ASC 740 Income Tax Accounting Challenges in 2013 Tackling Valuations of Deferred Tax Assets, Tax Expense and UTP Reporting, and Other Issues

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1 Presenting a live 110-minute teleconference with interactive Q&A ASC 740 Income Tax Accounting Challenges in 2013 Tackling Valuations of Deferred Tax Assets, Tax Expense and UTP Reporting, and Other Issues TUESDAY, MAY 28, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Douglas Sayuk, Partner, Clifton Douglas, San Jose, Calif. Cindy Frank, Senior Director, Tax Process Efficiency and Technology, BDO USA, Phoenix Jeffrey Zawada, Director, FreedMaxick CPAs, Buffalo, N.Y. For this program, attendees must listen to the audio over the telephone. Please refer to the instructions ed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at ext. 10.

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5 ASC 740 Income Tax Accounting Challenges in 2013 Seminar May 28, 2013 Cindy Frank, BDO USA Douglas Sayuk, Clifton Douglas Jeffrey Zawada, FreedMaxick CPAs

6 Today s Program Overview Of ASC 740 And Related Guidance [Cindy Frank] Slide 8 Slide 26 Specific Income Tax Accounting Issues, Best Practices [Douglas Sayuk, Cindy Frank and Jeffrey Zawada] Slide 27 Slide 96

7 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

8 Cindy Frank, BDO USA OVERVIEW OF ASC 740 AND RELATED GUIDANCE

9 FAS 109/ASC 740 Objectives Recognize: 1. The amount of taxes payable or refundable for the current year 2. Deferred tax liabilities and assets for the future tax consequences 9

10 Basic Principles A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year. A deferred tax liability or asset is recognized for estimated future taxes created by temporary differences. The measurement of current and deferred taxes is based on the provisions of the enacted tax law. Measurement of deferred tax assets is reduced if they will not be recognized. These principles apply to domestic federal income taxes, and foreign and state and local taxes that are based on income. 10

11 Components Of Income Tax Expense Current income tax expense (benefit) +/- Deferred income tax expense (benefit) = Total income tax expense (benefit) 11

12 Current Income Tax Expense Item Amount Pre-tax book income $1,000,000 Permanent differences 100,000 Financial taxable income $1,100,000 Temporary differences 200,000 Taxable income per return $1,300,000 Tax rate 40% Tax liability (current portion of tax expense) $520,000 This example replicates a typical tax return expense calculation and represents only the current portion of income tax expense. Without FAS 109/ASC 740 principles, our tax expense would be $520,

13 Deferred Tax Expense SFAS 109 requires the balance sheet approach to compute deferred taxes. To compute the deferred expense, you must compare the beginning balance of temporary differences to their ending balance. Temporary difference treatment in FAS 109/ASC 740 smoothens out the rate; there is no impact on book tax expense. 13

14 Components Of Total Expense Permanent differences: Arise from income that is permanently non-taxable and expense items are permanently non-deductible Affect either the financial statements or the tax return, but not both Will always increase or decrease your effective tax rate Will either cost tax dollars or save tax dollars 14

15 Current Income Tax Expense Item Amount Pre-tax book income $1,000,000 Permanent differences 100,000 Financial taxable income $1,100,000 Temporary differences 200,000 Taxable income per return $1,300,000 Tax rate 40% Tax liability (current portion of tax expense) $520,000 15

16 Permanent Differences Item Amount Pre-tax book income $1,000,000 Permanent differences Meals and entertainment 50,000 Fines and penalties 40,000 Lobbying expenses 10,000 Total permanent differences $100,000 Financial taxable income $1,100,000 16

17 Permanent Differences (Cont.) Permanent differences Item Amount Meals and entertainment 50,000 Fines and penalties 40,000 Lobbying expenses 10,000 Total permanent differences $100,000 Tax rate 40% Tax impact of permanent items $40,000 17

18 Permanent Differences (Cont.) Permanent differences will always affect your rate. Item Amount Pre-tax book income $1,000,000 Tax rate 40% Expected tax expense $400,000 Tax related to permanent items 40,000 Total expected tax expense $440,000 Effective tax rate = 440,000/1,000,000 = 44% (this is a short method of testing the rate) 18

19 Components Of Total Expense Temporary differences: Will generally have no impact on your effective tax rate Are book/tax differences that will be deductible or taxable in one or more future years Will either cost tax dollars or save tax dollars in the current year, and will have the opposite effect in a future year 19

20 Current Income Tax Expense, Revisited Item Amount Pre-tax book income $1,000,000 Permanent differences 100,000 Financial taxable income $1,100,000 Temporary differences 200,000 Taxable income per return $1,300,000 Tax rate 40% Tax liability (current portion of tax expense) $520,000 20

