rr-12-01.pdf

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Part I

Section 461.—General Rule for Taxable Year of Deduction

26 CFR 1.461-4: Economic performance.

Rev. Rul. 2012-1

ISSUES
Under the situations described below:

(1) Is the amount of X’s liability material for purposes of the recurring item
exception in §461(h)(3) of the Internal Revenue Code if the liability accrues over more
than one taxable year for financial accounting purposes?
(2) For purposes of the recurring item exception, does the accrual of X’s liability
over more than one taxable year result in better matching of the liability with related
income if X generates the related income in its trade or business over more than one
taxable year and the liability accrues over more than one taxable year for financial
accounting purposes?

2

(3) Is X’s liability that arises under a service contract properly characterized as a
“liability arising out of the provision of services” under § 1.461-4(d)(2), rather than a
“liability arising out of the provision of a warranty or service contract” under § 1.461-
4(g)(5)?
(4) Does the recurring item exception apply to X’s liability to provide services
pursuant to a service contract that is characterized as a “liability arising out of the
provision of services” under § 1.461-4(d)(2)?
FACTS
X
is a corporation that uses an accrual method of accounting, including the
recurring item exception provided in § 461(h)(3) and § 1.461-5, for federal income tax
purposes. X files its federal income tax returns on a calendar year basis and prepares
annual financial statements in accordance with generally accepted accounting
principles.
On July 1, 2011, X
enters into a one-year lease agreement for property it will use
in its trade or business to generate income over the period of the lease. The lease of
the property begins on July 1, 2011, and continues through June 30, 2012. The terms
of the lease agreement require X
to pay $50,000, the entire balance of the lease liability,
on July 1, 2011, and X
pays the $50,000 on that date. X’s financial statements account
for the lease agreement by recognizing the $50,000 expense ratably over the one-year
period of the lease.
In conjunction with entering into the lease agreement, X also enters into a one-
year service contract with a maintenance company unrelated to the lessor of the

3

property. The service contract begins on July 1, 2011, and continues through June 30,
2012. Under the terms of the service contract, the maintenance company will inspect
and clean the leased property monthly and provide any necessary repair and
maintenance services relating to the normal wear and tear or routine maintenance of
the property. The services to be provided to X under the service contract are general
services to be provided on an ongoing and recurring basis. The terms of the service
contract require X to pay $2,400, the entire balance of the liability, on July 1, 2011, and
X
pays the $2,400 on that date. X’s financial statements account for the service
contract by recognizing the $2,400 expense as the services are provided over the one-
year period of the contract.
X reasonably expects that it will enter into similar leases and service contracts on
a recurring basis in the future.
LAW
Section 461(a) provides that the amount of any deduction or credit must be taken
for the taxable year that is the proper taxable year under the method of accounting used
in computing taxable income.
Section 1.461-1(a)(2)(i) provides that, under an accrual method of accounting, a
liability is incurred, and generally taken into account for federal income tax purposes, in
the taxable year in which (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
(requirements (1) and (2) are collectively referred to as the “all events test”), and (3)
economic performance has occurred with respect to the liability. See also § 1.446-

4

1(c)(1)(ii)(A). All the events have occurred that establish the fact of the liability when (1)
the event fixing the liability, whether that be the required performance or other event,
occurs, or (2) payment is due, whichever happens earliest. Rev. Rul. 2007-3, 2007-1
C.B. 350; Rev. Rul. 80-230, 1980-2 C.B. 169; Rev. Rul. 79-410, 1979-2 C.B. 213,
amplified by Rev Rul. 2003-90, 2003-2 C.B. 353.
Section 461(h)(1) and § 1.461-4(a)(1) provide that, for purposes of determining
whether an accrual basis taxpayer can treat the amount of any liability as incurred, the
all events test is not treated as met any earlier than the taxable year in which economic
performance occurs with respect to the liability.
Section 1.461-4(d)(2)(i) provides that if the liability of a taxpayer arises out of the
providing of services or property to the taxpayer by another person, economic
performance occurs as the services or property is provided.
Section 1.461-4(d)(3)(i) provides that if the liability of a taxpayer arises out of the
use of property by the taxpayer, economic performance occurs ratably over the period
of time the taxpayer is entitled to the use of the property.
Section 1.461-4(g)(5) provides that if the liability of a taxpayer arises out of the
provision to the taxpayer of insurance, or a warranty or service contract, economic
performance occurs as payment is made to the person to which the liability is owed. A
warranty or service contract is a contract that a taxpayer enters into in connection with
property bought or leased by the taxpayer, pursuant to which the other party to the
contract promises to replace or repair the property under specified circumstances.
Section 1.461-4(g)(5)(i).

