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12.3 Intraperiod allocation—the basic model
Publication date: 13 Jul 2023
us Income taxes guide
Although ASC 740 outlines the basic model for intraperiod allocation in only a few paragraphs (primarily ASC 740-20-45-1 through ASC 740-20-45-14), application of the guidance can be complex and, at times, counterintuitive. When ASC 740 does not specifically allocate all or a portion of the total tax expense to a specific financial statement component or components, it allocates taxes based on what often is referred to as the “with-and-without” or “incremental” approach. The intraperiod tax allocation is performed once the overall tax provision is computed and simply allocates that overall provision to components of the income statement, OCI, and stockholders’ equity (i.e., the intraperiod tax allocation does not change the overall provision). This basic approach can be summarized in the following three steps:
Step 1: Compute the total tax expense or benefit (both current and deferred) for the period.
Step 2: Compute the tax effect of pre-tax income or loss from continuing operations, without consideration of the current-year pre-tax income or loss from other financial statement components. To this amount, the tax effects of the items that ASC 740 specifically allocates to continuing operations (as listed in TX 12.3.2.1) should be added.
Step 3: Allocate among the other financial statement components, in accordance with the guidance in ASC 740-20-45-11 through ASC 740-20-45-14, the portion of total tax that remains after the allocation of tax to continuing operations (the difference between the total tax expense (computed in Step 1) and the amount allocated to continuing operations (computed in Step 2)). If there is more than one financial statement component other than continuing operations, the allocation is made on a pro rata basis in accordance with each component’s incremental tax effects.
12.3.1 Intraperiod allocation—compute total tax expense or benefit
The first step in the intraperiod allocation process is to compute the total tax expense or benefit (both current and deferred) recognized in the financial statements. This includes the tax effects of all sources of income (or loss)—that is, the tax effects attributable to continuing operations, discontinued operations, items of OCI, certain changes in accounting principles, transactions among or with shareholders, and the effects of valuation allowance changes.
There are, however, specific tax allocation rules for the tax effect of certain transactions. For example, the tax effect of certain changes within the measurement period for a business combination that affect recognition of acquired tax benefits would be recorded in goodwill (see ASC 805-740-45-2(a) and TX 10). In addition, the tax effects of the specific transactions detailed in ASC 740-20-45-11 may require special considerations (see TX 12.3.3.3).
12.3.2 Intraperiod allocation—compute tax for continuing operations
Computing the tax effects to be allocated to continuing operations begins with the quantification of the tax effect for the year for continuing operations without consideration of the tax effects (both current and deferred) of current-year income from all other financial statement components. The tax effect of current-year income from pre-tax continuing operations should consider all of the information available at the end of the reporting period.
Example TX 12-1 illustrates allocation of the tax provision between continuing operations and discontinued operations and is adapted from ASC 740-20-55-14.
EXAMPLE TX 12-1
Determining the tax effects of pre-tax income from continuing operations with a loss from discontinued operations and NOL carryforward
Determining the tax effects of pre-tax income from continuing operations with a loss from discontinued operations and NOL carryforward
In 20X1, Company A has $10,000 of income from continuing operations and a $10,000 loss from discontinued operations. At the beginning of the year, the reporting entity has a $20,000 NOL carryforward for which the DTA is offset by a full valuation allowance. Company A did not reduce that valuation allowance during the year. The tax rate is 25%.
How should the tax provision for 20X1 be allocated between continuing operations and discontinued operations?
Analysis
ASC 740’s intraperiod allocation rules require that the amount of tax attributable to the current-year income from continuing operations be determined by a computation that does not consider the tax effects of items that are excluded from income from continuing operations. In this instance, without the current-year loss from discontinued operations of $10,000, no tax expense would be allocated to continuing operations because of the availability of the loss carryforward at the beginning of the year (which at the time had a valuation allowance recorded against it).
The tax effect on pre-tax continuing operations is computed before the tax effects of other financial statement components (in this case, before consideration of the loss from discontinued operations). Because a loss carryforward from the prior year was available for utilization, and there was income from continuing operations available to realize that carryforward, income from continuing operations is considered to “realize” the previously unrecognized NOL carryforward.
This result was arrived at as follows:
Step 1: Compute total tax expense or benefit |
||
20X1 pre-tax income/(loss) – Continuing operations |
$10,000 |
|
20X1 pre-tax income/(loss) – Discontinued operations |
(10,000) |
|
Pre-tax income/(loss) |
— |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance |
— |
|
Change in valuation allowance |
— |
|
20X1 Total tax provision/(benefit) |
$— |
|
Step 2: Compute tax attributable to continuing operations |
||
20X1 pre-tax income/(loss) – Continuing operations |
$10,000 |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance |
2,500 |
|
Change in valuation allowance |
(2,500) |
|
20X1 Total tax provision/(benefit) |
$— |
|
As discussed in TX 12.3.3, the third step would be to allocate the remaining tax to the other components.
Step 3: Allocate tax to categories other than continuing operations |
||
Total tax provision/(benefit) (Step 1) |
$— |
|
Tax provision/(benefit) allocated to continuing operations (Step 2) |
— |
|
Tax provision/(benefit) allocated to discontinued operations |
$— |
|
Example TX 12-2 illustrates allocation of the tax provision between continuing operations and discontinued operations when there is not an NOL carryforward.
EXAMPLE TX 12-2
Determining the tax effects of pre-tax income from continuing operations with a loss from discontinued operations and no NOL carryforward
In 20X1, Company A has $10,000 of income from continuing operations and a $10,000 loss from discontinued operations. Company A has no NOL carryforwards, and there is no valuation allowance. The tax rate is 25%.
How should the tax provision for 20X1 be allocated between continuing operations and discontinued operations?
Analysis
Intraperiod allocation would be performed in the following manner:
Step 1: Compute total tax expense or benefit |
||
20X1 pre-tax income/(loss) – Continuing operations |
$10,000 |
|
20X1 pre-tax income/(loss) – Discontinued operations |
(10,000) |
|
Pre-tax income/(loss) |
— |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance |
— |
|
Change in valuation allowance |
— |
|
20X1 total tax provision/(benefit) |
$— |
|
Step 2: Compute tax provision/(benefit) attributable to continuing operations |
||
20X1 pre-tax income/(loss) – Continuing operations |
$10,000 |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance |
2,500 |
|
Change in valuation allowance |
— |
|
20X1 total tax provision/(benefit) |
$2,500 |
|
As discussed in TX 12.3.3, the third step would be to allocate the remaining tax to the other components.
Step 3: Allocate tax to categories other than continuing operations |
|||
Total tax provision/(benefit) (Step 1) |
— |
||
Tax provision/(benefit) allocated to continuing operations (Step 2) |
2,500 |
||
Tax provision/(benefit) allocated to discontinued operations |
$(2,500) |
||
As a result of the application of the incremental approach, tax of $2,500 was allocated to continuing operations (the tax on the $10,000 of income) even though the $10,000 current-year loss from discontinued operations would serve to offset the $10,000 of income from continuing operations. The difference between the total tax expense of zero and the tax expense of $2,500 attributable to continuing operations is a $2,500 tax benefit. This $2,500 tax benefit is allocated to discontinued operations.
Example TX 12-3 illustrates allocation of the tax provision between continuing operations and discontinued operations when a current-year loss is recognized in the year generated.
EXAMPLE TX 12-3
Example of a current-year loss that is recognized in the year it was generated
Example of a current-year loss that is recognized in the year it was generated
USA Corp has pre-tax income from continuing operations of $10,000 and a pre-tax loss of $20,000 from discontinued operations for the year-ended December 31, 20X1. USA Corp historically has been profitable and expects to continue to be profitable. USA Corp has concluded that no valuation allowance is required at December 31, 20X1 based on projections of future taxable income. The tax rate is 25% for all years.
