IT2013_1069_CH02_v2_P1_7-22

Chapter 2:
Objectives and Basic Principles

Chapter Summary

In general, when a tax is based on income, most items that enter into pretax accounting income also enter into taxable income in the same year, and vice versa. Some events, however, are recognized for book purposes and for tax purposes in different years. Over time, as these differences reverse, they eventually offset each other. The FASB, and its predecessor, the Accounting Principles Board (APB), have consistently decided that the tax effects of these differences, referred to as deferred taxes, should be accounted for in the intervening periods.




2.1 Objectives of ASC 740

ASC 740-10-10-1 identifies two objectives of accounting for income taxes:

2.2 Basic Principles

The FASB concluded that the financial statements should reflect the current and deferred tax consequences of all events (with the only exceptions identified in ASC 740-10-25-3, as discussed in Section TX 2.3) that have been recognized in the financial statements or tax returns. To accomplish this goal, the following basic principles were established:

2.3 Exceptions to the Basic Principles

There are certain situations where deferred taxes are either not provided or not determined in the normal manner. Some basis differences are not temporary differences because their reversals are not expected to result in taxable or deductible amounts. In other circumstances, ASC 740-10-25-3 provides certain exceptions to the basic principles of the statement.

2.3.1 “Outside Basis” Differences and U.S. Steamship Exceptions

ASC 740-10-25-3(a) provides that a deferred tax liability should not be recognized for certain specified temporary differences unless it becomes apparent that they will reverse in the foreseeable future. The most notable of these relates to an excess book-over-tax “outside basis” difference of an investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration. The accounting for income taxes related to outside basis differences is discussed at length in Chapter TX 11.

ASC 740-10-25-3(b) (which refers to ASC 995-740-25-2) provides an exception for recording deferred taxes related to deposits in statutory reserve funds of U.S. steamship entities for temporary differences that arose in fiscal years beginning on or before December 15, 1992. However, deferred taxes are required for any temporary differences related to deposits in statutory reserve funds of U.S. steamship entities that arise in fiscal years beginning after December 15, 1992.

2.3.2 Leveraged Leases (ASC 740-10-25-3(c))

ASC 840-10-25-43 defines a leveraged lease as having all of the following characteristics at its inception: (i) it meets the criteria for a direct financing lease,
(ii) it involves at least three parties, (iii) the financing provided by the long-term creditor is nonrecourse as to the general credit of the lessor, (iv) the lessor’s net investment declines during the early years once the investment has been completed and rises during the later years of the lease before its elimination.

The accounting model for leveraged leases, prescribed in ASC 840-30, Capital Leases, is based on projected after-tax cash flows, and it thus predicts the future actual tax effects arising from the lease. Generally, these tax effects are based on the actual incremental tax effects expected to be realized in each future year as taxable income (loss) resulting from the leveraged lease transaction is reported on the tax return. The tax effects of leveraged leases are typically extremely important to their economics. The accounting model recognizes the importance of those tax effects in determining the pattern of income over the term of the lease.

ASC 740-10-25-3(c) leaves the basic model for accounting for leveraged leases in place. The taxable temporary differences arising from leveraged leases do not enter into the computation of the deferred tax liability. Rather, a deferred tax credit is computed under the ASC 840-30 model.

2.3.2.1 Purchased Leveraged Leases

ASC 840-10-25-27, ASC 840-30-25-10, ASC 840-30-30-15 and ASC 840-30-35-32 provide guidance with respect to accounting for leveraged leases acquired in a purchase business combination. ASC 805, Business Combinations, generally requires the allocation of the aggregate purchase price of the acquired entity to its individual assets and liabilities based on fair values before tax-effecting. However, the amount of the aggregate purchase price that is allocated to the investment in leveraged leases is determined on a tax-effected basis.

2.3.3 Nondeductible Goodwill (ASC 740-10-25-3(d))

The tax treatment (deductible vs. nondeductible) of goodwill may vary depending on the tax laws of the jurisdiction where the goodwill is recorded. In the United States, for example, under the 1993 Tax Act, goodwill that is “acquired” is amortizable for U.S. federal tax purposes over 15 years (goodwill that is “created” by a taxpayer is generally nondeductible).

