IT2013_1069_CH03_v2_P2_7-25

Chapter 3:
Temporary Differences

Chapter Summary

Temporary differences are the basis of the deferred tax calculation. A temporary difference exists when any difference between the tax basis of an asset or a liability and its reported amount in financial statements will result in taxable income or deductions upon the reversal of the difference. As discussed in Section TX 3.1, the recognition and measurement model under ASC 740 provides guidance for computing the tax bases of assets and liabilities for financial reporting purposes.

If a basis difference will not affect future taxable income, it is not a temporary difference. ASC 740-10-25-20 presents eight examples of taxable and deductible temporary differences; the first four are temporary differences resulting from items that are included within both pretax income and taxable income but in different periods. The other examples are temporary differences recorded in a business combination; temporary differences created by fixed asset indexation for tax purposes in jurisdictions that allow it; and two different types of temporary differences related to investment tax credits and certain other tax credits. These eight examples are not all inclusive. Other events not described in ASC 740-10-25-20 may give rise to temporary differences. Whatever the event or circumstance, a temporary difference will arise when a basis difference is expected to result in taxable or deductible amounts when the reported amount of an asset or liability in the financial statements is recovered or settled, respectively.





3.1 Temporary Difference—Defined

The definition of a temporary difference per ASC 740-10-20 is as follows:

A difference between the tax basis of an asset or liability computed pursuant to the requirements in Subtopic 740-10 for tax positions, and its reported amount in the financial statements that will result in taxable or deductible amounts in future years when the reported amount of the asset or liability is recovered or settled, respectively. ASC 740-10-25-20 cites eight examples of temporary differences. Some temporary differences cannot be identified with a particular asset or liability for financial reporting (see ASC 740-10-05-10 and ASC 740-10-25-24 through 25-25), but those temporary differences do meet both of the following conditions:

a. Result from events that have been recognized in the financial statements.

b. Will result in taxable or deductible amounts in future years based on provisions of the tax law.

Some events recognized in financial statements do not have tax consequences. Certain revenues are exempt from taxation and certain expenses are not deductible. Events that do not have tax consequences do not give rise to temporary differences.

Chapter TX 16, Accounting for Uncertainty in Income Taxes, includes a comprehensive analysis of the accounting for uncertainty in income taxes. While generally beyond the scope of this chapter, the recognition and measurement model affects the deferred tax calculation. That is, the tax bases of assets (including carryforwards) and liabilities are based on amounts that meet the recognition threshold and are measured pursuant to the measurement requirements. A tax basis computed pursuant to the recognition and measurement model may be different from a tax basis computed for and reported on a filed or expected-to-be-filed tax return. The model makes it clear that the tax basis that meets its recognition and measurement principles is the basis that should be used to calculate a temporary difference. Because many companies will start with a tax basis taken (or expected to be taken) on a tax return (because that information is more readily available), adjustments may be necessary to properly reflect the tax basis pursuant to the model. The following example illustrates the effect that a tax basis computed pursuant to the recognition and measurement model has on temporary differences and the deferred tax calculation:

Example 3-1: Temporary Differences and Tax Bases

Background/Facts:

A fixed asset was placed in service in a prior period with a cost basis for book and tax purposes of $2,000. In the current reporting period, the fixed asset has a book basis of $1,600 and zero tax basis (i.e., for book purposes, the asset is being depreciated over 10 years in equal amounts, while for tax purposes it was depreciated over two years). Hence, the $1,600 basis difference is attributable to accelerated depreciation deductions for tax purposes. However, under the recognition and measurement model for unrecognized tax benefits, the greatest amount of tax depreciation that should have been recorded on the prior and current tax returns cumulatively as of the reporting date is $800, not $2,000.

Question(s):

What is the fixed asset tax basis for financial statement purposes? What is the relevant temporary difference for the deferred tax calculation?

Analysis/Conclusion:

The tax basis for financial statement purposes is $1,200, which is the difference between the $2,000 cost basis and the $800 total tax depreciation deduction under the recognition and measurement principles. Therefore, the temporary difference relating to the fixed asset is $400, which is the difference between the $1,600 book basis reported in the financial statements and the $1,200 tax basis. Assuming an applicable tax rate of 35 percent, a deferred tax liability of $140 (i.e., 35 percent multiplied by the temporary difference of $400) would be recorded. In addition, a liability for unrecognized tax benefits of $420 is recognized (tax basis of $1,200 less tax basis on the tax return of $0 multiplied by 35 percent). See Chapter TX 16 for further discussion of the recognition and measurement model for unrecognized tax benefits.

3.2 Examples of Temporary Differences

As previously noted, the first four examples of temporary differences in ASC 740-10-25-20 result from items that are included within both pretax income and taxable income, but in different periods (for example, an asset is depreciated over a different period for book than for tax purposes). The remaining four examples illustrate other events that create book and tax basis differences, which are discussed below.

3.2.1 Business Combinations (ASC 740-10-25-20(h))

ASC 740 mandates that deferred taxes be provided for temporary differences that arise from a business combination. The differences between the book basis (as determined under ASC 805, Business Combinations) and the tax basis (as determined under the tax law and considering ASC 740’s recognition and measurement model) of the assets acquired and liabilities assumed will be temporary differences that result in deferred tax assets and liabilities. Section TX 10.4 discusses the accounting for deferred taxes in business combinations.

3.2.2 Indexation (ASC 740-10-25-20(g))

Fixed asset temporary differences are impacted by indexation in tax jurisdictions where the tax law allows the tax basis of assets to be indexed and when the tax returns are filed in the functional currency. The benefit of the upward revaluation of the tax basis will be recognized immediately if it satisfies the realization test. The tax laws of only a few countries permit indexing (other than countries that are hyperinflationary, which must use the U.S. dollar as the functional currency). As discussed in Section TX 2.3.5 and Section TX 11.5.5, if a company’s functional currency is not the local currency, the company must exclude the impact that indexing has on the tax basis from its determination of deferred taxes. Therefore, while some countries (e.g., hyperinflationary countries) typically provide for indexing, deferred taxes would not consider the effect of indexing on a tax basis.

3.2.2.1 Temporary Differences Related to U.K. Buildings1

1 This discussion is limited to U.K. buildings, and does not apply to land, fixtures or other types of property, plant and equipment that are not subject to the unique rules applicable to office, industrial and agricultural buildings in the U.K.

Deferred tax accounting related to U.K. buildings is complicated because U.K. buildings, with a limited exception, are not depreciated for tax purposes, although the tax basis is deducted in determining capital gain or loss upon disposal. The tax basis for determining capital gain is the original cost of the building plus indexation for changes in the retail pricing index; however, the tax basis for determining any capital loss is limited to the original cost2 of the building. Therefore, indexation cannot create or increase a capital loss. The discussion herein is divided into two types of commercial real estate: office buildings, and industrial and agricultural buildings. Separate analysis is needed because changes to U.K. tax law enacted in 2008 phased out tax depreciation through 2011 for industrial and agricultural buildings.

