IT2013_1069_CH04_v2_P1_7-22

Chapter 4:
Recognition and Measurement

Chapter Summary

To achieve the objectives stated in ASC 740-10-10 entities must compute deferred taxes to account for the expected future tax consequences of events that have been recognized in the financial statements or tax returns. The basic model for the recognition and measurement of deferred taxes consists of a five-step approach that accomplishes three primary objectives: (1) identification of all temporary differences, tax loss carryforwards, and tax credit carryforwards; (2) measurement of temporary differences using the proper applicable tax rate; and (3) assessment of the need for a valuation allowance.

Deferred tax asset and liability balances and the corresponding deferred tax expense recognized in the financial statements are determined for each tax-paying component in each jurisdiction.



4.1 Basic Approach for Deferred Taxes

The tax provision for a given year as computed under ASC 740 represents not only the amounts currently due, but also the change in the cumulative future tax consequences of items that have been reported for financial reporting purposes in one year and taxable income purposes (i.e., deferred tax) in another year. ASC 740 computes the current and deferred tax amounts separately, and the sum of the two equals the total provision. The total tax expense computed under the principles of ASC 740 (i.e., the sum of the current and deferred provisions) is meant to match the components of pretax income with their related tax effects in the same year, regardless of when the amounts are actually reported on a tax return. Because the tax provision reflected in the financial statements is typically computed several months before the actual tax return is filed, it may be necessary to develop systems and processes that allow the entity to determine which filing positions it would take based on information available at the time the provision is calculated.

In ASC 740, the computation of the tax provision focuses on the balance sheet. A temporary difference is created (1) when an item has been treated differently for financial reporting purposes and for tax purposes in the same period and (2) when an item is expected to reverse in a future period and create a tax consequence. The FASB believes that the tax effect of these differences, referred to as deferred taxes, should be accounted for in the intervening periods. A deferred tax asset or liability is computed based on the difference between the book basis for financial reporting purposes and the tax basis of the asset or liability.

This asset and liability method, required by ASC 740, measures the deferred tax liability or asset that is implicit in the balance sheet; it is assumed that assets will be realized and liabilities will be settled at their carrying amounts. If the carrying amounts of assets and liabilities differ from their tax bases, implicit future tax effects will result from reversals of the book-and tax-basis differences as a consequence of the enacted tax laws.

The basic ASC 740 model is applied through the completion of the following five steps:

Step 1: Identify temporary differences and tax loss carryforwards. There are two categories of these items: (1) taxable temporary differences that will generate future tax (i.e., deferred tax liabilities) and (2) deductible temporary differences that will reduce future tax (i.e., deferred tax assets).


Example 4-1 illustrates the identification of temporary differences and measurement of future tax consequences.

Example 4-1: Identifying Temporary Differences

Assume that to date tax depreciation has exceeded book depreciation. As a result, the book basis of the asset is greater than the tax basis. If the asset is recovered at its book carrying amount, taxable income will be the amount by which the book basis exceeds the tax basis (i.e., the taxing authority would consider the tax basis, as opposed to the book basis, to determine if there is taxable income). Because the proceeds received (i.e., asset recovered at the book amount) exceed the tax basis, taxable income exists for that difference. The primary goal of the asset and liability method is to measure the future tax impact of future taxable income or deductions. Taxable differences, like those described in this example, cause deferred tax liabilities.


Recovery of basis difference through sale:

If the asset were sold for its book basis of $700, there would be a taxable gain of $100.

Recovery of basis through operations:


Step 2: Identify tax loss carryforwards and tax credits. An entity may have all or a combination of federal, state and local, and foreign tax loss carryforwards and certain tax credits. Tax-loss carryforwards typically include net operating losses (NOLs) and capital losses, which, depending on the relevant jurisdiction’s applicable tax law, may be carried back to prior period(s) and/or forward to future period(s) to offset taxable income. Tax credits may include the U.S. federal and state research and experimentation credit (R&E credit), foreign tax credits (U.S. or other jurisdictions), the U.S. federal alternative minimum tax credit (AMT credit), investment tax credits, and potentially other tax credits. Depending on the relevant jurisdiction’s applicable tax law, tax credits may be carried back to prior period(s) and/or forward to future period(s) to offset tax payable. Tax credits generally provide a “dollar-for-dollar” benefit against tax payable.

Step 3: Determine which applicable rate should be used in deferred tax calculations. The applicable tax rate is the enacted tax rate based on enacted tax law, which should be applied when temporary differences reverse or are settled. Section TX 4.2 discusses several factors that should be considered in determining the applicable rate.

Step 4: Calculate the deferred tax assets and liabilities. This entails multiplying the gross temporary differences and tax loss carryforwards by the applicable rate and adding the resulting product to the tax credit carryforwards.

When tax laws are enacted and the change in tax rate is effective for future years, the year in which taxable and deductible temporary differences are expected to be reported on the tax return can affect the measurement of the tax asset or liability. This is because the applicable tax rate would be different depending on the year of expected reversal. If temporary differences are expected to reverse during years in which different levels of tax rates are expected to be applied based on varying levels of income (i.e., graduated rates), the year in which an item is expected to reverse could affect the measurement of the deferred tax asset or liability.

Step 5: Evaluate the need for a valuation allowance. Under ASC 740, deferred tax assets resulting from deductible temporary differences must be recorded, and the recorded assets must undergo a more-likely-than-not (i.e., over 50 percent probability) realization/impairment test. A valuation allowance must be established for deferred tax assets if it is more-likely-than-not that they will not be realized. While this may appear to be a relatively low threshold, ASC 740-10-30-23, prescribes that, in assessing the need for a valuation allowance, evidence should be weighted to the extent that it is objectively verifiable. Section TX 5.1 discusses factors to consider in the evaluation of the need for a valuation allowance.

4.2 Applicable Tax Rate



4.2.1 General Considerations

The applicable tax rate, which is used to measure deferred tax assets and liabilities, is the enacted tax rate that is expected to apply when temporary differences are expected to be settled or realized. An entity may utilize different applicable tax rates for several reasons, such as the type of temporary difference (e.g., ordinary income, capital gain), the jurisdiction of the temporary difference (e.g., domestic versus foreign or federal versus state) or the period during which the temporary difference is settled or realized (e.g., carryback or carryforward periods). For example, when there is an enacted change in tax rates, the applicable tax rate could be the pre-change or the post-change tax rate depending on when the future reversals are expected to occur. Moreover, in some jurisdictions, capital gains are taxed at a different rate than ordinary income. As a result, determining which applicable tax rate is appropriate may depend on the method of recovery and the inherent character of the income.


