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ASC 740 UPDATE CASE STUDIES
BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms.
Tax Executives Institute – Detroit Chapter – June 14, 2017
Case Study 1
Question:
Fulham Corporation, U.S. Corporation and a public business entity, adopted ASU 2016‐09, improvements to Employee Share based payments, on January 1, 2017. Fulham is in a full valuation allowance position with respect to its deferred tax asset position. At the date of adoption Fulham had excess tax benefits from exercises of stock options and vesting of RSUs embedded in its net operating loss carryovers. At the date of adoption no cumulative effect adjustment was recorded in retained earnings since the increase in the deferred tax asset was offset by a valuation allowance.
During the third quarter of 2017 Fulham determined that based on positive evidence that it was able to release its valuation allowance including the amount with respect to its excess tax benefits. Fulham management has suggested that retained earnings as of January 1, 2017 should be adjusted for the impact of the release of the valuation allowance with respect to excess tax benefits.
How would you respond to Fulham’s suggested accounting?
Answer:
In this situation the proper response would be that the release of the valuation allowance with respect to the excess tax benefits should be released through earnings (continuing operations or other elements) and that opening retained earnings should not be adjusted. The objective of the modified retrospective adjustment to retained earnings is meant to recast a company’s accounting for a particular item where it would have been at the beginning of the year as if it had always been on the revised method.
Case Study 2
Question:
Company M holds a 40% interest in a partnership that is accounted for under the equity method
Book basis is $4 million, Tax basis is $5 million
M has a DTA on the outside basis difference in the investment in partnership of $400 (40% tax
rate) No valuation allowance
M decides to buy‐out the other partner for $30 million and ultimately owns 100% afterwards
M’s initial investment in the partnership is stepped‐up to fair value of $20 million
Assets acquired and liabilities assumed are:
Purchase price $50,000,000
Liabilities assumed 100,000
Purchase price plus liabilities assumed $50,100,000
Less: FV of assets acquired
Cash and investments 700,000
Inventory 400,000
Fixed assets 500,000
IPR&D 10,700,000
Intangible Assets 14,300,000
Total $26,600,000
Goodwill $23,500,000
What are the deferred tax entries and tax consequences required as a result of the acquisition of the
remaining interest in the partnership? Also, what amount, if any, is considered tax‐deductible goodwill?
Answer:
Total
60%
40%
§1060 Allocation
Purchase price $50,000,000 $30,000,000 $20,000,000
Liabilities assumed 100,000 60,000 40,000 40,000
Purchase price plus liabilities assumed $50,100,000 $30,060,000 $20,040,000 40,000
Less: FV of assets acquired
Cash and investments 700,000 420,000 280,000 280,000
Inventory 400,000 240,000 160,000 160,000
Fixed assets 500,000 300,000 200,000 200,000
IPR&D 10,700,000 6,420,000 4,280,000 1,883,200
Intangible Assets 14,300,000 8,580,000 5,720,000 2,516,800
Total $26,600,000 $15,960,000 $10,640,000 $5,040,000
Goodwill $23,500,000 $14,100,000 $9,400,000
Tax basis $30,000,000 $5,000,000 5,000,000
Full tax basis Partial tax basis
Entry 1:
Reverse DTA on outside basis as no longer necessary
DR: Deferred Tax Expense $400,000
CR: DTA $400,000
In addition, a gain of $16,000,000 ($20M stepped‐up basis less book basis of $4M) will be recorded for
financial statement purposes with no corresponding deferred tax accounting since it is assumed that the
DTL which would be set up on the outside basis difference will reverse through P&L with the net deferred
on the inside basis difference recorded in acquisition accounting.
Entry 2:
Record deferred taxes through purchase accounting for inside basis differences
DR: Goodwill $2,240,000
CR: DTL $2,240,000
Calculated:
Total book basis of intangibles attributable to the 40% interest: $10,000,000
Total tax basis of intangibles allocated under §1060* $ 4,400,000
Taxable temporary difference $ 5,600,000
DTL at 40% tax rate $ 2,240,000
*(see Reg. 1.1060‐1b(8) – partial non‐recognition exchanges)
Goodwill:
Book Tax
Component 1 $14,100,000 $14,100,000 Lesser of tax deductible GW or book GW
Component 2 $11,600,000 ‐‐‐ Excess non‐deductible book goodwill
Total $25,700,000 $14,100,000
$14,100,000 of goodwill is deductible for income tax purposes. As there was no purchase price
remaining to allocate to goodwill under §1060 when allocating the tax basis of the equity method
investment, zero goodwill for tax purposes is attributable to the 40%.
