Appendix A — Implementation Guidance and Illustrations

55-1 This Section is an integral part of the requirements of this Subtopic. This Section provides additional guidance and illustrations that address the application of accounting requirements to specific aspects of accounting for income taxes, including disclosures. The guidance and illustrations that follow, unless stated otherwise, assume that the tax law requires offsetting net deductions in a particular year against net taxable amounts in the 3 preceding years and then in the 15 succeeding years. These assumptions about the tax law are for illustrative purposes only. This Subtopic requires that the enacted tax law for a particular tax jurisdiction be used for recognition and measurement of deferred tax liabilities and assets.

55-2 The guidance is organized as follows:

1. Application of accounting requirements for income taxes to specific situations
2. Subparagraph superseded by Accounting Standards Update No. 2015-17.
3. Income tax related disclosures.

Recognition and Measurement of Tax Positions — a Two-Step Process

55-3 The application of the requirements of this Subtopic related to tax positions requires a two-step process that separates recognition from measurement. The first step is determining whether a tax position has met the recognition threshold; the second step is measuring a tax position that meets the recognition threshold. The recognition threshold is met when the taxpayer (the reporting entity) concludes that, consistent with paragraphs 740-10-25-6 through 25-7 and 740-10-25-13, it is more likely than not that the taxpayer will sustain the benefit taken or expected to be taken in the tax return in a dispute with taxing authorities if the taxpayer takes the dispute to the court of last resort.

55-4 Relatively few disputes are resolved through litigation, and very few are taken to the court of last resort. Generally, the taxpayer and the taxing authority negotiate a settlement to avoid the costs and hazards of litigation. As a result, the measurement of the tax position is based on management’s best judgment of the amount the taxpayer would ultimately accept in a settlement with taxing authorities.

55-5 The recognition and measurement requirements of this Subtopic related to tax positions require that the entity recognize the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement.

55-6 See Examples 1 through 12 (paragraphs 740-10-55-81 through 55-123) for illustrations of this guidance.

Recognition of Deferred Tax Assets and Deferred Tax Liabilities

55-7 Subject to certain specific exceptions identified in paragraph 740-10-25-3, a deferred tax liability is recognized for all taxable temporary differences, and a deferred tax asset is recognized for all deductible temporary differences and operating loss and tax credit carryforwards. A valuation allowance is recognized if it is more likely than not that some portion or all of the deferred tax asset will not be realized. See Example 12 (paragraph 740-10-55-120) for an illustration of this guidance.

55-8 To the extent that evidence about one or more sources of taxable income is sufficient to eliminate any need for a valuation allowance, other sources need not be considered. Detailed forecasts, projections, or other types of analyses are unnecessary if expected future taxable income is more than sufficient to realize a tax benefit.

55-9 The terms forecast and projection refer to any process by which available evidence is accumulated and evaluated for purposes of estimating whether future taxable income will be sufficient to realize a deferred tax asset. Judgment is necessary to determine how detailed or formalized that evaluation process should be. Furthermore, information about expected future taxable income is necessary only to the extent positive evidence available from other sources (see paragraph 740-10-30-18) is not sufficient to support a conclusion that a valuation allowance is not needed. The requirements of this Subtopic do not require either a financial forecast or a financial projection within the meaning of those terms in the Statements on Standards for Attestation Engagements and Related Attest Engagements Interpretations [AT], AT section 301, Financial Forecasts and Projections issued by the American Institute of Certified Public Accountants.

55-10 See Example 12 (paragraph 740-10-55-120) for an illustration of a situation where detailed analyses are not necessary.

55-11 See Example 13 (paragraph 740-10-55-124) for an illustration of determining a valuation allowance for deferred tax assets.

Offset of Taxable and Deductible Amounts

55-12 The tax law determines whether future reversals of temporary differences will result in taxable and deductible amounts that offset each other in future years. The tax law also determines the extent to which deductible temporary differences and carryforwards will offset the tax consequences of income that is expected to be earned in future years. For example, the tax law may provide that capital losses are deductible only to the extent of capital gains. In that case, a tax benefit is not recognized for temporary differences that will result in future deductions in the form of capital losses unless those deductions will offset any of the following:

1. Other existing temporary differences that will result in future capital gains
2. Capital gains that are expected to occur in future years
3. Capital gains of the current year or prior years if carryback (of those capital loss deductions from the future reversal years) is expected.

Pattern of Taxable or Deductible Amounts

55-13 The particular years in which temporary differences result in taxable or deductible amounts generally are determined by the timing of the recovery of the related asset or settlement of the related liability. However, there are exceptions to that general rule. For example, a temporary difference between the tax basis and the reported amount of inventory for which cost is determined on a last-in, first-out (LIFO) basis does not reverse when present inventory is sold in future years if it is replaced by purchases or production of inventory in those same future years. A LIFO inventory temporary difference becomes taxable or deductible in the future year that inventory is liquidated and not replaced.

55-14 For some assets or liabilities, temporary differences may accumulate over several years and then reverse over several years. That pattern is common for depreciable assets. Future originating differences for existing depreciable assets and their subsequent reversals are a factor to be considered when assessing the likelihood of future taxable income (see paragraph 740-10-30-18(b)) for realization of a tax benefit for existing deductible temporary differences and carryforwards.

The Need to Schedule Temporary Difference Reversals

55-15 Reversal patterns of existing temporary differences may need to be scheduled under the requirements of this Subtopic as follows:

1. Subparagraph superseded by Accounting Standards Update No. 2015-17.
2. Deferred tax assets are recognized without reference to offsetting, and then an assessment is made about the need for a valuation allowance. Paragraph 740-10-30-18 lists four possible sources of taxable income that may be available to realize such deferred tax assets. In many cases it may be possible to determine without scheduling that expected future taxable income (see paragraph 740-10-30-18(b)) will be adequate to eliminate the need for a valuation allowance. Disclosure of the amounts and expiration dates (or a reasonable aggregation of expiration dates) of operating loss and tax credit carryforwards is required only on a tax basis and does not require scheduling.
3. The adoption of a tax rate convention for measuring deferred taxes when graduated tax rates are a significant factor will, in many cases, eliminate the need for the scheduling. In addition, alternative minimum tax rates and laws are a factor only in considering the need for a valuation allowance for a deferred tax asset for alternative minimum tax credit carryforwards. When there is a phased-in change in tax rates, however, scheduling will often be necessary. See paragraphs 740-10-55-24; 740-10-55-31 through 55-33; and Examples 14 through 16 (paragraphs 740-10-55-129 through 55-138).

55-16 Paragraph 740-10-30-18 lists four possible sources of taxable income that may be available to realize a future tax benefit for deductible temporary differences and carryforwards. One source is future taxable income exclusive of reversing temporary differences and carryforwards. Future originating temporary differences and their subsequent reversal are implicit in estimates of future taxable income. Where it can be easily demonstrated that future taxable income will more likely than not be adequate to realize future tax benefits of existing deferred tax assets, scheduling of reversals of existing taxable temporary differences would be unnecessary.

55-17 In other cases it may be easier to demonstrate that no valuation allowance is needed by considering the reversal of existing taxable temporary differences. Even in that case, the extent of scheduling will depend on the relative magnitudes involved. For example, if existing taxable temporary differences that will reverse over a long number of future years greatly exceed deductible differences that are expected to reverse over a short number of future years, it may be appropriate to conclude, in view of a long (for example, 15 years) carryforward period for net operating losses, that realization of future tax benefits for the deductible differences is thereby more likely than not without the need for scheduling.

55-18 A general understanding of reversal patterns is, in many cases, relevant in assessing the need for a valuation allowance. Judgment is crucial in making that assessment. The amount of scheduling, if any, that will be required will depend on the facts and circumstances of each situation.

55-19 The following concepts however, underlie the determination of reversal patterns for existing temporary differences:

1. The particular years in which temporary differences result in taxable or deductible amounts generally are determined by the timing of the recovery of the related asset or settlement of the related liability (see paragraph 740-10-55-13).
2. The tax law determines whether future reversals of temporary differences will result in taxable and deductible amounts that offset each other in future years (see paragraph 740-10-55-14).

55-20 State income taxes are deductible for U.S. federal income tax purposes and therefore a deferred state income tax liability or asset gives rise to a temporary difference for purposes of determining a deferred U.S. federal income tax asset or liability, respectively. The pattern of deductible or taxable amounts in future years for temporary differences related to deferred state income tax liabilities or assets should be determined by estimates of the amount of those state income taxes that are expected to become payable or recoverable for particular future years and, therefore, deductible or taxable for U.S. federal tax purposes in those particular future years.

55-21 An entity may have claimed certain deductions, such as repair expenses, on its income tax returns. However, the entity may have recognized a liability (including interest) for the unrecognized tax benefit of those tax positions. If scheduling of future taxable or deductible differences is necessary, liabilities for unrecognized tax benefits should be considered. Accrual of a liability for unrecognized tax benefits of expenses, such as repairs, has the effect of capitalizing those expenses for tax purposes. Those capitalized expenses are considered to result in deductible amounts in the later years, for example, as depreciation expense. If the liability for unrecognized tax benefits is based on an overall evaluation of the technical merits of the tax position, scheduling should reflect the evaluations made in determining the liability for unrecognized tax benefits that was recognized. The effect of those evaluations may indicate a source of taxable income (see paragraph 740-10-30-18(c)) for purposes of assessing the need for a valuation allowance for deductible temporary differences. Those evaluations may also indicate lower amounts of taxable income in other years. A deductible amount for any accrued interest related to unrecognized tax benefits would be scheduled for the future year in which that interest is expected to become deductible.

55-22 Minimizing complexity is an appropriate consideration in selecting a method for determining reversal patterns. The methods used for determining reversal patterns should be systematic and logical. The same method should be used for all temporary differences within a particular category of temporary differences for a particular tax jurisdiction. Different methods may be used for different categories of temporary differences. If the same temporary difference exists in two tax jurisdictions (for example, U.S. federal and a state tax jurisdiction), the same method should be used for that temporary difference in both tax jurisdictions. The same method for a particular category in a particular tax jurisdiction should be used consistently from year to year. A change in method is a change in accounting principle under the requirements of Topic 250. Two examples of a category of temporary differences are those related to liabilities for deferred compensation and investments in direct financing and sales-type leases.

Measurement of Deferred Tax Liabilities and Assets

55-23 The tax rate or rates that are used to measure deferred tax liabilities and deferred tax assets are the enacted tax rates expected to apply to taxable income in the years that the liability is expected to be settled or the asset recovered. Measurements are based on elections (for example, an election for loss carryforward instead of carryback) that are expected to be made for tax purposes in future years. Presently enacted changes in tax laws and rates that become effective for a particular future year or years must be considered when determining the tax rate to apply to temporary differences reversing in that year or years. Tax laws and rates for the current year are used if no changes have been enacted for future years. An asset for deductible temporary differences that are expected to be realized in future years through carryback of a future loss to the current or a prior year (or a liability for taxable temporary differences that are expected to reduce the refund claimed for the carryback of a future loss to the current or a prior year) is measured using tax laws and rates for the current or a prior year, that is, the year for which a refund is expected to be realized based on loss carryback provisions of the tax law. See Examples 14 through 16 (paragraphs 740-10-55-129 through 55-138) for illustrations of this guidance.

55-24 Deferred tax liabilities and assets are measured using enacted tax rates applicable to capital gains, ordinary income, and so forth, based on the expected type of taxable or deductible amounts in future years. For example, evidence based on all facts and circumstances should determine whether an investor’s liability for the tax consequences of temporary differences related to its equity in the earnings of an investee should be measured using enacted tax rates applicable to a capital gain or a dividend. Computation of a deferred tax liability for undistributed earnings based on dividends should also reflect any related dividends received deductions or foreign tax credits, and taxes that would be withheld from the dividend.

55-25 If deferred tax assets or liabilities for a state or local tax jurisdiction are significant, this Subtopic requires a separate deferred tax computation when there are significant differences between the tax laws of that and other tax jurisdictions that apply to the entity. In the United States, however, many state or local income taxes are based on U.S. federal taxable income, and aggregate computations of deferred tax assets and liabilities for at least some of those state or local tax jurisdictions might be acceptable. In assessing whether an aggregate calculation is appropriate, matters such as differences in tax rates or the loss carryback and carryforward periods in those state or local tax jurisdictions should be considered. Also, the provisions of paragraph 740-10-45-6 about offset of deferred tax liabilities and assets of different tax jurisdictions should be considered. In assessing the significance of deferred tax expense for a state or local tax jurisdiction, it is appropriate to consider the deferred tax consequences that those deferred state or local tax assets or liabilities have on other tax jurisdictions, for example, on deferred federal income taxes.

55-26 Local (including franchise) taxes based on income are within the scope of this Topic. A tax, to the extent it is based on capital, is a non-income-based tax. As indicated in paragraph 740-10-15-4(a), if there is an amount of a franchise tax based on income, that amount is considered an income tax. Any additional amount incurred is considered a non-income-based tax. An example that illustrates this guidance is presented in Example 17 (see paragraph 740-10-55-139).

55-27 The following discussion and Example 18 (see paragraph 740-10-55-145) refer to and describe a provision within the American Jobs Creation Act of 2004; however, they shall not be considered a definitive interpretation of any provision of the Act for any purpose.

55-28 On October 22, 2004, the Act was signed into law by the president. This Act includes a tax deduction of up to 9 percent (when fully phased-in) of the lesser of qualified production activities income, as defined in the Act, or taxable income (after the deduction for the utilization of any net operating loss carryforwards). This tax deduction is limited to 50 percent of W-2 wages paid by the taxpayer.

55-29 The qualified production activities deduction’s characteristics are similar to special deductions discussed in paragraph 740-10-25-37 because the qualified production activities deduction is contingent upon the future performance of specific activities, including the level of wages. Accordingly, the deduction should be accounted for as a special deduction in accordance with that paragraph.

55-30 The special deduction should be considered by an entity in measuring deferred taxes when graduated tax rates are a significant factor and assessing whether a valuation allowance is necessary as required by paragraph 740-10-25-37. Example 18 (see paragraph 740-10-55-145) illustrates the application of the requirements of this Subtopic for the impact of the qualified production activities deduction upon enactment of the Act in 2004.

Alternative Minimum Tax

55-31 Temporary differences such as depreciation differences are one reason why tentative minimum tax may exceed regular tax. Temporary differences, however, ultimately reverse and, absent a significant amount of preference items, total taxes paid over the entire life of the entity will be based on the regular tax system. Preference items are another reason why tentative minimum tax may exceed regular tax. If preference items are large enough, an entity could be subject, over its lifetime, to the alternative minimum tax system; and the cumulative amount of alternative minimum tax credit carryforwards would expire unused. No one can know beforehand which scenario will prevail because that determination can only be made after the fact. In the meantime, this Subtopic requires procedures that provide a practical solution to that problem.

55-32 Under the requirements of this Subtopic, an entity shall:

1. Measure the total deferred tax liability and asset for regular tax temporary differences and carryforwards using the regular tax rate
2. Measure the total deferred tax asset for all alternative minimum tax credit carryforward
3. Reduce the deferred tax asset for alternative minimum tax credit carryforward by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of that deferred tax asset will not be realized.

