Accounting for Income Taxes: 2014 Year-end Hot Topics
January 2014
Calendar year 2014 has seen considerable activity in the legislative and regulatory landscapes both in the United States and abroad. These developments, combined with an environment of political and economic uncertainty, have added to the existing challenges in accounting for income taxes.
The global tax environment continues to evolve as companies are faced with a rapidly-changing business landscape, increased stakeholder scrutiny, and a heightened enforcement environment. Trends in responsibility and integrated reporting, as well as the use of non-GAAP measures have also gained momentum.
Managing tax risks and addressing a perception that companies may not be paying their "fair share" of tax are in the spotlight as stakeholders have increasingly shown interest in these areas. Tax planning and certain areas of tax accounting have become Boardroom issues.
As in prior years, this publication is focused on topics we believe will be widely relevant to the preparation of 2014 year-end financial statements. Some topics have been discussed in our prior annual publications; however, their continuing importance warrants their inclusion in 2014. For information related to presentation and disclosure, please refer to the separate PwC Tax Accounting Services Income Tax Disclosure publication.
Unless specifically indicated, the discussion and references throughout the publication pertain to US generally accepted accounting principles (US GAAP) and reporting considerations.
Under US GAAP, Accounting Standards Codification (ASC) 740, Income Taxes, requires companies to measure current and deferred income taxes based upon the tax laws that are enacted as of the balance sheet date of the relevant reporting period. As a result, for the measurement of deferred tax assets and liabilities, the applicable tax rate applied to cumulative temporary differences is based upon the enacted law for the period in which the temporary differences are expected to be realized or settled. Thus, even legislation having an effective date in the future will typically cause an immediate financial reporting consequence upon enactment.
Under International Financial Reporting Standards (IFRS), International Accounting Standard (IAS) No. 12, Income Taxes, requires companies to measure current and deferred income taxes based on the tax laws that are enacted or substantively enacted as of the balance sheet date of the relevant reporting period. This can mean that for a particular reporting period, the effects of a tax law may be reported under IFRS but not under US GAAP. For additional information, please refer to the PwC Global Tax Accounting Services publication Around the World: When to account for tax law changes..
At each reporting date, other tax law developments, such as federal, state, and international court decisions, should also be timely considered for effects on existing uncertain tax positions, or on positions expected to be taken in the future. The existence of controls to proactively monitor, evaluate, and timely consider the accounting implications of such matters is critical.
The following highlights several 2014 tax law changes and developments around the world.
Significant changes include: (1) eliminating the bank franchise tax and subjecting all corporations to a revised corporate franchise tax, (2) reducing the corporate tax rate from 7.1% to 6.5%, (3) increasing the MTA surcharge rate from 17% to 25.6%, (4) establishing a 0% tax rate for "qualified New York manufacturers", (5) phasing out the capital base tax rate to 0% by 2021, (6) implementing a new unitary combined reporting system, (7) revising the net operating loss provisions, and (8) establishing a single receipts factor apportionment formula with customer sourcing provisions.
New York City has yet to conform to these changes; taxpayers will be required to determine their overall state and city liabilities under two different tax regimes.
On September 11, 2014, Governor Rick Snyder signed legislation (S.B. 156) retroactively repealing the Multistate Tax Compact from the state statutes, effective January 1, 2008. The legislation is intended to supersede the Michigan Supreme Court's decision and potentially relieve the state from paying refund claims to other taxpayers who elected the three-factor apportionment formula.
Throughout 2014, the Financial Accounting Standards Board (FASB) has continued to take steps to clarify or amend existing accounting guidance. In addition, the FASB has introduced several income tax accounting topics as part of its initiative to reduce complexity in accounting standards.
The following Accounting Standards Updates (ASUs) should be considered in the preparation of year-end financial statements and beyond.
In January 2014, the FASB issued a new standard permitting entities to account for investments in low income housing tax credit (LIHTC) projects using the 'proportional amortization' method if certain conditions are met which include 1) it is probable that the tax credits allocable to the investor will be available, 2) the investor does not have the ability to exercise significant influence over the operating and financial policies of the entity, 3) substantially all of the projected benefits are from tax credits and other tax benefits, 4) the investor's projected yield based solely on the cash flows from the tax credits and other tax benefits is positive, and 5) the investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the investor's liability is limited to its capital investment.
Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received. The net investment performance is recognized in the income statement as a component of income taxes. The use of the proportional amortization method is an accounting policy election to be made once and thereafter applied to all eligible investments in LIHTC programs.
For public entities, the new guidance will be effective for fiscal years beginning after December 15, 2014. For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2014. Early adoption is permitted.
In January 2014, the FASB issued new guidance on two accounting alternatives previously approved by the Private Company Council (PCC).
The new standards provide private companies with: (1) an alternative accounting model for goodwill that permits amortization of goodwill on a straight-line basis over a maximum of ten years, and (2) a simplified hedge accounting approach for qualifying interest rate swaps.
