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

3.5 Other Considerations and Exceptions

There are other exceptions and special situations that result in additional considerations when an entity is determining the appropriate amounts of DTAs and DTLs to present in the financial statements. See Section 3.4 for a discussion of exceptions to recording deferred taxes for outside basis differences.

3.5.1 Changes in Tax Laws and Rates

ASC 740-10

25-47 The effect of a change in tax laws or rates shall be recognized at the date of enactment.

25-48 The tax effect of a retroactive change in enacted tax rates on current and deferred tax assets and liabilities shall be determined at the date of enactment using temporary differences and currently taxable income existing as of the date of enactment.

Under ASC 740-10-25-47 and ASC 740-10-35-4, the effect of a change in tax laws or rates on DTAs and DTLs should be recognized on the date of enactment of the change. A change in tax rate may affect the measurement of DTAs and DTLs. Those DTAs and DTLs that exist as of the enactment date and are expected to reverse after the effective date of the change in tax rate should be adjusted on the basis of the new statutory tax rate. Any DTAs and DTLs expected to reverse before the effective date should not be adjusted to the new statutory tax rate.

To determine the DTAs and DTLs that exist as of the enactment date, a reporting entity should calculate temporary differences by comparing the relevant book and tax basis amounts as of the enactment date. To determine book basis amounts as of the enactment date, the reporting entity should apply U.S. GAAP on a year-to-date (YTD) basis up to the enactment date. For example:

Any book basis accounts that must be remeasured at fair value under U.S. GAAP would be adjusted to fair value as of the enactment date (e.g., certain investments in securities or derivative assets or liabilities).
Book balances that are subject to depreciation or amortization would be adjusted to reflect current period-to-date depreciation or amortization up to the enactment date.
Book basis account balances such as pension and other postretirement assets and obligations for which remeasurement is required as of a particular date (and for which no events have occurred that otherwise would require an interim remeasurement) would not be remeasured as of the enactment date if the enactment date does not coincide with the remeasurement date of the account balances (i.e., no separate valuation of the benefit obligation is required as of the enactment date) for purposes of adjusting the temporary difference that will be measured to the new statutory tax rate as of the enactment date. For example, assume a calendar-year reporting entity has a pension plan with an annual measurement date of December 31 and a tax law change is enacted on December 22. The entity would adjust its balance sheet accounts for the effects of current-year net periodic pension cost and other contribution and benefit payment activity through the date of enactment but not for the impact of the remeasurement of pension plan assets and liabilities.
Any book basis balances associated with share-based payment awards that are classified as liabilities would be remeasured (on the basis of fair value, calculated value, or intrinsic value, as applicable) as of the enactment date. In addition, for those share-based payment awards that ordinarily would result in future tax deductions, compensation cost would be determined on the basis of the YTD requisite service rendered up to the enactment date.

3.5.1.1 Retroactive Changes in Tax Laws or Rates and Expiring Provisions That May Be Reenacted

If retroactive tax legislation is enacted, the effects are recognized as a component of income tax expense or benefit from continuing operations in the financial statements for the interim or annual period that includes the enactment date. The FASB reached this conclusion because it believes that the event to be recognized is the enactment of new legislation. Therefore, the appropriate period in which to recognize the retroactive provisions of a new law is the period of enactment.

Further, entities should not anticipate the reenactment of a tax law or rate that is set to expire or has expired. Rather, under ASC 740-10-30-2, an entity should consider the currently enacted tax law, including the effects of any expiration, in calculating DTAs and DTLs.

If the provision is subsequently reenacted, the entity would look to ASC 740-10-25-47 and measure the effect of the change as of the date of reenactment.

3.5.1.2 Enacted Changes in Tax Laws or Rates That Affect Items Recognized in Equity

Changes in tax law may also affect DTAs and DTLs attributable to items recognized in equity, including (1) foreign currency translation adjustments under ASC 830, (2) actuarial gains and losses and prior service cost or credit recognized under ASC 715, (3) unrealized holding gains and losses on certain available-for-sale (AFS) debt securities under the investment guidance in ASC 320, (4) tax benefits recognized in a taxable business combination accounted for as a common-control merger, and (5) certain tax benefits recognized after a quasi-reorganization.

The FASB concluded that the effect of changes in tax law related to items recorded directly in shareholders’ equity must always be recorded in continuing operations in the period of enactment (see Chapter 6 for intraperiod allocation guidance). This requirement could produce unusual relationships between pretax income from continuing operations and income tax expense or benefit, as illustrated in the example below.

Example 3-33

Assume the following:

An entity’s only temporary difference at the end of years 20X2 and 20X3 is the foreign currency translation adjustment of $500, which arose in year 20X1 and resulted in the recording of a $105 DTL.
The applicable tax rate at the end of 20X1 and 20X2 is 21 percent. A tax law change is enacted at the beginning of year 20X3 that changes the applicable tax rate to 25 percent.
The following tables show the income statements for 20X2 and 20X3 and the balance sheets at the end of 20X2 and 20X3:

The following is an analysis of the facts in this example:

Changes in tax laws affect the DTAs and DTLs of items originally recorded directly in shareholders’ equity. The effect of the change is recognized as an increase or decrease to a DTL or DTA and a corresponding increase or decrease in income tax expense or benefit from continuing operations in the period of enactment.
Tax law changes can significantly affect an entity’s ETR because the effect of the change is computed on the basis of all cumulative temporary differences and carryforwards on the measurement date. In this case, the 4 percent tax rate increase related to the CTA amounts to $20 and is reflected as deferred tax expense in 20X3.
After a tax rate change, the tax consequence previously recorded in shareholders’ equity no longer “trues up” given the current tax rate (i.e., because the tax effects are reversed at 25 percent after being initially recorded in equity at 21 percent, a 4 percent differential is created in equity). This “differential” may continue to be recorded as a component of OCI until an entire category (e.g., AFS securities, pension liabilities) that originally gave rise to the difference has been eliminated completely (e.g., if the entire marketable security portfolio were sold). An exception to this accounting might exist if the entity specifically tracks its investments for income tax purposes (as discussed in Section 6.2.5.1), identifying which investments have tax effects reflected in equity at the old rate and which have tax effects reflected in equity at the new rates. However, because this level of tracking is usually impractical, the applicability of this alternative would be rare.

