Final Regs on Economic Performance Requirement

 [4830-01]

 ACTION: Temporary and final regulations.

 SUMMARY: This document contains final regulations relating to the requirement that economic performance occur in order for an amount to be incurred with respect to any item of a taxpayer using an accrual method of accounting. This document also renumbers temporary regulations relating to the economic performance requirement. Changes to the applicable law were made by the Tax Reform Act of 1984. The regulations affect all taxpayers that use an accrual method of accounting and are necessary to provide them with guidance needed to comply with these changes.

 DATES: These regulations are effective April 10, 1992. In general, the final regulations apply to liabilities that would, under the law in effect before the enactment of section 461(h), be allowable as a deduction or otherwise incurred after July 18, 1984. In the case of certain liabilities that require payment to another person in order for economic performance to occur, the regulations apply to liabilities that would, but for the enactment of section 461(h), be allowable as a deduction or otherwise incurred for taxable years beginning after December 31, 1991. In the case of the economic performance requirement for certain employee benefit provisions, the final regulations provide that economic performance generally is satisfied to the extent that any amount is otherwise deductible under the provisions and, effective April 10, 1992, the final regulations remove temporary regulations concerning employee benefits.

 FOR FURTHER INFORMATION: Contact Linda M. Kroening of the Office of Assistant Chief Counsel (Income Tax and Accounting), on (202) 377-7976 (not a toll-free call), or Robert M. Casey of that office on (202) 566-3637 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

On June 7, 1990, the Internal Revenue Service published a notice of proposed rulemaking in the Federal Register (55 FR 23235) regarding the economic performance requirement of section 461(h). The preamble to that notice contains an explanation of the proposed rules. A public hearing was held on October 22, 1990. After consideration of the public comments regarding the proposed regulations, the regulations are adopted as revised by this Treasury decision.

EXPLANATION OF STATUTORY PROVISIONS

Section 461(h) provides that in determining whether an amount has been incurred with respect to any item, the all events test is not treated as met any earlier than when economic performance with respect to the item occurs. Under section 461(h)(4), the all events test is met with respect to any item if all events have occurred which determine the fact of the liability and the amount of the liability can be determined with reasonable accuracy.

 Section 461(h) provides that, except as otherwise provided in regulations prescribed by the Secretary, the following general principles determine when economic performance occurs. In the case of liabilities to provide services and property ("service and property liabilities"), section 461(h) generally provides that economic performance occurs as the services or property is provided. Where the liability of a taxpayer arises out of the use of property, economic performance occurs as the taxpayer uses the property. If the liability of a taxpayer requires payment to another person and arises under a workers compensation act or out of any tort, economic performance occurs as the payments to such person are made. Finally, in the case of any other liability of a taxpayer, economic performance occurs at the time determined under regulations prescribed by the Secretary.

 Although section 461(h) generally requires economic performance to occur before an item may be treated as incurred, section 461(h)(3) provides an exception to this general rule for certain recurring items ("the recurring item exception"). If the recurring item exception applies, an item may be treated as incurred in the taxable year before economic performance occurs.

PUBLIC COMMENTS

APPLICATION OF SECTION 461(h) TO ITEMS OTHER THAN DEDUCTIONS IN GENERAL

The proposed regulations provide that a liability is incurred in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. The regulations define a liability as any item allowable as a deduction, cost, or expense, except for certain items for which the Code provides alternative timing rules. Thus, section 461(h) applies to allowable deductions and any amount otherwise allowable as a capitalized cost, as a cost taken into account in computing cost of goods sold, as a cost allocable to a long-term contract, or as any other cost or expense.

 Commentators argued that the proposed regulations incorrectly apply section 461(h) to cost of goods sold, basis, and certain other exclusions. According to the commentators, Congress did not intend section 461(h) to apply to these items.

 The Service and the Treasury Department believe section 461(h) and its legislative history indicate that Congress intended the rules of section 461(h) to apply to both exclusions and deductions. First, section 461(h) and the all events test codified therein are not limited to deductions. Unlike the old all events test contained in section 1.461-1(a)(2) of the regulations, which applied to determine when an "expense" was "deductible," the all events test in section 461(h)(4) applies to determine when "any item" is "incurred." Second, the legislative history contemplates the application of the economic performance rules to capital items or other items that are not deductible in the year incurred. See H.R. Rep. No. 432 Part 2, 98th Cong., 2d Sess. 1254-55 (1984) (describing the difficulty of applying a discounting mechanism to capital items); see also Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 262 (1984) (providing an example applying the economic performance rules to highway construction costs, which in 1984 were ordinarily treated as deferred costs). Third, adoption of the commentators' position would unreasonably narrow the scope of the economic performance rules relating to the provision of services and property in sections 461(h)(2)(A) and (B) to items that are merely incidental to the provision of services and property, such as deductible supplies and distribution costs. In view of the statutory language and the legislative history cited above, the Service and the Treasury Department believe that such a narrow application of the economic performance principles is inconsistent with congressional intent. Therefore, the final regulations continue to apply economic performance to both exclusions and deductions.

SUBDIVIDERS OF REAL ESTATE

Rev. Proc. 75-25, 1975-1 C.B. 720, provides a procedure that allows subdividers of real estate to add the estimated cost of future improvements to the actual cost or other basis of property sold for the purpose of determining gain or loss resulting from the sale. The preamble to the proposed regulations states that because economic performance must occur in order for a liability to be taken into account, "the statute and the regulations override Rev. Proc. 75-25. . . ."

 Several commentators suggested that the Service retain the estimated cost allocation rules of Rev. Proc. 75-25. In response, the Service issued Notice 91-4, 1991-1 C.B. 315, to provide interim guidance while the Service studied ways, consistent with the purposes and principles of section 461(h), to address the special circumstances of subdividers of real estate. In general, Notice 91-4 provides that the procedures of Rev. Proc. 75-25 will remain in effect until the issuance of further rules under section 461(h).

 The Service and the Treasury Department believe that the economic performance requirement of section 461(h) applies to the real estate sales described in Rev. Proc. 75-25 and that the allocation rules of Rev. Proc. 75-25 must be changed to reflect the requirements of section 461(h). However, in order to address the special circumstances of real estate developers, the Service is publishing Rev. Proc. 92-29 in 1992-17 I.R.B. (April 27, 1992).

 In general, under Rev. Proc. 92-29 subdividers of real estate may request consent to add the estimated cost of future improvements to the basis of property for the purpose of determining gain or loss resulting from the sale. However, the total cost that may be added to the basis of property sold may not exceed the taxpayer's total costs that have been incurred within the meaning of section 461(h) with respect to these improvements. Subdividers that do not request consent as outlined under Rev. Proc. 92-29 may not add the cost of future improvements to the basis of benefited properties until the costs of the improvements are incurred within the meaning of section 461(h).

  Rev. Proc. 92-29 provides an automatic procedure under which developers may obtain consent to add the estimated cost of future improvements to the basis of property sold. Moreover, Rev. Proc. 92-29 provides streamlined information reporting requirements for developers using this method of accounting.

PROVISION OF SERVICES OR PROPERTY

The proposed regulations provide that if the liability of a taxpayer arises out of the providing of services or property to the taxpayer by another person, economic performance occurs as the services or property is provided. If the liability of a taxpayer requires the taxpayer to provide services or property, economic performance occurs as the taxpayer incurs costs (within the meaning of section 1.446-1(c)(1)(ii)) in satisfying the liability.

 Commentators recommended that the final regulations treat payment as economic performance for service or property liabilities. These commentators suggested that in the case of services or property to be provided by the taxpayer, economic performance should occur no later than the date the taxpayer pays a third party to assume the taxpayer's liability to provide the services or property and the third party becomes primarily liable to provide the services or property. Similarly, in the case of services or property to be provided to the taxpayer by another person, the commentators argued that economic performance should occur no later than the date the taxpayer pays the person that is to provide the services or property.

 In support of this "payment trump" rule, commentators have made the following argument: section 461(h) was enacted to prevent taxpayers from taking undiscounted deductions currently for expenses that are economically incurred in the future. In cases where payment is made in advance of economic performance, the amount of the liability has been properly discounted to its value as of the date of payment. Therefore, the deduction is not overstated, and the policy of section 461(h) is satisfied because the tax result is equivalent to delaying the deduction until the event of economic performance occurs.

 The Service and the Treasury Department believe that the policy of section 461(h) would be fulfilled in the case of prepaid liabilities only if the payor and the payee are in the same tax position. By prepaying the liability, the payor has shifted the liability for tax on the investment income generated by the payment to the payee for the period of time between the payment and economic performance. Thus, if the payee is not subject to tax or is subject to tax at a lower rate than the payor, the tax result would not be the equivalent of delaying the deduction until economic performance occurs and the policy of section 461(h) would be frustrated.

 Moreover, the legislative history indicates that payment should not, as a general rule, be treated as economic performance. The House Report explains that "[i]f the liability of the taxpayer requires a payment to another person for the providing of services or property to the taxpayer by another person, economic performance occurs when such other person provides the property or services." House Report at 1255. The General Explanation adds that if the liability requires the taxpayer to provide property or perform services, "economic performance generally does not occur as payments are made, except as specifically provided in the Code or regulations." General Explanation at 262. The Service and the Treasury Department have concluded that, although a payment rule is appropriate for certain specific types of liabilities discussed below, the generally applicable payment trump rule requested by the commentators would provide a vehicle for income shifting between taxpayers. Therefore, the regulations do not adopt the commentators' suggestions.

 Thus, except as provided under a special rule described in the next section or in the case of a long-term contract, if the taxpayer's liability arises out of the providing of services or property to the taxpayer by another person, the final regulations provide that economic performance occurs as the services or property is provided to the taxpayer, not when the taxpayer pays for the services or property. Similarly, if the liability of the taxpayer requires the taxpayer to provide services or property, economic performance occurs as the taxpayer incurs costs (within the meaning of section 1.446-1(c)(1)(ii)) in satisfying the liability.

THE 3 1/2-MONTH RULE

The proposed regulations provide that, for purposes of the economic performance requirement, a taxpayer may treat services or property as provided to the taxpayer as the taxpayer makes payment to the person providing the services or property, but only if the taxpayer can reasonably expect the person to provide the services or property within 3 1/2 months after payment ("the 3 1/2-month rule").

 Some commentators suggested that the 3 1/2-month rule be expanded to, for example, 6 months. The Service and the Treasury Department believe that the 3 1/2-month rule appropriately operates to relieve taxpayers of the burdens incident to determining precisely when services and property are provided, while assuring that economic performance occurs within a reasonable time following payment. An extension of the 3 1/2-month rule would undermine the general section 461(h) statutory rule that economic performance must occur before the taxpayer may take an item into account. Accordingly, the final regulations do not adopt this suggestion.

 Commentators also said EXAMPLE 9 of section 1.461-4(d)(6) of the proposed regulations, which illustrates the 3 1/2-month rule, suggests that an executory contract satisfies the all events test. The examples in the proposed and final regulations are intended to illustrate the principles of economic performance; they are not intended to illustrate all aspects of the all events test. Nevertheless, this example and EXAMPLE 8 of section 1.461-4(d)(6) of the proposed regulations are removed from the final regulations to avoid any implication that an executory contract satisfies the all events test.

LONG-TERM CONTRACTS

 The proposed regulations provide that in the case of a liability of a taxpayer that arises out of another person's providing services or property to the taxpayer that is an expense attributable to a long-term contract reported on the percentage of completion method, economic performance occurs (i) as services or property is provided to the taxpayer, or, if earlier, (ii) as the taxpayer makes payment in satisfaction of the liability to the person providing the services or property. Commentators expressed concern that the long-term contract rule would accelerate the time at which an expense is incurred under the percentage-of-completion method and, consequently, would accelerate the time for reporting income. They argued that expenses of a long-term contract should be subject to the same rule applicable to other service or property liabilities, i.e., economic performance should occur when the services or property is provided to the taxpayer. Alternatively, other commentators argued that economic performance with respect to expenses of a long-term contract should occur on the later of (i) the date that the services or property is provided to the taxpayer, or (ii) the date that payment is made in satisfaction of the liability to the person providing the services or property.

 The Service and the Treasury Department believe that the economic performance rule contained in the proposed regulations will not result in an acceleration of income under the percentage of completion method. That is, income recognized under the rule contained in the proposed regulations will not exceed the income that would be recognized by applying the all events test without economic performance. Moreover, the rule is necessary to prevent a deferral of income recognition under the percentage of completion method. Therefore, the final regulations do not adopt the commentators' suggestion.

EMPLOYEE BENEFIT PLANS

In the preamble to the proposed regulations, the Service invited comments on the interaction between the economic performance requirement and employee benefit provisions, including sections 83 (property transferred in connection with the performance of services), 404 (employer contributions to a plan of deferred compensation), and 419 (welfare benefit funds). In addition, the proposed regulations would remove section 1.461(h)-4T, which in general provides that economic performance occurs for a contribution or compensation subject to section 404 or section 419 as the taxpayer makes the contribution or pays the compensation. Commentators suggested that the final regulations retain the rules contained in section 1.461(h)-4T.

