Income taxes Revised September 2013

Transcription

1 Financial reporting developments A comprehensive guide Income taxes Revised September 2013

2 To our clients and other friends This guide is designed to summarize the accounting literature related to accounting for income taxes. Accounting Standards Codification Topic 740 includes financial accounting and reporting guidance for the effects of income taxes that result from an entity s activities during the current and preceding years. It codified the guidance that was previously included in Statement 109, APB 23 and other FASB statements and EITF consensuses. This publication has been updated for Ernst & Young interpretative guidance through September We have updated and expanded our guidance covering a variety of topics including valuation allowances, business combinations, intercompany transactions, changes in tax status, foreign and domestic subsidiary temporary differences, interim reporting and accounting for government assistance. We have additionally added a new chapter on accounting for the income tax effects of share-based payments and have updated our guidance on presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists pursuant to the issuance of ASC Updated and expanded sections are indicated in the respective heading as well as in Appendix D. Excerpts from and references to the Accounting Standards Codification are contained within this guide. Guidance that may still be applicable but is based on non-authoritative standards not included in the FASB's Accounting Standards Codification is included in an appendix. Ernst & Young professionals are prepared to help you identify and understand the issues related to income taxes. In addition, our audit and tax professionals would be pleased to discuss with you any other issues related to your tax and financial reporting needs. Revised September 2013 Financial reporting developments Income taxes

3 Contents 1 Introduction Scope General State income taxes Partnerships and other flow-through entities Excise taxes not-for-profit foundations Objectives and basic principles Basic approach Exceptions to comprehensive accounting for deferred taxes Leveraged leases Leveraged lease tax credits as source of taxable income Impact of change in effective tax rate Impact of AMT on leveraged lease accounting Leveraged leases acquired in business combinations Intercompany transactions (updated October 2011 and September 2013) Measurement of prepaid tax on intercompany transactions Consideration of NOLs and intercompany transactions (updated September 2013) Deferred tax asset is realizable Classification of prepaid tax on intercompany transactions Impact of subsequent changes in tax rates on prepaid (accrued) taxes attributable to intercompany transactions Changes in realizability of prepaid (accrued) taxes attributable to intercompany transactions (updated September 2013) Uncertain tax position considerations (updated September 2013) Foreign currency differences Nonmonetary temporary differences Monetary temporary differences Taxation of unrealized gains and losses Taxation of realized gains and losses Tax indexation of nonmonetary assets Remeasurement in highly-inflationary economies Highly inflationary economy change in functional currency General price-level changes restatement of financial statements Temporary differences Temporary vs. permanent differences Identifying cumulative temporary differences Temporary differences related to LIFO inventory Temporary differences change in tax method of accounting Tax-to-tax differences Temporary differences related to state income taxes Financial reporting developments Income taxes i

4 Contents Different tax and fiscal year ends Payments to the IRS to retain fiscal year Impact on deferred taxes of ability to delay payment Tax-planning strategies Government assistance received (investment tax credits and government grants) (updated October 2011and September 2013) Scope (updated September 2013) Investment tax credits Grant accounting (updated October 2011) Temporary differences related to government assistance received (updated September 2013) Other considerations (updated September 2013) Temporary differences examples Temporary differences financial services industry Scheduling the reversal of temporary differences Determining reversal dates Examples of temporary difference reversal patterns Change in method used to determine reversal pattern Basis differences without future tax consequences permanent differences Temporary differences without financial reporting asset or liability (updated October 2011) Recognition and measurement Applicable tax rates Average graduated tax rates Enacted tax rate Dividends received deductions Rate differential on distributed or undistributed earnings (including subsidiary dividend paid tax credits) (updated September 2013) Consolidated financial statements (updated September 2013) Separate financial statements of a subsidiary (updated September 2013) Shareholders tax credits for dividends paid Tax holidays Applicable tax rate in a tax holiday period Alternative minimum tax Overview of the US corporate AMT system Effect of the AMT on deferred tax calculations Examples of AMT calculations and related tax provisions State and local income taxes State applied vs. enacted tax rates Estimating deferred state income taxes Income apportionment State taxes based on the greater of franchise tax or income tax Revised Texas franchise tax Franchise tax effect on deferred state income taxes State taxes based on items other than income Special deductions Domestic production activities deduction Financial reporting developments Income taxes ii

