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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 examples illustrate other events that create book and tax basis differences.
TX 3.3.1 through TX 3.3.7 include examples of transactions or events that can result in temporary differences for both categories noted above.

3.3.1 Temporary differences—business combinations

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

3.3.2 Temporary differences—indefinite-lived assets

Under ASC 740-10-25-20, recognition of deferred taxes assumes that the carrying value of an asset will be recovered through sale or depreciation. Thus, although indefinite-lived assets (e.g., land, indefinite-lived intangibles, and the portion of goodwill that is tax deductible) are not depreciated or amortized for book purposes, a deferred tax asset or liability is recognized for the difference between the book and tax basis of such assets as long the basis of the asset is deductible or taxable in the future. Though the tax effects may be delayed indefinitely, ASC 740-10-55-63 states that “deferred tax liabilities may not be eliminated or reduced because a reporting entity may be able to delay the settlement of those liabilities by delaying the events that would cause taxable temporary differences to reverse.”
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 valuation allowance assessments.

3.3.3 Temporary differences—inflation indexation

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

3.3.4 Share based compensation

Under ASC 718, Compensation–Stock compensation, the difference between the expense recognized for financial reporting purposes and the deduction taken on the tax return is also considered to be a temporary difference for which a deferred tax asset is recognized. Refer to TX 17 for guidance on how ASC 740 applies to stock-based compensation.

3.3.5 Investment tax credits

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

3.3.5.1 Investment tax credits–accounting methods

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

3.3.5.2 Investment tax credits–temporary differences

In accordance with ASC 740-10-25-20(e) and 25-20(f), a temporary difference may arise when accounting for an ITC if (a) the relevant tax law requires that the reporting entity reduce its tax basis in the property or (b) if use of the deferral method reduces the book basis in the underlying asset. Regardless of the method chosen to account for ITCs, we believe there are two acceptable approaches to account for the initial recognition of temporary differences between the book and tax bases of the asset:
  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 10.8.2.1 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 3-1 and Example TX 3-2 illustrate application of various ITC methods.
EXAMPLE TX 3-1
Accounting for investment tax credits with no tax basis reduction
Company A is entitled to an ITC for 30% of the purchase price of certain qualifying assets. The ITC can be used to reduce the company’s income tax obligation in the year the assets are purchased. The tax law does not require a reduction to the tax basis of the qualifying assets. The applicable tax rate is 25%.
On January 1, 20X1, Company A purchases $100 of qualifying assets. The assets will be depreciated for both financial statement and tax purposes on a straight-line basis over a 5-year period. There are no uncertain tax positions relating to the ITC or tax depreciation.
How should Company A account for the ITC?
Analysis
The deferral method–reduction in book basis
Under the deferral method, the ITC ($30) is reflected as a reduction to income taxes payable and to the carrying value of the qualifying assets. Therefore, a deductible temporary difference arises since the recorded amount of the qualifying assets is $30 less than its tax basis. Company A can use either the gross-up or income statement method to account for the initial recognition of the temporary difference.
  1. The gross-up method. Under the gross-up method, the recognition of the DTA related to the initial $30 deductible temporary difference would result in a further reduction in the recorded amount of the qualifying assets, which would, in turn, increase the deductible temporary difference related to the qualifying assets. To avoid this iterative process, the ultimate carrying amount of the asset and the ultimate DTA can be determined using simultaneous equations.

    Using simultaneous equations yields a DTA of $10 and a corresponding reduction to the recorded amount of the qualifying assets of $10. Thus, the qualifying assets should be recorded at $60 ($100 purchase price less the $30 ITC and $10 DTA) together with a DTA of $10.

    The simultaneous equations can be combined into the following formula:
    DTA =
    Tax Rate
    x
    (Tax Basis – initial book basis)
    (1 – Tax Rate)

    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 20X1 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).
  2. 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 20X1 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 20X1 and each of the subsequent four years, the following entries would be recorded:
Dr. Depreciation expense
$20
Cr. Accumulated depreciation
$20
To record depreciation of PP&E ($100 purchase price depreciable over 5 years).
Dr. Income tax payable
$5
Cr. Current income tax expense
$5
To record current tax benefit of depreciation for tax purposes ($100 purchase price depreciable over 5 years @ 25% tax rate).
In this example, because the book and tax depreciation periods are the same (5 years), no temporary difference would arise in subsequent years (assuming there is no impairment).
EXAMPLE TX 3-2
Accounting for investment tax credits with tax basis reduction
Company A is entitled to an ITC for 30% of the purchase price of certain qualifying assets. The ITC can be used to reduce the company’s income tax obligation in the year the assets are purchased. The tax law requires that the tax basis of the qualifying assets be reduced by 50% of the ITC (e.g., a $30 ITC reduces the tax basis by $15). The applicable tax rate is 25%.
On January 1, 20X1, Company A purchases $100 of qualifying assets. The assets will be depreciated for both financial statement and tax purposes on a straight-line basis over a 5-year period. There are no uncertain tax positions relating to the ITC or tax depreciation.
How should Company A account for the ITC?
Analysis
The deferral method–reduction in book basis
Under the deferral method, the ITC ($30) is reflected as a reduction to income taxes payable and to the carrying value of the qualifying assets. Because the tax basis of the asset will only be reduced by 50% of the ITC a deductible temporary difference arises. The carrying amount of the qualifying assets will be reduced by the full amount of the ITC ($30), while the tax basis will be reduced by only 50% of the ITC ($15) resulting in a temporary difference of $15. Company A can use either the gross-up or income statement method to account for the temporary difference.
  1. The gross-up method. Under the gross-up method, the recognition of the DTA related to the initial $15 deductible temporary difference results in a further reduction in the recorded amount of the qualifying assets, which would, in turn, increase the deductible temporary difference related to the qualifying assets. To avoid this iterative process, the ultimate carrying amount of the asset and the ultimate DTA can be determined using simultaneous equations.

