
or provide a safe harbor allowing specified categories of taxpayers to
use methods of accounting for recognizing income other than an accrual
method under section 451? Is there any particular authority under the
Code that would allow changing the timing of deductions in this context
under section 451 or another section of Subchapter E?
    4. Does the authority granted to the Secretary by section
451(c)(4)(B)(vii) to exclude certain payments from the definition of an
advance payment also authorize the imposition of conditions unrelated
to an accrual method of accounting with respect to any such exclusions?
For example, could the Secretary require that a taxpayer use an
alternative method of accounting as a condition for excluding a type of
payment from the definition of advance payment?
    5. Does the authority granted to the Secretary by section
451(c)(4)(B)(vii) to
[[Page 47178]]
exclude certain payments from the definition of advance payment also
authorize the imposition of a time limit on such exclusion? For
example, could an exclusion under section 451(c)(4)(B)(vii) be limited
to a specified number of years after which all remaining amounts would
have to be recognized in income? If so, what would be an appropriate
time limit?
    6. Does the authority granted to the Secretary by section
451(c)(4)(B)(vii) allow deferral of income in an amount equal to the
estimated future performance costs while requiring current recognition
of estimated profits not in excess of the amounts of advance payments?
If so, does the authority granted to the Secretary by section
451(c)(4)(B)(vii) permit rules to account for the time value of money
for any variances in estimated costs or profits?
    7. Would it be inappropriate to reduce the amount a C corporation
would be permitted to defer for a given taxable year under a potential
exclusion under section 451(c)(4)(B)(vii) by an amount equal to the
excess of (i) distributions the C corporation made to its shareholders
with respect to its stock, over (ii) the C corporation's taxable income
for that taxable year?.
3. Advance Payment Acceleration Provisions
    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 Sec.  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.
4. Advance Payments and Financial Statement Adjustments
    Section 451(c) does not address the treatment of financial
statement adjustments that cause amounts to not be included in income.
    Proposed Sec.  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 Sec.
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 Sec.  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.
5. Short Taxable Years and the 92-Day Rule
    Section 451(c) does not provide rules relating to the treatment of
short taxable years. Proposed Sec.  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).
6. Performance Obligations for AFS and Non-AFS Taxpayers
    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
Sec.  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 Sec.  1.451-8(b)(4) defines the term
performance obligation by cross-reference to proposed Sec.  1.451-
3(c)(3) for purposes of the allocation rule provided in section
451(c)(4)(D).
    Proposed Sec.  1.451-8(b)(7) defines the term transaction price by
cross-reference to proposed Sec.  1.451-3(c)(6). Proposed Sec.  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 Sec.  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.
[[Page 47179]]
Proposed Sec.  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 Sec.  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 Sec.  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.
7. Accelerated Cost Offset
    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 Sec.  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 Sec.  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 Sec.  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 Sec.  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
Sec.  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\1/2\ 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:
    1. Under what authority would it be appropriate for the Secretary
to permit a taxpayer to use book PCM as its tax method? When inventory
is involved, what limitations could be instituted to ensure that book
PCM could not be used to recover costs related to inventoriable goods
prior to the time when such costs could be recovered under sections 471
and 263A? Under what specific authority would it be appropriate to
permit a book PCM method to be used to recover costs related to
inventoriable goods?
    2. Would elective use of book PCM for tax purposes provide an
appropriate cost offset? Would such a method be characterized as one
that reports contract revenue according to a taxpayer's book method,
while accounting for costs, including nondeductible costs, as
deductions under the Code? If not, how would such a method account for
costs for federal income tax purposes?
    3. Rather than make book PCM elective, would it be appropriate for
the definition of ``unique item'' for purposes of section 460 to be
expanded?
[[Page 47180]]
    4. Section 460 requires use of the look-back method to compensate
for improper acceleration or deferral of income under PCM. It also
requires that all contract income be reported no later than the year
following contract completion. Would elective use of a PCM under
section 460 without these provisions invite abuse? If so, how could
such abuse be prevented?
8. Section 451(c) Is a Method of Accounting
    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.
Proposed Applicability Date
    Section 7805(b)(1)(A) and (B) of the Code generally provides that
no temporary, proposed, or final regulation relating to the internal
revenue laws may apply to any taxable period ending before the earliest
of (A) the date on which such regulation is filed with the Federal
Register, or (B) in the case of a final regulation, the date on which a
proposed or temporary regulation to which the final regulation relates
was filed with the Federal Register.
    These regulations are proposed to apply to taxable years beginning
on or after the date the final regulations are published in the Federal
Register. Until the date the Treasury decision adopting these
regulations as final regulations is published in the Federal Register,
a taxpayer may rely on these proposed regulations for taxable years
beginning after December 31, 2017, provided that the taxpayer: (1)
Applies all the applicable rules contained in these proposed
regulations, and (2) consistently applies these proposed regulations to
all advance payments. See section 7805(b)(7).
Statement of Availability of IRS Documents
    The IRS notice, revenue ruling, and revenue procedures cited in
this preamble are published in the Internal Revenue Bulletin (or
Cumulative Bulletin) and are available from the Superintendent of
Documents, U.S. Government Publishing Office, Washington, DC 20402, or
by visiting the IRS website at http://www.irs.gov.
Special Analysis
l. Regulatory Planning and Review
    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.
2. Need for the Proposed Regulations
    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.
[[Page 47181]]
3. Overview of the Proposed Regulations
    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.
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. 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
[[Page 47182]]
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.
II. Paperwork Reduction Act
    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
Sec. Sec.  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
[[Page 47183]]
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 Sec.  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 Sec.  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 Sec.  1.451-8(c).\a\ 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 Sec.  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 Sec.  1.451-8(c) and
(d). See the revenue procedure accompanying these proposed regulations.
---------------------------------------------------------------------------
    \a\ This estimate is based on data from the Compliance Data
Warehouse of accrual-method taxpayers (includes C corporations, S
corporations, partnerships, and sole proprietorships) with an AFS
that E-filed schedule M-3 during 2012-2016. Schedule M-3 is used to
report a net income (loss) reconciliation but not all taxpayers who
should file an M-3 do so. The rules for filing the M-3 differ based
on taxpayer status. For example, for C corporations, in general only
those with assets of $10 million or more file an M-3 schedule with
their Form 1120.
