5.7 Exceptions and Special Situations | DART – Deloitte Accounting Research Tool

5.7.1 AMT Valuation Allowances

A corporate AMT was introduced in 2022 as part of the Inflation Reduction Act. While deferred taxes will continue to be measured at the regular tax rate (as discussed in Section 3.3.4.10), a corporate AMT will have an effect on existing DTAs in the regular tax system if an entity expects to perpetually pay corporate AMT (e.g., while an NOL for an entity that is expected to perpetually pay corporate AMT might result in a reduction in tax under the regular system, the NOL may not be available for corporate AMT purposes and the entity might pay corporate AMT tax on the income sheltered by the NOL in the regular tax system). We believe that there are two acceptable approaches to assessing the realizability of DTAs in the regular system for perpetual corporate AMT taxpayers.10

Under the first approach, the entity would assess the realizability of its DTAs11 on the basis of all available information. If, for example, the expected tax benefit of an NOL is less than the reported amount because the utilization of the NOL will result in incremental corporate AMT, an entity would have to use a valuation allowance to reflect the actual amount of tax benefit that will be realized with respect to the NOL. Alternatively, the entity could assess the realizability of its DTAs solely on the basis of the regular tax system without taking into account amounts due under the corporate AMT system (i.e., any incremental impact of the corporate AMT would be accounted for in the period in which the corporate AMT is incurred).

The example below illustrates these approaches for a perpetual corporate AMT taxpayer.

Example 5-22

Assume that Entity A:

Had $1,000 of pre-2018 NOL carryforwards and no corporate AMT credit or NOL carryforward.
Expects sufficient future income to fully utilize its pre-2018 NOL carryforward.
Expects to be a corporate AMT taxpayer perpetually and, accordingly, will need to record a full valuation allowance against any corporate AMT credit carryforwards that arise in future years.

For simplicity, assume that there are no other permanent or temporary differences or attributes.

Entity A could select either of the following approaches to assess the realizability of DTAs in the regular system:

Approach 1 — The utilization of the NOL reduces the regular tax liability of $210 down to the corporate AMT liability of $150. As a result, the NOL only results in a reduction of future cash outflows of $60, necessitating a $150 valuation allowance against the $210 NOL DTA.
Approach 2 — The $150 incremental cost of corporate AMT would be accounted for in the period in which it arises, and no valuation allowance would be recorded against the $210 NOL DTA because there is sufficient regular taxable income expected in future years.

In addition, the Inflation Reduction Act allows entities to reduce their corporate AMT tax liability by certain general business credits. Entities applying the first approach that have a valuation allowance because of an inability to use such credits in the regular tax system would need to consider whether such credits may now be realizable as a result of the corporate AMT.

5.7.2 Assessing Realization of a DTA for Regular Tax NOL Carryforwards When Considering Future GILTI Inclusions

Under the GILTI tax regime, foreign taxes paid or accrued in the year of the inclusion may be creditable against U.S. taxes otherwise payable, subject to certain limitations (e.g., foreign source income, expense allocations). If not used in the year of inclusion, however, the FTC would be permanently lost. Further, because IRC Section 250 deductions are limited to 50 percent of taxable income after NOL deductions, use of NOLs could reduce or eliminate the eligibility for an IRC Section 250 deduction. Therefore, as a result of expected future GILTI inclusions, a U.S. entity that has historically experienced cumulative losses may expect that existing NOL carryforwards, for which a valuation allowance has historically been recorded, will now be used. Use of the NOL carryforwards may, however, result in an actual cash tax savings that is less than the DTA (before reduction for any valuation allowance) and, in some cases, may result in no cash tax savings at all because, without the NOL, the entity would have been eligible for an IRC Section 250 deduction that would have reduced the net taxable income inclusion and would have been able to use FTCs.

There are two acceptable views regarding how an entity should consider future GILTI inclusions when assessing the realizability of NOL DTAs. The first is that an entity would consider future GILTI inclusions on the basis of tax law ordering rules when estimating available sources of future taxable income to assess the realizability of DTAs. Under a tax law ordering approach, the future reduction or elimination of the IRC Section 250 deduction and FTCs will not result in the need for a valuation allowance for an entity’s existing NOL DTAs. Use of a tax law ordering approach is consistent with Example 18 in the ASC 740-10 implementation guidance (see ASC 740-10-55-145 through 55-148). The same conclusion would apply to DTAs for other tax attributes and deductible temporary differences.

