A Closer Look at Tax Consequences for Revenue Recognition for Portfolio Companies (article)
Companies generally must use the same method of accounting to recognize revenue for tax accounting purposes as they do for financial reporting purposes, unless the financial reporting method is inconsistent with tax regulations or guidance. This can create scenarios where private equity and venture capital groups (as well as their portfolio companies) may have different methods of accounting for tax and financial reporting purposes. The adoption of the new revenue recognition standard under ASC Topic 606 introduces additional complexities, as tax accounting methods may not automatically conform to the new financial reporting standard. When inconsistencies emerge, taxpayers must request IRS consent using Form 3115 to change their tax method of accounting for revenue recognition. The differences between accounting methods for tax and financial reporting purposes may require portfolio companies to recognize revenue for income tax purposes earlier than under previous guidance.
General Rules for Revenue Recognition for Tax Purposes
Under the accrual method of accounting, tax revenue is recognized when all events have occurred to give the taxpayer a fixed right to the revenue, and the amount of the revenue is determinable with reasonable accuracy (all events test). All events occur at the earlier of the time revenue is due, paid, or earned through required performance. Reporting entities recognize revenue earned from the sale of goods when the customer assumes the benefits and burdens of ownership under the terms of the contract, satisfying the so-called “benefits and burdens” test. When the contract is for the performance of services, the reporting entity recognizes contract revenue when the performance of the contracted services is considered complete (the performance test).
For the most part, the new revenue recognition standard under ASC Topic 606 follows similar logic. Reporting entities recognize revenue based on the transfer of control of the good or services to the customer. There are differences, however, between ASC Topic 606 standards and tax rules, particularly for probable collection, variable consideration, timing, and bundled contracts.
Adding a further wrinkle to the potential inconsistency in accounting for financial reporting and income tax purposes is the new tax law known as the Tax Cuts and Jobs Act (TCJA). The TCJA makes changes designed with reference to ASC Topic 606, which will be discussed later.
ASC Topic 606 specifies that there must be a probable chance of collection in order for the reporting entity to recognize any amount of revenue. Tax rules are slightly different, and narrowly define a “doubtful collectability” exception to revenue recognition that may not dovetail with ASC Topic 606’s new financial reporting concepts. Revenue may be recognizable for tax purposes even though it does not meet the “probable chance of collection” definition under the new revenue recognition standard.
Under ASC Topic 606, revenue from contracts with variable consideration is measured based on estimates of the amount of revenue the reporting entity expects to receive. Such estimates are appropriate when it is probable (defined as 75-80 percent likelihood under U.S. Generally Accepted Accounting Principles (U.S. GAAP)) that a significant reversal of revenues will not occur upon resolution of the contingencies or uncertainties. Variable revenues might include the seller’s right to incentives or bonuses, or the seller’s concessions for discounts, credits, rebates, refunds, or penalties.
When variable consideration is estimated under ASC Topic 606, the seller may not necessarily have a fixed right to receive the revenue under the benefits and burdens test or under the performance test for tax purposes. This would result in book-tax differences for any contingent amounts of revenue recognized under the new financial reporting standard.
Timing & Tax Reform Changes
Revenue is recognized either over time or at a point in time under ASC Topic 606. When revenue is recognized at a point in time, the reporting entity determines when control transfers by evaluating factors such as title transfer, possession, customer acceptance, or the buyer’s acceptance of the risk and reward of ownership. When revenue is recognized over time (common with contracts for services), the revenue recognition occurs as progress is made toward satisfying the performance obligation.
Some of these timing criteria may not align with the benefits and burdens test that will still be used for tax purposes. For example, a partially completed project does not produce revenue recognition for tax purposes, unless certain services are “severable” under the terms of the contract.
The TCJA amplifies the need to analyze the timing of revenue recognition for book and tax because it adds a new criteria that could override the historical tax provisions for revenue recognition. Referred to as a “book-tax conformity” rule, an accrual basis taxpayer may not treat the all-events test as being met for an item of gross income any later than when revenue for this item is recognized for financial reporting purposes. This may require companies to recognize revenue for tax purposes sooner than they did in the past.
ASC Topic 606 requires all entities to allocate sales price among performance obligations (distinct goods and services) based on the goods’ or services’ standalone selling prices. Previous tax rules dictated that transaction price allocation follows the prices for separate elements stated specifically in the contract, which may not have been consistent with identified performance obligations or the seller’s standalone selling prices associated with those obligations. However, the TCJA requires that contract price allocations between multiple performance obligations for tax purposes follow the contract price allocations made for financial reporting purposes.
Take a Look at Your Books
The substantial changes to revenue recognition under the TCJA and ASC Topic 606 require careful analysis by private equity and venture capital groups, including their portfolio companies, to ascertain whether a change in their tax accounting methods for revenue is permitted or even required. In those instances, companies should review recently published guidance by the IRS that will simplify IRS Form 3115 applications related to transitions to ASC Topic 606. The scope of this guidance is limited to exclude many scenarios affected by ASC Topic 606. Further, separate guidance is anticipated to address the accounting method changes for advance payments covered by the TCJA.
Expert Help May Be Required
Private equity and venture capital groups, including their portfolio companies, that have adopted or are considering early adoption of ASC Topic 606 should talk with their tax advisor about the implications of these changes. Updates to income tax strategies, the timing of payments from customers, and business plans may be necessary for companies that experience an acceleration of income tax liabilities. For more information, please contact us.