IT2013_1069_CH05_v2_P2_7-23

Chapter 5:
Valuation Allowance

Chapter Summary

Evaluating the need for and amount of a valuation allowance for deferred tax assets often requires significant judgment and extensive analysis of all the positive and negative evidence available to determine whether all or some portion of the deferred tax assets will not be realized. A valuation allowance must be established for deferred tax assets when it is more-likely-than-not (a probability level of more than 50 percent) that they will not be realized. In general, “realization” refers to the incremental benefit achieved through the reduction in future taxes payable or an increase in future taxes refundable from the deferred tax assets, assuming that the underlying deductible differences and carryforwards are the last items to enter into the determination of future taxable income.




5.1 Assessing the Need for a Valuation Allowance

ASC 740’s valuation allowance assessment is at once subjective as well as mechanical. A number of factors entering into the assessment are highly subjective: assessing whether the weight of available evidence supports the recognition of some or all of an entity’s deferred tax assets; determining how objectively verifiable an individual piece of evidence is, and thus how much weight should be given to the evidence; and establishing the reversal patterns for existing temporary differences. However, once those determinations have been made, the process of computing the valuation allowance that should be recorded is mechanical. This mechanical process is important and will have an impact when the weight of available evidence suggests that income in applicable future periods will be insufficient to support the realization of all deferred tax assets. In circumstances where a partial valuation allowance is warranted, the valuation allowance required generally must be supported through detailed scheduling of reversals of temporary differences.

Some have used formulas as a starting point to determine the valuation allowance. These can be good techniques to organize the thought process for evaluating the need for a valuation allowance, but they are not a substitute for reasoned judgment. The valuation allowance recorded should be based on management’s judgment of what is more-likely-than-not considering all available information, both quantitative and qualitative. An approach in which a valuation allowance is determined by reference to a certain percentage of an entity’s deferred tax assets would not be appropriate.

Ultimately, the realization of deferred tax assets will depend on the existence of future taxable income, sources of which are covered in Section TX 5.4.

5.1.1 Evidence to Be Considered

ASC 740-10-30-17 states that “all available evidence shall be considered in determining whether a valuation allowance for deferred tax assets is needed.” This includes historical information supplemented by all currently available information about future years. Many events occurring subsequent to an entity’s year-end but before the financial statements are released that provide additional evidence (negative or positive) regarding the likelihood of realization of existing deferred tax assets should be considered when determining whether a valuation allowance is needed.

Items that clearly represent subsequent-period events (e.g., the tax effects of a natural catastrophe, such as an earthquake or a fire) should be recognized in the period in which they occur, because that is when the pretax effect, if any, will be recorded. In addition, the effects on the valuation allowance assessment of certain fundamental transactions, such as an initial public offering, other major financing transactions, or a business combination, should not be taken into account until the transactions are complete.


Example 5-1: NOL Carryforward Limitations Due to a Pending Business Combination

Background/Facts:

Corporation A had previously generated net operating losses (NOLs) that resulted in a $20 million deferred tax asset (DTA). Based on the operations of Corporation A, the NOLs are expected to be fully utilized within the carryforward period; therefore, no valuation allowance has been recorded. Corporation A has negotiated and agreed to the terms of a merger with Corporation B. The merger is expected to be consummated in January 2013. It is anticipated that the merger will trigger a limitation under IRC Section 382, which restricts how much of Corporation A’s premerger NOLs can be utilized in a given year. Because of this anticipated limitation, Corporation A believes that only $5 million of the NOL-related DTA will be utilized after the business combination is consummated.

Question:

Should Corporation A consider the anticipated impact of the merger (i.e., Section 382 limitation) in its evaluation of the need for a valuation allowance on December 31, 2012?

Analysis/Conclusion:

No. The tax effects of a business combination should not be recognized before the transaction has been consummated. However, Corporation A should consider whether the financial statements should include additional disclosure of the merger’s potential tax consequences (e.g., the merger’s effect on the existing NOLs), in accordance with guidance included in ASC 275 Risks and Uncertainties.

Example 5-2: How Much Hindsight Should be Used in the Determination of the Need for a Valuation Allowance When Assessing the Need for a Valuation Allowance as Part of a Restatement of Prior Results?

Background/Facts:

Company A is restating its financial statements for the prior three years (2002-2004) for items unrelated to taxes. Prior to the restatement and the commensurate filing of amended tax returns, Company A was profitable for each of the three years in the restated period and as a result had no valuation allowance recorded against any of its existing deferred tax assets. After taking into consideration the pretax accounting entries, Company A now reflects a significant loss for the year-ended December 31, 2002, which is of sufficient size to put it into a three-year cumulative loss position at December 31, 2002. On a restated basis, Company A reports a loss for 2003, but in 2004, it returned to significant profitability.

At December 31, 2002, Company A had a post-restatement deferred tax asset relating primarily to net operating losses that will expire in 20 years. If the financial results at December 31, 2002 included the restatement items, there would have been significant uncertainty as to whether Company A would return to profitability in future periods.

As part of the restatement, Company A is reviewing whether it requires a valuation allowance on the restated accounts for the years presented.

Question:

Can Company A utilize the knowledge of the profitable results in 2004 as positive evidence in evaluating whether a valuation allowance is considered necessary for the 2002 restated accounts?

Analysis/Conclusion:

ASC 740-10-30-17 states, “All available evidence, both positive and negative, shall be considered to determine whether, based on the weight of that evidence, a valuation allowance for deferred tax assets is needed. Information about an entity’s current financial position and its results of operations for the current and preceding years ordinarily is readily available. That historical information is supplemented by all currently available information about future years.” We believe that the “all available evidence” standard applies to the information that would have been available at the time of the original issuance of the financial statements.

In the case above, although Company A returned to significant profitability in 2004, only information available as of the original issuance date of the financial statements should be used in determining the valuation allowance as of the end of 2002.

ASC 740-10-30-21 states, “Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years.” Due to the uncertainty of future GAAP income that existed at December 31, 2002, positive evidence of sufficient weight was not available to overcome the significant negative evidence of cumulative losses at December 31, 2002.

In determining whether the valuation allowance is still necessary as of December 31, 2003, and December 31, 2004, respectively, Company A should re-evaluate the need for a valuation allowance based on all evidence that would have been available at the time of the issuance of the original 2003 and 2004 financial statements. It is conceivable that Company A, in its restated financial statements, would report a valuation allowance in 2002 and a reversal of the valuation allowance in 2004 based on the weight of available evidence available at the time the original financial statements were issued—even though both years are within the restatement period.

5.1.2 Weighting of Available Evidence

ASC 740-10-30-5(e), requires an entity to assess the need for a valuation allowance. It reads as follows:

Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more-likely-than-not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more-likely-than-not to be realized.

While ASC 740’s “more-likely-than-not” threshold for recognition of an allowance is a lower asset impairment threshold than other asset impairment thresholds within the U.S. GAAP framework, the prescribed weighting of evidence as mandated by ASC 740-10-30-23, makes the recognition of a deferred tax asset for an entity that has exhibited cumulative losses in recent years quite difficult.


ASC 740-10-30-23 reads:

An entity shall use judgment in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence shall be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed for some portion or all of the deferred tax asset. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.


5.1.3 Cumulative Losses and Other Negative Evidence

5.1.3.1 General

ASC 740-10-30-21 indicates that it is difficult to avoid a valuation allowance when there is negative evidence such as cumulative losses in recent years. Other examples of negative evidence include:

Losses expected in early future years.

A history of potential tax benefits expiring unused.

Uncertainties whose unfavorable resolution would adversely affect future results.

Brief carryback, carryforward periods in jurisdictions where results are traditionally cyclical or where a single year’s reversals of deductible differences will be larger than the typical level of taxable income.


Of the negative evidence cited, “cumulative losses in recent years” probably will have to be considered most frequently. ASC 740 deliberately does not define this term. Generally, we believe that the guideline, not a “bright line” but a starting point, should be cumulative pretax results as adjusted for permanent items (e.g., nondeductible goodwill impairments) for three years (the current and the two preceding years). This measure generally would include discontinued operations, other comprehensive income (OCI) and extraordinary items, as well as all other so-called “nonrecurring” items, such as restructuring or impairment charges. That is, all items, other than the cumulative effect of accounting changes, should be included in the determination of cumulative losses.

While such items may not be indicative of future results, they are part of total results, and there may be discontinued operations, OCI, extraordinary items, and other nonrecurring charges in future years. Also, while otherwise arbitrary, three years generally seems to be a long enough period to not be overly influenced by one-time events, but not so long that it would be irrelevant as a starting point for gauging the future. Further, we believe it is appropriate to conclude that there are cumulative losses in situations where an entity is projecting near-term future operating losses that will put it in a three-year cumulative loss position. In addition, the impact of a profitable discontinued operation should be carefully evaluated when the ongoing businesses otherwise would have had a cumulative loss.

This suggested guideline is admittedly an arbitrary measure and judgment is necessary to determine the weight given to the results of this specific calculation. However, as discussed above, ASC 740-10-30-23 requires that the weight given to the potential effect of negative and positive evidence “be commensurate with the extent to which it can be objectively verified.” Moreover, it indicates that “a cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.” The FASB in its deliberations has indicated that an entity would need objective positive evidence of sufficient quality and quantity to support a conclusion that, based on the weight of all available evidence, a valuation allowance is not needed.1

1 ASC 740-10-30-23.


When considering cumulative losses, it may be necessary to segregate earnings (losses) subject to capital gain rules from those subject to taxes at ordinary rates. This concept is illustrated in the following example:

Example 5-3: Considerations When Evaluating the Need for a Valuation Allowance on Deferred Tax Assets that are Capital in Nature

Background/Facts:

Corporation X (“Corp X”) has a history of profitable operations and is projecting continued profitability from its operations. Consequently, Corp X determined that no valuation allowance was necessary for its deferred tax assets in prior periods. However, in the current year, Corp X generated unrealized and realized losses on its portfolio of available-for-sale (“AFS”) equity securities.

As of the end of the current year, Corp X has recorded a deferred tax asset for
(1) accumulated capital loss carryforwards, (2) net unrealized losses on AFS equity securities that, if sold, would result in additional capital losses and (3) temporary differences (for example, reserves) subject to ordinary income tax rates. Under the tax law, Corp X can only utilize capital losses to offset realized capital gains. A net capital loss in a particular year may be carried back 3 years and forward 5 years.

Corp X has generated the following gains/(losses) in recent years:


On the basis of total income, Corp X is not in a cumulative loss position. Although Corp X has generated capital gain income in the past, the realized and unrealized losses generated in the current year that are capital in nature were significant enough to put Corp X into a cumulative loss position related to its assets that are capital in nature. Corp X expects to generate capital gains in the future, which is why it continues to stay invested in the market; however, management realizes that the assessment of whether or when such gains would occur is inherently subjective in nature.

Question:

Can Corp X consider its expectation that it will generate future capital gains during the relevant carryforward period(s) when analyzing the need for a valuation allowance on its deferred tax assets that are capital in nature?

Analysis/Conclusion:

In assessing the need for a valuation allowance, ASC 740-10-30-17 indicates that all available evidence should be considered. However, the weight given to the positive and negative evidence should be commensurate with the extent to which the information can be objectively verified (ASC 740-10-30-23).

Because a portion of the deferred tax assets are capital in nature, Corp X must assess the realizability of these deferred tax assets separately from the deferred tax assets that are ordinary in nature. Although Corp X has not incurred cumulative losses in recent years in total, as presented above, Corp X has incurred cumulative losses related to its assets that are capital in nature. As discussed in ASC 740-10-30-21, cumulative losses in recent years represent negative evidence that is difficult to overcome. As a result, the positive evidence needed to overcome the significant negative evidence of cumulative losses must be objectively verifiable. Expectations about the future are inherently subjective, and therefore they generally will not be sufficient to overcome negative evidence that includes cumulative losses in recent years.

In this case, Corp X determined that its history of ordinary income combined with its expectations of future ordinary income provided sufficient evidence that no valuation allowance was necessary for its deferred tax assets that are ordinary in nature. However, Corp X determined that it would not be able to rely on its ability to generate capital gains in the future given the significant capital losses generated in the current year (which gave rise to cumulative losses of a capital nature) and, therefore, must look to other sources of capital gain income (e.g., tax-planning strategies or carryback availability). Because Corp X did not have any other sources of capital gain income, it determined that a full valuation allowance was required on its deferred tax assets that are capital in nature.

The existence of cumulative losses (or lack thereof) is only one piece of evidence that should be considered in assessing the need for a valuation allowance. While ASC 740-10-30-21 states that it will be difficult for positive evidence to overcome the types of negative evidence cited, ASC 740-10-30-22 gives examples of positive evidence that might be necessary to avoid a valuation allowance when there is such negative evidence: a firm sales backlog of profitable orders, unrealized (and unrecognized) appreciation in net assets, and a strong earnings history exclusive of a loss that can be demonstrated to be an aberration.


Management’s belief that the tax assets will be realized is not by itself sufficient, objective positive evidence to overcome objective negative evidence, such as recent losses. Indeed, management may conclude that, while it believes that the deferred tax assets will be realized, the weight of objective evidence requires a valuation allowance. In these circumstances, public entities should be mindful that the SEC does not allow assertions, whether stated or implied, in the forepart of the prospectus for a public offering or a periodic report (e.g., Form 10-K) that are inconsistent with the assumptions used in the preparation of the financial statements.

When there are cumulative pretax losses (as defined above) and either future taxable income (exclusive of reversing temporary differences and carryforwards) or tax-planning strategies are being considered to support some or all of the deferred tax assets (i.e., to avoid a valuation allowance), PwC engagement teams are required to consult with the Accounting Services Group within PwC’s National Professional Services Group. This consultation requirement is applicable in the first reporting period in which a company that has (or expects to have) cumulative losses (as defined above) proposes to recognize some or all of its net deferred tax assets without an offsetting valuation allowance.

The consultation requirement applies to any tax jurisdiction or tax-paying component of an entity that has (or is expected to have) cumulative losses over a three-year period (or a shorter period if operations commenced less than three years ago). For this purpose, “tax-paying component” encompasses situations where separate tax returns are filed in a given jurisdiction or where income and losses are required to be tracked by type or character—e.g., capital versus ordinary or “life” versus “non-life” for an insurance company.

Once a PwC engagement team has satisfied the consultation requirement with regard to a company with cumulative losses, there is no requirement to re-consult in any subsequent reporting period unless the factors relied upon to support the original conclusion have failed to materialize or are no longer supportable or new information that previously was not considered constitutes additional negative evidence. Consider the following scenarios:

Scenario 1: In Year 1, a company initially encounters a situation in which it has a three-year cumulative loss driven almost entirely by a significant restructuring charge that the company viewed as non-recurring. The company has a backlog of customer contracts and is able to forecast profitable operations over the next year or so. On that basis, the company believes its deferred tax assets are more-likely-than-not to be realized in Year 1. The engagement team consults in that period with the National Professional Services Group and agrees with the company’s determination. While still in a three-year cumulative loss in the subsequent year (i.e., Year 2), the company was able to achieve the forecasted results used in the prior year assessment of deferred tax assets. In this scenario, the engagement team would not be required to consult in Year 2 because there has not been a deterioration or significant change in the facts and circumstances relied upon to support the conclusion in the reporting period when the client first entered into the cumulative loss position.

Scenario 2: Assume the same Year 1 facts as in Scenario 1; however, in the subsequent year (i.e., Year 2), the company missed its forecast due to the loss of a significant customer and a further round of restructuring charges. The company continues to believe it can rely upon future projections of income to support the deferred tax assets in Year 2. In this scenario, the engagement team would be required to consult in Year 2 due to the deterioration in facts, even if the company believed its outlook has improved since the prior year.

Scenario 3: In Year 1, a company initially encounters a situation in which it has a three-year cumulative loss and supports its deferred tax assets by relying upon a tax-planning strategy that includes the sale of appreciated non-core assets. The engagement team consults in Year 1 with the National Professional Services Group and agrees with the company’s determination. The company had projected minimal profitability; however, such future income was not considered objectively verifiable and therefore was not relied on to support the deferred tax assets in Year 1. In the subsequent year, the company achieves its forecast but is still in a cumulative loss position. The company determines that the value of the non-core assets has deteriorated but has identified another tax-planning strategy that includes the capitalization of intercompany debt. Reliance on a new tax-planning strategy represents a significant change in facts from the original consultation in Year 1. As a result, the engagement team would be required to consult in the reporting period such change in facts occurs (i.e., in Year 2).

The scenarios above are meant to illustrate the application of the consultation requirement and are not a complete list of all potential situations.

5.1.3.2 Examples of Situations Where Positive Evidence Outweighed Significant Negative Evidence

We have dealt with several situations where it was determined that positive evidence outweighed significant negative evidence so that no, or only a small, valuation allowance was necessary. Each of these situations is based on specific facts and circumstances. Similar situations may not necessarily result in the same conclusions.

1. An entity underwent a leveraged buyout (LBO) and incurred a large amount of debt as a result of that transaction. For several years after the LBO, the entity incurred substantial losses. Without the interest expense on the LBO-related debt, however, the entity would have been profitable.

Recently, the entity had an initial public offering (IPO) of equity securities. The proceeds of the IPO were used to completely pay off the LBO debt.

After the IPO and the related payoff of the LBO debt, the entity concluded that future income would preclude the need for a valuation allowance for its NOL carryforward deferred tax asset.


On the contrary, in a situation somewhat similar to the above, an entity was incurring significant losses as a result of interest on LBO-related debt. However, the entity planned to undergo an IPO three or four years into the future.

Due to the uncertainty regarding the entity’s ability to carry out an IPO, it was concluded that a full valuation allowance was appropriate for the NOL carryforward deferred tax asset.


2. During the past five years, a bank incurred substantial losses as a direct result of commercial real estate and lesser-developed-country (LDC) loans. The bank has fully reserved these problem loans and has not originated any new commercial real estate or LDC loans. The bank’s core earnings, which are primarily from consumer and non-real estate commercial lending, historically have been, and continue to be, very profitable.

Management forecasts that, based on historical trends, these core earnings will, over the next five years, be more than sufficient to recover the losses resulting from the old commercial real estate and LDC loans. Accordingly, it was concluded that a valuation allowance was not necessary for the bank’s deferred tax asset.


3. An entity had three separate and distinct lines of business. Historically, two of the lines have been, and continue to be, profitable. The third line incurred substantial losses that led to an NOL carryforward on the entity’s consolidated tax return. The entity recently discontinued its unprofitable line and sold the related assets.

The historical profit levels of the continuing operations were such that the entity could “utilize” the NOL in approximately eight years. Because this was well within the NOL carryforward period in the applicable tax jurisdiction, it was concluded that a valuation allowance was not necessary for the entity’s NOL carryforward deferred tax asset.


4. A company had significant losses in the first two years of operations due to substantial start-up costs and marketing expenses. During year 3, the company incurred losses in the first three quarters and income in the last quarter which resulted in a near breakeven year. In year 4, although the entity reported increasing levels of income in each quarter, it was still in a three-year cumulative loss position at the end of its fiscal year. Management’s projections show continued profitability with significant growth going forward. NOL carryforwards were expected to be utilized well in advance of their expiration dates, even without considering any further growth in future years.

