Chapter 2 — Financial Statement Accounting and Disclosure Topics

2.12 Income Taxes

Overall, the themes of SEC staff comments on financial reporting and disclosures related to income taxes have remained relatively consistent year over year. For example, the SEC staff has continued to issue comments to registrants on the following:

Valuation allowances (see Section 2.12.1).
Disclosures related to the income tax rate (see Section 2.12.2).
Tax effects of significant or unusual transactions that occurred during the period (see Section 2.12.3).
Noncompliance with disclosure requirements (e.g., omission of required disclosures) (see Section 2.12.4).

The SEC staff continues to request early-warning disclosures to help financial statement users understand key estimates and assumptions that registrants made in recording items related to income taxes and how changes to those estimates and assumptions could potentially affect the financial statements in the future. The SEC staff also continues to issue comments on non-GAAP measures with a particular focus on the income tax impact of the adjustments made to the GAAP measures. For additional information about early-warning disclosures and non-GAAP measures, see Sections 3.1 and 3.4, respectively.

Historically, the SEC staff has stated that boilerplate language should be avoided with respect to income tax disclosures within MD&A and the financial statements, and that approaches more conducive to effective disclosure would include:

Using the income tax rate reconciliation as a starting point and describing the details of the material items.
Discussing significant foreign jurisdictions, including statutory rates, effective rates, and the current and future impact of reconciling items and uncertain tax positions.
Providing meaningful disclosures about known trends and uncertainties, including expectations regarding the countries where registrants operate.

Changing Lanes

On August 16, 2022, the Inflation Reduction Act of 2022 (IRA) was signed into law. The IRA contains a number of tax-related provisions, including:

A 15 percent book minimum tax (“corporate alternative minimum tax”) on adjusted financial statement income of applicable corporations.
A plethora of clean-energy tax incentives in the form of tax credits, some of which include a direct-pay option or transferability provisions.
A 1 percent excise tax on certain corporate stock buybacks.

Many of the impacts of the new legislation are effective for financial reporting periods and tax years beginning on or after January 1, 2023. In addition, more than 135 countries have agreed to participate in a “two-pillar” international tax approach developed by the Organisation for Economic Co-operation and Development, which includes establishing a global minimum corporate tax rate of 15 percent (see Deloitte’s February 1, 2023, Financial Reporting Alert for more information). Accordingly, SEC filers should consider disclosing, when material, the anticipated current and future impact of the newly enacted law on their results of operations, financial position, liquidity, and capital resources in MD&A as part of their quarterly and annual filings.

2.12.1 Valuation Allowances

Examples of SEC Comments

We note that you released $[X] million of your tax valuation allowance in [the fiscal year], on the basis of management’s reassessment of the amount of U.S. deferred tax assets that are more likely than not to be realized. We also note your disclosure that management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Please provide us, and revise your disclosures here or in critical accounting policies in MD&A to provide, a more specific and comprehensive analysis of your assessment of the realizability of your deferred tax assets as of [the fiscal year-end]. Your analysis should include, but not be necessarily limited to, the following:
- Clarify your disclosure that you achieved twelve quarters of cumulative pretax income in the U.S. in light of the tabular disclosures . . . ;
- Clarify if the deferred tax liabilities you are relying on reverse in the same period and jurisdiction and are of the same character as the temporary differences that gave rise to the deferred tax assets;
- Quantify the projected taxable income and the time periods over which it will be required to be generated for you to fully utilize your deferred tax assets;
- Describe the nature of any tax planning strategies, including any uncertainties, risks, and assumptions associated with those strategies;
- Discuss all the positive and negative evidence you considered and how such evidence was weighted; and
- Discuss any other significant estimates and assumptions used in your analysis.
Please refer to ASC 740-10-30-16 [through] 30-25, ASC 740-10-55-39 [through] 55-48, and ASC 740-10- 55-120 [through] 55-123 for guidance.
Please consider expanding your disclosure to provide a more comprehensive discussion and analysis of the specific positive and negative evidence you considered in determining the realizability of the material components of your deferred tax assets. In this regard, we note the Company is in a cumulative three year net loss position at the [fiscal year-end]. Please tell us how you concluded that no significant valuation allowance was needed.
We note your disclosure that due to cumulative previous losses incurred by the Company, the Company is unable to conclude it is more likely than not to realize its deferred tax asset in excess of the deferred tax liability and accordingly, the Company has recorded a full valuation allowance as of [the end of fiscal year 1] and [the end of the second quarter of fiscal year 2]. We also note you have recorded net income for [fiscal year 1] and [the first two quarters of fiscal year 2]. Please ensure you consider all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance for deferred tax assets is needed. Refer to ASC 740-10-30-16 through 30-25 for guidance. Additionally, please revise future filings to discuss the factors that impact your estimates and judgment regarding the realizability of your deferred tax asset and the measurement of your valuation allowance. Refer to ASC 740-10-50-21 for guidance.

