Valuation Allowances in the Mining Industry – Are Your Deferred Tax Assets Realizable?

October 2021

BY

Daniel NewtonPartner, National Tax Office, ASC 740 Technical Practice Leader

Clint DobsonTax Partner

Thomas FaasTax Managing Director

The mining industry is naturally cyclical, the result of lengthy investment in exploration and development, high production costs, limited reserves resulting in a constant need to locate new deposits, and the potential for revenue volatility due to market risk. Ever present in the sometimes decades-long mining cycle are geopolitical and regulatory risks, geological uncertainties, technology risks and safety risks, not to mention challenges relating to social responsibility and environmental concerns.
 
For many mining businesses, the risks and challenges already inherent in the sector have been compounded by the coronavirus pandemic, with many commodity prices dropping due to decreased demand for certain products. In addition, mandatory lockdowns, distancing requirements and other worker safety precautions, government regulations and border closures have created business disruptions, adding to the already high cost of mining operations.
 
Despite all of these issues, some mining businesses – especially those in the precious metals sector– have fared well during the pandemic. Gold and silver, generally considered safe haven investments for protecting wealth and for hedging financial market risk, saw prices rally to reach historic highs in 2020, with prices lower but still near historic highs in 2021. However, even for these commodities, the question is “what does the future hold?” Regardless of their financial situation, mining businesses likely will be required to forecast their future taxable income when assessing whether they must record a “valuation allowance” against their deferred tax assets. A valuation allowance is required under U.S. generally accepted accounting principles (GAAP) to bring a business’ deferred tax assets in line with anticipated future realization.
 

When are Valuation Allowances Required?

U.S. GAAP – specifically the rules contained in ASC 740 Accounting for Income Taxes - requires companies to assess the realizability of their deferred tax assets each reporting period. Deferred tax assets reflect the future favorable tax effects of tax attributes such as net operating loss, capital loss and tax credit carryforwards. Deferred tax assets also may result from differences between the book and tax basis of assets and liabilities, whereby the reversal of such difference results in a future tax benefit.
 
To the extent it is “more likely than not” (i.e., there is a greater than 50% chance) that some or all of the taxpayer’s existing deferred tax assets will not be realized, ASC 740 requires the taxpayer to record a “valuation allowance” for the unrealizable amount. A valuation allowance is generally recorded as deferred tax expense in the interim reporting period in which the valuation allowance is determined to be required. However, depending on the facts and circumstances, the intraperiod tax allocation rules in ASC 740 may require the valuation allowance to be recorded to equity, other comprehensive income, or acquisition accounting. Any increase or decrease to a valuation allowance in a subsequent period is recorded through tax expense or the other categories described above.
 
The realizability of deferred tax assets and the amount of any valuation allowance must be assessed for each relevant taxing jurisdiction, based on each jurisdiction’s tax rules and the taxpayer’s specific facts and circumstances.
 

When are Deferred Tax Assets Considered Realizable?

According to ASC 740, whether a business’ deferred tax assets are realizable ultimately depends on the existence of sufficient taxable income of the appropriate character (e.g., ordinary income or capital gain) within the appropriate tax period. ASC 740 sets forth four sources of taxable income that should be considered when assessing the realizability of deferred tax assets. These are, in order of least subjective to most subjective:
 
  • Taxable income in permitted carryback years
  • Future reversals of existing taxable temporary differences
  • Tax planning strategies
  • Future taxable income exclusive of reversing temporary differences and carryforwards
 
Evaluating whether a valuation allowance is needed usually requires significant judgment. ASC 740 states that companies must assess all available evidence, both positive and negative. The weight given to the positive and negative evidence should be based on the extent to which the evidence is objectively verifiable.
 
Examples of negative evidence include recent “cumulative losses” (generally interpreted to mean a cumulative pre-tax book loss, reflective of permanent differences, over a consecutive 36-month period) or a history of volatile price or earnings trends or other circumstances that could negatively impact future profits. Examples of positive evidence include sufficient future income from existing contracts, the ability and intent to realize sufficient taxable gain on appreciated assets and a history of earnings coupled with evidence that a recent loss is an isolated event rather than a continuing condition.
 

