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Presenting a live 110‐minute teleconference with interactive Q&A

ASC 740 and Valuations of Deferred Tax Assets

ASC 740 and Valuations of Deferred Tax Assets

Tackling Tough Valuation and Disclosure Challenges and Recovering Prior Allowances

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific WEDNESDAY, MAY 2, 2012

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Douglas Sayuk, Partner, Clifton Douglas, San Jose, Calif.g y , , g , , Mathew DeMong, Tax Engagement Senior Manager, BDO USA, Boston

(2)

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(3)

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(4)

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(5)

ASC 

 

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ASC 740 and Valuations of Deferred Tax 

Assets Seminar

May 2, 2012

Mathew DeMong, BDO USA

mdemong@bdo.com

Douglas Sayuk, Clifton Douglas

(6)

Today’s Program

Overview Of Material Terms Of ASC 740 And Other Guidance [Douglas Sayuk]

Slide 7 – Slide 12

Tax-Related Issues [Mathew DeMong]

Slide 13 – Slide 52

Valuation Issues Arising With Deferred Tax Assets [Douglas Sayuk]

(7)

OVERVIEW OF MATERIAL 

Douglas Sayuk, Clifton Douglas

OVERVIEW OF MATERIAL 

TERMS OF ASC 740 AND 

(8)

Introduction: DTA Build       

From Recession

From Recession

_____________________________________________________

RECESSION

RECESSION

=

TAX LOSSES

=

DTA BUILD

DTA BUILD

(9)

Introduction: DTA Build From 

Recession (Cont.)

Recession (Cont.)

_____________________________________________________

DATE

DOW

EVENT

Oct. 9, 2007

14,164

Dow Hits All Time High

July 2, 2008

11,215

Dow Closes >20% Below 10/07 High

M

h 9 2009

6 547

D

Cl

t P t 1997 L

53 8%

March 9, 2009

6,547

Dow Closes at Post 1997 Low – 53.8% 

Below 10/07 High

(10)

Introduction: DTA Utilization 

From Economic Recovery

From Economic Recovery

_____________________________________________________

IMPROVING ECONOMY

IMPROVING ECONOMY

=

2011/2012 DTA

UTILIZATION/POTENTIAL VA

RELEASE

RELEASE

(11)

Introduction: Increased DTA Accounting 

F

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From Business Combinations

_____________________________________________________

Improving Economy

Improving Economy

=

Increasing Business

Combinations

Combinations

=

Increasing Tax Accounting Under

ASC 805 10 5 (FAS 141R)

(12)

Introduction: Basic Terminology

Introduction: Basic Terminology

_____________________________________________________

• ASC Topic 740 (previously FAS 109): Accounting for Income Taxes

• ASC Topic 740-10, et seq. (previously FIN 48): Accounting for

Uncertainty in Income Taxes

• Deferred tax asset (DTA): Cumulative deductible temporary difference

(

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• Deferred tax liability (DTL): Cumulative taxable temporary difference

• Valuation allowance (VA): A contra- or reduction account to deferred

tax assets, which represents that portion of total deferred tax assets that

the firm judges is unlikely to be realized.

• Tax attribute: A type of loss or credit that may reduce taxable income or

• Tax attribute: A type of loss or credit that may reduce taxable income or

tax liability, respectively (e.g., net operating loss or research credit).

(13)

TAX RELATED ISSUES

Mathew DeMong, BDO USA

(14)

Agenda For This Section

Tax-related issues

A. Effective tax rates and interim accounting for taxes

B. Business combinations and accounting for taxes

(15)

Overview Of Interim

Overview Of Interim

(Quarterly) Reporting

Interim reports are for a period less than one year

Interim reports are for a period less than one year.

An estimated effective tax rate for the year is used to determine income

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tax expense for interim periods.

The complexity of the estimated annual effective tax rate calculation will

depend upon:

- The number of tax jurisdictions in which the company operates

- The nature and extent of the “permanent difference” items

p

Do not include the tax related to “significant unusual or extraordinary

(16)

Estimated Annual Effective Tax Rate

Estimated Annual Effective Tax Rate

Total tax expense for the year results from separate calculations of

Total tax expense for the year results from separate calculations of

current tax expense and deferred tax expense.

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Estimates of both current and deferred tax expense attributed to

“ordinary income” will be required, to calculate the estimated annual

effective tax rate for the year.

The rate is the ratio of estimated annual income tax expense to estimated

pre-tax ordinary income.

(17)

Discrete Items

Discrete Items

Tax expense/benefit related to “ordinary” income shall be computed at the

Tax expense/benefit related to ordinary income shall be computed at the

estimated annual effective tax rate (EAETR), and the tax expense/benefit

related to all other items shall be individually computed and recognized

when the items occur (FIN 18 Par 6)

when the items occur (FIN 18, Par. 6).

