Chapter 5 — Valuation Allowances
Chapter 5 — Valuation Allowances
5.1 Introduction
This chapter provides guidance on the amount at which an entity should
measure a tax asset in its financial statements when the recognition criteria for that
asset or liability have been met in accordance with ASC 740. Specifically, this chapter
focuses on how to evaluate DTAs for realizability and when a valuation allowance would
be appropriate. As the complexity of an entity’s legal structure and jurisdictional
footprint increases, so do the challenges related to measuring tax assets and
liabilities. However, the guidance in this chapter applies equally to highly complex
organizations as well as to simple entities that operate in a single jurisdiction.
A valuation allowance may be required to be recorded against DTAs so the financial
statements reflect the amount of the net DTA that is expected to be used in the future
(i.e., realized). Expected realization of DTAs must meet the more-likely-than-not
standard to be recorded in the financial statements without a valuation allowance. The
more-likely-than-not concept is discussed below.
5.2 Basic Principles of Valuation Allowances
ASC 740-10
30-16 As established in paragraph
740-10-30-2(b), there is a basic requirement to reduce the
measurement of deferred tax assets not expected to be realized.
An entity shall evaluate the need for a valuation allowance on a
deferred tax asset related to available-for-sale debt securities
in combination with the entity’s other deferred tax assets.
30-17 All
available evidence, both positive and negative, shall be
considered to determine whether, based on the weight of that
evidence, a valuation allowance for deferred tax assets is
needed. Information about an entity’s current financial position
and its results of operations for the current and preceding
years ordinarily is readily available. That historical
information is supplemented by all currently available
information about future years. Sometimes, however, historical
information may not be available (for example, start-up
operations) or it may not be as relevant (for example, if there
has been a significant, recent change in circumstances) and
special attention is required.
30-18
Future realization of the tax benefit of an existing deductible
temporary difference or carryforward ultimately 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.
The following four possible sources of taxable income may be
available under the tax law to realize a tax benefit for
deductible temporary differences and carryforwards:
- Future reversals of existing taxable temporary differences
- Future taxable income exclusive of reversing temporary differences and carryforwards
- Taxable income in prior carryback year(s) if carryback is permitted under the tax law
- Tax-planning strategies (see paragraph 740-10-30-19)
that would, if necessary, be implemented to, for
example:
- Accelerate taxable amounts to utilize expiring carryforwards
- Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss
- Switch from tax-exempt to taxable investments.
Evidence available about each of those possible sources of
taxable income will vary for different tax jurisdictions and,
possibly, from year to year. To the extent evidence about one or
more sources of taxable income is sufficient to support a
conclusion that a valuation allowance is not necessary, other
sources need not be considered. Consideration of each source is
required, however, to determine the amount of the valuation
allowance that is recognized for deferred tax assets.
30-19 In
some circumstances, there are actions (including elections for
tax purposes) that:
- Are prudent and feasible
- An entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused
- Would result in realization of deferred tax assets.
This Subtopic refers to those actions as tax-planning strategies.
An entity shall consider tax-planning strategies in determining
the amount of valuation allowance required. Significant expenses
to implement a tax-planning strategy or any significant losses
that would be recognized if that strategy were implemented (net
of any recognizable tax benefits associated with those expenses
or losses) shall be included in the valuation allowance. See
paragraphs 740-10-55-39 through 55-48 for additional guidance.
Implementation of the tax-planning strategy shall be primarily
within the control of management but need not be within the
unilateral control of management.
30-20 When
a tax-planning strategy is contemplated as a source of future
taxable income to support the realizability of a deferred tax
asset, the recognition and measurement requirements for tax
positions in paragraphs 740-10-25-6 through 25-7; 740-10-25-13;
and 740-10-30-7 shall be applied in determining the amount of
available future taxable income.
30-21
Forming a conclusion that a valuation allowance is not needed is
difficult when there is negative evidence such as cumulative
losses in recent years. Other examples of negative evidence
include, but are not limited to, the following:
- A history of operating loss or tax credit carryforwards expiring unused
- Losses expected in early future years (by a presently profitable entity)
- Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years
- A carryback, carryforward period that is so brief it would limit realization of tax benefits if a significant deductible temporary difference is expected to reverse in a single year or the entity operates in a traditionally cyclical business.
30-22
Examples (not prerequisites) of positive evidence that might
support a conclusion that a valuation allowance is not needed
when there is negative evidence include, but are not limited to,
the following:
- Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures
- An excess of appreciated asset value over the tax basis of the entity’s net assets in an amount sufficient to realize the deferred tax asset
- A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for example, an unusual or infrequent item) is an aberration rather than a continuing condition.
30-23 An
entity shall use judgment in considering the relative impact of
negative and positive evidence. The weight given to the
potential effect of negative and positive evidence shall be
commensurate with the extent to which it can be objectively
verified. The more negative evidence that exists, the more
positive evidence is necessary and the more difficult it is to
support a conclusion that a valuation allowance is not needed
for some portion or all of the deferred tax asset. A cumulative
loss in recent years is a significant piece of negative evidence
that is difficult to overcome.
30-24
Future realization of a tax benefit sometimes will be expected
for a portion but not all of a deferred tax asset, and the
dividing line between the two portions may be unclear. In those
circumstances, application of judgment based on a careful
assessment of all available evidence is required to determine
the portion of a deferred tax asset for which it is more likely
than not a tax benefit will not be realized.
30-25 See paragraphs 740-10-55-34
through 55-38 for additional guidance related to carrybacks and
carryforwards.
Related Implementation Guidance and Illustrations
- Recognition of Deferred Tax Assets and Deferred Tax Liabilities [ASC 740-10-55-7].
- Offset of Taxable and Deductible Amounts [ASC 740-10-55-12].
- Pattern of Taxable or Deductible Amounts [ASC 740-10-55-13].
- The Need to Schedule Temporary Difference Reversals [ASC 740-10-55-15].
- Operating Loss and Tax Credit Carryforwards and Carrybacks [ASC 740-10-55-34].
- Tax-Planning Strategies [ASC 740-10-55-39].
- Example 4: Valuation Allowance and Tax-Planning Strategies [ASC 740-10-55-96].
- Example 12: Basic Deferred Tax Recognition [ASC 740-10-55-120].
- Example 13: Valuation Allowance for Deferred Tax Assets [ASC 740-10-55-124].
- Example 19: Recognizing Tax Benefits of Operating Loss [ASC 740-10-55-149].
- Example 20: Interaction of Loss Carryforwards and Temporary Differences [ASC 740-10-55-156].
- Example 21: Tax-Planning Strategy With Significant Implementation Cost [ASC 740-10-55-159].
- Example 22: Multiple Tax-Planning Strategies Available [ASC 740-10-55-163].
5.2.1 The More-Likely-Than-Not Standard
A key concept underlying the measurement of a DTA is that the amount to be recognized
is the amount that is “more likely than not” expected to be realized. ASC
740-10-30-5(e) requires that DTAs be reduced “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.”
A more-likely-than-not standard for measuring DTAs could be applied positively or
negatively. That is, an asset could be measured on the basis of a presumption that
it would be realized, subject to an impairment test, or it could be measured on the
basis of an affirmative belief about realization. Because the threshold of the
required test is “slightly more than 50 percent,” the results would seem to be
substantially the same under either approach. However, some view an affirmative
approach as placing a burden of proof on the entity to provide evidence to support
measurement “based on the weight of the available evidence.” Regardless of whether
an entity views the more-likely-than-not threshold positively or negatively, the
entity should fully assess all of the available evidence and be able to substantiate
its determination.
Further, the more-likely-than-not threshold for recognizing a valuation allowance is
a lower threshold than impairment or loss thresholds found in other sections of the
Codification. For example, ASC 450-20-25-2 requires that an estimated loss from a
loss contingency be accrued if the loss is probable and can be reasonably estimated. Further, ASC 360-10-35-17 requires that an impairment loss of long-lived assets be recognized “only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value.” In paragraphs A95 and A96 of the Basis for Conclusions of Statement 109, the FASB rejected the term “probable”
with respect to the measurement of DTAs and believes that the criterion should be
“one that produces accounting results that come closest to the expected outcome,
that is, realization or nonrealization of the deferred tax asset in future years.”
If the same assumptions about future operations are used, this difference in
recognition criteria could cause an entity to recognize a valuation allowance
against a DTA but not to recognize an asset impairment or a loss contingency.
5.2.2 Positive and Negative Evidence
In determining whether a valuation allowance is needed, an entity must use judgment
and consider the relative weight of the available negative and positive evidence.
Further, ASC 740-10-30-23 states, in part, that the “weight given to the potential
effect of negative and positive evidence shall be commensurate with the extent to
which it can be objectively verified.” For example, information about the entity’s
current financial position and income or loss for recent periods may constitute
objectively verifiable evidence, while less weight may be given to a long-term
forecast of sales and income for a new product.
An entity that has no objectively verifiable negative evidence needs only to
determine whether it is more likely than not that the DTA will be realized. If the
more-likely-than-not assertion can be supported, often by using management’s
subjective projections of future income, there is no need for a valuation allowance.
However, if the entity is in a cumulative loss position (which is considered a piece
of objectively verifiable negative evidence), it must have objectively verifiable
positive evidence to overcome this negative evidence.
While objectively verifiable positive evidence is needed to offset any objectively
verifiable negative evidence (e.g., cumulative losses in recent periods) in the
assessment of whether a valuation allowance is required, subjective positive
evidence (e.g., management’s future income projections that incorporate future
earnings growth) may be sufficient to overcome certain types of subjective negative
evidence (e.g., negative trends in the entity’s industry outlook that may not be
specific to the entity itself). As discussed throughout this chapter, the entity
should evaluate both the positive and the negative evidence to determine whether a
valuation allowance is required.
5.2.2.1 Cumulative Losses and Other Forms of Negative Evidence
ASC 740-10-30-21 states that “cumulative losses in recent years” are a type of
negative evidence for entities to consider in evaluating the need for a
valuation allowance. However, ASC 740 does not define “cumulative losses in
recent years.” In deliberating whether to define the term, the FASB discussed
the possibility of imposing conditions that would require such losses to be (1)
cumulative losses for tax purposes that were incurred in tax jurisdictions that
were significant to an entity for a specified number of years, (2) cumulative
losses for tax purposes that were incurred in all tax jurisdictions in which an
entity operated during a specified number of years, (3) cumulative pretax
accounting losses incurred in the reporting entity’s major markets or its major
tax jurisdictions for a specified number of years, and (4) cumulative
consolidated pretax accounting losses for a specified number of years. However,
the FASB ultimately decided not to define the term.
Because there is no authoritative definition of this term,
management must use judgment in determining whether an entity has negative
evidence in the form of cumulative losses. In making that determination,
management should generally consider the relevant tax-paying component’s1 results before tax from all sources (e.g., amounts recognized in
discontinued operations and OCI) for the current year and previous two years,
adjusted for recurring permanent differences. (e.g., meals and entertainment,
and tax-exempt interest). Use of a “three-year” convention arose, in part, as a
result of proposed guidance in the exposure draft on FASB Statement 109. This
guidance was omitted in the final standard (codified in ASC 740) because the
FASB decided that a bright-line definition of the term “cumulative losses in
recent years” might be problematic. Paragraph 103 of Statement 109’s Basis for
Conclusions states that the “Board believes that the more likely than not
criterion required by [ASC 740] is capable of appropriately dealing with all
forms of negative evidence, including cumulative losses in recent years.” The
paragraph further indicates that the more-likely-than-not criterion “requires
positive evidence of sufficient quality and quantity to counteract negative
evidence in order to support a conclusion that . . . a valuation allowance is
not needed.” A three-year period, however, generally supports the
more-likely-than-not recognition threshold because it typically covers several
operating cycles of the entity, and one-time events in a given cycle do not
overly skew the entity’s analysis.
