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3.3 Examples of temporary differences
Publication date: 31 Dec 2022
us Income taxes guide 3.3
The first four examples of temporary differences in ASC 740-10-25-20 (reproduced in TX 3.2) result from items that are included within both pretax income and taxable income, but in different periods (for example, an asset is depreciated over a different period for book than for tax purposes). The remaining examples illustrate other events that create book and tax basis differences.
3.3.1 Temporary differences—business combinations
ASC 805-740 requires recognition of deferred taxes for temporary differences that arise from a business combination. The differences between the book bases (as determined under ASC 805, Business Combinations) and the tax bases (as determined under the tax law and considering ASC 740’s recognition and measurement model) of the assets acquired and liabilities assumed are temporary differences that result in deferred tax assets or liabilities. TX 10 discusses the accounting for deferred taxes in business combinations.
3.3.2 Temporary differences—indefinite-lived assets
Under ASC 740-10-25-20, recognition of deferred taxes assumes that the carrying value of an asset will be recovered through sale or depreciation. Thus, although indefinite-lived assets (e.g., land, indefinite-lived intangibles, and the portion of goodwill that is tax deductible) are not depreciated or amortized for book purposes, a deferred tax asset or liability is recognized for the difference between the book and tax basis of such assets as long the basis of the asset is deductible or taxable in the future. Though the tax effects may be delayed indefinitely, ASC 740-10-55-63 states that “deferred tax liabilities may not be eliminated or reduced because a reporting entity may be able to delay the settlement of those liabilities by delaying the events that would cause taxable temporary differences to reverse.”
3.3.3 Temporary differences—inflation indexation
Some foreign tax jurisdictions allow for the tax bases of assets and liabilities to be indexed to inflation rates for tax purposes. Assuming the functional currency of the reporting entity in that jurisdiction is the local currency, for financial reporting purposes, the book bases of such assets do not change with inflation. Thus, when the tax bases are indexed for inflation, temporary differences arise as a result of the change in tax basis and those differences give rise to deferred taxes under ASC 740-10-25-20(g).
If, on the other hand, the jurisdiction in question is deemed to be hyperinflationary under ASC 830 and the functional currency is not the local currency, differences between the book and tax bases of assets can arise as a result of remeasuring the local currency assets into the functional currency using historical exchange rates. ASC 740-10-25-3(f) prohibits recognition of deferred taxes for temporary differences related to changes in exchange rates or indexing of nonmonetary assets and liabilities that, under ASC 830-10, are remeasured from the local currency into the functional currency using historical exchange rates (i.e., the functional currency is the reporting currency). Refer to TX 13 for additional guidance on foreign currency matters.
3.3.4 Share based compensation
Under ASC 718, Compensation–Stock compensation, the difference between the expense recognized for financial reporting purposes and the deduction taken on the tax return is also considered to be a temporary difference for which a deferred tax asset is recognized. Refer to TX 17 for guidance on how ASC 740 applies to stock-based compensation.
3.3.5 Investment tax credits
An investment tax credit (ITC) is a tax credit tied to the acquisition of an asset and that reduces income taxes payable. An ITC relates to the acquisition of qualifying depreciable assets either directly or through a flow-through equity method investment and is typically determined as a percentage of the cost of the asset. An ITC may also reduce the tax basis of the asset in some cases. Production tax credits, which vary in amount depending upon the output of the underlying assets, do not qualify as ITCs. Once a reporting entity determines that a tax credit qualifies as an ITC, the ITC would be reflected in the financial statements (1) to the extent it has been used to reduce income taxes otherwise currently payable, or, (2) if an allowable carryforward is considered realizable under the provisions of ASC 740-10-30-18.
What differentiates an ITC from other income tax credits or government grants is not always easy to discern because they often share at least a few characteristics. Care should be taken in assessing whether a particular credit should be accounted for as an investment credit, another type of income tax credit, or a government grant. Credits that are not within the scope of ASC 740 cannot apply the ITC guidance that is part of ASC 740. Refer to TX 1 for a discussion of the determination of whether credits and other tax incentives should be accounted for under ASC 740.