— Significant or unusual items that will be separately reported or

reported net of their related tax effect

reported net of their related tax effect

— Effects of change in judgment related to beginning of the year

valuation allowances or liabilities for tax exposure items (FIN 48

liabilities)

liabilities)

— Effects of changes in tax laws or rates

— Provision to return adjustments

(18)

Computing Income Tax Provisions

Computing Income Tax Provisions

In Interim Periods

Compute year-to-date income tax expense/benefit

— Estimated annual effective tax rate (EAETR)

— Multiply EAETR by year-to-date ordinary income (loss) at end of

the period

— Add tax expense/benefit related to discrete items and other

exceptions to the general rules

(19)

Example 1

Example 1

If a company estimates its annual income to be $250,000 and estimates an R&D

credit of $15,000, what is its effective rate if the company computes its taxes at a

34% rate?

The effective tax rate would be 28%, computed in the following manner:

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$85 000

($250 000

34%)

- Gross taxes would be $85,000 ($250,000 x 34%)

- Net taxes would be $70,000 ($85,000 gross tax - $15,000 R&D credit

- ETR would be 28% ($70,000 net taxes/$250,000 annual income)

What would the income tax provision for the first quarter be if there was $50,000

of income in the first quarter?

of income in the first quarter?

(20)

Example 2

Example 2

A company’s estimated ETR is 30%. During the third quarter, the company had

$75,000 net income. Its year-to-date income is $200,000, and it had previously

reported $45,000 in taxes.

What is the third quarter income tax provision?

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The third quarter income tax provision is computed by multiplying the

year-to-date income by the ETR and deducting prior quarter income taxes.

$200,00 x 30% = $60,000

$60,000 - $45,000 = $15,000

(21)

Example 3

Example 3

A company originally estimated its ETR at 30% for the year. During the

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third quarter, the company had $75,000 net income. Its year-to-date

income is $200,000, and it had previously reported $20,000 in taxes.

What is the ETR for the third quarter?

As noted in the earlier question year-to-date tax is $60 000

As noted in the earlier question, year-to-date tax is $60,000

The tax for the quarter is $60,000 - $20,000 = $40,000

(22)

Multiple Jurisdictions

Multiple Jurisdictions

Rate may be computed based on one overall rate unless:

Rate may be computed based on one overall rate, unless:

- The company anticipates losses for which no benefit can be

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recognized, and

- Is unable to make an estimate or ordinary income or related tax.

If there is a jurisdiction that anticipates a loss for which no benefit can be

recognized, then:

- Compute effective rate separately for that jurisdiction

- Apply it to that jurisdiction’s YTD ordinary income

(23)

Multiple Jurisdictions: Example

Multiple Jurisdictions: Example

(24)

Business Combinations

Business Combinations

General rule (ASC 740-25-3&4)

Each identified asset and liability is assigned its respective fair value

[refer to ASC 805-10-5,10&15].

A deferred tax liability (DTL) or asset (DTA) is then established for the

difference between book and tax bases resulting from the purchase price

difference between book and tax bases resulting from the purchase price

allocation and for any carryforwards.

DTA may include future benefits of NOLs and tax credit carryforwards.

The need for a valuation allowance must be assessed

The need for a valuation allowance must be assessed.

Exceptions where DTAs or DTLs are not recorded at purchase (ASC 740-25-3&4):

Goodwill not deductible for tax purposes

Acquired Opinion 23 (ASC 740 & 942) differences

Leveraged leases

(25)

Business Combinations (Cont )

Business Combinations (Cont.)

Measurement period

Measurement period

- Initial accounting for business combination is incomplete by the end

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of the reporting period.

- The measurement period shall not exceed a year from the

acquisition date.

- Allows retrospective adjustments accounted for under acquisition

accounting (i.e. goodwill)

New knowledge about facts and circumstances that existed

- New knowledge about facts and circumstances that existed

(26)

Purchase Price Accounting: Examples

Purchase Price Accounting: Examples

Deferred tax liability recorded in purchase accounting

The stock of Target a consumer brand manufacturer is acquired by Corporation X

The stock of Target, a consumer brand manufacturer, is acquired by Corporation X

on 03/31/2004 for $1,500. Market-related and customer-related intangibles are

identified and recorded for book purposes under FAS 141R (ASC 805-10-5, 10&15)

in the amount of $600. Assume no Sect. 338 election, a 40% effective tax rate and

$ 0 t b i i th i t

ibl h ld b t

t

$-0- tax basis in the intangibles held by target.

Book

Tax

Difference

DTL

Id

ifi d I

ibl

$600

$ 0

$600

Identified Intangibles

$600

$-0-

$600

Tax Rate

x 40% = $240

Journal Entry:

Dr. Goodwill

$240

(27)

Purchase Price Accounting: Examples (Cont )

Purchase Price Accounting: Examples (Cont.)

Deferred tax asset recorded in purchase accounting

The stock of Target, a consumer brand manufacturer, is acquired by Corporation Y

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on 03/31/2004 for $950. Market-related and customer-related intangibles are

identified and recorded for book purposes under FAS 141R (ASC 805-10-5,10&15) in

the amount of $300. Assume no Sect. 338 election, a 40% effective tax rate and

historic tax basis of intangibles held by target from prior acquisition of $500

historic tax basis of intangibles held by target from prior acquisition of $500.

