12.2 Income Tax Credits

The guidance in ASC 740-10-25-46 on ITCs specifies that an entity can use either the deferral method or the flow-through method to account for the receipt of an ITC. The ITC guidance originated in APB Opinion 2 in response to a U.S. federal tax law enacted in 1962. More specifically, APB Opinion 2 noted that the tax law provided for an ITC generally “equal to a specified percentage of the cost of certain depreciable assets acquired and placed in service.” Since then, the U.S. tax law has evolved and the number and types of tax credits has significantly increased, including many that are still considered to be ITCs under the IRC.

Because the ASC master glossary does not define ITCs, entities must use judgment to determine whether a credit qualifies for ITC accounting. We believe that in making this determination, an entity should evaluate the characteristics of the credit within the context of the original guidance in APB Opinion 2. Accordingly, to be characterized as an ITC, the credit must first qualify as an income tax credit within the scope of ASC 740. That is, it cannot be a refundable tax credit or a transferable tax credit that an entity has elected to account for outside the scope of ASC 740. Second, the credit should be received as a result of the placement into service of an asset that is acquired or constructed. The amount of an ITC is generally equal to a specified percentage of the acquired or constructed asset (i.e., receipt of the credit should not be tied to production). In addition, the benefit received should be in the form of a tax credit that provides a reduction to taxes payable as opposed to a tax deduction that is factored into the determination of taxable income. The characterization of a tax credit under the tax law may also be considered a factor in the evaluation of the treatment of the tax credit. Given the significant judgment involved in the determination of whether a tax credit qualifies for ITC accounting, consultation with an entity’s tax and accounting advisers is encouraged. Once an income tax credit has been determined to be an ITC, an entity can elect to use either the deferral method or the flow-through method, as discussed below.

Under the deferral method, the ITC would result in a reduction to income taxes payable (or an increase in a DTA if the credit is carried forward to future years, subject to assessment for realization) that is recognized either as a reduction to the carrying value of the related asset or as a deferred credit (i.e., the credit is treated as deferred income). The benefit of the ITC is either reflected in net income as a reduction to depreciation expense or recognized as deferred income over the productive life of the related property (rather than as a reduction to income tax expense).1 Under this method, in a manner consistent with the guidance in ASC 740-10-25-20(f), temporary differences may be created either when the financial statement carrying amount of the acquired property is reduced or deferred income is recorded. In some cases, receipt of the credit results in a statutory reduction in the tax basis of the related asset, which may affect the temporary basis difference.

Under the flow-through method, the ITC would result in (1) a reduction to income taxes payable for the year in which the credit arises (or an increase in a DTA if the credit is carried forward to future years, subject to assessment for realization) and (2) an immediate reduction to income tax expense. When this method is applied, temporary differences are generally created only if a statutory reduction in tax basis occurs.

The following two approaches are acceptable for recording the tax effect of temporary differences created by ITCs:

• Gross-up approach — Under this approach, there is no immediate income statement recognition because the DTA or DTL is recorded as an adjustment to the carrying value of the acquired property (or as a deferred credit). The simultaneous equations method is used to calculate the final book basis of the acquired property and the DTA or DTL. (For the FASB’s guidance on, and an illustration of, the simultaneous equations method, see ASC 740-10-25-51 and ASC 740-10-55-171 through 55-182.)
• Income statement approach — Under this approach, the DTA or DTL is recorded with an offset to income tax expense.

Both approaches are discussed below in greater detail. Note that the approach an entity selects is an accounting policy election that should be applied consistently. In addition, since this guidance applies only to the accounting for ITCs, an entity should not analogize to other situations. In circumstances other than those related to ITCs, consultation with accounting advisers is recommended.

Regardless of an entity’s intent, we believe that a transferable credit should remain within the scope of ASC 740 if it (1) can be used only to reduce an income tax liability either for the entity that generated it or the entity to which it is transferred and (2) would never be refundable by the government. While we believe that it is most appropriate to account for the credits under ASC 740, on the basis of feedback received from the FASB staff, we believe that it would also be acceptable for an entity to account for the transferable credits in a manner similar to refundable credits (i.e., which are not within the scope of ASC 740) since the company generating the credit does not need taxable income to monetize the credit.

In addition to the accounting policy decision discussed above, there are considerations related to the realizability assessment of the related DTA and certain interim reporting considerations. The impacts of the accounting policy elections are summarized in the decision tree below.

An entity that purchases a transferable credit should generally record a DTA for the amount of tax credits purchased and a deferred credit for the difference between the amount paid and the DTA recognized in accordance with ASC 740 (such deferred credit does not represent a DTL). The deferred credit will be reversed and recognized as an income tax benefit in proportion to the deferred tax expense recognized on realization of the associated DTA (i.e., as the credits are used on the tax return).