On Dec. 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act (Tax Act). Several provisions have extraordinary implications to financial statement reporting under generally accepted accounting principles in the United States (U.S. GAAP). ASC 740, Accounting for Income Tax, is fairly extensive and robust, but there is no precedent for the extent of corporate changes found in the Tax Act. This discussion highlights some of the material matters.
The Tax Act lowered the federal corporate tax rate to a flat 21 percent, which commenced Jan. 1, 2018. While the sum total of all temporary1
differences for all reporting periods up to and including Dec. 31, 2017, were deferred tax measured at 35 percent, the rate change to 21 percent represents a 40 percent decrease of all full-reversal-period amounts. But the change in tax rates is only the tip of the iceberg.
Reduction of the U.S. Corporate Tax Rate
ASC 740-10-05-5 states that there are two basic principles related to accounting for income taxes in application of the recognition and measurement aspects: to recognize estimated taxes payable or refundable on tax returns for the current year, and to recognize deferred tax liabilities and/or assets for the estimated future tax affects attributable to temporary differences and carryforwards. So, at any financial reporting date, deferred tax liabilities (for C corporations) represent the cumulative future tax costs of reversing temporary differences that will increase future taxable income and/or income tax, and deferred tax assets represent the cumulative future tax benefits of reversing temporary differences that will decrease future taxable income and/or income tax, each provided for at the statutory rate of 35 percent (since 1993). Additionally, some items of deferred tax, generally assets, have had an allowance assessment associated with its items pertaining to the expectation of realization of the tax benefits. Items such as net operating losses, capital losses, and minimum tax credits may present questions about realizability, especially those items that have specific expiration dates.
Off the bat, ASC 740-10-30-8 provides that deferred liabilities and assets be cumulatively valued based on the enacted rate in effect at the report date. In this case, Dec. 22, 2017, represents the date of enactment for the 21 percent rate, meaning that financial statements for periods ending after that date (such as the calendar year ending Dec. 31, 2017) will need to be revalued using the new 21 percent rate. The impact of the tax rate change to 21 percent is to be recognized as a component of income tax expense in the reporting period including that date of enactment. So, even though the new rate would not change the current liabilities until tax years after 2017, the deferred tax assets and liabilities would be revised at Dec. 31, 2017.
Some additional matters also will apply to any state tax temporary differences (per ASC 740-10-55-20) that affect the calculation of deferred federal taxes. Accordingly, the federal deferred tax effects of state-deferred taxes and unrecognized benefits related to state taxes must be measured.
There are some other tax law changes that may have implications with the tax rate reduction adjustments. As discussed below, to the extent valuation allowances previously provided might need reconsideration, these reconsideration adjustments would also be reflected at Dec. 31, 2017.
Repeal of the Corporate Alternative Minimum Tax
The corporate alternative minimum tax (AMT) has been repealed for years beginning after Dec. 31, 2017, but remaining unused minimum tax credits (from prior corporate AMT) will be permitted to be applied against regular tax in 2018 through 2021. Credits above the offsettable tax may be refunded at 50 percent in 2018 through 2020, and any remaining balance in 2021. Because of the nature of the corporate AMT, many businesses may have provided a valuation allowance due to uncertainty that the benefit would be realized. Now with the Tax Act, this valuation allowance may need to be reconsidered, as well as realizability.
Net Operating Losses
Net operating losses (NOLs) arising in years beginning after Dec. 31, 2017, will be limited in use to offset future taxable income, in that the NOL cannot exceed 80 percent of the future taxable income. Further, NOLs may no longer be carried back to earlier tax years. However, the carryforward limit of 20 years has been lifted, so NOLs may now be carried forward in perpetuity. As with deferred tax assets arising from AMT credits, deferred tax assets may have had a valuation allowance provided over uncertainty of realization. With no expiration for carryforward, full realization is quite likely.
The Tax Act provides for 100 percent expensing of fixed assets acquired and placed in service on or after Sept. 27, 2017, and through Dec. 31, 2022. The expensing decreases 20 percent per year thereafter, reaching 0 percent in 2026. Use of these accelerated deductions with tax recognition of 100 percent expense in the year acquired will accelerate the recognition of deferred tax liabilities.
