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IRS Provides Economic Performance Safe Harbor for Ratable Service Contracts.

(Parker Tax Publishing July 31, 2015)

The IRS has provided a safe harbor for accrual method taxpayers to treat economic performance as occurring ratably on contracts that provide services on a regular basis. Under the safe harbor, which is effective for tax years ending on or after July 30, 2015, a taxpayer can ratably expense the cost of regular and routine services as the services are provided under the contract. The IRS also provides procedures for obtaining automatic consent to change to the safe harbor method of accounting. Rev. Proc. 2015-39.

Background

Under the accrual method of accounting, a liability is incurred, and generally taken into account for federal income tax purposes, in the tax year in which (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy (collectively referred to as the "all events test"), and (3) economic performance has occurred with respect to the liability.

In general, if the liability of a taxpayer is based on services performed for the taxpayer, economic performance occurs as the person provides those services.

Two exceptions allow a taxpayer to accelerate the accrual of a liability into a year prior to the year that the services are performed: the 3-1/2 month rule and the recurring item exception.

Under the 3-1/2 month rule in Reg. Sec. 1.461-4(d)(6)(ii), 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 3-1/2 months after the taxpayer makes the payment. Reg. Sec. 1.461-4(d)(6)(iv) provides that if different services are required to be provided to the taxpayer under a single contract, economic performance occurs over the time each service is provided. In Caltex Oil Venture v. Commissioner, 138 T.C. 18, 36 (2012), the Tax Court construed the 3-1/2 month rule as contemplating that all of the services called for under an undifferentiated, nonseverable contract must be provided within 3-1/2 months of payment.

Under the recurring item exception in Code Sec. 461(h)(3)(A) and Reg. Sec. 1.461-5(b), a liability is treated as incurred for a tax year if: (1) at the end of the tax year, all the events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (2) economic performance occurs on or before the earlier of the date that the taxpayer files a timely return (including extensions) for the tax year, or the 15th day of the ninth calendar month after the close of the tax year; (3) the liability is recurring in nature; and (4) either the amount of the liability is not material or the accrual of the liability in the tax year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the tax year in which economic performance occurs.

Safe Harbor for Ratable Service Contracts

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 in order to apply the 3-1/2 month rule and the recurring item exception.

A contract is a ratable service contract 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, such that the benefits of receiving each occurrence of the service is 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 renewal provisions will not be considered in determining whether a contract exceeds 12 months.

If a single contract includes services that satisfy the above requirements and services (or other items) that do not satisfy those requirements, the services (or other items) that do not satisfy the requirements must be separately priced for the contract to qualify as a ratable service contract.

The safe harbor is effective for tax years ending on or after July 30, 2015.

Consent to Change to Method of Accounting under the Safe Harbor

A change in the treatment of ratable service contracts to conform to the safe harbor method is a change in method of accounting and a taxpayer wishing to change to the safe harbor method must use the automatic consent procedures in Rev. Proc. 2015-13 and Rev. Proc. 2015-14. As such, the IRS has modified Rev. Proc. 2015-14 to add new Section 19.21, Economic Performance Safe Harbor for Ratable Service Contracts, to the list of automatic changes.

OBSERVATION: The designated automatic accounting method change number for a change to the safe harbor for ratable service contract is "220."

The eligibility rule in section 5.01(1)(f) of Rev. Proc. 2015-13, requiring that the taxpayer has not made or requested a change for the same item during any of the five tax years ending with the year of change, does not apply to a taxpayer that wants to make a change for a taxpayer's first, second, or third tax years ending on or after July 30, 2015.

Illustrations of the Safe Harbor Method

The following examples illustrate the application of the safe harbor method of accounting for ratable service contracts. In each example the taxpayer uses an accrual method of accounting for federal income tax purposes, including the use of the 3-1/2 month rule and the recurring item exception, and files its returns on a calendar year basis.

Example 1: On December 31, 2015, Taxpayer enters into a one-year service contract with Janitors Inc. to provide janitorial services on a daily basis to Taxpayer until the end of 2016, at a cost of $3,000 a month to be paid by the end of the prior month. On December 31, 2015, Taxpayer makes a $3,000 payment for the services to be provided in January 2016. As of December 31, 2015, all events have occurred to establish the fact of Taxpayer's $3,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

The contract in Example 1 meets the requirements of a ratable service contract because the janitorial services are to be provided on a regular basis (daily); each daily occurrence of the janitorial service provides independent value, such that the benefits from each occurrence of the service are not dependent on the receipt of previous or subsequent janitorial services; and the contract term does not exceed 12 months. Thus, Taxpayer may treat economic performance as occurring ratably under the contract and under the 3-1/2 month rule Taxpayer incurs a liability in 2015 for the $3,000 paid in 2015.