How should the current-year tax benefit be allocated between continuing operations and discontinued operations?
Analysis
Intraperiod allocation would be performed as follows:
Step 1: Compute total tax expense or benefit |
||
20X1 pre-tax income/(loss) – Continuing operations |
$10,000 |
|
20X1 pre-tax income/(loss) – Discontinued operations |
(20,000) |
|
Pre-tax income/(loss) |
(10,000) |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance changes |
(2,500) |
|
Valuation allowance change |
— |
|
20X1 total tax provision/(benefit) |
$(2,500) |
|
Step 2: Compute tax provision/(benefit) attributable to continuing operations |
||
20X1 pre-tax income/(loss) – Continuing operations |
$10,000 |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance change |
2,500 |
|
Change in valuation allowance |
— |
|
20X1 total tax provision/(benefit) attributable to continuing operations |
$2,500 |
|
As discussed in TX 12.3.3, the third step would be to allocate the remaining tax to the other components.
Step 3: Allocate tax to categories other than continuing operations |
||
Total tax provision/(benefit) (Step 1) |
$(2,500) |
|
Tax provision/(benefit) allocated to continuing operations (Step 2) |
2,500 |
|
Tax provision/(benefit) allocated to discontinued operations |
$(5,000) |
|
12.3.2.1 Tax allocation of specific items to continuing operations
In addition to the tax effect of the current-year income from pre-tax continuing operations, certain components of total income tax expense or benefit for the year to be included in the tax provision/(benefit) from continuing operations include:
Tax effects of changes in tax laws or rates (discussed below) |
|
Tax effects of changes in tax status (discussed below) |
|
Tax effects of change in assertion related to prior years’ unremitted earnings of foreign subsidiaries (TX 12.3.2.2)
|
|
The effect of a changed assessment about the realizability of DTAs that existed at the beginning of the year because of a change in the expectation of taxable income available in future years that does not relate to source-of-loss items (TX 12.3.2.3) |
|
Tax-deductible dividends paid to shareholders |
|
Tax effects of changes in unrecognized tax benefits for which backward tracing is not required nor elected (TX 15.7) |
|
Clearing of disproportionate tax effects lodged in OCI (TX 12.3.3.3) |
Changes in tax laws, rate, or an entity’s tax status
Adjustments to deferred tax balances are necessary when tax laws or rates change or an entity’s tax status changes. All such deferred tax adjustments, including those elements of deferred tax that relate to items originally reported in other financial statement components (such as OCI), are required to be reflected entirely in continuing operations.
The current and deferred tax effects of a retroactive change in tax laws are also included in income from continuing operations as of the date of enactment, even if the tax effects of those items were previously recorded outside of continuing operations. See TX 7 for information on changes in tax laws or rates and TX 8 for information on changes in tax status.
12.3.2.2 Tax allocation of changes in indefinite reversal assertion
The tax effects that result from a change in an entity’s assertion about its intent to indefinitely reinvest prior undistributed earnings of foreign subsidiaries, or foreign corporate joint ventures that are permanent in duration, should be reported in continuing operations in the period in which the change in assertion occurs. Thus, if an entity concluded that it could no longer assert that it would indefinitely reinvest its prior-years’ undistributed foreign earnings, it would not be appropriate to “backwards trace” the accrual of the tax consequences of the previously accumulated foreign CTA within OCI—even if that is where the amounts would have been allocated if the entity had never asserted indefinite reinvestment of those earnings in those prior periods.
It should be noted, however, that the tax effects on CTA arising in the current year are subject to the rules of ASC 740-20-45-11(b). That paragraph states that the tax effects of gains and losses included in OCI, but excluded from net income, that occur during the year should be charged or credited directly to OCI. As a result, it is important to distinguish the tax effects of the change in assertion between current-year and prior-years’ items.
The tax effect of an entity's change in assertion may be reported in continuing or discontinued operations if the change is due to the disposition of an entity. Refer to TX 12.4.2.2 for additional guidance.
Example TX 12-4 illustrates intraperiod allocation considerations related to a change in the indefinite reinvestment assertion.
EXAMPLE TX 12-4
Change in indefinite reinvestment assertion
Change in indefinite reinvestment assertion
USA Corp has a profitable foreign subsidiary, Deutsche AG, with $900 of book-over-tax outside basis difference as of December 31, 20X1 for which it asserts indefinite reinvestment under ASC 740-30-25-17. Accordingly, as of that date, USA Corp had not recorded a DTL related to the potential reversal of this difference.
- Deutsche AG’s functional currency is its local currency; thus, translation adjustments that result from translating Deutsche AG’s financial statements into USA Corp’s reporting currency (US dollars) are reported in OCI.
- At December 31, 20X1, $180 of the $900 outside basis difference arose from cumulative net CTA gains reported in OCI.
- During the second quarter of 20X2, because of increased liquidity needs in the US, USA Corp no longer intends to indefinitely reinvest its accumulated foreign earnings. As a result of this change in circumstances, the exemption in ASC 740-30-25-17 from providing deferred taxes is no longer available with respect to USA Corp’s book-over-tax basis difference in Deutsche AG.
- During the first six months of 20X2, pre-tax income from continuing operations is zero, and exchange rate movements result in a pre-tax gain of $120 reported in OCI. As a result, the accumulated CTA balance at June 30, 20X2, prior to recording any DTL, is a credit of $300 ($180 plus $120).
What are the intraperiod tax effects of the change in indefinite reinvestment assertion?
Analysis
USA Corp should measure the tax on the reversal of the outside basis difference of $1,020 ($900 plus $120) at June 30, 20X2. Of this amount, the tax effect of the reversal of the outside basis difference that arose in prior years, $900 in this case, would be allocated to continuing operations as a current-period expense. The tax liability associated with current year-to-date CTA movement of $120 would be allocated to OCI.
12.3.2.3 Intraperiod allocation for changes in valuation allowances
ASC 740-10-55-38 and ASC 740-20-45-3 set forth various rules for allocation of the benefits of previously-unrecognized losses and loss carryforwards. In addition, ASC 740-10-45-20 discusses the proper intraperiod allocation for changes in valuation allowances. We believe that these rules also apply to deductible temporary differences for which a tax benefit has never been recognized (i.e., in cases when a valuation allowance has been provided against the related DTA from its inception).
Excerpt from ASC 740-10-55-38
- The tax benefit of an operating loss carryforward that resulted from a loss on discontinued operations in a prior year and that is first recognized in the financial statements for the current year:
- Is allocated to continuing operations if it offsets the current or deferred tax consequences of income from continuing operations
- Is allocated to a gain on discontinued operations if it offsets the current or deferred tax consequences of that gain
- Is allocated to continuing operations if it results from a change in circumstances that causes a change in judgment about future realization of a tax benefit.
- The current or deferred tax benefit of a loss from continuing operations in the current year is allocated to continuing operations regardless of whether that loss offsets the current or deferred tax consequences of a gain on discontinued operations that:
- Occurred in the current year
- Occurred in a prior year (that is, if realization of the tax benefit will be by carryback refund)
- Is expected to occur in a future year.
The tax benefit of an operating loss carryforward or carryback (other than for the exceptions related to the carryforwards identified at the end of this paragraph) shall be reported in the same manner as the source of the income or loss in the current year and not in the same manner as the source of the operating loss carryforward or taxes paid in a prior year or the source of expected future income that will result in realization of a deferred tax asset for an operating loss carryforward from the current year. The only exception is the tax effects of deductible temporary differences and carryforwards that are allocated to shareholders’ equity in accordance with the provisions of paragraph 740-20-45-11(c) through (f).
