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Section 461(d): a code section whose time has gone.

The Issue

Section 461(d) of the Internal Revenue Code of 1986 is captioned "Limitation on Acceleration of Accrual of Taxes." It provides, in part:

In the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction...then...such taxes shall be treated as accruing at the time they would have accrued but for such action by such taxing jurisdiction....

The purpose of section 461(d) is to prevent a change in a taxing authority's law (other than a federal law) from causing the acceleration of the deductibility of a tax expense into an earlier year than that which would have been the case under the prior law. The statutory provision was originally intended to prevent the acceleration of property tax deductions. It has, however, been applied to the accrual of income taxes. As a result, California taxpayers-as well as others--bear an inequitable federal tax burden. In addition, the specific deduction requirements of section 461(d) create unusual and impractical results. With the addition of section 461(h)'s economic performance standard to the Code in 1984, taxpayers are provided by law and regulation with specific guidance on when all types of taxes are deductible. Section 461(d), hence, is a section of the Code whose time has come: It should be repealed.

The Harsh Result in Rev. Rul. 79-410

To place this issue in perspective, it is necessary to review the law and regulations as they existed prior to the 1984 enactment of section 461(h). The California Bank and Corporation Franchise Tax (CFT) is an annual tax imposed for the privilege of doing business in the State. Its treatment under the prior law and regulations is well summarized in Rev. Rul. 79-410, 1979-2 C.B. 213. The Law and Analysis section of the ruling discusses how section 461 (prior to its amendment in 1984) applies to the CFT. Section 461 is entitled "General Rule for Taxable Year of Deduction" and subsection (a) of section 461 provides that "[t]he amount of any deduction or credit allowed by this subtitle shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income." Rev. Rul. 79-410 concludes that the CFT, as it existed prior to 1966 and 1972, was (in whole prior to 1966 and in part prior to 1972) a "prepaid" tax. Thus, the CFT based on income in year 1 was levied for the privilege of doing business in year 2 (the "privilege year"), and the tax based on the income in year 2 was for the privilege of doing business in year 3, and so on.

Under this analysis, the CFT accrued on the books during year 1 was, pursuant to section 461, properly chargeable to a prepaid asset account and not deductible until the subsequent "privilege" year. For years subsequent to 1971, California law no longer calls for the "prepayment" of the CFT and Rev. Rul. 79-410 appropriately concludes that (under the general rule of section 461) the tax expense for CFT accrues in the "income year" on which that tax is based. Thus, the CFT is no longer chargeable to a prepaid account with the deduction deferred until the "privilege year" but rather is appropriately a current expense in year 1 as accrued in year 1. As such, it should be deductible in year 1.

And it would be, except for section 461(d). As previously noted, section 461(d) is intended to prevent a change in state law from triggering the acceleration of the federal deductibility of a tax expense. In the case of the CFT, absent section 461(d), the 1972 change in the CFT law would have caused both the 1971 and the 1972 CFT to accrue for federal tax purposes in 1972. Under section 461(d), however, taxpayers were required to continue deducting the CFT as though the 1972 (and other post1960) law changes did not occur. Thus, Rev. Rul. 79-410 concludes that even though the California law had changed, taxpayers must continue deducting the CFT as though the tax is a prepayment for doing business in the upcoming year (the "privilege year" method).

Rev. Rul. 79-410 goes one step further. Using the term "California tax year" to describe the year in which CFT is deductible under pre-1972 California law, the ruling concludes:

For federal income tax purposes the California franchise tax continues to accrue in the California tax year. This is true for corporations that were subject to the tax prior to 1972 and corporations commencing the conduct of business in California after 1971....(Emphasis added.)

In other words, the CFT is never deductible by an accrual basis taxpayer under any method other than that which was proper under California law as it existed prior to the 1966 and 1972 changes. This conclusion is based on Treas. Reg. [section] 1.46-1(d)(1), which provides:

Any such action which, but for the provisions of section 461(d) and this paragraph, would accelerate the time for accruing a tax is to be disregarded in determining the time for accruing such tax for purposes of the deduction allowed for such tax. Such action is to be disregarded not only with respect to a taxpayer (whose taxable income is computed under an accrual method of accounting) upon whom the tax is imposed at the time of such action, but also with respect to such a taxpayer upon whom the tax is imposed at any time subsequent to such action....(Emphasis added.)(1)

Genesis of Section 461(d)

Section 461(d) was enacted to prevent taxpayers from obtaining a double deduction for property taxes in the year that their state taxing authorities changed the lien date of such State taxes to the last day of the income year (year in which the income was earned and for which the tax return is filed) from the first day of the privilege year (year following the income year, also known as the "taxable year"). This is clearly evidenced by the legislative history of Public Law No. 86-781, which was enacted in 1960. The Conference Report on that law provides:

Several States in recent years have changed this accrual date from January 1 to December 31 in order to provide an extra accrual date for State taxes. This amendment, which would be effective for years after 1960 and thus put the State and taxpayers on proper notice, would change the law to provide for only one accrual for State taxes in any one taxable year where the State legislature has changed the accrual date, and would thus eliminate the additional deduction available under existing law.

