Recent SEC Comment Letters

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1 Accounting for Income Taxes Moderator: David Gaul, Vice President Tax Cypress Semiconductor Recent SEC Comment Letters: Rusty Thomas, Partner KPMG Jeff Sokol, Partner Deloitte Complex Tax Accounting Issues: Chad Bowar, Partner - Ernst & Young Ty Kanaaneh, Partner - PwC 2011 High Tech Tax Institute Nov 8, 2011 Intraperiod Allocation and Tax Holidays: Jim Songey, Partner Grant Thornton Scott Jaconetty BDO Seidman 1 Recent SEC Comment Letters 2

2 Rusty Thomas Tax Partner, KPMG Jeff Sokol Tax Partner, Deloitte Foreign Income & Foreign Tax Rates SEC Comment Please consider providing disclosures to explain in greater detail the impact on your effective income tax rates and obligations of having proportionally higher earnings in countries where you have lower statutory tax rates. You should consider explaining the relationship between the foreign and domestic effective tax rates in greater detail We refer you to Item 303(a)(3)(i) of Regulation S-K and Section III.B of SEC Release

3 Foreign Income & Foreign Tax Rates Item 303(a)(3)(i) of Regulation S-K : A company should describe any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations and, in each case, the extent to which income was so affected. In addition, describe any other significant components of revenues or expenses that, in the registrant s judgment, should be described in order to understand the registrant s results of operations. Section. III. B of Sec Release No Disclosure should emphasize material information that is required or promotes understanding and provide investors and other users with material information that is necessary to an understanding of the company s financial condition and operation performance. 5 Foreign Income & Foreign Tax Rates Response Letter We advise the Staff that we disclosed the impact of earnings in foreign jurisdictions, along with how those earnings impact our effective tax rate comparatively to the higher tax rate in the U.S., in the following sections of our Filings: (a) MD&A of K, and (b) on income tax footnote of the Q Q. We respectively submit that our earnings from our recurring foreign operations were not materially affected by any unusual or infrequent events or transactions, which would necessitate additional disclosures as stated in Item 303(a)(3)(i) of Reg. S-K. We believe that we have met the preceding criteria (i.e. material information) because our disclosures indicate the risk that our tax rate could fluctuate depending on the geographic distribution of our worldwide earnings 6

4 Foreign Income & Foreign Tax Rates Response Letter, cont. In future filings, we will expand our MD&A discussion of our effective tax rate by providing more detail on our mix of U.S. and international income before income taxes, as well as changes in the effective tax rate due to changes in unrecognized tax benefits. We will ensure that future MD&A disclosures address the impact on our effective tax rate of emphasizing production and distribution through our regional operational centers, particularly those in Ireland, Singapore and Puerto Rico, and any anticipated impact of economic uncertainty 7 Foreign Rate Differential SEC Comment Please clarify what the foreign rate differential represents in each of the three years presented. As part of your response, explain how the foreign rate differential is determined in each fiscal year and identify the significant components of this item. 8

5 Foreign Rate Differential Response Letter The significant component of foreign rate differentials in each of the three years relates to the undistributed earnings of certain foreign subsidiaries that we intend to reinvest indefinitely in those foreign subsidiaries. We determine the impact to the tax rate as a result of earning income in foreign jurisdictions with lower effective tax rates than the statutory federal income tax rate in the following manner: We determine the U.S. liability related to the foreign earnings by taking the total amount of foreign earnings and multiplying it by the federal statutory tax rate of 35%. We then compare the amount above to the actual amount of foreign taxes that have been expensed in the current year, which in certain locations includes local income taxes, potential withholding taxes, and other franchise taxes based on income. The difference between the two amounts represents the amount of the benefit that we recognize. 9 Foreign Rate Differential Response Letter We note the Staff s comment, and in response thereto, respectfully advise the Staff as follows: (i) For each of the last three years, the differences between U.S. and foreign tax rates on foreign income, including withholding taxes represents the difference between the actual foreign taxes expensed and the foreign taxes that would have been expensed assuming a hypothetical application of a notional 35% tax rate to our foreign income. This number has increased as our foreign income taxed at rates below the notional 35% tax rate has increased. (ii) There are no other significant components within this item other than the computation noted above. (iii) The Company performed a comprehensive review in 2010 of its expenses and income related to transfer pricing as part of its ongoing tax strategy. This review resulted in changes to our mix of income across tax jurisdictions and an increase in the difference between the notional 35% U.S. tax rate and foreign tax rates on foreign income, including withholding taxes. 10

