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As discussed above, the effect of a change in tax laws or rates on a deferred tax liability or asset must be reflected in the period of enactment.
When determining the effect of a tax law change, entities must consider the law change’s effect on the deferred tax balances existing at the enactment date and, to the extent the law change is retroactive, its effect on taxable income through the enactment date. For entities that prepare quarterly financial statements, estimating the effect of the law using the most recent quarter end, adjusted for known material transactions between the enactment date and the quarter end, usually is sufficient.
For other entities, calculating the effect of the law change may require additional work. The effect of reversals of beginning deferred tax balances for the period through the enactment date has to be considered, as well as the deferred tax effects of originating temporary differences. Computing this effect, however, requires measuring temporary differences and the related deferred taxes at an interim date, that is, the date of enactment. For determining the effect of a tax rate change, the deferred taxes actually accrued through the enactment date (by application of the estimated annual effective tax rate to year-to-date ordinary income and by discrete recognition of other tax effects) should be used (see more about computing deferred taxes for interim periods in TX 7.4.1).
In the interim period in which a rate change is enacted, the tax used in computing the new estimated annual effective tax rate combines:
  • Tax currently payable or refundable on estimated ordinary income for the current year, reflecting the effect of the rate change to the extent that it is effective for the current year.
  • The deferred tax expense attributable to estimated ordinary income for the year (including changes in the valuation allowance that are reflected in the effective tax rate computation). This computation would be based on the newly enacted rate and would exclude the impact of the rate change on deferred taxes existing at the date of the rate change. The deferred tax balances used in computing the deferred tax expense would be after adjustment for the rate change.
Application of the new estimated annual effective tax rate to year-to-date ordinary income would inherently adjust the deferred taxes originating in prior interim periods in the current year. The adjustment of the beginning-of-year deferred tax balances for the rate change would be reflected as a discrete item in the interim period of the enactment. When items other than ordinary income have been reported in prior interim periods, both their current and deferred tax effects would be adjusted in the interim period of the enactment.
Regardless of whether they are a component of ordinary income or some other aspect of the annual tax provision, all adjustments to reflect a tax rate change are measured as of the enactment date and reflected in income from continuing operations.

7.4.1 Computing deferred taxes in an interim period

When a change in tax law is enacted on a date that is not close to an enterprise’s year-end, a question arises as to how temporary differences should be computed as of an interim date. We have identified three potential approaches:
a) Assume that the entity files a short-period tax return as of the date of the law’s enactment. The tax laws govern how annual deductions such as depreciation are allowed in a short-period return. The existing book bases of the assets and liabilities would be compared with these “pro forma” tax bases to determine the temporary differences.
b) Assume that net temporary differences arise and reverse evenly throughout the year. For example, if the beginning net temporary difference is $100 and the projected ending net temporary difference is $220, the temporary difference increases by $10 a month as the year progresses.
c) Assume that net temporary differences arise in the same pattern that pretax accounting income is earned. That is, if pretax income is earned 10%, 20%, 30%, and 40% in the first through fourth quarters, respectively, then temporary differences would increase or decrease on that basis as well.
In terms of the asset-and-liability approach underlying ASC 740, the first alternative might be viewed as the most intuitive, but it is inconsistent with the principles of interim reporting, which treat an interim period as an integral component of the annual period, not as a discrete period. The second alternative would be practical; however, like the first alternative, it is inconsistent with how an entity estimates its quarterly tax provision and, thus, its deferred tax accounts. The third alternative avoids both of those inconsistencies and would be relatively easy to compute. Whichever method is chosen, it should be applied consistently.

7.4.2 Retroactive tax rate change

ASC 740-10-25-48 addresses the accounting for retroactive rate changes.

ASC 740-10-25-48

The tax effect of a retroactive change in enacted tax rates on current and deferred tax assets and liabilities shall be determined at the date of enactment using temporary differences and currently taxable income existing as of the date of enactment.

In addition, ASC 740-10-45-16 specifies that the cumulative tax effect of a retroactive rate change should be included in income from continuing operations.
ASC 740-10-45-17 further clarifies that, “the tax effect of a retroactive change in enacted tax rates on current or deferred tax assets and liabilities related to those items is included in income from continuing operations in the period of enactment.”
Further, to the extent there were other items not included in income from continuing operations, the rate used prior to the date of enactment should not be adjusted.