5 Contents 6 Valuation allowances Sources of taxable income Liabilities for uncertain tax positions as a source of taxable income (updated September 2013) Appropriate character of taxable income Carryforwards that do not expire Future reversal of existing temporary differences Limitations on taxable temporary differences related to indefinite-lived assets as a source of future taxable income (updated October 2011) Operating loss and tax credit carrybacks (updated September 2013) Availability of tax credits Tax benefit substitution vs. realization Tax-planning strategies Tax-planning strategies optionality Tax-planning strategies examples Consideration of significant expenses Classification of expenses to implement tax-planning strategies Tax elections Future taxable income Consistency of assumptions and projections Recovery of investments in subsidiaries Undistributed earnings of a foreign subsidiary Projections of future income Originating and reversing temporary differences Evaluation of positive and negative evidence Cumulative losses (updated October 2011) Unusual, nonrecurring and noncash charges Emergence from bankruptcy Going concern opinion Other negative evidence Evaluation of operating loss and tax credit carryforwards Limitation of net operating loss carryforwards (updated October 2011 and September 2013) Considerations for the release of a valuation allowance (updated October 2011) Available evidence Foreign tax credit carryforwards Effect of Alternative Minimum Tax (AMT) on deferred tax assets Future tax benefits deemed worthless Valuation allowances in a business combination Intraperiod tax allocations Valuation allowances for certain debt and equity securities Valuation allowances for amounts recorded in other comprehensive income related to postretirement benefit plans Financial reporting developments Income taxes iii

6 Contents 7 A change in the valuation allowance General Changes in valuation allowances business combinations Valuation allowances for temporary differences related to undistributed earnings of a foreign subsidiary Intraperiod tax allocations Valuation allowances for certain debt and equity securities Valuation allowances for amounts recorded in other comprehensive income related to postretirement benefit plans An enacted change in tax laws or rates Changes in tax laws and rates Regulatory changes akin to legislative changes Enactment date Enactment date (United States) Enactment date (Australia) Provisional measures Effects of rate changes on deferred tax assets Retroactive change in enacted tax rates Changes in tax rates following adoption of new accounting standards Change in tax law or rates related to items not recognized in continuing operations Changes in tax accounting methods Discretionary change in tax accounting methods Nondiscretionary change in tax accounting methods Change in tax accounting methods due to change in tax law Other discussions of the impact of changes in tax rates Change in the tax status of an entity General (updated September 2013) Conversion of a partnership to a corporation (updated September 2013) Outside basis considerations related to a conversion of a partnership to a corporation (updated September 2013) Change in tax status as a result of acquisition (updated September 2013) Change in tax status subsequent event (updated September 2013) Change in tax status effective date versus financial reporting date (updated September 2013) Built-in gains (updated October 2011) Upon consummation of initial public offering Loss of nontaxable status REIT conversion (updated September 2013) Regulated entities General Regulatory-assisted acquisitions of financial institutions Business combinations Impact of regulatory requirements Financial reporting developments Income taxes iv

7 Contents 11 Business combinations General Tax effects of basis differences (updated September 2013) Changes in tax basis (updated September 2013) Tax effects of obtaining a step-up in inside-tax basis of acquired net assets (updated September 2013) Tax effects of a post-acquisition merger (updated September 2013) Post-combination intercompany transactions (updated September 2013) Identifiable intangible assets and goodwill Non-deductible goodwill Non-deductible identified intangible assets Purchase price allocation differences Tax-deductible goodwill Amortization of tax-deductible goodwill Excess tax-deductible goodwill in pre-asc 805 transactions Changes in acquirer s valuation allowance as a result of a business combination Tax consequences of contingent consideration At acquisition taxable Post acquisition taxable At acquisition non-taxable Deferred tax asset outside-basis difference Deferred tax liability outside-basis difference Post acquisition non-taxable Deferred tax asset outside-basis difference Deferred tax liability outside-basis difference Deferred taxes for acquisition-related costs Excess tax basis over financial reporting basis Excess financial reporting basis over tax basis Deposit-based intangibles Acquired research and development deferred tax liabilities Impairment of identifiable intangible assets and goodwill Impairment of tax deductible goodwill Impairment of non-deductible goodwill Allocation of subsequent impairments to deductible and nondeductible goodwill Foreign currency temporary differences from push-down adjustments Effects of change in tax laws or rates subsequent to a business combination Valuation allowance in a business combination Changes in a valuation allowance established at the acquisition date Pre-statement 141(R) business combinations Changes in a tax uncertainty established at the acquisition date Pre-statement 141(R) business combinations Effect of acquirer-specific attributes on measurement of acquired deferred taxes Valuation allowance for acquired deferred tax assets Apportioned tax rates Unborn foreign tax credits Assertion regarding indefinite reinvestment (updated September 2013) Financial reporting developments Income taxes v

