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5.5 Future reversals of existing taxable temporary differences
Publication date: 31 Dec 2023
us Income taxes guide
Reversal of existing taxable temporary differences must be considered as a source of taxable income for purposes of assessing deferred tax asset realization. The mere existence of taxable temporary differences does not make them a source of taxable income for the recognition of deductible temporary differences. Scheduling generally will need to be performed at some level to determine whether the existing taxable temporary differences will reverse in a period that will allow them to be a source of income to realize deductible temporary differences.
In some cases, scheduling can be an in-depth detailed analysis of reversal patterns, specifically tracking reversals of taxable and deductible temporary differences in order to ensure the realizability of existing deductible temporary differences. In other cases, obtaining a general understanding of reversal patterns is sufficient. Refer to TX 4.2.1 for guidance on scheduling the reversal of temporary differences.
When assessing the realizability of DTAs, reporting entities need to evaluate all of the relevant tax laws and other evidence. While detailed scheduling is not required by ASC 740 in all cases, it is necessary when it has an impact on the valuation allowance assessment.
ASC 740-10-25-38 specifically precludes anticipating future tax losses. As a result, when future taxable income cannot be relied upon, our view is that the benefit of any reversing taxable temporary differences (and the effect of any taxable income limitation) be determined with an assumption of breakeven future income.
Example TX 5-5 illustrates considerations related to limitations on the use of net operating loss carryforwards in determining the need for a valuation allowance.
EXAMPLE TX 5-5
Limitations on the use of net operating loss carryforwards
Limitations on the use of net operating loss carryforwards
In the prior year, Company A determined that a valuation allowance for deferred tax assets was not required for its foreign subsidiary, Company B, based on the scheduling of taxable and deductible temporary differences, along with tax loss carryforwards.
Company B has recorded DTAs based on deductible temporary differences and NOLs of $180 and $120, respectively. In addition, Company B has recorded DTLs for taxable temporary differences of $300. The existing inventory of deductible and taxable temporary differences is expected to reverse ratably over the next three years. Company B is unable to rely on a projection of taxable income (exclusive of reversing temporary differences). There are no other sources of future taxable income, such as tax-planning strategies or actions.
Historically, Company B had the ability to carry forward tax losses on a fifteen-year basis with no limitation on the amount utilized. In the current period, the government enacted tax law changes that impacted the utilization of existing losses in fiscal years commencing in 20X1 (the current year) and thereafter. Under the new provisions, NOLs expire in three years and can only be utilized to offset 70% of taxable income in any given year.
Company B expects to earn $40 in taxable income in each of the next three years from its reversing net temporary differences.
The following table summarizes NOL utilization after application of the new loss limitation rule:
Account |
BOY 20X1 |
Reversal 20X1 |
Reversal 20X2 |
Reversal 20X3 |
Temporary deductible differences—other |
$180 |
($60) |
($60) |
($60) |
Temporary taxable differences |
$300 |
100 |
100 |
100 |
Taxable income |
40 |
40 |
40 |
|
NOL utilization (70% limitation) |
(28) |
(28) |
(28) |
|
NOL remaining |
$120 |
$92 |
$64 |
$36 |
In determining the need for a valuation allowance, how should Company A consider the loss limitations imposed by the tax law change enacted in Company B’s jurisdiction?
Analysis
According to ASC 740-10-55-36, provisions in the tax law that limit utilization of an operating loss or tax credit carryforward should be applied in determining whether it is more-likely-than-not that some or all of the deferred tax asset will not be realized by reduction of taxes payable on taxable income during the carryforward period.
The restrictions enacted by the government pose new evidence that may shift loss utilization into later years or suggest that income in future periods will be insufficient to support realization of existing deferred tax assets. As a result, a partial valuation allowance could be required.
Under the new tax law enacted in 20X1, the NOLs expire in three years and are only available to offset 70% of taxable income in any given year. Accordingly, a partial valuation allowance would be required for the NOLs expected to remain at the end of the carryforward period ($36 that exist at the end of 20X3) and would be expected to expire prior to realization.
A similar scheduling exercise would be required if Company B previously maintained a full valuation allowance against its net DTAs. Assume Company B had taxable temporary differences of $210 that reverse ratably over three years and a full valuation allowance recorded against its net DTAs. The following table summarizes the valuation allowance assessment assuming application of the loss limitation:
Account |
BOY 20X1 |
Reversal 20X1 |
Reversal 20X2 |
Reversal 20X3 |
Temporary deductible differences—other |
$180 |
($60) |
($60) |
($60) |
Temporary taxable differences |
$210 |
70 |
70 |
70 |
Taxable income |
10 |
10 |
10 |
|
NOL utilization (70% limitation) |
(7) |
(7) |
(7) |
|
NOL remaining |
$120 |
$113 |
$106 |
$99 |
Net DTA (30% tax rate) |
$27 |
$30 |
||
Valuation allowance |
($27) |
($30) |
Company B would need to increase the existing valuation allowance from $27 to $30 to account for the NOLs that are expected to expire prior to realization. Even if Company B were in an overall net deferred tax liability position, a valuation allowance may be required if income in future periods is insufficient to support realization of NOLs prior to expiration.