 The Service and the Treasury Department believe that the specific timing rules contained in section 404, section 404A, and section 419 generally should take precedence over the more general economic performance rules. Therefore, the final regulations remove section 1.461(h)-4T and provide that, except as provided in any regulation, revenue procedure, or revenue ruling, the economic performance requirement is satisfied to the extent that any amount is otherwise deductible under section 404, section 404A, or section 419.

PROPERTY TRANSFERRED IN CONNECTION WITH SERVICES.

Section 83(h) provides that a deduction for property transferred for the performance of services is generally taken in the taxable year in which the service provider includes the value of the property in income. The proposed regulations, however, would allow a deduction for the transfer only upon the later of the satisfaction of the section 83 requirements or the occurrence of economic performance. In many cases, this "later of" rule would not delay the deduction beyond the period provided under section 83(h) because economic performance would occur earlier than or coincident with the recognition of income by the service provider. Economic performance could delay the deduction, however, in cases where the service provider recognizes income prior to the performance of the services. For example, where the service provider makes an election under section 83(b) to accelerate recognition on property that is not substantially vested until the related services are performed, the proposed regulations would delay the deduction under section 83(h) until the period in which the services are performed.

 The final regulations do not address the interaction between section 461(h) and section 83. Although comments on section 83 were specifically requested in the preamble to the proposed regulations, few comments were received. The Service and the Treasury Department believe, however, that there may be cases in which the specific timing rules in section 83(h) should take precedence over the more general economic performance rules, such as where an employee makes a section 83(b) election to recognize income on property that is not substantially vested. On the other hand, the Service and the Treasury Department are concerned that there are also cases, particularly those involving nonemployees, in which taxpayers would be able to frustrate the policy of section 461(h) merely by transferring to a service provider property that is subject to section 83 rather than cash. (See PROVISION OF SERVICES OR PROPERTY above for a discussion of the policy of section 461(h).)

 Therefore, the final regulations specifically reserve on the interaction between section 461(h) and section 83, and the Service and the Treasury Department once again invite comments on this subject. In particular, comments are requested as to those cases in which it would be appropriate for section 83(h) to govern exclusively the timing of deductions.

USE OF PROPERTY BY THE TAXPAYER

The proposed regulations provide that if the liability of a taxpayer arises out of the use of property by the taxpayer, economic performance occurs ratably over the period of time the taxpayer is entitled to use the property. Several commentators suggested modifications to this ratable rule in the case of liabilities for the use of property that are measured by events or conditions other than the passage of time.

 The final regulations address the commentators' suggestion by providing two exceptions to the ratable rule. Under the first exception, if a liability varies with the frequency of use of the property, economic performance occurs as the property is used. For example, if a five-year lease obligates the taxpayer to pay an amount for each time a machine is used, economic performance occurs each time the taxpayer uses the machine. Under the second exception, if a liability depends on the income earned from the property, economic performance occurs as the income is earned. For example, if a five- year lease obligates the taxpayer to pay an amount based on a percentage of the gross profits generated by the property, economic performance occurs as gross profit from the property is earned by the taxpayer.

 Commentators asked that the regulations clarify the relationship between section 461(h) and section 467, which concerns the accrual method of accounting for certain payments for the use of services or property. The Service and the Treasury Department believe that the interaction of sections 461(h) and 467 should be addressed in a regulations project under section 467. Accordingly, the final regulations do not address this issue.

NOTIONAL PRINCIPAL CONTRACTS

The term "notional principal contract" generally describes an agreement between two parties to exchange payments calculated by reference to a notional principal amount. The term typically encompasses interest rate swap agreements, commodity swap agreements, interest rate cap and floor agreements, currency swap agreements and other similar contracts.

The proposed regulations reserved on notional principal contracts. On July 10, 1991, the Internal Revenue Service published a notice of proposed rulemaking in the Federal Register (56 FR 31350) concerning the application of section 446 with respect to notional principal contracts. The section 446 proposed regulations contain rules concerning the application of economic performance to notional principal contracts. As a result, these final regulations reserve on notional principal contracts.

PAYMENT LIABILITIES GENERALLY

SCOPE OF THE RULES

Section 1.461-4(g) of the proposed regulations identifies six types of liabilities, in addition to liabilities arising under a workers compensation act or out of any tort, for which payment constitutes economic performance. These liabilities are (1) liabilities arising out of a breach of contract; (2) liabilities arising out of a violation of law; (3) rebates and refunds; (4) awards, prizes, and jackpots; (5) amounts paid for insurance, warranty, and service contracts; and (6) taxes other than creditable foreign taxes. The proposed regulations also provide that if section 461(h) or the regulations thereunder do not otherwise provide economic performance rules for a liability (an "other" liability of section 1.461-4(g)(7)), economic performance occurs as payment is made to the person to which the liability is owed.

 Commentators objected to the rules in the proposed regulations making payment economic performance for liabilities other than liabilities arising under a workers compensation act or out of any tort. For example, in the case of liabilities for property taxes, some commentators argued that economic performance should occur on the lien date or the assessment date. Commentators also argued that liabilities to provide prizes, awards, or jackpots are service liabilities arising from the provision of entertainment services and that economic performance occurs with respect to these liabilities as the entertainment services are provided (i.e., using the rules for service liabilities).

 The Service and the Treasury Department have concluded that payment is the appropriate time for economic performance to occur for these "payment liabilities." The payment rule was chosen because of the nature of the liabilities and the difficulty in applying the statutory rules to these liabilities. For example, in the case of liabilities arising out of a breach of contract or violation of law, it is often difficult to distinguish among actions based on breach of contract, violation of law, and tort because many such actions are brought on alternative grounds and settled without any objective determination of the prevailing theory. In the case of certain awards and prizes, payment is often the most objective evidence of performance. In the case of jackpots, a prolonged period may elapse between the date the value of the jackpot is determined and the date it is paid. In each of these cases, the payment rule protects against overstatement of the deduction and provides an objective rule for determining when economic performance occurs.

 In prescribing rules for the listed payment liabilities, other than liabilities arising under a workers compensation act or out of any tort, the Service exercised its broad regulatory authority provided by section 461(h). Section 461(h)(2)(D) authorizes the Secretary to issue regulations that determine the time for economic performance in the case of liabilities for which section 461(h) does not expressly provide rules. Moreover, section 461(h)(2) authorizes the Secretary to issue regulations that change the time for economic performance in the case of liabilities for which section 461(h)(2) expressly provides rules. Thus, the final regulations retain the payment rule for the liabilities in section 1.461-4(g). However, the final regulations provide that, in the case of these liabilities, the Service may issue alternative or additional rules by regulation, revenue procedure, or revenue ruling.

DEFINITION OF PAYMENT

The proposed regulations provide that "payment" has the same meaning as it has for taxpayers using the cash receipts and disbursements method of accounting. Under the proposed regulations, payment does not include an amount transferred as a loan, refundable deposit, or contingent payment with respect to which the taxpayer may be or may become entitled to receive a refund or credit.

 Commentators expressed concern about whether the proposed regulations were intended to change the meaning of payment for cash method taxpayers. For example, commentators questioned whether a payment of estimated tax, under circumstances that would give rise to a deduction for a cash method taxpayer, would be considered a payment for purposes of the economic performance requirement in light of the possibility that part of the estimated tax might be refunded or credited to the taxpayer.

 When determining whether payment would have been made by a cash basis taxpayer, the Service intends to follow the law existing at the time of the payment. In response to the commentators' suggestions, the final regulations clarify that the definition of tax payment is determined under the principles of current law; therefore, a payment generally includes estimated tax payments.

 Under the proposed regulations, payment does not include the furnishing of a note or other evidence of indebtedness of the taxpayer. Commentators objected to this rule and asked that the regulations provide that the furnishing of a taxpayer's note or other evidence of indebtedness is payment if the debt bears an arms'-length rate of interest and the recipient of the debt is an accrual method taxpayer. Other commentators recommended that the furnishing of the taxpayer's debt be treated as payment whether or not the recipient is an accrual method taxpayer.

 The Service and the Treasury Department believe that consistent use of the cash method definition of payment provides an administrable rule that is consistent with congressional intent. Therefore, the final regulations do not adopt either of these suggestions.

PAYMENT TO THE PERSON TO WHICH THE LIABILITY IS OWED

In the case of liabilities requiring payment, the proposed regulations provide that economic performance occurs when payment is made to the person to which the liability is owed. Generally, a payment to a trust, escrow account, fund, or any person other than the person to which a liability is owed does not constitute economic performance. Commentators recommended that the regulations eliminate the requirement that payment must be made to the person to which the liability is owed. In the case of a liability requiring payment, the commentators argued that economic performance should be satisfied if the taxpayer pays a third party to assume the liability and the third party becomes primarily liable to satisfy the taxpayer's liability.

In the case of liabilities arising under a workers compensation act or out of any tort, section 461(h)(2)(C) provides that economic performance occurs as payments are made to the person to which the liability is owed. As explained above (see PROVISION OF SERVICES OR PROPERTY), the Service and the Treasury Department believe that the policy of section 461(h) would be frustrated if, by prepaying their liability, taxpayers were permitted to shift the investment income to other taxpayers. The third party payment rule, recommended by commentators, would lead to such a shifting of income between taxpayers. Moreover, the Service and the Treasury Department believe that compliance with and administration of the economic performance rules will be eased by having the same payment rule for all payment liabilities. Therefore, the final rules do not adopt the commentators' recommendation.

PAYMENT IN THE CASE OF LIABILITIES THAT ARE ASSUMED IN CONNECTION WITH THE SALE OF A TRADE OR BUSINESS

Section 1.461-4(g)(1)(ii)(C) of the proposed regulations provides that if, in connection with the sale or exchange of an entire trade or business by a taxpayer, the purchaser expressly assumes a payment liability arising out of the trade or business that the taxpayer (but for the economic performance requirement) would have been entitled to incur as of the date of the sale, the taxpayer is deemed to make payments with respect to the liability as the amount of the liability is included in the amount realized on the transaction by the taxpayer.

 One commentator recommended that a similar rule be provided in the case of service and property liabilities expressly assumed by the purchaser of the taxpayer's trade or business and properly included in the amount realized from the sale. Acceleration of economic performance in the case of the sale or exchange of an entire trade or business is proper because these sales are often followed by liquidations of the selling entity. In these cases, but for an acceleration of economic performance, the seller would be precluded from taking into account the liability. Therefore, the regulations adopt this suggestion.

 Commentators also recommended that section 1.461-4(g)(1)(ii)(C) be applied to liabilities that are assumed in connection with a sale or exchange of assets representing less than the entire trade or business where the seller is required to include the assumed liabilities in income. A sale or exchange of these business assets does not present the same liquidation concerns that arise in the context of a sale of an entire trade or business. The Service and the Treasury Department believe that adopting this recommendation could significantly undermine the principles of economic performance by allowing taxpayers to accelerate some business deductions while continuing to own the business. Consequently, the final regulations do not adopt the commentators' recommendation.

 Several commentators recommended that section 1.461-4(g)(1)(ii)(C) be applied to contingent liabilities. The Service and the Treasury Department believe that the tax treatment of contingent liabilities should be addressed in a separate regulations project. Accordingly, the final regulations do not adopt the recommendation.

REBATES AND REFUNDS

The proposed regulations provide that if the liability of a taxpayer is to pay a rebate or refund to another person, economic performance occurs as payment is made to the person to which the liability is owed. Because payment provides the most objective evidence of economic performance for a rebate or refund, this rule provides certainty for taxpayers and is administrable by the Service. Rev. Rul. 63-182, 1963-2 C.B. 194, permits a natural gas utility to deduct the amount to be refunded to customers in the same year the utility includes the supplier refund in income where the taxpayer forwards the refund to its customers within 12 months after receiving the refund. The Conference Report authorizes the Service to provide a rule for natural gas supplier refunds similar to the rule in Rev. Rul. 63-182. H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 875-876 (1984), 1984-3 C.B. Vol.2 129-130.

 Commentators have argued that, in the case of public utility refunds, economic performance should not be delayed until payment. With respect to natural gas suppliers, commentators have pointed to the legislative history in support of their position. In the case of other public utility refunds, commentators have argued that there is no reason to distinguish between natural gas suppliers and other public utilities.

 The potential for mismatching is present for all payors of refunds, and the Service and the Treasury Department are not convinced that refunds by public utilities should be treated more favorably than refunds by other taxpayers. However, the recurring item exception provides relief to all public utilities where refunds are paid within a reasonable period following receipt of the related income. The Service and the Treasury Department believe the recurring item exception carries out the legislative intent with respect to public utility rebates without creating inequities in the treatment of other rebates. Therefore, the final regulations do not provide any special rules for natural gas suppliers or other public utilities.

