Ninth AnnualDomestic Tax Conference8 May 2014 | Chicago

Accounting for income taxes:hot topics and developments

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Today’s presenters

Angela EvansBrian FoleyKathy Ford

Joan Schumaker

Agenda

► Developments► Legislative and other developments► Accounting standard updates► SEC areas of focus► PCAOB focus on internal controls► New COSO internal control framework

► Tax provision challenges► Tax restatements and practice issues► Reduce risk in tax accounting calculations

► Internal control over financial reporting► Design considerations► Best practice responses

Developments

Legislative and other developmentsChanges in tax laws and rates

Legislative developments continue to occur in 2014 and include:► Austria –

► disallow deductions for interest and royalty payments made to affiliated companies► abolish tax goodwill amortization for acquisitions after 28 February 2014► exclude foreign group members that are resident in countries outside the EU from

Austrian tax groups► limit domestic group’s ability to offset its income with losses of foreign group

members to 75% of the domestic group income, starting in 2015► Chile –

► increased the current FTC limits to be used in Chile (both in the presence andabsence of a tax treaty)

► expanded the foreign taxes that can be credited (beyond a foreign two tier structure)► expanded the possible carryover of FTC (effective 1 January 2014)

► Iceland – enacted new transfer pricing rules (effective 1 January 2014)

Legislative and other developmentsChanges in tax laws and rates

► Korea –► eliminated deductibility of reserves used as future R&D► decreased the R&D investment tax credit for medium and large companies (effective 1 January

2014)► Panama – repealed on a retroactive basis the worldwide income tax system enacted at

the end of 2013 and reinstated its territorial income tax system (effective 31 December2013)

► U.S. Reminder – Extenders such as CFC look-through rule, Subpart F active financingexception and research credit expired 31 December 2013► Deferred taxes should also be measured consistent with enacted tax law

Legislative and other developmentsChanges in tax laws and rates

► New York State (NYS) – key components of the proposal include:► Repeal of existing bank franchise tax and its merger into a substantially modified general corporation franchise

tax► Reduction in general franchise tax rate from 7.1% to 6.5% (beginning on or after 1 January 2016); Increase in

Metropolitan Transportation Business Tax Surcharge rate► 0% tax rate on the business income base for qualified NYS manufacturers (beginning on or after 1 January

2014)► Adoption of an economic presence nexus standard► Change in computation of NYS’s NOLs from a pre-apportioned NOL to a post-apportioned NOL, and provision of

an NOL conversion subtraction► Adoption of a single receipts factor for all NYS taxpayers► Change in sourcing of sales to NYS to provide for customer sourcing► Elimination of the current subsidiary capital and related franchise tax provisions; and phase out of the capital

base tax through 2020

► Effective tax years beg. on or after 1/1/15, with exceptions noted

► Transitory Tax Regime (TTR) was introduced in 2007 to achieve tax neutrality in theGAAP conversion to IFRS, which began in 2008► Required continued application beyond 2007 of pre-IFRS Brazilian GAAP for tax purposes► 17 September 2013 - TTR Regulations NI 1, 397/2013 issued and provides specific guidance

► Requires Old Brazilian GAAP to determine 2008-2013 interest on net equity deductions, taxabledividends, equity adjustments and other tax attributes► Assess possible exposure

► Provisional Measure (PM) 627/2013 published 12 November 2013 terminates TTReffective 1 January 2015, with early adoption allowed 1 January 2014► PM was issued by the President and is valid► Approval deadline extended to 21 April 2014 by Congress or its cancelled► Aligns Brazilian GAAP to IFRS for tax purposes► Impacts many areas including goodwill and investment in affiliates► Transition to IFRS for tax purposes may affect book and tax bases and tax accounts