5

Section 461(h)(3)(A) and § 1.461-5(b) provide a recurring item exception to the
general rule of economic performance. Under the recurring item exception, a liability is
treated as incurred for a taxable year if: (i) at the end of the taxable year, all events
have occurred that establish the fact of the liability and the amount can be determined
with reasonable accuracy; (ii) economic performance occurs on or before the earlier of
(a) the date that the taxpayer files a timely return (including extensions) for the taxable
year, or (b) the 15th day of the ninth calendar month after the close of the taxable year;
(iii) the liability is recurring in nature; and (iv) either (A) the amount of the liability is not
material or (B) the accrual of the liability in the taxable year results in a better matching
of the liability with the income to which it relates than would result from accruing the
liability for the taxable year in which economic performance occurs. Section
461(h)(3)(B) provides that in making a determination under the materiality and matching
requirements, the treatment of the liability on financial statements shall be taken into
account.
Section 1.461-5(b)(4)(i) provides that in determining whether a liability is material,
consideration is given to the amount of the liability in absolute terms and in relation to
the amount of other items of income and expense attributable to the same activity.
Section 1.461-5(b)(4)(ii) provides that a liability is material if it is material for financial
statement purposes under generally accepted accounting principles. Section 1.461-
5(b)(4)(iii) provides that a liability that is immaterial for financial statement purposes
under generally accepted accounting principles may be material for purposes of the
materiality requirement of the recurring item exception.

6

Section 1.461-5(b)(5)(i) provides that in determining whether the matching
requirement of the recurring item exception is satisfied, generally accepted accounting
principles are an important factor, but are not dispositive. Section 1.461-5(b)(5)(ii)
provides that in the case of a liability described in § 1.461-4(g)(5) (insurance, warranty
or service contract), the matching requirement of the recurring item exception is
deemed satisfied.
ANALYSIS
Lease liability

On July 1, 2011, all the events have occurred that establish the fact of X
’s lease
liability (because X’s payment is due under the lease agreement on that date) and the
amount of the lease liability can be determined with reasonable accuracy. Because the
lease liability arises out of the use of property provided to X
, economic performance
occurs ratably over the period of time that X is entitled to use the property. Section
1.461-4(d)(3)(i). Therefore, unless the recurring item exception applies, X
’s lease
liability is incurred ratably over the one-year lease period beginning July 1, 2011 and
ending June 30, 2012.
To apply the recurring item exception to its lease liability, X
must, in part,
demonstrate either that the lease liability is immaterial or that recognizing the liability in
a year prior to the ratable use of the property results in a better matching of the expense
to the related income. In determining whether a liability is immaterial, the legislative
history of the recurring item exception provides:

7
If an item is considered material for financial statement purposes, it will also be
considered material for tax purposes. For example, assume that a calendar-year
taxpayer enters into a one-year maintenance contract on July 1, 1985. If the
amount of the expense is prorated between 1985 and 1986 for financial
statement purposes, it should be prorated for tax purposes. If, however, the full
amount is deducted in 1985 for financial statement purposes because it is not
material under generally accepted accounting principles, it may (or may not) be
considered an immaterial item for purposes of [the recurring item] exception.
H.R. Conf. Rep. 98-861, at 874 (1984) (original formatting omitted). The example
legislative history makes clear that a liability is material under the recurring item
exception if it is deemed sufficiently material
in the
for financial statement purposes so that it
accrue
B) that
s over more than one taxable year.
Consistent with the legislative history, and with the directive in § 461(h)(3)(
the treatment of a liability on financial statements be taken into account, § 1.461-
5(b)(4)(ii) provides that a liability is material if it is material for financial statement
purposes under generally accepted accounting principles. Because X
’s lease liab
accrues over more than one taxable year for financial statement purposes under
generally accepted accounting principles, the lease liability is material for purposes of
applying the recurring item exception. Therefore, to apply the recurring item exception
to its lease liability, X
ility

must demonstrate that recognizing the liability in a year prior to
the ratable use of the property results in a better matching of the liability to the incom
to which it relates than would result fro
e
m accrual of the liability in the taxable year in
eption
which economic performance occurs.
In determining whether the matching requirement of the recurring item exc
is satisfied, the treatment of a liability on financial statements must be taken into

