Excerpt from Accounting Standards Codification
8 An enacted change in tax laws or rates
8.4 Retroactive change in enacted tax rates Excerpt from Accounting Standards Codification Excerpt from Accounting Standards Codification
Income Taxes — Overall Recognition
740-10-25-48
The tax effect of a retroactive change in enacted tax rates on current and deferred tax assets and liabilities shall be determined at the date of enactment using temporary differences and currently taxable income existing as of the date of enactment.
Initial Measurement 740-10-30-26
The reported tax effect of items not included in income from continuing operations (for example, discontinued operations, extraordinary items, cumulative effects of changes in accounting principles, and items charged or credited directly to shareholders' equity) that arose during the current fiscal year and before the date of enactment of tax legislation shall be measured based on the enacted rate at the time the transaction was recognized for financial reporting purposes.
Other Presentation Matters 740-10-45-16
Paragraph 740-10-25-48 provides the recognition guidance when a tax law retroactively changes tax rates. In such cases, the cumulative tax effect is included in income from continuing operations.
740-10-45-17
Paragraph 740-10-30-26 provides the measurement guidance for a change in tax rates on items not included in income from continuing operations that arose during the current fiscal year and prior to the date of enactment. In such cases, the tax effect of a retroactive change in enacted tax rates on current or deferred tax assets and liabilities related to those items is included in income from continuing operations in the period of enactment.
ASC 740-10-45-15 requires deferred tax liabilities and assets be adjusted for the effect of a change in tax laws or rates when enacted and that the effect be included in income from continuing operations. In addition, ASC 740-10-25-48 requires the tax effect of a retroactive change in enacted tax rates on current and deferred tax assets and liabilities should be determined at the date of enactment using temporary differences and currently taxable income existing as of the date of enactment. The cumulative tax effect is included in income from continuing operations (ASC 740-10-45-16). See Chapter 5,
Recognition and measurement, for further discussion.
ASC 740-10-30-26 requires the reported tax effect of items not included in income from continuing operations (for example, discontinued operations, extraordinary items, cumulative effects of changes in accounting principles, and items charged or credited directly to shareholders’ equity) arising during the current fiscal year and prior to the enactment date should be measured based on the enacted rate at the time the transaction was recognized for financial reporting purposes. As discussed above, the tax effect of a retroactive change in enacted tax rates on current or deferred tax assets and liabilities related to those items is included in income from continuing operations in the period of enactment (ASC 740-10-45-17). That is, the effect of a tax rate change is not backwards traced.
Companies must consider two principal factors in determining the effects of a tax rate change on income from continuing operations. The first is the effect of the retroactive rate change, if applicable, on
estimated taxable income through the enactment date. The second is the effect of the rate change on deferred tax balances existing at the enactment date, effectively requiring companies to estimate their temporary differences as of the enactment date. For public companies and others subject to periodic reporting requirements, estimating temporary differences as of the most recent quarter often will be adequate, with appropriate adjustments for material unusual or infrequent transactions between the enactment date and quarter-end. For companies that do not prepare interim financial statements, calculating the effect of the change will require additional effort. For such companies, the effect of reversals of beginning deferred tax balances for the period through the enactment date will have to be considered, as well as the deferred tax effects of originating temporary differences. Calculating the effects of a retroactive rate change is illustrated in the following example.
