As businesses gain a post-pandemic sense of cautious optimism, business acquisitions or combinations are on this rise. Factoring large in most transaction negotiations are the tax consequences to the deal, which require businesses and their owners to understand and anticipate these tax consequences. While there are many to be concerned with, a popular concern pertains to the tax ramifications related to deferred revenue – the advance payment a company receives for products or services to be provided in the future. Organizations that are highly acquisitive need to understand these tax issues when negotiating the deal and when later completing purchase accounting.
Tax Treatment of Deferred Revenue
For taxpayers using the overall accrual method, the general rule that governs the timing of revenue recognition under U.S. tax law is to recognize an item of gross income at the earlier of the time when it is due, paid, earned, or included as revenue in the taxpayer’s applicable financial statement (AFS). But for advance payments, there is an important exception to this general rule that allows the taxpayer to defer recognition until the time the advance payments are reported as revenue in the taxpayer’s AFS (subject to a maximum deferral period). Under this “deferral method,” taxpayers generally may follow their book treatment and defer recognition until the tax year that follows the year of the advance payment. Taxpayers essentially employ book conformity for tax revenue recognition during the year of the advance payment (but not necessarily after that year).
Asset Acquisitions Including Deferred Revenue
When a company acquires assets that constitute a trade or business, it generally obtains a tax basis in the acquired assets equal to the cash purchase price plus any liabilities assumed. In other words, this represents a “step up” to the seller’s historical tax basis in the assets sold. As discussed in a previous article, generally accepted accounting principles (GAAP) require that deferred revenue liabilities assumed by the buyer must be recorded at fair value, which is essentially the cost necessary to deliver goods or services to customers under previous contracts with the seller.
When a buyer assumes deferred revenue liabilities as part of an asset acquisition, the tax consequences are not entirely clear. Over the years, two generally accepted approaches have been utilized: the Assumption Method and the Fragmentation Method. Below are some basic explanations to help distinguish these methods so that businesses and business owners can determine which might work out best.
Assumption Method
Under the Assumption Method (sometimes called the “assumed liability approach”), the deferred revenue liability is treated in the same manner as any contingent liability. In this regard, the seller includes the relief of the liability in its amount realized, and the buyer eventually includes the liability in the tax basis of its acquired assets. Because the liability is treated as contingent in nature, the buyer does not receive tax basis in its acquired assets for the buyer’s actual costs to fulfill the contract until all events have occurred and are complete (the “all-events test”).
Because the buyer does not immediately obtain tax basis until the all-events test is met, there may be a difference between the basis of assets (such as goodwill) for book and tax purposes upon acquisition, which could require deferred taxes to be provided. However, it is common for taxpayers to utilize the “peek ahead” approach and assume the liability will be settled. In this case, no deferred taxes will be required on the appropriate amount of the assumed deferred revenue liability.
Despite this accounting short-cut, there is a potential complication. Recall that deferred revenue liabilities are recorded at fair value for GAAP purposes. For tax purposes, recall that the buyer eventually obtains tax basis in its acquired assets equal to the buyer’s actual costs to fulfill the deferred revenue contracts. Obviously, the fair value of the estimated liability will be different than the actual costs that are eventually incurred pursuant to the liability. To the extent this fair value exceeds the actual costs that are eventually incurred to settle the liability (as is the case in nearly all circumstances), the excess “profit” will never be taxable. This built-in profit that will never be recognized for tax purposes must be factored into the buyer’s deferred taxes on purchase accounting.
Notwithstanding this complication, there are other matters to consider with respect to tracking the eventual satisfaction of the deferred revenue liability.
Cost of Fulfillment
As noted above, the buyer must capitalize and depreciate/amortize actual fulfillment costs into the tax basis of the acquired assets. Depending on the financial statement treatment for these costs (e.g., current expense), a book/tax difference may be created at the time these costs are reported in financial statements that require deferred taxes. This should be tracked over time and, depending on the organization’s size or the cost of fulfillment, could be a cumbersome task. For instance, the ability to distinguish acquired customer contracts from post-acquisition customer contracts may be challenging when hundreds or thousands of contracts are involved. Companies may want to consider recording an uncertain tax position for potential tax exposures if this tax method is not followed.
Fragmentation Method
The other generally accepted approach to account for the tax consequences of acquired deferred revenue liabilities is the “Fragmentation Method,” which is sometimes called the “bifurcation approach.” The Fragmentation Method requires extra up-front work in the deal and contract negotiations, and it requires the buyer to recognize additional gross income, but it would provide for a current deduction to the buyer of the costs to fulfill the obligation rather than capitalization of those costs under the Assumption Method.
Under the Fragmentation Method, the buyer’s assumption of the deferred revenue liability is treated as a distinct transaction that is separate from the overall acquisition. The Fragmentation Method is accepted by the IRS only when contractual terms call for it explicitly. When properly structured, the buyer includes the amount of the deferred revenue liability in the buyer’s taxable gross income immediately. Also, the buyer currently deducts its actual costs to settle the liability. To the extent the amount of the deferred revenue liability exceeds these actual costs, the buyer will be taxable on this “profit” from a lifetime perspective.
This is a significant difference compared to the Assumption Method. Although Fragmentation Method is simpler from an accounting and tracking perspective, it causes the buyer to potentially recognize more lifetime taxable income than would result under the Assumption Method.
Final Thoughts
It is critical for buyers and sellers to be aware of options surrounding the tax treatment of deferred revenue acquired in any merger and acquisition transaction. Purchase agreements should address the economics of advance payments, book and tax ramifications, and any estimated costs related to the buyer’s future obligations. Buyers must also consider the ability or practicality of tracking particular customer contracts in order to choose the appropriate method.
The ins and outs of these methods can get tricky, so it’s wise to have an expert review your deferred revenue accounting. Finding an experienced tax provider will help you better understand which tax method could be suitable for you.
Where Can I Learn More?
For more information on tax ramifications for deferred revenue, contact us.
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