55-33 Paragraph 740-10-30-18 identifies four sources of taxable income that shall be considered in determining the need for and amount of a valuation allowance. No valuation allowance is necessary if the deferred tax asset for alternative minimum tax credit carryforward can be realized in any of the following ways:

1. Under paragraph 740-10-30-18(a), by reducing a deferred tax liability from the amount of regular tax on regular tax temporary differences to not less than the amount of tentative minimum tax on alternative minimum taxable temporary differences
2. Under paragraph 740-10-30-18(b), by reducing taxes on future income from the amount of regular tax on regular taxable income to not less than the amount of tentative minimum tax on alternative minimum taxable income
3. Under paragraph 740-10-30-18(c), by loss carryback
4. Under paragraph 740-10-30-18(d), by a tax-planning strategy such as switching from tax-exempt to taxable interest income.

Operating Loss and Tax Credit Carryforwards and Carrybacks

55-34 An operating loss, certain deductible items that are subject to limitations, and some tax credits arising but not utilized in the current year may be carried back for refund of taxes paid in prior years or carried forward to reduce taxes payable in future years. A receivable, to the extent it meets the recognition requirements of this Subtopic for tax positions, is recognized for the amount of taxes paid in prior years that is refundable by carryback of an operating loss or unused tax credits of the current year.

55-35 A deferred tax asset, to the extent it meets the recognition requirements of this Subtopic for tax positions, is recognized for an operating loss or tax credit carryforward. This requirement pertains to all investment tax credit carryforwards regardless of whether the flow-through or deferral method is used to account for investment tax credits.

55-36 In assessing the need for a valuation allowance, provisions in the tax law that limit utilization of an operating loss or tax credit carryforward are applied in determining whether it is more likely than not that some portion or all of the deferred tax asset will not be realized by reduction of taxes payable on taxable income during the carryforward period. Example 19 (see paragraph 740-10-55-149) illustrates recognition of the tax benefit of an operating loss in the loss year and in subsequent carryforward years when a valuation allowance is necessary in the loss year.

55-37 An operating loss or tax credit carryforward from a prior year (for which the deferred tax asset was offset by a valuation allowance) may sometimes reduce taxable income and taxes payable that are attributable to certain revenues or gains that the tax law requires be included in taxable income for the year that cash is received. For financial reporting, however, there may have been no revenue or gain and a liability is recognized for the cash received. Future sacrifices to settle the liability will result in deductible amounts in future years. Under those circumstances, the reduction in taxable income and taxes payable from utilization of the operating loss or tax credit carryforward gives no cause for recognition of a tax benefit because, in effect, the operating loss or tax credit carryforward has been replaced by temporary differences that will result in deductible amounts when a nontax liability is settled in future years. The requirements for recognition of a tax benefit for deductible temporary differences and for operating loss carryforwards are the same, and the manner of reporting the eventual tax benefit recognized (that is, in income or as required by paragraph 740-20-45-3) is not affected by the intervening transaction reported for tax purposes. Example 20 (see paragraph 740-10-55-156) illustrates recognition of the tax benefit of an operating loss in the loss year and in subsequent carryforward years when a valuation allowance is necessary in the loss year.

55-38 Except as noted in paragraph 740-20-45-3, the manner of reporting the tax benefit of an operating loss carryforward or carryback is determined by the source of the income or loss in the current year and not by the source of the operating loss carryforward or taxes paid in a prior year or the source of expected future income that will result in realization of a deferred tax asset for an operating loss carryforward from the current year. Deferred tax expense (or benefit) that results because a change in circumstances causes a change in judgment about the future realization of the tax benefit of an operating loss carryforward is allocated to continuing operations (see paragraph 740-10-45-20). Thus, for example:

1. The tax benefit of an operating loss carryforward that resulted from a loss on discontinued operations in a prior year and that is first recognized in the financial statements for the current year:
   1. Is allocated to continuing operations if it offsets the current or deferred tax consequences of income from continuing operations
   2. Is allocated to a gain on discontinued operations if it offsets the current or deferred tax consequences of that gain
   3. Is allocated to continuing operations if it results from a change in circumstances that causes a change in judgment about future realization of a tax benefit.
2. The current or deferred tax benefit of a loss from continuing operations in the current year is allocated to continuing operations regardless of whether that loss offsets the current or deferred tax consequences of a gain on discontinued operations that:
   1. Occurred in the current year
   2. Occurred in a prior year (that is, if realization of the tax benefit will be by carryback refund)
   3. Is expected to occur in a future year.

Tax-Planning Strategies

55-39 Expectations about future taxable income incorporate numerous assumptions about actions, elections, and strategies to minimize income taxes in future years. For example, an entity may have a practice of deferring taxable income whenever possible by structuring sales to qualify as installment sales for tax purposes. Actions such as that are not tax-planning strategies, as that term is used in this Topic because they are actions that management takes in the normal course of business. For purposes of applying the requirements of this Subtopic, a tax-planning strategy is an action that management ordinarily might not take but would take, if necessary, to realize a tax benefit for a carryforward before it expires. For example, a strategy to sell property and lease it back for the expressed purpose of generating taxable income to utilize a carryforward before it expires is not an action that management takes in the normal course of business. A qualifying tax-planning strategy is an action that:

1. Is prudent and feasible. Management must have the ability to implement the strategy and expect to do so unless the need is eliminated in future years. For example, management would not have to apply the strategy if income earned in a later year uses the entire amount of carryforward from the current year.
2. An entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused. All of the various strategies that are expected to be employed for business or tax purposes other than utilization of carryforwards that would otherwise expire unused are, for purposes of this Subtopic, implicit in management’s estimate of future taxable income and, therefore, are not tax-planning strategies as that term is used in this Topic.
3. Would result in realization of deferred tax assets. The effect of qualifying tax-planning strategies must be recognized in the determination of the amount of a valuation allowance. Tax-planning strategies need not be considered, however, if positive evidence available from other sources (see paragraph 740-10-30-18) is sufficient to support a conclusion that a valuation allowance is not necessary.

55-40 Paragraph 740-10-30-19 indicates that tax-planning strategies include elections for tax purposes. The following are some examples of elections under current U.S. federal tax law that, if they meet the criteria for tax-planning strategies, should be considered in determining the amount, if any, of valuation allowance required for deferred tax assets:

1. The election to file a consolidated tax return
2. The election to claim either a deduction or a tax credit for foreign taxes paid
3. The election to forgo carryback and only carry forward a net operating loss.

55-41 Because the effects of known qualifying tax-planning strategies must be recognized (see Example 22 [paragraph 740-10-55-163]), management should make a reasonable effort to identify those qualifying tax-planning strategies that are significant. Management’s obligation to apply qualifying tax-planning strategies in determining the amount of valuation allowance required is the same as its obligation to apply the requirements of other Topics for financial accounting and reporting. However, if there is sufficient evidence that taxable income from one of the other sources of taxable income listed in paragraph 740-10-30-18 will be adequate to eliminate the need for any valuation allowance, a search for tax-planning strategies is not necessary.

55-42 Tax-planning strategies may shift estimated future taxable income between future years. For example, assume that an entity has a $1,500 operating loss carryforward that expires at the end of next year and that its estimate of taxable income exclusive of the future reversal of existing temporary differences and carryforwards is approximately $1,000 per year for each of the next several years. That estimate is based, in part, on the entity’s present practice of making sales on the installment basis and on provisions in the tax law that result in temporary deferral of gains on installment sales. A tax-planning strategy to increase taxable income next year and realize the full tax benefit of that operating loss carryforward might be to structure next year’s sales in a manner that does not meet the tax rules to qualify as installment sales. Another strategy might be to change next year’s depreciation procedures for tax purposes.

55-43 Tax-planning strategies also may shift the estimated pattern and timing of future reversals of temporary differences. For example, if an operating loss carryforward otherwise would expire unused at the end of next year, a tax-planning strategy to sell the entity’s installment sale receivables next year would accelerate the future reversal of taxable temporary differences for the gains on those installment sales. In other circumstances, a tax-planning strategy to accelerate the future reversal of deductible temporary differences in time to offset taxable income that is expected in an early future year might be the only means to realize a tax benefit for those deductible temporary differences if they otherwise would reverse and provide no tax benefit in some later future year(s). Examples of actions that would accelerate the future reversal of deductible temporary differences include the following:

1. An annual payment that is larger than an entity’s usual annual payment to reduce a long-term pension obligation (recognized as a liability in the financial statements) might accelerate a tax deduction for pension expense to an earlier year than would otherwise have occurred.
2. Disposal of obsolete inventory that is reported at net realizable value in the financial statements would accelerate a tax deduction for the amount by which the tax basis exceeds the net realizable value of the inventory.
3. Sale of loans at their reported amount (that is, net of an allowance for bad debts) would accelerate a tax deduction for the allowance for bad debts.

55-44 A significant expense might need to be incurred to implement a particular tax-planning strategy, or a significant loss might need to be recognized as a result of implementing a particular tax-planning strategy. In either case, that expense or loss (net of any future tax benefit that would result from that expense or loss) reduces the amount of tax benefit that is recognized for the expected effect of a qualifying tax-planning strategy. For that purpose, the future effect of a differential in interest rates (for example, between the rate that would be earned on installment sale receivables and the rate that could be earned on an alternative investment if the tax-planning strategy is to sell those receivables to accelerate the future reversal of related taxable temporary differences) is not considered.

55-45 Example 21 (see paragraph 740-10-55-159) illustrates recognition of a deferred tax asset based on the expected effect of a qualifying tax-planning strategy when a significant expense would be incurred to implement the strategy.

55-46 Under this Subtopic, the requirements for consideration of tax-planning strategies pertain only to the determination of a valuation allowance for a deferred tax asset. A deferred tax liability ordinarily is recognized for all taxable temporary differences. The only exceptions are identified in paragraph 740-10-25-3. Certain seemingly taxable temporary differences, however, may or may not result in taxable amounts when those differences reverse in future years. One example is an excess of cash surrender value of life insurance over premiums paid (see paragraph 740-10-25-30). Another example is an excess of the book over the tax basis of an investment in a domestic subsidiary (see paragraph 740-30-25-7). The determination of whether those differences are taxable temporary differences does not involve a tax-planning strategy as that term is used in this Topic.

55-47 Example 22 (see paragraph 740-10-55-163) provides an example where an entity has identified multiple tax-planning strategies.

55-48 Under current U.S. federal tax law, approval of an entity’s change from taxable C corporation status to nontaxable S corporation status is automatic if the criteria for S corporation status are met. If an entity meets those criteria but has not changed to S corporation status, a strategy to change to nontaxable S corporation status would not permit an entity to not recognize deferred taxes because a change in tax status is a discrete event. Paragraph 740-10-25-32 requires that the effect of a change in tax status be recognized at the date that the change in tax status occurs, that is, at the date that the change is approved by the taxing authority (or on the date of filing the change if approval is not necessary). For example, as required by paragraph 740-10-25-34, if an election to change an entity’s tax status is approved by the taxing authority (or filed, if approval is not necessary) early in Year 2 and before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) for Year 1, the effect of that change in tax status shall not be recognized in the financial statements for Year 1.

Examples of Temporary Differences

55-49 The following guidance presents examples of temporary differences. These examples are intended to be illustrative and not all-inclusive. Any references to various tax laws shall not be considered definitive interpretations of such laws for any purpose.

55-50 Differences between the recognition for financial accounting purposes and income tax purposes of discount or premium resulting from determination of the present value of a note should be treated as temporary differences in accordance with this Topic.

55-51 The issuance of convertible debt with a beneficial conversion feature results in a basis difference for purposes of applying this Topic. The recognition of a beneficial conversion feature effectively creates two separate instruments-a debt instrument and an equity instrument-for financial statement purposes while it is accounted for as a debt instrument, for example, under the U.S. Federal Income Tax Code. Consequently, the reported amount in the financial statements (book basis) of the debt instrument is different from the tax basis of the debt instrument. The basis difference that results from the issuance of convertible debt with a beneficial conversion feature is a temporary difference for purposes of applying this Topic because that difference will result in a taxable amount when the reported amount of the liability is recovered or settled. That is, the liability is presumed to be settled at its current carrying amount (reported amount). The recognition of deferred taxes for the temporary difference of the convertible debt with a beneficial conversion feature should be recorded as an adjustment to additional paid-in capital. Because the beneficial conversion feature (an allocation to additional paid-in capital) created the basis difference in the debt instrument, the provisions of paragraph 740-20-45-11(c) apply and therefore the establishment of the deferred tax liability for the basis difference should result in an adjustment to the related components of shareholders’ equity.

55-52 An entity may use the LIFO method to value inventories for tax purposes which may result in LIFO inventory temporary differences, that is, for the excess of the amount of LIFO inventory for financial reporting over its tax basis.

55-53 Even though a deferred tax liability for the LIFO inventory of a subsidiary will not be settled if that subsidiary is sold before the LIFO inventory temporary difference reverses, recognition of a deferred tax liability is required regardless of whether the LIFO inventory happens to belong to the parent entity or one of its subsidiaries.

55-54 The following guidance and Example 23 (see paragraph 740-10-55-165) refer to provisions of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003; however, they shall not be considered definitive interpretations of the Act for any purpose. That Example provides a simple illustration of this guidance.

55-55 As indicated in paragraph 715-60-05-9, on December 8, 2003, the president signed the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 into law. The Act introduces a prescription drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. An employer’s eligibility for the 28 percent subsidy depends on whether the prescription drug benefit available under its plan is at least actuarially equivalent to the Medicare Part D benefit.

55-56 The Act excludes receipt of the subsidy from the taxable income of the employer for federal income tax purposes. That provision affects the accounting for the temporary difference related to the employer’s accrued postretirement benefit cost under the requirements of this Topic.

55-57 In the periods in which the subsidy affects the employer’s accounting for the plan, it shall have no effect on any plan-related temporary difference accounted for under this Topic because the subsidy is exempt from federal taxation. That is, the measure of any temporary difference shall continue to be determined as if the subsidy did not exist. Example 23 (see paragraph 740-10-55-165) provides a simple illustration of this guidance.

55-58 The following guidance refers to provisions of the Tax Reform Act of 1986 and the Omnibus Budget Reconciliation Act of 1987; however, it shall not be considered a definitive interpretation of the Acts for any purpose.

55-59 A change in tax law may require a change in accounting method for tax purposes, for example, the uniform cost capitalization rules required by the Tax Reform Act of 1986. For calendar-year taxpayers, inventories on hand at the beginning of 1987 are revalued as though the new rules had been in effect in prior years. That initial catch-up adjustment is deferred and taken into taxable income over not more than four years. This deferral of the initial catch-up adjustment for a change in accounting method for tax purposes gives rise to two temporary differences.

55-60 One temporary difference is related to the additional amounts initially capitalized into inventory for tax purposes. As a result of those additional amounts, the tax basis of the inventory exceeds the amount of the inventory for financial reporting. That temporary difference is considered to result in a deductible amount when the inventory is expected to be sold. Therefore, the excess of the tax basis of the inventory over the amount of the inventory for financial reporting as of December 31, 1986, is considered to result in a deductible amount in 1987 when the inventory turns over. As of subsequent year-ends, the deductible temporary difference to be considered would be the amount capitalized for tax purposes and not for financial reporting as of those year-ends. The expected timing of the deduction for the additional amounts capitalized in this example assumes that the inventory is not measured on a LIFO basis; temporary differences related to LIFO inventories reverse when the inventory is sold and not replaced as provided in paragraph 740-10-55-13.