There is an alternate view with respect to the recognition of a DTL with respect to the gain recognized
on the previously owned 40% interest. Pursuant to this view deferred tax expense would be recorded
with respect to the gain recognized with the inherent DTL morphed into the inside DTL with any
residual deferred tax recorded in acquisition accounting.
Case Study 3
Question:
Alpha Corp. forms a partnership (Beta) with Omega Corp. with the ownership of 80% and 20%,
respectively. Alpha contributes $1,000 and Omega contributes $250 to Beta. Beta then acquires the
outstanding stock of a foreign corporation for $1,250. That year, the foreign corporation earns $500 of
net income, which is not distributed to its owner. Beta earns $500 of net income (earnings from foreign
corporation), which is also not distributed.
At the end of the year, Alpha’s investment in the partnership is equal to $1,400 ($1,000 original
investment and 80% * $500 of partnership earnings). Alpha’s tax basis of its investment in the
partnership is $1,000. The $400 basis difference is entirely due to the undistributed earnings of the
partnership’s investment in the foreign corporation.
Should Alpha record a deferred tax liability for the excess book basis over tax basis of its investment in
the partnership?
Answer:
It depends. A deferred tax liability would not need to be recognized for the basis difference if Alpha is
able to demonstrate that the ASC 740‐30‐25‐17 (APB 23) exception applies to the partnership’s
investment in the foreign corporation.
Case Study 4
Question:
Tax rate is 30%.
XYZ Company owns a 70% interest in ABC partnership which is consolidated for book purposes. The partnership’s consolidated pre‐tax operating results for 20X7 are:
Revenue $140,000
Less: Expenses (40,000)Income before income tax expense $100,000
Prepare the income statement for XYZ for 20X7, assuming that the partnership is its only business unit.
Answer:
Revenue $140,000 Less: Expenses (40,000)
Income before income tax expense 100,000Income tax expense (21,000)
Net income 79,000Less net income attributable to non-controlling interest (30,000)1
Net income attributable to controlling interest $49,000
Since the partnership is not a taxable entity, XYZ would only include the tax expense associated with its portion of the partnership operating results in the tax calculation. This creates a variance between the expected and actual tax expense reported.
1 ($100,000 X 30%) ‐ $0 income tax expense
Case Study 5
Question:
Delta Co., a U.S. C corporation, has a calendar year end. Delta is very profitable and pays federal
tax at a 35% rate. During 2017 the federal rate changes from 35% to 20% on 6/30/17 effective
for tax years beginning on or after 1/1/2018. As of December 31, 2016 Delta’s deferred tax
position was as follows:
Gross Net
Depreciation
(500)@35%
(175)
Bad Debts 200 @35% 70
Available for sale securities 100 @35% 35
Delta is projecting income for financial reporting purposes of $4,000 for 2017 and assume it is earned ratably over each quarter. Delta has projected its ending deferred tax balance as of 12‐ 31‐17 to be as follows:
Gross Net
Depreciation
(700) @20%
$(140)
Bad Debts $300 @20% 60
In addition the amounts in OCI are as follows (note – OCI is always calculated discretely, Q3 & Q4 are presented as actual to demonstrate the accounting for OCI:
12/31/16 3/31/17 6/30/17 9/30/17 12/31/17
Gross Rate
Net DTA
$100 $100 $150 $200 $200X35% X35% X20% X20% X20%
$35 $35 $30 $40 $40
Based on the above calculate the tax provisions for Q1, Q2, Q3 and year end (assume for year‐ end that projected equals actual)
Answer: When determining the effect of a tax law change entities must consider the tax law changes effect on the deferred tax balances at the date of enactment. In this example we are assuming that the income is earned ratably and that the related deferred items increase ratably. The following would be a reasonable methodology for determining the tax provisions at each quarter end.