Under the alternative accounting model related to goodwill, goodwill existing as of the balance sheet date would be classified as a finite-lived asset.
For companies assessing the need for a valuation allowance on deferred tax assets, the classification of goodwill as a finite-lived asset may result in taxable temporary differences which support the realization of deferred tax assets. It should be noted that while this alternative accounting model is a departure from the prior guidance, it does not change the prohibition on recording deferred tax for book-over-tax goodwill in a business combination.
These standards are effective for fiscal years beginning after December 15, 2014, with early adoption permitted.
In May 2014, the FASB issued new guidance that resulted from a joint project with the International Accounting Standards Board (IASB) which clarified the principles for recognizing revenue and developed a common revenue standard for US GAAP and IFRS.
The core principle of the standard is that an entity should recognize revenue which depicts the transfer of promised goods or services to customers in an amount that reflects the consideration that the entity expects to be entitled to in exchange for those goods or services.
While there is no financial reporting impact for this year-end, there is nothing precluding proactive tax planning or the assessment of any potential impacts the new revenue standard may have on (1) existing tax return accounting methods or (2) processes, controls, or data needs that may result to properly compute taxable income and apply the principles of ASC 740.
For public entities that apply US GAAP, the amendments in this ASU are effective for fiscal years beginning after December 15, 2016. For nonpublic entities that apply US GAAP, the amendments are effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. Early adoption to the public entities' effective date would be permitted for nonpublic entities.
For IFRS filers, the equivalent standard (IFRS 15) should be applied for annual periods beginning on or after January 1, 2017. Early adoption is permitted.
For more information on the new standard, please refer to the "Tax accounting method changes" section of this publication.
In 2014, the FASB gave consideration to several topics related to income taxes which could reduce complexity under their broader simplification initiative. The initiative evolved as a result of feedback from the Financial Accounting Foundation's (FAF) Post-Implementation Reviews of FAS 109 and FAS 123 (R) which were completed in November of 2o13 and August of 2014, respectively. At present, there are two projects that are focused on the simplification of income tax accounting: the income tax project and the stock-based compensation project.
Income Tax Project
In October of 2014, the FASB agreed to issue an exposure draft related to two income tax accounting topics. The draft is expected to be issued in January 2015 with a 120-day comment period.
The first proposed change would require recognition of the current and deferred income tax consequences of an intra-entity asset transfer when the transfer occurs. This would eliminate the current exception which requires both the buyer and seller in a consolidated reporting group to defer the income tax consequences of an intra-entity asset transfer. The second proposed change would require the classification of all deferred tax assets and liabilities as non-current on the balance sheet. This would replace the current guidance which requires deferred taxes for each tax-paying component of an entity to be presented as a net current asset or liability and a net non-current asset or liability.
If adopted, these changes would be effective for financial reporting years beginning after December 15, 2016 for public entities. For nonpublic entities, changes would be effective for the year-end financial statements for financial reporting years beginning after December 15, 2017 and interim periods in the following year. Early adoption to the public entities' effective date would be permitted for nonpublic entities.
In addition to these two proposed changes, the FASB instructed its staff to research the possibility of entirely eliminating the intraperiod tax allocation rules and to reassess the disclosure requirements relating to unremitted earnings and other outside basis differences in foreign subsidiaries as part of its broader Disclosure Framework Project
Stock Compensation Project
In October of 2014, the FASB decided to add income tax accounting related to stock-based compensation to its agenda. The Board agreed to address the possible recognition of all windfalls and shortfalls within income tax expense. That proposed treatment would replace the current guidance which allocates tax effects between equity and income tax expense based upon several factors requiring complex tracking and computations. Furthermore, the Board agreed to include the possible elimination of the current requirement to display the gross amount of windfall as an operating outflow and financing inflow in the cash flow statement.
During 2014, the IFRS Interpretations Committee (IFRIC) considered changes to International Accounting Standard 12 related to the recognition of deferred tax assets for unrealized losses on available-for-sale (AFS) debt securities and the recognition of current income tax on uncertain tax positions. These changes would be another step towards US GAAP and IFRS income tax accounting convergence.
In May, the IFRIC recommended to the International Accounting Standards Board that the assessment of recognizing a deferred tax asset related to an AFS debt security would be made in combination with the entity's other deferred tax assets. In addition, the ability and intention to hold the investment until the recovery of its amortized cost basis would not in itself provide a basis for recognizing the deferred tax asset. This recommendation is similar to the guidance expected to be issued by the FASB related to the valuation allowance assessment on the deferred tax asset as part of the Board's project on financial instruments.
Calendar year 2014 has continued to see a significant number of tax-related comment letters issued by the staff of the Securities and Exchange Commission (SEC). Of the comment letters released to the public between January 1, 2014 and September 30, 2014, almost 500 of the comments related to tax matters. Of those tax- related comments, approximately 80% related to the following areas: indefinite reinvestment of foreign earnings, presentation of the effective tax rate, valuation allowance assessments, and uncertain tax positions.
