The new tax law that is informally referred to as the Tax Cuts and Jobs Act (TCJA) included many perks for businesses, but it also established new protocols for the recognition of gross income that may be detrimental. These new provisions may accelerate when income taxes are payable for certain businesses, as the recognition of gross income may be required earlier than would have been previously required for tax purposes.
TCJA includes a provision that requires a new “Earlier of Test” with respect to the taxation of gross income. An item of gross income (i.e., revenue) is included in the gross income of a taxable year at the earliest of the time when the “All Events Test” is met, or when such revenue is taken into account as revenue for financial accounting purposes in either:
- An applicable financial statement of the taxpayer, or
- Such other financial statements as the secretary may specify for purposes of this subsection.
Examples of applicable financial statements include annual filings with the Securities and Exchange Commission (SEC) (e.g., 10-K), audited financial statements prepared under generally accepted accounting principles, financial statements filed with an agency of a foreign government using International Financial Reporting Standards, and other financial statements filed with a regulatory or government body.
TCJA provides an exception to the new Earlier of Test in the case that the taxpayer utilizes a special method of accounting, such as the deferral method for certain advance payments, the installment method for gain recognition where not all payments are received during the tax year, or the completed contract method for certain long-term contracts with customers. These are valuable nuances of the new provision under TCJA that may be applicable to some companies. In addition to requiring the new Earlier of Test, TCJA also requires that contract price allocations between multiple performance obligations are required to be made for tax purposes in the same manner as such allocations are made in the applicable financial statements.
How Does This Result in an Acceleration of Income Taxes That Are Payable?
As a result of the Earlier of Test, if revenue is recognized sooner for financial statement purposes than is otherwise required under the All Events Test, it will result in an acceleration of the taxability of such gross income over the time it would otherwise be taxable under the All Events Test. Under the All Events Test, revenue is recognized when all events have occurred to give the taxpayer a fixed right to the revenue, and the amount of such revenue is determinable with reasonable accuracy. This test is commonly applied to result in revenue recognition for tax purposes at the earlier of the time such revenue is due, paid, or earned through required performance.
Of particular concern are changes under the new revenue recognition guidance (ASC Topic 606) which may result in accelerated revenue recognition compared to the preceding accounting guidance (ASC Topic 605). Three scenarios of concern follow:
A software vendor has historically sold software licenses bundled with three years of post-contract customer support (PCS). Payment was due monthly over the three-year period. Under ASC Topic 605 the software vendor was recognizing revenue ratably over three years. When ASC Topic 606 is adopted, the software vendor recognizes revenue allocated to the providing of software when the software is delivered, and the revenue allocated to the PCS ratably over three years. Under ASC Topic 606 the software vendor experiences a significant acceleration of revenue recognition.
For tax purposes, revenue generated from the provision of services is recognized under the All Events Test when earned through required performance, and in that case, only when the provision of stipulated services is complete (i.e., not incrementally as services are rendered). Revenue generated with respect to licenses is recognized under the All Events Test ratably over the period the licensee is entitled to use the property. These rules did not change under TCJA. Whereas ASC Topic 606 now requires immediate recognition for a portion of the software vendor’s revenue under the previous example, the result under the All Events Test is now trumped by the Earlier of Test. Assuming the revenue is allocated 50-50 between the software and PCS, income taxes are now payable on half of the entire contracted amount in the year the software is delivered.
A company provides services performed over three months in 2018 that are designed to assist a client in the expansion of business. The company receives fixed price payments based on the number of new customers obtained by their client and the number of times the customers renew with their client. The contingent payments may stretch out for periods of up to 10 years. Under ASC Topic 605, the contingent payments were not recognized as revenue until the contingency was resolved, resulting in revenue being recognized each year the customer renewed with their client. Under ASC Topic 606, the company estimated the amount of variable consideration (contingent payments) to which it expects to be entitled, and determined that the constraint on variable consideration does not apply. After adopting ASC Topic 606 in 2018, the company estimates and recognizes 10 years’ worth of revenue over the three months that services are performed.
Under the All Events Test, the taxpayer does not have a fixed right to contingent consideration until the conditions are resolved that entitle the taxpayer unconditionally to the revenue. But as is the case in the previous example, in this case the Earlier of Test trumps the All Events Test and requires revenue recognition for tax purposes at the same time stipulated under ASC Topic 606. As a result, income taxes are now payable in 2018 on the amount that the company estimates it will receive over a ten year period.
A company sells a mix of products and services to a customer. For financial statement purposes the product and the service are considered to be separate performance obligations. When writing the contract, the company provides a discount on the product. The product is delivered in 2018 while the service is delivered in 2019. For financial statement purposes, the revenue for both the product and service is allocated based on the standalone selling price of each, resulting in the equipment being allocated more revenue than is contractually stated.
For tax purposes, former rules provided that contract price allocations specified in written agreements between a buyer and seller must be respected by each party. This standard is now replaced under TCJA with a conformity requirement as to allocations made for financial reporting purposes (which are not beholden necessarily to allocations specified in the written agreement). The result is that taxable income now must be computed in 2018 based on the higher allocated amount of product revenue, rather than the contractual amount.
What Happens Now?
ASC Topic 606 is required to be adopted for public entities, for annual reporting periods beginning after Dec. 15, 2017, including interim periods within that reporting period (i.e., Jan. 1, 2018 for calendar year end) and for all others, the guidance is effective for annual reporting periods beginning after Dec. 15, 2018 (i.e.. Dec. 31, 2019 for calendar year end).
Entities already adopting or considering early adoption of the guidance should talk with their tax advisor about the implications of these changes. Planning for income tax strategies, the timing of payments from customers, and business plans may be necessary for companies that experience an acceleration of income tax due under the TCJA. Several issues may result from this guidance or continue to be open questions pending guidance from the Internal Revenue Service (IRS), for instance: how should amounts recognized in retained earnings as a result of the transition adjustment when switching to ASC Topic 606 be taxed, how should changes in estimates within the applicable financial reporting framework be handled, and what other types of financial statements will the Commissioner include in the definition of an applicable financial statement.
We will continue to monitor developments and any IRS regulations or rules that are published to provide further guidance on the application of these provisions, including the availability of automatic accounting method change procedures to adopt the new rules under TCJA.
Please contact Mark Winiarski of MHM’s Professional Standards Group or your local tax advisor for more information.
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