Tax reform will significantly affect corporate accounting for and reporting of income taxes, and the corresponding processes and controls related to issuing financial statements. The accounting effects of the dramatically altered tax code must be recognized in financial statements beginning in December, 2017, and beyond. The income statement, balance sheet, statement of owners’ equity, and cash flow statement can, and likely will, be modified as a result of tax reform.
Major financial reporting issues concern unrepatriated foreign earnings, tax levies, stranded tax effects, valuation allowance, disclosures, and other interim reporting requirements.
Unrepatriated Foreign Earnings
The Tax Act does not change existing guidance related to how an entity currently accounts for income tax effects of its investments in certain foreign entities. However, an understanding of how the entity has formerly applied this guidance is vital to determining the related accounting implications.
With limited exceptions, the guidance in ASC 740 requires entities to recognize a deferred tax liability (DTL) or deferred tax asset (DTA) for the estimated tax effects attributable to temporary differences and carryforwards. An exception is when undistributed earnings of foreign subsidiaries and foreign joint ventures are, or will be, indefinitely invested in the foreign entity.
To avoid higher tax rates, a parent entity often indefinitely reinvests the earnings of a foreign subsidiary, which results in a difference between the book carrying amount of the investment, and the tax basis in the stock of the subsidiary (also known as the “outside basis”). Although the book carrying amount of the investment is increased by the subsidiary’s earnings included in the parent’s net income, the tax basis remains unchanged unless the subsidiary is consolidated in the parent’s U.S. federal tax return. Therefore, if an entity did not elect the indefinite reinvestment assertion and recorded a DTL, it should recognize the one time transition tax on its foreign earnings by recognizing a payable and adjusting the deferred tax amounts. Similarly, an entity that elected to apply the indefinite reinvestment assertion and did not record deferred taxes, should recognize the one time transition tax on its foreign earnings by recognizing a payable.
All entities should recognize the effects of this one-time transition tax on unrepatriated foreign earnings, as well as the effects on deferred taxes for unrepatriated foreign earnings as a component of income tax expense (or benefit) in income from continuing operations for the period that includes the enactment date of Dec 22, 2017.
An entity may still have remaining outside basis differences related to its foreign subsidiaries, even after taking into account the one-time transition tax for its earnings and profits (E&P). Entities need to continue to evaluate these differences and to record them appropriately.
Tax Levies (BEAT & GILTI)
Tax reform includes some levies to prevent certain income from escaping the tax net which will impact financial statements The “Base Erosion Anti-Abuse Tax” (BEAT) generally imposes a tax on deductible payments to any foreign-related party and a minimum tax on certain domestic corporations’ modified taxable income. Additionally, BEAT applies to certain domestic corporations with $500 million or more in annual gross receipts over a three-year period, and have a base erosion percentage of 3 percent or higher for the taxable year.
Another levy is the “Global Intangible Low-Taxed Income” (GILTI), a minimum tax on certain foreign income deemed to be in “excess" of a routine return based on tangible asset investment. U.S. shareholders of controlled foreign corporations (CFCs) are subject to current U.S. tax on their GILTI, effective for tax years beginning in 2018. In general, GILTI is defined as the excess of a U.S. shareholder’s aggregated net tested income from CFCs over a routine return, on certain qualified tangible assets.
Stranded Tax Effects
The tax effect related to changes in the tax law is always reflected in income tax expense (or benefit) from continuing operations, regardless of where the related tax provision or benefit was previously recorded. For entities that must remeasure for example, their available for sale security deferred tax positions for the new rate change, that may create a mismatch with the remeasured deferred tax position and the contra-AOCI asset or liability embedded in AOCI.
Under FASB ASU 2018-02, entities must reclassify the stranded tax effects from AOCI to retained earnings for each period in which the effect of the tax rate change is recorded. The amount of the reclassification would be the difference between (1) the amount initially charged or credited directly to OCI at the previously enacted U.S. federal corporate income tax rate that remains in AOCI, and (2) the amount that would have been charged or credited directly to OCI using the newly enacted 21 percent rate, excluding the effect of any valuation allowance previously charged to income from continuing operations.
Valuation Allowance Assessment
Another impact is to valuation allowance assessment. An entity is required to establish a valuation allowance if it determines that it is more likely than not that all, or part of its deferred tax assets will not be realizable. Whether DTAs are realizable depends largely on the:
- Existence of sufficient future taxable income of the appropriate character within the statutory carryback or carryforward period, such as future reversals of existing taxable temporary differences
- Future taxable income exclusive of reversing temporary differences and carryforwards
- Taxable income in prior carryback years if carryback is permitted under the tax law, and
- Tax planning strategies that would be implemented
Any changes to the factors that an entity would consider in determining whether DTAs are realizable might impact whether a valuation allowance is required, or the amount of the allowance.
Tax reform has brought sweeping changes, so deferred tax positions impacted by tax reform will need to be reevaluated for realizability. For example, AMT credit carryforwards are now fully refundable over a four year period, so any valuation allowance previously recorded against AMT credit carryforwards would generally need to be reversed.
Disclosures
Entities are required to disclose information about the material financial reporting impacts of tax reform for which the accounting under ASC 740 is incomplete, i.e., effects not shown on financial statements, according to SEC Staff Accounting Bulletin 118. The bulletin applies whether or not a reasonable estimate can be made. Such disclosures should be provided in each reporting period until the accounting for the tax effects of the reform act is complete, including disclosing tax amounts for both deferred and current tax assets and liabilities that have not yet been recorded, the reason(s) why they have not been recorded, and what additional information is needed to recorded them.
Interim Reporting and Other Considerations
U.S. GAAP requires an entity to record the tax effect of a change in tax laws, or rates on taxes currently payable or refundable for the current year in the period that includes the enactment date. The effects should be reflected by calculating the estimated annual effective tax rate beginning no earlier than the first interim period that includes the enactment date. Therefore, for entities with year-ends after December 31, 2017, the impact of tax reform on the estimated annual effective tax rate effective January 1, 2018, should be factored into their interim-period that includes December 22, 2017.
Any adjustment to DTAs and DTLs, and related valuation allowance, should be reflected in interim financial statements for the period that includes the enactment date and should not be allocated to subsequent interim periods.
Other areas impacted by tax reform include discounting, impairment of assets and other fair value determinations, financial covenants, uncertain tax positions, state income tax implications, and internal controls.
Joseph Bailey is the Accounting Editor at Bloomberg Tax.