Alternatively, an entity could assess the realizability of DTAs on the basis of the incremental economic benefit they would produce. In other words, because future GILTI inclusions are an integrated part of the regular tax system, an entity would determine how much, if any, benefit is expected to be realized from an entity’s existing NOL carryforwards on a “with-and-without” basis. That is, a DTA would be recognized for only the amount of incremental tax savings the DTAs are expected to produce after the entity considers all facts and circumstances, elements of the tax law, and other factors that would otherwise limit the availability of the IRC Section 250 deduction and use of the FTCs.

We believe that when measuring U.S. GILTI DTAs and DTLs (more specifically, evaluating whether future IRC Section 250 deductions should affect the measurement of GILTI DTAs and DTLs), an entity should apply an approach that is consistent with its assessment of how future IRC Section 250 deductions affect the realizability of an NOL DTA.

For example, if the entity evaluates the realizability of NOL DTAs on the basis of the incremental economic benefit the NOLs would produce (i.e., the “with-and-without” approach described above), it would be appropriate for the entity to factor in the IRC Section 250 deduction that would be available without the NOL when measuring its GILTI DTAs and DTLs. Alternatively, if the entity evaluates the realizability of NOL DTAs on the basis of tax law ordering rules, the measurement of GILTI DTAs and DTLs should take into account only the impact of the IRC Section 250 deduction that will actually be available after use of the NOL in the year the GILTI DTAs and DTLs reverse, because the ordering rules would suggest that the maximum amount of GILTI deduction will not be obtained in those circumstances.

5.7.3 Determination of the Need for a Valuation Allowance Related to FTCs

In their U.S. tax returns, taxpayers are allowed to elect either to deduct direct foreign taxes incurred on foreign-source earnings or to claim a credit for such taxes. Credits for foreign taxes incurred are subject to certain limitations (e.g., such credits are limited to the amount calculated by using the U.S. statutory rate and cannot be used against U.S. taxes imposed on domestic income). Taxpayers are also permitted to claim a credit for indirect (or deemed-paid) foreign taxes (i.e., taxes included for U.S. tax purposes on the underlying income of a foreign subsidiary or more-than-10-percent investee when the underlying income is remitted as dividends). In this situation, pretax income is grossed up for the amount of taxes credited. If the taxpayer elects not to claim a credit for deemed-paid taxes, the income is not grossed up.

According to the IRC,12 a taxpayer must choose between either deducting or claiming a credit for the foreign taxes that are paid in a particular tax year. The election to claim the credit or deduction is made annually and may be changed at any time while the statute of limitations remains open. In the case of an overpayment as a result of not claiming a credit for foreign taxes, a claim for credit or refund may be filed within 10 years from the time the return is filed or two years from the time the tax is paid, whichever is later.13

Creditable foreign taxes paid or deemed paid in a given year give rise to an FTC. An FTC can be either recorded as a reduction in taxes payable (with a corresponding increase in taxable income with respect to deemed-paid taxes) or taken as a tax deduction (for direct-paid taxes) in arriving at taxable income. Any FTC not currently allowed because of various current-year limitations (i.e., an excess FTC) should be recognized as a DTA. ASC 740-10-30-2(b) states, “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.” An exception to this are FTCs related to GILTI. Excess GILTI FTCs may not be carried forward or carried back; therefore, a DTA should not be recorded for any excess GILTI FTCs. See Section 3.4.10 for additional information about FTCs created by GILTI.

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

Measurements [of deferred tax liabilities and assets] 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.

Although, given the statute extension, the decision of whether to take a credit or deduct foreign taxes may not be finalized until subsequent periods, the ability to deduct foreign taxes qualifies as a tax-planning strategy and should be taken into account in the determination of the minimum DTA that should be recognized for financial reporting purposes as of any reporting date.

In determining a valuation allowance against the DTA, an entity must compare the annual tax benefit associated with either deducting foreign taxes or claiming them as credits. In some circumstances in which an FTC carryover might otherwise have a full valuation allowance, recovery by way of a deduction may yield some realization through recognition of the federal tax benefit of a deduction. In such circumstances, it is not appropriate for an entity to assume no realization of the FTC solely on the basis of a tax credit election (i.e., leading to a full valuation allowance) when the entity is able to change the election to a deduction in subsequent periods and realize a greater benefit than is provided by claiming a credit for the year in question.

Since the election to claim foreign taxes as either a deduction or a credit is an annual election, the calculation of the appropriate valuation allowance should be determined on the basis of the foreign taxes paid or deemed paid in a given year.