The effect of a change in the beginning-of-the-year balance of a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years ordinarily shall be included in income from continuing operations. The only exceptions are changes to valuation allowances of certain tax benefits that are adjusted within the measurement period as required by paragraph 805-740-45-2 related to business combinations and the initial recognition (that is, by elimination of the valuation allowances) of tax benefits related to the items specified in paragraph 740-20-45-11(c) through (f). The effect of other changes in the balance of a valuation allowance are allocated among continuing operations and items other than continuing operations as required by paragraphs 740-20-45-2 and 740-20-45-8.
Under these rules, the intraperiod allocation depends on whether the benefit of the loss or deduction is recognized or realized in the year in which it is generated and whether the income to allow for the realization of the loss relates to the current year or future years. In situations when a reporting entity has recorded a valuation allowance on its beginning-of-year tax attributes, such as net operating losses and capital loss carryforwards, or other DTAs that can be realized in the current year by income from continuing operations, the benefit of this realization is generally allocated to continuing operations rather than to the financial statement component that gave rise to the deferred tax asset in the earlier year.
These rules can be summarized as follows:
- When there is an increase or decrease in the valuation allowance applicable to beginning-of-year DTAs that results from changes in circumstances that cause the assessment of the likelihood of realization of these assets by income in future years to change, the effect is reflected in continuing operations. An increase or decrease can include the initial recording of a valuation allowance, a change in measurement of a previously recorded valuation allowance, or a full release of a valuation allowance. This is true except for the initial recognition of source-of-loss items, as discussed in TX 12.3.2.4. See TX 12.3.3.2 for a discussion of valuation allowance changes as a result of NOL carryforward limitations after an initial public offering.
- When income in the current year allows for the release of a valuation allowance, the resulting benefit is allocated to the current-year component of income that allows for its recognition (subject to certain exceptions, such as the initial recognition of source-of-loss items, see TX 12.3.2.4).
- When the tax benefit of a loss in the current year is recognized and would have been realizable absent taxable income in another component, it is allocated to the component that generated the loss regardless of the financial statement source of the taxable income that allows for its recognition. This principle is the same whether the source of income is (a) taxable income in the current year, (b) taxable income in a prior year to which the current-year loss can be carried back, or (c) taxable income that is expected to occur in future years.
Example TX 12-5, Example TX 12-6, and Example TX 12-7 illustrate the general rules for the recording of changes in valuation allowances.
EXAMPLE TX 12-5
Change in valuation allowance on beginning-of-year DTAs resulting from current year income and changes in projections of income in future years
Change in valuation allowance on beginning-of-year DTAs resulting from current year income and changes in projections of income in future years
In 20X2, USA Corp has $1,200 of pre-tax income from continuing operations and $600 of pre-tax income from discontinued operations. At the beginning of the year, USA Corp has a $2,000 net operating loss carryforward (which was generated in prior years by what are now discontinued operations) that has been reflected as a DTA of $500 less a valuation allowance of $500 (i.e., no net DTA has been recognized).
At year-end 20X2, based on the weight of available evidence, management concludes that the ending DTA is realizable based on projections of future taxable income. The statutory tax rate for all years is 25%.
How should the tax provision for 20X2 be allocated between continuing operations and discontinued operations?
Analysis
Intraperiod allocation would be performed in the following manner:
Step 1: Compute total tax expense or benefit |
||
20X2 pre-tax income/(loss) – Continuing operations |
$1,200 |
|
20X2 pre-tax income/(loss) – Discontinued operations |
600 |
|
Pre-tax income/(loss) |
1,800 |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance release |
450 |
|
Valuation allowance release |
(500) |
|
20X2 total tax provision/(benefit) |
($50) |
|
Step 2: Compute tax provision/(benefit) attributable to continuing operations |
||
20X2 pre-tax income/(loss) – Continuing operations |
$1,200 |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance release |
300 |
|
Change in valuation allowance |
||
Resulting from current year income |
(300) |
|
Resulting from projections of future year income |
(200) |
|
20X2 total tax provision/(benefit) attributable to continuing operations |
($200) |
|
Since the determination of tax allocated to continuing operations is made first, and because we generally regard all income from projections of taxable income in future years to be attributed to continuing operations, valuation allowance changes usually are recorded in continuing operations. In making this determination, we believe that changes in judgment regarding the projections of future-year income should be attributed to continuing operations, even when the change in estimate about the future is affected by another financial statement component.
Without consideration of the current-year income from discontinued operations of $600, continuing operations would have realized a $300 DTA relating to net operating loss carryforwards that had a valuation allowance recorded against them at 12/31/X1. In addition, the valuation allowance on the $200 DTA relating to the remaining carryforward would have been realized through the projection of future pre-tax income from continuing operations. ASC 740-10-45-20 indicates that the release of the valuation allowance based on income expected in future years should be allocated to continuing operations despite the fact that the losses previously had been generated from what are now discontinued operations.
As discussed in TX 12.3.3, the third step would be to allocate the remaining tax to the other components.
Step 3: Allocated tax to categories other than continuing operations |
||
Total tax provision/(benefit) (Step 1) |
($50) |
|
Tax provision/(benefit) allocated to continuing operations (Step 2) |
(200) |
|
Tax provision/(benefit) allocated to discontinued operations |
$150 |
|
Because the entire DTA could be supported by the current-year income from continuing operations and by projections of future income, none of the valuation allowance release has been allocated to discontinued operations.
EXAMPLE TX 12-6
Example of decreases in valuation allowance resulting from current-year income
Example of decreases in valuation allowance resulting from current-year income
At December 31, 20X1, USA Corp has a net DTA of $1,000, including a DTA for net operating loss carryforwards of $1,200 and a DTL for the excess of book basis over tax basis in fixed assets of $200. Because of the existence of significant negative evidence at December 31, 20X1, and the lack of positive evidence of sufficient quality and quantity to overcome the negative evidence, a full valuation allowance was recorded against this $1,000 net DTA.
During 20X2, USA Corp generated pre-tax income from continuing operations of $100 and pre-tax income from discontinued operations of $800. Assume a tax rate of 25%. At December 31, 20X2, based on the weight of available evidence, a full valuation allowance on the existing DTA of $775 ($1,000 of beginning-of-year DTA less $225 (25% of the sum of pre-tax income from both continuing and discontinued operations of $900)) was still required.
What is the intraperiod allocation of the valuation allowance release of $225 that resulted from the current-year realization of net DTAs?
Analysis
Intraperiod allocation would be performed in the following manner:
Step 1: Compute total tax expense or benefit |
||
20X2 pre-tax income/(loss) – Continuing operations |
$100 |
|
20X2 pre-tax income/(loss) – Discontinued operations |
800 |
|
Pre-tax income/(loss) |
900 |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance release |
225 |
|
Valuation allowance release |
(225) |
|
20X2 total tax provision/(benefit) |
$— |
|
Step 2: Compute tax provision/(benefit) attributable to continuing operations |
||
20X2 pre-tax income/(loss) – continuing operations |
$100 |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance release |
25 |
|
Valuation allowance release |
(25) |
|
20X2 total tax provision/(benefit) attributable to continuing operations |
$— |
|
Absent effects of the income from discontinued operations, the provision for continuing operations would be zero, composed of $25 of tax on the $100 of pre-tax income offset by the $25 benefit from the reversal of the valuation allowance on the DTA related to the net operating losses that would have been utilized. The remaining reversal of the valuation allowance of $200 is solely due to an item occurring outside of continuing operations and not a change in judgement related to future realizability.
