Although many buyers are aware of how revenue recognition and deferred revenue affect a company’s earnings, the tax implications of deferred revenue are often overlooked. Deferred revenue can affect post-close income tax liability, how both sides value net operating losses (NOLs) in negotiations, the timing of certain deal mechanics and more.

We explain below some key buy-side deal considerations when purchasing or investing in a corporate target that has material deferred revenue. These concepts are often relevant for acquisition targets in the technology industry but can be relevant for any corporate target with deferred revenue.

While the fact patterns discussed below are simplified for ease of illustration, they are representative of the dynamics present with respect to income taxes in many technology company acquisitions.

Tax-deferred revenue, in general

Internal Revenue Code section 451(b)¹ and Treasury Regulations section 1.451-3 provide that, if a taxpayer uses an accrual method of accounting for federal income tax purposes and has an applicable financial statement (AFS)², the all-events test under Treas. Reg. section 1.451-1(a) for any item of gross income, or portion thereof, is met no later than when that item, or portion thereof, is taken into account as AFS revenue.

This provision essentially requires accrual-basis taxpayers to recognize income at the earliest of when cash is received, a taxpayer has a right to bill for cash, or income is recognized for AFS purposes (as amounts are typically considered earned when a performance obligation is considered satisfied under ASC 606).

An exception to this rule exists under IRC section 451(c) and Treas. Reg. section 1.451-8, which allows taxpayers to choose a deferral method and recognize as income only a portion of such advance payment in the taxable year in which it is received, thereby deferring the recognition of the remainder to the following taxable year if such income is also deferred for AFS purposes.

Applying this election to a typical technology company, a taxpayer may enter into a software subscription contract for 36 months, billed at contract signing. While AFS will typically recognize this income ratably over the term of the contract, and tax rules will generally say that the entire amount is income upon signing under a full-inclusion method, if a one-year deferral method is elected, tax would recognize one-third of the contract income in year one (similar to AFS), and the remaining two-thirds in year two (assuming full calendar year tax periods).

Depending on how a transaction is structured, a taxpayer may have one or more short tax years³. In general, short tax years are treated as tax years for purposes of applying IRC section 451(c) and Treas. Reg. section 1.451-8.

This can result in the recognition of advance payments in taxable income before they otherwise would be, as the recognition of advanced payments generally cannot be deferred beyond the next succeeding tax year following receipt. An exception exists under Treas. Reg. section 1.451-8(c)(6) when the next succeeding tax year is 92 days or less in length. The impact of these concepts will be illustrated in the examples below.

Additionally, in the context of a transaction, taxpayers should be aware that AFS may adjust or write down deferred revenue to fair market value for opening balance sheet purposes. Assuming the transaction is not structured as a taxable event for tax purposes, the write-down could result in an acceleration of income, as amounts can only be deferred for tax to the extent that they are also deferred for AFS⁴.

Note that the above rules differ slightly for taxpayers without an applicable financial statement but are generally analogous to the above. Outside the scope of this article, the AFS income inclusion rule does not apply to items of income for which the taxpayer uses a special method of accounting, such as the installment method or long-term contract rules.

Deferred revenue: ‘Your watch, my watch’

Responsibility for income taxes in middle market M&A transactions commonly is determined by “your-watch, my-watch” construct.

Broadly speaking, tax liabilities for pre-closing periods are computed assuming a closing of the books on the transaction date. Sellers are responsible for any resultant pre-closing income tax liability, often through inclusion of the same in indebtedness. Buyers, in turn, through their ownership in the company, are responsible for the income taxes in post-closing periods.

Deferred revenue is a complicating factor when negotiating and applying a your-watch, my watch construct. Although the company has received an advance payment in a pre-closing period, the revenue—and therefore the associated tax liability—will be recognized in a post-closing tax period. Absent specific purchase agreement provisions to the contrary, the buyer will ultimately bear the cost of the income taxes. The result might be viewed as inequitable from a buyer perspective, especially if the sellers receive credit for closing cash, which is not uncommon.

Accordingly, a buyer should consider negotiating to place on the sellers the responsibility for income taxes resulting from closing date deferred revenue.

Net operating losses and IRC section 382

In many middle market M&A technology deals, a target corporation will have NOLs. While this tax attribute belongs to the target corporation and will potentially be available to reduce cash taxes in post-closing periods, buyers should be aware that section 382 imposes limitations on the amount of NOLs a corporation can utilize in a given year.⁵ A target corporation may have preexisting section 382 limitations on their NOLs, and in many circumstances, a limitation will also be triggered by the transaction itself.

When a corporation undergoes a change in ownership, a section 382 limitation must be calculated. The yearly limitation use of NOLs in post-change periods is based on the adjusted equity value of the corporation on the date of the change, multiplied by the applicable federal rate (AFR) effective in the month of the change.

Additionally, a corporation may increase its section 382 limitation in each of the first five years post-change to the extent the corporation is a net unrealized built-in gain (NUBIG) corporation and has recognized built-in gains (RBIGs) in the five-year recognition period.

A corporation has a NUBIG to the extent that the aggregate fair market value (FMV) of its assets exceeds its aggregate tax basis in its assets on the date of ownership change, subject to certain adjustments and a de minimis threshold.⁶

RBIG is determined on an asset-by-asset basis. A corporation will have RBIG if:

i)    An asset has a built-in gain on the change date (i.e., FMV in excess of its tax basis).

ii)   That built-in gain is subsequently recognized in taxable income during the five-year recognition period. The aggregate RBIG increasing a corporation’s section 382 limitation in the five-year recognition period is limited to NUBIG.

