Keep It Simple: FASB Issues ASU on Income Taxes (December 19, 2019)

Accordingly, the FASB amended ASC 740-10-15-4(a) to state that an entity should include the amount of tax based on income in the tax provision and should record any incremental amount recorded as a tax not based on income. This amendment effectively reverses the order in which an entity determines the type of tax under current U.S. GAAP. In addition, the ASU amends the illustrative examples referred to and included in ASC 740-10-55-26 and ASC 740-10-55-139 through 55-144. The FASB notes that such amendments are consistent with the accounting for other incremental taxes, such as the base erosion anti-abuse tax. Moreover, in paragraph BC12 of the ASU, the FASB concluded that subjecting these taxes to the disclosure requirements in ASC 740 will result in greater transparency of franchise tax amounts.

After a business combination, certain transactions or events may increase the tax basis of the entity’s assets, including goodwill. The previous guidance in ASC 740-10-25-4 prohibited recognition of a DTA for a subsequent step-up in the tax basis of goodwill that is related to the portion of goodwill from a prior business combination for which a DTL was not initially recognized, except when “the newly deductible goodwill amount exceeds the remaining balance of book goodwill.”

Stakeholders noted that the previous guidance in U.S. GAAP did not necessarily result in outcomes that reflected the economics of the underlying transactions. For example, an entity may sacrifice a net operating loss carryforward in exchange for tax basis in goodwill. From an economic perspective, such an entity has exchanged one asset for another and yet may be precluded from recognizing the asset received.

In response to stakeholder feedback, the FASB removed the previous guidance in ASC 740-10-25-54 that prohibited recognition of a DTA for a step-up in tax basis “except to the extent that the newly deductible goodwill amount exceeds the remaining balance of book goodwill.” Instead, the amended guidance contains a model under which an entity can consider a list of factors in determining whether the step-up in tax basis is related to the business combination that caused the initial recognition of goodwill or to a separate transaction. If the step-up is related to the business combination in which the book goodwill was originally recognized, the entity would not record a DTA for the step-up in basis except to the extent that the newly deductible goodwill amount exceeds the remaining balance of book goodwill. If the step-up is related to a subsequent transaction, however, the entity would record a DTA. The Board decided that this revised guidance “better reflects the economic consequences of separate transactions because it results in the recognition of an asset instead of expense when the step up in tax basis results in a future tax benefit.”

In paragraph BC19 of the ASU, the Board acknowledged that entities will still need to apply judgment in making this determination.

Because stakeholders had indicated that the original guidance was unclear, the FASB added ASC 740-10-30-27A, which clarifies that legal entities that are not subject to tax (e.g., certain partnerships and disregarded SMLLCs) are not required to include, in their separate financial statements, amounts of consolidated current and deferred taxes. An entity, however, may elect to allocate current and deferred tax expense from its consolidated parent entity in its stand-alone financial statements, as long as the legal entity is not subject to tax and is disregarded by the taxing authority. In addition, the Board added ASC 740-10-50-17A, which requires that when a legal entity that is both not subject to tax and disregarded by the taxing authority elects to include the allocated amount of current and deferred tax expense in its separately issued financial statements in accordance with ASC 740-10-30-27A, it must disclose that fact and provide the disclosures required by ASC 740-10-50-17.

Paragraph BC22 of the ASU notes that one reason to allow such a policy election is that some entities (e.g., certain rate-regulated entities or entities with cost-plus revenue arrangements) may, for business reasons, want to include in their separate financial statements an allocation of the tax amounts incurred by the consolidating parent entity as a result of transactions generated by the entity not subject to tax.

 

Connecting the Dots

Under the aforementioned policy election, an SMLLC (a disregarded entity for tax) is permitted to include a tax provision in its separate financial statements, but a partnership (a regarded entity for tax) is not.

Stakeholders provided feedback on the difficulty of applying this exception, which they noted (1) was often overlooked, (2) provided little perceived benefit to users of financial statements, (3) was applied inconsistently in practice, and (4) often yielded counterintuitive results. On the basis of this feedback, the FASB removed the exception in ASC 740-20-45-7. While some respondents disagreed with the removal of this exception and believed that its removal may indeed increase costs for certain entities, the FASB noted that “overall, the scenarios in which removing the exception would decrease the cost of applying Topic 740 are likely more common than those scenarios in which removing the exception would increase costs.” In addition, the ASU amends the illustrative example in ASC 740-20-55-10 through 55-14 to conform with the removal of the exception in ASC 740-20-45-7.

