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The first four examples of temporary differences in ASC 740-10-25-20 (reproduced in TX 3.2) result from items that are included within both pretax income and taxable income, but in different periods (for example, an asset is depreciated over a different period for book than for tax purposes). The remaining four examples illustrate other events that create book and tax basis differences.
Below are some examples of transactions or events that can result in temporary differences.

3.3.1 Temporary differences—business combinations

ASC 805-740 requires recognition of deferred taxes for temporary differences that arise from a business combination. The differences between the book bases (as determined under ASC 805, Business Combinations) and the tax bases (as determined under the tax law and considering ASC 740’s recognition and measurement model) of the assets acquired and liabilities assumed are temporary differences that result in deferred tax assets and liabilities. TX 10 discusses the accounting for deferred taxes in business combinations.

3.3.2 Temporary differences—indefinite-lived assets

Under ASC 740-10-25-20, recognition of deferred taxes assumes that the carrying value of an asset will be recovered through sale or depreciation. Thus, although indefinite-lived assets (e.g., land, indefinite-lived intangibles, and the portion of goodwill that is tax deductible) are not depreciated or amortized for book purposes, a deferred tax asset or liability is recognized for the difference between the book and tax basis of such assets. Though the tax effects may be delayed indefinitely, ASC 740-10-55-63 states that “deferred tax liabilities may not be eliminated or reduced because an entity may be able to delay the settlement of those liabilities by delaying the events that would cause taxable temporary differences to reverse.”
Refer to TX 4 for a discussion of the appropriate applicable tax rate to apply to temporary differences related to indefinite-lived assets and TX 5 for implications of taxable temporary differences related to indefinite-lived assets (so called “naked credits”) on the consideration of a valuation allowance for deferred tax assets.

3.3.3 Temporary differences—inflation indexation

Some foreign tax jurisdictions allow for the tax bases of assets and liabilities to be indexed to inflation rates for tax purposes. Assuming the functional currency of the entity in that jurisdiction is the local currency, for financial reporting purposes, the book bases of such assets do not change with inflation. Thus, when the tax bases are indexed for inflation, temporary differences arise as a result of the change in tax basis and those differences give rise to deferred taxes under ASC 740-10-25-20(g).
If, on the other hand, the jurisdiction in question is deemed to be hyperinflationary under ASC 830 and the functional currency is not the local currency, differences between the book and tax bases of assets can arise as a result of remeasuring the local currency assets into the functional currency using historical exchange rates. ASC 740-10-25-3(f) prohibits recognition of deferred taxes for temporary differences related to changes in exchange rates or indexing of nonmonetary assets and liabilities that, under ASC 830-10, are remeasured from the local currency into the functional currency using historical exchange rates (i.e., the functional currency is the reporting currency). Refer to TX 13 for additional guidance on foreign currency matters.

3.3.3.1 Temporary differences–UK buildings

Deferred tax accounting related to UK buildings is complicated because UK buildings, with a limited exception, are not depreciated for tax purposes, although the tax basis is deducted in determining the gain or loss upon disposal. This discussion does not apply to land, fixtures or other types of property, plant and equipment that are not subject to the unique rules applicable to office, industrial and agricultural buildings in the UK. The tax basis for determining the taxable gain is the original cost of the building indexed for inflation based on the relevant index published by the UK revenue authority. However, indexation cannot create or increase a capital loss. Therefore, the tax basis for determining any capital loss is limited to the original cost of the building.
Deferred tax assets recorded for UK office buildings may have two components. The first component arises from depreciation for book purposes that reduces the carrying amount of the asset when no depreciation is taken for tax purposes. A second component may arise if (a) a gain on disposal of the building is expected and (b) inflation indexation will reduce the gain on sale.
We believe there are two acceptable approaches to measuring that second component:
  • Alternative 1: estimate the selling price (fair market value) and the indexed tax basis as of the current balance sheet date
  • Alternative 2: estimate the selling price and the indexed tax basis of the building at the projected future date when the sale is expected to occur
Mechanically, the calculation of the gain or loss under the two alternatives is the same. The difference is the use of an estimated sale price and an indexed tax basis as of the current balance sheet date (alternative 1) versus an estimated sale price and indexed tax basis at a projected future date (alternative 2). While either of the two alternatives is acceptable, the remainder of this section focuses on alternative 1 because, in our experience, most companies employ this alternative in practice.
Example TX 3-2 demonstrates the analysis required to determine whether indexation provides an incremental tax benefit.
EXAMPLE TX 3-2
UK buildings — temporary differences
A UK office building is purchased in 2015 for £100. As of December 31, 2016, the book value of the building (net of accumulated depreciation) is £90. Based purely on a comparison of historical tax cost to the current book basis, there is a temporary difference at the balance sheet date of £10.
How would the reporting entity determine whether there is an incremental deductible temporary difference arising from inflation indexation following Alternative 1?
Analysis
The buyer would first need to determine whether indexing would be expected to provide incremental tax benefit. The following table shows the analysis at various assumed estimated selling prices (Row F) and assumed levels of indexation (Row D):
Scenario
1
2
3
A
Original tax basis (cost)
£100
£100
£100
B
Net book value (cost less depreciation)
90
90
90
C
Deductible temporary difference
10
10
10
D
Indexed tax basis (at the current balance sheet date)
105
105
140
E
Potential incremental temporary difference (D-A)
5
5
40
F
Projected selling price (at the current balance sheet date)
125
100
130
G
Gain / (loss) before indexing (F - A)
25
-
30
H
Gain with indexing [(F- D) ≥ 0]
20
-
-
I
Incremental temporary difference from indexing tax basis (E ≤ G)
5
-
30
J
Total deductible temporary difference (C + I)
15
10
40
Based on the above, the buyer would record an incremental deductible temporary difference arising from inflation indexation in scenarios 1 and 3, but would receive no incremental benefit from scenario 2.

