Executive summary: Tax treatment of PCM contracts in an M&A Transaction
Taxpayers (buyer or seller) investigating an mergers and acquisitions (M&A) transaction where the business being acquired accounts for long-term contracts using the percentage of completion method (PCM) need to be aware of the special rules that apply in the year of the transaction. Failure to do so could provide unexpected tax results to both the purchaser and seller. Similar to issues that arise with deferred revenue in the year of an M&A transaction, the PCM accounting for tax purposes can differ from generally accepted accounting principles (GAAP), and transactions which appear similar may have varying consequences.
The basics of the percentage of completion method
Generally, in a fully taxable asset transaction, the seller is treated as completing the contract on the date of the transaction and the buyer is treated as entering into a new contract.1 In a non-taxable transaction where a new taxpayer will complete the contract, the seller’s responsibility to account for the contract terminates and the buyer is treated as “stepping into the shoes” of the seller.2 More complex issues arise in a partially taxable transaction, where a company may be treated as selling a portion of its assets and rolling over a portion, as commonly seen in the private equity context.
The analysis below provides a general discussion of the PCM and then takes a deeper dive into mid-contract changes in the taxpayer completing a contract under taxable asset transactions and certain tax-deferred transactions.
Defining long-term contracts
With certain exceptions and special rules beyond the scope of our discussion, section 460(f)(1) defines a long-term contract as “any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into.”3
Computing income under PCM
The rules for computing income under the PCM are found in Reg. section 1.460-4(b)(2), and consist of the following steps:
- Compute the completion factor. The completion factor is the ratio of the cumulative allocable contract costs incurred through the end of the taxable year over the estimated total allocable contract costs that the taxpayer reasonably expects to incur under the contract.
- Compute the amount of cumulative gross receipts. This amount is determined by multiplying the completion factor by the total contract price.
- Compute the amount of current-year gross receipts. This amount (which may be positive or negative) is equal to the amount of cumulative gross receipts for the current taxable year less the amount of cumulative gross receipts from the immediately preceding taxable year.
- Compute taxable income. This amount is equal to current-year gross receipts less the allocable contract costs incurred during the current taxable year.
A taxpayer generally may make an election to postpone reporting income and costs until the tax year in which at least 10% of allocable contract costs have been incurred.4 The following two examples will be utilized throughout the discussion below, and it is assumed that there is no difference between the book and tax treatment under the PCM.
Facts: In Year 1, Seller enters into a long-term contract for $100 with expected costs of $75 that is expected to complete in Year 3. At the end of Year 1, Seller has completed 80 percent of the contract (i.e., has incurred $60 of total expected costs). However, Seller has only billed $50 on the contract. In this case, for Year 1 Seller recognizes $80 of revenue under the contract, $60 of costs, and as of the end of Year 1 has a debit balance/asset account for “costs in excess of billings” of $30.
Facts: In Year 1, Seller enters into a long-term contract for $100 with expected costs of $75 that is expected to complete in Year 3. At the end of Year 1, Seller has completed 60 percent of the contract (i.e., has incurred $40 of total expected costs), but has billed $80 on the contract. In this case, for Year 1, Seller recognizes $60 of revenue under the contract, $40 of costs, and as of the end of Year 1 has a credit balance/liability account for “billings in excess of costs” of $20.
Tax consequences for a “Mid-Contract” transfer
As discussed above, an M&A transaction or reorganization may involve a transfer of a long-term contract prior to its completion. Commonly referred to as a “mid-contract” transfer, the transaction involves a transfer of a contract by a taxpayer (“Transferor” or “Seller”), who reported income under the PCM, to a new taxpayer (“Transferee” or “Buyer”), who is now responsible for completing the contract. When a mid-contract transfer occurs as a result of an M&A transaction, Seller and Buyer’s tax consequences depend on whether such transaction was a fully taxable asset transaction or non-taxable/ deferred tax transaction.
Fully taxable asset transactions
A fully taxable asset transaction, such as a sale under section 1001 or a section 338 deemed asset sale, is governed by the constructive completion rules.5 Under these rules, on the date of the mid-contract transfer, Seller is treated as if it has completed the contract and Buyer is treated as entering into a new contract. As such, Seller’s obligations under the contract are terminated and income or expense is recognized on the contract.
First, Seller must determine the total contract price. The total contract price is any amount the Seller received in the transaction that is allocated to the contract plus any amounts the Seller has received or reasonably expects to receive under the contract. That amount is then reduced by any amount Seller paid to Buyer, and by any transaction costs, that are allocable to the contract. Once the total contract price is determined Seller is able to determine whether they have a profit or a loss on the contract. To the extent the parties agree to a payment from Buyer to Seller in a transaction covered by sections 1060 or 338, the payment is treated as made to the contract as opposed to assets in the seven-asset class allocation.6
Facts: In Year 1, Seller enters into a long-term contract for $100 with expected costs of $75 that is expected to complete in Year 3. As of the end of Year 1, Seller has completed 80 percent of the contract (i.e., has incurred $60 of cost) and for federal income tax purposes recognizes $80 of revenue and $60 of costs. However, Seller has only billed $50 under the contract. In Year 2, before incurring any additional costs on the contract, Seller enters into a fully taxable asset transaction with Buyer. If the parties do not agree on a payment to Seller allocable to the contract, the Seller would realize a loss of $10 on the contract ($50 received minus $60 costs incurred). As part of the transaction, assume Seller negotiates with Buyer for an additional $30 payment for the contract.