8 Contents Income tax effects of replacement awards classified as equity issued in a business combination Accounting for the tax effects of Incentive Stock Options (ISOs) Differences in measurement of deferred taxes in separate financial statements of subsidiary Tax effects of a business combination achieved in stages Outside-basis differences Deferred tax liabilities for domestic subsidiaries acquired in stages Deferred tax liabilities for foreign subsidiaries acquired in stages Limitations on deferred tax assets for subsidiaries Inside-basis differences Noncontrolling interests Reporting noncontrolling interests and income taxes in the consolidated income statement Changes in ownership interest in a subsidiary other than in a business combination Decreases in a parent s ownership interest in a subsidiary without loss of control Increases in a parent s ownership interest in a subsidiary Other tax effects of change in ownership of subsidiary (updated October 2011) Loss of control of a subsidiary Asset acquisitions Asset acquisitions Asset acquired with tax basis greater than book basis Asset purchased for more than tax basis Deferred credit from tangible asset acquisition Deferred credit from the acquisition of assets recorded at fair value Valuation allowance reduced due to acquired intangible asset Purchase of future tax benefits Transaction directly with a governmental taxing authority Foreign and domestic subsidiaries and US steamship entity temporary differences General (updated October 2011) Investments in foreign subsidiaries Foreign vs. domestic subsidiaries Investments that are essentially permanent in duration Inside basis differences of foreign subsidiaries Partial reinvestment Dividends (updated October 2011) Other situations involving indefinite reversal Change in status of foreign investees Foreign equity method investees and corporate joint ventures Exceptions to recognition of deferred taxes on undistributed earnings and US possessions Foreign operational structures Branch offices (updated October 2011 and September 2013) Partnerships Hybrid structures (updated September 2013) Financial reporting developments Income taxes vi

9 Contents Sub-part F income (updated October 2011) Deferred taxes allocated to translation adjustments Original investment not indefinitely reinvested Hedge of a net investment Applicability of ASC exception to consolidated variable interest entities ASC and acquisition accounting Consideration of unborn foreign tax credits (updated September 2013) Advance corporate tax payments and refunds (UK) Frequently asked questions Undistributed domestic earnings before Bad-debt reserves of savings and loan associations Statutory reserve funds of US steamship companies Investments in domestic subsidiaries Basis differences with tax consequences Outside-basis differences in joint ventures Outside-basis differences in equity method investees applicable rate (updated September 2013) Dividends received deduction Basis differences without tax consequences Expected manner of recovery of investment Change in expected manner of recovery of investment Partnerships (updated September 2013) Limitations on deferred tax assets Intraperiod tax allocation Income tax expense (benefit) allocated to continuing operations the incremental approach Tax effect of pretax income from continuing operations Exception to general principle of allocation to continuing operations Level of application (updated September 2013) Changes in tax laws, rates or tax status Changes in the valuation allowance Tax benefit of dividends on shares held by ESOP Tax benefit of dividends on allocated ESOP shares Tax benefit of dividends on unallocated ESOP shares Unallocated shares accounted for under SOP 76-3 (non-authoritative) Items charged or credited directly to shareholders equity Income taxes for debt and equity securities classified as available-for-sale Initial recognition of unrealized loss Valuation allowances Deferred tax assets related to unrealized losses on debt securities Subsequent to initial recordation Changes due to changes in portfolio value (updated October 2011) Reductions resulting from a change in judgment Increases resulting from a change in judgment Income tax rate changes Backward-tracing of tax effects Financial reporting developments Income taxes vii

10 Contents Cumulative translation adjustment Foreign currency hedges Cash flow hedges Deferred taxes for postretirement benefit plans Recognition of deferred taxes for activity in postretirement benefit plans Valuation allowances Subsequent recognition of valuation allowance Valuation allowance changes due to changes in amounts in other comprehensive income related to postretirement benefit plans Change in judgment resulting in decreased valuation allowance Change in judgment resulting in increased valuation allowance Lingering effects of changes in judgment on other comprehensive income Income tax rate changes Income tax consequences of issuing convertible debt with a beneficial conversion feature Tax effects of convertible debt instruments that may be settled in cash upon conversion Order of tax deductions for excess stock compensation prior to application of ASC Tax effects of transactions among or with shareholders (updated October 2011) Tax effects of spin-off transactions (updated October 2011) Need for a valuation allowance by the subsidiary when there is a spin-off transaction (updated October 2011) Tax benefits of pre-reorganization temporary differences and carryforwards Operating loss tax benefit backwards tracing prohibited Intraperiod tax allocation examples Reorganizations General Bankruptcies Separate financial statements of a subsidiary General SEC staff position Carve out financial statements Financial statement presentation Balance sheet presentation (updated October 2011) Offset of deferred tax assets and liabilities (updated September 2013) State and local income taxes and valuation allowance (updated September 2013) Disclosures about balance sheet accounts Components of balance sheet deferred tax amounts Net operating loss and tax credit carryforwards Subsequent recognition of tax benefits Indefinite reversal exceptions Other balance sheet related disclosures Financial reporting developments Income taxes viii