55-61 The other temporary difference is related to the deferred income for tax purposes that results from the initial catch-up adjustment. As stated above, that deferred income likely will be included in taxable income over four years. Ordinarily, the reversal pattern for this temporary difference should be considered to follow the tax pattern and would also be four years. This assumes that it is expected that inventory sold will be replaced. However, under the tax law, if there is a one-third reduction in the amount of inventory for two years running, any remaining balance of that deferred income is included in taxable income for the second year. If such inventory reductions are expected, then the reversal pattern will be less than four years.

55-62 Paragraph 740-10-35-4 requires recognition of the effect of a change in tax law or rate in the period that includes the enactment date. For example, the Tax Reform Act of 1986 was enacted in 1986. Therefore, the effects are recognized in a calendar-year entity’s 1986 financial statements.

55-63 The Omnibus Budget Reconciliation Act of 1987 requires family-owned farming businesses to use the accrual method of accounting for tax purposes. The initial catch-up adjustment to change from the cash to the accrual method of accounting is deferred. It is included in taxable income if the business ceases to be family-owned (for example, it goes public). It also is included in taxable income if gross receipts from farming activities in future years drop below certain 1987 levels as set forth in the tax law. The deferral of the initial catch-up adjustment for that change in accounting method for tax purposes gives rise to a temporary difference because an assumption inherent in an entity’s statement of financial position is that the reported amounts of assets and liabilities will be recovered and settled. Under the requirements of this Topic, deferred tax liabilities may not be eliminated or reduced because an entity may be able to delay the settlement of those liabilities by delaying the events that would cause taxable temporary differences to reverse. Accordingly, the deferred tax liability is recognized. If the events that trigger the payment of the tax are not expected in the foreseeable future, the reversal pattern of the related temporary difference is indefinite.

55-64 An entity may change from taxable C corporation status to nontaxable S corporation status. An entity that makes that status change shall continue to recognize a deferred tax liability to the extent that the entity would be subject to a corporate-level tax on net unrecognized built-in gains.

55-65 A C corporation that has temporary differences as of the date of change to S corporation status shall determine its deferred tax liability in accordance with the tax law. Since the timing of realization of a built-in gain can determine whether it is taxable, and therefore significantly affect the deferred tax liability to be recognized, actions and elections that are expected to be implemented shall be considered. For purposes of determining that deferred tax liability, the lesser of an unrecognized built-in gain (as defined by the tax law) or an existing temporary difference is used in the computations described in the tax law to determine the amount of the tax on built-in gains. Example 24 (see paragraph 740-10-55-168) illustrates this guidance.

55-66 Gain or loss resulting from an involuntary conversion of a nonmonetary asset to monetary assets that is not recognized for income tax reporting purposes in the same period in which the gain or loss is recognized for financial reporting purposes is a temporary difference for which a deferred tax liability or deferred tax asset should be recognized as required by this Subtopic.

Treatment of Certain Payments to Taxing Authorities

55-67 An entity may make payments to taxing authorities for different reasons. The following guidance addresses certain of these payments.

55-68 The following guidance refers to provisions of the Tax Reform Act of 1986 and the Revenue Act of 1987; however, it shall not be considered a definitive interpretation of the Acts for any purpose.

55-69 The guidance addresses how a payment should be recorded in the financial statements of an entity for a payment to a taxing authority to retain their fiscal year.

55-70 On December 22, 1987, the Revenue Act of 1987 was enacted, which allowed partnerships and S corporations to elect to retain their fiscal year rather than adopt a calendar year for tax purposes as previously required by the Tax Reform Act of 1986. Entities that elected to retain a fiscal year are required to make an annual payment in a single installment each year that approximates the income tax that the partners-owners would have paid on the short-period income had the entity switched to a calendar year. The payment is made by the entity and is not identified with individual partners-owners. Additionally the amount is not adjusted if a partner-owner leaves the entity.

55-71 In this fact pattern, partnerships and S corporations should account for the payment as an asset since the payment is viewed as a deposit that is adjusted annually and will be realized when the entity liquidates, its income declines to zero, or it converts to a calendar year-end.

55-72 The following guidance refers to provisions which may be present in the French tax structure; however, it shall not be considered a definitive interpretation of the historical or current French tax structure for any purpose.

55-73 The French income tax structure is based on the concept of an integrated tax system. The system utilizes a tax credit at the shareholder level to eliminate or mitigate the double taxation that would otherwise apply to a dividend. The tax credit is automatically available to a French shareholder receiving a dividend from a French corporation. The precompte mobilier (or precompte) is a mechanism that provides for the integration of the tax credit to the shareholder with the taxes paid by the corporation. The precompte is a tax paid by the corporation at the time of a dividend distribution that is equal to the difference between a tax based on the regular corporation tax rate applied to the amount of the declared dividend and taxes previously paid by the corporation on the income being distributed. In addition, if a corporation pays a dividend from earnings that have been retained for more than five years, the corporation loses the benefit of any taxes previously paid in the computation of the precompte.

55-74 Paragraph 740-10-15-4(b) sets forth criteria for determining whether a tax that is assessed on an entity based on dividends distributed is, in effect, a withholding tax for the benefit of recipients of the dividend to be recorded in equity as part of the dividend distribution in that entity’s separate financial statements. A tax that is assessed on a corporation based on dividends distributed that meets the criteria in that paragraph, such as the French precompte tax, should be considered to be in effect a withholding of tax for the recipient of the dividend and recorded in equity as part of the dividend paid to shareholders.

55-75 An employer that withdraws excess plan assets from its pension plan may be subject to an excise tax. If the excise tax is independent of taxable income, that is, it is a tax due on a specific transaction regardless of whether there is any taxable income for the period in which the transaction occurs, it is not an income tax and the employer should recognize it as an expense (not classified as income taxes) in the period of the withdrawal.

55-76 Example 26 (see paragraph 740-10-55-202) illustrates a transaction directly with a governmental taxing authority.

55-77 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-78 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-79 Paragraph 740-10-50-9 requires disclosure of the significant components of income tax expense attributable to continuing operations. The sum of the amounts disclosed for the components of tax expense should equal the amount of tax expense that is reported in the statement of earnings for continuing operations. Insignificant components that are not separately disclosed should be combined and disclosed as a single amount so that the sum of the amounts disclosed will equal total income tax expense attributable to continuing operations. Separate disclosure of the tax benefit of operating loss carryforwards and tax credits and tax credit carryforwards that have been recognized as a reduction of current tax expense and deferred tax expense is required. There are a number of ways to satisfy that disclosure requirement. Three acceptable approaches, referred to as the gross method, the net method, and the statutory tax rate reconciliation method, are illustrated in Example 29 (see paragraph 740-10-55-212).

55-80 Income tax expense is defined as the sum of current and deferred tax expense, and the amount to be disclosed under any of the above approaches is only the amount by which total income tax expense from continuing operations has been reduced by tax credits or an operating loss carryforward. For example, assume that a tax benefit is recognized for an operating loss or tax credit carryforward by recognizing a deferred tax asset in Year 1, with no valuation allowance required because of an existing deferred tax liability. Further, assume that the carryforward is realized on the tax return in Year 2. For financial reporting in Year 2:

1. Current tax expense will be reduced for the tax benefit of the operating loss or tax credit carryforward realized on the tax return.
2. Deferred tax expense will be larger (or a deferred tax benefit will be smaller) by the same amount.

In those circumstances, the operating loss or tax credit carryforward affects only income tax expense (the sum of current and deferred tax expense) in Year 1 when a tax asset (with no valuation allowance) is recognized. There is no effect on income tax expense in Year 2 because the separate effects on current and deferred tax expense offset each other. Accordingly, the requirement for separate disclosure of the effects of tax credits or an operating loss carryforward is not applicable for Year 2. However, that disclosure requirement applies to financial statements for Year 1 that are presented for comparative purposes.

55-81 This Example illustrates the initial and subsequent determination by an entity of the unit of account for a tax position. Paragraph 740-10-25-13 requires an entity to determine an appropriate unit of account for an individual tax position. The following Cases illustrate:

1. The determination of the unit of account (Case A)
2. A change in the unit of account (Case B).

55-82 Cases A and B share all of the following assumptions.

55-83 An entity anticipates claiming a $1 million research and experimentation credit on its tax return for the current fiscal year. The credit comprises equal spending on 4 separate projects (that is, $250,000 of tax credit per project). The entity expects to have sufficient taxable income in the current year to fully utilize the $1 million credit. Upon review of the supporting documentation, management believes it is more likely than not that the entity will ultimately sustain a benefit of approximately $650,000. The anticipated benefit consists of approximately $200,000 per project for the first 3 projects and $50,000 for the fourth project.

Case A: Determining the Unit of Account — A Prerequisite to Recognition Assessment

55-84 This Case illustrates an entity’s initial determination of the unit of account for a tax position.

55-85 In its evaluation of the appropriate amount to recognize, management first determines the appropriate unit of account for the tax position. Because of the magnitude of expenditures in each project, management concludes that the appropriate unit of account is each individual research project. In reaching this conclusion, management considers both the level at which it accumulates information to support the tax return and the level at which it anticipates addressing the issue with taxing authorities. In this Case, upon review of the four projects including the magnitude of expenditures, management determines that it accumulates information at the project level. Management also anticipates the taxing authority will address the issues during an examination at the level of individual projects.

55-86 In evaluating the projects for recognition, management determines that three projects meet the more-likely-than-not recognition threshold. However, due to the nature of the activities that constitute the fourth project, it is uncertain that the tax benefit related to this project will be allowed. Because the tax benefit related to that fourth project does not meet the more-likely-than-not recognition threshold, it should not be recognized in the financial statements, even though tax positions associated with that project will be included in the tax return. The entity would recognize a $600,000 financial statement benefit related to the first 3 projects but would not recognize a financial statement benefit related to the fourth project.

Case B: Change in the Unit of Account

55-87 This Case illustrates a change in an entity’s initial determination of the unit of account for a tax position.

55-88 In Year 2, the entity increases its spending on research and experimentation projects and anticipates claiming significantly larger research credits in its Year 2 tax return. In light of the significant increase in expenditures, management reconsiders the appropriateness of the unit of account and concludes that the project level is no longer the appropriate unit of account for research credits. This conclusion is based on the magnitude of spending and anticipated claimed credits and on previous experience and is consistent with the advice of external tax advisors. Management anticipates the taxing authority will focus the examination on functional expenditures when examining the Year 2 return and thus needs to evaluate whether it can change the unit of account in subsequent years’ tax returns.

55-89 Determining the unit of account requires evaluation of the entity’s facts and circumstances. In making that determination, management evaluates the manner in which it prepares and supports its income tax return and the manner in which it anticipates addressing issues with taxing authorities during an examination. The unit of account should be consistently applied to similar positions from period to period unless a change in facts and circumstances indicates that a different unit of account is more appropriate. Because of the significant change in the tax position in Year 2, management’s conclusion that the taxing authority will likely examine tax credits in the Year 2 tax return at a more detailed level than the individual project is reasonable and appropriate. Accordingly, the entity should reevaluate the unit of account for the Year 2 financial statements based on the new facts and circumstances.

55-90 The guidance in paragraph 740-10-25-7(b) on evaluating a taxing authority’s widely understood administrative practices and precedents shall be taken into account when assessing the more-likely-than-not recognition threshold established in paragraph 740-10-25-6. This Example illustrates such consideration.

55-91 An entity has established a capitalization threshold of $2,000 for its tax return for routine property and equipment purchases. Assets purchased for less than $2,000 are claimed as expenses on the tax return in the period they are purchased. The tax law does not prescribe a capitalization threshold for individual assets, and there is no materiality provision in the tax law. The entity has not been previously examined. Management believes that based on previous experience at a similar entity and current discussions with its external tax advisors, the taxing authority will not disallow tax positions based on that capitalization policy and the taxing authority’s historical administrative practices and precedents.

55-92 Some might deem the entity’s capitalization policy a technical violation of the tax law, since that law does not prescribe capitalization thresholds. However, in this situation the entity has concluded that the capitalization policy is consistent with the demonstrated administrative practices and precedents of the taxing authority and the practices of other entities that are regularly examined by the taxing authority. Based on its previous experience with other entities and consultation with its external tax advisors, management believes the administrative practice is widely understood. Accordingly, because management expects the taxing authority to allow this position when and if examined, the more-likely-than-not recognition threshold has been met.

55-93 The guidance in paragraph 740-10-25-7(b) on evaluating a taxing authority’s widely understood administrative practices and precedents shall be taken into account when assessing the more-likely-than-not recognition threshold established in paragraph 740-10-25-6. This Example illustrates such consideration.

55-94 An entity has been incorporated in Jurisdiction A for 50 years; it has filed a tax return in Jurisdiction A in each of those 50 years. The entity has been doing business in Jurisdiction B for approximately 20 years and has filed a tax return in Jurisdiction B for each of those 20 years. However, the entity is not certain of the exact date it began doing business, or the date it first had nexus, in Jurisdiction B.

55-95 The entity understands that if a tax return is not filed, the statute of limitations never begins to run; accordingly, failure to file a tax return effectively means there is no statute of limitations. The entity has become familiar with the administrative practices and precedents of Jurisdiction B and understands that Jurisdiction B will look back only six years in determining if there is a tax return due and a deficiency owed. Because of the administrative practices of the taxing authority and the facts and circumstances, the entity believes it is more likely than not that a tax return is not required to be filed in Jurisdiction B at an earlier date and that a liability for tax exposures for those periods is not required.

55-96 Paragraph 740-10-30-20 requires that entities determine the amount of available future taxable income from a tax-planning strategy based on the application of the recognition and measurement requirements of this Subtopic for tax positions. This Example illustrates the recognition aspect of that requirement.

55-97 An entity has a wholly owned subsidiary with certain deferred tax assets as a result of several years of losses from operations. Management has determined that it is more likely than not that sufficient future taxable income will not be available to realize those deferred tax assets. Therefore, management recognizes a full valuation allowance for those deferred tax assets both in the separate financial statements of the subsidiary and in the consolidated financial statements of the entity.

55-98 Management has identified certain tax-planning strategies that might enable the realization of those deferred tax assets. Management has determined that the strategies will meet the minimum statutory threshold to avoid penalties and that it is not more likely than not that the strategies would be sustained upon examination based on the technical merits. Accordingly, those strategies may not be used to reduce the valuation allowance on the deferred tax assets. Only a tax-planning strategy that meets the more-likely-than-not recognition threshold would be considered in evaluating the sufficiency of future taxable income for realization of deferred tax assets.

55-99 This Example illustrates the recognition and measurement criteria of this Subtopic to tax positions where the tax law is unambiguous. The recognition and measurement criteria of this Subtopic applicable to tax positions begin in paragraph 740-10-25-5 for recognition and paragraph 740-10-30-7 for measurement.

