Accounting for income taxes: hot topics and developments

22nd Annual Health Sciences Tax Conference Accounting for income taxes: hot topics and developments December 3, 2012

Accounting for income taxes: hot topics and developments Page 2

► Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

► These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.

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Disclaimer

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Views expressed in this presentation are not necessarily those of Ernst & Young LLP.


Presenters

► Tricia Brosnan Vice President of Global Tax Operations Pfizer Inc.

► Jay Fischbein Tax Director for Janssen Pharmaceuticals Johnson & Johnson

► Joan Schumaker Ernst & Young LLP New York, NY +1 212 773 8569 [email protected]

► Mitchell Stauffer Ernst & Young LLP Chicago, IL 60606 +1 312 879 5720 [email protected]


Topics

► Recent developments: ► US, state and local ► Extenders ► Tax reform

► Current issues in restatements ► U.S. Securities and Exchange Commission (SEC) areas

of focus ► Public Company Accounting Oversight Board (PCAOB) inspections ► Financial accounting update:

► International Financial Reporting Standards (IFRS) ► Financial Accounting Standards Board (FASB) and International

Accounting Standards Board (IASB) joint projects

Recent developments


Recent developments

► State and local: ► California — November 6, 2012 ballot initiative (Proposition 39) making single

sales factor mandatory as of January 1, 2013 ► Washington, DC — September 14, 2012 — combined reporting regulations became final

— October 2, 2012 — mayor approved legislation amending reporting provisions for 90 days; final legislation can take months or a year — If enactment of combined reporting results in an increase in combined group’s net deferred tax liability, a “FAS 109” deduction is provided

► Massachusetts — Effective July 1, 2012, law postponed for one additional year “FAS 109” deduction which was scheduled to begin in 2013 — The deduction, enacted in 2008 in combined reporting legislation, was originally to be claimed over seven years beginning in 2012

► New Jersey — Voluntary disclosure initiative for companies with nexus from the use of intangible assets in NJ — Disclosure through January 15, 2013 for periods beginning after

December 31, 2003 ► New York State — August 23, 2012: Department of Taxation and Finance issued

proposed amendments to combined reporting regulation


Recent developments

► US: ► Internal Revenue Service Notice 2012-73: announces intent to issue a

delay in the effective date to January 1, 2014 of the tangible property temporary regulations

► Key business tax provisions that expired on December 31, 2011 include: ► Exceptions under subpart F for active financing income ► “Look-through” treatment of payments between related controlled foreign corporations ► The research tax credit ► 100% bonus depreciation of qualified property ► Increased expensing to US$500,000/US$2 million and an expanded Section 179 property

definition ► The work opportunity tax credit ► The new markets tax credit ► 15-year straight-line cost recovery for certain business improvements ► The wind energy production tax credit ► Incentives for biodiesel and renewable diesel ► The cellulosic biofuel producer tax credit


Recent developments

► US (cont.): ► Key business tax provisions that expire December 31, 2012 include:

► Extension of 50% additional first-year depreciation for property placed in service after December 31, 2011

► Election to accelerate alternative minimum tax (AMT) credits in lieu of additional first-year depreciation

► Increased Section 179 dollar limitations for expensing to US$125,000/US$500,000 ► Repeal of collapsible corporation rules ► Tax-exempt bonds for educational facilities


Expired and expiring tax laws Tax accounting

► Computation of estimated annual effective tax rate (EAETR) for interim reporting purposes should include the effects of enacted tax law or rates. ► Tax benefits of expired provisions should not be included in the

computation of the interim or annual tax provision until tax law is reinstated.

► Be prepared to recognize the effects of reinstatement, if any, by December 31, 2012.

► Review extender provisions that expire at December 31, 2012 for exclusion from 2013 forecast estimated annual effective tax rate.


