Taxable Year of Income Inclusion Under an Accrual Method of Accounting and Advance Payments for Goods, Services, and Other Items, 810-863 [2020-28653]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 86, Number 3 (Wednesday, January 6, 2021)]
[Rules and Regulations]
[Pages 810-863]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-28653]



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Vol. 86

Wednesday,

No. 3

January 6, 2021

Part IV





Department of the Treasury





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Internal Revenue Service





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26 CFR Part 1





Taxable Year of Income Inclusion Under an Accrual Method of Accounting 
and Advance Payments for Goods, Services, and Other Items; Final Rule

Federal Register / Vol. 86 , No. 3 / Wednesday, January 6, 2021 / 
Rules and Regulations

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9941]
RIN 1545-BO68 and 1545-BO78


Taxable Year of Income Inclusion Under an Accrual Method of 
Accounting and Advance Payments for Goods, Services, and Other Items

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations regarding the timing 
of income inclusion under an accrual method of accounting, including 
the treatment of advance payments for goods, services, and certain 
other items. The regulations reflect changes made by the Tax Cuts and 
Jobs Act and affect taxpayers that use an accrual method of accounting 
and have an applicable financial statement. These final regulations 
also affect taxpayers that use an accrual method of accounting and 
receive advance payments.

DATES: 
    Effective Date: The regulations are effective on December 30, 2021.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.451-3(m), 1.451-8(h), and 1.1275-2(l)(2).

FOR FURTHER INFORMATION CONTACT: Concerning any provisions in Sec.  
1.451-3 within the jurisdiction of the Associate Chief Counsel (Income 
Tax & Accounting), Jo Lynn Ricks, (202) 317-4615, Sean Dwyer, (202) 
317-4853, or Doug Kim, (202) 317-4794, and concerning any provisions in 
Sec.  1.451-8 within the jurisdiction of the Associate Chief Counsel 
(Income Tax & Accounting), Jo Lynn Ricks, (202) 317-4615, or David 
Christensen, (202) 317-4861; concerning any provisions in Sec.  1.451-3 
or Sec.  1.451-8 within the jurisdiction of the Associate Chief Counsel 
(Financial Institutions & Products), Deepan Patel, (202) 317-3423, or 
Charles Culmer, (202) 317-4528 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains amendments to the Income Tax Regulations (26 
CFR part 1) under section 451(b) and (c) of the Internal Revenue Code 
(Code).
    On December 22, 2017, section 451(b) and (c) were amended by 
section 13221 of Public Law 115-97 (131 Stat. 2054), commonly referred 
to as the Tax Cuts and Jobs Act (TCJA). Section 451(b) was amended to 
provide that, for a taxpayer using an accrual method of accounting 
(accrual method taxpayer), the all events test for an item of gross 
income, or portion thereof, is met no later than when the item, or 
portion thereof, is included in revenue for financial accounting 
purposes on an applicable financial statement (AFS). Section 451(c) was 
amended to provide that an accrual method taxpayer may use the deferral 
method of accounting provided in section 451(c) for advance payments. 
Unless otherwise indicated, all references to section 451(b) and 
section 451(c) hereinafter are references to section 451(b) and section 
451(c), as amended by the TCJA.

I. Section 451(b)

    In general, section 451(a) provides that the amount of any item of 
gross income is included in gross income for the taxable year in which 
it is received by the taxpayer, unless, under the method of accounting 
used in computing taxable income, the amount is to be properly 
accounted for as of a different period. Under Sec.  1.451-1(a), accrual 
method taxpayers generally include items of income in gross income in 
the taxable year when all the events occur that fix the right to 
receive the income and the amount of the income can be determined with 
reasonable accuracy (all events test). All the events that fix the 
right to receive income occur when (1) the required performance takes 
place, (2) payment is due, or (3) payment is made, whichever happens 
first. Revenue Ruling 2003-10, 2003-1 C.B. 288; Revenue Ruling 84-31, 
1984-1 C.B. 127; Revenue Ruling 80-308, 1980-2 C.B. 162.
    Section 451(b)(1)(A) provides that, for an accrual method taxpayer, 
the all events test for an item of gross income, or portion thereof, is 
met no later than when the item, or portion thereof, is included as 
revenue in an AFS (AFS Income Inclusion Rule).
    Section 451(b)(1)(B) lists exceptions to the AFS Income Inclusion 
Rule. The AFS Income Inclusion Rule does not apply to taxpayers that do 
not have an AFS for a taxable year or to any item of gross income from 
a mortgage servicing contract.
    Section 451(b)(1)(C) codifies the all events test, stating that the 
all events test is met for any item of gross income if all the events 
have occurred which fix the right to receive such income and the amount 
of such income can be determined with reasonable accuracy.
    Section 451(b)(2) provides that the AFS Income Inclusion Rule does 
not apply for any item of gross income the recognition of which is 
determined using a special method of accounting, ``other than any 
provision of part V of subchapter P (except as provided in clause (ii) 
of paragraph (1)(B)).''
    Section 451(b)(3) defines an AFS, as referenced in section 
451(b)(1)(A)(i), by providing a hierarchical list of financial 
statements.
    Section 451(b)(4) provides that for purposes of section 451(b), in 
the case of a contract which contains multiple performance obligations, 
the allocation of the transaction price to each performance obligation 
is equal to the amount allocated to each performance obligation for 
purposes of including such item in revenue in the taxpayer's AFS.
    Section 451(b)(5) provides that, if the financial results of a 
taxpayer are reported on the AFS for a group of entities, the group's 
financial statement shall be treated as the AFS of the taxpayer.

II. Section 451(c)

    Section 451(c) provides special rules for the treatment of advance 
payments. Section 451(c)(1)(A) provides the general rule requiring an 
accrual method taxpayer to include an advance payment in gross income 
in the taxable year of receipt. However, section 451(c)(1)(B) permits a 
taxpayer to elect to include any portion of the advance payment in 
gross income in the taxable year following the year of receipt to the 
extent income is not included in revenue in the AFS in the year of 
receipt. Section 451(c)(1)(B) generally codifies Revenue Procedure 
2004-34, 2004-22 I.R.B. 991, which provided for a similar deferral 
period.
    Section 451(c)(2)(A) provides the Secretary of the Treasury or his 
delegate (Secretary) with the authority to provide the time, form and 
manner for making the election under section 451(c)(1)(B), and the 
categories of advance payments for which an election can be made. Under 
section 451(c)(2)(B), the election is effective for the taxable year 
that it is first made and for all subsequent taxable years, unless the 
taxpayer receives the consent of the Secretary to revoke the election. 
Section 451(c)(3) provides that the deferral election does not apply to 
advance payments received in the taxable year that the taxpayer ceases 
to exist.
    Section 451(c)(4)(A) defines advance payment for purposes of 
section 451(c). Under section 451(c)(4)(A), the term advance payment 
means any payment that meets the following three requirements: (1) The 
full inclusion of the payment in gross income in the year of receipt is 
a permissible method of accounting; (2) any portion of the

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advance payment is included in revenue in an AFS for a subsequent tax 
year; and (3) the advance payment is for goods, services, or such other 
items that the Secretary has identified. Section 451(c)(4)(B) lists 
certain payments that are excluded from the definition of advance 
payment and gives the Secretary the authority to identify other 
payments to be excluded from the definition. Section 451(c)(4)(C) 
provides a special definition of the term ``receipt'' for purposes of 
the definition of advance payment, and section 451(c)(4)(D) states that 
rules similar to those for allocating the transaction price among 
performance obligations in section 451(b)(4) also apply for purposes of 
section 451(c).

III. Prior Guidance

    On April 12, 2018, the Department of the Treasury (Treasury 
Department) and the IRS issued Notice 2018-35, 2018-18 I.R.B. 520, 
providing interim guidance on the treatment of advance payments and 
requesting suggestions for future guidance under section 451(b) and 
section 451(c). On September 27, 2018, the Treasury Department and the 
IRS issued Notice 2018-80, 2018-42 I.R.B. 609, announcing that the 
Treasury Department and the IRS intend to issue proposed regulations 
providing that accrued market discount is not includible in income 
under section 451(b).
    On September 9, 2019, the Treasury Department and the IRS published 
proposed regulations under section 451(b) (REG-104870-18, 84 FR 47191) 
(proposed section 451(b) regulations) and proposed regulations under 
section 451(c) (REG-104554-18, 84 FR 47175) (proposed section 451(c) 
regulations), referred to collectively hereinafter as the ``proposed 
regulations.'' The notices of proposed rulemaking for section 451(b) 
and (c) reflect consideration of the comments received in response to 
Notice 2018-35.
    A public hearing on the proposed regulations was held on December 
10, 2019, at which two speakers provided testimony. The Treasury 
Department and the IRS received approximately ten written comments 
responding to the proposed regulations.
    After the comment period for the proposed regulations closed, the 
Treasury Department and the IRS received a comment letter regarding the 
allocation of transaction price for contracts that include both income 
subject to section 451 and income subject to a special method of 
accounting provision, specifically, section 460. In response to these 
comments, in the Explanation of Provisions of a notice of proposed 
rulemaking (REG-132766-18) that was published on August 5, 2020 (85 FR 
47508), the Treasury Department and the IRS suggested allocation rules 
and requested comments regarding the application of section 451(b)(2) 
and (4) to contracts with income that is accounted for in part under 
proposed Sec.  1.451-3 and in part under a special method of 
accounting. No formal comments were received regarding these suggested 
rules.
    Comments received before these regulations were substantially 
developed, including all comments received on or before the deadline 
for comments on November 8, 2019, were carefully considered in 
developing these regulations. Copies of the comments received are 
available for public inspection at https://www.regulations.gov or upon 
request. After consideration of the comments received and the testimony 
at the public hearing, this Treasury decision adopts the proposed 
regulations as revised in response to such comments and testimony. The 
comments and the revisions are discussed in the Summary of Comments and 
Explanation of Revisions section of this preamble.

Summary of Comments and Explanation of Revisions

I. Overview

    This Summary of Comments and Explanation of Revisions section 
summarizes the formal written comments and some of the informal 
commentary, both in writing and at public events, addressing the 
proposed regulations. Comments merely summarizing or interpreting the 
proposed regulations or recommending statutory revisions generally are 
not discussed in this preamble. Similarly, comments outside the scope 
of this rulemaking generally are not addressed in this Summary of 
Comments and Explanation of Revisions section.

II. Comments and Explanation of Revisions Regarding the Proposed 
Section 451(b) Regulations

A. Realization and Recognition

    As noted in the preamble to the proposed section 451(b) 
regulations, footnote 872 of the Conference Report to the TCJA states 
that section 451(b) was not intended to revise the rules associated 
with when an item is realized for Federal income tax purposes and does 
not require the recognition of income in situations where the Federal 
income tax realization event has not taken place. See H.R. Rep. No. 
115-466, at 428 fn. 872 (2017) (Conf. Rep.). As also noted in the 
preamble to the proposed section 451(b) regulations, footnote 874 of 
the Conference Report provides, by way of example, that the timing 
rules of section 451(b) apply to unbilled receivables for partially 
performed services. Id. at 428 fn. 874.
    Commenters provided little commentary on footnote 874, except to 
state that it is contrary to footnote 872. Instead, the commenters 
presented two views. First, some commenters highlighted footnote 872 
and cited case law to support the claim that a realization event is, 
and has always been, a prerequisite for income recognition. These 
commenters acknowledged, however, that the case law frames the issue 
not in terms of ``realization'' but rather in terms of whether a seller 
has a fixed right to income under the all events test.
    Second, some commenters suggested definitions of realization. 
However, these recommended definitions differ, particularly as to 
whether realization applies to the provision of services. For example, 
some commenters described realization as applying to both contracts for 
the provision of services and contracts for the sale of goods, and 
stated that realization occurs when the taxpayer has a ``fixed and 
unconditional right to payment'' under the contract. One commenter 
reasoned that existing judicial precedents require realization without 
distinguishing between whether the income is for the performance of 
services or the sale of property. Another commenter asserted that 
realization means there has been a sale or disposition under section 
1001(a), suggesting that realization applies only to the sale of 
property. In sum, these commenters suggested that the proposed section 
451(b) regulations do not give effect to footnote 872 in the Conference 
Report and ask that the final regulations either explicitly define 
realization or clarify when realization occurs in certain 
circumstances, such as where a taxpayer produces goods for customers or 
where a taxpayer provides non-severable services to customers.
    The Treasury Department and the IRS have considered these comments 
and decline to define the term realization in the final regulations. 
Congress did not explicitly define realization in the Conference 
Report. Some of the suggested definitions of realization, particularly 
the ones equating realization with the all events test, would nullify 
the AFS Income Inclusion Rule entirely, which is clearly contrary to 
Congress' intent. Accordingly, it is reasonable to conclude that 
Congress intended a different concept of realization that would give 
full effect to

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the statute. Further, the final regulations do not clarify when 
realization occurs in specific circumstances. Realization is a factual 
determination that, while closely aligned with the all events test, has 
different meanings in different contexts.
    Section 451 is a timing provision and the amendments to section 
451(b)(1)(A) by TCJA were intended to modify the timing of income to 
require an accrual method taxpayer with an AFS to treat the right to 
income as fixed, under the all events test, no later than the time at 
which the item (or portion thereof) is taken into account in its AFS. 
The statute thus reflects Congress' intent to incorporate timing 
concepts from the financial reporting rules in the tax timing rules for 
including items in gross income. It does not seek to answer whether the 
AFS income inclusion has been realized. Accordingly, the focus of the 
final regulations is on the appropriate taxable year of AFS income 
inclusion.

B. Scope of AFS Income Inclusion Rule

1. Proposed Sec.  1.451-3(b): General Rule
    The general AFS Income Inclusion Rule in the proposed section 
451(b) regulations provides that, if a taxpayer includes an item of 
gross income, or portion thereof, in revenue in the taxpayer's AFS, the 
taxpayer must include the item in gross income under section 451(b). In 
addition to commenting that the general rule in the proposed section 
451(b) regulations potentially overrides the realization requirement, 
contrary to footnote 872 of the Conference Report, commenters suggested 
that the rule is overbroad and could cause taxpayers to incur a tax 
liability without having the money to pay the liability.
    The Treasury Department and the IRS note that the potential to 
incur a tax liability without having the money to pay the liability is 
inherent in the accrual method. However, the Treasury Department and 
the IRS acknowledge that the proposed AFS Income Inclusion Rule could 
exacerbate this situation and that the proposed rule could result in 
inclusions that would be inconsistent with footnote 872 of the 
Conference Report. Accordingly, the final regulations provide that, 
under the AFS Income Inclusion Rule, the all events test under Sec.  
1.451-1(a) for any item of gross income, or portion thereof, is met no 
later than when that item, or portion thereof, is ``taken into account 
as AFS revenue.'' In determining when an item of gross income is 
``taken into account as AFS revenue,'' AFS revenue is reduced by 
amounts that the taxpayer does not have an enforceable right to recover 
if the customer were to terminate the contract on the last day of the 
taxable year. The determination of whether the taxpayer has an 
enforceable right to recover amounts of AFS revenue is governed by the 
terms of the contract and applicable Federal, state, or international 
law, and includes amounts recoverable in equity and liquidated damages.
    The revised rule is designed to reconcile the intended preservation 
of the realization concept, consistent with footnote 872 of the 
Conference Report, with the intended scope of section 451(b), as 
illustrated in footnote 874 of the Conference Report. The revised rule 
is also consistent with concepts illustrated in Example 4 in the Joint 
Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-
18) at 163 (Dec. 20, 2018) (Blue Book). In the example, the taxpayer 
enters into a contract with a customer for a customized piece of 
machinery. Under the contract, the taxpayer will not invoice the 
customer until the item is delivered to the customer, the customer 
accepts the machinery, and title to the machinery has transferred to 
the customer. The contract specifically provides that, if the customer 
withdraws from the agreement, the taxpayer has an enforceable right to 
payment as the work is performed, even if the contract is not 
completed. The taxpayer does not complete the machinery in year one but 
includes an amount in revenue in its AFS in year one. Example 4 
concludes that, under the AFS Income Inclusion Rule, the taxpayer is 
required to recognize the amount in year one. The revised AFS Income 
Inclusion Rule in the final regulations incorporates the key elements 
reflected in Example 4.
    To reduce any additional compliance burdens, the final regulations 
provide an alternative method to determine when an item of gross income 
is treated as ``taken into account as AFS revenue'' under the AFS 
Income Inclusion Rule. Under the ``alternative AFS revenue method'', 
the taxpayer does not reduce AFS revenue by amounts that the taxpayer 
lacks an enforceable right to recover if the customer were to terminate 
the contract on the last day of the taxable year. The alternative AFS 
revenue method is a method of accounting that applies to all items of 
gross income in the trade or business that are subject to the AFS 
income inclusion rule. Taxpayers using the alternative AFS revenue 
method may also use the AFS cost offset method provided in the final 
regulations.
    Under the final regulations two additional adjustments to AFS 
revenue are made in determining whether an item of gross income is 
treated as ``taken into account as AFS revenue.'' These adjustments 
apply both under the AFS Income Inclusion Rule and under the 
alternative AFS revenue method. First, if the transaction price, as 
defined in Sec.  1.451-3(a)(14), was increased because a significant 
financing component is deemed to exist under the standards the taxpayer 
uses to prepare its AFS, then any AFS revenue attributable to such 
increase is disregarded. In such situations, total AFS revenue taken 
into account over the term of the contract exceeds the stated 
consideration in the contract and such excess is, for AFS purposes, 
offset by a corresponding interest expense. Because such excess is 
generally not imputed income for Federal income tax purposes and a 
deduction for the AFS interest expense is generally not imputed for 
Federal income tax purposes, it is necessary to adjust AFS revenue to 
prevent the improper acceleration, or overreporting, of gross income. 
If situations arise in which imputed income and imputed deductions are 
also required for Federal income tax purposes, an adjustment to AFS 
revenue is still appropriate as the amount and timing of the imputed 
income would be outside the scope of section 451 and the regulations 
thereunder. Second, to the extent that AFS revenue reflects a reduction 
for (1) amounts that are cost of goods sold or liabilities that are 
required to be accounted for under other provisions of the Code, such 
as section 461, including liabilities for allowances, rebates, 
chargebacks, rewards issued in credit card and other transactions and 
other reward programs, and refunds (for example, estimated returns 
based on historic practice), regardless of when any such amount is 
incurred (Liability Amounts); or (2) amounts anticipated to be in 
dispute or anticipated to be uncollectable, the taxpayer must increase 
AFS revenue by such amounts. The Treasury Department and the IRS have 
determined that adjustments for such amounts are necessary to prevent 
the taxpayer from effectively taking such amounts into account for 
Federal income tax purposes in a taxable year prior to the taxable year 
in which they are otherwise permitted to be taken into account under 
other provisions of the Code. Additionally, if AFS revenue is not 
adjusted for Liability Amounts in the taxable year that such amounts 
are otherwise permitted to be taken into account, then a taxpayer may 
obtain an improper double benefit by taking such amounts into account 
to reduce taxable income under another provision of the Code while also 
deferring an equal

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amount of gross income to a later year under Sec.  1.451-3. The AFS 
revenue adjustments in the final regulations do not preclude a taxpayer 
from accounting for trading stamps and premium coupons under Sec.  
1.451-4. However, the Treasury Department and the IRS are still 
evaluating whether the rules in Sec.  1.451-4 should be modified or 
clarified in light of certain financial reporting changes under ASC 
606.
    On a separate issue relating to the scope of the AFS Income 
Inclusion Rule, taxpayers questioned, in light of the realization 
discussion in footnote 872, whether the AFS Income Inclusion Rule 
applies to the sale of goods. Since Example 4 of the Blue Book involves 
the sale of goods, it is reasonable to conclude that Congress intended 
for the AFS Income Inclusion Rule, as revised, to extend to contracts 
for the sale of goods. Accordingly, as with the proposed section 451(b) 
regulations, the final regulations provide that the AFS Income 
Inclusion Rule applies to contracts for the sale of goods.
2. Proposed Sec.  1.451-3(b): Cost Offset for AFS Income Inclusions
    Proposed Sec.  1.451-3(b) does not provide for a cost offset when 
an amount is included under the AFS Income Inclusion Rule. The preamble 
to the proposed section 451(b) regulations discusses reasons for not 
providing a cost offset, including the potential for income distortions 
and Congressional intent that a cost offset not be provided. The 
preamble to the proposed section 451(b) regulations requests comments 
on this issue.
    Multiple commenters proposed allowing an offset for the cost of 
goods sold (COGS) when income is included under the AFS Income 
Inclusion Rule. Commenters pointed out that the term ``item of gross 
income'' generally means total sales net of COGS. See, for example, 
Sec.  1.61-3(a). Commenters also described situations where income 
might be distorted by inclusions in early years of a multi-year 
contract with the costs being allowed in later years without income to 
offset. Commenters expressed concern that, in these situations, or more 
generally, the AFS Income Inclusion Rule might operate as a tax on 
gross receipts.
    One commenter suggested that the statute uses the AFS as a backstop 
to timing recognition of revenue because the AFS provides a good 
standard by which to determine when a taxpayer receives an economic 
benefit. The commenter acknowledged that there has been a policy 
interest in achieving greater book-tax conformity in a variety of 
areas. The commenter recommended that, if the final regulations use the 
AFS to measure the receipt of an economic benefit, then the final 
regulations also should reflect the AFS standards that require certain 
items of income be reported ``net'' of offsetting items.
    Commenters also noted that, for AFS purposes, credit card issuers 
generally report interchange fees net of estimated reward costs and 
report credit card late fees net of estimated uncollectable amounts. 
Commenters explained that reward costs and uncollectable credit card 
late fees ``are so closely aligned with the realization of income that 
AFS standards require those items to be presented separately in the 
revenue section of the income statement but concurrently as to 
timing.'' One commenter expressed concern that not reducing interchange 
fees by estimated reward costs and credit card late fees by estimated 
uncollectable amounts in determining the amount of income recognized 
under the AFS Income Inclusion Rule would result in the inclusion of 
more income for Federal income tax purposes than was reported on the 
AFS.
    Accordingly, commenters recommended that the final regulations 
provide that the all events test and the economic performance 
requirement under section 461 should be deemed to be met for items that 
are ``closely aligned'' with income amounts recognized under the AFS 
Income Inclusion Rule. Commenters explained that section 461 should be 
deemed to be met for items such as estimated reward costs and estimated 
uncollectable late fees to the extent these items are reported on the 
revenue section of the AFS as a reduction to amounts subject to the AFS 
Income Inclusion Rule. One commenter further explained that this 
treatment would be consistent with the clear reflection of income 
doctrine of section 446. Alternatively, one commenter recommended 
modifying the definition of transaction price under proposed Sec.  
1.451-3(c)(6) to reduce interchange fees by the amount of reward costs 
that satisfy section 461 and credit card late fees by amounts that are 
considered uncollectable for AFS purposes.
    The Treasury Department and the IRS have considered these comments 
and have determined that a cost offset based on estimates of future 
costs would be inappropriate. As discussed in the preamble to the 
proposed section 451(b) regulations, allowing a cost offset based on 
estimated costs would be inconsistent with sections 461, 263A, and 471, 
and the regulations under those sections of the Code. In addition, a 
cost offset based on estimated costs would increase the possibility of 
income distortions as the costs of goods would effectively be 
recovered, through income deferral, prior to the taxable year in which 
the cost was actually incurred.
    However, the Treasury Department and the IRS agree with comments 
suggesting that taxpayers should be afforded the flexibility of 
applying an offset for costs incurred against AFS income inclusions 
from the future sale of inventory, the ``AFS cost offset method.'' 
Accordingly, a taxpayer that uses the AFS cost offset method determines 
the amount of gross income includible for a year prior to the year in 
which ownership of inventory transfers to the customer by reducing the 
amount of revenue it would otherwise be required to include under the 
AFS Income Inclusion Rule for the taxable year (AFS inventory inclusion 
amount) by the cost of goods related to the item of inventory for the 
taxable year, the ``cost of goods in progress offset.'' The net result 
is the amount that is required to be included in gross income for that 
year under the AFS Income Inclusion Rule. The deferred revenue, that 
is, the revenue that was reduced by the cost of goods in progress 
offset for a taxable year prior to the taxable year that ownership of 
the item of inventory is transferred to the customer, is generally 
taken into account in the taxable year in which ownership of the item 
of inventory is transferred to the customer.
    The final regulations provide that the cost of goods in progress 
offset for each item of inventory for the taxable year is calculated as 
(1) the cost of goods incurred through the last day of the taxable 
year, (2) reduced by the cumulative cost of goods in progress offset 
amounts attributable to the items of inventory that were taken into 
account in prior taxable years, if any. However, the cost of goods in 
progress offset cannot reduce the AFS inventory inclusion amount for 
the item of inventory below zero. Further, the cost of goods in 
progress offset attributable to one item of inventory cannot reduce the 
AFS inventory inclusion amount attributable to a separate item of 
inventory. Any cost of goods that were not used to offset AFS inventory 
inclusion amounts because they were subject to limitation are 
considered when the taxpayer determines the cost of goods in progress 
offset for that item of inventory in a subsequent taxable year.
    The cost of goods in progress offset is determined by reference to 
the costs and expenditures related to each item of inventory produced 
or acquired for resale, which costs have been incurred

[[Page 814]]

under section 461 and have been capitalized and included in inventory 
under sections 471 and 263A or any other applicable provision of the 
Code at the end of the year. However, the cost of goods in progress 
offset does not reduce the costs that are capitalized to the item of 
inventory produced or acquired for resale by the taxpayer under the 
contract. That is, while the cost of goods in progress offset reduces 
the AFS inventory inclusion amount, it does not affect how and when 
costs are capitalized to inventory under sections 471 and 263A or any 
other applicable provision of the Code or when those capitalized costs 
will be recovered. Instead, the cost of goods in progress offset serves 
only to reduce or ``offset'' any AFS income inclusion amounts for the 
item of inventory and defer such amounts to the taxable year in which 
ownership of the item of inventory is transferred to the customer.
    The costs of goods comprising the cost of goods in progress offset 
must be determined by applying the inventory accounting methods used by 
the taxpayer for Federal income tax purposes. A taxpayer must calculate 
its cost of goods in progress offset by reference to all costs that the 
taxpayer has permissibly capitalized and allocated to items of 
inventory under its inventory method, but may not consider costs that 
are not properly capitalized under such method.
    In the taxable year in which ownership of the item of inventory is 
transferred to the customer, any revenue deferred by way of a prior 
year cost offset is included in gross income in the year of the 
transfer along with any additional revenue that is otherwise required 
to be included in gross income under the AFS Income Inclusion Rule for 
such year. Although no cost offset is permitted in such year, the 
taxpayer would recover costs capitalized and allocated to the item of 
inventory transferred as cost of goods sold in such year in accordance 
with sections 471 and 263A or any other applicable provision of the 
Code. However, if in a taxable year prior to the taxable year in which 
ownership of the item of inventory is transferred to the customer, 
either (A) the taxpayer dies or ceases to exist in a transaction other 
than a transaction to which section 381(a) applies, or (B) the 
taxpayer's obligation to the customer with respect to the item of 
inventory ends other than in a transaction to which 381(a) applies or 
certain section 351(a) transactions between members of the same 
consolidated group, then all payments received for the item of 
inventory that were not previously included in gross income as a result 
of the application of the cost offset rules are required to be included 
in gross income in such year.
    The Treasury Department and the IRS adopted this approach in the 
final regulations because the AFS cost offset method provides options 
for taxpayers. All taxpayers that are required to account for income 
from the sale of inventory under the AFS income inclusion rule and that 
report AFS revenue in a taxable year prior to the taxable year in which 
ownership of the item of inventory is transferred to the customer will 
generally be required to accelerate income inclusions under such rule. 
However, taxpayers have the option of using the AFS cost offset method 
to reduce the amount of income they are required to accelerate under 
such rule. The AFS cost offset allows taxpayers to reasonably match 
income inclusions and incurred cost of goods, and more clearly reflects 
income.
    The final regulations adopt a cost of goods sold offset based on 
incurred costs because the approach is consistent with Sec.  1.61-3 and 
more objective than a cost of goods sold offset based on projected 
future costs. In addition, the AFS cost offset method provides a degree 
of parity for sellers of goods with service providers who deduct costs 
as incurred without capitalizing the costs to inventory. A cost offset 
based on projected future cost of goods sold was rejected because it is 
inconsistent with sections 461(h), 263A and 471, and the regulations 
under those sections of the Code. Further, Congress rejected the 
deferral method for advance payments in former Sec.  1.451-5(c), which 
contained a cost of goods sold offset for estimated future costs. See 
Conf. Rep. at 429 fn. 880.
    The AFS cost offset method is a method of accounting that applies 
to all items of income eligible for the AFS cost offset method in the 
trade or business. The method applies to items at the trade or business 
level so that taxpayers can choose to apply the method only to trades 
or businesses where the burden of determining costs incurred relative 
to the related reduction in AFS income inclusion amount warrants the 
adoption of the method. If a taxpayer uses the AFS cost offset method 
for a trade or business it must use the method for all eligible items 
in that trade or business. Further, if a taxpayer uses the AFS cost 
offset method, it must also use the advance payment cost offset method 
in Sec.  1.451-8(e). The advance payment cost offset method is 
discussed later in this preamble. Special coordination rules exist for 
taxpayers that use the AFS cost offset method and the advance payment 
cost offset method and that have income from the sale of an item of 
inventory that is required to be accounted for under both Sec. Sec.  
1.451-3 and 1.451-8 because certain payments received for such item 
meet the definition of an advance payment under Sec.  1.451-8(a)(1). 
See Sec.  1.451-3(c)(1) for such coordination rules.
    The AFS cost offset method reduces the amount of income from the 
sale of an item of inventory that is required to be accelerated under 
the AFS Income Inclusion Rule by an amount of incurred cost of goods 
related to the item. However, the offsets to interchange fees and 
credit card late fees recommended by the commenters are based on 
estimated reward costs and uncollectable late fees rather than incurred 
costs of goods. Accordingly, the final regulations do not allow a cost 
offset for interchange fees, credit card late fees, and similar items 
of revenue that are subject to the AFS Income Inclusion Rule and 
reported net of estimated future amounts for AFS purposes.
3. Proposed Sec.  1.451-3(c)(4) and (c)(6)(ii): Revenue, Transaction 
Price and Increases in Consideration
    Proposed Sec.  1.451-3(c)(4) provides that, for the AFS Income 
Inclusion Rule, revenue means all transaction price amounts includible 
in gross income under section 61 of the Code. Proposed Sec.  1.451-
3(c)(6) provides that the transaction price is the gross amount of 
consideration to which a taxpayer expects to be entitled for AFS 
purposes in exchange for transferring goods, services, or other 
property, but not including, among other things, ``increases in 
consideration'' to which a taxpayer's entitlement is contingent on the 
occurrence or nonoccurrence of a future event for the period in which 
the amount is contingent.
    Commenters expressed confusion about the phrase ``increases in 
consideration'' because the definition of transaction price otherwise 
refers to ``amounts'' and does not distinguish between increases and 
decreases. Commenters asserted that there is no reason to treat 
``increases'' in consideration different from other consideration 
because all consideration is not realized until the taxpayer has a 
fixed right to payment. Commenters concluded that any portion of the 
contract price subject to a contractual contingency, for example, a 
future performance, is excluded from the transaction price until the 
contingency is satisfied. In addition, one commenter noted that it is 
unclear when there is a contingent ``increase'' in consideration,

[[Page 815]]

and taxpayers could revise the contract terms to meet this requirement.
    The Treasury Department and the IRS agree with these comments. The 
term ``increases in consideration'' was meant to signal income items 
that are subject to a condition precedent, such as bonus payments that 
require complete performance before the taxpayer is entitled to the 
bonus payment. The final regulations have been revised to remove the 
reference to ``increases in consideration'' entirely. The concept is 
now subsumed by the general rule that, to determine when an item of 
gross income is ``taken into account as AFS revenue'' under the AFS 
Income Inclusion Rule, AFS revenue is reduced by amounts that the 
taxpayer does not have an enforceable right to recover if the customer 
were to terminate the contract at the end of the taxable year. If an 
amount is contingent due to a condition precedent, such as with some 
bonus payments, and the taxpayer would not have an enforceable right to 
recover such amount if the customer were to terminate the contract at 
the end of the taxable year, the AFS Income Inclusion Rule does not 
require the taxpayer to include such amount in gross income in the 
current year.
4. Proposed Sec.  1.451-3(c)(6)(ii): Rebuttable Presumption
    Proposed Sec.  1.451-3(c)(6)(ii) provides a rebuttable presumption 
that amounts included in revenue in an AFS are presumed to not be 
contingent on the occurrence or nonoccurrence of a future event unless, 
upon examination of all the facts and circumstances existing at the end 
of the taxable year, it can be established to the satisfaction of the 
Commissioner that the amount is contingent on the occurrence or 
nonoccurrence of a future event.
    Commenters requested that the final regulations remove the 
rebuttable presumption regarding contingent consideration. Commenters 
reasoned that the rebuttable presumption imposes a higher standard of 
proof upon taxpayers than is ordinarily required to establish that 
consideration is contingent. Additionally, commenters noted that basing 
the presumption on the treatment of the consideration for financial 
reporting purposes is not sensible because the financial accounting 
rules do not make the conclusion dependent on whether the consideration 
is or is not contingent on the occurrence or non-occurrence of a future 
event. Rather, under the Financial Accounting Standards Board (FASB) 
and International Accounting Standards Board, Accounting Standards 
Codification (ASC) Topic 606 and International Financial Reporting 
Standards (IFRS) 15, Revenue from Contracts with Customers 
(collectively, ASC 606), the recognition of contingent consideration is 
based on a determination of the likely outcome of the contingency. 
Accordingly, commenters recommended that the final regulations 
eliminate the presumption in favor of noncontingency.
    As noted earlier, the final regulations have been revised to remove 
the reference to ``contingent consideration'' entirely. The concept is 
now subsumed by the general rule that, to determine when an item of 
gross income is ``taken into account as AFS revenue'' under the AFS 
Income Inclusion Rule, AFS revenue is reduced by amounts that the 
taxpayer does not have an enforceable right to recover if the customer 
terminates the contract at the end of the taxable year. Given this 
change, the final regulations remove the rebuttable presumption that a 
taxpayer has an enforceable right to amounts included in AFS revenue.
5. Proposed Sec.  1.451-3(c)(6)(ii): Enforceable Right to Payment
    Commenters requested that the final regulations clarify or remove 
the rule in proposed Sec.  1.451-3(c)(6)(ii) that treats amounts for 
which the taxpayer has an ``enforceable right to payment'' for 
performance completed to date as not contingent on the occurrence or 
nonoccurrence of a future event. First, commenters reasoned that the 
rule is ambiguous, resulting in controversies with exam. Second, 
commenters asserted that, assuming the phrase ``enforceable right to 
payment'' is based on the financial statement rules in ASC 606, this 
standard effectively overrides the tax realization requirement 
requiring a fixed, unconditional right to payment. Further, commenters 
reasoned that the rule is inconsistent with the exception for increases 
in consideration to which a taxpayer's entitlement is contingent on the 
occurrence or nonoccurrence of a future event.
    The Treasury Department and the IRS agree with these comments. As 
discussed earlier, the final regulations modify the general AFS Income 
Inclusion Rule by reducing the AFS revenue that is accelerated and 
included in gross income. Under the AFS Income Inclusion Rule, to 
determine when the item of gross income is ``taken into account as AFS 
revenue,'' AFS revenue is reduced by amounts that the taxpayer does not 
have an ``enforceable right'' to recover if the customer were to 
terminate the contract on the last day of the taxable year. The term 
``enforceable right'' is specifically defined in Sec.  1.451-3(a)(9) as 
any right that a taxpayer has under the terms of a contract or under 
applicable federal, state, or international law, including rights to 
amounts recoverable in equity or liquidated damages.
6. Proposed Sec.  1.451-3(c)(6)(iii): Reductions for Amounts Subject to 
Section 461 and Disputed Income
    Proposed Sec.  1.451-3(c)(6)(iii) provides that the ``transaction 
price'' does not include reductions for amounts subject to section 461, 
including amounts anticipated to be in dispute, returns, and rewards 
issued in credit card transactions. One commenter recommended that the 
final regulations clarify that rewards issued in credit card 
transactions are subject to section 461 and do not reduce original 
issue discount (OID) income in any circumstance, regardless of the 
structure of the credit card program. The commenter requested this 
clarification because taxpayers have taken different positions on the 
treatment of these rewards while the IRS has taken the position that 
rewards do not reduce OID income. The commenter stated that the better 
approach is to treat these rewards as liabilities under section 461. 
The commenter further explained that treating these rewards as amounts 
subject to section 461 in all circumstances would create uniformity 
among credit card issuers, reduce controversy between taxpayers and the 
IRS, and ease the compliance burden on taxpayers by eliminating the 
need for a facts and circumstances analysis of each credit card 
program. The Treasury Department and the IRS agree with the commenter 
and have modified the final regulations in Sec.  1.451-3(b)(2)(i)(A)(1) 
to clarify that rewards issued in a credit card transaction are items 
subject to section 461.
    Commenters also questioned whether the AFS Income Inclusion Rule 
modifies the treatment of income amounts subject to an actual dispute 
or a clerical error (disputed income amounts). The AFS Income Inclusion 
Rule does not modify the treatment of disputed income amounts. The 
principles set forth in Revenue Ruling 2003-10, 2003-1 C.B. 288, 
continue to apply. For example, an accrual method taxpayer does not 
accrue gross income in the taxable year of sale if, during the year of 
sale, the customer disputes its liability to the taxpayer. In addition, 
if an accrual method taxpayer overbills a customer due to a clerical 
mistake, and the customer disputes the liability in the subsequent 
taxable year, the taxpayer must accrue gross income in the taxable year 
of sale for the correct amount.

[[Page 816]]

Lastly, if a taxpayer ships excess quantities of goods and the customer 
does not dispute the shipment and agrees to pay for the excess 
quantities of goods, the taxpayer accrues gross income in the amount of 
the agreed payment in the taxable year of the sale.
    In response to these comments, the final regulations clarify that, 
under the AFS Income Inclusion Rule, to the extent that AFS revenue was 
reduced for amounts anticipated to be in dispute or anticipated to be 
uncollectable, AFS revenue is increased by such amounts. Accordingly, 
although ASC 606 reduces the transaction price for anticipated disputes 
to determine the amount of revenue to include on an AFS, see ASC 606-
10-32-6, AFS revenue is increased for amounts anticipated to be in 
dispute or anticipated to be uncollectable, because those amounts are 
included in gross income until they are actually disputed.

C. Proposed Sec.  1.451-3(c)(5): Special Method of Accounting

    Proposed Sec.  1.451-3(c)(5) provides a non-exhaustive list of 
examples of special methods of accounting to which the AFS Income 
Inclusion Rule generally does not apply. Commenters requested that the 
final regulations include the methods of accounting for notional 
principal contracts under Sec.  1.446-3 and the timing rules for 
stripped bonds under section 1286 as examples of special methods of 
accounting. The Treasury Department and the IRS adopt these comments in 
the final regulations and have added additional special methods for 
clarification purposes. The list of special methods of accounting 
remains non-exhaustive.

D. Proposed Sec.  1.451-3(d): Exceptions to the AFS Income Inclusion 
Rule

    Proposed Sec.  1.451-3(d) describes the exceptions to the AFS 
Income Inclusion Rule. The proposed rule clarifies that the AFS Income 
Inclusion Rule does not apply unless all of the taxpayer's entire 
taxable year is covered by an AFS. In addition, the AFS Income 
Inclusion Rule does not cover items of income in connection with a 
mortgage servicing contract. A commenter requested that an exception be 
added for any amount that has not yet been realized for Federal income 
tax purposes. As discussed earlier, the Treasury Department and the IRS 
decline to adopt this suggestion because providing rules on realization 
is beyond the scope of these final regulations.

