Chapter 1:
Scope of ASC 740

Chapter Summary

Accounting Standards Codification (ASC) 740, Income Taxes addresses how companies should account for and report the effects of taxes based on income. While the scope of ASC 740 appears to be self-explanatory (i.e., ASC 740 applies to all income based tax structures), the unique characteristics of tax structures across the United States and the world can make it quite difficult to determine whether a particular tax structure is a tax based on income. Matters are further complicated when the determination involves the U.S. tax treatment of a structure such as a single-member limited liability company or entails applying the “check the box” rules for entity classification. This chapter looks at what would constitute a tax based on income and discusses the applicability of ASC 740 to various types of entities.


1.1 Scope of ASC 740

1.1.1 In General (ASC 740-10-15-3)

ASC 740’s principles and requirements apply to domestic and foreign entities in preparing financial statements in accordance with U.S. GAAP, including not-for-profit entities (NFP) with activities that are subject to income taxes, including the following:

Domestic federal (national) income taxes (U.S. federal income taxes for U.S. entities) and foreign, state, and local (including franchise) taxes based
on income

An entity’s domestic and foreign operations that are consolidated, combined, or accounted for by the equity method

In short, any income-based tax that an entity must pay to a governmental authority is subject to the provisions of ASC 740.

It is also important to note that ASC 740 applies to all entities that are part of a reporting entity. It will be necessary, therefore, to consider the tax impact of other entities that interact with the companies that make up the financial reporting entity (e.g., equity-method investees and entities that are combined due to common control, or variable interest entities (VIEs) required to be consolidated under ASC 810 Consolidation)—not just the tax impact of consolidated subsidiaries.

1.1.2 Scope Exceptions (ASC 740-10-15-4)

ASC 740 explicitly states that it does not address:

A franchise tax to the extent it is based on capital and there is no additional tax based on income (Section TX 1.2.2.1)

A withholding tax for the benefit of the recipients of a dividend (Section TX 1.2.1.1)

1.2 Defining a “Tax Based on Income”

1.2.1 In General

As discussed above in Section TX 1.1.1, the principles of ASC 740 are applicable to “taxes based on income.” However, authoritative literature under U.S. GAAP does not clearly define the term “tax based on income” or specify characteristics that differentiate taxes based on income from taxes that are not. The legal definition of the tax structure (as an income tax or otherwise) is not determinative in an evaluation of whether a tax structure should be accounted for as a tax based on income. 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. That being said, the tax structure does not need to include all income statement accounts in order to be an income tax. A tax on a subset of the income statement, such as a tax on net investment income (which taxes investment income less investment-related expenses), would also appear to be a tax on income, since it would employ the net income concept. In general, practice has been that a “tax based on income” would even apply to tax regimes in which revenues or receipts are reduced by only one category of expense.

To define income taxes, we look to the ASC Master Glossary, which defines income taxes as “domestic and foreign federal (national), state, and local (including franchise) taxes based on income.” ASC 740 establishes standards of financial accounting and reporting for the tax consequences of “revenues, expenses, gains, or losses that are included in taxable income” (ASC 740-10-05-1). The ASC Master Glossary defines taxable income as “the excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the governmental taxing authority.” Thus, we believe that implicit in ASC 740 is the concept that taxes on income are determined after revenues and gains are reduced by expenses and losses. Therefore, as discussed in Section TX 1.2.2.2, taxes based solely on revenues (e.g., gross receipts tax) would not be subject to ASC 740.

1.2.1.1 Withholding Taxes—Entities That Withhold Taxes for the Benefit of Others

ASC 740-10-15-4 indicates that a withholding tax for the benefit of the recipients of a dividend is not an income tax of the entity that pays the dividend if both of the following conditions are met:

The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does not reduce future income taxes the entity would otherwise pay.

Shareholders receiving the dividend are entitled to claim the withholding as tax paid by the entity, on their behalf, either as a refund or as a reduction of taxes otherwise due, regardless of the tax status of the shareholders.

This guidance indicates that if both of the above conditions are met, the withholding tax would not be considered an income tax of the entity that pays the dividend. We believe that this guidance would also apply to withholding taxes for the benefit of the recipients of interest, royalty or other payments if the above conditions are satisfied.