ASC 805-740-25-3 prohibits the recognition of a deferred tax liability for the reported amount of goodwill (or portion thereof) that is not deductible for tax purposes. Because goodwill is the residual in the purchase price allocation under ASC 805, establishing a deferred tax liability for the basis difference in goodwill would result in an increase in the amount of goodwill. This in turn would require an increase in the deferred tax liability, which would further increase goodwill.

The FASB concluded that the resulting grossing up of goodwill and the deferred tax liability would not add to the relevance of financial reporting. Thus, while it is assumed that other assets and liabilities will be recovered and settled at their carrying amounts, there is in this treatment of goodwill an implicit assumption that its carrying amount will be recovered on an after-tax basis.


2.3.4 Tax Effects of Intra-entity Transactions (ASC 740-10-25-3(e))

As quoted above, ASC 740-10-25-3(e) prohibits the recognition of a deferred tax asset for basis differences relating to intra-entity (i.e., intercompany) profits. This treatment of intra-entity profit is an exception to the asset and liability approach prescribed by ASC 740. In consolidation, there is a deductible temporary difference for the excess of the buyer’s tax basis over the cost to the seller, which normally would require recording a deferred tax asset for the gross deductible difference. But ASC 810-10-45-8 defers the tax paid by the seller and ASC 740-10-25-3(e) prohibits recognition by the buyer of a deferred tax asset for the temporary difference.

2.3.4.1 In General

Ordinarily, there are tax effects when an asset is sold or transferred between affiliated companies that are consolidated for financial statement purposes but file separate tax returns. Under ASC 740-10-25-3(e) and ASC 810-10-45-8 no immediate tax impact should be recognized in the consolidated financial statements as a result of these intra-entity transfers of assets. Furthermore, this exception applies to intra-entity transfers involving affiliated entities domiciled in two different jurisdictions (e.g., a U.S. corporation and a non-U.S. corporation) as well as affiliated entities domiciled in the same jurisdiction but that file separate income tax returns (e.g., two affiliated U.S. corporations that are not included in the same U.S. corporate income tax return and hence are considered separate tax-paying components of the reporting entity’s consolidated financial statements).

After the consummation of the transaction, there generally will be no temporary difference in either the seller’s or the buyer’s separate financial statements. The seller’s separate financial statements generally will reflect the profit on the sale and a tax payable on that profit. The buyer’s separate financial statements will reflect the asset at the intra-entity transfer price, which will be the buyer’s tax basis.

In consolidation, however, the seller’s pretax profit will be deferred, and the asset will be carried at its cost to the seller until it is sold to an unrelated third party or otherwise recovered (e.g., amortized, impaired, etc.). Similarly, ASC 810-10-45-8 precludes an entity from reflecting a tax benefit or expense from an intra-entity transfer between entities that file separate tax returns, whether or not such entities are in different tax jurisdictions, until the asset has been sold to a third party or otherwise recovered.

Therefore, the taxes paid (if any) by the seller, as well as any other tax consequences (e.g., as a result of temporary difference reversals), are deferred in consolidation. In addition, no deferred tax asset is recorded in the buyer’s jurisdiction for the difference between the tax basis and consolidated carrying amount of the asset. Instead, the tax benefit from any step up in tax basis is recognized as it is realized each period, via deduction on the tax return. This will necessitate tracking intra-entity activity so as not to misstate the deferred taxes.

Special consideration should be given to the effects of changes in measurement of uncertain tax positions when accounting for intra-entity transactions (see Section TX 16.5) and accounting for the release of a valuation allowance concurrent with an intra-entity asset transaction (see Section TX 2.3.4.2.1.2) to ensure that the intra-entity exception in ASC 740-10-25-3(e) is appropriately applied.

We believe the above discussion ordinarily applies to intra-entity transfers of assets, including fixed and intangible assets, but not to the transfer of stock of a subsidiary (as discussed below). For intra-entity transfers of fixed or intangible assets, the deferred charge is typically amortized as the book basis of the asset is depreciated by the buyer. In the case of an intra-entity transfer of an asset that is not depreciated for book purposes (e.g., an indefinite-lived intangible) but is depreciated by the buyer for tax purposes, we believe that the deferred charge should be amortized over the asset’s tax life.