The Tax Act combines qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property into a group eligible for faster write-off, depreciable over 10 years (previously 15 years). Further, these improvement costs are now eligible for the Section 179 expense election.
Depreciation limitations for listed property (automobiles) have been raised beyond the bonus depreciation options.
The effects of the acceleration of deductions under the 100 percent bonus depreciation, shorter depreciation periods for improvements, Section 179 for improvements, and higher deductions for listed automobiles can have offsetting implications elsewhere, such as the 80 percent limit with NOLs, usable minimum tax credits, and restrictions to allowable interest expense (discussed below).
Interest Deduction Limitation
The Tax Act limits permitted net interest expense to 30 percent of adjusted taxable income. The taxable income has an add-back to earnings before interest, taxes, depreciation, and amortization (or EBITDA). Allowable net interest expense is the lesser of the actual interest expense or 30 percent of the adjusted income above. This applies in 2018 through 2021. Thereafter, the adjusted income adds back only the interest expense and taxes. Any excess in allowable interest is suspended and carried forward to a future year (without expiration). Interest expenses not currently allowed, thus, will generate timing difference to yield more deferred tax assets.
Note, there is a small-business exemption (businesses with gross receipts under $25 million) where the interest limitations will not apply, as well as an exemption (from add-back) for floor plan interest.
Internal Revenue Code Section 162(m) has been expanded to specifically include the CFO as a covered employee, which limits the deduction for compensation to a maximum of $1 million. While the CFO may, in some companies, already have been classified as a covered employee,2
this adds another key C-suite employee to potential nondeductible compensation. While not a deferred tax issue, it will impact taxes currently payable. Permanent changes (differences that never reverse) also affect the effective annual income tax rate.
Meals, Entertainment, Dues, and Memberships
The repeal of all entertainment expenses; membership dues with respect to any club organized for business, pleasure, recreation, or other social purposes; and any meals deemed entertainment (and 50 percent of meals provided to employees through employer eating facility) creates an increase in lost deductions, particularly for businesses that invest heavily in networking to drive sales and revenue. The impact of the effective annual tax rates will need to be accounted for.
Valuation and Uncertain Positions
Historically, deferred tax assets may have had valuation provisions for uncertainty of realization (primarily due to expirations of carryforward benefits). Without carryforward expiring deductions and losses, many of these valuation provisions may be less likely to be required.
With regard to uncertain tax positions (referred to as FIN 48 matters), the provisions and related financial statement disclosures are triggered by tax positions that reach the more-likely-than-not threshold.3
Accordingly, many of the limiting provisions of the new tax law, especially with regard to interpretations applied before deeper regulations are provided, may result in additional accrued tax liabilities and disclosure of said interpretations.
The Tax Act subjects a one-time transition tax for unrepatriated foreign earnings at a rate of 15.5 percent for earnings and profit attributable to cash and certain liquid assets, and 8 percent on other earnings and profit. Additionally, global intangible low-taxed income (GILTI), which imposes a tax on foreign income in excess of a deemed return on intangible assets of a foreign corporation, and Base Erosion and Anti-Abuse Tax (BEAT), which is calculated using a lower rate applied to a calculation that eliminates the deduction for certain base-erosion payments made to foreign corporations, are among the more involved and complex changes to international reporting that will likely be outside the expected scope of most nonpublic companies. However, the expansiveness of the related disclosures (necessary to fully and understandably convey the implications) will be significant.
Accounting Standards Update No. 2015-17 (ASU 2015-17) provides great simplification. It allows companies, upon adoption, to reflect all deferred taxes as long-term liabilities and/or assets, rather than the long-standing requirement of bifurcating deferred tax assets and liabilities as current and long-term based on expected timing of reversal. ASU 2015-17 applies to public companies for years beginning after Dec. 15, 2016, and for nonpublic companies in years beginning after Dec. 15, 2017. However, ASU 2015-17 permits early adoption, which appears to be a “no brainer” for private companies to simplify the complexities the Tax Act presents.
