Chapter 7:
Change in Tax Laws or Rates
Chapter Summary
ASC 740 requires that the tax effects of changes in tax laws or rates be recognized in the period in which the law is enacted. Those effects, both current and deferred, are reported as part of the tax provision attributable to continuing operations, regardless of the category of income in which the underlying pretax income/expense or asset/liability was or will be reported. This chapter contains illustrative examples of the concepts surrounding changes in tax laws or rates and expands the discussion to include the accounting for automatic, nonautomatic, and nondiscretionary changes in tax return accounting methods.
7.1 Determining the Enactment Date
ASC 740-10-45-15 requires that the effects of a change in tax law or rates be recognized in the period that includes the enactment date. While the date of enactment is not explicitly defined, we believe that “enactment” occurs when the law has been subjected to the full legislative process.
For U.S. federal tax purposes, the enactment date is most often the date the President signs the bill into law. Enactment can occur in other ways, such as when the second house of Congress affirmatively overrides a presidential veto. The key concept is that the full legislative process is complete. Most states follow the same or similar processes.
Many foreign countries have requirements similar to those in the United States in that an official, such as the President, must sign legislation into law. For others, enactment occurs only after the law is published in an official publication, similar to a federal register.
The SEC, as well as the FASB and the AICPA International Practices Task Force, has long held the view that legislation should not be considered “enacted” until the foreign country’s official ultimately signs it into law and the full legislative process is complete (i.e., the law cannot be overturned without additional legislation). Thus, future (i.e., not fully enacted) rate changes cannot be anticipated and should not be recognized.
7.2 Distinguishing Between Interpretive and Legislative Regulations
Once tax legislation has been enacted, most jurisdictions employ a governmental department or agency (e.g., the U.S. Department of Treasury) to promulgate regulations necessary to implement and interpret the tax laws. In determining the proper accounting for changes in tax regulations, it is important to understand whether the regulation in question is interpretive or legislative in nature. (In some circumstances, judgment will be required to determine whether a regulation is interpretive or legislative in nature.)
Interpretive: In the U.S. federal context, the majority of Treasury regulations are interpretive in nature. Interpretive regulations are meant to interpret or clarify existing tax laws. In deliberating the guidance on accounting for unrecognized tax benefits, the FASB concluded that a change in judgment that results in subsequent recognition, derecognition, or change in measurement of a tax position should be recognized as a discrete item in the period in which the change occurs (i.e., as a nonrecognized subsequent event). Thus, the effects of interpretive regulations issued or changed after the balance sheet date but before the issuance of the financial statements should not be reflected in the prior period financial statements. Only a footnote disclosure of the event (if material) would be required. See Section 16.5.5 for more information.
Legislative: In the U.S. federal context, legislative regulations are issued pursuant to a specific delegation by Congress and, thus, generally have the full force and effect of law. Issuances of or changes to legislative regulations should be accounted for as changes in tax law in the period of enactment in accordance with the provisions of ASC 740-10-45-15.
Although the timing for recording the effects of newly issued or changes to existing interpretive and legislative regulations, which occur after the balance sheet date but before the issuance of the financial statements, are the same, the tax effects of the two types of regulations are subject to different intraperiod allocation rules. This may affect the component to which the related tax effects are allocated. See Section TX 16.9.1 and Section TX 12.2.2.2.1 for more information.
7.3 Accounting for Rate Changes
The total effect of tax rate changes on deferred tax balances is recorded as a component of the income tax provision related to continuing operations for the period in which the law is enacted, even if the assets and liabilities relate to other components of the financial statements, such as discontinued operations, a prior business combination, or items of accumulated other comprehensive income.
As discussed in ASC 740-10-55-23 and 740-10-55-129 through 55-135, an enacted change in future tax rates often requires detailed analysis. Depending on when the rate change becomes effective, some knowledge of when temporary differences will reverse will be necessary in order to estimate the amount of reversals that will occur before and after the rate change.