55-100 An entity has taken a tax position that it believes is based on clear and unambiguous tax law for the payment of salaries and benefits to employees. The class of salaries being evaluated in this tax position is not subject to any limitations on deductibility (for example, executive salaries are not included), and none of the expenditures are required to be capitalized (for example, the expenditures do not pertain to the production of inventories); all amounts accrued at year-end were paid within the statutorily required time frame subsequent to the reporting date. Management concludes that the salaries are fully deductible.

55-101 All tax positions are subject to the requirements of this Subtopic. However, because the deduction is based on clear and unambiguous tax law, management has a high confidence level in the technical merits of this position. Accordingly, the tax position clearly meets the recognition criterion and should be evaluated for measurement. In determining the amount to measure, management is highly confident that the full amount of the deduction will be allowed and it is clear that it is greater than 50 percent likely that the full amount of the tax position will be ultimately realized. Accordingly, the entity would recognize the full amount of the tax position in the financial statements.

55-102 This Example demonstrates an application of the measurement requirements of paragraph 740-10-30-7 for a tax position that meets the paragraph 740-10-25-6 requirements for recognition. Measurement in this Example is based on identified information about settlement.

55-103 In applying the recognition criterion of this Subtopic for tax positions, an entity has determined that a tax position resulting in a benefit of $100 qualifies for recognition and should be measured. The entity has considered the amounts and probabilities of the possible estimated outcomes as follows.

55-104 Because $60 is the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement, the entity would recognize a tax benefit of $60 in the financial statements.

55-105 As in the preceding Example, this Example also demonstrates an application of the measurement requirements of paragraph 740-10-30-7 for a tax position determined to meet recognition requirements. While measurement in this Example is also based on identified information about settlement, the information is more limited than in the preceding Example.

55-106 In applying the recognition criterion of this Subtopic for tax positions an entity has determined that a tax position resulting in a benefit of $100 qualifies for recognition and should be measured. There is limited information about how a taxing authority will view the position. After considering all relevant information, management’s confidence in the technical merits of the tax position exceeds the more-likely-than-not recognition threshold, but management also believes it is likely it would settle for less than the full amount of the entire position when examined. Management has considered the amounts and the probabilities of the possible estimated outcomes.

55-107 Because $75 is the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement, the entity would recognize a tax benefit of $75 in the financial statements.

55-108 This Example demonstrates an application of the measurement requirements of paragraph 740-10-30-7 for a tax position that meets the paragraph 740-10-25-6 requirements for recognition. Measurement in this Example is based on settlement of a similar tax position with the taxing authority.

55-109 In applying the recognition criterion of this Subtopic for tax positions, an entity has determined that a tax position resulting in a benefit of $100 qualifies for recognition and should be measured. In a recent settlement with the taxing authority, the entity has agreed to the treatment for that position for current and future years. There are no recently issued relevant sources of tax law that would affect the entity’s assessment. The entity has not changed any assumptions or computations, and the current tax position is consistent with the position that was recently settled. In this case, the entity would have a very high confidence level about the amount that will be ultimately realized and little information about other possible outcomes. Management will not need to evaluate other possible outcomes because it can be confident of the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement without that evaluation.

55-110 This Example demonstrates an application of the measurement requirements of paragraph 740-10-30-7 for a tax position that meets the paragraph 740-10-25-6 requirements for recognition. Measurement in this Example is based on the timing of the deduction.

55-111 In Year 1, an entity acquired a separately identifiable intangible asset for $15 million that has an indefinite life for financial statement purposes and is, therefore, not subject to amortization. Based on some uncertainty in the tax code, the entity decides for tax purposes to deduct the entire cost of the asset in Year 1. While the entity is certain that the full amount of the intangible is ultimately deductible for tax purposes, the timing of deductibility is uncertain under the tax code. In applying the recognition criterion of this Subtopic for tax positions, the entity has determined that the tax position qualifies for recognition and should be measured. The entity believes it is 25 percent likely it would be able to realize immediate deduction upon settlement, and it is certain it could sustain a 15-year amortization for tax purposes. Thus, the largest Year 1 benefit that is greater than 50 percent likely of being realized upon settlement is the tax effect of $1 million (the Year 1 deduction from straight-line amortization of the asset over 15 years).

55-112 At the end of Year 1, the entity should reflect a deferred tax liability for the tax effect of the temporary difference created by the difference between the financial statement basis of the asset ($15 million) and the tax basis of the asset computed in accordance with the guidance in this Subtopic for tax positions ($14 million, the cost of the asset reduced by $1 million of amortization). The entity also should reflect a tax liability for the tax-effected difference between the as-filed tax position ($15 million deduction) and the amount of the deduction that is considered more likely than not of being sustained ($1 million). The entity should evaluate the tax position for accrual of statutory penalties as well as interest expense on the difference between the amounts reported in the financial statements and the tax position taken in the tax return.

55-113 This Example demonstrates an application of the measurement requirements of paragraph 740-10-30-7 for a tax position that meets the paragraph 740-10-25-6 requirements for recognition. Measurement in this Example is based on a change in timing of deductibility.

55-114 In 20X1 an entity took a tax position in which it amortizes the cost of an acquired asset on a straight-line basis over three years, while the amortization period for financial reporting purposes is seven years. After one year, the entity has deducted one-third of the cost of the asset in its income tax return and one-seventh of the cost in the financial statements and, consequently, has a deferred tax liability for the difference between the financial reporting and tax bases of the asset.

55-115 In accordance with the requirements of this Subtopic, the entity evaluates the tax position as of the reporting date of the financial statements. In 20X2, the entity determines that it is still certain that the entire cost of the acquired asset is fully deductible, so the more-likely-than-not recognition threshold has been met according to paragraph 740-10-25-6. However, in 20X2, the entity now believes based on new information that the largest benefit that is greater than 50 percent likely of being realized upon settlement is straight-line amortization over 7 years.

55-116 In this Example, the entity would recognize a liability for unrecognized tax benefits based on the difference between the three- and seven-year amortization. In 20X2, no deferred tax liability should be recognized, as there is no longer a temporary difference between the financial statement carrying value of the asset and the tax basis of the asset based on this Subtopic’s measurement requirements for tax positions. Additionally, the entity should evaluate the need to accrue interest and penalties, if applicable under the tax law.

55-117 Paragraphs 740-10-25-6 and 740-10-25-8 require that tax positions be recognized and measured based on information available at the reporting date. This Example demonstrates the effect of information becoming available after the reporting date but before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25).

55-118 Entity A has evaluated a tax position at its most recent reporting date and has concluded that the position meets the more-likely-than-not recognition threshold. In evaluating the tax position for recognition, Entity A considered all relevant sources of tax law, including a court case in which the taxing authority has fully disallowed a similar tax position with an unrelated entity (Entity B). The taxing authority and Entity B are aggressively litigating the matter. Although Entity A was aware of that court case at the recent reporting date, management determined that the more-likely-than-not recognition threshold had been met. After the reporting date, but before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25), the taxing authority prevailed in its litigation with Entity B, and Entity A concludes that it is no longer more likely than not that it will sustain the position.

55-119 Paragraph 740-10-40-2 provides the guidance that an entity shall derecognize a previously recognized tax position in the first period in which it is no longer more likely than not that the tax position would be sustained upon examination, and paragraphs 740-10-25-14; 740-10-35-2; and 740-10-40-2 establish that subsequent recognition, derecognition, and measurement shall be based on management’s best judgment given the facts, circumstances, and information available at the reporting date. Because the resolution of Entity B’s litigation with the taxing authority is the information that caused Entity A to change its judgment about the sustainability of the position and that information was not available at the reporting date, the change in judgment would be recognized in the first quarter of the current fiscal year.

55-120 This Example illustrates the guidance in paragraphs 740-10-55-7 through 55-9 relating to recognition of deferred tax assets and liabilities, including when a detailed analysis of sources of taxable income may not be necessary in considering the need for a valuation allowance for deferred tax assets. In this Example, an entity has $2,400 of deductible temporary differences and $1,500 of taxable temporary differences at the end of Year 3 (the current year).

55-121 A deferred tax liability is recognized at the end of Year 3 for the $1,500 of taxable temporary differences, and deferred tax asset is recognized for the $2,400 of deductible temporary differences. All available evidence, both positive and negative, is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed for some portion or all of the deferred tax asset. If evidence about one or more sources of taxable income (see paragraph 740-10-30-18) is sufficient to support a conclusion that a valuation allowance is not needed, other sources of taxable income need not be considered. For example, if the weight of available evidence indicates that taxable income will exceed $2,400 in each future year, a conclusion that no valuation allowance is needed can be reached without considering the pattern and timing of the reversal of the temporary differences, the existence of qualifying tax-planning strategies, and so forth.

55-122 Similarly, if the deductible temporary differences will reverse within the next 3 years and taxable income in the current year exceeds $2,400, nothing needs to be known about future taxable income exclusive of reversing temporary differences because the deferred tax asset could be realized by carryback to the current year. A valuation allowance is needed, however, if the weight of available evidence indicates that some portion or all of the $2,400 of tax deductions from future reversals of the deductible temporary differences will not be realized by offsetting any of the following:

1. The $1,500 of taxable temporary differences and $900 of future taxable income exclusive of reversing temporary differences
2. $2,400 of future taxable income exclusive of reversing temporary differences
3. $2,400 of taxable income in the current or prior years by loss carryback to those years
4. $2,400 of taxable income in one or more of the circumstances described above and as a result of a qualifying tax-planning strategy (see paragraphs 740-10-55-39 through 55-48).

Paragraph 740-10-55-8 provides guidance on when a detailed analysis of sources of taxable income may not be necessary in considering the need for a valuation allowance for deferred tax assets.

55-123 Detailed analyses are not necessary, for example, if the entity earned $500 of taxable income in each of Years 1–3 and there is no evidence to suggest it will not continue to earn that level of taxable income in future years. That level of future taxable income is more than sufficient to realize the tax benefit of $2,400 of tax deductions over a period of at least 19 years (the year(s) of the deductions, 3 carryback years, and 15 carryforward years) in the U.S. federal tax jurisdiction.

55-124 This Example illustrates the guidance in paragraphs 740-10-55-7 through 55-9 relating to recognition of a valuation allowance for a portion of a deferred tax asset in one year and a subsequent change in circumstances that requires adjustment of the valuation allowance at the end of the following year. This Example has the following assumptions:

1. At the end of the current year (Year 3), an entity’s only temporary differences are deductible temporary differences in the amount of $900.
2. Pretax financial income, taxable income, and taxes paid for each of Years 1-3 are all positive, but relatively negligible, amounts.
3. The enacted tax rate is 40 percent for all years.

55-125 A deferred tax asset in the amount of $360 ($900 at 40 percent) is recognized at the end of Year 3. If management concludes, based on an assessment of all available evidence (see guidance in paragraphs 740-10-30-17 through 30-24), that it is more likely than not that future taxable income will not be sufficient to realize a tax benefit for $400 of the $900 of deductible temporary differences at the end of the current year, a $160 valuation allowance ($400 at 40 percent) is recognized at the end of Year 3.

55-126 Assume that pretax financial income and taxable income for Year 4 turn out to be as follows.

55-127 The $50 pretax loss in Year 4 is additional negative evidence that must be weighed against available positive evidence to determine the amount of valuation allowance necessary at the end of Year 4. Deductible temporary differences and carryforwards at the end of Year 4 are as follows.

55-128 The $360 deferred tax asset recognized at the end of Year 3 is increased to $380 ($950 at 40 percent) at the end of Year 4. Based on an assessment of all evidence available at the end of Year 4, management concludes that it is more likely than not that $240 of the deferred tax asset will not be realized and, therefore, that a $240 valuation allowance is necessary. The $160 valuation allowance recognized at the end of Year 3 is increased to $240 at the end of Year 4. The $60 net effect of those 2 adjustments (the $80 increase in the valuation allowance less the $20 increase in the deferred tax asset) results in $60 of deferred tax expense that is recognized in Year 4.

55-129 This Example illustrates the guidance in paragraph 740-10-55-23 for determination of the tax rate for measurement of a deferred tax liability for taxable temporary differences when there is a phased-in change in tax rates. At the end of Year 3 (the current year), an entity has $2,400 of taxable temporary differences, which are expected to result in taxable amounts of approximately $800 on the future tax returns for each of Years 4–6. Enacted tax rates are 35 percent for Years 1–3, 40 percent for Years 4–6, and 45 percent for Year 7 and thereafter.

55-130 The tax rate that is used to measure the deferred tax liability for the $2,400 of taxable temporary differences differs depending on whether the tax effect of future reversals of those temporary differences is on taxes payable for Years 1–3, Years 4–6, or Year 7 and thereafter. The tax rate for measurement of the deferred tax liability is 40 percent whenever taxable income is expected in Years 4–6. If tax losses are expected in Years 4–6, however, the tax rate is:

1. 35 percent if realization of a tax benefit for those tax losses in Years 4–6 will be by loss carryback to Years 1–3
2. 45 percent if realization of a tax benefit for those tax losses in Years 4–6 will be by loss carryforward to Year 7 and thereafter.

55-131 This Example illustrates the guidance in paragraph 740-10-55-23 for determination of the tax rate for measurement of a deferred tax asset for deductible temporary differences when there is a change in tax rates. This Example has the following assumptions:

1. Enacted tax rates are 30 percent for Years 1–3 and 40 percent for Year 4 and thereafter.
2. At the end of Year 3 (the current year), an entity has $900 of deductible temporary differences, which are expected to result in tax deductions of approximately $300 on the future tax returns for each of Years 4–6.

55-132 The tax rate is 40 percent if the entity expects to realize a tax benefit for the deductible temporary differences by offsetting taxable income earned in future years. Alternatively, the tax rate is 30 percent if the entity expects to realize a tax benefit for the deductible temporary differences by loss carryback refund.

55-133 Further assume for this Example both of the following:

1. The entity recognizes a $360 ($900 at 40 percent) deferred tax asset to be realized by offsetting taxable income in future years.
2. Taxable income and taxes payable in each of Years 1–3 were $300 and $90, respectively.

55-134 Realization of a tax benefit of at least $270 ($900 at 30 percent) is assured because carryback refunds totaling $270 may be realized even if no taxable income is earned in future years. Recognition of a valuation allowance for the other $90 ($360 – $270) of the deferred tax asset depends on management’s assessment of whether, based on the weight of available evidence, a portion or all of the tax benefit of the $900 of deductible temporary differences will not be realized at 40 percent tax rates in future years.

55-135 Alternatively, if enacted tax rates are 40 percent for Years 1–3 and 30 percent for Year 4 and thereafter, measurement of the deferred tax asset at a 40 percent tax rate could only occur if tax losses are expected in future Years 4–6.

55-136 This Example illustrates the guidance in paragraph 740-10-55-23 for determination of the average graduated tax rate for measurement of deferred tax liabilities and assets by an entity for which graduated tax rates ordinarily are a significant factor. At the end of Year 3 (the current year), an entity has $1,500 of taxable temporary differences and $900 of deductible temporary differences, which are expected to result in net taxable amounts of approximately $200 on the future tax returns for each of Years 4–6. Enacted tax rates are 15 percent for the first $500 of taxable income, 25 percent for the next $500, and 40 percent for taxable income over $1,000. This Example assumes that there is no income (for example, capital gains) subject to special tax rates.

