Provision Challenges. Allowances. Tax Executives Institute. May 7, 2012

Transcription

1 Selected Tax Provision Challenges Valuation Allowances Tax Executives Institute May 7, 2012

2 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG 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 e t 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. 1

3 Dated material THE MATERIAL CONTAINED IN THESE COURSE MATERIALS IS CURRENT AS OF THE DATE PRODUCED. THE MATERIALS HAVE NOT BEEN AND WILL NOT BE UPDATED TO INCORPORATE ANY TECHNICAL CHANGES TO THE CONTENT OR TO REFLECT ANY MODIFICATIONS TO A TAX SERVICE OFFERED SINCE THE PRODUCTION DATE. YOU ARE RESPONSIBLE FOR VERIFYING WHETHER OR NOT THERE HAVE BEEN ANY TECHNICAL CHANGES SINCE THE PRODUCTION DATE AND WHETHER OR NOT THE FIRM STILL APPROVES ANY TAX SERVICES OFFERED FOR PRESENTATION TO CLIENTS. YOU SHOULD CONSULT WITH WASHINGTON NATIONAL TAX AND RISK MANAGEMENT-TAX TAX AS PART OF YOUR DUE DILIGENCE. 2

4 Valuation allowance general concept FASB ASC (e) (SFAS (e)): Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. Recognition or non-recognition of a valuation allowance is not optional A valuation allowance must be adjusted as circumstances change 3

5 Determining if a valuation allowance is necessary All available evidence, positive and negative, must be considered when assessing the need for a valuation allowance. Future realization of the tax benefit from a carryforward/carryback ultimately depends on the existence of sufficient taxable income of the appropriate character within the carryback period and carryforward period available under the law. 4

6 Valuation allowance level of analysis Need for valuation allowance is generally determined separately for each jurisdiction Even within a single jurisdiction, need for valuation allowance with respect to different types of carryovers must often be evaluated individually due to different carryback/carryover periods and differing limitations on utilization 5

7 Certain future events not anticipated Future Business Combinations Anticipated Changes in Tax Laws and Rates Anticipated Changes in Tax Status Sale of Held-to-Maturity Securities Sales of Indefinite-Life Intangible Assets Net Losses in Future Years Expected Forgiveness of Debt Changes in Fair Value of Assets and Liabilities Events Dependent upon Future Market Conditions 6

8 Evaluation of more likely than not criterion Company must consider: All available negative evidence All available positive evidence Evidence will include objective and subjective information Weight given to the potential effect of negative and positive evidence should be based on the extent that it can be objectively verified 7

9 Valuation allowance evidence Examples of negative evidence Cumulative losses in recent years Past/expected future losses Brief carryback and carryforward periods Special character of income (e.g., capital gains, foreign source income) required to realize tax benefits History of carryforwards expiring unused Management historically unable to accurately forecast future earnings Unfavorable trends, developments, or contingencies Going-concern issues 8

10 Cumulative losses in recent years Significant piece of negative evidence that is difficult to overcome Presumption: Valuation allowance is needed if cumulative losses in recent years However, not determinative by itself Presumption may be overcome 9

11 Cumulative losses in recent years (continued) No methodology prescribed in ASC 740 In practice, generally: Losses = pre-tax book income losses including, discontinued operations including, extraordinary items excluding, cumulative effect of changes in accounting principles Recent years = current year and prior two years 10

12 Review question One of the examples of negative evidence is cumulative losses in recent years. True or False: When evaluating historical cumulative losses, the Company should consider taxable losses rather than pre-tax book losses. 11

13 Valuation allowance evidence Examples of positive evidence Strong earnings history Appreciated net asset values Taxes paid in potential carryback years Availability of tax planning strategies Favorable recent developments Sales backlog 12

14 Valuation allowance evidence (continued) Weigh positive evidence (indicating DTA will be realized) against negative evidence (indicating DTA will not be realized) Items weighted based on extent to which they can be objectively verified 13

15 Valuation allowance sources of income Realization of tax benefits of deductible temporary differences and carryovers is dependent upon enterprise having: Sufficient taxable income Of an appropriate character Within the statutory carryback/carryforward period Sources of income Taxable income in carryback years Future reversals of existing temporary differences Forecasted future taxable income exclusive of reversing temporary differences and carryforwards Tax planning strategies 14

