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5.6 Tax-planning strategies
Publication date: 31 Dec 2023
us Income taxes guide
Tax-planning strategies must meet several criteria to be used to support realization of deferred tax assets, as described in ASC 740-10-30-19.
Excerpt from ASC 740-10-30-19
In some circumstances, there are actions (including elections for tax purposes) that:
a. Are prudent and feasible
b. An entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused
c. Would result in realization of deferred tax assets.
This Subtopic refers to those actions as tax-planning strategies. An entity shall consider tax-planning strategies in determining the amount of valuation allowance required. Significant expenses to implement a tax-planning strategy or any significant losses that would be incurred if that strategy were implemented (net of any recognizable tax benefits associated with those expenses or losses) shall be included in the valuation allowance. See paragraphs 740-10-55-39 through 55-48 for additional guidance. Implementation of the tax-planning strategy shall be primarily within the control of management but need not be within the unilateral control of management.
Although the ASC 740 criteria is explicit, it is not necessarily easy to interpret. The following bullets provide additional context for how we believe companies should interpret the tax-planning strategy criteria.
- Prudent and feasible — Management must have the ability to implement the strategy and expect to do so unless the need is eliminated in future years. If management would not implement a strategy because it would not be in the entity’s best interests, it would not be prudent. If management does not have the ability to carry out the strategy, it would not be feasible. The strategy need not be in the unilateral control of management, but it must be primarily within its control. For example, restrictions in loan agreements would have to be considered in determining whether a strategy is feasible.
- Ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused — Strategies that the entity takes ordinarily for business reasons are generally not tax-planning strategies.
ASC 740-10-30-20 makes it clear that the unit of account, recognition, and measurement principles for unrecognized tax benefits should be applied when determining whether a tax-planning strategy provides a source of future taxable income for the realization of deferred tax assets. In effect, a proposed tax-planning strategy would need to meet the ASC 740 more-likely-than-not recognition threshold from a tax law perspective. Assuming recognition is met (and the tax-planning strategy was determined to be prudent and feasible), the amount of taxable income that would be provided by the tax-planning strategy should be measured as the largest amount of benefit that is more-likely-than-not to be realized.
Some tax-planning strategies (e.g., triggering a LIFO reserve or shifting a tax-exempt portfolio to taxable) create additional taxable income. Other tax-planning strategies may affect only the timing of specific taxable income or deductions.
In some cases, tax-planning strategies may only extend the period of future years to which the entity may look for additional taxable income to be generated other than from reversals. As mentioned in ASC 740-10-55-37, a reduction in taxable income or taxes payable as a result of NOLs and credit carryforwards does not solely constitute recognition of a tax benefit. To the extent that a tax-planning strategy results in the utilization of existing NOLs and credits merely through replacement with a temporary difference that will result in future deductible amounts, absent future taxable income to realize the deferred tax asset, the tax-planning strategy may not result in realization of the deferred tax asset. Realization would be achieved only if the entity was able to support the existence of a future source of taxable income.
A tax-planning strategy that triggers a gain on the appreciation of certain assets for tax purposes (including LIFO inventories) may require special consideration. ASC 740-10-30-22 cites appreciation in net assets as an example of positive evidence. For the strategy to create additional taxable income rather than merely affect the timing of taxable income and deductions, the appreciation would have to be unrecognized and unrealized. Recognized, but unrealized, appreciation (e.g., certain securities carried at market value under ASC 320, Investments—Debt Securities and ASC 321, Investments—Equity Securities, but not subject to the mark-to-market tax rules) would have generated a taxable temporary difference that would already have been considered as a source of income.
An available tax-planning strategy to create additional taxable income may not ensure realization of deferred tax assets if future operating losses are expected to offset the taxable income from the strategy. Example TX 5-7 demonstrates this concept.
EXAMPLE TX 5-7
Potential tax-planning strategy that only reduces future loss
Potential tax-planning strategy that only reduces future loss
XYZ Company has experienced a history of operating losses over the past five years that total $20 million and has a net deferred tax asset of $5 million (tax rate of 25%) arising primarily from NOL carryforwards from such losses. A full valuation allowance has historically been recorded against the net deferred tax asset.
