Double Taxation: A Take On All Things Taxes

Donald Marron, Director of the Tax Policy Center, was recently asked to testify before the House of Representatives about the messy state of affairs that is the annual “tax extenders” dance.

As we discussed here, our current Internal Revenue Code is not a static document; rather it is in a constant state of flux, with provisions often being established with a finite life, expiring, and then retroactively being reinstated. Over the years, enough of these provisions have come along that each year, they are grouped together in what is commonly referred to as a “tax extenders” package, and the nation breathlessly awaits to see if they will be granted another year.

Obviously, this is no way to administer tax policy. While some of the extenders are of little monetary consequence to taxpayer — take, for example, the $250 deduction for supplies for  K-12 teachers — others, like the R&D credit, represent billions of dollars in annual tax benefit. With companies uncertain from year to year whether the R&D credit will be extended, the tax benefit related to any research endeavors becomes tenuous, thereby stifling innovation.

To illustrate, the R&D credit expired at the end of 2011. It is now June 2012, and the fate of the credit for 2012 is still undecided. Now, perhaps businesses will carry on R&D activities in the absence of any tax incentive, but perhaps not. This is why the annual extenders dance has to change.

To do so, Marron explains, we must embrace fundamental tax reform that would create a simpler, fairer Code that “eliminates the pointless expiration of tax provisions that deserve longer lives.” Since reform is highly unlikely given the current political quagmire, however, Marron offers some additional ideas for grappling with the extenders, starting with differentiating between the different classes of provisions included in the annual extender package.

For those extenders originally enacted to address a national or regional emergency — such as bonus depreciation, the COD exclusion for primary residence mortgages, and certain Hurricane benefits — Congress should permit them to expire if no rationalization continues to exist for their inclusion in the statute.  

Other groups of extenders, Marron adds, should be subject to a sunset congressional review to determine the necessity of keeping them in the Code.

Lastly, a group of extenders that represent good policy and would have been permanent or long-lived if not for budgetary resources — such as the aforementioned teachers deduction and the R&D credit — should be made permanent or renewed for a prolonged period.

Marron goes on to advise Congress to change the way it addresses the extenders, starting with their default mindset. The presumption, Marron argues, needs to be that the extenders will expire, rather than be extended. That way, special interest groups will have to establish why the provision continue to have merit, rather than placing the burden of proof on those who want to see outdated or unfair provisions expire.

In addition, Marron makes a point shared by many, explaining that in order to expedite the extension of necessary provisions, the “extender package” has to be broken into smaller parts, even if that means that lesser known provisions will die off without the protection afforded by their more popular brethren.

Finally, Marron points out that many provisions have been given a short life because it is easier to “pay” for  a one year deduction in a budget proposal than a longer-lived provision. To remove this incentive to create provisions with an annual expiration date, Marron suggests changing the budget rules to require that any temporary tax provision be assumed to last no less than five years in the official budget baseline. Thus, if a policymaker wants to enact a new deduction, they will have to account for it in the budget for a minimum of five years, making it more difficult to rationalize with budget offsets.

Personally, we love Marron’s testimony, and agree wholeheartedly with his take on the ridiculousness of the annual extender package. From the perspective of a tax adviser, it becomes very difficult to explain to clients that certain provisions of the Code expire on a year to year basis, and it puts us in a precarious position where we are forced to predict whether expired provisions will continue to be extended. All it takes to lose an important client, of course, is to be wrong once.

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The deductibility of accrued liabilities — like state capitals and women — can be a bit tricky.

In general, whether an accrued expense is deductible for tax purposes is governed by I.R.C. § 461 Specifically, I.R.C. § 461(h) and Regulation § 1.461-1(a)(2)(i) provide that an accrued expense is deductible in the tax year in which all three tests are met:

(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, and

(3) economic performance has occurred with respect to the liability.

