Chapter 3 — Book-Versus-Tax Differences and Tax Attributes
Chapter 3 — Book-Versus-Tax Differences and Tax Attributes
3.1 Background
While many of an entity’s transactions receive identical tax and financial reporting
treatment, there are some situations in which they will be treated differently,
giving rise to book-versus-tax differences. Such differences may be “permanent” or
“temporary.”
When a transaction affects the computation of income or loss for
income tax reporting purposes but not for financial reporting purposes, or vice
versa, and does not result in a difference between the income tax and
financial reporting basis in an asset or liability, a permanent difference between
financial reporting and taxable income arises. The income tax effects of permanent
items are generally reflected in income tax expense corresponding with the amount of
taxes payable or refundable for the current year and the entity’s annual effective
tax rate (AETR). Deferred taxes are not recorded for permanent differences.
However, an entity does record deferred taxes for temporary differences. Typically,
temporary differences do not affect total income tax expense or the entity’s AETR in
the absence of a phased-in change in tax rate or other similar situations discussed
later in this chapter. Rather, temporary differences generate additional taxable
income or loss when the related amount for financial reporting purposes is recovered
(asset) or settled (liability). For this reason, deferred taxes are always recorded
on taxable and deductible temporary differences unless one of the exceptions in ASC
740-10-25-3 applies.
See Sections
1.3.2.1 and 1.3.3.1 for additional information about permanent and temporary
differences, respectively, and their effects on income tax expense and the AETR.
3.2 Permanent Differences
ASC 740-10
Basis Differences That
Are Not Temporary Differences
25-30 Certain 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. One example, depending on the
provisions of the tax law, could be the excess of cash
surrender value of life insurance over premiums paid. That
excess is a temporary difference if the cash surrender value
is expected to be recovered by surrendering the policy, but
is not a temporary difference if the asset is expected to be
recovered without tax consequence upon the death of the
insured (if under provisions of the tax law there will be no
taxable amount if the insurance policy is held until the
death of the insured).
25-31 Tax-to-tax differences
are not temporary differences. Recognition of a deferred tax
asset for tax-to-tax differences is prohibited as tax-to-tax
differences are not one of the exceptions identified in
paragraph 740-10-25-3. An example of a tax-to-tax difference
is an excess of the parent entity’s tax basis of the stock
of an acquired entity over the tax basis of the net assets
of the acquired entity.
FASB Statement 109, which was codified in ASC 740, effectively
described permanent differences as differences that arise from statutory provisions
under which (1) specified revenues are exempt from taxation and (2) specified
expenses are not allowable as deductions in the determination of taxable income.
In addition, ASC 740-10-25-31 provides guidance on tax-to-tax
differences. For example, as a result of a nontaxable business combination, the
acquiror’s tax basis in the acquired stock (i.e., outside basis) may exceed the tax
basis in the acquired entity’s assets and liabilities (i.e., inside basis). Since
such differences are not temporary differences, the recognition of a DTA is
prohibited under ASC 740.
The table below illustrates many of the more common permanent
differences that result from the application of U.S. federal tax law to items
recognized for financial reporting purposes.
|
Accounting Description
|
Accounting Treatment
|
Tax Treatment
|
|---|---|---|
|
Tax-exempt securities:
| ||
|
1. Interest income
|
Income
|
Tax exempt (IRC Section 103).
|
|
2. Interest paid on debt incurred to buy or carry
tax-exempt securities
|
Expense
|
Not deductible (IRC Section 265).
|
|
3. Amortization of bond premium
|
Expensed by using interest method (ASC
835-30-35-2)
|
Not deductible (IRC Section 171(a));
however, basis of bond must be reduced by amount of
amortization (IRC Section 1016(a)(5)).
|
|
4. Gains or losses upon disposition
|
Income (loss)
|
|
|
Illegal bribes and kickbacks
|
Expense
|
Not deductible.
|
|
Treble damages; payments involving criminal
proceedings
|
Expense
|
Not deductible (IRC Section 162(g)).
|
|
Expenses paid or incurred to influence the
general public with respect to legislative matters,
elections, or referendums
|
Expense
|
Not deductible (IRC Section
162(e)(1)(c)).
|
|
Expenses paid or incurred with respect to
legislative matters that are not in direct interest to the
taxpayer’s trade of business
|
Expense
|
Not deductible (IRC Treas. Reg.
1.162-20(c)).
|
|
Fines and penalties paid to the government
of the United States, a territory or possession of the
United States, the District of Columbia, a foreign country,
or a political subdivision of any of the above for the
violation of any law
|
Expense
|
Not deductible (IRC Section 162(f)).
|
|
Worthless debts from political parties
|
Expense
|
Generally, not deductible. May be deducted
by banks and other taxpayers if more than 30 percent of all
receivables accrued during normal course of business are due
from political parties (IRC Section 271).
|
|
Income and expenses from sources within
possessions of the United States
|
Income and expense
|
Income may be exempt and deductions not
allowed if certain conditions are met (IRC Section 931).
|
|
Certain expenses that a taxpayer chooses to
claim a credit in lieu of (i.e., foreign tax credit [FTC],
jobs credit)
|
Expense
|
Not deductible.
|
|
Entertainment expense
|
Expense
|
Not deductible (IRC Section 274(a)).
|
|
Meals expense
|
Expense
|
50 percent is not deductible for tax
purposes (IRC Section 274(n)).
|
|
Political contributions
|
Expense
|
Not deductible (IRC Treas. Reg.
1.162-20(c)(1)).
|
|
Certain losses on the disposition of
consolidated-group subsidiary stock
|
Expense
|
Not deductible (IRC Treas. Reg. 1.1502-36).
|
3.2.1 Special Deductions
ASC 740-10
Anticipated Future Special Deductions
25-37 The tax benefit of
statutory depletion and other types 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 for
purposes of offsetting a deferred tax liability for
taxable temporary differences at the end of the current
year. 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.
See Section 740-10-30 for measurement requirements
related to determining tax rates and a valuation
allowance for deferred tax assets.
Other common permanent differences that result from the
application of U.S. federal tax law include special deductions. The tax law
permits certain entities to recognize certain tax benefits for special
deductions. Such deductions are reflected in pretax income for tax reporting
purposes but not for financial reporting purposes and therefore give rise to
permanent differences. While the term “special deduction” is not defined, ASC
740-10-25-37 and ASC 740-10-55-27 through 55-30 offer four examples: (1) tax
benefits for statutory depletion, (2) deductions for certain health benefit
entities (e.g., Blue Cross/Blue Shield providers), (3) deductions for small life
insurance companies, and (4) a deduction for domestic production activities. In
addition, the deduction for foreign-derived intangible income (FDII) qualifies
as a special deduction.
The next sections summarize the special deductions discussed
above.
3.2.1.1 Statutory Depletion
IRC Sections 611–613 allow entities in certain extractive
industries, such as oil and gas and mining, to take a deduction for
“depletion” when determining taxable income for U.S. federal tax purposes.
The depletion deduction for a particular taxable year is calculated as the
greater of cost depletion or percentage depletion. Cost depletion is based
on the cost of the reserves, and percentage depletion is based on
multiplying gross income from the property by a specified statutory
percentage, subject to certain limitations. As with other special
deductions, entities cannot anticipate the tax benefit from statutory
depletion when measuring the DTL related to a taxable temporary difference
at year-end. The statutory depletion tax benefit would be recognized no
earlier than the year in which the depletion is deductible on the entity’s
income tax return.
3.2.1.2 Blue Cross/Blue Shield Organizations
IRC Section 833 entitles Blue Cross and Blue Shield plans to
special tax deductions that are not available to other insurers. The
deduction allowed for any taxable year is the excess (if any) of (1) 25
percent of the sum of (a) claims incurred during the taxable year and (b)
expenses incurred in connection with the administration, adjustment, or
settlement of claims over (2) the “adjusted surplus” as of the beginning of
the taxable year.
3.2.1.3 Domestic Production Activities Deduction
The domestic production activities deduction was enacted
into law in the United States on October 22, 2004, as part of the American
Jobs Creation Act of 2004 (the “Jobs Creation Act”). The Jobs Creation Act
allowed for a tax deduction of up to 9 percent of the lesser of (1)
qualified production activities income or (2) taxable income (after the
deduction for the use of any NOL carryforwards). This tax deduction was
limited to 50 percent of W-2 wages paid by the taxpayer. ASC 740-10-55-27
through 55-30 provide implementation guidance clarifying that the production
activities deduction should be accounted for as a special deduction in
accordance with ASC 740-10-25-37. The domestic production activities
deduction was repealed upon enactment of the Tax Cuts and Jobs Act of 2017
(the “2017 Act”).
3.2.1.4 Foreign-Derived Intangible Income
IRC Section 250 allows a domestic corporation an immediate
deduction against U.S. taxable income for a portion of its FDII. The amount
of the deduction depends, in part, on the corporation’s U.S. taxable income.
The percentage of income that can be deducted is reduced in taxable years
beginning after December 31, 2025.
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
1
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.
2
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.”
3
For ease of illustration,
currency differences are ignored.
4
If the local country DTA has a full
valuation allowance associated with it, however, no DTL for
a forgone FTC would be recorded.
5
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).
3.4 Outside Basis Differences
ASC 740-10
25-1 This
Section establishes the recognition requirements necessary
to implement the objectives of accounting for income taxes
identified in Section 740-10-10. The following paragraph
sets forth the basic recognition requirements while
paragraph 740-10-25-3 identifies specific, limited
exceptions to the basic requirements.
25-2 Other than
the exceptions identified in the following paragraph, the
following basic requirements are applied in accounting for
income taxes at the date of the financial statements:
- A tax liability or asset shall be recognized based on the provisions of this Subtopic applicable to tax positions, in paragraphs 740-10-25-5 through 25-17, for the estimated taxes payable or refundable on tax returns for the current and prior years.
- A deferred tax liability or asset shall be recognized for the estimated future tax effects attributable to temporary differences and carryforwards.
25-3 The only exceptions in
applying those basic requirements are:
- Certain exceptions to the
requirements for recognition of deferred taxes
whereby a deferred tax liability is not recognized
for the following types of temporary differences
unless it becomes apparent that those temporary
differences will reverse in the foreseeable future:
- An excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration. See paragraphs 740-30-25-18 through 25-19 for the specific requirements related to this exception.
- Undistributed earnings of a domestic subsidiary or a domestic corporate joint venture that is essentially permanent in duration that arose in fiscal years beginning on or before December 15, 1992. A last-in, first-out (LIFO) pattern determines whether reversals pertain to differences that arose in fiscal years beginning on or before December 15, 1992. See paragraphs 740-30-25-18 through 25-19 for the specific requirements related to this exception.
- 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. See paragraphs 942-740-25-1 through 25-3 for the specific requirements related to this exception.
- Policyholders’ surplus of stock life insurance entities that arose in fiscal years beginning on or before December 15, 1992. See paragraph 944-740-25-2 for the specific requirements related to this exception.
- Subparagraph superseded by Accounting Standards Update No. 2017-15.
- The pattern of recognition of after-tax income for leveraged leases or the allocation of the purchase price in a purchase business combination to acquired leveraged leases as required by Subtopic 842-50.
- A prohibition on recognition of a deferred tax liability related to goodwill (or the portion thereof) for which amortization is not deductible for tax purposes (see paragraph 805-740-25-3).
- A prohibition on recognition of a deferred tax asset for the difference between the tax basis of inventory in the buyer’s tax jurisdiction and the carrying value as reported in the consolidated financial statements as a result of an intra-entity transfer of inventory from one tax-paying component to another tax-paying component of the same consolidated group. Income taxes paid on intra-entity profits on inventory remaining within the consolidated group are accounted for under the requirements of Subtopic 810-10.
- A prohibition on recognition of a deferred tax liability or asset for differences related to assets and liabilities that, under Subtopic 830-10, are remeasured from the local currency into the functional currency using historical exchange rates and that result from changes in exchange rates or indexing for tax purposes. See Subtopic 830-740 for guidance on foreign currency related income taxes matters.
ASC 740-30
25-1 This
Section provides guidance on the accounting for specific
temporary differences related to investments in subsidiaries
and corporate joint ventures, including differences arising
from undistributed earnings. In certain situations, these
temporary differences may be accounted for differently from
the accounting that otherwise requires comprehensive
recognition of deferred income taxes for temporary
differences.
25-2 Including
undistributed earnings of a subsidiary (which would include
the undistributed earnings of a domestic international sales
corporation eligible for tax deferral) in the pretax
accounting income of a parent entity either through
consolidation or accounting for the investment by the equity
method results in a temporary difference.
25-3 It shall
be presumed that all undistributed earnings of a subsidiary
will be transferred to the parent entity. Accordingly, the
undistributed earnings of a subsidiary included in
consolidated income shall be accounted for as a temporary
difference unless the tax law provides a means by which the
investment in a domestic subsidiary can be recovered tax
free.
25-4 The
principles applicable to undistributed earnings of
subsidiaries in this Section also apply to tax effects of
differences between taxable income and pretax accounting
income attributable to earnings of corporate joint ventures
that are essentially permanent in duration and are accounted
for by the equity method. Certain corporate joint ventures
have a life limited by the nature of the venture, project,
or other business activity. Therefore, a reasonable
assumption is that a part or all of the undistributed
earnings of the venture will be transferred to the investor
in a taxable distribution. Deferred taxes shall be recorded,
in accordance with the requirements of Subtopic 740-10 at
the time the earnings (or losses) are included in the
investor’s income.
25-5 A deferred
tax liability shall be recognized for both of the following
types of taxable temporary differences:
- An excess of the amount for financial reporting over the tax basis of an investment in a domestic subsidiary that arises in fiscal years beginning after December 15, 1992.
- An excess of the amount for financial reporting over the tax basis of an investment in a 50-percent-or-less-owned investee except as provided in paragraph 740-30-25-18 for a corporate joint venture that is essentially permanent in duration.
Paragraphs 740-30-25-9 and 740-30-25-18
identify exceptions to the accounting that otherwise
requires comprehensive recognition of deferred income taxes
for temporary differences arising from investments in
subsidiaries and corporate joint ventures.
25-6 Paragraph
740-30-25-18 provides that a deferred tax liability is not
recognized for either of the following:
- An excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary that meets the criteria in paragraph 740-30-25-17.
- Undistributed earnings of a domestic subsidiary that arose in fiscal years beginning on or before December 15, 1992, and that meet the criteria in paragraph 740-30-25-17. The criteria in that paragraph do not apply to undistributed earnings of domestic subsidiaries that arise in fiscal years beginning after December 15, 1992, and as required by the preceding paragraph, a deferred tax liability shall be recognized if the undistributed earnings are a taxable temporary difference.
