ASC 740-10-25-37 and ASC 740-10-30-13 stipulate that the tax benefit of special deductions should be recognized no earlier than the year in which the deductions can be taken on the tax return. ASC 740 does not define “special deductions,” but offers three examples: (1) statutory depletion, (2) special deductions available for certain health benefit entities, and (3) special deductions for small life insurance companies. The FASB also concluded in ASC 740-10-55-29 that the IRC Section 199 deduction for qualified domestic production activities also qualifies as a special deduction. The IRC Section 199 deduction was repealed as part of the 2017 Tax Cuts and Jobs Act (“the 2017 Act”). The 2017 Act also introduced a new deduction for foreign-derived intangible income (FDII). We believe that FDII should be accounted for as a special deduction.

As discussed in ASC 740-10-55-30, a reporting entity estimating future taxable income to determine the applicable rate should consider future special deductions in its deferred tax computations if graduated rates are a significant factor or if the reporting entity is assessing the need for a valuation allowance and must consider future taxable income (excluding reversals of temporary differences). Therefore, although tax benefits from special deductions are recognized no earlier than the year in which the special deductions are deductible on a tax return, they may affect the calculation of deferred taxes because their future tax benefit is implicitly recognized in the determination of the average graduated tax rate and the assessment of the need for a valuation allowance.

If the special deduction is statutory depletion, the estimates of future taxable income will be reduced by the total future statutory depletion that is expected to be deductible in future years on all properties, not just the statutory depletion related to the carrying amount of properties on the balance sheet date (i.e., the total statutory depletion includes both the current depletion and statutory depletion on assets to be acquired). Because statutory depletion generally is not limited by the adjusted basis in the property, it is possible that the taxpayer’s aggregate deductions for depletion will exceed the property’s adjusted basis.

As with other assets and liabilities, the temporary difference related to properties for which statutory depletion is available should be measured as the difference between the tax basis of the asset and its reported amount in the financial statements. As noted above, the reporting entity should recognize the tax benefit of the special deduction no earlier than the year in which the deductions can be made on the tax return. Accordingly, a deferred tax liability should be recognized for this temporary difference, even though it is probable that future tax depletion will exceed book depletion. The tax basis in a depletable property represents the historical-cost basis of the property less the property’s aggregate deductions for depletion that the reporting entity reports on its tax returns. The tax basis of the property, however, cannot be reduced below zero.

In certain jurisdictions, tax holidays (i.e., periods of full or partial exemption from tax) are provided as an incentive for certain entities. This raises the question of whether a tax asset should be established for the future tax savings of a tax holiday on the premise that such savings are akin to an NOL carryforward. In these cases, the FASB concluded that a deferred tax benefit should not be recorded. In reaching this conclusion, the FASB distinguished between two types of tax holidays: one that is generally available to any entity within a class of entities and one that is controlled by a specific entity that qualifies for it. The first type was likened to a general exemption from taxation for a class of entities creating nontaxable status, while the second type was perceived to be unique because it was not necessarily available to any entity within a class of entities and, as a result, might conceptually require the recognition of deferred tax benefits. As discussed in ASC 740-10-25-35 through ASC 740-10-25-36, the FASB decided to prohibit recognition of a deferred tax asset for any tax holiday (including those considered unique) because of the practical problems associated with (1) distinguishing between a general tax holiday and a unique tax holiday and (2) measuring the deferred tax asset associated with future benefits expected from tax holidays.

In order to properly account for a tax holiday, careful consideration must be given to the specific aspects of the tax holiday, including the approval process, terms, and conditions. In general, the effects on existing deferred income tax balances resulting from the initial qualification for a tax holiday should be treated in a manner similar to a voluntary change in tax status, which under ASC 740-10-25-33 is recognized on the approval date or on the filing date if approval is not necessary. Therefore, the effects of a tax holiday should be recognized in the deferred tax computation upon receipt of the last necessary approval for the tax holiday.

