Chapter 3 — Book-Versus-Tax Differences and Tax Attributes

3.3 Temporary Differences

ASC 740-10

25-18 Income taxes currently payable for a particular year usually include the tax consequences of most events that are recognized in the financial statements for that year.

25-19 However, because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenues, expenses, gains, and losses, differences arise between:

The amount of taxable income and pretax financial income for a year
The tax bases of assets or liabilities and their reported amounts in financial statements.

Guidance for computing the tax bases of assets and liabilities for financial reporting purposes is provided in this Subtopic.

25-20 An assumption inherent in an entity’s statement of financial position prepared in accordance with generally accepted accounting principles (GAAP) is that the reported amounts of assets and liabilities will be recovered and settled, respectively. Based on that assumption, a difference between the tax basis of an asset or a liability and its reported amount in the statement of financial position will result in taxable or deductible amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled. Examples include the following:

Revenues or gains that are taxable after they are recognized in financial income. An asset (for example, a receivable from an installment sale) may be recognized for revenues or gains that will result in future taxable amounts when the asset is recovered.
Expenses or losses that are deductible after they are recognized in financial income. A liability (for example, a product warranty liability) may be recognized for expenses or losses that will result in future tax deductible amounts when the liability is settled.
Revenues or gains that are taxable before they are recognized in financial income. A liability (for example, subscriptions received in advance) may be recognized for an advance payment for goods or services to be provided in future years. For tax purposes, the advance payment is included in taxable income upon the receipt of cash. Future sacrifices to provide goods or services (or future refunds to those who cancel their orders) will result in future tax deductible amounts when the liability is settled.
Expenses or losses that are deductible before they are recognized in financial income. The cost of an asset (for example, depreciable personal property) may have been deducted for tax purposes faster than it was depreciated for financial reporting. Amounts received upon future recovery of the amount of the asset for financial reporting will exceed the remaining tax basis of the asset, and the excess will be taxable when the asset is recovered.
A reduction in the tax basis of depreciable assets because of tax credits. Amounts received upon future recovery of the amount of the asset for financial reporting will exceed the remaining tax basis of the asset, and the excess will be taxable when the asset is recovered. For example, a tax law may provide taxpayers with the choice of either taking the full amount of depreciation deductions and a reduced tax credit (that is, investment tax credit and certain other tax credits) or taking the full tax credit and a reduced amount of depreciation deductions.
Investment tax credits accounted for by the deferral method. Under the deferral method as established in paragraph 740-10-25-46, investment tax credits are viewed and accounted for as a reduction of the cost of the related asset (even though, for financial statement presentation, deferred investment tax credits may be reported as deferred income). Amounts received upon future recovery of the reduced cost of the asset for financial reporting will be less than the tax basis of the asset, and the difference will be tax deductible when the asset is recovered.
An increase in the tax basis of assets because of indexing whenever the local currency is the functional currency. The tax law for a particular tax jurisdiction might require adjustment of the tax basis of a depreciable (or other) asset for the effects of inflation. The inflation-adjusted tax basis of the asset would be used to compute future tax deductions for depreciation or to compute gain or loss on sale of the asset. Amounts received upon future recovery of the local currency historical cost of the asset will be less than the remaining tax basis of the asset, and the difference will be tax deductible when the asset is recovered.
Business combinations and combinations accounted for by not-for-profit entities (NFPs). There may be differences between the tax bases and the recognized values of assets acquired and liabilities assumed in a business combination. There also may be differences between the tax bases and the recognized values of assets acquired and liabilities assumed in an acquisition by a not-for-profit entity or between the tax bases and the recognized values of the assets and liabilities carried over to the records of a new entity formed by a merger of not-for-profit entities. Those differences will result in taxable or deductible amounts when the reported amounts of the assets or liabilities are recovered or settled, respectively.
Intra-entity transfers of an asset other than inventory. There may be a difference between the tax basis of an asset in the buyer’s tax jurisdiction and the carrying value of the asset reported in the consolidated financial statements as the result of an intra-entity transfer of an asset other than inventory from one tax-paying component to another tax-paying component of the same consolidated group. That difference will result in taxable or deductible amounts when the asset is recovered.

25-21 The examples in (a) through (d) in paragraph 740-10-25-20 illustrate revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than the year in which they are recognized in pretax financial income. Those differences between taxable income and pretax financial income also create differences (sometimes accumulating over more than one year) between the tax basis of an asset or liability and its reported amount in the financial statements. The examples in (e) through (i) in paragraph 740-10-25-20 illustrate other events that create differences between the tax basis of an asset or liability and its reported amount in the financial statements. For all of the examples, the differences result in taxable or deductible amounts when the reported amount of an asset or liability in the financial statements is recovered or settled, respectively.

25-22 This Topic refers collectively to the types of differences illustrated by the examples in paragraph 740-10-25-20 and to the ones described in paragraph 740-10-25-24 as temporary differences.

25-23 Temporary differences that will result in taxable amounts in future years when the related asset or liability is recovered or settled are often referred to as taxable temporary differences (the examples in paragraph 740-10-25-20(a), (d), and (e) are taxable temporary differences). Likewise, temporary differences that will result in deductible amounts in future years are often referred to as deductible temporary differences (the examples in paragraph 740-10-25-20(b), (c), (f), and (g) are deductible temporary differences). Business combinations and intra-entity transfers of assets other than inventory (the examples in paragraph 740-10-25-20(h) through (i)) may give rise to both taxable and deductible temporary differences.

25-24 Some temporary differences are deferred taxable income or tax deductions and have balances only on the income tax balance sheet and therefore cannot be identified with a particular asset or liability for financial reporting.

25-25 That occurs, for example, when revenue on a long-term contract with a customer is recognized over time using a measure of progress to depict performance over time in accordance with the guidance in Subtopic 606-10, for financial reporting that is different from the recognition pattern used for tax purposes (for example, when the contract is completed). The temporary difference (income on the contract) is deferred income for tax purposes that becomes taxable when the contract is completed. Another example is organizational costs that are recognized as expenses when incurred for financial reporting and are deferred and deducted in a later year for tax purposes.

25-26 In both instances, there is no related, identifiable asset or liability for financial reporting, but there is a temporary difference that results from an event that has been recognized in the financial statements and, based on provisions in the tax law, the temporary difference will result in taxable or deductible amounts in future years.

25-27 An entity might be able to delay the future reversal of taxable temporary differences by delaying the events that give rise to those reversals, for example, by delaying the recovery of related assets or the settlement of related liabilities.

25-28 A contention that those temporary differences will never result in taxable amounts, however, would contradict the accounting assumption inherent in the statement of financial position that the reported amounts of assets and liabilities will be recovered and settled, respectively; thereby making that statement internally inconsistent. Because of that inherent accounting assumption, the only question is when, not whether, temporary differences will result in taxable amounts in future years.

25-29 Except for the temporary differences addressed in paragraph 740-10-25-3, which shall be accounted for as provided in that paragraph, an entity shall recognize a deferred tax liability or asset for all temporary differences and operating loss and tax credit carryforwards in accordance with the measurement provisions of paragraph 740-10-30-5.

Related Implementation Guidance and Illustrations

Examples of Temporary Differences [ASC 740-10-55-49].
Example 23: Effects of Subsidy on Temporary Difference [ASC 740-10-55-165].
Example 24: Built-In Gains of S Corporation [ASC 740-10-55-168].
Example 26: Direct Transaction With Governmental Taxing Authority [ASC 740-10-55-202].

3.3.1 Overview

A temporary difference is a difference between the financial reporting basis and the income tax basis of assets and liabilities, determined in accordance with the recognition and measurement criteria of ASC 740 (see Section 3.3.3.1 for additional guidance on this term as used herein), of an asset or liability that will result in a taxable or deductible item in future years when the financial reporting basis of the asset or liability is recovered or settled, respectively. The appropriate identification of temporary differences is important because DTAs and DTLs are recorded for all temporary differences unless an exception applies.

The term “timing difference” was used in APB Opinion 11 (before the FASB’s codification of U.S. GAAP) to describe differences between the periods in which transactions affect taxable income and the periods in which they enter into the determination of pretax financial accounting income. Timing differences were described as differences that originate in one period and reverse or “turn around” in one or more subsequent periods.

As used in ASC 740, the term “temporary difference” encompasses more than the timing differences defined in APB Opinion 11 and described above. The method that an entity uses to calculate temporary differences under ASC 740 stresses the economic impact of recovering and settling assets and liabilities at their reported amounts. Consequently, a DTA or DTL will be recognized for almost all basis differences that exist on the balance sheet date. ASC 740-10-20 defines a temporary difference as follows:

A difference between the tax basis of an asset or liability computed pursuant to the requirements in Subtopic 740-10 for tax positions, and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled, respectively. Paragraph 740-10-25-20 cites examples of temporary differences. Some temporary differences cannot be identified with a particular asset or liability for financial reporting (see paragraphs 740-10-05-10 and 740-10-25-24 through 25-25), but those temporary differences do meet both of the following conditions:

Result from events that have been recognized in the financial statements
Will result in taxable or deductible amounts in future years based on provisions of the tax law.

Some events recognized in financial statements do not have tax consequences. Certain revenues are exempt from taxation and certain expenses are not deductible. Events that do not have tax consequences do not give rise to temporary differences.

An often-cited example illustrating this point is an excess of the reported amount of an acquired identified intangible asset for financial reporting purposes (e.g., a customer list that has no tax basis). Although, under tax law, an entity in this situation will not receive a tax deduction in the future for the recovery of the intangible asset, recognition of a DTL is nevertheless required because it is assumed, for financial reporting purposes, that the entity will generate future revenues at least equal to the recorded amount of the investment and that recovery will result in future taxable amounts.

ASC 740-10-25-20 gives examples of situations in which a difference between the tax basis of an asset or liability and its reported amount in the financial statements will result in taxable or deductible amounts in future year(s) when the reported amount of the asset or liability is recovered or settled.

There are two categories of temporary basis differences: “inside” basis differences and “outside” basis differences. An inside basis difference is a difference between the carrying amount, for financial reporting purposes, of an individual asset or liability and its tax basis.1 An inside basis difference might, for example, result from an entity’s election to use an accelerated depreciation method for determining deductions on a specific item of personal property for income tax purposes while using the straight-line method of depreciation for that item for financial reporting purposes.

An outside basis difference is the difference between the carrying amount of an entity’s investment (e.g., an investment in a consolidated subsidiary) for financial reporting purposes and the underlying tax basis in that investment (e.g., the tax basis in the subsidiary’s stock). See Section 3.4 for a discussion of outside basis differences.

Temporary differences are basis differences that will give rise to a tax deduction or taxable income when the related asset is recovered or liability is settled for its financial reporting carrying value.

3.3.2 Determining Whether a Basis Difference Is a Temporary Difference

ASC 740-10-25-30 states, in part, that “[c]ertain basis differences may not result in taxable or deductible amounts in future years when the related asset or liability for financial reporting is recovered or settled and, therefore, may not be temporary differences for which a deferred tax liability or asset is recognized.” An entity must recognize DTAs and DTLs in the absence of (1) a tax law provision that would allow the recovery or settlement, without tax consequences, of an asset or liability that gives rise to a taxable or deductible basis difference and the entity has the intent and ability to recover or settle the item in a tax-free manner or (2) a specific exception identified in ASC 740.

3.3.2.1 Examples of Basis Differences That Are Not Temporary Differences

Some basis differences do not result in taxable or deductible amounts in future years and are not considered temporary differences. Examples include the following:

3.3.2.1.1 Entity-Owned Life Insurance

Under U.S. federal tax law, expenditures for certain insurance premiums on officers and directors are not deductible for tax purposes. However, for financial reporting purposes, the cash surrender value of life insurance policies for which the entity is the beneficiary is reported in its balance sheet as an asset. Because the proceeds of such a policy are not taxable under the tax law if they are held until the death of the insured, no DTL would be recognized for the basis difference (excess of cash surrender value over total premiums paid) under ASC 740 provided that management intended not to realize the benefits available under the policy before the death of the executives. A history of reversions, before the death of an insured that results in realization of a portion or all of the excess cash surrender value, would generally be inconsistent with an assertion that proceeds will not be taxable. However, loans that are collateralized against the surrender value of such policies might not be considered inconsistent with that assertion (e.g., if the action is taken primarily to reduce the cost of borrowed funds).

3.3.2.1.2 Domestic Subsidiaries

The excess of a parent entity’s investment in the stock of a domestic subsidiary for financial reporting purposes over the tax basis in that stock is not a taxable temporary difference for which recognition of a DTL is required if the tax law provides a means by which the reported amount of the investment could be recovered tax free and the entity expects to use that means. Under U.S. federal tax law, such means include a tax-free liquidation or a statutory merger. See further discussion in Section 3.4.3.

