Calendar year 2012 has seen considerable
activity across the global legislative and regulatory landscapes. In addition to one-off changes to tax laws in
several key territories, certain legislative trends have had a significant impact
on income tax accounting. These developments,
combined with the continued economic uncertainty, have added to the complexity
and judgment involved in accounting for income taxes.
As in prior years, this publication is
focused on the topics we believe will be most relevant to the preparation of
2012 year-end financial statements. Some
topics have been discussed in our prior annual publications, however their
continuing importance warranted including them again in 2012. Where relevant, PwC publications which may go
into more depth or provide greater insight into a topical area have also been
referenced. Unless specifically
indicated, the discussion and references all pertain to accounting standards
and related reporting considerations based upon US GAAP.
The topics covered in this 2012 publication
are as follows:
Under US GAAP, Accounting Standards
Codification (ASC) 740, Accounting for
Income Taxes, requires companies to measure current and deferred income
taxes based on the tax laws that are enacted
as of the balance sheet date of the relevant reporting period. With respect to deferred tax assets and
liabilities, that means measurement is based upon enacted law that is expected
to apply when the temporary differences are expected to be realized or
settled. Thus, even legislation having
an effective date considerably in the future will typically cause an immediate
financial reporting consequence. Under International Financial Reporting
Standards (IFRS), International Accounting Standard (IAS) No. 12, Income Taxes, requires companies to
measure current and deferred income taxes based on the tax laws that are enacted or substantively enacted, as of the balance sheet date of
the relevant reporting period.
While the following is not a
comprehensive list, we have highlighted several key tax law changes and
developments in selected jurisdictions.
Calendar year 2012 has continued to see an
increase in the number of tax-related comment letters issued by the staff of
the Securities and Exchange Commission (SEC).
Of the letters originally issued to companies after December 31, 2011
and released to the public between January 1, 2012 and September 30, 2012,
approximately 250 of the comments identified related to tax matters. Of those tax-related comments, 80% of the
comments related to the following areas: indefinite reinvestment of foreign
earnings, presentation of the effective tax rate, valuation allowance
assessments and uncertain tax positions.
Clearly, matters of judgment continue to
be an area of focus for the SEC. We have
continued to see an increased emphasis on providing more accurate, transparent
and plain language disclosures of significant assertions and estimates. There has been a significant amount of
attention given to accumulated foreign earnings and the presentation of the
foreign effective tax rate. We have
noted a continued emphasis that disclosures within Management's Discussion and
Analysis of Financial Condition and Results of Operations (MD&A) and
financial statement footnotes around liquidity and capital resources be
consistent with the registrants' indefinite reinvestment assertions related to
foreign earnings. Further, recent SEC
comment letters have reminded companies of the requirement to disclose the
amount of the temporary basis difference and the unrecorded tax liability if
practicable to calculate, or to explain why the calculation of the unrecorded
liability is not practicable.
We expect these topics to be continued
areas of focus by regulators (including the SEC and the Public Company
Accounting Oversight Board (PCAOB)), investors and commentators in 2013.
The assessment of an uncertain tax
position is a continuous process which does not end with the initial
determination of a position’s sustainability.
As of each balance sheet date, unresolved positions must be reassessed
based upon new information. The
accounting standard requires that changes in the expected outcome of an
uncertain tax position be based on new information, and not on a mere
re-evaluation of existing information.
New
information - New information can relate to
developments in case law, changes in tax law, new regulations issued by taxing
authorities, interactions with the taxing authorities, or other
developments. Such developments could
potentially change the estimate of the amount that is expected to eventually be
sustained or cause a position to meet or fail to meet the recognition
threshold.
In assessing uncertain tax positions, an
organization is required to recognize the benefit of a tax position in the
first interim period that one of the following conditions is met:
Effective
settlement - For a tax position to be considered
effectively settled all three of the following conditions must be met:
In jurisdictions like the US where the
taxing authority can re-examine tax positions that gave rise to a net operating
loss or other carry-forwards in the year those carry-forwards are claimed, the judgment
as to whether effective settlement has occurred becomes more complex. To the extent that the requirements of
effective settlement are met, the resulting tax benefit is required to be
reported (application of effective settlement criterion is not elective).
Special
examination procedures - Taxing authorities may
have special examination procedures available to reduce or eliminate
uncertainty either prior to or during an examination.