3.5.1.3 Change in Tax Law That Allows an Entity to Monetize an Existing DTA or Tax Credit in Lieu of Claiming the Benefit in the Future

A tax authority may enact a tax law that allows entities to monetize an existing DTA before the asset would otherwise be realized as a reduction of taxes payable. For example, a prior law in the United States allowed entities to claim a refundable credit for their AMT carryforward and research credits in lieu of claiming a 50 percent bonus depreciation on qualified property placed in service during a particular period.

ASC 740-10-35-4 states the following regarding an entity’s assessment of a change in tax law that affects the measurement of DTAs and DTLs and realization of DTAs:

Deferred tax liabilities and assets shall be adjusted for the effect of a change in tax laws or rates. A change in tax laws or rates may also require a reevaluation of a valuation allowance for deferred tax assets.

Accordingly, the entity must adjust its DTAs and DTLs, along with any related valuation allowances, in the first period in which the law was enacted if the entity expects to realize the asset by electing the means provided by the newly enacted tax law.

For example, an entity may have a valuation allowance for a particular DTA because it was not more likely than not that the asset would have been realizable before the change in tax law occurred. However, the new tax law provides the entity a means of realizing the DTA. The reduction of the valuation allowance will affect the income tax provision in the first period in which the law was enacted. If, however, no valuation allowance is recognized for the entity’s DTA, the reduction in the DTA (a deferred tax expense) is offset by the cash received from monetizing the credits (a current tax benefit). Therefore, in this case, the reduction of the DTA does not affect the income tax provision.

See Section 7.3.2 for further guidance on accounting for changes in tax laws or rates in an interim period.

See Section 2.7 for guidance on whether refundable tax credits are within the scope of ASC 740 and are accordingly classified within income tax expense/benefit in the financial statements.

For a discussion of the intraperiod tax allocation rules with respect to changes in tax laws or rates, see Chapter 6.

3.5.2 Changes in Tax Status of an Entity

ASC 740-10

25-32 An entity’s tax status may change from nontaxable to taxable or from taxable to nontaxable. An example is a change from a partnership to a corporation and vice versa. A deferred tax liability or asset shall be recognized for temporary differences in accordance with the requirements of this Subtopic at the date that a nontaxable entity becomes a taxable entity. A decision to classify an entity as tax exempt is a tax position.

25-33 The effect of an election for a voluntary change in tax status is recognized on the approval date or on the filing date if approval is not necessary and a change in tax status that results from a change in tax law is recognized on the enactment date.

25-34 For example, if an election to change an entity’s tax status is approved by the taxing authority (or filed, if approval is not necessary) early in Year 2 and before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) for Year 1, the effect of that change in tax status shall not be recognized in the financial statements for Year 1.

Cessation of an Entity’s Taxable Status

40-6 A deferred tax liability or asset shall be eliminated at the date an entity ceases to be a taxable entity. As indicated in paragraph 740-10-25-33, the effect of an election for a voluntary change in tax status is recognized on the approval date or on the filing date if approval is not necessary and a change in tax status that results from a change in tax law is recognized on the enactment date.

ASC 740-10-25-32 states that a DTL or DTA is recognized for temporary differences in existence on the date a nontaxable entity becomes a taxable entity. Conversely, under ASC 740-10-40-6, DTAs and DTLs should be eliminated when a taxable entity becomes a nontaxable entity. ASC 740-10-45-19 notes that the effect of a change in tax status should be recorded in income from continuing operations. This section provides an overview of considerations when an entity has a change in tax status.

For a discussion of the intraperiod tax allocation rules with respect to a change in tax status, see Chapter 6.

3.5.2.1 Recognition Date

ASC 740-10-25-33 indicates that the effect of an entity’s election to voluntarily change its tax status is recognized when the change is approved or, if approval is unnecessary (e.g., approval is perfunctory), on the filing date. Therefore, the recognition date is either the filing date, if regulatory approval is deemed perfunctory, or the date regulatory approval is obtained. The recognition date for a change in tax status that results from a change in tax law, such as the change that occurred in the U.S. federal tax jurisdiction for Blue Cross/Blue Shield entities as a result of the enactment of the Tax Reform Act of 1986, is the enactment date.

If an entity voluntarily elects to change its tax status after the entity’s year-end but before the issuance of its financial statements, that subsequent event should be disclosed but not recognized (a nonrecognized subsequent event). For example, if an entity filed an election on January 1, 20X9, before the financial statements for the fiscal year ended December 31, 20X8, are issued, the entity should disclose the change in tax status and the effects of the change (i.e., pro forma financial information), if material, in the 20X8 financial statements. See Section 14.7.1 for a discussion of the potential disclosure impact when an entity changes its tax status from nontaxable to taxable.

3.5.2.2 Effective Date

The effective date of an entity’s election to voluntarily change to nontaxable status can differ depending on the laws of the applicable tax jurisdiction. For example, in the United States, the effective date of a change in status election from a C corporation to an S corporation can be either of the following:

Retroactive to the beginning of the year in which the election is filed if the filing or necessary approval occurs within the first two and a half months of the fiscal year (i.e., by March 15 for a calendar-year-end entity).
At the beginning of the next fiscal year (i.e., January 1, 20X1, for a calendar-year-end entity).

In scenario 1, the effective date would be January 1 of the current year and would be accounted for no earlier than when the election is filed; in scenario 2, however, the effective date would be January 1 of the following year for calendar-year-end entities. Note that for a change to nontaxable status in scenario 2, the effect of the change in status would be recognized on the approval date or filing date, provided that approval is perfunctory, as illustrated in Example 3-34.

3.5.2.3 Measurement — Change From Nontaxable to Taxable

When an entity changes its status from nontaxable to taxable, DTAs and DTLs should be recognized for any temporary differences in existence on the recognition date (unless the entity is subject to one of the recognition exceptions in ASC 740-10-25-3). The entity should measure those recognizable temporary differences in accordance with ASC 740-10-30.

