| REG-105946-00 |
February 17, 2001 |
Mid-contract Change in Taxpayer
DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-105946-00] RIN 1545-AY31
TITLE: Mid-contract Change in Taxpayer
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
SUMMARY: This document contains proposed regulations concerning a
mid-contract change in taxpayer of a contract that has been
accounted for under a long-term contract method of accounting. A
taxpayer that is a party to such a contract will be affected by
these proposed regulations. This document also provides notice of a
public hearing on the proposed regulations.
DATES: Written comments must be received by May 17, 2001. Outlines
of oral comments to be presented at the public hearing scheduled for
June 13, 2001, at 10 a.m. must be received by May 30, 2001.
ADDRESSES: Send submissions to CC:M&SP:RU (REG-105946-00), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday
through Friday between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU
(REG-105946-00), Courier's Desk, Internal Revenue Service, 1111
Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers
may submit comments electronically via the Internet by selecting the
"Tax Regs" option on the IRS Home Page, or by submitting comments
directly to the IRS Internet site at
http://www.irs.gov/prod/tax_regs/regslist.html. The public hearing
will be held in room 6718, Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed
regulations, John Aramburu or Leo F. Nolan II at (202) 622-4960;
concerning submissions of comments, the hearing, and/or to be placed
on the building access list to attend the hearing, Guy Traynor of
the Regulations Unit at (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of
proposed rulemaking have been submitted to the Office of Management
and Budget for review in accordance with the Paperwork Reduction Act
of 1995 (44 U.S.C. 3507(d)). Comments on the collections of
information should be sent to the Office of Management and Budget ,
Attn: Desk Officer for the DEPARTMENT OF THE TREASURY, Office of
Information and Regulatory Affairs, Washington, DC 20503, with
copies to the Internal Revenue Service , Attn: IRS Reports Clearance
Officer, W:CAR:MP:FP:S:O, Washington, DC 20224. Comments on the
collections of information should be received by April 16, 2001.
Comments are specifically requested concerning:
Whether the proposed collections of information are necessary
for the proper performance of the functions of the Internal Revenue
Service, including whether the information will have practical
utility;
The accuracy of the estimated burden associated with the
proposed collections of information (see below);
How the quality, utility, and clarity of the information to
be collected may be enhanced;
How the burden of complying with the proposed collections of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
Estimates of capital or start-up costs and costs of
operation, maintenance, and purchase of services to provide
information.
The collection of information in this proposed regulation is
in §1.460- 6(g)(3)(ii)(C). The information collected in
§1.460-6(g) (3)(ii)(C) is required to provide certain
recipients of long-term contracts with the information needed to
make look- back calculations. This collection of information is
mandatory. The likely respondents are for-profit entities.
Estimated total reporting burden: 10,000 hours.
Estimated average burden per respondent: 2 hours.
Estimated number of respondents: 5000.
Estimated annual frequency of responses: On occasion.
An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless the
collection of information displays a valid control number.
Books or records relating to a collection of information must
be retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns
and tax return information are confidential, as required by 26
U.S.C. 6103.
Background
Section 460 of the Internal Revenue Code was enacted by
section 804 of the Tax Reform Act of 1986, Public Law 99-514 (100
Stat. 2085, 2358-2361). Section 460 was amended by section 10203 of
the Omnibus Budget Reconciliation Act of 1987, Public Law 100-203
(101 Stat. 1330, 1330-394); by sections 1008(c) and 5041 of the
Technical and Miscellaneous Revenue Act of 1988, Public Law 100-647
(102 Stat. 3342, 3438-3439 and 3673-3676); by sections 7621 and
7811(e) of the Omnibus Budget Reconciliation Act of 1989, Public Law
101-239 (103 Stat. 2106, 2375-2377 and 2408-2409); by section 11812
of the Omnibus Budget Reconciliation Act of 1990, Public Law 101-508
(104 Stat. 1388, 1388-534 to 1388-536); by sections 1702(h) (15) and
1704(t)(28) of the Small Business Job Protection Act of 1996, Public
Law 104-188 (110 Stat. 1755, 1874, 1888); and by section 1211 of the
Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat. 788,
998-1000).
Section 460(h) directs the Secretary to prescribe regulations
to the extent necessary or appropriate to carry out the purpose of
section 460, including regulations to prevent a taxpayer from
avoiding section 460 by using related parties, pass-through
entities, intermediaries, options, and other similar arrangements.
Explanation of Provisions
Overview
Generally, manufacturing and construction contracts not
completed within the taxable year they are entered into are long-
term contracts. A manufacturing contract, however, is not a long-
term contract unless it requires the manufacture of a unique item or
an item normally requiring more than 12 months to complete. Section
460 generally requires that long-term contracts be accounted for
under the percentage-of- completion method (PCM) and that taxpayers
make a look-back computation of interest to compensate the
government (or the taxpayer) for any underestimation
(overestimation) of income from the contract. However, home
construction contracts and certain contracts of smaller construction
contractors are exempt from these requirements. Moreover,
residential builders are entitled to use the 70/30 percentage- of-
completion/ capitalized cost method (PCCM), and certain shipbuilders
are entitled to use the 40/60 PCCM. A long-term contract or a
portion of a long-term contract that is exempt from the PCM may be
accounted for under any permissible method, including the completed
contract method (CCM) or the exempt percentage-of- completion method
(EPCM). These long-term contract methods of accounting (i.e., the
PCM, PCCM, CCM and EPCM) are described in proposed §1.460-4.
