March Tax accounting services: Key areas of focus when accounting for income taxes during interim periods

Transcription

1 March 2012 Tax accounting services: Key areas of focus when accounting for income taxes during interim periods

2 Tax accounting services About this paper At the close of every quarter, companies recognize income tax expense or benefit in their respective quarterly financial statements in accordance with interim reporting guidance under FASB Accounting Standards Codification 740, Income Taxes (ASC 740). This particular guidance employs a methodology that distinguishes between elements recognized through the use of an estimated annual effective tax rate (AETR) and specific events that are discretely recognized as they occur. While these concepts seem straightforward, when applied, this accounting model can present formidable challenges to many companies and can sometimes produce unexpected results. This publication highlights the basics as well as key areas of focus when accounting for income taxes during interim periods. The basic model With limited exceptions, the accounting literature requires the use of an estimated AETR, which is intended to represent a company s best estimate of its expected tax provision on a world-wide basis for the full year. The estimated AETR is determined for each interim period and generally includes federal, foreign, state and local income taxes, including the effects of credits, special deductions, capital gains taxed at different rates, and realization of deferred tax assets. In essence, anything that is expected to impact a tax return in a given jurisdiction should generally be included in the calculation, to the extent such an effect can be estimated. Once calculated, the estimated AETR is applied to year-to-date operating results related to ordinary income or loss in order to compute a year-todate tax provision or benefit. The interim period tax related to ordinary income is the difference between the year-to-date amount computed and any such amounts reported in previous interim periods. Throughout the year, however, other events and transactions may occur that impact continuing operations but do not represent ordinary income. The tax effects of such events would not be included in the computation of the company s estimated AETR, as the AETR should be used only for purposes of recording the tax effect of current-year ordinary income or loss. Because the estimate of full-year income and the AETR may not always have a direct relationship with quarterly income, application of the AETR may produce counterintuitive results in some instances. For example, consider a company with a significant subsidiary operating in a jurisdiction with a high tax rate as compared to the rest of the consolidated financial reporting group. If that subsidiary generates the majority of its expected annual income in the first quarter, then the estimated AETR would result in the first quarter tax provision for the consolidated group being substantially lower than it would be had a discrete calculation been performed. However, assuming the basic model is applied correctly, the tax provision would accurately reflect the tax effects for the consolidated group on a full-year basis. 2 Accounting for income taxes during interim periods

3 Ordinary income The starting point in computing the estimated AETR is anticipated ordinary income for the year. The accounting literature defines ordinary activity as income or loss from continuing operations before income taxes. Under the interim period accounting model, the general presumption is that all income is ordinary in nature. However, exceptions include items that are unusual in nature or infrequent in occurrence. Items that are unusual generally possess a high degree of abnormality and are unrelated to, or only incidentally related to, common activities of a company. Events or transactions that are generally classified as infrequent in occurrence are not reasonably expected to recur in the foreseeable future. The accounting literature also clarifies that events and transactions that are separately reported in a company s financial statements are presumed to be unusual or infrequent, and therefore are excluded from ordinary income. In analyzing whether the nature of an event is unusual or infrequent, companies should consider the context of the specific industry in which they operate, as well as the current economic landscape. In addition to items that are unusual in nature or infrequent in occurrence, the accounting literature specifically excludes from the definition of ordinary income extraordinary items (i.e., items that are both unusual and infrequent), discontinued operations, and cumulative effects of changes in accounting principles. Tax effects of these items are accounted for as discrete events, as further discussed below. Discrete events Tax effects outside of ordinary income are accounted for discretely in the interim period in which they occur. Determining whether the tax effects of a transaction should be recorded discretely may require careful consideration of the relevant facts and circumstances. For example, tax effects associated with restructuring costs may warrant discrete treatment in circumstances where there has been no history of restructuring and there is presently no reasonable expectation of recurring restructuring charges in the future. On the other hand, a company with a history of restructuring charges may conclude that a restructuring charge is not unusual or infrequent, and the associated tax effects would be included in the calculation of the estimated AETR. Companies should be mindful that circumstances that result in discrete period treatment for one entity may not result in the same treatment for another due to specific facts in relation to the unusual in nature or infrequency of occurrence criteria. Examples of items that require discrete treatment include, but are not limited to: Change in tax law or rates Companies that operate in multiple jurisdictions often encounter changes in tax law and statutory tax rates that need to be accounted for in the financial statements. An adjustment impacting existing deferred tax assets and liabilities should be treated discretely in the interim period that includes the date of enactment, which in the US federal jurisdiction is the date the president signs a tax bill into law. However, companies should keep in mind that the prospective effects of the very same change would be included in a company s estimated AETR computation. In analyzing whether the nature of an event is unusual or infrequent, companies should consider the context of the specific industry in which they operate, as well as the current economic landscape. Accounting for income taxes during interim periods 3