In determining whether the recognition
threshold has been met, management may consider pursuing such options as a
Private Letter Ruling (PLR), Competent Authority resolution, pre-filing
agreement, or Advance Pricing Agreement (APA).
These rulings and agreements, if issued to the taxpayer by the taxing
authority, typically form the basis for meeting the recognition threshold.
The IRS Compliance Assurance Process
(CAP) program for large corporate taxpayers is an additional
consideration. Under CAP, participating
taxpayers work with an IRS team to identify and resolve potential tax matters
before the income tax return is filed each year. These pre-filing communications with the IRS
may be viewed as new information by an organization in support of a
re-evaluation of a position's measured benefit.
Valuation allowances
The evaluation of the need for, and
amount of, a valuation allowance for deferred tax assets (DTAs) is an area of
challenge for organizations. The
assessment requires significant judgment and thorough analysis of all positive
and negative evidence available to determine whether all or a portion of the
DTAs is likely to be realized.
Likelihood in this context is determined based upon a prescribed
weighting of evidence in accordance with its objective verifiability. Accordingly, recent results are given more
weight than future projections.
As companies perform their assessments,
the following reminders may be helpful:
Jurisdictional
assessment - The valuation allowance assessment is
generally performed on a jurisdiction-by-jurisdiction basis which is in
contrast to other areas of accounting such as goodwill impairment testing and
may differ from how a company views its business. For example, a company may be highly
profitable at the segment and reporting unit level, but may be in a cumulative
loss position within a particular jurisdiction.
Further, where the local tax law does not allow for consolidation, the
valuation allowance assessment may be at the separate legal entity level as
opposed to the jurisdictional level.
All
available evidence - The accounting standard
requires that all available evidence be considered in determining whether a
valuation allowance is needed, including events occurring subsequent to
year-end but before the financial statements are released. However, a valuation allowance assessment
should not consider transactions over which the company does not have control
until such transactions are complete.
For example, initial public offerings, business combinations, and
financing transactions are generally not considered as part of a valuation
allowance assessment until the transactions are completed.
Triggering
events or changes in circumstances - In assessing
potential changes to a valuation allowance (i.e., either establishing or
releasing), it is important to consider what has actually changed from the
prior assessment and whether a change in assessment is warranted. Based on the short time period between the
issuance of an entity’s year-end financial statements and release of its
first-quarter Form 10-Q, changes in judgment during this period would be
expected to be relatively uncommon and generally would result from a specific
event or change in circumstances that could not have been foreseen.
An entity should consider the appropriate
timing to release the valuation allowance when circumstances change. Cumulative income is not a prerequisite to
releasing a valuation allowance. An
entity must consider the totality of all positive and negative evidence when
considering whether to establish or release a valuation allowance. In jurisdictions that allow for unlimited
carryforward of certain tax attributes, a lower level of sustained
profitability may be sufficient evidence to support realization of the deferred
tax assets as compared to jurisdictions in which attributes are subject to
expiration.
Intra-entity
transfers - An intra-entity transfer of assets may
trigger the release of a valuation allowance.
Before applying the deferral of the recognition of tax expense generated
as part of an intra-entity sale of assets, a company should first determine
whether the transaction results in the realization of its existing tax
attributes. If tax benefits from attributes
are realizable, the intra-entity deferral provision should not apply to the
valuation allowance release and the recognition of that income tax benefit.
Tax-planning strategies that involve an intra-entity asset transfer
from a higher tax-rate jurisdiction where the entity currently does not pay
taxes (as a result of losses) to a lower tax-rate jurisdiction (where the
entity does pay taxes) result in the tax benefit of the tax-planning strategy
being measured at the lower tax rate. In
effect, the tax-rate differential is effectively regarded as a cost associated
with implementing the strategy.
Character
of DTAs - The realization of DTAs is dependent upon
the existence of sufficient taxable income of the appropriate character (e.g.,
ordinary or capital) within the carryback or carry-forward period and must
create incremental cash tax savings. For
example, if tax losses are carried back to prior years freeing up tax credits
(which were originally used to reduce the tax payable) rather than resulting in
a refund, a valuation allowance would still be necessary if there are no
sources of income which allow for the realization of the tax credits. In other words, utilization does not always
mean realization. The substitution of
one DTA for a future DTA, without a source of income for the future DTA's
realization, does not represent realization.