21 Temporary Differences Year-End 12/31/2011 Current Year Activity Year-End 12/31/2012 Bad debt reserve $300,000 $250,000 $550,000 Accrued bonus 200,000 (50,000) 150,000 Total change in temp differences $500,000 $200,000 $700,000 Tax rate 40% 40% 40% Tax impact of temporary differences $200,000 $80,000 $280,000 21

22 Temporary Differences (Cont.) Entry to record impact of temporary differences Debit Credit Deferred tax asset $80,000 Income tax expense $80,000 22

23 Remember Current Expense? Item Amount Pre-tax book income $1,000,000 Permanent differences 100,000 Financial taxable income $1,100,000 Temporary differences 200,000 Taxable income per return $1,300,000 Tax rate 40% Tax liability (current portion of tax expense) $520,000 23

24 Journal Entries Entries to record tax provision Debit Credit Deferred tax asset $80,000 Income tax expense $80,000 Income tax expense $520,000 Current tax payable $520,000 24

25 Income Tax Expense Income statement looks like: Item Amount Deferred tax benefit (reduces tax expense $(80,000) Current income tax expense 520,000 Total income tax expense $440,000 25

26 Remember This Shortcut Method? Item Amount Pre-tax book income $1,000,000 Tax rate 40% Expected tax expense $400,000 Tax related to permanent items 40,000 Total expected tax expense $440,000 Effective tax rate = 440,000/1,000,000 = 44% (this is a short method of testing the rate) 26

27 Douglas Sayuk, Clifton Douglas Cindy Frank, BDO USA Jeffrey Zawada, FreedMaxick CPAs SPECIFIC INCOME TAX ACCOUNTING ISSUES, BEST PRACTICES

28 VALUING AND REPORTING DEFERRED TAX ASSETS

29 Calculating The Deferred Tax Asset Deferred Tax Assets General Approach Example Step 1: Identify temporary differences $3,000,000 Step 2: Identify NOL carryovers 7,000,000 Cumulative timing differences $10,000,000 Step 3: Determine applicable tax rate 40.00% Deferred tax asset before credits $4,000,000 Step 4: Identify tax credits 500,000 Step 5: Calculate gross deferred tax assets $4,500,000 Step 6: Value the deferred tax assets (2,500,000) Step 7: Calculate net deferred tax assets $2,000,000 In steps 5-7, current deferred tax assets/liabilities and non-current deferred tax assets/liabilities should be aggregated, for balance sheet presentation purposes. 29

30 Deferred Tax Assets: Specific Issues I. Applicable tax rate A. Use enacted tax rate applicable when differences are expected to affect the taxes payable B. Consider effect of federal deductions for state taxes 1. Generally, this has the effect of reducing the state rate to 65% of the full amount (100% 35% federal rate). 2. A few states permit a deduction for other state income taxes. C. Always use the regular tax rate, even when in an AMT situation D. Understand implications of tax holidays with limited durations II. Foreign branches A. Foreign DTAs result in a reduction to the future U.S. foreign tax credit. B. Thus, a DTL must be established for the future reduction to the FTC. C. This has the effect of eliminating a double-counting of branch DTAs. 30

31 Valuing The Deferred Tax Assets I. Consider other DTA reductions prior to valuation allowance A. Worthless DTAs Sect. 382 B. ASC (FIN 48) DTA reductions (e.g., R&D credit reserves) II. Valuation allowance A. Remaining gross DTA subject to VA under more-likely-than-not standard B. While not a bright-line test, the prior three years of cumulative financial operations (pre-tax income +/- permanent items) is often considered strong objective evidence. C. Partial VAs based on forecasted future taxable income are not uncommon, but these can appear to distort the tax rate if sustained for multiple years. D. VA should be allocated pro rata between current and non-current DTAs (without netting of DTLs), regardless of the specific asset to which it is related. 31

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33 Valuation Allowance Allocation DTA/(DTL) DTA Ratio VA VA Allocated Classified Current DTA A $2,000, % x $9,000,000 = $1,800,000 Current DTL n/a Total current DTA $2,000,000 $(1,800,000) $200,000 Non-current DTA B $8,000,000 B/(A+B) 80.00% x $9,000,000 $7,200,000 Non-current DTL C $(1,000,000) Total non-current DTA $7,000,000 $(7,200,000) $(200,000) Total gross DTA A+B+C $9,000,000 Valuation allowance (9,000,000) A/(A+B) Net DTA $ % $- 0 - General rules for classification: 1. Tracks balance sheet classification of underlying asset/liability (e.g., fixed asset DTAs are non-current) 2. Where not tied to an actual balance sheet account, based on when DTA is expected to reverse (i.e., less than one year is current, greater than one year is non-current) = 33

