Income Taxes

ASC 740
Scope

► The guidance in this topic shall be applied for accounting and reporting the effects of taxes based on
income

► The guidance in this topic applies to

► Domestic federal (national) income taxes (U.S. federal income taxes for U.S. entities) and foreign,
state, and local (including franchise) taxes based on income
► An entity’s domestic and foreign operations that are consolidated, combined, or accounted for by the
equity method

► The guidance in this topic does not apply to

► Franchise tax (Where such tax is not based on Income)
► Withholding taxes – entities that pay dividend
► Withholding taxes – entities that receive dividend
► Credits and other tax incentives

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Examples

Identify if the following taxes are covered under the scope of ASC 740?

Gross Receipts Tax No

Margin Tax Yes

Franchise Tax based on equity No

Tonnage Tax No

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Objectives

ASC 740-10-10-1 identifies two objectives of accounting for income taxes:

Recognize the amount of taxes payable or Current

refundable for the current year. Tax

Recognize deferred tax liabilities and assets for

the future tax consequences of events that have Deferred
been recognized in an entity’s financial Tax
statements or tax returns.

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Income Tax Items in the Financial Statements

► Balance Sheet Line Items

► (Current) Income tax payable
(Current) Income tax receivable
► Current and noncurrent deferred tax liability
Current and noncurrent deferred tax asset

► Income Statement Line Item

► “Income tax expenses” comprising of

► Current income tax expense / benefit

► Deferred income tax expense / benefit

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Definitions

Current tax payable / receivable Deferred tax liability / asset

Balance is recognized for the estimated is recognized for the estimated future
Sheet taxes payable or refundable on tax effects attributable to temporary
tax returns differences and carry-forwards

Current income tax Deferred income

expenses tax expenses

Income
Statement Income tax expenses

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Deferred taxes
Recognition & Measurement

The basic ASC 740 model is applied through the completion of the following steps:

1. Determine difference between GAAP B/S and tax B/S

2. Determine whether difference is temporary / permanent

3. Identify tax loss carryforwards and tax credits

4. Determine the tax rate to apply to temporary differences and loss carryforwards

5. Calculate deferred tax assets and liabilities

6. Evaluate the need for valuation allowance

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Permanent & Temporary differences

► Permanent differences
Book-tax differences that increase or decrease current tax liabilities without
any future tax implications affecting tax expense (i.e. effects will not reverse in
the future)
→ deferred taxes are not recognized

► Temporary differences
A difference between the book and tax basis of an asset or liability that will result in taxable or deductible
amounts in future years when the reported amount of the asset or liability is recovered or settled (i.e.
effects will reverse in the future)
→ deferred taxes are recognized

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Examples: Permanent & Temporary Differences

Permanent Differences Temporary Differences

► 30% non-deductible meals & entertainment
expenses
► tax-free sale of investments
► non-deductible fines
► non-deductible donations
► book depreciation ≠ tax depreciation (e.g.
accelerated)
► Accruals expensed for book, not yet allowed for
tax (e.g. Gratuity expenses)

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Case Study

► An entity has an item of PP&E whose cost is fully tax deductible,

► Deductions being given over a period shorter than the period over which the asset is being depreciated
under US GAAP.

► At the reporting date,

► the asset has been depreciated to $500,000 for financial reporting; and $300,000 for tax purposes.

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Case Study

► An entity (FY Ended : 31 December 2015) holds a medium-term cash deposit on which interest of
$10,000 is received annually on 31 March.

► The interest is taxed in the year of receipt.

► At 31 December 2015, the entity recognises a receivable of $7,000 in respect of interest accrued but not
yet received.

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Applicable tax rate

► The applicable tax rate used to measure deferred tax assets and liabilities is the enacted tax rate
that is expected to apply when temporary differences are expected to be settled or realized

► An entity may utilize different applicable tax rate depending on type of temporary difference

► When graduated tax rates are a significant factor, deferred taxes may need to be computed using the
average graduated tax rate

► The lowest graduated tax rate (other than zero) should be used whenever the estimated average
graduated rate would otherwise be zero

► The applicable rate related to undistributed earnings should reflect any dividends-received deductions,
deductions or credits for foreign taxes, or withholding taxes

► For companies that expect to be Base Erosion and Anti –Abuse tax (BEAT) taxpayers deferred tax
assets and liabilities will be measured at regular tax rates and that any BEAT tax exposure will be
recognized as a period cost.