Notwithstanding the cumulative loss evidence, as a result of the company’s demonstrated ability to recover the NOLs based on existing levels of taxable income, it was concluded that no valuation allowance is necessary.


5.1.4 Assessing Changes in the Valuation Allowance

The need for a valuation allowance is a subjective judgment made by management. Obviously, such judgments will change from period to period. However, there should be clear, explainable reasons for changes. In assessing changes in the valuation allowance, it is important to consider again the basis for amounts previously provided and how new information modifies previous judgments. For example, consideration should be given to whether the results for the current year provide additional insights as to the recoverability of deferred tax assets or as to management’s ability to forecast future results.

Said another way, the amount of deferred tax assets, net of the valuation allowance and the amount of change in the valuation allowance in the current year, should make sense considering the prior year’s assessment, current year’s earnings, and other available evidence. In general, if adjustments are made in the first quarter, the entity should be able to explain the change from the preceding year-end. Based on the short time period between 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, significant event or change in facts and circumstances that could not have been foreseen.

5.2 SEC Staff Views on Disclosure and Valuation Allowance Assessments

Establishing a Valuation Allowance too Late

The SEC staff (the staff) continues to focus on the judgments and disclosures related to valuation allowances. The staff has required additional disclosures in certain circumstances in which net deferred tax assets are recorded. When valuation allowances are established, the staff may inquire whether the previous analysis was appropriate and, with the benefit of hindsight, may challenge prior years’ financial statements.

Reducing a Valuation Allowance too Late

The staff also has questioned the provision or retention of a valuation allowance when it appears to be overly conservative and when it may suggest earnings management (i.e., “selecting” the future period(s) in which to release the valuation allowance by modifying assumptions that are not easily susceptible of verification). In particular, the staff has questioned limiting the estimate of future income used in determining the valuation allowance to a relatively short time horizon. See Section TX 5.4.4.2.2.2 for further discussion.

The staff has emphasized that the estimates used in the ASC 740 valuation allowance assessment should be consistent with other estimates involving assumptions about the future used in the preparation of the financial statements and in other filing disclosures. When income projections for only limited future periods have been used in determining the valuation allowance, the staff has asked certain registrants, including those whose core business involves assets whose amortization is closely tied to revenue projections, to explain the longer periods used to amortize such assets.

The staff also has observed that the ASC 740 determination of the valuation allowance and the ASC 360, Property, Plant and Equipment, assessment of impairment of long-lived assets both rely on estimates of future results. Registrants should be prepared to explain and provide support for differences that exist in management’s estimates of future results when making these determinations. Even if the ASC 740 and ASC 360 assessments are consistent, but are both very conservative, there could be a staff challenge to excessive ASC 740 valuation allowances and to premature or excessive impairment write-downs, especially in periods preceding an IPO. See Section TX 5.4.4.2.2.4 for further discussion.

Disclosures

The adequacy and consistency of disclosures also have been challenged. As noted earlier, the staff will not allow assertions, whether stated or implied, in the forepart of the prospectus for a public offering or a periodic report that are inconsistent with the assumptions used in the preparation of the financial statements. The staff has objected specifically to certain optimistic assertions made by management in the forepart of periodic reports, while objective evidence disclosed in the financial statements led management to establish a full valuation allowance against deferred tax assets.

The following excerpt from an SEC comment illustrates a discrepancy between assertions made in management’s discussion and analysis and the establishment of a full valuation allowance against deferred tax assets in the financial statements:

The staff has reviewed the Company’s supplemental response to the previous comment regarding the 100 percent reserve against net deferred tax assets, and believes that management’s discussion and analysis in future filings should be expanded to disclose the general development risks, as described in your previous response to us, that lead to the conclusion that it was more-likely-than-not that the Company’s deferred tax benefits would not be realized. See the criteria specified in ASC 740-10-30-5 and the requirement in Item 303(a)(3) of Regulation S-K to disclose events and uncertainties that management reasonably expects will have a material impact on results of operations. If management concluded it was more-likely-than-not that the deferred tax assets would not be realized based upon all evidence including the general development risks, then it appears that management would also reasonably expect that such general development risks would have a material impact on results of operations (not just revenues) and should therefore be disclosed in the MD&A section. Please revise.

Furthermore, the staff has suggested that when a short time horizon is used in the income projections underlying the valuation allowance, the “risk factors” or other appropriate sections in a prospectus must include management’s conclusion that current evidence indicates that it is more-likely-than-not that there will be no income in later periods.

Additional disclosures regarding valuation allowances may be required by ASC 275, Risks and Uncertainties. When it is at least reasonably possible that a material adjustment of the valuation allowance will occur in the near term, the financial statements must disclose this possibility. This requirement is discussed in ASC 275-10-50-6 through 50-15, and an example relating to the valuation allowance is given in ASC 275-10-55-219 through 55-222. Refer to Section TX 15.7 for additional guidance.

In situations where the valuation allowance assessment is difficult, clients undoubtedly will be interested in the staff’s areas of focus. However, that focus should not be interpreted as a recommendation by the staff to release the valuation allowance. Rather, it emphasizes the importance—in determining the valuation allowance—of using a balanced, supportable approach that is consistent with other important assertions underlying the financial statements and with management’s non-financial statement disclosures throughout SEC filings. We expect that the staff will continue to focus on management’s judgment in its assessment of the need for a valuation allowance.

5.3 Other Considerations

5.3.1 Evaluating the Effect of a Restructuring

When an entity is determining whether positive evidence outweighs negative evidence in forming a conclusion that a valuation allowance is not needed, it may be appropriate for the effect of a restructuring (i.e., an implemented plan to exit an activity) to be considered. In evaluating assumptions that decrease historical costs, it is appropriate to consider the effect of cost-cutting measures that have been successfully implemented to date. These measures are likely to impact the historical earnings trend in two ways. First, these measures usually require an earnings charge at the time they are implemented, which may not recur in the future. Second, they should result in a reduction of ongoing operating costs.

To the extent that the reduction in costs associated with the restructuring measures can be “objectively verified,” it is appropriate for an entity to consider those reductions as positive evidence when assessing the need for a valuation allowance. However, the effects that these cost-cutting measures may have on revenues and profitability also should be considered carefully (e.g., a significant reduction in sales force generally would correlate to a loss of sales volume). A strategy to implement an exit plan at some future date would be difficult to objectively verify because it is a future event.

An entity with significant negative evidence, such as a history of recent losses, normally will find it very difficult to demonstrate that even an implemented exit plan provides sufficient objective evidence that the entity will be restored to profitability, prior to the time that it actually becomes profitable. In these circumstances, it would be that much more difficult to demonstrate that an unimplemented exit plan provides sufficient objective evidence to overcome the negative evidence present.

5.3.2 Determining the Need for a Valuation Allowance in a Business Combination

When assessing the need for a valuation allowance against deferred tax assets at the date of business combination, all available evidence should be considered. Historical performance, as well as future projections, should be considered, with more weight assigned to information that is objectively verifiable.

In particular:

It may be appropriate to consider certain pro forma adjustments to the historical operating results of the acquired entity to provide an indication of the future earnings capabilities of the acquired entity after acquisition. For example, in a case where a significant amount of debt is pushed down to the acquired entity in conjunction with the acquisition, it would be appropriate to consider the past results of the acquired entity adjusted to reflect the interest expense that will be incurred on the debt. Conversely, in a case where significant overhead or debt is eliminated from the target, it may be appropriate to adjust the historical operating results in order to provide a more accurate depiction of the business.

In all cases, the greatest emphasis should be placed on information that is objectively verifiable. For example, anticipated “synergies” that are expected to result from the business combination may not be objectively verifiable until they can be demonstrated. On the other hand, it may be appropriate to reduce or exclude certain historical operating costs to the extent they relate to identified redundancies such as duplicate accounting systems that will be eliminated post combination.

An analysis of all available evidence may result in the recognition of a valuation allowance on the deferred tax assets of the acquired entity in conjunction with the acquisition or in some cases, no valuation allowance on the acquired deferred tax assets even though the target company may have previously recorded a valuation allowance in its historical financial statements. See Section TX 10.5.2 for additional discussions on evaluation the future combined results in a business combination.

5.3.3 Going-Concern Uncertainty

SAS 59 requires an explanatory paragraph when the auditor concludes that substantial doubt exists regarding an entity’s ability to continue as a going concern for a reasonable period of time, which is usually understood to be one year from the date of the balance sheet. In many circumstances, the factors that lead to the inclusion of such an explanatory paragraph also would constitute significant negative evidence under ASC 740. Because of the severity of the situations in which such an explanatory paragraph is required, we believe that a valuation allowance almost always would be required for all deferred tax assets that are not assured of realization by either (1) carryback to prior tax years or (2) reversals of existing taxable temporary differences. However, there may be circumstances, albeit relatively uncommon, where the immediate cause for the going-concern uncertainty is not directly related to the entity’s operations, and, absent the matter that led to the uncertainty, the entity would expect to continue generating operating and taxable profits.

Conversely, the absence of a going-concern explanatory paragraph does not, by itself, constitute positive evidence about the realization of deferred tax assets. For example, if an auditor considered issuing a going-concern explanatory paragraph, but ultimately concluded that it was not needed (because the entity had sufficient sources of cash flow with which to meet its debt-service requirements and remain in existence for a reasonable period of time), this would not necessarily indicate that the entity would have future taxable income. Similarly, an assessment stating that a valuation allowance is required for all or a portion of an entity’s deferred tax assets is not necessarily indicative of the existence of a going-concern problem.

In addition to going-concern considerations, there are certain entities that, by their nature, ordinarily are required to record a valuation allowance for deferred tax assets that are not supported by either a carryback or a reversal of existing temporary differences. Examples include entities emerging from bankruptcy; development-stage entities, as defined by ASC 915, Development Stage Entities; and other start-up operations. An exception might be a subsidiary in the development stage whose parent has the ability, under the tax law, to cause the subsidiary to generate sufficient taxable income, and the intent to do so, if necessary.

When we have performed extended going concern procedures (regardless of whether a going concern opinion is ultimately rendered), and the company asserts that it can consider future taxable income to support realization of deferred tax assets, PwC engagement teams are required to consult with the Accounting Services Group within PwC’s National Professional Services Group.

5.4 Sources of Taxable Income

Future realization of deferred tax assets is dependent on taxable income of the appropriate character (e.g., ordinary or capital) within the carryback and carryforward periods available under the tax law. ASC 740-10-30-18 identifies four sources of such taxable income that may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards. They are listed here in order of the most objective to the most subjective.

Taxable income in prior carryback years if carryback is permitted under the relevant tax law.

Future reversals of existing taxable temporary differences (including liabilities for unrecognized tax benefits).

Tax-planning strategies.

Future taxable income exclusive of reversing temporary differences and carryforwards.


The first two sources are those for which it is unnecessary to look to future events other than reversals of the temporary differences: actual taxable income in the available carryback period and reversing taxable temporary differences that offset deductible temporary differences or carryforwards either in the reversal year or in the applicable carryback and carryforward periods. The third source is tax-planning strategies, which are actions that management ordinarily might not take but would take, if necessary, to realize a tax benefit for a carryforward before it expires. Finally, the fourth source, taxable income expected to be generated in the future (aside from reversing temporary differences), frequently requires the greatest attention in assessing whether a valuation allowance is necessary, since it requires estimates and judgments about future events, which are difficult to objectively verify. All four sources are discussed in more detail below.

It is important to reiterate that the underlying assumptions about the business and prospective outlook used to evaluate and determine future taxable income and the realizability of assets should be consistent with the assumptions used for other financial reporting projections.

5.4.1 Taxable Income in Prior Carryback Years if Carryback Is Permitted under the Tax Law

Taxable income that can be carried back to prior years is the most objectively verifiable source of income and should be considered first. To the extent that sufficient taxable income of the appropriate character (i.e., ordinary or capital) exists, and is not subject to limitations under current tax law in the carryback period, there is no need to consider other sources of taxable income in concluding that a valuation allowance is not necessary. However, if it is insufficient, an entity must consider one or more of the other sources of taxable income.

5.4.1.1 Special Considerations for Carrybacks

5.4.1.1.1 Liabilities for Unrecognized Tax Benefits as a Source of Taxable Income

A liability for unrecognized tax benefits should be considered a source of taxable income in the carryback period for purposes of determining the expected realization of a deferred tax asset. Because settlement with the taxing authority is presumed to be at the recorded amount of the liability, the position’s resolution effectively amounts to additional taxable income over the taxable income expected on the “as-filed” or expected-to-be-filed tax return. Therefore, unrecognized tax benefits should be viewed as an additional source of taxable income and be considered as part of the assessment of whether a deferred tax asset is realizable. Consistent with all sources of taxable income, and to the extent necessary under the relevant tax law, the character of the uncertain tax position should be considered. For example, in the United States, an uncertain tax position that avoided recognition of a capital gain may provide a source of income to realize capital losses that otherwise would not be realizable. In addition to character, an understanding of the period in which the taxing authority would assess the tax (to the extent the position was lost) also would need to be considered. For example, if the period in which the taxing authority adjusts taxable income is not within the carryback period for which the assessment of realizability of deferred tax assets is made, then the income is not available as a source.

5.4.1.1.2 Carrybacks That Free Up Credits

Since the applicable tax rate at which deferred taxes are recorded is the tax rate prior to consideration of credits, there is a special consideration when it is expected that net deductible temporary differences reversing in a single future year will be included in a tax loss that will be carried back to prior years and will, at least partially, free up tax credits (which were used originally to reduce the tax payable) rather than result in a refund. We believe that realization of deferred tax assets represents incremental cash tax savings. Merely replacing one deferred tax asset (deductible temporary difference) with another deferred tax asset (credit carryforward), when there is not a source of income to realize it, does not represent realization of the initial deferred tax asset, and a valuation allowance would be necessary. Refer to the following example:

Example 5-4: Loss Carryback

Company A generated a $2.0 billion net operating loss in Year X. The loss was carried back to the second and first preceding tax years to offset $95.0 million and $166.0 million of taxable income, respectively. As a result of carrying back the NOL, credits that previously were utilized in the carryback years were no longer needed. As a result, the $6.0 million and $10.0 million of research and experimentation (R&E) credits were “freed up” and would be available as a carryforward for use in future years.


As Company A has no projected taxable income, a portion of the loss carried back was not realized (ASC 740-10-55-37), but rather resulted in the establishment of a new deferred tax asset in the form of a credit carryforward. Absent any other sources of future taxable income, Company A would need to establish a valuation allowance against the R&E and minimum tax credit carryforwards that were released and generated, respectively, through the loss carryback.


Therefore, of the $2.0 billion NOL (deferred tax asset) that Company A generated in Year X, $261.0 million will be realized as a benefit through the current-year provision vis-à-vis the loss carryback. The remaining NOL balance of $1.739 billion will result in a deferred tax asset of approximately $608.7 million (tax-effected at 35 percent) for which a valuation allowance should be established. Furthermore, a valuation allowance should be established against the $16.0 million of freed-up R&E credits as well as approximately $5.2 million of minimum tax credits for which Company A has determined realization to be not more-likely-than-not. Therefore, Company A’s total valuation allowance balance at the end of Year X is approximately $629.9 million.

5.4.1.1.3 Carryback Availability That May Not Be Used

As discussed above, ASC 740-10-30-18 states, “To the extent evidence about one or more sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered.” This might be read to indicate that a computation considering only three sources—reversing temporary differences, carryback availability, and available strategies—would determine the maximum level of valuation allowance that would be required if no future taxable income was anticipated. However, with regard to carryback availability companies should carefully consider whether carryback availability truly provides an incremental source of taxable income to support realization of deferred tax assets.

Carryback availability will provide a source of income to realize a deferred tax asset only if carryback actually will occur. In general, we believe that the valuation allowance assessment should consider what the company actually expects to report on its tax return in the carryback window. Assume, for example, that management is projecting taxable income in the near term. That taxable income may preclude actual carryback. Accordingly, in that situation carryback availability would not provide an incremental source of taxable income to support the realization of a deferred tax asset.

If, however, a company is projecting taxable losses in the near term or is unable to rely on its projections of taxable income, it may be appropriate to consider carryback as an incremental source of taxable income to support realization of the deferred tax assets. For example, if a company has a three year cumulative loss and determines that it is unable to rely on its projections of future taxable income (e.g., because objectively verifiable evidence indicates the Company will have losses in the future), it may be appropriate to consider carryback availability as a source of income to realize deferred tax assets. Judgment must be applied in determining whether carryback availability provides an incremental source of taxable income.

5.4.2 Future Reversals of Existing Taxable Temporary Differences

To the extent that reversal of existing taxable temporary differences is used as a source of taxable income that provides assurance of realization, a scheduling process may be needed to establish whether appropriate offset to deductible temporary differences is provided. In some cases, scheduling can be an in-depth detailed analysis of reversal patterns, specifically tracking reversals of taxable temporary differences in order to ensure the realizability of existing deductible temporary differences. In other cases, obtaining a general understanding of reversal patterns is sufficient. Refer to Section TX 5.5 for further discussion.


This observation can be illustrated as follows:

Example 5-5: Should Deferred Tax Liabilities Related to an Outside Basis Difference Be Used as a Source of Future Taxable Income in Determining the Need for a Valuation Allowance?

Background/Facts:

Parent X owns a foreign subsidiary and has established a deferred tax liability for the excess of book over tax basis in the investment. Although until the current period there was no definitive plan for repatriation, management could not assert indefinite reversal in accordance with ASC 740-30-25-17 due to uncertainty concerning its plans. Parent X is not profitable in its home jurisdiction and has significant net deferred tax assets (including NOL carryforwards) that carry a full valuation allowance.

Question(s):

Can Parent X use the deferred tax liability related to the outside basis difference in the foreign subsidiary as a source of taxable income in assessing the realizability of its deferred tax assets? If not, at what point would the deferred tax liability be considered a viable source of taxable income, thus supporting reversal of a portion of the valuation allowance?

Analysis/Conclusion:

When a taxable temporary difference related to the outside basis difference in a foreign subsidiary (e.g., related to undistributed foreign earnings) is viewed as a source of taxable income to support recovery of deferred tax assets, a company’s plans with respect to the timing of repatriation should be considered. Parent X would not be able to consider the taxable temporary difference on the outside basis difference as a source of taxable income for purposes of realization of its deferred tax assets if reversal is not expected to occur within the carryforward period (e.g., near-term repatriation of the cash might not be feasible). Alternatively, repatriation might be viewed similarly to a tax-planning strategy since presumably management might undertake a repatriation plan solely to prevent the loss carryforward from expiring unutilized, assuming such a strategy would be both prudent and feasible.

Conversely, a company asserting indefinite reinvestment under ASC 740-30-25-17 would be precluded from relying on repatriation as a tax-planning strategy (ASC 740-30-25-11 through 25-13).