As discussed in Chapter TX 4, beginning at Section TX 4.2.3, the timing of reversals of temporary differences may not be the only consideration in the determination of the applicable rate to apply to those temporary differences. The applicable rate is determined by reference to the rate expected to be in effect in the year in which the reversal affects the amount of taxes payable or refundable. For example, assume that reversals are expected to occur in a future year after a change in enacted tax rates takes effect. Also assume an expectation that taxable results for that year will be a loss that will be carried back to a year before the rate change takes effect, and that the reversals will increase or decrease only the amount of the loss carryback. In those circumstances, the rate in effect for the carryback period is the applicable rate. Similarly, if rates changed in a prior year and carryback of a future tax loss to pre-change years is expected, then the pre-change tax rate will be the applicable rate for reversals whose effect will be to increase or decrease the loss carryback.
The calculation is even more complicated if the reversing temporary differences both reduce current-year taxable income and generate losses that are expected to be carried back to a pre-change year. Assuming graduated rates are not a significant factor, the tax effects of the reversals ordinarily should be determined on an incremental basis. Specifically, if the net reversing difference—the excess of deductible over taxable differences included in the expected tax loss—was less than or equal to the projected amount of the tax loss, the applicable rate would be the pre-change rate; the post-change rate would be applied to the amount of the net reversal that exceeded the projected tax loss.
Example 7-1: Determining the Applicable Rate When Temporary Differences Both Reduce Taxable Income and Generate Losses Expected to Be Carried Back
Assume that as a result of new tax legislation, the statutory tax rate drops from 35 percent to 30 percent and that an entity estimates $900 of pretax book income and $1,000 of net reversals of deductible temporary differences that will result in a taxable loss of $100 in the post-change period. Also assume that the entity expects to carry back this loss to a pre-change period.
Because $900 of the temporary differences is expected to reduce taxable income and the resulting taxes payable in the post-change period, the lower post-change rate of 30 percent should be applied to those deductible temporary differences. Conversely, because the remaining $100 of deductible temporary differences is expected to be carried back to a pre-change 35 percent rate period, the 35 percent rate should be applied to that portion of the reversing deductible temporary differences.
A similar, but opposite, approach may be appropriate when taxable income is expected for a post-change year but its amount is less than the amount of a net reversing taxable difference—that is, there is an excess of taxable over deductible reversals. If a tax loss in that year could be carried back to a pre-change year, the applicable rate would be the future rate only to the extent of the estimated taxable income for the year of reversal, and the current rate would be applied to the balance of the reversals. If a tax loss in the reversal year would be carried forward, the rate expected to be in effect in the carryforward years would be the applicable rate for all the reversals.
Example 7-2: Determining the Applicable Rate When There Are Pretax Losses and Net Reversing Taxable Temporary Differences That Create Taxable Income
Assume that as a result of new tax legislation, the statutory tax rate drops from 35 percent to 30 percent and that an entity estimates $900 of pretax book loss and $1,000 of net reversals of taxable temporary differences that result in taxable income of $100 in the post-change period. Also assume that the entity has sufficient taxable income in the relevant carryback period to absorb losses.
Applying the incremental concept to deferred taxes, $900 of the $1,000 net reversing taxable temporary differences would be reflected using the pre-change rate (since it serves to offset what would have been carried back and benefited at the pre-change rate), with the balance, $100, reflected at the post-change rate.
In some cases, enacted tax legislation may involve a phase-in of several different rates over a period of time. The key questions in the analysis will be (1) when will
the temporary differences reverse, and (2) will the reversals reduce taxes payable
in the years of reversal or will they result in a carryback or carryforward that will generate a tax refund from an earlier year or reduce a tax payable in a future year, each of which has a different tax rate? ASC 740-10-55-129 through 55-130 provides an example (see Chapter TX 4, Example 4-3). Additionally, enacted tax legislation may also include a provision that changes the tax rate in a particular year if specified conditions occur. Example 7-3 illustrates how a company should consider contingent income tax rates when measuring its deferred taxes.
