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

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 of the property under section 1001. (6) A transfer of property from the fund, however, would continue to be treated as a disposition of the property by the taxpayer for fair market value. Consequently, the difference between the taxpayer's adjusted basis in the property and its fair market value would be taken into income at the time the property is transferred from the fund to the third-party claimant; if the property is returned to the taxpayer, no additional income would be recognized in respect of the property. (Any income earned while the property was held in the fund would have already been recognized by the taxpayer pursuant to Prop. Reg. [section] 1.461-2(f)(ii).)

The preamble to the proposed regulations invites taxpayer comments relating to the application of section 461(f) to liabilities for which the proposed regulations designate payment as economic performance. (1990-27 I.R.B. at 24.) TEI recommends that the regulations provide that the transfer of property to the fund shall constitute payment for purposes of section 461(h); such a result is clearly consistent with the general thrust of section 461(f).

3. Prop. Reg. [section] 1.461-4(d)(2)(ii):

Treatment of Long-Term

Contracts

Prop. Reg. [section] 1.461-4(d)(2) addresses the application of the economic performance requirement in respect of property or services provided to the taxpayer. With respect to an expense attributable to a long-term contract of a taxpayer that uses the percentage-of-completion method prescribed by section 460 of the Code, Prop. Reg. [section] 1.461-4(d)(2)(ii) provides that economic performance occurs on the earlier of (i) the date that property or services are provided to the taxpayer, or (ii) the date payment is made by the taxpayer in satisfaction of a liability to a person providing property or services.

Under the percentage-of-completion method, a taxpayer reports taxable income as costs are incurred, not as revenues are received or products shipped. Thus, costs are not capitalized in the same manner that an inventory manufacturer would capitalize costs. Enactment of the economic performance requirement did not alter a manufacturer of inventory's deduction of product costs, because such costs constitute the manufacturer's cost of goods sold and are deducted (under both prior and current law) only when the inventory is sold. In contrast, for a long-term contract taxpayer, the incurring of a cost itself becomes a taxable event; consequently, such a taxpayer is vitally concerned about when a cost is incurred.

TEI submits that the proposed regulations err in tying economic performance to the earlier of the date that property or services are provided to the taxpayer or the date payment is made by the taxpayer in satisfaction of a liability to a person providing property or services. The proposed rule would adversely affect the relationship between a long-term contract taxpayer and his suppliers, and would do so in a manner that unfairly penalizes the taxpayer by accelerating the date for the reporting of taxable income.

In industries where long-term contracts are common (the aerospace and defense industries), the ultimate customer (the U.S. government) routinely makes progress (or advance) payments to its suppliers. These progress payments most often do not contain elements of profit. Rather, progress payments are made to reduce the amount of self-financing that a contractor undertakes, which in turn reduces the cost of products sold to the government; otherwise, only contractors that are heavily capitalized could afford to wait until a contract was completed before receiving payment. This concept extends down the chain from prime contractor to the smalles subcontractor. In fact, the smaller the subcontractor, the more likely that progress payments will be part of the contract terms.

Under Prop. Reg. [Section] 1.461-4(d)(2)(ii)(B), payment by a taxpayer to one of its subcontractors is considered economic performance. This means that the taxpayer must include the payment as a cost incurred on a long-term contract and, under the percentage-of-completion rules of section 460, report taxable income. This result is contrary to economic reality and undermines legitimate government contracting and defense policy. As previously stated, progress payments are a means of financing aerospace and defense suppliers. The proposed rule, however, would exacerbate the contractor's need for capital because it could impose a tax on income, frequently before such income is earned in an economic sense.

TEI submits that the more appropriate rule in the context of long-term contract taxpayers would be to provide that economic performance will be deemed to occur on the later of (i) the date that property or services are provided to the taxpayer, or (ii) the date that payment is made in satisfaction of the liability to the person providing the property or services. We recognize that this rule would treat long-term contract taxpayers differently from other taxpayers; we submit that such unique treatment is justified inasmuch as long-term contract taxpayers, unlike other taxpayers, must recognize income as they incur cost.

4. Prop. Reg. [Section] 1.461-4(d)(3):

Use of Property Provided to

the Taxpayer

Prop. Reg. [Section] 1.461-4(d)(3) provides that if a liability arises out of the use of property by the taxpayer, economic performance occurs ratably over the period of time the taxpayer is entitled to the use of the property. The application of the rule is illustrated by Examples 7 and 10 under Prop. Reg. [Section] 1.461-4(d)(6).

TEI is concerned about the interaction of Prop. Reg. [Section] 1.461-4(d)(3) with Prop. Reg. [Section] 1.446-1(c)(1)(ii)(A), which prescribes general rules with respect to the accrual method of accounting. As explained below, we are specifically concerned that the two provisions could be read in tandem to provide that amounts incurred in acquiring a lease or license are not includible in the basis of the leasehold or license acquired by the taxpayer.

For example, Example 10 under Prop. Reg. [Section] 1.461-4(d)(3) concerns the proper treatment of a $100,000 payment made on December 30, 1990, in respect of the exclusive use of a patent for five years beginning on January 1, 1991. TEI submits that the regulations should confirm that the taxpayer has a basis of $100,000 in the exclusive license it has acquired and, further, that the taxpayer-license should be regarded as acquiring an asset, the cost of which may be amortized over its life (in this case, five years). Thus, should the taxpayer choose to sell the license to a third party or choose to abandon the asset, the unamortized portion of the taxpayer's $100,000 basis should be taken into account in determining the amount of gain or loss. Moreover, for purposes of allocating interest expense under section 263A(f) and Treas. Reg. [Section] 1.861-8, the license should be taken into account as an asset to the extent of the taxpayer's unamortized basis.

