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ASC 740 and Valuations of Deferred Tax Assets ASC 740 and Valuations of Deferred Tax Assets

Tackling Tough Valuation and Disclosure Challenges and Recovering Prior Allowances

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific WEDNES DAY, MAY 2, 2012

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Douglas S ayuk, Partner, Clifton Douglas, S an Jose, Calif. g y , , g , , Mathew DeMong, Tax Engagement S enior Manager, BDO USA, Boston

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ASC d V l ti f D f d T ASC 740 and Valuations of Deferred Tax Assets Seminar

May 2, 2012 Mathew DeMong, BDO US A mdemong@ bdo.com Douglas S ayuk, Clifton Douglas doug@ cliftondouglas.com

Today’s Program

Overview Of Material Terms Of AS C 740 And Other Guidance [Douglas S ayuk] S lide 7 – S lide 12 Tax-Related Issues [Mat hew DeMong] S lide 13 – S lide 52 Valuation Issues Arising With Deferred Tax Assets [Douglas S ayuk] S lide 53– S lide 79

OVERVIEW OF MATERIAL

Douglas Sayuk, Clifton Douglas

OVERVIEW OF MATERIAL TERMS OF ASC 740 AND OTHER GUIDANCE

Introduction: DTA Build From Recession From Recession

_____________________________________________________

RECESSION RECESSION = TAX LOSSES = DTA BUILD DTA BUILD

8

Introduction: DTA Build From Recession (Cont.) Recession (Cont.)

_____________________________________________________

DATE DOW EVENT

• Oct. 9, 2007

14,164 Dow Hits All Time High July 2, 2008 11,215 Dow Closes >20% Below 10/07 High M h 9 2009 6 547 D Cl t P t 1997 L 53 8% March 9, 2009 6,547 Dow Closes at Post 1997 Low – 53.8% Below 10/07 High

• Jan. 4, 2010

10,584 Dow Recovery Under Way But Slow

Source: 1) Dow Jones - Monthly Bar Chart - Semi-log Scale - 1971-2012 2) DowJonesClose.com – Dow Jones Industrial Average Closing Prices 9

Introduction: DTA Utilization From Economic Recovery From Economic Recovery

_____________________________________________________

IMPROVING ECONOMY IMPROVING ECONOMY = 2011/2012 DTA UTILIZATION/POTENTIAL VA RELEASE RELEASE

10

Introduction: Increased DTA Accounting F B i C bi ti From Business Combinations

_____________________________________________________

Improving Economy Improving Economy = Increasing Business Combinations Combinations = Increasing Tax Accounting Under ASC 805 10 5 (FAS 141R) ASC 805-10-5 (FAS 141R)

11

Introduction: Basic Terminology Introduction: Basic Terminology

_____________________________________________________

• ASC Topic 740 (previously FAS 109): Accounting for Income Taxes
• ASC Topic 740-10, et seq. (previously FIN 48): Accounting for

Uncertainty in Income Taxes

• Deferred tax asset (DTA): Cumulative deductible temporary difference

( ) y

• Deferred tax liability (DTL): Cumulative taxable temporary difference
• Valuation allowance (VA): A contra- or reduction account to deferred

tax assets, which represents that portion of total deferred tax assets that the firm judges is unlikely to be realized.

• Tax attribute: A type of loss or credit that may reduce taxable income or
• Tax attribute: A type of loss or credit that may reduce taxable income or

tax liability, respectively (e.g., net operating loss or research credit).

• More likely than not (MLTN): A likelihood of greater than 50%

12

TAX RELATED ISSUES

Mathew DeMong, BDO USA

TAX‐RELATED ISSUES

Agenda For This Section

Tax-related issues A. Effective tax rates and interim accounting for taxes B. Business combinations and accounting for taxes C. Tax accounting for stock-based compensation

BDO US A, LLP, a Delaware limited liability partnership, is the U.S . member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.

Overview Of Interim Overview Of Interim (Quarterly) Reporting

Interim reports are for a period less than one year Interim reports are for a period less than one year. An estimated effective tax rate for the year is used to determine income t f i t i i d tax expense for interim periods. The complexity of the estimated annual effective tax rate calculation will depend upon:

• The number of tax j urisdictions in which the company operates
• The nature and extent of the “ permanent difference” items

p Do not include the tax related to “ significant unusual or extraordinary items” in estimated annual effective tax rate.

AS C 740 and Valuations of Deferred Tax Assets Page 15

items in estimated annual effective tax rate.

Estimated Annual Effective Tax Rate Estimated Annual Effective Tax Rate

Total tax expense for the year results from separate calculations of Total tax expense for the year results from separate calculations of current tax expense and deferred tax expense. E ti t f b th t d d f d t tt ib t d t Estimates of both current and deferred tax expense attributed to “ ordinary income” will be required, to calculate the estimated annual effective tax rate for the year. The rate is the ratio of estimated annual income tax expense to estimated pre-tax ordinary income.