4.2.2 Graduated Tax Rates

Before the appropriate applicable rate can be identified, it must be determined whether graduated tax rates are a significant factor. Under current U.S. federal tax law, for example, all taxable income must be taxed at a single flat rate of 35 percent if taxable income exceeds a certain amount. If taxable income neither meets nor exceeds this threshold, then consideration must be given to the impact of graduated tax rates.

When graduated tax rates are a significant factor, deferred taxes may need to be computed using the average graduated tax rate applicable to the amount of estimated annual taxable income in the periods during which the deferred tax assets and liabilities are expected to be realized or settled (e.g., when income levels are expected to fluctuate in and out of different tax brackets). Graduated tax rates are likely to be a significant factor for smaller U.S. entities or the specific operations of a larger entity in certain tax jurisdictions. Example 4-2 demonstrates the application of graduated tax rates in the United States.

Example 4-2: Determining the Applicable Rate if Graduated Rates Are
a Significant Factor (ASC 740-10-55-136 through 55-138)

In Jurisdiction X, enacted tax rates are currently 15 percent for the first $50,000 of taxable income, 25 percent for the next $25,000, 35 percent for the next $25,000, 39 percent for the next $235,000, and 34 percent for $335,000 to $10 million of taxable income. This example assumes that no income is subject to a special tax rate (e.g., a capital gain tax rate if different than the ordinary income tax rate).

The average graduated rate will differ depending on the expected level of annual taxable income (including reversing differences) in the next three years, which, in this example, is the number of years over which the reversal of existing temporary difference is expected. The average tax rate will be one of the following:

15 percent if the estimated annual level of taxable income in the next three years is $50,000 or less.

18.33 percent if the estimated annual level of taxable income in the next three years is $75,000.

22.25 percent if the estimated annual level of taxable income in the next three years is $100,000.

28 percent if the estimated annual level of taxable income in the next three years is $150,000.

Because temporary differences may reverse in different periods and estimated taxable income may fluctuate in each period, more than one applicable tax rate may be appropriate at each balance sheet date. Future taxable income cannot be forecasted with precision and detailed scheduling of future taxable income and reversals might not produce more reliable amounts. For this reason, making an aggregate calculation using a single applicable rate based on the estimated average annual taxable income in future years is typically sufficient. If annual taxable income is expected to be $150,000 over the next three years, a rate of 28 percent would be used to measure the existing temporary differences that are expected to reverse over the next three years. This is acceptable even though the expected reversal of those temporary differences could occur in one year for which the tax rate is 15 percent and in another year for which the tax rate is 39 percent.

However, situations may arise in which a specific applicable rate should be used for specific reversals of temporary difference. For example:

If an unusually large temporary difference is expected to reverse in a single year, it may be appropriate to determine the expected applicable rate that applies to future taxable income in that specific year, since use of an average rate may result in a materially inaccurate deferred tax balance.

If future taxable income (excluding reversals) is expected to reach an unusual level in a single year, it may be appropriate to apply that applicable tax rate to all reversals expected in that year. 

Judgment should be applied to determine when the use of a specific applicable tax rate is appropriate.

The lowest graduated tax rate (other than zero) should be used whenever the estimated average graduated rate would otherwise be zero (e.g., when losses are anticipated).

4.2.3 Determining the Applicable Rate

The applicable tax rate is based on the period in which the reversal of the temporary difference is expected to impact taxes payable (or refundable), and not only on the period in which the temporary difference is expected to reverse. That is, the period in which the temporary difference reverses may not be the period in which the temporary difference impacts tax payable or refundable. The examples below illustrate this distinction.

Example 4-3: Determination of the Applicable Tax Rate if Changes in Tax Rate Are Phased-In (ASC 740-10-55-129 through 55-130)

Background/Facts:

Assume that at the end of Year 3 (the current year), an entity has $2,400 of taxable temporary differences, which are expected to result in taxable amounts of approximately $800 on each future tax return for the fourth, fifth, and sixth years. Enacted tax rates are 35 percent for Years 1 through 3, 40 percent for Years 4 through 6, and 45 percent for Year 7 and thereafter.

Question:

Which applicable tax rate should be utilized?

Analysis/Conclusion:

The tax rate used to measure the deferred tax liability for the $2,400 of taxable temporary differences differs depending on whether the tax effect of future reversals of those temporary differences impacts taxes payable for Years 1 through 3, Years 4 through 6, or Year 7 and thereafter. The tax rate for measurement of the deferred tax liability is 40 percent whenever taxable income is expected in the fourth, fifth, and sixth years. However, if tax losses are expected in Years 4 through 6, the tax rate will be one of the following:

35 percent if a tax benefit for those tax losses in Years 4 or 5 will be realized by means of a loss carryback to the second and third years.

45 percent if a tax benefit for those tax losses in Years 4 through 6 will be realized by means of a loss carryforward to Year 7 and thereafter.

Example 4-4: Determination of Applicable Tax Rate if Tax Rates Change
(ASC 740-10-55-131 through 55-135)

Background/Facts:

Assume that enacted tax rates are 30 percent for Years 1 through 3, and 40 percent for Year 4 and thereafter. At the end of Year 3 (the current year), an entity has $900 of deductible temporary differences, which are expected to result in tax deductions of approximately $300 on each future tax return for the fourth, fifth, and sixth years.

Question:

Which applicable tax rate should be utilized?

Analysis/Conclusion:

The answer depends on how and when a tax benefit or loss is expected. The tax rate will be 40 percent if the entity expects to realize a tax benefit for the deductible temporary differences by offsetting taxable income earned in future years. Alternatively, the tax rate will be 30 percent if the entity expects to realize a tax benefit for the deductible temporary differences via a loss-carryback refund.

If enacted tax rates are 40 percent for Years 1 through 3 and 30 percent for Year 4 and thereafter, measurement of the deferred tax asset at a 40% tax rate can only be made if tax losses are expected in Years 4, 5, and 6.