In very rare circumstances, it may be acceptable for entities that have business
cycles longer or shorter than three years to use a period longer or shorter than
three years to determine whether they have a cumulative loss. To support this
determination, an entity must demonstrate that it operates in a cyclical
industry and that a period other than three years is more appropriate. For
example, a four-year period or a two-year period may be acceptable if the entity
can demonstrate that it operates in a cyclical business and the business cycles
correspond to those respective periods. If a period other than three years is
used, the entity should consult with its income tax accounting advisers and
apply the period it selects consistently (i.e., in each reporting period).
Even though there is no bright-line three-year cumulative loss test, the SEC has
consistently questioned registrants that had a three-year cumulative loss about
why there was not a valuation allowance and asked for documentation to support
such a determination.
When determining whether cumulative losses in recent years
exist, an entity should generally not exclude nonrecurring items from its
results. It may, however, be appropriate for the entity to exclude nonrecurring
items when projecting future income in connection with its determination of the
amount of the valuation allowance needed. See Section 5.3.2.2.2 for further discussion
of the development of objectively verifiable future income estimates.
Cumulative losses are one of the most objectively verifiable forms of negative
evidence. Thus, an entity that has suffered cumulative losses in recent years
may find it difficult to support an assertion that a DTA could be realized if
such an assertion is based on subjective forecasts of future profitable results
rather than an actual return to profitability.
The examples below illustrate different types of negative evidence that an entity
should consider in determining whether a valuation allowance is required.
Example 5-1
Cumulative Losses in
Recent Years
- An entity has incurred operating losses for financial reporting and tax purposes over the past two years. The losses for financial reporting purposes exceed operating income for financial reporting purposes, as measured cumulatively for the current year and two preceding years.
- A currently profitable entity has a majority ownership interest in a newly formed subsidiary that has incurred operating and tax losses since its inception. The subsidiary is consolidated for financial reporting purposes. The tax jurisdiction in which the subsidiary operates prohibits it from filing a consolidated tax return with its parent. This would be negative evidence for the DTA of the subsidiary in that jurisdiction.
Example 5-2
A History of
Operating Loss or Tax Credit Carryforwards Expiring
Unused
- An entity has generated tax credit carryforwards during the current year. During the past several years, tax credits, which originated in prior years, expired unused. There are no available tax-planning strategies that would enable the entity to use the tax benefit of the carryforwards.
- An entity operates in a cyclical industry. During the last business cycle, it incurred significant operating loss carryforwards, only a portion of which were used to offset taxable income generated during the carryforward period, while the remainder expired unused. The entity has generated a loss carryforward during the current year.
Example 5-3
Losses Expected in
Early Future Years
- An entity that is currently profitable has a significant investment in a plant that produces its only product. The entity’s chief competitor has announced a technological breakthrough that has made the product obsolete. As a result, the entity is anticipating losses over the next three to five years, during which time it expects to invest in production facilities that will manufacture a completely new, but as yet unidentified, product.
- An entity operates in an industry that is cyclical in nature. The entity has historically generated income during the favorable periods of the cycle and has incurred losses during the unfavorable periods. During the last favorable period, the entity lost market share. Management is predicting a downturn for the industry during the next two to three years.
Example 5-4
Unsettled
Circumstances That if Unfavorably Resolved Would
Adversely Affect Profit Levels on a Continuing Basis
in Future Years
- During the past several years, an entity has manufactured and sold devices to the general public. The entity has discovered, through its own product testing, that the devices may malfunction under certain conditions. No malfunctions have been reported. However, if malfunctions do occur, the entity will face significant legal liability.
- In prior years, the entity manufactured certain products that required the use of industrial chemicals. The entity contracted with a third party, Company X, to dispose of the by-products. Company X is now out of business, and the entity has learned that the by-products were not disposed of in accordance with environmental regulations. A governmental agency may propose that the entity pay for clean-up costs.
Example 5-5
A Carryback or
Carryforward Period That Is So Brief That It Would
Limit Realization of Tax Benefits if (1) a
Significant Deductible Temporary Difference Is
Expected in a Single Year or (2) the Entity Operates
in a Traditionally Cyclical Business
An entity operates in a state
jurisdiction with a one-year operating loss carryforward
period. During the current year, it implemented a
restructuring program and recorded estimated closing
costs in its financial statements that will become
deductible for tax purposes next year. The deductible
amounts exceed the taxable income expected to be
generated during the next two years.
5.2.2.2 Positive Evidence Considered in the Determination of Whether a Valuation Allowance Is Required
When an entity has negative evidence, such as a cumulative loss
position, it should also evaluate what positive evidence exists. ASC
740-10-30-22 gives the following examples of positive evidence that, when
present, may overcome negative evidence in the assessment of whether a valuation
allowance is needed to reduce a DTA to an amount more likely than not to be
realized:
- Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures
- An excess of appreciated asset value over the tax basis of the entity’s net assets in an amount sufficient to realize the deferred tax asset
- A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for example, an unusual or infrequent item) is an aberration rather than a continuing condition.
The example below illustrates situations in which entities have
positive evidence that may indicate that a valuation allowance would not be
necessary.
Example 5-6
Scenarios Based on
ASC 740-10-30-22(a)
For example:
-
An entity enters into a noncancelable long-term contract that requires the customer to purchase minimum quantities and that therefore will generate sufficient future taxable income to enable use of all existing operating loss carryforwards.
-
During the current year, an entity merges with Company L, which operates in a different industry that is characterized by stable profit margins. The tax law does not restrict use of preacquisition NOL carryforwards. Company L’s existing contracts will produce sufficient taxable income to enable use of the loss carryforwards.
Scenario Based on
ASC 740-10-30-22(b)
An entity has invested in land that has
appreciated in value, and the land is not integral to
the entity’s business operations. If the land were sold
at its current market value, the sale would generate
sufficient taxable income for the entity to use all tax
loss carryforwards. The entity would sell the land and
realize the gain if the operating loss carryforward
would otherwise expire unused. After considering its
tax-planning strategy, the entity determines that the
fair value of the entity’s remaining net assets exceeds
its tax and financial reporting basis.
Scenario Based on
ASC 740-10-30-22(c)
An entity incurs operating losses that
result in a carryforward for tax purposes. The losses
resulted from the disposal of a subsidiary whose
operations are not critical to the continuing entity,
and the company’s historical earnings, exclusive of the
subsidiary losses, have been strong.
Examples 5-7 through
5-102 illustrate additional situations in which entities that have had negative
evidence might conclude that no valuation allowance is required (or that only a
small valuation allowance is necessary) as a result of available positive
evidence.
Example 5-7
An entity experienced operating losses
from continuing operations for the current year and two
preceding years and is expected to return to
profitability in the next year. Positive evidence
included (1) completed plant closings and cost
restructuring that permanently reduced fixed costs
without affecting revenues and that, if implemented
earlier, would have resulted in profitability in prior
periods and (2) a long history during which no tax loss
carryforwards expired unused.
Example 5-8
An entity with a limited history
incurred cumulative operating losses since inception.
The losses were attributable to the company’s highly
leveraged capital structure, which included indebtedness
with a relatively high interest rate. Positive evidence
included a strict implementation of cost containment
measures, an increasing revenue base, and a successful
infusion of funds from the issuance of equity
securities, which were used, in part, to reduce
high-cost debt capital.
Example 5-9
An entity incurred cumulative losses in
recent years; the losses were directly attributable to a
business segment that met the criteria in ASC 205-20 for
classification as a discontinued operation for financial
reporting purposes. Positive evidence included a history
of profitable operations outside the discontinued
segment.
Example 5-10
An entity suffered significant losses in
its residential real estate loan business. The entity
has recently discontinued the issuance of new
residential real estate loans, has disposed of all
previously held residential real estate loans, and has
no intention of purchasing real estate loans in the
future. Positive evidence included a history of
profitable operations in the entity’s primary business,
commercial real estate lending.
Footnotes
5.3 Sources of Taxable Income
To assess whether DTAs meet the more-likely-than-not threshold for
realization, an entity needs to consider its sources of future taxable income. Taxable
income of the appropriate character (e.g., capital or ordinary), within the appropriate
time frame, is necessary for the future realization of DTAs.
When determining whether a valuation allowance is needed, an entity must
(1) evaluate each of the four sources of taxable income discussed below in accordance
with how objectively verifiable it is and (2) consider that each may represent positive
evidence that future taxable income will be generated. In addition, the entity may also
have to consider negative evidence in its analysis.
As noted in Section 5.2, ASC
740-10-30-18 lists four sources of taxable income that may enable realization of a DTA,
stating, in part:
The following four possible sources of taxable
income may be available under the tax law to realize a tax benefit for deductible
temporary differences and carryforwards:
- Future reversals of existing taxable temporary differences
- Future taxable income exclusive of reversing temporary differences and carryforwards
- Taxable income in prior carryback year(s) if carryback is permitted under the tax law
- Tax-planning strategies (see paragraph 740-10-30-19) that
would, if necessary, be implemented to, for example:
- Accelerate taxable amounts to utilize expiring carryforwards
- Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss
- Switch from tax-exempt to taxable investments.
The possible sources listed in ASC 740-10-30-18(a) and (c) above can
often be objectively verified. Because the sources listed in ASC 740-10-30-18(b) and (d)
are based on future events, their determination is more subjective. An entity should
first consider the objectively verifiable sources. If, within the appropriate time
frame, those sources will generate sufficient taxable income of the right character
(e.g., capital or ordinary), an entity may not need to assess the likelihood of other
future taxable income.
The implementation guidance in ASC 740-10-55-16 and 55-17 illustrates
that the timing of the deductions and other benefits associated with a DTA must coincide
with the timing of the taxable income. An entity may devise a qualifying tax-planning
strategy (the source listed in ASC 740-10-30-18(d) above) to change the timing or
character of the future taxable income. Such a strategy should be given more weight (see
ASC 740-10-30-23) than a forecast of future taxable income from future events (the
source listed in ASC 740-10-30-18(b) above) since it constitutes more objectively
verifiable evidence of realizability. To help illustrate how to weigh the four sources
of future taxable income, we will discuss each source in more detail below.
5.3.1 Future Reversals of Existing Taxable Temporary Differences
When evaluating whether an existing taxable temporary difference is
a source of future taxable income under ASC 740-10-30-18(a), an entity must have a
general understanding of the reversal patterns of temporary differences because such
an understanding is relevant to the measurement of DTAs in the entity’s assessment
of the need for a valuation allowance under ASC 740-10-30-18. The example below
illustrates the future reversals of existing taxable temporary differences as a
source of taxable income.
Example 5-11
Existing Taxable Temporary Differences That Will Reverse
in the Future
Generally, the existence of sufficient
taxable temporary differences will enable use of the tax
benefit of operating loss carryforwards, tax credit
carryforwards, and deductible temporary differences,
irrespective of future expected income or losses from other
sources identified in ASC 740-10-30-18. For example, if an
entity has $300,000 of taxable temporary differences that
are expected to reverse over the next 10 years (which
represents objectively verifiable positive evidence) and
deductible temporary differences of $25,000 that are
expected to reverse within the next several years,
realization of the DTA is more likely than not and no
valuation allowance would be necessary even if future losses
are expected or a cumulative loss exists as of the
measurement date (the latter of which would represent
objectively verifiable negative evidence; see the discussion
in Section 5.3.2.1). Because the reversing
future taxable temporary differences are objectively
verifiable positive evidence, they may be used to outweigh
the objectively verifiable negative evidence of cumulative
losses.
Another simple example is the temporary
difference that is often created by the accrual of warranty
reserves. In most tax jurisdictions, tax deductions for
accrued warranty costs are not permitted until the
obligation is settled. The temporary differences
attributable to warranty accruals for financial reporting
purposes should be scheduled to reverse during the years in
which the tax deductions are expected to be claimed.
