Background
In 2014, FASB launched a simplification initiative to improve and simplify accounting standards through a series of projects, adding to its technical agenda simplifications to the accounting rules for income taxes under ASC 740.Part of the FASB’s overall Simplification Initiative is to update and address complexities in income tax accounting. The Simplification Initiative aims to identify, evaluate, and improve areas of generally accepted accounting principles (GAAP) that can reduce cost and complexity while improving the usefulness of the information provided to financial statement users.
Existing contents of ASC 740 before the amendment
Before the amendment, the following extraordinary items were included as part of the exceptions in applying ASC 740:- An 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.
- An exception to the requirement to recognize a deferred tax liability for equity method investments when a foreign subsidiary becomes an equity method investment.
- An exception to the ability not to recognize a deferred tax liability for a foreign subsidiary when a foreign equity method investment becomes a subsidiary.
- An 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.
Eliminated Exceptions:
Intraperiod Tax AllocationPreviously, GAAP provided an exception in determining the effect of income tax on income from continuing operations without considering the impact of items not included in continuing operations. The exception requires an entity with a loss from continuing operations to consider all items, including discontinued operations and other comprehensive income when calculating the tax benefits from continuing operations.
The update removed this exception to the incremental approach for intraperiod tax allocation, and as a result, the effects of items outside continuing operations, even at a loss, are not considered when calculating the tax effect on continuing operations.
Deferred Tax Liabilities (DTL)Changes from a Subsidiary to an Investment
Before the update, an entity was required to recognize a DTL where the book basis exceeds the tax basis in a foreign equity method investee. However, an exemption to this general rule was provided under ASC 740, which states that an entity does not need to recognize a DTL related to the transition-date outside-basis difference if it had been asserting indefinite reversal to its investment in the former subsidiary when there is a change from a foreign subsidiary to equity method investee.
Under the amended provisions, an entity should recognize a DTL on the entire outside basis differences of a foreign subsidiary that became a foreign equity method investment. This would create consistency with the general principle of the current U.S. GAAP, where an entity recognizes DTL for a taxable outside-basis difference in the equity method investment if it is no longer eligible to assert indefinite reinvestment of earnings.
Changes from an Investment to a Subsidiary
Previously, an entity was required to continue to recognize a DTL for a foreign equity method investment that became a subsidiary. The amendment removes the exception under ASC 740-30-25-16 that freezes the DTL on the outside basis of the difference recorded before the investment became a subsidiary. Consistent with the current U.S. GAAP, an entity needs to reverse the DTL and recognize a tax benefit if it has indefinite reinvestment of earnings of the subsidiary.
Interim-Period Tax Calculation
ASC 740-270 provided an exception to the general methodology for the interim-period income taxes calculation if the year-to-date loss exceeds the anticipated loss for the year. The guideline limits the recognition of income tax benefits when an entity with an ordinary loss for the interim period exceeds the anticipated ordinary loss for the year. The income tax benefit is limited to the amount that would be recognized if the year-to-date ordinary loss were the anticipated ordinary loss for the full fiscal year.
The update removed the exception on the limits of the income tax benefit recognized in the interim period to the income tax benefit recognized as though the year-to-date ordinary loss were the expected loss for the current year. As a result, there will no longer be limitations to the tax benefits recognized in the interim period, and the computation of the income tax benefits at each interim period is based on its estimated annual effective tax rate.
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Simplifying Accounting for Income Taxes
Franchise Tax or other Similar TaxesIn some jurisdictions, franchise taxes are calculated based on the greater of two calculations — income-based and non-income-based. ASC 740 does not apply franchise taxes on a non-income-based measure (e.g., capital) when there is no additional tax-based income. It further states that franchise taxes on income-based measures should only be included as income tax expense if it exceeds the capital-based tax.
Under the current updates, an entity must first account for the franchise tax or similar tax as a portion of income tax expense and account for any incremental amount as a non-income-based tax portion in pretax income. In addition, entities must record deferred taxes using the statutory income tax rate, and the entity does not need to consider the effect of potentially paying a non-income-based tax in future years when evaluating the realizability of deferred tax assets. The update is consistent with the accounting for other incremental taxes.