AS C 740 and Valuations of Deferred Tax Assets Page 16

Discrete Items Discrete Items

Tax expense/ benefit related to “ ordinary” income shall be computed at the Tax expense/ benefit related to ordinary income shall be computed at the estimated annual effective tax rate (EAETR), and the tax expense/ benefit related to all other items shall be individually computed and recognized when the items occur (FIN 18 Par 6) when the items occur (FIN 18, Par. 6). —S ignificant or unusual items that will be separately reported or reported net of their related tax effect reported net of their related tax effect —Effects of change in j udgment related to beginning of the year valuation allowances or liabilities for tax exposure items (FIN 48 liabilities) liabilities) —Effects of changes in tax laws or rates —Provision to return adj ustments

AS C 740 and Valuations of Deferred Tax Assets Page 17

Computing Income Tax Provisions Computing Income Tax Provisions In Interim Periods

Compute year-to-date income tax expense/ benefit —Estimated annual effective tax rate (EAETR) —Multiply EAETR by year-to-date ordinary income (loss) at end of the period —Add tax expense/ benefit related to discrete items and other exceptions to the general rules

AS C 740 and Valuations of Deferred Tax Assets Page 18

Example 1 Example 1

If a company estimates its annual income to be $250,000 and estimates an R&D credit of $15,000, what is its effective rate if the company computes its taxes at a 34% rate? The effective tax rate would be 28% , computed in the following manner: G ld b $85 000 ($250 000 34% )

• Gross taxes would be $85,000 ($250,000 x 34%

)

• Net taxes would be $70,000 ($85,000 gross tax - $15,000 R&D credit
• ETR would be 28%

($70,000 net taxes/ $250,000 annual income) What would the income tax provision for the first quarter be if there was $50,000

• f income in the first quarter?
• f income in the first quarter?

The income tax provision for the first quarter would be $50,000 x 28% = $14,000.

AS C 740 and Valuations of Deferred Tax Assets Page 19

Example 2 Example 2

A company’ s estimated ETR is 30% . During the third quarter, the company had $75,000 net income. Its year-to-date income is $200,000, and it had previously reported $45,000 in taxes. What is the third quarter income tax provision? Th hi d i i i i d b l i l i h The third quarter income tax provision is computed by multiplying the year-to- date income by the ETR and deducting prior quarter income taxes.

$200,00 x 30% = $60,000

$60,000 - $45,000 = $15,000 The ETR for the quarter is 20% ($15,000 / $75,000)

AS C 740 and Valuations of Deferred Tax Assets Page 20

Example 3 Example 3

A company originally estimated its ETR at 30% for the year. During the p y g y y g third quarter, the company had $75,000 net income. Its year-to-date income is $200,000, and it had previously reported $20,000 in taxes. What is the ETR for the third quarter? As noted in the earlier question year-to-date tax is $60 000 As noted in the earlier question, year-to-date tax is $60,000 The tax for the quarter is $60,000 - $20,000 = $40,000 Therefore, the ETR for the third quarter is 53.33% ($40,000/ $75,000).

AS C 740 and Valuations of Deferred Tax Assets Page 21

Multiple Jurisdictions Multiple Jurisdictions

Rate may be computed based on one overall rate unless: Rate may be computed based on one overall rate, unless:

• The company anticipates losses for which no benefit can be

i d d recognized, and

• Is unable to make an estimate or ordinary income or related tax.

If there is a j urisdiction that anticipates a loss for which no benefit can be recognized, then:

• Compute effective rate separately for that j urisdiction
• Apply it to that j urisdiction’ s YTD ordinary income

AS C 740 and Valuations of Deferred Tax Assets Page 22

Multiple Jurisdictions: Example Multiple Jurisdictions: Example

AS C 740 and Valuations of Deferred Tax Assets Page 23

Business Combinations Business Combinations

General rule (AS C 740-25-3&4)

–

Each identified asset and liability is assigned its respective fair value [refer to AS C 805-10-5,10&15].

–

A deferred tax liability (DTL) or asset (DTA) is then established for the difference between book and tax bases resulting from the purchase price difference between book and tax bases resulting from the purchase price allocation and for any carryforwards.

–

DTA may include future benefits of NOLs and tax credit carryforwards. The need for a valuation allowance must be assessed

–

The need for a valuation allowance must be assessed. Exceptions where DTAs or DTLs are not recorded at purchase (AS C 740-25-3&4):

–

Goodwill not deductible for tax purposes

–

Acquired Opinion 23 (AS C 740 & 942) differences Leveraged leases

AS C 740 and Valuations of Deferred Tax Assets Page 24

–

Leveraged leases 24

Business Combinations (Cont ) Business Combinations (Cont.)

Measurement period Measurement period

• Initial accounting for business combination is incomplete by the end

f th ti i d

• f the reporting period.
• The measurement period shall not exceed a year from the

acquisition date.

• Allows retrospective adj ustments accounted for under acquisition

accounting (i.e. goodwill) New knowledge about facts and circumstances that existed

• New knowledge about facts and circumstances that existed

as of the acquisition date

AS C 740 and Valuations of Deferred Tax Assets Page 25

Purchase Price Accounting: Examples Purchase Price Accounting: Examples

Deferred tax liability recorded in purchase accounting The stock of Target a consumer brand manufacturer is acquired by Corporation X The stock of Target, a consumer brand manufacturer, is acquired by Corporation X

• n 03/ 31/ 2004 for $1,500. Market-related and customer-related intangibles are

identified and recorded for book purposes under FAS 141R (AS C 805-10-5, 10&15) in the amount of $600. Assume no S

• ect. 338 election, a 40%

effective tax rate and $ 0 t b i i th i t ibl h ld b t t $-0- tax basis in the intangibles held by target. Book Tax Difference DTL Id ifi d I ibl $600 $ 0 $600 Identified Intangibles $600 $-0- $600 Tax Rate x 40% = $240 Journal Entry:

• Dr. Goodwill

$240

• Cr. Deferred Tax Liability

$240

AS C 740 and Valuations of Deferred Tax Assets Page 26

Purchase Price Accounting: Examples (Cont ) Purchase Price Accounting: Examples (Cont.)