In addition to that basic analysis, the use of indexation can create a deferred tax liability. If a company sells a building and reinvests the proceeds in a replacement building, which will also be used in the business, UK tax law provides a mechanism for any gain to be “rolled over” (i.e., as a reduction to the tax basis of the new building). As a result, a taxable temporary difference (the excess of cost (purchase price) of the new building over its tax basis which has been reduced by the ‘rolled-over’ gain) arises for the new building warranting recognition of a deferred tax liability. The temporary difference would generally reverse based on the future book depreciation of the new building.
For example, assume the sale of a building results in a £1 million gain for tax purposes. That gain is “rolled over” so that a replacement building purchased for £10 million has a tax basis of £9 million. For ASC 740 purposes, at the date of acquisition of the new building a taxable temporary difference of £1 million exists for which a deferred tax liability would be recognized. The underlying temporary difference would be expected to reverse over the period it will take for the book cost of £10 million to be depreciated to a net book value of £9 million.
A question may arise as to whether future indexation that is expected to provide incremental tax benefit should be considered in measuring the deferred tax liability. Under ASC 740, deferred taxes are measured based on temporary differences that exist at the balance sheet date. The tax basis of the asset is not increased until time passes and the actual inflation index is published. Therefore, we believe that the indexation for tax purposes, which is tied to future years’ inflation rates, should not be anticipated for purposes of reducing a deferred tax liability. Rather, the tax basis of the asset as of the balance sheet date is used to measure the temporary difference. The impact of indexation would be recognized in each future year when the annual inflation rate is determined.

3.3.4 Investment tax credits

An investment tax credit (ITC) is a tax credit tied to the acquisition of an asset and that reduces income taxes payable. An ITC usually relates to the acquisition of qualifying depreciable assets and is determined as a percentage of the cost of the asset. An ITC may also reduce the tax basis of the asset in some cases. Production tax credits, which vary in amount depending upon the output of the underlying assets, do not qualify as ITCs. Once an entity determines that a tax credit qualifies as an ITC, the ITC would be reflected in the financial statements (1) to the extent it has been used to reduce income taxes otherwise currently payable, or, (2) if an allowable carryforward is considered realizable under the provisions of ASC 740-10-30-18.
What differentiates an ITC from other income tax credits and from grants is not always easy to discern because they often share at least a few characteristics. Care should be taken in assessing whether a particular credit should be accounted for as an investment credit, another type of income tax credit, a non-income tax credit, or a government grant. Refer to TX 1 for a discussion of the determination of whether credits and other tax incentives should be accounted for under ASC 740.

3.3.4.1 Investment tax credits—accounting methods

ASC 740-10-25-46 provides two acceptable methods to account for ITCs:
  1. The “deferral” method, under which the tax benefit from an ITC is deferred and amortized over the book life of the related property.
  2. The “flow-through” method, under which the tax benefit from an ITC is recorded in the period that the credit is generated. The ITC is a current income tax benefit.
As specified in ASC 740-10-25-46, the deferral method is preferable, although both are acceptable. The use of either method is an accounting policy election that should be consistently applied.
When the deferral method is elected, the tax benefit from an ITC is typically recognized as a reduction in the book basis of the acquired asset and thereafter reflected in pretax income as a reduction of depreciation expense. Alternatively, a deferred credit can be recognized when the ITC is generated. The deferred credit would be amortized as a reduction to the income tax provision over the life of the qualifying asset. The presentation on the income statement under this approach is similar to the flow-through method in that the ITC benefit is reported within the income tax provision. However, unlike the flow-through method, which recognizes the full benefit of the ITC in the period it is generated, the income tax provision approach under the deferral method recognizes the benefit over time based on the productive life of the asset.
The application of either approach alternative under the deferral method represents an accounting policy election that should be consistently applied.