Other developmentsBrazil provisional measures

Things we have our eye onFederal

► President Obama’s fiscal year 2015 budget tax proposals – the ObamaAdministration proposed several tax law changes affecting businesses,including:► Limiting the deductibility of certain interest expenses for US companies that are

part of a worldwide consolidated group► Subjecting certain income from related-party contract manufacturing arrangements

to tax► Increasing the research credit and making it a permanent part of the tax code,

rather than a provision that expires every one to two years► Repealing the last-in/first-out and the lower-of-cost-or-market inventory accounting

methods► Eliminating the tax deduction that US companies currently receive for expenses

related to moving operations overseas

Things we have our eye onFederal

Chairman Camp’s Tax Reform Act of 2014, includes:► Tax rate lowered to 25% (five-year phase-in)► AMT (alternative minimum tax) repealed – AMT credits refundable► Major changes to corporate tax expenditures► Limit deduction of an NOL carryforward or carryback to 90% of taxable income. Repeal certain

special NOL carryback rules► 20-year amortization for deductible goodwill and certain other intangible assets► Modified alternative simplified credit (ASC) permanently extended equal to 15% of qualified research

expenses for the year that exceed 50% of average of qualified expenses for preceding three years► Establishes a new foreign dividend exemption system:

► 95% deduction for dividends from certain foreign subsidiaries► Transition: deemed inclusion of deferred foreign earnings at

► 8.75% for earnings in cash, cash equivalents and short term assets

► 3.5% for other earnings

Things we have our eye onInternational

► The OECD’s (Organization for Economic Co-operation and Development)Action Plan on Addressing Base Erosion and Profit Shifting (BEPS) aimed atgovernment concern about the potential for multinational corporations (MNC)to reduce their tax liabilities through shifting of income to no or low taxjurisdictions pending actions include:► Changes to the OECD Transfer Pricing Guidelines► Changes to the OECD Model Treaty► Changes to the OECD Model Treaty Commentary► Recommendations regarding the design of domestic rules► Country by Country Reporting Model

Financial reporting considerationsTangible property final regulations

► Considerations for 2014 reporting► All provisions are effective in 2014

► Consider impact on current and deferred taxes for the year► Can affect valuation allowance judgments and estimated annual

effective tax rate► Consider when the reversal of the deferred tax liability for any section

481(a) adjustment is to be included in estimated taxes

Note: Refer to ASC 740-10-55-59 through -61 for guidance on incometax accounting consequences of a method change

Accounting standard developments

Accounting standard updatesPresentation of unrecognized tax benefits (ASU 2013-11)

► ASU 2013-11, Presentation of an Unrecognized Tax Benefit (UTB) When aNet Operating Loss (NOL) Carryforward, a Similar Tax Loss, or a Tax CreditCarryforward Exists

► Effective for fiscal years, and interim periods within those years, beginningafter 15 December 2013 for public entities and fiscal years beginning after15 December 2014 for nonpublic entities

► Determine whether a deferred tax asset (DTA) is available for offset based onthe DTAs that exist at the reporting date and assume tax position isdisallowed at the reporting date► Present liability associated with UTBs as a reduction to related DTA for NOL, similar

tax loss or tax credit carryforward if such settlement is required or expected► Present UTB as a liability; not combined with DTA if net settlement is not required

or expected► Applied prospectively. Retrospective application is permitted.

Accounting standard updatesPresentation of unrecognized tax benefits – example

► In Country Z, disallowed tax positions must be settledwith available NOL carryforwards

► Assume Company A has, tax effected, a $75 NOL and $50 in unrecognizedtax benefits for which a liability is recorded

► Does not change disclosure of unrecognized tax benefits, which are requiredto be presented gross

Footnote disclosure Prior to adoption of ASU 2013-11 Following adoption of ASU 2013-11Deferred tax assets

Accrued environmental costs $100 $100

Net operating loss carryforwards 75 25

Less: valuation allowance 30 30

Total deferred tax assets(matches balance sheet)

$145 $95

Accounting standard updatesAffordable housing projects (ASU 2014-01)

► Accounting Standards Update (ASU) 2014-01, Accounting for Investments in QualifiedAffordable Housing Projects, issued January 2014

► If conditions met, allows investors to elect the proportional amortization method toaccount for investments in low income housing tax credits (LIHTC)► Replaces effective yield method► Investor amortizes to income tax expense the cost of investment in proportion to the tax credits

and other tax benefits it receives

► Effective for interim and annual periods beginning after 15 December 2014. Earlyadoption permitted. New disclosures.

