A Roadmap to Accounting for

Income Taxes
November 2020
The FASB Accounting Standards Codification® material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, PO Box 5116, Norwalk, CT
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Publications in Deloitte’s Roadmap Series

Business Combinations
Business Combinations — SEC Reporting Considerations
Carve-Out Transactions
Comparing IFRS Standards and U.S. GAAP
Consolidation — Identifying a Controlling Financial Interest
Contingencies, Loss Recoveries, and Guarantees
Contracts on an Entity’s Own Equity
Convertible Debt
Current Expected Credit Losses
Distinguishing Liabilities From Equity
Earnings per Share
Environmental Obligations and Asset Retirement Obligations
Equity Method Investments and Joint Ventures
Equity Method Investees — SEC Reporting Considerations
Fair Value Measurements and Disclosures
Foreign Currency Transactions and Translations
Guarantees and Collateralizations — SEC Reporting Considerations
Impairments and Disposals of Long-Lived Assets and Discontinued Operations
Income Taxes
Initial Public Offerings
Leases
Noncontrolling Interests
Non-GAAP Financial Measures and Metrics
Revenue Recognition
SEC Comment Letter Considerations, Including Industry Insights
Segment Reporting
Share-Based Payment Awards
Statement of Cash Flows

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Contents
Prefacexix

Contactsxx

Chapter 1 — Overview 1
1.1 Background of ASC 740 2
1.2 Objectives of ASC 740 2
1.2.1 Understanding “Events That Have Been Recognized in an Entity’s Financial Statements or Tax
Returns” 4
1.2.2 Understanding “the Amount of Taxes Payable or Refundable for the Current Year” 4
1.2.2.1 Permanent Differences 4
1.2.3 Understanding “Deferred Tax Liabilities and Assets” and “Future Tax Consequences” 5
1.2.3.1 Temporary Differences 5
1.2.3.2 Attributes 6
1.2.4 Complexities in Applying ASC 740 7

Chapter 2 — Scope 8
2.1 Introduction 8
2.2 Taxes Based on Income 10
2.3 Taxes Assessed in Lieu of Income Tax 10
2.4 Certain Entities Exempt From Income Taxes on the Basis of Legal Form 10
2.5 Hybrid Taxes 11
2.6 Accounting for Withholdings on Certain Payments (e.g., Dividends, Interest, Royalties,
or License Fees)  13
2.6.1 Accounting for a Withholding Tax by the Payor 13
2.6.2 Accounting for a Withholding Tax by the Recipient 13
2.7 Refundable Tax Credits 15
2.7.1 Selling Income Tax Credits to Monetize Them 15
2.8 Obligations for Indemnification of Uncertain Tax Positions of a Subsidiary Upon Sale —
Subsidiary Previously Filed a Separate Tax Return 16

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Chapter 3 — Book-Versus-Tax Differences and Tax Attributes 18

3.1 Background  18
3.2 Permanent Differences  18
3.2.1 Special Deductions 20
3.2.1.1 Statutory Depletion 20
3.2.1.2 Blue Cross/Blue Shield Organizations 21
3.2.1.3 Small Life Insurance Companies 21
3.2.1.4 Domestic Production Activities Deduction 21
3.2.1.5 Foreign-Derived Intangible Income  21
3.3 Temporary Differences  21
3.3.1 Overview 24
3.3.2 Determining Whether a Basis Difference Is a Temporary Difference 25
3.3.2.1 Examples of Basis Differences That Are Not Temporary Differences 25
3.3.3 Measurement of Temporary Differences 26
3.3.3.1 Tax Bases Used in the Computation of Temporary Differences  27
3.3.3.2 Anticipation of Future Losses  27
3.3.3.3 Tax Basis That Adjusts in Accordance With or Depends on a Variable 28
3.3.4 Measurement of Deferred Taxes  29
3.3.4.1 Graduated Tax Rates 32
3.3.4.2 Phased-In Changes in Tax Rates 36
3.3.4.3 Tax Rate Used in Measuring Receivables and DTAs Related to Operating Losses and Tax
Credits37
3.3.4.4 Measuring Deferred Taxes on Indefinite-Lived Assets  38
3.3.4.5 Effect of Tax Holidays on the Applicable Tax Rate  39
3.3.4.6 Consideration of Certain State Matters 39
3.3.4.7 Determining the Applicable Tax Rate When Different Rates Apply to Distributed
and Undistributed Earnings 42
3.3.4.8 Deferred Tax Measurement in Jurisdictions in Which an Income Measure Is Less Than
Comprehensive  44
3.3.4.9 Deferred Tax Treatment of Hybrid Taxes  46
3.3.4.10 Consideration of U.S. AMT Credit Carryforwards  49
3.3.4.11 AMT Rate Not Applicable for Measuring DTLs 49
3.3.4.12 Measurement of Deferred Taxes When Entities Are Subject to BEAT 50
3.3.5 Tax Method Changes  50
3.3.5.1 Considering the Impact of Tax Method Changes 51
3.3.5.2 When to Recognize the Impact of Tax Method Changes 53
3.3.6 Foreign Operations  56
3.3.6.1 Foreign Subsidiaries’ Basis Differences 56
3.3.6.2 Revaluation Surplus 57
3.3.6.3 Accounting for Foreign Branch Operations 58
3.4 Outside Basis Differences  64
3.4.1 Definition of Foreign and Domestic Investments 71
3.4.1.1 Definition of Subsidiary and Corporate Joint Venture 72

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3.4.1.2 Potential DTA: Foreign and Domestic Subsidiaries and Corporate Joint Ventures 72
3.4.1.3 Potential DTL: Domestic Subsidiary  73
3.4.2 Tax Consequences of a Change in Intent Regarding Remittance of
Pre-1993 Undistributed Earnings 74
3.4.3 Tax-Free Liquidation or Merger of a Subsidiary 74
3.4.4 Potential DTL: Foreign Subsidiary and Foreign Corporate Joint Venture 76
3.4.5 DTL for a Portion of an Outside Basis Difference  76
3.4.5.1 Evidence Needed to Support the Indefinite Reinvestment Assertion  77
3.4.5.2 Ability to Overcome the Presumption in ASC 740-30-25-3 After a Change in
Management’s Plans for Reinvestment or Repatriation of Foreign Earnings 78
3.4.5.3 Change in Indefinite Reinvestment Assertion — Recognized or Nonrecognized
Subsequent Event 79
3.4.6 Measuring Deferred Taxes on Outside Basis Differences in Foreign Investments 79
3.4.7 [Deleted]
3.4.8 Outside Basis Difference in a Foreign Subsidiary — Subpart F Income 80
3.4.9 Outside Basis Difference in a Foreign Subsidiary — Deferred Subpart F Income 82
3.4.10 Global Intangible Low-Taxed Income  82
3.4.10.1 GILTI Accounting Policy Election 83
3.4.10.2 GILTI Deferred Method — Overview 84
3.4.10.3 GILTI Deferred Method — Measurement of Deferred Taxes 84
3.4.10.4 GILTI Deferred Method — Other Considerations 85
3.4.11 Deemed Repatriation Transition Tax (IRC Section 965)  86
3.4.11.1 Classification of the Transition Tax Liability 86
3.4.11.2 Measurement of Transition Tax Obligation in Periods Before Inclusion in the
Income Tax Return  87
3.4.11.3 Measurement of the Transition Tax Obligation — Discounting  87
3.4.11.4 Measurement of the Transition Tax Liability — Tax Planning  88
3.4.12 “Unborn” FTCs — Before the 2017 Act 88
3.4.12A Foreign Exchange Gain (or Loss) on Distributions From a Foreign Subsidiary When
There Is No Overall Taxable (or Deductible) Outside Basis Difference 90
3.4.13 Withholding Taxes Imposed on Distributions From Disregarded Entities and Foreign
Subsidiaries 93
3.4.13.1 View 1 — Parent Jurisdiction Perspective  94
3.4.13.2 View 2 — Foreign Jurisdiction Perspective  95
3.4.13.3 Determining the Income Tax Effects of Distributions of Previously Taxed Earnings and
Profits in a Single-Tier or Multi-Tier Legal Entity Structure 95
3.4.14 Withholding Taxes — Foreign Currency Considerations 96
3.4.15 Tax Consequences of Investments in Pass-Through or Flow-Through Entities 97
3.4.16 Accounting for the Tax Effects of Contributions to Pass-Through Entities in Control-to-
Control Transactions 99
3.4.17 Other Considerations 103
3.4.17.1 Consideration of the VIE Model in ASC 810-10 in the Evaluation of Whether to
Recognize a DTL 103

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3.4.17.2 Recognition of a DTA or DTL Related to a Subsidiary Classified as a

Discontinued Operation 104
3.4.17.3 State Tax Considerations  105
3.5 Other Considerations and Exceptions  106
3.5.1 Changes in Tax Laws and Rates  106
3.5.1.1 Retroactive Changes in Tax Laws or Rates and Expiring Provisions That May
Be Reenacted 107
3.5.1.2 Enacted Changes in Tax Laws or Rates That Affect Items Recognized in Equity 107
3.5.1.3 Change in Tax Law That Allows an Entity to Monetize an Existing DTA or Tax
Credit in Lieu of Claiming the Benefit in the Future  109
3.5.2 Changes in Tax Status of an Entity  109
3.5.2.1 Recognition Date  110
3.5.2.2 Effective Date  110
3.5.2.3 Measurement — Change From Nontaxable to Taxable  111
3.5.2.4 Measurement — Change From Taxable to Nontaxable  111
3.5.3 Tax Effects of a Check-the-Box Election 111
3.5.4 Real Estate Investment Trust 113
3.5.4.1 Recognition Date for Conversion to a REIT 113
3.5.4.2 Change in Tax Status to Nontaxable: Built-in Gain Recognition and Measurement 114
3.5.5 Tax Consequences of Bad-Debt Reserves of Thrift Institutions  116
3.5.6 Tax Effects of Intra-Entity Profits on Inventory  119
3.5.6.1 Subsequent Changes in Tax Rates Involving Intra-Entity Transactions 120
3.5.7 Income Tax Consequences of Debt With a Conversion Feature Accounted for
Separately as a Derivative 121
3.5.8 Leases  123
3.5.8.1 Deferred Tax Consequences of Synthetic Leases 124
3.5.9 Accounting for Temporary Differences Related to ITCs  125
3.5.10 Tax Consequences of Securities Classified as HTM, Trading, and AFS  130
3.5.10.1 HTM Securities 130
3.5.10.2 Trading Securities 131
3.5.10.3 AFS Securities 131

Chapter 4 — Uncertainty in Income Taxes 132

4.1 Overview and Scope  132
4.1.1 UTB Decision Tree and Assumptions in Recognition and Measurement 133
4.1.2 Consideration of Tax Positions Under ASC 740 134
4.1.2.1 Tax Positions Related to Entity Classification  134
4.1.2.2 Unit of Account 135
4.2 Recognition 136
4.2.1 Meaning of the Court of Last Resort and Its Impact on Recognition 138
4.2.2 Legal Tax Opinions Not Required  139
4.2.3 Consideration of Widely Understood Administrative Practices and Precedents 139

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4.3 Measurement 140
4.3.1 Information Affecting Measurement of Tax Positions 140
4.3.2 Cumulative-Probability Table 141
4.3.3 Cumulative-Probability Approach Versus Best Estimate 141
4.3.4 Use of Aggregation and Offsetting in Measuring a Tax Position 142
4.3.5 Tax Positions That Are Considered Binary 142
4.4 Interest (Expense and Income) and Penalties 143
4.4.1 Interest Expense 143
4.4.2 Interest Income 143
4.4.3 Penalties 143
4.5 Subsequent Changes in Recognition and Measurement 145
4.5.1 Decision Tree for the Subsequent Recognition, Derecognition, and Measurement of
Benefits of a Tax Position 147
4.5.2 New Information  148
4.5.3 Effectively Settled Tax Positions 149
4.6 Other Topics 150
4.6.1 Accounting for the Tax Effects of Tax Positions Expected to Be Taken in an Amended
Tax Return or Refund Claim or to Be Self-Reported Upon Examination 150
4.6.2 State Tax Positions 152
4.6.2.1 Economic Nexus 152
4.6.2.2 Due Process 153
4.6.3 Uncertain Tax Positions in Transfer Pricing Arrangements 154
4.6.3.1 Determination of the Unit of Account  154
4.6.3.2 Recognition  155
4.6.3.3 Measurement  155
4.6.4 Uncertainty in Deduction Timing 157
4.6.5 Deferred Tax Consequences of UTBs 160
4.6.6 UTBs and Spin-Off Transactions 161

Chapter 5 — Valuation Allowances 163

5.1 Introduction 163
5.2 Basic Principles of Valuation Allowances 163
5.2.1 The More-Likely-Than-Not Standard 165
5.3 Sources of Taxable Income 166
5.3.1 Future Reversals of Existing Taxable Temporary Differences  167
5.3.1.1 Determining the Pattern of Reversals of Existing Taxable Temporary Differences 168
5.3.1.2 Realization of a DTA Related to an Investment in a Subsidiary: Deferred Income
Tax Exceptions Not a Source of Income 168
5.3.1.3 Using the Reversal of a DTL for an Indefinite-Lived Asset as a Source of Taxable
Income After Enactment of the 2017 Act 169
5.3.1.4 Deemed Repatriation Transition Tax as a Source of Future Taxable Income  170
5.3.1.5 Use of Attributes That Result in Replacement or “Substitution” of DTAs 171

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5.3.2 Future Taxable Income 172

5.3.2.1 Cumulative Losses: An Objectively Verifiable Form of Negative Evidence 173
5.3.2.2 Positive Evidence Considered in the Determination of Whether a Valuation
Allowance Is Required 176
5.3.2.3 Effect of Nonrecurring Items on Estimates of Future Income and Development
of Objectively Verifiable Future Income Estimates 177
5.3.3 Taxable Income in Prior Carryback Year(s) if Carryback Is Permitted Under the Tax Law  183
5.3.4 Tax-Planning Strategies  184
5.3.4.1 Examples of Qualifying Tax-Planning Strategies  185
5.3.4.2 Examples of Nonqualifying Tax-Planning Strategies  187
5.3.4.3 Recognition and Measurement of a Tax-Planning Strategy 188
5.3.5 Determining of the Need for a Valuation Allowance by Using the Four Sources of
Taxable Income 192
5.4 Consideration of Future Events When Assessing the Need for a Valuation Allowance 194
5.5 Reduction of a Valuation Allowance When Negative Evidence Is No Longer Present 195
5.6 Going-Concern Opinion as Negative Evidence 195
5.7 Exceptions and Special Situations 196
5.7.1 AMT Valuation Allowances 196
5.7.2 Assessing Realization of a DTA for Regular Tax NOL Carryforwards When Considering
Future GILTI Inclusions 196
5.7.3 Determination of the Need for a Valuation Allowance Related to FTCs 197
5.7.4 Evaluating a DTA (for Realization) Related to a Debt Security Attributed to an Unrealized
Loss Recognized in OCI 199
5.7.4.1 Before the Adoption of ASU 2016-01 201
5.7.4.2 After the Adoption of ASU 2016-01 202
5.7.5 Assessing Realization of Tax Benefits From Unrealized Losses on AFS Securities 203
5.7.6 Application of ASC 740-20-45-7 to Recoveries of Losses in AOCI 204
5.7.7 Realization of a DTA of a Savings and Loan Association: Reversal of a Thrift’s Base-
Year Tax Bad-Debt Reserve 205
5.7.8 Accounting for Valuation Allowances in Separate or Carve-Out Financial Statements 206
5.7.9 Accounting for a Change in a Valuation Allowance in an Interim Period  206
5.7.10 Accounting Considerations for Valuation Allowances Related to Business Combinations  206
5.7.11 Accounting Considerations for Valuation Allowances Related to Share-
Based Payment DTAs  206
5.8 Examples Illustrating the Determination of the Pattern of Reversals of Temporary Differences  206
5.8.1 State and Local Tax Jurisdictions 206
5.8.2 Unrecognized Tax Benefits  206
5.8.3 Accrued Interest and Penalties 207
5.8.4 Tax Accounting Method Changes 207
5.8.5 LIFO Inventory 208
5.8.6 Obsolete Inventory 208
5.8.7 Cash Surrender Value of Life Insurance 208
5.8.8 Land 208
5.8.9 Nondepreciable Assets 209
5.8.10 Assets Under Construction 209

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5.8.11 Disposal of Long-Lived Assets by Sale 209

5.8.12 Costs Associated With Exit or Disposal Activities 209
5.8.13 Loss Contingencies 209
5.8.14 Organizational Costs 209
5.8.15 Long-Term Contracts 210
5.8.16 Pension and Other Postretirement Benefit Obligations 210
5.8.17 Deferred Income and Gains 211
5.8.18 Allowances for Doubtful Accounts 211
5.8.19 Property, Plant, and Equipment 211

Chapter 6 — Intraperiod Allocation 213

6.1 Background  213
6.2 Method for Allocating Income Taxes to Components of Comprehensive Income and
Shareholders’ Equity 213
6.2.1 General Rule 217
6.2.1.1 General “With-and-Without” Rule 217
6.2.2 Changes in Valuation Allowances 219
6.2.3 Special Situations 220
6.2.3.1  Quasi-Reorganization Tax Benefits  220
6.2.3.2 Fresh-Start Accounting  220
6.2.4 AFS Debt Securities: Valuation Allowance for Unrealized Losses 221
6.2.5 Out-of-Period Items 222
6.2.5.1 Intraperiod Allocation of Out-of-Period Items Related to Components Classified as
Discontinued Operations 223
6.2.6 Stranded Taxes  226
6.2.6.1 Security-by-Security Approach  226
6.2.6.2 Portfolio Approach  226
6.2.6.3 ASU 2018-02 227
6.2.7 Transactions Among or With Shareholders  232
6.2.7.1 Tax Consequences of Transactions Among (and With) Shareholders 232
6.2.8 Other Special Considerations  233
6.2.8.1 Holding Gains and Losses Recognized for Both Financial Reporting and
Tax Purposes 233
6.2.8.2 Change in Tax Status to Taxable: Accounting for an Increase in Tax Basis 235
6.2.8.3 Income Tax Accounting Considerations Related to When a Subsidiary
Is Deconsolidated 236
6.2.9 Tax Benefits for Dividends Paid to Shareholders: Recognition 238
6.2.10 Treatment of Tax Benefit for Dividends Paid on Shares Held by an ESOP 238
6.2.11 Exception to the General Rule  239
6.2.11.1 Intraperiod Tax Allocation When There Is a Loss From Continuing Operations
in the Current Period 239
6.2.12 Application of ASC 740-20-45-7 to Amounts Credited Directly to APIC 242
6.2.13 Application of ASC 740-20-45-7 to Foreign Currency Exchange Gains 243

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6.2.14 Consideration of Credit Entries for Reclassification Adjustments That Are Recorded

in OCI During the Reporting Period When the Exception to the General Intraperiod Tax
Allocation Rule Is Applied 244
6.2.15 Application of ASC 740-20-45-7 to Recoveries of Losses in AOCI 245
6.2.16 Implications of the Character of Income (or Loss) When the Exception to the General
Intraperiod Tax Allocation Rule Is Applied 247

Chapter 7 — Interim Reporting 248

7.1 Overview 248
7.1.1 The Basic Interim Provision Model 252
7.2 Items Accounted for Separately From the AETR 253
7.2.1 Significant Unusual or Infrequent Items 259
7.2.2 Components of Pretax Income That Are Not Estimable 261
7.2.3 Exclusion of a Jurisdiction From the AETR 261
7.2.3.1 Loss Jurisdiction for Which No Tax Benefit Can Be Recognized  261
7.2.3.2 Inability to Estimate AETR in Dollars or Unreliable Estimate of Ordinary Income
(or Loss) or Related Tax Expense (or Benefit) 265
7.2.4 Excess Tax Benefits and Deficiencies Related to Share-Based Payment Awards 266
7.2.4.1 Interim Tax Effects of Awards Expected to Expire Unexercised During the Year 266
7.2.4.2 Measuring the Excess Tax Benefit or Tax Deficiency Associated With Share-Based
Compensation: Tax Credits and Other Items That Affect the ETR 266
7.2.5 Tax-Exempt Interest  267
7.2.6 Interest Expense When Interest Is Classified as Income Tax Expense  267
7.3 Items Excluded in Part From the AETR 268
7.3.1 Valuation Allowances 268
7.3.1.1 Recognition of the Tax Benefit of a Loss in an Interim Period  271
7.3.1.2 YTD Pretax Loss Exceeds the Anticipated Pretax Loss for the Full Year 272
7.3.2 Changes in Tax Laws and Rates Occurring in Interim Periods 272
7.3.2.1 Retroactive Changes in Tax Laws 273
7.3.2.2 Administratively Effective Date of New Legislation  276
7.3.3 Changes in Judgment Related to UTBs 277
7.3.3.1 Changes in Judgment Regarding a Tax Position Taken in the Current Year 278
7.3.3.2 Changes in Judgment Regarding a Tax Position Taken in the Prior Year 279
7.3.4 Changes in an Indefinite Reinvestment Assertion  279
7.4 Intraperiod Tax Allocation in Interim Periods 280
7.4.1 Recognition of the Tax Benefit of an Operating Loss Carryforward in an Interim Period 282
7.4.2 Intraperiod Tax Allocation When There Is a Loss From Continuing Operations and
Income in Discontinued Operations 283
7.5 Other Considerations 285
7.5.1 Inability to Make a Reliable Estimate of the AETR 285
7.5.2 Nonrecognized Subsequent Events  285
7.5.3 Balance Sheet Effects of the Interim Provision for Income Taxes 286
7.5.4 Required Interim Disclosures  287

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Chapter 8 — Accounting for Income Taxes in Separate Financial Statements 288

8.1 Introduction 288
8.2 Determining Whether an Allocation of Income Taxes Is Required in Separate or Carve-Out
Financial Statements 288
8.2.1 Separate Financial Statements Composed of One or More Taxable Legal Entities 290
8.2.2 Separate Financial Statements of Nontaxable Legal Entities or “Pass-Through” Entities 290
8.2.3 Carve-Out Financial Statements (i.e., Statements Composed of One or More
Unincorporated Divisions, Branches, Disregarded Entities, or Lesser Components
of the Parent Reporting Entity)  290
8.2.4 Separate Financial Statements of Single-Member LLCs 291
8.2.5 Abbreviated Financial Statements 292
8.3 Allocating Current and Deferred Income Tax Expense in the Income Statement of Separate and
Carve-Out Financial Statements 293
8.3.1 Acceptable Methods of Allocating Tax to Separate and Carve-Out Financial Statements 293
8.3.1.1 Separate-Return Method  293
8.3.1.2 Parent-Company-Down Method  297
8.3.2 Preferable Allocation Method for Financial Statements Filed With the SEC 298
8.3.3 Change in Application of Tax Allocation Methods 298
8.3.4 Tax-Sharing Agreements  299
8.3.4.1 General  299
8.3.4.2 Tax-Sharing Agreements That Are Not Acceptable for Financial Reporting Purposes 299
8.3.5 Allocating Benefits to a Subsidiary for Parent’s Interest Expense  301
8.3.6 “Return-to-Provision” Adjustments in Separate or Carve-Out Financial Statements 301
8.4 Current and Deferred Income Taxes in the Balance Sheet of Separate and Carve-Out Financial
Statements 302
8.4.1 Requirement to Record DTAs and DTLs in Separate or Carve-Out Financial Statements 302
8.4.2 Method for Recording DTAs and DTLs in the Balance Sheet of Separate or Carve-Out
Financial Statements 303
8.4.3 Recognition of DTAs Related to Temporary Differences for Which the Separate or
Carve-Out Entity Has Been Paid by Another Member of the Consolidated Filing Group 303
8.4.4 Recording Deferred Income Taxes in the Balance Sheet Under the Separate-
Return Method 304
8.4.4.1 Taxable Temporary Differences Resulting From Investments in Foreign
Subsidiaries and Foreign Corporate Joint Ventures in Separate Financial
Statements Prepared by Using the Separate-Return Method  304
8.4.4.2 Current Taxes Payable or Receivable and UTBs Liability Under the Separate-
Return Method  305
8.4.4.3 DTAs Related to Tax Attributes Under the Separate-Return Method 306
8.5 Valuation Allowance in Separate or Carve-Out Financial Statements  308
8.5.1 Separate-Return Method  309
8.5.2 Parent-Company-Down Method  309
8.6 Change in Status of the Separate Reporting Entity 309
8.7 Disclosures Required in the Separate Financial Statements of a Member of a Consolidated
Tax Return 309
8.7.1 Disclosures in Separate or Carve-out Financial Statements to Be Included in a Filing
With the SEC 310

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8.7.2 Disclosures in Separate or Carve-Out Financial Statements That Will Not Be Included

in a Filing With the SEC 310
8.7.3 Disclosures in Abbreviated Separate or Carve-Out Financial Statements 311
8.7.4 Disclosures Associated With Attributes (i.e., NOL or Tax Credit Carryforwards) in
Separate or Carve-Out Financial Statements  311

Chapter 9 — Foreign Currency Matters 312

9.1 Overview 312
9.2 Remeasurement 315
9.2.1 Nonmonetary Assets and Liabilities  317
9.2.2 Indexing of the Tax Basis  319
9.2.3 Monetary Assets and Liabilities When the Reporting Currency Is the Functional Currency 320
9.2.3.1 Local-Currency-Denominated Monetary Assets and Liabilities  320
9.2.3.2 Reporting-Currency-Denominated Monetary Assets and Liabilities  321
9.3 Price-Level-Adjusted Financial Statements  323
9.4 Cumulative Translation Account Overview  324
9.4.1 Recognition of Deferred Taxes for Temporary Differences Related to the CTA 324
9.5 Hedge of a Net Investment in a Foreign Subsidiary 326
9.6 Changes in an Entity’s Functional Currency  326
9.6.1 Changes From the Local Currency to the Reporting Currency  326
9.6.2 Change in the Functional Currency When an Economy Ceases to Be Considered
Highly Inflationary  330
9.7 Long-Term Intra-Entity Loans to Foreign Subsidiaries  331
9.7.1 Deferred Tax Considerations When Intra-Entity Loans That Are of a Long-Term-
Investment Nature Are Denominated in the Subsidiary’s Functional Currency 331
9.7.1.1 Unit of Account 332
9.7.2 Deferred Tax Considerations When Intra-Entity Loans That Are of a Long-Term-Investment
Nature Are Denominated in the Parent’s Functional Currency 333
9.8  Changes in U.S. Deferred Income Taxes Related to a Foreign Branch CTA  334

Chapter 10 — Share-Based Payments 337

10.1 Background and Scope  337
10.1.1 Nonvested Shares 338
10.1.2 Share Options  338
10.1.2.1 Qualifying Transfers  339
10.1.2.2 Nonqualifying Transfers  339
10.1.3 Restricted Share Units and SARs  339
10.1.4 Employee Stock Purchase Plans  339
10.2 Deferred Tax Effects of Share-Based Payments  340
10.2.1 Equity-Classified Awards That Ordinarily Result in a Deduction 341
10.2.2 Liability-Classified Awards That Ordinarily Result in a Deduction 342
10.2.3 Determining Deductibility of Awards Under IRC Section 162(m) 343
10.2.4 Excess Tax Benefits and Tax Deficiencies  344
10.2.4.1 Excess Tax Benefits and Tax Deficiencies in Interim Financial Statements  346
10.2.4.2 Tax Deficiency Resulting From Expiration of an Award  346

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Deloitte | A Roadmap to Accounting for Income Taxes (November 2020)

10.2.5 Deferred Tax Effects of a Change in Share Price on Equity-Classified Awards 347

10.2.6 Deferred Tax Effects of a Change in Share Price on Liability-Classified Awards  347
10.2.7 Deferred Tax Effects of a Change in Tax Status of an Award 351
10.2.8 Deferred Tax Effects of Changes in Tax Rates  352
10.2.9 Deferred Tax Effects of IRC Section 83(b) Elections and “Early” Exercises of NQSOs  352
10.2.10 Deferred Tax Effects When Compensation Cost Is Capitalized  352
10.3 Permanent Differences Resulting From Share-Based Payment Awards 354
10.3.1 Equity- and Liability-Classified Awards That Do Not Ordinarily Result in a Deduction 354
10.3.2 Tax Benefits of Dividends on Share-Based Payment Awards 355
10.4 “Recharge Payments” Made by Foreign Subsidiaries  355
10.5 Cost-Sharing Arrangements  356
10.6 Accounting Considerations for Valuation Allowances Related to Share-Based Payment DTAs  357
10.7 Deferred Tax Effects of Replacement Awards Issued in a Business Combination  358
10.7.1 Tax Effects of Replacement Awards Issued in a Business Combination That Ordinarily
Would Result in a Deduction 359
10.7.1.1 Income Tax Accounting as of the Acquisition Date  359
10.7.1.2 Income Tax Accounting After the Acquisition Date  359
10.7.1.3 Income Tax Accounting Upon Vesting or Exercise of the Share-Based
Payment Awards  360
10.7.2 Tax Effects of Replacement Awards Issued in a Business Combination That Would Not
Ordinarily Result in Tax Deductions 362
10.7.2.1 Tax Effects of a Disqualifying Disposition in a Business Combination 362
10.7.3 Exchange of Vested Acquiree Employee Awards for Unvested Share Awards of Acquirer in a
Business Combination 363

Chapter 11 — Business Combinations 364

11.1 Introduction 364
11.1.1 Measurement Period 367
11.1.2 Asset Acquisitions 367
11.1.3 Taxable Versus Nontaxable Business Combination  368
11.1.4 Other General Considerations 369
11.2 General Principles of Income Tax Accounting for a Business Combination 369
11.2.1 Identifying Parts of the Business Combination 369
11.2.2 Change in Tax Status as a Result of Acquisition 370
11.2.3 The Applicable Tax Rate 371
11.2.3.1 Tax Holidays 372
11.2.3.2 State Tax Footprint 372
11.3 Recognition and Measurement of Temporary Differences Related to Identifiable Assets
Acquired and Liabilities Assumed 372
11.3.1 Basis Differences 373
11.3.1.1 Inside Basis Difference  373
11.3.1.2 Outside Basis Difference  373
11.3.2 Goodwill 375
11.3.2.1 Pre-FASB Statement 141(R) Transactions 380

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11.3.2.2 Amortization of Goodwill 383

11.3.2.3 Private Company Alternative 384
11.3.2.4 Impairment Testing 385
11.3.2.5 Disposal of Goodwill 391
11.3.3 Bargain Purchase 394
11.3.4 Other Assets Acquired  396
11.3.4.1 Other Intangibles 396
11.3.4.2 Reacquired Rights 397
11.3.4.3 R&D Assets 399
11.3.4.4 Leveraged Leases Acquired  400
11.3.4.5 Obtaining Tax Basis Step-Up of Acquired Assets Through Direct Transaction With
Governmental Taxing Authority  401
11.3.5 Liabilities Assumed 402
11.3.5.1 Contingencies 402
11.3.5.2 Environmental Liabilities 406
11.3.6 Other Considerations  408
11.3.6.1 Transaction Costs 409
11.3.6.2 Contingent Consideration 411
11.3.6.3 Business Combinations Achieved in Stages 416
11.3.6.4 Accounting for the Settlement of a Preexisting Relationship 420
11.3.6.5 Accounting for Assets Acquired in a Business Combination That Were Subject to
an Intra-Entity Sale 422
11.3.6.6 Recognition of Changes in Indemnification Assets Under a Tax Indemnification
Arrangement423
11.3.6.7 Acquired Current Taxes Payable 424
11.4 Accounting for Uncertainty in Income Taxes in Business Combinations 424
11.4.1 Changes in Uncertain Income Tax Positions Acquired in a Business Combination 425
11.5 Valuation Allowances 427
11.5.1 Accounting for Changes in the Acquirer’s and Acquiree’s Valuation Allowances as of
and After the Acquisition Date 429
11.5.2 Assessing the Need for a Valuation Allowance as of and After the Acquisition Date 430
11.6 Share-Based Payments 431
11.6.1 Tax Benefits of Tax-Deductible Share-Based Payment Awards Exchanged in a
Business Combination 433
11.6.1.1 Income Tax Accounting as of the Acquisition Date  433
11.6.1.2 Income Tax Accounting After the Acquisition Date  433
11.6.1.3 Income Tax Accounting Upon Exercise of the Share-Based Payment Awards  433
11.6.2 Settlement of Share-Based Payment Awards Held by the Acquiree’s Employees 437
11.7 Other Considerations 438
11.7.1 Deconsolidation 438
11.7.1.1 Income Statement Considerations  438
11.7.1.2 Balance Sheet Considerations  439
11.7.2 Discontinued Operations 440

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11.7.3 Pushdown Accounting Considerations 440

11.7.3.1 Applicability of Pushdown Accounting to Income Taxes and Foreign Currency
Translation Adjustments 440
11.7.4 Other Forms of Mergers  442
11.7.4.1 Successor Entity’s Accounting for the Recognition of Income Taxes When the
Predecessor Entity Is Nontaxable 442
11.7.4.2 Accounting for the Elimination of Income Taxes Allocated to a Predecessor Entity
When the Successor Entity Is Nontaxable 444
11.7.4.3 Change in Tax Status as a Result of a Common-Control Merger 446
11.8 Asset Acquisitions 446

Chapter 12 — Other Investments and Special Situations 450

12.1 Introduction  450
12.2 Noncontrolling Interests 450
12.2.1 Accounting for the Tax Effects of Transactions With Noncontrolling Shareholders 450
12.2.2 Noncontrolling Interests in Pass-Through Entities: Income Tax Financial Reporting
Considerations 452
12.3 Equity Method Investee Considerations 453
12.3.1 Deferred Tax Consequences of an Investment in an Equity Method Investment
(a 50-Percent-or-Less-Owned Investee) 453
12.3.1.1 Potential DTL: Domestic Investee 453
12.3.1.2 Potential DTL: Foreign Investee 453
12.3.1.3 Potential DTA: Foreign and Domestic Investee 454
12.3.2 Tax Effects of Investor Basis Differences Related to Equity Method Investments 454
12.3.3 Change in Investment From a Subsidiary to an Equity Method Investee 455
12.3.4 Accounting for an ITC Received From an Investment in a Partnership Accounted for
Under the Equity Method 457
12.3.4.1 Approach 1 — Account for ITCs as an Income Tax Benefit 458
12.3.4.2 Approach 2 — Apply a Model Similar to the Deferral Method 458
12.3.5 Presentation of Tax Effects of Equity in Earnings of an Equity Method Investee 458
12.4 QAHP Investments 459
12.4.1 Tax Benefits Resulting From Investments in Affordable Housing Projects 463
12.4.1.1 The Proportional Amortization Method  464
12.4.1.2 Other Methods 465
12.4.2 Applicability of the Proportional Amortization Method to a QAHP Investment That
Generates Other Tax Credits in Addition to Affordable Housing Credits 466
12.4.3 Recognizing Deferred Taxes When the Proportional Amortization Method Is Used
to Account for an Investment in a QAHP 467
12.4.3.1 Illustrative Examples 468
12.5 Regulated Entities 471
12.5.1 Regulated Entities Subject to ASC 980 471
12.6 Special Situations 472
12.6.1 Distinguishing a Change in Estimate From a Correction of an Error 472

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Chapter 13 — Presentation of Income Taxes 474

13.1 Background  474
13.2 Statement of Financial Position Classification of Income Tax Accounts 474
13.2.1 Presentation of Deferred Federal Income Taxes Associated With Deferred State
Income Taxes 476
13.2.2 Balance Sheet Classification of the Liability for UTBs 477
13.2.3 Interaction of UTBs and Tax Attributes 477
13.2.4 Balance Sheet Presentation of UTBs Resulting From Transfer Pricing Arrangements 478
13.3 Income Statement 478
13.3.1 Classification of Interest and Penalties in the Financial Statements 478
13.3.2 Capitalization of Interest Expense 479
13.3.3 Interest Income on UTBs 479
13.3.4 Presentation of Professional Fees 479

Chapter 14 — Disclosure of Income Taxes 481

14.1 Overview 481
14.2 Balance Sheet 481
14.2.1 Deferred Taxes 482
14.2.1.1 Required Level of Detail 483
14.2.1.2 Definition of “Significant” With Respect to Disclosing the Tax Effect of Each Type of
Temporary Difference and Carryforward That Gives Rise to DTAs and DTLs 483
14.2.2 Other Balance Sheet Disclosure Considerations 483
14.2.2.1 Disclosure of Temporary Difference or Carryforward That Clearly Will Never
Be Realized 483
14.2.2.2 Disclosure of Outside Basis Differences 484
14.3 Income Statement 484
14.3.1 Rate Reconciliation  485
14.3.1.1 Evaluating Significance of Reconciling Items in the Rate Reconciliation 486
14.3.1.2 Appropriate Federal Statutory Rate for Use in the Rate Reconciliation of a
Foreign Reporting Entity 487
14.3.1.3 Computing the “Foreign Rate Differential” in the Rate Reconciliation 487
14.3.2 Other Income Statement Disclosure Considerations 488
14.3.2.1 Disclosure of the Components of Deferred Tax Expense 488
14.3.2.2 Disclosure of the Tax Effect of a Change in Tax Law, Rate, or Tax Status 488
14.4 UTB-Related Disclosures 489
14.4.1 The Tabular Reconciliation of UTBs 489
14.4.1.1 Items Included in the Tabular Disclosure of UTBs From Uncertain Tax Positions
May Also Be Included in Other Disclosures 490
14.4.1.2 Periodic Disclosures of UTBs 490
14.4.1.3 Presentation of Changes Related to Exchange Rate Fluctuations in the Tabular
Reconciliation 490
14.4.1.4 Disclosure of Fully Reserved DTAs in the Reconciliation of UTBs 491
14.4.1.5 Disclosure of the Settlement of a Tax Position When the Settlement Amount
Differs From the UTB 491
14.4.1.6 Consideration of Tabular Disclosure of UTBs in an Interim Period 491

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14.4.1.7 Presentation in the Tabular Reconciliation of a Federal Benefit Associated With

Unrecognized State and Local Income Tax Positions 492
14.4.2 Disclosure of UTBs That, if Recognized, Would Affect the ETR 492
14.4.2.1 Example of UTBs That, if Recognized, Would Not Affect the ETR 492
14.4.3 Disclosure of UTBs That Could Significantly Change Within 12 Months of the
Reporting Date 493
14.4.3.1 Disclosure of Expiration of Statute of Limitations 494
14.4.3.2 Disclosure Requirements for Effectively Settled Tax Positions 494
14.4.3.3 Interim Disclosure Considerations Related to UTBs That Will Significantly Change
Within 12 Months 495
14.4.4 Separate Disclosure of Interest Income, Interest Expense, and Penalties 495
14.4.4.1 Interest Income on UTBs 496
14.4.5 Disclosure of Liabilities for UTBs in the Contractual Obligations Table 496
14.4.6 Disclosing the Effects of Income Tax Uncertainties in a Leveraged Lease Entered
Into Before the Adoption of ASC 842 497
14.5 Public Entities Not Subject to Income Taxes 497
14.5.1 Tax Bases in Assets 498
14.6 Disclosure of the Components of Income (or Loss) Before Income Tax Expense (or Benefit)
as Either Foreign or Domestic  498
14.6.1 Branches 499
14.6.2 Intra-Entity Transactions 499
14.6.2.1 Intra-Entity Transactions Not Subject to ASC 740-10-25-3(e) 500
14.6.2.2 Intra-Entity Transactions Subject to ASC 740-10-25-3(e) 500
14.7 Pro Forma Financial Statements 501
14.7.1 Change in Tax Status to Taxable: Pro Forma Financial Reporting Considerations 501
14.8 Statement of Cash Flows 502
14.9 Additional Disclosure Requirements 502
14.10 Disclosures Outside the Financial Statements — MD&A 502

Appendix A — Implementation Guidance and Illustrations 504

Appendix B — Changes Under ASU 2019-12: Simplifying the Accounting

for Income Taxes 578

Appendix C — FASB Proposes Changes to Income Tax Disclosure Requirements 584

Appendix D — Glossary of Terms in the ASC 740 Topic and Subtopics 590

Appendix E — Sample Disclosures of Income Taxes 602

Appendix F — Differences Between U.S. GAAP and IFRS Standards 623

Appendix G — Titles of Standards and Other Literature 638

Appendix H — Abbreviations 645

Appendix I — Changes Made in the November 2020 Edition of This Publication 647

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Preface
November 2020

To our friends and clients:

We are pleased to present the November 2020 edition of A Roadmap to Accounting for Income Taxes. This
Roadmap provides Deloitte’s insights into and interpretations of the income tax accounting guidance in
ASC 7401 and the differences between that standard and IFRS® Standards (in Appendix F). The income
tax accounting framework has been in place for many years; however, views on the application of that
framework to current transactions continue to evolve because structures and tax laws are continually
changing. Therefore, use of this Roadmap, though it is intended as a helpful resource, is not a substitute
for consultation with Deloitte professionals on complex income tax accounting questions or transactions.