Determining the applicable rate can be even more complicated. The tax effects of temporary difference reversals are ordinarily determined on an incremental basis (assuming that graduated rates are not a significant factor). For example, assume that a company (1) expects to have pretax book earnings of $50 in a future year and (2) anticipates that existing net deductible differences of $200 will reverse in that year, resulting in a taxable loss of $150 for that future year. Assume also that the future year has a different enacted tax rate than the years in the carryback period because an existing law changes the tax rate applicable to that future year. In this case, the deferred tax asset related to the deductible temporary difference, which will result in a future year’s taxable loss and will be carried back (i.e., $150), should be recorded at the applicable rate in the carryback period (i.e., pre-rate-change period). The portion of the deductible temporary difference that shelters the pretax book income from current-year tax (i.e., $50) or would result in a net operating loss carryforward (because the losses in the carryback period cannot be absorbed) should be recorded at the future applicable rate (i.e., the post-rate change).

If there are two applicable rates for the net reversals and those reversals are expected in a particular year, the decision to apply the current or future rate to deductible and taxable differences (to the extent that they offset each other) will be arbitrary. Regardless of which applicable rate is applied, the effect is the same: The entity discloses in the footnotes to the financial statements the deferred tax assets and liabilities.

4.2.4 Complexities in Determining the Applicable Tax Rate

4.2.4.1 Ordering Effects

In some jurisdictions, capital gains are taxed at a lower rate than ordinary income (e.g., capital gains are taxed at 15 percent and the ordinary income tax rate is 30 percent). Determining the applicable tax rate to apply to the gross temporary difference can be complicated if, in some jurisdictions, an ordinary loss can be offset by a capital gain that occurs in the same year. This might be viewed as (1) the ordinary loss attracting a tax benefit only at the capital gain rate (e.g., measurement of a deferred tax benefit resulting from an ordinary loss of $100, for example, would be $15 instead of $30 if the ordinary loss is expected to offset capital income), or as (2) the capital gain being taxed at the rate applicable to ordinary income (e.g., measurement of a deferred tax liability resulting from a gross taxable temporary difference of $100 that is expected to reverse as capital gain income would be $30 instead of $15 if the expected capital gain income is offset by ordinary loss).

When determining the applicable tax rate in such circumstances, the reversal of a temporary difference (e.g., an ordinary loss carryforward of $100 or a taxable temporary difference of $100 that is expected to reverse as capital gain income) is considered the last item to enter the calculation of taxable income in the period during which a temporary difference is expected to reverse. For example, if at the reporting date, $100 of gross taxable temporary difference is expected to result in capital gain income in a subsequent period, the capital gain income of $100 is the last amount to enter the calculation of the subsequent period’s taxable income. If an ordinary loss is expected in a subsequent period and the ordinary loss is sufficient to offset the expected capital gain resulting from the reversal of the temporary difference, the ordinary income tax rate (e.g., 30 percent) would be used to record the deferred tax liability (e.g., $30 deferred tax liability). If, however, the ordinary loss is insufficient to absorb an additional $100 of capital gain income, the capital gain income tax rate (e.g., 15 percent) would be used to record the deferred liability (e.g., $15 deferred tax liability). Similarly, the deferred tax benefit resulting from $100 of ordinary loss carryforward that is expected to offset ordinary and capital taxable income in a subsequent period would be measured at the capital income tax rate (e.g., 15 percent) to the extent that it is expected to offset capital gain income after any capital loss is considered.

4.2.4.2 Undistributed Earnings

The applicable rate related to undistributed earnings should reflect any dividends-received deductions, deductions or credits for foreign taxes, or withholding taxes (ASC 740-10-55-24). For example, in the U.S. jurisdiction, if taxable differences reverse into dividend income generated from a nonsubsidiary U.S. corporation taxed at 35 percent, that income will result in a dividends-received deduction (DRD) of 70 percent or 80 percent, depending on the level of ownership (i.e., only 30 percent or 20 percent, respectively, of the dividend income is taxed). If a reversal of the temporary difference occurs when taxable income enables the use of the deduction, the entity can incorporate the DRD in measuring its deferred tax liabilities by using an applicable rate of 10.5 percent (i.e., statutory rate of 35 percent less 70 percent DRD) or 7 percent (i.e., statutory rate of 35 percent less 80 percent DRD), respectively.

The above approach is complicated by the fact that the applicable tax rate applied
to the taxable temporary difference is generally the tax rate before application of existing credit carryforwards (e.g., operating loss carryforwards, capital loss carryforwards, and foreign tax credits or FTCs). Unlike a DRD that is incorporated into the tax rate applied to the deferred tax liabilities, deferred tax assets are separately recorded for existing credit carryforwards. Therefore, while existing credit carryforwards may be used to offset the deferred tax liability for taxable differences associated with unremitted earnings from a nonsubsidiary U.S. corporation, the tax rate applied to the temporary difference would not incorporate the expected use of the credit carryforwards because the credit carryforwards are separately recorded
as deferred tax assets.

4.2.4.3 Special Deductions

ASC 740-10-25-37 and 740-10-30-13 stipulate that the tax benefit of special deductions should be recognized no earlier than the year in which the deductions can be taken on the tax return. ASC 740 does not define “special deductions,” but offers three examples: (1) statutory depletion, (2) special deductions available for certain health benefit entities, and (3) special deductions for small life insurance companies. Other accounting literature provides two more examples of special deductions: (1) ASC 942-740-35-1 through 35-3 indicate that the percentage-of-taxable-income-bad-debt deduction for an S&L is also a special deduction, and
(2) the FASB concluded in ASC 740-10-55-29 that the IRC Section 199 deduction for qualified domestic production activities also qualifies as a special deduction.

As discussed in ASC 740-10-55-30, an entity estimating future taxable income to determine the applicable rate should consider future special deductions in its deferred tax computations if graduated rates are a significant factor or if the entity is assessing the need for a valuation allowance and must consider future taxable income (excluding reversals of temporary differences). Therefore, although tax benefits from special deductions are recognized no earlier than the year in which the special deductions are deductible on a tax return, they affect the calculation of deferred taxes because their future tax benefit is implicitly recognized in the determination of the average graduated tax rate and the assessment of the need for a valuation allowance.

If the special deduction is statutory depletion, the estimates of future taxable income will be reduced by the total future statutory depletion that is expected to be deductible in future years on all properties, not just the statutory depletion related to the carrying amount of properties on the balance sheet date (i.e., the total statutory depletion includes both the current depletion and the to-be-acquired statutory depletion). Because percentage depletion generally is not limited by the adjusted basis in the property, it is possible that the taxpayer’s aggregate deductions for depletion will exceed the property’s adjusted basis.