Determining Whether a
Temporary Difference Is a Taxable Temporary
Difference
25-7 Whether an
excess of the amount for financial reporting over the tax
basis of an investment in a more-than-50-percent-owned
domestic subsidiary is a taxable temporary difference shall
be assessed. It is not a taxable temporary difference if the
tax law provides a means by which the reported amount of
that investment can be recovered tax-free and the entity
expects that it will ultimately use that means. For example,
tax law may provide that:
- An entity may elect to determine taxable gain or loss on the liquidation of an 80-percent-or-more-owned subsidiary by reference to the tax basis of the subsidiary’s net assets rather than by reference to the parent entity’s tax basis for the stock of that subsidiary.
- An entity may execute a statutory merger whereby a subsidiary is merged into the parent entity, the noncontrolling shareholders receive stock of the parent, the subsidiary’s stock is cancelled, and no taxable gain or loss results if the continuity of ownership, continuity of business entity, and certain other requirements of the tax law are met.
25-8 Some
elections for tax purposes are available only if the parent
owns a specified percentage of the subsidiary’s stock. The
parent sometimes may own less than that specified
percentage, and the price per share to acquire a
noncontrolling interest may significantly exceed the
per-share equivalent of the amount reported as
noncontrolling interest in the consolidated financial
statements. In those circumstances, the excess of the amount
for financial reporting over the tax basis of the parent’s
investment in the subsidiary is not a taxable temporary
difference if settlement of the noncontrolling interest is
expected to occur at the point in time when settlement would
not result in a significant cost. That could occur, for
example, toward the end of the life of the subsidiary, after
it has recovered and settled most of its assets and
liabilities, respectively. The fair value of the
noncontrolling interest ordinarily will approximately equal
its percentage of the subsidiary’s net assets if those net
assets consist primarily of cash.
Recognition of
Deferred Tax Assets
25-9 A deferred
tax asset shall be recognized for an excess of the tax basis
over the amount for financial reporting of an investment in
a subsidiary or corporate joint venture that is essentially
permanent in duration only if it is apparent that the
temporary difference will reverse in the foreseeable
future.
25-10 For
example, if an entity decides to sell a subsidiary that
meets the requirements of paragraphs 205-20-45-1A through
45-1D for measurement and display as a discontinued
operation and the parent entity’s tax basis in the stock of
the subsidiary (outside tax basis) exceeds the financial
reporting amount of the investment in the subsidiary, the
decision to sell the subsidiary makes it apparent that the
deductible temporary difference will reverse in the
foreseeable future. Assuming in this example that it is more
likely than not that the deferred tax asset will be
realized, the tax benefit for the excess of outside tax
basis over financial reporting basis shall be recognized
when it is apparent that the temporary difference will
reverse in the foreseeable future. The same criterion shall
apply for the recognition of a deferred tax liability
related to an excess of financial reporting basis over
outside tax basis of an investment in a subsidiary that was
previously not recognized under the provisions of paragraph
740-30-25-18.
25-11 The need
for a valuation allowance for the deferred tax asset
referred to in paragraph 740-30-25-9 and other related
deferred tax assets, such as a deferred tax asset for
foreign tax credit carryforwards, shall be assessed.
25-12 Paragraph
740-10-30-18 identifies four sources of taxable income to be
considered in determining the need for and amount of a
valuation allowance for those and other deferred tax assets.
One source is future reversals of temporary differences.
25-13 Future
distributions of future earnings of a subsidiary or
corporate joint venture, however, shall not be considered
except to the extent that a deferred tax liability has been
recognized for existing undistributed earnings or earnings
have been remitted in the past.
25-14 A tax
benefit shall not be recognized, however, 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.
Ownership Changes in
Investments
25-15 An investment in common
stock of a subsidiary may change so that it is no longer a
subsidiary because the parent entity sells a portion of the
investment, the subsidiary sells additional stock, or other
transactions affect the investment. If a parent entity did
not recognize income taxes on its equity in undistributed
earnings of a subsidiary for the reasons cited in paragraph
740-30-25-17 (and the entity in which the investment is held
ceases to be a subsidiary), it shall accrue in the current
period income taxes on the temporary difference related to
its remaining investment in common stock in accordance with
the guidance in Subtopic 740-10.
25-16 Paragraph superseded by
Accounting Standards Update No. 2019-12.
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). From a consolidated financial
reporting perspective, an entity’s financial reporting carrying amount in a
consolidated subsidiary is eliminated; however, book-to-tax differences in this
amount may still result in the need to record deferred taxes.
How an investor should apply the guidance in ASC 740-30 on temporary
differences related to investments depends on the type of investment and whether the
financial reporting carrying value exceeds the tax basis or vice versa.
The table below summarizes the types of investments and the relevant
guidance.
|
Investment
|
DTA Considerations
|
DTL Considerations
|
|---|---|---|
|
Under ASC 740-30-25-9, a DTA is recognized
for the “excess of the tax basis over the amount for
financial reporting . . . only if it is apparent that the
temporary difference will reverse in the foreseeable
future.”
|
Under ASC 740-30-25-5, recognition of a DTL
depends on when the excess of the financial reporting basis
over the tax basis of the investment arose:
|
|
Under ASC 740-30-25-9, a DTA is recognized
for the “excess of the tax basis over the amount for
financial reporting . . . only if it is apparent that the
temporary difference will reverse in the foreseeable
future.”
|
Under ASC 740-30-25-18, a DTL should not be
recognized on the excess of the financial reporting basis
over the tax basis of an investment unless it becomes
apparent that the temporary difference will reverse in the
foreseeable future (i.e., the indefinite reversal criteria
are not met).6
|
|
Equity method investee (generally, ownership
of less than 50 percent but more than 20 percent) that is
not a corporate joint venture
|
A DTA is recognized for the excess of the
tax basis of the investment over the amount for financial
reporting and must be assessed for realizability (in most
jurisdictions, the loss would be capital in character).
|
A DTL is recorded on the excess of the
financial reporting basis over the tax basis of the
investment.
|
|
Cost method investee7
|
Generally, a DTA is recognized for the
excess of the tax basis of the investment over the amount
for financial reporting (if applicable) and must be assessed
for realizability (in most jurisdictions, the loss would be
capital in character).
|
Generally, a DTL is recorded on the excess
of the financial reporting basis over the tax basis of the
investment (if applicable).
|
Deferred taxes are always recorded on taxable and deductible
temporary differences unless a specific exception applies.
3.4.1 Definition of Foreign and Domestic Investments
ASC 740-10-25-3(a)(1) contains an exception to the requirement to provide a DTL
for the “excess of the amount for financial reporting over the tax basis of an
investment in a foreign subsidiary or a foreign corporate joint
venture” (emphasis added), while ASC 740-30-25-7 contains an exception to the
requirement to provide a DTL for the “excess of the amount for financial
reporting over the tax basis of an investment in a more-than-50-percent-owned
domestic subsidiary” (emphasis added). Accordingly, it is important
to determine whether an entity is a foreign or domestic entity.
An entity should determine whether an investment is foreign or
domestic on the basis of the relationship of the investee to the tax
jurisdiction of its immediate parent rather than the relationship of the
investee to the ultimate parent of the consolidated group. This determination
should be made from the “bottom up” through successive tiers of consolidation.
At each level, it is necessary to determine whether the subsidiaries being
consolidated are foreign or domestic with respect to the consolidating entity. A
subsidiary that is treated as a domestic subsidiary under the applicable tax law
of its immediate parent would be considered a domestic subsidiary under ASC 740.
The examples below illustrate this concept.
Example 3-17
A U.S. parent entity, P, has a majority-owned domestic
subsidiary, S1, which has two investments: (1) a
majority ownership interest in a foreign entity, FS1,
and (2) an ownership interest in a foreign corporate
joint venture, FCJV1. In preparing its consolidated
financial statements, S1 consolidates FS1 and applies
the equity method of accounting to its investment in
FCJV1. Under ASC 740, S1 would consider its investments
in FS1 and FCJV1 to be in a foreign subsidiary
and foreign corporate joint venture,
respectively. Parent P would treat S1 as a domestic
subsidiary when consolidating S1.
Example 3-18
A U.S. parent entity, P, has a majority
ownership interest in a subsidiary (chartered in a
foreign country), FS, which has two investments: (1) a
majority ownership interest in another entity, S1, and
(2) an ownership interest in another corporate joint
venture entity, S2. Both S1 and S2 are located in the
same foreign country in which FS is chartered. When
preparing the consolidated financial statements, FS
would consider S1 and S2 a domestic
subsidiary and domestic
corporate joint venture, respectively, in
determining whether to recognize deferred taxes in the
foreign country on the outside basis difference of FS’s
investments in S1 and S2. Parent P would consider FS a
foreign subsidiary.
Example 3-19
A foreign parent entity, FP, prepares U.S. GAAP financial
statements and has two investments: (1) a majority-owned
investment in a U.S. entity, US1, and (2) an investment
in a corporate joint venture located in the United
States, JVUS1. In preparing its consolidated financial
statements, FP would consider US1 and JVUS1 a foreign
subsidiary and a foreign corporate joint
venture, respectively.
Example 3-20
A foreign entity, FP2, prepares U.S. GAAP financial
statements and has two investments: (1) a majority-owned
investment in another entity, S1, and (2) an investment
in a corporate joint venture, JV1. Both S1 and JV1 are
located in the same foreign country in which FP2 is
chartered. In preparing its consolidated financial
statements, FP2 would consider S1 and JV1 a domestic
subsidiary and a domestic corporate joint
venture, respectively.
Example 3-21
A U.S. parent entity, P, has a majority
ownership interest in a subsidiary (chartered in a
foreign country), FS, that has two investments: (1) a
majority ownership interest in another entity, S1,
located in the same foreign country in which FS is
chartered, and (2) an investment in a corporate joint
venture located in the United States, JVUS1. Before
being consolidated by P, FS would treat S1 as a domestic subsidiary and would
apply the equity method of accounting to JVUS1, as a foreign corporate joint venture
to determine whether to recognize deferred taxes on the
outside basis difference of its investments in S1 and
JVUS1.
3.4.1.1 Definition of Subsidiary and Corporate Joint Venture
An entity should use the following guidance to determine whether an
investment is in either a subsidiary or a corporate joint venture:
ASC 810-10-20 defines a subsidiary as follows:
An entity, including an
unincorporated entity such as a partnership or trust, in which another
entity, known as its parent, holds a controlling financial interest.
(Also, a variable interest entity that is consolidated by a primary
beneficiary.)
However, ASC 740-10-20 does not specifically define the term
“subsidiary” and does not refer to the definition in ASC 810-10. Rather, in
practice, the definition of subsidiary in APB Opinion 18 (codified in ASC
323) has been applied. APB Opinion 18 states that subsidiary refers to “a
corporation which is controlled, directly or indirectly, by another
corporation. The usual condition for control is ownership of a majority
(over 50%) of the outstanding voting stock.” Accordingly, while the
definition in ASC 810 includes partnerships and trusts, those entities are
not considered subsidiaries under ASC 740 because the earnings of such
entities generally pass directly through to their owners. See Section 3.4.15 for
further discussion of pass-through entities.
The term corporate joint venture is defined in ASC 740-10-20 as follows:
A
corporation owned and operated by a small group of entities (the joint
venturers) as a separate and specific business or project for the mutual
benefit of the members of the group. A government may also be a member
of the group. The purpose of a corporate joint venture frequently is to
share risks and rewards in developing a new market, product or
technology; to combine complementary technological knowledge; or to pool
resources in developing production or other facilities. A corporate
joint venture also usually provides an arrangement under which each
joint venturer may participate, directly or indirectly, in the overall
management of the joint venture. Joint venturers thus have an interest
or relationship other than as passive investors. An entity that is a
subsidiary of one of the joint venturers is not a corporate joint
venture. The ownership of a corporate joint venture seldom changes, and
its stock is usually not traded publicly. A noncontrolling interest held
by public ownership, however, does not preclude a corporation from being
a corporate joint venture.
3.4.1.2 Potential DTA: Foreign and Domestic Subsidiaries and Corporate Joint Ventures
ASC 740-30-25-9 states:
A deferred tax
asset shall be recognized for an excess of the tax basis over the amount
for financial reporting of an investment in a subsidiary or corporate
joint venture that is essentially permanent in duration only if it is
apparent that the temporary difference will reverse in the foreseeable
future.
As used in ASC 740-30-25-9, the term “foreseeable future”
refers to an entity’s ability to reasonably anticipate the reversal of the
outside basis difference. Further, we believe that in this context,
“reverse” is intended to mean “be realized” (i.e., be taken as a deduction
on the parent’s income tax return). Since a deductible outside basis
difference in a subsidiary generally results in a deduction on the parent’s
income tax return only upon sale or taxable liquidation of the subsidiary,
under ASC 740-30-25-9, a DTA would rarely be recognized before the criteria
in ASC 360-10-45-9 through 45-11 are met for classification of assets as
held for sale. While future earnings of the subsidiary may reduce the
deductible outside basis temporary difference, those future earnings do not
result in a reversal of the temporary difference, as the term “reverse” is
used in ASC 740-30-25-9. In other words, future earnings of the subsidiary
do not result in a deduction on the parent’s income tax return. Therefore,
anticipated future earnings of the subsidiary should not be relied upon to
support a conclusion that “the temporary difference will reverse in the
foreseeable future” and that a DTA can be recorded under ASC
740-30-25-9.
At the point at which the criteria in ASC 360-10-45-9 through 45-11 for a
measurement date have been satisfied, the deferred tax consequences of the
deductible outside basis difference should be recognized as a DTA. In
accordance with ASC 740-10-30-18, realization of the related DTA “depends on
the existence of sufficient taxable income of the appropriate character (for
example, ordinary income or capital gain) within the carryback, carryforward
period available under the tax law.” If it is not more likely than not that
all or a portion of the DTA will be realized, a valuation allowance is
necessary.
ASC 740-30-25-9 through 25-13 apply to more-than-50-percent-owned
subsidiaries (foreign or domestic) but do not apply to
50-percent-or-less-owned foreign or domestic investees. However, an entity
will need to use judgment to determine whether a recognition exception
applies to a subsidiary that is consolidated by applying the variable
interest entity (VIE) guidance when less than 50 percent of the voting
interest is owned by the investor. See Section 3.4.17.1
for consideration of the VIE model in ASC 810-10 in the evaluation of
whether to recognize a DTL.
3.4.1.3 Potential DTL: Domestic Subsidiary
ASC 740-30-25-7 applies to investments in a
more-than-50-percent-owned domestic subsidiary and assumes that the
subsidiary would be consolidated under ASC 810 (see Section 3.4.1.1). ASC
740-30-25-7 does not allow for the application of the indefinite reversal
exception to the recognition of DTLs for undistributed earnings of a
domestic subsidiary or corporate joint venture generated in fiscal years
beginning on or after December 15, 1992. Therefore, under ASC 740-30-25-3,
DTLs must be recognized “unless the tax law provides a means by which the
investment in a domestic subsidiary can be recovered tax free” and the
entity expects that it will ultimately use that means. The holder of the investment must meet both criteria to avoid recording
the DTL (see Section 3.4.3 for
more information).