Based on the introduction of a new product line, Company XYZ is currently projecting that, for the next three years, it will experience losses of approximately $5 million in the aggregate before it “turns the corner” and becomes profitable. Due to appreciation in the real estate market, Company XYZ’s investment in a shopping mall property is now valued at approximately $500,000 more than the carrying amount in its financial statements. The entity proposes to reverse $125,000 ($500,000 × 25%) of its valuation allowance based on a tax-planning strategy to sell the investment in the shopping mall. The shopping mall is not a “core” asset of the entity, and management asserts that it would sell the shopping mall property, if necessary, before it would permit the NOL carryforward to expire unused.
Should the valuation allowance be reduced for the tax-planning strategy?
Analysis
No. Even if XYZ Company executed the tax-planning strategy in a year during which it is projecting losses, the gain realized on the sale of the appreciated asset would not shift the Company into a profitable position. In the above case, based on (1) the entity’s history of losses, (2) an unproven new product line, and (3) the fact that the entity does not anticipate being profitable for at least three years, little weight can be assigned to the projection of profitability. Accordingly, there is no incremental tax benefit (at least for the foreseeable future), as the potential gain on the sale of the shopping mall property would only reduce what otherwise would be a larger operating loss. Thus, it would not be appropriate to reduce the valuation allowance.
The consideration of future losses in Example TX 5-7 differs from the principle established in ASC 740-10-25-38, which notes that “the anticipation of the tax consequences of future tax losses is prohibited.” ASC 740-10-25-38 considers that a company anticipating losses for the foreseeable future might conclude that there is no need to record deferred tax liabilities because they might not represent an incremental increase to the company’s tax liability. However, the Board rejected this notion. In this context, future losses are considered as part of determining whether the implementation of the proposed tax-planning strategy will indeed provide a source of income for the realization of deferred tax assets. Future losses should also be considered when determining whether a tax-planning action will provide a source of income, as discussed further in Example TX 5-8.
It is important to differentiate tax-planning actions from tax-planning strategies. Tax-planning actions are typically contemplated in the ordinary course of business while tax-planning strategies are those that a company ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused. Tax-planning actions are only reflected in estimates of future taxable income when scheduling or projecting income if the entity is currently in a position to employ those actions and has already done so or will do so in the near-term. Therefore, the timing of the recognition of the effects of tax-planning actions is different than for tax-planning strategies, which are anticipated based on management’s intent and ability, if necessary.
Example TX 5-8 illustrates considerations when distinguishing between a tax-planning strategy and a tax-planning action.
EXAMPLE TX 5-8
Tax-planning action vs. tax-planning strategy
Tax-planning action vs. tax-planning strategy
Company X acquires certain entities in Europe that have net deferred tax assets. In completing an evaluation of the recoverability of the net deferred tax assets and assessing the need for a valuation allowance, Company X considers the following:
- Company X is contemplating a new business model to create an operating platform that is substantially different from the current platform. The new platform would involve the creation of a new European headquarters to centralize many of the risks and functions currently borne by various entities. Aside from the European headquarters operation, the other European territories would be established as contract manufacturers. As a result of the new platform, income would be shifted to certain entities, which would allow Company X to take advantage of more favorable tax rates and may in some cases shift income to certain jurisdictions that currently generate net operating losses and require full valuation allowances.
- Company X has noted that combining two of its entities in Jurisdiction A for tax purposes would allow it to utilize all of its existing net operating losses.
Do either of the above considerations qualify as a tax-planning strategy as defined in ASC 740-10-30-19?
Analysis
The first scenario would not be considered a tax-planning strategy, but rather a tax-planning action, as the action is contemplated in the ordinary course of business and is a planned operational change in the company’s underlying organization. In this case, it seems clear that the specific action is being undertaken for reasons that go well beyond realizing an existing tax attribute. The tax-planning action would be considered in the forecast at the time that it is completed, or when Company X commits to implementation in the near term with no significant uncertainties or contingencies.
The second scenario might qualify as a tax-planning strategy as the action is one that management would take in order to realize the benefit of its net operating losses prior to expiration.
The distinction between a tax-planning strategy and a tax-planning action is important because of how they are considered in valuation allowance assessments. It also dictates how the costs associated with each are handled. For purposes of determining the need for a valuation allowance, a tax-planning strategy can be anticipated and incorporated into future income projections. On the contrary, any potential future income from an anticipated tax-planning action ordinarily would not be included in projections until the company effects the action or commits to implementing the action in the near term because the impacts of the tax-planning action would not be objectively verifiable. However, in circumstances when the effects of the tax-planning action are objectively verifiable (i.e., no significant uncertainties or contingencies exist), the anticipated effects of such action would be included and incorporated into overall future income projections.