Step up in tax bases of goodwill
When an entity enters a business combination transaction that results in goodwill under ASC 805, amounts presented and recognized for income tax and financial reporting purposes may differ. Under the current guidelines, a deferred tax asset (DTA) is recognized only when the tax basis of goodwill exceeds the book basis of goodwill. However, no recognition of DTL is allowed under ASC 805. If the step up in the tax basis of goodwill relates to the portion of goodwill from a previous business combination for which a DTL was not recognized, then-current guidance prohibits an entity from recognizing a DTA for the increase in tax basis, except up to the extent that the tax-deductible goodwill exceeds the remaining book balance of goodwill. This results in the non-recording of DTA for the step-up based on goodwill unless it would have recorded a deferred tax asset when the business combination had occurred. These principles are also important to understand within the context of nonprofit financial reporting, where proper recognition and compliance with ASC guidelines remain critical despite differing organizational structures.
The update removed the existing guidelines under ASC 740-10-25-54 and requires that an entity determine whether the tax basis step-up transaction relates to a prior business combination in which the book goodwill was initially recognized or to a separate transaction. ASU 2019-12 includes factors to consider that may indicate that the step up in tax basis relates to a separate transaction, which includes but is not limited to the following:
- A significant lapse in time between the transactions has occurred.
- The tax basis in the newly created goodwill is not the direct result of the settlement of liabilities recorded in connection with the acquisition.
- The step up in tax basis is based on a valuation of the goodwill or the business that was performed as of a date after the business combination.
- The transaction resulting in the step up in tax basis requires more than a simple tax election.
- The entity incurs a cash tax cost or sacrifices existing tax attributes to achieve the step-up in tax basis.
- The transaction resulting in the step up in tax basis was not contemplated at the time of the business combination.
If the step-up tax basis transaction is part of the business combination, DTA should be recognized only when it exceeds the remaining balance of book goodwill recognized in that business combination. However, if the step-up tax basis transaction relates to a separate transaction, an entity should record a DTA for the additional tax basis on goodwill.
Separate financial statements of entities not subject to tax
Previously, the guidelines did not specify a requirement to allocate the consolidated amounts of current and deferred tax expenses to entities not subject to taxes.
The update provides that an entity is not required to allocate the consolidated amount of current and deferred tax expenses to legal entities that are not subject to tax in their separate financial statements. However, legal entities that are not subject to tax and disregarded by taxing authorities may elect to allocate the consolidated amount of current and deferred tax expenses.
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Enacted changes in tax laws
Under the old guidelines, an entity is required to recognize the income tax effects of an enacted change in tax law on deferred tax assets or liabilities on the date of enactment or on the period during which the law is effective, whichever occurred later. When there is a change in income tax rate enacted in one interim period but effective in another, complexities arise concerning deferred tax balances and taxes payable.
The update requires entities to reflect the effect of a change in tax law used in the computation of the annual tax rate in the period it was enacted instead of the period that includes the effective date.
Transition Requirements and Effective DateChanges in ownership of foreign equity method investments or foreign subsidiaries must be accounted for using a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption.
Franchise taxes partially based on income must be accounted for using 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 period of adoption.
Allocation of income taxes for entities not subject to tax should be applied retrospectively for all periods presented.
All other amendments should be applied on a prospective basis.
For public business entities, ASU 2019-12 is 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 for interim periods within fiscal years beginning after December 15, 2022. Early adoption of the amendments is permitted.
Complexities about Accounting for Income taxes?Accounting for income taxes is about determining the amount of taxes payable or refundable in the current year and deferred tax assets and liabilities for the future tax consequences of events recognized in an enterprise’s financial statements or tax returns. Recognition, timing, presentation, and disclosures needed for deferred tax assets and liabilities are just one of the complexities hurdled by every entity. In addition, an entity may not be well versed in reconciling differences and recognizing them in the accounting books versus state laws. All of these situations can pose challenges to accurate income tax reporting.
