National Professional Services Group

Guide to Accounting for Income Taxes2007

This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PricewaterhouseCoopers LLP, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. The content of this publication is based on information available as of November 15, 2007. Accordingly, certain aspects of this publication may be superseded as new guidance or interpretations emerge. Financial statement preparers and other users of this publication are therefore cautioned to stay abreast of and carefully evaluate subsequent authoritative and interpretative guidance that is issued.

Portions of various FASB pronouncements and other FASB materials included in this work, copyright by Financial Accounting Standards Board, 401 Merritt 7, Norwalk, CT 06856, are reproduced by permission. All rights reserved. No part of these FASB documents may be further reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the FASB.

Dear Clients and Friends: It has been almost fifteen years since FAS 109 was issued, yet the accounting for income taxes continues to pose many challenges for preparers, users, and auditors. Among those challenges are the tax accounting rules for intraperiod allocation, business combinations, and foreign operations. New challenges arose with the FASB's issuance in June 2006 of FIN 48, which sets out a new comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that it has taken or expects to take on a tax return. PricewaterhouseCoopers is pleased to offer this comprehensive manual on the accounting for income taxes. It is intended to assist you in interpreting the existing literature in this complex area of accounting by bringing together all of the key guidance into one publication, providing several comprehensive examples to help navigate the guidance, and offering our own perspective throughout, based on both analysis of the guidance and experience in applying it. While this publication is intended to clarify the fundamental requirements involved in the accounting for income taxes and to highlight key points that should be considered before transactions are undertaken, needless to say it cannot substitute for a thorough analysis of the facts and circumstances surrounding proposed transactions and of the relevant accounting literature. Nonetheless, we trust that you will find in these pages the information and insights needed to work with greater confidence and certainty when applying the provisions of FAS 109 and the related authoritative literature surrounding the accounting for income taxes.

PricewaterhouseCoopers

Table of Contents

Chapter 1: 1.1 1.1.1 1.1.2 1.1.2.1 1.1.2.2 1.1.2.3 1.2 1.2.1 1.2.2 1.2.2.1 1.2.2.2 1.2.2.3 1.2.2.4 1.2.2.5 1.2.3 1.2.3.1 1.2.3.2 1.3

Scope of FAS 109 (3 -5) Scope of FAS 109 ......................................................................................... In General (FAS 109, par. 4)......................................................................... Scope Exceptions (FAS 109, par. 5) ........................................................... Accounting for Investment Tax Credits .......................................................... Discounting..................................................................................................... Accounting for Interim-Period Income Taxes ................................................. Defining a Tax Based on Income ............................................................ In General ...................................................................................................... Application of Guidance to Specific Tax Jurisdictions and Tax Structures .............................................................................................. Higher of an Income-Based or Capital-Based Computation .......................... Gross-Receipts Tax........................................................................................ Michigan Single Business Tax ....................................................................... Texas Margin Tax........................................................................................... Private FoundationExcise Tax on Net Investment Income .......................... Attributes of Taxes Not Based on Income................................................. Timing Differences Inherent in the Computation of Taxes Not Based on Income ........................................................................................... Tax Credit Carryforwards for Tax Regimes Not Based on Income................ Accounting by Jurisdiction (Separate Calculation versus Blended Rate)............................................................................................................... Applicability of FAS 109 to an Entitys Legal Form .................................. Single-Member and Multiple-Member Limited Liability Companies (under U.S. Tax Law) ............................................................... Partnerships ................................................................................................. Investments in Partnerships ........................................................................... General Application of FAS 109 to the Separate Financial Statements of Partnerships ............................................................................ Master Limited Partnerships........................................................................... Real Estate Investment Trusts (REITs) and Regulated Investment Companies (RICs).......................................................................................... State Income Taxes...................................................................................... Separate Calculation versus Blended Rate ................................................... Treatment of Apportionment Factors ............................................................. Changes in state income tax rates caused by changes in how a state apportions income .................................................................................

5 8 8 8 8 8 9 9 9 10 10 12 12 13 13 14 14 15

15 17 17 17 17 17 18 18 19 19 19 19

1.4 1.4.1 1.4.2 1.4.2.1 1.4.2.2 1.4.2.2.1 1.4.2.2.2 1.4.3 1.4.3.1 1.4.3.2 1.4.3.2.1

Chapter 2: 2.1 2.2

Objectives and Basic Principles (6-9) Objectives of FAS 109.................................................................................. Basic Principles............................................................................................

21 24 24

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2.3 2.3.1 2.3.2 2.3.2.1 2.3.3 2.3.4 2.3.4.1 2.3.4.1.1 2.3.4.1.2 2.3.4.2 2.3.4.2.1 2.3.4.2.2 2.3.5 2.4 2.4.1 2.4.2 2.4.3

Exceptions to the Basic Principles of FAS 109 (par. 9)............................ APB 23 Differences and U.S. Steamship Exceptions (par. 9(a) and par. 9(b))................................................................................................. Leveraged Leases (par. 9(c))....................................................................... Purchased Leveraged Leases........................................................................ Nondeductible Goodwill and Excess Deductible Goodwill (par. 9(d))...... Tax Effects of Intercompany Transactions (par. 9(e)) .............................. In General (par. 9(e))...................................................................................... Deferred Charge Differentiated from Deferred Tax Asset.............................. Quantifying the Amount of Tax Deferred under Par. 9(e) .............................. Certain Exceptions in the Application of Par. 9(e).......................................... Inapplicability of Par. 9(e) to the Intercompany Sale of Subsidiary Stock ..... Intercompany Transfers Reported at Predecessor Basis .............................. Certain Foreign Exchange Amounts (par. 9(f)) ......................................... Other Considerations................................................................................... Discounting................................................................................................... Volatility......................................................................................................... Need for Judgment.......................................................................................

25 25 25 26 26 26 27 28 28 28 28 30 30 31 31 32 33

Chapter 3: 3.1 3.2 3.2.1 3.2.2 3.2.2.1 3.2.3 3.2.3.1 3.2.3.2 3.2.4 3.2.4.1 3.2.4.2 3.2.4.3 3.2.4.4 3.2.5 3.2.6 3.2.7 3.2.8 3.3 3.3.1 3.4 3.4.1 3.4.2 3.4.3

Temporary Differences (10-15) Temporary DifferenceDefined ................................................................. Examples of Temporary Differences.......................................................... Business Combinations (FAS 109, par. 11(h)) .......................................... Indexation (FAS 109, par. 11(g)) ................................................................. Temporary Differences Related to U.K. Office Buildings ............................... Temporary Differences Related to Investment Credits (FAS 109, par. 11(e) and (f))......................................................................... Foreign Investment Credits and Grants ......................................................... Effect on Leases............................................................................................. Debt Instruments.......................................................................................... Contingently Convertible Debt........................................................................ Debt Instruments with Temporary Differences that May Not Result in Future Deductible Amounts............................................................................ Convertible Debt with a Beneficial Conversion Feature and Detachable Warrants...................................................................................... Tax Implications of Induced Conversions ...................................................... Low-Income Housing Credits...................................................................... Synthetic Fuels Projects.............................................................................. Subsidies under the Medicare Prescription Drug Act of 2003 ................ IRC Section 162(m) Limitation .................................................................... Basis Differences That Will Reverse with No Tax Consequence ............ Excess Cash Surrender Value of Life Insurance ...................................... Issues to Be Considered in Identifying Temporary Differences ............. Basis Differences That Are Not Accounted for Under the Basic Model for Deferred Taxes ............................................................................ Temporary Differences Where Reversal Might Not Occur in the Foreseeable Future ...................................................................................... Consideration of Settlement at Book Carrying Value ..............................