2 If a building was acquired prior to March 31, 1982, companies can use a “March 82 value,” instead of its actual original cost, when calculating capital gain or loss on disposal. This is the market value of the property as of March 31, 1982.

Office Buildings:

Deferred tax assets recorded for U.K. office buildings may potentially have two components. First, there is a deferred tax asset (DTA) arising from book depreciation (because there is no tax depreciation). Second, there may be an incremental DTA arising from indexation. That is, an incremental DTA may be recorded in addition to the regular DTA from book depreciation if the expected tax on disposition after considering indexation would be less than the expected tax without considering indexation.

Therefore, the primary accounting issue needing consideration is whether the tax basis created by indexation will provide an incremental tax benefit upon ultimate disposition. The answer depends on whether the building is expected to be sold for gain. We believe there are two acceptable alternatives to determine the expected capital gain and the effect of indexation:

Alternative 1: determine the selling price (fair market value) and the indexed tax basis as of the current balance sheet date.

Alternative 2: estimate the selling price and the projected future indexed tax basis of the building at the projected time of sale.

Mechanically, the calculation of the gain or loss under the two alternatives is the same. The difference is the use of an estimated sale price and an indexed tax basis as of the current balance sheet date (alternative 1) versus at an estimated future date (alternative 2). While either of the two alternatives is acceptable, the remaining discussion herein is limited to alternative 1 because, in practice, most companies follow this alternative.

The following example demonstrates the analysis required to determine whether indexation provides an incremental tax benefit.

Example 3-2: U.K. Buildings—Temporary Differences

A U.K. office building is purchased in 1999 for £100. As of December 31, 2000, the book value of the building (net of accumulated depreciation) is £90. Accordingly, there is a book-tax basis difference at the balance sheet date is £10 (the difference between the original cost and the carrying amount, which is related to accumulated depreciation).


The reporting entity needs to determine whether there is an incremental deductible temporary difference arising from indexing and it follows alternative 1 (i.e., selling price and indexed tax basis are determined as of the current balance sheet date).

The table below illustrates whether indexing provides incremental tax benefit at various levels of current balance-sheet-date projected selling prices and indexing:


There are also ancillary issues to consider:

Prohibition of Discounting—the prohibition in ASC 740 on discounting deferred taxes is not changed with respect to the DTA recorded for indexation.

Valuation Allowance—a valuation allowance would be provided if DTAs are not expected to be realized. In the case of U.K. buildings, because capital gains can be used to offset ordinary (trading) current-year losses, the reduction of a capital gain on a specific building (e.g., as a result of indexing) may not reduce future tax payable. As a result, the realization assessment of capital loss items cannot be done in isolation from the realization assessment of ordinary losses. The reporting entity must project overall income in the U.K. jurisdiction to support realization of the deferred tax asset. If, when estimating future taxes, capital losses will not be utilized, a valuation allowance is required to the extent that consideration of the balance-sheet-date DTAs increases the unused losses from all sources (i.e., ordinary or trading and capital losses).

Use of Indexing to Reduce a Deferred Tax Liability (DTL)—Occasionally, a company sells a building and reinvests the proceeds in a replacement building, which will also be used in the business. In the U.K., any capital gain can be “rolled over” (i.e., applied to reduce the tax basis of the new building). As a result, a taxable temporary difference (the excess of cost over tax basis) arises for the new building. A deferred tax liability would be established. The temporary difference would generally reverse based on the future book depreciation of the replacement asset to be recognized subsequent to the balance sheet date.

For example, assume the sale of a building gives rise to £1 million capital gain for tax purposes. That gain is “rolled over” so that a replacement building costing £10 million has a tax basis of £9 million. For ASC 740 purposes, there will initially be a taxable temporary difference of £1 million for which a deferred tax liability would be recorded upon the “roll over,” and it will be deemed to reverse over the period it will take for the original book cost to be depreciated to a net book value of £9 million.

The question is whether the taxable temporary difference can be reduced in future years not only by book depreciation, but also by tax indexing when it is expected to provide incremental tax benefit. We believe that the annual indexation amount, which is tied to future years’ inflation rates, is a discrete event and should not be anticipated for purposes of not recognizing a deferred tax liability. Rather, the existing tax basis of the asset must be considered when an entity measures the temporary difference and the impact of indexation on deferred taxes should be recognized in each future year when the annual indexation rate is determined.

Industrial and Agricultural Buildings:

The 2008 U.K. Finance Act phases out tax depreciation on industrial and agricultural buildings over a four-year period from 2008 to 2011, and allows for losses on the sale of industrial and agricultural buildings to be treated as capital losses (previously these losses were treated as ordinary losses). Because tax depreciation will not be allowed starting from 2012, the accounting issue needing consideration is whether temporary differences that originated from depreciation should be reversed. The assessment was required when the 2008 Finance Act was enacted.

We accepted two supportable alternatives for determining the amount of deferred taxes related to industrial and agricultural buildings. The alternative selected is an accounting policy choice which should be applied consistently.

Alternative A—Under Alternative A, the only relevant tax basis, after the depreciation phase-out period, for which temporary differences should be calculated, is the tax basis on sale. ASC 740 presumes that any sale will be at book value. However, the relevant tax basis assumed to exist on sale depends on whether the sale is expected to produce gain or loss. If the sale is expected to produce gain (i.e., the adjusted book basis is greater than the original cost adjusted for indexation3), the tax basis is assumed to be the original cost adjusted for indexing. If the sale is expected to produce a loss (i.e., the adjusted book basis is less than the adjusted tax basis), the tax basis is assumed to be the adjusted tax basis (original cost less accumulated tax deprecation). A deferred tax liability that arose from prior book-tax depreciation differences would be retained if a gain is expected. Conversely, a deferred tax asset (subject to realization assessment) would exist if a loss is expected. However, if neither gain nor loss is expected (i.e., when the adjusted book basis is less than the original cost adjusted for indexation, but greater than the adjusted tax basis) no deferred taxes would be needed because there would be no anticipated tax consequences for the presumed sale at book value.

3 This may occur, for example, as a result of a revaluation arising from a non-taxable business combination.

Alternative B—Under Alternative B the adjusted tax basis continues to be the relevant tax basis to use to determine which temporary differences should be calculated because the potential future tax benefit that the company would be entitled to upon abandonment of the building (i.e., capital loss) has been reduced by the tax depreciation already taken. This alternative is supported by ASC 740-10-25-20(d), which indicates that expenses that are deductible before they are recognized in financial income are temporary differences, and that, in this case, amounts received upon the future recovery of the book value of the building will exceed the remaining tax basis and consequently will be taxable when the asset is recovered. Under this alternative, the accounting for existing and additional depreciation-related temporary difference does not change as a result of the enactment of the U.K. Finance Act of 2008.

The following example highlights the differences between Alternative A and Alternative B:

Assume a company has an industrial building with an original cost adjusted for indexation of £1,200, adjusted book basis of £1,000 and an adjusted tax basis of £700. Using these facts, prior to enactment of the Finance Act, a deferred tax liability would have been recorded for the tax effect of the £300 taxable temporary difference (i.e., no impact for indexing on the deferred taxes).