4 Changes related to a prior-year tax provision A company s annual tax provision is generally calculated using the best available information. However, in some instances, differences exist between the amount of tax expense estimated in the financial statements and the actual amount of tax expense reported on a company s corporate income tax return. Such differences, typically referred to as provision-toreturn adjustments, are generally accounted for in a subsequent period when the tax return is filed. A change in the current year that relates to a prior-year tax provision does not generally constitute a tax effect on current-year ordinary income. As such, the provision-to-return adjustments should not be incorporated into a company s AETR analysis. Change in tax status Companies often undertake internal restructurings of their business operations, which may involve a change in tax status for one or more of the entities involved, such as from nontaxable to taxable. For example, a company may file an election to change the entity classification of a foreign subsidiary from a controlled foreign corporation to a disregarded entity for US federal income tax purposes. When a company initiates an action or election that results in a change, the accounting literature requires the tax effects of the change to be excluded from the estimated AETR. Specifically, the tax consequence of a voluntary change in tax status should be recognized discretely in the period when approval is granted by the respective taxing authority or the filing date, if approval is automatic. When a company initiates an action or election that results in a change, the accounting literature requires the tax effects of the change to be excluded from the estimated AETR. 4 Accounting for income taxes during interim periods

5 Exceptions to the use of the estimated AETR approach Despite the challenges that companies face in complying with the interim reporting requirements, there are only two instances for which the accounting model permits a company to depart from the estimated AETR approach. These exceptions are narrowly defined in the accounting literature as (1) jurisdictions with pretax losses for which no tax benefit can be realized and (2) jurisdictions for which a reliable estimate cannot be made. Jurisdictions with pre-tax losses for which no tax benefit can be realized Under the AETR approach, companies with year-to-date ordinary losses, anticipated ordinary losses for the year, or both generally yield an AETR that recognizes a tax benefit associated with the losses. However, when a company operates in a jurisdiction that generates ordinary losses but does not expect to realize them, the accounting model requires the exclusion of the respective jurisdiction from the world-wide estimated AETR calculation. Instead, companies are required to separately compute an effective tax rate for the given jurisdiction. This exception commonly presents itself in circumstances where a company has determined that its deferred tax assets are not realizable on a morelikely-than-not basis and has recorded a full valuation allowance. Jurisdictions for which a reliable estimate cannot be made The second exception is relevant in situations where a reliable estimate cannot be made of some or all of the information that is ordinarily required to determine the estimated AETR. This might be the case in situations where a company anticipates break-even to marginal profit for the year, but has significant permanent book and tax differences that would result in a wide variability in the estimated AETR. In that circumstance, the accounting model requires the associated tax impacts to be separately computed and recorded discretely in the period in which they occur. Companies should be mindful that determining whether a reliable estimate can be made requires significant judgment. Careful consideration should be given to available facts and circumstances before reaching a conclusion. Further, a company s assertion that it cannot develop a reliable estimate should be consistent with its other financial statement disclosures and communications to investors and analysts. Accounting for income taxes during interim periods 5