35 40 42 42 42 43 46 47 49 49 49 50 50 51 52 53 53 54 55 55 56 56 57 57

ii / Table of Contents

3.4.4 3.4.5 3.4.6

Temporary Differences Not Identified with an Asset or a Liability (FAS 109, par. 15) ......................................................................................... Treating a Change in the Tax Accounting Method as a Temporary Difference .................................................................................. U.S. Federal Temporary Differences Relating to State Income Taxes................................................................................................

58 58 59

Chapter 4: 4.1 4.2 4.2.1 4.2.2 4.2.3 4.2.4 4.2.4.1 4.2.4.2 4.2.4.3 4.2.4.4 4.2.4.5 4.2.4.6 4.2.4.7 4.2.4.8 4.2.4.9 4.2.4.10 4.2.5 4.2.5.1 4.2.5.2 4.2.5.3

Recognition and Measurement (16-19) Basic Approach for Deferred Taxes ........................................................... Applicable Tax Rate ..................................................................................... General Considerations............................................................................... Graduated Tax Rates ................................................................................... Determining the Applicable Rate................................................................ Complexities in Determining the Applicable Tax Rate............................. Ordering Effects ............................................................................................. Undistributed Earnings ................................................................................... Special Deductions......................................................................................... Tax Holidays................................................................................................... Nonamortizing/Nondepreciating Assets ......................................................... Worthless Deductions and Loss Carryforwards........................................... Dual-Rate Jurisdictions .................................................................................. Hybrid Tax Systems ....................................................................................... Foreign-Branch Operations ............................................................................ Aggregating Computations for Separate Jurisdictions................................... Alternative Minimum Tax Considerations ................................................. AMTGeneral Background ........................................................................... The Interaction of AMT with FAS 109 Accounting ......................................... Other AMT Systems .......................................................................................

61 64 66 66 67 68 70 70 70 71 73 74 76 76 79 79 80 80 80 81 84

Chapter 5: 5.1 5.1.1 5.1.2 5.1.3 5.1.3.1 5.1.3.2 5.1.4 5.2

Valuation Allowance (20-25) Assessing the Need for a Valuation Allowance ........................................ Evidence to Be Considered......................................................................... Weighting of Available Evidence................................................................ Cumulative Losses and Other Negative Evidence ................................... General........................................................................................................... Examples of Situations Where Positive Evidence Outweighed Significant Negative Evidence........................................................................ Assessing Changes in the Valuation Allowance ...................................... SEC Staff Views on Disclosure and Valuation Allowance Assessments ............................................................................. Other Considerations................................................................................... Evaluating the Effect of a Restructuring.................................................... Going-Concern Uncertainty ........................................................................ Sources of Taxable Income......................................................................... Taxable Income in Prior Carryback Years If Carryback Is Permitted Under the Tax Law...................................................................... Special Considerations for Carrybacks ..........................................................

85 89 89 91 92 92 93 95

95 97 97 97 98 99 99

5.3 5.3.1 5.3.2 5.4 5.4.1 5.4.1.1

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5.4.1.1.1 5.4.1.1.2 5.4.2 5.4.2.1 5.4.3 5.4.3.1 5.4.3.2 5.4.3.2.1 5.4.3.2.2 5.4.3.2.3 5.4.3.2.4 5.4.3.2.5 5.4.3.3 5.4.3.4 5.4.3.4.1 5.4.3.4.2 5.4.3.5 5.4.3.5.1 5.4.3.5.2 5.4.3.6 5.4.4 5.4.4.1 5.4.4.2 5.4.4.2.1 5.4.4.2.2 5.5 5.5.1 5.5.1.1 5.5.1.2 5.5.1.2.1 5.5.1.2.2 5.5.1.2.3 5.5.1.2.4 5.5.1.2.5 5.5.1.2.6 5.5.1.2.7 5.5.1.2.8 5.5.1.2.9 5.5.1.2.10 5.5.1.2.11 5.5.1.2.12 5.5.2 5.5.2.1 5.5.2.2

Carrybacks That Free Up Credits .................................................................. Carryback Availability That May Not Be Used ............................................... Future Reversals of Existing Taxable Temporary Differences................ Deferred Tax Liabilities on Indefinite-Lived Intangible Assets Naked Credits........................................................................................... Tax-Planning Strategies .............................................................................. Tax-Planning Strategies Defined ................................................................... Examples of Common Tax-Planning Strategies ............................................ Sales of Appreciated Assets .......................................................................... Sale-Leaseback.............................................................................................. LIFO Reserves ............................................................................................... Shifting Tax-Exempt Portfolios ....................................................................... Noneconomic Tax-Planning Strategies.......................................................... Costs to Implement a Tax-Planning Strategy................................................. Examples of Actions That Do Not Qualify as Tax-Planning Strategies ......... Excluding a Loss Subsidiary from Tax Consolidation .................................... Acquiring a Profitable Enterprise.................................................................... Issues in Evaluating Tax-Planning Strategies................................................ Time Value of Money ..................................................................................... FIN 48............................................................................................................. Consistent Use in Different Jurisdictions........................................................ Future Taxable Income Exclusive of Reversing Temporary Differences and Carryforwards................................................................... General........................................................................................................... Considerations When Projecting and Scheduling Future Taxable Income Other than Reversals of Existing Temporary Differences ................. Originating Temporary Differences in Future Projections .............................. Projecting Future Pretax Book Income .......................................................... Scheduling Future Taxable Income............................................................ When Is It Necessary? ................................................................................. General Approach to Scheduling ................................................................... Patterns of Temporary Difference Reversals ................................................. Depreciable and Amortizable Assets ............................................................. Assets and Liabilities Measured at Present Value ......................................... Deferred Foreign Taxes ................................................................................. Tax Return Accounting Method Changes ...................................................... Deferred Revenue or Income ......................................................................... Sale-Leasebacks............................................................................................ Reserves for Bad Debts and Loan Losses..................................................... Inventory Reserves ........................................................................................ Reserves for Litigation.................................................................................... Warranty Reserves......................................................................................... Stock Appreciation Rights .............................................................................. Other............................................................................................................... Examples of Scheduling.............................................................................. Example of Scheduling Future Taxable Income ............................................ Example of Unused Deduction.......................................................................

99 101 102 103 104 105 108 108 110 111 113 113 115 116 116 116 117 117 118 118 119 120 121 121 121 128 128 129 129 130 132 138 139 140 140 140 141 141 141 141 141 143 143 145

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Chapter 6: 6.1 6.2 6.2.1 6.2.1.1 6.2.1.2 6.2.1.3 6.2.1.4 6.2.1.5 6.2.2 6.2.3 6.2.4 6.2.5 6.2.5.1 6.2.5.2

A Change in Valuation Allowance (26)

147

Recording the Effects of Changes in Valuation - In General ..................... 149 Changes in Valuation Allowance in Specific Areas ................................... Changes in Valuation Allowance Business Combinations................... Establishment of a Valuation Allowance Against An Acquired Companys Deferred Tax Assets at the Time of Acquisition.......................... Acquired Tax Benefits Initially Recognized in a Period Subsequent to a Business Combination................................................................................. Decrease in the Acquirers Valuation Allowance at the Time of a Business Combination.................................................................................... Effects of Tax Law Changes on a Valuation Allowance Recorded Against Acquired Tax Benefits in a Business Combination ........................... Ordering of Recognition of Tax Benefits ........................................................ Changes in Valuation Allowance Related to Items of Other Comprehensive Income............................................................................... Changes in Valuation Allowance Resulting from Transactions Among or With Shareholders...................................................................... Changes in Valuation Allowance in a Nontaxable Transfer or Exchange .................................................................................................. Changes in Valuation Allowance in Spin-Off Transactions..................... Recording an Increase to the Valuation Allowance by the Parent Enterprise When a Subsidiary Is Spun Off in a Nontaxable Transaction......... Recording a Valuation Allowance on a Subsidiarys Assets When a Spin-Off Creates the Need for a Valuation Allowance ................................... 150 150 150 150 150 150 150 151 151 151 152 152 152

