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Although most items fall within the definition of ordinary income, there are also items which should be excluded from the definition of ordinary income. In some cases, the standard is clear regarding items that should be excluded from the definition of ordinary income, and other times, judgment will be necessary.

16.3.1 Interim provision—significant unusual or infrequent items

ASC 740-270-30-12 provides guidance related to specific items that should be excluded from the annual effective tax rate calculation. In addition, ASC 270-10-45-11A states that “gains or losses from disposal of a component of a reporting entity, and unusual or infrequently occurring items shall not be prorated over the balance of the fiscal year.”

ASC 740-270-30-12

Taxes related to an employee share-based payment award within the scope of Topic 718 when the deduction for the award for tax purposes does not equal the cumulative compensation costs of the award recognized for financial reporting purposes, significant unusual or infrequently occurring items that will be reported separately or items that will be reported net of their related tax effect shall be excluded from the estimated annual effective tax rate calculation.

The definition of “ordinary income (or loss)” referred to in ASC 740-270-20 differentiates ordinary income from items that are unusual in nature or that occur infrequently.
An item does not need to be both unusual and infrequent to be excluded from the estimated annual effective tax rate calculation. Deciding whether an item is unusual or infrequent is an area of significant judgment, and a company’s business model or industry may be relevant to that evaluation. For example, catastrophe losses (e.g., losses resulting from natural disasters, such as hurricanes) are not unusual or infrequent for property and casualty insurance companies because those companies are in the business of insuring customers against those risks. However, the losses from a hurricane may well be unusual or infrequent for a manufacturing company with only one of its plants in a hurricane zone.
Example TX 16-1 illustrates the impact of goodwill impairment on an interim period tax provision.
EXAMPLE TX 16-1
Impact of goodwill impairment on interim period tax provisions
Company ABC recorded a financial statement impairment of goodwill during the second quarter.
Would the impairment of goodwill be considered an unusual or infrequent item that requires discrete treatment, or should it be considered a component of the estimated annual ETR?
Analysis
While judgment is necessary to determine whether a goodwill impairment should be classified as an unusual or infrequent item, in circumstances in which there has been no history of goodwill impairments and there is presently no reasonable expectation of significant goodwill impairments in the future, the tax effect of the impairment would typically qualify for discrete treatment in the period in which the impairment is recorded.
Example TX 16-2 compares the quarterly (and year-to-date) tax consequences of a restructuring charge that is classified as a discrete item to an item that is part of ordinary income.
EXAMPLE TX 16-2
The impact of including or excluding an item in the annual ETR
In the first quarter, Company ABC projected $165 of annual pre-tax book income and $190 of annual pre-tax book income adjusted for permanent items and an annual ETR of 28.8%. In the second quarter, Company ABC recorded a $50 restructuring charge. The restructuring had not been anticipated at the end of the first quarter. As a result, Company ABC now projects $115 of annual pre-tax book income and $140 of annual pre-tax book income adjusted for permanent items. The statutory tax rate for the jurisdiction is 25%.
What is the impact of the restructuring charge if it is classified as discrete item versus an item that is part of ordinary income?
Analysis
The following table illustrates the tax impact between the annual ETR including and excluding the restructuring charge:
Estimated Annual ETR (excluding restructuring charge)
Estimated Annual ETR (including restructuring charge)
Pre-tax book income (before restructuring)
$165.0
$165.0
Less:
Restructuring expense
(50.0)
Projected pre-tax book income (after restructuring)
$165.0
$115.0
Add back: Nondeductible meals & entertainment
25.0
25.0
Projected pre-tax income adjusted for permanent items
$190.0
$140.0
Statutory rate
25%
25%
Projected tax expense on pre-tax income plus permanent items
$47.5
$35.0
Estimated Annual ETR
28.8%
30.4%
Tax benefit from restructuring ($50.0 x 25%)
(12.5)
Projected tax expense for the year
$35.0
$35.0
Q1
Q2
Q3
Q4
Pre-tax book income (before restructuring)
$50.0
$30.0
$60.0
$25.0
Less: Restructuring expense in Q2
(50.0)
Pre-tax book income
$50.0
$(20.0)
$60.0
$25.0
Quarterly YTD tax expense if restructuring impairment is considered unusual or infrequent and the tax effects are reported entirely in Q2
$14.4
$(3.9)
$17.3
$7.2
Reported quarterly YTD ETR (discrete)
28.8%
19.5%
28.8%
28.8%
Reported year-to-date ETR (discrete)
28.8%
35.0%
30.1%
30.4%
Quarterly YTD tax expense if restructuring impairment is considered ordinary and the forecasted ETR is used for the remainder of the year)
$14.4
$(5.3)
$18.3
$7.6
Reported quarterly YTD effective rate (spread)
28.8%
26.4%
30.4%
30.4%
Reported year-to-date ETR (spread)
28.8%
30.4%
30.4%
30.4%