E. Proposed Sec.  1.451-3(g): Contracts With Multiple Performance 
Obligations

1. Proposed Sec.  1.451-3(g): Allocation of Transaction Price to 
Contracts With Multiple Performance Obligations Subject to Section 
451(b)
    Proposed Sec.  1.451-3(g) provides that if a taxpayer's contract 
with a customer has multiple performance obligations subject to section 
451(b), transaction price is allocated to performance obligations as 
transaction price is allocated to performance obligations in the 
taxpayer's AFS.
    The final regulations clarify that each performance obligation 
yields an item of gross income that must be accounted for separately 
under the AFS Income Inclusion Rule. When a contract contains multiple 
performance obligations, to determine the amount of gross income 
allocated to each performance obligation, the transaction price 
determined under the taxpayer's applicable accounting principles, is 
allocated to each corresponding item of gross income in accordance with 
how the transaction price is allocated to each performance obligation 
for AFS purposes. If the accounting standards used to prepare the AFS 
identify a single performance obligation that yields more than one 
corresponding item of gross income, the portion of the transaction 
price amount that is allocated to the single performance obligation for 
AFS purposes must be further allocated among the corresponding items of 
gross income using any reasonable method.
    The final regulations simplify the definition of transaction price. 
The final regulations define the term transaction price to mean the 
total amount of consideration to which a taxpayer is, or expects to be, 
entitled from all performance obligations under a contract. The 
transaction price is determined under the standards the taxpayer uses 
to prepare its AFS. Accordingly, adjustments to the transaction price 
that were reflected in the transaction price definition in the proposed 
regulations have, to the extent relevant under these final regulations, 
been moved to operative rules to ensure clarity. See Sec.  1.451-
3(b)(2) and (d)(3).
    In addition, the final regulations clarify how the transaction 
price should be allocated to the extent the transaction price includes 
a reduction for liabilities, amounts anticipated to be in dispute or 
anticipated to be uncollectable, or a significant financing component 
that is deemed to exist under the standards the taxpayer uses to 
prepare its AFS. The final regulations clarify that the taxpayer must 
determine the specific performance obligation to which such reduction 
relates and increase the transaction price allocable to the 
corresponding item of gross income by the amount of the reduction 
(specific identification approach). If it is impracticable from the 
taxpayer's records to use the specific identification approach, the 
final regulations allow taxpayers to use any reasonable method to 
allocate the amount to the items of gross income in the contract. The 
final regulations also provide that a pro-rata allocation of this 
amount across all items of gross income under the contract based on the 
relative transaction price amounts allocated to the items for AFS 
purposes is a reasonable method.
    Similarly, the final regulations clarify how the transaction price 
should be allocated if the transaction price was increased because a 
significant financing component is deemed to exist under the standards 
the taxpayer uses to prepare its AFS. In this situation, the taxpayer 
must determine the specific performance obligation to which such amount 
relates and decrease the transaction price amount allocable to the 
corresponding item of gross income by such amount (the ``specific 
identification approach''). If it is impracticable from the taxpayer's 
records to use the specific identification approach, the taxpayer may 
use any reasonable method to allocate such amount to the items of gross 
income in the contract. The final regulations provide that a pro-rata 
allocation of such amount across all items of gross income under the 
contract based on the relative transaction price amounts allocated to 
the items for AFS purposes is a reasonable method.
2. Proposed Sec.  1.451-3(g): Contracts With Income Subject to Sec.  
1.451-3 and Income Subject to a Special Method of Accounting
    In the proposed regulations, the Treasury Department and the IRS 
requested comments on the allocation of the transaction price for 
contracts that include both income subject to section 451 and income 
subject to a special method of accounting provision, specifically, 
section 460. A commenter to the proposed regulations suggested that the 
allocation provisions under section 460 and the regulations thereunder, 
and not section 451(b)(4), should control the amount of gross income 
from a long-term contract that is accounted for under section 460. The 
commenter noted that using this approach is appropriate in light of 
section 451(b)(2), which reflects Congress's intent to not disturb the 
treatment of amounts for which the

[[Page 817]]

taxpayer uses a special method of accounting.
    The Treasury Department and the IRS believe that a rule is 
necessary to address the application of section 451(b)(2) and (4) to 
contracts with income that is accounted for in part under Sec.  1.451-3 
and in part under a special method of accounting and suggested rules 
for public comment in the preamble of a separate notice of proposed 
rulemaking published in the Federal Register on August 5, 2020 (85 FR 
47508). The suggested rules provided that if an accrual method taxpayer 
with an AFS has a contract with a customer that includes one or more 
items of gross income subject to a special method of accounting (as 
defined in proposed Sec.  1.451-3(c)(5)) and one or more items of gross 
income subject to section 451, the allocation rules under section 
451(b)(4) do not apply to determine the amount of each item of gross 
income that is accounted for under the special method of accounting 
provision. Rather, the taxpayer first allocates the transaction price 
to the item(s) of gross income subject to a special method of 
accounting (as determined under the special method of accounting). The 
remainder of the transaction price, the ``residual amount'', is then 
allocated to the items of gross income that are subject to Sec.  1.451-
3. To the extent the contract contains more than one item of gross 
income that is subject to section 451, the residual amount would be 
allocated to each such item in proportion to the amounts allocated to 
the corresponding performance obligations for AFS purposes. The 
Treasury Department and the IRS requested comments on these suggested 
allocation rules. However, no formal comments were received regarding 
these suggested rules.
    The final regulations largely adopt the rules suggested in the 
preamble to the separate notice of proposed rulemaking published in the 
Federal Register on August 5, 2020 (85 FR 47508). Accordingly, the 
final regulations provide that the transaction price allocation rule in 
Sec.  1.451-3(d)(1) does not apply to determine the amount of each item 
of gross income that is subject to a special method of accounting. 
Rather, the final regulations provide that the transaction price is 
first allocated to items of gross income subject to a special method of 
accounting, as determined under the special method of accounting. For 
this purpose, a special method of accounting has the meaning set forth 
in Sec.  1.451-3(a)(13), except as otherwise provided in guidance 
published in the Internal Revenue Bulletin (see Sec.  601.601(d)).
    To determine the transaction price allocated to items of gross 
income subject to a special method of accounting, the taxpayer must 
first adjust the AFS transaction price by the amounts described in the 
final paragraph of part II.B.1 of this Summary of Comments and 
Explanation of Revisions. Accordingly, if the AFS transaction price 
includes a reduction for cost of goods sold, liabilities, amounts 
expected to be in dispute or anticipated to be uncollectible, or a 
significant financing component that exists under the standards the 
taxpayer uses to prepare its AFS, the taxpayer must increase the 
transaction price amount by the amount of such reduction. If the AFS 
transaction price has been increased because a significant financing 
component exists under the standards the taxpayer uses to prepare its 
AFS, the taxpayer must decrease the transaction price amount by the 
amount of such increase.
    After the taxpayer makes the adjustments to the transaction price 
described earlier, the taxpayer first allocates such amount to the 
item(s) of gross income subject to a special method of accounting, and 
then allocates the remainder (residual amount) to the item(s) of gross 
income that are subject to Sec.  1.451-3. If the contract, contains 
more than one item of gross income that is subject to Sec.  1.451-3, 
the taxpayer allocates the residual amount to these items in proportion 
to the amounts allocated to the corresponding performance obligations 
for AFS purposes or as otherwise provided in guidance published in the 
Internal Revenue Bulletin (see Sec.  601.601(d)).

F. Proposed Sec.  1.451-3(i): Special Ordering Rule for Certain Items 
of Income for Debt Instruments

    Under proposed Sec.  1.451-3(i), if a fee is not treated by a 
taxpayer as discount or as an adjustment to the yield of a debt 
instrument over the life of the instrument (such as points) in its AFS, 
and the fee otherwise would be treated as creating or increasing OID 
for Federal income tax purposes (specified fee), then the rules in the 
proposed regulations under section 451(b) apply before the rules in 
sections 1271 through 1275 and the corresponding regulations. Proposed 
Sec.  1.451-3(i)(2) provides three examples of specified fees: Credit 
card late fees, credit card cash advance fees, and interchange fees 
(specified credit card fees). Interchange fees are sometimes labeled 
merchant discount in certain private label credit card transactions.
    Commenters requested that the final regulations provide that 
promotional discount, which also is sometimes labeled merchant 
discount, is not a specified fee. Promotional discount arises when a 
credit card issuer charges a fee to a merchant as compensation for 
accepting a below market interest rate on a credit card balance during 
a promotional period. Commenters explained that promotional discount is 
generally included in income over a promotional or similar period on a 
taxpayer's AFS and, despite possible alternative labeling, is, in 
substance, an adjustment to the yield of a debt instrument for AFS 
purposes. The Treasury Department and the IRS agree that any fee that 
adjusts the yield of a debt instrument for AFS purposes over the life 
of the instrument or another period should not be a specified fee. 
Therefore, the final regulations do not include the phrase ``over the 
life of the instrument'' in the definition of a specified fee but add 
the phrase ``spread over a period of time'' to clarify the definition. 
Thus, a fee that adjusts the yield of a debt instrument over a 
promotional or similar period for AFS purposes, such as promotional 
discount, is not a specified fee under the final regulations.
    One commenter agreed that section 451(b) was not intended to affect 
the application of the general OID timing rules to OID other than for 
certain fees that are not treated as discount for AFS purposes, 
including the specified credit card fees. Accordingly, the commenter 
agreed with the rules in proposed Sec.  1.451-3(i) and the inclusion of 
the general OID timing rules as a special method of accounting. Except 
as provided in the preceding paragraph, the definition of specified 
fees in the proposed regulations is adopted in the final regulations.

G. Proposed Sec.  1.451-3(k): Cumulative Rule for Multi-Year Contracts

    The proposed regulations provide that for a multi-year contract, a 
taxpayer must take into account the cumulative amounts included in 
income in prior taxable years on the contract in order to determine the 
amount to be included for the taxable years remaining in the contract. 
The proposed regulations contain two examples that illustrate this 
rule.
    The final regulations clarify that if the item of gross income from 
a multi-year contract is from the sale of an item of inventory and the 
taxpayer uses the AFS cost offset method, the taxpayer must first 
determine the ``AFS inventory

[[Page 818]]

inclusion amount'' for the taxable year. The taxpayer determines the 
AFS inventory inclusion amount for the taxable year by first taking the 
greater of: (1) The cumulative amount of revenue from the item of 
inventory that satisfies the all events test under Sec.  1.451-1(a) 
through the last day of the taxable year, less the portion of any 
advance payment received that is deferred to a subsequent taxable year 
under Sec.  1.451-8, if applicable, or (2) the cumulative amount of 
revenue from the item of inventory that is treated as taken into 
account as AFS revenue through the last day of the taxable year and 
identifies the larger of the two amounts or if the two amounts are 
equal, the equal amount. The taxpayer then reduces such amount by the 
prior year AFS inventory inclusion amount for that item of inventory, 
if any, to determine the AFS inventory inclusion amount for the current 
taxable year. Lastly, the taxpayer reduces the AFS inventory inclusion 
amount for the taxable year by the cost of goods in progress offset for 
the taxable year (which generally equals the costs of goods in progress 
for the item of inventory as of the end of the year less the portion of 
such costs that were taken into account as a cost of goods in progress 
offset for a prior taxable year). This net amount is the amount 
required to be included in gross income in the taxable year. However, 
in the taxable year in which ownership of the item of inventory is 
transferred to the customer, the taxpayer performs the same ``greater 
of'' computation noted earlier, but rather than subtract the prior year 
AFS inventory inclusion amount for the item of inventory (which is 
gross of cost offsets) from the result of the ``greater of'' 
computation, the taxpayer subtracts all prior year gross income 
inclusions for the item of inventory from the result of the ``greater 
of'' computation. This net amount is the amount required to be included 
in gross income in the taxable year of ownership transfer. The effect 
of this computation is that any revenue reduced by a cost offset in a 
prior year is included in gross in the taxable year in which ownership 
of the item of inventory is transferred to the customer. Although no 
cost offset is permitted in such year, the taxpayer would recover costs 
capitalized and allocated to the item of inventory transferred as cost 
of goods sold in such year in accordance with sections 471 and 263A or 
any other applicable provision of the Code.
    In the case of any other item of gross income from a multi-year 
contract, the taxpayer first compares the cumulative amount of the item 
of gross income that satisfies the all events test under Sec.  1.451-
1(a) through the last day of the taxable year with the cumulative 
amount of revenue from the item of gross income that is treated as 
taken into account as AFS revenue through the last day of the taxable 
year and identifies the larger of the two amounts (or, if the two 
amounts are equal, the equal amount). The taxpayer then reduces such 
amount by all prior year inclusion amounts attributable to the item of 
gross income, if any, to determine the amount required to be included 
in gross income in the current taxable year. Special coordination rules 
for applying Sec.  1.451-8 are also provided to the extent certain 
payments received under a multi-year contract are advance payments. The 
analysis in the examples is updated to reflect the clarifications to 
the rule.

H. Proposed Sec.  1.1275-2(l): OID Rule for Income Item Subject to 
Section 451(b)

    Under proposed Sec.  1.1275-2(l), notwithstanding any other rule in 
sections 1271 through 1275 and Sec. Sec.  1.1271-1 through 1.1275-7, 
if, and to the extent, a taxpayer's item of income for a debt 
instrument is subject to the timing rules in proposed Sec.  1.451-3(i) 
(including credit card late fees, credit card cash advance fees, or 
interchange fees), then the taxpayer does not take the item into 
account to determine whether the debt instrument has any OID. As a 
result, the taxpayer does not treat the item as creating or increasing 
any OID on the debt instrument. Commenters agree with these rules and 
note that these rules confirm that the current treatment of items other 
than specified fees will not be affected by section 451(b). The 
commenters also note that removing specified fees, including specified 
credit card fees, from the calculation of OID will permit taxpayers to 
apply only the rules of section 451(b) to these fees, without also 
having to apply the OID rules, thereby reducing taxpayer compliance 
burdens. Accordingly, the Treasury Department and the IRS adopt the 
rules in proposed Sec.  1.1275-2(l) in the final regulations.

I. Other Comments

1. Burial Plots and Interment Rights
    Commenters request clarification on the treatment of income from 
contracts with customers for the sale of burial plots or interment 
rights, on a pre-need basis (pre-need contracts). The terms of the pre-
need contracts typically require the customer to make an initial down 
payment and pay the balance of the sales price over several years. If 
the purchaser cancels or fails to perform under the contract before the 
entire purchase price is paid, commenters represent that, under every 
state law, the taxpayer's sole remedy is to keep all or a portion of 
the installment payments previously received from the customer as 
liquidated damages. Commenters highlighted that there may be an 
extended period of time between the date the pre-need contract is 
executed and the date the taxpayer collects the full sales price from 
the customer.
    Commenters represented that ASC 606 requires the entire transaction 
price from a pre-need contract, net of costs, to be included in revenue 
in the year in which the parties execute the contract. However, for 
Federal income tax purposes, commenters requested that the final 
regulations clarify that taxpayers with pre-need contracts should not 
include the unpaid balance of the transaction price in income in the 
taxable year the contract is executed under the AFS Income Inclusion 
Rule. In commenters' view, the sale of a burial plot should not be 
treated as a completed sale for tax purposes until the entire sales 
price of the burial plot is paid by the customer and ownership rights 
in the burial plot are transferred. Further, the taxpayer does not have 
an enforceable right to payment for the entire transaction price of the 
plot if the customer cancels or fails to perform under the contract.
    Commenters concluded that these taxpayers should be entitled to 
recover any allocable cost basis in the burial plot before including in 
gross income any of the installment payments received from the 
customer. Commenters viewed the sale of a burial plot as the sale of an 
interest in real property and assert that the basis recovery rules of 
sections 1016 and 1001 apply to prepayments for burial plots. Under 
this approach, prepayments for the purchase price of a burial plot 
before the sale of the plot first decrease the taxpayer's basis in the 
burial plot. See Sec.  1.1016-2(a). When the prepayments exceed the 
taxpayer's basis in the burial plot, the taxpayer recognizes the excess 
amount as gain. See Sec.  1.1001-1(c)(1). Accordingly, commenters 
requested that the final regulations clarify the application of 
sections 1001 and 1016 to the sale of pre-need burial plots.
    Commenters also requested clarification on the income recognition 
treatment of pre-need contracts with customers for the sale of 
interment rights. Commenters noted that the ASC 606 treatment for pre-
need contracts for the sale of interment rights resemble the treatment 
for pre-need contracts for the sale of burial rights. Commenters viewed 
the receipt of any installment payments prior to the transfer of those 
rights and prior to the payment of the

[[Page 819]]

entire transaction price to be controlled by sections 1001 and 1016, 
rather than by sections 451 and 471. Under this rationale, a taxpayer's 
treatment of the down payment and the installment payments from pre-
need contracts in its AFS should not determine the timing of income for 
tax purposes. Instead, commenters suggested that the amounts received 
before the transfer of the interment rights should be viewed as a 
return of capital and a reduction in the taxpayer's basis in the 
interment space.
    The IRS and the Treasury Department agree that the sale of burial 
plots and interment rights are governed by sections 1001 and 1016 but 
consider the determination of whether a sale has occurred to be a 
factual issue. If a sale has occurred under the facts and 
circumstances, any income resulting from the sale is realized under 
section 1001 and the right to the income is fixed, therefore the AFS 
Income Inclusion Rule does not result in the acceleration of AFS 
revenue. If the sale has not occurred, and the right to the future 
payments is extinguished if the customer cancels the contract, the AFS 
Income Inclusion Rule does not require acceleration because there is no 
enforceable right to the future payments if the contract is cancelled 
by the customer provided that the taxpayer is not using the alternative 
AFS revenue method in Sec.  1.451-3(b)(2)(ii).
2. Book Percentage-of-Completion Method (Book PCM)
    One commenter expressed interest in a Book PCM option as a special 
method of accounting that taxpayers with contracts accounted for using 
an over-time method of accounting for revenue under ASC 606 could elect 
to include the full amount of revenue reported on its AFS without 
regard to any offset or exception provided in these regulations, but 
with an offset for the allocable costs reported on its AFS, with some 
potential tax adjustments. Under ASC 606, the over-time method, where 
taxpayers recognize revenue over time (as opposed to at a point in 
time) is used for the following contracts where control over promised 
goods or services is transferred over time: (1) Where the customer 
controls the asset as it is created or enhanced by the entity's 
performance under the contract; (2) where the customer receives and 
consumes the benefits of the entity's performance as it performs under 
the contract; or (3) where the entity's performance creates or enhances 
an asset that has no alternative use to the entity, and the entity has 
the right to receive payment for work performed to date and expects to 
fulfill the contract as promised. An entity using an ``over-time 
method'' recognizes revenue using either: (1) An output method, which 
measures the value of the goods and services transferred to date to the 
customer (for example, units produced); or (2) an input method, which 
recognizes revenue based on the entity's efforts or inputs (for 
example, labor hours expended, costs incurred) as compared to the 
expected total costs to satisfy the performance obligation.
    Other commenters expressed concern about allowing a Book PCM 
option. Some commenters suggested that limiting a Book PCM option to 
only taxpayers that must report revenue on a particular over-time 
basis, such as an input cost-incurred method, could create more 
complexity, not less. Other commenters suggested that, while a Book PCM 
option might achieve some book-tax conformity, they would still want 
the opportunity to take advantage of tax rules that provide more 
beneficial timing than available under Book PCM, such as additional 
first year depreciation. The Treasury Department and the IRS will 
continue studying the feasibility and efficacy of an optional Book PCM 
approach. At this time, however, the Treasury Department and the IRS 
decline to adopt the Book PCM option set forth by commenters because of 
the concerns raised regarding the complexity and the desire by some 
taxpayers to obtain more beneficial timing under tax rules when using a 
Book PCM method.
3. AFS Issues
    No formal comments were received regarding the definition of AFS in 
proposed Sec.  1.451-3(c)(1). Accordingly, the definition of AFS 
remains largely unchanged in these final regulations. See Sec.  1.451-
3(a)(5). One commenter questioned the statutory language in section 
451(b) regarding financial statements prepared using international 
financial reporting standards (IFRS). Specifically, section 
451(b)(3)(B) provides that a financial statement made on the basis of 
IFRS is an AFS for section 451(b) if the financial statement is filed 
with a foreign government agency that is equivalent to the United 
States Securities and Exchange Commission (SEC) and has financial 
reporting standards not less stringent than the standards imposed by 
the SEC. Proposed Sec.  1.451-3(c)(1)(iii)(A) and the final regulations 
Sec.  1.451-3(a)(5)(ii)(A) mirror the statutory language. The commenter 
questioned whether the requirement in section 451(b)(3)(B) that the 
financial reporting standards of a foreign agency or government be not 
less stringent than the standards required by the SEC, refers solely to 
reporting standards related to revenue or if it also refers to 
reporting standards for other items that are not related to revenue. 
The statutory language does not distinguish the reporting standards 
between revenue and other items that are not related to revenue. 
Additionally, Revenue Procedure 2004-34, which was the model for the 
definition of AFS in section 451(b)(3), did not have similar language. 
Accordingly, based on the plain language of the statute, if the 
financial reporting standard for any item is less stringent than SEC 
reporting standards, even if that standard does not relate to revenue 
reporting, the statement will not be an AFS under proposed Sec.  1.451-
3(c)(1)(iii)(A) or Sec.  1.451-3(a)(5)(ii)(A) of the final regulations. 
However, the financial reporting standards relativity requirement does 
not prevent the IFRS financial statements from qualifying as an AFS 
under proposed Sec.  1.451-3(c)(1)(iii)(B) or (C) or Sec.  1.451-
3(a)(5)(ii)(B) or (C) of the final regulations.
    No formal comments were received regarding the AFS issues addressed 
in proposed Sec.  1.451-3(h)(1). Accordingly, the rules regarding an 
AFS that covers a group of entities (consolidated AFS rules) and 
mismatched reporting periods remain largely unchanged in these final 
regulations. However, the Treasury Department and the IRS are aware of 
questions regarding the application of certain aspects of the 
consolidated AFS rules. Under proposed Sec.  1.451-3(h)(1)(i), if a 
taxpayer's results are reported on the AFS for a group of entities, the 
taxpayer's AFS is the group's AFS. Proposed Sec.  1.451-3(h)(3) 
provides that if a group's AFS does not separately state items, the 
portion of the revenue allocable to the taxpayer is determined by 
relying on the source documents that were used to create the group's 
AFS.
    Under the proposed regulations, it was unclear whether the portion 
of the AFS revenue allocable to the taxpayer includes amounts that are 
subsequently eliminated in the group's AFS (consolidated AFS). 
Accordingly, the final regulations clarify that, if the consolidated 
AFS does not separately state items, the portion of the AFS revenue 
allocable to the taxpayer is determined by relying on the taxpayer's 
separate source documents used to create the consolidated AFS and 
includes amounts that are subsequently eliminated in the consolidated 
AFS.

[[Page 820]]

III. Comments and Revisions Regarding Sec.  1.451-8

A. Proposed Sec.  1.451-8(b)(1)(i): Definition of Advance Payment

1. Prepayments for Pre-Need Burial Plots
    Under section 451(c)(4)(A), the term advance payment means any 
payment that meets the following three requirements: (1) The full 
inclusion of the payment in gross income in the year of receipt is a 
permissible method of accounting; (2) any portion of the advance 
payment is included in revenue in an AFS for a subsequent tax year; and 
(3) the advance payment is for goods, services, or such other items 
that the Secretary has identified. Proposed Sec.  1.451-8(b)(1)(i) 
largely mirrors the definition of an advance payment in section 4.01 of 
Revenue Procedure 2004-34, which expands upon the goods, services, and 
other items for which a payment can qualify as an advance payment.
    One commenter requested that the Secretary exercise the authority 
to broaden the definition of advance payment to include prepayments for 
the sale of an interest in real property, including pre-need burial 
plots. If the comment is adopted, prepayments for pre-need burial plots 
would be eligible for the one-year deferral of income.
    Commenters agreed that taxpayers in the death care industry 
uniformly treat the entire amount of the sales price for pre-need 
burial plots as income on an AFS in the year the pre-need contract is 
executed. To qualify as an advance payment, a portion of the prepayment 
must be included in revenue by the taxpayer in an AFS for a subsequent 
taxable year. Section 451(c)(4)(A)(ii). Since prepayments for pre-need 
burial plots cannot meet this requirement, these prepayments cannot 
qualify as advance payments. For this reason, the Treasury Department 
and the IRS decline to adopt this comment in the final regulations.
    No other requests were received to expand the definition of advance 
payment. Accordingly, the list of items that are included in the 
definition of advance payment under proposed Sec.  1.451-8(b)(1)(i) is 
unchanged.
2. Amount of Payment Included in AFS Revenue in a Subsequent Year
    Under section 451(c)(4)(A) and proposed Sec.  1.451-8(a)(1)(i), for 
a payment to qualify as an advance payment, a portion of the payment 
must be included in revenue in an AFS for a subsequent tax year. The 
final regulations clarify that to determine the amount of the payment 
that is taken into account as AFS revenue, the taxpayer must adjust AFS 
revenue for any amounts described in Sec.  1.451-3(b)(2)(i)(A), (C), 
and (D). As a result, to the extent that AFS revenue in the taxable 
year of receipt reflects, for example, a reduction for liabilities that 
are required to be accounted for under provisions such as section 461 
or amounts anticipated to be in dispute, AFS revenue in the taxable 
year of receipt must be increased by such amounts.
    The final regulations make similar clarifying changes to the 
deferral method for taxpayers with an AFS in Sec.  1.451-8(c). Under 
Sec.  1.451-8(c), a taxpayer that uses the deferral method must include 
all or a portion of the advance payment in gross income in the taxable 
year of receipt to the extent ``taken into account as AFS revenue'' as 
of the end of the taxable year of receipt, and include the remaining 
portion of the advance payment in gross income in the following taxable 
year. To determine the extent that an advance payment is treated as 
``taken into account as AFS revenue'' as of the end of the taxable year 
of receipt, the taxpayer must adjust AFS revenue by the amounts 
described in Sec.  1.451-3(b)(2)(i)(A), (C), and (D). Accordingly, to 
the extent that AFS revenue reflects a reduction for liabilities that 
are accounted for under other provisions of the Code such as section 
461 or amounts anticipated to be in dispute, AFS revenue is increased 
by such amounts. Further, if the transaction price, as defined in Sec.  
1.451-3(a)(14), was increased because a significant financing component 
is deemed to exist under the standards the taxpayer uses to prepare its 
AFS, then any AFS revenue attributable to such increase is disregarded.

B. Proposed Sec.  1.451-8(b)(1)(ii)(H): Specified Good Exception

    Proposed Sec.  1.451-8(b)(1)(ii) lists exceptions to the definition 
of an advance payment. Specifically, proposed Sec.  1.451-
8(b)(1)(ii)(H) provides that an advance payment does not include a 
payment received in a taxable year earlier than the taxable year 
immediately preceding the taxable year of the contractual delivery date 
for a specified good. Proposed Sec.  1.451-8(b)(8) defines the 
``contractual delivery date'' as the month and year of delivery listed 
in the written contract to the transaction. A ``specified good'' is 
defined in proposed Sec.  1.451-8(b)(9) as a good for which: (1) The 
taxpayer does not have the goods of a substantially similar kind and in 
a sufficient quantity at the end of the taxable year the upfront 
payment is received; and (2) the taxpayer recognizes all of the revenue 
from the sale of the good in its AFS in the year of delivery. If the 
prepayment satisfies the specified good exception, the prepayment is 
analyzed under section 451(b) and Sec.  1.451-1.
1. Contractual Delivery Date Requirement
    Some commenters generally requested that the Treasury Department 
and the IRS re-examine the contractual delivery date requirement. One 
commenter requested that the definition of contractual delivery date be 
broadened to include contracts where the delivery date can be 
reasonably determined based on all the facts and circumstances as 
provided in the contract. Another commenter requested that the 
exception be modified to cover any contract for the sale or production 
of goods where, based on all of the facts and circumstances, it is 
reasonably certain that the taxpayer's performance to which the advance 
payment relates will in fact take place. The same commenter also 
suggested that if the definition of the contractual delivery date was 
broadened, the requirement regarding the period of time between when an 
advance payment is received and the delivery date for a specified good 
could be modified to require that the expected delivery date occur more 
than 24 months after the advance payment is received.
    The Treasury Department and the IRS decline to adopt the comments 
to broaden the definition of contractual delivery date in the final 
regulations because the suggested approaches would decrease 
administrability and increase uncertainty for taxpayers and the 
potential for litigation. Therefore, the definition of contractual 
delivery date in the final regulations continues to be limited to 
situations where the written contract provides the month and year of 
delivery for the goods.
    In addition, because the Treasury Department and the IRS are not 
broadening the definition of contractual delivery date, it is not 
necessary to limit the specified good exception to situations where 
there is more than 24 months between the date the advance payment is 
received and the contractual delivery date. The recommended rule is 
more restrictive than the rule in the proposed regulation which 
requires the payment to be received in a taxable year earlier than the 
taxable year immediately preceding the taxable year of the contractual 
delivery date. Accordingly, the Treasury Department and the IRS decline 
to adopt this recommendation.

[[Page 821]]

2. Requirement That AFS Revenue Must Be Recognized in the Year of 
Delivery
    One commenter questioned why the specified good exception in the 
proposed section 451(c) regulations is restricted to situations where 
all the revenue from the sale of the good is recognized in the 
taxpayer's AFS in the year of delivery. The commenter requested that 
the exception be expanded to include situations where the taxpayer 
recognizes the revenue for Federal income tax purposes no later than 
the time when the revenue related to the production of the goods is 
recognized for financial accounting purposes. As a result, taxpayers 
using the over-time method to report revenue under ASC 606 could be 
eligible for the exception.
    Payments that qualify for the specified good exception are subject 
to the general accrual method of accounting rules under section 451(a) 
and (b), including the all events test under section 451(b)(1)(C) and 
Sec.  1.451-1(a) and the existing case law that addresses the all 
events test. The specified good exception was narrowly crafted to allow 
a taxpayer meeting the requirements to evaluate its treatment of 
qualifying payments under the all events test under section 
451(b)(1)(C) and Sec.  1.451-1(a) and the existing case law that 
addresses the all events test. Taxpayers that meet the specified good 
exception criteria, unlike those taxpayers that use the over-time 
method to report revenue from the sale of goods under ASC 606, are 
generally not required to test the payment for inclusion under the AFS 
income inclusion rule in section 451(b)(1)(A), as the payment is not 
taken into account as AFS revenue until the specified good is delivered 
to the customer, and is only required to analyze the payment for 
inclusion under the all events test in section 451(b)(1)(C). 
Additionally, taxpayers that use the over-time method under ASC 606 
generally incur production costs as AFS revenue is recognized and can 
therefore benefit from the advance payment cost offset method under 
Sec.  1.451-8(e). However, taxpayers that use the point-in-time method 
to report revenue from the sale of goods under ASC 606 and that meet 
the rest of the specified good exception criteria generally don't incur 
production costs until closer to the delivery date and may not be able 
to benefit from the advance payment cost offset method under Sec.  
1.451-8(e). For these reasons, the Treasury Department and the IRS 
decline to expand the specified good exception to situations where 
taxpayers are using the over-time method to report revenue under ASC 
606.
    For this reason, the Treasury Department and the IRS do not adopt 
this comment. Therefore, the definition of specified good in the final 
regulations retains the requirement that the taxpayer recognizes all of 
the revenue from the sale of the good in its AFS in the year of 
delivery.
3. Integral Services
    A commenter requested that the definition of ``specified good'' in 
proposed Sec.  1.451-8(b)(8) be expanded to include ``integral 
services'' furnished for the good. However, the commenter provided no 
definition of integral services, a term which could be broadly 
construed resulting in audit controversies. Moreover, the Conference 
Report expresses Congress' intent for section 451(c) to override former 
Sec.  1.451-5, which defined an advance payment to include prepayments 
for services that were integral to the sale or disposition of goods. 
See H.R. Rep. No. 115-466, at 429 fn. 880 (2017) (Conf. Rep.). For 
these reasons, the Treasury Department and the IRS decline to accept 
this comment.
4. Reasonable Estimate of Unused Net Operating Loss (NOL)
    One commenter requested that, if certain proposed changes to the 
specified good exception are not adopted, the Treasury Department and 
the IRS should include an exclusion to the definition of ``advance 
payment'' for prepayments where the taxpayer reasonably estimates, 
based on the facts at the time the agreement is entered into, that it 
will have a NOL that remains unused for the 5-year period after the 
year the prepayments received are included in the taxpayer's taxable 
income. The requested rule would be difficult to administer because it 
requires a taxpayer to estimate that it will have an NOL that remains 
unused for a 5-year period after the advance payments are included in 
gross income. Accordingly, the Treasury Department and the IRS decline 
to adopt this comment in the final regulations.
5. Tax Consequences of Meeting the Specified Good Exception
    Several commenters provided examples in which payments that qualify 
for the specified good exception in proposed Sec.  1.451-8(a)(1)(ii)(H) 
are deferred and included in gross income when the payment is 
recognized as revenue in the taxpayer's AFS in the year the good is 
delivered. As mentioned in part III.B.2 of this Summary of Comments and 
Explanation of Revisions and for additional clarification, payments 
that qualify for the specified good exception are subject to the 
general accrual method of accounting rules under section 451(a) and 
(b), including the all events test under section 451(b)(1)(C) and Sec.  
1.451-1 and the existing case law that addresses the all events test.
6. Method To Treat Prepayments Satisfying the Specified Good Exception 
as Advance Payments
    One commenter asked that the specified good exception be made 
optional, particularly if meeting the specified good exception does not 
result in deferral of the prepayment to match the book timing of the 
payment. The commenter noted that some taxpayers may prefer the section 
451(c) regime, especially if there is some uncertainty whether the 
contract meets the specified good exception. Further, some taxpayers 
that had the choice of a longer deferral under Sec.  1.451-5 or a one-
year deferral under Revenue Procedure 2004-34 still chose the 1-year 
deferral.
    The Treasury Department and the IRS agree with this comment. 
Accordingly, the final regulations allow taxpayers to treat all 
prepayments that satisfy the specified good exception as advance 
payments subject to section 451(c), the ``specified good section 451(c) 
method.'' See Sec.  1.451-8(f). The requested election provides 
flexibility for taxpayers. If the taxpayer does not use the specified 
good section 451(c) method, payments satisfying the specified good 
exception are not eligible for the deferral method provided in section 
451(c) and Sec.  1.451-8 but are subject to section 451(b) and Sec.  
1.451-1(a). If the taxpayer uses the specified good section 451(c) 
method, the prepayment is generally deferred for one year; however, if 
a taxpayer also uses the advance payment cost offset method under Sec.  
1.451-8(e) to account for such prepayments, a portion of the prepayment 
may be deferred until the year in which ownership of the good is 
transferred to the customer.
    The specified good section 451(c) method is a method of accounting. 
The method applies to all payments that satisfy the specified good 
exception that are received by each trade or business that uses the 
method. The use of this method results in the adoption of, or a change 
in, a method of accounting under section 446. See Sec.  1.451-8(g).

C. Proposed Sec.  1.451-8(c)(2)(i)(B): Acceleration of Advance Payments

    Under proposed Sec.  1.451-8(c)(2)(i)(B), a taxpayer that uses the 
deferral method generally includes an advance payment in gross income 
when it satisfies its

[[Page 822]]

obligation for the advance payment. Example 11 of proposed Sec.  1.451-
8(c)(8)(xi) provides an example of a travel agent that received 
commission income when it purchased and delivered the ticket to the 
customer but did not include the commission in revenue in its AFS until 
the following year. The example concludes that the commission is not an 
advance payment because it was not earned by the taxpayer in a 
subsequent taxable year.
    Example 11 incorrectly concludes that the payment for the 
commission is not an advance payment. The payment for the commission 
income is an advance payment because it meets the definition of an 
advance payment under section 451(c)(4), including the requirement that 
a portion of the payment is included in the taxpayer's revenue in an 
AFS for a subsequent taxable year. However, the commission income is 
included in income in the year of receipt because the taxpayer's 
obligation with respect to the advance payment was satisfied in that 
year. Accordingly, in the final regulations, this example has been 
moved and revised into an example of the rules on the acceleration of 
advance payments. In addition, the analysis has been changed to clarify 
that (1) the commission income is an advance payment, and (2) the 
taxpayer's satisfaction of its obligation for the advance payment 
caused the commission to be included in income in the year of receipt.

D. Proposed Sec.  1.451-8(c)(5): Contracts With Multiple Performance 
Obligations

    Section 451(c)(4) provides that for purposes of the rules for 
advance payments, rules similar to the rules in section 451(b)(4), 
which allocate transaction price among multiple performance 
obligations, apply. Proposed Sec.  1.451-8(c)(5) provides rules for 
taxpayers with an AFS for allocating the transaction price when there 
is more than one performance obligation in a contract. Specifically, 
those taxpayers allocate the transaction price based on the method in 
proposed Sec.  1.451-3(g), namely, using the allocation in the 
taxpayer's AFS. No formal comments were received on this provision.
    Under the proposed regulations it was not clear whether the 
taxpayer was required to allocate the payment to multiple performance 
obligations based on their relative transaction price or based on the 
payment allocation used for AFS purposes. Accordingly, the final 
regulations clarify that advance payments received under a contract 
with multiple performance obligations are allocated to the 
corresponding item of gross income in the same manner that the payments 
are allocated to the performance obligations in the taxpayer's AFS. 
This rule is consistent with the requirement in section 451(c)(4)(D) 
that ``rules similar to the rules in [section 451](b)(4) shall apply,'' 
because it follows the manner in which the taxpayer allocates the 
payment for AFS purposes.
    The rule for taxpayers without an AFS remains unchanged. See Sec.  
1.451-8(d)(4).
2. Proposed Sec.  1.451-8(c)(6): Contracts With Advance Payments That 
Include Items Subject to a Special Method of Accounting
    The proposed regulations requested comments on the allocation of a 
payment when the contract includes income subject to section 451(c) and 
income subject to section 460, but no comments were received.
    Consistent with the objective criteria standard under Section 
5.02(4) of Rev. Proc. 2004-34, the final regulations provide that if 
(1) a contract with a customer includes item(s) of gross income subject 
to a special method of accounting and item(s) of gross income described 
in Sec.  1.451-8(a)(1)(i)(C), and (2) the taxpayer receives an 
allocable payment, then the taxpayer must determine the portion of the 
payment allocable to the items of gross income described in Sec.  
1.451-8(a)(1)(i)(C) based on objective criteria. The taxpayer is deemed 
to satisfy the objective criteria standard when it allocates the 
payment to each item of gross income in proportion to the amounts 
determined in Sec.  1.451-3(d)(5) or as otherwise provided in guidance 
published in the Internal Revenue Bulletin (see Sec.  601.601(d)).
    This rule is consistent with the requirement in section 
451(c)(4)(D) that ``rules similar to the rules in [section 451](b)(4) 
shall apply.'' The final regulations also provide a similar allocation 
rule for taxpayers using the non-AFS deferral method.