5.5.1 Naked credits
“Naked credits” are deferred tax liabilities that have an indefinite reversal pattern, such as a deferred tax liability that relates to an asset with an indefinite useful life (e.g., land, goodwill, indefinite-lived intangible asset). Naked credits would not ordinarily serve as a source of income for the realization of deferred tax assets with a finite loss carryforward period. In situations when another source of taxable income is not available, a valuation allowance on deferred tax assets is necessary even though an entity may be in an overall net deferred tax liability position.
However, if a company can determine the expected timing of the reversal of the temporary difference, it may be appropriate to consider a naked credit as a source of income for the realization of deferred tax assets. For example, if a company enters into a sale agreement and as a result, an indefinite-lived intangible asset was classified as held for sale pursuant to ASC 360-10-45-9, the timing of the reversal of the deferred tax liability is now predictable, and therefore can be considered as a source of income to support realization of deferred tax assets. Another example is an indefinite-lived intangible for in-process R&D depending on when the reversal of the deferred tax liability is expected.
In a situation when the deductible temporary difference is indefinite in nature, it may be appropriate to use a deferred tax liability related to an indefinite-lived asset as a source of income to support realization of a deferred tax asset in a jurisdiction with unlimited carryforward. This assumes that they are within the same jurisdiction, of the appropriate character, and that the deferred tax asset is realizable if the taxable income were to become available.
Example TX 5-6 demonstrates valuation allowance considerations when there is a deferred tax liability related to an indefinite-lived asset in a jurisdiction with an unlimited loss carryforward period.
EXAMPLE TX 5-6
Deferred tax liability related to an indefinite-lived asset in a jurisdiction with an unlimited loss carryforward period
Deferred tax liability related to an indefinite-lived asset in a jurisdiction with an unlimited loss carryforward period
Company A is in a jurisdiction with an unlimited NOL carryforward period. Included in Company A’s net deferred tax asset is a deferred tax liability recorded for the basis difference in an indefinite-lived intangible asset. There have been significant historical losses and the taxable temporary difference related to the indefinite-lived intangible asset is the only source of income available to support realization of the deferred tax asset related to the NOL carryforward. In this jurisdiction, the use of NOLs is limited to 80% of taxable income in any given year. The taxable temporary difference related to the indefinite-lived asset is equal to Company A’s NOL carryforward.
Should Company A consider the taxable temporary difference associated with the indefinite-lived asset as a source of taxable income to support realization of the NOL deductible temporary difference?
Analysis
Yes. Because there is an unlimited loss carryforward period, the taxable temporary difference related to the indefinite-lived asset would constitute a source of taxable income to support the realization of the deferred tax assets with an unlimited carryforward period since both have indefinite reversal or expiration periods. This assumes that both are within the same tax jurisdiction, of the appropriate character, and that the deferred tax asset is realizable if the taxable income from the taxable temporary difference were to become available.
However, as a result of the tax law limitation on the utilization of a net operating loss to 80% of taxable income, Company A will still need a partial valuation allowance because in this circumstance, the reversal of the taxable temporary difference is the only source of income.
There may be cases when an indefinite-lived deferred tax asset will not be realizable at the time the naked credit reverses. For example, if tax-deductible goodwill associated with the naked credit is subsequently impaired, the deferred tax liability will reverse and provide taxable income at the time of impairment. However, this may not support realization of a deferred tax asset related to land since the deduction is dependent on the sale or impairment of the land. By contrast, if the deferred tax asset was an NOL carryforward in an unlimited carryforward jurisdiction, the NOL deferred tax asset would be realizable at the time of the goodwill impairment.
5.5.2 Book amortization of tax-deductible goodwill
ASC 350-20-35-63 provides companies that do not meet the definition of a public business entity with the option to amortize goodwill generated by a business combination on a straight-line basis over 10 years (or less). The guidance does not specifically address income tax accounting implications of electing this option. In addition to the complexities discussed in TX 10.8.4, electing this alternative may affect existing valuation allowances on deferred tax assets.
When a company elects to apply the goodwill amortization accounting alternative, any taxable temporary difference associated with goodwill would be expected to reverse because goodwill is also being amortized for tax purposes (albeit generally over a different period) (see TX 10.8 for discussion around components of goodwill). As a result, a company should consider the taxable temporary differences associated with goodwill as a source of taxable income when evaluating recoverability of its deferred tax assets.
In the period a company adopts the goodwill amortization accounting alternative, it may determine that it can reverse all or part of its valuation allowance because of the additional source of taxable income. This change in judgment is an indirect effect of a change in accounting principle and, therefore, it should be recognized as an income tax benefit in continuing operations in the period of adoption and not as part of the change in accounting principle.
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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