Example 5-6: Whether Deferred Tax Credits Related to Leveraged Leases Can Be Considered in Determining the Amount of a Valuation Allowance for Deferred Tax Assets

Background/Facts:

Corporation X needs a valuation allowance for its deferred tax assets because it has cumulative losses in recent years. However, Corporation X has deferred tax liabilities that reduce the amount of valuation allowance required. Corporation X also has a portfolio of leveraged leases (as defined in ASC 840-10-25-43) that are accounted for under ASC 840, Leases. Corporation X has recorded deferred taxes from leveraged leases following the leveraged lease accounting model in ASC 840 and reflects the balance in a line item in the balance sheet titled “Deferred taxes from leveraged leases” in accordance with ASC 840-30-45-5.

Question:

Should the leveraged lease deferred taxes (“deferred tax credits”) be considered as providing a source of taxable income under ASC 740-10-30-18, if the underlying taxable temporary differences will reverse during the periods that will allow them to be a source of income to realize some of Company X’s deferred tax assets?

Analysis/Conclusion:

Yes. Leveraged lease deferred tax credits are not the same as deferred tax liabilities. Accounting for these credits is excluded from the scope of ASC 740 (see ASC 740-10-25-3c). Nevertheless, the underlying taxable temporary difference should be considered as a possible source of taxable income under ASC 740-10-30-18. However, because of differences in accounting for income taxes between the leveraged lease model and the ASC 740 asset-and-liability approach, the balance of the deferred credits may not provide a dollar-for-dollar offset to deferred tax assets. Accordingly, integration (see next paragraph below and ASC 840-30-45-6) of the results of accounting for income tax under the two standards is required when unrecognized deductible temporary differences or carryforwards unrelated to a leveraged lease could be offset by taxable amounts resulting from the reversal of the taxable temporary differences related to leveraged leases. A valuation allowance is not required for deferred tax assets if they will be realized by taxable income arising from the reversal of the taxable temporary differences related to the leveraged leases (subject to this integration process).

The concept of “integration” includes “converting” the balance of ASC 840 deferred tax credits to the equivalent deferred tax liability balance. The latter would be the deferred tax liability that would be recognized if the tax effects of leveraged leases were measured by applying the asset-and-liability approach of ASC 740, rather than leveraged lease model in ASC 840, to the pretax leveraged lease accounting. Potential differences between the leveraged lease model and the asset-and-liability approach would typically include differences in accounting for income tax rate changes and investment tax credits. See PwC ARM 4650.542 for further discussion.

Example 5-7: Consideration of limitations on the use of net operating loss carryforwards in assessing the need for a valuation allowance

Background/Facts:

Company A, a U.S. multinational, is assessing the need for a valuation allowance on deferred tax assets maintained by one if its foreign subsidiaries, Company B. As of the prior balance sheet date, Company A determined that, based on the weight of all available evidence, a valuation allowance for deferred tax assets was not required for Company B. This conclusion was based upon the scheduling of taxable and deductible temporary differences, along with tax loss carryforwards. The reversal patterns were such that the full benefit of the deferred tax asset was expected to be realized. Given this source of taxable income was sufficient to fully realize the deferred tax assets, no further consideration was required of any remaining sources.

Historically, Company B had the ability to carry forward tax losses on a fifteen-year basis with no limitation on the amount utilized. In the current period, the foreign government enacted tax law changes that impacted the utilization of existing losses in fiscal years commencing in 201X and thereafter. Under the new provisions, tax loss carryforwards can only be utilized to offset 70 percent of taxable income in any given year.

Question:

In determining the need for a valuation allowance, should Company A consider the loss limitations imposed by the tax law change enacted in Company B’s jurisdiction?

Analysis/Conclusion:

Yes. ASC 740-10-55-36 requires an entity to assess the recognition of a tax benefit for carryforwards as follows:

In assessing the need for a valuation allowance, provisions in the tax law that limit utilization of an operating loss or tax credit carryforward are applied in determining whether it is more-likely-than-not that some portion or all of the deferred tax asset will not be realized by reduction of taxes payable on taxable income during the carryforward period.

The loss restrictions enacted by the foreign government pose new evidence that may shift loss utilization into later years or suggest that income in future periods will be insufficient to support realization of existing deferred tax assets. As a result, a partial valuation allowance could be required.

Assume that Company B has recorded deferred tax assets (“DTAs”) based on deductible temporary differences (“Other”) and net operating losses (“NOLs”) of $180 and $120, respectively. In addition, Company B has recorded deferred tax liabilities (“DTLs”) for taxable temporary differences of $300. Company B is unable to rely on a projection of taxable income (exclusive of reversing temporary differences) and the existing inventory of deductible and taxable temporary differences is expected to reverse ratably over the next three years. Assume there are no other sources of future taxable income, such as tax-planning strategies or actions.

Under local tax law enacted in 20X1, the NOLs expire in three years and are only available to offset 70 percent of taxable income in any given year. The following table summarizes the computed NOL utilization after application of the loss limitation:


Accordingly, a partial valuation would be required for the remaining NOLs of $36 that are expected to expire prior to realization.

A similar scheduling exercise would be required if Company B previously maintained a full valuation allowance against its net DTAs. For example, assume a similar fact pattern with Company B instead having taxable temporary differences of $210 and a full valuation allowance recorded against its net DTAs. The following table summarizes the valuation allowance before and after application of the loss limitation:


Accordingly, Company B would need to increase the existing valuation allowance from $27 to $30 to account for the NOLs that are expected to expire prior to realization. Similarly, in situations when an entity is in an overall net deferred tax liability position, a valuation allowance may be required if income in future periods is insufficient to support realization of NOLs prior to expiration.

When assessing the realizability of DTAs, companies need to evaluate all of the relevant tax laws and other evidence. As a reminder:

Because the NOL limitation (in this case) is determined by reference to future taxable income levels, some have observed that future losses would make the imposition of the limitation irrelevant. However, ASC 740-10-25-38 specifically precludes anticipating future tax losses. As a result, in situations where future taxable income cannot be relied upon, our view is that the benefit of any reversing taxable temporary differences (and the effect of any NOL limitation) be determined with an assumption of zero or break-even future income.

While detailed scheduling is not required by ASC 740 in all cases, it is necessary when it has an impact on the valuation allowance assessment.

5.4.2.1 Deferred Tax Liabilities on Indefinite-Lived Intangible Assets—
“Naked Credits”

One example of a deferred tax liability that would not ordinarily serve as a source of income for the realization of deferred tax assets is a deferred tax liability that relates to an asset with an indefinite useful life (e.g., land, goodwill, indefinite-lived intangibles) that is located in a jurisdiction where there is a finite loss carryforward period. In this case, the deferred tax liability, commonly referred to as a “naked credit,” will not reverse until some indefinite future period when the asset is either sold or written down due to impairment.

Such taxable temporary differences generally cannot be used as a source of taxable income to support the realization of deferred tax assets relating to reversing deductible temporary differences, including loss carryforwards with expiration periods. In those situations where another source of taxable income is not available, a valuation allowance on deferred tax assets is necessary even though an entity may be in an overall net deferred tax liability position.

However, if the company can determine the expected timing of the reversal of the temporary difference, it may be appropriate to consider this deferred tax liability as a source of income for the realization of deferred tax assets. For example, if a Company enters into a sale agreement and as a result an indefinite-lived intangible asset was classified as held for sale pursuant to ASC 360-10-45-9, the timing of the reversal of the deferred tax liability is now predictable, and therefore can be considered as a source of income to support realization of deferred tax assets. Another example is an indefinite-lived intangible for in process R&D depending on when the reversal of the deferred tax liability is expected. See Section TX 10.4.5 for further discussion.

As a general rule, when an entity has more than one asset with an indefinite useful life and one or more of those assets is in a net deductible temporary difference position at the balance sheet date (e.g., due to an impairment charge recorded for book purposes), the taxable temporary differences related to other indefinite-lived assets should not be offset against such deductible amounts when assessing the need for a valuation allowance. Offsetting is not generally appropriate because the reversal of the deferred tax asset is not indefinite (i.e., reversal will occur as the tax basis is amortized).

However, in a situation where the deductible temporary difference is truly indefinite in nature it may be appropriate to use a deferred tax liability related to an indefinite-lived asset as a source of income to support realization of the deferred tax asset (assuming that they are within the same jurisdiction, of the appropriate character and that the deferred tax asset is realizable if the taxable income were to become available). A taxable temporary difference related to indefinite-lived assets would provide a source of taxable income to support realization of deferred tax assets in jurisdictions with an unlimited carryforward (e.g., Alternative Minimum Tax (AMT) credit carryforwards in the U.S.).

This is illustrated as follows:

Example 5-8: Determining the Amount of Valuation Allowance Necessary When There is a Deferred Tax Liability Related to an Indefinite-lived Asset in a Jurisdiction with an Unlimited Loss Carryforward Period

Background/Facts:

Company A is in a jurisdiction with an unlimited NOL carryforward period. Included in the net deferred tax asset is a deferred tax liability recorded for an indefinite-lived intangible asset. There have been significant historical losses and the taxable temporary difference related to the indefinite-lived intangible asset is the only source of income available to support realization of the deferred tax asset related to the NOL carryforward.

Question:

Should Company A consider the taxable temporary difference associated with the indefinite-lived asset as a source of taxable income to support realization of the NOL deductible temporary difference?

Analysis/Conclusion:

By definition, a naked credit tax effect arises when income tax attributes such as NOLs and credits have expiration periods. In such cases, it is generally not appropriate to offset deferred tax liabilities with indefinite/unknown reversal patterns against deferred tax assets that are scheduled to reverse or will expire over time.

However, if there is an unlimited loss carryforward period, the taxable temporary difference related to the indefinite-lived asset would constitute a source of taxable income to support the realization of the deferred tax assets related to attributes with an unlimited carryforward period since both have indefinite reversal or expiration periods. (This assumes that both are within the same tax jurisdiction, of the appropriate character and that the deferred tax asset is realizable if the taxable income were to become available.)

It should be noted that a similar analysis would apply if Company A were a U.S. corporation with accumulated AMT credits since such attributes have an unlimited carryforward period.

There may be cases, however, that an indefinite-lived deferred tax asset will not be realizable at the time the taxable temporary difference reverses. Therefore, it may not always be appropriate to characterize a taxable temporary difference related to an indefinite-lived asset as a source of taxable income to support the realization of an indefinite-lived deductible temporary difference. For example, if a deferred tax liability related to non-deductible goodwill was subsequently impaired (thus providing a source of taxable income at the time of impairment), a deferred tax asset related to land may not necessarily be realizable since the deduction is dependent on the sale or impairment of the land. By contrast, if the deferred tax asset was an NOL carryforward in an unlimited carryforward jurisdiction, the NOL deferred tax asset would be realizable at the time of the goodwill impairment.

5.4.3 Tax-Planning Strategies

In assessing the need for a valuation allowance, the consideration of tax-planning strategies is not elective; if there is an available tax-planning strategy that is prudent and feasible, it must be incorporated into the assessment.

As use of tax-planning strategies is not elective, the question arises as to the extent to which management must actively search for usable strategies.

A reasonable effort should be undertaken to find usable tax-planning strategies. Under ASC 740, these are actions that the entity is likely to implement if its projections of future taxable income otherwise would not be realized, so management should already be thinking about them as part of its regular tax planning. If a tax-planning strategy is discovered subsequently that appropriately could have been considered in a prior year, it will raise a question about whether the prior year’s financial statements should be restated. It could be asserted that the statements were issued originally in error because they failed to adequately recognize a potential tax-planning strategy existing at the balance sheet date. The FASB staff states, with respect to tax-planning strategies, in ASC 740-10-55-41:

Management should make a reasonable effort to identify those qualifying tax-planning strategies that are significant. Management’s obligation to apply qualifying tax-planning strategies in determining the amount of valuation allowance required is the same as its obligation to apply the requirements of other Topics for financial accounting and reporting. However, if there is sufficient evidence that taxable income from one of the other sources of taxable income listed in paragraph 740-10-30-18 will be adequate to eliminate the need for any valuation allowance, a search for tax-planning strategies is not necessary.

5.4.3.1 Tax-Planning Strategies Defined

ASC 740 identifies two functions of tax-planning strategies: (1) in assessing the valuation allowance for deferred tax assets, a tax-planning strategy may provide assurance of realization in a situation in which a valuation allowance otherwise might be necessary, and (2) a tax-planning strategy, whether or not used or needed to avoid a valuation allowance, may reduce the complexity of application of ASC 740.

For example, an entity could have a deferred tax liability in excess of the deferred tax assets recorded for a particular tax jurisdiction. However, it is not clear that the reversals of the taxable differences will offset, within the applicable carryback and carryforward periods, the reversals of the deductible differences and carryforwards represented by the tax assets. If future prospects are somewhat marginal, the entity may face a full-scale scheduling exercise to determine the extent to which reversing taxable differences will offset, both as to amount and timing, the deductible differences. But scheduling will be unnecessary if the entity has a valid tax-planning strategy that ensures that if any required future taxable income, other than reversals, is not generated, taxable income or deductions from reversals can be shifted among future years so that deductible differences and carryforwards will be offset by taxable differences.

As defined in ASC 740-10-30-19, a tax-planning strategy is a tax-planning action that meets certain criteria:

It must be prudent and feasible. Management must have the ability to implement the strategy and expect to do so unless the need is eliminated in future years. If management would not implement a strategy because it would not be in the entity’s best interests, it would not be prudent. If management does not have the ability to carry out the strategy, it would not be feasible. The strategy need not be in the unilateral control of management, but it must be primarily within its control. For example, restrictions in loan agreements would have to be considered in determining whether a strategy is feasible.

It is a strategy that an entity ordinarily might not take, but would take to prevent an operating loss, including an operating loss expected to result from the future reversal of a deductible difference, or to prevent a tax credit from expiring unutilized, and that would result in realization of deferred tax assets. Thus, strategies that the entity takes ordinarily, or that are designed to shift taxable income and deductions to take advantage of different tax rates, are generally not tax-planning strategies as defined, but would be considered tax-planning actions that are reflected in projections/scheduling if management expects to employ such an action (refer to the discussion of tax-planning at Section TX 5.4.4.2.2.1).


Some tax-planning strategies (e.g., triggering the LIFO reserve or shifting a tax-exempt portfolio to taxable) actually would create additional taxable income. Other tax-planning strategies may affect only the timing of specific taxable income or deductions. The latter would ensure realization of deferred tax assets if they provided appropriate offset of reversals of existing taxable differences against deductible differences. However, in some cases, they may only extend the period of future years to which the entity may look for additional taxable income to be generated other than from reversals. For example, a sale-leaseback typically would replace one deferred tax asset, that for an expiring loss carryforward, with another, that for the deferred gain for book purposes arising from the sale-leaseback. As mentioned in ASC 740-10-55-37, a reduction in taxable income or taxes payable as a result of NOLs and credit carryforwards does not constitute recognition of a tax benefit. The utilization of existing NOLs and credits is merely replaced by a temporary difference that will result in future deductible amounts.

Thus, absent future taxable income to realize the deferred tax asset related to the deferred gain, the sale-leaseback does not in itself realize the deferred tax asset. Realization would be achieved only if the entity was able to support the existence of a future source of taxable income that would be generated in the leaseback period.

A tax-planning strategy that triggers a gain on the appreciation of certain assets for tax purposes (including LIFO inventories) may require special consideration. ASC 740-10-30-22 cites appreciation in net assets as an example of positive evidence. For the strategy to create additional taxable income rather than merely affect the timing of taxable income and deductions, the appreciation would have to be unrecognized and unrealized. Recognized, but unrealized, appreciation (e.g., certain marketable securities carried at market under ASC 320, Investments—Debt and Equity Securities, but not subject to the mark-to-market tax rules) would already be considered a taxable temporary difference.

An available tax-planning strategy to create additional taxable income may not ensure realization of deferred tax assets if future operating losses are expected, which would offset the taxable income from the strategy. Refer to the following example:

Example 5-9: Potential Tax-Planning Strategy That Only Reduces Future Loss

Background/Facts:

XYZ Company has experienced a history of operating losses over the past five years that total $20.0 million and has a net deferred tax asset of $8.0 million (tax rate of 40 percent) arising primarily from NOL carryforwards from such losses. A full valuation allowance historically has been recorded against the net deferred tax asset.

Based on the introduction of a new product line, Company XYZ currently is projecting that, for the next three years, it will experience losses of approximately $5.0 million in the aggregate before it “turns the corner” and becomes profitable. Due to appreciation in the real estate market, Company XYZ’s investment in a shopping mall property is now valued at approximately $500,000 more than the carrying amount in its financial statements. The entity proposes to reverse $200,000 ($500,000 x 40%) of its valuation allowance based on a tax-planning strategy to sell the investment in the shopping mall. The shopping mall is not a “core” asset of the entity, and management asserts that it would sell the shopping mall property, if necessary, before it would permit the NOL carryforward to expire unused.

Question:

Should the valuation allowance be reduced for the tax-planning strategy?

Analysis/Conclusion:

We believe that a tax-planning strategy to sell appreciated assets constitutes a subset of the broader source of future taxable income from operations. Thus, it would not be appropriate to reduce a valuation allowance when it appears that the tax-planning strategy will only reduce an expected future loss. In the above case, based on (1) the entity’s history of losses, (2) an unproven new product line, and
(3) the fact that the entity does not anticipate being profitable for at least three years, little weight can be assigned to the projection of profitability. Accordingly, there is no incremental tax benefit (at least for the foreseeable future), as the potential gain on the sale of the shopping mall property would only reduce what otherwise would be a larger operating loss.

PwC Observation: The consideration of future losses in this analysis differs from the principle established in ASC 740-10-25-38, which notes that “the anticipation of the tax consequences of future tax losses is prohibited.” ASC 740-10-25-38 considers the fact that, for example, if a company was anticipating losses for the foreseeable future, one conceptually might conclude that there was no need to record deferred tax liabilities because they might not represent an incremental increase to the company’s tax liability. However, the Board rejected this notion. In this context, future losses are considered as part of determining whether the implementation of the proposed tax-planning strategy will indeed provide a source of income for the realization of deferred tax assets.

Example 5-10: Determining When a Particular Tax-Planning Action Would Constitute a “Tax-Planning Strategy,” as Defined in ASC 740

Background/Facts:

Company X acquires certain entities in Europe that have net deferred tax assets. In completing an evaluation of the recoverability of the net deferred tax assets and assessing the need for a valuation allowance, Company X considers the following two actions:

1. Company X is contemplating a new business model to create an operating platform that is substantially different from the current platform. The new platform would involve the creation of a new European headquarters to centralize many of the risks and functions currently borne by various entities. Aside from the European headquarters operation, the other European territories would be established as contract manufacturers. As a result of the new platform, income would be shifted to certain entities, which would allow Company X to take advantage of more favorable tax rates and may in some cases shift income to certain jurisdictions that currently generate net operating losses and require full valuation allowances.

2. Company X is discussing combining two of its German entities for tax purposes, which would allow it to utilize all of its existing net operating losses (absent combining the two entities, Company X would need to provide a full valuation allowance).

Question:

Do either of the above considerations qualify as a “tax-planning strategy” as defined in ASC 740-10-30-19?

Analysis/Conclusion:

ASC 740-10-30-19 defines a tax-planning strategy as an action that an entity ordinarily might not take, but would take to prevent a tax attribute from expiring unused. It goes on to say that the action must be prudent and feasible and result in the realization of deferred tax assets.

