State taxes based on the greater of franchise tax or income tax Excerpt from Accounting Standards Codification Excerpt from Accounting Standards Codification

Income Taxes — Overall Scope and Scope Exception 740-10-15-4

The guidance in this Topic does not apply to the following transactions and activities:

a. A franchise tax to the extent it is based on capital and there is no additional tax based on income.

If there is an additional tax based on income, that excess is considered an income tax and is subject to the guidance in this Topic. See Example 17 (paragraph 740-10-55-139) for an example of the determination of whether a franchise tax is an income tax.

Implementation Guidance and Illustrations 740-10-55-139

The guidance in paragraph 740-10-55-26 addressing when a tax is an income tax is illustrated using the following historical example.

740-10-55-140

In August 1991, a state amended its franchise tax statute to include a tax on income apportioned to the state based on the federal tax return. The new tax was effective January 1, 1992. The amount of franchise tax on each corporation was set at the greater of 0.25 percent of the corporation's net taxable capital and 4.5 percent of the corporation's net taxable earned surplus. Net taxable earned surplus was a term defined by the tax statute for federal taxable income.

740-10-55-141

In this Example, the total computed tax is an income tax only to the extent that the tax exceeds the capital-based tax in a given year.

740-10-55-142

A deferred tax liability is required to be recognized under this Subtopic for the amount by which the income-based tax payable on net reversing temporary differences in each future year exceeds the capital-based tax computed for each future year based on the level of capital that exists as of the end of the year for which deferred taxes are being computed.

740-10-55-143

The portion of the current tax liability based on income is required to be accrued with a charge to income during the period in which the income is earned. The portion of the deferred tax liability related to temporary differences is required to be recognized as of the date of the statement of financial position for temporary differences that exist as of the date of the statement of financial position.

740-10-55-144

Because the state tax is an income tax only to the extent that the tax exceeds the capital-based tax in a given year, under the requirements of this Subtopic, deferred taxes are recognized for temporary differences that will reverse in future years for which annual taxable income is expected to exceed 5.5% (.25% of net taxable capital/4.5% of taxable income) of expected net taxable capital. In measuring deferred taxes, see paragraph 740-10-55-138 to determine whether a detailed analysis of the net reversals of temporary differences in each future year is warranted. While the tax statutes of states differ, the accounting described above would be appropriate if the tax structure of another state was essentially the same as in this Example.

Franchise taxes are often referred to as “privilege” taxes because the tax is levied on all entities granted authority by the state to conduct business within its jurisdiction (i.e., the state allows the company to have the privilege of operating within the state). An example of a state franchise tax is included in ASC 740-10-55-139 through ASC 740-10-55-144. In this example, the amount of franchise tax owed by a corporation was the greater of (A) 0.25 percent of the corporation’s net taxable capital, as defined, or (B) 4.5 percent of the corporation’s net taxable earned surplus. Net taxable earned surplus was a term defined by the tax statute and is based on federal taxable income. Additionally, the total computed tax is an income tax only to the extent that the tax exceeds the capital-based tax in a given year

(ASC 740-10-55-141).

We believe a franchise tax with essentially the same tax structure as the example above should be considered to be comprised of two elements under ASC 740, a franchise tax and an income tax. To the extent the tax is based on net taxable capital, it is a franchise tax that should be accrued in the year to which the privilege relates. If there is additional tax due based on income, that excess is considered to be an income tax that should be accrued in the year the income was earned. The income-based franchise tax should be included in a company’s estimated annual effective tax rate for purposes of applying ASC 740-270 to interim financial statements.

Illustration 5-8

Assume net taxable capital at 31 December 20X0 is $10.0 million and net taxable earned surplus is

$1.0 million for the year ended 31 December 20X0. Also, assume that the privilege period to which the franchise tax relates is 20X1 franchise taxes for 20X0 and would be computed as follows:

Net taxable capital at 31 December 20X0 $ 10,000,000

Tax rate 0.25%

Franchise tax based on capital $ 25,000 A

Net taxable earned surplus — 20X0 $ 1,000,000

Tax rate 4.50%

Franchise tax based on income $ 45,000 B

Additional tax based on income $ 20,000 B — A

Based upon the above assumptions, the company would recognize $20,000 (or $45,000 income tax less

$25,000 capital tax) of the franchise tax as income tax expense in 20X0. This is because net taxable earned surplus for the 20X1 franchise tax period is based on income earned in calendar 20X0. On the other hand, the remaining $25,000 tax based on capital relates to the calendar 20X1 privilege period and would be recognized in 20X1 as an operating expense. That is, the $25,000 is not a tax based on income. If the franchise tax based on capital had exceeded the franchise tax based on earnings, no amount would be recognized in 20X0.

