IT2013_1069_CH12_v2_P1_7-22

Chapter 12:

Intraperiod Tax Allocation

Chapter Summary

ASC 740 provides rules for allocating the total tax expense (or benefit) for the year among the various financial statement components, including components of net income (e.g., continuing operations, discontinued operations, and extraordinary items), components of comprehensive income that are excluded from net income, and other items reflected directly in contributed capital or retained earnings. This process of allocation is referred to in ASC 740 as “intraperiod allocation.” In this chapter, we discuss the accounting model for intraperiod allocation and some of the intricacies in the model’s application.






12.1 Level of Application

While ASC 740 does not explicitly state the level of application of the intraperiod allocation rules, implicitly those allocation rules should be applied at the jurisdictional level when only one return is filed within a jurisdiction, and at the tax-return level when more than one tax return is filed within a jurisdiction (e.g., where a consolidated tax return is not filed).


12.2 The Basic Model

Although ASC 740 outlines the basic model for intraperiod allocation in only a few paragraphs (primarily ASC 740-20-45-1 through 45-14), application of the guidance can be complex and counterintuitive. When ASC 740 does not specifically allocate all or a portion of the total tax expense to a specific financial statement component or components, it allocates taxes based on what often is referred to as the “with-and-without” or “incremental” approach. This basic approach can be summarized in the following three steps:

Step 1: Compute the total tax expense or benefit (both current and deferred) for the period.

Step 2: Compute the tax effect of pretax income or loss from continuing operations, without consideration of the current-year pretax income from other financial statement components, plus or minus the tax effects of the items (as listed in Section TX 12.2.2.2) that ASC 740 specifically allocates to continuing operations.

Step 3: Allocate among the other financial statement components, in accordance with the guidance in ASC 740-20-45-12 through 45-14, the portion of total tax that remains after allocation of tax to continuing operations [the difference between the total tax expense (computed in Step 1) and the amount allocated to continuing operations (computed in Step 2)].1

1 If there is more than one financial statement component other than continuing operations, the allocation is made on a pro rata basis in accordance with each component’s incremental tax effects. See Section TX 12.2.3 for a discussion of the application of ASC 740-20-45-14.

12.2.1 Step 1: Compute Total Tax Expense or Benefit

The first step in the intraperiod allocation process is to compute the total tax expense or benefit (both current and deferred) recognized in the financial statements. This includes the tax effects of all sources of income (or loss)—that is, the tax effects attributable to continuing operations, discontinued operations, extraordinary items, items of other comprehensive income, certain changes in accounting principles, and the effects of valuation allowance changes. The only exceptions relate to (1) certain changes within the measurement period for a business combination that affect recognition of acquired tax benefits (ASC 805-740-45-2), (2) tax effects allocated to additional paid-in capital when applying the exception to the basic approach to allocating a change in valuation allowance that is outlined in ASC 740-20-45-3, and (3) the additional exception related to certain quasi reorganizations articulated in ASC 852-740-45-3.

12.2.2 Step 2: Compute Tax Attributable to Continuing Operations

12.2.2.1 Tax Effect of Current-Year Income from Pretax Continuing Operations

Computing the tax effects to be allocated to continuing operations begins with the quantification of the tax effect for the year for continuing operations without consideration of the tax effects (both current and deferred) of current-year income from all other financial statement components.

Some examples of computing the tax effect of current-year income from pretax continuing operations using the basic model for intraperiod allocation appear below:

Example 12-1: ASC 740-20-55-14

ASC 740-20-45-7 discusses allocation to continuing operations and ASC 740-20-55-14 provides an example of the with-and-without or incremental approach. The facts from that example and some additional discussion follow.

Background/Facts:

Assume that in 20X6 an entity has $1,000 of income from continuing operations and a $1,000 loss from discontinued operations. At the beginning of the year, the entity has a $2,000 net operating loss carryforward for which the deferred tax asset, net of its valuation allowance, is zero, and the entity did not reduce that valuation allowance during the year.

Question:

How should the tax provision for 20X6 be allocated between continuing operations and discontinued operations?

Analysis/Conclusion:

In this instance, no tax expense would be allocated to continuing operations because of the availability of the loss carryforward at the beginning of the year. The tax effect on pretax continuing operations is computed before the tax effects of other financial statement components (in this case, before consideration of the loss from discontinued operations). Because a carryforward loss from the prior year was available for utilization, and there was income from continuing operations available to realize that carryforward, income from continuing operations is considered to “realize” the previously unrecognized net operating loss carryforward.

This result was arrived at in the following manner:


As can be seen in the example above, the intraperiod allocation rules cause the entity to allocate tax effects as if $1,000 of NOL carryforward was utilized against the income from continuing operations rather than offsetting the taxable income from continuing operations with the current-year loss from discontinued operations. As a result, the loss from discontinued operations is treated as restoring the NOL carryforward. But, because the entity maintains a full valuation allowance, no tax benefit is recorded in discontinued operations for the loss carryforward.

Example 12-2: ASC 740-20-55-14 Fact Pattern Without NOL Carryforward

Background/Facts:

Assume the same facts as those in Example 12-1, above, except that there is no NOL carryforward.

Analysis/Conclusion:

Intraperiod allocation would be performed in the following manner:


As a result of the application of the incremental approach, tax of $400 was allocated to continuing operations (the tax on the $1,000 of income) even though the $1,000 current-year loss from discontinued operations would serve to offset the $1,000 of income from continuing operations. The difference between the total tax expense of zero and the tax expense of $400 attributable to continuing operations is a $400 tax benefit. This $400 tax benefit is allocated to discontinued operations.


The tax effect of current-year income from pretax continuing operations should consider all of the information available at the end of the reporting period, adjusted to ignore the tax effects (both balance sheet and income statement) of the current-period income or loss from financial statement components other than continuing operations. Thus, to the extent that pretax income or loss from financial statement components other than continuing operations causes a change in a deferred tax balance or in taxes payable for the current period, these effects should be disregarded when determining the amount to be allocated to continuing operations. Example 12-3 illustrates one instance of how this would be applied.

Example 12-3: Computing the Tax Effect Attributable to Pretax Continuing Operations

Assume the following:

Company A, a calendar-year company, in recent years has recognized unrealized losses for “other than temporary impairments” (OTTI) of available-for-sale (AFS) securities within its investment portfolio. Because these unrealized losses are not currently deductible, the current-year, mark-to-market adjustment (recorded as a current-year pretax loss in income from continuing operations) has created a deductible temporary difference (DTD) that happens to be capital in character. In the United States, capital losses can be used to offset only capital gain income. Excess capital losses may be carried back three years and forward five years. Company A has evaluated the positive and negative evidence related to investments of a capital nature within its portfolio and concluded that it cannot consider projections of future capital gains that could support the realization of those DTAs.

The pretax result from continuing operations was breakeven in 20X6 except for a current-year loss of $150,000 attributable to additional OTTI recorded in 20X6. In addition, as a result of a worsening economy during the year, $250,000 of unrealized gains on other AFS securities held by Company A lost all of their prior net appreciation. This market value decline was considered to be temporary and, as a result, the $250,000 pretax loss was recognized in other comprehensive income.

At both December 31, 20X5 and 20X6, Company A has $200,000 of capital gains available in the carryback period. Based on the facts and circumstances, Company A would be willing to sell its OTTI securities in order to support the recognition of the deductible temporary differences that are capital in nature.

At December 31, 20X5, Company A has a deductible temporary difference of $275,000 related to OTTI and a taxable temporary difference (TTD) of $250,000 related to appreciated AFS securities. The deferred tax components for 20X5 and 20X6 appear below:


At December 31, 20X5, no valuation allowance was recorded because Company A has sufficient capital gain income of $450,000 (available from the sale of appreciated AFS securities of $250,000 plus capital gains available in the carryback period of $200,000) to allow for the realization of the DTD attributable to OTTI of $275,000. At December 31, 20X6, however, only the $200,000 of carryback potential is available. Thus, $225,000 of DTDs (or $90,000 tax-effected at 40 percent) will need a valuation allowance.

Intraperiod allocation would be performed as follows:



Following the incremental approach, the entire $90,000 valuation allowance recorded during the year was allocated to other comprehensive income (OCI) because, absent the current-year pretax loss on the AFS securities reported in OCI, no valuation allowance would have been required (that is, the DTDs associated with the $150,000 OTTI loss recognized in 20X6 would have been fully recoverable based on continuing operations, if there had been no change in the pretax carrying value of AFS securities). In this example, the valuation allowance was required because the pretax loss in AFS securities during the year was responsible for the reversal of the taxable temporary difference that existed at the beginning of the year and that served as a source of income for the realization of the existing deferred tax asset.

12.2.2.2 Other Items Specifically Allocated to Continuing Operations

In addition to the tax effect of the current-year income from pretax continuing operations, ASC 740 specifically requires certain components of total income tax expense or benefit for the year to be included in the tax provision/(benefit) from continuing operations. Such components include:


12.2.2.2.1 Changes in Tax Laws or an Entity’s Tax Status

Adjustments to deferred tax balances are necessary when tax laws or rates change (ASC 740-10-35-4) or an entity’s tax status changes (ASC 740-10-25-32 and ASC 740-10-40-6). All such deferred tax adjustments, including those elements of deferred tax that relate to items originally reported in other financial statement components (such as OCI), are required to be reflected entirely in continuing operations.

When a change in tax law is enacted with retroactive effect, ASC 740-10-25-48 and ASC 740-10-45-16 specify that the tax effects (current as well as deferred) of items excluded from income from continuing operations arising during the current year, but prior to the date of enactment, should be adjusted to reflect the rate change as of the enactment date, with the adjustment also reflected in income from continuing operations.

For a more detailed discussion on these topics, see Chapter TX 7 for changes in tax laws or rates and Chapter TX 8 for changes in tax status.

12.2.2.2.2 Change in Indefinite Reversal Assertion for Foreign Subsidiary

The tax effects that result from a change in an entity’s assertion about its intent to indefinitely reinvest prior undistributed earnings of foreign subsidiaries or foreign corporate joint ventures that are permanent in duration should be reported in continuing operations in the period in which the change in assertion occurs. Thus, if a company concluded that it could no longer assert that it would indefinitely reinvest its prior-years’ undistributed foreign earnings, it would not be appropriate to “backwards trace” the accrual of the tax consequences of the previously accumulated foreign currency translation adjustments within OCI—even if that is where the amounts would have been allocated if the company had never asserted indefinite reinvestment of those earnings in those prior periods. It should be noted, however, that the tax effects on currency translation adjustments (CTA) arising in the current year are subject to the rules of ASC 740-20-45-11(b). That paragraph states that the tax effects of gains and losses included in OCI, but excluded from net income, that occur during the year should be charged or credited directly to OCI. As a result, it is important to distinguish the tax effects of the change in assertion between current-year and prior-years’ items.

Example 12-4: Change in Indefinite Reinvestment Assertion

Background/Facts:

Company Y has a profitable foreign subsidiary, Subsidiary S, with $900 of outside basis difference (i.e., book net assets of Subsidiary S in Company Y’s consolidation over Company Y’s tax basis in its shares of Subsidiary S) as of December 31, 20X5, that meets the indefinite reinvestment criteria of ASC 740-30-25-17. Accordingly, as of that date, Company Y had not recorded a deferred tax liability related to the potential reversal (e.g., repatriation of unremitted earnings) of this difference. Subsidiary S’s functional currency is its local currency; thus, translation adjustments that result from translating Subsidiary S’s financial statements into Company Y’s reporting currency (U.S. dollars) are reported in OCI. At December 31, 20X5, $180 of the $900 outside basis difference arose from cumulative net CTA gains reported in OCI.