ASC 740-10-30-5(e) requires entities to reduce deferred tax assets (DTAs) 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 [DTAs] will not be realized. The valuation allowance shall be sufficient to reduce the [DTA] to the amount that is more likely than not to be realized.” ASC 740-10-30-16 through 30-25 provide additional guidance. In light of this guidance, the SEC staff has commented when registrants’ filings indicate that no valuation allowance has been recorded, when it seems that the valuation allowance recorded is insufficient, or when a valuation allowance has been recorded but there is evidence to suggest that an allowance is not needed. More recently, the staff has asked registrants about reversals of, or other changes in, their valuation allowance, particularly when registrants reverse only a portion of their valuation allowance.

The SEC staff has reminded registrants that in assessing the realizability of DTAs, they should consider cumulative losses in recent years to be significant negative evidence and that to avoid recognizing a valuation allowance, they would need to overcome such evidence with significant objective and verifiable positive evidence.

The SEC staff has indicated that factors for registrants to consider in making a determination about whether they should reverse a previously recognized valuation allowance would include:

The magnitude and duration of past losses.
The magnitude and duration of current profitability.
Changes in the above two factors that drove losses in the past and those currently driving profitability.

Further, the SEC staff has noted that registrants should bear in mind that the goal of the assessment is to determine whether sufficient positive evidence outweighs existing negative evidence. The staff has emphasized the importance of evidence that is objectively verifiable and has noted that such evidence carries more weight than evidence that is not. In addition, registrants should (1) assess the sustainability of profits in jurisdictions in which an entity was previously in a cumulative loss position and (2) consider their track record of accurately forecasting future financial results. Doubts about the sustainability of profitability in a period of economic uncertainty may give rise to evidence that would carry less weight in a valuation allowance assessment. Similarly, a registrant’s poor track record of accurately forecasting future results would result in future profit projections that may be very uncertain and should carry less weight in the overall assessment.

The SEC staff has also pointed out that registrants’ disclosures should include a discussion of the specific factors or reasons that led to a reversal of a valuation allowance to effectively answer the question, why now? Such disclosures would include a comprehensive analysis of all available positive and negative evidence and how the registrant weighed each piece of evidence in its assessment. In addition, the staff has reminded registrants that the same disclosures would be expected when there is significant negative evidence and a registrant concludes that a valuation allowance is necessary.