Example TX 16-3 illustrates the impact of a capital gain on an interim period tax provision.
EXAMPLE TX 16-3
Impact of capital gains on interim period tax provisions
Company ABC is a manufacturing company that invests excess funds in a portfolio of debt securities classified as available-for-sale securities under ASC 320, Investments - Debt and Equity Securities. The interest income generated from the portfolio has been consistent with management estimates since inception and is included in the development of Company ABC's annual ETR. The portfolio, by design, contains low-risk investments, and the company has typically held the debt securities to maturity and therefore experienced minimal capital gains or losses.
During the third quarter, there is significant appreciation in one of the debt securities and Company ABC realizes a capital gain when the security is unexpectedly redeemed by the issuer prior to maturity. This gain will allow utilization of historical capital loss carryforwards for which Company ABC had previously recorded a full valuation allowance.
Company ABC determined that the redemption and resulting capital gain were unusual and/or infrequent, given their history of holding debt securities to maturity and presented the item as a separate component of income from continuing operations.
Should the related tax effect be included or excluded from the estimated annual ETR calculation?
How should the benefit from the release of the valuation allowance on the historical capital loss carryforwards be reported?
Analysis
Because the redemption was deemed to be unusual and separately reported, Company ABC would not include the tax effect in the estimate of the ETR. Since the gain (which is treated discretely) is triggering the release of the valuation allowance, the release of the valuation allowance should also be recognized discretely in the period of the redemption.
Even if Company ABC determined that the redemption did not need to be separately reported, and was not significant or unusual, it would still need to consider whether an estimate could be made of capital gains for purposes of determining the ETR. In situations when capital gains and losses cannot be estimated, discrete treatment might be appropriate (see TX 16.5). However, in situations when an entity's business model and operations inherently include the generation of capital gains and losses, those expectations should be considered in determining the estimated annual ETR.

Example TX 16-4 illustrates the interim period accounting when a parent company plans to purchase the noncontrolling interest in a partnership.
EXAMPLE TX 16-4
Interim period accounting when a parent company plans to purchase the noncontrolling interest in a partnership
Company ABC consolidates a 60%-owned partnership (a flow-through entity for tax purposes) and is preparing its first quarter tax provision. Company ABC expects to purchase the 40% noncontrolling interest (NCI) in the third quarter of the current year. The timing and terms of the expected acquisition are established, and pursuant to Company ABC’s rights under the partnership agreement, Company ABC concludes that the transaction is primarily within its control. The purchase of the NCI will increase Company ABC’s estimated annual ETR because Company ABC currently consolidates the partnership (i.e., includes 100% of the partnership’s results in pre-tax income), but only recognizes the tax expense associated with 60% of the partnership’s income. The tax on the remaining 40% is the tax obligation of the noncontrolling interest holder and is not recognized in Company ABC's consolidated financial statements.
Should the anticipated third-quarter purchase of the NCI have an impact on Company ABC's ETR in the first quarter?
Analysis
The first hurdle is whether the anticipated acquisition of an ownership interest should ever be considered in the annual estimated ETR prior to consummation. In the case of most business acquisitions or dispositions between unrelated third parties, we believe those transactions should not be considered in the ETR until they occur. However, in light of the fact that the anticipated purchase of the noncontrolling interest in this fact pattern is primarily within Company ABC’s control, we believe it may be appropriate to consider including the transaction in the ETR. The second hurdle is whether Company ABC views the transaction as ordinary or not. If it is considered unusual/infrequent, it should be treated as discrete when the purchase of the NCI occurs. The nature of Company ABC’s business, their reasons for holding the partnership investment, and their relationship with the noncontrolling interest holder are all factors that Company ABC would consider in making that assessment.