During the second quarter of 20X6, because of increased liquidity needs in the United States, Company Y no longer intends to indefinitely reinvest its accumulated foreign earnings. As a result of this change in circumstances, the exemption in ASC 740-30-25-17 from providing deferred taxes is no longer available with respect to Company Y’s book-over-tax basis difference in Subsidiary S.

During the first six months of 20X6, pretax income from continuing operations is zero, and exchange rate movements result in a pretax gain of $120 reported in OCI. As a result, the accumulated CTA balance at June 30, 20X6, prior to recording any deferred tax liability, is a credit of $300.

Analysis/Conclusion:

During the second quarter of 20X6, Company Y should record an income tax liability on the entire $1,020 outside basis difference at June 30, 20X6. Of this amount, the tax liability associated with the portion of the outside basis difference that arose in prior years, $900 in this case, would be allocated to continuing operations as a current-period expense, and the tax liability associated with current-year-to-date CTA movement of $120 would be allocated to OCI.

12.2.2.2.3 Changes in the Valuation Allowance

12.2.2.2.3.1 General Rules

ASC 740-10-45-20 discusses the proper intraperiod allocation for changes in valuation allowances. In addition, ASC 740-20-45-3, and ASC 740-10-55-38 set forth various rules for allocation of the benefits of previously-unrecognized losses and loss carryforwards.2

2 We believe that those rules also apply to deductible temporary differences for which tax benefit has not yet been recognized (i.e., in cases where a valuation allowance has been provided against the related deferred tax asset from its inception).

Under these rules, the intraperiod allocation depends on whether the benefit of the loss or deduction is recognized or realized in the year in which it is generated and whether the income to allow for the realization of the loss relates to the current year or future years.

These rules can be summarized as follows:

When there is an increase or decrease in the valuation allowance applicable to beginning-of-year deferred tax assets that results from changes in circumstances which cause the assessment of the likelihood of realization of these assets by income in future years to change, the effect is reflected in continuing operations. This is true except for the initial recognition of source-of-loss items, as discussed in Section TX 12.2.2.2.3.2.

When income in the current year allows for the release of a valuation allowance, the resulting benefit is allocated to the current-year component of income that allows for its recognition (except for the initial recognition of source-of-loss items).

When the tax benefit of a loss in the current year is recognized, it is allocated to the component that generated the loss regardless of the financial statement source of the taxable income that allows for its recognition. This principle is the same whether the source of income is (a) taxable income in the current year, (b) taxable income in a prior year to which the current-year loss can be carried back, or (c) taxable income that is expected to occur in future years.

A question may arise with respect to the allocation of a previously unrecognized tax benefit that could be recognized in the current year based on either (1) changes in estimates about future taxable income (which would allocate the benefit to continuing operations) or (2) a component of income in the current year other than continuing operations. Because the determination of tax allocated to continuing operations is made first (“primacy of continuing operations”) and because we generally would regard all income from projections of taxable income in future years to be attributed to continuing operations, valuation allowance changes usually are recorded in continuing operations. In making this determination, we believe that changes in judgment regarding the projections of future-year income should be attributed to continuing operations, even when the change in estimate about the future is affected by another financial statement component.

Some examples of these general rules for the recording of changes in valuation allowance follow.

Example 12-5: Change in Valuation Allowance on Beginning-of-Year DTAs Resulting from Changes in Projections of Income in Future Years

Background/Facts:

In 20X6 an entity has $1,000 of pretax income from continuing operations and $500 of pretax income from discontinued operations. At the beginning of the year, the entity has a $2,000 net operating loss carryforward (which was generated in prior years by what are now discontinued operations) that has been reflected as a deferred tax asset of $800 less a valuation allowance of $800 (i.e., no net DTA has been recognized). At year-end 20X6, based on the weight of available evidence, management concludes that the ending DTA is realizable based on projections of future taxable income in excess of $1,000. The statutory tax rate for all years is 40 percent.

Question:

How should the tax provision for 20X6 be allocated between continuing operations and discontinued operations?

Analysis/Conclusion:

Intraperiod allocation would be performed in the following manner:



Because the entire deferred tax asset could be supported by the current-year income from continuing operations and by projections of future income, none of the valuation allowance release has been allocated to discontinued operations.

Example 12-6: Example of Decreases in Valuation Allowance Resulting from Current-Year Income

Background/Facts:

At December 31, 20X6, Company A has a net deferred tax asset (DTA) of $1,000 including a DTA for net operating loss carryforwards of $1,200 and a deferred tax liability (DTL) for the excess of book basis over tax basis in fixed assets of $200. Because of the existence of significant negative evidence at December 31, 20X6, and the lack of positive evidence of sufficient quality and quantity to overcome the negative evidence, a full valuation allowance was recorded against this $1,000 net DTA. During 20X7, Company A generated pretax income from continuing operations of $100 and pretax income from discontinued operations of $800. Assume a tax rate of 40 percent. At December 31, 20X7, based on the weight of available evidence, a full valuation allowance on the existing deferred tax asset of $640 [$1,000 of beginning-of-year DTA less $360 (40% of the sum of pretax income from both continuing and discontinued operations of $900)] was still required.

Question:

What is the intraperiod allocation of the valuation allowance release of $360 that resulted from the current-year realization of net deferred tax assets?

Analysis/Conclusion:

Intraperiod allocation would be performed in the following manner:



Example 12-7: Example of a Current-Year Loss That Is Recognized in the Year It Was Generated

Background/Facts:

Company A has pretax income from continuing operations of $10,000 and a pretax loss of $20,000 from discontinued operations for the year-ended December 31, 20X6. Company A historically has been profitable and has $5,000 of taxable income available in prior periods to which current-year losses could be carried back. Company A has concluded that no valuation allowance is required at December 31, 20X6, based on projections of future taxable income. The tax rate is 40% for all years.

Question:

How should the current-year tax benefit of $4,000 ($10,000 loss x 40%) be allocated between continuing operations and discontinued operations?

Analysis/Conclusion:

Intraperiod allocation would be performed as follows:



Note: Of the $8,000 tax benefit recorded in discontinued operations, $2,000 is realizable through a carryback of current-year losses to prior years ($5,000 of carryback capacity at a 40 percent tax rate), $4,000 is realized by current-year income from continuing operations ($10,000 at 40 percent), and a $2,000 deferred tax asset relating to net operating loss carryforwards ($5,000 at 40 percent) is supported by projections of future taxable income. Because no valuation allowance is required (and thus the entire benefit of the current-year loss is recognized in the year it was generated), the benefit of the loss is allocated to the component that gave rise to the loss which, in this case, is discontinued operations.

12.2.2.2.3.2 Source-of-Loss Items

The initial recognition, regardless of when it occurs, of the tax benefits of certain deductible differences and carryforwards is classified on the basis of the source of loss that generates them rather than on the basis of the source of income that utilizes, or is expected to utilize them.


The initial recognition of tax benefits for the items listed below should be allocated directly to the related components of shareholders’ equity regardless of the source of income that allows for their realization:

Increases or decreases to contributed capital

Certain deductions for employee stock options recognized differently for financial reporting and tax purposes (see further discussion of the treatment of stock-based compensation in Chapter TX18). We also believe that the tax effects of favorable and unfavorable adjustments relating to such deductions resulting from changes in assessments of uncertain tax positions should be recorded in equity (see Section TX 16.9 for a discussion on intraperiod allocation and liabilities for unrecognized tax benefits)

Tax-deductible dividends on unallocated shares held by an ESOP (such dividends are charged to retained earnings)

Deductible temporary differences and carryforwards that existed at the date of a quasi reorganization3

3 A quasi reorganization is a voluntary accounting procedure by which a company with an accumulated retained earnings deficit adjusts its accounts to obtain a “fresh start.”


Example 12-8: Application of the Source-of-Loss Rule

Background/Facts:

Assume that in 20X6 an entity has $1,000 of income from continuing operations. The applicable tax rate is 40 percent. The entity has a net operating loss carryforward of $1,250 relating to deductible expenditures reported in contributed capital, resulting in a beginning-of-year deferred tax asset of $500 ($1,250 x 40%). This $500 deferred tax asset (DTA) has a full valuation allowance recorded against it that was established at the date of a capital-raising transaction and was not subsequently reduced (making the acquired DTA a source-of-loss item). It is concluded that a full valuation allowance also is required at year-end. There are no permanent or temporary differences (either current year or cumulative) other than the net operating loss carryforward noted above.

Question:

How should tax expense/benefit be allocated?

Analysis/Conclusion:

Given the facts, the total tax expense would be zero (the tax effect of the $1,000 pretax income at a 40 percent statutory tax rate would be offset by the reversal of $400 of the $500 valuation allowance that had been recorded on the carryforward DTA). Because the tax benefit was initially recognized after the period in which it was generated (by means of utilizing $1,000 of the carryforward to offset the pretax income of $1,000), the reversal of the valuation allowance should be backward traced to equity, consistent with ASC 740-10-45-3 and ASC 740-20-45-11(c).

As a result, the entry to allocate tax for the year would be as follows:


12.2.2.2.3.3 Determining Which Deferred Tax Asset Was Realized in Order to Source the Release of a Valuation Allowance

The general rules for allocating the effects of changes in valuation allowances discussed at Section TX 12.2.2.2.3.1 apply to most changes in valuation allowances. However, because of the source-of-loss exceptions for the initial recognition of certain tax benefits and because a deductible temporary difference may reverse and be utilized on a tax return but be replaced with another deductible temporary difference within the same year (thus not realizing a tax benefit), the determination of which carryforward or deductible temporary difference produced a realized tax benefit during the year may become important when applying the intraperiod allocation rules. This subsection explores the ordering rules that should be applied when addressing the question, “Which deferred tax asset produced a recognizable tax benefit?”

Recognition of a Tax Benefit for Carryforwards and Other Deductible Temporary Differences (ASC 740-10-55-37)

When there are both DTAs at the beginning of the year and DTAs arising in the current year from sources other than continuing operations, a change in the valuation allowance must be “sourced” to the assets that gave rise to the change.

In determining whether the reversal of a particular deductible temporary difference or carryforward provided a benefit, one must consider the interaction of originating temporary differences with loss and other carryforwards. Just because a net operating loss carryforward was utilized (used on the tax return), it does not mean that a benefit was realized (provided incremental cash tax savings). ASC 740-10-55-37 indicates that the reversal of a DTD as a deduction or through the use of a carryforward does not constitute realization when reversal or utilization resulted because of the origination of a new DTD. This is because the DTA that has been utilized has simply been replaced by the originating DTA without providing for realization. Accordingly, ASC 740-10-55-37 indicates that the “source” of the benefit of the originating DTD would not be the component of income in which the originating DTD arose; rather, it would take on the source of the deduction or carryforward that it replaced.

The specific example in ASC 740-10-55-37 refers only to deferred revenue, but the reference to ASC 740-20-45-3 makes it clear that the same rationale applies when an origination or increase of a DTD during the year allows for the utilization of a deduction or carryforward which originated in equity (e.g., the tax benefit and related valuation allowance recorded in equity, consistent with ASC 740-20-45-11(c) through (f)).

Example 12-9: Application of ASC 740-10-55-37

On December 31, 20X5, Company X raised new capital from its investors. Company X has recorded a deferred tax asset related to a $2,000 loss carryforward arising from a large expenditure related to the capital-raising transaction, for which a full valuation allowance was also recognized and recorded in equity. In 20X6, Company X generated a pretax loss from continuing operations of $1,000. Included in this $1,000 loss was $3,000 of warranty reserve expense that is not deductible until paid for income tax purposes.