E. Cost Offset for Advance Payments

    The proposed regulations do not provide for a cost offset. The 
preamble to the proposed regulations explains the rationale for 
rejecting a cost offset and requests comments on this issue.
    As they did with respect to the proposed section 451(b) 
regulations, commenters requested that the final regulations under 
section 451(c) provide a cost offset, such as a COGS offset for 
expected future costs against advance payments for the sale of goods. 
Commenters asserted that a COGS offset is supported by the definition 
of ``receipt'' in section 451(c)(4)(C), which refers to an ``item of 
gross income.'' Under section 61 and Sec.  1.61-3(a), for the sale of 
goods, an item of gross income generally means total sales revenue 
minus the cost of goods sold. Commenters cited Hagen Advertising 
Displays, Inc. v. Commissioner, 407 F.2d 1105 (6th Cir. 1969), as 
support for this position. In Hagen Advertising, the Sixth Circuit 
Court of Appeals acknowledged that, to determine the proper amount of 
gross income for advance payments for the sale of goods to be delivered 
in the future, it would be appropriate for a taxpayer to reduce the 
amount of the advance payment by the estimated cost of the goods to be 
delivered. Otherwise, denying an offset for related COGS would tax the 
return of capital. Id. at 1110. Accordingly, commenters asserted that 
denying a COGS offset could result in an impermissible tax on gross 
receipts.
    Commenters also asserted that not allowing a cost offset could 
result in a mismatch of revenue and costs and fails to clearly reflect 
income. According to commenters, a taxpayer would be required to report 
the full amount of an advance payment in income, in excess of the 
expected profit associated with that portion of the total contract 
price being reported. When the costs are actually incurred in 
subsequent years, the taxpayer would report losses with no associated 
revenue, which, in extreme cases where the losses cannot be used, could 
result in a permanent loss of the tax benefit of the cost. For a 
limited-life business, the acceleration of revenue recognition may 
result in NOLs that are permanently lost, as expenses trail income 
throughout the life cycle of the business. The commenters pointed out 
that this mismatch of income and associated costs does not reflect the 
reality of the overall amount of gross income realized by the taxpayer 
on the contract as a whole.
    Further, commenters reasoned that allowing a cost offset under 
section 451(c) will not violate the economic performance requirement of 
section 461(h). Since the acceleration of advance payments under 
section 451(c) is a departure from accrual method accounting, the costs 
related to the payments should also depart from accrual method 
concepts. Commenters pointed out that the allowance of a cost offset 
for expected future COGS against substantial advance payments under 
former Sec.  1.451-5(c), based on Hagen Advertising, coexisted with 
section 461(h) for over 33 years. In addition, the purpose of section 
461(h) was not to eliminate an offset for estimated COGS for inventory 
to be delivered in the near future, but to defer a deduction for costs 
where the obligation was fixed but was

[[Page 823]]

going to be performed many years in the future. Here, commenters 
asserted that a COGS offset would help to determine the proper amount 
of gross income to be accelerated, which is not what the economic 
performance requirement was intended to prevent.
    Commenters also reasoned that section 451(c) was not meant to 
codify all aspects of Revenue Procedure 2004-34, including the lack of 
a cost offset in Revenue Procedure 2004-34. Announcement 2004-48, 2004-
1 C.B. 998, explains that a COGS offset was not permitted in Revenue 
Procedure 2004-34 because it was inconsistent with the simplification 
that the revenue procedure was meant to achieve, and taxpayers could 
still qualify for a COGS offset under former Sec.  1.451-5(c). 
Commenters also found it significant that the term ``receipt'' in 
section 451(c) uses the specific term ``an item of gross income,'' 
while the definition of received in Revenue Procedure 2004-34 uses the 
general term ``income.''
    The Treasury Department and the IRS have considered these comments 
and have determined that a cost offset based on estimates of future 
costs would be inappropriate. As discussed in the preamble to the 
proposed section 451(c) regulations, allowing a cost offset based on 
estimated costs would be inconsistent with sections 461, 263A, and 471, 
and the regulations under those sections of the Code and difficult for 
the IRS to administer. Additionally, allowing a cost offset based on 
estimated costs is inconsistent with Congress' intent to override 
former Sec.  1.451-5(c). Former Sec.  1.451-5(c) permitted a cost 
offset for both incurred and estimated costs against certain advance 
payments that were required to be included in gross income in a taxable 
year prior to the year in which ownership of the item of inventory was 
transferred to the customer, and was recently withdrawn in final 
regulations published in the Federal Register on July 15, 2019. See 
H.R. Rep. No. 115-466, at 429 fn. 880 (2017) (Conf. Rep.); see also, 84 
FR 33691 (July 15, 2019). However, the Treasury Department and the IRS 
agree with comments suggesting that taxpayers should be afforded the 
flexibility of applying an offset for costs incurred against advance 
payments for the future sale of inventory. In this case, the final 
regulations provide that a taxpayer determines the amount of the 
advance payment that is included in gross income for the taxable year 
by reducing the amount that would otherwise be included in gross income 
for such taxable year under the taxpayer's full inclusion method or 
deferral method, as applicable (advance payment inventory inclusion 
amount) by the cost of goods related to the item of inventory, the 
``cost of goods in progress offset.'' The method allows taxpayers to 
offset advance payments included in income under either the full 
inclusion method or under the deferral method. The portion of any 
advance payment that is offset by a cost of goods in progress offset 
for a taxable year is deferred and generally included in gross income 
in the taxable year in which ownership of the item of inventory is 
transferred to the customer.
    Specifically, the final regulations provide that the cost of goods 
in progress offset for an item of inventory for each taxable year is 
calculated as the cost of goods incurred for such item through the last 
day of the taxable year, reduced by the cumulative cost of goods in 
progress offset amounts in prior taxable years, if any. However, the 
cost of goods in progress offset cannot reduce the advance payment 
inventory inclusion amount for the taxable year below zero. Further, 
the cost of goods in progress offset attributable to one item of 
inventory cannot reduce the advance payment inventory inclusion amount 
attributable to a separate item of inventory. Any incurred costs that 
were not used to offset the advance payment for the item of inventory 
because they were subject to limitation are considered when the 
taxpayer determines the cost of goods in progress offset in a 
subsequent taxable year. In addition, the cost of goods in progress 
offset does not apply to the advance payment inventory inclusion amount 
that is included in gross income as a result of the acceleration rules 
in Sec.  1.451-8(c)(4), and any advance payments previously deferred by 
way of a cost of goods in progress offset in a prior year are 
accelerated under such rule.
    The cost of goods in progress offset is determined by reference to 
the costs and expenditures related to items of inventory produced or 
acquired for resale, which costs have been incurred under section 461 
and have been capitalized and included in inventory under sections 471 
and 263A or any other applicable provision of the Code as of the end of 
the year. The taxpayer must be able to demonstrate that the costs are 
properly capitalizable under the Code to the items of inventory 
produced or acquired for resale under the contract to which the 
taxpayer is applying the cost of goods in progress offset. For a sale 
of a gift card or customer reward program points, this requirement 
cannot be met, and no cost of goods in progress offset is permitted. 
However, the cost of goods in progress offset does not reduce the costs 
that are capitalized to the items of inventory produced or acquired for 
resale by the taxpayer under the contract. That is, while the cost of 
goods in progress offset reduces the amount of the advance payment 
included in income, it does not affect how and when costs are 
capitalized to inventory under sections 471 and 263A or any other 
applicable provision of the Code or when those capitalized costs will 
be recovered.
    The costs of goods comprising the cost of goods in progress offset 
must be determined by applying the taxpayer's inventory accounting 
methods. A taxpayer must calculate its cost of goods in progress offset 
by reference to all costs that the taxpayer has permissibly capitalized 
and allocated to items of inventory under its method of accounting for 
inventories for federal income tax purposes, but may not consider costs 
that are not properly capitalized under such method.
    The Treasury Department and the IRS provided this cost offset 
method in the final regulations because it provides a reasonable 
matching of income from advance payments and incurred cost of goods, 
and more clearly reflects income. The advance payment cost offset 
method is a method of accounting that applies to all advance payments 
received by a trade or business for items of inventory that satisfy the 
criteria in Sec.  1.451-8(e). If a taxpayer chooses to use the advance 
payment cost offset method for a trade or business, it must also use 
the AFS cost offset method in Sec.  1.451-3(c) for that trade or 
business. See prior discussion regarding coordination between the AFS 
cost offset method and the advance payment cost offset method. 
Additional guidance on the cost offset method for advance payments may 
be provided in guidance published in the Internal Revenue Bulletin (see 
Sec.  601.601(d)).

F. Continued Application of Revenue Procedure 2004-32 and Revenue 
Procedure 79-38

    Commenters requested clarification of whether Revenue Procedure 
2004-32, 2004-1 C.B. 988, and Revenue Procedure 79-38, 1997-2 C.B. 501, 
remain in effect after the enactment of section 451(c). Revenue 
Procedure 2004-32 allows an accrual method taxpayer to account for 
income from credit card annual fees ratably over the period covered by 
the fees, as described in section 4 of Revenue Procedure 2004-32. 
Revenue Procedure 79-38 generally allows accrual method manufacturers, 
wholesalers, and retailers of motor vehicles or other durable goods to 
include a portion of an

[[Page 824]]

advance payment related to the sale of a multi-year service warranty 
contract in gross income over the life of the service warranty 
obligation. Revenue Procedure 2004-32 and Revenue Procedure 79-38 
remain effective after the enactment of section 451(c) and may be 
relied upon after these regulations are finalized.

Effect on Other Documents

    The preamble to proposed Sec.  1.451-3 requested comments on the 
proposed obsolescence of Revenue Procedure 2004-33, 2004-1 C.B. 989 
(relating to credit card late fees), Revenue Procedure 2005-47, 2005-2 
C.B. 269 (relating to credit card cash advance fees), Revenue Procedure 
2013-26, 2013-22 I.R.B. 1160 (relating to a safe harbor method of 
accounting for OID on a pool of credit card receivables), and Chief 
Counsel Notice CC-2010-018 (relating to interchange). Instead of 
obsoleting Revenue Procedure 2013-26, commenters recommended limiting 
the scope of Revenue Procedure 2013-26 to OID that is not subject to 
the timing rules in proposed Sec.  1.451-3(i) and thus, not excluded 
from the OID rules under proposed Sec.  1.1275-2(l). Commenters 
explained that retaining Revenue Procedure 2013-26 would allow 
taxpayers to continue to use the proportional method described in the 
revenue procedure as a safe harbor method of accounting for certain 
amounts that are not OID under section 1272, such as bond premium and 
market discount, as well as certain kinds of OID such as promotional 
discount. See discussion of promotional discount in part II.F. of the 
Summary of Comments and Explanation of Revisions. The Treasury 
Department and the IRS agree with the recommendations not to obsolete 
Revenue Procedure 2013-26. In addition, the Treasury Department and the 
IRS intend to modify Revenue Procedure 2013-26 to make clear that the 
safe harbor method does not apply to any specified fees, including the 
specified credit card fees. However, based on section 451(b) and the 
final regulations, Revenue Procedure 2004-33, Revenue Procedure 2005-
47, and Chief Counsel Notice CC-2010-018 no longer provide current 
guidance on the treatment of the specified credit card fees. 
Accordingly, these items are obsolete as of January 1, 2021.
    In addition, Revenue Procedure 2004-34, Revenue Procedure 2011-18, 
Revenue Procedure 2013-29 and Notice 2018-35 are obsolete for taxable 
years beginning on or after January 1, 2021. Taxpayers that relied on 
the now obsoleted guidance should determine whether a change in method 
of accounting occurs once they cease to use the obsoleted guidance.

Applicability Dates

    In general, the rules in Sec. Sec.  1.451-3 and 1.451-8 apply for 
taxable years beginning on or after January 1, 2021. However, the rules 
in Sec.  1.451-3(j) for specified fees that are not specified credit 
card fees apply for taxable years beginning on or after January 6, 
2022. Also, for a specified credit card fee as defined in Sec.  1.451-
3(j)(2), Sec.  1.1275-2(l)(1) applies for taxable years beginning on or 
after January 1, 2021, and, for a specified fee that is not a specified 
credit card fee, Sec.  1.1275-2(l)(1) applies for taxable years 
beginning on or after January 6, 2022.
    However, pursuant to section 7805(b)(7), taxpayers and their 
related parties, within the meaning of sections 267(b) and 707(b), may 
apply the rules in these final regulations, in their entirety and in a 
consistent manner, to a taxable year beginning after December 31, 2017, 
and before January 1, 2021, provided that, once applied to such a 
taxable year, such rules are applied in their entirety and in a 
consistent manner to all subsequent taxable years. Notwithstanding the 
preceding sentence, pursuant to section 7805(b)(7), taxpayers and their 
related parties, within the meaning of sections 267(b) and 707(b), may 
apply the rules in these final regulations that apply to specified 
credit card fees in their entirety and in a consistent manner, to a 
taxable year beginning after December 31, 2018, and before January 1, 
2021, provided that, once applied to such a taxable year, such rules 
are applied in their entirety and in a consistent manner to all 
subsequent taxable years. Taxpayers that choose to apply the rules in 
the final regulations to a taxable year beginning before January 1, 
2021 must follow the rules for changes in method of accounting under 
section 446 and the applicable procedural guidance.
    Alternatively, a taxpayer may rely on the proposed regulations for 
taxable years beginning after December 31, 2017 (or December 31, 2018, 
in the case of specified credit card fees) and before January 1, 2021.
    In the case of a specified fee that is not a specified credit card 
fee, a taxpayer may neither choose to apply the final regulations to, 
nor rely on the proposed regulations for, a taxable year beginning 
after December 31, 2018, and before January 6, 2022.

Statement of Availability of IRS Documents

    The IRS Notices, Revenue Rulings, and Revenue Procedures cited in 
this document are published in the Internal Revenue Bulletin (or 
Cumulative Bulletin) and are available from the Superintendent of 
Documents, U.S. Government Publishing Office, Washington, DC 20402, or 
by visiting the IRS website at https://www.irs.gov.

Special Analyses

I. Regulatory Planning and Review--Economic Analysis

    Executive Orders 12866, 13563, and 13771 direct agencies to assess 
costs and benefits of available regulatory alternatives and, if 
regulation is necessary, to select regulatory approaches that maximize 
net benefits (including potential economic, environmental, public 
health and safety effects, distributive impacts, and equity). Executive 
Order 13563 emphasizes the importance of quantifying both costs and 
benefits, of reducing costs, of harmonizing rules, and of promoting 
flexibility. For purposes of E.O. 13771 this rule is regulatory.
    These regulations have been designated as subject to review under 
Executive Order 12866 pursuant to the Memorandum of Agreement (April 
11, 2018) between the Treasury Department and the Office of Management 
and Budget (OMB) regarding review of tax regulations. The Office of 
Information and Regulatory Affairs has designated these regulations as 
economically significant under section 1(c) of the MOA. Accordingly, 
the OMB has reviewed these regulations.

A. Need for the Final Regulations

    The Tax Cuts and Jobs Act (TCJA) substantially modified the 
statutory rules of section 451, which generally governs when income is 
recognized for Federal tax purposes. As a result of those changes, the 
Treasury Department and the IRS recognized that questions were likely 
to arise regarding the definitions and rules that taxpayers are 
required to apply in calculating a business's gross income. To provide 
greater specificity, the Treasury Department and the IRS previously 
issued separate proposed regulations related to section 451(b) and 
451(c) on September 9, 2019.
    The proposed regulations regarding section 451(b): (1) Clarify how 
section 451(b) applies to multi-year contracts; (2) provide rules for 
taxpayers whose financial results are included on an Applicable 
Financial Statement (AFS) covering a group of entities; (3) describe 
and clarify the definition of transaction price and revenue; (4) 
specify the allocation of a transaction price in the

[[Page 825]]

case of a contract which contains multiple performance obligations; and 
(5) specify rules for certain debt instruments.
    The proposed regulations for section 451(c) describe the deferral 
rules for advance payments for taxpayers with and without an AFS; (2) 
provide acceleration rules for taxpayers that cease to exist; (3) 
clarify the treatment of financial statement adjustments for taxpayers 
with deferred advance payments; (4) provide rules relating to the 
treatment of short taxable years for taxpayers deferring advance 
payments; and (5) define and clarify the treatment of performance 
obligations. They also list items excluded from the definition of an 
advance payment. In response to taxpayer comments received during the 
development of the proposed regulations, that list includes goods for 
which (1) the taxpayer does not have goods of a substantially similar 
kind and in a sufficient quantity at the end of the taxable year the 
upfront payment is received; and (2) the taxpayer recognizes all of the 
revenue from the sale of the good in its AFS in the year of delivery.
    Comments were received on the proposed regulations for 451(b) and 
451(c) requesting further clarification of or changes to those 
regulations. Based on these comments, the Treasury Department and the 
IRS determined that final regulations are needed to bring clarity to 
instances where the statute may be subject to multiple interpretations 
in the absence of further guidance and to respond to comments received 
on the proposed regulations. Among other benefits, the final 
regulations provide greater certainty and consistency in the 
application of section 451 by taxpayers and the IRS.

B. Background and Overview of Final Regulations

    Under section 451(a) of the Code, income is ``recognized'' (that 
is, included in gross income for tax purposes) in the year in which it 
is received by the taxpayer unless it is properly accounted for in a 
different period under the taxpayer's method of accounting. Because of 
this latter condition, the tax treatment of certain items of income 
depends on the method of accounting a taxpayer is using. For taxpayers 
using the accrual method of accounting, income is generally recognized 
in the year in which all events have occurred that fix the right to 
receive that income and the amount of income can be determined with 
reasonable accuracy (all events test).
    The timing of income recognition on a firm's financial statement 
may deviate from these principles. Both the U.S. generally accepted 
accounting principles (GAAP) and the international financial reporting 
standards (IFRS) provide income recognition rules that differ from tax 
reporting rules under certain circumstances. For example, financial 
accounting rules may require revenue to be recognized when the costs of 
providing goods or services pursuant to a contract are incurred, while 
the all-events test may not be satisfied until the contract obligation 
is fulfilled. New accounting standards released by the Financial 
Accounting Standards Board (FASB) and the International Accounting 
Standards Board (IASB) in 2014 further accelerated the timing of income 
recognition for financial reporting purposes, widening the gap between 
financial and tax reporting.
    The timing of income recognition for tax purposes may also deviate 
from the all-events test in certain circumstances. For instance, 
receipt of payment by the business satisfies the all events test. 
However, recognition of certain payments for goods or services not yet 
provided may be deferred to the year following receipt of payment, to 
the extent that recognition is also deferred on the taxpayer's AFS. 
Such payments are referred to as ``advance payments.''
    Prior to the enactment of TCJA on December 22, 2017, taxpayers were 
generally permitted to defer the tax on these advance payments; in 
other words, advance payments could be recognized in a later taxable 
year. Under prior law, the period over which an advance payment was 
deferred varied depending on the alternative regulatory treatment 
chosen (Revenue Procedure 2004-34 or Sec.  1.451-5) and, within Sec.  
1.451-5, the type of good for which an advance payment was accepted 
(inventoriable goods versus non-inventoriable goods).
    Under Revenue Procedure 2004-34, a taxpayer who receives an advance 
payment includes the advance payment in taxable income in the year of 
receipt to the extent that the payment is earned (if the taxpayer does 
not have an AFS) or, if the taxpayer has an AFS, to the extent that the 
payment is included in revenues in the AFS. The taxpayer includes the 
remaining amount of the advance payment in taxable income in the next 
taxable year, unless the next taxable year is a short year of 92 days 
or less. In the event of such a short year, the taxpayer includes in 
taxable income the part of the advance payment included in revenue in 
the AFS for the short tax year or, in the case of a taxpayer that does 
not have an AFS, the part of the advance payment which is earned in the 
short tax year. The remaining balance of the advance payment is 
included in income for the taxable year following the short tax year. 
Revenue Procedure 2004-34 applies to numerous types of advance payments 
beyond advance payments for the provision of services and sales of 
goods. For example, it applies to advance payments for the use of 
intellectual property and software, the occupancy or use of property if 
the occupancy or use is ancillary to the provision of services, 
guaranty or warranty contracts, subscriptions, memberships in 
organizations, and eligible gift card sales.
    Under Sec.  1.451-5, advance payments were defined more narrowly 
than under Revenue Procedure 2004-34 to include payments received by an 
accrual-method taxpayer for the future sale of goods held by the 
taxpayer in the ordinary course of trade or business and as payments 
for the building, installing, constructing, or manufacturing of goods 
by the taxpayer in a future taxable year. Such advance payments were 
generally included in taxable income either in the year of receipt or 
in the year in which the payment was properly accruable under the 
taxpayer's method of accounting.
    An exception to this general rule occurred in the case of certain 
advance payments for certain goods properly held in inventory by the 
taxpayer. In the case of such goods, the receipt of a substantial 
advance payment required that all previously unrecognized advance 
payments be included in taxable income by the end of the second taxable 
year following the taxable year in which the substantial advance 
payment was received. The taxpayer was considered to have received a 
substantial advance payment if the sum of the advance payment received 
in the current taxable year and prior taxable years for the same 
contract was greater than or equal to total inventoriable costs and 
expenditures.
    The TCJA substantially amended section 451 providing, among other 
things, new rules addressing deviations from the all-events test. The 
amended section 451(b) more closely aligns when income is recognized 
for Federal tax purposes with when it is recognized on businesses' 
financial accounting statements. In particular, section 13221 of the 
TCJA amends section 451(b), such that an item of gross income must be 
included in gross income no later than the period when the item is 
included in revenue on an AFS. Thus, this new rule requires taxpayers 
to recognize income upon the earlier of when the all-events test is met 
or when the taxpayer includes the amount in revenue

[[Page 826]]

(broadly defined) in its AFS (AFS income inclusion rule). For these 
taxpayers, income recognition is accelerated for tax purposes when 
income has been recognized for financial accounting purposes before the 
all events test has been satisfied.
    The amendments made to section 451(b) only apply to taxpayers that 
use accrual accounting and have an AFS. Neither the statutory changes 
to 451(b) nor the final regulations regarding 451(b) change the time at 
which income is recognized for accrual method taxpayers without an AFS.
    Section 451(c), added by the TCJA, allows accrual-method taxpayers 
to elect to recognize as income only a portion of an advance payment in 
the taxable year in which it is received, and then recognize the 
remainder in the following taxable year. Section 451(c) essentially 
codifies the deferral method of accounting for advance payments that 
was permitted in Revenue Procedure 2004-34. (Joint Committee on 
Taxation, General Explanation of Public Law 115-97, (Washington, U.S. 
Government Publishing Office, December 2018), at 167.) The new section 
451(c), a subject of the final regulations, addresses how advance 
payments are defined and when they need to be recognized in a 
business's gross income.

C. Economic Analysis

1. Baseline
    In this analysis, the Treasury Department and the IRS assess the 
benefits and costs of the final regulations relative to a no-action 
baseline reflecting anticipated Federal income tax-related behavior in 
the absence of these final regulations.
2. Summary of Economic Effects
    The final regulations provide certainty and consistency in the 
application of sections 451(b) and 451(c) by providing definitions and 
clarifications regarding the statute's terms and rules. In the absence 
of the guidance provided in these final regulations, the chance that 
different taxpayers might interpret the statute differently is 
exacerbated. For example, two similarly situated taxpayers might 
interpret the statutory provisions pertaining to the definition of 
advanced payments differently, with one taxpayer pursuing a project 
that another comparable taxpayer might decline because of a different 
interpretation of how the income may be treated under section 451(c). 
If this second taxpayer's activity is more profitable, an economic loss 
arises. Similar situations may arise under each of the provisions 
addressed by these regulations. Certainty and clarity over tax 
treatment generally also reduce compliance costs for taxpayers.
    An economic loss might also arise if all taxpayers have similar 
interpretations under the baseline of the tax treatment of particular 
items of income but those interpretations differ slightly from the 
interpretation Congress intended for these income streams. For example, 
the final regulations may specify a tax treatment that few or no 
taxpayers would adopt in the absence of specific guidance but that 
nonetheless advances Congressional intent. In these cases, guidance 
provides value by bringing economic decisions closer in line with the 
intent and purpose of the statute.
    While no guidance can curtail all differential or inaccurate 
interpretations of the statute, the final regulations significantly 
mitigate the chance for differential or inaccurate interpretations and 
thereby increase economic efficiency.
    Because the final regulations clarify the tax treatment of items of 
gross income for certain taxpayers, there is the possibility that 
business decisions may change as a result of these regulations. The 
final regulations generally have the effect of delaying the timing of 
tax liability, thus reducing effective tax rates for affected 
taxpayers. This reduction in effective tax rates, viewed in isolation, 
will generally lead to an increase in economic activity by these 
taxpayers.
    This delay in the timing of tax liability, viewed in isolation, 
will also decrease Federal tax revenue. A decrease in Federal tax 
revenue either increases the deficit or necessitates increases in other 
taxes or a reduction in spending. This revenue effect will be mitigated 
to some degree by improved economic performance (and accompanying tax 
revenues) under these regulations due to (i) the enhanced alignment in 
the timing of taxes on income and costs; (ii) the enhanced certainty 
and clarity provided by the final regulations as described previously; 
and (iii) enhanced economic activity due to lower effective tax rates 
for affected taxpayers.
    The Treasury Department and the IRS have not estimated these 
effects relative to the no-action baseline or alternative regulatory 
approaches because they do not have readily available data or models 
that measure: (i) The volume of cost offsets allowed under the final 
regulations; \1\ (ii) the effect on economic activity by affected 
taxpayers from the enhanced alignment of income and costs under the 
final regulations relative to the no-action baseline or alternative 
regulatory approaches; (iii) the tax positions that taxpayers would 
take on other provisions of the final regulations, relative to the no-
action baseline or alternative regulatory approaches; or (iv) the 
economic activities that taxpayers would engage in under those tax 
positions.
---------------------------------------------------------------------------

    \1\ Cost offsets are not reported on current tax returns and 
will not be separately reported on future tax returns.
---------------------------------------------------------------------------

    The Treasury Department and the IRS have also not made projections 
of any change in compliance costs arising from the final regulations, 
relative to the no-action baseline. Treasury generally projects that 
compliance costs will be lower under the final regulations relative to 
the no-action baseline because enhanced clarity and certainty reduce 
compliance costs. The Treasury Department and the IRS recognize that 
some taxpayers may take advantage of favorable provisions in the final 
regulations and that this decision could increase their compliance 
costs. Taxpayers would not take advantage of these provisions, however, 
unless the overall treatment was beneficial to the taxpayer.
    The proposed regulations noted that the economic analysis of the 
final regulations under section 451(c) would address the economic 
effects of regulatory guidance, if any, under sections 460 and 461(h) 
or other sections of the Code that interact with section 451(c), that 
was issued between the proposed and final regulations. Since the 
release of the proposed regulations on September 5, 2019, no such 
regulatory guidance has been issued.
    The proposed regulations for 451(b) and 451(c) solicited comments 
on the economic effects of the proposed regulations. No such comments 
were received.
3. Number of Affected Taxpayers
    The Treasury Department and the IRS estimate that between 174,000 
and 299,000 entities are likely to be affected by the final 
regulations.
    Section 451(b) and (c) and the regulations under Sec.  1.451-3 
affect only those business entities that (i) use an accrual method of 
accounting, and (ii) have an AFS. One provision in Sec.  1.451-8 
applies to accrual method taxpayers without an AFS. Regarding the 
accrual method of accounting, section 13102 of TCJA modified section 
448 to expand the number of taxpayers eligible to use the cash receipts 
and disbursements method of accounting (cash method of accounting). In 
general, C corporations and partnerships with a C corporation

[[Page 827]]

partner are now permitted to use the cash method of accounting if 
average annual gross receipts are $25 million or less for taxable years 
beginning in 2018 (up from $5 million or less in 2017). This amount was 
adjusted for inflation for taxable years beginning after December 31, 
2018. The amount was $26 million in taxable year 2019.
    The statute and the regulations generally affect only those 
entities that also have an AFS although one provision in the 
regulations under Sec.  1.451-8 applies to non-AFS taxpayers. The 
Treasury Department and the IRS do not have readily available data to 
measure the prevalence of these affected entities. However, Schedule M-
3, which is used to reconcile an entity's net income or loss for tax 
purposes with its book income or loss, reports whether an entity has a 
certified audited income statement. Schedule M-3 is required to be 
filed only by entities with at least $10 million of assets. This 
population is more likely to possess an AFS and, conversely, entities 
that do not file Schedule M-3 are less likely to possess an AFS or 
otherwise be affected by the regulations as owners and/or creditors of 
such smaller entities are less likely to require the entity to certify 
its financial results via a financial statement audit. Data are 
currently available only for electronic filers.
    The Treasury Department and the IRS estimated the number of 
affected taxpayers separately for entities with gross receipts of $26 
million or less and those with gross receipts above $26 million. For 
taxable year 2017, 89 percent of accrual-method entities filing Forms 
1120, 1120-S, and 1065 with gross receipts of $26 million or less were 
filers of electronic tax forms. About 11 percent, or 288,000 returns, 
included a Schedule M-3. About 40 percent of the returns with Schedule 
M-3, or 113,000, indicated they had a certified audited income 
statement.\2\ Based on the assumption that filers of paper tax forms 
have the same incidence as electronic filers and that entities that do 
not file a Schedule M-3 generally do not have an AFS, then the Treasury 
Department and the IRS estimate that roughly 127,000 (113,000/0.89) 
entities with gross receipts of $26 million or less are accrual-method 
entities that have an AFS. If 5 percent of entities that do not file a 
Schedule M-3 also have an AFS, then approximately 251,000 of these 
entities are potentially impacted by the final regulations.
---------------------------------------------------------------------------

    \2\ Data are based on estimates from the IRS's Research, Applied 
Analytics and Statistics Division using data from the Compliance 
Data Warehouse.
---------------------------------------------------------------------------

    For entities with gross receipts above $26 million and that are 
accrual method entities, the comparable calculations are that 95 
percent of returns are e-filed and that 73 percent of those included a 
Schedule M-3. Based on the assumption that filers of paper tax forms 
have the same incidence as electronic filers and that entities that do 
not include a Schedule M-3 generally do not have an AFS, the Treasury 
Department and the IRS estimate that 47,000 (45,000/0.95) entities with 
gross receipts above $26 million are accrual-method entities that have 
an AFS. If 5 percent of entities that do not file a Schedule M-3 also 
have an AFS, then approximately 48,000 of these entities are 
potentially affected by these regulations.
    Together, these calculations imply that between 174,000 and 299,000 
entities are potentially affected by the final regulations.

                  Corporation and Partnership Returns Using an Accrual Method of Accounting ***
                                    [Taxable year 2017; thousands of returns]
----------------------------------------------------------------------------------------------------------------
                                  Entities with gross receipts not        Entities with gross receipts  greater
                                      greater than $26 million                      than $26 million
                             -----------------------------------------------------------------------------------
                                 E-filed     Paper-filed      Total        E-filed     Paper-filed      Total
----------------------------------------------------------------------------------------------------------------
Returns.....................         2,503           307         2,810            73             4            77
Returns with a Schedule M-3.           288          * 35         * 323            62           * 3          * 65
Returns with a Schedule M-3            113          * 14         * 127            45           * 2          * 47
 and an audited income
 statement..................
Returns without a Schedule M-        2,215         * 272       * 2,487            11           * 1          * 12
 3..........................
Returns without a Schedule M-       ** 111         ** 13        ** 124          ** 1          ** 0          ** 1
 3, but with an audited
 income statement
 (estimated)................
Returns with an audited             ** 224         ** 27        ** 251         ** 46          ** 2         ** 48
 income statement...........
----------------------------------------------------------------------------------------------------------------
* Estimates are obtained by assuming paper-filed returns are similar to e-filed returns as regards the incidence
  of a filing entity having a Schedule M-3 and an audited income statement.
** Estimates are obtained by assuming that 5 percent of returns without a Schedule M-3 have an audited income
  statement.
*** This table does not include sole proprietorships because the number of sole proprietorships with gross
  receipts above $26 million that used accrual accounting was statistically indistinguishable from zero in 2017.
  The number of sole proprietorships with gross receipts of $26 million or below that are affected by these
  regulations is projected to be minimal.
Source: Data compiled by the IRS Research, Applied Analytics and Statistics Division using data from the
  Compliance Data Warehouse. The total number of accrual method returns of corporations and partnerships may
  differ slightly from other estimates due to different data sources.

4. Economic Effects of Provisions Under Section 451(b)
a. Provisions Substantially Revised From the Proposed Section 451(b) 
Regulations
i. Cost Offset Under Section 451(b)
    Section 451(b) as amended by TCJA addresses the timing of revenue 
recognition for tax purposes but makes no mention of the timing of cost 
recognition. The Treasury Department and the IRS considered three 
options for addressing the treatment of costs under section 451(b): (i) 
Do not allow a cost offset; (ii) allow a cost offset for incurred 
costs; and (iii) expand the allowance for incurred costs by further 
allowing a cost offset for projected costs. The proposed regulations 
did not provide a cost offset for the AFS income inclusion rule.
    In the proposed section 451(b) regulations (in this part C.4, 
proposed regulations), the Treasury Department and the IRS argued that 
allowing a cost offset would be inconsistent with the economic 
performance rules under section 461 and inventory accounting rules 
under section 471. The proposed regulations further argued that 
Congress did not make clear any intention to alter those sections of 
the Code or their

[[Page 828]]

associated regulations. The proposed regulations stated, however, that 
the subject was still under consideration and requested comments 
addressing appropriate cost offset rules.
    In response to the comments received, the Treasury Department and 
the IRS have decided to include in the final regulations an offset for 
the cost of goods in progress (cost offset). This cost offset allows 
taxpayers to reduce the amount of revenue from the sale of inventory 
that is otherwise required to be included in gross income under the AFS 
income inclusion rule in a taxable year prior to the year in which 
ownership of the inventory is transferred to the customer and defer 
such revenue to the taxable year in which the ownership of the 
inventory is transferred to the customer. The amount of such reduction, 
or cost offset, is determined by reference to the inventoriable costs 
incurred to date. The offset applies only to incurred costs, not 
estimated or projected costs. Further, the cost offset cannot reduce 
the amount of revenue that is included in gross income under the AFS 
inclusion rule below zero. Any incurred costs subject to this 
limitation may be carried forward to determine the cost offset in 
subsequent taxable years.
    The cost offset in the final regulations generally reduces the 
amount of revenue that is required to be included in gross income in a 
taxable year prior to the year in which ownership of inventory is 
transferred to the customer relative to the proposed regulations. An 
improved match of income and cost timing is generally held to provide a 
more accurate measure of economic activity and thus would lead to a 
more efficient tax system than under the proposed regulations, within 
the context of the statute and the overall Code.
    This enhanced alignment in the tax treatment of revenue and costs 
can be expected to reduce financing costs for at least some projects 
and taxpayers. This reduction in financing costs relative to the 
proposed regulations may arise because in some cases under the proposed 
regulations, the inability of taxpayers to match the timing of revenue 
and cost associated with a project leads to a large, front-loaded tax 
liability, which may require a costly rebalancing of other assets, 
particularly for liquidity-constrained taxpayers. Taxpayers who 
experience a reduction in financing costs as a result of these final 
regulations, relative to the proposed regulations, may, as a result, 
increase other expenditures, including investment. The provision of the 
cost offset in the final regulations may further encourage longer-run 
projects relative to the proposed regulations.
    The Treasury Department and the IRS considered expanding the cost 
offset to allow for projected costs, with several possible formats for 
how projected costs would be accounted for. Allowing an offset for 
projected costs would entail a higher administrative burden than the 
offset (only) for incurred costs and would not definitively improve the 
alignment of when income and costs are recognized for tax purposes 
relative to the offset for incurred costs. The Treasury Department and 
the IRS project that under an offset for projected costs, more disputes 
would likely arise over the projected costs because taxpayers would 
have an incentive to overstate projected costs in order to delay income 
recognition.
    The Treasury Department and the IRS have not estimated the 
difference in compliance costs, administrative burden, or income-cost 
alignment (and any subsequent effects on economic activity) between the 
final regulations and alternative regulatory approaches using projected 
costs. The Treasury Department and the IRS have not undertaken this 
estimation because they do not have sufficiently detailed data or 
models that capture possible differences in cost offset formats that 
use incurred costs versus projected costs.
ii. Scope of the AFS Income Inclusion Rule
    The final regulations also address concerns raised by commenters 
regarding recent changes to the financial accounting standards. The 
commenters suggested that the AFS inclusion rule is overly broad in 
light of these new standards, which generally accelerate AFS revenue 
recognition relative to the prior standards, and could cause taxpayers 
to incur a tax liability before they receive, or have a fixed right to 
receive, the money to pay the liability. Accordingly, the final 
regulations provide that under the AFS inclusion rule, amounts taken 
into account as AFS revenue include only those amounts that the 
taxpayer has an enforceable right to recover if the customer were to 
terminate the contract at the end of the taxable year.
    The final regulations further provide, however, that a taxpayer may 
treat any amount reported as AFS revenue as being taken into account as 
AFS revenue regardless of whether the taxpayer has an enforceable right 
to recover such amounts. The Treasury Department and the IRS project 
that this option will lead to reduced compliance burden, reduced 
administrative burden, and to fewer taxpayer disputes relative to an 
alternative regulatory approach under which amounts taken into account 
as AFS revenue include only those amounts that the taxpayer has an 
enforceable right to recover if the customer were to terminate the 
contract at the end of the taxable year. Under this ``enforceable 
right'' approach, taxpayers would be required to analyze each contract 
to determine amounts for which the taxpayer has an enforceable right to 
recover if the customer were to terminate the contract at the end of 
the year; this analysis would be potentially costly.
    The Treasury Department and the IRS also considered an alternative 
regulatory approach under which taxpayers would be permitted to defer 
``increases'' in the transactions price that are taken into account as 
AFS revenue in a given year but to which a taxpayer's entitlement is 
contingent on a future event (contingent transaction price approach). 
This alternative regulatory approach was reflected in the proposed 
regulations. However, commenters expressed confusion as to what 
constitutes an ``increase'' in the transaction price and the types of 
contingencies that were intended to be included within the scope of the 
rule. Because of the uncertainties created by the contingent 
transaction price approach, and the potential for multiple 
interpretations, the Treasury Department and the IRS decided against 
this approach. The enforceable right standard adopted by the final 
regulations may accelerate income inclusion relative to the contingent 
transaction price approach, although the Treasury Department and the 
IRS recognize that the opposite result may hold for some taxpayers.
    The Treasury Department and the IRS have not estimated the 
differences in income inclusion between the final regulations and this 
alternative regulatory approach because they do not have readily 
available data on the income inclusion timing differences under an 
enforceable right standard versus the contingent transactions price 
approach. Because of this lack of data, the Treasury Department and the 
IRS have further not estimated the difference in compliance costs 
between the final regulations and the alternative regulatory approach.
b. Provisions Not Substantially Revised From the Proposed Section 
451(b) Regulations
i. Application of the AFS Income Inclusion Rule to Multi-Year Contracts
    The final regulations clarify how section 451(b) applies to multi-
year contracts. The Treasury Department and

[[Page 829]]

the IRS considered two alternative approaches for such contracts: (i) 
An annual approach and (ii) a cumulative approach. Under an annual 
approach, for each taxable year under the contract a taxpayer would 
compare the amount of income taken into account as AFS revenue for that 
taxable year and the amount of income that meets the requirements for 
recognition under the all events test for that same taxable year to 
determine its gross income inclusion for that taxable year; that is, 
the taxpayer would include the larger of the two amounts. The total 
amount of gross income recognized under the contract through the end of 
such taxable year is not to exceed the total contract price.
    In contrast, under a cumulative approach, in each taxable year a 
taxpayer would compare the cumulative amount of revenue included in its 
AFS up to and including that taxable year with the cumulative amount of 
income that meets the requirements for recognition under the all events 
test up to and including that taxable year. The taxpayer would then 
take the larger of the two amounts and reduce it for any prior taxable 
year income inclusions with respect to that item of gross income to 
determine the amount that is required to be included in gross income in 
the current taxable year.
    The difference between the annual approach and the cumulative 
approach are illustrated by the following example. In 2021, D, an 
engineering services provider, enters into a non-severable contract 
with a customer to provide engineering services through 2024 for a 
total of $100x. Under the contract, D receives payments of $25x in each 
calendar year of the contract. For its AFS, D reports $50x, $0, $20x, 
and $30x of AFS revenue from the contract for 2021, 2022, 2023, and 
2024, respectively. D has an enforceable right, as defined in Sec.  
1.451-3(a)(9), to recover all amounts reported as AFS revenue through 
the end of a given contract year if the customer were to terminate the 
contract on the last day of such year. The $25x payment received for 
2023 is an advance payment, as defined in Sec.  1.451-8(a)(1), because 
$5x of the $25x payment is reported as AFS revenue for 2024. D uses the 
full inclusion method for advance payments.
    The accompanying table shows the treatment of gross income under 
the two approaches.

