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.
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
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 |
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 |
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.
When assessing the realizability of DTAs, companies 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, in situations 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 break-even future income.