Example 5-23

Deduction Benefit Greater Than Credit Benefit

Entity X, a U.S. entity, paid direct foreign taxes of $100 in 20X9. On the basis of the applicable limitations, X is permitted to use $10 of FTC against its 20X9 taxes payable; X is allowed to carry back the remaining $90 for one year and carry it forward for 10 years, which gives rise to a DTA. The U.S. federal income tax rate is 21 percent.

Entity X must evaluate the realizability of the DTA for the FTC. The maximum valuation allowance will be limited by any benefit that X would realize by amending its 20X9 tax return to take a deduction rather than allowing the remaining $90 FTC to expire unused. If X has sufficient taxable income to take the deduction in 20X9, the benefit that can be realized by taking a tax deduction would be $21 (21% tax rate × $100 of foreign taxes paid). A $10 benefit has already been taken for the FTC through the credit election; therefore, X should at least realize an additional $11 benefit for the carryforward taxes as a result of the option to take a deduction ($21 available deduction less the $10 credit taken in 20X9). Therefore, the maximum valuation allowance that X should consider for the $90 FTC carryforward is $79. Note that the FTC was not created by GILTI.

Example 5-24

Credit Benefit Greater Than Deduction Benefit

Assume the same facts as in the example above, except that Entity X is permitted to use $40 of FTC against its 20X9 taxes payable. Since the benefit that can be realized by taking a deduction for the $100 creditable taxes is $21 (as calculated in the example above) and $40 has already been recognized as a benefit in the financial statements, the entire remaining $60 FTC carryforward may be subject to a valuation allowance if X does not expect to be able to generate sufficient foreign-source income in the future. Note that the valuation allowance cannot reduce the DTA below zero.

Example 5-25

Deemed-Paid Taxes

Entity X, a U.S. entity, receives a distribution of $300 from its foreign subsidiary, Y, on the basis of Y’s underlying income of $400, taxable at 25 percent in the foreign jurisdiction. The distribution brings with it $100 of creditable foreign taxes (i.e., $100 in deemed-paid taxes of X) ($400 income × 25% tax rate). For tax year 20X9, there is a $400 dividend (consisting of the $300 distribution and a $100 gross-up for the deemed-paid taxes associated with the decision to take a credit for the 20X9 foreign income taxes paid by Y). As a result of the FTC limitation, X is permitted to use $10 of FTC against its 20X9 taxes payable and is allowed to carry back the remaining $90 for one year and carry it forward for 10 years, which gives rise to a DTA. Entity X did not have a sufficient FTC limitation to use the FTC in the prior year. The U.S. federal income tax rate is 21 percent. Total U.S. federal income tax paid by X in 20X9 would be $74, which is calculated as ($400 dividend × 21% tax rate) – $10 FTC. If X chose to “deduct,” rather than credit, the FTC in 20X9, the tax paid would be $63 ($300 distribution × 21% tax rate).

The gross-up under the credit option effectively results in X’s paying an additional $11 in tax in 20X9 related to the foreign-source income, which is calculated as ($100 deemed-paid taxes × 21% tax rate) – $10 FTC. The remaining $90 of FTC may be used in a future period; however, there are no additional gross-ups in those periods. In evaluating the realizability of the DTA for the $90 excess FTC, if X no longer expected to realize the FTC, it could benefit from amending the 20X9 tax return for a “deduction” (effectively, this is an exclusion of the gross-up from income and no FTC, rather than a deduction). Electing a deduction would result in a refund of $11 ($74 − $63) because of the removal of the gross-up. Accordingly, the maximum valuation allowance is $79 ($90 – $11 refund).

Alternatively, if, instead of a $10 credit limitation, $75 of FTC could be used in 20X9, the FTC would have given rise to a $54 benefit in 20X9, or ($100 × 21%) − $75. In evaluating the realizability of the DTA for the $25 carryforward, X could not benefit from amending the 20X9 tax return for a deduction since the benefit of the FTC already taken exceeds the tax cost of the gross-up. The deduction would result in a benefit of only $21 ($100 × 21%), compared with the credit of $75 in 20X9. Accordingly, the maximum valuation allowance in this alternative is $25.

Note that the decision to deduct, rather than credit, the FTC in a given year applies to both paid and deemed-paid taxes. The benefit obtained from amending a return to deduct paid foreign taxes rather than letting the FTC expire will be offset in part or in full by loss of the benefit on deemed-paid taxes otherwise creditable that year.