    In this example, the simultaneous equations method (illustrated in Example TX 3-1) yields a DTA of $5 and a corresponding reduction to the recorded amount of the qualifying assets. Thus, the qualifying assets should be recorded at $65 ($100 purchase price less the $30 ITC and $5 DTA) together with a DTA of $5. In 20X1 and each of the subsequent four years, income taxes payable would be adjusted by $4.25 to record the current tax benefit of depreciation ($100 purchase price less $15 reduction in tax basis over 5 years @ 25% tax rate) and an annual entry of $1 to adjust the deferred tax asset based on the ending temporary difference between the book and tax basis arising from the difference in the annual depreciation charge for book and tax purposes ($4 tax-over-book depreciation @ 25% tax rate).
  2. The income statement method. Under the income statement method, the recognition of the DTA related to the initial deductible temporary difference of $15 results in the recognition of a $3.75 DTA and a corresponding benefit in the income tax provision. In 20X1 and each of the subsequent four years, income taxes payable would be adjusted by $4.25 to record the current tax benefit of depreciation ($100 purchase price less $15 reduction in tax basis over 5 years @ 25% tax rate) and an annual entry of $0.75 to adjust the deferred tax asset based on the ending temporary difference between the book and tax basis arising from the difference in the annual depreciation charge for book and tax purposes ($3 tax-over-book depreciation @ 25% tax rate).
The flow-through method
Under the flow-through method, the ITC ($30) is reflected as a current income tax benefit. Under this approach, the recognition of the ITC does not affect the book basis of the qualifying assets. Therefore, the recorded amount of the qualifying assets remains at $100 while the tax basis is reduced to $85, resulting in a taxable temporary difference of $15. The accounting for this temporary difference depends on whether the reporting entity uses the gross-up or income statement method.
  1. The gross-up method. Under the gross-up method, the recognition of the DTL related to the initial $15 taxable temporary difference results in a further increase in the recorded amount of the qualifying assets, which would, in turn, increase the taxable temporary difference related to the qualifying assets. Consistent with the gross up method illustrated previously, the simultaneous equation will result in recording a DTL of $5 and an increase in the qualifying asset of $5. Thus, the qualifying asset should be recorded at $105 ($100 purchase price plus the DTL of $5) together with a DTL of $5. In 20X1 and each of the subsequent four years, income taxes payable would be adjusted by $4.25 to record the current tax benefit of depreciation ($100 purchase price less $15 reduction in tax basis over 5 years @ 25% tax rate) and an annual entry of $1 to adjust the deferred tax liability based on the ending temporary difference between the book and tax basis arising from the difference in the annual depreciation charge for book and tax purposes ($4 book-over-tax depreciation @ 25% tax rate).
  2. The income statement method. Under the income statement method, the recognition of the DTL related to the initial taxable temporary difference of $15 results in the recognition of a $3.75 DTL and a corresponding expense in the income tax provision. In 20X1 and each of the subsequent four years, income taxes payable would be adjusted by $4.25 to record the current tax benefit of depreciation ($100 purchase price less $15 reduction in tax basis over 5 years @ 25% tax rate) and an annual entry of $0.75 to adjust the deferred tax liability based on the ending temporary difference between the book and tax basis arising from the difference in the annual depreciation charge for book and tax purposes ($3 book-over-tax depreciation @ 25% tax rate).

3.3.5.3 Investment tax credits through equity method investments

There is no specific guidance on how to account for investment tax credits received in conjunction with an investment accounted for under the equity method. While the deferral approach (i.e., netting the credit against the carrying amount of the investment and amortizing the benefit of the credit against the earnings of the investment) is described only in terms of investments in depreciable property, we are aware that the deferral approach is being applied in practice to other types of assets by analogy. In these circumstances, it is important to understand the underlying nature of the credit, the conditions that generated the credit, and the manner of recovery. Also, it is important to discern whether the credit is attributable to the investor or the investee.
If a reporting entity elects the fair value option for purposes of accounting for its equity method investment, we believe the flow through method should be applied as it aligns with the reporting entity’s election to reflect the fair value of the investment.