In the narrow case of intra-entity transfers of assets that are not subject to sale in the foreseeable future and are not depreciated for either book or tax purposes, a literal interpretation of ASC 740-10-25-3(e) and ASC 810-10-45-8 would result in an indefinite deferral of the tax effects of the transaction. However, we do not believe that an indefinite deferral is consistent with the intent of ASC 810-10-45-8 which is essentially a matching objective. Further, we do not believe that the guidance contemplated a transaction whereby the tax effects would be indefinitely deferred.

Accordingly, while we will not object in this narrow case to an accounting policy of indefinitely deferring the tax consequences, we believe that another alternative would be to identify a reasonable period of time over which to amortize the deferred charge. One approach would be to consider the overall economics of the transaction. Presumably, the company was willing to incur a tax charge in the seller’s jurisdiction because the transferred assets are expected to provide a better “after-tax” return in the buyer’s jurisdiction. We believe that it would be appropriate for a company to amortize the tax effects over the period of time in which the transferred asset is expected to generate the return. Another approach might be to look to the tax life of a similar asset in a jurisdiction that provides for tax amortization. Furthermore, in limited circumstances, the tax effects of an intra-entity sale might be recognized immediately as indicated in Example 2-2.

A company should consider the approach chosen as an accounting policy election that is applied consistently to similar transactions. Further, to the extent an intra-entity transaction has tax consequences for both the buying and selling entities, we believe that the approach chosen should be applied consistently to both the buyer and the seller (e.g., we do not believe it would be appropriate for the seller to indefinitely defer the tax effects of the transaction while the buyer amortizes the tax effects over a period of time).

Also, the requirement of ASC 810-10-45-8 that the seller’s tax consequences be deferred applies when pretax profit has not already been recognized in the consolidated financial statements in periods prior to the period in which the intra-entity transfer of assets occurs. For example, the pretax effect of changes in the value of certain marketable securities accounted for under ASC 320, Investments—Debt and Equity Securities, as available-for-sale or trading securities would be included in other comprehensive income (for available-for-sale securities) or pretax income (for trading securities) as the securities are marked to market every reporting period. The periodic adjustment would be included in the current and deferred tax calculations. A subsequent transfer of such securities between affiliated entities filing separate income tax returns would be within the scope of ASC 740-10-25-3(e) being that it is an intra-entity transfer of assets. However, such a transfer would not trigger the deferral requirement in ASC 810-10-45-8 because the pretax effects from the securities’ mark-to-market adjustments would already have been recognized in prior periods. This is because, for financial statement purposes, the pretax income would already have been recognized in prior periods and any tax currently payable or refundable arising from a taxable transfer would be offset by the reversal of the deferred taxes that had been established in prior periods.

2.3.4.1.1 Deferred Charge Differentiated from Deferred Tax Asset

Taxes paid that result from intra-entity transfers and that are deferred for financial reporting purposes (deferred charges) are different from deferred tax assets recognized under ASC 740-10-30-5. Deferred tax assets are subject to revaluation for tax rate changes and are subject to realizability considerations using the model prescribed in ASC 740. However, the deferred charges are not subject to the realizability model prescribed in ASC 740 nor are they affected by tax rate changes.

That is because the deferred tax for an intra-entity transfer represents the deferred tax effect of a past event. The amount will not be changed by future events other than the sale or depreciation, including market write-down or impairment measured on a pretax basis, of the related asset. The only realization test applied would be part of an overall realization test for the related inventory or other asset. Thus, the carrying amounts of the asset and the deferred charge, in total, should not exceed the anticipated after-tax proceeds on sale or other recovery.

2.3.4.1.2 Quantifying the Amount of Tax Deferred under ASC 740-10-25-3(e)

A question may arise as to the amount of tax paid by the seller on the intra-entity profit. We believe that, generally, the profit should be the last item to enter into the seller’s computation of taxes payable in the period of the sale, and the deferred tax should be calculated as the differential in taxes payable with and without the intra-entity profit. If the sale affects deferred tax expense in the seller’s separate statements (e.g., if the tax basis of the asset sold is higher or lower than the seller’s carrying amount prior to the sale), that effect should be deferred in consolidation.