11 Contents 18.3 Disclosures about Income statement accounts SEC staff position Disclosure of changes in tax laws or rates Interest and penalties due to taxing authorities Professional fees Reconciliation to statutory rate Illustrative financial statement note disclosure (updated September 2013) Management s discussion and analysis SEC staff positions Management s discussion and analysis disclosure requirements Accounting for uncertainty in income taxes Introduction Scope Taxes within scope Entities within scope Unit of account Unit of account Consistency Attribution of income taxes to the entity or its owners Recognition More likely than not Examination by the taxing authority Evaluating the technical merits of individual tax positions Administrative practices and precedents Self-reporting obligation Disaggregation General reserves Tax indemnification agreements (updated October 2011) Tax indemnification agreements in a business combination (updated October 2011) Tax indemnification agreements in a spin-off transaction (updated October 2011) Other tax indemnification agreements (updated October 2011) Measurement of tax positions Measurement Highly certain tax positions Documentation of highly certain tax positions Measurement of a tax position after an audit settlement Differences related to timing Tax planning strategies Tax planning strategies Subsequent recognition, derecognition and measurement Subsequent recognition Effectively settled Change in assessment of technical merits Effect of completion of an audit on change in measurement Examples various stages of an audit on recognition and measurement Audit milestones Financial reporting developments Income taxes ix

12 Contents Derecognition of a tax position New information vs. new evaluation Changes in judgment Intraperiod tax allocation (updated September 2013) Subsequent events Interim reporting Interest and penalties Interest Penalties Classification Classification as current or non-current Accounting policy election Interaction with ASC Presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists (updated September 2013) Subsequent to the adoption of ASU (updated September 2013) Prior to the adoption of ASU (updated September 2013) Disclosures Disclosures under ASC 740 for uncertain tax positions (Illustration 19-5 updated September 2013) Disclosure example Interim reporting Implementation SEC shares views on the guidance in ASC 740 related to uncertainty in income taxes adoption issues Questions and interpretative responses Interim reporting Estimated annual effective tax rate Operations taxable in multiple jurisdictions Income tax effects of a change in an indefinite reinvestment assertion Effect of new tax legislation (updated October 2011) Computation of interim period tax (or benefit) Exception of general principle of allocating income tax (benefit) to continuing operations Ability to estimate the annual effective tax rate Reversal of taxable temporary differences Tax (or benefit) applicable to significant unusual or infrequently occurring items, discontinued operations, or extraordinary items (updated October 2011) Basis of tax provision (updated September 2013) Discontinued operations (updated October 2011 and September 2013) Gain from the disposal of a component of an entity (updated October 2011) Using a prior-year operating loss carryforward (updated September 2013) Examples Estimated annual effective tax rate computation and effect of new tax legislation Calculation of first quarter income tax expense Calculation of second quarter income tax expense when a change in tax rates occurs Financial reporting developments Income taxes x

13 Contents Accounting for income taxes if an ordinary loss is anticipated for the fiscal year Realization of the full tax benefit of losses when company has ordinary losses in all interim periods Realization of the full tax benefit of losses when company has ordinary income and losses in interim periods and for the year-to-date period Partial realization of the tax benefit of losses when company has ordinary losses in all interim periods Partial realization of the tax benefit of losses when company has ordinary income and losses in interim periods and for the yearto-date period (Illustration 20-9 updated October 2011) Accounting for income taxes upon the use of prior-year net operating loss carryforwards Reversal of valuation allowance because of current-year ordinary income Reversal of valuation allowance because of estimated ordinary income in future years Share-based payment (updated September 2013) ASC 718 overview Tax effects of awards that normally result in a tax deduction Measuring deferred taxes for deductible awards The effect on deferred tax assets of the IRC Section 162(m) limitation Section 162(m)(6) limitations for certain health insurance providers Valuation allowances on deferred tax assets Realization of tax benefits Tax deduction exceeds recognized compensation cost Tax deduction is less than recognized compensation cost Determining the pool of excess tax benefits Entities to be included in the pool of excess tax benefits Net unrealized excess tax benefits acquired in a purchase business combination Determining when an excess tax benefit is realized and measuring the excess tax benefit Identifying and measuring deductions realized during the period Aggregation of shortfalls and windfalls Identifying and measuring excess tax benefits in foreign jurisdictions Realization of tax benefits on awards subject to graded vesting Tax effects of liability awards and Section 83(b) elections Examples of the accounting for the tax consequences of nonqualified stock options Tax deduction exceeds the amount of cumulative compensation cost recognized Tax deduction is less than the amount of cumulative compensation cost recognized Tax effects of awards that normally do not result in a tax deduction Accounting for a change in the tax status of an award (e.g., disqualifying disposition) Modifications of incentive stock options Other issues Income tax effects of replacement awards classified as equity issued in a business combination Financial reporting developments Income taxes xi