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Tax Holidays

► There are tax jurisdictions that may grant an entity a holiday from income taxes for a specified period.
These are commonly referred to as tax holidays. An entity may have an expected future reduction in
taxes payable during a tax holiday

► Recognition of a deferred tax asset for any tax holiday is prohibited because of the practical problems
associated with
► distinguishing between general tax holiday and unique tax holiday
► measuring the deferred tax asset associated with future benefits expected from tax holidays

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Example

► Assume a foreign tax jurisdiction grants XY a 10-year tax holiday, not linked to any other performance
criteria, and reduces XY’s taxable income by 100%. Further, assume the enacted tax rate is 40% and XY
has $1,000 (deductible) and $250 of (taxable) temporary differences, with a 15-year reversal period.

► When XY obtains the tax holiday, it would remeasure its deductible and taxable temporary differences
that are expected to reverse in the tax holiday period and recognize a $200 deferred tax expense (or
[$750 x 40%] — $100) in earnings, computed as follows:

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Example

Expected reversal pattern

Before During After After

consideration holiday holiday consideration
of tax holiday period period of tax holiday
Gross deductible
temporary differences $1,000 $667 $333 $1,000
Gross taxable
temporary differences (250) (167) (83) (250)
750 500 250 750
Applicable tax rate 40% 0% 40% -
$300 $— $100 $100

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Calculation of deferred tax – Case study

► Facts
► 40% tax rate
► $1,000 cost of fixed assets
► accelerated depreciation for tax purposes
► $300 – U.S. GAAP basis of asset
$200 – Tax basis of asset

► Determination of deferred taxes

► in the future: tax depreciation < book depreciation
► taxable income > book income in the future
► additional tax liability in the future
► to be accrued now
► 40% x $100 = $40 Deferred tax liability
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Case study (contd.)

► Facts:
► Asset purchased on December 31, 2000
► 3 years useful lives, depreciation starts in 2001
► 25% Applicable tax rate
► 300 Purchase costs that were directly expensed for US GAAP purposes but capitalized for tax
purposes
► 1.700 U.S. GAAP net income before depreciation expense

U.S. GAAP Tax

Net book value 1.200 1.500

Annual depreciation 400 500

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Case study (contd.)

Determination of current income taxes

2000 2001 2002 2003

Net income before depreciation expense 1,700 1,700 1,700 1,700
- Depreciation expense 0 -400 -400 -400
= U.S. GAAP net income 1,700 1,300 1,300 1,300

Taxable income before depreciation expense 1,700 1,700 1,700 1,700

+ Add-back of purchase costs 300
- Depreciation expense -500 -500 -500
= Taxable income 2,000 1,200 1,200 1,200
x Tax rate x25% x25% x25% x25%
= Current income taxes 500 300 300 300

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Case study (contd.)

Determination of deferred taxes

2000 2001 2002 2003

U.S. GAAP net book value 1.200 800 400 0
Tax base 1.500 1.000 500 0
Temporary difference 300 200 100 0
x 25% x25% x25% x25% x25%
= DTA 75 50 25 0

CY DTA 75 50 25 0
PY DTA 0 75 50 25
Change = Deferred tax (expense) / income 75 -25 -25 -25

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Case study (contd.)

Hypothetical effective tax rate without recognition of deferred taxes:

Income statement 2000 2001 2002 2003

Accounting profit before depreciation 1.700 1.700 1.700 1.700
Depreciation 0 -400 -400 -400
U.S. GAAP net income before taxes 1.700 1.300 1.300 1.300

Current income tax expenses -500 -300 -300 -300

Deferred income tax expenses 0 0 0 0
Total income tax expense -500 -300 -300 -300

U.S. GAAP net income 1.200 1.000 1.000 1.000

Total income tax expenses -500 -300 -300 -300

/ U.S. GAAP net income before taxes 1.700 1.300 1.300 1.300
= Effective Tax Rate 29,41% 23,08% 23,08% 23,08%

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Case study (contd.)

