New FASB guidance, IRS and Court rulings address tax accounting method issues

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1 Accounting Methods Spotlight / Issue 8 / August 2014 Did you know? p1 / Other guidance p2/ Cases p5 New FASB guidance, IRS and Court rulings address tax accounting method issues In this month s issue, you will receive insight on the new FASB proposal to simplify inventory measurement, and the potential tax implications of such proposal. In addition, we have included discussions on: Treasury and IRS corrections to the final tangible property regulations under Section 263(a); whether a taxpayer and its subsidiary, a single member LLC, can be considered separate trades or businesses for purposes of selecting a method of accounting; final regulations concerning the deductibility of partnership start-up and organizational expenditures following a technical termination; and proposed regulations on the accounting method for calculating gains and losses on shares in money market funds. This month s issue also discusses the U.S. Tax Court's recent finding that certain unredeemed discounts do not meet the "all events" test, and are not eligible for the exception provided in Treas. Reg. Section , and thus are not deductible until redeemed. Did you know..? FASB issues proposal to simplify inventory measurement As part of its simplification initiative, the Financial Accounting Standards Board (FASB) issued on July 15, 2014 a proposed Accounting Standards Updates (ASU) that would simplify the measurement of inventory under U.S. Generally Accepted Accounting Principles (GAAP). The proposed ASU addresses stakeholder concerns about the complexity of current guidance on measuring inventory. Current GAAP rules require reporting organizations to measure inventory at the lower of cost or market. Market generally is the replacement or reproduction cost of the inventory; however, market cannot exceed the net realizable value, which is the selling price less the cost to complete and dispose of the item, (known as the ceiling ) and cannot

2 be lower than the net realizable value less a normal profit margin (known as the floor ). The proposed guidance would require inventory to be measured at the lower of cost or net realizable value. Thus, under the proposed ASU, market would be replaced with net realizable value. GAAP defines this concept as the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. If the proposed changes become final, taxpayers would no longer have to consider replacement cost or net realizable value less a normal profit margin when measuring inventory. Importantly, the proposal does not amend guidance on measuring the cost of inventory. Companies may continue to apply LIFO, FIFO, or average cost to determine the cost of inventory. The FASB proposes that the changes become effective for fiscal years, including quarterly reports, that begin after December 15, 2014, but early adoption would be permissible. The tax law contains specific requirements with respect to the valuation of inventory. Generally, normal goods may be valued at cost or lower of cost or market, with market determined based on reproduction or replacement cost or in some cases an actual offering price. Subnormal goods are measured at bona fide selling prices less the cost of disposition (similar to the GAAP net realizable value concept). Despite the similarity of the tax rules for normal goods with the current GAAP rule and the tax rules for subnormal goods to the proposed GAAP rule, there are further qualifications within the GAAP and tax rules that generally prevent a taxpayer from following the GAAP market valuation for those goods for tax purposes. As such, any change in inventory valuation for GAAP purposes likely will impact only the determination of book-tax differences and deferred taxes. Other guidance Treasury and IRS correct and clarify final repair regulations On July 18, 2014, the IRS issued corrections to the final repairs regulations under Section 263(a). Although the corrections are mostly administrative in nature, one substantive change clarifies how to make an election to capitalize and depreciate rotable, temporary, and standby emergency spare parts ("eligible M&S") under Treas. Reg. Sec (d) of the final regulations. According to the Treasury and IRS, as currently published, Treas. Reg. Sec (d)(3) could be misleading. The final regulations in Treas. Reg. Sec (d)(1) states that in general, a taxpayer makes the election to capitalize and depreciate eligible M&S. However, Treas. Reg. Sec (d)(3) which articulates the manner of making the election, states that the taxpayer makes the election to capitalize and recover eligible M&S. The July corrections modify the -3(d)(3) rule to conform to -3(d)(1), such that an election is made by capitalizing the amounts paid to acquire or produce an eligible M&S and by beginning to depreciate the capitalized amounts under the applicable provisions, such as under the Modified Accelerated Cost Recovery System (MACRS) under Section 168. The temporary regulations provided a similar election to capitalize and depreciate all materials and supplies (M&S) under Treas. Reg. Sec T(d), and contained similar language to the language corrected in final regulations. The final regulations allows taxpayers to choose to apply Section T(d) to amounts paid or incurred in taxable years beginning on or after January 1, 2012, and before January 1, Because the language in Treas. Reg. Sec T(d)(3) can no longer be corrected, Section (j)(3) clarifies that the manner for making the election to capitalize 2 PwC