2.12.2 Income Tax Rate (Including Rate Reconciliation and Effective Tax Rate)

Examples of SEC Comments

We note that there have been significant changes in your effective tax rate in recent periods. Specifically, the effective rate was [A]% for [year 1], [B]% for [year 2], and [C]% for the [first through third quarters of year 3]. There appear to be multiple factors contributing to these fluctuations which include foreign losses in [Country X] with no tax benefits, tax benefits on the repatriation of foreign earnings, additional tax expense related to an underaccrual and tax expense on a settlement with [foreign] tax authorities. Please address the following:
- In your discussion of the effective tax rate, please quantify the extent to which each significant factor contributed to the fluctuation in the effective tax rate from period to period;
- Please help us better understand the nature of the additional expense recorded related to the underaccrual of tax expense and in a settlement with [foreign] authorities, including what periods the underaccrual and settlement relate to and the extent to which these factors impact the effective tax rate; and
- Please help us better understand why you are generating tax benefits rather than incurring tax expense on the repatriation of foreign earnings pursuant to ASC 740.
Please provide us with a breakdown of the tax differential and non-deductible expense line items included in the effective tax rate reconciliation and tell us what consideration you gave to Rule 4-08(h)(2) of Regulation S-X to provide a further quantitative breakdown of such amounts. Also, considering the significant changes in the effective tax rate, please tell us what consideration you gave to providing an expanded discussion of the factors that impacted your tax provision. In this regard, we note the disclosures . . . only address the impact for the change in the valuation allowance and not the changes in the line items noted herein.
We note from your tax rate reconciliation . . . that foreign income taxed at lower rates significantly impacted your effective tax rates in each of the reported periods. Please revise future filings to provide greater insight into the nature of this reconciling item, including the primary taxing jurisdictions where your foreign earnings are derived and the relevant statutory rates in those jurisdictions. Disclose any incentivized tax rates you have been granted and briefly describe the factual circumstances of any tax holidays, the per share effects of the tax holiday, and the date upon which any special tax status terminates. Refer to ASC 740-10-50-12 and SAB Topic 11.C.
Please tell us each of the individual components of the [X]% and [Y]% benefits in your “other, net” reconciling item in your rate reconciliations for [year 2] and [year 1], respectively.
Revise your discussions of income taxes in this note and in MD&A in future filings to disclose the estimated annual effective tax rate used in computing your year-to-date provision for income taxes. Refer to ASC 740-270-25 and ASC 740-270-50.
Please disclose a reconciliation using percentages or dollar amounts of the reported amount of income tax expense attributable to continuing operations for the year to the amount of income tax expense that would result from applying domestic federal statutory tax rates. Refer to ASC 740-10-50-12.

Registrants often pay income taxes in multiple jurisdictions other than the domestic federal jurisdiction (e.g., domestic state and local jurisdictions, foreign federal and foreign local or provincial jurisdictions), and the applicable income tax rates vary in each jurisdiction and therefore affect the registrant’s effective tax rate. Further, tax laws often differ from financial accounting standards; therefore, permanent differences can arise between pretax income for financial reporting purposes and taxable income. Although such differences are not uncommon, the SEC staff often requests that registrants provide greater transparency into the underlying reasons for differences between the federal statutory rate and the registrant’s effective tax rate. The staff may also request additional details about events that gave rise to a significant change in a registrant’s effective tax rate as compared with prior periods.

One tax-rate-related disclosure requirement that has received increased scrutiny in recent years is the obligation to provide a rate reconciliation in annual filings. In accordance with ASC 740 and Regulation S-X, Rule 4-08(h)(2), registrants must disclose, by using percentages or dollar amounts, a reconciliation of income tax expense or benefit attributable to continuing operations to the amount that would have resulted from applying domestic federal statutory tax rates (the regular rates, not the alternative minimum tax rates) to pretax income from continuing operations.

In addition, registrants should disclose the estimated amount and the nature of each significant reconciling item. ASC 740-10-50 does not define “significant.” However, Rule 4-08(h)(2) states that public entities should disclose (on an individual basis) all reconciling items that constitute 5 percent or more of the computed amount (i.e., income before tax multiplied by the applicable domestic federal statutory tax rate). Reconciling items may be aggregated in the disclosure if they are individually less than 5 percent of the computed amount.