These proposed regulations address the Federal income tax treatment
of a change in taxpayer prior to completion of a long-term contract
accounted for under a long-term contract method of accounting.
Existing Guidance on Transfers of Long-term Contracts
In the case of transactions not governed by section 381, such as
those occurring prior to its effective date, numerous cases have
required a taxpayer to take into income items that under its method
of accounting would be deferred past the date of the transaction.
These cases have involved both taxable and nontaxable transactions,
e.g., liquidations and reorganizations. For example, in the case of
a disposition of a long-term contract accounted for under the CCM,
the transferor was required to recognize income earned on the
contract prior to its transfer, with the amount earned determined
under some variant of the PCM. These cases generally relied on
section 446(b), section 482 and/or the assignment of income doctrine
to allocate income to the transferor. See e.g., Jud Plumbing and
Heating, Inc. v. Commissioner, 153 F.2d 681 (5th Cir.
1946); Standard Paving Co. v. Commissioner,190 F.2d 330 (10
th Cir.), cert. denied, 342 U.S. 860 (1951); Central Cuba
Sugar Co. v. Commissioner, 198 F.2d 214 (2 Cir.), cert. denied, 344
U.S. 874 nd (1952); Dillard-Waltermire, Inc. v. Campbell, 255 F.2d
433 (5 Cir. 1958); and th Midland-Ross Corp. v. United States, 485
F.2d 110 (6 Cir. 1973). In addition, th §1.451-5(f) of the
regulations has been cited as support for taxing a transferor who
has deferred advance payments under its long-term contract method of
accounting. See Rotolo v. Commissioner, 88 T.C. 1500 (1987).
Under section 381(c)(4), in the case of a section 381
transaction, an acquiring corporation generally must use the method
of accounting used by the transferor. Further, regulations under
§1.381(c)(4)-1 require the acquiring corporation to take into
account the transferor's items of income or deduction which, because
of its method of accounting, were not required or permitted to be
included or deducted by the transferor in computing taxable income
prior to the date of the transfer. Consistent with section 381, the
IRS has held that section 381 generally requires a transferee to
account for a long-term contract transferred pursuant to a section
381 transaction using the CCM used by the transferor and, thus, to
report the entire gain or loss from the contract. Accordingly, the
decisions in the Standard Paving line of cases are generally not
applicable to transactions to which section 381 applies. Rev. Rul.
70-83 (1970-1 C.B. 85). In addition, section 351 generally has been
interpreted to prevent recognition of gain or loss by a transferor
from a section 351 transfer of partially completed long-term
contracts accounted for by the transferor using the CCM. See GCM
39258 (July 13, 1984) applying Rev. Rul. 80-198 (1980-2 C.B. 113)
(no gain or loss is recognized to a cash basis transferor with
respect to unrealized accounts receivable and unrecognized accounts
payable transferred in a section 351 transaction).
In 1990, the IRS issued proposed regulations (REG-20930-86)
(55 FR 23755) that addressed the treatment of a mid-contract change
in taxpayer of a contract accounted for using PCM for purposes of
applying the look-back method. Generally, these proposed regulations
provided that the successor to the contract "stepped into the shoes"
of the predecessor with respect to the PCM. Thus, the successor was
to continue to use the same PCM used by the predecessor both for
purposes of reporting income under the contract and recomputing
income under the look-back method. No look-back calculation was to
be made until the successor completed the contract, and the
successor was liable for look-back interest attributable to both
pre- and post- transaction years. On the other hand, except in the
case of taxable dispositions to unrelated parties, the successor
could not recover look-back interest owed by the government that was
attributable to pre-transaction years. These proposed regulations
were withdrawn. One criticism of the regulations was that step-in-
the- shoes treatment was inappropriate in the case of taxable
dispositions.
Proposed Provisions
Consistent with the existing guidance described above and in
response to comments received on the 1990 proposed regulations,
these proposed regulations divide the rules regarding a mid-contract
change in taxpayer of a long-term contract accounted for under a
long-term contract method into two categories -- constructive
completion transactions and step-in-the-shoes transactions. For this
purpose, the step-in-the-shoes rules apply to the following
transactions --
(1) Transactions described in section 381 (i.e., liquidations
under section 332 and reorganizations described in section
368(a)(1)(A), (C), (D), (F), or (G));
(2) Transactions described in section 351;
(3) Transactions described in section 368(a)(1)(D) with
respect to which the requirements of section 355 (or so much
of section 356 as relates to section 355) are met (divisive
"D" reorganization);
(4) Transfers (e.g. sales) of S corporation stock;
(5) Conversion to or from an S corporation;
(6) Members joining or leaving a consolidated group; and
(7) Any other transaction designated in the Internal Revenue
Bulletin by the Internal Revenue Service. See 26 CFR
601.601(d)(2)(ii).