5.7.4 Unrealized Losses on AFS Debt Securities Recognized in OCI

AFS debt securities are carried at fair value, and unrealized gains or losses are reported as increases or decreases in OCI. ASC 740-20-45-11(b) requires that entities charge or directly credit to OCI the tax effects of unrealized gains and losses that occur during the year that are included in OCI. ASC 740-10-25-20 states the following, part:

An assumption inherent in an entity’s statement of financial position prepared in accordance with [U.S. 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. [Emphasis added]

Thus, an entity ordinarily assumes that the recovery of the carrying amount of its AFS debt securities portfolio is the portfolio’s fair value as of each balance sheet date. In many tax jurisdictions, unrealized holding losses would be tax deductible if the debt securities were recovered at their carrying value on the balance sheet date; therefore, the difference between the carrying amount of a debt security and its tax basis would be a deductible temporary difference. It is not appropriate to assume that an entity will not incur a tax consequence for unrealized losses on its equity security investments classified as AFS because market changes in the fair value of equity securities are not within the unilateral control of an investor entity.

5.7.4.1 Evaluating the Realizability of DTAs Related to Unrealized Losses on AFS Debt Securities Recognized in OCI

When unrealized losses are deductible only upon recovery of the AFS securities, the temporary differences associated with unrealized gains and losses on debt securities may be unlike other types of temporary differences because (in the absence of potential adjustments related to credit risk) if an entity holds the debt security until recovery of its amortized cost, the unrealized gains and losses will reverse over the contractual life of the investment, resulting in no cumulative comprehensive book income and no past or future tax loss. Accordingly, questions have arisen regarding how to assess the realizability of such DTAs.

In January 2016, the FASB issued ASU 2016-01, which clarified that “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].” The ASU addresses the diversity in practice that results from (1) an entity’s evaluation of such DTAs for realizability independently of the entity’s other DTAs or on the basis of its facts and circumstances and (2) its conclusion that the DTA recognized for unrealized losses on an AFS debt security included in OCI did not require a source of future taxable income for realization. Under ASU 2016-01, however, the fact that the unrealized losses are expected to reverse is not sufficient by itself to support a conclusion that such DTAs are realizable. In other words, an entity is not permitted to rely solely on the assertion that its intent and ability to hold the debt security until maturity will result in the recovery of the unrealized losses given that the recovery of such losses may only partially offset the entity’s potential future losses.

Example 5-26

Company A has a portfolio of AFS debt securities that have incurred unrealized losses due to interest rate fluctuations, resulting in the recognition of DTAs in OCI. In accordance with the guidance in ASU 2016-01, A must evaluate its DTAs from both the net operating carryforwards and unrealized losses in combination with one another. Accordingly, in the absence of other positive evidence such as objective and verifiable projections of future taxable income (see Sections 5.2.2 and 5.7.4.3 for additional discussion), A would need a valuation allowance on the DTAs related to its AFS debt securities.

5.7.4.2 Determining the Character of DTAs Related to Unrealized Losses on AFS Debt Securities Recognized in OCI

Future realization of tax benefits, whether tax loss carryforwards or deductible temporary differences, ultimately depends on the existence of sufficient taxable income of the appropriate character (e.g., ordinary or capital gain) within the carryback and carryforward periods prescribed under tax law. For most entities, the assessment of the realization of tax benefits from unrealized losses on an AFS debt securities portfolio will often depend on the inherent assumptions used for financial reporting purposes concerning the ultimate recovery of the carrying amount of the portfolio.

In many cases, recovery of an AFS debt security at fair value would result in a capital loss deduction. In those cases, an entity would need to assess whether it is more likely than not to realize the loss on the basis of available evidence. Evidence the entity would consider might include (1) future reversals of existing taxable temporary differences expected to generate capital gain income, (2) projections of future capital gain income exclusive of reversing temporary differences, (3) capital gain income in prior carryback years if carryback is permitted under the tax law, and (4) tax-planning strategies that would generate capital gain income. In this situation, the entity should evaluate such available evidence to determine whether it is more likely than not that it would have, or could generate, sufficient capital gain income during the carryback and carryforward periods prescribed under tax law.

In certain circumstances, an entity might assert that it will hold the AFS debt security until recovery of its amortized cost rather than, as ASC 326 might require, incurring current-period losses attributable to an actual sale or impairment losses in earnings. For example, in accordance with ASC 326-30-35-10, if an entity intends to sell an impaired AFS security, it must write down the security's amortized cost basis to its fair value, write off any existing allowance for credit losses, and recognize in earnings any incremental impairment. Although securities classified as AFS can, by definition, be sold if circumstances change, we believe that the representations an entity makes on a security-by-security basis to satisfy the ASC 326 criteria to avoid recognizing a write-down in the income statement could be consistent with a conclusion that the deductible temporary difference will reverse over the contractual life of the investment in a manner that will not be capital in nature. Such representations would be that the entity does not have a current intent to sell the securities and it is not more likely than not that the entity will be required to sell them before recovering its amortized cost basis. However, the decline in fair value must result from market conditions and not a deterioration of the credit standing of the issuer, and the entity must not, in fact, intend to sell the securities.

