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On January 6, 2021, the Treasury Department and Internal Revenue Service (IRS) published final regulations under IRC Section 451 (T.D. 9941), which were previously released on the IRS website on December 21, 2020. The final regulations include guidance related to (1) timing of income inclusion for taxpayers with an applicable financial statement using an accrual method of accounting (Treas. Reg. Section 1.451-3 under IRC Section 451(b)) and (2) advance payments for goods, services, and certain other items (Treas. Reg. Section 1.451-8 under IRC Section 451(c)).

The final regulations are generally applicable for tax years beginning on or after January 1, 2021. Taxpayers may choose to apply the final regulations, in their entirety and in a consistent manner, to tax years beginning before the effective date (December 30, 2020) or may continue to rely on the proposed regulations for tax years beginning after December 31, 2017, and before the effective date of the final regulations.

The final regulations address several key issues and concerns raised by taxpayers, including application of IRC Section 61 prior to recognizing income under IRC Section 451, the coordination of tax items and methods with those used for financial reporting purposes, the application of special methods of accounting for income, and optional "cost offset" methods to limit acceleration of income, among other issues. Taxpayers should note that the final regulations are very fact-dependent, and application of the final regulations will require taxpayers to have a deep understanding of their specific facts and circumstances and in many instances are likely to result in book-tax differences.

Implications: This provides taxpayers the opportunity to consider impacts to their 2020 tax returns. For 2020 tax years, taxpayers have the opportunity to apply the proposed regulations or the final regulations, in their entirety and in a consistent manner.

Treas. Reg. Section 1.451-3

Background: IRC Section 451(b)

The final regulations interpret IRC Section 451 as amended by Public Law No. 115-97, which is known as the "Tax Cuts and Jobs Act" (TCJA), as well as update and clarify proposed regulations the Treasury Department and IRS published September 9, 2019 (Prop. Reg. Section 1.451-3 under IRC Section 451(b) (REG-104870-18) and Prop. Reg. Section 1.451-8 under IRC Section 451(c) (REG-104554-18), herein referred to as the "proposed regulations").

IRC Section 451 provides the general rule for the timing of income recognition for accrual method taxpayers. Under Treas. Reg. Section 1.451-1(a), accrual method taxpayers generally include an item of gross income in the tax year that all events occur that fix the right to receive the income and the amount is determinable with reasonable accuracy (the "all events" test). All the events that fix the right to receive income occur upon the earliest of (1) the required performance (i.e., income is earned), (2) payment is due, or (3) payment is received.

The TCJA amended IRC Section 451(b) by adding IRC Section 451(b)(1)(C), which codifies the all events test, and IRC Section 451(b)(1)(A) which provides that, for accrual method taxpayers, the all events test for any item of gross income (or portion thereof) is met no later than when the item (or portion thereof) is included in revenue for financial accounting purposes on an applicable financial statement (AFS) or other financial statement specified by the Secretary (AFS Income Inclusion Rule). As such, IRC Section 451(b) generally adds a component to the analysis requiring income recognition at the earlier of when the all events test is met or when taken into account as revenue in the taxpayer's AFS.

Due to the coordination of timing of income recognition for tax purposes with timing of when revenue is taken into account in the taxpayer's AFS, the TCJA also added IRC Section 451(b)(4) providing that for contracts with multiple performance obligations, the allocation of the transaction price to each performance obligation is equal to the amount allocated to each performance obligation for purposes of including such item in revenue in the taxpayer's AFS.

Finally, in coordination with the general rule for income recognition, the TCJA added IRC Section 451(b)(2), which respects special methods of accounting for income recognition, and generally provides that the AFS Income Inclusion Rule does not apply for any item of gross income the recognition of which is determined using a special method of accounting.

Treas. Reg. Section 1.451-3

Treas. Reg. Section 1.451-3 provides guidance for IRC Section 451(b), the general rule for the tax year of including an item of gross income. As discussed below, the final regulations are significantly different from the proposed regulations and attempt to (1) provide further clarity on major uncertainties between the statute, legislative history, bluebook interpretation and the proposed regulations and (2) reconcile the tax rules with the framework and rules governing when revenue is taken into account in an AFS.