Chapter 7: 7.1 7.2

Change in Tax Laws or Rates (27)

153

Determining the Enactment Date................................................................ 155 Distinguishing Between Interpretive and Legislative Regulations ................................................................................................... 155 Accounting for Rate Changes..................................................................... 156 Interim-Period Considerations.................................................................... Computing Deferred Taxes in an Interim Period....................................... Retroactive Tax Rate Change EITF 93-13 ............................................... Retroactive Changes in Tax Laws or Rates Following Adoption of an Accounting Standard ......................................................................... Leveraged Leases ........................................................................................ 158 159 159 160 163

7.3 7.4 7.4.1 7.4.2 7.4.3 7.4.4 7.5 7.5.1

7.5.2

Valuation Allowances .................................................................................. 163 Valuation Allowances Relating to Assets Acquired in a Prior Business Combination: Adjustments in the Period of Enactment and Subsequent Releases........................................................................... 163 Valuation Allowances Established in Connection with a Business Combination: Releases After the Period That Includes the Date of Enactment................................................................................................. 164 Disclosure Requirements ............................................................................ 165 Changes in Tax Accounting Methods ........................................................ 165

7.6 7.7

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7.7.1 7.7.2 7.7.3

Automatic Changes...................................................................................... 165 Voluntary Changes Requiring Approval (acceptable method to acceptable method)...................................................................................... 166 Changes Required by Taxing Authorities or by Taxpayers Correcting Errors ......................................................................................... 166

Chapter 8: 8.1 8.2 8.3 8.3.1 8.3.2 8.4 8.4.1 8.4.2 8.4.3 8.5

Change in the Tax Status of an Enterprise (28)

167

General Rule for Changes in Tax Status.................................................... 169 Loss of Nontaxable Status .......................................................................... 169 Switching Tax Status ................................................................................... 169 Switching to Nontaxable Status ................................................................. 169 Switching to Taxable Status........................................................................ 170 Post-1986 S Corporation Elections/Built-in Gains.................................... Deferred Tax Liability After the Change to S Corporation Status ........... Tax-Planning Actions................................................................................... Financial Statement Reporting ................................................................... 171 172 173 173

Increase in Tax Basis upon the Conversion of a Partnership to a Corporation .......................................................................................... 174 NOL Carryforward Limitation Following an Initial Public Offering.............................................................................................. 174 Business Combination Considerations ..................................................... S Corporation Election Invalidated by Acquisition by C Corporation ...... Common-Control Merger Involving an S Corporation ............................. Restructuring as Part of a Business Combination ................................... 175 175 175 175

8.6

8.7 8.7.1 8.7.2 8.7.3 8.8 8.8.1 8.8.2

Other Illustrations of Changes in Tax Status ............................................ 176 The American Jobs Creation Act of 2004 Tonnage Tax........................... 176 Effective Date of a REIT Conversion .......................................................... 177

Chapter 9: 9.1

Regulated Enterprises (29)

179

The Regulatory Process and Recording of a Regulatory Asset/Liability ............................................................................................... 181 Changes in Tax Rates .................................................................................. 184 Adjustments to Regulatory Asset/Liability................................................ 184 Changes in Tax Rates when No Regulatory Asset was Originally Recorded ..................................................................................... 185 Deferred or Unamortized Investment Tax Credit (ITC) ............................. 186 Interim Financial Reporting......................................................................... 186

9.2 9.2.1 9.2.2

9.3 9.4

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Chapter 10: 10.1

Business Combinations (30)

189

Taxable Versus Nontaxable Business Combinations and the Related Tax Considerations ...................................................................................... 191 Considerations on the Date of an Acquisition .......................................... The Basic Model ........................................................................................... Identification and Quantification of Temporary Differences and Carryforwards ................................................................................................. Nontaxable Flow-Through Entities............................................................... Exceptions to the Comprehensive Model of Recognizing Deferred Taxes............................................................................................... Determining the Applicable Tax Rate............................................................. Tax Rate Changes and Business Combinations............................................ Valuation Allowance Considerations.............................................................. Effects on Purchase Accounting .................................................................... Limitations on Acquired Benefits .................................................................... Combined Future Results............................................................................... Determining the Acquirers Temporary Differences in an Interim Period ......... Other Considerations on the Business Combination Date............................. Impact That a Change in Tax Basis Has on Separate Historical Financial Statements (EITF 94-10) ................................................................ Differences in Allocation Methodologies Between FAS 141 and the U.S. IRC ................................................................................................... A Foreign Equity-Method Investee That Becomes a Subsidiary.................... Acquisition of Indexed Assets and Liabilities ................................................. In-Process Research and Development ........................................................ Contingent Liabilities ...................................................................................... Tax Effect of a Contingent Purchase Price .................................................... Certain Transactions Triggering Book Gain or Loss With Carryover Tax Basis................................................................................................................ LIFO Inventories............................................................................................. Direct Costs of the Acquisition ( Transaction Costs)............................ Uncertain Tax Positions .............................................................................. Goodwill Considerations upon Acquisition .............................................. Components of Goodwill ................................................................................ Negative Goodwill Allocated to Certain Noncurrent Assets......................... Considerations in Periods Subsequent to the Acquisition ..................... Goodwill ........................................................................................................ Excess Tax-Deductible Goodwill.................................................................... Goodwill Impairment....................................................................................... Disposal of Goodwill....................................................................................... Subsequent Changes in Recognition and Measurement for Acquired Uncertain Tax Positions.............................................................. Later Initial Recognition of Acquired Tax Benefits................................... Initial Recognition of Acquired Tax Benefits................................................... Order of Utilization.......................................................................................... Tax Rate Changes ......................................................................................... Subsequent Realization after Partial Acquisitions ......................................... Later Recognition of Acquired Tax Benefits in Situations Involving Multiple Acquisitions....................................................................................... Subsequent Derecognition of Acquired Tax Benefits .................................... Subsequent Inventory Transactions .......................................................... 192 192 192 193 193 197 197 197 198 198 200 201 201 201 202 204 204 204 205 207 208 212 214 218 218 218 220 223 223 223 224 225 228 228 228 231 231 232 235 235 235

10.2 10.2.1 10.2.1.1 10.2.1.1.1 10.2.1.1.2 10.2.1.2 10.2.1.2.1 10.2.1.3 10.2.1.3.1 10.2.1.3.2 10.2.1.3.3 10.2.1.3.4 10.2.1.4 10.2.1.4.1 10.2.1.4.2 10.2.1.4.3 10.2.1.4.4 10.2.1.4.5 10.2.1.4.6 10.2.1.4.7 10.2.1.4.8 10.2.1.4.9 10.2.2 10.2.3 10.2.4 10.2.4.1 10.2.4.2 10.3 10.3.1 10.3.1.1 10.3.1.2 10.3.1.3 10.3.2 10.3.3 10.3.3.1 10.3.3.1.1 10.3.3.1.2 10.3.3.1.3 10.3.3.1.4 10.3.3.2 10.3.4

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10.4 10.4.1 10.4.2 10.4.3

Other Transactions ...................................................................................... Tax Accounting Issues Related to a Leveraged Buyout (LBO) ............... Fresh-Start Accounting ............................................................................... Common-Control Transactions ..................................................................

