Current Developments – New GAAP
Requirements and Effect on Accounting
for Income Taxes
Greg Pfahl/John Monahan
December 8, 2016
New Revenue Recognition
StandardReplacing industry-specific guidance, the ASU focuses on a new
five-step analysis to be applied to all contracts with customers to
transfer goods or services. These steps include:
1. Identify the contract(s) with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the
contract
5. Recognize revenue when (or as) the entity satisfies a performance
obligation.
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New Revenue Recognition
Standard• The model indicates that revenue should be recognized when
(or as) an entity transfers control of goods or services to a
customer at the amount to which the entity expects to be
entitled.
• Depending on whether certain criteria are met, revenue is
recognized either over time, in a manner that demonstrates the
entity's performance, or at a point when control of the goods or
services is transferred to the customer.
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New Revenue Recognition
StandardPractically all companies will be affected to some extent
– Change in timing of recognizing revenue
– Significant increase in required disclosures
– Impact will vary depending on industry and current accounting practices
– Companies will need to consider changes that might be necessary to
information technology systems, processes, and internal controls to
capture new data and address changes in financial reporting
© 2016 Hein & Associates LLP.All rights reserved.
New Revenue Recognition
StandardEffective Dates
– Public – annual reporting periods beginning after December 15, 2017
– All other – annual reporting periods beginning after December 15, 2018
– Early adoption only permitted as of the original effective date for public
companies
– Transition methods – Full retrospective or modified retrospective
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New Revenue Recognition
Standard
Tax Considerations
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• Companies will need to asses if new book standard of revenue recognition is allowed for tax purposes.
• Will likely affect temporary difference related to deferred revenue
• For tax purposes, can be on a cash method of deferred revenue recognition or defer revenue recognition up to one year under Regs. Sec. 1.451-5 or Rev. Proc. 2004-34– One year deferral cannot exceed the financial
accounting deferral
New Revenue Recognition
Standard
Tax Considerations
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• Companies will need to consider the impact that
an acceleration of book revenue may have on
their cash taxes
• The IRS considers a change in the underlying
book method to be a method change for which
consent is required– However, for taxpayers using Rev. Proc. 200434, consent may
be obtained automatically under Rev. Proc. 2015-14
New Revenue Recognition
Standard
Tax Considerations
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• It is important to understand that if a company’s tax method
has been following financial accounting and the company
changes its book method, it cannot simply change its tax
method to follow the new book method.
• Rather, it needs to evaluate whether applying the tax rules
would result in the same answer as the new book method, and
if so, the company will have to file a Form 3115 to change it tax
method to implement it on its tax return
New Lease Standard
• The new standard does not fundamentally
change lease accounting from the lessor’s
perspective
• From a lessee’s perspective, the most significant
change from prior lease guidance is that lessees
are required to recognize the rights and
obligations resulting from most operating leases
as assets and liabilities on the balance sheet
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New Lease Standard
• Prior to the new standard, a lessee did not recognize assets and liabilities arising from most operating leases– While recognizing assets the related expense in the
income statement, the lease obligations were off-balance sheet liabilities under previous GAAP
• As a result of recognizing the rights and obligations arising from most leases on the balance sheet, the new standard will dramatically impact the balance sheet of lessee
© 2016 Hein & Associates LLP.All rights reserved.
New Lease Standard
Effective Dates
– Public – fiscal years beginning after December 15, 2018, including
interim periods within those fiscal years
– All other – Fiscal years beginning after December 15, 2019, and interim
periods beginning after December 15, 2020annual reporting periods
– Early adoption permitted
– Transition method – Modified retrospective as of the beginning of the
earliest period presented
© 2016 Hein & Associates LLP.All rights reserved.
New Lease Standard
Tax Considerations
• The new standard does not change the
treatment of leases for income tax purposes
• A lessee that is not otherwise required to
capitalize the lease for income tax purposes will
not have any tax basis in the right-of-use asset
and related lease liability recorded for tax
purposes
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New Lease Standard
Tax Considerations
• Differences are temporary in nature – Must recognize a deferred tax liability for excess
GAAP basis in the right-of-use asset
– Must recognize a deferred tax asset for the excess GAAP basis in the related lease liability
• Other tax considerations– State apportionment
• State definition of property
• Effect on rent expense
– Franchise/Net Worth taxes
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Balance Sheet Classification of
Deferred TaxesASU 2015-17, Simplifying the Balance Sheet Classification of Deferred Taxes
• New guidance requires all deferred tax assets and liabilities to be classified as noncurrent on the balance sheet
– Any related valuation allowances are also to be classified as noncurrent
– Netting of deferred tax assets and liabilities from different jurisdictions is still prohibited
• Effective Dates
– Effective after December 15, 2016 for public companies and after December 15, 2017 (interim periods in the following year) for private companies
– Earlier application is permitted for all entities as of the beginning of any interim or annual reporting period
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Balance Sheet Classification of
Deferred Taxes
ASU 2015-17, Simplifying the Balance Sheet
Classification of Deferred Taxes
• Adoption guidance
– New guidance may be applied prospectively or retrospectively
– Required disclosures for first interim and first annual period of
change:
• The nature and reason for the change in accounting principle
• Prospective change: a statement that prior periods were not
retrospectively adjusted
• Retrospective change: quantitative information about the effects of the
accounting change on prior periods
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Intra-entity transactions under ASC
740-10-25-3(e)The FASB decided the following regarding the exception to recognizing tax effects in intra-entity asset transfers:
• To eliminate the exception for all intra-entity transfers except for transfers of inventory
• The FASB decided not to provide specific guidance on the treatment of the tax effects of intra-entity transfers in the determination of interim tax provision (e.g., inclusion in the annual effective tax rate versus discrete reporting)
• The Board decided to issue a final standard with an effective date for annual periods beginning after December 15, 2017 for public companies and December 15, 2018 (one year later for interim) for private companies
• Early adoption will be permitted although the specifics of when early adoption may be available were unclear from the Board’s discussion
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Overview of Purchase Accounting –
Treatment of Goodwill and Other
Intangibles
John Monahan
December 8, 2016
ASC 740 – Basic Principles
• A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year (current provision).
• A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards (deferred provision).
• The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted law.
• The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized (valuation allowance).
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ASC 805
Business Combinations - Basics• Requires that all business combinations be recorded using the
“acquisition” method of accounting
• The acquisition method requires:– Identification of the acquirer
– Determination of the acquisition date
– Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, and
– Recognizing and measuring goodwill or a gain from a bargain purchase
• Determine the acquirer. Business combination is defined as– A transaction or “other event” in which an acquirer obtains control of one
or more businesses. (Control defined under ASC 810-10 requirements)
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ASC 805
Business Combinations - Basics• Determine the acquisition date
– Date on which the acquirer obtains control of the acquiree, usually on the date of the legal transfer of consideration (i.e., closing date)
– On the acquisition date, acquirer shall recognize and measure all consideration transferred (including equity consideration), assets acquired and liabilities assumed
• Recognize identifiable assets acquired and liabilities assumed– To qualify for recognition, identifiable assets and liabilities assumed
must meet the definitions under FASB Concepts Statement 6 (para 12)
– The recognition standard may cause the acquirer to recognize assets (i.e., brand names, etc.) that were not recorded by the acquirer
– Assets recognized using the measurement principle by looking to fair value as of the acquisition date. (ASC 805-20-30-1)
© 2016 Hein & Associates LLP.All rights reserved.
ASC 805
Business Combinations - Basics• Goodwill defined in ASC 805-10-20 as the excess of cost of:
– Consideration transferred as measured based on fair value, plus the fair value of non-controlling interests and the fair value of previously acquired equity interests, over
– The net of the acquisition date amounts of the identifiable assets acquired and liabilities assumed as measured under ASC 805 (fair value approach)
• ASC 805-30-25-2 requires that the acquirer recognize gain in earnings on the acquisition date to the extent of the measured bargain purchase– Total consideration is less than the fair market value of assets acquired
and liabilities assumed
– The term “Negative Goodwill” from old FAS 141 no longer applies
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ASC 805
Business Combination - Intangibles• Provides for the recognition of intangible assets,
apart from goodwill, where the intangible asset meets one of two criteria:– Recorded separately if it is either separable or transferable
(e.g., sold, rented, licensed, transferred or exchanged), or
– Recorded separately if it arises from contractual or other legal right (regardless of whether rights are separable or transferable)
• Identified Intangible – defined as an asset that lacks physical substance and specifically excludes goodwill
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ASC 805
Business Combination - Intangibles• Illustrative list of identifiable intangibles acquired:
– Marketing-related intangibles (trademarks, tradenames, trade dress, internet domain names, non-compete agreements)
– Customer-related intangibles (customer lists, customer contracts, noncontractual customer relationships, order backlog)
– Artistic-related intangibles (plays, movies, books, music, newspapers, photos, video)
– Contract-based intangibles (royalty agreements, supply contracts, employment agreements, broadcast rights)
– Technology-based intangibles (software, patents, databases, trade secrets, formulas)
© 2016 Hein & Associates LLP.All rights reserved.
ASC 805Business Combinations – Other Issues
• Noncontrolling Interest in Acquiree – acquirer shall measure a noncontrolling interest of an acquiree based on fair value at the acquisition date
• Contingent Consideration – acquirer shall include the fair value of contingent consideration as a component of the total consideration transferred at the acquisition
– Contingent consideration as ultimately settled may increase or decrease acquired goodwill or intangibles and thus impact deferreds
• Step Acquisition – acquirer shall recognize 100% of the assets and liabilities when “control” is acquired, with a gain or loss recorded to P&L for previously acquired interests
– Often results in a book gain of previously acquired interests if there were prior impairments
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ASC 805 and ASC 740Tax Accounting and Business Combinations
• In a business combination, the consideration transferred (i.e., cash, other assets, liabilities assumed, contingent consideration, equity interests) is considered the appropriate fair value of the enterprise.
• The acquiring entity shall assign the fair value to the assets acquired and liabilities assumed based on their estimated fair values, with any excess assigned to goodwill.
• Deferred taxes should be recognized on the acquisition date for the future tax consequences of the differences between the assigned values and tax bases of the assets acquired and liabilities assumed (ASC 805-740-25-3).
– The deferred tax adjustment ordinarily will increase or decrease acquired goodwill or intangible assets.
– Compute opening balance sheet deferred taxes based on the applicable tax rate for the jurisdiction that has the basis difference (U.S. federal/ U.S. State/ Foreign).
© 2016 Hein & Associates LLP.All rights reserved.
ASC 805 and ASC 740Tax Accounting and Business Combinations
• Acquiring entity shall account for the potential tax effects of temporary differences, carryforwards, and any income tax uncertainties of an acquiree that exist at the acquisition date or arise as a result of the acquisition.
