The adoption of the ASC 606 Revenue Recognition standard has reached the far corners of almost every industry, sending a wave of tax implications over corporations and businesses alike. Spanning into the software sector, these revisions have significantly altered requirements surrounding the timing of revenue recognition for on-premise software providers—potentially accelerating an income tax liability to the corporation.
On-premise software providers of multi-year term licenses are now facing two major tax implications when changing their revenue recognition policies to align with ASC 606 revisions: acceleration of previously deferred revenue and incremental “unbilled revenue.”
Acceleration of Previously Deferred Revenue
Provided the on-premise software is deemed to be a functional and distinct license, providers must now recognize an allocation of the customer revenues associated with the license immediately, in year one, instead of recognizing the entire software fee ratably over the multi-year term period. The prior revenue recognition methodology of recognizing revenue over the term of the arrangement was more attractive to companies because it was more manageable, predictable, and often aligned cash tax payments to the period in which the revenue was recognized for accounting purposes (unless there was significant advance payments on the multi-year term arrangement).
Historically, an accrual method filer could invoice and collect from its customers annually for the multi-year term license fee and recognize the income for tax purposes over the multi-year term in the same manner as old revenue recognition rules.
If you are a private company that adopted ASC 606 on January 1, 2019, certain amounts collected from customers and remaining as deferred revenue as of December 31, 2018 may be recorded as an adjustment to the opening balance of retained earnings as of December 31, 2018. Depending on the company’s tax accounting method for deferred revenue, this adjustment could be recognized as additional income on the company’s 2019 tax return, resulting in a significant increase in 2019 taxable income and cash tax obligations.
Incremental “Unbilled Revenue”
Another implication potentially causing stress among on-premise software providers is the requirement to recognize the entire amount of revenue under a multi-year term software license in year one and pay the related tax obligation in-full, regardless of whether the company has received payment from the client for their products or services at the time of recognition.
This change primarily results from the introduction of a new tax code section, IRC section 451(b), which requires taxpayers to recognize revenue for tax purposes no later than the period in which such revenue is included in the underlying financial statements. As a result, if the fact pattern now results in immediate revenue recognition for Generally Accepted Accounting Principles (GAAP) purposes, even though the underlying cash is not received until a future period, taxpayers will need to recognize that revenue for tax purposes, as well as in the year recognized in the financial statements.
When recording the cumulative effect of the adoption of ASC 606 in the pre-2019 period, some businesses are required to record revenue in opening-retained earnings that were previously “off balance sheet” from a GAAP perspective (commonly referred to as Backlog) with an offsetting Debit to a Contract Asset account (e.g. Unbilled Revenue, etc).
In general, this revenue is also required to be recognized for tax purposes. However, there is some relief here to be aware of, as the impact of this change in Book and Tax accounting methods can generally be spread over four years pursuant to section 481(a).
Recently, a client approached Wolf & Company seeking advice on how to navigate the tax implications of their policy changes over revenue recognition. Unfortunately, the accounting and resulting tax impact on existing contracts upon adoption could not be avoided. Collaboration ensued on a go-forward solution, and adopting a tactic that would have the on-premise software provider change their offerings from multi-year license contracts to annual license contracts proved to be the answer.
This spread the revenue recognition similar to the prior revenue recognition policies and aligned the resulting tax liability with cash receipts. The company began recognizing income in the period in which the underlying cash was received and only paid tax on that income—easing the cash tax burden on the company. It also aligned the cash tax liability with cash tax receipts, further mitigating the total impact of ASC 606 Revenue Recognition.
Wolf & Company helped the client by collaborating on alternative solutions to problems and challenges brought on by ASC 606. Also, by working with the company to guide them in understanding the accounting and tax rules, the client was able to remedy proceedings to alleviate some of the cash tax burdens associated with the update.