The SEC staff has noted the following issues related to registrants’ tax rate reconciliation disclosures:

Labels related to reconciling items were unclear, and disclosures about material reconciling items did not adequately describe the underlying nature of these items.
For material reconciling items related to foreign tax jurisdictions, registrants did not disclose in MD&A (1) each material foreign jurisdiction and its tax rate and (2) how each jurisdiction affects the amount in the tax rate reconciliation.
Registrants have inappropriately aggregated material reconciling items that are greater than 5 percent of the amount they calculated by multiplying the pretax income by the statutory tax rate.
Amounts reflected in the tax rate reconciliation were inconsistent with related amounts disclosed elsewhere in a registrant’s filing.
Corrections of errors were inappropriately reflected as changes in estimates.

Further, in past speeches, the SEC staff has remarked that registrants (1) continue to use boilerplate language in the tax rate reconciliation that does not describe the components shown and (2) would provide more meaningful information to investors if they explain why certain events that affected the effective tax rate occurred and how those events will affect the tax rate going forward. The staff has also noted that when the “foreign rate differential” and other components of the tax rate reconciliation are not easily understood or transparent, registrants might consider preparing the tax rate reconciliation on a disaggregated basis (e.g., by country) in a tabular format.

2.12.3 Transaction-Specific Disclosures

Examples of SEC Comments

You disclose that the $[X] million intangible asset recorded as of [the end of the first quarter] includes $[X] million of costs capitalized to record an offset to a deferred tax liability related to the exercise of your option to acquire an exclusive license from [Entity Y] related to patent rights and know-how to develop and commercialize compounds and products for [Item Z]. You also disclose . . . that this deferred tax liability was created when [Y] sold its license and know-how to you for stock in a transaction under Section 351 of the Internal Revenue Code (Section 351 transaction) which treats the acquisition of the license and know-how as a tax-free exchange. Please provide us with a detailed analysis explaining how you determined that this transaction met the requirements to be considered a tax-free exchange under Section 351. In this regard, it would appear that under Section 351 an exchange would be considered tax free if (a) the property was exchanged solely for stock of the company and (b) immediately after the exchange the transferor controlled the company via 80% or more ownership of voting stock. Based on your beneficial ownership table on . . . your Form S-1 filed [one month after the end of the second quarter], it appears that [Y] owns only [X]% of your outstanding shares.
We note that in the third quarter . . . , you released approximately $[X] million of valuation allowance related to the [Country A] deferred tax assets you acquired in connection with your purchase of [Entity M]. We also understand that you finalized your purchase price allocation as of [the end of the third quarter]. Please tell us the facts and circumstances that led to the release of your valuation allowance and your consideration of ASC 805-740-45-2 in determining whether to record the change in valuation allowance to income tax expense or as an adjustment to goodwill during the measurement period.
Please describe the nature of the foreign tax restructuring in [year 1] that gave rise to the $[X] million in deferred tax assets and revise your disclosures to describe the restructuring. Also, confirm whether these are the same deferred tax assets of your [foreign] subsidiary . . . that would give rise to an income tax benefit in excess of $[Y] million if the valuation allowance were released. If they are the same, revise your disclosures to clarify.
[Y]ou disclose that the deferred tax liability associated with the in-process research and development intangible asset from your acquisition of [Company A] is not considered positive evidence of future income in part because it is an indefinite-lived intangible asset. Please tell us why you did not record some income tax benefit outside acquisition accounting under ASC 805-740-30-3 associated with any net operating loss generated in [year 1]. In this regard, we note that net operating losses since the enactment of the Tax Cuts and Jobs Act do not expire. In your response, tell us the amount of net operating loss generated in [year 1].
You disclose . . . that your effective tax rate in [year 2] includes tax benefits from taxable losses arising from Hurricanes Irma, Harvey and Maria. Please tell us how the tax benefits from these catastrophes impact your effective tax rate in [year 2] and reference for us the authoritative literature you rely upon to support your position. In this regard, it appears that these events contributed to pre-tax income in [year 2] being less than that in [year 1], but it also appears that any differences between tax deductions taken on your return in [year 2] and your GAAP loss reserves associated with these catastrophes would be temporary differences that do not impact your overall effective tax rate.