6 Undistributed Earnings SEC Comment In future filings please clarify why you believe it is not practicable to determine the amount of unrecognized deferred tax liability related to undistributed earnings of foreign subsidiaries. 11 Undistributed Earnings ASC : All of the following information shall be disclosed whenever a deferred tax liability is not recognized because of the exceptions to comprehensive recognition of deferred taxes related to subsidiaries and corporate joint ventures: a. a description of the types of temporary differences for which a deferred tax liability has not been recognized and the types of events that would cause these temporary differences to become taxable; b. the cumulative amount of each type of temporary difference; c. The amount of the unrecognized deferred tax liability for temporary differences related to investments in foreign subsidiaries and foreign corporate joint ventures that are essentially permanent in duration if determination of that liability is practicable or a statement that determination is not practicable 12

7 Undistributed Earnings Response Letter we asserted, pursuant to ASC , that the undistributed earnings of foreign subsidiaries are indefinitely invested in foreign operations. It is not practicable to calculate the potential liability as there is a significant amount of uncertainty due to the fact that dividends received from our foreign subsidiaries could bring additional foreign tax credits, which could ultimately reduce the U.S. tax cost of the dividend. In addition, significant judgment is required to analyze any additional local withholding tax and other indirect tax consequence that may arise due to the distribution of these earnings. These reasons make it impracticable to accurately calculate the amount of deferred tax liabilities related to the undistributed earnings, particularly in light of the fact that we have no current intention of distributing these unremitted earnings. As a result, we respectfully submit that we should not be required to add anything additional to our current disclosure 13 Undistributed Earnings A Second Response Letter The Company believes that it is not practicable to determine the amount of the unrecognized deferred tax liability on undistributed earnings as of January 1, 2011, principally due to the difficulty in determining the amount and use of foreign tax credits. There are many factors and assumptions that are required to estimate the use of these credits Accordingly, in future annual filings, [] plans to include a disclosure similar to the following: Except as noted below and where required by U.S. tax laws and generally accepted accounting principles, no provision was made for U.S. income taxes on the undistributed earnings of the Company s foreign affiliates, as the Company intends to use those earnings in its foreign operations for an indefinite period of time. As of the fiscal year end 20xx, the undistributed earnings of the Company s foreign affiliates was approximately $xx million. If the Company had not intended to utilize the undistributed earnings in its foreign operations for an indefinite period of time, the deferred tax liability as of fiscal year end 20xx would have been in the range of $xx million to $xx million. 14

8 Liquidity Related Disclosure SEC Comments Tell us your consideration of providing liquidity disclosures to discuss the potential tax impact associated with the repatriation of undistributed earnings of foreign subsidiaries. In this regard, consider disclosing the amount of investments that are currently held by your foreign subsidiaries and disclose the impact of repatriating the undistributed earnings of foreign subsidiaries. We refer you to Item 303(a)(1) of Regulation S-K and Section IV of SEC Release Liquidity Related Disclosure SEC Comments We note your response to prior comment 2 and your liquidity discussion where you indicate that the company intends for certain cash balances to remain outside of the U.S. and that you believe you have sufficient sources of liquidity to meet your U.S. liquidity needs through ongoing cash flows, external borrowings or both. While we note your intent is to permanently reinvest such funds outside of the U.S., we continue to believe you should consider providing enhanced liquidity to disclose the amount of cash and investments held by foreign subsidiaries that would be subject to the potential tax impact associated with the repatriation of undistributed earnings on foreign subsidiaries. In this respect, this disclosure would illustrate that some investments are not presently available to fund domestic operations such as the payment of dividends, corporate expenditures or acquisitions without paying a significant amount of taxes upon their repatriation. 16

