Missed items in the tax provision, which is the estimated amount of income taxes a company expects to pay this year, are a leading cause of financial statement restatements. Accounting for income taxes can often become routine for companies with consistent operations, as many roll their positions forward and perform the same tasks from the prior year or quarter. However, circumstances may change, and there may be a key reporting requirement that gets missed because it has not applied to the company in the past.
This article highlights a few key Accounting Standards Codification (ASC) Topic 740, Income Taxes, tax matters that we have seen numerous companies miss or overlook in tax provisions in recent years, including:
- Intraperiod tax allocation rules.
- Hanging credits for indefinite-lived intangibles amid valuation allowance positions.
- Jurisdictional netting of deferred tax assets and deferred tax liabilities.
- Improper disclosure of tax attributes and carryforwards.
- Failure to consider the alternative minimum tax (AMT) when using net operating loss (NOL) carryovers.
- Improper recognition or derecognition of uncertain tax positions under FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes, which is now mostly incorporated into ASC Subtopic 740-10.
- Improper disclosure of Accounting Principles Board (APB) Opinion No. 23, Accounting for Income Taxes—Special Areas, positions for indefinite reinvestment of foreign earnings
- Failure to calculate outside basis difference for nonconsolidated entities, including foreign entities and domestic partnerships
Although tax professionals may already be familiar with these items, this article's goal is to remind companies about reporting requirements that may have fallen off their radar screen. If the business has had any unusual transactions or changes in circumstances during the period, a practitioner should be sure to thoroughly consider the various tax accounting implications that may be outside normal processes.
Intraperiod tax allocation rules
The intraperiod tax allocation rules require items to be stated net of tax. For many companies, it is rare to have any income statement component other than net income from continuing operations. When circumstances change, companies often forget to allocate total income tax expense or benefit for the year among the different components that may occur infrequently. These components include:
- Continuing operations.
- Discontinued operations.
- Other comprehensive income (items not included on the income statement because they have not been realized, such as foreign currency translation gains and losses).
- Other items that affect shareholders' equity.
The general rule of thumb is that the tax item should follow the book item of income, gain, expense, or loss.
Example 1: The tax effect of cumulative translation adjustments would be allocated specifically to other comprehensive income, whereas the tax effect of a tax rate change for the current year would be reflected in continuing operations.
The intraperiod allocation rules can get quite complex and yield some very nonintuitive results. For financial statement components other than continuing operations, make sure to look closely at the allocation of the tax expense or benefit.
Hanging credits for indefinite-lived intangibles amid valuation allowance positions
Indefinite-lived intangible assets such as goodwill, trademarks, and perpetual franchises are not amortized for financial statement purposes, but they are instead evaluated for their value being impaired each year. When preparing the income statement, it is easy to get in the habit of netting deferred tax assets and deferred tax liabilities and calling it a day. However, if there are deferred tax liabilities related to indefinite-lived intangibles together with a valuation allowance position, practitioners should take a second look. A valuation allowance occurs when a company lets various carryforwards expire unused or has excess losses.
Reversals of deferred tax liabilities that relate to indefinite-lived intangible assets, often referred to as "naked credits" or "hanging credits," generally may not be used in realizing deferred tax assets.
Topic 740 provides specific guidance on what items to consider in the assessment of realization of deferred tax assets. One consideration is the existence of future reversals of existing deferred tax liabilities. Generally, a valuation allowance may not be needed if, after considering other evidence, sufficient deferred tax liabilities will reverse to produce taxable income in the future.
Indefinite-lived intangible assets are not amortizable or depreciable for book purposes, but they usually are amortizable over a 15-year period for tax purposes. Due to the indefinite nature of indefinite-lived intangible assets, their related deferred tax liability reversal is difficult to determine; therefore, the associated deferred tax liability may not be used when assessing the need for a valuation allowance.
Even though the rules are fairly straightforward, hanging credits that get missed are still a leading cause of financial statement restatements.
Jurisdictional netting of deferred tax assets or liabilities
Topic 740 requires that deferred tax assets and deferred tax liabilities be separately stated on the financial statements if they:
- Are from different taxpaying jurisdictions, or
- Arise from different taxpaying entities.