----------------------------------------------------------------------------------------------------------------
                                       2021            2022            2023            2024            Total
----------------------------------------------------------------------------------------------------------------
Payments........................            $25x            $25x            $25x            $25x           $100x
AFS Revenue.....................             50x              0x             20x             30x            100x
Gross Income (cumulative                     50x              0x             25x             25x            100x
 approach)......................
Gross Income (annual approach)..             50x             25x             25x              0x            100x
----------------------------------------------------------------------------------------------------------------

    An annual approach could accelerate the recognition of taxable 
income to a greater degree than what is reflected in revenue for AFS 
purposes. In this example, such an approach would ignore in 2022 the 
fact that cumulative AFS revenue of $50x had been recognized as taxable 
gross income in 2021. Accordingly, the annual approach would require 
that an additional $25x of income be recognized in 2022, since a 
payment of that amount was received in that year. In effect, an annual 
approach would accelerate the recognition of $25x from 2023 to 2022 
relative to gross income recognition under the cumulative AFS income 
inclusion rule.
    The Treasury Department and IRS concluded that the extent of 
acceleration of income that may occur when using an annual approach 
would be excessive relative to the cumulative approach when considered 
against the intent and purpose of the statute. The final regulations 
therefore adopt the cumulative approach.
    The Treasury Department and the IRS have not estimated the 
difference in compliance costs, administrative burden, or economic 
activity between the final regulations and an alternative regulatory 
approach of using an annual comparison. The Treasury Department and the 
IRS have not undertaken this estimation because they do not have 
sufficiently detailed data or models that capture possible differences 
in taxpayers' income inclusions under these two alternative regulatory 
approaches.
ii. Applicable Financial Statement Covering a Group of Entities
    The final regulations provide rules for taxpayers whose financial 
results are included on an AFS covering a group of entities. These 
rules specify that, if a taxpayer's financial results are reported on 
the AFS for a group of entities, the taxpayer's AFS is the group's AFS. 
However, if the taxpayer also reports financial results on a separate 
AFS that is of equal or higher priority, then the separate AFS is the 
taxpayer's AFS. The rules also specify how a taxpayer using a group AFS 
is to determine the amount of revenue allocated to the taxpayer. The 
Treasury Department and the IRS considered as an alternative not 
providing substantive rules on how taxpayers should apply the AFS 
income inclusion rule when their financial results are included in an 
AFS for a group of entities. This alternative was rejected because it 
would have increased compliance burdens and potentially led to 
similarly situated taxpayers applying the AFS income inclusion rule 
differently.
    The Code does not specify how the AFS income inclusion rule is to 
function whenever the AFS accounting period and the taxable year do not 
coincide. The final regulations do not adopt a single, one-size-fits-
all approach, but rather provide taxpayers three separate options for 
addressing this situation. A change from one option to another, 
however, would be considered a change in method of accounting requiring 
the permission of the IRS. By providing taxpayers with several options, 
the final regulations will minimize taxpayer compliance costs when 
dealing with non-congruent tax and financial accounting periods 
relative to an alternative approach of specifying a single option, with 
no significant revenue implications or effects on economic decisions.
iii. Revenue in an AFS
    The final regulations describe and clarify the definition of AFS 
revenue to broadly include amounts characterized as revenue in a 
taxpayer's AFS as well as amounts reported in other comprehensive 
income or retained earnings provided such amounts relate to an item of 
gross income that is subject to the rules under section 451(b) and (c). 
The Treasury Department and the IRS considered and rejected a narrower 
definition of revenue or a definition that was tied to the AFS 
definition of revenue. The definition of revenue advanced in the final 
regulations is consistent with the current application of the all 
events test under Sec.  1.451-1(a) and ensures that all relevant 
financial statement items are taken into account for tax purposes. In 
contrast, a narrow definition of revenue would allow, or even 
encourage, taxpayers to avoid the AFS income inclusion rule by not

[[Page 830]]

classifying an item as revenue on their financial statement.
iv. Rules for Certain Debt Instruments
    Section 451(b)(2) states that the AFS inclusion rule does not apply 
to items of gross income for which a taxpayer uses a special method of 
accounting provided under the Code. However, the Code does not apply 
this exception to special accounting rules that apply to original issue 
discount (OID), market discount, and certain other items with respect 
to debt instruments under part V of Subchapter P of the Code.
    The final regulations implement this provision by providing a non-
exhaustive list of special methods of accounting, and by clarifying how 
section 451(b) applies to certain credit card receivables. The final 
regulations specifically except from section 451(b) the timing rules 
for accrued market discount on bonds and the general OID timing rules, 
as well as the timing rules for OID determined with respect to special 
debt instruments (contingent payment and variable rate debt 
instruments, certain hedged debt instruments, and inflation-indexed 
debt instruments). Nevertheless, following the legislative history of 
the TCJA (see Conference Report, p. 276), the final regulations provide 
that credit card late fees, credit card cash advance fees, and 
interchange fees are subject to the AFS income inclusion rule. The 
final regulations further specify that if these credit card fees are 
subject to the AFS income inclusion rule, they are not to be taken into 
account in determining whether a debt instrument associated with them 
has OID. Existing rules continue to apply to these items for taxpayers 
not possessing an AFS. The Treasury Department and the IRS expect that 
this treatment will provide a straightforward application of section 
451(b) consistent with Congressional intent without unnecessarily 
complicating OID calculations and adding to taxpayer compliance 
burdens.
    The Treasury Department and the IRS considered and rejected a 
broader application of the AFS income inclusion rule to include all 
amounts determined under the OID and market discount accounting 
methods, even in cases where the items are treated as discount or as an 
adjustment to the yield of a debt instrument over the life of the 
instrument in its AFS for financial reporting purposes. The final 
regulations do not subject these amounts to the AFS income inclusion 
rule because these special accounting methods do not generally rely on 
the all events test to determine the timing of income inclusion and 
these current special accounting methods provide workable income-
recognition timing rules that appropriately measure income. The 
Treasury Department and the IRS expect that subjecting these items to 
the AFS income inclusion rule of section 451(b) would disrupt and 
complicate current tax accounting practices with no general economic 
benefit.
5. Economic Effects of Provisions Under 451(c)
a. Provisions Substantially Revised From the Proposed Section 451(c) 
Regulations
i. Cost Offset for Advance Payments
    The Treasury Department and the IRS considered three options for 
addressing the treatment of costs under section 451(c): (i) No cost 
offset; (ii) a cost offset for incurred costs; and (iii) a cost offset 
that further allowed for projected costs. The proposed section 451(c) 
regulations (in this part C.5, proposed regulations) did not provide 
for a cost offset for advanced payments. At the time, the Treasury 
Department and the IRS argued that Congress intentionally simplified 
the rules for advance payments by limiting the deferral of advance 
payments for taxpayers with an AFS to a prescribed statutory method 
that (1) does not include an accelerated cost offset, (2) is consistent 
with Revenue Procedure 2004-34, and (3) overrides Sec.  1.451-5. 
Taxpayers commenting on the proposed regulations were concerned that 
the failure to provide a cost offset rule in 451(c) would cause a 
mismatch of income and expenses and result in the taxation of gross 
receipts. For example, if a business has a multi-year contract to build 
or manufacture a highly customized good, it would report any advance 
payment in income in the year of receipt or in the following taxable 
year. If it uses the advance payment to purchase materials and to pay 
workers as part of the project, it would recover those costs only when 
the sale takes place. Under the proposed regulations, the statute would 
generate a tax on the total amount of the advance payment in the first 
years of the contract with all related costs being recovered later in 
the contract.
    In response to these comments on the proposed regulations, the 
Treasury Department and the IRS have written the final regulations to 
include an offset for cost of goods in progress (cost offset). This 
cost offset allows taxpayers to reduce the amount of an advance payment 
for the future sale of inventory that is required to be included in 
gross income in a year prior to the year in which ownership of the 
inventory is transferred to the customer. The amount of such reduction, 
or cost offset, is equal to the inventoriable costs incurred as of the 
end of the taxable year in which the advance payment is required to be 
included in gross income under the taxpayer's method of accounting for 
advance payments. This provision of the final regulations allows 
taxpayers to offset advance payments included in income under either 
the full inclusion method or the deferral method. However, the cost of 
goods in progress offset cannot reduce the amount of the advance 
payment income inclusion below zero. Any incurred costs subject to this 
limitation may be carried forward to determine the cost of goods in 
progress in subsequent taxable years.
    The cost offset in the final regulations generally reduces the 
amount of the advance payment that is required to be included in gross 
income in a taxable year prior to the year in which ownership of the 
inventory is transferred to the customer relative to the proposed 
regulations. An improved match of income and cost timing is generally 
held to provide a more accurate measure of economic activity and thus 
provide a more efficient tax system than under the proposed 
regulations. For further discussion of the economic effects of the cost 
offset for advance payments and for income more generally see 4.a.i.
    The Treasury Department and the IRS considered expanding the cost 
offset to allow for projected costs, with several possible formats 
being considered for how projected costs would be treated. Allowing an 
offset for projected costs would entail a higher administrative burden 
than the offset for incurred costs and may not definitively improve the 
alignment of when income and costs are recognized for tax purposes 
relative to the offset for incurred costs.
    The Treasury Department and the IRS have not estimated the 
difference in compliance costs, administrative burden, or income-cost 
alignment (and any subsequent effects on economic activity) between the 
final regulations and alternative regulatory approaches using projected 
costs associated with advance payments. The Treasury Department and the 
IRS have not undertaken this estimation because they do not have 
sufficiently detailed data or models that capture possible differences 
in cost offset formats that use incurred costs versus projected costs.

[[Page 831]]

b. Provisions Not Substantially Revised From the Proposed Regulations
i. Deferral Methods Under Section 451(c)
    The statute prescribes a particular deferral method for accrual-
method taxpayers that have an AFS (AFS taxpayers) but does not 
explicitly describe a deferral method to be used by taxpayers that do 
not have an AFS (non-AFS taxpayers). To remedy this gap, the proposed 
and final regulations describe and clarify that a method similar to the 
deferral method available to non-AFS taxpayers under Revenue Procedure 
2004-34 will be available to non-AFS taxpayers.
    The Treasury Department and the IRS considered and rejected a 
narrow interpretation of section 451(c) that would have precluded non-
AFS taxpayers from using a deferral method similar to that provided in 
Revenue Procedure 2004-34. Section 451(c) does not explicitly prohibit 
the use of such a method by non-AFS taxpayers, and the Treasury 
Department and IRS continue to have authority under the Code to 
prescribe a deferral method for such taxpayers. Precluding non-AFS 
taxpayers from using a deferral method similar to that of AFS taxpayers 
would treat AFS and non-AFS taxpayers quite differently regarding 
business decisions they might make that are otherwise similar. Such 
treatment would result in a less economically efficient tax system, 
which generally treats similar economic decisions similarly.
ii. Advance Payment Acceleration Provisions
    If a taxpayer ceases to exist by the close of a taxable year in 
which an advance payment has been received and deferred, then issues 
may arise as to when or whether the remaining amount of the payment 
will be recognized as taxable income because there may not be a 
succeeding taxable year in which such income can be recognized.
    Under the statute, if the taxpayer dies or ceases to exist by the 
close of the taxable year in which the advance payment was received, 
any remaining untaxed amounts of advance payments must be included in 
income in the year they were received. The final regulations extend 
this payment ``acceleration'' rule to situations in which a performance 
obligation is satisfied or otherwise ends in the taxable year of 
receipt or in a succeeding short taxable year, a treatment that is 
consistent with a similar rule in Revenue Procedure 2004-34.
    The Treasury Department and the IRS considered not modifying or 
expanding the acceleration rule contained in section 451(c) but 
rejected this alternative because the remaining amount may never be 
included in income, thus risking a permanent exclusion of the amount 
from taxable income. The possibility of a permanent exclusion of income 
provides incentives for taxpayers to structure payments in ways that 
avoid tax liability, thus reducing Federal tax revenue without 
providing an accompanying general economic benefit. The proposed and 
final regulations treat the expanded set of accelerated transactions 
consistently with similar types of transactions based on the timing and 
structure of the payments involved.
iii. Advance Payments and Financial Statement Adjustments
    Under the statute, if a taxpayer counts an advance payment as an 
item of deferred revenue, under certain conditions (for example, 
certain acquisitions of one corporation by another), the taxpayer may 
be required by its system of accounting to adjust that item on the 
balance sheet in a subsequent year. The item would then not be included 
in current earnings or AFS revenues. In this case, taxpayers might 
argue that they can exclude the amount deferred from taxable income 
because it is never ``earned'' nor included in revenue under their AFS. 
If this argument were upheld, taxpayers could convert an income 
``deferral'' amount into an income ``exemption'' amount. To address 
this issue and avoid this possibility, the proposed and final 
regulations specify that such financial statement adjustments are to be 
treated as ``revenue.''
    The Treasury Department and the IRS considered not providing 
clarity on the treatment of financial statement write-downs but 
rejected that approach because it would have risked an inappropriate 
permanent exclusion of income. The possibility of a permanent exclusion 
of income provides incentives for taxpayers to structure payments in 
ways that avoid tax liability, thus reducing Federal tax revenue 
without providing an accompanying general economic benefit.
iv. Short Taxable Years and the 92-Day Rule
    Section 451(c) does not provide a rule relating to the treatment of 
short taxable years. In the absence of such a rule, it will be unclear 
to taxpayers how they should implement the deferral method provided in 
section 451(c) in the case of a short taxable year. To address this 
issue, the proposed and final regulations provide rules relating to the 
treatment of short taxable years for advance payments that are 
generally consistent with Revenue Procedure 2004-34. The Treasury 
Department and the IRS considered and rejected not providing short 
taxable year rules because such a decision would have created 
significant confusion among taxpayers, increased administrative costs 
for the IRS, and increased compliance costs for taxpayers.
v. Performance Obligations for Non-AFS Taxpayers
    A performance obligation is generally a contractual arrangement 
with a customer to provide a good, service or a series of goods or 
services that are basically the same and have a routine pattern of 
transfer. Further, each performance obligation in a contract generally 
yields a separate item of gross income. The Treasury Department and the 
IRS interpret the statute as requiring taxpayers to allocate payments 
attributable to multiple items of gross income in the same manner as 
such payments are allocated to the corresponding performance 
obligations in the taxpayer's AFS. The statute does not, however, 
specify the allocation rules to be used by non-AFS taxpayers.
    To address this issue, the proposed and final regulations provide 
allocation rules for non-AFS taxpayers consistent with a similar rule 
in Revenue Procedure 2004-34. That rule specifies that a payment that 
is attributable to multiple items of gross income is required to be 
allocated to such items in a manner that is based on objective 
criteria. The objective criteria standard will be satisfied if the 
allocation method is based on payments the taxpayer regularly receives 
for an item or items that are regularly sold or provided separately. 
The Treasury Department and the IRS considered not providing allocation 
rules for non-AFS taxpayers but rejected such an approach because it 
would have treated similarly situated taxpayers quite differently and 
would have led to increased administrative costs for the IRS and 
increased compliance costs for taxpayers relative to the rules provided 
in the final regulations. While the allocation rules for AFS taxpayers 
and non-AFS taxpayers differ to some degree under the final 
regulations, the chosen provision provides a rule upon which non-AFS 
taxpayers can rely, while minimizing the differences between AFS and 
non-AFS taxpayers in this regard within the constraints imposed by the 
statute.

[[Page 832]]

vi. Specified Good Exception
    Section 451(c) provides that certain items are excluded from the 
definition of an advance payment. Those items include rent; insurance 
premiums governed by subchapter L; payments with respect to financial 
instruments; payments with respect to certain warranty or guaranty 
contracts; payments subject to section 871(a), 881, 1441, or 1442; 
payments in property to which section 83 applies; and other payments 
identified by the Secretary. This list of items excluded from the 
definition of an advance payment is generally comparable to the list of 
items excluded from the definition of an advance payment in Revenue 
Procedure 2004-34.
    Prior to release of the proposed regulations, several commenters 
requested that the list of excluded items be expanded to include 
certain goods that require a significant amount of capital to produce 
and that may require considerable time from development to delivery. 
Generally, for financial statement purposes, such manufacturers 
recognize revenue related to these goods when the product is completed 
and delivered and the title and risk of loss have transferred to the 
customer.
    To address this issue, the proposed regulations crafted a narrow 
specified-goods exception for taxpayers who receive advance payments 
but do not perform the work or deliver the good for several years in 
the future. Specifically, an exclusion was introduced for certain goods 
for which a taxpayer requires a customer to make an upfront payment 
under the contract if (i) the contracted delivery month and year of the 
good occurs at least two taxable years after an upfront payment, (ii) 
the taxpayer does not have the good or a substantially similar good on 
hand at the end of the year the upfront payment is received, and (iii) 
the taxpayer recognizes all of the revenue from the sale of the good in 
its AFS in the year of delivery.
    The final regulations make one minor modification to the specified 
good exception. In response to comments, the final regulations give 
taxpayers the option to treat upfront payments that satisfy the 
criteria for the specified good exception as a typical advance payment 
under section 451(c). In other words, taxpayers have the option of 
including the advance payment in gross income under the full inclusion 
method or the deferral method. This flexibility in the section 451(c) 
regime reduces uncertainty for taxpayers who may be unsure if a 
contract meets the specified good exception relative to the proposed 
regulations. It also allows taxpayers using the 1-year deferral under 
Revenue Procedure 2004-34 prior to the passage of the TCJA the option 
to continue to do so.
    The Treasury Department and the IRS considered as an alternative 
not using the authority granted to the Secretary in section 
451(c)(4)(B)(vii) to exclude certain payments. For manufacturers of 
highly customizable goods with a delivery date more than two years 
after the upfront payment, the one-year deferral period has the 
potential to increase book-tax accounting differences relative to the 
final regulations. For some companies, a one-year deferral period may 
require the creation of separate records to track advance payments for 
accounting and tax purposes. Thus, for these taxpayers, the final 
regulations may provide greater conformity between accounting (book) 
income and taxable income to the extent that applicable case law would 
defer the inclusion of income related to the specified goods exception.
II. Paperwork Reduction Act
    These regulations do not impose any additional information 
collection requirements in the form of reporting, recordkeeping 
requirements or third-party disclosure requirements related to tax 
compliance. Instead, because section 451(b) and section 451(c) and 
these regulations provide various methods of accounting affecting the 
timing of income inclusion, taxpayers without an existing method of 
accounting for these items may initially adopt such method without the 
consent of the Commissioner. However, the consent of the Commissioner 
under section 446(e) and the accompanying regulations is required 
before implementing method changes from one method to another method. 
See Sec. Sec.  1.451-3(l) and 1.451-8(g). Some of the methods of 
accounting referenced by and discussed in these regulations are 
represented in the following chart.

------------------------------------------------------------------------
           Section                    Brief description of method
------------------------------------------------------------------------
Sec.   1.451-3(b)(2)(i)......  Application of AFS income inclusion rule
                                by making all AFS revenue adjustments.
Sec.   1.451-3(b)(2)(ii).....  Application of AFS income inclusion rule
                                by making certain AFS revenue
                                adjustments (Alternative AFS Revenue
                                method).
Sec.   1.451-3(c)............  AFS cost offset method.
Sec.   1.451-3(i)(4).........  Computing revenue when the AFS and
                                taxable years are mismatched.
Sec.   1.451-3(l)............  Change in the method of recognizing
                                revenue in an AFS.
Sec.   1.451-8(c)............  Deferral method for taxpayers with an
                                AFS.
Sec.   1.451-8(d)............  Deferral method for taxpayer without an
                                AFS.
Sec.   1.451-8(e)............  Advance payment cost offset method.
Sec.   1.451-8(f)............  Election for the specified goods
                                exception to not apply.
Sec.   1.451-8(g)............  Change in the method for recognizing
                                advance payments on an AFS.
------------------------------------------------------------------------

    Taxpayers request consent to use a method in these regulations by 
filing Form 3115, Application for Change in Accounting Method (Parts I, 
II, IV and Schedule B). Filing of Form 3115 and any statements attached 
thereto (for taxpayers who are required to do so or who elect certain 
methods of accounting described in the regulations) is the sole 
collection of information requirement imposed by the statute and the 
regulations.
    For the Paperwork Reduction Act (PRA), the reporting burden 
associated with the collections of information in these regulations 
will be reflected in the IRS Form 3115 PRA Submissions (OMB control 
numbers 1545-0074 for individual filers, 1545-0123 for business filers, 
and 1545-2070 for all other types of filers).
    In 2018, the IRS released and invited comment on a draft of Form 
3115 to give the public the opportunity to benefit from certain 
specific revisions made to the Code. The IRS received no comments on 
the forms during the comment period. Consequently, the IRS made the 
forms available in January 2019 for use by the public. Form 3115 
applies to changes of accounting methods generally and is therefore 
broader than section 451(b).
    On November 25, 2019, the Treasury Department and the IRS published 
Revenue Procedure 2019-43, 2019-28 I.R.B. 1107, which updated Revenue 
Procedure 2018-31, and provides a

[[Page 833]]

global list of automatic method change procedures, including procedures 
for taxpayers to comply with various provisions in section 451(b) and 
(c) and the proposed regulations. Under the procedures, taxpayers can 
request permission to change to a method of accounting to comply with 
the various provisions in section 451(b) and (c) and the proposed 
regulations using reduced filing requirements, such as by filing a 
short Form 3115, or for certain taxpayers, by using a streamlined 
method change procedure that involves not filing a Form 3115.
    The current status of the PRA submissions that will be revised as a 
result of the information collections in these regulations is provided 
in the accompanying table. As described earlier, the reporting burdens 
associated with the information collections in these regulations are 
included in the aggregated burden estimates for OMB control numbers 
1545-0074 (in the case of individual filers of Form 3115), 1545-0123 
(in the case of business filers of Form 3115 and filers subject to 
Revenue Procedure 2018-31). The overall burden estimates associated 
with the OMB control numbers identified later are aggregate amounts 
that relate to the entire package of forms associated with the 
applicable OMB control number and will in the future include, but not 
isolate, the estimated burden of the tax forms that will be created or 
revised as a result of the information collections in these 
regulations. These numbers are therefore unrelated to the future 
calculations needed to assess the burden imposed by these regulations. 
These burdens have been reported for other income tax regulations that 
rely on the same information collections, and the Treasury Department 
and the IRS urge readers to recognize that these numbers are duplicates 
and to guard against overcounting the burdens imposed by tax provisions 
prior to the TCJA.
    No burden estimates specific to the forms affected by these 
regulations are currently available. The Treasury Department and the 
IRS have not estimated the burden, including that of any new 
information collections, related to the requirements under these 
regulations. For the OMB control numbers discussed in the preceding 
paragraphs, the Treasury Department and the IRS estimate PRA burdens on 
a taxpayer-type basis rather than a provision-specific basis. Those 
estimates capture both changes made by the TCJA and those that arise 
out of discretionary authority exercised in these regulations and other 
regulations that affect the compliance burden for that form.
    The Treasury Department and IRS request comment on all aspects of 
information collection burdens related to these regulations, including 
estimates for how much time it would take to comply with the paperwork 
burdens described earlier for each relevant form and ways for the IRS 
to minimize the paperwork burden. In addition, when available, drafts 
of IRS forms are posted for comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.htm. IRS forms are available at https://www.irs.gov/forms-instructions. Forms will not be finalized until after 
they have been approved by OMB under the PRA.

----------------------------------------------------------------------------------------------------------------
       Form/  revenue  procedure              Type of filer          OMB no.(s)                Status
----------------------------------------------------------------------------------------------------------------
Form 3115.............................  All other Filers (mainly        1545-2070  Published in the Federal
                                         trusts and estates)                        Register on 2/15/17. Public
                                         (Legacy system).                           comment period closed on 4/
                                                                                    17/17.
                                       -------------------------------------------------------------------------
                                         Link: https://www.federalregister.gov/documents/2017/02/15/2017-02985/proposed-information-collection-comment-request.
                                       -------------------------------------------------------------------------
                                        Business (NEW Model).....       1545-0123  Published in the Federal
                                                                                    Register on 10/8/18. Public
                                                                                    comment period closed on 12/
                                                                                    10/18.
                                       -------------------------------------------------------------------------
                                        Link: https://www.federalregister.gov/documents/2018/10/09/2018-21846/proposed-collection-comment-request-for-forms-1065-1065-b-1066-1120-1120-c-1120-f-1120-h-1120-nd.
                                       -------------------------------------------------------------------------
                                        Individual (NEW Model)...       1545-0074  Limited scope submission
                                                                                    (1040 only) on 10/11/18 at
                                                                                    OIRA for review. Full ICR
                                                                                    submission for all forms in
                                                                                    2019.
                                       -------------------------------------------------------------------------
                                        Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201808-1545-031 031.
----------------------------------------------------------------------------------------------------------------
Revenue Procedure 2018-31.............  IRS Research estimates...       1545-0123  Published in the Federal
                                                                                    Register on 9/30/19. Public
                                                                                    Comment period closed on 12/
                                                                                    23/19.
                                       -------------------------------------------------------------------------
                                        Link: https://www.federalregister.gov/documents/2019/10/22/2019-23009/proposed-collection-comment-request-for-rev-proc-2018-31.
----------------------------------------------------------------------------------------------------------------

III. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that these regulations will not have a significant 
economic impact on a substantial number of small entities within the 
meaning of section 601(6) of the Regulatory Flexibility Act (small 
entities). This certification can be made because the Treasury 
Department and the IRS have determined that the regulations may affect 
a substantial number of small entities but have also concluded that the 
economic effect on small entities as a result of these regulations is 
not expected to be significant. Section 451(b) requires that an item of 
income be included in gross income for tax purposes no later than when 
the item is counted as revenue in an AFS. Due to the revised financial 
accounting standards for calculating revenue in an AFS under ASC 606, 
the result of section 451(b) generally will be to move the recognition 
of income forward by a year or two compared to previous law. Section 
451(c) provides rules regarding the treatment of advance payments. 
These regulations provide general guidance on the rules, including the 
scope of the rules, exceptions to the rules, definitions of key terms, 
and examples demonstrating applicability of the rules.
    The Treasury Department and the IRS have estimated the number of 
small

[[Page 834]]

business entities that may be affected by the statute and these 
regulations. Section 451(b) and (c) and the regulations under Sec.  
1.451-3 affect only those business entities that (i) use an accrual 
method of accounting, and (ii) have an AFS. One provision in Sec.  
1.451-8 applies to accrual method taxpayers without an AFS. The 
remaining provisions in Sec.  1.451-8 apply to accrual method taxpayers 
with an AFS.
    Regarding the accrual method of accounting, section 13102 of TCJA 
modified section 448 to expand the number of taxpayers eligible to use 
the cash receipts and disbursements method of accounting (cash method 
of accounting). In general, C corporations and partnerships with a C 
corporation partner are now permitted to use the cash method of 
accounting if average annual gross receipts are $25 million or less for 
taxable years beginning in 2018 (up from $5 million or less in 2017). 
The $25 million figure is considered for adjustment for inflation 
annually. This amount was adjusted for inflation for taxable years 
beginning after December 31, 2018. The amount was $26 million for 
taxable year 2019. The Treasury Department and the IRS estimate that 
approximately 3,128,000 business entities with gross receipts of $26 
million or less used an accrual method of accounting in taxable year 
2017, which represents approximately 8.5 percent of all business 
entities with gross receipts of $26 million or less. The Treasury 
Department and the IRS project that in future years, the number of 
entities with gross receipts not greater than $26 million that will be 
using the accrual method will be less than 8.5 percent of all entities 
with gross receipts of $26 million or less.
    Many small business entities use the cash method of accounting, as 
opposed to an accrual method, and thus are not subject to these 
regulations. The percent of returns that use an accrual method of 
accounting, by entity types and for entities with gross receipts not 
greater than $26 million, is shown in the accompanying table.

                          Total Returns and Returns Using Accrual Method of Accounting
                                               [Taxable year 2017]
----------------------------------------------------------------------------------------------------------------
                            Entities with gross receipts not greater than $26 million
-----------------------------------------------------------------------------------------------------------------
                                                                                   Returns using
                                                                                    an accrual      Percent of
                             Entity                                Total returns     method of     returns using
                                                                    (thousands)     accounting    accrual method
                                                                                    (thousands)    of accounting
----------------------------------------------------------------------------------------------------------------
C corporations..................................................           1,570             691              44
S corporations..................................................           4,684           1,146              24
Partnerships....................................................           3,884             912              23
Sole proprietors and LLCs.......................................          26,425             379               1
                                                                 -----------------------------------------------
    All entities................................................          36,425           3,128             8.5
----------------------------------------------------------------------------------------------------------------
Source: Internal Revenue Service, RAAS, KDA.

    The Treasury Department and the IRS next examined the second 
condition, that entities with an AFS are affected by section 451(b) and 
the regulations. The Treasury Department and the IRS do not have 
readily available data to measure the prevalence of entities with an 
AFS, as defined in the statute and in Sec.  1.451-3(b)(1). However, 
Schedule M-3, which is used to reconcile an entity's net income or loss 
for tax purposes with its book income or loss, reports whether an 
entity has a certified audited income statement. The Schedule M-3 is 
required to be filed only by entities with at least $10 million of 
assets. This population is more likely to possess an AFS and, 
conversely, entities that do not file Schedule M-3 are less likely to 
possess an AFS as owners and/or creditors of such smaller entities are 
less likely to require the entity to certify its financial results via 
a financial statement audit. Data is currently available only for 
electronic filers.
    For taxable year 2017, approximately 89 percent of accrual-method 
entities filing Forms 1120, 1120-S, and 1065 with gross receipts of $26 
million or less were filers of electronic tax forms. About 11 percent, 
or 288,000 returns, included a Schedule M-3. About 40 percent of the 
returns with Schedule M-3, or 113,000, indicated they had a certified 
audited income statement. Based on the assumption that filers of paper 
tax forms have the same incidence as electronic filers and that 
entities that do not file a Schedule M-3 generally do not have an AFS, 
then the Treasury Department and the IRS estimate that roughly 127,000 
(113,000/0.89) entities with gross receipts of $26 million or less are 
accrual-method entities that have an AFS. If 5 percent of entities that 
do not file a Schedule M-3 also have an AFS then approximately 224,000 
entities with gross receipts of $26 million or less are potentially 
affected by these regulations. These estimates of affected filing 
entities are reproduced in the following table.

          Corporation and Partnership Returns Using An Accrual Method of Accounting--Taxable Year 2017
                                             [Thousands of returns]
----------------------------------------------------------------------------------------------------------------
                            Entities with gross receipts not greater than $26 million
-----------------------------------------------------------------------------------------------------------------
                                                                      E-filed       Paper-filed
                                                                      returns         returns      Total returns
----------------------------------------------------------------------------------------------------------------
Returns.........................................................           2,503             307           2,810
Returns with a Schedule M-3.....................................             288            * 35           * 323
Returns with a Schedule M-3 and an audited income statement.....             113            * 14           * 127
Returns without a Schedule M-3..................................           2,215           * 272         * 2,487
Returns without a Schedule M-3, but with an audited income                ** 111           ** 13          ** 124
 statement......................................................

[[Page 835]]

 
Returns with an audited income statement........................          ** 224           ** 27          ** 251
----------------------------------------------------------------------------------------------------------------
* Estimates are obtained by assuming paper-filed returns are similar to e-filed returns as regards the incidence
  of a filing entity having a Schedule M-3 and an audited income statement.
** Estimates are obtained by assuming that 5% of returns without a Schedule M-3 have an audited income
  statement. This compares with approximately 40% of returns with a Schedule M-3 having such a statement.
Source: Non-italic entries are estimates taken from the IRS Research, Applied Analytics and Statistics KDA
  Division using data from the Compliance Data Warehouse. The total number of accrual method returns of
  corporations and partnerships differs slightly from that reported in the earlier table due to the use of
  different data sources for the two estimates. Italicized entries are additional estimates obtained in the
  manner indicated in the table notes.

    This rule would not have a significant economic impact on small 
entities affected. The costs to comply with these regulations are 
reflected in modest reporting activities. Taxpayers needing to make 
method changes pursuant to these regulations will be required to file a 
Form 3115. The Treasury Department and the IRS have provided 
streamlined procedures for certain taxpayers to change their method of 
accounting to comply with section 451(b) and (c), and plan to provide 
streamlined procedures for such taxpayers to change to the methods of 
accounting described in these regulations. Under the streamlined 
procedures, eligible taxpayers would either complete only a portion of 
the Form 3115 or would not complete the Form 3115 at all to comply with 
the guidance. The streamlined method change procedures are available to 
taxpayers, other than a tax shelter, who satisfy the gross receipts 
test under section 448(c) and for taxpayers making such a method change 
which results in a zero section 481(a) adjustment. In addition, 
contemporaneous with these regulations, the Treasury Department and the 
IRS are issuing a streamlined procedure for taxpayers using a section 
451(b) method who have a change in their AFS for revenue recognition 
that requires a method change for tax purposes.
    The estimated cumulative annual reporting and/or recordkeeping 
burden for the statutory method changes relating to the streamlined 
procedures used to be described under OMB control number 1545-1551. In 
2019, OMB number 1545-1551 was merged into OMB number 1545-0123. The 
estimated number of respondents, after taking into account the 
streamlined procedures that are being issued is 28,046 respondents, and 
a total annual reporting and/or recordkeeping burden of 34,279 hours. 
The estimated annual burden per respondent/recordkeeper under OMB 
control number 1545-0123 before publication of this revenue procedure 
varies from \1/6\ hour to 8\1/2\ hours, depending on individual 
circumstances, with an estimated average of 1\1/2\ hours. The estimated 
monetized burden for compliance is $95 per hour. The estimated 
cumulative annual reporting and/or recordkeeping burden for the method 
changes described under OMB control number 1545-0123 after the revenue 
procedure is accounted for is 28,046 respondents, and a total annual 
reporting and/or recordkeeping burden is 34,279 hours. These burdens 
are essentially unaffected by these regulations.
    Accordingly, the Secretary certifies that the rule will not have a 
significant economic impact on a substantial number of small entities.
    Pursuant to section 7805(f), the notice of proposed rulemaking 
preceding this final rule was submitted to the Chief Counsel for the 
Office of Advocacy of the Small Business Administration for comment on 
its impact on small business. No comments on the notice were received 
from the Chief Counsel for the Office of Advocacy of the Small Business 
Administration.

IV. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA) 
requires that agencies assess anticipated costs and benefits and take 
certain actions before issuing a final rule that includes any Federal 
mandate that may result in expenditures in any one year by a state, 
local, or tribal government, in the aggregate, or by the private 
section, of $100 million in 1995 dollars, update annually for 
inflation. This rule does not include any Federal mandate that may 
result in expenditures by state, local, or tribal governments, or by 
the private section in excess of that threshold.

V. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on state and local 
governments, and is not required by statute, or preempts state law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive order. This final rule does not have 
federalism implications and does not impose substantial direct 
compliance costs on state and local governments or preempt state law 
within the meaning of the Executive order.

VI. Congressional Review Act

    The Administrator of the Office of Information and Regulatory 
Affairs of the Office of Management and Budget has determined that this 
is a major rule for purposes of the Congressional Review Act (5 U.S.C. 
801 et seq.). Under 5 U.S.C. 801(a)(3), a major rule takes effect 60 
days after the rule is published in the Federal Register.
    Notwithstanding this requirement, 5 U.S.C. 808(2) allows agencies 
to dispense with the requirements of 5 U.S.C. 801 when the agency for 
good cause finds that such procedure would be impracticable, 
unnecessary, or contrary to the public interest and the rule shall take 
effect at such time as the agency promulgating the rule determines. 
Pursuant to 5 U.S.C. 808(2), the Treasury Department and the IRS find, 
for good cause, that a 60-day delay in the effective date is contrary 
to the public interest.
    Following the amendments to section 451(b) and (c) by the TCJA, the 
Treasury Department and the IRS published the proposed regulations to 
provide certainty to taxpayers. In particular, as demonstrated by the 
wide variety of public comments in response to the proposed regulations 
received,

[[Page 836]]

taxpayers continue to express uncertainty regarding the proper 
application of the statutory rules under section 451(b) and (c). This 
is especially the case for taxpayers in the manufacturing and retail 
industries producing or reselling inventoriable goods because the final 
regulations allow such taxpayers to more clearly reflect their income 
for Federal income tax purposes compared to the approach of the 
proposed regulations. An earlier effective date will allow taxpayers to 
implement the final regulations earlier to take advantage of certain 
provisions in the Coronavirus Aid, Relief, and Economic Security Act, 
Public Law 116-136 (March 27, 2020) that were designed to enhance 
liquidity, such as the 5-year net operating loss carryback provisions. 
Consistent with Executive Order 13924 (May 19, 2020), the Treasury 
Department and the IRS have therefore determined that an expedited 
effective date of the final regulations would more appropriately 
provide such critical businesses greater liquidity needed to remain 
open or ``re-open by providing guidance on what the law requires.'' 85 
FR 31353-54. Accordingly, the Treasury Department and the IRS have 
determined that the rules in this Treasury decision will take effect on 
the date of filing for public inspection in the Federal Register.

Drafting Information

    The principal author of these regulations is Jo Lynn Ricks (Office 
of the Associate Chief Counsel (Income Tax and Accounting)). Other 
personnel from the Treasury Department and the IRS, including Kate 
Abdoo, John Aramburu, James Beatty (formerly Income Tax and 
Accounting), David Christensen, Alexa Dubert, Sean Dwyer, Peter Ford, 
Christina Glendening, Anna Gleysteen, Charlie Gorham, Evan Hewitt, 
William Jackson, Doug Kim, Tom McElroy, and Karla Meola, Office of the 
Associate Chief Counsel (Income Tax and Accounting); and William E. 
Blanchard, Charles Culmer, and Deepan Patel, Office of the Associate 
Chief Counsel (Financial Institutions and Products), participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order for Sec. Sec.  1.451-3 and 1.451-8 to read, 
in part, as follows:

    Authority:  26 U.S.C. 7805.
* * * * *
    Section 1.451-3 also issued under 26 U.S.C. 451(b)(1)(A)(ii), 
(b)(3)(C) and 461(h).
    Section 1.451-8 also issued under 26 U.S.C. 451(c)(2)(A), (3), 
(4)(A)(iii), (4)(b)(vii), and 461(h).
* * * * *

0
Par. 2. Section 1.446-1 is amended by adding a parenthetical sentence 
between the first and second sentences of paragraph (c)(1)(ii)(A) to 
read as follows:


Sec.  1.446-1   General rule for methods of accounting.

* * * * *
    (c) * * *
    (1) * * *
    (ii) * * *
    (A) * * * (See Sec.  1.451-1 for rules relating to the taxable year 
of inclusion.) * * *

0
Par. 3. Section 1.446-2 is amended by removing ``or'' at the end of 
paragraph (a)(2)(i)(E), removing the period at the end of paragraph 
(a)(2)(i)(F) and adding ``; or'' in its place, and adding paragraph 
(a)(2)(i)(G) to read as follows:


Sec.  1.446-2   Method of accounting for interest.

    (a) * * *
    (2) * * *
    (i) * * *
    (G) Section 1.451-3(j) (special ordering rule for specified fees).
* * * * *

0
Par. 4. Section 1.451-1 is amended by:
0
a. Adding ``(all events test)'' to the end of the second sentence of 
paragraph (a).
0
b. Redesignating paragraphs (b) through (g) as (d) through (i).
0
c. Adding new paragraphs (b) and (c).
    The additions read as follows:


Sec.  1.451-1   General rule for taxable year of inclusion.

* * * * *
    (b) Timing of income inclusion for accrual method taxpayers with an 
applicable financial statement. For the timing of income inclusion for 
taxpayers that have an applicable financial statement, as defined in 
Sec.  1.451-3(b)(1), and that use an accrual method of accounting, see 
section 451(b) and Sec.  1.451-3.
    (c) Special rule for timing of income inclusion from advance 
payments. For the timing of income inclusion for taxpayers that receive 
advance payments, as defined in Sec.  1.451-8(a)(1), and that use an 
accrual method of accounting, see section 451(c) and Sec.  1.451-8.
* * * * *

0
Par. 5. Section 1.451-3 is added to read as follows:


Sec.  1.451-3   Timing of income inclusion for taxpayers with an 
applicable financial statement using an accrual method of accounting.