Limitations
on NOL utilization - Some of the recent tax law
changes may have an impact on a company’s assessment of the realizability of
its deferred tax assets. For example,
recent legislation in certain European countries has limited the amount of
taxable income that can be offset by NOLs in a given tax year. In a situation where a company is relying
upon reversing temporary differences to support the recovery of all or a
portion of an NOL DTA, a valuation allowance may be required (or may need to be
increased) to reflect the shifting of loss utilization as a result of the
limitation into later years.
Outside basis differences - When a taxable temporary difference related to the outside basis
in a foreign subsidiary (e.g., related to undistributed foreign earnings) is
viewed as a source of taxable income to support recovery of DTAs, a company’s
plan with respect to the timing of reversal of the difference should be
considered. Taxable temporary
differences on equity method investments may also be considered as a source of
taxable income provided there is an appropriate expectation as to the timing
and character of reversal in relation to DTAs.
Deferred
tax liabilities - Taxable temporary differences
associated with indefinite-lived assets (e.g., land, goodwill, indefinite-lived
intangibles) generally cannot be used as a source of taxable income. Thus, a valuation allowance on DTAs may be
necessary even when an enterprise is in an overall net deferred tax liability
(DTL) position.
In jurisdictions with unlimited
carryforward periods for tax attributes (e.g., net operating losses, AMT credit
carryforwards and other non-expiring loss or credit carryforwards), the related
DTAs can be supported by the indefinite-lived DTLs, assuming they are within
the same jurisdiction and the relevant tax law would allow for the offset of
the carry-forward against the accrued liability.
Disclosures - The SEC staff continues to focus on the judgments and disclosures
relating to valuation allowance assessments.
They have regularly required that disclosures include a discussion of
the evidence considered, including reference to negative evidence such as
recent losses, how the evidence was weighted, the basis for the conclusion as to
whether a valuation allowance is or is not required and the possibility for
near-term changes. Other areas of focus
by the staff include:
The assertion of indefinite reinvestment
of foreign subsidiary earnings continues to be one of the more complex and
judgmental areas of accounting for income taxes. The growth in unremitted foreign earnings and
ongoing uncertainty within the global economy has made the application of the
assertion more challenging.
When evaluating this assertion, companies
should consider the following:
Few areas in accounting for income taxes
are more difficult to apply than the tax accounting for the effects of
fluctuations in foreign currency values.
The following are some key aspects of
this complex area to keep in mind:
The accounting for business combinations
is an area of challenge for many organizations due to its technical complexity,
the involvement of cross-functional teams, as well as constraints on the
availability of timely information.
Business combinations often involve a
considerable amount of business, legal and tax planning. There is no direct guidance that addresses
whether the tax effects of elections or post-acquisition transactions should be
included in acquisition accounting. Practice
in this area is evolving.
We believe the following factors should
generally be considered in the assessment of whether the tax effects of such
events should be included in acquisition accounting:
Bargain purchase refers to a transaction in which the fair value of
the net assets acquired exceeds the fair value of consideration
transferred. Such excess is sometimes
referred to as “negative goodwill.”
The tax rules for each separate
jurisdiction may require a different treatment for bargain purchases. Tax rules often require the allocation of
negative goodwill to certain assets through the use of a residual method,
resulting in decreased tax bases. The
recognition of the resulting deferred tax liabilities then leads to a reduction
in the bargain purchase gain for financial reporting and may result in the
recognition of goodwill.
The impact on the acquiring company’s
deferred tax assets and liabilities, including any changes in a valuation
allowance assessment, caused by an acquisition is recorded in the acquiring
company’s financial statements outside of acquisition accounting (i.e., not as
a component of acquisition accounting).
Deferred tax liabilities recorded in
acquisition accounting may be a source of taxable income to support recognition
of deferred tax assets of the acquired company, the acquirer’s, or both. Where some but not all of the combined deferred
tax assets are supported by deferred tax liabilities recorded in acquisition
accounting, the acquirer will need to apply an accounting policy to determine
which assets are being recognized. We
believe there are two acceptable accounting policies. One policy is to consider the recoverability
of deferred tax assets acquired in the acquisition before considering the
recoverability of the acquirer’s existing deferred tax assets. An alternative policy is to recognize
deferred tax assets based upon which assets will be realized first under the
tax law.
A non-controlling interest (NCI) is the
portion of equity (net assets) in a subsidiary not attributable, directly or
indirectly, to the parent.