5.3.1.1 Determining the Pattern of Reversals of Existing Taxable Temporary Differences
Although ASC 740-10-55-22 states, in part, that the “methods
used for determining reversal patterns should be systematic and logical,” ASC
740 does not specify in detail how the reversal patterns for each class of
temporary differences should be treated and indicates that in many situations
there might be more than one logical approach. The amount of scheduling of
reversal patterns that might be necessary, if any, will therefore depend on the
specific facts and circumstances. The implementation guidance in ASC
740-10-55-12 and 55-13 suggests that two concepts are important to determining
the reversal patterns for existing temporary differences:
- The “tax law determines whether future reversals of temporary differences will result in taxable and deductible amounts that offset each other in future years.”
- The “particular years in which temporary differences result in taxable or deductible amounts generally are determined by the timing of the recovery of the related asset or settlement of the related liability.”
Further, ASC 740-10-55-22 states that “[m]inimizing complexity is an appropriate
consideration in selecting a method for determining reversal patterns” and that
an entity should use the same method of reversal when measuring the deferred tax
consequences for a “particular category of temporary differences for a
particular tax jurisdiction.” For example, if the loan amortization method and
the present value method are both systematic and logical reversal patterns for
temporary differences that originate as a result of assets and liabilities that
are measured at present value, an entity engaged in leasing activities should
consistently use either of those methods for all its temporary differences
related to leases that are recorded as lessor receivables, because those
temporary differences are related to a particular category of items. If that
same entity also has temporary differences resulting from loans receivable, a
different method of reversal might be used because those differences are related
to another category of temporary differences.
ASC 740-10-55-22 also states, in part:
If
the same temporary difference exists in two tax jurisdictions (for example,
U.S. federal and a state tax jurisdiction), the same method should be used
for that temporary difference in both tax jurisdictions. The same method for
a particular category in a particular tax jurisdiction should be used
consistently from year to year.
An entity should report any change in the method of reversal as a change in
accounting principle in accordance with ASC 250.
See Section 5.8 for additional examples of existing temporary
differences and some common methods for determining the pattern of their
reversal.
5.3.1.2 Realization of a DTA Related to an Investment in a Subsidiary: Deferred Income Tax Exceptions Not a Source of Income
The future reversal of an existing taxable temporary difference
for which a DTL has not been recognized under the indefinite reversal criteria
of ASC 740-30-25-17 should not be considered a source of taxable income in
accordance with the source listed in ASC 740-10-30-18(a) discussed above. ASC
740-30-25-13 indicates that an entity should not consider future
distributions of future earnings of a subsidiary or corporate joint
venture in assessing the need for a valuation allowance unless a DTL has been
recognized for existing undistributed earnings or earnings have been
remitted in the past. Similarly, an entity should not consider future
reversals of existing taxable temporary differences as a source of
taxable income unless a DTL has been recognized on the related taxable temporary
difference (i.e., an unrecognized DTL is not a source of future taxable income).
The example below illustrates this concept.
Example 5-12
An Unrecognized DTL Is Not a Source of Future Taxable
Income
Assume that before the enactment of the
2017 Act, Entity X, a U.S. domestic parent entity, has a
wholly owned foreign subsidiary, FS1. The amounts for
financial reporting and the tax basis of X’s investment
in FS1 are $2,000 and $1,000, respectively, on December
31, 20X1 (i.e., X has a taxable outside basis difference
related to its investment in FS1). Further assume that X
has an NOL DTA of $1,000, with a 20-year carryforward
period.3
Entity X has not recorded a DTL related to its investment
in FS1 because X asserts that the indefinite
reinvestment criteria have been met for the $1,000
taxable temporary difference, which is attributable to
undistributed earnings. In addition, FS1 has not
previously remitted earnings.
Ordinarily, before the enactment of the
2017 Act, an existing taxable temporary difference
(e.g., from the undistributed earnings of FS1) would
have been a potential source of taxable income for
consideration in the assessment of the need for a
valuation allowance. However, X has not previously
accrued a DTL on the earnings of FS1, and FS1 has not
remitted earnings in the past; therefore, X cannot
consider the reversal of the outside basis taxable
temporary difference associated with its investment in
FS1 as a source of taxable income when determining
whether it is more likely than not that the NOL DTA is
realizable.
5.3.1.3 Using the Reversal of a DTL for an Indefinite-Lived Asset as a Source of Taxable Income After Enactment of the 2017 Act
Enactment of the 2017 Act modified aspects of U.S. federal tax
law regarding NOL carryforwards. Under previous U.S. federal tax law, NOLs
generally had a carryback period of two years and a carryforward period of
twenty years. For NOLs incurred in years subject to the new federal tax rules,
the 2017 Act eliminates, with certain exceptions, the NOL carryback period and
permits an indefinite carryforward period, with some limitations as discussed
below. However, the provision to eliminate the NOL carryback period was
temporarily repealed with the enactment of the CARES Act, which reinstated a
five-year carryback period for certain taxable years (see Section 5.3.3 for further
information about the carryback period).
As discussed in Section 5.3, one of the four sources of
future taxable income is a reversal of an existing taxable temporary difference.
After implementation of the 2017 Act, a taxable temporary difference associated
with an indefinite-lived asset is generally considered to be a source of taxable
income that justifies the realization of either NOLs with an unlimited
carryforward period or disallowed interest carryforwards with unlimited
carryforward periods. This would also generally be true for a deductible
temporary difference that is scheduled to reverse into an NOL with an unlimited
carryforward period. However, because the 2017 Act includes restrictions on the
ability to use NOLs and disallowed interest carryforwards with unlimited
carryforward periods (i.e., NOLs arising in years subject to the new rules are
limited in use to 80 percent of taxable income and the amount of net business
interest an entity can deduct is limited to 30 percent of modified taxable
income), no more than 80 percent or 30 percent of the indefinite-lived taxable
temporary difference would serve as a source of taxable income with respect to
the NOL or disallowed interest carryforward, respectively.4
However, an entity may sometimes have both NOLs with an
unlimited carryforward period and disallowed interest carryforwards with an
unlimited carryforward period, meaning that portions of the indefinite-lived
taxable temporary difference might serve as a source of taxable income for both
because of the limitations provided in the 2017 Act. For example, because the
annual interest limitation is calculated before NOLs are taken into account, the
taxable temporary difference associated with an indefinite-lived asset would
first be a source of taxable income for the disallowed interest carryforward
(limited to 30 percent of the taxable temporary difference, as discussed above),
but then any remaining taxable temporary difference on the indefinite lived
asset might also be a source of taxable income for NOLs with an unlimited
carryforward period (limited to 80 percent of the remaining taxable temporary
difference, as discussed above).
For existing U.S. federal jurisdiction NOLs created before the
effective date of the 2017 Act and in jurisdictions that have finite-lived NOLs,
the reversal of a DTL related to an indefinite-lived asset generally cannot be
used as a source of taxable income to support the realization of such
finite-lived DTAs. This is because a taxable temporary difference related to an
indefinite-lived asset (e.g., land, indefinite-lived intangible assets, and
tax-deductible “component 1” goodwill) will reverse only when the
indefinite-lived asset is sold. If a sale of an indefinite-lived asset is not
expected in the foreseeable future, the reversal of the related DTL generally
cannot be scheduled, so an entity generally cannot consider the reversal a
source of future taxable income when assessing the realizability of DTAs, other
than for indefinite-lived DTAs. However, there are circumstances such as the
following in which it may be appropriate to consider a DTL related to an
indefinite-lived asset as a source of taxable income for a finite-lived NOL:
- If the sale of an indefinite-lived asset is expected in the foreseeable future (e.g., the asset is classified as held for sale) and the related DTL can therefore be scheduled to reverse.
- If it is anticipated that the indefinite-lived asset will be reclassified as finite-lived. For example, an R&D asset acquired in a business combination that is initially classified as indefinite-lived will be reclassified as finite-lived once the project is completed or abandoned.
5.3.1.4 Deemed Repatriation Transition Tax as a Source of Future Taxable Income
Under certain circumstances, an entity would record a liability
for the transition tax in the financial statements for the year that included
the enactment date but would not include the deemed repatriation and
corresponding tax in that year’s tax return. We believe that it would be
appropriate in these circumstances for the entity to consider the corresponding
one-time deemed repatriation income inclusion to be a source of taxable income
when analyzing the realization of DTAs recorded in the financial statements in
the period in which the transition tax liability is recorded. The entity should
verify that the one-time deemed repatriation income inclusion coincides with the
timing of the deductions and other benefits associated with the DTAs.
However, if the entity elects to defer payment of the transition tax liability
over a period of up to eight years, the transition tax liability itself does not
represent a source of taxable income in future periods when analyzing the
realization of DTAs that remain after the deemed repatriation has been included
in the entity’s income tax return. This is because settlement of the transition
tax liability in a future year or years will not result in taxable income.
See Chapter 3 for a discussion of outside
basis differences and the deemed repatriation transition tax.
5.3.2 Future Taxable Income
Management projections are inherently subjective.5 Therefore, future taxable income under ASC 740-10-30-18(b) is generally
considered to be subjectively determined as opposed to objectively determined.
An entity will consider a number of factors in preparing subjective projections of
future taxable income, including the following:
- The reasonableness of management’s business plan and its impact on future taxable income, including management’s history of carrying out its stated plans and its ability to carry out its plans (given contractual commitments, available financing, or debt covenants).
- The reasonableness of financial projections based on historical operating results.
- The consistency of assumptions in relation to prior periods and projections used in other financial statement estimates (e.g., goodwill impairment analysis).
- Consistency with relevant industry data, including short- and long-term trends in the industry.
- The reasonableness of financial projections when current economic conditions are considered.
See Section
5.4 for further considerations related to future events.
5.3.2.1 Future Taxable Income When an Entity has Cumulative Losses
An entity that has cumulative losses is generally prohibited
from using an estimate of subjectively determined future earnings to support a
conclusion that realization of an existing DTA is more likely than not if such a
forecast is not based on objectively verifiable information. An objectively
verifiable estimate of future income is based on operating results from the
reporting entity’s recent history.
5.3.2.2 Effect of Nonrecurring Items on Estimates of Future Income and Development of Objectively Verifiable Future Income Estimates
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 when determining
the amount of the valuation allowance needed to reduce the DTA to an amount that
is more likely than not to be realized. Management’s projections of future
income are inherently not objectively verifiable, and therefore, such
projections alone would not be enough to outweigh objectively verifiable
negative evidence such as cumulative losses. However, to the extent that
management’s future income projections are adjusted to be based solely on objectively verifiable evidence (e.g., when
an estimate is based on operating results from the entity’s recent history, no
subjective assumptions have been made, and there is no contrary evidence
suggesting that future taxable income would be less than historical results),
entities may give more weight to the positive evidence from such estimates.
That is, such estimates should be based on objectively verifiable evidence (e.g.,
an estimate of future income that does not include reversals of taxable
temporary differences and carryforwards and that is based on operating results
from the entity’s recent history without subjective assumptions). An entity with
objective negative evidence may look to its recent operating history to
determine how much, if any, income exclusive of temporary differences is
expected in future years. The entity typically begins this determination by
analyzing income or loss for financial reporting purposes during its current
year and two preceding years and adjusts for certain items as discussed
below.
When preparing an objectively verifiable estimate of future income or loss by
using historical income or loss for financial reporting purposes in recent
years, an entity should generally not consider the effects of discontinued
operations and nonrecurring items. Generally, these items are not relevant to or
indicative of an entity’s ability to generate taxable income in future years.
Examples of nonrecurring items that an entity usually excludes from its
historical results when preparing such estimates of future income include:
- One-time restructuring charges that permanently remove fixed costs from future cash flows.
- Large litigation settlements or awards that are not expected to recur in future years.
