When an entity is determining whether positive evidence outweighs negative evidence in forming a conclusion that a valuation allowance is not needed, it may be appropriate for the effect of a restructuring (i.e., an implemented plan to exit an activity) to be considered. In evaluating assumptions that decrease historical costs, it would not be appropriate to consider the effect of cost-cutting measures until they have been successfully implemented. These measures are likely to impact the historical earnings trend in two ways. First, these measures usually require an earnings charge at the time they are implemented, which may not recur in the future. Second, they should result in a reduction of ongoing operating costs.

To the extent that the reduction in costs associated with the restructuring measures can be “objectively verified,” it is appropriate for an entity to consider those reductions in future projections as positive evidence when assessing the need for a valuation allowance. However, the effects that these cost-cutting measures may have on revenues and profitability also should be considered carefully (e.g., a significant reduction in sales force generally would correlate to a loss of sales volume). In contrast, if the strategy is to implement an exit plan at some future date, that would be difficult to objectively verify because it is a future event.

An entity with significant negative evidence, such as a history of recent losses, normally will find it very difficult to demonstrate that even an implemented exit plan provides sufficient objective evidence that the entity will be restored to profitability until it actually becomes profitable.

In concept, future taxable income (other than reversals) includes the effect of future originating temporary differences for assets in place, as well as their reversals. It also includes the origination and reversals for depreciable or amortizable assets to be acquired in the future. Thus, future taxable income embraces not only future book income and future permanent differences, but also temporary differences other than reversals of those existing at the balance sheet date. Estimating future originations and their reversals on a year-by-year basis generally would be quite an exhaustive exercise, and one that could not be very precise.

However, shortcuts may be employed. For example, the net amount of recurring temporary differences may be expected to remain at approximately the same level at each future balance sheet date (i.e., new originations may be assumed to replace reversals each year). The year-by-year effect of future originating differences could be approximated at an amount equal to reversals of existing temporary differences. The net originations would be deductible if the net reversals were taxable, and vice versa.

However, shortcut approaches must be used with care. Originating deductible differences may provide the taxable income that “uses” reversing deductible differences, but at the same time they will create new deductible differences, which will reverse in later future periods. For example, an originating deductible difference for accrued vacation increases taxable income in the year of accrual but when the vacation is taken or paid, the temporary difference will reverse and will decrease taxable income in a future period. Consistent with ASC 740-10-55-37, we do not believe that a tax benefit is realized from the reversals of existing deductible differences if they are only replaced by new deductible differences that will not be realized. Thus, inclusion of taxable income from originating differences in the scheduling may require companies to consider whether the deductible differences they create will be realized. This could extend the analysis further and further into the future. Ultimately, there must be future pretax income after considering permanent differences to realize the benefit of the existing deductible differences.

Because of the imprecise nature of the estimates of future taxable income other than reversals, we believe that specific consideration of future originations of temporary differences is generally not warranted. Rather, estimates of future pretax book income, adjusted for future permanent differences that are expected to be significant, usually will suffice as a surrogate for future taxable income. However, the actual timing of deductions and taxable income is relevant under the tax law and must be considered in applying ASC 740. Thus, care should be taken to ensure that large net originations that might alter the analysis are not likely to occur before skipping specific consideration of future originations of temporary differences for purposes of assessing the need for a valuation allowance.

FASB Staff Q&A #4 on base erosion and anti-abuse tax (BEAT) states that companies should account for BEAT as a period cost – that is, a company should not consider BEAT in the measurement of deferred taxes. The FASB staff Q&A document also notes that “[t]he staff also believes that an entity would not need to evaluate the effect of potentially paying the BEAT in future years on the realization of deferred tax assets recognized under the regular tax system because the realization of the deferred tax asset (for example, a tax credit) would reduce its regular tax liability, even when an incremental BEAT liability would be owed in that period.”

