Rev. Rul. 88-30
1988-1 C.B. 187, 1988-19 I.R.B. 4.
Internal Revenue Service
Revenue Ruling
QUALIFIED DISCOUNT COUPONS
Published: May 9, 1988
SECTION 466. - QUALIFIED DISCOUNT COUPONS REDEEMED AFTER CLOSE OF TAX YEAR, 26 CFR 1.466-1: Method of accounting for the redemption cost of qualified discount coupons
(Also Section 481; 1.481-1.)
Qualified discount coupons. Guidance is provided regarding the timing and calculation of the section 481(a) adjustments that occur by virtue of abandoning the method of accounting previously allowed under section 466 of the Code.
Rev. Rul. 88-30 provides guidance relating to the calculation of the section 481(a) adjustments that stem from the redemption of qualified discount coupons. In the first fact situation, an accrual method corporate taxpayer issues and redeems coupons that qualified for special accounting treatment provided by former section 466. Starting with its tax year beginning January 1, 1979, the corporation elected to account for its coupon redemption costs under former section 466. Since this election would have resulted in a negative section 481(a) adjustment for 1979, the corporation established a suspense account, the effect of which was to defer indefinitely the full deduction of the transitional adjustment, so long as the company continued to issue and redeem discount coupons. The company continued in this manner through 1986 and had a closing balance in the suspense account of $10x on December 31, 1986.
As a result of the 1986 Act's repeal of section 466, starting with the tax year beginning January 1, 1987, the only redemption costs that the corporation may deduct are those related to coupons actually received during the tax year. Since the corporation had already deducted, for its 1986 tax year, costs related to coupons received during the first half of 1987, section 481(a) required the company to make an adjustment to income for 1987. This adjustment resulted in a net increase in taxable income (a positive section 481(a) adjustment) of $30x (exclusive of the $10x balance in the company's suspense account). Less than 75 percent of this $30x adjustment was attributable to the one-, two-, or three-tax-year period immediately preceding the year of change.
In situation two, the facts are the same as situation one, except that the corporation first elected to use the method provided by former section 466 for its tax year beginning January 1, 1985.
In situation three, the facts are the same as situation one, except that the highest percentage of the company's $30x 1987 positive section 481(a) adjustment that was attributable to the one-, two-, or three-tax-year period immediately preceding 1987 was 90 percent.
In situation four, the facts are the same as situation one, except that, under section 481(a), the corporation's 1979 election to use the accounting method provided by section 466 resulted in a $20x net increase in taxable income for 1979. Because this net section 481(a) adjustment was positive, the company did not establish a suspense account. Instead, in accordance with section 466(f), the company took one-tenth of this positive adjustment into income in each of the years 1979 through 1986, leaving an unamortized balance of $4x as of January 1, 1987. Consequently, of the 10-year period over which the section 481(a) adjustment resulting from the initial election was to be spread under section 466(f), two years remained when the company was required to change its method of accounting as a result of the repeal of section 466.
ISSUE. In each of the four situations, how should the corporation account for the change in method of accounting required as a result of the repeal of section 466 by the 1986 Act?
HOLDINGS. In situation one, the Service held that the corporation must reduce the net positive section 481(a) adjustment of $30x by the $10x balance in its suspense account and take one-fourth of the resulting amount, or $5x, into income in each of its tax years 1987 through 1990.
In situation two, the Service held that the corporation must reduce the net positive section 481(a) adjustment of $30x by the $10x balance in its suspense account and take one-half of the resulting amount ($10x) into income in 1987 and one-half in 1988.
In situation three, the Service held that the corporation must first reduce the net positive section 481(a) adjustment of $30x by the $10x balance in its suspense account; 90 percent of the resulting $20x ($18x) must be recognized in three equal portions of $6x over the period 1987 through 1989. The remaining $2x, the Service said, is taken into income in 1990.
In situation four, the Service held that the corporation must take into income the unamortized portion of the previous positive section 481(a) adjustment ($4x) in two equal portions of $2x in 1987 and 1988. The corporation must take the net positive section 481(a) adjustment of $30x arising in the year of change into income in four equal increments of $7.5x in 1987 through 1990.