H.R. Rep. No. 2213, 86th Cong. Ist Sess. 905 (1960) (emphasis added). Unfortunately, the drafters of section 461(d) wrote the statutory provision so broadly that it encompasses any type of tax and did not limit its application to situations where there was an attempted double deduction of taxes.

Section 461(d) and the Hitachi Case

In Hitachi Sales Corp. of America v. Commissioner, T.C. Memo 1992-504, the California-based taxpayer deducted its March 31st CFT accrual on each of its 1982, 1983, and 1984 tax returns. The Internal Revenue Service disallowed the deductions for such franchise taxes on the grounds that an accrual was not permitted by section 461(d) and the pertinent regulations.

At trial, the IRS and taxpayer stipulated that Hitachi had consistently accrued and deducted its CFT on the last day of the income year. They also stipulated that the IRS had been inconsistent in its position on when the CFT is deductible.(2) In essence, Hitachi and the IRS agreed that for the fiscal years March 31, 1982 through 1984, Hitachi had deducted its CFT in accordance with section 461(a)'s all-events test(3)--namely, on the last day of the income year. The parties disagreed, however, on whether section 461(d) prevented accrual of such taxes until the following year. The dispute thus centered on the applicability of section 461(d). Judge Halpern held for the Commissioner, thereby denying Hitachi the deduction, even though Hitachi was not attempting to deduct two years' taxes in a single year.

Judge Halpern explained that "we must assume that Congress knew how to draft a statute limited solely to double dip years and that the fact that the statute was not so drafted was intentional on the part of Congress."

Hence, the wording of section 461(d) was the controlling factor in the decision in the Hitachi case, not the purpose of the provision or the inequity visited upon the taxpayer by the Tax Court's decision. No consideration was seemingly given to the proper matching of income and expense or to the fact that denying the deduction for CFT resulted in a year where income was not clearly reflected. Taxpayers paying the CFT are thus being penalized as a result of a poorly drafted statutory provision that was enacted in response to what was perceived to be an organized raid on the federal risc by the States.

Other States Taxes and Section 461(d)

What can be applied to California taxes can also applied to taxes imposed by other States. In fact, it already has--to a taxpayer that applied for a change in its method of accounting for the Maryland Gross Receipts Tax. Specifically, in General Counsel Memorandum 39590 (Dec. 4, 1986), the IRS Office of Chief Counsel opined:

We agree with the position of the Corporate Tax Division that under section 461 and the all events test of Treas. Reg. Sec. 1.461-1(a)(2), the taxpayer should properly accrue and deduct the gross receipts tax imposed by the State of Maryland in the calendar year following the end of the income year. We reach this conclusion, because section 461(d) requires that, in the case of accrual basis taxpayer, to the extent any action of a taxing jurisdiction taken after December 31, 1960, accelerates the time for accruing a tax liability, then such taxes shall be treated as accruing at the time they would have accrued but for such action of the taxing jurisdiction.

In reaching this conclusion, the IRS discussed how the Maryland Gross Receipts Tax had been amended several times since December 31, 1960, but that prior to that date the tax had been calculated on the basis of gross receipts for the preceding calendar year and payable in the then-current taxable year.

Thus, in Maryland (as in California) a situation exists under which the deductibility of a state tax must be based on an extinct law. Were the timing of the deduction to be based on current law, it is clear that the Maryland Gross Receipts would be deductible as accrued in the current (income) year.

Like Judge Halpern's decision in Hitachi, General Counsel Memorandum 39590 implicitly recognized that the result was at odds with, or at least went beyond, what Congress intended in enacting section 461(d)--the double dip:

Furthermore, although section 461(d) was aimed at the problem of accruing two years' tax in one year, the language of the section itself is broader in that it applies to any action that will accelerate tax...Thus, by its language...section 461(d) applies to any acceleration of the time for accruing state tax, even if there is...no potential problem of taxpayer claiming two years' state tax in one year.

Therefore, because we have concluded that section 461(d) is applicable to any action causing an acceleration of the time for accruing state taxes regardless of the motivation for the action and regardless whether a section 481 adjustment would be made, we conclude that...section 461(d) bars the accrual of the Maryland gross receipts tax until the calendar year following the income year.

The Relevance of Section 461(h)

Section 461(h) adds a new dimension to the deductibility of accrued liabilities, and it underscores the superfluity of section 461(d). Paragraph (1) of section 461(h) pronounces a general rule that "the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs."(4) Paragraph (2) sets forth several principles governing when economic performance occurs but also contains a broad (and overriding) grant of regulatory authority to the Secretary of the Treasury. Thus, under section 461(h), a liability is deductible if it meets the above described all-events test and economic performance has occurred as defined in the regulations.

With respect to the CFT, the all-events test is certainly satisfied by the end of the year for which the tax is to be paid. As Rev. Rul. 79-410 recognized, but for section 461(d), the CFT (as currently structured) as determined on the income of year 1 is accruable and deductible in year 1 (the income year). In other words, if the deductibility of the CFT in the income year were determined under section 461(h), the question would turn only on whether economic performance occurs in the income year. A review of the applicable regulations demonstrates that it likely does.