---------------------------------------------------------------------------
    For a taxpayer with an AFS that uses the deferral method in
proposed Sec.  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 Sec.
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.
[[Page 47184]]
[GRAPHIC] [TIFF OMITTED] TP09SE19.001
III. Regulatory Flexibility Act
    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.
[[Page 47185]]
----------------------------------------------------------------------------------------------------------------
                                                                       Number of returns (taxable year 2016)
                                                                                    (thousands)
                                                                 -----------------------------------------------
                             Entity                                                    Method of accounting
                                                                    All returns  -------------------------------
                                                                                      Accrual          Cash
----------------------------------------------------------------------------------------------------------------
C Corporations:
    Gross Receipts >$25 mil.....................................              30              28               2
    Gross Receipts [lE]$25 mil..................................           1,567             700             867
                                                                 -----------------------------------------------
        Total...................................................           1,597             728             869
S Corporations:
    Gross Receipts >$25 mil.....................................              41              34               7
    Gross Receipts [lE]$25 mil..................................           4,551           1,140           3,411
                                                                 -----------------------------------------------
        Total...................................................           4,592           1,174           3,418
Partnerships:
    Gross Receipts >$25 mil.....................................              20              17               3
    Gross Receipts [lE]$25 mil..................................           3,743             860           2,883
                                                                 -----------------------------------------------
        Total...................................................           3,763             877           2,886
Sole Proprietors and LLCs:
    Gross Receipts >$25 mil.....................................               1               1               0
    Gross Receipts [lE]$25 mil..................................          25,524             358          25,166
                                                                 -----------------------------------------------
        Total...................................................          25,525             359          25,166
All Entities:
    Gross Receipts >$25 mil.....................................              92              80              12
    Gross Receipts [lE]$25 mil..................................          35,385           3,058          32,327
                                                                 -----------------------------------------------
        Total...................................................          35,477           3,138          32,339
----------------------------------------------------------------------------------------------------------------
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 Sec.  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
Sec.  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 Sec.  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 8\1/2\
hours, depending on individual circumstances, with an estimated average
of 1\1/4\ 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.
IV. Unfunded Mandates Reform Act
    Section 202 of the Unfunded Mandates Reform Act of 1995 requires
that agencies assess anticipated costs and benefits and take certain
other
[[Page 47186]]
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.
V. Executive Order 13132: Federalism
    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.
Comments and Requests for a Public Hearing
    Before these proposed regulations are adopted as final regulations,
consideration will be given to any comments that are submitted timely
to the IRS as prescribed in this preamble under the ADDRESSES heading.
The Treasury Department and the IRS request comments on all aspects of
the proposed regulations. All comments will be available at http://www.regulations.gov or upon request. A public hearing will be scheduled
if requested in writing by any person that timely submits written
comments. If a public hearing is scheduled, notice of the date, time,
and place for the public hearing will be published in the Federal
Register.
Effect on Other Documents
    When finalized, these proposed regulations will obsolete Revenue
Procedure 2004-34, Revenue Procedure 2011-18, Revenue Procedure 2013-29
and Notice 2018-35.
Drafting Information
    The principal author of these proposed regulations is Peter E.
Ford, IRS Office of the Associate Chief Counsel (Income Tax and
Accounting). However, other personnel from the Treasury Department and
the IRS participated in their development.
List of Subjects in 26 CFR Part 1
    Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
    Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
    Authority: 26 U.S.C. 7805 * * *
    Sections 26 U.S.C. 451(c)(2)(A), (3), (4)(A)(iii), (4)(B)(vii);
0
Par. 2. Section 1.451-8 is added to read as follows:
Sec.  1.451-8  Advance payments for goods, services, and certain other
items.
    (a) In general. Except as provided in paragraph (c) or (d) of this
section, an accrual method taxpayer shall include an advance payment in
gross income no later than in the taxable year in which the taxpayer
receives the advance payment as provided under Sec.  1.451-1(a).
    (b) Definitions. Except as otherwise provided in this section, the
following definitions apply for purposes of this section:
    (1) Advance payment--(i) In general. An advance payment is a
payment received by a taxpayer if:
    (A) The full inclusion of the payment in the gross income of the
taxpayer for the taxable year of receipt is a permissible method of
accounting, without regard to this section;
    (B) Any portion of the payment is included in revenue by the
taxpayer in an applicable financial statement for a subsequent taxable
year;
    (C) The payment is for:
    (1) Services;
    (2) The sale of goods;
    (3) The use, including by license or lease, of intellectual
property, including copyrights, patents, trademarks, service marks,
trade names, and similar intangible property rights, such as franchise
rights and arena naming rights;
    (4) The occupancy or use of property if the occupancy or use is
ancillary to the provision of services, for example, advance payments
for the use of rooms or other quarters in a hotel, booth space at a
trade show, campsite space at a mobile home park, and recreational or
banquet facilities, or other uses of property, so long as the use is
ancillary to the provision of services to the property user;
    (5) The sale, lease, or license of computer software;
    (6) Guaranty or warranty contracts ancillary to an item or items
described in paragraph (b)(1)(i)(C)(1), (2), (3), (4), or (5) of this
section;
    (7) Subscriptions in tangible or intangible format. Subscriptions
for which an election under section 455 is in effect is not included in
this paragraph (b)(1)(i)(C)(7);
    (8) Memberships in an organization. Memberships for which an
election under section 456 is in effect are not included in this
paragraph (b)(1)(i)(C)(8);
    (9) An eligible gift card sale;
    (10) Any other payment specified by the Secretary in other guidance
published in the Internal Revenue Bulletin (see Sec.  601.601(d)(2));
or
    (11) Any combination of items described in paragraphs
(b)(1)(i)(C)(1) through (10) of this section.
    (ii) Exclusions from the definition of advance payment. An advance
payment does not include:
    (A) Rent, except for amounts paid with respect to an item or items
described in paragraph (b)(1)(i)(C)(3), (4) or (5) of this section;
    (B) Insurance premiums, to the extent the inclusion of those
premiums is governed by subchapter L;
    (C) Payments with respect to financial instruments (for example,
debt instruments, deposits, letters of credit, notional principal
contracts, options, forward contracts, futures contracts, foreign
currency contracts, credit card agreements (including rewards or
loyalty points under such agreements), financial derivatives, or
similar items), including purported prepayments of interest;
    (D) Payments with respect to service warranty contracts for which
the taxpayer uses the accounting method provided in Revenue Procedure
97-38 (1997-2 CB 479);
    (E) Payments with respect to warranty and guaranty contracts under
which a third party is the primary obligor;
    (F) Payments subject to section 871(a), 881, 1441, or 1442;
    (G) Payments in property to which section 83 applies; and
    (H) 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.