3/31/17 6/30/17 9/30/17 12/31/17
Q1 Q2 Q3 Q4
Pre‐tax $4000 $4,000 $4000 $4000
Temporary diffs (100) (100) (100) (100)
Taxable income 3900 3900 3900 3900
X 35% 35% 35% 35%
Estimated current tax $1,365 $1,365 $1,365 $1,365
Projected Deferred tax expense1 35 20 20 20
$1,400 $1,385 $1,385 $1,385
Rate 35% 34.6% 34.6% 34.6%
Q1 Pretax $1000. $2,000 $3,000 $4,000
Rate X35% X34.6% X34.6% X34.6%
Tax @ rate $350 $692 $1,038 $1,384
Discrete Change in rate2
(45) (45) (45)
Rate change in OCI3 15 15 15
Total tax expense Continuing operations
$350 $662 $1008 $1,354
Quarterly Tax
Continuing operations $350 $312 $346 $346
OCI ‐ (10) (10)
Total Expense $350 $302 $336 $346
The key point in the above example is to demonstrate that the deferred impact of the rate change is recorded in continuing operations in the period of enactment. This also includes the rate change ascribed to items recorded in other comprehensive income.
In the above example the $45 is calculated as the BOY deferred @ 20% which is the amount of the rate change. The rate change with respect to the current year increase in deferred is recorded via the rate applied to Y‐T‐D income. Footnotes: 1. Projected deferred tax expense:
Q1 BOY $105 (net DTL $400x35%) EOY 140 Projected Expense $35 Q2, Q3, Q4 BOY $ 60 (net DTL $300x20%) EOY 80 Projected Expense $20
2. Discrete change in rate: BOY net deferreds ($300x20%) – $105=$45
3. OCI rate change discrete: BOY $100x35% = $35 Q1 100x20% = 20 Rate Change $15
Case study 6
Question: Tottenham, Inc. a U.S. publicly traded C Corporation has been in losses for the past several years and has only recorded deferred tax assets to the extent of its reversing taxable temporary differences. Its deferred tax profile at 12/31/17 is as follows:
Gross Rate Net
Net Operating loss carryover
$5,000
35%
$1,750
Temporary differences $2,000 35% 700
Intangible assets ($6,100) 35% ($2,100)
Goodwill ($1,000) 35% ($350)
Val Allowance ($350)
Net deferred tax liability ($350)
The net operating loss carryovers have a remaining life of 20 years and the intangible assets will reverse pro rata over the next four years. The bad debt differential will reverse in 2018.
On January 1, 2018 federal tax legislation is passed which designates all existing net operating losses as well as any future carryovers to have an unlimited carryover period and eliminates any carryback period that existed.
The legislation also provided that the NOL can only offset 90% of taxable income in any given year. Based on the above determine what adjustment, if any, Tottenham would need to record with respect to the change in tax law.
Answer: In this fact pattern Tottenham would need to schedule the reversal of its existing deferred taxes in order to determine what adjustment, if any, would be needed due to the recently passed legislation. The following table summarizes the computation of the deferred tax assets after the application of the loss limitation and the extension of the net operating loss carryforward period:
Account Reversal Reversal Reversal Reversal Reversal
1/1/18 2018 2019 2020 2021 Infinite
Bad debts $2,000 (2,000)
Intangible assets (6,000) 1,500 1,500 1,500 1,500
Goodwill (1,000) ‐ ‐ ‐ ‐ 1,000
Taxable income (500) 1,500 1,500 1,500 1,000
NOL loss limitation ‐ ‐ (1,350) (1,350) (1,350) (900)
NOL remaining 5,000 5,500 4,150 2.800 1,450 550
Rate X35%
Val Allowance $193
As can be seen from this simple example scheduling can be quite complex. Although ASC 740 does not require an entity to perform detailed scheduling in this situation it would be required in order to determine the pattern and the timing of the reversal of temporary differences in order to ascertain the need and amount of the valuation allowance. Although the carryforward period has been extended the fact that the NOL is limited to 90% of taxable income still necessitates that a valuation allowance be recorded.