The constructive completion rules apply to all other transactions.
A constructive completion transaction results in the taxpayer
originally reporting income under the long-term contract (old
taxpayer) recognizing income from the contract based on a contract
price that takes into account any amounts realized from the
transaction or paid by the old taxpayer to the taxpayer subsequently
reporting income under the long-term contract (new taxpayer) that
are allocable to the contract. Similarly, the new taxpayer in a
constructive completion transaction is treated as though it entered
into a new contract as of the date of the transaction, with the
contract price taking into account the purchase price and any amount
paid by the old taxpayer that is allocable to the contract.
In the case of a step-in-the-shoes transaction, the old
taxpayer's obligation to account for the contract terminates on the
date of the transaction and is assumed by the new taxpayer. The new
taxpayer must assume the old taxpayer's methods of accounting for
the contract, with both the contract price and allocable contract
costs based on amounts taken into account by both parties. However,
in the case of a tax avoidance transaction, the IRS may allocate
income with respect to a transferred long- term contract between the
old and new taxpayers. Section §1.451-5(f) will not be applied
to a mid-contract change in taxpayer of a contract accounted for
under a long- term contract method.
In the case of a step-in-the-shoes transaction in which the
transferor's basis in the stock of the transferee is determined by
reference to its basis of the property transferred, the basis in the
stock of the transferee attributable to the transfer of a long- term
contract will not be appropriate unless the amount previously
received by the transferor under the long-term contract equates to
the amount previously recognized as gross receipts by the
transferor. Under both the PCM and the CCM, however, it is common
for the amount received with respect to a long-term contract to
differ from the amount recognized because the receipt of progress
payments does not affect the recognition of income. To address this
situation, the proposed regulations provide that, in the case of a
section 351 transaction or a divisive "D" reorganization, the old
taxpayer must adjust its basis in the stock of the new taxpayer by
the difference between the amount the old taxpayer has recognized
with respect to the contract and the amount the old taxpayer has
received or reasonably expects to receive under the contract. The
IRS and Treasury Department specifically request comments with
respect to this rule.
The proposed regulations also provide rules for applying the
look-back method in the case of a mid-contract change in taxpayer.
For constructive completion transactions, the look-back method is
applied by the old taxpayer with respect to pre- transaction years
upon the transaction date and, if applicable, by the new taxpayer
with respect to post-transaction years upon contract completion. For
step-in-the- shoes transactions, the look-back method is applied
only by the new taxpayer upon contract completion. The new taxpayer
must account for pre- and post-transaction years, with special rules
governing the calculation of look-back interest in the case of pre-
transaction years. The proposed regulations also require the old
taxpayer in such cases to provide certain information to the new
taxpayer in order to enable the new taxpayer to make the necessary
look-back calculations.
The proposed regulations reserve on whether a mid-contract
change in taxpayer that results from a partnership transaction,
including a transaction described in section 721, a transaction
described in section 731, and a transfer (e.g., sale) of a
partnership interest, should be treated as a constructive
completion, or a step-in-the- shoes, transaction. Although these
transactions are similar to other step-in-the-shoes transactions,
such as nonrecognition transactions (e.g., sections 351 and 332) and
transactions where the party responsible for performing the contract
has not changed (e.g., sales of S corporation stock and members
joining or leaving consolidated groups), the IRS and Treasury
Department are concerned that step-in-the-shoes treatment for these
partnership transactions could more readily facilitate the shifting
of income to tax indifferent parties than in other situations and
thus are concerned about monitoring such activities solely through
an anti-abuse rule. In addition, other issues, such as the treatment
of long-term contracts under section 704(c), 751, and 752,
significantly complicate, and could thwart, the application of the
step-in-the-shoes rule with respect to mid- contract changes
involving partnership transactions. The IRS and Treasury Department
request comments on the appropriate treatment for mid-contract
changes in taxpayer resulting from these partnership transactions.
Proposed Effective Date
These regulations are proposed to be applicable for transactions
on or after the date they are published in the Federal Register as
final regulations.
Special Analyses
It has been determined that this notice of proposed
rulemaking is not a significant regulatory action as defined in
Executive Order 12866. Therefore, a regulatory assessment is not
required. It also has been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to
these regulations. Pursuant to section 7805(f) of the Internal
Revenue Code, this notice of proposed rulemaking will be submitted
to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
It is hereby certified that the collection of information in
these regulations will not have a significant economic impact on a
substantial number of small entities. This certification is based on
the fact that the relevant information is already maintained by
taxpayers. Therefore, a Regulatory Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.
Comments and Public Hearing
Before these proposed regulations are adopted as final
regulations, consideration will be given to any electronic or
written comments (a signed original and eight (8) copies) that are
submitted timely to the IRS. The IRS and Treasury Department
specifically request comments on the clarity of the proposed rule
and how it could be made easier to understand. All comments will be
available for public inspection and copying.