Book

Tax

Difference

DTA

Identified Intangibles

$300

$500

$200

Identified Intangibles

$300

$500

$200

Tax Rate

x 40% =

$80

Journal Entry:

Journal Entry:

Dr. Deferred Tax Assets

$80

(28)

Tax Deductible: Goodwill

Tax Deductible: Goodwill

If tax deductible goodwill, ASC 740 separates into two components:

First component

-

Equals lesser of “book” goodwill or “tax” goodwill

A diff

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-

Any difference between the book and tax basis in future years is a

temporary difference.

Second component - Remainder

-

If book goodwill, then a tax benefit is never recognized (permanent

difference)

-

If tax goodwill, then that excess tax goodwill meets the definition of

a temporary difference. A DTA must be recognized at the acquisition

date.

(29)

Excess Tax Deductible Goodwill

Excess Tax Deductible Goodwill

FASB observed calculation as follows for initial recording of DTA:

FASB observed calculation as follows for initial recording of DTA:

(Tax rate/(1-Tax rate)) * “Preliminary temporary difference”

“Preliminary temporary difference” is the excess of the tax goodwill over

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the book goodwill.

(30)

Excess Tax Deductible Goodwill:

Example

Acquiring company purchases 100% of the assets of Target Co. Goodwill of

$

$

$40M is recorded for financial reporting purposes, and $50M of goodwill is

recorded for tax purposes. The company’s effective tax rate is 40%.

DTA to record =

$10M * (.40/(1 - .40) = 6.67M

Acquiring Co. records the following assets:

Goodwill

$33 3M

Goodwill

$33.3M

(31)

Transaction Costs

Transaction Costs

Accounted for separately from the business combination

Accounted for separately from the business combination

Expensed for books as incurred

Companies are permitted to anticipate transaction structure, if sufficient

evidence of transaction type exists at the filing date.

(32)

Valuation Allowances In

Valuation Allowances In

Business Combinations

Established at time of business combination

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Evaluate evidence

Combined company’s past and expected future results of

operations as of the acquisition date

(33)

Subsequent Release Of VA

Subsequent Release Of VA

Release of VA on acquired deferred tax assets in future years must be

Release of VA on acquired deferred tax assets in future years must be

included in income from continuing operations, if outside of the

measurement period.

Changes within the measurement period resulting from new information,

that existed at the acquisition date, will be recognized through goodwill.

(34)

Indefinite Lived Intangibles:

Indefinite Lived Intangibles:

“Naked Credits”

DTLs resulting from temporary differences that can be offset by the

existing reversing deductible temporary differences, NOLs or credits may

be considered a source of income to eliminate or reduce the need for a

be considered a source of income, to eliminate or reduce the need for a

VA.

ۛ Companies often net DTLs against DTAs to compute VA.

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ۛ Indefinite-lived intangibles and goodwill are not amortized.

ۛ DTLs on indefinite lived intangibles often create a “naked

credit.”

DTL from indefinite-lived intangibles cannot be used as a source of income

to offset DTAs with definite lives, when computing VA.

(35)

Valuation Allowances: Example Of

Indefinite-Lived Intangibles DTL

Example:

- Current tax loss, full valuation allowance

- $1,000 of tax amortization on goodwill; no other book/tax differences

- Tax rate = 40%

Total provision = $400

- Current provision = $0

p

- Deferred provision = $400

• To establish the DTL for the basis difference in goodwill

• The indefinite-lived asset temporary difference cannot be

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considered a source of income to reduce the VA.

(36)

Acquired Tax Uncertainties

Acquired Tax Uncertainties

Uncertain tax positions are reviewed at acquisition and recorded at fair

Uncertain tax positions are reviewed at acquisition and recorded at fair

value, if certain conditions are met.

“M

lik l th t” t d d

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“More likely than not” standard or contractual test is applied to determine

if an accrual is warranted.

(37)

Adjustments To Acquired

Adjustments To Acquired

Tax Uncertainties

Adjustments (i.e. true-ups) are permitted to purchase accounting within

the measurement period.

Any adjustments after the measurement period are required to be

recognized in the income statement.

Any adjustment based on new information that arose after the transaction

date is an adjustment to income, regardless of time frame.

(38)

In-Process Research And Development

In-Process Research And Development

Measured at FV and capitalized and written off in the future through

Measured at FV and capitalized and written off in the future through

amortization/impairment charges

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Non-taxable acquisitions: Establish deferred tax liability at purchase date

Can potentially result in a naked credit

(39)

Contingent Consideration

Contingent Consideration

Determine the FV of all payments and record at acquisition date without

Determine the FV of all payments and record at acquisition date, without

regard to the likelihood of the payment.

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Initial recognition is recorded to goodwill, and any subsequent mark to

market changes are charged to the P&L.

(40)

Stock-Based Compensation: Overview

Stock-Based Compensation: Overview

ASC 718 applies to all transactions involving the issuance by a company of its own

equity in exchange for goods or services.

The entity will recognize an increase in equity or a liability, depending upon the

type of award as the award vests.

ASC 718 requires all entities to recognize compensation expense in an amount

equal to the fair value of share-based payments granted to employees over the

requisite service period.

requisite service period.