Even though the $2,000 net operating loss carryforward was utilized during the year, no realization of deferred tax assets occurred because the loss from pretax continuing operations only served to increase the net deferred tax asset (and related valuation allowance). As a result, while the $2,000 net operating loss carryforward was consumed on the tax return, it was not realized; rather, it was merely transformed into the deductible temporary difference for the warranty reserve. If Company X changed its assessment about the realizability of its deferred tax assets in 20X7 (assuming no originating or reversing temporary differences in 20X7), $2,000 of the $3,000 release would be allocated to equity in accordance with ASC 740-20-45-3 through 45-4.

Example 12-10: Effect of ASC 740-10-55-37 on Ordering

Deductible temporary differences that reverse and manifest themselves into an originating temporary difference (or an NOL carryforward) have not been realized. Instead, that portion of the originating temporary difference takes on the character of the reversing DTA. The following example demonstrates how ASC 740-10-55-37 can affect the ordering in intraperiod allocation.

Background/Facts:

Assume that an entity has the following taxable income:


Also Assume:

Coming into the year, there are no available carryforwards or income available in carryback years.

The DTD that is reversing was originally established in equity with a full valuation allowance of $1,000 against it. This valuation allowance has not been reduced subsequently.

The DTA at the end of the current year requires a full valuation allowance.

The statutory tax rate is 40 percent.

Analysis/Conclusion:

The total tax expense for the year is zero because there was no pretax income for the year ($1,000 income from continuing operations less $1,000 loss from discontinued operations), and the reversing equity-related DTDs created a taxable loss of $1,000 for which the related DTA requires a full valuation allowance.

ASC 740’s intraperiod allocation rules would allocate a tax expense of $400 to continuing operations and a tax benefit of $400 to discontinued operations. Even though the ordering rules generally would consider the reversal of the equity-related DTDs before the current-year loss from discontinued operations, no tax benefit is allocated to the reversing equity-related DTDs because the DTA that arose in equity has merely has been transformed into a DTA relating to an NOL carryforward. Said another way, while the equity-related DTDs reversed, they did not provide for incremental cash tax savings and thus were not realized.

Had the loss from discontinued operations in this example been $300, then $700 of the reversing equity-related DTDs would have been realized (resulting in incremental cash tax savings). As a result, the total tax expense of zero would be allocated as follows:


Applying the Intraperiod Allocation General Rule for Ordering to Stock-based Compensation

Under the general rule for ordering tax benefits, items included in continuing operations generally are considered to enter into tax computations before items included in other components. The tax deduction that corresponds to the recognized book compensation cost is accounted for in continuing operations under ASC 740. Complexities arise when considering the windfall tax benefit recorded in additional paid-in capital (APIC).

ASC 718-20-55-20 provides that the tax benefit and credit to APIC for a windfall tax benefit should not be recorded until the deduction reduces income taxes payable. In some cases, an entity may have current-year windfall tax benefits and NOL (or tax credit) carryforwards from earlier years, both of which are available to offset taxable income in the current year. In the U.S., the current-year stock compensation deduction (which would encompass the windfall tax benefit) would be used to offset taxable income before the NOL carryforwards because all current-year deductions take priority over NOL carryforwards in the tax return. For this situation, the ASC 718 Resource Group agreed that either of the following two approaches would be acceptable to determine the order in which tax attributes should be considered:

With-and-without approach: Follow the with-and-without intraperiod tax allocation approach as described in ASC 740-20-45-7, which would result in windfall tax benefits being utilized last. That is, a windfall benefit would be recognized in APIC only if an incremental benefit was provided after considering all other tax attributes presently available to the entity.

Tax law ordering approach: Apply the tax law. That is, allocate the benefit based on provisions in the tax law that identify the sequence in which those amounts are utilized for tax purposes.

An entity should treat its decision to adopt either approach as an accounting policy decision, which should be followed consistently. The table below provides a simplified illustration of the differences between the with-and-without and tax law ordering approaches for an entity with no valuation allowance (Company A) and an entity with a full valuation allowance (Company B).

Example 12-11: With-and-Without and Tax Law Ordering Approaches

Background/Facts:

The applicable tax rate is 40 percent in all periods.

Income taxes payable are zero at the beginning of the period.

Taxable income before the excess tax deduction for stock-based compensation is $700,000.

Current-year excess tax deduction for stock-based compensation is $200,000.

NOL carryforward from prior years’ operating losses is $1,000,000 (deferred tax asset of $400,000).

Analysis/Conclusion:

Company A: No Valuation Allowance

Following the with-and-without approach, windfall tax benefits are the last item to be utilized to offset taxable income. The NOL carryforward generated from operations in prior years is sufficient to offset current-year taxable income before consideration of windfall tax benefits. Therefore, the excess tax deduction for stock-based compensation does not reduce taxes payable, and Company A would not record a windfall tax benefit to APIC. The deferred tax asset would be reduced by $280,000 (the $700,000 of taxable income assumed to be offset by NOL carryforwards multiplied by the 40 percent tax rate). The windfall tax benefit of $80,000 ($200,000 excess tax deduction multiplied by the 40 percent tax rate) would not be recognized until such time as that deduction was deemed to produce a reduction in taxes payable. At this point, while the NOL carryforward has been reduced to $300,000 for book purposes, $500,000 of NOL carryforward remains on the return (on the tax return, the $200,000 stock-based compensation deduction reduces taxable income to $500,000 and only $500,000 of the NOL carryforward is used). The $200,000 difference must be tracked “off balance sheet” and, when it is utilized in subsequent periods, the reduction in taxes payable is credited to APIC.

Following the tax law ordering approach, the current-year excess tax deduction for stock-based compensation would be used to offset taxable income before utilization of the NOL carryforward. The excess tax deduction of $200,000 would reduce taxable income, and Company A would record the windfall tax benefit of $80,000 to APIC. In addition, the deferred tax asset would be reduced by $200,000 ($500,000 of NOL carryforward utilized to offset remaining taxable income multiplied by the 40 percent tax rate).

The differences between the with-and-without approach and the tax law ordering approach for Company A can be summarized as follows:


Company B: Full Valuation Allowance

The same assumptions apply to Company B, except that Company B has a full valuation allowance recorded against its deferred tax assets.

Following the with-and-without approach, Company B would record the same entries as Company A except that Company B also would release $280,000 of the valuation allowance related to the NOL carryforward that was utilized. The release of valuation allowance would reduce income tax expense to zero in the current period. The windfall tax benefit of $80,000 ($200,000 excess tax deduction multiplied by the 40 percent tax rate) would not be recognized until such time as that deduction was deemed to produce a reduction in taxes payable. As in the “no valuation allowance” scenario, the $200,000 difference between the NOL carryforward for book and tax purposes must be tracked “off balance sheet” and, when it is utilized in subsequent periods, the reduction in taxes payable is credited to APIC.

Following the tax law ordering approach, Company B would record the same entries as Company A except that Company B would release only $200,000 of the valuation allowance related to the NOL carryforward that was utilized. In this scenario, Company B’s financial statements would reflect $80,000 of income tax expense in the current period (income tax expense of $280,000 less release of the valuation allowance of $200,000).

The differences between the with-and-without approach and the tax law ordering approach for Company B can be summarized as follows:



Even in cases where the tax law ordering approach is followed, there will be occasions when only a portion of an NOL carryforward attributed to a given tax year is utilized. In these cases, a convention will need to be adopted for purposes of determining how much, if any, of the NOL carryforward that was utilized should be deemed to relate to windfall tax benefits. We believe that it is generally appropriate in this scenario to consider the windfall tax benefit to be the last portion of the NOL carryforward utilized consistent with the incremental approach, whereby items relating to other components of income enter into intraperiod allocation last. For example, assume an entity had an NOL carryforward from the prior year of $1,000,000 that resulted from operating losses of $600,000 and excess tax deductions of $400,000, the latter of which was not reflected as a deferred tax asset in light of the requirements of ASC 718-20-55-20 (which would prohibit the recording of a deferred tax asset on net operating loss carryforwards created by windfall tax benefits). In the current year, the entity generated taxable income of $700,000. Following an approach of utilizing windfall tax benefits last, the entity would be deemed to have utilized all of the available NOL carryforward from operations and would recognize a windfall tax benefit in APIC related to only $100,000 of the total available excess deductions of $400,000.

The determination of whether a windfall tax benefit has been realized is not only affected by NOL carryforwards but also by other carryforwards (e.g., foreign tax credit and R&D credit carryforwards). Determination of whether a windfall benefit has been realized when there are credit carryforwards is influenced by whether the tax law ordering or the with-and-without approach is being followed. The logic in Example 12-11 that was used to determine whether a windfall tax benefit was realized when the windfall interacted with an NOL carryforward may also be used to determine whether a windfall tax benefit is realized when the windfall interacts with these other carryforwards.

For example, a windfall tax deduction might reduce taxable income on the tax return, and therefore limit utilization of R&D credits that were generated during the year, thereby creating an R&D credit carryforward. If the tax law ordering approach is followed, the windfall tax deductions are considered to be used before the R&D credits, in which case the stock option windfall deduction would be recorded in the financial statements through APIC and a deferred tax asset is recorded for the R&D credit carryforward. If the with-and-without approach is followed, the R&D credits are considered to be used before the windfall tax deductions and no benefit is recognized in APIC. As in Example 12-11 above, the R&D credit carryforward on the tax return must be tracked “off-balance sheet” and, when it is utilized in subsequent periods, the reduction in taxes payable is credited to APIC.

For discussion of other intraperiod allocation complexities relating to ASC 718, such as the acceptable methods of accounting for the indirect effects of windfall deductions, and ASC 718’s interaction with the U.S. AMT, see Example 12-19.

12.2.3 Step 3: Allocate the Remaining Portion of Tax Expense or Benefit to
Other Components

The portion of total tax that remains after allocation of tax to continuing operations (the difference between the total tax expense (computed in Step 1 above) and the amount allocated to continuing operations (computed in Step 2 above) is then allocated among the other financial statement components in accordance with the guidance in ASC 740-20-45-14.

The tax effects excluded from continuing operations will relate to current or deferred taxable income or deductions arising from revenue and expense items recognized in other components in the current year.

ASC 740-20-45-12 states:

If there is only one item other than continuing operations, the portion of income tax expense or benefit for the year that remains after the allocation to continuing operations is allocated to that item.

ASC 740-20-45-14 states:

If there are two or more items other than continuing operations, the amount that remains after the allocation to continuing operations shall be allocated among those other items in proportion to their individual effects on income tax expense or benefit for the year. When there are two or more items other than continuing operations, the sum of the separately calculated, individual effects of each item sometimes may not equal the amount of income tax expense or benefit for the year that remains after the allocation to continuing operations. In those circumstances, the procedures to allocate the remaining amount to items other than continuing operations are as follows:

a. Determine the effect on income tax expense or benefit for the year of the total net loss for all net loss items.

b. Apportion the tax benefit determined in (a) ratably to each net loss item.

c. Determine the amount that remains, that is, the difference between (1) the amount to be allocated to all items other than continuing operations and (2) the amount allocated to all net loss items.

d. Apportion the tax expense determined in (c) ratably to each net gain item.

12.2.3.1 Determining the Individual Effects on Income Tax Expense or Benefit

We believe that the individual effects on income tax expense or benefit of a specific financial statement component represent that component’s incremental tax effect (on a jurisdiction-by-jurisdiction basis) on consolidated tax expense or benefit. Accordingly, we believe that this amount should be quantified by means of comparing the difference between the total tax expense or benefit computed for the year that includes all sources of income and loss and the total tax expense or benefit for the year computed with all sources of income and loss except for the financial statement component being quantified. While that amount may not be the amount that ultimately is allocated to the respective financial statement component, it represents the individual incremental effect of the item for purposes of applying the allocation procedure outlined in ASC 740-20-45-14. All items (other than continuing operations) should be given equal priority for purposes of intraperiod tax allocation, unless there is specific guidance that provides otherwise.

