Stay Informed Pharmaceutical and Life Sciences Industry Alert 2015-3 FASB Income tax projects update A PLS perspective Background The FASB has accelerated the pace of rulemaking in recent months, largely due to its Simplification Initiative. The Simplification Initiative is described by the FASB as a tightly-focused initiative to make narrow-scope simplifications and improvements to accounting standards through a series of short-term projects. This initiative, coupled with the Disclosure Framework project, which is designed to improve the effectiveness of footnote disclosures, has generated a number of projects in various stages from inception to completion that will have an impact on a company's accounting and disclosure. Currently, the Simplification Initiative projects relating to income taxes include: Balance sheet classification of deferred income taxes Intra-entity asset transfers Employee share-based payment accounting improvements: Accounting for income taxes The Disclosure Framework project is currently in its initial deliberations, however, the FASB has made tentative decisions regarding income tax disclosures that are worth highlighting at this stage. In addition, the FASB recently issued a proposed Accounting Standards Update (ASU) regarding new disclosures for government grants and some tax incentives. The purpose of this Alert is to identify and explain those FASB projects that will impact accounting or disclosures related to income taxes, provide an update on each project s status, and highlight the implications that may be of interest to companies in the Pharmaceutical and Life Sciences sector. Balance sheet classification of deferred income taxes On November 20, 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes, which is effective for annual and interim periods beginning after December 15, 2016. It is expected that many companies will take advantage of the option to early adopt the standard in the next recurring filing. Current guidance requires that companies separate deferred tax assets (DTAs) and deferred tax liabilities (DTLs) into net current and net noncurrent amounts for each tax jurisdiction based on the classification of the related asset or liability for financial reporting. DTAs/DTLs not related to assets and liabilities for financial reporting are classified based on the expected reversal date. Any valuation allowance is required to be allocated on a pro rata basis, by jurisdiction, between current and noncurrent DTAs. Under the new standard, DTAs and DTLs for each tax jurisdiction are to be classified as noncurrent in a classified balance sheet. Companies in the PLS sector are expected to have a change on the balance sheet subsequent to adoption in order to reflect all deferred taxes as noncurrent. Companies have the option to adopt the new guidance prospectively or retrospectively (i.e., by reclassifying the comparative balance sheet). Even companies that have a full valuation allowance would be expected to report a change, primarily due to the elimination of the existing requirement to allocate valuation allowances based on gross current and noncurrent DTAs. PwC 1
This proposal potentially offers a bit of relief to companies in the sector as proper classification of deferred taxes is an area where companies tend to spend time executing and monitoring controls. However, companies should be aware that the change to noncurrent classification may have a significant impact on working capital. For example, a company with a restructuring reserve reflected as a current liability will now report the related DTA as noncurrent. Also, a company with tax credit or net operating loss (NOL) carryforwards expected to be used in the next 12 months will now report the related DTAs as noncurrent. As a result, companies are encouraged to review financial covenants and other restrictive clauses that may be impacted by this change, as well as revisit qualitative disclosures regarding deferred taxes. Intra-entity asset transfers On January 22, 2015, the FASB issued a proposed ASU that would eliminate the intra-entity transfer exception in ASC 740, Income Taxes. Intra-entity transfers occur frequently in large organizations; in the PLS sector, these include transfers of inventory within supply chains (often times with complex structures that include numerous tax jurisdictions). Although not as frequent, intra-entity transfers of intellectual property between legal entities, often referred to as IP migrations, can be very significant to an organization. Under the current model, the buyer and the seller in a consolidated reporting group are generally required to defer the income tax consequences of intra-entity asset transfers when the profits from such transfers are eliminated in consolidation. Both the seller s and the buyer s tax consequences are recognized when the asset is sold to an outside party or, in the case of long-lived assets, in one or more subsequent periods. Under the proposed accounting model, the exception would be eliminated and the seller s tax expense on the profit from the transfers of assets and the buyer s deferred tax benefit on the increased tax basis would be recognized when the transfers occur. As a result, companies will be required to account for the tax consequences of an intra-entity transfer even though the pre-tax profit is eliminated in consolidation. The proposed change to accounting for intra-entity transfers could have a significant impact on a company s income tax provision for the period in which the transfers occur and, in turn, its effective tax rate in future periods. It may also engender the need for additional disclosure, including, but not limited to, those related to the tax rate reconciliation. The FASB has been redeliberating since the end of the comment period in May 2015. At its October 5, 2015 meeting, the FASB asked the staff to perform additional, but narrowly scoped research on the costs and benefits of a revised proposal whereby companies would be required to continue to apply the current guidance to inventory transactions, while the new proposed guidance would apply to all other asset transfers. PwC 2