As presented in the table below, matters of management judgment continue to be an area of focus for the SEC. Emphasis on providing accurate, transparent, and plain language disclosures for significant assertions and estimates should be considered by preparers when assessing their existing and future disclosures.
With respect to deferred tax asset valuation allowance assessments, the SEC seeks to more deeply understand the facts, circumstances, judgments, and decisions made by companies. They are interested in a company's assessment and weighting of the positive and negative evidence, including in situations where there has been a recent return to profitability.
A notable amount of attention is given to accumulated foreign earnings and the presentation of the effective tax rate, including foreign rate reconciling items. The SEC often requests quantitative and qualitative details to support the amounts included in the 'foreign rate reconciling items' line item. Common requests include: (1) a discussion of how the line item was computed by identifying its significant components and (2) a reconciliation detailed by country.
The SEC staff has continued to emphasize that a registrant's indefinite reinvestment assertion(s) related to foreign earnings should be consistent with its disclosures within: (1) Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A), (2) financial statement footnotes, and (3) other publicly available information. The staff has frequently required additional disclosure in the liquidity section of the MD&A of potential tax effects from repatriating offshore cash and cash equivalents.
SEC comment letters have also reminded preparers of the requirement to disclose an estimate of the unrecorded tax liability relating to unremitted earnings, if practicable to calculate. In some of those cases, the SEC has challenged management's assertion of impracticability. Preparers asserting impracticability should be prepared to articulate the basis for their view. Disclosure should include the events which could cause a liability to be recorded in the future.
We expect areas of management judgment – particularly in the areas of valuation allowance, foreign tax rates and unremitted earnings – to be a continued area of focus by regulators, investors, and commentators in 2015.
The accounting for an uncertain tax position does not end with the initial determination of a position's sustainability. As of each balance sheet date, uncertain positions must be reassessed with the existence of new information.
New information – New information can relate to developments in case law, changes in tax law, new regulations issued by taxing authorities, interactions with the taxing authorities, or other developments. Such developments could potentially change the estimate of the amount that is expected to eventually be sustained or cause a position to meet or fail to meet the recognition threshold. While the definition of what can constitute new information is expansive, new or fresh re-assessment of the same information does not constitute new information.
Effective settlement – For a tax position to be considered effectively settled, all three of the following conditions must be met:
If the requirements of effective settlement are met, the resulting tax benefit is required to be reported.
Jurisdictional netting – On a jurisdictional basis, ASU No. 2013-11 generally requires an unrecognized tax benefit (UTB) to be presented in the financial statements as a reduction to a deferred tax asset for an NOL carryforward, similar tax loss, or tax credit carryforward. This would be the case except when an NOL carryforward, similar tax loss, or tax credit carryforward is not available under the tax laws of the applicable jurisdiction to settle any additional income taxes resulting from the disallowance of a tax position. In such instances, the UTB should be recorded as a liability and cannot be offset against the deferred tax asset. The assessment as to whether a deferred tax asset is available is based on the UTB and deferred tax asset that exist at the reporting date and should be made assuming disallowance of the tax position at the reporting date.
Disclosures – Required disclosures related to income tax uncertainties are often extensive and can be highly sensitive. For more information, please refer to the PwC Tax Accounting Services publication – Income tax disclosure.
The evaluation of the need for, and amount of, a valuation allowance for deferred tax assets is an area that often presents challenges for financial statement preparers. The assessment requires significant judgment and a thorough analysis of the totality of both positive and negative evidence available to determine whether all or a portion of the deferred tax asset is more likely than not to be realized. In this analysis, the accounting standard proscribes that the weight given to each piece of positive or negative evidence be directly related to the extent to which that evidence can be objectively verified. Accordingly, recent financial results are given more weight than future projections.
As preparers perform their assessments, the following reminders may be helpful:
Level at which assessment is performed – Where local law within a jurisdiction allows for consolidation, a valuation allowance assessment generally should be performed at the consolidated jurisdictional level.
However, where the local tax law does not allow for consolidation, the valuation allowance assessment would typically need to be performed at the separate legal-entity level.
All available evidence – The accounting standard requires that all available evidence be considered in determining whether a valuation allowance is needed, including events occurring subsequent to the balance sheet date but before the financial statements are released. However, a valuation allowance assessment should generally not anticipate certain fundamental transactions such as initial public offerings, business combinations, and financing transactions until those transactions are completed.
Triggering events or changes in circumstances – There should be clear, explainable reasons for changes in a valuation allowance. In assessing possible changes, it is important to consider again the basis for amounts previously provided and how new information modifies previous judgments. For example, consideration should be given to whether the results for the current year provide additional insights as to the recoverability of deferred tax assets or as to management's ability to forecast future results. The mere existence of cumulative losses in recent years or for that matter, cumulative income in recent years, is not conclusive in and of itself of whether a valuation allowance is or is not required.