236 236 237 237

Chapter 11: 11.1 11.1.1 11.1.2 11.1.2.1 11.1.2.2 11.1.3 11.1.4 11.1.4.1 11.1.4.2

Opinion 23 Temporary Differences (31-34) Accounting for the Outside Basis of Investments.................................... Difference Between Outside and Inside Bases ......................................... Domestic Versus Foreign Subsidiaries ..................................................... Classification as Domestic or Foreign............................................................ Tiered Foreign Subsidiaries ........................................................................... Overview of Potential Deferred Tax Assets and Liabilities Related to Outside Basis Differences ...................................................................... Potential Deferred Tax Liabilities, Domestic Subsidiaries, and Domestic Corporate Joint Ventures........................................................... In General....................................................................................................... Domestic Subsidiaries and Domestic Corporate Joint Ventures: Excess Book-Over-Tax Outside Basis Differences That Arose in Fiscal Years Beginning On or Before December 15, 1992....................................... Domestic Subsidiaries: Excess Book-Over-Tax Outside Basis Differences That Arose in Fiscal Years Beginning After December 15, 1992........................................................................................ Domestic, 50-Percent-or-Less-Owned Investees: Excess Book-Over-Tax Outside Basis Differences That Arose in Fiscal Years Beginning After December 15, 1992 ......................................... Exception for Domestic Subsidiaries Under Par. 33 of FAS 109 ................... Ability and Intent to Recover Tax-free the Investment in the Domestic Subsidiary....................................................................................... Meaning of Significant Cost Under Par. 33 of FAS 109 .............................. Potential State Tax Considerations................................................................ Consideration of Lower-Tier Foreign Subsidiaries Owned by a Domestic Subsidiary....................................................................................... Special Considerations for Savings & Loan Associations and Stock Life Insurance Companies.................................................................... Potential Deferred Tax Liabilities, Foreign Subsidiaries, and Foreign Corporate Joint Ventures.............................................................. Outside Basis Differences: Undistributed Earnings and Other Differences ........................................................................................... Indefinite Reversal Criterion: the APB 23 Exception...................................... Partial Reinvestment Assertion ...................................................................... Evidence Required ......................................................................................... Effect of Distributions Out of Current-Year Earnings on an Indefinite Reversal Assertion ......................................................................................... Effect of Change in an Indefinite Reversal Assertion..................................... Inside Basis Differences That Meet the Indefinite Reversal Criterion............ APB 23 and Purchase Accounting ................................................................. APB 23 and FIN 46(R) ................................................................................... Foreign Corporate Joint Ventures That Are Not Permanent in Duration..................................................................................................... Measuring the Tax Effect of Outside Basis Differences (Domestic and Foreign) ............................................................................... Potential Deferred Tax Assets on Subsidiaries, Corporate Joint Ventures, and Equity Investees (Foreign and Domestic)......................... In General.......................................................................................................

241 245 245 246 246 246 248 250 250

250

11.1.4.3

251

11.1.4.4

11.1.4.5 11.1.4.5.1 11.1.4.5.2 11.1.4.5.3 11.1.4.5.4 11.1.4.6 11.1.5 11.1.5.1 11.1.5.2 11.1.5.3 11.1.5.4 11.1.5.5 11.1.5.6 11.1.5.7 11.1.5.8 11.1.5.9 11.1.6 11.1.7 11.1.8 11.1.8.1

251 251 251 253 254 255 255 257 257 258 259 259 260 261 261 262 262 262 263 265 265

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11.1.8.2 11.1.9 11.1.10 11.1.10.1 11.1.10.2 11.1.10.3 11.1.10.4 11.2 11.3 11.4 11.5 11.5.1 11.5.2 11.5.3 11.5.4 11.5.4.1 11.5.4.2 11.5.5 11.5.5.1 11.5.5.2 11.5.6 11.5.6.1 11.5.6.2 11.5.7 11.5.8 11.6 11.6.1 11.6.2 11.6.2.1 11.6.2.2 11.6.2.3

Recognition of Deferred Tax Assets on Foreign Tax Credits Prior to Meeting the Establishing Criteria Under Tax Law .......................................... Partnerships and Other Flow-Through Entities ........................................ Other Issues Related to Accounting for Outside Basis Differences ...... FIN 46(R) Considerations............................................................................... Changes from Investee to Subsidiary and from Subsidiary to Investee ........ Changes in a Parents Equity in the Net Assets of a Subsidiary That Result from the Subsidiarys Capital Transactions (SAB 51)......................... Tax-to-Tax (Inside Versus Outside Tax) Basis Differences ...........................

266 268 270 270 270 272 273

Certain Bad Debt Reserves for U.S. S&L Associations ........................... 273 Policyholders Surplus Account of Stock Life Insurance Companies ... 274 Deposits in Statutory Reserve Funds by U.S. Steamship Enterprises... 275 Tax Effects of Changes in Foreign Exchange Rate ................................. Translation of Foreign Deferred Taxes ...................................................... Transaction Gains and Losses ................................................................... Translation Adjustments on Outside Basis Differences.......................... Hedging ......................................................................................................... Hedging an Investment in a Foreign Subsidiary ............................................ Hedging a Deferred Tax Balance................................................................... U.S. Dollar Functional Currency ................................................................. Nonmonetary Assets and Liabilities ............................................................... Monetary Assets and Liabilities...................................................................... Indexed NOLs in Highly Inflationary Economies ...................................... Switching to a Highly Inflationary Economy ................................................... Economies That Are No Longer Highly Inflationary ...................................... Intraperiod Allocation as it Applies to the CTA Account ......................... Deferred Taxes on Intercompany Loans with Foreign Subsidiaries ...... Accounting for Branch Operations and Subpart F Income ..................... Branch Operations ....................................................................................... U.S. Subpart F Income: Income from Foreign Subsidiaries That Cannot Be Deferred...................................................................................... In General....................................................................................................... APB 23 and Potential Future Subpart F Income ............................................ APB 23 and Subpart Fs Previously Taxed Income ....................................... 275 275 275 275 276 276 276 277 277 279 279 279 280 281 282 283 283 288 288 289 290

Chapter 12: 12.1 12.2 12.2.1 12.2.2 12.2.2.1 12.2.2.2 12.2.2.2.1 12.2.2.2.2 12.2.2.2.3 12.2.3 12.2.3.1

Intraperiod Tax Allocation (35-38)

291

Level of Application ..................................................................................... 295 The Basic Model ........................................................................................... Step 1: Compute Total Tax Expense or Benefit ........................................ Step 2: Compute Tax Attributable to Continuing Operations.................. Tax Effect of Current-Year Income from Pretax Continuing Operations........ Other Items Specifically Allocated to Continuing Operations......................... Changes in Tax Laws or an Enterprises Tax Status ..................................... Change in Indefinite Reversal Assertion for Foreign Subsidiary.................... Changes in the Valuation Allowance.............................................................. Step 3: Allocate the Remaining Portion of Tax Expense or Benefit to Other Components ..................................................................... Determining the Individual Effects on Income Tax Expense or Benefit ......... 295 295 296 296 302 302 302 304 321 321

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12.2.3.2 12.2.3.2.1 12.2.3.2.2 12.2.3.2.3 12.2.3.2.4 12.2.3.2.5 12.2.3.2.6 12.2.3.3 12.2.3.3.1 12.2.3.3.2 12.2.3.3.3 12.2.3.3.4 12.3 12.3.1 Chapter 13: 13.1 13.2 Chapter 14: 14.1 14.1.1 14.1.2 14.1.3 14.2 14.3 14.4 14.5 14.6 14.7 14.8 Chapter 15: 15.1 15.1.1

Treatment of Specific Components Other than Continuing Operations......... Intraperiod Allocation for Equity Items Other than Items of Comprehensive Income ................................................................................. Items of Other Comprehensive Income ......................................................... Dividends........................................................................................................ Discontinued Operations ................................................................................ Complexities in Accounting for Windfall Benefits under FAS 123(R)............. Tax Effect of Changes in Accounting Principle .............................................. Miscellaneous Intraperiod Issues ................................................................... Income Tax Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature ....................................................................... Changes in Tax Basis Resulting from a Taxable Exchange between Entities under Common Control ..................................................................... Presentation of the Tax Effects of the Sale of Stock of a Subsidiary............. Recording Valuation Allowances in Conjunction with a Spin-off Transaction .......................................................................................