3.3.5.1 Investment tax credits–accounting methods
ASC 740-10-25-46 provides two acceptable methods to account for ITCs:
- The “deferral” method, under which the tax benefit from an ITC is deferred and amortized over the book life of the related property.
- The “flow-through” method, under which the tax benefit from an ITC is recorded in the period that the credit is generated.
As specified in ASC 740-10-25-46, the deferral method is preferable, although both are acceptable. The use of either method is an accounting policy election that should be consistently applied.
When the deferral method is elected, there are two acceptable approaches. The application of either approach under the deferral method represents an accounting policy election that should be consistently applied.
The first approach recognizes the tax benefit from an ITC as a reduction in the book basis of the acquired asset and thereafter reflects the benefit in pretax income as a reduction of depreciation expense. Alternatively, in the second approach, a deferred credit can be recognized when the ITC is generated. The deferred credit would be amortized as a reduction to the income tax provision over the life of the qualifying asset. The presentation on the income statement under this approach is similar to the flow-through method in that the ITC benefit is reported within the income tax provision. However, unlike the flow-through method, which recognizes the full benefit of the ITC in the period it is generated, the income tax provision approach under the deferral method recognizes the benefit over time based on the productive life of the asset.
3.3.5.2 Investment tax credits–temporary differences
In accordance with ASC 740-10-25-20(e) and 25-20(f), a temporary difference may arise when accounting for an ITC if (a) the relevant tax law requires that the reporting entity reduce its tax basis in the property or (b) if use of the deferral method reduces the book basis in the underlying asset. Regardless of the method chosen to account for ITCs, we believe there are two acceptable approaches to account for the initial recognition of temporary differences between the book and tax bases of the asset:
- The “gross-up” method, under which deferred taxes related to the temporary difference are recorded as adjustments to the carrying value of the qualifying assets. The gross-up method requires the use of the simultaneous equations method to calculate the deferred tax to be recognized (see TX 10.8.2.1 or ASC 740-10-55-170 through ASC 740-10-55-182).
- The “income statement” method, under which deferred taxes related to the temporary difference are recorded in income tax expense.
The use of one of these accounting methods reflects a choice of accounting policy that should be consistently applied.
Example TX 3-1 and Example TX 3-2 illustrate application of various ITC methods.
EXAMPLE TX 3-1
Accounting for investment tax credits with no tax basis reduction
Accounting for investment tax credits with no tax basis reduction
Company A is entitled to an ITC for 30% of the purchase price of certain qualifying assets. The ITC can be used to reduce the company’s income tax obligation in the year the assets are purchased. The tax law does not require a reduction to the tax basis of the qualifying assets. The applicable tax rate is 25%.
On January 1, 20X1, Company A purchases $100 of qualifying assets. The assets will be depreciated for both financial statement and tax purposes on a straight-line basis over a 5-year period. There are no uncertain tax positions relating to the ITC or tax depreciation.
How should Company A account for the ITC?
Analysis
The deferral method–reduction in book basis
Under the deferral method, the ITC ($30) is reflected as a reduction to income taxes payable and to the carrying value of the qualifying assets. Therefore, a deductible temporary difference arises since the recorded amount of the qualifying assets is $30 less than its tax basis. Company A can use either the gross-up or income statement method to account for the initial recognition of the temporary difference.
- The gross-up method. Under the gross-up method, the recognition of the DTA related to the initial $30 deductible temporary difference would result in a further reduction in the recorded amount of the qualifying assets, which would, in turn, increase the deductible temporary difference related to the qualifying assets. To avoid this iterative process, the ultimate carrying amount of the asset and the ultimate DTA can be determined using simultaneous equations.
Using simultaneous equations yields a DTA of $10 and a corresponding reduction to the recorded amount of the qualifying assets of $10. Thus, the qualifying assets should be recorded at $60 ($100 purchase price less the $30 ITC and $10 DTA) together with a DTA of $10.