- Historical interest expense on debt that has been restructured or refinanced.
- Historical fixed costs that have been reduced or eliminated.
- Large permanent differences that are included in pretax accounting income or loss but are not a component of taxable income.
- One-time severance payments related to management changes.
When adjusting historical income or loss for financial reporting
purposes to develop an estimate of future income or loss that is generally
considered to be objectively verifiable evidence, an entity may also need to
consider items occurring after the balance sheet date but before the issuance of
the financial statements. For example, a debt refinancing that is in process as
of the balance sheet date and consummated before the date of issuance of the
financial statements may constitute additional objectively verifiable evidence
when an entity is projecting future taxable income, since the entity’s normal
projections (which would have been used in the absence of the existence of
negative evidence in the form of cumulative losses) would routinely have
included this as a forecasted item. An entity must use judgment and carefully
consider the facts and circumstances in such situations.
Notwithstanding the above, the following items should generally not be considered nonrecurring:
- Unusual loss allowances (e.g., large loan loss or bad-debt loss provisions).
- Poor operating results caused by an economic downturn, government intervention, or changes in regulation.
- Operating losses attributable to a change in the focus or directives of a subsidiary or business unit.
- Onerous effects on historical operations attributable to prior management decisions when a new management team is engaged (excluding any direct employment cost reductions associated with the replacement of the old management team).
See Section 5.7.12 for considerations
related to the impact of interest limitations on the estimate of future taxable
income. Once the objectively verifiable estimate of future income has been
developed, this estimate may be used to support the realizability of DTAs.
Entities often use an average of the current and two prior years of adjusted
historical results as a basis from which to develop an objectively verifiable
estimate of annual taxable income for future periods.
The example below illustrates how an entity might develop an
estimate of future taxable income (excluding reversals of temporary differences
and carryforwards) that is based on objectively verifiable historical results
when objectively verifiable negative evidence in the form of cumulative losses
exists.
Example 5-13
Estimation of Future Taxable Income When Negative
Evidence in the Form of Cumulative Losses
Exists
Assume the following:
- Entity X, a calendar-year entity, operates in a single tax jurisdiction in which the tax rate is 25 percent.
- Tax losses and tax credits can be carried forward for a period of four years after the year of origination. However, carryback of losses or credits to recover taxes paid in prior years is not permitted.
- As of December 31, 20X3, X has a tax loss carryforward of $1,000 and a tax credit carryforward of $600, both of which expire on December 31, 20X7. Thus, to realize its DTA of $850, or ($1,000 × 25%) + $600, at the end of 20X3, X must generate $3,400 ($850 ÷ 25%) of future taxable amounts through 20X7 — the tax loss and tax credit carryforward period.
- There are (1) no tax-planning strategies available to generate additional taxable income and (2) no taxable temporary differences as of December 31, 20X3.
- Entity X has determined that a three-year period is the appropriate period for which it will assess whether negative evidence in the form of cumulative losses in recent years exists.
- Historical pretax income (loss) is $100, ($500), and ($1,000) for 20X3, 20X2, and 20X1, respectively.
- The following table shows historical income (loss) adjusted for nonrecurring items during the three-year period ending on December 31, 20X3, which X considers when estimating future income that does not include reversals of temporary differences and carryforwards:
Because X has positive average annual adjusted pretax
income (i.e., historical earnings when adjusted for
nonrecurring items), it may consider its average annual
adjusted pretax income as a starting point for
objectively estimating future taxable income (excluding
reversals of temporary differences and carryforwards).
However, the estimation of future income is not simply a
“mechanical exercise” in which X would multiply its
average annual adjusted pretax income by the number of
years remaining in the loss or credit carryforward
period. Rather, X should consider adjusting its average
annual pretax income for certain additional positive and
negative evidence that is present in the historical
period to develop an estimate that is based on
objectively verifiable evidence, including, but not
limited to:
- Its recent trend in earnings (i.e., the fact that earnings for the most recent year [20X3] are less than those of the prior year [20X2] and the three-year average annual adjusted pretax income, which might suggest that the use of average annual adjusted pretax income is inappropriate).
- The length and magnitude of pretax losses compared with the length and magnitude of pretax income (e.g., X has a significant cumulative loss and has only recently returned to a minor amount of profitability).
- The causes of its annual losses (e.g., X reported a pretax loss in 20X1 even on an adjusted basis) and cumulative losses.
- Anticipated changes in the business.
The weight given to the positive evidence in the form of
X’s estimate of future taxable income should be
commensurate with the extent to which it is based on
objectively verifiable historical results. Entity X
would then determine whether a valuation allowance is
needed on the basis of all available evidence, both
positive and negative.
5.3.2.2.1 Time Frame for Projection of Future Taxable Income
An entity should consider as many years as it can to reliably estimate future
taxable income on the basis of its specific facts and circumstances.
Although subjectivity may increase as the number of years increases, it
would usually not be appropriate for an entity to limit the number of years
it uses to estimate future taxable income, whether such estimates represent
management’s inherently subjective projections of future income or
objectively verifiable estimates of future income based on adjusted
historical results as determined by using the method discussed above. In
either case, limiting the period over which future taxable income is
estimated could inappropriately result in a smoothing of the income
statement impact of changes in a valuation allowance. For example, it would
not be appropriate to continue to add a year to the estimate of future
taxable income as each year passes so that changes in a valuation allowance
occur annually. Rather, in these situations, it may be reasonable to project
additional years of taxable income on the basis of historical operating
results by using the method discussed above. In some circumstances, however,
there may be a limited number of years over which future taxable income can
be estimated because significant changes are expected in the business (e.g.,
probable future withdrawal from the jurisdiction); in such circumstances,
the time frame used would be limited and should not change until a change in
facts and circumstances warrants an adjustment.
5.3.2.2.2 Effect of Excess Tax Deductions for Equity-Classified Share-Based Payment Awards on the Assessment of Future Taxable Income
Special consideration may be warranted when an entity has equity-classified
share-based payment awards. In forecasting future taxable income, an entity
should base its estimate of future excess tax deductions on its outstanding
awards and the stock price as of the balance sheet date. The assumptions the
entity uses in the valuation allowance assessment should be consistent with
those it uses in its disclosures under ASC 718-10-50-2(e) about its
share-based payment arrangements, including the number of shares, the
requisite service period, the maximum contractual term of the awards, the
number and weighted-average exercise price and grant-date fair values of the
award, the total intrinsic value of the awards, the expense recognized, and
information about modifications of the awards.
An entity should generally not anticipate that excess
share-based tax deductions will continue in perpetuity (i.e., such
deductions should not be considered recurring permanent differences). An
excess tax benefit exists when the amount of the tax deduction is greater
than the compensation cost recognized for financial reporting purposes
(exercise fair value is greater than the grant date fair value). Generally,
we do not believe that it would be appropriate for an entity to forecast
future increases or decreases in stock prices when estimating future taxable
income because those changes cannot be reliably estimated. See Chapter 10 for
additional guidance share-based payments.
5.3.2.3 Use of Attributes That Result in Replacement or “Substitution” of DTAs
ASC 740-10
55-37 An operating loss or
tax credit carryforward from a prior year (for which the
deferred tax asset was offset by a valuation allowance)
may sometimes reduce taxable income and taxes payable
that are attributable to certain revenues or gains that
the tax law requires be included in taxable income for
the year that cash is received. For financial reporting,
however, there may have been no revenue or gain and a
liability is recognized for the cash received. Future
sacrifices to settle the liability will result in
deductible amounts in future years. Under those
circumstances, the reduction in taxable income and taxes
payable from utilization of the operating loss or tax
credit carryforward gives no cause for recognition of a
tax benefit because, in effect, the operating loss or
tax credit carryforward has been replaced by temporary
differences that will result in deductible amounts when
a nontax liability is settled in future years. The
requirements for recognition of a tax benefit for
deductible temporary differences and for operating loss
carryforwards are the same, and the manner of reporting
the eventual tax benefit recognized (that is, in income
or as required by paragraph 740-20-45-3) is not affected
by the intervening transaction reported for tax
purposes. Example 20 (see paragraph 740-10-55-156)
illustrates recognition of the tax benefit of an
operating loss in the loss year and in subsequent
carryforward years when a valuation allowance is
necessary in the loss year.
ASC 740-10-55-37 describes a situation in which an NOL carryforward from a prior
year may be used to reduce taxable income (and taxes payable) on an entity’s
income tax return. In this scenario, the attribute is used to offset a gain in
the current year that must, in accordance with tax law, be included in taxable
income for the year in which cash is received. However, in doing so, the NOL
carryforward DTA may be replaced by another DTA because a liability is
recognized for financial reporting purposes under U.S. GAAP, and future
sacrifices to settle the liability will result in deductible amounts in future
years.
In situations such as these, in which a DTA for an attribute is replaced by a DTA
for a future deduction, the use of the attribute against the entity’s taxable
income (and, thus, the reduction in its income tax payable) generally would not
constitute realization of a tax benefit unless the entity has other sources of
future taxable income that the “replacement” or “substitute” DTA can be used to
offset. For example, this would be the case if the NOL carryforward was set to
expire and the “refresh” of the attribute (i.e., the use of the attribute and
substitution with a future deduction) allowed the company to access sources of
future taxable income that are more likely than not to arise in a period beyond
the end of the existing carryforward period for the attribute. In other words,
unless the future deduction that replaced the attribute can also be realized,
the use of the attribute does not constitute realization. If, on the other hand,
an economic benefit will result from the use of the attribute, realization has
occurred.
We believe that while ASC 740-10-55-37 does not specifically address such cases,
an entity would apply this principle to assess realization in situations in
which (1) the attribute already has a valuation allowance recorded against it
but will be used in a future year or (2) the entity is evaluating planning
strategies that it could execute in a subsequent year.
The example below from ASC 740-10-55-156 through 55-158 illustrates the guidance
in ASC 740-10-55-37 on the interaction of NOL carryforwards and temporary
differences.
ASC 740-10
Example 20: Interaction of Loss Carryforwards and
Temporary Differences
55-156 This Example
illustrates the guidance in paragraph 740-10-55-37 for
the interaction of loss carryforwards and temporary
differences that will result in net deductible amounts
in future years. This Example has the following
assumptions:
- The financial loss and the loss reported on the tax return for an entity’s first year of operations are the same.
- In Year 2, a gain of $2,500 from a transaction that is a sale for tax purposes but does not meet the sale recognition criteria for financial reporting purposes is the only difference between pretax financial income and taxable income.
55-157 Financial and taxable
income in this Example are as follows.
55-158 The $4,000 operating
loss carryforward at the end of Year 1 is reduced to
$1,500 at the end of Year 2 because $2,500 of it is used
to reduce taxable income. The $2,500 reduction in the
loss carryforward becomes $2,500 of deductible temporary
differences that will reverse and result in future tax
deductions when the sale occurs (that is, control of the
asset transfers to the buyer-lessor). The entity has no
deferred tax liability to be offset by those future tax
deductions, the future tax deductions cannot be realized
by loss carryback because no taxes have been paid, and
the entity has had pretax losses for financial reporting
since inception. Unless positive evidence exists that is
sufficient to overcome the negative evidence associated
with those losses, a valuation allowance is recognized
at the end of Year 2 for the full amount of the deferred
tax asset related to the $2,500 of deductible temporary
differences and the remaining $1,500 of operating loss
carryforward.
As illustrated above, in the absence of positive evidence (e.g., projections of
future taxable income), there will ultimately be no realization resulting from
use of the operating loss carryforward.
5.3.3 Taxable Income in Prior Carryback Year(s) if Carryback Is Permitted Under the Tax Law
The ability to recover taxes paid in the carryback period under ASC
740-10-30-18(c) is considered to be an objectively verifiable form of positive
evidence that can overcome negative evidence such as the following: (1) cumulative
losses; (2) a history of operating losses expiring unused; (3) losses expected in
early future years; (4) unsettled circumstances that, if unfavorably resolved, would
adversely affect future operations; and (5) a brief carryforward period, discussed
earlier.
