Reporting entities may consider the sale of appreciated assets in order to trigger taxable income equal to the appreciation on those assets. This is a potential tax-planning strategy. Because a valuation allowance assessment is based on the weight of available evidence, to be considered a tax-planning strategy, the appreciation would have to exist at the balance sheet date. If the sale would not be required until some future date, then there must be a reasonable basis for concluding that the appreciation would still exist.
Generally, an outright sale would have to be of assets that individually are not integral to the business (such as securities). Any outright sale of fixed assets used in operations entails economic considerations that go well beyond those typically involved in tax-planning strategies. Similarly, unrealized appreciation in intangibles generally cannot be severed from the business itself. Sales of these assets involve questions of whether the entity wants to remain in certain business lines, products, or marketing areas. In most cases, it would be difficult to make a realistic assessment about whether the outright sale of such assets would be prudent and feasible.
A sale of appreciated assets generally has an effect on taxable income beyond the sale date. For example, if appreciated debt securities are sold, interest income in future years will be reduced. Such impacts on future taxable income, other than reversals, should be considered.
The sale of appreciated debt securities classified as available-for-sale or trading could be considered an available tax-planning strategy. As discussed in ASC 320-10-25-5
, planning to sell appreciated securities that are classified as held-to-maturity does not qualify as a tax-planning action or strategy because considering them available-for-sale would be inconsistent with the held-to-maturity designation.
The sale of appreciated securities classiﬁed as available-for-sale or trading should only be considered an available tax-planning strategy to the extent that a company is prepared to sell the debt securities in order to realize the gains and utilize related loss carryforwards before they expire. If a company is not willing or able to sell the debt securities and trigger the realized gains, it would not be appropriate to consider the potential sale as a tax-planning strategy. However, due to the presumed tax advantages of utilizing carryforward attributes before they expire, it is essential to understand and document the business reasons for believing it would not be prudent or feasible to trigger the gains in such a case.
Tax-planning strategies involving available-for-sale or trading securities may impact both the timing and/or character of income. With respect to timing of income recognition, entities that have expiring attributes often will assert their ability and intent to sell appreciated securities, if necessary, to avoid the expiration of attributes, such as capital loss carryforwards. Entities also might assert their ability and intent to sell securities carried at an unrealized loss to take advantage of capital gains income that exists in the carryback period. Selling appreciated securities ensures that the deferred tax liability on the unrealized gains will serve as a source of income in the proper period to avoid the loss of the related attributes.
In either case, it is important that management perform a detailed-enough analysis to be able to conclude that sufficient income of the appropriate character will be generated (or exists in the carryback period). Management must also consider the sale of the securities to be prudent and feasible within the timeframe necessary to avoid the expiration of the attributes or the close of the carryback window.
US taxpayers and taxpayers in other jurisdictions with relatively short carryback provisions most likely will need to be ready to implement any strategy in the relative near term. Furthermore, because of the potential for volatility of market values of securities, expectations of invoking the strategy at a date in the distant future may not be appropriate. As a result, management should document and support its readiness and intent to sell securities and ensure this assertion is consistent with other financial statement assertions related to the securities (e.g., the determination of expected credit losses).
Available-for-sale debt securities with unrealized losses
indicates that there is an inherent assumption in a reporting entity’s balance sheet that the reported amounts of assets will be recovered and liabilities settled. Based on that assumption, a decline in fair value of a debt security below its tax basis is presumed to result in a future tax deduction, even though a loss has not yet been realized for book or tax purposes. Along with any other deferred tax assets, the company must evaluate the available evidence to determine whether realization of that future tax deduction is more-likely-than-not. An initial step in this assessment process is to determine whether a deferred tax asset related to an unrealized loss on a debt security will reverse through (1) holding the security until it recovers in fair value or (2) through sale at a loss.
Hold to recovery
A company’s assertion that it has the intent and ability to hold an available-for-sale debt security until it recovers in value (maturity, if necessary) will eventually result in recovery of the book basis of the security through collection of the contractual cash flows. While the recovery in book basis provides a source of future taxable income to be considered in the overall assessment of the need for a valuation allowance against the company’s deferred tax assets, this source of taxable income should not be viewed in isolation. In other words, to the extent that the expected recovery in book value of the available-for-sale debt security, in conjunction with other projected sources of income, is expected to result in positive future income for the company as a whole, such income may be used to support realization of deferred tax assets.