The simultaneous equations can be combined into the following formula:
DTA =Tax Ratex(Tax Basis – initial book basis)(1 – Tax Rate)
The following journal entries would be recorded:Dr. PP&E$100Cr. Cash$100To record the acquisition of the qualifying asset.Dr. Income tax payable$30Cr. PP&E$30To record the generation of the ITC.Dr. Deferred tax asset$10Cr. PP&E$10To record the deferred tax asset and corresponding reduction to the book basis of the PP&E based on the gross-up method.In 20X1 and each of the subsequent four years, the following entries would be recorded:Dr. Depreciation expense$12Cr. Accumulated depreciation$12To record depreciation of PP&E ($100 purchase price less ITC of $30 and deferred tax asset of $10 depreciable over 5 years).Dr. Income tax payable$5Cr. Current tax expense$5To record the current tax benefit of depreciation for tax purposes ($20 annual depreciation expense @ 25% tax rate).Dr. Deferred tax expense$2Cr. Deferred tax asset$2Annual entry to adjust the deferred tax asset based on the ending temporary difference between the book and tax bases of the asset arising from the difference in the annual depreciation charge for book and tax purposes ($8 tax-over-book depreciation @ 25% tax rate). - The income statement method. Under the income statement method, the recognition of the DTA related to the initial deductible temporary difference of $30 would result in the recognition of a $7.5 DTA and a corresponding benefit in the income tax provision. The following entries would be recorded:
Dr. PP&E$100Cr. Cash$100To record the acquisition of the qualifying asset.Dr. Income tax payable$30Cr. PP&E$30To record the generation of the ITC.Dr. Deferred tax asset$7.5Cr. Deferred tax expense$7.5To record the deferred tax benefit related to the ITC that will be recorded directly to the income statement ($30 temporary difference × 25% tax rate).In 20X1 and each of the subsequent four years, the following entries would be recorded:Dr. Depreciation expense$14Cr. Accumulated depreciation$14To record depreciation of PP&E ($100 purchase price less ITC of $30 depreciable over 5 years).Dr. Income tax payable$5Cr. Current income tax expense$5To record current tax benefit of depreciation for tax purposes ($100 purchase price depreciable over 5 years @ 25% tax rate).Dr. Deferred tax expense$1.5Cr. Deferred tax asset$1.5Annual entry to adjust the deferred tax asset based on the ending temporary difference between the book and tax bases of the asset arising from the difference in the annual depreciation charge for book and tax purposes ($6 tax-over-book depreciation @ 25% tax rate).
The flow-through method
Under the flow-through method, the ITC received ($30) would be reflected as a current income tax benefit. Under this approach, the recognition of the ITC would not affect the book basis of the qualifying assets and, therefore, no temporary difference arises at initial acquisition (i.e., the book basis equals the tax basis). The following journal entries would be recorded under the flow-through method:
Dr. PP&E |
$100 |
||
Cr. Cash |
$100 |
||
To record the acquisition of the qualifying asset. |
|||
Dr. Income tax payable |
$30 |
||
Cr. Current income tax expense |
$30 |
||
To record the generation of the ITC. |
|||
In 20X1 and each of the subsequent four years, the following entries would be recorded: |
|||
Dr. Depreciation expense |
$20 |
||
Cr. Accumulated depreciation |
$20 |
||
To record depreciation of PP&E ($100 purchase price depreciable over 5 years). |
|||
Dr. Income tax payable |
$5 |
||
Cr. Current income tax expense |
$5 |
||
To record current tax benefit of depreciation for tax purposes ($100 purchase price depreciable over 5 years @ 25% tax rate). |
|||
In this example, because the book and tax depreciation periods are the same (5 years), no temporary difference would arise in subsequent years (assuming there is no impairment).
EXAMPLE TX 3-2
Accounting for investment tax credits with tax basis reduction
Accounting for investment tax credits with tax basis reduction
Company A is entitled to an ITC for 30% of the purchase price of certain qualifying assets. The ITC can be used to reduce the company’s income tax obligation in the year the assets are purchased. The tax law requires that the tax basis of the qualifying assets be reduced by 50% of the ITC (e.g., a $30 ITC reduces the tax basis by $15). The applicable tax rate is 25%.