Some tax laws (e.g., those in certain U.S. state, local, or foreign tax
jurisdictions) permit taxpayers to carry back operating loss or tax credits to
obtain refunds of taxes paid in prior years. The extent to which the carryback
benefit is possible depends on the length of the carryback period and the amounts
and character of taxable income generated during that period.
While the enactment of the 2017 Act eliminated the ability to carry
back NOLs originating in years after December 31, 2017, the CARES Act repealed this
provision for certain taxable years. Under the CARES Act, NOLs that arise in taxable
years beginning after December 31, 2017, and before January 1, 2021, are allowed to
be carried back to each of the five taxable years that precede the taxable year of
that loss. Entities that generated taxable income in previous years may now be able
to carry back current year losses to those periods and, as a result, will need to
evaluate how this change in tax law affects their realizability assessment of DTAs.
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.
The example below illustrates taxable income in prior carryback
year(s) in situations in which carryback is permitted under the tax law as a source
of taxable income listed in ASC 740-10-30-18(c).
Example 5-14
Refunds Available by Carryback of Losses to Offset Taxable
Income in Prior Years
Assume that an entity has a deductible temporary difference
of $1,000 at the end of 20X1 and that pretax income and
taxable income are zero. If at least $1,000 of taxable
income is available for carryback refund of taxes paid
during the year in which the temporary difference becomes
deductible, realization of the DTAs for the net deductible
amount is more likely than not even though tax losses are
expected in early future years.
5.3.4 Tax-Planning Strategies
As indicated in ASC 740-10-30-18(d), among the sources of future
income that may enable realization of a DTA are “[t]ax-planning strategies (see
paragraph 740-10-30-19) that would, if necessary, be implemented to, for example:
- Accelerate taxable amounts to utilize expiring carryforwards
- Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss
- Switch from tax-exempt to taxable investments” (emphasis added).
Because future taxable income from the source listed in ASC
740-10-30-18(d) may be based on future events, it may be more subjective than that
from the sources listed in ASC 740-10-30-18(a) and (c).
The ASC master glossary defines a tax-planning strategy as follows:
An action
(including elections for tax purposes) that meets certain criteria (see
paragraph 740-10-30-19) and that would be implemented to realize a tax benefit
for an operating loss or tax credit carryforward before it expires. Tax-planning
strategies are considered when assessing the need for and amount of a valuation
allowance for deferred tax assets.
A qualifying tax-planning strategy must meet the criteria in ASC 740-10-30-19. That
is, the tax-planning strategy should be (1) “prudent and feasible”; (2) one that an
entity “ordinarily might not take, but would take to prevent an operating loss or
tax credit carryforward from expiring unused”; and (3) one that “[w]ould result in
realization of [DTAs].” ASC 740-10-55-39 clarifies these three criteria:
- For the tax-planning strategy to be prudent and feasible, “[m]anagement must have the ability to implement the strategy and expect to do so unless the need is eliminated in future years.” If the action is prudent but not feasible (or vice versa), it would not meet the definition of a tax-planning strategy. In determining whether an action constitutes a tax-planning strategy, an entity should consider all internal and external factors, including whether the action is economically prudent.
- Regarding criterion 2, strategies management would employ in the normal course of business are considered “implicit in management’s estimate of future taxable income and, therefore, are not tax-planning strategies.”
- Regarding whether the strategy would result in realization of DTAs (criterion 3 above), ASC 740-10-55-39(c) states, in part, that “[t]he effect of qualifying tax-planning strategies must be recognized in the determination of . . . a valuation allowance.” Further, the tax-planning strategy should result in the realization of a DTA, but only if it does not result in another DTA that would not be realized.
Management should have control over implementation of the tax-planning strategy. However, paragraph A107 of the Basis for Conclusions in FASB Statement 109 clarifies
that this control does not need to be unilateral. In determining whether a
tax-planning strategy is under management’s control, the entity should consider
whether, for example, the action is subject to approval by its board of directors
and whether approval is reasonably ensured.
Finally, to be considered a possible source of future taxable income, a tax-planning
strategy (and any associated taxable income generated from that strategy) must (1)
meet the more-likely-than-not recognition threshold and (2) be measured as the
largest amount of benefit that is more likely than not to be realized.
Because tax-planning strategies are a possible source of taxable income that an entity must consider when assessing the need for a valuation allowance, an entity must make a reasonable effort to identify qualifying tax-planning strategies. Question 27 of the FASB Staff Implementation Guide to Statement 109 addresses
whether management must “make an extensive effort to identify all tax-planning
strategies that meet the criteria for tax-planning strategies.” The answer, which
was codified in ASC 740-10-55-41, states, in part:
Because the effects of known
qualifying tax-planning strategies must be recognized . . . , management should
make a reasonable effort to identify those qualifying tax-planning strategies
that are significant. Management’s obligation to apply qualifying tax-planning
strategies in determining the amount of valuation allowance required is the same
as its obligation to apply the requirements of other Topics for financial
accounting and reporting. However, if there is sufficient evidence that taxable
income from one of the other sources of taxable income listed in paragraph
740-10-30-18 will be adequate to eliminate the need for any valuation allowance,
a search for tax-planning strategies is not necessary.
5.3.4.1 Examples of Qualifying Tax-Planning Strategies
The following are some possible examples (not all-inclusive) of qualifying
tax-planning strategies:
- Selling and subsequent leaseback of certain operating assets.
- Switching certain investments from tax-exempt to taxable securities.
- Filing a consolidated tax return versus separate stand-alone income tax returns.
- Disposing of obsolete inventory that is reported at net realizable value.
- Changing the method of accounting for inventory for tax purposes.
- Selling loans at an amount that is net of their allowance for doubtful accounts.
- Accelerating the funding of certain liabilities if that funding is deductible for tax purposes.
- Switching from deducting R&D costs to capitalizing and amortizing the costs for tax purposes.
- Electing to deduct foreign taxes paid or accrued rather than treating them as creditable foreign taxes.
- Accelerating the repatriation of foreign earnings for which deferred taxes were previously funded.
The examples below illustrate additional situations in which
entities use tax-planning strategies to provide evidence of future taxable
income to support the conclusion that no valuation allowance is required or that
a valuation allowance is necessary for only a portion of the entity’s DTAs.
Example 5-15
Acceleration of Taxable Amounts to Use
Carryforward
In 20X2, Entity A generates, for tax purposes, a $2,000
operating loss that cannot be used in the current tax
return. Tax law allows for a one-year carryforward.
However, after considering (1) future reversals of
existing taxable temporary differences, (2) future
taxable income exclusive of reversing taxable temporary
differences and carryforwards, and (3) taxable income in
the prior carryback years, A must record a valuation
allowance for the tax consequences of $1,000 of future
deductions that are not expected to be realized.
However, A has identified a tax-planning strategy that
involves selling at book value, and leasing back, plant
and equipment. This strategy would accelerate $600 of
taxable amounts (the excess depreciation in prior years)
that would otherwise reverse in years beyond the
carryforward period. For tax purposes, the sale would
accelerate the reversal of the taxable difference (the
excess-book-over-tax basis on the date of the
sale-leaseback) into taxable income in the year of the
sale. After considering the strategy, A must record a
valuation allowance at the end of 20X2 only for the $400
of the operating loss whose realization is not more
likely than not.
When A is considering the sale and
leaseback of assets as a tax-planning strategy, it
should be reasonable for A to conclude that the fair
value of the assets approximates the book value at the
time of the sale. If the assets have appreciated, the
sale and leaseback would create taxable income
(typically considered a capital gain). Conversely,
selling the assets at a loss would reduce the taxable
income that is created by the strategy. In addition, for
the sale and leaseback of assets to meet the criteria
for a qualifying tax-planning strategy, future taxable
income must otherwise be expected (because the sale and
leaseback of assets when the fair value approximates the
carrying value does not create additional taxable
income). Without future taxable income, the sale and
leaseback only postpones the expiration of the DTA.
Further, when measuring the valuation allowance
necessary (i.e., the impact of future lease payments on
taxable income), A must incorporate the future
implications of the tax-planning strategy into the
determination of the strategy’s effects (see Section
5.3.4.3 for more information about
measuring the tax benefits of tax-planning
strategies).
Example 5-16
Switch From Tax-Exempt to Taxable Investments
In 20X2, Entity B generates $2,000 of tax credits that
cannot be used in the current-year tax return. Tax law
permits a one-year credit carryforward to reduce income
taxes in 20X3. After considering (1) future reversals of
existing taxable temporary differences, (2) future
taxable income exclusive of taxable temporary
differences and carryforwards, and (3) taxable income in
the prior carryback years, B must record a valuation
allowance of $1,000.
However, B has identified a tax-planning strategy in
which its investment portfolio of tax-exempt securities
could, if sold and replaced with higher-yielding taxable
securities, generate sufficient taxable income during
20X3 to enable the use of $200 of the available tax
credit carryforward. Provided that the replacement of
tax-exempt securities is prudent and feasible, a
valuation allowance is recognized only for the $800 of
tax credit carryforwards whose realization is not more
likely than not. In assessing whether the tax-planning
strategy is prudent and feasible, B should determine
whether the replacement securities offer a better pretax
yield than the tax-exempt securities (i.e., if the yield
is identical, no benefit is derived from the change in
investment and the tax-planning strategy is therefore
not prudent).
5.3.4.2 Examples of Nonqualifying Tax-Planning Strategies
The following actions would generally not qualify as tax-planning strategies
because they would not meet one or more of the criteria in ASC 740-10-30-19 (as
discussed above):
-
Actions that are inconsistent with financial statement assertions. For example, to classify an investment in a debt security as HTM, an entity must positively assert that it has the ability and intent to hold the investment until maturity. It would be inconsistent with that assertion for the entity to simultaneously assert as a tax-planning strategy that it would sell securities classified as HTM to realize a DTA.However, the absence of a positive financial statement assertion does not necessarily preclude an action from qualifying as a tax-planning strategy. For example, an entity does not need to meet all the criteria for held-for-sale classification to assert as a tax-planning strategy that it would sell an appreciated asset to realize a DTA.
- Selling an entity’s principal line of business or selling certain operating assets (e.g., an indefinite-lived trade name) that are core to the business. Such an action would not be considered prudent.
- Selling advanced technology to a foreign government when such a sale is prohibited by statute. Such an action would not be considered feasible.
- Disposing of an unprofitable subsidiary, which is generally not considered an action that an entity “might not ordinarily take” and may not be feasible.
- Funding executive deferred compensation before the agreed-upon payment date. Such a strategy would generally not be considered prudent because, while it would result in reversal of a DTA, it would also result in an acceleration of income tax for the executive(s).
- Moving income from a nontax jurisdiction to a tax jurisdiction solely to realize operating loss carryforwards. This action would result in use of the asset in the jurisdiction receiving the income but not in an overall economic benefit since, irrespective of whether the entity took the action, it would not have incurred tax on the income.
In addition, changing a parent entity’s tax status generally would not qualify as
a tax-planning strategy because ASC 740-10-25-32 requires that the effect of a
change in tax status be recognized as of the date on which the change in tax
status occurs.
The example below illustrates a situation in which an entity
would not be able to use the proposed tax-planning strategy as positive evidence
to support the conclusion that no valuation allowance is necessary because the
tax-planning strategy does not align with positions taken elsewhere within the
financial statements.
Example 5-17
Tax-Planning Strategy That Is Inconsistent With
Financial Statement Assertions
Assume the following:
- An entity is measuring its DTAs and DTLs at the end of 20X2.
- Capital losses of $2 million were incurred in 20X2.