Types of equity-based compensation awards:

- Stock options

Stock options

- Non-vested stock and non-vested stock units

- Restricted stock

(41)

Tax Treatment Of Share-Based

Tax Treatment Of Share-Based

Compensation

— Incentive stock options

Non qualified stock options

— Non-qualified stock options

(42)

Excess Tax Benefits And Tax Shortfalls

Excess Tax Benefits And Tax Shortfalls

Excess tax benefits

— Excess tax benefits

Commonly referred to as a windfall/windfall tax benefit

(43)

Example: Disqualifying Dispositions

Example: Disqualifying Dispositions

Of ISOs

ABC grants an ISO with a grant-date fair value of $100. Since the award is an ISO,

no corresponding tax benefit or deferred tax asset is recorded. A disqualifying

disposition occurs in which the company can take a $120 deduction in its tax

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return. The tax rate is 40%.

What tax entry should be recorded by ABC in 2011 to record the disqualifying

disposition?

disposition?

ABC would record a tax benefit of $40 in the income statement and an increase to

additional paid-in capital of $8 (($120 less $100) × 40% tax rate).

Dr. taxes payable $48

(44)

Example: Disqualifying Dispositions

Example: Disqualifying Dispositions

Of ISOs (Cont.)

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ABC grants an ISO with a grant-date fair value of $100. Since the award is an ISO,

no corresponding tax benefit or deferred tax asset is recorded. A disqualifying

disposition occurs in which the company can take a $90 deduction in its tax return.

The tax rate is 40%.

The tax rate is 40%.

What tax entry should be recorded by ABC in 2011 to record the disqualifying

disposition?

ABC would record a tax benefit of $36 in the income statement ($90 × 40% tax

rate).

Dr. taxes payable $36

(45)

Example 1: Excess Tax Benefits

Example 1: Excess Tax Benefits

ABC grants an equity-classified option award with a grant-date fair value

of $100 and a $200 exercise price; the fair market value of the underlying

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shares on the exercise date is $400. The vesting period is four years. The

award is exercised in Year 5. ABC’s tax rate is 40%. How does this windfall

get recorded?

$40 increase to APIC; $0 reduction of income tax expense

- $80 tax benefit – tax deduction of $200 ($400 stock price less

$200 exercise price of option) *40% tax rate

- Previously recognized DTA reversing – cumulative compensation

cost of $100 * 40% tax rate

- Excess tax benefit of $40 ($80 tax benefit - $40 previously

recognized DTA)

(46)

Example 1: Excess Tax Benefits (Cont )

Example 1: Excess Tax Benefits (Cont.)

Year One Entries

Dr. stock compensation $25

Cr. APIC $25

Dr. DTA $10

(47)

Example 1: Excess Tax Benefits (Cont )

Example 1: Excess Tax Benefits (Cont.)

Year Two Four Entries

Year Two-Four Entries

Same as year one

At The End Of Year Four:

Total stock compensation deducted in - $100

financial statements

(48)

Example 1: Excess Tax Benefits (Cont )

Example 1: Excess Tax Benefits (Cont.)

Year Five – Options Are Exercised

FMV $400

Exercise Price ($200)

FMV $400

Exercise Price ($200)

Tax Deduction

$200 X 40% = $80

Book Deduction

$100 X 40% = $40

Excess Tax Ded

$100 X 40% = $40

Dr. tax expense $40

Cr. DTA $40

Dr. tax payable $80

Cr. tax expense $40

Cr. tax expense $40

Cr. APIC $40

(49)

Timing For Recognition Of

Timing For Recognition Of

Excess Tax Benefits

Tax benefit and credit to APIC for excess tax benefit is recognized in the

Tax benefit and credit to APIC for excess tax benefit is recognized in the

period that deduction reduces taxes payable.

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dit APIC

— Therefore, a company would only be allowed to credit APIC

when a benefit is actually received.

— Reduction of taxes payable may occur in a subsequent period.

NOL generated in period the tax deduction is taken

(50)

Utilization Of Tax Attributes

Utilization Of Tax Attributes

Approach to determining realization of excess tax benefits:

Approach to determining realization of excess tax benefits:

— With-and-without

— Tax-law ordering

(51)

Shortfalls

Shortfalls

ABC has a DTA at the beginning of the year of $2 million. $500k worth of

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DTA

options were cancelled during the year. Thus, there is an end-of-year DTA

of $1.5 million.

What tax entry should be recorded by ABC in 2010 to record the

disqualifying disposition?

Dr. APIC $500k (if APIC pool)

Cr. DTA $500k

(52)

Circular 230 Disclosure

Circular 230 Disclosure

To ensure compliance with Treasury Department regulations we

To ensure compliance with Treasury Department regulations, we

wish to inform you that any tax advice that may be contained in this

communication (including any attachments) is not intended or written to

be used and cannot be used for the purpose of (i) avoiding tax-related

be used, and cannot be used, for the purpose of (i) avoiding tax related

penalties under the Internal Revenue Code or applicable state or local tax

law provisions or (ii) promoting, marketing or recommending to another

party any tax-related matters addressed herein. Before implementing any

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of our year-end tax planning ideas, it is imperative that you discuss these

ideas with your tax advisor as it applies to your specific set of

(53)

VALUATION ISSUES ARISING 

Douglas Sayuk, Clifton Douglas

(54)

VA Issues Arising With DTA:

Assessing VA Needs

• The VA assessment isThe VA assessment is both subjective and mechanicalboth subjective and mechanical.

