ASC 740 FAQs - Accounting Implications of IRC Regulations Under Sections 163(j), 250 and 951A Issued in Calendar Q3 2020
Background
The U.S. Treasury issued three major regulation packages in July 2020 that contain significant changes to the previously released proposed regulations. As these are legislative regulations, calendar year companies will likely need to account for the impact in Q3 2020. Read on for more information about the applicable dates of the regulations, highlights and answers to frequently asked questions on how to address these provisions for Q3 2020.
Issuance and Applicable Dates
On July 28, 2020, Treasury issued final and proposed regulations under Internal Revenue Code Section 163(j), which contains rules that limit the deductibility of interest expense. The final regulations are effective for taxable years beginning on or after November 13, 2020. As clarified by the final regulations published in the Federal Register on September 14, 2020, the final regulations can be applied, however, for any taxable year beginning after December 31, 2017, at the election of the taxpayer. The proposed regulations are effective 60 days after Treasury adopts them as final and they are published in the Federal Register. The 2020 proposed regulations may also be applied retroactively, with certain exceptions, to years beginning after December 31, 2017, provided the taxpayer also applies the final regulations for such earlier periods.
Alternatively, as clarified by the final regulations published in the Federal Register on September 14, 2020, a taxpayer may apply proposed regulations issued in 2018 for any period before the final regulations become effective, with the additional option to early adopt the provision in the final regulations to increase adjusted taxable income by depreciation recorded in cost of goods sold. Such regulations should be consistently applied.
On July 23, 2020, Treasury issued final regulations under Section 951A with respect to the high-tax exclusion applicable to global intangible low-taxed income (GILTI). The final regulations apply to taxable years of foreign corporations beginning on or after July 23, 2020, and to taxable years of U.S. shareholders in which or with which such taxable years of such foreign corporation’s end. However, the final regulations also may be applied, at the taxpayer’s election, to tax periods beginning after December 31, 2017. At the same time, Treasury also issued proposed regulations providing rules to conform the high-tax exception under the Subpart F rules with the high-tax exclusion under the GILTI provisions. These proposed regulations are effective, with certain exceptions, for taxable years of controlled foreign corporations (CFCs) beginning after the date the Treasury decision adopting these rules as final regulations is filed with the Federal Register, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporation’s end.
Lastly, final Section 250 regulations, published on July 15, 2020, are effective for taxable years beginning on or after January 1, 2021. These regulations provide guidance regarding the deduction for foreign-derived intangible income and GILTI. Taxpayers may rely on these regulations, or the prior proposed regulations, for taxable years beginning before 2021. For a summary of the final Section 250 regulations see BDO’s July 2020 alert.
Highlights from the Regulations
Section 163(j)
- Loan commitment fees, loan origination fees, guaranteed payments to a partner for use of capital and debt instrument hedging gains and losses are not treated as interest expense for purposes of Section 163(j).
- Depreciation or amortization expense capitalized to inventory for tax purposes and recovered through cost of goods sold is an increase to adjusted taxable income in the year of capitalization.
- The final regulations do not provide a coordination rule for computing Section 163(j) taxable income with other provisions that limit deductions based on taxable income such as Sections 250, 170 and 172. Rather, the regulations will allow any reasonable method, including the method prescribed in the 2018 proposed regulations.
- The separate return limitation year rules for interest were modified and the so-called “overlap” rule under Section 382 was adopted.
- For interest expense of CFCs, the methodology for determining adjusted taxable income under the CFC group election was changed, as was the definition of CFC groups. Further, U.S. shareholders may benefit from the “excess taxable income” of the CFC group, which will increase the U.S. shareholder’s adjusted taxable income. For additional analysis, refer to BDO’s August 2020 alert on the international aspects of the 2020 Section 163(j) proposed regulations.
Section 951A and Subpart F
- The rules provide for a high-tax exclusion whereby tested income of so- called “tested units” of CFCs that have an effective tax rate of at least 90% of the U.S. rate will not give rise to a GILTI inclusion to the U.S. shareholder(s). In such case, any Section 960 gross up and foreign tax credit will not be allowed. The election is made on a year-by-year basis.