A public hearing has been scheduled for June 13, 2001, at 10
a.m. in room 6718, Internal Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC. Due to building security procedures,
visitors must enter at the 10th Street entrance, located between
Constitution and Pennsylvania Avenue, NW. In addition, all visitors
must present photo identification to enter the building. Because of
access restrictions, visitors will not be admitted beyond the
immediate entrance area more than 15 minutes before the hearing
starts. For information about having your name placed on the
building access list to attend the hearing, see the "FOR FURTHER
INFORMATION CONTACT" section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons who wish to present oral comments at the hearing must submit
written comments and an outline of the topics to be discussed and
the time to be devoted to each topic (signed original and eight (8)
copies) by May 30, 2001. A period of 10 minutes will be allotted to
each person for making comments. An agenda showing the scheduling of
the speakers will be prepared after the deadline for receiving
outlines has passed. Copies of the agenda will be available free of
charge at the hearing. Drafting Information
The principal author of these proposed regulations is John
Aramburu, Office of Associate Chief Counsel (Income Tax and
Accounting). However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is
proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to
read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. In §1.381(c)(4)-1, a sentence is added at the
end of paragraph (a)(2) to read as follows:
§1.381(c)(4)-1 Method of accounting.
(a) * * *
(2) * * *See §1.460-4(k) for rules relating to transfers
of contracts accounted for using a long-term contract method of
accounting in a transaction to which section 381 applies.
* * * * *
Par. 3. Section 1.460-0 is amended by:
1. Revising the entry for paragraph (k) of §1.460-4.
2. Adding entries for paragraphs (k)(1) through (k)(6) of
§1.460-4.
3. Revising the entry for paragraph (g) of §1.460-6.
4. Adding entries for paragraphs (g) through (g)(3) of
§1.460-6.
The revisions and additions read as follows:
§1.460-0 Outline of regulations under section 460.
* * * * *
§1.460-4 Methods of accounting for long-term contracts. 15
* * * * *
(k) Mid-contract change in taxpayer.
(1) In general.
(2) Constructive completion transactions.
(i) Scope.
(ii) Old taxpayer.
(iii) New taxpayer.
(3) Step-in-the-shoes transactions.
(i) Scope.
(ii) Old taxpayer.
(iii) New taxpayer.
(A) Method of accounting.
(B) Contract price.
(C) Contract costs.
(4) Anti-abuse rule.
(5) Examples.
(6) Effective date.
* * * * *
§1.460-6 Look-back method.
* * * * *
(g) Mid-contract change in taxpayer.
(1) In general.
(2) Constructive completion transactions.
(3) Step-in-the-shoes transactions.
(i) General rules.
(ii) Application of look-back method to pre-transaction period.
(A) Method.
(B) Interest accrual period.
(C) Information old taxpayer must provide.
(iii) Application of look-back method to post-transaction years.
* * * * *
Par. 4. Section 1.460-4 is amended by:
1. Adding a sentence at the end of paragraph (a).
2. Revising paragraph (k).
The revision and addition read as follows:
§1.460-4 Methods of accounting for long-term contracts.
(a) * * * Finally, paragraph (k) of this section provides
rules relating to a mid- contract change in taxpayer of a contract
accounted for using a long-term contract method of accounting. * * *
* *
(k) Mid-contract change in taxpayer --
(1) In general. The rules in this paragraph (k) apply if
prior to the completion of a long-term contract accounted for using
a long-term contract method by a taxpayer (old taxpayer), there is a
transaction that makes another taxpayer (new taxpayer) responsible
for reporting income from the same contract. For purposes of this
paragraph (k) and §1.460-6(g), an old taxpayer also includes
any old taxpayer(s) (e.g., predecessors) of the old taxpayer. In
addition, a change in status from taxable to tax exempt or from
domestic to foreign, and vice versa, will be considered a change in
taxpayer. Finally, a contract will be treated as the same contract
if the terms of the contract are not substantially changed in
connection with the transaction, whether or not the customer agrees
to release the old taxpayer from any or all of its obligations under
the contract. The rules governing constructive completion
transactions are provided in paragraph (k) (2) of this section,
while the rules governing step-in-the-shoes transactions are
provided in paragraph (k)(3) of this section. For application of the
look-back method to mid-contract changes in taxpayers for contracts
accounted for using the PCM, see §1.460-6(g).
(2) Constructive completion transactions --
(i) Scope. The constructive completion rules in this
paragraph (k)(2) apply to transactions that result in a change in
the taxpayer responsible for reporting income from a contract and
that are not described in paragraph (k)(3)(i) of this section
(constructive completion transactions). Constructive completion
transactions generally include, for example, taxable sales under
section 1001 and deemed asset sales under section 338.