– Acquiring entity shall not record deferred taxes for book goodwill in excess of tax deductible goodwill
– Deferred tax assets are recorded at the acquisition date for tax deductible goodwill that exceeds book goodwill
– Record deferred tax assets for acquired attributes (i.e., NOLs, general business credits, foreign tax credits, capital losses, etc.)
• ASC 805 maintains the basic concepts for recording deferred tax assets and liabilities related to all book/tax basis differences
© 2016 Hein & Associates LLP.All rights reserved.
ASC 805- Accounting for Income
Taxes in a Business Combination• ASC805/740 requires the recognition of a deferred tax
liability in the opening balance sheet for identified intangibles recorded for books that have no tax basis
• Occurs primarily in transactions involving tax-free reorganizations or the acquisition of the stock of a target corporation (no asset step-up for tax)
• ASC 805/740 requires the recognition of a deferred tax asset in the opening balance sheet for tax deductible goodwill or intangibles that have a smaller book basis
© 2016 Hein & Associates LLP.All rights reserved.
ASC 805- Accounting for Income
Taxes in a Business Combination
• Ex: Deferred Tax Liability recorded in purchase
accounting• The stock of Target, a consumer brand manufacturer, is acquired by Corporation X on
03/31/2013 for $1,500. Market-related and customer-related intangibles are identified
and recorded for book purposes in the amount of $600. Assume no section 338
election, a 40% effective tax rate, and $0 tax basis in the intangibles held by Target.
© 2016 Hein & Associates LLP.All rights reserved.
ASC 805-740-25-3 Book Tax Difference DTL
Identified Intangibles 600$ -$ 600$
Tax Rate 40% 240$
Journal Entry:
Dr. Goodwill 240$
Cr. Deferred Tax Liability 240$
ASC 805- Accounting for Income Taxes
in a Business Combination
• Ex: Deferred Tax Asset recorded in purchase
accounting• The stock of Target, a consumer brand manufacturer is acquired by Corporation Y on
03/31/2013 for $950. Market-related and customer-related intangibles are identified
and recorded for book purposes in the amount of $300. Assume no section 338
election, a 40% effective tax rate and historic tax basis of intangibles held by Target
from prior acquisition of $500.
© 2016 Hein & Associates LLP.All rights reserved.
ASC 805-740-25-3 Book Tax Difference DTA
Identified Intangibles 300$ 500$ 200$
Tax Rate 40% 80$
Journal Entry:
Dr. Deferred Tax Asset 80$
Cr. Goodwill 80$
ASC 350 – Goodwill and Intangible
Assets • Excess of purchase price over the value of identified tangible
and intangible assets is treated as goodwill
• Goodwill will not be amortized for book purposes (exception provided for private companies who can elect to amortize)
• Goodwill is tested for impairment at least annually for amounts recorded in the “reporting units.” Generally, look to segments as defined under ASC 280 to determine the “reporting unit”
• Goodwill impairment loss is recorded as a component of income from operations (i.e., pre-tax income) or to discontinued operations if the business unit is sold
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ASC 350 – Goodwill and
Intangibles• Intangible assets identified under ASC 805 –
determine the useful life of the intangible asset:
– Intangibles with an indefinite useful life – no amortization
– Intangibles with a useful life – amortize over the useful life
– Amortize based on residual value of intangible with an useful life
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Illustration of How Recognition of Tax Benefits
on Acquisition Date Affect Deferred Taxes
• Company A, newly formed HoCo, acquires 100% of Company B stock in a
taxable purchase on 01/01/2016 for $600,000 plus assumed liabilities.
Company B has an NOL carryforward of $10,000 with fair value and tax
basis information as follows:
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FAIR VALUE TAX BASIS
TEMPORARY
DIFFERENCE
DEFERRED TAX
LIABILITY/(ASSET)
ACCOUNTS RECEIVABLE 70,000$ 75,000$ (5,000)$ (1,750)$
INVENTORY 90,000$ 80,000$ 10,000$ 3,500$
FIXED ASSETS 200,000$ 100,000$ 100,000$ 35,000$
INTANGIBLE ASSETS 100,000$ 50,000$ 50,000$ 17,500$
ACCOUNTS PAYABLE 35,000$ 35,000$ -$ -$
LONG-TERM DEBT 185,000$ 180,000$ (5,000)$ (1,750)$
TENTATIVE DEFERRED TAX LIABILITY 52,500$
NOL CARRYFORWARD (3,500)$
NET DEFERRED TAX LIABILITY 49,000$
Note: the NOL carryforward is a future deductible amount and decreases the deferred tax liability
otherwise recognized. Assumes a 35% tax rate.
Company A – Opening Balance
Sheet
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Accounts Receivable 70,000
Inventory 90,000
Fixed Assets 200,000
Intangible Assets 100,000
Deferred Tax Asset 7,000
Goodwill 409,000
Total Assets 876,000$
Accounts Payable 35,000
Deferred Tax Liability 56,000
Long Term Debt 185,000
Equity 600,000
Total Liabilities and Equity 876,000$
Accounting for Tax Deductible
Goodwill• ASC 740 and ASC 805 provide an exception to
comprehensive recognition of deferred taxes for nondeductible goodwill
• Prior to enactment of IRC Section 197, in August 1993, acquired goodwill was never tax deductible– Accordingly goodwill amortization for financial reporting
was a “permanent difference”
• IRC Section 197 permits companies to deduct acquired goodwill over a 15-year period– Applies only to asset acquisitions and stock acquisitions in
which a Section 338 election is made
© 2016 Hein & Associates LLP.All rights reserved.
Tax Deductible Goodwill
• Accounting rules are complex (ASC 805-740-25-8)
– First, divide goodwill into two components:• Component 1 = Financial reporting goodwill equal to tax
goodwill– Generally will create a deferred tax liability in subsequent reporting
periods when tax benefits are realized for tax deductible goodwill
• Component 2 = Financial reporting goodwill in excess of tax goodwill or tax goodwill in excess of book goodwill
– Existing rules apply to excess book goodwill (i.e., no deferred tax recorded for book goodwill in excess of tax goodwill)
– Goodwill impairment charge for financial reporting treated as a “permanent difference”
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Tax Deductible Goodwill
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Illustration of Excess Financial
Reporting Goodwill• Assumptions:
– Company A acquires Company B in an asset acquisition
– The carrying and fair values of Target’s assets and liabilities (for both financial
reporting and tax purposes) are as follows:
© 2016 Hein & Associates LLP.All rights reserved.
HISTORIC
BOOK VALUE
BOOK FAIR
VALUE TAX BASIS TAX FAIR VALUE
ACCOUNTS RECEIVABLE 70,000$ 70,000$ 75,000$ 70,000$
INVENTORY 80,000$ 90,000$ 80,000$ 90,000$
FIXED ASSETS 100,000$ 200,000$ 100,000$ 200,000$
ACCOUNTS PAYABLE (35,000)$ (35,000)$ (35,000)$ (35,000)$
ACCRUED LIABILITIES (180,000)$ (185,000)$ (180,000)$ (180,000)$
NET WORTH 35,000$ 140,000$ 40,000$ 145,000$
Assumed Tax Rate: 35%
The difference in fair values between financial reporting and tax relates to certain liabilities that are
recognized for financial reporting but not for income tax purposes (e.g., OPEB liabilities, restructuring
costs, etc.)
The purchase price and tax rates are as follows:
Purchase price: $500,000 plus assumed liabilities
Illustration of Excess Financial
Reporting Goodwill
• The calculation of goodwill is as follows:
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BOOK TAX
PURCHASE PRICE 720,000$ 715,000$
FAIR VALUE OF NET ASSETS (360,000)$ (360,000)$
GOODWILL 360,000$ 355,000$
LESS: TAX DEDUCTIBLE AMOUNT 355,000$
EXCESS BOOK GOODWILL 5,000$
Component 2 goodwill (excess book goodwill over tax goodwill) of
$5,000 represents a "permanent difference"
Consider the impact of opening balance sheet DTA/DTL when
measuring component 1 and component 2 goodwill
Component 1 goodwill equal to $355,000
Illustration of Excess Financial
Reporting Goodwill
• The calculation of deferred taxes is as
follows:
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CARRYING
VALUE TAX BASIS TEMPORARY
DEFERRED TAX
(ASSET)/
LIABILITY
ACCOUNTS RECEIVABLE 70,000$ 70,000$ -$ -$
INVENTORY 90,000$ 90,000$ -$ -$
FIXED ASSETS 200,000$ 200,000$ -$ -$
TOTAL LIABILITIES 220,000$ 215,000$ (5,000)$ (1,750)$
TOTAL DEFERRED ASSETS (1,750)$ ADJUSTED EXCESS FINANCIAL
REPORTING GOODWILL 3,250$
Component 2 goodwill (excess of book goodwill over tax goodwill) is thus reduced from $5,000 to
$3,250
Tax Deductible Goodwill
• Tax deductible goodwill in excess of financial reporting goodwill– Under ASC 805, a deferred tax asset is created at the acquisition
date for tax goodwill that exceeds book goodwill (Component 2)
– The iterative process resulting from the deferred tax asset requires an adjustment to book goodwill in the opening balance sheet
– Formula to measure the DTA for excess tax goodwill;• Tax Rate / (1 – Tax Rate) x Preliminary Temp Diff = DTA
– Keep in mind that transaction costs are not considered a portion of the Component 2 tax deductible goodwill to measure the required deferred tax asset
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ASC 350 – Accounting for Income Taxes
for Goodwill and Intangible Assets
• Unusual results of ASC 805/350 and ASC 740:
– Since goodwill is not amortized for book purposes, tax deductions for goodwill create deferred tax liabilities over time
– Tax deductions for long-lived intangible assets acquired (no book amortization) create deferred tax liabilities over time
– Deferred tax liabilities recorded due to acquired intangibles that have zero or low tax basis may substantially increase book goodwill. Impairment issues may be magnified for post-deal impairment testing.
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ASC 350 – Accounting for Income Taxes
for Goodwill and Intangible Assets
• Unusual results of ASC 805/350 and ASC 740 (cont.):
– Deferred tax liabilities recorded for acquired long-lived intangibles in the opening balance sheet may not be viewed as a source of future taxable income for purposes of measuring valuation allowances (e.g.,“naked credits”)
– Tax benefits are not recognized to tax expense (P&L) in post-acquisition periods for the use of acquired NOLs or the tax benefits form tax deductible goodwill amortization
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Goodwill Impairment
• When goodwill is subsequently impaired for book purposes the deferred tax impact will be as follows:– If no tax-deductible goodwill exists, no deferred tax implications
arise
– If tax-deductible goodwill exists, and book goodwill exceeds tax goodwill, the impairment must be allocated pro rata to the two components of book goodwill to determine the deferred tax effect
• The impairment is allocated pro rata to the two components based on the book carrying amounts
– If tax-deductible goodwill exceeds book goodwill, no allocation is necessary and the impairment will increase the DTA or reduce the DTL
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Goodwill Impairment – An Example
• Assumptions:
– Goodwill for reporting unit X suffers and impairment loss of $400 four years after
the acquisition data
– Tax related goodwill is deductible over 15 years
– Applicable tax rate of 40%
© 2016 Hein & Associates LLP.All rights reserved.