    (2) Applicable financial statement. Applicable financial statement
has the same meaning as provided in proposed Sec.  1.451-3(c)(1).
    (3) Eligible gift card sale. Eligible gift card sale means the sale
of a gift card or gift certificate if:
    (i) The taxpayer is primarily liable to the customer, or holder of
the gift card,
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for the value of the card until redemption or expiration; and
    (ii) The gift card is redeemable by the taxpayer or by any other
entity that is legally obligated to the taxpayer to accept the gift
card from a customer as payment for items listed in paragraphs
(b)(1)(i)(C)(1) through (11) of this section.
    (4) Performance obligation. Performance obligation has the same
meaning as provided in proposed Sec.  1.451-3(c)(3).
    (5) Received. An item of gross income is received by the taxpayer
if it is actually or constructively received, or if it is due and
payable to the taxpayer.
    (6) Revenue. Revenue has the same meaning as provided in proposed
Sec.  1.451-3(c)(4) and is determined under the rules provided in
proposed Sec.  1.451-3.
    (7) Transaction price. Transaction price has the same meaning as
provided in proposed Sec.  1.451-3(c)(6).
    (8) Contractual delivery date. Contractual delivery date means the
month and year of delivery listed in the written contract to the
transaction.
    (9) Specified good. A specified good means a good for which:
    (i) During the taxable year a payment is received, 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 to transfer the good to the
customer; and
    (ii) All the revenue from the sale of the good is recognized in the
taxpayer's AFS in the year of delivery.
    (c) Deferral method for taxpayers with an applicable financial
statement (AFS)--
    (1) In general. An accrual method taxpayer with an AFS that
receives an advance payment may elect the deferral method described in
this paragraph (c) if the taxpayer is able to determine the extent to
which advance payments are included in revenue in its AFS in the
taxable year received, including a short taxable year (if applicable).
A taxpayer that uses the deferral method must:
    (i) Include the advance payment, or any portion thereof, in gross
income in the taxable year of receipt to the extent included in revenue
in its AFS; and
    (ii) Include the remaining portion of such advance payment in gross
income in the taxable year following the taxable year in which such
payment is received.
    (2) Acceleration of advance payments--(i) In general. A taxpayer
that uses the deferral method described in this paragraph (c) must
include in gross income for the taxable year of receipt or, if
applicable, for a short taxable year described in paragraph (c)(4) of
this section, all advance payments not previously included in gross
income:
    (A) If, in that taxable year, the taxpayer either dies or ceases to
exist in a transaction other than a transaction to which section 381(a)
applies; or
    (B) If, and to the extent that, in that taxable year, the
taxpayer's obligation with respect to the advance payments is satisfied
or otherwise ends other than in:
    (1) A transaction to which section 381(a) applies; or
    (2) A section 351(a) transfer that is part of a section 351
transaction in which:
    (i) Substantially all assets of the trade or business (including
advance payments) are transferred;
    (ii) The transferee adopts or uses the deferral method in the year
of transfer; and
    (iii) The transferee and the transferor are members of the same
consolidated group, as defined in Sec.  1.1502-1(h).
    (ii) Example. Ceasing to exist. A is a calendar year taxpayer
and is in the business of selling and licensing computer software
(off the shelf, fully customized, and semi-customized) and providing
customer support. On July 1, 2018, A enters into a 2-year software
maintenance contract and receives an advance payment. Under the
contract, A will provide software updates if it develops an update
within the contract period, as well as online and telephone customer
support. A ceases to exist on December 1, 2018, in a transaction
that does not involve a section 351(a) transfer described in
paragraph (c)(2)(i)(B)(2) of this section and is not a transaction
to which section 381(a) applies. For federal income tax purposes, A
must include the entire advance payment in gross income in its 2018
taxable year.
    (3) Financial statement adjustments--(i) In general.
Notwithstanding section 451(c)(4)(A)(ii), if a taxpayer treats an
advance payment as an item of deferred revenue in its AFS and writes-
down or adjusts that item, or portion thereof, to an equity account
(for example, retained earnings) or otherwise writes-down or adjusts
that item of deferred revenue in a subsequent taxable year, revenue for
that subsequent taxable year includes that item, or portion thereof,
that is written down or adjusted.
    (ii) Examples--(A) Example 1. On May 1, 2018, A, a corporation
that files its federal income tax return on a calendar year basis,
received $100 as an advance payment for a 2-year contract to provide
services. For financial accounting purposes, A recorded $100 as a
deferred revenue liability in its AFS, expecting to report \1/4\ of
the advance payment in revenue in its AFS for 2018, \1/2\ for 2019,
and \1/4\ for 2020. On August 31, 2018, C, an unrelated corporation
that files its federal income tax return on a calendar year basis,
acquired all of the stock of A, and A joined C's consolidated group.
A's short taxable year ended on August 31, 2018, and, as of that
date, A had included only \1/4\ ($25) of the advance payment in
revenue in its AFS. On September 1, 2018, after the stock
acquisition, and in accordance with purchase accounting rules, C
wrote down A's deferred revenue liability to its fair value of $10
as of the date of the acquisition. The $10 will be included in
revenue on A's AFS in accordance with the method of accounting A
uses for financial accounting purposes. For federal income tax
purposes, A uses the deferral method. For federal income tax
purposes, A must take \1/4\ ($25) of the advance payment into income
for its short taxable year ending August 31, 2018, and the remainder
of the advance payment ($75) ($65 write down + $10 future financial
statement revenue) must be included in income for A's next
succeeding taxable year.
    (B) Example 2. On May 1, 2018, B, a corporation that files its
federal income tax return on a calendar year basis, received $100
advance payment for a contract to be performed in 2018, 2019, and
2020. On August 31, 2018, D, a corporation that is not consolidated
for federal income tax purposes, acquired all of the stock of B.