The validity of that conclusion should be assessed on the basis of all facts and circumstances, including the fact that the decline in fair value results from market conditions and not a deterioration of the issuer's credit standing or the entity’s ability to hold the investments until recovery. Factors that are often relevant to this assessment include, but are not limited to, the investor’s current financial position, its recent securities trading activity, its expectations concerning future cash flow or capital requirements, and the conclusions reached in regulatory reports. Entities making this assertion would still need to assess recovery of the DTA in combination with their other DTAs.

Example 5-27

Company A has a portfolio of AFS debt securities that have incurred unrealized losses due to interest rate fluctuations, resulting in the recognition of DTAs in OCI. Even with such losses, however, A is in a cumulative income position. It has recorded a full valuation allowance against certain of its capital loss carryforwards because it has not been able to forecast a source of future taxable income of the appropriate character. Although A has determined that it is not more likely than not to realize its existing capital loss carryover DTAs, it may not need a valuation allowance against its AFS debt securities if it can assert that it will hold the AFS debt security until recovery of its amortized cost, with the unrealized gains and losses reversing over the contractual life of the investment unless a capital loss is recognized.

5.7.4.3 Evaluating the Recovery of AFS Debt Securities and Estimates of Future Income

Some companies may be in a cumulative loss position due to unrealized losses in OCI related to securities classified as AFS. In such cases, questions arise related to how to estimate future income. As discussed in Section 5.3.2.2, when objectively verifiable negative evidence is present (e.g., cumulative losses), an entity may develop an estimate of future taxable income or loss that is also considered to be objectively verifiable for determining the amount of the valuation allowance needed to reduce the DTA to an amount that is more likely than not to be realized. In a manner similar to the discussion in the previous section of the character of the losses and acknowledging that securities classified as AFS can, by definition, be sold if circumstances change, we believe that the representations an entity makes on a security-by-security basis to satisfy the ASC 326 criteria to avoid recognizing a write-down in the income statement could be consistent with projections of future income from the recovery of the securities. Such representations would be, as noted previously, that the entity does not have a current intent to sell the securities and it is not more likely than not that the entity will be required to sell them before recovering its amortized cost basis.

Under certain circumstances, unrealized losses recorded in OCI on AFS debt securities may not be indicative of an entity’s ability to generate taxable income in future years. For example, an entity in a net cumulative loss position may be in a cumulative income position in the absence of the mark-to-market losses on AFS debt securities. In these circumstances, an entity may be able to develop an objectively verifiable estimate of future income by adjusting its historical income or loss for financial reporting purposes in recent years to remove the unrealized gains or losses recorded in OCI on AFS debt securities. If the entity is also able to assert that it will hold the AFS debt securities until recovery of its amortized cost, the entity can also consider the projection of future income associated with the recovery of the AFS debt securities over the contractual life of the investment. The projection of income from holding the AFS debt securities until recovery would be limited to the recovery of the mark-to-market loss.

Consultation is encouraged, particularly in situations in which significant negative evidence in the form of cumulative losses otherwise exists. (See Section 5.2.2 for more information.)

Example 5-28

Company A has a portfolio of AFS debt securities that have incurred unrealized losses of $150 million over the last three years due to interest rate fluctuations, resulting in the recognition of DTAs. The unrealized loss was recorded in OCI. As a direct result of such losses, A is in a cumulative loss position of $50 million (i.e., A would have cumulative income of $100 million (assume $33 million per year) if not for the unrealized losses recorded in OCI). Company A has no intent to sell its AFS debt securities and it is not more likely than not that it will be required to sell before it recovers the amortized cost basis. Accordingly, in developing an estimate of future income by adjusting its historical loss for financial reporting purposes in recent years, A removes the $150 million unrealized loss recorded in OCI associated with the AFS debt securities, in a manner similar to a nonrecurring item. As a result, A’s objectively verifiable estimate of ongoing future income is $33 million per year. Company A can also estimate an additional $150 million of future income, associated with the recovery of the unrealized loss, over the recovery period of the AFS debt securities.

