Often viewed as a “public company problem,” private organizations may want to consider implementation of internal controls similar to Sarbanes-Oxley (SOX) Section 404 requirements. The inherent benefits of a strong control environment may be of significant value to a private company by providing: enhanced accountability throughout the organization, reduced risk of fraud, improved processes and financial reporting, and more effective inclusion of the Board of Directors.
Private organizations, while not always smaller, often have limited resources in specialty areas, including accounting for income tax. This resource constraint—the work being done outside the core accounting team—combined with the complexity of the issues, means private companies are ideal candidates for, and can achieve significant benefit from, internal controls enhancements. Thinking beyond the present, the following are five reasons private companies may want to adopt public-company-level controls:
Future Initial Public Offering (IPO) – Walk before you run! If the company believes an IPO may be in its future, it’s better to “practice” before the company is required to be SOX compliant. A phased approach to implementation can drive important changes in company culture as it prepares to become a public organization. Recently published reports analyzing IPO activity reveal that material weaknesses reported by public companies were disproportionately attributable to recent IPO companies. Making a rapid change to SOX compliance can place a heavy burden on a newly public company.
Private Equity (PE) Buyer – If the possibility of the company being sold to a PE buyer exists, enhanced financial reporting controls can provide the potential buyer with an added layer of security or comfort regarding the financial position of the company. Further, if the PE firm has an exit strategy that involves an IPO, the requirement for strong internal controls may be on the horizon.
Rapid Growth – Private companies that are growing rapidly, either organically or through acquisition, are susceptible to errors and fraud. The sophistication of these organizations often outpaces the skills and capacity of their support functions, including accounting, finance, and tax. Standard processes with preventive and detective controls can mitigate the risk that comes with rapid growth.
Assurance for Private Investors and Banks – Many users other than public shareholders may rely on financial information. The added security and accountability of having controls in place is a benefit to these users, as the enhanced credibility may impact the cost of borrowing for the organization.
Peer-focused Industries – While not all industries are peer-focused, some place significant weight on the leading practices of their peers. Further, some industries require enhanced levels of security and control. For example, utility companies, industries with sensitive customer data (financial or medical), and tech companies that handle customer data often look to their peer group for leading practices, including their control environment. When the peer group is a mix of public and private companies, the private company can benefit from keeping pace with the leading practices of their public peers.
Private companies are not immune from the intense scrutiny of numerous stakeholders over accountability and risk. Companies with a clear understanding of the inherent risks that come from negligible accounting practices demonstrate their ability to think beyond the present, and to be better prepared for future growth or change in ownership
Companies and individuals currently find themselves in unchartered territory as the world responds to the novel coronavirus (COVID-19). The implications of COVID-19 are having a direct impact on many people, for which the health and well-being of individuals and their families are paramount. In addition, companies are also being forced to deal with the ramifications of this pandemic on their businesses. To react to these challenges, governments around the world have been responding to COVID-19 in various ways, including enacting economic stimulus packages.
In the United States, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act)[1] was enacted into law on March 27, 2020, to respond to the economic challenges many are facing due to COVID-19. The CARES Act includes several business provisions that may impact a company’s accounting for income taxes. In addition, the impact of COVID-19 itself on businesses draws attention to certain provisions in ASC 740.
This alert will highlight observations and insights from an ASC 740 perspective that companies should consider as they confront these challenges to their businesses.
Change in Tax Law – CARES Act
President Trump signed into law the CARES Act on March 27, 2020, making this a Q1 event for calendar year companies. ASC 740 requires that an entity must recognize the effect of a change in tax law or rates in the period that includes the date of enactment.[2] The business provisions in the CARES Act need to be analyzed and the estimated impact of those provisions recorded as part of continuing operations during the quarter.
Modification for Net Operating Losses – Interim Reporting
The CARES Act provides for a five-year carryback of net operating losses generated in taxable years beginning after December 31, 2017, and before January 1, 2021.[3] As many companies now face a strain on their cash flow, the benefit from a carryback of a loss to a prior period will help with cash flow when taxes paid in prior years are refunded.