1.2.1.2 Withholding Taxes—Entities That Receive Dividends, Interest, Royalties
or Other Income

The ASC 740-10-15-4 exception does not apply to entities that have taxes withheld from dividends, interest, royalties or other income on their behalf. Accordingly, these entities must determine whether such withholding taxes are income taxes which must be accounted for in accordance with ASC 740.

In many cases, withholding taxes will be deemed to be income taxes of the entity that receives the dividends, interest, royalties or other income. Withholding taxes are typically considered under local country laws, together with respective tax treaties, to be prepayments of (or in lieu of) local income taxes. In other words, the withholding taxes are essentially a substitute for a complete income tax calculation because the recipient of the payment (against which the tax is withheld) is outside the country and may not otherwise be required to file a local income tax return. If the company that received the dividends, interest, royalties or other income were to file an income tax return in the local jurisdiction, it would be able to claim the withholdings as a prepayment of the income taxes. In the U.S., such withholding taxes would typically be expected to generate foreign tax credits, and thus directly interact with the recipient entity’s U.S. income tax computation. If withholding taxes are determined to be income taxes, they would be subject to the accounting requirements of ASC 740. In situations in which taxes have not been withheld and the withholding would have qualified as an income tax, companies should be mindful of ASC 740’s requirements for the accounting for uncertain tax positions.

1.2.2 Application of Guidance to Specific Tax Jurisdictions and Tax Structures

As noted above, we historically have seen tax laws enacted in a number of jurisdictions where, based on the manner in which the tax is computed, it is not always clear whether the tax meets the definition of a “tax based on income.” In some cases, the tax might be just partially based on income (e.g., the taxpayer pays the higher of an income tax or equity-based tax in any given year). In other cases, the multiple characteristics of the enacted tax law and the law’s overall complexity may make it difficult to determine whether the tax is based (either wholly or partially) on income. Below are our views on certain tax regimes that have been enacted in various taxing jurisdictions.

1.2.2.1 Higher of an Income-Based or Capital-Based Computation

As noted in Section TX 1.1.2, franchise taxes based on capital are explicitly scoped out of ASC 740. However, certain states impose on corporations a franchise tax that is computed as the higher of a tax based on income or a tax based on capital. As discussed in ASC 740-10-15-4, any taxes based on income in excess of the franchise tax based on capital are subject to ASC 740. The Financial Accounting Standards Board (FASB) provided an example of one such tax in ASC 740-10-55-139 through 55-144. The example indicates that the franchise tax was an income tax only to the extent that it exceeded the capital-based tax in a given year. The same approach would be appropriate for any state tax that is similarly determined (i.e., is the higher of a capital-based computation or an income-based computation).

In such states, there is the question of how ASC 740 should be applied in determining the applicable tax rate that is used to compute deferred tax assets and deferred tax liabilities for temporary differences and carryforwards. We infer from ASC 740-10-55-144 that the tax operates as a graduated tax. Assuming that the statute prescribes a single tax rate for the income-based calculation, the tax rate is zero on the amount of taxable income for which the income-based tax calculation would equal the capital-based computation, and any additional taxable income is taxed at the tax rate prescribed in the statute. When graduated rates are a significant factor, the applicable rate is the average rate that is expected to be applicable to the amount of estimated taxable income in the reversal year(s).

Example 1-1: Higher of an Income-Based or a Capital-Based Computation

Background/Facts:

A state tax is the greater of (1) a tax based on income (e.g., 4.5 percent of taxable income) or (2) a tax based on equity (e.g., .25 percent of equity). In this example, the company’s equity is $200,000 each year. In year 1, book income is $13,000 and taxable income is $16,000 due to an originating deductible temporary difference of $3,000.

Question:

How should the tax based on income be reported?

Analysis/Conclusion:

Based on the facts above, the current tax provision would be calculated as follows:


In measuring the deferred tax asset and computing the deferred tax provision, an entity should base the applicable rate on the incremental expected tax rate for the year that the deductible temporary difference is anticipated to reverse. If the $3,000 temporary difference was expected to reverse in year 2 (at which point, it is estimated, the taxable income will be $15,000), the applicable state tax rate at which the year 1 deferred tax asset would be calculated would be computed as follows:


As a result, the deferred tax asset for year 1 is calculated by tax-effecting the $3,000 temporary difference at 1.167%, resulting in a $35 deferred tax asset.