Realization and recognition

A critical issue for taxpayers since the addition of the AFS Income Inclusion Rule in the TCJA has been reconciling when an amount is realized as income under IRC Section 61 and the regulations thereunder versus the timing of income recognition under IRC Section 451. Many taxpayers were concerned that the AFS Income Inclusion Rule undermined the concept of a tax realization event as a requirement to recognize an item of income for tax purposes.

The Treasury Department and IRS declined to define the term "realization" in the final regulations and declined to clarify when realization occurs in specific circumstances. The Preamble provides that IRC Section 451 is a timing provision and that "[r]ealization is a factual determination that, while closely aligned with the all events test, has different meanings in different contexts." The amendments to IRC Section 451 by the TCJA were intended only to modify the timing of income recognition, and not realization, for accrual method taxpayers with an AFS, and the statute reflects Congress' intent to incorporate timing concepts from financial reporting revenue recognition rules into the tax timing rules governing income recognition.

Implications: The silence of the final regulations on what constitutes a realization event will continue to cause confusion for taxpayers as they consider factually whether amounts represent an item of income under IRC Section 61 and try to reconcile this analysis with book characterizations that may not align with the tax analysis. The final regulations do introduce an "enforceable right" concept, providing that amounts taken into account under the AFS Income Inclusion Rule include only those amounts that the taxpayer has an enforceable right to recover if the customer were to terminate the contract at the end of the tax year. This provision is anticipated to require significant taxpayer analysis.

Determining AFS revenue

Enforceable right

Taxpayers have also expressed significant concerns that the AFS Income Inclusion Rule is overly broad. Specifically, taxpayers have noted that IRC Section 451b(1)(A), requiring a taxpayer to include an item in income no later than when recognized as revenue in its AFS, may often cause taxpayers to incur a tax liability without having the money to pay the liability. The final regulations address this concern by providing two options for income recognition for taxpayers — an AFS Income Inclusion Rule and an Alternative AFS Revenue Method. Both options are methods of accounting that apply to all items of gross income in the trade or business, unless a special method of accounting applies.

Under the AFS Income Inclusion Rule, "AFS revenue" is reduced by amounts that the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract on the last

day of the tax year. It is important to note that the determination of enforceable right is governed by the terms of the contract and applicable federal, state, or international law. This concept of enforceable right in the final regulations replaces the concept in the proposed regulations of "increases in consideration" to the transaction price, which caused confusion for many taxpayers.

Implications: For taxpayers to take advantage of the enforceable right provision, taxpayers need a detailed understanding of their specific facts. The analysis to determine the amounts to which a taxpayer has an enforceable right will require a detailed understanding of the specific contract terms for each amount in question, as well as interpretation and application of relevant contract law.

To alleviate additional compliance burdens that would be required to apply the AFS Income Inclusion Rule, the final regulations provide an Alternative AFS Revenue Method, under which the taxpayer does not reduce AFS revenue by amounts that the taxpayer lacks an enforceable right to recover if the customer were to terminate the contract on the last day of the tax year. This simplified Alternative AFS Revenue Method, however, will require taxpayers to accelerate recognition of all AFS revenue.

Additional adjustments to AFS revenue

Under the final regulations, there are two additional adjustments in determining the amount taken into account as AFS revenue, regardless of whether the taxpayer applies the AFS Income Inclusion Rule or the Alternative AFS Revenue Method. First, any increase in AFS revenue attributable to a significant financing component is disregarded. Second, to the extent that AFS revenue reflects a reduction for (1) amounts that are cost of goods sold or liabilities that are required to be accounted for under other provisions of the Code, such as IRC Section 461, or (2) amounts anticipated to be in dispute or anticipated to be uncollectable, the taxpayer must increase AFS revenue by such amounts.

Opportunities to limit tax recognition of certain accelerated book income

The final regulations do not provide a cost offset under the provisions of IRC Sections 461, 471, and 263A when an amount is included under the AFS Income Inclusion Rule. The Treasury Department and IRS note that allowing a cost offset based on estimated costs would be inconsistent with IRC Sections 461, 471, and 263A, and would increase the possibility of income distortions. With this said, the final regulations allow a taxpayer to reduce the amount of revenue it would otherwise be required to include under the AFS Income Inclusion Rule for the tax year by the cost of goods related to the item of inventory for the tax year, referred to as the "cost of goods in progress offset." This reduction is referred to in the final regulations as an "AFS cost offset method."