Deferred tax asset recorded in purchase accounting The stock of Target, a consumer brand manufacturer, is acquired by Corporation Y g q y p

• n 03/ 31/ 2004 for $950. Market-related and customer-related intangibles are

identified and recorded for book purposes under FAS 141R (AS C 805-10-5,10&15) in the amount of $300. Assume no S

• ect. 338 election, a 40%

effective tax rate and historic tax basis of intangibles held by target from prior acquisition of $500 historic tax basis of intangibles held by target from prior acquisition of $500. Book Tax Difference DTA Identified Intangibles $300 $500 $200 Identified Intangibles $300 $500 $200 Tax Rate x 40% = $80 Journal Entry: Journal Entry:

• Dr. Deferred Tax Assets

$80

• Cr. Goodwill

$80

AS C 740 and Valuations of Deferred Tax Assets Page 27

Tax Deductible: Goodwill Tax Deductible: Goodwill

If tax deductible goodwill, AS C 740 separates into two components:

–

First component

• Equals lesser of “ book” goodwill or “ tax” goodwill

A diff b t th b k d t b i i f t i

• Any difference between the book and tax basis in future years is a

temporary difference.

–

S econd component - Remainder

• If book goodwill, then a tax benefit is never recognized (permanent

difference)

• If tax goodwill, then that excess tax goodwill meets the definition of

a temporary difference. A DTA must be recognized at the acquisition date.

AS C 740 and Valuations of Deferred Tax Assets Page 28

Excess Tax Deductible Goodwill Excess Tax Deductible Goodwill

FAS B observed calculation as follows for initial recording of DTA: FAS B observed calculation as follows for initial recording of DTA: (Tax rate/ (1-Tax rate)) * “ Preliminary temporary difference” “ Preliminary temporary difference” is the excess of the tax goodwill over y p y g the book goodwill.

AS C 740 and Valuations of Deferred Tax Assets Page 29

Excess Tax Deductible Goodwill: Example

Acquiring company purchases 100%

• f the assets of Target Co. Goodwill of

$ $ $40M is recorded for financial reporting purposes, and $50M of goodwill is recorded for tax purposes. The company’ s effective tax rate is 40% . DTA to record = $10M * (.40/ (1 - .40) = 6.67M Acquiring Co. records the following assets: Goodwill $33 3M Goodwill $33.3M Deferred tax asset $6.67M

AS C 740 and Valuations of Deferred Tax Assets Page 30

Transaction Costs Transaction Costs

Accounted for separately from the business combination Accounted for separately from the business combination Expensed for books as incurred Companies are permitted to anticipate transaction structure, if sufficient evidence of transaction type exists at the filing date.

AS C 740 and Valuations of Deferred Tax Assets Page 31

Valuation Allowances In Valuation Allowances In Business Combinations

Established at time of business combination E l id Evaluate evidence Combined company’ s past and expected future results of

• perations as of the acquisition date

AS C 740 and Valuations of Deferred Tax Assets Page 32

Subsequent Release Of VA Subsequent Release Of VA

Release of VA on acquired deferred tax assets in future years must be Release of VA on acquired deferred tax assets in future years must be included in income from continuing operations, if outside of the measurement period. Changes within the measurement period resulting from new information, that existed at the acquisition date, will be recognized through goodwill.

AS C 740 and Valuations of Deferred Tax Assets Page 33

Indefinite Lived Intangibles: Indefinite Lived Intangibles: “Naked Credits”

DTLs resulting from temporary differences that can be offset by the existing reversing deductible temporary differences, NOLs or credits may be considered a source of income to eliminate or reduce the need for a be considered a source of income, to eliminate or reduce the need for a VA.

Companies often net DTLs against DTAs to compute VA.

d f l d bl d d ll d

Indefinite-lived intangibles and goodwill are not amortized. DTLs on indefinite lived intangibles often create a “ naked

credit.” DTL from indefinite-lived intangibles cannot be used as a source of income to offset DTAs with definite lives, when computing VA.

AS C 740 and Valuations of Deferred Tax Assets Page 34

Valuation Allowances: Example Of Indefinite-Lived Intangibles DTL

Example:

• Current tax loss, full valuation allowance
• $1,000 of tax amortization on goodwill; no other book/ tax differences
• Tax rate = 40%

Total provision = $400

• Current provision = $0

p

• Deferred provision = $400
• To establish the DTL for the basis difference in goodwill
• The indefinite-lived asset temporary difference cannot be

p y considered a source of income to reduce the VA. Total tax expense = $400

AS C 740 and Valuations of Deferred Tax Assets Page 35

Acquired Tax Uncertainties Acquired Tax Uncertainties

Uncertain tax positions are reviewed at acquisition and recorded at fair Uncertain tax positions are reviewed at acquisition and recorded at fair value, if certain conditions are met. “ M lik l th t” t d d t t l t t i li d t d t i “ More likely than not” standard or contractual test is applied to determine if an accrual is warranted.

AS C 740 and Valuations of Deferred Tax Assets Page 36

Adjustments To Acquired Adjustments To Acquired Tax Uncertainties

Adj ustments (i.e. true-ups) are permitted to purchase accounting within the measurement period. Any adj ustments after the measurement period are required to be recognized in the income statement. Any adj ustment based on new information that arose after the transaction date is an adj ustment to income, regardless of time frame.

AS C 740 and Valuations of Deferred Tax Assets Page 37

In-Process Research And Development In-Process Research And Development

Measured at FV and capitalized and written off in the future through Measured at FV and capitalized and written off in the future through amortization/ impairment charges N t bl i iti E t bli h d f d t li bilit t h d t Non-taxable acquisitions: Establish deferred tax liability at purchase date Can potentially result in a naked credit

AS C 740 and Valuations of Deferred Tax Assets Page 38

Contingent Consideration Contingent Consideration

Determine the FV of all payments and record at acquisition date without Determine the FV of all payments and record at acquisition date, without regard to the likelihood of the payment. I iti l iti i d d t d ill d b t k t Initial recognition is recorded to goodwill, and any subsequent mark to market changes are charged to the P&L. S ignificant deviation from tax treatment

