Taxpayer not properly accounting for advance payments.

The Office of Chief Counsel advised that a taxpayer was not properly using the method of accounting for advance payments in Regs. Sec. 1.451-5 for certain payments the taxpayer received pursuant to long-term agreements for the sale of goods.

Background

Taxpayer A manufactures Product C for use in various industries. When the demand for C grew rapidly in previous years, A developed a business model to exploit the increased demand and insulate itself from dramatic decreases in future demand or new competition that might affect prices. A therefore negotiated long-term supply contracts with some of its customers that would ensure steady demand to justify a substantial increase in production. These supply contracts were take or pay, in that the customer agreed to pay for a certain quantity of C, whether or not it actually took delivery. In return, A agreed to stand ready to deliver the specified quantity of C at specified times at set prices. Each customer also agreed to pay A nonrefundable advance payments.

Terms of original contracts: A entered into long-term contracts with various customers beginning in year 1. The contracts specified minimum yearly quantities that the customer would purchase, and A would deliver, at fixed prices over a term of years. The majority of the contracts were for the same term of years. All of the original contracts had a take-or-pay feature and an initial, nonrefundable advance payment (IAP). The contracts specified that the IAP is to be applied to purchases ratably over the contract period on a per-unit basis.

For book and tax purposes, A recognized income from the sale of goods as the goods were shipped and recognized income from long-term contracts at the average price over the term of each contract. For tax purposes, A adopted the method in Regs. Sec. 1.451-5, under which A included advance payments in income in the tax year in which they are recognized for book purposes. Therefore, because A

Taxpayer not properly accounting for advance payments recognized long-term contract income at the average contract price for book purposes, it deferred initial recognition of the IAP and included the IAP in income ratably over the term of each agreement. For book and tax purposes, A recorded the IAP in a deferred revenue liability account and recorded an additional deferral for each sale based on a difference between the average contract price and the actual amount stated on the sales invoice.

Terms of modified contracts...