As discussed in TX 12.3.3, the third step would be to allocate the remaining tax to the other components.
Step 3: Allocate tax to categories other than continuing operations |
||
Total tax provision/(benefit) (Step 1) |
$— |
|
Tax provision/(benefit) related to continuing operations (Step 2) |
— |
|
Tax provision/(benefit) allocated to discontinued operations |
$— |
|
As a result of the application of the incremental approach, there is $0 tax expense to allocate to discontinued operations. The $800 of income from discontinued operations and associated tax expense of $200 ($800 multiplied by the 25% tax rate) is fully offset by a release of the valuation allowance, resulting in $0 tax expense from discontinued operations.
EXAMPLE TX 12-7
Example of increase in valuation allowance resulting from current year losses in continuing operations and OCI
Example of increase in valuation allowance resulting from current year losses in continuing operations and OCI
USA Corp, a calendar-year company, has the following activity:
- USA Corp disposed of land and incurred a 20X2 pre-tax capital loss in continuing operations of $150,000. In the US, capital losses can be used to offset only capital gain income, and excess capital losses may be carried back three years and forward five years.
- During 20X2, there was an additional $250,000 unrealized pre-tax loss recognized in OCI related to AFS debt securities which results in a deductible temporary difference that is capital in nature.
- At December 31, 20X1, USA Corp had $200,000 of capital gains. Because the $150,000 20X2 capital loss on disposal of land is carried back to 20X1, there is still carryback capacity of $50,000 of capital gains remaining at December 31, 20X2.
- At December 31, 20X1, no valuation allowance was recorded because USA Corp had sufficient capital gains in the carryback period to utilize the DTAs attributable to the AFS debt securities.
- At December 31, 20X2, as only $50,000 of capital gains are available in the carryback period, $56,250 (($275,000 less $50,000) x 25%)) of the deductible temporary differences will need a valuation allowance.
- At December 31, 20X1, USA Corp has a deductible temporary difference of $25,000 related to AFS debt securities. The deferred tax components for 20X1 and 20X2 appear below:
In thousands |
12/31/X1 |
Change |
12/31/X2 |
||
Deductible temporary difference attributable to AFS debt securities |
$25,000 |
$250,000 |
$275,000 |
||
Tax rate |
25% |
25% |
25% |
||
DTA/(DTL) before valuation allowance |
6,250 |
62,500 |
68,750 |
||
Valuation allowance |
— |
(56,250) |
(56,250) |
||
Net DTA |
$6,250 |
$6,250 |
$12,500 |
How should the tax provision for 20X2 be allocated between continuing operations and OCI?
Analysis
Step 1: Compute total tax expense or benefit |
||
20X2 pre-tax income/(loss) – Continuing operations |
$(150,000) |
|
20X2 pre-tax income/(loss) – OCI |
(250,000) |
|
Pre-tax income/(loss) |
(400,000) |
|
Tax rate |
25% |
|
Expected tax expense/(benefit) before valuation allowance |
(100,000) |
|
Increase/(decrease) in valuation allowance |
56,250 |
|
20X2 total tax provision/(benefit) |
$(43,750) |
|
Step 2: Compute tax provision/(benefit) attributable to continuing operations |
||
20X2 pre-tax income/(loss) – Continuing operations |
$(150,000) |
|
Tax rate |
25% |
|
Expected tax provision/(benefit) before valuation allowance |
(37,500) |
|
Increase/(decrease) in valuation allowance |
— |
|
20X2 total tax expense/(benefit) |
($37,500) |
|
The current-year loss in continuing operations is fully benefited because, in this fact pattern, absent the 20X2 loss reported in OCI, no valuation allowance would have been required due to existing capital gains in the carryback period.
As discussed in TX 12.3.3, the third step would be to allocate the remaining tax to the other components.
Step 3: Allocate tax to categories other than continuing operations |
||
Total tax expense/(benefit) (Step 1) |
($43,750) |
|
Tax provision/(benefit) allocated to continuing operations (Step 2) |
(37,500) |
|
Tax expense/(benefit) allocated to OCI |
($6,250) |
|
Following the incremental approach, the entire $56,250 valuation allowance recorded during the year was allocated to OCI because, absent the current-year pre-tax loss on the AFS debt securities reported in OCI, no valuation allowance would have been required.
12.3.2.4 Intraperiod application of the source-of-loss rule
Regardless of when it occurs, the initial recognition of the tax benefits of certain deductible differences and carryforwards is classified on the basis of the source of loss that generated them, rather than on the basis of the source of income that utilizes or is expected to utilize them. This aspect of intraperiod allocation sometimes is referred to as "backwards tracing." ASC 740-20-45-3 prohibits backwards tracing except for items specifically included in ASC 740-20-45-11(c) through ASC 740-20-45-11(f). Those specific items should be allocated directly to the related components of shareholder's equity regardless of the source of income that allows for their realization.
The treatment as source-of-loss items only applies to the initial recognition of the tax benefit. If the benefit of a loss carryforward attributable to a tax deduction received in connection with issuing capital stock was previously recognized in equity, but a valuation allowance is recorded subsequently against that item, it would lose its identity as a source-of-loss item. Accordingly, the subsequent re-recognition of the benefit of the carryforward would be recorded based on the “with and without” intraperiod allocation process. That is, the benefit would be allocated based on the general rules for changes in valuation allowances, as noted at TX 12.3.2.3.
Example TX 12-8 illustrates application of the source-of-loss rule.
EXAMPLE TX 12-8
Application of the source-of-loss rule
Application of the source-of-loss rule
In 20X1, USA Corp has $1,000 of income from continuing operations. The applicable tax rate is 25%. USA Corp has a net operating loss carryforward of $1,200 relating to deductible expenditures reported in contributed capital, resulting in a beginning-of-year DTA of $300 ($1,200 × 25%). This $300 DTA has a full valuation allowance recorded against it that was established at the date of a capital-raising transaction and was not subsequently reduced (making the DTA a source-of-loss item).
USA Corp concluded that a full valuation allowance is required at year-end. There are no permanent or temporary differences (either current year or cumulative) other than the net operating loss carryforward noted above.
How should tax expense/benefit be allocated?
Analysis
In Step 1, total tax expense would be zero because the tax effect of the $1,000 pre-tax income at a 25% statutory tax rate would be offset by the reversal of $250 of the $300 valuation allowance that had been recorded on the DTA. Because the tax benefit was initially recognized after the period in which it was generated (by means of utilizing $1,000 of the carryforward to offset the pre-tax income of $1,000), the reversal of the valuation allowance should be backward traced to equity.
As a result, the entry to allocate tax for the year would be as follows:
Dr. Deferred tax provision – continuing operations |
$250 |
||
Dr. Valuation allowance |
$250 |
||
Cr. DTA |
$250 |
||
Cr. Equity |
$250 |
||
12.3.2.5 Determining the source of a realized tax benefit
The general rules for allocating the effects of changes in valuation allowances discussed at TX 12.3.2.3 apply to most changes in valuation allowances. However, because of the source-of-loss exceptions for the initial recognition of certain tax benefits and because a deductible temporary difference may reverse and be utilized on a tax return but be replaced with another deductible temporary difference within the same year (thus not realizing a tax benefit), the determination of which carryforward or deductible temporary difference produced a realized tax benefit during the year may become important when applying the intraperiod allocation rules.
When there are both DTAs at the beginning of the year and DTAs arising in the current year from sources other than continuing operations, a change in the valuation allowance must be “sourced” to the assets that gave rise to the change.