- Capital losses can be used only to offset capital gains; no capital gains occurred in 20X2.
- The capital gains tax rate is 50 percent.
-
The entity has an investment portfolio of debt securities that it has classified as HTM in accordance with ASC 320. The portfolio has the following attributes:
- An assumption inherent in the preparation of the financial statements is that an other-than-temporary impairment (OTTI) has not occurred in accordance with ASC 320-10-35-33A though 35-33C6 because (1) the entity does not have the intent to sell any of the securities in the portfolio, (2) it is not more likely than not that the entity will be required to sell any of the securities in the portfolio before recovery, and (3) the entity expects to recover the entire amortized cost basis of the securities in the portfolio.
- Management is considering a tax-planning strategy to sell the debt securities to generate an $800,000 taxable gain to reduce the valuation allowance that would otherwise be necessary. No cost would be incurred on the sale.
The strategy is inconsistent with the
assumptions inherent in the preparation of the financial
statements. If the entity assumed the sale of the debt
securities to recognize a tax benefit of $400,000
($800,000 × 50%), such a strategy would conflict with
ASC 320’s HTM classification. The strategy may also
conflict with the entity’s OTTI assumptions (i.e.,
intent to sell; see ASC 320-10-35-33A) and potentially
other financial statement assertions, such as the
entity’s use of Approach 1, described in Section 5.7.4.1, to
evaluate DTAs on its debt securities’ unrealized losses.
The tax-planning strategy described above would be
inconsistent with the assumption made in the application
of Approach 1, which requires the entity to assert its
intent and ability to hold the debt security until
recovery.
5.3.4.3 Recognition and Measurement of a Tax-Planning Strategy
ASC 740-10-30-20 states the following about recognition and measurement of a
tax-planning strategy:
When a tax-planning strategy is contemplated as a
source of future taxable income to support the realizability of a deferred
tax asset, the recognition and measurement requirements for tax positions in
paragraphs 740-10-25-6 through 25-7; 740-10-25-13; and 740-10-30-7 shall be
applied in determining the amount of available future taxable
income.
To be contemplated as a possible source of future taxable income, a tax-planning
strategy (and its associated taxable income) must (1) meet the
more-likely-than-not recognition threshold and (2) be measured as the largest
amount of benefit that is more likely than not to be realized.
Further, regarding measurement of the benefits of a tax-planning strategy, ASC
740-10-30-19 states, in part:
Significant expenses to implement a
tax-planning strategy or any significant losses that would be recognized if
that strategy were implemented (net of any recognizable tax benefits
associated with those expenses or losses) shall be included in the valuation
allowance.
The examples below illustrate the measurement of a valuation
allowance in three different scenarios: (1) when no tax-planning strategy is
available, (2) when the cost of implementing a tax-planning strategy under ASC
740 has an incremental tax benefit, and (3) when the cost of implementing a
tax-planning strategy under ASC 740 has no incremental tax benefit. For all
three examples, assume that “cumulative losses in recent years,” as discussed in
ASC 740-10-30-21 and Section
5.3.2.1, do not exist.
Example 5-18
No Tax-Planning Strategy Is Available
Assume the following:
- The entity operates in a single tax jurisdiction where the applicable tax rate is 25 percent.
- The measurement date for DTAs and DTLs is in 20X1.
- A $10,000 operating loss carryforward will expire on December 31, 20X2. No carryback refunds are available.
- Taxable temporary differences of $2,000 exist at the end of 20X1, $1,000 of which is expected to reverse in each of years 20X2 and 20X3.
- No qualifying tax-planning strategies to accelerate taxable income to 20X2 are available.
-
The following table illustrates, on the basis of historical results and other available evidence, the estimated taxable income exclusive of reversing temporary differences and carryforwards expected to be generated during 20X2:
The following table shows the computation of the DTL,
DTA, and valuation allowance at the end of 20X1:
A valuation allowance of $1,000 is necessary because
$4,000 of the $10,000 of operating loss carryforward
will expire in 20X2.
Example 5-19
Cost of Tax-Planning Strategy Has an Incremental Tax
Benefit
Assume the following:
- The entity operates in a single tax jurisdiction where the applicable tax rate is 25 percent.
- The measurement date for DTAs and DTLs is in 20X1.
- A $9,000 operating loss carryforward will expire on December 31, 20X2. No carryback refunds are available.
- Taxable temporary differences of $10,000 exist at the end of 20X1. The temporary differences result from investments in equipment for which accelerated depreciation is used for tax purposes and straightline depreciation is used for financial reporting purposes.
- Taxable temporary differences of $2,000 are expected to reverse in each of years 20X2–20X6.
-
The following table illustrates, before any qualifying tax-planning strategies are considered and on the basis of historical results and other available evidence, the estimated taxable income exclusive of reversing temporary differences and carryforwards expected to be generated during 20X2:
- Management has identified a qualifying tax-planning strategy to sell and lease back the equipment in 20X2, thereby accelerating the reversal of the remaining temporary difference of $8,000 to 20X2.
- The estimated cost attributable to the qualifying strategy is $1,000.
The following table illustrates the computation of the
DTAs and valuation allowance at the end of 20X1:
When the effects of the qualifying tax-planning strategy
are taken into account, the total estimated taxable
income for 20X2 of $12,000 ($4,000 estimated taxable
income plus $8,000 accelerating the reversal of the
taxable temporary difference) exceeds the $9,000
operating loss carryforward. However, in a manner
consistent with the guidance in ASC 740-10-55-44 (and as
illustrated in ASC 740-10-55-159), a valuation allowance
for the cost of the tax-planning strategy, net of any
related tax benefit, should reduce the tax benefit
recognized. Therefore, a valuation allowance of $750
would be required. The tax benefit of the cost of the
strategy in this example is recognized as a reduction of
the valuation allowance because sufficient taxable
income is available to cover the cost in 20X2 after the
results of the strategy are considered.
Example 5-20
Cost of Tax-Planning Strategy Has No Incremental Tax
Benefit
Assume the following:
- The entity operates in a single tax jurisdiction where the applicable tax rate is 25 percent.
- The measurement date for DTAs and DTLs is in 20X1.
- A $10,000 operating loss carryforward will expire on December 31, 20X2. No carryback refunds are available.
- Taxable temporary differences of $3,000 exist at the end of 20X1. The temporary differences result from investments in equipment for which accelerated depreciation is used for tax purposes and straight-line depreciation is used for financial reporting purposes.
- Taxable temporary differences of $1,000 are expected to reverse in each of years 20X2–20X4.
-
The following table illustrates, before any qualifying tax-planning strategies are considered and on the basis of historical results and other available evidence, the estimated taxable income exclusive of reversing temporary differences and carryforwards expected to be generated during 20X2:
- Management has identified a qualifying tax-planning strategy to sell and lease back the equipment in 20X2, thereby accelerating the reversal of $2,000 of taxable income to 20X2.
- Estimated costs attributable to the qualifying tax-planning strategy are $500.
The following table illustrates the computation of the
DTAs and valuation allowance at the end of 20X1:
5.3.5 Determining the Need for a Valuation Allowance by Using the Four Sources of Taxable Income
The example below illustrates all the concepts in Section 5.3 and shows how,
when positive and negative evidence is present, an entity uses the four sources of
taxable income described in ASC 740-10-30-18 to determine whether a valuation
allowance is required.
Example 5-21
Assume the following:
- Entity A is measuring its DTAs and DTLs as of year 20X2.
- Entity A operates and is subject to tax solely in Jurisdiction X.
- The enacted tax rate is 21 percent for all years.
- The DTA balance at the beginning of 20X2 is $0.
- Tax law permits a two-year carryback and five-year carryforward of operating losses
- Entity A’s DTL is scheduled to reverse over a period of five years.
Computation of the DTA and DTL
Entity A has identified all temporary differences existing at
the end of 20X2. The measurement of DTAs and DTLs is as
follows:
Available Evidence
In assessing whether a valuation allowance
is required, A has identified the following evidence:
- Negative evidence
- Entity A has been historically profitable but has incurred a loss in 20X2 as a result of one-time restructuring of certain operations.
- Entity A operates in a traditionally cyclical business.7
- Positive evidence
- Tax benefits have never expired unused.8
- Entity A has a strong earnings history at the close of 20X2.9 While it incurred a loss in 20X2, the loss was an aberration that resulted from one-time charges, and A is expected to return to profitability in 20X3.
- Entity A is not in a cumulative loss position in 20X2 and does not forecast that it will be in a cumulative loss position in 20X3.
- Entity A has identified certain tax planning strategies that (1) it has determined are prudent, feasible, and outside of the company’s normal operations and (2) would accelerate taxable amounts so that the expiring carryforward of the NOL generated in 20X2 could be used.
Assessment of Realization
On the basis of the available evidence,
management has concluded that it is more likely than not
that some portion of the $93 of tax benefits from $440 ($275
+ $165) of deductions will not be realized in future tax
returns.
To determine the amount of valuation
allowance required, management has considered four sources
of taxable income. As part of this analysis, the company is
forecasting taxable income of $25 in each of the next five
tax years (i.e., the carryforward period) and has $55 of
taxable income in the carryback period. The company is
forecasting $35 of taxable income from future reversals of
existing taxable temporary differences that will reverse
over the carryforward period. Finally, the company has
identified a tax-planning strategy in which its investment
portfolio of tax-exempt securities could be sold and
replaced with higher-yielding taxable securities, generating
taxable income of $26 and implementation costs of $1 during
the carryforward period. The company’s analysis is as
follows:
Upon considering the timing, amounts, and character of the
four sources of taxable income available for use of existing
tax benefits, management concludes that all such income can
be used without limitation. For example, all of the taxable
temporary differences will reverse during the same period as
the deductible temporary items. Therefore, A expects to
realize $240 of $440 of deductions and will record a
valuation allowance of $42 ($200 × 21%) on the $200 of
deductions that is not expected to be realized.
Entity A would record the following journal entry:
The following is an analysis of the facts in the above example:
- Entity A may need to estimate the amount and timing of future income in determining whether it is more likely than not that existing tax benefits for deductible temporary differences and carryforwards will be realized in future tax returns.
- In determining the valuation allowance, A was required to consider (1) the amounts and timing of future deductions or carryforwards and (2) the four sources of taxable income that enable utilization: future taxable income exclusive of reversals of temporary differences, taxable income available for carryback refunds, taxable temporary differences, and tax-planning strategies. If A had been able to conclude that a valuation allowance was not required on the basis of one or more sources, A would not have needed to consider the remaining sources. In this case, A needed to consider all four sources, after which it determined that a valuation allowance was required.
- The assessment is based on all available evidence, both positive and negative.
Footnotes
3
The conclusion reached in this
example would have been the same even if the NOL’s
carryforward period had been indefinite.
4
The CARES Act temporarily eliminated the 80 percent
limitation for NOLs used in taxable years beginning before January 1,
2021. It also temporarily increased the business interest expense
limitation from 30 percent to 50 percent for taxable years beginning in
2019 and 2020 and allows entities to elect to use their adjusted taxable
income for the last taxable year beginning in 2019 as their adjusted
taxable income for taxable years beginning in 2020. As a result,
entities will need to consider how this temporary change affects their
previous conclusions about the realizability of deferred taxes. For
example, an NOL used in 2019 will not be limited to a percentage of
taxable income and thus an indefinite-lived taxable temporary difference
reversing in 2019 will not be limited as a source of taxable income with
respect to this NOL. 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.
5
The projections referred to here are management’s estimates
of future income based on metrics and qualitative information used by the
entity, which might include future growth assumptions and other subjective
management assertions.
6
ASU
2016-13 was issued in June 2016
and significantly amends the guidance in U.S. GAAP
on the measurement of financial instruments. In
November 2019, the FASB issued ASU
2019-10, which established the
following effective dates for ASU 2016-13: for
public business entities (PBEs) that meet the U.S.