AS C 740 and Valuations of Deferred Tax Assets Page 39

Stock-Based Compensation: Overview Stock-Based Compensation: Overview

AS C 718 applies to all transactions involving the issuance by a company of its own equity in exchange for goods or services. The entity will recognize an increase in equity or a liability, depending upon the type of award as the award vests. AS C 718 requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments granted to employees over the requisite service period. requisite service period. Types of equity-based compensation awards:

• S

tock options S tock options

• Non-vested stock and non-vested stock units
• Restricted stock
• S

hare appreciation rights (cash-settled and/ or stock-settled)

AS C 740 and Valuations of Deferred Tax Assets Page 40

S hare appreciation rights (cash settled and/ or stock settled)

Tax Treatment Of Share-Based Tax Treatment Of Share-Based Compensation

—Incentive stock options Non qualified stock options —Non-qualified stock options

AS C 740 and Valuations of Deferred Tax Assets Page 41

Excess Tax Benefits And Tax Shortfalls Excess Tax Benefits And Tax Shortfalls

Excess tax benefits —Excess tax benefits Commonly referred to as a windfall/ windfall tax benefit —Tax shortfalls

AS C 740 and Valuations of Deferred Tax Assets Page 42

Example: Disqualifying Dispositions Example: Disqualifying Dispositions Of ISOs

ABC grants an IS O with a grant-date fair value of $100. S ince the award is an IS O, no corresponding tax benefit or deferred tax asset is recorded. A disqualifying disposition occurs in which the company can take a $120 deduction in its tax p p y

• return. The tax rate is 40%

. What tax entry should be recorded by ABC in 2011 to record the disqualifying disposition? disposition? ABC would record a tax benefit of $40 in the income statement and an increase to additional paid-in capital of $8 (($120 less $100) × 40% tax rate).

• Dr. taxes payable $48
• Cr. tax provision benefit $40

Cr APIC $8

AS C 740 and Valuations of Deferred Tax Assets Page 43

• Cr. APIC $8

Example: Disqualifying Dispositions Example: Disqualifying Dispositions Of ISOs (Cont.)

h d f l f $ h d ABC grants an IS O with a grant-date fair value of $100. S ince the award is an IS O, no corresponding tax benefit or deferred tax asset is recorded. A disqualifying disposition occurs in which the company can take a $90 deduction in its tax return. The tax rate is 40% . The tax rate is 40% . What tax entry should be recorded by ABC in 2011 to record the disqualifying disposition? ABC would record a tax benefit of $36 in the income statement ($90 × 40% tax rate).

• Dr. taxes payable $36
• Cr. tax provision benefit $36

AS C 740 and Valuations of Deferred Tax Assets Page 44

Example 1: Excess Tax Benefits Example 1: Excess Tax Benefits

ABC grants an equity-classified option award with a grant-date fair value

• f $100 and a $200 exercise price; the fair market value of the underlying

p ; y g shares on the exercise date is $400. The vesting period is four years. The award is exercised in Year 5. ABC’ s tax rate is 40% . How does this windfall get recorded? $40 increase to APIC; $0 reduction of income tax expense

• $80 tax benefit – tax deduction of $200 ($400 stock price less

$200 exercise price of option) *40% tax rate

• Previously recognized DTA reversing – cumulative compensation

cost of $100 * 40% tax rate

• Excess tax benefit of $40 ($80 tax benefit - $40 previously

recognized DTA)

• Excess tax benefit is a windfall that is recognized as APIC.

AS C 740 and Valuations of Deferred Tax Assets Page 45

cess ta be e t s a w d all t at s ecog ed as C.

Example 1: Excess Tax Benefits (Cont ) Example 1: Excess Tax Benefits (Cont.)

Year One Entries

• Dr. stock compensation $25
• Cr. APIC $25
• Dr. DTA $10
• Cr. DT - benefit $10

$

AS C 740 and Valuations of Deferred Tax Assets Page 46

Example 1: Excess Tax Benefits (Cont ) Example 1: Excess Tax Benefits (Cont.)

Year Two Four Entries Year Two-Four Entries S ame as year one At The End Of Year Four: Total stock compensation deducted in - $100 financial statements Total DTA recorded - $40

AS C 740 and Valuations of Deferred Tax Assets Page 47

Example 1: Excess Tax Benefits (Cont ) Example 1: Excess Tax Benefits (Cont.)

Year Five – Options Are Exercised FMV $400 Exercise Price ($200) FMV $400 Exercise Price ($200) Tax Deduction $200 X 40%

= $80

Book Deduction $100 X 40%

= $40

Excess Tax Ded $100 X 40%

= $40

• Dr. tax expense $40
• Cr. DTA $40
• Dr. tax payable $80
• Cr. tax expense $40
• Cr. tax expense $40
• Cr. APIC $40

AS C 740 and Valuations of Deferred Tax Assets Page 48

Timing For Recognition Of Timing For Recognition Of Excess Tax Benefits

Tax benefit and credit to APIC for excess tax benefit is recognized in the Tax benefit and credit to APIC for excess tax benefit is recognized in the period that deduction reduces taxes payable. Th f ld l b ll d t dit APIC —Therefore, a company would only be allowed to credit APIC when a benefit is actually received. —Reduction of taxes payable may occur in a subsequent period. NOL generated in period the tax deduction is taken

AS C 740 and Valuations of Deferred Tax Assets Page 49

Utilization Of Tax Attributes Utilization Of Tax Attributes

Approach to determining realization of excess tax benefits: Approach to determining realization of excess tax benefits: —With-and-without —Tax-law ordering

AS C 740 and Valuations of Deferred Tax Assets Page 50

Shortfalls Shortfalls

ABC has a DTA at the beginning of the year of $2 million. $500k worth of i ll d d i h Th h i d f DTA

• ptions were cancelled during the year. Thus, there is an end-of-year DTA
• f $1.5 million.