Deferred tax asset utilization vs. realization – The realization of deferred tax assets is dependent upon the existence of sufficient taxable income of an appropriate character that would allow for incremental cash tax savings. For example, if tax losses are carried back to prior years, freeing up tax credits (which were originally used to reduce the tax payable) rather than resulting in a refund, a valuation allowance would still be necessary if there are no additional sources of income to support the realization of the freed-up tax credits.
Certain tax-planning strategies may provide a source of income for the apparent recognition of deferred tax assets in one jurisdiction, but not provide incremental tax savings to the consolidated entity. In order to avoid a valuation allowance in reliance on a tax-planning strategy, we believe that the tax-planning strategy should provide cash savings to the consolidated entity. In a situation where there is an unlimited carryforward period, we do not believe a tax planning strategy can be utilized for the realization of deferred tax assets. The reason for this is because a tax-planning strategy is intended to be a backup plan for realizing attributes that would otherwise expire.
Outside basis differences – The reversal of an outside basis difference in a foreign subsidiary cannot be viewed as a source of taxable income when the foreign earnings are asserted to be indefinitely reinvested.
Taxable temporary differences on equity method investments can be considered as a source of taxable income provided there is an appropriate expectation as to the timing and character of reversal in relation to the deferred tax assets.
Indefinite-lived assets – Taxable temporary differences associated with indefinite-lived assets (e.g., land, goodwill, indefinite-lived intangibles) generally cannot be used as a source of taxable income. Thus, a valuation allowance on deferred tax assets may be necessary even when an enterprise is in an overall net deferred tax liability position.
However, in jurisdictions with unlimited carryforward periods for tax attributes (e.g., NOLs, AMT credit carryforwards, and other non-expiring loss or credit carryforwards), deferred tax assets may be supported by the indefinite-lived deferred tax liabilities. To the extent a jurisdiction has annual limitations on carryforward usage, a valuation allowance may need to be considered, despite an unlimited carryforward period.
Disclosures – Due to the significant judgments involved in determining whether a deferred tax asset is realizable, clear and transparent disclosures are crucial. For more information, please refer to the PwC Tax Accounting Services publication –Income tax disclosure.
The assertion of indefinite reinvestment of foreign subsidiary earnings continues to be one of the more complex and judgmental areas of accounting for income taxes. The growth in unremitted foreign earnings together with differences in global tax laws has made the application of the indefinite reinvestment assertion a matter of heightened concern for many stakeholders.
Companies should consider the following when evaluating their indefinite reinvestment assertion:
Disclosures - Due to the significant judgments involved in assessing indefinite reinvestment as well as the potential magnitude of the unrecorded deferred tax liability, disclosure must be carefully considered. For more information, please refer to the PwC Tax Accounting Services publication - Income tax disclosure.
Various forms of capital financing result in differences between an issuer's financial reporting basis and the tax basis of financial instruments. These basis differences must be assessed to determine whether a temporary difference exists for which a deferred tax asset or liability should be provided. Often, this will depend on the manner in which the financing is expected to be settled and whether the settlement method is within the company's control.
The following are some tax accounting aspects of this complex area to keep in mind:
Classification of debt versus equity– In evaluating whether certain basis differences in financial instruments are considered temporary differences for which deferred taxes should be recognized, it is necessary to have an understanding of the appropriate classification for both financial reporting and tax purposes. Certain financial instruments may be structured in a way that requires debt or liability treatment for financial reporting purposes but equity treatment under the applicable tax law, or vice versa. A basis difference that is created from a financial instrument that, upon reversal, has no corresponding tax impact (e.g., a hybrid financial instrument treated as equity for tax purposes and liability for US GAAP purposes) would not be considered a temporary difference for which deferred taxes would be recognized.
Characterization of an instrument as debt or equity for US federal income tax purposes depends on the terms of the instrument and all surrounding facts and circumstances.
The proper identification of the financial instrument's classification for both US GAAP and tax purposes is the starting point in evaluating whether any applicable book-tax basis difference will result in the recognition of deferred taxes at issuance and/or throughout the term of the instrument.
Permanent Items – Permanent items related to financial instruments may arise due to specific provisions within the tax law. For instance, the applicable high yield debt obligation (AHYDO) rules pursuant to Section 163(e)(5) may result in the permanent disallowance of interest deductions on certain debt instruments.
Companies should assess the potential impact of permanent items at the time of the issuance of the financial instrument and consider the impact on the entity's effective tax rate.
Embedded Derivatives – A convertible debt instrument (i.e., hybrid financial instrument) may require bifurcation of the embedded derivative from the host contract for financial reporting purposes, but remain viewed as one instrument for tax purposes. In situations where the instrument is treated differently for book and tax purposes, a book-tax basis difference may result for which deferred taxes would need to be recognized. Deferred taxes would be considered for both the host contract and the bifurcated embedded derivative. While those deferred tax balances will typically offset at issuance, the temporary differences will not remain equal over time as the bifurcated embedded derivative will be marked to fair value on an ongoing basis while the premium or discount on the host contract will be accounted for under other applicable US GAAP. However, in certain situations (e.g., instrument treated as equity for tax purposes) where there is no future tax effect anticipated with the settlement of the hybrid financial instrument, we would not expect deferred taxes to be recognized.