16.3.2 Interim provision—discontinued operations

See ASC 205-20-45-1 for a discussion of what constitutes a discontinued operation. Under that guidance, the results of operations and the gain or loss from disposal of discontinued operations are presented net of tax and outside of continuing operations in the income statement. Pursuant to the guidance in ASC 740-270-30-12, items reported net of their related tax effect (e.g., discontinued operations) are excluded from the ETR calculation. The tax effect of the gain or loss from disposal of the discontinued operation should be recognized when it occurs under ASC 740-270-25-2.

16.3.3 Interim provision—change in accounting principle

The cumulative effect of a change in accounting principle is presented net of its related tax effects outside of continuing operations. Therefore, pursuant to the guidance in ASC 740-270-30-12, these changes and their related tax effects are excluded from the ETR calculation and should be recognized when they occur under ASC 740-270-25-2.

16.3.4 Interim provision—limited exceptions for other items

In general, ordinary income is defined broadly under ASC 740-270 such that most items will be considered part of the ETR calculation. However, there are a number of specific exceptions.

16.3.4.1 Interim provision—tax-exempt interest

Tax-exempt securities often form a portion of ordinary income of an entity that routinely invests in such securities and the related interest may be appropriately considered in the annual ETR calculation. However, it is also acceptable to exclude tax-exempt interest from the annual ETR calculation based on a specific discussion in the basis for conclusions in FASB Interpretation No. 18, Accounting for income taxes in interim periods, paragraph 80. The FASB acknowledged the then-common practice of excluding tax-exempt interest from the estimated annual ETR calculation and explicitly acknowledged their decision not to provide specific guidance on this issue.
Whichever approach is selected should be applied consistently.

16.3.4.2 Interim provision—investment tax credits

ASC 740-270-30-14 and ASC 740-270-30-15 provide guidance for the impact of investment tax credits (ITCs) on the estimated annual ETR. Whether investment tax credits are included or excluded in the ETR calculation depends, in part, on the accounting treatment selected for the credits—the flow-through method or the deferral method. As described in ASC 740-270-30-14, if the deferral method is elected, amortization of the deferred ITCs does not need to be considered in estimating the ETR. See TX 3 for additional guidance for the accounting for investment tax credits.

ASC 740-270-30-14

Certain investment tax credits may be excluded from the estimated annual effective tax rate. If an entity includes allowable investment tax credits as part of its provision for income taxes over the productive life of acquired property and not entirely in the year the property is placed in service, amortization of deferred investment tax credits need not be taken into account in estimating the annual effective tax rate; however, if the investment tax credits are taken into account in the estimated annual effective tax rate, the amount taken into account shall be the amount of amortization that is anticipated to be included in income in the current year (see ASC 740-10-25-46 and 740-10-45-28).

16.3.4.3 Interim provision—income from equity method investments

It is typically appropriate to record an investor’s equity in the net income of a 50% (or-less) owned investee on an after-tax basis (i.e., the investee would provide taxes in its financial statements based on its own estimated annual ETR calculation). It may be appropriate to exclude any incremental tax incurred at the investor level (e.g., the deferred tax liability for unremitted earnings) from the calculation of the investor’s overall ETR calculation. Instead, this incremental tax would be calculated based on a separate ETR calculation related to the investee (i.e., the amount of incremental tax expected to be incurred in the annual period divided by the estimated annual amount of equity method income). We are aware of diversity in practice in this area and, to the extent material, recommend disclosure of the selected method.