What tax entry should be recorded by ABC in 2010 to record the disqualifying disposition?

• Dr. APIC $500k (if APIC pool)
• Cr. DTA $500k

AS C 740 and Valuations of Deferred Tax Assets Page 51

Circular 230 Disclosure Circular 230 Disclosure

To ensure compliance wit h Treasury Depart ment regulat ions we To ensure compliance wit h Treasury Depart ment regulat ions, we wish t o inform you t hat any t ax advice t hat may be cont ained in t his communicat ion (including any at t achment s) is not int ended or writ t en t o be used and cannot be used for t he purpose of (i) avoiding t ax-relat ed be used, and cannot be used, for t he purpose of (i) avoiding t ax relat ed penalt ies under t he Int ernal Revenue Code or applicable st at e or local t ax law provisions or (ii) promot ing, market ing or recommending t o anot her part y any t ax-relat ed mat t ers addressed herein. Before implement ing any p y y f p g y

• f our year-end t ax planning ideas, it is imperat ive t hat you discuss t hese

ideas wit h your t ax advisor as it applies t o your specific set of circumst ances.

AS C 740 and Valuations of Deferred Tax Assets Page 52

VALUATION ISSUES ARISING

Douglas Sayuk, Clifton Douglas

WITH DEFERRED TAX ASSETS

VA Issues Arising With DTA: Assessing VA Needs

• The VA assessment is both subjective and mechanical

The VA assessment is both subjective and mechanical.

• The subjective evaluation can include, but is not limited to, any of the following factors:
• Assessing whether the weight of the available evidence supports the recognition
• f some or all of an entity’s DTA
• f some or all of an entity s DTA
• Determining how objectively verifiable an individual piece of evidence is and how

much weight it should be given

• Establishing the reversal patterns for existing temporary differences
• Once the subjective evaluation has been made, the valuation allowance computation

process is mechanical.

• Valuation allowance formulae can be helpful but are no substitute for reasoned

Valuation allowance formulae can be helpful but are no substitute for reasoned judgment in evaluating the need for a valuation allowance.

• Valuation allowance recorded should be based on management’s judgment of what is

MLTN, considering all available information, both quantitative and qualitative MLTN, considering all available information, both quantitative and qualitative.

54

VA Issues Arising With DTA: VA Evidence To Be Considered Evidence To Be Considered

• ASC 740-10-30-17 provides that “all available evidence shall be considered in

p determining whether a valuation allowance for DTA is needed.”

• Evidence includes historical information along with all currently available information

about future years. y

• Events occurring subsequent to an entity’s year-end but before the financial

statements are released, and that provide additional evidence (negative or positive) regarding the likelihood of realization of existing DTA, should be considered. g g g ,

• The effects on the VA assessment of certain fundamental transactions, such as an IPO,
• ther major financing transactions or a business combination, should not be taken

into account until the transactions are complete. p

• Typically, the factors given the most weight are the least subjective, resulting in the

following order from strongest to weakest evidence: 1) Carryback claims, 2) reversal of temporary differences, 3) tax planning strategies, 4) future taxable income exclusive of p y , ) p g g , ) temporary differences

55

VA Issues Arising With DTA: VA E id T B C id d E l Evidence To Be Considered – Example

• Facts: Company A is restating FS for the prior three years (2008-2010)

Facts: Company A is restating FS for the prior three years (2008 2010) for items unrelated to taxes. Prior to the restatement, Company A was profitable for 2008-2010 without a VA against any of its DTA. Post- restatement, Company A has losses for 2008 and 2009, but remains significantly profitable in 2010.

• Question: Can Company A utilize the knowledge of the profitable results

in 2010 as positive evidence in evaluating whether a VA is considered necessary for the 2008 restated accounts? Answer: No Although Company A returned to significant profitability in

• Answer: No. Although Company A returned to significant profitability in

2010, only information available as of the original issuance date of the FS should be used in determining the VA as of the end of 2008. However, this 2008 VA likely would be reversed in 2010 based on the available evidence 2008 VA likely would be reversed in 2010 based on the available evidence that year, which included significant profitability.

56

VA Issues Arising With DTA: g Objective Evidence Preference

• The weight given to the potential effects of negative and positive

evidence shall be commensurate with the extent to which they can be

• bjectively verified
• bjectively verified.
• The more negative evidence that exists, the more positive evidence

is necessary and the more difficult it is to support a conclusion that a VA is necessary, and the more difficult it is to support a conclusion that a VA is not needed for some portion or all of the DTA.

• For example, a cumulative loss in recent years is a significant piece

p , y g p

• f negative evidence that is difficult to overcome.

57

VA Issues Arising With DTA:

• Forming a conclusion that a valuation allowance is not needed is difficult when

Negative Evidence

Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence”… examples include: C l ti l i t

• Cumulative losses in recent years
• History of expiring tax attributes
• Losses expected in early future years
• Unsettled circumstances that may adversely affect future operations and

profit levels on a continuing basis in future years

• A brief carryback, carryforward period

58

VA Issues Arising With DTA: Negative g g Evidence - Cumulative Losses

• Out of all the negative evidence, “cumulative losses in recent years” probably will

have to be considered most frequently. ASC 740 d lib t l d t d fi thi t b t it t ti i t i ft i t t d t

• ASC 740 deliberately does not define this term, but its starting point is often interpreted to

be cumulative pre-tax results as adjusted for permanent items (e.g., non-deductible goodwill impairments) for three years (the current and the two preceding years).

• All items, other than the cumulative effect of accounting changes, should be included

in the determination of cumulative losses.

• When considering cumulative losses, it may be necessary to segregate earnings

(losses) subject to capital gain rules from those subject to taxes at ordinary rates.

