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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 Allowances1pm 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
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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
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]
OVERVIEW OF MATERIAL
Douglas Sayuk, Clifton Douglas
OVERVIEW OF MATERIAL
TERMS OF ASC 740 AND
Introduction: DTA Build
From Recession
From Recession
_____________________________________________________RECESSION
RECESSION
=
TAX LOSSES
=
DTA BUILD
DTA BUILD
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
Introduction: DTA Utilization
From Economic Recovery
From Economic Recovery
_____________________________________________________IMPROVING ECONOMY
IMPROVING ECONOMY
=
2011/2012 DTA
UTILIZATION/POTENTIAL VA
RELEASE
RELEASE
Introduction: Increased DTA Accounting
F
B
i
C
bi
ti
From Business Combinations
_____________________________________________________Improving Economy
Improving Economy
=
Increasing Business
Combinations
Combinations
=
Increasing Tax Accounting Under
ASC 805 10 5 (FAS 141R)
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
(
)
y
• 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).
TAX RELATED ISSUES
Mathew DeMong, BDO USA
Agenda For This Section
Tax-related issues
A. Effective tax rates and interim accounting for taxes
B. Business combinations and accounting for taxes
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
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.
E ti
t f b th
t d d f
d t
tt ib t d t
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.
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
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
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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ld
b
$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?
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?
Th hi d
i
i i i
d b
l i l i h
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
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
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
i d d
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
Multiple Jurisdictions: Example
Multiple Jurisdictions: Example
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
Business Combinations (Cont )
Business Combinations (Cont.)
Measurement period
Measurement period
- Initial accounting for business combination is incomplete by the end
f th
ti
i d
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
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
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
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
b t
th b k d t b i i f t
i
-
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.
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.
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
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.
Valuation Allowances In
Valuation Allowances In
Business Combinations
Established at time of business combination
E l
id
Evaluate evidence
Combined company’s past and expected future results of
operations as of the acquisition date
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.
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.
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
p
y
considered a source of income to reduce the VA.
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
t
t l t t i
li d t d t
i
“More likely than not” standard or contractual test is applied to determine
if an accrual is warranted.
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.
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
N
t
bl
i iti
E t bli h d f
d t li bilit t
h
d t
Non-taxable acquisitions: Establish deferred tax liability at purchase date
Can potentially result in a naked credit
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.
I iti l iti
i
d d
t
d ill
d
b
t
k
t
Initial recognition is recorded to goodwill, and any subsequent mark to
market changes are charged to the P&L.
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
Tax Treatment Of Share-Based
Tax Treatment Of Share-Based
Compensation
— Incentive stock options
Non qualified stock options
— Non-qualified stock options
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
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
p
p y
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
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
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
p
;
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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)
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
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
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% = $80Book Deduction
$100 X 40% = $40Excess Tax Ded
$100 X 40% = $40Dr. tax expense $40
Cr. DTA $40
Dr. tax payable $80
Cr. tax expense $40
Cr. tax expense $40
Cr. APIC $40
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.
Th
f
ld l b ll
d t
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
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
Shortfalls
Shortfalls
ABC has a DTA at the beginning of the year of $2 million. $500k worth of
i
ll d
d i h
Th
h
i d f
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
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
p
y
y
f
p
g
y
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
VALUATION ISSUES ARISING
Douglas Sayuk, Clifton Douglas
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
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
VA Issues Arising With DTA: VA
E id
T B C
id
d
E
l
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
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
p ,
cumulative loss in recent years is a significant piece
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g
p
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:
C
l ti
l
i
t
• 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
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.
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
hi t i
l
i
i it
th
b
i
li
l d
ith
l
th NOL
historical earnings in its other business lines, coupled with a lengthy NOL
VA Issues Arising With DTA:
Positive Evidence
• Examples of
positive evidence
include, but are not limited to, the
following:
S l
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kl
th t
ill
d
th
h t
bl
•
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
VA Issues Arising With DTA – Positive
E id
Of T
bl I
S
Th f ll
i
f
ibl
f t
bl i
b
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
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.
VA Issues Arising With DTA – Scheduling
Future Taxable Income
•
Scheduling future taxable income is necessary when it matters
g
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.
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
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 notelective. 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
VA Issues Arising With DTA: Ineffective
Tax Planning Strategies
• Actions that
generally would not qualify as tax planning strategies
g
y
q
y
p
g
g
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
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.
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 tosignificant 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
VA Issues Arising With DTA: Specific
Issues – Carrybacks Free Up Credits
C
id
ti
t b
i
t
t d d
tibl t
diff
• 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.
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 to2009 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
VA Issues Arising With DTA: Specific
I
FTC C
f
d
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.
D
t th
t i
t
li
ti
i
t
it
ill b
diffi
lt t
id
VA f
• 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.
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
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
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
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 CCorporation. 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 .
Special Circumstances: Tax Holidays
Special Circumstances: Tax Holidays
_______________________________________________
• A determination must be made as to
whether a DTA should be
t bli h d f
th f t
t
i
f
t
h lid
th
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
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 aa 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.
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 gtransferred 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