For net operating losses generated or utilized during this period, the 80% taxable income limitation for net operating losses will not apply, including losses carried back. It should be noted, however, that the 80% limitation on the usage of net operating losses is reinstated for years beginning after December 31, 2020.
Companies can elect, on a year-by-year basis, to forgo a carryback for 2018, 2019 and 2020 losses. In addition, an election under IRC Section 965(n)[4] will automatically be deemed to have been made to a Transition Tax period unless an election is made to exclude the Transition Tax year from a carryback claim. In addition, the CARES Act included a technical correction so that carryback and carryforward provisions apply to taxable years beginning after December 31, 2017. Lastly, losses that are carried forward from these years continue to be carried forward indefinitely.
For interim reporting purposes, companies may need to consider:
Any current tax benefit for 2020 losses that are expected to be carried back to prior years would be part of the company’s annual effective tax rate (AETR) calculation, including the potential benefit related to different tax rates (35% vs. 21%).
Any current tax benefit from the carryback of 2019 and 2018 losses, including the potential benefit related to different tax rates (35% vs. 21%), would generally be recorded discretely in the quarter.
A company recognizes a change in the valuation allowance in an interim period through its estimate of the annual effective tax rate if the change relates to either (a) deferred tax assets originating during the year or (b) deferred tax assets existing at the beginning of the year that are expected to be realized as a result of current year ordinary income.[5]
A company recognizes a change in the valuation allowance discretely in the interim period if the change relates to deferred tax assets existing at the beginning of the year that are expected to be realized in future years.[6]
Example – Current Year Loss Expected to be Carried Back
Facts:
Federal tax rate is 35% for 2015, 2016, and 2017 and 21% for 2018 and 2019
Calendar year company – Q1 2020
Forecasted ordinary loss in 2020 of 500K
Loss is carried back in full to 2015-2019
No valuation allowance at beginning or end of the year
Entity has one temporary difference for definite-lived book intangible assets
State taxes ignored for simplicity
Deferred Tax Asset (Deferred Tax Liability)
Deferred Tax Asset(Deferred Tax Liability)
Deferred Tax
1-Jan-20
31-Dec-20
Expense(benefit)
Intangible assets
(300.00)
(200.00)
Tax effected
(63.00)
(42.00)
(21.00)
Current tax expense
Current year ordinary loss
(500.00)
Reverse book intangible amortization
100.00
Forecasted taxable loss
(400.00)
Carryback to:
Tax Effect
2015
100.00
(35.00)
2016
200.00
(70.00)
2018
100.00
(21.00)
Current tax expense (benefit)
400.00
(126.00)
Deferred tax expense (benefit)
(21.00)
Total tax expense (benefit)
(147.00)
Effective Tax Rate
29.40%
The effective tax rate is higher than expected due to the carryback of the loss to 35% years in 2015 and 2016. For Q1 interim period, the AETR is 29% since the benefit relates to benefit from the current year loss.
The carryback of losses to prior tax years, including pre-TCJA[7] tax years, creates additional computational challenges. These include the effects of indirect impacts of carrybacks on prior year calculations, including, but not limited to, the former Domestic Production Activity Deduction, the IRC Section 250 deduction, and Uncertain Tax Positions. It would be expected that these indirect impacts due to 2020 losses carried back would be recorded as part of the 2020 AETR calculation. The indirect impacts from the carryback of 2018 and 2019 losses would be expected to be recorded discretely in the quarter.
The carryback of losses may “free up” credits that were otherwise used to reduce taxes in the carryback years. Such credits may be carried back or forward under the prevailing tax law. If some or all the credits can only be carried forward, consideration should be given to whether such carryforwards are realizable.