Example 2: On December 31, 2015, Taxpayer enters into a one-year service contract with Landscapers Inc. to provide landscape maintenance services to Taxpayer from January through December 2016 on a monthly basis at a cost of $4,000. The contract requires Taxpayer to prepay for the twelve months of services with the full payment of $48,000 due on December 31, 2015. As of December 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.

The contract in Example 2 meets the requirements of a ratable service contract and Taxpayer may treat economic performance as occurring ratably under the contract 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. Assuming that Taxpayer satisfies the requirements of the recurring item exception, and files its return on September 15, 2016, Taxpayer incurs a liability in 2015 of $34,000 (8.5 months/12 months x $48,000) for the services provided from January 1 through September 15, 2016. For the services provided from September 16 through December 31, 2016, the period outside of 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.

Example 3: On November 30, 2015, Taxpayer enters into a one-year contract for an environmental impact study with Enviro Co. Under the contract, Enviro must complete and deliver the study by November 30, 2016. Taxpayer will pay Enviro $100,000 when the contract is signed and $400,000 when the study is delivered. Enviro performs work on the study during 2015 and 2016 and delivers the completed study to Taxpayer on November 30, 2016. On November 30, 2015, all the events have occurred that establish the fact of Taxpayer's contractually-required payment of $100,000 and the amount of Taxpayer's liability under the contract can be determined with reasonable accuracy.

The contract in Example 3 does not satisfy the definition of a ratable service contract because the servicewill not be provided on a regular basis. Rather, the contract specifies that Enviro will provide to Taxpayer only one service, namely a completed and delivered impact study. Each instance of work on the study during the contract period does not provide independent value to Taxpayer. Instead, each instance of work on the study is dependent on the previous and subsequent work on the study to achieve its completion. Thus, Taxpayer may not treat economic performance as occurring ratably over the term of the service contract pursuant to the safe harbor and may not rely on the safe harbor to incur a liability for any portion of the $100,000 in 2015. Instead, economic performance occurs when the study is completed and a liability of $500,000 for this service is incurred upon its completion.

Example 4: On December 31, 2015, Taxpayer enters into a one-year service contract with IT Co. to provide various IT support and maintenance services to Taxpayer on a daily basis through December 31, 2016. In addition, IT Co. will create an updated human resources software application for Taxpayer (HR software development service). Taxpayer will pay IT Co. a flat fee of $3,000 a month for the IT services and the HR software development service, paid by the end of the prior month. On December 31, 2015, Taxpayer makes a $3,000 payment to IT Co. for the services to be provided in January 2016. As of December 31, 2015, all events have occurred to establish the fact of Taxpayer's $3,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

The contract in Example 4 does not meet the requirements of a ratable service contract because the contract includes the HR software development service, which is not provided on a regular basis. Under the terms of the contract, the HR software development service consists of only one service, an update to Taxpayer's human resources software application. Each instance of IT Co.'s work on updating the software application during the contract period is dependent on the previous and subsequent work to complete the update and does not provide independent value to Taxpayer. Because the contract does not separately price the HR software development service, Taxpayer may not treat economic performance as occurring on a ratable basis over the term of the service contract.

Example 5: Same facts as in Example 4, except that under the service contract the HR software development service is separately priced at $12,000, with $1,000 of the $3,000 monthly payment allocated to the software development service. The IT services described in the contract meet the requirements for a ratable service contract and Taxpayer may treat economic performance for the IT services as occurring ratably because the IT services are provided on a regular basis (daily); each daily occurrence of IT service provides independent value, such that the benefits from each occurrence of the service are not dependent on the receipt of prior or subsequent IT services; and the contract term does not exceed 12 months. Taxpayer incurs a liability in 2015 for $2,000 of the $3,000 payment for IT services under the 3-1/2 month rule. For the IT services provided from February through December 2016, economic performance occurs ratably as the services are provided to Taxpayer each day and a liability of $22,000 for these services is incurred in 2016. For the HR software development service liability, economic performance occurs when the service is completed and a liability of $12,000 for this service is incurred upon completion. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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