Although FASB Staff Q&A #4 indicates that companies would not need to evaluate the effect of the interaction of BEAT with the realizability of its deferred tax assets, we believe that companies may elect to do so. A company may choose to consider the effect of BEAT on realizability in order to avoid an abnormally high effective tax rate in a future year when a deferred tax asset is consumed in the regular tax calculation but a BEAT liability exists such that no benefit (or a reduced benefit) is realized from the deferred tax asset.

If companies elect to consider the impact of BEAT in assessing the realizability of their deferred tax assets, we believe one reasonable approach would be to consider the expected benefit of an NOL on a “with-and-without” basis. This approach would compare estimates of the total tax due considering utilization of NOLs (the “with” calculation) to an estimate in which the NOL does not exist (the “without” calculation). A valuation allowance would be recorded for the difference between these two amounts.

By necessity, this approach will require scheduling both future taxable income and future estimated BEAT payments. These projections would then need to be updated each period to reflect current projections.

A company may have NOLs and expect future global intangible low-taxed income (GILTI) inclusions. The GILTI inclusion will utilize the NOL. However, absent any NOLs, the GILTI inclusion would not have resulted in a cash tax payment due to availability of GILTI foreign tax credits and the Section 250 deduction. Thus, the use of NOLs does not provide an incremental cash tax savings.

We believe there are two acceptable views for considering the impact of GILTI on the assessment of the realizability of deferred tax assets.

Incremental cash tax savings approach - A company should look to whether the NOL reduces expected cash taxes payable to determine whether the related deferred tax asset is expected to be realized. A company may use a with-and-without approach that compares (1) what it expects its incremental cash taxes to be with the NOL and (2) what its incremental cash taxes would be without the NOL. A valuation allowance would be recorded for the difference (i.e., the extent to which the NOL does not provide an incremental benefit).

Tax law ordering approach - A company should look to tax law ordering to determine whether the existing NOL deferred tax asset is expected to be realized. NOLs have the potential to reduce or even fully eliminate the Section 250 deduction and foreign tax credit (FTC) benefits otherwise available with respect to GILTI inclusions. Based on the tax law ordering approach, NOL carryforwards are realizable if they will reduce the expected tax liability when utilized. Under this view, the fact that a company will be unable to utilize the future (and as yet unrecognized) Section 250 deductions or related FTCs that may otherwise have been available in the absence of the NOL carryforward is irrelevant. A valuation allowance should only be recorded to the extent future taxable income, inclusive of GILTI, does not support utilization of existing deferred tax assets.

For entities that have elected to recognize deferred taxes for basis differences that are expected to reverse as GLITI in future years, the policy choice for assessment of the valuation allowance and the measurement of deferred taxes should be consistent (see TX 11.10.3.1).

There are certain additional considerations that reporting entities should take into account when projecting future taxable income. These include the unique treatment of certain deferred tax assets and group relief considerations.

An unlimited carryforward period does not necessarily ensure realization, which is ultimately dependent on future income. Projections of future taxable income must consider all years that may provide a source of taxable income for the realization of deferred tax assets. The requirement that projections of future taxable income be objectively verifiable does not change when there is an unlimited carryforward period. In jurisdictions where an unlimited carryforward period exists and an entity has objectively demonstrated, or returned to, a level of profitability considered sustainable, it is often difficult to identify and objectively verify any negative evidence that would outweigh that positive evidence.

As a result, even though realization of deferred tax assets in a jurisdiction that has an unlimited carryforward period for net operating losses (or those deductible temporary differences that are expected to reverse and become indefinite-lived attributes) may be expected to occur in the distant future based on current projections, absent specific negative evidence of sufficient weight, the full deferred tax asset should be recognized. An entity should consider enhanced disclosures if deferred tax assets will be realized over an extended period of time. If an entity’s operations turn for the worse in future years, the change associated with a change in assessment about the realizability of deferred tax assets would be properly reflected in the period in which the operations deteriorated and the weight of existing negative evidence overcame the existing positive evidence.

Assessing the realization of deferred tax assets associated with OPEBs is problematic because the tax deductions typically will occur over a period of 40 or 50 years or even longer. It is unlikely that the reversal of significant taxable temporary differences for which deferred tax liabilities have been provided would extend into such distant future years.