55-137 The deferred tax liability and asset for those reversing taxable and deductible temporary differences in Years 4–6 are measured using the average graduated tax rate for the estimated amount of annual taxable income in future years. Thus, the average graduated tax rate will differ depending on the expected level of annual taxable income (including reversing temporary differences) in Years 4–6. The average tax rate will be:

1. 15 percent if the estimated annual level of taxable income in Years 4–6 is $500 or less
2. 20 percent if the estimated annual level of taxable income in Years 4–6 is $1,000
3. 30 percent if the estimated annual level of taxable income in Years 4–6 is $2,000.

55-138 Temporary differences usually do not reverse in equal annual amounts as in the Example above, and a different average graduated tax rate might apply to reversals in different future years. However, a detailed analysis to determine the net reversals of temporary differences in each future year usually is not warranted. It is not warranted because the other variable (that is, taxable income or losses exclusive of reversing temporary differences in each of those future years) for determination of the average graduated tax rate in each future year is no more than an estimate. For that reason, an aggregate calculation using a single estimated average graduated tax rate based on estimated average annual taxable income in future years is sufficient. Judgment is permitted, however, to deal with unusual situations, for example, an abnormally large temporary difference that will reverse in a single future year, or an abnormal level of taxable income that is expected for a single future year. The lowest graduated tax rate should be used whenever the estimated average graduated tax rate otherwise would be zero.

55-139 The guidance in paragraph 740-10-55-26 addressing when a tax is an income tax is illustrated using the following example.

55-140 A state’s franchise tax on each corporation is set at the greater of 0.25 percent of the corporation’s net taxable capital and 4.5 percent of the corporation’s net taxable earned surplus. Net taxable earned surplus is a term defined by the tax statute for federal taxable income.

55-141 In this Example, the amount of franchise tax equal to the tax on the corporation’s net taxable earned surplus is an income tax.

55-142 Deferred tax assets and liabilities are required to be recognized under this Subtopic for the temporary differences that exist as of the date of the statement of financial position using the tax rate to be applied to the corporation’s net taxable earned surplus (4.5 percent).

55-143 The portion of the total computed franchise tax that exceeds the amount equal to the tax on the corporation’s net taxable earned surplus should not be presented as a component of income tax expense during any period in which the total computed franchise tax exceeds the amount equal to the tax on the corporation’s net taxable earned surplus.

55-144 While the tax statutes of states or other jurisdictions differ, the accounting described in paragraphs 740-10-55-140 through 55-143 would be appropriate if the tax structure of another state or jurisdiction was essentially the same as in this Example.

55-145 Paragraph 740-10-55-27 introduces guidance relating to a special deduction for qualified production activities that may be available to an entity under the American Jobs Creation Act of 2004.

55-146 This Example illustrates how an entity with a calendar year-end would apply paragraphs 740-10-25-37 and 740-10-35-4 to the qualified production activities deduction at December 31, 2004. In particular, this Example illustrates the methodology used to evaluate the qualified production activities deduction’s effect on determining the need for a valuation allowance on an entity’s existing net deferred tax assets. This Example intentionally is not comprehensive (for example, it excludes state and local taxes).

55-147 This Example has the following assumptions:

1. Expected taxable income (excluding the qualified production activities deduction and net operating loss carryforwards) for 2005: $21,000
2. Expected qualified production activities income for 2005: $50,000
3. Net operating loss carryforwards at December 31, 2004, which expire in 2005: $20,000
4. Expected W-2 wages for 2005: $10,000
5. Assumed statutory income tax rate: 35%
6. Qualified production activities deduction: 3% of the lesser of qualified production activities income or taxable income (after deducting the net operating loss carryforwards); limited to 50% of W-2 wages: $30.

55-148 Based on these assumptions, the entity would not recognize a valuation allowance for the net operating loss carryforwards at December 31, 2004, because expected taxable income in 2005 (after deducting the qualified production activities deduction) exceeds the net operating loss carryforwards, as follows.

55-149 This Example illustrates the guidance in paragraphs 740-10-55-35 through 55-36 for recognition of the tax benefit of an operating loss in the loss year and in subsequent carryforward years when a valuation allowance is necessary in the loss year. This Example has the following assumptions:

1. The enacted tax rate is 40 percent for all years.
2. An operating loss occurs in Year 5.
3. The only difference between financial and taxable income results from use of accelerated depreciation for tax purposes. Differences that arise between the reported amount and the tax basis of depreciable assets in Years 1–7 will result in taxable amounts before the end of the loss carryforward period from Year 5.
4. Financial income, taxable income, and taxes currently payable or refundable are as follows.
   
5. At the end of Year 5, profits are not expected in Years 6 and 7 and later years, and it is concluded that a valuation allowance is necessary to the extent realization of the deferred tax asset for the operating loss carryforward depends on taxable income (exclusive of reversing temporary differences) in future years.

55-150 The deferred tax liability for the taxable temporary differences is calculated at the end of each year as follows.

55-151 The deferred tax asset and related valuation allowance for the loss carryforward are calculated at the end of each year as follows.

55-152 Total tax expense for each period is as follows.

55-153 In Year 5, $2,800 of the loss is carried back to reduce taxable income in Years 2–4, and $1,120 of taxes paid for those years is refunded. In addition, a $1,520 deferred tax liability is recognized for $3,800 of taxable temporary differences, and a $2,400 deferred tax asset is recognized for the $6,000 loss carryforward. However, based on the conclusion described in paragraph 740-10-55-149(e), a valuation allowance is recognized for the amount by which that deferred tax asset exceeds the deferred tax liability.

55-154 In Year 6, a portion of the deferred tax asset for the loss carryforward is realized because taxable income is earned in that year. The remaining balance of the deferred tax asset for the loss carryforward at the end of Year 6 equals the deferred tax liability for the taxable temporary differences. A valuation allowance is not needed.

55-155 In Year 7, the remaining balance of the loss carryforward is realized, and $760 of taxes are payable on net taxable income of $1,900. A $2,040 deferred tax liability is recognized for the $5,100 of taxable temporary differences.

55-156 This Example illustrates the guidance in paragraph 740-10-55-37 for the interaction of loss carryforwards and temporary differences that will result in net deductible amounts in future years. This Example has the following assumptions:

1. The financial loss and the loss reported on the tax return for an entity’s first year of operations are the same.
2. In Year 2, a gain of $2,500 from a transaction that is a sale for tax purposes but does not meet the sale recognition criteria for financial reporting purposes is the only difference between pretax financial income and taxable income.

55-157 Financial and taxable income in this Example are as follows.

55-158 The $4,000 operating loss carryforward at the end of Year 1 is reduced to $1,500 at the end of Year 2 because $2,500 of it is used to reduce taxable income. The $2,500 reduction in the loss carryforward becomes $2,500 of deductible temporary differences that will reverse and result in future tax deductions when the sale occurs (that is, control of the asset transfers to the buyer-lessor). The entity has no deferred tax liability to be offset by those future tax deductions, the future tax deductions cannot be realized by loss carryback because no taxes have been paid, and the entity has had pretax losses for financial reporting since inception. Unless positive evidence exists that is sufficient to overcome the negative evidence associated with those losses, a valuation allowance is recognized at the end of Year 2 for the full amount of the deferred tax asset related to the $2,500 of deductible temporary differences and the remaining $1,500 of operating loss carryforward.

55-159 This Example illustrates the guidance in paragraph 740-10-55-44 for recognition of a deferred tax asset based on the expected effect of a qualifying tax-planning strategy when a significant expense would be incurred to implement the strategy. This Example has the following assumptions:

1. A $900 operating loss carryforward expires at the end of next year.
2. Based on historical results and the weight of other available evidence, the estimated level of taxable income exclusive of the future reversal of existing temporary differences and the operating loss carryforward next year is $100.
3. Taxable temporary differences in the amount of $1,200 ordinarily would result in taxable amounts of approximately $400 in each of the next 3 years.
4. There is a qualifying tax-planning strategy to accelerate the future reversal of all $1,200 of taxable temporary differences to next year.
5. Estimated legal and other expenses to implement that tax-planning strategy are $150.
6. The enacted tax rate is 40 percent for all years.

55-160 Without the tax-planning strategy, only $500 of the $900 operating loss carryforward could be realized next year by offsetting $100 of taxable income exclusive of reversing temporary differences and $400 of reversing taxable temporary differences. The other $400 of operating loss carryforward would expire unused at the end of next year. Therefore, the $360 deferred tax asset ($900 at 40 percent) would be offset by a $160 valuation allowance ($400 at 40 percent), and a $200 net deferred tax asset would be recognized for the operating loss carryforward.

55-161 With the tax-planning strategy, the $900 operating loss carryforward could be applied against $1,300 of taxable income next year ($100 of taxable income exclusive of reversing temporary differences and $1,200 of reversing taxable temporary differences). The $360 deferred tax asset is reduced by a $90 valuation allowance recognized for the net-of-tax expenses necessary to implement the tax-planning strategy. The amount of that valuation allowance is determined as follows.

55-162 In summary, a $480 deferred tax liability is recognized for the $1,200 of taxable temporary differences, a $360 deferred tax asset is recognized for the $900 operating loss carryforward, and a $90 valuation allowance is recognized for the net-of-tax expenses of implementing the tax-planning strategy.

55-163 This Example illustrates the guidance in paragraphs 740-10-55-39 through 55-48 relating to tax-planning strategies. An entity might identify several qualifying tax-planning strategies that would either reduce or eliminate the need for a valuation allowance for a deferred tax asset. For example, assume that an entity’s required valuation allowance would be reduced $5,000 based on Strategy A, $7,000 based on Strategy B, and $12,000 based on both strategies. The entity may not recognize the effect of one of those strategies in the current year and postpone recognition of the effect of the other strategy to a later year.

55-164 The entity should recognize the effect of both tax-planning strategies and reduce the valuation allowance by $12,000 at the end of the current year. Paragraph 740-10-30-19 provides guidance on tax-planning strategies and establishes the requirement that strategies meeting the criteria set forth in that paragraph shall be considered in determining the required valuation allowance.

55-165 Paragraph 740-10-55-54 introduces guidance relating to a nontaxable subsidy that may be available to an entity under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. This Example illustrates that guidance.

55-166 Before the accounting for the effects of the Act, an employer’s carrying amount of accrued postretirement benefit cost (the amount recognized in the statement of financial position) is $100 for a noncontributory, unfunded prescription drug benefit plan with only inactive participants who are not yet eligible to collect benefits. Assuming a tax rate of 35 percent and no corresponding tax basis for the accrued postretirement benefit cost, the employer would report a $35 deferred tax asset related to that $100 deductible temporary difference. Because the employer has a policy of amortizing gains and losses under paragraph 715-60-35-29, upon recognition of a $28 actuarial gain resulting from the estimate of the expected subsidy, neither the carrying amount of accrued postretirement benefit cost nor the deferred tax asset would change. Subsequently, ignoring interest on the accumulated postretirement benefit obligation (which includes interest on the subsidy), as the actuarial gain related to the subsidy is amortized as a component of net periodic postretirement benefit cost, the carrying amount of accrued postretirement cost would be reduced. However, the associated temporary difference and deferred tax asset would remain unchanged. That is, after the gain related to the subsidy is amortized in its entirety, the carrying amount of accrued postretirement benefit cost would be $72, and the deferred tax asset would remain at $35.

55-167 For purposes of simplicity, this Example ignores complexities regarding the amount and timing of the subsidies reflected in the carrying amount of accrued postretirement benefit cost arising from any of the following:

1. Netting gains and losses and application of the corridor amortization approach described in paragraph 715-60-35-29
2. Recognition of additional subsidies through amortization of prior service costs that include effects of the subsidy
3. Reduction in future service and interest costs.

Those complexities must be considered in determining the temporary difference on which the deferred tax effects under this Topic will be based.

55-168 This Example illustrates an entity’s change from taxable C corporation status to nontaxable S corporation status, in accordance with the guidance provided in paragraph 740-10-55-65. This Example has the following assumptions:

1. An entity’s S corporation election is effective for calendar-year 1990 and that at the conversion date its assets comprise marketable securities, finished goods inventory, and depreciable assets as follows.
   
2. The entity has no tax loss or credit carryforwards available to offset the built-in gains.
3. The depreciable assets will be recovered by use in operations (and, therefore, will not result in a taxable amount pursuant to the tax law applied to built-in gains).
4. The marketable securities will be sold in the same year that the inventory is sold, the $50 built-in gain on the inventory is reduced by the $10 built-in loss on the marketable securities, and $40 would be taxed in the year that the inventory turns over and the securities are sold. Accordingly, the entity should continue to display in its statement of financial position a deferred tax liability for that $40 net taxable amount.

55-169 At subsequent financial statement dates until the end of the 10 years following the conversion date, the entity should remeasure the deferred tax liability for net built-in gains based on the provisions of the tax law. Deferred tax expense (or benefit) should be recognized for any change in that deferred tax liability.

55-170 Paragraph 740-10-25-51 addresses the accounting when an asset is acquired outside of a business combination and the tax basis of the asset differs from the amount paid. The following Cases illustrate the required accounting for purchase transactions that are not accounted for as business combinations in the following circumstances:

1. The amount paid is less than the tax basis of the asset (Case A).
2. The amount paid is more than the tax basis of the asset (Case B).
3. The transaction results in a deferred credit (Case C).
4. A deferred credit is created by a financial asset (Case D).
5. Subparagraph not used.
6. The result is a purchase of future tax benefits (Case F).

Case A: Amount Paid Is Less Than Tax Basis of Asset

55-171 This Case illustrates an asset purchase that is not a business combination in which the amount paid differs from the tax basis of the asset (tax basis is greater).

55-172 As an incentive for acquiring specific types of equipment in certain sectors, a foreign jurisdiction permits a deduction, for tax purposes, of an amount in excess of the cost of the acquired asset. To illustrate, assume that Entity A purchases a machine for $100 and its tax basis is automatically increased to $150. Upon sale of the asset, there is no recapture of the extra tax deduction. The tax rate is 35 percent.

55-173 In accordance with paragraph 740-10-25-51, the amounts assigned to the equipment and the related deferred tax asset should be determined using the simultaneous equations method as follows (where FBB is Final Book Basis; CPP is Cash Purchase Price; and DTA is Deferred Tax Asset):

55-174 In this Case, the following variables are known:

1. Tax Basis = $150
2. Tax Rate = 35 percent
3. CPP = $100.

55-175 The unknown variables (FBB and DTA) are solved as follows:

55-176 Accordingly, the entity would record the following journal entry.

Case B: Amount Paid Is More Than Tax Basis of Asset

55-177 This Case illustrates an asset purchase that is not a business combination in which the amount paid differs from the tax basis of the asset (tax basis is less).

55-178 Assume that an entity pays $1,000,000 for the stock of an entity in a nontaxable acquisition (that is, carryover basis for tax purposes). The acquired entity’s sole asset is a Federal Communications Commission (FCC) license that has a tax basis of zero. Since the acquisition of the entity is in substance the acquisition of an FCC license, no goodwill is recognized. A deferred tax liability would need to be recorded for the temporary difference (in this Case, the entire $1,000,000 plus the tax-on-tax effect from increasing the carrying amount of the FCC license acquired) related to the FCC license. The tax rate is 35 percent.