The same analysis should hold with respect to prepaid rent. See Example 7 under Prop. Reg. [Section] 1.461-4(d)(6).

The application of Prop. Reg. [Section] 1.461-4(d)(3) to contingent payments is unclear. Settled case law provides that if the cost of a license is not determinable, the taxpayer may take a deduction for the yearly contingent payments made under the terms of the license. Associated Patentees, Inc., 4 T.C. 979 (1945), acq. 1959-2 C.B. 3. The economic performance requirement should not be construed as requiring a different result. Thus, the regulations should confirm the continuing validity of the existing rule with respect to contingent payments.

5. Prop. Reg. [Section] 1.461-4(g)(1):

Treatment of Payment as

Constituting Economic

Performance

Prop. Reg. [Section] 1.461-4(g)(1) sets forth rules with respect to those liabilities for which payment must be made in order for economic performance to occur. [7]

a. Payment to a Person Other than

the Person to Whom the Liability

Is Owed

The proposed regulations state that, to satisfy the statute, payment must generally be made to the person to whom the liability is owed. Payment to any other person does not suffice unless there has been a valid assignment to the payee (see Prop. Reg. [Section] 1.461-4(g)(1)(iv)) or the conditions of Prop. Reg. [Section] 1.461-6 (relating to extinguishing or assignment of liabilities by the establishment of a fund) have been satisfied.

The preamble invites comments on whether further exceptions should be made to the rule that payment must be made to the person to whom a liability is owed. (1990-27 I.R.B. at 23.) TEI recommends that the final regulations clarify that the payments rule will be deemed satisfied if payment is made to another person at the direction of the person to whom the liability is owed.

b. Netting of Offsetting Accounts

Prop. Reg. [Section] 1.461-4(g)(1)(ii)(A) defines the term "payment" by reference to the cash receipts and disbursements method of accounting. TEI recommends that final regulations clarify that the netting of offsetting accounts constitutes payment for purposes of the economic performance requirement. Such offsetting constitutes a common, and efficient, business practice among taxpayers that deal in open accounts and engage in transactions going both ways with a settlement at month- or quarter-end.

c. Scope of Limitation on Contingent

Payments Not Constituting

Payment for Purposes of Economic

Performance Requirement

Prop. Reg. [Section] 1.461-4(g)(1)(ii)(A) also provides that "payment does not include an amount transferred as a loan, refundable deposit, or contingent payment with respect to which the taxpayer may be, or become, entitled to receive a refund or credit." (Emphasis added.) TEI recommends that final regulations clarify that the quoted language merely illustrates and does not expand upon the limitations imposed on the scope of the term "payment" by the general reference to the cash receipts and disbursements method of accounting. (8) Absent such a clarification, the regulations might be construed as providing that a payment of estimated state income tax will not be treated as a payment before the close of the statute of limitations for the taxable period, or perhaps, the due date of the return.

Indeed, the language of the proposed regulations might even be interpreted as denying a current deduction for a payment of state income tax on the ground the payment is contingent because the taxpayer may ultimately receive a refund of all or part of one year's tax by reason of net operating loss carrybacks. Such an interpretation, however, would be inconsistent with the rule that cash method taxpayers may treat all payments of state income taxes, including withholding and estimated taxes, as payments in the year paid or withheld despite the fact that all or part of the amounts may be refunded or credited at a later date. See Rev. Rul. 56-124, 1956-1 C.B. 97.

Finally, absent clarification, the quoted language of the regulations might be broad enough to deny a deduction for contributions made under a defined benefit plan on the ground that the employer has the right to receive any surplus asset remaining affter satisfaction of all liabilities under the plan. Such as result would be wrong.

TEI recommends that the final regulations clarify that the foregoing type of expenses will not be treated as contingent payments within the meaning of the limitation imposed by Prop. Reg. $S 1.461-4(g)(1)(ii)(A). At a minimum, the prefatory phrase "in addition" should be deleted from the last sentence of Prop. Reg. $S 1.461-4(g)(1)(ii)(A) to eliminate the inference that the term "payment" is narrower for purposes of the economic performance requirement than for purposes of the cash receipts and disbursements method of accounting.

d. Deemed Payment in Case of

Assumption of Liabilities

Prop. Reg. $S 1.461-4(g)(1)(ii)(C) provides for a deemed payment in the case of liabilities assumed in connection with the sale of a trade or business. TEI believes this is the correct result and recommends that it be made equally applicable to the sale of assets not constituting a trade or business.

6. Prop. Reg. $S 1.461-4(g)(6)(i):

Payment of Taxes

Prop. Reg $S 1.461-4(g)(6)(i) provides that if the liability of a taxpayer is to pay a tax, economic performance occurs as the tax is paid to the governmental authority that imposed the tax. TEI recommends that the regulations be revised to clarify that the witholding of a tax by a withholding agent of the governmental authority constitutes payment to that governmental authority.

7. Prop. Reg. $S 1.461-4(g)(6)

(ii)(B): Exception from

Payment Rule for Certain

Foreign Taxes

Prop. Reg. $S 1.461-4(g)(6)(ii)(B) provides an exception from the economic performance requirement for creditable foreign taxes. The preamble explains that the exception was provided to "preserve the matching principles underlying the foreigh tax credit provisions." Consistent with that decision, the regulations should also provide that, for purposes of computing the earnings and profits of a controlled foreign corporation, economic performance occurs when the requirements of the all events test other than economic performance are met.

8. Prop. Reg. $S 1.461-4(j)(2):

Effective Date in Respect of

Payment Rule

a. Overview

Prop. Reg. [section] 1.461-4(j)(2) provides a special effective date for the regulations in respect of those liabilities for which payment must be made in order for the economic performance requirement to be satisfied -- taxable years beginning after December 31, 1989. TEI believes that the adoption of a prospective-only effective date is perfectly proper, especially given the legislative history of section 461(h) and the long delay in the issuance of regulations.