Example 7-3: Treatment of Contingent State Income Tax Rates
Background/Facts:
State X has a corporate income tax rate of 5 percent. In the current year, State X enacts a revision to the tax law providing that, in the event specified budgetary goals are not met for a particular year, the 5 percent rate will be increased to 8 percent, retroactive to the beginning of that year. Company Y conducts business in State X and in accordance with ASC 740 must measure its deferred taxes based on the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred taxes are expected to be realized or settled.
Question:
Should Company Y measure its deferred taxes, at the 5 percent corporate tax rate or at the enacted, but contingently applicable, 8 percent rate?
Analysis/Conclusion:
Company Y should use judgment as to whether State X will meet the specified criteria to maintain the 5 percent corporate income tax rate in assessing the rate(s) to use in its accounting for income taxes. The measurement of State X deferred taxes should be recorded using Company Y’s best judgment as to the rate expected to be applicable upon realization or settlement, consistent with the guidance in ASC 740-10-30-9,which discusses graduated tax rates and other provisions of enacted tax laws to be considered in determining the tax rate to be applied. Because the outcome of the uncertainty in this case depends on factors that are external to any particular company, it may be important for Company Y to obtain relevant input and evidence as to the likelihood of State X meeting its budgetary goals.
This guidance is specific to enacted income tax rates that are contingent upon specified criteria to be measured at a future date rather than those that are contingent upon future legislative action (i.e., that would not be considered enacted).
The applicable rate would require ongoing monitoring and consideration should be given to disclosure of the uncertainty, the rate applied and the potential impact of a change in expectations. The effects of any changes in expectations should be accounted for as a change in estimate in the period in which the change in expectation occurs.
7.4 Interim-Period Considerations
As discussed above, the effect of a change in tax laws or rates on a deferred tax liability or asset must be reflected in the period of enactment.
When determining the effect of a tax law change, entities must consider the law change’s effect on the deferred tax balances existing at the enactment date and, to the extent the law change is retroactive, its effect on taxable income through the enactment date. For entities that prepare quarterly financial statements, estimating the effect of the law using the most recent quarter end, adjusted for known material transactions between the enactment date and the quarter end, usually is sufficient. For other entities, calculating the effect of the law change may require additional work. For such entities, the effect of reversals of beginning deferred tax balances for the period through the enactment date has to be considered, as well as the deferred tax effects of originating temporary differences.
Computing this effect, however, requires measuring temporary differences and the related deferred taxes at an interim date, that is, the date of enactment. For determining the effect of a tax rate change, the deferred taxes actually accrued through the enactment date (by application of the effective rate to year-to-date “ordinary” income and by discrete recognition of other tax effects) should be used (see more about computing deferred taxes for interim periods in Section TX 7.4.1).
In the interim period in which a rate change is enacted, the tax used in computing the new annual effective rate combines:
Tax currently payable or refundable on estimated “ordinary” income for the current year, reflecting the effect of the rate change to the extent that it is effective for the current year.
The deferred tax expense (the difference between the beginning-of-year and the estimated end-of-year balances in the balance sheet deferred tax accounts) attributable to estimated “ordinary” income for the year (including changes in the valuation allowance that are reflected in the effective rate computation). This computation would be based on the newly enacted rate, and thus the beginning-of-year deferred tax balance used in computing deferred tax expense would be after adjustment for the rate change.
Application of this new effective rate to year-to-date “ordinary” income would automatically include in the interim period of the enactment the adjustment of deferred taxes provided by application of the effective rate in prior interim periods. The adjustment of the beginning-of-year deferred tax balances for the rate change would be reflected as a discrete item in the interim period of the enactment. When items other than “ordinary” income have been reported in prior interim periods, both their current and deferred tax effects would be adjusted in the interim period of the enactment. While this approach may be acceptable for simple rate changes, more detailed analysis often may need to be performed.
All adjustments to reflect a rate change are measured as of the enactment date and reflected in income from continuing operations (See Example 7-4).