Illustration 8-5
Assume at 31 December 20X0, a calendar-year company has only one temporary difference, which related to the use of accelerated depreciation of fixed assets for tax purposes and straight-line depreciation for financial reporting purposes. At 31 December 20X0, the $15 million taxable
temporary difference and related deferred tax liability of $5.25 million (assuming a 35% effective tax rate) were scheduled to reverse as follows (in thousands):
20X1 20X2 20X3 Total
Reversal of taxable temporary
difference $ 4,000 $ 5,000 $ 6,000 $15,000
Expected tax rate 35% 35% 35% 35%
Deferred tax liability at 31 December $ 1,400 $ 1,750 $ 2,100 $ 5,250 Further, assume the company calculated its income tax expense, as reported in its interim 20X1 financial statements, using an effective tax rate of 35%. Based on this rate, the company recorded tax expense for the six months ended 30 June 20X1 as follows:
Application of effective tax rate to first and second quarter results:
Year-to-date pretax income $ 18,000
Estimated annual effective tax rate 35%
Income tax provision for six months ended 30 June 20X1 $ 6,300 Assuming the taxable temporary difference reverses ratably during each year (i.e., at 30 June 20X1,
$2 million of the taxable temporary difference for 20X1 had reversed), the income tax provision for the first six months of $6.3 million represents the net effect of current income tax expense of $7 million less $0.7 million (or $2 million x 35%) representing the reversal of the previously recognized deferred tax liability relating to the use of accelerated depreciation for tax purposes.
These amounts are calculated as follows (in thousands)
Year to date pretax income for financial reporting $ 18,000 Add: excess book over tax depreciation for first six months 2,000
Taxable income through 30 June 20X1 20,000
Statutory federal income tax rate 35%
Current income tax expense $ 7,000
Reduction in temporary difference — depreciation $ (2,000)
Statutory federal income tax rate 35%
Reversal of deferred tax liability $ (700)
In the quarter ended 30 September 20X1, new tax legislation was enacted on 10 August 20X1, which increased the tax rate from 35 percent to 40 percent, retroactive to 1 January 20X1. Accordingly, the company recalculated its estimated effective tax rate and determined that it had increased from 35 percent to 40 percent. The company also estimated its temporary differences as of 30 June 20X1, and determined no significant transactions occurred from that date through 10 August 20X1 that would materially affect its temporary differences. The effect of the rate change on previously reported income tax expense is calculated as follows (in thousands):
Effect of the rate change on taxable income for the first six months:
$18 million pre-tax income @ 5% effective tax rate change $ 900
$2 million excess book over tax depreciation 100
$2 million reversal of taxable temporary differences (100)
Effect of rate change on deferred tax liabilities at 30 June 20X1:
($15 million — $2 million = $13 million @ 5%) 650
$ 1,550
Therefore, third quarter income tax expense is increased by $1.55 million. This illustration assumes that third quarter income and changes in deferred taxes recorded through the date of the enacted change in tax law was not significant. If such changes were significant, there would be an additional impact of the change in tax law. See Section 20.8.1.2, Calculation of second quarter income tax expense when a change in tax rates occurs, for an example calculation where such interim effect is calculated. In addition, the estimated effective tax rate used for the remainder of the year will be 40 percent.
When considering the use of an interim date other than the enactment date for determining the impact of a change in tax rates, companies should consider whether any transactions occurred between the date used to estimate the deferred tax balances and the enactment date, which would materially affect the calculation. For example, significant equity transactions, business combinations, discontinued
operations, and extraordinary items should be considered. Transactions of this nature occurring between the balance sheet date used to estimate temporary differences and the enactment date should reflect the tax effects determined at the rate in existence at the transaction date. The effect of the rate change on these items should be reflected as part of income tax expense on income from continuing operations.
Also noteworthy is that a retroactive rate change could also affect the results of operations even if a company has no deferred taxes, see Section 8.6, Change in tax law or rates related to items not recognized in continuing operations, for further details.
In addition to the effects of the change in tax rates, consideration should be given to other changes in the law that affect a company’s effective tax rate. For example, a significant provision of the 1986 Tax Reform Act was the extension of the research and development (R&D) credit, which originally expired as of 30 June 1992. The Act retained the eligibility requirements of the prior law, but extended the credit to 30 June 1995, and was retroactive to 1 July 1992. Because tax calculations from 1 July 1992 through 30 June 1993 did not include the effect of the R&D credit extension, a catch-up adjustment was required in the third quarter of 1993 (for calendar-year companies) for the benefit of this change in the law, which was reported as a reduction of income tax expense from continuing operations. In addition, the
estimated annual effective tax rate for the remainder of the year was required to be adjusted to reflect the availability of the credit.