As with other assets and liabilities, the temporary difference related to properties for which statutory depletion is available should be measured as the difference between the tax basis of the asset and its reported amount in the financial statements. As noted above, the entity should recognize the tax benefit of the special deduction no earlier than the year in which the deductions can be made on the tax return. Accordingly, a deferred tax liability should be recognized for this temporary difference, even though it is probable that future tax depletion will exceed book depletion. The tax basis in a depletable property represents the historical-cost basis of the property less the property’s aggregate deductions for depletion that the entity reports on its tax returns. The tax basis of the property, however, cannot be reduced below zero. Consider the following example.

Example 4-5: Special Deduction for Depletion

Background/Facts:

An entity acquires a depletable property for $10,000, and no difference in the book basis and the tax basis exists at the time of acquisition. For book purposes, the entity uses a depletion method that results in a $1,000 annual depletion expense. For tax purposes, cost depletion is calculated as $1,000 annually; percentage depletion is $4,000 in the first year and $7,000 in the second year. For the first two years, percentage depletion is fully deductible.

Analysis/Conclusion:

At the end of Year 1, there is a $3,000 temporary difference (i.e., $9,000 net book value less $6,000 adjusted tax basis). At the end of Year 2, there is an $8,000 temporary difference (i.e., net book value of $8,000 less adjusted tax basis of zero). The cost-depletion amounts do not affect the determination of temporary differences because actual depletion deductions were based on percentage-depletion amounts that had actually been deducted in the taxpayer’s tax returns.

Further, the $1,000 excess statutory depletion created in Year 2 (i.e., the amount of depreciation claimed in excess of the existing tax basis) was not included among the items used to calculate the temporary difference because the property’s tax basis cannot be reduced below zero. However, excess statutory depletion is an AMT preference item that may affect the calculation of deferred taxes and the assessment of the valuation allowance.

4.2.4.4 Tax Holidays

In certain jurisdictions, tax holidays (i.e., periods of full or partial exemption from tax) are provided as an incentive for certain entities. The FASB added commentary around the issue concerning tax holidays1—whether a tax asset should be established for the future tax savings of a tax holiday on the premise that such savings are akin to an NOL carryforward. By concluding that a deferred tax benefit should not be recorded, the FASB distinguished between two types of tax holidays: one that is generally available to any entity within a class of entities and one that is controlled by a specific entity that qualifies for it. The first type was likened to a general exemption from taxation for a class of entities creating nontaxable status, while the second type was perceived to be “unique” because it was not necessarily available to any entity within a class of entities and, as a result, might conceptually require the recognition of deferred tax benefits. As discussed in ASC 740-10-25-35 through 25-36, the FASB decided to prohibit recognition of a deferred tax asset for any tax holiday (including those considered “unique”) because of the practical problems associated with (1) distinguishing between a general tax holiday and a unique tax holiday and (2) measuring the deferred tax asset associated with future benefits expected from tax holidays.

1 ASC 740-10-25-35 through 25-36.

In order to properly account for a tax holiday, careful consideration must be given to the specific aspects of the tax holiday, including the approval process, terms, and conditions. In general, the effects on existing deferred income tax balances resulting from the initial qualification for a tax holiday should be treated in a manner similar to a voluntary change in tax status, which under ASC 740-10-25-33, is recognized on the approval date or on the filing date if approval is not necessary. Therefore, the effects of a tax holiday (or extension of a tax holiday) should be recognized in the deferred tax computation upon receipt of the last necessary approval for the tax holiday (or extension).

In addition, differences often exist between the book basis and tax basis on balance sheet dates within the holiday period. Consistent with ASC 740-10-30-8, if these differences are scheduled to reverse during the tax holiday, deferred taxes should be measured for those differences based on the conditions of the tax holiday (e.g., full or partial exemption). That is, “the objective is to measure a deferred tax liability or asset using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.” If the differences are scheduled to reverse after the tax holiday, deferred taxes should be provided at the rate that is expected to be in effect after the tax holiday expires. The expiration of the holiday is similar to an enacted change in future tax rates, which must be recognized in the deferred tax computation. Tax-planning actions to accelerate taxable income into the holiday or to delay deductions until after the holiday would only be considered if the entity has committed to their implementation and such implementation is within the entity’s control. This is illustrated in the following example.

Example 4-6: Tax Holiday—Scheduling Temporary Differences

Background/Facts:

A foreign government grants a company a tax holiday. During the holiday, the company will be 100 percent exempt from taxation. Upon expiration of the holiday, the company will be subject to taxation at the statutory rate. The company is scheduling the reversal of existing temporary differences related to depreciable assets to determine whether any are expected to reverse after the tax holiday for which deferred taxes should be provided.

Question:

Should the company consider future originating differences related to its existing fixed assets when scheduling the reversal of existing temporary differences?

Analysis/Conclusion:

ASC 740-10-55-22 provides some ground rules for scheduling temporary differences. Among those ground rules are: (i) the method used should be systematic and logical; (ii) minimizing complexity is an appropriate consideration in selecting a method; and (iii) the same method should be used for all temporary differences within a particular category.

When scheduling the reversal of depreciable asset temporary differences to determine whether any are expected to reverse (and in what amount) after the expiration of a tax holiday, we believe that either of two approaches would be acceptable. One approach would consider future originating differences and the other would not. We believe that both methods are systematic and logical and can be reasonably supported.

A method that considers originating differences is based upon the view that future originating differences are inherent in the asset that exists at the balance sheet date and, therefore, should not be ignored.

A method that does not consider originating differences is based upon the view that only differences that exist at the balance sheet date should be considered. This method is consistent with the guidance in ASC 740-10-55-14, which indicates future originations and their reversals are a factor to be considered when assessing the likelihood of future taxable income. By implication, they would not be considered part of the reversal of the temporary difference existing at the balance sheet date. A method that does not consider originating differences may also minimize the complexity of the calculation.

Consider the following scenario:

Company A acquires a depreciable asset for $120 on January 1, 2008. The asset will be depreciated over 6 years for financial reporting and 3 years for tax purposes. Company A has been granted a four-year tax holiday by the government in the foreign country in which the asset was acquired and, therefore, will not pay taxes until 2012. The tax rate that will apply after expiration of the tax holiday is 40%.