34 DTA Movement Reconciliation: NOL Position Gross Amount Applicable Rate DTA Pre-tax book loss $(10,000,000) n/a Perm differences 2,000,000 n/a Temp differences 3,000, % 1,200,000 Taxable loss $(5,000,000) % 2,000,000 Tax credits 500, % 500,000 Change to DTA $3,700,000 Gross Amount Applicable Rate DTA Pre-tax book loss $(10,000,000) % $4,000,000 Perm differences 2,000, % (800,000) Tax credits 500, % 500,000 Change to DTA $3,700,000 34

35 Return To Provision (RTP) Adjustment During the provision preparation, a comparison is performed to identify any differences between the numbers used in last year s tax provision and the amounts used on the tax return. Generally computed during Q3 The differences are trued up as part of the tax provision preparation process for the succeeding year. 35

36 Return To Provision (RTP) Adjustment Adjustment resulting from the comparison of individual items included in the prior year provision to the final income tax returns Adjustments related to permanent items impact the current income tax expense on the income statement Adjust deferred income tax asset/liability in succeeding year to reflect impact of discrepancy on amount of tax paid in prior year Change in Estimate Change in estimate when new information,not available when the provision was prepared, becomes available after the provision is completed. Error Change can be attributed to facts known or knowable at the time the provision was prepared. Incorrect computation Incorrect information used during provision preparation 36

37 Return To Provision (RTP) Adjustment Return 12/31/2011 Provision 12/31/2011 Difference * Tax Effected Pre-tax book income $1,000,000 $1,000,000 $0 $0 Meals and entertainment 50,000 40,000 10,000 4,000 Allowance for bad debts 60,000 80,000 (20,000) (8,000) Tax depreciation (300,000) (400,000) 100,000 40,000 Taxable income $810,000 $720,000 $90,000 $36,000 * Assume 40% federal and state statutory rate 37

38 Return To Provision (RTP) Adjustment Entries to record tax provision true-up Debit Credit Current income tax expense $ 4,000 Deferred income tax expense 32,000 Income taxes payable $36,000 38

39 ANALYZING AND REPORTING UNCERTAIN TAX POSITIONS

40 Uncertain Tax Positions: Brief Overview I. Recognition: Determine whether position is sustainable on a more-likelythan-not basis ( on-off switch) A. Based on technical merits B. Administrative practices and precedents II. III. Measurement: Calculate the expected benefit of the position, based on cumulative probability approach A. Benefit greater than 50% of being realized upon settlement B. Assume taxing authority has full knowledge of facts Unrecognized tax benefits (UTBs): Tax effect of UTPs A. FIN 48 liabilities recorded on balance sheets B. Reduction of DTA (whether or not valuation allowance in recorded) C. Excludes interest and penalties and well as indirect benefits 40

41 Change In Recognition And Measurement I. A change in recognition or measurement may occur when: A. Management changes its judgment on the position. B. The statute of limitations tolls. C. The position is effectively settled. II. III. Change in judgment A. Critical issue: Was there a change in fact or authority? B. A simple reassessment of existing facts can result in a restatement issue. C. Consistency must be maintained; significant consideration should be given to when establishing a methodology. Statute of limitations A. Net operating loss and tax credit carrybacks/carryforwards B. Jurisdictional differences 41

42 Change In Recognition And Measurement (Cont.) IV. Effective settlement A. A tax position is considered effectively settled when: 1. The taxing authority has completed its examination procedures. 2. The company does not intend to appeal or litigate any aspect of the tax position. 3. Possibility is remote that the taxing authority would examine or reexamine the tax position, assuming it has full knowledge of all relevant information. B. Examination closure: Key considerations 1. A tax position does not need to be legally extinguished, and its resolution need not be certain, in order to re-measure a tax reserve. 2. Consider whether the issue was specifically reviewed or examined 3. If not, is it remote the tax period will be re-examined? 4. Effective settlement may not affect the tax position in other years, especially where the issue was not reviewed or horse-trading occurred. 42

43 Common Unrecognized Tax Benefits I. Transfer pricing A. Benefits and limitations of contemporaneous documentation B. Potential indirect effects competent authority and withholding taxes II. State nexus/permanent establishment A. Consider taxing authorities administrative policies and practices on SOL B. Potential indirect effects throwback and FTCs III. Foreign withholding taxes A. Who is liable? Joint vs. separate liability B. Potential indirect effects FTC (or deductions) IV. R&D credits V. Anti-deferral provisions (Subpart F, Sect. 956, etc.) 43