(ii) Old taxpayer. The old taxpayer is treated as completing
the contract on the date of the transaction. The total contract
price (or, gross contract price in the case of a long-term contract
accounted for under the CCM) for the old taxpayer is the sum of any
amounts realized from the transaction that are allocable to the
contract and any amounts the old taxpayer has received or reasonably
expects to receive under the contract after the transaction. Total
contract price (gross contract price) is reduced by any amount paid
by the old taxpayer to the new taxpayer, and by any transaction
costs, that are allocable to the contract. Thus, the old taxpayer's
allocable contract costs do not include any consideration paid, or
costs incurred, as a result of the transaction that are allocable to
the contract. In the case of a transaction subject to sections 338
or 1060, the amount realized from the transaction allocable to the
contract is determined by using the residual method under
§§1.338-6T and 1.338-7T.
(iii) New taxpayer. The new taxpayer is treated as entering
into a new contract on the date of the transaction. The new taxpayer
must evaluate whether the new contract should be classified as a
long-term contract within the meaning of §1.460-1(b) and
account for the contract under a permissible method of accounting.
For a new taxpayer who accounts for a contract using the PCM, the
total contract price is any amount the new taxpayer reasonably
expects to receive under the contract consistent with paragraph (b)
(4) of this section. Total contract price is reduced in the amount
of any consideration paid as a result of the transaction, and by any
transaction costs, that are allocable to the contract and is
increased in the amount of any consideration received as a result of
the transaction that is allocable to the contract. Similarly, the
gross contract price for a contract accounted for using the CCM is
all amounts the new taxpayer is entitled by law or contract to
receive consistent with paragraph (d)(3) of this section, adjusted
for any consideration paid (or received) as a result of the
transaction that is allocable to the contract. Thus, the new
taxpayer's allocable contract costs do not include any consideration
paid, or costs incurred, as a result of the transaction that are
allocable to the contract. In the case of a transaction subject to
sections 338 or 1060, the amount of consideration paid that is
allocable to the contract is determined by using the residual method
under §§1.338-6T and 1.338-7T.
(3) Step-in-the-shoes transactions --
(i) Scope. The step-in-the-shoes rules in this paragraph (k)
(3) apply to the following transactions that result in a change in
the taxpayer responsible for reporting income from a contract (step-
in-the-shoes transactions) --
(A) Transactions described in section 381 (i.e., liquidations
under section 332 and reorganizations described in section 368(a)(1)
(A), (C), (D), (F), or (G));
(B) Transactions described in section 351;
(C) Transactions described in section 368(a)(1)(D) with
respect to which the requirements of section 355 (or so much of
section 356 as relates to section 355) are met;
(D) Transfers (e.g., sales) of S corporation stock;
(E) Conversion to or from an S corporation;
(F) Members joining or leaving a consolidated group; and
(G) Any other transaction designated in the Internal Revenue
Bulletin by the Internal Revenue Service. See §601.601(d)(2)
(ii) of this chapter.
(ii) Old taxpayer -
(A) In general. The new taxpayer will "step into the shoes"
of the old taxpayer with respect to the contract. Thus, consistent
with §1.381(c)(4)- 1(a)(1)(ii), the old taxpayer's obligation
to account for the contract terminates on the date of the
transaction and is assumed by the new taxpayer, as set forth in
paragraph (k) (3)(iii) of this section. As a result, an old taxpayer
using the PCM is required to recognize income from the contract
based on the cumulative allocable contract costs incurred as of the
date of the transaction. Similarly, an old taxpayer using the CCM is
not required to recognize any revenue and may not deduct allocable
contract costs incurred with respect to the contract.
(B) Basis adjustment. In the case of transactions described
in paragraph (k)(3)(i)(B) or (C) of this section, the old taxpayer
must adjust its basis in the stock of the new taxpayer by reducing
such basis to the extent the amount the old taxpayer has received or
reasonably expects to receive under the contract exceeds the amount
recognized by the old taxpayer with respect to the contract or by
increasing such basis to the extent the amount the old taxpayer has
recognized with respect to the contract exceeds the amount the old
taxpayer has received or reasonably expects to receive under the
contract. However, the old taxpayer may not reduce its basis in the
stock of the new taxpayer below zero. If the old and new taxpayer do
not join in the filing of a consolidated Federal income tax return,
the old taxpayer must recognize income to the extent the basis in
the stock of the new taxpayer otherwise would be reduced below zero.
If the old and new taxpayer join in the filing of a consolidated
Federal income tax return, the old taxpayer must create an (or
increase an existing) excess loss account to the extent the basis in
the stock of the new taxpayer otherwise would be reduced below zero.
See §§1.1502-19 and 1.1502-32(a)(3)(ii).