While much of the judicial precedent and administrative rulings surrounding I.R.C. § 461 deal with the nuanced and confusing  “economic performance” test, tax advisers would be foolish to ignore the “all events” test. Advisers often pay this requirement little mind, assuming that if a liability has been accrued for financial accounting purposes, it is a fixed liability that satisfies the all-events test for tax purposes. Unfortunately, this is not the case.

The complexity of the all-events test was illustrated last week in TAM 201223015, which shed some light on how the Service determines when a liability to pay rebates to customers becomes fixed for purposes of I.R.C. § 461.

In the Ruling, Taxpayer was an accrual basis manufacturer who offered certain trade promotion rebates to customers.

Taxpayer sold products to multiple buyers. In its sales agreement, customers paid full price, and then Taxpayer would later remit a cash rebate to the customer based on the number of units purchased. Some of the agreements required a minimum purchase from the customer to become eligible for the rebate, while others did not. Taxpayer, however, as part of its regular business practice paid the rebates even to those customers who failed to acquire the minimum units.

Customers typically requested the rebates by submitting a formal invoice or other written request for payment, which Taxpayer may pay in cash or as a credit against future purchases.

Based on the forgoing, the IRS was faced with the following question: Does the liability to provide rebates become fixed and determinable when 1) customers purchase the goods from Taxpayer, 2) customers purchase the minimum amount of the goods necessary to “earn” a rebate, or 3), customers submit the required claim forms for the rebates?

Taxpayer argued that the rebate liabilities were fixed and determinable when customers purchase goods from Taxpayer, because at that time Taxpayer was obligated to pay the rebates under its sales agreements with its customers.

The field agent, to the contrary, argued that the rebate liabilities are not fixed and determinable at the time customers purchase goods from Taxpayer, but rather when customers submit claim forms and substantiation to Taxpayer to request payment of the rebates.

In reaching its decision to side with Taxpayer, the IRS first discredited the field’s claim that the rebate liability was not fixed until the customer submitted the formal claim for rebate. Citing Revenue Ruling 98-39, the IRS noted that the establishment of the fact of a liability under the all events test is not delayed by an additional requirement in a contract that a claim or documentation be submitted to obtain payment, if such act is ministerial, which it was held to be in the immediate case.

The IRS also concluded that the Taxpayer need not wait to consider the rebate liability “fixed” until the customer bought a minimum amount of units required by contract to trigger the rebate. Because the minimum purchase requirements in Taxpayer’s contracts were largely ambiguous, the IRS looked to Taxpayer’s business practice, which was to pay the rebates regardless of whether the minimum purchase requirements were met.

As a result, Taxpayer’s rebate liability was fixed — and the “all events test” met — when Taxpayer sold the units to its customers, not when the minimum required units were sold, and not when the customer submitted a formal claim for rebate.

The Ruling ended at this point, but as discussed earlier, this is not the end of the analysis required by Taxpayer in order to deduct the accrued rebates. The “all events” test is only the first of three required tests; Taxpayer must also establish that the amount of the liability can be determined with reasonable accuracy, and that “economic performance” has occurred with respect to the liability.

The “amount” test is typically fairly easy to establish, particularly in a situation such as this where the rebates can be computed at year end based on units sold.

Economic performance, on the other hand, poses a bigger problem. Under Treas. Reg. §1.461-4(g)(3), economic performance does not occur with respect to a liability for rebates until the rebates are paid to the customer. While that would seem to render Taxpayer’s victory in the TAM moot, since the rebate liability being fixed is useless without economic performance, Taxpayer can presumably use the “recurring item exception” under Treas. Reg. §1.461-5 to deduct the accrued rebates at year-end to the extent that economic performance (i.e., payment) will be made by the earlier of

1) the filing of the return, or

2) 8 1/2 months after year-end.

A few years ago, I put together this decision tree to aid in understanding the economic performance rules (and only the economic performance rules). If you’re interested, click When Are Accruals Tax Deductible.

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