Limited circumstances exist that can support the accounting for a tax holiday renewal at the continuing preferential rate when the extension requests are perfunctory in nature and the criteria to maintain the tax holiday is specific, objectively determinable, and within the reporting entity’s control. This determination requires consideration of the reporting entity’s specific facts and circumstances and the relevant tax laws.

Example TX 4-3 illustrates considerations in determining the timing of the recognition of a tax holiday.

EXAMPLE TX 4-3
Timing of the recognition of a tax holiday

Company A operates in Jurisdiction S. On November 5, 20X1 (i.e., Q4 20X1), Company A filed its initial application for a specific tax holiday in Jurisdiction S. The holiday lasts for five years and applies to corporations that meet certain objectively verifiable, statutory requirements with respect to the company's management, ownership, and foreign sales as a percentage of total sales. The statute that sets forth the requirements provides no discretion to the taxing authority or government officials to deny the application if the taxpayer meets the requirements set forth in the statute. On January 20, 20X2 (i.e., Q1 20X2), Company A receives a letter of acknowledgment from the taxing authority in Jurisdiction S acknowledging receipt of Company A’s application.

In which period should the Company A account for the effects of the tax holiday: (1) the period in which the Company A filed its application (i.e., Q4 20X1), or (2) the period in which the letter of acknowledgment was received (i.e., Q1 20X2)?

In general, we believe the tax effects resulting from the initial qualification for a tax holiday should be treated in a manner similar to a change in tax status (see TX 8). Accordingly, consistent with ASC 740-10-25-33, Company A should record the effects of the holiday in the period in which the application was filed, rather than in the period in which the acknowledgement letter was received.

In this instance, Company A was legally entitled to the holiday in Q4 20X1 at the point in time that it had both met all the requirements set forth in the applicable statute and formally filed its application. As such, there was no basis for the taxing authority to deny the application. Receipt of the acknowledgement letter was merely confirmation of Company A's entitlement to the holiday rather than formal approval of it.

It should be noted, however, that if there is discretion on the part of the taxing authority or any government official to deny the application or alter its terms, the effects of the holiday should not be reflected in the financial statements until the formal government approval date.

Differences often exist between the book basis and tax basis on balance sheet dates within the holiday period. Consistent with ASC 740-10-30-8, if these differences are scheduled to reverse during the tax holiday, deferred taxes should be measured for those differences based on the conditions of the tax holiday (e.g., full or partial exemption). ASC 740-10-30-8 states that “the objective is to measure a deferred tax liability or asset using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.” If the differences are scheduled to reverse after the tax holiday, deferred taxes should be provided at the enacted tax rate that is expected to be in effect after the tax holiday expires. The expiration of the holiday is similar to an enacted change in future tax rates, which must be recognized in the deferred tax computation. Tax-planning actions to accelerate taxable income into the holiday or to delay deductions until after the holiday would only be considered if the reporting entity has committed to their implementation and such implementation is within the reporting entity’s control.

Example TX 4-4 illustrates the consideration of originating differences when scheduling the reversal of temporary differences in the context of a tax holiday.

EXAMPLE TX 4-4
Tax holiday—scheduling temporary differences

A foreign government grants a company a tax holiday. During the holiday, the company will be 100% exempt from taxation. Upon expiration of the holiday, the company will be subject to taxation at the statutory rate. The company is scheduling the reversal of existing temporary differences related to depreciable assets to determine whether any are expected to reverse after the tax holiday for which deferred taxes should be provided.

Should the company consider future originating differences related to its existing fixed assets when scheduling the reversal of existing temporary differences?

ASC 740-10-55-22 provides ground rules for scheduling temporary differences. Some of those ground rules are: (i) the method used should be systematic and logical; (ii) minimizing complexity is an appropriate consideration in selecting a method; and (iii) the same method should be used for all temporary differences within a particular category.