- The 2020 proposed Subpart F regulations modify the high-tax exception under Subpart F to align with the high-tax exclusion under the GILTI regulations.
Section 250
- The final regulations confirm that net operating losses incurred in pre-2017 Tax Cuts and Jobs Act periods are considered in the Section 250(a)(2) taxable income limitation for the Section 250 deduction.
All three sets of regulations were issued in the third quarter of calendar 2020 and, therefore, should be considered from an ASC 740 perspective in such interim period.
Read on for responses to commonly asked questions concerning the ASC 740 implications of the issuance of these rules. Assume all the entities are calendar year corporations.
FAQs on Q3 2020 Income Tax Issues
Q1. How should entities consider the issuance of final regulations for tax provision purposes?
The Section 163(j), GILTI and Section 250 final regulations are considered legislative regulations as they were issued pursuant to statutory authority. Accordingly, changes due to the rules contained in the final regulations are considered similar to changes in tax law and generally should be accounted for as such.
Q2. Assume a taxpayer intends to adopt the high-tax exclusion under the Section 951A regulations retroactive to calendar 2018 and make the appropriate elections to do so. The election generates refunds of prior year federal taxes and a reduction of 2020 taxes. Are the refunds of current taxes treated as part of the annual effective tax rate (AETR) or are they treated discretely in the quarter?
A2. The refunds relating to years 2018 and 2019 are treated as discrete items and not as part of the AETR. The reduction of current taxes in 2020 is treated as part of the AETR.
Q3. Assume that a company has loan commitment fees in 2019 that were treated as interest expense for Section 163(j) purposes and gave rise to an interest carryforward to 2020. The company recorded a full valuation allowance against such deferred tax asset (DTA). If the entity adopts the Section 163(j) regulations retroactively, the fees will be fully deductible in 2019 and no DTA or valuation allowance will be required. How is the current tax benefit recorded in Q3 of 2020?
A3. The current tax benefit is recorded as a discrete item since it relates to a retroactive change in tax law.
Q4. What are the other ASC 740 consequences to adopting the GILTI high-tax exclusion in 2020?
A4. Assume a company adopts the high-tax exclusion for 2020, which eliminates all the GILTI-tested income of its CFCs from the U.S. shareholders taxable income. However, one of the CFCs has a tested loss in a jurisdiction where a full valuation allowance is recorded against the related DTA. Considering the guidance in ASC 740-270-30-36(a), the company had included the loss entity in its worldwide AETR since the tested loss created a U.S. tax benefit by reducing the GILTI inclusion.
If the entity adopts the high-tax exclusion in Q3 2020, it should exclude the loss jurisdiction from its worldwide AETR in future interim periods and compute a separate AETR for such entity since the loss will no longer create a U.S. tax benefit.
Q5. The 2020 GILTI regulations generally allow taxpayers to apply the final regulations prospectively or retroactively. Assume that, due to the number of entities, the complexity of its foreign organizational structure and the complex computations to determine if retroactive elections to apply the high-tax exclusion are beneficial, a calendar year company will be challenged to complete its analysis prior to the time the Form 10-Q is filed for Q3 of 2020. How should the company account for the impact of the regulations in Q3?
A5. Management should consider its best available information in recording the tax impact of the regulations. Such information should include, for example, its most recent updated quantitative and qualitative analysis, input from tax advisors and management’s ability and expectations in applying the regulations. It would not be appropriate, for example, to postpone commencement of the analysis of the impact of the regulations until later in the tax year when the tax department has more time and resources.
Note that if the company concludes in Q3 that it will elect the high-tax exclusion for all applicable prior years, the filing of amended returns and formal election of the high-tax exclusion do not necessarily have to be completed by the filing of the Form 10-Q, provided the company intends, and it is within its control, to timely file such returns and election.
Q6. Assume that an entity has a history of losses and has significant GILTI inclusions in years beginning in 2018, which provide a sufficient source of income to realize its NOLs. The company uses the tax law ordering approach to determine its valuation allowance in connection with GILTI. The company plans to adopt the high-tax exclusion retroactively, which will eliminate GILTI from taxable income for 2018-2020 and future years. Without the GILTI inclusions, the company does not have another source of income to use its NOLs except existing taxable temporary differences. Therefore, it is likely required to schedule its reversing temporary differences. The taxable temporary differences are insufficient to realize all the NOLs. What are the valuation allowance considerations?