The first scenario would not be considered a tax-planning strategy, but rather a tax-planning action, as the action is done in the ordinary course of business and is a planned operational change in the company’s underlying organization. In this case, it seems clear that the specific action is being undertaken for reasons that go well beyond realizing an existing tax attribute.

The second scenario might qualify as a tax-planning strategy as the action is one that management would take in order to realize a deferred tax asset.

The distinction between the two scenarios is important as it factors into any valuation allowance assessment and also dictates how the costs associated with each are handled. For purposes of determining the need for a valuation allowance, a tax-planning strategy can be anticipated and incorporated into future income projections. On the contrary, any potential future income from an anticipated tax-planning action ordinarily would not be included in projections until the company actually has effected the action because the impacts of the tax-planning action, as described in the fact pattern above, would not be objectively verifiable. However, in circumstances where the effects of the tax-planning action are objectively verifiable (i.e., no significant uncertainties or contingencies exist), the anticipated effects of such action would be included and incorporated into overall future income projections. Pursuant to ASC 740-10-30-19, the costs of implementing a tax-planning strategy (net of any tax benefits associated with those expenses) would be netted when the company determined the amount of valuation allowance to be recorded. Conversely, the costs of implementing a tax-planning action are recognized when incurred.

Determining whether a particular tax-planning action can be considered a tax-planning strategy depends largely on the specific facts and circumstances and requires significant judgment.

5.4.3.1.1 Tax-Planning Strategies in Jurisdictions Where NOL Carryforwards
Never Expire

By definition a tax-planning strategy is in part an action an entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused. The question then arises: if an NOL carryforward never expires, is it possible to consider tax-planning strategies as a source of taxable income to support realization of deferred tax assets.

The following example illustrates the general guidance in this situation:

Example 5-11: Consideration of Tax-planning Strategies in Jurisdictions where Net Operating Loss (NOL) Carryforwards Never Expire

Background/Facts:

As of December 31, 20X7, Company X has $40 million of NOL carryforwards for which it has recorded $10 million of deferred tax assets (i.e., a tax rate of 25 percent) and is evaluating the need for a valuation allowance. Company X has cumulative losses in recent years and cannot rely on projections of future taxable income. As a result, it is considering whether it can use tax-planning strategies as a source of taxable income.

The tax law in the jurisdiction in which Company X operates provides that NOL carryforwards do not expire, rather they can be used indefinitely. The Company has assets with an appreciated value of $50 million (i.e., fair value of $60 million and a book value of $10 million) that are not integral to the business. The Company does not have intentions to sell the appreciated assets, but it has asserted that it would do so, if necessary, to realize the tax benefit of the NOL carryforwards.

Question:

In assessing the need for a valuation allowance, can the Company consider a tax-planning strategy (for example, selling the appreciated assets) as a possible source of taxable income available to realize a tax benefit for the NOL carryforwards?

Analysis/Conclusion:

No. Although tax-planning strategies are one of the four sources of income that companies can typically consider when evaluating the need for a valuation allowance, ASC 740-10-30-19 defines a tax-planning strategy as an action that an entity “…ordinarily might not take, but would take to prevent a tax attribute from expiring unused.” ASC 740-10-55-39(b) clarifies this definition by indicating that strategies that are expected to be employed for business or tax purposes, other than utilization of carryforwards that otherwise expire unused, are not tax-planning strategies as that term is used in ASC 740.

Accordingly, a company with operations in a jurisdiction in which NOLs do not expire cannot consider tax-planning strategies as a possible source of taxable income. However, Company X would not be precluded from considering the other possible sources of taxable income noted in ASC 740-10-30-18, including consideration of the impact of an objectively verifiable tax-planning action on future income projections (See Example 5-10 in Section TX 5.4.3.1).

For example, if Company X had committed to a definitive plan to sell the appreciated assets (rather than simply asserting that it would be willing to sell them, if needed), it would be able to consider the anticipated incremental income from the sale when assessing the need for a valuation allowance. However, if the Company also expects to have future operating losses, it would have to consider whether the anticipated incremental taxable income from the sale of the appreciated assets would enable it to realize the NOL carryforwards or if it would only reduce what otherwise would be a larger operating loss. This concept is illustrated in Example 5-9 in Section TX 5.4.3.1.

The above conclusion may appear counterintuitive as the Company has unrecognized appreciated assets that, if currently sold, would generate taxable income sufficient to realize the NOLs. However, ASC 740-10-30-23 requires any source of income to be weighted “commensurate with the extent to which it can be objectively verified.” As there is no expiration on the NOLs and no definitive plan to sell the appreciated assets, the ability to verify whether the taxable income associated with the appreciated assets is sufficient to realize the existing NOLs becomes challenging. For example, since the Company would have no separate tax motivation for selling the appreciated assets in the near term (i.e., no expiring attributes), it would be difficult to objectively verify the fact that the unrealized appreciation will be available at some point in the distant future when the Company eventually sells the asset. Further, the Company could continue to generate losses for an indefinite period of time and consequently, the sale of appreciated assets might only reduce what otherwise would be additional NOLs.

5.4.3.2 Examples of Common Tax-Planning Strategies

Some specific types of potential tax-planning strategies are discussed below.

5.4.3.2.1 Sales of Appreciated Assets

The sale of appreciated assets, in order to trigger taxable income equal to the appreciation on the assets, is a potential tax-planning strategy. Because tax-planning strategies are considered in assessing the valuation allowance and because the valuation allowance is based on the weight of available evidence, we believe that, to be considered, the appreciation would have to exist at the balance sheet date. If the sale would not be required until some future date, then there must be a reasonable basis for concluding that the appreciation would still exist.

Generally, an outright sale would have to be of assets, such as securities, that individually are not integral to the business. Any outright sale of fixed assets used in operations entails economic considerations that go well beyond those typically involved in tax-planning strategies. Similarly, unrealized appreciation in intangibles generally cannot be severed from the business itself. Sales of these assets involve questions of whether the entity wants to remain in certain business lines, products, or marketing areas. In most cases, it would be difficult to make a realistic assessment about whether the outright sale of such assets would be prudent and feasible.

A sale of appreciated assets can be expected to have an effect on taxable income after the sale date. For example if appreciated debt securities are sold, interest income in future years will be reduced. Further, an outright sale of appreciated real estate generally will result in increased occupancy expense subsequent to the sale date. If appreciated real estate is sold and leased back, occupancy expense for book purposes may be largely unchanged because of amortization of the gain on the sale over the lease term, but occupancy expense for tax purposes is likely to be higher, offsetting the appreciation recognized for tax purposes. Such impacts on future taxable income, other than reversals, should be considered.

5.4.3.2.1.1 Appreciated Securities

The sale of appreciated securities classified as available-for-sale or trading could be considered an available tax-planning strategy. However, as discussed in ASC 320-10-25-5, appreciated securities that are classified as held-to-maturity do not qualify as tax-planning actions or strategies because considering them available-for-sale would be inconsistent with the held-to-maturity designation. Tax-planning strategies involving available-for-sale or trading securities may impact both the timing and/or character of income.

With respect to timing of income recognition, entities that have expiring attributes often will assert their ability and intent to sell appreciated securities, if necessary, to avoid the expiration of certain attributes, such as net operating or capital loss carryforwards. Entities also might assert their ability and intent to sell securities carried at an unrealized loss to take advantage of capital gain income that exists in the carryback period. Selling appreciated securities ensures that the deferred tax liability on the unrealized gains will serve as a source of income, in the proper period, to avoid the loss of the related attributes. Selling securities carried at an unrealized loss ensures that the deferred tax asset, which likely would be considered capital in nature, will be realized through income in the carryback period. In either case, it is important that management perform a detailed enough analysis to be able to conclude that sufficient income of the appropriate character will be generated (or exists in the carryback period) and that it would consider the sale of the securities to be prudent and feasible within the timeframe necessary to avoid the expiration of the attributes or the close of the carryback window.

U.S. taxpayers and taxpayers in other jurisdictions with relatively short carryback provisions most likely will need to be ready to implement any strategy in the relative near term. Furthermore, because of the potential for volatility of market values of securities, expectations of invoking the strategy at a distant future date may not be appropriate. As a result, management should document and support its readiness and intent to sell securities. The assertion of selling securities with unrealized losses as a tax-planning strategy would represent a trigger for the recognition of an other-than-temporary impairment on the securities, if it has not already been recognized.


5.4.3.2.1.2 Available-For-Sale Debt Securities with Unrealized Losses

ASC 740-10-25-20 states that, “An assumption inherent in an entity’s statement of financial position prepared in accordance with generally accepted accounting principles (GAAP) is that the reported amounts of assets and liabilities will be recovered and settled, respectively.” Based on that assumption, a decline in fair value of a debt security below its tax basis is presumed to result in a future tax deduction, even though a loss has not yet been realized for book or tax purposes. Along with any other deferred tax assets, the company must evaluate the available evidence to determine whether realization is more-likely-than-not. An initial step in this assessment process is to determine whether a deferred tax asset related to an unrealized loss on a debt security will reverse through (1) holding the security until it recovers in fair value or (2) through sale at a loss.

Hold to Recovery—Preferable View

A company’s assertion that it has the intent and ability to hold an available-for-sale debt security until it recovers in value (e.g., at maturity, if necessary) results in recovery of the book basis of the security through collection of the contractual cash flows. While the recovery in book basis provides a source of future taxable income to be considered in the overall assessment of the need for a valuation allowance against the company’s deferred tax assets, this source of taxable income should not be viewed in isolation. In other words, to the extent that the expected recovery in book value of the available-for-sale debt security, in conjunction with other projected sources of income, is expected to result in positive future income for the company as a whole, such income may be used to support realization of deferred tax assets.

However, if there is significant negative evidence, such as cumulative losses in recent years or an expectation of additional near-term losses, taxable income implicit in the expected recovery of the book basis of the available-for-sale security may only serve to reduce future losses of the company. In such circumstances, the expected appreciation would not provide support for the realization of deferred tax assets because there would be no incremental future tax benefit to the company. This would be the case even though the deductible temporary difference related to the available-for-sale debt security is expected to reverse as the respective book and tax bases of the investment converge upon maturity of the security.

A valuation allowance cannot be avoided unless there is evidence that the benefit of the deferred tax asset will be realized as a result of future taxable income (or one of the other potential sources identified in ASC 740-10-30-18). It is not sufficient to merely project that the deductible temporary difference will reverse.

Hold to Recovery—Alternative View

In November 2008, in connection with registrant submissions on this topic, the SEC staff advised that it would not object to an alternative view for deferred tax assets related to unrealized losses on AFS debt securities when a company asserts the ability and intent to hold the security to recovery (maturity, if necessary) and provided that the company prominently discloses this accounting policy and its impact. Under this view, these deferred tax assets would be evaluated separately from a company’s other deferred tax assets and, because the future taxable income implicit in the recovery of the book basis of the AFS debt securities will offset the deductions underlying the deferred tax assets, a valuation allowance would not be necessary (even in cases where a valuation allowance might be necessary for all other deferred tax assets). The SEC staff was clear that this alternative view should not be applied beyond the very narrow fact pattern described here.

We understand that the basis for the alternative view is the conflict some see in the objectives of ASC 320 and ASC 740 in this narrow fact pattern. With that in mind, the SEC staff encouraged the registrants to request clarification from the FASB.

The FASB has been addressing the matter in connection with its reconsideration of the pretax accounting for these and other financial instruments. As described in its most recent exposure draft on Recognition and Measurement of Financial Assets and Liabilities, the Board has reversed course from a prior exposure draft and has now proposed that deferred tax assets on debt instruments measured at fair value with changes in fair value recognized in other comprehensive income be evaluated separately from other deferred tax assets of an entity. These deferred tax assets would essentially be viewed as “placeholders” for the tax effects of the unrealized losses recognized in other comprehensive income. Such deferred tax assets would then reverse over time as the unrealized losses on the debt investments reverse over the period to maturity. An expectation of future taxable income would not be necessary in order to support realization, and a valuation allowance would not be necessary even when significant negative evidence, such as recent cumulative losses, results in a valuation allowance for all other deferred tax assets. An entity, however, would need to assert that it has the ability and intent to hold the investments to recovery to support not recording a valuation allowance. It is unclear how narrowly the FASB intends to apply this proposed approach, for example, whether it will apply by extension to other items that are recorded in other comprehensive income that could be expected to reverse over time.

The final outcome of this matter will depend on the Board’s redeliberations. Therefore, companies that are potentially affected by this issue should stay abreast of the Board’s redeliberations of this matter.

Sale at a Loss

A sale of a depreciated debt security would result in a tax loss. Avoiding a valuation allowance in that case may depend on having sufficient taxable income of the appropriate character (e.g., capital gains instead of ordinary income). Holding the security until maturity (or until the unrealized loss is eliminated) would effectively obviate the need to consider whether there are sources of capital gains to offset the potential capital loss implicit in the temporary difference. Therefore, the positive assertion of the intent and ability to hold the available-for-sale debt security until it recovers in value would alleviate the “character of income” concern for such a company. If such an assertion cannot be made, however, the company must look to available sources of capital gains for recovery of the deferred tax asset.

Although asserting the ability to hold a security until it recovers in value (e.g., at maturity, if necessary) may appear, on the surface, to be contrary to the available-for-sale classification under ASC 320, we do not believe that the two positions are incompatible. Classifying a security as held-to-maturity under ASC 320 requires a positive assertion of intent and ability to hold the security to maturity. However, an entity must only be able to assert that it has the intent and ability to hold a debt security to maturity, if necessary to recover its value, to consider the expected recovery in book value as a source of future taxable income.

When a debt security is classified as available-for-sale but management asserts that it will hold the asset until it recovers in value, we believe that the reversal pattern of the temporary difference would be determined as if the security would be carried at amortized cost in the future for book purposes using the balance-sheet-date market value as amortized cost at that date. The reversal in each future year would be determined as the difference between the recovery of book basis and the recovery of tax basis assigned to that year under the method—loan amortization or present value—that has been elected for the category of temporary differences (see Section TX 5.5.1.2.2.1) in which the security is included.


5.4.3.2.2 Sale-Leaseback

Another potential tax-planning strategy is the sale-leaseback of fixed assets that, because of accelerated tax depreciation, have a higher book than tax basis. For tax purposes, the sale would accelerate the reversal of the taxable temporary difference (the excess-book-over-tax basis at the date of the sale-leaseback) into taxable income in the year of the sale. Ideally, use of this strategy should be confined to an asset for which there is a reasonable basis to conclude that its fair value will at least equal its remaining book value at the time of the sale. If the sale would be at a loss, the taxable income that would be generated would be correspondingly reduced. And, if the loss reflects actual market depreciation, then the loss would be considered a cost of the strategy. On the other hand, a sale-leaseback of an appreciated asset could generate taxable income from appreciation in excess of the book basis which in the U.S. could be considered a capital gain. For sale-leaseback transactions to work as tax-planning strategies, the existence of future taxable income is imperative. Without future taxable income, a sale-leaseback merely changes the timing of temporary difference reversal patterns; therefore, scheduling is required.

The following example illustrates the use of a sale-leaseback, tax-planning strategy:

Example 5-12: Use of a Sale-Leaseback, Tax-Planning Strategy

In 2007, XYZ Company incurred a $20,000 loss, which it must carryforward. The carryforward expires in 20 years. XYZ also has deductible temporary differences totaling $4,000, which will reverse over the next four years, and a building used in operations with a taxable temporary difference of $25,000, which reverses over 25 years. Management has concluded that no future taxable income, other than reversals, can be assumed in assessing the realizability of deferred tax assets. The pattern of temporary difference reversals and loss-carryforward utilizations, before consideration of tax-planning strategies, is shown below:


This projection indicates that $4,000 of the loss carryforward would expire unused. A valuation allowance may be required, therefore, because $5,000 of the $25,000 taxable temporary difference for the building will reverse beyond the carryforward period. However, if, prior to 2028, XYZ sold the building for an amount at least equal to the then existing book basis and leased the facilities back, this would accelerate the reversal of the remaining $5,000 of taxable temporary differences into the carryforward period. If the sale-leaseback was prudent and feasible, it would eliminate the need for a valuation allowance.

5.4.3.2.3 LIFO Reserves

An entity may have a taxable temporary difference for LIFO inventories (i.e., the book LIFO carrying amount exceeds the LIFO tax basis). The most significant such differences arise in nontaxable business combinations. The resulting deferred tax liability typically would be expected to be paid only in the indefinite distant future. When there is no temporary difference because book LIFO and tax LIFO are the same, the LIFO reserve is typically a measure of unrealized appreciation. In either case, triggering the tax LIFO reserve could be a valid tax-planning strategy.

The use of LIFO generally is considered to be an almost permanent deferral of tax, and, from an economic prudence perspective, any entity would be reluctant to forgo this economic benefit. However, the question under ASC 740 is whether an entity would trigger all or part of its LIFO reserve in order to keep a loss or credit carryforward from expiring unused.

There are two ways that a LIFO reserve can be triggered for tax purposes. The first is simply to change to a different method of accounting for inventories for tax purposes. Electing to change to a different accounting method requires IRS permission, but approval should be perfunctory in most cases. An entity can also be required to change to a different method of accounting if it fails to meet the IRS requirements to be on LIFO.

Conformity for financial reporting purposes is required when LIFO is utilized for tax purposes, however, it is not required when LIFO is not used for tax purposes. It should be noted that if a change to a non-LIFO method is also made for financial-reporting purposes, the non-LIFO method would have to be justified as preferable in the circumstances, and an SEC registrant would need to obtain a preferability letter from its auditors.

For tax purposes, the difference between LIFO and the new method, essentially the LIFO reserve, is a tax-method change that is spread ratably over four years. Presumably, an entity would wait as long as possible before terminating its LIFO election, but, in order to maximize the benefit of the termination, it would have to be made in time to be effective no later than the beginning of the fourth year prior to the expiration of the carryforward.

Would termination of the LIFO election be prudent? If an entity on LIFO operates in a generally inflationary environment and expects the level of its inventories to remain stable or increase, there is generally no benefit in having a higher tax basis in its inventories. Further, terminating the LIFO election means that, if the entity is able to return to profitable operations, taxes in the future will be computed on a non-LIFO basis and will be higher. Under the relevant tax law, a reversion to LIFO will not be available for at least five years and, even then, only if the entity uses the LIFO method for financial reporting purposes.

On the other hand, an entity that actually is considering terminating LIFO in order to keep a carryforward from expiring may well be in dire straits. And it may, in fact, want to terminate tax LIFO to avoid having to use LIFO for book purposes. Use of a non-LIFO method would increase the carrying amount of inventories and could improve balance sheet ratios. The entity’s projected circumstances will have to be considered carefully in determining whether termination of the LIFO election would be prudent.

The second way a LIFO reserve can be triggered, which is a less drastic tax-planning strategy, and one that would release only a portion of the LIFO reserve, would involve a deliberate reduction of LIFO inventories to liquidate layers. Whether such an action would be prudent and feasible is heavily dependent on an entity’s structure and operations. Deliberate reductions are generally difficult to achieve because they involve undesirable and perhaps costly changes in operations or corporate structure, and their benefits may be minimal. Frequently, the bulk of the LIFO reserve relates to the oldest layers of inventory, so substantial liquidations would be required in order to release much of the reserve.