► Retrospective application. Option to continue effective yield method for existinginvestments as of the date of adoption.

► FASB considering project to expand to other tax credit investments

Regulatory developments

SEC focus areasEffective tax rate reconciliation

► Clearly label items in income tax rate reconciliation► For material rate reconciling items associated with foreign

jurisdictions, disclose the specific jurisdictions that materially affectthe effective tax rate, their tax rates, and information about theeffects of such foreign jurisdictions (e.g., magnitude and mix) on theeffective tax rate

► May question whether large “provision to return” or “true-up”adjustments reflect prior year errors rather than changesin estimates

► Registrants should determine that rate reconciliation information isconsistent with other disclosures in MD&A or footnotes

SEC focus areasValuation allowances

► Challenge boiler plate disclosure in footnotes and in MD&A related torealizability of deferred tax assets

► Disclosures about realizability of deferred tax assets should address:► Four sources of taxable income

► Prominence of each source and material uncertainties► Assumptions or limitations associated with each source

► Foreign tax credits and NOL carryforwards, including period over which expected tobe realized or otherwise expire

► Positive and negative evidence considered and relative weight of each supportingconclusion about the need for valuation allowance

SEC focus areasIndefinite reinvestment

► Disclose pursuant to ASC 740 the cumulative amount of temporarydifferences related to investments in foreign subsidiaries and foreigncorporate joint ventures that are indefinitely reinvested

► Disclose the amount of unrecognized DTL or if applicable, a statement thatdetermination of the amount is not practicable.

► Disclose the types of events or circumstances that would cause theunrecognized DTLs to become taxable (i.e., the events that would causerepatriation of foreign earnings)

► Challenge registrants when their indefinite reinvestment assertions appearinconsistent with the parent’s liquidity needs or disclosures elsewhere inthe filings

PCAOB focus areaInternal control over financial reporting (ICFR)

► Income taxes has been selected as a focus area by the PCAOB, and wecontinue to see an increase in the focus on income taxes

► PCAOB has found deficiencies in auditors’ reviews of internal controls relatedto income taxes► Failed to understand the likely sources of potential misstatement (i.e., identify What

Could Go Wrong (“WCGW”))► Failed to obtain an understanding of the review procedures performed

► Scope of review activities► Level of precision at which the review is performed► Source and reliability of information used to perform the control

► Failed to sufficiently test the operating effectiveness of review controls► Testing limited to management inquiries and observation of sign offs

► Failed to test controls separately outside of substantive testing

Tax provision challenges

Tax provision challengesRestatements

► General causes:► Application of tax technical rules

► Tax basis► Intraperiod tax allocation

► Interim periods► Accounting for outside-basis differences► Realizability of deferred tax assets (DTAs)

► DTLs as source of income► Tax planning strategies

Income taxerrors area leadingcause of

restatements

Appropriate application of tax basis

► Essential starting point: maintaining a detailed and accurate record of the taxbasis of all assets and liabilities, including those without a book basis► A fluctuation analysis of tax basis supporting the deferred tax balances may not

provide sufficient audit evidence► Common pitfall: Not properly identifying a tax basis or attribute or not

appropriately recording and tracking the tax basis or attribute in subsequentperiods► Requires technical understanding of tax law

► Often for multiple taxing jurisdictions► May be simple or complex

How is the tax basis evaluated?