8

than one
taxablel
account. Section 461(h)(3)(B). Generally accepted accounting principles are an
important factor, but are not dispositive. Section 1.461-5(b)(5)(i). Accruing a liability
over more than one taxable year results in better matching than accrual in a single,
earlier year if: (1) the liability accrues over more than one taxable year for financial
accounting purposes under generally accepted accounting principles; (2) the liability
relates to income that a taxpayer generates in its trade or business over more
year; and (3) there are no overriding facts or circumstances that indicate accrua
of the full liability in the earlier year results in a better match with the income.
X
has determined that under generally accepted accounting principles, its lease
liability should be recognized ratably over the period of the lease, and thus accrues the
liability on its financial statements over the period of the lease. Furthermore, X uses
leased property in its trade or business to generate income over the period of the leas
In addition, absent overriding facts or circumstances that indicate that accrual in the
earlier year would result in better matching, the accrual of the lease liability in a year
prior to the satisfaction of economic performance will not result in a better matching o
the liability with the related income as compared to accruing the liability for the taxable
year in which economic performance occurs. Because X
the
e.
f
’s lease liability is material
under § 1.461-5(b)(1)(iv)(A), and because it does not satisfy the matching requirement
of § 1.461-5(b)(1)(iv)(B), X
cannot use the recurring item exception to treat its lease
liability as incurred in 2011.
Service Contract Liability

9

On July 1, 2011, all the events have occurred that establish the fact of X
’s
service contract liability (because X’s payment is due under the service contract on tha
date) and the amount of the service contract liability can be determined with reasonable
accuracy. The applicable economic performance rule depends on whether the servi
contract liability arises out of the provision of services to X
t
ce
under § 1.461-4(d)(2)(i) (a
“service liability”), or whether the liability arises out of the provision to X of a warranty or
service contract under § 1.461-4(g)(5) (a “payment liability”). Further, the matching
require
ility
payer,
e
lar circumstance necessitating the repair or
replacee,
ment of the recurring item exception applies differently depending on whether the
service contract liability is a service liability under § 1.461-4(d)(2)(i) or a payment liab
under § 1.461-4(g)(5).
Section 1.461-4(g)(5)(i) defines a warranty or service contract as a contract that
a taxpayer enters into in connection with property bought or leased by the tax
pursuant to which the other party to the contract promises to replace or repair the
property under specified circumstances. The term “specified circumstances” implies th
occurrence of a unique or irregular circumstance necessitating the repair or
replacement of property. Thus, the warranty and service contracts contemplated in
§ 1.461-4(g)(5) are similar to insurance contracts, which also are characterized by the
occurrence of a unique or irregu
ment of property. The regulations recognize this similarity by treating insuranc
warranty contracts, and service contracts collectively as a single category of payment
liability under § 1.461-4(g)(5).

10

s

e types of liabilities is appropriate because a liability is triggered only
by the

The service contracts addressed in § 1.461-4(g)(5)(i) are distinguishable from
contracts for general services that are provided on an ongoing and recurring basis. Thi
distinction is reinforced in the deemed matching rule of § 1.461-5(b)(5)(ii), which
provides that the matching requirement is deemed satisfied only for certain payment
liabilities, including service contract liabilities addressed in § 1.461-4(g)(5). Deemed
matching for thes
occurrence of a unique or irregular circumstance. In contrast, a deemed
matching rule would be inappropriate for services that are performed on an ongoing and
recurring basis and contribute to the taxpayer’s income-generating activities over a
certain period.
The services to be provided to X
under the terms of the service contract are
general services to be provided on an ongoing and recurring basis rather than service
to be provided only in “specified circumstances.” Therefo
s
re, X
’s service contract liability
is a se1-rvice liability under §1.461-4(d)(2)(i), rather than a payment liability under §1.46
4(g)(5), for purposes of applying the economic performance rules. Accordingly, under
§ 1.461-4(d)(2), economic performance of X
’s service contract liability occurs as the
services are provided to X
over the term of the contract.
To apply the recurring item exception to its service contract liability, X
must,
part, demonstrate either that its liability is not material or that recognizing the liability
year prior to the performance of the services results in a better matching of the e
to the related income. In determining whether a liability is not material, § 461(h)(3)(B)
provides that financial statement treatment is considered, and both the legislative
in
in a
xpense

