Insights > Accounting for Income Taxes Under the CARES Act

Accounting for Income Taxes Under the CARES Act

The new Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law last month and is intended to mitigate impacts of the economic downturn for individuals and businesses most affected. The Act provides relief in the form of expanded unemployment insurance, the Paycheck Protection Program, a recovery tax rebate for individual taxpayers, various business tax provisions, emergency lending to businesses, health care provisions, and a relief fund for state and city governments. The Act also includes business tax provisions, such as favorable changes to the Net Operating Loss (NOL) carryback rules, interest expense limitations, and alternative minimum tax credit carryforwards.

Here is what companies should know about how to account for income taxes under the CARES Act.

Net Operating Loss Modifications

The Tax Cuts and Jobs Act of 2017 (TCJA) altered the rules related to Federal NOLs so that those generated after 2017 could not be carried back but could be carried forward indefinitely. The TCJA also limited NOL usage in any year to 80% of taxable income. The CARES Act made favorable changes to the NOL rules for corporations by eliminating the 80% of taxable income limitation for tax years 2018 through 2020 and allowing a five-year carryback of NOLs generated from 2018 through 2020. The five-year carryback will allow some taxpayers to utilize NOLs to offset income taxed at 35%, compared to the current 21% federal income tax rate.

The five-year carryback will allow some taxpayers to utilize NOLs to offset income taxed at 35%, compared to the current 21% federal income tax rate.

To the extent a corporation can take advantage of the carryback provisions and/or the repeal of the 80% limit, there are several areas to consider when determining the appropriate accounting treatment of the tax impacts under ASC 740. The carryback of the NOLs could change the assessment of the realization of the deferred tax asset (DTA), change the tax rate at which the NOLs are expected to be utilized, and create an annual effective tax rate (AETR) vs. discrete considerations in quarterly reporting.

Taxable income in prior carryback years is one of the four sources of taxable income provided by ASC 740 to support realization of deferred tax assets. It may be necessary to release valuation allowances for existing NOL DTAs if those NOLs can be carried back to prior years. The tax effect of releasing the valuation allowance on existing NOL DTAs as a result of the CARES Act should be recorded discretely in the period of enactment (first quarter of 2020 for calendar-year tax filers).

In addition to valuation allowance considerations, companies may need to remeasure DTAs for any NOLs expected to be carried back to a year before the federal tax rate change. For tax years after 2017, the federal income tax rate was reduced from 35% to 21% under the TCJA. For any NOLs the company expects to carryback to years prior to 2018, the related DTA should be remeasured at the tax rate anticipated to apply, or 35%. Similarly, any existing temporary differences (currently recorded at a 21% rate) that are expected to reverse during the current year and become part of an NOL that will be carried back to a 35% tax rate year should be remeasured to 35%. The impact of this remeasurement should be recorded discretely in the period of enactment. However, any tax benefit for the rate differential related to losses recognized during the current year should be included in the AETR.

Companies must also consider the impact of NOL carrybacks on other tax attributes and deductions that were utilized in those years. For example, the carryback of NOLs to a particular year could cause foreign tax credits or R&D credits to be carried forward to future years and could impact the usage of the domestic production activities deduction. These tax attributes would then need to be assessed for realizability. Additionally, for domestic corporations with foreign activity, changes to taxable income in the carryback years could impact foreign-derived intangible income, global low-taxed income, or base erosion and anti-avoidance tax.

The balance sheet presentation should reflect when NOLs are expected to be monetized. For example, a current tax receivable would be recorded if the NOL is expected to generate a cash tax refund within a year of the reporting period.

Business Interest Expense Limitations

The TCJA expanded the applicability of the interest limitation rules under Internal Revenue Code Section 163(j), which limits a taxpayer’s deductible interest expense to 30% of adjusted taxable income (ATI). For tax years beginning in 2019 and 2020, the CARES Act increases the ATI limitation to 50% from 30% and allows taxpayers to elect to use 2019 ATI in determining the 2020 limitation.