Intraperiod allocation

► Be mindful of the complexity of the intraperiod allocation rules► Common pitfalls:

► Failure to apply the exception (losses from continuing operations and income fromother sources)

► Failure to consider interaction of exception with the interim reporting rules► Inappropriate “backwards tracing”► Failure to follow 2 step process when income from discontinued operations is

recognized in an interim period and losses from continuing operations are expectedfor the year

Are there losses from continuing operations and income from another source?Does the financial reporting reflect the exception to

the intraperiod allocation rules?

Intraperiod allocation

► Exceptions to the general rule apply in all situations where there is:► A loss from continuing operations and► Cumulative income from all other sources

► Exception also applies to interim periods when company anticipates anordinary loss from continuing operations for the year

► Applicable even to periods of a full valuation allowance► Does not change overall annual tax provision (benefit)► However, may change tax provision (benefit) between interim periods

The result of this computation (as well as the need to do the computation)is often counterintuitive

Accounting for outside basis differences

► Outside basis differences may not be recognized if certain exceptionsare applicable► Section 14.1 of Income taxes FRD, General: summary of application of

exceptions and common entity types► Common pitfalls:

► Not providing taxes for outside basis difference related to investments inpartnerships or equity method investments

► No longer qualifying for exception with changes in investment ownership

Are the exceptions to outside basis differences appropriately applied?

Realizability of DTAs

► Same framework► Establishing a valuation allowance for the first time► Determining whether a valuation allowance continues to

be necessary

► Have all four sources of taxable income been considered?

Realizability of DTAs

► Future reversals of existing taxable temporary differences► Evaluate DTAs on a gross basis► Consider the timing of reversal of existing taxable temporary differences► Common pitfall: DTAs evaluated on a net basis► Common pitfall: Naked credits are used as a source of taxable income

Will the deferred tax liabilities result in taxable income inthe appropriate period?

Are there deferred tax liabilities associated with book balances that do not havea known period when they may affect the income statement?

Realizability of DTAs

► What is a tax planning strategy?► A strategy that is prudent and feasible► A strategy that a company ordinarily might not take, but would take to

prevent an operating loss or tax credit carryforward from expiring unused► A strategy that would result in the realization of deferred tax assets

► Common pitfalls► Substituting or refreshing one DTA with another without evaluating the

“new” DTA for realizability► Considering a projection of future taxable income a tax planning strategy

Realizability of DTAs

► Company A could sell a non-core asset► The book basis of the asset is $100► The tax basis of the asset is $10► The fair value of the asset is $300► The company has a net operating loss of $200 that is expected to expire

in 2 years► The enacted tax rate for the company is 30%► Assume the company was previously break even and has no taxable

temporary differences► Is the sale of a non-core asset a qualified tax planning strategy?

Realizability of DTAs

► Conclusion:► Yes and no

► A decision to sell an appreciated non-core asset may represent a taxplanning strategy to the extent it results in the reversal of a temporarydifference in an earlier period► In the example, the existing $90 taxable temporary difference may reverse

in an earlier period► In some cases what appear to be tax planning strategies also

represent forecasts of future income► Excess of fair value over book basis is a projection of future taxable income

► Pretax gain on sale would be subject to the same limitations as any otherprojections of future income

► In the example, the $200 excess is a projection► Projection of future taxable income is not a tax planning strategy

Tax provision challengesBest practice responses – reduce risk in calculations

► Improve calculations and detailed supporting workbooks/tools for:► Tax basis balance sheets to validate deferred taxes► Automate unrecognized tax benefit calculations for interest and cumulative translation

adjustments, and roll-forwards including interaction with other tax attributes and valuationallowance determinations

► Automate tracking of tax attributes and reconcile to tax returns► Indefinite reinvestment assertion documentation and determine outside basis differences and

compare to E&P calculations► Share-based payments – prove DTA balances, APIC pool, Section 162(m) adjustment, and

tracking of payments to foreign employees► Fixed asset deferred tax proof with reconciliation of sub-ledgers to general ledgers and

tax systems► Consider third party to test and improve tax provision Excel spreadsheets for enhanced efficiency,

accuracy and controls► Improve forecast data for legal entity calculations and engage finance for items outside tax’s

direct control

Internal control over financial reporting (ICFR)