COMPONENT
1 GOODWILL
COMPONENET
2 GOODWILL BOOK BASIS TAX BASIS
DEFERRED
TAXES
BALANCE AT ACQUISITION DATE 900$ 300$ 1,200$ 900$ -$
TAX AMORTIZATION -$ -$ -$ (240)$ (96)$
BALANCE BEFORE IMPAIRMENT TEST 900$ 300$ 1,200$ 660$ (96)$
IMPAIRMENT LOSS (300)$ (100)$ (400)$ -$ 120$
ENDING BALANCE 600$ 200$ 800$ 660$ 24$
$300 of the impairment loss represents a "temporary difference"
$100 of the impairment loss represents a "permanent difference"
Basic Asset vs. Stock Acquisition
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Section 338 Elections
• IRC 338 provides that if elected, a stock deal is treated as an asset deal for federal income tax purposes
• For all other purposes (i.e., legal, GAAP, regulatory), the transaction is a stock deal
• IRC 338(h)(10) election is generally available only for the sale of a subsidiary out of a U.S. consolidated tax group or an S corporation
– Sellers are generally subject to only one level of tax (versus two in the typical asset sale), but incremental taxes may still be incurred
– Requires a joint election to be filed between Buyer and Seller, among other statutory requirements (e.g., corporate purchaser, QSP, etc.)
• IRC 338(g) election is a unilateral election that may be filed by a corporate purchaser, which is often utilized in connection with foreign acquisitions
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Section 338(h)(10) Elections
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GAAP & Tax Accounting Differences
Domestic Stock vs. Asset Deal
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GAAP & Tax Accounting Differences
Domestic Stock vs. Asset Deal
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Identifying Acquired Tax Benefits
• Realization test for acquired tax benefits– An acquirer should consider the tax attributes and future taxable
income of the combined business when assessing whether acquired deferred tax assets are realizable.
– Deductible differences or carryforwards of the acquiree can be realized because the acquirer has sufficient taxable temporary differences that will generate future taxable income
• These new sources of future taxable income from the perspective of the combined business may make it possible to recognize deferred tax assets for the combined business at the date of acquisition.
• However, depending on the specific tax jurisdiction, there may be various limitations on the use of acquired tax benefits (Ex. Section 382 limitation).
• Any resulting DTA would be recorded through acquisition accounting
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Identifying Acquired Tax Benefits
• Realization test for acquired tax benefits
– Combined tax attributes or income may also
provide evidence as to the realizability of the
acquirer’s own deferred tax assets at the date of
acquisition.
– However, changes in the assessment of
realizability of the acquiring company’s deferred
tax assets are not included in acquisition
accounting
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Identifying Acquired Tax Benefits
• Changes to the acquired deferred tax assets after the business combination– The release of a valuation allowance that does not qualify as a
measurement period adjustment is reflected in income tax expense
– The release of a valuation allowance within the measurement period resulting from new information about facts and circumstances that existed at the acquisition date is reflected first as an adjustment to goodwill, then as a bargain purchase
– Changes resulting from discrete events or circumstances that arise within the measurement period and did not exist at the acquisition date generally would not be recorded in acquisition accounting
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Identifying Acquired Tax Benefits
• Changes in the acquirer’s deferred tax balances related to acquisition accounting– The impact on the acquiring company’s deferred tax
assets and liabilities caused by an acquisition is recorded in the acquiring company’s financial statements outside of acquisition accounting.
– Such impact is not a part of the fair value of the assets acquired and liabilities assumed.
– For example, for a company using a composite state tax rate, the expected post-combination results of the company may cause a change in the tax rate expected to be applicable when the deferred tax assets and liabilities reverse.
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Business Combinations – Tax
Uncertainties
• Recording tax uncertainties– In a taxable business combination, positions may be taken
in allocating the acquisition price and in filing subsequent tax returns, which are expected to be challenged by the taxing authority
– In nontaxable business combinations there may be uncertainties about the tax basis of individual assets or the pre-acquisition tax returns of the acquired business.
– Same recognition and measurement criteria with corresponding fair value of liability recorded to goodwill
• Treatment of indemnified items
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Business Combinations – Tax
Uncertainties
• Subsequent resolution of tax uncertainties in a business combination– Adjustments to uncertain tax positions made subsequent
to the acquisition date are recognized in earnings, unless they qualify as measurement period adjustments.
– Measurement period adjustments are recorded first as an adjustment to goodwill, then as a bargain purchase.
– Need to evaluate whether an adjustment within the measurement period relates to circumstances that were included in the acquirer’s assessment at the date of the acquisition
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ASC 805 Business Combinations –
Acquisition Costs
• Acquirer Acquisition Costs – acquirer shall not include acquisition costs (professional fees, IB fees, registrations costs, etc.) as part of the consideration transferred– Acquirer shall record transaction costs as an expense in
measuring pre-tax income from operations
– Potential for permanent differences for stock acquisitions
– Potential for uncertain tax positions for transaction costs treated as a current section 162(a) ordinary and necessary business expense
– Look to Treas. Reg. 1.263(a)-5 to determine what portion of transaction costs may be deductible for income tax purposes
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General Background – Treas. Reg.
§1.263(a)-5• A taxpayer must capitalize amounts paid to facilitate the
following transactions:– Acquisition of assets that constitute a trade or business
– Acquisition where the two parties are related within the meaning of §267(b) or 707(b) immediately after the transaction
– Acquisition of an ownership interest of the taxpayer (other than an acquisition by the taxpayer)
– Restructuring, recapitalization, or reorganization of the capital structure
– Transfers as described in §§351 or 721
– Formation of organization of a disregarded entity
– Acquisition of capital
– Borrowing
– Writing an option
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General Background (continued)
• Covered transactions include:
– A taxable acquisition by the taxpayer of assets that constitute a trade or business
– A taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of the Sections 267(b) or 707(b)
– A reorganization described in Section 368(a)(1)(A), or © or a reorganization described in Section 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under Section 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization).
© 2016 Hein & Associates LLP.All rights reserved.
General Background (continued)
• Bright-line test for certain acquisitive transactions-
– Capitalize any inherently facilitative amount
– Capitalize any amount related to activities performed after the earlier of:
• The date on which a letter of intent or exclusivity agreement is executed by representatives of the acquirer and the target; or
• The date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors.
– Comment: A letter of intent or exclusivity agreement could pre-date board approval by months while the due diligence is underway
© 2016 Hein & Associates LLP.All rights reserved.
General Background (continued)
• Documentation of success-based fees:– Regulations provide that the following documentation
requirements must be met:• Identify activities provided by the service provider
• The amount of fee (or percentage of time) allocable to each activity
• The amount of fee (or percentage of time) allocable to the performance of activities before and after the decision date
• Name, address and phone number of the service provider
– Historically, area of controversy with IRS-exam agents want detailed timesheets
– Documentation must be completed on or before due date of tax return (incl. extensions) for year during which transaction closes
© 2016 Hein & Associates LLP.All rights reserved.
General Background (continued)
• Documentation of success-based fees – safe harbor election
• Rev. Proc. 2011-29
– Creates a safe-harbor election for taxpayers seeking to allocate success-based fees between facilitative and non-facilitative amounts
– In lieu of requiring documentation specified under regulations, safe harbor allows use of a simplified, percentage-based allocation
– Elect to treat 70% of all success-based fees incurred as non-facilitative and remaining 30% is considered facilitative and must be capitalized
– Statement required in originally filed return
© 2016 Hein & Associates LLP.All rights reserved.
Recovery of Previously Capitalized
Costs• Professional fees incurred by target corporation provide a long-term
future benefit in the form of synergistic and resource benefits that are indefinite in nature and therefore must be capitalized
– Generally capitalized into a floating intangible
• In INDOPCO, the Supreme Court observed that capitalized costs could later be recovered by amortization or depreciation deductions over the life of the asset, or “where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise.”
• What event might allow for capitalized transaction costs to be recovered?
– Termination of relationship giving rise to the benefits (i.e., sale of the company, IPO, etc.) may be an identifiable event
– Losses must be evidenced by a “closed and completed transaction” that is fixed by “identifiable events” – Treas. Reg. Sec. 1.165-1(b)
© 2016 Hein & Associates LLP.All rights reserved.
Contact Information
© 2015 Hein & Associates LLP.All rights reserved.
John Monahan
Tax Partner
(303) 226-7013
Tax Accounting for Equity
Compensation
Brian Parmelee
December 8, 2016
Agenda
• Introduction
• Overview – ASC 718
• Specific Equity Arrangements –
Accounting Treatment
• Specific Equity Arrangements – Income
Tax Treatment
© 2016 Hein & Associates LLP.All rights reserved.
Introduction – ASC 718, Stock
Compensation
• Establishes deferred tax asset on cumulative book expense which is expected to result in future tax benefit
• Reverse deferred tax asset as award is settled for income tax purpose
• Complex and Audit risk
– Many granting jurisdictions
– Many types of awards, large amount of awards, and many grant dates
– Tax rules
© 2015 Hein & Associates LLP.All rights reserved.
Recognition of Compensation Cost
• Compensation cost recognized for
financial statement purposes under one of
two methods:
– Equity classified
– Liability classified
© 2016 Hein & Associates LLP.All rights reserved.
Equity Classified Method
• Fair value of equity award determined at grant date– Options/Stock appreciation rights – Black-Scholes or
binomial model
– Restricted stock/ Restricted stock unit– fair market value of stock
• Recognize compensation cost over requisite service period (generally vesting period)– Debit to compensation cost
– Credit to additional paid in capital
• Settlement– Forfeiture
– Expiration
– Exercise
© 2016 Hein & Associates LLP.All rights reserved.
Liability Classified Method
• Fair value of equity award determined at grant date
• Fair value remeasured at end of each reporting period until award settled
• True-up compensation cost for changes in fair value pro-rated for portion of requisite service period rendered
• After end of requisite service period, recognize change in compensation cost based on change in fair value
• Liability account credited instead of APIC
• Financial statement and tax compensation cost the same
© 2016 Hein & Associates LLP.All rights reserved.