9 Liquidity Related Disclosure Item 303(a)(1) of Regulation S-K Company should Identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant's liquidity increasing or decreasing in any material way. Sec. V. of SEC Release A company is required to include in MD&A the following information: historical information regarding sources of cash and capital expenditures; evaluation of the amounts and certainty of cash flows; the existence and timing of commitments for capital expenditures and other known and reasonably likely cash requirements; discussion and analysis of known trends and uncertainties; A description of expected changes in the mix and relative cost of capital resources 17 Liquidity Related Disclosure Response Letter We added the following MD&A disclosure in our 10-Q While we currently do not foresee a need to repatriate funds, should we require more capital in the U.S. than is generated by our operations locally, we could elect to repatriate funds held in foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates or increased interest expense. In future filings we will provide a cross reference in MD&A to our disclosure in the notes to the annual financial statements of the amount of temporary differences resulting from earnings for certain non-u.s. subsidiaries which are permanently reinvested outside the U.S. and the unrecognized deferred tax liability associated with these temporary differences 18

10 Liquidity Related Disclosure Sample Disclosure Our existing cash, cash equivalents and investment balances may fluctuate during the remainder of fiscal 2011 due to changes in our planned cash outlay, including changes in incremental costs such as direct and integration costs related to our acquisitions. A majority of our cash and investments are held by our foreign subsidiaries. Our intent is to permanently reinvest a significant portion of our earnings from foreign operations, and current plans do not anticipate that we will need funds generated from foreign operations to fund our domestic operations. In the event funds from foreign operations are needed to fund operations in the United States and if U.S. tax has not already been previously provided, we would be required to accrue and pay additional U.S. taxes in order to repatriate these funds. 19 Permanent Reinvestment SEC Comment You indicate that a provision has not been made for U.S. taxes on $[ ] million of undistributed earnings of international subsidiaries that could be subject to taxation if remitted to the U.S. You indicate that your intention is to reinvest these earnings permanently or only repatriate them when it is tax efficient to do so. Please tell us how you believe your policy complies with ASC In particular, please describe the specific plans you had as of [ ] 2010 for reinvestment of the undistributed earnings of international subsidiaries which demonstrated that the remittance of these earnings would be postponed indefinitely. We note that in the Liquidity and Capital Resources section you indicated that you repatriated foreign cash in

11 Permanent Reinvestment ASC The presumption in paragraph that all undistributed earnings will be transferred to the parent entity may be overcome, and no income taxes shall be accrued by the parent entity, for entities and periods identified in the following paragraph if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation. A parent entity shall have evidence of specific plans for reinvestment of undistributed earnings of a subsidiary which demonstrate that remittance of the earnings will be postponed indefinitely. These criteria required to overcome the presumption are sometimes referred to as the indefinite reversal criteria. Experience of the entities and definite future programs of operations and remittances are examples of the types of evidence required to substantiate the parent entity's representation of indefinite postponement of remittances from a subsidiary. The indefinite reversal criteria shall not be applied to the inside basis differences of foreign subsidiaries. 21 MD&A Disclosure Changes to ETR SEC Comment Please revise your MD&A to quantify and provide a more robust explanation of the specific tax items that affected changes in your effective tax rate. For example, you indicate that the increase in your effective tax rate in 2009 was the result of a discrete tax item and a change in the mix of U.S. and foreign income as well as a change in the mix of U.S. earnings in states with lower income tax rates. Please revise to quantify and explain the discrete tax item you refer to in your disclosures and please also quantify changes in the sources of income that affected your effective rate. 22

12 MD&A Disclosure Changes to ETR Response Letter Proposed revision: Income taxes The effective tax rate increased in 2009 to 45% from the 25% rate in The 2009 effective tax rate was higher primarily as a result of a 10% impact on the rate as a result of the repatriation of foreign earnings of $2 million with no corresponding foreign tax credit to offset the U.S. tax impact. The lesser 2008 effective tax rate was primarily a result of the following: 1.4% benefit on the rate related to the repatriation of $500,000 of earnings, which created beneficial foreign tax credits of $388,000; a 6.3% benefit from foreign earnings in low tax jurisdictions as compared to the U.S. tax rate; and a reduction in state taxes as a result of a reduction in the state blended tax rate against an opening deferred tax liability. 23 Valuation Allowance Advance Disclosure SEC Comment We note that you reversed substantially all of your tax valuation allowance in the fourth quarter of fiscal year Please tell us how you considered providing MD&A disclosure in prior periodic filings alerting readers to the reasonable likelihood that a change in your assessment could have a significant impact on future results. In this regard, it appears that cumulative earnings for the twelve quarters ended September 27, 2009 may have represented a known trend indicative of a potential change in your income tax provision. Please refer to Section III.B.3 of SEC Release