3.3.4.2 Investment tax credits–temporary differences

In accordance with ASC 740-10-25-20(e) and 25-20(f), a temporary difference may arise when accounting for an ITC if (a) the relevant tax law requires that the company reduce its tax basis in the property or (b) if use of the deferral method reduces the book basis in the underlying asset. Regardless of the method chosen to account for ITCs, we believe there are two acceptable approaches to account for the initial recognition of temporary differences between the book and tax bases of the asset:
  1. The “gross-up” method, under which deferred taxes related to the temporary difference are recorded as adjustments to the carrying value of the qualifying assets. The gross-up method requires the use of the simultaneous equations method to calculate the deferred tax to be recognized (see TX 10.7.2.1 or ASC 740-10-55-170 through ASC 740-10-55-182).
  2. The “income statement” method, under which deferred taxes related to the temporary difference are recorded in income tax expense.
The use of one of these accounting methods reflects a choice of accounting policy that should be consistently applied.
Example TX 3-3 and Example TX 3-4 illustrate application of various ITC methods.
EXAMPLE TX 3-3
Accounting for investment tax credits with no tax basis reduction
Company A is entitled to an ITC for 30% of the purchase price of certain qualifying assets. The ITC can be used to reduce the company’s income tax obligation in the year the assets are purchased. The tax law does not require a reduction to the tax basis of the qualifying assets. The applicable tax rate is 25%.
On January 1, 20X0, Company A purchases $100 of qualifying assets. The assets will be depreciated for both financial statement and tax purposes on a straight-line basis over a 5-year period. There are no uncertain tax positions relating to the ITC or tax depreciation.
How should Company A account for the ITC?
Analysis
The deferral method–reduction in book basis
Under the deferral method, the ITC ($30) is reflected as a reduction to income taxes payable and to the carrying value of the qualifying assets. Therefore, a deductible temporary difference arises since the recorded amount of the qualifying assets is $30 less than its tax basis. Company A can use either the gross-up or income statement method.
a. The gross-up method. Under the gross-up method, the recognition of the DTA related to the initial $30 deductible temporary difference would result in a further reduction in the recorded amount of the qualifying assets, which would, in turn, increase the deductible temporary difference related to the qualifying assets. To avoid this iterative process, the ultimate carrying amount of the asset and the ultimate DTA can be determined using simultaneous equations.
Using simultaneous equations yields a DTA of $10 and a corresponding reduction to the recorded amount of the qualifying assets of $10. Thus, the qualifying assets should be recorded at $60 ($100 purchase price less the $30 ITC and $10 DTA) together with a DTA of $10.
Simultaneous equations:
Equation A (determine final book basis (FBB) of equipment)
FBB – [Tax Rate × (FBB – Tax Basis)] = Initial Book Basis (IBB)
FBB – [(.25 × FBB) - (.25 × 100)] = 70
FBB - .25FBB + 25 = 70
.75FBB = 45
FBB = 60
Equation B (determine the deferred tax asset):
DTA = (Tax Basis – FBB) × Tax Rate
DTA = (100 – 60) × .25
DTA = 10
The simultaneous equations can be combined into the following formula:
The following journal entries would be recorded:
Dr. PP&E
$100
Cr. Cash
$100
To record the acquisition of the qualifying asset.
Dr. Income tax payable
$30
Cr. PP&E
$30
To record the generation of the ITC.
Dr. Deferred tax asset
$10
Cr. PP&E
$10
To record the deferred tax asset and corresponding reduction to the book basis of the PP&E based on the gross-up method.
In 20X0 and each of the subsequent four years, the following entries would be recorded:
Dr. Depreciation expense
$12
Cr. Accumulated depreciation
$12
To record depreciation of PP&E ($100 purchase price less ITC of $30 and deferred tax asset of $10 depreciable over 5 years).
Dr. Income tax payable
$5
Cr. Current tax expense
$5
To record the current tax benefit of depreciation for tax purposes ($20 annual depreciation expense @ 25% tax rate).
Dr. Deferred tax expense
$2
Cr. Deferred tax asset
$2
Annual entry to adjust the deferred tax asset based on the ending temporary difference between the book and tax bases of the asset arising from the difference in the annual depreciation charge for book and tax purposes ($8 tax-over-book depreciation @ 25% tax rate).
b. The income statement method. Under the income statement method, the recognition of the DTA related to the initial deductible temporary difference of $30 would result in the recognition of a $7.5 DTA and a corresponding benefit in the income tax provision. The following entries would be recorded:
Dr. PP&E
$100
Cr. Cash
$100
To record the acquisition of the qualifying asset.
Dr. Income tax payable
$30
Cr. PP&E
$30
To record the generation of the ITC.
Dr. Deferred tax asset
$7.5
Cr. Deferred tax expense
$7.5
To record the deferred tax benefit related to the ITC that will be recorded directly to the income statement ($30 temporary difference × 25% tax rate).