• The subjective evaluation can include, but is not limited to, any of the following factors: • Assessing whether the weight of the available evidence supports the recognition

of some or all of an entity’s DTA of some or all of an entity s DTA

• Determining how objectively verifiable an individual piece of evidence is and how much weight it should be given

Establishing the reversal patterns for existing temporary differences

• Once the subjective evaluation has been made, the valuation allowance computation process is mechanical.

Valuation allowance formulae can be helpful but are no substituteValuation allowance formulae can be helpful but are no substitute for reasonedfor reasoned judgment in evaluating the need for a valuation allowance.

• Valuation allowance recorded should be based on management’s judgment of what is MLTN, considering all available information, both quantitative and qualitative

(55)

VA Issues Arising With DTA: VA

Evidence To Be Considered

Evidence To Be Considered

ASC 740-10-30-17 provides that p “all available evidence shall be considered in determining whether a valuation allowance for DTA is needed.”

• Evidence includes historical information along with all currently available information about future yearsy .

Events occurring subsequent to an entity’s year-end but before the financial statements are released, and that provide additional evidence (negative or positive) regarding the likelihood of realization of existing DTA, should be considered.g g g ,

• The effects on the VA assessment of certain fundamental transactions, such as an IPO, other major financing transactions or a business combination, should not be taken into account until the transactions are completep .

Typically, the factors given the most weight are the least subjective, resulting in the following order from strongest to weakest evidence: 1) Carryback claims, 2) reversal of

(56)

VA Issues Arising With DTA: VA

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Evidence To Be Considered – Example

• Facts: Company A is restating FS for the prior three years (2008-2010)

Facts: Company A is restating FS for the prior three years (2008 2010)

for items unrelated to taxes. Prior to the restatement, Company A was

profitable for 2008-2010 without a VA against any of its DTA.

Post-restatement, Company A has losses for 2008 and 2009, but remains

significantly profitable in 2010.

•Question: Can Company A utilize the knowledge of the profitable results

in 2010 as positive evidence in evaluating whether a VA is considered

necessary for the 2008 restated accounts?

Answer: No Although Company A returned to significant profitability in

• Answer: No. Although Company A returned to significant profitability in

2010, only information available as of the original issuance date of the FS

should be used in determining the VA as of the end of 2008. However, this

2008 VA likely would be reversed in 2010 based on the available evidence

2008 VA likely would be reversed in 2010 based on the available evidence

(57)

VA Issues Arising With DTA:

g

Objective Evidence Preference

• The weight given to the potential effects of negative and positive

evidence shall be commensurate with the extent to which they can be

objectively verified

objectively verified

.

• The

more negative evidence that exists, the more positive evidence

is necessary

and the more difficult it is to support a conclusion that a VA

is necessary

, and the more difficult it is to support a conclusion that a VA

is not needed for some portion or all of the DTA.

• For example, a

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cumulative loss in recent years is a significant piece

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p

(58)

VA Issues Arising With DTA:

• Forming a conclusion that a valuation allowance is not needed is difficult when

Negative Evidence

Forming a conclusion that a valuation allowance is not needed is difficult when

there is

negative evidence

”… examples include:

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• Cumulative losses

in recent years

• History of

expiring tax attributes

• Losses expected

in early future years

• Unsettled circumstances

that may adversely affect future operations and

profit levels on a continuing basis in future years

(59)

VA Issues Arising With DTA: Negative

g

g

Evidence - Cumulative Losses

• Out of all the negative evidence, “cumulative losses in recent years” probably will have to be considered most frequently.

ASC 740 d lib t l d t d fi thi t b t it t ti i t i ft i t t d t • ASC 740 deliberately does not define this term, but its starting point is often interpreted to be cumulative pre-tax results as adjusted for permanent items (e.g., non-deductible goodwill impairments) for three years (the current and the two preceding years).

All items, other than the cumulative effect of accounting changes, should be included in the determination of cumulative losses.

• When considering cumulative losses, it may be necessary to segregate earnings (losses) subject to capital gain rules from those subject to taxes at ordinary rates.

(60)

VA Issues Arising With DTA: Negative

Evidence – Cumulative Losses Example

• Facts: Company B had four separate and distinct lines of business. Historically,

three of the lines have been/continue to be profitable, but the fourth line incurred

substantial losses that led to an NOL carryforward on the entity’s consolidated tax

return The unprofitable line was discontinued and its assets sold Historical profit

return. The unprofitable line was discontinued and its assets sold. Historical profit

levels of Company B were such that it could utilize the NOL carryforward within

eight years prior to the NOL’s expiration date.

• Question: Does sufficient positive evidence exist to support Company B’s

conclusion that a valuation allowance was not required against its consolidated

loss carryforward?