14 Contents Impact of research and development cost-sharing arrangements on deferred taxes Accounting for income tax benefits of dividends on share-based payments Accounting for payroll taxes on share-based payments (Not subject to ASC 740) Presentation Balance sheet classification of deferred tax assets arising from sharebased payments Presentation of excess tax benefits in the statement of cash flows Transition issues Deferred taxes in transition Modified prospective transition Calculating APIC credits available for deferred tax asset write-offs Calculating the initial pool of excess tax benefits under the original method Calculating the initial pool of excess tax benefits under the alternative method Initial pool calculation Subsequent recognition of tax benefits Calculating the initial APIC pool for companies that went public after Summary of deferred tax effects under modified-prospective transition Deferred taxes in transition prospective transition Accounting for valuation allowances on excess tax benefits recognized prior to the adoption of ASC A Abbreviations used in this publication... A-1 B Index of ASC references in this publication... B-1 C Non-authoritative guidance... C-1 C1 (Non-authoritative) Business combinations prior to adoption of Statement 141(R)... C-2 C1.1 General prior to adoption of Statement 141(R)... C-2 C1.2 Tax effects of basis differences prior to adoption of Statement 141(R)... C-3 C1.3 Identifiable intangible assets and goodwill prior to adoption of Statement 141(R)... C-4 C1.3.1 Non-deductible goodwill prior to adoption of Statement 141(R)... C-4 C1.3.2 Non-deductible identified intangible assets prior to adoption of Statement 141(R)... C-5 C1.3.3 Purchase price allocation differences prior to adoption of Statement 141(R)... C-5 C1.3.4 Tax-deductible goodwill prior to adoption of Statement 141(R)... C-5 C1.3.5 Immediate recognition of tax benefits in a business combination prior to adoption of Statement 141(R)... C-7 C1.3.6 Negative goodwill prior to adoption of Statement 141(R)... C-8 C1.3.7 Deposit-based intangibles prior to adoption of Statement 141(R)... C-11 C1.3.8 Acquired research and development deferred tax liabilities prior to adoption of Statement 141(R)... C-11 C1.3.9 Effect of acquirer-specific attributes on measurement of acquired deferred taxes prior to adoption of Statement 141(R)... C-12 C Apportioned tax rates Prior to adoption of Statement 141(R)... C-12 C Unborn foreign tax credits prior to adoption of Statement 141(R)... C-12 C Assertion regarding indefinite reinvestment prior to adoption of Statement 141(R)... C-13 Financial reporting developments Income taxes xii