ASC 740-10-30-26

The reported tax effect of items not included in income from continuing operations (for example, discontinued operations, cumulative effects of changes in accounting principles, and items charged or credited directly to shareholders’ equity) that arose during the current fiscal year and before the date of enactment of tax legislation shall be measured based on the enacted rate at the time the transaction was recognized for financial reporting purposes.

Sometimes, tax law or rate changes occur in the same year that new accounting standards are adopted and the effect of the law or rate change may be retroactive and thereby coincide with the accounting standard adoption date. As set forth in ASC 740-10-45-18, if an entity adopted a new accounting standard as of a date prior to the enactment date, the effect of the change in tax laws or rates would not be recognized in the cumulative effect of adopting the standard. Instead, the effect of the change in tax rate would be recognized in income from continuing operations for the period that included the enactment date. This would be true regardless of whether the change in tax laws or rates was retroactive to the earlier date.
Example TX 7-3 illustrates the computation of income tax expense when there is an enacted change in tax rates in an interim period.
EXAMPLE TX 7-3
Computation of income tax expense with an enacted change in tax rates in an interim period
Company A recognized a net deferred tax liability of $160 at December 31, 20X5 related to the temporary differences shown below. Assume that no valuation allowance was necessary for the deferred tax asset.
Fixed assets
Inventory
Book basis [A]
$2,000
$900
Tax basis [B]
1,500
1,000
Temporary difference: [A – B = C]
500
(100)
Federal tax rate for all future years [D]
40%
40%
Deferred tax liability or (asset) [C × D]
200
(40)
Net deferred tax liability at December 31, 20X5
$160
Company A projected that, at December 31, 20X6, the net deferred tax liability would be $280, based on a $300 increase in its taxable temporary difference. Therefore, for 20X6, the projected deferred tax expense will be $120 ($280 – $160).
Company A’s income tax expense for the first quarter of 20X6 was calculated as follows:
Step 1: Estimated taxable income:
Estimated annual pretax book income
$100,000
Less:
State income taxes
($5,000)
Dividends received deduction
(1,000)
Tax over book depreciation
(300)
Estimated taxable income
$93,700
Step 2: Annual effective tax rate:
Estimated taxable income
$93,700
Statutory federal income tax rate
40%
Estimated current income taxes payable
37,480
Estimated federal deferred tax expense [$300 increase in taxable temporary difference × tax rate of 40%]
120
37,600
Less: research and experimentation tax credit
(2,000)
Add: state income taxes (including deferred state income taxes of $400)
5,400
Estimated full-year income tax provision
$41,000
Estimated annual effective tax rate [$41,000/$100,000]
41%
Step 3: Income tax provision:
Year-to-date pretax income as of March 31, 20X6
$20,000
Estimated full-year effective income tax rate
41%
Income tax provision—first-quarter 20X6
$8,200
If an increase from 40% to 45% in the federal income tax rate was enacted on June 15, 20X6, retroactive to the beginning of the year, how would the effect of the change be reflected in income tax expense for the three and six months ended June 30, 20X6?
Analysis
Step 1: Update estimate of taxable income:
Estimated annual pretax book income
$100,000
Less:
State income taxes
($5,000)
Dividends received deduction
(1,000)
Tax over book depreciation
(300)
Estimated taxable income (unchanged from Q1)
$93,700
Step 2: Recalculate annual effective tax rate:
Estimated taxable income
$93,700
Statutory federal income tax rate
45%
Estimated current income taxes payable
42,165
Estimated federal deferred tax expense [$300 increase in taxable temporary difference × tax rate of 45%]
135
42,300
Less: research and experimentation tax credit
(2,000)
Add: state income taxes (including deferred state income taxes of $400)
5,400
Estimated full-year income tax provision
$45,700
Estimated annual effective tax rate [$45,700/$100,000]
45.7%
Step 3: Income tax provision:
Year-to-date pretax income as of June 30, 20X6
$30,000
Estimated annual effective tax rate
45.7%
Year-to-date income tax provision on ordinary income
$13,710
Less: first-quarter income tax provision
(8,200)
Second-quarter income tax provision
$5,510
Adjustment to December 31, 20X5 deferred tax balances
Deferred tax liability ($500 × [45% – 40%])
$25
Deferred tax asset ($100 × [45% – 40%])
(5)
Net increase in income tax expense
$20
Plus: second-quarter tax expense
5,510
Total second-quarter tax expense
$5,530
Total six months tax expense ($13,710 + $20)
$13,730

1Assume no net changes in the temporary differences and the related deferred tax balances between December 31, 20X5 and immediately prior to the change in the enactment date of the new tax rate (i.e., June 15, 20X6).

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