INSURANCE

Section 1.461-4(g)(5) of the proposed regulations provides that if the liability of the taxpayer arises out of the provision to the taxpayer of insurance, economic performance occurs as payment is made to the person to which the liability is owed. Several commentators argued that insurance is a service liability and that economic performance should occur ratably over the term of the insurance. Other commentators questioned whether, in the case of insurance premiums that are subject to adjustment after the close of the taxable year, an amount paid would be treated as a contingent payment and thereby not satisfy economic performance. The final regulations provide that "payment" has the same meaning as it has for taxpayers using the cash receipts and disbursements method of accounting. In making this determination, the law applicable at the time of the payment is applied. See, e.g., Rev. Rul. 83-66, 1983-1 C.B. 43, which addresses the treatment of premiums based on the best actuarial estimate that are subject to subsequent refund. Moreover, it is intended that, in determining the amount of the liability with respect to which economic performance has occurred during the taxable year, a taxpayer that has made a premium payment may treat economic performance as occurring with respect to that portion of the taxpayer's liability covered by the payment that can be computed with reasonable accuracy. With these clarifications in the term payment, the Service and the Treasury Department believe payment treatment provides an objective, equitable, and administrable economic performance rule in the context of insurance liabilities.

 Several commentators asked that the regulations clarify that economic performance occurs when a taxpayer pays an insurance premium for insurance to cover workers compensation or tort liabilities. The Service believes that Example 8 of proposed regulations section 1.461-4(g)(8), which is retained as Example 6 in the final regulations, adequately addresses this situation.

 Several commentators indicated that Example 6 of section 1.461-4(g)(8) of the proposed regulations might suggest that multi-period insurance liabilities incurred during the taxable year are currently deductible. Proposed regulation section 1.461-1(a)(2)(i) provides that section 461(h) and the regulations thereunder merely provide rules for determining when a liability may be treated as incurred under the all events test. Other rules determine the manner in which the liability is taken into account for Federal income tax purposes. For example, a liability that relates to the creation of an asset having a useful life extending substantially beyond the close of the taxable year is taken into account in the taxable year incurred through capitalization. In order to avoid confusion concerning multi- period insurance liabilities, Example 6 of the proposed regulations has been removed from the final regulations. Other examples in section 1.461-4(g)(8) illustrate the interaction of economic performance with the capitalization provisions.

TAXES

The regulations provide that economic performance for a tax liability occurs as the tax is paid to the governmental authority that imposed the tax. Commentators argued that the lien date or assessment date should be retained as the time economic performance occurs for real property taxes.

 The payment rule is necessary for tax liabilities because a prolonged period may elapse between the lien or assessment date and the date the taxes are paid. The Service and the Treasury Department believe that in these cases treating economic performance as occurring on the lien or assessment date would overstate the true cost of the expense and, consequently, fail to implement the principles of economic performance. Therefore, the final regulations retain payment as the time economic performance occurs for real property taxes.

 Commentators suggested that the Service provide an automatic procedure for making an election under section 461(c) to ratably accrue real property taxes. The Service is publishing Rev. Proc. 92-28 in 1992-17 I.R.B. (April 27, 1992), which provides a simplified procedure for making or revoking an election under section 461(c) for a taxpayer's first taxable year beginning after December 31, 1989, December 31, 1990, or December 31, 1991.

 Commentators also suggested that the ratable accrual rule of section 461(c) be extended to personal property taxes. The Service will study this suggestion and will provide further guidance if it determines that the rule should apply to personal property taxes.

 Section 1.461-4(g)(6)(iii)(B) of the proposed regulations provides that in the case of a liability of a taxpayer for certain taxes that are imposed by the authority of any foreign country or possession of the United States and that are creditable under section 901, economic performance occurs when the requirements of the all events test other than economic performance are met, whether or not the taxpayer elects to credit the taxes under section 901. One commentator asked that this rule be extended to (1) deductible foreign taxes that are noncreditable under section 901 and (2) foreign income taxes creditable by treaty.

 Because of the nature of deductible foreign taxes that are noncreditable under section 901, the Service and the Treasury Department believe that an extension of the rule in section 1.461-4(g)(6)(iii)(B) to noncreditable foreign taxes is inappropriate. For example, a foreign tax may be noncreditable under section 901 because it is not actually an income tax under United States standards but a levy for a specific economic benefit (e.g., a license to extract minerals). As to foreign taxes creditable by treaty, the Service and the Treasury Department believe that the rule in section 1.461-4(g)(6)(iii)(B) applies to those foreign taxes except as otherwise specifically provided by the terms of the applicable treaty. For these reasons, the final regulations do not adopt the commentator's suggestion.

RECURRING ITEM EXCEPTION

ELECTION TO USE THE RECURRING ITEM EXCEPTION

The proposed regulations require a taxpayer electing the recurring item exception to file a statement identifying the trade or business and the types of items with respect to which the recurring item exception is to be used.

Commentators recommended that a taxpayer be allowed to use the recurring item exception without filing a statement. The final regulations adopt this recommendation: a taxpayer may adopt the recurring item exception for the first taxable year beginning after December 31, 1989, December 31, 1990, or December 31, 1991, by accounting for items under the recurring item method.

TIME WHEN ECONOMIC PERFORMANCE MUST OCCUR

To qualify for recurring item treatment, section 461(h)(3)(A)(ii) provides that economic performance must occur within the shorter of a reasonable period after the close of the taxable year or 8 1/2 months after the close of the taxable year. The proposed regulations interpret the term "reasonable period" as ending on the date the taxpayer files a timely return for the taxable year. Commentators objected to this interpretation and argued that recurring item treatment should be available for any item otherwise eligible for recurring item treatment if, on the date the taxpayer files its income tax return for the taxable year, the taxpayer reasonably expects economic performance to occur within 8 1/2 months after the end of the taxable year. If economic performance with respect to the item does not occur within 8 1/2 months after the end of the taxable year, the commentators recommended that the regulations provide that the taxpayer file an amended return or take the item into account in the following taxable year.

The final regulations do not adopt the commentators' suggestion. The Service and the Treasury Department believe that the rule in the proposed regulations is a reasonable interpretation of section 461(h)(3)(A)(ii) and ensures that taxpayers deduct only items otherwise eligible for the recurring item exception. Without this rule, a taxpayer might deduct an item in anticipation of economic performance occurring within 8 1/2 months after the end of the taxable year and fail to amend the return if economic performance did not occur within that period.

LIABILITIES EXCLUDED FROM RECURRING ITEM TREATMENT

Section 461(h)(3)(C) provides that the recurring item exception does not apply to a liability arising under any workers compensation act or out of any tort. Section 1.461-5(c) of the proposed regulations provides that in addition to these liabilities, the recurring item exception does not apply to liabilities for violation of law, breach of contract, interest, or to the "other" liabilities of section 1.461-4(g)(7). Commentators objected to the proposed regulations, arguing that no liabilities other than those specified by section 461(h)(3)(C) may be excluded from the recurring item exception.

 The Service and the Treasury Department believe that they may properly exercise their regulatory authority to provide that the timing of economic performance for these payment liabilities is determined without regard to the recurring item exception. (See the discussion of this regulatory authority above in PAYMENT LIABILITIES GENERALLY, Scope of the rules.)

 Liabilities for violation of law and breach of contract are excluded from the recurring item exception because they often arise from facts that may also give rise to tort liabilities. Therefore, it may be difficult to determine whether a payment is made pursuant to a liability arising from a tort, a breach of contract, or a violation of law. As noted above, section 461(h)(3)(C) excludes tort and workers compensation liabilities from the recurring item exception. Denying the recurring item exception for all four types of liabilities provides consistent tax treatment for liabilities arising from similar facts, avoids the uncertainty associated with trying to determine the specific type of liability giving rise to the payment, and ensures that congressional intent with respect to the treatment of tort and workers compensation liabilities is carried out.

Congressional intent that economic performance for interest occurs with the passage of time is carried out by denying the recurring item exception for interest. Furthermore, the Service and the Treasury Department believe it is not appropriate to apply the recurring item exception to "other" liabilities without first identifying these liabilities. Nevertheless, the final regulations provide that the Service may issue alternative or additional rules by regulation, revenue procedure, or revenue ruling concerning the "other" liabilities. Accordingly, the final regulations do not adopt the commentators' objection.

NUCLEAR FUEL DISPOSAL COSTS

The final regulations include the continuing fees required by the Nuclear Waste Policy Act of 1982 among the payment liabilities that automatically satisfy the matching requirement of the recurring item exception.

ESTIMATED TAX AND THE RECURRING ITEM EXCEPTION

One commentator requested guidance concerning when an item that accrues in year 1 by satisfying the recurring item exception in year 2 should be taken into account for purposes of the annualization exception to the estimated tax payment requirement. The Service and the Treasury Department believe that this issue is more appropriately addressed in guidance issued under section 6655 concerning the annualization exception to the estimated tax payment requirement. Accordingly, the final regulations do not address this issue.

CUT-OFF METHOD OF CHANGE

Commentators asked whether a taxpayer that uses the cut-off method to change its method of accounting for an item in order to satisfy the economic performance requirement may also use the cut-off method to change to the recurring item exception with respect to the item. The regulations clarify that when a taxpayer uses the cut-off method to change its method of accounting for an item in order to satisfy the economic performance requirement, it must also use that method to change to the recurring item exception for the item.

USE OF THE RECURRING ITEM EXCEPTION FOR OPEN YEARS

The proposed regulations provide that if a taxpayer has incurred a type of liability prior to its first taxable year beginning after December 31, 1989, the taxpayer is granted the Commissioner's consent to change to the recurring item exception method of accounting for that type of liability, but only for its first taxable year beginning after December 31, 1989. Commentators questioned the application of this rule in the case of a failure to properly change to the recurring item exception for taxable years beginning before January 1, 1990.

In response to these questions, the final regulations provide that any taxpayer is granted consent to change to the recurring item exception method (or to modify a previous election to use the recurring item exception method) for the first taxable year beginning after December 31, 1991. In lieu of an election statement or a Form 3115, the final regulations allow taxpayers to change to the recurring item exception method (or to modify a previous election to use the recurring item exception method) by accounting for the item under the recurring item exception method on the timely filed original return for the first taxable year beginning after December 31, 1991. This change in method may be made using either the cut-off method or the full-year change method described in section 1.461-7T. A taxpayer that wishes to change its method of accounting to or from the recurring item exception method for subsequent years, must request the advance consent of the Commissioner pursuant to section 1.446-1(e)(3)(i) and Rev. Proc. 92-20, 1992-12 I.R.B. 10 (March 23, 1992). In addition, rules similar to those for the first taxable year beginning after December 31, 1991, also apply for the first taxable year beginning after December 31, 1989, or the first taxable year beginning after December 31, 1990, where the taxpayer properly used the recurring item exception method on its original return for the taxable year or on an amended return for the taxable year, provided the amended return is filed on or before October 7, 1992.

QUALIFIED FUNDS

Under section 468B, payment to a designated settlement fund constitutes economic performance in the case of certain tort liabilities. The proposed regulations extend the availability of section 468B treatment to certain other payment liabilities by providing that a payment to a "qualified fund" constitutes economic performance in the case of those liabilities. The Service and the Treasury Department have addressed the issues relating to qualified funds in the proposed regulations issued under section 468B. Therefore, the final regulations do not include rules for qualified funds.

CONTESTED LIABILITIES AND 461(f) FUNDS

The proposed regulations provide rules relating to the taxation of amounts transferred to an escrowee, trustee, or court in connection with a contested liability within the meaning of section 461(f) (i.e., a transfer to a "461(f) fund"). Commentators provided numerous comments concerning the proposed regulations. After reviewing these comments, the Service and the Treasury Department believe it is appropriate to address economic performance for 461(f) funds after final guidance is provided concerning funds under section 468B. Therefore, the final regulations reserve the treatment of 461(f) funds.

EFFECTIVE DATES

In general, the final regulations apply to liabilities that would, under the law in effect before the enactment of section 461(h), be allowable as a deduction or otherwise incurred after July 18, 1984. In the case of certain liabilities that require payment to another person in order for economic performance to occur, the regulations apply to liabilities that would, but for the enactment of section 461(h), be allowable as a deduction or otherwise incurred for taxable years beginning after December 31, 1991.

As to items with respect to which rules are not expressly provided under section 461(h), commentators requested that the regulations provide guidance for their treatment during the period from the effective date of section 461(h) to the effective date of the section 461(h) regulations ("the gap period"). In particular, they requested that taxpayers be allowed to rely on prior rulings to determine the time at which an item is incurred. If there is no ruling addressing an item, commentators requested that taxpayers be allowed to determine the time at which the item is incurred using the rules of the all events test without regard to economic performance or, alternatively, using the payment rules in the regulations.

Unlike its treatment of most new Code sections, Congress indicated that in the case of section 461(h), taxpayers could continue to rely on prior rulings and regulations until regulations are issued under section 461(h). However, Congress also indicated that taxpayer reliance should be limited to those instances in which the rulings and regulations are not inconsistent with the general principles of economic performance or with the exception for recurring items that is in the Code. Conference Report at 876. This limitation appears in the preamble of the proposed regulations. The Service and the Treasury Department believe that the language of the Conference Report provides the best guidance concerning treatment of items during the gap period. For example, in Notice 90-64, 1990-2 C.B. 347, the Service applied this guidance to the accrual of property taxes. Thus, the final regulations do not adopt the commentators' request.