• Answer: Yes. Although the mere exiting of a business often does not, in and of

itself, ensure future profitable operations, in this case Company B had a consistent

track record of profitable results in its other business lines. The consistent

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ith

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th NOL

historical earnings in its other business lines, coupled with a lengthy NOL

(61)

VA Issues Arising With DTA:

Positive Evidence

• Examples of

positive evidence

include, but are not limited to, the

following:

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Sales backlog that will produce more than enough taxable

income

to realize the DTA.

An

excess of appreciated asset value over the tax basis of the

An

excess of appreciated asset value over the tax basis of the

entity’s net assets

in an amount sufficient to realize the DTA.

A

A

strong earnings history

strong earnings history

exclusive of the loss that created the

exclusive of the loss that created the

future deductible amount, coupled with evidence indicating that the

loss is an aberration rather than a continuing condition

(62)

VA Issues Arising With DTA – Positive

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Evidence Of Taxable Income Sources

• The following four possible

sources of taxable income

may be

available under the tax law to realize a tax benefit for deductible

temporary differences and carryforwards:

• Future reversals

of existing taxable temporary differences

• Future taxable income

Future taxable income

, exclusive of reversing temporary

exclusive of reversing temporary

differences and carryforwards

• Taxable income in prior carryback year(s)

p

y

y

( )

, if carryback is

,

y

permitted under the tax law

(63)

VA Issues Arising With DTA:

• Future realization of a tax benefit sometimes will be expected for

a

Positive Evidence

• Future realization of a tax benefit sometimes will be expected for

a

portion, but not all, of a DTA

. The dividing line between the two

portions may be unclear.

• In those circumstances,

application of judgment, based on a careful

assessment of all available evidence, is required

to determine the

portion of a DTA for which it is MLTN a tax benefit will be realized.

p

• Future realization of the tax benefit of an existing deductible temporary

difference or carryforward ultimately depends on the existence of

sufficient taxable income of the appropriate character

(for example,

ordinary income or capital gain) within the carryback, carryforward period

available under the tax law.

(64)

VA Issues Arising With DTA – Scheduling

Future Taxable Income

Scheduling future taxable income is necessary when it matters

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y

, i.e., when

,

,

the assessment of the appropriate VA or the applicable tax rate could vary

materially depending on relatively minor shifts in the timing of taxable income.

• It is important to note that

scheduling will be the exception rather than the

• It is important to note that

scheduling will be the exception rather than the

rule

that detailed computations will have to be carried to this extreme.

Scheduling will have to be considered in the following situations

:

• Realization of the DTA is dependent upon future reversals of existing taxable

temporary differences (i.e., taxable income from sources other than reversing

taxable differences does not provide sufficient assurance of realization)

taxable differences does not provide sufficient assurance of realization).

• A change in the tax rate is enacted but will not take effect until a future year

or years.

(65)

VA Issues Arising With DTA – Positive

Evidence Of Future Taxable Income

To the extent that realization is not ensured by carryback, reversals of taxable temporary y y , p y differences or tax-planning strategies, and is therefore dependent on the existence of future taxable income, projections of future taxable income will be necessary.

• To the extent such recent results include aberrational items, favorable or unfavorable,

those items should be excluded from the results when determining a “core” level of earnings. • Guidelines for projecting future earnings for purposes of VA assessment include:

• Presumption that an entity with cumulative recent profits will remain profitable unlessPresumption that an entity with cumulative recent profits will remain profitable unless there is objectively verifiable evidence to the contrary

• Starting point = Amount and trend of pre-tax income adjusted for permanent items during the past year

during the past year

• Adjust historical earnings for unusual items (both positive and negative), the effects of purchase accounting or changes in capital structure

(66)

VA Issues Arise with DTA: Positive

Evidence – Tax Planning Strategies

In assessing the need for a VA the consideration of tax planning strategies is not

In assessing the need for a VA, the consideration of tax planning strategies is not

elective. If there is an available tax planning strategy that is prudent and feasible, it must be incorporated into the assessment.

• Actions that may qualify as tax planning strategies include but are not limited to the • Actions that may qualify as tax planning strategies include, but are not limited to, the following:

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

time

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

• Filing a consolidated or combined tax returng

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

(67)

VA Issues Arising With DTA: Ineffective

Tax Planning Strategies

• Actions that

generally would not qualify as tax planning strategies

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p

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include,

,

but are not limited to, the following:

• Selling certain operating assets that are important to future operations

• Disposing of a subsidiary that is not profitable

• Initiatives that reduce costs in order to increase the entity’s profitability

• Moving income from a non-tax jurisdiction to a taxable one, solely to realize

net operating loss carryforwards

•Planning involving technical determinations that do not meet the MLTN

standard

(68)

VA Issues Arising With DTA: Specific

Issues – Liabilities For UTBs

• A

liability for unrecognized tax benefits should be considered a

source of taxable income

in the carryback period, for purposes of

determining the expected realization of a DTA.

• Because

settlement with the taxing authority is presumed to be at

the recorded amount of the liability

, the position’s resolution effectively

amounts to additional taxable income over the taxable income expected

on an “as-filed” basis.

The

period in which the taxing authority would assess the tax

• The

period in which the taxing authority would assess the tax

should be considered, to ensure the DTA relate to the same period in

which additional taxable income is expected.

