As the 2008 financial statement year-end tax provision planning process begins, it is a good time to review some areas of Statement of Financial Accounting Standards No. 109 (FAS 109), Accounting for Income Taxes, that could require more analysis in preparing year-end tax provisions for companies.
Asset Retirement ObligationsThe Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 143 (FAS 143), Accounting for Asset Retirement Obligations, requires an entity to recognize the fair value of a liability for legal obligations associated with the retirement of a tangible long-lived asset in the period in which it is incurred if a reasonable estimate of fair value can be made. FAS 143 is applicable to all entities. Upon initial recognition of an asset retirement obligation (ARO), an entity capitalizes the ARO cost by increasing the carrying amount of the related long-lived tangible asset by the same amount as the liability. An entity subsequently allocates the ARO cost to expense in the income statement using a systematic and rational method over the useful life.
Generally, these liabilities are not deductible for income tax purposes when accrued for financial statement reporting, and this therefore creates a book/tax basis difference both in the long-lived tangible asset and in the ARO liability. Accordingly, an entity should recognize a deferred tax asset for the difference between the financial statement carrying value of the ARO liability and the tax basis, which is generally zero. The offset of the ARO liability for financial statement purposes is an increase in the asset carrying value of the respective asset. This additional asset value will result in a separate temporary book/tax basis difference for which an entity should recognize a deferred tax liability.
The deferred tax liability associated with the increase in the asset's financial statement carrying value will reverse as the asset is depreciated for financial statement purposes. Since most of these ARO liabilities are long term, an entity may not be able to estimate when the ARO deferred tax asset will be settled and deductible for tax purposes, resulting in the reversal of the deferred tax asset. Therefore, the entity should consider the need for a valuation allowance for the ARO deferred tax asset. In addition, FAS 143 requires an entity to recognize period-to-period changes in the ARO liability, which will require analysis of the ARO liability account to determine actual settlements versus changes in the estimated fair value of the ARO obligations.
Asset Impairment/Purchase AccountingIn a taxable business combination structured as an asset acquisition, tax basis is typically created in intangible assets and goodwill amortizable over a 15-year period. For GAAP purposes, such amortization is allowed only on intangible assets with a determinable life. Goodwill and indefinite-lived intangibles are not eligible for annual amortization charges under GAAP; rather, such assets are subject to an impairment analysis to determine whether the recorded book value of such assets is overstated. If it is determined that the recorded book value is overstated, then the purchaser generally records an impairment charge to the statement of operations to adjust the assets to their lower derived value.
If the book and tax basis of goodwill and indefinite-lived intangible assets is determined to be the same as of the acquisition date, no deferred income tax assets or liabilities would be recorded with respect to such assets. However, as the goodwill and indefinite-lived assets are not amortized for financial statement purposes while amortization is recognized for tax purposes, the book basis of goodwill prior to an impairment write-down will usually exceed the tax basis goodwill.
The purchaser recognizes a deferred tax liability for tax purposes until the asset is impaired for financial reporting purposes. If the impairment write-down reduces the book basis of tax deductible goodwill below the tax basis, the entire deferred liability would be reversed and a deferred tax asset would be recognized, subject to valuation allowance considerations. A partial impairment of tax deductible goodwill for financial reporting purposes that reduces the book basis below the tax basis would be expected to reverse in future years as amortization deductions are recognized for tax purposes.
Where differences may exist in the book and tax basis of goodwill at the acquisition date, tracking the various components of the goodwill asset becomes important. For instance, if additional proceeds are allocated to goodwill for book purposes rather than tax purposes, both a temporary and permanent component would exist with respect to this basis difference. Total book goodwill would first be allocated to the extent of the tax deductible amount, creating a temporary component. As in the scenario above, a deferred income tax liability would result as amortization is deducted for income tax purposes. Any book goodwill in excess of this first temporary component is considered permanent in nature.
If the purchaser later recognizes an impairment of a portion, but not all, of its goodwill attributable to that acquisition, the impairment would need to be allocated between the deductible and nondeductible components of goodwill. If the purchaser has maintained sufficient records to specifically identify the components of goodwill that are impaired, the impairment loss should be allocated to the deductible and nondeductible goodwill accordingly.