Commentators believed that the examination restriction of section 4 of Rev. Proc. 84-74, 1984-2 C.B. 736, which precludes a taxpayer that has been contacted for examination from making certain accounting method changes, should not apply to changes under section 461(h). Other commentators recommended that the final regulations adopt rules similar to those provided in Rev. Proc. 90-36, 1990-2 C.B. 357. Under Rev. Proc. 90-36, a taxpayer that has been contacted for examination is precluded from making a change in method of accounting only if the taxpayer has received written notification indicating that an adjustment is being proposed to the method of accounting. The final regulations do not contain an examination restriction for accounting method changes under the regulations to comply with the long-term contract rules, the payment liability rules, or the recurring item exception.

SPECIAL ANALYSES

It has been determined that these final rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C chapter 6) do not apply to these regulations, and, therefore, an initial Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, a copy of the rules was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

The principal authors of these regulations are Robert M. Casey and Linda M. Kroening of the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Service and Treasury Department also participated in their development.

LIST OF SUBJECTS

26 CFR 1.61-1 through 1.67-4T

Income taxes, Reporting and recordkeeping requirements.

26 CFR 1.261-1 through 1.289H-1T

Income taxes, Reporting and recordkeeping requirements.

26 CFR 1.446-1 through 1.469-11T

Accounting, Income taxes, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by removing the following citation:

Section 1.461-2T also issued under 26 U.S.C. 461(h).

Par. 2. The authority citation for part 1 is further amended by adding the following citations:

Authority: Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805. * * *

Section 1.446-1 also issued under 26 U.S.C. 461(h). * * *

Section 1.461-1 also issued under 26 U.S.C. 461(h).

Section 1.461-2 also issued under 26 U.S.C. 461(h).

Section 1.461-4 also issued under 26 U.S.C. 461(h).

Section 1.461-4 (d) also issued under 26 U.S.C. 460 and 26 U.S.C. 461(h).

Section 1.461-5 also issued under 26 U.S.C. 461(h).

Section 1.461-6 also issued under 26 U.S.C. 461(h).

Section 1.461-7T also issued under 26 U.S.C. 461(h). * * *

Par. 3. Section 1.61-3 is amended by adding a new sentence at the end of paragraph (a) to read as follows:

SECTION 1.61-3 GROSS INCOME DERIVED FROM BUSINESS.

(a) * * * Thus, for example, an amount cannot be taken into account in the computation of cost of goods sold any earlier than the taxable year in which economic performance occurs with respect to the amount (see section 1.446-1(c)(1)(ii)).

* * * * *

Par. 4. Section 1.263(a)-1 is amended by adding new text to the end of paragraph (b) to read as follows:

SECTION 1.263(a)-1 CAPITAL EXPENDITURES; IN GENERAL.

* * * * *

(b) * * * An amount referred to in paragraph (a) of this section is a capital expenditure that is taken into account through inclusion in inventory costs or a charge to capital accounts or basis no earlier than the taxable year during which the amount is incurred within the meaning of section 1.446-1(c)(1)(ii). Capital expenditures are subsequently recovered through depreciation, amortization, cost of goods sold, as an adjustment to basis, or otherwise, at such time as the property to which the amount relates is used, sold, or otherwise disposed of by the taxpayer, in accordance with applicable Code sections and guidance published by the Secretary.

* * * * *

Par. 5. Section 1.263A-1T is amended by adding a new sentence to the end of paragraph (a)(5)(i) to read as follows:

SECTION 1.263A-1T CAPITALIZATION AND INCLUSION IN INVENTORY COSTS OF CERTAIN EXPENSES (TEMPORARY).

(a) * * *

(5) * * *

(i) * * * However, the amount of any cost required to be capitalized may not be included in inventory or charged to capital accounts or basis beginning any earlier than the taxable year during which the amount is incurred within the meaning of section 1.446-1(c)(1)(ii).

* * * * *

Par. 6. Section 1.446-1 is amended by revising paragraph (c)(1)(ii) to read as follows:

SECTION 1.446-1 GENERAL RULE FOR METHODS OF ACCOUNTING.

* * * * *

(c) * * *

(1) * * *

(ii) ACCRUAL METHOD. (A) Generally, under an accrual method, income is to be included for the taxable year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Under such a method, a liability is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. (See paragraph (a)(2)(iii)(A) of section 1.461-1 for examples of liabilities that may not be taken into account until after the taxable year incurred, and see sections 1.461-4 through 1.461-6 for rules relating to economic performance.) Applicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary prescribe the manner in which a liability that has been incurred is taken into account. For example, section 162 provides that a deductible liability generally is taken into account in the taxable year incurred through a deduction from gross income. As a further example, under section 263 or 263A, a liability that relates to the creation of an asset having a useful life extending substantially beyond the close of the taxable year is taken into account in the taxable year incurred through capitalization (within the meaning of section 1.263A-1T(a)(5)), and may later affect the computation of taxable income through depreciation or otherwise over a period including subsequent taxable years, in accordance with applicable Code sections and guidance published by the Secretary.

(B) The term "liability" includes any item allowable as a deduction, cost, or expense for Federal income tax purposes. In addition to allowable deductions, the term includes any amount otherwise allowable as a capitalized cost, as a cost taken into account in computing cost of goods sold, as a cost allocable to a long-term contract, or as any other cost or expense. Thus, for example, an amount that a taxpayer expends or will expend for capital improvements to property must be incurred before the taxpayer may take the amount into account in computing its basis in the property. The term "liability" is not limited to items for which a legal obligation to pay exists at the time of payment. Thus, for example, amounts prepaid for goods or services and amounts paid without a legal obligation to do so may not be taken into account by an accrual basis taxpayer any earlier than the taxable year in which those amounts are incurred.

(C) No method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. The method used by the taxpayer in determining when income is to be accounted for will generally be acceptable if it accords with generally accepted accounting principles, is consistently used by the taxpayer from year to year, and is consistent with the Income Tax Regulations. For example, a taxpayer engaged in a manufacturing business may account for sales of the taxpayer's product when the goods are shipped, when the product is delivered or accepted, or when title to the goods passes to the customers, whether or not billed, depending on the method regularly employed in keeping the taxpayer's books.

* * * * *

Par. 7. Section 1.451-3 is amended by adding a new paragraph (a)(8) to read as follows:

SECTION 1.451-3 LONG-TERM CONTRACTS.

(a) * * *

(8) INCURRED. For purposes of this section, the term "incurred" has the same meaning as in section 1.446-1(c)(1)(ii).

* * * * *

Par. 8. New section 1.461-0 is added to read as follows:

SECTION 1.461-0 TABLE OF CONTENTS.

This section lists the captions that appear in the regulations under section 461 of the Internal Revenue Code.

SECTION 1.461-1 GENERAL RULE FOR TAXABLE YEAR OF DEDUCTION.

(a) General rule. (1) Taxpayer using cash receipts and disbursements method. (2) Taxpayer using an accrual method. (3) Effect in current taxable year of improperly accounting for a liability in a prior taxable year. (4) Deductions attributable to certain foreign income. (b) Special rule in case of death. (c) Accrual of real property taxes. (1) In general. (2) Special rules. (3) When election may be made. (4) Binding effect of election. (5) Apportionment of taxes on real property between seller and purchaser. (6) Examples. (d) Limitation on acceleration of accrual of taxes. (e) Dividends or interest paid by certain savings institutions on certain deposits or withdrawable accounts. (1) Deduction not allowable. (2) Computation of amounts not allowed as a deduction. (3) When amounts allowable.

SECTION 1.461-2 CONTESTED LIABILITIES.

(a) General rule. (1) Taxable year of deduction. (2) Exception. (3) Refunds includible in gross income. (4) Examples. (5) Liabilities described in paragraph (g) of section 1.461-4. [Reserved] (b) Contest of asserted liability. (1) Asserted liability. (2) Definition of the term "contest." (3) Example. (c) Transfer to provide for the satisfaction of an asserted liability. (1) In general. (2) Examples. (d) Contest exists after transfer. (e) Deduction otherwise allowed. (1) In general. (2) Example. (f) Treatment of money or property transferred to an escrowee, trustee, or court and treatment of any income attributable thereto. [Reserved] (g) Effective dates.

SECTION 1.461-3 PREPAID INTEREST. [RESERVED]

SECTION 1.461-4 ECONOMIC PERFORMANCE.

(a) Introduction. (1) In general. (2) Overview. (b) Exceptions to the economic performance requirement. (c) Definitions. (1) Liability. (2) Payment. (d) Liabilities arising out of the provision of services, property, or the use of property. (1) In general. (2) Services or property provided to the taxpayer. (3) Use of property provided to the taxpayer. (4) Services or property provided by the taxpayer. (5) Liabilities that are assumed in connection with the sale of a trade or business. (6) Rules relating to the provision of services or property to a taxpayer. (7) Examples. (e) Interest. (f) Timing of deductions from notional principal contracts. [Reserved] (g) Certain liabilities for which payment is economic performance. (1) In general. (2) Liabilities arising under a workers compensation act or out of any tort, breach of contract, or violation of law. (3) Rebates and refunds. (4) Awards, prizes, and jackpots. (5) Insurance, warranty, and service contracts. (6) Taxes. (7) Other liabilities. (8) Examples. (h) Liabilities arising under the Nuclear Waste Policy Act of 1982. (i) [Reserved] (j) Contingent liabilities. [Reserved] (k) Special effective dates. (1) In general. (2) Long-term contracts. (3) Payment liabilities. (l) [Reserved] (m) Change in method of accounting required by this section. (1) In general. (2) Change in method of accounting for long-term contracts and payment liabilities.

SECTION 1.461-5 RECURRING ITEM EXCEPTION.

(a) In general. (b) Requirements for use of the exception. (1) General rule. (2) Amended returns. (3) Liabilities that are recurring in nature. (4) Materiality requirement. (5) Matching requirement. (c) Types of liabilities not eligible for treatment under the recurring item exception. (d) Time and manner of adopting the recurring item exception. (1) In general. (2) Change to the recurring item exception method for the first taxable year beginning after December 31, 1991. (3) Retroactive change to the recurring item exception method. (e) Examples.

SECTION 1.461-6 ECONOMIC PERFORMANCE WHEN CERTAIN LIABILITIES ARE ASSIGNED OR ARE EXTINGUISHED BY THE ESTABLISHMENT OF A FUND.

(a) Qualified assignments of certain personal injury liabilities under section 130. (b) Section 468B. (c) Payments to other funds or persons that constitute economic performance. [Reserved] (d) Effective dates.

SECTION 1.461-7T QUESTIONS AND ANSWERS RELATING TO THE EFFECTIVE DATES OF SECTION 461(h).

Par. 9. Section 1.461-1 is amended by revising paragraph (a)(2) and the heading and text of paragraph (a)(3) to read as follows:

SECTION 1.461-1 GENERAL RULE FOR TAXABLE YEAR OF DEDUCTION.

(a) * * *

(2) TAXPAYER USING AN ACCRUAL METHOD -- (i) IN GENERAL. Under an accrual method of accounting, a liability (as defined in section 1.446-1(c)(1)(ii)(B)) is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. (See paragraph (a)(2)(iii)(A) of this section for examples of liabilities that may not be taken into account until a taxable year subsequent to the taxable year incurred, and see sections 1.461-4 through 1.461-6 for rules relating to economic performance.) Applicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary prescribe the manner in which a liability that has been incurred is taken into account. For example, section 162 provides that a deductible liability generally is taken into account in the taxable year incurred through a deduction from gross income. As a further example, under section 263 or 263A, a liability that relates to the creation of an asset having a useful life extending substantially beyond the close of the taxable year is taken into account in the taxable year incurred through capitalization (within the meaning of section 1.263A-1T(a)(5)), and may later affect the computation of taxable income through depreciation or otherwise over a period including subsequent taxable years, in accordance with applicable Code sections and guidance published by the Secretary. The principles of this paragraph (a)(2) also apply in the calculation of earnings and profits and accumulated earnings and profits.

(ii) UNCERTAINTY AS TO THE AMOUNT OF A LIABILITY. While no liability shall be taken into account before economic performance and all of the events that fix the liability have occurred, the fact that the exact amount of the liability cannot be determined does not prevent a taxpayer from taking into account that portion of the amount of the liability which can be computed with reasonable accuracy within the taxable year. For example, A renders services to B during the taxable year for which A charges $10,000. B admits a liability to A for $6,000 but contests the remainder. B may take into account only $6,000 as an expense for the taxable year in which the services were rendered.

(iii) Alternative timing rules. (A) If any provision of the Code requires a liability to be taken into account in a taxable year later than the taxable year provided in paragraph (a)(2)(i) of this section, the liability is taken into account as prescribed in that Code provision. See, for example, section 267 (transactions between related parties) and section 464 (farming syndicates).