11

history of § 461(h)(3) and § 1.461-5(b)(4)(ii) provide that a liability is material if it is
material for financial statement purposes under generally accepted accounting
principles. Because X
’s service contract liability accrues over more than one taxable
year for financial statement purposes under generally accepted accounting principles,
the liability is material for purposes of applying the recurring item exception. Therefor
to apply the recurring item exception to its service contract liability, X

e,
must demonstrate
that recognizing the liability in a year prior to the performance of the services results in a
better matching of the liability to the income to which it

relates than would result from
accruin
ly
g the liability in the taxable year in which economic performance occurs. The
deemed matching rule for certain payment liabilities in §1.461-5(b)(5)(ii) does not app
to X
’s service contract liability because X’s liability does not arise out of the provision of
a warranty or service contract under §1.461-4(g)(5).
In determining whether the matching requirement of the recurring item exceptio
is satisfied, generally accepted accounting principles are an important factor, but not
dispositive. Section 1.461-5(b)(5)(i). Under generally accepted accounting principles,
n

X

has determined that its service contract liability should be recognized as services are
provided over the period of the contract. Furthermore, the services provided to X
are
used in the ongoing operation of X’s trade or business to generate income over the
period of the contract. Absent any other overriding facts or circumstances that would
indicate better matching, the accrual of the service contract liability in a year prior to the
satisfaction of economic performance will not result in a better matching of the liability
with the related income as compared to accruing the liability for the taxable year in

12

which economic performance occurs. Because X
’s service contract liability is materia
under § 1.461-5(b)(1)(iv)(A), and because it does not satisfy the matching requirement
of § 1.461-5(b)(1)(iv)(B), X
l
cannot use the recurring item exception to treat its service
lity as incurred in 2011.
rovided only in “specified circumstances.” This revenue
ruling d
For purposes of the recurring item exception in § 461(h)(3), the amount of
X
contract liabi
Some contracts call for services to be performed on a recurring basis and for
additional performance to be p
oes not address the tax treatment for a mixed service and warranty contract.
HOLDINGS
(1)
’s lease liability is material.
(2) For purposes of the recurring item exception, the accrual of X’s lease lia
over more than one taxable year results in better matching of the liability with related
income.
bility

(3) X
’s service contract liability is properly characterized as a liability arising out
of services to the taxpayer under § 1.461-4(d)(2), rather than as a
t
of the provision
liability arising out of the provision to the taxpayer of a warranty or service contrac
under § 1.461-4(g)(5).
(4) The recurring item exception does not apply to X
’s service contract liability.
APPLICATION
Any change in a taxpayer’s method of accounting to conform to any of the
holdings in this revenue ruling is a change in method o

f accounting to which the
provisions of §§ 446 and 481 and the regulations thereunder apply. A taxpayer that

13
wants
11-
y to a
e for its first taxable year ending on or after
Decemon
liability; and
2(4) of Rev. Proc. 2011-14, the taxpayer must
ENTS

The principal author of this revenue ruling is Charles H. Kim of the Office of the
Associate Chief Counsel (Income Tax and Accounting). For further information
regarding this revenue ruling contact Charles H. Kim at (202) 622-5020 (not a toll free
call).
to change its method of accounting to conform to any of the holdings in this ruling
must follow the automatic change in accounting method provisions of Rev. Proc. 20
14, 2011-4 C.B. 330, with the following modifications:
(1) The scope limitations in section 4.02 of Rev. Proc. 2011-14 do not appl
taxpayer that wants to make the chang
ber 13, 2011, provided an issue is not under consideration, as defined in secti
3.09 of Rev. Proc. 2011-14, regarding whether all the events have occurred that
establish the fact of the
(2) For purposes of section 6.0
include on line 1a of the Form 3115 the designated automatic accounting method
change number “161.”
EFFECT ON OTHER DOCUM
Rev. Proc. 2011-14 is modified and amplified to include this automatic change in
section 19 of the APPENDIX.
DRAFTING INFORMATION