3.5.2.4 Measurement — Change From Taxable to Nontaxable

In a change to a nontaxable status, the difference between the net DTA and DTL immediately before the recognition date and the net DTA and DTL on the recognition date represents the financial statement effect of a change in tax status. If the recognition date of the change in nontaxable status is before the effective date, entities will generally need to schedule the reversal of existing temporary differences to estimate the portion of these differences that is expected to reverse after the recognition date. Temporary differences that are expected to reverse after the effective date should be derecognized, while those that are expected to reverse before the effective date should be maintained in the financial statements. However, some temporary differences may continue even after a change to nontaxable status, depending on the applicable tax laws (e.g., U.S. built-in gain tax). For further discussion of built-in gain taxes, see the next section.

3.5.2.5 Change in Tax Status to Nontaxable: Built-In Gain Recognition and Measurement

Upon an entity’s change in tax status from a taxable C corporation to a nontaxable S corporation or REIT, it may have net unrealized “built-in gains.” A built-in gain arises when the fair market value of an asset is greater than its adjusted tax basis on the date of the entity’s change in tax status. Under U.S. tax law, if a built-in gain associated with an asset is realized before the required holding period from the change in tax status expires (i.e., the recognition period), the entity would be subject to corporate-level tax on the gain. However, if this gain is realized after the recognition period, the built-in gain would not be subject to tax.

Whether an entity continues to record a DTL associated with the built-in gain tax on the date of conversion to nontaxable status depends on whether any of the net unrealized built-in gain is expected to be recognized and taxable during the recognition period. Any subsequent change in that determination would result in either recognition or derecognition of a DTL.

An entity should consider the items discussed in the sections below when determining when tax associated with an unrealized built-in gain should be recognized and how the related DTL should be measured, either upon conversion to nontaxable status or anytime during the recognition period.

3.5.2.5.1 Recognition

An entity must first determine whether it expects that a tax will be due on a net unrealized built-in gain within the recognition period. ASC 740-10-55-65 provides the following guidance on this topic:

A C corporation that has temporary differences as of the date of change to S corporation status shall determine its deferred tax liability in accordance with the tax law. Since the timing of realization of a built-in gain can determine whether it is taxable, and therefore significantly affect the deferred tax liability to be recognized, actions and elections that are expected to be implemented shall be considered.

The following are examples of items that an entity should consider when evaluating “actions and elections that are expected to be implemented” under ASC 740-10-55-65:

Management’s intentions regarding each item with a built-in gain — Whether a DTL is recorded for a temporary difference depends on management’s intentions for each item with a built-in gain. That is, an entity should evaluate management’s intent and ability to do what is necessary to prevent a taxable event (e.g., holding marketable securities for the minimum amount of time) before determining whether a DTL should be recorded.
Overall business plans — The conclusion about whether realization of a built-in gain is expected to trigger a tax liability for the entity should be consistent with management’s current actions and future plans. That is, the plans for assets should be consistent with, for example, the entity’s liquidity requirements and plans for expansion. Management’s budgets, forecasts, and analyst presentations are examples of information that could serve as evidence of management’s intended plans.
Past actions — The entity should also consider past actions to determine whether they support management’s ability to represent that, for example, an asset will be held for the minimum amount of time necessary to preclude a taxable event.
Nature of the item — The nature of the item could also affect whether a built-in gain is expected to result in a taxable event.

3.5.2.5.2 Measurement

Under ASC 740-10-55-65, if, after considering the “actions and elections that are expected to be implemented,” an entity expects to be subject to a built-in gain tax through the disposition of an asset within the recognition period, the entity must recognize the related DTL at the lower of:

The net unrecognized built-in gain (based on the applicable tax law).
The existing temporary difference as of the date of the change in tax status.

The DTL recognized should lead to the recognition of DTAs for attribute carryforwards (i.e., net operating or capital losses) that are expected to be used in the same year in which the built-in gain tax is triggered.

If the potential gain (first bullet above) exceeds the temporary difference (second bullet above), the related tax should not be recognized earlier than the period in which the pretax financial reporting income (or gain) is recognized (or is expected to be recognized in the case of amounts that would be considered “ordinary income,” as that term is used in connection with the AETR).

Further, ASC 740-10-55-169 requires an entity to “remeasure the deferred tax liability for net built-in gains based on the provisions of the tax law” as of each subsequent financial statement date “until the end of the 10 years following the conversion date.” This remeasurement should include a reevaluation of the recognition considerations noted above and should describe management’s intent and ability to do what is necessary to prevent a taxable event. Remeasurement of the DTL is generally recorded through continuing operations under the intraperiod tax guidance.

Example 3-34

Entity X, a C corporation, is a calendar-year-end entity and files an election on June 30, 20X8, to become a nontaxable S corporation effective January 1, 20X9. In this example, IRS approval is perfunctory for the voluntary change because the entity meets all the requirements to become an S corporation; therefore, the effect of the change in tax status should be recognized as of June 30, 20X8 (the recognition date).

Entity X’s change to nontaxable status will result in the elimination of the portion of all DTAs and DTLs related to temporary differences that are scheduled to reverse after December 31, 20X8, and will not be taxable under the provisions of the tax law for S corporations. The only remaining DTAs or DTLs in the financial statements as of June 30, 20X8, will be those associated with temporary differences that existed on the recognition date that will reverse during the period from July 1, 20X8, to December 31, 20X8, plus the tax effects of any temporary differences that will reverse after December 31, 20X8, that are taxable under the provisions of the tax law for S corporations (e.g., built-in gain tax). Entity X should record any effects of eliminating the existing DTAs and DTLs that will reverse after the effective date of January 1, 20X9, in income from continuing operations.

Entity X will not recognize net deferred tax expense or benefit during the period between the recognition date and the effective date of January 1, 20X9, in connection with basis differences that arise during this time unless they are scheduled to reverse before December 31, 20X8, or will be subject to tax under the tax law for S corporations.