(B) If the liability of a taxpayer is subject to section 165 (losses), section 170 (charitable contributions), section 192 (black lung benefit trusts), section 194A (employer liability trusts), section 468 (mining and solid waste disposal reclamation and closing costs), or section 468A (a)(certain nuclear decommissioning costs), the liability is taken into account as determined under that section and not under section 461 or the regulations thereunder.

(C) Section 461 and the regulations thereunder do not apply to any amount allowable under a provision of the Code as a deduction for a reserve for estimated expenses.

(D) Except as otherwise provided in any Internal Revenue regulation, revenue procedure, or revenue ruling, the economic performance requirement of section 461(h) and the regulations thereunder is satisfied to the extent that any amount is otherwise deductible under section 404 (employer contributions to a plan of deferred compensation), section 404A (certain foreign deferred compensation plans), or section 419 (welfare benefit funds). See section 1.461-4(d)(2)(iii).

(3) EFFECT IN CURRENT TAXABLE YEAR OF IMPROPERLY ACCOUNTING FOR A LIABILITY IN A PRIOR TAXABLE YEAR. Each year's return should be complete in itself, and taxpayers shall ascertain the facts necessary to make a correct return. The expenses, liabilities, or loss of one year generally cannot be used to reduce the income of a subsequent year. A taxpayer may not take into account in a return for a subsequent taxable year liabilities that, under the taxpayer's method of accounting, should have been taken into account in a prior taxable year. If a taxpayer ascertains that a liability should have been taken into account in a prior taxable year, the taxpayer should, if within the period of limitation, file a claim for credit or refund of any overpayment of tax arising therefrom. Similarly, if a taxpayer ascertains that a liability was improperly taken into account in a prior taxable year, the taxpayer should, if within the period of limitation, file an amended return and pay any additional tax due. However, except as provided in section 905(c) and the regulations thereunder, if a liability is properly taken into account in an amount based on a computation made with reasonable accuracy and the exact amount of the liability is subsequently determined in a later taxable year, the difference, if any, between such amounts shall be taken into account for the later taxable year.

* * * * *

Par. 10. Section 1.461-2 is amended by revising the heading, adding and reserving a new paragraph (a)(5), removing paragraphs (f), (g) and (h), adding and reserving a new paragraph (f), and adding a new paragraph (g) to read as follows:

SECTION 1.461-2 CONTESTED LIABILITIES.

(a) * * *

(5) LIABILITIES DESCRIBED IN PARAGRAPH (a) OF SECTION 1.461-4. [Reserved]

(f) TREATMENT OF MONEY OR PROPERTY TRANSFERRED TO AN ESCROWEE. TRUSTEE, OR COURT AND TREATMENT OF ANY INCOME ATTRIBUTABLE THERETO. [RESERVED]

(g) EFFECTIVE DATES. Paragraphs (a) through (e) of this section apply to transfers of money or property made in taxable years beginning after December 31, 1953, and ending after August 16, 1954.

Par. 11. Section 1.461-3T is redesignated as section 1.461-7T.

Par. 12. Section 1.461(h)-4T is removed.

Par. 13. Section 1.461-3 is added and reserved and sections 1.461-4 through 1.461-6 are added to read as follows:

SECTION 1.461-3 PREPAID INTEREST. [Reserved]

SECTION 1.461-4 ECONOMIC PERFORMANCE.

(a) INTRODUCTION -- (1) IN GENERAL. For purposes of determining whether an accrual basis taxpayer can treat the amount of any liability (as defined in section 1.446-1(c)(1)(ii)(B)) as incurred, the all events test is not treated as met any earlier than the taxable year in which economic performance occurs with respect to the liability.

(2) OVERVIEW. Paragraph (b) of this section lists exceptions to the economic performance requirement. Paragraph (c) of this section provides cross-references to the definitions of certain terms for purposes of section 461(h) and the regulations thereunder. Paragraphs (d) through (m) of this section and section 1.461-6 provide rules for determining when economic performance occurs. Section 1.461-5 provides rules relating to an exception under which certain recurring items may be incurred for the taxable year before the year during which economic performance occurs.

(b) EXCEPTIONS TO THE ECONOMIC PERFORMANCE REQUIREMENT. Paragraph (a)(2)(iii)(B) of section 1.461-1 provides examples of liabilities that are taken into account under rules that operate without regard to the all events test (including economic performance).

(c) DEFINITIONS. The following cross-references identify certain terms defined for purposes of section 461(h) and the regulations thereunder:

(1) LIABILITY. See paragraph (c)(1)(ii)(B) of section 1.446-1 for the definition of "liability."

(2) Payment. See paragraph (g)(1)(ii) of this section for the definition of "payment."

(d) LIABILITIES ARISING OUT OF THE PROVISION OF SERVICES, PROPERTY, OR THE USE OF PROPERTY -- (1) IN GENERAL. The principles of this paragraph (d) determine when economic performance occurs with respect to liabilities arising out of the performance of services, the transfer of property, or the use of property. This paragraph (d) does not apply to liabilities described in paragraph (e)(relating to interest expense) or paragraph (g) (relating to breach of contract, workers compensation, tort, etc.) of this section. In addition, except as otherwise provided in Internal Revenue regulations, revenue procedures, or revenue rulings this paragraph (d) does not apply to amounts paid pursuant to a notional principal contract. The Commissioner may provide additional rules in regulations, revenue procedures, or revenue rulings concerning the time at which economic performance occurs for items described in this paragraph (d).

(2) SERVICES OR PROPERTY PROVIDED TO THE TAXPAYER -- (i) IN GENERAL. Except as otherwise provided in paragraph (d)(5) of this section, if the liability of a taxpayer arises out of the providing of services or property to the taxpayer by another person, economic performance occurs as the services or property is provided.

(ii) LONG-TERM CONTRACTS. In the case of any liability of a taxpayer described in paragraph (d)(2)(i) of this section that is an expense attributable to a long-term contract with respect to which the taxpayer uses the percentage of completion method, economic performance occurs --

(A) As the services or property is provided; or, if earlier,

(B) As the taxpayer makes payment (as defined in paragraph (g)(1)(ii) of this section) in satisfaction of the liability to the person providing the services or property. See paragraph (k)(2) of this section for the effective date of this paragraph (d)(2)(ii).

(iii) EMPLOYEE BENEFITS -- (A) IN GENERAL. Except as otherwise provided in any Internal Revenue regulation, revenue procedure, or revenue ruling, the economic performance requirement is satisfied to the extent that any amount is otherwise deductible under section 404 (employer contributions to a plan of deferred compensation), section 404A (certain foreign deferred compensation plans), and section 419 (welfare benefit funds). See section 1.461-1 (a)(2)(iii)(D).

(3) PROPERTY TRANSFERRED IN CONNECTION WITH PERFORMANCE OF SERVICES. [Reserved]

(iv) CROSS-REFERENCES. See EXAMPLES 4 through 6 of paragraph (d)(7) of this section. See paragraph (d)(6) of this section for rules relating to when a taxpayer may treat services or property as provided to the taxpayer.

(3) USE OF PROPERTY PROVIDED TO THE TAXPAYER -- (i) IN GENERAL. Except as otherwise provided in this paragraph (d)(3) and paragraph (d)(5) of this section, if the liability of a taxpayer arises out of the use of property by the taxpayer, economic performance occurs ratably over the period of time the taxpayer is entitled to the use of the property (taking into account any reasonably expected renewal periods when necessary to carry out the purposes of section 461(h)). See Examples 6 through 9 of paragraph (d)(7) of this section.

(ii) EXCEPTIONS. If the liability of a taxpayer arises out of the use of property by the taxpayer and all or a portion of the liability is determined by reference to the frequency or volume of use of the property or the income from the property, economic performance occurs for the portion of the liability determined by reference to the frequency or volume of use of the property or the income from the property as the taxpayer uses the property or includes income from the property. See Examples 8 and 9 of paragraph (d)(7) of this section. This paragraph (d)(3)(ii) shall not apply if the District Director determines, that based on the substance of the transaction, the liability of the taxpayer for use of the property is more appropriately measured ratably over the period of time the taxpayer is entitled to the use of the property.

(4) SERVICES OR PROPERTY PROVIDED BY THE TAXPAYER -- (i) IN GENERAL. Except as otherwise provided in paragraph (d)(5) of this section, if the liability of a taxpayer requires the taxpayer to provide services or property to another person, economic performance occurs as the taxpayer incurs costs (within the meaning of section 1.446-1(c)(1)(ii)) in connection with the satisfaction of the liability. See Examples 1 through 3 of paragraph (d)(7) of this section.

(ii) BARTER TRANSACTIONS. If the liability of a taxpayer requires the taxpayer to provide services, property, or the use of property, and arises out of the use of property by the taxpayer, or out of the provision of services or property to the taxpayer by another person, economic performance occurs to the extent of the lesser of --

(A) The cumulative extent to which the taxpayer incurs costs (within the meaning of section 1.446-1(c)(1)(ii)) in connection with its liability to provide the services or property; or

(B) The cumulative extent to which the services or property is provided to the taxpayer.

(5) LIABILITIES THAT ARE ASSUMED IN CONNECTION WITH THE SALE OF A TRADE OR BUSINESS -- (i) IN GENERAL. If, in connection with the sale or exchange of a trade or business by a taxpayer, the purchaser expressly assumes a liability arising out of the trade or business that the taxpayer but for the economic performance requirement would have been entitled to incur as of the date of the sale, economic performance with respect to that liability occurs as the amount of the liability is properly included in the amount realized on the transaction by the taxpayer. See section 1.1001-2 for rules relating to the inclusion in amount realized from a discharge of liabilities resulting from a sale or exchange.

(ii) TRADE OR BUSINESS. For purposes of this paragraph (d)(5), a trade or business is a specific group of activities carried on by the taxpayer for the purpose of earning income or profit if every operation that is necessary to the process of earning income or profit is included in the group. Thus, for example, the group of activities generally must include the collection of income and the payment of expenses.

(iii) TAX AVOIDANCE. This paragraph (d)(5) does not apply if the District Director determines that tax avoidance is one of the taxpayer's principal purposes for the sale or exchange.

(6) RULES RELATING TO THE PROVISION OF SERVICES OR PROPERTY TO A TAXPAYER. The following rules apply for purposes of this paragraph (d):

(i) Services or property provided to a taxpayer include services or property provided to another person at the direction of the taxpayer.

(ii) A taxpayer is permitted to treat services or property as provided to the taxpayer as the taxpayer makes payment to the person providing the services or property (as defined in paragraph (g)(1)(ii) of this section), if the taxpayer can reasonably expect the person to provide the services or property within 3-1/2 months after the date of payment.

(iii) A taxpayer is permitted to treat property as provided to the taxpayer when the property is delivered or accepted, or when title to the property passes. The method used by the taxpayer to determine when property is provided is a method of accounting that must comply with the rules of section 1.446-1(e). Thus, the method of determining when property is provided must be used consistently from year to year, and cannot be changed without the consent of the Commissioner.

(iv) If different services or items of property are required to be provided to a taxpayer under a single contract or agreement, economic performance generally occurs over the time each service is provided and as each item of property is provided. However, if a service or item of property to be provided to the taxpayer is incidental to other services or property to be provided under a contract or agreement, the taxpayer is not required to allocate any portion of the total contract price to the incidental service or property. For purposes of this paragraph (d)(6)(iv), services or property is treated as incidental only if --

(A) The cost of the services or property is treated on the taxpayer's books and records as part of the cost of the other services or property provided under the contract; and

(B) The aggregate cost of the services or property does not exceed 10 percent of the total contract price.

(7) EXAMPLES. The following examples illustrate the principles of this paragraph (d). For purposes of these examples, it is assumed that the requirements of the all events test other than economic performance have been met, and that the recurring item exception is not used.

EXAMPLE 1. SERVICES OR PROPERTY PROVIDED BY THE TAXPAYER. (i) X corporation, a calendar year, accrual method taxpayer, is an oil company. During March 1990, X enters into an oil and gas lease with Y. In November 1990, X installs a platform and commences drilling. The lease obligates X to remove its offshore platform and well fixtures upon abandonment of the well or termination of the lease. During 1998, X removes the platform and well fixtures at a cost of $200,000.

(ii) Under paragraph (d)(4)(i) of this section, economic performance with respect to X's liability to remove the offshore platform and well fixtures occurs as X incurs costs in connection with that liability. X incurs these costs in 1998 as, for example, X's employees provide X with removal services (see paragraph (d)(2) of this section). Consequently, X incurs $200,000 for the 1998 taxable year. Alternatively, assume that during 1990 X pays Z $130,000 to remove the platform and fixtures, and that Z performs these removal services in 1998. Under paragraph (d)(2) of this section, X does not incur this cost until Z performs the services. Thus, economic performance with respect to the $130,000 X pays Z occurs in 1998.