The journal entry to record the tax expense for the year is as follows:


Another acceptable approach would be to use the applicable rate that the statute prescribes for the income-based computation, unless the reversals of temporary differences are what cause the income-based tax to exceed the capital-based computation. This approach is consistent with the FASB’s belief that deferred taxes should represent the incremental effect that reversing temporary differences and carryforwards have on future tax amounts (ASC 740-10-10-3). It should be noted that the FASB ultimately decided to use an “applicable rate” concept for deferred taxes, as opposed to measuring deferred tax assets and liabilities at their incremental value. Applying the alternative approach to the fact pattern in Example 1-1 would necessitate scheduling the reversal of the $3,000 temporary difference, as well as require determining the amount of the reversal that would provide incremental benefit in each succeeding year.

1.2.2.2 Gross Receipts Tax

A gross receipts tax is generally based upon a jurisdiction’s definition of “taxable gross receipts.” In devising this tax, many jurisdictions do not take into consideration any expenses or costs incurred to generate such receipts, except for certain stated cash discounts, bad debts, and returns and allowances. Because the starting point of the computation of a gross receipts tax is not “net” of expenses, we believe that a gross receipts tax is not a tax based on income for purposes of determining whether ASC 740 applies. In reaching this conclusion, we drew an analogy between a gross receipts tax and premium taxes that states often levy on insurance companies. A premium tax is reported as an operating expense, not as an income tax. In the case of the Ohio gross receipts tax that was enacted in 2005, the FASB staff informally agreed that a gross receipts tax is not a tax “based on income.”

However, in jurisdictions where the tax is calculated on modified gross receipts, consideration should be given as to whether it is a tax based on income. We believe that a modified gross receipts tax constitutes a tax based on income and should therefore be accounted for in accordance with ASC 740 if it is based on gross receipts that are reduced for certain costs (e.g., inventory, depreciable and amortizable assets, materials and supplies, wages, and/or other expenditures). One example of a tax based on modified gross receipts is Mexico’s flat tax which is broadly based on (i) receipts from the sale or disposition of property (including inventory), (ii) services rendered, (iii) royalties from unrelated parties and (iv) rentals of property. These receipts are offset by expenditures for (i) the acquisition of assets, (ii) services rendered, (iii) royalties to unrelated parties and (iv) rentals of property used in operations. Mexico’s flat tax is therefore considered a tax based on income, accounted for under ASC 740.

1.2.2.3 Single Business Tax

Prior to its repeal in July 2007, the Michigan “Single Business Tax” (SBT) was computed by adding payroll costs to, and subtracting certain capital expenditures from, income for the period. In many cases, the payroll and certain capital expenditures may have been larger than the entity’s income for the period. Notwithstanding that the law itself indicated that the SBT was not an income tax, we believe it met the ASC 740 definition of a “tax based on income.”

Although it appears clear that the legislature’s intent was to assess tax on a value-added basis, as opposed to an income-tax basis, it chose to use federal taxable income as its basis for quantifying the SBT. To this base, specific modifications were made to arrive at the SBT’s tax base. Additions to federal taxable income included items such as interest expense; state and foreign income taxes; interest and dividends from state obligations; federal net operating losses; federal capital loss carryovers or carrybacks; depreciation; compensation expense; and royalties paid. Subtractions included items such as certain dividends received, interest received, income from other entities, and royalties received.

When analyzed at a high level, the calculation of the SBT was similar in form to the calculation of the income-based franchise tax system that some states use. States with income-based taxes commonly use federal taxable income as the base, to which state-specific adjustments are then made. These modifications help the state satisfy its economic goals. Though the SBT was further removed from a pure income tax than the income tax resulting from more-traditional systems of state income tax, we nonetheless believe that the SBT was a tax based on income.

Because an entity may have had losses for both book and tax purposes and still have had a current liability for the SBT, we believe that classifying the related expense as either income tax expense or as a pretax operating expense was acceptable, as long as such classification was applied consistently. Regardless of the SBT’s classification in the income statement, it was an income tax and subject to the principles of ASC 740.