ANALYSIS. The Service's analysis consisted of an explanation of former section 466 and the legislative history of the provision's repeal. The Service noted that adjustments required by the repeal of section 466 were expected to be implemented through the application of Rev. Proc. 84-74, 1984-2 C.B. 736, which describes the appropriate period for taking into account an adjustment required by section 481(a) as a result of a change in accounting methods. The key to the Service's holdings was the interplay of Rev. Proc. 84-74, which sets out the number of years over which an adjustment is to be taken into account, with section 823 of the 1986 Act, which further limits the adjustment period.
ISSUE
If a taxpayer elected to account for the costs of redeeming discount coupons under former section 466 of the Internal Revenue Code, how should that taxpayer account for the change in method of accounting required as a result of the repeal of section 466 by the Tax Reform Act of 1986?
BACKGROUND
Section 823(a) of the Tax Reform Act of 1986 (the 1986 Act), 1986-3 (Vol. 1) C.B. 290, repealed section 466 of the Code. Section 466 allowed a current deduction for the costs of redeeming qualified discount coupons that were received during a statutory redemption period following the close of the tax year. The 'discount coupons' covered by former section 466 were a sales promotion device used to encourage the purchase of a specific product by allowing the purchaser of that product to receive a discount of its purchase price.
As a result of the repeal of section 466 of the Code, for tax years beginning after December 31, 1986, a taxpayer may deduct the costs of redeeming only those discount coupons actually received for redemption during the tax year. If a taxpayer elected to have former section 466 apply to the taxpayer's last tax year beginning before January 1, 1987, then the 1986 Act provides special rules (described below) regarding the required change in method of accounting.
FACTS
SITUATION I. Taxpayer W corporation files its income tax returns on a calendar year basis and computes taxable income under an accrual method of accounting. W issues and redeems discount coupons that qualified for the special accounting treatment provided by former section 466 of the Code.
Starting with its tax year beginning January 1, 1979, W elected to account for its coupon redemption costs under former section 466 of the Code. This change from W's previous method of accounting for those costs would have resulted in a net decrease in taxable income under section 481(a) (negative section 481(a) adjustment) for 1979. In accordance with former section 466(e), instead of applying section 481, W established a suspense account, the effect of which was to defer indefinitely the full deduction of the transitional adjustment, so long as W continued to issue and redeem discount coupons.
In tax years 1979 through 1986, W made the adjustments to this suspense account, and the corresponding adjustments to income, required by former section 466(e) of the Code and section 1.466- 1(e)(3) of the Income Tax Regulations. The closing balance in the suspense account as of December 31, 1986, was 10x dollars.
As a result of the 1986 Act's repeal of section 466 of the Code, starting with W's tax year beginning January 1, 1987, the only redemption costs that W may deduct are those related to coupons actually received during the tax year. Under former section 466, however, W had already deducted, for its 1986 tax year, costs related to coupons received during the first half of 1987. In order to prevent the same costs from reducing W's taxable income twice, section 481(a) requires an adjustment to income for the year of change, 1987. In W's case, this adjustment resulted in a net increase in taxable income (positive section 481(a) adjustment) of 30x dollars (not counting the 10x dollar balance in W's suspense account). Less than 75 percent of this 30x dollar adjustment was attributable to the 1-, 2-, or 3-tax-year period immediately preceding the year of change.
SITUATION 2. The facts are the same as in Situation 1, except that taxpayer X first elected to use the method provided by former section 466 of the Code for its tax year beginning January 1, 1985.
SITUATION 3. The facts are the same as in Situation 1, except that the highest percentage of taxpayer Y's 30x dollar 1987 positive section 481(a) adjustment that was attributable to the 1-, 2-, or 3- tax-year period immediately preceding 1987 was 90 percent.
SITUATION 4. The facts are the same as in Situation 1, except that, under section 481(a) of the Code, taxpayer Z's 1979 election to use the accounting method provided by section 466 resulted in a 20x dollar net increase in taxable income for 1979. Because this net section 481(a) adjustment was positive, Z did not establish a suspense account. Instead, in accordance with former section 466(f), Z took one-tenth of this positive adjustment into income in each of the years 1979 through 1986, leaving an unamortized balance of 4x dollars as of January 1, 1987. Thus, of the 10-year period over which the section 481(a) adjustment resulting from the initial election was to be spread under section 466(f), 2 years remained when Z was required to change its method of accounting as a result of the repeal of section 466.