Case Study 7
Question:
Delta Company which is a U.S. C Corporation operates a branch in country X. The U.S. tax rate is 40%
while the branch rate in country X is 20%. During 20x1 the years’ operating results of the parent and the
branch are as follows (U.S. results include branch results):
U.S. Country X Branch Elim Total
Pre‐tax income $300 $200 $(200) $300
The country X branch has tax depreciation in excess of book depreciation of $100. There are no
temporary differences or nondeductible/non includible amounts in the U.S.
Based on the above how would Delta record its tax provision for 20x1. Assume that Delta is able to avail
itself of foreign tax credits.
Answer:
U.S. Country X Branch Elim Total
Pre‐tax income $300 $200 $(200) $300
Temporary difference ‐ (100)
Taxable Income 300 200
Tax Rate 40% 20%
120 20
Foreign tax credit (20) ‐
Total current tax expense
Total Tax:
$100 U.S.
$20
Country X Branch
Total
$120
Current tax $100 $20 $120
Deferred tax 20 20
Def. tax for potential FTC (20) (20)
Total tax $80 $40 $120
Because the branch is taxable in both the U.S. and country X a taxable temporary difference needs to be
recorded in order to avoid double counting. In the case of Delta Company foreign taxes will be increased
when the DTL is settled in the county X branch. Since Delta is able to benefit from foreign tax credits an
offsetting DTA is recorded to reflect the potential benefit.
Case Study 8
Question:
The facts are the same as the previous example except that Delta is not able to credit foreign taxes but
rather claims them as deductions.
How would Delta record its 20x1 for provision based on the above.
Answer:
U.S.
Country X Branch
Elim
Total
Pre‐tax income $300 $200 $(200) $300
Temporary difference _ (100)
Foreign tax deduction (20)
Taxable income 280 100
Tax Rate 40% 20%
Current Tax $112 20 $132
Total tax:
U.S.
Country X Branch
Total
Current Tax $112 $20 $132
Deferred tax 20 20
U.S. benefit of
Deduction $20x40% (8) (8)
Total tax expense
$104
$40
$144
In the above fact pattern the U.S. DTA for impact of the foreign tax is only benefited for the tax effect of
the deduction. Due to this Delta’s overall tax expense is increased as compared to the prior example.
Case Study 9
Question:
Celtic Inc., a U.S. C Corporation, is doing business in the U.K. in branch form. The operating results for
20x1 are as follows:
U.S. U.K Elim Total
PBT $300 $(100) $100 $300
The tax rate in the U.S. is 35% and in the U.K. 20%. There are no other temporary or permanent
differences and no attributes being carried over from the previous years. In the past the U.K. has been
profitable but the U.S. has only been able to deduct the foreign tax paid by the U.K. as opposed to
claiming the credit.
What is the tax accounting for the combined operations?
Answer:
In this particular fact pattern we have seen two different positions taken. The first is as follows:
Generally when the branch has attributes (DTA’s included) the U.S. Company records a DTL when the
branch is in an overall DTA position under the theory that it is improper to recognize a double benefit
for the foreign attribute since it would have been used in the U.S. return. When it subsequently reverses
there will be no foreign tax credit or deductions to offset the inclusion of the foreign income in the U.S.
group.
An alternative view is as follows:
U.S. U.K Elim Total
Pre‐tax income $300 $(100) $100 $300
Tax rate 35% 20% ‐‐‐‐
Tax $105 (20)
DTL for U.K. carryover 7
Total tax expenses $112 $(20) $92
U.S. U.K. Elim Total
Pre‐tax income $300 $100 $100 $300
Tax Rate 35% 20%
Tax $105 $(20)
U.S. DTL on U.K. carryover 20
Total tax expense $125 $125 $105
Under this construction the U.S. DTL is only recorded at the expected cost of the deduction which in this
case will be $20x35%. When this eventually unwinds the overall tax rate will increase since there will be
no foreign tax credit or deduction to offset the inclusion of income in the U.S. tax accounts.