The body of this Roadmap combines the income tax accounting rules from ASC 740 with Deloitte’s
interpretations and examples in a comprehensive, reader-friendly format. The Roadmap reflects
Accounting Standards Updates (ASUs) issued by the FASB through October 31, 2020, and includes
pending content from recently issued ASUs. Readers should refer to the transition guidance in the FASB
Accounting Standards Codification or in the relevant ASU to determine the effective date(s) of the pending
guidance.

Each chapter of this publication typically starts with a brief introduction and includes excerpts from
ASC 740 or related guidance, Deloitte’s interpretations of those excerpts, and examples to illustrate the
relevant guidance. Some of the calculations in the examples use rounded numbers for simplicity. The
November 2020 edition of this Roadmap includes new guidance and editorial enhancements to reflect
our latest thinking and input from standard setters and regulators. Appendix I highlights all new content
as well as any substantive revisions to previous content.

For certain of the accounting issues discussed in this publication, multiple views or policies under U.S.
GAAP may be acceptable. Unless specifically noted otherwise, an accounting policy elected in these
situations should be consistently applied. Entities are encouraged to consult with their accounting
advisers for assistance in making such elections.

Subscribers to the Deloitte Accounting Research Tool (DART) may access any interim updates to
this publication by selecting the Roadmap from the Roadmap Series page on DART. If a “Summary
of Changes Since Issuance” displays, subscribers can view those changes by clicking the related links
or by opening the “active” version of the Roadmap.

We hope that you find this Roadmap a useful tool when considering the income tax accounting guidance.

Sincerely,

Deloitte & Touche LLP

1
For the full titles of standards, topics, and regulations, see Appendix G. For the full forms of abbreviations, see Appendix H.

xix
Contacts
If you are interested in income tax accounting related advisory services or if you have questions about
the information in this publication, please contact any of the following Deloitte professionals:

Matt Himmelman Patrice Mano

Partner Partner
Deloitte & Touche LLP Deloitte Tax LLP
+1 714 436 7277 +1 415 783 6079
[email protected] [email protected]

Steve Barta Paul Vitola

Partner Partner
Deloitte & Touche LLP Deloitte Tax LLP
+1 415 783 6392 +1 602 234 5143
[email protected] [email protected]

Chris Barton Chris Chiriatti

Managing Director Managing Director
Deloitte Tax LLP Deloitte & Touche LLP
+1 703 885 6300 +1 203 761 3039
[email protected] [email protected]

xx
 Contacts

Peggy Cullen Bernard De Jager

Partner Partner
Deloitte & Touche LLP Deloitte & Touche LLP
+1 312 486 9139 +1 415 783 4739
[email protected] [email protected]

Alice Loo
Managing Director
Deloitte Tax LLP
+1 415 783 6118
[email protected]

xxi
Chapter 1 — Overview
The accounting for income taxes under ASC 740 can be extremely complex. This chapter summarizes
the core concepts under ASC 740 and gives an overview of the objectives of the accounting for income
taxes.

ASC 740-10

05-1 The Income Taxes Topic addresses financial accounting and reporting for the effects of income taxes
that result from an entity’s activities during the current and preceding years. Specifically, this Topic establishes
standards of financial accounting and reporting for income taxes that are currently payable and for the tax
consequences of all of the following:
a. Revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than
the year in which they are recognized in financial income
b. Other events that create differences between the tax bases of assets and liabilities and their amounts
for financial reporting
c. Operating loss or tax credit carrybacks for refunds of taxes paid in prior years and carryforwards to
reduce taxes payable in future years.

05-5 There are two basic principles related to accounting for income taxes, each of which considers uncertainty
through the application of recognition and measurement criteria:
a. To recognize the estimated taxes payable or refundable on tax returns for the current year as a tax
liability or asset
b. To recognize a deferred tax liability or asset for the estimated future tax effects attributable to
temporary differences and carryforwards.

05-7 A temporary difference refers to a difference between the tax basis of an asset or liability, determined
based on recognition and measurement requirements for tax positions, and its reported amount in the
financial statements that will result in taxable or deductible amounts in future years when the reported amount
of the asset or liability is recovered or settled, respectively. Deferred tax assets and liabilities represent the
future effects on income taxes that result from temporary differences and carryforwards that exist at the end
of a period. Deferred tax assets and liabilities are measured using enacted tax rates and provisions of the
enacted tax law and are not discounted to reflect the time-value of money.

05-8 As indicated in paragraph 740-10-25-23, temporary differences that will result in taxable amounts
in future years when the related asset or liability is recovered or settled are often referred to as taxable
temporary differences. Likewise, temporary differences that will result in deductible amounts in future years
are often referred to as deductible temporary differences. Business combinations may give rise to both taxable
and deductible temporary differences.

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Deloitte | A Roadmap to Accounting for Income Taxes (November 2020)

ASC 740-10 (continued)

05-9 As indicated in paragraph 740-10-25-30, certain basis differences may not result in taxable or deductible
amounts in future years when the related asset or liability for financial reporting is recovered or settled and,
therefore, may not be temporary differences for which a deferred tax liability or asset is recognized.

05-10 As indicated in paragraph 740-10-25-24, some temporary differences are deferred taxable income or
tax deductions and have balances only on the income tax balance sheet and therefore cannot be identified
with a particular asset or liability for financial reporting. In such instances, there is no related, identifiable asset
or liability for financial reporting, but there is a temporary difference that results from an event that has been
recognized in the financial statements and, based on provisions in the tax law, the temporary difference will
result in taxable or deductible amounts in future years.

1.1 Background of ASC 740

A basic principle of the taxation of income in many jurisdictions, including the U.S. federal jurisdiction, is
that an entity is taxed only on its net earnings (i.e., it is taxed on total revenue after allowable expenses
incurred to generate the revenue have been deducted to arrive at a net amount of taxable income).
Generally, an entity applies a rate or series of rates to taxable income to determine a preliminary
amount of income tax owed for the period. In many jurisdictions, the entity then reduces that
preliminary amount by available income tax credits, if any, to determine the ultimate amount of tax
owed in a particular period.

If there were no differences between the way an entity determined its income before tax under U.S.
GAAP and its taxable income, and there were no tax credits available, a profitable entity could simply
multiply its U.S. GAAP income before tax by the statutory tax rate(s) applicable to the jurisdiction(s) in
which the income was earned and record an income tax payable and corresponding expense each
period. But there are many differences between income before tax determined under U.S. GAAP and
taxable income. Accordingly, ASC 740 provides a framework for the accounting for income taxes that
takes into account these differences. Under this framework, the amount of income tax expense an entity
is required to record in each period does not simply equal the amount of income tax payable in each
period. Rather, ASC 740 requires an entity to record income tax expense in each period as if there were
no differences between (1) the timing of the recognition of events in income before tax for U.S. GAAP
purposes and (2) the timing of the recognition of those events in taxable income. ASC 740 also requires
an entity to reduce income tax expense otherwise determined each period (or record an overall income
tax benefit) for the expected benefit of net operating losses (NOLs) and tax credits that, in many taxing
jurisdictions, may be carried forward or back to reduce taxable income in a future period or get a refund
of taxes paid in a prior period.

1.2 Objectives of ASC 740

ASC 740-10

10-1 There are two primary objectives related to accounting for income taxes:
a. To recognize the amount of taxes payable or refundable for the current year
b. To recognize deferred tax liabilities and assets for the future tax consequences of events that have been
recognized in an entity’s financial statements or tax returns.
As it relates to the second objective, some events do not have tax consequences. Certain revenues are exempt
from taxation and certain expenses are not deductible. In some tax jurisdictions, for example, interest earned
on certain municipal obligations is not taxable and fines are not deductible.

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 Chapter 1 — Overview

ASC 740-10 (continued)

10-2 Ideally, the second objective might be stated more specifically to recognize the expected future tax
consequences of events that have been recognized in the financial statements or tax returns. However, that
objective is realistically constrained because:
a. The tax payment or refund that results from a particular tax return is a joint result of all the items
included in that return.
b. Taxes that will be paid or refunded in future years are the joint result of events of the current or prior
years and events of future years.
c. Information available about the future is limited. As a result, attribution of taxes to individual items and
events is arbitrary and, except in the simplest situations, requires estimates and approximations.

10-3 Conceptually, a deferred tax liability or asset represents the increase or decrease in taxes payable or
refundable in future years as a result of temporary differences and carryforwards at the end of the current
year. That concept is an incremental concept. A literal application of that concept would result in measurement
of the incremental tax effect as the difference between the following two measurements:
a. The amount of taxes that will be payable or refundable in future years inclusive of reversing temporary
differences and carryforwards
b. The amount of taxes that would be payable or refundable in future years exclusive of reversing
temporary differences and carryforwards.
However, in light of the constraints identified in the preceding paragraph, in computing the amount of deferred
tax liabilities and assets, the objective is to measure a deferred tax liability or asset using the enacted tax rate(s)
expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be
settled or realized.

As noted in ASC 740-10-10-1, an entity’s overall objectives in accounting for income taxes under ASC
740 are to (1) “recognize the amount of taxes payable or refundable for the current year” (i.e., current tax
expense or benefit) and (2) “recognize deferred tax liabilities and assets for the future tax consequences of
events that have been recognized in an entity’s financial statements or tax returns” (resulting in deferred
tax expense or benefit). An entity’s total tax expense is generally the sum of these two components and
can be expressed as the following formula:

Total tax Current tax Deferred tax

expense = expense or + expense or
or benefit benefit benefit

Current tax expense or benefit — Taxes expected to be

reflected on the entity’s current tax return.

Deferred tax expense or benefit — Generally, the change

in the sum of the entity’s DTAs (net of any valuation
allowance) and DTLs during the period (i.e., the change
in the future tax consequences of events that have been
recognized differently for financial reporting and tax
purposes).

To understand and apply ASC 740, management and practitioners must be aware of these objectives,
which are discussed in more detail in the sections below.

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Deloitte | A Roadmap to Accounting for Income Taxes (November 2020)

1.2.1 Understanding “Events That Have Been Recognized in an Entity’s

Financial Statements or Tax Returns”
Although the form of financial statements for financial reporting purposes is significantly different from
the form of an income tax return, an entity could prepare a set of tax basis financial statements that
would look very similar to a set of financial statements prepared for financial reporting purposes by
using the information in the entity’s income tax return. The accounting for income taxes is most easily
understood if one first assumes that the income tax return is used to create such a set of tax basis
financial statements similar in form to a set of financial statements prepared for financial reporting
purposes. ASC 740-10-20 defines an event as a “happening of consequence to an entity.” An event has
an ASC 740 accounting consequence if it results in recognition in (1) the entity’s U.S. GAAP financial
statements for a period, (2) the entity’s tax basis financial statements for a period, or (3) both.

1.2.2 Understanding “the Amount of Taxes Payable or Refundable for the

Current Year”
An entity calculates the amount of income taxes payable or refundable for the current year by
completing its income tax return(s) for the year. That process will result in the determination of an
amount of income tax owed to a taxing authority or, in some circumstances, an amount of a refund due
to the entity from the taxing authority. A current income tax payable or refundable is recorded for such
amounts with an offset to current income tax expense in the income statement.

1.2.2.1 Permanent Differences
When an event is permanently recognized in a different manner or amount in U.S. GAAP financial
statements than it is in tax basis financial statements, a permanent difference between pretax net
income and taxable income arises. A common example of such an event in the United States is the
recognition of certain portions of meals and entertainment expenses that are not deductible for tax
purposes. Tax credits (whether used in the current period or carried forward to reduce income taxes
otherwise owed in a future period), which reduce the amount of tax owed but do not affect the amount
of income before tax for U.S. GAAP purposes, also create permanent differences.

Under ASC 740, entities inherently take into account the income tax effects of permanent differences
other than those created by tax credit carryforwards by recognizing current income tax expense
corresponding with “the amount of taxes payable or refundable for the current year.” In other words,
such permanent differences will affect the amount of the income tax payable and corresponding
current tax expense for the period. These permanent differences will also affect the income tax rate
the entity appears to be paying on its U.S. GAAP pretax income (i.e., the entity’s effective tax rate
(ETR)). For example, if a cash expenditure results in an expense for financial reporting purposes but
does not represent an expense for income tax purposes (i.e., because it is permanently disallowed),
the entity’s overall ETR for financial reporting purposes will be higher than its statutory rate. For this
reason, permanent differences are often described as having a “rate impact” under ASC 740. Permanent
differences do not give rise to DTAs and DTLs. For additional examples of common permanent
differences and a discussion of the related accounting, see Section 3.2.

The income tax effects of permanent differences created by tax credit carryforwards result in DTAs and
do not affect the amount of income taxes payable in the current period. See the discussion of attributes
in Section 1.2.3.2.

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 Chapter 1 — Overview

1.2.3 Understanding “Deferred Tax Liabilities and Assets” and “Future Tax

Consequences”
DTAs and DTLs (1) represent the future tax consequences of certain events that have been recognized
differently for financial reporting and tax purposes and (2) result from two primary sources: temporary
differences and attributes.

1.2.3.1 Temporary Differences
Temporary differences arise when an event is ultimately accounted for in the same manner and amount
for U.S. GAAP and tax purposes but in different periods. When such an event is recognized in either
the U.S. GAAP or tax basis financial statements, a temporary difference may arise between pretax net
income reported for financial reporting purposes and taxable income reported for income tax purposes.
Temporary differences will generate additional taxable income or loss when the related amount in the
U.S. GAAP basis financial statements is recovered (asset) or settled (liability).

Example 1-1

Entity X acquires a fixed asset with cash of $100 and capitalizes the expenditure for both financial reporting
and income tax purposes. For income tax purposes, X depreciates the fixed asset entirely in one year; however,
it depreciates it over five years for financial reporting purposes. After one year, the asset will have a carrying
amount or “basis” of $0 for income tax purposes but will have a carrying amount of $80 for financial reporting
purposes. This $80 basis difference is temporary because ultimately the entire $100 will be recognized as an
expense for both financial reporting and income tax purposes. Since the expense will be recognized in different
periods, a temporary difference arises in the treatment of the expenditure.

ASC 740-10-25-20 identifies a number of additional types of events that could create a temporary
difference. Such events and temporary differences are discussed in more detail in Chapter 3.

1.2.3.1.1 Future Tax Consequences of Temporary Differences

If an entity has recognized events differently in its financial statements than it has recognized them
in its tax returns and those differences are temporary, the entity must use a balance sheet model
in accordance with ASC 740 to recognize the future tax consequences of those events. A critical
assumption under this model is that all of the entity’s assets and liabilities will be recovered or settled,
respectively, at their financial statement carrying amount as determined under U.S. GAAP at the end of
the reporting period. To understand the importance of this assumption, management and practitioners
must understand the concepts of “financial statement carrying amount” and “tax basis.”

The initial “carrying amount” or “basis” for both financial reporting purposes and income tax purposes
can generally be thought of as the amount of consideration paid to acquire an asset or the amount of
consideration received upon incurring a liability. For example, the initial carrying amount or basis in a
fixed asset for both financial reporting and income tax purposes is typically the amount of cash paid
to acquire it. Similarly, the carrying amount or basis of a note payable is usually the amount of cash
received upon the note’s issuance. The initial carrying amount is subsequently adjusted for appreciation,
accretion, depreciation, amortization, or impairment (as permitted or required under financial reporting
and income tax reporting rules). That is, the carrying amount for financial reporting purposes and for
income tax purposes is the amount at which the asset or liability is reported in the U.S. GAAP and
(hypothetical) tax basis balance sheet at the end of the reporting period.

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Deloitte | A Roadmap to Accounting for Income Taxes (November 2020)

When an asset is recovered, an entity generally either pays income tax (at the statutory tax rate) on the
amount of proceeds in excess of the tax basis or takes a deduction for the amount by which the tax
basis exceeds the proceeds received. Similarly, the entity takes a deduction for the amount by which the
consideration paid to settle a liability exceeds the tax basis (a loss) or pays tax on the amount by which
the tax basis of the liability exceeds the consideration paid to settle it (a gain).

Under the balance sheet model, the entity compares the financial statement carrying amount of each
of its assets and liabilities with the carrying amount or “basis” of each of those assets and liabilities for
income tax purposes in the relevant taxing jurisdiction. Any difference between the carrying amount
of an asset or liability for financial reporting purposes and that for income tax purposes must be
analyzed to determine whether it is a temporary difference that gives rise to a DTA or DTL. The “future
tax consequences of events that have been recognized [differently] in an entity’s financial statements
[than in its] tax returns” are the tax effects, as described in the previous paragraph, that would arise
if the asset were recovered or the liability were settled at its financial statement carrying amount. If
a tax liability would result, the entity has a taxable temporary difference and records a DTL with a
corresponding deferred tax expense in the income statement. If a deduction would result, the entity has
a deductible temporary difference and records a DTA with a corresponding deferred tax benefit in the
income statement. If no tax consequence would arise, the basis difference is not a temporary difference
that gives rise to a DTA or DTL.

Example 1-2

Assume the same facts as in Example 1-1. At the end of the first year, the future tax consequences of the
events that X has temporarily recognized differently in its financial statements than it has recognized in its tax
returns (assuming X were to recover the asset for its financial statement carrying amount) would be a taxable gain
of $80. That is, the amount by which the $80 that hypothetically would be received upon the assumed recovery
exceeds the current tax basis of $0. Therefore, X would record a DTL at the end of the first year representing
the future tax consequence (a future tax payable on an $80 gain) of recovering the fixed asset for its financial
statement carrying amount. In other words, the tax benefit from the depreciation of the asset that X recognizes
in the tax basis financial statements in year 1 will not be available in future years to offset the $80 of income
assumed to arise upon recovery of the asset. If the tax rate is 20 percent, X would record a DTL for $16.

1.2.3.2 Attributes
In some jurisdictions, entities are permitted to carry forward or back losses (as determined under
income tax rules of the relevant jurisdiction) to offset earnings of a future or prior period (and potentially
get a refund of taxes paid on income of a previous period). These losses are commonly referred to as
NOL carryforwards or carrybacks. Similarly, an entity may be permitted to carry forward or back income
tax credits that it could not use in the current year. NOLs and tax credits that may be carried forward
are commonly referred to as “attributes.”

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 Chapter 1 — Overview

1.2.3.2.1 Future Tax Consequences of Attributes

The future tax consequence of an attribute is generally either a deferred deduction (i.e., an NOL
carryforward that can be used to reduce taxable income of a future period) or a deferred income
tax credit (to reduce the amount of income tax otherwise owed in a future period), each of which is
represented by a DTA. DTAs and corresponding deferred tax benefits are recorded for attributes,
subject to an assessment of realizability, to reflect the “future tax consequences” of the event
(generation of the NOL or tax credit carryforward) that has occurred in the entity’s tax basis financial
statements. The future tax consequence is the reduction in taxes owed as a result of applying a credit
carryforward to reduce taxes payable or applying an NOL carryforward to reduce taxable income of a
future period.

1.2.4 Complexities in Applying ASC 740

While the objectives of ASC 740 may seem straightforward in simple scenarios, there can be a
tremendous amount of complexity in the accounting for income taxes under ASC 740. The above
overview may serve as a foundation for an understanding of the concepts and complexities discussed in
the remaining chapters.

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Chapter 2 — Scope

2.1 Introduction
ASC 740 applies to the accounting for all taxes imposed on an entity by a taxing authority that are
based on the entity’s income. This may include taxes imposed by U.S. and foreign federal, state, and
local jurisdictions and is true regardless of how a tax is labeled by a particular jurisdiction. Although
this principle may appear simple, entities must often use significant judgment in determining whether
a tax is an income tax within the scope of ASC 740. Taxes that are not income taxes within the
scope of ASC 740 are accounted for in accordance with other U.S. GAAP generally applicable to the
recognition, measurement, and disclosure of assets and liabilities, income, and expenses throughout the
Codification. This can result in significant differences between the accounting for taxes under ASC 740
and the accounting for taxes under other Codification guidance. For example, deferred taxes are not
recognized for non-income-based taxes, and neither expense nor income associated with non-income-
based taxes is recorded in the income tax expense line in the statement of operations. In addition,
uncertainties about the recognition and measurement of a non-income-based tax in a particular
jurisdiction would not be accounted for in accordance with the guidance applicable to uncertain tax
positions in ASC 740-10.

ASC 740-10

15-1 The Scope Section of the Overall Subtopic establishes the pervasive scope for all Subtopics of the Income
Taxes Topic. Unless explicitly addressed within specific Subtopics, the following scope guidance applies to all
Subtopics of the Income Taxes Topic.

Entities
15-2 The principles and requirements of the Income Taxes Topic are applicable to domestic and foreign entities
in preparing financial statements in accordance with U.S. generally accepted accounting principles (GAAP),
including not-for-profit entities (NFP) with activities that are subject to income taxes.

15-2AA The guidance in this Subtopic relating to accounting for uncertainty in income taxes applies to all
entities, including tax-exempt not-for-profit entities, pass-through entities, and entities that are taxed in a
manner similar to pass-through entities such as real estate investment trusts and registered investment
companies.

Transactions
15-3 The guidance in the Income Taxes Topic applies to:
a. Domestic federal (national) income taxes (U.S. federal income taxes for U.S. entities) and foreign, state,
and local (including franchise) taxes based on income
b. An entity’s domestic and foreign operations that are consolidated, combined, or accounted for by the
equity method.

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 Chapter 2 — Scope

ASC 740-10 (continued)

15-4 The guidance in this Topic does not apply to the following transactions and activities:
a. A franchise tax to the extent it is based on capital and there is no additional tax based on income. If
there is an additional tax based on income, that excess is considered an income tax and is subject to the
guidance in this Topic. See Example 17 (paragraph 740-10-55-139) for an example of the determination
of whether a franchise tax is an income tax.
b. A withholding tax for the benefit of the recipients of a dividend. A tax that is assessed on an entity based
on dividends distributed is, in effect, a withholding tax for the benefit of recipients of the dividend and is
not an income tax if both of the following conditions are met:
1. The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does
not reduce future income taxes the entity would otherwise pay.
2. Shareholders receiving the dividend are entitled to a tax credit at least equal to the tax paid by
the entity and that credit is realizable either as a refund or as a reduction of taxes otherwise due,
regardless of the tax status of the shareholders.
See the guidance in paragraphs 740-10-55-72 through 55-74 dealing with determining whether a
payment made to a taxing authority based on dividends distributed is an income tax.

Pending Content (Transition Guidance: ASC 740-10-65-8)

15-4 The guidance in this Topic does not apply to the following transactions and activities:
a. A franchise tax (or similar tax) to the extent it is based on capital or a non-income-based amount
and there is no portion of the tax based on income. If a franchise tax (or similar tax) is partially
based on income (for example, an entity pays the greater of an income-based tax and a non-
income-based tax), deferred tax assets and liabilities shall be recognized and accounted for
in accordance with this Topic. Deferred tax assets and liabilities shall be measured using the
applicable statutory income tax rate. An entity shall not consider the effect of potentially paying
a non-income-based tax in future years when evaluating the realizability of its deferred tax
assets. The amount of current tax expense equal to the amount that is based on income shall be
accounted for in accordance with this Topic, with any incremental amount incurred accounted for
as a non-income-based tax. See Example 17 (paragraph 740-10-55-139) for an example of how to
apply this guidance.
b. A withholding tax for the benefit of the recipients of a dividend. A tax that is assessed on an entity
based on dividends distributed is, in effect, a withholding tax for the benefit of recipients of the
dividend and is not an income tax if both of the following conditions are met:
1. The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax
does not reduce future income taxes the entity would otherwise pay.
2. Shareholders receiving the dividend are entitled to a tax credit at least equal to the tax paid by
the entity and that credit is realizable either as a refund or as a reduction of taxes otherwise
due, regardless of the tax status of the shareholders.
See the guidance in paragraphs 740-10-55-72 through 55-74 dealing with determining whether a
payment made to a taxing authority based on dividends distributed is an income tax.

Related Implementation Guidance and Illustrations

• Treatment of Certain Payments to Taxing Authorities [ASC 740-10-55-67].
• Example 17: Determining Whether a Tax Is an Income Tax [ASC 740-10-55-139].

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2.2 Taxes Based on Income

740-10-15 (Q&A 08)
ASC 740 clearly indicates that “income taxes” are the only taxes within its scope. ASC 740-10-20 defines
income taxes as “[d]omestic and foreign federal (national), state, and local (including franchise) taxes
based on income,” and it defines taxable income as the “excess of taxable revenues over tax deductible
expenses and exemptions for the year as defined by the governmental taxing authority.”

Although ASC 740 provides no further guidance on this matter, the term “taxes based on income”
implies a tax system in which the tax payable is calculated on the basis of the entity’s revenue minus
the expenses allowed by the jurisdiction being considered. For the tax to be an income tax, the tax
computation would not need to include all income statement accounts but should include some
determination that would be meaningful to most taxpayers or meaningful in relation to the specific
income being taxed. A tax levied on a subset of the income statement, such as a tax on net investment
income (i.e., a tax on investment income less investment-related expenses), would also qualify as a tax
based on income since it would be computed on the basis of a portion of net income less expenses
incurred to generate the income.

For a tax to be an income tax within the scope of ASC 740, revenues and gains must be reduced by
some amount of expenses and losses allowed by the jurisdiction. Therefore, a tax based solely on
revenues (e.g., gross receipts or sales tax) would not be within the scope of ASC 740 because the taxable
base amount is not reduced by any expenses. A tax based on gross receipts, revenue, or capital should
be accounted for under other applicable authoritative literature (e.g., ASC 450).

2.3 Taxes Assessed in Lieu of Income Tax

In certain jurisdictions and for certain entities, an entity may be subject to certain taxes in lieu of an
income tax, such as an excise or other type of tax. For example, not-for-profit foundations that make
certain minimum distributions are generally exempt from U.S. federal income taxes but may be subject
to an excise tax on their net investment income. Such an excise tax meets the definition of a tax based
on income and therefore is within the scope of ASC 740. Alternatively, in some jurisdictions, qualifying
entities may be subject to an excise tax (e.g., based on a percentage of assets or sales) in lieu of an
income tax. Although this tax is levied in lieu of an income tax, it is not based on a measure of income
and therefore is not within the scope of ASC 740. Entities should carefully consider how each type of tax
is assessed to determine whether the tax should be included within the scope of ASC 740.

Further, the questions of whether an entity is subject to a tax based on income or a non-income-based
tax in a particular jurisdiction are not always mutually exclusive. See Section 2.5 for information on
hybrid tax regimes, in which an entity may be subject to both income and non-income-based taxes or be
subject to tax based on the higher of an income tax or a non-income-based tax.

2.4 Certain Entities Exempt From Income Taxes on the Basis of Legal Form
The legal form established for an entity may govern whether the entity is taxable or tax exempt. Many
entities are exempt from paying taxes because they qualify as either tax-exempt (e.g., not-for-profit
organization) or pass-through entities (e.g., Subchapter S corporation, partnership, and certain LLCs) or
because they function similarly to pass-through entities (e.g., REITs or RICs). To qualify for tax-exempt
or pass-through treatment, such entities must meet certain conditions under the relevant tax law.
According to the definition of a tax position in ASC 740-10-20, the recognition and measurement of a
decision to classify an entity as tax exempt should be evaluated under ASC 740. See Section 4.1.2.1 for
additional discussion of the evaluation of an entity’s tax-exempt status.

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 Chapter 2 — Scope

In addition, an entity may change its tax status, which may affect its designation as either a taxable or
nontaxable entity. Changes in tax status can be voluntary or involuntary, and the accounting treatment
for each may be different. See Section 3.5.2 for further discussion of an entity’s change in tax status.

2.5 Hybrid Taxes
740-10-15 (Q&A 20)
An entity’s tax obligation may not always be determined solely by applying either an income-based
measure or a non-income-based measure. In a hybrid tax regime, the entity may pay the greater of two
tax computations, one of which is typically based on taxable profit and the other of which is not (e.g., it
is based on gross revenue or capital). The tax rules and regulations of such a regime may state that an
entity must always pay income tax but must also calculate taxes on the basis of the non-income-based
measure(s). To the extent that the non-income-based measure or measures result in a larger amount,
the entity would pay the increment (in addition to the income tax). The description of the amounts
paid in a jurisdiction’s tax rules and regulations does not affect how a reporting entity determines the
component of the hybrid taxes that is considered an income tax for accounting purposes.

When an entity is paying taxes in a hybrid tax regime, the basis for determining which taxes qualify as
income taxes under ASC 740 may not always be clear, especially when certain taxes appear to have
characteristics of both an income tax and a gross-revenue or capital-based tax. ASC 740-10-15-4 and
the related implementation guidance beginning in ASC 740-10-55-139 establish a framework that
should be applied to all hybrid tax regimes. More specifically, the entity should consider the various
tax computations that can apply for the year. The non-income-tax component can be identified on the
basis of the amount of tax that would be payable if the entity has no taxable income. In other words, the
amount payable in the absence of income would be a non-income tax that is outside the scope of ASC
740. The tax payable for the year in excess of the portion that is considered a non-income tax would be
an income tax and within the scope of ASC 740.

For example, an entity in a certain jurisdiction may be subject to tax that is determined on the basis
of the greater of taxable income multiplied by an income tax rate or net equity multiplied by a capital
tax rate. Alternatively, an entity may be subject to tax in a jurisdiction in which the regular corporate
tax is based on the greater of a production-based computation or a profit-based computation (i.e., the
production-based computation is a fixed minimum amount per ton of product sold, but the total tax
due based on profits may exceed the production-based computation). In either of these jurisdictions,
the entity should determine the amount of tax that would be payable in the absence of taxable profit.
The amount payable in the absence of taxable income (i.e., the “floor” amount) is based on something
other than taxable income and is therefore outside the scope of ASC 740 and should be included in
pretax income. The floor amount should be included in pretax income, even if the total amount of
taxes payable for the year is actually a tax on taxable profits (the latter being the greater of the two
computations). Amounts payable in excess of the floor that result from an income tax computation are
considered to be a tax based on income and are therefore within the scope of ASC 740.

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Example 2-1

Assume that the regular corporate tax in Country A is based on the greater of 25 percent of taxable profit or 1
percent of net equity as of the last day of the prior year.

Assume that an entity’s net equity as of the last day of the prior year is $800,000 and that pretax income in the
current year is $80,000. The current tax computation is as follows:

Book pretax income $ 80,000

Originating taxable temporary difference 3,000
Taxable income $ 77,000

Current tax payable (based on income) $ 19,250 (77,000 × 25%)

Capital tax (“floor” amount) that is considered to be outside
the scope of ASC 740 8,000 (800,000 × 1%)
Current tax within the scope of ASC 740 $ 11,250

Changing Lanes
In December 2019, the FASB issued ASU 2019-12, which amends the requirements related to
the accounting for hybrid tax regimes discussed above. The FASB issued the ASU on the basis
of stakeholder feedback indicating that the guidance in ASC 740-10-15-4 on hybrid tax regimes
increased the cost and complexity of applying ASC 740, particularly when the tax amount
deemed to be a non-income tax was insignificant. Stakeholders also expressed concerns about
the complexity of the guidance on determining the appropriate tax rate an entity should use
when recording deferred taxes.

ASU 2019-12 amends ASC 740-10-15-4(a) to state that amounts based on taxable profit should
be included in the tax provision, with any incremental amount recorded as a non-income-based
tax. This amendment effectively reverses the order in which an entity determines the type of
tax under U.S. GAAP. For example, assume that (1) a local jurisdiction assesses an entity’s tax
as the greater of 25 percent of taxable income or 1 percent of equity and (2) the entity has
$100 of taxable income in the current year and book equity of $10,000. Tax expense of $25 is
therefore included in the tax provision and accounted for within the scope ASC 740. The excess
tax generated by the non-income-based measure of $75 ($10,000 × 1% – $25) is recorded as an
expense charged to income. Before the ASU, this scenario would have resulted in no income tax
expense since the tax on the entity’s equity is greater than the tax that would otherwise be due
on the basis of taxable income alone.

The ASU provides related amendments to the illustrative examples in ASC 740-10-55-26 and ASC
740-10-55-139 through 55-144. In the ASU, the FASB notes that the amendments are consistent
with the accounting for other incremental taxes, such as the base erosion anti-abuse tax (BEAT).

Entities should apply the ASU’s guidance by using either a full retrospective approach for all
periods presented or a modified retrospective approach, with a cumulative-effect adjustment
recorded through earnings as of the period of adoption. For more information about ASU
2019-12, see Appendix B.

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 Chapter 2 — Scope

2.6 Accounting for Withholdings on Certain Payments (e.g., Dividends,

Interest, Royalties, or License Fees)
740-10-15 (Q&A 22)
In some tax jurisdictions, dividends to owners and other payments (e.g., interest, royalty, or license
payments) may trigger a tax obligation to the tax authority in the payor’s jurisdiction (sometimes referred
to as a “withholding tax”). Such a tax may be required to be withheld from the payment by the payor and
remitted to the taxing authority. It is not always clear whether the payor or the recipient should account
for the tax as an income tax, and careful consideration is often required.

2.6.1 Accounting for a Withholding Tax by the Payor

Treatment of the withholding tax by the payor of the dividend will depend on whether the tax is
assessed on the payor or on the payee. This is a legal determination in the jurisdiction of the payor.

In some jurisdictions, a tax based on dividends distributed is assessed directly on the dividend payor.
In these cases, remittance of the withholding tax should be accounted for in equity as a part of the
dividend (rather than as an expense of the payor) only if both of the conditions outlined in ASC 740-10-
15-4(b) are met. ASC 740-10-15-4(b) states, in part:

A tax that is assessed on an entity based on dividends distributed is, in effect, a withholding tax for the benefit
of recipients of the dividend and is not an income tax if both of the following conditions are met:
1. The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does not
reduce future income taxes the entity would otherwise pay.
2. Shareholders receiving the dividend are entitled to a tax credit at least equal to the tax paid by the
entity and that credit is realizable either as a refund or as a reduction of taxes otherwise due, regardless
of the tax status of the shareholders.

If either of these criteria is not met, a tax assessed directly on the dividend payor should not be
considered a withholding for the benefit of the recipient. Instead, it should be accounted for by the
payor as either an income tax within the scope of ASC 740 or as a non-income based tax, depending on
the substance of the tax.

If the tax is accounted for by the payor as an income tax within the scope of ASC 740, any tax benefit to
the payor resulting from payment of the withholding tax should be recognized as part of tax expense or
benefit from continuing operations.

2.6.2 Accounting for a Withholding Tax by the Recipient

740-10-15 (Q&A 22)
Most taxes on dividends are assessed on the recipient of the dividend but are required to be withheld
and remitted to the taxing authority by the payor. In these instances, the remittance of the withholding
tax to the tax authority by the dividend payor is accounted for by the payor in its financial statements as
a reduction to equity (i.e., as a part of the dividend). The withholding tax may still, however, be viewed as
an income tax from the point of view of the recipient of the dividend since the tax is paid on behalf of
the recipient.

ASC 740 does not provide guidance on determining whether recipients of certain payments (e.g.,
dividends or royalties) should account for withholding taxes as income taxes within the scope of ASC 740.

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ASC 740-10-55-24 states the following regarding taxes withheld from dividends:

Deferred tax liabilities and assets are measured using enacted tax rates applicable to capital gains, ordinary
income, and so forth, based on the expected type of taxable or deductible amounts in future years. For
example, evidence based on all facts and circumstances should determine whether an investor’s liability for
the tax consequences of temporary differences related to its equity in the earnings of an investee should be
measured using enacted tax rates applicable to a capital gain or a dividend. Computation of a deferred
tax liability for undistributed earnings based on dividends should also reflect any related dividends
received deductions or foreign tax credits, and taxes that would be withheld from the dividend.
[Emphasis added]

It can be inferred from this guidance that the FASB intended withholding taxes on dividends to be a
component of income taxes. However, ASC 946-220-45-3 discusses the presentation of certain items
in the statement of operations of an investment company and suggests that withholding taxes might, in
fact, be considered as “other taxes.” ASC 946-220-45-3 states, in part:

All of the following expenses are commonly reported separately: . . .

g. Federal and state income taxes (these expenses shall be shown separately after the income category to
which they apply, such as investment income and realized or unrealized gains)
h. Other taxes (foreign withholding taxes shall be deducted from the relevant income item and presented
parenthetically or shown as a separate contra item in the income section).

Accordingly, the recipient of a dividend or other payment that is subject to withholding tax should
account for the withholding tax on the basis of its facts and circumstances. Relevant questions (not
all-inclusive or individually determinative) include the following:

• If the recipient had qualifying expenditures in the local jurisdiction or had established a local presence,
would the withholding tax be adjusted accordingly (i.e., would it not apply, or would it be reflected as
an estimated tax payment on the income tax return)?
If the recipient filed an income tax return in the payor’s jurisdiction, the fact that the taxable
income could be adjusted if there were qualifying expenditures and any withholding tax could
be claimed as an estimated payment would be a strong indicator that the withholding tax should
be considered an income tax.

• Is the payment effectively a distribution from the earnings of the paying entity? That is, is it a dividend
and not a return of capital or other expense?
If the amount was paid out of earnings of the paying entity, the withholding tax may represent
an incremental layer of tax, imposed on the recipient, on the income of the payor. For example,
although a dividend itself may seem to be revenue rather than income to the recipient (i.e., the
recipient has not been able to directly reduce the dividend by expenses), the withholding tax is
assessed on a net income figure (i.e., the paying entity has incurred expenses on its revenues) at
the time of distribution. Therefore, the recipient has indirectly been allowed a deduction for the
expenses associated with the revenue upon which the dividend is based given that the paying
entity has taken these deductions before making the dividend.

• Is the withholding tax creditable on an income tax return filed by the receiving entity or by the receiving
entity’s parent?
While the ability to take a credit for the tax on an income tax return would not itself indicate
that the tax is an income tax, many of the criteria used to evaluate whether the tax is creditable
would most likely be relevant in the determination of whether the tax is an income tax for U.S.
GAAP purposes.

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 Chapter 2 — Scope

2.7 Refundable Tax Credits

740-10-25 (Q&A 53)
Certain tax jurisdictions provide refundable credits (e.g., qualifying R&D credits in certain countries and
state jurisdictions and alternative fuel tax credits for U.S. federal income tax) that do not depend on the
entity’s ongoing tax status or tax position (e.g., an entity may receive a refund despite being in a taxable
loss position). Tax credits, such as refundable credits whose realization does not depend on the entity’s
generation of taxable income or the entity’s ongoing tax status or tax position, are not considered an
element of income tax accounting under ASC 740. Thus, even if the credit claims are filed in connection
with a tax return, the refunds are not considered part of income taxes and therefore are not within
the scope of ASC 740. In such cases, an entity would not record the credit as a reduction of income tax
expense; rather, the entity should determine the credit’s classification on the basis of its nature.

When determining the classification of these credits, an entity may consider them to be a form of
government grant or assistance. An entity may look to paragraphs 24 and 29 of IAS 20 for guidance
on government grants. Under paragraph 24 of IAS 20, an entity presents government grants related
to assets “either by setting up the grant as deferred income or by deducting the grant in arriving at the
carrying amount of the asset.” Further, paragraph 29 of IAS 20 states, “[g]rants related to income are
presented as part of profit or loss, either separately or under a general heading such as ‘Other Income’;
alternatively, they are deducted in reporting the related expense.”

In rare circumstances, a tax law may change the way a tax credit is realized. For example, a jurisdiction
may have historically required that a credit be realized on the tax return as a reduction in taxes payable
but subsequently changes the law so that the credit can be realized without an entity’s first incurring a
tax liability (i.e., the credit amount becomes refundable but was not when it arose). In this situation, an
entity would generally continue to apply ASC 740 to the credits recognized at the time of the law change.
Any new refundable credits earned after the tax law change would be accounted for as refundable
credits in accordance with the guidance in this section.

Credits whose realization ultimately depends on taxable income (e.g., investment tax credits (ITCs) and
R&D credits) are generally recognized as a reduction of income tax expense, regardless of whether they
are accounted for under the flow-through method or the deferral method (as described in ASC 740-10-
25-45 and 25-46). See Section 3.5.9 for further information and illustrative examples of the application
of these two methods.

2.7.1 Selling Income Tax Credits to Monetize Them

Some tax jurisdictions might allow an entity that generates certain types of income tax credit to either
use the credit to reduce its income tax liability or effectively “sell” all or a portion of it by assigning the
right to claim the credit to another qualified entity. If, however, the credit can be used only to reduce an
income tax liability either of the entity that generated it or the entity to which it is sold and would never
be refundable by the government, we believe that the credit is within the scope of ASC 740.