On January 1, 20X1, Company A purchases $100 of qualifying assets. The assets will be depreciated for both financial statement and tax purposes on a straight-line basis over a 5-year period. There are no uncertain tax positions relating to the ITC or tax depreciation.
How should Company A account for the ITC?
Analysis
The deferral method–reduction in book basis
Under the deferral method, the ITC ($30) is reflected as a reduction to income taxes payable and to the carrying value of the qualifying assets. Because the tax basis of the asset will only be reduced by 50% of the ITC a deductible temporary difference arises. The carrying amount of the qualifying assets will be reduced by the full amount of the ITC ($30), while the tax basis will be reduced by only 50% of the ITC ($15) resulting in a temporary difference of $15. Company A can use either the gross-up or income statement method to account for the temporary difference.
- The gross-up method. Under the gross-up method, the recognition of the DTA related to the initial $15 deductible temporary difference results in a further reduction in the recorded amount of the qualifying assets, which would, in turn, increase the deductible temporary difference related to the qualifying assets. To avoid this iterative process, the ultimate carrying amount of the asset and the ultimate DTA can be determined using simultaneous equations.
In this example, the simultaneous equations method (illustrated in Example TX 3-1) yields a DTA of $5 and a corresponding reduction to the recorded amount of the qualifying assets. Thus, the qualifying assets should be recorded at $65 ($100 purchase price less the $30 ITC and $5 DTA) together with a DTA of $5. In 20X1 and each of the subsequent four years, income taxes payable would be adjusted by $4.25 to record the current tax benefit of depreciation ($100 purchase price less $15 reduction in tax basis over 5 years @ 25% tax rate) and an annual entry of $1 to adjust the deferred tax asset based on the ending temporary difference between the book and tax basis arising from the difference in the annual depreciation charge for book and tax purposes ($4 tax-over-book depreciation @ 25% tax rate). - The income statement method. Under the income statement method, the recognition of the DTA related to the initial deductible temporary difference of $15 results in the recognition of a $3.75 DTA and a corresponding benefit in the income tax provision. In 20X1 and each of the subsequent four years, income taxes payable would be adjusted by $4.25 to record the current tax benefit of depreciation ($100 purchase price less $15 reduction in tax basis over 5 years @ 25% tax rate) and an annual entry of $0.75 to adjust the deferred tax asset based on the ending temporary difference between the book and tax basis arising from the difference in the annual depreciation charge for book and tax purposes ($3 tax-over-book depreciation @ 25% tax rate).
The flow-through method
Under the flow-through method, the ITC ($30) is reflected as a current income tax benefit. Under this approach, the recognition of the ITC does not affect the book basis of the qualifying assets. Therefore, the recorded amount of the qualifying assets remains at $100 while the tax basis is reduced to $85, resulting in a taxable temporary difference of $15. The accounting for this temporary difference depends on whether the reporting entity uses the gross-up or income statement method.
- The gross-up method. Under the gross-up method, the recognition of the DTL related to the initial $15 taxable temporary difference results in a further increase in the recorded amount of the qualifying assets, which would, in turn, increase the taxable temporary difference related to the qualifying assets. Consistent with the gross up method illustrated previously, the simultaneous equation will result in recording a DTL of $5 and an increase in the qualifying asset of $5. Thus, the qualifying asset should be recorded at $105 ($100 purchase price plus the DTL of $5) together with a DTL of $5. In 20X1 and each of the subsequent four years, income taxes payable would be adjusted by $4.25 to record the current tax benefit of depreciation ($100 purchase price less $15 reduction in tax basis over 5 years @ 25% tax rate) and an annual entry of $1 to adjust the deferred tax liability based on the ending temporary difference between the book and tax basis arising from the difference in the annual depreciation charge for book and tax purposes ($4 book-over-tax depreciation @ 25% tax rate).