6 Other complexities In addition to understanding the basic model and related limitations and exceptions, companies need to be aware of key areas that bring complexity to the process and, in many instances, require significant levels of judgment. This section encompasses various scenarios that companies commonly encounter when accounting for taxes in interim periods, yet could easily overlook and misapply. Companies with deferred tax liabilities attributable to indefinite-lived assets, such as land and goodwill, should consider their impact in the calculation of the estimated AETR. Changes in realizability of deferred tax assets At each reporting period, companies must assess the realizability of deferred tax assets based upon the weight of all available evidence, and establish a valuation allowance when it is more-likely-than-not that the assets will not be realized. A change in judgment regarding the need for a valuation allowance may need to be reflected in the estimated AETR or recognized discretely, or in some instances, both. For example, a change in judgment about the realizability of deferred tax assets in future years should be recognized discretely in the interim period in which the change occurs. However, a change related to current-year ordinary activity should be considered in determining the estimated AETR. Effects of deferred tax liabilities that do not represent a source of future income Companies with deferred tax liabilities attributable to indefinitelived assets, such as land and goodwill, should consider their impact in the calculation of the estimated AETR. In general, deferred tax liabilities associated with indefinite-lived assets are not expected to reverse in a finite period of time. As a consequence, these deferred tax liabilities, commonly referred to as naked credits, generally do not represent a future source of income when assessing deferred tax assets for realizability. Although companies may have a full valuation allowance recorded against deferred tax assets, an increase in this type of deferred tax liability (e.g., amortization of tax goodwill resulting in an increase to the related deferred tax liability) generally triggers a current tax expense that should be included in the company s determination of its estimated AETR. Zero-tax rate jurisdictions Many companies operate in jurisdictions that impose a zero tax rate, whether by statute or the granting of a tax holiday by the local taxing authority. Although the accounting standard does not specifically address zero-tax-rate jurisdictions in the context of interim reporting, there may be support for either its inclusion in or exclusion from the AETR computation. For example, a company may choose to exclude its pre-tax ordinary activity from the estimated AETR based on the notion that income in a zero-rate jurisdiction is effectively tax exempt. On the other hand, a company may choose to include its activity in the AETR calculation, unless it meets one of the two exceptions permitted in the accounting standards. Once decided, the treatment should be considered an accounting policy election consistently applied to all jurisdictions where the local income tax rate is zero. In the event that one approach over another has a significantly different financial statement impact, companies should consider making appropriate disclosures. 6 Accounting for income taxes during interim periods

7 Change in uncertain tax positions (UTPs) As companies assess the income tax impact of changes of UTPs during interim periods, it is important to distinguish between positions that relate to the current year and those that relate to prior years, as they may yield different results. When there is a change in judgment regarding a tax position that arose in a prior year, the corresponding tax effect of the change should be recognized as a discrete item in the period of change. For example, a company may reassess the tax benefit associated with its research and development credit taken on a priorperiod tax return after discussing the technical merits with the taxing authorities. Any subsequent change in the measurement of the UTP associated with the credit would be excluded from the company s estimated AETR. However, to the extent there is a change in assessment with respect to a current-year tax position, the tax effects should generally be incorporated into the company s estimated AETR. Companies should be mindful that the accounting literature requires discrete treatment of interest and penalties associated with UTPs. Regardless of whether a change in judgment relates to a tax position previously taken or expected to be taken in the current period, interest should be accrued as incurred and penalties recorded when the corresponding tax position is taken or anticipated. Income tax benefit limitations Occasionally, a company finds itself recording a greater loss during one quarter than it anticipates reporting for the full year. Implicit in the principle for recognizing an income tax benefit in interim periods is a limitation that prohibits recognition of a benefit at the end of any interim period that exceeds the benefit expected to be recognized for the full year, based on the world-wide estimated AETR calculation. Companies that face this scenario should be mindful of the limitation when calculating the interim period provision. Recognition of windfall tax benefits in interim periods An area for consideration in the context of stock-based compensation awards involves the recognition of windfall tax benefits. The accounting literature prohibits the recognition of a windfall tax benefit until it results in the reduction of taxes payable. For interim reporting purposes, companies should estimate their annual income taxes payable. And to the extent taxable income is anticipated for the full year, windfall tax benefits from awards exercised in an earlier period should be recognized as a reduction of income taxes payable with a corresponding adjustment to additional paid-in capital, even if the company incurred a year-to-date loss for the period. Conversely, companies that estimate taxable income for the full year, but don t expect to pay cash taxes due to the availability of net operating loss carryforwards, should not recognize the windfall benefits. Accounting for income taxes during interim periods 7