Case study 10
Question:
Blarney Co., a U.S. public Company purchases all of the outstanding stock of Kinsale Ltd located in the country of Moronika (MK). The purchase price paid by Blarney was $1,000,000 of which $250,000 was allocated to amortizable intangibles and $300,000 was allocated to goodwill. The intangibles are amortizable for book purposes over a five year period and there is no tax basis in either the intangibles or goodwill. At the time of the acquisition the exchange rate between the U.S. and MK was 1.0 to 1.5. The following were the exchange rates at the end of each subsequent year:
Year
Average Rate
Spot Rate
1. 1.75 2.0
2. 2.0 2.5
3. 2.7 3.0
4. 2.6 2.5
At the acquisition date Blarney did not record the acquisition accounting entries on the books of Kinsale but rather recorded them as a separate company in its general ledger system. The tax rate in MK is 20% and U.S. is 40%.
Blarney’s accounting for the goodwill and intangibles in its separate company books was as follows:
Int. & G.W
DTL
Equity
P&L
Ret. earnings
Acq Date 550,000 (50,000) (500,000)
Yr 1 500,000 (40,000) (500,000) (40,000)
Yr 2 450,000 (30,000) (500,000) (40,000) (40,000)
Yr 3 400,000 (20,000) (500,000) (40,000) (80,000)
Yr 4 350,000 (10,000) (500,000) (40,000) (120,000)
Based on the above what recommendation would you have made with respect to the above accounting?
Answer:
In the instant situation we believe that the above accounting is not correct since it fails to take into account the impact of F/X movements on the reported balances. The following would be what we perceive to be the appropriate accounting:
At Acquisition Accounting
Date
FC
F/X Rate
US $
Intangibles 825,000 1.5 550,000
Deferred tax liability
(DTL) (75,000) 1.5 (50,000)
Equity 750,000 1.5 500,000
Year 1
FC
F/X Rate
US $
Intangibles 750,000 2.0 375,000
DTL (60,000) 2.0 (30,000)
690,000 345,000
Amort exp. 75,000 1.75 42,860
Def. tax benefit
(15,000) 1.75 (8,575)
R.E. ―
Equity 750,000 1.50 500,000
CTA 120,715
(750,000) (345,000)
Year 2
F/X
FC Rate US $
Intangibles 675,000 2.5 270,000
DTL (45,000) 2.5 (18,000)
630,000 252,000
Amort exp. 75,000 2.0 37,500
Def. tax benefit
(15,000) 2.0 (7,500)
R.E. 60,000 ― 34,285
Equity (750,000) 1.5 (500,000)
CTA
183,715
(630,000) (252,000)
Year 3
FC
F/X Rate
US $
Intangibles 600,000 3.0 200,000
(DTL) (30,000) 3.0 (10,000)
570,000 190,000
Amort exp. 75,000 2.7 27,780
Def. tax benefit
(15,000) 2.7 (5,555)
R.E. 120,000 64,285
Equity (750,000) 1.5 (500,000)
CTA
223,490
(570,000) (190,000)
Year 4
F/X
FC Rate US $
Intangibles 525,000 2.5 210,000
(DTL) (15,000) 2.5 (6,000)
510,000 204,000
Amort exp. 75,000 2.6 28,850
Def. tax benefit
(15,000) 2.6 (5,770)
R.E. 180,000 ― 86,510
Equity (750,000) 1.5 (500,000)
CTA
186,410
(510,000) (204,000)
Case Study 11
Question:
Assume the following with respect to Arsenal Corporation as of its year ended December 31, 20X7:
Dr (Cr)
Beginning NOL carryforward $1,000
Current year pre‐tax book income 500
Current year temporary difference tax
depreciation greater than book
depreciation
(700)
State only tax credits generated in the
current year 500
Arsenal files in one state only. The book and tax depreciation and net operating loss carryovers are the
same for state and federal purposes. Arsenal has determined that it will be able to recognize its
deferred tax assets – the federal rate is 35% and the state rate is 8%.
Based on the above which of the following would be considered the appropriate footnote presentation.
A. Net operating loss carryover 482
State credit carryover 325
Fixed Assets (282)
B. Net operating loss carryover 482
State credits Federal effect of state temporary differences
500
(175)
Fixed assets (282)
C. Net operating loss carryover 516
State tax credit carryovers 500
Federal effect of state temporary differences Fixed assets
(190) (301)
D.