1.2.2.4 Texas Margin Tax

Texas’s “margin tax” is assessed on an entity’s Texas-sourced “taxable margin.” “Taxable margin” equals the lesser of (1) 70 percent of an entity’s total revenue or (2) 100 percent of its total revenue less, at the taxpayer’s annual election, (a) cost of goods sold or (b) compensation, as those terms are defined in the law. As discussed in Section TX 1.2.1, we believe that a tax based on income has a tax base that consists of income less deductible expenses. Because the margin tax has a base that possesses this characteristic, along with other characteristics of a tax based on income, the margin tax should be accounted for under ASC 740. We expect that a majority of companies will pay tax on either “revenue less cost of goods sold” or “revenue less compensation,” since those measures are likely to produce a smaller taxable margin than the “70 percent of total revenue” measure of “taxable margin.” Although this latter measure would not be equivalent to income (i.e., income less expenses), we view it as a maximum-threshold measure within a broader income tax structure. We do not view the Texas margin tax as an overall tax system that assesses tax based on sales or gross receipts (e.g., Ohio’s tax system), which would be characterized as a tax structure that is not based on income.

Because each of the measures of “taxable margin” have their own subset of applicable temporary differences (including the 70 percent of total revenue measure), scheduling may be required if an entity expects to be subject to more than one measure of taxable margin during future years in which it is anticipated that differences between the existing book basis and the tax basis will reverse. When an entity is measuring deferred taxes as part of this scheduling process, the margin tax’s Texas-apportioned enacted tax rate should be applied to the applicable temporary differences associated with the expected measure of taxable margin in a given year. We believe that if an entity expects to be subject to the “70 percent of total revenue” measure of taxable margin, the applicable rate for those revenue-related temporary differences (e.g., differences in recognition between the book basis and the tax basis for bad debts, deferred revenue, etc.) should be 70 percent of the Texas-apportioned enacted tax rate (reflecting the fact that 30 percent of the reversing revenue-related temporary differences would not impact taxes payable).

1.2.2.5 Private Foundation—Excise Tax on Net Investment Income

Some have questioned whether ASC 740 applies to the private foundation excise tax where the foundation reports securities at market value in its financial statements (for tax purposes, only realized gains are taxed, while in the financial statements, unrealized gains/losses are recorded). Even though this tax is considered an excise tax, it is considered an income tax for purposes of ASC 740, because the tax computation is based on an “income-type” number.

Accordingly, deferred taxes should be provided on private foundations’ untaxed, unrealized appreciation of securities. However, if the foundation is in a net unrealized depreciation position, it should consider the relevant tax law when assessing the realizability of the deferred tax assets. For example, under the U.S. tax code, capital losses for private foundations can be offset only by capital gains generated in the same year. There is no carryforward or carryback ability for capital losses; therefore, it is generally not appropriate to record a deferred tax asset for capital losses as there is no assurance of realization.

ASC 740-10-10-3 requires deferred taxes to be established using the rate that is expected to apply in the period that the temporary difference is expected to reverse. Private foundations have the ability to affect the rate that is used for their excise tax. For instance, if grants are increased by a certain amount, excise tax for the current year is computed at 1 percent rather than at the normal rate of 2 percent. However, in future years, the rate reverts to 2 percent, unless the grant-increase test is again met for those years. Accordingly, a question has arisen regarding the appropriate rate that should be used to record deferred taxes.

We believe that in the situation described above, the appropriate rate to record deferred taxes would be the 2 percent rate, because that is the normal enacted tax rate. Use of the 1 percent rate results from particular circumstances under the client’s control, which allows a temporary variation in the rate. Those circumstances consist of the requirement that during the tax year an entity make grant payments exceeding a base-period amount (and other requirements that are not relevant here). If the requirements are met during a year, the lower rate applies to that year’s tax. However, the lower rate will apply only to gains on securities sold during that year. As sales of securities held at year-end can occur only in subsequent years; as of the date of the year-end balance sheet, it cannot be known whether the foundation will later qualify for the lower rate. This is true even if the foundation has consistently qualified for the lower rate in previous years. Thus, for purposes of computing the deferred tax liability, a rate of 2 percent should be used.

