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1.2 Entities and taxes covered by ASC 740
Publication date: 30 Oct 2021 (updated 31 Dec 2022)
us Income taxes guide 1.2
As discussed in ASC 740-10-15-2, ASC 740’s principles and requirements apply to domestic and foreign entities, including not-for-profit (NFP) entities with activities that are subject to income taxes, and applies to federal, state, local (including some franchise), and foreign taxes based on income.
The guidance in the Income Taxes Topic applies to:
- Domestic federal (national) income taxes (U.S. federal income taxes for U.S. entities) and foreign, state and local (including franchise) taxes based on income.
- An entity’s domestic and foreign operations that are consolidated, combined, or accounted for by the equity method.
ASC 740 applies to all entities that are part of a reporting entity of a reporting entity and are subject to tax. It is necessary, therefore, to consider the tax impact of all entities that impact the reporting entity (e.g., equity-method investees, consolidated or combined entities under common control, variable interest entities consolidated under ASC 810 Consolidation).
1.2.1 Non-income-based taxes
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. This guidance removes certain exceptions to the general principles of ASC 740 and simplifies several other areas. ASU 2019-12 is effective for public business entities for annual reporting periods beginning after December 15, 2020, and interim periods within those reporting periods. For all other entities, it is effective for annual periods beginning after December 15, 2021, and interim periods within annual periods beginning after December 15, 2022. Early adoption is permitted in any interim or annual period. If a reporting entity chooses to early adopt, it must adopt all changes as a result of the ASU. The transition provisions vary by amendment.
If a tax system is based on the greater of an income-based calculation and a non-income-based calculation, ASU 2019-12 requires the amount of tax that is based on income to be accounted for under ASC 740 as an income-based tax, with any incremental amount accounted for as a non-income-based tax (i.e., “above the line”) recognized entirely in the period incurred. This amendment should be applied on either a retrospective basis for all periods presented or a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. See TX 1.2.1.1 for applicable guidance after adoption of ASU 2019-12 and TX 1.2.1.1A for applicable guidance before adoption of ASU 2019-12.
1.2.1.1 Non-income-based taxes (after adoption of ASU 2019-12)
ASC 740 does not apply to franchise (or similar) taxes based on capital or a non-income-based amount as long as there is no aspect of the tax based on income. If a franchise tax is partially based on income, it is subject to accounting in accordance with ASC 740.
Withholding taxes that a reporting entity pays to the tax authority on behalf of its shareholders are also outside of the scope of ASC 740.
Excerpt from ASC 740-10-15-4
The guidance in this Topic does not apply to the following transactions and activities:
- A franchise tax (or similar tax) to the extent it is based on capital or a non-income-based amount and there is no portion of the tax based on income. If a franchise tax (or similar tax) is partially based on income (for example, an entity pays the greater of an income-based tax and a non-income based tax), deferred tax assets and liabilities shall be recognized and accounted for accordance with this Topic. Deferred tax assets and liabilities shall be measured using the applicable statutory income tax rate. An entity shall not consider the effect of potentially paying a non-income-based tax in future years when evaluating the realizability of its deferred tax assets. The amount of current tax expense equal to the amount that is based on income shall be accounted for in accordance with this Topic, with any incremental amount incurred accounted for as a non-income-based tax. See Example 17 (paragraph 740-10-55-139) for an example of how to apply this guidance.
- A withholding tax for the benefit of the recipients of a dividend. A tax that is assessed on an entity based on dividends distributed is, in effect, a withholding tax for the benefit of recipients of the dividend and is not an income tax if both of the following conditions are met:
- The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does not reduce future income taxes the entity would otherwise pay.
- Shareholders receiving the dividend are entitled to a tax credit at least equal to the tax paid by the entity and that credit is realizable either as a refund or as a reduction of taxes otherwise due, regardless of the tax status of the shareholders.
Greater of an income-based or non-income-based tax computation (after adoption of ASU 2019-12)
Taxes based on capital or other non-income-based amounts are explicitly scoped out of ASC 740. However, certain jurisdictions (including several states in the US) impose a tax that is computed as the greater of a tax based on income or a tax based on capital or other non-income-based amounts. These are sometimes referred to as franchise taxes. As discussed in ASC 740-10-15-4, the amount of tax that is based on income (without regard to the amount that is based on capital or the non-income-based amount) is accounted for under ASC 740 as an income-based tax. If the tax based on capital or non-income-based amount is greater than the tax based on income, the incremental amount should be accounted for as a non-income-based tax and recognized as a pre-tax expense in the period incurred. ASC 740-10-55-139 through ASC 740-10-55-144 contains an example of the calculation.
