Editor: Mark Heroux, J.D.
In 2017, one of the most comprehensive pieces of tax legislation ever, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, was enacted. In addition to companies and practitioners needing to reevaluate key aspects of tax law, much focus was needed on the financial statement impact of these legislative changes in accordance with FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes. The COVID-19 pandemic has, again, heightened the focus on tax law changes and financial statement consequences with the March 27, 2020, enactment of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136.
In an attempt to create economic stimulus through the income tax regime, the CARES Act temporarily suspended or modified several elements of the TCJA (e.g., net operating loss (NOL) and interest limitation rules) and provided a key technical correction relating to qualified improvement property (QIP). This discussion highlights some of the key issues under Topic 740 that may arise in both interim and annual financial statements.
Remeasurement of deferred tax accounts
Topic 740 requires the effect of changes in income tax laws (or rates) on deferred tax assets (DTAs) and deferred tax liabilities (DTLs) to be recorded in continuing operations in the period that includes the date of enactment (i.e., March 27, 2020, in the case of the CARES Act). The impact on the income tax receivable or payable will also be recognized in the period of the enactment date even if the deferred tax balances relate to a prior period. When remeasuring the DTAs or DTLs, companies will need to consider future reversals and taxable temporary differences as of the enactment date to determine the applicable law to be used for each item. For example, due to the CARES Act, companies may have a different interest expense limitation (Sec. 163(j)) carryforward than originally recorded, or may be remeasuring tax basis in fixed assets due to the new ability to depreciate QIP over 15 years (or take 100% bonus depreciation). These potential changes will necessarily affect the DTAs or DTLs recorded.
Impacts for carryback claims
The CARES Act temporarily restored the ability to carry back NOLs originating in 2018, 2019, and 2020 to offset taxable income in the five preceding years. This creates the opportunity to recognize a current benefit for losses that would otherwise have been carried forward. If a company intends to elect out of the carryback or there is no historical taxable income to offset, companies should continue to record any NOLs generated as a DTA. Consistent with the TCJA, losses continue to be carried forward indefinitely.
Calendar-year taxpayers with NOLs originating in 2018 and 2019 that were initially measured at the current corporate income tax rate of 21% may now be carried back to offset taxable income that was taxed at pre-TCJA tax rates of up to 35%. However, the precise value of these NOL carrybacks may be affected by credits claimed, elections made, or other limitations that may exist in those prior years; as such, care must be taken in calculating the potential benefit from those NOLs. Taxpayers that anticipate carrying back these NOLs should record the expected benefit as an increase to income taxes receivable (or a reduction of income taxes payable). Any benefit received at a rate other than 21% will have an impact on the company's effective tax rate.
The TCJA eliminated the corporate alternative minimum tax (AMT) regime. Beginning in 2018, any NOL generated only affects regular federal tax and does not generate an NOL for AMT purposes. If carrying back an NOL to a year prior to 2018, companies may be subject to AMT, which could produce AMT credit carryforwards. AMT credits generated are refundable and should be considered in the company's calculation of the expected tax benefit. Additionally, companies that benefit from certain credits that can offset AMT should consider the corollary impacts to their credit carryforward.
In addition, the CARES Act allows any AMT credit carryforwards to be refunded in their entirety beginning in 2019 rather than a period of future years. The TCJA previously did not allow the credits to be fully refundable until 2021. Remaining credits should be included in the current-year income tax receivable and reclassified from noncurrent balance sheet accounts. Taxpayers may elect to make the credits fully refundable for tax years beginning in 2018.
For interim financial reporting purposes, the tax effects would be recognized during the period of enactment (e.g., the first quarter of 2020 for calendar year-end companies) and not allocated to subsequent interim periods through adjustments to the estimated annual effective tax rate.
Temporary differences as of the beginning of the financial statement year during which the CARES Act was enacted that will fully or partially reverse during the current year should be remeasured at the tax rate in the carryback period to the extent that these differences are expected to create or increase a current-year NOL that will be carried back. This remeasurement should be recorded as a discrete item. Temporary differences that originate in the year and are likely to contribute to a carried-back NOL will affect the estimated annual effective tax rate used during interim periods. Temporary differences expected to reverse in later years generally would not alter the calculation of the annual effective tax rate.
The company should give consideration to changes to its projected annual effective tax rate for the current year used in calculating interim tax provisions, including the impact of changes to forecasted income/loss and the company's ability to recognize the benefit of any losses forecasted for the current year.
To the extent that a company has not yet adopted the simplification provisions of Accounting Standards Update No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, additional care should be taken in determining the interim tax benefit of year-to-date losses.
Topic 740 requires companies to assess all evidence, both positive and negative, when evaluating the realizability of DTAs. A valuation allowance must be established for DTAs if it is more likely than not that all or a portion of the DTAs will not be realized. Topic 740 provides four sources of taxable income to consider when determining if the benefit should be realized for DTAs:
- Taxable income in prior carryback year(s), if carryback is permitted under the tax law;
- Future reversal of existing taxable temporary differences;
- Future taxable income exclusive of reversing temporary differences and carryforwards; and
- Tax planning strategies.
With changes under the CARES Act for use of NOLs, increased interest expense limitation, etc., companies should review the tax law changes and the ability to realize DTAs ultimately resulting in a recording or release of a valuation allowance. Companies should evaluate all available positive and negative evidence that impact each of the four sources of income, noting that enhanced financial modeling may be required in some instances. (However, if sufficient positive evidence of income arising from one source exists, it may not be necessary to evaluate other sources.)
In addition to considering changes arising in law (e.g., availability of NOL carrybacks and changes to interest limitations), companies should reevaluate future income forecasts, particularly in light of current economic conditions. A change in judgment of a valuation allowance with respect to future income is recorded as a discrete item in the interim quarter in continuing operations income or loss.
As with any tax position, in considering the impact of any aspect of the CARES Act, taxpayers need to evaluate their tax positions in accordance with the "recognition and measurement" framework of Topic 740, in which a tax benefit may only be recorded when it is more likely than not the position would be sustained on its technical merits, and the amount of benefit recorded is the largest amount of benefit for which it is more than 50% likely to realize upon ultimate settlement. To the extent there is perceived ambiguity or omissions in elements of the enacted legislation, companies should give careful consideration to all available technical authorities and weigh them accordingly in reaching their more-likely-than-not conclusions. To the extent companies recognized uncertain tax benefits due to statute expiration, they should consider the impact of any NOL carryback on those years. In the event of an NOL carryback, those years are now subject to audit, and those tax benefits may need to be reversed.
Mark Heroux, J.D., is a tax principal and leader of the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.