For a business combination achieved in
stages, the acquirer should remeasure its previously held equity interest in
the target as of the acquisition date and recognize the resulting holding gain
or loss (including the associated impact of the incremental deferred taxes) in
earnings. If upon obtaining control of a
domestic subsidiary the parent has the intent and ability under the tax law to
recover its investment in a tax-free manner, then any DTL related to the
outside basis difference on the previously held investment is reversed through
the acquirer’s income statement outside of acquisition accounting. If the subsidiary is foreign, then generally
the DTL (or a portion of that DTL) related to the outside basis difference on
the previously held investment must be retained. Where the acquired company is a partnership,
consistent with the treatment for corporate entities, staged acquisitions
result in the remeasurement of a previously held equity interest at fair
value. Consideration of the deferred tax
effects resulting from the acquisition of control of the partnership can vary
depending upon the circumstances.
The tax effects of an excess tax-over-book
basis in the stock of a subsidiary should be recognized when it becomes
apparent that the temporary difference will reverse in the foreseeable
future. In the context of a worthless
stock deduction, this requirement would generally be met in the earliest period
in which the investment is considered "worthless" for income tax
purposes.
A “disposal group" represents assets
and directly related liabilities to be disposed of together in a single
transaction. Whether deferred tax assets
and liabilities should be included in the disposal group depends on whether the
buyer will be seen as buying stock or assets.
The determination impacts both the buyer's acquired tax attributes and
the tax bases of assets and liabilities.
Depending upon the outcome, the buyer can be viewed as acquiring tax
benefits (assets) or assuming tax liabilities.
When evaluating tax accounting for
stock-based compensation, the following issues should be kept in mind:
Uncertain
tax positions and “backwards tracing” - While there
is generally a prohibition in the income tax accounting standard for “backwards
tracing”, there is an exception for certain equity items. We believe this would include both favorable
and unfavorable adjustments resulting from a change in the assessment of an
uncertain tax position as it relates to those equity items. To the extent a company has a sufficient pool
of windfall benefits, it should “backwards trace” to additional paid in capital
(APIC) the tax effect of increases and decreases to the liability for a UTP
associated with the windfall benefit.
Underwater
options - Declines in stock prices may suggest that
some stock-based compensation awards for which DTAs have been recorded are
unlikely to be exercised. In these
cases, absent negative evidence about future taxable income, companies should
neither record a valuation allowance nor reverse the DTA, even if there is no
expectation that the award will be exercised.
The DTA should be reversed only when the award has lapsed or been
forfeited. However, consideration should
be given to providing disclosure that may help users assess the economic
exposure to the company.
Permanent
differences - Generally a difference between the
book compensation charge and the tax deduction related to an equity award
results in temporary differences.
However, a difference that is not due to a change in fair value between
the respective book and tax measurement dates could result in a permanent
difference to be recorded through the income statement. This may arise, for example, if a restricted
stock award includes features that impact the grant date fair value for
financial reporting purposes but do not impact the fair value used for tax
purposes.
Repurchase of an award - The accounting for the repurchase of an award is affected by several factors, including whether the award is vested or unvested and the probability of vesting. From a US federal tax perspective, the amount of the cash settlement is generally deductible by the employer to the extent the entity has not previously taken a tax deduction for the award. When there is a repurchase of an award for cash, any remaining deferred tax asset (in excess of the tax benefit resulting from the repurchase, if any) related to the awards generally would be reversed as a shortfall. A cash settlement of incentive stock options (ISOs) will create a tax benefit reported in earnings (to the extent of book compensation) similar to a disqualifying disposition.
Clawback of an award - Entities may include a “clawback” provision in
stock-based compensation awards. These
features are becoming more prevalent, particularly due to certain legislation
such as the Dodd-Frank Act, and typically provide a company the right to
recover previously earned awards from an executive as the result of some
triggering event, such as a financial restatement or the executive’s breach of
an employment policy. The income tax
accounting for a clawback that has been triggered depends on the status of the
award at the time of the clawback and whether the entity has previously taken
the tax benefit from the stock-based compensation award. If the clawback occurs prior to the exercise
of a stock option (or the vesting of restricted stock for tax purposes) and no
tax deduction has been taken for the clawed-back awards, the related deferred
tax asset would be reversed through income tax expense and not considered a
shortfall. If an entity has taken a
deduction for a stock-based compensation award that is being clawed-back,
taxable income resulting from the clawback would be allocated to the various
components of the financial statements in accordance with intraperiod
allocation guidance.