A tax LIFO reserve may provide for a possible tax-planning strategy, which must be considered if an entity is providing a valuation allowance. However, it may be difficult to establish that such a tax-planning strategy would be prudent.

5.4.3.2.4 Shifting Tax-Exempt Portfolios

If an entity has a substantial portfolio of available-for-sale debt securities whose interest is tax-exempt, or corporate stock whose dividends allow for a dividends-received deduction, it may consider a tax-planning strategy to shift the portfolio to higher yielding securities with fully taxable interest or dividends. This would increase taxable income in future years and could be important in ensuring a source of future taxable income that will utilize regular tax loss carryforwards. It also might be considered by an entity that is an AMT taxpayer and that must consider whether deferred tax assets for AMT credit carryforwards and for regular deductible differences computed at the regular tax rate will be realized. Because tax-exempt interest and certain dividends-received deductions are added back in arriving at accumulated current earnings (ACE), the portfolio’s shift could operate to increase the income base for regular tax without substantially changing the income base for tentative minimum tax.

If tax-exempt debt securities are classified as held-to-maturity, the assessment of the valuation allowance under ASC 740 cannot contemplate the sale of these securities in order to purchase securities that would generate taxable income, per ASC 320-10-25-5(c). Such a classification under ASC 320 requires that an entity demonstrate the positive intent and ability to hold securities to maturity, and a tax-planning strategy that might require the sale of such securities prior to their maturity would be inconsistent with that assertion. A company could, however, have a tax-planning action or strategy to invest collections of interest and principal from the existing tax-exempt portfolio, or “new money” from sources previously invested in tax-exempt securities, in taxable securities.

An expected reduction in reported after-tax returns would not have to be accrued as a cost of the strategy. However, if there is currently market depreciation in the tax-exempt portfolio so that a loss would be realized on its sale, an intent to sell those assets, even in the context of a tax-planning strategy, likely would require the recognition of an other-than-temporary impairment loss on the securities.

5.4.3.2.5 Noneconomic Tax-Planning Strategies

Certain tax-planning strategies may provide a source of income for the apparent recognition of deferred tax assets in one jurisdiction, but not provide incremental tax savings to the consolidated entity. In order to avoid a valuation allowance in reliance on a tax-planning strategy, we believe that the tax-planning strategy generally
must provide cash savings to the consolidated entity. To the extent that the only
benefit a proposed tax-planning strategy provides is a financial reporting one
(i.e., the avoidance of the need to record a valuation allowance), we do not believe it constitutes “realization” of the deferred tax asset. Consider the following examples:

Example 5-13: Noneconomic Tax-Planning Strategies

Background/Facts:

Company A operates in the United States and in Switzerland. Due to poor U.S. sales, Company A has incurred losses resulting in significant NOL carryforwards. Its Swiss operations historically have been profitable, but due to the specifics of the local tax law, no tax is due on that income.

For financial reporting purposes, Company A has a deferred tax asset for the NOL sustained in the United States. In order to realize the deferred tax asset, Company A has proposed to move income from Switzerland to the United States in order to avoid the need for a valuation allowance on the U.S. NOL carryforward.

Question:

Does this represent a valid tax-planning strategy?

Analysis/Conclusion:

The proposed tax-planning strategy does not provide any incremental tax benefit to Company A, as the same amount of tax would be due to taxing authorities (on a consolidated basis) before and after consideration of the tax-planning strategy (i.e., zero tax rate in Switzerland versus no taxable income in the United States after consideration of the NOL carryforward). The only “benefit” achieved is a potential financial reporting benefit for the recording of an asset that in actuality would ultimately provide no incremental benefit to Company A. In fact, without a valid business purpose, one that would persist after Company A utilized all of its U.S. NOL carryforwards, for moving the income it would be difficult to imagine how such a strategy would be “prudent.”

However, if Company A has a valid business purpose for moving income from Switzerland to the United States and intends to do so, and, would continue to subject that income to U.S. tax after the losses are fully utilized, it may be appropriate to treat the movement of income from Switzerland to the United States as a tax-planning action and incorporate the effects in the projection of future taxable income.

Example 5-14: Assessing a Tax-Planning Strategy to Combine a Profitable and an Unprofitable Company

Background/Facts:

Company X, a U.S. company, has a wholly owned holding company that, in turn, wholly owns an operating company. The holding company and the operating company are in the same foreign jurisdiction but file separate returns. Historically, the holding company has generated losses (primarily due to interest expense from intercompany loans) and has significant NOL carryforwards. The operating company has generated profits in the past, which are expected to continue for the foreseeable future. In addition, the operating company has been benefiting from a tax holiday (i.e., a period of not paying taxes) for the past 15 years and expects the tax holiday to continue for the foreseeable future.

In assessing the need for a valuation allowance on the deferred tax asset arising from the NOLs, Company X considers a tax-planning strategy that would merge the two companies. It is projected that the combined company would be profitable and therefore would utilize the holding company’s NOLs. However, the merger would violate the conditions of the tax holiday, and the combined entity would become subject to the normal income tax rate.

Question:

Would the combination of the two companies be considered a prudent and feasible tax-planning strategy under ASC 740-10-30-19?

Analysis/Conclusion:

No. The implementation of the strategy might be feasible, but neither the holding company nor the operating company currently pays cash taxes. If the two companies were to merge, the tax holiday would be forfeited, and the combined company would be in a tax-paying position after using the NOLs. Since the tax-planning strategy is economically detrimental to Company X, it would not satisfy the requirement to be both prudent and feasible in order to qualify as a tax-planning strategy.

5.4.3.3 Costs to Implement a Tax-Planning Strategy

Determining whether a particular tax-planning action is a tax-planning strategy, or just a part of projecting future taxable income, often will not be clear. The distinction is important, as illustrated in Example 5-10. As previously mentioned, the tax benefit recognized for a tax-planning strategy, as defined, would be net of any expense or loss to be incurred in implementing the strategy. In effect, the expense, net of any recognizable tax benefits that it would generate, will be accrued as part of the valuation allowance. ASC 740-10-55-159 through 55-162, provides an example of such an accrual. However, it should be noted that if and when the tax-planning strategy actually is triggered and any related professional fees or other expenses are incurred, they should not be presented as components of income tax expense. This is the case even though such expenses would have been estimated for purposes of reducing the amount of tax benefit realizable as a result of the potential tax-planning strategy.

We believe that guidance related to costs of implementing a tax-planning strategy also applies in the case of an acquired temporary difference. If a tax-planning strategy is used to support acquired temporary differences and NOL carryforwards as of the opening balance sheet date, then only the “net” benefit should be recognized as a deferred tax asset in acquisition accounting.

Certain tax-planning strategies 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. In such circumstances, as illustrated in the following example, the tax benefit of the tax-planning strategy is measured at the lower tax rate. The tax rates differential effectively is a cost associated with implementing the strategy.

Example 5-15: Measuring the Benefit of a Cross–Jurisdiction Tax-Planning Strategy

Background/Facts:

Company A currently has a full valuation allowance recorded against its net deferred tax asset which is comprised primarily of expiring NOL carryforwards. Company A currently owns intellectual property (IP) in the United States that is used by its foreign subsidiary and that is expected to generate taxable income. Company A has incurred operating losses for several years and has significant negative evidence; however, its foreign subsidiary has been generating profits and paying foreign income taxes, albeit at a lower tax rate.

As a tax-planning strategy, Company A could sell the rights to this IP to the subsidiary. In this fact pattern, the value of the IP approximates the amount of Company A’s NOLs. Therefore, the utilization of the NOL carryforwards would offset Company A’s tax gain on the sale. In effect, the deferred tax asset related to the NOLs will be realized through increased tax amortization on the transferred IP asset that reduces tax payments in the foreign jurisdiction. In this regard, it must be more-likely-than-not that the foreign subsidiary will be profitable in future years at a level sufficient to utilize the amortization as tax deductions to reduce taxable income.

Absent objective and verifiable evidence of future taxable income in the subsidiary’s jurisdiction, this tax strategy would not result in the realization of deferred tax assets, and the valuation allowance should not be released. Simply transferring the IP and utilizing NOLs that have a full valuation allowance does not result in a realizable benefit if the IP is transferred to another jurisdiction and its new tax basis does not result in an incremental tax benefit to Company A.

In this case, the tax-planning strategy appears to meet the prudent and feasible criteria stipulated by ASC 740-10-30-19 since the subsidiary is paying taxes and could benefit from the tax amortization on the stepped-up IP tax basis.

Question:

To the extent that the above represents a valid tax-planning strategy, how should the effects of the strategy be measured? What should the accounting be if the strategy is actually implemented in a subsequent period?

Analysis/Conclusion:

In our view, the amount of the valuation allowance that should be reversed is equal to the amount of benefit that ultimately would be received in the subsidiary’s jurisdiction, which should be measured at the subsidiary’s tax rate.

For example, assume that the tax rate in the United States is 40 percent, and the tax rate in the subsidiary’s jurisdiction is 30 percent. As the tax benefit in the IP sale strategy ultimately will be realized at a 30 percent tax rate, the amount of U.S. deferred tax asset that does not require a valuation allowance as a result of the tax-planning strategy equals the gain multiplied by the 30 percent tax rate in the buyer’s jurisdiction. If the U.S. deferred tax asset was based on $100 of NOLs, which corresponds to a resulting deferred tax asset of $40 at 40 percent, the portion of the deferred tax asset that is expected to be realized under the strategy would be measured at a 30 percent tax rate. Therefore, $30 of the $40 valuation allowance should be reversed and a $10 valuation allowance should remain, absent any other source of future taxable income.

If in a subsequent period Company A actually implements the tax-planning strategy, the tax effect of the transaction is required to be deferred in the balance sheet consistent with the requirement in ASC 740-10-25-3(e) related to intra-entity asset transfers.

For example, if the IP is transferred for a $100 taxable gain, the entire NOL carryforward is utilized. In this case, both the deferred tax asset ($40) and the related valuation allowance ($10) are reversed, resulting in a net tax consequence of $30 on the sale. Consistent with the requirement in ASC 740-10-25-3(e), the net tax effect of $30 is required to be deferred on the balance sheet and amortized to income tax expense over the IP’s remaining useful life.

The subsidiary’s initial tax basis in the IP would likely be $100 in this case. However, a deferred tax asset for the tax-over-book basis is prohibited from being recognized in accordance with the requirements in ASC 740-10-25-10(3)(e). Rather, the tax benefit from amortization of the IP in the subsidiary’s jurisdiction is recognized as it is realized each year through deductions on the tax return and offsets (in the consolidated accounts) the additional tax expense from amortizing the $30 deferred charge over the IP’s remaining useful life.

To the extent that the valuation allowance release and IP transfer occurred in the same period, the accounting treatment would be the same as illustrated above based on the guidance in TX 2.3.4.2.1.2.

Section TX 2.3.4 provides additional guidance on intra-entity transactions.


5.4.3.4 Examples of Actions That Do Not Qualify as Tax-Planning Strategies

5.4.3.4.1 Excluding a Loss Subsidiary from Tax Consolidation

Questions have arisen regarding whether excluding a loss subsidiary from the consolidated tax return constitutes a tax-planning strategy. For example, assume a U.S. entity has three subsidiaries, two of which are profitable. The third has large losses, giving the consolidated group NOL carryforwards. The current profit and loss trends of each subsidiary are expected to continue into the near future. The entity is contemplating a tax-planning strategy to sell more than 20 percent, but less than 50 percent, of the loss subsidiary. As a result, the operating results of the loss subsidiary would no longer be included in the consolidated tax return, but would continue to be consolidated for financial reporting purposes. Those entities that remain in the consolidated tax return will be able to utilize the NOL carryforwards generated during the years when the loss subsidiary was included in the consolidated tax return. Is selling a minority interest in a subsidiary, such as that described above, an acceptable tax-planning strategy under the provisions of ASC 740?

No. This strategy does not result in an incremental cash tax savings and thus does not constitute realization of the deferred tax asset. The strategy lacks substance and is merely a recharacterization of an existing consolidated-return NOL as a future separate-return NOL, both of which would be incorporated within the same consolidated financial statements.

5.4.3.4.2 Acquiring a Profitable Entity

Acquiring a profitable business may provide a source of income that would result in realization of a deferred tax asset. However, we do not believe that a proposed business combination can be anticipated. As discussed at Section TX 5.1.1, transactions that are inherently outside the company’s control and fundamental to its organizational structure are not considered in the valuation allowance assessment, as in many other areas of GAAP, until they have been completed. Although this issue is not specifically addressed in ASC 740, we understand that the FASB discussed a similar fact pattern during the deliberations leading to ASC 740 and indicated that it did not intend for tax-planning strategies to be taken this far. Consequently, the tax effects of such events (e.g., the acquisition of an entity) should not be recognized before the events have occurred. See Section TX 10.5 for further discussion.

5.4.3.5 In Summary

Actions That May Qualify as Tax-Planning Strategies:

Selling operating assets and simultaneously leasing them back for a long period of time.

Accelerating the repatriation of foreign earnings for which deferred taxes previously were provided.

Funding a liability, where the funding is deductible on the tax return, before the expected payment date in order to generate a tax loss which would be available for carryback.

Filing a consolidated or combined tax return.

Electing to deduct foreign taxes paid or accrued rather than treating them as creditable foreign taxes.

Disposing of obsolete inventory that is reported at net realizable value in the financial statements.

Selling loans at their reported amount (i.e., net of an allowance for bad debts).

Shifting an investment portfolio classified as available-for-sale under ASC 320, from tax-exempt to taxable debt securities.

Changing from LIFO to some other method of accounting for inventories for tax purposes or deliberately reducing LIFO inventories to liquidate layers.

Electing out of the installment sales provisions for tax purposes.

Electing to capitalize and amortize research and development costs for tax purposes rather than deducting them currently if returned to profitability and running out of time to use other attributes based on carryforward periods.

Merging or liquidating subsidiaries into the parent in a tax-free transaction.

Actions That Generally Would Not Qualify as Tax-Planning Strategies:

Selling certain operating assets that are important to future operations, such as trademarks or patents.

Funding executive deferred compensation before the expected payment date, since it will trigger taxable income for the executives.

Disposing of a subsidiary that is not profitable (could be an action).

Initiatives that reduce costs in order to increase the entity’s profitability (could be an action).

Changing an entity’s tax status (the effect of a change in tax status is reflected on the approval date, or on the filing date if approval is not necessary, and is considered a discrete event).

Moving income from a nontax jurisdiction to a taxable one solely to realize net operating loss carryforwards.

5.4.3.6 Issues in Evaluating Tax-Planning Strategies

5.4.3.6.1 Time Value of Money

Although ASC 740 precludes discounting deferred taxes, the time value of money may need to be considered in assessing whether a tax-planning strategy is prudent. For instance, as discussed earlier in this chapter, the scheduling should not reflect forgoing a carryback, which would maximize a deferred tax asset (and thus delay the receipt of cash), if it is not reasonable to expect that the entity actually would take such an action given the time value of money. ASC 740-10-55-43 through 55-44 gives an example of a tax-planning strategy to sell installment sales receivables to accelerate the reversal of the related taxable temporary differences. If a higher rate of interest would be earned on the installment sales receivables than could be earned on an alternative investment, the interest rate differential—the reduction in future interest income—must be considered in determining whether the strategy would be prudent. If, after considering the time value of money, a tax-planning strategy is deemed to be prudent, the loss of future interest income is not considered a “cost” of the tax-planning strategy (refer to Section TX 5.4.3.3).

5.4.3.6.2 Unrecognized Tax Benefits

As previously mentioned, ASC 740-10-30-18 states that a tax-planning strategy may be a possible source of taxable income for the realization of deferred tax assets. ASC 740-10-30-20 makes clear that the unit of account, recognition, and measurement principles for unrecognized tax benefits should be applied when determining whether a tax-planning strategy provides a source of future taxable income for the realization of deferred tax assets. In effect, a proposed tax-planning strategy would need to meet the ASC 740 more-likely-than-not recognition threshold from a tax law perspective before the company considered whether it was also prudent and feasible. Assuming recognition is met (and the tax-planning strategy was determined to be prudent, feasible, and primarily within the company’s control), the amount of taxable income that would be provided by the tax-planning strategy should be measured as the largest amount of benefit that is more-likely-than-not to be realized.

5.4.3.6.3 Separate Statements of Subsidiary

It is important to evaluate tax-planning strategies for a subsidiary in the context of the consolidated group’s tax-planning objectives. Management of the subsidiary may not be in a position to be able to assess whether the strategy is prudent and feasible. A strategy that may seem prudent and feasible to management of the subsidiary may not be prudent and feasible in the context of the worldwide objectives. The parent company may have business plans for the subsidiary (e.g., discontinuances of certain product lines, relocation of certain functions to other countries or other U.S. subsidiaries, acquisition or other commencement of new operations which will be placed in the subsidiary) to which management of the subsidiary is not privy. It also may be necessary to obtain documentation from the parent company to support tax-planning strategies that have effects on other entities within the consolidated group to ascertain feasibility and prudency.

5.4.3.7 Consistent Use in Different Jurisdictions

Tax-planning strategies, which assume transactions affecting the timing of deductions and taxable income, must be reflected consistently across the entities (e.g., parent entity and its subsidiaries) and jurisdictions (e.g., federal and state) affected by the strategies. It is possible that actions or strategies that reduce taxes in one jurisdiction will increase taxes in another. Of course, when inconsistent tax elections are allowed in different tax jurisdictions (e.g., whether to file consolidated or separate returns), it may be appropriate to use different elections.

5.4.4 Future Taxable Income Exclusive of Reversing Temporary Differences
and Carryforwards

5.4.4.1 General

To the extent that realization is not ensured by carryback, reversals of taxable temporary differences, or tax-planning strategies, and is therefore dependent on the existence of future taxable income, projections of future taxable income will be necessary. The question arises whether the focus should be on future taxable income or future pretax book income. Although, the realization of tax benefits ultimately depends on the availability of taxable income, in general forecasts of future pretax book income (adjusted for permanent differences) should be used when assessing the realizability of deferred tax assets. Over the remaining lifespan of the entity, future taxable income will, in the aggregate, equal future pretax book income adjusted for permanent differences. In projecting future income, all available information should be considered. This includes operating results and trends in recent years, internal budgets and forecasts, analysts’ forecasts, industry trends, and anticipated changes in the business. Generally, the most recent results should be considered indicative of future results, absent evidence to the contrary.

However, to the extent such recent results include aberrational items, either favorable or unfavorable, those items should be excluded from the results when determining a “core” level of earnings. Also, in cyclical industries, recent results may not be at all indicative of near-term future results; rather, the phase of the cycle currently being experienced may indicate that improvement or deterioration should be expected.


For an entity that has demonstrated core earnings, we believe prospects for the near term are important, as they are likely to represent more objective positive evidence when compared with potential negative evidence based on business or macro-environmental risk factors that are not objectively verifiable. In addition to a baseline of current operating results, the projections should take into account factors such as any demonstrated cyclical aspects of the entity’s industry and the entity’s stage of development. Judgment is necessary in determining how detailed or formalized projections should be to assess the objective verifiability of the end result. The weight given to the forecast will be dependent on the extent to which the major assumptions can be objectively or independently supported, as well as the entity’s previously demonstrated ability to accurately budget and project future results.

