Chapter 2 — Scope | DART – Deloitte Accounting Research Tool

Chapter 2 — Scope

2.1 Introduction

ASC 740 applies to the accounting for all taxes imposed on an entity by a taxing authority that are based on the entity’s income. This may include taxes imposed by U.S. and foreign federal, state, and local jurisdictions and is true regardless of how a tax is labeled by a particular jurisdiction. Although this principle may appear simple, entities must often use significant judgment in determining whether a tax is an income tax within the scope of ASC 740. Taxes that are not income taxes within the scope of ASC 740 are accounted for in accordance with other U.S. GAAP generally applicable to the recognition, measurement, and disclosure of assets and liabilities, income, and expenses throughout the Codification. This can result in significant differences between the accounting for taxes under ASC 740 and the accounting for taxes under other Codification guidance. For example, deferred taxes are not recognized for non-income-based taxes, and neither expense nor income associated with non-income-based taxes is recorded in the income tax expense line in the statement of operations. In addition, uncertainties about the recognition and measurement of a non-income-based tax in a particular jurisdiction would not be accounted for in accordance with the guidance applicable to uncertain tax positions in ASC 740-10.

ASC 740-10

15-1 The Scope Section of the Overall Subtopic establishes the pervasive scope for all Subtopics of the Income Taxes Topic. Unless explicitly addressed within specific Subtopics, the following scope guidance applies to all Subtopics of the Income Taxes Topic.

Entities

15-2 The principles and requirements of the Income Taxes Topic are applicable to domestic and foreign entities in preparing financial statements in accordance with U.S. generally accepted accounting principles (GAAP), including not-for-profit entities (NFP) with activities that are subject to income taxes.

15-2AA The guidance in this Subtopic relating to accounting for uncertainty in income taxes applies to all entities, including tax-exempt not-for-profit entities, pass-through entities, and entities that are taxed in a manner similar to pass-through entities such as real estate investment trusts and registered investment companies.

Transactions

15-3 The guidance in the Income Taxes Topic applies to:

Domestic federal (national) income taxes (U.S. federal income taxes for U.S. entities) and foreign, state, and local (including franchise) taxes based on income
An entity’s domestic and foreign operations that are consolidated, combined, or accounted for by the equity method.

15-4 The guidance in this Topic does not apply to the following transactions and activities:

A franchise tax (or similar tax) to the extent it is based on capital or a non-income-based amount and there is no portion of the tax based on income. If a franchise tax (or similar tax) is partially based on income (for example, an entity pays the greater of an income-based tax and a non-income-based tax), deferred tax assets and liabilities shall be recognized and accounted for in accordance with this Topic. Deferred tax assets and liabilities shall be measured using the applicable statutory income tax rate. An entity shall not consider the effect of potentially paying a non-income-based tax in future years when evaluating the realizability of its deferred tax assets. The amount of current tax expense equal to the amount that is based on income shall be accounted for in accordance with this Topic, with any incremental amount incurred accounted for as a non-income-based tax. See Example 17 (paragraph 740-10-55-139) for an example of how to apply this guidance.
A withholding tax for the benefit of the recipients of a dividend. 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 and is not an income tax if both of the following conditions are met:
1. The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does not reduce future income taxes the entity would otherwise pay.
2. Shareholders receiving the dividend are entitled to a tax credit at least equal to the tax paid by the entity and that credit is realizable either as a refund or as a reduction of taxes otherwise due, regardless of the tax status of the shareholders.
See the guidance in paragraphs 740-10-55-72 through 55-74 dealing with determining whether a payment made to a taxing authority based on dividends distributed is an income tax.

Related Implementation Guidance and Illustrations

Treatment of Certain Payments to Taxing Authorities [ASC 740-10-55-67].
Example 17: Determining Whether a Tax Is an Income Tax [ASC 740-10-55-139].

2.2 Taxes Based on Income

ASC 740 clearly indicates that “income taxes” are the only taxes within its scope. ASC 740-10-20 defines income taxes as “[d]omestic and foreign federal (national), state, and local (including franchise) taxes based on income,” and it defines taxable income as the “excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the governmental taxing authority.”

