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Stay Ahead of the Curve: Exploring ASU 2023-02’s Revised Guidance on Accounting for Tax Equity Investments and its Impact on Tax Credit Recognition

Stay Ahead of the Curve_Exploring ASU 2023-02s Revised Guidance on Accounting for Tax Equity Investments and its Impact on Tax Credit Recognition - Scrubbed

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Stay Ahead of the Curve: Exploring ASU 2023-02’s Revised Guidance on Accounting for Tax Equity Investments and its Impact on Tax Credit Recognition

Stay Ahead of the Curve_Exploring ASU 2023-02s Revised Guidance on Accounting for Tax Equity Investments and its Impact on Tax Credit Recognition - Scrubbed

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The Financial Accounting Standards Board (FASB) recently issued Accounting Standards Update (ASU) 2023-02 —Investments—Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method. The Update provides consistency and comparability for all tax equity investments made to receive income tax credits and other income tax benefits by granting entities the option to use the proportional amortization method. The affected equity investments are those made in companies that undertake specific types of development projects encouraged by the US government, in areas such as pollution control, renewable energy, and green technology. As a benefit for undertaking such projects, companies receive tax credits from the US federal tax code and certain state and foreign tax jurisdictions. As there are limited opportunities for companies to use the tax credits, they typically transfer a portion of the tax credits and depreciation deductions generated by the projects to  investors in exchange for their investments. This article explores the key provisions and implications of ASU 2023-02, shedding light on how it will enhance financial reporting standards and promote transparency, accuracy, and relevance in financial statements.

The Stimulus: Why is there a need for an update?

Previously under ASU 2014-01 – Investments—Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects, the FASB allowed reporting entities to account for their investments in qualified affordable housing projects using the proportional amortization method, provided that certain conditions are met. The key criterion for using the proportional amortization method is that investments should be in low-income housing tax credit (LIHTC) structures. This limiting criterion resulted in inconsistent reporting on measuring, recognizing, and disclosing equity investments made primarily for receiving income tax credits and other income tax benefits. Stakeholders argue that other investments in structures that generate income tax credits through tax credit programs other than LIHTC structures serve the same purpose. Hence, the income tax credits and other income tax benefits received should be accounted for consistently with LIHTC projects.

Under the proportional amortization method, at the time of initial investment, the reporting entity recognizes the income tax credits in the financial statements during the year the credit arises. Immediate recognition of income tax credits for the entire benefit of tax credits to be received is prohibited. The amortization amount is the net between the initial investment and any expected residual value of the investment multiplied by the percentage of actual income tax credits and other income tax benefits allocated to the investor in the current period divided by the total estimated income tax credits and other income tax benefits expected to be received by the investor over the life of the investment. In financial statements, the net of income tax expense (or benefit) and the amortized amount is presented in profit or loss.

The Response: What is the Update?

To address the abovementioned inconsistency, the FASB issued ASU 2023-02, Investments–Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method (“ASU 2023-02“ or “Update”), on March 29, 2023. The Update applies to reporting entities that either have:

  1. tax equity investments that meet the conditions and who elect to account for those investments using the proportional amortization method; or
  2. an investment in a LIHTC structure through a limited liability entity that is not accounted for using the proportional amortization method and to which the LIHTC-specific guidance removed has been applied.
 

The amendments found in ASU 2023-02 remove the restriction that the proportional amortization method is only available for LIHTC structures. The Update allows reporting entities to use the proportional amortization method for their tax equity investments whether they are on LIHTC structures or not, provided that the below conditions are met:

  1. The income tax credits allocable to the tax equity investor will probably be available.
  2. The tax equity investor cannot exercise significant influence over the operating and financial policies of the underlying project.
  3. Substantially all of the projected benefits are from income tax credits and other income tax benefits.
  4. The tax equity investor’s projected yield is positive based solely on the cash flows from the income tax credits and other income tax benefits.
  5. The tax equity investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the tax equity investor’s liability is limited to its capital investment.

Any changes in the nature of the investment or the relationship with the underlying project require reevaluation, as the above conditions may no longer be met. Also, note that using the proportional amortization method is not required but rather at the entity’s discretion. This is because the FASB’s Emerging Issues Task Force recognized that the cost of requiring that entities evaluate whether an investment has met the criteria above is not justified by the benefits of investments in certain tax credits. The terms above thus grant the use of the proportional amortization method on a tax-credit-program-by-tax-credit-program basis rather than electing to apply such a method at the reporting entity level or to individual investments. As such, an entity must individually evaluate whether an investment qualifies for the proportional amortization method.

Other amendments included in ASU 2023-02 are the removal of specialized guidance in ASU 2014-01 provided to LIHTC investments that are not accounted for using the proportional amortization method. These include guidance indicating that it may be appropriate to apply the cost method to a LIHTC investment and the example related to the impairment of a LIHTC investment accounted for using the equity method. The Update also makes the delayed equity contributions guidance applicable only when the proportional amortization method is applied to a tax equity investment.

The Means: What are the required disclosures resulting from the Update?

The amendments require that disclosures enable users of annual and interim financial statements to understand the nature of the entity’s tax equity investments and the effect of the tax equity investments and related income tax credits and other income tax benefits on the investor’s financial position and operations. To meet this requirement, ASU 2023-02 provides guidance on the information to include in the disclosures, such as :

  1. The amount of income tax credits and other income tax benefits recognized during the period
  2. The balance of the investments and the line item in which the investments are recognized in the statement of financial position
  3. The amount of investment amortization recognized as a component of income tax expense (benefit)
  4. The amount of non-income-tax-related activity and other returns received that are recognized outside of income tax expense (benefit) and the line item in the statement of operations and cash flows in which they have been recognized
  5. Significant modifications or events that resulted in a change in the nature of the investment or a change in the relationship with the underlying project

The Timeline: When is the Update effective?

ASU 2023-02 will take effect for public business entities starting from fiscal years commencing after December 15, 2023, including interim periods within those fiscal years. For all other entities, it will be effective for fiscal years beginning after December 15, 2024, including interim periods within those fiscal years. Early adoption is permitted.