    (a) Definitions. The following definitions apply for this section:
    (1) AFS income inclusion amount. The term AFS income inclusion 
amount means the amount of an item of gross income that is required to 
be included in gross income under the AFS income inclusion rule in 
paragraph (b)(1) of this section.
    (2) AFS income inclusion rule. The term AFS income inclusion rule 
has the meaning provided in paragraph (b)(1) of this section.
    (3) AFS inventory inclusion amount. The term AFS inventory 
inclusion amount has the meaning provided in paragraph (c)(2)(i)(A) of 
this section.
    (4) AFS revenue. The term AFS revenue means revenue reported in the 
taxpayer's AFS. The characterization of an amount in the AFS is not 
determinative of whether the amount is AFS revenue. For example, AFS 
revenue can include amounts reported as other comprehensive income or 
adjustments to retained earnings in an AFS. See paragraph (b) of this 
section for adjustments to AFS revenue that may need to be made to 
apply the rules of this section.
    (5) Applicable financial statement (AFS). Subject to the rules in 
paragraph (a)(5)(iv) of this section, the terms applicable financial 
statement and AFS are synonymous and mean the taxpayer's financial 
statement listed in paragraph (a)(5)(i) through (iii) of this section 
that has the highest priority, including priority within paragraphs 
(a)(5)(i)(B) and (a)(5)(ii)(B) of this section. The financial 
statements are, in order of descending priority:
    (i) GAAP statements. A financial statement that is certified as 
being prepared in accordance with United States generally accepted 
accounting principles (GAAP) and is:
    (A) A Form 10-K (or successor form), or annual statement to 
shareholders, filed with the United States Securities and Exchange 
Commission (SEC);
    (B) An audited financial statement of the taxpayer that is used 
for:
    (1) Credit purposes;
    (2) Reporting to shareholders, partners, or other proprietors, or 
to beneficiaries; or

[[Page 837]]

    (3) Any other substantial non-tax purpose; or
    (C) A financial statement, other than a tax return, filed with the 
Federal Government or any Federal agency, other than the SEC or the 
Internal Revenue Service (IRS);
    (ii) IFRS statements. A financial statement that is certified as 
being prepared in accordance with international financial reporting 
standards (IFRS) and is:
    (A) Filed by the taxpayer with an agency of a foreign government 
that is equivalent to the SEC, and has financial reporting standards 
not less stringent than the standards required by the SEC;
    (B) An audited financial statement of the taxpayer that is used 
for:
    (1) Credit purposes;
    (2) Reporting to shareholders, partners, or other proprietors, or 
to beneficiaries; or
    (3) Any other substantial non-tax purpose; or
    (C) A financial statement, other than a tax return, filed with the 
Federal Government, Federal agency, a foreign government, or agency of 
a foreign government, other than the SEC, IRS, or an agency that is 
equivalent to the SEC or the IRS; or
    (iii) Other statements. A financial statement, other than a tax 
return, filed with the Federal Government or any Federal agency, a 
state government or state agency, or a self-regulatory organization 
including, for example, a financial statement filed with a state agency 
that regulates insurance companies or the Financial Industry Regulatory 
Authority. Additional financial statements beyond those included in 
this paragraph (a)(5)(iii) may be provided in guidance published in the 
Internal Revenue Bulletin (see Sec.  601.601(d) of this chapter).
    (iv) Additional rules for determining priority. If a taxpayer 
restates AFS revenue for a taxable year prior to the date that the 
taxpayer files its Federal income tax return for such taxable year, the 
restated AFS must be used instead of the original AFS. If using the 
restated AFS revenue results in a change in method of accounting, the 
preceding sentence applies only if the taxpayer receives permission to 
change its method of accounting to use the restated AFS revenue. In 
addition, if a taxpayer with different financial accounting and taxable 
years is required to file both annual financial statements and periodic 
financial statements covering less than a year with a government or 
government agency, the taxpayer must prioritize the annual financial 
statement in accordance with this paragraph (a)(5).
    (6) Cost of goods. The term cost of goods means the costs that are 
properly capitalized and included in inventory under sections 471 and 
263A or any other applicable provision of the Internal Revenue Code 
(Code) and that are allocable to an item of inventory for which an AFS 
inventory inclusion amount is calculated. See paragraph (c)(5)(iii) of 
this section for specific rules for taxpayers using simplified methods 
under section 263A.
    (7) Cost of goods in progress offset. The term cost of goods in 
progress offset has the meaning provided in paragraph (c)(3) of this 
section.
    (8) Cumulative cost of goods in progress offset. The term 
cumulative cost of goods in progress offset means the cumulative cost 
of goods in progress offset amounts under paragraph (c) of this section 
for a specific item of inventory that have reduced an AFS inventory 
inclusion amount attributable to such item of inventory in prior 
taxable years.
    (9) Enforceable right. The term enforceable right means any right 
that a taxpayer has under the terms of a contract or under applicable 
Federal, state, or international law, including rights to amounts 
recoverable in equity and liquidated damages. A contract can include, 
but is not limited to, a statement of work, purchase order, or invoice.
    (10) Equity method. The term equity method means a method of 
accounting for financial accounting purposes under which an investment 
is initially recorded at cost and subsequently increased or decreased 
in carrying value by the investor's proportionate share of income and 
losses and such income or losses are reported as separate items on the 
investor's statement of income.
    (11) Performance obligation. The term performance obligation means 
a promise in a contract with a customer to transfer to the customer a 
distinct good, service, or right; or a series of distinct goods, 
services, or rights, or a combination thereof, that are substantially 
the same and that have the same pattern of transfer to the customer. A 
performance obligation includes a promise to grant or transfer a right 
to use or access intangible property. Performance obligations in a 
contract are identified by applying the accounting standards the 
taxpayer uses to prepare its AFS. Additionally, to the extent the 
contract with the customer provides the taxpayer with an enforceable 
right to payment, the revenue from which is not allocated to a 
performance obligation described in the first two sentences of this 
paragraph (a)(11) in the taxpayer's AFS but is accounted for as a 
separate source of revenue in the taxpayer's AFS, such right shall be 
treated as a separate performance obligation under this section. A fee 
described in paragraph (j)(2) of this section is an example of an 
enforceable right that is treated as a separate performance obligation.
    (12) Prior income inclusion amounts. The term prior income 
inclusion amounts means amounts of an item of gross income that were 
required to be included in the taxpayer's gross income under this 
section or Sec.  1.451-8 in prior taxable years.
    (13) Special method of accounting. The term special method of 
accounting means a method of accounting expressly permitted or required 
under any provision of the Code, the regulations in this part, or other 
guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d) of this chapter) under which the time for taking an item of 
gross income into account in a taxable year is not determined under the 
all events test in Sec.  1.451-1(a). See, however, paragraph (j) of 
this section relating to certain items of income for debt instruments. 
The term special method of accounting does not include any method of 
accounting expressly permitted or required under this section. The 
following are examples of special methods of accounting to which the 
AFS income inclusion rule does not apply:
    (i) The crop method of accounting under sections 61 and 162;
    (ii) Methods of accounting provided in sections 453 through 460;
    (iii) Methods of accounting for notional principal contracts under 
Sec.  1.446-3;
    (iv) Methods of accounting for hedging transactions under Sec.  
1.446-4;
    (v) Methods of accounting for REMIC inducement fees under Sec.  
1.446-6;
    (vi) Methods of accounting for gain on shares in a money market 
fund under Sec.  1.446-7;
    (vii) Methods of accounting for certain rental payments under 
section 467;
    (viii) The mark-to-market method of accounting under section 475;
    (ix) Timing rules for income and gain associated with a transaction 
that is integrated under Sec.  1.988-5, and income and gain under the 
nonfunctional currency contingent payment debt instrument rules in 
Sec.  1.988-6;
    (x) Except as otherwise provided in paragraph (j) of this section, 
timing rules for original issue discount (OID) under section 811(b)(3) 
or 1272 (and the regulations in this part under section 1272 of the 
Code), income under the contingent payment debt instrument rules in 
Sec.  1.1275-4, income under the

[[Page 838]]

variable rate debt instrument rules in Sec.  1.1275-5, income and gain 
associated with a transaction that is integrated under Sec.  1.1275-6, 
and income under the inflation-indexed debt instrument rules in Sec.  
1.1275-7;
    (xi) Timing rules for de minimis OID under Sec.  1.1273-1(d) and 
for de minimis market discount (as defined in section 1278(a)(2)(C));
    (xii) Timing rules for accrued market discount under sections 1276 
and 1278(b);
    (xiii) Timing rules for short-term obligations under sections 1281 
through 1283;
    (xiv) Timing rules for stripped bonds under section 1286; and
    (xv) Methods of accounting provided in sections 1502 and 1503 and 
the regulations thereunder, including the method of accounting relating 
to intercompany transactions under Sec.  1.1502-13.
    (14) Transaction price amount. The term transaction price amount 
means the total amount of consideration to which a taxpayer is, or 
expects to be, entitled from all performance obligations under a 
contract. The transaction price amount is determined under the 
standards the taxpayer uses to prepare its AFS.
    (b) AFS income inclusion rule--(1) In general. Except as otherwise 
provided in this section, if a taxpayer uses an accrual method of 
accounting for Federal income tax purposes and has an AFS, the all 
events test under Sec.  1.451-1(a) for any item of gross income, or 
portion thereof, is met no later than when that item, or portion 
thereof, is taken into account as AFS revenue (AFS income inclusion 
rule). See paragraph (b)(2) of this section for rules regarding when an 
item of gross income, or portion thereof, is treated as taken into 
account as AFS revenue under the AFS income inclusion rule. See 
paragraph (c) of this section for optional rules to determine the AFS 
income inclusion amount for an item of gross income from the sale of 
inventory. See paragraph (d) of this section for rules regarding the 
allocation of the transaction price amount to multiple items of gross 
income. See paragraph (e) of this section for rules to determine the 
AFS income inclusion amount for an item of gross income from a multi-
year contract. See paragraphs (f) and (g) of this section for 
limitations of the AFS income inclusion rule. See paragraph (h) of this 
section for special rules that may affect the determination of AFS 
revenue under the AFS income inclusion rule. See paragraph (j) of this 
section for special ordering rules for certain items of income with 
respect to debt instruments.
    (2) Amounts taken into account as AFS revenue--(i) General rule. 
Unless the taxpayer uses the alternative AFS revenue method described 
in paragraph (b)(2)(ii) of this section, the amount of the item of 
gross income that is treated as taken into account as AFS revenue under 
paragraph (b)(1) of this section is determined by making adjustments to 
AFS revenue for the amounts described in paragraphs (b)(2)(i)(A) 
through (D) of this section.
    (A) If AFS revenue reflects a reduction for amounts described in 
paragraph (b)(2)(i)(A)(1) or (2) of this section, AFS revenue is 
increased by the amount of the reduction.
    (1) Cost of goods sold and liabilities that are required to be 
accounted for under other provisions of the Code such as section 461, 
including liabilities for allowances, rebates, chargebacks, rewards 
issued in credit card transactions and other reward programs, and 
refunds, regardless of when any amount described in this paragraph 
(b)(2)(i)(A)(1) is incurred.
    (2) Amounts anticipated to be in dispute or anticipated to be 
uncollectable.
    (B) If AFS revenue includes an amount the taxpayer does not have an 
enforceable right to recover if the customer were to terminate the 
contract on the last day of the taxable year (regardless of whether the 
customer actually terminates the contract), AFS revenue is reduced by 
such amount.
    (C) If the transaction price was increased because a significant 
financing component is deemed to exist under the standards the taxpayer 
uses to prepare its AFS, then any AFS revenue attributable to such 
increase is disregarded.
    (D) AFS revenue may be increased or reduced by additional amounts 
as provided in guidance published in the Internal Revenue Bulletin (see 
Sec.  601.601(d) of this chapter).
    (ii) Alternative AFS revenue method. A taxpayer that chooses to 
apply the AFS income inclusion rule by using the alternative AFS 
revenue method described in this paragraph (b)(2)(ii) in lieu of the 
rules in paragraph (b)(2)(i) of this section, determines the amount of 
the item of gross income that is treated as taken into account as AFS 
revenue under paragraph (b)(1) of this section by making adjustments to 
AFS revenue for only the amounts described in paragraphs (b)(2)(i)(A), 
(C), and (D) of this section. A taxpayer that uses the alternative AFS 
revenue method for a trade or business must apply the method to all 
items of gross income in the trade or business that are subject to the 
AFS income inclusion rule.
    (3) Exceptions. The AFS income inclusion rule in paragraph (b)(1) 
of this section does not apply to:
    (i) Any item of gross income, or portion thereof, if the timing of 
income inclusion for that item, or portion thereof, is determined using 
a special method of accounting;
    (ii) Any item of gross income, or portion thereof, in connection 
with a mortgage servicing contract; or
    (iii) Any taxable year that is not covered for the entire year by 
one or more AFS.
    (4) Examples. The following examples illustrate the provisions of 
paragraph (b) of this section. Unless the facts specifically state 
otherwise, the taxpayer has an AFS, is on a calendar year for Federal 
income tax purposes and AFS purposes, and uses an accrual method of 
accounting for Federal income tax purposes. Further, the taxpayer does 
not use the alternative AFS revenue method under paragraph (b)(2)(ii) 
of this section or the AFS cost offset method under paragraph (d) of 
this section, and does not use a special method of accounting:
    (i) Example 1: Provision of installation services--(A) Facts. In 
2021, B enters into a 2-year service contract with a customer to 
install the customer's manufacturing equipment for $100,000. Throughout 
the term of the contract, the customer retains control of the 
equipment. B begins providing the installation services in 2021 and 
completes the installation services in 2022. Under the contract, B 
bills the customer $55,000 in 2021 when installation begins, but does 
not have a fixed right to receive the remaining $45,000 until 
installation is complete and approved by the customer. However, if the 
customer were to terminate the contract prior to completion, B would 
have an enforceable right to payment for all services performed prior 
to the termination date. For its AFS, B reports $60,000 of AFS revenue 
for 2021 and $40,000 of AFS revenue for 2022, in accordance with the 
services performed in each respective year.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), B is 
required to include $55,000 in gross income in 2021 as B has a fixed 
right to receive $55,000 as of the end of 2021. However, under the AFS 
income inclusion rule, because B has an enforceable right to recover 
the entire $60,000 that was reported in AFS revenue for 2021 had the 
customer terminated the contract on the last day of 2021, the entire 
$60,000 is treated as taken into account as AFS revenue in 2021. 
Accordingly, the all events test is

[[Page 839]]

met for the $60,000 of gross income no later than the end of 2021 and B 
is required to include $60,000 in gross income in 2021.
    (ii) Example 2: Provision of goods included in AFS with enforceable 
right--(A) Facts. In November 2021, C enters into a contract with a 
customer to provide 50 customized computers for $80,000. Under the 
contract, C can bill $80,000 after the customer accepts delivery of the 
computers. However, the contract provides that C has an enforceable 
right to be paid for work performed to date if the customer were to 
terminate the contract prior to delivery. C produces and ships all of 
the computers in 2021. In 2022, the customer accepts delivery of the 
computers and C bills the customer. For its AFS, C reports $80,000 of 
AFS revenue for 2021.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), C does 
not have a fixed right to receive the $80,000 until the customer 
accepts delivery of the computers in 2022. However, under the AFS 
income inclusion rule, because C has an enforceable right to recover 
the entire $80,000 of AFS revenue that was reported for 2021 had the 
customer terminated the contract on the last day of 2021, the entire 
$80,000 is treated as ``taken into account as AFS revenue'' in 2021. 
Accordingly, the all events test is met for the $80,000 no later than 
in 2021 and C is required to include $80,000 in gross income in 2021.
    (iii) Example 3: Provision of services included in AFS with 
enforceable right--(A) Facts. In 2021, D, an engineering services 
provider, enters into a 4-year contract with a customer to provide 
services for a total of $100x. Under the contract, D bills and receives 
$25x for each year of the contract. If the customer were to terminate 
the contract prior to completion, D has an enforceable right to only 
the billed amounts. For its AFS, D reports $60x, $0, $20x, and $20x of 
AFS revenue from the contract for 2021, 2022, 2023, and 2024, 
respectively.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), D is 
required to include $25x in gross income in 2021 as D has a fixed right 
to receive $25x as of the end of 2021. Although D reports $60x of AFS 
revenue from the provision of services for 2021, D has an enforceable 
right to recover only $25x if the customer were to terminate the 
contract on the last day of 2021. Accordingly, pursuant to paragraph 
(b)(2)(i)(B) of this section, of the $60x of AFS revenue reported for 
2021, only $25x is treated as ``taken into account as AFS revenue'' 
under the AFS income inclusion rule. As a result, D is required to 
include only $25x in gross income in 2021. Similarly, in 2022, 2023 and 
2024, D includes in gross income only the yearly $25x contract payments 
under the all events test as only the billed amounts are treated as 
``taken into account as AFS revenue'' under the AFS income inclusion 
rule.
    (iv) Example 4: Sale of good under cost-plus contract--(A) Facts. 
In 2021, E, a manufacturer, enters into a contract with Fire Department 
for the manufacture and delivery of a fire truck. The fire truck takes 
10 months to manufacture at an estimated cost of $60,000. The contract 
provides E with an enforceable right to recover costs incurred in 
manufacturing the fire truck regardless of whether the Fire Department 
accepts delivery of the fire truck or terminates the contract, and an 
enforceable right to an additional $20,000 if the fire truck is 
accepted by the Fire Department. E does not have an enforceable right 
to recover any portion of the additional $20,000 if the Fire Department 
were to terminate the contract before it accepts the fire truck. E has 
an obligation to cure any defects if the customer rejects the fire 
truck. In August 2021, E begins manufacturing the fire truck ordered by 
Fire Department and incurs $30,000 of costs for materials and labor for 
the contract. For its AFS, E reports $40,000 of AFS revenue for 2021 
($30,000 costs plus $10,000 expected profit on the sale of the fire 
truck).
    (B) Analysis for 2021 taxable year. Under the all events test in 
Sec.  1.451-1(a), E is required to include $30,000 in gross income in 
2021 as E has a fixed right to receive $30,000 as of the end of 2021. 
Although E reports $40,000 of AFS revenue for 2021, E has an 
enforceable right to recover only $30,000 if the Fire Department were 
to terminate the contract on the last day of 2021. Accordingly, 
pursuant to paragraph (b)(2)(i)(B) of this section, of the $40,000 of 
AFS revenue reported for 2021, only $30,000 is treated as ``taken into 
account as AFS revenue'' under the AFS income inclusion rule. As a 
result, E is required to include only $30,000 in gross income in 2021.
    (v) Example 5: Sale of goods with AFS revenue adjustments--(A) 
Facts. In July 2021, F, a manufacturer of automobile parts, enters into 
a contract to sell 1,000 parts to a customer for $10 per part, for a 
total of $10,000 (1,000 x $10). The contract also provides that F will 
receive a $200 bonus if it delivers all the parts to the customer by 
February 1, 2022. F delivers 500 non-defective parts to the customer on 
December 31, 2021 and schedules the remaining 500 parts for delivery to 
the customer on January 1, 2022. F does not have an enforceable right 
to recover any portion of the $200 bonus if the customer were to 
terminate the contract before all 1,000 parts are delivered. F expects 
to earn the $200 bonus and have 5% of the non-defective parts returned. 
For its AFS, F reports $4,850 ($5,000 + $100-$250) of AFS revenue for 
2021, which includes a $100 (50% x $200) adjustment to increase AFS 
revenue for the expected bonus and a $250 (5% x $5,000) adjustment to 
decrease AFS revenue for anticipated returns.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), F is 
required to include $5,000, less the corresponding cost of goods sold 
under sections 263A and 471 as applicable, in gross income in 2021 as F 
has a fixed right to receive $5,000 from the delivery of 500 parts to 
the customer in 2021. However, F does not have a fixed right to receive 
any portion of the $200 delivery bonus as of the end of 2021 as the 
remaining 500 parts had yet to be delivered. Under the AFS income 
inclusion rule and, specifically, paragraphs (b)(2)(i)(A)(1) and 
(b)(2)(i)(B) of this section, the amount treated as ``taken into 
account as AFS revenue'' for 2021 is also $5,000, calculated as $4,850 
of AFS revenue that was reported for 2021, decreased by $100 for the 
expected delivery bonus that F does not have an enforceable right to 
recover if the customer were to terminate the contract as of the end of 
2021 and increased by $250 for anticipated return liabilities that are 
accounted for under section 461 ($4,850-$100 + $250 = $5,000). 
Accordingly, F is required to include $5,000, less the corresponding 
cost of goods sold determined under sections 263A and 471 as 
applicable, in gross income in 2021.
    (vi) Example 6: Chargebacks--(A) Facts. In November 2021, G, a 
pharmaceutical manufacturer, enters into a contract to sell 1,000 units 
to W, a wholesaler, for $10 per unit, totaling $10,000 (1,000 x $10). 
The contract also provides that G will credit or pay W $4 per unit (a 
40% ``chargeback'') for sales W makes to certain qualifying customers. 
G delivers 600 units to W on December 31, 2021, and bills W $6,000 
under the contract. W does not make any sales to qualifying customers 
in 2021. For its AFS, G reports $3,600 ($6,000-$2,400) of AFS revenue 
for 2021, which includes a reduction of the $6,000 of sales revenue by 
$2,400 (40% x $6,000) for anticipated chargebacks.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), G is 
required to include $6,000, less the corresponding cost of goods sold 
under sections 263A and 471 as applicable, in gross income in 2021 as G 
has a fixed right to receive $6,000

[[Page 840]]

from the delivery of 600 units to W in 2021. The anticipated 
chargebacks are liabilities that are accounted for under section 461. 
Under the AFS income inclusion rule and, specifically, paragraph 
(b)(2)(i)(A)(1) of this section, the amount treated as ``taken into 
account as AFS revenue'' for 2021 is also $6,000, calculated as $3,600 
of AFS revenue reported for 2021, increased by $2,400 of anticipated 
chargeback liabilities that are accounted for under section 461 ($3,600 
+ $2,400 = $6,000). Accordingly, G is required to include $6,000, less 
the corresponding cost of goods sold under sections 263A and 471 as 
applicable, in gross income in 2021.
    (vii) Example 7: Sale of property using a special method of 
accounting. In 2021, H, a financial services provider, sells a building 
for $100,000, payable in five annual payments of $20,000 together with 
adequate stated interest, starting in 2021. For its AFS, H reports 
$100,000 of AFS revenue for 2021 from the sale of the building. For 
Federal income tax purposes, H uses the installment method under 
section 453 for the sale of the building. Because the installment 
method under section 453 is a special method of accounting under 
paragraphs (a)(13)(ii) and (b)(3)(i) of this section, the AFS income 
inclusion rule does not apply to H's sale of the building. Accordingly, 
the gain from the sale is included in income as prescribed in section 
453.
    (viii) Example 8: Insurance contract renewals--(A) Facts. J, an 
insurance agent, is engaged by an insurance carrier to sell insurance. 
Pursuant to the contract between J and the insurance carrier, J is 
entitled to receive a $50 commission from the insurance carrier at the 
time a policy is sold to a customer. The contract also provides that J 
is entitled to receive an additional $25 commission each time a policy 
is renewed. J does not have an enforceable right to a renewal 
commission if the insurance carrier terminates the contract before a 
policy is renewed. J sells 1,000 one-year policies in 2021, of which 
800 are expected to be renewed in 2022 and 700 are expected to be 
renewed in 2023. J does not have any ongoing obligation to provide 
additional services to the insurance carrier or the customers after the 
initial sale of the policy. For its AFS, J reports $87,500 of AFS 
revenue for 2021, which includes $50,000 ($50 x 1,000) of commission 
income for policies sold in 2021 and an estimate of $37,500 ($25 x 
1,500) of commission income for the policies expected to be renewed in 
2022 and 2023.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), J is 
required to include $50,000 in gross income in 2021 as J has a fixed 
right to receive $50,000 of commission income for the policies it sold 
during 2021. However, as of the end of 2021, J does not have a fixed 
right to receive any commission income from anticipated policy 
renewals. Under the AFS income inclusion rule, although J reports 
$87,500 of AFS revenue for 2021, J does not have an enforceable right 
to recover the $37,500 of anticipated commission income from future 
policy renewals if the insurance carrier were to terminate the contract 
on the last day of 2021. Accordingly, pursuant to paragraph 
(b)(2)(i)(B) of this section, of the $87,500 of AFS revenue reported 
for 2021, only $50,000 is treated as ``taken into account as AFS 
revenue'' under the AFS income inclusion rule. As a result, J is 
required to include $50,000 in gross income in 2021. Alternatively, if 
J uses the alternative AFS revenue method in paragraph (b)(2)(ii) of 
this section, all $87,500 of AFS revenue reported for 2021 would be 
treated as ``taken into account as AFS revenue'' under the AFS income 
inclusion rule and J would be required to include $87,500 of commission 
income in gross income in 2021.
    (ix) Example 9: Escalating rents--(A) Facts. (1) K is a landlord in 
the business of leasing office space. On January 1, 2021, K enters into 
a 5-year lease with a tenant that provides for annual rent of $30,000 
for 2021 and increases by 5% each year over the lease term. The annual 
rents are due at the end of each year. Accordingly, the rent for each 
year (rounded to the nearest dollar) is as follows:

                   Table 1 to Paragraph (b)(4)(ix)(A)
------------------------------------------------------------------------
                Year                      Calculation       Total rent
------------------------------------------------------------------------
2021................................             $30,000         $30,000
2022................................       30,000 * 1.05          31,500
2023................................       31,500 * 1.05          33,075
2024................................       33,075 * 1.05          34,729
2025................................       34,729 * 1.05          36,465
                                     -----------------------------------
    Total Rent for Five Years.......  ..................         165,769
------------------------------------------------------------------------

    (2) The lease is not a section 467 rental agreement as defined 
under section 467(d). If the tenant terminates the lease early, the 
tenant must pay K the balance of the rent due for the remainder of the 
termination year. On its AFS, K reports AFS revenue from rents on a 
straight-line basis over the term of the lease, or approximately 
$33,154 per year ($165,769 total rent/5 years). Accordingly, for its 
AFS, K reports $33,154 of AFS revenue for 2021.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), K is 
required to include $30,000 in gross income in 2021 as K has a fixed 
right to receive $30,000 for the 2021 rental period under the terms of 
the lease agreement. Under the AFS income inclusion rule, although K 
reports $33,154 of AFS revenue for 2021, K has an enforceable right to 
recover only $30,000 if the tenant were to cancel the lease on the last 
day of 2021. Accordingly, pursuant to paragraph (b)(2)(i)(B) of this 
section, of the $33,154 of AFS revenue reported for 2021, only $30,000 
is treated as ``taken into account in AFS revenue'' under the AFS 
income inclusion rule. As a result, K is required to include $30,000 in 
gross income in 2021.
    (x) Example 10: Licensing income from digital services--(A) Facts. 
M is engaged in the business of licensing media entertainment content 
packages. M licenses content packages to customers by entering into 
subscription plans with customers. In January 2021, M enters into a 
two-year subscription plan with Customer. M charges Customer $40 per 
month billed monthly in arrears. If Customer terminates the plan prior 
to the two-year term, it must pay the balance of the subscription fee 
for the remaining term of the contract. For its AFS, M reports $960 
($40 x 24 months) of AFS revenue for 2021.
    (B) Analysis. Under the all events test in Sec.  1.451-1(a), M is 
required to include $480 in gross income in 2021 as M has a fixed right 
to receive $480 ($40 x 12) for the 12 months of media content licensed 
to Customer in 2021. M does

[[Page 841]]

not have a fixed right to receive any portion of the 2022 subscription 
fee as of the end of 2021 as such fee is not due under the terms of the 
subscription agreement until 2022 and M has yet to provide the media 
content for the 2022 subscription period. However, under the AFS income 
inclusion rule, because M has an enforceable right to recover all $960 
of AFS revenue reported for 2021 if Customer were to terminate the 
contract at the end of 2021, all $960 is treated as ``taken into 
account as AFS revenue'' in 2021. Accordingly, M is required to include 
$960 in gross income in 2021.
    (c) Cost offsets--(1) In general. This paragraph (c) provides an 
optional method of accounting that may be used to determine the AFS 
income inclusion amount for an item of gross income from the sale of 
inventory (AFS cost offset method). A taxpayer that uses the AFS cost 
offset method for a trade or business must apply this method to all 
items of gross income in the trade or business that meet the criteria 
in this paragraph (c). Additionally, a taxpayer that uses this method 
for a trade or business must also use the advance payment cost offset 
method described in Sec.  1.451-8(e) to account for all advance 
payments received by such trade or business that meet the criteria in 
Sec.  1.451-8(e), if applicable. A taxpayer that uses the AFS cost 
offset method to account for gross income from the sale of an item of 
inventory, but not the advance payment cost offset method because it 
does not receive any advance payments for such item, determines the 
corresponding AFS income inclusion amount for a taxable year by 
following the rules in paragraph (c)(2) of this section. A taxpayer 
that uses the AFS cost offset method and the advance payment cost 
offset method to account for gross income, including advance payments, 
from the sale of an item of inventory, determines the corresponding AFS 
income inclusion amount and the advance payment income inclusion 
amount, as defined in Sec.  1.451-8(a)(2), for a taxable year by 
following the rules in paragraph (c)(2) of this section rather than the 
rules under Sec.  1.451-8(e). However, if all payments received for the 
sale of an item of inventory meet the definition of an advance payment 
under Sec.  1.451-8(a)(1), a taxpayer that uses the advance payment 
cost offset method determines the corresponding advance payment income 
inclusion amount for a taxable year by following the rules in Sec.  
1.451-8(e).
    (2) AFS cost offset method. A taxpayer that uses the AFS cost 
offset method and, if applicable, the advance payment cost offset 
method, to account for gross income from the sale of an item of 
inventory determines the AFS income inclusion amount, or, if 
applicable, the advance payment income inclusion amount, for a taxable 
year prior to the taxable year in which ownership of the item of 
inventory is transferred to the customer by following the rules in 
paragraph (c)(2)(i) of this section, subject to the additional rules 
and limitations in paragraphs (c)(4) through (6) of this section. Such 
taxpayer determines the AFS income inclusion amount or, if applicable, 
the advance payment income inclusion amount, for the taxable year in 
which ownership of the item of inventory is transferred to the customer 
by following the rules in paragraph (c)(2)(ii) of this section. A 
taxpayer described in this paragraph (c)(2) that receives advance 
payments for the sale of the item of inventory may be required to 
include in gross income for a taxable year an amount that is comprised 
of both an AFS income inclusion amount and an advance payment income 
inclusion amount. In such case, it is not necessary to determine the 
portion of the total inclusion that is comprised of the AFS income 
inclusion amount and the portion of the total inclusion that is 
comprised of the advance payment income inclusion amount.
    (i) Determining gross income for a year prior to the year of sale. 
To determine the amount required to be included in gross income from 
the sale of an item of inventory for a taxable year prior to the 
taxable year in which ownership of the item of inventory is transferred 
to the customer, a taxpayer must first determine the AFS inventory 
inclusion amount for such item for such year by applying the steps in 
paragraph (c)(2)(i)(A) of this section. This AFS inventory inclusion 
amount is then reduced by the cost of goods in progress offset for the 
taxable year, as determined under paragraphs (c)(3) through (5) of this 
section. This net amount is required to be included in gross income for 
the taxable year.
    (A) AFS inventory inclusion amount for a taxable year. To determine 
the AFS inventory inclusion amount for an item of inventory for a 
taxable year:
    (1) The taxpayer first takes the greater of the amount described in 
paragraph (c)(2)(i)(A)(1)(i) of this section, or the amount described 
in paragraph (c)(2)(i)(A)(1)(ii) of this section (or if the two amounts 
are equal, the equal amount).
    (i) The cumulative amount of revenue from the item of inventory 
that satisfies the all events test under Sec.  1.451-1(a) through the 
last day of the taxable year, less any advance payment inventory 
inclusion amount, as defined in Sec.  1.451-8(a)(3), with respect to a 
subsequent taxable year.
    (ii) The cumulative amount of revenue from the item of inventory 
that is treated as ``taken into account as AFS revenue'' under 
paragraph (b)(2) of this section through the last day of the taxable 
year.
    (2) The taxpayer then reduces the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section by the amount computed under paragraph 
(c)(2)(i)(A)(1) of this section for that item of inventory for the 
immediately preceding taxable year.
    (B) [Reserved]
    (ii) Determining the gross income for the year of sale. To 
determine the amount required to be included in gross income from the 
sale of an item of inventory for the taxable year in which ownership of 
the item of inventory is transferred to the customer:
    (A) The taxpayer first takes the greater of the amount described in 
paragraph (c)(2)(ii)(A)(1) of this section, or the amount described in 
paragraph (c)(2)(ii)(A)(2) of this section (or if the two amounts are 
equal, the equal amount).
    (1) The cumulative amount of revenue from the item of inventory 
that satisfies the all events test under Sec.  1.451-1(a) through the 
last day of the taxable year, including the full amount of any advance 
payment received for the item of inventory.
    (2) The cumulative amount of revenue from the item of inventory 
that is treated as ``taken into account as AFS revenue'' under 
paragraph (b)(2) of this section through the last day of the taxable 
year.
    (B) The taxpayer then reduces such amount by any prior income 
inclusion amounts with respect to such item of inventory. This net 
amount is required to be included in gross income for the taxable year. 
The taxpayer does not further reduce such amount by a cost of goods in 
progress offset under paragraph (c)(3) of this section. However, the 
taxpayer is entitled to recover the costs capitalized to the item of 
inventory as cost of goods sold in accordance with sections 471 and 
263A or any other applicable provision of the Internal Revenue Code. 
See Sec.  1.61-3.
    (3) Cost of goods in progress offset for a taxable year. The cost 
of goods in progress offset for the taxable year is calculated as:
    (i) The cost of goods allocable to the item of inventory through 
the last day of the taxable year; reduced by
    (ii) The cumulative cost of goods in progress offset attributable 
to the item of inventory, if any.

[[Page 842]]

    (4) Limitations to the cost of goods in progress offset. The cost 
of goods in progress offset is determined separately for each item of 
inventory. Further, the cost of goods in progress offset attributable 
to one item of inventory cannot reduce the AFS inventory inclusion 
amount attributable to a separate item of inventory. The cost of goods 
in progress offset cannot reduce the AFS inventory inclusion amount for 
the taxable year below zero.
    (5) Inventory methods--(i) Inventory costs not affected by cost of 
goods in progress offset. The cost of goods comprising the cost of 
goods in progress offset does not reduce the costs that are capitalized 
to the items of inventory produced or items of inventory acquired for 
resale by the taxpayer. While the cost of goods in progress offset 
reduces the AFS inventory inclusion amount, the cost of goods in 
progress offset does not affect how and when costs are capitalized to 
inventory under sections 471 and 263A or any other applicable provision 
of the Internal Revenue Code or when those capitalized costs will be 
recovered.
    (ii) Consistency between inventory methods and AFS cost offset 
method. The costs of goods comprising the cost of goods in progress 
offset must be determined by applying the taxpayer's method of 
accounting for inventory for Federal income tax purposes. A taxpayer 
using the AFS cost offset method and, if applicable, the advance 
payment cost offset method must calculate its cost of goods in progress 
offset by reference to all costs that the taxpayer has permissibly 
capitalized and allocated to items of inventory under its method of 
accounting for inventory for Federal income tax purposes, but including 
no more costs than what the taxpayer has permissibly capitalized and 
allocated to items of inventory.
    (iii) Allocation of ``additional section 263A costs'' for taxpayers 
using simplified methods. If a taxpayer uses the simplified production 
method as defined under Sec.  1.263A-2(b), the modified simplified 
production method as defined under Sec.  1.263A-2(c), or the simplified 
resale method as defined under Sec.  1.263A-3(d) to determine the 
amount of its additional section 263A costs, as defined under Sec.  
1.263A-1(d)(3), to be included in ending inventory, then solely to 
compute the cost of goods in progress offset, the taxpayer must 
determine the portion of additional section 263A costs allocable to an 
item of inventory by multiplying its total additional section 263A 
costs accounted for under the simplified method for all items of 
inventory subject to the simplified method by the following ratio:
    Section 471 costs allocable to the specific item of inventory
    Total section 471 costs for all items of inventory subject to the 
simplified method
    (6) Acceleration of gross income. A taxpayer that uses the AFS cost 
offset method or the advance payment cost offset method must include in 
gross income for a taxable year prior to the taxable year in which an 
item of inventory is transferred to the customer, all payments received 
for the item of inventory that were not previously included in gross 
income:
    (i) If, in that taxable year, the taxpayer either dies or ceases to 
exist in a transaction other than a transaction to which section 381(a) 
applies; or
    (ii) If, and to the extent that, in that taxable year, the 
taxpayer's obligation to the customer with respect to the item of 
inventory ends other than in:
    (A) A transaction to which section 381(a) applies; or
    (B) A section 351(a) transfer that is part of a section 351 
transaction in which:
    (1) Substantially all assets of the trade or business, including 
the item of inventory, are transferred;
    (2) The transferee adopts or uses, in the year of the transfer, the 
same methods of accounting for the item of inventory under this section 
and Sec.  1.451-8 as those used by the transferor; and
    (3) The transferee and the transferor are members of the same 
consolidated group, as defined in Sec.  1.1502-1(h).
    (7) Additional procedural guidance. The IRS may publish procedural 
guidance in the Internal Revenue Bulletin (see Sec.  601.601(d) of this 
chapter) that provides alternative procedures for complying with the 
rules under this paragraph (c), including alternative methods of 
accounting for cost offsets.
    (8) Examples. The following examples illustrate the AFS cost offset 
method. Unless the facts specifically state otherwise, the taxpayer has 
an AFS, is on a calendar year for both Federal income tax purposes and 
AFS purposes, uses an accrual method of accounting for Federal income 
tax purposes, and does not use a special method of accounting. Further, 
the taxpayer properly applies its inventory accounting method, uses the 
AFS cost offset method under paragraph (c) of this section, and, except 
as otherwise provided, does not receive advance payments. Lastly, the 
taxpayer does not produce unique items, as described in Sec.  1.460-
2(a)(1) and (b), or any item that normally requires more than 12 
calendar months to complete, as determined under Sec.  1.460-2(a)(2) 
and (c). Any production period that exceeds 12 calendar months is due 
to unforeseen production delays.
    (i) Example 1--(A) Facts. During 2021, A enters into a contract 
with Customer to manufacture and deliver a good with a total contract 
price of $100x. The costs to produce the good are required to be 
capitalized under sections 471 and 263A as the good is inventory in the 
hands of A. Ownership of the good is transferred from A to Customer 
upon its delivery in 2022. A determines, under paragraph (c)(2)(i)(A) 
of this section, that its AFS inventory inclusion amount for 2021 is 
$20x. A incurs $12x of costs in 2021, and $48x of costs in 2022 ($60x 
in total) that are permissibly capitalized and allocated to the 
produced good under sections 471 and 263A. A has a fixed right to 
receive the $100x contract price when it delivers the good in 2022. A 
does not receive any payments from Customer prior to delivery. Further, 
all $100x is treated as ``taken into account as AFS revenue'' as of the 
last day of 2022.
    (B) Analysis for 2021. For 2021, A's AFS income inclusion amount, 
as determined under paragraph (c)(2)(i) of this section, is $8x ($20x 
AFS inventory inclusion amount less $12x cost of goods in progress 
offset, which is the cost of goods incurred through December 31, 2021).
    (C) Analysis for 2022. During 2022, ownership of the good is 
transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) 
of this section, A determines the AFS income inclusion amount for 2022 
by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2022 ($100x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2022 ($100x) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($100x) the prior income 
inclusion amounts attributable to the transferred good ($8x). This net 
amount of $92x is the AFS income inclusion amount for 2022. Although A 
does not reduce such amount by a cost of goods in progress offset under 
this paragraph (c), A is entitled to recover the $60x of costs 
capitalized to the good as cost of goods sold in 2022 in accordance 
with sections 471 and 263A. See Sec.  1.61-3. Accordingly, A's gross 
income for 2022 is $32x.