13 Valuation Allowance Advance Disclosure Response Letter We considered Section III.B.3 of SEC Release when addressing the potential for reversing the valuation allowance that had been established against our deferred tax assets in the Management s Discussion and Analysis in our filings. The Company was in a cumulative loss position in the first quarter of We believe that disclosure of the potential to reverse the valuation allowance at that time would have been premature as the Company had no positive income quarters in 2007 and only two quarters of positive pretax income in UTB 12-Month Look-Forward SEC Comment Regarding the $XX.X million benefit recognized as a result of the lapse in the statute of limitations for certain unrecognized tax benefits, you are required to provide transparent disclosure concerning unrecognized tax benefits when it is reasonably possible that they will significantly increase or decrease within 12 months of the reporting date. We believe such disclosure should have been provided in your 2008 financial statements regarding the lapse of the statute of limitations in 2009, please advise. If applicable, you should revise your financial statement footnote to fully comply with FASB ASC d with respect to any significant changes that may take place during Also disclose the tax years that remain subject to examination by major tax jurisdictions pursuant to ASC e. Provide a comprehensive, forward looking discussion in MD&A of the potential impact of any significant changes in unrecognized tax benefits on your future results of operations or explain to us why such disclosure is not necessary. 26

14 UTB 12-Month Look-Forward ASC An entity within the scope of this Topic (see paragraph A) shall disclose all of the following at the end of each annual reporting period presented: d. For positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months of the reporting date: 1. The nature of the uncertainty; 2. The nature of the event that could occur in the next 12 months that would cause the change; 3. An estimate of the range of the reasonably possible change or a statement that an estimate of the range cannot be made. 27 UTB 12-Month Look-Forward Response Letter In the third quarter of 2008, the Company was aware that the U.S. Federal statute of limitations for the year 2005 would potentially expire on September 15, However, the Company had been under a tax examination by the IRS for the years While the IRS field examiners had substantially completed their field work and provided their proposed adjustments, one of the issues the IRS reviewed was the effect of stock option backdating by former management. Stock option backdating was an IRS Tier 1 issue, meaning that all backdating cases in the U.S. were uniformly managed by a national issue owner. During 2007 and 2008, the resolution of backdating cases was a slow and evolving process. Thus, by the third quarter of 2008, it was not certain if the IRS would request an extension of the statute of limitations for 2005 to allow more time for the backdating issues to be reviewed further. We believed it would be unlikely that they would allow the statute to expire during the pendency of their review... 28

15 UTB 12-Month Look-Forward Response Letter, cont. In future filings, to the extent that such disclosures in our financial statement footnotes indicate significant future changes, the Company will also provide discussions in MD&A of potential future changes to unrecognized tax positions. Such discussion will include the timing and effect of potential expiration of statutes of limitations in major tax jurisdictions, potential effects of tax examinations in progress in major tax jurisdictions and potential changes due to pending changes in tax law and interpretations of regulations, if any. 29 Complex Tax Accounting Issues 30

16 Ty Kanaaneh Tax Partner, PWC Chad Bowar Tax Partner, Ernst & Young 31 Complex Tax Accounting Issues 1) Tax law changes 2) Intercompany transactions 3) Non-controlling interests 4) Changes in accounting estimates 5) Branch operations deferred tax accounting Acquisition accounting: 6) Subsequent intellectual property transfers 7) Contingent consideration 8) Acquisition related costs 32

