To incentivize foreign direct investment and economic development, governments have provided relief from income taxation in many creative ways. In addition to offering the traditional full tax holiday for a specified time period, governments now also provide reduced tax rates, exemptions, and similar special deductions. Some of these benefits are generally available to any enterprise operating in the jurisdiction; others require application or qualification procedures. Determining whether these government tax incentives are tax holidays for accounting purposes, or whether they should receive some other income tax accounting treatment, can be a challenge. In some cases, the incentives may represent government grants or subsidies that fall outside of income tax accounting. This Tax Accounting Insight provides a comparison of the potentially relevant accounting models and highlights some of the factors to consider in determining which model applies.
Neither US Generally Accepted Accounting Principles (US GAAP) nor International Financial Reporting Standards (IFRS) provide a definition of 'tax holiday'. There is, however, guidance on the proper tax accounting for tax holidays under US GAAP. Specifically, the Financial Accounting Standards Board (FASB) considered whether a deferred tax asset should be established for the future tax savings on the premise that such savings are similar to a net operating loss (NOL) carryforward or other tax attribute. In analyzing the issue, the FASB distinguished between two types of tax holidays: one that is generally available to any entity within a class of entities, and one that is controlled by a specific entity that qualifies for it. The first type was likened to a general exemption from taxation for a class of entities, creating nontaxable status for which a deferred tax asset should not be recognized. The second type was perceived to be a 'unique' type of tax holiday because it was not necessarily available to any entity within a class of entities and, as a result, might conceptually require the recognition of deferred tax benefits.
Ultimately, the FASB decided to prohibit recognition of a deferred tax asset for any tax holiday (including those considered unique), because of the practical problems associated with (1) distinguishing between a general tax holiday and a unique tax holiday and (2) measuring the deferred tax asset associated with future benefits expected from tax holidays.
So, although there is no official definition of a tax holiday, it's clear from the guidance that if the future anticipated benefit is the result of a tax holiday, there is no recognition of a deferred tax asset for that future benefit.
In general, under ASC 740, Income Taxes, the effects on existing deferred income tax balances resulting from the initial qualification for a tax holiday or its extension/renewal should be recognized on the approval date or on the filing date if approval is not necessary. There may be exceptions, for instance, if government approval is considered perfunctory because the qualification requirements can clearly and objectively be assessed. In those cases, depending upon a company's specific facts and circumstances, the effects of the holiday may be recorded prior to the final approval.
Additionally, differences often exist between the book and tax basis of assets and liabilities on balance sheet dates within the holiday period. If these differences are scheduled to reverse during the tax holiday, deferred taxes should be measured for the differences based on the conditions of the tax holiday (e.g., full or partial exemption). If the differences are scheduled to reverse after the tax holiday, deferred taxes should be provided at the enacted rate that is expected to be in effect after the tax holiday expires. The expiration of the holiday is similar to an enacted change in future tax rates, which must be recognized in the deferred tax computation. In some circumstances, tax planning actions to accelerate taxable income into the holiday period or to delay deductions until after the holiday may be considered.
There is no specific guidance under IFRS regarding tax holidays, but the treatment of holidays is typically not substantially different than under US GAAP. However, for temporary differences that reverse after the tax holiday period, deferred taxes should be measured at the enacted or 'substantively enacted' tax rates that are expected to apply after the tax holiday period.
Another form of government relief from taxation is the granting of additional tax basis, allowances, or exemption amounts (e.g., a tax credit carryforward). Tax credits granted at the outset of a relief or incentive program typically result from a company committing to expenditures or other transactions that will be incurred. As such, a tax credit may be a result of some incentivized action that will take place in the operations of the company. The amount of the initial credit, once calculated, results in an attribute that may be realized as a benefit in the current period through a reduction to the current period taxes due, if sufficient taxable income exists. If sufficient taxable income does not exist in the current period, the future benefit of the attribute may be reflected as a deferred tax asset, if carryforward is allowed under the local law. In other words, if there is an established and quantifiable future benefit it may be appropriate to recognize a deferred tax asset.
The future benefit would be subject to the traditional analysis for realization (based upon evidence of sufficient future taxable income). A similar framework would apply to a tax attribute in the form of additional tax basis.