While ASC 740-30-25-7 states that it applies only to
more-than-50-percent-owned domestic subsidiaries, an entity will need to use
judgment to determine whether a recognition exception applies to a
subsidiary that is consolidated under the VIE guidance when less than 50
percent of the voting interest is owned by the investor. See
Section 3.4.17.1 for considerations related to the
VIE model in ASC 810-10 in the evaluation of whether to recognize a DTL.
3.4.2 Tax Consequences of a Change in Intent Regarding Remittance of Pre-1993 Undistributed Earnings
It is possible for an entity to change its intent regarding remittance of the
portion of unremitted earnings that was generated for fiscal years beginning on
or before December 15, 1992, for domestic subsidiaries and domestic corporate
joint ventures that were previously deemed indefinitely invested.
An entity should apply the guidance in ASC 740-30-25-17 and ASC 740-30-25-19 to
tax consequences of a change in intent regarding unremitted earnings that arose
in fiscal years beginning on or before December 15, 1992. This guidance states,
in part:
25-17 The presumption in paragraph 740-30-25-3 that all
undistributed earnings will be transferred to the parent entity may be
overcome, and no income taxes shall be accrued by the parent entity . . . if
sufficient evidence shows that the subsidiary has invested or will invest
the undistributed earnings indefinitely or that the earnings will be
remitted in a tax-free liquidation. . . .
25-19 If
circumstances change and it becomes apparent that some or all of the
undistributed earnings of a subsidiary will be remitted in the foreseeable
future but income taxes have not been recognized by the parent entity, it
shall accrue as an expense of the current period income taxes attributable
to that remittance. If it becomes apparent that some or all of the
undistributed earnings of a subsidiary on which income taxes have been
accrued will not be remitted in the foreseeable future, the parent entity
shall adjust income tax expense of the current period.
Example 3-22
Assume that Entity X had $2,000 of unremitted earnings
from its investment in a domestic corporate joint
venture that arose in fiscal years beginning on or
before December 15, 1992, and that management has
determined that all of the pre-1993 corporate joint
venture earnings were indefinitely reinvested.
Therefore, no DTL has been recorded. In addition, assume
that during 20X1, unremitted earnings from the joint
venture were $1,000 and that X accrued the related
deferred income taxes on these earnings. During 20X2,
management of the joint venture changed its intent
regarding remitting joint venture earnings, concluding
that $1,000 of retained earnings would be distributed
(via a dividend) to X on December 31, 20X2, and $1,000
on December 31, 20X3, respectively.
ASC 740-10-25-3(a) states that whether reversals pertain
to differences that arose in fiscal years beginning on
or before December 15, 1992, is determined on the basis
of a LIFO pattern. Therefore, X would accrue, as of the
date the change in intent occurred in 20X2, a DTL for an
additional $1,000 of taxable income representing the tax
consequence of only $1,000 of pre-1993 unremitted
earnings; the deferred tax consequences of the other
$1,000 are related to income generated in post-1993
years, which was previously accrued in 20X1.
3.4.3 Tax-Free Liquidation or Merger of a Subsidiary
There may be instances in which it is acceptable to treat an
outside basis difference in a domestic subsidiary as a nontaxable temporary
difference. An analysis to achieve this treatment has quantitative and
qualitative thresholds.
In the assessment of whether the outside basis difference of an
investment in a domestic subsidiary is a taxable temporary difference in the
United States, an 80 percent investment in the subsidiary alone is not
sufficient for an entity to conclude that the outside basis difference is not a
taxable temporary difference. While U.S. tax law provides a means by which an
investment of 80 percent or more in a domestic subsidiary can be liquidated or
merged into the parent in a tax-free manner, an entity must also intend to ultimately use that means. Satisfying the tax
law requirements alone is not sufficient; the entity should also consider:
- Any regulatory approvals that may be required (e.g., in a rate-regulated entity in which a merger would be subject to regulatory approval and that approval is more than perfunctory).
- Whether the liquidation or merger is subject to approval by the noncontrolling interest holders.
- Whether it would be desirable for the entity to recover its investment in a tax-free manner. For example, if the entity’s outside basis in the subsidiary is significantly higher than the subsidiary’s inside basis, tax-free liquidation may be undesirable.
Some non-U.S. jurisdictions may stipulate similar rules for liquidation or merger
of a subsidiary into a parent in a tax-free manner. A similar analysis should be
performed on all subsidiaries for which the tax law provides a means by which a
reported investment can be recovered in a tax-free manner and the parent intends
to use that means.
In some circumstances, the parent may own less than the required
percentage under the applicable tax law (i.e., more than 50 percent but less
than 80 percent). In such cases, the parent may still be able to assert that it
can recover its investment in a tax-free manner (and thus not treat the outside
basis difference in the subsidiary as a taxable temporary difference) if it can
do so without incurring significant cost. ASC 740-30-25-8 states:
Some elections for tax purposes are available only if the
parent owns a specified percentage of the subsidiary's stock. The parent
sometimes may own less than that specified percentage, and the price per
share to acquire a noncontrolling interest may significantly exceed the
per-share equivalent of the amount reported as noncontrolling interest in
the consolidated financial statements. In those circumstances, the excess of
the amount for financial reporting over the tax basis of the parent’s
investment in the subsidiary is not a taxable temporary difference if
settlement of the noncontrolling interest is expected to occur at the point
in time when settlement would not result in a significant cost. That could occur, for example, toward the end of
the life of the subsidiary, after it has recovered and settled most of its
assets and liabilities, respectively. The fair value of the noncontrolling
interest ordinarily will approximately equal its percentage of the
subsidiary’s net assets if those net assets consist primarily of cash.
[Emphasis added]
In this context, one interpretation of significant cost could be that the costs
(based on fair value) of acquiring the necessary interest in that subsidiary to
recover it tax free are significant. In performing this assessment, the parent
can consider the cost that would be incurred at the end of the life of the
subsidiary (i.e., once the subsidiary’s assets have been converted to cash and
all outstanding liabilities have been settled). Under the “end-of-life”
scenario, the carrying value of the noncontrolling interest may be equivalent to
fair value. If the cost of assuming the noncontrolling interest at the “end of
the subsidiary’s life” is practicable, a tax-free liquidation or merger can be
assumed and the outside basis difference would not be treated as a taxable
temporary difference (as long as the tax law provides a means for a tax-free
liquidation or merger and the entity intends to use this means).
3.4.4 Potential DTL: Foreign Subsidiary and Foreign Corporate Joint Venture
ASC 740-30
Exceptions to Comprehensive Recognition of Deferred
Income Taxes
25-17 The
presumption in paragraph 740-30-25-3 that all
undistributed earnings will be transferred to the parent
entity may be overcome, and no income taxes shall be
accrued by the parent entity, for entities and periods
identified in the following paragraph if sufficient
evidence shows that the subsidiary has invested or will
invest the undistributed earnings indefinitely or that
the earnings will be remitted in a tax-free liquidation.
A parent entity shall have evidence of specific plans
for reinvestment of undistributed earnings of a
subsidiary which demonstrate that remittance of the
earnings will be postponed indefinitely. These criteria
required to overcome the presumption are sometimes
referred to as the indefinite reversal criteria.
Experience of the entities and definite future programs
of operations and remittances are examples of the types
of evidence required to substantiate the parent entity’s
representation of indefinite postponement of remittances
from a subsidiary. The indefinite reversal criteria
shall not be applied to the inside basis differences of
foreign subsidiaries.
25-18 As
indicated in paragraph 740-10-25-3, a deferred tax
liability shall not be recognized for either of the
following types of temporary differences unless it
becomes apparent that those temporary differences will
reverse in the foreseeable future:
- An excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration.
- Undistributed earnings of a domestic subsidiary or a domestic corporate joint venture that is essentially permanent in duration that arose in fiscal years beginning on or before December 15, 1992. A last-in, first-out (LIFO) pattern determines whether reversals pertain to differences that arose in fiscal years beginning on or before December 15, 1992.
25-19 If
circumstances change and it becomes apparent that some
or all of the undistributed earnings of a subsidiary
will be remitted in the foreseeable future but income
taxes have not been recognized by the parent entity, it
shall accrue as an expense of the current period income
taxes attributable to that remittance. If it becomes
apparent that some or all of the undistributed earnings
of a subsidiary on which income taxes have been accrued
will not be remitted in the foreseeable future, the
parent entity shall adjust income tax expense of the
current period.
Outside basis differences in foreign entities (i.e., the holder of the investment
is taxable in a jurisdiction different from the investee’s) are taxable
temporary differences. DTLs should be recorded for these taxable temporary
differences unless the exception in ASC 740-30-25-18(a) applies.
ASC 740-30-25-18(a) states that a DTL is not recognized for an “excess of the
amount for financial reporting over the tax basis of an investment in a foreign
subsidiary” unless it becomes apparent that the temporary difference will
reverse in the foreseeable future. See Section
3.3.1 for a discussion of inside and outside basis differences.
3.4.5 DTL for a Portion of an Outside Basis Difference
As noted above, ASC 740-30-25-18(a) states that a DTL is not required for an
“excess of the amount for financial reporting over the tax basis of an
investment in a foreign subsidiary or a foreign corporate joint venture that is
essentially permanent in duration” unless “it becomes apparent that those
temporary differences will reverse in the foreseeable future.” In certain
circumstances, an entity may require its foreign subsidiary or foreign corporate
joint venture to remit only a portion of undistributed earnings.
An entity is permitted to recognize a DTL only for the portion of the
undistributed earnings to be remitted in the future (remittances are not limited
to dividends or distributions). ASC 740-30-25-18 is not an all-or-nothing
requirement.
Example 3-23
Entity A has one subsidiary, B, a wholly owned subsidiary
in foreign jurisdiction X. Subsidiary B has $500,000 in
undistributed earnings, which represents the entire
outside basis difference in B (there has been no
fluctuation in the exchange rates). On the basis of
available evidence, A has historically concluded that no
part of this basis difference was expected to reverse in
the foreseeable future and that, therefore, the
indefinite reversal criteria in ASC 740-30-25-17 and
25-18 were met in accordance with management’s intent
and the associated facts and circumstances.
Consequently, A has not historically recorded a DTL on
its book-over-tax basis difference in its investment in
B.
In the current year, B has net income of
$300,000 and declares a one-time dividend for the full
$300,000. Subsidiary B has no plans to declare or pay
future dividends, and there are no other changes in
facts or circumstances to suggest that the indefinite
reversal assertion on the existing $500,000 outside
basis difference would be inappropriate. Further, the
one-time circumstances that led to the distribution of
the $300,000 are not expected to reoccur. In this
example, A could continue to assert the indefinite
reinvestment of B’s earnings in the future. Entity A
should document its intent and ability to indefinitely
reinvest the undistributed earnings; see the next
section for further discussion.
Example 3-24
Assume the same facts as in the example
above, except that the dividend was declared as a result
of projected shortfalls in Entity A’s working capital
requirements during the coming year. The ongoing
short-term capital needs of A may suggest that A can no
longer indefinitely reinvest the earnings of Entity B.
In this example, the indefinite reinvestment assertion
may no longer be appropriate and, if not, A should
record a DTL on its entire $500,000 outside basis
difference.
3.4.5.1 Evidence Needed to Support the Indefinite Reinvestment Assertion
ASC 740-30-25-3 states, in part, that it “shall be presumed
that all undistributed earnings of a subsidiary will be transferred to the
parent entity.” ASC 740-30-25-17 states that this presumption “may be
overcome, and no income taxes shall be accrued by the parent entity . . . if
sufficient evidence shows that the subsidiary has invested or will invest
the undistributed earnings indefinitely.”
An entity’s documented plan for reinvestment of foreign earnings would enable
it to overcome the presumption that all undistributed earnings of a foreign
subsidiary will be transferred to the parent entity. To support its
assertion that the undistributed earnings of a subsidiary will be
indefinitely reinvested, an entity should demonstrate that the foreign
subsidiary has both the intent and ability to indefinitely reinvest
undistributed earnings. Past experience with the entity, in and of itself,
would not be sufficient for an entity to overcome the presumption in ASC
740-30-25-3. In documenting its written plan for reinvestment of foreign
earnings, an entity should consider such factors as:
- Operating plans (for both the parent company and the subsidiary).
- Budgets and forecasts.
- Long-term and short-term financial requirements of the parent company and the subsidiary (i.e., working capital requirements and capital expenditures).
- Restrictions on distributing earnings (i.e., requirements of foreign governments, debt agreements, or operating agreements).
- History of dividends.
- Tax-planning strategies an entity intends to rely on to demonstrate the recoverability of DTAs.
This analysis is performed for each foreign subsidiary as of
each balance sheet date (see above for guidance on determining whether a
specific investment of a consolidated parent company is a foreign or
domestic subsidiary). This analysis should be performed on a
subsidiary-by-subsidiary basis and determined by using a bottom-up approach.
An entity could reach different conclusions for two subsidiaries within the
same jurisdiction.
Further, in a business combination, this analysis should be
performed by the acquirer as of the acquisition date, regardless of any
previous position taken by the acquiree or historical practice by the
subsidiary. As a result of the analysis, market participants could reach
different conclusions regarding the same acquiree.
3.4.5.2 Ability to Overcome the Presumption in ASC 740-30-25-3 After a Change in Management’s Plans for Reinvestment or Repatriation of Foreign Earnings
In some circumstances, an entity’s reinvestment or repatriation plan may
change because of different factors, such as the parent’s liquidity
requirements or changes in tax ramifications of repatriation.
An entity may have asserted previously that it had a plan to indefinitely
reinvest foreign earnings overseas to overcome the presumption described in
ASC 740-30-25-3 that undistributed foreign earnings will be transferred to
the parent entity. As a result of various factors, the same entity may later
decide to repatriate some or all of its undistributed foreign earnings.
A change in management’s intent regarding repatriation of earnings may taint
management’s future ability to assert that earnings are indefinitely
reinvested. However, it depends on the reason(s) for the change. The
following are a few questions an entity could consider in determining
whether management’s ability is tainted in this situation:
- Did management have sufficient evidence of a specific plan for reinvestment or repatriation of foreign earnings in the past?
- Is it clear that this change is a result of a temporary and identifiable event (e.g., a change in tax law available for a specified period)?
- Can management provide evidence that supports what has changed from its previous plans?
- Does management have a plan for reinvestment of future earnings?
Generally, if the conditions were met, management would be able to assert
indefinite reinvestment of foreign earnings in the future.
However, if management’s current actions indicate that its previous plan was
not supported by actual business needs (e.g., stated foreign capital
requirements were over what proved to be necessary), the change in intent
may call into question management’s ability to assert that future foreign
earnings are indefinitely reinvested.
3.4.5.3 Change in Indefinite Reinvestment Assertion — Recognized or Nonrecognized Subsequent Event
In some circumstances, an entity’s reinvestment or repatriation plan may
change because of various factors, such as the parent’s liquidity
requirements or changes in the tax ramifications of repatriation.