Effective tax rate with recognition of deferred taxes:

Income statement 2000 2001 2002 2003

Accounting profit before depreciation 1.700 1.700 1.700 1.700
Depreciation 0 -400 -400 -400
U.S. GAAP net income before taxes 1.700 1.300 1.300 1.300

Current income tax expenses -500 -300 -300 -300

Deferred income tax expenses 75 -25 -25 -25
Total income tax expense -425 -325 -325 -325

U.S. GAAP net income 1.275 975 975 975

Total income tax expenses -425 -325 -325 -325

/ U.S. GAAP net income before taxes 1.700 1.300 1.300 1.300
= Effective Tax Rate 25,00% 25,00% 25,00% 25,00%

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Valuation Allowance
Overview

► Deferred tax assets represent future tax deductions (or tax carry-forwards / tax credits) whose
realizability is dependent upon future taxable income
► Four sources of taxable income to be considered in determining whether a valuation allowance is
required (from least to most subjective):

Taxable income in prior carryback years, if carryback is permitted under the tax law
One

Future reversals of existing taxable temporary differences

Two

Tax planning strategies

Three

Future taxable income exclusive of reversing temporary differences

Four

► If a single source of taxable income is sufficient to eliminate the need for a valuation allowance, other
sources do not need to be considered.

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Valuation Allowance
Overview (Cont.)

► A deferred tax asset must be reduced by a valuation allowance if, based upon the weight of available
evidence, it is i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized

► Valuation allowances do not deal with the existence of the asset; instead, they address the realizability of
an asset

► All available evidence, both positive and negative, should be considered

► Whether a valuation allowance is necessary is based on the weight of positive and negative evidence.

► Evaluation regarding realizability of deferred tax assets is made on a gross as opposed to a net basis.

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Example

► Assume that a historically profitable company settles a significant lawsuit such that it is in a net operating
loss carry-forward position for tax purposes. The realization of a tax benefit associated with the net
operating loss carry-forward would be dependent upon whether future income of a sufficient amount was
considered more likely than not.

► Assuming objective evidence indicates that such income was considered more likely than not to occur in
the carry-forward period, then, in the absence of any evidence to the contrary, recognition of the deferred
tax asset without a valuation allowance would be appropriate.

► However, reaching a conclusion that a valuation allowance is not required would often be difficult when
there is negative evidence, such as cumulative losses in recent (i.e., the current and two preceding)
years.

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Case study

► Assume a company in a loss position has a deductible temporary difference of $500 at 31 December
20X3. Further, assume that the taxable loss for 20X3 was carried back and a receivable recognized (i.e.,
current recoverable taxes), leaving the following amounts of taxable income in carry-back years available
(a two-year carry-back period (current year and prior year) is allowed under the tax law):

20X0 $400
20X1 $800
20X2 $200

► Assuming additional taxable income is not expected in 20X4 and that the entire $500 deductible
temporary difference is expected to reverse in 20X4, only $200 of the carry-back potential can be
considered as a source of taxable income for purposes of determining the need for a valuation allowance
(i.e., when it reverses in 20X4, the deductible temporary difference could be carried back no further than
20X2).

► In the absence of appropriate other positive evidence, a valuation allowance would be

established at 31 December 20X3 for $300 of the temporary difference ($75 using a 25% tax rate)

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Enacted change in tax laws

► When deferred tax accounts are adjusted for the effect of a change in tax laws or rates, the effect shall
be included in income from continuing operations for the period that includes the enactment date.

► For interim reporting purposes, the effect of new legislation must be recognized in the interim period in
which the legislation is enacted even if the change in the tax rates is retroactive. Companies cannot
allocate the effects of rate changes to prior interim periods

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Enactment date

► Within US
ASC 740-10-25-47 requires deferred tax assets and liabilities to be adjusted for the effects of a change in
tax law or rates in the period that includes the enactment date. In the US, the enactment date is
considered to be the date that the President of the United States signs the legislation (or 10 days after
presentation to the President of the United States (except Sundays), if unsigned and not vetoed) and it
becomes law

► Outside US
ASC 740 does not specifically address how to determine the enactment date in jurisdictions outside the
United States. Simply stated, the enactment date is when all steps in the process for legislation to
become law have been completed

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Example

► Assume at 31 December 20X0 a company’s only temporary difference is a $2 million reserve for
expenses related to a litigation accrual (deductible temporary difference), which is expected to result in
tax deductions of $1 million in 20X1 and 20X2. Assume a change in the enacted tax rate occurs on 1
January 20X1 that decreases the tax rate to 21% for periods beginning on or after 1 January 20X1
versus the prior 35%.
► If the company expects to realize the tax benefit by offsetting taxable income in the future, the
applicable enacted tax rate on 1 January 20X1 and future periods would be 21% (resulting in a
deferred tax asset of $420,000).
► However, if the company expects to realize the tax benefit by loss carry-back (assuming a loss carry-
back is permitted under the tax law), the applicable enacted tax rate would be 35% (resulting in a
deferred tax asset of $700,000). Determinations of whether to carry-forward or carry-back tax
benefits are often dictated by the tax law