330 330 330 339 340 341 345 346 346 347 347 349

Exception to the Basic ModelPar. 140.................................................... 349 General Application of FAS 109, Par. 140.................................................. 349 Certain Quasi Reorganizations (39) 353

General .......................................................................................................... 355 Pre-reorganization Tax Benefits ................................................................. 355 Separate Financial Statements of a Subsidiary (40 and 49) Acceptable Methods .................................................................................... Separate Return Method.............................................................................. Benefits for Loss .......................................................................................... Other Methods .............................................................................................. 357 359 360 361 361

Tax Allocation Versus Tax Sharing Arrangements .................................. 362 Change in Method ........................................................................................ 363 Single-member and Multiple-member Limited Liability Companies ..................................................................................... 363 Disclosures ................................................................................................... 365 Impact of a Change in Tax Basis on Separate Historical Financial Statements .................................................................................................... 365 Uncertain Tax Positions and Separate Financial Statements of a Subsidiary.............................................................................................. 368 Carve-out Financial Statements.................................................................. 370 Financial Statement Presentation & Disclosure (41-48) 373

Balance Sheet Presentation ........................................................................ 377 Principles of Balance Sheet Classification................................................ 377

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15.1.2 15.1.3 15.1.4 15.2 15.3 15.3.1 15.3.2 15.3.3 15.3.4 15.4 15.5 15.5.1 15.5.1.1 15.5.1.2 15.5.1.2.1 15.5.1.2.2 15.5.1.2.3 15.5.1.2.4 15.5.1.2.5 15.5.1.3 15.5.1.4

Valuation Allowance and Balance Sheet Classification........................... 378 Offsetting and Multiple Jurisdictions......................................................... 379 Contingencies and Uncertain Tax Positions ............................................. 379 Balance Sheet Disclosures ......................................................................... 379 Income Statement Presentation ................................................................. Deferred Tax Expense or Benefit................................................................ Interest and Penalties .................................................................................. Professional Fees......................................................................................... Change in Tax Laws, Rates, or Status ....................................................... 382 383 383 384 384

Income Statement Disclosures ................................................................... 385 FIN 48 Disclosures ....................................................................................... Annual Disclosures...................................................................................... Disclosure of Accounting Policy on Classification of Interest and Penalties (FIN 48, par. 20) ............................................................................. Tabular Reconciliation of Unrecognized Tax Benefits (FIN 48, par. 21(a))......................................................................................... Comprehensive Basis .................................................................................... Disclosure of Gross Unrecognized Tax Benefits............................................ Interest and Penalties..................................................................................... Treatment of Deposits .................................................................................... Required Information...................................................................................... Unrecognized Tax Benefits That, If Recognized, Would Affect the Effective Tax Rate (FIN 48, par. 21(b)) .......................................................... Total Amount of Interest and Penalties Recognized in the Statement of Operations and Total Amount of Interest and Penalties Recognized in the Statement of Financial Position (FIN 48, par. 21(c)) ............................ Reasonably Possible Significant Changes in Unrecognized Tax Benefits That May Occur Within the Next 12 Months (FIN 48, par. 21(d)) .................. Tax Years Still Subject to Examination by a Major Tax Jurisdiction (FIN 48, par. 21(e))......................................................................................... Interim Disclosures ...................................................................................... 388 388 389 389 389 391 391 391 392 393

394 394 396 397

15.5.1.5 15.5.1.6 15.5.2 15.6 15.7 15.8 15.8.1 15.8.2 15.8.3 15.8.4 15.8.5 15.8.5.1 15.8.5.2 15.8.5.3 15.9

FAS 123(R) Tax-Related Disclosures ......................................................... 399 Significant Risks & Uncertainties Disclosure (SoP 94-6)......................... 400 SEC Disclosures........................................................................................... Additional Footnote Disclosures................................................................ Contractual Obligations Table .................................................................... Interim Reporting (Form 10-Q Filings) ....................................................... Schedule II Requirement ............................................................................. MD&A Disclosures ....................................................................................... Effective Tax Rate .......................................................................................... Accounting Estimates & Contingencies ......................................................... Realization of Deferred Tax Assets................................................................ 400 400 401 401 401 402 402 402 402

Exemptions for Nonpublic Entities ............................................................ 403

Chapter 16: 16.1

Accounting for Uncertainty in Income Taxes

405

Background................................................................................................... 407

Table of Contents / xi

16.2 16.2.1 16.2.1.1 16.2.1.1.1 16.2.1.2 16.2.1.3 16.2.1.4 16.2.1.5 16.2.2 16.2.2.1 16.2.2.2 16.2.2.3 16.3 16.3.1 16.3.1.1 16.3.1.2 16.3.1.3 16.3.1.4 16.3.2 16.3.2.1 16.3.2.2 16.3.2.3 16.3.2.4 16.3.2.5 16.3.2.5.1 16.3.2.5.2 16.3.2.6 16.3.2.7 16.3.2.8 16.3.2.9 16.3.2.10 16.3.2.11 16.3.2.11.1 16.4 16.4.1 16.4.1.1 16.4.1.2 16.4.1.3 16.4.1.4 16.4.1.5 16.4.2 16.4.2.1 16.4.3 16.4.4 16.5 16.5.1 16.5.2 16.5.3 16.5.3.1 16.5.3.2

Scope............................................................................................................. Enterprises Within the Scope of FIN 48 ..................................................... Foreign Registrants ....................................................................................... Non-U.S. Parent Enterprise............................................................................ FIN 48 and Business Combinations............................................................... Application of FIN 48 to Separate Financial Statements ............................... FIN 48 and Non-Income-based Taxes ........................................................... FIN 48 and Indemnifications........................................................................... Identifying Uncertain Tax Positions................................................................ Decision Not to File a Tax Return .................................................................. Equity and Partnership Investments .............................................................. Uncertain Tax Positions Relating to Temporary Differences ......................... Recognition................................................................................................... Unit of Account............................................................................................. Consistency in a Tax Positions Unit of Account ............................................ Consideration of Offsetting Positions ............................................................. A Single Unit of Account for Multiple Transactions That Are Similar ............. Unit of Account for Multiple Transactions That Are Dissimilar ....................... Recognition Threshold for Uncertain Tax Positions ....................................... More-likely-than-not Recognition Threshold .................................................. Sources of Authoritative Tax Laws................................................................. Tax Opinions and External Evidence ............................................................. Examination by Taxing Authority (Detection Risk) ......................................... Administrative Practices and Precedents....................................................... Administrative Practices and Precedents Available to Enterprises that Self-report................................................................................................ Nexus-Related Administrative Practices and Precedents.............................. Assessing Recognition When Potentially Offsetting Positions Exist.............. Assessing Recognition When Potentially Indirect Benefits Exist ................... Uncertainties Regarding Valuation................................................................. Timing Differences ......................................................................................... Amended Returns and Refund Claims........................................................... Interaction with Valuation Allowance Assessment ......................................... FIN 48 and Tax-Planning Strategy................................................................. Measuring the Tax Benefit to be Recorded ............................................... The Cumulative Probability Approach ....................................................... Calculation of Individual Probability and Possible Outcomes ........................ Consideration of Past Audit Experience......................................................... Use and Documentation of Cumulative Probability Table.............................. Highly Certain Tax Positions .......................................................................... Binary Tax Positions....................................................................................... FIN 48 Measurement and Transfer Pricing ................................................ Contemporaneous Documentation ................................................................ Interrelationship of Measurement and Recognition ................................. The Implications of Should Level Tax Opinions................................... Changes in Recognition and Measurement in Subsequent Periods..................................................................................... Considering the Impact of a Jurisdictions Dispute-Resolution Process ....................................................................... Effective Settlement of a Tax Position ....................................................... Other Considerations in the Tax Examination Process ........................... Amended Return/Tax Receivable .................................................................. Competent Authority.......................................................................................