Before the stock acquisition, on its AFS for 2018, B included $40 of
the advance payment in revenue, and $60 as a deferred revenue
liability. On September 1, 2018, after the stock acquisition and in
accordance with purchase accounting rules, D wrote down its $60
deferred revenue liability to $10 (its fair value) as of the date of
the acquisition. After the acquisition, B does not include in
revenue any of the $10 deferred revenue liability in its 2018 AFS. B
does include $5 in revenue in 2019, and $5 in revenue in 2020. For
federal income tax purposes, B uses the deferral method. For federal
income tax purposes, B must take $40 of the advance payment into
income in 2018, and the remainder of the advance payment ($60) ($50
write down + $10 future financial statement revenue) must be
included in income for B's next succeeding taxable year, 2019.
    (4) Short taxable year rule--(i) In general. If the taxpayer's next
succeeding taxable year is a short taxable year, other than a taxable
year in which the taxpayer dies or ceases to exist in a transaction
other than a transaction to which section 381(a) applies, and the short
taxable year consists of 92 days or less, a taxpayer using the deferral
method must include the portion of the advance payment not included in
the taxable year of receipt in gross income for the short taxable year
to the extent included in revenue in an AFS. Any amount of the advance
payment not included in the taxable year of receipt and the short
taxable year must be included in gross income for the taxable year
immediately following the short taxable year.
    (ii) Example. A is a calendar year taxpayer and is in the
business of selling and licensing
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computer software (off the shelf, fully customized, and semi-
customized) and providing customer support. On July 1, 2018, A
receives an advance payment for a 2-year software maintenance
contract. Under the contract, A will provide software updates if it
develops an update within the contract period, as well as online and
telephone customer support. A changes its taxable period to a fiscal
year ending March 31 so that A has a short taxable year beginning
January 1, 2019, and ending March 31, 2019. In its AFS, A includes
\1/4\ of the payment in revenue for the taxable year ending December
31, 2018; \1/6\ in revenue for the short taxable year ending March
31, 2019; \1/4\ in revenue for the taxable year ending March 31,
2020; and \1/4\ in revenue for the taxable year ending March 31,
2021. Because the taxable year ending March 31, 2019, is 92 days or
less, A must include \1/4\ of the payment in gross income for the
taxable year ending December 31, 2018, \1/6\ in gross income for the
short taxable year ending March 31, 2019, and the remaining amount
in gross income for the taxable year ending March 31, 2020.
    (5) Financial statement conformity requirement. A taxpayer that
uses the deferral method under this paragraph (c) must use the same
financial statement that is used to apply the rules in section 451(b)
and the accompanying regulations when applying the deferral method
provided in section 451(c) and these regulations.
    (6) Allocation of transaction price. A taxpayer using the deferral
method under this paragraph (c) must use the allocation rules provided
in proposed Sec.  1.451-3(g).
    (7) Rules relating to eligible gift card sales. For purposes of
paragraphs (b)(1)(i)(B) and (c)(1) of this section, if an eligible gift
card is redeemable by an entity described in paragraph (b)(3)(ii) of
this section whose financial results are not included in the taxpayer's
AFS, a payment will be treated as included by the taxpayer in revenue
in its AFS to the extent the gift card is redeemed by the entity during
the taxable year.
    (8) Examples. The following examples illustrate the rules of this
paragraph (c). In each example in paragraphs (c)(8)(i) through (xxv) of
this section, the taxpayer uses an accrual method of accounting for
federal income tax purposes and files its returns on a calendar year
basis. Except as stated otherwise, the taxpayer in each example has an
AFS.
    (i) Example 1. Services. On November 1, 2018, A, in the business
of giving dancing lessons, receives an advance payment for a 1-year
contract commencing on that date and providing for up to 48
individual, 1-hour lessons. A provides eight lessons in 2018 and
another 35 lessons in 2019. In its AFS, A includes \1/6\ of the
payment in revenue for 2018, and \5/6\ of the payment in revenue for
2019. A uses the deferral method. For federal income tax purposes, A
must include \1/6\ of the payment in gross income for 2018, and the
remaining \5/6\ of the payment in gross income for 2019.
    (ii) Example 2. Services. Assume the same facts as in Example 1
in paragraph (c)(8)(i) of this section, except that the advance
payment is received for a 3-year contract under which up to 96
lessons are provided. A provides eight lessons in 2018, 48 lessons
in 2019, and 40 lessons in 2020. In its AFS, A includes \1/12\ of
the payment in revenue for 2018, \1/2\ of the payment in revenue for
2019, and \5/12\ of the payment in gross revenue for 2020. For
federal income tax purposes, A must include \1/12\ of the payment in
gross income for 2018, and the remaining \11/12\ of the payment in
gross income for 2019.
    (iii) Example 3. Goods and Services. On June 1, 2018, B, a
landscape architecture firm, receives an advance payment for goods
and services that, under the terms of the agreement, must be
provided by December 2019. On December 31, 2018, B estimates that
\3/4\ of the work under the agreement has been completed. In its
AFS, B includes \3/4\ of the payment in revenue for 2018 and \1/4\
of the payment in revenue for 2019. B uses the deferral method. For
federal income tax purposes, B must include \3/4\ of the payment in
gross income for 2018, and the remaining \1/4\ of the payment in
gross income for 2019, regardless of whether B completes the job in
2019.
    (iv) Example 4. Repair Contracts. On July 1, 2018, C, in the
business of selling and repairing television sets, receives an
advance payment for a 2-year contract under which C agrees to repair
or replace, or authorizes a representative to repair or replace,
certain parts in the customer's television set if those parts fail
to function properly. In its AFS, C includes \1/4\ of the payment in
revenue for 2018, \1/2\ of the payment in revenue for 2019, and \1/
4\ of the payment in revenue for 2020. C uses the deferral method.
For federal income tax purposes, C must include \1/4\ of the payment
in gross income for 2018 and the remaining \3/4\ of the payment in
gross income for 2019.
