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8.3 Timing of accounting for a change in tax status
Publication date: 31 Dec 2022
us Income taxes guide
The impacts of a change in tax status may vary depending on whether a company is switching from a taxable to nontaxable status or vice-versa.
8.3.1 Changing to nontaxable status
As required by ASC 740-10-25-33, when a taxable entity switches to nontaxable status, the change in status should be recognized on the approval date if approval is necessary. If approval is not necessary, the change in status should generally be recognized at the filing date.
On the filing date (or approval date, if required), deferred taxes that will not be required after the effective date of the change to nontaxable status should be released to income. The entity will need to evaluate the expected reversal pattern of its temporary differences. Temporary differences that are expected to reverse prior to the effective date, while the entity is still taxable, should continue to be reflected in the financial statements. On the other hand, temporary differences that are expected to reverse subsequent to the effective date, when the entity will no longer be taxable, should be derecognized at the filing date if approval is not necessary. Deferred tax balances also may be required after the effective date if the entity is subject to the built-in gains tax (see TX 8.5).
8.3.2 Changing to taxable status
When a nontaxable entity switches to taxable status, or nontaxable status is retroactively revoked, the change in status should be recognized on the approval date, if approval is necessary. If approval is not necessary, the change in status should generally be recognized on the filing date. Deferred taxes should be provided on the filing date (or approval date, if required) for temporary differences (at that date) that will reverse after the effective date. Example TX 8-2 and Example TX 8-3 illustrate accounting for retroactive and prospective changes from nontaxable status.
EXAMPLE TX 8-2
Retroactive change from nontaxable status
Retroactive change from nontaxable status
On February 28, 20X1, Omega Corp revoked its nontaxable status, changing to taxable status retroactive to January 1, 20X1. No approval is required for this change. The following information relates to temporary differences at February 28, 20X1 assuming a 21% tax rate:
Book basis |
Tax basis |
Taxable/ (deductible) temporary difference |
Deferred tax asset / (liability) |
|
Accounts receivable |
$2,500 |
$2,800 |
($300) |
$63 |
Land |
600 |
500 |
100 |
(21) |
Machinery and equipment |
2,900 |
600 |
2,300 |
(483) |
Warranty reserve |
(1,000) |
— |
(1,000) |
210 |
Totals |
$5,000 |
$3,900 |
$1,100 |
($231) |
Omega Corp does not anticipate needing a valuation allowance at December 31, 20X1.
What is the impact of the retroactive change to taxable status?
Analysis
Omega Corp would record a net deferred tax liability of $231 ($1,100 at 21%) and a $231 deferred tax provision to income from continuing operations. Further, a current tax provision for the taxable income for the two months ended February 28, 20X1 would be accrued at February 28, 20X1.
If Omega Corp had not yet issued its 20X0 financial statements by February 28, 20X1, those statements should disclose the change in tax status and the effects of the change, if material.
EXAMPLE TX 8-3
Prospective change from nontaxable status
Prospective change from nontaxable status
On September 30, 20X1, Company A revoked its election to be treated as a nontaxable entity, thereby changing to taxable status effective January 1, 20X2. No approval is required for this change. The information below relates to temporary differences that existed at September 30, 20X1, and that will reverse after January 1, 20X2. It is not expected that a valuation allowance will be needed. An applicable rate of 21% has been assumed.
The following information relates to temporary differences at September 30, 20X1.
Book basis |
Tax basis |
Taxable / (deductible) temporary difference |
Deferred tax asset / (liability) |
|
Accounts receivable |
$2,200 |
$2,500 |
($300) |
$63 |
Land |
600 |
500 |
100 |
(21) |
Machinery and equipment |
3,000 |
800 |
2,200 |
(462) |
Warranty reserve |
(1,000) |
— |
(1,000) |
210 |
Totals |
$4,800 |
$3,800 |
$1,000 |
($210) |
The following information relates to temporary differences at December 31, 20X1.
Book basis |
Tax basis |
Taxable / (deductible) temporary difference |
Deferred tax asset / (liability) |
|
Accounts receivable |
$2,500 |
$2,800 |
($300) |
$63 |
Land |
600 |
500 |
100 |
(21) |
Machinery and equipment |
2,900 |
600 |
2,300 |
(483) |
Warranty reserve |
(1,000) |
— |
(1,000) |
210 |
Totals |
$5,000 |
$3,900 |
$1,100 |
($231) |
How should Company A record the accounting impact of the prospective change in taxable status?
Analysis
As a result of the revocation, Company A would record a net deferred tax liability of $210 ($1,000 at 21%) as of September 30, 20X1 and a $210 deferred tax provision to income from continuing operations.