55-179 In accordance with paragraph 740-10-25-51, the amounts assigned to the FCC license and the related deferred tax liability should be determined using the simultaneous equations method as follows (where FBB is Final Book Basis; CPP is Cash Purchase Price; and DTL is Deferred Tax Liability):

55-180 In this Case, the following variables are known:

1. Tax Basis = $0
2. Tax Rate = 35 percent
3. CPP = $1,000,000.

55-181 The unknown variables (FBB and DTL) are solved as follows:

55-182 Accordingly, the entity would record the following journal entry.

Case C: Transaction Results In Deferred Credit

55-183 This Case provides an illustration of a transaction that results in a deferred credit.

55-184 Entity A buys a machine for $50 with a tax basis of $200. The tax rate is 35 percent.

55-185 In accordance with paragraph 740-10-25-51, the amounts assigned to the machine and the deferred tax asset should be determined using the simultaneous equations method as follows (where FBB is Final Book Basis; CPP is Cash Purchase Price; and DTA is Deferred Tax Asset):

55-186 In this Case, the following variables are known:

1. Tax Basis = $200
2. Tax Rate = 35 percent
3. CPP = $50.

55-187 The unknown variables (FBB and DTA) are solved as follows:

55-188 The excess of the amount assigned to the deferred tax asset over the cash purchase price paid for the machine is recorded as a deferred credit. Accordingly, the entity would record the following journal entry.

Case D: Deferred Credit Created by Financial Asset

55-189 This Case provides an illustration of a deferred credit created by the acquisition of a financial asset.

55-190 Entity A acquires the stock of another corporation for $250. The principal asset of the corporation is a marketable equity security with a readily determinable fair value of $200 and a tax basis of $500. The tax rate is 35 percent. The acquired entity has no operations and so the acquisition is accounted for as an asset purchase and not as a business combination.

55-191 In accordance with paragraph 740-10-25-51, the acquired financial asset should be recognized at fair value, and a deferred tax asset should be recorded at the amount required by this Subtopic. The excess of the fair value of the financial asset and the deferred tax asset recorded over the cash purchase price should be recorded as a deferred credit. Accordingly, the entity would record the following journal entry.

Case E: Simultaneous Equations Method and Reduction in Preexisting Valuation Allowance

55-192 Paragraph not used.

55-193 Paragraph not used.

55-194 Paragraph not used.

55-195 Paragraph not used.

55-196 Paragraph not used.

55-197 Paragraph not used.

55-198 Paragraph not used.

Case F: Purchase of Future Tax Benefits

55-199 This Case provides an illustration of the purchase of future tax benefits.

55-200 A foreign entity that has nominal assets other than its net operating loss carryforwards is acquired by a foreign subsidiary of a U.S. entity for the specific purpose of utilizing the net operating loss carryforwards (this type of transaction is often referred to as a tax loss acquisition). It is presumed that this transaction does not constitute a business combination, since the acquired entity has no operations and is merely a shell entity. As a result of the time value of money and because the target entity is in financial difficulty and has ceased operations, the foreign subsidiary is able to acquire the shell entity at a discount from the amount corresponding to the gross deferred tax asset for the net operating loss carryforwards. Assume, for example, that $2,000,000 is paid for net operating loss carryforwards having a deferred tax benefit of $5,000,000 for which it is more likely than not that the full benefit will be realized. The tax rate is 35 percent.

55-201 In accordance with paragraph 740-10-25-51, the amount assigned to the deferred tax asset should be recorded at its gross amount (in accordance with this Subtopic) and the excess of the amount assigned to the deferred tax asset over the purchase price should be recorded as a deferred credit as follows.

55-202 Guidance is provided on various types of payments made to taxing authorities in paragraphs 740-10-55-67 through 55-75. This Example illustrates one possible payment situation.

55-203 In this Example, tax laws in a foreign country enable corporate taxpayers to elect to step up the tax basis for certain fixed assets ($1,000,000) to fair value ($2,000,000) in exchange for a current payment to the government of 3 percent of the step-up ($30,000). An entity would be expected to avail itself of this election (and make the upfront payment) as long as it believed that it was likely that it would be able to utilize the additional deductions (at a tax rate of 35 percent) that were created as a result of the step-up to reduce future taxable income and that the timing and amount of the resulting future tax savings justified the current payment. (For purposes of this Example, it is assumed that the transaction that accomplishes this step-up for tax purposes does not create a taxable temporary difference. A taxable temporary difference would exist, for example, if the tax benefit associated with the transaction with the governmental taxing authority becomes taxable in certain situations, such as those described in paragraph 830-740-25-7.)

55-204 In this Example, the tax effects of transactions directly with a taxing authority are recorded directly in income as follows.

55-205 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-206 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-207 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-208 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-209 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-210 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-211 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-212 Paragraph 740-10-55-79 provides guidance on satisfying the required disclosure of the significant components of income taxes and identifies three acceptable approaches illustrated in this Example:

1. The gross method (Case A)
2. The net method (Case B)
3. The statutory tax rate reconciliation method (Case C).

55-213 Cases A, B, and C share the following assumptions:

1. An entity has $1,588 of taxable income and $100 of investment tax credits for the current year. The $100 deferred tax asset for $295 of operating loss carryforwards was fully reserved at the beginning of the current year.
2. Pretax financial income from continuing operations is $5,000.
3. Income tax expense from continuing operations is $1,500.
4. Effective tax rate is 30%.
5. Statutory tax rate is 34%.

Case A: Gross Method

55-214 The first acceptable approach, illustrated as follows, to disclosure of components of income tax expense from continuing operations is referred to as the gross method.

Case B: Net Method

55-215 The second acceptable approach, illustrated as follows, to disclosure of components of income tax expense from continuing operations is referred to as the net method.

Case C: Statutory Tax Rate Reconciliation Method

55-216 The third acceptable approach, illustrated as follows, to disclosure of components of income tax expense from continuing operations is referred to as the statutory tax rate reconciliation method.

55-217 This Example illustrates the guidance in paragraph 740-10-50-15 for disclosures about uncertainty in income taxes.

55-218 This Example illustrates the guidance in paragraph 275-10-50-8 for disclosure relating to the realizability estimates of a deferred tax asset.

55-219 In this Example, Entity A develops, manufactures, and markets limited-use vaccines. The entity has a dominant share of the narrow market it serves. As of December 31, 19X4, the entity has no temporary differences and has aggregate loss carryforwards of $12 million that originated in prior years and that expire in varying amounts between 19X5 and 19X7. As of December 31, 19X4, the entity has a deferred tax asset of $4.8 million that represents the benefit of the remaining $12 million in loss carryforwards, and it has concluded at that date that a valuation allowance is unnecessary. The loss carryforwards arose during the entity’s development stage when it incurred high levels of research and development expenses prior to commencing sales. While the entity has earned, on average, $6 million income before tax (taxable income before carryforwards) in each of the last 5 years, future profitability in this competitive industry depends on continually developing new products. The entity has a number of promising new vaccines under development, but it is aware that other entities recently began testing vaccines that would compete with the vaccines being developed by the entity as well as products that will compete with the vaccines that are currently generating the entity’s profits. Rapid introduction of competing products or failure of the entity’s development efforts could reduce estimates of future profitability in the near term, which could affect the entity’s ability to fully utilize its loss carryforward.

55-220 Illustrative disclosure for the entity follows.

55-221 In addition to other disclosures, information as to the amount of loss carryforwards and their expiration dates and the amount of any valuation allowance with respect to the recorded deferred tax asset is required under This Subtopic.

55-222 The disclosure in this Example informs users that:

1. Realization of the deferred tax asset depends on achieving a certain minimum level of future taxable income within the next three years
2. Although management currently believes that achievement of the required future taxable income is more likely than not, it is at least reasonably possible that this belief could change in the near term, resulting in establishment of a valuation allowance.

55-223 Entity A has sales in Jurisdiction S but no physical presence. Management has reviewed the nexus rules for filing a return in Jurisdiction S and must determine whether filing a tax return in Jurisdiction S is required. In evaluating the tax position to file a tax return, management should consider all relevant sources of tax law. The evaluation of nexus has to be made for all jurisdictions where Entity A might be subject to income taxes. Each of these evaluations is a separate tax position that is subject to the recognition, measurement, and disclosure requirements of this Subtopic.

55-224 Entity S converted to an S Corporation from a C Corporation effective January 1, 20X0. In 20X7, Entity S disposed of assets subject to built-in gains and reported a tax liability on its 20X7 tax returns. Tax positions to consider related to the built-in gains tax include, but are not limited to:

1. Whether other assets were sold subject to the built-in gains tax
2. Whether the income associated with the calculation of the taxable amount of the built-in gains is correct
3. Whether the basis associated with the built-in gains calculation is correct.

It should be noted that whether or not Entity S is subject to the built-in gains tax also is a tax position subject to the provisions of this Subtopic.

55-225 Entity N, a tax-exempt not-for-profit entity, enters into transactions that may be subject to income tax on unrelated business income. Tax positions to consider include but are not limited to:

1. Entity N’s characterization of its activities as related or unrelated to its exempt purpose
2. Entity N’s allocation of revenue between activities that relate to its exempt purpose and those that are allocated to unrelated business income
3. The allocation of Entity N’s expenses between activities that relate to its exempt purpose and those that are allocated to unrelated business activities.

Even if Entity N were not subject to income taxes on unrelated business income, it still has a tax position of whether it qualifies as a tax-exempt not-for-profit entity.

55-226 Entity A, a partnership with two partners—Partner 1 and Partner 2—has nexus in Jurisdiction J. Jurisdiction J assesses an income tax on Entity A and allows Partners 1 and 2 to file a tax return and use their pro rata share of Entity A’s income tax payment as a credit (that is, payment against the tax liability of the owners). Because the owners may file a tax return and utilize Entity A’s payment as a payment against their personal income tax, the income tax would be attributed to the owners by Jurisdiction J’s laws whether or not the owners file an income tax return. Because the income tax has been attributed to the owners, payments to Jurisdiction J for income taxes should be treated as a transaction with the owners. The result would not change even if there were an agreement between Entity A and its two partners requiring Entity A to reimburse Partners 1 and 2 for any taxes the partners may owe to Jurisdiction J. This is because attribution is based on the laws and regulations of the taxing authority rather than on obligations imposed by agreements between an entity and its owners.

55-227 If the fact pattern in paragraph 740-10-55-226 changed such that Jurisdiction J has no provision for the owners to file tax returns and the laws and regulations of Jurisdiction J do not indicate that the payments are made on behalf of Partners 1 and 2, income taxes are attributed to Entity A on the basis of Jurisdiction J’s laws and are accounted for based on the guidance in this Subtopic.

55-228 Entity S, an S Corporation, files a tax return in Jurisdiction J. An analysis of the laws and regulations of Jurisdiction J indicates that Jurisdiction J can hold Entity S and its owners jointly and severally liable for payment of income taxes. The laws and regulations also indicate that if payment is made by Entity S, the payments are made on behalf of the owners. Because the laws and regulations attribute the income tax to the owners regardless of who pays the tax, any payments to Jurisdiction J for income taxes should be treated as a transaction with its owners.

55-229 Entity A, a partnership with 2 partners, owns a 100 percent interest in Entity B and is required to issue consolidated financial statements. Entity B is a taxable entity that has unrecognized tax positions and a related liability for unrecognized tax benefits. Because entities within a consolidated or combined group should consider the tax positions of all entities within the group regardless of the tax status of the reporting entity, Entity A should include in its financial statements the assets, liabilities, income, and expenses of both Entity A and Entity B, including those relating to the implementation of this Subtopic to Entity B. This is required even though Entity A is a pass-through entity.

55-1 Paragraph 740-20-45-8 states that the amount of income tax expense or benefit allocated to continuing operations is the tax effect of pretax income or loss from continuing operations that occurred during the year plus or minus certain adjustments.

55-2 The adjustments include the tax effects of:

1. Changes in circumstances that cause a change in judgment about the realization of deferred tax assets in future years
2. Changes in tax laws or rates
3. Changes in tax status
4. Tax-deductible dividends paid to shareholders.

55-3 The allocation of income tax expense between pretax income from continuing operations and other items shall include deferred taxes.

55-4 This Example illustrates allocation of current and deferred tax expense. The assumptions are as follows:

1. Tax rates are 40 percent for Years 1, 2, and 3 and 30 percent for Year 4 and subsequent years. No valuation allowances are required for deferred tax assets.
2. At the end of Year 1, there is a $500 taxable temporary difference relating to the entity’s contracting operations and a $200 deductible temporary difference related to its other operations. Determination of the entity’s deferred tax assets and liabilities at the end of Year 1 is as follows.
   
3. During Year 2, the entity decides that it will sell its contracting operations in Year 3. As a result, all temporary differences related to the contracting operations (the $500 taxable temporary difference that existed at the end of Year 1, plus an additional $200 taxable temporary difference that arose during Year 2) are now considered to result in taxable amounts in Year 3 because the contracting operations will be sold in Year 3.
4. At the end of Year 2, the entity also has $300 of deductible temporary differences ($100 of the temporary difference that existed at the end of Year 1, plus an additional $200 that arose during Year 2) from continuing operations.
5. For Year 2, the entity has $50 of pretax reported income from continuing operations and $200 of pretax reported income from discontinued operations.
6. Determination of the entity’s deferred tax asset and liability at the end of Year 2 is as follows.
   

55-5 Total deferred tax expense for Year 2 is $100 ($170 – $70). The deferred tax benefit of the deductible temporary differences related to the entity’s continuing operations during Year 2 is determined as follows.

55-6 The deferred tax expense for taxable temporary differences related to the entity’s discontinued operations during Year 2 is determined as follows.

55-7 Total tax expense and tax expense allocated to continuing and discontinued operations for Year 2 are determined as follows.

55-8 If there is only one item other than continuing operations, the portion of income tax expense or benefit for the year that remains after the allocation to continuing operations is allocated to that item. If there are two or more items other than continuing operations, the amount that remains after the allocation to continuing operations is allocated among those other items in proportion to their individual effects on income tax expense or benefit for the year.

55-9 The following Cases both present allocations of income tax to continuing operations when there is only one item other than income from continuing operations:

1. Loss from continuing operations with an extraordinary gain (Case A)
2. Income from continuing operations with a loss from discontinued operations (Case B).

Case A: Loss From Continuing Operations With a Gain on Discontinued Operations (Tax Benefit Realizable)

55-10 This Case illustrates allocation of income tax expense if there is only one item other than income from continuing operations. The assumptions are as follows:

1. The entity’s pretax financial income and taxable income are the same.
2. The entity’s ordinary loss from continuing operations is $500.
3. The entity also has a gain on discontinued operations of $900 that is a capital gain for tax purposes.
4. The tax rate is 40 percent on ordinary income and 30 percent on capital gains. Income taxes currently payable are $120 ($400 at 30 percent).
5. The entity has determined that the deferred tax asset that would have resulted from the loss from continuing operations if the gain on discontinued operations had not occurred would be expected to be realized (that is, a valuation allowance would not have been needed).