A6. In Q3, the company will need to re-assess its valuation allowance position in light of the elimination of a significant source of income (the GILTI inclusion). Assuming the company cannot rely on future taxable income due to its losses, it will be required to record a valuation allowance against the NOL DTAs (including NOLs that “spring to life” from the election of the high-tax exclusion) and that cannot be realized due to scheduling.
Further, due to the 80% taxable income limitation on the use of NOLs for 2021 and future periods, the scheduling should consider the potential increase to the valuation allowance for the tax impact of the 80% limitation.
A company recognizes a change in a valuation allowance discretely in the interim period of the change if the change relates to a beginning of the year valuation allowance and there is a change in circumstances that cause a change in judgment with respect to the realizability of DTAs in future years.
Therefore, the valuation allowance recognized in Q3 2020 related to the beginning of the year DTAs should be recorded discretely and reflected in continuing operations. Any valuation allowance recorded with respect to DTAs generated in the current year is recorded as part of the adjusted AETR.
Q7. Assume a company is profitable but has significant U.S. interest expense and is currently limited under Section 163(j). A full valuation allowance is recorded against its interest carryforwards but there is no valuation allowance against its other net DTAs. The company is very profitable overseas, reports GILTI inclusions and has no overseas debt. Based on its calculation of the impact of the 2020 proposed Section 163(j) regulations, the CFC group will generate substantial amounts of excess taxable income, which will increase the Section 163(j) limit for the U.S. group. The regulations, including the final regulations, will be adopted retroactively for all periods beginning after December 31, 2017. What are the valuation allowance considerations in Q3 2020?
A7. The excess taxable income from the CFCs will provide a source of income to deduct the U.S. interest expense. The company should forecast the impact of the proposed regulations for prior and, if necessary, future years to determine how much, if any, of a valuation allowance is needed. If the company concludes it will not only be able to deduct its interest expense incurred in 2018-2020, but also its forecasted interest in the future, it should record a current tax benefit for 2018-2020 and eliminate the DTA and associated valuation allowance. The benefit for 2018 and 2019 should be recorded as discrete items as a retroactive change in tax law and the 2020 benefit is recorded as part of the AETR.
Q8. Assume the same facts as question 7, except that the excess taxable income from the CFCs will enhance the U.S. Section 163(j) limitation, but not significantly. Specifically, there will be a current tax benefit and partial reduction of the carryforwards for years through 2020 but carryforwards continue to exist and will continue to build in future periods based on the forecasted U.S. Section 163(j) limitation. How should the company evaluate its valuation allowance for interest carryforwards?
A8. Based on these facts, some current tax benefit will be recorded due to the enhanced federal Section 163(j) limitation for 2018-2020. However, any DTAs for interest carryforwards projected at December 31, 2020, will require a valuation allowance since such carryforwards are not expected to provide a cash savings in future periods. Under the “with and without” incremental concept of ASC 740, the carryforwards are not deemed realizable but are merely “replaced” with new interest carryforwards.
Q9. Assume that an entity took the position in its 2019 return (inconsistent with the 2018 proposed Section 163(j) regulations) that loan commitment fees were not defined as interest and were not subject to the limitations of Section 163(j). The company was not at a more-likely-than-not threshold that the fees were not considered interest for Section 163(j) purposes. Accordingly, for financial statement purposes under the principles of ASC 740-10-25-6, it treated the fees as interest and the amounts were not treated as currently deductible in 2019. The company recorded a valuation allowance against the DTAs for its interest carryforwards. Thus, no tax benefit was recorded for the fees due to the position not meeting the recognition threshold. The company will adopt the 2020 final regulations retroactively. What are the UTP implications in Q3 2020?
A9. Due to the issuance of the final regulations and the company’s ability and intent to apply them retroactively to years beginning after December 31, 2017, the company may amend its 2019 return and claim a deduction for the fees. Therefore, a current tax benefit should be recorded discretely in Q3 for the refunds due for 2019. The DTA and valuation allowance that were recorded for financial statement purposes due to the UTP are reversed with no impact to tax expense.
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