16 Valuation allowance sources of income (continued) If evidence of one or more sources of taxable income is sufficient to support conclusion that no valuation allowance is needed, it is generally not necessary to consider other potential income sources Taxable income in prior years eligible for carryback and future reversals of taxable temporary differences generally more objective than projections of future taxable income 15

17 Scheduling of temporary differences Definition an exercise or analysis performed to determine the pattern and timing of reversal of temporary differences Not mandatory under FASB ASC 740, but useful in determining whether DTAs will be realized via utilization to offset future taxes that would otherwise be payable when DTLs reverse Methods employed should be systematic, logical, and applied consistently from year to year Objective is to minimize complexity in selecting method Degree of detail is a matter of professional judgment 16

18 Scheduling of temporary differences (continued) In estimating reversal patterns, consider the following: Pattern and time period Remaining carryforward and carryback periods Character of the taxable and deductible amounts Indefinite reversals Tax planning strategies 17

19 Scheduling of temporary differences Example Assumptions The company s tax rate is 30% Loss carryforward period is three years The company has never made any money, and carryback period is not applicable Question Does the company need to record a valuation allowance for all or a portion of the deferred tax assets? 18

20 Scheduling of temporary differences Example (continued) How much taxable income is available? 2008 Gross future (taxable) /deductible amounts Fair value adj. on acquisitions (50,000) 5,000 5,000 5,000 5,000 5,000 Depreciation differences (20,000) 1,000 1,000 1,000 1,000 1,000 Allowance for doubtful loans 40,000 (20,000) (20,000) Deferred bonus 20, (20,000) 000) Capitalized software (24,000) 8,000 8,000 8,000 Total net temporary differences (34,000) (26,000) (6,000) 14,000 6,000 6,000 Accumulated taxable income (loss) (26,000) (32,000) (18,000) (12,000) (6,000) 19

21 Scheduling of temporary differences Example (continued) The Company does not need to record a valuation allowance on all deferred tax assets because of the reversal of temporary differences in future years Reversal of temporary differences will create a taxable loss in 2009 and 2010 of $26,000 and $6,000, respectively Company can carryforward losses for three years, so these losses can be carried forward to 2012 and 2013, respectively The reversal of the taxable temporary differences results in taxable income of $14,000 in 2009, 2010, and 2011 and $6,000 in 2012 and 2013 (and into the future) Since the Company can carryforward losses for three years and the last taxable loss is expected in 2010, the reversal of these differences will create $54,000 in future taxable income ($14,000 + $14,000 + $14,000 + $6,000 + $6,000) Therefore, the Company can definitely prove that $16,200 ($54,000 x 30%) of the deferred tax assets more likely l than not will be realized However, as the future taxable income picture is bleak, the remaining deferred tax asset of $1,800 ($18,000 $16,200) might need a valuation allowance unless the Company has a prudent and feasible tax-planning strategy available 20

22 Deferred tax liability associated with an indefinite lived asset Leary, Inc. is a start-up pharmaceutical company backed by wealthy investors. Through its first two years of operations, Leary, Inc has a cumulative net loss of a total of $10 million. The primary asset on Leary s balance sheet is a trademark that it acquired in its acquisition of Huxley Corp. this year. The trademark, which is not being amortized due to its indefinite life classification, is reported on the balance sheet at $10 million, its fair value at the time of the acquisition. The tax basis s of the trademark a is $0 and, therefore, e e, Leary, Inc has recorded a $3 million deferred tax liability (both Huxley Corp. and Leary, Inc applicable tax rate is 30%). Leary, Inc. has recorded a deferred tax asset of $3 million related to the net operating loss carryforward. Leary, Inc has the ability to carryforward losses for 5 years, but cannot carryback losses to prior periods. The future outlook for the trademark is golden at least according to Leary, Inc. s management. Does Leary, Inc need a valuation allowance on the DTA? 21

23 Deferred tax liability associated with an indefinite lived asset (continued) Answer: YES, Leary, Inc. needs a valuation allowance Future reversals of existing taxable temporary differences Deferred tax liabilities related to intangibles with indefinite lives and goodwill cannot be used as a source of future taxable income because the timing of the reversal of these temporary differences is undeterminable and will not coincide with the reversal related to the NOL (in this case, only five years) Taxable income in prior carryback year(s), if carryback is permitted The tax law in this case does not allow NOLs to be carried back to prior years Future taxable income exclusive of temporary differences and carryforwards A cumulative loss in recent years (three years) is a significant piece of negative evidence that is difficult to overcome Tax planning strategies Selling the trademark is a possibility, but this is not prudent and feasible as it represents Leary, Inc. s only major asset on its balance sheet. Also, selling the asset is inconsistent with the indefinite life classification of the trademark 22