- The income statement method. Under the income statement method, the recognition of the DTL related to the initial taxable temporary difference of $15 results in the recognition of a $3.75 DTL and a corresponding expense in the income tax provision. In 20X1 and each of the subsequent four years, income taxes payable would be adjusted by $4.25 to record the current tax benefit of depreciation ($100 purchase price less $15 reduction in tax basis over 5 years @ 25% tax rate) and an annual entry of $0.75 to adjust the deferred tax liability based on the ending temporary difference between the book and tax basis arising from the difference in the annual depreciation charge for book and tax purposes ($3 book-over-tax depreciation @ 25% tax rate).
3.3.5.3 Investment tax credits through equity method investments
There is no specific guidance on how to account for investment tax credits received in conjunction with an investment accounted for under the equity method. While the deferral approach (i.e., netting the credit against the carrying amount of the investment and amortizing the benefit of the credit against the earnings of the investment) is described only in terms of investments in depreciable property, we are aware that the deferral approach is being applied in practice to other types of assets by analogy. In these circumstances, it is important to understand the underlying nature of the credit, the conditions that generated the credit, and the manner of recovery. Also, it is important to discern whether the credit is attributable to the investor or the investee.
If a reporting entity elects the fair value option for purposes of accounting for its equity method investment, we believe the flow through method should be applied as it aligns with the reporting entity’s election to reflect the fair value of the investment.
3.3.6 Low-income housing credits
Section 42 of the Internal Revenue Code provides a low-income housing credit (LIHTC) to owners of qualified residential rental projects. The LIHTC is generally available from the first year the building is placed in service and continues annually over a 10-year period, subject to continuing compliance with the qualified property rules. The LIHTC is subject to annual limitations, and any unused portion of the credit can be carried forward for 20 years. An LIHTC carryforward should be recognized as a deferred tax asset and evaluated for realization like any other deferred tax asset. The full amount of the aggregate LIHTC that is potentially available over the 10-year period should not be included in the tax provision in the initial year that the credit becomes available because the entire amount of the credit has not been “earned.” Only the portion of the LIHTC that is available to offset taxable income in each year should be included in the tax provision.
One of the more common structures in which LIHTC arise is through an investment in a limited liability entity that invests in qualified residential projects. Typically, an investor will account for its interest using the equity method. As such, a question arises as to whether the pretax results of the limited liability entity’s activities should be presented separate from the tax benefits (LIHTC) that are also passed through to the investor and usable on the investor’s tax return.
As noted in ASC 323-740-S99-2, the scope of ASC 323-740 is limited to investments in qualified affordable housing projects through limited liability entities that produce LIHTCs and should not be applied by analogy when accounting for investments in other projects for which substantially all of the benefits come from other tax credits and other tax benefits.
3.3.6.1 Qualifying for the proportional amortization method
Under ASC 323-740-25-1, an investor may elect to account for the investment using the proportional amortization method assuming the following conditions are met:
- It is probable that the tax credits allocable to the investor will be available.
- The investor does not have the ability to exercise significant influence over the operating and financial policies of the limited liability entity.
- Substantially all of the projected benefits are from tax credits and other tax benefits (for example, tax benefits generated from the operating losses of the investment).
- The investor’s projected yield based solely on the cash flows from the tax credits and other tax benefits is positive.
- The investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the investor’s liability is limited to its capital investment.
If the conditions are met and the proportional method is elected, investors would present the pretax effects and related tax benefits of such investments as a component of income taxes (“net” within income tax expense). If elected, the proportional amortization method must be applied as an accounting policy to all eligible investments in qualified affordable housing projects.
The application of ASC 810, Consolidation, may impact the accounting for investments in entities that hold investments in low-income housing credit projects because such entities may constitute variable interest entities. If an investor is required to consolidate the limited liability entity that manages or invests in qualified affordable housing projects, the proportional amortization method cannot be applied because it would not meet criteria b) listed above. Essentially, the investor would report the pretax results of the investment in pretax income and report the benefit from the LIHTC in the tax provision on a current basis.
3.3.6.2 Applying the proportional amortization method
The proportional amortization method requires the initial cost of the investment (inclusive of unconditional future capital commitments) to be amortized in proportion to the tax benefits received over the period that the investor expects to receive the tax credits and other tax benefits. The amortization is determined as follows:
The computation holds the initial investment balance constant each period (adjusted for any changes in the expected residual value). The amortization is based on a percentage of total tax benefits received in a particular year (numerator) relative to the total tax benefits expected over the life of the investment (denominator).