1.2.2.6 The American Jobs Creation Act of 2004 Tonnage Tax

Example 1-2: The American Jobs Creation Act of 2004 Tonnage Tax

Background/Facts:

The American Jobs Creation Act of 2004 (the Act) permits qualifying corporations to elect to be taxed under a tonnage tax regime on their taxable income from certain shipping activities in lieu of the U.S. corporate income tax or, for foreign corporations, the gross transportation tax.

The tonnage tax is calculated by multiplying the maximum corporate tax rate (35 percent) by the notional shipping income for the year. Notional shipping income is based on the weight (net tonnage) of each qualifying vessel and the number of days that the vessel was operated as a qualifying vessel during the year in U.S. foreign trade.

Accordingly, an electing corporation’s total tax for the year would be equal to the tonnage tax plus the income tax on nonqualifying activities.

No deductions are allowed against the notional shipping income of an electing corporation, and no credit is allowed against the tax imposed. Therefore, a company in a loss position will still owe the tonnage tax.

Qualifying companies may switch to this method of taxation by filing an election with the IRS. A corporation making the election must do so before the due date (including extensions) of the income tax return for the year for which the corporation elects to be subject to the tonnage tax regime. An election may be made prior to the filing of such return by filing a statement with the IRS.

Questions:

Should the tonnage tax be accounted for as an income-based tax pursuant to ASC 740 or as a non-income-based tax (e.g., an excise tax)? During what reporting period should the company account for the election?

Analysis/Conclusion:

We believe the appropriate treatment is to account for the tonnage tax as a non-income-based tax because the tax calculation is based on the tonnage of a company’s qualifying vessels and is not directly tied to the income of the corporation. ASC 740-10-05-1, supports this view, indicating that an income tax is based on a company’s revenues, expenses, gains, or losses that are included in its taxable income. ASC 740-10-20 defines taxable income as “the excess of taxable revenues over tax deductible expenses.” Thus, inherent in the ASC 740 notion of an income tax is the concept that taxes on income are determined after deducting expenses and losses from gross revenues and gains.

It should be noted that we view the election of the tonnage tax as a change in tax status for a corporation. See Chapter TX 8 for a discussion of changes in the tax status of an entity.

Lastly, if significant, disclosure should be included in a company’s financial statements once the decision has been made that the company will file the election.

1.2.3 Credits and Other Tax Incentives

There are many credits and other tax incentives available for amounts spent that qualify under various governmental (U.S. and foreign) programs. These programs may take many forms, including programs related to research and development, alternative fuels, renewable energy and emissions allowances. These programs often include tax credits, incentives or rebates, designed to foster infrastructure, research, and other targeted business investment. In some cases, these credits and incentives are transferrable or refundable.

While credits and incentives often arise in the tax laws and may be claimed on a tax return, a number of features can make them more equivalent to a government grant or subsidy. Therefore, each credit and incentive must be carefully analyzed to determine whether it should be accounted for under ASC 740 or whether it constitutes a government grant, in substance, and thus is subject to other guidance.

Several questions should be considered when analyzing whether a credit or other tax incentive should be accounted for under ASC 740 or not:

Is there a direct relationship between the benefit received and taxable income or the income tax liability otherwise due?

How is the benefit claimed?

If there is more than one manner in which the benefit may be obtained, is the election irrevocable?

Can the benefit be sold?

Is the benefit refundable? For example, if a benefit claimed on an income tax return exceeded tax otherwise due (including as a result of subsequent loss carryback), would the benefit nonetheless be refundable?

Is the benefit taxable? Does taxability depend upon the manner in which the benefit is obtained?

The application of income tax accounting is generally warranted if a particular credit or incentive can be claimed only on the income tax return and can be realized only through the existence of taxable income. Where there is no connection to income taxes payable or taxable income and where the credits are refundable, we believe the benefit should generally be accounted for under an income recognition model.

Some credits or other tax incentives may be refundable either through the income tax return or in some other manner (e.g., direct cash from the government) at the option of the taxpayer. In general, we believe that, regardless of the method a company chooses to monetize the benefit, if there is no direct linkage to a company’s income tax liability, the accounting would be outside the scope of ASC 740. There may be some exceptions to this general analysis. For example, if the method of monetizing the benefits could result in significantly different taxation of the benefit, it may be that the method of monetizing will impact the accounting for these benefits.

