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5.4 Taxable income in prior carryback years
Publication date: 31 Dec 2023
us Income taxes guide
When a tax attribute may be carried back to a prior year, and taxable income existed in a year to which carryback is permitted under the tax law, that carryback is an objectively verifiable source of income.
5.4.1 Carrybacks that free up credits
Deferred taxes are recorded at the applicable tax rate prior to consideration of credits. This may lead to a situation when net deductible temporary differences reversing in a single future year will be included in a tax loss, and that tax loss will be carried back to prior years and will at least partially free up tax credits rather than result in a refund (i.e., the credits had originally been used to reduce the tax payable). We believe that realization of deferred tax assets requires incremental cash tax savings. Merely replacing one deferred tax asset (e.g., a deductible temporary difference) with another deferred tax asset (e.g., a credit carryforward) when there is not a source of income to realize it does not represent realization of the initial deferred tax asset, and a valuation allowance would be necessary.
5.4.1.1 Carryback availability that may not be used
Companies should carefully consider whether carryback availability truly provides an incremental source of taxable income to support realization of deferred tax assets. In concept, carryback availability will provide a source of income to realize a deferred tax asset only if carryback will actually occur. In general, we believe that the valuation allowance assessment should consider what the company expects to report on its tax return in the carryback window.
For example, the Internal Revenue Code provides an election to forgo the carryback of a loss when there is available taxable income in the carryback years. An entity might make this election if rates in the carryforward period are higher than rates in the carryback period. An entity also might make this election if it has used foreign tax credits to reduce or even eliminate the actual taxes payable in the preceding three years. To that extent, the loss carryback will not result in a refund but will only free up the foreign tax credits. However, given the short carryforward period of ten years for foreign tax credits and other restrictive limitations on their use, any freed-up foreign tax credits might expire unused. The election to forgo a carryback should be reflected in the deferred tax computation only when that election actually is expected to be made.
Notwithstanding the preceding paragraphs, there may be situations where other sources of income are insufficient to realize a company’s deferred tax assets, and carryback is an available source of income that would provide incremental realization. In these situations, we believe a company should take that carryback into consideration in its valuation allowance.
5.4.1.2 Carryback and future originating differences
Reporting entities may have a deferred tax asset whose reversal may trigger taxable losses in near-term future years, which would, in turn, generate a loss carryback. Carryback availability should be considered in determining the amount of any valuation allowance. However, ASC 740 is not clear as to how to consider the impact of future originating deductible differences when evaluating the realizability of existing deferred tax assets via the carryback source. Example TX 5-4 demonstrates this concept.
EXAMPLE TX 5-4
Whether future originating differences should be considered when assessing carryback availability
Whether future originating differences should be considered when assessing carryback availability
As of December 31, 20X2, Company A has a net deferred tax asset. Company A was breakeven in 20X2. Company A has concluded that a valuation allowance is required on the net DTA for the portion of the DTA not supported by reversing taxable temporary differences and/or carryback capacity. In tax year 20X1, Company A generated taxable income. Under the relevant jurisdiction’s tax law, Company A is allowed a 2-year carryback of taxable loss and must carryback to the oldest year first. Therefore, Company A has a carryback source of income in 20X1 to support recoverability if a taxable loss is generated in 20X3.
As of December 31, 20X2, Company A expects to breakeven in 20X3 on both a book and taxable basis. Although the existing net DTA is expected to partially reverse in 20X3, the reversal is expected to be fully offset by the origination of additional deductible differences. If the actual 20X3 results occur as expected, no taxable loss would be available in 20X3 to carryback and the carryback availability from 20X1 would expire unutilized. However, if originations were not considered, the reversal of existing deductible temporary differences would exceed the reversal of taxable temporary differences in 20X3.
Should Company A consider future originating differences when assessing carryback availability as a potential source of taxable income to realize its net DTA?
Analysis
We believe there are two supportable views when assessing carryback availability as a potential source of taxable income:
View A — Company A should not consider future originating differences
Under this view, Company A would assess the realizability of the existing net DTA by solely assessing the expected reversal of existing temporary differences in the 20X3 year, assuming zero pretax book income in 20X3. This approach would not consider future originating temporary differences. If the assessment results in an expected tax loss in 20X3, which can be recovered by carryback to prior years within the carryback period (i.e., 20X1), then no valuation allowance for that portion of the DTA would be recorded.
This view would consider actual taxable income in the available carryback period to be a source of taxable income that is not dependent upon future events other than assumed reversals of existing temporary differences. The available carryback is considered objectively verifiable evidence supporting that amount of net DTA.
Under this view, it would be inappropriate to assume originating temporary differences in the 20X3 year, as the originating differences would be based on events that have not yet taken place.
View B — Company A should consider future originating differences
Under this view, Company A would assess the realizability of the existing net DTA by assessing the expected reversal of existing temporary differences along with an estimation of originating temporary differences. In essence, Company A would attempt to estimate its 20X3 taxable income/loss from reversing and originating temporary differences only. If taxable income or a breakeven result is anticipated, no carryback would be available in 20X3 and a full valuation allowance would be needed. If, however, a tax loss is expected in 20X3, which can be carried back to profitable prior years within the carryback period, the amount of loss from the reversal and origination of temporary differences eligible for carryback would provide a source of realization for the amount of DTAs as of December 31, 20X2 that will reverse in 20X3, indicating they would not need a valuation allowance.
This view is supported by the concept that carryback availability will provide a source of income to realize a DTA only if an actual carryback is expected to occur. In this case, the reversal of one DTA is expected to be replaced by an originating DTA and would not result in realization. This view, while potentially more complex to apply, is seen as more consistent with the overall expectations-based assessment of the tax consequences resulting from temporary differences.
Note that in both View A and View B, management should consider whether there are tax-planning strategies available to accelerate tax deductions (or delay future originations) in order to ensure carryback availability is utilized.
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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