Improve Your Tax Provision Process

The income tax provision represents the estimated amount of income tax expense that a company is required to accrue under GAAP for the current year. This includes the taxes related to each federal, state, local, and foreign jurisdiction in which the company is subject to income tax.  

The tax provision is part of the audited financial statements that impacts the company’s earnings and earnings per share. Additionally, control failures in the provision process are a leading cause of company financial restatements and material weaknesses. As a result, the tax provision is often the most scrutinized process, by both management and other stakeholders, that the tax department undertakes.    

Risk and Complexity  
Tax departments typically only have a few days or weeks at most to perform the complex year-end provision calculations required under ASC 740. Getting started early is not an option since pretax income is the starting point for the ASC 740 process. In other words, much of the provision process cannot actually be finalized until all of the other financial close processes have been completed.  

In addition, since the income tax provision process sits at the intersection of several bodies of technical rules, the corporate tax provision process is inherently complicated.   

ASC 740 introduces concepts such as valuation allowances, uncertain tax benefits and permanent reinvestment that require their own complex technical analysis under GAAP. Provision calculations require in-depth knowledge of both income tax technical rules in the various jurisdictions and a deep understanding of ASC 740 as proscribed by the Financial Accounting Standards Board (FASB). ASC 740 introduces concepts such as valuation allowances, uncertain tax benefits and permanent reinvestment that require their own complex technical analysis under GAAP.  

A Framework for Improving Tax Provision Processes  

Based on work with both leading Fortune 500 and large private companies, we have developed a simple but effective framework for analyzing challenges in the tax provision processes. For each topic in the provision, i.e., stock compensation, GILTI, valuation allowances, uncertain tax benefits, etc. the framework divides the topic amongst three-distinct phases. By analyzing each element by phase, you can more easily focus on risk and process improvement for the particular topic. Analyzing your process in the context of the tax provision phases below can help mitigate inaccuracy risks and potential control failures.  

Understand the Phase of the Tax Provision Workflow Process That is Causing the Problem  

Since tax provision is innately complicated, the more the process can be broken down into digestible components, the easier it is to manage, and when necessary, troubleshoot areas of concern. To simplify this process, it is critical to understand the overall tax provision workflow process for any given topic of the process. This process can be categorized into three key phases as follows:  

Business Facts  

• What legal structures, jurisdictions, general ledger and other data impact the specific provision process, but exist independent of tax law?  
• Essentially, this is the data that the tax department needs in order to perform its analysis and calculations. Often this data is not provided in the appropriate format or granularity for immediate use by the tax department. This results in many tax departments spending time manipulating the data so the actual tax work can be performed. For example, certain data might not be provided on an entity-by-entity basis as required by the tax department, so the tax department spends time allocating the amounts amongst the legal entities based on some set of informal rules or heuristics.   

Tax Law  

• What are the applicable tax laws that need to be applied to the business facts including items such as foreign tax credits, GILTI, and R&D credits?  
• This is the direct application of all the relevant tax laws to the company's data from the business facts phase. The tax department needs to stay up to date on any new tax developments and ensure that all the laws are being applied correctly. This is typically done in spreadsheets and should align directly with the actual rules that are imposed by the tax authorities.  

ASC 740  

• ASC 740 is the technical framework for accounting for income taxes. It leverages the information and values calculated in the business facts and tax law phases to create a proscribed set of calculations that aren’t required under tax law.   
• As mentioned before, ASC 740 introduces its own complex technical rules that need to be complied with from an accounting perspective.    

Often for a particular topic, companies combine more than one phase of the process in the same spreadsheet workbook. Though this isn’t inherently a problem, it often leads to conflating the challenges associated with each part of the process and may make it more difficult to identify the true underlying issues.   

Take the GILTI calculation for example. The challenges around GILTI in your provision process may stem from different phases of the process. If the challenge is getting the appropriate data needed from foreign jurisdictions, that is related to the business facts phase which is distinctively different from a challenge applying the actual complexities of the tax regulations in the Tax Law phase. Each of these challenges is a separate issue from the ASC 740 phase challenges of ensuring that the rate reconciliation correctly reflects the GILTI inclusion and other GILTI-related deductions and credits. When all of these issues are conflated it is more difficult to identify the areas where process improvements are needed.  

Consider, another example, a company that is experiencing an issue related to stock compensation.  Here are a few types of challenges that a tax department may encounter that are a result of different phases of the same process.  

