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A riddle, wrapped in a mystery, inside an enigma
The treatment of deferred revenue in an asset acquisition is a tale as old as time: buyer falls in love with seller's business and proposes to seller. Seller accepts buyer's proposal and transfers assets to the buyer for consideration, including the assumption of various working capital liabilities that are essential to the business (such as accounts payable or deferred revenue). Taxand USA explores the issue and its potential impact on businesses.
Deferred revenue occurs when a customer makes a payment in advance for goods provided or services rendered. For financial reporting purposes the advance payment sits on the books of the recipient as a liability until the recipient of the deferred revenue has performed the necessary actions in order to satisfy the financial reporting rules related to revenue recognition.
For US federal income tax purposes, an advance payment is generally included in taxable income of an accrual-method taxpayer when the payment is received (subject to certain exceptions). Therefore there may be a book-tax difference between the treatment of deferred revenue for financial reporting purposes and US federal income tax purposes.
For a taxpayer using the cash method of accounting for US federal income tax purposes, there is generally no deferred revenue for US federal income tax purposes, as all cash payments are recognised upon receipt (or constructive receipt), regardless of whether they have been earned or not. But, using its discretion, the IRS issued Revenue Procedure 2004-34, which provides for a limited deferral from recognition of certain advance payments received by accrual-method taxpayers when performance related to such advanced payments has not yet occurred. Specifically, providing a portion of advance payments (as defined by the Rev. Proc.) received by qualifying taxpayers in a tax year may be deferred from recognition until the end of the following tax year if certain conditions are met.
Also published in Thomson Reuters' Taxnet Pro, 8 May 2014
This is an area fraught with uncertainty. Taxpayers that are considering acquiring the assets of businesses with material amounts of deferred revenue should review the US federal income tax impact of accounting for such deferred revenue under both the Assumption Method and the Pierce Method. Businesses may also want to agree with the seller up front on which method will be used and include conforming language in the purchase agreement. Buyers and sellers should also consider inserting a provision in the purchase agreement confirming the value that is to be assigned to the anticipated fulfillment costs.