Proposed regulations concerning the economic performance requirement under Section 461(h) of the Internal Revenue Code.

• Author: Ezrati, Lester D.

Proposed Regulations Concerning the Economic Performance Requirement under Section 461(h) of the Internal Revenue Code

On June 6, 1990, the Internal Revenue Service issued proposed regulations under section 461(h) of the Internal Revenue Code, relating to the requirement that "economic performance" occur in order for an amount to be incurred by a taxpayer using an accrual method of accounting. The proposed regulations (IA-258-84) were published in the Federal Register on June 7, 1990--55 Fed. Reg. 23235--and in the July 2, 1990, issue of the Internal Revenue Bulletin (1990-27 I.R.B. 22).

For simplicity's sake, the proposed regulations are generally referred to as "the proposed regulations" and specific provisions are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

BACKGROUND

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 4,500 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayer and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is both administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax laws relating to the operations of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed section 461(h) regulations.

OVERVIEW

In developing final regulations concerning the economic performance requirement, TEI believes that two general points should be kept in mind:

First, in enacting section 461(h) of the Code, Congress was concerned with the premature accrual of deductions -- specifically, "[a]llowing a taxpayer to take deductions currently for an amount to be paid in the future." H.R. Rep. No. 98-432 (Part 2), 98th Cong., 2d Sess. 1254 (1984) (Report of the House Committee on Ways and Means). (1)(*1)

Second, section 461(h) was prompted not by general concern over the tax treatment of myriad routine, recurring business transactions under the accrual method of accounting, but rather by congressional concern over the treatment of special expense items such as mine reclamation and nuclear decommissioning expenses, workers compensation claims, and tort liabilities. (2)

To address these concerns, Congress enacted section 461(h), which added a third prong to the "all events" test for incurring deductions under the accrual method of accounting. Before the enactment of section 461(h) as part of the Deficit Reduction Act of 1984, an expense was deductible in the taxable year in which all the events had occurred which determined the fact of the liability, and the amount of the liability could be determined with reasonable accuracy. Treas. Reg. [section] 1.461-1(a)(2). Following the enactment of section 461(h), "economic performance" must also occur with respect to a liability before a deduction may be properly claimed.

In crafting regulations explaining the economic performance requirement, the IRS has generally been mindful of not only the constraints of statutory language, but also Congress's intent in enacting the provision. As our specific comments make clear, however, there are some provisions of the proposed regulations that seemingly lose sight of underlying congressional intent. For example, whereas Congress focused on time-value-of-money concepts and addressed the situation where a taxpayer accrued a deduction before it incurred any financial or economic cost in respect of the particular item, the proposed regulations would deny taxpayers a deduction in situations where payment has occurred (i.e., the economic cost has been incurred) and the "all events" test has otherwise been satisfied. (See Specific Comment No. 4.)

Furthermore, although generally applicable with respect to liabilities that would otherwise be allowable as a deduction after July 18, 1984, the proposed regulations eschew one of the fundamental questions raised by the six-year IRS delay in issuing guidance under section 461(h): what are the applicable rules for those liabilities in respect of which Prop. Reg. [section] 1.461-4(g) provides that payment is economic performance? (See Specific Comment No. 8.)

TEI also believes that the proposed regulataions place undue limitations on the adoption of the recurring item exception provided by section 461(h)(3) of the Code. Specifically, although Prop. Reg. [section] 1.461-5 generally confirms that section 461(h) will not operate to disrupt the prior treament of most routine business transactions, (3) the proposed regulations limit a taxpayer's ability to adopt the exception in respect of taxable years beginning before December 31, 1989. Because we believe that a taxpayer should not be penalized for failing to adopt the exception in years prior to the issuance of the proposed regulations, we recommend that the exception be made available in respect of all open years. (See Specific Comment No. 9.)

Finally, the proposed regulations unreasonably seek to expand the scope of the economic performance requirement beyond the accrual of deductions and credits to reach the computation of gross income. (See Specific Comment No. 10.)

In the comments that follow, TEI discusses the proposed regulations seriatim, addressing the foregoing issues as well as other questions. The Institute endeavors to respond forthrightly to the IRS's request for comments on specific issues and to propose alternative rules that are both consistent with the statutory requirements of section 461(h) and the underlying legislative history and that can be applied in a reasonable, fair, and administrable manner. We request that these comments be taken into account by the IRS in revising the regulations.

SPECIFIC COMMENTS

1. Interaction of Section 461(h)

   with Employee Benefit

   Provisions

   In the preamble to the proposed regulations, the IRS invites comments on the interaction between the economic performance requirement of section 461(h) and the employee benefit provisions including sections 83, 404, and 419. (1990-27 I.R.B. at 23.)

   The relationship between section 461(h) and certain employee benefit rules is addressed in Temp. Reg. [section] 1.461(h)-4T, which was promulgated in 1986. (T.D. 8075, reprinted in 1986-1 C.B. 45, 65). That section provides that economic performance occurs --

   (i) in the case of a [deferred compenstion] plan subject to section 404, either as the contribution is made under the plan or, if section 404(a)(5) is applicable, as an amount attributable to such contribution is includible in the gross income of an employee (or, if section 404(d) applies, a non-employee); or

   (ii) in the case of a welfare benefit fund, as a contribution is made to the welfare benefit plan.

   Absent the specific retention of the rule set forth in Temp. Reg. [section] 1.461(h)-4T, economic performance in respect of the contributions would be deemed to occur under the regulations as the services are provided to the taxpayers to whom the contributions relate. See Prop. Reg. [section] 1.461-4(d)(2). In respect of certain contributions, however -- especially those made pursuant to welfare benefit funds -- the time of performance of the services may be difficult to determine in a timely manner. Consequently, TEI favors the rule set forth in Temp. Reg. [section] 1.461(h)-4T.

   Adoption of a rule that ties economic performance to the taxpayer's making of a contribution to the plan would enhance taxpayer certainty and be fully consistent with the policy underlying the payment rule of Prop. Reg. [section] 1.461-4(g). (4) We submit that a rule based on the time services are performed is not necessary to vindicate time-value-of-money principles in light of the statutory restrictions on deductions already imposed by sections 419 and 419A.

2. Prop. Reg. [section] 1.461-2(f)(2)(i):

   Treatment of Funds for

   Contested Liabilities

   Section 461(f) of the Code provides rules in respect of contested liabilities, whereby a taxpayer may claim a current deduction for amounts transferred to an escrowee, trustee, or court (a qualified 461(f) fund) even though such liabilities are contested. Prop. Reg. [section] 1.461-2(f)(2)(i) provides that any transfer of property to a section 461(f) fund is, for purposes of section 1001, a disposition of the property by the taxpayer for fair market value on the date of the transfer.

   TEI objects to the treatment of a transfer of property to a 461(f) fund as a disposition of the property, which would trigger recognition of gain under section 1001. The rule in the proposed regulations is at odds with Prop. Reg. [section] 1.461-2(f)(2)(ii), which (i) provides that the taxpayer will be considered the owner of any qualified 461(f) fund, and thus (ii) requires that the income, deductions, and credits of the fund be taken into account by the taxpayer in computing the taxpayer's taxable income. Clearly, the taxpayer would not be required to recognize section 1001 income in respect of the property had no transfer been made (i.e., if the taxpayer had kept the property in its own name pending the outcome of the contest); rather, the recognition of such income would be deferred until the property is transferred to the third-party claimant. (5)

   Thus, TEI recommends that the regulations be revised to provide that a taxpayer's transfer of property to a qualified 401(f) fund will not be treated as a disposition...