5.7.5 Assessing Realization of Tax Benefits From Unrealized Losses on AFS Securities

Future realization of tax benefits, whether tax loss carryforwards or deductible temporary differences, ultimately depends on the existence of sufficient taxable income of the appropriate character (e.g., ordinary or capital gain) within the carryback and carryforward periods prescribed under tax law. For most entities, the assessment of the realization of tax benefits from unrealized losses on an AFS debt securities portfolio will often depend on the inherent assumptions used for financial reporting purposes concerning the ultimate recovery of the carrying amount of the portfolio.

ASC 740-10-25-20 concludes that an “assumption inherent in an entity’s statement of financial position prepared in accordance with [U.S. GAAP] is that the reported amounts of assets and liabilities will be recovered and settled, respectively.” Thus, an entity ordinarily assumes that the recovery of the carrying amount of its AFS debt securities portfolio is the portfolio’s fair value as of each balance sheet date. Whenever an unrealized holding loss exists, recovery at fair value would result in a capital loss deduction. Because U.S. federal tax law for most entities requires use of capital losses only through offset of capital gains, an entity would need to assess whether realization of the loss is more likely than not on the basis of available evidence. Evidence the entity would consider might include (1) the available capital loss carryback recovery of taxes paid in prior years and (2) tax-planning strategies to sell appreciated capital assets that would generate capital gains income. In this situation, the entity should evaluate such available evidence to determine whether it is more likely than not that it would have, or could generate, sufficient capital gain income during the carryback and carryforward periods prescribed under tax law.

Under certain circumstances, however, an entity might assume that recovery of its debt security investment portfolio classified as AFS will not result in a capital loss. This assumption is based on the fact that, to avoid sustaining a tax loss, an entity could choose to hold the securities until maturity, provided that their decline in fair value results from market conditions and not a deterioration of the credit standing of the issuer. If an entity proposes to rely on such an assumption, the validity of that assertion should be assessed on the basis of the entity’s ability to hold investments until maturity. Factors that are often relevant to this assessment include, but are not limited to, the investor’s current financial position, its recent securities trading activity, its expectations concerning future cash flow or capital requirements, and the conclusions reached in regulatory reports. The circumstances under which an entity applying ASC 740 could assume recovery of the carrying amount of a portfolio of debt securities classified as AFS without incurring a loss are expected to be infrequent.

An assumption that an entity will not incur a tax consequence for unrealized losses on its equity security investments classified as AFS is not appropriate because market changes in the fair value of equity securities are not within the unilateral control of an investor entity.

5.7.6 Application of ASC 740-20-45-7 to Recoveries of Losses in AOCI

A credit or gain may be recognized in OCI on a debt security that is classified as AFS but that remains in an overall loss position.

Example 5-29

Recoveries of Losses in AOCI

Entity A purchases a debt security on January 1, 20X1, for $1,000. The security is classified as held for sale for financial reporting purposes. During 20X1, the security declines in value so that its carrying amount for financial reporting purposes is $800 on December 31, 20X1. The unrealized loss of $200 is recognized in OCI in accordance with ASC 320. During 20X2, the security increases in value, and an unrealized gain of $150 is recognized in OCI. As a result, the security’s financial reporting carrying amount increases to $950.

Company A would not consider an unrealized gain recognized in OCI in the current year as a potential source of future income when applying the intraperiod allocation rules.

In other words, when a security remains in a net loss position even after a current-year unrealized gain, there is no taxable income expected in future years that would serve as a source of income for the current-year loss from continuing operations. This is substantiated by the fact that there is a DTA for a deductible temporary difference on the security since the tax basis is greater than the book basis. If the security in the example above is sold at the financial reporting amount of $950, there is a taxable loss and no gain; hence, nothing serves as a source of income that would benefit the current-year continuing operations loss.

Example 5-30

Assume the following:

Entity B:
- Determined, in 20X0, that a valuation allowance is needed to reduce its DTA to an amount that is more likely than not to be realized, or zero.
- Has a YTD pretax loss and is anticipating a pretax loss for the year for which no tax benefit can be recognized.
- Has a portfolio of four equity securities that are classified as AFS for financial reporting purposes and, therefore, the unrealized gains or losses are recognized in OCI in accordance with ASC 320.
- Purchased each equity security on January 1, 20X1, for $1,000.
During 20X1, a net unrealized gain of $50 on AFS securities is recognized in OCI.
During 20X2, a net unrealized gain of $150 is recognized in OCI.

See Section 6.2.7.1 for additional discussion of the intraperiod tax implications of the examples above.