LAW
Prior to its repeal, section 466(a) of the Code provided for an election by an accrual basis taxpayer to deduct costs incurred by the taxpayer with respect to the redemption of qualified discount coupons that were outstanding at the close of the tax year and that were received by the taxpayer within up to a 6- month period following the close of the tax year. The taxpayer also deducted the costs of coupons actually redeemed during the tax year to the extent those costs were not already deducted in an earlier year. The election applied to all qualified coupons issued in connection with the trade or business with respect to which the taxpayer made the election.
An election to use the method provided by former section 466 of the Code constituted a change in method of accounting. The statute provided that the section 481(a) adjustment caused by the election was to be taken into account under one of two specified methods, depending on whether the net adjustment was negative or positive.
First, former section 466(e) of the Code provided that, in the case of any election under section 466 that (but for section 466(e)) would result in a net decrease in taxable income under section 481(a)(2), the taxpayer, in lieu of applying section 481,
had to establish a suspense account for the trade or business for the tax year (year of change) for which the election was made. The initial opening balance of the suspense account for the year of change was the amount by which (A) the largest dollar amount that would have been taken into account for any of the 3 immediately preceding tax years, if section 466 had applied to those years, exceeded (B) the sum of the increases in income (and the decreases in deductions) which (but for section 466(e)) would have resulted under section 481(a)(2) for the year of change. At the close of each year, the suspense account was either (A) reduced by the excess (if any) of (i) the opening balance of the suspense account for the year over (ii) the amount deducted for the year under section 466(a), or (B) increased (but not in excess of the initial opening balance) by the excess (if any) of (i) the amount deducted under section 466(a) over (ii) the opening balance in the suspense account for the year. In the case of any reduction or increase in the suspense account, an amount equal to the reduction was allowed as a deduction for the year, or an amount equal to the increase was included in gross income.
Second, former section 466(f) of the Code provided that, in the case of any election under section 466 that resulted in a net increase in taxable income under section 481(a)(2), the increase was to be taken into account by the taxpayer in computing taxable income in each of the 10 tax years beginning with the year of change, in accordance with regulations. Section 1.466-1(e)(2) of the regulations provided for such a positive adjustment to be taken into income ratably over the 10-year period.
Section 481(a) of the Code provides that in computing taxable income for any taxable year, if the computation is under a method of accounting different from the method under which taxable income for the preceding tax year was computed, then there shall be taken into account those adjustments that are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted.
Section 823(c)(2) of the 1986 Act provides that, in the case of any taxpayer that elected to have former section 466 of the Code apply for the taxpayer's last tax year beginning before January 1, 1987, and that is required to change its method of accounting by reason of the amendments made by section 823 for any tax year, the change shall be treated as initiated by the taxpayer and as having been made with the consent of the Secretary. Under section 823(c)(2)(C), the net amount of adjustments required by section 481 of the Code to be taken into account by the taxpayer shall be reduced by the balance in the suspense account under former section 466(e) as of the close of the last tax year beginning before January 1, 1987, and shall be taken into account over a period not longer than 4 years.
According to the Report of the Senate Committee on Finance, the concepts of Rev. Proc. 84-74, 1984-2 C.B. 736, were expected generally to apply to determine the actual timing of recognition of income or expense as a result of the adjustments arising from section 823 of the 1986 Act. See S. Rep. No. 313, 99th Cong., 2d Sess. 159 (1986), 1986-3 (Vol. 3) C.B. 159. In addition, the Report of the Committee of Conference expressed the conferees' intention that (1) net operating loss and tax credit carryforwards be allowed to offset any positive section 481 adjustment, and (2) for the purpose of determining estimated tax payments, the section 481 adjustment be recognized in taxable income ratably throughout the tax year in question. See 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. (I-322 (1986), 1986-3 (Vol. 4) C.B. 322.