7.4.1 Computing Deferred Taxes in an Interim Period
When a change in tax law is enacted on a date that is not close to an enterprise’s year-end, the question arises as to how temporary differences should be computed as of an interim date. Three possibilities present themselves:
Assume that the entity files a short-period tax return as of the date of the law’s enactment. The tax laws govern how annual deductions such as depreciation are allowed in a short-period return. The existing book bases of the assets and liabilities would be compared with these “pro forma” tax bases to determine the temporary differences.
Assume that net temporary differences arise and reverse evenly throughout the year. For example, if the beginning net temporary difference is $100 and the projected ending net temporary difference is $220, the temporary difference increases by $10 a month as the year progresses.
Assume that net temporary differences arise in the same pattern that pretax accounting income is earned. That is, if pretax income is earned 10 percent, 20 percent, 30 percent, and 40 percent in the first through fourth quarters, respectively, then temporary differences would increase or decrease on that basis as well.
In terms of the asset-and-liability approach underlying ASC 740, the first alternative might be viewed as the most intuitive, but it is inconsistent with the principles of interim reporting that treat an interim period as a component of the full year and not a stand-alone period. The second alternative would be practical; however, like the first alternative, it is inconsistent with how an entity estimates its quarterly tax provision and, thus, its deferred tax accounts. The third alternative avoids the inconsistency and would be relatively easy to compute, at least for entities accustomed to computing an effective tax rate for quarterly reporting. Whichever method is chosen, it should be applied consistently.
7.4.2 Retroactive Tax Rate Change
In 1993, when the U.S. federal tax rate was increased from 34 percent to 35 percent retroactively to January 1, 1993, the EITF considered the issue of how to determine the tax effect of a retroactive change in enacted tax rates that is included in income from continuing operations for the period that includes the enactment date of the retroactive change. As set forth in ASC 740-10-25-48 and ASC 740-10-45-16, “the tax effect of a retroactive change in enacted tax rates on current and deferred tax assets and liabilities shall be determined at the date of enactment using temporary differences and currently taxable income existing as of the date of enactment…the cumulative tax effect is included in income from continuing operations.”
As set forth in ASC 740-10-30-26 and ASC 740-10-45-17, “the reported tax effect of items not included in income from continuing operations (for example, discontinued operations, extraordinary items, cumulative effects of changes in accounting principles, and items charged or credited directly to shareholders’ equity) that arose during the current fiscal year and before the date of enactment of tax legislation shall be measured based on the enacted rate at the time the transaction was recognized for financial reporting purposes…the tax effect of a retroactive change in enacted tax rates on current or deferred tax assets and liabilities related to those items is included in income from continuing operations in the period of enactment.”
7.4.3 Retroactive Changes in Tax Laws or Rates Following Adoption of an Accounting Standard
Sometimes, tax law or rate changes occur in the same year that new accounting standards are adopted and the effect of the law or rate change dates back to the accounting standard adoption date. As set forth in ASC 740-10-45-18, if an entity adopted a new accounting standard as of a date prior to the enactment date, the effect of the change in tax laws or rates would not be recognized in the cumulative effect of adopting the standard, but would be recognized in income from continuing operations for the period that included the enactment date. This would be true regardless of whether the change in tax laws or rates was retroactive to the earlier date.
Example 7-4: Computation of Income Tax Expense with an Enacted Change in
Tax Rates in an Interim Period
Background/Facts:
Company A recognized a net deferred tax liability of $160 at December 31, 20X5 related to the temporary differences shown below. (Assume that no valuation allowance was necessary for the deferred tax asset.)
Company A projected that, at December 31, 20X6, the net deferred tax liability would be $280, based on a $300 increase in its taxable temporary difference. Therefore, for 20X6, the projected deferred tax expense will be $120 ($280–$160).
Company A’s income tax expense for the first quarter of 20X6 was calculated
as follows:
Question:
If an increase from 40 percent to 45 percent in the federal income tax rate was enacted on June 15, 20X6, retroactive to the beginning of the year, how would the effect of the change be reflected in income tax expense for the three and six months ended June 30, 20X6?