Following Alternative A, the company assumes sale of the building at the book value. Accordingly, because the book basis is greater than the tax basis, but less than the original cost adjusted for indexation, the sale is not expected to produce gain and therefore the deferred tax liability is no longer necessary and can be reversed.

Following Alternative B, the adjusted tax basis is still relevant. Therefore, a deferred tax liability should continue to be provided. This depreciation-related temporary difference will reverse as the building is depreciated for book purposes.

Under both alternatives, continued book depreciation will eventually result in an adjusted tax basis in excess of the book basis. A deferred tax asset (subject to realization assessment) would be recorded for the deferred tax asset arising from book depreciation. Additionally, the accounting related to the incremental DTA from indexation, discussed in the context of U.K. office buildings, would also be considered. The alternative used to determine the expected capital gain and the effect of indexation for office buildings is considered an accounting policy choice which should be consistently applied to agricultural and industrial buildings.

3.2.3 Temporary Differences Related to Investment Tax Credits
(ASC 740-10-25-20(e) and (f))

1. The “deferral” method, under which the tax benefit from an investment tax credit (ITC) is deferred and amortized over the book life of the related property.

2. The “flow-through” method, under which the tax benefit from an ITC is recorded immediately in the period that the credit is generated (to the extent permitted by tax law).

ASC 740-10-25-46 indicates that the deferral method is preferable. The use of one of these methods would reflect a choice of accounting policy, which should be consistently applied.

When the deferral method is elected, the tax benefit from ITCs is typically reflected in pretax income (i.e., as a reduction of depreciation expense). However, we are aware of another acceptable interpretation under which the tax benefit is recognized in the income tax provision over the life of the asset. That is, instead of reducing the cost basis of the qualifying asset, a deferred credit is recognized for ITCs. The deferred credit is released to the income statement through the income tax provision over the life of the qualifying asset. An entity should adopt an accounting policy relating to the manner of applying the deferral method.

What differentiates an ITC from other income credits and from grants is not always easy to discern, because they often share at least a few characteristics. Considerable care should be taken in assessing whether a particular credit should be accounted for as an investment credit, an income tax credit, a non-income tax credit, or a governmental grant. Refer to Section TX 1.2.3 for discussion of the determination of whether credits and other tax incentives should be accounted for under ASC 740.

In accordance with ASC 740-10-25-20(e) and 25-20(f), a temporary difference may arise when accounting for an ITC depending on which accounting method is selected and the extent, if any, to which the tax law requires that the company reduce its tax basis in the property. In applying the deferral and flow-through methods, we believe there are two alternative methods of accounting for any resulting temporary difference:

1. The “gross-up” method, under which deferred taxes related to the temporary difference are recorded as adjustments to the carrying value of the qualifying assets.4

4 The gross-up method is supported by reference to ASC 740-10-25-49 through 25-55; ASC 740-10-45-22 through 45-24; and ASC 740-10-55-171 through 55-182.

2. The “income statement” method, under which deferred taxes related to the temporary difference are recorded in income tax expense.5

5 The income statement method is conceptually consistent with the flow-through method, which ASC 740-10-25-46 identifies as an allowable method of accounting for investment tax credits.

Similar to the choice between the deferral and flow-through methods, the use of one of these accounting methods reflects a choice of accounting policy that should be consistently applied.

The following examples illustrate application of these methods:

Example 3-3: Accounting for Investment Tax Credits with No Tax Basis Reduction

Facts/Question:

Company A is entitled to an ITC for 30% of the purchase price of certain qualifying assets. The ITC can be used to reduce the company’s income tax obligation in the year certain criteria are met. However, the tax law does not result in a reduction to the tax basis of the qualifying assets as a result of claiming the ITC. The applicable tax rate is 40%.

On January 1, 2010, Company A purchases $100 of qualifying assets (i.e., property). The assets will be depreciated for both financial statement and tax purposes on a straight-line basis over a 5-year period.

How should Company A account for the ITC?

Analysis/Conclusion:

As discussed in Section TX 3.2.3, there are two acceptable methods of accounting for ITCs:

1. The deferral method; and

2. The flow-through method.

In accordance with ASC 740-10-25-20(e) and 25-20(f), a temporary difference may arise when accounting for an ITC depending on which accounting method is selected and the extent, if any, to which the tax law requires that the company reduce its tax basis in the property.

Further, as discussed in TX 3.2.3, in applying the deferral and flow-through methods we believe there are two alternative methods of accounting for the resulting temporary differences:

1. The gross-up method; and

2. The income statement method.

Both the choice between the deferral method and the flow-through method, and the choice between the gross-up method and the income statement method represent accounting policy choices which should be applied consistently.

The Deferral Method:

As discussed in TX 3.2.3, the deferral method is preferable. Under the deferral method, the ITC received ($30) is reflected as a reduction in income taxes payable and the carrying value of the qualifying assets. This will result in less depreciation expense over the life of the asset and higher pre-tax income than would be the case under the flow-through method. The deferral method will result in less of a benefit to income taxes (as compared to the flow-through method) over the life of the asset.

In this example, a deductible temporary difference arises since the recorded amount of the qualifying assets will be reduced by $30, the amount of the ITC, to $70 while the tax basis is not reduced by the ITC. The accounting for the temporary difference depends upon whether the company uses the gross-up or income statement method.

a. The gross-up method. As a result of the adjustment described above, there is a deductible temporary difference of $30 related to the qualifying assets. Under the gross-up method, the related deferred tax asset (DTA) would give rise to a reduction in the recorded amount of the qualifying assets which, in turn, would increase the deductible temporary difference related to the qualifying assets. To avoid this iterative process, the amounts assigned to the qualifying assets and the related DTA can be determined using the simultaneous equations method. In this example, the simultaneous equations method yields a DTA of $20 and a reduction to the recorded amount of the qualifying assets of $20. Thus the qualifying assets should be recorded at $50 ($100 purchase price less the $30 ITC less the $20 DTA determined here) together with a DTA of $20. Under the gross-up method, the following journal entries are recorded at the time the ITC is received, January 1, 2010:



In the subsequent years, 2010 through 2014, the following entries are recorded:




b. The income statement method. Under the income statement method, there is no use of the simultaneous equations method. The deductible temporary difference of $30 results in the recognition of a $12 DTA and a corresponding immediate benefit in the income tax provision. Under the income statement method, the following entries are recorded at the time the ITC is received, January 1, 2010:



In the subsequent years, 2010 through 2014, the following entries are recorded:




The Flow-Through Method:

Under the flow-through method the ITC received ($30) is reflected in a reduction to income taxes payable and a current income tax benefit. In this example, under the flow-through method the gross-up and income statement methods are not applicable because the ITC does not result in a change in the tax basis of the qualifying assets and, therefore, there is no resulting temporary difference. The following journal entries are recorded under the flow-through method:




A Comparison of the Financial Statement Impact of the Methods:

The following table demonstrates the cumulative impact to the various income statement captions under each of the methods during the life of the qualifying assets:


Example 3-4: Accounting for Investment Tax Credits with Tax Basis Reduction

Facts/Question:

Company A is entitled to an ITC for 30% of the purchase price of certain qualifying assets. The ITC can be used to reduce the company’s income tax obligation in the year certain criteria are met. However, the tax law requires that the tax basis of the qualifying assets be reduced by 50% of the ITC (e.g., a $30 ITC reduces the tax basis by $15). The applicable tax rate is 40%.