Debt Extinguishment – A debt extinguishment can occur when the issuer reacquires its debt for cash, other assets, or equity. For accounting purposes, an extinguishment gain or loss will be recognized in earnings based on the difference between the reacquisition price and the net carrying amount of the original debt.
The reacquisition price is the amount paid to settle the debt, including any call premium, miscellaneous costs of reacquisition, and the fair value of any assets transferred or equity issued. The net carrying amount includes any unamortized debt issuance costs and any unamortized debt discount or premium related to the extinguished debt.
The related tax effects of a debt extinguishment need to be considered within the context of the applicable tax law. The acquisition or extinguishment of debt at a premium (i.e., paying more than the tax basis) may, in certain cases, result in a current tax benefit for the payment in excess of the tax basis. For instance, the applicable tax law may indicate that if a corporation pays a premium over the adjusted issue price (i.e., tax basis) to repurchase debt, the premium paid, in whole or in part, may be deductible as interest. However, there may be situations in which the premium paid to reacquire debt in excess of its tax basis may be disallowed (e.g., in the case of a convertible debt instrument where the premium paid relates to the conversion feature). The extinguishment of debt for an amount less than the adjusted issue price (i.e., tax basis) typically gives rise to cancellation of debt taxable income.
Debt extinguishment gains or losses are recognized in earnings, and therefore, any related current tax effects from the extinguishment or deferred taxes that are eliminated, or reversed, upon the extinguishment will also be recognized in the income statement through the income tax provision. However, there are certain exceptions under ASC 740 which would provide for the current and deferred tax implications to be recognized in stockholders' equity.
In many instances, there are tax effects when an asset is sold or transferred between affiliated companies that are consolidated for financial statement purposes, but file separate tax returns. The seller's separate financial statements will generally reflect the profit on the sale and a tax expense on that profit. The buyer's separate financial statements will reflect the asset at the intra-entity price, which will also be the buyer's tax basis. However, in consolidation, the seller's pretax profit will be eliminated, and the asset will be carried at its cost to the seller until sold to an unrelated third party or otherwise recovered (e.g., through amortization or impairment).
Deferral provisions under ASC 810, Consolidation and ASC 740 apply to these intercompany transfers of assets, whereby no immediate tax impact is recognized in the consolidated financial statements. The tax effects to the seller are deferred in consolidation and the buyer is prohibited from recognizing a deferred tax asset for the excess of the buyer's tax basis over the consolidated carrying amount of the asset. Instead, the tax benefit resulting from any step-up in tax basis is recognized as it is realized each period, via deduction on the tax return.
When the intra-entity transaction is the sale of stock of a subsidiary, it involves the "outside" tax basis. Because the guidance refers to the intra-entity transfer of assets, we do not believe that the exception should be extended to the transfer of stock of a subsidiary (i.e., an outside basis difference). Rather, the guidance related to outside basis differences would be applied.
The general rule is that a deferred tax asset cannot be recognized for an excess tax-over-book outside basis difference unless it is apparent that reversal will occur in the foreseeable future (e.g., the entity is planning to sell the subsidiary in the near future).
In certain cases, determining whether an arrangement is considered an intra-entity transfer of an asset is judgmental and depends on the facts and circumstances. This might be the case, for example, with regard to an intra-entity transfer of intellectual property (IP) related to in-process research & development.
In the case of an IP transaction, determining whether the arrangement constitutes a transfer as opposed to a license to use the asset is often judgmental and depends on the individual facts and circumstances. In some cases, the arrangement constitutes an outright sale or an exclusive license for the entire economic life of the IP, and there may be little doubt that an asset has been transferred. In other situations where the IP is being licensed, it may be difficult to determine whether the arrangement constitutes an in-substance sale or merely a temporary license of the IP. Intra-entity arrangements should be reviewed to determine whether they confer ownership rights and burdens and whether the benefits and risks associated with the IP have been transferred. One way to make this determination is to consider whether the new holder of the IP would recognize an asset on its separate balance sheet, if it were to prepare separate company financial statements.
In making this determination, the legal and contractual rights conveyed in the arrangement are the primary considerations, however, the relevant income tax laws should also be considered. While not necessarily a bright-line indication of the accounting treatment, the characterization of the arrangement and subsequent tax treatment under the relevant income tax laws, as either a license or a sale may provide additional context to assist with the determination.
Other special areas should be given consideration, including, but not limited to accounting for the release of a valuation allowance concurrent with an intra-entity asset transfer, intra-entity transfers as potential tax- planning strategies to support realization of deferred tax assets, the effects of changes in respective uncertain tax positions, and the effects of subsequent law changes or transactions such as a disposal via spinoff or sale of the seller and/or buyer entity.