(iii) New taxpayer --
(A) Method of accounting. Beginning on the date of the
transaction, the new taxpayer must account for the long-term
contract by using the same method of accounting used by the old
taxpayer prior to the transaction consistent with §1.381(c)
(4)-1(b) (4). The same method of accounting must be used for such
contract regardless of whether the old taxpayer's method is the new
taxpayer's principal method of accounting under §1.381(c)
(4)-1(b) (3) or whether the new taxpayer is otherwise eligible to
use the old taxpayer's method. Thus, if the old taxpayer uses the
PCM to account for the contract, the new taxpayer steps into the
shoes of the old taxpayer with respect to its completion factor and
percentage of completion methods (such as the 10-percent method),
even if the new taxpayer has not elected such methods for similarly
classified contracts. Similarly, if the old taxpayer uses the CCM,
the new taxpayer steps into the shoes of the old taxpayer with
respect to the CCM, even if the new taxpayer is not otherwise
eligible to use the CCM. However, the new taxpayer is not
necessarily bound by the old taxpayer's method for similarly
classified contracts entered into by the new taxpayer subsequent to
the transaction and must apply general tax principles, including
section 381, to determine the appropriate method to account for
these subsequent contracts. To the extent that general tax
principles allow the taxpayer to account for similarly classified
contracts using a method other than the old taxpayer's method, the
taxpayer is not required to obtain the consent of the Commissioner
to begin using such other method.
(B) Contract price. The total contract price for the new
taxpayer is the sum of any amounts the old taxpayer or new taxpayer
have received or reasonably expect to receive under the contract
consistent with paragraph (b)(4) of this section. Similarly, the
gross contract price in the case of a long-term contract accounted
for under the CCM includes all amounts the old taxpayer or new
taxpayer are entitled by law or by contract to receive consistent
with paragraph (d)(3) of this section.
(C) Contract costs. Total allocable contract costs for the
new taxpayer are the allocable contract costs as defined under
paragraph (b)(5) of this section incurred by either the old taxpayer
prior to or the new taxpayer after the transaction. Thus, any
payments between the old taxpayer and the new taxpayer with respect
to the contract are not treated as part of contract price or an
allocable contract cost.
(4) Anti-abuse rule. Notwithstanding this paragraph (k), in
tax avoidance cases, the Commissioner may allocate to the old (or
new) taxpayer the income from a long- term contract properly
allocable to the old (or new) taxpayer. For example, the
Commissioner may scrutinize a transaction in which a long-term
contract accounted for using the CCM, or using the PCM where the old
taxpayer has received advance payments in excess of its contribution
to the contract, is transferred to a tax indifferent party.
(5) Examples. The following examples illustrate the rules of
this paragraph (k). For purposes of these examples, it is assumed
that the contracts are long-term construction contracts accounted
for using the PCM prior to the transaction unless stated otherwise
and the contracts are not transferred in tax avoidance cases. The
examples are as follows:
Example 1. Constructive completion -- PCM.
(i) Facts. In Year 1, X enters into a contract. The total
contract price is $1,000,000 and the estimated total allocable
contract costs are $800,000. In Year 1, X incurs costs of $200,000.
In Year 2, X incurs additional costs of $400,000 before selling the
contract as part of the sale of its business in Year 2 to Y, an
unrelated party. At the time of sale, X has received $650,000 in
progress payments under the contract. The consideration allocable to
the contract under section 1060 is $150,000. Pursuant to the sale,
the new taxpayer Y immediately assumes X's contract obligations and
rights. Y is required to account for the contract using the PCM. In
Year 2, Y incurs additional allocable contract costs of $50,000. Y
correctly estimates at the end of Year 2 that it will have to incur
an additional $75,000 of allocable contract costs in Year 3 to
complete the contract.
(ii) Old taxpayer. For Year 1, X reports receipts of
$250,000 (the completion factor multiplied by total contract price
($200,000/$800,000 x $1,000,000)) and costs of $200,000, for a
profit of $50,000. X is treated as completing the contract in Year 2
because it sold the contract. For purposes of applying the PCM in
Year 2, the total contract price is $800,000 (the sum of the amounts
received under the contract and the amount realized in the sale
($650,000 + $150,000)) and the total allocable contract costs are
$600,000 (the sum of the costs incurred in Year 1 and Year 2
($200,000 + $400,000)). Thus, in Year 2, X reports receipts of
$550,000 (total contract price minus receipts already reported
($800,000 - $250,000)) and costs incurred in year 2 of $400,000, for
a profit of $150,000.
(iii) New taxpayer. Y is treated as entering into a new
contract in Year 2. The total contract price is $200,000 (the amount
remaining to be paid under the terms of the contract less the
consideration paid allocable to the contract ($1,000,000 - $650,000
- $150,000)). The estimated total allocable contract costs at the
end of Year 2 are $125,000 (the allocable contract costs that Y
reasonably expects to incur to complete the contract ($50,000 +
$75,000)). In Year 2, Y reports receipts of $80,000 (the completion
factor multiplied by the total contract price [($50,000/$125,000) x
$200,000] and costs of $50,000 (the costs incurred after the
purchase), for a profit of $30,000. For Year 3, Y reports receipts
of $120,000 (total contract price minus receipts already reported
($200,000 - $80,000)) and costs of $75,000, for a profit of $45,000.
Example 2. Constructive completion -- CCM.
(i) Facts.