In addition, because the net deferred tax liability increased from September 30 ($210) to December 31 ($231) due to an originating temporary difference, a deferred tax provision of $21 was recognized in the 20X1 financial statements. Because Company A remained a nontaxable entity during that period, there was no current tax provision in the period.
Example TX 8-4 discusses the timing of a retroactive “check-the-box” election.
EXAMPLE TX 8-4
When to consider the effect of a retroactive “check-the-box” election in accounting for US federal taxation of foreign subsidiary earnings
When to consider the effect of a retroactive “check-the-box” election in accounting for US federal taxation of foreign subsidiary earnings
Company X, a calendar year US Corporation, owns a Dutch holding company (FS1) which in turn owns several foreign subsidiaries including two UK companies (FS2 and FS3). Company X has maintained an indefinite reinvestment assertion with respect to FS1 and FS2 and therefore has not recorded deferred tax liabilities for the excess of book-over-tax basis in FS1 and FS2. FS2 holds an intercompany note due from FS3. Additional facts are as follows:
- In November 20X1, Company X undertakes a global restructuring of its treasury operations which results in the distribution of the intercompany note from FS2 to FS1.
- After the distribution was made, Company X discovers that as a result of currency fluctuations, the distribution, when converted into the functional currency of FS1, represents an amount exceeding the outside tax basis of FS2. For US tax purposes, without further action, the resulting gain at the FS1 level from the distribution would trigger subpart F income to Company X.
- In December 20X1, however, Company X decides to make a retroactive “check-the-box” (CTB) election on FS2 to treat it as a branch of FS1 for US federal tax purposes which results in no subpart F income in 20X1.
- The CTB election is filed in January 20X2, retroactively effective to the day prior to the November transfer, and does not require approval by the IRS.
- Company X concludes that there is no uncertainty with respect to its position that there was no subpart F income in 20X1.
When should Company X consider the effect of the CTB election in its financial statements (i.e., Q4 20X1 or Q1 20X2)?
Analysis
In this specific fact pattern, we believe there are two acceptable approaches.
Under one view, the CTB election could be considered to result in a change of status of FS2 for all US tax purposes (i.e., converting from a controlled foreign subsidiary to a foreign branch of another legal entity) and therefore the change in status provisions in ASC 740 would determine the accounting. Company X would apply the guidance on changes in tax status in ASC 740-10-25-33 through ASC 740-10-25-34, which require recognition of the effect of an election for a voluntary change in tax status on the election filing date if approval is not necessary. Prior to the election filing date, the situation described above would result in the recognition by Company X of a current tax liability for subpart F income. Company X would recognize the current tax liability related to subpart F income in its 20X1 consolidated financial statements and then derecognize this liability in Q1 20X2 when the CTB election is filed. Company X should provide disclosure of the fact that the tax liability recorded in Q4 20X1 will be derecognized in Q1 20X2.
Alternatively, in this fact pattern, the CTB election on FS2 could be viewed as equivalent to many tax return elections that are available to Company X and therefore would be considered at year-end as part of determining current year taxable income. In making this determination the follow factors are relevant:
- Company X qualifies for and intends to make the election which does not require approval by the IRS.
- The election is primarily within Company X’s control, and there are no significant costs or uncertainties as to its ability to make the election on a timely basis.
Under this view, in its 20X1 financial statements, Company X would take into account the expected CTB election, and therefore not recognize a current tax liability for subpart F income. Additional support for this view can be found in analogous situations, such as (1) an outside basis difference in a domestic subsidiary where the tax law provides a means to recover such basis difference tax free and the entity expects it will ultimately do so (see TX 11), or (2) an election for an automatic change from one permissible tax accounting method to another (see TX 6).
While the allocation and timing of recognition of a change in tax status guidance is specific, there may be judgment involved in some circumstances. For example, a check-the-box election may be leveraged as part of obtaining a worthless stock deduction. While a check-the-box election is generally considered a change in tax status, recognition of a tax benefit for a worthless stock deduction may occur when it becomes apparent that the existing temporary difference will reverse in the foreseeable future (rather than when the check-the-box election is made). See Example TX 11-3. Another example includes the impact of a change in connection with a business combination (see TX 8.6). Assessing all the facts and circumstances of a change is important to determining the appropriate timing and recognition of a change.
Finally, in general, the tax effects resulting from the initial qualification for a tax holiday should be treated in a manner similar to a change in tax status (i.e., when the election is filed or approved, if approval is necessary). See section TX 4.3.3.3 for further discussion of tax holidays.
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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