Analysis/Conclusion:
1 Assume no net changes in the temporary differences and the related deferred tax balances between December 31, 20X5 and immediately prior to the change in the enactment date of the new tax rate (i.e., June 15, 20X6).
7.4.4 Leveraged Leases
ASC 840-30-S99-2 discusses SEC Staff views on the effect of a change in tax law or rate on leveraged leases. When a change in income tax rates is enacted, all components of a leveraged lease should be recalculated from inception through the end of the life of the lease based on the revised after-tax cash flows. The difference between the amount originally recorded and the recalculated amount would be included in income in the current year.
7.5 Valuation Allowances
An enacted tax law or tax rate change entails reconsideration of the realizability of existing deferred tax assets. Consistent with ASC 740-10-45-15, any adjustment to an existing deferred tax asset through the creation or adjustment of an existing valuation allowance should be included in income from continuing operations for the period that includes the enactment date.
In some instances, tax rate changes may be enacted after year-end but before the financial statements are issued. In those situations, also in accordance with ASC 740-10-45-15, the enacted change would not be recognized until the period that includes the enactment date. Some might argue that any valuation allowance for deferred tax assets should take into consideration the impact of a decrease in tax rates. However, the Board’s intent is that the impact of all tax rate or tax law changes be reflected in the period of enactment, regardless of the effect on deferred assets and liabilities in financial statements for earlier periods. Accordingly, the impact on the valuation allowance of a decrease in tax rates enacted after year-end but before the financial statements are issued, would not be recorded at year-end. However, when changes in tax laws or rates are enacted subsequent to year-end but before the financial statements are released, the effect on existing deferred tax assets or liabilities should be disclosed.
7.5.1 Valuation Allowances Relating to Assets Acquired in a Prior Business Combination
The effect of a change in tax law or rate that results in a change in valuation allowance that was initially recorded in acquisition accounting should be included in income from continuing operations pursuant to ASC 740-10-45-15. This applies to any reduction in the valuation allowance that otherwise would not have been recognized, regardless of whether the valuation allowance is reduced in the period of the tax law or rate change or in a subsequent period.
7.6 Disclosure Requirements
An entity’s financial statements should disclose all adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates. When rate changes occur, the reconciliation of the effective tax rate should include an item for the effect of rate changes enacted in the current year.
We believe that it generally would be adequate to disclose the effect of the rate change on (1) beginning-of-year deferred tax balances and (2) taxes, both current and deferred, provided prior to the enactment date in categories other than continuing operations. Both of these would be items in the rate reconciliation. Other disclosures also might be satisfactory. In any case, the amount(s) disclosed should be clearly described. For further discussion on the disclosure requirements related to enacted changes in tax laws or rates, see Section TX 15.3.4.
7.7 Changes in Tax Methods of Accounting
For U.S. federal tax purposes, the two most important characteristics of a tax method of accounting (hereinafter “accounting method”) are (1) timing and
(2) consistency. If the method does not affect the timing for including items of income or claiming deductions, it is not an accounting method and generally IRS approval is not needed to change it. In order to affect timing, it must determine the year in which an income or expense item is to be reported. Said differently, if the issue is whether income is taxable or whether an expense is deductible, then an accounting method is not involved.
In general, to establish an accounting method, the method must be consistently applied. In this regard, the consistency requirement varies depending upon whether an accounting method is proper or improper:
The use of a proper accounting method in a single U.S. federal return constitutes consistency and, therefore, the adoption of an accounting method.
An improper accounting method is adopted after it has been used consistently in at least two consecutive returns.
Once an accounting method has been adopted for federal tax purposes, any change must be requested by the taxpayer and approved by the IRS. Changes in accounting methods cannot be made by amending returns. Rather, there are two procedures for requesting changes from the IRS: (1) automatic and (2) non-automatic. In the case of an automatic change, IRS consent is deemed to have been received once all the requirements of the IRS guidance are met. With a non-automatic change, IRS consent is received only upon written consent from the IRS. In either case, the request for change is filed by the taxpayer on federal Form 3115, Application for Change in Accounting Method.