55-11 Income tax expense is allocated between the pretax loss from operations and the gain on discontinued operations as follows.

55-12 The effect of the $500 loss from continuing operations was to offset an equal amount of capital gains that otherwise would be taxed at a 30 percent tax rate. However, the guidance in paragraph 740-20-45-7 requires that an entity determine the tax effects of pretax income from continuing operations by a computation that does not consider the tax effects of items that are not included in continuing operations. The entity has determined that, absent the capital gain from discontinued operations, a valuation allowance would not have been needed on the deferred tax asset resulting from the $500 loss from continuing operations. Thus, $200 ($500 at 40 percent) of tax benefit is allocated to continuing operations. The $320 incremental effect of the gain on discontinued operations is the difference between $120 of total tax expense and the $200 tax benefit allocated to continuing operations.

Case A1: Loss From Continuing Operations With a Gain on Discontinued Operations (Tax Benefit Not Realizable)

55-12A This Case illustrates allocation of income tax expense if there is only one item other than income from continuing operations. The assumptions are the same as in Case A except that the entity has determined that the deferred tax asset that would have resulted from the loss from continuing operations if the gain on discontinued operations had not occurred would not be expected to be realized (that is, a valuation allowance would have been needed).

55-12B Income tax expense is allocated between the pretax loss from operations and the gain on discontinued operations as follows.

55-12C The effect of the $500 loss from continuing operations was to offset an equal amount of capital gains that otherwise would be taxed at a 30 percent tax rate. However, the guidance in paragraph 740-20-45-7 requires that an entity determine the tax effects of pretax income from continuing operations by a computation that does not consider the tax effects of items that are not included in continuing operations. The entity has determined that, absent the capital gain from discontinued operations, a valuation allowance would have been needed on the deferred tax asset resulting from the $500 loss from continuing operations. Thus, zero tax benefit is allocated to continuing operations. The $120 incremental income tax expense related to the gain on discontinued operations is the difference between $120 of total tax expense and the zero tax benefit allocated to continuing operations.

Case B: Income From Continuing Operations With a Loss From Discontinued Operations

55-13 This Case further illustrates the general requirement to determine the tax effects of pretax income from continuing operations by a computation that does not consider the tax effects of items that are not included in continuing operations.

55-14 To illustrate, assume that in the current year an entity has $1,000 of income from continuing operations and a $1,000 loss from discontinued operations. At the beginning of the year, the entity has a $2,000 net operating loss carryforward for which the deferred tax asset, net of its valuation allowance, is zero, and the entity did not reduce that valuation allowance during the year. No tax expense should be allocated to income from continuing operations because the $2,000 loss carryforward is sufficient to offset that income. Thus, no tax benefit is allocated to the loss from discontinued operations.

55-15 This Example illustrates the guidance in paragraphs 740-20-45-7 through 45-8 for allocation of the tax benefit of a tax credit carryforward that is recognized as a deferred tax asset in the current year. The assumptions are as follows:

1. The entity’s pretax financial income and taxable income are the same.
2. Pretax financial income for the year comprises $300 from continuing operations and $400 from a gain on discontinued operations.
3. The tax rate is 40 percent. Taxes payable for the year are zero because $330 of tax credits that arose in the current year more than offset the $280 of tax otherwise payable on $700 of taxable income.
4. A $50 deferred tax asset is recognized for the $50 ($330 – $280) tax credit carryforward. Based on the weight of available evidence, management concludes that no valuation allowance is necessary.

55-16 Income tax expense or benefit is allocated between pretax income from continuing operations and the gain on discontinued operations as follows.

55-17 Absent the gain on discontinued operations and assuming it was not the deciding factor in reaching a conclusion that a valuation allowance is not needed, the entire tax benefit of the $330 of tax credits would be allocated to continuing operations. The presence of the gain on discontinued operations does not change that allocation.

55-18 Income taxes are sometimes allocated directly to shareholders’ equity or to other comprehensive income. This Example illustrates the allocation of income taxes for translation adjustments under the requirements of Subtopic 830-30 to other comprehensive income. In this Example, FC represents units of foreign currency.

55-19 A foreign subsidiary has earnings of FC 600 for Year 2. Its net assets (and unremitted earnings) are FC 1,000 and FC 1,600 at the end of Years 1 and 2, respectively.

55-20 The foreign currency is the functional currency. For Year 2, translated amounts are as follows.

55-21 A $260 translation adjustment ($1,200 + $660 - $1,600) is reported in other comprehensive income and accumulated in shareholders’ equity for Year 2.

55-22 The U.S. parent expects that all of the foreign subsidiary’s unremitted earnings will be remitted in the foreseeable future, and under the requirements of Subtopic 740-30, a deferred U.S. tax liability is recognized for those unremitted earnings.

55-23 The U.S. parent accrues the deferred tax liability at a 20 percent tax rate (that is, net of foreign tax credits, foreign tax credit carryforwards, and so forth). An analysis of the net investment in the foreign subsidiary and the related deferred tax liability for Year 2 is as follows.

55-24 For Year 2, $132 of deferred taxes are charged against earnings, and $52 of deferred taxes are reported in other comprehensive income and accumulated in shareholders’ equity.

55-1 This Section, which is an integral part of the requirements of this Subtopic, provides Examples of applying the required accounting for interim period income taxes to some specific situations. In general, the Examples illustrate matters unique to accounting for income taxes at interim dates. The Examples do not include consideration of the nature of tax credits and events that do not have tax consequences or illustrate all possible combinations of circumstances.

55-2 The following Cases illustrate the guidance in Sections 740-270-30 and 740-270-35 for accounting for income taxes applicable to ordinary income (or loss) at an interim date if ordinary income is anticipated for the fiscal year:

1. Ordinary income in all interim periods (Case A)
2. Ordinary income and losses in interim periods (Case B)
3. Changes in estimates (Case C).

55-3 Cases A and B share all of the following assumptions:

1. For the full fiscal year, an entity anticipates ordinary income of $100,000. All income is taxable in one jurisdiction at a 50 percent rate. Anticipated tax credits for the fiscal year total $10,000. No events that do not have tax consequences are anticipated. No changes in estimated ordinary income, tax rates, or tax credits occur during the year.
2. Computation of the estimated annual effective tax rate applicable to ordinary income is as follows.
   
3. Tax credits are generally subject to limitations, usually based on the amount of tax payable before the credits. In computing the estimated annual effective tax rate, anticipated tax credits are limited to the amounts that are expected to be realized or are expected to be recognizable at the end of the current year in accordance with the provisions of Subtopic 740-10. If an entity is unable to estimate the amount of its tax credits for the year, see paragraphs 740-270-30-17 through 30-18.

Case A: Ordinary Income in All Interim Periods

55-4 The entity has ordinary income in all interim periods. Quarterly tax computations are as follows.

Case B: Ordinary Income and Losses in Interim Periods

55-5 The following Cases illustrate ordinary income and losses in interim periods:

1. Year-to-date ordinary income (Case B1)
2. Year-to-date ordinary losses, realization more likely than not (Case B2)
3. Year-to-date ordinary losses, realization not more likely than not (Case B3).

55-6 The entity has ordinary income and losses in interim periods; there is not an ordinary loss for the fiscal year to date at the end of any interim period. Quarterly tax computations are as follows.

55-7 The entity has ordinary income and losses in interim periods, and there is an ordinary loss for the year to date at the end of an interim period. Established seasonal patterns provide evidence that realization in the current year of the tax benefit of the year-to-date loss and of anticipated tax credits is more likely than not. Quarterly tax computations are as follows.

55-8 The entity has ordinary income and losses in interim periods, and there is a year-to-date ordinary loss during the year. There is no established seasonal pattern and it is more likely than not that the tax benefit of the year-to-date loss and the anticipated tax credits will not be realized in the current or future years. Quarterly tax computations are as follows.

Case C: Changes in Estimates

55-9 During the fiscal year, all of an entity’s operations are taxable in one jurisdiction at a 50 percent rate. No events that do not have tax consequences are anticipated. Estimates of ordinary income for the year and of anticipated credits at the end of each interim period are as shown below. Changes in the estimated annual effective tax rate result from changes in the ratio of anticipated tax credits to tax computed at the statutory rate. Changes consist of an unanticipated strike that reduced income in the second quarter, an increase in the capital budget resulting in an increase in anticipated investment tax credit in the third quarter, and better than anticipated sales and income in the fourth quarter. The entity has ordinary income in all interim periods. Computations of the estimated annual effective tax rate based on the estimate made at the end of each quarter are as follows.

55-10 Quarterly tax computations are as follows.

55-11 The following Cases illustrate the guidance in Section 740-270-30 for accounting for income taxes applicable to ordinary income (or loss) at an interim date if an ordinary loss is anticipated for the fiscal year:

1. Realization of the tax benefit of the loss is more likely than not (Case A)
2. Realization of the tax benefit of the loss is not more likely than not (Case B)
3. Partial realization of the tax benefit of the loss is more likely than not (Case C)
4. Reversal of net deferred tax credits (Case D).

55-12 Cases A, B, and C share the following assumptions.

1. For the full fiscal year, an entity anticipates an ordinary loss of $100,000. The entity operates entirely in one jurisdiction where the tax rate is 50 percent. Anticipated tax credits for the fiscal year total $10,000. No events that do not have tax consequences are anticipated.
2. If there is a recognizable tax benefit for the loss and the tax credits pursuant to the requirements of Subtopic 740-10, computation of the estimated annual effective tax rate applicable to the ordinary loss would be as follows.
   

55-13 Cases A, B, and C state varying assumptions with respect to assurance of realization of the components of the net tax benefit. When the realization of a component of the benefit is not expected to be realized during the current year or recognizable as a deferred tax asset at the end of the current year in accordance with the provisions of Subtopic 740-10, that component is not included in the computation of the estimated annual effective tax rate.

Case A: Realization of the Tax Benefit of the Loss Is More Likely Than Not

55-14 The following Cases illustrate when realization of the tax benefit of the loss is more likely than not:

1. Ordinary losses in all interim periods (Case A1)
2. Ordinary income and losses in interim periods (Case A2).

55-15 The entity has ordinary losses in all interim periods. The full tax benefit of the anticipated ordinary loss and the anticipated tax credits will be realized by carryback. Quarterly tax computations are as follows.

55-16 The entity has ordinary income and losses in interim periods and for the year to date. The full tax benefit of the anticipated ordinary loss and the anticipated tax credits will be realized by carryback. The full tax benefit of the maximum year-to-date ordinary loss can also be realized by carryback. Quarterly tax computations are as follows.

Case B: Realization of the Tax Benefit of the Loss Is Not More Likely Than Not

55-17 In Cases A1 and A2, if neither the tax benefit of the anticipated loss for the fiscal year nor anticipated tax credits were recognizable pursuant to Subtopic 740-10, the estimated annual effective tax rate for the year would be zero and no tax (or benefit) would be recognized in any quarter. That conclusion is not affected by changes in the mix of income and loss in interim periods during a fiscal year. However, see paragraph 740-270-30-18.

Case C: Partial Realization of the Tax Benefit of the Loss Is More Likely Than Not

55-18 The following Cases illustrate when partial realization of the tax benefit of the loss is more likely than not:

1. Ordinary losses in all interim periods (Case C1)
2. Ordinary income and losses in interim periods (Case C2).

55-19 The entity has an ordinary loss in all interim periods. It is more likely than not that the tax benefit of the loss in excess of $40,000 of prior income available to be offset by carryback ($20,000 of tax at the 50 percent statutory rate) will not be realized. Therefore the estimated annual effective tax rate is 20 percent ($20,000 benefit more likely than not to be realized divided by $100,000 estimated fiscal year ordinary loss). Quarterly tax computations are as follows.

55-20 The entity has ordinary income and losses in interim periods and for the year to date. It is more likely than not that the tax benefit of the anticipated ordinary loss in excess of $40,000 of prior income available to be offset by carryback ($20,000 of tax at the 50 percent statutory rate) will not be realized. Therefore the estimated annual effective tax rate is 20 percent ($20,000 benefit more likely than not to be realized divided by $100,000 estimated fiscal year ordinary loss), and the benefit that can be recognized for the year to date is limited to $20,000 (the benefit that is more likely than not to be realized). Quarterly tax computations are as follows.

Case D: Reversal of Net Deferred Tax Credits

55-21 The entity anticipates a fiscal year ordinary loss. The loss cannot be carried back, and future profits exclusive of reversing temporary differences are unlikely. Net deferred tax liabilities arising from existing net taxable temporary differences are present. A portion of the existing net taxable temporary differences relating to those liabilities will reverse within the loss carryforward period. Computation of the estimated annual effective tax rate to be used (see paragraphs 740-270-30-32 through 30-33) is as follows.

55-22 Quarterly tax computations are as follows.

55-23 Note that changes in the timing of the loss by quarter would not change this computation.

55-24 The following Cases illustrate accounting for income taxes applicable to unusual or infrequently occurring items when ordinary income is expected for the fiscal year:

1. Realization of the tax benefit is more likely than not at date of occurrence (Case A)
2. Realization of the tax benefit not more likely than not at date of occurrence (Case B).

55-25 Cases A and B illustrate the computation of the tax (or benefit) applicable to unusual or infrequently occurring items when ordinary income is anticipated for the fiscal year. These Cases are based on the assumptions and computations presented in paragraph 740-270-55-3 and Example 1, Cases A and B (see paragraphs 740-270-55-4 through 55-8), plus additional information supplied in Cases A and B of this Example. The computation of the tax (or benefit) applicable to the ordinary income is not affected by the occurrence of an unusual or infrequently occurring item; therefore, each Case refers to one or more of the illustrations of that computation in Example 1, Cases A and B (see paragraphs 740-270-55-4 through 55-8), and does not reproduce the computation and the assumptions. The income statement display for tax (or benefit) applicable to unusual or infrequently occurring items is illustrated in Example 7 (see paragraph 740-270-55-52).

Case A: Realization of the Tax Benefit Is More Likely Than Not at Date of Occurrence

55-26 As explained in paragraph 740-270-55-25, this Case is based on the computations of tax applicable to ordinary income that are illustrated in Example 1, Case A (see paragraph 740-270-55-4). In addition, the entity experiences a tax-deductible unusual or infrequently occurring loss of $50,000 (tax benefit $25,000) in the second quarter. Because the loss can be carried back, it is more likely than not that the tax benefit will be realized at the time of occurrence. Quarterly tax provisions are as follows.

55-27 Note that changes in assumptions would not change the timing of the recognition of the tax benefit applicable to the unusual or infrequently occurring item as long as realization is more likely than not.

Case B: Realization of the Tax Benefit Not More Likely Than Not at Date of Occurrence

55-28 As explained in paragraph 740-270-55-25, this Case is based on the computations of tax applicable to ordinary income that are illustrated in Example 1, Cases A and B1 (see paragraphs 740-270-55-4 through 55-6). In addition, the entity experiences a tax-deductible unusual or infrequently occurring loss of $50,000 (potential benefit $25,000) in the second quarter. The loss cannot be carried back, and available evidence indicates that a valuation allowance is needed for all of the deferred tax asset. As a result, the tax benefit of the unusual or infrequently occurring loss is recognized only to the extent of offsetting ordinary income for the year to date. Quarterly tax provisions under two different assumptions for the occurrence of ordinary income are as follows.