EXAMPLE 2. SERVICES OR PROPERTY PROVIDED BY THE TAXPAYER. (i) W corporation, a calendar year, accrual method taxpayer, sells tractors under a three-year warranty that obligates W to make any reasonable repairs to each tractor it sells. During 1990, W sells ten tractors. In 1992 W repairs, at a cost of $5,000, two tractors sold during 1990.

(ii) Under paragraph (d)(4)(i) of this section, economic performance with respect to W's liability to perform services under the warranty occurs as W incurs costs in connection with that liability. W incurs these costs in 1992 as, for example, replacement parts are provided to W (see paragraph (d)(2) of this section). Consequently, $5,000 is incurred by W for the 1992 taxable year.

EXAMPLE 3. SERVICES OR PROPERTY PROVIDED BY THE TAXPAYER; LONG-TERM CONTRACTS. (i) W corporation, a calendar year, accrual method taxpayer, manufactures machine tool equipment. In November 1992, W contracts to provide X corporation with certain equipment. The contract is not a long-term contract under section 460 or section 1.451-3. In 1992, W pays Z corporation $50,000 to lease from Z, for the one-year period beginning on January 1, 1993, testing equipment to perform quality control tests required by the agreement with X. In 1992, pursuant to the terms of a contract, W pays Y corporation $100,000 for certain parts necessary to manufacture the equipment. The parts are provided to W in 1993. W's employees provide W with services necessary to manufacture the equipment during 1993, for which W pays $150,000 in 1993.

(ii) Under paragraph (d)(4) of this section, economic performance with respect to W's liability to provide the equipment to X occurs as W incurs costs in connection with that liability. W incurs these costs during 1993, as services, property, and the use of property necessary to manufacture the equipment are provided to W (see paragraphs (d)(2) and (d)(3) of this section). Thus, $300,000 is incurred by W for the 1993 taxable year. See section 263A and the regulations thereunder for rules relating to the capitalization and inclusion in inventory of these incurred costs.

(iii) Alternatively, assume that the agreement with X is a long-term contract as defined in section 460(f), and that W takes into account all items with respect to such contracts under the percentage of completion method as described in section 460(b)(1). Under paragraph (d)(2)(ii) of this section, the $100,000 W pays in 1992 for parts is incurred for the 1992 taxable year, for purposes of determining the percentage of completion under section 460(b)(1)(A). W's other costs under the agreement are incurred for the 1993 taxable year for this purpose.

EXAMPLE 4. SERVICES OR PROPERTY PROVIDED TO THE TAXPAYER. (i) LP1, a calendar year, accrual method limited partnership, owns the working interest in a parcel of property containing oil and gas. During December 1990, LP1 enters into a turnkey contract with Z corporation pursuant to which LP1 pays Z $200,000 and Z is required to provide a completed well by the close of 1992. In May 1992, Z commences drilling the well, and, in December 1992, the well is completed.

(ii) Under paragraph (d)(2) of this section, economic performance with respect to LP1's liability for drilling and development services provided to LP1 by Z occurs as the services are provided. Consequently, $200,000 is incurred by LP1 for the 1992 taxable year.

EXAMPLE 5. SERVICES OR PROPERTY PROVIDED TO THE TAXPAYER. (i) X corporation, a calendar year, accrual method taxpayer, is an automobile dealer. On January 15, 1990, X agrees to pay an additional $10 to Y, the manufacturer of the automobiles, for each automobile purchased by X from Y. Y agrees to provide advertising and promotional activities to X.

(ii) During 1990, X purchases from Y 1,000 new automobiles and pays to Y an additional $10,000 as provided in the agreement. Y, in turn, uses this $10,000 to provide advertising and promotional activities during 1992.

(iii) Under paragraph (d)(2) of this section, economic performance with respect to X's liability for advertising and promotional services provided to X by Y occurs as the services are provided. Consequently, $10,000 is incurred by X for the 1992 taxable year.

EXAMPLE 6. USE OF PROPERTY PROVIDED TO THE TAXPAYER; SERVICES OR PROPERTY PROVIDED TO THE TAXPAYER. (i) V corporation, a calendar year, accrual method taxpayer, charters aircraft. On December 20, 1990, V leases a jet aircraft from L for the four-year period that begins on January 1, 1991. The lease obligates V to pay L a base rental of $500,000 per year. In addition, the lease requires V to pay $25 to an escrow account for each hour that the aircraft is flown. The escrow account funds are held by V and are to be used by L to make necessary repairs to the aircraft. Any amount remaining in the escrow account upon termination of the lease is payable to V. During 1991, the aircraft is flown 1,000 hours and V pays $25,000 to the escrow account. The aircraft is repaired by L in 1993. In 1994, $20,000 is released from the escrow account to pay L for the repairs.

(ii) Under paragraph (d)(3)(i) of this section, economic performance with respect to V's base rental liability occurs ratably over the period of time V is entitled to use the jet aircraft. Consequently, the $500,000 rent is incurred by V for the 1991 taxable year and for each of the next three taxable years. Under paragraph (d)(2) of this section, economic performance with respect to the liability to place amounts in escrow occurs as the aircraft is repaired. Consequently, V incurs $20,000 for the 1993 taxable year.

EXAMPLE 7. USE OF PROPERTY PROVIDED TO THE TAXPAYER. (i) X corporation, a calendar year, accrual method taxpayer, manufactures and sells electronic circuitry. On November 15, 1990, X enters into a contract with Y that entitles X to the exclusive use of a product owned by Y for the five-year period beginning on January 1, 1991. Pursuant to the contract, X pays Y $100,000 on December 30, 1990.

(ii) Under paragraph (d)(3)(i) of this section, economic performance with respect to X's liability for the use of property occurs ratably over the period of time X is entitled to use the product. Consequently, $20,000 is incurred by X for 1991 and for each of the succeeding four taxable years.

EXAMPLE 8. USE OF PROPERTY PROVIDED TO THE TAXPAYER. (i) Y corporation, a calendar year, accrual method taxpayer, enters into a five-year lease with Z for the use of a copy machine on July 1, 1991. Y also receives delivery of the copy machine on July 1, 1991. The lease obligates Y to pay Z a base rental payment of $6,000 per year at the beginning of each lease year and an additional charge of 5 cents per copy 30 days after the end of each lease year. The machine is used to make 50,000 copies during the first lease year: 20,000 copies in 1991 and 30,000 copies from January 1, 1992, to July 1, 1992. Y pays the $6,000 base rental payment to 2 on July 1, 1991, and the $2,500 variable use payment on July 30, 1992.

(ii) Under paragraph (d)(3)(i) of this section, economic performance with respect to Y's base rental liability occurs ratably over the period of time Y is entitled to use the copy machine. Consequently, $3,000 rent is incurred by Y for the 1991 taxable year. Under paragraph (d)(3)(ii) of this section, economic performance with respect to Y's variable use portion of the liability occurs as Y uses the machine. Thus, the $1,000 of the $2,500 variable-use liability that relates to the 20,000 copies made in 1991 is incurred by Y for the 1991 taxable year.

EXAMPLE 9. USE OF PROPERTY PROVIDED TO THE TAXPAYER. (i) X corporation, a calendar year, accrual method taxpayer, enters into a five-year product distribution agreement with Y, on January 1, 1992. The agreement provides for a payment of $100,000 on January 1, 1992, plus 10 percent of the gross profits earned by X from distribution of the product. The variable income portion of X's liability is payable on April 1 of each subsequent year. On January 1, 1992, X pays Y $100,000. On April 1, 1993, X pays Y $3 million representing 10 percent of X's gross profits from January 1 through December 31, 1992.

(ii) Under paragraph (d)(3)(i) of this section, economic performance with respect to X's $100,000 payment occurs ratably over the period of time X is entitled to use the product. Consequently, $20,000 is incurred by X for each year of the agreement beginning with 1992. Under paragraph (d)(3)(ii) of this section, economic performance with respect to X's variable income portion of the liability occurs as the income is earned by X. Thus, the $3 million variable-income liability is incurred by X for the 1992 taxable year.

(e) INTEREST. In the case of interest, economic performance occurs as the interest cost economically accrues, in accordance with the principles of relevant provisions of the Code.

(f) TIMING OF DEDUCTIONS FROM NOTIONAL PRINCIPAL CONTRACTS. [Reserved]

(g) CERTAIN LIABILITIES FOR WHICH PAYMENT IS ECONOMIC PERFORMANCE -- (1) IN GENERAL -- (i) PERSON TO WHICH PAYMENT MUST BE MADE. In the case of liabilities described in paragraphs (g)(2) through (7) of this section, economic performance occurs when, and to the extent that, payment is made to the person to which the liability is owed. Thus, except as otherwise provided in paragraph (g)(1)(iv) of this section and section 1.461-6, economic performance does not occur as a taxpayer makes payments in connection with such a liability to any other person, including a trust, escrow account, court-administered fund, or any similar arrangement, unless the payments constitute payment to the person to which the liability is owed under paragraph (g)(1)(ii)(B) of this section. Instead, economic performance occurs as payments are made from that other person or fund to the person to which the liability is owed. The amount of economic performance that occurs as payment is made from the other person or fund to the person to which the liability is owed may not exceed the amount the taxpayer transferred to the other person or fund. For special rules relating to the taxation of amounts transferred to "qualified settlement funds," see section 468B and the regulations thereunder. The Commissioner may provide additional rules in regulations, revenue procedures, and revenue rulings concerning the time at which economic performance occurs for items described in this paragraph (g).

(ii) PAYMENT TO PERSON TO WHICH LIABILITY IS OWED. Paragraph (d)(6) of this section provides that for purposes of paragraph (d) of this section (relating to the provision of services or property to the taxpayer) in certain cases a taxpayer may treat services or property as provided to the taxpayer as the taxpayer makes payments to the person providing the services or property. In addition, this paragraph (g) provides that in the case of certain liabilities of a taxpayer, economic performance occurs as the taxpayer makes payment to persons specified therein. For these and all other purposes of section 461(h) and the regulations thereunder:

(A) PAYMENT. The term "payment" has the same meaning as is used when determining whether a taxpayer using the cash receipts and disbursements method of accounting has made a payment. Thus, for example, payment includes the furnishing of cash or cash equivalents and the netting of offsetting accounts. Payment does not include the furnishing of a note or other evidence of indebtedness of the taxpayer, whether or not the evidence is guaranteed by any other instrument (including a standby letter of credit) or by any third party (including a government agency). As a further example, payment does not include a promise of the taxpayer to provide services or property in the future (whether or not the promise is evidenced by a contract or other written agreement). In addition, payment does not include an amount transferred as a loan, refundable deposit, or contingent payment.

(B) PERSON TO WHICH PAYMENT IS MADE. Payment to a particular person is accomplished if paragraph (g)(1)(ii)(A) of this section is satisfied and a cash basis taxpayer in the position of that person would be treated as having actually or constructively received the amount of the payment as gross income under the principles of section 451 (without regard to section 104(a) or any other provision that specifically excludes the amount from gross income). Thus, for example, the purchase of an annuity contract or any other asset generally does not constitute payment to the person to which a liability is owed unless the ownership of the contract or other asset is transferred to that person.

(C) LIABILITIES THAT ARE ASSUMED IN CONNECTION WITH THE SALE OF A TRADE OR BUSINESS. Paragraph (d)(5) of this section provides rules that determine when economic performance occurs in the case of liabilities that are assumed in connection with the sale of a trade or business. The provisions of paragraph (d)(5) of this section also apply to any liability described in paragraph (g)(2) through (7) of this section that the purchaser expressly assumes in connection with the sale or exchange of a trade or business by a taxpayer, provided the taxpayer (but for the economic performance requirement) would have been entitled to incur the liability as of the date of the sale.

(iii) PERSON. For purposes of this paragraph (g), "person" has the same meaning as in section 7701(a)(1), except that it also includes any foreign state, the United States, any State or political subdivision thereof, any possession of the United States, and any agency or instrumentality of any of the foregoing.

(iv) ASSIGNMENTS. If a person that has a right to receive payment in satisfaction of a liability described in paragraphs (g)(2) through (7) of this section makes a valid assignment of that right to a second person, or if the right is assigned to the second person through operation of law, then payment to the second person in satisfaction of that liability constitutes payment to the person to which the liability is owed.

(2) LIABILITIES ARISING UNDER A WORKERS COMPENSATION ACT OR OUT OF ANY TORT, BREACH OF CONTRACT, OR VIOLATION OF LAW. If the liability of a taxpayer requires a payment or series of payments to another person and arises under any workers compensation act or out of any tort, breach of contract, or violation of law, economic performance occurs as payment is made to the person to which the liability is owed. See Example 1 of paragraph (g)(8) of this section. For purposes of this paragraph (g)(2) --

(i) A liability to make payments for services, property, or other consideration provided under a contract is not a liability arising out of a breach of that contract unless the payments are in the nature of incidental, consequential, or liquidated damages; and

(ii) A liability arising out of a tort, breach of contract, or violation of law includes a liability arising out of the settlement of a dispute in which a tort, breach of contract, or violation of law, respectively, is alleged.

