BDO Knows: FASB Issues ASU on Simplifying the Accounting for Income Taxes – ASC 740

January 2020

January 2020

On December 18, 2019, the FASB issued Accounting Standards Update ASU 2019-12 on Simplifying the Accounting for Income Taxes. The decisions reflected in the ASU update specific areas of ASC 740, Income Taxes, to reduce complexity while maintaining or improving the usefulness of the information provided to users of financial statements.
 

Background

At its April 10, 2019, meeting, the FASB decided to add a project to its technical agenda to address simplifications to the accounting rules for income taxes under ASC 740. The project is part of the board’s overall Simplification Initiative. The objective of the Simplification Initiative is to identify, evaluate, and improve areas of GAAP for which cost and complexity can be reduced while maintaining or improving the usefulness of the information required to be reported by an entity. A draft ASU was issued by the FASB in May 2019 with 24 comment letters provided by stakeholders at the end of June 2019.
 

Simplification Initiatives

The board decided to remove the following exceptions from ASC 740, Income Taxes:
1. The exception to the incremental approach for intraperiod tax allocation when there is a loss from continuing operations and income or a gain from other items (for example, discontinued operations or other comprehensive income).[1] 

The removal of this exception simplifies intraperiod allocation. Now entities will determine the tax effect of pre-tax income or loss from continuing operations without consideration of the tax effects of other items that are not included in continuing operations.

An example of the original accounting and post-simplification accounting is as follows:

Assume a U.S. corporation has a loss carryover of $5,000 (tax-effected) at the beginning of the year and a full valuation allowance of $5,000. The entity has a pre-tax loss of $1,000 ($250 tax-effected) from continuing operations and $1,000 ($250 tax-effected) of income in Other Comprehensive Income (OCI). The entity determined that a full valuation allowance is required at the end of the year.

Under the original accounting for intraperiod tax allocation, the entity would have recorded the following entries, which result in an overall net tax provision of zero:

Debit: Tax Expense – OCI   ……………………………………………………………………………   $250
Credit:  Continuing Operations Benefit   ……………………………………………………………….   $250

The original accounting would require that the income from OCI be considered to determine the release of the valuation allowance to continuing operations in a situation where there is a loss from continuing operations for which no benefit would be recorded.

Under ASU 2019-12, no tax benefit is recorded in continuing operations and no tax expense is recorded in OCI for the above example.
 

BDO Insight

There have been significant practice issues with respect to this general exception to the incremental approach since intuitively practitioners would believe that a loss from continuing operations would require the application of a valuation allowance based on the facts. The general exception to the incremental approach was also applicable in situations where certain debt instruments that are bifurcated into debt and equity for financial reporting purposes result in a deferred tax liability being recorded in equity. Diversity in practice existed as to whether the deferred tax liability recorded in equity would be considered a source of income outside of continuing operations. Additional diversity existed as to whether items outside of continuing operations were looked at individually or in aggregate, as well as whether the cycling of items from OCI to continuing operations would be viewed as income outside of continuing operations. ASU 2019-12 removes these issues.
 

2. The exception to the requirement to recognize a deferred tax liability for equity method investments when a foreign subsidiary becomes an equity method investment.
 

BDO Insight

The removal of this exception requires the recognition of deferred taxes on the entire outside basis difference of the equity method investment even if the indefinite reversal criteria under ASC 740-30 was applied when the entity was accounted for as a subsidiary. ASU 2019-12 eliminates prior accounting, which provided that a portion of the outside basis difference was “frozen” until the period that it became apparent that any of the unremitted earnings (from the time the entity was a subsidiary) would be remitted.


3. The exception to the ability not to recognize a deferred tax liability for a foreign subsidiary when a foreign equity method investment becomes a subsidiary (therefore, an entity would have the ability to assert indefinite reinvestment for the entire basis difference of a subsidiary). 
 
Pre-simplification accounting required an entity to continue to reflect a deferred tax liability for the outside basis difference in a foreign equity method investment, even where the investee becomes a subsidiary.
 

BDO Insight

The simplification removes the exception where a temporary difference for the investor’s share of the undistributed earnings prior to the date it becomes a subsidiary shall continue to be treated as a temporary difference for which deferred taxes would be recorded. The removal of this exception also keeps a portion of the outside basis difference from being “frozen” and subject to deferred taxes.
 