Income Tax Deduction
• Tax deduction recorded when settlement
occurs
– Nonqualified stock options – exercise date
– Incentive stock options – date of disqualifying
disposition
– Stock appreciation rights – exercise
– Restricted stock – vesting date
– Restricted stock units – date stock is
transferred
© 2016 Hein & Associates LLP.All rights reserved.
Reconciling Timing Difference
• Use principles of ASC 740
• Grant date and requisite service period– Recognize deferred tax asset (DTA) as book
compensation cost recorded for awards expected to provide future tax deduction
• No DTA for incentive stock options
• No DTA for employee stock purchase plans
– Deferred tax benefit recorded in income statement based on book compensation cost for the reporting period
– Deferred tax liability (DTL) recorded when tax deduction occurs prior to recognizing book compensation cost (Section 83(b) election made)
© 2016 Hein & Associates LLP.All rights reserved.
Reconciling Timing Difference
• Tax Settlement– Deferred tax asset reversed with off setting entry to deferred tax
benefit
– Difference between deferred tax asset and actual tax benefit results in a “windfall” or “shortfall”
– Current rules:• Windfalls add to APIC pool and shortfalls reduce APIC pool, if any
• Excess shortfalls recorded as additional tax expense in current period
• May only recognize windfall benefit if there is a reduction in taxes payable
– New rules:• Windfalls and shortfalls recognized in income statement in period
realized
• Discrete item
• Effective for periods beginning after December 15, 2016
• May adopt earlier
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Options
• No DTA Recorded
• Tax benefit recorded only if there is a disqualifying disposition– Windfalls reflected in period of disqualifying
disposition
– No shortfall recorded
• $100,000 limitation– ISOs exceeding $100,000 annual limitation
(determined at date of grant) treated as nonqualified stock options
– Accelerating future vesting may cause ISOs to be treated as nonqualified stock options resulting in the need to establish DTA at that time
© 2016 Hein & Associates LLP.All rights reserved.
Income Tax Limitations – Section
162(M)• Applies only to publicly held corporations
• Limitation does not apply to performance-based compensation
• Methodologies for allocating limitation:– Equity first – DTA established on equity compensation up
to $1Million limitation before other compensation taken into account
– Salary first – DTA established on equity compensation only if available limit exists after taking into account cash compensation
– Pro Rata – Allocate $1Million to all compensation
• Future change in cash compensation could result in reduction to DTA and increase to tax expense
© 2016 Hein & Associates LLP.All rights reserved.
Modification of Awards
• Exchange of original award for a new award
• Additional compensation cost if fair value of new award greater than fair value of original award
• Record additional DTA if necessary on vested awards
• If there is a modification that causes equity classified award to become a liability classified award, DTA needs to be adjusted
• If modification to ISO results in loss of ISO status, then establish DTA as of modification date
© 2016 Hein & Associates LLP.All rights reserved.
Pool of Windfall Tax Benefits- Prior
to 2017
• Pool of realized windfall tax benefits available to offset shortfalls
• Hypothetical account in APIC
• Windfalls recorded only when associated tax deduction reduces taxes payable
• Reduce APIC pool by shortfalls but not below zero
• No tax benefit recorded if excess tax deduction part of net operating loss carryforward
• Business combinations may result in allocation of APIC pool
© 2016 Hein & Associates LLP.All rights reserved.
Windfall/ Shortfall Tax Benefits –
After 2016
• Windfalls and Shortfalls Reflected in income statement at the time award is settled for tax purposes
• No more APIC pool
• Included in net operating loss DTA, may need a valuation allowance on the NOL
• Effective for public business entities for annual reporting period beginning after December 15, 2016 and interim periods included in such period (other business entities 12 months later) –although early adoption is permitted
© 2016 Hein & Associates LLP.All rights reserved.
Business Combination
• Exchange of target awards for acquiring company awards
• Record DTA on Acquisition date for pre-combination portion of the fair value of vested awards acquirer is obligated to replace
• Fair value of replaced unvested awards expensed over requisite service period
• Fair value of awards acquirer not obligated to replace are expensed post-combination
• Windfalls and shortfalls recorded at time replacement awards settled
© 2016 Hein & Associates LLP.All rights reserved.
Business Combination - Example
© 2016 Hein & Associates LLP.All rights reserved.
Exercise Price 10.00$
FMV of stock on acquisition date 30.00$
FMV of option on acquisition date (Black-Scholes) 21.00$
Outstanding options exchanged 10,000,000
Fair value of options exchanged ($21 x 10,000,000) 210,000,000$
Deferred tax asset established at acquisition (40% tax rate) 84,000,000$
Total deemed consideration paid for stock options 294,000,000$
Actual tax benefit (exercise at $35 FMV -40% tax rate) 100,000,000$
Excess tax benefit ($100,000,000 - $84,000,000) 16,000,000$
Actual tax benefit (Exercise price $25 FMV - 40% tax rate) 60,000,000$
Deficit tax benefits (60,000,000 - $84,000,000) (24,000,000)$
Specific Equity Arrangements –
Accounting Treatment
© 2016 Hein & Associates LLP.All rights reserved.
Nonqualified Stock Option – Equity
ClassifiedEvent Action
Grant Date • Measure fair value of option (Black-Scholes, binomial model)
During Requisite Service Period
• Recognize Compensation cost and related DTA on options that vest and for which future tax deduction is expected
• Reverse entry for options forfeited• Reflect changes in tax rates• Record valuation allowance
Settlement Date, (exercise, cancel, lapse)
• Reverse prior tax entry and reconcile DTA• If tax deduction exceeds cumulative book expense, additional tax
benefit is a windfall• If tax deduction is less than cumulative book expense, a shortfall
occurs
© 2016 Hein & Associates LLP.All rights reserved.
Nonqualified Stock Option – Equity
Classified – Windfall ExampleFacts
• 10,000 options granted at $10• Fair value is $3 per option• One year vesting and all options vest
• Exercise when stock value is $25• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $30,000Cr. APIC $30,000
Dr. Deferred Tax Asset $12,000Cr. Deferred Tax Benefit $12,000
• Recognize compensation expense (10,000 x $3)
• Recognize deferred tax asset ($30,000 x 40%)
Exercise
Dr. Deferred Tax Benefit $12,000 Cr. Deferred Tax Asset $12,000
Dr. Current Taxes Payable $60,000 Cr. Current Tax Benefit $12,000Cr. APIC $48,000
• Reverse prior tax entry
• Calculate tax deduction/benefit (10,000 x $15 x 40%) and windfall ($60,000 -$12,000)
© 2016 Hein & Associates LLP.All rights reserved.
Nonqualified Stock Option – Equity
Classified – Shortfall ExampleFacts
• 10,000 options granted at $10• Fair value is $3 per option• One year vesting and all options vest
• Exercise when stock value is $12• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $30,000Cr. APIC $30,000
Dr. Deferred Tax Asset $12,000Cr. Deferred Tax Benefit $12,000
• Recognize compensation expense (10,000 x $3)
• Recognize deferred tax asset ($30,000 x 40%)
Exercise
Dr. Deferred Tax Benefit $12,000 Cr. Deferred Tax Asset $12,000
Dr. Current Taxes Payable $8,000 Dr. APIC or Current Tax Benefit $4,000
Cr. Current Tax Benefit $12,000
• Reverse prior tax entry
• Calculate tax deduction/benefit (10,000 x $2 x 40%) and shortfall ($8,000 -$12,000)
© 2016 Hein & Associates LLP.All rights reserved.
Stock Appreciation Right – Equity
ClassifiedEvent Action
Grant Date • Measure fair value of SAR (Black-Scholes, binomial model)
During Requisite Service Period
• Recognize Compensation cost and related DTA on SARs that vest and for which future tax deduction is expected
• Reverse entry for SARs forfeited• Reflect changes in tax rates• Record valuation allowance
Settlement Date, (exercise, cancel, lapse)
• Reverse prior tax entry and reconcile DTA• If tax deduction exceeds cumulative book expense, additional tax
benefit is a windfall• If tax deduction is less than cumulative book expense, a shortfall
occurs
© 2016 Hein & Associates LLP.All rights reserved.
Stock Appreciation Right– Equity
Classified – Windfall ExampleFacts
• 10,000 SARs granted at $10• Fair value is $3 per SAR• One year vesting and all SARs vest
• Exercise when stock value is $25• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $30,000Cr. APIC $30,000
Dr. Deferred Tax Asset $12,000Cr. Deferred Tax Benefit $12,000
• Recognize compensation expense (10,000 x $3)
• Recognize deferred tax asset ($30,000 x 40%)
Exercise
Dr. Deferred Tax Benefit $12,000 Cr. Deferred Tax Asset $12,000
Dr. Current Taxes Payable $60,000 Cr. Current Tax Benefit $12,000Cr. APIC $48,000
• Reverse prior tax entry
• Calculate tax deduction/benefit (10,000 x $15 x 40%) and windfall ($60,000 -$12,000)
© 2016 Hein & Associates LLP.All rights reserved.