[[Page 843]]

    (ii) Example 2--(A) Facts. In December of 2021, A enters into a 
contract with Customer to manufacture and deliver 10 items of inventory 
at a price of $10x per item by the end of 2023. A determines, under 
paragraph (c)(2)(i)(A) of this section, that the AFS inventory 
inclusion amount attributable to each item of inventory under the 
contract is $3x for 2021. A also incurs $10x of inventory costs during 
2021. Such costs are permissibly capitalized and allocated under 
sections 471 and 263A and are allocated equally to each item of 
inventory under the contract ($1x per item). During 2022, the taxpayer 
incurs $18x of costs to finish manufacturing 6 of the 10 items and 
delivers such items to Customer in October of 2022. Such costs are 
permissibly capitalized and allocated under sections 471 and 263A and 
are allocated equally to each of the 6 items delivered in October of 
2022 ($3x per item). Upon delivering the 6 items, ownership of the 
delivered items transfers to Customer, A has a fixed right to receive 
$60x of the total contract price, and all $60x is treated as ``taken 
into account as AFS revenue.'' A does not incur any inventory costs 
during 2022 that are allocable to the 4 remaining undelivered items, 
nor does the taxpayer have an AFS inventory inclusion amount 
attributable to such items for 2022. During 2023, A incurs $12x of 
costs to finish manufacturing the 4 remaining items and delivers such 
items to Customer. Such costs are permissibly capitalized and allocated 
under sections 471 and 263A and are allocated equally to each of the 4 
items delivered in 2023 ($3x per item). Upon delivering the 4 remaining 
items, ownership of the items transfers to Customer, A has a fixed 
right to receive the remaining $40x contract price, and all $40x is 
treated as ``taken into account as AFS revenue.''
    (B) Analysis for 2021 A's AFS income inclusion amount for 2021 is 
$2x per item ($3x AFS inventory inclusion amount per item less $1x cost 
of goods in progress offset per item, which is the cost of goods as of 
December 31, 2021). Accordingly, A's total gross income inclusion for 
2021 is $20x.
    (C) Analysis for 2022. During 2022, ownership of 6 of the 10 items 
is transferred to Customer. Accordingly, pursuant to paragraph 
(c)(2)(ii) of this section, A determines the AFS income inclusion 
amount for 2022 by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2022 ($10x per 
item); or
    (ii) The cumulative amount of revenue that is treated as taken into 
account as AFS revenue through the last day of 2022 ($10x per item) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($10x per item) the prior 
income inclusion amounts attributable to each transferred item ($2x per 
item). This net amount of $8x per item is the AFS income inclusion 
amount for each transferred item for 2022. Although A does not reduce 
such amount by a cost of goods in progress offset under this paragraph 
(c), A is entitled to recover the $4x of costs capitalized to each item 
delivered as cost of goods sold in 2022 in accordance with sections 471 
and 263A. Accordingly, on an aggregate basis, A's gross income for 2022 
is $24x (aggregate AFS income inclusion amount for the 6 items 
delivered in 2022 of $ 48x less aggregate cost of goods sold of $24x). 
A does not include any amounts in gross income for 2022 with respect to 
the 4 items of inventory that were not delivered to Customer until 2023 
as A does not have an AFS inventory inclusion amount attributable to 
such items for 2022.
    (D) Analysis for 2023. During 2023, ownership of the 4 remaining 
items are transferred to Customer. Based on the facts, A did not have 
an AFS inventory inclusion amount attributable to the 4 remaining items 
for 2022, nor did it incur any cost for such items in 2022 so the 
analysis for the 4 remaining items for 2023 is similar to the analysis 
for the 6 items transferred to the customer in 2022 on a per item 
basis. Pursuant to paragraph (c)(2)(ii) of this section, A determines 
the AFS income inclusion amount for 2023 by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2023 ($10x per 
item); or
    (ii) The cumulative amount of revenue that is treated as taken into 
account as AFS revenue through the last day of 2023 ($10x per item) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($10x per item) the prior 
income inclusion amounts attributable to each transferred item ($2x per 
item). This net amount of $8x per item is the AFS income inclusion 
amount for each transferred item for 2023. Although A does not reduce 
such amount by a cost of goods in progress offset under this paragraph 
(c), A is entitled to recover the $4x of costs capitalized to each item 
delivered as cost of goods sold in 2023 in accordance with sections 471 
and 263A. On an aggregate basis, A's gross income for 2023 is $16x 
(aggregate AFS income inclusion amount for the 4 items delivered in 
2023 of $32x less aggregate cost of goods sold of $16x).
    (iii) Example 3--(A) Facts. In December of 2021, A enters into a 
contract with Customer to manufacture and deliver a good with a total 
contract price of $100x. The costs to produce the good are required to 
be capitalized under sections 471 and 263A as the good is inventory in 
the hands of the taxpayer. Ownership of the good is transferred from A 
to Customer upon its delivery in January of 2023. A determines, under 
paragraph (c)(2)(i)(A) of this section, that its AFS inventory 
inclusion amount for 2021 and 2022 is $40x per year. A incurs $25x of 
costs each year ($75x in total) that are permissibly capitalized and 
allocated to the manufactured good under sections 471 and 263A. A has a 
fixed right to receive the $100x contract price when it delivers the 
good in January of 2023. A does not receive any payments from Customer 
prior to delivery. Further, all $100x is treated as ``taken into 
account as AFS revenue'' as of the last day of 2023.
    (B) Analysis for 2021 and 2022. For 2021, A's AFS income inclusion 
amount, as determined under paragraph (c)(2)(i) of this section, is 
$15x ($40x AFS inventory inclusion amount for 2021 less the $25x cost 
of goods in progress offset for 2021, which is equal to the cost of 
goods as of December 31, 2021). For 2022, A's AFS income inclusion 
amount is $15x ($40x AFS inventory inclusion amount for 2022 less the 
$25x cost of goods in progress offset for 2022, which is the $50x cost 
of goods as of December 31, 2022 less the 25x cumulative cost of goods 
in progress offset amount taken into account in 2021).
    (C) Analysis for 2023. During 2023, ownership of the good is 
transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) 
of this section, A determines the AFS income inclusion amount for 2023 
by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2023 ($100x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2023 ($100x) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($100x) the prior income 
inclusion amounts attributable to the transferred good of $30x ($15x 
for 2021 and $15x for 2022). This net amount of $70x is the AFS income 
inclusion

[[Page 844]]

amount for 2023. Although A does not reduce such amount by a cost of 
goods in progress offset under this paragraph (c), A is entitled to 
recover the $75x of costs capitalized to the good as cost of goods sold 
in 2023 in accordance with sections 471 and 263A. See Sec.  1.61-3. 
Accordingly, A's gross income for 2025 is -$5x.
    (iv) Example 4--(A) Facts. In December 2021, A enters into a 
contract with Customer to manufacture and deliver a good with a total 
contract price of $100x. A reports $5x of AFS revenue for 2021, $90x of 
cumulative AFS revenue through the end of 2022, and $100x of cumulative 
AFS revenue through the end of 2023. A has an enforceable right to 
recover all AFS revenue reported through the end of each contract year 
if Customer were to terminate the contract on the last day of each 
year. Under the terms of the contract, A is entitled to and receives a 
payment of $40x in 2021 and a payment of $60x when Customer accepts 
delivery of the good in 2023, which is also when ownership of the good 
transfers to Customer. The costs to produce the good are required to be 
capitalized under sections 471 and 263A as the good is inventory in the 
hands of A. A incurs $10x of costs in 2021, $55x of costs in 2022, and 
$5x of costs in 2023 ($70x in total). Such costs are permissibly 
capitalized and allocated to the produced good under sections 471 and 
263A. A uses the AFS cost offset method under paragraph (c) of this 
section and accounts for advance payments, as defined in Sec.  1.451-
8(a)(1), under the deferral method and advance payment cost offset 
method under Sec.  1.451-8(c) and (e), respectively.
    (B) Analysis for 2021. The $40x payment A receives in 2021 meets 
the definition of an advance payment under Sec.  1.451-8(a)(1) as the 
full inclusion of $40x in gross income in the year of receipt is a 
permissible method of accounting, a portion of the payment ($35x) is 
``taken into account as AFS revenue'' in a subsequent year, and the 
payment is for a good. Pursuant to Sec.  1.451-8(a)(3), A's advance 
payment inventory inclusion amount for 2022 is $35x (the portion of the 
payment deferred for AFS purposes). Pursuant to paragraph (c)(2)(i) of 
this section, A must first determine the AFS inventory inclusion amount 
for 2021 by applying the rules in paragraph (c)(2)(i)(A) of this 
section. A then reduces such amount by the cost of goods in progress 
offset for 2021, as determined under paragraphs (c)(3) through (5) of 
this section.
    (1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first 
takes the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2021, less any 
advance payment inventory inclusion amount attributable to a subsequent 
year ($5x, determined as the $40x under the all events test, less the 
$35x of advance payment inventory inclusion amount attributable to 
2022); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2021 ($5x) (or if 
the two amounts are equal, the equal amount).
    (2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then 
subtracts from such amount ($5x) the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section for the item of inventory for the 
immediately preceding year ($0). This net amount of $5x is the AFS 
inventory inclusion amount for 2021.
    (3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this 
$5x AFS inventory inclusion amount by the cost of goods in progress 
offset for 2021 of $5x, determined as the cost of goods as of December 
31, 2021 of $10x, less the cumulative cost of goods in progress offset 
taken into account in prior years of $0, less 5x for the AFS inventory 
inclusion amount limitation under paragraph (c)(4) of this section. 
Accordingly, A is required to include $0 in gross income for 2021.
    (C) Analysis for 2022. Pursuant to paragraph (c)(2)(i) of this 
section, A must first determine the AFS inventory inclusion amount for 
2022 by applying the rules in paragraph (c)(2)(i)(A) of this section. A 
then reduces such amount by the cost of goods in progress offset for 
2022, as determined under paragraphs (c)(3) through (5) of this 
section.
    (1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first 
takes the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2022 ($40x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2022 ($90x).
    (2) Pursuant to (c)(2)(i)(A)(2) of this section, A then subtracts 
from such amount ($90x) the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section for the item of inventory for 2021 
($5x). This net amount of $85x is the AFS inventory inclusion amount 
for 2022.
    (3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this 
$85x AFS inventory inclusion amount by the cost of goods in progress 
offset for 2022 of $60x, determined as the cost of goods as of December 
31, 2022 of $65x, less the cumulative cost of goods in progress offset 
taken into account in prior years of $5x. Accordingly, A is required to 
include $25x in gross income for 2022.
    (D) Analysis for 2023. During 2023, ownership of the good is 
transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) 
of this section, A determines its gross income inclusion for 2023 by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2023 ($100x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2023 ($100x) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($100x) the prior income 
inclusion amounts attributable to the transferred good of $25x ($0 for 
2021 plus $25x for 2022). A is required to include this net amount of 
$75x in gross income for 2023. Although A does not reduce such amount 
by a cost of goods in progress offset under this paragraph (c), A is 
entitled to recover the $70x of costs capitalized to the good as cost 
of goods sold in 2023 in accordance with sections 471 and 263A. See 
Sec.  1.61-3. Accordingly, A's gross income for 2023 is $5x.
    (v) Example 5--(A) Facts. The same facts as in paragraph (c)(8)(iv) 
of this section (Example 4) apply, except that in 2022, A's obligation 
to Customer with respect to the good ends other than in a transaction 
to which section 381(a) applies, or a section 351 transaction described 
in paragraph (c)(6)(ii)(B) of this section. A does not receive any 
additional payments in 2022.
    (B) Analysis for 2021. The analysis for 2021 is the same as in 
paragraph (c)(8)(iv) of this section (Example 4).
    (C) Analysis for 2022. Because, in 2022, A's obligation to Customer 
with respect to the good ends in a transaction other than a transaction 
described in paragraph (c)(6)(ii)(A) or (B) of this section, A is 
required to apply the acceleration rules in paragraph (c)(6) of this 
section. Accordingly, because A received $40x of payments as of the 
date of the transaction, but did not include any portion of such 
payments in gross income in prior years, A is required to include the 
remaining $40x of the payments received in gross income in 2022 
pursuant to paragraph (c)(6) of this section. A is not permitted to 
further reduce the $40x income inclusion by a cost of goods in progress 
offset under this paragraph (c).

[[Page 845]]

    (vi) Example 6--(A) Facts. In 2021, A enters into a contract with 
Customer to produce and deliver a good. The contract provides that A 
will receive payments equal to AFS costs plus a 100% mark-up, however, 
A can only bill the customer on December 31, 2022 and, if the good is 
not delivered by December 31, 2022, A can also bill Customer upon 
delivery of the good, for the AFS costs (plus markup) incurred to date, 
less any amounts previously billed. A recognizes AFS revenue based on a 
percentage of completion (cost to cost) method. A recognizes AFS 
revenue of $100 through the last day of 2021, $150 through the last day 
of 2022, and $300 through the last day of 2023, and has an enforceable 
right to all AFS revenue reported as of the end of each year if the 
customer were to terminate the contract on the last day of the year. A 
bills the customer $150 on December 31 of 2022 and $150 in 2023 when A 
delivers the good and ownership transfers to Customer. The costs to 
produce the good are required to be capitalized under sections 471 and 
263A as the good is inventory in the hands of the taxpayer. A incurs 
the following costs each year that are permissibly capitalized and 
allocated to the produced good under sections 471 and 263A: $125 in 
2021; $0 in 2022; and $25 in year 2023.
    (B) Analysis for taxable year 2021. Pursuant to paragraph (c)(2)(i) 
of this section, A must first determine the AFS inventory inclusion 
amount for 2021 by applying the rules in paragraph (c)(2)(i)(A) of this 
section. A then reduces such amount by the cost of goods in progress 
offset for 2021, as determined under paragraphs (c)(3) through (5) of 
this section.
    (1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first 
takes the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2021 ($0); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2021 ($100).
    (2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then 
subtracts from such amount ($100) the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section for the item of inventory for the 
immediately preceding year ($0). This net amount of $100 is the AFS 
inventory inclusion amount for 2021.
    (3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this 
$100 AFS inventory inclusion amount by the cost of goods in progress 
offset for 2021 of $100. Although A's cost of goods in progress as of 
the end of 2021 is $125, the cost of goods in progress offset is 
limited to $100, the amount of A's AFS inventory inclusion amount for 
2021. Accordingly, A is required to include $0 in gross income in 2021.
    (C) Analysis for taxable year 2022. Pursuant to paragraph (c)(2)(i) 
of this section, A must first determine the AFS inventory inclusion 
amount for 2022 by applying the rules in paragraph (c)(2)(i)(A) of this 
section. A then reduces such amount by the cost of goods in progress 
offset for 2022, as determined under paragraphs (c)(3) through (5) of 
this section.
    (1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first 
takes the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2022 ($150 due 
under the terms of the contract); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2022 ($150) (or 
if the two amounts are equal, the equal amount).
    (2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then 
subtracts from such amount ($150) the amount determined under paragraph 
(c)(2)(i)(A)(1) of this section for the item of inventory for the 
immediately preceding year ($100). This net amount of $50 is the AFS 
inventory inclusion amount for 2022.
    (3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this 
$50 AFS inventory inclusion amount by the cost of goods in progress 
offset for 2022 of $25, determined as $125 cost of goods as of December 
31, 2022 minus $100 cumulative cost of goods in progress offset amount 
taken into account in 2021. Accordingly, A is required to include $25 
in gross income for 2022.
    (D) Analysis for taxable year 2023. During 2023, ownership of the 
good is transferred to the customer. Accordingly, pursuant to paragraph 
(c)(2)(ii) of this section, A determines its gross income inclusion for 
2023 by:
    (1) First taking the greater of:
    (i) The cumulative amount of revenue that satisfies the all events 
test under Sec.  1.451-1(a) through the last day of 2023 ($300x); or
    (ii) The cumulative amount of revenue that is treated as ``taken 
into account as AFS revenue'' through the last day of 2025 ($300x) (or 
if the two amounts are equal, the equal amount).
    (2) Then subtracting from such amount ($300x) the prior income 
inclusion amounts attributable to the transferred good of $25 ($0 for 
2021 plus $25 for 2022). This net amount of $275 is the AFS income 
inclusion amount for 2023. Although A does not reduce such amount by a 
cost of goods in progress offset under this paragraph (c), A is 
entitled to recover the $150 of costs capitalized to the good as cost 
of goods sold in 2023 in accordance with sections 471 and 263A. See 
Sec.  1.61-3. Accordingly, A's gross income for 2023 is $125 ($275 AFS 
income inclusion amount less $150 cost of goods sold).
    (d) Contracts with multiple performance obligations--(1) In 
general. Each performance obligation generally yields a corresponding 
item of gross income that must be accounted for separately under the 
AFS income inclusion rule in paragraph (b)(1) of this section. Except 
as provided in paragraph (d)(5) of this section, if a contract contains 
more than one performance obligation, and thus yields more than one 
corresponding item of gross income, the transaction price amount shall 
be allocated to each corresponding item of gross income in accordance 
with the transaction price amount allocated to each performance 
obligation for AFS purposes, subject to the adjustments to the 
transaction price amount and special allocation rules in paragraph 
(d)(3) of this section.
    (2) Single performance obligation with more than one item of gross 
income. If a single performance obligation yields more than one 
corresponding item of gross income, the transaction price amount 
allocated to the single performance obligation for AFS purposes must be 
further allocated among the corresponding items of gross income using 
any reasonable method.
    (3) Adjustments to transaction price amount and special allocation 
rules--(i) Increases to transaction price amount. If the transaction 
price amount includes a reduction for amounts described in paragraph 
(b)(2)(i)(A)(1) or (2) of this section, or has been reduced because a 
significant financing component is deemed to exist under the standards 
the taxpayer uses to prepare its AFS, the taxpayer must determine the 
specific performance obligation to which such reduction relates and 
increase the transaction price amount allocable to the corresponding 
item of gross income by the amount of such reduction (specific 
identification approach). If it is impracticable from the taxpayer's 
records to use the specific identification approach, the taxpayer may 
use any reasonable method to allocate the reduction amount to the items 
of gross income in the contract. A pro-rata allocation of the reduction 
amount across all items of gross income under the contract based on the 
relative

[[Page 846]]

transaction price amounts allocated to such items under paragraph 
(d)(1) of this section is a reasonable method.
    (ii) Decrease to transaction price amount. If the transaction price 
amount has been increased because a significant financing component is 
deemed to exist under the standards the taxpayer uses to prepare its 
AFS, the taxpayer must determine the specific performance obligation to 
which such amount relates and decrease the transaction price amount 
allocable to the corresponding item of gross income by such amount 
(specific identification approach). If it is impracticable from the 
taxpayer's records to use the specific identification approach, the 
taxpayer may use any reasonable method to allocate such amount to the 
items of gross income in the contract. A pro-rata allocation of such 
amount across all items of gross income under the contract based on the 
relative transaction price amounts allocated to such items under 
paragraph (d)(1) of this section is a reasonable method.
    (4) Examples. The following examples illustrate the rules of 
paragraph (d)(1) through (3) of this section. Unless the facts 
specifically state otherwise, the taxpayer has an AFS, is on a calendar 
year for Federal income tax purposes and AFS purposes, and uses an 
accrual method of accounting for Federal income tax purposes.
    (i) Example 1--(A) Facts. On November 1, 2021, A, a software 
developer, enters into a contract with a customer to transfer a 
software license, perform software installation services, and provide 
technical support for a two-year period for $100x. The installation 
service does not significantly modify the software and the software 
remains functional without the technical support. A receives an 
additional $10x bonus if the installation service is performed before 
February 1, 2022, which A expects to receive. Further, the customer is 
entitled to a refund of $2x if technical support does not meet 
performance standards set forth in the contract, which A expects it 
will pay to the customer. For its AFS, A identifies three performance 
obligations in the contract:
    (1)(i) The software license;
    (ii) The installation service; and
    (iii) Technical support.
    (2) Also, for its AFS, A determines that the transaction price 
amount is $108x, determined as $100x contract price plus $10x bonus for 
installation services minus $2x customer refund. Finally, for its AFS, 
A allocates the $108x transaction price amount to the three performance 
obligations as follows: $60x to the software license; $40x to the 
installation service ($30x + $10x bonus); and $8x to technical support 
($10x-$2x refund).
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, A's 
contract with the customer has three performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, A is required to allocate the $108x transaction price amount 
to each corresponding item of gross income in accordance with the 
transaction price amount allocated to each respective performance 
obligation for AFS purposes. Accordingly, A initially allocates $60x to 
the software license item, $40x to the installation service item, and 
$8 to the technical support item. However, because the transaction 
price amount was reduced by the anticipated refund of $2x, which 
relates specifically to the technical support item, A must increase the 
transaction price allocable to that item of gross income pursuant to 
the specific identification approach in paragraph (d)(3) of this 
section. Accordingly, the amount allocated to the item of gross income 
related to technical support is $10x.
    (ii) Example 2--(A) Facts. In 2021, B, a manufacturer and servicer 
of airplane parts, enters into a contract with a customer to sell 
airplane parts in 2021 and to service those parts, as necessary, in 
2021, 2022, and 2023 for $100x. B regularly sells the airline parts and 
the services separately. For its AFS, B identifies two performance 
obligations in the contract:
    (1)(i) The sale of airplane parts; and
    (ii) The services for those parts.
    (2) The customer receives a refund of $5x if it does not require a 
specified level of service for the parts, which B expects it will pay 
to the customer. Also, for its AFS, B determines that the transaction 
price amount is $95x, determined as the $100x contract price minus the 
$5x refund that it expects to pay the customer. Finally, for its AFS, B 
allocates the $95x transaction price amount to the two performance 
obligations as follows: $40x to the sale of parts and $55x to the 
provision of services ($60x-$5x refund).
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, B's 
contract with the customer has two performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, B is required to allocate the $95x transaction price amount to 
each corresponding item of gross income in accordance with the 
transaction price amount allocated to each respective performance 
obligation for AFS purposes. Accordingly, B initially allocates $40x to 
the sale of parts item and $55x to the provision of services item. 
However, because the transaction price amount was reduced by the 
anticipated refund of $5x, which relates specifically to provision of 
services item, B must increase the transaction price allocable to that 
item of gross income pursuant to the specific identification approach 
in paragraph (d)(3) of this section. Accordingly, the amount allocated 
to the item of gross income related to servicing the parts is $60x.
    (iii) Example 3: Reward points--(A) Facts. On December 31, 2021, U, 
in the business of selling consumer electronics, sells a new TV for 
$1,000 and gives the customer 50 reward points. Each reward point is 
redeemable for a $1 discount on any future purchase of U's products. 
For its AFS, U identifies two performance obligations from the 
transaction:
    (1)(i) The sale of the TV; and
    (ii) The provision of rewards points.
    (2) Also, for its AFS, U allocates $950 of transaction price amount 
to the sale of the TV and the remaining $50 of the transaction price 
amount to the reward points.
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, U's 
contract with the customer has two performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, U is required to allocate the $1,000 transaction price amount 
to each corresponding item of gross income in accordance with the 
transaction price amount allocated to each respective performance 
obligation for AFS purposes. Accordingly, U allocates the transaction 
price amount as follows: $950 to the TV sale item and $50 to the reward 
points item. If U reports any portion of the $50 payment allocated to 
the reward points as AFS revenue for 2022, or later, the payment is an 
advance payment, as defined in Sec.  1.451-8(a)(1), and may be 
accounted for under the deferral method if U satisfies the criteria in 
Sec.  1.451-8(c).
    (iv) Example 4: Airline reward miles--(A) Facts. On January 1, 
2021, W, a passenger airline company, sells a customer a $700 airline 
ticket to fly roundtrip in 2021. As part of the purchase, the customer 
receives 7,000 points (air miles) from W to be redeemed for future air 
travel. For its AFS, W identifies two performance obligations in the 
contract:
    (1)(i) The sale of the airline ticket; and

[[Page 847]]

    (ii) The provision of air miles.
    (2) W also anticipates that it will issue a rebate to the customer 
for $10. Also, for its AFS, W determines that the transaction price 
amount is $690, determined as the $700 ticket price minus the 
anticipated $10 rebate. Finally, for its AFS, W allocates the $690 
transaction price amount to the separate performance obligations as 
follows: $660 to the ticket ($670-$10 rebate = $660) and $30 to the air 
miles.
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, W's 
contract with the customer has two performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, W must allocate the $690 transaction price amount to each 
corresponding item of gross income in accordance with the transaction 
price amount allocated to each respective performance obligation for 
AFS purposes. Accordingly, W initially allocates $660 to the ticket 
sale item and $30 to the air miles item. However, because the 
transaction price amount was reduced by the anticipated rebate of $10x, 
which relates to the ticket sale item, W must increase the transaction 
price allocable to that item of gross income pursuant to paragraph 
(d)(3) of this section. Accordingly, the amount allocated to the item 
of gross income related to the ticket sale is $670. If W reports any 
portion of the $30 payment allocated to the air miles item as AFS 
revenue for 2022, or later, the payment is an advance payment, as 
defined in Sec.  1.451-8(a)(1), and may be accounted for under the 
deferral method if W satisfies the criteria in Sec.  1.451-8(c).
    (v) Example 5: Contract with significant financing component 
amounts--(A) Facts. On January 1, 2021, C, a manufacturer and servicer 
of airline parts, enters into a contract with a customer to sell 
airline parts in December 2022, and to service those parts, as 
necessary, through 2024. The contract contains two alternative payment 
options: payment of $5,000 in December 2022 when the customer obtains 
control of the parts or payment of $4,000 when the contract is signed. 
The customer pays $4,000 when the contract is signed, which reflects an 
implicit interest rate of 11.8% and is C's incremental borrowing rate. 
C regularly sells the airline parts and the services separately. For 
its AFS, C identifies two performance obligations in the contract:
    (1)(i) The sale of airplane parts; and
    (ii) The services for those parts.
    (2) Also, for its AFS, although the contract only requires the 
customer to pay $4,000, the transaction price is increased by $1,000 to 
$5,000 because the customer is deemed to provide financing to C under 
the standards C uses to prepare its AFS. The $1,000 increase is 
attributable to a significant financing component. Finally, for its 
AFS, C allocates the $5,000 transaction price amount to the separate 
performance obligations as follows: $3,750 to the sale of parts ($3,000 
upfront payment plus $750 financing component) and $1,250 ($1,000 
upfront payment plus $250 financing component) to the provision of 
services.
    (B) Analysis. Pursuant to paragraph (d)(1) of this section, C's 
contract with the customer has two performance obligations, and each 
performance obligation yields a corresponding item of gross income that 
is accounted for separately. Pursuant to paragraph (d)(1) of this 
section, C must allocate the $5,000 transaction price amount to each 
corresponding item of gross income in accordance with the transaction 
price amount allocated to each respective performance obligation for 
AFS purposes. Accordingly, C initially allocates $3,750 to the sale of 
the parts item and $1,250 to the provision of services item. However, 
because the transaction price was increased by a significant financing 
component of $1,000, $750 of which was allocated to sale of the parts 
item and $250 of which was allocated to the provision of services item, 
pursuant to paragraph (d)(3) of this section, C must decrease the 
transaction price amount allocable to the sale of parts item from 
$3,750 to $3,000 and must decrease the transaction price allocable to 
the provision of services from $1,250 to $1,000.
    (5) Contracts accounted for in part under this section and in part 
under a special method of accounting--(i) In general. If a taxpayer has 
a contract with a customer that includes one or more items of gross 
income that are subject to a special method of accounting and one or 
more items of gross income that are subject to this section (special 
method/451 contract), the transaction price allocation rule in 
paragraph (d)(1) of this section does not apply to determine the amount 
of each item of gross income that is subject to a special method of 
accounting. For purposes of this paragraph (d)(5)(i), a special method 
of accounting has the meaning set forth in paragraph (a)(13) of this 
section, except as otherwise provided in guidance published in the 
Internal Revenue Bulletin (see Sec.  601.601(d) of this chapter). For 
special method/451 contracts, paragraphs (d)(5)(ii) and (iii) of this 
section apply to determine the transaction price amount and the portion 
of such amount that is allocated to each item of gross income that is 
subject to this section.
    (ii) Transaction price adjustments. If the transaction price amount 
for the special method/451 contract includes a reduction for amounts 
described in paragraph (b)(2)(i)(A)(1) or (2) of this section, or has 
been reduced because a significant financing component is deemed to 
exist under the standards the taxpayer uses to prepare its AFS, the 
taxpayer must increase the transaction price amount by the amount of 
such reduction. If the transaction price amount for the special method/
451 contract has been increased because a significant financing 
component is deemed to exist under the standards the taxpayer uses to 
prepare its AFS, the taxpayer must decrease the transaction price 
amount by the amount of such increase.
    (iii) Transaction price allocation. After the taxpayer determines 
the adjusted transaction price amount for the special method/451 
contract under paragraph (d)(5)(ii) of this section, the taxpayer first 
allocates such amount to the item(s) of gross income subject to a 
special method of accounting and then allocates the remainder (residual 
amount) to the item(s) of gross income that are subject to this 
section. If the contract contains more than one item of gross income 
that is subject to this section, the taxpayer allocates the residual 
amount to such items in proportion to the amounts allocated to the 
corresponding performance obligations for AFS purposes or as otherwise 
provided in guidance published in the Internal Revenue Bulletin (see 
Sec.  601.601(d) of this chapter).
    (iv) Example--(1) Facts. B is a calendar-year accrual method 
taxpayer with an AFS. In 2020, B enters into a $100x contract to 
design, build, operate and maintain a toll road. The contract meets the 
definition of a long-term contract under Sec.  1.460-1(b)(1). B 
determines that the obligations to design and build the toll road are 
long-term contract activities under Sec.  1.460-1(d)(1) and accounts 
for the gross income from these activities under section 460 and the 
regulations in this part under section 460 of the Code. In addition, B 
determines that the obligations to operate and maintain the toll road 
are non-long-term contract activities under Sec.  1.460-1(d)(2) and 
that the gross income attributable to these activities is required to 
be accounted for under this section. B determines that of the $100x 
transaction price amount, $60x is properly allocable to the items of 
gross income that are subject to section 460

[[Page 848]]

and the regulations in this part under section 460 of the Code. 
However, for its AFS, B allocates $55x of the transaction price amount 
to performance obligations that are long-term contract activities, $30x 
to the toll road operation performance obligation and $15x to the toll 
road maintenance performance obligation.
    (2) Analysis. A method of accounting under section 460 is a special 
method of accounting that is within the scope of paragraph (d)(5) of 
this section. Pursuant to paragraph (d)(5) of this section, B first 
allocates $60x of the transaction price amount to the items of gross 
income that are subject to section 460 and the regulations in this part 
under section 460 of the Code and then allocates the residual amount of 
$40x to the two items of gross income that are required to be accounted 
for under this section in proportion to the amounts allocated to the 
corresponding performance obligations for AFS purposes. Accordingly, B 
allocates $26.7 x ($30x/$45x x $40x residual amount) to the toll road 
operations item of gross income and $13.3x ($15x/$45x x $40x residual 
amount) to the toll road maintenance item of gross income.
    (e) Cumulative rule for multi-year contracts--(1) In general. In 
the case of an item of gross income from a multi-year contract, a 
taxpayer determines the AFS income inclusion amount for a taxable year 
by applying the steps in paragraph (e)(1)(i) or (ii) of this section. 
For this paragraph (e), the term multi-year contract means a contract 
that spans more than one taxable year.
    (i) Inventory items. If the item of gross income is from the sale 
of an item of inventory and the taxpayer uses the cost offset method 
under paragraph (c) of this section, see paragraph (c) of this section.
    (ii) Other items of gross income. For all other items of gross 
income, the taxpayer first compares the cumulative amount of the item 
of gross income that satisfies the all events test under Sec.  1.451-
1(a) through the last day of the taxable year, including the full 
amount of any advance payment received for such item in a prior taxable 
year, with the cumulative amount of the item of gross income that is 
treated as ``taken into account as AFS revenue'' under paragraph (b)(2) 
of this section through the last day of the taxable year and identifies 
the larger of the two amounts (or, if the two amounts are equal, the 
equal amount). The taxpayer then reduces such amount by all prior year 
inclusion amounts attributable to the item of gross income, if any, to 
determine the AFS income inclusion amount for the current taxable year. 
If, however, the taxpayer receives an advance payment, as defined in 
Sec.  1.451-8(a)(1), that is allocable to an item of gross income from 
a multi-year contract, the taxpayer applies the applicable rules in 
Sec.  1.451-8, rather than the rules in this paragraph (e)(1)(ii), to 
determine the amount of the item of gross income that is required to be 
included in gross income in the taxable year in which such advance 
payment is received, or, if applicable, in a short taxable year 
described in Sec.  1.451-8(c)(6).
    (2) Examples. The following examples illustrate the rules of 
paragraph (e)(1) of this section. Unless the facts specifically state 
otherwise, the taxpayer has an AFS, is on a calendar year for both 
Federal income tax purposes and AFS purposes and uses an accrual method 
of accounting for Federal income tax purposes. Further, the taxpayer 
does not use a special method of accounting.
    (i) Example 1: Provision of services included in AFS revenue with 
full inclusion method for advance payments--(A) Facts. In 2021, D, an 
engineering services provider, enters into a nonseverable contract with 
a customer to provide engineering services through 2024 for a total of 
$100x. Under the contract, D receives payments of $25x in each calendar 
year of the contract. For its AFS, D reports $50x, $0, $20x, and $30x 
of AFS revenue from the contract for 2021, 2022, 2023, and 2024, 
respectively. D has an enforceable right to recover all amounts 
reported as AFS revenue through the end of a given contract year if the 
customer were to terminate the contract on the last day of such year. 
The $25x payment received in 2023 is an advance payment, as defined in 
Sec.  1.451-8(a)(1), because $5x of the $25x payment is reported as AFS 
revenue for 2024. D uses the full inclusion method for advance 
payments.
    (B) Taxable year 2021. Under the all events test in Sec.  1.451-
1(a), D is required to include $25x in gross income in 2021 as $25x is 
due under the terms of the contract and received by D during 2021. D 
does not have a fixed right to receive any portion of the remaining $75 
as such amount is not due under the terms of the contract until future 
years and is also contingent on D's completion of the nonseverable 
services. Under the AFS income inclusion rule, because D has an 
enforceable right to recover all $50x reported as AFS revenue for 2021 
if the customer were to terminate the contract on the last day of such 
year, all $50x is treated as ``taken into account as AFS revenue'' in 
2021. Accordingly, D is required to include $50x in gross income in 
2021.
    (C) Taxable year 2022. Under the all events test in Sec.  1.451-
1(a), D is required to include $50x in gross income through the end of 
2022 as $50x is due under the terms of the contract and received by D 
as of the end of 2022. D does not have a fixed right to receive any 
portion of the remaining $50 as such amount is not due under the terms 
of the contract until future years and is also contingent on D's 
completion of the nonseverable services. Under the AFS income inclusion 
rule, because D has an enforceable right to recover all $50x reported 
as AFS revenue through the end of 2022 if the customer were to 
terminate the contract on the last day of such year, all $50x is 
treated as ``taken into account as AFS revenue'' as of the last day of 
2022. Under the cumulative rule in paragraph (e)(1)(ii) of this 
section, D compares the cumulative all events test amount of $50x with 
the cumulative AFS revenue amount of $50x and selects the larger of the 
two amounts (or if the two amounts are equal, the equal amount). From 
this equal amount of $50x, D subtracts the prior income inclusion 
amount of $50x. Accordingly, under the cumulative rule D is not 
required to include any amount in gross income in 2022.
    (D) Taxable year 2023. The payment received during 2023 meets the 
definition of an advance payment under Sec.  1.451-8(a)(1). 
Accordingly, pursuant to paragraph (e)(1)(ii) of this section, D must 
determine the amount that is required to be included in gross income in 
2023 under the rules in Sec.  1.451-8. Because D uses the full 
inclusion method under Sec.  1.451-8(b), D is required to include the 
$25x that was due and received during 2023 in gross income in 2023.
    (E) Taxable year 2024. Under the all events test in Sec.  1.451-
1(a), D is required to include $100x in gross income through the end of 
2024 as $100x is due under the terms of the contract and received by D 
as of the end of 2024. Under the AFS income inclusion rule, because D 
has an enforceable right to recover all $100x reported as AFS revenue 
through the end of 2024 if the customer were to terminate the contract 
on the last day of such year, all $100x is treated as ``taken into 
account as AFS revenue'' through the last day of 2024. Under the 
cumulative rule in paragraph (e)(1)(ii) of this section, D compares the 
cumulative all events test amount of $100x with the cumulative AFS 
revenue amount of $100x and selects the larger of the two amounts (or, 
if the two amounts are equal, the equal amount). From this equal amount 
of $100x, D subtracts the prior income inclusion amount of $75x ($50x 
from 2021 plus

[[Page 849]]

$0x from 2022 plus $25x from 2023). Accordingly, under the cumulative 
rule D is required to include $25 in gross income in 2024. The example 
in this paragraph (e)(2)(i)(E) is summarized in the following table:

                                        Table 2 to Paragaph (e)(2)(i)(E)
----------------------------------------------------------------------------------------------------------------
                                       2021            2022            2023            2024            Total
----------------------------------------------------------------------------------------------------------------
All Events/Full Inclusion Income            $25x            $25x            $25x            $25x           $100x
AFS Revenue.....................             50x               0             20x             30x            100x
Cumulative rule income..........             50x               0             25x             25x            100x
----------------------------------------------------------------------------------------------------------------

    (ii) Example 2: Provision of services included in AFS revenue with 
deferral method for advance payments--(A) Facts. The facts are the same 
as in paragraph (e)(2)(i) of this section (Example 1), except D elects 
to use the deferral method under Sec.  1.451-8(c) to account for 
advance payments.
    (B) Taxable years 2021 and 2022. The analysis for tax years 2021 
and 2022 is the same as in paragraph (e)(2)(i) of this section (Example 
1).
    (C) Taxable year 2023. The payment received during 2023 meets the 
definition of an advance payment under Sec.  1.451-8(a)(1). 
Accordingly, pursuant to paragraph (e)(1)(ii) of this section, D must 
determine the amount that is required to be included in gross income in 
2023 under the rules in Sec.  1.451-8. Because D uses the deferral 
method under Sec.  1.451-8(b), D is required to include $20x of the 
$25x payment in gross income in 2023 as $20x of such payment was 
treated as ``taken into account as AFS revenue'' as of the end of 2023.
    (D) Taxable year 2024. Under the all events test in Sec.  1.451-
1(a), D is required to include $100x in gross income through the end of 
2024. Under the AFS income inclusion rule, because D has an enforceable 
right to recover all $100x reported as AFS revenue through the end of 
2024 if the customer were to terminate the contract on the last day of 
such year, all $100x is treated as ``taken into account as AFS 
revenue'' through the last day of 2024. Under the cumulative rule in 
paragraph (e)(1)(ii) of this section, D compares the cumulative all 
events test amount of $100x, which includes the full amount of the $25 
advance payment received in 2023, with the cumulative AFS revenue 
amount of $100x and selects the larger of the two amounts (or, if the 
two amounts are equal, the equal amount). From this equal amount of 
$100x, D subtracts the prior income inclusion amount of $70x ($50x from 
2021 plus $0x from 2022 plus $20x from 2023). Accordingly, under the 
cumulative rule D is required to include $30x in gross income in 2024. 
The example in this paragraph (e)(2)(ii)(D) is summarized in the 
following table:

                                       Table 3 to Paragraph (e)(2)(ii)(D)
----------------------------------------------------------------------------------------------------------------
                                       2021            2022            2023            2024            Total
----------------------------------------------------------------------------------------------------------------
All Events Test/Deferral Method             $25x            $25x        \1\ $20x            $30x           $100x
 Income.........................
AFS Revenue amount..............             50x               0             20x             30x            100x
Cumulative rule income..........             50x               0             20x             30x            100x
----------------------------------------------------------------------------------------------------------------
\1\ $5x of the advance payment in 2023 is deferred and taken into income in 2024.