ASC 740-10-50-14 requires all entities to “disclose the nature and effect of any other significant matters affecting comparability of information for all periods presented.” In accordance with this requirement, the SEC staff has reminded registrants that it is looking for disclosures that help the reader understand the company’s big-picture tax situation, including the tax effects of any significant or unusual events that took place during the period (e.g., significant restructuring activities, acquisitions, divestitures, or intercompany transfers). When disclosing information about these transactions, registrants should provide detailed descriptions of the events and clear explanations of how those events affected income taxes during the period and may affect income taxes in future periods. Registrants with such transactions should consider disclosing the following:

Whether temporary or permanent differences were created as a result of the transactions.
The accounting impact of the temporary or permanent differences created.
The expected impact of the transactions on the effective tax rate in future periods.
The actual or expected impact on the registrants’ assertions related to indefinitely reinvested foreign earnings, if the transactions involved foreign entities.
The actual or expected impact on the registrants’ conclusions with respect to the realizability of DTAs and the need for a valuation allowance.

2.12.4 Noncompliance With Disclosure Requirements

Examples of SEC Comments

Please tell us and revise to disclose the components of income (loss) before income tax expense (benefit) as either domestic or foreign, if material. See Rule 4-08(h) of Regulation S-X.
Please tell us your consideration for disclosing the cumulative amount of undistributed foreign earnings that are considered indefinitely reinvested in accordance with ASC 740-30-50-2 in light of your disclosure that you intend to indefinitely reinvest your undistributed foreign earnings.
We note that the line item “other impact of foreign operations” in your effective tax rate reconciliation has grown significantly. To the extent any of the items in this amount exceed the 5% disclosure threshold in Rule 4-08(h)(2) of Regulation S-X, please revise to disclose these amounts separately.
[T]ell us your consideration for disclosing those items that account for more than 1.05 percentage points of your effective tax rate in [year 2] and 1.75 percentage points in [year 1] as stipulated in Rule 4-08(h)(2) of Regulation S-X.
We note the reversal of $[X] million of your tax reserves primarily due to the settlement of an audit of your fiscal [year 1] through [year 3] federal corporate income tax returns. We also note your disclosure in prior filings that in [year 10], a preliminary understanding was reached with the IRS regarding the contested issues for the audit and post-audit years. Please tell us and disclose in more detail the reason for the significant change in amounts from the preliminary understanding to the final settlement.
We note that you are currently litigating a tax matter with the [foreign] tax authority. Considering the potential significance, please tell us why you have not included a discussion of this matter in your financial statement footnotes disclosures or revise accordingly. We refer you to ASC 740-10-50-15(d).

As demonstrated in the sample comments above, registrants can expect to receive comments from the SEC staff when (1) required disclosures have been omitted, (2) registrants do not fully comply with the various disclosure requirements, and (3) amounts and descriptions of events are inconsistent with disclosures elsewhere in the report. Registrants should carefully review the numerous disclosures required by U.S. GAAP and SEC Regulations S-K and S-X to ensure that disclosures in the footnotes and in MD&A are complete and accurate. Recent comments have raised the following issues:

Omission of required disclosures (e.g., components of income [loss] before income tax expense [benefit] as either domestic or foreign).
Limited or missing description of the income tax effects of any of the following:
- An accounting change or error, including amounts and classification within the financial statements.
- The adoption of an accounting standard.
- Tax elections, tax receivable agreements, and tax holidays.
- Unrecognized tax benefits (UTBs) when it is reasonably possible that the total amounts of UTBs will significantly increase or decrease within 12 months of the reporting date.
Use of inappropriate non-GAAP measures related to income taxes.
Unclear line-item descriptions in the financial statements or in disclosures (e.g., generic titles in the rate reconciliation).
Amounts in disclosures that do not reconcile to amounts presented in the financial statements or disclosed elsewhere in the report.
Limited discussion in MD&A of matters related to income taxes.

Other Deloitte Resources

Roadmap, Income Taxes