Section 5.06 of Rev. Proc. 84-74 describes the appropriate period for taking into account an adjustment, whether positive or negative, required by section 481(a) of the Code as a result of a change in methods of accounting. Sections 6.02 and 03 divided methods of accounting into 'Category A' and 'Category B.' Because Category A includes only methods whose use is clearly erroneous, the method authorized by former section 466 was a Category B method. Generally, under section 5.06(1)(e), the total net adjustment attributable to a change from a Category B method is to be taken into account ratably over the number of tax years (not to exceed 6) the taxpayer has used the method of accounting that is being changed. Under section 5.06(1)(a), however, when the entire net amount of the adjustment is attributable to the tax year immediately preceding the year of change, the adjustment is taken into account in the year of change. Under section 5.06(1)(b), if the method has been used for more than 3 years, and section 5.06(1)(a) does not apply, but 67 percent or more of the net amount of the adjustment is attributable to the 1-, 2-, or 3-tax-year period immediately preceding the year of change, then the highest percent attributable to the 1-, 2-, or 3-tax-year period is taken into account ratably over a 3-tax- year period beginning with the year of change, with any remaining balance taken into account ratably over the remainder of the number of years the taxpayer used the method (or 3 years, whichever is less). When the method of accounting being changed has been used for 4 years, 75 percent rather than 67 percent is used in applying section 5.06(1)(b). For purposes of 5.06(1)(a) and (1)(b), the amount of the adjustment that is attributable to a given period is the difference between the amount of the adjustment determined under section 481(a) for the year of change and the amount that would have been required under section 481(a) had the same change been made at the beginning of the period in question.
ANALYSIS
In SITUATION 1, W's change from accounting for coupon redemption costs under section 466 of the Code results in a net positive section 481(a) adjustment of 30x dollars for 1987, the year of change. W also has an opening balance of 10x dollars for 1987 in the section 466(e) suspense account that W was required to establish when it elected to use the section 466 method in 1979. W is not allowed to deduct an amount equal to the full suspense account balance in the year of change. Instead, under section 823(c)(2)(C) of the 1986 Act, the suspense account balance must be netted against the positive net section 481(a) adjustment. The resulting balance of 20x dollars is to be recognized over a period that is determined by applying the concepts of Rev. Proc. 84-74.
In this situation, section 5.06(1)(e) of Rev. Proc. 84-74 would normally call for recognition of the adjustment ratably over a 6-year period beginning in the year of change (here, 1987), because W used the section 466 method for 8 years. Under section 823(c)(2)(C) of the 1986 Act, however, the total adjustment period may not exceed 4 years. Accordingly, the net section 481(a) adjustment, after reduction by the suspense account balance, must be taken into income ratably over a 4-year period beginning in 1987.
In SITUATION 2, as in Situation 1, X must first net the balance in its section 466(e) suspense account against the positive section 481(a) adjustment, resulting in a net balance of 20x dollars. In this case, however, X has used the method described in former section 466 of the Code for only 2 years. In requiring that the adjustment be taken into account over a period not longer than 4 years, the 1986 Act and the accompanying legislative history suggest that a shorter adjustment period may be appropriate. Consistent with section 5.06(1)(e) of Rev. Proc. 84-74, therefore, the positive section 481(a) adjustment, after reduction for the amount in the suspense account, must be taken into account in two equal portions in X's tax years 1987 and 1988.
SITUATION 3 differs from SITUATION 1 in that a high percentage of Y's positive section 481(a) adjustment for 1987 is attributable to the period immediately preceding the year of change. In such situations, Rev. Proc. 84-74 requires the acceleration of all or a portion of the adjustment that would otherwise be taken into account ratably over the total adjustment period. For example, under section 5.06(1)(a) of Rev. Proc. 84-74, when the entire net amount of the adjustment is attributable to the year immediately preceding the year of change, the full adjustment is taken into account in the year of change. If, as in Situation 3, that is not the case but at least a certain percent or more of the adjustment is attributable to the 1-, 2-, or 3-tax-year period preceding the year of change, then under section 5.06(1)(b) an amount equal to the highest such percent is taken into account ratably over a 3-year period. The balance is taken into account ratably over a period equal to the remaining number of years the taxpayer previously used the method being changed, or 3 years, whichever is shorter. (The total adjustment period thus cannot exceed 6 years.) The threshold percentage used in applying section 5.06(1)(b) is 67 percent if the method being changed was used for more than 4 years, and 75 percent if the method was used for 4 years.