The following example demonstrates the notion of core earnings:

Example 5-16: Core Earnings

Company A has a gross deferred tax asset balance of $2.6 million and a gross deferred tax liability balance of $0.4 million at the end of the current year. In the prior year, Company A’s pretax income was $1.7 million. In the current year, Company A reported pretax income of $1.0 million, inclusive of the impact of a settlement related to employment discrimination of $0.6 million. The allegation of discrimination was believed to be isolated and represented the first allegation of employment discrimination ever encountered by Company A. No further allegations were expected. In determining Company A’s core earnings, it would be reasonable to conclude that core earnings of approximately $1.6 million exist as the settlement was isolated and was not indicative of Company A’s future profits (i.e., this event generated an isolated one-time charge, resulting in a distortion of income for the period that would not be representative of Company A’s ability to generate profits in the future).

Therefore, in its assessment of valuation allowance needs against its net deferred tax asset balance of $2.2 million at the end of the current year, Company A would consider its current-year core earnings of $1.6 million, which is the reported pretax income adjusted for the one-time settlement charge. Based on the facts presented, it is more-likely-than-not that Company A will realize the future benefits of its deferred tax assets and not have to record a valuation allowance against its net deferred tax asset balance at the end of the current year.

5.4.4.2 Considerations When Projecting and Scheduling Future Taxable Income Other Than Reversals of Existing Temporary Differences

5.4.4.2.1 Originating Temporary Differences in Future Projections

Future taxable income, other than reversals, includes, in concept, the effect of future originating temporary differences for assets in place, as well as their reversals. It also includes the origination and reversals for depreciable or amortizable assets to be acquired in the future. Thus, future taxable income embraces not only future book income and future permanent differences, but also temporary differences, other than reversals of those existing at the balance sheet date. Estimating future originations and their reversals on a year-by-year basis generally would be quite an exhaustive exercise, and one that could not be very precise.

But shortcuts may be employed. For example, the net amount of recurring temporary differences may be expected to remain at approximately the same level at each future balance sheet date (i.e., new originations may be assumed to replace reversals each year). The year-by-year effect of future originating differences could be approximated at an amount equal to reversals of existing temporary differences; of course, the net originations would be deductible if the net reversals were taxable, and vice versa.

However, shortcut approaches, and the consideration of future originations in general, must be used with care. Originating deductible differences may provide the taxable income that “uses” reversing deductible differences, but at the same time they will create new deductible differences, which will reverse in later future periods. For example, an originating deductible difference for accrued vacation increases taxable income in the year of accrual but when the vacation is taken or paid, the temporary difference will reverse and will decrease taxable income in a future period. Consistent with ASC 740-10-55-37, we do not believe that a tax benefit is realized from the reversals of existing deductible differences if they are only replaced by new deductible differences that will not be realized. Thus, inclusion of taxable income from originating differences in the scheduling, or other analysis, may require, in turn, consideration of whether the deductible differences they create will be realized. This could extend the analysis further and further into the future. Ultimately, there must be future pretax income, after considering permanent differences, to realize the benefit of the existing deductible differences.


5.4.4.2.2 Projecting Future Pretax Book Income

In general, once the results of scheduling reflect the temporary difference reversals in the years they are expected to take place, future taxable income amounts for each year should be scheduled to determine the net taxable result for each future year.

The following are guidelines for projecting future earnings for purposes of the valuation allowance assessment:

It is generally presumed that an entity with cumulative profits in recent years (or that is in a cumulative loss situation, but has demonstrated a return to sustainable profitability) will remain profitable unless there is objectively verifiable evidence to the contrary.

The starting point should be the amount and trend of book income (i.e., pretax income adjusted for permanent items) during the past year because this evidence is typically the most objective indicator available.

While projections of future income should be consistent with historical results, it is sometimes necessary, in determining the existence of core earnings that have been demonstrated in the past and that would be reasonable to assume for the future, to “adjust” the historical earnings for unusual items (both positive and negative), the effects of purchase accounting, or changes in capital structure. For example, if the proceeds of a recent public offering were used to pay down debt, the interest expense in periods prior to the offering should be adjusted to arrive at historical core earnings, which forms the starting point for projections of future periods.

Favorable improvements in profitability based on items such as built-in growth rates and “synergistic” effects of recently completed acquisitions should be approached with a high degree of skepticism. Since growth rates and the effects of acquisitions are inherently difficult to objectively verify, generally very little weight can be given to their effects until demonstrated.

Projections of future taxable income must consider all years that may provide a source of taxable income for the realization of deferred tax assets.

In certain cases, a probability-weighted model for projecting future taxable income should be used, following a process consistent with the one for determining “expected cash flows” described in Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements (CON 7), and ASC 360-10-55-23 through 55-32. The results of a CON 7 analysis are most useful when the various inputs into the analysis can be objectively verified. In applying this approach, each scenario (with its own annual projection of taxable income) should be weighted based on the company’s assessment of the expected outcome, which in turn contributes to the overall probability-weighted projected income for the year. The result of such an analysis should be compared with the level of core earnings to assess the reasonableness of the result.

5.4.4.2.2.1 Tax-Planning

After detailed scheduling of future taxable income has been performed and after all the carryback and carryforward rules have been applied, there may still be years in which there is net taxable income, and also years with net deductions. There also may be loss carryforwards that will not be fully used against taxable income scheduled during the carryforward years, and years with net taxable income beyond the carryforward period. In addition, there may be an opportunity to shift income to years with lower tax rates, or deductions to years with higher tax rates.

There may also be an opportunity to change the manner of recovery of an asset or settlement of a liability, thereby changing the nature of taxable income between capital and ordinary. This could be advantageous when there is a difference between enacted capital gain and ordinary income tax rates or when there are capital losses—either incurred and carried forward or expected—which can be used only against capital gains.

Faced with a specific pattern of taxable income and loss, an entity can attempt to minimize its net tax liability through tax planning. The objective of tax planning is to minimize the overall tax cost. Often, tax planning can be used to accelerate or delay the recognition of income or deductions to take advantage of otherwise unused deductions and carryforwards. While the deferred tax computation usually focuses on the regular tax liability, an entity evaluating tax-planning items also would consider any significant effect that it would have on AMT.

Tax-planning effects reflected in the scheduling or other estimates of future taxable income should be actions that an entity expects to undertake unless changed circumstances or estimates in future years eliminate the need. The final scheduling or other estimate of future taxable income should reflect what is likely to occur. See Section TX 5.4.3 for further guidance.

5.4.4.2.2.2 Short-Term Outlook Approach

While it is difficult to generalize, once an entity concludes that positive evidence outweighs negative evidence so that some or all of a valuation allowance can be released, we would not normally expect that release to occur over a number of successive years. A particular concern arises when an entity that has returned to profitability reflects no tax provision or benefit, net of valuation allowance release, for a length of time.

In this regard, the SEC has questioned the retention of a valuation allowance when it appears to be overly conservative and when it may suggest earnings management (i.e., “selecting” the future period(s) in which to release the valuation allowance by modifying assumptions that are not easily susceptible to verification).

We have observed an approach in practice of limiting the estimate of future income used in determining the valuation allowance to a relatively short time horizon, such as projecting out the same number of years as the entity has been profitable or projecting out for the same period (e.g., three years) that the company uses for internal budgetary purposes. Except in certain rare situations, based on the individual facts and circumstances, we generally do not believe that such an approach is appropriate. Mere uncertainty about the sustainability of taxable income due to general business and macro-economic risk factors is not a valid reason to use a short-term outlook. This view is supported in ASC 740-10-30-17, which states, “All available evidence, both positive and negative, shall be considered to determine whether, based on the weight of that evidence, a valuation allowance for deferred tax assets is needed.” The use of projections based on a relatively short timeframe fails to consider all available evidence.

As a general rule, the appropriate place to consider the inherent risk of future operations is in the quantification of the core earnings or in the development of projections, not through excluding consideration of potential positive evidence that may be present in later years. Because of the inherently arbitrary nature of truncating projections of future taxable income after a specific short-term period, the use of this approach may be challenged and would need to be appropriately supported with specific facts and circumstances. Assuming such a short-term outlook approach was deemed appropriate, it would generally be acceptable only for a short timeframe. If the entity continued to meet or exceed projections, this myopic outlook would no longer be appropriate.

5.4.4.2.2.3 Unlimited Carryforward Period

As noted above, projections of future taxable income must consider all years that may provide a source of taxable income for the realization of deferred tax assets. In jurisdictions where an unlimited carryforward period exists and an entity has demonstrated, or returned to, a sustainable level of profitability, it is often difficult to identify and objectively verify any negative evidence that would outweigh that positive evidence.

As a result, even though realization of deferred tax assets in a jurisdiction that has an unlimited carryforward period for net operating losses may be expected to occur in the far distant future based on current projections, absent specific negative evidence of sufficient weight, the full deferred tax asset should be recognized. If an entity’s operations turn for the worse in future years, the change associated with a change in assessment about the realizability of deferred tax assets would be properly reflected in the period in which the operations deteriorated and the weight of existing negative evidence overcame the existing positive evidence.

5.4.4.2.2.4 Consistency of Projections with Other Accounting Estimates

As a starting point, the projections used for valuation allowance assessments should generally be consistent with other projections or estimates used in the preparation of the financial statements and in other filing disclosures (e.g., impairment tests under ASC 360, Property, Plant and Equipment or ASC 350, Intangibles—Goodwill and Other). This is particularly true when a company does not have cumulative losses in recent years or has returned to sustained profitability. In such cases, the SEC has challenged registrants that have used a short-term outlook when assessing the realizability of their deferred tax assets, but have used longer-term forecasts to support the carrying value or amortization periods of long-lived assets.

On the other hand, if a company has cumulative losses in recent years, it is generally appropriate to adjust the projections used in the valuation allowance analysis to a level that is objectively verifiable. Most recent historic results are generally considered to be the most objectively verifiable; although under circumstances in which sufficient evidence exists, it may be appropriate to consider “core earnings.” This is because the impairment models for long-lived assets generally consider management’s best estimates of future results, while ASC 740-10-30-23 requires the evidence considered in a valuation allowance assessment to be “weighted” based on the extent it can be objectively verified. Therefore, projections of taxable income (which are inherently subjective) generally will not carry sufficient weight to overcome the objective negative evidence of cumulative losses unless they are adjusted to a level that is objectively verifiable.

In either case, if a company uses assumptions in its valuation allowance assessment that are not consistent with other projections or estimates used in the preparation of its financial statements (or other disclosures), it should be prepared to explain and provide support for any such differences.

5.4.4.2.2.5 Special Considerations When There Are Cumulative Losses

Because a projection of future taxable income is inherently subjective, it generally will not carry sufficient weight to overcome the evidence of cumulative losses in recent years. As a result, the source of positive evidence needed to overcome the significant negative evidence of cumulative losses often must come from what has already been demonstrated (or is otherwise objectively verifiable). Accordingly, the foundation of the projection process is the amount and trend of book income (i.e., pretax income/(loss) adjusted for permanent items) during the past year because this evidence is typically the most objective indicator available.

If an entity has cumulative losses in recent years, but recently has returned to profitability, one must consider whether the evidence of recent earnings carries sufficient weight to overcome the weight of existing significant negative evidence, and whether the level of uncertainty about future operations allows a conclusion that the entity has indeed returned to sustainable profitability. See Section TX 5.1.3.1 for further guidance.

5.4.4.2.2.6 Special Considerations for Certain Deferred Tax Assets

The issue of future taxable income, other than reversals, can be particularly critical with respect to four specific types of deferred tax assets—net operating loss carryforwards, accruals for postretirement benefits other than pensions (discussed in Chapter TX 18), AMT credit carryforwards, and foreign tax credit (FTC) carryforwards.

Loss Carryforwards

Under ASC 740, tax loss carryforwards are treated just like deductible temporary differences. An asset is recorded for a loss carryforward and is reduced by a valuation allowance only if it is more-likely-than-not that the benefit will not be realized. This does not mean, however, that valuation allowances for loss carryforwards necessarily are uncommon. Tax loss carryforwards may be indicative of recent book losses, which, as discussed above, constitute objective negative evidence that is not easy to overcome.

Further, in a jurisdiction where there is a limit on the period during which a carryforward can be used, the fact that that period has started to run for a carryforward may result in more concern about its realizability than for deductible differences, which have not yet been claimed on the tax return. On the other hand, an unlimited carryforward period does not necessarily ensure realization, which is ultimately dependent on future income.

Other Postretirement Benefits (OPEBs)

Assessing the realization of deferred tax assets associated with OPEBs is problematic because the tax deductions typically will occur over a period of 40 or 50 years or even longer. It is unlikely that the reversal of significant taxable temporary differences for which deferred tax liabilities have been provided would extend into such distant future years.

We believe that the focus should be first on other deferred tax assets, which are expected to reverse in the foreseeable future and whose realization is dependent on future taxable income, other than offsetting taxable differences or carrybacks. If those tax assets are significant and if no valuation allowance is required for them, generally no valuation allowance should be required for the deferred tax asset associated with OPEB accruals.

OPEBs are payable over a period extending into the distant future, and in the United States, there are presently only limited ways to obtain tax deductions for OPEBs prior to actual benefit payments. As a result, there is very little advance funding of OPEB benefits.

Underlying the recorded OPEB obligation is a calculation that estimates future benefit payments attributable to service to date and discounts them to present value. This calculation measures the accumulated postretirement benefit obligation (APBO). ASC 715, Compensation—Retirement Benefits, requires the recognition of the entire APBO at each balance sheet date.

Thus, the accrued obligation at each balance sheet date is the present value of the estimated future benefit payments, which will generate tax deductions in the years paid. The reversal pattern can be determined by application of either the loan amortization or the present value method. See Section TX 5.5.1.2.2 for further discussion.

AMT Credit Carryforwards

Projections of taxable income are important in order to determine whether tax attributes that require special consideration, such as AMT credit carryforwards, will be realized. To utilize its AMT credits, a company must generate sufficient regular tax in excess of tentative minimum tax (the amount of tax computed under the AMT system).

As described in Section TX 4.2.5.1, an entity generates AMT credit carryforwards for every dollar of AMT paid. AMT credit carryforwards can be used in any future year to reduce the regular tax to the amount of tentative minimum tax (TMT) calculated for that year. A deferred tax asset is established for AMT credit carryforwards as for other tax credits. Assessing the realizability of AMT credit carryforwards, which is described in ASC 740-10-55-32 through 55-33, can be difficult.

In circumstances where, before consideration of AMT carryforwards, the deferred tax liability exceeds deferred tax assets for deductible differences and loss and FTC carryforwards, it is possible that reversals of the temporary differences at the balance sheet date will ensure future realization of some or all of the AMT credits. First, there is a 15 percent differential in rates between regular tax and TMT computations. Further, depreciation deductions for regular tax generally run ahead of those for AMT, and the amount of the regular-tax taxable temporary differences generally will exceed the amount of AMT taxable temporary differences. Ordinarily, we would expect the AMT reversals to occur with the regular tax reversals. For taxable depreciation differences, both would occur over the remaining book life of the underlying asset. Thus, an aggregate calculation may be sufficient. In these instances, to the extent that a net deferred tax liability provided for regular-tax temporary differences and carryforwards (other than AMT credits) exceeds the TMT deferred tax liability generated by AMT temporary differences and carryforwards, it may be appropriate to consider that the AMT credit carryforwards are assured of realization.

There is another circumstance, undoubtedly rare, in which reversals of temporary differences could ensure realization of AMT credits, but by carryback rather than carryforward. This circumstance would require that (1) AMT net deductible differences in excess of regular net deductible differences were expected to reverse in years in which they could be carried back to recover AMT paid and (2) such carryback was anticipated to actually occur (i.e., the reversing deductible differences were not expected to be offset by taxable income other than from reversals).

To realize AMT credit carryforwards in excess of the amount that is assured by existing temporary differences or carryback, an entity must become a regular taxpayer. Judging that likelihood requires taking a close look at what has caused the entity to be subject to AMT in the past and then assessing the prospects for the future. If the AMT position has resulted from timing differences (i.e., deductions entering into regular taxable income faster than into alternative minimum taxable income [AMTI]), it may be possible to predict that, ultimately, there will be a net reversal, which will cause regular tax to exceed TMT. However, the AMT position may have resulted from permanent differences between regular taxable income and AMTI—for example, statutory depletion in the extractive industries—or from limits on use of loss carryforwards, FTCs, or FTC carryforwards in computing TMT, which will result in their expiration. In these circumstances, the entity, to avoid a valuation allowance, may have to be able to predict, supported by objective positive evidence, that its future tax posture will be significantly different from the current one. Absent the ability to project income, tax-planning strategies would need to be considered.

FTC Carryforwards under U.S. Federal Tax Law

When foreign source earnings are included in the U.S. tax return, a credit can be taken, with certain limitations, for the taxes paid or accrued on those earnings in the foreign country or countries. Credits also are generated by foreign taxes actually paid by (or on behalf of) the U.S. entity directly to a foreign taxing authority (e.g., withholding taxes on dividends or income taxes on branch income) and deemed paid (income tax paid by a foreign subsidiary or a 10 percent-or-more-owned investee included in earnings and profits for U.S. tax purposes, when the underlying income is remitted as dividends). If a credit for taxes deemed paid is to be claimed, the dividends included in U.S. taxable income must be grossed up by the amount of the deemed-paid taxes.

Foreign tax credits cannot be used to reduce a U.S. tax liability on domestic-source income. In general, if foreign taxes were paid on foreign-source income in the aggregate at a rate in excess of the U.S. statutory rate, the use of the credits is limited to the tax that would have been paid if the U.S. statutory rate had been used. Foreign-source income includes grossed-up dividends and is reduced by allocations of certain domestic deductions (e.g., administrative costs, interest, etc.). Also, the FTC limitation must be calculated separately for certain categories of foreign-source income. Use of the credits also may be limited if there is a taxable loss from domestic sources since such a loss would offset the foreign-source income before the credits were applied.

FTCs can be carried back one year and forward ten years. To realize the deferred tax asset recorded for FTC carryforwards under ASC 740, an entity must be able to generate sufficient future foreign-source taxable income, and that income must, in the aggregate, have been taxed in foreign jurisdictions at less than 35 percent. The FTC carryforwards can be used only if, and to the extent that, a 35 percent rate exceeds the future credits generated by the future foreign-source income itself. In addition, the entity must not anticipate a taxable loss from domestic sources in the years in which the carryforwards must be used.

In many cases, therefore, it will be difficult to avoid a valuation allowance for FTC carryforwards. Unless the circumstances that generated the carryforwards were aberrational, it is likely that future foreign-source income also will generate excess FTCs, which will become additional carryforwards, rather than utilize existing FTC carryforwards.

As discussed in Chapter TX 11, because ASC 740 continues the indefinite reinvestment exemption for unremitted earnings of foreign subsidiaries, it also prohibits, in assessing the need for a valuation allowance, considering the future taxable income that would result from remitting unremitted earnings for which no tax has been provided based on the indefinite reinvestment exemption. But what about future earnings of those subsidiaries?