Although ASC 740 provides no further guidance on this matter, the term “taxes based on income” implies a tax system in which the tax payable is calculated on the basis of the entity’s revenue minus the expenses allowed by the jurisdiction being considered. For the tax to be an income tax, the tax computation would not need to include all income statement accounts but should include some determination that would be meaningful to most taxpayers or meaningful in relation to the specific income being taxed. A tax levied on a subset of the income statement, such as a tax on net investment income (i.e., a tax on investment income less investment-related expenses), would also qualify as a tax based on income since it would be computed on the basis of a portion of net income less expenses incurred to generate the income.

For a tax to be an income tax within the scope of ASC 740, revenues and gains must be reduced by some amount of expenses and losses allowed by the jurisdiction. Therefore, a tax based solely on revenues (e.g., gross receipts or sales tax) would not be within the scope of ASC 740 because the taxable base amount is not reduced by any expenses. A tax based on gross receipts, revenue, or capital should be accounted for under other applicable authoritative literature (e.g., ASC 405, ASC 450). See Section 2.2.4 of Deloitte’s Roadmap Contingencies, Loss Recoveries, and Guarantees for further discussion of differentiating between contingent liabilities and contractual or legal liabilities in connection with taxes that are not within the scope of ASC 740.

2.3 Taxes Assessed in Lieu of Income Tax

In certain jurisdictions and for certain entities, an entity may be subject to certain taxes in lieu of an income tax, such as an excise or other type of tax. For example, not-for-profit foundations that make certain minimum distributions are generally exempt from U.S. federal income taxes but may be subject to an excise tax on their net investment income. Such an excise tax meets the definition of a tax based on income and therefore is within the scope of ASC 740. Alternatively, in some jurisdictions, qualifying entities may be subject to an excise tax (e.g., based on a percentage of assets or sales) in lieu of an income tax. Although this tax is levied in lieu of an income tax, it is not based on a measure of income and therefore is not within the scope of ASC 740. Entities should carefully consider how each type of tax is assessed to determine whether the tax should be included within the scope of ASC 740.

Further, the questions of whether an entity is subject to a tax based on income or a non-income-based tax in a particular jurisdiction are not always mutually exclusive. See Section 2.5 for information on hybrid tax regimes, in which an entity may be subject to both income and non-income-based taxes or be subject to tax based on the higher of an income tax or a non-income-based tax.

2.4 Certain Entities Exempt From Income Taxes on the Basis of Legal Form

The legal form established for an entity may govern whether the entity is taxable or tax-exempt. Many entities are exempt from paying taxes because they qualify as either tax-exempt (e.g., not-for-profit organization) or pass-through entities (e.g., Subchapter S corporation, partnership, and certain LLCs) or because they function similarly to pass-through entities (e.g., real estate investment trusts [REITs] or regulated investment companies). To qualify for tax-exempt or pass-through treatment, such entities must meet certain conditions under the relevant tax law. According to the definition of a tax position in ASC 740-10-20, the recognition and measurement of a decision to classify an entity as tax-exempt should be evaluated under ASC 740. See Section 4.1.2.1 for additional discussion of the evaluation of an entity’s tax-exempt status.

In addition, an entity may change its tax status, which may affect its designation as either a taxable or nontaxable entity. Changes in tax status can be voluntary or involuntary, and the accounting treatment for each may be different. See Section 3.5.2 for further discussion of an entity’s change in tax status.

2.5 Hybrid Taxes

ASC 740-10-15-4(a) notes that amounts based on taxable income should be included in the tax provision, with any incremental amount recorded as a non-income-based tax. For example, assume that (1) a local jurisdiction assesses an entity’s tax as the greater of 25 percent of taxable income or 1 percent of equity and (2) the entity has $100 of taxable income in the current year and book equity of $10,000. Tax expense of $25 is therefore included in the tax provision and accounted for within the scope ASC 740. The excess tax generated by the non-income-based measure of $75 ($10,000 × 1% – $25) is recorded as an expense charged to income.

2.6 Accounting for Withholdings on Certain Payments (e.g., Dividends, Interest, Royalties, or License Fees)

In some tax jurisdictions, dividends to owners and other payments (e.g., interest, royalty, or license payments) may trigger a tax obligation to the tax authority in the payor’s jurisdiction (sometimes referred to as a “withholding tax”). Such a tax may be required to be withheld from the payment by the payor and remitted to the taxing authority. It is not always clear whether the payor or the recipient should account for the tax as an income tax, and careful consideration is often required.

