IRS Chief Counsel - Deferral of income recognition for contracts for the sale of goods 

December 10: The IRS publicly posted a field advice memorandum* (prepared by attorneys in the IRS Office of Chief Counsel) concluding that the taxpayer (a product manufacturer) must immediately recognize advance payments received in prior years under long-term contracts guaranteeing supply of the product to customers because the taxpayer’s liability under these agreements had ended. 20134801F (release date November 29, 2013, and dated October 25, 2013).

Read the field advice memo [PDF 117 KB]

Background

The redacted field advice memo reveals the following facts:


  • The taxpayer manufactured a product for use in various industries.
  • Demand for the product grew rapidly a few years ago, and the taxpayer developed a business model to exploit the increased demand and insulate itself from dramatic decreases in future demand or new competition that might affect prices.
  • The taxpayer negotiated long-term supply contracts with some of its customers. These supply contracts were “take or pay”—i.e., the customer agreed to pay for a certain quantity of the product, whether or not it actually took delivery. In return, the taxpayer agreed to stand ready to deliver the specified product at specified times at set prices.
  • Each customer agreed to pay non-refundable advance payments.

The taxpayer, therefore, entered into long-term supply contracts with various customers. The contracts specify minimum yearly quantities that the customer would purchase, and the taxpayer would deliver, at fixed prices over a term of years.


  • All of the original contracts had the “take or pay” feature and an initial, non-refundable advance payment specifically applied to purchases ratably over the contract period on a per-unit basis.
  • Subsequently, the contracts were amended when the market for the product changed. The taxpayer then turned to negotiate contract modifications on a case-by-case basis.

For book and tax purposes, the taxpayer recognized income from the sale of goods as the goods were shipped, and recognized income from the long-term supply contracts at the average price over the term of each contract.


For tax purposes, the taxpayer adopted the method in Reg. section 1.451-5—i.e., advance payments were included in income in the tax year in which they were recognized for book purposes. Therefore, because the taxpayer recognized long-term contract income at the average contract price for book purposes, the taxpayer deferred initial recognition of the advance payments and included the payments in income ratably over the term of each agreement.

Field advice memo

In response to questions as to whether the taxpayer could continue to defer recognition of the advance payments (given the modifications to the contracts), or whether the taxpayer had changed its method of accounting to an improper method, the IRS field advice memo concludes:


  • The taxpayer’s actions showed that its liability under the agreements had ended and that it was required immediately to recognize as income all previously unrecognized advance payments received in prior years.
  • The taxpayer’s method of accounting was not consistent with Reg. section 1.451-5 because it was not applying the advance payments to goods as they were shipped.
  • In the alternative, the taxpayer had improperly changed its method of accounting.

*Field advice memo documents are prepared by IRS field attorneys in the Office of Chief Counsel, are reviewed by an Associate Office, and are subsequently issued to IRS field or service center employees. The memo cannot be used or cited as precedent.




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