3.3.6 Investments in tax credit structures (after adoption of ASU 2023-02)

Various jurisdictions offer tax credits to incentivize certain types of investment and development. These projects include development of low-income housing projects, rehabilitation of historic structures, investments in the infrastructure of economically-challenged geographic areas, and renewable energy projects such as solar and wind. Additionally, the US Inflation Reduction Act of 2022 (IRA) significantly expanded the availability of climate and energy-related tax credits.
In many cases, the developers and/or operators of these projects may not generate sufficient taxable income to benefit from the governmental tax credits. In response, various investment structures have been developed that involve operating the project using a specifically-created legal entity that is a pass-through entity for tax purposes, with investors investing in the equity of the pass-through entity. In return, the investors receive an allocation of the income tax credits and other income tax benefits (typically driven by depreciation deductions) that the project generates, and in some cases a portion of the net cash flow generated by the project. These structures often include complex provisions governing the investors’ shares of the project’s benefits over the life of the project, which are often disproportionate to the investors’ ownership percentage. They may also include put or call provisions at various dates that may result in the investors’ interests being repurchased for cash.
Typically, tax equity investments have a sponsor, who manages the operations of the project, and one or more “tax equity investors,” with all of these parties owning a percentage of the pass-through entity’s equity. For the tax equity investors, such investments would typically qualify for the equity method of accounting under ASC 323 due to the SEC staff’s position (in ASC 323-30-S99-1) that investments in all limited partnerships should be accounted for using the equity method unless the investor’s interest is “so minor that the limited partner may have virtually no influence over partnership operating and financial policies,” which is generally viewed as investments of less than 3% to 5%. This guidance is typically applied to other similar legal forms of pass-through entities, such as limited liability companies that are treated as partnerships for tax purposes.
As discussed below, some tax equity investors may elect to account for their investment using a method other than the equity method, such as the proportional amortization method (PAM). PAM results in (1) the tax credit investment being amortized in proportion to the allocation of tax credits and other tax benefits in each period and (2) net presentation within the income tax line item.
New guidance
In March 2023, the FASB issued ASU 2023-02, Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method (a consensus of the Emerging Issues Task Force). ASU 2023-02 expands the use of PAM to a tax equity investment in various tax credits that meet certain criteria. Prior to ASU 2023-02, PAM was only allowed for investments in low-income housing tax credit (LIHTC) structures, as discussed in TX 3.3.6A.
See TX 3.3.6.8 for information on the transition to and effective date of ASU 2023-02.

3.3.6.1 Overview of the proportional amortization method

For an investor in a pass-through entity, the income tax credits and other income tax benefits that are allocated to the investor typically would be presented as a reduction to the investor’s income tax expense; however, the investor’s share of the project’s earnings or losses for financial reporting purposes typically would be reflected in pretax income. As a result, the total economic impact of these investments may be spread across different line items in the income statement.
However, ASC 323-740 allows an investor in certain tax credit structures to account for its investment using an approach described as the proportional amortization method (PAM) if those investments are made primarily for the purpose of receiving income tax credits and other income tax benefits and meet specified criteria.
Under PAM, the initial cost of the investment in the tax credit structure is amortized to income tax expense in proportion to the income tax credits and other income tax benefits received each period in relation to the total of such benefits to be received over the life of the investment. The application of PAM is illustrated in TX 3.3.6.4.
PAM is an available accounting policy election that needs to be made on a tax-credit-program-by-tax-credit-program basis. For those types of investments for which the policy election is made, each investment must still meet the criteria included in ASC 323-740-25-1 to qualify to use PAM described in TX 3.3.6.3.

3.3.6.2 Proportional amortization method — eligible investments

The guidance in ASC 323-740 only applies to the tax equity investor; it does not apply to the project sponsors or other parties (e.g., lenders). For an investment to be within the scope of ASC 323-740, it must be an investment in common stock or “in substance common stock,” as that phrase is defined in ASC 323-10-20. ASC 323-30-15-3 further extends the guidance in ASC 323 to investments in partnerships, unincorporated joint ventures, and limited liability companies, as long as these investments are not accounted for as debt securities under ASC 860-20-35-2. Further, ASC 323-740 cannot be applied to investments in the form of a loan.
Reporting entities can make a policy election to apply PAM on a tax-credit-program-by-tax-credit-program basis. A “tax credit program” is not specifically defined in the guidance; reporting entities can apply judgment in their particular circumstances as to how they wish to group similar types of investments. Common tax credit programs may include LIHTC, new markets tax credits (NMTC), historic rehabilitation tax credits (HTC), solar, and wind. Reporting entities will need to apply their grouping conventions consistently. For example, if a reporting entity determined that solar investment tax credits constituted a “tax credit program” and it elected to apply PAM to investments in solar investment tax credit structures, then it would be required to apply PAM to all investments in solar investment tax credit structures unless an individual investment in a solar investment tax credit structure did not meet the criteria for application of PAM.

3.3.6.3 Qualifying for the proportional amortization method

For any investment in a tax credit program for which the election has been made to apply PAM, the criteria in ASC 323-740-25-1 will be assessed to determine whether the specific investment can be accounted for under PAM. If the investment does not meet all of the criteria, it would be accounted for under other appropriate methods of accounting, such as the equity method (see TX 3.3.6.9). However, the disclosure guidance in ASC 323-740 would still be applicable for these investments (see FSP 16.5.4).