17 Tax Law Changes ASC Deferred tax liabilities and assets shall be adjusted for the effect of a change in tax laws or rates. The effect shall be included in income from continuing operations for the period that includes the enactment date. 33 Tax Law Changes All adjustments to reflect the rate change are measured as of the enactment date and reflected in income from continuing operations Retroactive tax rate changes Revaluation of existing DTAs Subsequent changes to a DTA/VA initially recorded in purchase accounting The effect of the change would be recognized in income from continuing operations in the period of enactment 34

18 Tax Law Changes 35 Intercompany Transactions ASC (e) and ASC [formerly FAS 109 9(e)] ASC (e) provides the following exception to the asset and liability approach prescribed by ASC 740: A prohibition on recognition of a deferred tax asset for the intra-entity difference between the tax basis of the assets in the buyer s jurisdiction and their cost as reported in the consolidated financial statements. If income taxes have been paid on intra-entity profits on assets remaining within the consolidated group, those taxes shall be deferred or the intra-entity profits to be eliminated in consolidation shall be appropriately reduced. to be eliminated in consolidation shall be appropriately reduced. 36

19 Intercompany Transactions Basic premise of ASC (e) Ordinarily there are tax effects when an asset is sold or transferred between affiliated companies that file separate tax returns Under par. 3(e) Tax impact is deferred Carries forward the matching concept by requiring taxes to be deferred until seller s pre-tax profit is recognized Typically applies when an entity sells, transfers or contributes an asset to an affiliate Applies even if company does not record a book gain 37 Intercompany Transactions Applicability of ASC (e) Typically applies to intercompany transfers of assets involving entities domiciled in two different jurisdictions However, it also applies to entities domiciled in the same jurisdiction but file separate income tax returns 38

20 Intercompany Transactions Applicability of ASC (e) Applies to inter-company transfers of assets such as: Inventory Fixed assets Intangible assets such as intellectual property Does not apply to inter-company transfers of stock of a subsidiary 39 Intercompany Transactions Deferred charges Deferred charges recorded represents the tax effect of a past event Not the same as deferred tax assets Not subject to revaluation for tax rate changes Not subject to valuation allowance under ASC 740 Recognized when related asset is sold outside the group or otherwise recovered or derecognized (i.e., amortized or impaired) 40

21 Intercompany Transactions Deferred charges Realization test No stand-alone realization test prescribed in accounting literature If the related asset (e.g., inventory or PP&E) is impaired, a proportionate write-down of the deferred charge should occur Carrying amount of asset (e.g., inventory) and the deferred charge, in total, should not exceed the anticipated aftertax cash flows 41 Non-controlling Interests - ASC 810 A non-controlling interest (NCI) is the portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to the parent. NCIs are generally classified as a component of equity. Parent Unrelated 3 rd party 80% 20% Sub B 42

22 Balance sheet presentation Assets Liabilities Equity Parent Company investors and Non-controlling interest 43 Income statement presentation Sales Costs, Expenses, Other Net Income +/- Non-controlling Interest Income Attributable to Parent Company shareholders EPS Attributable to Parent Company shareholders 44

23 Transactions with Non-controlling Interest Purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions Net assets will not change for subsequent purchase or sale transactions with NCI as long as control is maintained. Upon a loss of control, the interest sold as well as any interest retained will be measured at fair value with any gain or loss recognized in earnings 45 Example 1 Non-controlling corporate interest Company A has an 80% ownership interest in Subsidiary B. The other 20% is owned by an unrelated party. Company A consolidates the financial statements of Subsidiary B. Company A had pre-tax income from continuing operations of $400 for the year ended December 31, This amount includes $100 of pre-tax income from continuing operations from Subsidiary B. Company s tax rate is 40%. 46

24 Example 1 Non-controlling corporate interest (cont.) Analysis Assuming Sub B is a C-corporation Income from continuing operations, before tax $400 Income tax expense 160(a) Net Income 240 Less: Net income attributable to non-controlling interest 12(b) Net Income attributable to Company A $228 (a) = $400*40% (b) =$60*20% [calculated as ($100-(100*40%))*20%] 47 Example 2 Non-controlling partnership interest Analysis Assuming Subsidiary B is a Partnership Income from continuing operations, before tax $400 Income tax expense $152(c) Net income $248 Less: Net income attributable to non-controlling interest $ 20(d) Net income attributable to Company A $228 (c)= $380*40% [calculated as ($400-(100*20%))*40%] (d)= $100*20% 48