3.3.2.1.3 Nontaxable Entities

Under U.S. federal tax law, C corporations are taxed on their income and gains directly, whereas nontaxable flow-through entities such as S corporations and partnerships are not directly taxed, but their income and gains are passed through to the individual tax returns of their shareholders. Generally, basis differences in assets and liabilities held by nontaxable entities are not taxable/deductible temporary differences for which deferred taxes should be recorded. However, see Section 3.5.2.5 for a discussion of unrealized built-in gains for which a DTL is required.

3.3.2.1.4 Income Tax Effects on Medicare Part D Subsidy Receipts

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “2003 Act”) established a prescription drug benefit under Medicare Part D and a federal subsidy to employers offering retiree prescription drug coverage that provides a benefit that is at least as valuable as Medicare Part D coverage. An employer’s promise to provide postretirement prescription drug coverage (“coverage”) is recorded as a component of the other postretirement benefit obligation. When that coverage benefit meets certain criteria, the employer becomes eligible to receive the federal retiree drug subsidy (the “subsidy”), which is then recorded as an offset against the obligation determined under ASC 715-60 (i.e., the postretirement benefit obligation is recorded net of the subsidy, and the net amount is actuarially determined). Under the 2003 Act, the subsidy received was not considered taxable income to the employer for federal income tax purposes, but the employer was permitted to deduct the entire cost of providing the prescription drug coverage. However, while the Patient Protection and Affordable Care Act and the Health Care and Education Affordability Reconciliation Act of 2010 repealed the provision in the 2003 Act that permitted deduction of the entire cost of prescription drug coverage, it did not change the treatment of the subsidy (it remains nontaxable). Because the portion of the prescription drug costs that will be offset by the subsidy is no longer tax deductible, and the subsidy remains nontaxable, the temporary difference and related DTA should be determined without regard to (1) the portion of the cost of prescription drug coverage that will be offset by the subsidy and (2) the subsidy itself. ASC 740-10-55-57 states that “[i]n the periods in which the subsidy affects the employer’s accounting for the plan,” the subsidy should not affect any plan-related temporary differences that are accounted for under ASC 740 because the subsidy is exempt from federal taxation.

3.3.3 Measurement of Temporary Differences

ASC 740-10

Anticipation of Future Losses Not Permitted

25-38 Conceptually, under an incremental approach as discussed in paragraph 740-10-10-3, the tax consequences of tax losses expected in future years would be anticipated for purposes of:

a. Nonrecognition of a deferred tax liability for taxable temporary differences if there will be no future sacrifice because of future tax losses that otherwise would expire unused

b. Recognition of a deferred tax asset for the carryback refund of taxes paid for the current or a prior year because of future tax losses that otherwise would expire unused.

However, the anticipation of the tax consequences of future tax losses is prohibited.

Anticipated Future Tax Credits

25-39 Certain foreign jurisdictions tax corporate income at different rates depending on whether that income is distributed to shareholders. For example, while undistributed profits in a foreign jurisdiction may be subject to a corporate tax rate of 45 percent, distributed income may be taxed at 30 percent. Entities that pay dividends from previously undistributed income may receive a tax credit (or tax refund) equal to the difference between the tax computed at the undistributed rate in effect the year the income is earned (for tax purposes) and the tax computed at the distributed rate in effect the year the dividend is distributed.

25-40 In the separate financial statements of an entity that pays dividends subject to the tax credit to its shareholders, a deferred tax asset shall not be recognized for the tax benefits of future tax credits that will be realized when the previously taxed income is distributed; rather, those tax benefits shall be recognized as a reduction of income tax expense in the period that the tax credits are included in the entity’s tax return.

25-41 The accounting required in the preceding paragraph may differ in the consolidated financial statements of a parent that includes a foreign subsidiary that receives a tax credit for dividends paid, if the parent expects to remit the subsidiary’s earnings. Assume that the parent has not availed itself of the exception for foreign unremitted earnings that may be available under paragraph 740-30-25-17. In that case, in the consolidated financial statements of a parent, the future tax credit that will be received when dividends are paid and the deferred tax effects related to the operations of the foreign subsidiary shall be recognized based on the distributed rate because, as assumed in that case, the parent is not applying the indefinite reversal criteria exception that may be available under that paragraph. However, the undistributed rate shall be used in the consolidated financial statements to the extent that the parent has not provided for deferred taxes on the unremitted earnings of the foreign subsidiary as a result of applying the indefinite reversal criteria recognition exception.

25-50 The tax basis of an asset is the amount used for tax purposes and is a question of fact under the tax law. An asset’s tax basis is not determined simply by the amount that is depreciable for tax purposes. For example, in certain circumstances, an asset’s tax basis may not be fully depreciable for tax purposes but would nevertheless be deductible upon sale or liquidation of the asset. In other cases, an asset may be depreciated at amounts in excess of tax basis; however, such excess deductions are subject to recapture in the event of sale.

As discussed in Section 3.3.1, a temporary difference is a difference between the financial reporting basis and the income tax basis, determined in accordance with the recognition and measurement criteria of ASC 740, of an asset or liability that will result in a taxable or deductible item in future years when the financial reporting basis of the asset or liability is recovered or settled, respectively. Once the temporary difference is determined, an entity should determine the amount at which the DTAs and DTLs should be measured (see Section 3.3.4). Measurement of temporary differences involves identification of the financial reporting carrying value and tax basis as well as consideration of the level of uncertainty regarding each position taken by the entity.

3.3.3.1 Tax Bases Used in the Computation of Temporary Differences

The tax bases of assets and liabilities used to compute temporary differences as well as loss and tax credit carryforwards may not necessarily be consistent with information contained in as-filed tax returns or the schedules used to prepare such returns. Instead, such tax bases and carryforwards are computed on the basis of amounts that meet the recognition threshold of ASC 740 and are measured in accordance with ASC 740. That is, for financial reporting purposes, income tax assets and liabilities, including DTAs and DTLs, are computed on the basis of what might be characterized as a “hypothetical ASC 740 tax return,” which may reflect tax bases of (1) assets and liabilities and (2) tax loss and credit carryforwards that may not be consistent with the as-filed tax return. See Chapter 4 for details.

3.3.3.2 Anticipation of Future Losses

ASC 740-10-25-38 states, in part, that in the determination of whether a basis difference is a taxable or deductible temporary difference, “the anticipation of the tax consequences of future tax losses is prohibited.” Therefore, an entity is not permitted to anticipate the tax consequences of future tax losses when measuring temporary differences and deferred tax consequences of existing taxable temporary differences.

Under such circumstances, a DTL established in the initial period in which future losses are expected would be eliminated in subsequent years when the tax losses are actually incurred. Therefore, under ASC 740, an entity that expects not to pay income taxes in the future because of expected tax losses is prohibited from avoiding recognition of a DTL for the tax consequences of taxable temporary differences that exist as of the balance sheet date.

As the complexity of an entity’s legal structure and jurisdictional footprint increases, so do the challenges with measuring tax assets and liabilities. Consultation with tax and accounting advisers is encouraged in these situations.

3.3.3.3 Tax Basis That Adjusts in Accordance With or Depends on a Variable

In some situations, an item’s tax basis may adjust in accordance with an outside factor, or it may depend on a variable that may or may not be within the entity’s control. For example, an item’s tax basis might only be deductible for tax purposes if a certain event occurs (such as holding the associated asset for a specific period), or the tax basis may change in conformity with the sales price of the asset if sold. Under ASC 740-10-25-20, there is an inherent assumption in an entity’s statement of financial position that the reported amounts of assets and liabilities will be recovered or settled, respectively, at their carrying values. This principle is applied even if there are certain indicators, such as the fair value of the related balance, that will permit the asset or liability to be recovered or settled, respectively, above or below the carrying value. In these instances, the tax basis and corresponding temporary difference should generally be determined as of the balance sheet date if the asset or liability was recovered at carrying value. The example below demonstrates the tax accounting implications associated with that assumption.

Example 3-1

Entity A constructs a building in Jurisdiction U, which permits entities to claim depreciation deductions for tax purposes. In addition, the tax law in the jurisdiction requires entities to determine the gain or loss upon the sale of a qualifying building as follows:

Sales price greater than original cost — The tax basis of the building is restored to original cost on sale if the selling price exceeds the original cost, and any resulting gain is recognized as a capital gain instead of an ordinary gain.
Sales price between the adjusted tax basis and original cost — No taxable gain or loss results if the selling price is between the adjusted tax basis and the original cost.
Sales price less than the adjusted tax basis — If the sales price is less than the building’s adjusted tax basis, the resulting loss is recognized as a capital loss instead of an ordinary loss.

On December 31, 20X1, A’s building is classified as held for sale under ASC 360-10-45-9. The temporary difference and deferred tax position should be determined as if the asset will be recovered at its book basis as of the reporting date. ASC 740-10-25-20 requires an entity to assume that the carrying value of the asset will be recovered (i.e., any current marketplace conditions should not be factored into the assessment of the asset’s tax basis). Accordingly, even if the current fair value of the property exceeds the original cost (which would indicate that a future sales price exceeds the original cost, potentially triggering complete restoration of the basis to original cost), the temporary difference should still be analyzed as of the balance sheet date as if the sales price were the carrying value of the asset. A DTA or reduction of a DTL resulting from the potential restoration of basis would not be recognized.

3.3.4 Measurement of Deferred Taxes

ASC 740-10

General

30-1 This Section provides guidance on the measurement of total income tax expense. While most of this guidance focuses on the initial measurement of deferred tax assets and liabilities, including determining the appropriate tax rate to be used, the requirements for measuring current taxes payable or refundable are also established. This guidance also addresses the consideration and establishment of a valuation allowance for deferred tax assets. Requirements for entities that issue separate financial statements and are part of a group that files a consolidated tax return are also established in this Section.

Basic Requirements

30-2 The following basic requirements are applied to the measurement of current and deferred income taxes at the date of the financial statements:

The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated.
The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.

30-3 Total income tax expense (or benefit) for the year is the sum of deferred tax expense (or benefit) and income taxes currently payable or refundable.

Deferred Tax Expense (or Benefit)

30-4 Deferred tax expense (or benefit) is the change during the year in an entity’s deferred tax liabilities and assets. For deferred tax liabilities and assets recognized in a business combination or in an acquisition by a not-for-profit entity during the year, it is the change since the acquisition date. Paragraph 830-740-45-1 addresses the manner of reporting the transaction gain or loss that is included in the net change in a deferred foreign tax liability or asset when the reporting currency is the functional currency.

Pending Content (Transition Guidance: ASC 805-60-65-1)

30-4 Deferred tax expense (or benefit) is the change during the year in an entity’s deferred tax liabilities and assets. For deferred tax liabilities and assets recognized in a business combination or in an acquisition by a not-for-profit entity during the year, it is the change since the acquisition date. For deferred tax liabilities and assets recognized by a corporate joint venture upon formation, during the year that includes the formation date, it is the change since the formation date. Paragraph 830-740-45-1 addresses the manner of reporting the transaction gain or loss that is included in the net change in a deferred foreign tax liability or asset when the reporting currency is the functional currency.

30-5 Deferred taxes shall be determined separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction. That determination includes the following procedures:

Identify the types and amounts of existing temporary differences and the nature and amount of each type of operating loss and tax credit carryforward and the remaining length of the carryforward period.
Measure the total deferred tax liability for taxable temporary differences using the applicable tax rate (see paragraph 740-10-30-8).
Measure the total deferred tax asset for deductible temporary differences and operating loss carryforwards using the applicable tax rate.
Measure deferred tax assets for each type of tax credit carryforward.
Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. The valuation allowance shall be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.

Income Taxes Payable or Refundable (Current Tax Expense [or Benefit])

30-6 Income taxes payable or refundable (current tax expense [or benefit]) are determined under the recognition and measurement requirements for tax positions established in paragraph 740-10-25-2 for recognition and in this Section for measurement.

30-7 A tax position that meets the more-likely-than-not recognition threshold shall initially and subsequently be measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. Measurement of a tax position that meets the more-likely-than-not recognition threshold shall consider the amounts and probabilities of the outcomes that could be realized upon settlement using the facts, circumstances, and information available at the reporting date. As used in this Subtopic, the term reporting date refers to the date of the entity’s most recent statement of financial position. For further explanation and illustration, see Examples 5 through 10 (paragraphs 740-10-55-99 through 55-116).

Applicable Tax Rate Used to Measure Deferred Taxes

30-8 Paragraph 740-10-10-3 establishes that the objective is to measure a deferred tax liability or asset using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized. Deferred taxes shall not be accounted for on a discounted basis.

