Transactions involving subscription-based software companies are becoming an increasingly larger part of the private equity deal market. The attractive nature of long-term committed revenue inherent in these business carries with it deal-specific tax issues that need to be addressed. One of those issues is the taxation of deferred revenue. Depending on the specific facts of a transaction, a transaction can result in the acceleration or deferral of recognition of income for federal income tax purposes with respect to previously received subscription payments in an often arbitrary manner. As a result, sponsors should consider the impact that a transaction has on the taxation of subscription payments early in the course of a transaction to ensure that such often hidden tax liability is appropriately accounted for in the economics of the deal. Failure to do so can create a significant hurdle to finalizing an otherwise agreed transaction.
As a general matter, when a company receives a subscription payment for an annual or multiyear subscription, it accounts for the subscription payment under generally accepted accounting principles (GAAP) as a deferred revenue liability. As the related services are performed, the liability is reduced with the corresponding amount being recognized as revenue. Because the liability to perform the previously paid for services are prominently displayed on the company’s balance sheet, sponsors are often laser focused on the economics relating to a company’s deferred revenue liability.
Generally, accrual based taxpayers are required to recognize the receipt of cash in income when received. In order to bring the taxation of advance payments somewhat in line with the corresponding financial accounting treatment, federal income tax principles, as pronounced in Revenue Procedure 2004-34 generally allow an accrual method taxpayer to recognize advance payments in line with a company’s applicable financial statement, provided that such income cannot be deferred more than a single tax year. Herein lies the root of the issue.
A simple example is helpful to illustrate. On July 1, 2017, a calendar year company receives a $240 payment for a two year subscription. Under GAAP, the company would immediately book a $240 deferred liability. $10 of the deferred revenue liability would burn off each month with the company recognizing $10 per month of revenue over the course of the two-year subscription period. From a federal income tax perspective, absent a transaction, the company would recognize $60 of gross income in its 2017 tax year and $180 of gross income in its 2018 tax year. If the company is a C corporation for tax purposes and its stock is sold into a consolidated group on July 1, 2018 (causing its tax year to end on that date), the entire $180 of gross income deferred from 2017 would be accelerated and recognized in the pre-closing six-month tax year, and any gross income resulting from payments from new subscriptions received in the first six months of 2018 (if not naturally burning off during those first six months) would be recognized in the post-closing six-month tax year. However if the stock were sold on March 1, 2018 (causing its tax year to end on that date), only $20 of the gross income deferred from 2017 (i.e., the amount naturally burning off during January and February) would be recognized in the pre-closing two-month tax year, and the remaining $160 of gross income deferred from 2017 and any gross income resulting from payments from new subscriptions received in January or February 2018 (if not naturally burning off during those two months) would be recognized in the post-closing ten-month tax year. If the company is a partnership for tax purposes and its equity is sold on March 1, 2018 (in a transaction resulting in a “technical termination”), not only would the entire $180 of gross income deferred from 2017 be accelerated and recognized in the pre-closing two-month tax year, but all gross income resulting from payments from new subscriptions received in January or February 2018 would also be accelerated and recognized in the pre-closing two-month tax year.
As illustrated above, in the baseline case, tax often does not follow book with respect to deferred revenue. Depending on the structure of the transaction, the tax status of the company and the date of the timing of the closing of the transaction, the disconformity between book and tax can become more pronounced as, some or all of the taxable income relating to deferred revenue can be accelerated. Thus it is important to focus on the tax liability relating to deferred revenue when negotiating the parameters of the economic deal in a transaction to ensure that deal that is ultimately cut leaves the parties in the position they expect with respect to such tax liability.