8 Change in indefinite reinvestment assertions During an interim period, a company may change its intentions as to whether it will indefinitely reinvest undistributed earnings of foreign subsidiaries or corporate joint ventures that are permanent in duration. Such change would result in the recording or adjustment of deferred taxes on outside basis differences. Under these circumstances, the tax effect of a change in judgment for the establishment of a deferred tax liability associated with an accumulated outside basis difference as of the beginning of the year should be recorded discretely in the interim period during which the assertion changed. However, once the determination has been made, companies should be mindful to reflect the tax on the portion of unremitted earnings associated with the current-year activity in the computation of the estimated AETR. Business combinations The acquisition of a business can significantly impact the acquiring company s estimated AETR. Because a business combination is a transaction that is not typically anticipated or accounted for in periods prior to the acquisition date, no effect should be given in the estimated AETR before the period in which the transaction is consummated. As the interim reporting model does not specifically address acquisitions that have been consummated during the year, more than one approach may be appropriate. The first approach incorporates the expected results of the newly acquired business in the estimated AETR in the first interim period in which the purchase is consummated. Alternatively, a second approach would be to divide the annual period into pre- and postacquisition periods and determine an estimated AETR for each of the two separately. Whichever approach is chosen, it represents an accounting policy that should be applied consistently in subsequent periods. Nonrecognized subsequent events If a significant pre-tax event occurs after the interim balance sheet date but before financial statement issuance, companies must consider whether the estimated AETR calculation should be updated. For example, subsequent to a company s reporting period end date, the entity disposed of a product line, which significantly changed the company s current estimate of ordinary income and thereby its estimated AETR. The interim tax accounting model requires a revision of the estimated AETR at each interim period to reflect a company s best current estimate. Based on that premise, companies could reasonably conclude that the company s best estimate should consider all available information before the date of issuance. Alternatively, since the pre-tax effects of the nonrecognized subsequent event are not reflected in the financial statements for the period being reported on, you could reasonably conclude that the tax effects should be excluded from the interim calculation of the estimated AETR. Companies should give careful consideration to the approach taken. Once chosen, the approach should be consistently applied as an accounting policy. In either case, however, several other examples of a subsequent event must be reported discretely, without the same allowance for a policy choice. Again, these include: tax effects attributable to changes in tax laws or rates, new information received after the reporting date related to the assessment of uncertain tax positions and extraordinary items, and other significant unusual or infrequent items. 8 Accounting for income taxes during interim periods

9 Disclosures Interim financial statement disclosures Interim reporting disclosure requirements focus on drawing readers attention toward significant changes and derivations from audited disclosures. Disclosure requirements for significant income-tax-related items generally include, but are not limited to: Tax effects of unusual or infrequent items Changes in estimates or provisions for income taxes, such as changes in the realizability of deferred tax assets Variations in the customary relationship between income tax expense and pre-tax accounting income, if not otherwise apparent Changes related to uncertain income tax positions Tax impacts of significant risks and uncertainties Interim Management s Discussion and Analysis (MD&A) disclosures In a similar fashion, interim MD&A disclosures are intended to enable readers to assess significant changes in financial condition. This includes addressing significant changes in the results of operations that did not arise from or are not necessarily representative of the ongoing business. In other words, readers of the financial statements should be entitled to assume that a company s effective tax rate for the most recent periods will continue into the nearterm future. If items impacting the AETR will not recur, such that the expected AETR will be appreciably different going forward, disclosure would generally be appropriate. Consistent with other financial statement disclosures, MD&A should also disclose the impact that recently issued accounting standards are expected to have on the financial statements of the registrant when adopted in a future period. Accounting for income taxes during interim periods 9

10 In conclusion Preparation of an interim income tax provision can be complex and far from intuitive. Among various key considerations, deriving the estimated AETR, accounting for discrete events, determining if exceptions to the estimated AETR approach are applicable, and ensuring proper disclosure can present challenges to many organizations. For more information about accounting for income taxes in interim periods, see Chapter 17, Accounting for Income Tax in Interim Periods, in the PwC Guide to Accounting for Income Taxes. 10 Accounting for income taxes during interim periods

11 Contacts PwC is committed to helping companies navigate today s tax accounting issues. Our national and global network of specialized tax accounting resources can help you tackle a wide range of tax accounting needs. With that in mind, please visit to view our comprehensive library of tax accounting thought leadership, webcasts, and tools addressing the business and technical issues related to tax accounting. For more information, please reach out to your local PwC partner and/or the primary authors. Leah Alfonso Director, National Office Phone: leah.n.alfonso@us.pwc.com Kristin Dunner Manager, Tax Accounting Services Phone: kristin.n.dunner@us.pwc.com Ken Kuykendall US Tax Accounting Services & Tax IFRS Leader Phone: o.k.kuykendall@us.pwc.com Jennifer Spang National Office & Tax Accounting Services Phone: jennifer.a.spang@us.pwc.com Accounting for income taxes during interim periods 11

12 12 Accounting for income taxes during interim periods

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