16.3.4.4 Interim provision—changes in uncertain tax positions

Pursuant to ASC 740-10-25-14 through ASC 740-10-25-15, the existence of new information that results in a change in judgment that causes subsequent recognition, derecognition, or a change in measurement of a tax position taken in a prior annual period is to be recognized as a discrete item (including interest and penalties) in the period in which the change occurs. For example, if an event during an interim period (e.g., a court case or tax ruling related to another taxpayer with a similar exposure) prompts a change in the assessment of the sustainability of a tax position taken in a prior year, the effect of the change should be recorded discretely in the period in which the assessment changes.
However, pursuant to ASC 740-270-35-6, if the event results in a change in the assessment with respect to a current-year tax position that is considered part of ordinary income, the new assessment should generally be incorporated into the revised ETR that will be applied to the year-to-date ordinary income. If the tax uncertainty relates to a pre-tax item that is accounted for discretely, such as discontinued operations, then the change in assessment would simply be part of the calculation of the tax effect of that item.

16.3.4.5 Interim provision—interest and penalties

ASC 740-10-25-56 requires accrual of interest on the liability for unrecognized tax benefits from the first period in which the interest would begin accruing according to the provisions of the relevant tax law. Therefore, interest expense should be accrued as incurred and should be excluded from the estimated annual ETR calculation. ASC 740-10-25-57 indicates that a penalty should be recorded when a tax position giving rise to a penalty is taken or anticipated to be taken on the tax return, or when the entity’s judgment about whether the position gives rise to a penalty changes. Therefore, penalties should also be accrued as incurred and should be excluded from the estimated annual ETR calculation. Interest and penalties should be accounted for discretely as they occur under ASC 740-270-25-2 since they are not related to ordinary income.

16.3.4.6 Interim provision—change in tax law or rate

ASC 740-270-25-5 through ASC 740-270-25-6 discuss when to recognize the effect of changes in tax laws.

ASC 740-270-25-5

The effects of new tax legislation shall not be recognized prior to enactment. The tax effect of a change in tax laws or rates on taxes currently payable or refundable for the current year shall be recorded after the effective dates prescribed in the statutes and reflected in the computation of the annual effective tax rate beginning in the first interim period that includes the enactment date of the new legislation. The effect of a change in tax laws or rates on a deferred tax liability or asset shall not be apportioned among interim periods through an adjustment of the annual effective tax rate.

ASC 740-270-25-6

The tax effect of a change in tax laws or rates on taxes payable or refundable for a prior year shall be recognized as of the enactment date of the change as tax expense (benefit) for the current year. See Example 6 (paragraph 740-270-55-44) for illustrations of accounting for changes caused by new tax legislation.

In accordance with ASC 740-270-25-5 through ASC 740-270-25-6, adjustments to deferred tax assets and liabilities as a result of a change in tax law or rates should be accounted for discretely in continuing operations at the date of enactment. Similarly, the effects of a retroactive change in tax rates should be accounted for discretely in continuing operations in the interim period in which the law is enacted. However, the prospective effects of a change in tax law or rates on tax expense for the year of enactment should be reflected in the estimated annual ETR calculation. See TX 7.4 (including Example TX 7-2) for more information on the accounting for changes in tax law.

16.3.4.7 Interim provision—change in tax status

As specified in ASC 740-10-25-32 through ASC 740-10-25-34, the effect of a voluntary change in tax status should be recognized discretely on (1) the date that approval is granted by the taxing authority or (2) the filing date, if approval is unnecessary. The entire effect of a change in tax status should be recorded in continuing operations in accordance with ASC 740-10-45-19. TX 8 offers more information on the accounting for changes in tax status.

16.3.4.8 Interim provision—change in valuation allowance

The need for a valuation allowance must be reassessed at each interim reporting date. Under the guidance in ASC 740-270-25-4 and depending on the circumstances that lead to a change in valuation allowance, the change may be reflected in the estimated annual ETR or recognized discretely in the interim period during which the change in judgment occurred, or both.