The preamble, however, disabuses taxpayers of the notion that prospectivity is anything more than an illusion: it coyly "reminds" taxpayers that section 461(h) --

became effective after July 15, 1984, and that for the period beginning after July 18, 1984, taxpayers are not entitled to rely on regulations or rulings that are inconsistent with the general principles of economic performance or with the generic exception for recurring items. (1990-27 I.R.B. at 24.)

Thus, after wrestling with the issue for more than half a decade, the IRS declined to answer it, "officially" leaving open the question of what rule is to be applied to certain liabilities -- in particular, state and local taxes -- during the six-year interregnum between the enactment of the Deficit Reduction Act of 1984 and the promulgation of the regulations. (9)

TEI welcomes the application of the general rule of prospectivity in respect of Prop. Reg. [section] 1.461-4(g). We strenuously object, however, to the application of the payment rule in respect of liabilities incurred prior to the issuance of the regulations, as well as to the IRS's approach to the question of what rule should obtain during the six-year gap between the enactment of the statute and the promulgation of regulations. These two issues are considered separately below. Because the most significant taxpayer concerns relate to the proper treatment of state and local tax liabilities, our comments focus on those liabilities.

b. Proper Treatment of State and

Local Property Taxes under

Section 461(h) Prior to the

Issuance of Regulations

i. General Comments. TEI submits that neither section 461(h) nor its legislative history mandates an abandonment of the IRS's outstanding rulings that state and local taxes are accrued as of the lien (or personal liability) date or the assessment date of those taxes. Consequently, we believe that the retroactive application of regulations overturning such rulings would not only be at odds with the general principles underlying section 7805(b) of the Code, but would also be inconsistent with the legislative history of secton 461(h) which accords taxpayers a right to rely on outstanding rulings pending the promulgation of regulations.

ii. Economic Performance in Respect of State and Local Taxes. At the outset, recognition should be given to the fact that state and local property taxes are not the type of expenses that prompted Congress to enact section 461(h). Thus, we believe the grafting of the economic performance standard on the "all events" test does not require a deferral of the deduction beyond the date on which the deduction would otherwise accrue under the "all events" test. Rather, we believe that regulations under section 461(h)(2)(D) could properly provide that economic performance occurs at the time the tax lien attaches or the tax is assessed.

Such a rule would be consistent with the legislative history of the statute. Specifically, it would comport with the following statement from the report of the Senate Committee on Finance:

The committee expects that these regulations will provide that economic performance might be considered to occur earlier than indicated by the above principles where existing regulations or rulings permit earlier accruals and the taxpayer accounts for such items consistently from year to year. For example, in the case of state and local property taxes, the regulations could provide that economic performance may be treated as having occurred at the time the tax lien attaches or the time the tax is assessed. Thus, the expenses could continue to be accrued at the same time as under present law. [S. Print No. 98-169, supra, at 268 (emphasis added).]

Consequently, TEI recommends that the regulations be revised to provide that payment of state and local taxes is not always necessary in order to have a proper accrual under section 461(h) and, hence, that taxpayers may continue to accrue state and loal taxes under the lien-date or assessment-date method. We recognize that the recurring item exception under Prop. Reg. [section] 1.461-5 ameliorates the unwarranted deferral of the deduction for state and local taxes under the proposed payment test -- see Example 10 under Prop. Reg. [section] 1.461-4(g)(8) -- but we nevertheless recommend that the underlying rule be reevaluated. (10)

iii. The IRS's Authority to Issue Retroactive Regulations. TEI acknowledges that the IRS does not share its view of continuing validity of lien-date or assessment-date accruals under the economic performance test. What particularly concerns us is the possibility that the IRS might seek to impose such a rule retroactively to July 18, 1984. Although the proposed regulations do not explicitly adopt this rule, the preamble's less-than-subtle "reminder" more than intimates that the IRS's position is that the regulations do, in effect, have retroactive effect.

It is true that interpretative regulations are generally applicable on a retroactive basis and, thus, that regulations under sectin 461(h) would generally relate back to the provision's effective date. The legislative history makes clear, however, that taxpayers are entitled to rely on extant rulings until the issuance of economic performance regulations (or, alternatively, the revocation or modification of the rulings). Specifically, the Conference Report states:

Until new regulations are issued under these provisions or the existing rulings are revoked or clarified, taxpayers may continue to rely on these rulings to the extent they are not inconsistent with the general principles of economic performance or the generic exception for recurring items. [H.R. Rep. No. 98-861, supra, at 876 (emphasis added).]

IRS representatives have averred that lien-date and assessment-date accruals are inconsistent with the principles of economic performance and, consequently, that taxpayers could not rely on outstanding rulings that sanctioned such accruals. TEI respectfully disagrees. First, the Senate Committee on Finance expressly anticipated the issuance of regulations deeming economic performance to occur in respect of state and local property taxes "at the time the tax lien attaches or the time the tax is assessed." Indeed, in light of the statement in the Senate Report that regulations could interpret the economic performance standard to "provide that expenses [state and local property taxes] could continue to be accrued at the same time as under present law," we suggest it is somewhat disingenuous to contend that lien-date or assessment-date accruals are inconsistent with "the general principles of economic performance." S. Print No. 98-169, supra, at 268. We further suggest that such accruals are "not inconsistent with . . . the generic exception for recurring items." H.R. Rep. No. 98-861, supra, at 876.