The carryback of losses on Form 1139[8] may re-open the statute of limitations for an otherwise closed year.[9] In such situations, consideration should be given to the recognition of a prior year uncertain tax position that had previously been reduced due to closure of the statute of limitations. In these instances, required disclosure on Schedule UTP (Uncertain Tax Position Statement) may also be impacted.
Modification of Limitation on Business Interest – Interim Reporting
The CARES Act provides for the relaxation of the limitation of adjusted taxable income (ATI) as determined under IRC Section 163(j) from 30% to 50% when determining the deduction for business interest expense for the 2019 and 2020 periods.[10] Further, for any taxable year beginning in 2020, a taxpayer may elect to substitute the ATI for the last taxable year beginning in 2019 for the 2020 ATI limitation calculation.
From an ASC 740 perspective, companies may need to consider:
Any increased deduction for interest in 2020 periods due to 50% limit would be recorded as part of the AETR calculation.
Any increased deduction for interest in 2019 periods due to 50% limit would be recorded discretely in the quarter.
In the case of partnerships, the increased IRC Section 163(j) limit from 30% to 50% of ATI does not apply to taxable years beginning in 2019, but rather it applies to taxable years beginning in 2020. In addition, 50% of any excess interest expense at the end of 2019 is deemed deductible in 2020. The remainder is subject to the provisions of IRC Section 163(j).
Example – 2020 projected with partnership interest and loss and excess interest deductions Company X, a U.S. corporation, conducts a significant part of its business in a partnership, PRS, in which it owns a 90% interest and is consolidated for financial reporting purposes. X has been allocated excess interest deductions since IRC Section 163(j) became effective (2018 year, X reports on a calendar year end for both book & tax purposes).
X had the following amounts of excess interest allocated:
2018
400
2019
500
2020
500
X has always been profitable since inception but is expecting to generate a tax loss of $300 absent any incremental benefit from the CARES Act. Due to an inability to project potential excess future Adjusted Taxable Income, X has recorded a valuation allowance against the excess interest carryovers. Under the provisions of the CARES Act, in 2020 X is able to utilize without limitation 50% of the excess interest from 2019 ($250) and an incremental $40 in 2020 due to the 50% ATI limitation (assumes ATI of $200, of which $60 of interest is inherent in the $300 loss leaving an additional $40 available from the CARES Act provisions). The result for 2020 is a potential carryback of $590.
In the instant situation, X should recognize the benefit of the utilization of the excess interest expense deduction from 2019 as a discrete item in its 2020 tax provision since it is realizable solely based on a retroactive change in tax law. The 2020 amount should be considered part of the AETR since it relates to current year amounts and is retroactive to the beginning of the year.
Additional Interim Considerations Due to COVID-19
Impairments Due to the economic impact of the COVID-19 pandemic, the possibility of impairments on assets and goodwill is increased. Significant judgement would be required to determine whether the tax impact of such impairments would be recorded discretely in the quarter or included as part of the AETR calculation. It can be argued that if impairments have occurred in the past, the impacts may be recorded as part of the AETR calculation. Alternatively, the uniqueness of the COVID-19 pandemic might also suggest that the underlying event is highly unusual and non-recurring and therefore may be considered discrete.
Goodwill impairments when tax-deductible goodwill exists presents challenges with respect to deferred taxes. In these situations, consider the following example:
Example – Goodwill Impairment X in performing its annual impairment testing for one of its reporting units determined that the fair value of the unit was $1,100 while its carrying amount was $1,200. The unit had $400 of goodwill, all of which was tax deductible, a deferred tax liability of $100 related to the Component 1 goodwill and other net assets of $900. X has adopted ASU 2017-04 Intangibles-Goodwill and other (Topic 350) -Simplifying the Test for Goodwill Impairment. The following is the calculation of the impairment based upon the above:
Carrying Amount
Fair Value
Preliminary Impairment
Deferred Tax Adjustment
Carrying Amount after Impairment
Goodwill
400
(100)
(27)
n1
273
Other assets
900
900
Deferred tax liability
(100)
27
(73)
Total
1,200
1,100
(100)
1,100
n1 $27 = $100 * ((21%/(1-21%))
X would report a $127 goodwill impairment charge partially offset by a $27 deferred tax benefit that would be recorded in the income tax line. In cases where tax deductible goodwill exists companies will need to solve the impairment via the use of the simultaneous equation as illustrated above.