2.3.4.1.3 Intra-entity Intellectual Property Migration Arrangements

Determining whether an arrangement to migrate intellectual property (IP) is an intra-entity transfer of an asset as opposed to merely a license to use the asset is often judgmental and depends on facts and circumstances. To the extent it is determined to be an asset transfer, the exception in ASC 740-10-25-3(e) would apply and any net tax consequences of the transfer (both current and deferred) are suspended in the balance sheet and subsequently amortized to income over the period of economic benefit. Alternatively, if the arrangement constitutes a license, the intra-entity transfer provisions in ASC 740 would not apply and any tax consequences are recognized immediately.

In some cases, the arrangement constitutes an outright sale or an exclusive license for the entire economic life of the IP and there may be little doubt that an asset has been transferred. However, in other cases, it may be difficult to determine whether the arrangement constitutes an in-substance sale of the IP (or a portion thereof) or merely a license to use the IP.

Intra-entity arrangements should be reviewed to determine whether they confer ownership rights and burdens and whether the benefits and risks associated with the IP have been transferred. To be considered an “asset,” consistent with the FASB Concept Statement definition of an asset (CON 6, Elements of Financial Statements), the arrangement should convey probable future economic benefits that are controlled by the entity in the in-bound jurisdiction. One way to think about this is to evaluate whether the holder of the IP would recognize an asset on its separate balance sheet, if it were to prepare one. In this regard, the legal and contractual rights conveyed in the arrangement are the primary considerations.

Further, the relevant income tax laws should also be considered. While not necessarily determinative of the accounting treatment, the characterization of the arrangement under income tax law as either a license or a sale may provide additional clues. This might include, for example, whether the arrangement is considered a sale or disposal in the out-bound jurisdiction and whether tax basis has been created in the in-bound jurisdiction.

There are circumstances, however, when the income tax accounting effect from an intra-entity IP migration would be similar regardless of whether the arrangement constitutes an asset transfer versus a licensing arrangement.

The following example illustrates the accounting for the tax effect of post-acquisition migration of acquired IP:

Example 2-1: Accounting for the Tax Effect of Post-Acquisition Migration
of Acquired Intellectual Property

Background/Facts:

Company X, a U.S. multinational, acquires in a nontaxable acquisition the shares of Company B, a U.S. company which has developed IP. In acquisition accounting, Company X records the IP at its fair value, determined using an income approach based on expected worldwide revenues. Company X also records a deferred tax liability for the related taxable temporary difference which equals the full carrying value of the IP because the tax basis of the IP is zero. The deferred tax liability effectively represents the expected U.S. tax from the recovery of the IP’s carrying value.

Post acquisition, Company X decides to restructure the ownership of the acquired IP consistent with its evolving overall business and tax strategy by providing a non-exclusive license to its Bermuda subsidiary. The non-exclusive license gives the Bermuda subsidiary commercialization rights covering all territories outside the U.S. In exchange, the Bermuda subsidiary would pay royalties to Company X commensurate with the income to be generated outside the U.S. Rather than paying such royalties over time, Company X and its Bermuda subsidiary agree that the Bermuda subsidiary will make a lump-sum payment of all royalties. The lump-sum payment is determined by discounting all expected royalties at an appropriate discount rate. Under U.S. tax law, the lump-sum payment is included in Company X’s taxable income upon receipt. If, instead of making a lump-sum payment of all expected royalties, the Bermuda subsidiary were to pay periodic royalties, U.S. tax consequences would occur over time as period royalties are included in taxable income.

Question:

How should Company X account for the tax effect related to the intra-entity arrangement?

Analysis/Conclusion:

In this fact pattern, we do not believe that there should be any tax provision effect to Company X in the period in which the intra-entity lump sum royalty is paid. (This assumes that the value at which the IP is on the books equals or approximates the value at which it is transferred for tax purposes.) Regardless of whether the arrangement constitutes an intra-entity transfer of an asset or a license, the lump-sum payment has merely accelerated the U.S. tax consequences to Company X of recovering the carrying value of the portion of the IP related to non-U.S. territories which, in turn, causes a partial reversal of the related deferred tax liability. By paying current U.S. tax on the entire value of the non-U.S. rights, Company X will not have to pay a second tax when its Bermuda subsidiary recovers the non-U.S. value through generation of foreign source income. Therefore, the deferred tax liability pertaining to the expected U.S. tax from the recovery of the non-U.S. rights is no longer needed.