We believe that the focus should be first on other deferred tax assets that are expected to reverse in the foreseeable future and whose realization is dependent on future taxable income other than offsetting taxable differences or carrybacks. If those tax assets are significant and if no valuation allowance is required for them because sufficient forecasted taxable income is expected, generally no valuation allowance should be required for the deferred tax asset associated with OPEB accruals.

The reversal pattern for OPEBs can be determined by application of one of two methods—the loan amortization method or the present value method. See TX 5.8.2.2 for further discussion of those two methods.

When foreign source earnings are included in a US tax return, a credit can be taken (with certain limitations) for the income taxes paid or accrued on those earnings in the foreign country or countries (e.g., foreign income taxes attributable to Subpart F income or global intangible low-taxed income. Credits also are generated by foreign taxes actually paid by (or on behalf of) the US entity directly to a foreign taxing authority (e.g., income taxes on branch income, withholding taxes on distributions of foreign income previously taxed in the US, or withholding taxes on interest, royalties or other payments received by a US entity from foreign sources).

The tax laws governing the use of foreign tax credits are complex and contain various limitations and provisions (e.g., the requirement to allocate and apportion certain US expenses to the various categories of foreign source income) that must be considered in the valuation allowance assessment. In many cases, it will be difficult to avoid a valuation allowance for FTC carryforwards. Unless the circumstances that generated the carryforwards were aberrational, it is likely that future foreign source income will generate excess FTCs that will become additional carryforwards rather than utilize existing FTC carryforwards.

FTC limitations must be calculated separately for certain categories of foreign-source income (i.e., general basket, passive income basket, GILTI basket, and branch income basket). Generally, FTCs can be carried back one year and forward ten years. FTCs attributable to GILTI are not allowed to be carried back or carried forward. To realize the deferred tax asset recorded for FTC carryforwards, an entity must be able to generate sufficient future taxable income in total in addition to sufficient foreign-source taxable income (within the applicable category). In addition, generally that income must, in the aggregate, have been taxed in foreign jurisdictions at less than the US tax rate A valuation allowance would generally be expected for excess foreign tax credits resulting from income taxed in countries where the tax rate is higher than the company’s US tax rate. Use of the credits also may be limited if there is a taxable loss from domestic sources since such a loss would offset the foreign-source income before the credits were applied.

Certain tax jurisdictions provide a “group relief” mechanism. Group relief permits companies under common ownership that file individual tax returns in the same tax jurisdiction to claim the losses of another group member or surrender losses to another group member for use in their respective individual tax returns.

For purposes of assessing the need for a valuation allowance in the consolidated financial statements, the group relief provisions must be considered. In other words, it is not appropriate to assess the need for a valuation allowance at each individual company and then aggregate them in the consolidated financial statements if group relief would provide for recovery of losses that one of the individual companies could not utilize.

Example TX 5-15 depicts the consideration of group relief in assessing the need for a valuation allowance.

EXAMPLE TX 5-15
Assessing the need for a valuation allowance in jurisdictions with group relief

Company A owns 100% of Company B. Both companies are based in the UK, file separate tax returns, and have net operating loss carryforwards. Company A expects to generate taxable income in future years, but Company B expects to continue to generate taxable losses. Their respective NOLs and income/loss projections are as follows:

The UK permits group relief, whereby the losses in one entity in a group may be transferred to another entity in the group. However, restrictions apply to the use of NOLs generated prior to April 1, 2017 (‘old’ tax losses). These must first be used to offset the taxable income of the entity that generated them before they can be used to offset another group member’s loss. In addition, old tax losses may only be transferred between group entities in the year in which they are created. If they cannot be used to provide group relief in that year, they are generally carried forward and restricted to use by the entity that generated the loss.

For NOLs generated on or after April 1, 2017, these restrictions do not apply.

For the current year consolidated financial statements of the group, how much of a valuation allowance should be recorded against the NOLs?