GAAP definition of an SEC filer, ASU 2016-13 is
effective for fiscal years beginning after
December 15, 2019, including interim periods
therein. For all other entities, the ASU is
effective for fiscal years beginning after
December 15, 2022, and interim periods therein.
Early adoption is permitted for fiscal years
beginning after December 15, 2018, including
interim periods within those fiscal years.
7
Indicates a source of evidence
that can be verified objectively
8
See footnote 7.
9
See footnote 7.
5.4 Consideration of Future Events When Assessing the Need for a Valuation Allowance
In general, entities should consider all available information about future events when
determining whether a valuation allowance is needed for DTAs.
Entities must exercise professional judgment when assessing information
that is obtained after the balance sheet date but before the financial statements are
issued or are available to be issued. See Section 5.3.2.2 for further discussion of the
effect of nonrecurring items on estimates of future income.
The following are future events that entities should not consider or anticipate when
assessing the realizability of DTAs:
- Changes in tax laws or rates (see ASC 740-10-35-4).
- Changes in tax status (see ASC 740-10-25-32 and 25-33).
- Expected business combinations.
- Expected initial public offerings (IPOs).
- Events that are inconsistent with financial reporting assertions as of the balance sheet date. For example, anticipating sales of HTM securities would be inconsistent with management’s intent and with the classification of such securities. Similarly, entities should not anticipate the sale of indefinite-lived intangible assets that are not classified as held for sale as of the reporting date, because doing so would be inconsistent with management’s assessment of the useful life of these assets.
- Events that depend on future market conditions or that are otherwise not within the entity’s control. For example, an entity should not anticipate income associated with forgiveness of indebtedness to reduce an otherwise required valuation allowance.
5.5 Reduction of a Valuation Allowance When Negative Evidence Is No Longer Present
When an entity concludes that negative evidence (as discussed in ASC 740-10-30-21) exists
and that realization of all or a portion of its DTA as of that date is not more likely
than not, the entity would recognize a valuation allowance to reduce its DTA to an
amount that is more likely than not to be realized. However, circumstances may change
over time such that in a subsequent year, the negative evidence discussed in ASC
740-10-30-21 is no longer present.
If an entity has returned to profitability for a sustained period, the
entity should assume, in the absence of evidence to the contrary, that favorable
operations or conditions will continue in the future. Further, as discussed in Section 5.3.2.2.1, unless the
facts and circumstances dictate otherwise, an entity should not limit the estimate of
future income to (1) a specific period (e.g., the period over which it measures
cumulative losses in recent periods) or (2) general uncertainties. For example, it would
be inappropriate to project taxable income for only three years and assume that taxable
income beyond three years would be zero solely on the basis of the uncertainty in
projecting taxable income beyond three years (such a projection would be particularly
inappropriate if income is projected in connection with other financial statement
assertions, such as those about impairment tests). Therefore, the valuation allowance
provided in prior years for which negative evidence was present should be eliminated in
the period in which the negative evidence ceases to exist.
5.6 Going-Concern Opinion as Negative Evidence
PCAOB AS 2415 and AICPA AU-C Section 570 require an explanatory paragraph in the
auditor’s report when the auditor concludes that “substantial doubt about the entity’s
ability to continue as a going concern for a reasonable period of time remains.” In
addition, ASC 205-40 requires an entity’s management to evaluate whether conditions or
events raise substantial doubt about the entity’s ability to continue as a going concern
and, if so, “whether its plans that are intended to mitigate those [relevant] conditions
and events, when implemented, will alleviate substantial doubt.” In circumstances in
which management has identified conditions or events that raise substantial doubt that
has not been alleviated by its plans and an explanatory paragraph that has been added to
the auditor’s report, a valuation allowance would generally be recorded for all DTAs
whose realization is not assured by either offsetting existing taxable temporary
differences or carryback to open tax years. However, in very limited circumstances, the
immediate cause of the going-concern uncertainty may not be directly related to the
entity’s operations, in which case a full valuation allowance may not be required.
The fact that (1) management has not identified conditions or events that raise
substantial doubt, (2) management has identified conditions or events that raise
substantial doubt but has determined its plans alleviate the substantial doubt, or (3) a
going-concern explanatory paragraph is not included in the auditor’s report does not
automatically constitute positive evidence about the realization of DTAs. Similarly,
when an entity concludes that it must record a valuation allowance for all or part of
its DTAs, a going-concern problem may not necessarily exist. For example, an entity that
generates sufficient positive cash flows to service its debt and support the book value
of its assets (i.e., the entity’s assets are not impaired), but that is experiencing
financial reporting losses (i.e., recent cumulative losses), would have negative
evidence about the realization of DTAs. In this case, the positive evidence may not be
sufficient to overcome the negative evidence; thus, the entity would provide a valuation
allowance for all or part of its DTAs. However, the auditor may conclude, on the basis
of positive cash flows and other factors, that it is not necessary to provide a
going-concern reference in the auditor’s report, and management may likewise conclude
that conditions or events do not raise substantial doubt about the entity’s ability to
continue as a going concern.
5.7 Exceptions and Special Situations
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).
Footnotes
10
An entity would need to select one approach as a policy
choice and apply it consistently.
11
Related to deductible temporary differences or attributes.
12
IRC Section 275(a)(4) and Treas. Reg. 26 CFR Section §
1.901-1(h)(2).
13
Treas. Reg. 26 CFR Section § 301.6511(d)-3.
14
IRC Section 163(j) limits the ability of certain
corporations to deduct interest paid or accrued on indebtedness. In general,
this limit applies to interest paid or accrued by certain corporations (when
no U.S. federal income tax is imposed on the interest income) whose
debt-to-equity ratio exceeds 1.5 to 1.0 and when net interest expense
exceeds 50 percent of the adjusted taxable income. The 2017 Act removed the
debt-to-equity safe harbor, expanded interest deductibility limitations, and
generally limited the interest deduction on business interest to (1)
business interest income plus (2) 30 percent of the taxpayer’s adjusted
taxable income. The CARES Act temporarily increased the 30 percent
limitation of adjusted taxable income to 50 percent for taxable years
beginning in 2019 and 2020. It also permitted entities to use their 2019
adjusted taxable income for the 2020 taxable year. 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.
5.8 Examples Illustrating the Determination of the Pattern of Reversals of Temporary Differences
The following examples describe several types of temporary differences and provide some
common methods (i.e., for illustrative purposes only) for determining the pattern of
their reversal. Other methods may also be acceptable if they are consistent with the
guidance in ASC 740-10-55 on determining reversal patterns.
5.8.1 State and Local Tax Jurisdictions
In the computation of an entity’s U.S. federal income tax liability,
income taxes that are paid to a state or municipal jurisdiction are deductible.
Thus, ASC 740-10-55-20 states, in part:
[A] deferred state [or municipal] income
tax liability or asset gives rise to a temporary difference for purposes of
determining a deferred U.S. federal income tax asset or liability, respectively.
The pattern of deductible or taxable amounts in future years for temporary
differences related to deferred state [or municipal] income tax liabilities or
assets should be determined by estimates of the amount[s] of those state [and
local] income taxes that are expected to become . . . deductible or taxable for
U.S. federal tax purposes in those particular future years.
5.8.2 Unrecognized Tax Benefits
Under the tax law, an entity may have a basis for deductions (e.g., repair expenses)
and may have accrued a liability for the probable disallowance of those deductions
(a UTB). If such deductions are disallowed, they would be capitalized for tax
purposes and would then be deductible in later years. ASC 740-10-55-21 states that
the accrual of the liability in this situation “has the effect of [implicitly]
capitalizing those expenses for tax purposes” and that those “expenses are
considered to result in deductible amounts in the later years” in which, for tax
purposes, the deductions are expected to be allowed. Moreover, this paragraph states
that “[i]f the liability for unrecognized tax benefits is based on an overall
evaluation of the technical merits of the tax position, scheduling should reflect
the evaluations made in determining the liability for unrecognized tax benefits that
was recognized.”
The change in the timing of taxable income or loss caused upon the disallowance of
expenses may affect an entity’s realization assessment of a DTA recognized for the
tax consequences of deductible temporary differences, operating loss, and tax credit
carryforwards. For example, upon disallowance of those expenses, taxable income for
that year will be higher. Similarly, taxable income for years after the disallowance
will be lower because the deductions are being amortized against taxable income in
those years. An entity should consider the impact of disallowance in determining
whether realization of a DTA meets the more-likely-than-not recognition threshold in
ASC 740.
5.8.3 Accrued Interest and Penalties
An entity that takes an aggressive position in a tax return filing often will accrue
a liability in its financial statements for interest and penalties that it would
incur if the tax authority successfully challenged that position. Such an entity
should schedule a deductible amount for the accrued interest for the future year in
which that interest is expected to become deductible as a result of settling the
underlying issue with the tax authority.
Because most tax jurisdictions do not permit deductions for penalties, a temporary
difference does not generally result from the accrual of such amounts for financial
reporting purposes.
5.8.4 Tax Accounting Method Changes
ASC 740-10-55-59 states, in part, that a “change in tax law may
require a change in accounting method for tax purposes, for example, the uniform
cost capitalization rules required by the Tax Reform Act of 1986.” Under the uniform
capitalization rules, calendar-year entities revalued “inventories on hand at the
beginning of 1987 . . . as though the new rules had been in effect in prior years.”
The resulting adjustment was included in the determination of taxable income or loss
over not more than four years. ASC 740-10-55-58 through 55-62 indicate that the
uniform capitalization rules initially gave rise to two temporary differences.
ASC 740-10-55-60 and 55-61 describe these two temporary differences as follows:
One temporary difference is related to the additional amounts initially
capitalized into inventory for tax purposes. As a result of those additional
amounts, the tax basis of the inventory exceeds the amount of the inventory
for financial reporting. That temporary difference is considered to result
in a deductible amount when the inventory is expected to be sold. Therefore,
the excess of the tax basis of the inventory over the amount of the
inventory for financial reporting as of December 31, 1986, is considered to
result in a deductible amount in 1987 when the inventory turns over. As of
subsequent year-ends, the deductible temporary difference to be considered
would be the amount capitalized for tax purposes and not for financial
reporting as of those year-ends. The expected timing of the deduction for
the additional amounts capitalized in this example assumes that the
inventory is not measured on a LIFO basis; temporary differences related to
LIFO inventories reverse when the inventory is sold and not replaced as
provided in paragraph 740-10-55-13.
The other temporary difference is related to the deferred income for tax
purposes that results from the initial catch-up adjustment. As stated above,
that deferred income likely will be included in taxable income over four
years. Ordinarily, the reversal pattern for this temporary difference should
be considered to follow the tax pattern and would also be four years. This
assumes that it is expected that inventory sold will be replaced. However,
under the tax law, if there is a one-third reduction in the amount of
inventory for two years running, any remaining balance of that deferred
income is included in taxable income for the second year. If such inventory
reductions are expected, then the reversal pattern will be less than four
years.
5.8.5 LIFO Inventory
ASC 740-10-55-13 states:
The particular years in which temporary differences
result in taxable or deductible amounts generally are determined by the timing
of the recovery of the related asset or settlement of the related liability.
However, there are exceptions to that general rule. For example, a temporary
difference between the tax basis and the reported amount of inventory for which
cost is determined on a [LIFO] basis does not reverse when present inventory is
sold in future years if it is replaced by purchases or production of inventory
in those same future years. A LIFO inventory temporary difference becomes
taxable or deductible in the future year that inventory is liquidated and not
replaced.