In practice, most purchasers do not maintain proper records and must allocate the impairment in a systematic and rational method (e.g., pro rata, first reduce deductible goodwill, or first reduce nondeductible goodwill) between the two components of goodwill. The preferable method is to allocate the impairment on a pro-rata basis because other methods would not be supportable in the absence of sufficient records to directly attribute the impairment to either or both components of goodwill.
Indefinite-Lived Intangible AssetsAnother common issue that often goes overlooked in accounting for income taxes under FAS 109 is the recognition of deferred taxes on indefinite-lived assets. In certain instances, an entity may establish indefinite-lived intangible assets for financial reporting purposes while there is no related asset for tax purposes. The book/tax difference creates a deferred tax liability that will reverse either when the asset is disposed of or when the asset is impaired. There are also times when the book basis and tax basis of an intangible asset are initially equal, but through different amortization methods, period or asset impairments, or write-offs, a temporary difference arises subsequent to the acquisition or creation of the intangible asset.
One common example of this situation is when goodwill is created in the asset acquisition of another business. The goodwill created through the acquisition could initially be the same for book and tax purposes. However, as the tax goodwill is amortized under Sec. 197 over 15 years, the related book goodwill will remain at the original recorded amount until such time as GAAP determines the goodwill has been impaired or is worthless.
Generally, an entity cannot use deferred tax liabilities associated with indefinite- lived assets (e.g., land, goodwill, intangible assets) as a source of income for the realization of deferred tax assets. An unusual situation arises when a loss company with a full valuation allowance does not have available taxable income to support the realization of the deferred tax asset. In this situation, a deferred tax liability is established for the difference between the book basis and tax basis of the indefinite-lived intangible asset, and deferred taxes are recognized. In the goodwill example above, deferred taxes will still be recognized as the goodwill is amortized each period, thereby increasing the net deferred tax liability even if a full valuation allowance is established against the deferred tax assets.
This concept can become especially complicated when an entity has multiple indefinite-lived intangible assets. Assets cannot be combined when determining whether the indefinite-lived intangible assets are in a net deductible or net taxable position for evaluating the need for a valuation allowance. An entity should track each indefinite-lived intangible asset on an individual basis to avoid falling into this trap.
Valuation AllowancesIn applying FAS 109, a company recognizes deferred tax assets for deductible temporary differences, net operating loss carryforwards, and tax credit carryforwards based on the provisions of the enacted tax law. An important second step in this process is to assess the need for a valuation allowance, which reduces the deferred tax assets by the amount of any tax benefits that, based on available evidence, are not expected to be realized. The evaluation of deferred tax assets is made on a gross basis; therefore, this step is not limited to companies in a net deferred tax asset position.
Assessing the need for a valuation allowance requires management to analyze all available evidence, both positive and negative, to determine if it is more likely than not (a likelihood of more than 50%) that some or all of the deferred tax asset will not be realized. If negative evidence (e.g., a history of operating losses) exists, management must determine if there is positive evidence sufficient to outweigh the negative evidence.
Positive evidence refers to the existence of one or more of the following four sources of taxable income:
- Future reversals of existing taxable temporary differences and carryforwards;
- Forecasted future taxable income exclusive of reversing temporary differences and carryforwards;
- Taxable income in carryback year(s) if a carryback is permitted under the tax law; and
- Tax-planning strategies.
In this context, a tax-planning strategy is a prudent action that a company ordinarily might not take but would consider to prevent an operating loss or tax credit carryforward from expiring unused. It includes plans that would accelerate taxable events to utilize expiring carryforwards, change the character of taxable or deductible amounts from ordinary income or loss to capital income or loss, or change the nature of income from tax exempt to taxable.
To the extent that evidence about one or more of the listed sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources do not have to be considered. However, if management concludes that a valuation allowance is necessary, all four sources must be considered to calculate the amount of the valuation allowance.
It is important to note that a valuation allowance is not used to derecognize the benefits of uncertain tax positions. A valuation allowance is used only to reduce assets that have already been recognized and measured under the provisions of FAS Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, to an amount that is more likely than not to be realized by generating sufficient taxable income.
Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or firstname.lastname@example.org.