The current year tax effects resulting from the increased ATI limitation should be reflected in the current year AETR. The income tax effects of changes in the prior year ATI limitation should be accounted for discretely in the interim period that includes the date of enactment. These effects may include changes in the valuation allowance and other indirect effects from the change in taxable income as a result of the increased deduction.

Companies should also consider the impact of the legislation being enacted so close to the end of the first quarter for calendar year filers. An election is required if a taxpayer chooses to utilize the 2019 ATI in determining the 2020 limitation. It is possible that a company will need more time to complete the work and modeling necessary to make this determination. In this case, management should make its best estimate based on information known or knowable as of the balance sheet date.

Alternative Minimum Tax Credits

The TCJA repealed the corporate alternative minimum tax (AMT) effective for tax years beginning after 2017. However, AMT credits from prior years could be carried forward as refundable credits to tax years through 2021. For tax years beginning in 2018, the CARES Act accelerates the ability of companies to receive refunds of AMT credits.

The ability of a company to utilize its AMT credit carryforwards could be impacted by the acceleration of the ability to use the credits. As such, valuation allowances may no longer be necessary for all or a portion of the credit carryforwards. Updated valuation allowance analysis should be completed for companies with AMT credit carryforwards.

Companies should consider the potential rate impact if additional deductions result in increased NOLs that can be utilized in 35% tax rate years.

AMT credits may have been presented as a DTA or an income tax receivable in the prior period balance sheet. For companies that present a classified balance sheet, the tax receivable may be classified as current or non-current. The presentation of the asset related to AMT credits should be updated to reflect the company’s expectation as to when the credits will be utilized. If the company expects to monetize the credit in 2018 or 2019, it should be presented as a current receivable in the current period financial statements.

Qualified Improvement Property

The TCJA amended IRC Sec. 168(e)(3)(E) to exclude qualified leasehold improvement property (QLIP), qualified restaurant property (QRP), and qualified retail improvement property (QRIP) from 15-year property and amended 168(e) to remove QLIP, QRP, and QRIP as property classifications. These classifications were replaced with qualified improvement property (QIP), which was intended to be classified as 15-year property, but the TCJA inadvertently failed to make this classification. The CARES Act makes a technical correction to the TCJA to provide a 15-year recovery period for QIP as well as slightly altering the definition of QIP. The technical correction makes QIP eligible for bonus depreciation and is effective as if enacted as part of the TCJA. This technical correction provides companies with the opportunity to amend their 2018 returns or file an automatic method change in 2019 or future years claiming bonus depreciation and changing the recovery period of QIP. In some cases, this could result in increased NOLs that could be carried back to 35% tax rate years.

The impact of the QIP technical correction on any position taken in a prior period should be recorded discretely in the interim period that includes the date of enactment. Companies should consider the potential rate impact if additional deductions result in increased NOLs that can be utilized in 35% tax rate years.

Additionally, some companies may have taken the position that QLIP, QRP, or QRIP were 15-year property and were eligible for bonus depreciation in prior years. Under the TCJA, this position may not have met the more-likely-than-not threshold and precluded the company from recognizing the related tax impacts. The technical correction made by the CARES Act constitutes new information that may allow for recognition of the tax position taken by meeting the MLTN threshold under ASC 740-10-25-6. The release of any tax reserves as well as related interest and penalties accrued should be accounted for discretely in the current period.

The CARES Act makes significant changes to certain sections of the Internal Revenue Code, creating potentially meaningful tax savings opportunities for corporations including the chance to generate immediate cash flow. With these modifications come challenges in determining the appropriate treatment of the tax impacts in a company’s financial statements. These challenges include altered valuation allowance analysis, balance sheet classification changes, remeasurement of DTA’s, AETR vs. discrete determinations, and uncertain tax position considerations.

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