(69)

VA Issues Arising With DTA: Specific

Issues – Liabilities For UTBs, Example

FACTS: As of 2010, Company C has a $1,000 NOL carryforward offset by VA due to

significant negative evidence. In 2011, Company C expects to report taxable income of $500 on its tax return, which includes a $100 deduction that is an UTB. A full VA remains for 2011. • QUESTION: Should Company C net the liability from the 2011 UTB with the 2010 NOL carryforward on its 2011 balance sheet?

• ANSWER: No The company should recognize the 2010 NOL carryforward separatelyANSWER: No. The company should recognize the 2010 NOL carryforward separately

from the 2011 UTB liability. The 2011 UTB liability would be a source of income, for the purposes of assessing whether a VA is necessary for the NOL carryforwards. Assuming a 40% tax rate, the entry for the $100 UTB would be:

Dr. Deferred Tax Asset $40 [$100 x 40%] Cr. FIN 48 Liability $40

(70)

VA Issues Arising With DTA: Specific

Issues – Carrybacks Free Up Credits

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• Consideration must be given to

net deductible temporary differences

reversing in a single future year that will be included in a tax loss

that will be carried back to prior years and that will, at least partially,

free up tax credits

originally used to reduce the payable rather than

free up tax credits

originally used to reduce the payable rather than

resulting in a refund.

• The

The

applicable tax rate at which deferred taxes are recorded is the

applicable tax rate at which deferred taxes are recorded is the

tax rate prior to consideration of credits

. Thus, it merely replacing one

deferred tax asset (deductible temporary difference) with another deferred

tax asset (credit carryforward), when there is not a source of income to

(

y

),

realize it, does not represent realization of the initial deferred tax asset;

and a valuation allowance would be necessary.

(71)

VA Issues Arising With DTA: Specific

Issues – Carrybacks Example

FACTS C E t d $1 illi NOL i 2011 Th l i d b k t

FACTS: Company E generated a $1 million NOL in 2011. The loss was carried back to

2009 and 2010 to offset the entire $500,000 of taxable income. The 2008/2009 tax expense of $200,000 was previously offset with $150,000 of research credit generated during those years, reducing the liability to $50,000. As a result of carrying back the

NOL dit th t i l tili d i th b k l d d

NOL, credits that previously were utilized in the carryback years were no longer needed. As a result, $150,000 of research credits previously utilized in 2008 and 2009 were

“freed up” and would be available as a carryforward for use in future years.

QUESTION I C E i d t ff t it “f d ” dit ith VA?

• QUESTION: Is Company E required to offset its “freed up” credits with VA?

• ANSWER: Yes. As Company E has no projected taxable income, a portion of the loss p y p j p carried back was not realized but rather resulted in the establishment of a new DTA in the form of a credit carryforward. Absent any other sources of future taxable income, Company E would need to establish a VA against the research credit carryforwards that were

(72)

VA Issues Arising With DTA: Specific

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Issues – FTC Carryforwards

• Many limitations exist on the ability of a company to utilize its foreign tax credits

• Many limitations exist on the ability of a company to utilize its foreign tax credits

(FTCs). Therefore,

to realize the DTA recorded for FTC carryforwards under

ASC 740, an entity must be able to generate sufficient future foreign source

taxable income

; and that income must, in the aggregate, have been taxed in

foreign jurisdictions at less than 35%.

• The FTC carryforwards can be used only if, and to the extent that,

a 35% rate

exceeds the future credits generated by the future foreign source income

exceeds the future credits generated by the future foreign source income

itself. The entity also

must not anticipate a taxable loss from domestic

sources

in the years in which the carryforwards must be used.

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• Due to the stringent realization requirements, it will be

difficult to avoid a VA for

FTC

carryforwards. Unless the circumstances that generated the carryforwards

were aberrational, it is likely that future foreign source income also will generate

excess FTCs - which will become additional carryforwards - rather than utilize

y

existing FTC carryforwards.

(73)

Special Circumstances: Initial Public Offering –

DTA/VA Concerns

DTA/VA Concerns

_______________________________________________

For a private company to file an S 1 generally audited financial statements for the

For a private company to file an S-1, generally audited financial statements for the last three years must be included.

• External auditors may require additional support for a private company’s DTA for these prior years as part of the S 1 filing

these prior years as part of the S-1 filing.

• Typical DTA-related studies required for substantiation may include credit

(oftentimes research credit) studies and IRC §§382/383 studies to support NOLs and credits

and credits.

• DTA supporting studies can be resource- and time-consuming and should be started well in advance of an S-1 filing.

• A private company may anticipate using a portion of IPO proceeds to pay off debt. Upon consummation of the IPO, the company should reassess its tax position considering the reduction in interest deduction. This increase in future taxable

(74)

Special Circumstances: Initial Public    

Offering Example

Offering – Example

_______________________________________________

• FACTS: An entity underwent a leveraged buyout (LBO) and incurred a large

y

g

y

(

)

g

amount of debt as a result of that transaction. For several years after the

LBO, the entity incurred substantial losses. Without the interest expense on

the LBO-related debt, however, the entity would have been profitable. The

entity had an IPO which resulted in proceeds used to pay off the LBO debt

entity had an IPO, which resulted in proceeds used to pay off the LBO debt.