Source of Taxable Income #1: Taxable Income in Carryback Years

Taxable income in prior years is already known and, therefore, is the most objectively verifiable of the four sources of taxable income for realizing deferred tax assets. Taxable income in carryback years may be considered only to the extent a loss or credit is permitted to be carried back, and only if the carryback would result in an incremental tax benefit in the carryback period. Note that following the passage of the CARES Act, net operating losses generated in 2021 and later years may only be carried forward for U.S. federal tax purposes. However, different carryback/carryforward rules may apply in other jurisdictions.
 

Source of Taxable Income #2: Future reversals of existing taxable temporary differences

If the amount of taxable income in carryback years is not sufficient to realize the full amount of the business’ deferred tax assets, or if the business has losses, credits or other deductible temporary differences that are not permitted to be carried back, the business should next look to future reversals of existing taxable temporary differences as a source of future taxable income. A typical mining business may record deferred tax liabilities for the following taxable temporary differences, among others:
 
  • Investments in property and equipment, which are subject to depreciation
  • Development expenditures, which are subject to depletion
  • Mineral royalty and leasing arrangements
  • Mineral value that is “beyond proven and probable”
 
A valuation allowance may be required even in cases where the entity reports a net deferred tax liability (i.e., total taxable temporary differences exceed total deductible temporary differences). Reasons for this include:
 
  • Reversals of taxable temporary differences must offset deductible temporary differences in the appropriate tax period(s). In many cases, the reversal of existing taxable temporary differences will need to be scheduled out into future years and in sufficient detail to ensure all deferred tax assets will be realized.
 
  • Certain taxable temporary differences may be required to be excluded from the analysis. For example, the reversal of a taxable temporary difference that relates to an asset with an indefinite useful life (a “naked credit”), such as mineral value that is beyond proven and probable, may not be an appropriate source of taxable income for the realization of a loss in a jurisdiction with a limited carryforward period. However, naked credits can be used as a source of income for indefinite lived deferred tax assets such as U.S. post-2017 net operating losses and Internal Revenue Code Section 163(j) interest limitations.
 

Source of Taxable Income #3: Tax Planning Strategies

ASC 740 requires businesses to evaluate possible tax planning strategies as a source of future taxable income when determining whether a valuation allowance is required. ASC 740 defines tax planning strategies as tax elections or other actions that:
 
  • Are prudent and feasible
  • An entity ordinarily might not take, but would take to prevent a loss or tax credit from expiring unused
  • Would result in realization of deferred tax assets
 
Examples of tax planning strategies may include, for example, the sale of an appreciated asset that is not integral to the taxpayer’s core business, electing to file a consolidated or combined tax return with a profitable entity or changing a tax accounting method to shift taxable income into an appropriate tax period.
 
It is important to note that tax planning strategies generally may not be used as a source of future taxable income to support realization of tax losses or credits that do not expire.

Source of Taxable Income #4: Future Taxable Income Exclusive of Reversing Temporary Differences and Carryforwards

To the extent taxable income from the above three sources of income is insufficient, the business must look to projections of future taxable income as a means of realizing its deferred tax assets. Projecting future results is inherently subjective, requiring significant judgment based on all available evidence. This can be especially challenging for mining businesses given the industry’s cyclical nature and potential for revenue volatility, resulting in a company’s inability to forecast future commodity prices.
 
Mining businesses should consider the following when projecting future operating results:
 
  • Has the business incurred a recent cumulative book loss? A recent cumulative loss is objectively verifiable negative evidence that is difficult to overcome when projecting future taxable income, unless it can be proven that the reason for the cumulative loss is an aberration rather than a projection of actual operating results.
 
  • For businesses just coming out of a period of losses, the existence of recent earnings may not by itself be sufficient positive evidence to support a projection of future taxable income. Projections of future taxable income must be supported by objectively verifiable assumptions that consider economic conditions (including, for example, the effects of covid), industry cycles and risks and earnings trends.
 
  • Given the industry’s cyclical nature, even mining businesses with a recent history of profits (such as the precious metals sector) will need to support their ability to generate future taxable income. When preparing projections, these businesses should consider where they are in the business cycle.
 
  • The use of industry databases to forecast commodity prices may not be reliable for these projections, depending on the assumptions used in determining the forecasted price and to what extent the assumptions are objectively verifiable. Forecasted taxable income becomes less objectively verifiable the further out into the future the forecast relates.