ASC 740 doesn't define special deductions, but does offer several examples: (1) statutory depletion, (2) special deductions available for certain health benefit entities, (3) special deductions for small life insurance companies, and (4) IRC section 199 deductions for qualified domestic production activities. In general, the specified special deductions have tax law requirements or limitations that are based upon future performance of specific activities. This future-performance requirement or other limitation generally differentiates the deduction from being equivalent to a tax-rate reduction.
The tax benefit of a special deduction should be recognized no earlier than the year in which the deduction can be taken on the tax return, thereby yielding a permanent benefit in the period of recognition. As such, the benefits of a special deduction should not be anticipated for purposes of offsetting a deferred tax liability for taxable temporary differences at the end of the current year, or as a rate reduction that is applied in measuring deferred taxes.
The benefit of special deductions would impact deferred taxes to the extent the estimation of future taxable income, including the special deduction, affects the graduated rates expected to apply to the deferred taxes. If the special deduction causes taxable income to fall within a lower graduated rate, then deferred tax should be measured at the lower rate. Anticipated benefits should also be considered in assessing the realizability of deferred tax assets if the entity must consider future taxable income, including the benefits from special deductions. Even though there's no reference to special deductions within IFRS, considerations similar to those described under US GAAP are often applied.
While some benefits provided in the income tax laws may be claimed on an income tax return, a number of factors may require that the benefit not be reflected within income taxes, but instead be accounted for in pre-tax income. Some additional factors may need to be considered when making that determination. But generally, a benefit that's refundable even when exceeding tax otherwise due would not be accounted for within the income tax accounts. The benefit would follow a pre-tax income recognition and measurement model.
Given these fine distinctions and limited accounting guidance, a variety of factors should be analyzed to conclude on the appropriate accounting treatment of tax law incentives. Answers to the following questions can help the analysis:
Be mindful that no one factor is necessarily determinative and an analysis of all facts and circumstances should be performed with respect to each particular law or program. If the benefits offered under a particular government incentive regime vary, and are subject to negotiation and agreement with the local authorities, it's possible that different accounting models may apply to different companies under the same jurisdiction's incentive regime.
Disclosure is required with respect to tax holidays and should be considered with respect to the effects of all significant incentives.
Determining whether an incentive falls within the scope of income taxes and identifying the proper income tax accounting treatment for the various new and creative incentive regimes that governments are offering can be challenging. Careful analysis of the specific aspects of the incentive regime is needed to determine its accounting effects. If it's concluded that the government incentive constitutes a tax holiday, a deferred tax asset should not be recorded for the future anticipated benefits. However, the applicable rate utilized to determine deferred taxes should be assessed so that deferred taxes that are expected to reverse within and after the holiday period are tax-effected appropriately. If it's determined that the government incentive is effectively a tax carryforward asset or additional tax basis, then a deferred tax asset should be recorded. This deferred tax asset would be subject to an assessment of realizability performed for all deferred tax assets. An incentive that's considered a special deduction would be recognized in the year in which the benefit is reported in the tax return. If the incentive is more equivalent to a grant or a subsidy, it would be accounted for as part of pre-tax income.
To learn more about tax incentives and financial reporting, refer to Patent box and technology incentives: Tax and Financial reporting considerations and Understanding financial reporting for green and stimulus incentives.
Access a PDF copy of the article on PwC.com.
For a deeper discussion of how this issue might affect your business, please contact your local PwC partner or one of the individuals listed below :
Ken Kuykendall
Global & US Tax Accounting Services Leader
+1 (312) 298-2546
o.k.kuykendall@us.pwc.com
Marjorie Dhunjishah
Latin America & US Tax Accounting Services Partner
+51 (1) 211-6500
marjorie.dhunjishah@pe.pwc.com
David Wiseman
Global & US Tax Accounting Services Partner
+1 (617) 530-7274
david.wiseman@us.pwc.com
Janet Anderson
EMEA Tax Accounting Services Leader
+32 (2) 710-4323
janet.anderson@be.pwc.com
Terry SY Tam
Asia Tax Accounting Services Leader
+86 (21) 2323-1555
terry.sy.tam@cn.pwc.com
Tim Hale
Asia Tax Accounting Services
+852 2289 3783
timothy.j.hale@hk.pwc.com