30-9 Under tax law with a graduated tax rate structure, if taxable income exceeds a specified amount, all taxable income is taxed, in substance, at a single flat tax rate. That tax rate shall be used for measurement of a deferred tax liability or asset by entities for which graduated tax rates are not a significant factor. Entities for which graduated tax rates are a significant factor shall measure a deferred tax liability or asset using the average graduated tax rate applicable to the amount of estimated annual taxable income in the periods in which the deferred tax liability or asset is estimated to be settled or realized. See Example 16 (paragraph 740-10-55-136) for an illustration of the determination of the average graduated tax rate. Other provisions of enacted tax laws shall be considered when determining the tax rate to apply to certain types of temporary differences and carryforwards (for example, the tax law may provide for different tax rates on ordinary income and capital gains). If there is a phased-in change in tax rates, determination of the applicable tax rate requires knowledge about when deferred tax liabilities and assets will be settled and realized.

30-10 In the U.S. federal tax jurisdiction, the applicable tax rate is the regular tax rate, and a deferred tax asset is recognized for alternative minimum tax credit carryforwards in accordance with the provisions of paragraph 740-10-30-5(d) through (e).

30-11 The objective established in paragraph 740-10-10-3 relating to enacted tax rate(s) expected to apply is not achieved through measurement of deferred taxes using the lower alternative minimum tax rate if an entity currently is an alternative minimum tax taxpayer and expects to always be an alternative minimum tax taxpayer. No one can predict whether an entity will always be an alternative minimum tax taxpayer. Furthermore, it would be counterintuitive if the addition of alternative minimum tax provisions to the tax law were to have the effect of reducing the amount of an entity’s income tax expense for financial reporting, given that the provisions of alternative minimum tax may be either neutral or adverse but never beneficial to an entity. It also would be counterintuitive to assume that an entity would permit its alternative minimum tax credit carryforward to expire unused at the end of the life of the entity, which would have to occur if that entity was always an alternative minimum tax taxpayer. Use of the lower alternative minimum tax rate to measure an entity’s deferred tax liability could result in understatement for either of the following reasons:

It could be understated if the entity currently is an alternative minimum tax taxpayer because of temporary differences. Temporary differences reverse and, over the entire life of the entity, cumulative income will be taxed at regular tax rates.
It could be understated if the entity currently is an alternative minimum tax taxpayer because of preference items but does not have enough alternative minimum tax credit carryforward to reduce its deferred tax liability from the amount of regular tax on regular tax temporary differences to the amount of tentative minimum tax on alternative minimum tax temporary differences. In those circumstances, measurement of the deferred tax liability using alternative minimum tax rates would anticipate the tax benefit of future special deductions, such as statutory depletion, which have not yet been earned.

30-12 If alternative tax systems exist in jurisdictions other than the U.S. federal jurisdiction, the applicable tax rate is determined in a manner consistent with the tax law after giving consideration to any interaction (that is, a mechanism similar to the U.S. alternative minimum tax credit) between the two systems.

Effect of Anticipated Future Special Deductions and Tax Credits on Deferred Tax Rates

Anticipated Future Special Deductions

30-13 As required by paragraph 740-10-25-37, the tax benefit of special deductions ordinarily is recognized no earlier than the year in which those special deductions are deductible on the tax return. However, some portion of the future tax effects of special deductions are implicitly recognized in determining the average graduated tax rate to be used for measuring deferred taxes when graduated tax rates are a significant factor and the need for a valuation allowance for deferred tax assets. In those circumstances, implicit recognition is unavoidable because those special deductions are one of the determinants of future taxable income and future taxable income determines the average graduated tax rate and sometimes determines the need for a valuation allowance.

Anticipated Future Tax Credits

30-14 Paragraph 740-10-25-39 notes that certain foreign jurisdictions may tax corporate income at different rates depending on whether that income is distributed to shareholders. Paragraph 740-10-25-40 addresses recognition of future tax credits that will be realized when the previously taxed income is distributed. Under these circumstances, the entity shall measure the tax effects of temporary differences using the undistributed rate.

30-15 As noted in paragraph 740-10-25-41, the accounting required in the consolidated financial statements of a parent that includes a foreign subsidiary that receives a tax credit for dividends paid may differ from the accounting required for the subsidiary. See that paragraph for the rates required to be used to measure deferred income taxes in such consolidated financial statements.

Related Implementation Guidance and Illustrations

Alternative Minimum Tax [ASC 740-10-55-31].
Example 14: Phased-In Change in Tax Rates [ASC 740-10-55-129].
Example 15: Change in Tax Rates [ASC 740-10-55-131].
Example 16: Graduated Tax Rates [ASC 740-10-55-136].
Example 18: Special Deductions [ASC 740-10-55-145].

ASC 740-10-30-8 states that a DTL or DTA should be measured by “using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.”

ASC 740-10-55-23 states, in part:

The tax rate or rates . . . 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.

Determining the tax rate to apply to certain types of temporary differences and carryforwards may not always be straightforward.

3.3.4.1 Graduated Tax Rates

ASC 740-10-30-9 states that the single flat tax rate “shall be used for measurement of a deferred tax liability or asset by entities for which graduated tax rates are not a significant factor.” Entities that typically pay tax at the highest graduated tax rates will not find such rates a significant factor in determining the rate used for measuring DTAs and DTLs. However, for some entities, graduated tax rate structures, such as those found in the tax laws of many states and other tax jurisdictions, may affect the determination of the applicable tax rate used to measure deferred tax consequences under ASC 740.

ASC 740-10-30-9 further states that “[e]ntities for which graduated tax rates are a significant factor shall measure a deferred tax liability or asset using the average graduated tax rate applicable to the amount of estimated annual taxable income in the periods in which the deferred tax liability or asset is estimated to be settled or realized.” When determining whether graduated tax rates are significant and, consequently, the applicable tax rate for measuring DTAs and DTLs, an entity must, at least notionally, estimate future taxable income for the year(s) in which existing temporary differences or carryforwards will enter into the determination of income tax. That notional estimate begins with pretax accounting income adjusted for permanent differences and the reversal of existing taxable and deductible temporary differences. Further, projections of future income should be consistent with projections made elsewhere by the entity. The example below illustrates the measurement of DTAs and DTLs when graduated tax rates are a significant factor.

Example 3-2

Assume the following:

At the end of 20X1, Entity X, which operates in a single tax jurisdiction, has $30,000 of deductible temporary differences, which are expected to result in tax deductions of approximately $10,000 for each of the next three years: 20X2–20X4.
Historically, the tax jurisdiction’s graduated tax rate structure has affected the determination of X’s income tax liability.
The graduated tax rates in the tax jurisdiction are as follows:
Entity X’s estimate of pretax income for each of years 20X2–20X4 is $410,000, $110,000, and $60,000, respectively, excluding reversals of temporary differences.

Estimated taxable income and estimated income taxes payable for those years are computed as follows:

Entity X’s average applicable tax rate is 23.8 percent, or ($3,400 + $2,230 + $1,500) ÷ $30,000. Therefore, X recognizes a DTA of $7,130 ($30,000 × 23.8%) at the end of 20X1. A valuation allowance would be recognized if realization of all or a portion of the DTA does not meet the more-likely-than-not recognition threshold in ASC 740.

If, after initially recording the DTA or DTL, X changes its estimate of the applicable tax rate because of changes in its estimate of taxable income in some future year, the effect of such a change in the estimated applicable tax rate should be included in income from continuing operations in the period of the change in estimate.

If X’s estimate of taxable income for 20X2 to 20X4 was $335,000 to $10 million per year, the amount of income tax liability would not be affected by the graduated rate structure and, therefore, X may not be required to estimate amounts and periods over which existing temporary differences will reverse. In this situation, X would measure the DTA at the 34 percent rate.

3.3.4.1.1 Measurement When Future Tax Losses Are Expected in a Graduated Tax Rate Structure

If tax losses that would otherwise expire unused are expected in future years, an entity would use the lowest tax rate in a graduated tax structure, rather than zero, to measure a DTL for tax consequences of taxable temporary differences. The example below illustrates the measurement of the deferred tax consequences of taxable temporary differences when tax losses are expected in future years.

Example 3-3

Assume that Entity X has $200,000 of taxable temporary differences at the end of 20X1 that will reverse in 20X2 and that the enacted statutory tax rate is as follows:

In addition, assume that (1) X expects to incur a tax loss of $500,000 next year that includes the reversal of taxable temporary differences and (2) the loss will expire unused because loss carrybacks and carryforwards are prohibited under tax law. At the end of 20X1, X would record a DTL of $20,000 ($200,000 × 10%) because the lowest tax rate of 10 percent, rather than a zero tax rate, is used to measure the deferred tax consequences of the existing taxable temporary differences if losses are expected in future years and those losses are expected to expire unused.

Assume that X’s expectations about the future are correct and that, during 20X2, it incurs a substantial loss carryforward that expires unused. At the end of 20X2, X would eliminate the $20,000 DTL established at the end of 20X1 and would record a corresponding credit as a component of income tax expense (benefit) from continuing operations for 20X2 (i.e., the DTL eliminated in the loss year is the tax benefit recognized as a result of the loss in continuing operations that will not be carried back).

3.3.4.1.2 Anticipation of Future Special Deductions in a Graduated Tax Rate Structure

An entity is not permitted to anticipate tax benefits for special deductions when measuring the DTL for taxable temporary differences at the end of the current year. ASC 740-10-25-37 requires the “tax benefit of special deductions ordinarily [to be] recognized no earlier than the year in which those special deductions are deductible on the tax return.” However, the future tax effects of special deductions may nevertheless affect (1) “the average graduated tax rate to be used for measuring deferred taxes when graduated tax rates are a significant factor” and (2) “the need for a valuation allowance for deferred tax assets.” ASC 740-10-25-37 states, in part, that “[i]n those circumstances, implicit recognition is unavoidable because those special deductions are one of the determinants of future taxable income and future taxable income determines the average graduated tax rate and sometimes determines the need for a valuation allowance.”

Example 3-4

Measurement of Existing Temporary Differences When Special Deductions Are Anticipated and the Average Graduated Tax Rate to Be Used Is a Significant Factor

Assume the following:

Entity X is measuring the deferred tax consequences of an existing $300,000 taxable temporary difference at the end of 20X1 that is expected to reverse and enter into X’s determination of taxable income in 20X2.
Entity X is considered a small life insurance company under the tax law and is entitled to a special deduction that is equal to 60 percent of taxable income before the special deduction.
Under tax law, income is taxed at the following rates:

The following table illustrates how X determines the DTL at the end of 20X1 in each of three independent scenarios in which taxable income (loss) is expected in 20X2:

Measurement of the deferred tax consequences of a taxable temporary difference does not reflect any tax benefit for future special deductions unless graduated tax rates are a factor that is significant in the measurement of an entity’s tax liability. If graduated tax rates are significant, a portion of the benefit of a special deduction will be recognized through a reduction of the average graduated tax rate used to measure the tax consequences of taxable temporary differences.

3.3.4.2 Phased-In Changes in Tax Rates

A phased-in change in tax rates occurs when an enacted law specifies that the tax rate applied to taxable income will change in future periods. One of the more significant phased-in changes occurred under the U.S. federal tax law enacted in 1986, which stipulated that the corporate tax rate would be 46 percent in 1986, 40 percent in 1987, and 34 percent in 1988 and thereafter.

ASC 740-10-55-129 and 55-130 illustrate the measurement of a DTL for the tax consequences of taxable temporary differences when there is a phased-in change in tax rates under three different scenarios: (1) when future income is expected, (2) when future losses are expected, and (3) when taxable income in years after expected loss years is expected to be offset by tax loss carryforwards.

3.3.4.2.1 Measurement When Contingent Phased-In Changes in Tax Rates Are Enacted

In certain jurisdictions, the change in tax rates may be contingent on an event outside an entity’s control. ASC 740 does not provide guidance on determining what rate to use when there is more than one possible rate and this determination is contingent on events that are outside an entity’s control. Therefore, entities in jurisdictions in which a phased-in change in tax rates is enacted will need to establish a policy (see alternative approaches below) for determining the rate to be used in measuring DTAs and DTLs. This policy should be consistently applied and contain proper documentation of the scheduling of DTAs and DTLs, the basis for judgments applied, and the conclusions reached.

The example below illustrates a jurisdiction in which there is more than one possible rate and the change in tax rates is contingent on an event outside the entity’s control.

Example 3-5

In March 2008, the State of West Virginia legislature passed a bill (S.B. 680) to provide business tax relief over future years in the form of phased-in reductions in the corporate net income tax (CNIT) rate. The rate reduction schedule was as follows:

With the exception of the rate reduction in 2009, the rate reductions can be suspended or reversed if the state’s rainy day funds fall below 10 percent of the state’s general revenue budget as of the preceding June 30 (the “10 percent test”). For example, if the 10 percent test is not passed on June 30, 2011, the 7.75 percent rate reduction is suspended until the test is passed in a subsequent year. The suspension (and any subsequent suspension) continues until the 10 percent test is passed, and then the rate reduction will occur on the following January 1. The 10 percent test continues on an annual basis after January 1, 2014, and if the test is not passed, the rate will remain 7.75 percent until the test is again passed.