On January 1, 2010, Company A purchases $100 of qualifying assets (i.e., property). The assets will be depreciated for both financial statement and tax purposes on a straight-line basis over a 5-year period.

How should Company A account for the ITC?

Analysis/Conclusion:

As discussed in Section TX 3.2.3, there are two acceptable methods of accounting for ITCs:

1. The deferral method; and

2. The flow-through method.

In accordance with ASC 740-10-25-20(e) and 25-20(f), a temporary difference may arise when accounting for an ITC depending on which accounting method is selected and the extent, if any, to which the tax law requires that the company reduce its tax basis in the property. In a scenario where the tax law requires that the tax basis be reduced, the application of the deferral method will result in a deductible temporary difference if the amount of the basis reduction required is less than the amount of the ITC. Alternatively, application of the flow-through method will result in a taxable temporary difference.

Further, as discussed in TX 3.2.3, in applying the deferral and flow-through methods we believe there are two alternative methods of accounting for the resulting temporary differences:

1. The gross-up method; and

2. The income statement method.

Both the choice between the deferral method and the flow-through method, and the choice between the gross-up method and the income statement method represent accounting policy choices which should be applied consistently.

The Deferral Method:

As discussed in TX 3.2.3, the deferral method is preferable. Under the deferral method, the ITC received ($30) is reflected as a reduction in income taxes payable and the carrying value of the qualifying assets. This will result in less depreciation expense over the life of the asset and higher pre-tax income than would be the case under the flow-through method. The deferral method will result in less of a benefit to income taxes (as compared to the flow-through method) over the life of the asset.

In this example, a deductible temporary difference arises because the recorded amount of the qualifying assets will be reduced by $30, the amount of the ITC, to $70 while the tax basis is reduced by $15 (50% of the ITC) to $85. The accounting for the temporary difference depends upon whether the company uses the gross-up or income statement method.

a. The gross-up method. As a result of the adjustments described above, there is a deductible temporary difference of $15 related to the qualifying assets. Under the gross-up method, the related DTA would give rise to a reduction in the recorded amount of the qualifying assets which, in turn, would increase the deductible temporary difference related to the qualifying assets. To avoid this iterative process, the amounts assigned to the qualifying assets and the related DTA can be determined using the simultaneous equations method. In this example, the simultaneous equations method yields a DTA of $10 and a reduction to the recorded amount of the qualifying assets of $10. Thus, the qualifying assets should be recorded at $60 ($100 purchase price less the $30 ITC less the $10 DTA determined here) together with a DTA of $10. Under the gross-up method, the following journal entries are recorded at the time the ITC is received, January 1, 2010:



In the subsequent years, 2010 through 2014, the following entries are recorded:




b. The income statement method. Under the income statement method, there is no use of the simultaneous equations method. The deductible temporary difference of $15 results in the recognition of a $6 DTA and a corresponding immediate benefit in the income tax provision. Under the income statement method, the following entries are recorded at the time the ITC is received, January 1, 2010:



In the subsequent years, 2010 through 2014, the following entries are recorded:




The Flow-Through Method:

Under the flow-through method the ITC received ($30) is reflected in a reduction to income taxes payable and a current income tax benefit. While, under the flow-through method, there is no reduction to the recorded amount of the qualifying assets as a direct result of receiving the ITC, in this example the tax basis of the qualifying assets is reduced by 50% of the amount of the ITC. Therefore, the recorded amount of the qualifying assets remains at $100 while the tax basis is reduced to $85, resulting in a taxable temporary difference of $15. The accounting for the related deferred tax liability depends upon whether the company uses the gross-up or income statement method.

a. The gross-up method. As a result of the adjustment described above, there is a taxable temporary difference of $15 in the qualifying assets. Under the gross-up method, the related DTL would give rise to an increase in the recorded amount of the qualifying assets, which, in turn, increases the taxable temporary difference related to the qualifying assets. As described under the deferral method, to avoid this iterative process, the simultaneous equations method is used to determine the related DTL and recorded amount of the qualifying assets. In this example, the simultaneous equations method will result in recording the qualifying assets at $110, with a DTL of $10. Under the gross-up method, the following journal entries are recorded:






b. The income statement method. Under the income statement method, there is a $15 taxable temporary difference resulting in the recognition of a $6 DTL and a corresponding immediate expense in the income tax provision. Under the income statement method, the following journal entries are recorded:






A Comparison of the Financial Statement Impact of the Methods:

The following table demonstrates the cumulative impact to the various income statement captions under each of the methods during the life of the qualifying assets:


3.2.3.1 Foreign Investment Tax Credits and Grants

Similar treatment is appropriate for ITCs earned in foreign tax jurisdictions. Some foreign countries make investment grants that do not depend on tax reductions for realization and that might not be taxable. It appears that deferred grants generally should be treated as temporary differences in the computation of deferred foreign tax, potentially with the flow-through effect (described previously) for U.S. investment credits.

The following example illustrates the calculation of the temporary differences associated with foreign grants:

Example 3-5: Temporary Differences Associated with Foreign Grants

Background/Facts:

Company A receives a government grant that will fully reimburse it for the acquisition of a $100 fixed asset. The applicable tax law requires that the grant proceeds reduce the tax basis of the fixed asset; in this instance, the tax basis is reduced to zero and will not provide any future tax deductions from depreciation or upon sale. For financial reporting purposes, Company A records the fixed asset at $100 and records the $100 of grant proceeds as a deferred revenue liability. The deferred revenue will be recognized over a time period and pattern consistent with the fixed asset depreciation. Thus, at the date of acquisition of the asset/receipt of the grant, Company A has (1) a taxable temporary difference resulting from the excess of the book basis of the fixed asset ($100) over its tax basis ($0) and (2) a deductible temporary difference resulting from the excess of the book basis of the deferred revenue liability ($100) over its tax basis ($0).

Question:

Should the temporary differences associated with the fixed asset and deferred revenue be netted or evaluated individually in determining deferred tax balances?

Analysis/Conclusion:

We believe that either approach is acceptable. Company A needs to elect an accounting policy and consistently apply it. As discussed above, two separate temporary differences exist. However, in an analogous situation, ASC 740-10-25-20(f) indicates that investment tax credits are viewed as a reduction of the cost of the related asset for tax purposes. This would seem to indicate that the temporary differences associated with the fixed asset and deferred revenue may be netted and compared with the tax basis. In this instance, there would be no net book or tax basis associated with the fixed asset, and no deferred tax balances would be required.

In this fact pattern, there would be no practical difference between the two approaches. Deferred tax liabilities related to fixed assets are generally noncurrent, and because the deferred revenue will be recognized over a time period and pattern consistent with the fixed asset depreciation, the related deferred tax asset also would be classified as noncurrent. Thus, the balance sheet presentation would be the same under both methods. Also, because the temporary differences will reverse in exactly offsetting amounts in all future periods, there would be no difference in the tax provision under the net and gross methods. The only difference between the two methods is disclosure of a deferred tax asset and a deferred tax liability in the tax footnote under the “gross” approach.