    (v) Example 5. Online website Design. D, in the business of
building and designing websites, receives advance payments that
oblige D to build and design various websites. D tracks each request
for a website with unique identifying numbers. On July 20, 2018, D
receives online payments for 2 websites. One of the website requests
is submitted and processed on September 1, 2018, and the other is
submitted and processed on February 1, 2020. In its AFS, D includes
the payment for the September 1, 2018, website in revenue for 2018
and the payment for the February 1, 2020, website in revenue for
2020. D uses the deferral method. For federal income tax purposes, D
must include the payment for the September 1, 2018, website in gross
income for 2018 and the payment for the February 1, 2020, website in
gross income for 2019.
    (vi) Example 6. Gift Cards. E, a hair styling salon, receives
advance payments for gift cards that may later be redeemed at the
salon for hair styling services or hair care products at the face
value of the gift card. The gift cards look like standard credit
cards, and each gift card has a magnetic strip that, in connection
with E's computer system, identifies the available balance. The gift
cards may not be redeemed for cash and have no expiration date. In
its AFS, E includes advance payments for gift cards in revenue when
redeemed. E is not able to determine the extent to which advance
payments are included in revenue in its AFS for the taxable year of
receipt and therefore does not meet this requirement of paragraph
(c)(1) of this section. Therefore, E may not use the deferral method
for these advance payments.
    (vii) Example 7. Gift Cards. Assume the same facts as in Example
6 in paragraph (c)(8)(vi) of this section, except that the gift
cards have an expiration date 12 months from the date of sale, E
does not accept expired gift cards, and E includes unredeemed gift
cards in revenue in its AFS for the taxable year in which the cards
expire. Because E tracks the sale date and the expiration date of
the gift cards for purposes of its AFS, E is able to determine the
extent to which advance payments are included in revenue for the
taxable year of receipt. Therefore, E meets this requirement of
paragraph (c)(1) of this section and may use the deferral method for
these advance payments.
    (viii) Example 8. Online Subscriptions. G is in the business of
compiling and providing business information for a particular
industry in an online format accessible over the internet. On
September 1, 2018, G receives an advance payment from a subscriber
for 1 year of access to its online database, beginning on that date.
In its AFS, G includes \1/3\ of the payment in revenue for 2018 and
the remaining \2/3\ in revenue for 2019. G uses the deferral method.
For federal income tax purposes, G must include \1/3\ of the payment
in gross income for 2018 and the remaining \2/3\ of the payment in
gross income for 2019.
    (ix) Example 9. Membership Fees. On December 1, 2018, H, in the
business of operating a chain of ``shopping club'' retail stores,
receives advance payments for membership fees. Upon payment of the
fee, a member is allowed access for a 1-year period to H's stores,
which offer discounted merchandise and services. In its AFS, H
includes \1/12\ of the payment in revenue for 2018 and \11/12\ of
the payment in revenue for 2019. H uses the deferral method. For
federal income tax purposes, H must include \1/12\ of the payment in
gross income for 2018, and the remaining \11/12\ of the payment in
gross income for 2019.
    (x) Example 10. Cruise. In 2018, I, in the business of operating
tours, receives payments from customers for a 10-day cruise that
will take place in April 2019. Under the agreement, I charters a
cruise ship, hires a crew and a tour guide, and arranges for
entertainment and shore trips for the customers. In its AFS, I
includes the payments in revenue for 2019. I uses the deferral
method. For federal income tax purposes, I must include the payments
in gross income for 2019.
    (xi) Example 11. Travel agent services. On November 1, 2018, J,
a travel agent, receives payment from a customer for an airline
flight that will take place in April 2019. J purchases and delivers
the airline ticket to the customer
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on November 14, 2018. J retains a portion of the customer's payment
(the excess of the customer's payment over the cost of the airline
ticket) as its commission. Because J is not required to provide any
services after the ticket is delivered to the customer, J earns its
commission when the airline ticket is delivered. The customer may
cancel the flight and receive a refund from J only to the extent the
airline itself provides refunds. In its AFS, J includes its
commission in revenue for 2019. The commission is not an advance
payment because the payment is not earned by J, in whole or in part,
in a subsequent taxable year. Thus, J may not use the deferral
method for this payment.
    (xii) Example 12. Broadcasting Rights. K, a professional sports
franchise, is a member of a sports league that enters into contracts
with television networks for the right to broadcast games to be
played between teams in the league. The money received by the sports
league under the contracts is divided equally among the member
teams. The league entered into a 3-year broadcasting contract
beginning October 1, 2018. K receives three equal installment
payments on October 1 of each contract year, beginning in 2018. In
its AFS, K includes \1/4\ of the first installment payment in
revenue for 2018 and \3/4\ in revenue for 2019; K includes \1/4\ of
the second installment in revenue for 2019 and \3/4\ in revenue for
2020; K includes \1/4\ of the third installment in revenue for 2020
and \3/4\ in revenue for 2021. K uses the deferral method. Each
installment payment constitutes an advance payment under paragraph
(b)(1) of this section. For federal income tax purposes, K must
include \1/4\ of the first installment payment in gross income for
2018 and \3/4\ in gross income for 2019; \1/4\ of the second
installment in gross income for 2019 and \3/4\ in gross income for
2020; and \1/4\ of the third installment in gross income for 2020
and \3/4\ in gross income for 2021.
    (xiii) Example 13. Insurance Claims Administration. L is in the
business of negotiating, placing, and servicing insurance coverage
and administering claims for insurance companies. On December 1,
2018, L enters into a contract with an insurance company to provide
property and casualty claims administration services for a 4-year
period beginning January 1, 2019. Pursuant to the contract, the
insurance company makes four equal annual payments to L; each
payment relates to a year of service and is made during the month
prior to the service year (for example, L is paid on December 1,
2018, for the service year beginning January 1, 2019). In its AFS, L
includes the first payment in revenue for 2019; the second payment
in revenue for 2020; the third payment in revenue for 2021; and the
fourth payment in revenue for 2022. L uses the deferral method. Each
annual payment constitutes an advance payment under paragraph (b)(1)
of this section. For federal income tax purposes, L must include the
first payment in gross income for 2019; the second payment in gross
income for 2020; the third payment in gross income for 2021; and the
fourth payment in gross income for 2022.