15 Contents C1.4 Impairment of identifiable intangible assets and goodwill prior to adoption of Statement 141(R)... C-13 C1.4.1 Impairment of tax deductible goodwill prior to adoption of Statement 141(R)... C-14 C1.4.2 Impairment of non-deductible goodwill prior to adoption of Statement 141(R)... C-14 C Allocation of subsequent impairments to deductible and nondeductible goodwill prior to adoption of Statement 141(R)... C-14 C1.4.3 Foreign currency temporary differences from push-down adjustments prior to adoption of Statement 141(R)... C-15 C1.5 Effects of change in tax laws or rates subsequent to a business combination prior to adoption of Statement 141(R)... C-16 C1.6 Valuation allowance in a business combination prior to adoption of Statement 141(R)... C-17 C1.6.1 Acquired company tax benefits prior to adoption of Statement 141(R)... C-17 C Subsequent recognition of acquired company deductible temporary differences and carryforwards prior to adoption of Statement 141(R)... C-19 C Decrease in valuation allowance established in a business combination as a result of a change in tax law prior to adoption of Statement 141(R)... C-20 C1.6.2 Acquiring company valuation allowance reduced in a business combination prior to adoption of Statement 141(R)... C-21 C Subsequent recognition of acquiring company deductible temporary differences and tax carryforwards prior to adoption of Statement 141(R)... C-22 C1.6.3 Acquiring company valuation allowance increased in a business combination prior to adoption of Statement 141(R)... C-22 C1.7 Post combination net operating losses prior to adoption of Statement 141(R)... C-22 C1.8 Ordering pre and post acquisition tax benefits prior to adoption of Statement 141(R)... C-23 C1.9 Tax benefits of nonqualified options issued in a purchase business combination prior to adoption of Statement 123(R) and Statement 141(R)... C-25 C2 (Non-authoritative) Asset acquisitions prior to adoption of Statement 141(R)... C-27 C2.1 Asset acquisitions prior to adoption of Statement 141(R)... C-27 C2.1.1 Asset acquired with tax basis greater than book basis prior to adoption of Statement 141(R)... C-28 C2.1.2 Asset purchased for more than tax basis prior to adoption of Statement 141(R)... C-29 C2.1.3 Deferred credit from tangible asset acquisition prior to adoption of Statement 141(R)... C-30 C2.1.4 Deferred credit from the acquisition of assets recorded at fair value prior to adoption of Statement 141(R)... C-31 C2.1.5 Valuation allowance reduced due to acquired intangible asset prior to adoption of Statement 141(R)... C-32 C2.1.6 Purchase of future tax benefits prior to adoption of Statement 141(R)... C-33 C2.1.7 Transaction directly with a governmental taxing authority prior to adoption of Statement 141(R)... C-34 C3 (Non-authoritative) income tax exposures (contingencies) prior to adoption of the accounting for uncertainty in income taxes in ASC C-36 C3.1 Initial recognition of tax benefits prior to adoption of FIN C-36 C3.2 Accounting for income tax exposures prior to adoption of FIN C-37 C3.3 Recording an accrual for income tax exposures in the financial statements prior to adoption of FIN C-39 C3.4 Interest prior to adoption of FIN C-40 Financial reporting developments Income taxes xiii

16 Contents C3.5 Income tax reserves established in purchase business combinations prior to adoption of FIN 48 and Statement 141(R)... C-41 C3.5.1 Tax allocation uncertainties in a business combination prior to adoption of FIN 48 and Statement 141(R)... C-41 C3.5.2 Income tax uncertainties in a business combination prior to adoption of FIN 48 and Statement 141(R)... C-44 C3.5.3 Deferral of FIN 48 and adoption of Statement 141(R) for certain nonpublic enterprises... C-45 C3.6 Disclosure prior to adoption of FIN C-46 C4 (Non-authoritative) Income taxes attributable to stock based compensation arrangements prior to adoption of Statement 123(R)... C-47 C4.1 General prior to adoption of Statement 123(R)... C-47 C4.1.1 APB 25 accounting prior to adoption of Statement 123(R)... C-47 C4.1.2 Statement 123 accounting prior to adoption of Statement 123(R)... C-48 C4.1.3 Taxation of stock-based compensation arrangements prior to adoption of Statement 123(R)... C-48 C4.2 Deferred taxes for stock-based compensation prior to adoption of Statement 123(R)... C-49 C4.2.1 Tax deduction exceeds book expense prior to adoption of Statement 123(R)... C-50 C4.2.2 Book expense exceeds tax deduction prior to adoption of Statement 123(R)... C-51 C4.2.3 Non-deductible awards expensed for book prior to adoption of Statement 123(R)... C-54 C Subsequent changes to the tax status of an award prior to adoption of Statement 123(R)... C-55 C4.2.4 Rescissions of stock option exercises prior to adoption of Statement 123(R)... C-56 C4.2.5 Subsequent changes in the fair market value of underlying stock prior to adoption of Statement 123(R)... C-56 C4.2.6 Expired unexercised options prior to adoption of Statement 123(R)... C-57 C4.3 Valuation allowance considerations prior to adoption of Statement 123(R)... C-57 C4.3.1 Recognition of a valuation allowance after initial recognition of deferred tax assets attributable to excess tax deductions prior to adoption of Statement 123(R)... C-57 C4.4 Other stock based compensation arrangements prior to adoption of Statement 123(R)... C-58 C4.5 Net operating losses utilized before current year excess stock compensation tax deductions prior to adoption of Statement 123(R)... C-58 C4.6 Classification in statement of cash flows of the income tax benefit received for stock-based compensation prior to adoption of Statement 123(R)... C-60 C4.7 Tax benefits of nonqualified options issued in a purchase business combination prior to adoption of Statement 123(R) and Statement 141(R)... C-61 C4.8 Impact of stock compensation tax benefits on EPS computation prior to adoption of Statement 123(R)... C-61 C4.8.1 Computing the tax benefit component of the assumed proceeds prior to adoption of Statement 123(R)... C-62 C4.8.2 Impact of valuation allowance on the tax benefit component of the assumed proceeds prior to adoption of Statement 123(R)... C-65 D Summary of important changes... D-1 Financial reporting developments Income taxes xiv