For most entities, an assumption that inventory will be replaced through purchases or
production does not ordinarily present difficulty. However, if there is doubt about
the ability of an entity to continue to operate as a going concern, the entity
should evaluate available evidence to determine whether it can make this assumption
when measuring DTAs and DTLs under ASC 740. The ability to assume that inventory can
be replaced might affect the recognition of a DTA when realization depends primarily
on the reversal of a taxable temporary difference. For example, if an entity is
unable to replace inventory because of financial or operating difficulties, a
taxable temporary difference resulting from LIFO inventory accounting would reverse
at that time and not be available to offset the tax consequences of future
deductions for retirement benefits that have been accrued for financial reporting
purposes but that will become deductible many years in the future when the benefits
are paid.
5.8.6 Obsolete Inventory
For financial reporting purposes, inventory may be written down to
net realizable value (e.g., when obsolescence occurs). Generally, for tax purposes,
the benefit of such a write-down cannot be realized through deductions until
disposition of the inventory. Thus, in such circumstances, there is a deductible
temporary difference between the reported amount of inventory and its underlying tax
basis. This temporary difference should be assumed to be deductible in the period in
which the inventory deductions are expected to be claimed (i.e., in the period in
which the inventory dispositions occur).
5.8.7 Cash Surrender Value of Life Insurance
Under ASC 325-30, an asset is recognized for financial reporting purposes in the
amount of the cash surrender value of life insurance purchased by an entity. ASC
740-10-25-30 cites the “excess of cash surrender value of life insurance over
premiums paid” as an example of a basis difference that “is not a temporary
difference if the [cash surrender value] is expected to be recovered without tax
consequence upon the death of the insured.” If, however, the policy is expected to
be surrendered for its cash value, the entity would include in taxable income any
excess cash surrender value over the cumulative premiums paid (note that the tax
basis in the policy is generally equal to cumulative premiums paid). The resulting
taxable temporary difference should be scheduled to reverse in the year in which the
entity expects to surrender the policy.
5.8.8 Land
The financial reporting basis of the value assigned to land may differ from the tax
basis. Such a difference may result from (1) property acquired in a nontaxable
business combination, (2) differences between capitalized costs allowable under
accounting standards and those allowable under tax law, or (3) property recorded at
predecessor cost for financial reporting purposes because it was acquired through a
transaction among entities under common control. Regardless of the reason for the
difference, the entity should assume that the temporary difference will reverse in
the year in which the land is expected to be sold to an unrelated third party;
otherwise, the timing of the reversal would be indefinite.
5.8.9 Nondepreciable Assets
In some jurisdictions, certain office buildings and other real estate cannot be
depreciated under local tax law. The tax authority may permit the tax basis of such
property to be routinely increased for the approximate loss in purchasing power
caused by inflation. The tax basis, as adjusted for indexing, is used to measure the
capital gain or loss. For financial reporting purposes, depreciation is recognized
on such assets. The effects of indexing for tax purposes and depreciation for
financial reporting purposes create deductible temporary differences that reverse
upon disposition of the associated assets.
5.8.10 Assets Under Construction
For financial reporting purposes, the carrying amount and tax basis of an asset under
construction for an entity’s own use may differ as a result of differences in
capitalized costs (e.g., interest capitalized under ASC 835-20 may differ from the
amount to be capitalized for tax purposes). The difference between the amount
reported for construction in progress for financial reporting purposes and its
related tax basis should be scheduled to reverse over the expected depreciable life
of the asset, which should not commence before the date on which the property is
expected to be placed into service.
5.8.11 Disposal of Long-Lived Assets by Sale
A deductible temporary difference results when, under ASC 360-10-35-37, a loss is
recognized for a write-down to fair value less costs to sell for assets to be
disposed of by sale. Because the deductions for losses cannot generally be applied
to reduce taxable income until they occur, the temporary difference should be
assumed to reverse during the period(s) in which such losses are expected to be
deductible for tax purposes.
5.8.12 Costs Associated With Exit or Disposal Activities
Under ASC 420, the fair value of certain exit or disposal costs (e.g., contract
termination) is recorded on the date the activity is initiated (e.g., contract
termination date) and is accreted to its settlement amount on the basis of the
discount rate initially used to measure the liability. Generally, an entity cannot
apply the deductions for exit or disposal activities to reduce taxable income until
they occur; therefore, the resulting deductible temporary differences should be
scheduled to reverse during the period(s) in which such losses are expected to be
deductible for tax purposes.
5.8.13 Loss Contingencies
Under ASC 450, the estimated losses on contingencies that are accrued for financial
reporting purposes when it is probable that a liability has been incurred and the
amount of the loss can be reasonably estimated are not deductible for tax purposes
until paid. The resulting deductible temporary differences should be scheduled to
reverse during the periods in which the losses are expected to be deductible for tax
purposes.
5.8.14 Organizational Costs
In the U.S. federal tax jurisdiction, an entity generally uses the
straight-line method to defer organizational costs and amortize them to income over
five years. Such costs are recognized as an expense for financial reporting purposes
in the period in which they are incurred unless an entity can clearly demonstrate
that the costs are associated with a future economic benefit. If the costs are
reported as an expense in the period in which they are incurred, any deductible
temporary differences should be scheduled to reverse on the basis of the future
amortization of the tax basis of the organizational asset recorded for tax
purposes.
5.8.15 Long-Term Contracts
Before the Tax Reform Act of 1986, use of the completed-contract
method for tax purposes resulted in significant temporary differences for many
entities that used the percentage-of-completion method for financial reporting
purposes. The Tax Reform Act of 1986 eliminated this use of the completed-contract
method (except for small contractors that are defined under the law), requiring that
an entity determine taxable income by using the percentage-of-completion method or a
hybrid of the completed-contract and percentage-of-completion methods for contracts
entered into after February 1986.
For entities that are permitted to continue using the completed-contract method for
tax purposes, a temporary difference will result in future taxable income in the
amount of gross profit recognized for financial reporting purposes. The reversal of
these differences would be assumed to occur on the basis of the period in which the
contract is expected to be completed.
If the percentage-of-completion method is used for both tax and financial reporting
purposes, temporary differences may nevertheless result because the gross profit for
tax purposes may be computed differently from how gross profit is computed for book
purposes. To schedule the reversals of these temporary differences, an entity would
generally need to estimate the amount and timing of gross profit for tax and
financial reporting purposes.
If a hybrid method is used for tax purposes and the percentage-of-completion method
is used for financial reporting purposes, the temporary differences might be
allocated between the portions of the contract that are accounted for under the
completed-contract method and those accounted for under the percentage-of-completion
method for tax purposes. Under this approach, the amount attributable to the use of
the completed-contract method for tax purposes might be scheduled to reverse,
thereby increasing taxable income, during the year in which the contract is expected
to be completed. The amount of temporary differences attributable to differences in
the percentage-of-completion methods for financial reporting and tax purposes might
be allocated and scheduled on the basis of the estimates of future gross profit for
financial reporting and tax purposes.
5.8.16 Pension and Other Postretirement Benefit Obligations
Under ASC 715, an employer generally recognizes the estimated cost of providing
defined benefit pension and other postretirement benefits to its employees over the
estimated service period of those employees. It records an asset or liability
representing the amount by which the present value of the estimated future cost of
providing the benefits either exceeds or is less than the fair value of plan assets
at the end of the reporting period.
Under U.S. tax law, however, an employer generally does not receive a deduction until
it makes a contribution to its pension plan or pays its other postretirement benefit
obligations (e.g., retiree medical costs). Because tax law generally precludes an
entity from taking deductions for these costs until the pension contribution is made
or the other postretirement benefit obligations are paid, the accounting required
under ASC 715 usually results in significant taxable or deductible temporary
differences for employers that provide such benefits.
ASC 715-30-55-4 and 55-5 explain that a taxable temporary difference related to an
overfunded pension obligation will reverse if (1) the plan is terminated to
recapture excess assets or (2) periodic pension cost exceeds future amounts funded.
For an overfunded obligation, we believe that the pattern of taxable amounts in
future years should generally be determined to be consistent with the pattern in
scenario (2). That is, we believe that the pattern of taxable amounts in future
years that will result from the temporary difference should generally be considered
the same as the pattern of estimated net periodic pension cost (as that term is
defined in ASC 715-30-20) for financial reporting for the following year and
succeeding years, if necessary, until future net periodic pension cost, on a
cumulative basis, equals the amount of the temporary difference. Under this
approach, additional employer contributions to the plan, if any, are ignored. It may
be estimated, however, that in early years, there will be net periodic pension
income (because the plan is significantly overfunded). If so, the existing
overfunded amount will not be recovered until the later years for which it is
estimated that there will be net periodic pension cost.
For an underfunded plan, the pattern of deductible amounts in future years that will
result from the temporary difference could be considered the same as the pattern by
which estimated future tax-deductible contributions are expected to exceed future
interest cost on the benefit obligation existing at the end of the reporting period.
This approach is similar to determining the pattern of reversals for other
discounted liabilities (e.g., amortizing a loan). Under this approach, each
estimated tax-deductible contribution to the plan in future years would be allocated
initially to (1) estimated future interest expense on the projected benefit
obligation existing at the end of the reporting period and then to (2) the projected
benefit obligation existing at the end of the reporting period.
5.8.17 Deferred Income and Gains
For tax purposes, certain revenue or income is taxed upon receipt of cash (e.g.,
rental income, loan, or maintenance fees received in advance). However, for
financial reporting purposes, such income is deferred and recognized in the period
in which the fee or income is earned. The amounts deferred in an entity’s balance
sheet will result in a deductible temporary difference because, for tax purposes, no
tax basis in the item exists.
Temporary differences from revenues or gains deferred for financial reporting
purposes, but not for tax purposes, should be assumed to result in deductible
amounts when the revenues or gains are expected to be earned or generated (i.e.,
when the deferred credit is expected to be settled).
5.8.18 Allowances for Doubtful Accounts
The Tax Reform Act of 1986 requires most taxpayers to use the specific charge-off
method to compute bad-debt deductions for tax purposes. For financial reporting
purposes, entities recognize loan losses in the period in which the loss is
estimated to occur. Such recognition creates a deductible temporary difference in
the amount of the allowance for doubtful accounts established for financial
reporting purposes. It is expected that an allowance for doubtful accounts as of the
current balance sheet date will result in deductible amounts in the year(s) in which
such accounts (1) are expected to be determined to be worthless for tax purposes or
(2) are planned to be sold (if held for sale).
5.8.19 Property, Plant, and Equipment
An entity might find it necessary to schedule the reversals of
temporary differences related to depreciable assets for two primary reasons: (1) to
assess whether it has sufficient taxable income of the appropriate character, within
the carryback/carryforward period available under the tax law, to conclude that
realization of a DTA is more likely than not and (2) to calculate the tax rate used
to measure DTAs and DTLs by determining the enacted tax rates expected to apply to
taxable income in the periods in which the DTLs or DTAs are expected to be settled
or realized. In each case, the entity must estimate the amounts and timing of
taxable income or loss expected in future years. Further, ASC 740-10-55-14 states,
in part, “For some assets or liabilities, temporary differences may accumulate over
several years and then reverse over several years. That pattern is common for
depreciable assets.”
Example 5-32
The following example illustrates the scheduling of temporary
differences for depreciable assets. Assume the following:
- An entity acquired depreciable assets for $1,000 at the beginning of 20X1.
- For financial reporting purposes, the property is depreciated on a straight-line basis over five years; for tax purposes, the modified accelerated cost recovery method is used.
-
The following table illustrates the depreciation schedules:
In December 20X1, the temporary difference of $150 (financial
statement carrying amount of $800 less tax basis of $650)
will result in a future net taxable amount. If the
originating differences are considered, the temporary
difference of $150 should be scheduled to reverse in the
following manner as of the end of 20X1:
If the entity does not consider future originating
differences to minimize the complexity of scheduling
reversal patterns, a first-in, first-out pattern would be
used and the $150 taxable temporary difference would be
scheduled as follows on December 31, 20X1: