On Dec. 22, 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law. This legislation represents the most significant change in U.S. tax law since 1986. Corporations and other taxpaying entities will need to address the financial statement impacts of the tax law changes in the reporting period that includes Dec. 22, 2017. Topic 740 of the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC), “Income Taxes,” requires that the effects of a change in tax law and rates be accounted for in the period of enactment (ASC 740-270-25-5). In addition, an entity’s deferred tax assets and liabilities are required to be adjusted to reflect the effect of a change in enacted tax rates, in the period in which the law is enacted (ASC 740-10-35).
Effects of the TCJA on deferred tax assets and liabilities
Impact of rate changes
The enacted law reduces the corporate tax rate from 35 percent to 21 percent for tax years beginning after Dec. 31, 2017. As a result of the enacted law, a company will be required to revalue deferred tax assets and liabilities at the enacted rate, and reflect that change in its financial statements for the period that includes the date of enactment, since the deferred tax items would be expected to reverse at the reduced rate. For companies with tax years that begin before Dec. 31, 2017, but end after that date (for example, fiscal year companies with year-ends in 2018, but that began in 2017), the rate change will impact both the current year tax expense and the deferred tax expense, as the tax rate for the fiscal year will be a blended rate based on the period before and after Dec. 31, 2017 (see IRC section 15).
The changes to deferred tax items would be recorded in continuing operations and would not be subject to the intraperiod allocations.
Rate changes related to accumulated other comprehensive income (AOCI) and prior business combinations
As mentioned previously, the effect of changes in income tax laws on deferred taxes that are initially recorded as part of shareholders’ equity or AOCI are recorded as components of tax expense or benefit in continuing operations. Further, the effects of tax rate changes on items initially recorded in connection with a prior business combination also are reflected in tax expense or benefit from continuing operations. This is consistent with ASC 740’s general prohibition against backward tracing of tax effects. With respect to business combinations, this would apply regardless of how soon after an acquisition the new law is enacted. For example, a business combination that occurred in 2017 prior to enactment of the TCJA would record initial deferred taxes at the rate in effect on the date of the acquisition, and then record any impact of the rate change through tax expense or benefit.
With respect to items recorded in equity, the above will result in having disproportionate tax effects recorded in AOCI. Assume for example that an entity’s effective tax rate was reduced from 35 percent to 21 percent as a result of the new tax law, and at the date of enactment it had an unrealized loss of $1,000 in its available-for-sale securities portfolio. Prior to the change there would be a $650 debit in AOCI ($1,000 loss net of $350 tax benefit). As a result of the 14 percent change in the effective tax rate, the deferred tax asset would be credited by $140 with an offsetting debit to income tax expense from continuing operations. The balance in AOCI would remain at $650. This disproportionate effect will continue to stay in AOCI until the individual securities are disposed of (if the company accounts for the tax effects of AOCI on an item-by-item basis), or when the entire security portfolio is disposed of. The decision of whether to account for the changes on an item-by-item basis or using a portfolio approach is an accounting policy election that must be consistently applied. Several financial institutions are concerned with the impact this may have on their regulatory capital and have asked the FASB to consider amending the requirements as more fully discussed below.
Changes in net operating loss (NOL) carryforwards and carrybacks
The enacted law makes several changes to NOL carryforwards. First, for NOLs arising in taxable years beginning after Dec. 31, 2017, such losses may only offset 80 percent of current year taxable income. Secondly, for NOLs arising in taxable years ending after Dec. 31, 2017, these losses may not be carried back, and can be carried forward indefinitely. These changes will affect a company’s assessment of the ability to utilize an NOL against deferred tax liabilities. In the case of indefinite-lived NOLs, these losses will be available to offset indefinite-lived deferred tax liabilities, such as deferred tax liabilities for goodwill amortization. The limitation on NOL carryforwards to 80 percent of current year income and the elimination of NOL carrybacks may require scheduling of reversal of deferred tax liabilities and assets to support recognition of certain deferred tax assets. Further, an entity with a full valuation allowance related to its net deferred tax assets will need to consider whether its gross deferred tax liabilities will require a provision on 20 percent of the tax.
Repeal of the corporate alternative minimum tax (AMT)
The TCJA repeals the corporate AMT, effective for taxable years beginning after Dec. 31, 2017. In addition, the TCJA will continue to allow existing AMT credits to offset regular tax liability, after other credits. Also, under the TCJA, any AMT credits that are not used to reduce regular tax will be refunded, starting in years beginning after 2017 and before 2022, in an amount equal to 50 percent (100 percent in tax years beginning in 2021) of the excess of the available AMT credit for the year over the amount allowable against the regular tax. Therefore, the full AMT credit will be refunded in the 2021 tax year. For financial statement purposes, this would result in a release of a valuation allowance against any AMT credits since those credits are now ultimately realizable, either as a reduction of future regular tax liability or as a refund. We believe the AMT credit carryforward should still be recorded as a deferred tax asset since the amount that is refundable will not be determined until actual taxable income is known for a given year.