Example 12-12: Allocation of Tax Expense/Benefit to Financial Statement Components Other Than Continuing Operations

Background/Facts:

Company A is a well-established manufacturing company that has taken a turn for the worse over the past several years. During 20X6, Company A sold one of its nonperforming businesses and, going forward, will focus on its remaining businesses. Although Company A is optimistic about the future, management has concluded that a valuation allowance will be necessary for all net deferred tax assets not supported by either carryback availability or future reversals of existing taxable temporary differences. There are no available tax-planning strategies and no weight can be given to projections of future taxable income from operations.

The Company’s 20X6 statement of net loss and comprehensive loss, before considering the effect of income taxes, is as follows:


Additional Information:

The Company paid $40 in income taxes in 20X5 (representing $100 of taxable income available in the carryback period). Disregard any effects of AMT.

Included in SG&A are $50 of nondeductible meals and entertainment expenses.

The loss on discontinued operations in 20X6 consists entirely of losses from operations (there was no gain or loss on disposition).

Taxable temporary differences related to fixed assets will reverse within the NOL carryforward period and are considered a source of income to support realization of the deferred tax assets.

Assume that the entire portfolio of AFS securities represents debt securities that are classified as available-for-sale but management has no particular expectation that these debt securities will be sold prior to maturity. Accordingly, management does not expect the unrealized depreciation at 20X5 or 20X6 to result in a realized capital loss.

Company A’s temporary differences and tax attributes, and the related deferred tax assets and liabilities, were as follows at December 31, 20X5, and 20X6:



Analysis/Conclusion:





Because continuing operations, without considering the effects of financial statement components outside of continuing operations, would have had a net DTL of $20 and because, in this fact pattern, it has been assumed that all of the DTLs serve as a source of taxable income available for the recognition of DTAs, no valuation allowance is required on a “without” basis. Thus, none of the valuation allowance increase is allocated to continuing operations.


As a result of performing steps 1 and 2, there is a tax benefit of $20 to be allocated to all components other than continuing operations. If there were only one component other than continuing operations, the $20 would be allocated to that component. Because there is more than one component, the incremental tax effect of each individual component must be computed.



Without considering the effects of the current-year loss from discontinued operations of $400, the balance sheet would have reflected a net DTL of $12. Because the company’s deferred tax balance would have been a net DTL and because, in this example, it has been assumed that all of the DTLs serve as a source of taxable income available for the recognition of DTAs, no valuation allowance would be required on a “without discontinued operations” basis.



Without considering the effects of the current-year loss from AFS securities of $45, the balance sheet would have reflected a net DTA of $130 before consideration of whether a valuation allowance would be required. Because one of the assumed facts is that there are no sources of taxable income other than reversing taxable temporary differences, a valuation allowance would be required for the full $130 net DTA on a “without AFS securities” basis.



Without considering the effects of the current-year income from derivatives of $25, the balance sheet would have reflected a net DTA of $158, before consideration of whether a valuation allowance would be required. Because one of the assumed facts is that there are no sources of taxable income other than reversing taxable temporary differences, a valuation allowance would be required for the full $158 DTA on a “without OCI-derivatives” basis.

The incremental effects of all components other than continuing operations are as follows:


Note: Because the sum of the parts ($12) does not equal the amount left to be allocated ($20), the allocation procedure as outlined in ASC 740-20-45-14 must be performed. The first step in this process is to calculate the incremental effects during the year of all the loss items in the aggregate.



Without considering the effects of the current-year loss from discontinued operations of $400 and the current-year loss in AFS securities of $45, the balance sheet would have reflected a net DTL of $30. Because the balance sheet would have reflected a net DTL and because in this example it has been assumed that all of the DTLs serve as a source of taxable income available for the recognition of DTAs, no valuation allowance would be required on a “without all loss items” basis.

Once the incremental effect of the loss items has been computed, tax expense or benefit is allocated as follows (ASC 740-20-45-14):


Note: Once the benefit related to the loss items is allocated to the loss items, the residual between the amount to be allocated to components other than continuing operations (in this case ($20)) and the amount allocated to the loss items in aggregate (in this case ($30)) is allocated pro rata based on each income category’s incremental tax effect. Because there is only one item of income outside of continuing operations, the amount left to be allocated of $10 is allocated to that component.

Allocate expenses to the income categories ratably based on each category’s incremental tax effect.



12.2.3.2 Treatment of Specific Components Other Than Continuing Operations

12.2.3.2.1 Intraperiod Allocation for Equity Items Other Than Items of
Comprehensive Income

ASC 740 and ASC 718 specifically allocate to shareholders’ equity the tax effects of changes during the year of the following items:

Cumulative effect adjustments to beginning retained earnings for changes in accounting principle or error correction (ASC 740-20-45-11(a)); see Section TX 12.2.3.2.6 for additional discussion);

Increases or decreases in contributed capital (ASC 740-20-45-11(c));

Expenses for employee stock options recognized differently for financial reporting and tax purposes (ASC 740-20-45-11(d));

Income tax benefits relating to dividends and dividend equivalents that are charged to retained earnings and are paid to employees for equity that is classified as nonvested equity shares, as nonvested equity share units, and as outstanding equity share options (ASC 718-740-45-8 through 45-12; see Section TX 12.2.3.2.3 for additional discussion on dividends and dividend equivalents);

Deductible temporary differences and carryforwards that existed, but for which a valuation allowance was required, at the date of a quasi reorganization (ASC 740-20-45-11(f));

Tax effects credited directly to retained earnings resulting from deductible dividends paid on unallocated shares held by an ESOP and charged to retained earnings (ASC 740-20-45-11(e)); and

Changes in the tax bases of assets and liabilities caused by transactions among or with shareholders, including the effect of valuation allowances initially required upon recognition of any related deferred tax assets. Changes in valuation allowances occurring in subsequent periods shall be included in the income statement (ASC 740-20-45-11(g)).

12.2.3.2.2 Items of Other Comprehensive Income

Certain gains and losses are included in comprehensive income but excluded from net income. Such items, when recognized, are reflected directly in OCI, a component of shareholders’ equity. Generally, the tax effect of gains and losses recorded in OCI should also be recorded in OCI (ASC 740-20-45-11(b)). These gains and losses include:

Foreign currency translation gains and losses reflected in the CTA account within OCI for foreign operations using a foreign functional currency or the foreign currency transaction gain or loss on a nonderivative instrument (ASC 830; see Section TX 12.2.3.2.2.1);

Unrealized gains and losses on AFS debt and equity securities (ASC 320; see Section TX 12.2.3.2.2.2);

Net unrecognized gains and losses and unrecognized prior service cost related to pension and other postretirement benefit arrangements (ASC 715); and

The effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedge instrument (ASC 815).


12.2.3.2.2.1 Cumulative Translation Adjustments (CTA)

Some pretax transaction gains and losses (ASC 830-20-35-2) and all translation adjustments are recorded directly in the CTA account. In addition, ASC 830-20-45-5 requires the tax effects of these items to be attributed to the CTA account, subject to intraperiod allocation.

Allocation to the CTA account is required for both current and deferred taxes on transaction gains and losses recorded in the CTA account and for deferred taxes on translation adjustments. With respect to deferred taxes provided by a parent or investor for an “outside basis” temporary difference, the method of allocating the tax effect on the current year change in this outside basis temporary difference between continuing operations and other items (such as CTA) must be considered. Although several alternatives exist, the method chosen should be consistently applied. Amounts that are ultimately allocated to CTA include:

The capital gain or loss effect of revaluation of contributed capital;

The effect of exchange rate changes on beginning-of-year deferred taxes provided on unremitted earnings; and

The effects of changes in the valuation allowance and changes in tax-planning actions that are not appropriately allocated to continuing operations.

The computation will also require appropriate consideration of foreign withholding taxes and limitations on utilization of foreign tax credits. Refer to Section TX 11.5.7.

12.2.3.2.2.2 Unrealized Gains and Losses on “Available-for-Sale” Debt and Equity Securities (ASC 320)

ASC 320 requires that investments classified as available-for-sale be carried at fair value. This would generally result in temporary differences because the laws in most tax jurisdictions defer the recognition of gains and losses from investments until the investments are sold. ASC 320 reflects pretax changes in market value as other comprehensive income. ASC 740-20-45-11(b), requires that the tax effects of pretax changes to OCI occurring during the year be recorded net against the pretax changes in OCI.

Appreciation on Available-for-Sale (AFS) Securities When There Is a Valuation Allowance

When there is a valuation allowance applicable to beginning-of-year deferred tax assets and there is a change in circumstances during the year that causes the assessment of the likelihood of realization in future years to change, the effect is reflected in continuing operations. However, if the reversal of the valuation allowance is directly related to the appreciation of the company’s available-for-sale portfolio during the current year (current-period income) and not to expectations of taxable income in future periods, the reversal of the valuation allowance is recorded in OCI.

Example 12-13: Appreciation in AFS Securities When There Is a Valuation Allowance

Background/Facts:

Assume the following facts for Company A:

Tax rate of 40 percent

At year-end 20X5, a full valuation allowance on Company A’s net deferred tax asset as shown:


During 20X6, financial results for pretax continuing operations were breakeven and $4,000 of pretax gains from unrealized appreciation on AFS securities was included in OCI.

At December 31, 20X6, management concluded that a full valuation allowance continued to be required.

Analysis/Conclusion:

Based on these facts, Company A has a total tax expense of zero and a net deferred tax asset of $1,400 ($7,500 pretax deductible temporary difference (DTD) and NOL carryforward at December 31, 20X5, less $4,000 pretax OCI gain = $3,500 net pretax at December 31, 20X6, times 40%) with a full valuation allowance. As pretax income related to continuing operations is zero, no tax provision or benefit is allocated to it. Due solely to the income from available-for-sale securities of $4,000, $1,600 of the prior-year valuation allowance was released. As a result, the entire valuation allowance release of $1,600 would offset the tax attributable to the $4,000 pretax gain from OCI of $1,600 ($4,000 times 40%), resulting in no tax allocated to the AFS component of other comprehensive income.


ASC 320, Investments—Debt and Equity Securities also provides guidance on how tax effects of AFS securities would be allocated under ASC 740’s intraperiod allocation rules.

Example 12-14: Intraperiod Allocation Related to Reclassifications from Accumulated Other Comprehensive Income

Background/Facts:

In Year 1, Company X purchased equity securities for $200 accounted for as available-for-sale. At the end of Year 1, the AFS securities had a fair value of $150, resulting in an unrealized loss of $50 recorded through OCI. In Year 2, Company X sold all of the AFS securities for $150, which resulted in reclassification of the pretax loss of $50 from accumulated OCI to earnings. Company X reported pretax income from continuing operations of $200 inclusive of the loss realized on the AFS securities and a reclassification gain of $50 in OCI (thus, the effect on comprehensive pretax income from the disposition of the AFS securities is nil). Company X’s tax rate is 40 percent.

Question:

Does the reclassification adjustment of $50 from accumulated OCI to earnings impact the intraperiod tax allocation given that the net effect on comprehensive net income is nil?

Analysis/Conclusion:

Yes. Reclassification adjustments, such as gains and losses on AFS securities reclassified from accumulated OCI to earnings, form part of the current period income (loss) from continuing operations and current period income (loss) in OCI. Therefore, their income tax effect should be evaluated in the same manner as any other item of income or loss reported in the current period. They should be considered in ASC 740’s three-step, intraperiod allocation approach. As shown in the table, Company X would first calculate the total tax expense or benefit recognized in the financial statements (“all in”). Second, it would compute the tax attributable only to its continuing operations, and third allocate the difference between these two steps to any other category (which in this case is only OCI).