44 Example Of Indirect Effects Facts: A U.S. company determines that $100 of foreign taxes should have been withheld on royalty payment made to it by a foreign customer. The company determines that it has joint liability for payment of the tax in the foreign jurisdiction and that a reserve is required for this amount. However, the company concludes that it will also receive a $100 foreign tax credit for the taxes withheld, which it can use to offset U.S. taxes. Conclusion: Ignoring potential interest and penalties, this has no potential future net cash impact to the company, as the FTC will fully offset the foreign taxes paid. However, this must still be disclosed as a $100 UTB. The journal entries would be as follows: Dr. tax expense $100 Cr. FIN 48 reserve $100 To record withholding tax reserve Dr. DTA $100 Cr. tax expense $100 To record FTC DTA 44

45 Uncertain Tax Positions: Required Disclosures I. All entities A. Interest and penalties 1. Classification 2. Current and cumulative amounts B. Reasonably possible increases or decreases in UTBs within next 12 months 1. Nature of uncertainty and potential event causing the change 2. Estimate of amount (or statement that cannot be reasonably estimated) C. Tax years that remain open to examination in major jurisdictions II. Public companies A. Tabular reconciliation of UTBs 1. Increases: Current year and prior year 2. Decreases: Settlements, tolling of statutes, changes in judgment B. Total amount of UTBs, if recognized, would affect the ETR. 45

46 FINANCIAL STATEMENT DISCLOSURES: OVERVIEW, ISSUES AND SEC COMMENTS

47 Reported, Discussed And Disclosed Reported amounts Balance sheet presentation Income statement presentation Statement of cash flows (SFAS No. 95) Changes in equity, net of taxes 47

48 Reported, Discussed And Disclosed (Cont.) Discussions MD&A (management discussions and analysis) Commission guidance regarding management s discussion and analysis of financial condition and results of operations: MD&A should be a discussion and analysis of a company s business as seen through the eyes of those who manage that business. Management has a unique perspective on its business that only it can present. As such, MD&A should not be a recitation of financial statements in narrative form or otherwise uninformative series of technical responses to MD&S requirements, neither of which provides this important management perspective. 48

49 Reported, Discussed And Disclosed (Cont.) Discussions (Cont.) Effective tax rate Forecasted rate for following year Critical accounting policies Liquidity Contractual obligations 49

50 Reported, Discussed And Disclosed (Cont.) Disclosed Significant accounting policies Income taxes including, but not limited to: Components of income before taxes Income tax expense (domestic and/or foreign) Rate reconciliation (for public enterprise) Individual items in excess of 5% Components of net deferred tax asset/liability, valuation allowances Certain information related to FIN 48 amounts 50

51 Disclosure Requirements Financial statement presentation Classification Entities Jurisdictions 51

52 Disclosure Requirements (Cont.) Financial statement disclosure Components of the net deferred tax asset or liability Information for certain deferred tax liabilities not recognized Components of income tax expense (continuing operations) Income tax expense or benefit allocated to continuing operations and separately allocated to other items Rate reconciliation (public enterprise) Certain carryforwards and certain valuation allowances Certain disclosures for members of a consolidated group 52

53 Disclosure Requirements (Cont.) FIN 48 disclosure Policy on interest and penalty classification Tabular reconciliation Unrecognized tax benefit that, if recognized, would affect the effective tax rate Total interest and penalties Unrecognized tax benefits reasonable possible of significant change in the next 12 months Nature of uncertainty Nature of even that could occur Estimate of range of possible change or a statement that an estimate cannot be made Tax years open to examination 53

54 Disclosure Requirements (Cont.) What to remember: Understand the netting rules when it comes to current and non-current deferred tax assets and liabilities Understand how amounts are compiled and reported from different jurisdictions Significant accounting policies related to tax should be disclosed (SFAS 109, FIN 48, policies on interest and penalties). Components of income (from different jurisdictions) Components of expense (by jurisdiction, by classification) Rate reconciliation (dollars or percentages) Details for amounts > 5% of total for public companies Robust disclosures for estimates and changes in estimates (valuation allowances, uncertain tax positions) 54

55 SEC Comments: Areas Of Focus Management estimates and judgments Valuation allowances Basis for having or not having a VA Timing of recording changes Consistency with other forward-looking information FIN 48-related items Paragraph 21 disclosures Interest and penalty policy disclosures Disclosures and adjustments on adoption Timing of recording changes 55