If there is significant negative evidence, such as cumulative losses in recent years or an expectation of additional near-term losses, taxable income implicit in the expected recovery of the book basis of the available-for-sale security may only serve to reduce future losses of the company. In such circumstances, the expected appreciation would not provide support for the realization of deferred tax assets because there would be no incremental future tax benefit to the company. This would be the case even though the deductible temporary difference related to the available-for-sale debt security is expected to reverse as the respective book and tax bases of the investment converge upon maturity of the security.
Companies cannot avoid a valuation allowance unless there is evidence that the benefit of the deferred tax asset will be realized as a result of future taxable income (or one of the other potential sources identified in ASC 740-10-30-18
). It is not sufficient to merely project that the deductible temporary difference will reverse.
Sale at a loss
A sale of a depreciated debt security would result in a tax loss that is capital in nature. Avoiding a valuation allowance in that case may depend on having sufficient taxable income of the appropriate character (i.e., capital gains instead of ordinary income). Holding the security until maturity (or until the unrealized loss is eliminated) would effectively eliminate the need to consider whether there are sources of capital gains to offset the potential capital loss implicit in the temporary difference. Therefore, the positive assertion of the intent and ability to hold the available-for-sale debt security until it recovers in value would alleviate the “character of income” concern for such a company. If such an assertion cannot be made, however, the company must look to available sources of capital gains for recovery of the deferred tax asset.
Although asserting the ability to hold a security until it recovers in value (maturity, if necessary) may appear, on the surface, to be contrary to the available-for-sale classification under ASC 320
, we do not believe that the two positions are incompatible. Classifying a security as held-to-maturity under ASC 320
requires a positive assertion of intent and ability to hold the security to maturity
. However, an entity must only be able to assert that it has the intent and ability to hold a debt security to maturity, if necessary to recover its value
, to consider the expected recovery in book value as a source of future taxable income.
When a debt security is classified as available-for-sale, but management asserts that it will hold the asset until it recovers in value, we believe that the reversal pattern of the temporary difference would be determined as if the security would be carried at amortized cost in the future for book purposes using the balance-sheet-date market value as amortized cost at that date. The reversal in each future year would be determined as the difference between the recovery of book basis and the recovery of tax basis assigned to that year under the method—loan amortization or present value—that has been elected for the category of temporary differences in which the security is included. The loan amortization method and the present value method are illustrated in Example TX 5-19.
Question TX 5-1 addresses whether a company that has debt securities with unrealized gains and debt securities with unrealized losses must consider the debt securities and their related temporary differences together (net) when assessing whether a valuation allowance is necessary for any of its deferred tax assets.
Question TX 5-1
A company has debt securities with unrealized gains and debt securities with unrealized losses. For purposes of assessing whether a valuation allowance is necessary for any of its deferred tax assets (not just those related to the debt securities with unrealized losses), must the debt securities and their related temporary differences be considered together (net)?
No. A company may assert that it will hold the debt securities with unrealized losses until they recover in value (maturity, if necessary), meaning that the deferred tax asset associated with those debt securities would reverse over time, and the related income would be ordinary in character. At the same time, it could assert that it would sell the debt securities with unrealized gains (e.g., as a tax-planning strategy) in order to generate capital gains income and prevent any existing capital loss tax attributes from expiring. If the company has no capital loss tax attributes, then assessing the debt securities with unrealized losses separate from the debt securities with unrealized gains has no practical benefit or accounting impact.
Question TX 5-2 addresses considerations when a company asserts that it will hold debt securities with unrealized losses until they recover and subsequently sells a debt security for a gain.
Question TX 5-2
A reporting entity has debt securities with unrealized losses, and asserts that it will hold the securities until they recover (maturity, if necessary). In the following year, some of the securities are now in an unrealized gain position, while others are still in an unrealized loss position. If the entity sells any of the securities, would that be problematic due to its assertion that it would hold them until recovery (maturity, if necessary)?
If the entity sells securities that are still in an unrealized loss position, the action would potentially be inconsistent with an assertion to hold to recovery. However, because management’s assertion is to hold the security until it recovers in value, sale of an available-for-sale security that is in an unrealized gain position would not be inconsistent with this assertion.