See ASC 740-10-55-168 for an example illustrating the measurement of a DTL associated with an unrecognized built-in gain resulting from an entity’s change from a taxable C corporation to a nontaxable S corporation.

3.5.3 Tax Effects of a Check-the-Box Election

U.S. multinational companies typically conduct business in foreign jurisdictions through entities that are organized under the laws of the jurisdictions in which they operate. These entities might take the legal form of a corporation or partnership in their respective jurisdictions. Notwithstanding an entity’s classification in the foreign jurisdiction, the U.S. Treasury has promulgated entity-classification income tax regulations, commonly referred to as the check-the-box regulations, under which an eligible foreign entity22 may separately elect its tax classification, or tax status, for U.S. income tax reporting purposes. Under the check-the-box regulations, an eligible entity may elect, for U.S. income tax reporting purposes, to be treated as a corporation, treated as a partnership (if it has more than one owner), or disregarded (i.e., treated as an entity not separate from its owner if it has only one owner). An eligible entity electing to be treated as a disregarded entity is considered a branch of its parent for U.S. income tax purposes.

As a result of an eligible entity’s check-the-box election to change its status from a regarded foreign corporation to a disregarded branch of a U.S. parent, the post-check-the-box operations of the foreign entity will become taxable when earned for U.S. tax purposes, requiring the parent entity to recognize U.S. deferred taxes on existing temporary differences and eliminate any outside basis difference (as opposed to the nonrecognition of an outside basis difference because of the application of an exception). Similarly, a foreign subsidiary directly owned by a U.S. parent may have previously elected, for U.S. income tax reporting purposes, to be treated as a disregarded entity. If the entity elects, for U.S. income tax reporting purposes, to “uncheck the box” and change its status from a disregarded entity to a regarded foreign corporation, the taxable income or loss of the foreign entity will no longer be immediately included in taxable income of the U.S. parent, requiring the derecognition of U.S. deferred taxes on the assets held inside the foreign corporation. Although the guidance in ASC 740-10-25-32 predates the introduction of the check-the-box regulations, the need to recognize or derecognize DTAs and DTLs as a result of the election makes the check-the-box election analogous to a change in tax status. Accordingly, we generally believe that the tax effects of recognizing or derecognizing DTAs and DTLs should be recorded in continuing operations on the approval date or on the filing date if approval is not necessary.

Example 3-35

Assume that a U.S. parent owns 100 percent of FS, which operates in Jurisdiction X and is not otherwise taxable in the United States. The U.S. parent had previously directed FS to check the box and be treated as a branch for U.S. tax purposes. At year-end 20X1, the U.S. parent states that it plans for FS to uncheck the box in 20X2, resulting in the derecognition (if nontaxable) or reversal (if taxable) of U.S. deferred taxes on inside basis differences. If an outside basis difference exists when the box is unchecked, the U.S. parent will need to assess it for recognition under the exceptions in ASC 740-30-25-18(a) and ASC 740-30-25-9.

The plan to have FS uncheck the box should be accounted for as a change in status, and the tax effects (including the initial recognition of any outside basis difference DTA or DTL) should be reflected in 20X2.

However, there may be other circumstances in which a check-the-box election may not appear as analogous to a change in tax status. For example, if the check-the-box election affects only an entity’s recognition or measurement of the tax effects of its outside basis difference of its investment in the subsidiary, an alternative view is that the check-the-box election may appear to simply be an election (rather than a change in status) that could be accounted for at the time the parent intends to make it. In support of this alternative view, we note that (1) the guidance on change in status in ASC 740-10-25-32 predates the introduction of the check-the-box regulations and (2) the guidance in ASC 740-30-25-18(a) and ASC 740-30-25-9 is intent focused and forward looking (i.e., it permits the entity to determine whether the amounts will reverse in the foreseeable future). Accordingly, if a check-the-box election for a foreign corporation is expected to result in only the avoidance of a reversal of either a taxable or deductible temporary difference with respect to the outside basis difference in a subsidiary, it would be appropriate to recognize (and measure) the related deferred tax effects when the entity is internally committed to making the election and the election is within the entity’s control.

Because the appropriate accounting for a check-the-box election can depend on the facts and circumstances, consultation with income tax accounting advisers is encouraged.

Example 3-36

Assume that a U.S. parent owns 100 percent of FS1, which operates in Jurisdiction X and is not taxable in the United States. FS1 owns 100 percent of FS2, which operates in Jurisdiction Y and is also not taxable in the United States. FS2 is eligible to make a check-the-box election for U.S. income tax reporting purposes. FS1 had a transaction with FS2 on December 15, 20X1, that gives rise to a type of income that the U.S. parent must recognize under the Subpart F rules (i.e., a deemed dividend that would result in a current tax payable). For U.S. income tax-planning purposes, however, the U.S. parent plans to cause FS2 to make a check-the-box election that will result in FS2’s treatment as a foreign disregarded entity effective on December 1, 20X1, allowing the U.S. parent to avoid recognizing the deemed dividend in 20X1 (i.e., the transaction will no longer be between FS1 and FS2 since under U.S. tax law they will be considered a single legal entity).23

As of December 31, 20X1, the check-the-box election had not yet been filed, but the U.S. parent has the intent and ability to cause FS2 to file the election and will do so by February 13, 20X2, the last day the election can be made and still be effective as of December 1, 20X1 (generally such elections can be made with retroactive effect of up to 75 days).

The U.S. parent could record a current tax liability for the deemed dividend between FS1 and FS2 that occurred in 20X1 and recognize the effects of the check-the-box election (i.e., the reversal of the current tax liability) in 20X2. Alternatively, because the check-the-box election will not change the tax status of FS2 in its local jurisdiction or from the perspective of FS1 (i.e., there are no other tax effects of the election), the U.S. parent could assert that (1) the election should be considered relevant only under the guidance on taxable temporary differences in foreign subsidiaries (generally, no DTL is recognized unless it is foreseeable that the temporary difference will reverse) and, as a result of the planned election, (2) the outside basis difference related to its investment in FS1 will not reverse. Under this alternative view, the U.S. parent’s intent and ability to direct FS2 to make the election would be considered in the measurement of the U.S. parent’s deferred and current tax liability related to its investment in FS1 as of December 31, 20X1 (i.e., no deferred or current tax liability would be recognized).