5.6.4.1 Revised Texas franchise tax

On 18 May 2006, Texas revised its franchise tax (the Revised Tax). The Revised Tax created a new franchise tax. The new franchise tax replaces the taxable capital and earned surplus components with a tax based on “taxable margin”. Taxable margin is defined as the entities “total revenues” less (at the election of the taxpayer) the greater of “cost of goods sold” or “compensation” (compensation would include wages and cash compensation as well as benefits). However, the entity’s taxable margin would be capped at 70% of the entity’s total revenues. The Revised Tax also provides for the carryforward of prior tax credits, subject to limitations, as well as a temporary tax credit.

We believe the Revised Tax, while based on an entity’s margins (as discussed above), is nonetheless, a tax based substantially on income, and as such is subject to the provisions of ASC 740. Accordingly, the signing into law of the Revised Tax bill represented a change in tax law and the corresponding financial statement impact should be recognized in the period the law is enacted (i.e., 18 May 2006), despite an effective date of 1 January 2008. Additionally, companies with qualifying tax credit carryforwards would continue to analyze the realizability of those credits to determine the need for a valuation allowance as required by ASC 740. Shortly after the Revised Tax was enacted, the FASB declined to add to its agenda a project to provide guidance relating to the accounting implications of the Revised Tax, — principally whether or not it should be accounted for under ASC 740. In their deliberations, the FASB staff noted that the tax is based substantially on a measure of income and as a result believes it is subject to ASC 740.

Since the Revised Tax does not provide for the carryforward of business operating losses, a temporary credit was included using as the basis for the credit, the net operating losses for Texas tax purposes, to be reported on the entity’s franchise tax report due prior to 1 January 2008. However, one of the significant areas of uncertainty in the Revised Tax was how the temporary tax credit should be

calculated. Since that time, the Texas State Comptroller’s Office has issued a margin tax calculator that is intended to assist constituents in calculating the franchise tax due. In the instructions to the calculator the following computational guidance regarding the temporary credit is included: “In addition, a

corporation may take a credit based on business losses accrued under Tax Code Section 171.110(e) that were not expired or exhausted on a report due prior to January 1, 2008. The credit is 10 percent of the business losses multiplied by the appropriate margins tax rate and expires September 1, 2016. Texas Tax Code 171.111.” We believe the instructions, as issued by the Comptroller’s Office, provide sufficient clarification such that the appropriate temporary credit that exists as of the enactment date (based on losses, for Texas tax purposes, that were incurred as of the enactment date) can now be calculated for financial reporting purposes. The impact of the Texas tax losses post the enactment date on the

temporary credit calculation should be reflected as they occur versus the anticipated in the calculation of the credit on enactment.

5.6.4.2 Franchise tax effect on deferred state income taxes

ASC 740 does not require specific accounting for deferred state income taxes. The guidance for the accounting of income taxes in ASC 740 requires recognition of a current tax asset or liability for the estimated taxes payable or refundable on tax returns for the current year and a deferred tax asset or liability for the estimated future tax effects attributable to temporary differences and carryforwards that are measured at the enacted tax rates.

Accordingly, under ASC 740, deferred taxes are recognized for temporary differences that will reverse in future years for which annual taxable income is expected to exceed the capital-based tax computation based on the level of existing capital at year-end. ASC 740-10-55-138 and its discussion of graduated tax rates, should be considered when determining whether a detailed analysis of the net reversals of temporary differences in each future year (i.e., scheduling) is warranted. In most cases ASC 740 does not require temporary difference to be scheduled. See Section 4.3, Scheduling the reversal of temporary differences, for further discussion.