ASC 740-270-25-4

The tax benefit of an operating loss carryforward from prior years shall be included in the effective tax rate computation if the tax benefit is expected to be realized as a result of ordinary income in the current year. Otherwise, the tax benefit shall be recognized in the manner described in paragraph 740-270-45-4 in each interim period to the extent that income in the period and for the year to date is available to offset the operating loss carryforward or, in the case of a change in judgment about realizability of the related deferred tax asset in future years, the effect shall be recognized in the interim period in which the change occurs.

ASC 740-270-45-4

Paragraph 740-20-45-3 requires that the manner of reporting the tax benefit of an operating loss carryforward recognized in a subsequent year generally is determined by the source of the income in that year and not by the source of the operating loss carryforward or the source of expected future income that will result in realization of a deferred tax asset for the operating loss carryforward. The tax benefit is allocated first to reduce tax expense from continuing operations to zero with any excess allocated to the other source(s) of income that provides the means of realization, for example, discontinued operations, other comprehensive income, and so forth. That requirement also pertains to reporting the tax benefit of an operating loss carryforward in interim periods.

As prescribed by ASC 740-270-25-7, the interim accounting for the effect of a change in the beginning-of-the-year balance of a valuation allowance will depend on whether the change is being driven by income in future years or the current year.

ASC 740-270-25-7

The effect of a change in the beginning-of-the-year balance of a valuation allowance as a result of a change in judgment about the realizability of the related deferred tax asset in future years shall not be apportioned among interim periods through an adjustment of the effective tax rate but shall be recognized in the interim period in which the change occurs.

Under ASC 740, companies should include the changes in valuation allowance in determining the ETR for the year when the change relates to deductible temporary differences and carryforwards expected to originate during the current year as well as decreases to the valuation allowance associated with current year income (refer to Example TX 16-5 for further details). If there is a reduction in the valuation allowance for beginning-of-year deferred tax assets that results from income other than ordinary income (e.g., discontinued operations), the benefit should be reflected discretely in year-to-date results (presuming, of course, that current-year continuing operations and projections of future income could not have supported the realization).

Example TX 16-5 illustrates a change in the assessment of the realizability of beginning-of-year deferred tax assets as a result of changes in projections of future income.
EXAMPLE TX 16-5
Change in assessment of the realizability of beginning-of-year deferred tax assets as a result of changes in projections of future income
At the end of the second quarter, a company determines that future taxable income for the current year and for future years will be higher than estimated at the end of the previous year due to an increase in sales orders. This will permit a decrease in the valuation allowance against deferred tax assets related to NOL carryforwards that existed at the beginning of the year.
The company had $3,000,000 of NOL carryforwards available at the beginning of the year. At that time, the enacted tax rate was 33.5%. Management maintained a valuation allowance of $1,005,000 for the full amount of the deferred tax asset related to the NOL carryforward at the end of the prior year. Although the company broke even for the first three months of the current year, a second quarter increase in net income and sales orders has prompted the company to (1) revise its estimate of current-year income from zero to $200,000 and (2) change the expectation regarding income in future years to be sufficient to allow recognition of the entire deferred tax asset. This will permit a full reversal of the valuation allowance for NOL carryforwards that existed at the beginning of the year.
Should this change in judgment be recorded as a discrete event that is accounted for in the second quarter, or should the change be allocated to subsequent interim periods as part of the estimated annual ETR calculation?
Analysis
The decrease in the valuation allowance is the result of a change in judgment about income in both the current and future periods. Thus, the release of the valuation allowance has two components: (1) the portion related to a change in estimate regarding current-year income and (2) the portion related to a change in estimate about future years’ income.
The first component is recognized in income by adjusting the estimated annual ETR for the current year (i.e., the reduction in the valuation allowance is spread over the current year-to-date results and subsequent quarters through the revised ETR). The second component is recognized entirely in the second quarter as a discrete item.
As a result of revising the estimate of future profitability at the end of the second quarter, the company calculates current-year income taxes as follows:
Estimated full-year pre-tax income
$200,000
Tax expense:
Tax on current-year income at 33.5%
67,000
Reversal of valuation allowance related to current year income
(67,000)
Total current tax
$—
Estimated ETR at end of second quarter [$0 / $200,000]
0.0%
Reversal of valuation allowance based on future years’ income
($1,005,000 less $67,000 current year portion)
(938,000)
Total tax provision (benefit)
(938,000)
Net income
$1,138,000

