Recently, FASB issued a new Accounting Standards Update (ASU 2019-12), Simplifying the Accounting for Income Taxes. The new standard amends section 740 of the Accounting Standards Codification (ASC), eliminating some problematic exceptions and technicalities.
CPAs hoping the new standards would reduce the overall complexity of deferred income taxes will be disappointed. The basic principles have not changed; instead, FASB has focused on a wide range of provisions that seem to be excessively complicated. The most significant of these is a revision to the accounting for franchise taxes, which previously required accountants to weigh the likelihood that future taxes will be based on capital rather than income. This provision by itself is likely to impact companies doing business in New York, Illinois, and other states that impose corporate franchise taxes.
Franchise Taxes
Franchise taxes are state or local taxes, generally based on the greater of a percentage of capital or a percentage of net income. As such, they may be based on income one year but based on capital in the next. Hence, deferred tax assets and liabilities realized in a year when the franchise tax is based on capital will impact overall tax liability only in an indirect way.
Previously, FASB applied principles of deferred tax accounting only to any likely income-based tax in excess of the tax based on capital. As such, when evaluating the realizability of deferred taxes, accountants needed to consider the effect of potentially paying a non-income-based tax in future years. Under ASU 2019-12, deferred tax accounting applies to all franchise taxes based on income, with any incremental amount based on capital to be recorded as a non-income-based tax in the period incurred. This non-income-based tax should not be presented in the income statement as a component of income tax expense. Furthermore, when evaluating the realizability of its deferred tax assets, an entity no longer needs to consider the likelihood of paying a non-income-based tax in the future.
Intraperiod Tax Allocations
Intraperiod tax allocation involves allocating the income tax provision among continuing operations, special items (such as gain or loss from continuing operations), shareholders’ equity, and other comprehensive income. In general, FASB prescribes computing the tax effect of income from continuing operations independently, without considering the tax effects of other items. For example, a company with positive income from continuing operations and a loss from discontinued operations would compute the provision for income taxes based solely on income from continuing operations, and then separately compute the tax benefit from the loss from discontinued operations. This means a company would compute the provision for income taxes directly based on income from continuing operations and apply any incremental income taxes to the other items.
An exception to this general rule applied when there was a current period loss from continuing operations offset by income from other items. In order to determine the tax benefit from a loss from continuing operations, accountants would consider all components, including discontinued operations and items charged or credited directly to equity. This meant computing the provision for income taxes based upon all taxable income items and then allocating an income tax benefit to the loss from continuing operations, offset by income tax provisions applied to the other taxable items.
This exception existed for a variety of reasons: A pretax gain outside of continuing operations may provide taxable income to support realizing tax benefits as a result of the loss from continuing operations. Furthermore, a gain or income outside of continuing operations may impact the realizability of a deferred tax asset.
ASU 2019-12 eliminates this exception so that even when there is a loss from continuing operations, the tax benefit from that loss should be computed without considering the tax effects of other items—that is, by applying the effective income tax rate directly to income from continuing operations—and applying any incremental income taxes to other items.
Step-up in the Tax Basis of Goodwill
Companies may transact with a government or another entity to elect a step-up in the tax basis of certain fixed assets, including goodwill, in exchange for a current payment or sacrifice of an existing tax attribute (such as a net operating loss carryforward). Under prior guidance, a step-up in the tax basis of goodwill could offset an existing deferred tax liability from the acquisition but could not result in recording additional deferred tax assets (DTA). Instead, such a payment would be recognized as an expense on the income statement even though the payment had in substance created a DTA.
ASU 2019-12 provides entities with more flexibility in accounting for such a step-up in tax basis. An entity must first determine whether the step-up in tax basis is related to a business combination where the book goodwill was originally recognized or related to a separate transaction. That the entity incurs a cash tax cost or sacrifices existing tax attributes to achieve the step-up in tax basis would be one of several factors indicating that the step-up is related to a separate transaction, thereby permitting the entity to record a DTA corresponding to the newly created tax goodwill. Other factors include a significant lapse in time between the transactions or a step-up in tax basis that is based on a valuation performed after the business combination. (See ASC 740-10-25-54 for a full list of criteria.)
In the event that the step-up in tax basis is determined to relate to the business combination where book goodwill was originally recognized, then an additional DTA, as under the prior guidance, can only be recognized to the extent that newly deductible goodwill exceeds the remaining balance of book goodwill.
Single Member Limited Liability Companies
The prior guidance was silent on whether a parent entity was required to allocate consolidated amounts of current and deferred taxes to single-member limited liability companies. As such, some parent companies are allocated while others do not.