3 and depreciate M&S under Section T(d)(3), is the same for making the election under Treas. Reg. Sec (d)(3). Observation: As a result of changing the requirements to make an election for M&S from capitalizing and recovering the costs to capitalizing and depreciating the costs, a taxpayer is prevented from making an election to capitalize M&S that would be disposed in the year of acquisition in order to convert what would be a section 162 deduction into a section 165 loss. Corporation and LLC are separate for purposes of selecting a method of accounting In CCA , the IRS concluded that a corporation and a limited liability company ( LLC ) are separate and distinct trades or businesses for purposes of selecting methods of accounting under Section 446(d). The taxpayer in question is a corporation for federal income tax purposes. The taxpayer s subsidiary converted to an LLC, with the taxpayer being its sole member. The LLC did not make an election under Treas. Reg. Sec to be treated as a corporation; as a result, the LLC is treated as a division of the taxpayer. The taxpayer and LLC have separate books and records, prepared at the taxpayer s location. The taxpayer and LLC are in different geographic locations and do not share employees, except for the highest-level executives. Under Section 446(d), a taxpayer engaged in multiple trades or businesses may select different methods of accounting for each trade or business. Further, Treas. Reg. Sec (d) provides factors to be used to determine when a taxpayer has multiple trades or businesses and when different methods of accounting may or may not be appropriate. In this CCA, the IRS concluded that determining whether the taxpayer and LLC were separate and distinct trades or businesses was a factual determination, and that available information failed to convince the IRS that the two entities were not separate and distinct trades or businesses. Failure to make an election to treat the LLC as a corporation does not preclude the LLC from being treated as a separate and distinct trade or business for purposes of Section 446. Therefore, the IRS determined that the taxpayer and LLC were separate and distinct trades or businesses under Section 446(d). IRS issues final regulations on the deductibility of partnership startup expenditures following a technical termination Recently, the IRS released final regulations (T.D. 9681) clarifying its position on the deductibility of start-up expenditures and organizational expenses capitalized by a partnership when the partnership has a technical termination. The final regulations generally adopt the positions taken in the proposed regulations issued in December 2013 (78 FR 73753), which were intended to eliminate uncertainty as to whether a partnership is entitled to immediately deduct any unamortized start-up and organizational expenses upon its technical termination. Sections 195 and 709 address the deductibility of start-up expenditures and organizational expenses, respectively, incurred by a partnership in connection with creating or organizing a partnership or acquiring an interest in a partnership. In general, start-up expenditures and organizational expenses must be capitalized. However, an election is available to taxpayers that generally permits a deduction for the first $5,000 of start-up expenditures and $5,000 of organizational expenses, with the remaining amounts amortized over 180 months. In any case where a partnership is disposed of or liquidated before the end of the amortization period, the Code generally provides that any unamortized start-up expenditures and organizational expenses attributable to the partnership may be deducted upon disposition or liquidation of the business. 3 PwC

4 The final regulations were issued to address the deductibility of start-up expenditures and organizational expenses in the context of a technical termination of a partnership under Section 708(b)(1)(B). Under this section, a partnership is considered terminated if there is a sale or exchange of 50 percent or more of the total interest in the partnership capital and profits within a 12 month period. The proposed regulations clarified that this type of termination does not constitute the type of disposition or liquidation that should trigger a deduction of unamortized Section 195 expenditures or Section 709 expenses. Instead, the new partnership should continue to amortize those expenditures using the same amortization period(s) adopted by the terminating