In business dealings,
transactions often occur that include variables based on future events that can be difficult to ascertain (for example, a company may sell in an amount stock along with a percentage of that company's net profits.) As these transactions are contingent on payments that occur in the future, and the total
selling
Sales are activities related to selling or the number of goods sold in a given targeted time period. The delivery of a service for a cost is also considered a sale.
The seller, or the provider of the goods or services, completes a sale in r ...
price cannot be determined as of the end of the taxable year of the sale, they are known as Contingent Payment Sales. Because of the uncertainty surrounding the final amounts of these transactions, they are difficult to evaluate for the purpose of tax liability. Section 483 of the
Internal Revenue Code
The Internal Revenue Code (IRC), formally the Internal Revenue Code of 1986, is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 ...
provides descriptions for the handling of contingent payments and interest on contingent payments.
Methods of computing tax liability for contingent sales
Maximum Selling Price
If the maximum amount of sales can be determined in the year in which they occur by assuming that all contingencies are met, the
price
A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the c ...
can be calculated in a manner similar to the installment sales method. If the amount is reduced in subsequent years, than the formula is recomputed accordingly.
Fixed Period
If the maximum selling price cannot be determined, but the period over which payments may be received is fixed, then the seller's basis is recovered ratably over the period during which payment may be received under the contract.
* If the agreement neither specifies a stated maximum price nor limits payments to a fixed period, than a question arises as to whether a sale has realistically occurred.
[Treas. Reg. §15.A453-1(c)(4)(i)]
Example in Finance
General Mills Acquisition Case
Seeking to build growth momentum,
General Mills
General Mills, Inc., is an American multinational manufacturer and marketer of branded processed consumer foods sold through retail stores. Founded on the banks of the Mississippi River at Saint Anthony Falls in Minneapolis, the company orig ...
studied areas of potential growth and value creation in the spring of 1998. This had generated some smaller acquisitions and a general receptivity to acquisition proposals by the firm. In early 2000, the firm's financial advisers suggested that
Diageo
Diageo plc () is a Multinational corporation, multinational alcoholic beverage company, with its headquarters in London, England. It operates from 132 sites around the world. It was the world's largest distiller before being overtaken by Kweich ...
might be interested in selling Pillsbury, in an effort to focus Diageo on its beverage business, and that Pillsbury would complement General Mills’ existing businesses.
In March 2000, Diageo's chief operating officer contacted General Mills’ chairman and CEO to explore a possible sale of Pillsbury. General Mills submitted its proposed deal terms to Diageo in June 2000—the total proposed payment was $10.0 billion. Diageo submitted an
asking price
Ask price, also called offer price, offer, asking price, or simply ask, is the price a seller states they will accept.
The seller may qualify the stated asking price as firm or negotiable. Firm means the seller is implying that the price is fixed ...
of $10.5 billion. The two sides would budge no further, and it looked as if the negotiations would
founder. General Mills did not want to issue more than one-third of its post-transaction shares to Diageo, and believed that its shares were undervalued in the stock market. Diageo believed it was necessary to value General Mills’ shares at the current trading prices. In an effort to bridge the difference in positions, the two firms agreed upon including in the terms of the deal a contingent payment on the first anniversary of the transaction that would depend on General Mills’ share price. James Lawrence, chief financial officer of General Mills, said, “We genuinely believe this is a way in which they could have their
cake
Cake is a flour confection made from flour, sugar, and other ingredients, and is usually baked. In their oldest forms, cakes were modifications of bread, but cakes now cover a wide range of preparations that can be simple or elaborate, ...
and we could eat it, too. There’s no question in my mind that, absent this instrument, we wouldn’t have been able to reach this deal.”
David Van Benschoten, General Mills’ treasurer, added that the contingent payment was another example of the “development of the use of
ptionsin the past 20 years as finance has come to first understand, and work with, the constructs of optionality.”
References
{{reflist
Payments
Business terms