3.5.4 Real Estate Investment Trust

A corporate entity may elect to be a REIT if it meets certain criteria under the U.S. IRC. As a REIT, an entity is allowed a tax deduction for dividends paid to shareholders. By paying dividends equal to its annual taxable income, a REIT can avoid paying income taxes on otherwise taxable income. This in-substance tax exemption would continue as long as (1) the entity intends to continue to pass all the qualification tests, (2) there are no indicators of failure to meet the qualifications, and (3) the entity expects to distribute substantially all of its income to its shareholders.

3.5.4.1 Recognition Date for Conversion to a REIT

The IRS is not required to approve an entity’s election of taxable status as a REIT; nor does the entity need to file a formal election. Rather, to be eligible for taxable status as a REIT, an entity must meet the IRC requirements of a REIT. For example, the entity must:

Establish a legal structure appropriate for a REIT (i.e., corporation, trust, or association that is not a financial institution or subchapter L insurance company).
Distribute the accumulated E&P of the corporation to the shareholders before election of REIT status.
Adopt a calendar tax year.
File its tax return as a REIT (Form 1120-REIT) by the normal due date.

Because ASC 740 does not specifically address when the tax effects of a conversion to REIT status should be recognized, diversity has developed in practice. One view is that the effect of a conversion to REIT status would be recognized when the entity has committed to a plan to convert its tax status and has met all the legal requirements to be a REIT under the IRC, including the distribution of accumulated E&P of the corporation to the shareholders. An entity must use judgment to determine what constitutes its commitment to conversion (e.g., approval by the board of directors, securing financing to distribute accumulated E&P, public announcement). The recognition date of conversion to REIT status generally would not be contingent on the filing of the first tax return as a REIT because this is normally a perfunctory step.

Alternatively, some entities have analogized an election of REIT status to a change in tax status (i.e., taxable to nontaxable) in accordance with ASC 740-10-25-32 (see the next section). According to this view, the recognition of REIT status would most likely not be until the election is made with the IRS upon the entity’s filing of its initial-year tax return (the filing date).

3.5.5 Tax Consequences of Bad-Debt Reserves of Thrift Institutions

Regulatory authorities require U.S. savings and loan associations and other qualified thrift lenders to appropriate a portion of earnings to general reserves and to retain the reserves as a protection for depositors. The term “general reserves” is used in the context of a special meaning within regulatory pronouncements. Provisions of the U.S. federal tax law permit a savings and loan association to deduct an annual addition to a reserve for bad debts in determining taxable income. This annual addition generally differs significantly from the bad-debt experience upon which determination of pretax accounting income is based. Therefore, taxable income and pretax accounting income of an association usually differ.

ASC 942-740-25-1 precludes recognition of a DTL for the tax consequences of bad-debt reserves “for tax purposes of U.S. savings and loan associations (and other qualified thrift lenders) that arose in tax years beginning before December 31, 1987” (i.e., the base-year amount), “unless it becomes apparent that those temporary differences will reverse in the foreseeable future.” That is, the indefinite reversal notion of ASC 740-30-25-17 is applied to the entire amount of the base-year bad-debt reserve for tax purposes. ASC 942-740-25-2 states that a DTL should be recognized for the tax consequences of bad-debt reserves for “tax purposes . . . that arise in tax years beginning after December 31, 1987.” That is, the excess of a tax bad-debt reserve over the base-year reserve is a temporary difference for which deferred taxes must be provided.

Application of the guidance in ASC 942-740-25-2 effectively results in a “two-difference” approach to the measurement of deferred tax consequences of bad-debt reserves of thrift institutions:

Difference 1 — A DTL is not recognized for the amount of tax bad-debt reserve that is less than the tax base-year amount (generally, amounts established at the beginning of the tax year in 1988). However, a DTL is recognized for any excess of the tax bad-debt reserve over the base-year amount.
Difference 2 — A DTA is recognized for the entire allowance of bad debt established for financial reporting purposes (i.e., the “book” bad-debt reserve). As with any DTA, a valuation allowance is necessary to reduce the DTA to an amount that is more likely than not to be realized.

Example 3-37

This example illustrates the application of the two-difference approach for a thrift institution. Assume the following:

The tax law froze the tax bad-debt reserve at the end of 1987. This limitation does not apply to use of future percentage of taxable income (PTI) deductions. However, experience method deductions for years after 1987 are limited to amounts that increase the tax bad-debt reserve to the base-year amount. Under this method, a thrift is allowed a tax deduction to replenish its bad-debt reserve to the base-year amount.
The thrift elected to adopt ASC 740 retroactively to January 1, 1988.
An annual election is permitted under the tax law. Bad-debt deductions may be computed on (1) the experience method or (2) the PTI method. The PTI is 8 percent.
The association has no temporary differences other than those arising from loan losses.
The enacted tax rate for all years is 25 percent.

Deferred tax amounts are shown below.

Income statement amounts are shown below (select accounts).

As indicated above, ASC 942-740-25-1 concludes that the indefinite reversal notion of ASC 740-30-25-17 is applied to the entire amount of the tax base-year bad-debt reserve of savings and loan associations and other qualified thrift lenders. That is, a DTL is not recognized for the amount of tax bad-debt reserve that is less than the tax base-year reserve.

If the savings and loan association or thrift has the ability to refill the base-year reserve but has elected not to take the tax deductions to refill the base-year amount, the excess represents a potential tax deduction for which a DTA is recognized subject to a valuation allowance, if necessary. However, if the base-year reserve has been reduced because of a reduction in the amount of the qualifying loans, the exception provided in ASC 942-740-25-1 and 25-2 that applies to the base-year bad-debt reserve under ASC 740 should apply only to the current remaining base-year amount, as determined in accordance with IRC Section 585. Future increases in the base-year amount are a form of special deduction, as described in ASC 740-10-25-37, that should not be anticipated.