TEI recognizes that the premature accrual provision approved by the Senate (and discussed in the Senate Report) differs from the version of section 461(h) that was ultimately enacted by Congress (and discussed in the Conference Report). We submit, however, that absent any statement to the contrary in the Conference Report, the IRS cannot just facilely assume that the Senate Report should be discarded. After all, the Senate Report does not state that lien-date or assessment-date accruals could be sanctioned under the regulations even though such accruals are inconsistent with "the general principles of economic performance" (the language in the Conference Report); rather, it states that the regulations could provide that economic performance in fact occurs at the time the lien attaches or the time the tax is assessed.

Moreover, even if the legislative history of section 461(h) does not directly sanction taxpayers' continuing reliance on outstanding rulings (at least until the issuance of contrary regulations), we do not believe the IRS can support a claim that lien-date or assessment-date accruals are so clearly inconsistent with the principles of economic performance that the rule in the proposed regulations hould be applied on a retroactive basis. Indeed, the IRS's own actions -- or inaction -- since the enactment of section 461(h) underscores the impropriety of applying the regulations retroactively.

For example, if lien-date or assessment-date accruals were patently inconsistent with the economic performance test, then why did it take the IRS nearly six years to advise taxpayers of the "proper" treatment of state and local property taxes? Why was not a notice or announcement issued immediately (or at least before the passage of more than half a decade), formally alerting taxpayers of that inconsistency and advising them of their inability to rely on outstanding rulings? Stated simply, absent guidance from the IRS, how could taxpayers have been expected to divine that the treatment sanctioned in outstanding revenue rulings was clearly inconsistent with the economic performance requirement?

If the foregoing argument reads too much into the IRS's failure to act (even in light of the statement in the Conference Report confirming taxpayers' right to rely on outstanding rulings in the absence of IRS action), then how are taxpayers to interpret the IRS's express approval of lien-date or assessment-date accruals following the enactment of section 461(h)? Specifically, TEI is aware that the IRS has approved taxpayer requests for permission to change to the lien-date and assessment-date accounting method (from the ratable accrual method under section 461(c)) for taxable years beginning after the effective date of section 461(h). Although other taxpayers may not formally rely on such IRS actions under section 6110(j)(3), we submit they could reasonably conclude that the IRS did not believe lien-date and assessment-date accruals were inconsistent with the general principles of economic performance.

In summary, taxpayers could reasonably have concluded that lien-date and assessment-date accruals were consistent with the economic performance test bases on --

* language in the committee reports;

* the IRS's failure to notify taxpayers that it disagreed with that conclusion (by revoking or modifying outstanding rulings); and

* the IRS's express sanctioning of such accruals by granting permission to change accounting methods.

Consequently, we submit that the Conference Report's injunction that taxpayers should be permitted to rely on outstanding rulings must be followed and, thus, that the regulations under section 461(h) in respect of the accrual of state and local property taxes should expressly apply on a prospective-only basis.

iv. The "Wisdon" of Invoking Section 7805(b). The retroactivity issue properly has two components: (i) whether the IRS has authority ti issue retroactive regulations (which is discussed immediately above), and (ii) whether, notwithstanding any such authority, the IRS should prudently decide not to apply its regulations on a retroactive basis. TEi believes that even if the IRS has the authority to apply the section 461n') regulations in respect of state property taxes retroactively (back to July 18, 1984), it should choose not to do so. Rather, under section 7805(b), the regulations should be applied on a prospective-only basis.

Section 7805(b) has been properly referred to as the tax system's "safety valve" -- as a mechanism by which changes in longstanding rules can be made tolerable if not palatable. We submit it should be used where, notwithstanding the IRS's legal authority to apply a rule retroactively, such a decision would undermine the integrity of the tax system and, concomitantly taxpayer confidence in the fairness of the system.

We acknowledge that the situation in respect of section 461(h) -- a new Code provision -- differs from those cases where the IRS changes its position in the absence of any statutory change (such as is the case, for example, in respect of package design costs). Nevertheless, we submit that in light of the legislative history of section 461(h), as well as the long period of time that has elapsed since the passage of the provision, the principles underlying section 7805(b) should prompt the IRS to apply the regulations on a prospective-only basis. This position is reinforced by our concern that the approach to the retroactivity issue evinced in the proposed regulations will potentially disrupt the audit process.

c. The Efficacy of the IRS's

"Punting" the Retroactivity Issue

As previously stated, by providing that Prop. Reg. [section] 1.461-4(g) would apply only with respect to liabilities otherwise incurred in taxable years beginning after December 31, 1990, the IRS "officially" left open the question of what rule is to be applied to certain liabilities -- in particular, state and local taxes -- during the six-year gap between the enactment of the economic performance requirement and the promulgation of the regulations. TEI objects to the IRS's decision to "punt" on the retroactivity issue: it merely defers a decision on what the applicable rule is during the interregnum and serves to foster audit disputes and litigation.

The clear implication of the "reminder" in the preamble concerning the effective date of the statute is that IRS field agents will apply the proposed regulations on a retroactive basis. Indeed, in some IRS districts examining agents have already taken this position, and we have been informally advised by National Office representatives that field agents are expected to apply section 461(h) (for all open years) in a manner not inconsistent with the proposed regulations. Thus, the IRS has all but invited -- and, indeed, expects -- audit disputes and litigation on the subject.

TEI submits that the IRS's approach -- the promulgation of a prospective rule coupled with a "reminder" effectively warning taxpayers that the rule will apply retroactively -- cannot help but breed taxpayer cynicism about the disrespect for the tax system. The IRS's approach, which arguably betrays a lack of confidence in the technical validity of Prop. Reg. [section] 1.461-4(g), may defer widespread criticism to another day, but it cannot properly be characterized as representing good tax administration.

d. Summary

For the foregoing reasons, TEI strongly recommends that the IRS promptly announce that Prop. Reg. [section] 1.461-4(g) will be applied on a fully prospective basis and specifically confirm that, in respect of state and local tax liabilities otherwise incurred prior to January 1, 1991, taxpayers may deduct such taxes consistent with prior practice if in accord with extant rulings relating to lien-date and assessment-date accruals.