The $938,000 valuation allowance release attributable to future years' income would be accounted for as a discrete event in the second quarter.
The tax benefit associated with the income from the current year would be incorporated into the annual ETR calculation and would offset the current tax expense on the income generated during the current year resulting in a 0.0% ETR for the six-month period. At the end of the year, assuming no other temporary differences arising during the year, the deferred tax asset account would have a balance of $938,000, and there would be no valuation allowance. The following is a summary of activity by quarter, which demonstrates the release of the valuation allowance.
Tax (or benefit)
Reporting period
Quarterly income/
(loss)
Year-to-date income/
(loss)
Est. annual effective tax rate
Year-to-date
Less previously provided
Reporting period amount
ETR
Discrete
First quarter
$ —
$ —
0.0%
$ —
$ —
$ —
$ —
Second quarter
50,000
50,000
0.0%
$(938,000)
(938,000)
Third quarter
50,000
100,000
0.0%
(938,000)
(938,000)
Fourth quarter
100,000
200,000
0.0%
(938,000)
(938,000)
Fiscal year
$200,000
$(938,000)

The 0.0% ETR consists of the current tax provision of $67,000 on the current year income of $200,000, fully offset by the deferred tax benefit of the corresponding release of the valuation allowance.
If, in the third quarter, Company A revises its forecast of current year ordinary income to $500,000, the annual ETR remains zero (because there is sufficient NOL to shelter current year ordinary income). Company A would record a discrete period adjustment in the third quarter to reflect the effect of the change to the amount expected to reverse in future years. This would effectively reverse a portion of the discrete period benefit recognized in an earlier interim period because more of the valuation allowance reversal is being attributed to current year earnings.

16.3.4.9 Interim provision—indefinite reinvestment assertion

A company may change its intentions or the facts and circumstances may change, which may impact whether it will indefinitely reinvest undistributed earnings of foreign subsidiaries, or of corporate joint ventures that are essentially permanent in duration, and thus whether deferred taxes need to be recognized. In these situations, the tax effect of the change in judgment for the establishment (or reversal) of the deferred tax liability related to an outside basis difference that had accumulated as of the beginning of the year should be excluded from the annual ETR calculation and recognized in the interim period during which the intention or assertion changes.
The tax effect of a change in intention or assertion related to earnings (ordinary income) generated during the current year should be included in the company’s estimated annual ETR calculation.

16.3.4.10 Change in estimate related to prior-year tax provision

As discussed in TX 16.2, the language in ASC 740-270-25-2 provides that the estimated annual ETR approach should only be used to record the tax effect of ordinary income for the current period. A change in estimate in the current year that is related to a prior-year tax provision does not constitute a tax effect of current-year income. Therefore, the effects of this type of change should be recorded discretely in the interim period during which the change in estimate occurs. TX 6.3 presents guidance for determining whether a change in the prior-year tax provision is an error or a change in estimate.
1 Calculated as pre-tax income x annual ETR (Quarterly pre-tax book income x 28.8%)
2 Calculated as pre-tax income x annual ETR plus discrete adjustment ($30 x 28.8%) + (($50) x 25%)
4 Reported ETR is the rate derived from taking the reported total tax provision divided by pre-tax book income (i.e., the rate implied from the reported financial statements).
3 Calculated as pre-tax income x annual ETR plus catch up from Q1 change in AETR ($50 x (28.8% - 30.4%)+(($20) x 30.4%)
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