Example 3-38

Assume that Entity B, a bank holding company, acquires a 100 percent interest in a stock savings and loan association, Entity T, in a 20X0 business combination. In 20X1, B directs T to transfer a substantial portion of its existing loan portfolio to a sister corporation operating under a bank charter. The transfer was not contemplated as of the acquisition date. Further, assume that under IRC Section 585, this transfer reduces the tax base-year bad-debt reserve but the transfer of loans to a sister entity does not result in a current tax liability for the corresponding reduction in the base-year bad-debt reserve.

If management did not contemplate the transfer before 20X1, the effect of recording an additional DTL for the tax consequences of the reduction in the base-year bad-debt reserve for tax purposes should be recognized as a component of income tax expense from continuing operations in 20X1. The decision in 20X1 to transfer the loans is the event that causes the recognition of the deferred tax consequences of the reduction in the bad-debt reserve, and the additional expense should be recognized in that period.

3.5.6 Tax Effects of Intra-Entity Profits on Inventory

After an intra-entity sale of inventory or other assets occurs at a profit between affiliated entities that are included in consolidated financial statements but not in a consolidated tax return, the acquiring entity’s tax basis of that asset exceeds the reported amount in the consolidated financial statements. This occurs because, for financial reporting purposes, the effects of gains or losses on transactions between entities included in the consolidated financial statements are eliminated in consolidation. A DTA is recorded for the excess of the tax basis over the financial reporting carrying value of assets other than inventory that results from the intra-entity sale.

With respect to inventory, ASC 740-10-25-3(e) requires that income taxes paid on intra-entity profits on inventory remaining within the group be accounted for under the consolidation guidance in ASC 810-10 and prohibits recognition of a DTA for the difference between the tax basis of the inventory in the buyer’s tax jurisdiction and its cost as reported in the consolidated financial statements (i.e., after elimination of intra-entity profit). Specifically, ASC 810-10-45-8 states, “If income taxes have been paid on intra-entity profits on inventory remaining within the consolidated group, those taxes shall be deferred or the intra-entity profits to be eliminated in consolidation shall be appropriately reduced.”

The FASB concluded that in these circumstances, an entity’s income statement should not reflect a tax consequence for intra-entity sales of inventory that are eliminated in consolidation. Under this approach, the tax paid or payable from the sale is deferred upon consolidation (as a prepaid income tax or as an increase in the carrying amount of the related asset) and is not included in tax expense until the inventory or other asset is sold to an unrelated third party. This prepaid tax is different from deferred taxes that are recorded in accordance with ASC 740 because it represents a past event whose tax effect has simply been deferred, rather than the future taxable or deductible differences addressed by ASC 740. The example below illustrates these conclusions for a situation involving the transfer of inventory.

Example 3-39

Assume the following:

A parent entity, P, operates in a jurisdiction, A, where the tax rate is 25 percent. Parent P’s wholly owned subsidiary, S, operates in a jurisdiction, B, where the tax rate is 35 percent.
Parent P sells inventory to S at a $100 profit, and the inventory is on hand at year-end. Assume that P purchased the inventory for $200. Therefore, S’s basis for income tax reporting purposes in Jurisdiction B is $300.
Parent P prepares consolidated financial statements and, for financial reporting purposes, gains and losses on intra-entity transactions are eliminated in consolidation.

The following journal entry shows the income tax impact of this intra-entity transaction on P’s consolidated financial statements.

The FASB concluded that although the excess of the buyer’s tax basis over the cost of transferred assets reported in the consolidated financial statements meets the technical definition of a temporary difference, in substance an entity accounts for this temporary difference by recognizing income taxes related to intra-entity gains that are not recognized in consolidated financial statements. The FASB decided to eliminate that conflict by prohibiting the recognition of deferred taxes in the buyer’s jurisdiction for those differences and deferring the recognition of expense for the tax paid by the seller.

Assume that in a subsequent period, S sold the inventory that it acquired from P to an unrelated third party for the exact amount it previously paid P — $300. The following journal entry shows the sales and related tax consequences that should be reflected in P’s consolidated financial statements.

3.5.6.1 Subsequent Changes in Tax Rates Involving Intra-Entity Transactions

If a jurisdiction changes its tax rates after an intra-entity transaction but before the end product is sold to a third party, the prepaid tax that was recognized should not be revalued. This prepaid tax is different from deferred taxes that are recorded in accordance with ASC 740 (which would need to be revalued) because it represents a past event whose tax effect (i.e., tax payment) has simply been deferred, rather than the future taxable or deductible difference addressed by ASC 740. Thus, a subsequent change in the tax rates in either jurisdiction (buyer or seller) does not result in a change in the actual or future tax benefit to be received. In other words, a future reduction in rates in the seller’s market does not change the value because the transaction that was taxed has passed and is complete. In the buyer’s market, a change in rates does not make the previous tax paid in the other jurisdiction any more or less valuable either. The deferral is simply an income statement matching matter that arises in consolidation whose aim is recognition of the ultimate tax effects (at the actual rates paid) in the period of the end sale to an external third party. Hence, prepaid taxes associated with intra-entity profits do not need to be revalued.

3.5.7 Income Tax Accounting for Convertible Instruments With Embedded Conversion Features

In August 2020, the FASB issued ASU 2020-06 to simplify an entity’s accounting for convertible instruments (ASC 470-20) and contracts on an entity’s own equity (ASC 815). Of the five models of accounting for convertible instruments under ASC 470-20, the ASU removed the requirement for the separate allocation of proceeds attributable to the issuance of (1) a convertible debt instrument with a cash conversion feature (CCF) and (2) a convertible instrument with a beneficial conversion feature (BCF). As a result, after adopting the ASU’s guidance, entities will not separately present in equity an embedded conversion feature in such debt. Instead, they will account for a convertible debt instrument wholly as debt, in the same manner as they would such an instrument for U.S. federal income tax purposes, eliminating the difference between book and tax basis in these debt instruments.

The ASU did not change the accounting for the other three types of convertible instruments: (1) convertible instruments with an embedded derivative where the embedded derivative is bifurcated and accounted for as a derivative instrument in accordance with ASC 815-15, separate from the host contract, (2) traditional convertible debt treated wholly as debt, and (3) convertible debt issued at a substantial premium in which any residual amount in excess of its principal amount is allocated to equity.