9. Prop. Reg. [section] 1.461-5:

Recurring Item Exception

a. Period with Which Economic

Performance Must Occur

Prop. Reg. [section] 1.461-5 provides rules implementing the recurring item exception of section 461(h)(3) of the Code. For the exception to be available to a taxpayer, section 461(h)(3)(A)(ii) of the Code requires that economic performance must occur within the shorter of --

(1) a reasonable period after the close of such taxable year, or

(ii) 8-1/2 months after the close of such taxable year.

Although the proposed regulations echo the statute's 8-1/2-month rule, [11] they convert the statutory term "a reasonable period after the close of such taxable year" into the following: [12]

The date the taxpayer files a timely (including extensions) return for that taxable year.

The preamble is silent on why the proposed regulations make no reference to the statute's "reasonable period" provision. TEI believes that the regulations should properly provide objective indicia to which taxpayers (and the IRS) can turn in applying the subjective "reasonable period" standard. We question, however, the IRS's effort to completely supplant the statutory standard with a standard tied only to the timely filing of the taxpayer's return. The timely-return standard has no basis in the legislative history of section 461(h) and will spawn unwarranted administrative burdens.

The proposed regulatiosn deny the possibility of economic performance "reasonably" occurring more than 8-1/2 months after the end of the taxable year. We believe such occasions may frequently arise. For example, in many states, a taxpayer's income tax return is due one month after the federal tax return; in such a state, the extended due date for a tax return is October 15 -- 9-1/2 months after the close of the taxable year. Although the economic performance requirement is satisfied by other than the filing of a state income tax return (i.e., by payment of the taxes under Prop. Reg. [section] 1.461-4(g)(6)), we believe that with respect to such liabilities the occurrence of economic performance within 9-1/2 months would satisfy the "reasonable period" prong of section 461(h)(3)(a)(ii).

Thus, 8-1/2 months may well be the "shorter" of the two standards set forth in the statute, and the IRS erred in proposing a rule effectively stating it will always be the longer of the two. Had Congress intended to tie the recurring item exception to the earlier of 8-1/2 months or the timely filing of the tax return, it could clearly have done so.

The proposed regulations can produce harsh results. Assume, for example, a calendar-year taxpayer that is required to pay its state income taxes for Year 1 on April 15 of Year 2. If the taxpayer files its federal income tax return for Year 1 on the original due date of March 15 (of Year 2), the recurring item exception will not be available in respect of the state tax payments under the standard contained in the proposed regulations. [13] TEI acknowledges that the proposed regulations would not totally deny the taxpayer the opportunity to deduct the state taxes in Year 1; in such a case, however, the taxpayer would be required to file an amended return. See Prop. Reg. [section] 1.461-5(b)(2). TEI submits that taxpayers should not be required to assume the administrative burden and expense of filing an amended federal return in such a situation. [14] Rather, TEI recommends that a general 8-1/2-month rule be adopted without regard to the filing date of the taxpayer's return. Alternatively, the IRS could designate certain types of liabilities (e.g., state tax payments) in respect of which economic performance within 8-1/2 months will be deemed to satisfy the requirements of section 461(h)(3)(a)(ii), without regard to when the taxpayer's return is filed.

b. Time and Manner for Adopting

Recurring Item Exception

Prop. Reg. [section] 1.461-5(d) sets forth rules relating to the time and manner for adopting the recurring item exception. TEI submits that the proposed regulations place undue limitations on the adoption of the recurring item exception in respect of taxable years beginning before December 31, 1989.

Specifically, the proposed regulations state if a taxpayer has incurred a type of liability prior to its first taxable year beginning after 1989, then the taxpayer may adopt the recurring item exception but only for years beginning after December 31, 1989. TEI submits that this rule should be liberalized, and that taxpayers should be permitted to adopt the recurring item exception with respect to all open years.

In other words, a taxpayer should not be penalized for failing to adopt the recurring item exception in years prior to the issuance of regulations addressing the scope of the economic performance requirement. The proposed regulations indisputably set forth positions that taxpayers may not have reasonably anticipated; for example, given the legislative history of section 461(h), it was not clear that payment is required before economic performance will be deemed to occur in respect of certain liabilities (such as state and local taxes). See Prop. Reg. [section] 1.461-4(g) and Comment 8. Thus, absent IRS guidance to the contrary, a taxpayer may reasonably have concluded that it was not necessary to elect the recurring item exception in order to preserve the current deductibility of such liabilities under section 461(h). To deny taxpayers in such circumstances the ability to avail themselves of the recurring item exception leaves open the possibility that a harsher rule will be applied to years before the IRS issued guidance than to years after such guidance was provided. [15] This seems especially inappropriate since neither section 461 nor the relevant committee reports make any reference to an affirmative taxpayer obligation to adopt the recurring item exception.

Consequently, TEI recommends that the regulations be revised to provide taxpayers an opportunity to adopt the recurring item exceptions in respect of all open years. We also recommend that the regulations be revised to clarify that a new election need not be made when a new company joins the affiliated group; if the parent corporation has previously elected to adopt the recurring item exception, a new member of the group should be deemed to have made the election.

10. Application of Proposed

Regulations to Items of

Gross Income

a. Overview

The proposed regulations seek to extend the economic performance requirement to the computation of items of gross income under section 61 of the Code, as follows:

* Prop. Reg. [section] 1.446-1(c)(1)(ii)(B) states that "[t]he term liability includes any item allowable as a deduction, cost, or expense for federal income tax purposes. In addition to allowable deductions, the term includes any amount otherwise allowable . . . as a cost taken into account in computing cost of goods sold . . . ."

