Simplifying the Accounting for Income Taxes
In December, the FASB issued a new standard intended to improve and simplify accounting for income taxes. ASU 2019-12 removes some exceptions in ASC 740, Income Taxes and provides clarification on certain other tax accounting principles, marking a considerable change to the current guidance. Since many companies will be affected by at least one—if not several—of the updates, it is important to understand the changes and to develop a robust plan to proactively address them.
Here are seven key ways that the new standard will impact accounting for income taxes and what companies can do to prepare for the transition. While several of these topics have specific recognition requirements as indicated below, all others must be recognized on a prospective basis.
The new standard is effective for public calendar year-end companies starting after December 15, 2020 and for all other calendar year-end companies starting after December 15, 2022.
Intraperiod income tax allocation
Companies are now required to calculate the tax effect from continuing operations independently of the effect of discontinued operations, other comprehensive income, and other sections of the financial statements, a concept known as Intraperiod Income Tax Allocation. Prior US GAAP included an exception to this basic principle wherein any company with a loss from continuing operations would be required to consider items outside of continuing options such as those noted above (e.g., discontinued operations, other comprehensive income) when calculating the total tax benefit. ASU 2019-12 removed this exception, which means the total benefit of a loss from continuing operations is allocated to continuing operations first, and the amount of tax expense for other items of income or gain is the difference between total tax expense and the loss from continuing operations. The removal of this exception does not, however, change the requirement to evaluate the calculated benefit for valuation allowance purposes prior to its recognition in the financial statements.
Realization of the tax benefit of ordinary losses
At the conclusion of each interim reporting period (quarter), a company is required to estimate the annual effective tax rate for the fiscal year, which is then used to calculate the year-to-date provision. Prior to ASU 2019-12, if the year-to-date loss in the quarter exceeded the anticipated loss for the full year, the maximum benefit recorded was the tax-affected anticipated loss for the year. The ASU removes this exception, which means companies now record the benefit from the year-to-date loss in the quarter even if the anticipated loss for the full year is less.
Ownership changes in foreign investments
As a result of the ASU, the recognition of outside basis differences in foreign investments due to changes in ownership percentages no longer has exceptions. This means that when the ownership percentage of a foreign subsidiary decreases, resulting in an equity method investment, the total outside basis difference in the investment is recorded. Alternatively, when the ownership of an equity method investment increases and the new subsidiary can assert it has the intent and ability to indefinitely reinvest its earnings, the deferred tax liability on the outside basis difference that existed prior to the ownership change is not recorded.
Legacy GAAP included guidance for situations where a company increased its ownership stake in an equity method investment and became a subsidiary. Prior to the ASU, in these cases, the related outside basis differences not previously recognized because the earnings were indefinitely reinvested or would be remitted in a tax-free manner were frozen. This caused complexity because the company would need to track the deferred tax liability prior to the ownership change separately from changes in the outside basis differences of the newly formed subsidiary after the ownership change.
Changes in ownership of foreign investments must be recognized on a modified retrospective basis through a cumulative-effect adjustment to retained earnings at the beginning of the fiscal year of adoption of the ASU.
ASU 2019-12 addresses complexities in accounting for situations where jurisdictions require a company to pay the greater of an income-based tax or non-income-based tax for franchise tax purposes. For these sitations, the new guidance flips the ordering of the calculation by requiring the portion of the franchise tax (or similar tax) related to income be first recognized as an income tax expense, along with its related deferred tax assets and liabilities. Any portion of incremental tax not related to income, such as tax computed from an entity’s capital, is recognized as a non-income-based tax and is included in pre-tax income.
Under previous guidance, an entity was required to first recognize the non-income-based portion in pre-tax income and then recognize any incremental income-tax-based portion in current and deferred income taxes. This caused unnecessary confusion in situations where the non-income tax amount was insignificant.
Franchise tax calculations must be recognized on a retrospective basis for all periods presented or on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption of the ASU.
Step-up in the tax basis of goodwill
When accounting for a business combination under ASC 805, the amounts assigned to goodwill may differ for income tax and financial reporting purposes, resulting in a deferred tax asset when the tax basis of goodwill exceeds the book basis. Conversely, when the book basis of goodwill exceeds the tax basis, no deferred tax liability is created.
The ASU provides clarification on the accounting treatment of goodwill when a step-up in tax basis occurs. If the step-up relates to a prior business combination in which book goodwill was recorded, then no deferred tax asset is recognized unless the newly created tax-deductible goodwill exceeds the remaining balance of book goodwill from the original business combination. However, if a step-up in tax basis does not relate to goodwill from a prior business combination, the step-up is considered a separate transaction, and a deferred tax asset is recorded for the entire amount of the newly created tax goodwill. To assist companies in identifying situations that are separate transactions, the FASB included several examples in the ASU.
Allocating consolidated current and deferred tax expenses
Prior guidance requires allocation of current and deferred tax expenses for a group that files a consolidated tax return to its members when those members issue separate financial statements. This guidance was unclear in which entities would be considered “members” of the group that would require tax allocation. The ASU clarifies this by stating that an entity is not required to allocate the consolidated amount of current and deferred tax expense to legal entities that are not subject to tax. However, an entity may elect to allocate the consolidated amount of current and deferred tax expense to wholly owned legal entities that are both not subject to tax and disregarded for tax purposes. This election is made on an entity-by-entity basis.
Allocation of current and deferred tax expense to entities not subject to income tax must be recognized on a retrospective basis for all periods presented within the entity’s separate financial statements.
Recognizing effects of tax law changes
The final notable update in the ASU changes the interim period in which an entity recognizes the effects of changes in tax laws or tax rates in its estimated annual effective tax rate calculation. The new guidance replaces effective date with enactment, which now requires companies to recognize all the effects of a changes in tax law or tax rates, both on deferred taxes and on the estimated annual effective tax rate, in the same quarter. Previously, a change was not included in the estimated annual effective tax rate until it became effective, but its effects were recognized in deferred tax assets and liabilities on the date of enactment.
The new standard is effective for public calendar year-end companies starting after December 15, 2020 and for all other calendar year-end companies starting after December 15, 2022. Early adoption is permitted for companies that adopt all amendments simultaneously. While the changes are not immediately effective, companies should prepare early. By understanding the implications of the new standard and working with advisors and auditors to address any changes they expect to recognize in their future financial statements, companies can ensure a successful transition.