ASU 2019-12 clarifies that a parent may choose to elect to allocate consolidated amounts of current and deferred taxes to legal entities that are both 1) not subject to tax and 2) disregarded by taxing authorities—such as single member limited liability companies. This election is generally limited to wholly owned pass-through entities. It can be applied on an entity-by-entity basis; a parent may elect to allocate taxes to some single member limited liability investments, but not others. As with all entities with separately issued financial statements that are members of a consolidated tax return, disclosures about allocations should include the nature of the entity and the election, the aggregate amount of current and deferred tax expenses, intercompany balances between affiliates, the methods used to allocate current and deferred tax expense and compute intercompany balances, and any changes in these methods.
Equity Method Investments and Foreign Subsidiaries
Previously, ASC 740 provided for an important exception to the general presumption in deferred tax accounting that all of the undistributed earnings of a subsidiary will be transferred to the parent entity. This exception said that “if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation,” then no income taxes shall be accrued by the parent entity (ASC 740-30-25-17).
Under this prior guidance, when investment in such a subsidiary was reduced so that it was no longer considered to be a subsidiary, the outside basis difference for the investment was frozen until it became apparent that any of the undistributed earnings will be remitted. This required the entity to track the frozen amount of the basis and any subsequent changes to the outside basis separately.
ASU 2019-12 eliminates this exception, so that if the remaining investment in common stock is accounted for by the equity method, and the parent entity did not already recognize income taxes on its equity in undistributed earnings of the subsidiary, then the parent will accrue income taxes on the temporary difference related to its remaining investment in common stock.
Similarly, under the previous guidance, if an entity were “promoted” from an equity method investment to a subsidiary, then the entity could not derecognize a deferred tax liability as long as the parent’s share of subsidiary dividends did not exceed its share of subsidiary earnings. This exception was also eliminated by ASU 2019-12.
Changes in Tax Rates During Interim Periods
The prior standards required an entity to recognize the income tax effects of an enacted tax law change on deferred tax assets or liabilities on the enactment date while recording the tax effect of a change in tax law on taxes payable or refundable after the effective date of the tax law. As such, if a tax law were enacted at the beginning of the year with an effective date in the middle of the year, then the entity would be required to recognize the effects of the new law on deferred tax assets and liabilities as of the enactment date but could not recognize the effects of the new law on the effective tax rate until the effective date.
ASU 2019-12 eliminates any references to an effective date so that the effects of the new tax rate are introduced during the period of the enactment date.
Limitation of Year-to-Date Loss in an Interim Period
At the end of each interim period, an entity uses its best estimate of the annual effective tax rate to calculate income taxes on a year-to-date basis for that period. If the entity’s ordinary loss for the year-to-date period exceeds the anticipated ordinary loss for the year, however, then the income tax benefit recognized in the year-to-date period would be limited to the income tax benefit computed based on the year-to-date ordinary loss. ASU 2019-12 eliminates this exception, so that a company may recognize a tax benefit in a given interim period that exceeds the tax benefit expected to be received based on the estimated ordinary loss for the year.
Minor Changes
The new standard also made a few minor changes to the ASC. It clarified that the tax benefit from tax-deductible dividends on employee stock ownership plan shares should be recognized in income taxes allocated to continuing operations on the income statement, rather than a different component of the income statement. Furthermore, it corrected an example of tax accounting for limited partnership investment in a qualified affordable housing project (ASC 323-740-55-8).
Transition
For public business entities, the new standards took effect for fiscal years beginning after December 15, 2020, and the interim periods therein. For all other entities, the standards take effect one year later. Early adoption is permitted and, given the nature of the update, is logical for most entities.
According to FASB, changes that impact an interim period should reflect any adjustments as of the beginning of the annual period that includes the interim period. Adoption of changes related to single-member limited liability companies should be made on a retrospective basis, at the beginning of the earliest period presented in the financial statements. Changes made associated with changes in ownership of foreign equity method investments or subsidiaries should be made on a modified retrospective basis, at the beginning of the period when the accounting change was made. Changes to accounting for franchise taxes could be recorded on either a retrospective or a modified retrospective basis. All other changes in ASU 2019-12 can be made on a prospective basis during the period of the change.
When adopting the provisions of ASU 2019-12, entities should disclose the nature of and reason for the accounting principle change, the transition method used, and the financial statement line items impacted by the change.
The amendments to ASC 740 listed in ASU 2019-12 eliminate many exceptions to general tax accounting principles that may have cost accountants significant time to address—with questionable benefits to financial statement users. The most important of these is the change to accounting for state and local franchise taxes. Some of these exceptions were obscure enough that they may have been overlooked by accountants and auditors. As such, the new standards take a meaningful step towards simplifying GAAP for income taxes.