Few areas in accounting for income taxes are more difficult to apply than the tax accounting for the effects of fluctuations in foreign currency values.
The following are some aspects to keep in mind:
The accounting for business combinations can be challenging due to the unique nature of each transaction, need for cross-functional knowledge, and constraints on the availability of timely information.
Business combinations typically involve a considerable amount of business, legal, and tax planning. Determining whether the tax effects of elections or transactions occurring after an acquisition should be included in acquisition accounting is often judgmental.
We believe the following factors should generally be considered in making that assessment:
Bargain purchase refers to a transaction in which the fair value of the net assets acquired exceeds the fair value of consideration transferred. Such excess is often referred to as ''negative goodwill' and if it is determined to exist, will lead to recognition of a bargain purchase gain for financial statement purposes.
The tax rules for each separate jurisdiction may require a different treatment for bargain purchases. Tax rules often require the allocation of negative goodwill to certain assets through the use of a residual method, resulting in decreased tax bases. The recognition of the resulting deferred tax liabilities then leads to a reduction in the bargain purchase gain for financial reporting and may result in the recognition of goodwill.
The impact on the acquiring company's deferred tax assets and liabilities, including changes in a valuation allowance assessment caused by an acquisition, is recorded in the acquiring company's financial statements outside of acquisition accounting (i.e., not as a component of acquisition accounting). Additionally, deferred tax assets/liabilities of the acquiring company may need to be adjusted due to changes in applicable tax rates post-acquisition (e.g., related to changes to the state apportionment factors).
Deferred tax liabilities recorded in acquisition accounting may be a source of taxable income to support recognition of deferred tax assets of the acquired company as well as the acquirer. Where some but not all of the combined deferred tax assets are supported by deferred tax liabilities recorded in acquisition accounting, the acquirer will need to apply an accounting policy to determine which assets are being recognized. Additionally, the acquiring entity should consider any necessary changes to the company's indefinite reinvestment assertion upon consummation of the acquisition.
For a business combination achieved in stages, the acquirer should re-measure its previously held equity interest in the target as of the acquisition date and recognize the resulting holding gain or loss (including the associated impact of deferred taxes) in earnings. If, upon obtaining control of a domestic subsidiary, the parent has the intent and ability under the tax law to recover its investment in a tax-free manner, then the deferred tax liability related to the outside basis difference on the previously held investment is reversed through the acquirer's income statement outside of acquisition accounting.
If the subsidiary is foreign, then generally the deferred tax liability (or a portion thereof) related to the outside basis difference on the previously held investment must be retained under a special accounting rule.
A non-controlling interest (NCI) is the portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to the parent.
A 'disposal group' represents assets and directly related liabilities to be disposed of together in a single transaction. Whether deferred tax assets and liabilities should be included in the disposal group depends on whether the buyer will be seen as buying stock or assets. Depending upon the outcome, the buyer can be viewed as acquiring tax benefits (assets) or assuming tax liabilities.
On May 28, 2014, the FASB and IASB issued their long-awaited converged standard on revenue recognition titled Revenue from Contracts with Customers (Topic 606 and IFRS 15).
The new standard could affect the revenue recognition practices of many companies that have contracts with customers to provide goods, services, or non-financial assets, with a corresponding impact on cash taxes (generally in situations involving advance payments), book-tax differences, and deferred tax positions.
Because tax law generally prescribes special rules for recognition of revenue for tax purposes, most changes introduced by the new revenue recognition standard will likely affect computation of book-to-tax differences and the related deferred taxes. Nonetheless, the new standard could change the manner in which revenue is recognized for book purposes and complicate the determination of book-tax differences.
For example, the tax law requires recognition of revenue from the sale of goods when the 'benefits and burdens of ownership' of the property are transferred to the customer, which generally is more consistent with the current US GAAP 'risks and rewards' model. As a result, the new 'transfer of control' model could result in new book-tax differences.
Similar complexities could arise if the transfer of control model changes the timing of the recognition of services, long-term contract, or licensing revenue for financial accounting purposes but not tax purposes. To the extent the timing of an item of income changes, companies would need the capability to track book-tax differences.
Companies may wish to file an Application for Change in Accounting Method, Form 3115, to change the existing method of recognizing revenue for federal income tax purposes to better align the existing tax reporting methods to the new revenue recognition requirements.
When a request for a change in accounting method is reflected in a company's financial statements depends on whether or not a company is changing from a proper or improper accounting method and whether or not the change qualifies as an automatic or non-automatic change. We believe that the change of the accounting method under the above circumstances would qualify as a change from a proper accounting method.
In our view, automatic changes (i.e., those enumerated in the applicable Internal Revenue guidance) from one permissible accounting method to another should be reflected in the financial statements when management has concluded that it is qualified, and has the intent and ability, to file an automatic change in accounting method.
Multinational companies should also consider the impact of the new standard that can vary by country.