partnership. The final regulations adopt the proposed regulations with one clarification to emphasize that the amortization period does not restart for the new partnership. The final regulations are effective on July 23, 2014, and apply to any technical termination of a partnership that occurs after December 8, IRS issues proposed regulations on calculation of gains and losses on shares in money market funds In response to the SEC s recent issuance of rules that change how certain money market fund ( MMF ) shares are priced, the IRS has issued proposed regulations (REG ) that provide a simplified method of accounting for gains and losses on these shares. The proposed regulations also provide guidance regarding the related information reporting requirements. In issuing these regulations, the IRS intends to simplify tax compliance for holders of shares in MMFs affected by the SEC regulations. An MMF is a type of Investment Company that is subject to certain requirements prescribed under the Investment Company Act of 1940 (the Act ). Under the Act, an MMF is required to invest in short term, low risk, and liquid securities. Typically, an MMF s objective is to earn interest for shareholders while maintaining a net asset value of $1 per share. Because of the inherent low risk and high liquidity, many investors utilize MMFs for cash management purposes, depositing and withdrawing funds from the account on a regular (e.g., daily) basis. Historically, an MMF could compute its price per share for purposes of distribution, redemption, and repurchase in several ways, including the amortized cost method and the penny-rounding method. Under the amortized cost method, an MMF s net asset value was determined using the fund s securities acquisition cost plus any amortization of premium or accretion of discount. The penny-rounding method further provided that the MMF's net asset value should be rounded to the nearest one percent in computing the price per share. Before the new SEC rules were adopted, MMFs could use either of these methods, or a combination of both. Using these methods, MMFs were able to maintain stable prices for their shares allowing investors to redeem shares at prices which were at or near their original basis. The SEC proposed new MMF reform rules in June 2013 that effectively barred the use of both the amortized cost method and the penny-rounding method, except in certain limited circumstances. The new rules provide that an MMF should determine its net asset value using current market-based factors as opposed to historical acquisition costs. Additionally, price per share must be computed under the basis point rounding method, which generally requires rounding to a minimum of the fourth decimal place. The new method causes a regular fluctuation (or float ) in the share price for MMFs. Under the tax law, shareholders in these MMFs now would be required to compute gain or loss on every redemption of shares, resulting in a significant compliance burden given the frequency with which these shares are often purchased and redeemed by investors. The IRS s proposed regulations are intended to address this compliance burden by providing a simplified method of accounting for floating net asset value MMF shares. 4 PwC

5 Under the proposed method, the shareholders gain or loss is based on the aggregate of all transactions in a period and on aggregate fair market values, instead of requiring the calculation of gain or loss on individual transactions. The taxpayer would determine the net gain or loss from shares in the MMF by taking the change in value of all shares in the MMF over the period minus the taxpayer's net investment in the MMF during the period. The character of the gain or loss is dependent upon the character of the underlying shares and any net capital gain or loss on the shares should be considered short term. The proposed regulations also include provisions addressing information reporting requirements for the floating net asset value MMF shares as well as the application of the wash sale rules under the SEC MMF reform rules. The proposed regulations specifically provide that the simplified net asset value method is a method of accounting as defined under Section 446. Taxpayers may adopt this new method in the first taxable year in which they hold shares in a floating net asset value MMF. Alternatively, taxpayers who have already adopted a method of accounting for gains and losses on such shares must file a change in method of accounting to change to the net asset value method. Such a change will be implemented on a cut-off basis, as prescribed under the proposed regulations. Comments on the proposed regulations are due by October 27, Taxpayers may rely on the proposed regulations in adopting the net asset value method for taxable years ending on or after July 28, 2014 and beginning before the date of publication of the final regulations. Cases Tax Court finds deductions for unredeemed discounts do not meet all events test In Giant Eagle Inc. v. Commissioner, T.C. Memo (July 23, 2014), the Tax Court found that Giant Eagle, the owner of supermarket and gas station chains, was not entitled to a deduction for unredeemed discounts. In its decision, the court noted that the unredeemed discounts did not satisfy the all events test as the liability for these discounts became fixed when they were redeemed, not when they were earned by the customer. During the years at issue in the case, Giant Eagle offered a discounted gasoline and diesel fuel promotion through a program known as fuelperks!. Customers who participated in this program could earn fuelperks! by presenting a customer loyalty card when making purchases of qualified goods or services, which could then be redeemed to reduce the retail price per gallon of gasoline or diesel fuel at a Giant Eagle gas station. The program required that all fuelperks! be aggregated and used to reduce the price of fuel to the greatest extent possible at the time of redemption. Any excess fuelperks! would be saved on the customer s loyalty card and carried over until their expiration, 3 months from the last day of the month in which they were earned. Generally, under Section 461(a), an accrual method taxpayer is entitled to a deduction in the year an expense is incurred, regardless of when that expense is paid. An expense is incurred under the all events test when: (1) all events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability. If all three requirements are satisfied, the taxpayer may deduct the liability in the current tax year. Giant Eagle deducted on its tax return the estimated costs of redeeming a portion of the issued fuelperks! that were unexpired and unredeemed at the end of each tax year. Giant Eagle contended that it met the requirements of the all events test with respect to the unredeemed fuelperks!. Conversely, the IRS disallowed the deduction claiming that Giant Eagle failed the first requirement of the test as all events had not occurred to establish their liability for the unredeemed fuelperks!. 5 PwC

6 The Tax Court ruled in favor of the IRS, noting that because the redemption of fuelperks! was structured as a discount against the retail price of fuel, the purchase of fuel was a condition precedent to their redemption. Therefore, Giant Eagle s liability for the fuelperks! did not become fixed until the time of their redemption when fuel was purchased (i.e., fuelperks! that were unredeemed at the end of the tax year were not eligible for a current year deduction). The regulations under Treas. Reg. Sec provide an exception to the general tax rules when a taxpayer issues trading stamps or premium coupons with sales, or is engaged in the business of selling trading stamps or premium coupons, and such stamps or coupons are redeemable for merchandise, cash, or other property. Under the regulations, the taxpayer may reduce their current year gross receipts with respect to such sales by the cost of the merchandise, cash, or other property redeemed (or to be redeemed in the future). This exception is intended to better match the timing of revenues and associated expenses as it relates to the trading stamps and premium coupons. As an alternative argument, Giant Eagle asserted that the fuelperks! program qualified for the exception under Treas. Reg. Sec and they should therefore be entitled to reduce their gross receipts by the estimated future costs of redeeming outstanding fuelperks!. The IRS contested that the exception should not apply because the fuelperks! were not redeemable in merchandise, cash, or other property. Again, the Tax Court ruled in favor of the IRS. The court noted that the regulations under Treas. Reg. Sec are an exception to the general all-events test under section 461. However, the court observed that the ability for the customer to redeem fuelperks! was conditioned on their future purchase of gasoline. Citing logic from a prior revenue ruling (Rev. Rul ), the court reasoned that allowing a current deduction for redemptions that are conditioned on a future purchases would result in a mismatching of expenses and revenues. Thus, the court concluded that the taxpayer is not entitled to a deduction or reduction in gross receipts for the unredeemed fuelperks!, upholding the IRS s deficiency assessment. Let s talk For a deeper discussion of how these issues might affect your business, please contact: Annette Smith, Washington, DC +1 (202) annette.smith@us.pwc.com Adam Handler, Los Angeles +1 (213) adam.handler@us.pwc.com Dennis Tingey, Phoenix +1 (602) dennis.tingey@us.pwc.com Christine Turgeon, New York +1 (646) christine.turgeon@us.pwc.com Jennifer Kennedy, Washington, DC +1 (202) jennifer.kennedy@us.pwc.com Ross Margelefsky, New York +1 (646) ross.margelefsky@us.pwc.com George Manousos, Washington, DC +1 (202) george.manousos@us.pwc.com 2014 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a Delaware limited liability partnership), which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. SOLICITATION 6 PwC This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.