Employee share-based payment accounting improvements Accounting for income taxes On June 8, 2015, the FASB issued a Proposed ASU, Improvements to Employee Share-Based Payment Accounting, to amend ASC Topic 718, Compensation Stock Compensation. Share-based awards are a common form of compensation for employees and executives in the PLS sector. Under current GAAP, companies must determine for each award whether the difference between the deduction for tax purposes and the compensation cost recognized for financial reporting purposes results in either an excess tax benefit or a tax deficiency. Excess tax benefits (i.e., windfalls ) are recognized in APIC, while tax deficiencies (i.e., shortfalls ) are recognized in APIC only to the extent of previously accumulated windfalls, if any, with the remainder recognized in income tax expense. Further, windfalls are not recognized until they reduce cash taxes payable. As a result, a company with an NOL carryforward would be required to track any portion of the NOL that resulted from a windfall as off balance sheet. Under the proposed guidance, all windfalls and shortfalls would be recognized as income tax expense or benefit in the income statement. In addition, under the new guidance, an entity would now recognize windfalls regardless of whether the benefit reduces taxes payable in the current period, subject to normal valuation allowance considerations. In combination with high volatility in share prices in the sector, especially in certain sub-sectors such as bio-tech, there are potentially significant tax windfalls and shortfalls that companies will recognize in the income statement once the new guidance goes into effect. Further, in order to avoid the need to estimate the impact of windfalls and shortfalls on a company s effective tax rate during interim periods, the FASB decided to introduce a rule that will mandate that the impacts will be treated as discrete items for purposes of interim period accounting. In addition, under the proposed guidance, windfalls will no longer be separated from other income tax cash flows and thus, will be classified as an operating activity. Currently, when a company recognizes a windfall tax benefit, it is shown as a cash outflow to arrive at operating cash flows and as a cash inflow from financing. Once the proposed change goes into effect, companies with significant stock based compensation programs may experience lower reported income tax expense, but higher effective tax rate volatility from quarter to quarter. Companies may also experience higher reported cash flows from operating activities. The FASB has decided to require different adoption methodologies based on the individual requirement. Refer to the appendix for further details. The comment period ended on August 14, 2015 and the FASB has currently indicated that it expects to issue the final ASU in the first quarter of 2016. Disclosures by business entities about government assistance On November 12, 2015, the FASB issued a proposed ASU, Disclosures by Business Entities about Government Assistance. As companies in the PLS sector commonly enter into agreements with government entities, both domestic and foreign, to obtain funding for research and development, this proposal may have a significant impact. Currently, GAAP lacks explicit guidance for the accounting for government grants received by business entities, resulting in diversity in practice in the recognition, measurement, and disclosure related to some forms of government assistance. PwC 3
The proposal is intended to increase the transparency of information provided in the financial statements about government assistance i.e., tax credits, tax exemptions, tax abatements, loan guarantees, grants, and low-interest or interest-free loans. There are a number of proposed disclosure requirements, which include background on the arrangement (nature, accounting policy, and form of the assistance), as well as a description of the assistance received that is not directly recognized in the financial statements (such as the benefit from a loan guarantee, a below-market rate, or tax or other expenses that have been abated). A key item to note in the exposure draft is that the term government is broadly defined and includes related governmental entities and inter-governmental organizations. Examples include national revenue authorities (i.e., the IRS in the United States) and government agencies or departments (e.g., the Department of Energy, the National Institute of Health). In its current form, the proposed standard would require additional disclosure, inclusive of contract details possibly subject to confidentiality, for many companies in the sector. The comment period is set to close on February 10, 2016, at which point the FASB will redeliberate. No timeline has been announced for a final standard. Disclosure framework: foreign earnings Tentative decisions Although the Disclosure Framework project is in its early stages of initial deliberations, certain of the more significant proposed changes to disclosure requirements are targeted to foreign earnings and foreign taxes overall. These initial decisions, if included as final standards, may be significant to many in the sector and are worth taking note of even at this early stage. The FASB has tentatively decided that entities would be required to disclose the following related to foreign earnings: Income before taxes disaggregated between domestic and foreign earnings. Foreign earnings would be further disaggregated for any country