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.
Loss carryforwards that do not expire
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.
Other postretirement benefits (OPEBs)
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.
FTC carryforwards under US federal tax law
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.
“Group relief”
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:
Year |
Company A |
Company B |
Consolidated |
Current year NOL |
£(100) |
£(150) |
£(250) |
Year 2 profit (loss) |
50 |
(90) |
(40) |
Year 3 profit (loss) |
40 |
(80) |
(40) |
Year 4 profit (loss) |
40 |
(60) |
(20) |
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?
Analysis
The consolidated financial statements should reflect a full valuation allowance for the £250 of NOLs as the consolidated group is expecting future taxable losses, and the NOLs will not provide any incremental tax savings. Any income in Company A will be offset by the losses in Company B and therefore, with or without the NOL carryforward from Company A, there would be no tax liability.