REGULATIONS OF CONSTRUCTION CONTRACTS

Senator MONTOYA. I have a question which has been presented to me by Senator Allott of Colorado. Here is the preliminary statement that should go in the record attributable to Senator Allott.

I have received many expressions of concern from the contracting industry because the Treasury Department is persisting in attempting to change regulations which prescribe methods of accounting for long-term construction contracts. It is my understanding that these methods of accounting have been standing for over 50 years and have gone unchanged by the Congress during that time even though many tax reform acts have been enacted.

I am told that the Treasury Department and IRS withdrew certain proposed regulations in this area some one year ago. I am wondering what is behind this latest attempt at changing this area of the tax practice. It is my understanding that Mr. Lawrence N. Woodworth, who is the Chief of Staff of the Joint Committee on Internal Revenue Taxation, has written the Treasury Department recommending that it reconsider its proposed regulation on Methods of Accounting for Long-Term Construction Contracts.

Mr. Woodworth pointed out to the Treasury Department that any change in this area should be made by legislation and that with regard to the latest promulgation of regulations in this area he suggested that they be withdrawn for legislative review.

My question is: Why does the Treasury Department persist in attempting to change its long-standing practice when it is apparently a matter which should be left to the province of the Congress?

Mr. WALTERS. Mr. Chairman, I had anticipated a question of this nature, and I have a three-page, single-space response I could make. Senator MONTOYA. Would you give me the gist of it?

Mr. WALTERS. Yes, sir.

Senator MONTOYA. The response will be made a part of the record at this point and then you can give me the gist.

(The information follows:)

In major part, the long-term contract regulations. project grew out of the Treasury's efforts to deal with the advance payment problem. As you know, the Supreme Court held in American Automobile Association (367 U.S. 687) and Schlude (372 U.S. 128) that advance payments for services were taxable as gross income in the year of receipt. In 1969 the Court of Appeals for the Second Circuit extended this rationale in Hagen (407 F.2d 1105) to advance payments for the sale of goods.

To ameliorate this harsh result and to bring the tax treatment of advance payments into conformity with the financial accounting treatment, we modified the regulations last year to permit accrual basis taxpayers to defer inclusion of advance payments for the sale of goods until the goods are shipped and the proceeds of sale are earned. These regulations, however, contain the so-called "strict" booking requirement which permits deferral of an advance payment only to the extent that it is deferred in all of the taxpayer's financial reports.

We also realized that the advance payment problem might be applicable to progress payments made to taxpayers using a long-term contract method (i.e. either completed contract or percentage of completion) rather than the accrual method. To deal with this problem, and also to conform the tax treatment of long-term contracts with financial accounting treatment, in March 1971, we proposed to amend the long-standing long-term contract regulations. These proposals would have permitted the use of the completed contract method of accounting for long-term contracts only if it were used in all of the taxpayer's financial reports. This conformity requirement was, of course, consistent with that in the advance payments for goods regulations.

Many protests were received, both in writing and at the public hearing. As a result, the March 1971 proposals were withdrawn and new regulations were proposed on December 15, 1971. These proposals would eliminate the strict conformity requirement. In its place would be a provision which would require a taxpayer on the longterm contract method to use percentage of completion for all long-term contracts unless the taxpayer could demonstrate that estimates of the costs to complete a contract or of the extent of progress toward completion of the contract are not reasonably dependable. Moreover, the taxpayer's use of percentage of completion in

his financial reports to owners would constitute evidence that estimates of the costs to complete or of the extent of progress toward completion are reasonably dependable. Reports to creditors would be generally disregarded.

This is the so-called "evidentiary" test.

Although the proposal contains fairly liberal transition rules, there is no grandfather clause available to growing taxpayers.

A hearing on the December 1971 proposals was held on March 21, 1972, and we are currently evaluating the testimony, as well as the numerous written comments. We are focusing particularly on the evidentiary test. The comments have made the principal points (1) that estimates of the percentage of completion are not sufficiently reliable in most cases to appropriately give rise to tax liability, and (2) that because of retainages, progress payments generally lag behind expenditures under the contract, and, accordingly, no economic profit arises until completion of the contract.

Although we have made no firm decisions on these regulations, after concluding our consideration of the comments received, both orally and in writing, we expect to make some changes in the proposed regulations before they are issued in final form.

CHANGES IN REGULATION

Mr. WALTERS. The gist of it is that in an attempt to secure some greater equity in the area where there is advance payment, the Treasury and the Service did issue regulations to make some changes.

As to the specific proposal mentioned, we did receive a large volume of protest and this is being reconsidered. I do not know at this time what will be the final outcome. The public hearing on this proposed regulation was held in March. So we are still reviewing the oral comments received as well as the written comments. It is safe to say that the regulation will not be issued in final form as it was proposed. There will be some change. Just how much or what, I do not know at this time. I will be happy to provide a copy of this more technical answer for the record, sir.

CLOSING REMARKS

Senator MONTOYA. I believe that is all we have to ask today. If we require further information we shall call you back.

Mr. WALTERS. Mr. Chairman, as you know, we are always available and happy to respond to the committee.

Senator MONTOYA. We will call you back for a conference before assessment.

Mr. WALTERS. All right, sir. We would be happy to come back at any time. We particularly would like to extend to you and any other members of the committee, as well as to Mr. Gonzales and Mr. Bonner, an invitation at your convenience to see some of our IDRS equipment. Senator MONTOYA. I would like to see it and I will one of these days. Probably I could see it better right here in Washington than out in the field.

Mr. WALTERS. We will be getting it here in the next few months. Senator MONTOYA. Where do you have it?

Mr. WALTERS. The nearest we have it now is in the southwest region in Austin, Tex. But I would think that probably in Albuquerque we could have you see the station there. This is the beauty of the thing. You can walk into the Albuquerque office and provide your identification, your social security number, and within seconds we can have answers to your questions from Austin.

Senator MONTOYA. I would also like to see how it operates at the other end.

Mr. WALTERS. Yes. That would be at the Service Center.

Senator MONTOYA. Which is the closest Service Center to Washington?

Mr. WALTERS. Austin is the only one having IDRS now.

Mr. BARRRON. It will be installed in the Mid-Atlantic region, and the Philadelphia Service Center would be the closest.

Senator MONTOYA. I look forward to visiting it.

Mr. BARRON. I think you will be pleased with it.

Senator MONTOYA. Thank you, gentlemen. Pertinent data from the justifications will be inserted in the record at this point. (The justifications follow :)

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