* Prop. Reg. [section] 1.461-4(g)(3), relating to the treatment of rebates and refunds, states that "[i]f the liability of a taxpayer is to pay a rebate or refund to another person . . . , economic performance occurs as payment is made to the person to which the liability is owed. This paragraph (g)(3) applies to all rebates, refunds and payments or transfers in the nature of a rebate or refund regardless of whether they are characterized as a deduction from gross income, an adjustment to gross receipts or total sales, or an adjustment or addition to cost of goods sold."

* Prop. Reg. [section] 1.61-3(a) states that "an amount cannot be taken into account in the computation of cost of goods sold any earlier than the taxable year in which economic performance occurs with respect to the amount."

TEI submits that the foregoing provisions of the proposed regulations exceed the statutory authority granted to the IRS to implement the economic performance requirement. The proposed regulations disregard the settled and proper distinction that exists between items of gross income under section 61 and section 162 deductions. Because the economic performance requirement was engrafted on the Code as part of section 461 (which applies in respect of deductions), it cannot properly be extended to reach items of gross income (which is governed by section 451). (16)

b. Statutory Framework

Section 63 of the Code defines taxable income as "gross income minus deductions." In addressing the propriety or impropriety of the IRS's effort to extend the reach of the economic performance requirement to the determination of gross income, the following additional provisions of the Code and regulations are relevant:

* Section 61(a)(2), which defines gross income to include gross income derived from businesses.

* Treas. Reg. [section] 1.61-3(a), which provides that "in a manufacturing, merchandising, or mining business, 'gross income' means total sales, less the cost of godds sold . . . ." (Emphasis added.)

* Section 161, which authorizes deductions for items specified in sectins 162 through 196 for computing taxable income under secton 63.

Just as the inclusion of "gross income" and the allowance for "deductions" are governed by separate and distinct provisions of the Code, the taxable year for recognition of those items is governed by separate provisions of the Code, which are contained in Part 2 of Subchapter E, "Accounting Periods and Methods of Accounting." Thus, Subpart B contains section 451, which prescribes the taxable year for which items of gross income are included; and Subpart C contains section 461, which prescribes the taxable year for which deductions are allowed. There is no statutory link which applies section 461 to an item of gross income.

c. Judicial Construction of

Statutory Provisions

The courts have repeatedly affirmed the importance and the validity of the distinct treatment of items of gross income and deductions. They have consistently precluded the IRS from applying tax principles for deductions to itms of gross income and the IRS has acquiesced to those decisions. Moreover, the courts have expressly ruled that section 461 principles are not to be applied to the determination of gross income.

For example, in Pittsburgh Milk Company v. Commissioner, 26 T.C. 707 (1956), illegal rebates wee held to represent adjustments to the sales price of milk and not deductions from gross income. Thus, the IRS's efforts to invoke section 162(c)(2) (which disallows a deduction for such illegal payments) to preclude a reduction in taxpayer's taxable income was rejected. The Tax Court reasoned that section 162(c) was intended to disallow only deductions from gross income and provided no authority to adjust exclusions required to compute gross income. (17)

In an apparent response to Pittsburgh Milk and other cases, Treas. Reg. [section] 1.61-3 was modified to state that gross income is to be determined "without subtraction of . . . amounts which are of a type for which a deducton would be disallowed under section 162(c), (f), or (g)." (A similar change was made to Treas. Reg. [section] 1.471-3.) However, in Max Sobel Wholesale Liquors v. Commissioenr, 69 T.C. 477 (1977), aff'd, 620 F.2d 670 (9th Cir. 1980), and Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1981), the revisions to the regulations were rejected as inconsistent with the Code. (18) In 1982, the IRS acquiesced to this line of cases (1982-2 C.B. 1) and issued Rev. Rul. 85-149, 1982-2 C.B. 56, which explicitly held that price rebates that are illegal payments within the meaning of section 162(c)(2) of the Code when made by the seller directly to the purchaser may nevertheless be subtracted from gross sales to determine gross income, notwithstanding the Treas. Reg. 1.61-3(a).

The irrelevancy of section 461 to the determination of gross income is particularly important in dealing with inventories. In National Home Products, Inc. v. Commissioner, 71 T.C. 501 (1979), the Tax Court determined that casualty losses of inventories were not deductions subject to the "reasonable prospect of recovery" test set forth in Treas. Reg. [section] 1.165-1(d)(2)(i), which determines the year of deductibility of casualty losses under section 165. In National Home Products, the Commissioner had argued that it would be inconsistent to allow inventory losses to be reflected in the cost of goods sold for a year at the end of which there was a reasonable prospect of recovery of such losses while other losses would be disallowed under similar circumstances. The court, however, dismissed that argument out of hand, as follows:

This is simply recognition of the fact that use of inventories in computing gross income for both book and tax purposes is unique and warrants use of different rules to correctly reflect income. (71 T.C. at 530.)