When scheduling the reversal of depreciable asset temporary differences to determine whether any are expected to reverse (and in what amount) after the expiration of a tax holiday, we believe that it is acceptable to either consider or exclude future originating differences. We believe that both methods are systematic and logical and can be reasonably supported.

A method that considers originating differences is based upon the view that future originating differences are inherent in the asset that exists at the balance sheet date and, therefore, should not be ignored.

A method that does not consider originating differences is based upon the view that only differences that exist at the balance sheet date should be considered. This method is consistent with the guidance in ASC 740-10-55-14, which indicates that future originations and their reversals are a factor to be considered when assessing the likelihood of future taxable income. By implication, they would not be considered part of the reversal of the temporary difference existing at the balance sheet date. A method that does not consider originating differences may also minimize the complexity of the calculation.

In circumstances in which the tax holiday is contingent on meeting a certain status or maintaining a certain level of activities, a reporting entity must make the determination as to whether or not it has met the requirements to satisfy the conditions of the holiday. If a reporting entity has initially met such conditions and expects to continue to meet them, it should measure its temporary differences using the holiday tax rate. If the reporting entity later determines that it no longer meets the necessary conditions of the tax holiday (e.g., it is no longer able to maintain a required level of activity within the tax jurisdiction), it would need to remeasure its deferred taxes at the statutory rate and recognize an additional tax liability for any potential retroactive effects in the period that the determination is made.

In accordance with ASC 740-10-10-3, a reporting entity should establish deferred taxes using the enacted tax rate expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.

Example TX 4-5 illustrates the accounting for NOLs during a tax holiday that does not start until the reporting entity first has taxable income.

EXAMPLE TX 4-5
Accounting for NOLs during a tax holiday

As an incentive to establish operations in Jurisdiction B, the taxing authority in Jurisdiction B provides Company A with a two-year tax holiday commencing with the first year in which taxable income is generated (i.e., after full utilization of all net operating losses generated during the start-up phase). After the initial two-year holiday, Company A is eligible for a reduced corporate tax rate during the remaining benefit period. The benefit period is defined by Jurisdiction B as no more than twelve years from the year in which operations commenced. Thus, for example, if Company A takes five years to utilize its NOLs, it will have a subsequent two-year period at the zero-percent rate and a five-year period at the reduced tax rate (a total of twelve years). However, if Company A does not fully utilize its NOLs before the expiration of the twelve-year period, it will not be entitled to the tax holiday and any future earnings after utilization of the NOLs will be taxed at the full tax rate.

What is the appropriate tax rate to apply to the NOLs that will be generated during the start-up phase?

ASC 740-10-25-35 through ASC 740-10-25-36 prohibits the recognition of deferred tax assets for a tax holiday. However, in this fact pattern, the tax holiday does not start until the company first has taxable income, which will not occur until after the NOLs are fully utilized. As a result, the NOLs that are generated and expected to be utilized in a tax year prior to the start of the zero-percent rate period should be measured at the normal statutory tax rate in Jurisdiction B (i.e., the tax that will be avoided prior to the start of the holiday period). ASC 740-10-10-3 provides that deferred tax assets and liabilities are measured at the enacted tax rate that is expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be settled or realized. In this case, the NOLs effectively delay the start of the holiday period.

The deferred tax asset related to these NOLs, like all deferred tax assets, should be evaluated for realizability.

Example TX 4-6 illustrates deferred measurement considerations when a reporting entity expects to incur future tax losses before the tax holiday begins.

EXAMPLE TX 4-6
Tax holidays and expected future tax losses

A foreign government grants a reporting entity a ten-year tax holiday, which starts when the reporting entity begins to generate taxable income. During the holiday, the reporting entity will be exempt from taxation. The reporting entity currently expects that it will incur losses for the next five years and then return to profitability. The reporting entity has taxable temporary differences related to property, plant, and equipment that will reverse over the next twenty years.

Is the applicable exemption period ten years or fifteen years (i.e., five years of expected losses and ten years of tax holiday)?