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VA Issues Arising With DTA: Negative Evidence – Cumulative Losses Example

• Facts: Company B had four separate and distinct lines of business. Historically,

three of the lines have been/continue to be profitable, but the fourth line incurred substantial losses that led to an NOL carryforward on the entity’s consolidated tax return The unprofitable line was discontinued and its assets sold Historical profit

• return. The unprofitable line was discontinued and its assets sold. Historical profit

levels of Company B were such that it could utilize the NOL carryforward within eight years prior to the NOL’s expiration date.

• Question: Does sufficient positive evidence exist to support Company B’s

conclusion that a valuation allowance was not required against its consolidated loss carryforward?

• Answer: Yes. Although the mere exiting of a business often does not, in and of

itself, ensure future profitable operations, in this case Company B had a consistent track record of profitable results in its other business lines. The consistent hi t i l i i it th b i li l d ith l th NOL historical earnings in its other business lines, coupled with a lengthy NOL carryforward period, is considered sufficient positive evidence.

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VA Issues Arising With DTA: Positive Evidence

• Examples of positive evidence include, but are not limited to, the

following: S l b kl th t ill d th h t bl

• Sales backlog that will produce more than enough taxable

income to realize the DTA.

• An excess of appreciated asset value over the tax basis of the
• An excess of appreciated asset value over the tax basis of the

entity’s net assets in an amount sufficient to realize the DTA.

• A strong earnings history exclusive of the loss that created the

A strong earnings history exclusive of the loss that created the future deductible amount, coupled with evidence indicating that the loss is an aberration rather than a continuing condition

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VA Issues Arising With DTA – Positive E id Of T bl I S

Th f ll i f ibl f t bl i b

Evidence Of Taxable Income Sources

• The following four possible sources of taxable income may be

available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards:

• Future reversals of existing taxable temporary differences
• Future taxable income exclusive of reversing temporary

Future taxable income, exclusive of reversing temporary differences and carryforwards

• Taxable income in prior carryback year(s), if carryback is

p y y ( ), y permitted under the tax law

• Tax-planning strategies that would, if necessary, be implemented

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VA Issues Arising With DTA:

• Future realization of a tax benefit sometimes will be expected for a

Positive Evidence

• Future realization of a tax benefit sometimes will be expected for a

portion, but not all, of a DTA. The dividing line between the two portions may be unclear.

• In those circumstances, application of judgment, based on a careful

assessment of all available evidence, is required to determine the portion of a DTA for which it is MLTN a tax benefit will be realized. p

• Future realization of the tax benefit of an existing deductible temporary

difference or carryforward ultimately depends on the existence of sufficient taxable income of the appropriate character (for example,

• rdinary income or capital gain) within the carryback, carryforward period

available under the tax law.

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VA Issues Arising With DTA – Scheduling Future Taxable Income

• Scheduling future taxable income is necessary when it matters, i.e., when

g y , , the assessment of the appropriate VA or the applicable tax rate could vary materially depending on relatively minor shifts in the timing of taxable income.

• It is important to note that scheduling will be the exception rather than the
• It is important to note that scheduling will be the exception rather than the

rule that detailed computations will have to be carried to this extreme.

• Scheduling will have to be considered in the following situations:
• Realization of the DTA is dependent upon future reversals of existing taxable

temporary differences (i.e., taxable income from sources other than reversing taxable differences does not provide sufficient assurance of realization) taxable differences does not provide sufficient assurance of realization).

• A change in the tax rate is enacted but will not take effect until a future year
• r years.

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VA Issues Arising With DTA – Positive Evidence Of Future Taxable Income

• To the extent that realization is not ensured by carryback, reversals of taxable temporary

y y , p y differences or tax-planning strategies, and is therefore dependent on the existence of future taxable income, projections of future taxable income will be necessary.

• To the extent such recent results include aberrational items, favorable or unfavorable,

those items should be excluded from the results when determining a “core” level of earnings.

• Guidelines for projecting future earnings for purposes of VA assessment include:
• Presumption that an entity with cumulative recent profits will remain profitable unless

Presumption that an entity with cumulative recent profits will remain profitable unless there is objectively verifiable evidence to the contrary

• Starting point = Amount and trend of pre-tax income adjusted for permanent items

during the past year during the past year

• Adjust historical earnings for unusual items (both positive and negative), the effects of

purchase accounting or changes in capital structure

• Approach favorable improvement in profitability with a high degree of skepticism

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VA Issues Arise with DTA: Positive Evidence – Tax Planning Strategies

• In assessing the need for a VA the consideration of tax planning strategies is not
• In assessing the need for a VA, the consideration of tax planning strategies is not
• elective. If there is an available tax planning strategy that is prudent and feasible, it must be

incorporated into the assessment.

• Actions that may qualify as tax planning strategies include but are not limited to the
• Actions that may qualify as tax planning strategies include, but are not limited to, the

following:

• Selling operating assets and simultaneously leasing them back for a long period of

time time

• Accelerating the repatriation of foreign earnings for which deferred taxes previously

were provided

• Filing a consolidated or combined tax return

g

• Electing to deduct foreign taxes paid or accrued, rather than treating them as

creditable foreign taxes

• Electing to capitalize and amortize research and development costs
• Merging or liquidating subsidiaries into the parent in a tax-free transaction

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VA Issues Arising With DTA: Ineffective Tax Planning Strategies

• Actions that generally would not qualify as tax planning strategies include,

g y q y p g g , but are not limited to, the following:

• Selling certain operating assets that are important to future operations
• Disposing of a subsidiary that is not profitable
• Initiatives that reduce costs in order to increase the entity’s profitability
• Moving income from a non-tax jurisdiction to a taxable one, solely to realize

net operating loss carryforwards

• Planning involving technical determinations that do not meet the MLTN

standard

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VA Issues Arising With DTA: Specific Issues – Liabilities For UTBs

• A liability for unrecognized tax benefits should be considered a

source of taxable income in the carryback period, for purposes of determining the expected realization of a DTA.