Stock Appreciation Right– Equity
Classified – Shortfall ExampleFacts
• 10,000 options granted at $10• Fair value is $3 per SAR• One year vesting and all SARs vest
• Exercise when stock value is $12• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $30,000Cr. APIC $30,000
Dr. Deferred Tax Asset $12,000Cr. Deferred Tax Benefit $12,000
• Recognize compensation expense (10,000 x $3)
• Recognize deferred tax asset ($30,000 x 40%)
Exercise
Dr. Deferred Tax Benefit $12,000 Cr. Deferred Tax Asset $12,000
Dr. Current Taxes Payable $8,000 Dr. APIC or Current Tax Benefit $4,000
Cr. Current Tax Benefit $12,000
• Reverse prior tax entry
• Calculate tax deduction/benefit (10,000 x $2 x 40%) and shortfall ($8,000 -$12,000)
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option– Equity
Classified- Qualifying DispositionEvent Action
Grant Date • Measure fair value of Option (Black-Scholes, binomial model)
During Requisite Service Period
• Recognize Compensation cost (no related DTA recorded) on options that vest
• Reverse entry for options forfeited• Reflect changes in tax rates
Settlement Date, (exercise, cancel, lapse)
• No impact
Qualifying Disposition –Dispose after 1-year and 2-year Holding Periods
• No Impact
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option- Equity
Classified- Qualifying Disposition
Facts
• 10,000 ISOs granted at $10• Fair value is $3 per option• One year vesting and all ISOs vest
• Exercise when stock value is $25• Qualifying disposition at $30• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $30,000Cr. APIC $30,000
• Recognize compensation expense (10,000 x $3)
Exercise
• No tax entry
Disposition
• No tax entry
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option – Equity
Classified-Disqualifying DispositionEvent Action
Grant Date • Measure fair value of Option (Black-Scholes, binomial model)
During Requisite Service Period
• Recognize Compensation cost (no related DTA recorded) on options that vest
• Reverse entry for options forfeited• Reflect changes in tax rates
Settlement Date,(exercise, cancel, lapse)
• No impact
DisqualifyingDisposition –Dispose within 1-year and 2-year Holding Periods
• Record income tax benefit of compensation cost• If tax deduction greater than cumulative book compensation cost,
then tax benefit associated with excess tax deduction treated as a windfall
• If tax deduction less than cumulative book compensation cost, then credit to income tax expense limited to actual tax benefit
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option - Equity Classified-
Disqualifying Disposition (Windfall)
Facts
• 10,000 ISOs granted at $10• Fair value is $3 per Option• One year vesting and all ISOs vest
• Exercise when stock value is $25• Disqualifying disposition at $30• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $30,000Cr. APIC $30,000
• Recognize compensation expense (10,000 x $3)
Exercise
• No tax entry
Disposition
Dr. Current Taxes Payable $60,000Cr. Current Tax Benefit $12,000 Cr. APIC $48,000
• Calculate tax deduction/benefit (10,000 x ($25 - $10) x 40% and windfall ($60,000 -$12,000)
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option- Equity Classified-
Disqualifying Disposition (No Windfall)
Facts
• 10,000 ISOs granted at $10• Fair value is $3 per Option• One year vesting and all ISOs vest
• Exercise when stock value is $25• Disqualifying disposition at $12• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $30,000Cr. APIC $30,000
• Recognize compensation expense (10,000 x $3)
Exercise
• No tax entry
Disposition
Dr. Current Taxes Payable $8,000Cr. Current Tax Benefit $8,000
• Calculate tax deduction/benefit (10,000 x ($12 - $10) x 40% - no windfall or shortfall
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock – Equity Classified
– No Section 83(b) ElectionEvent Action
Grant Date • Measure fair value of stock
During Requisite Service Period
• Recognize Compensation cost and related DTA shares that vest and are expected to result in future tax deduction
• Reverse entry for restricted stock forfeited• Reflect changes in tax rates• Record valuation allowance
Vesting Date • Reverse DTA• If tax deduction is greater than cumulative book compensation
cost, additional tax benefit is a windfall• If tax deduction less than cumulative book compensation cost, a
shortfall occurs
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock – Equity Classified – No
Section 83(b) Election With Windfall
Facts
• 10,000 restricted stock granted• Fair value of stock is $10• One year vesting and all shares vest
• Fair value of stock is $25 at vesting• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $100,000Cr. APIC $100,000
Dr. Deferred Tax Asset $40,000Cr. Deferred Tax Benefit $40,000
• Recognize compensation expense (10,000 x $10)
• Recognize deferred tax asset ($100,000 x 40%)
Vesting
Dr. Deferred Tax Benefit $40,000Cr. Deferred Tax Asset $40,000
Dr. Current Taxes Payable $100,000Cr. Current Tax Benefit $40,000 Cr. APIC $60,000
• Reverse prior tax entry
• Calculate tax deduction/ benefit (10,000 x $25 x 40%) and windfall ($100,000 -$40,000)
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock – Equity Classified – No
Section 83(b) Election With Shortfall
Facts
• 10,000 restricted stock granted• Fair value of stock is $10• One year vesting and all shares vest
• Fair value of stock is $8 at vesting• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $100,000Cr. APIC $100,000
Dr. Deferred Tax Asset $40,000Cr. Deferred Tax Benefit $40,000
• Recognize compensation expense (10,000 x $10)
• Recognize deferred tax asset ($100,000 x 40%)
Vesting
Dr. Deferred Tax Benefit $40,000Cr. Deferred Tax Asset $40,000
Dr. Current Taxes Payable $32,000Dr. APIC or Current Tax Benefit $8,000
Cr. Current Tax Benefit $40,000
• Reverse prior tax entry
• Calculate tax deduction/ benefit (10,000 x $8 x 40%) and shortfall ($32,000 - $40,000)
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock – Equity Classified
– Section 83(b) ElectionEvent Action
Grant Date • Measure fair value of stock• Record DTL with respect to income tax deduction
During Requisite Service Period
• Recognize Compensation cost• Reflect book tax benefit as a debit to DTL
Vesting Date • No further adjustment• No windfall or shortfall as book and tax deductions are the same
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock – Equity Classified –
Section 83(b) Election
Facts
• 10,000 restricted stock granted• Fair value of stock is $10• One year vesting and all shares vest
• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Current Taxes Payable $40,000Cr. Current Tax Benefit $40,000
Dr. Deferred Tax Benefit $40,000Cr. Deferred Tax Liability $40,000
Dr. Compensation Cost $100,000Cr. APIC $100,000
Dr. Deferred Tax Liability $40,000Cr. Deferred Tax Benefit $40,000
• Recognize tax benefit of tax deduction (10,000 x $10 x 40%)
• Recognize Compensation Expense (10,000 x $10)
• Write down of deferred tax liability recorded ($100,000 x 40%)
Vesting
No Tax Entry
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock Unit – Equity
ClassifiedEvent Action
Grant Date • Measure fair value of stock
During Requisite Service Period
• Recognize Compensation cost and related DTA on shares that vest and expected to result in future tax deduction
• Reverse entry for restricted stock units forfeited• Reflect changes in tax rates• Record valuation allowance
Vesting Date • No impact
Transfer Date • Reverse DTA• If tax deduction greater than cumulative book compensation
cost, additional tax benefit is a windfall• If tax deduction less than cumulative book compensation cost, a
shortfall occurs
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock Unit – Equity Classified –
Windfall
Facts
• 10,000 restricted stock units granted• Fair value of stock is $10• One year vesting and all shares vest
• Fair value of stock is $25 at vesting• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $100,000Cr. APIC $100,000
Dr. Deferred Tax Asset $40,000Cr. Deferred Tax Benefit $40,000
• Recognize Compensation Expense (10,000 x $10)
• Recognize deferred tax asset ($100,000 x 40%)
Vesting
Dr. Deferred Tax Benefit $40,000Cr. Deferred Tax Asset $40,000
Dr. Current Taxes Payable $100,000Cr. Current Tax Benefit $40,000 Cr. APIC $60,000
• Reverse prior tax entry
• Calculate tax deduction/benefit (10,000 x $25 x 40%) and windfall ($100,000 -$40,000)
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock Unit – Equity Classified –
Shortfall
Facts
• 10,000 restricted stock units granted• Fair value of stock is $10• One year vesting and all shares vest
• Fair value of stock is $8 at vesting• Combined tax rate of 40%
Recognition of expense and DTA
Dr. Compensation Cost $100,000Cr. APIC $100,000
Dr. Deferred Tax Asset $40,000Cr. Deferred Tax Benefit $40,000
• Recognize Compensation Expense (10,000 x $10)
• Recognize deferred tax asset ($100,000 x 40%)
Vesting
Dr. Deferred Tax Benefit $40,000Cr. Deferred Tax Asset $40,000
Dr. Current Taxes Payable $32,000Dr. APIC or Current Tax Benefit $8,000
Cr. Current Tax Benefit $40,000
• Reverse prior tax entry
• Calculate tax deduction/benefit (10,000 x $8 x 40%) and shortfall ($32,000 - $40,000)
© 2016 Hein & Associates LLP.All rights reserved.
Specific Equity Arrangements –
Income Tax Treatment
© 2016 Hein & Associates LLP.All rights reserved.
Nonqualified Stock Option
• Generally, exercise price equal to or greater than FMV as of date of grant to avoid deferred compensation rules under section 409A and deduction limit under section 162(m)
• Shareholder approval not required other than for section 162(m) purposes
• Income Tax deduction– None at time of grant
– None at the time of vesting as long as issued at FMV
– At date of exercise, deduction equal to amount included in service provider’s gross income (FMV less exercise price)
© 2016 Hein & Associates LLP.All rights reserved.
Nonqualified Stock Option
• Included in income means– Service provider filed income tax return and included
the amount on such income tax return
– Deemed to have included in income if employer timely files information return (Form W-2 and/or Form 1099MISC)
• Timing of deduction– Employer’s tax year which includes last day of service
provider’s tax year in which amount included in gross income
– Special rule- If stock is substantially vested upon transfer, then under the company’s normal method of accounting
© 2016 Hein & Associates LLP.All rights reserved.
Nonqualified Stock Option
• Withholding and reporting requirements with respect to employee
– Report compensation in Boxes 1, 3, and 5 of form W-2
– Compensation subject to income tax and FICA withholdings
– Compensation also reflected in Box 12 of Form W-2 with code “V”
• For non-employee, report on form 1099MISC in box 7, non-employee compensation
© 2016 Hein & Associates LLP.All rights reserved.
Nonqualified Stock Option -
Example
Facts
• 10,000 restricted stock granted with $10 exercise price (FMV) on June 10, 2015• FMV of stock on date of exercise (September 12, 2016) is $25
Results
• Employee recognizes $150,000 of compensation (10,000 x [$25 - $10])• Employer must withhold income taxes, Medicare taxes, social security taxes• Employer reports $150,000 of compensation income on employee’s 2016 Form W-2• Since stock was fully vested upon transfer, employer entitled to an income tax
deduction under its normal method of accounting
© 2016 Hein & Associates LLP.All rights reserved.
Stock Appreciation Right
• Generally, exercise price equal to or greater than FMV as of date of grant to avoid deferred compensation rules under section 409A and deduction limit under section 162(m)
• Shareholder approval not required other than for section 162(m) purposes
• Income Tax Deduction– None at time of grant
– None at time of vesting as long as issued at FMV
– At date of exercise, deduction equal to amount included in service provider’s gross income (FMV less exercise price)
© 2016 Hein & Associates LLP.All rights reserved.
Stock Appreciation Right
• Included in income means– Service provider filed income tax return and included
the amount on such income tax return
– Deemed to have included in income if employer timely files information return (Form W-2 and/or Form 1099MISC)
• Timing of deduction – Stock Issued– Employer’s tax year which includes last day of service
provider’s tax year in which amount included in gross income
– Special rule- if stock is substantially vested upon transfer, then under company’s normal method of accounting
© 2016 Hein & Associates LLP.All rights reserved.
Stock Appreciation Right
• Timing of deduction – Cash Payment– If exercised in same year as vesting, then deduct under
normal method of accounting
– If exercised in year after vesting, then treated as deferred compensation and deduct in tax year which includes last day of service provider’s tax year in which amount included in gross income
• Withholding and reporting requirements with respect to employee– Report compensation in Boxes 1, 3, and 5 of Form W-2
– Compensation subject to income tax and FICA withholdings
• For non-employee, report on form 1099MISC in box 7, non-employee compensation
© 2016 Hein & Associates LLP.All rights reserved.