In some cases, the benefit received under these programs may be taxable and the taxability might vary depending on the manner chosen to obtain the benefit. This may impact the analysis of the accounting treatment of a particular credit or incentive. In this regard, it is also important to understand if the choice is irrevocable. If so, it might indicate that the taxability could produce a different accounting answer. In these cases, we believe that if a company needs to choose to receive the benefit in a certain way (e.g., as a tax credit) to avoid taxation, the appropriate accounting could be to include it in determining income tax expense.

The following diagram may be helpful in identifying questions to ask when analyzing which accounting model to apply:


1.2.4 Attributes of Taxes Not Based on Income

There is the question of whether entities should account for (1) timing differences inherent in the computation of taxes that are not based on income and (2) tax credit carryforwards relating to taxes that are not based on income.

1.2.4.1 Timing Differences Inherent in the Computation of Taxes Not Based
on Income

We believe that the effects of timing differences that might be reflected in the computation of a tax that is not based on income should not be reflected in the financial statements as deferred tax assets or deferred tax liabilities because taxes that are not based on income are not within the scope of ASC 740. For example, in the case of a gross receipts tax, there may be differences between when gross receipts are included in GAAP income and when those amounts are included in the taxable base of gross receipts. Although these differences in the timing of recognition between GAAP and tax are analogous to temporary differences as defined in ASC 740, we do not believe that this analogy alone is sufficient to justify recording an asset or a liability.

1.2.4.2 Tax Credit Carryforwards for Tax Regimes Not Based on Income

Similarly, we believe that the analogy to the recording of a deferred tax asset in ASC 740 for credits useable against taxes not based on income is not in itself sufficient to warrant the recording of an asset. FASB Concepts Statement No. 6, Elements of Financial Statements, defines an asset as embodying “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” In many cases, therefore, an asset should not be recorded for non-income tax credit carryforwards, because the future benefit often depends upon a future event (e.g., the generation of future income that is subject to tax). However, we do believe that if a tax benefit can be achieved without future transactions (e.g., if a credit carryforward can be used to offset a tax on outstanding equity), it might be possible to justify recognizing an asset. Entities should make sure they understand the nature of how the carryforward arose and whether incremental benefit will be provided. We generally believe that if credit carryforwards are used but it is expected that new credits will continually replenish them (and be in larger amounts), there would be no incremental tax benefit, since the amount of tax paid would be the same with or without the tax credit carryforwards.

1.3 Accounting by Jurisdiction (Separate Calculation versus Blended Rate)

Although deferred taxes ordinarily must be determined separately for each tax-paying component in each tax jurisdiction, ASC 740-10-55-25 acknowledges that in certain situations the tax computations for two or more jurisdictions can be combined. This is possible when (1) the same operations are taxed in two or more jurisdictions and (2) either there are no significant differences between the tax laws of the jurisdictions (e.g., carryback and carryforward periods are similar, as are the significant components of the tax laws) or any difference in computation would have no significant effect, given the company’s facts and circumstances. In making this determination, companies should also consider the provisions of ASC 740-10-45-6 about the offset of deferred tax liabilities and assets of different jurisdictions.

In practice, many companies employ a “blended rate” approach at the legal-entity level to simplify the income tax calculation for entities operating in multiple jurisdictions (e.g., operating in multiple U.S. states). Management should be able to support its decision to use a blended rate and must not presume that a blended-rate approach is acceptable. Use of this approach should be continually assessed in light of the considerations enumerated in ASC 740-10-55-25 and other practical considerations. This may make the use of a blended rate unacceptable—especially as more and more states continue to decouple their tax calculations from the U.S. federal tax calculation. Examples of when problems can result from the use of a blended rate include the following:

When an entity enters or exits a particular jurisdiction.

When an entity needs to schedule deductible temporary differences and taxable temporary differences in order to determine the realizability of deferred tax assets for a component jurisdiction.

When there is a change in the assessment of a valuation allowance in one of the component jurisdictions.

