Missed items in the income tax provision 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. Oftentimes, circumstances may change, and there may be a key financial reporting requirement that gets missed because it hasn’t applied to a company’s fact pattern in the past.
This article highlights a few key Accounting Standards Codification Topic 740 (ASC 740) income tax accounting matters that we have seen numerous companies overlook on tax provisions in recent years, including:
- Intraperiod Tax Allocation Rules
- Hanging Credits for Indefinite-Lived Intangibles Amid Valuation Allowance (VA) Positions
- Jurisdictional Netting of Deferred Tax Assets and Deferred Tax Liabilities
- Improper Disclosure of Attributes and Carryforwards
- Improper Recognition or De-Recognition of FIN 48 (ASC 740-10) Items
- Improper Disclosure of APB 23 Positions
- Failure to Calculate Outside Basis Difference for Non-Consolidated Entities, Including Foreign Entities and Domestic Partnerships
Although these items may already be familiar, our goal is to remind companies about financial reporting requirements that may have fallen off their radar. Companies that have had any unusual transactions or changes in circumstances during the period should be sure to thoroughly consider the various tax accounting implications that may be outside their normal process.
Accounting for Income Taxes: Commonly Missed Tax Matters
Intraperiod Tax Allocation Rules
It’s rare for many companies to have any income statement component other than 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
- 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, but there are various exceptions under the “with” and “without” approach prescribed in the guidance.
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 non-intuitive results. Companies that have financial statement components other than continuing operations should take a close look at how tax expenses or benefits are allocated.
Hanging Credits for Indefinite-Lived Intangibles Amid VA Positions
It’s easy to get in the habit of netting your deferred tax assets and deferred tax liabilities and calling it a day. However, if a company has deferred tax liabilities related to indefinite-lived intangibles and a VA position, a second look may be needed. Reversals of deferred tax liabilities that relate to indefinite-lived intangible assets, often referred to as a “naked credit” or “hanging credit,” generally may not be used in the realization assessment of finite-lived deferred tax assets.
ASC 740 provides specific guidance on what items to consider in the assessment of realization of deferred tax assets, one being the existence of future reversals of existing deferred tax liabilities. In general, a VA may not be needed if, after considering other evidence, there are sufficient deferred tax liabilities that will reverse to produce taxable income in the future.
Indefinite-lived intangible assets are not amortizable or depreciable for book purposes but usually are amortizable over a 15-year period for tax purposes. Due to the indefinite nature of these 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 VA.
Despite the rules being fairly straightforward, “hanging credits” that get missed are still a leading cause of financial statement restatements. Indefinite-lived deferred tax assets for net operating losses (NOLs) and interest carryforwards after the Tax Cuts and Jobs Act of 2017 (TCJA) have added another wrinkle to the required analysis.
Jurisdictional Netting of Deferred Tax Assets or Liabilities
ASC 740 requires that deferred tax assets and deferred tax liabilities must be separately stated on the financial statements if they:
- Are from different tax-paying jurisdictions, or
- Arise from different tax-paying entities
This is commonly missed when an entity that has historically operated in a single 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, be sure the provision tool is netting the deferred tax assets and deferred tax liabilities independently for each jurisdiction. In practice, most U.S. companies do not net by state, only by country.
Improper Disclosure of Attributes & Carryforwards
When examining both the amounts and expiration dates to be disclosed for NOLs 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.
Improper Recognition or De-Recognition of FIN 48 (ASC 740-10) Items
Under FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, 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 examination.
Companies often fail to de-recognize a FIN 48 liability when the tax position is effectively settled or when the statute of limitations has expired.
After settling with the IRS regarding an examination of the research and development credit, the liability and accrued interest related to this uncertain tax position should be de-recognized.
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 it may be using incorrect apportionment methods because the correct information is unavailable, e.g., market-based sourcing versus cost of performance sourcing.
Improper Disclosure of APB 23 Positions
ASC 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 Accounting Principles Board Opinion Number 23 (APB 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, i.e., they are permanently reinvested. Companies should confirm 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 ASC 740. Both a parent and 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.
A common misconception is that APB 23 is no longer relevant after the TCJA. If anything, the TCJA made the related calculations even more complex than they were before, although the materiality of the residual tax amounts may be much less in many scenarios.
Failure to Calculate Outside Basis Difference for Non-Consolidated Entities, Including Foreign Entities & Domestic Partnerships
When a company cannot make the APB 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. Outside basis differences should generally be recorded for domestic partnerships, as permanent reinvestment does not apply in that context. The calculation of the deferred tax liability depends on a variety of factors, including whether it is a domestic or foreign entity and the form of the entity. While many jurisdictions (including the U.S.) no longer tax the repatriation of unremitted earnings in most common scenarios, companies also must consider in their calculations:
- Cumulative translation adjustments,
- Withholding taxes,
- Transactions with non-controlling shareholders, and
- Other comprehensive income items
ASC 740 is inherently complex, and the correct answers are often non-intuitive. Letting the provision process drift to autopilot can be hazardous.
For additional information on how any of the topics in this article might impact your financial statements, please reach out to a professional at FORVIS.