ASC 740-30-25-19 indicates that the impact of the change in plans would be
accounted for in the period in which management’s plans change (e.g., when
management no longer can assert that all, or a portion, of its foreign
earnings are indefinitely reinvested). However, an entity may need to use
judgment to identify the period in which management’s decision to change its
plans occurred, especially if this decision occurs soon after the balance
sheet date.
An entity should consider the nature and timing of the factors that
influenced management’s decision to change its plans when evaluating whether
a change in management’s plans for reinvestment or repatriation is a
recognized or nonrecognized subsequent event under ASC 855. Specifically, if
identifiable events occurred after the balance sheet date that caused the
facts or conditions that existed as of the balance sheet date to change
significantly, and management changed its intent regarding indefinite
reinvestment because of the new facts, the change in intent may be a
nonrecognized subsequent event.
In contrast, if the change in intent after the balance sheet date is due to
factors other than responding to the occurrence of an identifiable event,
the facts or conditions that existed at the end of the period are unlikely
to have changed significantly. Therefore, if prior-period financial
statements have not been issued or are not yet available to be issued (as
these terms are defined in the subsequent-event guidance in ASC 855-10-20),
the entity would generally be required to record the effect of the change in
management’s plan in these financial statements (i.e., a recognized
subsequent event).
Example 3-25
Assume that an identifiable event
(e.g., a change in tax rates associated with
repatriation of foreign earnings) occurs in period 2
and that this event causes management to reconsider
and change its plans in that period. The change in
tax rates is an identifiable event that caused the
facts or conditions that existed at the end of
period 1 to change significantly. In this case, the
effect of the change in plans, which is attributable
specifically to the change in tax rate, should be
recorded in period 2 (i.e., a nonrecognized
subsequent event).
In contrast, an entity may change
its repatriation plans because of operating factors
or liquidity needs and, shortly after a reporting
period, may not be able to assert that its foreign
earnings are indefinitely reinvested. In this case,
an entity must perform a careful analysis to
determine whether the conditions causing the changes
in management’s plans existed at the end of the
reporting period. The results of this analysis will
affect whether the accounting effect of the change
in plans should be recorded as a recognized or
nonrecognized subsequent event under ASC 855.
3.4.6 Measuring Deferred Taxes on Outside Basis Differences in Foreign Investments
As discussed above, analysis of deferred taxes on outside basis
differences requires a bottom-up approach whereby an entity must consider its
outside basis difference at each level in the organization chart. The entity
should start with the lowest entity in the organization structure and determine
whether such entity’s direct parent’s financial reporting carrying amount is
greater or less than its tax basis. When performing this analysis, the entity
should consider the expected manner of recovery (e.g., sale, liquidation,
dividend). ASC 740-10-55-24 states, in part, that the “[c]omputation of a
deferred tax liability for undistributed earnings based on dividends should also
reflect any related dividends received deductions or foreign tax credits, and
taxes that would be withheld from the dividend.” Thus, the parent entity should
consider withholding taxes, FTCs, and participation exemptions (i.e., a
dividends received deduction) when determining the amount of DTL to be
recognized.
Many jurisdictions tax earnings of foreign subsidiaries and
foreign corporate joint ventures that are essentially permanent in duration
(collectively, “foreign investments”) upon distribution of such earnings. Where
the immediate parent entity’s outside basis taxable temporary difference in a
foreign investment would close upon remittance of foreign earnings and is not
indefinitely reinvested, the parent entity would need to recognize a DTL for the
additional tax to be imposed in its jurisdiction upon receipt of the earnings.
The parent entity may be able to avail itself of a participation exemption and,
as stated above, should factor such an exemption into the amount of DTL to be
recognized.
For example, in the United States, companies may be entitled to
a 100 percent dividends received deduction on the repatriation of earnings that
have not previously been taxed. Further, any foreign taxes properly attributable
to the earnings that are subject to the 100-percent-dividends-received deduction
are not available as an FTC since those earnings are not subject to U.S. federal
income tax. The repatriation of earnings to which the
100-percent-dividends-received deduction applies generally should reduce the
outside basis difference because the distribution reduces the financial
reporting carrying value of the investment but does not reduce the U.S. tax
basis in the investment. While there may be no U.S. federal income tax
implications of the distribution, there can nonetheless be additional foreign
withholding tax and state taxes.
In other instances, however, an outside basis difference may be
expected to reverse in a taxable manner, irrespective of whether there is a
distribution (e.g., through future Subpart F or GILTI inclusions). To the extent
that earnings have been previously taxed (situations involving Subpart F, GILTI,
or IRC Section 965 are discussed further below), for example, a U.S. company
would receive a basis increase for U.S. income tax purposes. Upon distribution,
such earnings are not taxed again; rather, the U.S. tax basis in the investment
is reduced by the amount of the previously taxed earnings distributed. In a
manner similar to earnings subject to the 100-percent-dividends-received
deduction, there can still be additional withholding taxes and state taxes
incurred on a repatriation of earnings to the U.S. company; see Section 3.4.13 for a
discussion of withholding taxes. In addition, there may be foreign exchange
gains or losses that are taxable/deductible upon repatriation, capital gains
upon sale of an investment, or foreign income taxes. If a U.S. company is not
indefinitely reinvested in the outside basis difference in its investment in a
foreign subsidiary or foreign corporate joint venture that is essentially
permanent in duration, it may need to recognize a DTL with respect to its
investment.
3.4.7 [Reserved]
3.4.8 Outside Basis Difference in a Foreign Subsidiary — Subpart F Income
Under ASC 740-30-25-18, unless it becomes clear that this
type of temporary difference will reverse in the foreseeable future, a
DTL should not be recognized for an “excess of the amount for financial
reporting over the tax basis of an investment in a foreign subsidiary or a
foreign corporate joint venture that is essentially permanent in duration.”
Further, there is a rebuttable presumption under ASC 740-30-25-3 that all
undistributed earnings will be transferred by a subsidiary to its parent. This
rebuttable presumption may be overcome if the criteria of ASC 740-30-25-17 are
met (i.e., sufficient evidence shows the subsidiary has invested or will invest
the undistributed earnings indefinitely).
Under Subpart F of the Internal Revenue Code, a U.S. parent may
be taxed on specified income of a foreign subsidiary (commonly referred to as
Subpart F income) when earned by the foreign subsidiary (e.g., certain types of
passive income are treated as Subpart F income). When recognized for
tax-reporting purposes by the U.S. parent, Subpart F income increases the
outside tax basis in a foreign subsidiary. Likewise, when recognized for
financial reporting purposes by the foreign subsidiary (and thus in the U.S.
parent’s consolidated financial statements), such income increases the U.S.
parent’s book basis in the foreign subsidiary.
Subpart F income may result in taxable income for the U.S.
parent in the same amount and same period as that in which the income is
recognized by the foreign subsidiary for financial reporting purposes. In such
cases, current taxable income would be recognized in the period in which the
income is recognized for financial reporting purposes, and there would generally
be no change in the U.S. parent’s outside basis difference in the foreign
subsidiary (i.e., because the book basis and tax basis both generally increase
by an equal amount). However, Subpart F income may be taxed in a later period
than the period in which the income is recognized for financial reporting
purposes. In these cases, there will be an increase in the parent’s book basis
in the subsidiary attributable to Subpart F income recognized for financial
reporting purposes with no change in the corresponding tax basis. This section
does not apply to situations involving Subpart F income that will not be
immediately taxable as a result of other circumstances (e.g., a situation in
which the Subpart F income is deferred when there is a deficit in E&P but
will become includable when the foreign subsidiary in question has positive
earnings).
A U.S. parent that, according to ASC 740-30-25-18(a), does not
recognize a DTL on its outside basis taxable temporary difference in a foreign
subsidiary should generally recognize a DTL for the portion of the outside basis
difference that corresponds to amounts already recognized for financial
reporting purposes by the foreign subsidiary that will be treated as Subpart F
income when considered to be earned for tax reporting purposes (i.e., amounts
within the foreign subsidiary that would give rise to taxable temporary
differences under U.S. tax law).
The portion of the outside basis taxable temporary difference
that corresponds to an inside Subpart F temporary difference should be treated
as though it is apparent that it will reverse “in the foreseeable future” and
will thus require the recognition of a DTL. Since Subpart F income is often
related to passive types of income, in most cases neither the U.S. parent nor
the foreign subsidiary can control when it will become taxable to the U.S.
parent. Therefore, a deferred tax expense and outside basis DTL should be
recognized in the period in which the income is recognized for financial
reporting purposes. This is true even if the U.S. parent does not intend to
distribute the associated earnings of the foreign subsidiary and irrespective of
whether the U.S. parent has elected to treat GILTI as a period cost. See
Section 3.4.10
for a discussion of GILTI deferred taxes.
Example 3-26
Entity P, a U.S. parent, owns Entity F, a foreign
subsidiary that, in turn, owns an equity method
investment that does not meet the ASC master glossary’s
definition of a corporate joint venture. Entity P’s tax
basis was not affected by undistributed earnings of the
equity investee. In addition, its investment (book
basis) in F increases by the amount of equity method
income recognized by the subsidiary, which increases the
outside basis difference in the investment in F (since
P’s tax basis was not affected by the undistributed
earnings of the equity investee). When F sells or
receives a distribution from the equity method investee,
the gain or distribution will be treated as Subpart F
income that P must recognize immediately. Further, as an
equity investor, F has no control over when it might
receive a dividend from the equity investee, nor can it
assert indefinite reinvestment in the equity method
investee because it is not a subsidiary or corporate
joint venture that is essentially permanent in duration;
therefore, P should not consider the outside basis
difference in F that is attributable to the unremitted
earnings of the equity method investee to be eligible
for treatment as indefinitely reinvested. Accordingly, P
should recognize a DTL for that portion of the outside
basis difference that will reverse when the investment
in the equity investee is recovered, which would trigger
recognition of Subpart F income and increase P’s tax
basis in F (which has the effect of reversing the
corresponding outside basis difference).
3.4.9 Outside Basis Difference in a Foreign Subsidiary — Deferred Subpart F Income
The previous section discusses Subpart F income that will be
immediately taxable when considered earned for tax reporting purposes. However,
sometimes Subpart F income will actually be deferred, even after it has been
earned for tax reporting purposes (“deferred Subpart F income”) because of
certain U.S. tax limitations. For example, the amount of currently taxable
Subpart F income of any CFC for any taxable year may not exceed such CFC’s
E&P for the year. Accordingly, while such amounts may be deferred and
recaptured in a future year, current-year Subpart F income is limited to actual
E&P earnings.
Assume, for example, that Company Y, a CFC, earns $100 of
Subpart F income and generates a non-Subpart F loss of $40 in year 1. Company Y
earns $200 of Subpart F income in each of years 2 and 3, $10 of non-Subpart F
income in year 2, and $100 of non-Subpart F income in year 3. Because Y’s
E&P is $60 in year 1, the amount of Subpart F income attributable to Y in
year 1 that Y’s U.S. shareholder must include in its year 1 taxable income is
limited to $60. However, in year 2, Y’s U.S. shareholder must include $10 of Y’s
deferred Subpart F income from year 1. Likewise, in year 3, the U.S. shareholder
must include the remaining $30 of Company Y’s deferred Subpart F income from
year 1 that was not taxed in years 1 and 2. Thus, all the deferred Subpart F
income from year 1 is recaptured.
If the existence of deferred Subpart F income suggests that some
part of the outside basis difference will reverse in the foreseeable future, a
DTL should be recorded. However, the mere existence of deferred Subpart F
earnings does not automatically suggest that a part of the outside basis
difference will reverse in the foreseeable future. Rather, all the facts and
circumstances must be assessed. For example, if a recovery and settlement of the
subsidiary’s assets and liabilities were to give rise to the taxation of the
deferred Subpart F income, a DTL would be recognized provided that the amount of
the deferred Subpart F income does not exceed the outside basis difference in
the foreign subsidiary.
If an entity uses the financial reporting carrying amounts of
the assets and liabilities to determine whether some part of the outside basis
difference would be expected to reverse in the foreseeable future, the DTL
recognized would take into account only the tax consequences associated with
events that already have occurred and been reported in the financial statements.
When additional events, such as future earnings, must occur (e.g., when the
recovery of assets and settlement of liabilities alone does not result in the
E&P needed to make all the deferred Subpart F income taxable to the U.S.
parent), no DTL would be recognized until the financial statements include such
future earnings. To assess the effect of recovering assets and settling
liabilities, the entity might need to schedule the recovery or settlement. For
example, the recovery of certain assets would result in E&P and the
settlement of certain liabilities would result in reductions in E&P;
however, it could become apparent that the outside basis difference will reverse
in the foreseeable future when the entity expects assets to be recovered before
the liabilities are settled.
3.4.10 Global Intangible Low-Taxed Income
The 2017 Act created a new requirement that certain income
(i.e., GILTI) earned by a CFC must be included currently in the gross income of
the CFCs’ U.S. shareholder. GILTI is the excess of the shareholder’s “net CFC
tested income” over the net deemed tangible income return (the “routine
return”), which is defined as the excess of (1) 10 percent of the aggregate of
the U.S. shareholder’s pro rata share of the qualified business asset investment
(QBAI) of each CFC with respect to which it is a U.S. shareholder over (2) the
amount of certain interest expense taken into account in the determination of
net CFC-tested income.
A domestic corporation is permitted a deduction of up to 50
percent of the sum of the GILTI inclusion and the amount treated as a dividend
in accordance with IRC Section 78 (“IRC Section 78 gross-up”). If the sum of the
GILTI inclusion (and related IRC Section 78 gross-up) and the corporation’s FDII
(see Section
3.2.1.4) exceeds the corporation’s taxable income, the deductions
for GILTI and for FDII are reduced by the excess. As a result, the GILTI
deduction can be no more than 50 percent of the corporation’s taxable income
(and will be less if the corporation is also entitled to an FDII deduction). The
maximum GILTI deduction is reduced to 37.5 percent for taxable years beginning
after December 31, 2025.
3.4.10.1 GILTI Accounting Policy Election
There may be situations in which a U.S. investor in a CFC
has a financial reporting carrying value (i.e., book basis) that does not
equal its outside tax basis for U.S. tax purposes in its foreign investment,
resulting in an outside basis difference in the foreign investment. In
addition, the U.S. investor would have a U.S. tax basis in the CFC’s
underlying assets and liabilities held that will be used for calculating
GILTI inclusions. Accordingly, a U.S. investor may have book/U.S. tax inside
basis differences that, upon reversal, will increase or decrease the GILTI
inclusion and, because GILTI inclusions increase the U.S. tax basis in the
foreign investment, will also affect the outside basis difference in the
foreign investment.
In January 2018, the FASB staff issued a Q&A document, which states that a
company may elect, as an accounting policy, to either (1) treat taxes due on
future U.S. inclusions in taxable income under the GILTI provision as a
current-period expense when incurred or (2) factor such amounts into the
company’s measurement of its deferred taxes (the “GILTI deferred method”).