In 20X0 and each of the subsequent four years, the following entries would be recorded:
Dr. Depreciation expense
$14
Cr. Accumulated depreciation
$14
To record depreciation of PP&E ($100 purchase price less ITC of $30 depreciable over 5 years).
Dr. Income tax payable
$5
Cr. Current income tax expense
$5
To record current tax benefit of depreciation for tax purposes ($100 purchase price depreciable over 5 years @ 25% tax rate).
Dr. Deferred tax expense
$1.5
Cr. Deferred tax asset
$1.5
Annual entry to adjust the deferred tax asset based on the ending temporary difference between the book and tax bases of the asset arising from the difference in the annual depreciation charge for book and tax purposes ($6 tax-over-book depreciation @ 25% tax rate).
The flow-through method
Under the flow-through method, the ITC received ($30) would be reflected as a current income tax benefit. Under this approach, the recognition of the ITC would not affect the book basis of the qualifying assets and, therefore, no temporary difference arises at initial acquisition (i.e., the book basis equals the tax basis). The following journal entries would be recorded under the flow-through method:
Dr. PP&E
$100
Cr. Cash
$100
To record the acquisition of the qualifying asset.
Dr. Income tax payable
$30
Cr. Current income tax expense
$30
To record the generation of the ITC.
In 20X0 and each of the subsequent four years, the following entries would be recorded:
Dr. Depreciation expense
$20
Cr. Accumulated depreciation
$20
To record depreciation of PP&E ($100 purchase price depreciable over 5 years).
Dr. Income tax payable
$5
Cr. Current income tax expense
$5
To record current tax benefit of depreciation for tax purposes ($100 purchase price depreciable over 5 years @ 25% tax rate).
In this example, because the book and tax depreciation periods are the same (5 years), no temporary difference would arise in subsequent years (assuming there is no impairment).
EXAMPLE TX 3-4
Accounting for investment tax credits with tax basis reduction
Company A is entitled to an ITC for 30% of the purchase price of certain qualifying assets. The ITC can be used to reduce the company’s income tax obligation in the year the assets are purchased. The tax law requires that the tax basis of the qualifying assets be reduced by 50% of the ITC (e.g., a $30 ITC reduces the tax basis by $15). The applicable tax rate is 25%.
On January 1, 20X0, Company A purchases $100 of qualifying assets. The assets will be depreciated for both financial statement and tax purposes on a straight-line basis over a 5-year period. There are no uncertain tax positions relating to the ITC or tax depreciation.
How should Company A account for the ITC?
Analysis
The deferral method–reduction in book basis
Under the deferral method, the ITC ($30) is reflected as a reduction to income taxes payable and to the carrying value of the qualifying assets. Because the tax basis of the asset will only be reduced by 50% of the ITC a deductible temporary difference arises. The carrying amount of the qualifying assets will be reduced by the full amount of the ITC ($30), while the tax basis will be reduced by only 50% of the ITC ($15) resulting in a temporary difference of $15. Company A can use either the gross-up or income statement method to account for the temporary difference.
a. The gross-up method. Under the gross-up method, the recognition of the DTA related to the initial $15 deductible temporary difference results in a further reduction in the recorded amount of the qualifying assets, which would, in turn, increase the deductible temporary difference related to the qualifying assets. To avoid this iterative process, the ultimate carrying amount of the asset and the ultimate DTA can be determined using simultaneous equations.
In this example, the simultaneous equations method (illustrated in Example TX 3-3) yields a DTA of $5 and a corresponding reduction to the recorded amount of the qualifying assets. Thus, the qualifying assets should be recorded at $65 ($100 purchase price less the $30 ITC and $5 DTA) together with a DTA of $5.
The following journal entries would be recorded:
Dr. PP&E
$100
Cr. Cash
$100
To record the acquisition of the qualifying asset.
Dr. Income tax payable
$30
Cr. PP&E
$30
To record the generation of the ITC.
Dr. Deferred tax asset
$5
Cr. PP&E
$5
To record the deferred tax asset and corresponding reduction to the book basis of the PP&E based on the simultaneous equations.
In 20X0 and each of the subsequent four years, the following entries would be recorded:
Dr. Depreciation expense
$13
Cr. Accumulated depreciation
$13
To record depreciation of PP&E ($100 purchase price less ITC of $30 and deferred tax asset of $5 depreciable over 5 years).
Dr. Income tax payable
$4.3
Cr. Current tax expense
$4.3
To record the current tax benefit of depreciation $100 purchase price less $15 reduction in tax basis depreciable over 5 years @ 25% tax rate).
Dr. Deferred tax expense
$1
Cr. Deferred tax asset
$1
Annual entry to adjust the deferred tax asset based on the ending temporary difference between the book and tax bases arising from the difference in the annual depreciation charge for book and tax purposes ($4 tax-over-book depreciation @ 25% tax rate).