ASC 323-740-25-1

A reporting entity that invests in projects that generate income tax credits and other income tax benefits from a tax credit program through limited liability entities (that is, the investor) may elect to account for those investments using the proportional amortization method (described in paragraphs 323-740-35-2 and 323-740-45-2) if elected in accordance with paragraph 323-740-25-4, provided all of the following conditions are met:
a. It is probable that the income tax credits allocable to the investor will be available.
aa. The investor does not have the ability to exercise significant influence over the operating and financial policies of the underlying project.
aaa. Substantially all of the projected benefits are from income tax credits and other income tax benefits (for example, tax benefits generated from the operating losses of the investment). Projected benefits include, but are not limited to, income tax credits, other income tax benefits, and other non-income-tax-related benefits, including refundable tax credits (that is, those tax credits not dependent upon an investor’s income tax liability). Tax credits accounted for outside of the scope of Topic 740 (for example, refundable tax credits) shall be included in total projected benefits, but not in income tax credits and other income tax benefits when evaluating this condition. This condition shall be determined on a discounted basis using a discount rate that is consistent with the cash flow assumptions utilized by the investor for the purpose of making a decision to invest in the project.
b. The investor's projected yield based solely on the cash flows from the income tax credits and other income tax benefits is positive.
c. 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.

Significant influence criterion
The significant influence criterion in ASC 323-740-25-1(aa) makes clear that PAM is only appropriate for passive investors seeking principally to obtain tax credits and other tax benefits, as opposed to being actively involved in, or having the ability to significantly influence, the management of the underlying project. Because certain of the tax credit structures that may be eligible to use PAM involve multiple legal entities, ASC 323-740-25-1A clarifies that significant influence should be evaluated in relation to the operating and financial policies of the underlying project. The guidance should be considered holistically, considering where in the overall structure the significant operating decisions over the project (versus protective decisions over the tax benefits) are made, and assessing the investor’s level of influence over such entities.
The term “significant influence” in this criterion is the same as that used in applying the equity method guidance under ASC 323. However, as noted in ASC 323-740-25-1A, this is limited to the indicators of significant influence in ASC 323-10-15-6 and ASC 323-10-15-7. Judgment is necessary to apply the guidance in ASC 323-10-15-7.
In some cases, significant judgment will need to be applied to assess whether or not the investor can exert significant influence over the operations of the project, including consideration of any veto or consent rights the investor holds and the governance structure of the project. For example, holding a board seat may be an indication that an investor can exert significant influence. For further details about evaluating significant influence, refer to EM 1.3 and EM 2.1.
“Substantially all” criterion
One of the more significant criteria in evaluating the overall economics of the investment in the tax credit equity structure and whether the investment was made primarily for the purpose of receiving income tax credits and other income tax benefits is the guidance in ASC 323-740-25-1(aaa) that “substantially all of the projected benefits are from income tax credits and other income tax benefits (for example, tax benefits generated from the operating losses of the investment).” In the Basis for Conclusions of ASU 2023-02, the FASB observed that “substantially all” is not a defined term in GAAP and that it did not intend to change how the phrase is applied in ASC 323-740-25-1(aaa) or in other areas of GAAP (e.g., leases, assessing the definition of a “business”). Thus, there is no “bright line” threshold but, in practice, “substantially all” typically has been interpreted to mean at least 90%.
Refundable/transferable credits not considered “income taxes”
Some credits or other tax incentives may be monetized through the income tax return or in another manner (e.g., direct cash payments received from the government, or the sale of tax credits to other taxpayers). While credits and incentives often arise in the tax laws and may be claimed on a tax return, they may not always be subject to ASC 740 for accounting purposes if their realization does not depend on an entity’s taxable income. Each credit, incentive, and tax benefit must be analyzed to determine whether it should be accounted for under ASC 740 or whether it is subject to other guidance. For further consideration, refer to TX 1.2.4.
For the purpose of applying the substantially all test, the existence of refundable tax credits (sometimes referred to as “direct-pay” credits, or any other tax credits not in the scope of ASC 740) in a tax credit structure does not automatically preclude an investor from applying PAM. However, only income tax credits and other benefits accounted for under ASC 740 are eligible for consideration as income tax benefits in the substantially all test. Any credits not subject to ASC 740 would still be included in the denominator (the total projected benefits from the investment) but such credits would be excluded from the numerator of the substantially all ratio. Excluding refundable tax credits from the numerator is consistent with the accounting treatment of a refundable tax credit as a grant and not as an income tax benefit within the scope of ASC 740.
Certain types of credits are refundable (i.e., subject to a direct-pay election) or transferable (i.e., they can be sold for cash) only by the entity that engages in the activities or transactions that generate the credit. In the context of a tax credit investment structure, the investee is the entity that generates the tax credits that must make the election each year to either pass the tax credits through to its investors for use on their tax returns, seek a refund from the tax authorities for refundable (direct-pay) tax credits, or sell transferable tax credits to another taxpayer for cash (and presumably distribute such cash to investors in the latter two cases). If the credits are passed through to the investors for use on their tax returns, such tax credits would be nonrefundable and nontransferable by the investor and thus subject to the scope of ASC 740 at the investor level and included in the numerator of the substantially all test. Conversely, cash distributions to investors, even if funded by the refund or transfer of such credits by the investee would not be considered tax benefits. Therefore, there should be reasonable expectation that an investor in a tax credit investment structure that generates refundable or transferable tax credits will receive the tax credit for use on its tax return rather than the investee electing direct-pay or selling the credit. If the investor expected that the investee would allocate the credits directly to the investor but instead elected direct-pay or to sell the credit, that could lead to a reassessment event (see TX 3.3.6.7).
Discounted cash flows and income tax benefits
ASC 323-740-25-1(aaa) indicates that all of the cash flows and income tax benefits arising from the project should be discounted in applying the substantially all test. The standard does not specify a discount rate but indicates that it should be consistent with the assumptions utilized by the investor when making the decision to invest in the project. Similarly, we believe the cash flow assumptions used in the calculation (e.g., anticipated tax credits and other tax benefits, operating cash flows from the project over the life of the investment, disposal date, sale proceeds, exercise of a put or call option) should reflect the investor’s cash flow assumptions used in making its investment. The tax benefits and cash flows should be considered over the reporting entity’s expected investment holding period, which may be less than the life of the underlying project (as these investments may include put and/or call options that are exercised by one of the parties).