If the arrangement constitutes an intra-entity transfer of an asset, the deferral procedures in ASC 740-10-25-3(e) apply and any net tax consequences of the transfer are deferred and amortized to income over the period of economic benefit. Alternatively, if the arrangement constitutes a license, the intra-entity transfer provisions in ASC 740 would not apply.

In this case, the net income statement effect is likely to be zero under either scenario as the current tax expense is offset by a deferred tax benefit from the partial reversal of the deferred tax liability. Importantly, however, this would not be the case if the value assigned for tax purposes at the time of the IP migration differs from the carrying amount, of the IP, if any, on the entity’s balance sheet. This might be the case, for example, if the IP was internally generated or acquired at an earlier date.

2.3.4.2 Certain Exceptions in the Application of ASC 740-10-25-3(e)

2.3.4.2.1 Intra-entity Sale of Subsidiary Stock

When the intra-entity transaction is the sale of stock of a subsidiary, it involves the “outside” tax basis.1 Because both ASC 740-10-25-3(e) and ASC 810-10-45-8 refer to the intra-entity transfer of assets, we do not believe that the exception should be extended to the transfer of stock of a subsidiary (i.e., an outside basis difference). Rather, the guidance related to outside basis differences would be applied in the usual manner (see Chapter TX 11). Accordingly, we believe that any tax paid on the intra-entity transfer of a subsidiary’s stock should not be deferred.

1 An “outside” basis difference is the difference between the book carrying value and tax basis of an entity.

Further, often the fair value of the stock of the subsidiary transferred will become the outside tax basis of that subsidiary and may exceed its outside book basis. The general rule, as addressed in ASC 740-30-25-9, is that a deferred tax asset cannot be recognized for an excess tax-over-book outside basis difference unless it is apparent that reversal will occur in the foreseeable future (e.g., the outside basis difference is deductible in some systematic fashion or the entity is planning to sell the subsidiary in the near future).

Example 2-2: Application of ASC 740-10-25-3(e), to the Sale of Cost-Method Investments

Background/Facts:

Assume Company X, a U.S. corporation, has a wholly owned holding company in Switzerland (Holdings) that has a wholly owned subsidiary in Brazil and that also owns 5 percent of the stock of an entity in Argentina. Holdings accounts for its investment in the Argentine entity using the cost method. In the current year, Holdings sells all of its stock in both the Brazilian subsidiary and the Argentine entity to Company X, recognizing a pretax gain on both transactions, which is appropriately eliminated in consolidation but results in tax payments. Assume that after the intra-entity transfer, Company X does not have a definitive plan to sell either investment outside the group.

Question:

What is the appropriate financial statement accounting for the tax consequences of the sale of shares in the Brazilian subsidiary and in the Argentine cost-method investment?

Analysis/Conclusion:

Pursuant to ASC 740-10-25-3(e) and ASC 810-10-45-8, no tax benefit or expense should be recognized in the financial statements from an intra-entity sale of assets, until the assets have been sold to a third party or their cost otherwise has been recovered (e.g., amortized, impaired, etc.) in the consolidated financial statements. Rather, the tax consequences should be deferred, similar to the pretax profit that is deferred.

An intra-entity sale of the stock of a subsidiary differs from an intra-entity sale of assets as it involves outside tax basis. ASC 740-10-25-3(e) and ASC 810-10-45-8 both refer to the intra-entity sale of assets; therefore, any tax paid on an intra-entity transfer of a subsidiary’s stock generally should not be deferred.

In the scenario described above, the sale of the Brazilian entity is clearly an intra-entity sale of the subsidiary’s stock and accordingly the tax effects should be recognized immediately. Note that the fair value of the subsidiary transferred in this case becomes the outside tax basis of the subsidiary, which may exceed its outside book basis. In such an instance, a deferred tax asset for the outside basis difference would be recorded only if it was apparent that reversal of the temporary difference would occur in the foreseeable future.