Under ASC 740-30-25-13, those earnings cannot be considered in assessing the realizability of FTC carryforwards, or any other item that gives rise to a deferred tax asset, “except to the extent that a deferred tax liability has been recognized for existing undistributed earnings or earnings have been remitted in the past.” Thus, if there has been a past policy or practice of remitting a certain percentage of the earnings from a particular subsidiary, that percentage of the subsidiary’s projected future earnings can be considered in assessing the valuation allowance. The idea is that if an entity invokes the indefinite reinvestment exception and does not recognize deferred tax liabilities for some or all of its unremitted foreign earnings, then it is precluded from having a net deferred tax asset for related FTC carryforwards, unless the realizability of those carryforwards is supported by an established pattern of dividends that does not contradict its assertions under ASC 740-30-25-17. Whether an “established pattern” of dividends exists is a matter of judgment to be assessed on a case-by-case basis. However, if there have been no dividends, or if there has been no pattern of dividend payments to date, or if a change in pattern is required to support realization of the deferred tax asset, then a valuation allowance is required for as long as it takes to reasonably conclude that a pattern has been established.

Other future foreign-source income can and should be considered. This would include earnings from foreign entities where the indefinite reinvestment exception is not used and foreign branch income. Consideration also should be given to royalties from subsidiaries or others and to rental income and interest that are treated as foreign-source income under the tax law. These latter sources may be particularly important in assessing realization because, assuming an efficient worldwide tax footprint, those “earnings” typically will not have been taxed at high rates in the foreign jurisdictions.

5.5 Scheduling Future Taxable Income

Scheduling future taxable income, if carried to its full extent, involves extensive number-crunching. At the extreme, it would be tantamount to estimating what the tax return would look like for each future year in which temporary differences reverse.

5.5.1 When Is It Necessary?

The simple answer is: When it matters. That is, when the assessment of the appropriate valuation allowance or the applicable tax rate could vary materially depending on relatively minor shifts in the timing of taxable income. For example, scheduling will have to be considered in the following situations:

The realization of the deferred tax asset is dependent upon future reversals of existing taxable temporary differences. In other words there is a deferred tax asset, but the likelihood of future taxable income from sources other than reversing taxable differences does not provide sufficient assurance of realization to avoid a valuation allowance. ASC 740 requires that projections of future taxable income must consider all years that may provide a source of taxable income for the realization of deferred tax assets. The entity must determine to what extent reversals of taxable differences ensure realization through offsetting. This situation could occur not only where future prospects are marginal or worse, but also in jurisdictions where carryback and carryforward periods are relatively limited, future results are expected to be erratic, or there is a limitation on the use of certain tax attributes. For example, certain states limit the amount of NOL available in any one period.

A change in the tax rate is enacted but will not take effect until a future year or years. The entity must determine the amount of temporary differences for which the current tax rates are applicable and the amount of temporary differences for which the rates enacted for the future will be applicable.

While a detailed deferred tax computation is illustrated later in this chapter, we believe it will be the exception rather than the rule that detailed computations will have to be carried to this extreme. The specific facts and circumstances will determine the extent to which scheduling and detailed tax computations are necessary.

5.5.1.1 General Approach to Scheduling

There are two basic approaches to the scheduling exercise. In one approach, only reversals of temporary differences, actual carryback availability, and available strategies are considered. This approach would be used when prospects for other future taxable income are bleak, and the net deferred tax liability or asset might approximate the result of a detailed tax computation based on the scheduling of reversing differences only. However, consideration should be given to the extent to which carryback availability provides assurance of realization. An abbreviation of this approach, a scheduling of reversals of temporary differences only, also could be used to determine the amount of reversals that will occur before, and the amount that will occur after, an enacted future rate change when taxable income is expected in each future year. The other approach includes estimated future taxable income other than reversals. This scheduling approach does not result in a computation of the net deferred tax liability or asset. However, when it is not clear whether all deductible differences and carryforwards will be used, this second approach can be used to estimate the amount that will expire unused. This approach also may be employed to determine the applicable rate when enacted future rate changes and carrybacks from future years exist.

While the following discussion is in the context of full-scale scheduling and detailed deferred tax computations, reasonable approaches to aggregate temporary differences may be sufficient in many cases. For example, when there is a loss carryforward that expires in 10 years, the question may be the amount of reversals that will occur during the remainder of the carryforward period, and year-by-year scheduling will be unnecessary.

5.5.1.2 Patterns of Temporary Difference Reversals

Scheduling temporary differences can be extremely technical. For each class of temporary differences, the pattern of reversal must be determined. ASC 740-10-55-15 through 55-22 acknowledges that in many cases there is more than one logical approach. It further notes that the consideration of reversal patterns is relevant primarily in assessing the need for a valuation allowance. Judgment is critical in that assessment, and attempts at precision in predicting future taxable income, other than reversals, would be pointless. The guiding concepts in determining reversal patterns are stated in ASC 740-10-55-12 through 55-14.

The particular years in which temporary differences result in taxable or deductible amounts generally are determined by the timing of the recovery of the related asset or settlement of the related liability. The tax law determines whether future reversals of temporary differences will result in taxable and deductible amounts that offset each other in future years.

In addition, ASC 740-10-55-15 through 55-22 provides some ground rules:

The methods used for determining reversal patterns should be systematic and logical.

Minimizing complexity is an appropriate consideration in selecting a method.

The same method should be used for all temporary differences within a particular category of temporary differences for a particular tax jurisdiction.

The same method for a particular category in a particular tax jurisdiction should be used consistently from year to year.

“Category” is not defined in the guidance but two examples are cited: (1) liabilities for deferred compensation and (2) investments in direct financing and sales-type leases. Different methods may be used for different categories of temporary differences. If the same temporary difference exists in two tax jurisdictions (e.g., U.S. federal and a state tax jurisdiction), the same method should be used for that temporary difference in both tax jurisdictions.

A change in method is a change in accounting principle subject to the guidance in ASC 250, Accounting Changes and Error Corrections. Such a change, if material in its effects, would have to be justified as a change to a preferable method, and an SEC registrant would be required to obtain a preferability letter from its independent auditors.

5.5.1.2.1 Depreciable and Amortizable Assets

Only reversals of temporary differences at the balance sheet date would be scheduled. As indicated in ASC 740-10-55-14, the future originations and their reversals would be part of future taxable income, other than from reversing differences, which is one of the sources of future taxable income to be considered in assessing the need for a valuation allowance.

Example 5-17: Depreciable Assets

To illustrate, assume that a $12,000 taxable temporary difference relates to a depreciable asset with a future pattern of depreciation expense at December 31, 2000, as follows:


Under ASC 740, the $12,000 temporary difference would be deemed to reverse on a FIFO basis as follows:


The origination of the additional $5,200 temporary difference in 2001 and 2002 and its reversal in 2008 through 2010 are not considered part of the reversal of the temporary difference existing at the balance sheet date. They are, instead, considered part of the future taxable income other than reversals.

We believe that the following methods of categorizing temporary differences for determining reversal patterns may be used:

Asset-by-asset approach.

Asset category (e.g., buildings).

Total property, plant, and equipment category.

However, to the extent that certain assets within a particular category are indefinite-lived assets for financial reporting purposes (e.g., land, goodwill, indefinite-lived intangibles), we believe that, as a general rule when assessing the need for a valuation allowance, those assets should be isolated and the reversal of taxable temporary differences associated with them not scheduled. For example, in assessing the need for a valuation allowance, a taxable temporary difference associated with land that there is no present plan to dispose of, should not be offset against deductible temporary differences associated with depreciable plant and equipment.

5.5.1.2.1.1 Tax Lives Longer than Book Lives

There will be certain assets for which tax lives are longer than book lives. For these assets, book depreciation generally will run ahead of tax depreciation. In preparing the financial statements, it is assumed that the asset will be abandoned or taken out of service and disposed of at the end of its book depreciable life. Accordingly, the remaining tax basis at the end of the book life would be expected to be available as a tax deduction at that time. Thus, the excess-tax-over-book basis at the balance sheet date generally would be expected to reverse in the last year of the book life.

5.5.1.2.1.2 Construction in Progress

There may be a difference between the book basis and tax basis of construction in progress. The timing of reversal will depend on when book and tax depreciation commence. If there is an excess tax basis, it will reverse in the first years in which tax depreciation exceeds book depreciation. An excess book basis will reverse in the first years in which book depreciation exceeds that taken for tax.

5.5.1.2.1.3 Nonamortizable Tax Intangibles (Other than Goodwill)

In business combinations in which the tax basis of the acquired entity’s assets and liabilities is stepped up, tax basis may have been assigned to identifiable intangible assets other than goodwill. In some taxing jurisdictions the intangibles (e.g., tradenames) may not be amortizable for tax purposes, even though they may be for book purposes. In these circumstances, the laws of the particular taxing jurisdiction(s) would need to be considered to assess whether the recovery of the tax basis of the intangibles is allowed other than through a disposition or liquidation of the entire business. For example, whether the tax basis can be recovered by disposition or abandonment of the intangible asset. (In the U.S., since the 1993 Tax Act, losses generated upon disposition of intangibles are generally disallowed for US tax purposes.) If the basis can be recovered, consideration should also be given to the appropriate tax rate(s) to apply to gains and losses resulting from the relevant disposal options.

While these assets may seem similar to goodwill, they are different in their nature and do not represent a residual. In future periods, book amortization will give rise to a temporary difference for the excess tax basis, and a deferred tax asset will be recognized for the deductible temporary difference. While there may be no plans for sale or disposition of the intangibles, and it would not be expected to occur (if at all) before some distant future year, under the ASC 740 comprehensive allocation system, reversal of the temporary difference would be assumed. The question is whether a valuation allowance must be established.

To the extent that a loss on the sale of the intangible asset is expected, the company needs to consider whether there will be sufficient future taxable income of appropriate character available to realize the loss.

5.5.1.2.2 Assets and Liabilities Measured at Present Value

This broad grouping includes many financial instruments (e.g., loans receivable and long-term debt), leases that are capitalized by the lessee or recorded as receivables by the lessor, most accruals for individual deferred compensation contracts, and OPEB obligations. The FASB staff specified two basic approaches for scheduling the reversal of temporary differences related to assets and liabilities that are measured at present value.2 The same basic approaches are presumably available for determining patterns of reversal under ASC 740 as well. With respect to an asset or liability measured at present value, the aggregate future cash payments will exceed the “principal” balance (i.e., book basis or tax basis, as the case may be) at the balance sheet date, and the difference between the two scheduling methods involves the portion of future cash payments expected in each future year that is deemed to recover or settle the “principal” balance at the balance sheet date.

2 Question 10 of the Special Report on FAS 96.

The two approaches are termed the loan amortization method and the present value method. Under the loan amortization method, future payments are considered to apply first to accrued interest, with the balance applied to principal. The application to principal would be the reversal. Under this method, when payments are level, annual reversals will increase each year. This model mirrors the model used generally in financial statements in accounting for assets and liabilities measured at present value (i.e., the reversal amount for each future year will be the amount by which the recorded asset or liability is expected to be reduced in that year). The recorded asset (liability) may be expected to increase in a future year if the payment(s) receivable (payable) in that year will be less than the interest income (expense) expected to accrue. Therefore, no reversal would be deemed to occur in that year.

The present value method assigns to each reversal year the present value at the balance sheet date of the payment to be made in that year. When payments are level, annual reversals will decrease each year. The present value method can be viewed as considering each required future payment as a separate zero-coupon asset or liability, with all interest accruing unpaid from the balance sheet date to the payment date. In contrast, the loan amortization method (and the financial statement model) emphasizes that the series of payments constitutes a single contract.

The results of the two different methods in a very simple application can be illustrated as follows:

Example 5-18: Assets and Liabilities Measured at Present Value and under the Loan Amortization Methods

Assume that on December 31, 20X1, an asset or liability is recorded in the amount of $614,457. This amount represents the present value, using a 10 percent interest rate, of 10 payments due on December 31 of each of the next 10 years. The reversal patterns under the two methods would be as follows:


The reversal for 20X2 under the loan amortization method is based on the allocation of the 20X2 payment ($100,000) first to interest ($61,446) and the remainder to principal ($38,554). Under the present value method, the reversal assigned to 20X2 is the present value at December 31, 20X1, of the lease payment to be made on December 31, 20X2, and is calculated to be $90,909.

Note that when the asset or liability requires a series of level payments from the balance sheet date until liquidation, the reversal pattern derived under the loan amortization method is the exact reverse of that derived under the present value method.

It generally will be easier to apply the loan amortization method because the reversal amounts are usually consistent with the financial statement amounts. Accordingly, they may be readily available, and the reversals deemed to occur in future years for a particular asset or liability may not change from year to year. Application of the present value method, by contrast, may require computations to be made solely to determine the reversals. Further, the reversal deemed to occur in any specific future year for any particular asset or liability will change from year to year. This occurs because, as the period between the balance sheet date and the future year decreases, the discount to present value also decreases, and the reversal deemed to occur in that future year increases.

While both may be acceptable, we believe the loan amortization method is preferable because it is consistent with the “interest method” required by ASC 835, Interest. Whichever method is selected, it must be used consistently.

5.5.1.2.2.1 Financial Instruments

Carried at Amortized Cost for both Book and Tax

The selected method, loan amortization or present value, is applied separately to the book basis and to the tax basis of the financial instrument. Application to book basis would use the interest rate embedded in the book accounting, and application to tax basis would use the interest rate implicit in the tax accounting. In effect, the reversal of the temporary difference at the balance sheet date that is deemed to occur in each future year is the difference between the recovery in that year under the selected method of the book basis and of the tax basis.

In general, the reversal pattern under the loan amortization method would track the change in the temporary difference, assuming neither the book nor the tax balance increases during any year. However, assume a loan receivable with a tax basis equal to the principal amount, a lower book basis, and the entire principal due at maturity (similar considerations would arise for long-term debt with all principal due at maturity, a tax basis equal to the principal amount, and a lower book basis), the amortization method3 would schedule the reversal of the entire temporary difference in the year of maturity, since it is only in that year that recovery of (reduction in) the tax basis occurs. The amount of the temporary difference would change each year and, accordingly, the amount of the reversal deemed to occur in the year of maturity also would change in each year’s deferred tax calculations.

3 As defined by Question 10 in the FASB Special Report on FAS 96.

However, we believe that it also would be an acceptable application of the loan amortization method under ASC 740 to consider the reversals of the temporary difference at the balance sheet date to occur as the book basis is accreted to the principal amount and the temporary difference is correspondingly reduced. Under this approach, the expected future book interest income in excess of taxable interest income in each future year would be deemed to result in a tax deduction in that year. Even though actual tax deductions are not expected to occur in this pattern, the pattern would reflect the book income expected to be recognized without being reported as taxable income.

There are situations (e.g., marketable bonds) where discount or premium for tax purposes is amortized on a straight line basis or is not amortized at all. We believe that it would be reasonable in such cases to consider the temporary difference to reverse in the pattern in which it is expected to reduce.

ASC 310 requires amortization of certain net fees or costs (i.e., those related to revolving credits) on a straight-line basis. Assuming that the net fees or costs were taxable (deductible) on loan origination, we believe it would be appropriate to schedule deductions (taxable income) based on expected book amortization.

Carried at Fair Value for Both Book and Tax

When a security is carried at market for both book and tax purposes, there typically should be no significant temporary differences.

Carried at Amortized Cost for Book and Fair Value for Tax

When a debt security is carried at amortized cost under ASC 320 (i.e., a held-to-maturity security), but marked to market for tax, the reversal pattern of the temporary difference may be problematic. Because the security is classified as held-to-maturity, the premium or discount for tax purposes will be presumed to disappear over the remaining life of the instrument, but it will not amortize in any systematic pattern. Rather, the market value, and tax basis, will change as a result of the shortening of the period to maturity and of changes in market interest rates and in the issuer’s credit standing. In such circumstances, it appears reasonable to assume, for purposes of determining the reversal pattern, that market interest rates and issuer’s credit standing will remain unchanged to maturity. The reversal pattern would be determined in the same way as if tax reporting in the future were to be based on amortized cost using the balance-sheet-date tax basis as amortized cost at that date. The reversal in each future year would be determined as the difference between the recovery of book basis and the recovery of tax basis assigned to that year under the method, either loan amortization or present value, elected for the category of temporary differences in which the security is included, as discussed in this chapter.

Carried at Fair Value for Book and Amortized Cost for Tax

When a security is carried at market under ASC 320, but at cost or amortized cost for tax purposes, the reversal pattern will depend on management’s intentions and expectations. For example, we believe that it would not be prudent to anticipate changes in market prices in determining reversal patterns. Accordingly, the timing of the reversal of the balance-sheet-date unrealized appreciation or depreciation of an equity security should correspond to the period in which management intends to sell and should be consistent with the operating plans of the entity.

On the other hand, when a debt security is classified as available-for-sale, but management has no particular expectation that it will be sold prior to maturity, the best approach may be to assume that the security will be held to maturity and that market interest rates and the issuer’s credit standing will remain unchanged. The reversal pattern then would be determined as if the security were to be carried at amortized cost in the future for book purposes using the balance-sheet-date market value as amortized cost at that date. The reversal in each future year would be determined as the difference between the recovery of book basis and the recovery of tax basis assigned to that year under the method, either loan amortization or present value, elected for the category of temporary differences in which the security is included.

For a debt security expected to be sold within the next few years but considerably in advance of its scheduled maturity, it may be appropriate to consider reversals to occur in the years prior to expected sale in the pattern suggested for a debt security for which there is no particular expectation for sale, with the balance of the temporary difference reversal assigned to the year in which sale is expected.

5.5.1.2.2.2 Leases

When a lessor records its investment in leased property as a sales-type or direct-financing lease, the book asset is measured at present value, and the accounting is similar to that for a loan receivable. The lessor accrues interest on its investment and applies lease payments to reduce it. However, for tax purposes, if the lease is a “true lease,” the lessor owns a depreciable asset and depreciates the tax basis as permitted by the tax law.

A lessee that capitalizes a lease obligation that is a “true lease” for tax purposes will amortize the asset over the lease term (or shorter useful life) in its financial statements. The liability is measured at present value, and the lessee accrues interest on the recorded obligation and applies lease payments to reduce it. However, the lessee is entitled to tax deductions for the full amount of its lease payments.

Both of these situations involve a single transaction, a lease. However, the FASB took the position that both the lessor in a direct-financing or sales-type lease and the lessee in a capital lease have two temporary differences.4 Under this view, a lessee with a capitalized lease has both a book asset and a book liability, each with a tax basis of zero. A similar situation would exist for a seller-lessee in a sale-leaseback of real estate that failed to qualify for sale-leaseback accounting in accordance with ASC 840, Leases. The effect of the capital gains tax on the sale-leaseback is discussed later in Section TX 5.5.1.2.6. In addition, a lessor in a direct-financing or sales-type lease has an investment in the lease (an asset measured at present value) for book purposes with no tax basis, and property for tax purposes with no book basis.