3.3.6.4 Applying the proportional amortization method

PAM requires the initial cost of the investment (inclusive of unconditional future capital commitments – see “Delayed equity contributions” in TX 3.3.6.7) less the expected residual value (e.g., expected proceeds upon exercise of a put or call option) to be amortized in proportion to the tax benefits received over the period that the investor expects to receive the income tax credits and other income tax benefits. This amortization is presented net of the related tax credits and other tax benefits within the income statement as a component of income tax expense (benefit). The amortization is determined as follows:
The computation holds the initial investment balance constant each period (adjusted for any changes in the expected residual value). The amortization is based on a percentage of total income tax benefits received in a particular year (numerator) relative to the total income tax benefits expected over the life of the investment (denominator).
Example TX 3-3 illustrates the application of PAM.
EXAMPLE TX 3-3
Example of the application of PAM
On January 1, 2023:
  • Investor A made a $1M investment in a renewable energy project in return for a 5% limited partnership interest.
  • The project is eligible for a tax credit. Investor A anticipates it will receive an annual tax credit allocation of $100,000 each year for 8 years. There is no reduction of the project’s tax basis as a result of the income tax credits. The income tax credits are not subject to recapture. Investor A’s tax rate is 25%.
  • Investor A plans to sell its investment on December 31, 2032 for an estimated residual value of $50,000 pursuant to a put right in the partnership agreement.
  • Investor A will receive cash distributions, which it expects to amount to $2,000 per year, based on a fixed percentage of the project’s net cash flow over the life of the project.
This example assumes that all cash flows, except for the initial investment, occur on December 31 of each year. Depreciation expense is computed for book and tax purposes using the straight-line method with a 10 year life.
Investor A has elected to use PAM to account for its tax equity investments in this type of tax credit program in accordance with paragraph ASC 323-740-25-4. All of the criteria described in paragraph ASC 323-740-25-1 are met.
How should Investor A determine annual amortization for its tax equity investment under PAM?
Analysis
Year
Net investment
(1)
Amortization of investment
(2)
Income tax credits
(3)
Net tax losses
(4)
Other income tax benefits from tax losses
(5)
Income tax credits and other income tax benefits
(6)
Income tax credits and other income tax benefits, net of amortization
(7)
Non-income tax-related cash returns
(8)
1
$885,448
$114,552
$100,000
$98,000
$24,500
$124,500
$9,948
$2,000
2
770,896
114,552
100,000
98,000
24,500
124,500
9,948
2,000
3
656,344
114,552
100,000
98,000
24,500
124,500
9,948
2,000
4
541,792
114,552
100,000
98,000
24,500
124,500
9,948
2,000
5
427,240
114,552
100,000
98,000
24,500
124,500
9,948
2,000
6
312,688
114,552
100,000
98,000
24,500
124,500
9,948
2,000
7
198,136
114,552
100,000
98,000
24,500
124,500
9,948
2,000
8
83,584
114,552
100,000
98,000
24,500
124,500
9,948
2,000
9
61,041
22,542
0
98,000
24,500
24,500
1,958
2,000
10
50,000
11,041
0
48,000*
12,000
12,000
959
52,000*
TOTAL
$950,000
$800,000
$930,000
$232,500
$1,032,500
$82,500
$70,000
(1) End-of-year carrying amount of the investment net of amortization in column (2)
(2) Initial investment of $1M less expected residual value of $50,000 x (total income tax credits and other income tax benefits received during the year in Column (6)) / total anticipated income tax benefits over the life of the investment of $1,032,500)
(3) Income tax credits allocated to the investor for the year
(4) Income tax losses, principally from depreciation, passed on to the investor for the year
(5) Column (4) x 25% tax rate
(6) Column (3) + Column (5)
(7) Column (6) – Column (2)
(8) Non-income-tax-related benefits, representing the cash proceeds received by the investor based on the cash generated by the project as well as the cash proceeds received upon exercise of the put right, are recognized in current period pretax earnings when received
* The net tax loss in year 10 reflects the income tax loss passed on to the investor from the investee, net of the tax gain on the proceeds received upon exercise of the put right. Likewise, the non-income tax-related cash returns includes $50,000 in proceeds received upon exercise of the put right.

Question TX 3-2
Can a reporting entity that elects PAM apply the deferral method for any investment tax credits that are allocated to the investor through the equity method investment?
PwC response
No. ASC 323-740-65-2(f) states that when a reporting entity applies PAM, it must use the “flow-through” method as described in ASC 740-10-25-46 for investment tax credits. That is the case even if the reporting entity has otherwise elected the “deferral” method of accounting for other investment tax credits.