408 409 409 409 410 411 411 411 412 413 414 414 415 415 417 418 418 418 419 419 422 423 424 424 426 426 428 428 429 430 432 433 435 435 436 437 437 438 439 439 440 440 441 441

441 444 444 449 449 449

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16.5.3.3 16.5.3.4 16.5.4 16.5.5 16.5.6

Relevance of Resolution Experience to Future Periods ................................ Enterprises Not Subject to Audit by a Taxing Authority ................................. Subsequent Derecognition.......................................................................... Subsequent Events ...................................................................................... Recording the Effects of Changes in Recognition and Measurement During the Year .................................................................... Interest and Penalties .................................................................................. Interest........................................................................................................... Interest Income on Uncertain Tax Positions .................................................. Penalties........................................................................................................ Accounting Policy Election for Classification of Interest and Penalties ................................................................................................ Balance Sheet Classification ...................................................................... Background................................................................................................... SEC Required Balance Sheet Display of FIN 48 Liabilities ........................... Classification/Presentation of FIN 48 Liability When NOL and Tax Credit Carryforwards Exist.......................................................................... Gross Presentation ...................................................................................... Net Presentation ..........................................................................................

450 450 450 450 452 452 452 453 455 457 458 459 459 461 461 464

16.6 16.6.1 16.6.1.1 16.6.2 16.6.3

16.7 16.7.1 16.7.1.1 16.7.2 16.7.2.1 16.7.2.2 16.8 16.8.1 16.9 16.9.1 16.10 16.10.1 16.11

Disclosures ................................................................................................... 466 Annual Disclosures...................................................................................... 466 Intraperiod Allocation .................................................................................. 466 FIN 48 and Backwards Tracing ................................................................... 466 Documentation ............................................................................................. 467 Role and Use of Tax Opinion Letters ......................................................... 468 Comparison With IAS 12.............................................................................. 468

Chapter 17: 17.1 17.1.1 17.1.1.1 17.1.1.1.1 17.1.1.1.2 17.1.1.1.3 17.1.1.1.4 17.1.2 17.1.2.1 17.1.2.1.1 17.1.2.1.2 17.1.2.1.3 17.1.2.2 17.1.2.2.1 17.1.2.2.2 17.1.3 17.1.4

Accounting for Income Taxes in Interim Periods Accounting for Interim-Period Income Taxes ........................................... Method of Computing an Interim Tax Provision ....................................... Determining the Elements and Tax Effects of Ordinary Income .................... FIN 18s Definition of Tax (or Benefit) Related to Ordinary Income............... Items Excluded from the Definition of Ordinary Income................................. Limited Exceptions for Certain Items ............................................................. Other Items That Do Not Represent the Tax Effect Attributable to Ordinary Income............................................................................................. Computing the Tax Provision Attributable to Ordinary Income.............. Estimate Annual Effective Tax Rate............................................................... Methodology................................................................................................... Best Current Estimate .................................................................................... Limitation on Benefits of Losses, Credits, and Rate Differentials in Loss Periods................................................................................................... Exceptions to the Use of an Expected Annualized Effective Rate................. Jurisdictions with Pretax Losses and No Tax Benefit Realized ..................... Jurisdictions For Which a Reliable Estimate Cannot Be Made...................... Tax Effects Other than the Tax on Current-Year Ordinary Income ......... Intraperiod Allocation in Interim Periods...................................................

469 472 472 472 472 473 475 477 482 482 482 483 484 486 487 487 490 491

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17.1.4.1 17.1.4.2 17.1.4.3 17.1.4.4 17.1.4.4.1 17.1.4.5 17.1.4.6 17.1.5 17.1.5.1 17.1.5.2 17.1.5.3 17.1.5.4 17.1.6 17.1.6.1

General Overview........................................................................................... Subsequent Revisions.................................................................................... Intraperiod Allocation That Reflects Discontinued Operations Prior to the Date on Which They are Classified as Held for Sale or Disposed Of ............ Changes in Valuation Allowance.................................................................... Initial Recognition of Source-of-Loss Items.................................................... FAS 109, par. 140 Considerations ................................................................. Considering the Effects of FAS 123(R)s Tax Accounting During Interim Periods ............................................................................................... Other Complexities ...................................................................................... Business Combinations.................................................................................. Effects of Naked Credits on the Estimated Annual Effective Tax Rate ....... Different Financial Reporting and Tax Year-End ........................................... When Disclosure of Components of Interim Tax Expense Is Required......... Disclosures ................................................................................................... Interim Financial Statement Disclosures.......................................................

491 491 491 492 495 496 499 500 500 502 502 503 504 504

Chapter 18: 18.1 18.2 18.2.1 18.3 18.4 18.5 18.5.1 18.5.2 18.5.3 18.5.4 18.6 18.6.1 18.7 18.7.1 18.7.2 18.7.2.1 18.8 18.8.1 18.8.2 18.9

Income Tax Accounting for Stock-Based Compensation

507

Introduction................................................................................................... 509 Background and Basics of Accounting for Stock-Based Compensation Under FAS 123(R) and FAS 109 ........................................ 509 Income Tax Accounting for Liability-Classified Awards.......................... 511 Guidance Before FAS 123(R) ...................................................................... 511 Accounting for Income Taxes Related to Various Awards ...................... 511 Income Tax Accounting for Nonqualified Stock Options ........................ Initial Recognition and Classification of a Deferred Tax Asset............... Change in Tax Rates .................................................................................... Employer Payroll Taxes............................................................................... Accounting for Options That Are Forfeited or Expire Unexercised........ 512 512 512 512 513

Income Tax Accounting for Incentive Stock Options............................... 515 Disqualifying Dispositions .......................................................................... 515 Income Tax Accounting for Restricted Stock and Restricted Stock Units............................................................................................................... Initial Recognition and Classification of the Deferred Tax Asset ........... Measurement of Tax Deduction for Restricted Stock .............................. IRC Section 83(b) Elections ...........................................................................

516 517 517 517

Income Tax Accounting for Stock Appreciation Rights........................... 519 Cash-Settled SARs....................................................................................... 519 Stock-Settled SARs...................................................................................... 519 Accounting for the Tax Benefit of Dividends on Restricted Stock and Options........................................................................................ 520 Modification of Awards................................................................................ 521 Pool of Windfall Tax Benefits...................................................................... 521

18.10 18.11

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18.11.1 18.11.2 18.11.3 18.11.3.1 18.11.3.2 18.11.3.3 18.11.4 18.11.4.1 18.11.4.2 18.11.5

18.11.6 18.11.7

General Guidance......................................................................................... Determining the Pool of Windfall Tax Benefits Using the Long-Form Method....................................................................................... Transition Considerations Under the Long-Form Method....................... Nonqualified Stock Options ............................................................................ Incentive Stock Options.................................................................................. Restricted Stock ............................................................................................. Determining the Pool of Windfall Tax Benefits Using the Short-Cut Method ......................................................................................... Transition Considerations Under the Short-Cut Method ................................ Accounting Policy Election Regarding the Use of the Short-Cut Method ...... Determining the Pool of Windfall Tax Benefits for Enterprises That Became Public Entities After the Effective Date of FAS 123 but Prior to Adopting FAS 123(R)............................................................... Determining the Pool of Windfall Tax Benefits for Prospective Adopters .................................................................................. Determining the Tax Benefit from Awards with Graded Vesting and Separate Fair Values............................................................................. Business Combinations, Equity Restructurings, and Separately Reporting Subsidiaries ................................................................................ Impact of Business Combinations, Equity Restructurings, Spin-offs, Equity-Method Investments, Majority-Owned Subsidiaries, and Bankruptcy on the Pool of Windfall Tax Benefits ..................................... Tax Effects of Awards Exchanged in a Business Combination .............. Pool of Windfall Tax Benefits for Separately Reporting Subsidiaries .... Example: Options Exchanged in a Business Combination ..................... Fair Value of Options Exchanged .................................................................. Entry to Record Fair Value Allocated to Future Service ................................ Requisite-Service-Period Entries ................................................................... Exercised OptionsOptions Vested at Closing Date .................................... Exercised OptionsOptions Unvested at Closing Date ................................

