In VECO Corp. et al. v. Commissioner, 141 T.C. No. 14 (Nov. 20, 2013), the Tax Court rejected a taxpayer's proposed change in accounting method because the court determined that the all-events tests had not been met for some deductions and that the recurring item exception to economic performance did not apply to the other deductions claimed.
VECO Corp. was a common parent of an affiliated group that had engaged in various business activities, including oil and gas field services, manufacturing, construction and equipment leasing. The company elected to change its method of accounting for the fiscal year ended March 31, 2005, to (1) deduct liabilities in the year they were incurred under the all events test, with modifications under the recurring item exception for insurance and maintenance agreement payments; and (2) related to rent liabilities for which economic performance was not satisfied by payment, deduct the liabilities in the year in which the liabilities were fixed and could be determined reasonably accurately, and economic performance had occurred.
The IRS determined the taxpayer was not entitled to the deductions and issued a notice of deficiency for the taxpayer's fiscal year ended March 31, 2005. The agency argued that regarding several service contracts, insurance premiums, and real property and equipment leases, the first requirement of the all-events test was not satisfied, because all of the events had not occurred to establish the fact of the liabilities as of March 31, 2005.
Regarding all of the deductions except the insurance premium expense deduction, the IRS argued that the economic performance prong of the all-events test was not satisfied, because the 3 ½ month rule and the recurring item exception did not apply.
VECO Corp. argued that it had satisfied all of the requirements of the all-events test because its execution of the relevant agreements and assumption of binding legal obligations under those agreements fixed the fact of the liabilities underlying the deductions. The taxpayer also argued that it satisfied the economic performance requirement because of the recurring item exception applied.
The Tax Court disagreed with the taxpayer's proposition that the mere execution of a contract, without more, establishes the fact of the liability. The court noted that Rev. Rul. 2007-3 states that the fact of the liability is established on the earlier of the event fixing the liability (such as the required performance) or the date the payment was unconditionally due. The Tax Court applied that test to determine the amounts for which the fact of the liability was established as of March 31, 2005, for the taxpayer's service contracts, insurance contracts, and real property and equipment leases.
For the remaining contracts at issue with fixed liabilities, the Tax Court analyzed the recurring item exception to determine if the taxpayer had proved that each item in dispute was not material, and/or economic performance related to each item in dispute occurred within the shorter of a reasonable period after the close of the fiscal year ended March 31, 2005, or within 8 ½ months after the close of that fiscal year.
Section 461(h)(3)(B) provides that in determining the materiality of an item, the treatment of the item on a taxpayer's financial statements should be taken into account. The court looked to the legislative history of the recurring item exception and concluded that if a taxpayer prorates a liability arising under a contract over two or more taxable years for financial statement purposes, but takes an inconsistent position on its tax returns, the liability is material. VECO accrued the liabilities related to the remaining contracts over more than one year for financial statement purposes.
On its March 31, 2006, financial statements, VECO treated the disputed deductions as expenses for that year but deducted those expenses on its tax return for the fiscal year ended March 31, 2005. Guided by Section 461(h)(3)(B) and an example in legislative history, the Tax Court concluded that the liabilities were material to VECO because they were prorated between two years on VECO's financial statements and VECO took an inconsistent position with respect to the liabilities for financial statement and tax purposes. Accordingly, the Tax Court held that VECO could not use the recurring item exception with respect to the remaining contracts.
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