b. The income statement method. Under the income statement method, the recognition of the DTA related to the initial deductible temporary difference of $15 results in the recognition of a $3.8 DTA and a corresponding benefit in the income tax provision. Under the income statement method, the following entries would be recorded:
Dr. PP&E
$100
Cr. Cash
$100
To record the acquisition of the qualifying asset.
Dr. Income tax payable/cash
$30
Cr. PP&E
$30
To record the generation of the ITC.
Dr. Deferred tax asset
$3.8
Cr. Deferred tax expense
$3.8
To record the deferred tax benefit related to the ITC that will be recorded directly to the income statement ($15 temporary difference × 25% tax rate).
In 20X0 and each of the subsequent four years, the following entries would be recorded:
Dr. Depreciation expense
$14
Cr. Accumulated depreciation
$14
To record depreciation of PP&E ($100 purchase price less ITC of $30 depreciable over 5 years).
Dr. Income tax payable
$4.3
Cr. Current tax expense
$4.3
To record the current tax benefit of depreciation for tax purposes ($100 purchase price less $15 reduction in tax basis depreciable over 5 years @ 25% tax rate).
Dr. Deferred tax expense
$0.8
Cr. Deferred tax asset
$0.8
Annual entry to adjust the deferred tax asset based on the ending temporary difference between the book and tax bases of the asset arising from the difference in the annual depreciation charge for book and tax purposes ($3 tax-over-book depreciation @ 25% tax rate).
The flow-through method
Under the flow-through method, the ITC ($30) is reflected as a current income tax benefit. Under this approach, the recognition of the ITC does not affect the book basis of the qualifying assets. Therefore, the recorded amount of the qualifying assets remains at $100 while the tax basis is reduced to $85, resulting in a taxable temporary difference of $15. The accounting for this temporary difference depends on whether the company uses the gross-up or income statement method.
a. The gross-up method. Under the gross-up method, the recognition of the DTL related to the initial $15 taxable temporary difference results in a further increase in the recorded amount of the qualifying assets, which would, in turn, increase the taxable temporary difference related to the qualifying assets. To avoid this iterative process, the ultimate carrying amount of the asset and the ultimate DTA can be determined using simultaneous equations.
In this example, the simultaneous equations method (illustrated in Example TX 3-3) will result in recording a DTL of $5 and an increase in the qualifying asset of $5. Thus, the qualifying asset should be recorded at $105 ($100 purchase price plus the DTL of $5) together with a DTL of $5.
The following journal entries would be recorded:
Dr. PP&E
$100
Cr. Cash
$100
To record the acquisition of the qualifying asset.
Dr. Income tax payable
$30
Cr. Current tax expense
$30
To record the generation of the ITC.
Dr. PP&E
$5
Cr. Deferred tax liability
$5
To record the deferred tax liability and corresponding increase in the book basis of the PP&E based on the simultaneous equations.
In the subsequent years 20X0 through 20X4, the following entries would be recorded:
Dr. Depreciation expense
$21
Cr. Accumulated depreciation
$21
To record depreciation of PP&E ($100 purchase price plus deferred tax liability of $5 depreciable over 5 years).
Dr. Income tax payable
$4.3
Cr. Current tax expense
$4.3
To record the current tax benefit of depreciation for tax purposes ($100 purchase price less $15 reduction in tax basis depreciable over 5 years @ 25% tax rate).
Dr. Deferred tax liability
$1
Cr. Deferred tax expense
$1
Annual entry to adjust the deferred tax liability based on the ending temporary difference between the book and tax bases of the asset arising from the difference in the annual depreciation charge for book and tax purposes ($4 book-over-tax depreciation @ 25% tax rate).
b. The income statement method. Under the income statement method, the recognition of the DTL related to the initial taxable temporary difference of $15 results in the recognition of a $3.8 DTL and a corresponding expense in the income tax provision. Under the income statement method, the following journal entries would be recorded:
Dr. PP&E
$100
Cr. Cash
$100
To record the acquisition of the qualifying asset.
Dr. Income tax payable
$30
Cr. Current tax expense
$30
To record the generation of the ITC.
Dr. Deferred tax expense
$3.8
Cr. Deferred tax liability
$3.8
To record the deferred tax provision related to the ITC ($15 temporary difference @ 25% tax rate).
In the subsequent years 2010 through 2014, the following entries would be recorded:
Dr. Depreciation expense
$20
Cr. Accumulated depreciation
$20
To record depreciation of PP&E ($100 purchase price depreciable over 5 years).
Dr. Income tax payable/cash
$4.3
Cr. Current tax expense
$4.3
To record the current tax benefit of depreciation for tax purposes ($100 purchase price less $15 reduction in tax basis depreciable over 5 years @ 25% tax rate).
Dr. Deferred tax liability
$0.8
Cr. Deferred tax expense
$0.8
Annual entry to adjust the deferred tax asset based on the ending temporary difference between the book and tax bases of the asset arising from the difference in the annual depreciation charge for book and tax purposes ($3 book-over-tax depreciation @ 25% tax rate).