7.7.1 Transition to New Accounting Method
In general, whenever a taxpayer changes its accounting method, the tax law provides mechanisms to transition from the old to the new accounting method. The “cut-off” approach results in a prospective change starting in the year of change for new transactions. Old transactions continue to be accounted for using the old accounting method.
The other, more common, method of transition is a “cumulative catch-up” approach which triggers an Internal Revenue Code §481(a) adjustment. Under this method, a taxpayer must begin using the new accounting method on the first day of the year of change as if it were always used (i.e., for both old and new transactions). Generally, a negative §481(a) adjustment (i.e., reduction of taxable income) is taken into taxable income in one tax year (the year of change) while a positive adjustment (i.e., increase to taxable income) is spread over four years.
7.7.1.1 Positive §481(a) Adjustments
Accounting method changes that result in a positive adjustment and do not conform to the book treatment for the related item will generally result in two temporary differences. The first temporary difference is the basis difference between book and tax because the methods are not conformed (there may or may not have already been a temporary difference depending on whether the book and tax treatments were previously the same). The second relates to the §481(a) adjustment. The issue of what temporary differences exist when a taxpayer changes its accounting method is addressed in ASC 740-10-55-59 through 55-61. In the example provided, a change in tax law required a change in accounting method for tax purposes related to inventory. The guidance concludes that the change gives rise to two temporary differences. The first relates to the temporary difference already in existence on the inventory. The second relates to the deferral of the catch-up adjustment (i.e., the §481(a) adjustment), which represents deferred income for tax purposes with no book basis and, as such, is a taxable temporary difference for which a deferred tax liability is recorded.
7.7.1.2 Negative §481(a) Adjustments
In contrast to the scenario described above, accounting method changes that result in a negative adjustment and do not conform to the book treatment for the related item will generally result in one temporary difference. That is, the only temporary difference is the basis difference between book and tax because the methods were not conformed. A §481(a) adjustment is made in the year of change but, because taxpayers are allowed to take a negative adjustment in its entirety in the year of change, the §481(a) adjustment only affects the current payable and does not result in any future tax consequences.
7.7.2 Timing
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.
7.7.2.1 Voluntary Changes from Proper Accounting Methods
Changes from proper accounting methods generally arise when there are two or more permissible methods of accounting for a particular item, and the taxpayer desires to change to a more favorable method. These changes can either be automatic or non-automatic.
Automatic changes are granted if the change being requested is one that qualifies for automatic approval by the IRS and the taxpayer complies with all of the provisions of the automatic change request procedure for that year. We believe that 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. This treatment is based on the notion of perfunctory consent. An automatic change in accounting method is similar to other annual elections that are made by the taxpayer upon filing the tax return. Management should make its best estimate as to how it will treat such items when filing its tax return and account for the items in a consistent manner when preparing the financial statements.
Non-automatic changes, however, require the affirmative consent of the IRS. The effects of a non-automatic change from another proper method should not be reflected in the financial statements until approval is granted because there is discretion on the part of the IRS to deny the application or alter its terms. Appropriate financial statement or MD&A disclosure of pending requests for method changes should be considered.
7.7.2.2 Voluntary Changes from Improper Accounting Methods
A taxpayer may determine that it is using an improper accounting method. As a result, the company will need to consider whether the historical financial statements contained an error and the effects of any unrecognized tax benefits, including potential interest and penalties. Refer to Section TX 17.1.1.4.7 for a more detailed discussion on discerning a financial statement error from a change in estimate.
Once a company determines that it is using an improper method, it may desire to change its accounting method voluntarily to one which is permissible by filing a Form 3115 with the IRS. When a taxpayer files for a change from an improper to a proper accounting method, the taxpayer receives “audit protection” for prior years. Additionally, because the §481(a) adjustment is typically a positive adjustment, it is generally spread over four years. A company should record in the financial statements the tax effects attributable to a voluntary change from an improper method to a permissible method when the Form 3115 has been filed with the IRS.