3.2.3.2 Effect on Leases

The ASC 740 treatment of the deferred investment credit will affect the after-tax income patterns for direct-financing leases. For direct-financing leases, practice mostly has been to defer the investment credit and amortize it as additional return on the lessor’s investment. Thus, if there is no need for a valuation allowance in any period, there would be (1) a tax benefit reflected in income in the period that the investment credit is generated and used and (2) offsetting tax charges in later periods.

For leveraged leases, deferral of any available investment credit is a condition for using the ASC 840-10 leveraged-lease model. Section TX 2.3.2 discusses the effect of treating the deferred investment credit from a leveraged lease as a temporary difference.

3.2.4 Debt Instruments

Differences frequently arise between the financial reporting basis and the tax basis of debt instruments. These basis differences must be assessed to determine whether a temporary difference exists for which a deferred tax asset or liability should be provided. Often, the determination of whether a basis difference is a temporary difference will depend on the manner in which the liability is expected to be settled and whether the settlement method is within the company’s control.

3.2.4.1 Contingently Convertible Debt

A company issues contingently convertible debt that is convertible into common stock once the common stock reaches a target market price. In lieu of deducting the stated rate of interest actually paid to the note holders, the tax law allows the company, in certain cases, to deduct interest equal to that of comparable nonconvertible fixed-rate debt. Total interest deductions for tax purposes will therefore exceed total interest expense recognized for financial reporting purposes. However, interest deductions in excess of the stated rate will be recaptured for tax purposes, in whole or in part, if the debt is retired (either through redemption or at maturity) or converted to stock with a value of less than the adjusted tax basis of
the debt.

Does the excess interest deduction result in a taxable temporary difference for which a deferred tax liability should be provided? In this example, reversal of the difference (i.e., recapture of the excess interest deduction) is not within the company’s control because conversion is at the option of the holder and, even upon conversion, interest recapture is dependent on the market value of the common stock at that time. We believe that a deferred tax liability should be recorded for the tax effect of redeeming the debt at its stated amount. Upon conversion of the notes, the deferred tax liability would be reversed, with a corresponding credit to additional paid-in capital for the tax effect of the conversion.

3.2.4.2 Convertible Debt and Call Option

A company purchases, in conjunction with issuing a convertible debt instrument, a call option to buy the same number of its own shares that it would have to issue if the holders elect to convert their interest to equity. The purchase of a call option is recorded in stockholder’s equity at inception and is not marked-to-market in subsequent periods consistent with ASC 815-40, Derivatives and Hedging. From a tax perspective, a purchased call option is treated as an original-issue discount and, as such, is (1) deductible as interest expense (in addition to cash interest) during the periods the liability is outstanding and (2) integrated with the stated principle resulting in an adjusted issue price (i.e., tax basis) that is lower than the liability’s carrying amount. The questions that arise are whether the future tax benefits from the original-issue discount represent a deductible temporary difference, consistent with ASC 740-10-25-20, and, in making this determination, should management’s expectation as to whether the holder will elect to convert its interest to equity factor into the analysis.

We believe that the reversal of the original-issue discount basis difference is not within the control of the issuer; instead, it is the holder of the note who controls whether to hold the debt or convert to equity; therefore, a deductible temporary difference exists. At inception, a deferred tax asset will need to be recognized through stockholder’s equity consistent with ASC 740-20-45-11(c) and ASC 740-10-55-51 (see Section TX 3.2.4.4 for a discussion on ASC 740-10-55-51). If the debt were converted to equity prior to maturity and if under the relevant tax laws and applicable facts the remaining original issue discount is non-deductible, then the charge to remove any remaining deferred tax asset would also be recorded against equity.

ASC 470-20-15 clarifies that convertible debt instruments that may be settled in cash upon conversion, including instruments settled partially in cash, are not considered debt instruments within the scope of ASC 470-20. ASC 470-20-25 and 30 clarify that issuers of such instruments would have to account for the liability and equity components of the instrument separately and in a manner that reflects interest expense at the interest rate of similar nonconvertible debt. That is, issuers of such instruments need to allocate the proceeds from issuance of the instrument between the liability component and the embedded conversion option (i.e., the equity component). This allocation is first done by determining the carrying amount of the liability component based on the fair value of a similar liability excluding the embedded conversion option, and then allocating to the embedded conversion option the excess of the initial proceeds ascribed to the convertible debt instrument over the amount allocated to the liability component. That excess is reported as a debt discount and is initially recognized in additional paid-in capital. In subsequent periods, it is amortized as interest cost over the instrument’s expected life using the interest method.

From a tax accounting perspective, the application of ASC 470-20 will often result in a basis difference associated with the liability component. The basis difference is measured as the difference between the liability component’s carrying value (i.e., the stated principle amount or par value adjusted for the debt discount created under the provisions of ASC 470-20) and the convertible debt instrument’s tax basis (which would generally be its original issue price adjusted for any original-issue discount or premium). While the debt discount is accreted to income, it is not considered deductible interest for tax purposes. Consequently, the accretion of the debt discount would result in tax consequences (i.e., a portion of the book interest expense would not be deductible) and the basis difference created by a debt discount is a temporary difference (consistent with ASC 740-10-25-20 and ASC 740-10-55-51). At inception, a deferred tax liability needs to be recorded through additional paid-in capital. In subsequent periods, the deferred tax liability will be reduced and a deferred tax benefit will be recognized through earnings as the debt discount is amortized to pre-tax income.

ASC 470-20 may apply to certain convertible debt instruments that contain contingent interest provisions (contingently convertible debt). It may also apply to convertible debt instruments for which the issuer purchases a call option on its own shares. Both of these instruments enable the issuer to receive additional tax deductions (in addition to cash interest) that may be more comparable with the tax benefit an issuer would expect to receive on nonconvertible debt. Companies that issue these forms of convertible debt will have to record deferred tax liabilities for the debt discount that arises as a result of applying the accounting model in the FSP in addition to recording deferred tax assets for tax original-issue discounts and deferred tax liabilities for potential recapture of interest deductions. While these temporary differences relate to the same liability and can be tracked and computed on a combined/net basis, companies may choose to separately track the temporary differences and the deferred tax amounts in their income tax provision work papers or tax accounting systems.

ASC 470-20 is effective for fiscal years beginning after December 15, 2008 and for interim periods within those fiscal years. It is required to be applied retrospectively to convertible debt instruments that are within the scope of this guidance and were outstanding during any period presented in the financial statements. A cumulative effect adjustment must be recognized as of the beginning of the first period presented.