3.3.4.3 Investment tax credits related to equity method investments

There is no specific guidance on how to account for investment tax credits received in conjunction with an investment accounted for under the equity method. While the deferral approach (i.e., netting the credit against the carrying amount of the investment and amortizing the benefit of the credit against the earnings of the investment) is described only in terms of investments in depreciable property, we are aware that the deferral approach is being applied in practice to other types of assets by analogy. In these circumstances, it is important to understand the underlying nature of the credit, the conditions that generated the credit, and the manner of recovery. Also, it is important to discern whether the credit inures directly to the investor or is attributable to the investee.

3.3.4.4 Temporary differences–investment grants

Some governments may provide grants to subsidize investments in certain assets, the receipt of which neither depends on taxable income nor is subject to tax. However, those grants may affect the tax basis of the asset, in which case a temporary difference may arise.

3.3.5 Asset acquisitions–monetary exchanges

In a typical acquisition of an asset in a transaction involving a monetary exchange, the book and tax bases of the asset are equal to the monetary purchase price (historical cost). Therefore, there is generally no temporary difference or related deferred tax to record at the acquisition date.
Sometimes, a group of assets may be purchased in a transaction that is not accounted for as a business combination under ASC 805, usually because the group of assets does not meet the definition of a business. In those cases, a difference between the book and tax bases of the assets may arise. ASC 740-10-25-51 prohibits any immediate income tax expense or benefit from the recognition of those deferred taxes, and, instead, requires the use of simultaneous equations (see Example TX 3-3) to determine the assigned value of the asset and the related deferred tax asset or liability.
ASC 740-10-25-51 further provides that there may be instances when the simultaneous equations could, in theory, reduce the basis of an asset to less than zero. Under ASC 740, this is not allowed and instead, a deferred credit is generated. The deferred credit is not a temporary difference under ASC 740. The deferred credit is amortized to income tax expense in proportion to the utilization of the DTA arising from the realization of the tax benefits that gave rise to the deferred credit. Importantly, in the event that subsequent to the acquisition it becomes necessary to record a valuation allowance on the deferred tax asset, ASC 740-10-45-22 requires that the effect of such adjustment be recognized in continuing operations as part of income tax expense. ASC 740-10-45-22 further requires that a “proportionate share of any remaining unamortized deferred credit balance arising from the accounting shall be recognized as an offset to income tax expense. The deferred credit shall not be classified as part of deferred tax liabilities or as an offset to deferred tax assets.”
ASC 740-10-55-171 through ASC 740-10-55-191 provides examples of the accounting for asset acquisitions that are not accounted for as business combinations in the following circumstance:
  • The amount paid is less than the tax basis of the asset (Example 25 Case A).
  • The amount paid is more than the tax basis of the asset (Example 25 Case B).
  • The transaction results in a deferred credit (Example 25 Case C).
  • A deferred credit is created by the acquisition of a financial asset (Example 25 Case D).
In addition to acquiring other assets, an entity may purchase future tax benefits from a third party other than a government acting in its capacity as a taxing authority, such as NOLs. ASC 740-10-25-52 provides that the acquired tax benefits should be recorded using the simultaneous equation with no immediate impact to income tax expense or benefit. This is illustrated in Example 25, Case F, in ASC 740-10-55-199.
Conversely, according to ASC 740-10-25-53, "[t]ransactions directly between a taxpayer and a government (in its capacity as a taxing authority) shall be recorded directly in income (in a manner similar to the way in which an entity accounts for changes in tax laws, rates, or other tax elections under this Subtopic)."
Asset acquisitions may result in the recognition of a DTA that is not expected to be realized (i.e., a full valuation allowance is required). Accounting for the recognition of the valuation allowance in these cases may not be straight forward. Example TX 3-5 illustrates accounting for deferred tax valuation allowances in a purchase of assets.
EXAMPLE TX 3-5
Accounting for deferred tax valuation allowances in a purchase of assets
Company A purchases two assets from an unrelated third party in a transaction considered to be an asset acquisition (not a business combination). Total consideration is $8 million in cash. The assets acquired consist of (1) a 20% equity interest in an entity that will be accounted for using the equity method and (2) a marketing-rights intangible allowing Company A to market the products and services of the investee entity in certain territories. The intangible asset has an estimated economic life of five years. The tax rate is 25%.
Under ASC 805-50-30, the purchase price is allocated $6 million to the stock investment and $2 million to the intangible asset. For tax purposes, the $8 million purchase price is allocable in its entirety to the equity interest. The differences in purchase price allocation for book and tax creates two temporary differences: a deductible temporary difference of $2 million related to the equity method investment and a taxable temporary difference of $2 million related to the intangible asset.
Company A has determined that the ultimate manner of recovering its equity method investment is through disposal (i.e., dividends are not expected to be paid) and therefore the deductible temporary difference of $500,000 ($2,000,000 @25%) is expected to result in a capital loss. Company A has no other existing sources of capital gain income and, therefore, will need to recognize a valuation allowance against the DTA.
How should Company A account for the valuation allowance?
Analysis
The recognition of the valuation allowance would result in the immediate recognition of a deferred income tax expense, which appears to contradict the specific prohibition against immediate income statement recognition in ASC 740-10-25-51.
We believe the prohibition in ASC 740-10-25-51 extends to any valuation allowance related to deferred tax assets arising in the asset acquisition. As a result, the deferred tax asset of $500,000 would be recorded along with a valuation allowance, rather than using a simultaneous equation to calculate the deferred tax asset and a corresponding adjustment to the asset. As a result of recording the deferred tax asset and valuation allowance, there is no net impact on the provision.
The remaining deferred tax effect is the recognition of the deferred tax liability related to the marketing intangible. The calculation of the deferred tax liability will be through a simultaneous equation. Under the gross up approach, the recognition of the deferred tax liability related to the marketing intangible would, in turn, increase the book basis of the asset. As such, the amount of the deferred tax liability and adjustment to the carrying amount of the asset is determined by using a simultaneous equation:
In this example,
Thus, Company A would record the following journal entry:
Dr. Equity method investment
$6,000,000
Dr. Intangible asset – marketing rights
2,666,667
Dr. Deferred tax asset – equity method investment
500,000
Cr. Cash
$8,000,000
Cr. Deferred tax liability – marketing rights intangible
666,667
Cr. Deferred tax asset – valuation allowance
500,000

To record the asset acquisition and the related deferred taxes.