3.3.6.5 Balance sheet classification of investments in tax credit structures

ASC 323-740 is silent about the balance sheet classification of investments accounted for under PAM. Investments in tax credit structures should not be classified as deferred tax assets as they are neither the result of a difference between the tax basis and reported amount in the financial statements of an asset or liability nor are they analogous to tax credit carryforwards.
See FSP 16.5.4 for disclosure considerations.

3.3.6.6 Deferred taxes related to investments accounted for using PAM

The tax benefits associated with credits received through an investment in a tax credit structure are recognized as they are allocated to the investor each period. If those credits are not utilized in the current year by the investor and are carried forward, they would be accounted for together with any other deferred tax assets of the investor.
With respect to the investment itself, we believe that the book basis of the investment essentially represents the purchase of tax benefits, which is analogous to the guidance in ASC 740-10-55-199 through ASC 740-10-55-201, and therefore deferred taxes should generally not be recognized for the difference between the book and tax basis of the investment. However, if an investor receives tax deductions in excess of the tax basis (i.e., negative tax basis), 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.
In addition, if the expected manner of recovering the investment was through a sale to a third party, we believe it may be appropriate for deferred taxes to be recognized. This is because recovery of the asset for an amount different than the tax basis would trigger a tax consequence.

3.3.6.7 Other considerations when applying the proportional amortization method

ASC 323-740 provides guidance for other items that may arise when applying PAM, including the presentation of cash flows and other benefits that are not income tax benefits, accounting for delayed equity contributions, as well as impairment and reassessment considerations.
Presentation of cash and other benefits not considered “income tax” benefits
Under PAM, all income tax benefits (both credits and other benefits, such as the tax benefit of depreciation deductions) are reflected in the income tax expense line, along with amortization of the investment cost (excluding any residual value, such as the estimated put or call price, determined on an undiscounted basis) in proportion to the tax benefits received during the period, as described in TX 3.3.6.4. However, ASC 323-740-35-5 states that any non-income-tax-related benefits received from the investee (which could either be cash flow from operations or credits that are not considered income tax credits under ASC 740) should be included in pretax earnings when realized or realizable. Similarly, any gains or losses on the sale of the investment should also be included in pretax earnings at the time of sale.
Delayed equity contributions
In some investment structures, the investor may fund certain contributions at inception, and may also agree to fund additional amounts in the future, either upon fixed dates, as requested by the project sponsor, or upon resolution of a defined contingent event. These are referred to in ASC 323-740 as “delayed equity contributions.”
For all investments accounted for using PAM, reporting entities are required to gross up the balance sheet, i.e., recognize the additional cost of the investment and a liability for the future contribution at inception, for delayed equity contributions related to the investment if they are unconditional and legally binding. If a delayed equity contribution is contingent upon a future event, the investor would recognize the liability, and corresponding increase in the cost of the investment, when that contingent event becomes probable. In both instances, when the investment is increased due to the delayed equity contribution liability being recorded, the proportional amortization percentage is applied to the entire investment balance in the application of PAM described in TX 3.3.6.4.
This guidance is applicable to all investments that are accounted for using PAM, but cannot be applied to investments that are not accounted for using PAM. For investments that are not accounted for using PAM, reporting entities should apply other applicable GAAP to such funding commitments, such as ASC 440, Commitments, or ASC 460, Guarantees.
Impairment
Under PAM, an investment must be tested for impairment whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of the investment will not be realized (ASC 323-740-35-6). The impairment loss is the difference between the excess of carrying value over fair value. Previously recognized impairment losses cannot be reversed. This differs from the other-than-temporary impairment guidance in ASC 323-10-35-32 applicable to other equity method investments, which in some circumstances requires more judgment in assessing whether the investment is impaired.
Reassessment
The assessment of whether an investment qualifies for PAM is performed as of the date that the investment is entered into. However, as described in ASC 323-740-25-1C, certain events , such as a change in the nature of the investment (for example, if the investment is no longer in a pass-through entity for tax purposes) or a change in the relationship with the underlying project, may cause a reassessment of PAM eligibility.
We believe that changes in the tax law or modifications of the investment agreements that significantly affect the economics of the investment would also require reassessment. Similarly, we believe that changes in how the tax credits generated by the investee are distributed to the reporting entity (i.e., cash versus tax credits; see TX 3.3.6.3 for further detail) could give rise to a reassessment. Although not explicitly stated in ASU 2023-02, during the course of the EITF deliberations, the Task Force indicated that the reassessment calculations should consider all tax benefits and cash flows over the life of the investment – i.e., historical tax benefits and cash flows received through the date of the reassessment as well as remaining projected tax benefits and cash flows.