Pursuant to ASC 740-10-30-19, the costs of implementing a tax-planning strategy (net of any tax benefits associated with those expenses) would be included when the company determined the amount of valuation allowance to be recorded. Conversely, the costs of implementing a tax-planning action are recognized when incurred as these costs are related to an action that a company may take in the ordinary course of business for reasons other than realization of tax attributes. See TX 5.6.5 for additional information on the cost of tax-planning strategies.
Determining whether a particular action can be considered a tax-planning strategy depends largely on the specific facts and circumstances and requires significant judgment. Sometimes companies may have a tax-planning strategy that is valid in one year that becomes invalid in a subsequent year. For example, assume a company concludes that a sale of its non-strategic investment in a parcel of appreciated real estate would generate a gain, and that the strategy meets the criteria in ASC 740-10-30-19. However, in a subsequent year, the parcel may become strategic due to the company considering expanding into the geography where the real estate is located. Alternatively, the value of the real estate may decline such that its sale would no longer generate a gain. Both of these circumstances (or others like them) could cause the tax-planning strategy to no longer meet the criteria in ASC 740-10-30-19. If the impact on the valuation allowance determination is significant, management should consider disclosing the nature of the change regarding the tax-planning strategy and its financial statement impact.
5.6.1 Requirement to consider tax-planning strategies
The consideration of tax-planning strategies is not elective when assessing the need for a valuation allowance. If there is an available tax-planning strategy that is prudent and feasible, it must be incorporated into the assessment unless the company’s other sources of taxable income are sufficient to realize its DTAs. This requirement often leads to a question about the extent to which management must actively search for usable strategies.
Management should undertake a reasonable effort to identify prudent and feasible tax-planning strategies. If a tax-planning strategy is discovered in the current year that could have been considered in a prior year, it could raise a question about whether the prior year’s financial statements were misstated. The FASB provides the following guidance with regard to the identification of tax-planning strategies:
Because the effects of known qualifying tax-planning strategies must be recognized (see Example 22 [paragraph 740-10-55-163]), management should make a reasonable effort to identify those qualifying tax-planning strategies that are significant. Management’s obligation to apply qualifying tax-planning strategies in determining the amount of valuation allowance required is the same as its obligation to apply the requirements of other Topics for financial accounting and reporting. However, if there is sufficient evidence that taxable income from one of the other sources of taxable income listed in paragraph 740-10-30-18 will be adequate to eliminate the need for any valuation allowance, a search for tax-planning strategies is not necessary.
Tax-planning strategies (1) may provide assurance of realization in a situation in which a valuation allowance otherwise might be necessary, and (2) may reduce the complexity of applying ASC 740 whether or not the tax-planning strategy is used or needed to avoid a valuation allowance. The latter purpose suggests that it is in management’s best interests to identify tax-planning strategies, even beyond what is required as part of a valuation allowance assessment. For example, an entity could have a deferred tax liability in excess of the deferred tax assets recorded for a particular tax jurisdiction. However, it is not clear that the reversals of the taxable differences will offset the reversals of the deductible differences and carryforwards represented by the tax assets within the applicable carryback and carryforward periods. If future prospects are marginal, the entity may face a full-scale scheduling exercise to determine the extent to which reversing taxable differences will offset the deductible differences both as to amount and timing. But scheduling would be unnecessary if the entity has a valid tax-planning strategy that ensures that taxable income or deductions from reversals can be shifted among future years if any required future taxable income, other than reversals, is not generated, such that deductible differences and carryforwards will be offset by taxable differences.
5.6.2 Tax-planning strategies where carryforwards never expire
By definition, a tax-planning strategy is an action an entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused. The question then arises: if an NOL carryforward never expires, is it possible to consider tax-planning strategies as a source of taxable income to support realization of deferred tax assets?
Example TX 5-9 illustrates the general guidance related to tax-planning strategies in jurisdictions where NOL carryforwards never expire.
EXAMPLE TX 5-9
Tax-planning strategies in jurisdictions where NOL carryforwards never expire
Tax-planning strategies in jurisdictions where NOL carryforwards never expire
As of December 31, 20X1, Company X has $40 million of NOL carryforwards for which it has recorded $10 million of deferred tax assets (i.e., a tax rate of 25%) and is evaluating the need for a valuation allowance. Company X has cumulative losses in recent years and cannot rely on projections of future taxable income. As a result, it is considering whether it can use tax-planning strategies as a source of taxable income.