Upon the adoption of ASU 2020-06, the income tax accounting guidance applicable to convertible instruments with a CCF or a BCF is superseded (see below). However, the ASU does not directly address situations in which the conversion feature is bifurcated and accounted for as a separate derivative liability. In such cases, there is typically a difference between the book and tax basis of both the debt instrument and the conversion feature accounted for as a derivative liability. These basis differences result because, although the convertible debt instrument is separated into two units of accounting for financial reporting purposes (the debt instrument and the conversion feature), the debt is typically not bifurcated for tax purposes. In such circumstances, deferred taxes should be recorded for the basis differences of both the debt and the derivative liability.

The tax basis difference associated with a debt conversion feature that is a derivative liability is considered a deductible temporary difference. ASC 740-10-20 defines a temporary difference as a difference “that will result in taxable or deductible amounts in future years when the reported amount of the . . . liability is recovered or settled.” Further, ASC 740-10-20 states that “[e]vents that do not have tax consequences do not give rise to temporary differences.” This conclusion is also based by analogy on the income tax accounting guidance on BCFs and conversion features bifurcated from convertible debt instruments that may be settled in cash upon conversion.

Accordingly, any difference between the financial reporting basis and tax basis of both the convertible debt instrument and the derivative liability should be accounted for as a temporary difference in accordance with ASC 740. However, as demonstrated in the example below, if the settlement of the convertible debt and derivative liability at an amount greater than their combined tax basis would not result in a tax-deductible transaction, a net DTA should not be recorded.

Example 3-40

On January 1, 20X1, Entity A issues 100,000 convertible notes at their par value of $1,000 per note, raising total proceeds of $100 million. The embedded conversion feature must be accounted for separately from the convertible notes (i.e., as a derivative instrument under ASC 815). On January 1, 20X1, and December 31, 20X1, the derivative liability has a fair value of $40 million and $35 million, respectively. The notes bear interest at a fixed rate of 2 percent per annum, payable annually in arrears on December 31, and mature in 10 years. The notes do not contain embedded prepayment features other than the conversion option.

The tax basis of the notes is $100 million, and A’s tax rate is 25 percent. Entity A is entitled to tax deductions based on cash interest payments but will receive no tax deduction if the payment of consideration upon settlement is in excess of the tax basis of the convertible notes ($100 million), regardless of the form of that consideration (cash or shares).

Transaction costs are not considered in this example.

As shown above, the deferred tax balances will typically offset each other at issuance. However, the temporary differences will not remain equivalent because the derivative liability will typically be marked to fair value on an ongoing basis while the discount on the debt will accrete toward the principal balance, as shown below.

Because A presumes that the liabilities will be settled at their current carrying value (reported amount) in the future and the combined carrying value is less than the combined tax basis, the settlement will result in a taxable transaction. Accordingly, the basis differences meet the definition of a temporary difference under ASC 740 and a net DTL is recorded. However, if the fair value of the derivative liability would have increased and the combined carrying value (reported amount) of the convertible debt and derivative liability would have exceeded the combined tax basis, the basis differences would not meet the definition of a temporary difference under ASC 740 because the settlement of convertible debt and derivative liability at an amount greater than their combined basis would not result in a tax-deductible transaction.

Therefore, it is acceptable for A to record deferred taxes for the basis differences but only to the extent that the combined carrying value of the convertible debt and derivative liability is equal to or less than the combined tax basis. In other words, at any point, A could have a net DTL related to the combined carrying value but not a net DTA.

The guidance below reflects the income tax accounting before the adoption of ASU 2020-06 for convertible instruments with a CCF and a BCF.

Entities that issue convertible instruments must assess whether an instrument’s conversion feature should be accounted for separately (bifurcated) in accordance with relevant U.S. GAAP (e.g., ASC 470-20). Under U.S. GAAP, an entity must also determine whether a conversion feature that is bifurcated should be classified as equity or as a derivative.

Before the adoption of ASU 2020-06, ASC 740-10-55-51 addresses the accounting for tax consequences of convertible debt instruments that contain a BCF that is bifurcated and accounted for as equity. In addition, the income tax accounting guidance in ASC 470-20-25-27 before the ASU’s adoption addresses situations in which (1) a convertible debt instrument may be settled in cash upon conversion and (2) the conversion feature is bifurcated and accounted for as equity.

Further, ASC 740-10-55-51 addresses the income tax accounting for BCFs before the adoption of ASU 2020-06. It states, in part:

The issuance of convertible debt with a beneficial conversion feature results in a basis difference for purposes of applying this Topic. The recognition of a beneficial conversion feature effectively creates two separate instruments — a debt instrument and an equity instrument — for financial statement purposes while it is accounted for as a debt instrument, for example, under the U.S. Federal Income Tax Code. Consequently, the reported amount in the financial statements (book basis) of the debt instrument is different from the tax basis of the debt instrument. The basis difference that results from the issuance of convertible debt with a beneficial conversion feature is a temporary difference for purposes of applying this Topic because that difference will result in a taxable amount when the reported amount of the liability is recovered or settled. That is, the liability is presumed to be settled at its current carrying amount (reported amount).

Before the adoption of ASU 2020-06, the convertible debt guidance in ASC 470-20-25-27 addresses the income tax accounting for conversion features bifurcated from convertible debt instruments that may be settled in cash upon conversion. This paragraph states, in part:

Recognizing convertible debt instruments within the scope of the Cash Conversion Subsections as two separate components — a debt component and an equity component — may result in a basis difference associated with the liability component that represents a temporary difference for purposes of applying Subtopic 740-10.

3.5.8 Leases

A lease’s classification for accounting purposes does not affect its classification for tax purposes. Thus, an entity needs to determine the tax classification of a lease under the applicable tax laws. While the classification may be similar for either purpose, the differences between tax and accounting principles and guidance often result in book/tax differences.