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Accounting for Income Tax Uncertainties

Tax Position

► A position in a previously filed tax return or a position expected to be taken in a future tax return

► Reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods

► Can result in
► permanent reduction of income taxes payable
► a deferral of income taxes otherwise currently payable to future years
► a change in the expected realizability of deferred tax assets

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Accounting for Income Tax Uncertainties

Tax Position (coned)

► The term tax position also encompasses, but is not limited to:
► A decision not to file a tax return
► An allocation or a shift of income between jurisdictions
► The characterization of income or a decision to exclude reporting taxable income in a tax return
► A decision to classify a transaction, entity, or other position in a tax return as tax exempt
► An entity’s status, including its status as a pass-through entity or a tax-exempt not-for-profit entity

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Accounting for Income Tax Uncertainties

Tax Position (coned)

► Applies to all tax positions (may increase or decrease taxable income) accounted for in accordance with
ASC 740

► Does not apply to taxes that are not substantially based on income

► Applies to all entities including pass through entities , non taxable entities and entities whose tax liability
is subject to a 100% credit for dividends paid

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A Two-Step Process

1. Recognition How likely is it that the tax benefit will be sustained?

MLTN not MLTN

Highly certain or
2. Measurement
uncertain tax position?

highly certain uncertain

no UTP total tax benefit UTP accrual

accrual <minus> for 100% of
largest tax benefit that is the tax
>50% likely of being realized position
= UTP accrual

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Highly Certain vs. Uncertain Tax Positions

► ASC 740 applies to all income tax positions

► Highly certain tax positions

► Based on clear and unambiguous tax law
► Clearly meets MLTN recognition standard and greater than 50 percent likely than 100 percent of
benefit will be sustained

► Uncertain tax positions (UTP)

► Determination of UTP’s is subject to two-step process
► Appropriate Unit of Account for a tax position is a matter of judgment and requires consideration of:
► The manner in which the enterprise prepares and supports its tax return, and
► The approach the enterprise anticipates the tax authority will take during exam

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Step 1: Initial Recognition

► ASC 740 reflects the benefit recognition approach

► A tax benefit is recognized when it is “more likely than not” to be sustained based on the technical merits
of the position
► Conclusion regarding financial statement recognition takes into account tax technical merits, facts
and circumstances
► Assumes that tax position will be examined by taxing authority
► Each position must stand on its own merits
► Administrative practices and precedents deal with limited technical violations of the tax law
► Authority will not take issue with the tax position or limit scope
► Broad understanding in practice

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Step 2: Measurement

► A tax position that meets the “more likely than not” recognition threshold shall initially and subsequently
be measured as the largest amount of tax benefit that is greater than 50 percent likely of being
(cumulative probability concept)
► Based upon facts and circumstances determined at the reporting date

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Measurement: Scenario 1 (Uncertain)

Possible Estimated Outcome ($) Individual Probability of Cumulative Probability of

Occurring (%) Occurring (%)

$ 100 5% 5%
$ 80 25% 30%
$ 60 25% 55%
$ 50 20% 75%
$ 40 10% 85%
$ 20 10% 95%
$ 0 5% 100%
100%

$60 is the largest amount of tax benefit that is greater than 50 percent likely of being realized

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Measurement: Scenario 2 (Uncertain)

Possible Estimated Outcome ($) Individual Probability of Cumulative Probability of

Occurring (%) Occurring (%)

$ 100 25% 25%

$ 75 50% 75%
$ 50 25% 100%
100%

$75 is the largest amount of tax benefit that is greater than 50 percent likely of being realized

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Measurement: Scenario 3 (Certain)

Possible Estimated Outcome ($) Individual Probability of Cumulative Probability of

Occurring (%) Occurring (%)

$ 100 55% 55%

$ 0 45% 100%
100%

$100 is the largest amount of tax benefit that is greater than 50 percent likely of being realized

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Step 2: Measurement (Cont.)