The following are two alternative approaches, based on this example, that an entity might use to determine the applicable tax rate in any given year:

Alternative 1

An entity might view the phased-in rate reduction as being similar to a graduated tax rate or, alternatively, as an exemption from a graduated tax rate. (For examples illustrating graduated tax rates, see ASC 740-10-55-136 through 55-138.) Under ASC 740, when a tax jurisdiction has a two-rate schedule, an entity should determine whether the graduated rates have a material effect and, if so, should forecast its future income to determine which rate to apply to its taxable temporary differences. In the above example, the entity would need to assess whether the 10 percent test will be passed to determine its future rate by period.

An entity should have sufficient documentation regarding its assessment of whether the 10 percent test will be met in future periods (e.g., consideration of the state’s budget forecasts, spending levels, anticipated needs for rainy day funds), since this is the basis under law for applying the lower of two applicable tax rates in any given year.

Alternative 2

An entity might establish a policy to use the highest enacted rate potentially applicable for a future period as the applicable rate until the contingency is resolved (i.e., the 10 percent test is passed). The lower rate would be applied only to DTAs and DTLs for which the associated liability is expected to be settled or asset recovered in that one period, because an assumption that subsequent 10 percent tests will be passed for those future periods would be inappropriate.

3.3.4.3 Tax Rate Used in Measuring Receivables and DTAs Related to Operating Losses and Tax Credits

In measuring temporary differences and certain tax attributes, entities should pay close attention to the appropriate tax rate to be used. For example, operating losses and some tax credits that arise but are not used in the current year may be carried back to recover taxes paid in prior years or carried forward to reduce taxes payable in future years. An entity usually first considers whether an operating loss or tax credit may be carried back to recover taxes paid in previous years. If the entity intends to carry back an operating loss or tax credit, it recognizes a receivable (current tax benefit) for the amount of taxes paid in prior years that is refundable by carryback of a current-year operating loss or tax credit. The entity measures the current income tax receivable by using the rate applicable to the prior year(s) for which the refund is being claimed.

The entity then carries forward any remaining NOL or tax credit to reduce future taxes payable. NOL and tax credit carryforwards are recognized as DTAs in the period in which they arise. In accordance with ASC 740-10-10-3, the entity measures such DTAs by “using the enacted tax rate(s) expected to apply to taxable income in the periods in which” the DTAs are expected to be realized. (See Section 3.3.4.1 for guidance on determining the applicable tax rate when an entity operates in a jurisdiction with graduated tax rates.) For details on determining whether a valuation allowance is needed, see Chapter 5.

Example 3-6

In the current year, Entity A has pretax book income of $2,000 and $2,500 of current-year deductions that give rise to future taxable temporary differences; a tax loss of $500 is therefore created. Also in the current year, the statutory rate was scheduled to increase from 35 percent to 40 percent. Assume that A plans to elect to carry back the tax loss, which is allowable under the local tax law.

In this example, the applicable tax rate would be the enacted rate for the year the loss is carried back to. In the current year, A would measure the taxable temporary difference related to the $2,000 current-year deductions at 40 percent, since the temporary difference will reverse after the statutory tax rate has increased to 40 percent, and measure the receivable related to the NOL of $500 at 35 percent, since A would carry back the $500 loss to offset prior-year income taxed at 35 percent.

3.3.4.4 Measuring Deferred Taxes on Indefinite-Lived Assets

Under ASC 350, an intangible asset whose life extends beyond the foreseeable horizon is classified as having an indefinite life (“indefinite-lived intangible asset”). An indefinite-lived intangible asset is not amortized for financial reporting purposes until its useful life is determined to be no longer indefinite. However, the applicable tax law may allow or require such assets to be amortized. Since the amortization is deductible in the determination of taxable income, a temporary difference arises between the financial reporting carrying value and the tax basis of indefinite-lived intangible assets.

An entity would recognize deferred taxes for a temporary difference related to an indefinite-lived asset (e.g., land and indefinite-lived intangible assets). Although the tax effect related to these items may be delayed indefinitely, the ability to do so is not a factor in the determination of whether a temporary difference exists.

ASC 740-10-25-20 states, in part:

An assumption inherent in an entity’s statement of financial position prepared in accordance with generally accepted accounting principles (GAAP) is that the reported amounts of assets and liabilities will be recovered and settled, respectively. Based on that assumption, a difference between the tax basis of an asset or a liability and its reported amount in the statement of financial position will result in taxable or deductible amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled.

Further, ASC 740-10-55-63 addresses this issue, stating that “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.”

Certain jurisdictions may impose a tax rate for ordinary income that is different from the tax rate for income that is capital (i.e., capital gains). In those instances, ASC 740 does not provide specific guidance on how to determine which tax rate (i.e., ordinary or capital) is “expected” to apply in the future.

Unlike depreciable or amortizable assets, which are presumed to be recovered through future revenues, indefinite-lived intangible assets are not presumed to decline in value (i.e., they are not expected to be consumed over time). However, as noted in ASC 350-30-35-4, the “term indefinite does not mean the same as infinite or indeterminate.” Further, entities are required to evaluate the remaining useful life of indefinite-lived intangible assets during each reporting period; when an intangible asset’s useful life is no longer considered indefinite, the carrying value of the asset must be amortized. When an indefinite-lived intangible asset becomes finite-lived, it is generally presumed that the asset will be recovered through future revenues.

Therefore, in jurisdictions in which the ordinary tax rate and capital gains tax rate differ, entities should determine, on the basis of their specific facts and circumstances, the expected manner of recovery of the carrying value of indefinite-lived intangible assets (e.g., through sale or eventual consumption when the asset becomes finite-lived). The tax rate used to measure deferred taxes for indefinite-lived intangible assets should be consistent with the expected manner of recovery. For example, if an entity determines that the expected manner of recovery is through sale of the indefinite-lived intangible asset, the entity should use the capital gains tax rate in measuring deferred taxes related to that asset.

See Section 5.3.1.3 for guidance on whether an entity can use the reversal of a DTL related to an indefinite-lived asset as a source of taxable income to support the realization of DTAs.

3.3.4.5 Effect of Tax Holidays on the Applicable Tax Rate

ASC 740-10

25-35 There are tax jurisdictions that may grant an entity a holiday from income taxes for a specified period. These are commonly referred to as tax holidays. An entity may have an expected future reduction in taxes payable during a tax holiday.

25-36 Recognition of a deferred tax asset for any tax holiday is prohibited because of the practical problems in distinguishing unique tax holidays (if any exist) for which recognition of a deferred tax asset might be appropriate from generally available tax holidays and measuring the deferred tax asset.

When a tax jurisdiction grants an exemption from tax on income that would otherwise give rise to an income tax obligation, the event is sometimes referred to as a tax holiday. In most jurisdictions that offer tax holidays, the benefit is available to any entity that qualifies for the holiday (similarly to the election of S corporation status under U.S. federal tax law). For other jurisdictions, tax holidays may involve a requirement that is controlled by the entity. For example, the jurisdiction may, for economic reasons, waive income taxes for a given period if an entity constructs a manufacturing facility located within the jurisdiction.

In accordance with ASC 740-10-25-35 and 25-36, recognition of a DTA to reflect the fact that an entity will not be paying taxes for the period of the tax holiday is prohibited. However, an entity’s use of a rate that reflects the tax holiday to record a DTA or DTL for temporary differences scheduled to reverse during the period of the tax holiday does not violate the “[r]ecognition of a deferred tax asset for any tax holiday is prohibited” language of ASC 740-10-25-36. Rather, in such circumstances, a DTL or DTA is merely reduced from one computed at the statutory tax rate as if a tax holiday did not apply to one computed at the statutory tax rate that is in effect during a tax holiday. The example below illustrates the accounting for the tax benefits of a tax holiday.

Example 3-7

Assume that at the end of 20X1, an entity operates in a tax jurisdiction with a 50 percent tax rate and that $1,000 of a total of $2,000 of taxable temporary differences will reverse during years in which that jurisdiction grants the entity an unconditional tax holiday at a zero tax rate. Therefore, a DTL of $500 ($1,000 × 50%) would be recognized in the entity’s balance sheet at the end of 20X1. Further assume that in 20X2, a year covered by the tax holiday, the entity generates $3,000 of taxable income in that jurisdiction and that $1,000 of taxable temporary differences reversed, as expected. During 20X2, the entity would make no adjustment to its DTL (because the taxable temporary difference reversed as expected) and no current tax payable or current tax expense would be recognized for the taxable income generated during 20X2. Note that SAB Topic 11.C would require disclosures about the effects of the tax holiday.

3.3.4.6 Consideration of Certain State Matters

An entity should consider the three factors below when (1) determining the enacted tax rate that is expected to apply in periods in which the DTAs or DTLs are expected to be recovered or settled and (2) measuring DTAs and DTLs in U.S. state income tax jurisdictions.

3.3.4.6.1 State Apportionment

In the measurement of DTAs and DTLs for U.S. state income tax jurisdictions, state apportionment factors are part of the computation. State apportionment factors are used to allocate taxable income to various states and are determined in accordance with the income tax laws of each state. The factors are typically based on the percentage of sales, payroll costs, and assets attributable to a particular state. Apportionment factors are not tax rates, but because entities must consider them in determining the amount of income to apportion to an individual state, they play a large role in the measurement of an entity’s state DTAs and DTLs. The applicable state deferred tax rate is the product of the applicable apportionment factor and the enacted state tax rate (i.e., the expected apportionment factor × state tax rate = applicable state deferred tax rate). To calculate the state DTA or DTL, an entity multiplies the applicable state deferred tax rate by the temporary difference.

Since it is not uncommon for states to revise their apportionment rules, an entity should consider enacted changes in tax law when measuring deferred taxes. The apportionment factors generally should be those that are expected to apply when the asset or liability underlying the temporary difference is recovered or settled on the basis of existing facts and circumstances and enacted tax law. Further, an entity should assume that temporary differences will reverse in tax jurisdictions in which the related assets or liabilities are subject to tax and therefore should apply the enacted tax rate for that particular state when measuring deferred state taxes (i.e., when measuring the related DTA or DTL, an entity should not assume that taxable or deductible amounts related to temporary differences will be shifted to a different tax jurisdiction through future intra-entity transactions).

The entity could use actual apportionment factors for recent years, adjusted for any expected changes either in the business activities in that state or to reflect already enacted tax laws for that jurisdiction, as a reasonable estimate when measuring deferred taxes. Expected changes, such as a business combination or the disposition of a long-lived asset, should not be reflected in the apportionment factors until they are recognized in the financial statements.

While expected changes are generally not reflected in apportionment factors until they are recognized in the financial statements, if an entity has decided to sell long-lived assets and the held-for-sale criteria in ASC 360-10-45-9 have been met, the entity must consider the future sale when (1) accounting for outside basis difference DTAs and DTLs and (2) anticipating income from the sale of those assets as part of evaluating the realizability of DTAs for valuation purposes (see Sections 3.4.17.2 and 5.3.1.3). Therefore, in a manner consistent with other principles in ASC 740 on accounting for deferred taxes, once the held-for-sale classification is reflected in the entity’s financial statements, we believe that it would be acceptable for an entity to also anticipate the sale of long-lived assets classified as held for sale when estimating the state apportionment factor. Similarly, it would also be acceptable to adjust apportionment factors to reflect planned internal restructuring activities in the period in which the entity has committed to a restructuring plan, all remaining steps to complete the plan are within the entity’s control, and there are no regulatory hurdles or other significant uncertainties that need to be overcome for the restructuring to be completed. That is, the remaining steps to effectuate the internal restructuring do not depend on events or actions outside the reporting entity’s control.

3.3.4.6.2 Optional Future Tax Elections

States may enact changes to the tax rate or apportionment factor that can be implemented through a tax election that is available for tax purposes only in periods after the reporting date. If the entity expects that it will make the election, it should consider the election when measuring its DTAs and DTLs. ASC 740-10-55-23 states, in part:

Measurements [of DTAs and DTLs] 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. [Emphasis added]

ASC 740-10-45-15 requires that a change in tax law that gives rise to a change in the measurement of DTAs and DTLs (such as a change in the apportionment rules) be reflected in the period that includes the enactment date. For example, a state may change its tax law to allow a taxpayer to elect to apportion income on the basis of a single-sales factor election. If an entity expects to make the single-factor election, it must recognize, in the interim or annual period that includes the enactment date, the effect that the election will have on the amount of the DTA or DTL relative to the temporary differences expected to reverse in years in which the election is effective. Any tax effect is included in income from continuing operations (see Chapter 6 for intraperiod allocation guidance).