    (xiv) Example 14. Internet Services. M is a cable internet
service provider that enters into contracts with subscribers to
provide internet services for a monthly fee (paid prior to the
service month). For those subscribers who do not own a compatible
modem, M provides a rental cable modem for an additional monthly
charge (also paid prior to the service month). Pursuant to the
contract, M will replace or repair the cable modem if it proves
defective during the contract period. In December 2018, M receives
payments from subscribers for January 2019 internet service and
cable modem use. In its AFS, M includes the entire amount of these
payments in revenue for 2019. M uses the deferral method. Because a
subscriber's use of a cable modem is ancillary to the provision of
internet services by M, and because the cable modem warranty is
ancillary to the use of the cable modem, the payments are advance
payments. For federal income tax purposes, M must include the
advance payments in gross income for 2019.
    (xv) Example 15. License Agreement. On January 1, 2019, N enters
into, and receives advance payments pursuant to, a 5-year license
agreement for the use of N's trademark. Under the contract, the
licensee pays N both the first-year (2019) license fee and the
fifth-year (2023) license fee upon commencement of the agreement.
The fees for the second, third, and fourth years are payable on
January 1 of each license year. The contract provides the customer
with access to N's trademark throughout the term of the agreement.
In its AFS, N includes the fees in revenue for the respective
license year. N uses the deferral method. For federal income tax
purposes, N must include the first-year license fee in gross income
for 2019, the second-year and the fifth-year license fee in gross
income for 2020, the third-year license fee in gross income for
2021, and the fourth-year license fee in gross income for 2022.
    (xvi) Example 16. Computer Software Subscription. On July 1,
2018, O, in the business of licensing computer software (off the
shelf, fully customized, and semi-customized) and providing customer
support, receives an advance payment for a 2-year ``software
subscription contract'' under which O will provide software updates
if it develops an update within the contract period, as well as
online and telephone customer support. In its AFS, O includes \1/4\
of the payment in revenue for 2018, \1/2\ in revenue for 2019, and
the remaining \1/4\ in revenue for 2020, regardless of when O
provides updates or customer support. O uses the deferral method.
For federal income tax purposes, O must include \1/4\ of the payment
in gross income for 2018 and \3/4\ in gross income for 2019.
    (xvii) Example 17. Performance Obligation. P is in the business
of licensing computer software (off the shelf, fully customized, and
semi-customized) and providing customer support. On July 1, 2018, P
receives an advance payment of $100 for a 2-year software
subscription that includes a 1-year ``software maintenance
contract'' under which P will provide integral software updates
within the contract period, as well as a ``customer support
agreement'' for online and telephone customer support. In its AFS, P
allocates $80 of the payment to the subscription agreement and $20
to the customer support agreement. With respect to the $80 allocable
to the subscription agreement, P includes \1/4\ ($20) in revenue for
2018, \1/2\ ($40) in revenue for 2019, and the remaining \1/4\ ($20)
in revenue for 2020. With respect to the $20 allocable to the
customer support agreement, P includes \1/2\ ($10) in revenue for
2018, and the remaining \1/2\ ($10) in revenue for 2019 regardless
of when P provides the customer support. For federal income tax
purposes, P must include $30 in gross income for 2018 ($20 allocable
to the subscription agreement and $10 allocable to the customer
support agreement) and the remaining $70 in gross income for 2019.
    (xviii) Example 18. Gift Cards Administered by Another. Q
corporation operates department stores. U corporation, V
corporation, and W corporation are wholly owned domestic
subsidiaries of Q that file a consolidated federal income tax return
with Q. X corporation is a controlled foreign subsidiary of Q that
is prohibited from filing a consolidated return with Q. U sells
Brand A goods, V sells Brand B goods, X sells Brand C goods, and Z
is an unrelated entity that sells Brand D goods. W administers a
gift card program for the Q consolidated group, X, and Z. Pursuant
to the underlying agreements, W issues gift cards that are
redeemable for goods or services offered by U, V, X, and Z. In
addition, U, V, X, and Z sell gift cards to customers on behalf of W
and remit amounts received to W. The agreements provide that W is
primarily liable to the customer for the value of the gift card
until redemption, and U, V, X, and Z are obligated to accept the
gift card as payment for goods or services. When a customer
purchases goods or services with a gift card at U, V, X, or Z, W
reimburses that entity for the sales price of the goods or services
purchased with the gift card, up to the total gift card value. In
2018, W sells gift cards with a total value of $900,000, and, at the
end of 2018, the unredeemed balance of the gift cards is $100,000.
In the consolidated group's AFS, the group includes revenue from the
sale of a gift card when the gift card is redeemed. W tracks sales
and redemptions of gift cards electronically, is able to determine
the extent to which advance payments are included in revenue in its
consolidated AFS for the taxable year of receipt, and meets the
requirements of paragraph (c)(1) of this section. The payments W
receives from the sale of gift cards are advance payments because
they are payments for eligible gift cards. Thus, W is eligible to
use the deferral method. At the end of 2018, W includes $800,000 in
income in its consolidated AFS. Under the deferral method, W must
include $800,000 of the payments from gift card sales in gross
income in 2018 and the remaining $100,000 of the payments in gross
income in 2019.
    (xix) Example 19. Gift Cards of Affiliates. R is a Subchapter S
corporation that operates an affiliated restaurant corporation and
manages other affiliated restaurants. These other restaurants are
owned by other Subchapter S corporations, partnerships, and limited
liability companies. R has a partnership interest or an equity
interest in some of the restaurants. R administers a gift
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card program for participating restaurants. Each participating
restaurant operates under a different trade name. Under the gift
card program, R and each of the participating restaurants sell gift
cards, which are issued with R's brand name and are redeemable at
all participating restaurants. Participating restaurants sell the
gift cards to customers and remit the proceeds to R, R is primarily
liable to the customer for the value of the gift card until
redemption, and the participating restaurants are obligated under an
agreement with R to accept the gift card as payment for food,
beverages, taxes, and gratuities. When a customer uses a gift card
to make a purchase at a participating restaurant, R is obligated to
reimburse that restaurant for the amount of the purchase, up to the
total gift card value. In R's AFS, R includes revenue from the sale
of a gift card when a gift card is redeemed at a participating
restaurant. R tracks sales and redemptions of gift cards
electronically, is able to determine the extent to which advance
payments are included in revenue in its AFS for the taxable year of
receipt, and meets the requirements of paragraph (c)(1) of this
section. The payments R receives from the sale of gift cards are
advance payments because they are payments for eligible gift card
sales. Thus, for federal income tax purposes, R is eligible to use
the deferral method. In the taxable year of receipt, R must include
the advance payment in income to the extent included in its AFS, and
must include any remaining amount in income in the taxable year
following the taxable year of receipt.