56 SEC Comments: Areas Of Focus (Cont.) Management estimates and judgments (Cont.) Adequacy of disclosure Rate reconciliation items Deferred tax assets and liabilities Uncertain tax positions Timing of reversal Expiration of NOLs in various jurisdictions Other Contingency obligations table 56

57 SEC Comments: Areas Of Focus (Cont.) What to remember SEC Comments SEC may ask for clarification related to management s material estimates and/or judgments. Changes in estimates should be well-documented. Responses to SEC comment letters are easier if the company has documentation related to: Alternative views considered Company policies that provide guidance on estimates Criteria used in evaluation Consider information that could be important to the user of the financial statements 57

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59 DECIDING ON APPROPRIATE INTRA-PERIOD ALLOCATIONS

60 Intraperiod Tax Allocations I. Income tax expense or benefit should be allocated among: A. Continuing operations B. Other components 1. Discontinued operations 2. Extraordinary items 3. Other comprehensive income 4. Items charged or credited directly to shareholders equity II. Steps in allocation process A. Step 1 - Calculate total tax expense B. Step 2 - Determine tax related to continuing operations C. Step 3 - Allocate remainder to other components (disc. ops, OCI, etc.) 60

61 Intraperiod Tax Allocations: Example NOL Carryover w/ VA No NOL Carryover No VA NOL Carryover No VA Pre-tax Income cont. ops $3,000,000 $3,000,000 $3,000,000 Pre-tax Income disc. ops (1,000,000) (1,000,000) (1,000,000) Pre-tax income $2,000,000 $2,000,000 $2,000,000 NOL carryover (2,000,000) Taxable income $- 0 - $2,000,000 $2,000,000 Tax rate 40.00% 40.00% 40.00% Total tax expense $- 0 - $800,000 $800,000 A Related to continuing ops $3MM x 40%= 1,200,000 1,200,000 B Current benefit Deferred benefit Allocated to disc. ops A-B (400,000) (400,000) Note: Net operating losses and other deferred tax assets are utilized before the impact of other components are considered. 61

62 Application Of ASC Under this exception to the general rules, all components should be considered in determining the tax benefit resulting from continuing operations losses. NOL Carryovers/Full Valuation Allowance Year X1 Year X2 Pre-tax income cont. ops $(2,000,000) $2,000,000 Pre-tax gain/(loss) OCI (AFS) 2,000,000 (2,000,000) Pre-tax income $-0- $-0- Tax rate 40.00% 40.00% Total tax expense $-0- No tax expense due to NOL $-0- Related to continuing ops (800,000) -0- $(2MM) x 40%= C/F and valuation allowance Allocated to disc. ops $2MM x 40%= 800, Note: Even though the two-year impact of the OCI gain/loss is $nil, the tax effect of the Year X1 application of this rule does not reverse out in Year X2. Rather, the disproportionate tax effects become lodged in OCI and only reverse under very limited circumstances. 62

63 INTERIM PERIOD TAX COMPUTATION CALCULATIONS

64 Interim Period Tax Computation I. Guidance 64 A. ASC The tax (or benefit) related to ordinary income (or loss) shall be computed at an estimated annual effective tax rate, and the tax (or benefit) related to all other items shall be individually computed and recognized when the items occur. 2. Ordinary income or loss a. Includes continuing operations before income taxes or benefit b. Excludes significant unusal or infrequently occuring items (rare) c. Excludes extraordinary items, cumulative effects of changes in accounting principles and discontinued operations

65 Interim Period Tax Computation (Cont.) I. Calculation A. Caluclate estimated effective tax rate 1. Forecast annual pre-tax income by entity/tax filing jurisdiction 2. Calculate current and deferred provisions 3. Consider federal, state and foreign B. Apply estimated effective tax rate 1. Multiply estimated effective tax rate by actual yearto-date worldwide pre-tax income C. Layer on items recorded discretely 65

66 Interim Period Tax Computation (Cont.) I. Items recorded discretely in the interim period A. Prior-year uncertain tax positions B. Current-year uncertain tax positions related to income excluded from the effective tax rate calculation C. Interest and penalties related to uncertain tax positions D. Change in tax law E. Change in tax status F. Changes in realizability of deferred tax assets G. Changes in judgment regarding APB 23 items (unremitted earnings of foreign subsidiaries and other outside basis items) H. Changes in estimates from prior-year provisions (provision to return adjustments) 66

67 Interim Period Tax Computation (Cont.) I. Modification to estimated effective tax rate approach (ASC through ASC ) 67 A. Loss limitation (year-to-date loss exceeds the full-year expected loss, and full realization of tax benefit is assured, i.e. no need for a valuation allowance) A. Recalculate tax based on year-to-date results B. Good example: ASC B. Loss limitation (year-to-date loss exceeds the full year expected loss, and partial realization of tax benefit is assured) A. Calculate estimated effective tax rate based on amount of tax benefit assured B. Recalculate tax based on year-to-date results C. Good example: ASC