3.3.6.8 ASU 2023-02: Transition and effective date

ASU 2023-02 is effective for public business entities for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. For all other entities, ASU 2023-02 is effective for fiscal years beginning after December 15, 2024, including interim periods within those fiscal years. Early adoption of ASU 2023-02 is permitted, including in an interim period. If an entity elects to early adopt in an interim period, the guidance should be applied as of the beginning of the fiscal year that includes the interim period. All amendments in the ASU can be adopted on either a retrospective or a modified retrospective basis.
All amendments in the ASU can be adopted on either a retrospective or a modified retrospective basis. The same transition method should be applied to all amendments, except for certain specific amendments affecting LIHTC investments that are not accounted for under PAM, which can be adopted using a prospective transition method instead as further described below. The transition date for reporting entities that choose the retrospective transition method is the beginning of the earliest period presented. The transition date for those entities that choose the modified retrospective transition method is the beginning of the fiscal year of adoption.
As of the transition date, reporting entities will evaluate all applicable investments in tax programs for which the reporting entity elects to apply PAM and for which it still expects to receive income tax credits or other income tax benefits. The assessment of whether applicable investments qualify to use PAM under the criteria in ASC 323-740-25-1 is performed as of the date that the investment was entered into, or as of a subsequent “reassessment” date if applicable. In applying the “substantially all” test in the guidance, the reporting entity will need to include actual benefits received as of the transition date in addition to remaining expected future benefits.
If there are delayed equity contributions associated with an investment that qualifies for PAM, the reporting entity should use actual equity contributions made and remaining equity contributions expected to be made as of the transition date to calculate the appropriate amounts to record upon adoption.
On the transition date, reporting entities will record a cumulative effect adjustment to retained earnings. The cumulative effect adjustment is the difference between the previous accounting and new accounting since the initial date of each impacted investment.
ASC 323-740 previously included specialized guidance for all LIHTC investments, regardless of whether they were accounted for using PAM. ASU 2023-02 removes these limited exceptions so that LIHTC investments will now be accounted for under other applicable GAAP if they do not qualify for PAM or the reporting entity elects not to apply PAM to LIHTC investments. Three amendments of this nature include:
  1. removing the cost method for LIHTC investments that was previously grandfathered under ASC 323-740-25-2A
  2. removing the previous impairment guidance that was applicable to LIHTC investments applying the equity method rather than PAM, and
  3. removing the guidance in ASC 323-740-25-3 related to delayed equity contributions for LIHTC investments that do not use PAM.
For these three LIHTC-specific amendments, a reporting entity can apply the same transition method as other amendments or a prospective transition method. The transition method can be elected independently for each of these three amendments. A prospective transition means retaining existing investment balances upon adoption and then beginning to follow the new guidance as of the beginning of the fiscal year of adoption. This is different from “grandfathering” existing investments and only applying the new guidance to new investments.

3.3.6.9 Other methods for accounting for investments in tax credit structures

Investors in tax credit structures that do not qualify for PAM (or do not elect to apply it) typically account for their investments under the equity method of accounting, often using the hypothetical liquidation at book value (HLBV) method (see EM 4.1.4 for more on the HLBV method). The pretax results of the investment are reported in pretax income, and the benefits from any income tax credits that are passed through to them are reported in the income tax provision. Investors that do not account for equity investments using PAM or the equity method of accounting will apply the equity investment accounting guidance in ASC 321, Investments – Equity Securities. See EM 1.3.2 and EM 1.3.3 for consideration of whether the equity investments should be accounted for under the equity method. Investments that are accounted for as loans would not be in the scope of ASC 323 and therefore not eligible for PAM.
In the case of an investor applying the equity method to the investment, deferred taxes may arise between the carrying amount of the investment and its related tax basis. This would give rise to deferred taxes independent of any deferred tax related to a carryforward of the credit.

3.3.6A Low-income housing credits (before adoption of ASU 2023-02)

Section 42 of the Internal Revenue Code provides a low-income housing credit (LIHTC) to owners of qualified residential rental projects. The LIHTC is generally available from the first year the building is placed in service and continues annually over a 10-year period, subject to continuing compliance with the qualified property rules. The LIHTC is subject to annual limitations, and any unused portion of the credit can be carried forward for 20 years. An LIHTC carryforward should be recognized as a deferred tax asset and evaluated for realization like any other deferred tax asset. The full amount of the aggregate LIHTC that is potentially available over the 10-year period should not be included in the tax provision in the initial year that the credit becomes available because the entire amount of the credit has not been “earned.” Only the portion of the LIHTC that is available to offset taxable income in each year should be included in the tax provision.
One of the more common structures in which LIHTC arise is through an investment in a limited liability entity that invests in qualified residential projects. Typically, an investor will account for its interest using the equity method. As such, a question arises as to whether the pretax results of the limited liability entity’s activities should be presented separate from the tax benefits (LIHTC) that are also passed through to the investor and usable on the investor’s tax return.
As noted in ASC 323-740-S99-2, the scope of ASC 323-740 is limited to investments in qualified affordable housing projects through limited liability entities that produce LIHTCs and should not be applied by analogy when accounting for investments in other projects for which substantially all of the benefits come from other tax credits and other tax benefits.