As of December 31, 2008, Company A has a book-over-tax basis difference in the depreciable asset of $20. At the end of the tax holiday, the basis difference will have increased to $40.

If Company A considers originating differences, it would record a deferred tax liability (“DTL”) of $8 ($20 x 40%) at December 31, 2008. This method could be described as a LIFO approach whereby, the last originations are considered the first to reverse. Company A would not record a DTL on the entire $40 basis difference that will exist at the end of the tax holiday because only $20 of that basis difference exists at the balance sheet date. At December 31, 2009, Company A would increase its DTL by $8 to $16 ($40 x 40%). Company A would not adjust the DTL again until 2012. Beginning in 2012, Company A would presumably begin to pay taxes and the DTL would reverse in 2012 and 2013.

If Company A does not consider originating differences, it would not record a DTL at December 31, 2008. The $20 basis difference that exists at December 31, 2008, is assumed to reverse on a FIFO basis in 2011. At December 31, 2009, Company A would record a DTL of $8 because $20 of the book over tax basis is expected to reverse after the tax holiday expires in 2012. At December 31, 2010, Company A would increase its DTL by another $8 to $16 because $40 of the book over tax basis is expected to reverse after the tax holiday expires in 2012. Company A would not adjust the DTL again until 2012. Beginning in 2012, Company A would presumably begin to pay taxes and the DTL would reverse in 2012 and 2013.

In circumstances in which the tax holiday is contingent on meeting a certain status or maintaining a certain level of activities, an entity must make the determination as to whether or not it has met the requirements to satisfy the conditions of the holiday. If a company has initially met such conditions and expects to continue to meet them, it should measure its temporary differences using the holiday tax rate. If the entity later determines that it no longer meets the necessary conditions of the tax holiday (e.g., it is no longer able to maintain a required level of activity within the tax jurisdiction), it would need to remeasure its deferred taxes at the statutory rate and recognize an additional tax liability for any potential retroactive effects in the period that the determination is made.

Example 4-7: Tax Holiday

Background/Facts:

A foreign government grants a company a ten-year tax holiday, which starts when the company begins to generate taxable income. During the holiday, the company will be 100 percent exempt from taxation. The company currently expects that it will incur losses for the next five years and, therefore, believes that it should only tax-effect temporary differences that reverse after fifteen years. The company has taxable temporary differences related to property, plant, and equipment.

Question:

Is the applicable exemption period ten years or fifteen years?

Analysis/Conclusion:

The company should view the tax holiday as ten years, not fifteen years. To do otherwise would be tantamount to anticipating future tax losses, an action that ASC 740-10-25-38, precludes. Accordingly, temporary differences should be scheduled for each balance sheet date, and only those differences that reverse in periods after the tax holiday should be tax-effected. In this case, the applicable tax holiday on each balance sheet date would remain ten years, as long as the company incurs losses.

4.2.4.5 Nonamortizing/Nondepreciating Assets

For assets that are amortized or depreciated for financial reporting purposes, the assumption is that the carrying value of the asset will be recovered over time through revenues, which are typically taxed at the ordinary rate. Accordingly, deferred tax assets and liabilities that result from temporary differences relating to such items are normally recognized at the ordinary tax rate.

However, for assets that are not amortized or depreciated for financial reporting purposes (e.g., land, indefinite-lived intangible assets, and tax-deductible goodwill), the assumption is that the asset will not decline in value (i.e., any revenues generated by the asset are not a recovery of the asset’s carrying value). The carrying value of the asset is not scheduled to be recovered at any specific time in the future. In fact, the asset will have an indefinite life. ASC 740-10-25-20 requires one to assume that the carrying value of an asset will be recovered and therefore does not allow the consideration of future impairments. The carrying value of an asset that is not being amortized for financial reporting purposes can only be recovered through a future sale.

In jurisdictions where the ordinary tax rate and capital gains tax rate differ, the applicable tax rate for a temporary difference relating to an asset that is not being depreciated or amortized for financial reporting purposes would be the tax rate (i.e., ordinary or capital gains) applicable to the expected recovery of the asset (e.g., a future sale of the asset).

It should also be noted that taxable temporary differences related to assets that are not amortized or depreciated for financial reporting purposes generally cannot be used as a source of taxable income to support the realization of deferred tax assets relating to the reversal of deductible temporary differences. Implications of the valuation allowance associated with such taxable temporary differences, which are referred to as “naked credits,” are discussed in Section TX 5.4.2.1.

Examples 4-8 and 4-9 illustrate the appropriate applicable tax rate for indefinite-lived intangible assets in a jurisdiction where the capital gains tax rate differs from the ordinary rate.

Example 4-8: Determining the Applicable Tax Rate for an Indefinite-Lived Intangible Asset Generated in a Nontaxable Business Combination

Background/Facts:

A business combination is structured as a nontaxable purchase with a carryover tax basis for the individual assets. An indefinite-lived intangible asset with no tax basis is included among the acquired assets.

Question:

Which rate should be applied to an indefinite-lived intangible asset acquired in a nontaxable business combination?

Analysis/Conclusion:

If the asset is sold for an amount equivalent to the value assigned to the asset in the business combination, a gain would result and would be taxed at the capital gains tax rate. If graduated rates exist or if enacted tax rates reflect increases or decreases in future years, management must estimate when it is likely to sell the intangible asset (which may be in the distant future). This determination will dictate which rate should be used to record the deferred tax liability at inception.

Example 4-9: Determining the Applicable Tax Rate for an Indefinite-Lived Intangible Asset Generated in a Taxable Business Combination

Background/Facts:

A business combination is structured as a taxable purchase. The basis assigned to an acquired indefinite-lived intangible asset is the same for financial reporting and tax purposes.

Question:

Which rate should be applied to an indefinite-lived intangible asset acquired in a taxable business combination?

Analysis/Conclusion:

In this case, no deferred tax liability would be recorded at the time of the business combination. However, because the indefinite-lived intangible asset is amortized for tax purposes, a taxable temporary difference would arise. If the amortization recognized for tax purposes would be “recaptured” at the ordinary tax rate in the event of a sale, the applicable tax rate would be the ordinary tax rate. The post-acquisition amortization for tax purposes would produce a current tax benefit at the ordinary tax rate, while an equal and offsetting deferred tax liability would be recognized via the ordinary tax rate if “recapture” is required. If upon the sale of the asset the tax amortization is not “recaptured” at the ordinary tax rate, the deferred tax liability must be recorded at the capital-gains tax rate, even though the current tax benefit from amortization is recorded at the ordinary income tax rate.