3.3.4.6.3 Use of a Blended Rate to Measure Deferred Taxes

Deferred taxes ordinarily must be determined separately for each tax-paying component2 in each tax jurisdiction. However, in practice, some entities employ a “blended-rate” approach in measuring deferred taxes at the legal-entity level. Such an approach may simplify the ASC 740 calculation for entities operating in multiple jurisdictions (e.g., operating in multiple U.S. states).

ASC 740-10-55-25 states:

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.

An entity should use significant judgment and continually assess whether it is acceptable to use a blended-rate approach in light of (1) the considerations in ASC 740-10-55-25, among others, and (2) the specific facts and circumstances. For example, a change in circumstances in one of the jurisdictions from one year to the next (e.g., a nonrecurring event or a change in tax rate) may result in a conclusion that the use of a blended rate is unacceptable.

In all cases, the results of using a blended-rate approach should not be materially different from the results of separately determining deferred taxes for each tax-paying component in each tax jurisdiction.

3.3.4.7 Determining the Applicable Tax Rate When Different Rates Apply to Distributed and Undistributed Earnings

Certain tax jurisdictions might allow for different tax rates on ordinary income and capital gains, while others may allow for different tax rates depending on whether earnings are distributed (dual-rate jurisdictions). Below are two examples of situations in which determining the applicable tax rate may be complex.

3.3.4.7.1 Distributed and Undistributed Earnings and Tax Credit on Distribution

Germany, under its prior laws, serves as an example of a jurisdiction in which corporate income is taxed at different rates depending on whether it is distributed to shareholders. ASC 740-10-25-39 states:

Certain foreign jurisdictions tax corporate income at different rates depending on whether that income is distributed to shareholders. For example, while undistributed profits in a foreign jurisdiction may be subject to a corporate tax rate of 45 percent, distributed income may be taxed at 30 percent. Entities that pay dividends from previously undistributed income may receive a tax credit (or tax refund) equal to the difference between the tax computed at the undistributed rate in effect the year the income is earned (for tax purposes) and the tax computed at the distributed rate in effect the year the dividend is distributed.

This example thus involves consideration of whether the distributed rate or the undistributed rate should be used to measure the tax effects of temporary differences.

ASC 740-10-30-14 (which applies only to the separate financial statements of an entity in the applicable jurisdiction and not the consolidated financial statements of the entity’s parent) states that an entity should use the undistributed rate to measure the tax effects of temporary differences. This is because it is appropriate for an entity to recognize the tax benefit from the future tax credit only when the entity had actually distributed assets to its shareholders and included the tax credit in its tax return. Recognizing the tax benefit before that point would constitute an overstatement of the entity’s assets and equity. This is similar to the accounting for a “special deduction” discussed in ASC 740-10-25-37 (see Section 3.2.1).

However, the rate to be used in the applicable jurisdiction by a parent in its consolidated financial statements is different from that used for the separate financial statements of the foreign subsidiary. Specifically, ASC 740-10-25-41 states, in part, that “in the consolidated financial statements of a parent, the future tax credit that will be received when dividends are paid and the deferred tax effects related to the operations of the foreign subsidiary shall be recognized based on the distributed rate,” as long as the parent is not applying the indefinite reversal criteria of ASC 740-30-25-17. The basis for ASC 740-10-25-41 is that the parent has the unilateral ability to require the foreign subsidiary to pay dividends and that the consolidated financial statements reflect all other tax effects of distributing earnings. In addition, the consolidated financial statements are intended to provide users with information regarding the total amount of net assets and liabilities available to creditors. Requiring an entity to provide additional taxes at the parent level on the basis of repatriation of earnings, but not to record the tax benefit associated with that repatriation, would result in an understatement of the assets available to creditors.

Conversely, ASC 740-10-25-41 states, in part, that the “undistributed rate shall be used in the consolidated financial statements to the extent that the parent has not provided for deferred taxes on the unremitted earnings of the foreign subsidiary as a result of applying the indefinite reversal criteria recognition exception.” This is consistent with ASC 740-30-25-14, which states, in part:

A tax benefit shall not be recognized . . . for tax deductions or favorable tax rates attributable to future dividends of undistributed earnings for which a deferred tax liability has not been recognized under the requirements of paragraph 740-30-25-18.

In other words, it would be inappropriate to record a tax benefit attributable to a distribution when all other tax effects of distributing these earnings have not been recorded.

3.3.4.7.2 Distributed Earnings and Deferral of Tax Payments

Unlike Germany, whose former tax law offers credits on distributed profits, Mexico’s former tax law enabled taxpayers to defer tax payments. Under this law, income taxes were assessed on current earnings at a rate of 35 percent. However, the law required current payment only on income taxes computed at a lower tax rate (e.g., 30 percent for the year 2000) of taxable income at the time the tax return was filed. The remaining payment of 5 percent was due to the government as dividend payments were made to the entity’s shareholders.

In this situation, an entity should use the tax rate of 35 percent to record taxes in its separate financial statements because the deferred tax amount represents an unavoidable liability for the company and the amount of that tax is not available for distribution to shareholders. ASC 740-10-25-3 addresses a similar situation — “policyholders’ surplus” of stock life insurance companies — that illustrates the need to accrue taxes at the higher rate.

3.3.4.8 Deferred Tax Measurement in Jurisdictions in Which an Income Measure Is Less Than Comprehensive

It is increasingly common for tax jurisdictions to assess tax on businesses on the basis of an amount computed as gross receipts less certain current-period deductions that are specifically identified by statute (“adjusted gross receipts”). The tax assessed on adjusted gross receipts may be in addition to, or in lieu of, a tax based on a comprehensive income measure. Individual tax jurisdictions that assess taxes on the basis of adjusted gross receipts typically define which entities are taxable, what constitutes gross receipts, and which deductions are permitted. In addition, an entity may have certain assets that do not appear to directly interact, or that only partially interact, with the adjusted gross receipts tax base.

Section 2.2 discusses (1) taxes that are based wholly or partially on gross receipts and (2) how to determine whether any part of the tax due under such a regime is within the scope of ASC 740. 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. If an entity determines that some portion of the future taxes payable will be within the scope of ASC 740, it must then determine how to measure its deferred taxes.

When applying the principles of ASC 740 to book and tax basis differences in these individual tax jurisdictions, an entity may encounter various complexities. Recovery and settlement of book assets and liabilities, respectively, with a tax basis that is different from their respective book carrying values will result in a subsequent-period tax consequence. Accordingly, an entity must apply the principles in ASC 740 carefully when assessing whether to recognize a DTL or DTA for the estimated future tax effects attributable to temporary differences. In doing so, an entity must determine whether there is:

A basis difference under ASC 740 for all or a portion of the book carrying value of assets and liabilities in the statement of financial position.
A temporary difference and, if so, whether it is a taxable or deductible temporary difference for which a DTA or DTL must be recognized.

Consider the following scenarios:

Scenario 1 — A tax jurisdiction permits raw material purchases to be deducted from gross receipts in the period in which the materials are acquired but prohibits any deduction for internal labor costs incurred in any period. At the end of the reporting period, the book carrying value of an entity’s inventory of $100 includes $80 of raw materials purchased from third parties and $20 of capitalized labor costs. Accordingly, the tax basis of the inventory is $0 at the end of the reporting period.
Scenario 2 — A tax jurisdiction prohibits deductions for acquired capital assets. The entity is permitted to compute the period taxable gross receipts on the basis of total revenues less either a cost of goods sold deduction, a compensation deduction, or 30 percent of total revenues. Accordingly, the tax basis of the entity’s property, plant, and equipment (PP&E) is $0 at the end of the reporting period.

In practice, there are two views on how an entity should recognize the DTL related to its inventory and PP&E book-versus-tax basis difference that exists at period-end.

Information from Scenario 1 above is used to illustrate the two views.

3.3.4.8.1 View 1 — Record Deferred Taxes on the Entire Book/Tax Basis Difference

At the end of the reporting period, the temporary difference related to the inventory is $100, for which a DTL would be recorded. This view is consistent with the presumption in ASC 740-10-25-20 that the reported amounts of assets and liabilities will be recovered and settled, respectively, and that basis differences will generally result in a taxable or deductible amount in some future period. Adjusted gross receipts will increase by $100 in the future when the inventory is recovered (i.e., sold) at its book carrying value. There will be no deduction for cost of sales because the $80 of material costs is deducted in the period in which the materials are acquired and no tax deduction is permitted in any period for labor-related costs.

As noted above, a premise underlying the application of ASC 740 is that all assets are expected to be recovered at their reported amounts in the statement of financial position. If that recovery will result in taxable income in a future period (or periods), the items represent a taxable temporary difference and DTLs should be recognized regardless of whether the nature of the asset recovery is by sale or use or represents an observable direct deduction from jurisdictional gross receipts.

3.3.4.8.2 View 2 — Record Deferred Taxes Only on Items That Will Enter Into the Measurement of Both Book and Taxable Income in a Current or Future Period

At the end of the reporting period, the temporary difference related to the inventory is $80, for which a DTL would be recorded because only $80 of the capitalized inventory costs is (or was) deductible for tax reporting purposes. The capitalized labor element of $20 represents a nondeductible basis difference between the financial statements and tax return (i.e., a “permanent” difference) because the tax jurisdiction does not permit entities to make any deductions for labor costs in computing the tax assessed.

3.3.4.9 Deferred Tax Treatment of Hybrid Taxes

In a hybrid tax regime, an entity pays the greater of two tax computations, one of which is typically based on taxable income and the other of which is not (e.g., it is based on gross revenue or capital). The tax rules and regulations of such a regime may state that an entity must always pay income tax but must also calculate taxes on the basis of the non-income-based measure(s). To the extent that the non-income-based measure or measures result in a larger amount, the entity would pay the difference between the income tax and the amount determined by using the non-income-based measure. This distinction may affect how the tax authority in the jurisdiction can use the tax revenue (e.g., income tax revenue may be used for general purposes, but the incremental tax may be earmarked for a specific purpose). The description of the amounts paid in the tax rules and regulations does not affect how a reporting entity determines the component of the hybrid taxes that is considered an income tax for accounting purposes.

An entity’s first step in making this distinction should be to carefully assess whether taxes due under a hybrid regime represent an income tax within the scope of ASC 740 or a non-income tax accounted for under other U.S. GAAP (see Section 2.5 which addresses scoping considerations for hybrid tax regimes). In a manner similar to assessing taxes based on adjusted gross receipts (see Section 3.3.4.8), if the entity determines that some portion of the future taxes payable will be within the scope of ASC 740, the entity must then decide how to measure its deferred taxes.

As discussed in ASC 740-10-10-3, the objective of measuring deferred taxes is to use “the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.” However, in a hybrid tax regime, because some component of an entity’s overall tax liability (even when the amount payable is determined as a percentage of taxable income) may be accounted for as a component of pretax income, questions have often arisen about the appropriate tax rate to use for measuring DTAs and DTLs. ASC 740-10-15-4(a) states that an entity should include in the tax provision the amount of tax that is based on income and should record any incremental amount as a tax that is not based on income. As a result, deferred taxes should, in a manner consistent with the objective of ASC 740-10-10-3, be recognized on the basis of “the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.”

3.3.4.10 Consideration of U.S. AMT Credit Carryforwards

ASC 740-10

25-42 The following guidance refers to provisions of the Tax Reform Act of 1986; however, it shall not be considered a definitive interpretation of the Act for any purpose.

25-43 The Tax Reform Act of 1986 established an alternative minimum tax system in the United States. Under the Act, an entity’s federal income tax liability is the greater of the tax computed using the regular tax system (regular tax) or the tax under the alternative minimum tax system. A credit (alternative minimum tax credit) may be earned for tax paid on an alternative minimum tax basis that is in excess of the amount of regular tax that would have otherwise been paid. With certain exceptions, the alternative minimum tax credit can be carried forward indefinitely and used to reduce regular tax, but not below the alternative minimum tax for that future year. The alternative minimum tax system shall be viewed as a separate but parallel tax system that may generate a credit carryforward. Alternative minimum tax in excess of regular tax shall not be viewed as a prepayment of future regular tax to the extent that it results in alternative minimum tax credits.

25-44 A deferred tax asset is recognized for alternative minimum tax credit carryforwards in accordance with the provisions of paragraphs 740-10-30-5(d) through (e).

The 2017 Act repealed corporate alternative minimum tax (AMT) for tax years beginning after December 31, 2017. Taxpayers with AMT credit carryforwards that have not yet been used may claim a refund in future years for those credits even though no income tax liability exists.