It is important to note that, upon financial statement recognition of a change from an improper accounting method, the taxpayer will also need to consider the impact the change will have on any previously accrued interest and penalties on a liability for unrecognized tax benefits related to the improper method (refer to Section TX 7.7.3.1). Any liability for unrecognized tax benefits previously recorded should be reclassified to a deferred tax liability, which now represents the deferred tax consequences of the §481(a) adjustment.
Similar to a change from a proper accounting method, the determination as to what temporary differences result from a change from an improper accounting method depends on whether the change (1) results in an adjustment that is taken all in one year (negative adjustment) or spread over four years (positive adjustment) and (2) whether the change is a change to conform to the book treatment for the related item.
7.7.3 Unrecognized Tax Benefit Considerations
Generally, filing a Form 3115 to request a change in accounting method precludes the IRS from raising the same accounting method as an issue in an earlier year. Audit protection starts at the time the application is filed. However, until a company actually files for an accounting method change, the company is at risk for having its prior open years’ tax positions adjusted by the IRS.
7.7.3.1 Interest and Penalties
In general, jurisdictions have statutes and regulations that include explicit provisions requiring a company to pay interest and penalties in the event a tax or other obligation is not timely met. In particular, a taxpayer is obligated by operation of law to remit these amounts until and unless the governmental authority agrees to waive some or all of the amounts otherwise owed. As noted in Section TX 7.7.3, upon filing Form 3115, a taxpayer receives audit protection and the IRS is precluded from raising the same issue in an earlier year. As a result, we believe that if an entity is changing from an improper accounting method to a proper one, the reversal of previously accrued interest and penalties should generally be recognized in the period in which the method change request is filed (i.e., when Form 3115 is filed).
7.7.4 Involuntary Changes from Improper Accounting Methods
In certain cases, taxing authorities require an enterprise to change its accounting method(s) (e.g., the IRS discovers an improper accounting method during an examination). Taxpayers who are contacted for examination and required by the IRS to change an accounting method (“involuntary change”) generally receive less favorable terms and conditions than taxpayers who voluntarily request a change from an improper accounting method.
When the IRS makes an adjustment to an accounting method, it normally makes the change in one of two ways. It can impose an accounting method change or it can resolve an accounting method issue on a non-accounting-method-change basis. When an accounting method is changed, the taxpayer must use the new method in future years. When an accounting method issue is resolved on a non-accounting-method-change basis, the resolution does not constitute a change in accounting method. Consequently, resolution of an accounting issue on a non-accounting-method-change basis does not preclude a taxpayer from continuing to use its current (and improper) accounting method.
If a taxpayer continues to use its current (and improper) accounting method, the taxpayer will need to consider the effects of any unrecognized tax benefits, including potential interest and penalties.
7.7.5 Other Considerations
Changes in accounting methods as a result of a change in tax law—In the event that a change in accounting method is tied to a change in tax law, the tax effects of the change would be reported through earnings attributable to continuing operations in the period in which the change in tax law is enacted (pursuant to ASC 740-10-45-15) unless IRS permission is required to change the accounting method, in which case the tax effects of the change would be reported in the period in which IRS permission is granted.
Determination of earnings and profits (“E&P”)—The Income Tax Regulations (the “Regulations”) provide that the amount of E&P will be dependent on the accounting method used for federal income tax purposes unless a specific provision authorizes a different accounting method for E&P purposes. The Regulations do not specify the adjustment to be made to E&P upon a change in accounting method that results in either a positive or negative §481(a) adjustment. However, in general, and unless otherwise specified, just as a taxpayer should follow the new accounting method for reporting taxable income, the §481(a) adjustment should also be taken into account (whether positive or negative) over the same period in determining E&P.
State tax implications—In instances where states do not conform to federal provisions for income tax purposes, additional tracking of temporary differences by state tax jurisdiction may be required. Furthermore, consideration should be given to the federal and state similarities and differences with respect to the process and procedures for applying for an accounting method change.