In situations in which an entity does not have sufficient taxable income to use all or a portion of the
income tax credit or in which using it might take multiple tax years, the entity might achieve a better
economic benefit (i.e., present value benefit) by selling the credit. In such situations, the entity that
generated the credit should initially recognize and measure it in accordance with the recognition and
measurement criteria of ASC 740. To the extent that the income tax credit does not reduce income
taxes currently payable, the entity would recognize a DTA for the carryforward and assess it for
realizability in a manner consistent with the sources of income cited in ASC 740-10-30-18.1 See Section
5.3 for additional discussion. If the entity were to subsequently sell the income tax credit, such sale

1
Generation of taxable income sufficient to permit realization of a DTA will be predicated upon the normal course of business. That is, we do not
believe that an entity can factor in its ability to sell the underlying tax attribute as a basis for realizing the related DTA.

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Deloitte | A Roadmap to Accounting for Income Taxes (November 2020)

should be treated no differently than the sale of any other asset, with gain or loss recognized in pretax
earnings for any difference between the proceeds received and the recorded carrying value (i.e., the DTA
for the income tax credit recognized under the guidance in ASC 740 on recognition and measurement).

2.8 Obligations for Indemnification of Uncertain Tax Positions of a Subsidiary

Upon Sale — Subsidiary Previously Filed a Separate Tax Return
740-10-15 (Q&A 17)
In a sale transaction, it is common for one party to indemnify the other for a particular contingency.
If the acquiree previously filed a separate tax return from the parent (i.e., seller), the indemnification
agreement between the buyer and seller might be related to income tax positions taken by the acquiree
before the transaction. In these situations, we believe that the seller’s indemnification obligation is not
within the scope of ASC 740 (i.e., because the seller is not jointly and severally liable for the income tax
obligations of the acquiree when the acquiree filed a separate return). Rather, the seller should account
for the indemnification obligation in accordance with other applicable U.S. GAAP.

Example 2-2

Assume that Company A enters into an agreement to sell 100 percent of the outstanding stock in its wholly
owned subsidiary, Company Z, to Company B. Before the sale, Z files a separate tax return in which a tax
position is taken that requires the recognition of a liability for an unrecognized tax benefit (UTB). As part of the
purchase agreement, A indemnifies B for any future settlement with the tax authority in connection with the
uncertain tax position taken by Z in its prior tax return.

Because Z filed a separate tax return, A is not directly liable for any of Z’s tax obligations after the sale. By
indemnifying B for any loss related to Z’s prior tax positions, however, A has entered into a guarantee contract,
which would generally be within the scope of ASC 460 (see ASC 460-10-15-4(c) and ASC 460-10-55-13(c)).

Therefore, A would generally recognize a guarantee liability on the sale date and on each reporting date
thereafter in accordance with the recognition and measurement provisions of ASC 460.

Assume the following:

• The uncertain tax benefit is $110.

• Settlement of the indemnification liability would result in a deduction for the seller.
• The guarantee is within the scope of ASC 460, and the initial guarantee liability determined under ASC
460 is $100.
• Company A has an ETR of 25 percent.
• For A, the disposition of Z does not qualify for presentation as a discontinued operation in accordance
with ASC 205-20.
The following entries illustrate A’s accounting for the UTB upon the sale of Z.

To record the indemnification liability (recognition would adjust the seller’s gain and loss on sale):

Gain/loss on sale 100

Indemnification liability 100

To record the deductible temporary difference related to the difference between the reported amount and the
tax basis of the indemnification liability (i.e., 25% of $100):

DTA 25
Deferred tax benefit 25

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 Chapter 2 — Scope

Example 2-2 (continued)

If the UTB liability were ultimately settled with the tax authority for $76, Z would make a cash payment to the
tax authority and A would make a cash payment to B in satisfaction of its indemnification liability. The following
entries illustrate A’s accounting upon settlement.

To record the settlement of its indemnification liability — by transferring cash to B — for less than the recorded
amount of the guarantee liability:

Indemnification liability 100

Cash 76
Gain/loss on settlement 24

To record the reduction in taxes payable related to the deduction for the payment of the indemnification and
reversal of the related DTA, resulting in total net current and deferred tax expense in the period of payment of
$6 ($25 deferred tax expense less $19 current tax benefit [i.e., 25% of $76]):

Deferred tax expense 25

DTA 25
Current tax payable 19
Current tax benefit 19

The acquirer in such a business combination may be required to record an indemnification asset under
ASC 805. Section 11.3.6.6 provides interpretive guidance, including examples, related to the acquirer’s
accounting in such circumstances.

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Chapter 3 — Book-Versus-Tax Differences
and Tax Attributes

3.1 Background
While many of an entity’s transactions receive identical tax and financial reporting treatment, there are
some situations in which they will be treated differently, giving rise to book-versus-tax differences. Such
differences may be “permanent” or “temporary.”

When an event is permanently recognized in a different manner or amount for financial reporting
purposes than it is for tax reporting purposes, a permanent difference between pretax net income and
taxable income arises. The income tax effects of permanent items are generally reflected in income tax
expense corresponding with the amount of taxes payable or refundable for the current year and the
entity’s annual effective tax rate (AETR). Deferred taxes are not recorded for permanent differences.

However, an entity does record deferred taxes for temporary differences. Typically, temporary
differences do not affect total income tax expense or the entity’s AETR in the absence of a phased-in
change in tax rate or other similar situations discussed later in this chapter. Rather, temporary
differences generate additional taxable income or loss when the related amount for financial reporting
purposes is recovered (asset) or settled (liability). For this reason, deferred taxes are always recorded on
taxable and deductible temporary differences unless one of the exceptions in ASC 740-10-25-3 applies.

See Sections 1.2.2.1 and 1.2.3.1 for additional information about permanent and temporary differences,
respectively, and their effects on income tax expense and the AETR.

3.2 Permanent Differences
740-10-25 (Q&A 40)

ASC 740-10

Basis Differences That Are Not Temporary Differences

25-30 Certain basis differences may not result in taxable or deductible amounts in future years when the
related asset or liability for financial reporting is recovered or settled and, therefore, may not be temporary
differences for which a deferred tax liability or asset is recognized. One example, depending on the provisions
of the tax law, could be the excess of cash surrender value of life insurance over premiums paid. That excess is
a temporary difference if the cash surrender value is expected to be recovered by surrendering the policy, but
is not a temporary difference if the asset is expected to be recovered without tax consequence upon the death
of the insured (if under provisions of the tax law there will be no taxable amount if the insurance policy is held
until the death of the insured).

25-31 Tax-to-tax differences are not temporary differences. Recognition of a deferred tax asset for tax-to-tax
differences is prohibited as tax-to-tax differences are not one of the exceptions identified in paragraph 740-10-
25-3. An example of a tax-to-tax difference is an excess of the parent entity’s tax basis of the stock of an
acquired entity over the tax basis of the net assets of the acquired entity.

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 Chapter 3 — Book-Versus-Tax Differences and Tax Attributes

FASB Statement 109, which was codified in ASC 740, effectively described permanent differences as
differences that arise from statutory provisions under which (1) specified revenues are exempt from
taxation and (2) specified expenses are not allowable as deductions in the determination of taxable
income.

In addition, ASC 740-10-25-31 provides guidance on tax-to-tax differences. For example, as a result of
a nontaxable business combination, the acquiror’s tax basis in the acquired stock may exceed the tax
basis in the acquired entity’s assets and liabilities. Since such differences are not temporary differences,
the recognition of a DTA is prohibited under ASC 740.

The following table illustrates many of the more common permanent differences that result from the
application of U.S. federal tax law to items recognized for financial reporting purposes.

Accounting
Accounting Description Treatment Tax Treatment

Tax-exempt securities:
1. Interest income Income Tax exempt (IRC Section 103).
2. Interest paid on debt incurred to buy Expense Not deductible (IRC Section 265).
or carry tax-exempt securities

3. Amortization of bond premium Expensed by using Not deductible (IRC Section 171(a)); however,
interest method basis of bond must be reduced by amount
(ASC 835-30-35-2) of amortization (IRC Section 1016(a)(5)).
4. Gains or losses upon disposition Income (loss) a. No gain or loss if held to maturity
(HTM) by original buyer.
b. If sold or redeemed before maturity,
capital gain (loss).

Illegal bribes and kickbacks Expense Not deductible.

Treble damages; payments involving Expense Not deductible (IRC Section 162(g)).
criminal proceedings

Expenses paid or incurred to influence the Expense Not deductible (IRC Section 162(e)(1)(c)).
general public with respect to legislative
matters, elections, or referendums

Expenses paid or incurred with respect Expense Not deductible (IRC Treas. Reg. 1.162-20(c)).
to legislative matters that are not in direct
interest to the taxpayer’s trade of business

Fines and penalties paid to the government Expense Not deductible (IRC Section 162(f)).
of the United States, a territory or possession
of the United States, the District of Columbia,
a foreign country, or a political subdivision of
any of the above for the violation of any law

Worthless debts from political parties Expense Generally, not deductible. May be deducted
by banks and other taxpayers if more than
30 percent of all receivables accrued during
normal course of business are due from
political parties (IRC Section 271).

Income and expenses from source within Income and Income may be exempt and deductions not
possessions of the United States expense allowed if certain conditions are met (IRC
Section 931).

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Deloitte | A Roadmap to Accounting for Income Taxes (November 2020)

(Table continued)

Accounting
Accounting Description Treatment Tax Treatment

Certain expenses that a taxpayer chooses to Expense Not deductible.

claim a credit in lieu of (i.e., foreign tax credit
(FTC), jobs credit)

Entertainment expense Expense 100 percent reduction in expense for tax

purposes (IRC Section 274(a)).

Meals expense Expense 50 percent is not deductible for tax

purposes (IRC Section 274(n)).

Political contributions Expense Not deductible (IRC Treas. Reg. 1.162-20(c)(1)).

Certain losses on the disposition of Expense Not deductible (IRC Treas. Reg. 1.1502-36).
consolidated-group subsidiary stock

3.2.1 Special Deductions
740-10-30 (Q&A 13)

ASC 740-10

Anticipated Future Special Deductions

25-37 The tax benefit of statutory depletion and other types of special deductions such as those that may be
available for certain health benefit entities and small life insurance entities in future years shall not be anticipated
for purposes of offsetting a deferred tax liability for taxable temporary differences at the end of the current
year. The tax benefit of special deductions ordinarily is recognized no earlier than the year in which those
special deductions are deductible on the tax return. However, some portion of the future tax effects of special
deductions are implicitly recognized in determining the average graduated tax rate to be used for measuring
deferred taxes when graduated tax rates are a significant factor and the need for a valuation allowance for
deferred tax assets. In those circumstances, implicit recognition is unavoidable because those special deductions
are one of the determinants of future taxable income and future taxable income determines the average
graduated tax rate and sometimes determines the need for a valuation allowance. See Section 740-10-30 for
measurement requirements related to determining tax rates and a valuation allowance for deferred tax assets.

Other common permanent differences that result from the application of U.S. federal tax law include
special deductions. The tax law permits certain entities to recognize certain tax benefits for special
deductions. Such deductions are reflected in pretax income for tax reporting purposes but not for
financial reporting purposes and therefore give rise to permanent differences. While the term “special
deduction” is not defined, ASC 740-10-25-37 and ASC 740-10-55-27 through 55-30 offer four examples:
(1) tax benefits for statutory depletion, (2) deductions for certain health benefit entities (e.g., Blue
Cross/Blue Shield providers), (3) deductions for small life insurance companies, and (4) a deduction for
domestic production activities. In addition, the deduction for foreign-derived intangible income (FDII)
qualifies as a special deduction.

Sections 3.2.1.1 through 3.2.1.5 summarize the special deductions discussed above.

3.2.1.1 Statutory Depletion
IRC Sections 611–613 allow entities in certain extractive industries, such as oil and gas and mining,
to take a deduction for “depletion” when determining taxable income for U.S. federal tax purposes.
The depletion deduction for a particular taxable year is calculated as the greater of cost depletion or
percentage depletion. Cost depletion is based on the cost of the reserves, and percentage depletion
is based on multiplying gross income from the property by a specified statutory percentage, subject

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 Chapter 3 — Book-Versus-Tax Differences and Tax Attributes

to certain limitations. As with other special deductions, entities cannot anticipate the tax benefit from
statutory depletion when measuring the DTL related to a taxable temporary difference at year-end. The
statutory depletion tax benefit would be recognized no earlier than the year in which the depletion is
deductible on the entity’s income tax return.

3.2.1.2 Blue Cross/Blue Shield Organizations

IRC Section 833 entitles Blue Cross and Blue Shield plans to special tax deductions that are not available
to other insurers. The deduction allowed for any taxable year is the excess (if any) of (1) 25 percent of
the sum of (a) claims incurred during the taxable year and (b) expenses incurred in connection with the
administration, adjustment, or settlement of claims over (2) the “adjusted surplus” as of the beginning of
the taxable year.

3.2.1.3 Small Life Insurance Companies

IRC Section 806 allows small life insurance companies to take a deduction equal to 60 percent of the
entity’s tentative life insurance company taxable income (LICTI) up to $3 million. The deduction is phased
out for tentative LICTI from $3 million to $15 million. In addition, the small life insurance company
deduction is disallowed if a company has assets of $500 million or more.

3.2.1.4 Domestic Production Activities Deduction

The domestic production activities deduction was enacted into law in the United States on October 22,
2004, as part of the American Jobs Creation Act of 2004 (the “Jobs Creation Act”). The Jobs Creation Act
allowed for a tax deduction of up to 9 percent of the lesser of (1) qualified production activities income
or (2) taxable income (after the deduction for the use of any NOL carryforwards). This tax deduction
was limited to 50 percent of W-2 wages paid by the taxpayer. ASC 740-10-55-27 through 55-30 provide
implementation guidance clarifying that the production activities deduction should be accounted for as
a special deduction in accordance with ASC 740-10-25-37. The domestic production activities deduction
was repealed upon enactment of the Tax Cuts and Jobs Act of 2017 (the “2017 Act”).

3.2.1.5 Foreign-Derived Intangible Income

IRC Section 250 allows a domestic corporation an immediate deduction against U.S. taxable income for
a portion of its FDII. The amount of the deduction depends, in part, on the corporation’s U.S. taxable
income. The percentage of income that can be deducted is reduced in taxable years beginning after
December 31, 2025.

3.3 Temporary Differences
ASC 740-10

25-18 Income taxes currently payable for a particular year usually include the tax consequences of most events
that are recognized in the financial statements for that year.

25-19 However, because tax laws and financial accounting standards differ in their recognition and
measurement of assets, liabilities, equity, revenues, expenses, gains, and losses, differences arise between:
a. The amount of taxable income and pretax financial income for a year
b. The tax bases of assets or liabilities and their reported amounts in financial statements.
Guidance for computing the tax bases of assets and liabilities for financial reporting purposes is provided in
this Subtopic.

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ASC 740-10 (continued)

25-20 An assumption inherent in an entity’s statement of financial position prepared in accordance with
generally accepted accounting principles (GAAP) is that the reported amounts of assets and liabilities will be
recovered and settled, respectively. Based on that assumption, a difference between the tax basis of an asset
or a liability and its reported amount in the statement of financial position will result in taxable or deductible
amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts
of liabilities are settled. Examples include the following:
a. Revenues or gains that are taxable after they are recognized in financial income. An asset (for example,
a receivable from an installment sale) may be recognized for revenues or gains that will result in future
taxable amounts when the asset is recovered.
b. Expenses or losses that are deductible after they are recognized in financial income. A liability (for
example, a product warranty liability) may be recognized for expenses or losses that will result in future
tax deductible amounts when the liability is settled.
c. Revenues or gains that are taxable before they are recognized in financial income. A liability (for
example, subscriptions received in advance) may be recognized for an advance payment for goods or
services to be provided in future years. For tax purposes, the advance payment is included in taxable
income upon the receipt of cash. Future sacrifices to provide goods or services (or future refunds to
those who cancel their orders) will result in future tax deductible amounts when the liability is settled.
d. Expenses or losses that are deductible before they are recognized in financial income. The cost of an
asset (for example, depreciable personal property) may have been deducted for tax purposes faster
than it was depreciated for financial reporting. Amounts received upon future recovery of the amount of
the asset for financial reporting will exceed the remaining tax basis of the asset, and the excess will be
taxable when the asset is recovered.
e. A reduction in the tax basis of depreciable assets because of tax credits. Amounts received upon future
recovery of the amount of the asset for financial reporting will exceed the remaining tax basis of the
asset, and the excess will be taxable when the asset is recovered. For example, a tax law may provide
taxpayers with the choice of either taking the full amount of depreciation deductions and a reduced
tax credit (that is, investment tax credit and certain other tax credits) or taking the full tax credit and a
reduced amount of depreciation deductions.
f. Investment tax credits accounted for by the deferral method. Under the deferral method as established
in paragraph 740-10-25-46, investment tax credits are viewed and accounted for as a reduction of the
cost of the related asset (even though, for financial statement presentation, deferred investment tax
credits may be reported as deferred income). Amounts received upon future recovery of the reduced
cost of the asset for financial reporting will be less than the tax basis of the asset, and the difference will
be tax deductible when the asset is recovered.
g. An increase in the tax basis of assets because of indexing whenever the local currency is the functional
currency. The tax law for a particular tax jurisdiction might require adjustment of the tax basis of a
depreciable (or other) asset for the effects of inflation. The inflation-adjusted tax basis of the asset would
be used to compute future tax deductions for depreciation or to compute gain or loss on sale of the
asset. Amounts received upon future recovery of the local currency historical cost of the asset will be
less than the remaining tax basis of the asset, and the difference will be tax deductible when the asset is
recovered.
h. Business combinations and combinations accounted for by not-for-profit entities (NFPs). There may be
differences between the tax bases and the recognized values of assets acquired and liabilities assumed
in a business combination. There also may be differences between the tax bases and the recognized
values of assets acquired and liabilities assumed in an acquisition by a not-for-profit entity or between
the tax bases and the recognized values of the assets and liabilities carried over to the records of a new
entity formed by a merger of not-for-profit entities. Those differences will result in taxable or deductible
amounts when the reported amounts of the assets or liabilities are recovered or settled, respectively.
i. Intra-entity transfers of an asset other than inventory. There may be a difference between the tax basis
of an asset in the buyer’s tax jurisdiction and the carrying value of the asset reported in the consolidated
financial statements as the result of an intra-entity transfer of an asset other than inventory from
one tax-paying component to another tax-paying component of the same consolidated group. That
difference will result in taxable or deductible amounts when the asset is recovered.

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ASC 740-10 (continued)

25-21 The examples in (a) through (d) in paragraph 740-10-25-20 illustrate revenues, expenses, gains, or losses
that are included in taxable income of an earlier or later year than the year in which they are recognized in
pretax financial income. Those differences between taxable income and pretax financial income also create
differences (sometimes accumulating over more than one year) between the tax basis of an asset or liability
and its reported amount in the financial statements. The examples in (e) through (i) in paragraph 740-10-25-20
illustrate other events that create differences between the tax basis of an asset or liability and its reported
amount in the financial statements. For all of the examples, the differences result in taxable or deductible
amounts when the reported amount of an asset or liability in the financial statements is recovered or settled,
respectively.

25-22 This Topic refers collectively to the types of differences illustrated by the examples in paragraph 740-10-
25-20 and to the ones described in paragraph 740-10-25-24 as temporary differences.

25-23 Temporary differences that will result in taxable amounts in future years when the related asset
or liability is recovered or settled are often referred to as taxable temporary differences (the examples in
paragraph 740-10-25-20(a), (d), and (e) are taxable temporary differences). Likewise, temporary differences
that will result in deductible amounts in future years are often referred to as deductible temporary differences
(the examples in paragraph 740-10-25-20(b), (c), (f), and (g) are deductible temporary differences). Business
combinations and intra-entity transfers of assets other than inventory (the examples in paragraph 740-10-25-
20(h) through (i)) may give rise to both taxable and deductible temporary differences.

25-24 Some temporary differences are deferred taxable income or tax deductions and have balances only on
the income tax balance sheet and therefore cannot be identified with a particular asset or liability for financial
reporting.

25-25 That occurs, for example, when revenue on a long-term contract with a customer is recognized over time
using a measure of progress to depict performance over time in accordance with the guidance in Subtopic
606-10, for financial reporting that is different from the recognition pattern used for tax purposes (for example,
when the contract is completed). The temporary difference (income on the contract) is deferred income for tax
purposes that becomes taxable when the contract is completed. Another example is organizational costs that
are recognized as expenses when incurred for financial reporting and are deferred and deducted in a later year
for tax purposes.

25-26 In both instances, there is no related, identifiable asset or liability for financial reporting, but there is
a temporary difference that results from an event that has been recognized in the financial statements and,
based on provisions in the tax law, the temporary difference will result in taxable or deductible amounts in
future years.

25-27 An entity might be able to delay the future reversal of taxable temporary differences by delaying
the events that give rise to those reversals, for example, by delaying the recovery of related assets or the
settlement of related liabilities.

25-28 A contention that those temporary differences will never result in taxable amounts, however, would
contradict the accounting assumption inherent in the statement of financial position that the reported amounts
of assets and liabilities will be recovered and settled, respectively; thereby making that statement internally
inconsistent. Because of that inherent accounting assumption, the only question is when, not whether,
temporary differences will result in taxable amounts in future years.

25-29 Except for the temporary differences addressed in paragraph 740-10-25-3, which shall be accounted
for as provided in that paragraph, an entity shall recognize a deferred tax liability or asset for all temporary
differences and operating loss and tax credit carryforwards in accordance with the measurement provisions of
paragraph 740-10-30-5.

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ASC 740-10 (continued)

Related Implementation Guidance and Illustrations

• Examples of Temporary Differences [ASC 740-10-55-49].
• Example 23: Effects of Subsidy on Temporary Difference [ASC 740-10-55-165].
• Example 24: Built-In Gains of S Corporation [ASC 740-10-55-168].
• Example 26: Direct Transaction With Governmental Taxing Authority [ASC 740-10-55-202].

3.3.1 Overview
740-10-25 (Q&A 39)
A temporary difference is a difference between the financial reporting basis and the income tax basis,
determined in accordance with the recognition and measurement criteria of ASC 740 (see Section
3.3.3.1 for additional guidance on this term as used herein), of an asset or liability that will result in a
taxable or deductible item in future years when the financial reporting basis of the asset or liability is
recovered or settled, respectively. The appropriate identification of temporary differences is important
because DTAs and DTLs are recorded for all temporary differences unless an exception applies.

The term “timing difference” was used in APB Opinion 11 (before the FASB’s codification of U.S. GAAP) to
describe differences between the periods in which transactions affect taxable income and the periods
in which they enter into the determination of pretax financial accounting income. Timing differences
were described as differences that originate in one period and reverse or “turn around” in one or more
subsequent periods.

As used in ASC 740, the term “temporary difference” encompasses more than the timing differences
defined in APB Opinion 11 and described above. The method that an entity uses to calculate temporary
differences under ASC 740 stresses the economic impact of recovering and settling assets and liabilities
at their reported amounts. Consequently, a DTA or DTL will be recognized for almost all basis differences
that exist on the balance sheet date. ASC 740-10-20 defines a temporary difference as follows:

A difference between the tax basis of an asset or liability computed pursuant to the requirements in Subtopic
740-10 for tax positions, and its reported amount in the financial statements that will result in taxable or
deductible amounts in future years when the reported amount of the asset or liability is recovered or settled,
respectively. Paragraph 740-10-25-20 cites examples of temporary differences. Some temporary differences
cannot be identified with a particular asset or liability for financial reporting (see paragraphs 740-10-05-10 and
740-10-25-24 through 25-25), but those temporary differences do meet both of the following conditions:
a. Result from events that have been recognized in the financial statements
b. Will result in taxable or deductible amounts in future years based on provisions of the tax law.

Some events recognized in financial statements do not have tax consequences. Certain revenues are exempt
from taxation and certain expenses are not deductible. Events that do not have tax consequences do not give
rise to temporary differences.

An often-cited example illustrating this point is an excess of the reported amount of an acquired
identified intangible asset for financial reporting purposes (e.g., a customer list that has no tax basis).
Although, under tax law, an entity in this situation will not receive a tax deduction in the future for the
recovery of the intangible asset, recognition of a DTL is nevertheless required because it is assumed, for
financial reporting purposes, that the entity will generate future revenues at least equal to the recorded
amount of the investment and that recovery will result in future taxable amounts.

ASC 740-10-25-20 gives examples of situations in which a difference between the tax basis of an
asset or liability and its reported amount in the financial statements will result in taxable or deductible
amounts in future year(s) when the reported amount of the asset or liability is recovered or settled.

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 Chapter 3 — Book-Versus-Tax Differences and Tax Attributes

There are two categories of temporary basis differences: “inside” basis differences and “outside”
basis differences. An inside basis difference is a difference between the carrying amount, for financial
reporting purposes, of an individual asset or liability and its tax basis. An inside basis difference might,
for example, result from an entity’s election to use an accelerated depreciation method for determining
deductions on a specific item of personal property for income tax purposes while using the straight-line
method of depreciation for that item for financial reporting purposes.

An outside basis difference is the difference between the carrying amount of an entity’s investment
(e.g., an investment in a consolidated subsidiary) for financial reporting purposes and the underlying tax
basis in that investment (e.g., the tax basis in the subsidiary’s stock). See Section 3.4 for a discussion of
outside basis differences.

Temporary differences are basis differences that will give rise to a tax deduction or taxable income when
the related asset is recovered or liability is settled for its financial reporting carrying value.

3.3.2 Determining Whether a Basis Difference Is a Temporary Difference

ASC 740-10-25-30 states that “[c]ertain basis differences may not result in taxable or deductible
amounts in future years when the related asset or liability for financial reporting is recovered or
settled and, therefore, may not be temporary differences for which a deferred tax liability or asset is
recognized.” An entity must recognize DTAs and DTLs in the absence of (1) a tax law provision that would
allow the recovery or settlement, without tax consequences, of an asset or liability that gives rise to a
taxable or deductible basis difference and the entity has the intent and ability to recover or settle the
item in a tax-free manner or (2) a specific exception identified in ASC 740.

3.3.2.1 Examples of Basis Differences That Are Not Temporary Differences

740-10-25 (Q&A 43)
Some basis differences do not result in taxable or deductible amounts in future years and are not
considered temporary differences. Examples include the following:

3.3.2.1.1 Entity-Owned Life Insurance

Under U.S. federal tax law, deductions for certain insurance premiums on officers and directors are
not deductible for tax purposes. However, for financial reporting purposes, the cash surrender value of
life insurance policies for which the entity is the beneficiary is reported in its balance sheet as an asset.
Because the proceeds of such a policy are not taxable under the tax law if they are held until the death
of the insured, no DTL would be recognized for the basis difference (excess of cash surrender value over
total premiums paid) under ASC 740 provided that management intended not to realize the benefits
available under the policy before the death of the executives. A history of reversions, before the death
of an insured that results in realization of a portion or all of the excess cash surrender value, would
generally be inconsistent with an assertion that proceeds will not be taxable. However, loans that are
collateralized against the surrender value of such policies might not be considered inconsistent with that
assertion (e.g., if the action is taken primarily to reduce the cost of borrowed funds).

3.3.2.1.2 Domestic Subsidiaries
The excess of a parent entity’s investment in the stock of a domestic subsidiary for financial reporting
purposes over the tax basis in that stock is not a taxable temporary difference for which recognition of
a DTL is required if the tax law provides a means by which the reported amount of the investment could
be recovered tax free and the entity expects to use that means. Under U.S. federal tax law, such means
include a tax-free liquidation or a statutory merger. See further discussion in Section 3.4.3.

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3.3.2.1.3 Nontaxable Entities
Under U.S. federal tax law, C corporations are taxed on their income and gains directly, whereas
nontaxable flow-through entities such as S corporations and REITs are not directly taxed, but their
income and gains are passed through to the individual tax returns of their shareholders. Generally, basis
differences in assets and liabilities held by nontaxable entities are not taxable/deductible temporary
differences for which deferred taxes should be recorded. However, see Section 3.5.4.2 for a discussion
of unrealized built-in gains for which a DTL is required.

3.3.2.1.4 Income Tax Effects on Medicare Part D Subsidy Receipts

715-30-25 (Q&A 13)
The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “2003 Act”)
established a prescription drug benefit under Medicare Part D and a federal subsidy to employers
offering retiree prescription drug coverage that provides a benefit that is at least as valuable as
Medicare Part D coverage. An employer’s promise to provide postretirement prescription drug coverage
(“coverage”) is recorded as a component of the other postretirement benefit obligation. When that
coverage benefit meets certain criteria, the employer becomes eligible to receive the federal retiree drug
subsidy (the “subsidy”), which is then recorded as an offset against the obligation determined under ASC
715-60 (i.e., the postretirement benefit obligation is recorded net of the subsidy, and the net amount is
actuarially determined). Under the 2003 Act, the subsidy received was not considered taxable income to
the employer for federal income tax purposes, but the employer was permitted to deduct the entire cost
of providing the prescription drug coverage. However, while the Patient Protection and Affordable Care
Act and the Health Care and Education Affordability Reconciliation Act of 2010 repealed the provision in
the 2003 Act that permitted deduction of the entire cost of prescription drug coverage, it did not change
the treatment of the subsidy (it remains nontaxable). Because the portion of the prescription drug
costs that will be offset by the subsidy is no longer tax deductible, and the subsidy remains nontaxable,
the temporary difference and related DTA should be determined without regard to (1) the portion of
the cost of prescription drug coverage that will be offset by the subsidy and (2) the subsidy itself. ASC
740-10-55-57 states that “[i]n the periods in which the subsidy affects the employer’s accounting for the
plan,” the subsidy should not affect any plan-related temporary differences that are accounted for under
ASC 740 because the subsidy is exempt from federal taxation.

3.3.3 Measurement of Temporary Differences

ASC 740-10

Anticipation of Future Losses Not Permitted

25-38 Conceptually, under an incremental approach as discussed in paragraph 740-10-10-3, the tax
consequences of tax losses expected in future years would be anticipated for purposes of:
a. Nonrecognition of a deferred tax liability for taxable temporary differences if there will be no future
sacrifice because of future tax losses that otherwise would expire unused
b. Recognition of a deferred tax asset for the carryback refund of taxes paid for the current or a prior year
because of future tax losses that otherwise would expire unused.
However, the anticipation of the tax consequences of future tax losses is prohibited.

Anticipated Future Tax Credits

25-39 Certain foreign jurisdictions tax corporate income at different rates depending on whether that income is
distributed to shareholders. For example, while undistributed profits in a foreign jurisdiction may be subject to
a corporate tax rate of 45 percent, distributed income may be taxed at 30 percent. Entities that pay dividends
from previously undistributed income may receive a tax credit (or tax refund) equal to the difference between
the tax computed at the undistributed rate in effect the year the income is earned (for tax purposes) and the
tax computed at the distributed rate in effect the year the dividend is distributed.

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ASC 740-10 (continued)

25-40 In the separate financial statements of an entity that pays dividends subject to the tax credit to its
shareholders, a deferred tax asset shall not be recognized for the tax benefits of future tax credits that will be
realized when the previously taxed income is distributed; rather, those tax benefits shall be recognized as a
reduction of income tax expense in the period that the tax credits are included in the entity’s tax return.

25-41 The accounting required in the preceding paragraph may differ in the consolidated financial statements
of a parent that includes a foreign subsidiary that receives a tax credit for dividends paid, if the parent expects
to remit the subsidiary’s earnings. Assume that the parent has not availed itself of the exception for foreign
unremitted earnings that may be available under paragraph 740-30-25-17. In that case, in the consolidated
financial statements of a parent, the future tax credit that will be received when dividends are paid and the
deferred tax effects related to the operations of the foreign subsidiary shall be recognized based on the
distributed rate because, as assumed in that case, the parent is not applying the indefinite reversal criteria
exception that may be available under that paragraph. However, the undistributed rate shall be used in the
consolidated financial statements to the extent that the parent has not provided for deferred taxes on the
unremitted earnings of the foreign subsidiary as a result of applying the indefinite reversal criteria recognition
exception.

25-50 The tax basis of an asset is the amount used for tax purposes and is a question of fact under the tax
law. An asset’s tax basis is not determined simply by the amount that is depreciable for tax purposes. For
example, in certain circumstances, an asset’s tax basis may not be fully depreciable for tax purposes but would
nevertheless be deductible upon sale or liquidation of the asset. In other cases, an asset may be depreciated at
amounts in excess of tax basis; however, such excess deductions are subject to recapture in the event of sale.

As discussed in Section 3.3.1, a temporary difference is a difference between the financial reporting
basis and the income tax basis, determined in accordance with the recognition and measurement
criteria of ASC 740, of an asset or liability that will result in a taxable or deductible item in future years
when the financial reporting basis of the asset or liability is recovered or settled, respectively. Once the
temporary difference is determined, an entity should determine the amount at which the DTAs and DTLs
should be measured (see Section 3.3.4). Measurement of temporary differences involves identification
of the financial reporting carrying value and tax basis as well as consideration of the level of uncertainty
regarding each position taken by the entity.

3.3.3.1 Tax Bases Used in the Computation of Temporary Differences

740-10-25 (Q&A 01)
The tax bases of assets and liabilities used to compute temporary differences as well as loss and
tax credit carryforwards may not necessarily be consistent with information contained in as-filed tax
returns or the schedules used to prepare such returns. Instead, such tax bases and carryforwards are
computed on the basis of amounts that meet the recognition threshold of ASC 740 and are measured
in accordance with ASC 740. That is, for financial reporting purposes, income tax assets and liabilities,
including DTAs and DTLs, are computed on the basis of what might be characterized as a “hypothetical
ASC 740 tax return,” which may reflect tax bases of (1) assets and liabilities and (2) tax loss and credit
carryforwards that may not be consistent with the as-filed tax return. See Chapter 4 for details.

3.3.3.2 Anticipation of Future Losses

ASC 740-10-25-38 states that in the determination of whether a basis difference is a taxable or
deductible temporary difference, “the anticipation of the tax consequences of future tax losses is
prohibited.” Therefore, an entity is not permitted to anticipate the tax consequences of future tax losses
when measuring temporary differences and deferred tax consequences of existing taxable temporary
differences.

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Under such circumstances, a DTL established in the initial period in which future losses are expected
would be eliminated in subsequent years when the tax losses are actually incurred. Therefore, under
ASC 740, an entity that expects not to pay income taxes in the future because of expected tax losses
is prohibited from avoiding recognition of a DTL for the tax consequences of taxable temporary
differences that exist as of the balance sheet date.

As the complexity of an entity’s legal structure and jurisdictional footprint increases, so do the challenges
with measuring tax assets and liabilities. Consultation with tax and accounting advisers is encouraged in
these situations.

3.3.3.3 Tax Basis That Adjusts in Accordance With or Depends on a Variable

In some situations, an item’s tax basis may adjust in accordance with an outside factor, or it may depend
on a variable that may or may not be within the entity’s control. For example, an item’s tax basis might
only be deductible for tax purposes if a certain event occurs (such as holding the associated asset for
a specific period), or the tax basis may change in conformity with the sales price of the asset if sold.
Under ASC 740-10-25-20, there is an inherent assumption in an entity’s statement of financial position
that the reported amounts of assets and liabilities will be recovered or settled, respectively, at their
carrying values. This principle is applied even if there are certain indicators, such as the fair value of
the related balance, that will permit the asset or liability to be recovered or settled, respectively, above
or below the carrying value. In these instances, the tax basis and corresponding temporary difference
should generally be determined as of the balance sheet date if the asset or liability was recovered at
carrying value. The example below demonstrates the tax accounting implications associated with that
assumption.

Example 3-1

Entity A constructs a building in Jurisdiction U, which permits entities to claim depreciation deductions for tax
purposes. In addition, the tax law in the jurisdiction requires entities to determine the gain or loss upon the
sale of a qualifying building as follows:

• Sales price greater than original cost — The tax basis of the building is restored to original cost on sale if
the selling price exceeds the original cost, and any resulting gain is recognized as a capital gain instead of
an ordinary gain.
• Sales price between the adjusted tax basis and original cost — No taxable gain or loss results if the selling
price is between the adjusted tax basis and the original cost.
• Sales price less than the adjusted tax basis — If the sales price is less than the building’s adjusted tax basis,
the resulting loss is recognized as a capital loss instead of an ordinary loss.
On December 31, 20X1, A’s building is classified as held for sale under ASC 360-10-45-9. The temporary
difference and deferred tax position should be determined as if the asset will be recovered at its book basis
as of the reporting date. ASC 740-10-25-20 requires an entity to assume that the carrying value of the asset
will be recovered (i.e., any current marketplace conditions should not be factored into the assessment of the
asset’s tax basis). Accordingly, even if the current fair value of the property exceeds the original cost (which
would indicate that a future sales price exceeds the original cost, potentially triggering complete restoration
of the basis to original cost), the temporary difference should still be analyzed as of the balance sheet date as
if the sales price were the carrying value of the asset. A DTA or reduction of a DTL resulting from the potential
restoration of basis would not be recognized.

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3.3.4 Measurement of Deferred Taxes

740-10-30 (Q&A 71)

ASC 740-10

General
30-1 This Section provides guidance on the measurement of total income tax expense. While most of this
guidance focuses on the initial measurement of deferred tax assets and liabilities, including determining the
appropriate tax rate to be used, the requirements for measuring current taxes payable or refundable are also
established. This guidance also addresses the consideration and establishment of a valuation allowance for
deferred tax assets. Requirements for entities that issue separate financial statements and are part of a group
that files a consolidated tax return are also established in this Section.

Basic Requirements
30-2 The following basic requirements are applied to the measurement of current and deferred income taxes
at the date of the financial statements:
a. The measurement of current and deferred tax liabilities and assets is based on provisions of the
enacted tax law; the effects of future changes in tax laws or rates are not anticipated.
b. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that,
based on available evidence, are not expected to be realized.

30-3 Total income tax expense (or benefit) for the year is the sum of deferred tax expense (or benefit) and
income taxes currently payable or refundable.

Deferred Tax Expense (or Benefit)

30-4 Deferred tax expense (or benefit) is the change during the year in an entity’s deferred tax liabilities and
assets. For deferred tax liabilities and assets recognized in a business combination or in an acquisition by
a not-for-profit entity during the year, it is the change since the acquisition date. Paragraph 830-740-45-1
addresses the manner of reporting the transaction gain or loss that is included in the net change in a deferred
foreign tax liability or asset when the reporting currency is the functional currency.

30-5 Deferred taxes shall be determined separately for each tax-paying component (an individual entity or
group of entities that is consolidated for tax purposes) in each tax jurisdiction. That determination includes the
following procedures:
a. Identify the types and amounts of existing temporary differences and the nature and amount of each
type of operating loss and tax credit carryforward and the remaining length of the carryforward period.
b. Measure the total deferred tax liability for taxable temporary differences using the applicable tax rate
(see paragraph 740-10-30-8).
c. Measure the total deferred tax asset for deductible temporary differences and operating loss
carryforwards using the applicable tax rate.
d. Measure deferred tax assets for each type of tax credit carryforward.
e. Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is
more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax
assets will not be realized. The valuation allowance shall be sufficient to reduce the deferred tax asset to
the amount that is more likely than not to be realized.

Income Taxes Payable or Refundable (Current Tax Expense [or Benefit])

30-6 Income taxes payable or refundable (current tax expense [or benefit]) are determined under the
recognition and measurement requirements for tax positions established in paragraph 740-10-25-2 for
recognition and in this Section for measurement.

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ASC 740-10 (continued)

30-7 A tax position that meets the more-likely-than-not recognition threshold shall initially and subsequently
be measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon
settlement with a taxing authority that has full knowledge of all relevant information. Measurement of a tax
position that meets the more-likely-than-not recognition threshold shall consider the amounts and probabilities
of the outcomes that could be realized upon settlement using the facts, circumstances, and information
available at the reporting date. As used in this Subtopic, the term reporting date refers to the date of the entity’s
most recent statement of financial position. For further explanation and illustration, see Examples 5 through 10
(paragraphs 740-10-55-99 through 55-116).

Applicable Tax Rate Used to Measure Deferred Taxes

30-8 Paragraph 740-10-10-3 establishes that the objective is to measure a deferred tax liability or asset using
the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or
asset is expected to be settled or realized. Deferred taxes shall not be accounted for on a discounted basis.

