To the extent realization is not assured by carryback, reversals of taxable temporary differences, or tax-planning strategies, projections of future taxable income will be necessary. Companies sometimes question whether the focus should be on future taxable income or future pretax book income. Although the realization of tax benefits ultimately depends on the availability of taxable income, in general, forecasts of future pretax book income (adjusted for permanent differences) should be used when assessing the realizability of deferred tax assets. This is because over the remaining lifespan of the entity, future taxable income will, in the aggregate, equal future pretax book income adjusted for permanent differences. Estimates of future taxable income may be particularly relevant when evaluating realizability of tax carryforwards or other attributes subject to a relatively short remaining carryforward period.
In projecting future income, all available information should be considered. This includes operating results and trends in recent years, internal budgets and forecasts, and anticipated changes in the business. Generally, the most recent results should be considered indicative of future results, absent evidence to the contrary.
Question TX 5-3 addresses valuation allowance considerations when a company can objectively demonstrate that it will have taxable income that will allow for utilization of tax credits in an upcoming year but the entity is projecting book losses for the foreseeable future.
Question TX 5-3
An entity is projecting book losses for the foreseeable future, but can objectively demonstrate that it will have taxable income in an upcoming year that would fully utilize the tax credits it has generated before they expire. Should it record a valuation allowance on the tax credits?
PwC response
No. The company should undertake an analysis that is similar to a scheduling exercise to determine whether the credit carryforward will result in incremental tax savings. If the conclusion is that the tax credit will reduce overall taxes paid, then it will be realized and should not attract a valuation allowance, despite the fact that the entity is projecting future book losses.

5.7.1 Assessment of appropriate outlook period

While it is difficult to generalize, once an entity concludes that positive evidence outweighs negative evidence so that some or all of a valuation allowance can be released, we would not normally expect the release of the valuation allowance to occur over a number of successive years. A particular concern arises when an entity that has returned to profitability reflects no tax provision or benefit, net of valuation allowance release, for a length of time.
In this regard, the SEC staff has questioned the retention of a valuation allowance when it appears to be overly conservative and when it may suggest earnings management (i.e., “selecting” the future period(s) in which to release the valuation allowance by modifying assumptions that are not objectively verifiable).
We have observed that companies sometimes limit the estimate of future income used in determining the valuation allowance to a relatively short time horizon, such as projecting out the same number of years as the entity has been profitable, or projecting out for the same period (e.g., three years) that the company uses for internal budgetary purposes. Except in certain rare situations based on the individual facts and circumstances, we generally do not believe that such an approach is appropriate. Mere uncertainty about the sustainability of taxable income due to general business and macro-economic risk factors is not a valid reason to use a short-term outlook. This is because the use of projections based on a relatively short timeframe fails to consider all available evidence.
As a general rule, the appropriate place to consider the inherent risk of future operations is in the quantification of earnings from core operations or in the development of projections, not through excluding consideration of potential positive evidence that may be present in later years. Because of the inherently arbitrary nature of truncating projections of future taxable income after a specific short-term period, the use of this approach may be challenged and would need to be appropriately supported with specific facts and circumstances. Assuming such a short-term outlook approach was deemed appropriate, it would generally be acceptable only for a short timeframe. If the entity continued to meet or exceed projections, this myopic outlook would no longer be appropriate.

5.7.2 Consistency of projections with other accounting estimates

As a starting point, the projections used for valuation allowance assessments should generally be consistent with other projections or estimates used in the preparation of the financial statements and in other filing disclosures (e.g., impairment tests under ASC 360, Property, Plant and Equipment or ASC 350, Intangibles—Goodwill and Other). This is particularly true when a company does not have cumulative losses in recent years or has returned to sustained profitability. In such cases, the SEC staff has challenged registrants that have used a short-term outlook when assessing the realizability of their deferred tax assets, but have used longer-term forecasts to support the carrying value or amortization periods of long-lived assets.
On the other hand, if a company has cumulative losses in recent years, it is generally appropriate to adjust the projections used in the valuation allowance analysis to a level that is objectively verifiable. Most recent historic results are generally considered to be the most objectively verifiable; although under circumstances in which sufficient evidence exists, it may be appropriate to consider earnings from core operations (see TX The impairment models for long-lived assets generally consider management’s best estimates of future results, while ASC 740-10-30-23 requires the evidence considered in a valuation allowance assessment to be “weighted” based on the extent it can be objectively verified. If a company has cumulative losses in recent years, projections of taxable income (which are inherently subjective) generally will not carry sufficient weight to overcome the objective negative evidence of cumulative losses unless they are adjusted to a level that is objectively verifiable.
If a company uses assumptions in its valuation allowance assessment that are not consistent with other projections or estimates used in the preparation of its financial statements (or other disclosures), it should be prepared to explain and provide support for any such differences.