This required separation is commonly missed when an entity that has historically operated in a single tax jurisdiction expands into a new jurisdiction. The existing tax provision template may not include the mechanism to properly net the deferred items across jurisdictions. If a company operates in multiple jurisdictions, a practitioner should make sure the provision tool nets deferred tax assets and deferred tax liabilities independently for each jurisdiction.
Improper disclosure of attributes and carryforwards
When examining both the amounts and expiration dates to be disclosed for operating loss and tax credit carryforwards, companies should examine their state-specific carryforward items. These often have different carryforward periods than federal items, and the statute can change from year to year. Companies should remove expired carryforwards and properly record expiration dates.
Failure to consider AMT when using NOL carryovers
Companies may expect to fully offset their regular tax liability with large NOL carryforwards, but they must also consider the AMT when calculating tax expense under Topic 740. The AMT NOL may be substantially less than the regular tax NOL.
Under the AMT system, companies may only offset their AMT liability with 90% of their AMT NOL. This means that, even though companies may have zero regular taxable income and zero regular tax, they may have an AMT liability. They must also consider that the AMT NOL may be different from the regular tax NOL.
Companies must also consider the AMT tax credit when calculating their income tax expense under Topic 740. A company pays AMT when the tentative minimum tax is greater than the regular tax for that year. When a company pays AMT, it generates an AMT credit that may be used to reduce regular tax in future years. Companies must consider the availability of an AMT credit carryforward so they do not overstate their tax expense.
Improper recognition or derecognition of FIN 48 (Subtopic 740-10) items
Under FIN 48, companies must recognize the financial statement impacts of a tax position when it is "more likely than not" to be realized, which refers to a likelihood of more than 50% that the position will be sustained upon IRS examination.
Companies often fail to derecognize a FIN 48 liability when the tax position is effectively settled or when the statute of limitation has expired.
Example 2: After settling with the IRS after an examination of the research and development credit, the liability and accrued interest for this uncertain tax position should be derecognized.
Many companies also fail to record a FIN 48 liability. When a company has an uncertain position related to a state tax issue, it needs to record a related liability. This issue often arises when a company either is not filing a tax return in a state where it may have an obligation to file, or may be using incorrect apportionment methods because the correct information to apportion income is unavailable (e.g., market-based sourcing vs. cost-of-performance sourcing).
Improper disclosure of APB 23 positions
Topic 740 generally requires entities to record a deferred tax liability for the excess amount of the difference between the investment in a foreign subsidiary's tax basis and book basis. However, under APB Opinion No. 23, entities do not have to record a deferred tax liability if they can assert that the basis difference will not reverse in the foreseeable future. Companies should ensure the specific plans for reinvestment are well-documented and revisited annually.
Historical patterns alone are not enough evidence for management to support the assertion that the foreign unremitted earnings are permanently reinvested, as required under Topic 740. Both a parent and a subsidiary's financial requirements should be considered when performing this analysis. As part of the analysis, many companies assert that the domestic parent company does not need the funds produced by the foreign subsidiary. However, in the event that the parent company becomes strapped for cash, the company may no longer be able to make this assertion.
Failure to calculate difference in outside basis for nonconsolidated entities
When a company cannot make the APB Opinion No. 23 assertion, it is required to record a deferred tax asset or liability for the difference between the tax basis and book basis of an investment in a foreign subsidiary or a domestic partnership. The calculation of the deferred tax liability depends on a variety of factors, including whether it is a domestic or a foreign entity and the form of the entity. Additionally, although most outside basis differences occur because of unremitted earnings, companies must also consider in their calculations:
- Cumulative translation adjustments.
- Transactions with noncontrolling shareholders.
- Other comprehensive income items.
Topic 740 is inherently complex, and the correct answers are often nonintuitive. Letting the provision process drift to autopilot can be hazardous.
Phil Laminack is a tax manager, and Don Dismuke is a partner, both at Dixon Hughes Goodman LLP in Atlanta.
A version of this article appeared on the Dixon Hughes Goodman website.