    (f) No change in the treatment of a transaction. Except as provided 
in paragraph (j) of this section and Sec.  1.1275-2(l), the AFS income 
inclusion rule does not change the treatment of a transaction or the 
character of an item for Federal income tax purposes. The following are 
examples of transactions where the treatment or character for AFS 
purposes does not change the treatment of the transaction or character 
of the item for Federal income tax purposes:
    (1) A transaction treated as a lease, license, or similar 
transaction for Federal income tax purposes that is treated as a sale 
or financing for AFS purposes, and vice versa;
    (2) A transaction or instrument that is not required to be marked-
to-market for Federal income tax purposes but that is marked-to-market 
for AFS purposes;
    (3) Asset sale and liquidation treatment under section 336(e) or 
338(h)(10);
    (4) A distribution of a corporation or the allocable share of 
partnership items or an income inclusion under section 951, 951A, or 
1293(a) for Federal income tax purposes that is accounted for under the 
equity method for AFS purposes;
    (5) A distribution of previously taxed earnings and profits of a 
foreign corporation; and
    (6) A deposit, return of capital, or conduit payment that is not 
gross income for Federal income tax purposes that is treated as AFS 
revenue.
    (g) No change to exclusion provisions and the treatment of non-
recognition transactions--(1) In general. The AFS income inclusion rule 
accelerates the time at which the all events test under Sec.  1.451-
1(a) is treated as satisfied, and therefore does not change the 
applicability of any exclusion provision, or the treatment of non-
recognition transactions, in the Code, the regulations in this part, or 
other guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d) of this chapter). The following are examples of exclusion 
provisions and non-recognition transactions that are not affected by 
the AFS income inclusion rule:
    (i) Any non-recognition transaction, within the meaning of section 
7701(a)(45), including, for example, a liquidation described in 
sections 332 and 337, an exchange described in section 351, a 
distribution described in section 355, a reorganization described in 
section 368, a contribution described in section 721, or transactions 
described in sections 1031 through 1045; and
    (ii) Items specifically excluded from income under sections 101 
through 140.
    (2) Example: Non-recognition provisions not changed for Federal 
income tax purposes--(i) Facts. Taxpayer (Distributing) is a calendar-
year accrual method C corporation with an AFS. On December 31, 2021, 
Distributing:
    (A)(1) Contributes assets to a wholly owned subsidiary (Controlled) 
in exchange for Controlled stock and $100x; and

[[Page 850]]

    (2) Distributes all the Controlled stock pro rata to its 
shareholders.
    (B) The transaction qualifies as a reorganization under section 
368(a)(1)(D) and a distribution to which section 355 applies (D 
reorganization). Distributing's realized gain on the transferred assets 
for book and tax purposes is $150x. On January 15, 2022, in pursuance 
of the plan of reorganization, Distributing distributes the $100x to 
its shareholders. Consequently, no gain to Distributing is recognized 
under section 361(b)(1)(A). On Distributing's 2021 AFS, Distributing 
recognizes revenue of $150x related to the D reorganization.
    (ii) Analysis. For Federal income tax purposes, under section 361, 
Distributing does not recognize gain on Distributing's:
    (A)(1) Contribution of assets to Controlled;
    (2) Receipt of Controlled stock and cash; and
    (3) Distribution of Controlled stock and cash to Distributing's 
shareholders.
    (B) Pursuant to paragraph (g) of this section, the AFS income 
inclusion rule does not change the result of this paragraph (g)(2).
    (h) Additional AFS issues--(1) AFS covering groups of entities--(i) 
In general. If a taxpayer's financial results are reported on the AFS 
for a group of entities (consolidated AFS), the taxpayer's AFS is the 
consolidated AFS. However, if the taxpayer's financial results are also 
reported on a separate AFS that is of equal or higher priority to the 
consolidated AFS under paragraph (a)(5) of this section, then the 
taxpayer's AFS is the separate AFS.
    (ii) Example. Taxpayer B, a reseller of computers and electronics, 
is a calendar-year accrual method taxpayer. In 2021, B's financial 
results are included in P's consolidated financial statement, which is 
certified as being prepared in accordance with GAAP, and is a Form 10-K 
filed with the SEC. B also has a separate audited financial statement 
prepared in accordance with GAAP that is used for credit purposes. B 
must use its parent corporation's consolidated Form 10-K as its AFS.
    (2) Separately listed items. If a consolidated AFS is treated as 
the taxpayer's AFS, the taxpayer must include the amount of any items 
listed separately in the consolidated AFS, including any notes or other 
supplementary data that is considered part of the consolidated AFS, in 
determining the amount of AFS revenue allocated to the taxpayer.
    (3) Non-separately listed items. If a consolidated AFS does not 
separately list items for the taxpayer, the portion of the AFS revenue 
allocable to the taxpayer is determined by relying on the taxpayer's 
separate source documents that were used to create the consolidated AFS 
and includes amounts subsequently eliminated in the consolidated AFS. 
Whether a taxpayer that changes the source documents it uses for this 
purpose from one taxable year to another taxable year has changed its 
method of accounting is determined under the rules of section 446.
    (4) Computation of AFS revenue for the taxable year when the AFS 
covers mismatched reportable periods--(i) In general. If a taxpayer's 
AFS is prepared on the basis of a financial accounting year that 
differs from the taxpayer's taxable year, the taxpayer must use one of 
the following permissible methods of accounting described in paragraph 
(h)(4)(i)(A) through (C) of this section to determine the AFS income 
inclusion amount for the taxable year:
    (A) The taxpayer computes AFS revenue as if its financial reporting 
period is the same as its taxable year by conducting an interim closing 
of its books using the accounting principles it uses to prepare its 
AFS.
    (B) The taxpayer computes AFS revenue by including a pro rata 
portion of AFS revenue for each financial accounting year that includes 
any part of the taxpayer's taxable year. If the taxpayer's AFS for part 
of the taxable year is not available by the due date of the return 
(with extension), the taxpayer must make a reasonable estimate of AFS 
revenue for the pro rata portion of the taxable year for which an AFS 
is not yet available. See Sec.  1.451-1(a) for adjustments after actual 
amounts are determined.
    (C) If a taxpayer's financial accounting year ends five or more 
months after the end of its taxable year, the taxpayer computes AFS 
revenue for the taxable year based on the AFS revenue reported on the 
AFS prepared for the financial accounting year ending within the 
taxpayer's taxable year. For this paragraph (h)(4)(i)(C), if a taxpayer 
uses a 52-53 week year for financial accounting or Federal income tax 
purposes, the last day of such year shall be deemed to occur on the 
last day of the calendar month ending closest to the end of such year.
    (ii) Examples. The following examples illustrate the principles of 
paragraph (j)(4) of this section.
    (A) Example 1: Interim closing of the books. A is a calendar year 
taxpayer. For its AFS, A's financial results are reported on a June 30 
fiscal year. Using the method described in paragraph (h)(4)(i)(A) of 
this section, for the taxable year 2021, A uses the financial results 
reported on its June 30, 2021 AFS to determine whether an item of gross 
income is treated as ``taken into account as AFS revenue'' from January 
1, 2021, through June 30, 2021, and uses financial data and accounting 
procedures from its June 30, 2022 AFS to prepare an interim closing of 
the books as of December 31, 2021 to determine whether an item of gross 
income is treated as ``taken into account as AFS revenue'' from July 1, 
2021, through December 31, 2021.
    (B) Example 2: Pro rata approach. A is a calendar year taxpayer. 
For its AFS, A's financial results are reported on a June 30 fiscal 
year. Using the method described in paragraph (h)(4)(i)(B) of this 
section, for the taxable year 2021, A computes AFS revenue for the 2021 
tax year by taking the AFS revenue for the financial accounting year 
ending June 30, 2021 and multiplying it by a ratio equal to the number 
of days in the financial accounting year that are part of the 2021 tax 
year/365 and then adding to that amount the AFS revenue for the 
financial accounting year ending June 30, 2022 multiplied by the number 
of days in the financial accounting year that are part of the 2021 tax 
year/365.
    (C) Example 3: AFS revenue for the taxable year based on AFS ending 
in taxpayer's taxable year. The same facts as in paragraph 
(h)(4)(ii)(B) of this section (Example 2) apply, except that A uses the 
method described in paragraph (h)(4)(i)(C) of this section. For the 
taxable year 2021, A uses the financial results reported on its June 
30, 2021 AFS to determine whether an item of gross income is treated as 
``taken into account as AFS revenue'' as of the end of its 2021 taxable 
year. Accordingly, any AFS revenue reported on the taxpayer's June 30, 
2022 AFS is disregarded when determining whether an item of gross 
income is treated as ``taken into account as AFS revenue'' as of the 
end of the 2021 taxable year.
    (i) [Reserved]
    (j) Special ordering rule for certain items of income for debt 
instruments--(1) In general. If an item of income, or portion thereof, 
with respect to a debt instrument is described in paragraph (j)(2) of 
this section, the rules of this section apply before the rules in 
sections 1271 through 1275 and Sec. Sec.  1.1271-1 through 1.1275-7 
(OID rules). Therefore, an item of income, or portion thereof, 
described in paragraph (j)(2) of this section may not be included in 
income later than when that item, or portion thereof, is treated as 
taken into account as AFS revenue, as determined under paragraph (b)(2) 
of this section, regardless of whether the timing of income inclusion 
for that item is

[[Page 851]]

normally determined using a special method of accounting. See also 
Sec.  1.1275-2(l) for the treatment of the items described in paragraph 
(j)(2) of this section under the OID rules.
    (2) Specified fees. Paragraph (j)(1) of this section applies to 
fees (specified fees) that are not spread over a period of time as 
discount or as an adjustment to the yield of a debt instrument (such as 
points) in the taxpayer's AFS and, but for paragraph (j) of this 
section and Sec.  1.1275-2(l), would be treated as creating or 
increasing OID for Federal income tax purposes. For example, the 
following specified fees (specified credit card fees) are described in 
this paragraph (j)(2):
    (i) A payment of additional interest or a similar charge provided 
with respect to amounts that are not paid when due on a credit card 
account (for example, credit card late fees);
    (ii) Amounts charged under a credit card agreement when the 
cardholder uses the credit card to conduct a cash advance transaction 
(for example, credit card cash advance fees); and
    (iii) Amounts a credit or debit card issuer is entitled to upon a 
purchase of goods or services by one of its cardholders (for example, 
interchange fees, which are sometimes labeled merchant discount in 
certain private label credit card transactions).
    (3) Example. C, a credit card issuer, is a calendar-year accrual 
method taxpayer with a calendar year AFS. In 2021, a cardholder uses 
C's credit card to purchase $100 of merchandise from a merchant and the 
cardholder earns a reward of 1% of the purchase price of $100 ($1) as 
part of C's cardholder loyalty program. Upon purchase, C becomes 
entitled to an interchange fee equal to 2% of the purchase price of 
$100 ($2). For its AFS, C reports the $2 of interchange fees as AFS 
revenue for 2021. C's $2 of interchange fees is described in paragraph 
(j)(2)(iii) of this section. Under paragraph (j)(1) of this section, C 
must apply the rules in this section before applying the OID rules. See 
also Sec.  1.1275-2(l). Therefore, C's $2 of interchange fees is 
included in gross income in 2021, the year it is treated as ``taken 
into account as AFS revenue.'' Under paragraph (b)(2)(i)(A) of this 
section, the $2 of interchange revenue is not reduced by the $1 reward. 
Even if C reports interchange fees net of rewards in its AFS for 2021 
($2 of interchange fee minus $1 reward liability), under paragraph 
(b)(2)(i)(A) of this section, C includes $2 of interchange revenue in 
gross income in 2021. See sections 162 and 461(h) for the treatment of 
the reward by C.
    (k) Treatment of adjustments to deferred revenue in an AFS--(1) In 
general. If a taxpayer treats an item of gross income as deferred 
revenue in its AFS and writes down or adjusts that item, or portion 
thereof, to an equity account (for example, retained earnings) or 
otherwise writes down or adjusts that item of deferred revenue in a 
subsequent taxable year, AFS revenue for that subsequent taxable year 
is increased or decreased, as applicable by the amount of that item, or 
portion thereof, that is written down or adjusted. See Sec.  1.451-
8(c)(5).
    (2) Example--(i) Facts. D, a remanufacturer of industrial 
equipment, is a calendar-year, accrual method taxpayer with a calendar 
year AFS. On January 1, 2021, D enters into a contract with a customer 
and receives a payment of $100x to remanufacture equipment in 2021 and 
2022. The contract is not a long-term contract under section 460. For 
its AFS 2021, D performs remanufacturing services and reports $40x of 
the $100x payment as AFS revenue for 2021, and treats $60x of the $100x 
payment as deferred revenue.
    (ii) Facts for taxable year 2022. On January 1, 2022, all of the 
stock of D is acquired by an unrelated third party and D adjusts 
deferred AFS revenue to $50x (the expected cost to provide the 
services) by charging $10x ($60x-$50x = $10x) to retained earnings. In 
addition, for 2022, D performs remanufacturing services and reports 
$50x of the deferred revenue as AFS revenue.
    (iii) Analysis for taxable year 2022. Under paragraph (k)(1) of 
this section, D's $10x write down to deferred revenue for 2022 is 
treated as ``taken into account as AFS revenue'' for 2022.
    (l) Methods of accounting--(1) In general. Except as otherwise 
provided in this section, a change to comply with this section is a 
change in method of accounting to which the provisions of sections 446 
and 481 and the regulations in this part under sections 446 and 481 of 
the Code apply. A taxpayer seeking to change to a method of accounting 
permitted in this section must secure the consent of the Commissioner 
in accordance with Sec.  1.446-1(e) and follow the administrative 
procedures issued under Sec.  1.446-1(e)(3)(ii) for obtaining the 
Commissioner's consent to change its accounting method. For example, 
the use of the AFS income inclusion rule under paragraph (b)(1) of this 
section under which the taxpayer determines the amount of the item of 
gross income that is treated as ``taken into account as AFS revenue'' 
by making the adjustments provided in paragraph (b)(2)(i) of this 
section, the use of the AFS income inclusion rule under paragraph 
(b)(1) of this section under which the taxpayer determines the amount 
of the item of gross income that is treated as ``taken into account as 
AFS revenue'' by making only the adjustments provided in paragraph 
(b)(2)(ii) of this section (the alternative AFS revenue method), the 
AFS cost offset method under paragraph (c) of this section, the use of 
a method of determining AFS revenue under paragraph (i)(4) of this 
section, are methods of accounting under section 446 and the 
regulations in this part under section 446 of the Code. In addition, a 
change in the manner of recognizing revenue in an AFS that changes or 
could change the timing of the inclusion of income for Federal income 
tax purposes is generally a change in method of accounting under 
section 446 and the regulations in this part under section 446 of the 
Code. However, a change resulting from the restatement of AFS revenue 
may not always constitute a change in method of accounting under 
section 446 and the regulations in this part under section 446 of the 
Code. For example, a restatement of AFS revenue to correct an error 
described in Sec.  1.446-1(e)(2)(ii)(b) does not constitute a change in 
method of accounting under section 446.
    (2) Transition rule for changes in method of accounting--(i) In 
general. Except as provided in paragraph (l)(2)(ii) of this section, a 
taxpayer that makes a qualified change in method of accounting for the 
taxpayer's first taxable year beginning after December 31, 2017, is 
treated as making a change in method of accounting initiated by the 
taxpayer under section 481(a)(2). A taxpayer obtains the consent of the 
Commissioner to make the change in method of accounting by using the 
applicable administrative procedures that govern changes in method of 
accounting under section 446(e). See Sec.  1.446-1(e)(3).
    (ii) Special rules for OID and specified credit card fees. The 
rules of paragraph (l)(2)(i) of this section apply to a qualified 
change in method of accounting for the taxpayer's first taxable year 
beginning after December 31, 2018, if the change relates to a specified 
credit card fee as defined in paragraph (j)(2) of this section. For 
paragraph (l) of this section, the section 481(a) adjustment period for 
any adjustment under section 481(a) for a change in method of 
accounting described in the preceding sentence is six taxable years.

[[Page 852]]

    (iii) Qualified change in method of accounting. For paragraph 
(l)(2) of this section, a qualified change in method of accounting 
means any change in method of accounting that is required by section 
13221 of Public Law 115-97, 131 Stat. 2054 (2017) (TCJA), or was 
prohibited under the Internal Revenue Code of 1986 prior to TCJA 
section 13221 and is now permitted as a result of TCJA section 13221.
    (m) Applicability date--(1) In general. Except as provided in 
paragraph (m)(2) of this section, this section applies for taxable 
years beginning on or after January 1, 2021.
    (2) Delayed application with respect to certain fees. 
Notwithstanding paragraph (m)(1) of this section, paragraph (j) of this 
section applies to specified fees (as defined in paragraph (j)(2) of 
this section) that are not specified credit card fees (as defined in 
paragraph (j)(2) of this section) for taxable years beginning on or 
after January 6, 2022.
    (3) Early application of this section--(i) In general. Except as 
provided in paragraph (m)(3)(ii) of this section, taxpayers and their 
related parties, within the meaning of sections 267(b) and 707(b), may 
apply both the rules in this section and, to the extent relevant, the 
rules in Sec.  1.451-8, in their entirety and in a consistent manner, 
to a taxable year beginning after December 31, 2017, and before January 
1, 2021, provided that, once applied to a taxable year, the rules in 
this section and, to the extent relevant, the rules in Sec.  1.451-8, 
are applied in their entirety and in a consistent manner to all 
subsequent taxable years. See section 7508(b)(7) and Sec.  1.451-8(h).
    (ii) Certain fees--(A) Specified credit card fees. In the case of 
specified credit card fees, a taxpayer and its related parties, within 
the meaning of sections 267(b) and 707(b), may apply both the rules in 
this section and the rules in Sec.  1.1275-2(l), in their entirety and 
in a consistent manner, to a taxable year beginning after December 31, 
2018, and before January 1, 2021, provided that, once applied to a 
taxable year, the rules in this section and Sec.  1.1275-2(l) that 
apply to specified credit card fees are applied in their entirety and 
in a consistent manner to all subsequent taxable years (other than the 
rules applicable to specified fees that are not specified credit card 
fees). See section 7508(b)(7) and Sec.  1.1275-2(l)(2).
    (B) Specified fees. Paragraphs (m)(3)(i) and (m)(3)(ii)(A) of this 
section do not apply to specified fees that are not specified credit 
card fees.

0
Par. 6. Section 1.451-8 is added to read as follows:


Sec.  1.451-8   Advance payments for goods, services, and certain other 
items.

    (a) Definitions. Except as otherwise provided in this section, the 
following definitions apply for this section:
    (1) Advance payment--(i) In general. An advance payment is a 
payment received by a taxpayer if:
    (A) The full inclusion of the payment in the gross income of the 
taxpayer for the taxable year of receipt is a permissible method of 
accounting, without regard to this section;
    (B) Any portion of the payment is taken into account as AFS revenue 
for a subsequent taxable year, or, if the taxpayer does not have an 
applicable financial statement any portion of the payment is earned by 
the taxpayer in a subsequent taxable year. To determine the amount of 
the payment that is treated as ``taken into account as AFS revenue,'' 
the taxpayer must adjust AFS revenue for any amounts described in Sec.  
1.451-3(b)(2)(i)(A), (C), and (D);
    (C) The payment is for:
    (1) Services;
    (2) The sale of goods;
    (3) The use, including by license or lease, of intellectual 
property, including copyrights, patents, trademarks, service marks, 
trade names, and similar intangible property rights, such as franchise 
rights and arena naming rights;
    (4) The occupancy or use of property if the occupancy or use is 
ancillary to the provision of services, for example, advance payments 
for the use of rooms or other quarters in a hotel, booth space at a 
trade show, campsite space at a mobile home park, and recreational or 
banquet facilities, or other uses of property, so long as the use is 
ancillary to the provision of services to the property user;
    (5) The sale, lease, or license of computer software;
    (6) Guaranty or warranty contracts ancillary to an item or items 
described in paragraph (a)(1)(i)(C)(1), (2), (3), (4), or (5) of this 
section;
    (7) Subscriptions in tangible or intangible format. Subscriptions 
for which an election under section 455 is in effect is not included in 
this paragraph (a)(1)(i)(C)(7);
    (8) Memberships in an organization. Memberships for which an 
election under section 456 is in effect are not included in this 
paragraph (a)(1)(i)(C)(8);
    (9) An eligible gift card sale;
    (10) Any other payment identified by the Secretary of the Treasury 
or his delegate (Secretary) under section 451(c)(4)(A)(iii), including 
in guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2) of this chapter); or
    (11) Any combination of items described in paragraphs 
(a)(1)(i)(C)(1) through (10) of this section.
    (ii) Exclusions from the definition of advance payment. An advance 
payment does not include:
    (A) Rent, except for amounts paid for an item or items described in 
paragraph (a)(1)(i)(C)(3), (4), or (5) of this section;
    (B) Insurance premiums, to the extent the inclusion of those 
premiums is governed by Subchapter L of the Internal Revenue Code;
    (C) Payments with respect to financial instruments (for example, 
debt instruments, deposits, letters of credit, notional principal 
contracts, options, forward contracts, futures contracts, foreign 
currency contracts, credit card agreements (including rewards or 
loyalty points under such agreements), financial derivatives, or 
similar items), including purported prepayments of interest;
    (D) Payments with respect to service warranty contracts for which 
the taxpayer uses the accounting method provided in Revenue Procedure 
97-38, 1997-2 C.B. 479 (see Sec.  601.601(d)(2) of this chapter);
    (E) Payments with respect to warranty and guaranty contracts under 
which a third party is the primary obligor;
    (F) Payments subject to section 871(a), 881, 1441, or 1442;
    (G) Payments in property to which section 83 applies;
    (H) Payments received in a taxable year earlier than the taxable 
year immediately preceding the taxable year of the contractual delivery 
date for a specified good (specified good exception) unless the 
taxpayer uses the method under paragraph (f) of this section;
    (I) Any other payment identified by the Secretary under section 
451(c)(4)(B)(vii), including in guidance published in the Internal 
Revenue Bulletin (see Sec.  601.601(d)(2) of this chapter); and
    (J) Any combination of items described in paragraphs (a)(1)(ii)(A) 
through (I) of this section.
    (2) Advance payment income inclusion amount. The term advance 
payment income inclusion amount means the amount of the advance payment 
that is required to be included in gross income for the taxable year 
under the applicable rules in this section.
    (3) Advance payment inventory inclusion amount. The term advance 
payment inventory inclusion amount means the amount of the advance 
payment from the sale of an item of

[[Page 853]]

inventory that, but for the cost of goods in progress offset, would be 
includable in gross income under paragraph (b), (c), or (d) of this 
section, as applicable, for the taxable year.
    (4) AFS revenue. The term AFS revenue has the same meaning as 
provided in Sec.  1.451-3(a)(4).
    (5) Applicable financial statement. The term applicable financial 
statement (AFS) has the same meaning as provided in Sec.  1.451-
3(a)(5).
    (6) Contractual delivery date. The term contractual delivery date 
means the month and year of delivery listed in the original written 
contract to the transaction entered into between the parties prior to 
initial receipt of any payments.
    (7) Cost of goods. The term cost of goods means the costs that are 
properly capitalized and included in inventory under sections 471 and 
263A or any other applicable provision of the Internal Revenue Code and 
that are allocable to an item of inventory for which an advance payment 
inventory inclusion amount is calculated. See paragraph (e)(6) of this 
section for specific rules for a taxpayer using the simplified methods 
under section 263A.
    (8) Cost of goods in progress offset. The term cost of goods in 
progress offset has the meaning provided in paragraph (e)(4) of this 
section.
    (9) Cumulative cost of goods in progress offset. The term 
cumulative cost of goods in progress offset means the cumulative cost 
of goods in progress offset amounts under paragraph (e) of this section 
for a specific item of inventory that have reduced an advance payment 
inventory inclusion amount attributable to such item of inventory in 
prior taxable years.
    (10) Eligible gift card sale. The term eligible gift card sale 
means the sale of a gift card or gift certificate if:
    (i) The taxpayer is primarily liable to the customer, or holder of 
the gift card, for the value of the card until redemption or 
expiration; and
    (ii) The gift card is redeemable by the taxpayer or by any other 
entity that is legally obligated to the taxpayer to accept the gift 
card from a customer as payment for items listed in paragraphs 
(a)(1)(i)(C)(1) through (11) of this section.
    (11) Enforceable right. The term enforceable right has the same 
meaning as provided in Sec.  1.451-3(a)(9).
    (12) Performance obligation. The term performance obligation has 
the same meaning as provided in Sec.  1.451-3(a)(11).
    (13) Prior income inclusion amounts. The term prior income 
inclusion amounts means the amount of an item of gross income that was 
included in the taxpayer's gross income under this section or Sec.  
1.451-3 in a prior taxable year.
    (14) Received. An item of gross income is received by the taxpayer 
if it is actually or constructively received, or if it is due and 
payable to the taxpayer.
    (15) Specified good. The term specified good means a good for 
which:
    (i) During the taxable year a payment is received, the taxpayer 
does not have on hand, or available to it in such year through its 
normal source of supply, goods of a substantially similar kind and in a 
sufficient quantity to satisfy the contract to transfer the good to the 
customer; and
    (ii) All the revenue from the sale of the good is recognized in the 
taxpayer's AFS in the year of delivery.
    (16) Transaction price. The term transaction price has the same 
meaning as provided in Sec.  1.451-3(a)(14).
    (b) In general. Except as provided in paragraph (c) or (d) of this 
section, an accrual method taxpayer shall include an advance payment in 
gross income no later than in the taxable year in which the taxpayer 
receives the advance payment.
    (c) Deferral method for taxpayers with an applicable financial 
statement (AFS)--(1) In general. An accrual method taxpayer with an AFS 
that receives an advance payment may elect the deferral method 
described in this paragraph (c) if the taxpayer can determine the 
extent to which the advance payment is taken into account as AFS 
revenue as of the end of the taxable year of receipt and, if 
applicable, a short taxable year described in paragraph (c)(6) of this 
section. Except as otherwise provided in this section, a taxpayer that 
uses the deferral method described in this paragraph (c) must:
    (i) Include the advance payment, or any portion thereof, in gross 
income in the taxable year of receipt to the extent taken into account 
as AFS revenue as of the end of such taxable year, as determined under 
paragraph (c)(2) of this section; and
    (ii) Include the remaining portion of such advance payment in gross 
income in the taxable year following the taxable year in which such 
payment is received (next succeeding year).
    (2) Adjustments to AFS revenue. The amount of an advance payment 
that is treated as ``taken into account as AFS revenue'' as of the end 
of the taxable year of receipt under paragraph (c)(1)(i) of this 
section is determined by adjusting AFS revenue by amounts described in 
Sec.  1.451-3(b)(2)(i)(A), (C), and (D), as applicable.
    (3) Examples. The following examples demonstrate the rules in 
paragraphs (c)(1) and (2) of this section.
    (i) Example 1: Gift cards not eligible for deferral method. E, a 
hair styling salon, receives advance payments for gift cards that may 
later be redeemed at the salon for hair styling services or hair care 
products at the face value of the gift card. The gift cards may not be 
redeemed for cash and have no expiration date. E does not track the 
sale date of the gift cards and includes advance payments for gift 
cards in AFS revenue when redeemed. Because E is unable to determine 
the extent to which advance payments are taken into account as AFS 
revenue for the taxable year of receipt, E cannot use the deferral 
method for these advance payments.
    (ii) Example 2: Gift cards eligible for deferral method. The same 
facts as in paragraph (c)(3)(i) of this section (Example 1) apply, 
except that the gift cards have an expiration date 12 months from the 
date of sale, E does not accept expired gift cards, and E includes 
unredeemed gift cards in AFS revenue for the taxable year in which the 
cards expire. Because E tracks the sale date and the expiration date of 
the gift cards for its AFS, E can determine the extent to which advance 
payments are taken into account as AFS revenue for the taxable year of 
receipt. Therefore, E meets the requirement of paragraph (c)(1) of this 
section and may elect the deferral method for these advance payments.
    (4) Acceleration of advance payments--(i) In general. A taxpayer 
that uses the deferral method described in this paragraph (c) must 
include in gross income for the taxable year, all advance payments not 
previously included in gross income:
    (A) If, in that taxable year, the taxpayer either dies or ceases to 
exist in a transaction other than a transaction to which section 381(a) 
applies; or
    (B) If, and to the extent that, in that taxable year, the 
taxpayer's obligation for the advance payments is satisfied or 
otherwise ends other than in:
    (1) A transaction to which section 381(a) applies; or
    (2) A section 351(a) transfer that is part of a section 351 
transaction in which:
    (i) Substantially all assets of the trade or business, including 
advance payments, are transferred;
    (ii) The transferee adopts or uses the deferral method in the year 
of transfer; and
    (iii) The transferee and the transferor are members of the same 
consolidated group, as defined in Sec.  1.1502-1(h).

[[Page 854]]

    (ii) Examples. The following examples illustrate the rules in 
paragraph (c)(4) of this section. In each of the following examples, 
the taxpayer is a C corporation, uses an accrual method of accounting 
for Federal income tax purposes and files its returns on a calendar 
year basis. In addition, the taxpayer has an AFS and uses the deferral 
method in paragraph (c) of this section.
    (A) Example 1: Ceasing to exist. A is in the business of selling 
and licensing off the shelf, fully customized, and semi-customized 
computer software and providing customer support. On July 1, 2021, A 
enters into a 2-year software maintenance contract and receives an 
advance payment. Under the contract, A will provide software updates if 
it develops an update within the contract period, as well as online and 
telephone customer support. A ceases to exist on December 1, 2021, in a 
transaction that does not involve a section 351(a) transfer described 
in paragraph (c)(4)(i)(B)(2) of this section and is not a transaction 
to which section 381(a) applies. For Federal income tax purposes, A 
must include the entire advance payment in gross income in its 2021 
taxable year.
    (B) Example 2: Satisfaction of obligation--(1) Facts. On November 
1, 2021, J, a travel agent, receives payment from a customer for an 
airline flight that will take place in April 2022. J purchases and 
delivers the airline ticket to the customer on November 14, 2021. J 
retains the excess of the customer's payment over the cost of the 
airline ticket as its commission. The customer may cancel the flight 
and receive a refund from J only to the extent the airline itself 
provides refunds. In its AFS, J includes its commission in revenue for 
2022.
    (2) Analysis. The payment for commission income is an advance 
payment. Because J is not required to provide any services after the 
ticket is delivered to the customer on November 14, 2021, J satisfies 
its obligation to the customer for its commission when the airline 
ticket is delivered. Thus, for Federal income tax purposes, J must 
include the commission in gross income for 2021.
    (5) Financial statement adjustments--(i) In general. If a taxpayer 
treats an advance payment as an item of deferred revenue in its AFS and 
writes-down or adjusts that item, or portion thereof, to an equity 
account such as retained earnings, or otherwise writes-down or adjusts 
that item of deferred revenue in a subsequent taxable year, AFS revenue 
for that subsequent taxable year is increased or decreased, as 
applicable, by the amount that is written down or adjusted. See Sec.  
1.451-3(k).
    (ii) Examples. The following examples illustrate the rules in 
paragraph (c)(5) of this section. In each of the following examples, 
the taxpayer is a C corporation, uses an accrual method of accounting 
for Federal income tax purposes and files its returns on a calendar 
year basis. In addition, the taxpayer has an AFS and uses the deferral 
method in paragraph (c) of this section.
    (A) Example 1--(1) Facts. On May 1, 2021, A received $100 as an 
advance payment for a 2-year contract to provide services. For 
financial accounting purposes, A recorded $100 as a deferred revenue 
liability in its AFS, expecting to report \1/4\ ($25) of the advance 
payment in AFS revenue for 2021, \1/2\ ($50) for 2022, and \1/4\ ($25) 
for 2023. On August 31, 2021, C, an unrelated corporation that files 
its Federal income tax return on a calendar year basis and that is a 
member of a consolidated group, acquired all of the stock of A, and A 
joined C's consolidated group. A's short taxable year ended on August 
31, 2021, and, as of that date, A had included \1/4\ ($25) of the 
advance payment in AFS revenue. On September 1, 2021, after the stock 
acquisition, and in accordance with purchase accounting rules, C wrote 
down A's deferred revenue liability to its fair value of $10 as of the 
date of the acquisition. The $10 is included in revenue on A's AFS in 
accordance with the method of accounting A uses for financial 
accounting purposes.
    (2) Analysis. For Federal income tax purposes, A must take \1/4\ 
($25) of the advance payment into income for its short taxable year 
ending August 31, 2021 and must include the remainder of the advance 
payment ($75) ($65 write down + $10 future financial statement revenue) 
in income for its next succeeding taxable year.
    (B) Example 2--(1) Facts. On May 1, 2021, B received $100 as an 
advance payment for a contract to be performed in 2021, 2022, and 2023. 
On August 31, 2021, D, a corporation that is not a member of a 
consolidated group for Federal income tax purposes, acquired all of the 
stock of B. Before the stock acquisition, for 2021, B included $40 of 
the advance payment in AFS revenue, and $60 as a deferred revenue 
liability. On September 1, 2021, after the stock acquisition and in 
accordance with purchase accounting rules, B, at D's direction, wrote 
down its $60 deferred revenue liability to $10 (its fair value) as of 
the date of the acquisition. After the acquisition, B does not take 
into account as AFS revenue any of the $10 deferred revenue liability 
in its 2021 AFS. B does include $5 in revenue in 2022, and $5 in 
revenue in 2023.
    (2) Analysis. For Federal income tax purposes, B must include $40 
of the advance payment into income in 2021 and must include the 
remainder of the advance payment ($60) ($50 write down plus $10 future 
financial statement revenue) in income for the 2022 taxable year.
    (6) Short taxable year rule--(i) In general. If the taxpayer's next 
succeeding taxable year is a short taxable year, other than a taxable 
year in which the taxpayer dies or ceases to exist in a transaction 
other than a transaction to which section 381(a) applies, and the short 
taxable year consists of 92 days or less, a taxpayer using the deferral 
method must include the portion of the advance payment not included in 
the taxable year of receipt in gross income for the short taxable year 
to the extent taken into account as AFS revenue as of the end of such 
taxable year, as determined under paragraph (c)(2) of this section. Any 
amount of the advance payment not included in gross income in the 
taxable year of receipt or the short taxable year, must be included in 
gross income for the taxable year immediately following the short 
taxable year.
    (ii) Example 1--(A) Facts. A is a calendar year taxpayer and is in 
the business of selling and licensing off the shelf, fully customized, 
and semi-customized computer software and providing customer support. 
On July 1, 2021, A enters into a 2-year software maintenance contract 
and receives an advance payment of $240 under the contract. Under the 
contract, A will provide software updates if it develops an update 
within the contract period, as well as provides online and telephone 
customer support. A changes its taxable period to a fiscal year ending 
March 31. As a result, A has a short taxable year beginning January 1, 
2022, and ending March 31, 2022. In its AFS, A includes 6/24 ($60) of 
the payment in revenue for the taxable year ending December 31, 2021 to 
account for the six-month period July 1 through December 31, 2021; 3/24 
($30) in revenue for the short taxable year ending March 31, 2022 to 
account for the three-month period January 1 through March 31, 2022; 
12/24 ($120) in revenue for the taxable year ending March 31, 2023; and 
3/24 ($30) in revenue for the taxable year ending March 31, 2024.
    (B) Analysis. Because the taxable year ending March 31, 2021, is 92 
days or less, A must include 6/24 ($60) of the payment in gross income 
for the taxable year ending December 31, 2021, 3/24 ($30) in gross 
income for the short

[[Page 855]]

taxable year ending March 31, 2022, and 15/24 ($150), the remaining 
amount, in gross income for the taxable year ending March 31, 2023.
    (iii) Example 2--(A) Facts. On May 1, 2021, B received $100 as an 
advance payment for a contract to be performed in 2021, 2022, and 2023. 
On October 31, 2021, C, an unrelated corporation that files its federal 
income tax return on a calendar year basis and that is a member of a 
consolidated group, acquired all the stock of B and B joined C's 
consolidated group. Before the stock acquisition, for 2021, B included 
$40 of the advance payment in AFS revenue, and $60 as a deferred 
revenue liability. On November 1, 2021, after the stock acquisition and 
in accordance with purchase accounting rules, C wrote down B's $60 
deferred revenue liability to $10 (its fair value) as of the date of 
the acquisition. After the acquisition, B does not include in revenue 
any of the $10 deferred revenue liability in its 2021 AFS. B includes 
$5 in revenue in 2022, and $5 in revenue in 2023.
    (B) Analysis. For Federal income tax purposes, B must take $40 of 
the advance payment into income in its short tax year ending October 
31, 2021. B's subsequent tax year, the short tax year ending December 
31, 2021, is a tax year that is 92 days or less. Therefore, under 
paragraph (c)(6)(i) of this section, B generally will include the 
portion of the advance payment not included in the taxable year of 
receipt in gross income for this short taxable year to the extent taken 
into account as AFS revenue. Although for AFS purposes, no amount is 
recognized in revenue for the short period beginning November 1, 2021 
and ending on December 31, 2021, under paragraph (c)(5)(i) of this 
section, B must treat the amount of the write-down as AFS revenue in 
the taxable year in which the write-down occurs. Therefore, B must 
include $50 of the advance payment into income in the short tax year 
ending December 31, 2021 (equal to the $50 write down plus $0 
recognized in B's AFS for the period beginning on November 1, 2021 and 
ending December 31, 2021), and must include the remainder of the 
advance payment ($10) in income for the 2022 taxable year.
    (7) Financial statement conformity requirement. A taxpayer that 
uses an AFS to apply the rules under Sec.  1.451-3 must use the same 
AFS and, if applicable, the same method of accounting under Sec.  
1.451-3(h)(4), to apply the deferral method in paragraph (c) of this 
section. Additionally, the AFS rules under Sec.  1.451-3(h) also apply 
for purposes of this section.
    (8) Contracts with multiple performance obligations--(i) General 
rule. If a taxpayer is using the deferral method under this paragraph 
(c) and the taxpayer's contract with a customer has more than one 
performance obligation, then any payments received under the contract 
are allocated to the corresponding item of gross income in the same 
manner as such payments are allocated to the performance obligations in 
the taxpayer's AFS.
    (ii) Example: Computer software subscription with multiple 
performance obligations--(A) Facts. P is in the business of licensing 
off the shelf, fully customized, and semi-customized computer software 
and providing customer support. P uses an accrual method of accounting 
for Federal income tax purposes, files its returns on a calendar year 
basis, and has an AFS. On July 1, 2021, P receives an advance payment 
of $100 for a 2-year software subscription comprised of:
    (1)(i) A 1-year ``software maintenance contract'' under which P 
will provide software updates within the contract period; and
    (ii) A ``customer support agreement'' for online and telephone 
customer support.
    (2) P reflects the software maintenance contract and the customer 
support agreement as two separate performance obligations in its AFS 
and allocates $80 of the payment to the software maintenance contract 
and $20 to the customer support agreement. P includes the $80 allocable 
to the software maintenance payment in AFS revenue as follows: \1/4\ 
($20) in AFS revenue for 2021; \1/2\ ($40) in AFS revenue for 2022; and 
the remaining \1/4\ ($20) in AFS revenue for 2023. Regarding the $20 
allocable to the customer support payment, P includes \1/2\ ($10) in 
AFS revenue for 2021, and the remaining \1/2\ ($10) in AFS revenue for 
2022 regardless of when P provides the customer support.
    (B) Analysis. Since the software maintenance contract and the 
customer support agreement are two separate performance obligations, 
each yielding a separate item of gross income, paragraph (c)(8) of this 
section requires P to allocate the $100 payment to each item of gross 
income in the same manner as the payment is allocated to each 
performance obligation in P's AFS. For Federal income tax purposes, P 
must include $30 in gross income for 2021 ($20 allocable to the 
software maintenance contract and $10 allocable to the customer support 
agreement) and the remaining $70 is included in gross income for 2022.
    (iii) Contracts with advance payments that include items subject to 
a special method of accounting--(A) In general. The portion of the 
payment allocable to the items of gross income described in paragraph 
(a)(1)(i)(C) of this section from a contract that includes one or more 
items of gross income subject to a special method of accounting and one 
or more items of gross income described in paragraph (a)(1)(i)(C) of 
this section must be determined based on objective criteria.
    (B) Allocation deemed to be based on objective criteria. A 
taxpayer's allocation method is based on objective criteria if an 
allocation of the payment to each item of gross income is in proportion 
to the amounts determined in Sec.  1.451-3(d)(5) or as otherwise 
provided in guidance published in the Internal Revenue Bulletin (see 
Sec.  601.601(d) of this chapter).
    (iv) Example--(A) Facts. B is a calendar-year accrual method 
taxpayer with an AFS. In 2020, B enters into a $100x contract to 
design, build, operate and maintain a toll road and receives an up-
front payment of $100x. The contract meets the definition of a long-
term contract under Sec.  1.460-1(b)(1). B properly determines that the 
obligations to design and build the toll road are long-term contract 
activities under Sec.  1.460-1(d)(1) and accounts for the gross income 
from these activities under section 460. In addition, B properly 
determines that the obligations to operate and maintain the toll road 
are non-long-term contract activities under Sec.  1.460-1(d)(2) and 
that the gross income attributable to these activities is accounted for 
under section 451(b). B allocates $60x of the transaction price amount 
to the long-term contract activities and the remaining $40x to the non-
long-term contract activity pursuant to Sec.  1.451-3(d)(5). For AFS 
purposes, B allocates $55x of the transaction price amount to the 
performance obligations that are long-term contract activities and $45x 
to the non-long-term contract activities. B uses the deferral method of 
accounting.
    (B) Analysis. For Federal income tax purposes, a method of 
accounting under section 460 is a special method of accounting under 
paragraph (c)(8)(iv) of this section. Pursuant to paragraph (c)(8)(iv) 
of this section, B must allocate the payment among the item(s) of gross 
income that are subject to section 460 and the item(s) of gross income 
described in paragraph (a)(1)(i)(C) of this section based on objective 
criteria. B's allocation is deemed to be based on objective criteria if 
it allocates the payment in proportion to the amounts determined under 
Sec.  1.451-3(d)(5). That

[[Page 856]]

is, $60x to the items of gross income subject to section 460 and $40x 
to the items of gross income described in paragraph (a)(1)(i)(C) of 
this section.
    (9) Special rule relating to eligible gift card sales. For 
paragraphs (a)(1)(i)(B) and (c)(1) of this section, if an eligible gift 
card is redeemable by an entity described in paragraph (a)(10)(ii) of 
this section whose financial results are not included in the taxpayer's 
AFS, a payment will be treated as included by the taxpayer in its AFS 
revenue to the extent the gift card is redeemed by such entity during 
the taxable year.
    (10) Examples. The following examples illustrate the rules of 
paragraph (c) of this section. In each of the following examples, the 
taxpayer uses an accrual method of accounting for Federal income tax 
purposes and files its returns on a calendar year basis. In addition, 
the taxpayer in each example has an AFS and uses the deferral method 
under paragraph (c) of this section. Further, the taxpayer does not use 
the advance payment cost offset method in paragraph (e) of this 
section.
    (i) Example 1: Services. On November 1, 2021, A, in the business of 
giving dancing lessons, receives an advance payment of $480 for a 1-
year contract commencing on that date and providing for up to 48 
individual, 1-hour lessons. A provides eight lessons in 2021 and 
another 35 lessons in 2022. A takes into account \1/6\ ($80) of the 
payment as AFS revenue for 2021, and \5/6\ ($400) of the payment as AFS 
revenue for 2022. For Federal income tax purposes, under the deferral 
method in paragraph (c) of this section, A must include \1/6\ ($80) of 
the payment in gross income for 2021, and the remaining \5/6\ ($400) of 
the payment in gross income for 2022.
    (ii) Example 2: Services. The same facts as in paragraph (c)(10)(i) 
of this section (Example 1) apply. A receives an advance payment of 
$960 for a 3-year contract under which A provides up to 96 lessons. A 
provides eight lessons in 2021, 48 lessons in 2022, and 40 lessons in 
2023. A takes into account 1/12 ($80) of the payment as AFS revenue for 
2021, \1/2\ ($480) of the payment as AFS revenue for 2022, and 5/12 
($400) of the payment as AFS revenue for 2023. For Federal income tax 
purposes, under the deferral method in paragraph (c) of this section, A 
must include 1/12 ($80) of the payment in gross income for 2021, and 
the remaining 11/12 ($880) of the payment in gross income for 2022.
    (iii) Example 3: Services. On June 1, 2021, B, a landscape 
architecture firm, receives an advance payment of $100 for landscape 
services that, under the terms of the agreement, must be provided by 
December 2022. On December 31, 2021, B estimates that \3/4\ of the work 
under the agreement has been completed. B takes into account \3/4\ 
($75) of the payment as AFS revenue for 2021, and \1/4\ ($25) of the 
payment as AFS revenue for 2022. For Federal income tax purposes, under 
the deferral method in paragraph (c) of this section, B must include 
\3/4\ ($75) of the payment in gross income for 2021, and the remaining 
\1/4\ ($25) of the payment in gross income for 2022, regardless of 
whether B completes the job in 2022.
    (iv) Example 4: Repair contracts. On July 1, 2021, C, in the 
business of selling and repairing television sets, receives an advance 
payment of $100 for a 2-year contract under which C agrees to repair 
the customer's television set. C takes into account \1/4\ ($25) of the 
payment as AFS revenue for 2021, \1/2\ ($50) of the payment as AFS 
revenue for 2022, and \1/4\ ($25) of the payment as AFS revenue for 
2023. For Federal income tax purposes, under the deferral method in 
paragraph (c) of this section, C must include \1/4\ ($25) of the 
payment in gross income for 2021 and the remaining \3/4\ ($75) of the 
payment in gross income for 2022.
    (v) Example 5: Online website design. On July 20, 2021, D, a 
website designer, receives an online payment of $75 to design a website 
for Customer to be completed on February 1, 2023. D designs and 
completes Customer's website on February 1, 2023. D takes into account 
the $75 payment for Customer's website as AFS revenue for 2023. The $75 
payment D receives for Customer's website is an advance payment. For 
Federal income tax purposes, under the deferral method in paragraph (c) 
of this section, D must include the $75 payment for the website in 
gross income for 2022.
    (vi) Example 6: Online subscriptions. G is in the business of 
compiling and providing business information for a particular industry 
in an online format accessible over the internet. On September 1, 2021, 
G receives an advance payment from a subscriber for 1 year of access to 
its online database, beginning on that date. G takes into account \1/3\ 
of the payment as AFS revenue for 2021 and the remaining \2/3\ as AFS 
revenue for 2022. For Federal income tax purposes, under the deferral 
method in paragraph (c) of this section, G must include \1/3\ of the 
payment in gross income for 2021 and the remaining \2/3\ of the payment 
in gross income for 2022.
    (vii) Example 7: Membership fees. On December 1, 2021, H, in the 
business of operating a chain of ``shopping club'' retail stores, 
receives advance payments for membership fees. The membership fees are 
not prepaid dues income subject to section 456. Upon payment of the 
fee, a member is allowed access for a 1-year period to H's stores, 
which offer discounted merchandise and services. H takes into account 
1/12 of the payment as AFS revenue for 2021 and 11/12 of the payment as 
AFS revenue for 2022. For Federal income tax purposes, under the 
deferral method in paragraph (c) of this section, H must include 1/12 
of the payment in gross income for 2021, and the remaining 11/12 of the 
payment in gross income for 2022.
    (viii) Example 8: Cruise. In 2021, I, in the business of operating 
tours, receives $20x payments from customers for a 10-day cruise that 
will take place in April 2022. Under the agreement, I charters a cruise 
ship, hires a crew and a tour guide, and arranges for entertainment and 
shore trips for the customers. I takes into account the $20x payments 
as AFS revenue for 2022. For Federal income tax purposes, I must 
include the $20x payments in gross income for 2022.
    (ix) Example 9: Broadcasting rights--(A) Facts. K, a professional 
sports franchise, is a member of a sports league that enters into 
contracts with television networks for the right to broadcast games to 
be played between teams in the league. The league entered into a 2-year 
broadcasting contract beginning October 1, 2021. K receives two 
payments of $100x on October 1 of each contract year, beginning in 
2021. K estimates that for each contract year, 25% of the broadcasting 
rights are transferred by December 31 of the year of payment, and the 
remaining 75% of the broadcasting rights are transferred in the 
following year. K takes into account \1/4\ ($25x) of the first 
installment payment as AFS revenue for 2021 and \3/4\ ($75x) as AFS 
revenue for 2022. K takes into account \1/4\ ($25x) of the second 
payment as AFS revenue for 2022 and \3/4\ ($75x) as AFS revenue for 
2023.
    (B) Analysis. Each installment payment is an advance payment under 
paragraph (a)(1) of this section because a portion of each payment is 
included in AFS revenue for a subsequent taxable year and the payment 
relates to the use of intellectual property. For Federal income tax 
purposes, under the deferral method in paragraph (c) of this section, K 
must include \1/4\ ($25x) of the first $100x installment payment in 
gross income for 2021 and \3/4\ ($75x) of the first installment payment 
in gross income for 2022. In addition, K must include \1/4\ ($25x) of 
the second $100x payment in gross income for 2022 and \3/4\ ($75x) of 
the second installment payment in gross income for 2023.