2.6.1 Accounting for a Withholding Tax by the Payor

Treatment of the withholding tax by the payor of the dividend will depend on whether the tax is assessed on the payor or on the payee. This is a legal determination in the jurisdiction of the payor.

In some jurisdictions, a tax based on dividends distributed is assessed directly on the dividend payor. In these cases, remittance of the withholding tax should be accounted for in equity as a part of the dividend (rather than as an expense of the payor) only if both of the conditions outlined in ASC 740-10-15-4(b) are met. ASC 740-10-15-4(b) states, in part:

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 and is not an income tax if both of the following conditions are met:

The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does not reduce future income taxes the entity would otherwise pay.
Shareholders receiving the dividend are entitled to a tax credit at least equal to the tax paid by the entity and that credit is realizable either as a refund or as a reduction of taxes otherwise due, regardless of the tax status of the shareholders.

If either of these criteria is not met, a tax assessed directly on the dividend payor should not be considered a withholding for the benefit of the recipient. Instead, it should be accounted for by the payor as either an income tax within the scope of ASC 740 or as a non-income based tax, depending on the substance of the tax.

If the tax is accounted for by the payor as an income tax within the scope of ASC 740, any tax benefit to the payor resulting from payment of the withholding tax should be recognized as part of tax expense or benefit from continuing operations.

2.6.2 Accounting for a Withholding Tax by the Recipient

Most taxes on dividends are assessed on the recipient of the dividend but are required to be withheld and remitted to the taxing authority by the payor. In these instances, the remittance of the withholding tax to the tax authority by the dividend payor is accounted for by the payor in its financial statements as a reduction to equity (i.e., as a part of the dividend). The withholding tax may still, however, be viewed as an income tax from the point of view of the recipient of the dividend since the tax is paid on behalf of the recipient.

ASC 740 does not provide guidance on determining whether recipients of certain payments (e.g., dividends or royalties) should account for withholding taxes as income taxes within the scope of ASC 740.

ASC 740-10-55-24 states the following regarding taxes withheld from dividends:

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. [Emphasis added]

It can be inferred from this guidance that the FASB intended withholding taxes on dividends to be a component of income taxes. However, ASC 946-220-45-3 discusses the presentation of certain items in the statement of operations of an investment company and suggests that withholding taxes might, in fact, be considered as “other taxes.” ASC 946-220-45-3 states, in part:

All of the following expenses are commonly reported separately: . . .

g. Federal and state income taxes (these expenses shall be shown separately after the income category to which they apply, such as investment income and realized or unrealized gains)

h. Other taxes (foreign withholding taxes shall be deducted from the relevant income item and presented parenthetically or shown as a separate contra item in the income section).

Accordingly, the recipient of a dividend or other payment that is subject to withholding tax should account for the withholding tax on the basis of its facts and circumstances. Relevant questions (not all-inclusive or individually determinative) include the following:

If the recipient had qualifying expenditures in the local jurisdiction or had established a local presence, would the withholding tax be adjusted accordingly (i.e., would it not apply, or would it be reflected as an estimated tax payment on the income tax return)?

If the recipient filed an income tax return in the payor’s jurisdiction, the fact that the taxable income could be adjusted if there were qualifying expenditures and any withholding tax could be claimed as an estimated payment would be a strong indicator that the withholding tax should be considered an income tax.
Is the payment effectively a distribution from the earnings of the paying entity? That is, is it a dividend and not a return of capital or other expense?

If the amount was paid out of earnings of the paying entity, the withholding tax may represent an incremental layer of tax, imposed on the recipient, on the income of the payor. For example, although a dividend itself may seem to be revenue rather than income to the recipient (i.e., the recipient has not been able to directly reduce the dividend by expenses), the withholding tax is assessed on a net income figure (i.e., the paying entity has incurred expenses on its revenues) at the time of distribution. Therefore, the recipient has indirectly been allowed a deduction for the expenses associated with the revenue upon which the dividend is based given that the paying entity has taken these deductions before making the dividend.
Is the withholding tax creditable on an income tax return filed by the receiving entity or by the receiving entity’s parent?

While the ability to take a credit for the tax on an income tax return would not itself indicate that the tax is an income tax, many of the criteria used to evaluate whether the tax is creditable would most likely be relevant in the determination of whether the tax is an income tax for U.S. GAAP purposes.