Treas. Reg. [section] 1.461-4 (which was promulgated on April 9, 1992) prescribes rules on when economic performance occur. Subsection (g) describes certain liabilities for which economic performance has not occurred until the liability is paid, with paragraph (6) specifically addressing taxes:

[I]f 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.. ..[P]ayments includes payment of estimated income tax and payments of tax where the taxpayer subsequently files a claim for credit or refund.... In certain cases, a liability to pay tax is permitted to be taken into account in the taxable year before the taxable year during which economic performance occurs under the recurring item exception of [section] 1.461-5.

Clearly, under section 461(h) and Treas. Reg. [section] 1.461-4, the CFT is deductible when paid.

The recurring item exception mentioned in Treas. Reg. [section] 1,461-4(g)(6) is set forth in section 461(h)(3) and provides, in pertinent part:

[A]n item shall be treated as incurred during any taxable year if--

(i) the all events test with respect to such item is met during such taxable year,

(ii) economic performance with respect to such item occurs within the shorter of - (I) a reasonable period after the close of such taxable year, or

(II) 8 months after the close of such taxable year,

(iii) such item is recurring in nature and the taxpayer consistently treats items of such kind as incurred in the taxable year in which the requirements of clause (i) are met, and

(iv) either--

(I) such item is not a material item, or

(II) the accrual of such item in the taxable year in which the requirements of clause (i) are met results in a more proper match against income than accruing such item in the taxable year in which economic performance occurs.

Based on the foregoing analysis of the all-events test and economic performance regulations, a reasonable argument can be made that the CFT under current California law would qualify for current deductibility under the recurring item exception. There does not appear to be any question that the liability for CFT is fixed and determinable by the end of the income year. Section 461(h) requires that a tax must actually be paid in order for economic performance to occur. CFT is generally paid during the income year in the form of estimated tax payments. If CFT is deemed a recurring item--which seems reasonable--any payments of CFT made within 8 months after the end of the income year should also be deductible in the income year. Deduction of CFT in the income year certainly results in a more proper match against income than deducting it in the subsequent year as prescribed by section 461(d). In addition, CFT is generally deducted in the income year for financial statement purposes.

In 1984, Congress enacted the economic performance standard to restrict taxpayer's ability to deduct prematurely certain deductions. Section 461(h) (and the pertinent regulations) set forth comprehensive rules tO effectuate congressional intent. It appears certain that the rules in section 461(h) are sufficient to prevent any taxpayer abuse (or perceived abuse) in the timing of the deduction for CFT. (For example, section 461(h) prevents double deductions by requiring amounts to be spread over a specified period as a section 481 adjustment.)

Conclusion

Section 461(d) has outlived its usefulness and operates not only to subvert the general scheme of section 461(h) but to exact effecting harsh and unreasonable results (as in Hitachi and General Counsel Memorandum 39590). Surely, section 461(d) (as interpreted in Rev. Rul. 79-410) causes strange results. A new corporation must refer to California (or other States') law as it was in December 31, 1960, to determine when a tax becomes deductible, even if the law has been changed many times in the interim.5 The absurdity of such a rule is patent. In light of section 461(h), the special rule for the accrual of taxes in section 461(d) should be repealed. Section 461(h) is consistent with generally accepted accounting principles as it relates to the proper deducting of the California Franchise Tax (and other taxes) and represents current legislative thinking as to the timing of the deduction for such taxes.

1 The California law was changed in 1972 in part to correct a state abuse where a profitable corporation could pay no tax, other than the minimum tax, in the year of liquidation. Since, under the law at that time, a corporation had to be in existence on the first day of the privilege year to owe the tax, a profitable corporation could liquidate before year-end and never pay the tax on the profit it earned during its last income year. Under current law, in the year a corporation liquidates, it must now pay tax based in part on the earnings during its last income year (the year in which the corporation liquidates).

2 The IRS first applied the accrual method of accounting to CFT in Rev. Rul. 68-305, 1968-1 C.B. 213, holding that the taxes could be deducted in the income year. This position was sustained by the IRS's Examination Division in 1977 (and endorsed by the Los Angeles District Director), even though California's law had been amended in 1972. Later, however, the IRS announced in Rev. Rul. 79-410 that the accrual method could not be used for CFT, even though the tax is due on the last day of the income year and is calculated based on income earned entirely within the income year.

3 Treas. Reg. [section] 1.461-1(a)(2).

4 I.R.C. [section] 461(h)(4) states that "[f]or purposes of this subsection, the all events test is met with respect to any item if all events have occurred which determine the fact of a liability and the amount of such liability can be determined with reasonable accuracy."

5 Section 461(d) virtually invites noncompliance by new companies or companies expanding into new States. Will they be able to investigate fully the changes that have been made to the States' taxing schemes to ascertain whether a change subsequent to December 31, 1960, alters when the taxes paid to the States may be deducted?
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Author:Nissen, Russell C.
Publication:Tax Executive
Date:Jan 1, 1994
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