For assets that are amortized for financial reporting purposes, the presumption in the deferred tax accounting model is that the carrying value of the asset will be recovered over time through the reporting entity’s ordinary activities, which would be taxed at the ordinary rate. Accordingly, deferred tax assets and liabilities that result from temporary differences relating to such items are normally recognized at the ordinary tax rate.

However, for assets that are not amortized for financial reporting purposes (e.g., indefinite-lived intangible assets and tax-deductible goodwill), the presumption inherent in the pretax accounting is that the value of the asset does not decline (i.e., any revenues generated by the asset are not a recovery of the asset’s carrying value). Thus, the carrying value of the asset is not scheduled to be recovered at any specific time in the future—it has an indefinite life.

As indicated in ASC 740-10-25-20, the deferred tax accounting model is predicated on the assumption that assets will be recovered at their carrying amounts. Thus, future changes, such as an impairment, are not anticipated. Furthermore, ASC 740-10-30-8 indicates that reporting entities should use enacted tax rates expected to apply to taxable income in the periods in which the deferred tax liability or asset is “expected to be settled or realized.” When the ordinary tax rate and the capital gains tax rate differ, the question arises as to which rate—the ordinary rate used if an asset is recovered through use or the capital rate that would be used if an asset will be recovered through sale—is the “applicable tax rate” for a temporary difference relating to an asset with an indefinite life for book purposes. Importantly, in some instances, the deferred tax may be measured using both rates depending on the tax law. For example, in some jurisdictions, the tax law has provisions for recapturing amortization previously taken at the ordinary rate and then incremental capital gains (over the original cost basis of the asset) would be taxed at the capital gains rate.

ASC 350-30-35-4 clarifies that the term “indefinite” does not equate to “infinite.” An indefinite-lived intangible asset is not amortized because there is no foreseeable limit on the period of time over which it will be consumed—not because the useful life is unlimited, or the asset is not consumed. While no anticipation of a future impairment is appropriate, the expectation is that eventually the asset will be consumed through ordinary use. This supports using the ordinary tax rate. The alternative perspective is that the future consumption through use of the asset may not be assumed or anticipated, and thus the only way it will be recovered is through sale. This would support using the capital gains tax rate.

We believe that a reporting entity should consider the specific facts and circumstances relating to the asset (i.e., whether the asset will be consumed over an indefinite period of time or recovered through sale) and apply the tax rate (ordinary or capital) that is expected to apply in the future.

It should also be noted that taxable temporary differences related to assets that are not amortized for financial reporting purposes generally cannot be used as a source of taxable income to support the realization of deferred tax assets relating to the reversal of deductible temporary differences or tax attributes with defined expiry dates. They can, however, be considered a source of income to support realization of tax attributes with an unlimited carryforward period and deductible temporary differences expected to reverse into an attribute (e.g., NOL) with an indefinite carryforward period. Implications to the valuation allowance assessment when such taxable temporary differences are present are discussed in TX 5.5.1.

When deductions or loss carryforwards are expected to expire unutilized, it is generally not appropriate to use zero as the applicable tax rate. Rather, a deferred tax asset should be recorded at the applicable tax rate and a valuation allowance of an equal amount would be provided. However, in certain rare situations, it may be appropriate to use a zero rate or to write off the asset against the valuation allowance. This reduces the valuation allowance and the gross deferred tax assets disclosed.

A write-off might be appropriate if there is only a remote likelihood that the carryforward will be utilized. This may be the case, for example, when a reporting entity has a loss carryforward that has not yet expired in a country where the reporting entity no longer conducts business. As with many other areas of ASC 740, this determination requires the use of professional judgment and a careful consideration of the relevant facts and circumstances.