• Because settlement with the taxing authority is presumed to be at

the recorded amount of the liability, the position’s resolution effectively amounts to additional taxable income over the taxable income expected

• n an “as-filed” basis.

The period in which the taxing authority would assess the tax

• The period in which the taxing authority would assess the tax

should be considered, to ensure the DTA relate to the same period in which additional taxable income is expected.

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VA Issues Arising With DTA: Specific Issues – Liabilities For UTBs, Example

• FACTS: As of 2010, Company C has a $1,000 NOL carryforward offset by VA due to

significant negative evidence. In 2011, Company C expects to report taxable income of $500

• n its tax return, which includes a $100 deduction that is an UTB. A full VA remains for 2011.
• QUESTION: Should Company C net the liability from the 2011 UTB with the 2010 NOL

carryforward on its 2011 balance sheet?

• ANSWER: No The company should recognize the 2010 NOL carryforward separately

ANSWER: No. The company should recognize the 2010 NOL carryforward separately from the 2011 UTB liability. The 2011 UTB liability would be a source of income, for the purposes of assessing whether a VA is necessary for the NOL carryforwards. Assuming a 40% tax rate, the entry for the $100 UTB would be:

• Dr. Deferred Tax Asset

$40 [$100 x 40%]

• Cr. FIN 48 Liability

$40 If the NOL related to windfall tax deductions then no entry would be recorded for FIN 48 If the NOL related to windfall tax deductions, then no entry would be recorded for FIN 48.

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VA Issues Arising With DTA: Specific Issues – Carrybacks Free Up Credits

C id ti t b i t t d d tibl t diff

• Consideration must be given to net deductible temporary differences

reversing in a single future year that will be included in a tax loss that will be carried back to prior years and that will, at least partially, free up tax credits originally used to reduce the payable rather than free up tax credits originally used to reduce the payable rather than resulting in a refund.

• The applicable tax rate at which deferred taxes are recorded is the

The applicable tax rate at which deferred taxes are recorded is the tax rate prior to consideration of credits. Thus, it merely replacing one deferred tax asset (deductible temporary difference) with another deferred tax asset (credit carryforward), when there is not a source of income to ( y ), realize it, does not represent realization of the initial deferred tax asset; and a valuation allowance would be necessary.

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VA Issues Arising With DTA: Specific Issues – Carrybacks Example

FACTS C E t d $1 illi NOL i 2011 Th l i d b k t

• FACTS: Company E generated a $1 million NOL in 2011. The loss was carried back to

2009 and 2010 to offset the entire $500,000 of taxable income. The 2008/2009 tax expense of $200,000 was previously offset with $150,000 of research credit generated during those years, reducing the liability to $50,000. As a result of carrying back the NOL dit th t i l tili d i th b k l d d NOL, credits that previously were utilized in the carryback years were no longer needed. As a result, $150,000 of research credits previously utilized in 2008 and 2009 were “freed up” and would be available as a carryforward for use in future years. QUESTION I C E i d t ff t it “f d ” dit ith VA?

• QUESTION: Is Company E required to offset its “freed up” credits with VA?
• ANSWER: Yes. As Company E has no projected taxable income, a portion of the loss

p y p j p carried back was not realized but rather resulted in the establishment of a new DTA in the form of a credit carryforward. Absent any other sources of future taxable income, Company E would need to establish a VA against the research credit carryforwards that were released through the loss carryback. In this case, a tax benefit could only be claimed for g y y the incremental refund of $50,000.

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VA Issues Arising With DTA: Specific I FTC C f d Issues – FTC Carryforwards

• Many limitations exist on the ability of a company to utilize its foreign tax credits
• Many limitations exist on the ability of a company to utilize its foreign tax credits

(FTCs). Therefore, to realize the DTA recorded for FTC carryforwards under ASC 740, an entity must be able to generate sufficient future foreign source taxable income; and that income must, in the aggregate, have been taxed in foreign jurisdictions at less than 35%.

• The FTC carryforwards can be used only if, and to the extent that, a 35% rate

exceeds the future credits generated by the future foreign source income exceeds the future credits generated by the future foreign source income

• itself. The entity also must not anticipate a taxable loss from domestic

sources in the years in which the carryforwards must be used. D t th t i t li ti i t it ill b diffi lt t id VA f

• Due to the stringent realization requirements, it will be difficult to avoid a VA for

FTC carryforwards. Unless the circumstances that generated the carryforwards were aberrational, it is likely that future foreign source income also will generate excess FTCs - which will become additional carryforwards - rather than utilize y existing FTC carryforwards.

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Special Circumstances: Initial Public Offering – DTA/VA Concerns DTA/VA Concerns

_______________________________________________

• For a private company to file an S 1 generally audited financial statements for the
• For a private company to file an S-1, generally audited financial statements for the

last three years must be included.

• External auditors may require additional support for a private company’s DTA for

these prior years as part of the S 1 filing these prior years as part of the S-1 filing.

• Typical DTA-related studies required for substantiation may include credit

(oftentimes research credit) studies and IRC §§382/383 studies to support NOLs and credits and credits.

• DTA supporting studies can be resource- and time-consuming and should be

started well in advance of an S-1 filing.

• A private company may anticipate using a portion of IPO proceeds to pay off debt.

Upon consummation of the IPO, the company should reassess its tax position considering the reduction in interest deduction. This increase in future taxable income may result in the release of VA against DTA income may result in the release of VA against DTA.