As companies seek to incentivize high performance among employees, the popularity of share-based compensation and equity incentive plans continues to increase. Mobility of workforces and evolving global tax and regulatory compliance requirements raise significant challenges in administering equity incentive plans which are often global in nature. In addition, tax accounting for equity incentive plans remains a complex area for many companies due to the uniqueness of the accounting principles coupled with diverse tax laws.
When evaluating tax accounting for stock-based compensation, the following issues should be kept in mind:
While there is generally a prohibition in the income tax accounting standard against "backwards tracing", there is an exception for certain equity items (e.g., recognition of windfalls and shortfalls included in equity). We believe this would include both favorable and unfavorable adjustments resulting from a change in the assessment of an uncertain tax position. Accordingly, to the extent a company has a sufficient pool of windfall benefits, it should "backwards trace" to additional paid-in capital (APIC) the tax effect of increases and decreases to the liability for an uncertain tax position associated with the windfall benefit.
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 current guidance in ASC 718, Stock Compensation, provides that the tax benefit and related credit to APIC for a windfall tax benefit should not be recorded until the deduction reduces income taxes payable. If a company has windfall tax benefits and NOLs or other carryforwards from earlier years, there are two acceptable methods to determine the order in which tax attributes should be considered: (1) the with-and-without approach or (2) tax law ordering approach.
Under the with-and-without approach, windfall tax benefits would be used last, whereas under tax law ordering approach, the provisions in the applicable tax law would determine the sequence in which windfall tax benefits are used.
An entity should treat its decision to adopt either approach as an accounting policy decision and follow the approach consistently. A policy decision to account for utilization of windfall tax benefits based on tax law ordering will often be less complex to administer as compared with the with-and-without approach. In addition, following the tax law ordering approach should reduce the need to track differences between the treatment of carryforwards for book purposes as compared with the treatment of the carryforwards for tax return purposes.
Declines in stock prices may suggest that some stock-based compensation awards for which deferred tax assets have been recorded are unlikely to be exercised. In these cases, absent negative evidence about future taxable income, companies should neither record a valuation allowance nor reverse the deferred tax asset, even if there is no expectation that the award will be exercised. The deferred tax asset should be reversed only when the award has lapsed or been forfeited. However, consideration should be given to providing disclosure that may help users assess the expected impact to the company.
Generally a difference between the book compensation charge and the tax deduction related to an equity award results in temporary differences. However, a difference that is not due to a change in fair value between the respective book and tax measurement dates could result in a permanent difference to be recorded through the income statement. This may arise, for example, if a restricted stock award includes features that impact the grant date fair value for financial reporting purposes but do not impact the fair value used for tax purposes.
Permanent differences could also arise from awards being subject to excessive compensation limitations under IRC 162(m).
Entities may also use a profits interest as an incentive for its employees. When an employee is granted a profits interest, there may be an opportunity under tax laws to take the interests into income on the grant date when the value is typically zero for the employee. This treatment effectively eliminates any future tax deduction for the entity. In situations such as these, a permanent difference would result when the book expense is recognized.
The principles of the income tax accounting standard are applicable to taxes based on income. Although the literature does not clearly define this term, we believe that a tax based on income is predicated on a concept of income less allowable expenses incurred to generate and earn that income.
Examples of taxes which would generally not be based on income include:
Some state or foreign taxes (or their portion) may also not be considered as taxes based on income. For example, certain states and jurisdictions impose franchise taxes that are computed as the higher of a tax based on income or a tax based on capital.
Only the portion of the tax which is based on income and which exceeds the tax based on capital is subject to ASC 740.
For example, if a tax based on income is $100 and a tax based on capital is $80, then only a portion of the tax based on income, i.e., $20 that exceeds the tax based on capital ($100-$80), would be subject to ASC 740. In a reverse situation, where a tax based on income is $80 and a tax based on capital is $100, no portion of income tax will be accounted for under ASC 740.
This scenario also raises questions as to how ASC 740 would be applied in determining the applicable tax rate that is used to compute deferred tax assets and liabilities. In computing the deferred tax provision, an entity should base the applicable tax rate on the incremental expected tax rate for the year(s) in which the temporary difference is expected to reverse. Another acceptable approach would be to use the applicable rate that the statute prescribes for the income-based computations. In this case companies may need to perform additional analysis to determine whether a valuation allowance is required against the resulting deferred tax assets.
Taxes that do not meet the criteria in the income tax accounting standard should not be recognized, measured, presented, classified or otherwise treated as an income tax. Thus, for example, deferred tax accounting and the provisions of uncertain tax positions would not be applicable to taxes outside the scope. Companies would instead apply the guidance set forth in ASC 450, Contingencies, or other applicable literature regarding the recognition of non-income based tax exposures. When applying such guidance to situations of uncertainty involving non-income based tax exposures, we believe assessments should be performed assuming the taxing authority is fully aware of relevant facts (i.e., without considering the risk of detection).
Allocating income tax expense (or benefit) to the various components of the financial statements (e.g., continuing operations, discontinued operations, and OCI) is a complex area of tax accounting.