Further, deferred tax assets and liabilities should be measured using the applicable statutory income tax rate when associated with an income based taxed. However, under ASC 740-10-15-4 it is not necessary to consider whether the income-based tax or non-income-based tax is expected to be greater in years that temporary differences will reverse for purposes of assessing deferred tax assets for realizability. In other words, even if a temporary difference reverses in a year that the entity expects to be subject to a greater non-income-based tax and, therefore, the reversal would reduce that non-income based tax, that fact should not be considered when assessing the realizability of deferred tax assets.
1.2.1.1 A Non-income-based taxes (before adoption of ASU 2019-12)
ASC 740 does not apply to franchise taxes (or similar) based on capital or a non-income-based amount as long as there is no aspect of the tax based on income. It also does not apply to withholding taxes that an entity pays to the tax authority on behalf of its shareholders.
The guidance in this Topic does not apply to the following transactions and activities:
- A franchise tax to the extent it is based on capital and there is no additional tax based on income. If there is an additional tax based on income, that excess is considered an income tax and is subject to the guidance in this Topic. See Example 17 (paragraph 740-10-55-139) for an example of the determination of whether a franchise tax is an income tax.
- A withholding tax for the benefit of the recipients of a dividend. A tax that is assessed on an entity based on dividends distributed is, in effect, a withholding tax for the benefit of recipients of the dividend and is not an income tax if both of the following conditions are met:
- The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does not reduce future income taxes the entity would otherwise pay.
- Shareholders receiving the dividend are entitled to a tax credit at least equal to the tax paid by the entity and that credit is realizable either as a refund or as a reduction of taxes otherwise due, regardless of the tax status of the shareholders.
Greater of an income-based or non-income-based tax computation (before adoption of ASU 2019-12)
Taxes based on capital are explicitly scoped out of ASC 740. However, certain jurisdictions (including several states in the US) impose a tax that is computed as the greater of a tax based on income or a tax based on capital. These are sometimes referred to as franchise taxes. As discussed in ASC 740-10-15-4, taxes based on income in excess of the tax based on capital are subject to ASC 740. ASC 740-10-55-139 through ASC 740-10-55-144 contains an example of the calculation. If either of the taxes being compared is considered a tax based on income, the entity would need to develop an expectation of what portion of the tax in future periods represents the income-based portion and recognize deferred taxes on that portion.
In such circumstances, there is the question of how ASC 740 should be applied in determining the applicable tax rate used to compute deferred tax assets and deferred tax liabilities for temporary differences and carryforwards. We infer from ASC 740-10-55-144 that these tax regimes effectively operate as graduated rate systems, in which the total computed tax is an income tax only to the extent that the tax exceeds the non-income-based tax in a given year. Accordingly, assuming that the statute prescribes a single tax rate for the income-based calculation, the tax rate would be zero if the income-based tax calculation equals the non-income-based computation. Any additional taxable income would be taxed at the tax rate prescribed in the statute.
When graduated rates are a significant factor, the applicable rate is the average rate that is expected to be applicable to the amount of estimated taxable income in the reversal years. See additional discussion in TX 4.3.1.
New guidance
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. If a tax system is based on the greater of an income-based calculation and a non-income-based calculation, ASU 2019-12 requires the amount of tax that is based on income to be accounted for under ASC 740 as an income-based tax, with any incremental amount accounted for as a non-income-based tax (i.e., “above the line”) recognized entirely in the period incurred. See TX 1.2.1 and TX 1.2.1.1 for additional information on ASU 2019-12, including effective dates and transition requirements, and post-adoption guidance.
1.2.2 Withholding taxes—entities that pay dividends
ASC 740-10-15-4 indicates that a withholding tax for the benefit of the recipients of a dividend is not an income tax of the entity that pays the dividend if certain conditions are met. We believe that this guidance would also apply to withholding taxes for the benefit of the recipients of interest, royalty, or other payments if those same conditions are satisfied.
1.2.3 Withholding taxes—entities that receive dividends
Reporting entities that have taxes withheld by another entity from dividends, interest, royalties or other income on their behalf must determine whether such withholding taxes are income taxes that must be accounted for in accordance with ASC 740.