(3) REBATES AND REFUNDS. If the liability of a taxpayer is to pay a rebate, refund, or similar payment to another person (whether paid in property, money, or as a reduction in the price of goods or services to be provided in the future by the taxpayer), economic performance occurs as payment is made to the person to which the liability is owed. This paragraph (g)(3) applies to all rebates, refunds, and payments or transfers in the nature of a rebate or refund regardless of whether they are characterized as a deduction from gross income, an adjustment to gross receipts or total sales, or an adjustment or addition to cost of goods sold. In the case of a rebate or refund made as a reduction in the price of goods or services to be provided in the future by the taxpayer, "payment" is deemed to occur as the taxpayer would otherwise be required to recognize income resulting from a disposition at an unreduced price. See Example 2 of paragraph (g)(8) of this section. For purposes of determining whether the recurring item exception of section 1.461-5 applies, a liability that arises out of a tort, breach of contract, or violation of law is not considered a rebate or refund.

(4) AWARDS, PRIZES, AND JACKPOTS. If the liability of a taxpayer is to provide an award, prize, jackpot, or other similar payment to another person, economic performance occurs as payment is made to the person to which the liability is owed. See Examples 3 and 4 of paragraph (g)(8) of this section.

(5) INSURANCE, WARRANTY, AND SERVICE CONTRACTS. If the liability of a taxpayer arises out of the provision to the taxpayer of insurance, or a warranty or service contract, economic performance occurs as payment is made to the person to which the liability is owed. See Examples 5 through 7 of paragraph (g)(8) of this section. For purposes of this paragraph (g)(5) --

(i) A warranty or service contract is a contract that a taxpayer enters into in connection with property bought or leased by the taxpayer, pursuant to which the other party to the contract promises to replace or repair the property under specified circumstances.

(ii) The term "insurance" has the same meaning as is used when determining the deductibility of amounts paid or incurred for insurance under section 162.

(6) TAXES -- (i) IN GENERAL. Except as otherwise provided in this paragraph (g)(6), if 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. For purposes of this paragraph (g)(6), payment includes payments of estimated income tax and payments of tax where the taxpayer subsequently files a claim for credit or refund. In addition, for purposes of this paragraph (g)(6), a tax does not include a charge collected by a governmental authority for specific extraordinary services or property provided to a taxpayer by the governmental authority. Examples of such a charge include the purchase price of a parcel of land sold to a taxpayer by a governmental authority and a charge for labor engaged in by government employees to improve that parcel. In certain cases, a liability to pay a 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. See Example 8 of paragraph (g)(8) of this section.

(ii) LICENSING FEES. If the liability of a taxpayer is to pay a licensing or permit fee required by a governmental authority, economic performance occurs as the fee is paid to the governmental authority, or as payment is made to any other person at the direction of the governmental authority.

(iii) EXCEPTIONS -- (A) REAL PROPERTY TAXES. If a taxpayer has made a valid election under section 461(c), the taxpayer's accrual for real property taxes is determined under section 461(c). Otherwise, economic performance with respect to a property tax liability occurs as the tax is paid, as specified in paragraph (g)(6)(i) of this section.

(B) CERTAIN FOREIGN TAXES. If the liability of a taxpayer is to pay an income, war profits, or excess profits tax that is imposed by the authority of any foreign country or possession of the United States and is creditable under section 901 (including a creditable tax described in section 903 that is paid in lieu of such a tax), economic performance occurs when the requirements of the all events test (as described in section 1.446-1(c)(1)(ii)) other than economic performance are met, whether or not the taxpayer elects to credit such taxes under section 901(a).

(7) Other liabilities. In the case of a taxpayer's liability for which economic performance rules are not provided elsewhere in this section or in any other Internal Revenue regulation, revenue ruling or revenue procedure, economic performance occurs as the taxpayer makes payments in satisfaction of the liability to the person to which the liability is owed. This paragraph (g)(7) applies only if the liability cannot properly be characterized as a liability covered by rules provided elsewhere in this section. If a liability may properly be characterized as, for example, a liability arising from the provision of services or property to, or by, a taxpayer, the determination as to when economic performance occurs with respect to that liability is made under paragraph (d) of this section and not under this paragraph (g)(7).

(8) EXAMPLES. The following examples illustrate the principles of this paragraph (g). For purposes of these examples, it is assumed that the requirements of the all events test other than economic performance have been met and, except as otherwise provided, that the recurring item exception is not used.

EXAMPLE 1. LIABILITIES ARISING OUT OF A TORT. (i) During the period 1970 through 1975, Z corporation, a calendar year, accrual method taxpayer, manufactured and distributed industrial products that contained carcinogenic substances. In 1992, a number of lawsuits are filed against Z alleging damages due to exposure to these products. In settlement of a lawsuit maintained by A, Z agrees to purchase an annuity contract that will provide annual payments to A of $50,000 for a period of 25 years. On December 15, 1992, Z pays W, an unrelated life insurance company, $491,129 for such an annuity contract. Z retains ownership of the annuity contract.

(ii) Under paragraph (g)(2) of this section, economic performance with respect to Z's liability to A occurs as each payment is made to A. Consequently, $50,000 is incurred by Z for each taxable year that a payment is made to A under the annuity contract. (Z must also include in income a portion of amounts paid under the annuity, pursuant to section 72.) The result is the same if in 1992 Z secures its obligation with a standby letter of credit.

(iii) If Z later transfers ownership of the annuity contract to A, an amount equal to the fair market value of the annuity on the date of transfer is incurred by Z in the taxable year of the transfer (see paragraph (g)(1)(ii)(B) of this section). In addition, the transfer constitutes a transaction to which section 1001 applies.

EXAMPLE 2. REBATES AND REFUNDS. (i) X corporation, a calendar year, accrual method taxpayer, manufactures and sells hardware products. X enters into agreements that entitle each of its distributors to a rebate (or discount on future purchases) from X based on the amount of purchases made by the distributor from X during any calendar year. During the 1992 calendar year, X becomes liable to pay a $2,000 rebate to distributor A. X pays A $1,200 of the rebate on January 15, 1993, and the remaining $800 on October 15, 1993. Assume the rebate is deductible (or allowable as an adjustment to gross receipts or cost of goods sold) when incurred.

(ii) If X does not adopt the recurring item exception described in section 1.461-5 with respect to rebates and refunds, then under paragraph (g)(3) of this section, economic performance with respect to the $2,000 rebate liability occurs in 1993. However, if X has made a proper election under section 1.461-5, and as of December 31, 1992, all events have occurred that determine the fact of the rebate liability, X incurs $1,200 for the 1992 taxable year. Because economic performance (payment) with respect to the remaining $800 does not occur until October 15, 1993 (more than 8 1/2 months after the end of 1992), X cannot use the recurring item exception for this portion of the liability (see section 1.461-5). Thus, the $800 is not incurred by X until the 1993 taxable year. If, instead of making the cash payments to A during 1993, X adjusts the price of hardware purchased by A that is delivered to A during 1993, X's "payment" occurs as X would otherwise be required to recognize income resulting from a disposition at an unreduced price.

EXAMPLE 3. AWARDS, PRIZES AND JACKPOTS. (i) W corporation, a calendar year, accrual method taxpayer, produces and sells breakfast cereal. W conducts a contest pursuant to which the winner is entitled to $10,000 per year for a period of 20 years. On December 1, 1992, A is declared the winner of the contest and is paid $10,000 by W. In addition, on December 1 of each of the next nineteen years, W pays $10,000 to A.

(ii) Under paragraph (g)(4) of this section, economic performance with respect to the $200,000 contest liability occurs as each of the $10,000 payments is made by W to A. Consequently, $10,000 is incurred by W for the 1992 taxable year and for each of the succeeding nineteen taxable years.

EXAMPLE 4. AWARDS, PRIZES, AND JACKPOTS. (i) Y corporation, a calendar year, accrual method taxpayer, owns a casino that contains progressive slot machines. A progressive slot machine provides a guaranteed jackpot amount that increases as money is gambled through the machine until the jackpot is won or until a maximum predetermined amount is reached. On July 1, 1993, the guaranteed jackpot amount on one of Y's slot machines reaches the maximum predetermined amount of $50,000. On October 1, 1994, the $50,000 jackpot is paid to B.

(ii) Under paragraph (g)(4) of this section, economic performance with respect to the $50,000 jackpot liability occurs on the date the jackpot is paid to B. Consequently, $50,000 is incurred by Y for the 1994 taxable year.

EXAMPLE 5. INSURANCE, WARRANTY, AND SERVICE CONTRACTS. (i) V corporation, a calendar year, accrual method taxpayer, manufactures toys. V enters into a contract with W, an unrelated insurance company, on December 15, 1992. The contract obligates V to pay W a premium of $500,000 before the end of 1995. The contract obligates W to satisfy any liability of V resulting from claims made during 1993 or 1994 against V by any third party for damages attributable to defects in toys manufactured by V. Pursuant to the contract, V pays W a premium of $500,000 on October 1, 1995.

(ii) Assuming the arrangement constitutes insurance, under paragraph (g)(5) of this section economic performance occurs as the premium is paid. Thus, $500,000 is incurred by V for the 1995 taxable year.

EXAMPLE 6. INSURANCE, WARRANTY, AND SERVICE CONTRACTS. (i) Y corporation, a calendar year, accrual method taxpayer, is a common carrier. On December 15, 1992, Y enters into a contract with Z, an unrelated insurance company, under which Z must satisfy any liability of Y that arises during the succeeding 5 years for damages under a workers compensation act or out of any tort, provided the event that causes the damages occurs during 1993 or 1994. Under the contract, Y pays $360,000 to Z on December 31, 1993.

(ii) Assuming the arrangement constitutes insurance, under paragraph (g)(5) of this section economic performance occurs as the premium is paid. Consequently, $360,000 is incurred by Y for the 1993 taxable year. The period for which the $360,000 amount is permitted to be taken into account is determined under the capitalization rules because the insurance contract is an asset having a useful life extending substantially beyond the close of the taxable year.

EXAMPLE 7. INSURANCE, WARRANTY, AND SERVICE CONTRACTS. Assume the same facts as in Example 6, except that Y is obligated to pay the first $5,000 of any damages covered by the arrangement with Z. Y is, in effect, self-insured to the extent of this $5,000 "deductible." Thus, under paragraph (g)(2) of this section, economic performance with respect to the $5,000 liability does not occur until the amount is paid to the person to which the tort or workers compensation liability is owed.

EXAMPLE 8. TAXES. (i) The laws of State A provide that every person owning personal property located in State A on the first day of January shall be liable for tax thereon and that a lien for the tax shall attach as of that date. In addition, the laws of State A provide that 60% of the tax is due on the first day of December following the lien date and the remaining 40% is due on the first day of July of the succeeding year. On January 1, 1992, X corporation, a calendar year, accrual method taxpayer, owns personal property located in State A. State A imposes a $10,000 tax on X with respect to that property on January 1, 1992. X pays State A $6,000 of the tax on December 1, 1992, and the remaining $4,000 on July 1, 1993.

(ii) Under paragraph (g)(6) of this section, economic performance with respect to $6,000 of the tax liability occurs on December 1, 1992. Consequently, $6,000 is incurred by X for the 1992 taxable year. Economic performance with respect to the remaining $4,000 of the tax liability occurs on July 1, 1993. If X has adopted the recurring item exception described in section 1.461-5 as a method of accounting for taxes, and as of December 31, 1992, all events have occurred that determine the liability of X for the remaining $4,000, X also incurs $4,000 for the 1992 taxable year. If X does not adopt the recurring item exception method, the $4,000 is not incurred by X until the 1993 taxable year.

(h) LIABILITIES ARISING UNDER THE NUCLEAR WASTE POLICY ACT OF 1982. Notwithstanding the principles of paragraph (d) of this section, economic performance with respect to the liability of an owner or generator of nuclear waste to make payments to the Department of Energy ("DOE") pursuant to a contract required by the Nuclear Waste Policy Act of 1982 (Pub. L. 97-425, 42 U.S.C. 10101-10226 (1982)) occurs as each payment under the contract is made to DOE and not when DOE satisfies its obligations under the contract. This rule applies to the continuing fee required by 42 U.S.C. 10222(a)(2) (1982), as well as the one-time fee required by 42 U.S.C. 10222(a)(3) (1982). For rules relating to when economic performance occurs with respect to interest, see paragraph (e) of this section.

(i) [Reserved]

(j) CONTINGENT LIABILITIES. [Reserved]

(k) SPECIAL EFFECTIVE DATES -- (1) IN GENERAL. Except as otherwise provided in this paragraph (k) and section 1.461-7T, section 461(h) and this section apply to liabilities that would, under the law in effect before the enactment of section 461(h), be allowable as a deduction or otherwise incurred after July 18, 1984. For example, the economic performance requirement applies to all liabilities arising under a workers compensation act or out of any tort that would, under the law in effect before the enactment of section 461(h), be incurred after July 18, 1984. See, however, Q&A-2 of section 1.461-7T, which provides an election to make this change in method of accounting applicable to either the portion of the first taxable year that occurs after July 18, 1984 ("part-year change method"), or the entire first taxable year ending after July 18, 1984 ("full-year change method"). See also Q&A-12 of section 1.461-7T for special effective date rules for interest.