In paragraph BC31 of the ASU, the FASB decided that the exception in ASC 740-30-25-15 increases “the cost and complexity of applying Topic 740” because it essentially required an entity to bifurcate its outside basis difference in the investment and account for the components separately. The original outside basis difference that existed when the subsidiary became an equity method investment was “frozen”; however, subsequent changes in the outside basis difference were recognized separately. The FASB removed this exception in ASC 740-30-25-15, which previously restricted recognition of a DTL on the portion of the outside basis difference that existed before the subsidiary became an equity method investment. Under the new guidance, an entity will need to recognize a DTL related to the outside basis difference of an equity method investment when the subsidiary becomes an equity method investment. Accordingly, an entity “shall accrue in the current period income taxes on the temporary difference related to its remaining investment in common stock.” This guidance is now consistent with current U.S. GAAP under which an equity method investor is prohibited from asserting indefinite reinvestment of earnings to avoid recording deferred taxes on its outside basis differences.

In a manner similar to its observations related to ASC 740-30-25-15 above, the FASB noted that this historical requirement increased the cost and complexity of applying ASC 740 because an entity essentially needed to bifurcate its outside basis difference in the subsidiary and account for the components separately. This complicated the accounting for investments and foreign subsidiaries and reduced comparability among entities (i.e., some of a reporting entity’s subsidiaries may not have been eligible to apply the exception simply because of the nature of the investment before they became subsidiaries).

To decrease the complexity of applying ASC 740 and increase the usefulness of information for financial statement users, the FASB removed the exception in ASC 740-30-25-16 that “froze” the DTL on the outside basis difference that existed before the investment became a subsidiary. Accordingly, an entity may need to reverse a DTL if it asserts indefinite reinvestment of earnings of the subsidiary at the time of the ownership change. This treatment results in consistency among all of the entity’s subsidiaries for which indefinite reinvestment is asserted.

As a result, to reduce the cost and complexity of applying ASC 740, the FASB amended ASC 740-270-25-5 to require that the effects of an enacted change in tax law on taxes currently payable or refundable for the current year be reflected in the computation of the annual effective tax rate (AETR) in the first interim period that includes the enactment date of the new legislation. In addition, the example in ASC 740-270-55-44 through 55-49 was also amended to reflect the change. This amendment superseded the example in ASC 740-270-55-50 and 55-51.

The FASB determined that the elimination of this exception would reduce the time and cost associated with remediating errors while not adversely altering the information provided to stakeholders on an interim basis within an entity’s quarterly financial statements. Thus, the FASB removed the exception in ASC 740-270-30-28. In paragraph BC42 of the ASU, the Board acknowledges that removal of the exception may result in recognition of tax benefits in an interim period that exceed the tax benefits that would be received on the basis of the year-to-date loss. However, the FASB decided that the benefit to financial statement users of limiting the tax benefits would not outweigh the costs of the limitation.

Upon transition, entities are required to disclose (1) the nature and reason for the change in accounting principle, (2) the transition method selected for each topic applicable to the entity, and (3) a description of the impact of the adoption on the specific financial statement line items affected by the change in accounting principle. In paragraph BC57 of the ASU, the Board states that it would not be cost-beneficial “to require quantitative disclosures that would effectively require an entity to maintain two sets of accounting records solely to meet disclosure requirements that would not be required when preparing the entity’s basic financial statements.” Accordingly, no such quantitative disclosure requirement exists.

For all other entities, the guidance is effective for fiscal years beginning after December 15, 2021, and for interim periods beginning after December 15, 2022. Early adoption for these entities is also permitted, including adoption in interim or annual periods for which financial statements have not yet been made available for issuance.

If an entity early adopts these amendments in an interim period, it should reflect any adjustments as of the beginning of the annual period that includes that interim period. In addition, an entity that elects to early adopt the standard is required to adopt all of the amendments in the same period (i.e., an entity cannot select which amendments to early adopt).