In many cases, withholding taxes will be deemed to be income taxes of the entity that receives the dividends, interest, royalties or other income. Withholding taxes are typically considered under local country laws, together with respective tax treaties, to be prepayments of (or in lieu of) local income taxes. In other words, the withholding taxes are essentially a substitute for a complete income tax calculation because the recipient of the payment (against which the tax is withheld) is outside the country and may not otherwise be required to file a local income tax return. If the company that received the dividends, interest, royalties or other income were to file an income tax return in the local jurisdiction, it would be able to claim the withholdings as a prepayment of its income taxes otherwise due in that jurisdiction. For US-based entities, such withholding taxes may generate foreign tax credits, and thus directly interact with the recipient entity’s US income tax computation. While the withholding taxes may be creditable against the US income tax liability, this alone does not determine if the withholding tax is an income tax that is within the scope of ASC 740. In situations in which a payor has not withheld taxes and the withholding tax would have qualified as an income tax, and the company does not record a tax liability, ASC 740’s requirements for the accounting for uncertain tax positions should be considered.
1.2.4 Credits and other tax incentives
Certain expenditures may generate credits or other tax incentives under various governmental programs. These programs take many forms, including programs related to research and development, alternative fuels, renewable energy, and emissions allowances. These programs are often designed to foster infrastructure, research, and other targeted business investment. In some cases, these credits and incentives are transferrable or refundable.
While credits and incentives often arise in the tax laws and may be claimed on a tax return, they may not be subject to ASC 740. A number of features can make them more akin to a government grant or subsidy. Therefore, each credit and incentive must be carefully analyzed to determine whether it should be accounted for under ASC 740, whether in substance it constitutes a government grant, or whether another accounting framework may apply..
The application of income tax accounting is warranted if a particular credit or incentive can be claimed only on the income tax return and can be realized only through the existence of taxable income. When there is no connection to income taxes payable or taxable income and when the credits are refundable regardless of whether an entity has an income tax liability, we believe the benefit should be accounted for outside of the income tax model and presented within pre-tax income.
Some credits or other tax incentives may be refundable either through the income tax return or in some other manner (e.g., direct cash received from the government) at the option of the taxpayer. In the case of a refundable credit, regardless of the method a reporting entity chooses to monetize the benefit, the accounting would be outside the scope of ASC 740 if the monetization of the credit does not have a direct linkage to a reporting entity’s income tax liability. This would apply to credits with a “direct-pay” option (wherein an eligible entity can elect to treat the amount of the credit as a payment of tax) even if there are other options to monetize (e.g., the ability to transfer or sell the credit to a third party). There may be some exceptions. For example, if the method of monetizing the benefits could result in significantly different taxation of the benefit, it may be that the method of monetization will impact the accounting for these benefits. If, for example, a company will be taxed by a jurisdiction if they claim a refund for the credit but not taxed if they reflect the credit through the income tax return, it may be appropriate to reflect the credit in accordance with ASC 740 if the impact of the incremental tax would be significant and therefore the company intends to reflect the credit on the income tax return.
On August 16, 2022, the Inflation Reduction Act (IRA) was signed into law. The IRA includes significant extensions, expansions, and enhancements of numerous energy-related tax credits and also creates new credits in multiple categories. The law provides an election to transfer (i.e., sell) certain credits to another taxpayer. The transfer may be for all or a portion of a credit, but any credit may only be transferred once. The transferee only has the option to use the credit against their income tax liability. The cash received in exchange for the credits transferred is not includable in taxable income of the transferor nor deductible to the transferee.
ASC 740 does not directly address how to account for nonrefundable transferable credits that may be used by a reporting entity as a reduction of income tax payable on its income tax return or that may be sold to another taxpayer. As it relates to the specific credit transferability provisions introduced by the IRA, we understand that the FASB staff believes it is most appropriate to account for such credits as part of the provision for income taxes under ASC 740, regardless of whether the reporting entity that receives the credit claims the credit on its tax return or if that entity sells the credit to another taxpayer. The FASB staff further believes that if a credit is sold, it is most appropriate for any difference between the notional amount of the credit originally received and the proceeds from sale to be recorded in the income tax provision. Because there is no directly applicable GAAP, the FASB staff acknowledges that other views may be acceptable, such as accounting for transferable credits similar to refundable or direct-pay credits by accounting for the entire credit outside of the tax line.
If a reporting entity accounts for transferable credits, including any difference between the proceeds and the notional value of the credits, as part of the income tax provision, it would be appropriate for the reporting entity to consider any expected sale of the credits as a source of realization in its valuation allowance assessment.
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