The tax law in the jurisdiction in which Company X operates provides that NOL carryforwards do not expire. Company X has assets with an appreciated value of $50 million (i.e., fair value of $60 million and a book value of $10 million) that are not integral to the business. Company X does not have intentions to sell the appreciated assets, but it has asserted that it would do so, if necessary, to realize the tax benefit of the NOL carryforwards.
In assessing the need for a valuation allowance, can Company X consider a tax-planning strategy of selling the appreciated assets as a possible source of taxable income available to realize a tax benefit for the NOL carryforwards?
Analysis
No. ASC 740-10-55-39(b) indicates that strategies that are expected to be employed for business or tax purposes, other than utilization of carryforwards that otherwise expire unused, are not tax-planning strategies as that term is used in ASC 740.
Accordingly, a company with operations in a jurisdiction in which NOLs do not expire cannot consider tax-planning strategies as a possible source of taxable income. Company X would not be precluded from considering the other possible sources of taxable income noted in ASC 740-10-30-18, including consideration of the impact of an objectively verifiable tax-planning action on future income projections (see Example TX 5-8). For example, if Company X had committed to a definitive plan to sell the appreciated assets such that the assets were classified as held-for-sale (rather than simply asserting that it would be willing to sell them, if needed), it would be able to consider the anticipated incremental income from the sale when assessing the need for a valuation allowance if the incremental income from the sale could be considered objectively verifiable. However, Company X would have to consider whether the anticipated incremental taxable income from the sale of the appreciated assets would enable it to realize the NOL carryforwards, rather than simply reducing what otherwise would be a larger operating loss.
The conclusion in Example TX 5-9 may appear counterintuitive as the company has unrecognized appreciated assets that, if currently sold, would generate taxable income sufficient to realize the NOLs. However, ASC 740-10-30-23 requires any source of income to be weighted “commensurate with the extent to which it can be objectively verified.” As there is no expiration on the NOLs and no definitive plan to sell the appreciated assets, the ability to verify whether the taxable income associated with the appreciated assets is sufficient to realize the existing NOLs becomes challenging. For example, since there would be no separate tax motivation for selling the appreciated assets in the near term (i.e., no expiring attributes), it would be difficult to objectively verify the fact that the unrealized appreciation will be available at some point in the distant future when the assets are eventually sold.
5.6.3 Examples of common tax-planning strategies
Reporting entities employ a wide variety of tax-planning strategies, some more straightforward than others. The following list represents some common actions that may qualify as tax-planning strategies.
- Selling operating assets and simultaneously leasing them back for a long period of time
- Selling an appreciated asset that is not core to the business (TX 5.6.3.1)
- Filing a consolidated or combined tax return with a profitable entity
- Disposing of obsolete inventory that is reported at net realizable value in the financial statements
- Selling loans at their amortized basis (i.e., net of an allowance for credit losses)
- Shifting an investment portfolio classified as available-for-sale or trading under ASC 320 from tax-exempt to taxable debt securities
- Changing from LIFO to some other method of accounting for inventories for tax purposes or deliberately reducing LIFO inventories to liquidate layers
- Electing out of the installment sales provisions for tax purposes
The following sections discuss specifics of tax-planning strategies related to the sale of appreciated assets as well as tax-planning strategies often used when a reporting entity has available-for-sale debt securities with unrealized losses.
5.6.3.1 Sales of appreciated assets
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.
Appreciated securities
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).
5.6.3.2 Available-for-sale debt securities with unrealized losses
ASC 740-10-25-20 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 assertion
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.
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
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)?
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)?
PwC response
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)?
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)?
PwC response
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 securities until they recover in value, sale of an available-for-sale security that is in an unrealized gain position would not be inconsistent with this assertion.
5.6.4 Noneconomic tax-planning strategies
Certain tax-planning strategies may provide a source of income for the apparent recognition of deferred tax assets in one jurisdiction, but not provide incremental tax savings to the consolidated entity. In order to avoid a valuation allowance by relying on a tax-planning strategy, we believe the tax-planning strategy generally must provide cash savings to the consolidated entity. To the extent that the only benefit a proposed tax-planning strategy provides is a financial reporting one (i.e., the avoidance of the need to record a valuation allowance), we do not believe it constitutes “realization” of the deferred tax asset.
Example TX 5-10 demonstrates the concept of a noneconomic tax-planning strategy.
EXAMPLE TX 5-10
Noneconomic tax-planning strategies
Noneconomic tax-planning strategies
Company A operates in Jurisdictions A and B. Due to poor sales in Jurisdiction A, Company A has incurred losses resulting in significant NOL carryforwards. Its operations in Jurisdiction B have historically been profitable, but due to the specifics of the local tax law, no tax is due on that income.
For financial reporting purposes, Company A has a deferred tax asset for the NOL sustained in Jurisdiction A. In order to realize the deferred tax asset, and avoid the need for a valuation allowance, Company A has proposed to move income from Jurisdiction B to Jurisdiction A.
Does this represent a valid tax-planning strategy?
Analysis
No. The proposed tax-planning strategy does not provide any incremental tax benefit to Company A, as the same amount of tax would be due to taxing authorities (on a consolidated basis) before and after consideration of the tax-planning strategy (i.e., zero tax rate in Jurisdiction B versus no taxable income in Jurisdiction A after consideration of the NOL carryforward). The only “benefit” achieved is a potential financial reporting benefit for the recording of an asset that in actuality would ultimately provide no incremental benefit to Company A. In addition, without a valid business purpose, this action would cause Company A to pay taxes once it utilized all of its NOL carryforwards in Jurisdiction A. It would likely be difficult for management to therefore conclude that this strategy would be prudent.
If Company A intends to move income from Jurisdiction B to Jurisdiction A for a valid business purpose, and would continue to subject that income to tax after the losses are fully utilized, it may be appropriate to treat the movement of income as a tax-planning action and incorporate the effects in the projection of future taxable income.
Example TX 5-11 discusses how to assess a tax-planning strategy to combine a profitable company with an unprofitable company.
EXAMPLE TX 5-11
Assessing a tax-planning strategy to combine a profitable and an unprofitable company
Assessing a tax-planning strategy to combine a profitable and an unprofitable company
Company X, a US company, has a wholly-owned holding company that, in turn, owns 100% of an operating company. The holding company and the operating company are in the same foreign jurisdiction but file separate returns. Historically, the holding company has generated losses (primarily due to interest expense from intercompany loans) and has significant NOL carryforwards. The operating company has generated profits in the past, which are expected to continue for the foreseeable future. In addition, the operating company has been benefiting from a tax holiday (i.e., a period of not paying taxes) for the past 15 years and expects the tax holiday to continue for the foreseeable future.
In assessing the need for a valuation allowance on the deferred tax asset arising from the NOLs, Company X considers a tax-planning strategy that would merge the two companies. It is projected that the combined company would be profitable and therefore would utilize the holding company’s NOLs. However, the merger would violate the conditions of the tax holiday, and the combined entity would become subject to the normal income tax rate.
Would the combination of the two companies be considered a prudent and feasible tax-planning strategy under ASC 740-10-30-19?
Analysis
No. Implementing the strategy might be feasible, but neither the holding company nor the operating company currently pay cash taxes. If the two companies were to merge, the tax holiday would be forfeited, and the combined company would be in a tax-paying position after using the NOLs. Since the tax-planning strategy is economically detrimental to Company X, it would not satisfy the requirement to be prudent in order to qualify as a tax-planning strategy.
5.6.5 Costs to implement a tax-planning strategy
The tax benefit recognized for a tax-planning strategy would be net of any expense or loss to be incurred in implementing the strategy. ASC 740-10-55-159 through ASC 740-10-55-162 provide an example of how implementation costs impact the valuation allowance.
If and when the tax-planning strategy actually is triggered and any related professional fees or other expenses are incurred, they should not be presented as components of income tax expense. This is the case even though such expenses would have been estimated for purposes of reducing the amount of tax benefit realizable as a result of the potential tax-planning strategy.
Certain tax-planning strategies involve an intra-entity asset transfer from a higher tax-rate jurisdiction where the entity currently does not pay taxes as a result of losses to a lower tax-rate jurisdiction where the entity does pay taxes. In such circumstances, as illustrated in Example TX 5-12, the tax benefit of the tax-planning strategy is measured at the lower tax rate. The tax rate differential effectively is a cost associated with implementing the strategy.
