12.2 Income Tax Credits
12.2.1 Accounting for Temporary Differences Related to Investment Tax Credits
ASC 740-10
25-45 An investment credit
shall be reflected in the financial statements to the
extent it has been used as an offset against income
taxes otherwise currently payable or to the extent its
benefit is recognizable under the provisions of this
Topic.
25-46 While it shall be
considered preferable for the allowable investment
credit to be reflected in net income over the productive
life of acquired property (the deferral method),
treating the credit as a reduction of federal income
taxes of the year in which the credit arises (the
flow-through method) is also acceptable.
Pending Content (Transition
Guidance: ASC 323-740-65-2)
25-46
While it shall be considered preferable for the
allowable investment credit to be reflected in net
income over the productive life of acquired
property (the deferral method), treating the
credit as a reduction of federal income taxes of
the year in which the credit arises (the
flow-through method) is also acceptable. For
investments that meet the conditions in paragraph
323-740-25-1 for which an entity has elected to
apply the proportional amortization method, the
flow-through method shall be used.
The guidance in ASC 740-10-25-46 on investment tax credits (ITCs) specifies that
an entity can use either the deferral method or the flow-through method to
account for the receipt of an ITC (e.g., upon purchase or upon the placement of
a purchased or constructed asset in service) as an item of income in the
financial statements.
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, temporary differences may be created when either the
financial statement carrying amount of the acquired property is reduced or when
a deferred credit 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:
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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.
Example 12-1
ITC With No Statutory Reduction to Tax Basis
Assume the following:
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Entity A invests in a qualifying asset for $1,000 that entitles A to an ITC for 25 percent of the purchase price, and it records the following initial entry:Entry 1ATo record the initial purchase.
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In accordance with the tax law, there is no associated reduction in the tax basis of the related asset.
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Entity A’s applicable tax rate is 21 percent.
Deferral Method
Under the deferral method, A recognizes the reduction in
taxes payable and records the offsetting credit as a
reduction in the carrying value of the asset, as shown
in the following journal entry:
Entry 1B
If there is no corresponding adjustment to the tax basis
of the qualifying asset (per the tax law), a deductible
temporary difference of $250 arises. The accounting
treatment for the DTA depends on whether A has elected
the gross-up approach or the income statement
approach.
Gross-Up Approach
Under the gross-up approach, A’s application of a
simultaneous equation yields a DTA of $66 (rounded) and
a reduction to the recorded amount of the qualifying
asset of $66 (rounded). Thus, the qualifying asset
should be recorded at $684 ($1,000 purchase price less
the $250 ITC less the $66 DTA). Entity A will record all
of the entries above as well as the following entry to
account for the qualifying asset, the ITC, and the
initial basis difference in the qualifying asset:
Entry 1C
Income Statement
Approach
Under the income
statement approach, A records a DTA of $53 as a
component of income tax expense. Entity A will record
Entry 1B above and the following entry to account for
the initial basis difference in the qualifying
asset:
Entry 1D
Flow-Through Method
Under the flow-through method, A recognizes the reduction
in taxes payable and records the offsetting credit as a
current income tax benefit, as shown in the following
journal entry:
Entry 1E
Because there is no adjustment to the book basis of the
qualifying asset and it is assumed that there is no
adjustment to the tax basis of the qualifying asset (per
the tax law), no deductible temporary difference arises.
Therefore, the gross-up and income statement approaches
are not applicable.
Example 12-2
ITC With Statutory Reduction to Tax Basis
Assume the same facts as in the example above, except
that in accordance with the tax law, there is an
associated reduction in the tax basis of the related
property equal to 50 percent of the ITC (i.e., $125).
Entity A records the same initial entry as follows:
Entry 2A
Deferral Method
Under the deferral method, A recognizes the reduction in
taxes payable and records the offsetting credit as a
reduction in the carrying value of the asset, as shown
in the following journal entry:
Entry 2B
Because the corresponding adjustment to the tax basis of
the qualifying asset (per the tax law) differs from that
of the adjustment made to the carrying value of the
qualifying asset, a deductible temporary difference of
$125 arises ($750 book basis vs. $875 tax basis). The
accounting treatment for the related DTA depends on
whether A has elected the gross-up approach or the
income statement approach.
