Simplifying the accounting for income taxes

Editor: Mark Heroux, J.D.

As part of its initiative to reduce complexity in accounting standards, FASB issued Accounting Standards Update (ASU) No. 2019-12 in late 2019 for the purpose of simplifying accounting for income taxes. The amendments involve removing certain exceptions to the general principles in FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes, and making certain other modifications.

This item summarizes key aspects of these simplifying amendments, but first it briefly discusses the effective date.

Effective date

The amendments in ASU 2019-12 are effective for public business entities for fiscal years beginning after Dec. 15, 2020. For all other business entities, the amendments are effective for fiscal years beginning after Dec. 15, 2021.

Early adoption of the amendments is permitted, including adoption in any interim or annual period for which financial statements have not yet been issued or made available for issuance. An entity that elects to early-adopt the amendments in the interim period should reflect any adjustments as of the beginning of the annual period that includes the interim period. In addition, an entity that early-adopts ASU 2019-12 is required to adopt all the amendments in the same period.

Entities are required to disclose the nature of and reason for the change in accounting principle, the transition method, and a qualitative description of the financial statement line items affected by the change. An entity shall disclose these in the first fiscal year after the entity’s adoption date and in the interim periods within the first fiscal year.

Key changes

As noted above, FASB released ASU 2019-12 as part of its initiative to reduce complexity in accounting standards. Some of the key changes adopted to simplify accounting for income taxes are summarized here.

Intraperiod tax allocations: Intraperiod tax allocation is the process of allocating total tax expense or benefit to components of the income statement (such as continuing operations, discontinued operations, and other comprehensive income). An entity generally allocates total income tax expense or benefit by first determining the amount attributable to continuing operations and then allocating the remaining tax expense or benefit to items other than continuing operations.

However, there is an exception when an entity incurs a loss from continuing operations and gain from another component that often results in allocating a tax benefit to continuing operations and tax expense to another component. ASU 2019-12 removes the exception. Instead, an entity will follow the general intraperiod allocation of total tax expense regardless of whether there is a loss from continuing operations. Income from discontinued operations and other items are no longer considered in determining the amount of tax benefit that is allocated to continuing operations. This guidance is required to be adopted prospectively in the period of adoption for allocations made after the adoption date.

Ownership changes in foreign investments — transition to the equity method of accounting: When an entity transitions from the subsidiary to the equity method of accounting for a foreign investment, it does not recognize a deferred tax liability related to the transition date outside basis difference if the parent had been asserting that earnings were indefinitely reinvested in the former subsidiary and changes this assertion at the time of the accounting method change. This is an exception to the principle that an entity must recognize a deferred tax liability for a taxable outside basis difference under the equity method of accounting when there is no indefinite reinvestment assertion.

ASU 2019-12 removes the exception. If an outside basis difference must be recorded due to a change in the assertion when the accounting method changes to the equity method, an entity should recognize a deferred tax liability on the entire outside basis difference of the foreign equity method investment.

Ownership changes in foreign investments — transition from the equity method of accounting: Under current guidance, when a foreign equity method investment transitions to a subsidiary, it maintains the deferred tax liability previously recognized even if it asserts that earnings are indefinitely reinvested when the investment becomes a subsidiary. The requirement that an entity freeze the outside basis difference of a foreign equity method investment that becomes a subsidiary represents an exception to the general principle for accounting for outside basis differences of foreign subsidiaries.

ASU 2019-12 removes the exception, and no deferred tax liability is recorded if an entity subsequently asserts that earnings are indefinitely reinvested after becoming a subsidiary.

The new guidance is applied on a modified retrospective basis, with a cumulative-effect adjustment recorded through retained earnings as of the beginning of the period of adoption.

Year–to–date losses: Under existing Topic 740 guidance, an entity is required to make its best estimate of the annual effective tax rate for the full fiscal year at the end of each interim period and use that rate to calculate its income taxes on a year-to-date basis.

However, the existing guidance includes an exception when the ordinary loss for an interim period exceeds the expected loss for the current year. The guidance limits the income tax benefit recognized in the interim period to the income tax benefit recognized as though the year-to-date ordinary loss were the expected loss for the current year.

ASU 2019-12 removes the exception. An entity will no longer limit the tax benefit recognized in the interim period and compute its income tax benefit at each interim period based on its estimated annual effective tax rate. This guidance must be adopted using a prospective approach in the period of adoption.

Franchise taxes partially based on income: Existing guidance under Topic 740 specifies that franchise taxes based on income should be included in income tax expense only to the extent they exceed the franchise taxes that are not based on income.

ASU 2019-12 amends this guidance to require an entity to first determine the amount related to income-based tax and record this portion as income tax expense, and any excess amount due to a minimum non—income-based tax should be reflected in pretax income. Deferred taxes should be recorded using the statutory income tax rate.

This guidance can be adopted by using either a retrospective approach or a modified retrospective approach, with a cumulative-effect adjustment recorded through retained earnings as of the beginning of the period of adoption.

Step–up tax basis of goodwill: After a business combination that results in the recognition of goodwill under FASB ASC Topic 805, Business Combinations, certain transactions may result in additional tax basis in goodwill. Under current guidance, an entity recognizes a deferred tax asset only if the newly tax-deductible goodwill exceeds the remaining balance of book goodwill that was previously recognized in the business combination.

ASU 2019-12 requires an entity to consider a list of factors to determine whether the tax basis step-up transaction relates to the previous business combination for which the book goodwill was originally recognized or to a separate transaction. To the extent that a goodwill step-up transaction is considered a separate transaction unrelated to the original business combination, an entity should record a deferred tax asset for this additional tax basis in goodwill. This guidance must be adopted using a prospective approach in the period of adoption for transactions after the adoption date.

Separate financial statements of legal entities not subject to tax: Under the existing guidance in Topic 740, consolidated current and deferred tax expense should be allocated among the members of a group of entities that files a consolidated tax return if those entities issue separate financial statements. The guidance does not specify whether the requirement to allocate current and deferred income taxes to members that are included in a consolidated tax return applies to entities that are not subject to tax (single-member limited liability companies that are disregarded entities in their consolidated financial statements).

ASU 2019-12 clarifies that an entity is not required, but may elect, to allocate the consolidated amount of current and deferred tax expense to the separate financial statements issued by entities not subject to tax. This guidance must be adopted on a retrospective approach in the period of adoption.

Enacted changes in tax laws: Existing guidance under Topic 740 requires an entity to recognize the income tax effects of an enacted change in tax law on deferred tax assets or liabilities on the date of enactment. However, there is an exception for tax laws with delayed effective dates. An entity may not adjust its annual effective tax rate for a tax law change until the period in which the law is effective.ASU 2019-12 requires that changes in tax law are reflected in the effective tax rate in the period of enactment instead of in the period that includes the effective date. This guidance must be adopted using a prospective transition approach in the period of adoption.

EditorNotes

Mark Heroux, J.D., is a tax principal in 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 mark.heroux@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.