17 Contents Notice to readers: This publication includes excerpts from and references to the FASB Accounting Standards Codification (the Codification or ASC). The Codification uses a hierarchy that includes Topics, Subtopics, Sections and Paragraphs. Each Topic includes an Overall Subtopic that generally includes pervasive guidance for the topic and additional Subtopics, as needed, with incremental or unique guidance. Each Subtopic includes Sections that in turn include numbered Paragraphs. Thus, a Codification reference includes the Topic (XXX), Subtopic (YY), Section (ZZ) and Paragraph (PP). Throughout this publication references to guidance in the codification are shown using these reference numbers. References are also made to certain pre-codification standards (and specific sections or paragraphs of pre-codification standards) in situations in which the content being discussed is excluded from the Codification. This publication has been carefully prepared but it necessarily contains information in summary form and is therefore intended for general guidance only; it is not intended to be a substitute for detailed research or the exercise of professional judgment. The information presented in this publication should not be construed as legal, tax, accounting, or any other professional advice or service. Ernst & Young LLP can accept no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. You should consult with Ernst & Young LLP or other professional advisors familiar with your particular factual situation for advice concerning specific audit, tax or other matters before making any decisions. Portions of FASB publications reprinted with permission. Copyright Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT , USA. Portions of AICPA Statements of Position, Technical Practice Aids, and other AICPA publications reprinted with permission. Copyright American Institute of Certified Public Accountants, 1211 Avenue of the Americas, New York, NY , USA. Copies of complete documents are available from the FASB and the AICPA. Financial reporting developments Income taxes xv

18 1 Introduction Excerpt from Accounting Standards Codification Income Taxes Overall Overview and Background The Income Taxes Topic addresses financial accounting and reporting for the effects of income taxes that result from an entity s activities during the current and preceding years. Specifically, this Topic establishes standards of financial accounting and reporting for income taxes that are currently payable and for the tax consequences of all of the following: a. Revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than the year in which they are recognized in financial income. b. Other events that create differences between the tax bases of assets and liabilities and their amounts for financial reporting. c. Operating loss or tax credit carrybacks for refunds of taxes paid in prior years and carryforwards to reduce taxes payable in future years. Generally, most items included in pretax income for financial reporting purposes also are included in taxable income in the same year when taxes are based on income. However, certain items are recognized for financial reporting purposes before or after they are recognized for tax purposes. Over time, these differences arise in one period, reverse in another period, and eventually offset each other. In ASC 740, Income Taxes these differences should be recognized based on the impact on taxes payable if the entity s assets were converted to cash and liabilities settled at the amounts reported for financial statement purposes. Illustration 1-1 Assume in Year 1 Company LML received a $100 payment for services to be rendered the following year, concluded one of its customers would not remit the $50 remaining balance due for services rendered during the prior year (and the receivable was written-off in Year 4), and purchased an asset for $100 that was depreciable for financial reporting purposes over four years but the tax law allowed the asset to be depreciated over three years. The impact of these differences, as increases or (decreases) in financial reporting and taxable income are as follows: Year 1 book/tax Year 2 book/tax Year 3 book/tax Year 4 book/tax Total book/tax Deferred revenue recognized for book when earned, taxed when received / / / / 100 / 100 Bad debts recognized for book when incurred, deducted when written off (50) / / / /(50) (50) / (50) Depreciation 4-year life for book, 3-year life for tax (25) /(33) (25) /(33) (25) /(34) (25) / (100)/(100) Net book/tax differences (75) / /(33) (25) /(34) (25) /(50) (50) / (50) Financial reporting developments Income taxes 1