30-9 Under tax law with a graduated tax rate structure, if taxable income exceeds a specified amount, all
taxable income is taxed, in substance, at a single flat tax rate. That tax rate shall be used for measurement of
a deferred tax liability or asset by entities for which graduated tax rates are not a significant factor. Entities
for which graduated tax rates are a significant factor shall measure a deferred tax liability or asset using the
average graduated tax rate applicable to the amount of estimated annual taxable income in the periods in
which the deferred tax liability or asset is estimated to be settled or realized. See Example 16 (paragraph
740-10-55-136) for an illustration of the determination of the average graduated tax rate. Other provisions
of enacted tax laws shall be considered when determining the tax rate to apply to certain types of temporary
differences and carryforwards (for example, the tax law may provide for different tax rates on ordinary income
and capital gains). If there is a phased-in change in tax rates, determination of the applicable tax rate requires
knowledge about when deferred tax liabilities and assets will be settled and realized.

30-10 In the U.S. federal tax jurisdiction, the applicable tax rate is the regular tax rate, and a deferred tax asset
is recognized for alternative minimum tax credit carryforwards in accordance with the provisions of paragraph
740-10-30-5(d) through (e).

30-11 The objective established in paragraph 740-10-10-3 relating to enacted tax rate(s) expected to apply
is not achieved through measurement of deferred taxes using the lower alternative minimum tax rate if an
entity currently is an alternative minimum tax taxpayer and expects to always be an alternative minimum
tax taxpayer. No one can predict whether an entity will always be an alternative minimum tax taxpayer.
Furthermore, it would be counterintuitive if the addition of alternative minimum tax provisions to the tax
law were to have the effect of reducing the amount of an entity’s income tax expense for financial reporting,
given that the provisions of alternative minimum tax may be either neutral or adverse but never beneficial to
an entity. It also would be counterintuitive to assume that an entity would permit its alternative minimum tax
credit carryforward to expire unused at the end of the life of the entity, which would have to occur if that entity
was always an alternative minimum tax taxpayer. Use of the lower alternative minimum tax rate to measure an
entity’s deferred tax liability could result in understatement for either of the following reasons:
a. It could be understated if the entity currently is an alternative minimum tax taxpayer because of
temporary differences. Temporary differences reverse and, over the entire life of the entity, cumulative
income will be taxed at regular tax rates.
b. It could be understated if the entity currently is an alternative minimum tax taxpayer because of
preference items but does not have enough alternative minimum tax credit carryforward to reduce its
deferred tax liability from the amount of regular tax on regular tax temporary differences to the amount
of tentative minimum tax on alternative minimum tax temporary differences. In those circumstances,
measurement of the deferred tax liability using alternative minimum tax rates would anticipate the tax
benefit of future special deductions, such as statutory depletion, which have not yet been earned.

30-12 If alternative tax systems exist in jurisdictions other than the U.S. federal jurisdiction, the applicable tax
rate is determined in a manner consistent with the tax law after giving consideration to any interaction (that is,
a mechanism similar to the U.S. alternative minimum tax credit) between the two systems.

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ASC 740-10 (continued)

Effect of Anticipated Future Special Deductions and Tax Credits on Deferred Tax Rates
Anticipated Future Special Deductions
30-13 As required by paragraph 740-10-25-37, the tax benefit of special deductions ordinarily is recognized
no earlier than the year in which those special deductions are deductible on the tax return. However, some
portion of the future tax effects of special deductions are implicitly recognized in determining the average
graduated tax rate to be used for measuring deferred taxes when graduated tax rates are a significant factor
and the need for a valuation allowance for deferred tax assets. In those circumstances, implicit recognition
is unavoidable because those special deductions are one of the determinants of future taxable income and
future taxable income determines the average graduated tax rate and sometimes determines the need for a
valuation allowance.

Anticipated Future Tax Credits

30-14 Paragraph 740-10-25-39 notes that certain foreign jurisdictions may tax corporate income at different
rates depending on whether that income is distributed to shareholders. Paragraph 740-10-25-40 addresses
recognition of future tax credits that will be realized when the previously taxed income is distributed. Under
these circumstances, the entity shall measure the tax effects of temporary differences using the undistributed
rate.

30-15 As noted in paragraph 740-10-25-41, the accounting required in the consolidated financial statements
of a parent that includes a foreign subsidiary that receives a tax credit for dividends paid may differ from
the accounting required for the subsidiary. See that paragraph for the rates required to be used to measure
deferred income taxes in such consolidated financial statements.

Related Implementation Guidance and Illustrations

• Alternative Minimum Tax [ASC 740-10-55-31].
• Example 14: Phased-In Change in Tax Rates [ASC 740-10-55-129].
• Example 15: Change in Tax Rates [ASC 740-10-55-131].
• Example 16: Graduated Tax Rates [ASC 740-10-55-136].
• Example 18: Special Deductions [ASC 740-10-55-145].

ASC 740-10-30-8 states that a DTL or DTA should be measured by “using the enacted tax rate(s)
expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected
to be settled or realized.”

ASC 740-10-55-23 states, in part:

The tax rate or rates . . . used to measure deferred tax liabilities and deferred tax assets are the enacted tax
rates expected to apply to taxable income in the years that the liability is expected to be settled or the asset
recovered. Measurements are based on elections (for example, an election for loss carryforward instead of
carryback) that are expected to be made for tax purposes in future years. Presently enacted changes in tax laws
and rates that become effective for a particular future year or years must be considered when determining the
tax rate to apply to temporary differences reversing in that year or years. Tax laws and rates for the current year
are used if no changes have been enacted for future years. An asset for deductible temporary differences that
are expected to be realized in future years through carryback of a future loss to the current or a prior year (or
a liability for taxable temporary differences that are expected to reduce the refund claimed for the carryback of
a future loss to the current or a prior year) is measured using tax laws and rates for the current or a prior year,
that is, the year for which a refund is expected to be realized based on loss carryback provisions of the tax law.

Determining the tax rate to apply to certain types of temporary differences and carryforwards may not
always be straightforward.

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3.3.4.1 Graduated Tax Rates

740-10-30 (Q&A 18)
ASC 740-10-30-9 states that the single flat tax rate “shall be used for measurement of a deferred
tax liability or asset by entities for which graduated tax rates are not a significant factor.” Entities
that typically pay tax at the highest graduated tax rates will not find such rates a significant factor in
determining the rate used for measuring DTAs and DTLs. However, for some entities, graduated tax rate
structures, such as those found in the tax laws of many states and other tax jurisdictions, may affect the
determination of the applicable tax rate used to measure deferred tax consequences under ASC 740.

ASC 740-10-30-9 further states that “[e]ntities for which graduated tax rates are a significant factor
shall measure a deferred tax liability or asset using the average graduated tax rate applicable to the
amount of estimated annual taxable income in the periods in which the deferred tax liability or asset is
estimated to be settled or realized.” When determining whether graduated tax rates are significant and,
consequently, the applicable tax rate for measuring DTAs and DTLs, an entity must, at least notionally,
estimate future taxable income for the year(s) in which existing temporary differences or carryforwards
will enter into the determination of income tax. That notional estimate begins with pretax accounting
income adjusted for permanent differences and reversal of existing taxable and deductible temporary
differences. Further, projections of future income should be consistent with projections made elsewhere
by the entity. Example 3-2 below illustrates the measurement of DTAs and DTLs when graduated tax
rates are a significant factor.

Example 3-2

Assume the following:

• At the end of 20X1, Entity X, which operates in a single tax jurisdiction, has $30,000 of deductible
temporary differences, which are expected to result in tax deductions of approximately $10,000 for each
of the next three years: 20X2–20X4.
• Historically, the tax jurisdiction’s graduated tax rate structure has affected the determination of X’s
income tax liability.
• The graduated tax rates in the tax jurisdiction are as follows:

Taxable Income
Over Not Over Tax Rate
$ 0 $ 50,000 15%
50,000 75,000 25%
75,000 100,000 34%
100,000 335,000 39%
335,000 10,000,000 34%
10,000,000 15,000,000 35%
15,000,000 18,333,333 38%
18,333,333 35%

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Example 3-2 (continued)

• Entity X’s estimate of pretax income for each of years 20X2–20X4 is $410,000, $110,000, and $60,000,
respectively, excluding reversals of temporary differences.
Estimated taxable income and estimated income taxes payable for those years are computed as follows:

Future Years

20X2 20X3 20X4

Estimated pretax income —
exclusive of temporary differences $ 410,000 $ 110,000 $ 60,000
Reversing deductible temporary
differences (10,000) (10,000) (10,000)
(a) Estimated taxable income $ 400,000 $ 100,000 $ 50,000
Tax based on graduated tax rates:
($50,000 × 15%) 7,500 7,500 7,500
($25,000 × 25%) 6,250 6,250
($25,000 × 34%) 8,500 8,500
($235,000 × 39%) 91,650
(over $335,000 × 34%) 22,100
(b) Estimated tax $ 136,000 $ 22,250 $ 7,500
(c) Applicable tax rate (b ÷ a) 34% 22.3% 15%
Deferred income tax ($10,000 × c) $ 3,400 $ 2,230 $ 1,500

Entity X’s average applicable tax rate is 23.8 percent ([$3,400 + $2,230 + $1,500] ÷ $30,000). Therefore, X
recognizes a DTA of $7,130 ($30,000 × 23.8%) at the end of 20X1. A valuation allowance would be recognized if
realization of all or a portion of the DTA does not meet the more-likely-than-not recognition threshold in ASC 740.

If, after initially recording the DTA or DTL, X changes its estimate of the applicable tax rate because of changes
in its estimate of taxable income in some future year, the effect of such a change in the estimated applicable
tax rate should be included in income from continuing operations in the period of the change in estimate.

If X’s estimate of taxable income for 20X2–20X4 was from $335,000 to $10 million per year, the amount of
income tax liability would not be affected by the graduated rate structure and, therefore, X may not be required
to estimate amounts and periods over which existing temporary differences will reverse. In this situation, X
would measure the DTA at the 34 percent rate.

3.3.4.1.1 Measurement When Future Tax Losses Are Expected in a Graduated Tax

Rate Structure
740-10-30 (Q&A 12)
If tax losses that would otherwise expire unused are expected in future years, an entity would use the
lowest tax rate in a graduated tax structure, rather than zero, to measure a DTL for tax consequences
of taxable temporary differences. Example 3-3 illustrates the measurement of the deferred tax
consequences of taxable temporary differences when tax losses are expected in future years.

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Example 3-3

Assume that Entity X has $200,000 of taxable temporary differences at the end of 20X1 that will reverse in 20X2
and that the enacted statutory tax rate is as follows:

Taxable Income Tax Rate

$1–$100,000 10%
$100,001 and above 20%

In addition, assume that (1) X expects to incur a tax loss of $500,000 next year that includes the reversal of
taxable temporary differences and (2) the loss will expire unused because loss carrybacks and carryforwards
are prohibited under tax law. At the end of 20X1, X would record a DTL of $20,000 ($200,000 × 10%)
because the lowest tax rate of 10 percent, rather than a zero tax rate, is used to measure the deferred tax
consequences of the existing taxable temporary differences if losses are expected in future years and those
losses are expected to expire unused.

Assume that X’s expectations about the future are correct and that, during 20X2, it incurs a substantial loss
carryforward that expires unused. At the end of 20X2, X would eliminate the $20,000 DTL established at the
end of 20X1 and would record a corresponding credit as a component of income tax expense (benefit) from
continuing operations for 20X2 (i.e., the DTL eliminated in the loss year is the tax benefit recognized as a result
of the loss in continuing operations that will not be carried back).

3.3.4.1.2 Anticipation of Future Special Deductions in a Graduated Tax Rate

Structure
An entity is not permitted to anticipate tax benefits for special deductions when measuring the DTL
for taxable temporary differences at the end of the current year. ASC 740-10-25-37 requires the “tax
benefit of special deductions ordinarily [to be] recognized no earlier than the year in which those special
deductions are deductible on the tax return.” However, the future tax effects of special deductions may
nevertheless affect (1) “the average graduated tax rate to be used for measuring deferred taxes when
graduated tax rates are a significant factor” and (2) “the need for a valuation allowance for deferred tax
assets.” ASC 740-10-25-37 states, “In those circumstances, implicit recognition is unavoidable because
those special deductions are one of the determinants of future taxable income and future taxable
income determines the average graduated tax rate and sometimes determines the need for a valuation
allowance.”

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Example 3-3A

Measurement of Existing Temporary Differences When Special Deductions Are Anticipated and the
Average Graduated Tax Rate to Be Used Is a Significant Factor
Assume the following:

• Entity X is measuring the deferred tax consequences of an existing $300,000 taxable temporary
difference at the end of 20X1 that is expected to reverse and enter into X’s determination of taxable
income in 20X2.
• Entity X is considered a small life insurance company under the tax law and is entitled to a special
deduction that is equal to 60 percent of taxable income before the special deduction.
• Under tax law, income is taxed at the following rates:

Taxable Income Tax Rate

$0–$50,000 15%
$50,001–$75,000 25%
$75,001–$100,000 34%
$100,001–$335,000 39%
$335,001–$10,000,000 34%
$10,000,001–$15,000,000 35%
$15,000,001–$18,333,333 38%
$18,333,334 and over 35%

The following table illustrates how X determines the DTL at the end of 20X1 in each of three independent
scenarios in which taxable income (loss) is expected in 20X2:

Scenarios

A B C
1. Expected future taxable income
(loss) for 20X2, excluding
temporary differences $ 1,000,000 $ 100,000 $ (400,000)
2. Taxable temporary difference 300,000 300,000 300,000
3. Special deduction ([1+2] × 60%) (780,000) (240,000) —
4. Expected future taxable income
(loss) $ 520,000 $ 160,000 $ (100,000)
5. Expected future tax liability* $ 176,800 $ 45,650 $ —
6. Applicable tax rate (5 ÷ 4) 34%*** 28.5%† 15%**
7. DTL (2 × 6) $ 102,000 $ 85,500 $ 45,000

* Calculated by using the statutory tax rates.

** If there are no other sources of taxable income that would support a conclusion that realization of the loss is
more likely than not, ASC 740 requires that the lowest graduated tax rate, rather than zero, be used to measure
the deferred tax consequences of the taxable temporary difference (as discussed in Section 3.3.4.1.1).
*** ($50,000 × 15%) + ($25,000 × 25%) + ($25,000 × 34%) + ($235,000 × 39%) + ($185,000 × 34%).
† ($50,000 × 15%) + ($25,000 × 25%) + ($25,000 × 34%) + ($60,000 × 39%).

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Example 3-3A (continued)

Measurement of the deferred tax consequences of a taxable temporary difference does not reflect any
tax benefit for future special deductions unless graduated tax rates are a factor that is significant in the
measurement of an entity’s tax liability. If graduated tax rates are significant, a portion of the benefit of a special
deduction will be recognized through a reduction of the average graduated tax rate used to measure the tax
consequences of taxable temporary differences.

3.3.4.2 Phased-In Changes in Tax Rates

A phased-in change in tax rates occurs when an enacted law specifies that the tax rate applied to
taxable income will change in future periods. One of the more significant phased-in changes occurred
under the U.S. federal tax law enacted in 1986, which stipulated that the corporate tax rate would be 46
percent in 1986, 40 percent in 1987, and 34 percent in 1988 and thereafter.

ASC 740-10-55-129 and 55-130 illustrate the measurement of a DTL for the tax consequences of taxable
temporary differences when there is a phased-in change in tax rates under three different scenarios:
(1) when future income is expected, (2) when future losses are expected, and (3) when taxable income in
years after expected loss years is expected to be offset by tax loss carryforwards.

3.3.4.2.1 Measurement When Contingent Phased-In Changes in Tax Rates Are

Enacted
740-10-30 (Q&A 14)
In certain jurisdictions, the change in tax rates may be contingent on an event outside an entity’s
control. ASC 740 does not provide guidance on determining what rate to use when there is more than
one possible rate and this determination is contingent on events that are outside an entity’s control.
Therefore, entities in jurisdictions in which a phased-in change in tax rates is enacted will need to
establish a policy (see alternative approaches below) for determining the rate to be used in measuring
DTAs and DTLs. This policy should be consistently applied and contain proper documentation of the
scheduling of DTAs and DTLs, the basis for judgments applied, and the conclusions reached.

Example 3-4 below illustrates a jurisdiction in which there is more than one possible rate and the
change in tax rates is contingent on an event outside the entity’s control.

Example 3-4

In March 2008, the State of West Virginia legislature passed a bill (S.B. 680) to provide business tax relief over
future years in the form of phased-in reductions in the corporate net income tax (CNIT) rate. The rate reduction
schedule was as follows:

Schedule — CNIT Rate

Tax years beginning on or after January 1, 2009 8.50%
Tax years beginning on or after January 1, 2012 7.75%
Tax years beginning on or after January 1, 2013 7.00%
Tax years beginning on or after January 1, 2014 6.50%

With the exception of the rate reduction in 2009, the rate reductions can be suspended or reversed if the
state’s rainy day funds fall below 10 percent of the state’s general revenue budget as of the preceding June 30
(the “10 percent test”). For example, if the 10 percent test is not passed on June 30, 2011, the 7.75 percent rate
reduction is suspended until the test is passed in a subsequent year. The suspension (and any subsequent
suspension) continues until the 10 percent test is passed, and then the rate reduction will occur on the
following January 1. The 10 percent test continues on an annual basis after January 1, 2014, and if the test is
not passed, the rate will revert to 7.75 percent until the test is again passed.

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Example 3-4 (continued)

The following are two alternative approaches, based on this example, that an entity might use to determine the
applicable tax rate in any given year:

Alternative 1
An entity might view the phased-in rate reduction as being similar to a graduated tax rate or, alternatively, as
an exemption from a graduated tax rate. (For examples illustrating graduated tax rates, see ASC 740-10-55-136
through 55-138.) Under ASC 740, when a tax jurisdiction has a two-rate schedule, an entity should determine
whether the graduated rates have a material effect and, if so, should forecast its future income to determine
which rate to apply to its taxable temporary differences. In the above example, the entity would need to assess
whether the 10 percent test will be passed to determine its future rate by period.

An entity should have sufficient documentation regarding its assessment of whether the 10 percent test will be met
in future periods (e.g., consideration of the state’s budget forecasts, spending levels, anticipated needs for rainy day
funds), since this is the basis under law for applying the lower of two applicable tax rates in any given year.

Alternative 2
An entity might establish a policy to use the highest enacted rate potentially applicable for a future period as
the applicable rate until the contingency is resolved (i.e., the 10 percent test is passed). The lower rate would
be applied only to DTAs and DTLs for which the associated liability is expected to be settled or asset recovered
in that one period, because an assumption that subsequent 10 percent tests will be passed for those future
periods would be inappropriate.

3.3.4.3 Tax Rate Used in Measuring Receivables and DTAs Related to Operating

Losses and Tax Credits
740-10-30 (Q&A 67)
In measuring temporary differences and certain tax attributes, entities should pay close attention to the
appropriate tax rate to be used. For example, operating losses and some tax credits that arise but are
not used in the current year may be carried back to recover taxes paid in prior years or carried forward
to reduce taxes payable in future years. An entity usually first considers whether an operating loss or
tax credit may be carried back to recover taxes paid in previous years. If the benefit from an operating
loss or tax credit is carried back, the entity recognizes a receivable (current tax benefit) for the amount
of taxes paid in prior years that is refundable by carryback of a current-year operating loss or tax credit.
The entity measures the current income tax receivable by using the rate applicable to the prior year(s)
for which the refund is being claimed.

The entity then carries forward any remaining NOL or tax credit to reduce future taxes payable. NOL
and tax credit carryforwards are recognized as DTAs in the period in which they arise. In accordance with
ASC 740-10-10-3, the entity measures such DTAs by “using the enacted tax rate(s) expected to apply to
taxable income in the periods in which” the DTAs are expected to be realized. (See Section 3.3.4.1 for
guidance on determining the applicable tax rate when an entity operates in a jurisdiction with graduated
tax rates.) For details on determining whether a valuation allowance is needed, see Chapter 5.

Example 3-5

In the current year, Entity A has pretax book income of $2,000 and $2,500 of current-year deductions that give
rise to future taxable temporary differences; a tax loss of $500 is therefore created. Also in the current year,
the statutory rate was scheduled to increase from 35 percent to 40 percent. Assume that A plans to elect to
carry back the tax loss, which is allowable under the local tax law.

In this example, the applicable tax rate would be the enacted rate for the year the loss is carried back to. In the
current year, A would measure the taxable temporary difference related to the $2,000 current-year deductions
at 40 percent, since the temporary difference will reverse after the statutory tax rate has increased to 40
percent, and measure the receivable related to the NOL of $500 at 35 percent, since A would carry back the
$500 loss to offset prior-year income taxed at 35 percent.

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3.3.4.4 Measuring Deferred Taxes on Indefinite-Lived Assets

740-10-30 (Q&A 66)
Under ASC 350, an intangible asset whose life extends beyond the foreseeable horizon is classified
as having an indefinite life (“indefinite-lived intangible asset”). An indefinite-lived intangible asset
is not amortized for financial reporting purposes until its useful life is determined to be no longer
indefinite. However, the applicable tax law may allow or require such assets to be amortized. Since
the amortization is deductible in the determination of taxable income, a temporary difference arises
between the financial reporting carrying value and the tax basis of indefinite-lived intangible assets.

An entity would recognize deferred taxes for a temporary difference related to an indefinite-lived asset
(e.g., land and indefinite-lived intangible assets). Although the tax effect related to these items may be
delayed indefinitely, the ability to do so is not a factor in the determination of whether a temporary
difference exists.

ASC 740-10-25-20 states, in part:

An assumption inherent in an entity’s statement of financial position prepared in accordance with generally
accepted accounting principles (GAAP) is that the reported amounts of assets and liabilities will be recovered
and settled, respectively. Based on that assumption, a difference between the tax basis of an asset or a liability
and its reported amount in the statement of financial position will result in taxable or deductible amounts in
some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities
are settled.

Further, ASC 740-10-55-63 addresses this issue, stating that “deferred tax liabilities may not be
eliminated or reduced because an entity may be able to delay the settlement of those liabilities by
delaying the events that would cause taxable temporary differences to reverse. Accordingly, the deferred
tax liability is recognized.”

Certain jurisdictions may impose a tax rate for ordinary income that is different from the tax rate for
income that is capital (i.e., capital gains). In those instances, ASC 740 does not provide specific guidance
on how to determine which tax rate (i.e., ordinary or capital) is “expected” to apply in the future.

Unlike depreciable or amortizable assets, which are presumed to be recovered through future revenues,
indefinite-lived intangible assets are not presumed to decline in value (i.e., they are not expected to be
consumed over time). However, as noted in ASC 350-30-35-4, the “term indefinite does not mean the
same as infinite or indeterminate.” Further, entities are required to evaluate the remaining useful life of
indefinite-lived intangible assets during each reporting period; when an intangible asset’s useful life is no
longer considered indefinite, the carrying value of the asset must be amortized. When an indefinite-lived
intangible asset becomes finite-lived, it is generally presumed that the asset will be recovered through
future revenues.

Therefore, in jurisdictions in which the ordinary tax rate and capital gains tax rate differ, entities should
determine, on the basis of their specific facts and circumstances, the expected manner of recovery
of the carrying value of indefinite-lived intangible assets (e.g., through sale or eventual consumption
when the asset becomes finite-lived). The tax rate used to measure deferred taxes for indefinite-lived
intangible assets should be consistent with the expected manner of recovery. For example, if an entity
determines that the expected manner of recovery is through sale of the indefinite-lived intangible asset,
the entity should use the capital gains tax rate in measuring deferred taxes related to that asset.

See Section 5.3.1.3 for guidance on whether an entity can use the reversal of a DTL related to an
indefinite-lived asset as a source of taxable income to support the realization of DTAs.

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3.3.4.5 Effect of Tax Holidays on the Applicable Tax Rate

740-10-30 (Q&A 15)

ASC 740-10

25-35 There are tax jurisdictions that may grant an entity a holiday from income taxes for a specified period.
These are commonly referred to as tax holidays. An entity may have an expected future reduction in taxes
payable during a tax holiday.

25-36 Recognition of a deferred tax asset for any tax holiday is prohibited because of the practical problems
in distinguishing unique tax holidays (if any exist) for which recognition of a deferred tax asset might be
appropriate from generally available tax holidays and measuring the deferred tax asset.

When a tax jurisdiction grants an exemption from tax on income that would otherwise give rise to an
income tax obligation, the event is sometimes referred to as a tax holiday. In most jurisdictions that offer
tax holidays, the benefit is available to any entity that qualifies for the holiday (similarly to the election
of S corporation status under U.S. federal tax law). For other jurisdictions, tax holidays may involve a
requirement that is controlled by the entity. For example, the jurisdiction may, for economic reasons,
waive income taxes for a given period if an entity constructs a manufacturing facility located within the
jurisdiction.

In accordance with ASC 740-10-25-35 and 25-36, recognition of a DTA to reflect the fact that an entity
will not be paying taxes for the period of the tax holiday is prohibited. However, an entity’s use of a rate
that reflects the tax holiday to record a DTA or DTL for temporary differences scheduled to reverse
during the period of the tax holiday does not violate the “[r]ecognition of a deferred tax asset for any
tax holiday is prohibited” language of ASC 740-10-25-36. Rather, in such circumstances, a DTL or DTA
is merely reduced from one computed at the statutory tax rate as if a tax holiday did not apply to one
computed at the statutory tax rate that is in effect during a tax holiday. Example 3-6 below illustrates the
accounting for the tax benefits of a tax holiday.

Example 3-6

Assume that at the end of 20X1, an entity operates in a tax jurisdiction with a 50 percent tax rate and that
$1,000 of a total of $2,000 of taxable temporary differences will reverse during years in which that jurisdiction
grants the entity an unconditional tax holiday at a zero tax rate. Therefore, a DTL of $500 ($1,000 × 50%) would
be recognized in the entity’s balance sheet at the end of 20X1. Further assume that in 20X2, a year covered by
the tax holiday, the entity generates $3,000 of taxable income in that jurisdiction and that $1,000 of taxable
temporary differences reversed, as expected. During 20X2, the entity would make no adjustment to its DTL
(because the taxable temporary difference reversed as expected) and no current tax payable or current tax
expense would be recognized for the taxable income generated during 20X2. Note that SAB Topic 11.C would
require disclosures about the effects of the tax holiday.

3.3.4.6 Consideration of Certain State Matters

740-10-30 (Q&A 01)
An entity should consider the three factors below when (1) determining the enacted tax rate that is
expected to apply in periods in which the DTAs or DTLs are expected to be recovered or settled and
(2) measuring DTAs and DTLs in U.S. state income tax jurisdictions.

3.3.4.6.1 State Apportionment
In the measurement of DTAs and DTLs for U.S. state income tax jurisdictions, state apportionment
factors are part of the computation. State apportionment factors are used to allocate taxable income
to various states and are determined in accordance with the income tax laws of each state. The factors
are typically based on the percentage of sales, payroll costs, and assets attributable to a particular state.

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Apportionment factors are not tax rates, but because entities must consider them in determining the
amount of income to apportion to an individual state, they play a large role in the measurement of an
entity’s state DTAs and DTLs. The applicable state deferred tax rate is the product of the applicable
apportionment factor and the enacted state tax rate (i.e., the expected apportionment factor × state
tax rate = applicable state deferred tax rate). To calculate the state DTA or DTL, an entity multiplies the
applicable state deferred tax rate by the temporary difference.

Since it is not uncommon for states to revise their apportionment rules, an entity should consider
enacted changes in tax law when measuring deferred taxes. The apportionment factors generally should
be those that are expected to apply when the asset or liability underlying the temporary difference is
recovered or settled on the basis of existing facts and circumstances and enacted tax law. Further, an
entity should assume that temporary differences will reverse in tax jurisdictions in which the related
assets or liabilities are subject to tax and therefore should apply the enacted tax rate for that particular
state when measuring deferred state taxes (i.e., when measuring the related DTA or DTL, an entity
should not assume that taxable or deductible amounts related to temporary differences will be shifted
to a different tax jurisdiction through future intra-entity transactions).

The entity could use actual apportionment factors for recent years, adjusted for any expected changes
either in the business activities in that state or to reflect already enacted tax laws for that jurisdiction,
as a reasonable estimate when measuring deferred taxes. Expected changes, such as a business
combination or the disposition of a long-lived asset, should not be reflected in the apportionment
factors until they are recognized in the financial statements.

While expected changes are generally not reflected in apportionment factors until they are recognized
in the financial statements, if an entity has decided to sell long-lived assets and the held-for-sale criteria
in ASC 360-10-45-9 have been met, the entity must consider the future sale when (1) accounting for
outside basis difference DTAs and DTLs and (2) anticipating income from the sale of those assets as
part of evaluating the realizability of DTAs for valuation purposes (see Sections 3.4.17.2 and 5.3.1.3).
Therefore, in a manner consistent with other principles in ASC 740 on accounting for deferred taxes,
once the held-for-sale classification is reflected in the entity’s financial statements, we believe that it
would be acceptable for an entity to also anticipate the sale of long-lived assets classified as held for
sale when estimating the state apportionment factor. Similarly, it would also be acceptable to adjust
apportionment factors to reflect planned internal restructuring activities in the period in which the
entity has committed to a restructuring plan, all remaining steps to complete the plan are within the
entity’s control, and there are no regulatory hurdles or other significant uncertainties that need to be
overcome for the restructuring to be completed. That is, the remaining steps to effectuate the internal
restructuring do not depend on events or actions outside the reporting entity’s control.

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3.3.4.6.2 Optional Future Tax Elections

States may enact changes to the tax rate or apportionment factor that can be implemented through
a tax election that is available for tax purposes only in periods after the reporting date. If the entity
expects that it will make the election, it should consider the election when measuring its DTAs and DTLs.
ASC 740-10-55-23 states, in part:

Measurements [of DTAs and DTLs] are based on elections (for example, an election for loss carryforward
instead of carryback) that are expected to be made for tax purposes in future years. Presently enacted
changes in tax laws and rates that become effective for a particular future year or years must be
considered when determining the tax rate to apply to temporary differences reversing in that year
or years. Tax laws and rates for the current year are used if no changes have been enacted for future years.
[Emphasis added]

ASC 740-10-45-15 requires that a change in tax law that gives rise to a change in the measurement of
DTAs and DTLs (such as a change in the apportionment rules) be reflected in the period that includes
the enactment date. For example, a state may change its tax law to allow a taxpayer to elect to
apportion income on the basis of a single-sales factor election. If an entity expects to make the single-
factor election, it must recognize, in the interim or annual period that includes the enactment date, the
effect that the election will have on the amount of the DTA or DTL relative to the temporary differences
expected to reverse in years in which the election is effective. Any tax effect is included in income from
continuing operations (see Chapter 6 for intraperiod allocation guidance).

3.3.4.6.3 Use of a Blended Rate to Measure Deferred Taxes

740-10-30 (Q&A 64)
Deferred taxes ordinarily must be determined separately for each tax-paying component1 in each
tax jurisdiction. However, in practice, some entities employ a “blended-rate” approach in measuring
deferred taxes at the legal-entity level. Such an approach may simplify the ASC 740 calculation for
entities operating in multiple jurisdictions (e.g., operating in multiple U.S. states).

ASC 740-10-55-25 states:

If deferred tax assets or liabilities for a state or local tax jurisdiction are significant, this Subtopic requires a
separate deferred tax computation when there are significant differences between the tax laws of that and
other tax jurisdictions that apply to the entity. In the United States, however, many state or local income taxes
are based on U.S. federal taxable income, and aggregate computations of deferred tax assets and liabilities for
at least some of those state or local tax jurisdictions might be acceptable. In assessing whether an aggregate
calculation is appropriate, matters such as differences in tax rates or the loss carryback and carryforward
periods in those state or local tax jurisdictions should be considered. Also, the provisions of paragraph 740-10-
45-6 about offset of deferred tax liabilities and assets of different tax jurisdictions should be considered.
In assessing the significance of deferred tax expense for a state or local tax jurisdiction, it is appropriate to
consider the deferred tax consequences that those deferred state or local tax assets or liabilities have on other
tax jurisdictions, for example, on deferred federal income taxes.

An entity should use significant judgment and continually assess whether it is acceptable to use a
blended-rate approach in light of (1) the considerations in ASC 740-10-55-25, among others, and (2) the
specific facts and circumstances. For example, a change in circumstances in one of the jurisdictions from
one year to the next (e.g., a nonrecurring event or a change in tax rate) may result in a conclusion that
the use of a blended rate is unacceptable.

In all cases, the results of using a blended-rate approach should not be materially different from the
results of separately determining deferred taxes for each tax-paying component in each tax jurisdiction.

1
As defined in ASC 740-10-30-5, a tax-paying component is “an individual entity or group of entities that is consolidated for tax purposes.”

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3.3.4.7 Determining the Applicable Tax Rate When Different Rates Apply to

Distributed and Undistributed Earnings
740-10-30 (Q&A 11)
Certain tax jurisdictions might allow for different tax rates on ordinary income and capital gains, while
others may allow for different tax rates depending on whether earnings are distributed (dual-rate
jurisdictions). Below are two examples of situations in which determining the applicable tax rate may be
complex.

3.3.4.7.1 Distributed and Undistributed Earnings and Tax Credit on Distribution

Germany, under its prior laws, serves as an example of a jurisdiction in which corporate income is taxed
at different rates depending on whether it is distributed to shareholders. ASC 740-10-25-39 states:

Certain foreign jurisdictions tax corporate income at different rates depending on whether that income is
distributed to shareholders. For example, while undistributed profits in a foreign jurisdiction may be subject to
a corporate tax rate of 45 percent, distributed income may be taxed at 30 percent. Entities that pay dividends
from previously undistributed income may receive a tax credit (or tax refund) equal to the difference between
the tax computed at the undistributed rate in effect the year the income is earned (for tax purposes) and the
tax computed at the distributed rate in effect the year the dividend is distributed.

This example thus involves consideration of whether the distributed rate or the undistributed rate
should be used to measure the tax effects of temporary differences.

ASC 740-10-30-14 (which applies only to stand-alone entities in the applicable jurisdiction and not to
subsidiaries of U.S. entities) states that an entity should use the undistributed rate to measure the tax
effects of temporary differences, since it is appropriate to recognize the tax benefit from the future tax
credit only when the entity had actually distributed assets to its shareholders and included the tax credit
in its tax return. Recognizing the tax benefit before that point would constitute an overstatement of the
entity’s assets and equity. This is similar to the accounting for a “special deduction” discussed in ASC
740-10-25-37 (see Section 3.2.1).

However, the rate to be used in the applicable jurisdiction by a parent in its consolidated financial
statements is different from that used for stand-alone foreign entities. Specifically, ASC 740-10-25-41
states that “in the consolidated financial statements of a parent, the future tax credit that will be
received when dividends are paid and the deferred tax effects related to the operations of the foreign
subsidiary shall be recognized based on the distributed rate,” as long as the parent is not applying the
indefinite reversal criteria of ASC 740-30-25-17. The basis for ASC 740-10-25-41 is that the parent has
the unilateral ability to require the foreign subsidiary to pay dividends and that the consolidated financial
statements reflect all other tax effects of distributing earnings. In addition, the consolidated financial
statements are intended to provide users with information regarding the total amount of net assets
and liabilities available to creditors. Requiring an entity to provide additional taxes at the parent level on
the basis of repatriation of earnings, but not to record the tax benefit associated with that repatriation,
would result in an understatement of the assets available to creditors.

Conversely, ASC 740-10-25-41 states that the “undistributed rate shall be used in the consolidated
financial statements to the extent that the parent has not provided for deferred taxes on the unremitted
earnings of the foreign subsidiary as a result of applying the indefinite reversal criteria recognition
exception.” This is consistent with ASC 740-30-25-14, which states, in part:

A tax benefit shall not be recognized . . . for tax deductions or favorable tax rates attributable to future
dividends of undistributed earnings for which a deferred tax liability has not been recognized under the
requirements of paragraph 740-30-25-18.

In other words, it would be inappropriate to record a tax benefit attributable to a distribution when all
other tax effects of distributing these earnings have not been recorded.

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3.3.4.7.2 Distributed Earnings and Deferral of Tax Payments

Unlike Germany, whose former tax law offers credits on distributed profits, Mexico’s former tax law
enabled taxpayers to defer tax payments. Under this law, income taxes were assessed on current
earnings at a rate of 35 percent. However, the law required current payment only on income taxes
computed at a lower tax rate (e.g., 30 percent for the year 2000) of taxable income at the time the tax
return was filed. The remaining payment of 5 percent was due to the government as dividend payments
were made to the entity’s shareholders.

In this situation, an entity should use the tax rate of 35 percent to record taxes in its separate financial
statements because the deferred tax amount represents an unavoidable liability for the company and
the amount of that tax is not available for distribution to shareholders. ASC 740-10-25-3 addresses a
similar situation — “policyholders’ surplus” of stock life insurance companies — that illustrates the need
to accrue taxes at the higher rate.

If a liability exists at the subsidiary entity level and no other exemptions in ASC 740-10-25-3 are
applicable (i.e., the indefinite reversal criteria of ASC 740-30-25-17 cannot be applied to analogous
types of differences), derecognition of the tax liability (even in consolidation) would be possible only in
accordance with the liability guidance in ASC 405-20-40-1, which states, in part:

A debtor shall derecognize a liability if and only if it has been extinguished. A liability has been extinguished if
either of the following conditions is met:
a. The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes
the following:
1. Delivery of cash
2. Delivery of other financial assets
3. Delivery of goods or services
4. Reacquisition by the debtor of its outstanding debt securities whether the securities are cancelled
or held as so-called treasury bonds.
b. The debtor is legally released from being the primary obligor under the liability, either judicially or by the
creditor.

Because neither of these criteria has been met, all companies, regardless of whether they state that
earnings are indefinitely reinvested, should accrue taxes and provide for the deferred tax effects of
Mexican operations at the stated statutory rate of 35 percent.

Some might argue that, at the consolidated level, the former Mexican tax law appears similar to the
guidance in ASC 740-10-25-41 in that a non-Mexican parent of a Mexican subsidiary is able to effectively
defer the additional tax indefinitely by electing not to distribute earnings. However, in substance, the two
tax laws and resulting tax consequences are very different.

Under ASC 740-10-25-41, the undistributed rate should be used when a shareholder will not repatriate
earnings, because it would be inconsistent to record in the consolidated financial statements a tax
benefit associated with an earnings distribution but not to recognize a liability for all other tax effects of
distributing these earnings.

Conversely, under the former Mexican tax law, an entity incurred a liability at the time it earned taxable
income. While the entity was permitted to defer the liability until a distribution was made, the “net”
unpaid tax would never represent earnings attributable to shareholders. Rather, the entity would always
be liable to the government for the full amount of the tax. Thus, unlike use of the undistributed rate
under ASC 740-10-25-41, use of the undistributed rate in this situation under the former Mexican tax
law would artificially inflate equity by reflecting amounts that shareholders can never realize.

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Still others might argue that, in substance, this incremental tax has characteristics of a withholding tax
(especially with respect to a non-Mexican parent). However, in form, the obligating events that give
rise to a tax liability vary substantially. In a withholding tax situation, the incremental tax is assessed
(or the obligating event occurs) on the distribution date. Under the former Mexican tax law, however
(irrespective of the ultimate payment terms), tax was assessed only at the time income was generated.
In addition, withholding taxes are generally intended as a tax on shareholders, whereas the Mexican tax
was assessed as a tax on the corporation and its income.

Accordingly, under the former tax law for income subject to Mexican income tax, the statutory rate
should be used to accrue taxes and should be applied to all temporary differences. In addition, the
incremental tax amount associated with current earnings should be recorded as a deferred tax item
that is not a DTL.

3.3.4.8 Deferred Tax Measurement in Jurisdictions in Which an Income Measure

Is Less Than Comprehensive
740-10-30 (Q&A 23)
It is increasingly common for tax jurisdictions to assess tax on businesses on the basis of an amount
computed as gross receipts less certain current-period deductions that are specifically identified by
statute (“adjusted gross receipts”). The tax assessed on adjusted gross receipts may be in addition to, or
in lieu of, a tax based on a comprehensive income measure. Individual tax jurisdictions that assess taxes
on the basis of adjusted gross receipts typically define which entities are taxable, what constitutes gross
receipts, and which deductions are permitted. In addition, an entity may have certain assets that do not
appear to directly interact, or that only partially interact, with the adjusted gross receipts tax base.

The starting point for a jurisdictional assessment of business taxes on adjusted gross receipts is typically
total revenues and not net income. Section 2.4 discusses (1) taxes that are based wholly or partially
on gross receipts and (2) how to determine whether any part of the tax due under such a regime is
within the scope of ASC 740. For a tax to be an income tax within the scope of ASC 740, revenues and
gains must be reduced by some amount of expenses and losses allowed by the jurisdiction. If, after
determining that amount, an entity does not expect to have an income tax component or expects to
have an income tax component infrequently, no deferred taxes should be recognized. If, however, the
entity determines that some portion of the future taxes payable will be within the scope of ASC 740, it
must then determine how to measure its deferred taxes.