5.7.7 Realization of a DTA of a Savings and Loan Association: Reversal of a Thrift’s Base-Year Tax Bad-Debt Reserve

An entity is not permitted to consider the tax consequences of a reversal of a thrift’s base-year tax bad-debt reserve in assessing whether a valuation allowance is necessary for a DTA recognized for the tax consequences of a savings and loan association’s bad-debt reserve unless a DTL has been recognized for that taxable temporary difference. As stated in ASC 942-740-25-1, a DTL for base-year bad-debt reserves is not recognized “unless it becomes apparent that those temporary differences will reverse in the foreseeable future.”

See Section 3.5.5 for additional discussion of the guidance in ASC 942-740-25 on a thrift’s bad-debt reserves.

5.7.8 Accounting for Valuation Allowances in Separate or Carve-Out Financial Statements in Interim and Annual Periods

See Section 8.5 for specific guidance on valuation allowances accounted for in separate or carve-out financial statements.

5.7.9 Accounting for a Change in a Valuation Allowance in an Interim Period

See Section 7.3.1 for guidance on changes in valuation allowances in an interim period. For a discussion of intraperiod tax allocations for valuation allowances, see Section 7.4.

5.7.10 Accounting Considerations for Valuation Allowances Related to Business Combinations

See Section 11.5 for a discussion of (1) recognition of an acquiring entity’s tax benefit not considered in acquisition accounting, (2) recording a valuation allowance in a business combination, and (3) issues related to accounting for changes in the acquirer’s and acquiree’s valuation allowance as of and after the acquisition date.

5.7.11 Accounting Considerations for Valuation Allowances Related to Share-Based Payment DTAs

See Section 10.6 for guidance on the determination of a valuation allowance for deferred taxes associated with share-based payment awards.

5.7.12 Accounting Considerations for Valuation Allowances Related to IRC Section 163(j) Carryforwards

Entities should carefully consider the impact of the IRC Section 163(j)14 limitation on the valuation allowance assessment of Section 163(j) interest carryforward DTAs and other DTAs.

When developing an estimate of future taxable income or loss in accordance with the guidance in Section 5.3.2.3, an entity should consider the effects of the IRC Section 163(j) limitation in a manner similar to its consideration of nonrecurring items for which it adjusts its historical results. However, the ability to adjust historical operating results to obtain an objectively verifiable estimate of future taxable income does not change the fact that the entity would still need to consider such losses as part of its prior earnings history (i.e., the entity may not exclude such losses in determining whether it has cumulative losses in recent years) in a manner similar to its consideration of the nonrecurring items discussed above. The example below illustrates this scenario.

Example 5-31

Consideration of the Impact of an IRC Section 163(j) Limitation on the Estimation of Future Taxable Income When Negative Evidence Exists in the Form of Cumulative Losses

Assume the following:

Entity A has determined that it is appropriate to use a three-year period in assessing whether negative evidence exists in the form of cumulative losses in recent years.
As of December 31, 2020, A is in a cumulative-loss position, with a pretax loss of $58, $60, and $52 for 2018, 2019, and 2020 respectively.
Entity A anticipates being subject to the IRC Section 163(j) limitation for the foreseeable future.
Because A is in a cumulative-loss position, it uses its recent earnings history, adjusted for nonrecurring items and recurring permanent differences, to project future taxable income in evaluating the realizability of its DTAs.
Entity A has determined that it has (1) recurring permanent differences of $5 in each year of its recent tax years and (2) an objectively verifiable nonrecurring item of $5 in 2019.

The following table shows amounts that were included in pretax loss for each of the last three tax years:

In addition, because interest expense is a component of A’s pretax loss, when A adjusts its recent earnings history as part of developing objectively verifiable future income projections, it would consider whether the amount that it can deduct under IRC Section 163(j) is limited and, if so, adjust its estimate of future taxable income accordingly.

Further, the limitation percentage for allowable interest has been, and is expected to continue to be, 30 percent of adjusted taxable income. For taxable year 2021, adjusted taxable income is equal to pretax income (or loss), adjusted for nonrecurring items, recurring permanent differences, net interest expense, and depreciation and amortization. For taxable years after 2021, adjusted taxable income is equal to pretax income (or loss), adjusted for nonrecurring items, recurring permanent differences, and net interest expense.