The sale of the Argentine entity is an intra-entity sale of stock; however, the sale is of the stock of a cost-method investment and not of a subsidiary. Ordinarily, the intra-entity sale of a cost-method investment should be treated similar to an intra-entity sale of assets. However, with a cost-method investment, the underlying assets would not be expected to be amortizable for either book or tax purposes. Therefore, absent an anticipated sale of the investment outside the group, application of the tax deferral provisions would result in an indefinite deferral of the prior tax effects of the sale in the consolidated balance sheet. In this case, consistent with the guidance in TX 2.3.4.1 above, we believe it would be acceptable to either (1) indefinitely defer the tax effects until disposition or impairment of the cost method investment or (2) amortize the tax effects over the period of time in which the transferred investment is expected to generate an economic benefit (e.g., through reduced after-tax returns on dividends).

Further, although application of ASC 740-10-25-3(e) and ASC 810-10-45-8 is not optional for transactions within their scope, in this narrow circumstance, by analogy to our view on the intra-entity transfer of shares in a subsidiary, we would also not object to the immediate recognition of the tax effects of the intra-entity sale of a cost-method investment.

2.3.4.2.1.1 Reversal of Previously Unrecorded Book-Over-Tax Outside Basis Differences

An intra-entity transfer may trigger the reversal of an outside book-over-tax basis difference for which a deferred tax liability had not been provided previously, either because (1) the indefinite reversal criterion (ASC 740-30-25-18) was applicable and previously had been met or (2) the scenario suggested for a domestic subsidiary in ASC 740-30-25-7 previously had been contemplated. In these cases, the tax corresponding to the existing outside basis difference should be charged to expense in the period in which the expectations changed, which may be in advance of the actual intra-entity transaction.

2.3.4.2.1.2 Release of Valuation Allowance Concurrent with an Intra-entity Asset Transfer

An intra-entity transfer may trigger the release of a valuation allowance. Before the intra-entity asset transfer exception is applied, a company must first determine whether its existing tax attributes are realizable. If a tax benefit from a carryforward is realized, or is considered realizable, the intra-entity deferral provision should not apply to a valuation allowance release and an income tax benefit must be recognized. The tax cost triggered by the asset transfer is then deferred in accordance with the guidance on intra-entity asset transfers in Section TX 2.3.4. See Section TX 5.4.3.3 for a discussion of intra-entity asset transfers considered as part of the valuation allowance assessment.

2.3.4.2.2 Intra-entity Transfers Reported at Predecessor Basis

In preparation for a spin-off transaction, an intra-entity sale may occur to transfer specific assets (e.g., fixed assets or intangible assets) to an entity that will eventually be spun off (i.e., the transferee). When the spin-off occurs, the acquired asset will be recorded at predecessor basis in the separate financial statements of the transferee. A basis difference on the acquired asset would exist (historical cost for book purposes versus fair value of the asset for tax purposes). We believe there are two approaches to considering this basis difference in the separate financial statements of the transferee.

One view is that the transferee could record the deferred tax asset (assuming that the fair value and tax basis is greater than the book basis) on its books. This view ignores the intra-entity exception in ASC 740-10-25-3(e) under the theory that this exception only applies in consolidation. Under this approach, the deferred charge that was originally recorded in the consolidated statements, that included both the transferor and the transferee, is essentially recharacterized as a deferred tax asset within the transferee’s separate, carve-out financial statements. If this view is taken, we believe the corresponding credit, and any tax rate differential, would be recorded within the equity of the transferee in accordance with ASC 740-20-45-11 at the time of the spin.

A second view is that the ASC 740-10-25-3 deferral (previously recorded by the transferor in the consolidated financial statements) is inherited by the transferee at its carrying amount when the transferee leaves the consolidated group. This view is predicated on the fact that the deferral is in effect part of the carrying amount of the assets that are being assumed by the transferee at book value. Under this view, the transferee inherits the deferral and essentially continues the accounting (on its own books) that was previously performed by the transferor.