2.7 Refundable Tax Credits

Certain tax jurisdictions provide refundable credits (e.g., qualifying R&D credits in certain countries and state jurisdictions and alternative fuel tax credits for U.S. federal income tax) that do not depend on the entity’s ongoing tax status or tax position (e.g., an entity may receive a refund despite being in a taxable loss position). Tax credits, such as refundable credits whose realization does not depend on the entity’s generation of taxable income or the entity’s ongoing tax status or tax position, are not considered an element of income tax accounting under ASC 740. Thus, even if the credit claims are filed in connection with a tax return, the refunds are not considered part of income taxes and therefore are not within the scope of ASC 740. In such cases, an entity would not record the credit as a reduction of income tax expense; rather, the entity should determine the credit’s classification on the basis of its nature.

When determining the classification of these credits, an entity may consider them to be a form of government grant or assistance. An entity may look to paragraphs 24 and 29 of IAS 20 for guidance on government grants. Under paragraph 24 of IAS 20, an entity presents government grants related to assets “either by setting up the grant as deferred income or by deducting the grant in arriving at the carrying amount of the asset.” Further, paragraph 29 of IAS 20 states, “Grants related to income are presented as part of profit or loss, either separately or under a general heading such as ‘Other Income’; alternatively, they are deducted in reporting the related expense.”

In rare circumstances, a tax law may change the way a tax credit is realized. For example, a jurisdiction may have historically required that a credit be realized on the tax return as a reduction in taxes payable but subsequently changes the law so that the credit can be realized even though an entity has not first incurred a tax liability (i.e., the credit amount becomes refundable but was not when it arose). In this situation, an entity would generally continue to apply ASC 740 to the credits recognized at the time of the law change. Any new refundable credits earned after the tax law change would be accounted for as refundable credits in accordance with the guidance in this section.

Credits whose realization ultimately depends on taxable income (e.g., investment tax credits [ITCs] and R&D credits) would be within the scope of ASC 740. See Section 12.2 for more information about the accounting for ITCs.

2.7.1 Selling Income Tax Credits to Monetize Them

Some tax jurisdictions might allow an entity that generates certain types of income tax credit to either use the credit to reduce its income tax liability or effectively “sell” all or a portion of it by assigning the right to claim the credit to another qualified entity. If, however, the credit can be used only to reduce an income tax liability either of the entity that generated it or the entity to which it is sold and would never be refundable by the government, we believe that the credit is within the scope of ASC 740.1

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. In such situations, the entity that generated the credit should initially recognize and measure it in accordance with the recognition and measurement criteria of ASC 740. To the extent that the income tax credit does not reduce income taxes currently payable, the entity would recognize a DTA for the carryforward and assess it for realizability in a manner consistent with the sources of income cited in ASC 740-10-30-18.2 See Section 5.3 for additional discussion.

If the entity were to subsequently sell the income tax credit, we understand based on a FASB staff technical inquiry that it would be most appropriate to reflect any proceeds and resulting gain/loss on the sale as a component of the tax provision. Alternatively, we believe 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 (i.e., the DTA for the income tax credit recognized under the guidance in ASC 740 on recognition and measurement).

Footnotes

1

While we believe accounting for the credits within the scope of ASC 740 is most appropriate, consistent with feedback received from the FASB staff, we believe it would also be acceptable for a company to account for the transferable credits in a manner similar to refundable credits as the company generating the credit does not need taxable income in order to monetize the credit.

2

While we believe such assessment would generally be predicated upon the normal course of business (i.e., an entity would not factor in its ability to sell the underlying tax attribute as a basis for realizing the related DTA), we understand based on a technical inquiry with the FASB staff that it would also be acceptable to consider the expected proceeds when assessing realizability.

2.8 Obligations for Indemnification of Uncertain Tax Positions of a Subsidiary Upon Sale — Subsidiary Previously Filed a Separate Tax Return

In a sale transaction, it is common for one party to indemnify the other for a particular contingency. If the acquiree previously filed a separate tax return from the parent (i.e., seller), the indemnification agreement between the buyer and seller might be related to income tax positions taken by the acquiree before the transaction. In these situations, we believe that the seller’s indemnification obligation is not within the scope of ASC 740 (i.e., because the seller is not jointly and severally liable for the income tax obligations of the acquiree when the acquiree filed a separate return). Rather, the seller should account for the indemnification obligation in accordance with other applicable U.S. GAAP.