Connecting the Dots

On March 27, 2020, Congress enacted the CARES Act to help the nation respond to the COVID-19 pandemic. Among other significant business tax provisions, the CARES Act amends Section 53(e) of the 2017 Act so that beginning in 2018, all prior-year minimum tax credits are potentially available for refund for the first taxable year of a corporation. Companies should classify any remaining AMT credits on the balance sheet (i.e., current versus noncurrent asset) to reflect the timing of when those credits will be used. For further information about the CARES Act and the subsequent income tax accounting, see Deloitte’s April 9, 2020 (updated September 18, 2020), Heads Up. See also the next section, which discusses certain considerations for companies subject to the corporate AMT before the enactment of the CARES Act.

The Inflation Reduction Act includes a 15 percent corporate AMT on the “adjusted financial statement income” of applicable corporations, effective for taxable years beginning after December 31, 2022. The corporate AMT under the act is similar in many ways to the since-repealed, pre-2018 U.S. AMT system applicable to corporations. In addressing that system, ASC 740 specifies that “[i]n the U.S. federal tax jurisdiction, the applicable tax rate [for measuring US federal deferred taxes] is the regular tax rate.” It further notes that a DTA would be recognized for AMT credit carryforwards available under the system, which would then be assessed for realization. We believe that the corporate AMT under the Inflation Reduction Act should be accounted for in a similar manner. See Section 5.7.1 for a discussion of the potential interrelationship between the corporate AMT and the valuation allowance assessment.

Changing Lanes

In October 2021, more than 135 countries and jurisdictions agreed to participate in the OECD’s “two-pillar” international tax approach, which includes establishing a global minimum corporate tax rate of 15 percent. The OECD introduced the Pillar Two framework, which is designed to ensure that large multinational enterprises (MNEs) (i.e., with annual consolidated group revenues of at least 750 million euros) pay a minimum level of tax on the income arising in each jurisdiction in which they operate. Whether such global anti-base erosion (“GloBe") rules apply to a jurisdiction is determined on the basis of a jurisdictional ETR calculation in which the numerator is “adjusted covered taxes” and the denominator is “GloBe income.” The determination of adjusted covered taxes generally starts with “covered taxes,” which include the current tax expense and deferred tax expense of each constituent entity and is generally based on the parent’s financial reporting standard, adjusted for certain items. Meanwhile, GloBe income is derived from profit or loss, calculated under financial accounting standards, with specific GloBe adjustments.

The Pillar Two provisions are made up of two interrelated rules: the income inclusion rule (IIR) and the undertaxed profits rule (UTPR). The IIR is applied by a parent entity in an MNE group by using an ordering rule that generally gives priority to the application of the rule to the entities closest to the top in the chain of ownership (the “top-down”) approach. The top-down approach imposes a 15 percent tax for income generated in a low-tax jurisdiction. The UTPR applies to low-tax entities that are not subject to tax under an IIR, serving as a backstop to the IIR. Countries also have the option to adopt a qualified domestic minimum top-up tax (QDMTT). The QDMTT is credited against liability otherwise owed under an IIR or the UTPR so that the jurisdiction in which the income is generated is owed the tax.

Although the enactment date is determined on a jurisdictional basis, the IIR is set to be effective on January 1, 2024, and the UTPR in January 2025. Because of the significant impact this new framework will have on many organizations, the OECD released “Safe Harbours and Penalty Relief: Global Anti-Base Erosion Rules (Pillar Two),” which provides transitional country-by-country reporting and is intended to reduce the compliance burden of applying the full GloBE rules in the first few years of adoption (2024–2026).

Under U.S. GAAP, entities are required to adjust deferred tax accounts for the effect of a change in tax law or rates in the period of enactment. However, Pillar Two is based on financial accounting net income, with limited adjustments (GloBe income). In addition, Pillar Two is designed to be an incremental tax to ensure that entities are paying 15 percent of GloBe income on a jurisdictional basis. Whether incremental tax will be due under Pillar Two depends on future events, such as income earned or losses generated in a jurisdiction, permanent items, and a substance-based exclusion. As a result, an entity may not know whether it will always be required to remit an incremental tax under the Pillar Two rules. Thus, the characteristics of the Pillar Two rules are similar to those of the pre-2018 corporate AMT system for which guidance exists in ASC 740.

At the FASB’s February 1, 2023, meeting, the FASB staff announced that the global minimum tax imposed under the Pillar Two rules, as published by the OECD, is an AMT and that deferred taxes would not be recognized or adjusted for the effect of global minimum taxes that conform to the Pillar Two rules. As support for its conclusion, the FASB staff cited the guidance in ASC 740-10-30-10 and 30-12 as well as ASC 740-10-55-31 and 55-32. Accordingly, the incremental effects of the Pillar Two rules, once enacted, are expected to be accounted for as period costs (i.e., the increase in tax payable would be reflected in an entity’s financial statements only after a law is actually effective).

3.3.4.11 AMT Rate Not Applicable for Measuring DTLs

It is not appropriate for an entity subject to the U.S. federal tax jurisdiction, including Blue Cross/Blue Shield organizations or other entities subject to special deductions under the tax law, to use the 20 percent AMT rate to measure their DTLs. ASC 740-10-30-10 states that “[i]n the U.S. federal tax jurisdiction, the applicable tax rate is the regular tax rate” (emphasis added) and that an entity recognizes a DTA for AMT credit carryforwards if realization is more likely than not.

In addition, ASC 740-10-25-37 states, in part:

The tax benefit of . . . special deductions such as those that may be available for certain health benefit entities and small life insurance entities in future years shall not be anticipated.

As stated in ASC 740-10-30-11, the failure to use the regular tax rate would result in an understatement of deferred taxes if the AMT results from preferences but the entity has insufficient AMT credit carryovers to reduce its effective rate on taxable temporary differences to the AMT rate. In this situation, use of the AMT rate to measure DTAs and DTLs would anticipate the tax benefit of special deductions.

3.3.4.12 Measurement of Deferred Taxes When Entities Are Subject to BEAT

For tax years beginning after December 31, 2017, a corporation is potentially subject to tax under the BEAT provision if the controlled group of which it is a part has sufficient gross receipts and derives a sufficient level of “base erosion tax benefits.” Under the BEAT, a corporation must pay a base erosion minimum tax amount (BEMTA) in addition to its regular tax liability after credits. The BEMTA is generally equal to the excess of (1) a fixed percentage of a corporation’s modified taxable income (taxable income determined without regard to any base erosion tax benefit related to any base erosion payment, and without regard to a portion of its NOL deduction) over (2) its regular tax liability (reduced by certain credits). The fixed percentage is generally 5 percent for taxable years beginning in 2018, 10 percent for years beginning after 2018 and before 2026, and 12.5 percent for years after 2025. However, the fixed percentage is 1 percentage point higher for banks and securities dealers (i.e., 6, 11, and 13.5 percent, respectively).

In January 2018, the FASB staff issued a Q&A document stating that companies should measure deferred taxes without regard to BEAT (i.e., should continue to measure deferred taxes at the regular tax rate), with any payment of incremental BEAT reflected as a period expense. The BEAT system can be analogized to an AMT system in place before enactment of the 2017 Act. ASC 740 notes that when alternate tax systems like the AMT exist, deferred taxes should still be measured at the regular tax rate. Because the BEAT provisions are designed to be an “incremental tax,” an entity can never pay less than its statutory tax rate of 21 percent. Like AMT preference items, related-party payments made in the year of the BEMTA are generally the BEMTA’s driving factor. The AMT system and the BEAT system were both designed to limit the tax benefit of such “preference items.” Further, as was the case under the AMT system, an entity may not know whether it will always be subject to the BEAT tax, and we believe that most (if not all) taxpayers will ultimately take measures to reduce their BEMTA exposure and therefore ultimately pay taxes at the regular rate or as close to it as possible. Accordingly, while there is no credit under the 2017 Act such as the one that existed under the AMT regime, the similarities between the two systems are sufficient to allow BEAT taxpayers to apply the existing AMT guidance in ASC 740 and measure deferred taxes at the 21 percent statutory tax rate. (See ASC 740-10-30-8 through 30-12 and ASC 740-10-55-31 through 55-33.)

3.3.5 Tax Method Changes

For U.S. federal income tax purposes, the periods in which income is taxable and expenditures are deductible may depend on the taxpayer’s federal income tax accounting method. While entities are required to apply their established federal income tax accounting method unless they affirmatively change the method to be used, an entity might determine that it is using an impermissible federal income tax accounting method and decide to change to a permissible method. Alternatively, a taxpayer that is using a permissible federal income tax accounting method may decide to change to a different permissible method.

Method changes generally result in a negative or positive adjustment to taxable income during the year in which the method change becomes effective. A negative (“favorable”) adjustment results in a deduction recognized in the year of change. A positive (“unfavorable”) adjustment results in an increase in taxable income that is generally recognized over four tax years.

To change its federal income tax accounting method, an entity must file a Form 3115. A method change that requires advance written consent from the IRS before becoming effective is referred to as a “manual” or “nonautomatic” method change. Conversely, a method change that is deemed to be approved by the IRS when the Form 3115 is filed with the IRS is referred to as an “automatic” method change.

3.3.5.1 Considering the Impact of Tax Method Changes

In determining the financial statement impact of a change in a federal income tax accounting method, an entity should consider whether the change is (1) from an impermissible method to a permissible method or (2) from a permissible method to another permissible method.

3.3.5.1.1 Impermissible to Permissible

An entity that is using an impermissible federal income tax accounting method should assess its tax position by applying the recognition and measurement principles of ASC 740-10 to determine whether the improper accounting method results in an uncertain tax position for which a UTB, interest, and penalties should be recorded in the financial statements.

Changes from an impermissible to a permissible federal income tax accounting method generally result in an unfavorable adjustment that is recognized as an increase in taxable income over four tax years. Further, when an entity files a Form 3115 for a change from an impermissible to a permissible federal income tax accounting method and obtains consent from the IRS (either automatic deemed consent or express written consent), it receives “audit protection” for prior tax years, which provides relief from interest and penalties.

A change in a U.S. federal income tax accounting method that results in an unfavorable adjustment and does not conform to the financial accounting treatment for the related item (i.e., the new permissible accounting method for U.S. federal income tax purposes differs from the financial reporting accounting method) will usually result in two temporary differences:

The difference between the new income tax basis of the underlying asset or liability and the financial reporting carrying amount.
A future taxable income adjustment under IRC Section 481(a), which represents the cumulative taxable income difference between historical taxable income determined under the previous federal income tax accounting method and historical taxable income determined under the new federal income tax accounting method.

In substance, a positive IRC Section 481(a) adjustment results in a deferred revenue item for tax purposes with no corresponding amount for book purposes. Therefore, the positive IRC Section 481(a) adjustment represents a taxable temporary difference, and the related tax consequences should be accounted for as a DTL.

3.3.5.1.2 Permissible to Permissible

An entity that is using a permissible federal income tax accounting method generally does not have a UTB. A change from a permissible federal income tax accounting method to another permissible federal income tax accounting method may result in a favorable or unfavorable adjustment to cumulative taxable income. In a manner similar to how an entity would recognize an unfavorable adjustment for a change from an impermissible method to a permissible method, an unfavorable adjustment for a change from a permissible method to another permissible method is generally recognized over four tax years, resulting in two temporary differences when the new federal income tax accounting method does not conform to the financial accounting treatment for the related item. A change in a federal income tax accounting method that results in a favorable adjustment and does not conform to the financial accounting treatment for the related item will generally result in one temporary difference — specifically, the difference between the income tax basis of the underlying asset or liability and the financial reporting carrying amount. The entire favorable IRC Section 481(a) adjustment is recognized in the tax return in the year of change.

Example 3-8

Change From an Impermissible Federal Income Tax Accounting Method to a Permissible Method With a Positive (Unfavorable) Adjustment

In prior years, Company A, a profitable company, accrued a liability for employee bonuses on the basis of amounts earned under its corporate bonus plan. As of December 31, 20X3, the liability for accrued bonuses was $400. For federal income tax purposes, A had deducted the bonuses in the year accrued. In analyzing its tax position in accordance with ASC 740-10, A determined that for federal income tax purposes, the bonuses did not qualify as a federal income tax deduction when accrued for financial reporting purposes. Consequently, A recorded a $100 liability ($400 × 25% tax rate) for the UTB and accrued a $5 liability for accrued interest as of the year ended December 31, 20X3. Company A’s policy is to classify interest related to UTBs as income taxes payable. Further, A recognized a DTA of $100 for the accrued bonuses that is actually deductible in future years.

