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, conditions, and expiration. 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.
Sometimes holidays may be extended or renewed. Renewals should generally be accounted for when approval is received. However, there may be limited circumstances when a reporting entity may continue to consider the preferential holiday rate. For example, 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, it may be appropriate to consider the renewal when recognizing and measuring deferred taxes. This determination requires consideration of the reporting entity’s specific facts and circumstances and the relevant tax laws.
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. 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 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?
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 related to its existing fixed assets 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 related to its existing fixed assets 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?
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 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)?
The tax holiday is ten years. Accordingly, the reversal of temporary differences should be scheduled at each balance sheet date, and only those differences that reverse in periods beyond the ten-year tax holiday should be tax-effected. In this case, the applicable tax holiday on each balance sheet date would remain ten years, as long as the reporting entity incurs losses. The reporting entity may not consider the five years of losses before it expects the holiday to begin because anticipating future tax losses is prohibited by ASC 740-10-25-38