4. The exception to the general methodology for calculating income taxes in an interim period when a year-to-date loss exceeds the anticipated loss for the year.

The removal of this exception allows an entity to record a benefit for a year-to-date loss in excess of its forecasted loss. Pre-simplification accounting limited the tax benefit in an interim period to the tax benefit of the forecasted loss in cases where the effective tax rate is higher than the statutory rate due to permanent differences or a foreign tax rate differential.

An example of the original accounting and post-simplification accounting is as follows:[1]

For the full fiscal year, an entity anticipates an ordinary loss of $100,000. The entity operates entirely in one jurisdiction, where the tax rate is 50 percent. A total of $10,000 in tax credits is anticipated for the fiscal year.  The company does not anticipate any events that do not have tax consequences.
 
If there is a recognizable tax benefit for the loss and the tax credits, the estimated annual effective tax rate that applies to the ordinary loss would be computed as follows.
 
Tax benefit at statutory rate ($100,000 at 50%)   $(50,000)
Tax credits   (10,000)
Net tax benefit   $(60,000)
Estimated annual effective tax rate ($60,000 ÷ $100,000)   60%

The entity has the following year-to date ordinary income and losses for the following interim periods:
 
  Q1 Q2 Q3 Q4
Year-to-date        
Ordinary income/(loss) $20,000 $(60,000) $(140,000) $(100,000)
 
The full tax benefit of the anticipated ordinary loss and the anticipated tax credits will be realized through carryback. The full tax benefit of the maximum year-to-date ordinary loss can also be realized through carryback.
 
Given these facts, how should the interim reporting guidance be applied?
 

 Answer Pre-Simplification:

        Tax (or Benefit)  
 
 
Reporting Period
 
 
Quarterly Income/(Loss)
 
 
Year-to-Date Income/(Loss)
Estimated Annual Effective Tax Rate  
Year-to-Date
 
Less Previously Provided
 
Reporting Period Amount
 
Computed
 
Limited to[1]
First
quarter
 
$    20,000
 
$    20,000
 
60%
 
$    12,000
 
 
 
   $     --             
 
$   12,000
Second
quarter
 
(80,000)
 
(60,000)
 
60%
 
(36,000)
 
 
 
12,000
 
(48,000)
Third
quarter
 
(80,000)
 
(140,000)
 
60%
 
(84,000)
 
 $80,000
 
(36,000)
 
(44,000)
Fourth
quarter
 
40,000
 
(100,000)
 
60%
 
(60,000)
 
 
 
(80,000)
 
20,000
Fiscal
year
 
$(100,000)
 
 
 
 
 
 
 
 
 
 
 
$(60,000)
                 
 
 

With Simplification:

        Tax (or Benefit)  
 
 
Reporting Period
 
 
Quarterly Income/(Loss)
 
 
Year-to-Date Income/(Loss)
Estimated Annual Effective Tax Rate  
Year-to-Date
 
Less Previously Provided
 
Reporting Period Amount
 
Computed
 
Limited to
First
quarter
 
$    20,000
 
$    20,000
 
60%
 
$    12,000
 
 
 
   $     --             
 
$   12,000
Second
quarter
 
(80,000)
 
(60,000)
 
60%
 
(36,000)
 
 
 
12,000
 
(48,000)
Third
quarter
 
(80,000)
 
(140,000)
 
60%
 
(84,000)
 
 
 
(36,000)
 
(48,000)
Fourth
quarter
 
40,000
 
(100,000)
 
60%
 
(60,000)
 
 
 
(84,000)
 
24,000
Fiscal
year
 
$(100,000)
 
 
 
 
 
 
 
 
 
 
 
$(60,000)
                 
 
The amendments in ASU 2019-12 also simplify the accounting for income taxes by:
  1. Requiring that an entity recognize a franchise tax (or similar tax) that is partially based on income as an income-based tax and account for any incremental amount incurred as a non-income-based tax.
  2. Requiring that an entity evaluate when a step up in the tax basis of goodwill should be considered part of a business combination in which the book goodwill was originally recognized or should be considered a separate transaction. Note, the amount of a deferred tax asset recorded in a business combination may differ from the amount recorded in a separate transaction.
 