2.3.5 Certain Foreign Exchange Amounts (ASC 740-10-25-3(f))

ASC 740-10-25-3(f) prohibits the recognition of deferred taxes that, under ASC 830-10, Foreign Currency Matters, are remeasured from the local currency to the functional currency using historical exchange rates. This situation can result from either: (1) changes in exchange rates or (2) indexing for tax purposes. ASC 830-10-45-18 provides common nonmonetary balance sheet items that are remeasured using historical exchange rates. See Section TX 11.5 for a discussion of the accounting for foreign exchange movements with respect to ASC 740.

2.4 Other Considerations

2.4.1 Discounting

Although it might seem logical that an asset and liability approach to accounting for the impact of income taxes would give some consideration to the time value of money (i.e., a deduction today is worth more to an entity than a deduction ten years in the future), ASC 740-10-05-07 and ASC 740-10-30-8 specifically preclude entities from present-valuing or discounting when measuring deferred taxes. There are conceptual arguments both for and against discounting deferred taxes for the time value of money. A strong reason not to discount deferred taxes is that such discounting would involve numerous operational issues, including the selection of the appropriate discount rate(s). Most importantly, discounting would routinely require an entity to undertake a detailed analysis of future reversals of temporary differences to determine the future years in which the deferred tax amounts would become taxable or deductible. The FASB did not believe that the benefit of discounting outweighed the effort required to achieve that benefit. As a result, the time value of money is not considered in the accounting for income taxes (aside from an assessment of whether a tax-planning strategy is prudent and feasible). We believe this prohibition on discounting also extends to income tax receivables and payables.

Example 2-3: Prohibition on Discounting of Income Tax Receivable

Background/Facts:

Company X operates in a tax jurisdiction where carrybacks of net operating losses do not result in a current tax refund, but rather in a credit carryforward. The resulting credit carryforward either will be offset against the tax on taxable income over the subsequent three-year period or will result in a cash refund from the taxing authority if not used during the carryforward period.

As a result of a recent audit, the timing of a deduction taken in a previous period by Company X was disallowed. Company X was allowed to claim the deduction in a more recent period, further increasing its loss for that period. Company X filed an amended return and elected to carryback the incremental loss (as provided for under the relevant tax code), which created a credit carryforward. Due to the large amount of pre-existing net operating loss carryforwards (which the entity had not elected to carryback in the original return for that period) and the forecasted level of financial results, management deemed the recovery of the credit carryforward, through offset against tax on future taxable income, to be remote. Consequently, Company X considered a cash payment by the taxing authority in three years to be virtually certain.

Question:

Should the anticipated future receipt of the cash payment be discounted to reflect the time value of money?

Analysis/Conclusion:

No. We believe that discounting this income tax attribute would not be appropriate. We believe that this tax attribute is part of an income-based tax system that is accounted for pursuant to ASC 740. Under ASC 740-10-25-2, the tax attribute gives rise to a deferred tax asset. ASC 740-10-05-07 and ASC 740-10-30-8 prohibit discounting of deferred tax balances in all circumstances. The tax attribute represents a credit carryforward that eventually may result in a cash payment to the company. However, the attribute does not represent a current claim to cash and may in fact be offset against tax on taxable income at any time before the expiration of the three-year carryforward period.

Notwithstanding the conclusion above, even if the credit were deemed to be an “income tax” receivable (akin to a tax settlement receivable) instead of a deferred tax asset, the relevant guidance on discounting would be ASC 835-30, Imputation of Interest. While ASC 835-30 generally requires discounting of claims for cash with maturities in excess of a company’s operating cycle, ASC 835-30-15-3(e) explicitly excludes “income tax settlements” from such guidance. In certain situations, however, tax settlements with a local taxing authority may not meet the definition of an “income tax” under ASC 740 and therefore would be within the scope of ASC 835-30.

Example 2-4: Discounting of a Tax Receivable from a Taxing Authority Relating to a Non-Income-Based Tax

Background/Facts:

State X passed a law to replace an income tax with a gross receipts tax (determined not to be subject to ASC 740). As part of the law enacting the gross receipts tax, a new credit was created that would allow certain companies with recorded deferred tax assets relating to net operating loss carryforwards to convert those deferred tax assets into transitional credits to be used to offset future gross receipts tax liabilities. Under the law, transitional credit carryforwards that remained unused after 25 years would become refundable in cash so long as the company remained subject to the gross receipts tax.