In determining whether the reversal of a particular deductible temporary difference or carryforward provided a benefit, one must consider the interaction of originating temporary differences with loss and other carryforwards. Just because a net operating loss carryforward was utilized (used on the tax return), it does not mean that a benefit was realized. ASC 740-10-55-37 indicates that the reversal of a deductible temporary difference as a deduction or through the use of a carryforward does not constitute realization when reversal or utilization resulted because of the origination of a new deductible temporary difference. This is because the DTA that has been utilized has simply been replaced by the originating DTA without providing for realization. Accordingly, ASC 740-10-55-37 indicates that the "source" of the benefit of the originating deductible temporary difference would not be the component of income in which the originating deductible temporary difference arose; rather, it would take on the source of the deduction or carryforward that it replaced.
The specific example in ASC 740-10-55-37 is in regard to deferred revenue, but the reference to ASC 740-20-45-3 makes it clear that the same rationale applies when an origination or increase of a deductible temporary difference during the year allows for the utilization of a deduction or carryforward that originated in equity (e.g., the tax benefit and related valuation allowance are recorded in equity, consistent with ASC 740-20-45-11(c) and (f)).
Example TX 12-9 illustrates a reduction in an NOL from an equity transaction that is replaced by a subsequent originating DTA.
EXAMPLE TX 12-9
Example of a reduction in an NOL from an equity transaction that is replaced by a subsequent originating DTA
Example of a reduction in an NOL from an equity transaction that is replaced by a subsequent originating DTA
On December 31, 20X1, USA Corp raised new capital from its investors. USA Corp recorded a DTA related to a $2,000 loss carryforward arising from a large expenditure related to the capital-raising transaction, for which a full valuation allowance was also recognized and recorded in equity.
In 20X2, USA Corp generated a pre-tax loss from continuing operations of $1,000. Included in this $1,000 loss was $3,000 of warranty reserve expense that is not deductible until paid for income tax purposes. Taxable income for the year of $2,000 was offset by the utilization of a net operating loss carryforward, resulting in net taxable income of $0 as shown below.
Pre-tax loss from continuing operations |
($1,000) |
Originating deductible temporary differences |
3,000 |
Usage of loss carryforward, which was originally recorded in equity |
(2,000) |
Taxable income |
$— |
Was the utilized loss carryforward realized (such that the source of loss exception would allocate the tax benefit to equity) or was it merely transformed into a deductible temporary difference?
Analysis
Even though the $2,000 net operating loss carryforward was utilized during the year, no realization of DTAs occurred because the loss from pre-tax continuing operations only served to increase the net DTA (and related valuation allowance). As a result, while the $2,000 net operating loss carryforward was “consumed” on the tax return, it was not realized; rather, it was transformed into the deductible temporary difference for the warranty reserve. The carryforward did not result in incremental cash tax savings.
Deductible temporary differences that reverse and manifest themselves into an originating temporary difference (or an NOL carryforward) have not been realized. Instead, that portion of the originating temporary difference (i.e., the warranty reserve) takes on the character of the reversing DTA related to the NOL, and a $2,000 tax benefit would be allocated to equity, in accordance with ASC 740-20-45-3, once the tax benefit of the loss carryforward is recognized in a future period.
Example TX 12-10 demonstrates how ASC 740-10-55-37 can affect the ordering in intraperiod allocation.
EXAMPLE TX 12-10
Determining the impact of originating temporary differences on the application of source of loss rules
Determining the impact of originating temporary differences on the application of source of loss rules
USA Corp has the following taxable income/(loss):
Income/(loss) from continuing operations |
$1,000 |
|
Income/(loss) from discontinued operations |
(1,000) |
|
Reversing deductible temporary differences originally recorded in equity |
(1,000) |
|
Taxable loss carryforward |
$(1,000) |
- Coming into the year, there are no available carryforwards or income available in carryback years.
- The deductible temporary difference that is reversing was originally established in equity with a full valuation allowance of $1,000 against it. This valuation allowance has not been reduced subsequently.
- The DTA at the end of the current year requires a full valuation allowance, despite income in the current year, because the company is projecting losses.
- The statutory tax rate is 25%.
How should the source of loss rules be applied in the allocation of tax expense for the year?
Analysis
The total tax expense for the year is zero because there was no pre-tax income for the year ($1,000 income from continuing operations less $1,000 loss from discontinued operations), and the reversing equity-related deductible temporary differences created a taxable loss of $1,000 for which the related DTA requires a full valuation allowance.
ASC 740's intraperiod allocation rules would allocate a tax expense of $250 to continuing operations and a tax benefit of $250 to discontinued operations. No tax benefit is allocated to the reversing equity-related deductible temporary differences because the DTA that arose in equity has merely been transformed into a DTA relating to an NOL carryforward. Said another way, while the equity-related deductible temporary differences reversed, they did not provide for incremental cash tax savings and thus were not realized. A tax benefit will be allocated to equity, in accordance with ASC 740-20-45-3, once the NOL DTA is realized in a future period.
Had the loss from discontinued operations in this example instead been $300, then $700 of the reversing equity-related deductible temporary differences would have been realized (resulting in incremental cash tax savings). As a result, the total tax expense of zero would be allocated as follows:
Tax expense/(benefit) allocated to continuing operations |
$250 [1,000 × 25%] |
Tax expense/(benefit) allocated to discontinued operations |
$(75) [(300) × 25%] |
Tax expense/(benefit) allocated to equity in accordance with ASC 740-20-45-3 |
$(175) [(700) × 25%] |
12.3.3 Intraperiod allocation of remaining tax to other components
The portion of total tax that remains after allocation of tax to continuing operations (i.e., the difference between the total tax expense computed in Step 1 and the amount allocated to continuing operations computed in Step 2) is then allocated among the other financial statement components in accordance with the guidance in ASC 740-20-45-11, ASC 740-20-45-12, and ASC 740-20-45-14.
The tax effects of the following items occurring during the year shall be charged or credited directly to other comprehensive income or to related components of shareholders' equity:
- Adjustments of the opening balance of retained earnings for certain changes in accounting principles or a correction of an error. Paragraph 250-10-45-8 addresses the effects of a change in accounting principle, including any related income tax effects.
- Gains and losses included in comprehensive income but excluded from net income (for example, translation adjustments accounted for under the requirements of Topic 830 and changes in the unrealized holding gains and losses of securities classified as available-for-sale as required by Topic 320).
- An increase or decrease in contributed capital (for example, deductible expenditures reported as a reduction of the proceeds from issuing capital stock).
- Subparagraph superseded by Accounting Standards Update No. 2016-09.
- Subparagraph superseded by Accounting Standards Update No. 2016-09.
- Deductible temporary differences and carryforwards that existed at the date of a quasi reorganization.
- All changes in the tax bases of assets and liabilities caused by transactions among or with shareholders shall be included in equity including the effect of valuation allowances initially required upon recognition of any related deferred tax assets. Changes in valuation allowances occurring in subsequent periods shall be included in the income statement.
If there is only one item other than continuing operations, the portion of income tax expense or benefit for the year that remains after the allocation to continuing operations is allocated to that item.
If there are two or more items other than continuing operations, the amount that remains after the allocation to continuing operations shall be allocated among those other items in proportion to their individual effects on income tax expense or benefit for the year. When there are two or more items other than continuing operations, the sum of the separately calculated, individual effects of each item sometimes may not equal the amount of income tax expense or benefit for the year that remains after the allocation to continuing operations. In those circumstances, the procedures to allocate the remaining amount to items other than continuing operations are as follows:
- Determine the effect on income tax expense or benefit for the year of the total net loss for all net loss items.
- Apportion the tax benefit determined in (a) ratably to each net loss item.
- Determine the amount that remains, that is, the difference between the amount to be allocated to all items other than continuing operations and the amount allocated to all net loss items.