For example, situations may exist where reporting entities put intercompany tax planning structures in place that may result in the accumulation of NOLs in a particular jurisdiction that will not be realized for a long period of time. In these cases, recording a valuation allowance versus writing off the asset is appropriate. Unlike Example TX 4-6, the reporting entity is still doing business in the jurisdiction. In the United States, in certain circumstances, IRC Section 382 imposes a limitation on the utilization of net operating losses, credit carryforwards, built-in losses, and built-in deductions after an ownership change. When this (or a similar) limitation mathematically precludes use of a portion of a carryforward or a deductible difference, it is appropriate for a reporting entity to write off the deferred tax asset. This would be the case, for example, if a reporting entity has NOLs in excess of the maximum amount that could be utilized over the carryforward period as determined by the Section 382 limitation calculation.

If carryforwards and built-in losses are subject to the same aggregate limitation, the estimate of the “permanent” loss of tax benefits should be reflected as an unallocated reduction of gross deferred tax assets.

Certain jurisdictions tax corporate income at different rates depending on whether (and, in some cases, when) that income is distributed. For example, a jurisdiction may have a tax system under which undistributed profits are subject to a corporate tax rate of 45% and distributed income is taxed at 30%. Entities that pay dividends from previously undistributed income receive a tax credit (or tax refund) equal to the difference between (1) the tax computed at the “undistributed rate” (45% in this example) in effect during the period in which the income was earned and (2) the tax computed at the “distributed rate” (30% in this example). The opposite scenario may also exist where the tax rate assessed on an entity’s income when distributed is higher than the rate applicable to undistributed earnings.

ASC 740-10-25-39 through ASC 740-10-25-41 contains the only authoritative literature regarding such dual-rate jurisdictions. It was written within the context of a particular tax regime that existed at the time in which the “undistributed” tax rate was higher than the “distributed” tax rate. Accordingly, that guidance only explicitly addresses the appropriate accounting in a dual-rate regime that allows for the recovery of prior taxes paid (e.g., tax credit or refund) when those earnings are distributed. In the instance of a dual-rate regime that requires the payment of additional tax when dividends are distributed (i.e., distributed tax rate is higher than undistributed tax rate), application of the guidance in ASC 740-10-25-39 through ASC 740-10-25-41 requires interpretation in the broader context of the ASC 740 model, as further discussed below.

The guidance depends on whether the assessment is in the context of the consolidated parent’s financial statements or the separate financial statements of the subsidiary, and whether that subsidiary is in a foreign jurisdiction relative to its parent (i.e., eligible for the indefinite reinvestment exception).

Under ASC 740-10-25-40, when the distributed tax rate is lower than the undistributed tax rate, the subsidiary paying dividends (i.e., distributing income) does not recognize a deferred tax asset for the potential future tax credits that will be realized when (if) the previously taxed income is distributed. Instead, those tax benefits shall be recognized as a reduction of income tax expense in the period that the tax credits are included in the entity's tax return. Accordingly, the entity should use the undistributed rate to measure the tax effects of temporary differences.

In the consolidated financial statements of the parent, the tax effects related to operations of its subsidiary when the foreign subsidiary distributes income is dependent on whether the parents asserts indefinite reinvestment with respect to the earnings of the subsidiary.

Although not specifically addressed by the FASB, we believe that similar treatment should be applied by investors when measuring the tax effects of a corporate joint venture in a jurisdiction in which the distributed rate differs from the undistributed rate because ASC 740-10-25-3 specifically extends the application of the indefinite reversal exception to an investment in a foreign corporate joint venture that is essentially permanent in duration.

Example TX 4-7 illustrates application of the guidance in ASC 740-10-25-39 related to dual-rate jurisdictions.

EXAMPLE TX 4-7
Use of distributed and undistributed tax rates as applicable rates

In Country X, companies are subject to a 25% income tax rate plus an additional 10% corporate income tax assessment if their taxable income is not distributed before the end of the subsequent year. The additional tax assessment is due in the second subsequent year (i.e., the undistributed rate is effectively 35%, which is higher than the distributed rate of 25%).

Which rates should be used by companies in Country X?