EXAMPLE TX 5-12
Measuring the benefit of a cross-jurisdiction tax-planning strategy
Measuring the benefit of a cross-jurisdiction tax-planning strategy
Company A currently has a full valuation allowance recorded against its net deferred tax asset, which is comprised primarily of expiring NOL carryforwards. Company A currently owns intellectual property (IP) in Jurisdiction A that is used by its foreign subsidiary and that is expected to generate taxable income. Company A has incurred operating losses for several years in Jurisdiction A and has significant negative evidence; however, its foreign subsidiary has been generating profits and paying foreign income taxes, albeit at a lower tax rate.
Company A has a tax-planning strategy to sell the rights to this IP to the subsidiary. The value of the IP approximates the amount of Company A’s NOLs. Therefore, the utilization of the NOL carryforwards would offset Company A’s tax gain on the sale. In effect, the tax benefit related to the NOLs will be realized through increased tax amortization on the transferred IP asset that reduces tax payments in the foreign jurisdiction. In this regard, management determines it is more-likely-than-not that the foreign subsidiary will be profitable in future years at a level sufficient to utilize the amortization as tax deductions to reduce taxable income.
Management also concludes that the tax-planning strategy appears to meet the prudent and feasible criteria stipulated by ASC 740-10-30-19 since the subsidiary is paying taxes and could benefit from the tax amortization on the stepped-up IP tax basis.
How should the effects of the tax-planning strategy be measured? What should the accounting be if the strategy is actually implemented in a subsequent period?
Analysis
In our view, the amount of the valuation allowance that should be reversed is equal to the amount of benefit that ultimately would be received in the subsidiary’s jurisdiction, which should be measured at the subsidiary’s tax rate. For example, assume that the tax rate in Jurisdiction A is 25% and the tax rate in the subsidiary’s jurisdiction is 15%. As the tax benefit in the IP sale strategy ultimately will be realized at a 15% tax rate, the amount of US deferred tax asset that does not require a valuation allowance as a result of the tax-planning strategy equals the gain multiplied by the 15% tax rate in the buyer’s jurisdiction. If Jurisdiction A’s deferred tax asset was based on $100 of NOLs, which corresponds to a resulting deferred tax asset of $25, the portion of the deferred tax asset that is expected to be realized under the strategy would be measured at a 15% tax rate. Therefore, $15 of the $25 valuation allowance should be reversed and a $10 valuation allowance should remain, absent any other source of future taxable income.
If in a subsequent period, Company A actually implements the tax-planning strategy, the net income statement impact in consolidation would be zero. Jurisdiction A would recognize $15 of net tax expense on the gain on sale, and the buyer’s jurisdiction would recognize a net tax benefit of $15 from recording a deferred tax asset for the tax-over-book basis of the IP.
If the facts were different, and there was not objective and verifiable evidence of future taxable income in the subsidiary’s jurisdiction, this tax-planning strategy would not result in the realization of deferred tax assets, and the valuation allowance should not be released. Simply transferring the IP and utilizing NOLs that have a full valuation allowance does not result in a realizable benefit if the IP is transferred to another jurisdiction and its new tax basis does not result in an incremental tax benefit to Company A.
5.6.6 Examples of actions that are not tax-planning strategies
There are certain actions that companies sometimes undertake that generally do not qualify as tax-planning strategies. Some examples include:
- Selling certain operating assets that are important to future operations, such as trademarks or patents
- Excluding a loss subsidiary from tax consolidation
- Acquiring a profitable entity (see TX 5.6.6.1)
- Disposing of a subsidiary that is not profitable (could be an action)
- Initiatives that reduce costs in order to increase the entity’s profitability (could be an action)
- Changing an entity’s tax status (the effect of a change in tax status is reflected on the approval date, or on the filing date if approval is not necessary, and is considered a discrete event)
- Moving income from a nontax jurisdiction to a taxable one solely to realize net operating loss carryforwards (see Example TX 5-10)
5.6.6.1 Valuation allowance impact of acquiring a profitable entity
Acquiring a profitable business may provide a source of income that would result in realization of a deferred tax asset. However, we do not believe that a proposed business combination can be anticipated. As discussed at TX 5.2.1, transactions that are inherently outside the company’s control and fundamental to its organizational structure are not considered in the valuation allowance assessment until they have been completed, consistent with many other areas of GAAP.
5.6.7 Issues in evaluating tax-planning strategies
There are additional considerations that may complicate management’s evaluation of possible tax-planning strategies.