68 Interim Period Tax Computation (Cont.) I. Example ASC Ordinary Income Tax Reporting Period Reporting Period Year-to- Date Overall Estimated Annual Effective Tax Rate Year-to- Date - Computed Year-to- Date - Limited Less Previously Reported Reporting Period First Qtr 20,000 20,000 60% 12,000-12,000 Second Qtr (80,000) (60,000) 60% (36,000) 12,000 (48,000) Third Qtr (80,000) (140,000) 60% (84,000) (80,000) (36,000) (44,000) Fourth Qtr 40,000 (100,000) 60% (60,000) (80,000) 20,000 Fiscal Year (100,000) (60,000) Year to date ordinary loss ($140,000 X 50%) (70,000) Estimated Tax Credits (10,000) (80,000) 68

69 Interim Period Tax Computation (Cont.) I. Example ASC (overall ETR limited to partial unrealizable losses) Ordinary Income Tax Reporting Period Reporting Period Year-to- Date Overall Estimated Annual Effective Tax Rate Year-to- Date - Computed Year-to- Date - Limited Less Previously Reported Reporting Period First Qtr 20,000 20,000 20% 4,000-4,000 Second Qtr (80,000) (60,000) 20% (12,000) 4,000 (16,000) Third Qtr (80,000) (140,000) 20% (28,000) (20,000) (12,000) (8,000) Fourth Qtr 40,000 (100,000) 20% (20,000) (20,000) - Fiscal Year (100,000) (20,000) 69

70 Interim Period Tax Computation (Cont.) C. ASC (a) If a separate jurisdiction has yearto-date ordinary loss or anticipates ordinary loss for the year, and no tax benefit can be recognized, then that entity should be excluded from the estimated effective tax rate calculation. 70

71 Interim Period Tax Computation (Cont.) I. Example ASC Anticipated ordinary income for the fiscal year: In the United States $ 60,000 In Country A 40,000 Total $ 100,000 Anticipated tax for the fiscal year: In the United States ($60,000 at 50% statutory rate) $ 30,000 In Country A ($40,000 at 20% statutory rate) 8,000 Total $ 38,000 Overall estimated annual effective tax rate ($38,000 / $100,000) 38% 71

72 Interim Period Tax Computation (Cont.) I. Example ASC quarterly tax computation Ordinary Income Tax Overall Estimated Reporting Period United States Country A Total Year-to- Date Annual Effective Tax Rate Year-to- Date Less Previously Reported Reporting Period First Qtr 5,000 15,000 20,000 20,000 38% 7,600-7,600 Second Qtr 10,000 10,000 20,000 40,000 38% 15,200 7,600 7,600 Third Qtr 10,000 10,000 20,000 60,000 38% 22,800 15,200 7,600 Fourth Qtr 35,000 5,000 40, ,000 38% 38,000 22,800 15,200 Fiscal Year 60,000 40, ,000 38,000 72

73 Interim Period Tax Computation (Cont.) I. Example ASC ordinary loss; realization not MLTN I. Country B history of losses, 40% rate, expected tax benefit will not be realized on these losses Ordinary Income Tax Overall Reporting Period United States Country A Country B Total Year-to- Date Estimated Annual Effective Tax Rate Year-to- Date - Excluding Country B Less Previously Reported Reporting Period First Qtr 5,000 15,000 (5,000) 15,000 15,000 38% 7,600-7,600 Second Qtr 10,000 10,000 (25,000) (5,000) 10,000 38% 15,200 7,600 7,600 Third Qtr 10,000 10,000 (5,000) 15,000 25,000 38% 22,800 15,200 7,600 Fourth Qtr 35,000 5,000 (5,000) 35,000 60,000 38% 38,000 22,800 15,200 Fiscal Year 60,000 40,000 (40,000) 60,000 38,000 Note: Format above different than actual ASC example 73

74 Interim Period Tax Computation (Cont.) I. Example ASC what if country B was included Anticipated ordinary income for the fiscal year: In the United States $ 60,000 In Country A 40,000 In Country B (40,000) Total $ 60,000 Anticipated tax for the fiscal year: In the United States ($60,000 at 50% statutory rate) $ 30,000 In Country A ($40,000 at 20% statutory rate) 8,000 Total $ 38,000 Overall estimated annual effective tax rate ($38,000 / $60,000) 63.33% 74