- Apportion the tax expense determined in (c) ratably to each net gain item.
12.3.3.1 Determining the intraperiod tax effects of other components
We believe that the individual effects on income tax expense or benefit of a specific financial statement component represent that component’s incremental tax effect (on a jurisdiction-by-jurisdiction basis) on consolidated tax expense or benefit. Accordingly, we believe that this amount should be quantified by means of comparing the difference between the total tax expense or benefit computed for the year that includes all sources of income and loss and the total tax expense or benefit for the year computed with all sources of income and loss except for the financial statement component being quantified.
While that amount may not be the amount that ultimately is allocated to the respective financial statement component, it represents the individual incremental effect of the item for purposes of applying the allocation procedure outlined in ASC 740-20-45-14. All items (other than continuing operations) should be given equal priority for purposes of intraperiod tax allocation, unless there is specific guidance that provides otherwise.
12.3.3.2 Intraperiod allocation for equity items other than OCI
ASC 740 specifically allocates to shareholders’ equity the tax effects of changes during the year of the following items:
- Cumulative effect adjustments to beginning retained earnings for changes in accounting principle or error correction (ASC 740-20-45-11(a)); see TX 12.4.4 for additional discussion);
- Increases or decreases in contributed capital (ASC 740-20-45-11(c)), including the tax effect of items that are classified in equity for financial statement purposes such as:
- Issuance costs that are recorded as a reduction of proceeds received on equity issuances for book purposes but which are deductible for tax purposes; and
- The tax effects of the exercise of a financial instrument classified as equity (other than stock-based compensation under ASC 718) by the issuer;
- Deductible temporary differences and carryforwards that existed, but for which a valuation allowance was required, at the date of a quasi reorganization (ASC 740-20-45-11(f)); and
- Changes in the tax bases of assets and liabilities caused by transactions among or with shareholders, including the effect of valuation allowances initially required upon recognition of any related DTAs. Changes in valuation allowances occurring in subsequent periods shall be included in the income statement (ASC 740-20-45-11(g)).
Question TX 12-1 discusses intraperiod tax allocation considerations for changes in a deferred tax asset balance, or a valuation allowance, that are a result of limitations in future utilization of a NOL carryforward due to an initial public offering.
Question TX 12-1
Should the tax consequences of reducing a deferred tax asset (or increasing a valuation allowance) related to NOL carryforwards for which future utilization is limited as a result of the tax change in ownership rules after completing an initial public offering be charged to contributed capital or recognized in the income statement?
Should the tax consequences of reducing a deferred tax asset (or increasing a valuation allowance) related to NOL carryforwards for which future utilization is limited as a result of the tax change in ownership rules after completing an initial public offering be charged to contributed capital or recognized in the income statement?
PwC response
The effects of writing off a deferred tax asset (or recording a valuation allowance) in these circumstances should be recognized in the income statement. ASC 740-10-45-21 states that changes in valuation allowances due to changed expectations about the realization of deferred tax assets caused by transactions among or with shareholders should be included in the income statement. The guidance further concludes that the write-off of a pre-existing deferred tax asset in these circumstances should be charged to income because the same net effect results from eliminating a deferred tax asset or increasing a valuation allowance to 100% of the amount of the related deferred tax asset.
This guidance differs from the guidance for changes in tax bases of assets and liabilities that are caused by transactions with or among shareholders for which ASC 740-20-45-11(g) concludes the related tax effects should be included in equity.
12.3.3.3 Intraperiod allocation for OCI items
Certain gains and losses are included in comprehensive income but excluded from net income. Such items, when recognized, are reflected directly in OCI, a component of shareholders’ equity. Generally, the tax effect of gains and losses recorded in OCI should also be recorded in OCI (ASC 740-20-45-11(b)). These gains and losses include:
- Foreign currency translation gains and losses reflected in the CTA account within OCI for foreign operations using a foreign functional currency or the foreign currency transaction gain or loss on a nonderivative instrument (ASC 830);
- Unrealized gains and losses on AFS debt securities (ASC 320);
- Net unrecognized gains and losses and unrecognized prior service cost related to pension and other postretirement benefit arrangements (ASC 715); and
- The effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedge instrument (ASC 815).
When a jurisdiction (and in some cases a separate filing when entities within a jurisdiction do not file a consolidated return) includes more than one item of OCI (e.g., derivatives under ASC 815 and AFS debt securities under ASC 320), each item should be treated as a separate component of the financial statements, at a level no higher than the separate components presented in the statement of comprehensive income as discussed in ASC 220-10-45-13 for purposes of the application of intraperiod allocation. As a result, the incremental tax effect of each separate component of OCI income should be considered. We also believe that both favorable and unfavorable adjustments (for changes in uncertain tax positions assessments) to deferred taxes recorded in OCI should, depending on the accounting policy election, either be (1) backwards traced to OCI or (2) recognized in income tax from continuing operations (refer to TX 15.7 for additional discussion on uncertain tax positions and intraperiod allocation).
CTA
Some pre-tax transaction gains and losses (ASC 830-20-35-2) and all translation adjustments (ASC 830-30-45-21) are recorded directly in the CTA account. ASC 830-20-45-5 requires the tax effects of these items to be attributed to the CTA account.
Allocation to the CTA account is required for both current and deferred taxes on transaction gains and losses recorded in the CTA account and for deferred taxes on translation adjustments. With respect to deferred taxes provided by a parent or investor for an “outside basis” temporary difference, the method of allocating the tax effect on the current year change in this outside basis temporary difference between continuing operations and other items (such as CTA) must be considered. Refer to TX 13.9 for additional information on intraperiod tax allocation for CTA.
If withholding taxes are accrued as part of the outside basis temporary difference, the treatment of foreign currency movements will likely differ from the treatment of amounts reported as part of CTA. Refer to TX 13.3.
Unrealized gains and losses on AFS debt securities (ASC 320)
ASC 320 requires that debt investments classified as AFS be carried at fair value. This would generally result in temporary differences because the laws in most tax jurisdictions defer the recognition of gains and losses from investments until the investments are sold.
ASC 320 reflects pre-tax changes in market value as OCI. ASC 740-20-45-11(b) requires that the tax effects of pre-tax changes to OCI occurring during the year be recorded net against the pre-tax changes in OCI.
Example TX 12-11 illustrates considerations related to appreciation in AFS debt securities when there is a valuation allowance.
EXAMPLE TX 12-11
Appreciation in AFS debt securities when there is a valuation allowance
Appreciation in AFS debt securities when there is a valuation allowance
Assume the following facts for USA Corp:
- Tax rate of 25%
- At year-end 20X1, there is a full valuation allowance on USA Corp’s net DTA as shown:
DTA for NOLs carryforwards |
$2,000 |
|
DTA for unrealized loss on AFS debt securities |
1,000 |
|
DTA before valuation allowance |
3,000 |
|
Less: valuation allowance |
(3,000) |
|
Net DTA |
$— |
- During 20X2, financial results for pre-tax continuing operations were breakeven and $4,000 of pre-tax gains from unrealized appreciation on AFS debt securities was included in OCI.
- At December 31, 20X2, management concluded that a full valuation allowance continued to be required.
How much tax should be allocated to the AFS component of OCI?
Analysis
When there is a valuation allowance applicable to beginning-of-year DTAs and there is a change in circumstances during the year that causes the assessment of the likelihood of realization in future years to change, the effect would be reflected in continuing operations. However, if the reversal of the valuation allowance is directly related to the appreciation of a reporting entity’s AFS debt security during the current year (current-period income) and not to expectations of taxable income in future periods, the reversal of the valuation allowance would be recorded in OCI.