When applying the principles of ASC 740 to book and tax basis differences in these individual tax
jurisdictions, an entity may encounter various complexities. Recovery and settlement of book assets and
liabilities, respectively, with a tax basis that is different from their respective book carrying values will
result in a subsequent-period tax consequence. Accordingly, an entity must apply the principles in ASC
740 carefully when assessing whether to recognize a DTL or DTA for the estimated future tax effects
attributable to temporary differences. In doing so, an entity must determine:
1. Whether there is a basis difference under ASC 740 for all or a portion of the book carrying value
of assets and liabilities in the statement of financial position.
2. If there is a basis difference, whether it is temporary and thus must be recognized under
ASC 740.
3. If there is a temporary difference, whether it is a taxable or deductible temporary difference for
which a DTA or DTL must be recognized.

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Consider the following scenarios:

• Scenario 1 — A tax jurisdiction permits raw material purchases to be deducted from gross
receipts in the period in which the materials are acquired but prohibits any deduction for
internal labor costs incurred in any period. At the end of the reporting period, the book carrying
value of an entity’s inventory of $100 includes $80 of raw materials purchased from third parties
and $20 of capitalized labor costs. Accordingly, the tax basis of the inventory is $0 at the end of
the reporting period.

• Scenario 2 — A tax jurisdiction prohibits deductions for acquired capital assets. The entity is
permitted to compute the period taxable gross receipts on the basis of total revenues less
either a cost of goods sold deduction, a compensation deduction, or 30 percent of total
revenues. Accordingly, the tax basis of the entity’s property, plant, and equipment (PP&E) is $0 at
the end of the reporting period.

In practice, there are two views on how an entity should recognize the DTL related to its inventory and
PP&E book-versus-tax basis difference that exists at period-end.

Information from Scenario 1 above is used to illustrate the two views.

3.3.4.8.1 View 1 — Record Deferred Taxes on the Entire Book/Tax Basis Difference

At the end of the reporting period, the temporary difference related to the inventory is $100, for which
a DTL would be recorded. This view is consistent with the presumption in ASC 740-10-25-20 that the
reported amounts of assets and liabilities will be recovered and settled, respectively, and that basis
differences will generally result in a taxable or deductible amount in some future period. Adjusted gross
receipts will increase by $100 in the future when the inventory is recovered (i.e., sold) at its book carrying
value. There will be no deduction for cost of sales because the $80 of material costs is deducted in the
period in which the materials are acquired and no tax deduction is permitted in any period for labor-
related costs.

As noted above, a premise underlying the application of ASC 740 is that all assets are expected to be
recovered at their reported amounts in the statement of financial position. If that recovery will result in
taxable income in a future period (or periods), the items represent a taxable temporary difference and
DTLs should be recognized regardless of whether the nature of the asset recovery is by sale or use or
represents an observable direct deduction from jurisdictional gross receipts.

3.3.4.8.2 View 2 — Record Deferred Taxes Only on Items That Will Enter Into the
Measurement of Both Book and Taxable Income in a Current or Future Period
At the end of the reporting period, the temporary difference related to the inventory is $80, for which
a DTL would be recorded because only $80 of the capitalized inventory costs is (or was) deductible
for tax reporting purposes. The capitalized labor element of $20 represents a nondeductible basis
difference between the financial statements and tax return (i.e., a “permanent” difference) because the
tax jurisdiction does not permit entities to make any deductions for labor costs in computing the tax
assessed.

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3.3.4.9 Deferred Tax Treatment of Hybrid Taxes

740-10-30 (Q&A 74)
In a hybrid tax regime, an entity pays the greater of two tax computations, one of which is typically based
on taxable profit and the other of which is not (e.g., it is based on gross revenue or capital). The tax rules
and regulations of such a regime may state that an entity must always pay income tax but must also
calculate taxes on the basis of the non-income-based measure(s). To the extent that the non-income-
based measure or measures result in a larger amount, the entity would pay the difference between
the income tax and the amount determined by using the non-income-based measure. This distinction
may affect how the tax authority in the jurisdiction can use the tax revenue (e.g., income tax revenue
may be used for general purposes, but the incremental tax may be earmarked for a specific purpose).
The description of the amounts paid in the tax rules and regulations does not affect how a reporting
entity determines the component of the hybrid taxes that is considered an income tax for accounting
purposes.

An entity’s first step in making this distinction should be to carefully assess whether taxes due under a
hybrid regime represent an income tax within the scope of ASC 740 or a non-income tax accounted for
under other U.S. GAAP (see Section 2.5 which addresses scoping considerations for hybrid tax regimes).
In a manner similar to assessing taxes based on adjusted gross receipts (see Section 3.3.4.8), if the
entity determines that some portion of the future taxes payable will be within the scope of ASC 740, the
entity must then decide how to measure its deferred taxes.

As discussed in ASC 740-10-10-3, the objective of measuring deferred taxes is to use “the enacted tax
rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is
expected to be settled or realized.” However, in a hybrid tax regime, because some component of an
entity’s overall tax liability (even when the amount payable is determined as a percentage of taxable
profits) may be accounted for as a component of pretax income, questions have often arisen about the
appropriate tax rate to use for measuring DTAs and DTLs.

The tax rate used to measure deferred taxes should take into account the total amount of taxes
expected to be paid that will be treated as a component of pretax income. The appropriate tax rate is
determined by dividing the amount expected to be classified as an income tax by total taxable income.

In determining the tax rate that is expected to apply when temporary differences reverse, entities that
treat a portion of the tax paid as a component of pretax income are effectively subject to a graduated
tax system, since the implicit tax rate (amount treated as income tax divided by taxable income) will be
lower than the enacted rate and may vary from period to period as pretax income fluctuates (although
most entities should be able to base their tax rate on an expected average level of income). Accordingly,
if the amount to be treated as a component of pretax income significantly affects an entity’s implicit tax
rate, the entity should generally apply the guidance in ASC 740-10-55-136 through 55-138 on graduated
tax rates when computing the applicable enacted tax rate. The estimated future annual income used
to determine the appropriate tax rate should be estimated taxable income including permanent items
and special deductions. As noted in ASC 740-10-25-37, the effects of future special deductions (or
other permanent differences) should also be considered, since “those special deductions are one of the
determinants of future taxable income and future taxable income determines the average graduated tax
rate” (this concept is illustrated in Example 3-3). The tax used in the determination of the appropriate
tax rate should, however, be computed before the reduction for credits.

Examples 3-7 and 3-8 illustrate the measurement of deferred taxes in a hybrid tax regime before the
adoption of ASU 2019-12. See the Changing Lanes discussion below for additional information about
ASU 2019-12 and its effect on measuring deferred taxes in a hybrid tax regime.

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Example 3-7

Measurement of Deferred Taxes in a Hybrid Tax Regime Before Adoption of ASU 2019-12
Assume the same facts as in Example 2-1, in which an entity is taxed on the basis of the greater of 25 percent
of taxable profit or 1 percent of net equity as of the last day of the prior year. Deferred taxes would be
calculated as follows (provided that the entity expects to owe taxes in future years in excess of the “floor,” so
those taxes are therefore within the scope of ASC 740 and the entity must record deferred taxes):

Deferred Tax Computation

Expected book pretax income in year 2 $ 72,000
Expected reversal of taxable temporary difference in year 2 3,000
Expected taxable income in year 2 75,000
Enacted statutory income tax rate expected to apply in year 2 25%
Expected year 2 current tax computed on income 18,750
Expected year 2 capital tax (same as year 1 because of distributions) 8,000 (800,000 × 1%)
Expected year 2 current tax within the scope of ASC 740 before
adoption of ASU 2019-12 $ 10,750

Deferred Taxes Calculated by Using Graduated Tax Method

Rate to be applied to temporary difference 14.3% (10,750 ÷ 75,000)
Deferred tax to be provided in year 1 $ 430 (3,000 × 14.3%)

In limited circumstances, it may be acceptable to use the enacted statutory tax rate to measure deferred
taxes in a hybrid tax regime. For example, in such a regime, an entity will not pay income taxes unless
its level of taxable income is high enough (i.e., exceeds a minimum threshold) to result in a tax liability
greater than the liability determined by using the non-income-based measure. If an entity expects to
have taxable income in future years that is greater than that minimum (and that is therefore subject to
an income-based tax), each incremental dollar of taxable income in those years (including reversals of
taxable temporary differences) would be taxed at the enacted statutory rate. Similarly, each incremental
dollar of loss or deduction (including reversals of deductible temporary differences) would result
in a benefit at the enacted statutory rate. In such circumstances, using the enacted statutory rate
to measure deferred taxes fully allows for the incremental effect that the reversal of the temporary
difference will have on future taxes payable. This alternative approach is premised on the facts that
(1) while variability of the ETR in a hybrid tax regime makes it analogous to a graduated-rate system, the
graduated-rate guidance is not directly applicable, and (2) ASC 740-10-10-3 states, in part:

Conceptually, a deferred tax liability or asset represents the increase or decrease in taxes payable or
refundable in future years as a result of temporary differences and carryforwards at the end of the current
year. That concept is an incremental concept. A literal application of that concept would result in measurement
of the incremental tax effect as the difference between the following two measurements:
a. The amount of taxes that will be payable or refundable in future years inclusive of reversing temporary
differences and carryforwards
b. The amount of taxes that would be payable or refundable in future years exclusive of reversing
temporary differences and carryforwards.

While the FASB ultimately decided to require that entities measure DTAs and DTLs by using enacted
rates in light of constraints associated with implementing the incremental approach, we believe that,
given the unique nature of hybrid tax regimes, application of the principle described in ASC 740-10-10-3
would be acceptable in the limited circumstances discussed above.

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Use of this method would not be acceptable, however, if the deferred tax items, in and of themselves
(e.g., existing NOL carryforwards or other similar large deductible temporary differences), would reduce
the amount of income tax payable to an amount that is less than the non-income-based tax payable (i.e.,
the “floor”), since no benefit is realized for those deductions. This type of scenario is illustrated in the
example below.

Example 3-8

Measurement of Deferred Taxes in a Hybrid Tax Regime Before Adoption of ASU 2019-12
Assume that the regular corporate tax in Country A is the greater of (1) 10 percent of taxable profit or (2) 1
percent of net equity as of the last day of the current year. Further assume that losses can be used to offset
future income but cannot be carried back.

Year 1 Year 2 Year 3

Graduated Statutory Graduated Statutory

Tax Method Tax Method Tax Method Tax Method
Capital $ 800 $ 800 $ 800 $ 800 $ 800
Pretax income (loss) 100 (100) (100) 100 100
Taxable income before
NOL carryforward 100 (100) (100) 100 100
NOL carryforward* N/A N/A N/A (100) (100)
Taxable income 100 (100) (100) — —
Statutory tax rate 10% 10% 10% 10% 10%
Total current tax computed
on income (greater of
capital or income) 10 8 8 8 8
Capital tax 8 8 8 8 8
Current tax within scope of
ASC 740 before adoption
of ASU 2019-12 2 — — — —
Deferred tax expense
(benefit) — (2) (10) 2 10
Total taxes — capital and
income $ 10 $ 6 $ (2) $ 10 $ 18

* NOLs can be only carried forward.

As depicted above, when there is $100 of pretax income in year 1, excluding the effects of special
deductions or permanent differences, one would expect a total of $10 of tax expense ($8 pretax
expense and $2 tax expense). However, when the statutory tax rate is used to measure the NOL
DTA, there is a net tax benefit of $2 ($8 pretax expense and $10 income tax benefit) in year 2 (i.e., the
year in which the NOL DTA is recognized) and a total tax expense of $18 ($8 pretax expense and $10
income tax expense) in year 3 (i.e., the year in which the NOL DTA is used), an amount higher than
the total expected tax expense of $10. When the NOL DTA is measured at the implicit graduated rate
of 2 percent, there is a $10 net expense in the year in which the NOL is used ($8 pretax expense and
$2 income tax expense), which is identical to what would be recognized in the absence of an NOL
carryforward.

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Changing Lanes
As noted in Section 2.5, to reduce the cost and complexity of applying ASC 740, ASU 2019-12
amends ASC 740-10-15-4(a) to state that if there is an amount that is based on taxable
profit, it should be included in the tax provision, with any incremental amount recorded as a
non-income-based tax. Under the ASU, the order in which an entity determines the type of tax
under U.S. GAAP is reversed.

As a result, the need to calculate the implicit tax rate when measuring deferred taxes in a hybrid
regime (illustrated in Examples 3-7 and 3-8) is eliminated. Instead an entity should measure its
deferred taxes by using the applicable statutory tax rate after adoption. For more information
about ASU 2019-12, see Appendix B.

3.3.4.10 Consideration of U.S. AMT Credit Carryforwards

740-10-30 (Q&A 22)

ASC 740-10

25-42 The following guidance refers to provisions of the Tax Reform Act of 1986; however, it shall not be
considered a definitive interpretation of the Act for any purpose.

25-43 The Tax Reform Act of 1986 established an alternative minimum tax system in the United States. Under
the Act, an entity’s federal income tax liability is the greater of the tax computed using the regular tax system
(regular tax) or the tax under the alternative minimum tax system. A credit (alternative minimum tax credit)
may be earned for tax paid on an alternative minimum tax basis that is in excess of the amount of regular
tax that would have otherwise been paid. With certain exceptions, the alternative minimum tax credit can be
carried forward indefinitely and used to reduce regular tax, but not below the alternative minimum tax for that
future year. The alternative minimum tax system shall be viewed as a separate but parallel tax system that
may generate a credit carryforward. Alternative minimum tax in excess of regular tax shall not be viewed as a
prepayment of future regular tax to the extent that it results in alternative minimum tax credits.

25-44 A deferred tax asset is recognized for alternative minimum tax credit carryforwards in accordance with
the provisions of paragraphs 740-10-30-5(d) through (e).

The 2017 Act repealed corporate alternative minimum tax (AMT) for tax years beginning after December
31, 2017. Taxpayers with AMT credit carryforwards that have not yet been used may claim a refund in
future years for those credits even though no income tax liability exists.

Connecting the Dots

On March 27, 2020, Congress enacted the CARES Act to help the nation respond to the
COVID-19 pandemic. Among other significant business tax provisions, the CARES Act amends
Section 53(e) of the 2017 Act so that beginning in 2018, all prior-year minimum tax credits are
potentially available for refund for the first taxable year of a corporation. Companies should
classify any remaining AMT credits on the balance sheet (i.e., current versus noncurrent asset)
to reflect the timing of when those credits will be used. For further information about the
CARES Act and the subsequent income tax accounting, see Deloitte’s Heads Up, “Highlights of
the CARES Act.” See also Section 3.3.4.11 below, which discusses certain considerations for
companies subject to the corporate AMT before the enactment of the CARES Act.

3.3.4.11 AMT Rate Not Applicable for Measuring DTLs

740-10-30 (Q&A 21)
It is not appropriate for an entity subject to the U.S. federal tax jurisdiction, including Blue Cross/
Blue Shield organizations or other entities subject to special deductions under the tax law, to use
the 20 percent AMT rate to measure their DTLs. ASC 740-10-30-10 states that “[i]n the U.S. federal

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tax jurisdiction, the applicable tax rate is the regular tax rate” (emphasis added) and that an entity
recognizes a DTA for AMT credit carryforwards if realization is more likely than not.

In addition, ASC 740-10-25-37 states, in part:

The tax benefit of . . . special deductions such as those that may be available for certain health benefit entities
and small life insurance entities in future years shall not be anticipated.

As stated in ASC 740-10-30-11, the failure to use the regular tax rate would result in an understatement
of deferred taxes if the AMT results from preferences but the entity has insufficient AMT credit
carryovers to reduce its effective rate on taxable temporary differences to the AMT rate. In this situation,
use of the AMT rate to measure DTAs and DTLs would anticipate the tax benefit of special deductions.

3.3.4.12 Measurement of Deferred Taxes When Entities Are Subject to BEAT

For tax years beginning after December 31, 2017, a corporation is potentially subject to tax under the
BEAT provision if the controlled group of which it is a part has sufficient gross receipts and derives a
sufficient level of “base erosion tax benefits.” Under the BEAT, a corporation must pay a base erosion
minimum tax amount (BEMTA) in addition to its regular tax liability after credits. The BEMTA is generally
equal to the excess of (1) a fixed percentage of a corporation’s modified taxable income (taxable income
determined without regard to any base erosion tax benefit related to any base erosion payment, and
without regard to a portion of its NOL deduction) over (2) its regular tax liability (reduced by certain
credits). The fixed percentage is generally 5 percent for taxable years beginning in 2018, 10 percent for
years beginning after 2018 and before 2026, and 12.5 percent for years after 2025. However, the fixed
percentage is 1 percentage point higher for banks and securities dealers (i.e., 6, 11, and 13.5 percent,
respectively).

In January 2018, the FASB staff issued a Q&A document stating that companies should measure
deferred taxes without regard to BEAT (i.e., should continue to measure deferred taxes at the regular
tax rate), with any payment of incremental BEAT reflected as a period expense. The BEAT system can
be analogized to an AMT system in place before enactment of the 2017 Act. ASC 740 notes that when
alternate tax systems like the AMT exist, deferred taxes should still be measured at the regular tax rate.
Because the BEAT provisions are designed to be an “incremental tax,” an entity can never pay less than
its statutory tax rate of 21 percent. Like AMT preference items, related-party payments made in the year
of the BEMTA are generally the BEMTA’s driving factor. The AMT system and the BEAT system were both
designed to limit the tax benefit of such “preference items.” Further, as was the case under the AMT
system, an entity may not know whether it will always be subject to the BEAT tax, and we believe that
most (if not all) taxpayers will ultimately take measures to reduce their BEMTA exposure and therefore
ultimately pay taxes at the regular rate or as close to it as possible. Accordingly, while there is no credit
under the 2017 Act such as the one that existed under the AMT regime, the similarities between the
two systems are sufficient to allow BEAT taxpayers to apply the existing AMT guidance in ASC 740 and
measure deferred taxes at the 21 percent statutory tax rate. (See ASC 740-10-30-8 through 30-12 and
ASC 740-10-55-31 through 55-33.)

3.3.5 Tax Method Changes

For U.S. federal income tax purposes, the periods in which income is taxable and expenditures are
deductible may depend on the taxpayer’s federal income tax accounting method. While entities are
required to apply their established federal income tax accounting method unless they affirmatively
change the method to be used, an entity might determine that it is using an impermissible federal
income tax accounting method and decide to change to a permissible method. Alternatively, a taxpayer
that is using a permissible federal income tax accounting method may decide to change to a different
permissible method.

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Method changes generally result in a negative or positive adjustment to taxable income during the
year in which the method change becomes effective. A negative (“favorable”) adjustment results in a
deduction recognized in the year of change. A positive (“unfavorable”) adjustment results in an increase
in taxable income that is generally recognized over four tax years.

To change its federal income tax accounting method, an entity must file a Form 3115. A method
change that requires advance written consent from the IRS before becoming effective is referred to
as a “manual” or “nonautomatic” method change. Conversely, a method change that is deemed to be
approved by the IRS when the Form 3115 is filed with the IRS is referred to as an “automatic” method
change.

3.3.5.1 Considering the Impact of Tax Method Changes

In determining the financial statement impact of a change in a federal income tax accounting method,
an entity should consider whether the change is (1) from an impermissible method to a permissible
method or (2) from a permissible method to another permissible method.

3.3.5.1.1 Impermissible to Permissible
An entity that is using an impermissible federal income tax accounting method should assess its tax
position by applying the recognition and measurement principles of ASC 740-10 to determine whether
the improper accounting method results in an uncertain tax position for which a UTB, interest, and
penalties should be recorded in the financial statements.

Changes from an impermissible to a permissible federal income tax accounting method generally result
in an unfavorable adjustment that is recognized as an increase in taxable income over four tax years.
Further, when an entity files a Form 3115 for a change from an impermissible to a permissible federal
income tax accounting method and obtains consent from the IRS (either automatic deemed consent
or express written consent), it receives “audit protection” for prior tax years, which provides relief from
interest and penalties.

A change in a U.S. federal income tax accounting method that results in an unfavorable adjustment and
does not conform to the financial accounting treatment for the related item (i.e., the new permissible
accounting method for U.S. federal income tax purposes differs from the financial reporting accounting
method) will usually result in two temporary differences:

• The difference between the new income tax basis of the underlying asset or liability and the
financial reporting carrying amount.

• A future taxable income adjustment under IRC Section 481(a), which represents the cumulative
taxable income difference between historical taxable income determined under the previous
federal income tax accounting method and historical taxable income determined under the
new federal income tax accounting method.

In substance, a positive IRC Section 481(a) adjustment results in a deferred revenue item for tax
purposes with no corresponding amount for book purposes. Therefore, the positive IRC Section 481(a)
adjustment represents a taxable temporary difference, and the related tax consequences should be
accounted for as a DTL.

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3.3.5.1.2 Permissible to Permissible
An entity that is using a permissible federal income tax accounting method generally does not have a UTB.
A change from a permissible federal income tax accounting method to another permissible federal
income tax accounting method may result in a favorable or unfavorable adjustment to cumulative
taxable income. In a manner similar to how an entity would recognize an unfavorable adjustment for
a change from an impermissible method to a permissible method, an unfavorable adjustment for a
change from a permissible method to another permissible method is generally recognized over four tax
years, resulting in two temporary differences when the new federal income tax accounting method does
not conform to the financial accounting treatment for the related item. A change in a federal income
tax accounting method that results in a favorable adjustment and does not conform to the financial
accounting treatment for the related item will generally result in one temporary difference — specifically,
the difference between the income tax basis of the underlying asset or liability and the financial
reporting carrying amount. The entire favorable IRC Section 481(a) adjustment is recognized in the tax
return in the year of change.

Example 3-9

Change From an Impermissible Federal Income Tax Accounting Method to a Permissible Method
With a Positive (Unfavorable) Adjustment
In prior years, Company A, a profitable company, accrued a liability for employee bonuses on the basis of
amounts earned under its corporate bonus plan. As of December 31, 20X3, the liability for accrued bonuses
was $400. For federal income tax purposes, A had deducted the bonuses in the year accrued. In analyzing its
tax position in accordance with ASC 740-10, A determined that for federal income tax purposes, the bonuses
did not qualify as a federal income tax deduction when accrued for financial reporting purposes. Consequently,
A recorded a $100 liability ($400 × 25% tax rate) for the UTB and accrued a $5 liability for accrued interest as
of the year ended December 31, 20X3. Company A’s policy is to classify interest related to UTBs as income
taxes payable. Further, A recognized a DTA of $100 for the accrued bonuses that is actually deductible in future
years.
In the first quarter of 20X4, A filed a Form 3115 to change from the impermissible federal income tax
accounting method for employee bonuses to the permissible method of deducting the bonus amounts when
paid. The accounting method change results in the following changes to the income tax accounts:

Impact of
Form 3115/
Current-Year
Debit (Credit) Before Change After

DTA — accrued bonus $ 100 — $ 100

UTB liability (105) $ 105* —
Current tax payable — (25)** (25)
Noncurrent DTL — IRC Section 481(a)
adjustment — (75)*** (75)
Income tax (benefit) — (5)* —
* Reversal of UTB and interest liability upon IRS consent (either automatic deemed consent or express written consent).
** Current liability for the IRC Section 481(a) adjustment that is taxable in the current year.
*** DTL for the IRC Section 481(a) taxable temporary difference that is taxable in periods beyond one year.

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Example 3-10

Change From a Permissible Federal Income Tax Accounting Method to Another Permissible Method
With a Negative (Favorable) Adjustment
For federal income tax purposes, Company B, a profitable company, uses the full inclusion method for advance
payments received for the sale of goods (i.e., for federal income tax purposes, the full amount of advance
payments is included in taxable income in the period in which they are received). For financial reporting
purposes, B defers the recognition of revenue upon receipt of the $800 of advance payments; the deferral
results in a deductible temporary difference and the recognition of a DTA of $200.

After completing a review of its federal income tax accounting methods, B files a Form 3115 to change to a
one-year deferral method for federal income tax purposes in accordance with Revenue Procedure 2004-34.
This results in a favorable IRC Section 481(a) adjustment of $800 that will be recognized on the current-year
federal income tax return. Since this item is a change from a permissible method to another permissible
method, there is no UTB. Assume that B has a current tax payable of $1,000 before the IRC Section 481(a)
adjustment. The accounting method change results in the following adjustments to the income tax accounts:

Impact of
Debit (Credit) Before Form 3115 After
DTA — advance payments $ 200 $ (200)* $ —
Current tax payable (1,000) 200** (800)
* Reversal of original DTA recorded.
** Decrease to current tax payable because of favorable IRC Section 481(a) adjustment.

3.3.5.2 When to Recognize the Impact of Tax Method Changes

In determining when to recognize the impact of a change in a federal income tax accounting method, an
entity should consider the following:

• Whether the change is (1) from an impermissible method to a permissible method or (2) from a
permissible method to another permissible method.

• Whether the change is nonautomatic (“manual”) or automatic.

A manual method change requires the affirmative written consent of the IRS after receipt of Form 3115
from the entity requesting the change. An entity will be granted an automatic method change if (1) the
requested change qualifies for automatic approval by the IRS under published guidance and (2) the
entity complies with all provisions of the automatic change request procedures.

3.3.5.2.1 Impermissible to Permissible
3.3.5.2.1.1 Manual Method Change
Generally, the reversal of UTBs, interest, and penalties as a result of a manual change in a federal
income tax accounting method from an impermissible method to a permissible method should
be recognized when audit protection is received (i.e., when the entity has filed a Form 3115 and
has received the affirmative written consent of the IRS). However, if the entity has met all of the
requirements of such method change, there may be circumstances in which the ultimate consent of the
IRS is considered perfunctory (i.e., IRS approvals for similar method change requests have always been
granted). In these circumstances, if it would be unreasonable for the IRS to withhold consent, we believe
that an entity may reflect the change in the period in which the Form 3115 is filed. Consultation with tax
and accounting advisers is encouraged in these situations.

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3.3.5.2.1.2 Automatic Method Change

If an entity meets all of the requirements for an automatic method change and complies with all
provisions of the automatic change request procedures, consent from the IRS is not required.
Accordingly, the financial statement impact should be reflected when the entity has filed a Form 3115.

3.3.5.2.2 Permissible to Permissible
3.3.5.2.2.1 Manual Method Change
Generally, the impact of a manual change in a federal income tax accounting method from one
permissible method to another permissible method should be recognized when the entity has filed a
Form 3115 and has received the affirmative written consent of the IRS. However, if consent of the IRS is
considered perfunctory, the financial statement impact of such method change may be reflected when
the entity has concluded that it is qualified and has the intent and ability to file a Form 3115 with the IRS,
but no earlier than the first interim period of the year in which the Form 3115 will be filed.

3.3.5.2.2.2 Automatic Method Change

If an entity meets all requirements for an automatic method change from one permissible method to
another permissible method, consent from the IRS is not required. Accordingly, the financial statement
impact should be reflected when the entity has concluded that it qualifies for the method change and
that it has the intent and ability to file a Form 3115.

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3.3.5.2.3 Summary
The following flowchart summarizes the timing for recognition of changes in U.S. federal income tax
accounting method:

Is current accounting
method permissible?

Yes No

(Permissible) (Impermissible)
Yes No
Is method change Has a Form 3115
automatic? been filed?

No Yes

Record impact when Assess need for UTB

taxpayer has “intent and reassess when
and ability.” Form 3115 is filed.

(Manual) Is the method change

Will IRS consent be automatic or is consent
perfunctory? perfunctory?

Yes No No Yes

Record impact when the

taxpayer has “intent and
ability” but no earlier Record impact when Record impact when
than the year in which consent is received. Form 3115 is filed.
the Form 3115 will be
filed.

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3.3.6 Foreign Operations
3.3.6.1 Foreign Subsidiaries’ Basis Differences
740-10-25 (Q&A 65)
Multinational companies often have multiple layers of financial reporting, and each layer may be
prepared by using a different basis of accounting. For example, a foreign subsidiary of a U.S.-based
multinational company may have to prepare the following sets of accounts:
1. Financial statements prepared in accordance with U.S. GAAP for inclusion in the consolidated
financial statements of the U.S. parent (U.S. GAAP financial statements).
2. Financial statements prepared in accordance with the comprehensive basis of accounting
required by the jurisdiction in which the subsidiary resides (local GAAP or statutory financial
statements).
3. Books and records prepared in accordance with the requirements of the tax authority of
the jurisdiction in which the subsidiary resides for local income tax reporting purposes (local
jurisdiction tax basis).

While it is not necessary for a foreign subsidiary to prepare statutory financial statements in order
to prepare U.S. GAAP financial statements, a foreign subsidiary that is subject to statutory reporting
requirements will often use a reconciliation approach to prepare its U.S. GAAP financial statements. That
is, the foreign subsidiary will often prepare statutory financial statements first and identify differences
between those amounts and the local jurisdiction tax basis (commonly referred to as “stat-to-tax
differences”) when determining deferred taxes to be recognized in the statutory financial statements.
The foreign subsidiary will then adjust those financial statements to reconcile or convert them to U.S.
GAAP (commonly referred to as “stat-to-GAAP differences”).

Questions often arise concerning how deferred taxes should be computed for purposes of a company’s
consolidated financial statements prepared in accordance with U.S. GAAP when both stat-to-GAAP and
stat-to-tax differences are present. Accordingly, temporary differences related to assets and liabilities
of a foreign subsidiary are computed on the basis of the difference between the reported amount in
the U.S. GAAP financial statements and the tax basis of the subsidiary’s assets and liabilities (which
inherently includes both stat-to-GAAP and stat-to-tax differences) because ASC 740-10-20 defines a
temporary difference as “[a] difference between the tax basis of an asset or liability . . . and its reported
amount in the financial statements.”

Companies that use the reconciliation approach, however, will generally develop temporary differences
for each asset and liability in two steps. Accordingly, when using the reconciliation approach, companies
must ensure that any deferred taxes on the statutory books (related to stat-to-tax differences) are not
double counted in the U.S. GAAP financial statements.

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Example 3-11

Assume the following:

• A U.S. parent consolidates FS, a foreign corporation operating in Jurisdiction Y, which has a 20 percent
income tax rate.
• FS is required to file statutory financial statements with Y and prepares these financial statements in
accordance with its local GAAP.
• FS has one asset with a basis of $4 million, $6 million, and $7 million for local income tax, statutory, and
U.S. GAAP reporting purposes, respectively.2
Corporation FS’s deferred taxes related to the single asset may be determined by comparing its U.S. GAAP basis
of $7 million with its local income tax basis of $4 million to arrive at its total DTL of $0.6 million ([$7 million –
$4 million] × 20%) for U.S. GAAP financial statement purposes.

Alternatively, if FS uses a reconciliation approach, FS’s stat-to-tax basis difference is $2 million ($6 million – $4
million), resulting in the recording of a $0.4 million ($2 million × 20%) DTL in FS’s statutory financial statements.
FS’s stat-to-GAAP adjustment (difference) is $1 million ($7 million – $6 million), resulting in an additional DTL of
$0.2 million ($1 million × 20%) for purposes of the U.S. GAAP financial statements. The total DTL reported in
the U.S. GAAP financial statements in connection with FS’s asset is $0.6 million, representing the $0.4 million
recorded in the statutory financial statements and the $0.2 million recorded as part of the stat-to-GAAP
reconciling adjustments. For presentation purposes, the $0.4 million DTL related to the stat-to-tax difference
and the $0.2 million DTL related to the stat-to-GAAP difference should be combined and presented as a single
DTL in the balance sheet and disclosures.

If the U.S. parent does not take into consideration the $0.4 million DTL already recorded in the statutory
financial statements and records an incremental $0.6 million DTL as a U.S. GAAP adjustment, it would
effectively double count the temporary difference associated with the $2 million basis difference between the
statutory and tax bases of the asset.

3.3.6.2 Revaluation Surplus
Inside basis differences within a U.S. parent’s foreign subsidiary whose local currency is the functional
currency may result from foreign laws that allow for the occasional restatement of fixed assets for tax
purposes to compensate for the effects of inflation. The amount that offsets the increase in tax basis of
fixed assets is sometimes described as a credit to revaluation surplus, which some view as a component
of equity for tax purposes. That amount becomes taxable in certain situations, such as in the event
of a liquidation of the foreign subsidiary or if the earnings associated with the revaluation surplus are
distributed. In this situation, it is assumed that no mechanisms are available under the tax law to avoid
eventual treatment of the revaluation surplus as taxable income. ASC 740-30-25-17 clarifies that the
indefinite reversal criterion should not be applied to inside basis differences of foreign subsidiaries.
Because the inside basis difference related to the revaluation surplus results in taxable amounts
in future years in accordance with the provisions of the foreign tax law, it qualifies as a temporary
difference even though it may be characterized as a component of equity for tax purposes. Therefore,
as described in ASC 830-740-25-7, a DTL must be provided on the amount of the revaluation surplus.
This view is based on ASC 740-10-25-24, which indicates that some temporary differences are deferred
taxable income and have balances only for income tax purposes. Therefore, these differences cannot be
identified with a particular asset or liability for financial reporting purposes.

2
For ease of illustration, currency differences are ignored.

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3.3.6.3 Accounting for Foreign Branch Operations

740-10-25 (Q&A 73)
A U.S. corporation generally conducts business in a foreign country by establishing either a branch or a
separate legal entity in that country. A true branch generally refers to a fixed site (e.g., an office or plant)
in which a U.S. corporation conducts its operations. However, a branch can also refer to a separate
foreign legal entity that the U.S. corporation has elected to treat as a disregarded entity under the
U.S. Treasury entity-classification income tax regulations (commonly referred to as the “check-the-box”
regulations, under which an eligible entity may elect its tax classification, or tax status, for U.S. income
tax reporting purposes).

A foreign branch is not considered a separate taxable entity for U.S. income tax reporting purposes;
rather, it is an extension of its U.S. parent. Accordingly, any income or loss generated by a foreign branch
is (1) included in the U.S. parent company’s income tax return (i.e., subject to U.S. income taxes) in the
period in which it is earned and (2) generally subject to tax in the local country. That is, foreign branches
are generally subject to double taxation (in the United States and in the local country). To mitigate the
effects of this double taxation, U.S. income tax law allows a U.S. corporation to either deduct the income
taxes incurred in the local country or claim those income taxes as an FTC in its U.S. income tax return
(i.e., the local-country taxes affect the determination of U.S. tax). The foreign branch is required to
account for income tax in its local country in accordance with ASC 740

Because a branch is subject to taxation in two different countries, it will generally have at least two
sets of temporary differences related to its activities. One set of temporary differences will reflect the
differences between the book and tax basis of the assets and liabilities of the branch as determined
under the local-country tax law (i.e., the in-country temporary differences). The other set of temporary
differences will reflect the differences between the book and tax basis of the assets and liabilities of
the branch as determined under U.S. tax law (the “U.S. temporary differences”). Further, because local-
country income taxes can be deducted when the parent computes U.S. taxable income, or credited
against taxes on the branch income when it computes U.S. income taxes payable, the in-country DTAs
and DTLs give rise to U.S. temporary differences, and U.S. DTLs and DTAs should be established to
account for the U.S. income tax effects of the future reversal of in-country DTAs and DTLs.

The accounting for U.S. temporary differences related to a foreign branch is similar to that for federal
temporary differences related to state taxes, as illustrated in the following table:

Foreign
Branch U.S. State
Files local tax return Yes Yes
Maintains local DTAs and DTLs Yes Yes
Computes U.S. federal tax consequences of reversal of local DTAs and DTLs Yes Yes

In accordance with U.S. income tax law, an entity incurring foreign income taxes may, from year to year,
elect to either claim an FTC or deduct the foreign taxes. Theoretically, FTCs are more beneficial, but
because there are restrictions on the credits’ use, the entity may choose to deduct the foreign taxes.
An entity that elects to claim an FTC but is unable to use all of it may carry forward any excess (i.e., the
excess cannot be deducted because of the election to claim credits for foreign taxes incurred that year).

In assessing the U.S. tax impact of the reversal of in-country DTAs and DTLs, an entity should estimate
whether it will claim FTCs or deductions in the year in which such in-country DTAs and DTLs reverse. If an
entity determines that it will be claiming FTCs in the year in which a net in-country DTL reverses, the entity
would record an “anticipatory” FTC DTA, subject to realizability considerations. This anticipatory FTC DTA
is unlike most tax credits, which are typically not recognized until generated on a tax return, because it

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represents the direct U.S. tax consequences of an inside “in-country” temporary difference. See Section
5.7.3 for more information about determining the need for a valuation allowance related to FTCs.

Similarly, the U.S. corporation would recognize a DTL for “forgone” FTCs associated with an in-country
DTA (i.e., the gross in-country DTA reduced by a valuation allowance) because, when the branch
generates income in future years that is offset by an in-country loss carryforward or a deductible
temporary difference (or both), that income will be taxable in the United States without corresponding
FTCs related to the income.

The examples below illustrate the deferred tax accounting related to branch temporary differences. For
simplicity, the effects of foreign currency have been disregarded.

Example 3-12

FTC Election Anticipated in the United States

Parent Co. (a U.S. parent company) establishes Branch Co. (a branch) in Country X. Parent Co. is subject to tax
in the United States at 21 percent, and Branch Co. is subject to tax in X at 15 percent. In addition, the taxes paid
by Branch Co. in X are fully creditable in the United States without limitation, and Parent Co. intends to claim
FTCs in the year in which the foreign temporary difference reverses.

There is a temporary difference related to Branch Co.’s operations in the current year, which is the same under
the tax laws in both X and the United States, as shown below:

Deductible
(Taxable)
Temporary
Description Book Basis Tax Basis Difference
PP&E $ 2,500,000 $ 1,500,000 $ (1,000,000)

Since Branch Co. is subject to tax in both the United States and X, Branch Co. computes its deferred taxes
separately for each jurisdiction. In X, Branch Co. determines that it has a DTL of $150,000, which is equal to the
temporary difference shown above multiplied by the local tax rate in X of 15 percent.

In the United States, Parent Co. determines that it has a DTL of $210,000 related to PP&E, which is equal to the
temporary difference shown above multiplied by the U.S. tax rate of 21 percent. However, because the taxes
paid in X are fully creditable in the United States when actually incurred, Parent Co. also determines that it
has an anticipatory FTC DTA equal to Branch Co.’s DTL in X ($150,000). That is, when the temporary difference
reverses, Branch Co. will pay additional taxes of $150,000 in X, but because such foreign taxes paid will be
claimed as a credit by Parent Co., Parent Co. will effectively receive a benefit equal to 100 percent of Branch
Co.’s DTL or, in other words, a dollar-for-dollar reduction of its income taxes payable. A summary of the impact
of the above on the consolidated balance sheet is as follows

Description Parent Co. Branch Co. Consolidated

Deferred taxes related to PP&E $ (210,000) $ (150,000) $ (360,000)

Anticipatory FTC DTA 150,000 — 150,000

Total deferred taxes $ (60,000) $ (150,000) $ (210,000)

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Example 3-13

Foreign Tax Deduction Anticipated in the United States

Assume the same facts as those in Example 3-12, except that Parent Co. anticipates deducting the foreign
taxes in its income tax return when the temporary difference reverses (instead of claiming them as an FTC).

In this scenario, there would be no changes to Branch Co.’s or Parent Co.’s accounting for their respective DTL
related to the PP&E. However, instead of recording an anticipatory FTC DTA for 100 percent of Branch Co.’s
DTL, Parent Co. would recognize a foreign tax deduction DTA equal to 21 percent of Branch Co.’s DTL. That
is, because Parent Co. will deduct the foreign taxes on its income tax return, it will receive a benefit equal to
only 21 percent (i.e., the statutory rate) of the deduction. The following table summarizes the impact on the
consolidated balance sheet of the above:

Description Parent Co. Branch Co. Consolidated

Deferred taxes related to PP&E $ (210,000) $ (150,000) $ (360,000)

U.S. foreign tax deduction DTA 31,500 — 31,500

Total deferred taxes $ (178,500) $ (150,000) $ (328,500)

Example 3-14

Foreign Branch Losses

Parent Co. (a U.S. parent company) establishes Branch Co. (a branch) in Country X. Parent Co. is subject to tax
in the United States at 21 percent, and Branch Co. is subject to tax in X at 15 percent. In addition, the taxes
paid by Branch Co. in X are fully creditable in the United States without limitation, and Parent Co. intends to
elect to claim FTCs in the year in which the foreign temporary difference reverses.