3.2.4.3 Debt Instruments with Temporary Differences That May Not Result in Future Deductible Amounts

A company issues discounted convertible debt, which, for financial reporting purposes, is accreted to face value through a charge to interest expense over the life of the debt. For example, a company issues debt with a face value of $100 in exchange for $80 cash. The tax basis of the debt is $80. The book basis of the debt is also initially $80. However, for book purposes, the debt must be accreted to $100. In certain tax jurisdictions, the tax law allows deductions if the debt is extinguished by repurchase or repayment at maturity, but does not allow deductions if the debt is converted into equity. For book purposes, the debt is converted at its carrying value on the conversion date.

This leads to two questions: (1) is there a future deductible temporary difference between the book basis and tax basis of the debt, to the extent that the discount has been accreted for book purposes and (2) does the answer change if management expects the holders to convert the debt into equity (i.e., in which case there would be no future tax deduction)?

The FASB staff addressed this matter and indicated that a temporary difference exists to the extent that the debt has a different basis for book and tax purposes, irrespective of expectations that the holders are likely to convert. The FASB staff further indicated that ASC 740-10-25-30 would not apply in this situation (see Section TX 3.3 for a discussion of this guidance). The staff believes that the notion of “control” is implicit in the term “expects,” which is used in connection with management’s expectations regarding officer’s life insurance. Therefore, because the holders of the convertible debt (not management) control the outcome (debt vs. equity), it would not be appropriate to analogize this temporary difference to cash surrender value. Further, we believe that if the debt is ultimately converted to equity, the corresponding charge to reverse the deferred tax asset would be to shareholders’ equity in accordance with ASC 740-20-45-11(c), even though the tax benefit from establishing the deferred tax asset was originally credited to the income statement.

3.2.4.4 Convertible Debt with a Beneficial Conversion Feature
and Detachable Warrants

ASC 740-10-55-51 concluded that the initial difference between the book value of convertible debt issued with a beneficial conversion feature (BCF) and its tax basis is a temporary difference. A resulting deferred tax liability should be recorded with an offset to additional paid-in capital in accordance with ASC 740-20-45-11(c). Pursuant to ASC 250-10, Accounting Changes and Error Corrections, the guidance should be applied by retrospective application to all instruments with a BCF accounted for under ASC 470-20, Debt. Therefore, this guidance would also be applicable to debt instruments that were converted (or extinguished) in prior periods, but are still presented in the financial statements.

For example, assume a company issues convertible debt with detachable warrants for total consideration of $200. Pursuant to ASC 470-20, $160 of the proceeds are allocated to the convertible debt and $40 of the proceeds are allocated to the warrants (additional paid-in capital). The company also records a BCF of $40 that further reduces the initial carrying amount of the debt to $120. Assume that (1) the conversion feature does not require bifurcation under ASC 815-10, (2) the warrants are accounted for as permanent equity, and (3) the company’s tax rate is 40 percent.

In this example, recognition of the BCF creates a $40 difference between the $120 financial reporting amount and the $160 tax basis of the debt. For convertible debt subject to ASC 470-20, this difference will reverse either through amortization of the discount or upon conversion or settlement of the debt. Pursuant to ASC 740-10-55-51, a $16 deferred tax liability should be established ($40 x 40%) upon issuance of the debt and warrants. The offset should be recorded to additional paid-in capital.

As the BCF is amortized, the related deferred tax liability is released to income. Because the BCF amortization is not a tax-deductible expense, the release of the deferred tax liability offsets the current tax expense.

3.2.4.5 Tax Implications of Induced Conversions of Convertible Debt

Under ASC 470-20 an induced conversion results in an inducement charge that is measured as the fair value of the equity securities or other inducement consideration issued in excess of the fair value of the equity securities, which are issuable pursuant to the original conversion terms. However, a taxable gain could result from an induced conversion transaction if the carrying value of the debt were to exceed the market value of the equity securities issued. A loss for tax purposes cannot result from such a transaction. ASC 740-20-45-11(c) indicates that the tax effect of an increase or decrease to contributed capital is charged or credited directly to shareholders’ equity. Accordingly, the taxes paid on the tax gain resulting from conversion should be charged to equity.

Assume, for example, the following fact pattern:

An entity issues a $1,000 convertible bond with a 6 percent coupon rate.

The bond is originally convertible into twenty-five shares of common stock.

The market price of the stock at the date on which the bond was issued is $40.

Subsequently, the market price of the stock drops to $20, and the entity offers
an additional fifteen shares of stock in order to induce conversion.

The tax rate is 40 percent.

For accounting purposes, the entity in the above example recognizes a $300 income statement charge (fifteen incremental shares at $20 per share) as a result of the inducement. For tax purposes, however, the difference between the carrying amount of the debt ($1,000) and the fair value of the equity securities issued (40 shares at $20 per share, or $800) is a $200 taxable gain. A tax benefit should be recognized in relation to the inducement expense recorded for financial reporting purposes if the inducement results in an incremental tax savings to the entity.

The FASB staff addressed this and agreed that both the actual taxes paid on the gain ($200 x 40%, or $80) and the taxes “avoided” by issuing the inducement shares ($300 x 40%, or $120) should be charged to equity. The latter portion is determined by applying a with-and-without approach to the inducement portion of the transaction. If there was no inducement, 25 shares would have been issued with a value of $500, as opposed to the $1,000 carrying value. This would result in a $500 tax gain. That is, without the inducement, the tax expense would have been $200 (tax gain of $500 x 40%); with the inducement, the tax expense would only be $80. Thus, the inducement produces a $120 benefit that should be allocated to continuing operations, with a corresponding charge to shareholders’ equity.

If, in the above fact pattern, the stock price decreased to $30 instead of $20, and the entity decided to issue an additional fifteen shares to induce conversion, there would be no actual tax consequences because the fair value of the equity securities ($1,200) would be greater than the tax basis of the debt. A loss for tax purposes cannot result from such a transaction. However, a $100 tax benefit would be recognized in the income statement, with a corresponding tax charge recorded in equity. The $100 tax benefit represents the tax expense avoided on what would otherwise have been a $250 taxable gain if there had been no inducement (the 25 shares would have been issued with a value of $750, as opposed to the $1,000 carrying value).

3.2.5 Low-Income Housing Credits

Section 42 of the Internal Revenue Code provides a low-income housing credit (LIHC) to owners of qualified residential rental projects. The LIHC is generally available from the first year the building is placed in service and continues annually over a ten-year period, subject to continuing compliance with the qualified property rules. Generally, the LIHC will affect the computation of the current tax provision, rather than the deferred tax provision, in the year that the credit is actually used on the taxpayer’s tax return. However, the LIHC is subject to annual limitations, and any unused portion of the credit can be carried forward for twenty years. An LIHC carryforward should be recognized as a deferred tax asset and evaluated for realization like any other deferred tax asset. The full amount of the LIHC that is potentially available over the ten-year period should not be included in the tax provision in the initial year that the credit becomes available, because the entire amount of the credit has not been “earned” and, thus, is not available to offset taxable income in the year that the qualified property is placed in service.