Inability to Forecast ASC 740-270 requires companies to recognize income tax expense in interim periods with the view that each interim period is part of the overall annual period. Companies are generally required to forecast their AETR and apply that rate to ordinary income in each reporting period. The tax expense or benefit for all other items are individually computed and recognized discretely.[11] If an entity is unable to estimate a part of its ordinary income (or loss) or the related tax (or benefit) but is otherwise able to make a reliable estimate, the tax (or benefit) applicable to the item that cannot be estimated shall be reported in the interim period in which the item is reported.[12]
Some companies may not be able to accurately forecast income or loss due to the economic disruptions caused by COVID-19. In such situations, especially if modest fluctuations in forecasted earnings cause volatility in the AETR, companies should consider calculating their interim tax provision on a discrete basis as opposed to using the AETR approach. Careful consideration should be given to this judgement and the related disclosure requirements, especially if forecasts are used to support other parts of a company’s financial statements.
Year-to-Date Losses Exceed Forecasted Losses for the Year Prior to a company’s adoption of Accounting Standards Update (ASU) 2019-12, where the year-to-date loss exceeds the estimated loss for the year, an exception under the accounting rules limit the tax benefit in an interim period to the tax benefit of the forecasted loss. ASU 2019-12 removed this exception and allows an entity to record a benefit for a year-to-date loss when that loss exceeds its forecasted loss. Companies that are expected to be in a position where the year-to-date losses will exceed their forecasted loss for the year may want to consider early adoption of the ASU. It should be noted, however, that should a company decide to early adopt ASU 2019-12, all provisions of the ASU need to be adopted.
Valuation Allowance Assessment In general, a valuation allowance must be recognized to the extent that it is more likely than not that some or all of the deferred tax assets will not be realized.[13] Companies must assess all available evidence, both positive and negative, objective and subjective, in determining the need for a valuation allowance. Future realization of the tax benefit of existing deferred tax assets ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income versus capital gain) within the carryback, carryforward period available under the law. ASC 740[14] provides for four sources of taxable income that may be available to realize the benefit of deferred tax assets:
Future reversals of existing taxable temporary differences
Future taxable income exclusive of reversing temporary differences and carryforwards
Taxable income in prior carryback year(s) if carryback is permitted under the tax law
Tax-planning strategies
The CARES Act has placed renewed emphasis on the third source of taxable income. As described earlier, net operating losses generated in years beginning after December 31, 2017, and before January 1, 2021, can be carried back five taxable years. In addition, the changes to IRC Section 163(j) allow for the election of an enhanced deduction of interest for the years 2019 and 2020.
The ability to carryback losses is a source of income in assessing the need for a valuation allowance and will likely cause some companies to reassess their valuation allowance position. Similarly, the relaxation of the rules for interest deductibility may, in some cases, reduce valuation allowances previously recorded.
The impairment of tax-deductible goodwill may create a deferred tax asset for which a company would need to assess its realizability. Further, an impairment could reduce or eliminate a deferred tax liability that was used as a source of income for indefinite-lived deferred tax assets.
Similarly, entities that have historically relied upon reversing taxable temporary difference related to non-deductible book intangibles as a source of income to realize existing deferred tax assets may find this source of income eliminated in whole or in part as a result of impairments to the book intangibles. In the entity’s consideration of other sources of income as part of its valuation allowance assessment, specifically future taxable income, the effects of COVID-19 on projected results should be considered.
These changes may require companies to re-visit their valuation allowance considerations and reflect changes to their valuation allowances either as part of their estimated AETR, or as a discrete adjustment in the period. In addition, companies should consider the appropriate intraperiod allocation of changes in valuation allowances.