The AFS cost offset method is a method of accounting that applies to all items of income eligible for the AFS cost offset method in the trade or business. If a taxpayer uses the AFS cost offset method, it must also use the advance payment cost offset method in Treas. Reg. Section 1.451-8(e).

Implications: Despite the name, this provision does not provide a cost offset. Rather, this provision allows taxpayers to defer a portion of revenue (determined by the cost of goods in progress offset) to the tax year in which ownership of the item of inventory is transferred to the customer. Taxpayers applying this provision will almost certainly have a new or changing book-tax difference.

It is important to note that this limitation of accelerated income is not a cost offset based on amounts used for financial reporting — the determination of the cost of goods in progress offset is calculated based on tax rules under IRC Sections 461, 471, and 263A.

Application of the cost of goods in progress offset will require taxpayers to implement an additional tracking system for such items. While the cost of goods in progress offset reduces AFS revenue for the applicable tax year, it does not affect how and when costs are capitalized to inventory under IRC Sections 471 and 263A. Therefore, taxpayers will likely face additional data and administrative requirements to accurately track inventory for AFS revenue purposes as compared to general tax purposes.

Furthermore, taxpayers that adopt this optional method to limit the acceleration of income under IRC Section 451(b) need to consider the cost of goods in progress offset calculation on their deferral methods for advance payments. This will require changes to historic deferred revenue calculations and impact the amount of income that may be deferred under the advance payment provisions in IRC 451(c) and Treas. Reg. Section 1.451-8.

Allocation of transaction price

IRC Section 451(b)(4) provides that, in the case of a contract with multiple performance obligations (e.g., a sales contract of goods with related services), the allocation of the transaction price to each performance obligation shall be equal to the amount allocated to each performance obligation for purposes of including such item in revenue in the AFS of the taxpayer.

The final regulations clarify that each separate performance obligation for financial reporting purposes yields an item of gross income for tax purposes that must be accounted for separately under the AFS Income Inclusion Rule. However, there may be single performance obligations for financial reporting purposes that yield multiple items of gross income for tax purposes.

Implications: The updated definition of performance obligation further incorporates financial reporting concepts into the federal income tax analysis, but taxpayers should note there may still likely be differences between items identified for financial reporting and tax purposes. Taxpayers will need to understand all performance obligations identified for financial reporting purposes, the methods applied to each performance obligation for financial reporting purposes, and any potential differences in the treatment for financial reporting and tax purposes.

Special methods of accounting

The final regulations provide a non-exclusive list of examples of special methods of accounting to which the AFS Income Inclusion Rule generally does not apply, including methods of accounting provided in IRC Sections 453 through 460, methods of accounting for certain rental payments under IRC Section 467, the mark-to-market method of accounting under IRC Section 475, etc.

The final regulations address the treatment of contracts that include provisions with income subject to both Treas. Reg. Section 1.451-3 and one or more special methods of accounting. Specifically, the transaction price is first allocated to items of gross income subject to a special method of accounting, as determined under the special method of accounting. The remainder of the transaction price is the "residual amount," which is allocated among items of income subject to Treas. Reg. Section 1.451-3.

Implications: The proposed regulations requested comments on the treatment of contracts with income subject to Prop. Reg. Section 1.451-3 and income subject to a special method of accounting. The rules provided in the final regulations reflect comments received from taxpayers and limit additional administrative burdens by respecting the special method of accounting currently applied by the taxpayer.

Rules for certain specified fees

Taxpayers historically treated certain credit card fees associated with pools of credit card receivables as creating or increasing original issue discount (OID) on those pools, thus permitting the receipt of this income to be deferred over a substantial period. Pursuant to the final regulations, however, any item of income attributable to any fee received with respect to a debt instrument (whether or not a credit card receivable) that is not spread over a period of time as discount or as an adjustment to the yield of the debt instrument in the taxpayer's AFS, and that would otherwise be treated as creating or increasing OID for tax purposes, is subject to the provisions of IRC Section 451 prior to the application of the OID rules. Once the final regulations become effective, such fees generally will have to be included in gross income upon receipt. Such fees could include, for example, a consent fee paid on a debt instrument in return for the modification of financial covenants.