In this example, total tax for the period is $100. Without the disposition of AFS securities, the total tax would also be $100 (income from continuing operations would be $250 and there would be no gain in OCI). However, while the net tax effect of the reclassification adjustment in step 1 of the intraperiod allocation model is nil, there is a tax effect to allocate to continuing operations and a consequent tax offset to OCI. In this example, the reclassification adjustment resulted in splitting the total tax effect for the period ($100) between continuing operations and OCI.

Note that reclassification adjustments that are credits in OCI, such as in the example above, can also sometimes serve as a source of income that enables recognition of a tax benefit from a current-year loss in continuing operations when the loss in continuing operations would otherwise require a valuation allowance (refer to ASC 740-20-45-7 and Section TX 12.3).

12.2.3.2.2.3 Disproportionate Tax Effects Lodged in OCI

How Tax Effects Become Lodged in OCI

The tax effects reflected directly in OCI are determined pursuant to ASC 740’s intraperiod allocation rules. Under this incremental approach, subsequent adjustments to deferred taxes originally charged or credited to OCI are not necessarily reflected in OCI. Specific circumstances in which subsequent adjustments are not reflected in OCI, but instead are reflected in continuing operations, include:

A change in enacted tax rates (because ASC 740-10-45-15 requires that the effect of a tax law change on deferred tax assets and liabilities is reflected in continuing operations).

A change in the valuation allowance for beginning-of-year deferred tax assets that results from a change in circumstances that causes a change in judgment about the realizability of deferred tax assets in future years (because ASC 740-10-45-20 requires that this type of change in valuation allowance be reflected entirely in continuing operations).

In certain circumstances, the application of the exception to the “with-and-without approach” described in ASC 740-20-45-7 (refer to Section TX 12.3) may also result in a disproportionate tax effect in OCI.

As a result of these requirements, the tax effect lodged in OCI will not necessarily equal the net deferred tax asset or liability that is recognized in the balance sheet for the temporary differences related to the pretax items recorded in OCI.

Clearing Disproportionate Tax Effects Lodged in Accumulated Other Comprehensive Income

A common question when a distortion exists in OCI is, “What, if anything, should be done about the ‘reconciling items’ that remain in OCI as a result of the change in valuation allowance or change in tax rate effects having been charged or credited to continuing operations?”

ASC 740 is silent as to the disposition of a disproportionate tax effect lodged in OCI. We believe that the OCI balance must be eliminated when the circumstances upon which it is premised cease to exist. Presumably, the pretax items in OCI ultimately will be cleared to income (perhaps in an indefinite, distant future period). For example, sale of a foreign operation or actions that result in a complete liquidation requires that the related CTA account balance be recognized in income. As discussed above, if a disproportionate tax effect related to such an item has been lodged in OCI, following the prescribed ASC 740 intraperiod allocation procedures, a tax effect may remain in OCI even after the pretax item has been reclassified to income. Because the disproportionate tax effect at one time was reflected in income (either in continuing operations or in the cumulative effect of initial application of ASC 740), its clearing ordinarily will be to income from continuing operations.

Clearing Disproportionate Tax Effects Related to Unrealized Gains and Losses of “Available-for-Sale” Debt and Equity Securities (ASC 320)

When there is a disproportionate tax effect relating to AFS securities, the question arises as to whether the necessity to clear tax effects is determined on an item-by-item (individual investment) or an aggregate portfolio basis. The following subsections discuss each of these two approaches in more detail.

Item-by-Item approach:

Under the item-by-item approach, a portion of the disproportionate tax effect is assigned to each individual investment in an unrealized gain or loss position at the effective date of the change. When one of those individual investments is sold or is impaired on an other than temporary basis in accordance with ASC 320, the assigned portion of the reconciling item is removed from the available-for-sale component of OCI and charged or credited to income from continuing operations. In this way, the tax effect that related to items of accumulated OCI that was charged or credited entirely to continuing operations is offset by charges or credits to income from continuing operations in later periods, as the individual investments are sold or impaired on an other than temporary basis.

Aggregate portfolio approach:

Under the aggregate portfolio approach, the disproportionate tax effect remains intact as long as the investment portfolio remains. Thus, if an entity with unrealized gains and losses on equity securities elects the aggregate approach, there presumably will be no need to completely clear the disproportionate tax effect from accumulated OCI as long as the entity holds an available-for-sale portfolio.


Comparing the two approaches:

The item-by-item approach obviously requires considerably more time and effort to implement. Given the absence of authoritative guidance and the fact that either approach will produce “out-of-period” tax effects, proponents of the aggregate portfolio approach argue that the item-by-item approach does not pass a reasonable cost–benefit test and therefore is inconsistent with the FASB’s rationale for prohibiting “backwards tracing” in the first place.

We have discussed these issues with the FASB staff, and they have advised us that (a) they see meritorious arguments in support of both approaches; (b) they have no basis on which to object to either approach; and (c) in the absence of further guidance on their part or the part of another authoritative body, either approach should be acceptable in practice, provided that it is used consistently. The consistency requirement would not be violated if an entity employed the item-by-item method for one financial statement component and not another. Once an accounting policy is chosen for a particular item, that policy should be applied consistently unless a change can be justified as a change to a preferable policy (consistent with the guidance in ASC 250-10-45-1, for changes in accounting principles).

Example 12-15: Disproportionate Effect Being Lodged in Other Comprehensive Income Resulting from a Change in Valuation Allowance

An industrial company’s investment in noncurrent marketable equity securities, which originally cost $1,000, had a market value of $900 at the end of 20X1. The company accounts for this investment as an available-for-sale security under ASC 320, so that the unrealized loss of $100 was charged to OCI during 20X1. The company recorded a deferred tax asset of $35, but it also provided a $35 valuation allowance; thus no tax benefit was recognized in OCI on the $100 pretax OCI loss.

In 20X2, the market value of the securities did not change. However, as a result of a change in circumstances, the company changed its estimate of future taxable income and eliminated the valuation allowance. The tax benefit of $35 was reflected in continuing operations pursuant to ASC 740-10-45-20.

At the end of 20X2, the company had the following balance sheet accounts for the investment:


In early 20X3, the company sold the securities for $900. Upon the sale, the company recognized in continuing operations a $100 loss on the sale; the $100 previously recognized in OCI was reclassified to income pursuant to ASC 220.

As a result of the sale, the company was able to reduce its taxes currently payable by $35, and it reflected this tax benefit in its current tax expense. However, deferred tax expense reflected the reversal of the $35 deferred tax asset related to the previously unrealized loss. Accordingly, the overall net tax effect recognized in comprehensive income on the sale was zero.

That is, as it relates to comprehensive income (the “with” calculation), nothing has happened; the $100 pretax loss has been reclassified between components of accumulation OCI and, because there was no valuation allowance at the beginning 20X3, there is no net tax benefit (the current benefit from the realized loss is offset by the deferred expense associated with the realization of the related deferred tax asset). In continuing operations (the “without” calculation), the reclassification reduced pretax income by $100, resulting in a $35 tax benefit. In the intraperiod allocation for 20X3, therefore, the $35 difference between these two calculations is allocated to OCI. This results in a net reclassification adjustment of $65 (compared with the $100 accumulated OCI balance at the beginning of 20X3), and the $35 of tax expense that had become “lodged” in OCI with the establishment of a valuation allowance in 20X1 remains “lodged” in accumulated OCI. Because there was no longer any basis for an OCI balance, the company cleared the $35 debit to deferred tax expense in continuing operations.

In this scenario, the company recognized in continuing operations a $100 pretax loss on the investment in 20X3, but since the $35 tax benefit was recognized in continuing operations in 20X2 when the valuation allowance was released, no tax benefit was recorded in continuing operations (the $35 tax benefit on the current-year loss was offset by the clearing of the $35 amount that had been lodged in OCI).

Example 12-16: Disproportionate Effect Being Lodged in OCI When Adjustments (Such as Changes in Tax Laws or Rates) Are Not Reflected in OCI

Background/Facts:

Assume that in 20X6 an entity acquires, at a cost of $50, marketable equity securities that are classified as available-for-sale in accordance with ASC 320. The fair market value of the securities declines to $30 as of the end of 20X6 and the entity records the unrealized loss of $20 in OCI. As required by ASC 740-20-45-11(b) the tax effect of the temporary difference related to the $20 unrealized loss (i.e., the recognition of a deferred tax asset, assuming that no valuation allowance is required), measured at the currently enacted rate of 40 percent, also is credited to OCI. At December 31, 20X6, a law was enacted (effective January 1, 20X7) to reduce the capital gains tax rate from 40 percent to 30 percent.

Question:

What is the accounting for the tax effects of this temporary difference (a) at the date of the tax rate change, (b) upon a subsequent change in the fair market value, and
(c) when the securities subsequently are sold?

Analysis/Conclusion:

a. Change in tax rates or laws: As stated in ASC 740-10-45-15, and as discussed above at Section TX 12.2.2.2.1, the effect of a change in tax rates must be included in income from continuing operations during the period that includes the enactment date. Therefore, as of the date of enactment of the tax rate change (in this case, December 31, 20X6), the entry to adjust the deferred tax asset would be:


This accounting treatment creates a difference between (1) the “expected” net-of-tax balance in the available-for-sale component of OCI and (2) the actual balance:


If, as of the date of the tax rate change, the securities portfolio was in an unrealized gain position, similar accounting treatment would apply. It should be noted, however, that if the tax rate change resulted in a decrease in the deferred tax liability related to the unrealized gains and, as a direct consequence, the entity had to increase its valuation allowance related to other deductible temporary differences, then the adjustment to the valuation allowance also would be charged to continuing operations as part of the effect of the tax rate change, since it would represent a direct effect of the law change.

b. Subsequent change in fair market value: If the fair market value of the securities increased to $40 by the end of 20X7, the $20 unrealized loss would be reduced to $10 and the related $6 deferred tax asset would be reduced to $3. As noted above, the intraperiod tax-allocation provisions of ASC 740-20-45-11(b) require that the tax effects related to “gains and losses included in comprehensive income but excluded from net income” (including, for example, changes in the fair value of AFS securities under ASC 320) also be excluded from net income. Thus, the deferred tax effect that results from the $10 reduction of the temporary difference related to the unrealized loss is allocated directly to the AFS component of OCI. The entries at the end of 20X7 would be as follows:


The net impact of the change in fair market value is “as expected.” The reduction in the unrealized loss and the related deferred tax effect are both allocated directly to OCI, with no income statement impact.

At the end of 20X7, the “reconciling item” that was created when the tax law was changed in 20X6 is still intact:


c. Sale of Securities: If the securities were then sold in January 20X8 for $50 (equal to original cost), the entry to record the sale would be:


The temporary difference related to the $10 of unrealized loss that remained at the end of 20X7 reverses upon the sale of the asset in 20X8 and, as in 20X7, the deferred tax effect of eliminating of the remaining $3 deferred tax asset is allocated directly to the available-for-sale of OCI. The entry is as follows:


Prior to the clearing of the lodged tax effect of $2 that resulted from the 20X6 law change, the impact on the 20X8 income statement is “as expected,” that is, the changes in the unrealized loss and the related deferred tax effect are both allocated directly to OCI and, because there was no realized gain or loss, no income-statement impact results. However, in this instance, as the company sold its entire portfolio of securities and the circumstances under which the lodged tax effect was premised ceased to exist, the $2 lodged tax effect should be cleared to continuing operations.