Section 5.06(1)(b) of Rev. Proc. 84-74 would apply only to a taxpayer that has used the section 466 method for 4 years or more prior to the year of change. Under Rev. Proc. 84-74, the relevant threshold percentage for a taxpayer that has used the accounting method being changed for more than 4 years is 67 percent. However, a taxpayer that has used a method for 4 years, and is therefore limited to a total adjustment period of 4 years, must accelerate a portion of the adjustment if the amount of the adjustment attributable to the 1-, 2-, or 3-tax-year period preceding the year of change is 75 percent or more. Use of 75 percent rather than 67 percent in the case of a 4-year adjustment period prevents section 5.06(1)(b) from deferring, rather than accelerating, a portion of the adjustment. Under section 823(c)(2)(C)(ii) of the 1986 Act, every taxpayer making the change from the use of section 466 is limited to a 4-year adjustment period, even if the method was used for more than 4 years. In order to be consistent with the concepts of Rev. Proc. 84-74, section 5.06(1)(b) must be applied only in a way that accelerates recognition of part of the adjustment. Accordingly, even if a taxpayer employed the section 466 method for more than 4 years prior to the year of change, that taxpayer must apply section 5.06(1)(b) by using a 75 percent threshold.
In SITUATION 3, Y used the method provided by former section 466 of the Code for 8 years prior to repeal. The highest percent of Y's adjustment attributable to the 1-, 2-, or 3-tax-year period preceding 1987 was 90 percent. Because this is more than 75 percent, Y must, after netting its suspense account balance against the positive 1987 section 481(a) adjustment, include 30 percent of the resulting balance in income in each of the years 1987 through 1989 and must include the remaining 10 percent in income in 1990.
Unlike the first three situations, SITUATION 4 involves a taxpayer whose original election to account for coupon redemption costs under former section 466 of the Code resulted in a net positive section 481(a) adjustment. Z has been including one-tenth of this adjustment in income each year since the election.
There is no explicit guidance in either the 1986 Act or its legislative history concerning the proper treatment of the unamortized portion of such an adjustment. Former sections 466(e) and 466(f) of the Code provided for the treatment of negative and positive adjustments, respectively. Section 823 of the 1986 Act, in repealing section 466, specified a method of handling suspense account balances, and that method differed from the method set out in section 466(e). There is no evidence, however, of any intent to change the original 10- year adjustment period that was provided for positive adjustments by former section 466(f). Accordingly, taxpayers must continue to amortize such adjustments over the remainder of that 10-year period.
In SITUATION 4, Z used the accounting method to be changed for more than 4 years. Under section 823(c)(2)(C) of the 1986 Act, in each of the years 1987 through 1990 Z must take into account one- fourth of the 1987 section 481(a) adjustment resulting from the repeal of section 466 of the Code. In addition, the unamortized portion of Z's original 1979 adjustment is taken into income in 1987 and 1988.
HOLDING
Taxpayers that previously accounted for discount coupon redemption costs under the method described in former section 466 of the Code must account for the section 481(a) adjustment required by the repeal of that provision over a period of up to 4 years starting with the first tax year beginning after December 31, 1986. They must apply the concepts of Rev. Proc. 84-74, as set forth in this ruling, to determine the actual timing of recognition of income or expense. Any suspense account balance resulting from a taxpayer's prior election to use section 466 must be netted with the adjustment that results from the repeal of section 466. The balance of a previous positive section 481(a) adjustment continues to be amortized over the period originally prescribed.
Specifically, in SITUATION 1, W must reduce the net positive section 481(a) adjustment of 30x dollars by the 10x dollar balance in its suspense account and take one-fourth of the resulting amount, or 5x dollars, into income in each of its tax years 1987 through 1990.
In SITUATION 2, X must reduce the net positive section 481(a) adjustment of 30x dollars by the 10x dollar balance in its suspense account and take one-half of the resulting amount, or 10x dollars, into income in 1987 and one-half in 1988.
In SITUATION 3, Y must first reduce the net positive section 481(a) adjustment of 30x dollars by the 10x dollar balance in its suspense account; 90 percent of the resulting 20x dollars, or 18x dollars, must be recognized in three equal portions of 6x dollars over the period 1987 through 1989. The remaining 2x dollars is taken into income in 1990.
In SITUATION 4, Z must take into income the unamortized portion of the previous positive section 481(a) adjustment, or 4x dollars, in two equal portions of 2x dollars in 1987 and 1988. Z must take the net positive section 481(a) adjustment of 30x dollars arising in the year of change into income in four equal increments of 7.5x dollars in 1987 through 1990.
DRAFTING INFORMATION
The principal author of this revenue ruling is Timothy P. Sebastian of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Sebastian on (202) 566-2750 (not a toll-free call).
Rev. Rul. 88-30, 1988-1 C.B. 187, 1988-19 I.R.B. 4.