► Basis for conclusions regarding amounts and probabilities could include

► Reports issued by tax authorities to settle the issue in prior years
► Evidence of tax authority administrative practices and precedents with acceptance of settlement
practices

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Subsequent Recognition

► Subsequent recognition occurs when any of the following conditions are met:
► The “more likely than not” threshold is met by the reporting date
► The tax matter is ultimately settled through negotiation or litigation
► The statute of limitations expires

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Subsequent De-recognition or Change in Measurement

► Derecognize a previously recognized tax position in the first period that it is no longer “more likely than
not”

► Changes in measurement should also be reflected in the period that such change occurs

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Interest and Penalties

► Interest is a period cost

► Interest accrual is based upon the difference between the amount of tax benefit recognized in the
financial statements and the amount recognized in the tax return

► Accrue statutory penalties when a tax position does not exceed the minimum statutory threshold required
to avoid penalties

► Tax law provisions that address interest and penalties may vary between jurisdictions and periods
► If deductible, record net of tax

► Classification of interest and penalties is an accounting policy election

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Disclosure of Tax Uncertainties

► Tabular reconciliation of aggregate beginning and ending unrecognized tax benefits

► The following items must be presented separately in the table at the end of each annual period:
► The gross amounts of the increases and decreases in unrecognized tax benefits as a result of tax
positions taken during a prior period
► The gross amounts of the increases and decreases in unrecognized tax benefits as a result of tax
positions taken during the current period
► The amount of decreases in unrecognized tax benefits relating to settlements with taxing authorities
► Reductions to unrecognized tax benefits as a result of lapse of the applicable statute of limitations

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Disclosure of Tax Uncertainties

► The amount of unrecognized tax benefits that, if recognized, would change the effective tax rate

► The classification of interest and penalties, the amount of interest and penalties included in the income
statement each period, and the total amount of interest and penalties accrued in the statement of
financial position

► If it is reasonably possible that estimate of the tax benefit will change significantly within 12 months, then
disclose:
► The nature of uncertainty
► The nature of the event that would cause the change
► An estimate of the range of the reasonably possible change, or state that an estimate cannot be
made

► Description of open tax years by major jurisdiction

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Disclosure of Tax Uncertainties
Sample

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Disclosure of Tax Uncertainties
Sample (Cont..)

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Tax-Related Disclosures in the Footnotes

1. Tax expense breakdown

► current vs. deferred
► domestic vs. foreign

2. Schedule of deferred tax assets and liabilities per balance sheet items

3. Effective tax rate reconciliation

4. Schedule of net operating losses (NOLs)

► amounts
► expiration dates

5. Income tax credits

► amounts
► expiration dates

6. Uncertain Tax Positions (discussed in separate section)

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Tax-Related Disclosures in the Footnotes
Sample

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Tax-Related Disclosures in the Footnotes
Sample

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Tax-Related Disclosures in the Footnotes
Sample

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Tax-Related Disclosures in the Footnotes
Sample

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Balance Sheet Disclosure

► Separate deferred tax assets / deferred tax liabilities into two classifications (ASC 740-10-45-5):
► Current
► Noncurrent

► For a particular component and within a particular tax jurisdiction (ASC 740-10-45-6):
► Net current (short-term) DTA / DTL
► Net noncurrent (long-term) DTA / DTL

► Current Taxes Payable / (Receivable)

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Effective Tax Rate Reconciliation
(ASC 740-10-50-12)

► Public companies must provide Effective Tax Rate Reconciliation in dollars or percentages between:
► The reported amount of income tax expense
► The amount of income tax expense that would result from applying federal statutory rates to pre-tax
financial income

► Regulation S-X provides: Separately disclose a reconciling item if it is more than 5% of the amount
computed by multiplying pre-tax income by the statutory tax rate.

► Non-public companies can omit numerical reconciliation.

► Nature and effect of any other significant matters affecting comparability of information.

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Example: Effective Tax Rate Reconciliation

IncomeTax
Taxable Income x Tax Rate Liability
U.S. GAAP net income before tax 3,00,000 1,20,000
Deduction of tax-free gain* (1,00,000) (40,000)
Add-back donations* 10,000 4,000
Add-back of M&E* 30,000 12,000
Taxable Income 2,40,000 x 40% 96,000
*permanent differences
96,000 Total income tax expenses
3,00,000 / Net income before tax
32.00% = Effective tax rate

U.S. GAAP net income before tax 3,00,000

x Enacted tax rate x 40%
= Expected income tax expense 1,20,000
Income tax expenses per Income Statement 96,000
Difference = Amount to be reconciled 24,000

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Example: Effective Tax Rate Reconciliation

1. U.S. GAAP net income before tax 3,00,000

2. x Enacted tax rate x 40%
3. = Expected income tax expense 1,20,000
4. Tax-free gain (40,000)
5. Donations 4,000
6. Meals & entertainment 12,000
7. Effective tax expenses per Income Statement 96,000
8. Effective tax rate 32%

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Example: Effective Tax Rate Reconciliation based on %

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Thank You