Example 12-17: Disproportionate Tax Effects Lodged in OCI as a Result of the Application of the Exception to the “With-and-Without” Approach

Background/Facts:

Company X owns AFS securities accounted for under ASC 320. In 20X8, Company X reported a pre-tax loss from continuing operations of $100 and a pre-tax unrealized gain in OCI of $100 generated by AFS securities. Company X maintains a full valuation allowance. The intraperiod income tax allocation for 20X8 is summarized in the table (refer to Section TX 12.2 for discussion of the basic model):


As shown in the table above, there is no tax benefit to record for the loss in continuing operations (step 2) under the “with-and-without” tax allocation approach because of the full valuation allowance.

However, ASC 740-20-45-7 provides an exception to the “with-and-without” approach to intraperiod tax allocation by requiring that all items (e.g., extraordinary items, discontinued operations, and so forth) be considered for purposes of determining the amount of tax benefit that results from a loss from continuing operations. Accordingly, as demonstrated in the table above, Company X applied the exception in ASC 740-20-45-7 and recorded a deferred tax benefit in continuing operations and a deferred tax expense in OCI. This effectively grossed up the components of comprehensive income with no net effect on the balance sheet since the deferred tax asset was offset by a deferred tax liability (Refer to Section TX 12.3.1 for further discussion).

In 20X9, Company X incurred more losses from continuing operations and due to market conditions also reduced the value of its AFS securities by $100. The $100 pre-tax loss in OCI effectively reversed the prior year’s unrealized gain in accumulated other comprehensive income (AOCI).

Question:

What should be the intraperiod tax allocation in 20X9 assuming there are no other items of income or loss? When should the tax effect (i.e., a deferred tax expense) recorded in 20X8 be cleared out of AOCI?

Analysis/Conclusion:

Under the “with-and-without” three-step intraperiod allocation approach, the “with” (step 1) and continuing operations (step 2) tax effects are nil in 20X9 given the full valuation allowance status. Therefore, there is no tax effect allocable to OCI (step 3). The recognition of loss in OCI without a corresponding tax effect creates what is referred to as a disproportionate effect.

Clearing Disproportionate Tax Effects Related to Pension and OPEB Plans
(ASC 715)

When there is a disproportionate tax effect relating to pension and OPEB plans accounted for under ASC 715, the question arises as to when it would be appropriate to clear the disproportionate tax effect lodged in AOCI.

As discussed near the beginning of this Section TX 12.2.3.2.2.3, we believe that a disproportionate tax effect lodged in AOCI should be eliminated when the circumstances upon which it is premised cease to exist. As it relates to pension and OPEB plans, because the plan is what gives rise to the DTA, we believe that the disproportionate effect should not be cleared until the plan has been terminated. Because the unit of account is the pension or OPEB plan itself, we do not believe that a pro-rata approach to clearing the disproportionate effects related to an individual plan would be an appropriate alternative. For example, it would not be appropriate to clear the disproportionate effects as gains/losses and prior service costs/credits are amortized out of AOCI and into income.

12.2.3.2.2.4 Allocation of Items of Other Comprehensive Income in an Outside Basis Temporary difference

As with other temporary differences, the allocation of deferred taxes between continuing operations and other items, such as other comprehensive income, must be considered with respect to deferred taxes provided by a parent or investor for the outside basis temporary difference.

Example 12-18: Measurement of an Outside Basis Temporary Difference in a Partnership When the Partnership has Other Comprehensive Income

Background/Facts:

Company X consolidates a partnership in which it owns a 70 percent interest. The remaining 30 percent partnership interest is owned by an unrelated party. In the current year, the partnership generates $100,000 of book income from continuing operations and $50,000 of other comprehensive income. The partnership’s taxable income for the current year is $80,000. In previous years, Company X has recorded a deferred tax liability for an excess book-over-tax basis in the partnership (outside basis difference). Company X’s applicable tax rate is 40 percent.

Question:

Does the outside book basis include Company X’s share of the partnership’s OCI? If so, what is the intraperiod allocation of any deferred tax expense related to Company X’s share of the partnership’s OCI?

Analysis/Conclusion

The outside book basis includes Company X’s share of the partnership’s OCI. The investor’s financial reporting book basis of an investment in a partnership or a corporation encompasses the investor’s share of comprehensive income. This would occur whether the investor consolidates or applies the equity method of accounting. Therefore, Company X’s share of the partnership’s OCI is a part of the overall outside basis difference between book and tax similar to any difference between its share of partnership book income and taxable income.

In this circumstance, Company X’s outside book basis would increase by 70 percent of consolidated partnership comprehensive income or $105,000 (the remaining partnership comprehensive income of $45,000 is attributable to the noncontrolling shareholder). Its outside tax basis would increase by 70 percent of partnership taxable income or $56,000. Accordingly, Company X has an additional outside-basis taxable temporary difference of $49,000 (i.e., the excess of its share of comprehensive income over taxable income) and an additional deferred tax liability of $19,600. Consistent with ASC 740-20-45-11(b), Company X would recognize $14,000 of the deferred tax expense in OCI (i.e., its share of the partnership’s OCI or $35,000 times 40 percent).

12.2.3.2.3 Dividends

ASC 740-20-45-8(d) requires that the benefit of tax-deductible dividends be reflected in continuing operations. This general rule includes the tax effects of tax-deductible dividends on unallocated ESOP shares that are accounted for under ASC 718, as such dividends are not charged to retained earnings (ASC 718-740-45-7). However, ASC 740-20-45-11(e), provides an exception for tax-deductible dividends on unallocated shares held by an ESOP charged to retained earnings. In this case, the corresponding tax effect also is reflected in retained earnings.

In addition, ASC 718-740-45-8 through 45-12 concludes that, when an income tax benefit is realized from dividends or dividend equivalents that are charged to retained earnings and are paid to employees for equity-classified nonvested equity shares, nonvested equity share units, and outstanding equity share options, the tax benefit should be recognized as an increase in additional paid-in capital (APIC) if the related awards are expected to vest. However, if the related awards are not expected to vest, the dividends or dividend equivalents are recognized as compensation costs. A change in forfeiture estimates requires a reclassification of dividends and dividend equivalents between retained earnings and compensation expense and a corresponding reclassification of the related tax benefits between APIC and income tax from continuing operation (see Chapter TX 18 for additional discussion).

ASC 718-740-45-8 through 45-12 retains the requirement in ASC 718-20-55-20 that income tax benefits of dividends and dividend equivalents should not be recognized (in APIC or in the income tax provision when a change in vesting estimates occurs) until the deduction reduces income tax payable.

12.2.3.2.4 Discontinued Operations

12.2.3.2.4.1 Restating Prior-Period Presentation for Discontinued Operations

In the period when operations meeting the criteria in ASC 205-20-45-1 for discontinued operations are disposed of or classified as held-for-sale, prior years’ results are segregated retroactively between continuing and discontinued operations in accordance with ASC 205-20-45-3 through 45-5. When this occurs, a new allocation of tax expense or benefit to continuing operations must be determined for the current and prior years. There may be, in prior years’ financial statements restated to reflect the discontinued operations, one or more items other than continuing operations and the operations now presented as discontinued. ASC 740-270-45-8 specifies that the amount of tax to be allocated to discontinued operations should be the difference between the tax originally allocated to continuing operations and the tax allocated to the restated amount of continuing operations. This often will result in a different amount than would result from a complete reapplication of the intraperiod allocation rules; however, it may be simpler to apply as amounts of tax allocated to other components of income (loss) recognized in the prior years are not restated. Example 15-2 in Section TX 15.3.4 discusses the accounting when a change in tax law occurred in the prior period being restated for discontinued operations.


The reallocation of the tax expense originally allocated to continuing operations between continuing and discontinued operations in the restated income statements should be based entirely on estimates that were made in preparing the prior years’ financial statements and should not reflect any hindsight. Changes in the valuation allowance for beginning-of-year DTAs could raise questions in determining the split. To the extent the discontinued operations were included in a consolidated tax return along with the remaining continuing operations, the change in valuation allowance resulting from the change in judgment about the realizability of DTAs in future years should be recorded in continuing operations consistent with the “general rule” set forth in ASC 740-10-45-20, as discussed previously. This would be the case even if the change in estimate related to beginning-of-year DTAs that arose in operations that are now classified as discontinued. As set forth at Section TX 12.2.2.2.3.2, if the benefit of a loss is not recognized in the year when the loss is incurred, it will not, when recognized in a subsequent year, be classified on the basis of the source of the loss. Thus, the fact that a loss carryforward or deductible difference arose from operations in a prior year that subsequently were classified as discontinued would not be relevant in classifying the tax benefit initially recognized in the current year.

There is one situation, however, where departure from the general rule may be appropriate. If the discontinued operations filed a separate tax return, it may be appropriate to record in discontinued operations the change in assessment about the realizability of DTAs in future years.

A question also could arise when the disposal results in a different realization, or estimate of future realization, of DTAs from that reflected in the beginning-of-year valuation allowance. Deferred tax assets (or liabilities) that relate to a subsidiary’s inside basis temporary differences may simply disappear, perhaps indirectly realized in the pretax gain or loss on sale of the subsidiary’s stock. These tax effects should be reflected as the tax effects of the gain or loss on disposal, even though implicitly they may reflect a change in the valuation allowance related to beginning-of-year DTAs.

12.2.3.2.4.2 Recording Previously Unrecognized Deferred Tax Effects of Outside Basis Differences of Subsidiaries

A question arises as to the intraperiod allocation of a deferred tax expense/benefit in the following situation: The entity’s discontinued operation is in a subsidiary with an outside basis difference. The entity has not previously recorded a deferred tax liability or asset for the outside basis difference, for one of three possible reasons:

An excess outside book-over-tax basis difference related to an investment in a foreign subsidiary was not recorded as a deferred tax liability because of the “indefinite reversal” criteria of ASC 740-30-25-17.

An excess outside book-over-tax basis difference related to an investment in a domestic subsidiary was not considered a taxable temporary difference because the entity expected that the difference would reverse without tax effect (ASC 740-30-25-7).

A deferred tax asset was not recognized for a deductible temporary difference because it was not apparent that the excess outside tax basis would reverse in the foreseeable future (ASC 740-30-25-9).

Consistent with ASC 740-30-25-10, the entity should record a deferred tax asset or liability for the outside basis difference when its expectation has changed and, in any event, no later than the date on which the component of the entity is classified as held-for-sale. There are precedents in practice that support intraperiod allocation of the related tax benefit or expense to either discontinued operations or continuing operations. We would not object to allocation to either component, provided that appropriate disclosures were made and that the approach chosen was followed consistently.

12.2.3.2.5 Complexities in Accounting for Windfall Benefits under ASC 718

In previous sections of this chapter, the illustrations related to windfall tax benefits have assumed a single tax rate applicable in all periods when calculating the windfall tax benefit resulting from the settlement of a stock-based compensation award. Entities may receive certain tax deductions that impact their effective tax rate and thus the incremental tax benefit of the excess tax deduction. For example, IRC Section 199 provides an entity with a permanent tax deduction related to its qualified production activities. In accordance with ASC 740-10-55-147 through 55-148, the deferred tax asset that an entity records for the book compensation cost should not be adjusted to reflect an IRC Section 199 deduction that the entity is likely to receive. However, the IRC Section 199 deduction affects the incremental tax benefit of the excess tax deduction when using the with-and-without approach to calculate the windfall tax benefit.

Example 12-18 illustrates three alternative approaches for calculating the incremental windfall tax benefit recorded to APIC when an entity is entitled to an IRC Section 199 deduction.

Example 12-19: Calculation of Windfall Tax Benefits Including Impact of
IRC Section 199 Deduction

Background/Facts:

The applicable tax rate is 35 percent.