The decision tree below illustrates the approach for
determining the deferred tax accounting for outside basis differences in
foreign investments that are expected to reverse as a result of the GILTI
provision.
3.4.10.2 GILTI Deferred Method — Overview
We believe that in a manner consistent with the mechanics of
the GILTI computation, GILTI DTAs and DTLs should generally be computed on a
U.S.-shareholder-by-U.S.-shareholder basis if the GILTI deferred method is
elected. Further, when multiple U.S. shareholders are includable in a U.S.
consolidated income tax return, the aggregation rules applicable to such
consolidated tax filings should be considered. Multiple CFCs within the same
U.S. consolidated tax return group would be analyzed in the aggregate. If a
U.S. shareholder has a mixture of profitable and unprofitable CFCs that, in
the aggregate, are not profitable to the extent that future GILTI inclusions
are not expected at the U.S. shareholder level, no GILTI DTAs and DTLs would
be recorded. Conversely, if a U.S. shareholder has a mixture of profitable
and unprofitable CFCs that, in the aggregate, are profitable to the extent
that future GILTI inclusions are expected, that U.S. shareholder should
measure GILTI DTAs and DTLs as discussed below.
3.4.10.3 GILTI Deferred Method — Measurement of Deferred Taxes
In determining the amount of U.S.-investor-level deferred
taxes necessary for foreign investments under this model, companies should
“look through” the outside basis of the CFC to determine how the book/U.S.
tax inside basis differences will reverse and how such reversals will affect
future GILTI inclusions and the outside basis difference.
Unlike other situations involving outside basis differences
in foreign subsidiaries, this “look through” approach (see Section 3.4.15) would
be employed even if no overall outside basis difference in the CFC exists,
or if only an overall deductible outside basis difference in the CFC exists.
In addition, in assessing the GILTI impact of the CFC’s
underlying assets and liabilities, a company would, in a fashion similar to
branch accounting, recognize U.S. DTAs or DTLs to account for the U.S.
income tax effects of the future reversal of any in-country DTAs and DTLs
(also referred to as “anticipatory foreign tax credit/deduction” or
“anticipatory” DTAs and DTLs). When determining the amount of a U.S.
anticipatory DTA or DTL, an entity must carefully consider all applicable
provisions in the tax law, since the amount of the incremental foreign taxes
that will be creditable and realizable, or forgone, because of the future
reversal of the local in-country DTAs and DTLs may be difficult to assess
and subject to limitations (e.g., an 80 percent limitation, limitations as a
result of expense allocations, and a limitation on utilization as a result
of the absence of a carryforward or carryback period, as well as tax rate
differences). For example, a local-country DTL that will reverse in the same
year(s) in which a GILTI inclusion is expected may be creditable against the
U.S. tax in that year, subject to the 80 percent limitation. In addition,
U.S. DTAs that reverse in the same year as the local in-country deferred
might further limit the FTC. Future FTCs directly related to future book
income and future expense allocation limitations directly related to future
book expense generally should not be included in the measurement of the
anticipatory DTA or DTL until such income or expense, or both, are
recognized (i.e., such FTCs and expense allocation limitations should be
limited to those directly tied to existing temporary differences). See also
Section
3.3.6.3.1, which discusses the measurement of anticipatory
DTAs and DTLs.
While many “branch-like” principles are employed in the
look-through model described above, unlike a branch, a CFC that will have substantially all of its income
taxable in the United States as a result of a GILTI inclusion may
still have a residual outside basis difference that is not related to the
CFC’s underlying assets or liabilities (i.e., inside/outside tax basis
disparities). An entity should then analyze that residual outside basis
difference to determine whether it would result in a taxable or deductible
amount when the investment is recovered and whether an ASC 740 outside basis
exception (i.e., ASC 740-30-25-18(a) or ASC 740-30-25-9) applies. For more
information about accounting for foreign branch operations, see Section 3.3.6.3.
In summary, recorded GILTI DTAs and DTLs under the
look-through model will consist of the following three items:
- DTAs and DTLs related to inside book/U.S. tax basis differences that will affect future GILTI inclusions, identified by “looking through” the CFC’s outside basis to the CFC’s underlying assets and liabilities.
- DTAs and DTLs related to the U.S. tax consequences of settling the CFC’s in-country DTAs or DTLs (i.e., anticipatory DTAs and DTLs).
- Any DTA or DTL related to a residual outside basis temporary difference for which an exception has not been applied.
There have been a number of discussions with the FASB and
SEC staffs about the more significant aspects of the guidance on measuring
GILTI-related deferred taxes. Accordingly, while other acceptable accounting
approaches may exist, entities that plan to apply methods that are
inconsistent with those discussed herein are strongly encouraged to consult
with their income tax accounting advisers.
3.4.10.4 GILTI Deferred Method — Other Considerations
3.4.10.4.1 Net Deemed Tangible Income Return
Given that the CFC’s routine return is excluded from the
GILTI inclusion, we believe that there is more than one acceptable
approach to accounting for the routine return in the measurement of
GILTI DTAs and DTLs, including the following:
- Special deduction — The routine return could be treated akin to a special deduction, with the benefit recognized when the GILTI inclusion is reduced by the routine return. Under this approach, the routine return is viewed as dependent on future events, including future investments in QBAI and interest expense deductions, and it therefore would not be factored into the tax rate expected to apply to the temporary differences.
- Graduated tax rate — Under this approach, the amount of taxable income equal to the routine return would be considered income taxed at a zero rate. Accordingly, if the routine return represents a significant factor, companies would measure GILTI DTAs and DTLs by using the average graduated tax rate applicable to the amount of estimated annual taxable income in the periods in which the aforementioned deferred taxes are estimated to be settled or realized. Companies will need to use judgment in determining the periods in which GILTI DTAs and DTLs will reverse and the estimated annual taxable income in each of those periods. See Section 3.3.4.1.
Other models may also be acceptable in certain
situations (e.g., a portion of the book/U.S. tax basis difference that
will reverse and represent a routine return might not be considered a
taxable temporary difference for which a deferred tax would be recorded
in accordance with ASC 740-10-25-30).
The approach an entity selects would be an accounting
policy election that, like all other such elections, must be applied
consistently.
3.4.10.4.2 IRC Section 250 Deduction (the “GILTI Deduction”)
The GILTI deduction is intended to lower the GILTI
income inclusion (with the intent of lowering the ETR on the included
income) and, in many cases, will immediately apply when a company has a
GILTI inclusion. Accordingly, we believe that if a company generally
expects to be able to apply the full GILTI deduction in the period in
which the GILTI DTAs and DTLs reverse, it should consider the deduction
in the measurement of the GILTI DTAs and DTLs in accordance with ASC
740-10-55-24 (see guidance in Appendix
A). As noted above, however, the GILTI deduction is “up
to,” rather than “guaranteed” to be, 50 percent and could be reduced by
the taxable income limitation, which is applied in combination with the
FDII deduction. An entity should carefully consider this limitation when
factoring the GILTI deduction into the measurement of U.S. GILTI DTAs
and DTLs. For example, when the taxable income limitation and expense
allocation limitations are expected to apply and be significant (e.g.,
in situations in which the U.S. operations generate significant losses
or an entity expects to forgo the GILTI deduction because it expects to
use existing NOL carryforwards), entities may conclude that factoring
the GILTI deduction into the rate is not appropriate. See additional
discussion in Section
5.7.2.
3.4.11 Deemed Repatriation Transition Tax (IRC Section 965)
Under the 2017 Act, a U.S. shareholder of a specified foreign
corporation (SFC)8 was required to include in gross income, at the end of the SFC’s last tax
year beginning before January 1, 2018, the U.S. shareholder’s pro rata share of
certain of the SFC’s undistributed and previously untaxed post-1986 foreign
E&P. The inclusion generally was reduced by foreign E&P deficits that
were properly allocable to the U.S. shareholder. In addition, the mandatory
inclusion was reduced by the pro rata share of deficits of another U.S.
shareholder that is a member of the same affiliated group. A foreign
corporation’s E&P were taken into account only to the extent that they were
accumulated during periods in which the corporation was an SFC (referred to
below as a “foreign subsidiary”). The amount of E&P taken into account was
the greater of the amount determined as of November 2, 2017, or December 31,
2017, unreduced by dividends (other than dividends to other SFCs) during the
SFC’s last taxable year beginning before January 1, 2018.
The U.S. shareholder’s income inclusion was offset by a
deduction designed to generally result in an effective U.S. federal income tax
rate of either 15.5 percent or 8 percent. The 15.5 percent rate applied to the
extent that the SFCs held cash and certain other assets (the U.S. shareholder’s
“aggregate foreign cash position”), and the 8 percent rate applied to the extent
that the income inclusion exceeded the aggregate foreign cash position.
The 2017 Act permits a U.S. shareholder to elect to pay the net
tax liability9 interest free over a period of up to eight years.
3.4.11.1 Classification of the Transition Tax Liability
The transition liability should be recorded as a
current/noncurrent income tax payable. ASC 210 provides general guidance on
the classification of accounts in statements of financial position. An
entity should classify as a current liability only those cash transition tax
payments that management expects to make within the next 12 months. The
installments that the entity expects to settle beyond the next 12 months
should be classified as a noncurrent income tax payable.
3.4.11.1.1 Classification of Transition Tax Obligation in Periods Before Inclusion in the Income Tax Return
In certain circumstances, the transition tax was not
reported in an entity’s tax return for the year that included the
enactment date. On the basis of the unique nature of tax reform and the
mandatory one-time deemed repatriation income inclusion, we believe that
it would be appropriate, in those circumstances, to classify the deemed
repatriation transition tax liability as a current/noncurrent income tax
payable in the period that includes the enactment date.
3.4.11.2 Measurement of Transition Tax Obligation in Periods Before Inclusion in the Income Tax Return
Although we generally believe that the recognition of a DTL
related to a foreign subsidiary would be limited to the amount that
corresponds to the entity’s outside basis difference in the foreign
subsidiary, we also believe that, given the unique circumstances presented
in Section
3.4.11, it would be appropriate to record the entire amount
of the deemed repatriation transition tax in the period of enactment even if
it exceeds the outside basis difference in the foreign subsidiary. Under
these circumstances, the E&P subject to taxation related to past events
and transactions are simply payable in a subsequent year.
3.4.11.3 Measurement of the Transition Tax Obligation — Discounting
Although ASC 740-10-30-8 clearly prohibits discounting of
DTAs and DTLs, it does not address income tax liabilities payable over an
extended period. In January 2018, the FASB staff issued a Q&A document, which states that the
deemed repatriation transition tax liability should not be discounted. The
FASB staff stated in the Q&A that “paragraph 740-10-30-8 prohibits the
discounting of deferred tax amounts. Due to the unique nature of the tax on
the deemed repatriation of foreign earnings, the staff believes that the
guidance in paragraph 740-10-30-8 should be applied by analogy to the
payable recognized for this tax.” The FASB staff also noted the following in
the Q&A:
- ASC 835-30 applies to the accounting for business transactions conducted at arm’s length and the interest rate “should represent fair and adequate compensation to the supplier.”
- “[T]he transition tax liability is not the result of a bargained” arm’s length transaction.
- The scope exception in ASC 835-30-15-3(e) that indicates that ASC 835-30 does not apply to “transactions where interest rates are affected by tax attributes or legal restrictions prescribed by a governmental agency (such as, income tax settlements)” would apply to the transition tax obligation.
- Because the amount of the deemed repatriation transition tax is inherently subject to uncertain tax positions, measurement of the ultimate amount to be paid is potentially subject to future adjustment. Since uncertain tax positions are not discounted, it would not be appropriate to discount the transition tax liability “when the uncertain tax position is undiscounted.”
3.4.12 “Unborn” FTCs — Before the 2017 Act
When a U.S. company has concluded that the earnings of one or
more of its foreign subsidiaries will not be indefinitely reinvested, the U.S.
parent must recognize a DTL related to the portion of the outside basis
difference for which reversal is foreseeable. Under U.S. federal tax law, when
the U.S. parent receives a dividend from a foreign subsidiary, the parent is
permitted to treat itself as having paid the foreign taxes that were paid by the
foreign subsidiary. The parent does this by grossing up the taxable amount of
the dividend by an amount equal to the related taxes. An FTC is allowed in an
amount equal to this gross-up; such a credit is commonly referred to as a
“deemed paid” credit. In certain circumstances, a deemed-paid FTC may exceed the
U.S. taxes on the grossed-up dividend and, when the dividend is actually paid,
such an excess FTC (commonly referred to as a “hyped credit”) will be available
to offset U.S. taxes otherwise payable on unrelated foreign source income in the
year of the dividend (or to offset U.S. taxes on foreign source income in prior
or subsequent tax years by carryback or carryforward of the excess FTCs).
Alternatively, instead of claiming an FTC, the U.S. parent can choose to deduct
the foreign taxes by not grossing up the taxable amount of the dividend on its
U.S. federal tax return.
A DTA should not be recognized for the anticipated excess FTCs
that will arise in a future year when the foreign subsidiary pays the dividend.
The anticipated excess FTC that will arise in a future period when the dividend
is paid is considered to be “unborn.” The example below illustrates the
circumstances that can lead to an unborn FTC.
Example 3-27
Terms Used
- FC — Functional currency (in this example, the local currency is the functional currency).
- E&P — Earnings and profits (similar to retained earnings but generally measured by using a tax concept of profit).
- Tax pool — The cumulative taxes paid in connection with the E&P. The pool is (1) measured in U.S. dollars (USDs) by translating the amount payable each year at the average exchange rate for the year and (2) reduced by the amounts lifted (i.e., considered to be “born”) with prior dividends.
When Sub A distributes 100 FC in a
future period, the U.S. parent will receive $110 (based
on the reporting-date exchange rate). If the U.S. parent
deducted foreign taxes in the year of the distribution,
it would simply report the $110 as taxable income and
determine the related tax liability — that is, it would
not separately claim a deduction for deemed-paid foreign
taxes. However, in this example, the U.S. parent has
determined that it will claim an FTC for the foreign
taxes paid by Sub A. Under U.S. tax law, the dividend
received will be grossed up for the taxes paid by Sub A
in connection with its earnings. In this example, Sub A
has cumulative E&P of 400 LC. Because it is
distributing 100 LC, it is distributing 25 percent of
its total E&P. Therefore, 25 percent of the
cumulative tax pool is treated as associated with the
100 LC being distributed. To be entitled to claim the
$250 as an FTC, the U.S. parent must gross up the $110
received for the related taxes (25 percent of the tax
pool of $1,000, or $250). As noted in Section
3.4.10, such gross-ups are required by
IRC Section 78 and are often referred to as “IRC Section
78 gross-ups” for this reason. Since the U.S. parent is
now paying tax on an amount that corresponds to Sub A’s
pretax income that is being distributed, the U.S. parent
is entitled to claim the IRC Section 78 gross-up amount
as an FTC. In this example, the resulting $250 of FTC is
greater than the U.S. tax on Sub A’s pretax income of
$126. The excess amount is an unborn hyped FTC related
to Sub A. The U.S. parent did not actually pay the $250
of foreign taxes but is deemed to have paid those taxes,
and the first moment it is deemed to have paid those
taxes is when the dividend is received from Sub A.