Example 2-1

Assume that Company A enters into an agreement to sell 100 percent of the outstanding stock in its wholly owned subsidiary, Company Z, to Company B. Before the sale, Z files a separate tax return in which a tax position is taken that requires the recognition of a liability for an unrecognized tax benefit (UTB). As part of the purchase agreement, A indemnifies B for any future settlement with the tax authority in connection with the uncertain tax position taken by Z in its prior tax return.

Because Z filed a separate tax return, A is not directly liable for any of Z’s tax obligations after the sale. By indemnifying B for any loss related to Z’s prior tax positions, however, A has entered into a guarantee contract, which would generally be within the scope of ASC 460 (see ASC 460-10-15-4(c) and ASC 460-10-55-13(c)).

Therefore, A would generally recognize a guarantee liability on the sale date and on each reporting date thereafter in accordance with the recognition and measurement provisions of ASC 460.

Assume the following:

The uncertain tax benefit is $110.
Settlement of the indemnification liability would result in a deduction for the seller.
The guarantee is within the scope of ASC 460, and the initial guarantee liability determined under ASC 460 is $100.
Company A has an ETR of 25 percent.
For A, the disposition of Z does not qualify for presentation as a discontinued operation in accordance with ASC 205-20.

The following entries illustrate A’s accounting for the UTB upon the sale of Z.

To record the indemnification liability (recognition would adjust the seller’s gain and loss on sale):

To record the deductible temporary difference related to the difference between the reported amount and the tax basis of the indemnification liability (i.e., 25% of $100):

If the UTB liability were ultimately settled with the tax authority for $76, Z would make a cash payment to the tax authority and A would make a cash payment to B in satisfaction of its indemnification liability. The following entries illustrate A’s accounting upon settlement.

To record the settlement of its indemnification liability — by transferring cash to B — for less than the recorded amount of the guarantee liability:

To record the reduction in taxes payable related to the deduction for the payment of the indemnification and reversal of the related DTA, resulting in total net current and deferred tax expense in the period of payment of $6 ($25 deferred tax expense less $19 current tax benefit [i.e., 25% of $76]):

The acquirer in such a business combination may be required to record an indemnification asset under ASC 805. Section 11.3.6.5 provides interpretive guidance, including examples, related to the acquirer’s accounting in such circumstances.

2.9 Income Taxes Paid by the Entity on Behalf of Its Owners

A pass-through entity, which would not normally be subject to tax, may elect to pay income taxes under a pass-through entity tax regime. In these situations, ASC 740 provides guidance on whether the income taxes are attributed to the pass-through entity or its owners. The determination is based on the laws and regulations of each specific jurisdiction. If an income tax is attributable to the entity, the entity should account for the tax in accordance with ASC 740, including the recognition of deferred taxes if applicable. Conversely, if an income tax is attributable to the owners, the pass-through entity would account for the income taxes paid by applying other guidance. The examples in ASC 740-10-55-226 through 55-228 provide a high-level framework for making this assessment:

ASC 740-10

Example 35: Attribution of Income Taxes to the Entity or Its Owners

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.

Example 36: Attribution of Income Taxes to the Entity or 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.

Example 37: Attribution of Income Taxes to the Entity or Its Owners

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.

The examples in the guidance above highlight certain characteristics that an entity should consider, including:

Whether the jurisdiction also allows the owners to file tax returns and use their pro rata share of tax paid by the entity as a credit against their tax liability.
Whether the entity and the owners are joint and severally liable for payment of income taxes in the jurisdiction.

In many cases, however, the tax law may not specifically state whether the entity and the owners are jointly and severally liable. In these instances, an entity should consider the following:

Whether the owners are ultimately liable if the entity is required (or makes an election) but ultimately fails to pay the tax.
Whether the entity, owners, or both are responsible for paying taxes associated with uncertain tax positions.

No single characteristic is individually determinative with respect to an evaluation of the scope of the taxes paid. Rather, a preponderance of the evidence would be needed to support the conclusion reached. Accordingly, determining whether a tax is attributable to the entity or the owner may be challenging and will, by definition, depend on the specific laws and regulations of the respective jurisdictions.