Deferred revenue treatment in loss transaction
TAX BLOG |
The IRS recently provided guidance (CCA 201629007) regarding the treatment of deferred revenue in a reverse merger transaction. In this transaction, the seller, a loss corporation, had deferred revenue obligations related to items of prepaid income.
Section 382 generally limits the use of pre-transaction NOLs to offset post transaction income. There are situations where the limitation can be increased. To determine if there are any adjustments to the limitation from the transaction, the loss corporation uses a deemed asset sale approach. This approach treats the transaction as a hypothetical asset sale by the loss corporation to an unrelated buyer who assumes all the corporation’s liabilities. The assets are valued at fair market value immediately before the merger date.
There are 5 steps under this approach, however, in this instance, only the first 3 applied to the loss corporation. To compute the adjustment, a taxpayer totals the amounts from the following steps:
- The amount realized in the deemed asset sale, including the estimated value of contingent liabilities, decreased by,
- Any liability of the corporation that would be included in the amount realized on the deemed asset sale, but only if the corporation would be allowed a deduction on payment of the liability, decreased by,
- The aggregate adjusted bases of the corporation’s assets at the time of the deemed asset sale.
In the guidance, the taxpayer included deferred revenue in its Step 1 amount, but did not reduce Step 2 by the deferred revenue. The taxpayer argued that the deferred revenue obligated it to provide services and the obligation was assumed by the buyer in the deemed asset sale. Then the deferred revenues were properly excluded in Step 2 as the receipt of the revenues only created potential obligations and the deferred revenues do not represent deductible liabilities as of the merger date.
The IRS concluded that including the deferred revenue as an assumed liability includable in the amount realized on the deemed asset sale, and then excluding the deferred revenue is not a proper approach. If the liability is included in the Step 1 amount and the payment of the liability would allow the taxpayer a deduction, it must be backed out under Step 2. Alternatively, the amount would not be includable in Step 1, and thus, no need to remove in Step 2.
This is the second guidance item released in 2016 related to proper treatment of deferred revenue in a transaction (See our previous alert here). The treatment of deferred revenue in a transaction, whether it originates from a buy/sell stock acquisition, an asset acquisition, or a reverse merger is not always clear. When undergoing a transaction of any nature, a taxpayer with deferred revenue should consult its tax advisors to assist in determining the proper recognition period or treatment of deferred revenue.