Editor: Mary Van Leuven, J.D., LL.M.
On Dec. 13, 2011, the IRS released Rev. Rul. 2012-1, which addresses the application of the economic performance rules and whether the recurring-item exception may be applied to accelerate economic performance with respect to liabilities for the lease of equipment and a related maintenance agreement. The determination of when economic performance occurs is a key factor in determining when a liability is properly taken into account under Sec. 461 and Regs. Sec. 1.461-1(a)(2)(i).
In general, an accrual-basis taxpayer is allowed a deduction for an otherwise deductible expense in the period in which the following three-prong test (the first two prongs of which are referred to collectively as the “all-events test”) is met:
- All events have occurred that determine the fact of the liability;
- The amount of the liability can be determined with reasonable accuracy; and
- Economic performance has occurred with respect to the liability (Regs. Sec. 1.461-1(a)(2)(i)).
The all-events test is met when (1) the event fixing the liability occurs (whether the event is the required performance or another event) or (2) payment is due, whichever happens earlier (see, e.g., Rev. Rul. 2007-3).
In general, economic performance occurs for a liability arising out of the provision of property or services to the taxpayer by another person, as the property or services are provided (Regs. Sec. 1.461-4(d)(2)). If the liability arises out of the use of property by the taxpayer (e.g., rent), economic performance generally occurs ratably over the period the taxpayer is entitled to the use of the property (Regs. Sec. 1.461-4(d)(3)). For liabilities arising out of the provision to the taxpayer of insurance or a warranty or service contract, economic performance occurs as payment is made to the person to whom the liability is owed (Regs. Sec. 1.461-4(g)(5)). For this purpose, a “warranty or service contract” is a contract that a taxpayer enters into in connection with property bought or leased by the taxpayer, under which the other party to the contract promises to replace or repair the property in specified circumstances.
The recurring-item exception of Sec. 461(h) and Regs. Sec. 1.461-5 provides an exception to the general rules of economic performance. If a taxpayer is eligible to use the recurring-item exception for a particular liability, then economic performance will be deemed to occur at year end. The recurring-item exception may be used if (1) the all-events test has been met; (2) the liability is recurring in nature; (3) economic performance occurs within 8½ months of year end; and (4) either the amount of the liability is not material or the accrual of the liability in the earlier year results in a better matching of the liability with the income to which it relates.
For purposes of determining whether the amount is “material” under the recurring-item exception, consideration is given to the amount of the liability in absolute terms and in relation to the amount of other items of income and expense attributable to the same activity. The liability is deemed to be material if it is material for financial statement purposes under GAAP, but a liability that is immaterial for GAAP purposes may nevertheless be considered material for purposes of the recurring-item exception (Regs. Sec. 1.461-5(b)(4)).
For purposes of determining whether the matching requirement is met under the recurring-item exception, GAAP principles are important but not dispositive (Regs. Sec. 1.461-5(b)(5)(i)). In the case of a liability under an insurance, warranty, or service contract (as defined in Regs. Sec. 1.461-4(g)(5)), the matching requirement of the recurring-item exception is deemed satisfied (Regs. Sec. 1.461-5(b)(5)(ii)).
Rev. Rul. 2012-1
In Rev. Rul. 2012-1, the IRS addressed the application of the economic performance rules and the recurring-item exception to liabilities for an equipment lease and a related maintenance agreement for the property. The facts in the ruling were as follows:
- Accrual-basis, calendar-year taxpayer (X) entered into a lease agreement for property used in its trade or business, with a term starting July 1, 2011, and ending June 30, 2012. Under the lease terms, X was required to prepay the full amount of the lease liability on July 1, 2011. For financial statement purposes, the payment was expensed ratably over the one-year period of the lease.
- In conjunction with the lease agreement, X entered into a one-year maintenance agreement, with the same term as the lease, with a company unrelated to the lessor. Under the terms of the service contract, the maintenance company was required to inspect and clean the leased property monthly and provide any necessary repair and maintenance services for the normal wear and tear or routine maintenance of the property. The ruling specified that “the services to be provided to X under the service contract are general services to be provided on an ongoing and recurring basis.” The terms of the agreement required X to prepay the entire amount of the liability on July 1, 2011. For GAAP purposes, the payment was expensed ratably over the one-year period of the contract.
For both the lease liability and underlying maintenance liability, the IRS noted that the all-events test was met upon payment, since prepayment was required under the respective contracts. Therefore, the sole issue addressed in the revenue ruling was when economic performance occurred.
As noted above, economic performance for a lease liability generally occurs as the underlying property is used. As such, under the general rule, X would be entitled to a deduction of only one-half of its prepayment under the lease—i.e., the portion relating to the use of property during 2011. Therefore, the first issue addressed in the ruling was whether X was permitted to apply the recurring-item exception to the lease liability in order to accelerate economic performance for the 2012 portion of the lease. Specifically, the analysis focused on the final requirement under the recurring-item exception—whether the amount of the liability was immaterial or the acceleration of the deduction resulted in better matching.