3.3.6A.1 Qualifying for the proportional amortization method

Under ASC 323-740-25-1, an investor may elect to account for the investment using the proportional amortization method assuming the following conditions are met:
  1. It is probable that the tax credits allocable to the investor will be available.
  2. The investor does not have the ability to exercise significant influence over the operating and financial policies of the limited liability entity.
  3. 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).
  4. The investor’s projected yield based solely on the cash flows from the tax credits and other tax benefits is positive.
  5. The investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the investor’s liability is limited to its capital investment.
If the conditions are met and the proportional method is elected, investors would present the pretax effects and related tax benefits of such investments as a component of income taxes (“net” within income tax expense). If elected, the proportional amortization method must be applied as an accounting policy to all eligible investments in qualified affordable housing projects.
The application of ASC 810, Consolidation, may impact the accounting for investments in entities that hold investments in low-income housing credit projects because such entities may constitute variable interest entities. If an investor is required to consolidate the limited liability entity that manages or invests in qualified affordable housing projects, the proportional amortization method cannot be applied because it would not meet criteria b) listed above. Essentially, the investor would report the pretax results of the investment in pretax income and report the benefit from the LIHTC in the tax provision on a current basis.

3.3.6A.2 Applying the proportional amortization method

The proportional amortization method requires the initial cost of the tax equity investment less the expected residual value to be amortized in proportion to the tax benefits received over the period that the investor expects to receive the income tax credits and other income tax benefits. The initial cost is inclusive of unconditional future capital commitments (see “Delayed equity contributions” in TX 3.3.6.7) and the residual value is the expected proceeds upon exercise of a put or call option. The amortization is determined as follows:
View image
The computation holds the initial investment balance constant each period (adjusted for any changes in the expected residual value). The amortization is based on a percentage of total tax benefits received in a particular year (numerator) relative to the total tax benefits expected over the life of the investment (denominator).
Under the proportional amortization method, an investment must be tested for impairment whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of the investment will not be realized (ASC 323-740-35-6). The impairment loss is the difference between the excess of carrying value over fair value. Previously recognized impairment losses cannot be reversed.

3.3.6A.3 Balance sheet classification of LIHTC

ASC 323-740 is silent about the balance sheet classification of investments accounted for under the proportional amortization method. Investments in qualified affordable housing projects would not meet the definition of a deferred tax asset. These investments are neither the result of a difference between the tax basis and reported amount in the financial statements, nor are they analogous to a tax credit carryforward because the tax credits under the low-income housing credit program are earned over time and, therefore, are not available at the time of initial investment.

3.3.6A.4 Deferred taxes related to proportional amortization

The tax benefits associated with low-income housing credits are recognized as they are reflected on the tax return each period. Therefore, we believe that deferred taxes should not be recognized on the basis difference of the investment. The reason there is a basis difference under the proportional amortization method is because the book basis of the investment is amortized as the tax credits are allocated to the investor (which is reflected in the book basis assigned to the tax credits), while there is no corresponding reduction in the tax basis of the investment (allocating the credits to the investor does not reduce the tax basis). The source of this difference is analogous to the basis difference that arises when a reporting entity purchases tax benefits as discussed in ASC 740-10-55-199 through ASC 740-10-55-201. In both situations, the basis difference is expected to be recovered or settled through realization of tax benefits (not pretax income) even though the financial statement carrying amount is not characterized as a deferred tax item in the financial statements.
We believe that the treatment of deferred taxes is also indirectly addressed in the example included in ASC 323-740-55. Deferred taxes were not provided in the proportional amortization method computation but were provided in the equity method and cost method computations. However, if an investor receives tax deductions in excess of the tax basis (i.e., negative tax basis) when applying the proportional amortization method, we would expect a deferred tax liability (or current tax liability) to be recognized for the potential “tax recapture” that will be imposed on the excess tax deductions.
If, however, the expected manner of recovering the investment was through a sale to a third party, we would expect deferred taxes to be recognized. In this case, the recovery of the asset for an amount different than the tax basis would trigger a tax consequence.

3.3.6A.5 Other methods for accounting for LIHTC

Investors that do not qualify for the proportional amortization method (or do not elect to apply it) account for their investments under the equity method or cost method of accounting. The pretax results of the investment are reported in pretax income, and the benefits from any low-income housing credits that are passed through to them are reported in their income tax provision.
Prior to the changes in ASC 323-740-25-1, an effective yield method was allowable in limited circumstances. Investors that were applying the effective yield method to investments held prior to adopting the current standard may continue to do so.
ASC 323-740-55 contains a detailed numerical example illustrating the different approaches to accounting for investments in LIHTC. In the case of an investor applying the cost or equity method to the investment, deferred taxes may arise between the carrying amount of the investment and its related tax basis, which would give rise to deferred taxes independent of any deferred tax related to a carryforward of the credit.

3.3.7 Global intangible low-taxed income (GILTI)

For tax years beginning after December 31, 2017, the 2017 US tax reform legislation introduces new provisions intended to prevent the erosion of the US tax base. This is achieved, in part, through US taxation of certain global intangible low-taxed income (GILTI). In short, GILTI inclusions will impact companies that have foreign earnings generated without a large aggregate foreign fixed asset base.
In considering the accounting for the impacts of GILTI, a question arises as to whether deferred taxes should be recognized for basis differences that are expected to reverse as GILTI in future years or if GILTI inclusions should be treated as period costs in each year incurred. Acknowledging the lack of specific guidance, the FASB staff concluded in its Q&A #5 that entities can apply either view as an accounting policy election. Companies will need to disclose their policy election. Measuring the impact of GILTI on deferreds introduces challenges that would not be present if treated as a period item. See TX 11.10.3.1 for a discussion on how to measure GILTI deferred taxes.

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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