1. The general ledger information is incorrect. The data that supports the stock comp deduction does not tie out or is not rolled forward.   
2. The reports the tax department receives from the accounting team are accurate, but there is an error in the calculation of the book-to-tax differences.  
3. The reports data is correct, and the tax department is correctly applying the tax law, but tax ASC 740 calculation incorrectly reflects an item as a permanent adjustment rather than a temporary item.    

In the above outlined scenario, only by first identifying the specific issue at hand, in this case an error related to stock compensation, can a company take corrective action. To take it a step further, if a company incorrectly reported its provision because of stock compensation and the root cause of the issue related to the business facts phase (i.e., inaccurate or incomplete data was provided to the tax department), even more ASC 740 training around stock compensation would not remediate the risk in the future. That is distinctively different from a situation where, for example, the company did not record a deferred tax asset for the stock compensation expense related to certain stock awards. In that instance, the issue would be an ASC 740 concern. Either outcome would be reflected in the provision process and would result in an error, but the remediation of the issue would be distinctively different due to the phase of the process that caused the error.  

Maintain an Uncertain Tax Positions Checklist  

One of the most important tasks related to uncertain tax positions is to maintain a consistent evaluation process. This process should include a checklist of questions focused on the above identified key phases of the workflow process. These questions can be used as a filter to determine whether or not an uncertain benefit needs to be accounted for.  

Documenting the following checklist for each jurisdiction that you do business in can help ensure that you have captured any changes to existing uncertain tax benefits or new uncertain tax positions. Notice that this checklist follows the same provision phase workflow described above. Each question should be evaluated in the context of its potential impact on uncertain tax positions.  

Business Facts  

• Has my business changed its operations in this jurisdiction?  
• Has my company acquired a business in this jurisdiction?  
• Has my company changed its operating structure, or has it done new types of sales, new expansions?  

Tax Law  

• Have the laws or regulations changed for this jurisdiction?  
• Have authorities opened or closed any exams?  
• Have any statutes expired?  
• Have there been any inquiries or notices not necessarily reaching the level of an exam?   
• When company tax returns were filed, did the company take a position that contradicts forecasted tax provision?  
• Is the tax department, internally or externally, engaged in technical writing supported by tax law to document why it is taking a certain position?  If so, this is a red flag that your company may be dealing with a position that is not highly certain. That doesn’t mean it results in an uncertain tax benefit, but it likely reaches the level that it is likely subject to the uncertain tax benefit analysis and evaluation.  

ASC 740  

• Any changes in uncertain tax benefits needs to be accounted for in the appropriate period and classified appropriately for disclosure?  
• For companies with NOLs and credit carryforwards, are any netting of uncertain tax benefits against the underlying attributes updated?  
• For companies that have a noncurrent payable, are interest and penalties calculated and accrued as part of income tax expense?  
• Are the changes incorporated in the appropriate period as either discrete items or part of the annual effective tax rate for interim purposes?  

Analyze Valuation Allowance  

When determining whether or not a company needs to record a valuation allowance (VA) to offset a deferred tax asset, the analysis requires a similar phased approach.    

• Business Facts 
  • Does the company have a history of losses?  
  • Does the company forecast earnings or losses?  
  • Has the business entered into new contracts or lost contracts that would change its expectations with respect to earnings or losses?  
  • Has the business changed its cost structure in a way that would impact future earnings or losses?  

• Tax Law 
  • Is the company going to produce enough taxable earnings to use credits, NOLs, or other deferred taxes?  
  • How do the temporary items reverse in future years?  
  • Is there a history of attributes expiring unused?  

• ASC 740 
  • Are the negative and positive evidence from above based on verifiability and judgment?  
  • Do tax planning strategies enable the utilization of deferred tax assets? 
  • If the company applies tax law, would it be able to use the attribute or the deferred tax asset? The answer to this question leads to the answer as to whether or not a company needs to allocate a VA.  
  • Are the changes incorporated in the appropriate period as either discrete items or part of the annual effective tax rate for interim purposes?  

The challenges with determining the VA can occur in any phase of the process. Are you experiencing difficulties because the forecasting team isn’t providing info by legal entity? Is the tax department struggling with the tax law calculations due to a need for more technical knowledge? Is the challenge managing the impact of the VA on the income tax rate reconciliation?   

By leveraging a consistent framework for dividing each process into phases you can more easily identify where process risks can be mitigated, or improvement opportunities can be made.  

Nick Frank is the Bloomberg Tax & Accounting Product Lead