IRS Rules When A Liability for Customer Rebates Becomes “Fixed,” Which is More Exciting Than it Sounds
The deductibility of accrued liabilities — like state capitals and women — can be a bit tricky.
In general, whether an accrued expense is deductiblefor tax purposes is governed by I.R.C. § 461 Specifically, I.R.C. § 461(h) and Regulation § 1.461-1(a)(2)(i) provide that an accrued expense is deductible in the tax year in which all three tests are met:
(1) all the events have occurred that establish the fact of the liability,
(2) the amount of the liability can be determined with reasonable accuracy, and
(3) economic performance has occurred with respect to the liability.
While much of the judicial precedent and administrative rulings surrounding I.R.C. § 461 deal with the nuanced and confusing “economic performance” test, tax advisers would be foolish to ignore the “all events” test. Advisers often pay this requirement little mind, assuming that if a liability has been accrued for financial accounting purposes, it is a fixed liability that satisfies the all-events test for tax purposes. Unfortunately, this is not the case.
The complexity of the all-events test was illustrated last week in TAM 201223015, which shed some light on how the Service determines when a liability to pay rebates to customers becomes fixed for purposes of I.R.C. § 461.
In the Ruling, Taxpayer was an accrual basis manufacturer who offered certain trade promotion rebates to customers.
Taxpayer sold products to multiple buyers. In its sales agreement, customers paid full price, and then Taxpayer would later remit a cash rebate to the customer based on the number of units purchased. Some of the agreements required a minimum purchase from the customer to become eligible for the rebate, while others did not. Taxpayer, however, as part of its regular business practice paid the rebates even to those customers who failed to acquire the minimum units.
Customers typically requested the rebates by submitting a formal invoice or other written request for payment, which Taxpayer may pay in cash or as a credit against future purchases.
Based on the forgoing, the IRS was faced with the following question: Does the liability to provide rebates become fixed and determinable when 1) customers purchase the goods from Taxpayer, 2) customers purchase the minimum amount of the goods necessary to “earn” a rebate, or 3), customers submit the required claim forms for the rebates?
Taxpayer argued that the rebate liabilities were fixed and determinable when customers purchase goods from Taxpayer, because at that time Taxpayer was obligated to pay the rebates under its sales agreements with its customers.
The field agent, to the contrary, argued that the rebate liabilities are not fixed and determinable at the time customers purchase goods from Taxpayer, but rather when customers submit claim forms and substantiation to Taxpayer to request payment of the rebates.
In reaching its decision to side with Taxpayer, the IRS first discredited the field’s claim that the rebate liability was not fixed until the customer submitted the formal claim for rebate. Citing Revenue Ruling 98-39, the IRS noted that the establishment of the fact of a liability under the all events test is not delayed by an additional requirement in a contract that a claim or documentation be submitted to obtain payment, if such act is ministerial, which it was held to be in the immediate case.
The IRS also concluded that the Taxpayer need not wait to consider the rebate liability “fixed” until the customer bought a minimum amount of units required by contract to trigger the rebate. Because the minimum purchase requirements in Taxpayer’s contracts were largely ambiguous, the IRS looked to Taxpayer’s business practice, which was to pay the rebates regardless of whether the minimum purchase requirements were met.
As a result, Taxpayer’s rebate liability was fixed — and the “all events test” met — when Taxpayer sold the units to its customers, not when the minimum required units were sold, and not when the customer submitted a formal claim for rebate.
The Ruling ended at this point, but as discussed earlier, this is not the end of the analysis required by Taxpayer in order to deduct the accrued rebates. The “all events” test is only the first of three required tests; Taxpayer must also establish that the amount of the liability can be determined with reasonable accuracy, and that “economic performance” has occurred with respect to the liability.
The “amount” test is typically fairly easy to establish, particularly in a situation such as this where the rebates can be computed at year end based on units sold.
Economic performance, on the other hand, poses a bigger problem. Under Treas. Reg. §1.461-4(g)(3), economic performance does not occur with respect to a liability for rebates until the rebates are paid to the customer. While that would seem to render Taxpayer’s victory in the TAM moot, since the rebate liability being fixed is useless without economic performance, Taxpayer can presumably use the “recurring item exception” under Treas. Reg. §1.461-5 to deduct the accrued rebates at year-end to the extent that economic performance (i.e., payment) will be made by the earlier of
1) the filing of the return, or
2) 8 1/2 months after year-end.
A few years ago, I put together this decision tree to aid in understanding the economic performance rules (and only the economic performance rules). If you’re interested, click When Are Accruals Tax Deductible.