In 20X6, Branch Co. generated an operating loss of $1 million that is allowed to be carried forward indefinitely
under the tax law in X. Branch Co. concludes that it will be able to realize the loss carryforward against taxable
income it will generate in future years and, therefore, no valuation allowance is necessary. Parent Co. generated
taxable income of $3 million (excluding the loss generated by Branch Co.) in 20X6.

In this scenario, Branch Co. recognizes a deferred tax benefit of $150,000 by establishing a DTA for the
in-country loss carryforward ($1 million loss × the local tax rate). Further, Parent Co. would recognize a current
benefit of $210,000 ($1 million × the U.S. tax rate) because, as a result of Branch Co.’s loss, it would reduce
the amount of taxes it would otherwise owe in the United States. In the absence of any “anticipatory” FTC
or deduction accounting entries recorded by Parent Co., both Parent Co. and Branch Co. would recognize a
benefit for the loss (i.e., a double benefit); however, Parent Co. must also record a DTL for forgone FTCs equal
to the DTA recognized by Branch Co. As a result, the total benefit recognized in the consolidated financial
statements related to the Branch Co. loss in the year in which the loss occurs is equal to the current benefit
recognized by Parent Co. ($210,000), as shown below:

Description Parent Co. Branch Co. Consolidated

DTA (deferred benefit) related to Branch Co. loss $ — $ 150,000 $ 150,000
Current benefit related to Branch Co. loss 210,000 — 210,000
DTL for forgone FTCs (deferred expense) related (150,000) — (150,000)
to Branch Co. loss
Total tax benefit (expense) $ 60,000 $ 150,000 $ 210,000

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Example 3-14 (continued)

Further assume that in 20X7, Branch Co. generates $1 million of taxable income and uses its entire loss
carryforward (i.e., Branch Co. pays no income taxes in 20X7 in X). Branch Co. would reverse its DTA related to
the loss carryforward and recognize a deferred tax expense of $150,000. The income generated by Branch Co.
would also be included in Parent Co.’s income tax return in 20X7. Because no taxes are paid in X on the income,
Parent Co. cannot claim an FTC and therefore incurs a current tax expense in the United States of $210,000
as a result of an increase in the amount of taxes it would have otherwise owed in X. Parent Co. also reverses
the DTL that it had recognized related to Branch Co.’s DTA and recognizes a deferred tax benefit of $150,000.
As a result, the total expense recognized in the 20X7 consolidated financial statements related to Branch Co.
income in 20X7 is equal to the current expense recognized by Parent Co. ($210,000), as shown below:

Description Parent Co. Branch Co. Consolidated

Reduction of DTA (deferred tax expense)

related to Branch Co. loss $ — $ (150,000) $ (150,000)

Current expense related to Branch Co. income (210,000) — (210,000)

Reduction of a DTL for forgone FTCs (deferred
tax benefit) 150,000 — 150,000
Total tax benefit (expense) $ (60,000) $ (150,000) $ (210,000)

3.3.6.3.1 Measurement Complexities Attributable to Jurisdictional Rate Differences

Regardless of jurisdictional rate differences, an anticipatory FTC DTA is generally measured at the
gross amount of taxes to be paid to the foreign jurisdiction because the settlement of an in-country
taxable temporary difference will, in fact, result in an equivalent amount of FTCs in the United States.
While the jurisdictional rate difference between the U.S. and foreign rate might affect an entity’s ability
to ultimately realize a benefit for the gross amount of such FTCs, an entity would address realization
issues by using a valuation allowance (see Section 5.7.3). Questions have arisen, however, about how to
measure a DTL for forgone FTCs when the U.S. tax rate is lower than the in-country tax rate because no
similar “realization” mechanism exists with respect to DTLs.

On the basis, in part, of informal discussions with the FASB staff, we believe that there are two
acceptable approaches for measuring a DTL for forgone FTCs associated with an in-country DTA when
an entity has a single branch:

• Approach 1 — Under this approach, commonly referred to as the “mirror-image” approach,

a DTL for forgone FTCs would be measured at 100 percent of the in-country DTA(s) of the
branch if it is assumed that the U.S. corporation anticipates claiming FTCs (versus a foreign tax
deduction) in the years that the in-country DTA(s) are expected to reverse.

• Approach 2 — Under this approach, the DTL for forgone FTCs would generally be measured
at the “lesser of” the local rate or the U.S. rate.3 If the U.S. rate is lower than the foreign rate,
the DTL for forgone FTCs would generally be measured at an amount equal to the U.S. rate
multiplied by the income implied solely from recovery of the in-country temporary differences
(or attributes) under the fundamental premise in ASC 740 that all assets and liabilities are
settled at their carrying values. If the foreign rate is lower than the U.S. rate, a measurement
consistent with that in Approach 1 will generally be used. By measuring the DTL for forgone FTCs
in this fashion, an entity acknowledges that the actual forgone FTC should not exceed the U.S.
rate (i.e., the entity generally would not have been able to use the excess FTCs, had they been

3
If the local country DTA has a full valuation allowance associated with it, however, no DTL for a forgone FTC would be recorded.

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available, because the FTC can only be used to reduce tax on branch income and cannot be
used to reduce tax on other income in the tax return).

In situations in which an entity has multiple branches with rates both in excess of and below the U.S.
rate, additional complexities associated with applying Approach 2 may arise because foreign taxes paid
in one branch can be used to reduce U.S. taxes paid on income in another branch. As a result, the
actual forgone FTC from a branch with a foreign rate that is higher than the U.S. rate could exceed the
U.S. tax rate if the entity could have otherwise used the forgone FTCs to reduce U.S. tax paid on income
in a branch with a foreign rate lower than the U.S. rate. We believe that in these situations, the entity
should generally apply Approach 2 by determining the forgone FTC on an aggregate basis. Such an
amount would typically be calculated as noted above (i.e., the income implied solely from recovery of the
in-country temporary differences or attributes). We believe that an acceptable alternative view, however,
would be for the entity to include all future income in determining the “expected rate to be applied” to
the DTL for forgone FTCs. Including all future income arguably results in a measurement of the DTL for
forgone FTCs at the amount that represents the entity’s true economic cost of recovering the in-country
DTAs of the branches. Accordingly, we believe that application of either approach would be acceptable.
Regardless of the method used, however, the DTL for forgone FTCs should not result in a larger DTL
than the amount determined on the basis of 100 percent of the in-country DTA(s) (Approach 1).4

Example 3-14A

Foreign Branch DTL for Forgone FTCs — Higher In-Country Tax Rate
Parent Co. (a U.S. parent company) establishes Branch Co1 (a branch) in Country X and Branch Co2 (another
branch) in Country Y. Parent Co. is subject to tax in the United States at 21 percent, Branch Co1 is subject to tax
in X at 40 percent, and Branch Co2 is subject to tax in Y at 5 percent.

Assume the following:

• Branch Co1’s and Branch Co2’s temporary differences are as follows:

Deductible
In-Country Tax Temporary
Inside Asset Book Basis Basis Difference DTA/(DTL)
Branch Co1 $ — $ 100,000 $ 100,000 $ 40,000

Branch Co2 $ — $ 100,000 $ 100,000 $ 5,000

• Branch Co1 and Branch Co2 conclude that they will be able to realize the DTAs and, therefore, no
valuation allowance is necessary.
• The in-country temporary differences are forecasted to reverse in the same year and the operations of
Branch Co1 and Branch Co2 are expected to generate pretax book income (exclusive of a reversal of
temporary differences) of $200,000 and $10 million, respectively.
• Parent Co. does not have a U.S. tax basis in the underlying assets giving rise to the above in-country
DTAs (therefore, there is no U.S. DTA to record on Parent Co.’s books).

4
In scenarios in which all of the in-country tax rates of the branches are lower than the U.S. tax rate, the measurement of the DTL for a forgone FTC
should be the same under all three approaches (i.e., 100 percent of the in-country DTA).

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Example 3-14A (continued)

Approach 1 — Mirror Image

Under the mirror image approach, Parent Co. would recognize a DTL for forgone FTCs of $45,000 (equal to 100
percent of the $45,000 in-country DTAs).

U.S. DTL for a

Inside Asset In-Country DTA Forgone FTC
Branch Co1 $ 40,000 $ (40,000)

Branch Co2 5,000 (5,000)

Total $ 45,000 $ (45,000) [c]

Approach 2 — Lesser of Local Tax Rate or U.S. Tax Rate

U.S. Tax Effects if Implied Income From In-Country Temporary Differences (or Attributes) Is Taken Into
Account
If Parent Co.’s policy is to measure the forgone FTCs resulting from its foreign branches’ in-country DTAs by
taking into account implied income from in-country temporary differences (or attributes), Parent Co. would
recognize a DTL of $42,000 because $42,000 is the amount of the forgone FTCs (assuming that this number
reflects only the amount of book income required for recovering the in-country deductible temporary
differences). Under this approach, the DTL for a forgone FTC should never be more than the mirror image DTL
of $45,000. Measurement of the DTL for forgone FTCs is calculated as follows:

Foreign Tax With Local Tax Basis Foreign Tax Without Local Tax Basis

Branch Branch Branch Branch

Co1 Co2 Total Co1 Co2 Total
Pretax book income $ 100,000 $ 100,000 $ — $ 100,000 $ 100,000 $ —
Reversal of temporary (100,000) (100,000) — — — —
difference
Taxable income — — — 100,000 100,000 200,000
Tax rate 40% 5% — 40% 5% —
Foreign taxes paid $ — $ — $ — $ 40,000 $ 5,000 $ 45,000

U.S. Tax With U.S. Tax Without

Local Tax Basis Local Tax Basis
Taxable income $ 200,000 $ 200,000
U.S. tax rate 21% 21%
U.S. tax liability before FTCs 42,000 42,000
FTCs — (42,000)*
U.S. tax liability after FTCs $ 42,000 [a] $ — [b]
DTL for forgone FTCs = $42,000
([a] – [b]) ≤ [c]
* Branch Co1 and Branch Co2 have paid $45,000 in foreign taxes; however, the forgone FTC (and,
likewise, the DTL for forgone FTCs) would be limited to $42,000.

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Example 3-14A (continued)

U.S. Tax Effects if Forecasted Income Is Taken Into Account

If Parent Co.’s policy is to measure the forgone FTCs resulting from its foreign branches’ in-country DTAs
by taking into account forecasted income, Parent Co. would recognize a DTL of $45,000, which is the same
amount for the DTL for forgone FTCs as the mirror-image approach; however, that may not always be the case.
Measurement of the DTL for forgone FTCs is calculated as follows:

Foreign Tax With Local Tax Basis Foreign Tax Without Local Tax Basis

Branch Branch Branch Branch

Co1 Co2 Total Co1 Co2 Total
Pretax book income $ 200,000 $ 10,000,000 $ — $ 200,000 $ 10,000,000 $ —
Reversal of temporary
difference (100,000) (100,000) — — — —
Taxable income 100,000 9,900,000 10,000,000 200,000 10,000,000 10,200,000
Tax rate 40% 5% — 40% 5% —
Foreign taxes paid $ 40,000 $ 495,000 $ 535,000 $ 80,000 $ 500,000 $ 580,000

U.S. Tax With U.S. Tax Without

Local Tax Basis Local Tax Basis
Taxable income $ 10,200,000 $ 10,200,000
U.S. tax rate 21% 21%
U.S. tax liability before FTCs 2,142,000 2,142,000
FTCs (535,000) (580,000)
U.S. tax liability after FTCs $ 1,607,000 [a] $ 1,562,000 [b]
DTL for forgone FTCs = $45,000
([a] – [b]) ≤ [c]

3.4 Outside Basis Differences

ASC 740-10

25-1 This Section establishes the recognition requirements necessary to implement the objectives of
accounting for income taxes identified in Section 740-10-10. The following paragraph sets forth the basic
recognition requirements while paragraph 740-10-25-3 identifies specific, limited exceptions to the basic
requirements.

25-2 Other than the exceptions identified in the following paragraph, the following basic requirements are
applied in accounting for income taxes at the date of the financial statements:
a. A tax liability or asset shall be recognized based on the provisions of this Subtopic applicable to tax
positions, in paragraphs 740-10-25-5 through 25-17, for the estimated taxes payable or refundable on
tax returns for the current and prior years.
b. A deferred tax liability or asset shall be recognized for the estimated future tax effects attributable to
temporary differences and carryforwards.

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ASC 740-10 (continued)

25-3 The only exceptions in applying those basic requirements are:

a. Certain exceptions to the requirements for recognition of deferred taxes whereby a deferred tax liability
is not recognized for the following types of temporary differences unless it becomes apparent that those
temporary differences will reverse in the foreseeable future:
1. An excess of the amount for financial reporting over the tax basis of an investment in a foreign
subsidiary or a foreign corporate joint venture that is essentially permanent in duration. See
paragraphs 740-30-25-18 through 25-19 for the specific requirements related to this exception.
2. Undistributed earnings of a domestic subsidiary or a domestic corporate joint venture that is
essentially permanent in duration that arose in fiscal years beginning on or before December 15,
1992. A last-in, first-out (LIFO) pattern determines whether reversals pertain to differences that arose
in fiscal years beginning on or before December 15, 1992. See paragraphs 740-30-25-18 through
25-19 for the specific requirements related to this exception.
3. Bad debt reserves for tax purposes of U.S. savings and loan associations (and other qualified thrift
lenders) that arose in tax years beginning before December 31, 1987. See paragraphs 942-740-25-1
through 25-3 for the specific requirements related to this exception.
4. Policyholders’ surplus of stock life insurance entities that arose in fiscal years beginning on or before
December 15, 1992. See paragraph 944-740-25-2 for the specific requirements related to this
exception.
b. Subparagraph superseded by Accounting Standards Update No. 2017-15
c. The pattern of recognition of after-tax income for leveraged leases or the allocation of the purchase
price in a purchase business combination to acquired leveraged leases as required by Subtopic 840-30
d. A prohibition on recognition of a deferred tax liability related to goodwill (or the portion thereof) for
which amortization is not deductible for tax purposes (see paragraph 805-740-25-3).
e. A prohibition on recognition of a deferred tax asset for the difference between the tax basis of inventory
in the buyer’s tax jurisdiction and the carrying value as reported in the consolidated financial statements
as a result of an intra-entity transfer of inventory from one tax-paying component to another tax-paying
component of the same consolidated group. Income taxes paid on intra-entity profits on inventory
remaining within the consolidated group are accounted for under the requirements of Subtopic 810-10.
f. A prohibition on recognition of a deferred tax liability or asset for differences related to assets and
liabilities that, under Subtopic 830-10, are remeasured from the local currency into the functional
currency using historical exchange rates and that result from changes in exchange rates or indexing for
tax purposes. See Subtopic 830-740 for guidance on foreign currency related income taxes matters.

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ASC 740-10 (continued)

Pending Content (Transition Guidance: ASC 842-10-65-1)

25-3 The only exceptions in applying those basic requirements are:

a. Certain exceptions to the requirements for recognition of deferred taxes whereby a deferred
tax liability is not recognized for the following types of temporary differences unless it becomes
apparent that those temporary differences will reverse in the foreseeable future:
1. An excess of the amount for financial reporting over the tax basis of an investment in a foreign
subsidiary or a foreign corporate joint venture that is essentially permanent in duration. See
paragraphs 740-30-25-18 through 25-19 for the specific requirements related to this exception.
2. Undistributed earnings of a domestic subsidiary or a domestic corporate joint venture that is
essentially permanent in duration that arose in fiscal years beginning on or before December
15, 1992. A last-in, first-out (LIFO) pattern determines whether reversals pertain to differences
that arose in fiscal years beginning on or before December 15, 1992. See paragraphs 740-30-
25-18 through 25-19 for the specific requirements related to this exception.
3. Bad debt reserves for tax purposes of U.S. savings and loan associations (and other qualified
thrift lenders) that arose in tax years beginning before December 31, 1987. See paragraphs
942-740-25-1 through 25-3 for the specific requirements related to this exception.
4. Policyholders’ surplus of stock life insurance entities that arose in fiscal years beginning on or
before December 15, 1992. See paragraph 944-740-25-2 for the specific requirements related
to this exception.
b. Subparagraph superseded by Accounting Standards Update No. 2017-15
c. The pattern of recognition of after-tax income for leveraged leases or the allocation of the purchase
price in a purchase business combination to acquired leveraged leases as required by Subtopic
842-50
d. A prohibition on recognition of a deferred tax liability related to goodwill (or the portion thereof) for
which amortization is not deductible for tax purposes (see paragraph 805-740-25-3).
e. A prohibition on recognition of a deferred tax asset for the difference between the tax basis of
inventory in the buyer’s tax jurisdiction and the carrying value as reported in the consolidated
financial statements as a result of an intra-entity transfer of inventory from one tax-paying
component to another tax-paying component of the same consolidated group. Income taxes paid
on intra-entity profits on inventory remaining within the consolidated group are accounted for
under the requirements of Subtopic 810-10.
f. A prohibition on recognition of a deferred tax liability or asset for differences related to assets and
liabilities that, under Subtopic 830-10, are remeasured from the local currency into the functional
currency using historical exchange rates and that result from changes in exchange rates or
indexing for tax purposes. See Subtopic 830-740 for guidance on foreign currency related income
taxes matters.

ASC 740-30

25-1 This Section provides guidance on the accounting for specific temporary differences related to
investments in subsidiaries and corporate joint ventures, including differences arising from undistributed
earnings. In certain situations, these temporary differences may be accounted for differently from the
accounting that otherwise requires comprehensive recognition of deferred income taxes for temporary
differences.

25-2 Including undistributed earnings of a subsidiary (which would include the undistributed earnings of
a domestic international sales corporation eligible for tax deferral) in the pretax accounting income of a
parent entity either through consolidation or accounting for the investment by the equity method results in a
temporary difference.

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ASC 740-30 (continued)

25-3 It shall be presumed that all undistributed earnings of a subsidiary will be transferred to the parent entity.
Accordingly, the undistributed earnings of a subsidiary included in consolidated income shall be accounted
for as a temporary difference unless the tax law provides a means by which the investment in a domestic
subsidiary can be recovered tax free.

25-4 The principles applicable to undistributed earnings of subsidiaries in this Section also apply to tax effects
of differences between taxable income and pretax accounting income attributable to earnings of corporate
joint ventures that are essentially permanent in duration and are accounted for by the equity method. Certain
corporate joint ventures have a life limited by the nature of the venture, project, or other business activity.
Therefore, a reasonable assumption is that a part or all of the undistributed earnings of the venture will be
transferred to the investor in a taxable distribution. Deferred taxes shall be recorded, in accordance with the
requirements of Subtopic 740-10 at the time the earnings (or losses) are included in the investor’s income.

25-5 A deferred tax liability shall be recognized for both of the following types of taxable temporary differences:
a. An excess of the amount for financial reporting over the tax basis of an investment in a domestic
subsidiary that arises in fiscal years beginning after December 15, 1992.
b. An excess of the amount for financial reporting over the tax basis of an investment in a 50-percent-or-
less-owned investee except as provided in paragraph 740-30-25-18 for a corporate joint venture that is
essentially permanent in duration.
Paragraphs 740-30-25-9 and 740-30-25-18 identify exceptions to the accounting that otherwise requires
comprehensive recognition of deferred income taxes for temporary differences arising from investments in
subsidiaries and corporate joint ventures.

25-6 Paragraph 740-30-25-18 provides that a deferred tax liability is not recognized for either of the following:
a. An excess of the amount for financial reporting over the tax basis of an investment in a foreign
subsidiary that meets the criteria in paragraph 740-30-25-17.
b. Undistributed earnings of a domestic subsidiary that arose in fiscal years beginning on or before
December 15, 1992, and that meet the criteria in paragraph 740-30-25-17. The criteria in that paragraph
do not apply to undistributed earnings of domestic subsidiaries that arise in fiscal years beginning
after December 15, 1992, and as required by the preceding paragraph, a deferred tax liability shall be
recognized if the undistributed earnings are a taxable temporary difference.

Determining Whether a Temporary Difference Is a Taxable Temporary Difference

25-7 Whether an excess of the amount for financial reporting over the tax basis of an investment in a more-
than-50-percent-owned domestic subsidiary is a taxable temporary difference shall be assessed. It is not a
taxable temporary difference if the tax law provides a means by which the reported amount of that investment
can be recovered tax-free and the entity expects that it will ultimately use that means. For example, tax law may
provide that:
a. An entity may elect to determine taxable gain or loss on the liquidation of an 80-percent-or-more-owned
subsidiary by reference to the tax basis of the subsidiary’s net assets rather than by reference to the
parent entity’s tax basis for the stock of that subsidiary.
b. An entity may execute a statutory merger whereby a subsidiary is merged into the parent entity, the
noncontrolling shareholders receive stock of the parent, the subsidiary’s stock is cancelled, and no
taxable gain or loss results if the continuity of ownership, continuity of business entity, and certain other
requirements of the tax law are met.

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ASC 740-30 (continued)

25-8 Some elections for tax purposes are available only if the parent owns a specified percentage of the
subsidiary’s stock. The parent sometimes may own less than that specified percentage, and the price per share
to acquire a noncontrolling interest may significantly exceed the per-share equivalent of the amount reported
as noncontrolling interest in the consolidated financial statements. In those circumstances, the excess of the
amount for financial reporting over the tax basis of the parent’s investment in the subsidiary is not a taxable
temporary difference if settlement of the noncontrolling interest is expected to occur at the point in time when
settlement would not result in a significant cost. That could occur, for example, toward the end of the life of the
subsidiary, after it has recovered and settled most of its assets and liabilities, respectively. The fair value of the
noncontrolling interest ordinarily will approximately equal its percentage of the subsidiary’s net assets if those
net assets consist primarily of cash.

Recognition of Deferred Tax Assets

25-9 A deferred tax asset shall be recognized for an excess of the tax basis over the amount for financial
reporting of an investment in a subsidiary or corporate joint venture that is essentially permanent in duration
only if it is apparent that the temporary difference will reverse in the foreseeable future.

25-10 For example, if an entity decides to sell a subsidiary that meets the requirements of paragraphs 205-20-
45-1A through 45-1D for measurement and display as a discontinued operation and the parent entity’s tax
basis in the stock of the subsidiary (outside tax basis) exceeds the financial reporting amount of the investment
in the subsidiary, the decision to sell the subsidiary makes it apparent that the deductible temporary difference
will reverse in the foreseeable future. Assuming in this example that it is more likely than not that the deferred
tax asset will be realized, the tax benefit for the excess of outside tax basis over financial reporting basis shall
be recognized when it is apparent that the temporary difference will reverse in the foreseeable future. The
same criterion shall apply for the recognition of a deferred tax liability related to an excess of financial reporting
basis over outside tax basis of an investment in a subsidiary that was previously not recognized under the
provisions of paragraph 740-30-25-18.

25-11 The need for a valuation allowance for the deferred tax asset referred to in paragraph 740-30-25-9 and
other related deferred tax assets, such as a deferred tax asset for foreign tax credit carryforwards, shall be
assessed.

25-12 Paragraph 740-10-30-18 identifies four sources of taxable income to be considered in determining the
need for and amount of a valuation allowance for those and other deferred tax assets. One source is future
reversals of temporary differences.

25-13 Future distributions of future earnings of a subsidiary or corporate joint venture, however, shall not be
considered except to the extent that a deferred tax liability has been recognized for existing undistributed
earnings or earnings have been remitted in the past.

25-14 A tax benefit shall not be recognized, however, for tax deductions or favorable tax rates attributable to
future dividends of undistributed earnings for which a deferred tax liability has not been recognized under the
requirements of paragraph 740-30-25-18.

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ASC 740-30 (continued)

Ownership Changes in Investments

25-15 An investment in common stock of a subsidiary may change so that it is no longer a subsidiary because
the parent entity sells a portion of the investment, the subsidiary sells additional stock, or other transactions
affect the investment. If the remaining investment in common stock shall be accounted for by the equity
method, the investor shall recognize income taxes on its share of current earnings of the investee entity in
accordance with the provisions of Subtopic 740-10. If a parent entity did not recognize income taxes on its
equity in undistributed earnings of a subsidiary for the reasons cited in paragraph 740-30-25-17 (and the
entity in which the investment is held ceases to be a subsidiary), it shall accrue as a current period expense
income taxes on undistributed earnings in the period that it becomes apparent that any of those undistributed
earnings (prior to the change in status) will be remitted. The change in the status of an investment would not
by itself mean that remittance of these undistributed earnings shall be considered apparent. If a parent entity
recognizes a deferred tax liability for the temporary difference arising from its equity in undistributed earnings
of a subsidiary and subsequently reduces its investment in the subsidiary through a taxable sale or other
transaction, the amount of the temporary difference and the related deferred tax liability will change.

Pending Content (Transition Guidance: ASC 740-10-65-8)

25-15 An investment in common stock of a subsidiary may change so that it is no longer a subsidiary
because the parent entity sells a portion of the investment, the subsidiary sells additional stock, or other
transactions affect the investment. If a parent entity did not recognize income taxes on its equity in
undistributed earnings of a subsidiary for the reasons cited in paragraph 740-30-25-17 (and the entity in
which the investment is held ceases to be a subsidiary), it shall accrue in the current period income taxes
on the temporary difference related to its remaining investment in common stock in accordance with the
guidance in Subtopic 740-10.

25-16 An investment in common stock of an investee (other than a subsidiary or corporate joint venture) may
change so that the investee becomes a subsidiary because the investor acquires additional common stock, the
investee acquires or retires common stock, or other transactions affect the investment. A temporary difference
for the investor’s share of the undistributed earnings of the investee prior to the date it becomes a subsidiary
shall continue to be treated as a temporary difference for which a deferred tax liability shall continue to be
recognized to the extent that dividends from the subsidiary do not exceed the parent entity’s share of the
subsidiary’s earnings subsequent to the date it became a subsidiary.

Pending Content (Transition Guidance: ASC 740-10-65-8)

25-16 Paragraph superseded by Accounting Standards Update No. 2019-12.

An outside basis difference is the difference between the carrying amount of an entity’s investment (e.g.,
an investment in a consolidated subsidiary) for financial reporting purposes and the underlying tax basis
in that investment (e.g., the tax basis in the subsidiary’s stock). From a consolidated financial reporting
perspective, an entity’s financial reporting carrying amount in a consolidated subsidiary is eliminated;
however, book-to-tax differences in this amount may still result in the need to record deferred taxes.

How an investor should apply the guidance in ASC 740-30 on temporary differences related to
investments depends on the type of investment and whether the financial reporting carrying value
exceeds the tax basis or vice versa.

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The following table summarizes the types of investments and the relevant guidance:

Investment DTA Considerations DTL Considerations

• Domestic subsidiary Under ASC 740-30-25-9, a DTA is Under ASC 740-30-25-5, recognition of a DTL
• Domestic corporate recognized for the “excess of the tax
basis over the amount for financial
depends on when the excess of the financial
reporting basis over the tax basis of the
joint venture
that is essentially reporting . . . only if it is apparent investment arose:
permanent in that the temporary difference will
nature reverse in the foreseeable future.” • If the outside basis difference arose
in fiscal years beginning on or before
December 15, 1992, no DTL should be
recorded unless the temporary difference
will reverse in the foreseeable future.
• If the entity is a more-than-50-percent-
owned subsidiary and the outside basis
difference arose in fiscal years beginning
after December 15, 1992, a DTL is
recorded under ASC 740-30-25-7 unless
the investment can be recovered in a tax-
free manner without significant cost and
the entity expects to use this means of
recovery.

• Foreign subsidiary Under ASC 740-30-25-9, a DTA is Under ASC 740-30-25-18, a DTL should not
• Foreign corporate recognized for the “excess of the tax
basis over the amount for financial
be recognized on the excess of the financial
reporting basis over the tax basis of an
joint venture
that is essentially reporting . . . only if it is apparent investment unless it becomes apparent that
permanent in that the temporary difference will the temporary difference will reverse in the
nature reverse in the foreseeable future.” foreseeable future (i.e., the indefinite reversal
criteria are not met).5

Equity method investee A DTA is recognized for the excess A DTL is recorded on the excess of the
(generally, ownership of the tax basis of the investment financial reporting basis over the tax basis of
of less than 50 percent over the amount for financial the investment.
but more than 20 reporting and must be assessed for
percent) that is not a realizability (in most jurisdictions, the
corporate joint venture loss would be capital in character).

Cost method investee6 Generally, a DTA is recognized for Generally, a DTL is recorded on the excess of
the excess of the tax basis of the the financial reporting basis over the tax basis
investment over the amount for of the investment (if applicable).
financial reporting (if applicable) and
must be assessed for realizability (in
most jurisdictions, the loss would be
capital in character).

Deferred taxes are always recorded on taxable and deductible temporary differences unless a specific
exception applies.

5
There may be situations in which the reversal of the excess of financial reporting over tax basis is apparent because of future global intangible
low-taxed income (GILTI) inclusions (e.g., excess of financial reporting over tax basis inside the controlled foreign corporation (CFC); see Section
3.4.10.
6
With certain exceptions, ASU 2016-01 eliminated the cost method. Exceptions include (1) qualified affordable housing projects that are not eligible
for the equity method and elect not to use the proportional amortization method and (2) investments in Federal Home Loan Bank and Federal
Reserve Bank stock issued to member financial institutions.

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3.4.1 Definition of Foreign and Domestic Investments

740-10-25 (Q&A 12)
ASC 740-10-25-3(a)(1) contains an exception to the requirement to provide a DTL for the “excess of
the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a
foreign corporate joint venture” (emphasis added), while ASC 740-30-25-7 contains an exception to the
requirement to provide a DTL for the “excess of the amount for financial reporting over the tax basis of
an investment in a more-than-50-percent-owned domestic subsidiary” (emphasis added). Accordingly, it
is important to determine whether an entity is a foreign or domestic entity.

An entity should determine whether an investment is foreign or domestic on the basis of the
relationship of the investee to the tax jurisdiction of its immediate parent rather than the relationship of
the investee to the ultimate parent of the consolidated group. This determination should be made from
the “bottom up” through successive tiers of consolidation. At each level, it is necessary to determine
whether the subsidiaries being consolidated are foreign or domestic with respect to the consolidating
entity. A subsidiary that is treated as a domestic subsidiary under the applicable tax law of its immediate
parent would be considered a domestic subsidiary under ASC 740. Examples 3-15 through 3-19 below
illustrate this concept.

Example 3-15

A U.S. parent entity, P, has a majority-owned domestic subsidiary, S1, which has two investments: (1) a majority
ownership interest in a foreign entity, FS1, and (2) an ownership interest in a foreign corporate joint venture,
FCJV1. In preparing its consolidated financial statements, S1 consolidates FS1 and applies the equity method of
accounting to its investment in FCJV1. Under ASC 740, S1 would consider its investments in FS1 and FCJV1 to
be in a foreign subsidiary and foreign corporate joint venture, respectively. Parent P would treat S1 as a
domestic subsidiary when consolidating S1.

Example 3-16

A U.S. parent entity, P, has a majority ownership interest in a subsidiary (chartered in a foreign country), FS,
which has two investments: (1) a majority ownership interest in another entity, S1, and (2) an ownership
interest in another corporate joint venture entity, S2. Both S1 and S2 are located in the same foreign country
in which FS is chartered. When preparing the consolidated financial statements, FS would consider S1 and S2
a domestic subsidiary and domestic corporate joint venture, respectively, in determining whether to
recognize deferred taxes in the foreign country on the outside basis difference of FS’s investments in S1 and
S2. Parent P would consider FS a foreign subsidiary.

Example 3-17

A foreign parent entity, FP, prepares U.S. GAAP financial statements and has two investments: (1) a majority-
owned investment in a U.S. entity, US1, and (2) an investment in a corporate joint venture located in the United
States, JVUS1. In preparing its consolidated financial statements, FP would consider US1 and JVUS1 a foreign
subsidiary and a foreign corporate joint venture, respectively.

Example 3-18

A foreign entity, FP2, prepares U.S. GAAP financial statements and has two investments: (1) a majority-owned
investment in another entity, S1, and (2) an investment in a corporate joint venture, JV1. Both S1 and JV1
are located in the same foreign country in which FP2 is chartered. In preparing its consolidated financial
statements, FP2 would consider S1 and JV1 a domestic subsidiary and a domestic corporate joint
venture, respectively.

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Example 3-19

A U.S. parent entity, P, has a majority ownership interest in a subsidiary (chartered in a foreign country), FS, that
has two investments: (1) a majority ownership interest in another entity, S1, located in the same foreign country
in which FS is chartered, and (2) an investment in a corporate joint venture located in the United States, JVUS1.
Before being consolidated by P, FS would treat S1 as a domestic subsidiary and would apply the equity
method of accounting to JVUS1, as a foreign corporate joint venture to determine whether to recognize
deferred taxes on the outside basis difference of its investments in S1 and JVUS1.

3.4.1.1 Definition of Subsidiary and Corporate Joint Venture

740-10-25 (Q&A 11)
An entity should use the following guidance to determine whether an investment is in either a subsidiary
or a corporate joint venture:

ASC 810-10-20 defines a subsidiary as follows:

An entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as
its parent, holds a controlling financial interest. (Also, a variable interest entity that is consolidated by a primary
beneficiary.)

However, ASC 740-10-20 does not specifically define the term “subsidiary” and does not refer to the
definition in ASC 810-10. Rather, in practice, the definition of subsidiary in APB Opinion 18 (codified
in ASC 323) has been applied. APB Opinion 18 states that subsidiary refers to “a corporation which is
controlled, directly or indirectly, by another corporation. The usual condition for control is ownership
of a majority (over 50%) of the outstanding voting stock.” Accordingly, while the definition in ASC 810
includes partnerships and trusts, those entities are not considered subsidiaries under ASC 740 because
the earnings of such entities generally pass directly through to their owners. See Section 3.4.15 for
further discussion of pass-through entities.

The term corporate joint venture is defined in ASC 740-10-20 as follows:

A corporation owned and operated by a small group of entities (the joint venturers) as a separate and specific
business or project for the mutual benefit of the members of the group. A government may also be a member
of the group. The purpose of a corporate joint venture frequently is to share risks and rewards in developing a
new market, product or technology; to combine complementary technological knowledge; or to pool resources
in developing production or other facilities. A corporate joint venture also usually provides an arrangement
under which each joint venturer may participate, directly or indirectly, in the overall management of the joint
venture. Joint venturers thus have an interest or relationship other than as passive investors. An entity that is
a subsidiary of one of the joint venturers is not a corporate joint venture. The ownership of a corporate joint
venture seldom changes, and its stock is usually not traded publicly. A noncontrolling interest held by public
ownership, however, does not preclude a corporation from being a corporate joint venture.

3.4.1.2 Potential DTA: Foreign and Domestic Subsidiaries and Corporate Joint

Ventures
ASC 740-30-25-9 states:

A deferred tax asset shall be recognized for an excess of the tax basis over the amount for financial reporting
of an investment in a subsidiary or corporate joint venture [foreign or domestic] that is essentially permanent in
duration only if it is apparent that the temporary difference will reverse in the foreseeable future.

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As used in ASC 740-30-25-9, the term “foreseeable future” refers to an entity’s ability to reasonably
anticipate the reversal of the outside basis difference. Further, we believe that in this context, “reverse”
is intended to mean “be realized” (i.e., be taken as a deduction on the parent’s income tax return).
Since a deductible outside basis difference in a subsidiary generally results in a deduction on the
parent’s income tax return only upon sale or taxable liquidation of the subsidiary, under ASC 740-30-
25-9, a DTA would rarely be recognized before the criteria in ASC 360-10-45-9 through 45-11 are
met for classification of assets as held for sale. While future earnings of the subsidiary may reduce
the deductible outside basis temporary difference, those future earnings do not result in a reversal
of the temporary difference, as the term “reverse” is used in ASC 740-30-25-9. In other words, future
earnings of the subsidiary do not result in a temporary difference deduction on the parent’s income tax
return. Therefore, anticipated future earnings of the subsidiary should not be relied upon to support a
conclusion that “the temporary difference will reverse in the foreseeable future” and that a DTA can be
recorded under ASC 740-30-25-9.

At the point at which the criteria in ASC 360-10-45-9 through 45-11 for a measurement date have
been satisfied, the deferred tax consequences of the deductible outside basis difference should be
recognized as a DTA. In accordance with ASC 740-10-30-18, realization of the related DTA “depends on
the existence of sufficient taxable income of the appropriate character (for example, ordinary income or
capital gain) within the carryback, carryforward period available under the tax law.” If it is not more likely
than not that all or a portion of the DTA will be realized, a valuation allowance is necessary.

ASC 740-30-25-9 through 25-13 apply to more-than-50-percent-owned subsidiaries (foreign or

domestic) but do not apply to 50-percent-or-less-owned foreign or domestic investees. However, an
entity will need to use judgment to determine whether a recognition exception applies to a subsidiary
that is consolidated by applying the variable interest entity (VIE) guidance when less than 50 percent of
the voting interest is owned by the investor. See Section 3.4.17.1 for consideration of the VIE model in
ASC 810-10 in the evaluation of whether to recognize a DTL.

3.4.1.3 Potential DTL: Domestic Subsidiary

ASC 740-30-25-7 applies to investments in a more-than-50-percent-owned domestic subsidiary and
assumes that the subsidiary would be consolidated under ASC 810 (see Section 3.4.1.1). ASC 740-30-
25-7 does not allow for the application of the indefinite reversal exception to the recognition of DTLs
for undistributed earnings of a domestic subsidiary or corporate joint venture generated in fiscal years
beginning on or after December 15, 1992. Therefore, under ASC 740-30-25-3, DTLs must be recognized
“unless the tax law provides a means by which the investment in a domestic subsidiary can be recovered
tax free” and the entity expects that it will ultimately use that means. The holder of the investment
must meet both criteria to avoid recording the DTL.

While ASC 740-30-25-7 states that it applies only to more-than-50-percent-owned domestic subsidiaries,
an entity will need to use judgment to determine whether a recognition exception applies to a subsidiary
that is consolidated under the VIE guidance when less than 50 percent of the voting interest is owned
by the investor. See Section 3.4.17.1 for considerations related to the VIE model in ASC 810-10 in the
evaluation of whether to recognize a DTL.

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3.4.2 Tax Consequences of a Change in Intent Regarding Remittance of

Pre-1993 Undistributed Earnings
740-10-25 (Q&A 18)
It is possible for an entity to change its intent regarding remittance of the portion of unremitted earnings
that was generated for fiscal years beginning on or before December 15, 1992, for domestic subsidiaries
and domestic corporate joint ventures that were previously deemed indefinitely invested.

An entity should apply the guidance in ASC 740-30-25-17 and ASC 740-30-25-19 to tax consequences
of a change in intent regarding unremitted earnings that arose in fiscal years beginning on or before
December 15, 1992. This guidance states, in part:

25-17 The presumption in paragraph 740-30-25-3 that all undistributed earnings will be transferred to the
parent entity may be overcome, and no income taxes shall be accrued by the parent entity . . . if sufficient
evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the
earnings will be remitted in a tax-free liquidation. . . .

25-19 If circumstances change and it becomes apparent that some or all of the undistributed earnings of a
subsidiary will be remitted in the foreseeable future but income taxes have not been recognized by the parent
entity, it shall accrue as an expense of the current period income taxes attributable to that remittance. If it
becomes apparent that some or all of the undistributed earnings of a subsidiary on which income taxes have
been accrued will not be remitted in the foreseeable future, the parent entity shall adjust income tax expense
of the current period.

Example 3-20

Assume that Entity X had $2,000 of unremitted earnings from its investment in a domestic corporate joint
venture that arose in fiscal years beginning on or before December 15, 1992, and that management has
determined that all of the pre-1993 corporate joint venture earnings were indefinitely reinvested. Therefore, no
DTL has been recorded. In addition, assume that during 20X1, unremitted earnings from the joint venture were
$1,000 and that X accrued the related deferred income taxes on these earnings. During 20X2, management
of the joint venture changed its intent regarding remitting joint venture earnings, concluding that $1,000 of
retained earnings would be distributed (via a dividend) to X on December 31, 20X2, and $1,000 on December
31, 20X3, respectively.

ASC 740-10-25-3(a) states that whether reversals pertain to differences that arose in fiscal years beginning on
or before December 15, 1992, is determined on the basis of a LIFO pattern. Therefore, X would accrue, as of
the date the change in intent occurred in 20X2, a DTL for an additional $1,000 of taxable income representing
the tax consequence of only $1,000 of pre-1993 unremitted earnings; the deferred tax consequences of the
other $1,000 are related to income generated in post-1993 years, which was previously accrued in 20X1.

3.4.3 Tax-Free Liquidation or Merger of a Subsidiary

740-30-25 (Q&A 12)
There may be instances in which it is acceptable to treat an outside basis difference in a domestic
subsidiary as a nontaxable temporary difference. An analysis to achieve this treatment has quantitative
and qualitative thresholds.