Tax reform proposals

► Reduction in US corporate tax rate ► A lower US corporate tax rate has been proposed in every tax budget or reform plan

submitted. ► If enacted, possibility the rate reduction is phased in ► Consider 2013–2014 income deferral or deduction acceleration decisions:

► Real after-tax cash benefit if a lower tax rate is enacted and deductions are accelerated into a 35% tax year or income is deferred into a lower rate year

► Increase in taxable temporary differences may result in a discrete financial statement benefit upon enactment (assuming a lower rate is enacted

► Effective tax rate impact recognized in the period of enactment of legislation that lowers corporate tax rate.

► Broadening of tax base ► Territorial regime ► Base erosion provisions ► Model effective tax rate under legislative proposals

Current issues in restatements


Restatements

Restatement statistics — 2011 No. %

Restatement statistics — 2010 No. %

Big R — audit opinion revised

39 1.0% Big R — audit opinion revised

42 1.1%

Little r — audit opinion not revised

24 0.6% Little r — audit opinion not revised

23 0.6%


Restatements

Top 3 topics — 2011 No. % Top 3 topics — 2010 No. %

Income taxes 18 20% Revenue recognition 21 17%

Revenue recognition 9 10% Income taxes 15 12%

Statement of cash flows 5 6% Derivatives 9 7%


Related income tax accounting topics

► Application of tax technical rules: tax basis and carryback periods

► Realizability of deferred tax assets (DTAs) ► Accounting for outside basis differences ► Intercompany transactions ► Other


Application of tax technical rules: tax basis and carryback periods

► Incorrect identification or calculation of tax basis and carryback periods ► Requires technical understanding of tax law:

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

► Detailed record of tax basis


Realizability of DTAs

► Inappropriate evaluation of realizability of DTAs, resulting in inappropriate valuation allowance conclusion: ► Projections of taxable income does not equal tax planning strategy ► Substitution of a tax benefit does not equal realization ► Evaluating DTAs on a net basis and using naked credits as a

source of taxable income does not equal realization


Accounting for outside basis differences

► Inappropriate application of exceptions to deferred tax liability recognition for outside basis differences ► Not providing taxes for basis difference related to investments in:

► Partnerships ► Equity method investments

► No longer qualifying for exception with changes in investment ownership

► Corporate joint ventures


Intercompany transactions

► Paying close attention to intercompany transactions ► Change in tax basis in buying jurisdiction must be eliminated. ► Prepaid tax is deferred until the asset leaves the

consolidated group.


Other quality occurrences

► Changing uncertain tax position (UTP) recognition without change in facts and circumstances

► Inappropriate current vs noncurrent presentation for deferred taxes and UTPs


UTP changes in judgment

► Change in judgment as to recognition or measurement ► To be based on new information vs simply changing an

interpretation or evaluation of previous information ► Expected to be supported by triggering events with new information

► Change in judgment that results in subsequent recognition, de-recognition or changes in measurement of a tax position that was taken in a prior annual period (including any interest and penalties) ► Discrete event recognized in earnings in the period (interim or

annual) in which the change occurs ► Change in judgment related to a tax position taken in prior

interim periods of the current year ► Include in EAETR

SEC areas of focus


SEC regulatory focus

► Foreign earnings ► Realizability of DTAs ► UTPs ► Indirect taxes — contingencies


Foreign earnings

► Indefinite reinvestment ► Not an all or nothing assertion ► Positive assertion requires specific documentation and evidence of

plans each reporting period

► Consider financial reporting implications of tax planning ► SEC comments

► Disaggregation in rate reconciliation ► Rate differences vs permanent differences

► Liquidity discussion and consistency with accounting


Realizability of DTAs

► SEC comments ► How evidence was weighted:

► Specific positive and negative evidence weighed ► “Robust and non-boilerplate” disclosure that explains weighting and

sources of income considered and objectivity of evidence ► Cumulative losses

► Difficult to support assertion that economic downturn is an aberration ► Timing and reason for changes in valuation allowance ► Consistency of assumptions ► Consistency of accounting with management’s discussion

and analysis


UTPs

► SEC comments: ► Compliance with disclosure requirements ► Proposed adjustments ► Changes and prior disclosure


Indirect taxes — contingencies

► SEC comments ► Continued focus on compliance with disclosure requirements

► Disclose the range of reasonably possible losses in excess of amount accrued, if any, or that exposures cannot be estimated or are not material.