Connecting the Dots

Under ASC 842, the lessee recognizes in its statement of financial position an ROU asset and a lease liability for most operating leases (including those related to synthetic lease arrangements). For income tax purposes, however, the lessor is still treated as the owner of the property, resulting in temporary differences with respect to each individual item and the need to record and track the deferred taxes on each temporary difference separately.

For example, if there is no tax basis in the ROU asset, a taxable temporary difference may arise. Similarly, if there is no tax basis in the lease liability, a deductible temporary difference may arise. The taxable and deductible temporary differences are separate and give rise to separate and distinct deferred tax amounts that generally should not be netted in the income tax disclosures. Entities should carefully consider the disclosure requirements in both ASC 740-10-50-2 and ASC 740-10-50-6 (see Chapter 14 for more information).

3.5.9 Consequences of Investments in Debt and Equity Securities

The guidance in ASU 2016-01 (now fully effective) significantly revised an entity’s accounting related to the classification and measurement of equity securities. For example, it amended the guidance in ASC 321 to require entities to carry all investments in equity securities, including other ownership interests (e.g., partnerships, unincorporated joint ventures, LLCs), at fair value, with any changes in value recorded through continuing operations.25

If the investments in equity securities are not measured at fair value for income tax purposes, the application of the fair value measurement requirements in ASC 321 will create either taxable or deductible temporary differences for which deferred taxes would be recognized. If a DTA is recognized, it must be assessed for realization.

The ASU largely retained the existing guidance on the classification and measurement of investments in debt securities. Under ASC 320, an entity may classify these investments as HTM, trading, or AFS. In accordance with ASC 320-10-25-1:

Debt securities that the entity has the positive intent and ability to hold until maturity are classified as HTM and are reported at amortized cost.
Debt securities that are bought and held principally to be sold in the near term are classified as trading securities and are reported at fair value, with any unrealized gains and losses included in earnings.
Debt securities not classified as either HTM or trading are classified as AFS and are reported at fair value, with unrealized gains and losses excluded from earnings and reported in OCI.

3.5.9.1 HTM Securities

Use of the amortized cost method of accounting for debt securities that are HTM often creates taxable or deductible temporary differences because, for financial reporting purposes, any discount or premium is amortized to income over the life of the investment. However, the cost method used for tax purposes does not amortize discounts or premiums. For example, because the amortization of a discount increases the carrying amount of the debt security for financial reporting purposes, a taxable temporary difference results when the tax basis in the investment remains unchanged under the applicable tax law. Accounting for the deferred tax consequences of any resultant temporary differences created by the use of the amortized cost method is relatively straightforward because both the pretax impact caused by the amortization of a discount or premium and its related deferred tax consequences are recorded in the income statement during the same period.

When the amortized cost method creates a deductible temporary difference, realization of the resultant DTA must be assessed. A valuation allowance is necessary to reduce the related DTA to an amount whose realization is more likely than not. The tax consequences of valuation allowances and any subsequent changes necessary to adjust the DTA to an amount that is more likely than not to be realized are generally charged or credited directly to income tax expense or benefit from continuing operations (exceptions to this general rule are discussed in ASC 740-20-45-3). This procedure produces a normal ETR for income tax expense from continuing operations. Since the preceding discussion pertains to HTM securities, the resulting income and losses are reported in continuing operations rather than in OCI.

3.5.9.2 Trading Securities

Trading securities that are reported at fair value create taxable and deductible temporary differences when the cost method is used for income tax purposes. For example, a temporary difference is created when the fair value of an investment and its corresponding carrying amount for financial reporting purposes differ from its cost for income tax purposes. Accounting for the deferred tax consequences of any temporary differences resulting from marking the securities to market for financial reporting purposes is charged or credited directly to income tax expense or benefit from continuing operations.

When mark-to-market accounting creates a deductible temporary difference, realization of the resulting DTA must be assessed. A DTA is reduced by a valuation allowance, if necessary, so that the net amount represents the tax benefit that is more likely than not to be realized. The tax consequences of establishing a valuation allowance and any subsequent changes that may be necessary are generally charged or credited directly to income tax expense or benefit from continuing operations (exceptions to this general rule are discussed in ASC 740-20-45-3). This procedure produces a normal ETR for income tax expense from continuing operations in the absence of a valuation allowance.

3.5.9.3 AFS Securities

Securities classified as AFS are marked to market as of the balance sheet date, which creates taxable and deductible temporary differences whenever the cost method is used for income tax purposes. For example, a DTL will result from taxable temporary differences whenever the fair value of an AFS security is in excess of the amount of its cost basis as determined under tax law. ASC 320-10-35-1 indicates that unrealized holding gains and losses must be excluded from earnings and reported as a net amount in OCI. In addition, ASC 740-20-45-11 provides guidance on reporting the tax effects of unrealized holding gains and losses. ASC 740-20-45-11(b) requires that the tax effects of gains and losses that occur during the year that are included in comprehensive income but excluded from net income (i.e., unrealized gains and losses on AFS securities) are also charged or credited to OCI. The example below illustrates this concept. An entity should evaluate the need for a valuation allowance on a DTA related to AFS securities in combination with the entity’s other DTAs. For further discussion of the evaluation (for realization) of a DTA related to AFS debt securities, see Section 5.7.4.

Example 3-41

Assume that at the beginning of the current year, 20X1, Entity X has no unrealized gain or loss on an AFS security. During 20X1, unrealized losses on AFS securities are $1,000 and the tax rate is 25 percent. As a result of significant negative evidence available at the close of 20X1, X concludes that a 50 percent valuation allowance is necessary. Therefore, X records a $250 DTA and a $125 valuation allowance. Accordingly, the carrying amount of the AFS portfolio is reduced by $1,000, OCI is reduced by $875, and a $125 net DTA (a DTA of $250 less a valuation allowance of $125) is recognized at the end of 20X1.

Footnotes

While check-the-box elections are most commonly considered in a foreign context, the same elections can be made for domestic entities.

The check-the-box election is not part of a larger restructuring transaction.

This requirement does not apply to investments that qualify for the equity method of accounting or to those that result in consolidation or for which the entity has elected the practicability exception to fair value measurement.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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.