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In the assessment of whether the outside basis difference of an investment in a domestic subsidiary is
a taxable temporary difference in the United States, an 80 percent investment in the subsidiary alone
is not sufficient for an entity to conclude that the outside basis difference is not a taxable temporary
difference. While U.S. tax law provides a means by which an investment of 80 percent or more in a
domestic subsidiary can be liquidated or merged into the parent in a tax-free manner, an entity must
also intend to ultimately use that means. Satisfying the tax law requirements alone is not sufficient; the
entity should also consider:

• Any regulatory approvals that may be required (e.g., in a rate-regulated entity in which a merger
would be subject to regulatory approval and that approval is more than perfunctory).

• Whether the liquidation or merger is subject to approval by the noncontrolling interest holders.
• Whether it would be desirable for the entity to recover its investment in a tax-free manner. For
example, if the entity’s outside basis in the subsidiary is significantly higher than the subsidiary’s
inside basis, tax-free liquidation may be undesirable.

Some non-U.S. jurisdictions may stipulate similar rules for liquidation or merger of a subsidiary into a
parent in a tax-free manner. A similar analysis should be performed on all subsidiaries for which the tax
law provides a means by which a reported investment can be recovered in a tax-free manner and the
parent intends to use that means.

In some circumstances, the parent may own less than the required percentage under the applicable
tax law (i.e., more than 50 percent but less than 80 percent). In such cases, the parent may still be able
to assert that it can recover its investment in a tax-free manner (and thus not treat the outside basis
difference in the subsidiary as a taxable temporary difference) if it can do so without incurring significant
cost. ASC 740-30-25-8 states, in part:

The parent sometimes may own less than that specified percentage, and the price per share to acquire
a noncontrolling interest may significantly exceed the per-share equivalent of the amount reported as
noncontrolling interest in the consolidated financial statements. In those circumstances, the excess of the
amount for financial reporting over the tax basis of the parent’s investment in the subsidiary is not a taxable
temporary difference if settlement of the noncontrolling interest is expected to occur at the point in time when
settlement would not result in a significant cost. That could occur, for example, toward the end of the life of
the subsidiary, after it has recovered and settled most of its assets and liabilities, respectively. The fair value of
the noncontrolling interest ordinarily will approximately equal its percentage of the subsidiary’s net assets if
those net assets consist primarily of cash. [Emphasis added]

In this context, one interpretation of significant cost could be that the costs (based on fair value) of
acquiring the necessary interest in that subsidiary to recover it tax free are significant. In performing
this assessment, the parent can consider the cost that would be incurred at the end of the life of the
subsidiary (i.e., once the subsidiary’s assets have been converted to cash and all outstanding liabilities
have been settled). Under the “end-of-life” scenario, the carrying value of the noncontrolling interest
may be equivalent to fair value. If the cost of assuming the noncontrolling interest at the “end of the
subsidiary’s life” is practicable, a tax-free liquidation or merger can be assumed and the outside basis
difference would not be treated as a taxable temporary difference (as long as the tax law provides a
means for a tax-free liquidation or merger and the entity intends to use this means).

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3.4.4 Potential DTL: Foreign Subsidiary and Foreign Corporate Joint Venture

ASC 740-30

Exceptions to Comprehensive Recognition of Deferred Income Taxes

25-17 The presumption in paragraph 740-30-25-3 that all undistributed earnings will be transferred to the
parent entity may be overcome, and no income taxes shall be accrued by the parent entity, for entities and
periods identified in the following paragraph if sufficient evidence shows that the subsidiary has invested or
will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation.
A parent entity shall have evidence of specific plans for reinvestment of undistributed earnings of a subsidiary
which demonstrate that remittance of the earnings will be postponed indefinitely. These criteria required to
overcome the presumption are sometimes referred to as the indefinite reversal criteria. Experience of the
entities and definite future programs of operations and remittances are examples of the types of evidence
required to substantiate the parent entity’s representation of indefinite postponement of remittances from
a subsidiary. The indefinite reversal criteria shall not be applied to the inside basis differences of foreign
subsidiaries.

25-18 As indicated in paragraph 740-10-25-3, a deferred tax liability shall not be recognized for either of the
following types of temporary differences unless it becomes apparent that those temporary differences will
reverse in the foreseeable future:
a. An excess of the amount for financial reporting over the tax basis of an investment in a foreign
subsidiary or a foreign corporate joint venture that is essentially permanent in duration.
b. Undistributed earnings of a domestic subsidiary or a domestic corporate joint venture that is essentially
permanent in duration that arose in fiscal years beginning on or before December 15, 1992. A last-in,
first-out (LIFO) pattern determines whether reversals pertain to differences that arose in fiscal years
beginning on or before December 15, 1992.

25-19 If circumstances change and it becomes apparent that some or all of the undistributed earnings of a
subsidiary will be remitted in the foreseeable future but income taxes have not been recognized by the parent
entity, it shall accrue as an expense of the current period income taxes attributable to that remittance. If it
becomes apparent that some or all of the undistributed earnings of a subsidiary on which income taxes have
been accrued will not be remitted in the foreseeable future, the parent entity shall adjust income tax expense
of the current period.

Outside basis differences in foreign entities (i.e., the holder of the investment is taxable in a jurisdiction
different from the investee’s) are taxable temporary differences. DTLs should be recorded for these
taxable temporary differences unless the exception in ASC 740-30-25-18(a) applies.

ASC 740-30-25-18(a) states that a DTL is not recognized for an “excess of the amount for financial
reporting over the tax basis of an investment in a foreign subsidiary” unless it becomes apparent that
the temporary difference will reverse in the foreseeable future. See Section 3.3.1 for a discussion of
inside and outside basis differences.

3.4.5 DTL for a Portion of an Outside Basis Difference

740-30-25 (Q&A 04)
As noted above, ASC 740-30-25-18(a) states that a DTL is not required for an “excess of the amount for
financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint
venture that is essentially permanent in duration” unless “it becomes apparent that those temporary
differences will reverse in the foreseeable future.” In certain circumstances, an entity may require its
foreign subsidiary or foreign corporate joint venture to remit only a portion of undistributed earnings.

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An entity is permitted to recognize a DTL only for the portion of the undistributed earnings to be
remitted in the future (remittances are not limited to dividends or distributions). ASC 740-30-25-18 is
not an all-or-nothing requirement.

Example 3-21

Entity A has one subsidiary, B, a wholly owned subsidiary in foreign jurisdiction X. Subsidiary B has $500,000 in
undistributed earnings, which represents the entire outside basis difference in B (there has been no fluctuation
in the exchange rates). On the basis of available evidence, A has historically concluded that no part of this basis
difference was expected to reverse in the foreseeable future and that, therefore, the indefinite reversal criteria
in ASC 740-30-25-17 and 25-18 were met in accordance with management’s intent and the associated facts
and circumstances. Consequently, A has not historically recorded a DTL on its book-over-tax basis difference in
its investment in B.

In the current year, B has net income of $300,000 and declares a one-time dividend for the full $300,000.
Subsidiary B has no plans to declare or pay future dividends, and there are no other changes in facts or
circumstances to suggest that the indefinite reversal assertion on the existing $500,000 outside basis
difference would be inappropriate. Further, the one-time circumstances that led to the distribution of the
$300,000 are not expected to reoccur. In this example, A could continue to assert the indefinite reinvestment
of B’s earnings in the future. Entity A should document its intent and ability to indefinitely reinvest the
undistributed earnings; see Section 3.4.5.1 below for further discussion.

Example 3-22

Assume the same facts as in Example 3-21, except that the dividend was declared as a result of projected
shortfalls in A’s working capital requirements during the coming year. The ongoing short-term capital needs
of A may suggest that A can no longer indefinitely reinvest the earnings of B. In this example, the indefinite
reinvestment assertion may no longer be appropriate and, if not, A should record a DTL on its entire $500,000
outside basis difference.

3.4.5.1 Evidence Needed to Support the Indefinite Reinvestment Assertion

740-30-25 (Q&A 11)
ASC 740-30-25-3 states that it “shall be presumed that all undistributed earnings of a subsidiary will be
transferred to the parent entity.” ASC 740-30-25-17 states that this presumption “may be overcome, and
no income taxes shall be accrued by the parent entity . . . if sufficient evidence shows that the subsidiary
has invested or will invest the undistributed earnings indefinitely.”

An entity’s documented plan for reinvestment of foreign earnings would enable it to overcome the
presumption that all undistributed earnings of a foreign subsidiary will be transferred to the parent
entity. To support its assertion that the undistributed earnings of a subsidiary will be indefinitely
reinvested, an entity should demonstrate that the foreign subsidiary has both the intent and ability to
indefinitely reinvest undistributed earnings. Past experience with the entity, in and of itself, would not be
sufficient for an entity to overcome the presumption in ASC 740-30-25-3. In documenting its written plan
for reinvestment of foreign earnings, an entity should consider such factors as:

• Operating plans (for both the parent company and the subsidiary).
• Budgets and forecasts.
• Long-term and short-term financial requirements of the parent company and the subsidiary (i.e.,
working capital requirements and capital expenditures).

• Restrictions on distributing earnings (i.e., requirements of foreign governments, debt

agreements, or operating agreements).

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• History of dividends.
• Tax-planning strategies an entity intends to rely on to demonstrate the recoverability of DTAs.
This analysis is performed for each foreign subsidiary as of each balance sheet date (see above for
guidance on determining whether a specific investment of a consolidated parent company is a foreign
or domestic subsidiary). This analysis should be performed on a subsidiary-by-subsidiary basis and
determined by using a bottom-up approach. An entity could reach different conclusions for two
subsidiaries within the same jurisdiction.

Further, in a business combination, this analysis should be performed by the acquirer as of the
acquisition date, regardless of any previous position taken by the acquiree or historical practice by the
subsidiary. As a result of the analysis, market participants could reach different conclusions regarding
the same acquiree.

3.4.5.2 Ability to Overcome the Presumption in ASC 740-30-25-3 After a Change in

Management’s Plans for Reinvestment or Repatriation of Foreign Earnings
740-30-25 (Q&A 01)
In some circumstances, an entity’s reinvestment or repatriation plan may change because of different
factors, such as the parent’s liquidity requirements or changes in tax ramifications of repatriation.

An entity may have asserted previously that it had a plan to indefinitely reinvest foreign earnings
overseas to overcome the presumption described in ASC 740-30-25-3 that undistributed foreign
earnings will be transferred to the parent entity. As a result of various factors, the same entity may later
decide to repatriate some or all of its undistributed foreign earnings.

A change in management’s intent regarding repatriation of earnings may taint management’s future
ability to assert that earnings are indefinitely reinvested. However, it depends on the reason(s) for
the change. The following are a few questions an entity could consider in determining whether
management’s ability is tainted in this situation:

• Did management have sufficient evidence of a specific plan for reinvestment or repatriation of
foreign earnings in the past?

• Is it clear that this change is a result of a temporary and identifiable event (e.g., a change in tax
law available for a specified period)?

• Can management provide evidence that supports what has changed from its previous plans?
• Does management have a plan for reinvestment of future earnings?
Generally, if the conditions were met, management would be able to assert indefinite reinvestment of
foreign earnings in the future.

However, if management’s current actions indicate that its previous plan was not supported by actual
business needs (e.g., stated foreign capital requirements were over what proved to be necessary), the
change in intent may call into question management’s ability to assert that future foreign earnings are
indefinitely reinvested.

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3.4.5.3 Change in Indefinite Reinvestment Assertion — Recognized or

Nonrecognized Subsequent Event
740-10-25 (Q&A 17)
In some circumstances, an entity’s reinvestment or repatriation plan may change because of various
factors, such as the parent’s liquidity requirements or changes in the tax ramifications of repatriation.

ASC 740-30-25-19 indicates that the impact of the change in plans would be accounted for in the
period in which management’s plans change (e.g., when management no longer can assert that all, or a
portion, of its foreign earnings are indefinitely reinvested). However, an entity may need to use judgment
to identify the period in which management’s decision to change its plans occurred, especially if this
decision occurs soon after the balance sheet date.

An entity should consider the nature and timing of the factors that influenced management’s decision
to change its plans when evaluating whether a change in management’s plans for reinvestment
or repatriation is a recognized or nonrecognized subsequent event under ASC 855. Specifically, if
identifiable events occurred after the balance sheet date that caused the facts or conditions that existed
as of the balance sheet date to change significantly, and management changed its intent regarding
indefinite reinvestment because of the new facts, the change in intent may be a nonrecognized
subsequent event.

In contrast, if the change in intent after the balance sheet date is due to factors other than responding
to the occurrence of an identifiable event, the facts or conditions that existed at the end of the period
are unlikely to have changed significantly. Therefore, if prior-period financial statements have not
been issued or are not yet available to be issued (as these terms are defined in the subsequent-event
guidance in ASC 855-10-20), the entity would generally be required to record the effect of the change in
management’s plan in these financial statements (i.e., a recognized subsequent event).

Example 3-23

Assume that an identifiable event (e.g., a change in tax rates associated with repatriation of foreign earnings)
occurs in period 2 and that this event causes management to reconsider and change its plans in that period.
The change in tax rates is an identifiable event that caused the facts or conditions that existed at the end of
period 1 to change significantly. In this case, the effect of the change in plans, which is attributable specifically
to the change in tax rate, should be recorded in period 2 (i.e., a nonrecognized subsequent event).

In contrast, an entity may change its repatriation plans because of operating factors or liquidity needs and,
shortly after a reporting period, may not be able to assert that its foreign earnings are indefinitely reinvested. In
this case, an entity must perform a careful analysis to determine whether the conditions causing the changes
in management’s plans existed at the end of the reporting period. The results of this analysis will affect whether
the accounting effect of the change in plans should be recorded as a recognized or nonrecognized subsequent
event under ASC 855.

3.4.6 Measuring Deferred Taxes on Outside Basis Differences in Foreign

Investments
As discussed above, analysis of deferred taxes on outside basis differences requires a bottom-up
approach whereby an entity must consider its outside basis difference at each level in the organization
chart. The entity should start with the lowest entity in the organization structure and determine
whether such entity’s direct parent’s financial reporting carrying amount is greater or less than its tax
basis. When performing this analysis, the entity should consider the expected manner of recovery (e.g.,
sale, liquidation, dividend). ASC 740-10-55-24 states that the “[c]omputation of a deferred tax liability
for undistributed earnings based on dividends should also reflect any related dividends received
deductions or foreign tax credits, and taxes that would be withheld from the dividend.” Thus, the parent

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entity should consider withholding taxes, FTCs, and participation exemptions (i.e., a dividends received
deduction) when determining the amount of DTL to be recognized.

Many jurisdictions tax earnings of foreign subsidiaries and foreign corporate joint ventures that are
essentially permanent in duration (collectively, “foreign investments”) upon distribution of such earnings.
Where the immediate parent entity’s outside basis taxable temporary difference in a foreign investment
would close upon remittance of foreign earnings and is not indefinitely reinvested, the parent entity
would need to recognize a DTL for the additional tax to be imposed in its jurisdiction upon receipt of the
earnings. The parent entity may be able to avail itself of a participation exemption and, as stated above,
should factor such an exemption into the amount of DTL to be recognized.

For example, in the United States, companies may be entitled to a 100-percent-dividends-received

deduction on the repatriation of earnings that have not previously been taxed. Further, any foreign taxes
properly attributable to the earnings that are subject to the 100-percent-dividends-received deduction
are not available as an FTC since those earnings are not subject to U.S. federal income tax. The
repatriation of earnings to which the 100-percent-dividends-received deduction applies generally should
reduce the outside basis difference because the distribution reduces the financial reporting carrying
value of the investment but does not reduce the U.S. tax basis in the investment. While there may be
no U.S. federal income tax implications of the distribution, there can nonetheless be additional foreign
withholding tax and state taxes.

In other instances, however, an outside basis difference may be expected to reverse in a taxable
manner, irrespective of whether there is a distribution (e.g., through future Subpart F or GILTI
inclusions). To the extent that earnings have been previously taxed (situations involving Subpart F, GILTI,
or IRC Section 965 are discussed further below), for example, a U.S. company would receive a basis
increase for U.S. income tax purposes. Upon distribution, such earnings are not taxed again; rather, the
U.S. tax basis in the investment is reduced by the amount of the previously taxed earnings distributed. In
a manner similar to earnings subject to the 100-percent-dividends-received deduction, there can still be
additional withholding taxes and state taxes incurred on a repatriation of earnings to the U.S. company;
see Section 3.4.13 for a discussion of withholding taxes. In addition, there may be foreign exchange
gains or losses that are taxable/deductible upon repatriation, capital gains upon sale of an investment,
or foreign income taxes. If a U.S. company is not indefinitely reinvested in the outside basis difference in
its investment in a foreign subsidiary or foreign corporate joint venture that is essentially permanent in
duration, it may need to recognize a DTL with respect to its investment.

[Section 3.4.7 has been deleted.]

3.4.8 Outside Basis Difference in a Foreign Subsidiary — Subpart F Income

740-30-25 (Q&A 18)
ASC 740-30-25-18(a) indicates that a DTL should not be recognized for an “excess of the amount for
financial reporting over the tax basis [‘outside basis difference’] of an investment in a foreign subsidiary
or a foreign corporate joint venture that is essentially permanent in duration . . . unless it becomes
apparent that those temporary differences will reverse in the foreseeable future” (emphasis
added). Further, there is a rebuttable presumption under ASC 740-30-25-3 that all undistributed
earnings will be transferred by a subsidiary to its parent. This rebuttable presumption may be overcome
if the criteria of ASC 740-30-25-17 are met (i.e., sufficient evidence shows the subsidiary has invested or
will invest the undistributed earnings indefinitely).

Under Subpart F of the Internal Revenue Code, a U.S. parent may be taxed on specified income
of a foreign subsidiary (commonly referred to as Subpart F income) when earned by the foreign
subsidiary (e.g., certain types of passive income are treated as Subpart F income). When recognized for
tax-reporting purposes by the U.S. parent, Subpart F income increases the outside tax basis in a foreign

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subsidiary. Likewise, when recognized for financial reporting purposes by the foreign subsidiary (and
thus in the U.S. parent’s consolidated financial statements), such income increases the U.S. parent’s
book basis in the foreign subsidiary.

Subpart F income may result in taxable income for the U.S. parent in the same amount and same period
as that in which the income is recognized by the foreign subsidiary for financial reporting purposes. In
such cases, current taxable income would be recognized in the period in which the income is recognized
for financial reporting purposes, and there would generally be no change in the U.S. parent’s outside
basis difference in the foreign subsidiary (i.e., because the book basis and tax basis both generally
increase by an equal amount). However, Subpart F income may be taxed in a later period than the
period in which the income is recognized for financial reporting purposes. In these cases, there will be
an increase in the parent’s book basis in the subsidiary attributable to Subpart F income recognized
for financial reporting purposes with no change in the corresponding tax basis. This section does not
apply to situations involving Subpart F income that will not be immediately taxable as a result of other
circumstances (e.g., a situation in which the Subpart F income is deferred when there is a deficit in E&P
but will become includable when the foreign subsidiary in question has positive earnings).

A U.S. parent that, according to ASC 740-30-25-18(a), does not recognize a DTL on its outside basis
taxable temporary difference in a foreign subsidiary should generally recognize a DTL for the portion
of the outside basis difference that corresponds to amounts already recognized for financial reporting
purposes by the foreign subsidiary that will be treated as Subpart F income when considered to be
earned for tax reporting purposes (i.e., amounts within the foreign subsidiary that would give rise to
taxable temporary differences under U.S. tax law).

The portion of the outside basis taxable temporary difference that corresponds to an inside Subpart F
temporary difference should be treated as though it is apparent that it will reverse “in the foreseeable
future” and will thus require the recognition of a DTL. Since Subpart F income is often related to passive
types of income, in most cases neither the U.S. parent nor the foreign subsidiary can control when it will
become taxable to the U.S. parent. Therefore, a deferred tax expense and outside basis DTL should be
recognized in the period in which the income is recognized for financial reporting purposes. This is true
even if the U.S. parent does not intend to distribute the associated earnings of the foreign subsidiary
and irrespective of whether the U.S. parent has elected to treat GILTI as a period cost. See Section
3.4.10 for a discussion of GILTI deferred taxes.

Example 3-24

Entity P, a U.S. parent, owns Entity F, a foreign subsidiary that, in turn, owns an equity method investment that
does not meet the ASC master glossary’s definition of a corporate joint venture. Entity P’s tax basis was not
affected by undistributed earnings of the equity investee. In addition, its investment (book basis) in F increases
by the amount of equity method income recognized by the subsidiary, which increases the outside basis
difference in the investment in F (since P’s tax basis was not affected by the undistributed earnings of the equity
investee). When F sells or receives a distribution from the equity method investee, the gain or distribution will
be treated as Subpart F income that P must recognize immediately. Further, as an equity investor, F has no
control over when it might receive a dividend from the equity investee, nor can it assert indefinite reinvestment
in the equity method investee because it is not a subsidiary or corporate joint venture that is essentially
permanent in duration; therefore, P should not consider the outside basis difference in F that is attributable to
the unremitted earnings of the equity method investee to be eligible for treatment as indefinitely reinvested.
Accordingly, P should recognize a DTL for that portion of the outside basis difference that will reverse when
the investment in the equity investee is recovered, which would trigger recognition of Subpart F income and
increase P’s tax basis in F (which has the effect of reversing the corresponding outside basis difference).

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3.4.9 Outside Basis Difference in a Foreign Subsidiary — Deferred Subpart F

Income
740-30-25 (Q&A 19)
Section 3.4.8 discusses Subpart F income that will be immediately taxable when considered earned for
tax reporting purposes. However, sometimes Subpart F income will actually be deferred, even after it
has been earned for tax reporting purposes (“deferred Subpart F income”) because of certain U.S. tax
limitations. For example, the amount of currently taxable Subpart F income of any CFC for any taxable
year may not exceed such CFC’s E&P for the year. Accordingly, while such amounts may be deferred and
recaptured in a future year, current-year Subpart F income is limited to actual E&P earnings.

Assume, for example, that Company Y, a CFC, earns $100 of Subpart F income and generates a
non-Subpart F loss of $40 in year 1. Company Y earns $200 of Subpart F income in each of years 2 and
3, $10 of non-Subpart F income in year 2, and $100 of non-Subpart F income in year 3. Because Y’s E&P
is $60 in year 1, the amount of Subpart F income attributable to Y in year 1 that Y’s U.S. shareholder
must include in its year 1 taxable income is limited to $60. However, in year 2, Y’s U.S. shareholder must
include $10 of Y’s deferred Subpart F income from year 1. Likewise, in year 3, the U.S. shareholder must
include the remaining $30 of Company Y’s deferred Subpart F income from year 1 that was not taxed in
years 1 and 2. Thus, all the deferred Subpart F income from year 1 is recaptured.

If the existence of deferred Subpart F income suggests that some part of the outside basis difference will
reverse in the foreseeable future, a DTL should be recorded. However, the mere existence of deferred
Subpart F earnings does not automatically suggest that a part of the outside basis difference will reverse
in the foreseeable future. Rather, all the facts and circumstances must be assessed. For example, if
a recovery and settlement of the subsidiary’s assets and liabilities were to give rise to the taxation of
the deferred Subpart F income, a DTL would be recognized provided that the amount of the deferred
Subpart F income does not exceed the outside basis difference in the foreign subsidiary.

If an entity uses the financial reporting carrying amounts of the assets and liabilities to determine
whether some part of the outside basis difference would be expected to reverse in the foreseeable
future, the DTL recognized would take into account only the tax consequences associated with events
that already have occurred and been reported in the financial statements. When additional events, such
as future earnings, must occur (e.g., when the recovery of assets and settlement of liabilities alone does
not result in the E&P needed to make all the deferred Subpart F income taxable to the U.S. parent),
no DTL would be recognized until the financial statements include such future earnings. To assess the
effect of recovering assets and settling liabilities, the entity might need to schedule the recovery or
settlement. For example, the recovery of certain assets would result in E&P and the settlement of certain
liabilities would result in reductions in E&P; however, it could become apparent that the outside basis
difference will reverse in the foreseeable future when the entity expects assets to be recovered before
the liabilities are settled.

3.4.10 Global Intangible Low-Taxed Income

The 2017 Act created a new requirement that certain income (i.e., GILTI) earned by a CFC must
be included currently in the gross income of the CFC’s U.S. shareholder. GILTI is the excess of the
shareholder’s “net CFC tested income” over the net deemed tangible income return (the “routine
return”), which is defined as the excess of (1) 10 percent of the aggregate of the U.S. shareholder’s pro
rata share of the qualified business asset investment (QBAI) of each CFC with respect to which it is a U.S.
shareholder over (2) the amount of certain interest expense taken into account in the determination of
net CFC-tested income.

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A domestic corporation is permitted a deduction of up to 50 percent of the sum of the GILTI inclusion
and the amount treated as a dividend in accordance with IRC Section 78 (“IRC Section 78 gross-up”).
If the sum of the GILTI inclusion (and related IRC Section 78 gross-up) and the corporation’s FDII
(see Section 3.2.1.5) exceeds the corporation’s taxable income, the deductions for GILTI and for FDII
are reduced by the excess. As a result, the GILTI deduction can be no more than 50 percent of the
corporation’s taxable income (and will be less if the corporation is also entitled to an FDII deduction). The
maximum GILTI deduction is reduced to 37.5 percent for taxable years beginning after December 31,
2025.

3.4.10.1 GILTI Accounting Policy Election

There may be situations in which a U.S. investor in a CFC has a financial reporting carrying value (i.e.,
book basis) that does not equal its outside tax basis for U.S. tax purposes in its foreign investment,
resulting in an outside basis difference in the foreign investment. In addition, the U.S. investor would
have a U.S. tax basis in the CFC’s underlying assets and liabilities held that will be used for calculating
GILTI inclusions. Accordingly, a U.S. investor may have book/U.S. tax inside basis differences that, upon
reversal, will increase or decrease the GILTI inclusion and, because GILTI inclusions increase the U.S. tax
basis in the foreign investment, will also affect the outside basis difference in the foreign investment.

In January 2018, the FASB staff issued a Q&A document, which states that a company may elect, as
an accounting policy, to either (1) treat taxes due on future U.S. inclusions in taxable income under
the GILTI provision as a current-period expense when incurred or (2) factor such amounts into the
company’s measurement of its deferred taxes (the “GILTI deferred method”).

The decision tree below illustrates the approach for determining the deferred tax accounting for outside
basis differences in foreign investments that are expected to reverse as a result of the GILTI provision.

Does the
company
expect to have a No
U.S. inclusion because
of the GILTI
provision?

No U.S. deferred taxes

Yes related to the GILTI
provision.

Has
the
company
Measure the DTAs and DTLs in Yes elected to factor
No
accordance with the discussion U.S. GILTI inclusions
in Sections 3.4.10.2 and 3.4.10.3. into its measurement
of deferred
taxes?

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3.4.10.2 GILTI Deferred Method — Overview

We believe that in a manner consistent with the mechanics of the GILTI computation, GILTI DTAs
and DTLs should generally be computed on a U.S.-shareholder-by-U.S.-shareholder basis if the
GILTI deferred method is elected. Further, when multiple U.S. shareholders are includable in a U.S.
consolidated income tax return, the aggregation rules applicable to such consolidated tax filings should
be considered. Multiple CFCs within the same U.S. consolidated tax return group would be analyzed
in the aggregate. If a U.S. shareholder has a mixture of profitable and unprofitable CFCs that, in the
aggregate, are not profitable to the extent that future GILTI inclusions are not expected at the U.S.
shareholder level, no GILTI DTAs and DTLs would be recorded. Conversely, if a U.S. shareholder has a
mixture of profitable and unprofitable CFCs that, in the aggregate, are profitable to the extent that future
GILTI inclusions are expected, that U.S. shareholder should measure GILTI DTAs and DTLs as discussed
below.

3.4.10.3 GILTI Deferred Method — Measurement of Deferred Taxes

In determining the amount of U.S.-investor-level deferred taxes necessary for foreign investments
under this model, companies should “look through” the outside basis of the CFC to determine how
the book/U.S. tax inside basis differences will reverse and how such reversals will affect future GILTI
inclusions and the outside basis difference.

Any residual outside basis difference that is not related to the CFC’s underlying assets or liabilities (i.e.,
inside/outside tax basis disparities) should then be analyzed in the determination of whether the basis
difference would result in a taxable or deductible amount when the investment is recovered and, if so,
whether an ASC 740 outside basis exception (i.e., ASC 740-30-25-18(a) or ASC 740-30-25-9) applies.
Unlike other situations involving outside basis differences in foreign subsidiaries, this “look through”
approach (see Section 3.4.15) would be employed even if no overall outside basis difference in the CFC
exists, or if only an overall deductible outside basis difference in the CFC exists.

In addition, in assessing the GILTI impact of the CFC’s underlying assets and liabilities, a company would,
in a fashion similar to branch accounting, recognize U.S. DTAs or DTLs to account for the U.S. income
tax effects of the future reversal of any in-country DTAs and DTLs (also referred to as “anticipatory
foreign tax credit/deduction” or “anticipatory” DTAs and DTLs). When determining the amount of a
U.S. anticipatory DTA or DTL, an entity must carefully consider all applicable provisions in the tax law,
since the amount of the incremental foreign taxes that will be creditable and realizable, or forgone,
because of the future reversal of the local in-country DTAs and DTLs may be difficult to assess and
subject to limitations (e.g., an 80 percent limitation, limitations as a result of expense allocations, and
a limitation on utilization as a result of the absence of a carryforward or carryback period, as well as
tax rate differences). For example, a local-country DTL that will reverse in the same year(s) in which a
GILTI inclusion is expected may be creditable against the U.S. tax in that year, subject to the 80 percent
limitation. In addition, U.S. DTAs that reverse in the same year as the local in-country deferred might
further limit the FTC. Future FTCs directly related to future book income and future expense allocation
limitations directly related to future book expense generally should not be included in the measurement
of the anticipatory DTA or DTL until such income or expense, or both, are recognized (i.e., such FTCs and
expense allocation limitations should be limited to those directly tied to existing temporary differences).
See also Section 3.3.6.3.1, which discusses the measurement of anticipatory DTAs and DTLs.

While many “branch-like” principles are employed in the look-through model described above, unlike
a branch, a CFC that will have substantially all of its income taxable in the United States as a result of
a GILTI inclusion still has an outside tax basis that is relevant in certain instances, such as a sale or
distribution. Accordingly, measurement of deferred taxes should also factor in the residual outside basis
difference as described above.

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For more information about accounting for foreign branch operations, see Section 3.3.6.3.

In summary, recorded GILTI DTAs and DTLs under the look-through model will consist of the following
three items:

• DTAs and DTLs related to inside book/U.S. tax basis differences that will affect future GILTI
inclusions, identified by “looking through” the CFC’s outside basis to the CFC’s underlying assets
and liabilities.

• DTAs and DTLs related to the U.S. tax consequences of settling the CFC’s in-country DTAs or
DTLs (i.e., anticipatory DTAs and DTLs).

• Any DTA or DTL related to a residual outside basis temporary difference for which an exception
has not been applied.

There have been a number of discussions with the FASB and SEC staffs about the more significant
aspects of the guidance on measuring GILTI-related deferred taxes. Accordingly, while other acceptable
accounting approaches may exist, entities that plan to apply methods that are inconsistent with those
discussed herein are strongly encouraged to consult with their income tax accounting advisers.

3.4.10.4 GILTI Deferred Method — Other Considerations

3.4.10.4.1 Net Deemed Tangible Income Return
Given that the CFC’s routine return is excluded from the GILTI inclusion, we believe that there is more
than one acceptable approach to accounting for the routine return in the measurement of GILTI DTAs
and DTLs, including the following:

• Special deduction — The routine return could be treated akin to a special deduction, with
the benefit recognized when the GILTI inclusion is reduced by the routine return. Under
this approach, the routine return is viewed as dependent on future events, including future
investments in QBAI and interest expense deductions, and it therefore would not be factored
into the tax rate expected to apply to the temporary differences.

• Graduated tax rate — Under this approach, the amount of taxable income equal to the routine
return would be considered income taxed at a zero rate. Accordingly, if the routine return
represents a significant factor, companies would measure GILTI DTAs and DTLs by using the
average graduated tax rate applicable to the amount of estimated annual taxable income in the
periods in which the aforementioned deferred taxes are estimated to be settled or realized.
Companies will need to use judgment in determining the periods in which GILTI DTAs and DTLs
will reverse and the estimated annual taxable income in each of those periods. See Section
3.3.4.1.

Other models may also be acceptable in certain situations (e.g., a portion of the book/U.S. tax basis
difference that will reverse and represent a routine return might not be considered a taxable temporary
difference for which a deferred tax would be recorded in accordance with ASC 740-10-25-30).

The approach an entity selects would be an accounting policy election that, like all other such elections,
must be applied consistently.

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3.4.10.4.2 IRC Section 250 Deduction (the “GILTI Deduction”)

The GILTI deduction is intended to lower the GILTI income inclusion (with the intent of lowering the
ETR on the included income) and, in many cases, will immediately apply when a company has a GILTI
inclusion. Accordingly, we believe that if a company generally expects to be able to apply the full GILTI
deduction in the period in which the GILTI DTAs and DTLs reverse, it should consider the deduction in
the measurement of the GILTI DTAs and DTLs in accordance with ASC 740-10-55-24 (see guidance in
Appendix A). As noted above, however, the GILTI deduction is “up to,” rather than “guaranteed” to be, 50
percent and could be reduced by the taxable income limitation, which is applied in combination with the
FDII deduction. An entity should carefully consider this limitation when factoring the GILTI deduction into
the measurement of U.S. GILTI DTAs and DTLs. For example, when the taxable income limitation and
expense allocation limitations are expected to apply and be significant (e.g., in situations in which the
U.S. operations generate significant losses or an entity expects to forgo the GILTI deduction because it
expects to use existing NOL carryforwards), entities may conclude that factoring the GILTI deduction into
the rate is not appropriate. See additional discussion in Section 5.7.2.

3.4.11 Deemed Repatriation Transition Tax (IRC Section 965)

Under the 2017 Act, a U.S. shareholder of a specified foreign corporation (SFC)7 was required to
include in gross income, at the end of the SFC’s last tax year beginning before January 1, 2018, the U.S.
shareholder’s pro rata share of certain of the SFC’s undistributed and previously untaxed post-1986
foreign E&P. The inclusion generally was reduced by foreign E&P deficits that were properly allocable to
the U.S. shareholder. In addition, the mandatory inclusion was reduced by the pro rata share of deficits
of another U.S. shareholder that is a member of the same affiliated group. A foreign corporation’s
E&P were taken into account only to the extent that they were accumulated during periods in which
the corporation was an SFC (referred to below as a “foreign subsidiary”). The amount of E&P taken
into account was the greater of the amount determined as of November 2, 2017, or December 31,
2017, unreduced by dividends (other than dividends to other SFCs) during the SFC’s last taxable year
beginning before January 1, 2018.

The U.S. shareholder’s income inclusion was offset by a deduction designed to generally result in an
effective U.S. federal income tax rate of either 15.5 percent or 8 percent. The 15.5 percent rate applied
to the extent that the SFCs held cash and certain other assets (the U.S. shareholder’s “aggregate foreign
cash position”), and the 8 percent rate applied to the extent that the income inclusion exceeded the
aggregate foreign cash position.

The 2017 Act permits a U.S. shareholder to elect to pay the net tax liability8 interest free over a period of
up to eight years.

3.4.11.1 Classification of the Transition Tax Liability

The transition liability should be recorded as a current/noncurrent income tax payable. ASC 210
provides general guidance on the classification of accounts in statements of financial position. An entity
should classify as a current liability only those cash transition tax payments that management expects to
make within the next 12 months. The installments that the entity expects to settle beyond the next 12
months should be classified as a noncurrent income tax payable.

7
An SFC includes all CFCs and all other foreign corporations (other than passive foreign investment companies) in which at least one domestic
corporation is a U.S. shareholder.
8
Net tax liability under IRC Section 965 is the excess, if any, of the taxpayer’s net income tax for the taxable year in which the IRC Section 965
inclusion amount is included over such taxpayer’s net income tax for the taxable year, excluding (1) the IRC Section 965 amount and (2) any
income or deduction properly attributable to a dividend received by such U.S. shareholder from any deferred foreign income corporation.

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3.4.11.1.1 Classification of Transition Tax Obligation in Periods Before Inclusion in

the Income Tax Return
In certain circumstances, the transition tax was not reported in an entity’s tax return for the year that
included the enactment date. On the basis of the unique nature of tax reform and the mandatory
one-time deemed repatriation income inclusion, we believe that it would be appropriate, in those
circumstances, to classify the deemed repatriation transition tax liability as a current/noncurrent income
tax payable in the period that includes the enactment date.

3.4.11.2 Measurement of Transition Tax Obligation in Periods Before Inclusion in

the Income Tax Return
Although we generally believe that the recognition of a DTL related to a foreign subsidiary would
be limited to the amount that corresponds to the entity’s outside basis difference in the foreign
subsidiary, we also believe that, given the unique circumstances presented in Section 3.4.11, it would
be appropriate to record the entire amount of the deemed repatriation transition tax in the period
of enactment even if it exceeds the outside basis difference in the foreign subsidiary. Under these
circumstances, the E&P subject to taxation related to past events and transactions are simply payable in
a subsequent year.

3.4.11.3 Measurement of the Transition Tax Obligation — Discounting

Although ASC 740-10-30-8 clearly prohibits discounting of DTAs and DTLs, it does not address income
tax liabilities payable over an extended period. In January 2018, the FASB staff issued a Q&A document,
which states that the deemed repatriation transition tax liability should not be discounted. The FASB
staff stated in the Q&A that “paragraph 740-10-30-8 prohibits the discounting of deferred tax amounts.
Because of the unique nature of the tax on the deemed repatriation of foreign earnings, the staff
believes that the guidance in paragraph 740-10-30-8 should be applied by analogy to the payable
recognized for this tax.” The FASB staff also noted the following in the Q&A:

• ASC 835-30 applies to the accounting for business transactions conducted at arm’s length and
the interest rate “should represent fair and adequate compensation to the supplier.”

• “[T]he transition tax liability is not the result of a bargained” arm’s length transaction.
• The scope exception in ASC 835-30-15-3(e) that indicates that ASC 835-30 does not apply to
“transactions where interest rates are affected by tax attributes or legal restrictions prescribed
by a governmental agency (such as, income tax settlements)” would apply to the transition tax
obligation.

• Because the amount of the deemed repatriation transition tax is inherently subject to uncertain
tax positions, measurement of the ultimate amount to be paid is potentially subject to future
adjustment. Since uncertain tax positions are not discounted, it would not be appropriate to
discount the transition tax liability “when the uncertain tax position is undiscounted.”

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3.4.11.4 Measurement of the Transition Tax Liability — Tax Planning

Typically, we would expect the one-time deemed repatriation transition tax to be based on the facts that
exist as of the balance sheet date (e.g., E&P amounts, cash and other asset balances) or a prior date if
required by law. However, in some instances, certain actions (or elections) that management expects to
take (make) in a subsequent reporting period and for which no other impediments or regulatory hurdles
to execution exist (i.e., the plans are within the entity’s control) can be considered in the measurement
of the tax liability. In such cases, an entity would need to use significant judgment and assess its
individual facts and circumstances.

Changing Lanes
The 2017 Act made many changes to how U.S. shareholders are taxed on earnings of foreign
investees. One of the areas affected was FTCs. The 2017 Act removed from U.S. federal tax law
the “pooling concept.” Under the pooling concept, a particular CFC had a pool of post-1986
unremitted E&P and a pool of post-1986 foreign taxes; upon repatriation, a portion of such
foreign taxes was attributed to the repatriation on the basis of the percentage of the post-1986
unremitted E&P that was repatriated compared with the total pool of post-1986 unremitted
E&P. As a result, the foreign taxes in the pool may have accumulated over a number of years
and potentially at different rates. Under the 2017 Act, U.S. shareholders calculate foreign taxes
on the basis of taxes that are “properly attributable to” the foreign earnings (e.g., GILTI, Subpart
F income) of the particular year in such a way that foreign taxes are no longer pooled.

