Tax deduction of provision and contingent expenses for corporations

1 : Do the tax authorities in the US allow the deduction of expenses incurred following the recognition of a provision or a contingent liability?

A provision is a liability that is of uncertain timing or amount, to be settled by the transfer of economic benefits

For instance, suppose a firm faces a lawsuit. The firm is expecting to pay 1000 pounds with a probability of 80%. As a result, the firm recognizes both a liability and an expense in its financial statement. Can the firm deduct this expense from its income for tax purposes?

2 : Another example is taken from IAS 37 ( I understand that IAS 37 is irrelevant for US companies-it's just an example)

The firm sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase. If minor defects were detected in all products sold, repair costs of 1 million would result. If major defects were detected in all products sold, repair costs of 4 million would result. The Firm’s past experience and future expectations indicate that, for the coming year, 75 per cent of the goods sold will have no defects, 20 per cent of the goods sold will have minor defects and 5 per cent of the goods sold will have major defects. In accordance with paragraph 24, an entity assesses the probability of an outflow for the warranty obligations as a whole.

The expected value of the cost of repairs is (the exact number does not matter)

(75% of nil) + (20% of 1m) + (5% of 4m) = 400,000

Can 400,000 be deducted from the firm income for taxation?

In addition, please refer me to a formal source (a law or a court ruling) regarding this issue.

Answer : 

1 : I guess it depends. The firm, the entity , should be entitled to a deduction as soon as it meets the all-events test (the fact of the liability is fixed and the amount is determinable). Section 461 (h) and § 1.461-1 (a) (2) (I) provide that, under the accrual method of accounting, a liability is incurred, and is generally taken into account for federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. Section 461 (h) (2) (A) (I) provides that, if the liability of the firm arises out of the providing of services to the taxpayer by another person, economic performance occurs as that person provides the services. Generally, in a transaction where one taxpayer is accruing a liability to pay another taxpayer, the last event necessary to establish the fact of liability under the all events test of § 1.461-1 (a) (2) (I) is the same event that fixes the right to receive income under the all events test of § 1.451-1 (a). In the case of a lawsuit there usually are no services to be performed and economic performance need not be considered.

2 : Basically, as we know, compared to variables such as useful lives of assets for depreciation purposes or collectability of accounts receivable, warranty costs can be wildly accurately unpredictable. After all a major failure in the production process may require a complete / partial recall of a product line which can be enormously expensive. Estimating warranty expense cannot possibly be an exact science because with continuing product innovation past warranty cost experience with established products will not necessarily be a good guide for estimating warranty expense associated with a new untested product. Technically, warranty expense is a contingent liability. Contingencies are possible economic events that may or may not occur in the future, as mentioned above: Provisions for warranties are governed by IAS 37 PROVISIONS, “QUOTE,” CONTINGENT LIABILITIES AND CONTINGENT ASSETS The key definitions are:

Provision:

A liability of uncertain timing or amount.

Liability:

*Present obligation as a result of past events

* Settlement is expected to result in an outflow of resources (payment)

Contingent liability:

* a possible obligation depending on whether some uncertain future event occurs, or

* a present obligation but payment is not probable or the amount cannot be measured reliably . When a manufacturer gives a warranty, it satisfies the criteria for a liability - there is a legal obligation and settlement is expected to result in an outflow of resources (whether by payment to repair the defect or by using up of spare parts maintained for this purpose), so that's why a warranty is a provision and not merely a contingent liability. From history, the manufacturer would know..Read More..