25 Changes in Accounting Estimates in Income Taxes ASC Master Glossary definition: The term change in accounting estimate indicates that a change in accounting estimate results from new information Change in accounting estimate: Prior period accrual that results from new information Later identification of information that was not reasonably knowable at the original balance sheet date that results in improved judgment In assessing whether information is knowable : Is information readily accessible? Nature, complexity, and frequency of occurrence If frequently occurring or recurring, appropriate internal controls needed 49 Changes in Accounting Estimates in Income Taxes Valuation allowances: Cumulative losses: Cumulative losses in recent years is not defined in ASC 740. Generally, look to 3 years cumulative loss as guideline vs. bright line. Timing of release. Uncertain tax positions: Subsequent recognition and measurement. Effective settlement. 50

26 Branch operations The operations of an enterprise conducted in a different country than which it is incorporated Different than a controlled foreign corporation ( CFC) which is a controlled company that is incorporated in a different country Often subject to tax in two jurisdictions (i.e., the foreign country where it operates and the home country) Two sets of temporary differences arise Similar to being taxed by federal and state jurisdictions in the U.S. Deferred taxes are also provided in the home country for the tax effects of foreign DTAs and DTLs Consider the interaction of foreign taxes with home country return (e.g., foreign tax credit or deduction) No concept of outside basis exists for a branch because the branch is not a separate taxable entity therefore indefinite reversal exception does not apply 51 Foreign branches ASC 740 implications The ASC 740 rules apply to branch operations and single member disregarded entities Accounting for branch operations requires the U.S. enterprise to take into account deferred taxes related to local country temporary differences and U.S. foreign temporary differences related to inside basis differences 52

27 Foreign branches deferred taxes Computing deferred taxes related to branch operations First, determine temporary differences in the local country and record any related deferred income tax using the local country applicable tax rate Second, determine any U.S. temporary differences and record the related deferred income tax using the residual U.S. tax rate Foreign deferred taxes recorded by the branch are a temporary difference for U.S. income tax provision purposes because it has a basis in U.S. GAAP statements and no U.S. income tax basis 53 Foreign branches deferred taxes Reversal of foreign deferred taxes impacts foreign taxes paid and U.S. foreign tax credits/deductions The U.S. enterprise must decide in the year of reversal whether to treat foreign taxes paid as a foreign tax credit or as a deduction The enterprise also must determine whether a valuation allowance is required A foreign DTA creates a U.S. DTL because it represents a reduction in future years foreign tax credits or deductions A foreign DTL creates a U.S. DTA because it represents an additional future period foreign tax credit or deduction 54

28 Foreign branches Example Facts Company P has a branch in Country X where the statutory tax rate is 25 percent In the current year, the branch has pretax income of $10,000. For Country X and U.S. tax purposes, the branch has excess tax-over-book depreciation of $5,000 and nondeductible inventory reserves of $3,000 For U.S. purposes, the branch is taxed at 40 percent Taxes paid to Country X will be claimed as a foreign tax credit Question How and in which jurisdictions should deferred taxes be recorded on the same depreciation and nondeductible reserves temporary differences? 55 Foreign branches Example (cont.) Nondeductible reserves Depreciation Branch DTL, Net Nondeductible reserves Depreciation DTA on Branch DTL, Net U.S. DTL, Net Total DTA/(DTL) Country X $750 (1,250) (500) U.S. $1,200 (2,000) 500 ($300) (a) ($800) ($3,000 x 25%) (($5,000) x 25%) ($3,000 x 40%) (($5,000) x 40%) ($500 x 100%) (a) Assuming the foreign taxes will be fully creditable in the U.S. 56