19 1 Introduction Absent guidance to the contrary, companies might account for income taxes on an as-paid basis. That is, the income tax expense recognized in a given period would equal the amount payable to the taxing authority. Although this approach would be reasonable if all items of income and expense were treated the same for financial and tax reporting purposes, that is not the case with most companies applying generally accepted accounting principles. Thus recognition of income tax expense on an as-paid basis would not result in the recognition of all costs and benefits attributable to transactions recognized in the financial statements. Illustration 1-2 Assume the same facts as Illustration 1-1, as well as the following: Company LML s book income, before consideration of the items in Illustration 1-1, was $100 in each period, There are no other differences between the financial and tax reporting, and The enacted statutory tax rate for all periods is 40%. Under the as-paid basis, Company LML s tax returns statements would reflect the following: Year 1 Year 2 Year 3 Year 4 Total Preliminary income $ $ $ $ $ Tax impact of above items 67.0 (33.0) (34.0) (50.0) (50.0) Taxable income Statutory tax rate 40% 40% 40% 40% 40% Current tax expense $ 66.8 $ 26.8 $ 26.4 $ 20.0 $ Under the as-paid basis, Company LML s financial statements would reflect the following: Year 1 Year 2 Year 3 Year 4 Total Preliminary income $ $ $ $ $ Book impact of above items (75.0) 75.0 (25.0) (25.0) (50.0) Pre-tax book income $ 25.0 $ $ 75.0 $ 75.0 $ Current tax expense (66.8) (26.8) (26.4) (20.0) (140.0) Net income (loss) $ (41.8) $ $ 48.6 $ 55.0 $ The as-paid basis does not accurately reflect the financial position or results of operations because a company would be subject to additional taxation if its assets were converted to cash and its liabilities extinguished at amounts reported in the financial statements. Thus, the FASB concluded income taxes should be provided in the income statement based on the taxes payable or refundable as if all of its assets were converted to cash and all of its liabilities were extinguished at their financial statement carrying amounts. Under ASC 740, companies must defer the tax impact of items recognized in earnings or the income tax return, but not both. Thus, the income taxes payable due to differences in the timing of recognizing revenues and expenses for tax and financial reporting purposes (e.g., deferred revenue, recognition of bad debt expense for financial reporting but not tax purposes, or the depreciation of assets for tax purposes on an accelerated method relative to the method for financial reporting) create differences between the financial reporting basis and tax basis of those items. Financial reporting developments Income taxes 2

20 1 Introduction Illustration 1-3 Assuming the same facts as described in Illustrations 1-1 and 1-2 above, Company LML would compute its deferred tax assets/(liabilities), and deferred tax benefit/(expense), as follows: Year 1 Gross/DT Year 2 Gross/DT Year 3 Gross/DT Year 4 Gross/DT Deferred revenue / 40.0 / / / Bad debts 50.0 / / / 20.0 / Asset, net of accumulated depreciation (8.0) / (3.2) (16.0) / (6.4) (25.0) /(10.0) / Gross book-tax difference/deferred tax asset/(liability) at end of period (142.0) / 56.8 (34.0) / 13.6 (25.0) / 10.0 / Less: net deferred tax asset/ (liability) at beginning of period Change in net deferred tax assets/(liabilities) 56.8 (43.2) (3.6) (10.0) A company s income tax expense (benefit) for financial reporting purposes is equal to the current tax expense (benefit) (i.e., amounts currently due per the income tax return) plus the deferred tax expense (benefit). As defined in the ASC Master Glossary deferred tax expense (benefit) is the change during the year in an entity s deferred tax liabilities and assets. For deferred tax liabilities and assets acquired in a purchase business combination during the year, it is the change since the combination date. Income tax expense (benefit) for the year is allocated among continuing operations, discontinued operations, extraordinary items, and items charged or credited directly to shareholders equity. That is, increases in deferred tax liabilities and reductions in deferred tax assets increase an entity s income tax expense while reductions in deferred tax liabilities and increases in deferred tax assets reduce an entity s income tax expense. Illustration 1-4 Continuing the assumptions in Illustrations 1-1 through 1-3 above, Company LML s income tax benefit (expense) for financial reporting purposes, as computed in accordance with ASC 740, would equal the actual taxes due plus the net change in deferred taxes for the year. Year 1 Year 2 Year 3 Year 4 Total Current tax expense $ (66.8) $ (26.8) $ (26.4) $ (20.0) $ (140.0) Deferred tax benefit (expense): Deferred revenue 40.0 (40.0) Bad debts 20.0 (20.0) Asset, net of accumulated depreciation (3.2) (3.2) (3.6) 10.0 Income tax expense under ASC 740 $ (10.0) $ (70.0) $ (30.0) $ (30.0) $ (140.0) Compared to the as-paid method noted above, under ASC 740, net income would be as follows: Year 1 Year 2 Year 3 Year 4 Total Pre-tax book income $ $ $ $ $ Book impact of above items (75.0) 75.0 (25.0) (25.0) (50.0) Pre-tax book income $ 25.0 $ $ 75.0 $ 75.0 $ Income tax expense under ASC 740 (10.0) (70.0) (30.0) (30.0) (140.0) Net income $ 15.0 $ $ 45.0 $ 45.0 $ Financial reporting developments Income taxes 3