ASC 740-10-55-24 states, in part, that the “[c]omputation of a
deferred tax liability for undistributed earnings based on dividends should also
reflect any related dividends received deductions or foreign tax credits, and
taxes that would be withheld from the dividend.” Thus, it requires a U.S. parent
to consider available FTCs when determining the DTL related to a distribution of
unremitted earnings from a foreign subsidiary.
We do not believe that in Example 3-27 a DTA should be established
for the $124 of unborn FTC, since the unborn FTC does not meet the definition of
a DTA. ASC 740-10-20 defines deferred tax asset as the “deferred tax
consequences attributable to deductible temporary differences and
carryforwards.”
Further, ASC 740-10-20 defines carryforwards, in part, as
follows:
Deductions or credits that cannot be utilized on
the tax return during a year that may be carried forward to reduce taxable
income or taxes payable in a future year. An operating loss carryforward is
an excess of tax deductions over gross income in a year; a tax credit
carryforward is the amount by which tax credits available for utilization
exceed statutory limitations.
The unborn FTC cannot be recognized as a DTA related to a
carryforward since such an amount is not a tax credit “available for
utilization” on a tax return that is carried forward for use on subsequent tax
returns because it exceeds statutory limitations. In other words, for an FTC to
be recognized as a “carryforward” DTA, the tax return must first show FTCs as
being carried forward. The $124 in this example has the potential to become a
carryforward if it is not fully used in the year in which Sub A pays the
dividend. However, as of the current reporting date, there is only a plan to
remit from Sub A in the foreseeable future (it is therefore necessary to measure
the DTL related to the taxable temporary difference in Sub A). Until the period
that includes the remittance causing the excess FTC to be born, no DTA should be
recognized, but the DTL related to the investment in Sub A could be reduced to
zero after taking the expected FTC into consideration.
Connecting the Dots
Since enactment of the 2017 Act, the relevance of unborn
FTCs has greatly diminished because almost all of the foreign earnings
are taxed in the United States in the period in which they are earned in
the form of Subpart F, GILTI, or branch income. Therefore, FTCs are
available to the U.S. parent in the same period in which the income is
earned.
3.4.12A Foreign Exchange Gain (or Loss) on Distributions From a Foreign Subsidiary When There Is No Overall Taxable (or Deductible) Outside Basis Difference
Before the issuance of FASB Statement 109, APB Opinion 23 provided guidance on the establishment of a liability for unremitted foreign earnings. That guidance stated that such earnings were presumed to be repatriated, and a liability should be recorded for the tax consequences of the remittance, unless a company could demonstrate specific plans for reinvestment. As a result of the adoption of the balance sheet approach in Statement 109, the concept of a liability for unremitted earnings evolved into the recognition of a DTL for an outside basis difference in a company’s investment in a foreign subsidiary. This is because unremitted earnings typically resulted in an increase in the book basis of the investment and no corresponding increase in its tax basis. Further, it was generally presumed under this approach that no income tax related to earnings of a foreign corporate subsidiary would be incurred in the parent’s tax jurisdiction until a repatriation occurred. The concepts in APB Opinion 23 and Statement 109 were codified in ASC
740-30-25-18(a), which states that an entity should recognize a DTL for an
“excess of the amount for financial reporting over the tax basis of an
investment in a foreign subsidiary or a foreign corporate joint venture that is
essentially permanent in duration” if the temporary difference will reverse in
the foreseeable future. In this context, it is still presumed that the
unremitted earnings in a foreign subsidiary or foreign corporate joint venture
will be distributed to its parent and that the outside basis temporary
difference will reverse unless the indefinite reversal criteria of ASC
740-30-25-17 are met.
However, the 2017 Act greatly increased the likelihood that a foreign subsidiary
may have positive cumulative unremitted foreign earnings even though the book
basis of the parent’s investment in the foreign subsidiary may not be greater
than its tax basis (e.g., the U.S. parent’s tax basis in the foreign subsidiary
may have increased as a result of taxable income inclusions related to the
transition tax under IRC Section 965 or GILTI). Sometimes, a distribution of the
unremitted earnings may even result in a reduction in the book basis of the
parent’s investment in the foreign subsidiary that exceeds the reduction in the
tax basis (i.e., the distribution could create or increase a deductible
temporary difference rather than result in the reversal of a taxable outside
basis difference) even though the distribution results in taxable income (i.e.,
for the currency gain) in the parent’s jurisdiction.
For example, the U.S. taxable income or loss of a U.S. parent as a result of the
remittance of earnings by a foreign corporate subsidiary is now typically
limited to any foreign currency gain or loss calculated for tax purposes. Such
amounts, however, would already have increased or decreased the book basis but
generally would not have affected the tax basis before distribution.
In these situations, a questions may arise about whether a U.S.
parent should record a DTL when (1) there is no overall outside basis difference
on its investment in a foreign subsidiary or the overall outside basis
difference is deductible, (2) the U.S parent intends to repatriate the foreign
subsidiary’s earnings, and (3) the entity expects that there will be a foreign
exchange gain in the parent’s jurisdiction upon distribution.
We believe that there are two acceptable approaches:
-
View A — A DTL should not be recognized when no overall outside basis taxable temporary difference exists as of the reporting date (i.e., the financial reporting basis does not exceed the tax basis) even if the entity would incur an income tax liability if the unremitted earnings were repatriated. This is because the recovery of the entire financial reporting carrying amount of the investment would result in either (1) no taxable gain (when there is no outside basis difference) or (2) a loss (when the basis difference is deductible) for tax purposes.
-
View B — If, in a prior period, a company has undistributed earnings that have been recognized in the financial statements that would trigger an investor-level tax upon distribution, and the company is not asserting that such earnings are indefinitely reinvested, the investor would disaggregate the outside basis difference into multiple components, such as (1) a temporary difference related to unremitted earnings, (2) a temporary difference related to financial statement gain or loss reported in OCI related to the unremitted earnings, and (3) other temporary differences that will not reverse as a result of a distribution of unremitted earnings (e.g., cumulative translation adjustment [CTA] reported in OCI related to the foreign subsidiary’s capital accounts or residual outside basis differences).10 The recognition of a DTL in this instance would be acceptable, irrespective of the overall outside basis difference in the investment in the subsidiary (i.e., disaggregation would be acceptable). This approach is consistent with the accounting discussed in Section 3.4.11.2 for the transition tax obligation and the guidance in ASC 740-30-25-19, which states, in part:If . . . it becomes apparent that some or all of the undistributed earnings of a subsidiary will be remitted in the foreseeable future but income taxes have not been recognized by the parent entity, it shall accrue as an expense of the current period income taxes attributable to that remittance.
Generally, the same two views would also apply to the reverse
scenario (i.e., there is no overall outside basis difference in a foreign
subsidiary or the overall outside basis difference is taxable, the entity
intends to remit the foreign earnings, and the entity expects that there will be
a tax benefit associated with a foreign exchange loss in the parent’s
jurisdiction upon distribution). However, additional considerations are
necessary when a DTA (as opposed to a DTL) is recorded because of the
requirements in ASC 740-30-25-9, which only allow for the recording of a
deferred tax asset related to a temporary difference in an investment that is
expected to reverse in the “foreseeable future.” We believe that a reporting
entity that meets this criterion may record a DTA even when no overall
deductible outside basis difference exists if it has definitive plans to
repatriate earnings in the foreseeable future. For additional details regarding
how to interpret the “foreseeable future” criteria related to recording a DTA,
see Section 3.4.1.2.
The application of either view described above would be considered an accounting
policy that should be consistently applied.
Example 3-28
Entity X, a U.S. entity, has a wholly owned subsidiary,
Entity Y, located in foreign jurisdiction Z. As of
December 31, 20X9, Y has the following balances and
outside basis difference, and it anticipates a
distribution of its accumulated unremitted earnings to X
in the foreseeable future:
Under View A described above, X would not record a DTL related
to its investment in Y, notwithstanding the fact that it will incur a tax
liability related to a financial statement gain of 5 USD on the planned 200 FC
remittance, since X has an overall deductible outside basis difference in Y.
Further, under the exception in ASC 740-30-25-9, X would not recognize a DTA for
its overall deductible temporary difference in Y unless it becomes apparent that
the deductible temporary difference will reverse in the foreseeable future.
Under this approach, a current-year tax expense will result from the
distribution in the year it is made (without an offset by any reversal of
deferred tax). Such expense can be viewed as attributable to X’s inability to
record a DTA on the incremental 5 USD deductible outside basis difference (i.e.,
that increase in the deductible temporary difference is subject to the exception
under ASC 740-30-25-9) rather than to the lack of establishing a DTL in a prior
period.
Under View B, X would record a DTL for the future tax effects of the financial
statement gain of 5 USD that would be triggered upon the distribution of 200 FC.
The remaining deductible temporary difference that is a component of the overall
deductible outside basis difference would be recorded when it becomes apparent
that the deductible temporary difference will reverse in the foreseeable future,
in a manner consistent with ASC 740-30-25-9.
See Section 3.4.11.2 for a discussion of the measurement of the
transition tax obligation in periods before its inclusion in the tax return.
3.4.13 Withholding Taxes Imposed on Distributions From Disregarded Entities and Foreign Subsidiaries
Multinational companies generally operate globally through
entities organized under the laws of the respective foreign jurisdiction that
govern the formation of legally recognized entities. These foreign entities
might be considered partnerships or corporations under local law; however,
sometimes no legal entity exists, and the assets and liabilities are simply
viewed as an extension of the parent entity doing business in the jurisdiction
(i.e., a “true branch” or “division”).
In the case of a legal entity, under U.S. Treasury Regulation
Sec. 301.7701-3 (the check-the-box regulations), certain eligible foreign
entities may elect to be disregarded as entities separate from their parents
(hereafter referred to as foreign disregarded entities). As a result of the
check-the-box election, the earnings of a foreign disregarded entity that is
owned directly by a U.S. entity will, like those of a branch, be taxable in the
United States as earned.
In many foreign jurisdictions, a resident corporation must pay a
withholding tax upon a distribution of earnings to its nonresident
shareholder(s). Since disregarded entities are often corporations under local
law, the applicability of withholding tax on distributions will generally depend
on whether the entity is regarded or disregarded for U.S. tax purposes. Although
the distributing entity remits the withholding tax to the local tax authority
(reducing the amount received by the parent), under the local tax statutes, the
tax is generally assessed on the recipient of the distribution.
In the case of a foreign disregarded entity, no outside basis
exists (from the perspective of U.S. tax law) because the foreign entity is
viewed as a division of the parent as a result of the U.S. check-the-box
election. In the case of a foreign regarded entity, its parent might still have
no taxable temporary difference in its investment in the foreign entity because
(1) all the unremitted earnings have already been taxed in the parent’s tax
jurisdiction (e.g., 100 percent of the unremitted earnings of a foreign
subsidiary were taxable to its U.S. parent as Subpart F income or GILTI in such
a way that the financial reporting carrying amount and the tax basis are equal)
or (2) CTA losses have reduced the financial reporting carrying value without a
corresponding reduction in its tax basis.
Even when no taxable temporary difference exists (either in the
assets of a disregarded entity or in the shares of a regarded entity), the
foreign entity may have earnings that could be distributed to its parent, at
which time withholding taxes would be imposed by the local tax authority.
We believe that there are two acceptable views on determining
whether a parent should recognize a DTL for withholding taxes that are within
the scope of ASC 740 and that would be imposed by the local tax authority on a
distribution from a disregarded entity or foreign subsidiary: (1) the parent
jurisdiction view and (2) the foreign jurisdiction view.
3.4.13.1 View 1 — Parent Jurisdiction Perspective
ASC 740-10-25-2 states, in part:
Other
than the exceptions identified in the following paragraph, the following
basic requirements are applied in accounting for income taxes at the
date of the financial statements: . . .
b. A deferred tax liability or asset shall
be recognized for the estimated future tax effects
attributable to temporary differences and carryforwards.
[Emphasis added]
Further, ASC 740-10-55-24 states:
Deferred tax liabilities and assets are measured using enacted tax
rates applicable to capital gains, ordinary income, and so forth, based
on the expected type of taxable or deductible amounts in future years.
For example, evidence based on all facts and circumstances should
determine whether an investor’s liability for the tax consequences of
temporary differences related to its equity in the earnings of an
investee should be measured using enacted tax rates applicable to a
capital gain or a dividend. Computation of a
deferred tax liability for undistributed earnings based on dividends
should also reflect any related dividends received deductions or
foreign tax credits, and taxes that would be withheld from the
dividend. [Emphasis added]
Under the parent jurisdiction view, a parent would apply ASC
740-10-55-24 by considering the withholding tax as a tax that the parent
would incur upon the reversal of a U.S. jurisdiction taxable temporary
difference that is attributable to unremitted earnings.
In the case of a disregarded entity, since (1) no outside
basis difference exists (because the foreign entity is viewed as a division
of the parent as a result of the U.S. check-the-box election) and (2) the
earnings of the foreign disregarded entity are taxed in the parent’s
jurisdiction as they are generated, there is generally no taxable temporary
difference related to the net assets of the disregarded entity (i.e., the
net assets that arose on account of unremitted earnings have a tax basis
since the income of the disregarded entity was recognized for U.S. tax
purposes as earned). In the absence of a U.S. taxable temporary difference
for which a DTL can be recognized, a DTL cannot be recognized for the future
withholding tax. Under this view, the withholding tax would be recognized in
the period in which the actual withholding tax arises (as a current tax
expense).
Similarly, a regarded foreign subsidiary would be unable to
recognize a DTL when (1) all of its unremitted earnings have already been
taxed by the United States (e.g., 100 percent of the unremitted earnings
were taxable as Subpart F income or GILTI in such a way that the financial
reporting carrying amount and the tax basis are equal) or (2) CTA losses
have reduced the financial reporting carrying value without a corresponding
reduction in its tax basis. Without a U.S. taxable temporary difference, the
requirement under ASC 740-10-55-24 for an entity to consider withholding
taxes (when recording a DTL for a basis difference related to unremitted
earnings expected to be reduced by remittances) would appear not to be
applicable.
However, if an outside basis difference does exist in the
parent’s investment in the foreign subsidiary, the parent would apply ASC
740-10-55-24 when measuring the DTL to be recognized (i.e., it would include
a DTL for the withholding tax).
3.4.13.2 View 2 — Foreign Jurisdiction Perspective
ASC 740-10-30-5 states, in part:
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.