55-29 This Example illustrates the guidance in paragraph 740-270-45-7. An entity anticipates ordinary income for the year of $100,000 and tax credits of $10,000. The entity has ordinary income in all interim periods. The estimated annual effective tax rate is 40 percent, computed as follows.

55-30 Quarterly tax computations for the first two quarters are as follows.

55-31 In the third quarter a decision is made to discontinue the operations of Division X, a segment of the business that has recently operated at a loss (before income taxes). The pretax income (and losses) of the continuing operations of the entity and of Division X through the third quarter and the estimated fourth quarter results are as follows.

55-32 No changes have occurred in continuing operations that would affect the estimated annual effective tax rate. Anticipated annual tax credits of $10,000 included $2,000 of credits related to the operations of Division X. The revised estimated annual effective tax rate applicable to ordinary income from continuing operations is 45 percent, computed as follows.

55-33 Quarterly computations of tax applicable to ordinary income from continuing operations are as follows.

55-34 Tax benefit applicable to Division X for the first two quarters is computed as follows.

55-35 The third quarter tax benefits applicable to both the loss from operations and the provision for loss on disposal of Division X are computed based on estimated annual income with and without the effects of the Division X losses. Current year tax credits related to the operations of Division X have not been recognized. It is assumed that the tax benefit of those credits will not be realized because of the discontinuance of Division X operations. Any reduction in tax benefits resulting from recapture of previously recognized tax credits resulting from discontinuance or current year tax credits applicable to the discontinued operations would be reflected in the tax benefit recognized for the loss on disposal or loss from operations as appropriate. If, because of capital gains and losses, and so forth, the individually computed tax effects of the items do not equal the aggregate tax effects of the items, the aggregate tax effects are allocated to the individual items in the same manner that they will be allocated in the annual financial statements. The computations are as follows.

55-36 The resulting revised quarterly tax provisions are summarized as follows.

55-37 The following Cases illustrate the guidance in paragraph 740-270-30-36 for accounting for income taxes applicable to ordinary income if an entity is subject to tax in multiple jurisdictions:

1. Ordinary income in all jurisdictions (Case A)
2. Ordinary loss in a jurisdiction; realization of the tax benefit not more likely than not (Case B)
3. Ordinary income or tax cannot be estimated in one jurisdiction (Case C).

55-38 Cases A, B, and C assume that an entity operates through separate corporate entities in two countries. Applicable tax rates are 50 percent in the United States and 20 percent in Country A. The entity has no unusual or infrequently occurring items during the fiscal year and anticipates no tax credits or events that do not have tax consequences. (The effect of foreign tax credits and the necessity of providing tax on undistributed earnings are ignored because of the wide range of tax planning alternatives available.) For the full fiscal year the entity anticipates ordinary income of $60,000 in the United States and $40,000 in Country A. The entity is able to make a reliable estimate of its Country A ordinary income and tax for the fiscal year in dollars. Computation of the overall estimated annual effective tax rate in Cases B and C is based on additional assumptions stated in those Cases.

Case A: Ordinary Income in All Jurisdictions

55-39 Computation of the overall estimated annual effective tax rate is as follows.

55-40 Quarterly tax computations are as follows.

Case B: Ordinary Loss in a Jurisdiction; Realization of the Tax Benefit Not More Likely Than Not

55-41 In this Case, the entity operates through a separate corporate entity in Country B. Applicable tax rates in Country B are 40 percent. Operations in Country B have resulted in losses in recent years and an ordinary loss is anticipated for the current fiscal year in Country B. It is expected that the tax benefit of those losses will not be recognizable as a deferred tax asset at the end of the current year pursuant to Subtopic 740-10; accordingly, no tax benefit is recognized for losses in Country B, and interim period tax (or benefit) is separately computed for the ordinary loss in Country B and for the overall ordinary income in the United States and Country A. The tax applicable to the overall ordinary income in the United States and Country A is computed as in Case A of this Example. Quarterly tax provisions are as follows.

Case C: Ordinary Income or Tax Cannot Be Estimated in One Jurisdiction

55-42 In this Case, the entity operates through a separate corporate entity in Country C. Applicable tax rates in Country C are 40 percent in foreign currency. Depreciation in that country is large and exchange rates have changed in prior years. The entity is unable to make a reasonable estimate of its ordinary income for the year in Country C and thus is unable to reasonably estimate its annual effective tax rate in Country C in dollars. Accordingly, tax (or benefit) in Country C is separately computed as ordinary income (or loss) occurs in Country C. The tax applicable to the overall ordinary income in the United States and Country A is computed as in Case A of this Example. Quarterly computations of tax applicable to Country C are as follows.

55-43 Quarterly tax provisions are as follows.

55-44 The following Example illustrates the guidance in paragraphs 740-270-25-5 through 25-6 for accounting in interim periods for the effect of new tax legislation on income taxes when legislation is effective in a future interim period.

1. Subparagraph superseded by Accounting Standards Update No. 2019-12.
2. Subparagraph superseded by Accounting Standards Update No. 2019-12.

Legislation Effective in a Future Interim Period

55-45 The assumed facts applicable to this Example follow.

55-46 For the full fiscal year, an entity anticipates ordinary income of $100,000. All income is taxable in one jurisdiction at a 50 percent rate. Anticipated tax credits for the fiscal year total $10,000. No events that do not have tax consequences are anticipated.

55-47 Computation of the estimated annual effective tax rate applicable to ordinary income is as follows.

55-48 Further, assume that new legislation creating additional tax credits is enacted during the second quarter of the entity’s fiscal year. The new legislation is effective on the first day of the third quarter. As a result of the estimated effect of the new legislation, the entity revises its estimate of its annual effective tax rate to the following.

55-49 The effect of the new legislation shall be reflected in the computation of the annual effective tax rate beginning in the first interim period that includes the enactment date of the new legislation. Accordingly, quarterly tax computations are as follows.

55-50 Paragraph superseded by Accounting Standards Update No. 2019-12.

55-51 Paragraph superseded by Accounting Standards Update No. 2019-12.

55-52 The following illustrates the location in an income statement display of the various tax amounts computed under this Subtopic.

55-1 This Section is an integral part of the requirements of this Subtopic. This Section provides illustrations that address the application of accounting requirements to specific aspects of accounting for income taxes in connection with business combinations. The illustrations that follow make various assumptions about the tax law. These assumptions about the tax law are for illustrative purposes only.

55-2 This Example illustrates the guidance in paragraphs 805-740-25-2 through 25-3 and 805-740-30-1 relating to the recognition and measurement of a deferred tax liability and deferred tax asset in a nontaxable business combination. The assumptions are as follows:

1. The enacted tax rate is 40 percent for all future years, and amortization of goodwill is not deductible for tax purposes.
2. A wholly owned entity is acquired for $20,000, and the entity has no leveraged leases.
3. The tax basis of the net assets acquired (other than goodwill) is $5,000, and the recognized value is $12,000. Future recovery of the assets and settlement of the liabilities at their assigned values will result in $20,000 of taxable amounts and $13,000 of deductible amounts that can be offset against each other. Therefore, no valuation allowance is necessary.

55-3 The amounts recorded to account for the business combination transaction are as follows.

55-4 This Example illustrates the guidance in paragraphs 805-740-25-3 and 805-740-45-2 relating to the recognition of a deferred tax asset and the related valuation allowance for acquired deductible temporary differences at the date of a nontaxable business combination and in subsequent periods when the tax law limits the use of an acquired entity’s deductible temporary differences and carryforwards to subsequent taxable income of the acquired entity in a consolidated tax return. The assumptions are as follows:

1. The enacted tax rate is 40 percent for all future years.
2. The purchase price is $20,000, and the assigned value of the net assets acquired is also $20,000.
3. The tax basis of the net assets acquired is $60,000. The $40,000 ($60,000 – $20,000) of deductible temporary differences at the combination date is primarily attributable to an allowance for loan losses. Provisions in the tax law limit the use of those future tax deductions to subsequent taxable income of the acquired entity.
4. The acquired entity’s actual pretax results for the two preceding years and the expected results for the year of the business combination are as follows.
   

55-5 The acquired entity’s pretax financial income and taxable income for Year 3 (after the business combination) and Year 4 are as follows.

55-6 At the end of Year 4, the remaining balance of acquired deductible temporary differences is $15,000 ($40,000 – $25,000). The deferred tax asset is $6,000 ($15,000 at 40 percent). Based on an assessment of all available evidence at the end of Year 4, management concludes that no valuation allowance is needed for that $6,000 deferred tax asset. Elimination of the $6,000 valuation allowance results in a $6,000 deferred tax benefit that is reported as a reduction of deferred income tax expense because the reversal of the valuation allowance occurred after the measurement period (see paragraph 805-740-45-2). Tax benefits realized in Years 3 and 4 attributable to reversals of acquired deductible temporary differences are reported as a zero current income tax expense. The consolidated statement of earnings would include the following amounts attributable to the acquired entity for Year 3 (after the business combination) and Year 4.

55-7 This Example illustrates the guidance in paragraph 805-740-25-3 if there is an elimination of the need for a valuation allowance for the deferred tax asset for an acquired loss carryforward based on offset against taxable temporary differences of the acquiring entity in a nontaxable business combination. This Example assumes that the tax law permits use of an acquired entity’s deductible temporary differences and carryforwards to reduce taxable income or taxes payable attributable to the acquiring entity in a consolidated tax return. The other assumptions are as follows:

1. The enacted tax rate is 40 percent for all future years.
2. The purchase price is $20,000. The tax basis of the identified net assets acquired is $5,000, and the assigned value is $12,000, that is, there are $7,000 of taxable temporary differences. The acquired entity also has a $16,000 operating loss carryforward, which, under the tax law, may be used by the acquiring entity in the consolidated tax return.
3. The acquiring entity has temporary differences that will result in $30,000 of net taxable amounts in future years.
4. All temporary differences of the acquired and acquiring entities will result in taxable amounts before the end of the acquired entity’s loss carryforward period.

55-8 In assessing the need for a valuation allowance, future taxable income exclusive of reversing temporary differences and carryforwards (see paragraph 740-10-30-18(b)) need not be considered because the $16,000 operating loss carryforward will offset the acquired entity’s $7,000 of taxable temporary differences and another $9,000 of the acquiring entity’s taxable temporary differences. The amounts recorded to account for the purchase transaction are as follows.

55-9 This Example illustrates the guidance in paragraphs 805-740-25-8 through 25-9 on accounting for the tax consequences of goodwill when tax-deductible goodwill exceeds the goodwill recorded for financial reporting at the acquisition date. The assumptions are as follows:

1. At the acquisition date, the reported amount of goodwill for financial reporting purposes is $600 before taking into consideration the tax benefit associated with goodwill and the tax basis of goodwill is $900.
2. The tax rate is 40 percent for all years.

55-10 As of the acquisition date, the goodwill for financial reporting purposes is adjusted for the tax benefit associated with goodwill by using the following simultaneous equations method. In the following equation, the Preliminary Temporary Difference variable is the excess of tax goodwill over book goodwill, before taking into consideration the tax benefit associated with goodwill, and the Deferred Tax Asset variable is the resulting deferred tax asset.

55-11 In this Example, the following variables are known:

55-12 The unknown variable (Deferred Tax Asset) equals $200, and the goodwill for financial reporting purposes would be adjusted with the following entry.

55-13 Goodwill for financial reporting would be established at the acquisition date at $400 ($600 less the $200 credit adjustment).

55-1 This Example illustrates the guidance in paragraphs 830-740-25-5 and 830-740-30-1 through 30-2. An entity has one asset, a nonmonetary asset that is not depreciated for financial reporting or tax purposes. The local currency is FC. Units of current purchasing power are referred to as CFC. The enacted tax rate is 40 percent. The asset had a price-level-adjusted financial reporting amount of CFC 350 and an indexed basis for tax purposes of CFC 100 at December 31, 19X2, both measured using CFC at December 31, 19X2. The entity has a taxable temporary difference of CFC 250 (CFC 350 – CFC 100) and a related deferred tax liability of CFC 100 (CFC 250 × 40 percent) using CFC at December 31, 19X2.

55-2 General price levels increase by 50 percent in 19X3, and indexing allowed for 19X3 for tax purposes is 25 percent. At December 31, 19X3, the asset has a price-level-adjusted financial reporting amount of CFC 525 (CFC 350 × 150 percent) and an indexed basis for tax purposes of CFC 125 (CFC 100 × 125 percent), using CFC at December 31, 19X3. The entity has a taxable temporary difference of CFC 400 (CFC 525 – CFC 125) and a related deferred tax liability of CFC 160 (CFC 400 × 40 percent) at December 31, 19X3, using CFC at December 31, 19X3. The deferred tax liability at December 31, 19X2 is restated to units of current general purchasing power as of December 31, 19X3. The restated December 31, 19X2 deferred tax liability is CFC 150 (CFC 100 × 150 percent). For 19X3, the difference between CFC 160 and CFC 150 is reported as deferred tax expense in income from continuing operations. The difference between the deferred tax liability of CFC 100 at December 31, 19X2 and the restated December 31, 19X2 deferred tax liability of CFC 150 is reported in 19X3 as a restatement of beginning equity.

55-3 The following is a tabular presentation of this Example.

55-1 This Section is an integral part of the requirements of this Subtopic.

55-2 This Example illustrates the application of the cost, equity, and proportional amortization methods of accounting for a limited liability investment in a qualified affordable housing project.

55-3 The following are the terms for this Example.

55-4 This Example has the following assumptions:

1. All cash flows (except initial investment) occur at the end of each year.
2. Depreciation expense is computed, for book and tax purposes, using the straight-line method with a 27.5 year life (the same method is used for simplicity).
3. The investor made a $100,000 investment for a 5 percent limited partnership interest in the project at the beginning of the first year of eligibility for the tax credit.
4. The partnership finances the project cost of $4,000,000 with 50 percent equity and 50 percent debt.
5. The annual tax credit allocation (equal to 4 percent of the project’s original cost) will be received for a period of 10 years.
6. The investor’s tax rate is 40 percent.
7. The project will operate with break-even pretax cash flows including debt service during the first 15 years of operations.
8. The project’s taxable loss will be equal to depreciation expense. The cumulative book loss (and thus the cumulative depreciation expense) recognized by the investor is limited to the $100,000 investment.
9. Subparagraph superseded by Accounting Standards Update No. 2014-01.
10. It is assumed that all requirements are met to retain allocable tax credits so there will be no recapture of tax credits.
11. The investor expects that the estimated residual value of the investment will be zero.
12. All of the conditions described in paragraph 323-740-25-1 are met to qualify the investment for the use of the proportional amortization method.

55-5 An analysis of the proportional amortization method follows.

55-6 Paragraph superseded by Accounting Standards Update No. 2014-01.

55-7 A detailed analysis of the cost method with amortization follows.

55-8 A detailed analysis of the equity method follows.

55-9 This Example is but one method for recognition and measurement of impairment of an investment accounted for by the equity method. Inclusion of this method in this Example does not indicate that it is a preferred method.

55-10 Paragraph superseded by Accounting Standards Update No. 2014-01.