Cutting Your Losses? Review the Accounting

Guidance released by the IRS underscores that the spirit, not the letter, of the rule must be followed with regard to canceling long-term contracts.

In guidance released last year, the Internal Revenue Service determined that research and development costs must be included in long-term contract costs, even if the agreement between companies is nixed. Revisiting the guidance is particularly relevant in a sluggish economy, where companies may be more inclined to cut their losses rather than stick with a failing deal.

The guidance, released on June 17, 2009 (LTR 200938020), includes an example that explains the IRS’s argument with regard to R&D costs. In the example, a subsidiary (SubCo) of the corporate taxpayer enters into a fixed-price contract with a company that we will call Beta Corp. SubCo is contracted to design, test, and fabricate a large piece of industrial machinery, dubbed C1. From the project’s inception, SubCo consistently treats the contract as a “long-term manufacturing contract” and determines its taxable income under the “percentage of completion” method of accounting.

Six months later, production of the C1 is essentially complete except for one of the high-pressure components. Apparently, SubCo encountered significant technical difficulties in developing the final component, which in turn caused the subsidiary to suffer significant time delays and cost overruns. About a month later, SubCo and Beta Corp. signed a settlement deed to terminate the contract.

To fully understand the position the IRS took in the guidance, taxpayers must consider the applicable rules. Section 460(a) of the Internal Revenue Code states that in the case of a long-term contract, the taxable income from an agreement is determined under the percentage-of-completion method of accounting. In addition, Section 460(b)(1) provides that the percentage of completion is determined by comparing the costs allocated to the contract — and incurred before the close of the taxable year — with the estimated total contract costs. The IRC goes on to say, in Section 460(c)(1), that all costs that directly benefit, or are incurred by reason of, the taxpayer’s long-term contract activities are allocated to the contract.

Just as important are the related rules, specifically Regulation Section 1.460-4(b)(7)(ii), which say that if a long-term contract is terminated before completion, the taxpayer must reverse the transaction in the taxable year of termination. To reverse the transaction, the taxpayer reports a loss or a gain equal to the cumulative allocable contract costs reported under the contract. That amount includes costs reported in all prior years, less the cumulative gross receipts reported under the contract in all prior years. Further, Regulation Section 1.460-5(b)(2)(vi) states that a taxpayer must allocate R&D expenses to its long-term contracts.

Reverse the Transaction

In the example, the taxpayer asserts that “reverse the transaction” means that it must reverse the application of Section 460 in its entirety. Therefore, argues the taxpayer, the allocable contract costs that must be reversed should be limited to those costs that would not have been deductible absent the application of Section 460. Accordingly, in the taxpayer’s view, the allocable contract costs do not include R&D costs. The reason cited: the R&D costs are payouts that would be deductible in the year incurred with or without regard to Section 460.

However, the IRS disagreed with the taxpayer, and explained its rationale in the guidance. It noted that the contract was a long-term contract. Just because the taxpayer treated the contract as terminated, said the IRS, does not mean that the contract was not a long-term contract, and that the company can reverse the application of Section 460 in its entirety. Rather the contract, though treated as terminated, is still a long-term contract, and therefore is subject to the requirements of the Internal Revenue Code. In this case, that means the contract is subject to the cost-allocation requirements of Section 460(c) and Regulation Section 1.460-5(b).

In addition, to comply with Regulation Section 1.460-4(b)(7), the taxpayer must reverse the transaction in the taxable year of termination, as prescribed in the rules. Under Section 460(c)(1) and Regulation Section 1.460-5(b)(2)(vi), “allocable contract costs” specifically include R&D costs that directly benefit performance of the long-term contracts.

As a result, the taxpayer must include the R&D costs in allocable contract costs to reverse the transaction under Regulation Section 1.460-4(b)(7)(i), with the result that the taxpayer’s gain on termination will be greater (or its loss will be smaller) than would have been the case if the R&D costs were not treated as costs allocable to the contract.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

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