Accordingly, from the perspective of the local jurisdiction
(i.e., the disregarded entity or subsidiary), two separate and distinct
taxpayers exist: (1) the distributing entity (which is generally viewed as a
taxable legal entity in the local jurisdiction) and (2) the parent. Under
the foreign jurisdiction view, the local jurisdiction taxes the distributing
entity on its earnings as they occur, and it taxes the parent entity only
when those “already net of tax” earnings are distributed. An entity that
applies this view evaluates each jurisdiction and considers the perspective
of the jurisdiction that is actually taxing the
recipient (i.e., the local jurisdiction imposing the withholding tax) when
determining whether the parent has a taxable temporary difference. From the
perspective of the local jurisdiction, the parent has a financial reporting
carrying amount in its investment in the distributing entity that is greater
than its local tax basis (i.e., from the perspective of the local
jurisdiction, the entities have a “parent-corporate subsidiary” relationship
since the election to disregard the entity is applicable only in the
parent’s jurisdiction and is not relevant in the local jurisdiction).
Therefore, from a local jurisdiction perspective, an “outside” taxable
temporary difference equal to the amount of such unremitted earnings that
would be subject to withholding tax exists and, in accordance with ASC
740-10-55-24, the measurement of the DTL should reflect withholding taxes to
be incurred when the taxable temporary difference reverses.
Under this view, even in the case of a disregarded entity,
the indefinite reversal criteria would be considered and, if the reversal of
the taxable temporary difference is not foreseeable, no deferred taxes
should be recognized.
3.4.13.3 Determining the Income Tax Effects of Distributions of Previously Taxed Earnings and Profits in a Single-Tier or Multi-Tier Legal Entity Structure
In some cases, a remittance of foreign earnings to the
parent may trigger tax consequences in multiple jurisdictions. For example,
a U.S. parent may have an investment in a foreign subsidiary that has
unremitted earnings that, upon remittance, may give rise to a withholding
tax in the foreign jurisdiction (a DTL) and an FTC or deduction for the
withholding taxes in the U.S. parent’s federal jurisdiction (a DTA). In
addition, a consolidated group may have a multi-tiered structure that
includes intermediate legal entities or “HoldCos” in between a parent and
its foreign subsidiaries.
In these instances, questions generally arise about how to
measure the deferred taxes related to a distribution. We believe that if a
company’s policy prohibits disaggregation of the U.S. parent’s outside basis
in the investee into multiple components to book a DTA or DTL (see Section 3.4.13), two different approaches
can be used to measure (1) the withholding tax liability at the foreign
subsidiary level and (2) the corresponding foreign tax deduction or credit
at the U.S. parent level.
One approach is to consider the various tax consequences of
a distribution, regardless of jurisdiction. This view is consistent with the
guidance in ASC 740-10-55-24, which states, in part, that the “[c]omputation
of a deferred tax liability for undistributed earnings . . . should also
reflect any related dividends received[,] deductions or foreign tax credits,
and taxes that would be withheld from the [distribution].” Under this
approach, an entity aggregates all tax consequences of the distribution,
regardless of the jurisdiction in which they are recognized, when assessing
whether there is an overall DTA or DTL with respect to the U.S. parent’ s
outside basis difference (i.e., whether there is an overall net DTL to
record). In situations in which the U.S. parent has a taxable outside basis
difference with respect to its investment in the foreign subsidiary, and
there is an overall DTL, the tax impact would be recorded (for single-tier
entities).11 While there would be an added level of complexity for multi-tier
entities, we believe that this view would still be acceptable if the U.S.
parent can represent that such earnings will move all the way “up the chain”
(i.e., from the second-tier subsidiary, to the HoldCos in between, to the
U.S. parent) in the same period so that the U.S. parent cannot be left with
a “naked” DTA (e.g., a DTA for an unborn FTC) related to an overall taxable
outside basis temporary difference in its investment in HoldCo as of the end
of the year.
A second approach would be to consider the tax consequences
of the distribution on a jurisdiction-by-jurisdiction basis. Under this
approach, a foreign tax deduction or credit would not be considered as part
of the measurement of the withholding tax liability because they exist in
different jurisdictions. Rather, in the case of withholding tax obligations
at a second-tier or lower foreign subsidiary jurisdiction, a foreign tax
deduction or credit could only be recorded if the U.S. parent, in fact, had
a deductible temporary difference in its investments in the first-tier
foreign subsidiary12 or, in the case of a withholding tax obligation at a first-tier
foreign subsidiary jurisdiction, if the foreign tax deduction or credit is a
direct consequence of the withholding tax liability itself (e.g., the
“state/federal” effect in a single-tier entity).
3.4.14 Withholding Taxes — Foreign Currency Considerations
While foreign withholding taxes are generally considered a
liability of the investor rather than the investee (i.e., are attributable to
the investor’s outside basis difference), such taxes will ultimately be payable
to the foreign government in local currency and, provided that the investor’s
functional currency is different from the investee’s local currency, represent
foreign-currency-denominated liabilities of the investor.
When the investor is a U.S. entity, the amount of a
non-USD-denominated, foreign withholding tax liability will change as a result
of fluctuations in the corresponding exchange rate between the U.S. parent
(i.e., the USD) and the applicable local currency of the first-tier foreign
subsidiary. Because the U.S. parent is the primary obligor, such a liability is
not recorded by the first-tier foreign subsidiary and is therefore not subject
to translation. Accordingly, the impact of fluctuations between the reporting
currency of the U.S. parent and the functional currency of the first-tier
foreign subsidiary should be recorded through continuing operations of the U.S.
parent as the related liability is remeasured in each reporting period in
accordance with ASC 830-20.
Questions have arisen related to how a first-tier foreign
subsidiary (or foreign corporate joint venture that is essentially permanent in
duration) should account for fluctuations in the value of a foreign withholding
tax liability related to earnings of a second-tier foreign subsidiary (or
foreign corporate joint venture that is essentially permanent in duration) (the
“second-tier foreign subsidiary”) that are not indefinitely reinvested when the
first-tier foreign subsidiary has the same local and functional currency as that
of the second-tier foreign subsidiary, which is not the reporting currency.
Because the withholding tax liability is denominated in the same
currency as the first-tier foreign subsidiary’s functional currency, the amount
of the withholding tax liability on the functional currency books of the
first-tier foreign subsidiary will not change as a result of exchange rate
fluctuations. Accordingly, the related liability would not be remeasured in each
reporting period, and the first-tier foreign subsidiary would not record
transaction gain or loss in accordance with ASC 830-20. However, because the
first-tier foreign subsidiary is the primary obligor, such a liability is
recorded by the first-tier foreign subsidiary and is therefore subject to
translation. Accordingly, the impact of fluctuations between the reporting
currency of the U.S. parent and the functional currency of the first-tier
foreign subsidiary should be recorded as a CTA through other comprehensive
income (OCI).
If the first-tier foreign subsidiary has a functional currency
that is different from (1) the local currency of the second-tier foreign
subsidiary or (2) the reporting currency, the reporting entity needs to account
for the fluctuations in the value of a foreign withholding tax liability related
to the earnings of a second-tier foreign subsidiary. The amount of a foreign
withholding tax liability denominated in the local currency of the second-tier
foreign subsidiary will change as a result of fluctuations in the corresponding
exchange rate between the applicable local currencies of the first-tier foreign
subsidiary and the second-tier foreign subsidiary. Accordingly, the impact of
fluctuations between the functional currencies of the first-tier foreign
subsidiary and the second-tier foreign subsidiary should be recorded through
continuing operations of the first-tier foreign subsidiary as the related
liability is remeasured in each reporting period in accordance with ASC 830-20.
In addition, because the first-tier foreign subsidiary is the primary obligor,
such a liability is recorded by the first-tier foreign subsidiary and is
therefore subject to translation. Accordingly, the impact of fluctuations
between the reporting currency of the parent and the functional currency of the
first-tier foreign subsidiary should be recorded as a CTA through OCI.
3.4.15 Tax Consequences of Investments in Pass-Through or Flow-Through Entities
Generally, “pass-through” or “flow-through” entities (e.g.,
partnerships and LLCs that have not elected to be taxed as corporations) are not
taxable. Rather, the earnings of such entities pass through or flow through to
the entities’ owners and are therefore reported by the owners in accordance with
the governing tax laws and regulations. See ASC 740-10-55-226 through 55-228 for
examples illustrating when income taxes are attributed to a pass-through entity
or its owners.
Further, while ASC 740 does provide for certain exceptions to
the recognition of deferred taxes for basis differences related to investments
in certain subsidiaries, those exceptions historically have not been applied to
pass-through or flow-through entities since those types of entities were not
subsidiaries as defined before the issuance of ASU 2010-08. Rather, at the time FASB Statement 109 (codified in ASC 740) was issued, APB Opinion 18 (codified in ASC
323) defined a subsidiary as “a corporation which is controlled, directly or
indirectly, by another corporation.”
An investor in a pass-through or flow-through entity should
determine the deferred tax consequences of its investment. Because pass-through
or flow-through entities are not subject to tax, an investor should not
recognize deferred taxes on the book and tax basis differences associated with
the underlying assets and liabilities of the entity (i.e., “inside basis
differences”) regardless of how the investor accounts for its interest in the
entity (e.g., consolidation, equity method, or cost method13). Rather, because any taxable income or tax losses resulting from the
recovery of the financial reporting carrying amount of the investment will be
recognized and reported by the investor, the investor’s temporary difference
should be determined by reference to the investor’s tax basis in the investment
itself.
Often, this outside basis difference will fully reverse as the
underlying assets and liabilities are recovered and settled, respectively.
However, differences can exist between the investor’s share of inside tax basis
and the investor’s outside tax basis in the investment, leading to a temporary
difference that will generally not reverse as a result of the operations of the
entity (a “residual” temporary difference). Nonetheless, because that residual
temporary difference will still ultimately be recognized as additional taxable
income or loss upon the dissolution of the partnership (if the dissolution is
taxable) or will be attached to the assets distributed in liquidation of the
investor’s interest (if the dissolution is nontaxable), the recognition of
deferred taxes related to an investment in a pass-through or flow-through entity
should always take into account (and reconcile back to) the entirety of the
outside basis difference.
Two acceptable approaches have developed in practice for measuring the DTA or DTL to be recognized for an
outside basis difference related to an investor’s investment in a consolidated pass-through or flow-through entity: (1)
the outside basis approach and (2) the look-through approach.
Under the outside basis approach, measurement of the DTA or DTL
is based on the entirety of the investor’s outside basis difference in the
pass-through or flow-through entity investment without regard to any of the
underlying assets or liabilities. While it is easy to perform this computation,
application of the outside basis approach can result in certain additional
practice issues. For example, an outside basis difference would generally be
considered capital in character under a “pure” outside basis approach because
such an approach assumes that (1) the investment will be recovered when it is
disposed of in its entirety and (2) the interest in a pass-through or
flow-through entity is capital in nature. However, as discussed above, the
recovery and settlement of the pass-through or flow-through entity’s individual
assets and liabilities through normal operations of the entity will result in
(1) reversal of the temporary difference before the investor disposes of the
investment, (2) the pass-through of income or loss to the owner that is ordinary
rather than capital in character, or (3) both. Among other things, the assumed
timing of reversal and the character of the resulting income or loss may have an
effect on the investor’s conclusions about the tax rate to be applied to the
temporary difference and whether a valuation allowance against the investor’s
DTAs is needed. Accordingly, for the reasons noted above, even those investors
applying an outside basis approach for measurement should generally consider the
recovery and settlement of the pass-through or flow-through entity’s underlying
assets and liabilities, respectively, when assessing character and
scheduling.
Under the look-through approach, the investor would “look
through” and notionally match up its outside temporary difference with its share
of inside temporary differences for purposes of (1) applying ASC 740’s
exceptions to deferred tax accounting and (2) determining the character (capital
versus ordinary) and resulting reversal patterns used for assessing the
applicable tax rate or realizability of DTAs. Only the residual difference (if
any) would take its character and reversal pattern exclusively from the
investment itself. For example, under this approach, the portion of the
investor’s outside basis temporary difference that is notionally attributed to
“inside” nondeductible goodwill or the pass-through entity’s own investment in a
foreign corporate subsidiary (with unremitted earnings that are indefinitely
reinvested) would be identified and the applicable exception in ASC 740 would be
applied (i.e., no DTL would be recorded for that portion of the investor’s
outside basis temporary difference).
The look-through approach recognizes that because the
pass-through or flow-through entity is consolidated, (1) the assets and
liabilities of the pass-through or flow-through entity are actually being
reported by the investor in the investor’s financial statements and (2) the
investor is the actual taxpayer when the pass-through or flow-through entity’s
underlying assets and liabilities are recovered and settled, respectively.
Accordingly, measuring the outside basis difference
under the look-through approach results in the recognition of deferred taxes in
a manner consistent with the characteristics of the underlying assets and
liabilities that will be individually recovered and settled, respectively.
When the look-through approach is applied, however, any residual
difference between the total of the investor’s share of the pass-through or
flow-through entity’s inside tax basis and the investor’s outside tax basis
related to the investment would still need to be taken into account. As noted
above, while this component of the outside basis difference often would not
become taxable or deductible until sale or liquidation of the entity, a DTA or
DTL would generally be recorded because there is no available exception to
apply. In some instances, however, it may be appropriate to apply, by analogy,
the exception to recognizing a DTA in ASC 740-30-25-9. While it is more
difficult to perform computations under the look-through approach than under the
outside basis approach, application of the look-through approach can potentially
alleviate some of the aforementioned practice issues regarding character and
scheduling that result from applying the outside basis approach.
The approach selected to measure the deferred tax consequences
of an investment in a pass-through or flow-through entity would be considered an
accounting policy that should be consistently applied to all similar
investments. In addition, given the complexities associated with applying either
alternative, consultation with appropriate accounting advisers is encouraged in
these situations.
3.4.16 Accounting for the Tax Effects of Contributions to Pass-Through Entities in Control-to-Control Transactions
ASC 810-10-45-22 provides examples of transactions in which a
parent’s ownership in a subsidiary changes but the parent retains control of the
subsidiary. Specifically:
- A “parent purchases additional ownership interests in its subsidiary.”
- A “parent sells some of its ownership interests in its subsidiary.”
- A “subsidiary reacquires some of its ownership interests” held by a nonaffiliated entity.
- A “subsidiary issues additional ownership interests” to a nonaffiliated entity.
When the parent maintains control over the subsidiary, the
parent accounts for changes in its ownership interest as equity transactions.
See Section 12.4.1.
When there are subsequent contributions by either the
controlling interest or the noncontrolling interest to the pass-through entity,
recognition of a gain or loss in equity by the controlling shareholder will
typically create an additional basis difference that will need to be addressed
(i.e., the controlling interest’s basis for financial and income tax reporting
purposes may change by different amounts). Further, under the look-through
approach, additional complexities can arise because of the applicable income tax
regulations governing the allocation to partners of items of income, gain, loss,
or deduction for U.S. tax purposes.14 For example, such transactions can often result in residual outside basis
differences (i.e., the investor’s outside tax basis will not equal its share of
the inside tax basis) that will usually not be deductible or taxable until a
sale or taxable liquidation of the partnership (e.g., distribution of cash
following a sale of the partnership’s assets).