5.7.3 Projecting future pretax book income

In general, once the results of scheduling reflect the temporary difference reversals in the years they are expected to take place, future taxable income amounts for each year should be scheduled to determine the net taxable result for each future year.
The following are guidelines for projecting future earnings for purposes of the valuation allowance assessment:
  • It is generally presumed that an entity with cumulative profits in recent years (or that is in a cumulative loss situation but has demonstrated a return to sustainable profitability) will remain profitable unless there is objectively verifiable evidence to the contrary.
  • As discussed in TX 5.7.2, although projections used for the valuation allowance assessment should be consistent with projections used elsewhere in preparing the financial statements, those projections may not always be objectively verifiable. If they are not, the starting point for the projection should be the amount and trend of book income (i.e., pretax income adjusted for permanent items) during the most recent year because this evidence is typically the most objective indicator available.
  • While projections of future income should be consistent with historical results, it is sometimes necessary to “adjust” the historical earnings for unusual items (both positive and negative), the effects of purchase accounting, or changes in capital structure. The goal of these adjustments would be to determine the existence of earnings from core operations that have been demonstrated in the past and that would be reasonable to assume for the future. For example, if the proceeds of a recent public offering were used to pay down debt, the interest expense in periods prior to the offering should be adjusted to arrive at historical earnings from core operations, which forms the starting point for projections of future periods. Likewise, if the company was recently acquired and is now heavily leveraged, the impact of the higher interest expense costs should be considered when assessing earnings from core operations in the prior periods.
  • Favorable improvements in profitability based on items such as built-in growth rates and “synergistic” effects of recently completed acquisitions should be approached with a high degree of skepticism. Since growth rates and the effects of acquisitions are inherently difficult to objectively verify, generally very little weight can be given to their effects until demonstrated. Earnings from core operations

A projection of future taxable income is inherently subjective and therefore carries less weight than the objective evidence presented by cumulative losses in recent years. As such, projected future taxable income, absent a history of strong earnings from core operations, generally will not be sufficient to overcome negative evidence that includes cumulative losses in recent years. On the other hand, an expectation of future taxable income supported by a recent history of strong earnings from core operations is an example of positive evidence under ASC 740 that may support a conclusion that a valuation allowance is not needed. Generally, the most recent results should be considered indicative of future results, unless there are certain aberrational items in the recent results or known changes that should be considered when determining projected future taxable income, such as the effects of purchase accounting or changes in capital structure.
Management should challenge themselves when evaluating whether items are truly aberrational and should therefore be excluded from a company’s analysis of earnings from core operations. In general, it is often difficult to obtain objectively verifiable evidence that such items are, in fact, aberrational. Management’s expectation—without sufficient corroborating evidence—is not enough to assert that items are aberrational. Also, it is often difficult to justify the exclusion of nonrecurring, unusual, or infrequent items because items of a similar nature may have occurred in the past or may be expected to occur in the future.
For an entity that has demonstrated earnings from core operations, we believe prospects for the near term are important, as they are likely to represent more objective positive evidence when compared with potential negative evidence based on business or macro-environmental risk factors that are not objectively verifiable. In addition to a baseline of current operating results, the projections should consider factors such as any demonstrated cyclical aspects of the entity’s industry and the entity’s stage of development. Management must exercise judgment when determining how detailed or formalized projections should be to assess the objective verifiability of the end result. The weight given to the forecast will be dependent on the extent to which the major assumptions can be objectively or independently supported, and the entity’s previously demonstrated ability to accurately budget and project future results. Refer to TX for illustrative examples of positive evidence related to earnings from core operations.
Assessing earnings from core operations
During the current year, Company A partially repaid its outstanding debt balance which will eliminate a portion of future interest expense. In assessing the realizability of its deferred tax assets, should Company A make any adjustments to its most recent results when estimating future taxable income?
It may be appropriate to adjust for certain items to determine the existence of earnings from core operations that have been demonstrated in the past and that would be reasonable to assume in the future. In this situation, Company A has partially paid down its debt which will reduce the amount of interest expense that has historically been included in its financial results. As such, it would be appropriate to adjust the historical earnings for the interest expense that will no longer recur as part of determining earnings from core operations for purposes of forecasting future taxable income.
This example illustrates a straightforward adjustment when using the most recent results as the baseline for projecting future taxable income. Many items, however, will require significant judgment in determining whether the impact should be adjusted for when determining future taxable income. For example, if Company A also had a significant legal settlement during the year or recorded a significant asset impairment, it would have to carefully assess whether it is appropriate to adjust historical results for these items when determining future taxable income. This assessment would include considering, for example, whether there is a recent history of similar events occurring (even if for different reasons) and the possibility that they may occur in the future (e.g., an impaired asset has significant remaining carrying value after the impairment). It is generally not appropriate to adjust for nonrecurring items when it is likely that items of a similar nature will occur in the future. Evaluating the effect of a restructuring

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. Originating temporary differences in future projections

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. Interaction of BEAT and the valuation allowance assessment

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. Interaction of GILTI and the valuation allowance assessment

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 Additional considerations for valuation allowances