Companies Not on a Calendar Year
Companies that are not on a calendar year (with the natural corporate tax rate transition) have extra concerns and considerations with regard to prorating the tax rates, and with regard to subsequent events.
For companies that had financial reporting periods before the enactment date but before the issuance of their financial statements, ASC 855, Subsequent Events, would necessitate the adjusting of the applicable (impacted) balances because of the rate changes and deferred taxes. For entities that have a fiscal year ending in 2018 (and beginning before the date of enactment), the implications of the blending of rates must be considered (with regard to currently payable taxes) based on a proportional rate and disclosure of the estimated annual rate.
FASB Weighs In
With all the interpretations being applied, the FASB has begun to weigh in. Here are its thoughts on five implementation issues and one other issue for which an exposure draft has been provided:
- Private companies, NFPs, and SAB 118 – Private companies and nonprofits have been permitted to apply SEC Staff Accounting Bulletin (SAB) No. 118, even though SEC’s views and interpretations are not directly applicable to these entities. The bulletin will permit reporting with reasonable estimates for the changes that may not be readily and specifically identified because the financial statement implications of the Tax Act change for the period on enactment. A company should disclose its accounting policy of applying SAB 118 in accordance with paragraphs 235-10-50-1 through 50-3 of ASC 235, Notes to Financial Statements.
- Whether to discount the tax liability on deemed repatriation – The FASB ruled that there should be no liability discount in company financial reports (no interest is imposed on the unpaid eight-year liability).
- Whether to discount refundable AMT credits – The FASB ruled that when it is determinable that the AMT credits will be used or ultimately refunded, such credits should not be discounted in company financial reports.
- Accounting for BEAT – The FASB ruled that deferred tax assets and liabilities should be measured in the financial statements at the regular tax rates rather than the lower rate used in calculating the BEAT (like AMT and alternate computations payable if higher).
- Accounting for GILTI – The FASB ruled on an optional election (policy election) to either recognize deferred assets/liabilities for basis differences expected to reverse as a result of the GILTI provisions in future years, or to include the tax on GILTI in the period in which it occurred, based on specific facts and circumstances.
1 Temporary (or timing) differences represent the items of revenue and expense recognized for financial statement purposes as compared to the recognition for income tax purposes.
- Accounting for stranded tax effects – The FASB voted to propose a one-time reclassification from accumulated other comprehensive income (AOCI) to retained earnings from the stranded tax effects from the new law’s tax rates. The proposal became GAAP via ASU 2018-02. Accordingly, the rate differential between the 35 percent rate and the newly enacted 21 percent will represent the reclassification of “stranded amounts.” Stranded tax effects are from the prior recognition of other comprehensive income (OCI) items (market losses and impairment recognitions, for example) where the deferred tax assets and liabilities hit AOCI. However, with the tax law enactment, all deferred tax asset and liability adjustments occur through comprehensive income and, thus, directly to retained earnings. The reclassification would, essentially, take that unadjusted spread of deferred tax consequence on other comprehensive income transactions, and restate them in AOCI at the new statutory rate. The ASU amendments are effective for all entities with fiscal years beginning after Dec. 15, 2018, as well as the interim periods within those fiscal years. Further, early adoption is permitted. If the ASU is not adopted until 2019, the update should be applied retrospectively to each period or periods in which the tax law rate change has been affected. When applied, entities would present reclassifications in the statement of shareholder equity and disclose them for the period of reclassification: the nature and reason for the change in accounting principle; description of prior-period info that is retrospectively adjusted; and the effect of the change on affected financial statement line items.
2 Treasury Regulation Section 1.162-27(c)(2)(i): a covered employee is one who, as of the last day of the year, is (a) the CEO, or (b) among the four highest-paid employees (exclusive of the CEO).
3 Per ASC 740-10-25-6: “An entity shall initially recognize the financial statements effects of a position when it is more likely than not, based on technical merits, that the position will be sustained upon examination. The term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation process, if any.”
James J. Newhard, CPA, is a sole practitioner in Paoli, Pa., a CPE presenter for the Loscalzo Institute, past president of PICPA’s Greater Philadelphia Chapter, and a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org or on Twitter @CatalystJimCPA.