4,000 stock options are granted on January 1, 2009, and all the options vest on December 31, 2009.

Compensation cost for the award is $400,000 and is recorded during 2009 for book purposes, along with the related deferred tax assets of $140,000.

Taxable income in 2010 is $1,000,000 before the IRC Section 199 deduction.

The stock options are exercised on July 1, 2010, when the intrinsic value (and the related tax deduction) is $500,000. Thus, the excess or windfall tax deduction is $100,000.

The IRC Section 199 deduction is fully phased in at 9 percent.

Analysis/Conclusion:

Calculation of the Windfall Tax Benefit:


Alternative A: Under this approach, an entity would calculate the windfall tax benefit as the difference between the “without” calculation of $350,350 and the “with” calculation of $318,500, or $31,850. The IRC Section 199 deduction results in an in-substance reduction of the tax rate to 31.85 percent, or 91 percent of the statutory rate. Therefore, another way to measure the windfall in this example is to compare the deferred tax asset of $140,000 with the tax benefit of $175,000 ($500,000 multiplied by 35%) and then multiply such difference (or $35,000) by
91 percent.

Alternative B: A second approach to calculating the windfall tax benefit would be to compare the recorded deferred tax asset with the incremental tax benefit of the deduction. In the example above, the $500,000 intrinsic value would result in a tax benefit of $159,250 ($500,000 tax deduction multiplied by the 35 percent statutory rate multiplied by 91 percent). The tax benefit of $159,250, compared with the deferred tax asset of $140,000, would result in an excess of $19,250, which would be recorded as the windfall tax benefit.

Alternative C: Under a third approach, an entity could elect to consider only the direct effects of the stock option deduction and ignore the impact of IRC Section 199. In this case, the windfall would be measured by comparing the tax deduction of $500,000 with the cumulative book compensation cost of $400,000. The tax benefit of the excess deduction, or $35,000 ($100,000 multiplied by 35 percent), is the windfall tax benefit calculated under this approach.

We believe that an entity could elect to use any of the above approaches to calculate windfall tax benefits. The approach an entity elects to use should be treated as an accounting policy decision which should be consistently followed and disclosed.

A similar allocation question arises when an entity calculates the effect of the research tax credit under U.S. tax regulations. Strict application of the with-and-without approach would appear to require allocating the benefit of the incremental research tax credit to APIC under either an Alternative A or Alternative B approach. Some entities, however, do not segregate this credit when measuring the windfall tax benefit; instead, they follow the practice of recognizing the full effect of the research tax credit in income from continuing operations, following the logic of Alternative C. The approach an entity elects to use should be applied consistently to all indirect effects of stock-based compensation deductions.


In certain situations, an entity may not pay regular tax because it has substantial NOL carryforwards; however, it may be subject to the alternative minimum tax (AMT), which is discussed more fully in Section TX 4.2.5.1. Regardless of whether the entity pays a regular tax or an AMT, the amount recognized as a windfall tax benefit (assuming no valuation allowance is needed) is the amount that reduces regular taxes payable, with the determination of the benefit subject to the policy election of tax law ordering or the with-and-without approach. That is, the tax saving from windfalls is measured at the regular tax rate (even though the entity may be paying AMT) since the windfalls effectively “save” an equivalent amount of regular NOL carryforwards that would otherwise have been used (Ex. 12-20 below illustrates this accounting). However, when any AMT credit carryforwards would be offset by a full valuation allowance, we believe the benefit recorded to APIC should be measured based on the amount of AMT saving that is a result of the windfalls.

Consider the following illustration:

Example 12-20: Income Tax Benefit under Alternative Minimum Tax

Background/Facts:

The company has NOL carryforwards of $100 million and no valuation allowance.

The company establishes deferred taxes for temporary differences at the regular tax rate (40 percent) in accordance with ASC 740-10-30-10.

The company has a current-year deduction from the exercise of nonqualified stock options of $10 million. These options were granted and exercised post-adoption of ASC 718 and resulted in book compensation expense of $6 million, with a corresponding deferred tax asset of $2.4 million.

Regular taxable income before the option deduction and NOLs is $30 million.

AMT income is $30 million, prior to considering the effects of the stock option deduction and the allowable NOL (90 percent).

The company has made a policy election to utilize the tax law ordering approach to calculate realized excess tax benefits from option exercises.

Calculation of the AMT tax:


After considering the above, the company will owe no regular taxes and will owe $400,000 in AMT tax.

Analysis/Conclusion:

Determination of Windfall Tax Benefit:

The company has a realized excess tax benefit of $1.6 million and should record a credit to APIC for this amount. This amount is equal to the $4 million excess deduction multiplied by the company’s regular tax rate of 40 percent.

It may appear that the excess tax benefit reduced current taxes by only $200,000 because, without the excess stock option deduction, the company would have paid $600,000 in AMT tax ($30 million in AMT taxable income reduced by NOLs up to 90 percent multiplied by 20 percent) but ultimately paid only $400,000. However, for this company (and all companies that do not expect to be AMT taxpayers perpetually), the AMT is prepaid regular tax because the company receives a credit against future regular tax due for any AMT tax paid. Therefore, the realized excess tax deduction should be the amount by which the excess tax deduction reduced regular taxes payable—not AMT taxes payable. In this example, the entire excess stock compensation reduced regular taxes payable. Therefore, the company should record $1.6 million of excess tax benefit in APIC.

The company would record the following journal entry to recognize the tax benefit from the exercise of the stock options and the deferred tax asset related to the AMT taxes paid:


It should be noted that, if the company had a policy of applying the with-and-without approach to determine realized tax benefits, none of the current-year stock option deductions would have been deemed to reduce regular taxes payable. This is because, under the with-and-without approach, the company’s NOL carryforwards would be deemed to reduce taxes payable prior to any windfall tax benefits.

12.2.3.2.6 Tax Effect of Changes in Accounting Principle

The cumulative effect adjustment from an accounting change generally will be included as an adjustment to beginning retained earnings. ASC 740-20-45-11(a) requires that the tax effect of the cumulative effect adjustment should also be recorded as an adjustment to beginning retained earnings, but the tax effects to be recorded are the effects that would have been recorded if the newly adopted accounting method had been used in prior years. Presumably, hindsight would not be used in this determination. Therefore, we believe that the tax effect of a cumulative effect of a change in accounting principle that is reported as an adjustment to beginning retained earnings is an adjustment of cumulative income tax expense from prior periods and not an allocation of the current period’s tax expense. For example, assume that an entity has a change in accounting principle that results in a cumulative increase in prior-year financial reporting income that is to be reported as a cumulative effect adjustment to beginning retained earnings. Such an increase also would have resulted in an increase in taxable temporary differences as of that date. The resulting deferred tax liability should be established by taking into account the deferred tax balances at the beginning of the year and the enacted tax rates expected to be in effect when those temporary differences reverse (as determined under ASC 740-10-30-8). Accordingly, if the taxable temporary differences would have allowed for a lesser valuation allowance at the beginning of the year on previously recorded deferred tax assets, the valuation allowance release also would be included in the cumulative effect. Although a change in accounting principle also may yield a revised estimate of future pretax book income, generally there will be no impact on taxable income. In any event, a change in expectation coincident with a change in accounting should not be considered part of the change in accounting.

If the cumulative effect is required to be reported as a component of net income, it would be subject to the intraperiod allocation rules. In calculating such cumulative effect, the intraperiod allocation rules would be applied to each prior period.


12.2.3.3 Miscellaneous Intraperiod Issues

12.2.3.3.1 Income Tax Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature

An entity may issue a convertible debt security with a nondetachable conversion feature. The nondetachable conversion feature is not accounted for separately under ASC 470. However, when an entity issues a convertible debt security with a nondetachable conversion feature that is “in-the-money,” ASC 470-20-25-5 requires the conversion feature to be accounted for separately. This type of conversion feature is defined as a beneficial conversion feature and is recognized and measured separately by allocating to additional paid-in capital a portion of the proceeds equal to the intrinsic value of the conversion feature. That intrinsic value is calculated at the commitment date as the difference between the conversion price and the fair value of the common stock or other securities into which the security is convertible, multiplied by the number of shares into which the security is convertible. The convertible security is recorded at par, and a discount is recognized for the amount that is allocated to additional paid-in capital. For tax purposes, the tax basis of the convertible debt security is the entire proceeds received at issuance of the debt. Thus, the book and tax bases of the liability are different. ASC 740-10-55-51 addresses whether a deferred tax liability should be recognized for that basis difference and indicates that:

1. The recognition of a beneficial conversion feature creates a difference between the book basis and tax basis (“basis difference”) of a convertible debt instrument,

2. That basis difference is a temporary difference for which a deferred tax liability should be recorded under ASC 740, and

3. The effect of recognizing the deferred tax liability at the date of issuance should be charged to equity in accordance with ASC 740-20-45-11(c).

As the discount created by the recognition of the beneficial conversion feature is amortized, which in certain circumstances is over a period shorter than the contractual life of the debt instrument, the temporary difference reverses. The effect of that reversal is a component of the deferred tax provision for the period(s).

Deferred taxes are also required for other types of convertible debt instruments such as convertible debt instruments that (1) may be partially or wholly settled in cash and are accounted for under ASC 470, (2) provide for certain contingent payments, and (3) have call options (see Chapter TX 3 for additional discussion). The intraperiod allocation guidance described above for convertible debt instruments with a beneficial conversion feature should also apply to the tax effects from these other types of convertible debt instruments.

12.2.3.3.2 Changes in Tax Basis Resulting from a Taxable Exchange between Entities under Common Control

Certain transfers of net assets or exchanges of shares between entities under common control result in a change in the reporting entity that receives the net assets. In practice, these transactions are accounted for in the financial statements of the receiving entity based on the transferring entity’s historical cost and acquisition accounting is not required (ASC 805-50-05-5 and related guidance in ASC 805). In a taxable transfer/exchange, new tax bases are established for the assets of one of the entities. Because a new basis is not established for book purposes, taxable temporary differences may be reduced or eliminated, and deductible temporary differences may be increased or created. Based on the guidance in ASC 740-20-45-11(g), we believe that, as of the transfer/exchange date, the tax effects attributable to any change in tax basis (net of valuation allowance, if necessary) should be charged or credited to contributed capital. If a valuation allowance is provided against the deferred tax assets at the combination date, any subsequent release of the valuation allowance should be reported as a reduction of income tax expense and reflected in continuing operations, unless the release is based on income recognized during the same year and classified in a category other than continuing operations, consistent with the guidance at Section TX 12.2.2.2.3. Similarly, if the reporting entity can no longer realize a preexisting deferred tax asset as a result of a transaction among or with its shareholders, ASC 740-10-45-21 requires that the write-off be recorded as part of income tax expense. Chapter TX 10 includes additional discussion on common control transactions (see Section TX 10.9).

12.2.3.3.3 Presentation of the Tax Effects of the Sale of Stock of a Subsidiary

12.2.3.3.3.1 Computing Gain or Loss on the Sale of a Subsidiary

If the sale of a subsidiary is structured as an asset sale (e.g., an asset acquisition or a share acquisition treated as an asset acquisition), the seller will reflect a gain or loss on the sale of the assets in pretax income and will recognize any current taxes, as well as the reversal of any deferred taxes related to the business, in the tax provision. If the transaction is structured as a stock sale (e.g., a third party purchases 100 percent of the parent’s stock in the subsidiary), the tax effects of the parent include the realization of any basis difference that exists on the parent’s investment in subsidiaries being sold. In addition, the historical tax bases of the subsidiary’s individual assets and liabilities generally transfer to the buyer. Is the presentation of the tax consequences of a stock sale different than it would be for the sale of the assets of the subsidiary? In particular, is the reversal of deferred taxes that are recorded on the subsidiary’s books included in the pretax gain or loss calculation, or should it be reflected in the tax provision? Where should the tax effects related to the parent’s tax basis in the shares of the subsidiary be reported?