Stock Appreciation Right- Example
Facts
• 10,000 SARs granted on June 10, 2015 when FMV is $10• FMV of stock on date of exercise (September 12, 2016) is $25 and stock transferred
Results
• Employee recognizes $150,000 of compensation (10,000 x [$25 - $10])• Employer must withhold income taxes, Medicare taxes, social security taxes• Employer reports $150,000 of compensation income on employee’s 2016 Form W-2• Since stock was fully vested upon transfer, employer entitled to an income tax
deduction under its normal method of accounting• If cash were paid• Vesting in year of exercise – deduction under normal method of accounting• Vesting in prior year – treated as deferred compensation
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option
• Must satisfy the rules under section 422
• Available only to employees of parent corporation or any 50% controlled corporation
• Option price must not be less than FMV of stock on date of grant
• Option must be granted within 10 years of plan’s effective date and exercised within 10 years of grant
• 10% shareholder – option price 110% of FMV and exercise period is 5 years
• Option not transferable other than by will
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option
• Shareholder approval of plan required
• $100,000 limit on total value of options that may become exercisable for the first time in any calendar year
• Provide employee with form 3921 for year of exercise
• Income tax impact– No employer income tax deduction upon grant, vesting or
exercise
– Income tax deduction available only at time of disqualifying disposition
• Stock disposed within 1 year of exercise, or
• Stock disposed within 2 years of grant
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option
• Income tax deduction– Amount of ordinary income recognized by employee which
is the lesser of• Spread at time of exercise, or
• Spread at time of disqualifying disposition
– Obtain deduction if amount included in the income of the employee
– Included in income means• Employee filed income tax return and included the amount on
such income tax return
• Deemed to have included in income if employer files Form W-2 or Form W-2c before the employer files tax return on which it is claiming deduction
– Deduction available to employer for its tax year which includes the date of the disqualifying disposition
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option
• Compensation income reported on form W-2, but not subject to withholding
• Disqualifying disposition includes any disposition except in the case of
– Transfer due to death
– Stock for stock acquisition
– Mere pledge or hypothecation
– Transfer to joint ownership with rights of survivorship
– Transfer to spouse incident to divorce
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option – Qualifying
Disposition - ExampleFacts
• 10,000 options granted with $10 exercise price (FMV) on June 10, 2014• FMV of stock on date of exercise (July 15, 2015) is $25• FMV of stock on date of disposition (September 12, 2016) is $28
Results
• Employer required to file 3921 for calendar year 2015• Employee does not recognize compensation income for regular tax purposes since
the stock was disposed after the expiration of the two holding periods• Employer is not entitled to an income tax deduction
© 2016 Hein & Associates LLP.All rights reserved.
Incentive Stock Option –
Disqualifying Disposition - ExampleFacts
• 10,000 options granted with $10 exercise price (FMV) on June 10, 2014• FMV of stock on date of exercise (July 15, 2015) is $25• FMV of stock on date of disposition (April 12, 2016) is $28
Results
• Employer required to file 3921 for calendar year 2015• Employee recognizes $150,000 of compensation in 2016 since the stock was
disposed within both the 1-year/2-year holding periods (10,000 x [$25 - $10])• Employer not required to withhold income taxes, Medicare taxes, or social security
taxes, but must report the income on a Form W-2• Employer is entitled to an income tax deduction in the amount of $150,000 for tax
year that includes April 12, 2016
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock
• Stock issued at date of grant subject to
substantial risk of forfeiture
• Forfeiture provision not satisfied, individual
must return shares to company
• Shareholder approval not required other
than for section 162(m) purposes
• Not subject to deferred compensation
rules under 409A
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock
• Income tax deduction– None at the time of grant (unless Section 83(b) election
made)
– At time of vesting, tax deduction equal to amount included in service provider’s gross income (FMV at time of vesting)
• Included in Income means– Service provider filed income tax return and included the
amount on such income tax return
– Deemed to have included in income if employer timely files information return (W-2 and/or 1099MISC)
• Employer entitled to deduction for its tax year which includes last day of service provider’s tax year in which amount included in income.
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock
• Withholding and reporting requirements – Employee– Report compensation in boxes 1, 3, and 5 of Form W-2
– Compensation subject to income tax and FICA withholdings
• For non-employees, report on form 1099MISC in box 7, non-employee compensation
• Section 83(b) election made by service provider– Deduction equal to FMV of stock on date of transfer which
is included in service provider’s income
– Deduction in employer’s tax year which includes last day of service provider’s tax year in which the amount is include in gross income
– Reverse deduction if stock is forfeited
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock- Example
Facts
• 4,000 restricted stock transferred on June 10, 2015 when FMV is $10• FMV of stock on date of vesting (September 12, 2016) is $25• No Section 83(b) election is made
Results
• Employee recognize $100,000 of compensation in 2016 (4,000 x $25) which is required to be reported on Form W-2
• Employer must withhold income taxes, Medicare taxes, and social security taxes• Since the stock was not fully vested upon transfer, employer entitled to income tax
deduction for its tax year that includes the last day of the employee’s tax year (December 31, 2016) in which the amount is included in income
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock- Section 83(b)
ExampleFacts
• 4,000 restricted stock transferred on June 10, 2015 when FMV is $10• FMV of stock on date of vesting (September 12, 2016) is $25• No Section 83(b) election is made
Results
• Employee recognize $40,000 of compensation in 2016 (4,000 x $10) which is required to be reported on Form W-2
• Employer must withhold income taxes, Medicare taxes, and social security taxes• Since the stock was not fully vested upon transfer, employer entitled to income tax
deduction for its tax year that includes the last day of the employee’s tax year (December 31, 2015) in which the amount is included in income
• No income tax impact on September 12, 2016 when the stock vests
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock Unit
• Promise to issue stock at a future date after risk of forfeiture lapses
• Forfeiture provision not satisfied, individual does not receive the stock
• Shareholder approval not required other than for section 162(m) purposes
• Subject to deferred compensation rules under section 409A if stock is transferred more than 2 ½ months after the calendar year in which the service provider vests
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock Unit
• Income Tax deduction– None at the time of grant and none at the time of vesting
– At time of transfer, tax deduction equal to amount included in service provider’s gross income (FMV at time of transfer)
• Included in income means– Service provider filed income tax return and included the
amount on such income tax return
– Deemed to have included in income if employer timely files information return (Form W-2 and/or Form 1099MISC)
• Since shares are substantially vested upon transfer, employer entitled to an income tax deduction under its normal method of accounting
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock Unit
• Withholding and reporting requirements –
Employee
– Report compensation in Boxes 1, 3, and 5 of
Form W-2
– Compensation subject to income tax and
FICA withholdings
• For non-employees, report on Form
1099MISC in Box 7, non-employee
compensation
© 2016 Hein & Associates LLP.All rights reserved.
Restricted Stock Unit - Example
Facts
• Promise made on June 10, 2015 to transfer 4,000 shares of stock within 45 days of vesting date
• Vesting Date (September 12, 2016)• Transfer shares on September 24, 2016 when FMV is $25
Results
• Employee recognize $100,000 of compensation in 2016 (4,000 x $25) which is required to be reported on Form W-2
• Employer must withhold income taxes, Medicare taxes, and social security taxes• Since the stock was fully vested upon transfer, employer entitled to income tax
deduction in accordance with its normal method of accounting
© 2016 Hein & Associates LLP.All rights reserved.
Contact Information
© 2015 Hein & Associates LLP.All rights reserved.
Brian Parmelee
Tax Director
(303) 294-7705
International Operations
Stu Myhill
December 8, 2016
Three Components of Consolidated
US Multinational Tax Provision
• Tax Provision of U.S. parent and other
domestic subsidiaries
• Tax Provision for the foreign business
– Entities, branches, or other foreign activities
• Impact on U.S. tax provision of foreign
entities, foreign branches, or other foreign
activities
© 2016 Hein & Associates LLP.All rights reserved.
Components of International Tax
Provision – (continued)
• Tax Provision of foreign business
– “Inside Basis”
– Current and deferred tax calculation
– Differences between U.S. GAAP and foreign
tax law
• U.S. GAAP income to statutory book income
• Statutory book income to local taxable income
© 2016 Hein & Associates LLP.All rights reserved.
Components of International Tax
Provision -
• Items of foreign activity potentially impacting U.S. tax provision
– Foreign branch activity flowing into U.S.
– Dividends from foreign subsidiaries
– Retained earnings of foreign subsidiaries
– Subpart F inclusions
– Foreign withholding tax on dividends, royalties, interest
– Foreign tax credits or deductions
– Foreign currency issues
© 2016 Hein & Associates LLP.All rights reserved.
Foreign Branch Operations
U.S. Foreign Branch Operations
• A branch represents the portion of U.S. operations located and taxed in a foreign jurisdiction
• Can be wholly owned foreign corporation electing to be treated as disregarded entity for U.S. tax purposes
• Branch operations subject to tax in two jurisdictions
129
Foreign Branch Activity
Foreign Branch Deferred Taxes
• Two sets of temporary differences that
give rise to deferred tax assets and
liabilities
• Adjust home country deferred taxes for the
effects of foreign deferred tax assets and
liabilities
130
Foreign Branch Deferred Taxes
• When a deferred foreign liability is settled, it
increases taxes paid, decreasing the home
country taxes paid because of additional foreign
tax credits or deductions.
• When a foreign tax asset is recovered, it
reduces taxes paid, increasing the home country
taxes because of lower foreign tax credits or
deductions.
131
International Operations Foreign Branch Deferred Taxes Example
Company A has a branch in Country X where the statutory tax rate is 25%
– In current year, branch has pretax income of $10,000
– For both Country X and US tax purposes, branch has excess tax-over-book depreciation of $5,000 and non-deductible inventory reserves of $3,000
– For U.S. tax purposes, the branch is taxed at 40%
– Taxes paid to Country X will be claimed as a foreign tax credit
How and in what jurisdiction should deferred taxes be recorded?
132
International Operations Foreign Branch Deferred Taxes Example
Country X
Nondeductible reserves $ 750 ($3,000 x 25%)
Depreciation (1,250) (($5,000) x 25%)
Branch DTL, Net $ (500)
U.S.