If circumstances change and the indefinite-lived asset is subsequently determined to have a finite useful life, the asset would be amortized or depreciated for book purposes prospectively over its estimated remaining useful life. Under this scenario, the asset would be recovered by means of revenue that is taxable at the ordinary tax rate over the asset’s amortization period. Accordingly, the deferred tax liability would be remeasured at the ordinary tax rate if it was previously measured at a different rate.

4.2.4.6 “Worthless” Deferred Tax Assets

When deductions or loss carryforwards are expected to expire unutilized, it is generally not appropriate to use zero as the applicable tax rate. Rather, a deferred tax asset should be recorded at the applicable tax rate and a valuation allowance of an equal amount would be provided. However, in certain rare situations it may be appropriate to use a zero rate or to write off the asset against the valuation allowance. This reduces the valuation allowance and the number of gross deferred tax assets that are disclosed.

A write-off might be appropriate if, for example, an entity has a loss carryforward that has not yet expired in a country where the entity no longer conducts its business. As with many other areas of ASC 740, this determination requires the use of professional judgment and a careful consideration of the relevant facts and circumstances.

Certain carryforwards (e.g., certain AMT carryforwards and foreign tax credit carryforwards) may have a corresponding, full valuation allowance. We believe that if there is only a remote likelihood that such an entity will ever utilize those carryforwards, it is acceptable for the entity to write off the deferred tax assets against the valuation allowance, thereby eliminating the need to disclose the gross amounts.

In the United States, IRC Section 382 imposes under certain circumstances a limitation on the utilization of net operating losses, credit carryforwards, built-in losses and built-in deductions after an ownership change. When this (or a similar) limitation may mathematically preclude use of a portion of a carryforward or a deductible difference, it is appropriate for an entity to write off the deferred tax asset. If carryforwards and built-in losses are subject to the same aggregate limitation, the estimate of the “permanent” loss of tax benefits should be reflected as an unallocated reduction of gross deferred tax assets.

4.2.4.7 Dual-Rate Jurisdictions

Certain foreign jurisdictions tax corporate income at different rates, depending on whether (and, in some cases, when) that income is distributed to shareholders. For example, assume that a jurisdiction has a tax system under which (1) undistributed profits are subject to a corporate tax rate of 45 percent and (2) distributed income is taxed at 30 percent. Entities that paid dividends from previously undistributed income received a tax credit (or tax refund) equal to the difference between (1) the tax computed at the “undistributed rate” in effect during the year in which the income was earned (for tax purposes) and (2) the tax computed at the “distributed rate” in effect during the year in which the dividend was distributed.

Under ASC 740-10-25-39 through 25-41, the financial statements of an entity subject to such a foreign jurisdiction should not recognize an asset for the tax benefits of future tax credits that will be realized when the previously taxed income is distributed. Rather, those tax benefits should be recognized as a reduction of income tax expense in the period during which the tax credits are included in the entity’s tax return. Accordingly, the entity should use the undistributed rate to measure the tax effects of temporary differences.

Under ASC 740-10-25-41, for purposes of preparing consolidated financial statements, a parent company with a foreign subsidiary that is entitled to a tax credit for dividends paid should recognize based on the distributed rate (1) the future tax credit that will be received when dividends are paid and (2) the deferred tax effects related to the operations of the foreign subsidiary. However, the undistributed rate should be used in the consolidated financial statements if the parent, as a result of applying the indefinite reversal criteria of ASC 740-30-25-17, has not provided for deferred taxes on the unremitted earnings of the foreign subsidiary.

Although not specifically addressed by the FASB, we believe that such treatment should also be applied by investors measuring the tax effects of a corporate joint venture in a jurisdiction in which the distributed rate differs from the undistributed rate because ASC 740-10-25-3 specifically extends the application of the indefinite reversal criteria to an investment in a foreign corporate joint venture that is essentially permanent in duration.

ASC 740-10-25-39 through 25-41 was written within the context of a German tax regime in which the “undistributed” rate was higher than the “distributed” rate. (That German tax regime is no longer in effect.) Conversely, in certain jurisdictions, the “distributed” rate exceeds the “undistributed” rate, and additional taxes are due whenever income is distributed to shareholders. In these situations, we believe that it is preferable to use the “distributed” rate to (1) record a liability for any additional taxes that would be owed when earnings are ultimately distributed and (2) to tax-effect temporary differences.

Support for this conclusion can be found in ASC 830-740-25-6 through 25-8, which describe an analogous situation whereby a revaluation surplus in Italy becomes taxable upon liquidation or distribution of earnings associated with the revaluation surplus to shareholders. For that situation, it was concluded that a deferred tax liability should be provided on the revaluation surplus. In 2002, the AICPA’s International Practice Task Force (IPTF) considered the impact of a tax regime in South Africa that imposed two corporate taxes, a primary tax imposed at the normal corporate statutory rate when income was earned and a secondary tax imposed upon distribution of accumulated earnings. Such a tax regime was effectively a dual corporate tax system. In deliberating whether the lower “undistributed” tax rate or the higher “distributed” tax rate should be used to record deferred taxes, the IPTF concluded that, while use of the higher “distributed” rate was preferable, use of the lower “undistributed” rate was acceptable if accompanied by the appropriate incremental disclosures. The SEC staff observer advised the IPTF that it would not object to either view.

The SEC staff also agreed with the IPTF’s conclusion that entities subject to the South African tax regime2 should provide a series of incremental disclosures. Those disclosures must include a description of the tax concept (i.e., what it is and how it works), how the entity is accounting for the tax (i.e., “undistributed” vs. “distributed” tax rate), the basis on which tax liabilities have been computed, and the amount of undistributed earnings on which a secondary tax (or similar tax) has been made. If the lower “undistributed” rate is used, however, incremental disclosures are required. These disclosures include the following:

2 The South African tax regime considered back in 2002 by the IPTF & SEC is no longer in effect.

A statement that requires (1) the company to pay additional taxes at the applicable tax rate on all distributions of dividends and the additional taxes to be recorded as an income tax expense in the period during which the company declares the dividends.

A statement that clarifies when the additional taxes will be owed to the government.

The amount of retained earnings that, if distributed, would be subject to the tax.