29 Subsequent IP Transfer Example Non-Taxable stock acquisition of U.S. parent with foreign sales subs Acquired Dev Tech Book Fair Value $100, Zero Tax basis 6 year book IP life IP Sold post acquisition to foreign affiliate Tax rate 35% 57 Subsequent IP Transfer Example Purchase Accounting: Post Acquisition IP Sale (FMV of Dev Tech now 120M) X 35% Book Basis Tax Basis DTL $100M 0 $35M* *Offset or debit recorded in goodwill $120M Proceeds <0> Tax Basis $120 Gain $42M Tax To Record Sales Entries: Debits Credits DR. Current Expense $42M CR. ITP $42M DR. Prepaid Tax $42M CR. Current Expense $42M DR. Current Expense $7M CR. Prepaid Tax $7M DR. DTL $5.833M CR. Deferred Exp $5.833M Note: Net P&L impact at the end of 6 years - $7M 58

30 Contingent Consideration Contingent payment arrangements that are an element of consideration transferred (not employee compensation) are recognized as of acquisition date as part of fair value transferred Subsequent changes in fair value do not affect acquisition date fair value, and will be recorded in P&L For tax purposes, purchaser generally does not recognize contingent payments until fixed and determinable To determine if DTA/DTL should be recorded at acquisition date, acquirer should evaluate ultimate tax consequences that will result if contingency is settled at its carrying amount (fair value) 59 Contingent Consideration Contingent consideration is now recognized as a liability as of the acquisition date. At the acquisition date, the accrued liability for the contingent consideration is recorded at fair value. Subsequent changes to the accrued liability for contingent consideration (based on new information) are now reported in the results of operations Tax provision impact will depend upon the nature of the acquisition 60

31 Contingent Consideration At Acquisition Taxable Business Combination (Asset Acquisition) Assume contingent consideration settled at carrying amount (tax basis will increase in goodwill and/or intangibles upon payment of consideration). Record deferred taxes as necessary. FAS still prohibits recording a DTL for book > tax basis in goodwill FAS141R now allows for recording a DTA for tax > book basis in goodwill Subsequent Changes to Accrual Adjust deferred taxes for subsequent changes to fair value of consideration Deferred tax expense or benefit is recorded through tax provision Do not revisit component 1 vs. component 2 goodwill from purchase If contingent liability increases, record DTA for goodwill even if book basis in goodwill exceeds tax basis in goodwill Note: consider imputed interest deductions on earn-out payments 61 Contingent Consideration Non-Taxable Business Combination (Share Purchase or Merger) At Acquisition Assume contingent consideration settled at carrying amount (tax basis in shares will increase upon payment of consideration). Calculate book vs. tax outside basis in shares and determine need for DTA or DTL. FAS prohibits recognition of DTA for tax > book outside basis unless difference reverses in foreseeable future. Subsequent Changes to Accrual Measure outside basis difference at time of change. Determine whether DTA or DTL should be adjusted for the change in the outside basis. May result in permanent difference for book expense (loss) if no DTA or DTL recorded (for increases/decreases in contingent payment obligation). Note: consider imputed interest deductions on earn-out payments

32 Contingent Consideration Example Non-Taxable transaction Contingent consideration of up to $600M Fair value of contingent consideration on acquisition date of $200M Fair value of contingent consideration at year end of $300M Outside basis difference is not expected to reverse in the foreseeable future No DTA on outside basis difference established on date of acquisition Increase to contingent consideration liability at year end of $100M results in permanent difference in the tax provision Acquisition-Related Costs Acquisition-related costs generally are expensed in the period that the related services are received Includes direct costs of the transaction, e.g., costs for services of lawyers, investment bankers, accountants, valuation experts and other third parties. Includes indirect costs of the transaction, e.g., recurring internal costs (e.g., the cost of maintaining an acquisition department). Requirement that acquisition-related costs be expensed does not extend to financing costs Debt issuance costs generally deferred and amortized over debt term Equity issuance costs generally treated as reduction in proceeds

33 Acquisition-Related Costs Tax treatment of acquisition-related costs Depending upon applicable tax law, costs may be deductible, included in tax-deductible goodwill, capitalized as separate intangible asset, or added to tax basis of stock acquired Revenue Procedure % deductible safe harbor for success based fees Tax accounting considerations Accounting policy election as to whether or not the business combination will actually close Tax accounting treatment is dictated by the policy election and applicable tax law. Tax-deductible goodwill attributable to acquisition costs is excluded from analysis of Component 1/Component 2 taxdeductible goodwill vs. book goodwill resulting from purchase price allocation Valuation allowance: mid-year release Intraperiod tax allocation: general rule & exception Tax holidays Selected Topics ASC 740 Accounting for Income Taxes Jim Songey, Grant Thornton LLP Scott Jaconetty, BDO 1