5.6.7.1 Time value of money consideration in tax-planning strategies
Although ASC 740 precludes discounting deferred taxes, the time value of money may need to be considered in assessing whether a tax-planning strategy is prudent. For instance, scheduling should not reflect forgoing a carryback that would maximize a deferred tax asset (and thus delay the receipt of cash) if it is not reasonable to expect that the entity actually would take such an action given the time value of money. ASC 740-10-55-43 through ASC 740-10-55-44 gives an example of a tax-planning strategy to sell installment sales receivables to accelerate the reversal of the related taxable temporary differences. If a higher rate of interest would be earned on the installment sales receivables than could be earned on an alternative investment, the interest rate differential—the reduction in future interest income—must be considered in determining whether the strategy would be prudent. If, after considering the time value of money, a tax-planning strategy is deemed to be prudent, the loss of future interest income is not considered a cost of the tax-planning strategy.
5.6.7.2 Evaluation of strategies—consolidated versus subsidiary
It is important to evaluate tax-planning strategies for a subsidiary in the context of the consolidated group’s tax-planning objectives. Management of the subsidiary may not be in a position to be able to fully assess whether the strategy is prudent and feasible. A strategy that may seem prudent and feasible to management of the subsidiary may not be prudent and feasible in the context of the worldwide objectives. The parent company may have business plans for the subsidiary (e.g., discontinuances of certain product lines, relocation of certain functions to other countries or other subsidiaries, acquisition or other commencement of new operations that will be placed in the subsidiary) to which management of the subsidiary is not privy. It also may be necessary to obtain documentation from the parent company to support tax-planning strategies that have effects on other entities within the consolidated group to ascertain feasibility and prudency.
Valuation allowance assessments generally should occur at the individual taxpaying component level (e.g., each subsidiary/jurisdiction in the consolidated financial statements). However, the assessment should also consider the evidence in the context of the consolidated entity. Example TX 5-13 demonstrates this concept.
EXAMPLE TX 5-13
Assessing realizability of deferred tax assets at a subsidiary in a consolidated group
Assessing realizability of deferred tax assets at a subsidiary in a consolidated group
Distributor 1 is a subsidiary in a consolidated entity as shown in the following diagram.
Distributor 1 is a separate legal entity in a separate tax jurisdiction and prepares a standalone tax return. Distributor 1 has a three-year cumulative loss, has no carrybacks or carryforwards to use, has no available tax-planning strategies, and future reversals of existing taxable temporary differences would not be sufficient to realize its deferred tax assets. However, due to a restructured transfer pricing arrangement with IPHC, Distributor 1 is to be compensated with a 3% profit on its net sales, and is therefore forecasting future taxable income for the foreseeable future.
What factors should the consolidated parent company consider when assessing the need for a valuation allowance on Distributor 1’s deferred tax assets?
Analysis
Generally, the assessment of the need for a valuation allowance for Distributor 1 should be based on its individual facts and circumstances (not those of the consolidated group). The primary positive evidence for Distributor 1 is its forecast for future taxable income, which is supported by historical sales results as well as the existence of the transfer pricing arrangement with IPHC. Assuming the forecasted future taxable income is sufficient to realize the existing deferred tax assets, it would seem that the parent company could conclude that Distributor 1 does not need a valuation allowance.
This example involves a situation where the restructured transfer pricing arrangement has already been executed and therefore should be considered in the valuation allowance analysis. If the facts were different and the company were assessing the appropriateness of a tax-planning strategy based on an anticipated plan to enact a transfer pricing agreement that has yet to occur, the company would need to assess the criteria in ASC 740-10-30-19 to determine if the strategy may be used to support realization of its deferred tax assets. If the anticipated transfer pricing arrangement only serves to create losses in IPHC for which no tax benefit can be recognized, such an arrangement would not result in realization of Distributor 1’s deferred tax assets.
5.6.7.3 Consistent use in different jurisdictions
Tax-planning strategies that assume transactions affecting the timing of deductions and taxable income must be reflected consistently across all entities (e.g., parent entity and its subsidiaries) and jurisdictions (e.g., federal and state) affected by the strategies. It is possible that actions or strategies that reduce taxes in one jurisdiction will increase taxes in another. Of course, when inconsistent tax elections are allowed in different tax jurisdictions (e.g., whether to file consolidated or separate returns), it may be appropriate to use different elections.
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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