In this example, USA Corp would have a total tax expense of zero and a net DTA of $2,000 with a full valuation allowance. As pre-tax income related to continuing operations is zero, no tax provision or benefit would be allocated to it. Due solely to the income from AFS debt securities of $4,000, $1,000 of the prior-year valuation allowance would be released. As a result, the entire valuation allowance release of $1,000 would offset the tax attributable to the $4,000 pre-tax gain from OCI of $1,000 ($4,000 times 25%), resulting in no tax allocated to the AFS component of OCI.
ASC 740-20-45-15 through ASC 740-20-45-18 contains guidance specific to the presentation of DTAs relating to losses on available-for-sale debt securities. However, as indicated in Question TX 12-2, that specific guidance is consistent with normal intraperiod guidance, including when an entity has a change in valuation allowance related to a DTA for unrealized losses on available-for-sale debt securities.
Question TX 12-2
At the end of 20X1, an entity had a DTA for unrealized losses on available-for-sale debt securities and concluded a valuation allowance against that DTA was not necessary due to the presence of a DTL which could serve as a source of income.
At the end of 20X2, that DTL is no longer available as a source of income and there are no other sources of income available to support realization. In addition, the company experienced additional current year unrealized losses on available-for-sale debt securities in OCI resulting in an increase to the DTA for unrealized losses on available-for-sale debt securities. The company records a full valuation allowance at the end of 20X2. Would the full valuation allowance be charged to OCI?
At the end of 20X1, an entity had a DTA for unrealized losses on available-for-sale debt securities and concluded a valuation allowance against that DTA was not necessary due to the presence of a DTL which could serve as a source of income.
At the end of 20X2, that DTL is no longer available as a source of income and there are no other sources of income available to support realization. In addition, the company experienced additional current year unrealized losses on available-for-sale debt securities in OCI resulting in an increase to the DTA for unrealized losses on available-for-sale debt securities. The company records a full valuation allowance at the end of 20X2. Would the full valuation allowance be charged to OCI?
PwC response
No. In this circumstance, a portion of the effect of recording a valuation allowance should be recognized in OCI while a portion should be recognized in continuing operations. The valuation allowance related to the 20X2 current year unrealized loss on available-for-sale debt securities from OCI would be recorded in OCI per ASC 740-20-45-4 and ASC 740-20-45-16. The valuation allowance related to the portion of the DTA for unrealized losses that existed as of the end of 20X1 would be recorded in continuing operations in accordance with ASC 740-10-45-20 since it is a change in the beginning-of-the-year balance of a valuation allowance that results from a change in circumstances that causes a change in judgement about the realizability of the related deferred tax asset in future years.
EXAMPLE TX 12-12
Intraperiod allocation related to reclassifications from AOCI
Intraperiod allocation related to reclassifications from AOCI
In Year 1, USA Corp purchased debt securities for $210 accounted for as AFS. At the end of Year 1, the AFS debt securities had a fair value of $150, resulting in an unrealized loss of $60 recorded through OCI. In Year 2, USA Corp sold all of the AFS debt securities for $150, which resulted in reclassification of the pre-tax loss of $60 (from Year 1) from AOCI to earnings.
USA Corp reported pre-tax income from continuing operations of $200 inclusive of the loss realized on the AFS debt securities and a reclassification gain of $60 in OCI (thus, the effect on comprehensive pre-tax income from the disposition of the AFS debt securities is zero). USA Corp’s tax rate is 25%.
Does the reclassification adjustment of $60 from AOCI to earnings impact the intraperiod tax allocation given that the net effect on comprehensive net income is zero?
Analysis
Yes. Reclassification adjustments, such as gains and losses on AFS debt securities reclassified from AOCI to earnings, form part of the current period income (loss) from continuing operations and current period income (loss) in OCI. Therefore, their income tax effect should be evaluated in the same manner as any other item of income or loss reported in the current period. They should be considered in ASC 740’s three-step intraperiod allocation approach.
Step 1: |
Step 2: |
Step 3: |
|
Total tax expense or benefit |
Tax attributable to continuing operations |
Allocate remaining tax to OCI |
|
Pre-tax income (loss) |
$260 |
$200 |
$60 |
Tax rate |
25% |
25% |
25% |
Tax (expense) benefit |
$(65) |
$(50) |
$(15) |
In this example, total tax for the period is $65. Without the disposition of AFS debt securities, the total tax would also be $65 (income from continuing operations would be $260 and there would be no gain in OCI). However, while the net tax effect of the reclassification adjustment in step 1 of the intraperiod allocation model is zero, there is a tax effect to allocate to continuing operations and a consequent tax offset to OCI. In this example, the reclassification adjustment resulted in splitting the total tax effect for the period of ($65) between continuing operations and OCI.
Disproportionate tax effects lodged in OCI
The tax effects reflected directly in OCI are determined pursuant to ASC 740’s intraperiod allocation rules. Under this incremental approach, subsequent adjustments to deferred taxes originally charged or credited to OCI are not necessarily reflected in OCI. Specific circumstances in which subsequent adjustments are not reflected in OCI, but instead are reflected in continuing operations, include:
- A change in enacted tax rates (because ASC 740-10-45-15 requires that the effect of a tax law change on DTAs and DTLs is reflected in continuing operations), and
- A change in the valuation allowance for beginning-of-year DTAs that results from a change in circumstances that causes a change in judgment about the realizability of DTAs in future years (because ASC 740-10-45-20 requires that this change in valuation allowance be reflected entirely in continuing operations).
As a result of these requirements, the tax effect lodged in OCI will not necessarily equal the net DTA or DTL that is recognized in the balance sheet for the temporary differences related to the pre-tax items recorded in OCI.
Question TX 12-3 addresses considerations related to “reconciling items” that remain in OCI as a result of the effects of a change in valuation allowance or change in tax rate having been charged or credited to continuing operations.
Question TX 12-3
What, if anything, should be done about the “reconciling items” that remain in OCI as a result of the change in valuation allowance or change in tax rate effects having been charged or credited to continuing operations?
What, if anything, should be done about the “reconciling items” that remain in OCI as a result of the change in valuation allowance or change in tax rate effects having been charged or credited to continuing operations?
PwC response
ASC 740 is silent as to the disposition of a disproportionate tax effect lodged in OCI. We believe that the OCI balance, including any related tax effects, must be eliminated when the circumstances upon which it is premised cease to exist. Presumably, the pre-tax items in OCI ultimately will be cleared to income (perhaps in an indefinite, distant future period). For example, sale of a foreign operation or actions that result in a complete liquidation requires that the related CTA account balance be recognized in income. Any disproportionate tax effect related to such an item that was lodged in OCI should also be cleared to income. Because the disproportionate tax effect at one time was reflected in income (either in continuing operations or in the cumulative effect of initial application of ASC 740), its clearing ordinarily will be to income from continuing operations.
Question TX 12-4 addresses whether the clearing of disproportionate tax effects related to AFS debt securities (ASC 320) should be determined on an item-by-item or an aggregate portfolio basis.
Question TX 12-4
When clearing disproportionate tax effects relating to AFS debt securities (ASC 320), should this be determined on an item-by-item (individual investment) or an aggregate portfolio basis?
When clearing disproportionate tax effects relating to AFS debt securities (ASC 320), should this be determined on an item-by-item (individual investment) or an aggregate portfolio basis?
PwC response
We believe there are two acceptable approaches for clearing the disproportionate tax effects of AFS debt securities.
Item-by-item approach:
Under the item-by-item approach, a portion of the disproportionate tax effect is assigned to each individual investment in an unrealized gain or loss position at the time of the event causing the disproportionate tax effect. When one of those individual investments is sold, the assigned portion of the reconciling item is removed from the AFS component of OCI and charged or credited to income from continuing operations.