Question(s):

Does the transitional credit meet the definition of an asset? If so, how should it be measured?

Analysis/Conclusion:

Statement of Financial Concepts 6 defines an asset, in part, as a probable future economic benefit that resulted from a past event.

We believe the transitional credit arising from the conversion of net operating loss carryforwards can be differentiated from other credits because of the ability of the company to claim a refund for the unused credit after 25 years, regardless of whether any tax liability has been incurred. Because of this feature, the credit is analogous to a receivable to be settled in cash in 25 years, with the ability to receive the benefit sooner by means of offset to a gross receipts tax liability. As the credit does not require any future event (the passage of time is not an event) to provide benefit, the transitional credit represents an asset. Although the company must remain subject to the gross receipts tax regime in order to claim the credit, all that is required for the company to meet that criterion is for it to stay in business in State X. The level of gross receipts is not relevant.

Because the transitional credit is analogous to a long-term receivable that does not bear interest, the asset recorded for the transitional credit should be carried at discounted present value consistent with the guidance in ASC 835-30. The present value would be measured by discounting the cash flows based on the timing of the company’s projected utilization of the transitional credit.

2.4.2 Volatility

ASC 740’s focus on the balance sheet ordinarily will not materially impact the relationship between the tax provision and income before taxes in the financial statements. In certain circumstances, however, the income tax expense/benefit may not bear the normal relationship to income before taxes.

A major cause of volatility is new tax laws or legislative changes in tax rates. Such changes in any jurisdiction in which an entity operates could cause an immediate, cumulative adjustment of the deferred tax asset or liability, with a corresponding effect on the tax provision. The deferred tax previously provided on items that will become taxable or deductible in a future year will be adjusted downward or upward to reflect the new laws or rates. This effect of a tax law change is recorded in continuing operations, as required by ASC 740-10-45-15. See Chapter TX 7 for further discussion on the effects of the accounting for changes in tax laws.

A change in the need for a valuation allowance against deferred tax assets (as discussed in Chapter TX 6) also can cause considerable volatility in reported results. In each financial reporting period, an entity must estimate the extent to which deductible differences and carryforwards (that may have been established over a period of a number of years) are more-likely-than-not to be realized (i.e., reduce future taxes payable). Because deductible differences and carryforwards typically originate over a period of years, adjustments to record or release a valuation allowance against deferred tax assets may far exceed the current-year pretax income or loss. When an entity that has been historically profitable incurs a large loss, or when an entity with historical losses is able to demonstrate the ability to sustain profitability, changes in the valuation allowance will magnify the change in the trend of the entity’s operations by adding a deferred tax expense to the pretax loss or by adding a deferred tax benefit to the newly generated pretax income. For additional discussion of valuation allowances, see Chapter TX 5.

2.4.3 Need for Judgment

A significant level of judgment is required in applying ASC 740. For example, when reversals of temporary differences will generate net deductions, either in the aggregate or over a span of future years, the recognition of deferred tax assets is based importantly on management’s assessment of its future prospects. At any reporting date, management would have to assess, for example, whether there was sufficient positive evidence in loss year(s) to recognize at least some of the tax benefit. Furthermore, as the entity starts to earn profits, management would have to assess the amount by which the valuation allowance could be reduced. Such an assessment would be necessary in each reporting period until the operating loss carryforward was realized or expired unused. While ASC 740 emphasizes the importance of objective evidence in making the assessment, the ultimate conclusion is bound to be subjective in many situations due to inherent estimates in forecasting future events.

The application of judgment is not limited to assessing the need for a valuation allowance. Judgment is required throughout the ASC 740 model. One of the most significant areas of judgment is the accounting for uncertain tax positions. ASC 740 prescribes a two-step approach for the recognition and measurement of tax benefits associated with significant uncertain tax positions taken by an entity that may be challenged and ultimately disallowed in whole or in part. This approach to accounting for uncertain tax positions, described more fully in Chapter TX 16, requires management’s judgment in both the assessment of the technical merits of the underlying tax position (i.e., “recognition”) and in the measurement of the amount of tax benefit (i.e., “measurement”) to be recorded (to the extent the position meets the more-likely-than-not benefit recognition threshold).