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 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. Like any other deferred tax asset, a company would need to consider the four sources of income under ASC 740-10-30-18 to support future realization of FTC carryforwards. 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 demonstrate that they will generate sufficient future taxable income in total in addition to sufficient future 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.
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:
Company A
Company B
Current year NOL
Year 2 profit (loss)
Year 3 profit (loss)
Year 4 profit (loss)
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?
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. Interaction of CAMT with deferred taxes and valuation allowances

The US corporate alternative minimum tax (CAMT) may factor into deferred tax computations in two ways.
  • First, a deferred tax asset is established for CAMT credit carryforwards (like other tax credit carryforwards), with the CAMT credit carryforwards subject to assessment for realization.
An entity generates CAMT credit carryforwards for every dollar of CAMT paid. CAMT credit carryforwards have an indefinite life and can be used in any future year to reduce regular tax up to the amount of minimum tax computed under the CAMT system for that year.
  • Second, the CAMT may make it difficult for companies to realize the full regular-tax benefit from deductible differences and carryforwards other than CAMT credit carryforwards.
While deferred taxes are recorded at the regular tax rate under ASC 740, if the deferred tax asset reverses in a period in which a company expects to pay CAMT taxes, then the full regular-tax benefit may not be realized. In this case, the deferred tax asset essentially reverses into a CAMT credit carryforward.
If a company concludes it is more-likely-than-not that the CAMT credit carryforward will be used, then no valuation allowance is required and recognition of a full regular-tax benefit would be appropriate.
However, if a company concludes it is not more-likely-than-not that it will realize its CAMT credit carryforward, as would be the case if it expects to be a perpetual CAMT taxpayer, it must also assess whether its regular deferred taxes are realizable. In this fact pattern, we understand that the FASB staff believes that the Codification does not contain guidance that specifically addresses whether a company should anticipate future years’ CAMT in its valuation allowance assessment for its regular deferred tax assets. As a result, the FASB staff believes that a company should make a policy election as to whether to consider the impact of its expectation of future years' CAMT on its valuation allowance assessment for its regular deferred tax assets. The accounting policy election should be applied consistently and accompanied by transparent disclosure. Interplay of stock compensation and valuation allowance

For most stock-based compensation awards, a reporting entity will recognize a related deferred tax asset. Like any other deferred tax assets, a valuation allowance may be needed if, based on the weight of the available positive and negative evidence, it is more-likely-than-not that the deferred tax asset will not be realized.
When an entity measures its deferred tax asset related to stock-based compensation awards or determines whether a valuation allowance is necessary, how far the award may be out-of-the-money is not a relevant datapoint. Rather, an entity should establish a valuation allowance only if it is more-likely-than-not that it will not have sufficient future taxable income to realize an economic benefit from the deferred tax asset. In particular, an entity should not consider whether a decline in its share price makes it likely an option would expire unexercised or that an exercise would not result in a tax deduction sufficient to recover the entire deferred tax asset. This is the case even when expiration of an unexercised award is imminent. For example, on December 31, 20X1, an entity would not record a valuation allowance on a deferred tax asset expected to reverse when an out-of-the-money award expires on January 15, 20X2. The entity should wait until the award’s expiration date to adjust the related deferred tax asset. If an entity expects that pending deferred tax write-offs will be material, it should disclose this expectation.
Question TX 5-4 considers whether future disqualifying dispositions of incentive stock options should be assumed when forecasting taxable income for purposes of assessing the need for a valuation allowance.
Question TX 5-4
Incentive stock options (ISOs) normally do not result in a tax deduction for the company that issued them. However, if the ISOs are exercised before a minimum holding period (known as a “disqualifying disposition”), they do provide a tax deduction to the company. If a company has a history of ISO disqualifying dispositions, should it assume future disqualifying dispositions when forecasting taxable income for purposes of assessing the need for a valuation allowance?
PwC response
When the realizability of deferred tax assets is based on projections of future taxable income, which incorporate a number of assumptions regarding the future, it may be appropriate to consider a consistent past history of significant disqualifying dispositions of ISOs in the projections of future taxable income. On the surface, this view may seem contrary to ASC 718-740-25-3, which states "[a] future event can give rise to a tax deduction for instruments that ordinarily do not result in a tax deduction. The tax effects of such an event shall be recognized only when it occurs." However, the purpose of that guidance was to clarify that a deferred tax asset should not be recognized for an award that, by its terms, does not provide the company with a tax deduction. Circumstances that may make it appropriate to consider the effects of future disqualifying dispositions include, but are not limited to, a consistent history of disqualifying dispositions or expectations of unusually large disqualifying dispositions.
Similar in concept, we believe that it is inappropriate to ignore anticipated future excess tax deductions (so-called windfall tax benefits) from other stock-based awards when forecasting taxable income for purposes of assessing realizability of deferred tax assets. This is particularly true when the windfalls are expected in the near term and the underlying assumptions (e.g., market price of the stock relative to exercise price) are objectively verifiable.
For interim accounting considerations of excess tax deductions, refer to TX 16.3.1.
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