Aggregate portfolio approach:
Under the aggregate portfolio approach, the disproportionate tax effect remains intact as long as the investment portfolio remains. Thus, if an entity with unrealized gains and losses on debt securities elects the aggregate approach, there presumably will be no need to completely clear the disproportionate tax effect from AOCI as long as the entity holds an AFS portfolio.
In applying the aggregate portfolio approach, we believe that the disproportionate tax effect should be cleared if at any point during the year the portfolio is liquidated, even if a portfolio is re-established during the same interim period. This view is based on the fact that, at the time the portfolio was completely liquidated, the circumstance upon which the original disproportionate effect was premised ceased to exist.
Example TX 12-13 illustrates disproportionate effects lodged in OCI resulting from a change in valuation allowance.
EXAMPLE TX 12-13
Disproportionate effect lodged in OCI related to a change in valuation allowance
Disproportionate effect lodged in OCI related to a change in valuation allowance
USA Corp's investment in debt securities, which originally cost $1,000, had a market value of $900 at the end of 20X1. The company accounts for this investment as an AFS debt security under ASC 320, resulting in an unrealized loss of $100 charged to OCI during 20X1. USA Corp recorded a DTA of $21, but it also provided a $21 valuation allowance; thus, no tax benefit was recognized in OCI on the $100 pre-tax OCI loss.
In 20X2, the market value of the securities did not change. However, as a result of a change in circumstances, USA Corp changed its estimate of future taxable income and eliminated the valuation allowance. The tax benefit of $21 was reflected in continuing operations pursuant to ASC 740-10-45-20. Because the initial DTA had a valuation allowance established through OCI, and the valuation allowance was released through continuing operations, a disproportionate tax effect was created within OCI that will be triggered upon the sale of the AFS debt securities.
At the end of 20X2, USA Corp had the following balance sheet accounts for the investment:
Debit |
Credit |
||
Investment |
$900 |
||
DTA |
$21 |
||
Shareholders’ equity |
|||
Retained earnings |
$21 |
||
Unrealized loss on AFS debt securities (AOCI) |
$100 |
||
In early 20X3, USA Corp sold the securities for $900.
How does the sale impact the disproportionate tax effects lodged in OCI?
Analysis
USA Corp recognized in continuing operations a $100 loss on the sale; the $100 loss previously recognized in OCI was reclassified to income pursuant to ASC 220. The reclass from OCI to continuing operations results in no cumulative pre-tax gain or loss in accumulated comprehensive income. USA Corp was able to reduce its taxes currently payable by $21, and it reflected this tax benefit in its current tax expense. However, deferred tax expense would reflect the reversal of the $21 DTA related to the previously unrealized loss. Accordingly, the overall net tax effect recognized in comprehensive income (the “with” calculation) on the sale would be zero.
In continuing operations (the “without” calculation), the reclassification would reduce pre-tax income by $100, resulting in a $21 tax benefit. In the intraperiod allocation for 20X3, therefore, the $21 difference between these two calculations is allocated to OCI. This results in a net reclassification adjustment of $79 (compared with the $100 AOCI balance at the beginning of 20X3) and $21 of tax expense “lodged” in OCI, as demonstrated below.
Debit |
Credit |
|
Realized loss – continuing operations |
$100 |
|
AOCI
|
$100 |
|
Income taxes payable or DTA |
$21 |
|
Current income tax benefit – continuing operations
|
$21 |
|
OCI – intraperiod tax allocation |
$21 |
|
DTA
|
$21 |
USA Corp must clear out the disproportionate tax effect since there is no longer any basis for an OCI balance. As a result, USA Corp clears the $21 debit to deferred tax expense in continuing operations.
Debit |
Credit |
|
Deferred tax expense – continuing operations |
$21 |
|
OCI – disproportionate tax effect
|
$21 |
In this scenario, USA Corp recognized in continuing operations a $100 pre-tax loss on the investment in 20X3, but since the $21 tax benefit was recognized in continuing operations in 20X2 when the valuation allowance was released, no net tax benefit was recorded in continuing operations (the $21 tax benefit on the current-year loss was offset by the clearing of the $21 amount that had been lodged in OCI). Because there is a $100 pre-tax loss recognized within continuing operations, with no net income tax benefit, the effective tax rate for USA Corp will be higher as a result.
Question TX 12-5 addresses when it would be appropriate to clear the disproportionate tax effect lodged in AOCI relating to pension and OPEB plans accounted for under ASC 715.
Question TX 12-5
When there is a disproportionate tax effect relating to pension and OPEB plans accounted for under ASC 715, Compensation, when would it be appropriate to clear the disproportionate tax effect lodged in AOCI?
When there is a disproportionate tax effect relating to pension and OPEB plans accounted for under ASC 715, Compensation, when would it be appropriate to clear the disproportionate tax effect lodged in AOCI?
PwC response
We believe that a disproportionate tax effect lodged in AOCI should be eliminated when the circumstances upon which it is premised cease to exist. As it relates to pension and OPEB plans, because the plan is what gives rise to the DTA, we believe that the disproportionate effect should not be cleared until the plan has been terminated. Because the unit of account is the pension or OPEB plan itself, we do not believe that a pro-rata approach to clearing the disproportionate effects related to an individual plan would be an appropriate alternative. For example, it would not be appropriate to clear the disproportionate effects as gains/losses and prior service costs/credits are amortized out of AOCI and into income.
Allocation of items of OCI in an outside basis temporary difference
As with other temporary differences, the allocation of deferred taxes between continuing operations and other items, such as OCI, must be considered with respect to deferred taxes provided by a parent or investor for the outside basis temporary difference.
Example TX 12-14 illustrates the measurement of an outside basis temporary difference in a partnership when the partnership has OCI.
EXAMPLE TX 12-14
Measurement of an outside basis temporary difference in a partnership when the partnership has OCI
Measurement of an outside basis temporary difference in a partnership when the partnership has OCI
USA Corp consolidates a partnership in which it owns a 70% interest. The remaining 30% partnership interest is owned by an unrelated party. In the current year, the partnership generates $100,000 of book income from continuing operations and $50,000 of OCI. The partnership’s taxable income for the current year is $80,000. In previous years, USA Corp has recorded a DTL for an excess book-over-tax basis in the partnership (outside basis difference). USA Corp’s applicable tax rate is 25%.
Does the outside book basis include USA Corp’s share of the partnership’s OCI? If so, what is the intraperiod allocation of any deferred tax expense related to USA Corp’s share of the partnership’s OCI?
Analysis
Yes. The investor’s financial reporting book basis of an investment in a partnership or a corporation encompasses the investor’s share of comprehensive income. This would occur whether the investor consolidates or applies the equity method of accounting. Therefore, USA Corp’s share of the partnership’s OCI is a part of the overall outside basis difference between book and tax, similar to any difference between its share of partnership book income and taxable income.
In this circumstance, USA Corp’s outside book basis would increase by 70% of consolidated partnership comprehensive income or $105,000 ($150,000 x 70%, the remaining partnership comprehensive income of $45,000 is attributable to the noncontrolling shareholder). Its outside tax basis would increase by 70% of partnership taxable income or $56,000. Accordingly, USA Corp has an additional outside basis taxable temporary difference of $49,000 (i.e., the excess of its share of comprehensive income over taxable income) and an additional DTL of $12,250. Consistent with ASC 740-20-45-11(b), USA Corp would recognize $8,750 of the deferred tax expense in OCI (i.e., its share of the partnership's OCI or $35,000 times 25%).
1 Refer to TX 12.4.2.2 for guidance related to outside basis differences in a discontinued operation.
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