We believe that in a stock sale there are two acceptable methods of accounting for the reversal/sale of deferred taxes on the inside basis differences of the subsidiary sold.

Under the first approach, the pretax book gain or loss would be computed based on the parent’s carrying value of the subsidiary, including the deferred tax assets and liabilities of the entity being sold. This view reflects the fact that the acquirer, by agreeing to buy the stock of the entity (and receiving the tax carryover basis), also is buying the future deductions or future taxable income inherent in the entity.

Example 12-21: Calculation of Pretax Gain or Loss of a Subsidiary
Inclusive of Deferred Taxes

Background/Facts:

A subsidiary holds one asset, with a carrying amount of $1,000 for book purposes and a tax basis of zero.

The tax rate for both the parent and subsidiary is 40 percent.

The subsidiary has recorded a $400 deferred tax liability related to that temporary difference.

The parent has a GAAP basis investment in the subsidiary of $600 ($1,000 pretax, less the $400 deferred tax liability recorded by the subsidiary) and a tax basis in the shares of the subsidiary of zero. The parent has not previously recorded a DTL on this book-over-tax outside basis difference. It is assumed that there was no held-for-sale accounting in an earlier period and, therefore, the guidance in Section TX 12.2.3.2.4.2 (which requires recognition of an outside-basis deferred tax no later than the held-for-sale date) does not apply.

The parent sells 100 percent of the stock of the subsidiary for $1,250.


The second approach is similar to that which is used for a sale of assets. Under this approach, the pretax gain or loss is calculated based on the selling price, less the net investment in the subsidiary, excluding deferred tax amounts. Any deferred tax amounts recorded on the subsidiary would be reversed through the tax provision. The following is an example of such a presentation.

Example 12-22: Calculation of Pretax Gain or Loss of a Subsidiary
Exclusive of Deferred Taxes

Assume same facts as Example 12-20.

Using the “exclusive of deferred taxes” approach, the presentation would be as follows:



The above examples assume that, on a pretax basis, the outside basis difference of the investment in the subsidiary equals the inside basis difference. However, this may not always be the case. As a consequence, it may be necessary to recognize additional deferred tax liabilities (or assets) on the parent’s books when it becomes apparent that a deferred tax liability on the outside basis difference no longer can be avoided (or that the outside basis will reverse in the foreseeable future for deferred tax assets). Such additional deferred tax liabilities should be recognized no later than the date on which the criteria of ASC 360-10-45-9 are met for classification as held-for-sale, consistent with the language in ASC 740-30-25-10 (Section TX 12.2.3.2.4) related to the recording of deferred tax assets. This does not, however, change the method of presentation discussed above.

Regardless of the presentation alternative selected for the tax effects attributable to inside basis differences, the tax effects associated with outside basis differences should always be reported in the tax provision.

Example 12-23: Whether to Include Deferred Taxes in the Carrying Amount of a Disposal Group Classified as Held-For-Sale

Background/Facts:

Company A has entered into a purchase and sale agreement with a buyer for a disposal group that meets the criteria in ASC 360-10-45-9 and therefore is classified as held-for-sale.

Question:

Should deferred tax assets and liabilities related to assets to be sold and liabilities to be assumed be included in the carrying amount of the held-for-sale disposal group?

Analysis/Conclusion:

It depends. According to ASC 360-10-15-4, a “disposal group” represents assets to be disposed of together as a group in a single transaction and liabilities directly associated with those assets that will be transferred in the transaction. A determination of whether deferred tax assets and liabilities should be included in the disposal group depends on whether the buyer will in fact be acquiring tax attributes and succeeding to the tax bases of assets and liabilities. That determination ultimately depends on the terms of the sale and the provisions of the relevant tax law in the applicable jurisdiction. In general, a disposal in the form of a sale of the shares of a corporation, in many jurisdictions results in the tax attributes and bases of the corporation’s assets and liabilities carrying over to the buyer. On the other hand, a sale which is structured or regarded under the applicable tax law as the sale of assets and liabilities generally does not include tax attributes and results in the buyer establishing new tax bases in those assets and liabilities. Accordingly, assuming the relevant tax law applied in the foregoing manner, the accounting analysis would be as follows:

Sale of shares—include deferred taxes in carrying amount

If the sale is structured as a sale of stock, deferred taxes associated with tax attributes and any book-tax basis differences in the assets and liabilities of the disposal group will be assumed by the buyer and should therefore be included in the carrying amount of the disposal group. That is because the deferred taxes meet the definition of assets to be disposed of or liabilities to be transferred (included in the definition of a disposal group in ASC 360-10-15-4).

Note that a decision to sell the shares of a subsidiary could require the recognition of additional deferred taxes associated with the difference between the seller’s carrying amount of the subsidiary’s net assets in the financial statements and its basis in the shares of the subsidiary. Because those deferred taxes will remain with, and be settled by the seller, they would not be included in the held-for-sale asset group. (Refer to ASC 740-30-25-10 and Chapter TX 11 for further guidance on the recognition of any temporary difference related to the outside basis difference.)

Sale of assets—exclude deferred taxes from carrying amount

If the sale is structured as an asset sale, the seller will retain and recover or settle the deferred tax assets and liabilities (e.g., any inside basis differences will reverse in the period of sale and become currently deductible by or taxable to the seller). Therefore, if an asset sale is expected, deferred taxes would not be included in the carrying amount of the assets and liabilities that are held for sale because they will not be transferred to the buyer (i.e., they are not part of the disposal group as defined in ASC 360-10-15-4).

12.3 Exception to the Basic Model—ASC 740-20-45-7

12.3.1 General Application of ASC 740-20-45-7

ASC 740-20-45-7 provides an exception to the “with” and “without” approach to intraperiod tax allocation. That paragraph states that all items (e.g., extraordinary items, discontinued operations, and so forth) should be considered for purposes of determining the amount of tax benefit that results from a loss from continuing operations and that should be allocated to continuing operations. We believe that “all items” means all items “below the line,” including gains and losses recognized in other comprehensive income and taxable amounts recognized in additional paid-in capital. In this regard, we believe the amortization of an unrecognized loss out of AOCI would constitute a source of other income and would be aggregated with all other “below-the-line” gains and losses for purposes of determining whether there is a net gain from sources other than continuing operations. Similarly, an other-than-temporary impairment (OTTI) recognized for previously unrealized losses on securities would constitute a source of other comprehensive income.

To the extent that income in another component represents a source of income that enables realization of the tax benefit of the current-year loss in continuing operations, the tax rate used to determine the amount of benefit in continuing operations should be based on the rate that is applicable to that other component. An example of this concept exists in ASC 740-20-55-10 (seen below in Example 12-22). In the facts of this example, ordinary income is taxed at a higher rate than capital gains and, as under U.S. tax law, an ordinary loss reported in the same period as a capital gain reduces the capital gain. The example also assumes that the loss from continuing operations is ordinary for tax purposes and that the extraordinary gain is a capital gain for tax purposes. ASC 740’s intraperiod rules allocate to the loss from continuing operations the capital gain tax actually avoided in the current year by the offset of the ordinary loss against the capital gain.

Example 12-24: ASC 740-20-55-10 Fact Pattern (Effect of Differing Tax Rates)

Background/Facts:

The following example illustrates allocation of income tax expense if there is only one item other than income from continuing operations. The assumptions are as follows:

The entity’s pretax financial income and taxable income are the same.

The entity’s ordinary loss from continuing operations is $500.

The entity also has an extraordinary gain of $900 that is a capital gain for tax purposes.

The tax rate is 40 percent on ordinary income and 30 percent on capital gains. Income taxes currently payable are $120 ($400 at 30 percent).

Analysis/Conclusion:

Income tax expense is allocated between the pretax loss from operations and the extraordinary gain as follows:


The effect of the $500 loss from continuing operations was to offset an equal amount of capital gains that otherwise would be taxed at a 30 percent tax rate. Thus, $150 ($500 at 30 percent) of tax benefit is allocated to continuing operations. The $270 incremental effect of the extraordinary gain is the difference between $120 of total tax expense and the $150 tax benefit allocated to continuing operations. In this case, an extraordinary gain taxable at the tax rate applicable to capital gains is offset, in part, by a loss from continuing operations.

Example 12-25: Application of ASC 740-20-45-7 to One Financial Statement Component Other Than Continuing Operations When a Valuation Allowance Exists

Background/Facts:

Company X, a calendar-year-end company, is taxable in only one jurisdiction. In its year-end 20X6 financial statements, Company X considers the following information when allocating its total tax expense to financial statement components:

Company X incurred a $3,000 pretax loss from continuing operations and $800 of pretax gain from discontinued operations during 20X6.

Company X anticipates that any net deferred tax asset at the end of the year will require a full valuation allowance.

The applicable tax rate is 40 percent.

Analysis/Conclusion:

Company X’s total tax expense/benefit for the year ended December 31, 20X5 is zero (“with” basis). The total pretax loss of $2,200 ($3,000 pretax loss from continuing operations less $800 pretax gain recorded in discontinued operations) results in the creation of an additional deferred tax asset of $880 ($2,200 x 40%), offset by a corresponding increase in the valuation allowance. On a “without” basis, no benefit would be allocated to continuing operations because the pretax loss of $3,000 would result in an operating loss carryforward of $1,200 accompanied by a full valuation allowance. However, the exception in ASC 740-20-45-7 (described above), requires that the $800 gain recorded in discontinued operations be considered when determining the amount of benefit allocable to continuing operations. Accordingly, Company X should allocate a tax benefit of $320 to continuing operations (the actual benefit realized by the discontinued operations gain) and a tax expense of $320 to discontinued operations ($800 x 40%).

If Company X instead had recognized only $700 of loss from continuing operations (assume all other factors were the same), the amount of tax benefit allocated to the loss from continuing operations would have been $280 ($700 x 40%). In other words, the amount of tax benefit allocated to continuing operations is limited to the lesser of (1) the tax effect of the loss from continuing operations or (2) the tax avoided on the overall net pretax income from all components other than continuing operations that provide a source of realization of the continuing operations loss.

Example 12-26: Application of ASC 740-20-45-7 to More Than One Financial Statement Component Other Than Continuing Operations When a Valuation Allowance Exists

Background/Facts:

Assume there is a $2,000 loss carryforward at the beginning and at the end of the year; the underlying DTA has a full valuation allowance at both dates. During the year, there is a $1,000 loss from continuing operations, $2,000 of income from discontinued operations, and an unrealized loss from AFS securities in OCI of $1,000. The applicable tax rate is 40 percent.

Analysis/Conclusion:

ASC 740-20-45-7 requires recognition of a $400 tax benefit in continuing operations because a benefit was realized from the loss in continuing operations. Looking to income from financial statement components other than continuing operations, $1,000 of net income existed to realize the tax benefit generated by the loss from continuing operations in the current year. In other words, absent the net income from these other sources, the loss carryforward would have grown larger (and required a valuation allowance). Since the total tax expense is zero, a tax charge of $400 must be allocated to discontinued operations and AFS securities in accordance with ASC 740-20-45-14. Following the ASC 740-20-45-14 methodology, losses are considered first. As the current-year loss from AFS securities provides no incremental tax benefit (the total tax expense for the year is no different with or without the current-year loss from AFS securities), no benefit is allocated to the current-year loss from AFS securities. As a result, with discontinued operations the only remaining component, the entire tax expense of $400 is allocated to discontinued operations.