When there is a tax law change that substantially changes the tax structure of one of the component states.

When there is a tax uncertainty that relates to only one or a subset of jurisdictions.

When differences would result in the application of ASC 740-20’s intraperiod allocation rules to one blended jurisdiction, as compared to applying those rules to multiple individual jurisdictions.

When jurisdictions are combined for purposes of calculating an income tax provision, some entities choose to employ an aggregate applicable rate (e.g., the federal applicable rate plus the applicable state rate, net of the federal effect at the applicable federal rate). In calculating a state tax provision, an entity’s use of a state rate, net of federal benefit, would be inconsistent with the principles of ASC 740, because the entity would effectively be netting the state tax with the deferred federal benefit. ASC 740-10-55-20 states that deferred state taxes result in a temporary difference for purposes of determining a deferred U.S. federal income tax asset or liability. ASC 740-10-45-6 states that “an entity shall not offset deferred tax liabilities and assets attributable to different tax jurisdictions.” Because ASC 740 does not allow the netting of different tax jurisdictions, a state tax rate should be applied separately to temporary differences; in calculating a temporary difference (for purposes of determining a deferred federal benefit) that arises from deferred state taxes, an entity should use a federal tax rate. As a practical matter, however, consideration of the federal effects of deferred state taxes (i.e., netting) is acceptable if the effects are not material. If the effects could be material, the use of a blended-rate approach may be precluded.

1.4 Applicability of ASC 740 to an Entity’s Legal Form

1.4.1 Single-Member and Multiple-Member Limited Liability Companies
(under U.S. Tax Law)

Questions often arise regarding how single-member and multiple-member limited liability companies (LLCs) should account for income taxes in their separate financial statements. Neither type of entity is specifically mentioned in ASC 740, but ASC 272, Limited Liability Entities, provides some guidance on accounting for multiple-member LLCs. See Section TX 14.4 for a discussion of the applicability of ASC 740 to the separate financial statements of a single member LLC.

1.4.2 Partnerships

1.4.2.1 Investments in Partnerships

ASC 740 does not address the accounting for tax effects related to investments in partnerships. This leaves certain questions unanswered. For instance, should the accounting of such investments be determined from the inside basis of the underlying assets, or should they be determined from the outside basis in the partnership interest?

We believe that measurement of deferred taxes related to an investment in a partnership should be based on the difference between the financial statement amount of the investment and its tax basis (that is, the outside basis difference). Deferred taxes are not based on the difference between the book basis and the tax basis within the partnership and, in many cases, are inherent in the outside basis difference. The measurement of deferred taxes using the outside basis of a partnership would be applicable regardless of whether the partnership investment was (1) carried via the cost method or equity method, (2) consolidated, or (3) pro rata consolidated.

See Section TX 11.1.9 for a more detailed discussion of accounting for the outside basis of a partnership investment.

1.4.2.2 General Application of ASC 740 to the Separate Financial Statements
of Partnerships

In the United States, general and limited partnerships (except certain “master limited partnerships” discussed below) are not subject to tax, because their earnings and losses are passed directly to their owners and taxed at that level. ASC 740 does not apply to such partnerships. In certain circumstances partnerships do represent taxable entities under local tax law (e.g., in Puerto Rico), which are responsible for their own entity-level tax on income. In those cases, ASC 740 is generally applicable.

Example 1-3: Partnership Subject to Income Tax

Background/Facts:

The New York City Unincorporated Business Tax (NYC UBT) is imposed on any unincorporated entity (including a partnership, fiduciary or corporation in liquidation) that is required to file Federal Form 1065, U.S. Return of Partnership Income, and is engaged in any trade, business, profession or occupation that is wholly or partly conducted in New York City. Any type of entity listed above and having total gross income exceeding $25,000 will generally be required to file a return on Form NYC-204, NYC Unincorporated Business Tax Return.

Question(s):

Should the NYC UBT be accounted for as an income-based tax pursuant to ASC 740 or as a non-income-based tax? If it is accounted for as an income-based tax, should the unincorporated entity/individual record deferred taxes for temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements?