Nondeductible reserves $ 1,200 ($3,000 x 40%)
Depreciation (2,000) (($5,000) x 40%)
DTA on Branch DTL, Net 500 ($500 x 100%)*
U.S. DTL, Net $ (300)
Total DTA/(DTL) $ (800)
* Assumes when paid will be fully creditable
133
Dividends from Foreign Subsidiaries
• Gross amount of dividend included in taxable
income of US recipient
– Also include Section 78 Gross-Up if taking foreign tax
credits
• Withholding tax on dividend included in US
recipient’s tax provision
• Portion of foreign taxes paid by foreign subsidiary
deductible or creditable to US recipient
– Reduces current tax if utilized in current year
– Deferred tax asset if results in loss (“NOL”) or tax credit
(“FTC”) carry-forward
134
Dividends from Foreign Subsidiaries
Example
Assume:
Earnings of UK Sub $200
Taxes $ 40
Cash $160
Dividend to U.S. parent $ 80
Withholding tax on dividend $ 8
Result:
Cash Dividend $ 80
Section 78 Gross Up $ 20
U.S. Taxable Income $100
U.S. Tax at 35% plus withholding tax of $8 $ 43
Foreign Tax Credit ($ 28)
Net U.S. Tax (Incremental Tax from Dividend) $ 15
135
Retained Earnings of Foreign
Subsidiaries
• Treatment in consolidated tax provision
differs depending upon if earnings are
“permanently reinvested”
– Permanently reinvested – no impact on US
tax provision
– Not permanently reinvested – tax effects of
outside book-tax basis difference in subsidiary
must be accounted for in U.S. tax provision
© 2016 Hein & Associates LLP.All rights reserved.
Indefinite Reversal Assertion (APB 23)
ASC 740-30-25-18(a)
– A deferred tax liability is not recognized for “an excess of an amount of financial reporting over tax basis of an investment in a foreign subsidiary that is essentially permanent in duration”
• Basis differences usually a result of:– Undistributed earnings
– Changes in foreign exchange
• Indefinite reversal criteria must be met
137
Indefinite Reversal Assertion
• Positive assertion of management’s intent to
indefinitely reinvest its foreign undistributed
earnings
• Management’s ability and intent to indefinitely
prevent the outside basis difference of a foreign
subsidiary from reversing with a tax
consequence
138
Indefinite Reversal Assertion
Evidence Required
• History of not distributing foreign earnings
does not replace specific reinvestment
plans
• Document and maintain specific
reinvestment plans
139
Indefinite Reversal Assertion
Evidence Required (cont.)
• Forecasts and budgets for parent and subsidiary
• Financial requirements of parent and subsidiary
• Remittance restrictions in a loan agreement of the subsidiary
• Remittance restrictions imposed by foreign government
140
Indefinite Reversal Assertion
• Positive Evidence
– No need of cashflow from foreign subs to
support U.S. operations
– Specific plans to reinvest foreign cash in
capital projects or acquisitions
– Foreign debt service requirements
© 2016 Hein & Associates LLP.All rights reserved.
Indefinite Reversal Assertion
• Negative Evidence
– U.S. debt service requirements
– Subpart F
© 2016 Hein & Associates LLP.All rights reserved.
Indefinite Reversal Assertion
Q: Can a company make a partial
reinvestment assertion?
A: Yes, a deferred tax liability can be
maintained on some, but not all, of the
outside basis difference if the assertion is
justified by the evidence.
143
Indefinite Reversal Assertion
Effect of Change in an Indefinite Reversal
Assertion• Some or all of undistributed subsidiary earnings will be
remitted in foreseeable future
• Parent adjustment to income tax expense and deferred
tax liability in the current period and make ASC 740-10-
50-2 disclosure
144
Foreign Currency Issues
• Functional currency - Currency of the primary
economic environment of the entity
• Reporting currency – Currency used to report
financial statements
145
Foreign Currency Issues
Translation gains and losses
– Deferred foreign income taxes are translated
at current rates if reporting currency is not
functional currency
– Translation adjustments are part of the
outside basis temporary difference on
investment in foreign subsidiary
146
Foreign Currency Issues
Transaction gains and losses
– Usually recognized in income for financial
reporting
– Gains and losses from foreign currency
transactions recognized for tax purposes
– Deferred tax accounting required if tax gains
or losses included in period different than for
financial reporting purposes
147
Foreign Currency Issues
Best Practices
– Prepare base calculations of foreign provisions in
the functional currency, not in U.S.$!
– Book all related provision entries on the foreign
books in functional currency, not topside in U.S.$!
• Be mindful of period issues
– Let the ERP software do the f/x translation
– Translate into U.S.$ in consolidated tax provision
workpapers using same f/x rates as ERP system
148
QUESTIONS?
149
State and Local Tax Provision –
Common Elements and Errors
Bill Mueldener
December 8, 2016
Common Elements
• Single biggest element for state tax
purposes:
Effective Tax Rate
– Broken into two components:
• Current Rate
• Deferred Rate
© 2016 Hein & Associates LLP.All rights reserved.
State Tax Provision Considerations
• Differences between the current and deferred rates:• Deferred should be booked at the tax rate in effect at
the time the deferred item is expected to turn.– All legislative changes to tax rates must be considered
(increases or decreases).
• Legislative changes impacting filing methodology in future years should be considered.– Does the state file on a combined, consolidated, or separate
company basis?
• Factors calculating the rate should represent the most accurate business information and changes known.
© 2016 Hein & Associates LLP.All rights reserved.
Calculation of the State Rate
One method of computing the current state tax
expense: blended effective rate computation
Company X Company X Company X
Total California Georgia
Pre-Tax Book Income $10,000,000 (A) $10,000,000 $10,000,000
State Apportionment 40% 20%
State Tax Rate 8.84% 6%
Current Blended Rate 4.74% (B) 3.54% 1.20%
Current State Provision $474,000 (A*B)
• Key Components: Income, Apportionment and Tax Rate
© 2016 Hein & Associates LLP.All rights reserved.
Common Provision Apportionment
Issues• Apportionment
– Property difference on current and deferred rate. • Property apportionment factor is typically the average of
BOY and EOY property.
– Sourcing of Sales• Sales of Goods vs. Services (current trend to move
towards market based sourcing of services)
• Sourcing of intangible income
• Inclusion of activity from ownership in a partnership
• Consideration of the definition of sales in a specific state
• Economic nexus and sourcing rules
– Other property and payroll sourcing issues
© 2016 Hein & Associates LLP.All rights reserved.
Concerns with a Simple Blended
Rate Calculation
Blended effective rate computationCompany X&Y Company X&Y Company Y
Total California (Unitary) Georgia (Separate)
Pre-Tax Book Income $10,000,000 (A) $10,000,000 ($1,000,000)
State Apportionment 40% 20%
State Tax Rate 8.84% 6%
Current Blended Rate 4.74% (B) 3.54% 1.20%
Current State Provision $474,000
© 2016 Hein & Associates LLP.All rights reserved.
State by State Computation
Example ComputationCompany X&Y Company X&Y Company Y
Total California (Unitary) Georgia (Separate)
Pre-Tax Book Income $10,000,000 $10,000,000 $3,000,000
Perm. Differences 2,000,000 1,000,000
Temp. Differences 50,000 50,000
State Modifications 300,000 100,000
Apportionable Income 12,350,000 4,150,000
State Apportionment 40% 20%
Pre-NOL State Income 4,940,000 830,000
State NOLs 500,000 0
State Taxable Income 4,440,000 830,000
State Tax Rate 8.84% 6%
Current State Tax Provision $441,800 (A+B) $ 392,000 (A) $ 49,800 (B)
© 2016 Hein & Associates LLP.All rights reserved.
State by State Computation
• Requires consideration of state level computation issues
– Items impacting individual state computation:• State filing methodology (separate, combined,
consolidated)
• State modifications and conformity to federal law
• “Top Side” accounting or tax adjustments
– State deferred tax items should be accounted for individually.
• State NOLs
• State tax credits
© 2016 Hein & Associates LLP.All rights reserved.
Valuation Allowance
• DTA is reduced by a valuation allowance if
it is more likely than not (i.e., >50%) that
some portion, or all, of the DTA will not be
realized.
– For example: NOL carryover provides no tax
benefit if there is no taxable income during
carryover period.
© 2016 Hein & Associates LLP.All rights reserved.
Forecasting the Effective Tax
Rate and Interim Reporting
John Monahan
December 8, 2016
Interim Reporting – Basic
Principles• ASC 740-270-30-2 APB 28, Interim Financial Reporting, ¶19
states that– “At the end of each interim period the company should make its best
estimate of the effective tax rate expected to be applicable for the full fiscal year.”
– “The rate so determined should be used in providing for income taxes on a current year-to-date basis.”
– “The effective tax rate should reflect anticipated investment tax credits, foreign tax rates, percentage deletion, capital gains rates, and other available tax planning alternatives.”
– “However, in arriving at this effective tax rate no effect should be included for the tax related to significant unusual, or extraordinary items that will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year.”
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Basic
Principles• ASC 740-270-25-9 (APB 28, Interim Financial Reporting, ¶29)
states that– “The tax effects of losses that arise in the early portion of a fiscal year
should be recognized only when the tax benefits are expected to be (a) realized during the year or (b) recognizable as a deferred tax asset at the end of the year in accordance with the provisions of [ASC 740].”
– “The effects of new tax legislation shall not be recognized prior to enactment.”
– “The tax effect of a change in tax laws or rates on taxes currently payable or refundable for the current year shall be reflected after the effective dates prescribed in the statutes in the computation of the annual effective tax rate beginning no earlier than the first interim period that includes the enactment date of the new legislation.”
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Basic
Principles
• ASC 740-270-25-2 (FIN 18, Accounting for Income Taxes in Interim Periods, ¶6), clarifies that:
– The tax (or benefit) related to ordinary income is to be computed using an estimated annual effective tax rate, and
– The tax (or benefit) related to all other items is to be individually computed and recognized when the event occurs (“discrete period items”)
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Basic
Principles
• Examples of Other Items:– Closing of prior years audits
– Expiration of the statute of limitations for prior tax years
– Subsequent recognition of uncertain tax position
– Change in tax law
– Change in tax status
– Certain changes in realizability of deferred tax assets
– Change in judgment about unremitted foreign earnings and other outside basis differences
– A significant, unusual or infrequent item
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Discrete Items
Change related to:
Interim Accounting
Treatment
Prior year uncertain tax position Discrete
Current year uncertain tax position (related to
ordinary income included in ETR) Included in ETR
Current year uncertain tax position (related to income
excluded from ETR) Discrete
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Discrete Items
• Interest and penalties recognized on uncertain tax positions– ASC 740-10-25-56 requires that interest be
accrued in the first period in which the interest would begin accruing according to the provisions of the relevant tax law. Therefore, interest would be excluded from ETR calculation.
– ASC 740-10-25-57 indicates that a penalty should be recorded when a position giving rise to a penalty is taken or anticipated to be taken on the current year’s tax return.
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Discrete Items
• Change in tax law– Adjustments to deferred tax assets and liabilities as a
result of a change in tax law or rates should be accounted for discretely in continuing operations at the date of enactment.