521 523 524 525 529 532 532 534 536

537 538 539

18.12 18.12.1

539

18.12.2 18.12.3 18.12.4 18.12.4.1 18.12.4.2 18.12.4.3 18.12.4.4 18.12.4.5 18.13 18.14 18.14.1 18.15 18.16 18.17 18.18 18.19 18.19.1 18.20 18.21 18.21.1 18.21.2

539 540 542 542 543 544 544 545 546

Net Operating Loss Carryforwards ............................................................ 547 Valuation Allowances .................................................................................. 548 Accounting for Settlements When There Is a Valuation Allowance ....... 549 Uncertain Tax Positions .............................................................................. 549 Intraperiod Tax Allocation ........................................................................... 550 Interim Reporting ......................................................................................... 550 Capitalized Compensation Cost ................................................................. 550 Multinational Enterprises ............................................................................ 553 Tax Benefit from Foreign Tax Credits ........................................................ 554 Cost-Sharing Pool ........................................................................................ 555 Income Tax Disclosures, Assumed Proceeds Under FAS 128, and Cash Flow Statement Presentation ............................................................ 556 Assumed Proceeds Under the Treasury Stock Method of FAS 128 ....... 557 Cash Flow Statement Presentation ............................................................ 557

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Chapter 19: 19.1 19.2 19.2.1 19.2.2

FAS 109 and IAS 12

561

Short-Term Convergence ............................................................................ 563 Comparison between U.S. GAAP and IFRS............................................... 563 Comparison between the FAS 109 and IAS 12 Models ............................ 563 Differences in Interpretation ....................................................................... 568

Appendix A B C Authoritative Pronouncements .................................................... 571 The FAS 109 Model ........................................................................ 579 Financial Statement Disclosure Requirements .......................... 581

xvi / Table of Contents

Executive Summary

Executive Summary / 1

Executive Summary Change: The one constant Benjamin Franklin once said that nothing in this world is certain but death and taxes. Had he been able to anticipate this centurys standard-setting activity, he might have phrased things somewhat differently. Nowadays, the only certainty about taxes is that things will change. Complexity Already complex, accounting for income taxes will become even more so as a result of new1 and forthcoming2 guidance here in the United States. FAS 109 has been around for some time3 - a fact that suggests companies have had sufficient time to fully acclimate themselves to the standards provisions. In the intervening years, however, the overall business environment has grown decidedly more complex. So too has accounting under U.S. generally accepted accounting principles (GAAP). The way that governments (local, federal and foreign) levy taxes is also more complex now. These factors have made the interpretation of FAS 109 (and the related guidance on accounting for income taxes) particularly challenging. Complications Where there is complexity, there is the greater likelihood of complications. In recent years, controls around the accounting for income taxes have been a critical source of material weakness in companies internal controls over financial reporting. Accounting for income taxes has also been a primary reason for restating financial statements. Further complications may arise as U.S. GAAP begins to converge with International Financial Reporting Standards (IFRS). While the Securities and Exchange Commission (SEC) ponders whether it will allow U.S. companies to file financial statements prepared under IFRS, many practitioners will want to become familiar with the similarities and differences between the two frameworks. How this manual helps We have kept these factors very much in mind while writing this manual. Intended as a practice aid for PricewaterhouseCoopers engagement teams and other parties, this manual serves as a central location for the following information: A comprehensive summary of FAS 109 and the relevant authoritative literature PwCs interpretation of that literature PwCs insights on accounting matters related to income taxes In reading this manual, it is important to remember that under FAS 109, as under any principles-based standard, circumstances particular to a given situation might lead to an accounting conclusion that differs from the one arrived in a similar but not identical situation (or might lead to more than one supportable conclusion). We hope it is with this understanding that our readers will use this manual.1

FASB Statement 123(R), Share-Based Payment, and FASB Interpretation 48, Accounting for Uncertainty in Income Taxes An Interpretation of FASB Statement No.109. FASB Statement 141(R) and FASB Statement 160. The FASB issued FAS 109 in 1992.

2 3

2 / Executive Summary

How this manual is organized The flow of this manual follows the linear progression of FAS 109. The beginning chapters address the following matters: The basic model of FAS 109 (e.g., the scope, objectives, and basic principles) Identification of temporary differences Recognition and measurement of deferred tax assets and liabilities Establishment of a valuation allowance Accounting for changes in tax laws and tax status The manual then moves on to some of the more complex areas of tax accounting: Business combinations Temporary differences under APB Opinion 234 Intraperiod allocation These three complex areas have in whole or in part been re-examined by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in their mutual effort to converge U.S. GAAP and IFRS. The converged guidance for business combinations is expected to go into effect upon the adoption of FAS 141(R). Noteworthy is that this manual addresses current U.S. GAAP related to business combinations and will be updated to reflect the issuance of FAS 141(R) and FAS 160. In their joint project on short-term convergence, the FASB and the IASB tentatively decided to maintain the FAS 109 guidance regarding intraperiod allocation and the accounting for the outside basis of foreign subsidiaries. However, FAS 109s model for intraperiod allocation will be revisited as part of the FASB/IASBs project on reporting financial performance. The final chapters of the manual deal with the following issues: Disclosure Separate financial statements of a subsidiary Interim reporting Tax accounting for share-based payments (FAS 123(R)) FIN 48 Summary of differences in accounting for income taxes between U.S. GAAP and IFRS As the environment continues to change, so will the content in this manual. This manual considers existing guidance as of November 15, 2007. Future editions will be released to keep pace not only with the issuance of FAS 141(R) and FAS 160, but also with other significant developments. Subsequent editions will also provide practitioners with guidance on navigating the many complexities of accounting for income taxes, which we believe (with the same conviction that Franklin had about death and taxes) will only keep proliferating.4

Accounting Principles Board Opinion 23, Accounting for Income TaxesSpecial Areas.

Executive Summary / 3

Chapter 1: Scope of FAS 109 (3-5)

Scope of FAS 109 (3-5) / 5

Chapter Summary FASB Statement No. 109, Accounting for Income Taxes (FAS 109 or the Statement) establishes standards on how companies should account for and report the effects of taxes based on income. While the scope of FAS 109 appears to be self-explanatory (i.e., FAS 109 applies to all income based tax structures), the unique characteristics of tax structures across the United States and the world can make it quite difficult to determine whether a particular tax structure is a tax based on income. Matters are further complicated when the determination involves the U.S. tax treatment of a structure such as a single-member limited liability company or entails applying the check the box rules for entity classification. This chapter looks at what would constitute a tax based on income and discusses the applicability of FAS 109 to various types of entities.

6 / Scope of FAS 109 (3-5)

Excerpt from Statement 109 3. This Statement establishes standards of financial accounting and reporting for income taxes that are currently payable and for the tax consequences of: a. Revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than the year in which they are recognized in financial income Other events that create differences between the tax bases of assets and liabilities and their amounts for financial reporting Operating loss or tax credit carrybacks for refunds of taxes paid in prior years and carryforwards to reduce taxes payable in future years.

b.

c.

This Statement supersedes Statement 96 and supersedes or amends other accounting pronouncements listed in Appendix D. 4. The principles and requirements of this Statement are applicable to: a. Domestic federal (national) income taxes (U.S. federal income taxes for U.S. enterprises) and foreign, state, and local (including franchise) taxes based on income An enterprises2 domestic and foreign operations that are consolidated, combined, or accounted for by the equity method Foreign enterprises in preparing financial statements in accordance with U.S. generally accepted accounting principles.

b. c.