[[Page 857]]

    (x) Example 10: Insurance claims administration--(A) Facts. L is in 
the business of negotiating, placing, and servicing insurance coverage 
and administering claims for insurance companies. On December 1, 2021, 
L enters into a contract with an insurance company to provide property 
and casualty claims administration services for a 4-year period 
beginning January 1, 2022. Pursuant to the contract, the insurance 
company makes four equal annual payments to L; each payment relates to 
a year of service and is made during the month prior to the service 
year. Since L does not perform any services related to the payment 
prior to the service year, L does not meet the requirements of Sec.  
1.451-1(a) for the payment prior to the service year. For example, L is 
paid on December 1, 2021, for the service year beginning January 1, 
2022. L takes into account the first payment as AFS revenue for 2022; 
the second payment as AFS revenue for 2023; the third payment as AFS 
revenue for 2024; and the fourth payment as AFS revenue for 2025.
    (B) Analysis. Each annual payment is an advance payment under 
paragraph (a)(1) of this section because each payment is taken into 
account as AFS revenue for a subsequent taxable year and the payment 
relates to services. For Federal income tax purposes, under the 
deferral method in paragraph (c) of this section, L must include: The 
first payment in gross income for 2022; the second payment in gross 
income for 2023; the third payment in gross income for 2024; and the 
fourth payment in gross income for 2025.
    (xi) Example 11: internet services--(A) Facts. M is a cable 
internet service provider that enters into contracts with subscribers 
to provide internet services for a monthly fee that is paid prior to 
the service month. For those subscribers who do not own a compatible 
modem, M provides a rental cable modem for an additional monthly 
charge, that is also paid prior to the service month. Pursuant to the 
contract, M will replace or repair the cable modem if it proves 
defective during the contract period. In December 2021, M receives 
$100x payments from subscribers for January 2022 internet service and 
cable modem use. M takes into account the entire $100x payments as AFS 
revenue for 2022.
    (B) Analysis. For Federal income tax purposes, the $100x payments 
are advance payments. Because M uses the deferral method in paragraph 
(c) of this section, M must include $100x in gross income for 2022.
    (xii) Example 12: License agreement--(A) Facts. On January 1, 2021, 
N receives a payment of $250 for entering into a 3-year license 
agreement for the use of N's trademark throughout the term of the 
agreement. The $250 payment reflects the first year (2021) license fee 
of $100 and the third year (2023) license fee of $150. The fee of $125 
for the second year is payable on January 1, 2022. N takes into account 
$100 of the $250 upfront payment as AFS revenue for 2021, $125 as AFS 
revenue for 2022, and $150 of the $250 payment as AFS revenue for 2023.
    (B) Analysis. For Federal income tax purposes, N received an 
advance payment of $150, the 2023 license fee, in 2021. Because N uses 
the deferral method in paragraph (c) of this section, N must defer the 
$150 payment and include it in gross income for 2022.
    (xiii) Example 13: Computer software subscription with one 
performance obligation--(A) Facts. On July 1, 2021, O, in the business 
of licensing off the shelf, fully customized, and semi-customized 
computer software and providing customer support, receives a payment of 
$100 for a 2-year ``software subscription contract'' under which O will 
provide software updates if it develops an update within the contract 
period, as well as online and telephone customer support. O determines 
that its obligations under the software subscription contract are one 
performance obligation for financial accounting purposes, which yields 
one item of gross income. O takes into account \1/4\ ($25) of the 
payment as AFS revenue for 2021, \1/2\ ($50) as AFS revenue for 2022, 
and the remaining \1/4\ ($25) as AFS revenue for 2023, regardless of 
when O provides updates or customer support.
    (B) Analysis. For Federal income tax purposes, the $100 payment is 
an advance payment. Because O uses the deferral method in paragraph (c) 
of this section, O must include \1/4\ ($25) of the payment in gross 
income for 2021 and \3/4\ ($75) in gross income for 2022.
    (xiv) Example 14: Gift cards administered by another--(A) General 
facts. Q is a corporation that operates department stores and is the 
common parent of a consolidated group (the Q group). U, V, and W are 
domestic corporations wholly owned by Q and members of the Q group. X 
is a foreign corporation wholly owned by Q and not a member of the Q 
group. U sells Brand A goods, V sells Brand B goods, X sells Brand C 
goods, and Z is an unrelated entity that sells Brand D goods. W 
administers a gift card program for the members of the Q group, X, and 
Z. Pursuant to the underlying agreements, W issues gift cards that are 
redeemable for goods or services offered by U, V, X, and Z. In 
addition, U, V, X, and Z sell gift cards to customers on behalf of W 
and remit amounts received to W. The agreements provide that W is 
primarily liable to the customer for the value of the gift card until 
redemption, and U, V, X, and Z are obligated to accept the gift card as 
payment for goods or services. When a customer purchases goods or 
services with a gift card at U, V, X, or Z, W reimburses that entity 
for the sales price of the goods or services purchased with the gift 
card, up to the total gift card value.
    (B) Facts for taxable year 2021. In 2021, W sells gift cards with a 
total value of $900, and, at the end of 2021, the unredeemed balance of 
the gift cards is $100. In Q group's AFS, the group includes revenue 
from the sale of a gift card when the gift card is redeemed. 
Accordingly, of the $900 of gift cards sold in 2021, $800 were redeemed 
and taken into account as AFS revenue for 2021. W tracks sales and 
redemptions of gift cards electronically, determines the extent to 
which advance payments are taken into account as AFS revenue in Q 
group's AFS for the taxable year of receipt and meets the requirements 
of paragraph (c)(1) of this section.
    (C) Analysis. The payments W receives from the sale of gift cards 
are advance payments because they are payments for eligible gift cards. 
Under the deferral method, W must include $800 of the payments from 
gift card sales in gross income in 2021 and the remaining $100 of the 
payments in gross income in 2022.
    (xv) Example 15: Gift cards of affiliates--(A) Facts. R is a 
Subchapter S corporation that operates an affiliated restaurant 
corporation and manages other affiliated restaurants. These other 
restaurants are owned by other Subchapter S corporations, partnerships, 
and limited liability companies. R has a partnership interest or an 
equity interest in some of the restaurants. R administers a gift card 
program for participating restaurants. Each participating restaurant 
operates under a different trade name. Under the gift card program, R 
and each of the participating restaurants sell gift cards, which are 
issued with R's brand name and are redeemable at all participating 
restaurants. Participating restaurants sell the gift cards to customers 
and remit the proceeds to R, R is primarily liable to the customer for 
the value of the gift card until redemption, and the participating 
restaurants are obligated under an agreement with R to accept the gift 
card as payment for food, beverages, taxes, and gratuities. When a 
customer uses a gift card to make a purchase at a participating 
restaurant, R is obligated

[[Page 858]]

to reimburse that restaurant for the amount of the purchase, up to the 
total gift card value. In R's AFS, R includes revenue from the sale of 
a gift card when a gift card is redeemed at a participating restaurant. 
R tracks sales and redemptions of gift cards electronically, is able to 
determine the extent to which advance payments are taken into account 
as AFS revenue for the taxable year of receipt and meet the 
requirements of paragraph (c)(1) of this section.
    (B) Analysis. The payments R receives from the sale of gift cards 
are advance payments because they are payments for eligible gift card 
sales. For Federal income tax purposes, R is eligible to use the 
deferral method. Using the deferral method, in the taxable year of 
receipt, R must include the advance payment in income to the extent 
taken into account as AFS revenue and must include any remaining amount 
in income in the taxable year following the taxable year of receipt. 
Under paragraph (c)(9) of this section, R is treated as taking into 
account revenue from the sale of a gift card as AFS revenue when a gift 
card is redeemed at a participating restaurant.
    (xvi) Example 16: Gift cards for domestic and international 
hotels--(A) Facts. S is a corporation that operates for the benefit of 
its franchisee members, who own and operate domestic and international 
individual member hotels. S administers a gift card program for its 
members by selling gift cards that may be redeemed for hotel rooms and 
food or beverages provided by any member hotel. The agreements 
underlying the gift card program provide that S is entitled to the 
proceeds from the sale of the gift cards, must reimburse the member 
hotel for the value of a gift card redeemed, and until redemption 
remains primarily liable to the customer for the value of the card. In 
S's AFS, S includes payments from the sale of a gift card when the card 
is redeemed. S tracks sales and redemptions of gift cards 
electronically, determines the extent to which advance payments are 
included in AFS revenue for the taxable year of receipt and meets the 
requirements of paragraph (c)(1) of this section.
    (B) Analysis. The payments S receives from the sale of gift cards 
are advance payments because they are payments for eligible gift card 
sales. Thus, for Federal income tax purposes, S is eligible to use the 
deferral method. Under the deferral method, in the taxable year of 
receipt, S must include in income the advance payment to the extent 
taken into account as AFS revenue and must include any remaining amount 
in income in the taxable year following the taxable year of receipt.
    (xvii) Example 17: Discount voucher--(A) Facts. On December 10, 
2021, T, in the business of selling home appliances, sells a washing 
machine for $500. As part of the sale, T gives the customer a 40% 
discount voucher for any future purchases of T's goods up to $100 in 
the next 60 days. In its AFS, T treats the discount voucher as a 
separate performance obligation and allocates $30 of the $500 sales 
price to the discount voucher. T takes into account $12 of the amount 
allocated to the discount voucher as AFS revenue for 2021 and includes 
$18 of the discount voucher as AFS revenue for 2022.
    (B) Analysis. For Federal income tax purposes, the $30 payment 
allocated to the discount voucher is an advance payment. Using the 
deferral method, T must include the $12 allocable to the discount 
voucher in gross income in 2021 and the remaining $18 allocated to the 
discount voucher in gross income in 2022.
    (xviii) Example 18: Rewards--(A) Facts. On December 31, 2021, U, in 
the business of selling consumer electronics, sells a new TV for $1,000 
and gives the customer 50 reward points. Each reward point is 
redeemable for a $1 discount on any future purchase of U's products. 
The reward points are not redeemable for cash and have a 2-year 
expiration date. U tracks the issue date, redemption date, and 
expiration date of each customer's reward points. Under the terms of 
U's reward program, when the customer redeems reward points they are 
deemed to use the earliest issued points first. In its AFS, U treats 
the rewards points as a separate performance obligation and allocates 
$50 of the $1,000 sales price to the rewards points. U is able to 
determine the extent to which a payment that is allocated to a reward 
point is taken into account in AFS revenue in the year of receipt. U 
does not take any of the amount allocated to the reward points into 
account as AFS revenue for 2021. U takes into account $25 of the reward 
points as AFS revenue for 2022 and $25 of the reward points as AFS 
revenue for 2023.
    (B) Analysis. For Federal income tax purposes, U's treatment of the 
reward points as a separate performance obligation for AFS purposes 
yields an item of gross income that must be accounted for separately. 
The $50 payment allocated to the reward points item is an advance 
payment as the full inclusion of the payment in gross income in the 
year of receipt is a permissible method of accounting without regard to 
this section, a portion of the payment is taken into account as AFS 
revenue in a subsequent taxable year, and the reward points are 
redeemable for an item described in paragraph (a)(1)(i)(C) of this 
section (goods). Because the entire amount of the $50 advance payment 
is taken into account as AFS revenue in tax years following the year of 
receipt, U defers the payment and includes the $50 payment in gross 
income in 2022.
    (xix) Example 19: Credit card rewards--(A) Facts. V issues credit 
cards and has a loyalty program under which cardholders earn reward 
points when they use V's credit card to make purchases. Each reward 
point is redeemable for $1 on any future purchases.
    (B) Analysis. Payments under credit card agreements, including 
rewards for credit card purchases, are excluded from the definition of 
an advance payment under paragraph (a)(1)(ii)(C) of this section. 
Accordingly, V cannot use the deferral method for these amounts.
    (xx) Example 20: Airline reward miles--(A) Facts. On January 1, 
2021, W, a passenger airline company, sells a customer a $700 airline 
ticket to fly roundtrip in 2021. As part of the purchase, the customer 
receives 7,000 reward points (air miles) from W to be used for future 
air travel. The reward points are not redeemable for cash and have a 2-
year expiration date. W tracks the issue date, redemption date, and 
expiration date of each customer's reward points. Under the terms of 
U's reward program, when the customer redeems reward points they are 
deemed to use the earliest issued points first. In its AFS, W treats 
the rewards points as a separate performance obligation and allocates 
$35 of the $700 ticket price to the reward points. W is able to 
determine the extent to which a payment that is allocated to a reward 
point is taken into account in AFS revenue in the year of receipt. W 
takes into account all $35 as AFS revenue in 2023 when the customer 
redeems the air miles.
    (B) Analysis. For Federal income tax purposes, W's treatment of the 
reward points as a separate performance obligation for AFS purposes 
yields an item of gross income that must be accounted for separately. 
The $35 allocated to the reward points item is an advance payment as 
the full inclusion of the payment in gross income in the taxable year 
of receipt is a permissible method of accounting without regard to this 
section, a portion of the payment is taken into account as AFS revenue 
in a subsequent taxable year, and the reward points are redeemable for 
an item described in paragraph (a)(1)(i)(C) of

[[Page 859]]

this section (services). Because the entire amount of the $35 advance 
payment is taken into account as AFS revenue in a tax year following 
the year of receipt, W defers the payment and includes the $35 payment 
in gross income in 2022.
    (xxi) Example 21: Chargebacks--(A) Facts. In 2021, X, a 
manufacturer of pharmaceuticals, enters into a contract to sell 1,000 
units to W, a wholesaler, for $10 per unit, totaling $10,000 (1,000 x 
$10 = $10,000). The contract also provides that X will credit W $4 per 
unit (chargeback) for sales W makes to qualifying customers. X delivers 
600 units to W on December 31, 2021, and bills W $6,000 under the 
contract. X anticipates that all of W's sales will be to qualifying 
customers and subject to chargeback. For AFS purposes, X adjusts its 
2021 AFS revenue of $6,000 by $2,400, the anticipated chargebacks, and 
reports $3,600 of AFS revenue.
    (B) Analysis. For Federal income tax purposes, under paragraph 
(a)(1)(i)(B) of this section, for a payment to qualify as an advance 
payment, a portion of the payment must be taken into account as AFS 
revenue for a subsequent taxable year. Under paragraph (a)(1)(i)(B) of 
this section, the amount of the payment included in AFS revenue for a 
subsequent taxable year is $0, calculated as the $6,000 payment reduced 
by $6,000 that is treated as taken into account as AFS revenue for 2021 
($3,600 of AFS revenue for 2021 + $2,400 of anticipated chargebacks 
(section 461 liabilities) which had reduced AFS revenue for 2021). 
Because no portion of the $6,000 is taken into account as AFS revenue 
in a subsequent taxable year (that is, on an AFS after 2021), the 
$6,000 payment received in 2021 is not an advance payment under 
paragraph (a)(1)(i) of this section.
    (d) Deferral method for taxpayers without an AFS (non-AFS deferral 
method)--(1) In general. Only a taxpayer described in paragraph (d)(2) 
of this section may elect to use the non-AFS deferral method of 
accounting described in paragraph (d)(4) of this section.
    (2) Taxpayers eligible to use the non-AFS deferral method. A 
taxpayer is eligible to use the non-AFS deferral method if the taxpayer 
does not have an applicable financial statement and can determine the 
extent to which advance payments are earned in the taxable year of 
receipt and, if applicable, a short taxable year described in paragraph 
(d)(6) of this section. The determination whether the advance payment 
is earned in the taxable year of receipt, or a short taxable year 
described in paragraph (d)(6) of this section, if applicable, is 
determined on an item by item basis.
    (3) Deferral of advance payments based on when payment is earned--
(i) In general. Except as otherwise provided in this section, a 
taxpayer that uses the non-AFS deferral method of accounting includes 
the advance payment in gross income for the taxable year of receipt to 
the extent that it is earned in that taxable year and includes the 
remaining portion of the advance payment in gross income in the next 
succeeding taxable year.
    (ii) When payment is earned. Under the non-AFS deferral method, a 
payment is earned when the all events test described in Sec.  1.451-
1(a) is met, without regard to when the amount is received, as defined 
under paragraph (a)(14) of this section, by the taxpayer. If a taxpayer 
is unable to determine the extent to which a payment is earned in the 
taxable year of receipt, or a short taxable year described in paragraph 
(d)(6) of this section, if applicable, the taxpayer may calculate the 
amount:
    (A) On a statistical basis if adequate data are available to the 
taxpayer;
    (B) On a straight-line basis over the term of the agreement if the 
taxpayer receives the advance payment under a fixed term agreement and 
if it is reasonable to anticipate at the end of the taxable year of 
receipt that the advance payment will be earned ratably over the term 
of the agreement; or
    (C) Using any other method that may be provided in guidance 
published in the Internal Revenue Bulletin (see Sec.  601.601(d) of 
this chapter).
    (4) Contracts with multiple items of gross income--(i) In general. 
If a taxpayer receives a payment that is attributable to one or more 
items described in paragraph (a)(1)(i)(C) of this section, the taxpayer 
must determine the portion of the payment that is allocable to such 
item(s) by using an allocation method that is based on objective 
criteria.
    (ii) Objective criteria. A taxpayer's allocation method for a 
payment described in paragraph (d)(4)(i) of this section is deemed to 
be based on objective criteria if the allocation method is based on 
payments the taxpayer receives for an item or items it regularly sells 
or provides separately or any method that may be provided in guidance 
published in the Internal Revenue Bulletin (see Sec.  601.601(d) of 
this chapter).
    (5) Acceleration of advance payments. The acceleration rules in 
paragraph (c)(4) of this section also apply to a taxpayer that uses the 
non-AFS deferral method under paragraph (d) of this section.
    (6) Short taxable year rule. If the taxpayer's next succeeding 
taxable year is a short taxable year, other than a taxable year in 
which the taxpayer dies or ceases to exist in a transaction other than 
a transaction to which section 381(a) applies, and the short taxable 
year consists of 92 days or less, a taxpayer using the non-AFS deferral 
method must include the portion of the advance payment not included in 
the taxable year of receipt in gross income for the short taxable year 
to the extent earned in such taxable year. Any amount of the advance 
payment not included in gross income in the taxable year of receipt, or 
the short taxable year, must be included in gross income for the 
taxable year immediately following the short taxable year.
    (7) Eligible gift card sale. For paragraphs (a)(1)(i)(B) and (d)(3) 
of this section, if an eligible gift card is redeemable by an entity 
described in paragraph (a)(10)(ii) of this section, including an entity 
whose financial results are not included in the taxpayer's financial 
statement, a payment will be treated as earned by the taxpayer to the 
extent the gift card is redeemed by such entity during the taxable 
year.
    (8) Examples. The following examples illustrate the rules of 
paragraph (d) of this section. In the examples in this paragaph (d)(8), 
the taxpayer is a calendar year taxpayer that uses the non-AFS deferral 
method described in paragraph (d) of this section. None of the taxable 
years are short taxable years.
    (i) Example 1--(A) Facts. A, a video arcade operator, receives 
payments in 2021 for tokens that customers use to play A's arcade 
games. The tokens cannot be redeemed for cash, are imprinted with the 
name of the arcade, but are not individually marked for identification. 
A completed a study on a statistical basis, based on adequate data 
available to A, and concluded that for payments received in 2021, 70% 
of tokens are expected to be used in 2021, 20% of tokens are expected 
to be used in 2022, and 10% of tokens are expected to never be used. 
Based on the study, under paragraph (d)(3)(ii)(A) of this section, A 
determines that 80% of the advance payments are earned for 2021 (70% 
for tokens expected to be used in 2021 plus 10% for tokens that are 
expected to never be used).
    (B) Analysis. For Federal income tax purposes, A must include 80% 
of the advance payments in gross income for 2021 and 20% of the advance 
payments in gross income for 2022.
    (ii) Example 2--(A) Facts. B is in the business of providing 
internet services. On September 1, 2021, B receives an

[[Page 860]]

advance payment from a customer for a 2-year term for access to its 
internet services, beginning on that date. B does not have an AFS. B is 
unable to determine the extent to which the payment is earned in the 
taxable year of receipt. However, at the close of the 2021 taxable 
year, it is reasonable for B to anticipate that the advance payment 
will be earned ratably over the term of the agreement.
    (B) Analysis. For Federal income tax purposes, pursuant to 
paragraph (d)(3)(ii)(B) of this section, B determines the extent to 
which the payment is earned in tax year 2021 on a straight-line basis 
over the term of the agreement and takes that amount into income in 
2021. The remaining amount of the advance payment is taken into gross 
income in the 2022 taxable year.
    (e) Advance payment cost offset method--(1) In general. This 
paragraph (e) provides an optional method of accounting for advance 
payments from the sale of inventory (advance payment cost offset 
method). A taxpayer that chooses to use the advance payment cost offset 
method for a trade or business must use the method of accounting for 
all advance payments received by that trade or business that meet the 
criteria in this paragraph (e). Additionally, a taxpayer that chooses 
to use this method for a trade or business and that has an AFS must 
also use the AFS cost offset method described in Sec.  1.451-3(c). A 
taxpayer that uses the AFS cost offset method and the advance payment 
cost offset method to account for gross income, including advance 
payments, from the sale of an item of inventory, determines the 
corresponding AFS income inclusion amount, as defined in Sec.  1.451-
3(a)(1), and the advance payment income inclusion amount for a taxable 
year by following the rules in Sec.  1.451-3(c)(2) rather than the 
rules under this paragraph (e). However, if all payments received for 
the sale of item of inventory meet the definition of an advance payment 
under paragraph (a)(1) of this section, a taxpayer that uses the 
advance payment cost offset method determines the corresponding advance 
payment income inclusion amount for a taxable year by:
    (i) Following the rules in paragraph (e)(2) of this section, 
subject to the additional rules and limitations in paragraphs (e)(5) 
through (8) of this section, if the taxable year is a taxable year 
prior to the taxable year in which ownership of the item of inventory 
is transferred to the customer; and
    (ii) Following the rules in paragraph (e)(3) of this section, 
subject to the additional rules and limitations in paragraphs (e)(5) 
through (8) of this section, if the taxable year is the taxable year in 
which ownership of the item of inventory is transferred to the 
customer.
    (2) Determining the advance payment income inclusion amount in a 
year prior to the year of sale. To determine the advance payment income 
inclusion amount for a taxable year prior to the year in which 
ownership of the item of inventory is transferred to the customer, the 
taxpayer must first determine the advance payment inventory inclusion 
amount for such item for such year. This advance payment inventory 
inclusion amount is then reduced by the cost of goods in progress 
offset for the taxable year, as determined under paragraphs (e)(4), 
(5), and (8) of this section. This net amount is the advance payment 
income inclusion amount for the taxable year.
    (3) Determining the advance payment income inclusion amount in the 
year of sale. The advance payment income inclusion amount for the 
taxable year in which ownership of the item of inventory is transferred 
to the customer is equal to the portion of any advance payment for such 
item that was not required to be included in gross income in a prior 
taxable year. This amount is not reduced by a cost of goods in progress 
offset under paragraph (e)(4) of this section. However, the taxpayer is 
entitled to recover the costs capitalized to the item of inventory as 
cost of goods sold in accordance with sections 471 and 263A or any 
other applicable provision of the Internal Revenue Code. See Sec.  
1.61-3.
    (4) Cost of goods in progress offset. The cost of goods in progress 
offset for the taxable year is calculated as:
    (i) The cost of goods allocable to the item of inventory through 
the last day of the taxable year; reduced by
    (ii) The cumulative cost of goods in progress offset attributable 
to the item of inventory, if any.
    (5) Limitations to the cost of goods in progress offset. The cost 
of goods in progress offset is determined separately for each item of 
inventory. The cost of goods in progress offset attributable to one 
item of inventory cannot reduce the advance payment inventory inclusion 
amount attributable to a different item of inventory. Further, the cost 
of goods in progress offset cannot reduce the advance payment inventory 
inclusion amount for the taxable year below zero.
    (6) Exception for gift cards. The cost of goods in progress offset 
in this paragraph (e) does not apply to eligible gift card sales or 
payments received for customer reward points.
    (7) Acceleration of advance payments. The acceleration rules in 
paragraph (c)(4) of this section also apply to a taxpayer that uses the 
advance payment cost offset method under this paragraph (e), regardless 
of whether the taxpayer uses such method in connection with the full 
inclusion method under paragraph (b) of this section, or the deferral 
method under paragraph (c) or (d) of this section. If an advance 
payment is subject to the acceleration rules, paragraph (e)(2) of this 
section does not apply to determine the advance payment income 
inclusion amount for the taxable year described in paragraph (c)(4) of 
this section. Further, a taxpayer that uses the advance payment cost 
offset method under this paragraph (e) applies paragraph 
(c)(4)(i)(B)(2)(ii) of this section by substituting ``same advance 
payment method as the transferor'' for ``deferral method.''
    (8) Inventory costs for the advance payment cost offset method--(i) 
Inventory costs not affected by cost of goods in progress offset. The 
cost of goods comprising the cost of goods in progress offset does not 
reduce the costs that are capitalized to the items of inventory 
produced or items of inventory acquired for resale by the taxpayer. 
While the cost of goods in progress offset reduces the amount of the 
advance payment inventory inclusion amount, the cost of goods in 
progress offset does not affect how and when costs are capitalized to 
inventory under sections 471 and 263A or any other applicable provision 
of the Internal Revenue Code or when those capitalized costs will be 
recovered.
    (ii) Consistency between inventory methods and advance payment cost 
offset method. The costs of goods comprising the cost of goods in 
progress offset must be determined by applying the taxpayer's methods 
of accounting for inventory for Federal income tax purposes. A taxpayer 
using the advance payment cost offset method must calculate its cost of 
goods in progress offset by reference to all costs that the taxpayer 
has permissibly capitalized and allocated to items of inventory under 
its methods of accounting for inventory for Federal income tax 
purposes, but including no more costs than what the taxpayer has 
permissibly capitalized and allocated to items of inventory.
    (iii) Allocation of ``additional section 263A costs'' for taxpayers 
using simplified methods. If a taxpayer uses the simplified production 
method as defined under Sec.  1.263A-2(b), the modified simplified 
production method as defined under Sec.  1.263A-2(c), or the simplified 
resale method as defined under Sec.  1.263A-3(d) to determine the 
amount of its ``additional section 263A

[[Page 861]]

costs,'' as defined under Sec.  1.263A-1(d)(3), to be included in 
ending inventory, then solely for computing the cost of goods in 
progress offset, the taxpayer must determine the portion of additional 
section 263A costs allocable to an item of inventory by multiplying its 
total additional section 263A costs accounted for under the simplified 
method for all items of inventory subject to the simplified method by 
the following ratio:

Section 471 costs allocable to the specific item of inventory
------------------------------------------------------------------------
Total section 471 costs for all items of inventory subject to the
 simplified method
 

    (9) Additional procedural guidance. The IRS may publish procedural 
guidance in the Internal Revenue Bulletin (see Sec.  601.601(d) of this 
chapter) that provides alternative procedures for complying with the 
rules under this paragraph (e), including alternative methods of 
accounting for cost offsets.
    (10) Examples. The following examples illustrate the rules of 
paragraph (e) of this section. In each of the following examples, the 
taxpayer is a C corporation, has an AFS, uses an accrual method of 
accounting for Federal income tax purposes, and uses a calendar year 
for Federal income tax purposes and AFS purposes. In addition, in each 
example, the taxpayer uses the deferral method and the advance payment 
cost offset method under paragraph (e) of this section. Lastly, the 
taxpayer does not produce unique items, as described in Sec.  1.460-
2(a)(1) and (b), or any item that normally requires more than 12 
calendar months to complete, as determined under Sec.  1.460-2(a)(2) 
and (c). Any production period that exceeds 12 calendar months is due 
to unforeseen production delays.
    (i) Example 1--(A) Facts. In December 2021, A enters into a 
contract with Customer to manufacture and deliver a good in 2024, with 
a total contract price of $100x. The costs to produce the good are 
required to be capitalized under sections 471 and 263A as the good is 
inventory in the hands of A. On the same day, A receives a payment of 
$40x from the customer. For its AFS, A reports all of the revenue from 
the sale of the good as AFS revenue in the year of delivery, which is 
also the year in which ownership of the good transfers from A to 
Customer. As of December 31, 2021, A has not incurred any cost to 
manufacture the good. The payment of $40x does not satisfy the 
specified good exception in paragraph (a)(1)(ii)(H) of this section, 
and thus qualifies as an advance payment. During 2022, A does not 
receive any additional payments on the contract and incurs $10x of 
costs to manufacture the good. A properly capitalizes and allocates 
such costs to the manufactured good under sections 471 and 263A.
    (B) Analysis. Because no portion of the $40x advance payment is 
taken into account as AFS revenue as of the end of 2021, A is not 
required to include any portion of the advance payment in gross income 
for 2021. For 2022, A's advance payment inventory inclusion amount is 
$40x, which is the amount of the advance payment that, but for the cost 
of goods in progress offset, would be includable in gross income in 
2022 under the deferral method. Pursuant to paragraph (e)(2) of this 
section, A reduces such amount by the $10x cost of goods in progress 
offset, determined as the costs of goods through the end of 2022 ($0 
costs incurred in 2021 plus 10x of costs incurred in 2022 = $10x). A is 
required to include this net amount of $30x in gross income in 2022. 
The remaining portion of the payment ($10x) is deferred and included in 
gross income in 2024, the taxable year in which ownership of the good 
is transferred to Customer.
    (ii) Example 2--(A) Facts. The same facts as in paragraph 
(e)(10)(i) of this section (Example 1) apply. In addition, in 2023, A 
incurs costs of $20x to manufacture the good but does not receive any 
additional payments from Customer.
    (B) Analysis. A includes $0 in gross income in 2023. A's cost of 
goods in progress offset for 2023 is $20x under paragraph (e)(4) of 
this section ($30x costs of goods through the last day of 2023 ($10x 
for 2022 plus $20x for 2023 = $30x) less $10x cumulative cost of goods 
in progress offset amounts taken in prior taxable years). However, 
because A's advance payment inventory inclusion amount for 2023 is $0, 
which is the amount of the advance payment that, but for the cost of 
goods in progress offset, would be includable in gross income in 2023 
under the deferral method, paragraph (e)(5) of this section limits the 
cost offset to $0.
    (iii) Example 3--(A) Facts. The same facts as in paragraph 
(e)(10)(i) of this section (Example 1) apply, except that in taxable 
year 2022, A incurs additional costs of $25x to manufacture the good, 
resulting in total costs of $35x to manufacture the good in taxable 
year 2022.
    (B) Analysis. For 2022, A's advance payment inventory inclusion 
amount is $40x, which is the amount of the advance payment that, but 
for the cost of goods in progress offset, would be includable in gross 
income in 2022 under the deferral method. Pursuant to paragraph (e)(2) 
of this section A reduces such amount by the $35x cost of goods in 
progress offset, determined as the costs of goods through the end of 
2022 ($0 costs incurred in 2021 plus $35x costs incurred in 2022 = 
$35x). A is required to include this net amount of $5x in gross income 
in 2022. The remaining portion of the payment ($35x) is deferred and 
included in gross income in 2024, the taxable year in which ownership 
of the good is transferred to the customer.
    (iv) Example 4--(A) Facts. The same facts as in paragraph 
(e)(10)(iii) of this section (Example 3) apply, except that for tax 
year 2023, A receives an additional advance payment of $60x, and does 
not incur any costs to manufacture the good in 2023. In 2024, A incurs 
the remaining $10x to manufacture the good, and delivers the good to 
Customer.
    (B) Analysis for 2023. Because no portion of the $60x advance 
payment is taken into account as AFS revenue as of the end of 2023, A 
is not required to include any portion of the $60x advance payment in 
gross income for 2023.
    (C) Analysis for 2024. In 2024, the ownership of the good is 
transferred to Customer. Accordingly, pursuant to paragraph (e)(3) of 
this section, A is required to include $95x, the remaining portion of 
all advance payments that were not required to be included in gross 
income in a prior taxable year ($100x of total advance payments 
received less $5x that was required to be included in gross income in 
2022). Although A does not reduce such amount by a cost offset, it 
reduces gross income in 2024 by recovering the $45x of costs 
capitalized to inventory as cost of goods sold ($35x costs incurred in 
2022 plus $10x costs incurred in 2024) in accordance with sections 471 
and 263A. Accordingly, A's gross income for 2024 is $50x.
    (f) Method treating payments qualifying for the specified goods 
exception as advance payments--(1) In general. A taxpayer may choose to 
use the specified good section 451(c)

[[Page 862]]

method to treat all payments that qualify for the specified goods 
exception in paragraph (a)(1)(ii)(H) of this section as advance 
payments that are eligible to be accounted for under this section. 
Under the specified good section 451(c) method, an advance payment is a 
payment received by the taxpayer in a taxable year earlier than the 
taxable year immediately preceding the taxable year of the contractual 
delivery date for a specified good. A taxpayer that chooses to use the 
specified good section 451(c) method for a trade or business must apply 
this method of accounting for all advance payments that meet the 
criteria described in paragraph (a)(1)(ii)(H) of this section.
    (2) Example: Method for the specified goods exception to not apply. 
On May 1, 2021, A, a corporation that files its Federal income tax 
return on the calendar year basis, receives a prepayment for $100x, for 
a contract to manufacture and deliver a good in September of 2023. All 
of the revenue from the sale of the good is recognized in A's AFS in 
the year of delivery. During 2021, A does not have on hand, or 
available to it in such year through its normal source of supply, goods 
of a substantially similar kind and in a sufficient quantity to satisfy 
the contract to transfer the good to the customer. The payment of $100x 
satisfies the specified good exception. A uses the method under 
paragraph (f) of this section to treat all payments that otherwise 
satisfy the specified good exception as advance payments under this 
section. For Federal income tax purposes, A must treat the payment of 
$100x as an advance payment and account for such payment under the full 
inclusion method in paragraph (b) of this section, or the deferral 
method in paragraph (c) of this section, as applicable. Additionally, 
the taxpayer may choose to apply the advance payment cost offset method 
in paragraph (e) of this section.
    (g) Election and methods of accounting--(1) Procedures for making 
election under section 451(c)(1)(B). An election to apply the deferral 
method under section 451(c)(1)(B) is made by the taxpayer filing a 
Federal income tax return reflecting the deferral method in computing 
its taxable income. If the application of the deferral method under 
section 451(c)(1)(B) results in the taxpayer changing its method of 
accounting, the election may only be made by the taxpayer complying 
with the method change procedures under this paragraph (g).
    (2) Methods of accounting. A change to comply with this section is 
a change in method of accounting to which the provisions of sections 
446 and 481 and the regulations in this part under sections 446 and 481 
of the Code apply. A taxpayer seeking to change to a method of 
accounting permitted in this section must secure the consent of the 
Commissioner in accordance with Sec.  1.446-1(e) and follow the 
administrative procedures issued under Sec.  1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to change its accounting method. 
For example, use of the full inclusion method under paragraph (b) of 
this section, the AFS deferral method under paragraph (c) of this 
section, the non-AFS deferral method under paragraph (d) of this 
section, the advance payment cost offset method under paragraph (e) of 
this section, and the specified good section 451(c) method under 
paragraph (f) of this section are adoptions of, or changes in, a method 
of accounting under section 446 of the Internal Revenue Code or the 
regulations in this part under section 446 of the Code. In addition, a 
change in the manner of recognizing advance payments in revenue in an 
AFS that changes or could change the timing of the inclusion of income 
for Federal income tax purposes is a change in method of accounting 
under section 446 and the regulations in this part under section 446 of 
the Code.
    (h) Applicability date--(1) In general. The rules of this section 
apply to taxable years beginning on or after January 1, 2021.
    (2) Early application. Taxpayers and their related parties, within 
the meaning of sections 267(b) and 707(b), may apply both the rules in 
this section and, to the extent relevant, the rules in Sec.  1.451-3, 
in their entirety and in a consistent manner, to a taxable year 
beginning after December 31, 2017, and before January 1, 2021, provided 
that, once applied to a taxable year, the rules in this section and, to 
the extent relevant, the rules in Sec.  1.451-3, are applied in their 
entirety and in a consistent manner to all subsequent taxable years. 
See section 7805(b)(7) and Sec.  1.451-3(m).

0
Par. 7. Section 1.1271-0 is amended by adding entries for Sec.  1.1275-
2(l) and (l)(1) and (2) to read as follows:


Sec.  1.1271-0   Original issue discount; effective date; table of 
contents.

* * * * *


Sec.  1.1275-2  Special rules relating to debt instruments.

* * * * *
    (l) OID rule for income item subject to section 451(b).
    (1) In general.
    (2) Applicability dates.
* * * * *

0
Par. 8. Section 1.1275-2 is amended by adding paragraph (l) to read as 
follows:


Sec.  1.1275-2   Special rules relating to debt instruments.

* * * * *
    (l) OID rule for income item subject to section 451(b)--(1) In 
general. Notwithstanding any other rule in sections 1271 through 1275 
and Sec. Sec.  1.1271-1 through 1.1275-7, if, and to the extent, a 
taxpayer's item of income with respect to a debt instrument is subject 
to the timing rules in Sec.  1.451-3 because the item of income is a 
specified fee described in Sec.  1.451-3(j) (such as credit card late 
fees, credit card cash advance fees, or interchange fees), then the 
taxpayer does not take the item into account to determine whether the 
debt instrument has any OID. As a result, the taxpayer does not treat 
the item as creating or increasing any OID on the debt instrument.
    (2) Applicability dates--(i) In general. Except as provided in 
paragraph (l)(2)(ii) and (iii) of this section, for a specified credit 
card fee as defined in Sec.  1.451-3(j)(2), paragraph (l)(1) of this 
section applies for taxable years beginning on or after January 1, 
2021, and, for a specified fee that is not a specified credit card fee, 
paragraph (l)(1) of this section applies for taxable years beginning on 
or after January 6, 2022.
    (ii) Early application. For a taxable year beginning after December 
31, 2018, and before January 1, 2021, a taxpayer and its related 
parties, within the meaning of sections 267(b) and 707(b), may choose 
to apply both paragraph (l)(1) of this section and the rules in Sec.  
1.451-3, in their entirety and in a consistent manner, to all specified 
credit card fees subject to Sec.  1.451-3, provided that once applied 
to a taxable year the rules in paragraph (l)(1) of this section and the 
rules in Sec.  1.451-3 that apply to specified credit card fees, are 
applied in their entirety and in a consistent manner for all subsequent 
taxable years. See section 7508(b)(7).

[[Page 863]]

    (iii) Applicability date for accounting method changes. Paragraph 
(l)(1) of this section will not apply in applying section 13221(e) of 
Public Law 115-97, 131 Stat. 2054 (2017), to determine the section 
481(a) adjustment period for any adjustment under section 481(a) for a 
qualified change in method of accounting required under section 451(b) 
and Sec.  1.451-3 for a specified credit card fee.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
    Approved: December 14, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-28653 Filed 12-30-20; 4:15 pm]
 BILLING CODE 4830-01-P