75 Interim Period Tax Computation (Cont.) I. Example ASC what if country B was included (Cont.) I. Country B history of losses, 40% rate, expected tax benefit will not be realized on these losses Ordinary Income Tax Overall Reporting Period United States Country A Country B Total Year-to- Date Estimated Annual Effective Tax Rate Year-to- Date - Including Country B Less Previously Reported Reporting Period First Qtr 5,000 15,000 (5,000) 15,000 15, % 9,500-9,500 Second Qtr 10,000 10,000 (25,000) (5,000) 10, % 6,333 9,500 (3,167) Third Qtr 10,000 10,000 (5,000) 15,000 25, % 15,833 6,333 9,500 Fourth Qtr 35,000 5,000 (5,000) 35,000 60, % 37,998 15,833 22,166 Fiscal Year 60,000 40,000 (40,000) 60,000 37,998 Note: Format above different than actual ASC example 75

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77 MERGER AND ACQUISITION TOPICS

78 Business Combinations: Key Steps Step 1: Determine transaction structure (stock vs. asset acquisition) Stock historical tax basis carryover; can lead to significant DTA/DTLs Asset tax basis stepped up to FMV; DTA/DTL may be minimal Step 2: Identify existing deferred tax assets and liabilities Typically, a short period cut-off provision is calculated. Consider the impact of stock awards and other non-recurring charges. When combined returns will be filed with the acquirer, the applicable tax rate in valuing DTA/DTLs should be reassessed. Step 3: Calculate DTA/DTL from purchase accounting fair value adjustments In a stock transaction, every FV adjustment will result in a DTA/DTL. Nongoodwill intangibles often result in a significant DTL. Consider the impact of an acquired DTL on the acquirer s VA, as the benefit of any release will be recorded to P&L. 78

79 Business Combinations: Key Steps (Cont.) Step 4: Evaluate deferred tax asset valuation Consider whether the combined operation s financial position changes the assessment of deferred tax asset utilization Changes to the acquired company s VA are recorded in purchase accounting, while the acquirer s VA is recorded outside of purchase accounting. Also consider the need to write-off DTAs due to Sect. 382, SRLY or other acquisition related limitations Step 5: Consider tax reserve needs 79 Leverage off of conclusions reached in due diligence Consider the impact of indemnifications Continue to evaluate information available at the acquisition date during the one-year measurment period

80 STOCK AWARD ISSUES

81 Stock Awards I. Guidance A. When the settlement of an award creates or increases a net operating loss A. This provides that the excess tax benefit and the credit to APIC (and our APIC pool) for the windfall should not be recorded until the deduction reduces income taxes payable. B. ASC A. A share option exercise may result in a tax deduction before the actual realization of the related tax benefit because the entity, for example, has a net operating loss carryforward. In that situation, a tax benefit and a credit to additional paid-in capital for the excess deduction would not be recognized until that deduction reduces taxes payable. 81

82 Stock Awards (Cont.) I. Result 82 A. Net operating losses A. The deferred tax asset on the company s net operating losses will differ from the net operating losses actually on its tax return. B. The net operating losses relating to this windfall tax benefit will have to be tracked separately. C. The net operating losses disclosed in the footnote should be the actual net operating losses per the tax return. D. The footnote should also disclose the amount of benefit still to be recorded in additional paid-in capital once the net operating loss carryforward is realized.

83 Stock Awards (Cont.) I. Accounting policy A. Generally two approaches allowed: A. With and without results in windfall tax benefits being realized last B. Tax law ordering results in windfall tax benefit being realized first (should be less complex) B. Election of method is an accounting policy that must be applied consistently. 83

84 Stock Awards (Cont.) I. Examples I. Facts: NOL carryforward from prior years actual per tax return $500,000 Deferred tax asset on NOL at 40% $200,000 Current-year taxable income (before excess tax deduction for stock-based comp) Current-year excess tax deduction for stock based compensation $600,000 $250,000 84

85 Example 1: No valuation allowance Stock Awards (Cont.) With and Without Without With Tax Law Ordering Taxable income before NOL and excess tax deduction $ 600,000 $ 600,000 $ 600,000 $ 600,000 Current year excess tax deduction for stock based compensation $ (250,000) $ - $ (100,000) $ (250,000) NOL Carryforward from prior years $ (500,000) $ (500,000) $ (500,000) $ (350,000) Taxable Income or NOL carryforward to next year $ (150,000) $ 100,000 $ - $ - Journal Entry Income Taxes Payable $ - $ - Current Tax Expense $ 40,000 $ 100,000 Deferred Tax Expense $ 200,000 $ 140,000 Deferred Tax Asset $ (200,000) $ (140,000) Additional Paid-in Capital $ (40,000) $ (100,000) Memo Entry - Debit / (Credit) Deferred Tax Asset $ 60,000 $ - Additional Paid-in Capital $ (60,000) $ - - With and Without - memo entry to reflect the $150,000 excess tax deduction for which there has been no cash benefit yet received Actual Remaining Net Operating Losses $ (150,000) $ (150,000) Deferred Tax Asset $ - $ 60,000 0% 40% 85