24 Future anticipated taxable income Exclusive of reversing temporary differences and carryforwards Ability to estimate future income Subjectivity generally increases as the number of years increase One year of profit does not necessarily equate to a 20 year trend Consider historical ability to forecast income Corporate budget cycle, industry business cycle, and impairment analysis may indicate appropriate # of years Best estimate of future amounts as many years as practical (not limited to a rolling fixed # of years) Evaluation of significant assumptions Consistency of budgets/forecast with other information and assumptions used in financial reporting Partial valuation allowances are among the most judgmental areas in income tax accounting 23

25 Tax planning strategies Definition prudent and feasible actions (including elections for tax purposes) that an enterprise ordinarily might not take but would take, if necessary, to realize a tax benefit for an operating loss or tax credit carryforward before it expires Goal is to alter timing or character of future taxable income or deductible expenses Reasonable effort must be made to identify tax planning strategies prior to booking valuation allowance Ability to implement the strategy must be primarily under the control of management 24

26 Tax planning strategies (continued) Search not optional Management must make reasonable effort Strategy must be prudent and feasible Management must have ability and intent Strategy must be consistent with other representations Implementation expenses or losses must be included in the valuation allowance Recognition and measurement of uncertain tax position guidance applies 25

27 Tax planning strategies (continued) Tax benefit must be reduced by net-of-tax amount of costs or losses that would be recognized if strategy were implemented Examples of potential tax planning strategies Sale and leaseback of plant and equipment (if overall appreciation in company net assets) Switch from tax-exempt to taxable investments Disposition of obsolete or excess inventory Extinguishing liabilities that give rise to tax deductions upon payment 26

28 Tax planning strategies Example How much taxable income is available NOW? 2008 Gross future (taxable) /deductible amounts Fair value adj. on acquisitions (50,000) 5,000 5,000 5,000 5,000 5,000 5,000 Depreciation differences (20,000) 1,000 1,000 1,000 1,000 1,000 1,000 Allowance for doubtful loans 40,000 (20,000) (20,000) Deferred bonus 20, (20,000) 000) Capitalized software (24,000) 8,000 8,000 8,000 Total net temporary differences (34,000) (6,000) (6,000) (6,000) 6,000 6,000 6,000 Accumulated taxable income (loss) (6,000) (12,000) (18,000) (12,000) (6,000) 0 Note: Ignore book income for purposes of this illustration (assume it is zero). 27

29 Tax planning strategies Example (continued) If the Company can delay the payment of the bonus until 2010 (a tax-planning strategy), then full realization of the deferred tax assets, without recording a valuation allowance, would appear proper Deferred tax liabilities related to the fair value adjustments and depreciation (gross $6,000 per year) reverse over 10 and 20 years, respectively Losses can be carried forward for 3 years Therefore, delaying the bonus payment until 2011 would give the company until 2014 to prove realization of the deferred tax assets However To be considered prudent and feasible, the delaying of the bonus payment would have to be legally possible in accordance with the contract 28

30 Changes in valuation allowance Changes in circumstances can cause a change in judgment about the future realizability of a deferred tax asset and result in a revision to the valuation allowance For interim reporting purposes, the accounting recognition for changes in the valuation allowance will depend upon when realization is expected (i.e., in the current year or in future years) 29

31 Changes in valuation allowance (continued) Recognize as part of the annual effective tax rate in the period the event occurs when: A benefit is expected to be realized because of current year ordinary income, or A valuation allowance is expected to be necessary at the end of the year for deductible temporary differences originating during the current year. Source: Paragraph 20 of APB Opinion 28 (as amended by Statement 109), paragraph 20 of FIN

32 Changes in valuation allowance (continued) Recognize entire amount of change as a discrete item in the interim period the event occurs when: An increase or decrease in the BOY valuation allowance is caused by a change in judgment about the realizability of deferred tax assets in future years. Source: Paragraph 20 of APB Opinion 28 (as amended by Statement 109), paragraph 37 of Statement 109 and paragraph 20 of FIN

33 Questions? Rachel McClain Senior Manager (404)

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