The IRS’s Rev. Proc. 2015-39, released in July 2015, provides a safe harbor for “ratable service contract” liabilities. Under this safe harbor, an accrual method taxpayer may treat economic performance for these items as occurring on a ratable basis. Because the safe harbor may result in an accelerated deduction for these liabilities in certain cases, taxpayers in a position to benefit from the safe harbor should consider filing Form 3115 to change their method of accounting for eligible service liabilities. The new procedure is effective for tax years ending on or after July 30, 2015.
Economic performance requirement
Under § 461, an accrual method taxpayer generally may deduct a liability in the taxable year in which (1) all the events occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability.
Regarding the economic performance requirement, the rules generally provide that, in the case of a liability that arises out of the provision of services to the taxpayer by another person, economic performance occurs as the person provides those services. However, the existing code and regulations do not define the phrase “as services are provided” for purposes of determining when economic performance occurs for such service liabilities.
The § 461 regulations also provide two exceptions to the general rule that permit a taxpayer to accelerate the deduction of a liability for services provided to the taxpayer into a year prior to the year the economic performance requirement is satisfied. These exceptions are the three-and-a-half-month rule and the recurring item exception.
- Under the three-and-a-half-month rule, a taxpayer may treat economic performance as occurring as the taxpayer makes payment to the person providing the services if the taxpayer can reasonably expect the person to provide the services within three and a half months after the taxpayer makes the payment.
- Under the recurring item exception, the economic performance requirement is met for a taxable year if the two-prong “all events” tests are satisfied as of year-end; economic performance occurs on or before the earlier of (A) the date the taxpayer files a timely return (including extensions) for the taxable year, or (B) the fifteenth day of the ninth calendar month after the close of the taxable year; the liability is recurring in nature; and either (A) the amount of the liability is not material or (B) the accrual of the liability in the taxable year results in a better matching of the liability with the income to which it relates than would result from accruing the liability in the taxable year that economic performance actually occurs.
Notably, prior to the issuance of Rev. Proc. 2015-39, these two exceptions were narrowly interpreted to require that all of the services called for under the contract be provided within the three-and-a-half-month or eight-and-a-half-month timeframe (i.e., “all or nothing”). See Caltex Oil Venture v. Commissioner, 138 T.C. 18 (2012), and IRS Advice Memorandum AM 2007-009 (2007). Furthermore, with respect to the recurring item exception, recent guidance essentially narrowed the types of liabilities that can meet the “not material” or “better matching” requirements, and thus qualify for the recurring item exception (e.g., rebates, refunds, certain taxes, insurance, and warranty liabilities). See Rev. Rul. 2012-1, 2012-1 I.R.B. 255, and VECO Corporation and Subsidiaries v. Commissioner, 141 T.C. 440 (2013).
Safe harbor - Ratable service contract defined
Under the safe harbor method of accounting for ratable service contracts, a taxpayer may treat economic performance as occurring on a ratable basis over the term of the service contract.
A contract is a “ratable service contract” eligible for the safe harbor if: (1) the contract provides for similar services to be provided on a regular basis, such as daily, weekly, or monthly; (2) each occurrence of the service provides independent value not dependent on the receipt of any previous or subsequent occurrence of the service, and; (3) the term of the contract does not exceed 12 months (contract renewals not taken into account).
Example. On Dec. 31, 2015, Taxpayer enters into a one-year service contract with X for monthly landscape maintenance services from January through December 2016. Under the contract Taxpayer pays X $4,000 a month to maintain Taxpayer’s grounds. The contract requires Taxpayer to prepay for the 12 months of services with the full payment of $48,000 due Dec. 31, 2015. On Dec. 31, 2015, Taxpayer makes the $48,000 payment to X. As of Dec. 31, 2015, all events have occurred to establish the fact of Taxpayer’s $48,000 contractually required payment and the amount of the liability is determinable with reasonable accuracy.
This contract meets the requirements of a ratable service contract under the revenue procedure because the maintenance services are to be provided on a regular basis (monthly); each occurrence of the maintenance service provides independent value, such that the benefits from each occurrence of the service are not dependent on the receipt of prior or subsequent maintenance services; and the contract term does not exceed 12 months.
Under the provisions of the revenue procedure, Taxpayer may treat economic performance as occurring ratably under the contract. Assuming Taxpayer satisfies the requirements of the recurring item exception, and files its return on Sept. 15, 2016, Taxpayer is allowed to incur a liability in 2015 of $34,000 (8.5 months/12 months x $48,000) for the services provided from Jan. 1 through Sept. 15, 2016. For the services provided from Sept. 16 through Dec. 31, 2016, the period outside the recurring item exception, economic performance occurs ratably as the services are provided to Taxpayer during that time and a liability for these services of $14,000 (3.5 months/12 months x $48,000) is incurred in 2016.
If a single contract includes both services that satisfy these requirements and services (or other items) that do not satisfy the requirements, the services (or other items) that do not satisfy the ratable service contract requirements must be separately priced in the contract for the contract to qualify for the safe harbor. The revenue procedure provides four examples to illustrate the practical application of the ratable service contract requirements as well as to highlight the necessity of satisfying the other applicable expense timing rules (e.g., all events tests, recurring item exception provisions).
Automatic accounting method change procedures
A change in the treatment of ratable service contracts to conform to the safe harbor method is an automatic change in method of accounting. To implement the automatic changes, taxpayers must file Form 3115 using the automatic change procedures in Rev. Proc. 2015-13 and newly added section 19.12 of Rev. Proc. 2015-14. The eligibility rule in Rev. Proc. 2015-13 prohibiting a taxpayer from applying for the same automatic change within five tax years does not apply to a taxpayer that wants to make this change for the taxpayer’s first, second, or third taxable years ending on or after July 30, 2015.
Note, however, that a change to begin using the three-and-a-half-month rule or the recurring item exception generally requires a separate advance consent Form 3115 be filed by the last day of the year of change pursuant to the procedures in Rev. Proc. 2015-13 (e.g., by Dec. 31, 2015 for a 2015 change requested by a calendar year-end taxpayer).
This revenue procedure is effective for tax years ending on or after July 30, 2015.
Taxpayers should review their service contracts and consider filing Form 3115 to change their method of accounting for eligible ratable service contract liabilities if they are in a position to benefit from an accelerated deduction under the safe harbor.
With respect to eligibility for the recurring item exception, note that ratable service contract liabilities may not qualify for this exception due to the restrictive interpretation of the “immaterial or better matching” requirement outlined in the authoritative guidance discussed above (i.e., Rev. Rul. 2012-1 and the VECO decision). Specifically, as outlined in the guidance, a liability is considered “material” and therefore ineligible for the recurring item exception if a taxpayer prorates the liability over two or more tax years for financial statement purposes but takes an inconsistent position on its tax returns.
For tax planning purposes, taxpayers that routinely incur significant service liabilities under multiple element contracts may wish to revise future contracts to separately price the deliverables so eligible ratable service elements may qualify for the safe harbor.
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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.