The courts have also explicitly held that section 461 is not to be applied to items of gross income. In Molsen v. Commissioner, 85 T.C. 485 (1985), the Commissioner asserted that the "all events" test of Treas. Reg. [subsection] 1.446-1(c)(1)(ii) and 1.461-1(a)(2) operated to preclude a cotton merchant, in valuing its ending inventory, from accruing an estimated liability at year end for cotton purchased under on-call contracts where the cotton had been delivered but the price had not yet been fixed. In holding that the expense accrual regulations were inapposite, the Tax Court stated:

In our view, the Commissioner's reliance, in part, on section 1.461-1(a)(2) of the regulations is misplaced. Although purchases are an "expense" in the colloquial sense, it is well settled that they are not a "deduction" within the meaning of section 461 and that they are not subject to the rules governing deductions under such section. Purchases are taken into account in computing the cost of goods sold, which is an offset, or exclusion, employed in the computation of gross profit and gross income (section 1.61-3(a), Income Tax, Regs.); whereas, throughout the Code, the term "deduction" is used to refer to amounts subtracted from gross income to arrive at taxable income. [85 T.C. at 502 (emphasis added and citations omitted).] (19)

In summary, the courts have consistently upheld the principle that the provisions of the Internal Revenue Code applicable to deductions do not apply to items of gross income. Thus, absent a clear legislative directive, section 461(h) should not be applied to provisions of the law not otherwise affected by section 461.

d. Legislative Intent in Enacting

Section 461(h)

The legislative history of the economic performance requirement provides no support for the proposition that Congress, in enacting section 461(h), intended to override the established tax policy distinction in the treatment of items of gross income versus deductions. To the contrary, the legislative history confirms that the purpose of section 461(h) is to prevent revenue loss resulting from the deduction of expenses prior to "economic performance."

Thus, the House Report on the Tax Reform Act of 1984 explained the reasons for adopting the economic performance requirement, as follows:

The committee believes that the rules relating to the time for accrual of a deduction by a taxpayer using the accrual method of accounting should be changed to take into account the time value of money. Recent court decisions in some cases have permitted accrual method taxpayers to deduct currently expenses that are attributable to activities to be performed or amounts to be paid in the future. [H.R. Rep. No. 98-432, supra, at 1254 (emphasis added).]

All of the court decisions cited in the House Report (20) addressed the issue of when to accrue section 161 deductions. None dealt with section 61 items of gross income. Making its concern crystal clear, the House Report framed the "Reasons for Change," as follows:

The committee believes that the rules relating to the time for accrual of a deduction by a taxpayer using the accrual method of accounting should be changed to take into account the time-value-of-money. . . . The committee is concerned about the potential revenue loss from such overstated deductions. [H.R. Rep. No. 98-432, supra, at 1254 (emphasis added).] (21)

Thus, the legislative history establishes without doubt that the purpose for enacting section 461(h) was to reverse case law liberalizing the timing of deductible expenses under section 461. TEI submits that absent specific evidence of congressional intent to expand the scope of section 461, such an expansion by administrative fiat is impermissible. As the Tax Court stated in Max Sobel, supra:

If Congress has intended to overrule the Pittsburgh Milk case, it is only reasonable to expect that the amendment would have been more specific in so doing or that the congressional intent would find expression in the Report of the Finance Committee accompanying the bill. No mention of any such intent is made in the Report of the Finance Committee accompanying the bill. S. Rept. 92-437, 92d Cong., 1st Sess. 72-73. (69 T.C. at 484-85.)

In other words, clearly established principles of law cannot be jettisoned from the tax law on the whim of the IRS in order to combat some perceived or chimerical abuse.

e. Summary

For the foregoing reasons, TEI submits that the portions of the proposed regulations relating to items of gross income should be withdrawn.

CONCLUSION

Tax Executives Institute appreciates this opportunity to present our view on the IRS's proposed regulations relating to the economic performance requirement of section 461(h) of the Internal Revenue Code. If you have any questions about the Institute's comments, please do not hesitate to call Lester D. Ezrati, chair of TEI's Federal Tax Committee, at (415) 857-2089 or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at (202) 638-5601.

(1) Accord S. Print No. 98-168, 98th Cong., 2d Sess. 266 (1984) (Report of the Senate Committee on Finance).

(2) Ironically, under the final legislation, these items are governed not by the general rules of section 461(h) but by more targeted provisions of the Code. Thus, an accrual of mining and solid waste reclamation and closing costs is governed by section 468; nuclear decommissioning costs are addressed by section 468A; and section 468B sets forth special ru les in respect of designated settlement funds. Workers compensation and tort liabilities are specially treated by section 461(h)(2)(C), which provides that economic performance in respect of such expense items occurs as payment is made.

(3) Accord H.R. Rep. No. 98-861, 98th Cong, 2d Sess. 873 (1984) (Conference Report on the Deficit Reduction Act of 1984) (recurring item exception is intended to "avoid disrupting normal business and accounting practices and imposing undue burdens on taxpayers").

(4) Section 404(a)(6) provides that a taxpayer shall be deemed to have made a payment on the last day of the preceding taxable year if the payment is on account of such taxable year and made within the extended due date of the return for such taxable year. TEI believes that the economic performance regulations should give force to this statutory provision by clarifying its controlling character in respect of the payment rule.

(5) The example set forth in Prop. Reg. [section] 1.461-2(f)(3), which essentially requires a double inclusion of income, underscores the illogical nature of the rule set forth in the proposed regulations. Although the result in the example has been justified on the ground that the regulations represent the IRS's effort "to devise a system that gives the taxpayer neither an advantage nor disadvantage to setting up a fund," that is not the result of rules requiring taxpayers at once (i) to recognize income upon the transfer of property to the fund and further (ii) to include in income any income earned by the fund. See Evans, IRS' Kempson Explains Contested Liabilities under Economic Performance Test, Tax Notes 1463 (Sept. 17, 1990) (interview with Kenneth Kempson, IRS Deputy Associate Chief Counsel (Technical)).

(6) The example in Prop. Reg. [section] 1.461-2(f)(3) would also have to be revised to state that the taxpayer's deduction under section 461(f) would be equal to the adjusted basis of the transferred property ($7,000).

(7) With respect to whether payment of state and local taxes is required in order to have a proper accrual under the economic performance requirement, see Specific Comment No. 8.b.