B & C
E. All of the above
Answer:
C
ASC 740‐10‐55‐20 states:
State income taxes are deductible for U.S. federal income tax purposes and therefore, a deferred state
income tax liability or asset gives rise to a temporary difference for purposes of determining a deferred
U.S. federal income tax asset or liability, respectively. The pattern of deductible or taxable amounts in
future years for temporary differences related to deferred state income tax liabilities or assets should be
determined by estimates of the amount of those state income taxes that are expected to become
payable or recoverable for particular future years and, therefore, deductible or taxable for U.S. federal
tax purposes in those particular future years.
ASC 740 generally requires separate identification of temporary differences and related deferred taxes
for each tax‐paying component of an entity in each tax jurisdiction, including U.S. federal, state, local
and foreign tax jurisdictions. ASC 740‐10‐45‐6 states the following regarding the offsetting of DTAs and
DTLs:
For a particular tax‐paying component of an entity and within a particular tax jurisdiction, all current
deferred tax liabilities and assets shall be offset and presented as a single amount and all noncurrent
deferred tax liabilities and assets shall be offset and presented as a single amount. However, an entity
shall not offset deferred tax liabilities and assets attributable to different tax‐paying components of
the entity or to different tax jurisdictions.
Answer A nets the federal benefit against the state deferred item. Calculation is as follows:
NOL carryover – ((.08 x .65) + .35) x 1,200 =$482
Fixed assets – ((.08 x .65) + .35 x (700) = ($282)
State only credits – (.65 x 50) = $325
The concern with this type of presentation is that in certain situations an entity might improperly assess
whether a valuation allowance is needed, could lead to improper balance sheet presentation and could
lead to improper footnote disclosures related to DTAs. Although we do see this in practice companies
should assess whether it causes any issues with respect to what was discussed above (in certain cases
there won’t be an issue).
Answer B discloses a separate deferred tax item for the state only tax credits. The deferred taxes are
calculated as follows:
NOL carryover ((8% x 1,200) + ((35% x (1‐8%) x 1,200) = $482
State credits since a state only deferred would record the full $500 credit
Federal impact of state only
deferred tax items $500 x 35% = ($175)
Fixed assets (8% x $700) + ((35% x (1‐8%) x $300) = ($282)
Under this construction the state benefit/detriment is netted versus the deferreds that are identical for
both federal and state purposes while the federal detriment (DTL) for the state only credit is recorded as
a separate deferred item. It appears that this would be an acceptable approach for those items where
the state and federal deferred tax items are the same. We believe it would be a rare situation whereby
federal and state NOLs are the same and would expect in most situations that the state NOLs would be
treated as a separate item.
Answer C records both the federal and state tax effected DTAs and DTLs without factoring in any state
tax effect. The state tax impact is reported as a separate deferred item. The calculations are as follows:
NOL carryover (8% x $1200) + (35% x $1,200) = $516
State credits since a state only deferred would record the full $500 credit
Federal effect of state
temporary
differences:
NOL (8% x $1,200) x 35% = ($34)
State credit (35% x $1,200) = ($175)
Fixed assets (8% x $700) x 35% = $19
($190)
Fixed assets (8% x $700) + (35% x $700) = ($301)
The presentation in C is one that at least one firm will only accept. We believe it is also acceptable since
it clearly reflects an entity’s deferred tax position.
Case Study 12
Question:
Assume a 40 percent tax rate: Dr.(Cr.)
Beginning NOL carry-forward $3,000 Beginning of year unrealized loss on for sale securities $3,000 Deferred tax asset $2,400 Valuation allowance ($2,400)
Current Year Activity:
Loss from continuing operations $1,000 * Unrealized gain on for sale securities ($800) * Unrealized loss that was reclassified to continuing operations ($200) Ending NOL carry forward $4,200 Ending unrealized loss on available for sale securities $2,000 Deferred tax asset $2,480 Valuation allowance ($2,480)
* Amount does not include $200 of unrealized loss (reclassification entry) on available for sale securities that was both earned and recorded in continuing operations during the current year
Determine the total tax expense and its allocation between continuing operations and other comprehensive income.