The facts are the same as in Example 1, except that X and Y
properly account for the contract under the CCM.
(ii) Old taxpayer. X does not report any income or costs from the
contract in Year 1. In Year 2, the contract is deemed complete for
X, and X reports its gross contract price of $800,000 (the sum of
the amounts received under the contract and the amount realized in
the sale ($650,000 + $150,000)) and its total allocable contract
costs of $600,000 (the sum of the costs incurred in Year 1 and Year
2 ($200,000 + $400,000)) in that year.
(iii) New taxpayer. Y is treated as entering into a new
contract in Year 2. Under the CCM, Y reports no gross receipts or
costs in Year 2. Y reports its gross contract price of $200,000 (the
amount remaining to be paid under the terms of the contract less the
consideration paid allocable to the contract ($1,000,000 - $650,000-
$150,000)) and its total allocable contract costs of $125,000 (the
allocable contract costs that Y incurred to complete the contract
($50,000 + $75,000)) in Year 3, the completion year, for a profit of
$75,000.
Example 3. Step-in-the-shoes -- PCM.
(i) Facts. The facts are the same as in Example 1, except that
X transfers the contract to Y in exchange for stock of Y in a
transaction that qualifies as a statutory merger described in
section 368(a)(1)(A) and does not result in gain or loss to X under
section 361(a).
(ii) Old taxpayer. For Year 1, X reports receipts of $250,000
(the completion factor multiplied by total contract price
($200,000/$800,000 x $1,000,000)) and costs of $200,000, for a
profit of $50,000. Because the mid-contract change in taxpayer
results from a transaction described in paragraph (k)(3)(i) of this
section, X is not treated as completing the contract in Year 2. In
Year 2, X reports receipts of $500,000 (the completion factor
multiplied by the total contract price and minus the Year 1 gross
receipts [($600,000/$800,000 x $1,000,000) - $250,000]) and costs of
$400,000, for a profit of $100,000.
(iii) New taxpayer. Because the mid-contract change in
taxpayer results from a step-in-the-shoes transaction, Y must
account for the contract using the same methods of accounting used
by X prior to the transaction. Total contract price is the sum of
any amounts that X and Y have received or reasonably expect to
receive under the contract, and total allocable contract costs are
the allocable contract costs of X and Y. Thus, the estimated total
allocable contract costs at the end of Year 2 are $725,000 (the
cumulative allocable contract costs of X and the estimated total
allocable contract costs of Y ($200,000 + $400,000 + $50,000 +
$75,000)). In Year 2, Y reports receipts of $146,552 (the completion
factor multiplied by the total contract price minus receipts
reported by the old taxpayer ([($650,000/$725,000) x $1,000,000] -
$750,000) and costs of $50,000, or a profit of $96,552. For Year 3,
Y reports receipts of $103,448 (the total contract price minus prior
year receipts ($1,000,000 - $896,552)) and costs of $75,000, for a
profit of $28,448.
Example 4. Step-in-the-shoes -- CCM.
(i) Facts. The facts are the same as in Example 3, except that
X properly accounts for the contract under the CCM.
(ii) Old taxpayer. X reports no income or costs from the
contract in Years 1, 2 or 3. (iii) New taxpayer. Because the mid-
contract change in taxpayer results from a step-in-the-shoes
transaction, Y must account for the contract using the same methods
of accounting used by X prior to the transaction. Thus, in Year 3,
the completion year, Y reports receipts of $1,000,000 and total
contract costs of $725,000, for a profit of $275,000.
Example 5. Step in the shoes -- Basis adjustment. The facts
are the same as in Example 1, except that X transfers the contract
(including the uncompleted property with a basis of $0) and $125,000
of cash to a new corporation, Z, in exchange for all of the stock of
Z in a section 351 transaction. Thus, under section 358(a), X's
basis in Z is $125,000. X must increase its basis in Z by $100,000
pursuant to paragraph (k)(3)(ii)(B) of this section because the
amount X recognized with respect to the contract, $750,000 ($250,000
receipts in Year 1 + $500,000 receipts in Year 2), exceeds the
amount X received under the contract, the $650,000 in progress
payments, by $100,000.
Example 6. Step in the shoes -- Basis adjustment. The facts
are the same as in Example 2, except that X receives progress
payments of $800,000 (rather than $650,000) and transfers the
contract (including the uncompleted property with a basis of
$600,000) and $125,000 of cash to a new corporation, Z, in exchange
for all of the stock of Z in a section 351 transaction. Thus, under
section 358(a), X's basis in Z is $725,000. X and Z do not join in
filing a consolidated Federal income tax return. X must reduce its
basis in the stock of Z by $725,000 to zero pursuant to paragraph
(k)(3)(ii)(B) of this section because the amount X received under
the contract, $800,000 in progress payments, exceeds the amount
recognized by X with respect to the contract, $0. In addition, X
must recognize income of $75,000 because X's basis in the stock of Z
otherwise would have been reduced below zero by $75,000 (800,000
unrecognized progress payments - 725,000 basis).