5. This Statement does not address: a. The basic methods of accounting for the U.S. federal investment tax credit (ITC) and for foreign, state, and local investment tax credits or grants (The deferral and flow-through methods as set forth in APB Opinions No. 2 and No. 4, Accounting for the Investment Credit, continue to be acceptable methods to account for the U.S. federal ITC.) Discounting (Paragraph 6 of APB Opinion No. 10, Omnibus Opinion-1966, addresses that subject.) Accounting for income taxes in interim periods (other than the criteria for recognition of tax benefits and the effect of enacted changes in tax laws or rates and changes in valuation allowances). (APB Opinion No. 28, Interim Financial Reporting, and other accounting pronouncements address that subject.)

b.

c.

2

The term enterprise is used throughout this Statement because accounting for income taxes is primarily an issue for business enterprises. However, the requirements of this Statement apply to the activities of a not-for-profit organization that are subject to income taxes.

Scope of FAS 109 (3-5) / 7

1.1 1.1.1

Scope of FAS 109 In General (FAS 109, par. 4) FAS 109s principles and requirements apply to the following: Domestic federal (national) income taxes (U.S. federal income taxes for U.S. enterprises) and foreign, state, and local (including franchise) taxes based on income An enterprises domestic and foreign operations that are consolidated, combined, or accounted for by the equity method A foreign enterprises financial statements that are being prepared in accordance with U.S. generally accepted accounting principles (GAAP) In short, any income-based tax that an enterprise must pay to a governmental authority is subject to the provisions of FAS 109. It is also important to note that FAS 109 applies to all entities that are part of a reporting entity. It will be necessary, therefore, to consider the tax impact of other entities that interact with the companies that make up the financial reporting entity (e.g., equity-method investees and entities that are combined due to common control, or variable interest entities ( VIEs) consolidated under FIN 46(R), Consolidation of Variable Interest Entities, an interpretation of ARB No. 51) not just the tax impact of consolidated subsidiaries.

1.1.2

Scope Exceptions (FAS 109, par. 5) FAS 109 explicitly states that it does not address: Accounting for investment tax credits Discounting of deferred taxes Accounting for income taxes in interim periods

1.1.2.1

Accounting for Investment Tax Credits The FASB specifically excluded from the scope of FAS 109 the basic methods of accounting for (1) the U.S. federal investment tax credit (ITC) and (2) foreign, state, and local investment tax credits or grants. (Enterprises are still allowed to account for investment tax credits by using the deferral and flow-through methods under Accounting Principles Board Opinion Nos. 2 and 4, Accounting for the Investment Credit.) What differentiates an investment tax credit (outside the scope of FAS 109) from other income tax credits (within the scope of FAS 109) and from grants (outside the scope of FAS 109) is not always easy to discern, since they often share at least a few characteristics. Considerable care should be taken in assessing whether a particular credit should be accounted for as an investment tax credit, an income tax credit, a non-income tax credit, or a governmental grant. See Section 3.2.3 for further discussion on the income tax accounting related to investment credits.

1.1.2.2

Discounting Although it might seem logical that an asset and liability approach to accounting for the impact of income taxes would give some consideration to the time value of money (a deduction today is worth more to an enterprise than a deduction ten years in the future),

8 / Scope of FAS 109 (3-5)

FAS 109 specifically precludes enterprises from present-valuing or discounting when measuring deferred taxes. There are conceptual arguments both for and against discounting deferred taxes for the time value of money. A strong reason not to discount deferred taxes is that such discounting would involve numerous operational issues, including the selection of the appropriate discount rate(s). Most importantly, discounting would routinely require an enterprise to undertake a detailed analysis of future reversals of temporary differences to determine the future years in which the deferred tax amounts would become taxable or deductible. The FASB did not believe that the benefit of discounting outweighed the effort required to achieve that benefit. As a result, the time value of money is not considered in the accounting for income taxes (aside from an assessment of whether a tax-planning strategy is prudent and feasible). See par. 6 of APB Opinion No. 10, Omnibus Opinion 1966, for a fuller discussion of discounting. 1.1.2.3 Accounting for Interim-Period Income Taxes The scope of FAS 109 does not include income taxes for interim periods (par. 5). However, the accounting for income taxes for interim periods does look to FAS 109 for the criteria for recognition of tax benefits, the accounting for the effect of enacted changes in tax laws or rates, and the accounting for changes in valuation allowance. When accounting for income taxes during interim periods, enterprises should refer to the primary authoritative guidance of the Accounting Principles Board (APB) in Opinion No. 28, Interim Financial Reporting, and of the FASB in Interpretation No. 18, Accounting for Income Taxes in Interim Periods an Interpretation of APB Opinion No. 28. See Chapter 17 for additional guidance on reflecting the effects of taxes during interim periods. 1.2 1.2.1 Defining a Tax Based on Income In General As discussed above in Section 1.1.1, the principles of FAS 109 are applicable to taxes based on income. However, FAS 109 and authoritative literature under U.S. GAAP do not clearly define the term tax based on income or specify characteristics that differentiate taxes based on income from taxes that are not. The legal definition of the tax structure (as an income tax or otherwise) is not determinative in an evaluation of whether a tax structure should be accounted for as a tax based on income. We believe that a tax based on income is predicated on a concept of income less allowable expenses incurred to generate and earn that income. That being said, the tax structure does not need to include all income statement accounts in order to be an income tax. A tax on a subset of the income statement, such as a tax on net investment income (which taxes investment income less investmentrelated expenses), would also appear to be a tax on income, since it would employ the net income concept. The Big 4 accounting firms have generally agreed with this concept when there have been significant changes in state tax law (e.g., in Texas and Ohio). To define income taxes, we look to Appendix E of FAS 109, which defines income taxes as domestic and foreign federal (national), state, and local (including franchise) taxes based on income. FAS 109 establishes standards of financial accounting and reporting for the tax consequences of revenues, expenses, gains, or losses that are included in taxable income (par. 3a). Appendix E of FAS 109 defines taxable income as the excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the governmental taxing authority. Thus, we believe that

Scope of FAS 109 (3-5) / 9

implicit in FAS 109 is the concept that taxes on income are determined after revenues and gains are reduced by expenses and losses. Therefore, as discussed in Section 1.2.2.2, taxes based solely on revenues (e.g., gross-receipts tax) would not be subject to FAS 109. 1.2.2 Application of Guidance to Specific Tax Jurisdictions and Tax Structures As noted above, we historically have seen tax laws enacted in a number of jurisdictions where, based on the manner in which the tax is computed, it is not always clear whether the tax meets the definition of a tax based on income. In some cases, the tax might be just partially based on income (e.g., the taxpayer pays the higher of an income tax or equity-based tax in any given year). In other cases, the multiple characteristics of the enacted tax law and the laws overall complexity may make it difficult to determine whether the tax is based (either wholly or partially) on income. Below are our views on certain tax regimes that have been enacted by specific taxing jurisdictions. 1.2.2.1 Higher of an Income-Based or Capital-Based Computation Certain states impose on corporations a franchise tax that is computed as the higher of a tax based on income or a tax based on capital. One such tax, the Texas franchise tax (enacted in 1991), is the subject of guidance that the Emerging Issues Task Force (EITF) released in Issue 91-8, Application of FASB Statement No. 96 to a State Tax Based on the Greater of a Franchise Tax or an Income Tax (EITF 91-8).1 EITF 91-8 states that the Texas franchise tax was an income tax only to the extent that it exceeded the capital-based tax in a given year. The same approach would seem to be appropriate for any state tax that is similarly determined (i.e., is the higher of a capital-based computation or an income-based computation). In such states, there is the question of how FAS 109 should be applied in determining the applicable tax rate that is used to compute deferred tax assets and deferred tax liabilities for temporary differences and carryforwards. We infer from EITF 91-8 that the tax operates as a graduated tax. Assuming that the statute prescribes a single tax rate for the income-based calcula