Analysis/Conclusion:

Although many of the entities that are subject to the NYC UBT might not be taxable for U.S. and state income tax purposes (for example, partnerships), we believe that the NYC UBT is an income-based tax, as defined in ASC 740, because the starting point for determining the taxable income base is the ordinary business income recorded on Federal Form 1065. That income is then adjusted to reflect certain New York City modifications (e.g., add-backs for contributions to partner retirement plans, guaranteed payments to partners for services performed, and income taxes paid to other tax jurisdictions). Accordingly, deferred taxes for the NYC UBT should be established for any taxable or deductible temporary differences related to the entity’s assets and liabilities. The establishment of those deferred tax assets and liabilities, as well as periodic changes in their amounts, should be recorded as part of income tax expense in the income statement, along with the current portion of the UBT incurred in any particular period.

1.4.2.2.1 Master Limited Partnerships

Under the Revenue Act of 1987, publicly traded limited partnerships (“master limited partnerships”) formed after December 17, 1987, are taxable as corporations for post-1987 years. Master limited partnerships that were already in existence on December 17, 1987 became taxable as corporations for years beginning after 1997. Certain limited partnerships have been exempt from both these rules (e.g., partnerships engaged in real estate transactions or in oil and gas activities).

Entities that become taxable after 1997 should provide the appropriate deferred taxes for the impact of post-1997 reversals of current temporary differences.

1.4.2.2.2 Real Estate Investment Trusts (REITs) and Regulated Investment Companies (RICs)

Other entities, such as regulated investment companies (RICs) and real estate investment trusts (REITs) are not subject to tax (by means of a dividends paid deduction) if distribution requirements and other conditions are met. ASC 740-10-50-16 requires nontaxable RICs and REITs that are publicly held to disclose the fact that they are not taxed. In addition, it requires publicly held nontaxable RICs and REITs to disclose the net difference between their tax bases and the reported amounts of their assets and liabilities. Presumably this disclosure is meant to indicate to an owner (or prospective owner) what future taxable income or deductions, disproportionate to reported amounts, will be generated for his/her ownership interest by the entity’s future operations. However, for some entities, the depreciation or depletion deductions available to individual owners will not be pro rata to ownership interests but will instead reflect the different outside tax bases of the individual owners. Further, each owner’s tax accounting (e.g., depletion calculations for mineral properties) might depend on his or her individual tax position. Thus, the entity itself frequently will not have information about individual owners’ tax bases.

It does not appear that disclosure of the aggregate tax bases would be meaningful in any event, since individual owners will not share the tax bases pro rata. We believe that if these circumstances make it impracticable for an entity to determine the aggregate tax bases of the individual owners, the entity should indicate this in its financial statements and explain that the amount would not be meaningful.

As RICs and REITs do not “pass through” tax losses to owners (as partnerships do), they must disclose the amount of any operating or capital loss carryforward.

1.4.3 State Income Taxes

1.4.3.1 Separate Calculation Versus Blended Rate

See Section TX 1.3, which discusses the considerations outlined in ASC 740-10-55-25 and addresses other practical considerations.

1.4.3.2 Treatment of Apportionment Factors

Many state tax jurisdictions assess a tax based on the portion of taxable income earned in their jurisdiction. The process used to determine a respective state’s share of an entity’s business is typically referred to as “apportionment.” Although each state has its own laws for determining apportionment, many states use the following three factors in their determination: sales within the jurisdiction compared with total sales; assets within the jurisdiction compared with total assets; and payroll within the jurisdiction compared with total payroll.

In each state that follows an apportionment formula, the calculation of deferred taxes should use the apportionment factors that are expected to apply in future years. All available information should be used in this calculation. In practice, preparers of financial statements often use their current factors or factors shown in their most recently filed tax returns as the primary basis for estimating their future apportionment. While that may be useful as a starting point, the analysis should be adjusted to reflect any anticipated changes and all available information.

1.4.3.2.1 Changes in State Income Tax Rates Caused by Changes in How a State Apportions Income

We believe that when a change in the state rate is attributable to a change in the way a state computes its apportionment factors, the effect of the change should generally be treated as a change in tax rate and recorded entirely under continuing operations, consistent with the treatment of enacted law changes that is described in ASC 740-10-45-15. See Chapter TX 7 for a discussion of changes in tax laws and rates.