(6) Effective date. This paragraph (k) is applicable for
transactions on or after the date they are published in the Federal
Register as final regulations.
Par. 5. In §1.460-6, paragraph (g) is revised to read as
follows:
§1.460-6 Look-back method.
* * * * *
(g) Mid-contract change in taxpayer --
(1) In general. The rules in this paragraph (g) apply if, as
described in §1.460-4(k), prior to the completion of a long-
term contract accounted for using the PCM or the PCCM by a taxpayer
(old taxpayer), there is a transaction that makes another taxpayer
(new taxpayer) responsible for reporting income from the same
contract. The rules governing constructive completion transactions
are provided in paragraph (g)(2) of this section, while the rules
governing step-in-the-shoes transactions are provided in paragraph
(g)(3) of this section. For purposes of this paragraph, pre-
transaction years are all taxable years of the old taxpayer in which
the old taxpayer reported (or should have reported) gross receipts
from the contract, and post-transaction years are all taxable years
of the new taxpayer in which the new taxpayer reported (or should
have reported) gross receipts from the contract.
(2) Constructive completion transactions. In the case of a
transaction described in §1.460-4(k)(2)(i) (constructive
completion transaction), the look-back method is applied by the old
taxpayer with respect to pre-transaction years upon the date of the
transaction and, if the new taxpayer uses the PCM or the PCCM to
account for the contract, by the new taxpayer with respect to post-
transaction years upon completion of the contract. The contract
price and allocable contract costs to be taken into account by the
old taxpayer or the new taxpayer in applying the look-back method
are described in §1.460-4(k)(2).
(3) Step-in-the-shoes transactions -- (i) General rules. In
the case of a transaction described in §1.460-4(k)(3)(i) (step-
in- the-shoes transaction), the look- back method is not applied at
the time of the transaction, but is instead applied for the first
time when the contract is completed by the new taxpayer. Upon
completion of the contract, the look-back method is applied by the
new taxpayer with respect to both pre- transaction years and post-
transaction years, taking into account all amounts reasonably
expected to be received by either the old or new taxpayer and all
allocable contract costs incurred during both periods as described
in §1.460-4(k)(3). The new taxpayer is liable for filing the
Form 8697 and for interest computed on hypothetical underpayments of
tax, and is entitled to receive interest with respect to
hypothetical overpayments of tax, for both pre- and post-
transaction years. Pursuant to section 6901, the old taxpayer will
be secondarily liable for any interest required to be paid with
respect to pre- transaction years reduced by any interest on pre-
transaction overpayments.
(ii) Application of look-back method to pre-transaction
period --
(A) Method. The new taxpayer must apply the look-back method
to each pre-transaction year that is a redetermination year using
the simplified marginal impact method described in paragraph (d) of
this section (regardless of whether or not the old taxpayer would
have actually used that method and without regard to the tax
liability ceiling).
(B) Interest accrual period. With respect to any hypothetical
underpayment or overpayment of tax for a pre-transaction year,
interest accrues from the due date of the old taxpayer's tax return
(not including extensions) for the taxable year of the underpayment
or overpayment until the due date of the new taxpayer's return (not
including extensions) for the completion year or the year of a post-
completion adjustment, whichever is applicable.
(C) Information old taxpayer must provide. In order to help
the new taxpayer to apply the look-back method with respect to pre-
transaction taxable years, any old taxpayer that reported income
from a long-term contract under the PCM or PCCM for either regular
or alternative minimum tax purposes is required to provide the
information described in this paragraph to the new taxpayer by the
due date (not including extensions) of the old taxpayer's income tax
return for the taxable year ending with, or the first taxable year
ending after, a step-in-the-shoes transaction described in
§1.460-4(k)(3)(i). The required information is as follows - -
(1) The portion of the contract reported by the old taxpayer
under PCM for regular and alternative minimum tax purposes (i.e.,
whether the old taxpayer used PCM, the 40/60 PCCM method, or the
70/30 PCCM method);
(2) The submethod used to apply PCM (e.g., the simplified
cost-to-cost method or the 10-percent method);
(3) The amount of total contract price reported by year;
(4) The numerator and the denominator of the completion
factor by year;
(5) The due date (not including extensions) of the old
taxpayer's income tax returns for each taxable year in which income
was required to be reported;
(6) Whether the old taxpayer was a corporate or a
noncorporate taxpayer by year; and
(7) Any other information required by the Commissioner by
administrative pronouncement.
(iii) Application of look-back method to post-transaction
years. With respect to post-transaction taxable years, the new
taxpayer must use the same look-back method it uses for other
contracts (i.e., the simplified marginal impact method or the actual
method) to determine the amount of any hypothetical overpayment or
underpayment of tax and the time period for computing interest on
these amounts.
* * * * *
David A. Mader
Deputy Commissioner of Internal Revenue
SEARCH:
You can search the entire Tax Professionals section, or all of Uncle Fed's Tax*Board. For a more focused search, put your search word(s) in quotes.
2001 Regulations Main | IRS Regulations Main | Home
|