(8) An expansive interpretation of Prop. Reg. [section] 1.461-4(g)(1)(ii)(A) is suggested by the use of the words "[i]n addition" immediately before the quoted language.

(9) See Evans, IRS's Kempson Explains Contested Liabilities under Economic Performance Test, tax Notes 1463 (Sept. 17, 1990) (interview with Kenneth Kempson, IRS Deputy Associate Chief Counsel (Technical), which states "[Mr. Kempson] indicated that the treatment in the period between enactment of section 461(h) and the effective date of the regulations remains an open question.").

(10) At a minimum, the IRS should liberalize the rule set forth in Prop. Reg. [section] 1.461-5(d) relating to the time with which a taxpayer may adopt the recurring item election. Specifically, as explained more fully in Comment 9.b., TEI submits that taxpayers should be permitted to elect the recurring item exception with respect to all open years; a taxpayer's ability to avail itself of the statutorily granted exception should not be limited to taxable years beginning after December 31, 1989.

(11) The proposed regulations render the statutory phrase, as follows: "the 15th day of the 9th calendar month after the close of that taxable year."

(12) We note that although the proposed regulations (and the statute) use the disjunctive "or" in setting forth the two events to which economic performance is tied, the conjunctive term "and" is the gramatically proper word.

(13) Although many corporate taxpayers not do file their returns until the extended due date of September 15 (8-1/2 months after the end of the taxable year), it is not at all unusual for taxpayers to file their returns before that extended due date. Among the reasons for the "early" filing of returns are the desire to obtain a more timely refund of overpaid taxes or the quicker utilization of net operating loss of credit carrybacks.

(14) We note that the Internal Revenue Code imposes no requirement on taxpayers to file amended returns and, further, that a taxpayer's filing of an amended return in order to avail itself of the recurring item exception could necessitate a taxpayer review of all items in the return -- not simply those implicated by the recurring item exception.

(15) For example, Prop. Reg. [section] 1.461-(h) provides that, notwithstanding Prop. Reg. [section] 1.461-4(d) relating to liabilities arising out of the provision of services, property, or use of property, economic performance with respect to liabilities of a taxpayer to make payments under the Nuclear Waste Policy Act of 1982 occurs as each payment is made. (Under that Act, owners or generators of nuclear waste make quarterly payments to the Department of Energy based on kilowatt hours generated using nuclear fuel.) A taxpayer's liability for such payments clearly falls within the recurring item exception, so that a payment made in the first quarter of a year (based on kilowatt hours generated in the last quarter of the prior year) would be deemed incurred in the prior year. Nevertheless, under Prop. Reg. [section] 1.461-5(d), a taxpayer that had not already made an election to adopt the recurring item exception would be denied an opportunity to deduct such expenses in accord with the favorable rule set forth in Prop. Reg. [section] 1.461-4(h) and the recurring item exception beginning before January 1, 1990. (Prop. Reg. [section] 1.461-4(j)(1) provides that Prop. Reg. [section] 1.461-4(h) is effective for liabilities incurred after July 18, 1984.)

(16) We recognize that the recurring item exception will operate to ameliorate the effect of the IRS's improper extension of the economic performance requirement to the determination of items of gross income. We nevertheless object to the proposed regulations, which also apply in respect of the determination of capitalized cost (basis). See 1990-27 I.R.B. at 24 ("the estimated cost of future improvements to subdivided real estate may not be added to the basis of lots sold if economic performance has not occurred with respect to those costs."). In this regard, we note that the promulgation of the proposed regulations has prompted legislative proposals to clarify the nonapplicability of section 461(h) to the determination of basis. S. 3039 (Real Estate Tax Basis Calculation Technical Correction Act of 1990) (introduced by Senator Pryor).

(17) See also Rosedale Dairy Co. v. Commissioner, 16 T.C.M. 1121 (1957); Harmony Dairy Co. v. Commissioner, 19 T.C.M. 582 (1960); Atzingen-Whitehouse Dairy, Inc. v. Commissioner, 36 T.C. 173 (1961); Bloomingdale Dairy Co. v. Commissioner, 20 T.C.M. 575 (1961); Haas Brothers, Inc. v. Commissioner, 73 T.C. 1217 (1980); Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1981).

(18) In Dixie Dairies, the Tax Court held that "if Congress had intended to overrule Pittsburgh Milk Co. by the enactment of section 162(c)(2), it would have been more specific in doing so. We agree with that assessment." 74 T.C. at 491-92.

(19) The court also noted that the regulations recognize that in some industries, the "all events" test is not to be applied in determining the costs of inventories, citing Treas. Reg. [section] 1.471-6, which permits livestock raisers and farmers to value livestock inventory under the "unit-livestock-price method," and Treas. Reg. [section] 1.471-8, which permits the retail method of accounting for inventory. See 85 T.C. at 503-04.

(20) The House Report cited the following cases: Spencer, White & Prentis, Inc. v. Commissioner, 144 F.2d 45 (2d Cir. 1944); Harold v. Commissioner, 192 F.2d 1002 (4th Cir. 1951); Crescent Wharf & Warehouse Co. v. Commissioner, 518 F.2d 772 (9th Cir. 1975); Lukens Steel Co. v. Commissioner, 442 F.2d 1131 (3d Cir. 1971); Mooney Aircraft, Inc. v. United States, 420 F.2d 400 (5th Cir. 1969); and Kaiser Steel Corp. v. United States, 411 F.2d 235 (9th Cir. 1983). H.R. Rep. No. 98-432, supra, at 1252-53; accord S. Print No. 98-169, supra, at 264-65.

(21) Accord S. Print No. 98-169, supra, at 266.
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