Changes related to section 162(m) and performance-based compensation
Previously IRC section 162(m) provided for a $1 million limitation on deductible compensation for certain covered employees of SEC filers that traded on an exchange. It also provided for an exception for performance-based compensation. The enacted law eliminates the exception for all performance-based compensation, including bonuses, stock options and restricted stock. It also expanded the covered employee group to include the chief financial officer and applies to a broader group of SEC filers. The law does provide a transition rule for payments that are made pursuant to a binding written contract in effect on Nov. 2, 2017. The new provisions require an analysis of deferred tax assets related to stock compensation to determine whether those assets are more likely than not to be realized, or whether they need to be written off at Dec. 31, 2017.
Other impacts on deferred tax assets and liabilities
Other areas of the legislation could impact deferred tax assets and liabilities. For example, changes in taxation of U.S. foreign subsidiaries and overall international taxation could affect the ability to utilize foreign tax credit carryforwards (e.g., reduced foreign source income, separate basket for foreign branches, changes to foreign source income rules).
Changes related to foreign subsidiaries of U.S. companies
The enacted law makes significant changes in the taxation of foreign subsidiaries of U.S. companies. As a result of these changes, a U.S. company will be required to include in U.S. taxable income the total amount of unremitted foreign earnings of its controlled foreign subsidiaries. This inclusion is effective for a foreign corporation’s final year beginning prior to 2018, which would include year’s ending Dec. 31, 2017. Therefore, companies will need to compute the incremental U.S. tax that would be payable under the enacted law. This will require companies to prepare an earnings and profits analysis for each of their foreign subsidiaries, and determine the available foreign tax pools, since the incremental tax can be offset by foreign taxes.
As a result of this change, the concept of permanent reinvestment in a foreign subsidiary would no longer be relevant as it relates to potential U.S. tax on foreign earnings. However, it would still apply to any withholding and state taxes that might be incurred on actual or anticipated dividend distribution. Further, the indefinite reversal concept that applies to basis difference in foreign subsidiaries will still apply to other outside basis differences, and would still apply to cumulative translation adjustments depending upon a company’s intentions regarding actual repatriation of the earnings. The tax that is due on the deemed repatriation may be paid over an eight-year period.
An entity that elects to pay the tax related to the repatriation over the eight-year period will need to record a portion of the payable as a current liability and a portion as a non-current liability. This amount should not be recorded as a deferred tax item as it represents an actual tax liability.
Fiscal year filing entities (i.e., non-calendar-year-end entities) will need to reflect the changes in the tax law in their quarter that includes Dec. 22, 2017.
The estimated annual effective tax rate for the current year should be adjusted in the quarter of enactment, and the effect of the rate change on current year income (including temporary differences that are originating and reversing in the current year) should be included in the estimated rate for the remainder of the year. The estimated change in the deferred tax items as of the beginning of the year should be treated as a discrete item in the quarter of enactment and should not be included in the computation of the estimated annual effective tax rate. Further, the effect of the rate change on all deferred tax items (including those that have been recorded through other comprehensive income, such as deferred taxes related to cumulative translation adjustments, unrealized gains and losses on securities, and pension expense recorded through other comprehensive income) is recorded through expense from continuing operations. Scheduling of deferred tax may be needed to determine the appropriate tax rate for reversal. A fiscal year entity could have some deferred tax items reverse in one year at a blended rate and other deferred tax items reverse at the statutory rate.
SEC Staff Accounting Bulletin 118
The SEC released Staff Accounting Bulletin (SAB) 118, which discusses certain tax accounting aspects of the TCJA. The SAB indicates that, due to the complexities inherent in the tax law changes, companies may not be able to complete a precise analysis of the impacts of the changes in the period that includes Dec. 22, 2017. The SAB provides that in cases where the company can make a reasonable estimate, it should record that estimate and make appropriate disclosures. If a reasonable estimate cannot be made, the company should not record anything, but will need to provide appropriate disclosure. There will be a measurement period of no more than a year from enactment for entities to adjust the estimates provided.
Potential changes or guidance from FASB
The FASB has indicated it is reaching out to companies, tax accounting specialists and auditors to learn about questions and issues that are surfacing as a result of the tax law change. The FASB already has indicated it will consider issuing guidance similar to that in SAB 118 for private companies as well as guidance related to the reporting of the tax rate change for items recorded in AOCI. While the exact time table has yet to be set, it is expected to be discussed by the FASB in early January and any changes to the ASC would be subject to public comment.