► SEC staff does not object to aggregation. ► SEC staff challenges unclear disclosures.

► Changes without prior disclosure ► SEC staff will challenge “surprise” disclosures and accruals.

► Use of non-standard terms

PCAOB inspections


PCAOB — inspections — income taxes

► PCAOB observation for auditors consistent with income tax restatement causes: ► DTAs ► Valuation allowance ► Tax contingency reserves ► Existence, completeness and/or valuation of other income

tax accounts


Income taxes Material weaknesses

► Material weakness defined: ► “A material weakness is a deficiency, or a combination of deficiencies, in internal

control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”

► Reasonable possibility is defined as “reasonably possible” or “probable,” as used in Accounting Standards Codification (ASC) 450, Contingencies (450-20-25-1) (formerly FAS 5) ► Probable: The future event or events are likely to occur ► Reasonably possible: The chance of the future event or events occurring is more than

remote, but less than likely

► A material weakness in internal control over financial reporting may exist even when financial statements are not materially misstated.

► Restatement (Big R) of previously issued financial statements to reflect the correction of a material misstatement is an indicator of a material weakness.


Income taxes Material weaknesses — nature

24%

67%

9% Nature of material weaknesses

Operation of control

Both (design and operation)

Design of control

Ernst & Young LLP analysis of public filings disclosing material weaknesses from 2010 – Q2 2012


Income taxes Material weaknesses — causes

0% 5% 10% 15% 20% 25% 30%

Lack of internal communication Error within data

Foreign entity oversight Oversight of third party

Lack of resources Lack of expertise

Error during preparation Lack of review

Frequency

Ernst & Young LLP analysis of public filings disclosing material weaknesses from Q1 2010 – Q2 2012

Multiple causes may be identified


Income taxes — internal control key considerations

► Understanding the process and identification of risk/control points: ► Sources of information ► Third parties (reliance, review, data) ► Unique, non-routine, infrequent classes of transactions

► Understanding controls: ► Who, when, what and how of the controls ► Control owner has appropriate authority and competence ► Management review/reconciliation controls — precision, sensitivity

evaluation, level of operation, controls ability to generate questions and identifying errors

► Data/communication: ► Completeness and accuracy ► Accuracy of underlying reports

► Documentation

Financial accounting update


Financial accounting IFRS update ►SEC update on IFRS status in US:

►SEC staff issued its final IFRS Work Plan Report (the Report) in July 2012.

►The Report does not include a recommendation to the SEC on how and whether to incorporate IFRS into US financial reporting.

►SEC staff indicated that many issues identified would be partly mitigated by an endorsement approach that retains a role for the FASB.

►No decision is expected before 2013.


Financial accounting FASB and IASB joint projects update

► FASB and IASB (the Boards) goal — improved, high-quality, converged accounting standards

► FASB and IASB joint convergence projects: ► Leases — Exposure Draft expected by first half of 2013

► Financial instruments — Exposure Draft on classification and measurement expected by the first half of 2013

► Financial Instruments — Exposure Drafts on impairments expected by end of 2012

► Consolidation — FASB Final Standard expected in first half of 2013

► Revenue recognition — Final Standard expected in first half of 2013

► The Boards have focused on financial instruments, revenue recognition, leases and insurance contracts. ► Certain lower-priority projects set aside for near term

► The Boards are re-deliberating many projects, making tentative decisions. ► These decisions are subject to change as the re-deliberations progress

► Effective dates and transition methods for several joint projects have not been finalized.

Economy & Finance

Accounting for income taxes: hot topics and developments