    (xx) Example 20. Gift Cards for Domestic and International
Hotels. S is a corporation that operates for the benefit of its
franchisee members, who own and operate domestic and international
individual member hotels. S collects membership fees from the member
hotels in exchange for providing a wide variety of management
support services, which include making reservations for customers at
the various member hotels. S also administers a gift card program
for its members by selling gift cards that may be redeemed for hotel
rooms and food or beverages provided by any member hotel. The
agreements underlying the gift card program provide that S is
entitled to the proceeds from the sale of the gift cards, must
reimburse the member hotel for the value of a gift card redeemed,
and until redemption remains primarily liable to the customer for
the value of the card. In S's AFS, S includes payments from the sale
of a gift card when the card is redeemed. S tracks sales and
redemptions of gift cards electronically, is able to determine the
extent to which advance payments are included in revenue in its AFS
for the taxable year of receipt, and meets the requirements of
paragraph (c)(1) of this section. The payments S receives from the
sale of gift cards are advance payments because they are payments
for eligible gift card sales. Thus, for federal income tax purposes,
S is eligible to use the deferral method. In the taxable year of
receipt, S must include in income the advance payment to the extent
included in its AFS, and must include any remaining amount in income
in the taxable year following the taxable year of receipt.
    (xxi) Example 21. Discount Voucher. On December 10, 2018, T, in
the business of selling home appliances, sells a washing machine for
$500. As part of the sale, T gives the customer a 40 percent
discount voucher for any future purchases of T's goods up to $100 in
the next 60 days. In its AFS, T treats the discount voucher as a
separate performance obligation and allocates $30 of the $500 sales
price to the discount voucher. T includes $12 of the amount
allocated to the discount voucher in revenue for 2018 and includes
$18 of the discount voucher in revenue for 2019. T uses the deferral
method. For federal income tax purposes, T must include the $12
allocable to the discount voucher in gross income in 2018 and the
remaining $18 allocated to the discount voucher in gross income in
2019.
    (xxii) Example 22. Rewards. On December 31, 2018, U, in the
business of selling consumer electronics, sells a new TV for $1,000
and gives the customer 50 reward points. Each reward point is
redeemable for a $1 discount on any future purchase of U's products.
The reward points are not redeemable for cash and have a 2-year
expiration date. U tracks each customer's reward points and does not
sell reward points separately. In its AFS, U treats the rewards
points as a separate performance obligation and allocates $45 of the
$1,000 sales price to the rewards points. U does not include any of
the amount allocated to the reward points in revenue for 2018. U
includes $25 of the reward points in revenue for 2019 and $20 of the
reward points in revenue for 2020. U uses the deferral method. For
federal income tax purposes, U does not include any amount of the
reward points in gross income in 2018, and includes the entire $45
allocated to the reward points in gross income in 2019.
    (xxiii) Example 23. Credit Card Rewards. V, a wholly owned
credit card company, issues credit cards. V also has a loyalty
program in which cardholders earn reward points for the use of its
credit card to make purchases. Each reward point is redeemable for a
$1 on any future purchases. V may not use the deferral method
because payments under credit card agreements including rewards for
credit card purchases are excluded from the definition of an advance
payment under paragraph (b)(1)(ii)(C) of this section.
    (xxiv) Example 24. Airline Reward Miles. On January 1, 2018, W,
in the business of transporting passengers on airplanes, sells a
customer a $700 airline ticket to fly roundtrip in 2018. As part of
the purchase, the customer also receives 7,000 points (air miles)
from W to be used for future air travel. In its AFS, W allocates
$665 to the roundtrip airfare and $35 to the air miles. In its AFS,
the $665 allocated to the airfare is included in Year 1 when the
customer takes the roundtrip flight. The $35 allocated to the air
miles is deferred and included in Year 3 when the customer redeems
the air miles. W uses the deferral method described in paragraph (c)
of this section. For federal income tax purposes, the $665 is
included in gross income in Year 1 and the $35 allocated to the air
miles is included in gross income in Year 2.
    (xxv) Example 25. Chargebacks. Taxpayer X, a manufacturer of
pharmaceuticals, is a calendar-year accrual method taxpayer with an
AFS. In addition to billing the wholesaler for the sale of the
pharmaceuticals at the wholesale acquisition cost under the
contract, X generally credits or pays wholesalers a chargeback of
40% of the wholesale acquisition cost for sales made by those
wholesalers to qualifying customers. In 2018, X enters into a
contract to sell 1,000 units to W, a wholesaler, for $10 per unit,
totaling $10,000 (1,000 x $10 = $10,000). The contract also provides
that X will issue a 40% chargeback for sales by W to certain
qualifying customers. X delivers 600 units to W on December 31,
2018, and bills W $6,000 under the contract. For AFS purposes, X
adjusts its revenue by 40% for all sales to W for anticipated
chargebacks. As such, in its 2018 AFS, X reports $3,600 ($6,000-
$2,400 = $3,600) of revenue from the contract with W, decreasing
revenue by $2,400 (40% x $6,000 = $2,400) for anticipated chargeback
claims. For federal income tax purposes, under proposed Sec.  1.451-
3(c)(4), X's 2018 revenue is $6,000 because revenue is not reduced
for anticipated chargebacks. Because no portion of the $6,000 is
included in revenue on an AFS in a subsequent taxable year (that is,
on an AFS after 2018), none of the $6,000 is an advance payment
under paragraph (b)(1)(i) of this section.
    (d) Deferral method for taxpayers without an AFS (non-AFS deferral
method)--(1) In general. Only a taxpayer described in paragraph (d)(2)
of this section may elect to use the non-AFS deferral method described
in paragraph (d)(4) of this section.
    (2) Taxpayers eligible to use the non-AFS deferral method. A
taxpayer is eligible to use the non-AFS deferral method if the taxpayer
does not have an applicable financial statement as defined in proposed
Sec.  1.451-3(c)(1) and is able to determine the extent to which
advance payments are earned in the taxable year of receipt, or a short
taxable year, if applicable.