While some would argue that the LIHC is similar to the ITC and that the full amount of the credit should be recognized in the year that the qualified housing is placed in service, we believe that the differing tax laws applicable to these credits necessitate a distinction in the recognition criteria for financial statement purposes. ITC is generally available to offset taxable income in the year that the qualified asset is placed in service and is subject to certain recapture provisions. Conversely, only a portion of the LIHC is available to offset taxable income in each year over a ten-year period and is subject to recapture during a fifteen-year compliance period. While each credit may be affected by recapture in future years, we believe that the initial recognition of the credit for financial statement purposes should be based on when the credit is actually available to offset taxable income in the tax return.

ASC 323-740, Investments-Equity Method and Joint Ventures reached several consensuses related to the accounting (by investors) for investments in limited partnerships that are formed to hold qualified affordable housing projects and distribute tax benefits to investors, including (1) the restricted conditions under which an entity may elect to account for its investment in an affordable housing project by using an “effective yield” method and, alternatively, (2) when the investment should be accounted for under the equity or cost method.


It should be noted that the application of ASC 810-10, Consolidation may impact the accounting for investments in entities that hold investments in LIHC projects, because such entities may constitute variable interest entities. See Section TX 11.1.10.1.

3.2.6 Synthetic Fuels Projects

Section 29 of the Internal Revenue Code, which has been redesignated as Section 45K, was enacted as part of the Crude Oil Windfall Profit Tax Act of 1980 to provide a tax credit based upon the production and sale of qualified fuels extracted or developed from non-conventional sources including liquid, gaseous, or solid synthetic fuels produced from coal. As a consequence of the available tax incentives, companies have developed projects to produce and sell solid synthetic fuels (“Synfuel”).

Given the tax-motivated nature of these investments, companies often desire to account for their investments in Synfuel projects (including the pretax effects) within income tax expense on the income statement. Some have proposed using the effective yield method by analogy to ASC 323-740-25-1. However, when the EITF reached the consensus on this issue, the SEC Observer stated that the staff believes it would be inappropriate to extend the effective yield method to analogous situations.

In response to the SEC concerns raised in connection with the use of the effective yield method, some practitioners have proposed accounting for investments in Synfuel projects under the equity or cost method (depending on the respective ownership interest), but presenting both the pretax results and tax credits on a net basis within income tax expense. This approach was discussed with the SEC staff who indicated their belief that there is no basis for netting pretax results of operations within the income tax line (presumably unless GAAP otherwise permits doing so). Rather, these investments should be accounted for under ASC 970-323, Real Estate, and ASC 323-10 in the conventional manner. In addition, the staff noted that there may be a need for additional transparency in these cases (in terms of enhanced disclosure in both the footnotes and in MD&A).

3.2.7 Subsidies Related to Medicare Part D

The Medicare Prescription Drug, Improvement and Modernization Act of 2003 provided for a tax-free subsidy to plan sponsors (i.e., employers) under certain circumstances, while payments for retirees’ health benefits remained fully deductible by the plan sponsor (i.e., plan sponsors received a tax deduction when they paid retiree health benefits, including prescription drug benefits, even though they would not be taxed on any subsidy received under the Act).

In March 2010, President Obama signed into law legislation that effectively resulted in these subsidy payments being taxable in tax years beginning after December 31, 2012. The Patient Protection and Affordable Care Act (the PPACA) contained a provision that changes the tax treatment of the subsidy by requiring the subsidy received to be offset against the amount of retiree health care payments that would be eligible for a tax deduction. Thus, the change in tax treatment does not actually affect the taxation of the subsidy itself. Instead, the subsidy received will reduce the employer’s tax deduction for the costs of retiree health care.

As a result of this change, the deferred tax asset on the employer’s balance sheet associated with the subsidy was required to be reduced. Although the law did not become effective until tax years beginning after December 31, 2012, under ASC 740, the impact of the change in tax law was immediately recognized in continuing operations in the financial reporting period that included the enactment date (i.e., the date signed into law by President Obama).


3.2.8 IRC Section 162(m) Limitation

The tax deduction that an employer is eligible for under IRC Section 83(h) may be subject to certain limitations. One limitation is the million-dollar limitation, established by IRC Section 162(m), which provides that, for public companies, the annual compensation paid to individual covered employees in excess of $1 million during the taxable year is not tax deductible. In general, the $1 million limitation does not apply to performance-based compensation. A determination regarding which employees qualify as covered employees is made as of the last day of the taxable year. Covered employees include the chief executive officer and the company’s four other most highly-compensated officers, pursuant to the SEC’s rules for executive-compensation disclosures in the annual proxy statement.

If annual compensation includes both cash compensation and stock-based-compensation (other than performance-based compensation), then a company should first assess whether or not a covered employee’s compensation will be subject to the Section 162(m) limitation. The anticipated effect of the Section 162(m) limitation should be considered, using one of three methods (as discussed below), when recognizing deferred tax assets for awards that may be subject to the limitation. The selection of a method should be treated as the election of an accounting policy and should be applied consistently.

We believe that any of the following approaches would be acceptable for determining whether a deferred tax asset should be recorded for stock-based compensation that is subject to the IRC Section 162(m) limitation:

The impact of future cash compensation takes priority over stock-based-compensation awards. For example, if the anticipated cash compensation is equal to or greater than the total tax-deductible annual compensation amount
($1 million) for the covered employee, an entity would not record a deferred tax asset associated with any stock-based-compensation cost for that individual.

The impact of the stock-based compensation takes priority over future cash compensation and a deferred tax asset would be recorded for the stock-based compensation up to the tax deductible amount.

Prorate the anticipated benefit of the tax deduction between cash compensation and stock-based compensation and reflect the deferred tax asset for the stock-based-compensation award based on a blended tax rate that considers the anticipated future limitation in the year such temporary difference is expected to reverse.

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“Act”) was signed into law to provide emergency liquidity to the U.S. economy. Under the Act’s Troubled Asset Relief Program (TARP), the U.S. Department of Treasury is authorized to purchase troubled assets directly from financial institutions or through auction. Entities that participate in the TARP or other government programs may be subject to new executive compensation restrictions and corporate governance standards.

3.3 Basis Differences That Will Reverse with No Tax Consequence

ASC 740-10-25-30 discusses the concept of basis differences that do not result in a tax effect when the related assets or liabilities are recovered or settled. As noted in the definition of a temporary difference, events that do not have tax consequences when a basis difference reverses do not give rise to temporary differences.

3.3.1 Excess Cash Surrender Value of Life Insurance

The excess of the cash surrender value of life insurance (a book asset) over the premiums paid (the tax basis) is a basis difference, which is typically not a temporary difference. When a company owns a life insurance policy, management typically intends to maintain the policy until the death of the insured, in which case the proceeds of the policy would not be taxable for regular tax purposes. ASC 740-10-25-30 cites this as an example of a basis difference that does not result in a tax effect when it reverses (because the proceeds are not taxable).

Implicit in the words “expected to be recovered” is the notion of an employer’s control over the decision to surrender or hold the policy until the death of the employee. If an employer corporation does not expect to keep an insurance policy in force until the death of the insured, it must record a deferred tax liability for the excess book-over-tax basis because the basis difference in this circumstance will be taxable when it reverses. Additionally, if a company previously believed it would keep a policy in force until the insured’s death but no longer believes that it will do so, then it must recognize a deferred tax liability on the basis difference even if it expects to keep the policy in force for a number of years. A company’s ability to control the decision about holding a policy until the death of the insured may be affected by the existence of any employee cancellation option.