The entity concluded that future income precluded the need for a VA once the

LBO debt was eliminated.

• QUESTION: Was the positive evidence related to future income sufficient to

outweigh the substantial negative evidence of cumulative recent year losses

caused by the LBO interest expense?

• ANSWER: Yes. Absent the interest expense from the LBO, the company

consistently demonstrated the ability to operate at a profit. The company’s

objectively verifiable “core earnings” were sufficient positive evidence to

O

outweigh the negative evidence related to cumulative losses caused by LBO

(75)

Special Circumstances: Initial Public    

Offering IRC §§ 382/383

Offering – IRC §§ 382/383

_______________________________________________

An IPO may result in a “change of control,” triggering tax attribute limitations of IRC §§382/383.

• A company considering going public should evaluate the impact of such a change of control on its use of tax attributes.

Federal, state and foreign tax attributes should be evaluated under their respective tax attribute limitation rules, as only some states follow the federal IRC §§382/383 change of control rules.

• Section 382/383 limitations may create “worthless” DTA, e.g., NOL and/or credit carryforwards that are expected to expire unutilized.

/ f f f

• When 382/383 limitations mathematically preclude use of a portion of a carryforward or a deductible difference, it is appropriate for a DTA to be written off rather than

(76)

Special Circumstances: Initial Public 

Offering Conversion To C Corporation

Offering – Conversion To C Corporation

_______________________________________________

As part of its IPO plan, an entity currently organized as a p p y y g pass-through entity (S p g y ( Corporation, LLC, partnership) generally would be required to covert to a C

Corporation. This results in DTA and/or DTL for the initial temporary differences at the time of the change in status.

• The recognition of initial temporary differences is recorded in income from continuing operations, and no current tax expense would result as of the date of the change in status.

• If the pass-through entity had liabilities for tax purposes, then the partners/shareholders would have a gain from the liabilities assumed by the

corporation. The new C corporation would obtain a step-up in tax basis in an amount equivalent to the gain. q g

• The pass-through entity’s gain and C corporation step-up in basis are considered direct consequences in the change of tax status, with the benefit recorded in income from continuing operationsg .

(77)

Special Circumstances: Tax Holidays

Special Circumstances: Tax Holidays

_______________________________________________

• A determination must be made as to

whether a DTA should be

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established for the future tax savings of a tax holiday

, on the

premise that such savings are similar to an NOL carryforward.

• ASC 740 10 25 35 et seq

prohibits recognition of a DTA

for any

• ASC 740-10-25-35, et seq.

prohibits recognition of a DTA

for any

tax holiday (including both “general” and “unique” tax holidays).

• Prohibition of DTA recognition is due to the

Prohibition of DTA recognition is due to the

practical problems

practical problems

associated with: 1) distinguishing between a “general” and “unique”

tax holiday, and 2) measuring the DTA associated with future benefits

expected from tax holidays.

p

y

• A DTA or DTL arising from a tax holiday should be

measured using

the enacted tax rates expected to apply to taxable income in the

(78)

Special Circumstances: Foreign      

Branch Operations

Branch Operations

_______________________________________________

U.S. federal deferred tax consequences arising from a business operation situated in a foreign branch are similar to the U.S. federal tax consequences arising from a

a foreign branch are similar to the U.S. federal tax consequences arising from a business operation located in a U.S. state and local jurisdiction.

• The foreign DTA or DTL will be a temporary difference in the computation of the deferred U.S. tax, because the foreign DTA or DTL has a book basis but no U.S. tax

deferred U.S. tax, because the foreign DTA or DTL has a book basis but no U.S. tax basis.

• When a foreign DTA is recovered, it reduces the foreign branch local country

current taxes and consequently the foreign taxes deductible by or creditable to the U.S. cu e t ta es a d co seque t y t e o e g ta es deduct b e by o c ed tab e to t e U S corporation.

• When a foreign DTA is settled, it increases foreign branch local country current taxes and foreign taxes deductible by or creditable to the U.S. corporation. g y p

• A foreign DTL recorded at the branch level would give rise to a U.S. DTA, while a

foreign DTA recorded at the branch level would give rise to a U.S. DTL.

(79)

Special Circumstances: Indefinite

R

l E

ti

Reversal Exception

The presumption per ASC 740-30-25-3 that all undistributed earnings will be p p p g

transferred to the parent entity may be overcome; and no income taxes will be accrued by the parent entity, for entities and periods identified, if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely.

Management must compile evidence to support its assertion that the foreign unremitted earnings are indefinitely reinvested, in order to qualify for the indefinite reversal exception. A mere history of not distributing foreign earnings does not serve as a replacement for specific reinvestment plans.

Acceptable evidence indicating specific reinvestment plans includes the following: • Forecasts and budgets

• Projected working capital/other capital needs in locations where earnings generated • Reasons why excess earnings not needed by parent/subsidiary

• Past history of dividend actions (or lack thereof) • Tax consequences of a decision to remit or reinvest

References

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