Under the guidance in ASC 740-10-25-39, tax would be provided at the undistributed rate (in this case, 35%) in the period during which the income is earned. Any reduction in the liability that arises when the income is ultimately distributed is not anticipated but is instead recognized in the period during which the distribution plan becomes final.

There is no authoritative guidance that expressly addresses instances of a dual-rate regime that requires the payment of additional tax when dividends are distributed (i.e., distributed tax rate is higher than undistributed tax rate). In a parent’s consolidated financial statements, the same considerations would apply as in the case when the distributed rate is lower.

For the separate financial statements of the entity in the foreign jurisdiction, use of either the distributed or the undistributed rate have been accepted in practice, although use of the higher distributed rate is generally considered preferable on the basis that those earnings ultimately cannot be delivered to the entity’s shareholders without incurring those taxes. As such, if the lower, undistributed rate is used, additional disclosures may be required.

Under the US federal income tax system, a branch represents a US corporate entity that physically conducts its business in another country. The branch income and losses are generally taxable in the branch home country based on the local country’s tax law and in the United States based on US federal income tax law. Under US federal tax law, local country taxes imposed on the branch are considered foreign taxes of the US corporation, which may deduct them as a business expense or claim them as a foreign tax credit. That is, the US corporation branch owner can deduct foreign branch taxes (i.e., a tax benefit measured at the US federal rate of 21%) or receive US foreign tax credits (i.e., a tax benefit measured at 100%), which, subject to limitations, can offset the US federal income tax imposed on the branch income. Because the branch is taxed in two jurisdictions under two different tax regimes, we would generally expect the reporting entity to have one set of temporary differences for the US return (i.e., those temporary differences would be included in the deferred tax computation for the US consolidated tax group) and another set of deferred taxes for foreign tax purposes.

TX 11.10.1 provides a more detailed discussion of the accounting for branch operations.

Although deferred taxes ordinarily must be determined separately for each tax-paying component in each tax jurisdiction, ASC 740-10-55-25 acknowledges that in certain situations the tax computations for two or more jurisdictions can be combined. This is possible when (1) the same operations are taxed in two or more jurisdictions and (2) either there are no significant differences between the tax laws of the jurisdictions (e.g., carryback and carryforward periods are similar, as are the significant components of the tax laws) or any difference in computation would have no significant effect, given the reporting entity’s facts and circumstances. In making this determination, reporting entities should also consider the provisions of ASC 740-10-45-6 about the offset of deferred tax liabilities and assets of different jurisdictions.

In practice, many reporting entities employ a “blended rate” approach at the legal-entity level to simplify the income tax calculation for reporting entities operating in multiple jurisdictions (e.g., operating in multiple US states). Management should be able to support its decision to use a blended rate and must not presume that a blended-rate approach is acceptable. Use of this approach should be continually assessed in light of the considerations enumerated in ASC 740-10-55-25 and other practical considerations. This may make the use of a blended rate unacceptable—especially as more and more states continue to decouple their tax calculations from the US federal tax calculation. Examples of when problems can result from the use of a blended rate include the following:

When jurisdictions are combined for purposes of calculating an income tax provision, some reporting entities choose to employ an aggregate applicable rate (e.g., the US federal applicable rate plus the applicable state rate, net of the federal effect at the applicable federal rate). In calculating a state tax provision, a reporting entity’s use of a state rate, net of federal benefit, would be inconsistent with the principles of ASC 740, because the reporting entity would effectively be netting the state tax with the deferred federal benefit. ASC 740-10-55-20 states that deferred state taxes result in a temporary difference for purposes of determining a deferred US federal income tax asset or liability. ASC 740-10-45-6 states that “an entity shall not offset deferred tax liabilities and assets attributable to different tax jurisdictions.”

Because ASC 740 does not allow the netting of different tax jurisdictions, a state tax rate should be applied separately to temporary differences; in calculating a temporary difference (for purposes of determining a deferred federal benefit) that arises from deferred state taxes, a reporting entity should use the federal tax rate.