Typically, an investor accounts for changes in the measurement
of deferred taxes on its investment in a pass-through entity that result from a
control-to-control transaction in equity in accordance with the intraperiod tax
allocation guidance in ASC 740-20-45-11. If the investor uses the look-through
approach in measuring deferred taxes on its investment in the pass-through
entity, such changes would include the impact of any residual outside basis
difference. If the residual outside basis difference represents future
deductible amounts, the investor must consider its policy on applying ASC
740-30-25-9, by analogy, to its investment in the pass-through entity.
Example 3-29
On January 1, 20X9, Company A
contributes a recently acquired business (net assets
including cash, subject to debt) with a fair value and
financial reporting and income tax bases of $20 million
to Partnership P for an 80 percent interest in P, and
Company B contributes cash of $5 million for a 20
percent interest in P. Partnership P is a pass-through
entity and is not subject to income taxes in any
jurisdiction in which it operates. Company A uses the
look-through approach in measuring deferred taxes with
respect to investments in consolidated pass-through
entities. At the time of the contribution, A’s outside
basis for financial and income tax reporting purposes
are $20 million and $20 million, respectively. Company
B’s and A’s share of inside bases held by the investment
upon formation were as follows:
During 20X9, P generates $12.5 million
of income through normal operations for both financial
and income tax reporting purposes and makes no
distributions. Company A’s outside basis for financial
and income tax reporting purposes are $30 million and
$30 million, respectively. Company B’s and A’s share of
inside bases held by the investment are as follows:
As of December 31, 20X9, P has
appreciated in value to $80 million; assume such
appreciation is attributable entirely to P’s goodwill.
Further assume that on December 31, 20X9, B contributes
an additional $20 million to P. The contribution
decreases A’s ownership to 64 percent,15 which results in A’s having a financial reporting
basis of $36.8 million16 in its investment in P. As a result of the
contribution, A must recognize a control-to-control gain
of $6.8 million ($36.8 million – $30 million) for
financial statement reporting purposes; essentially A
transitions from owning 80 percent of P’s $37.5 million
net book value17 to owning 64 percent of P’s $57.5 million net book
value after the contribution.
Immediately after the $20 million
contribution by the noncontrolling interest holders, B’s
and A’s shares of inside bases held by the investment
would be as follows:
However, the contribution does not
affect A’s tax basis in its investment in P, which
creates a taxable temporary difference of $6.8 million
and a DTL of $1.7 million. In this case, the allocation
method chosen in accordance with the applicable income
tax regulations will affect only whether the $6.8
million becomes taxable over time through certain
partnership allocations18 or not until the ultimate sale or taxable
liquidation of the partnership; in either case, a DTL is
required.
Assume a 25 percent tax rate. Company A
will make the following consolidated journal entry to
recognize the contribution made by the noncontrolling
interest holders:
Example 3-30
Assume the same facts as in the example
above except that on December 31, 20X9, Company A (not
Company B) contributes an additional $20 million to
Partnership P. The contribution increases A’s ownership
to 84 percent.19 As a result of the contribution, A must recognize
a control-to-control loss of $1.7 million (A has paid a
$1.7 million premium above book value to acquire the
additional interest); essentially A transitions from
owning 80 percent of P’s $37.5 million net book value20 to owning 84 percent of P’s $57.5 million net book
value after the contribution. Company A’s basis in P for
financial reporting purposes increases by $18.3 million;
however, its basis for income tax reporting purposes
increases by the entire $20 million contribution,
resulting in a deductible temporary difference of $1.7
million.
Because there is a difference between
the fair value and adjusted tax basis of the property
owned by the partnership at the time of A’s additional
contribution, consideration needs to be given to
whether, as a matter of tax law, A will be allocated
deductions equal to the fair value of its contribution
of $20 million. If the partnership’s allocation method
(the remedial method in this case since the goodwill has
no tax basis in the hands of the partnership) under the
applicable income tax regulations will allocate such
deductions to A, A should record a DTA for the
deductible temporary difference given that such a
difference will close through normal business
operations. Company A’s outside book and tax basis are
$48.3 million and $50 million, respectively. Company B’s
and A’s share of inside bases held by the investment
would be as follows:
Assume a 25 percent tax rate. The
resulting entry to record the control-to-control loss in
equity would be as follows:
If the partnership’s allocation method
will not allocate A deductions equal to its $20 million
contribution (i.e., the “traditional method” in this
case since the goodwill has no tax basis in the hands of
the partnership), such a deductible temporary difference
will reverse only upon P’s sale or taxable liquidation.
Company A should consider the application of ASC
740-30-25-9, by analogy, to such a residual temporary
difference. A summary of A’s outside basis and related
look-through temporary differences in its investment in
such a case would be as follows:
If A applied ASC 740-30-25-9 by analogy,
A would record the entry for the control-to-control loss
as follows:
3.4.17 Other Considerations
3.4.17.1 Consideration of the VIE Model in ASC 810-10 in the Evaluation of Whether to Recognize a DTL
For VIEs, an analysis of voting rights may not be effective
in the determination of control. Under the VIE model in ASC 810-10, a
reporting entity could be determined to have a controlling financial
interest in a VIE, and thus consolidate the VIE, if the reporting entity has
(1) the power to direct the activities that most significantly affect the
VIE’s economic performance and (2) the obligation to absorb losses of (or
right to receive benefits from) the VIE that could potentially be
significant to the VIE. A reporting entity that consolidates a VIE is known
as the primary beneficiary.
When accounting for a VIE under ASC 740, the reporting
entity must consider both inside and outside basis differences.
When determining whether an exception to recording an
outside basis difference applies to the primary beneficiary’s investment in
a VIE, the reporting entity should carefully consider the facts and
circumstances. The primary beneficiary should not assume that its
controlling financial interest (through which it has the power to direct the
activities that most significantly affect the VIE’s economic performance)
also gives it the power to direct all of the activities of the VIE that are
relevant to the determination of whether an exception to recording an
outside basis difference is applicable (e.g., when and if the VIE will
distribute earnings, the manner in which the primary beneficiary will
recover its investment, and so forth). Provided that the criteria for an
exception are met, a primary beneficiary of a VIE may apply the outside
basis exceptions.21 However, meeting some of these exceptions may be challenging. When
determining which party has the power to control decisions regarding the
distribution of earnings, for example, an entity should consider how the VIE
is controlled (i.e., through contract or governing documents rather than
voting interests) and the rights of other parties to the arrangement.
3.4.17.2 Recognition of a DTA or DTL Related to a Subsidiary Classified as a Discontinued Operation
ASC 740-30-25-9 states that “[a] deferred tax asset shall be
recognized for an excess of the tax basis over the amount for financial
reporting of an investment in a subsidiary or corporate joint venture that
is essentially permanent in duration only if it is apparent that the
temporary difference will reverse in the foreseeable future.” This criterion
(i.e., a reversal of a temporary difference in the foreseeable future) would
be met no later than when the “held-for-sale” criteria in ASC 360-10-45-9
are met. The same criterion should apply to the recognition of a DTL related
to an excess of financial reporting basis over outside tax basis of an
investment in a subsidiary. In other words, the deferred tax consequences of
temporary differences related to investments in foreign subsidiaries that
were not previously recognized as a result of application of the exception
in ASC 740-30-25-18(a) should be recognized when it becomes apparent that
the temporary difference will reverse in the foreseeable future.
Similarly, the potential tax consequences of basis
differences related to investments in domestic subsidiaries that were not
previously recognized because (1) the tax law provides a means to recover
the reported amount of the investment in a tax-free manner, and (2) the
entity had previously expected that it would ultimately use those means,
should be accrued when it becomes apparent that the reversal of those basis
differences will have a future tax consequence.
The tax effects of the recognition of DTAs and DTLs for
preexisting outside basis differences when an investee meets the criteria to
be classified as held for sale generally will give rise to an
“out-of-period” adjustment in the current period (see Section 6.2.4 for
further information on out-of-period adjustments and Section 6.2.4.1 for
guidance on the intraperiod allocation of such adjustments resulting from
the recognition of an outside basis difference associated with a subsidiary
classified as a discontinued operation).
Note that if the unrecognized outside basis difference DTL
will close through a GILTI inclusion, entities that have elected to treat
GILTI as a current-period expense, as discussed in Section 3.4.10.1,
would recognize the tax expense in the period in which the tax is incurred.
In other words, recognition of the tax expense may not coincide with the
held-for-sale date, as described above.
3.4.17.3 State Tax Considerations
In recognizing outside basis differences associated with
various investments, entities should pay close attention to certain state
tax considerations. ASC 740-30-25-7 and 25-8 provide guidance on assessing
whether the outside basis difference of an investment in a domestic
subsidiary is a taxable difference. This assessment should be performed on a
jurisdiction-by-jurisdiction basis. Accordingly, the outside basis
difference of an investment in a domestic subsidiary that is not a taxable
difference for federal purposes would also need to be assessed at the state
level.
An entity should consider the following factors in applying
the guidance in ASC 740-30-25-7 and 25-8 at the state level:
- Whether tax-free liquidation is permitted in the applicable state jurisdictions. See Section 3.4.3 for further discussion of tax-free liquidations.
- Whether the parent files a separate, combined, or consolidated return in the state jurisdiction and whether intra-entity transactions (e.g., dividends) are eliminated when subsidiaries are combined or consolidated in that state return.
- Whether a dividends received deduction is available in the state jurisdiction or whether federal taxable income is used as the starting point for the state tax liability calculation and is unadjusted for dividends received deductions taken on the federal return. A dividends received deduction is a deduction on an income tax return for dividends paid from a subsidiary to a parent.
See Section 3.3.4.6 for a discussion of further considerations
related to certain state matters, including optional future tax elections in
the measurement of DTAs and DTLs.
Example 3-31
Subsidiary B, a 90 percent owned
subsidiary of Entity A, operates in only one state
(State C), which does not permit a tax-free
liquidation in accordance with ASC 740-30-25-7.
Entity A is taxable in C. Subsidiary B is
consolidated in A’s federal return. The only outside
basis difference in B relates to $1,000 of
unremitted earnings, which A expects to be remitted
as dividends. For federal income tax purposes, since
A holds more than 80 percent of B, A can deduct 100
percent of the dividends it receives from B (i.e.,
the dividends received deduction). State C does not
adjust federal taxable income for the dividends
received deduction. In this example, the unremitted
earnings of B to A would not create a temporary
difference on which A should record a DTL.
Example 3-32
Assume the same facts as in the
example above except that State C adjusts federal
income for the dividends received deduction. For
federal purposes, Entity A can still deduct 100
percent of the dividends it receives from Subsidiary
B; thus, no temporary difference exists for federal
tax purposes. However, because C adjusts federal
income for the dividends received deduction, a
temporary difference exists for state income tax
purposes on which A should record a DTL because
state tax law does not provide a means by which the
reported amount of the investment can be recovered
tax free.
Footnotes
6
There may be situations in which the
reversal of the excess of financial reporting over
tax basis is apparent because of future global
intangible low-taxed income (GILTI) inclusions
(e.g., excess of financial reporting over tax basis
inside the controlled foreign corporation [CFC]);
see Section
3.4.10.
7
With certain exceptions, ASU 2016-01
eliminated the cost method. Exceptions include (1)
qualified affordable housing projects that are not
eligible for the equity method and elect not to use
the proportional amortization method and (2)
investments in Federal Home Loan Bank and Federal
Reserve Bank stock issued to member financial
institutions.
8
An SFC includes all CFCs and all other foreign
corporations (other than passive foreign investment companies) in which
at least one domestic corporation is a U.S. shareholder.
9
Net tax liability under IRC Section 965 is the excess,
if any, of the taxpayer’s net income tax for the taxable year in which
the IRC Section 965 inclusion amount is included over such taxpayer’s
net income tax for the taxable year, excluding (1) the IRC Section 965
amount and (2) any income or deduction properly attributable to a
dividend received by such U.S. shareholder from any deferred foreign
income corporation.
10
Additional disaggregation may be appropriate
in situations in which a portion of the outside basis
difference is related to intra-entity loans (see Section
9.7), basis differences that will reverse
because of Subpart F inclusions (see Section
3.4.8), or GILTI inclusions (see Section
3.4.10).
11
Presentation of the component parts would still be
disaggregated (i.e., a DTA in the United States would not be net on
the balance sheet against a foreign withholding tax DTL).
12
In the case of an unborn FTC, the U.S. parent would
also need to represent that the associated earnings will move all
the way “up the chain” in a manner similar to the example above.
13
With certain exceptions, ASU 2016-01 eliminated the cost
method. Exceptions include (1) QAHPs that are not eligible for the
equity method and elect not to use the proportional amortization method
and (2) investments in Federal Home Loan Bank and Federal Reserve Bank
stock issued to member financial institutions.
14
Treasury regulations promulgated under IRC Section
704(c) account for the difference between the fair value and the
adjusted tax basis in property at the time they are contributed to the
partnership. In addition, such regulations can result in adjustments in
certain other situations, including when the fair value of property
owned by the partnership is in excess of its adjusted tax basis at the
time of a contribution to the partnership.
15
(80 percent × $80 million [fair
value of the company]) ÷ ($80 million [fair value
of the company] + $20 million contribution) = 64
percent.
16
($37.5 million + $20 million) ×
64 percent = $36.8 million.
17
$25 million (initial GAAP basis)
+ $12.5 million (20X9 income) = $37.5 million.
18
IRC Section 704(c), as noted in
footnote 14, applies to reverse IRC Section 704(c)
layers created as a result of a revaluation. Upon
the contribution of $20 million by B, the partners
revalued the partnership property. Under IRC
Section 704(c), use of the “remedial method” will
generally result in the $6.8 million’s becoming
taxable over time, whereas use of the “traditional
method” will generally result in the $6.8
million’s becoming taxable upon the ultimate sale
or taxable liquidation of the partnership since
the goodwill has no tax basis in the hands of the
partnership.
19
(80 percent × $80 million [fair
value of the company]) + $20 million contribution
÷ ($80 million [fair value of the company] + $20
million contribution) = 84 percent.
20
$25 million (initial GAAP basis)
+ $12.5 million (20X9 income) = $37.5 million.
21
While the exception in ASC 740-30-25-7 refers to a
“more-than-50-percent-owned domestic subsidiary,” the exception was
written at a time when the usual condition for control was ownership
of a majority (over 50 percent) of the outstanding voting stock.
Accordingly, we believe that an entity is not automatically
prohibited from applying that exception simply because it owns less
than 50 percent of the VIE.
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
22
While check-the-box elections are most commonly
considered in a foreign context, the same elections can be made for
domestic entities.
23
The check-the-box election is
not part of a larger restructuring
transaction.
25
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.