A. Continuing operations $0 Other comprehensive income $0
B. Continuing operations ($320) Other comprehensive income $320
C. Continuing operations ($400) Other comprehensive income $400
D. (B) or (C)
Answer D
Total tax expense generally is allocated using a step-by-step approach. Under this approach, an enterprise first determines the amount of tax expense or benefit allocated to continuing operations and then proportionally allocates the remainder to items other than continuing operations.
In the question above, the total tax benefit is $0, because the increase in the deferred tax assets was offset by an increase in the valuation allowance.
Generally, the tax effect of income from continuing operations should be determined without considering the tax effect of items that are not included in continuing operations. ASC paragraph 740-20-45-7 provides an exception to this general approach by requiring all components, including discontinued operations, extraordinary items, and items charged or credited directly to equity, be considered when determining the tax benefit from a loss from continuing operations. For example, there may be situations in which an enterprise has a loss from continuing operations for which a valuation allowance would be required absent income being generated from another component outside continuing operations, for example discontinued operations.
In the question above, the company would record an income tax benefit in continuing operations of $320 ($800 x 40%) and an income tax expense in OCI of $320($800 x 40%). The entity should consider the $800 of unrealized gains on available for sale securities earned during the current year when determining the tax benefit from a loss from continuing operations. Some practitioners might advocate and thus there is diversity in practice that the reclassification of the unrealized loss to continuing operations should be treated as part of the gain on the for sale securities and thus would yield a benefit of $400 in continuing operations and an expense in OCI which would make C the Answer.
Case Study 13
Question:
As of 12/31/X7 Charlton, Inc., a US C Corporation, had a net operating loss carryover of $ 35,000 on
which it had maintained a full valuation allowance. During the fourth quarter Charlton sold subsidiary X
and recognized a book tax gain of $70,000, there were no permanent nor temporary differences except
for the net operating loss carry overs. The operating results of subsidiary X which Charlton sold will be
classified as discontinued operations in its 20X7 financial statements. Charlton generated a year to date
loss in continuing operations of ($10,000) and a loss from operations for subsidiary X of ($10,000).
Charlton is unable to project that it will have income from the remaining business. Charlton proposed to
record the following tax amounts in continuing operations and discontinued operations.
Exp./(Benefit)
Continuing Operations $(15,750)Discontinued Operations 21,000 Total tax expense $5,250
Carlton derived the above based upon the following:
Calculation of total tax expenses:
Charlton next took the results from discontinued operations of:
Loss from operations $(10,000)
Gain on Sale 70,000 Total Income 60,000Rate 35% Expense allocated disc.ops. 21,000Residual to continuing ops. (15,750) Total Tax Expense $5,250
Based on the above what recommendations would you make to Charlton with respect its proposed
accounting?
Answer:
Loss continuing operations $(10,000)Loss discontinued operations (10,000)Gain on Sale 70,000Utilization of NOL (Fully Valued) (35,000) Total taxable income 15,000Rate 35% Total Tax $5,250
Based on the above fact pattern we believe it would be appropriate for Charlton to change its
accounting for 20X7 to the following
Exp. (Benefit)
Continuing Operations $(3,500)Discontinued Operations 8,750 Total tax expense $5,250
The logic that Charlton should have used in the current situation was to prepare a with and without
calculation. Charlton did consider the with calculation and determined total tax expense. However, in
calculating on a without basis Charlton used a bottoms up approach of calculating the impact on
discontinued operations without considering the guidance in ASC 740‐20‐45‐12, 13 & 14 which would
have required Charlton to allocate expense/benefit to continuing operations prior to allocating to items
other than continuing operations. Had Charlton followed the above it would have first analyzed whether
a benefit should be recognized for the ($10,000) loss in continuing operations and would have
determined that pursuant to ASC 740‐20‐45‐7 that the income from discontinued operations be
considered a source of income in order to recognize the benefit . The next step in the analysis would
have been to determine whether the release of the beginning of the year valuation allowance ($12,250
($35,00 x 35%)) could be allocated to continuing operations based on projections of future year(s)’
income. In the above facts it was stated that Charlton could not project future income from the
continuing business and thus the release of the BOY valuation allowance would not be allocated to
continuing operations but would in effect be allocated to discontinued operation since the expense in
discontinued operations would be the residual amount after the allocation to continuing operations.