Updated COSO internal control framework

► In May 2013, Committee of Sponsoring Organizations (COSO)released the Internal Control – Integrated Framework: 2013 (2013framework) to provide an updated framework for designing andevaluating internal controls► Original 1992 framework is valid through 15 December 2014, after which

it is superseded by the 2013 framework► SEC staff have not mandated a specific transition date► The longer companies use the 1992 framework, the more likely they may

be questioned by the SEC staff► Disclose framework used

► Implementing the 2013 framework is opportunity for tax departmentsto obtain budget to close gaps while company-wide changes may beoccurring

COSO FrameworkPrinciples of effective internal control

1. Demonstrates commitment to integrity and ethical values2. Exercises oversight responsibility3. Establishes structure, authority and responsibility4. Demonstrates commitment to competence5. Enforces accountability

6. Specifies suitable objectives7. Identifies and analyzes risk8. Assesses fraud risk9. Identifies and analyzes significant change

10. Selects and develops control activities11. Selects and develops general controls over technology12. Deploys through policies and procedures

13. Uses relevant information14. Communicates internally15. Communicates externally

16. Conducts ongoing and/or separate evaluations17. Evaluates and communicates deficiencies

Control environment

Risk assessment

Control activities

Information and communication

Monitoring activities

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Tax ICFRPrecision and evidence of management review

► Thinking about precision – determine and document:► Nature of review procedures?

► Are the procedures capable of identifying errors?► Would the control identify errors or fraud that could be material to the financial statements?► Do the procedures address the relevant risks?

► Does control identify errors?► Nature of the errors? Examples?► If not, why?

► Nature of the questions; follow-up; outcome?► Is there contradictory evidence indicating the control is not suitably designed?► Is evidence sufficient to support the assessment?

Tax ICFRDesign example

Poor example Better exampleAppropriate personnel reviewthe return to provision true-upcalculation.

On an annual basis, in the period in which the federal income taxreturn is filed (when),the Chief Accounting Officer (who) reviewsthe return to provision calculation ensuring all positions taken onthe income tax return were appropriately considered in the prioryear income tax provision (what, why). All return to provision items$250k or greater (net of tax) are evaluated for the effect on thecurrent year or prior year income tax provision (what).Considerations are documented within the return to provisionworkpaper file and supported with supplemental evidence, ifnecessary (how).

Tax ICFRBest practice responses

► Address any increased auditor requirements► Review control design

► “Who, when, what and how” of the controls► Control owner has appropriate authority and competency► Management review controls – precision, sensitivity evaluation, level of operation, controls’ ability

to generate questions, and identify errors► Precision of the control is the sensitivity to which it functions (i.e., is the control sensitive enough to prevent

or detect errors or fraud that could result in material misstatement in the financial statements)► Qualitative and quantitative thresholds for reviewer for follow up

► Data► Completeness and accuracy► Integrity of underlying reports

► Workpapers with appropriate evidential support to document both the design andoperating effectiveness of review controls

Tax ICFRBest practice responses

► Evaluate effectiveness of internal controls design and operation based on currentbusiness and procedures

► Walk-through procedures and assess if process narrative or flowchart is up to date► Will a flowchart be required?

► Document performance of review controls – signature is not sufficient► Document the precision of review controls – frequency, nature and extent of issues identified► Retain evidence of issues identified and resolution of those issues► Document review thresholds and procedures that support manual controls (e.g., quantitative and

qualitative)

► Understand and document effectiveness of controls related to source data and inputs totax provision calculations

► Perform assessment of control execution and testing

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Thankyou!

Ninth AnnualDomestic Tax Conference8 May 2014 | Chicago