34 Valuation Allowance: Mid-Year Release ASC The effect of a change in the beginning-of-the-year of a valuation allowance as a result of a change in judgment about the realizability of the related deferred tax asset in future years Shall not be apportioned among interim periods through an adjustment of the effective tax rate Shall be recognized in the interim period in which the change occurs (See Example A) The change in the valuation allowance is necessary as a result of a change in judgment about the realizability of the related DTA in the current year The effect is spread over remaining interim periods in the year as an adjustment to the estimated AETR

35 Example Assume the following: Entity A has a DTA of $20,000 that relates to $50,000 of NOLs that all expire in 20X9 at the beginning of fiscal year 20X1 A full valuation allowance is recorded against the DTA because A believes, based on the available evidence, that is more likely than not that the DTA will not be realized Assume that A has no other DTAs or DTLs Entity A's tax rate is 40% At the beginning of the year, A estimates, based on new evidence, that it will earn $4,000 of income before tax in each of the quarters in 20X1 At the end of the second quarter, A estimates, based on new evidence, that it will earn $100,000 of taxable income in 20X2-20X4. A concludes that it's more like thank not that all of its DTAs will be realized. Example (Continued) The following table illustrate A's tax provision in each of the four quarters of 20X1

36 Intraperiod Tax Allocation General rule Exception Other comprehensive income: backward-tracing prohibition 72

37 General Rule ( ) The tax effect of pretax income or loss from continuing operations generally should be determined by a computation that does not consider the tax effects of items that are not included in continuing operations 73 Example 74

38 Exception Rule/With Rule The exception to that incremental approach is that all items (for example, extraordinary items, discontinued operations, other comprehensive income, and so forth) be considered in determining the amount of tax benefit that results from a loss from continuing operations and that shall be allocated to continuing operations 75 Example Assume the following: The entity's pretax financial income and taxable income are the same The entity's ordinary loss from continuing operations is $500 The entity also has a $500 extraordinary gain The tax rate is 40 percent Assume a full valuation allowance on any DTA 76

39 Example (Continued) Income tax expense is allocated between the pretax loss from operations and the extraordinary gain as follows. Total income tax expense $0 Tax benefit allocated to the loss from operations 200 Incremental tax expense allocated to the extraordinary gain $ Backward-tracing prohibition Subsequent changes in DTA/DTL are recognized in tax expense even though the original tax benefit/expense was not recognized in tax expense from continuing operations. 78

40 Example: DTA XXX Original entry OCI XXX OCI Valuation Allowance XXX XXX Changes in judgment resulting in decreased valuation allowance Changes in judgment resulting in increased valuation allowance Valuation allowance XXX Income tax expense XXX Income tax expense Valuation allowance XXX XXX 79 "Lingering effects" of changes in judgment on other comprehensive income Because of the prohibition against backwards tracing, dangling debits or credits will exist in other comprehensive income 80

41 Tax Holidays 81 ASC There are tax jurisdictions that may grant an entity a holiday from income taxes for a specified period. An entity may have an expected future reduction in taxes payable during a tax holiday ASC Recognition of a deferred tax asset for any tax holiday is prohibited because of the practical problems in distinguishing unique tax holidays for which recognition of a deferred tax asset might be appropriate from generally available tax holidays and measuring the deferred tax asset 82

42 Effect of tax holidays on the applicable tax rate Using a rate that reflects the tax holiday to record a DTA or DTL for temporary differences scheduled to reverse during the period of a tax holiday does not violate the "recognition of a deferred tax asset for any tax holiday is prohibited" language of ASC Tax consequences of tax holidays An entity cannot take benefit of the tax holding until the agreement is entered into. For example, if a company is 95% sure the holiday will be granted the tax benefit of the of the holiday cannot be recognized until the agreement is in place. 84