(2) LONG-TERM CONTRACTS. Except as otherwise provided in paragraph (m)(2) of this section, in the case of liabilities described in paragraph (d)(2)(ii) of this section (relating to long- term contracts), paragraph (d)(2)(ii) of this section applies to liabilities that would, but for the enactment of section 461(h), be allowable as a deduction or otherwise incurred for taxable years beginning after December 31, 1991.

(3) PAYMENT LIABILITIES. Except as otherwise provided in paragraph (m)(2) of this section, in the case of liabilities described in paragraph (g) of this section (other than liabilities arising under a workers compensation act or out of any tort described in paragraph (g)(2) of this section), paragraph (g) of this section applies to liabilities that would, but for the enactment of section 461(h), be allowable as a deduction or otherwise incurred for taxable years beginning after December 31, 1991.

(1) [Reserved]

(m) CHANGE IN METHOD OF ACCOUNTING REQUIRED BY THIS SECTION -- (1) IN GENERAL. For the first taxable year ending after July 18, 1984, a taxpayer is granted the consent of the Commissioner to change its method of accounting for liabilities to comply with the provisions of this section pursuant to any of the following procedures:

(i) The part-year change in method election described in Q&A-2 through Q&A-6 and Q&A-8 through Q&A-10 of section 1.461-7T;

(ii) The full-year change in method election described in Q&A-2 through Q&A-6 and Q&A-8 through Q&A-10 of section 1.461-7T; or

(iii) If no election is made, the cut-off method described in Q&A-1 and Q&A-11 of section 1.461-7T.

(2) CHANGE IN METHOD OF ACCOUNTING FOR LONG-TERM CONTRACTS AND PAYMENT LIABILITIES -- (i) FIRST TAXABLE YEAR BEGINNING AFTER DECEMBER 31, 1991. For the first taxable year beginning after December 31, 1991, a taxpayer is granted the consent of the Commissioner to change its method of accounting for long-term contract liabilities described in paragraph (d)(2)(ii) of this section and payment liabilities described in paragraph (g) of this section (other than liabilities arising under a workers compensation act or out of any tort described in paragraph (g)(2) of this section) to comply with the provisions of this section. The change must be made in accordance with paragraph (m)(1)(ii) or (m)(1)(iii) of this section, except the effective date is the first day of the first taxable year beginning after December 31, 1991.

(ii) RETROACTIVE CHANGE IN METHOD OF ACCOUNTING FOR LONG-TERM CONTRACTS AND PAYMENT LIABILITIES. For the first taxable year beginning after December 31, 1989, or the first taxable year beginning after December 31, 1990, a taxpayer is granted the consent of the Commissioner to change its method of accounting for long-term contract liabilities described in paragraph (d)(2)(ii) of this section and payment liabilities described in paragraph (g) of this section (other than liabilities arising under a workers compensation act or out of any tort described in paragraph (g)(2) of this section) to comply with the provisions of this section. The change must be made in accordance with paragraph (m)(1)(ii) or (m)(1)(iii) of this section, except the effective date is the first day of the first taxable year beginning after December 31, 1989, or the first day of the first taxable year beginning after December 31, 1990. The taxpayer may make the change in method of accounting, including a full-year change in method election under paragraph (m)(1)(ii) of this section and Q&A-5 of section 1.461-7T, by filing an amended return for such year, provided the amended return is filed on or before October 7, 1992.

SECTION 1.461-5 RECURRING ITEM EXCEPTION.

(a) IN GENERAL. Except as otherwise provided in paragraph (c) of this section, a taxpayer using an accrual method of accounting may adopt the recurring item exception described in paragraph (b) of this section as a method of accounting for one or more types of recurring items incurred by the taxpayer. In the case of the "other payment liabilities" described in section 1.461-4(g)(7), the Commissioner may provide for the application of the recurring item exception by regulation, revenue procedure or revenue ruling.

(b) REQUIREMENTS FOR USE OF THE EXCEPTION -- (1) GENERAL RULE. Under the recurring item exception, a liability is treated as incurred for a taxable year if --

(i) As of the end of that taxable year, all events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy;

(ii) Economic performance with respect to the liability occurs on or before the earlier of --

(A) The date the taxpayer files a timely (including extensions) return for that taxable year; or

(B) The 15th day of the 9th calendar month after the close of that taxable year;

(iii) The liability is recurring in nature; and

(iv) Either --

(A) The amount of the liability is not material; or

(B) The accrual of the liability for that taxable year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

(2) AMENDED RETURNS. A taxpayer may file an amended return treating a liability as incurred under the recurring item exception for a taxable year if economic performance with respect to the liability occurs after the taxpayer files a return for that year, but within 8 1/2 months after the close of that year.

(3) LIABILITIES THAT ARE RECURRING IN NATURE. A liability is recurring if it can generally be expected to be incurred from one taxable year to the next. However, a taxpayer may treat such a liability as recurring in nature even if it is not incurred by the taxpayer in each taxable year. In addition, a liability that has never previously been incurred by a taxpayer may be treated as recurring if it is reasonable to expect that the liability will be incurred on a recurring basis in the future.

(4) MATERIALITY REQUIREMENT. For purposes of this paragraph (b):

(i) In determining whether a liability is material, consideration shall be given to the amount of the liability in absolute terms and in relation to the amount of other items of income and expense attributable to the same activity.

(ii) A liability is material if it is material for financial statement purposes under generally accepted accounting principles.

(iii) A liability that is immaterial for financial statement purposes under generally accepted accounting principles may be material for purposes of this paragraph (b).

(5) MATCHING REQUIREMENT. (i) In determining whether the matching requirement of paragraph (b)(1)(iv)(B) of this section is satisfied, generally accepted accounting principles are an important factor, but are not dispositive.

(ii) In the case of a liability described in paragraph (g)(3) (rebates and refunds), paragraph (g)(4) (awards, prizes, and jackpots), paragraph (g)(5) (insurance, warranty, and service contracts), paragraph (g)(6) (taxes), or paragraph (h) (continuing fees under the Nuclear Waste Policy Act of 1982) of section 1.461-4, the matching requirement of paragraph (b)(1)(iv)(B) of this section shall be deemed satisfied.

(c) TYPES OF LIABILITIES NOT ELIGIBLE FOR TREATMENT UNDER THE RECURRING ITEM EXCEPTION. The recurring item exception does not apply to any liability of a taxpayer described in paragraph (e) (interest), paragraph (g)(2) (workers compensation, tort, breach of contract, and violation of law), or paragraph (g)(7) (other liabilities) of section 1.461-4. Moreover, the recurring item exception does not apply to any liability incurred by a tax shelter, as defined in section 461(i) and section 1.448-1T(b).

(d) TIME AND MANNER OF ADOPTING THE RECURRING ITEM EXCEPTION -- (1) IN GENERAL. The recurring item exception is a method of accounting that must be consistently applied with respect to a type of item, or for all items, from one taxable year to the next in order to clearly reflect income. A taxpayer is permitted to adopt the recurring item exception as part of its method of accounting for any type of item for the first taxable year in which that type of item is incurred. Except as otherwise provided, the rules of section 446(e) and section 1.446-1(e) apply to changes to or from the recurring item exception as a method of accounting. See Q&A-7 of section 1.461-7T for rules concerning the time and manner of adopting the recurring item exception for taxable years that include July 19, 1984. See Q&A- 3(d) of section 1.461-7T for an explanation of the term "type of item".

(2) CHANGE TO THE RECURRING ITEM EXCEPTION METHOD FOR THE FIRST TAXABLE YEAR BEGINNING AFTER DECEMBER 31, 1991 -- (i) IN GENERAL. For the first taxable year beginning after December 31, 1991, a taxpayer is granted the consent of the Commissioner to change to the recurring item exception method of accounting. A taxpayer is also granted the consent of the Commissioner to expand or modify its use of the recurring item exception method for the first taxable year beginning after December 31, 1991. For each trade or business for which a taxpayer elects to use the recurring item exception method, the taxpayer must use the same method of change (cut-off or full-year change) it is using for that trade or business under section 1.461-4(m). See Q&A-11 of section 1.461-7T for an explanation of how amounts are taken into account under the cut-off method (except that, for purposes of this paragraph (d)(2), the change applies to all amounts otherwise incurred on or after the first day of the first taxable year beginning after December 31, 1991). See Q&A-6 of section 1.461-7T for an explanation of how amounts are taken into account under the full-year change method (except that the change in method occurs on the first day of the first taxable year beginning after December 31, 1991). The full-year change in method may result in a section 481(a) adjustment that must be taken into account in the manner described in Q&A-8 and Q&A-9 of section 1.461-7T (except that the taxable year of change is the first taxable beginning after December 31, 1991).

(ii) MANNER OF CHANGING TO THE RECURRING ITEM EXCEPTION METHOD. For the first taxable year beginning after December 31, 1991, a taxpayer may change to the recurring item exception method by accounting for the item on its timely filed original return for such taxable year (including extensions). The automatic consent of the Commissioner is limited to those items accounted for under the recurring item exception method on the timely filed return, unless the taxpayer indicates a wider scope of change by filing the statement provided in Q&A-7(b)(2) of section 1.461-7T.

(3) RETROACTIVE CHANGE TO THE RECURRING ITEM EXCEPTION METHOD. For the first taxable year beginning after December 31, 1989, or December 31, 1990, a taxpayer is granted consent of the Commissioner to change to the recurring item exception method of accounting, provided the taxpayer complies with paragraph (d)(2) of this section on either the original return for such year or on an amended return for such year filed on or before October 7, 1992. For this purpose the effective date is the first day of the first taxable year beginning after December 31, 1989, or the first day of the first taxable year beginning after December 31, 1990. A taxpayer is also granted the consent of the Commissioner to expand or modify its use of the recurring item exception method for the first taxable year beginning after December 31, 1989, December 31, 1990, or December 31, 1991.

(e) EXAMPLES. The following examples illustrate the principles of this section:

EXAMPLE 1. REQUIREMENTS FOR USE OF THE RECURRING ITEM EXCEPTION. (i) Y corporation, a calendar year, accrual method taxpayer, manufactures and distributes video cassette recorders. Y timely files its federal income tax return for each taxable year on the extended due date for the return (September 15, of the following taxable year). Y offers to refund the price of a recorder to any purchaser not satisfied with the recorder. During 1992, 100 purchasers request a refund of the $500 purchase price. Y refunds $30,000 on or before September 15, 1993, and the remaining $20,000 after such date but before the end of 1993.

(ii) Under paragraph (g)(3) of section 1.461-4, economic performance with respect to $30,000 of the refund liability occurs on September 15, 1993. Assume the refund is deductible (or allowable as an adjustment to gross receipts or cost of goods sold) when incurred. If Y does not adopt the recurring item exception with respect to rebates and refunds, the $30,000 refund is incurred by Y for the 1993 taxable year. However, if Y has properly adopted the recurring item exception method of accounting under this section, and as of December 31, 1992, all events have occurred that determine the fact of the liability for the $30,000 refund, Y incurs that amount for the 1992 taxable year. Because economic performance (payment) with respect to the remaining $20,000 occurs after September 15, 1993 (more than 8 1/2 months after the end of 1992), that amount is not eligible for recurring item treatment under this section. Thus, the $20,000 amount is not incurred by Y until the 1993 taxable year.

EXAMPLE 2. REQUIREMENTS FOR USE OF THE RECURRING ITEM EXCEPTION; AMENDED RETURNS. The facts are the same as in EXAMPLE 2, except that Y files its income tax return for 1992 on March 15, 1993, and Y does not refund the price of any recorder before that date. Under paragraph (b)(1) of this section, the refund liability is not eligible for the recurring item exception because economic performance with respect to the refund does not occur before Y files a return for the taxable year for which the item would have been incurred under the exception. However, since economic performance occurs within 8 1/2 months after 1992, Y may file an amended return claiming the $30,000 as incurred for its 1992 taxable year (see paragraph (b)(2) of this section).

SECTION 1.461-6 ECONOMIC PERFORMANCE WHEN CERTAIN LIABILITIES ARE ASSIGNED OR ARE EXTINGUISHED BY THE ESTABLISHMENT OF A FUND.

(a) QUALIFIED ASSIGNMENTS OF CERTAIN PERSONAL INJURY LIABILITIES UNDER SECTION 130. In the case of a qualified assignment (within the meaning of section 130(c)), economic performance occurs as a taxpayer-assignor makes payments that are excludible from the income of the assignee under section 130(a).

(b) SECTION 468B. Economic performance occurs as a taxpayer makes qualified payments to a designated settlement fund under section 468B, relating to special rules for designated settlement funds.

(c) PAYMENTS TO OTHER FUNDS OR PERSONS THAT CONSTITUTE ECONOMIC PERFORMANCE. [Reserved]

(d) EFFECTIVE DATES. The rules in paragraph (a) of this section apply to payments after July 18, 1984.