There may be alternative minimum tax (AMT) income during the holding period and upon receipt of death proceeds. If this is the case, no deferred tax liability should be established. If the intent is to surrender the policy for its cash value, a deferred tax liability should be provided for the tax that will be paid on the excess of the cash surrender value over cumulative premiums paid. No deduction is available for regular tax purposes; however, there may be a deduction for AMT, if, upon surrender of a policy, cumulative premiums exceed the cash surrender value.

3.4 Issues to Be Considered in Identifying Temporary Differences

As noted earlier in the chapter, a temporary difference is a difference between the tax basis (determined under the tax law and taking into consideration the recognition and measurement model of ASC 740) of an asset or a liability and its reported amount in the statement of financial position that will result in taxable or deductible amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled. Because the definition of a temporary difference hinges on the difference between the book basis and tax basis of an item, the comparison of a GAAP-compliant balance sheet with a balance sheet that is prepared on a tax basis is often the best way to identify temporary differences. In many instances, there will be both a book and a tax basis (e.g., in the case of fixed assets). In other instances, there will be a GAAP basis and no tax basis, as in the case of GAAP expense accruals that are not tax deductible until they are paid. In yet other instances, there may be a tax basis but no GAAP basis, as in the case of organizational costs expensed for GAAP purposes but capitalized and amortized for tax purposes. Sections TX 3.4.1 to 3.4.5 discuss certain types of temporary differences.

3.4.1 Basis Differences That Are Not Accounted for Under the Basic Model for Deferred Taxes

ASC 740-10-25-3 lists the exceptions to the use of the comprehensive model for recognizing deferred taxes. These exceptions, which also are discussed in Section TX 2.3, include:

Indefinite reinvestment exceptions for an investment in a subsidiary or a corporate joint venture that is essentially permanent in duration.

Transitional procedures for temporary differences related to deposits in statutory reserve funds by U.S. steamship entities.

Accounting for leveraged leases, as required by ASC 840-10.

Prohibition against recognizing a deferred tax liability related to goodwill (or a portion thereof) for which amortization is not deductible for tax purposes.

For income taxes paid on intercompany profits on assets remaining within the group, prohibition against recognizing a deferred tax asset for the difference between the tax basis of the assets in the buyer’s tax jurisdiction and their cost as reported in the consolidated financial statements under ASC 810.

Prohibition against recognizing a deferred tax liability or asset for differences related to assets and liabilities that, under ASC 830-10, Foreign Currency Matters are remeasured from the local currency into the functional currency using historical exchange rates and that result from (1) changes in exchange rates or (2) indexing for tax purposes.

In addition, ASC 718-20-55-20 prohibits the recording of a deferred tax asset for windfall benefits that do not reduce taxes payable.

A tax-planning strategy cannot be used to avoid recording deferred taxes. ASC 740-10-55-46, states:

Under this Subtopic, the requirements for consideration of tax-planning strategies pertain only to the determination of a valuation allowance for a deferred tax asset. A deferred tax liability ordinarily is recognized for all taxable temporary differences. The only exceptions are identified in ASC 740-10-25-3. Certain seemingly taxable temporary differences, however, may or may not result in taxable amounts when those differences reverse in future years. One example is an excess of cash surrender value of life insurance over premiums paid (see paragraph 740-10-25-30). Another example is an excess of the book over the tax basis of an investment in a domestic subsidiary (see ASC 740-30-25-7). The determination of whether those differences are taxable temporary differences does not involve a tax-planning strategy as that term is used in this Topic.

3.4.2 Temporary Differences Where Reversal Might Not Occur
in the Foreseeable Future

The ASC 740 model does not take into account the timing of reversal. Although a company might be able to delay a tax effect indefinitely, the ability to do so is not a factor in determining whether a temporary difference exists. ASC 740-10-55-63 addressed this issue and stated in part:

Under the requirements of this Topic, deferred tax liabilities may not be eliminated or reduced because an entity may be able to delay the settlement of those liabilities by delaying the events that would cause taxable temporary differences to reverse. Accordingly, the deferred tax liability is recognized. If the events that trigger the payment of the tax are not expected in the foreseeable future, the reversal pattern of the related temporary difference is indefinite and the deferred tax liability should be classified as noncurrent.

As stated in Section TX 3.4.1, the only exceptions to the recognition of deferred taxes on temporary differences are listed in ASC 740-10-25-3, and in ASC 718-20-55-20.Thus, although it might be necessary to record a temporary difference that might not reverse in the foreseeable future, the determination that the temporary difference was indefinite (i.e., the reversal was not expected in the foreseeable future) could impact the assessment of whether (1) there would be a source of income to realize a deferred tax asset or (2) a deferred tax liability would provide a source of income to recognize other deferred tax assets. See Section TX 5.4 for additional discussion.

3.4.3 Consideration of Settlement at Book Carrying Value

ASC 740-10-25-20 notes that, inherent in an entity’s statement of financial position is the assumption that the reported amounts of assets will be recovered and the reported amounts of liabilities will be settled. Consequently, in the case of financial statement assets that do not have a corresponding tax basis (e.g., intangible assets established in a nontaxable business combination), there is the presumption that, if the asset were to be recovered at its book carrying value, the gain on the sale proceeds would represent a future tax effect that must be accounted for.

3.4.4 Temporary Differences Not Identified with an Asset or a Liability

Some temporary differences result from events that have been recognized in the financial statements, but are based on provisions of the tax law. Such temporary differences will be taxable or deductible in the future and therefore cannot be identified with a particular asset or liability for financial reporting purposes. For example, a temporary difference arises when a long-term contract is accounted for by the percentage-of-completion method for financial reporting and under the completed-contract method for tax purposes, with income on the contract deferred until contract completion. Hence, a temporary difference arises from the deferred income, and a deferred tax liability is required even though such temporary difference is not identified with a particular liability for financial reporting. Another example is organizational costs that are expensed as incurred for financial reporting, but are capitalized and amortized for tax purposes (ASC 740-10-25-24 through 25-26).

3.4.5 U.S. Federal Temporary Differences Relating to State Income Taxes

Example 3-6: Effect of State Temporary Differences on the Federal Tax Calculation

As referenced in ASC 740-10-55-20, the following addresses the treatment of the effect that state temporary differences have on the calculation of federal tax.

Question:

State income taxes are deductible for U.S. federal income tax purposes. Does a deferred state income tax liability or asset give rise to a temporary difference for purposes of determining a deferred U.S. federal income tax liability or asset?

Answer:

Yes. A deferred state income tax liability or asset gives rise to a temporary difference for purposes of determining a deferred U.S. federal income tax asset or liability, respectively. The pattern of deductible or taxable amounts in future years for temporary differences related to deferred state income tax liabilities or assets should be determined by estimates of the amount of those state income taxes that are expected to become payable or recoverable for particular future years and, therefore, deductible or taxable for U.S. federal tax purposes in those particular future years.