4 FASB Special Report on FAS 96.

We believe that it is acceptable but not required under ASC 740 to consider two temporary differences to exist in these situations. One effect would be in disclosure. Since, as discussed in Section TX 15.2, gross deferred tax assets and gross deferred tax liabilities must be disclosed, the lessor, using the two-difference approach, would include in its deferred tax assets the amount related to the tax basis of its depreciable property, and in its deferred tax liabilities, the amount related to taxable income to be reported on collection of its lease payments, which are deemed to be the recovery of its investment in the leased property. The lessee would include, in deferred tax assets, the amount for the future deductions for lease payments, which are deemed to reduce the capital lease obligation, and, in deferred tax liabilities, the amount for future taxable income equal to amortization of its leasehold asset. If, on the other hand, the lease is considered to generate a single temporary difference, a single net asset or liability would be included in the disclosure, generally a deferred tax liability for the lessor and a deferred tax asset for the lessee.

The one-difference approach may be simpler to conceptualize and to apply. It would simply net book/tax differences for each year. For example, the lessee in a capital lease generally would recognize book expense (amortization of the leasehold asset and interest on the capital lease obligation) faster than it could claim tax deductions for lease payments. In early years, when the deductible temporary difference was being accumulated, the reversal would be deemed to occur only after the “turnaround” (i.e., in the years when the tax deduction exceeded book expense).

But the two-difference approach would consider full reversal of both the asset and the liability. The two-difference method would recognize, in the reversal pattern, the excess book expense over tax deductions (i.e., future taxable income) that would occur in the years before the turnaround.

Regardless of whether the one-difference or two-difference approach is elected, it will be necessary, in determining the reversal pattern, to recognize that two reversals must be considered. There will be, in addition to the reversal of the asset (the lessor’s investment) or the liability (the lessee’s obligation) measured at present value, the reversal of the depreciable or amortizable asset (for tax purposes for the lessor, for book purposes for the lessee).

Also, the ASC 740 methodology always recognizes a deferred tax liability for taxable differences but may provide a valuation allowance against deferred tax assets. It is conceivable that, as a result, the net of the deferred tax balances (assets, liabilities, valuation allowance) under the two-difference approach could be a greater liability or smaller asset than under the one-difference approach. Of course, when scheduling or other detailed analysis is required, the impact of the different reversal patterns may depend on the pattern of the net reversals of other temporary differences.

5.5.1.2.2.3 Deferred Compensation

For deferred compensation contracts with individual employees, other than pensions and OPEBs, the accrued liability may represent the present value at the balance sheet date of stipulated payments scheduled to commence upon an employee’s retirement. Under the present value method, reversals are deemed to occur equal to the present value of payments to be made in each future year.

The loan amortization method assumes that any benefit payment applies first to interest accrued after the balance sheet date, including the interest from the balance sheet date to the retirement date, as well as the interest accruing between the retirement and payment dates. Under this approach, only a portion of payments due in the later payment years relates to the liability accrued at the balance sheet date.

In some cases, the present value at retirement of expected deferred compensation payments is accrued by straight-line charges over the period to retirement. Under ASC 715, Compensation—Retirement Benefits, the present value of the deferred compensation payments must be fully accrued at the “full eligibility date,” which may precede the retirement date. For simplicity, this discussion assumes those dates are the same.

Even when the accrual of the liability prior to the retirement date is not interest-adjusted, in concept, the liability is measured at present value. Thus, an appropriate approach is to apply the selected method, loan amortization or present value, to expected actual future payments to determine the reversal pattern of the liability that will be accrued at the retirement date. Then, those reversals would be deemed to relate to the accrued liability at the balance sheet date based on the ratio of the accrued liability to the expected liability at the retirement date.

When payments will be made for the remaining life of the employee rather than for a stipulated period, the actuarial assumption used in providing the accrual also should be used in estimating the timing of the payments. The method of payment (lump sum versus annuity), as well as early or late retirement options, may be at the employee’s election. Absent any data on likely employee options that are expected to be selected, management judgment will be required.

Pensions

Accounting for pensions under ASC 715 can give rise to a number of temporary differences. In general, there will be no pension asset or liability for tax purposes. Deductions are generally available for qualified arrangements when cash contributions are made. The pension asset or liability for financial reporting thus will constitute a temporary difference.

Because the accounting model for pensions estimates future benefit payments and discounts them to present values, at first it might seem appropriate to consider any pension an asset or liability to be measured at present value for purposes of determining reversal patterns. Further, the ASC 715 model for OPEBs is based on the model for pensions, and we consider the recorded OPEB obligation to be a liability measured at present value. However, because pension obligations typically are funded in advance to some extent, the U.S. federal tax code provides for a tax deduction of the funding, not the future benefit payment.

We believe that it is appropriate to base the reversal of a pension asset or liability on estimates of how and when the recorded asset or liability actually will be reduced. If it is expected that there will be increases in the recorded asset or liability before reductions occur, those would be ignored. The first reductions anticipated would be deemed to apply to the asset or liability existing at the balance sheet date. This approach is similar to that for depreciable assets, where increases in the temporary difference are ignored and reversals are applied on a FIFO basis. The approach we suggest may require consultation with the entity’s actuaries, but we do not believe that significant cost should be involved. Predictions of future events will be very important in estimating the pension reversal pattern.


There may be circumstances in which there is simply no way to make a reasonable estimate of when reduction of the pension temporary difference will occur. In that case, a pragmatic approach will be necessary. The FASB provided a pragmatic approach, which might be reasonable depending on the entity’s circumstances. Under this approach, the temporary difference, whether for an asset or a liability, is deemed to reverse pro rata over the average remaining service life of employees expected to receive benefits under the plan or, when all or almost all participants are inactive, over their average remaining life expectancy.5

5 FASB Special Report on FAS 96.

However, we do not believe that use of the loan amortization or present value methods is appropriate under ASC 740 for pension-related deferred tax balances. We believe that these methods were acceptable because the previous standard prohibited entities from considering future events. Under ASC 740 however, that prohibition has been removed.

5.5.1.2.3 Deferred Foreign Taxes

A foreign branch and/or a foreign subsidiary of a U.S. corporation may generate non-U.S.-source income that is required to be included in the U.S. corporation’s income tax return currently, that is, when the income is earned by the foreign branch or foreign subsidiary. The income and loss of a foreign branch are effectively considered the income or loss of the U.S. corporation branch owner and hence are currently includible in the U.S. corporation income tax return as though the foreign branch were a division of a U.S. corporation. The income of a foreign subsidiary of a U.S. corporation (commonly referred to as a “controlled foreign corporation” or a CFC) is currently includible in the U.S. corporation’s income tax return when the CFC either generates a certain type of foreign-source income considered under U.S. tax law as “subpart F income” or when it pays dividends from foreign-source earnings not previously taxed in the United States. Subpart F income includes certain types of foreign-source income (e.g., certain passive income, certain active business income generated from related parties) that under U.S. income tax law is currently includible in the U.S. corporation’s income tax return. U.S. taxation of subpart F income cannot be deferred—that is, U.S. tax is assessed on subpart F income when earned.

As the same item of income or loss of a foreign branch or a CFC might be taxable both in the foreign country (under the foreign country’s tax laws) and in the United States (under U.S. income tax laws), the U.S. corporation may have to keep two sets of temporary differences: one set of temporary differences for purposes of the U.S. return (those temporary differences would be included in the deferred tax computation for the U.S. consolidated tax group) and another set for foreign tax purposes. The deferred foreign tax asset or liability resulting from application of ASC 740 will be a temporary difference in the deferred U.S. tax computation because it has book basis but no tax basis (for U.S. tax purposes, foreign deferred taxes of the branch do not enter the computation of U.S. taxable income until the foreign temporary differences become current taxes).

For U.S. deferred tax computations, a deferred foreign tax asset of a branch is a taxable difference, and a deferred foreign tax liability is a deductible difference. A future benefit (deductible temporary difference) on the books of the foreign branch or subsidiary will result in less income tax paid for local country tax purposes. Accordingly, the U.S. parent will be entitled to a lesser foreign tax credit or deduction, as a result of the future benefit, than if the foreign branch or subsidiary had a future tax liability (taxable temporary difference). When a deferred foreign tax asset is recovered, it reduces foreign taxes paid, and when a deferred foreign tax liability is settled, it increases foreign taxes paid.

The U.S. tax temporary differences for deferred foreign taxes generally will reverse as the underlying foreign tax temporary differences reverse, but how the reversals will enter into the deferred tax computation will require special consideration. When projecting and scheduling future taxable income, the company needs to consider not only the temporary differences of its foreign operations, but also the sources of income; whether there is sufficient income of the appropriate source (i.e., foreign or U.S.) to utilize foreign tax credits; as well as how the credit or deduction will be incorporated into the projection of taxable income and/or the U.S. deferred tax computation (i.e., at 100 percent for a credit or an amount that is the U.S. federal tax effect from a deduction). The applicable rate in the U.S. deferred tax computation may be 100 percent if foreign taxes are expected to be credited rather than deducted when reversal occurs. U.S. taxpayers have an annual election to deduct foreign taxes paid or to take them as a credit against the tax liability. The use of foreign taxes paid as deductions generally will be of less benefit than their use as credits; however, there are limitations on the use of foreign tax credits, thereby making a deduction, which will reduce taxes paid, of greater benefit than a credit, which might expire.

In deciding whether to deduct or credit foreign taxes paid, the taxpayer also will have to consider any dividends received from foreign subsidiaries. If the taxpayer elects to credit foreign taxes actually paid, then it also must gross up the dividends included in its taxable income, claiming a foreign tax credit of an equal amount for taxes deemed-paid (i.e., the foreign income taxes paid by the foreign subsidiaries in earning the income remitted).

5.5.1.2.4 Tax Return Accounting Method Changes

The effect of a U.S. tax return accounting method change—the cumulative difference at the date of change between the old and new tax methods—generally is reflected in taxable income on a straight-line basis over a period of years, subject to acceleration in certain circumstances. The reversal pattern of the effect of the change, that is, the “spread,” is the pattern expected for actual tax return purposes. There will be another, separate, temporary difference if, after the tax return accounting method change, there is a difference between the book and tax bases of the asset or liability for which the change was made. Generally, this difference reverses when the asset or liability is reduced or disposed of. See Section TX 7.7 for a discussion relating to the accounting for various types of accounting method changes.

5.5.1.2.5 Deferred Revenue or Income

For many types of revenue that enter into taxable income currently but are deferred to some future period for financial reporting (e.g., rent received in advance), it may be difficult to discern just how the temporary difference reverses (i.e., what the future tax consequence will be of earning the income). Under ASC 740, the deferred revenue indicates that a future sacrifice will be required in order to earn the revenue and that sacrifice is measured by the amount of the deferred revenue. The deferred revenue frequently will include future gross profit (i.e., it will exceed the amount of tax deductions expected to be generated in earning the revenue). Nevertheless, the entire amount of deferred revenue must be considered a deductible difference. For purposes of considering its reversal pattern, it is probably easiest to think of the deferred revenue as a liability that will be settled by a deductible cash payment in the period recognized.

5.5.1.2.6 Sale-Leasebacks

One type of deferred income is the gain on a sale-leaseback. It is not uncommon for capital gains tax to be incurred on sales of real estate. Any benefit of a lower capital gains rate would be reflected in the current tax provision, and the deferred gain would be a deductible temporary difference. The deferred gain is deemed to reverse as ordinary deductions (i.e., the excess of future ordinary deductions for lease payments over future book expense, whether rent in an operating lease or depreciation in a capital lease).

5.5.1.2.7 Reserves for Bad Debts and Loan Losses

For specific reserves for bad debts, reversal will occur in the future year when the receivable is expected to be charged off. Generally, reversals would be expected to occur within three years. The same was true for specific reserves for loan losses prior to ASC 310, which permits those practices to be continued.

However, when an allowance for loss on a loan is based on present value measurements under ASC 310, the increase in the present value may be recognized with the passage of time. If so, this would indicate that the pattern of reversal of deductible temporary differences would be determined as discussed for financial instruments (i.e., using the loan amortization or present value method).

Unallocated reserves cannot be associated with an individual loan or trade receivable. Estimates of reversals should be based on management’s best estimate of when receivables or loans outstanding at the balance sheet date will result in actual charge-offs for tax purposes. For financial institutions to assume the sale or exchange of loans (to generate deductions), the loans would have to be carried at the lower of cost or market value. The carrying amount would consider the loan-loss reserves to the extent that they have been provided to cover losses on sales or swaps.

5.5.1.2.8 Inventory Reserves

Reversal occurs as the related inventory turns on a flow-of-goods basis. Obsolete inventory may be anticipated to be sold over, say, a three-year period, while damaged inventory may be expected to be sold for scrap in the next period.

5.5.1.2.9 Reserves for Litigation

The reversal pattern for accruals for litigation should be consistent with management’s intentions and the basis of the accrual. For example, if management intends to “vigorously contest” a claim, the reversal should take into account the sometimes ponderous pace of the legal process. If, on the other hand, management intends to settle and expects to have the ability to do so, reversal in the near term may be expected.

5.5.1.2.10 Warranty Reserves

The reversal pattern should be based on the period in which the claims are expected to be paid. Historical trends generally would be used to estimate the pattern of the reversals. The reversal period should not exceed the warranty period, except for processing delays.

5.5.1.2.11 Stock Appreciation Rights

The compensation expense recognized for book purposes will be deductible when employees exercise the related rights. The accrued compensation expense may in fact be reversed by market price declines. We believe, however, that reversal should be deemed to occur in the year(s) when exercise is anticipated.

5.5.1.2.12 Other

5.5.1.2.12.1 Contract Accounting

The percentage-of-completion method typically will be used for both book and tax purposes in accounting for contracts. However, the tax law measures completion of a contract on the basis of a cost-to-cost analysis and incorporates a number of accounting conventions, which may result in significant differences from the method employed for financial reporting. This temporary difference may originate over several periods and reverse over several periods. Reversals would be determined by estimating all future book and tax amounts. The accumulated differences at the balance sheet date would reverse in the first years in which the differences run in the opposite direction.

5.5.1.2.12.2 Future Taxable Income Other Than Reversals

When scheduling future taxable income for purposes of assessing the need for a valuation allowance, estimating and scheduling future taxable income, other than reversals, by year might be the least technical component of the scheduling process. However, it is generally the most difficult and often the most important. Estimating how much future taxable income the entity will generate involves a great deal of judgment. The extent to which deferred tax assets do not require a valuation allowance often will be dependent on this judgment. Refer to the guidance earlier in this chapter on developing a projection of future taxable income other than reversals.

5.5.1.2.12.3 Carrybacks and Carryforwards

In the United States, carryback and carryforward periods for corporations are generally 2 years and 20 years, respectively, with respect to newly generated NOLs. However, in certain countries, there is no carryback, but there is an indefinite carryforward period. There may be different rules for carrybacks and carryforwards in each city, state, and applicable foreign taxing jurisdiction.

Forgoing a Carryback

The Internal Revenue Code provides an election to forgo the carryback of a loss when there is available taxable income in the carryback years. For example, rates in the carryforward period may be higher than rates in the carryback period. An entity also might make this election if it has used foreign tax credits to reduce or even eliminate the actual taxes payable in the preceding three years. To that extent, the loss carryback will not result in a refund but will only free up the foreign tax credits. However, given the short carryforward period of ten years for foreign tax credits and other restrictive limitations on their use, any freed-up foreign tax credits might expire unused. What the entity can do instead is file an election in the year of the loss to carry it forward.

There may be other circumstances in which credits that would be freed up by carryback of a loss could, in turn, be used by further carryback to claim a refund of taxes paid in years preceding the loss carryback period. In such cases, a carryback benefit at or approaching the full statutory rate may be available.

The election to forgo a carryback should be reflected in the deferred tax computation only when that election actually is expected to be made. In certain circumstances, what actually is expected to take place will not minimize the deferred tax liability. One reason this might occur is that, while the time value of money impacts the actual tax-planning actions an entity expects to take, discounting deferred taxes is not permitted. For example, an entity might carry a loss back because of the time value of money (the benefit from having the cash from the refund immediately), even though the gross benefit—the nominal, undiscounted amount—would be expected to be greater with a carryforward. Depending on the tax rates in the carryback period and valuation allowance requirements, the carryback might have an unfavorable impact on deferred taxes.

5.5.2 Examples of Scheduling

5.5.2.1 Example of Scheduling Future Taxable Income

Example 5-19: Example of Scheduling Future Taxable Income

At the end of 2000, the company identified its temporary differences. The deductible differences exceed the taxable differences by $2,100. In assessing the realization of the deferred tax asset attributable to the $2,100 net deductible difference, the company considered all four sources of possible taxable income, in accordance with ASC 740-10-30-18. Before scheduling future taxable income—including a determination that it did not have any available prudent and feasible tax-planning strategies—the company scheduled the reversals of the temporary differences below. The “net temporary differences” line indicates the year-by-year taxable income or loss that would be generated solely by reversals of temporary differences existing at December 31, 2000.

The company then layered into the analysis its estimated future taxable income other than reversals. At this point, the “net future taxable income before carryback/carryforward” line indicates tax losses in two future years.

The company then applied the tax law for loss carrybacks and carryforwards to the expected future tax losses. Both years with tax losses can be carried back to prior years in the carryback period. At this point, the analysis indicates that all deductions will be used.

It might seem unnecessary in this particular case for the company to estimate and schedule future taxable income, other than reversals, in order to determine that there is sufficient taxable income to use all the deductions. If the carryback and carryforward rules of the tax law had been applied immediately after scheduling the reversals of the temporary differences, all the annual losses indicated on the “net temporary differences” line would have been used by carryback or carryforward. However, as discussed at Section TX 5.4.1.1.3, carryback availability may not support future realization of a deferred tax asset if, in fact, no actual carryback is expected.

In this example, the company has included in its scheduling its estimated future taxable income other than reversals. Those estimates may have been conservative because of the emphasis on objective evidence in the more-likely-than-not assessment, and thus the “future taxable income before carryback/carryforward” line may not be the company’s best estimate of whether there will be actual carrybacks. Nonetheless, the company has sufficient estimated future taxable income so that it is not relying solely on actual carryback to justify its deferred tax asset as more-likely-than-not of realization.

Example of scheduling future taxable income:


If the company had tax credit carryforwards or expected to generate tax credits in the future, the analysis would have to be expanded to incorporate the applicable tax rate and the credits. This would be necessary to assess the realization of the deferred tax assets recorded for the tax credits.

5.5.2.2 Example of Unused Deduction

Example 5-20: Example of Unused Deduction

At the end of 2000, the company has taxable temporary differences related to fixed assets of $10,000, which reverse at a rate $500 per year over the next 20 years. The company also has deductible temporary differences related to OPEB of $10,000, which reverse at the rate of $250 per year over the next 40 years. Expected taxable income, excluding the reversals of temporary differences, is $100 per year. As shown below, after considering the 2-year carryback and 20-year carryforward periods, $700 of the OPEB deductions would not offset any taxable income. Absent a tax-planning strategy, a valuation allowance for $700 of the deductible temporary differences that reverse in years 2027 through 2040 would be recorded.


The $700 of unused deductions consists of $50 in each year 2027–2040.

This example suggests a level of precision in estimates of future taxable income on a year-by-year basis. Even if estimates are made for distant future years on a year-by-year basis, such forecasts are inherently imprecise. However, when it is necessary to estimate the deductible differences or carryforwards that will not be used, an overall estimate would follow the approach illustrated.