In the first quarter of 20X4, A filed a Form 3115 to change from the impermissible federal income tax accounting method for employee bonuses to the permissible method of deducting the bonus amounts when paid. The accounting method change results in the following changes to the income tax accounts:

Example 3-9

Change From a Permissible Federal Income Tax Accounting Method to Another Permissible Method With a Negative (Favorable) Adjustment

For federal income tax purposes, Company B, a profitable company, uses the full inclusion method for advance payments received for the sale of goods (i.e., for federal income tax purposes, the full amount of advance payments is included in taxable income in the period in which they are received). For financial reporting purposes, B defers the recognition of revenue upon receipt of the $800 of advance payments; the deferral results in a deductible temporary difference and the recognition of a DTA of $200.

After completing a review of its federal income tax accounting methods, B files a Form 3115 to change to a one-year deferral method for federal income tax purposes. This results in a favorable IRC Section 481(a) adjustment of $800 that will be recognized on the current-year federal income tax return. Since this item is a change from a permissible method to another permissible method, there is no UTB. Assume that B has a current tax payable of $1,000 before the IRC Section 481(a) adjustment. The accounting method change results in the following adjustments to the income tax accounts:

3.3.5.2 When to Recognize the Impact of Tax Method Changes

In determining when to recognize the impact of a change in a federal income tax accounting method, an entity should consider the following:

Whether the change is (1) from an impermissible method to a permissible method or (2) from a permissible method to another permissible method.
Whether the change is nonautomatic (“manual”) or automatic.

A manual method change requires the affirmative written consent of the IRS after receipt of Form 3115 from the entity requesting the change. An entity will be granted an automatic method change if (1) the requested change qualifies for automatic approval by the IRS under published guidance and (2) the entity complies with all provisions of the automatic change request procedures.

3.3.5.2.1 Impermissible to Permissible

3.3.5.2.1.1 Manual Method Change

Generally, the reversal of UTBs, interest, and penalties as a result of a manual change in a federal income tax accounting method from an impermissible method to a permissible method should be recognized when audit protection is received (i.e., when the entity has filed a Form 3115 and has received the affirmative written consent of the IRS). However, if the entity has met all of the requirements of such method change, there may be circumstances in which the ultimate consent of the IRS is considered perfunctory (i.e., IRS approvals for similar method change requests have always been granted). In these circumstances, if it would be unreasonable for the IRS to withhold consent, we believe that an entity may reflect the change in the period in which the Form 3115 is filed. Consultation with tax and accounting advisers is encouraged in these situations.

3.3.5.2.1.2 Automatic Method Change

If an entity meets all of the requirements for an automatic method change and complies with all provisions of the automatic change request procedures, consent from the IRS is not required. Accordingly, the financial statement impact should be reflected when the entity has filed a Form 3115.

3.3.5.2.2 Permissible to Permissible

3.3.5.2.2.1 Manual Method Change

Generally, the impact of a manual change in a federal income tax accounting method from one permissible method to another permissible method should be recognized when the entity has filed a Form 3115 and has received the affirmative written consent of the IRS. However, if consent of the IRS is considered perfunctory, the financial statement impact of such method change may be reflected when the entity has concluded that it is qualified and has the intent and ability to file a Form 3115 with the IRS, but no earlier than the first interim period of the year in which the Form 3115 will be filed.

3.3.5.2.2.2 Automatic Method Change

If an entity meets all requirements for an automatic method change from one permissible method to another permissible method, consent from the IRS is not required. Accordingly, the financial statement impact should be reflected when the entity has concluded that it qualifies for the method change and that it has the intent and ability to file a Form 3115.

3.3.5.2.3 Summary

The decision tree below summarizes the timing for recognition of changes in U.S. federal income tax accounting method.

3.3.6 Foreign Operations

3.3.6.1 Foreign Subsidiaries’ Basis Differences

Multinational companies often have multiple layers of financial reporting, and each layer may be prepared by using a different basis of accounting. For example, a foreign subsidiary of a U.S.-based multinational company may have to prepare the following sets of accounts:

Financial statements prepared in accordance with U.S. GAAP for inclusion in the consolidated financial statements of the U.S. parent (U.S. GAAP financial statements).
Financial statements prepared in accordance with the comprehensive basis of accounting required by the jurisdiction in which the subsidiary resides (local GAAP or statutory financial statements).
Books and records prepared in accordance with the requirements of the tax authority of the jurisdiction in which the subsidiary resides for local income tax reporting purposes (local jurisdiction tax basis).

While it is not necessary for a foreign subsidiary to prepare statutory financial statements in order to prepare U.S. GAAP financial statements, a foreign subsidiary that is subject to statutory reporting requirements will often use a reconciliation approach to prepare its U.S. GAAP financial statements. That is, the foreign subsidiary will often prepare statutory financial statements first and identify differences between those amounts and the local jurisdiction tax basis (commonly referred to as “stat-to-tax differences”) when determining deferred taxes to be recognized in the statutory financial statements. The foreign subsidiary will then adjust those financial statements to reconcile or convert them to U.S. GAAP (commonly referred to as “stat-to-GAAP differences”).

Questions often arise concerning how deferred taxes should be computed for purposes of a company’s consolidated financial statements prepared in accordance with U.S. GAAP when both stat-to-GAAP and stat-to-tax differences are present. Accordingly, temporary differences related to assets and liabilities of a foreign subsidiary are computed on the basis of the difference between the reported amount in the U.S. GAAP financial statements and the tax basis of the subsidiary’s assets and liabilities (which inherently includes both stat-to-GAAP and stat-to-tax differences) because ASC 740-10-20 defines a temporary difference as “[a] difference between the tax basis of an asset or liability . . . and its reported amount in the financial statements.”

Companies that use the reconciliation approach, however, will generally develop temporary differences for each asset and liability in two steps. Accordingly, when using the reconciliation approach, companies must ensure that any deferred taxes on the statutory books (related to stat-to-tax differences) are not double counted in the U.S. GAAP financial statements.

Example 3-10

Assume the following:

A U.S. parent consolidates FS, a foreign corporation operating in Jurisdiction Y, which has a 20 percent income tax rate.
FS is required to file statutory financial statements with Y and prepares these financial statements in accordance with its local GAAP.
FS has one asset with a basis of $4 million, $6 million, and $7 million for local income tax, statutory, and U.S. GAAP reporting purposes, respectively.3

Corporation FS’s deferred taxes related to the single asset may be determined by comparing its U.S. GAAP basis of $7 million with its local income tax basis of $4 million to arrive at its total DTL of $0.6 million, or ($7 million – $4 million) × 20%, for U.S. GAAP financial statement purposes.

Alternatively, if FS uses a reconciliation approach, FS’s stat-to-tax basis difference is $2 million ($6 million – $4 million), resulting in the recording of a $0.4 million ($2 million × 20%) DTL in FS’s statutory financial statements. FS’s stat-to-GAAP adjustment (difference) is $1 million ($7 million – $6 million), resulting in an additional DTL of $0.2 million ($1 million × 20%) for purposes of the U.S. GAAP financial statements. The total DTL reported in the U.S. GAAP financial statements in connection with FS’s asset is $0.6 million, representing the $0.4 million recorded in the statutory financial statements and the $0.2 million recorded as part of the stat-to-GAAP reconciling adjustments. For presentation purposes, the $0.4 million DTL related to the stat-to-tax difference and the $0.2 million DTL related to the stat-to-GAAP difference should be combined and presented as a single DTL in the balance sheet and disclosures.

If the U.S. parent does not take into consideration the $0.4 million DTL already recorded in the statutory financial statements and records an incremental $0.6 million DTL as a U.S. GAAP adjustment, it would effectively double count the temporary difference associated with the $2 million basis difference between the statutory and tax bases of the asset.

3.3.6.2 Revaluation Surplus

Inside basis differences within a U.S. parent’s foreign subsidiary whose local currency is the functional currency may result from foreign laws that allow for the occasional restatement of fixed assets for tax purposes to compensate for the effects of inflation. The amount that offsets the increase in tax basis of fixed assets is sometimes described as a credit to revaluation surplus, which some view as a component of equity for tax purposes. That amount becomes taxable in certain situations, such as in the event of a liquidation of the foreign subsidiary or if the earnings associated with the revaluation surplus are distributed. In this situation, it is assumed that no mechanisms are available under the tax law to avoid eventual treatment of the revaluation surplus as taxable income. ASC 740-30-25-17 clarifies that the indefinite reversal criterion should not be applied to inside basis differences of foreign subsidiaries. Because the inside basis difference related to the revaluation surplus results in taxable amounts in future years in accordance with the provisions of the foreign tax law, it qualifies as a temporary difference even though it may be characterized as a component of equity for tax purposes. Therefore, as described in ASC 830-740-25-7, a DTL must be provided on the amount of the revaluation surplus. This view is based on ASC 740-10-25-24, which indicates that some temporary differences are deferred taxable income and have balances only for income tax purposes. Therefore, these differences cannot be identified with a particular asset or liability for financial reporting purposes.

3.3.6.3 Accounting for Foreign Branch Operations

A U.S. corporation generally conducts business in a foreign country by establishing either a branch or a separate legal entity in that country. A true branch generally refers to a fixed site (e.g., an office or plant) in which a U.S. corporation conducts its operations. However, a branch can also refer to a separate foreign legal entity that the U.S. corporation has elected to treat as a disregarded entity under the U.S. Treasury entity-classification income tax regulations (commonly referred to as the “check-the-box” regulations, under which an eligible entity may elect its tax classification, or tax status, for U.S. income tax reporting purposes).

A foreign branch is not considered a separate taxable entity for U.S. income tax reporting purposes; rather, it is an extension of its U.S. parent. Accordingly, any income or loss generated by a foreign branch is (1) included in the U.S. parent company’s income tax return (i.e., subject to U.S. income taxes) in the period in which it is earned and (2) generally subject to tax in the local country. That is, foreign branches are generally subject to double taxation (in the United States and in the local country). To mitigate the effects of this double taxation, U.S. income tax law allows a U.S. corporation to either deduct the income taxes incurred in the local country or claim those income taxes as an FTC in its U.S. income tax return (i.e., the local-country taxes affect the determination of U.S. tax). The foreign branch is required to account for income tax in its local country in accordance with ASC 740.

Because a branch is subject to taxation in two different countries, the consolidated financial statements will generally have at least two sets of temporary differences related to the branch’s activities. One set of temporary differences will reflect the differences between the book and tax basis of the assets and liabilities of the branch as determined under the local-country tax law (i.e., the in-country temporary differences). The other set of temporary differences will reflect the differences between the book and tax basis of the assets and liabilities of the branch as determined under U.S. tax law (the “U.S. temporary differences”). Further, because local-country income taxes can be deducted when the parent computes U.S. taxable income, or credited against taxes on the branch income when it computes U.S. income taxes payable, the in-country DTAs and DTLs give rise to U.S. temporary differences, and U.S. DTLs and DTAs should be established to account for the U.S. income tax effects of the future reversal of in-country DTAs and DTLs.

The accounting for U.S. temporary differences related to a foreign branch is similar to that for federal temporary differences related to state taxes, as illustrated in the table below.

In accordance with U.S. income tax law, an entity incurring foreign income taxes may, from year to year, elect to either claim an FTC or deduct the foreign taxes. Theoretically, FTCs are more beneficial, but because there are restrictions on the credits’ use, the entity may choose to deduct the foreign taxes. An entity that elects to claim an FTC but is unable to use all of it may carry forward any excess (i.e., the excess cannot be deducted because of the election to claim credits for foreign taxes incurred that year).

In assessing the U.S. tax impact of the reversal of in-country DTAs and DTLs, an entity should estimate whether it will claim FTCs or deductions in the year in which such in-country DTAs and DTLs reverse. If an entity determines that it will be claiming FTCs in the year in which a net in-country DTL reverses, the entity would record an “anticipatory” FTC DTA, subject to realizability considerations. This anticipatory FTC DTA is unlike most tax credits, which are typically not recognized until generated on a tax return, because it represents the direct U.S. tax consequences of an inside “in-country” temporary difference. See Section 5.7.3 for more information about determining the need for a valuation allowance related to FTCs.

Similarly, the U.S. corporation would recognize a DTL for “forgone” FTCs associated with an in-country DTA (i.e., the gross in-country DTA reduced by a valuation allowance) because, when the branch generates income in future years that is offset by an in-country loss carryforward or a deductible temporary difference (or both), that income will be taxable in the United States without corresponding FTCs related to the income.

The examples below illustrate the deferred tax accounting related to branch temporary differences. For simplicity, the effects of foreign currency have been disregarded.

Example 3-11

FTC Election Anticipated in the United States

Parent Co. (a U.S. parent company) establishes Branch Co. (a branch) in Country X. Parent Co. is subject to tax in the United States at 21 percent, and Branch Co. is subject to tax in X at 15 percent. In addition, the taxes paid by Branch Co. in X are fully creditable in the United States without limitation, and Parent Co. intends to claim FTCs in the year in which the foreign temporary difference reverses.