Further, when dividends are declared, the additional tax must be separately presented in the effective rate reconciliation (even if such amounts might satisfy the materiality criteria in Rule 4-08(h) of Regulation S-X, which would otherwise allow the tax to be combined with other items).

Example 4-10 illustrates the application of the above guidance.

Example 4-10: Use of Distributed and Undistributed Tax Rates
as Applicable Rates

In Country X, certain resident corporations are liable for regular corporate income tax at a rate of 30 percent and for a secondary tax calculated at 12.5 percent of distributed earnings (i.e., dividends) net of the secondary tax liability, which the company can declare during any dividend cycle. Mechanically, the secondary tax creates an effective tax rate of 37.38 percent on distributed earnings.

In our opinion, it is preferable to use the “distributed” rate to record the tax effects of temporary differences when it is higher than the “undistributed” rate. However, it is also acceptable to recognize a liability at the “undistributed” rate as long as appropriate disclosures are provided. No matter which approach is followed, companies should disclose a description of the tax concept (i.e., what it is and how it works) and how they are accounting for the tax. They should identify the basis on which tax liabilities are computed and any undistributed earnings on which a secondary tax provision is made.

In Country Y, companies are subject to a 25 percent income tax rate plus an additional 10 percent corporate income tax assessment if their taxable income is not distributed before the end of the subsequent year. The additional tax assessment is due in the second subsequent year (i.e., “undistributed” rate of 35 percent is higher than “distributed” rate of 25 percent). Provided that a company has no means of mitigating the effect of the additional tax, the company should follow the guidance in ASC 740-10-25-39 through 25-41 to account for the additional 10 percent.

Under that guidance, tax is provided at the undistributed rate (in this case 35 percent) in the period during which the income is earned. Any reduction in the liability that will arise when the income is ultimately distributed is not anticipated, but is instead recognized in the period during which the distribution plan becomes final. Disclosures that specify what the tax is and how it works are recommended.

4.2.4.8 Hybrid Tax Systems

Determining the applicable rate for hybrid tax systems can be difficult. For example, Mexico’s flat tax regime interacts with the regular income tax system, operates as a marginal tax, and has many similarities to an Alternative Minimum Tax (“AMT”) system (see Section TX 4.2.5 for a more detailed discussion of AMT considerations), However, unlike the AMT, the flat tax is not creditable against the regular income tax liability, is not carried forward indefinitely, and does not operate like a prepayment of the regular income tax liability. In these situations, we generally believe that deferred taxes should be calculated in accordance with the regime (i.e., flat tax or regular income tax) the entity expects to be subject to. If an enterprise expects to alternate between regimes, a hybrid approach may be necessary. In such cases, it is often necessary to schedule temporary difference reversals in order to properly state deferred tax balances.

Section TX 1.2.2.1 offers information on determining the applicable rate for tax regimes that levy tax based on the higher of a capital-based or an income-based tax.

4.2.4.9 Foreign-Branch Operations

Under the U.S. federal income tax system, a branch represents a U.S. corporate entity that physically conducts its business in another country. The branch income and losses are generally taxable in the branch home country based on the local country’s tax law and in the United States based on U.S. federal income tax law. Under U.S. federal tax law, local country taxes imposed on the branch are considered foreign taxes of the U.S. corporation, which may deduct them as a business expense or claim them as direct, creditable foreign taxes of a U.S. corporation. That is, the U.S. corporation branch owner can deduct foreign branch taxes (i.e., a tax benefit measured at 35 percent) or receive U.S. foreign tax credits (i.e., tax benefit measured at 100 percent), which, subject to limitations, can offset the U.S. federal income tax imposed on the branch income.

Because the branch is taxed in two jurisdictions under two different tax regimes, we would expect the entity to have one set of temporary differences for the U.S. return (i.e., those temporary differences would be included in the deferred tax computation for the U.S. consolidated tax group) and another set of deferred taxes for foreign tax purposes. It should be noted that, conceptually, U.S. federal deferred tax consequences arising from a business operation located in a foreign branch are similar to the U.S. federal tax consequences arising from a business operation located in a U.S. state and local jurisdiction. Therefore, the deferred foreign tax asset or liability resulting from the application of ASC 740 will be a temporary difference in the computation of the deferred U.S. tax because the deferred foreign asset or liability has a book basis but no U.S. tax basis (i.e., for U.S. tax purposes, foreign deferred taxes of the branch do not enter the computation of U.S. taxable income until they become current taxes).

Under U.S. tax law, when a deferred foreign tax asset is recovered, it reduces the foreign branch local country current taxes and consequently the foreign taxes deductible by or creditable to the U.S. corporation. Conversely, when a deferred foreign tax liability is settled, it increases foreign branch local country current taxes and foreign taxes deductible by or creditable to the U.S. corporation. Therefore, a foreign deferred tax liability recorded at the branch level would give rise to a U.S. deferred tax asset, while a foreign deferred tax asset recorded at the branch level would give rise to a U.S. deferred tax liability. When future realization of a foreign deferred tax asset is not more-likely-than-not (i.e., less than 50 percent likely) and a partial or full valuation allowance against the branch foreign tax asset is recorded, a U.S. deferred tax liability for the foreign tax asset at the branch level would not be required. Section TX 11.6 provides a more detailed discussion of the accounting for branch operations.

4.2.4.10 Aggregating Computations for Separate Jurisdictions

While deferred taxes are usually determined separately for each tax-paying component in each tax jurisdiction, ASC 740-10-55-25 acknowledges that there may be situations in which the tax computations for two or more jurisdictions can be combined. See Section TX 1.3 for a discussion of when jurisdictions can be combined for the purposes of applying ASC 740.

4.2.5 Alternative Minimum Tax Considerations

4.2.5.1 AMT—General Background

The corporate alternative minimum tax (AMT) is a separate, parallel U.S. tax system that was enacted in 1986 to ensure that corporations do not avoid their fair share of tax by utilizing certain provisions in the tax law.

As a separate parallel tax structure, the amounts of carrybacks and carryforwards for alternative minimum taxable income (AMTI) are determined separately from the amounts of carrybacks and carryforwards for regular tax. The amount of tax computed under AMT rules in a given year is called the tentative minimum tax (TMT). If TMT is higher than the regular tax in a given year, an AMT payment is required for the TMT in excess of the regular tax. In turn, any AMT paid generates a credit carryforward (AMT credit), which can be applied to reduce the regular tax in any future year to the amount of the TMT computed for that year. A carryforward of the AMT credit is not limited to any specific time frame.