Indefinite Reinvestment Assertion – ASC 740-30 The economic pressure caused by COVID-19 has created significant strain on the cash flows of many companies. As a result, companies may need to revisit their indefinite reinvestment assertion to determine whether they can continue to maintain that certain earnings are permanently reinvested. Considerations include any contradictory evidence related to the parent or upstream entity’s ability to service debt, meet working capital needs, or make required changes to infrastructure. Companies should update cash flow forecasts to see whether sufficient cash will be generated to service its debt and working capital obligations.
If a change in assertion is made, ASC 740 requires that the change in an entity’s ASC 740-30 assertion for temporary differences accumulated in prior years be recognized in continuing operations in the period in which its intentions change.[15] Current and deferred taxes should be considered for the following items:
Foreign withholding taxes
State income taxes
IRC Section 986(c) currency impacts related to previously taxed earnings
Other Considerations
Balance Sheet Classification & Current/Deferred Tax Issues: Under the TCJA, corporate Alternative Minimum Tax (AMT) credits were refundable over a four-year period during tax years beginning in 2018-2021. Under the CARES Act, any remaining corporate AMT credit is fully refundable for tax years beginning in 2019.[16] Alternatively, a taxpayer may elect to make the credit fully refundable for the tax year beginning in 2018.
As a result, companies that have remaining AMT credits that are to be refunded would be expected to classify these amounts as a current receivable.
Global Government Assistance In the current COVID-19 pandemic, governments and institutions across the globe are introducing measures to try to alleviate the impact on businesses, individuals and families. Fiscal and financial compensation measures are evolving over time: Government-backed loans to businesses, business tax rate relief, direct business grants, support for the self-employed, the extension of tax deadlines and the relaxation of rules on the payment of sickness benefits, are just some examples.
State and Local Tax Implications (SALT)
The provisions of the CARES Act present a new round of challenges for taxpayers as states laws differ with respect to the timing and application of federal tax legislation.
Summary
As new tax law emerges to address the economic impact of COVID-19, consideration should be given to the impact of such tax law changes in the period in which they are enacted.
[4] IRC Section 965, enacted as part of the 2017 Tax Cuts and Jobs Act, requires United States shareholders (as defined under Section 951(b)) to pay a transition tax on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States.
On December 18, 2019, the FASB issued Accounting Standards Update ASU 2019-12 on Simplifying the Accounting for Income Taxes. The decisions reflected in the ASU update specific areas of ASC 740, Income Taxes, to reduce complexity while maintaining or improving the usefulness of the information provided to users of financial statements.
Background: At its April 10, 2019, meeting, the FASB decided to add a project to its technical agenda to address simplifications to the accounting rules for income taxes under ASC 740. The project is part of the board’s overall Simplification Initiative. The objective of the Simplification Initiative is to identify, evaluate, and improve areas of GAAP for which cost and complexity can be reduced while maintaining or improving the usefulness of the information required to be reported by an entity. A draft ASU was issued by the FASB in May 2019 with 24 comment letters provided by stakeholders at the end of June 2019.
Transition and Effective Date: For public business entities, the amendments in the ASU 2019-12 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022.
Early adoption of the amendments is permitted, including adoption in any interim period for (1) public business entities for periods for which financial statements have not yet been issued and (2) all other entities for periods for which financial statements have not yet been made available for issuance. An entity that elects to early adopt the amendments in an interim period should reflect any adjustments as of the beginning of the annual period that includes that interim period. Additionally, an entity that elects early adoption must adopt all the amendments in the same period.
The amendments in ASU 2019-12 related to separate financial statements of legal entities that are not subject to tax should be applied on a retrospective basis for all periods presented.
The amendments related to changes in ownership of foreign equity method investments or foreign subsidiaries should be applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption.
The amendments related to franchise taxes that are partially based on income should be applied on either a retrospective basis for all periods presented or a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption.
All other amendments should be applied on a prospective basis.