Figure PPE 2-1 compares accounting considerations for asset acquisitions and business combinations specific to a number of topics, including deferred taxes. Figure PPE 2-1 also addresses deferred taxes on in-process research and development for both asset acquisitions and business combinations.

3.3.6 Asset acquisitions—nonmonetary exchanges

Both the GAAP treatment and tax treatment of nonmonetary exchange transactions may differ from the corresponding treatment of monetary exchange transactions. In most cases, the GAAP accounting requires recognition of the assets acquired at their fair value, but in some cases they may be recorded at the cost of the asset surrendered. In some jurisdictions, the tax law allows the acquirer to essentially substitute the tax basis in the asset disposed for the asset received (e.g., a like-kind exchange). To the extent that the tax basis in the acquired asset differs from the new book basis, a temporary difference exists that gives rise to deferred taxes. In those circumstances, we believe that the recognition of deferred taxes should be reflected immediately in the income statement. The rationale for this view is that the basis difference does not arise from the initial recognition of the asset but, rather, because of the deferral of the tax on the asset disposal.
To the extent that the assets were recorded at carryover basis (instead of fair value) for book purposes, and, as a result, there was no gain or loss on the transaction, ASC 740-10-25-51 would apply, which requires the use of simultaneous equations to determine the value of the asset and the related deferred tax asset as described in Example TX 3-3.
Example TX 3-6 illustrates the income tax accounting for a tax-free exchange of nonmonetary assets.
EXAMPLE TX 3-6
Income tax accounting for a tax-free exchange of nonmonetary assets
Entity X acquires Asset B in exchange for Asset R. The fair value of Asset B is $150. Entity X’s carrying amount of Asset R prior to the exchange is $100 and its tax basis is $80. The tax rate is 25%. For tax purposes, the transaction is structured such that Entity X can defer the taxable gain (i.e., the fair value of Asset B of $150 less the basis of Asset R of $80) on the exchange. The tax basis in Asset R of $80 will become the tax basis in Asset B.
Assume that the nonmonetary exchange has commercial substance, and is not an exchange transaction to facilitate sales to customers. Therefore, the exchange is measured at fair value for book purposes.
How would Entity X record the exchange?
Analysis
Entity X would record a gain of $50 on disposal of Asset R based on the difference in the fair values of Asset B ($150) and the carrying amount of Asset R ($100) and a corresponding deferred tax provision of $12.5 ($50 × 25%) on the gain.
Entity X would record the following entries on the transaction date:
Dr. PP&E - Asset B
$150 
Dr. Income tax expense – deferred
$12.5
Cr. PP&E - Asset R
$100 
Cr. Gain on sale
$50 
Cr. Deferred tax liability
$12.5

Prior to the sale of the asset, Entity X had a deferred tax liability of $5 in connection with Asset R (carrying value of Asset R of $100 versus tax basis of $80 × 25%). The total deferred tax liability related to Asset B is $17.5 (($150 book basis – $80 tax basis) × 25% = $17.5). The $12.5 deferred provision above recognizes the increase in the deferred tax liability as a result of the recognition of the gain.

Figure PPE 2-1 compares accounting considerations for asset acquisitions and business combinations specific to a number of topics, including deferred taxes. Figure PPE 2-1 also addresses deferred taxes on in-process research and development for both asset acquisitions and business combinations.

3.3.7 Temporary differences when issuing financial instruments

Differences frequently arise between the financial reporting basis and the tax basis of an issuer’s financial instruments. These basis differences must be assessed to determine whether a temporary difference exists for which a deferred tax asset or liability should be provided. Often, the determination of whether a basis difference is a temporary difference will depend on the manner in which the instrument is expected to be settled and whether the settlement method is within the company’s control. Refer to TX 9 for further guidance and examples.

