Estimates of Chargebacks and Rebates May be Sufficient to Meet the ‘All Events Test’ for Deductibility
July 16, 2012
Companies which utilize third party wholesalers may negotiate chargebacks and rebates as part of their sales contracts. This is particularly common in the pharmaceutical industry. To the extent that the wholesaler is unable to sell the product at a specified price, the manufacturer is often contractually obligated to provide rebates or chargebacks to compensate for the price differential. To ensure that the company reflects this potential liability on its books, it may accrue an estimated expense based upon historical rebates and chargebacks. Internal Revenue Section 461 requires that various tests must be met with respect to accruals and reserves in order to allow a taxpayer to take a deduction in the year an expense is booked. The first test is the “all events test” and the second is economic performance. Prior to the issuance of recent guidance it was unclear whether these accruals met the all events test.
All Events Test
The all events test is met with respect to any item if:
- All events have occurred which determine the fact of liability, and
- The amount of such liability can be determined with reasonable accuracy.
The timing of economic performance depends upon the type of accrual or reserve. IRC Section 461(h)(3) provides an exception for recurring items. If the all events test has been satisfied, the recurring item exception allows the taxpayer a deduction for items that are recurring in nature if:
- Such item is either immaterial, or
- The accrual of such item provides better matching against income than deducting such item in the taxable year in which economic performance occurs.
Economic performance for items meeting the recurring item exception occurs within the shorter of
- reasonable period after the close of such taxable year, or
- Eight and one-half months after the close of such taxable year.
Applicability to Chargeback and Rebate Reserves
The use of estimates when booking reserves or accruals will often cause the deduction to fail the all events test. In the past, there has been no clear guidance that the use of estimates for rebates or chargebacks was sufficient to meet the all events test. In fact, Field Service Advice (FSA 992, Vaughn # 992) issued in 1992 specifically addressed the issue and stated that the ultimate sale to the third party contract customer was the fact that fixed the liability. Therefore, there was uncertainty as to whether rebate and chargeback reserves meet the all events test and should, therefore, be deductible in the tax year recorded.
Recent advice set forth by the Chief Counsel (Field Service Advice 20121602F) provides that estimates may in some cases be acceptable. Field Service Advice (“FSA”) is provided when IRS agents in the field seek clarity regarding a particular issue they may feel is not specifically addressed in the tax code or regulations. The advice states, similar to the previous FSA, that the fixing event occurs when the wholesalers/distributors sell to end-user customers at prices below the acquisition cost. It is at this point that the wholesaler/distributor's right to demand a chargeback reimbursement is unconditional. Additional guidance was recently provided which further specifies that if the data allows the company to estimate the amount of its liability with reasonable accuracy, an estimate based on these reliable inputs and reasonable methodology will generally allow for a deduction in the year the liability is recorded. Therefore, if the data is found to be reliable, estimated chargeback and rebate reserves may be deductible in the year recorded based on the recurring item exception if the payout is made within eight and one-half months of the end of the taxable year.