Entity A’s estimate of its future taxable income, including the effects of its IRC Section 163(j) limitation, is shown below:

Adjusted Historical Results as of 2021 (Rounded for Simplicity)

Adjusted Historical Results Post-2021 (Rounded for Simplicity)

The assessment of future taxable income is not a purely mechanical exercise; A must consider all positive and negative evidence to develop an estimate that is based on objectively verifiable evidence. After considering all such evidence, including any contrary evidence that might suggest that future taxable income would be less than the adjusted historical results (i.e., the adjusted pretax loss of $50 adjusted for disallowed interest of $30 and $125 for 2021 and post-2021 tax years, respectively), A may be able to demonstrate that it will have taxable income after 2021 once it has factored in the impacts of IRC Section 163(j).

Like its evaluation of other tax attributes, an entity’s evaluation of IRC Section 163(j) carryforwards must be specific to the realizability of the carryforward. In December 2019, the AICPA issued Technical Q&As Section 3300, which addresses the evaluation of the realizability of existing DTAs related to disallowed interest deductions when there are (1) reversing DTLs and (2) an expectation of future interest expense that also will be limited under IRC Section 163(j). Technical Q&As Section 3300 states, in part:

[A]n entity should not recognize a valuation allowance if the taxable income to be generated upon reversal of its existing DTLs (ignoring future income or loss and future interest expense included in future income or loss) is sufficient to realize those DTAs, after considering reversal patterns and the 30% limitation. Whether an entity will continue to be in an interest limitation position each year in the future (resulting in an inability to use the Section 163(j) carryforward) is not relevant if the reversal of existing taxable temporary differences is sufficient to support realization of existing DTAs. Rather, if one source of future taxable income (the second source mentioned previously) exists, and that source is believed to be sufficient, then no other sources of future taxable income need to be evaluated.

If the reversal of existing taxable temporary differences is not sufficient to realize existing DTAs (for example, the entity is in a net DTA position), then additional sources of taxable income (for example, projections of future taxable income exclusive of reversing temporary differences and carryforwards) would be considered. In these situations, future limitations would be relevant and need to be considered in the projections and in assessing the realizability of any remaining DTAs, whether related to Section 163(j) or otherwise. Future income projections may represent an incremental source of taxable income for purposes of realizing those DTAs but would not affect the assessment of DTAs already deemed realizable as a result of the reversal of existing taxable temporary differences.

Additional consideration is necessary in the assessment of the realizability of DTAs, including those related to IRC Section 163(j) carryforwards, when there are (1) reversing DTLs, (2) an expectation of future interest expense, and (3) an expectation of future taxable income. Two acceptable approaches — the “additive approach” and the “integrated approach” — have developed in practice for the quantification of available sources of taxable income from “[f]uture reversals of existing taxable temporary differences” (per ASC 740-10-30-18(a)) and “[f]uture taxable income exclusive of reversing temporary differences and carryforwards” (per ASC 740-10-30-18(b)).

Under the additive approach, an entity calculates each source of such taxable income individually and then combines the sources to determine the amount of deferred taxes that are realizable. As described in ASC 740-10-30-18, two of the four such sources of this income are “[f]uture reversals of existing taxable temporary differences” (ASC 740-10-30-18(a)) and “[f]uture taxable income exclusive of reversing temporary differences and carryforwards” (ASC 740-10-30-18(b); emphasis added).

If a single source of income is sufficient, an entity does not need to look to a second source; if it is insufficient, the entity should look to the second source, which should be calculated individually and then combined with the first source. The entity should then add together the sources that do not overlap (i.e., future reversals of existing taxable temporary differences and future taxable income exclusive of the reversal of temporary differences and carryforwards) to determine the amount of deferred taxes that are realizable. This approach is consistent with the guidance in ASC 740-10-30-18 and Example 5-21.

In addition, under the additive approach, the realizable amount would include tax attributes from one source even if such amounts would be “squeezed out” and would not be realizable under the other source (e.g., if the existing IRC Section 163(j) carryforward DTA is realizable when the reversal of taxable temporary difference is scheduled but would actually be displaced by future interest in the entity’s projections of future taxable income).

Under the “integrated approach” (also known as the “lesser of valuation allowance approach”), if an entity determines that two different sources of income are expected to provide a source of taxable income and those sources are incremental to each other, the entity should combine them in determining the amount of deferred taxes that are realizable. While ASC 740-10-30 requires consideration of all four sources of taxable income described in ASC 740-10-30-18, the guidance does not explicitly state that each source must be viewed individually (in isolation). However, the amount of deferred taxes determined to be realizable under this approach can only result in the realization of an incremental DTA (i.e., it can never be less than the amount determined to be realizable in accordance with the analysis stemming from the “pure” scheduling of taxable temporary difference reversals).