that is significant to total earnings Domestic tax expense recognized in the period for taxes on foreign earnings Undistributed foreign earnings that are no longer asserted to be indefinitely reinvested during the current period and an explanation of the circumstances that caused the entity to change that assertion. Separate disclosure should be made for any country that is significant to the disclosed amount A further disaggregation of the current requirement to disclose the temporary difference for the cumulative amount of indefinitely reinvested foreign earnings if any country represents at least 10 percent of the disclosed amount This project also addresses other tax disclosure requirements, such as uncertain tax benefits. Further information pertaining to the initial decisions can be found at the FASB's Disclosure Framework site. At this point, the staff will perform further outreach on the potential changes to income tax disclosures prior to releasing an exposure draft. Questions PwC clients that have questions about this Industry Alert should contact their engagement partners. Engagement teams that have questions relating to US GAAP should contact Karen Young (973 236 5648), Brett Cohen (973 236 7201), John Hayes (973 236 4452), Kathy Michael (973 236 4210) or Jeff Zechnich (973 236 4462). PwC 4
Appendix Balance sheet classification of deferred income taxes Status: Final ASU issued on November 20, 2015. Effective Date: The standard is effective for annual and interim periods beginning after December 15, 2016 for public business entities. For all others, the standard is effective for annual periods beginning after December 15, 2017. Early adoption is permitted for all entities. Transition Method: The guidance may be applied either prospectively, for all deferred tax assets and liabilities, or retrospectively (i.e., by reclassifying the comparative balance sheet). If applied prospectively, entities are required to include a statement that prior periods were not retrospectively adjusted. If applied retrospectively, entities are required to include quantitative information about the effects of the change on prior periods. Where to Find Additional Information: In brief: FASB simplifies balance sheet classification of deferred taxes Intra-entity asset transfers Status: The FASB is currently redeliberating the exposure draft and has asked the staff to perform additional, but narrowly scoped research on the costs and benefits of a revised proposal whereby the current guidance would continue to be applied to inventory transactions. Effective Date: The standard would be effective for annual and interim periods beginning after December 15, 2016 for public business entities. For all others, the standard would be effective for annual periods beginning after December 15, 2017. Early adoption would be permitted for non-public companies, but not before the effective date for public business entities. Transition Method: Pending the results of the research to be performed by the staff at the recommendation of the Board at the October 5, 2015 meeting. Timing: Once the staff completes their research, the FASB will consider whether to (a) affirm the current proposal, which would eliminate the intra-entity asset transfer exception in its entirety or (b) clarify that the exception only applies to transfers of inventory. It is also possible the Board will revisit and potentially update their previous decisions on effective date and transition. Where to Find Additional Information: FASB Accounting for Income Taxes Projects Employee share-based payment accounting improvements Accounting for income taxes Status: Exposure draft redeliberations. Effective Date: The standard would be effective for annual and interim periods beginning after December 15, 2016 for public business entities. For all others, the standard would be effective for annual periods beginning after December 15, 2017 and interim periods within annual periods beginning after December 15, 2018. Early adoption would be permitted for all entities. Transition Method: The Board agreed on prospective adoption for the proposal that all excess tax benefits and tax deficiencies be recognized in the income statement. The Board agreed on a modified retrospective transition method, with a cumulative-effect adjustment recognized in equity, would be used for the proposal to remove the requirement to delay recognition of an excess tax benefit until the tax benefit PwC 5
is realized. Finally, the Board agreed on retrospective adoption for the proposal to remove the requirement that employers present excess tax benefits as a cash inflow from financing activities and a cash outflow from operating activities. Timing: A final standard is currently scheduled for Q1 2016. Where to Find Additional Information: FASB proposes to simplify the accounting for share-based payments Disclosures by business entities about government assistance Status: Exposure draft issued; comment period ends February 10, 2016. Effective Date: A proposed effective date was not included as a part of the exposure draft. Transition Method: Transition methods were not proposed as a part of the exposure draft. Timing: To be determined; the Board will consider comments and redeliberate following the comment period. Where to Find Additional Information: FASB Accounting for Income Taxes Projects Disclosure framework Foreign earnings Status: The FASB is currently conducting initial deliberations on this project. At its last meeting on October 21, 2015, the Board directed the staff to perform further outreach on all of the potential changes to income tax disclosures. No further meetings have been announced as of the date of this publication. Where to Find Additional Information: FASB Accounting for Income Taxes Projects PwC 6
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