In general, the AMT taxes a broader income base at a lower rate. Although companies may find themselves temporarily or indefinitely subject to the AMT, ASC 740-10-30-10 through 30-11 specifically state that the applicable tax rate for the U.S. federal jurisdiction is the regular tax rate, not the AMT rate.

4.2.5.2 The Interaction of AMT with ASC 740 Accounting




The AMT is considered in the ASC 740 deferred tax computation in two ways. First, an AMT credit carryforward existing on the balance sheet date is a deferred tax asset subject to the assessment for realization. Section TX 5.4.4.2.2.6 discusses considerations for assessing the need for a valuation allowance against AMT credit carryforwards.

Second, the AMT may make it more-likely-than-not that some regular-tax-deductible differences and carryforwards will not be fully realized. The possibility that some deferred tax assets might not be realizable must be considered by an entity that
(1) is currently paying AMT, or expects to pay AMT in the future, and (2) has significant deductible temporary differences or carryforwards for regular tax purposes. Deferred taxes must be recorded for regular-tax temporary differences at the regular tax rate. If the regular-tax-deductible differences and carryforwards offset taxable differences, a benefit at the regular tax rate is assured. This excludes the possible effect of the 90 percent limitation on use of NOL carryforwards against AMTI because a deferred tax liability has been recorded at the regular tax rate. However, if the regular-tax-deductible differences must be used against future taxable income, excluding reversals, and if it is likely that the entity will be an AMT taxpayer indefinitely, it may be appropriate to establish a valuation allowance to reduce the net deferred tax asset to the benefit amount that will be realized in the computation of TMT (i.e., the AMT rate applied to the AMT temporary differences).

When the regular-tax-deductible differences reverse, the excess of the tax benefit computed at the regular rate may be converted into an AMT credit carryforward and, as a result, the company may avoid the valuation allowance if it anticipates that the AMT credit carryforward will be used. This may be the case if the expected future AMT position will result from future origination of timing differences between regular taxable income and AMTI, which will reverse and cause regular tax in future years to exceed TMT.

For example, if an entity has an NOL carryforward in excess of taxable temporary differences, the tax effect of the NOL can generally be recognized as an asset if the NOL will fully offset the taxable temporary differences. There is an exception: If an entity believes that it will be unable to use the “future” AMT credit carryforward that would be generated if the limitation were applied and the AMT were paid, it cannot recognize the tax effect of the NOL as an asset. Instead, the valuation allowance should be increased so that the net deferred tax liability equals the amount of AMT that the entity (1) expects to pay on existing taxable temporary differences and (2) expects that it will be unable to recoup through realization of the related AMT credit carryforward. The valuation allowance keeps net deferred tax assets from being provided at a rate in excess of the expected future impact of the reversals.

As discussed above, an AMT taxpayer must provide tax on taxable differences at the regular tax rate. Some companies are in an AMT position because of permanent differences between regular taxable income and AMTI; they may expect that condition to continue indefinitely (i.e., indefinite AMT taxpayers). This requirement may cause such a taxpayer to state its deferred tax liability at an amount in excess of the expected future impact of the reversals.

An indefinite AMT taxpayer will also generate AMT credit carryforwards to reduce in the overall deferred tax computation, the deferred tax liability computed at the regular tax rate. If the taxpayer has been subject to AMT for many years, the deferred tax asset for AMT credit carryforwards may be sufficient to reduce the deferred tax liability to the AMT rate that is applied to AMT differences. Example 4-11 illustrates how this “mechanism” works.

Example 4-11: Alternative Minimum Tax

Background/Facts:

A life insurance company that qualifies as “small” under the tax law has a $1,000 depreciation-related taxable temporary difference. Its applicable “regular” tax rate is 35 percent. As explained in ASC 740-10-25-37 and ASC 740-10-30-13, the benefit of a special deduction is not reflected in the company’s determination of the applicable tax rate. Therefore, the company must recognize a $350 deferred tax liability for this temporary difference.

As a “small” life insurance company, the company may take a 60 percent special deduction on its regular taxable income. However, the deduction is an AMT preference item and, as such, must be added back to regular taxable income when the company is determining AMTI.

Prior to 1998, a life insurance company would always be considered an AMT taxpayer as long as it qualified as “small.” That was because the regular tax on any amount of income before the special deduction (i.e., 35 percent of the difference between 100 percent and 60 percent [or 14 percent]) was always going to be less than the AMT on that amount (i.e., 20 percent). For 1998 and subsequent years, however, a gross receipts test was added to the AMT provisions, whereby a company that meets certain requirements will not be subject to the AMT. Consequently, a life insurance company that qualified as “small” was no longer subject to the AMT automatically.

Assume that a company has $400 of existing AMT credit carryforwards at the end of the current period and that it reasonably expects to qualify as a “small” life insurance company for the foreseeable future. The company’s expectations are (1) that it will be taxed at AMT rates for the foreseeable future and (2) that it will never be able to utilize its AMT credit carryforwards.

Analysis/Conclusion:

Because the company was required to measure its deferred tax liability at the regular tax rate, rather than at the AMT rate, it may assume that it will have an equal amount of regular tax in excess of the AMT and that it may use the amount to recognize a deferred tax asset for existing AMT credit carryforwards.

The company in this example is required to recognize a $350 deferred tax liability, even though it reasonably expects that the reversal of the taxable temporary difference will result in only $200 of tax at the AMT rate. As a result, the company is permitted to assume that it will have $150 of excess regular tax in the future. This, in turn, allows $150 of the existing AMT credit carryforward to be recognized as a deferred tax asset.

In this example, the company achieves the “expected” result—a $200 net deferred tax liability. It should be noted, however, that the “expected” result would not have been achieved if the company did not possess at least $150 of existing AMT credit carryforwards. For example, if the company’s AMT credit carryforward at the end of the current period were only $100, its deferred tax asset would be only $100, and $250 would be the amount of its net deferred tax liability. Thus, the “mechanism” does not provide full relief until existing AMT credits are sufficient to draw down the deferred tax liability from the regular rate to the AMT rate.

Operating loss and foreign tax credit carryforwards for the AMT, rather than for regular tax purposes, are ignored unless a company is estimating future TMT and assessing the valuation allowance for regular-tax-deductible differences/loss and for AMT credit carryforwards.