Gross-Up Approach
Under the gross-up approach, A’s application of a
simultaneous equation yields a DTA of $33 (rounded) and
a reduction to the recorded amount of the qualifying
asset of $33 (rounded). Thus, the qualifying asset
should be recorded at $717 ($1,000 purchase price less
the $250 ITC less the $33 DTA determined herein). Entity
A will record the entries above and the following entry
to account for the initial basis difference in the
qualifying asset:
Entry 2C
Income Statement Approach
Under the income statement approach, A
records DTA of $26 as a component of tax expense. Entity
A will record Entry 2B and the following entry to
account for the qualifying asset, the ITC, and the
initial basis difference in the qualifying asset:
Entry 2D
Flow-Through Method
Under the flow-through method, A recognizes the reduction
in taxes payable and records the offsetting credit as a
current income tax benefit, as shown in the following
journal entry:
Entry 2E
Although there is no adjustment to the book basis of the
qualifying asset under this approach, the tax basis of
the qualifying asset (per the tax law) differs from the
book basis of the qualifying asset, and an initial
taxable temporary difference of $125 arises ($1,000 book
basis vs. $875 tax basis). The accounting treatment for
the related DTL depends on whether A has elected the
gross-up approach or the income statement approach.
Gross-Up Approach
Under the gross-up approach, A’s application of a
simultaneous equation yields a DTL of $33 (rounded) and
an increase to the recorded amount of the qualifying
asset of $33 (rounded). Thus, the qualifying asset
should be recorded at $1,033 ($1,000 purchase price plus
the $33 DTL determined herein). Entity A will record
Entry 2E and the following entry to account for the
initial basis difference in the qualifying asset:
Entry 2F
Income Statement Approach
Under the income statement approach, A
would not use the simultaneous equations method. Rather,
A would apply its tax rate of 21 percent to the taxable
temporary difference of $125, resulting in the
recognition of a DTL of $26 with the offset to deferred
tax expense. Entity A will record Entry 2E and the
following entry to account for the qualifying asset, the
ITC, and the initial basis difference in the qualifying
asset:
Entry 2G
12.2.2 Accounting for Transferable Tax Credits
As mentioned in Chapter 2.7, certain credits are sold in an effort to monetize
them. Of these credits, a transferability provision was introduced in 2022 for a
number of “eligible credits” as part of the Inflation Reduction Act. The
transferability provision allows an “eligible taxpayer” to elect to transfer
(i.e., sell) the credit, or some portion thereof, to an unrelated taxpayer. In
situations in which an entity does not have sufficient taxable income to use all
or a portion of the income tax credit or in which using it might take multiple
tax years, the entity might achieve a better economic benefit (i.e., present
value benefit) by selling the credit.
Regardless of 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 impact 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).
12.2.2.1 Accounting Considerations for Valuation Allowances Related to Transferable Credits
If an entity elects to account for a transferable tax credit in accordance
with ASC 740, the entity would recognize a DTA for the carryforward and
assess it for realizability. On the basis of a technical inquiry with the
FASB staff, we understand that it would be most appropriate to reflect any
proceeds and resulting gain or loss on the sale as a component of the tax
provision. Under this approach, and on the basis of the same FASB staff
inquiry, we understand that the valuation allowance could be determined by
either (1) factoring the expected sales proceeds into the assessment of the
realizability of the related DTA or (2) not factoring in the expected sales
when assessing the realizability of the related DTA. We believe that if the
expected sales proceeds are factored into the assessment of the
realizability of the DTA, the DTA (net of valuation allowance) would be
recognized in an amount equal to the amount expected to be realized (i.e.,
the expected sales proceeds). Any difference between the expected sales
proceeds and the actual sales proceeds would be recognized as a component of
income tax expense.
If the expected sales proceeds are not factored into the assessment, an
entity would exclude the expected proceeds, including any discount on the
sale of the credits, when assessing the realizability of the DTA, with the
gain or loss on sale recognized at the time of sale as a component of income
tax expense.
Alternatively, we believe that the sale could be treated no
differently than the sale of any other asset, with gain or loss recognized
in pretax earnings for any difference between the proceeds received and the
recorded carrying value of the DTA for the income tax credit that was
recognized in accordance with the guidance in ASC 740 on recognition and
measurement.2
See Section 12.2.2.2 for considerations related to the interim
reporting of this gain or loss.
12.2.2.2 Impact of Credits on Interim Reporting
In accordance with ASC 740-270-30-8, an entity’s AETR should
“reflect anticipated investment tax credits, foreign tax rates, percentage
depletion, capital gains rates, and other available tax planning
alternatives.” Therefore, regardless of the policy elections described in
Section 12.2.2, an entity would
generally include the effects of the credits in its annual AETR, including
gains and losses projected to occur during the year, if reasonably estimable
(i.e., the denominator would include the reasonably estimable gains or
losses that will affect pretax earnings for the year, and the numerator
would include the reasonably estimable net realizable amount of the tax
credits, along with gains or losses associated with the sale of the credit
that will affect the income tax provision).
Footnotes
1
We are also aware of an alternative view under which the deferred credit
would be reversed through the income tax provision.
2
If an entity’s policy is to reflect gain or loss in
pretax earnings, it would not be appropriate to consider the
expected sales proceeds when assessing realizability of the related
DTA.