Under the proportional amortization method, an investment must be tested for impairment whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of the investment will not be realized (ASC 323-740-35-6). The impairment loss is the difference between the excess of carrying value over fair value. Previously recognized impairment losses cannot be reversed.
3.3.6.3 Balance sheet classification of LIHTC
ASC 323-740 is silent about the balance sheet classification of investments accounted for under the proportional amortization method. Investments in qualified affordable housing projects would not meet the definition of a deferred tax asset. These investments are neither the result of a difference between the tax basis and reported amount in the financial statements, nor are they analogous to a tax credit carryforward because the tax credits under the low-income housing credit program are earned over time and, therefore, are not available at the time of initial investment.
3.3.6.4 Deferred taxes related to proportional amortization
The tax benefits associated with low-income housing credits are recognized as they are reflected on the tax return each period. Therefore, we believe that deferred taxes should not be recognized on the basis difference of the investment. The reason there is a basis difference under the proportional amortization method is because the book basis of the investment is amortized as the tax credits are allocated to the investor (which is reflected in the book basis assigned to the tax credits), while there is no corresponding reduction in the tax basis of the investment (allocating the credits to the investor does not reduce the tax basis). The source of this difference is analogous to the basis difference that arises when a reporting entity purchases tax benefits as discussed in ASC 740-10-55-199 through ASC 740-10-55-201. In both situations, the basis difference is expected to be recovered or settled through realization of tax benefits (not pretax income) even though the financial statement carrying amount is not characterized as a deferred tax item in the financial statements.
We believe that the treatment of deferred taxes is also indirectly addressed in the example included in ASC 323-740-55. Deferred taxes were not provided in the proportional amortization method computation but were provided in the equity method and cost method computations. However, if an investor receives tax deductions in excess of the tax basis (i.e., negative tax basis) when applying the proportional amortization method, we would expect a deferred tax liability (or current tax liability) to be recognized for the potential “tax recapture” that will be imposed on the excess tax deductions.
If, however, the expected manner of recovering the investment was through a sale to a third party, we would expect deferred taxes to be recognized. In this case, the recovery of the asset for an amount different than the tax basis would trigger a tax consequence.
3.3.6.5 Other methods for accounting for LIHTC
Investors that do not qualify for the proportional amortization method (or do not elect to apply it) account for their investments under the equity method or cost method of accounting. The pretax results of the investment are reported in pretax income, and the benefits from any low-income housing credits that are passed through to them are reported in their income tax provision.
Prior to the changes in ASC 323-740-25-1, an effective yield method was allowable in limited circumstances. Investors that were applying the effective yield method to investments held prior to adopting the current standard may continue to do so.
ASC 323-740-55 contains a detailed numerical example illustrating the different approaches to accounting for investments in LIHTC. In the case of an investor applying the cost or equity method to the investment, deferred taxes may arise between the carrying amount of the investment and its related tax basis, which would give rise to deferred taxes independent of any deferred tax related to a carryforward of the credit.
3.3.7 Global intangible low-taxed income (GILTI)
For tax years beginning after December 31, 2017, the 2017 US tax reform legislation introduces new provisions intended to prevent the erosion of the US tax base. This is achieved, in part, through US taxation of certain global intangible low-taxed income (GILTI). In short, GILTI inclusions will impact companies that have foreign earnings generated without a large aggregate foreign fixed asset base.
In considering the accounting for the impacts of GILTI, a question arises as to whether deferred taxes should be recognized for basis differences that are expected to reverse as GILTI in future years or if GILTI inclusions should be treated as period costs in each year incurred. Acknowledging the lack of specific guidance, the FASB staff concluded in their Q&A #5 that entities can apply either view as an accounting policy election. Companies will need to disclose their policy election. Measuring the impact of GILTI on deferreds introduces challenges that would not be present if treated as a period item. See TX 11.10.3.1 for a discussion on how to measure GILTI deferred taxes.
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