3.3.8 Low-income housing credits

Section 42 of the Internal Revenue Code provides a low-income housing credit (LIHC) to owners of qualified residential rental projects. The LIHC is generally available from the first year the building is placed in service and continues annually over a 10-year period, subject to continuing compliance with the qualified property rules. The LIHC is subject to annual limitations, and any unused portion of the credit can be carried forward for 20 years. An LIHC carryforward should be recognized as a deferred tax asset and evaluated for realization like any other deferred tax asset. The full amount of the aggregate LIHC that is potentially available over the 10-year period should not be included in the tax provision in the initial year that the credit becomes available because the entire amount of the credit has not been “earned.” Only the portion of the LIHC that is available to offset taxable income in each year should be included in the tax provision.
One of the more common structures in which LIHC arise is through an investment in a limited liability entity that invests in qualified residential projects. Typically, an investor will account for its interest using the equity method. As such, a question arises as to whether the pre-tax results of the limited liability entity’s activities should be presented separate from the tax benefits (LIHC) that are also passed through to the investor and usable on the investor’s tax return.
Under ASC 323-740-25-1, an investor may elect to account for the investment using the proportional amortization method assuming the following conditions are met:
a) It is probable that the tax credits allocable to the investor will be available.
b) The investor does not have the ability to exercise significant influence over the operating and financial policies of the limited liability entity.
c) Substantially all of the projected benefits are from tax credits and other tax benefits (for example, tax benefits generated from the operating losses of the investment).
d) The investor’s projected yield based solely on the cash flows from the tax credits and other tax benefits is positive.
e) The investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the investor’s liability is limited to its capital investment.
If the conditions are met and the proportional method is elected, investors would present the pretax effects and related tax benefits of such investments as a component of income taxes (“net” within income tax expense). If elected, the proportional amortization method must be applied as an accounting policy to all eligible investments in qualified affordable housing projects.
Investors that do not qualify for the proportional amortization method (or do not elect to apply it) would account for their investments under the equity method or cost method of accounting, and would report the pre-tax results of the investment in pre-tax income and the benefits from any LIHC that are passed through to them in their income tax provision.
The scope of ASC 323-740 is limited to investments in qualified affordable housing projects through limited liability entities that produce LIHCs and should not be applied by analogy when accounting for investments in other projects for which substantially all of the benefits come from other tax credits and other tax benefits. See ASC 323-740-S99-2.
It should be noted that the application of ASC 810, Consolidation, may impact the accounting for investments in entities that hold investments in LIHC projects because such entities may constitute variable interest entities. If an investor is required to consolidate the limited liability entity that manages or invests in qualified affordable housing projects, the proportional amortization method cannot be applied. Essentially, the investor would report the pre-tax results of the investment in pre-tax income and report the benefit from the LIHC in the tax provision on a current basis.
Prior to current guidance, an effective yield method was allowable in limited circumstances. Investors that were applying the effective yield method to investments held prior to adopting the current standard may continue to do so.
The proportional amortization method requires the initial cost of the investment (inclusive of unconditional future capital commitments) to be amortized in proportion to the tax benefits received over the period that the investor expects to receive the tax credits and other tax benefits. The amortization is determined as follows:
The computation will hold the initial investment balance constant each period (adjusted for any changes in the expected residual value). The amortization would be based on a percentage of total tax benefits received in a particular year (numerator) relative to the total tax benefits expected over the life of the investment (denominator).
ASC 323-740 is silent about the balance sheet classification of investments accounted for under the proportional amortization method. Investments in qualified affordable housing projects would not meet the definition of a deferred tax asset. These investments are neither the result of a difference between the tax basis and reported amount in the financial statements, nor are they analogous to a tax credit carryforward because the tax credits under the LIHC program are earned over time and, therefore, are not available at the time of initial investment.
ASC 323-740-55 contains detailed numerical examples of the different approaches to accounting for investments in LIHC. In the case of an investor applying the cost or equity method to the investment, deferred taxes may arise between the carrying amount of the investment and its related tax basis, which would give rise to deferred taxes independent of any deferred tax related to a carryforward of the credit. In the case of the proportional amortization method, however, the illustrations do not include a deferred tax asset or liability.
We believe that deferred taxes should not be recognized for an investment that is accounted for under the proportional amortization method. The investment itself essentially represents the collection of future tax credits and deductions, which are not subject to taxation. Thus, the reversal of any basis difference that exists while the investment is held for the purpose of receiving future tax benefits would not result in taxable or deductible amounts in future years. Recording deferred taxes in this case would effectively result in double counting because the investment is deemed to comprise almost exclusively future tax benefits (i.e., credits and tax deductions) that are not in turn subject to tax.
We believe that the treatment of deferred taxes are indirectly addressed in the examples. Deferred taxes were not provided in the proportional amortization method example, but were provided in the equity method and cost method examples. However, if an investor receives tax deductions in excess of the tax basis (i.e., negative tax basis) when applying the proportional amortization method, we would expect a deferred tax liability (or current tax liability) to be recognized for the potential “tax recapture” that will be imposed on the excess tax deductions.
If, however, the expected manner of recovering the investment was through a sale to a third party, we would expect deferred taxes to be recognized. In this case, the recovery of the asset for an amount different than the tax basis would trigger a tax consequence.

3.3.9 Global intangible low-taxed income (GILTI)

For tax years beginning after December 31, 2017, the 2017 US tax reform legislation introduces new provisions intended to prevent the erosion of the US tax base. This is achieved, in part, through US taxation of certain global intangible low-taxed income (GILTI). In short, GILTI inclusions will impact companies that have foreign earnings generated without a large aggregate foreign fixed asset base.
In considering the accounting for the impacts of GILTI, a question arises as to whether deferred taxes should be recognized for basis differences that are expected to reverse as GILTI in future years or if GILTI inclusions should be treated as period costs in each year incurred. Acknowledging the lack of specific guidance, the FASB staff concluded in their Q&A #5 that entities can apply either view as an accounting policy election. Companies will need to disclose their policy election. Measuring the impact of GILTI on deferreds introduces challenges that would not be present if treated as a period item. See TX 11.10.3 for a discussion on how to measure GILTI deferred taxes.
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