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Special Circumstances: Initial Public Offering Example Offering – Example

_______________________________________________

• FACTS: An entity underwent a leveraged buyout (LBO) and incurred a large

y g y ( ) g amount of debt as a result of that transaction. For several years after the LBO, the entity incurred substantial losses. Without the interest expense on the LBO-related debt, however, the entity would have been profitable. The entity had an IPO which resulted in proceeds used to pay off the LBO debt entity had an IPO, which resulted in proceeds used to pay off the LBO debt. The entity concluded that future income precluded the need for a VA once the LBO debt was eliminated.

• QUESTION: Was the positive evidence related to future income sufficient to
• utweigh the substantial negative evidence of cumulative recent year losses

caused by the LBO interest expense?

• ANSWER: Yes. Absent the interest expense from the LBO, the company

consistently demonstrated the ability to operate at a profit. The company’s

• bjectively verifiable “core earnings” were sufficient positive evidence to

O

• utweigh the negative evidence related to cumulative losses caused by LBO

interest expense.

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Special Circumstances: Initial Public Offering IRC §§ 382/383 Offering – IRC §§ 382/383

_______________________________________________

• An IPO may result in a “change of control,” triggering tax attribute limitations of IRC

§§382/383.

• A company considering going public should evaluate the impact of such a change
• f control on its use of tax attributes.
• Federal, state and foreign tax attributes should be evaluated under their

respective tax attribute limitation rules, as only some states follow the federal IRC §§382/383 change of control rules.

• Section 382/383 limitations may create “worthless” DTA, e.g., NOL and/or credit

carryforwards that are expected to expire unutilized. / f f f

• When 382/383 limitations mathematically preclude use of a portion of a carryforward
• r a deductible difference, it is appropriate for a DTA to be written off rather than

reflected as offset with a VA.

Source: Clifton Douglas article, “Act Public Before Going Public: How to Manage Tax Accounting When Preparing for an IPO,” Journal of Accountancy, October 2011

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Special Circumstances: Initial Public Offering Conversion To C Corporation Offering – Conversion To C Corporation

_______________________________________________

• As part of its IPO plan, an entity currently organized as a pass-through entity (S

p p y y g p g y ( Corporation, LLC, partnership) generally would be required to covert to a C

• Corporation. This results in DTA and/or DTL for the initial temporary differences at the

time of the change in status.

• The recognition of initial temporary differences is recorded in income from

continuing operations, and no current tax expense would result as of the date of the change in status.

• If the pass-through entity had liabilities for tax purposes, then the

partners/shareholders would have a gain from the liabilities assumed by the

• corporation. The new C corporation would obtain a step-up in tax basis in an amount

equivalent to the gain. q g

• The pass-through entity’s gain and C corporation step-up in basis are considered

direct consequences in the change of tax status, with the benefit recorded in income from continuing operations. g

76

Special Circumstances: Tax Holidays Special Circumstances: Tax Holidays

_______________________________________________

• A determination must be made as to whether a DTA should be

t bli h d f th f t t i f t h lid th established for the future tax savings of a tax holiday, on the premise that such savings are similar to an NOL carryforward.

• ASC 740 10 25 35 et seq prohibits recognition of a DTA for any
• ASC 740-10-25-35, et seq. prohibits recognition of a DTA for any

tax holiday (including both “general” and “unique” tax holidays).

• Prohibition of DTA recognition is due to the practical problems

Prohibition of DTA recognition is due to the practical problems associated with: 1) distinguishing between a “general” and “unique” tax holiday, and 2) measuring the DTA associated with future benefits expected from tax holidays. p y

• A DTA or DTL arising from a tax holiday should be measured using

the enacted tax rates expected to apply to taxable income in the periods in which the DTL or DTA is expected to be settled or realized.

77

Special Circumstances: Foreign Branch Operations Branch Operations

_______________________________________________

• U.S. federal deferred tax consequences arising from a business operation situated in

a foreign branch are similar to the U.S. federal tax consequences arising from a a foreign branch are similar to the U.S. federal tax consequences arising from a business operation located in a U.S. state and local jurisdiction.

• The foreign DTA or DTL will be a temporary difference in the computation of the

deferred U.S. tax, because the foreign DTA or DTL has a book basis but no U.S. tax deferred U.S. tax, because the foreign DTA or DTL has a book basis but no U.S. tax basis.

• When a foreign DTA is recovered, it reduces the foreign branch local country

current taxes and consequently the foreign taxes deductible by or creditable to the U.S. cu e t ta es a d co seque t y t e o e g ta es deduct b e by o c ed tab e to t e U S corporation.

• When a foreign DTA is settled, it increases foreign branch local country current taxes

and foreign taxes deductible by or creditable to the U.S. corporation. g y p

• A foreign DTL recorded at the branch level would give rise to a U.S. DTA, while a

foreign DTA recorded at the branch level would give rise to a U.S. DTL.

• When future foreign DTA realization is not MLTN, and a VA is recorded, a U.S.

DTL for the foreign tax asset at the branch level would not be required.

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Special Circumstances: Indefinite R l E ti Reversal Exception

• The presumption per ASC 740-30-25-3 that all undistributed earnings will be

p p p g transferred to the parent entity may be overcome; and no income taxes will be accrued by the parent entity, for entities and periods identified, if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely.

• Management must compile evidence to support its assertion that the foreign unremitted

earnings are indefinitely reinvested, in order to qualify for the indefinite reversal exception. A mere history of not distributing foreign earnings does not serve as a replacement for specific reinvestment plans.

• Acceptable evidence indicating specific reinvestment plans includes the following:
• Forecasts and budgets
• Projected working capital/other capital needs in locations where earnings generated
• Reasons why excess earnings not needed by parent/subsidiary
• Past history of dividend actions (or lack thereof)
• Tax consequences of a decision to remit or reinvest

R itt t i ti i l t f b idi

• Remittance restrictions in a loan agreement of a subsidiary
• Remittance restrictions by foreign governments resulting in forced reinvestment

79