Factors that may indicate that the step up in tax basis relates to a separate transaction include, but are not limited to, the following:
  1. A significant lapse in time between the transactions has occurred.
  2. The tax basis in the newly created goodwill is not the direct result of settlement of liabilities recorded in connection with the acquisition.
  3. The step up in tax basis is based on a valuation of the goodwill or business after the date of the business combination.
  4. The transaction resulting in the step up in tax basis requires more than a simple tax election.
  5. The entity must incur a cash tax cost or sacrifice existing tax attributes to achieve the step up in tax basis.
  6. The transaction resulting in the step up in tax basis was not contemplated at the time of the business combination.
 

BDO Insight

Certain transactions in foreign jurisdictions may provide for a step up in basis of goodwill for tax purposes and these transactions would need to be analyzed to determine if the creation of the tax-deductible goodwill should be accounted for as part of a business combination or as a separate transaction. For example, in some foreign jurisdictions, certain transactions allow for the step up of goodwill for tax purposes by making a substitute tax payment to the taxing authority.
 
  1. Specifying that an entity (or entities), in the separate financial statements, is not required to allocate the consolidated amount of current and deferred tax expense to a legal entity that is not subject to tax. However, an entity may elect[2] to do so (on an entity-by-entity basis) for a legal entity that is both not subject to tax and disregarded by the taxing authority (for example, disregarded entities such as single-member limited liability companies).
  2. Requiring that an entity reflect the effect of an enacted change in tax laws or rates in the annual effective tax rate computation in the interim period that includes the enactment date.
 

BDO Insight

This amendment will impact interim period tax calculations in instances where a tax law is enacted for U.S. GAAP purposes in an early interim period when a tax law or rate change is not effective until a later interim period. For example, under ASU 2019-12, if a tax rate change is enacted in Q1 that is effective for an entity in Q3, the entity would consider the impacts of the tax rate change in its Q1 interim period tax computation.
 
  1. Making minor codification improvements for income taxes related to employee stock ownership plans and investments in qualified affordable housing projects accounted for using the equity method.
 

Transition and Effective Date 

For public business entities, the amendments in the ASU 2019-12 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022.
 
Early adoption of the amendments is permitted, including adoption in any interim period for (1) public business entities for periods for which financial statements have not yet been issued and (2) all other entities for periods for which financial statements have not yet been made available for issuance. An entity that elects to early adopt the amendments in an interim period should reflect any adjustments as of the beginning of the annual period that includes that interim period. Additionally, an entity that elects early adoption must adopt all the amendments in the same period.
 
The amendments in ASU 2019-12 related to separate financial statements of legal entities that are not subject to tax should be applied on a retrospective basis for all periods presented.
 
The amendments related to changes in ownership of foreign equity method investments or foreign subsidiaries should be applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption.
 
The amendments related to franchise taxes that are partially based on income should be applied on either a retrospective basis for all periods presented or a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption.
 
All other amendments should be applied on a prospective basis.
 

How BDO Can Help

BDO can assist clients with the evaluation of the changes in ASC 740 to their particular fact patterns, including appropriate disclosures that should be included in financial statements.
 

For more information, please contact one of the following ASC 740 technical leaders:
 
Daniel Newton
Tax Partner – ASC 740 Practice Leader – National Tax Office
 
  William Connolly
Tax Managing Director – National Tax Office
 

 
Michael Williams
Tax Partner – National Practice Leader – ASC 740
 
  Thomas Faas
Tax Managing Director – National Tax Office
 

 
Steve Maniaci
Partner – National Assurance
ASC 740 Leader
   
 

[1]Because the year-to-date ordinary loss exceeds the anticipated ordinary loss for the fiscal year, the tax benefit recognized for the year-to-date loss was limited to the amount that would be recognized if the year-to-date ordinary loss were the anticipated ordinary loss for the fiscal year. The limitation is computed as follows:
 
Year-to-date ordinary loss multiplied by the statutory rate
   ($140,000 at 50%)
 
$(70,000)
Estimated tax credits for the year (10,000)
Year-to-date benefits (as limited) $(80,000)
 
[2] A reporting entity is not permitted to allocate current and deferred expense to partnerships or other pass-through entities that are not wholly owned, apart from state taxes where the entity is taxed at the state level.