– The effects of a retroactive change in tax rates should also be accounted for discretely in continuing operations in the interim period in which the law is enacted.
– Prospective effects of a change in tax law or rates on tax expense in the year of enactment should be reflected in the estimated annual effective tax rate calculation.
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Discrete Items
• Change in tax status
– The effect of a voluntary change in tax status
should be recognized discretely on
1. the date that approval is granted by the taxing
authority or
2. the filing date, if approval is unnecessary.
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Discrete Items
• Certain changes in the assessment of the realizability of deferred tax assets– The tax effect of a change in the beginning-of-the year balance
of a valuation allowance caused by a change in judgment about the realizability of the related deferred tax asset that results from changes in the projection of income expected to be available in future years should be recognized discretely in the interim period in which the change in judgment occurs.
– A change in judgment about the realizability of deferred tax assets resulting from changes in estimates of current-year ordinary income and/or deductible temporary differences and carryforwards that is expected to originate in ordinary income in the current year should be considered in determining the estimated annual effective tax rate.
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Discrete Items
• Certain changes in the assessment of the
realizability of deferred tax assets - Example
© 2016 Hein & Associates LLP.All rights reserved.
Estimated full year pre-tax income 500,000$
Tax expense:
Tax on current-year income at 35% 175,000
Reversal of valuation allowance related to current-year income (175,000)
Total current tax based on ETR -$
Reversal of valuation allowance based on future-years income (700,000)
Total tax provision (700,000)
Net income 1,200,000$
Estimated ETR at end of second quarter [($0) / $500,000] (0)%
The company has a $2.5M NOL carryfoward available at the beginning of the year. A valuation
allowance was recorded for the full amount of the related deferred tax asset for $875,000 (35%
rate). During Q2 of the current year, the full year forecast of pre-tax book income increased
from $0 to $500,000 causing partial utilization of the NOL carryforward. Adjusted future year
income forecasts have caused reversal of the remaining amount of the valuation allowance.
Interim Reporting – Discrete Items
• Change in judgment regarding unremitted foreign earnings and other outside-basis differences– The tax effect of the change in judgment for the
establishment/reversal of the deferred tax liability related to the outside basis difference that had accumulated as of the beginning of the year should be recorded in continuing operations in the interim period during which the intentions changed.
– The tax effect of the change in intentions on unremitted earnings of the current year should be reflected in the determination of the company’s ETR.
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Discrete Items
• Change in estimate related to a prior-year tax provision– The language in ASC 740-270-25-2, makes it
clear that the estimated annual effective tax rate approach should only be used to record the tax effect of current-year ordinary income.
– A change in estimate in the current year that is related to a prior-year tax provision does not constitute a tax effect on current-year income –therefore, change should be recorded discretely in period that change in estimate occurs.
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Discrete Items
• Change in estimate vs. error– Examples of errors
A mechanical error is made when calculating the income tax provision
Misapplications of ASC 740 and related accounting principles and interpretations are made.
The company chose to estimate rather than obtain an amount for tax provision purposes at the balance sheet date that was “readily accessible” in the company’s books and records, and the actual amount differs from the estimate.
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting – Discrete Items
• Change in estimate vs. error
– Examples of changes in estimateAn adjustment of a prior-period tax accrual that results
either from new information (including a change in facts and circumstances) or later identification of information that was not reasonably “knowable” at the original balance sheet date and that results in improved judgment would lead to a change in estimate.
An event occurs that results in a changed judgment with respect to the sustainability of an uncertain tax position
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting - Definitions
• Tax (or benefit) is defined to be the total income tax expense (or benefit), including the provision (or benefit) for income taxes both currently payable and deferred. ASC 740-270-20 (FIN 18, ¶5)
• “Ordinary” income (or loss) refers to income (or loss) from continuing operations before income taxes (or benefits)” excluding significant “unusual or infrequently occurring items.” Extraordinary items, discontinued operations, and cumulative effects of changes in accounting principles are also excluded from this term. ASC 740-270-20 (FIN 18, ¶5)
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting - Computation
• Steps to compute the interim tax provision using the annual effective tax rate1. Determine projected income, permanent differences,
credits and carryforwards for the entire year.
2. Calculate the projected total provision for the year (excluding discrete items).
3. Calculate the effective tax rate (ETR) for the year.
4. Apply the ETR to the year to date earnings (i.e. “Ordinary Income”.
5. Adjust interim provision for discrete period items, if any.
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting- Computation
© 2016 Hein & Associates LLP.All rights reserved.
Computing the Annual ETR: Example (Q3)
Q1-3 (Actual) Q4 (Estimate) Total (Estimate)
Pre-Tax Book Income 25,000 15,000 40,000
Permanent Items 3,000
Book Taxable Income 43,000
Statutory Tax Rate 28%
Extimated Annual Tax divided by 12,000
Pre-Tax Book Income 40,000
Estimated Annual effective Tax Rate 30%
Interim Reporting- Computation
© 2016 Hein & Associates LLP.All rights reserved.
Computing the Annual ETR: Example (Q3)
Total (Estimate)
Pre-Tax Book Income 25,000
Estimated Annual ETR 30%
"Ordinary" Tax 7,500
Audit Settlement (Q1) (1,000)
FIN 48 Interest (Q1) 100
Account Balance Correction (Q2) (500)
FIN 48 Interest (Q2) 100
Impairment (Permanent) (Q3) 3,000
FIN 48 Interest (Q3) 100
Total Tax Expense 9,300
Q3 Effective Tax Rate 37%
Interim Reporting
• Limitation on benefits of losses in loss
periods
– The ETR approach is modified by ASC 740-270-30-
30 through 30-34, which limit the tax benefit
recognized for a loss in interim periods to the amount
that is expected to be
(a) realized during the year or
(b) recognizable as a deferred tax asset at the end of the year.
© 2016 Hein & Associates LLP.All rights reserved.
Interim Reporting
• Limitation on benefits of losses in loss
periods – Example
© 2016 Hein & Associates LLP.All rights reserved.
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
Year-to-date ordinary income/(loss) 40,000$ (120,000)$ (280,000)$ (200,000)$
Annual Effective Rate
Tax benefit at statutory rate ($200,000 at 30%) (60,000)$
Tax Credits (15,000)
Net tax benefit (75,000)$
Estimated annual effective rate -37.50%
For the year, an entity anticipates an ordinary loss of $(200,000). A total of $15,000 in R&D credits
will be generated during the year. The entity operates in one jurisdiction where the statutory tax
rate is 30%. The entity has the following year-to-date ordinary income and losses for the following
interim periods:
Interim Reporting
• Limitation on benefits of losses in loss
periods – Example (cont.)
© 2016 Hein & Associates LLP.All rights reserved.
Reporting
period
Quarterly
income/(loss)
Year-to-date
income/(loss)
Estimated
annual
effective
tax rate Computed Limited to
Less
previously
provided
Reporting
period
amount
Q1 40,000$ 40,000$ 37.50% 15,000$ -$ 15,000$
Q2 (160,000) (120,000) 37.50% (45,000) 15,000 (60,000)
Q3 (160,000) (280,000) 37.50% (105,000) (99,000) (45,000) (54,000)
Q4 80,000 (200,000) 37.50% (75,000) (99,000) 24,000
Y/E (200,000)$ (75,000)$
Interim Reporting
• Limitation on benefits of losses in loss
periods – Example (cont.)
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Tax benefit at statutory rate ($280,000 at 30%) (84,000)$
Tax Credits (15,000)
Net tax benefit (99,000)$
Estimated annual effective rate -35.36%
Because the Q3 year-to-date ordinary loss exceeds the anticipated ordinary loss for the fiscal year,
the tax benefit recognized for the year-to-date loss is limited to the amount that would be
recognized if the year-to-date ordinary loss were the anticipated ordinary loss for the fiscal year.
The limitation is computed as follows:
Interim Reporting
• Exceptions to the use of the ETR approach– Jurisdictions with pretax losses for which no tax
benefit can be recognized
• When a company operates in a jurisdiction that has generated ordinary losses on a year-to-date basis or on the basis of the results anticipated for the full fiscal year and no benefit can be recognized on those losses, ASC 740-270-30-36(a) requires the company to exclude that jurisdiction’s income (or loss) from the overall ETR calculation.
• A separate ETR should be computed and applied to ordinary income (or loss) in that jurisdiction. Assuming the reason for no benefit is a full valuation allowance, the separate ETR for that jurisdiction would be zero.
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Interim Reporting
• Multiple Jurisdictions – Ordinary Loss in a
Jurisdiction with no realized tax benefit
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Interim Reporting
• Reliability of estimates
– When a company operates in a jurisdiction
where a “reliable estimate” of the translated
effective tax rate cannot be made, ASC 740-
270-30-36 (FIN 18, paragraph 22b) requires
the company to exclude the ordinary income
(or loss) in that jurisdiction and the related tax
(or benefit) attributable to “ordinary” income in
that jurisdiction from the overall estimate of
the ETR and interim period tax (or benefit).
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Interim Reporting
• Reliability of estimates– ASC 740-270-25-3 (FIN 18, paragraph 8, footnote 7) states that
if a “reliable estimate” of the ETR cannot be made, the actual tax rate for the year-to-date may represent the most appropriate estimate of the annual rate.
– The footnote continues: “If an enterprise is unable to estimate a part of its ‘ordinary’ income (or loss) or the related tax (or benefit) but is otherwise able to make a reliable estimate, the tax (or benefit) applicable to the item that cannot be estimated shall be reported in the interim period in which the item is reported.”
– This footnote makes it clear that the effective rate approach must be used to the extent that, but only to the extent that, a reliable estimate can be made.
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Current Developments Involving
Interim Reporting
• ASU 2016-09: Recognize windfall and shortfall tax benefits in tax expense
• Change will likely result in greater effective tax rate volatility
• Discrete interim reporting required to record the tax effect in the period in which they occur.
• Change: Recognition of tax consequences of intra-entity transfers (except transfers of inventory) in tax expense even though the pre-tax profits are eliminated in consolidation
• Companies should consider the impact on forecasting effective tax rate
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Impact of Accounting Standard Developments
Contact Information
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John Monahan
Tax Partner
(303) 226-7013
Oil & Gas Specific Issues & Concluding
Discussion on Practical Consideration
Patrick Hanley
December 8, 2016
Current Issues for
Oil & Gas Companies
• Valuation Allowances
• Section 382 Ownership Changes
• Cancellation of Debt Income (CODI)
• Error vs. Estimate
• Other
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Other Provision Considerations
• Understanding GAAP Treatment
• Tax Basis Balance Sheet
• Controls
• IPO Readiness
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Q & A
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THANK YOU!
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