The principles of the income tax
accounting standard are applicable to “taxes based on income.” Although the literature does not clearly
define this term, we believe that a tax based on income is predicated on a concept
of income less allowable expenses incurred to generate and earn that
income.
Examples of taxes which would generally
not be based on income include:
Taxes that do not meet the criteria in
the income tax accounting standard should not be recognized, measured,
presented, classified or otherwise treated as an income tax. Thus, for example, deferred tax accounting
and the provisions of uncertain tax positions would not be applicable to taxes
outside the scope. Companies would
instead apply the guidance set forth in ASC 450, Contingencies, or other
applicable literature regarding the recognition of non-income based tax
exposures. When applying such guidance
to situations of uncertainty involving non-income based tax exposures, we
believe assessments should be performed assuming the taxing authority is fully
aware of relevant facts (i.e., without considering the risk of detection).
In light of the focus by investors and
regulators on income tax-related disclosures, companies may wish to enhance
their procedures around the identification and development of income tax
disclosures.
Key reminders to consider as part of the
year-end process include:
United
Kingdom - Until proposals were published by the UK
Accounting Standards Board (ASB) in February 2012, it was expected that some
form of IFRS would be required to be adopted for the accounts of all UK
companies from January 1, 2015. However,
the February proposals confirmed that the intention is now to provide companies
with a choice, subject to certain criteria, of EU endorsed IFRS or a new
Financial Reporting Standard (FRS) for UK GAAP reporters. Both options are permitted with or without
reduced disclosures. Adoption of one of
the options will be mandatory from January 1, 2015, with early adoption
permitted from as early as 2013.
Although the FRS is based on the
principles of the IFRS for SMEs (small and medium-sized entities) standard, its
legal form will be a UK standard rather than an international standard. It is also currently proposed that the tax
accounting rules will be broadly based on the 'timing differences' or 'income
statement' approach currently included under UK GAAP. There will therefore continue to be
significant differences between accounting for income tax under this new UK
standard and IFRS or US GAAP.
United States - In the US, the staff of the SEC's Office of the Chief Accountant
("the staff") published its report in July 2012 on its Work Plan
aimed at helping the SEC evaluate the implications of incorporating IFRS into
the US financial reporting system. While
the staff report was not intended to, and does not, provide an answer to the
question of whether it is in the best interests of the US capital markets and
investors for a transition to IFRS to take place in the US, it does outline
areas where the staff believe improvements can be made to IFRS. The potential improvements include the
accounting for certain industry specific issues, the consistency of global
application, the interpretative process and the enforcement and co-ordination
activities of international regulators.
The report also states that adoption of IFRS as authoritative guidance
in the US is not supported by the vast majority of participants in the capital
markets and recommends that additional analysis be undertaken before any
decision is made about incorporating IFRS into the US financial reporting
system.
Access a PDF copy of the article on PwC.com.
PwC clients
that have questions about this Tax Accounting Services publication should
contact their engagement partner or the following PwC professionals:
Tax Accounting Services Group
Ken
Kuykendall
US Tax Accounting Services Leader
Phone: (312) 298–2546
Email: o.k.kuykendall@us.pwc.com
David
Wiseman
Tax Partner
Phone: (617) 530-7274
Email: david.wiseman@us.pwc.com
Douglas
Berg
Tax Managing Director
Phone: (313) 394-6217
Email: douglas.e.berg@us.pwc.com
Juliette
Wynne-Jones
Tax Director
Phone: (312) 298-4170
Email: juliette.h.wynne-jones@us.pwc.com
Kristin
Dunner
Tax Director
Phone: (617) 530-4482
Email: kristin.n.dunner@us.pwc.com
National Professional
Services Group
Edward
Abahoonie
Tax Partner
Phone: (973) 236-4448
Email: edward.abahoonie@us.pwc.com
Jennifer
Spang
Tax Partner
Phone: (973) 236-4757
Email: jennifer.a.spang@us.pwc.com
Steven
Schaefer
Tax Partner
Phone: (585) 231-6129
Email: steven.schaefer@us.pwc.com
Patrick
Young
Assurance Sr. Manager
Phone: (973) 236-5822
Email: patrick.d.young@us.pwc.com