86 Example 2: Full valuation allowance Stock Awards (Cont.) With and Without Without With Tax Law Ordering Taxable income before NOL and excess tax deduction $ 600,000 $ 600,000 $ 600,000 $ 600,000 Current year excess tax deduction for stock based compensation $ (250,000) $ - $ (100,000) $ (250,000) NOL Carryforward from prior years $ (500,000) $ (500,000) $ (500,000) $ (350,000) Taxable Income or NOL carryforward to next year $ (150,000) $ 100,000 $ - $ - Journal Entry Income Taxes Payable $ - $ - Current Tax Expense $ 40,000 $ 100,000 Valuation Allowance $ 200,000 $ 140,000 Deferred Tax Asset $ (200,000) $ (140,000) Additional Paid-in Capital $ (40,000) $ (100,000) Memo Entry - Debit / (Credit) Deferred Tax Asset $ 60,000 $ - Additional Paid-in Capital $ (60,000) $ - - With and Without - Memo entry to reflect the $150,000 excess tax deduction for which there has been no cash benefit yet received Actual Remaining Net Operating Losses $ (150,000) $ (150,000) Deferred Tax Asset $ - $ 60,000 Valuation Allowance $ - $ (60,000) 86

87 CURRENT AUDITOR RED FLAGS

88 Current Auditor Hot Topics I. PCAOB materiality guidelines II. Deferred tax asset disclosure A. Classification current vs. non-current B. Stock-based compensation 1. Terminations and cancellations 2. Sect. 83(b) elections C. Cost basis fixed/intangible assets D. True-up impact estimate vs. error III. Permanent reinvestment of foreign earnings rep under APB 23 A. Ability sufficient cash to fund domestic operations B. Intent established company policy; earnings need to fund operations C. Reasonable estimate of deferred taxes 88

89 Current Auditor Hot Topics (Cont.) IV. Valuation allowance A. Allocation between current and non-current assets B. Jurisdictional issues (e.g., cost plus entities) V. ASC (FIN 48) A. Statute of limitation periods B. Disclosure regarding changes in next 12 months VI. Intraperiod tax allocations to OCI 89

90 Current Auditor Red Flags I. Effective tax rate reconciliation A. Foreign effective tax rate varies significantly from statutory rate. II. Business combinations A. Contingent liabilities and consideration III. Deferred tax roll IV. Uncertain tax positions A. Inter-company transactions/transfer pricing B. Foreign audits 90

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92 RISK MITIGATION

93 Risk Mitigation I. Valuation allowance documentation II. ASC (APB 23) documentation III. Tax provision software IV. Department capability and internal controls 93

94 Risk Mitigation (Cont.) I. Valuation allowance documentation 94 I. Four sources of taxable income A. Taxable income in carryback years 1. Consider character of income B. Future reversal of existing temporary differences 1. Consider timing of future reversals C. Tax planning strategies 1. Must be prudent and feasible 2. Must be something management wouldn t ordinarily take 3. Must prevent deferred tax asset from expiring unused 4. Must result in the realization of a deferred tax asset

95 Risk Mitigation (Cont.) I. Valuation allowance documentation (Cont.) 95 D. Future taxable income exclusive of reversing temporary differences and carryforwards 1. Three-year cumulative pretax book earnings 2. Forecast accuracy!!! 3. How many years of forecasted pre-tax income would be needed to realize all of the deferred tax assets? 4. Document and consider company liquidity, backlog, market trends, losses of significant customers, forecast divestitures, and expected restructuring or changes in operations.

96 Risk Mitigation (Cont.) I. ASC (APB 23) documentation A. Document policy of permanent reinvestment B. Consider all aspects of outside basis differences (unremitted earnings, cumulative translation adjustments, transactions with non-controlling shareholders and other comprehensive income) C. Document uses of excess cash at foreign subsidiary (working capital needs, capital expenditures, acquisitions, repay inter-company obligations, loan to other foreign entities, etc. D. Document or forecast need or lack thereof of cash at the parent company 1. Operations, debt service, acquisitions, capital expenditures, intercompany obligations E. Consider history of earnings remittances 1. Consider policy of not remitting past earnings F. Consider dispositions/available for sale entities 96