Key points to consider include:
The basic model – 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 return is not filed).
The basic approach for intraperiod allocation (often referred to as the "with-and- without" or "incremental" approach) can be summarized in the following steps:
Exceptions to the with-and-without model – An exception to the use of the with-and-without approach occurs when there is a pre-tax loss from continuing operations and pre-tax income from other categories of income. Application of the exception makes it appropriate to consider, for example, a gain in OCI in the current year for purposes of allocating a tax benefit to a current-year loss from continuing operations. This would be the case even if the loss from continuing operations would have attracted no tax benefit under the with and without approach.
Changes in valuation allowance – Under the intraperiod tax allocation rules, the allocation of a tax benefit from a loss or deduction depends on:
The rules can be summarized as follows:
However, exceptions apply to these general rules as it relates to the initial recognition of tax benefits for certain items that are required to be "backwards traced". The initial recognition of tax benefits for these items (e.g., increases or decreases in contributed capital) should be allocated directly to the related component of shareholders' equity, regardless of the source of income that allows for their realization.
Tax effects lodged in OCI – Under the incremental approach, subsequent adjustments to deferred taxes originally charged or credited to OCI are not necessarily reflected in OCI. As a result, the tax effect lodged in OCI may not necessarily be proportionate to the pre-tax items recorded in OCI. ASC 740 is silent as to the disposition of a disproportionate tax effect lodged in OCI. General practice (as confirmed by the FASB staff) eliminates the disproportionate tax effect when the circumstances upon which it is premised cease to exist.
Market | Leader | Phone | |
Atlanta | Ben Stanga | +1-(615)-503-2577 | ben.stanga@us.pwc.com |
Northern California – San Jose | Ty Kanaaneh | +1-(408)-817-5729 | ty.h.kanaaneh@us.pwc.com |
Northern California – San Francisco | Adan Martinez | +1-(415)-498-6154 | adan.martinez@us.pwc.com |
Southern California | Darrell Poplock | +1-(213)-356-6158 | darrell.poplock@us.pwc.com |
Carolinas | Tamara Williams | +1-(704)-344-4146 | tamara.williams@us.pwc.com |
Chicago | Rick Levin | +1-(312)-298-3539 | richard.c.levin@us.pwc.com |
Florida | Rafael Garcia | +1-(305)-375-6237 | rafael.h.garcia@us.pwc.com |
Houston | Maria Collman | +1-(713)-356-5091 | maria.t.collman@us.pwc.com |
Lake Erie | Mike Tomera | +1-(412)-355-6095 | michael.tomera@us.pwc.com |
Michigan | Amy Solek | +1-(313)-394-6767 | amy.j.solek@us.pwc.com |
Minneapolis | Chad Berge | +1-(612)-596-4471 | chad.berge@us.pwc.com |
Missouri | Brian Sprick | +1-(314)-206-8509 | brian.sprick@us.pwc.com |
Northeast | David Wiseman | +1-(617)-530-7274 | david.wiseman@us.pwc.com |
New York Metro | Allen AhKao | +1-(973)-236-5730 | allen.p.ahkao@us.pwc.com |
New York Metro (Financial Services) | Gayle Kraden | +1-(646)-471-3263 | gayle.kraden@us.pwc.com |
New York Metro (Private Company Services) | Gary Pogharian | +1-(973)-236-5696 | gary.m.pogharian@us.pwc.com |
New York Metro (Financial Services) | John Triolo | +1-(646)-471-5536 | john.triolo@us.pwc.com |
Ohio, Kentucky, Indiana | Dan Staley | +1-(513)-723-4727 | daniel.j.staley@us.pwc.com |
Pacific Northwest | Suzanne Greer | +1-(206)-398-3339 | suzanne.greer@us.pwc.com |
Philadelphia | Diane Place | +1-(267)-330-6205 | diane.place@us.pwc.com |
Rockies | Mike Manwaring | +1-(720)-931-7411 | michael.manwaring@us.pwc.com |
North Texas | Steve Schoonmaker | +1-(512)-708–5492 | steve.schoonmaker@us.pwc.com |
Washington Metro | Jamie Grow | +1-(703)-918–3458 | james.b.grow@us.pwc.com |
David Wiseman +1-(617)-530-7274 david.wiseman@us.pwc.com |
Edward Abahoonie +1-(973)-236-4448 edward.abahoonie@us.pwc.com |
Steven Schaefer +1-(973)-236-7064 steven.schaefer@us.pwc.com |
Mark Wilmot +1-(313)-394-6685 mark.j.wilmot@us.pwc.com |
Kyle Quigley +1-(973)-236-7843 kyle.quigley@us.pwc.com |
Krystle Rodrigues +1-(973)-236-4924 krystle.rodrigues@us.pwc.com |
Katya Umanskaya +1-(312)-298-0268 ekaterina.umanskaya@us.pwc.com |
John Schmitt +1-(212)-312-7904 john.schmitt@us.pwc.com |