There is a temporary difference related to Branch Co.’s operations in the current year, which is the same under the tax laws in both X and the United States, as shown below:

Since Branch Co. is subject to tax in both the United States and X, Branch Co. computes its deferred taxes separately for each jurisdiction. In X, Branch Co. determines that it has a DTL of $150,000, which is equal to the temporary difference shown above multiplied by the local tax rate in X of 15 percent.

In the United States, Parent Co. determines that it has a DTL of $210,000 related to PP&E, which is equal to the temporary difference shown above multiplied by the U.S. tax rate of 21 percent. However, because the taxes paid in X are fully creditable in the United States when actually incurred, Parent Co. also determines that it has an anticipatory FTC DTA equal to Branch Co.’s DTL in X ($150,000). That is, when the temporary difference reverses, Branch Co. will pay additional taxes of $150,000 in X, but because such foreign taxes paid will be claimed as a credit by Parent Co., Parent Co. will effectively receive a benefit equal to 100 percent of Branch Co.’s DTL or, in other words, a dollar-for-dollar reduction of its income taxes payable. A summary of the impact of the above on the consolidated balance sheet is as follows:

Example 3-12

Foreign Tax Deduction Anticipated in the United States

Assume the same facts as in the example above except that Parent Co. anticipates deducting the foreign taxes in its income tax return when the temporary difference reverses (instead of claiming them as an FTC).

In this scenario, there would be no changes to Branch Co.’s or Parent Co.’s accounting for their respective DTL related to the PP&E. However, instead of recording an “anticipatory” FTC DTA for 100 percent of Branch Co.’s DTL, Parent Co. would recognize a foreign tax deduction DTA equal to 21 percent of Branch Co.’s DTL. That is, because Parent Co. will deduct the foreign taxes on its income tax return, it will receive a benefit equal to only 21 percent (i.e., the statutory rate) of the deduction. The following table summarizes the impact on the consolidated balance sheet of the above:

Example 3-13

Foreign Branch Losses

Parent Co. (a U.S. parent company) establishes Branch Co. (a branch) in Country X. Parent Co. is subject to tax in the United States at 21 percent, and Branch Co. is subject to tax in X at 15 percent. In addition, the taxes paid by Branch Co. in X are fully creditable in the United States without limitation, and Parent Co. intends to elect to claim FTCs in the year in which the foreign temporary difference reverses.

In 20X6, Branch Co. generated an operating loss of $1 million that is allowed to be carried forward indefinitely under the tax law in X. Branch Co. concludes that it will be able to realize the loss carryforward against taxable income it will generate in future years and, therefore, no valuation allowance is necessary. Parent Co. generated taxable income of $3 million (excluding the loss generated by Branch Co.) in 20X6.

In this scenario, Branch Co. recognizes a deferred tax benefit of $150,000 by establishing a DTA for the in-country loss carryforward ($1 million loss × the local tax rate). Further, Parent Co. would recognize a current benefit of $210,000 ($1 million × the U.S. tax rate) because, as a result of Branch Co.’s loss, it would reduce the amount of taxes it would otherwise owe in the United States. In the absence of any “anticipatory” FTC or deduction accounting entries recorded by Parent Co., both Parent Co. and Branch Co. would recognize a benefit for the loss (i.e., a double benefit); however, Parent Co. must also record a DTL for forgone FTCs equal to the DTA recognized by Branch Co. As a result, the total benefit recognized in the consolidated financial statements related to the Branch Co. loss in the year in which the loss occurs is equal to the current benefit recognized by Parent Co. ($210,000), as shown below:

Further assume that in 20X7, Branch Co. generates $1 million of taxable income and uses its entire loss carryforward (i.e., Branch Co. pays no income taxes in 20X7 in X). Branch Co. would reverse its DTA related to the loss carryforward and recognize a deferred tax expense of $150,000. The income generated by Branch Co. would also be included in Parent Co.’s income tax return in 20X7. Because no taxes are paid in X on the income, Parent Co. cannot claim an FTC and therefore incurs a current tax expense in the United States of $210,000 as a result of an increase in the amount of taxes it would have otherwise owed in X. Parent Co. also reverses the DTL that it had recognized related to Branch Co.’s DTA and recognizes a deferred tax benefit of $150,000. As a result, the total expense recognized in the 20X7 consolidated financial statements related to Branch Co. income in 20X7 is equal to the current expense recognized by Parent Co. ($210,000), as shown below:

3.3.6.3.1 Measurement Complexities Attributable to Jurisdictional Rate Differences

Determining the U.S. tax impact of a forgone FTC or foreign tax deduction upon reversal of in-country DTAs may be complex in certain situations. Questions have arisen about how to measure a DTL for forgone FTCs when the U.S. tax rate is lower than the in-country tax rate. If an entity uses 100 percent of the in-country DTA to measure its DTL for forgone FTCs, the U.S. DTL may be greater than the actual foreign tax credits forgone because of foreign tax credit limitations.

We believe that there are two acceptable approaches for measuring a DTL for forgone FTCs associated with an in-country DTA when an entity has a single branch:

Approach 1 — Under this method, commonly referred to as the “mirror-image” approach, a DTL for forgone FTCs would be measured at 100 percent of the in-country DTA(s) of the branch if it is assumed that the U.S. corporation anticipates claiming FTCs (versus a foreign tax deduction) in the years that the in-country DTA(s) are expected to reverse.
Approach 2 — Under this method, the DTL for forgone FTCs would generally be measured at the “lesser of” the local rate or the U.S. rate.4 If the U.S. rate is lower than the foreign rate, the DTL for forgone FTCs would generally be measured at an amount equal to the U.S. rate multiplied by the income implied solely from recovery of the in-country temporary differences (or attributes) under the fundamental premise in ASC 740 that all assets and liabilities are settled at their carrying values. If the foreign rate is lower than the U.S. rate, a measurement consistent with that in Approach 1 will generally be used. By measuring the DTL for forgone FTCs in this fashion, an entity acknowledges that the actual forgone FTC should not exceed the U.S. rate (i.e., the entity generally would not have been able to use the excess FTCs, had they been available, because an FTC can only be used to reduce tax on branch income and cannot be used to reduce tax on other income in the tax return).

Example 3-14

Foreign Branch — Higher In-Country Tax Rate

Parent Co. (a U.S. parent company) establishes Branch Co1 (a branch) in Country X. Parent Co. is subject to tax in the United States at 21 percent, and Branch Co1 is subject to tax in X at 40 percent.

Assume the following:

Branch Co1’s temporary difference is as follows:
Branch Co1 concludes that it will be able to realize the DTA and that therefore no valuation is necessary.
Parent Co. has the same book and U.S. tax basis in the underlying asset giving rise to the above in-country DTA (therefore, there is no U.S. temporary book-tax difference).

Approach 1 — Mirror Image

Under this approach, Parent Co. would recognize a DTL for forgone FTCs of $40,000 (equal to 100 percent of the $40,000 in-country DTAs).

Approach 2 — Lesser of Local Tax Rate or U.S. Tax Rate

Under this approach, Parent Co. would recognize a DTL for forgone FTCs of $21,000 (equal to the in-country temporary difference of $100,000 multiplied by 21 percent — the lesser of the local or U.S. tax rate).

In the measurement of the U.S. anticipatory FTC DTA, if a foreign branch has only in-country DTLs and has elected to use Approach 1, the entity may measure the U.S. anticipatory FTC DTA at 100 percent of the in-country DTL and address realization issues by using a valuation allowance (see Section 5.7.3). However, we believe that if an entity uses Approach 2 and measures its DTL for forgone FTCs at the lesser of the local or U.S. rate, it should be consistent in its approach and also measure its anticipatory FTC DTA at the lesser of the local or U.S. rate.

Example 3-15

Foreign Branch — Higher In-Country Tax Rate

Parent Co. (a U.S. parent company) owns Branch Co1 (a branch) in Country X. Parent Co. is subject to tax in the United States at 21 percent, and Branch Co1 is subject to tax in X at 40 percent.

Assume the following:

Branch Co1 has historically had only in-country DTAs and has used the lesser of the U.S. or local rate (i.e., Approach 2) to measure its foregone FTC DTL.
In the current year, Branch Co1 recognizes an in-country DTL related to Asset 2.
Branch Co1’s temporary differences are as follows:
Branch Co1 concludes that it will be able to realize the DTA and, therefore, no valuation is necessary.
Parent Co. has the same book and U.S. tax basis in the underlying assets giving rise to the above in-country deferred taxes (therefore, there are no U.S. temporary book-tax differences).

Parent Co. recognizes a U.S. forgone FTC DTL of $12,600 (equal to the $60,000 temporary difference measured at the lesser of the U.S. rate, 21 percent).

In situations in which an entity has multiple branches with rates both in excess of and below the U.S. rate, additional complexities associated with applying Approach 2 may arise because foreign taxes paid in one branch can be used to reduce U.S. taxes paid on income in another branch. As a result, the actual forgone FTC from a branch with a foreign rate that is higher than the U.S. rate could exceed the U.S. tax rate if the entity could have otherwise used the forgone FTCs to reduce U.S. tax paid on income in a branch with a foreign rate lower than the U.S. rate. We believe that in these situations, the entity should generally apply Approach 2 by determining the forgone FTC on an aggregate basis. Such an amount would typically be calculated as noted above (i.e., the income implied solely from recovery of the in-country temporary differences or attributes). However, we believe that an acceptable alternative view would be for the entity to include all future income in determining the “expected rate to be applied” to the DTL for forgone FTCs. Including all future income arguably results in a measurement of the DTL for forgone FTCs at the amount that represents the entity’s true economic cost of recovering the in-country DTAs of the branches. Accordingly, we believe that application of either approach would be acceptable. Regardless of the method used, however, the DTL for forgone FTCs should not result in a DTL that is larger than the amount determined on the basis of 100 percent of the in-country DTA(s) (Approach 1).5

Example 3-16

Foreign Branch DTL for Forgone FTCs — Higher In-Country Tax Rate

Parent Co. (a U.S. parent company) establishes Branch Co1 (a branch) in Country X and Branch Co2 (another branch) in Country Y. Parent Co. is subject to tax in the United States at 21 percent, Branch Co1 is subject to tax in X at 40 percent, and Branch Co2 is subject to tax in Y at 5 percent.

Assume the following:

Branch Co1’s and Branch Co2’s temporary differences are as follows:
Branch Co1 and Branch Co2 conclude that they will be able to realize the DTAs and, therefore, no valuation allowance is necessary.
The in-country temporary differences are forecasted to reverse in the same year and the operations of Branch Co1 and Branch Co2 are expected to generate annual pretax book income (exclusive of a reversal of temporary differences) of $200,000 and $10 million, respectively.
Parent Co. does not have a U.S. tax basis in the underlying assets giving rise to the above in-country DTAs (therefore, there is no U.S. DTA to record on Parent Co.’s books).

Approach 1 — Mirror Image

Under the mirror image approach, Parent Co. would recognize a DTL for forgone FTCs of $45,000 (equal to 100 percent of the $45,000 in-country DTAs).

Approach 2 — Lesser of Local Tax Rate or U.S. Tax Rate

U.S. Tax Effects if Implied Income From In-Country Temporary Differences (or Attributes) Is Taken Into Account

If Parent Co.’s policy is to measure the forgone FTCs resulting from its foreign branches’ in-country DTAs by taking into account implied income from in-country temporary differences (or attributes), Parent Co. would recognize a DTL of $42,000 because $42,000 is the amount of the forgone FTCs (provided that this number reflects only the amount of book income required for recovering the in-country deductible temporary differences). Under this approach, the DTL for a forgone FTC should never be more than the mirror image DTL of $45,000. Measurement of the DTL for forgone FTCs is calculated as follows:

U.S. Tax Effects if Forecasted Income Is Taken Into Account

If Parent Co.’s policy is to measure the forgone FTCs resulting from its foreign branches’ in-country DTAs by taking into account forecasted income, Parent Co. would recognize a DTL of $45,000, which is the same amount for the DTL for forgone FTCs as the mirror-image approach; however, that may not always be the case. Measurement of the DTL for forgone FTCs is calculated as follows:

Footnotes

Tax basis is determined in accordance with ASC 740-10-25-50 (see Section 3.3.3.1), subject to the recognition and measurement guidance in ASC 740. See Chapter 4.

As defined in ASC 740-10-30-5, a tax-paying component is “an individual entity or group of entities that is consolidated for tax purposes.”

For ease of illustration, currency differences are ignored.

If the local country DTA has a full valuation allowance associated with it, however, no DTL for a forgone FTC would be recorded.

In scenarios in which all of the in-country tax rates of the branches are lower than the U.S. tax rate, the measurement of the DTL for a forgone FTC should be the same under all three approaches (i.e., 100 percent of the in-country DTA).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.