    (3) Advance payment. For purposes of the non-AFS deferral method,
in applying paragraph (b)(1)(i)(B) of this section, an advance payment
is any portion of the payment received that is earned by the taxpayer,
in whole or in part, in a subsequent taxable year.
    (4) Deferral of advance payments based on when payment is earned--
(i) In general. The non-AFS deferral method described in this paragraph
(d) is a permissible method of accounting that may be used only by a
taxpayer described in paragraph (d)(2) of this section. Under the non-
AFS deferral method of accounting, a taxpayer includes the advance
payment in gross income for the taxable year of receipt, including, if
applicable, a short taxable year described in paragraph (d)(8) of this
section, to the extent that it is earned in that taxable year and
includes
[[Page 47191]]
the remaining portion of the advance payment in gross income in the
next succeeding taxable year.
    (ii) When payment is earned. A payment is earned when the all
events test described in Sec.  1.451-1(a) is met, without regard to
when the amount is received, as defined under paragraph (b)(5) of this
section, by the taxpayer. If a taxpayer is unable to determine the
extent to which a payment is earned in the taxable year of receipt, the
taxpayer may determine that amount:
    (A) On a statistical basis if adequate data are available to the
taxpayer;
    (B) On a straight line ratable basis over the term of the agreement
if the taxpayer receives advance payments under a fixed term agreement
and if it is not unreasonable to anticipate at the end of the taxable
year of receipt that the advance payment will be earned ratably over
the term of the agreement; or
    (C) By the use of any other basis that in the opinion of the
Commissioner results in a clear reflection of income.
    (5) Contracts with multiple obligations--(i) In general. If a
taxpayer receives a payment that is attributable to more than one item
described in paragraph (b)(1)(i)(C) of this section, the taxpayer must
allocate the payment to such items in a manner that is based on
objective criteria.
    (ii) Objective criteria. A taxpayer's allocation method with
respect to a payment described in paragraph (d)(5)(i) of this section
is based on objective criteria if the allocation method is based on
payments the taxpayer regularly receives for an item or items it
regularly sells or provides separately or any method that may be
provided in guidance published in the Internal Revenue Bulletin (see
Sec.  601.601(d) of this chapter).
    (6) Acceleration of advance payments. For purposes of this
paragraph (d), the acceleration rules provided in paragraph (c)(2) of
this section apply to a taxpayer that uses the non-AFS deferral method.
    (7) Advance payments in certain acquisitions and other financial
statement adjustments. For purposes of this paragraph (d), the rules
provided in paragraph (c)(3) of this section apply to a taxpayer that
uses the non-AFS deferral method.
    (8) Short taxable year rule. For purposes of this paragraph (d),
the short taxable year rule provided in paragraph (c)(4) of this
section applies to a taxpayer that uses the non-AFS deferral method.
    (9) Eligible gift card sale. For purposes of paragraphs
(b)(1)(i)(B) and (d)(4) of this section, if an eligible gift card is
redeemable by an entity described in paragraph (b)(3)(ii), including an
entity whose financial results are not included in the taxpayer's
financial statement, a payment will be treated as earned by the
taxpayer to the extent the gift card is redeemed by the entity during
the taxable year.
    (10) Examples. The rules of this paragraph (d) are illustrated by
the examples in paragraphs (d)(10)(i) and (ii). In each of these
examples, the taxpayer uses the non-AFS deferral method described in
this paragraph (d).
    (i) Example 1. A, a video arcade operator, receives payments in
2018 for game tokens that are used by customers to play the video
games offered by A. The tokens cannot be redeemed for cash. The
tokens are imprinted with the name of the video arcade, but they are
not individually marked for identification. A completed a study on a
statistical basis, based on adequate data available to A, and
concluded that for payments received in the current year, x percent
of tokens are expected to be used in the current year, y percent of
tokens are expected to be used in the next year, and the remaining z
percent of tokens are expected to never be used. Based on the study,
A treats as earned for 2018 x percent (for tokens expected to be
used in that year) as well as z percent (for tokens that are
expected to never be used). Using the study, A determines the extent
to which advance payments are earned in the taxable year of receipt.
A may determine the extent to which a payment is earned in the
taxable year of receipt on a statistical basis provided that any
portion that is not included in the taxable year of receipt is
included in the next succeeding taxable year. Thus, for federal
income tax purposes, A must include x percent and z percent of the
advance payments in gross income for 2018 and y percent of the
advance payments in gross income for 2019.
    (ii) Example 2. B is in the business of providing internet
services. On September 1, 2018, B receives an advance payment from a
customer for a 2-year term for access to its internet services,
beginning on that date. B does not have an AFS. B is unable to
determine the extent to which the payment is earned in the taxable
year of receipt. For federal income tax purposes, B may determine
the extent to which the payment is earned in the year of receipt on
a straight line ratable basis over the term of the agreement if it
is not unreasonable to anticipate at the end of the taxable year of
receipt that the advance payment will be earned ratably over the
term of the agreement.
    (e) Method of accounting. The use of the deferral method under
paragraph (c) of this section or the non-AFS deferral method under
paragraph (d) of this section is the adoption of, or a change in, a
method of accounting under section 446 of the Internal Revenue Code or
the accompanying regulations. In addition, a change in the manner of
recognizing advance payments in revenue in an AFS that changes or could
change the timing of the inclusion of income for federal income tax
purposes is a change in method of accounting under section 446 and the
accompanying regulations. A taxpayer may change its method of
accounting to use the methods described in paragraphs (c) or (d) of
this section, or change its manner of recognizing advance payments in
revenue in an AFS only with the consent of the Commissioner as required
under section 446(e) and the corresponding regulations.
    (f) Applicability date. The rules of this section are applicable
for taxable years beginning on or after the date of publication of the
Treasury decision adopting these rules as final regulations in the
Federal Register. Until the date the Treasury decision adopting these
regulations as final regulations is published in the Federal Register,
a taxpayer may rely on these proposed regulations for taxable years
beginning after December 31, 2017, provided that the taxpayer applies
all the applicable rules contained in these proposed regulations, and
consistently applies these proposed regulations to all advance
payments. See section 7805(b)(7).
Kirsten Wielobob,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2019-19197 Filed 9-5-19; 4:15 pm]
BILLING CODE 4830-01-P