Implications: The final regulations provide a delayed effective date for specified fees that are not specified credit card fees (i.e., credit card late fees, credit card cash advance fees, and interchange fees). This delayed effective date will give the Treasury and the IRS additional time to determine whether the definition of "specified fees" should be narrowed. Taxpayers for whom the timing of inclusion of such specified fees in income is a material concern may wish to consider approaching the IRS and Treasury and requesting relief.

Treas. Reg. Section 1.451-8

Background: IRC Section 451(c)

The TCJA added new IRC Section 451(c), which codifies and modifies Revenue Procedure 2004-34 (2004-22 IRB 991), the previous guidance for certain advance payments for goods, services and other specified items provided by the IRS. IRC Section 451(c) requires an accrual method taxpayer who receives an advance payment to include the amount thereof in income in the tax year of receipt; however, taxpayers may choose to recognize as income only a portion of such advance payment in the tax year in which it is received, and recognize the remainder in the following tax year if such income is also deferred for AFS purposes (the Deferral Method under Revenue Procedure 2004-34). Under IRC Section 451(c)(4)(A), the term advance payment means any payment that meets the following three requirements: (1) the full inclusion of the payment in gross income in the year of receipt is a permissible method of accounting; (2) any portion of the advance payment is included in revenue in an AFS for a subsequent tax year; and (3) the advance payment is for goods, services, or such other items that the Secretary has identified.

On April 12, 2018, the Treasury Department and IRS issued Notice 2018-35 (2018-18 IRB 520) providing guidance on the application of IRC Section 451(c) and permitting taxpayers to continue to rely on Revenue Procedure 2004-34 until further guidance related to advance payments was released.

Treas. Reg. Section 1.451-8

Treas. Reg. Section 1.451-8 provides guidance allowing optional limited deferral for advance payments for goods, services, and other items. As discussed below, the final regulations are generally consistent with the proposed regulations and emphasize consistency across methods applied for Treas. Reg. Section 1.451-3 and Treas. Reg. Section 1.451-8.

Specified goods exception

The proposed regulations provided an exception from the advance payment rules for certain transactions involving specified goods. Specifically, Prop. Reg. Section 1.451-8(b)(1)(ii)(H) provided that an advance payment does not include a payment received in a tax year earlier than the tax year immediately preceding the tax year of the contractual delivery date for a specified good. Prop. Reg. Section 1.451-8(b)(8) defines the "contractual delivery date" as the month and year of delivery listed in the written contract to the transaction. A "specified good" is defined in Prop. Reg. Section 1.451-8(b)(9) as a good for which: (1) the taxpayer does not have the goods of a substantially similar kind and in a sufficient quantity at the end of the tax year the upfront payment is received; and (2) the taxpayer recognizes all of the revenue from the sale of the good in its AFS in the year of delivery. If the prepayment satisfies the specified good exception, the prepayment is analyzed under IRC Section 451(b) and Treas. Reg. Section 1.451-1.

The final regulations generally retain the specified goods exception as provided in the proposed regulations. However, the Treasury Department and IRS have made the specified goods exception optional in the final regulations. Taxpayers that use the specified goods exception are subject to IRC Section 451(b) and Treas. Reg. Section 1.451-3 for such advance payments.

Opportunities to limit tax recognition of certain accelerated book income

As with the AFS Income Inclusion Rule, the final regulations do not provide a cost offset under the provisions of IRC Sections 461, 471, or 263A when an amount is included in AFS revenue for determining the amount of advance payments. With that said, the final regulations do provide the same "cost of goods in progress offset" for advance payments, allowing taxpayers the ability to limit the amount of revenue to be recognized in certain instances.

The AFS cost offset method is a method of accounting that applies to all items of income eligible for the AFS cost offset method in the trade or business. If a taxpayer uses the AFS cost offset method, it must use the method as described in both Treas. Reg. Section 1.451-3(d) and Treas. Reg. Section 1.451-8(d).

Implications: Taxpayers applying the cost of goods in progress offset for advance payments are required to apply the offset for purposes of the AFS Income Inclusion Rule as well. Taxpayers should carefully consider the data and tracking requirements to consistently apply this rule across all applicable transactions.

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