In concluding that the liability was material, the revenue ruling cited the legislative history of Sec. 461(h) and the language in the underlying regulations for the premise that the liability was considered material for GAAP purposes, since it accrued over more than one year. Therefore, the IRS concluded that it must be viewed as material for purposes of the recurring-item exception. Interestingly, the ruling failed to comment on whether the dollar amount of the liability was material for GAAP, which is generally the relevant question when it comes to considering what is material for financial reporting purposes. This would appear to be a significant factor in the analysis, given that Regs. Sec. 1.461-5(b)(4) specifically provides that consideration must be given to the amount of the liability in absolute terms and in relation to the amount of other items of income and expense attributable to the same activity.
In addressing the “better matching” requirement, the IRS applied a similar analysis. Although acknowledging that the regulations provide that GAAP principles are important but not dispositive, the revenue ruling said that, because the liability accrued over more than one year for GAAP purposes, and because it related to income that the taxpayer generated over more than one tax year and there were no “overriding facts or circumstances” that indicated accrual of the full liability resulted in a better match with income, the better-matching test was not met. Therefore, the ruling concluded that X could not apply the recurring-item exception to accelerate deduction of the lease liability.
Rev. Rul. 2012-1 next analyzed the application of the economic performance rules to X’s prepaid maintenance liability. The first question addressed was how to characterize the liability for purposes of the economic performance test—either as a “payment liability,” specifically, a liability under a “warranty or service contract” as described in Regs. Sec. 1.461-4(g)(5) (such that economic performance occurs upon prepayment of the liability during the 2011 tax year), or as a liability for services (such that economic performance occurs over the term of the agreement as the services are provided).
In concluding that X’s maintenance contract was properly characterized as a liability for services, as opposed to a payment liability, the IRS explained that “warranty or service contract” is defined in the regulations as a contract under which the other party promises to replace or repair the property under specified circumstances, which “implies the occurrence of a unique or irregular circumstance necessitating the repair or replacement of property.” In this way, the warranty and service contracts contemplated in the regulation are similar to insurance contracts, and the regulations recognize this similarity by treating insurance, warranty contracts, and service contracts collectively as a single category of payment liability.
For this reason, the revenue ruling held that X’s maintenance contract did not fall into this definition, because the services to be provided to X were general services to be provided on an ongoing and recurring basis, rather than services to be provided only in “specified circumstances.” This interpretation of the language in the regulation appears to be open to question, because the definition plainly provides merely that the contract specify in which circumstances the other party is required to replace or repair property, but does not require that those circumstances be unique or irregular.
As a result of the IRS’s conclusion that X’s payment under the maintenance agreement was characterized as a payment for services (for which economic performance occurs as the services are provided), the final issue addressed was whether X was permitted to apply the recurring-item exception to the maintenance liability to accelerate economic performance for the 2012 portion of the services. As with the lease liability, the analysis focused on the final requirement under the recurring-item exception—whether the amount of the liability was immaterial or the acceleration of the deduction resulted in better matching. As with the lease liability, in large part because the liability accrued over more than one year for GAAP purposes, the IRS concluded that the liability was material and that acceleration of the deduction did not result in a better matching of income and expense. Therefore, the ruling concluded that X could not apply the recurring-item exception to accelerate deduction of the maintenance liability.
Finally, Rev. Rul. 2012-1 provided that a change in a taxpayer’s method of accounting to conform to any of the determinations in the ruling is a change in method of accounting under Secs. 446 and 481, and a taxpayer that wants to change its method may follow the automatic method change provisions of Rev. Proc. 2011-14. For a taxpayer making the change for its first tax year ending on or after Dec. 13, 2011, the scope limitations in Section 4.02 of Rev. Proc. 2011-14 do not apply, provided an issue is not under consideration in an examination of whether the all-events test has been met.
Based on Rev. Rul. 2012-1, it appears that the IRS is likely to challenge the use of the recurring-item exception for an amount that clearly relates to a liability for services (including a liability under a contract for the provision of ongoing or recurring services), or for the use of property, and when the expenditure is spread over more than one tax year for GAAP purposes, regardless of whether the dollar amount of the liability is considered material for GAAP purposes. Therefore, taxpayers that fit squarely within this fact pattern may want to consider filing an accounting method change to stop applying the recurring-item exception going forward.
That being said, in cases when a liability for services (or property) is prepaid, and the services or property are reasonably expected to be provided within 3½ months of the prepayment, the taxpayer may be able to avail itself of the 3½-month rule under Regs. Sec. 1.461-4(d)(6), which does not contain the “materiality or better matching” requirement contained within the recurring-item exception.
Further, Rev. Rul. 2012-1 did not address the tax treatment of a “mixed service and warranty contract,” in which the contract calls for services to be performed on a recurring basis and for additional performance to be provided only in “specified circumstances.” Many maintenance contracts fall under this definition, such that additional services could be required or called for in addition to the scheduled or expected services.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.