Under the IRC section 338 approach in Notice 2003-65, a corporation may also calculate RBIG by comparing the actual tax depreciation or amortization on an asset in the five-year period to a hypothetical depreciation or amortization, calculated assuming the asset was placed in service at FMV on the change date. This rule is often beneficial for technology companies, many of which have minimal inside basis in their assets, but have significant value in self-created technology and other intangible assets.⁷ Please note that a detailed discussion of Notice 2003-65 is beyond the scope of this article.

Interaction between deferred revenue and section 382

Understanding and anticipating the interaction between deferred revenue and section 382 limitations is critical in negotiating the tax provisions of a purchase agreement and planning for cash taxes.

A buyer may look at a company’s deferred revenue and NOL balances and incorrectly assume that, while they will need to recognize the deferred revenue in a post-closing period, the seller is delivering them more than enough NOLs to offset the income. Even in situations where closing date NOLs far exceed closing date deferred revenue, the timing of revenue recognition and NOL availability may lead to unexpected consequences.

In this example, we see that, although the amount of closing date NOLs easily exceeds the closing date deferred revenue, the section 382 limitation creates a potential cash tax leakage.

Note that Treas. Reg. section 1.382-7 provides that deferred revenue is not RBIG, and thus does not increase the section 382 limitation.¹⁰ Correlatively, deferred revenue is also not included in the NUBIG calculation.¹¹

Short tax years and book write-down

As noted above, for tax purposes, deferred revenue under a one-year deferral method generally must be recognized no later than the tax year following the year of receipt. An important exception exists when a short tax year is 92 days or less. In that instance, deferred revenue as of the beginning of the tax period only needs to be recognized to the extent it is recognized in the taxpayer’s financial statements.

Although a discussion of financial accounting requirements is beyond the scope of this article, it is common that upon an acquisition to which purchase accounting applies, there will be a write-down of deferred revenue for financial accounting purposes.

For tax purposes, this write-down is treated as a recognition of that revenue for book purposes (in that AFS is no longer deferring the revenue), which causes the acceleration of tax-deferred revenue. The impact of this rule can be particularly pronounced when dealing with a short period near the end of a taxable year.

As this example shows, the book write-down, coupled with limited NOL availability in the two-month short period, creates tax consequences that could be rather unexpected and detrimental.

Other key considerations

Though beyond the scope of this article, buyers should also be mindful of three recent changes affecting the tax posture of technology companies:

• Under IRC section 174, as amended by the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers are required to capitalize and amortize specified research expenditures. Costs attributable to domestic research are amortized over five years, while costs attributable to non-U.S. research are amortized over 15 years. Significantly, capitalizable costs include both traditional research and development, as well as computer software development expenditures.
• Under IRC section 163(j), for tax years beginning after Dec. 31, 2021, the allowable interest expense deduction under section 163(j) is limited to 30% of tax basis EBIT (earnings before interest and taxes). Previously the limitation was based on 30% of tax basis EBITDA (earnings before interest, taxes, depreciation and amortization).
• Beginning on Jan. 1, 2023, bonus depreciation will phase down from 100% to 80%, limiting the amount of depreciation a buyer can claim on assets placed in service in the tax year.

These changes may significantly increase a company’s taxable income, putting an increased emphasis on section 382 limitations.

Conclusion

Buyers of technology companies should consider the income tax impact of closing date deferred revenue in deal economics, cash tax modeling and tax attribute valuation. The ability of NOLs to offset the inclusion of closing date deferred revenue in taxable income, or other operating income, is limited by section 382 in many instances. The interaction between timing rules for inclusion of deferred revenue and NOL availability should be considered in order to anticipate any unexpected cash tax liabilities.

^{[1] Section references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.
[2] As defined in IRC section 451(b)(3).
[3] A common example of this is when a corporate taxpayer joins or leaves a federal consolidated return group. Treas. Reg. section 1.1502-76(b)(1)(ii)(A).
[4] Treas. Reg. sections 1.451-3(k), 1.451-8(c)(5).
[5] See generally, IRC section 382(a).
[6] IRC section 382(h).
[7] Note that proposed regulations under Treas. Reg. section 1.382-7 (revised Jan. 14, 2020), if passed in their current form, would eliminate the ability to calculate RBIG in this manner. This would likely have a significant impact on the usability of NOLs post-closing in many technology deals. The applicability date of the final regulations (if and when issued) will be 30 days after the date the Treasury decision containing such final regulations is published in the Federal Register (delayed applicability date). Until such delayed applicability date, Notice 2003-65 will remain applicable to ownership changes to which the final regulations do not apply.
[8] Note that in most cases a corporation’s equity value for purposes of IRC section 382 will not be the same as the enterprise value. In this simplified fact pattern, the equity value and enterprise value are the same. In general, enterprise value is inclusive of equity and assumed liabilities.
[9] Buyers are advised to ensure that pre-closing income tax returns properly capture this deferred revenue acceleration, whether they control the preparation of the return or through review rights.
[10] “For purposes of IRC section 382(h), prepaid income is not recognized built-in gain. The term prepaid income means any amount received prior to the change date that is attributable to performance occurring on or after the change date.” Treas. Reg. section 1.382-7. The IRS has held that deferred revenue meets the definition of prepaid income as it is an item that of income that is attributable to the post-change period because that is the period in which performance occurred and expenses were incurred to earn the income. Preamble to T.D. 9330, 2007-2 C.B. 239, 240.
[11] See, e.g., ILM 201629007.}