Case Study 14
Question:
Patriot Corp, a U.S. headquarter company, has a wholly‐owned foreign subsidiary in Australia which it charges a yearly royalty of $100,000,000 which is based on 5% of Australia’s sales. The U.S. rate is 40% while the Australian rate is 30%. Patriot has yearly transfer pricing studies performed but it believes if audited that the I.R.S. would assert that the royalty should be based on 8% of sales ($160,000,000) and believes that this rate is greater than 50% likely of being accepted by the Internal Revenue Service. In addition, Patriot believes that Australia will assert that the royalty amount is overstated and feels at a more likely than not level that Australia will assert a 4% royalty rate. The U.S. Australian treaty allows for the remediation of double taxation via the competent authority process. Patriot’s prior experience has been that generally there will be a 50‐50 split at the CA level.
Based on the above what should Patriot record for the current year with respect to the royalty arrangement.
Answer:
Based on the facts Patriot should record the following
Dr. Taxes receivable Australia 6,000,000Cr. Taxes payable U.S. 8,000,000
Dr. Provision for income taxes 2,000,000
The above takes into account that an expected 50‐50 split of a proposed adjustment at the CA level would yield a 1% change in the royalty rate. The reason that there is an overall expense is due to the arbitrage between the U.S. and Australian tax rates. In addition, Patriot would disclose in its tabular roll forward of uncertain tax positions the $8,000,000 U.S. liability and disclose that the net impact would be $2,000,000 if settled in its disclosures.
Case Study 15
Question:
Assume a 40 percent tax rate Fulham Corporation acquires the stock of Wigan Corporation on December 31, 2012 in a nontaxable transaction. Both entities are U.S. Corporations and will join in filing consolidated income tax returns subsequent to the acquisition date with Fulham being the parent of the group.
At the date of acquisition Fulham has federal net operating loss carryovers of $10,000 and Wigan has federal net operating loss carryovers (state loss carryovers are ignored for this example) of $5,000. The net operating loss carryovers of both entities were generated as follows:
Fulham Wigan
December 31, 2008 $2,000
December 31, 2009 2,000
December 31, 2010 2,000
December 31, 2011 $2,000
December 31, 2012 4,000 3,000
Total $10,000 $5,000
As part of the acquisition, Wigan has a gross deferred tax liability of $7,000 which will reverse over the
next seven years and the combined group cannot rely on future taxable income to support the
realization of its deferred tax assets. Based on the above set of facts record the journal entries for the
purchase of Wigan. Also note that Wigan would set up a valuation allowance of $1,600 with respect to
its deferred tax assets.
Answer:
In the fact pattern described above there are two alternative views as to how the acquisition should be
recorded. Under the first view the DTLs would be considered a source of income first with respect to
Wigan’s net operating losses and second with regard to Fulham’s net operating losses. Based on this
view the following would be recorded:
Dr. DTA
$2,000
Dr. Valuation allowance
$800
DR. Goodwill
$800
Cr. Deferred tax benefit
$800
Cr. DTL
$2,800
Under the second view, realization of the deferred tax asset would be based solely on tax law ordering
and therefore in this situation, the earliest NOL’s are used first against the reversing taxable temporary
differences. The journal entry under this view would be as follows:
Dr. DTA
$400
Dr. Valuation allowance
$2,400
Dr. Goodwill
$2,400
Cr. Deferred tax benefit
$2,400
Cr. DTL
$2,800
There is diversity in practice with some firms that accept only the first view while others accept only the
second view. Additionally, there are other firms that state it is a policy choice which once elected needs
to be applied consistently on a go forward basis.
Circular 230 and General Disclaimer: These materials do not constitute tax or legal advice, and cannot be relied upon for purposes of avoiding penalties under the Internal Revenue Code. These materials may omit discussion of exceptions, qualification, definitions, effective dates, jurisdictional differences, and other relevant authorities and considerations. In no event should a reader rely on these materials in planning a specific transaction or litigation. Non-lawyers should not attempt to provide legal services or legal advice in circumstances where that would violate laws against the unauthorized practice of law. BDO will not be responsible for any error, omission, or inaccuracy in these materials.
Detroit TEI 2017 ALL Day Meeting – Wednesday, June 14, 2017 1