3.4.12 “Unborn” FTCs — Before the 2017 Act

740-10-30 (Q&A 76)
When a U.S. company has concluded that the earnings of one or more of its foreign subsidiaries
will not be indefinitely reinvested, the U.S. parent must recognize a DTL related to the portion of the
outside basis difference for which reversal is foreseeable. Under U.S. federal tax law, when the U.S.
parent receives a dividend from a foreign subsidiary, the parent is permitted to treat itself as having
paid the foreign taxes that were paid by the foreign subsidiary. The parent does this by grossing up
the taxable amount of the dividend by an amount equal to the related taxes. An FTC is allowed in an
amount equal to this gross-up; such a credit is commonly referred to as a “deemed paid” credit. In
certain circumstances, a deemed-paid FTC may exceed the U.S. taxes on the grossed-up dividend and,
when the dividend is actually paid, such an excess FTC (commonly referred to as a “hyped credit”) will be
available to offset U.S. taxes otherwise payable on unrelated foreign source income in the year of the
dividend (or to offset U.S. taxes on foreign source income in prior or subsequent tax years by carryback
or carryforward of the excess FTCs). Alternatively, instead of claiming an FTC, the U.S. parent can choose
to deduct the foreign taxes by not grossing up the taxable amount of the dividend on its U.S. federal tax
return.

A DTA should not be recognized for the anticipated excess FTCs that will arise in a future year when the
foreign subsidiary pays the dividend. The anticipated excess FTC that will arise in a future period when
the dividend is paid is considered to be “unborn.” The example below illustrates the circumstances that
can lead to an unborn FTC.

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Example 3-25

Terms Used
• FC — Functional currency (in this example, the local currency is the functional currency).
• E&P — Earnings and profits (similar to retained earnings but generally measured by using a tax concept
of profit).
• Tax pool — The cumulative taxes paid in connection with the E&P. The pool is (1) measured in U.S.
dollars (USDs) by translating the amount payable each year at the average exchange rate for the year
and (2) reduced by the amounts lifted (i.e., considered to be “born”) with prior dividends.

Sub A

Facts
Outside basis taxable temporary difference in Sub A $ 400
Portion of outside basis difference that is not indefinitely reinvested (in FC) 100
Total E&P (in FC) 400
Distribution as % of total E&P 0.25%
Tax pool (in USD) $ 1,000
Exchange rate (USD equivalent of 1.0 FC) 1.1
As of the most recent reporting date, the parent has identified
$110 (or 100 in FC) that Sub A will distribute in a future period.
Computation of U.S. Tax on Future Dividend
USD amount to be received $ 110
Foreign taxes deemed paid (% of E&P distributed × the tax pool) 250
U.S. taxable income recognized 360
U.S. tax rate 35%
U.S. tax liability before FTC (126)
FTC 250
Excess FTC $ 124

When Sub A distributes 100 FC in a future period, the U.S. parent will receive $110 (based on the reporting-
date exchange rate). If the U.S. parent deducted foreign taxes in the year of the distribution, it would simply
report the $110 as taxable income and determine the related tax liability — that is, it would not separately
claim a deduction for deemed-paid foreign taxes. However, in this example, the U.S. parent has determined
that it will claim an FTC for the foreign taxes paid by Sub A. Under U.S. tax law, the dividend received will be
grossed up for the taxes paid by Sub A in connection with its earnings. In this example, Sub A has cumulative
E&P of 400 LC. Because it is distributing 100 LC, it is distributing 25 percent of its total E&P. Therefore, 25
percent of the cumulative tax pool is treated as associated with the 100 LC being distributed. To be entitled to
claim the $250 as an FTC, the U.S. parent must gross up the $110 received for the related taxes (25 percent of
the tax pool of $1,000, or $250). As noted in Section 3.4.10, such gross-ups are required by IRC Section 78 and
are often referred to as “IRC Section 78 gross-ups” for this reason. Since the U.S. parent is now paying tax on an
amount that corresponds to Sub A’s pretax income that is being distributed, the U.S. parent is entitled to claim
the IRC Section 78 gross-up amount as an FTC. In this example, the resulting $250 of FTC is greater than the
U.S. tax on Sub A’s pretax income of $126. The excess amount is an unborn hyped FTC related to Sub A. The
U.S. parent did not actually pay the $250 of foreign taxes but is deemed to have paid those taxes, and the first
moment it is deemed to have paid those taxes is when the dividend is received from Sub A.

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ASC 740-10-55-24 states that the “[c]omputation of a deferred tax liability for undistributed earnings
based on dividends should also reflect any related dividends received deductions or foreign tax
credits, and taxes that would be withheld from the dividend.” Thus, it requires a U.S. parent to consider
available FTCs when determining the DTL related to a distribution of unremitted earnings from a foreign
subsidiary.

We do not believe that in Example 3-25 a DTA should be established for the $124 of unborn FTC, since
the unborn FTC does not meet the definition of a DTA. ASC 740-10-20 defines deferred tax asset as the
“deferred tax consequences attributable to deductible temporary differences and carryforwards.”

Further, ASC 740-10-20 defines carryforward, in part, as follows:

Deductions or credits that cannot be utilized on the tax return during a year that may be carried forward to
reduce taxable income or taxes payable in a future year. An operating loss carryforward is an excess of tax
deductions over gross income in a year; a tax credit carryforward is the amount by which tax credits available
for utilization exceed statutory limitations.

The unborn FTC cannot be recognized as a DTA related to a carryforward since such an amount is
not a tax credit “available for utilization” on a tax return that is carried forward for use on subsequent
tax returns because it exceeds statutory limitations. In other words, for an FTC to be recognized as
a “carryforward” DTA, the tax return must first show FTCs as being carried forward. The $124 in this
example has the potential to become a carryforward if it is not fully used in the year in which Sub A
pays the dividend. However, as of the current reporting date, there is only a plan to remit from Sub A in
the foreseeable future (it is therefore necessary to measure the DTL related to the taxable temporary
difference in Sub A). Until the period that includes the remittance causing the excess FTC to be born,
no DTA should be recognized, but the DTL related to the investment in Sub A could be reduced to zero
after taking the expected FTC into consideration.

Connecting the Dots

Since enactment of the 2017 Act, the relevance of unborn FTCs has greatly diminished because
almost all of the foreign earnings are taxed in the United States in the period in which they are
earned in the form of Subpart F, GILTI, or branch income. Therefore, FTCs are available to the
U.S. parent in the same period in which the income is earned.

3.4.12A Foreign Exchange Gain (or Loss) on Distributions From a Foreign

Subsidiary When There Is No Overall Taxable (or Deductible) Outside Basis
Difference
Before the issuance of FASB Statement 109, APB 23 provided guidance on the establishment of a
liability for unremitted foreign earnings. That guidance stated that such earnings were presumed to
be repatriated, and a liability should be recorded for the tax consequences of the remittance, unless a
company could demonstrate specific plans for reinvestment. As a result of the adoption of the balance
sheet approach in Statement 109, the concept of a liability for unremitted earnings evolved into the
recognition of a DTL for an outside basis difference in a company’s investment in a foreign subsidiary.
This is because unremitted earnings typically resulted in an increase in the book basis of the investment
and no corresponding increase in its tax basis. Further, it was generally presumed under this approach
that no income tax related to earnings of a foreign corporate subsidiary would be incurred in the
parent’s tax jurisdiction until a repatriation occurred. The concepts in APB 23 and Statement 109 were
codified in ASC 740-30-25-18(a), which states that an entity should recognize a DTL for an “excess of the
amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign
corporate joint venture that is essentially permanent in duration” if the temporary difference will reverse
in the foreseeable future. In this context, it is still presumed that the unremitted earnings in a foreign

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subsidiary or foreign corporate joint venture will be distributed to its parent and that the outside basis
temporary difference will reverse unless the indefinite reversal criteria of ASC 740-30-25-17 are met.

However, the 2017 Act greatly increased the likelihood that a foreign subsidiary may have positive
cumulative unremitted foreign earnings even though the book basis of the parent’s investment in the
foreign subsidiary may not be greater than its tax basis (e.g., the U.S. parent’s tax basis in the foreign
subsidiary may have increased as a result of taxable income inclusions related to the transition tax
under IRC Section 965 or GILTI). Sometimes, a distribution of the unremitted earnings may even result
in a reduction in the book basis of the parent’s investment in the foreign subsidiary that exceeds
the reduction in the tax basis (i.e., the distribution could create or increase a deductible temporary
difference rather than result in the reversal of a taxable outside basis difference) even though the
distribution results in taxable income (i.e., for the currency gain) in the parent’s jurisdiction.

For example, the U.S. taxable income or loss of a U.S. parent as a result of the remittance of earnings by
a foreign corporate subsidiary is now typically limited to any foreign currency gain or loss calculated for
tax purposes. Such amounts, however, would already have increased or decreased the book basis but
generally would not have affected the tax basis before distribution.

In these situations, a questions may arise about whether a U.S. parent should record a DTL when
(1) there is no overall outside basis difference on its investment in a foreign subsidiary or the overall
outside basis difference is deductible, (2) the U.S parent intends to repatriate the foreign subsidiary’s
earnings, or (3) the entity expects that there will be a foreign exchange gain in the parent’s jurisdiction
upon distribution.

We believe that there are two acceptable approaches:

• View A — A DTL should not be recognized when no overall outside basis taxable temporary
difference exists as of the reporting date (i.e., the financial reporting basis does not exceed the
tax basis) even if the entity would incur an income tax liability if the unremitted earnings were
repatriated. This is because the recovery of the entire financial reporting carrying amount of the
investment would result in either (1) no taxable gain (when there is no outside basis difference)
or (2) a loss (when the basis difference is deductible) for tax purposes.

• View B — If, in a prior period, a company has undistributed earnings that have been recognized
in the financial statements that would trigger an investor-level tax upon distribution, and the
company is not asserting that such earnings are indefinitely reinvested, the investor would
disaggregate the outside basis difference into multiple components, such as (1) a temporary
difference related to unremitted earnings, (2) a temporary difference related to financial
statement gain or loss reported in OCI related to the unremitted earnings, and (3) other
temporary differences that will not reverse as a result of a distribution of unremitted earnings
(e.g., cumulative translation adjustment (CTA) reported in OCI related to the foreign subsidiary’s
capital accounts or residual outside basis differences).9 The recognition of a DTL in this instance
would be acceptable, irrespective of the overall outside basis difference in the investment in
the subsidiary (i.e., disaggregation would be acceptable). This approach is consistent with the
accounting discussed in Section 3.4.11.2 for the transition tax obligation and the guidance in
ASC 740-30-25-19, which states, in part:

If . . . it becomes apparent that some or all of the undistributed earnings of a subsidiary will be
remitted in the foreseeable future but income taxes have not been recognized by the parent entity,
it shall accrue as an expense of the current period income taxes attributable to that remittance.

9
Additional disaggregation may be appropriate in situations in which a portion of the outside basis difference is related to intra-entity loans (see
Section 9.7), basis differences that will reverse because of Subpart F inclusions (see Section 3.4.8), or GILTI inclusions (see Section 3.4.10)).

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Generally, the same two views would also apply to the reverse scenario (i.e., there is no overall
outside basis difference in a foreign subsidiary or the overall outside basis difference is taxable, the
entity intends to remit the foreign earnings, and the entity expects that there will be a tax benefit
associated with a foreign exchange loss in the parent’s jurisdiction upon distribution). However,
additional considerations are necessary when a DTA (as opposed to a DTL) is recorded because of the
requirements in ASC 740-30-25-9, which only allow for the recording of a deferred tax asset related to a
temporary difference in an investment that is expected to reverse in the “foreseeable future.” We believe
that a reporting entity that meets this criterion may record a DTA even when no overall deductible
outside basis difference exists if it has definitive plans to repatriate earnings in the foreseeable future.
For additional details regarding how to interpret the “foreseeable future” criteria related to recording a
DTA, see Section 11.3.1.2.

The application of either view described above would be considered an accounting policy that should be
consistently applied.

Example 3-25A

Entity X, a U.S. entity, has a wholly owned subsidiary, Entity Y, located in foreign jurisdiction Z. As of December
31, 20X9, Y has the following balances and outside basis difference, and it anticipates a distribution of its
accumulated unremitted earnings to X in the foreseeable future:

(Taxable)/
Deductible
Book U.S. Tax Difference

Initial capital 1,000 1,000 —

Accumulated unremitted earnings 200 300* 100

CTA [gain/(loss)] 30** — (30)

Total outside basis 1,230 1,300 70

Effect of distribution (205)*** (200)† 5

Outside basis after distribution 1,025 1,100 75

* The investor’s taxable income is a result of the deemed repatriation transition tax calculation, GILTI, or Subpart
F; the outside basis in the investment has therefore increased for tax purposes.
** Of the 30 USD of total CTA, 5 USD are related to foreign currency gains on the translation of B’s book earnings,
and 25 USD are related to foreign currency gains on the translation of the invested book capital in B.
*** A hypothetical distribution by B to A of 200 FC (exchange rate was 1 FC = 1 USD when earned) as of the end of
the financial reporting period, which would result in a distribution of currency worth 205 USD (i.e., a realization
of the 5 USD of currency gain related to the previously undistributed earnings).
† The outside tax basis would decrease by 200 USD (i.e., 200 USD of previously taxed earnings and profits) and
the 5 USD foreign currency gain would be taxable upon distribution (and would have no impact on outside tax
basis).

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Under View A described above, X would not record a DTL related to its investment in Y, notwithstanding
the fact that it will incur a tax liability related to a financial statement gain of 5 USD on the planned
200 FC remittance, since X has an overall deductible outside basis difference in Y. Further, under
the exception in ASC 740-30-25-9, X would not recognize a DTA for its overall deductible temporary
difference in Y unless it becomes apparent that the deductible temporary difference will reverse in the
foreseeable future. Under this approach, a current-year tax expense will result from the distribution in
the year it is made (without an offset by any reversal of deferred tax). Such expense can be viewed as
attributable to X’s inability to record a DTA on the incremental 5 USD deductible outside basis difference
(i.e., that increase in the deductible temporary difference is subject to the exception under ASC 740-30-
25-9) rather than to the lack of establishing a DTL in a prior period.

Under View B, X would record a DTL for the future tax effects of the financial statement gain of 5 USD
that would be triggered upon the distribution of 200 FC. The remaining deductible temporary difference
that is a component of the overall deductible outside basis difference would be recorded when it
becomes apparent that the deductible temporary difference will reverse in the foreseeable future, in a
manner consistent with ASC 740-30-25-9.

See Section 3.4.11.2 for a discussion of the measurement of the transition tax obligation in periods
before its inclusion in the tax return.

3.4.13 Withholding Taxes Imposed on Distributions From Disregarded

Entities and Foreign Subsidiaries
740-10-25 (Q&A 72)
Multinational companies generally operate globally through entities organized under the laws of the
respective foreign jurisdiction that govern the formation of legally recognized entities. These foreign
entities might be considered partnerships or corporations under local law; however, sometimes no legal
entity exists, and the assets and liabilities are simply viewed as an extension of the parent entity doing
business in the jurisdiction (i.e., a “true branch” or “division”).

In the case of a legal entity, under U.S. Treasury Regulation Sec. 301.7701-3 (the check-the-box
regulations), certain eligible foreign entities may elect to be disregarded as entities separate from their
parents (hereafter referred to as foreign disregarded entities). As a result of the check-the-box election,
the earnings of a foreign disregarded entity that is owned directly by a U.S. entity will, like those of a
branch, be taxable in the United States as earned.

In many foreign jurisdictions, a resident corporation must pay a withholding tax upon a distribution of
earnings to its nonresident shareholder(s). Since disregarded entities are often corporations under local
law, the applicability of withholding tax on distributions will generally depend on whether the entity is
regarded or disregarded for U.S. tax purposes. Although the distributing entity remits the withholding
tax to the local tax authority (reducing the amount received by the parent), under the local tax statutes,
the tax is generally assessed on the recipient of the distribution.

In the case of a foreign disregarded entity, no outside basis exists (from the perspective of U.S. tax law)
because the foreign entity is viewed as a division of the parent as a result of the U.S. check-the-box
election. In the case of a foreign regarded entity, its parent might still have no taxable temporary
difference in its investment in the foreign entity because (1) all the unremitted earnings have already
been taxed in the parent’s tax jurisdiction (e.g., 100 percent of the unremitted earnings of a foreign
subsidiary were taxable to its U.S. parent as Subpart F income or GILTI in such a way that the financial
reporting carrying amount and the tax basis are equal) or (2) CTA losses have reduced the financial
reporting carrying value without a corresponding reduction in its tax basis.

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Even when no taxable temporary difference exists (either in the assets of a disregarded entity or in the
shares of a regarded entity), the foreign entity may have earnings that could be distributed to its parent,
at which time withholding taxes would be imposed by the local tax authority.

We believe that there are two acceptable views on determining whether a parent should recognize a
DTL for withholding taxes that are within the scope of ASC 740 and that would be imposed by the local
tax authority on a distribution from a disregarded entity or foreign subsidiary: (1) the parent jurisdiction
view and (2) the foreign jurisdiction view.

3.4.13.1 View 1 — Parent Jurisdiction Perspective

ASC 740-10-25-2 states, in part:

Other than the exceptions identified in the following paragraph, the following basic requirements are applied in
accounting for income taxes at the date of the financial statements: . . .
b. A deferred tax liability or asset shall be recognized for the estimated future tax effects
attributable to temporary differences and carryforwards. [Emphasis added]

Further, ASC 740-10-55-24 states:

Deferred tax liabilities and assets are measured using enacted tax rates applicable to capital gains, ordinary
income, and so forth, based on the expected type of taxable or deductible amounts in future years. For
example, evidence based on all facts and circumstances should determine whether an investor’s liability for
the tax consequences of temporary differences related to its equity in the earnings of an investee should be
measured using enacted tax rates applicable to a capital gain or a dividend. Computation of a deferred tax
liability for undistributed earnings based on dividends should also reflect any related dividends
received deductions or foreign tax credits, and taxes that would be withheld from the dividend.
[Emphasis added]

Under the parent jurisdiction view, a parent would apply ASC 740-10-55-24 by considering the
withholding tax as a tax that the parent would incur upon the reversal of a U.S. jurisdiction taxable
temporary difference that is attributable to unremitted earnings.

In the case of a disregarded entity, since (1) no outside basis difference exists (because the foreign
entity is viewed as a division of the parent as a result of the U.S. check-the-box election) and (2) the
earnings of the foreign disregarded entity are taxed in the parent’s jurisdiction as they are generated,
there is generally no taxable temporary difference related to the net assets of the disregarded entity
(i.e., the net assets that arose on account of unremitted earnings have a tax basis since the income of
the disregarded entity was recognized for U.S. tax purposes as earned). In the absence of a U.S. taxable
temporary difference for which a DTL can be recognized, a DTL cannot be recognized for the future
withholding tax. Under this view, the withholding tax would be recognized in the period in which the
actual withholding tax arises (as a current tax expense).

Similarly, a regarded foreign subsidiary would be unable to recognize a DTL when (1) all of its unremitted
earnings have already been taxed by the United States (e.g., 100 percent of the unremitted earnings
were taxable as Subpart F income or GILTI in such a way that the financial reporting carrying amount
and the tax basis are equal) or (2) CTA losses have reduced the financial reporting carrying value without
a corresponding reduction in its tax basis. Without a U.S. taxable temporary difference, the requirement
under ASC 740-10-55-24 for an entity to consider withholding taxes (when recording a DTL for a basis
difference related to unremitted earnings expected to be reduced by remittances) would appear not to
be applicable.

However, if an outside basis difference does exist in the parent’s investment in the foreign subsidiary,
the parent would apply ASC 740-10-55-24 when measuring the DTL to be recognized (i.e., it would
include a DTL for the withholding tax).

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3.4.13.2 View 2 — Foreign Jurisdiction Perspective

ASC 740-10-30-5 states, in part:

Deferred taxes shall be determined separately for each tax-paying component (an individual entity or group of
entities that is consolidated for tax purposes) in each tax jurisdiction.

Accordingly, from the perspective of the local jurisdiction (i.e., the disregarded entity or subsidiary), two
separate and distinct taxpayers exist: (1) the distributing entity (which is generally viewed as a taxable
legal entity in the local jurisdiction) and (2) the parent. Under the foreign jurisdiction view, the local
jurisdiction taxes the distributing entity on its earnings as they occur, and it taxes the parent entity
only when those “already net of tax” earnings are distributed. An entity that applies this view evaluates
each jurisdiction and considers the perspective of the jurisdiction that is actually taxing the recipient
(i.e., the local jurisdiction imposing the withholding tax) when determining whether the parent has a
taxable temporary difference. From the perspective of the local jurisdiction, the parent has a financial
reporting carrying amount in its investment in the distributing entity that is greater than its local tax
basis (i.e., from the perspective of the local jurisdiction, the entities have a “parent-corporate subsidiary”
relationship since the election to disregard the entity is applicable only in the parent’s jurisdiction and
is not relevant in the local jurisdiction). Therefore, from a local jurisdiction perspective, an “outside”
taxable temporary difference equal to the amount of such unremitted earnings that would be subject to
withholding tax exists and, in accordance with ASC 740-10-55-24, the measurement of the DTL should
reflect withholding taxes to be incurred when that taxable temporary difference reverses.

Under this view, even in the case of a disregarded entity, the indefinite reversal criteria would be
considered and, if the reversal of the taxable temporary difference is not foreseeable, no deferred taxes
should be recognized.

3.4.13.3 Determining the Income Tax Effects of Distributions of Previously Taxed

Earnings and Profits in a Single-Tier or Multi-Tier Legal Entity Structure
In some cases, a remittance of foreign earnings to the parent may trigger tax consequences in multiple
jurisdictions. For example, a U.S. parent may have an investment in a foreign subsidiary that has
unremitted earnings that, upon remittance, may give rise to a withholding tax in the foreign jurisdiction
(a DTL) and an FTC or deduction for the withholding taxes in the U.S. parent’s federal jurisdiction (a DTA).
In addition, a consolidated group may have a multi-tiered structure that includes intermediate legal
entities or “HoldCos” in between a parent and its foreign subsidiaries.

In these instances, questions generally arise about how to measure the deferred taxes related to a
distribution. We believe that if a company’s policy prohibits disaggregation of the U.S. parent’s outside
basis in the investee into multiple components to book a DTA or DTL (see Section 3.4.13), two different
approaches can be used to measure (1) the withholding tax liability at the foreign subsidiary level and
(2) the corresponding foreign tax deduction or credit at the U.S. parent level.

One approach is to consider the various tax consequences of a distribution, regardless of jurisdiction.
This view is consistent with the guidance in ASC 740-10-55-24, which states that the computation of a
deferred tax liability for undistributed earnings should also reflect any dividends received deductions
or FTCs as well as taxes that would be withheld from the distribution. Under this approach, an entity
aggregates all tax consequences of the distribution, regardless of the jurisdiction in which they are
recognized, when assessing whether there is an overall DTA or DTL with respect to the U.S. parent’s
outside basis difference (i.e., whether there is an overall net DTL to record). In situations in which the
U.S. parent has a taxable outside basis difference with respect to its investment in the foreign subsidiary,

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and there is an overall DTL, the tax impact would be recorded (for single-tier entities).10 While there
would be an added level of complexity for multi-tier entities, we believe that this view would still be
acceptable if the U.S. parent can represent that such earnings will move all the way “up the chain” (i.e.,
from the second-tier subsidiary, to the HoldCos in between, to the U.S. parent) in the same period so
that the U.S. parent cannot be left with a “naked” DTA (e.g., a DTA for an unborn FTC) related to an
overall taxable outside basis temporary difference in its investment in HoldCo as of the end of the year.

A second approach would be to consider the tax consequences of the distribution on a jurisdiction-
by-jurisdiction basis. Under this approach, a foreign tax deduction or credit would not be considered
as part of the measurement of the withholding tax liability because they exist in different jurisdictions.
Rather, in the case of withholding tax obligations at a second-tier or lower foreign subsidiary
jurisdiction, a foreign tax deduction or credit could only be recorded if the U.S. parent, in fact, had a
deductible temporary difference in its investments in the first-tier foreign subsidiary11 or, in the case
of a withholding tax obligation at a first-tier foreign subsidiary jurisdiction, if the foreign tax deduction
or credit is a direct consequence of the withholding tax liability itself (e.g., the “state/federal” effect in a
single-tier entity).

3.4.14 Withholding Taxes — Foreign Currency Considerations

While foreign withholding taxes are generally considered a liability of the investor rather than the
investee (i.e., are attributable to the investor’s outside basis difference), such taxes will ultimately be
payable to the foreign government in local currency and, provided that the investor’s functional currency
is different from the investee’s local currency, represent foreign-currency-denominated liabilities of the
investor.

When the investor is a U.S. entity, the amount of a non-USD-denominated, foreign withholding tax
liability will change as a result of fluctuations in the corresponding exchange rate between the U.S.
parent (i.e., the USD) and the applicable local currency of the first-tier foreign subsidiary. Because the
U.S. parent is the primary obligor, such a liability is not recorded by the first-tier foreign subsidiary and
is therefore not subject to translation. Accordingly, the impact of fluctuations between the reporting
currency of the U.S. parent and the functional currency of the first-tier foreign subsidiary should be
recorded through continuing operations of the U.S. parent as the related liability is remeasured in each
reporting period in accordance with ASC 830-20.

Questions have arisen related to how a first-tier foreign subsidiary (or foreign corporate joint venture
that is essentially permanent in duration) should account for fluctuations in the value of a foreign
withholding tax liability related to earnings of a second-tier foreign subsidiary (or foreign corporate joint
venture that is essentially permanent in duration) (the “second-tier foreign subsidiary”) that are not
indefinitely reinvested when the first-tier foreign subsidiary has the same local and functional currency
as that of the second-tier foreign subsidiary, which is not the reporting currency.

Because the withholding tax liability is denominated in the same currency as the first-tier foreign
subsidiary’s functional currency, the amount of the withholding tax liability on the functional currency
books of the first-tier foreign subsidiary will not change as a result of exchange rate fluctuations.
Accordingly, the related liability would not be remeasured in each reporting period, and the first-tier
foreign subsidiary would not record transaction gain or loss in accordance with ASC 830-20. However,
because the first-tier foreign subsidiary is the primary obligor, such a liability is recorded by the first-tier
foreign subsidiary and is therefore subject to translation. Accordingly, the impact of fluctuations between

10
Presentation of the component parts would still be disaggregated (i.e., a DTA in the United States would not be net on the balance sheet against a
foreign withholding tax DTL).
11
In the case of an unborn FTC, the U.S. parent would also need to represent that the associated earnings will move all the way “up the chain” in a
manner similar to the example above.

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the reporting currency of the U.S. parent and the functional currency of the first-tier foreign subsidiary
should be recorded as a CTA through other comprehensive income (OCI).

If the first-tier foreign subsidiary has a functional currency that is different from (1) the local currency of
the second-tier foreign subsidiary or (2) the reporting currency, the reporting entity needs to account for
the fluctuations in the value of a foreign withholding tax liability related to the earnings of a second-tier
foreign subsidiary. The amount of a foreign withholding tax liability denominated in the local currency of
the second-tier foreign subsidiary will change as a result of fluctuations in the corresponding exchange
rate between the applicable local currencies of the first-tier foreign subsidiary and the second-tier
foreign subsidiary. Accordingly, the impact of fluctuations between the functional currencies of the first-
tier foreign subsidiary and the second-tier foreign subsidiary should be recorded through continuing
operations of the first-tier foreign subsidiary as the related liability is remeasured in each reporting
period in accordance with ASC 830-20. In addition, because the first-tier foreign subsidiary is the
primary obligor, such a liability is recorded by the first-tier foreign subsidiary and is therefore subject to
translation. Accordingly, the impact of fluctuations between the reporting currency of the parent and the
functional currency of the first-tier foreign subsidiary should be recorded as a CTA through OCI.

3.4.15 Tax Consequences of Investments in Pass-Through or Flow-Through

Entities
740-30-25 (Q&A 06)
Generally, “pass-through” or “flow-through” entities (e.g., partnerships and LLCs that have not elected
to be taxed as corporations) are not taxable. Rather, the earnings of such entities pass through or
flow through to the entities’ owners and are therefore reported by the owners in accordance with the
governing tax laws and regulations. See ASC 740-10-55-226 through 55-228 for examples illustrating
when income taxes are attributed to a pass-through entity or its owners.

Further, while ASC 740 does provide for certain exceptions to the recognition of deferred taxes for basis
differences related to investments in certain subsidiaries, those exceptions historically have not been
applied to pass-through or flow-through entities since those types of entities were not subsidiaries as
defined before the issuance of ASU 2010-08. Rather, at the time FASB Statement 109 (codified in ASC
740) was issued, APB Opinion 18 (codified in ASC 323) defined a subsidiary as “a corporation which is
controlled, directly or indirectly, by another corporation.”

An investor in a pass-through or flow-through entity should determine the deferred tax consequences of
its investment. Because pass-through or flow-through entities are not subject to tax, an investor should
not recognize deferred taxes on the book and tax basis differences associated with the underlying
assets and liabilities of the entity (i.e., “inside basis differences”) regardless of how the investor accounts
for its interest in the entity (e.g., consolidation, equity method, or cost method12). Rather, because any
taxable income or tax losses resulting from the recovery of the financial reporting carrying amount of
the investment will be recognized and reported by the investor, the investor’s temporary difference
should be determined by reference to the investor’s tax basis in the investment itself.

Often, this outside basis difference will fully reverse as the underlying assets and liabilities are recovered
and settled, respectively. However, differences can exist between the investor’s share of inside tax
basis and the investor’s outside tax basis in the investment, leading to a temporary difference that
will generally not reverse as a result of the operations of the entity (a “residual” temporary difference).
Nonetheless, because that residual temporary difference will still ultimately be recognized as additional
taxable income or loss upon the dissolution of the partnership (if the dissolution is taxable) or will
be attached to the assets distributed in liquidation of the investor’s interest (if the dissolution is
12
With certain exceptions, ASU 2016-01 eliminated the cost method. Exceptions include (1) QAHPs that are not eligible for the equity method and
elect not to use the proportional amortization method and (2) investments in Federal Home Loan Bank and Federal Reserve Bank stock issued to
member financial institutions.

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nontaxable), the recognition of deferred taxes related to an investment in a pass-through or flow-

through entity should always take into account (and reconcile back to) the entirety of the outside basis
difference.

Two acceptable approaches have developed in practice for measuring the DTA or DTL to be recognized
for an outside basis difference related to an investor’s investment in a consolidated pass-through or
flow-through entity: (1) the outside basis approach and (2) the look-through approach.

Under the outside basis approach, measurement of the DTA or DTL is based on the entirety of the
investor’s outside basis difference in the pass-through or flow-through entity investment without regard
to any of the underlying assets or liabilities. While it is easy to perform this computation, application of
the outside basis approach can result in certain additional practice issues. For example, an outside basis
difference would generally be considered capital in character under a “pure” outside basis approach
because such an approach assumes that (1) the investment will be recovered when it is disposed of in
its entirety and (2) the interest in a pass-through or flow-through entity is capital in nature. However, as
discussed above, the recovery and settlement of the pass-through or flow-through entity’s individual
assets and liabilities through normal operations of the entity will result in (1) reversal of the temporary
difference before the investor disposes of the investment, (2) the pass-through of income or loss to the
owner that is ordinary rather than capital in character, or (3) both. Among other things, the assumed
timing of reversal and the character of the resulting income or loss may have an effect on the investor’s
conclusions about the tax rate to be applied to the temporary difference and whether a valuation
allowance against the investor’s DTAs is needed. Accordingly, for the reasons noted above, even those
investors applying an outside basis approach for measurement should generally consider the recovery
and settlement of the pass-through or flow-through entity’s underlying assets and liabilities, respectively,
when assessing character and scheduling.

Under the look-through approach, the investor would “look through” and notionally match up its
outside temporary difference with its share of inside temporary differences for purposes of (1) applying
ASC 740’s exceptions to deferred tax accounting and (2) determining the character (capital versus
ordinary) and resulting reversal patterns used for assessing the applicable tax rate or realizability of
DTAs. Only the residual difference (if any) would take its character and reversal pattern exclusively from
the investment itself. For example, under this approach, the portion of the investor’s outside basis
temporary difference that is notionally attributed to “inside” nondeductible goodwill or the pass-through
entity’s own investment in a foreign corporate subsidiary (with unremitted earnings that are indefinitely
reinvested) would be identified and the applicable exception in ASC 740 would be applied (i.e., no DTL
would be recorded for that portion of the investor’s outside basis temporary difference).

The look-through approach recognizes that because the pass-through or flow-through entity is
consolidated, (1) the assets and liabilities of the pass-through or flow-through entity are actually being
reported by the investor in the investor’s financial statements and (2) the investor is the actual taxpayer
when the pass-through or flow-through entity’s underlying assets and liabilities are recovered and
settled, respectively. Accordingly, measuring the outside basis difference under the look-through
approach results in the recognition of deferred taxes in a manner consistent with the characteristics of
the underlying assets and liabilities that will be individually recovered and settled, respectively.

When the look-through approach is applied, however, any residual difference between the total of
the investor’s share of the pass-through or flow-through entity’s inside tax basis and the investor’s
outside tax basis related to the investment would still need to be taken into account. As noted above,
while this component of the outside basis difference often would not become taxable or deductible
until sale or liquidation of the entity, a DTA or DTL would generally be recorded because there is no
available exception to apply. In some instances, however, it may be appropriate to apply, by analogy, the

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exception to recognizing a DTA in ASC 740-30-25-9. While it is more difficult to perform computations
under the look-through approach than under the outside basis approach, application of the look-
through approach can potentially alleviate some of the aforementioned practice issues regarding
character and scheduling that result from applying the outside basis approach.

The approach selected to measure the deferred tax consequences of an investment in a pass-through
or flow-through entity would be considered an accounting policy that should be consistently applied to
all similar investments. In addition, given the complexities associated with applying either alternative,
consultation with appropriate accounting advisers is encouraged in these situations.

3.4.16 Accounting for the Tax Effects of Contributions to Pass-Through

Entities in Control-to-Control Transactions
740-20-45 (Q&A 37)
ASC 810-10-45-22 provides examples of transactions in which a parent’s ownership in a subsidiary
changes but the parent retains control of the subsidiary. Specifically:

• A “parent purchases additional ownership interests in its subsidiary.”

• A “parent sells some of its ownership interests in its subsidiary.”
• A “subsidiary reacquires some of its ownership interests” held by a nonaffiliated entity.
• A “subsidiary issues additional ownership interests” to a nonaffiliated entity.
When the parent maintains control over the subsidiary, the parent accounts for changes in its ownership
interest as equity transactions. See Section 12.2.1.

When there are subsequent contributions by either the controlling interest or the noncontrolling
interest to the pass-through entity, recognition of a gain or loss in equity by the controlling shareholder
will typically create an additional basis difference that will need to be addressed (i.e., the controlling
interest’s basis for financial and income tax reporting purposes may change by different amounts).
Further, under the look-through approach, additional complexities can arise because of the applicable
income tax regulations governing the allocation to partners of items of income, gain, loss, or deduction
for U.S. tax purposes.13 For example, such transactions can often result in residual outside basis
differences (i.e., the investor’s outside tax basis will not equal its share of the inside tax basis) that
will usually not be deductible or taxable until a sale or taxable liquidation of the partnership (e.g.,
distribution of cash following a sale of the partnership’s assets).

Typically, an investor accounts for changes in the measurement of deferred taxes on its investment in
a pass-through entity that result from a control-to-control transaction in equity in accordance with the
intraperiod tax allocation guidance in ASC 740-20-45-11. If the investor uses the look-through approach
in measuring deferred taxes on its investment in the pass-through entity, such changes would include
the impact of any residual outside basis difference. If the residual outside basis difference represents
future deductible amounts, the investor must consider its policy on applying ASC 740-30-25-9, by
analogy, to its investment in the pass-through entity. See Section 3.4.16 for additional discussion.

13
Treasury regulations promulgated under IRC Section 704(c) account for the difference between the fair value and the adjusted tax basis in
property at the time they are contributed to the partnership. In addition, such regulations can result in adjustments in certain other situations,
including when the fair value of property owned by the partnership is in excess of its adjusted tax basis at the time of a contribution to the
partnership.

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Example 3-26

On January 1, 20X9, Company A contributes a recently acquired business (net assets including cash, subject to
debt) with a fair value and financial reporting and income tax bases of $20 million to Partnership P for an 80
percent interest in P, and Company B contributes cash of $5 million for a 20 percent interest in P. Partnership
P is a pass-through entity and is not subject to income taxes in any jurisdiction in which it operates. Company
A uses the look-through approach in measuring deferred taxes with respect to investments in consolidated
pass-through entities. At the time of the contribution, A’s outside basis for financial and income tax reporting
purposes are $20 million and $20 million, respectively. Company B’s and A’s share of inside bases held by the
investment upon formation were as follows:

Total B’s Basis A’s Basis

Book Tax Book Tax Book Tax Difference

Cash 10.0 10.0 2.0 2.0 8.0 8.0 —

PP&E 10.0 10.0 2.0 2.0 8.0 8.0 —

Intangibles 15.0 15.0 3.0 3.0 12.0 12.0 —

Liabilities (10.0) (10.0) (2.0) (2.0) (8.0) (8.0) —

Total 25.0 25.0 5.0 5.0 20.0 20.0 —

During 20X9, P generates $12.5 million of income through normal operations for both financial and income
tax reporting purposes and makes no distributions. Company A’s outside basis for financial and income tax
reporting purposes are $30 million and $30 million, respectively. Company B’s and A’s share of inside bases
held by the investment are as follows:

Total B’s Basis A’s Basis

Book Tax Book Tax Book Tax Difference

Cash 27.5 27.5 5.5 5.5 22.0 22.0 —

PP&E 8.0 8.0 1.6 1.6 6.4 6.4 —

Intangibles 12.0 12.0 2.4 2.4 9.6 9.6 —

Liabilities (10.0) (10.0) (2.0) (2.0) (8.0) (8.0) —

Total 37.5 37.5 7.5 7.5 30.0 30.0 —

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Example 3-26 (continued)

As of December 31, 20X9, P has appreciated in value to $80 million; assume such appreciation is attributable
entirely to P’s goodwill. Further assume that on December 31, 20X9, B contributes an additional $20 million to
P. The contribution decreases A’s ownership to 64 percent,14 which results in A’s having a financial reporting
basis of $36.8 million15 in its investment in P. As a result of the contribution, A must recognize a control-to-
control gain of $6.8 million ($36.8 million – $30 million) for financial statement reporting purposes; essentially
A transitions from owning 80 percent of P’s $37.5 million net book value16 to owning 64 percent of P’s $57.5
million net book value after the contribution.

Immediately after the $20 million contribution by the noncontrolling interest holders, B’s and A’s shares of
inside bases held by the investment would be as follows:

Total B’s Basis A’s Basis

Book Tax Book Tax Book Tax Difference

Cash 47.5 47.5 17.1 17.1 30.4 30.4 —

PP&E 8.0 8.0 2.9 2.9 5.1 5.1 —

Intangibles 12.0 12.0 4.3 4.3 7.7 7.7 —

Goodwill* — — — 6.8 — (6.8) 6.8

Liabilities (10.0) (10.0) (3.6) (3.6) (6.4) (6.4) —

Total 57.5 57.5 20.7 27.5 36.8 30.0 6.8

* Would represent notional future income allocable to A if the remedial allocation method is applicable.

However, the contribution does not affect A’s tax basis in its investment in P, which creates a taxable temporary
difference of $6.8 million and a DTL of $1.7 million. In this case, the allocation method chosen in accordance
with the applicable income tax regulations will affect only whether the $6.8 million becomes taxable over time
through certain partnership allocations17 or not until the ultimate sale or taxable liquidation of the partnership;
in either case, a DTL is required.

Assume a 25 percent tax rate. Company A will make the following consolidated journal entry to recognize the
contribution made by the noncontrolling interest holders:

Cash 20,000,000
Additional paid-in capital (APIC) 5,100,000
Noncontrolling interest 13,200,000
DTL 1,700,000

14
(80 percent × $80 million [fair value of the company]) ÷ ($80 million [fair value of the company] + $20 million contribution) = 64 percent.
15
($37.5 million + $20 million) × 64 percent = $36.8 million.
16
$25 million (initial GAAP basis) + $12.5 million (20X9 income) = $37.5 million.
17
IRC Section 704(c), as noted in footnote 13, applies to reverse IRC Section 704(c) layers created as a result of a revaluation. Upon the contribution
of $20 million by B, the partners revalued the partnership property. Under IRC Section 704(c), use of the “remedial method” will generally result in
the $6.8 million’s becoming taxable over time, whereas use of the “traditional method” will generally result in the $6.8 million’s becoming taxable
upon the ultimate sale or taxable liquidation of the partnership since the goodwill has no tax basis in the hands of the partnership.

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Example 3-27

Assume the same facts as in Example 3-26 except that on December 31, 20X9, Company A (not B) contributes
an additional $20 million to Partnership P. The contribution increases A’s ownership to 84 percent.18 As a
result of the contribution, A must recognize a control-to-control loss of $1.7 million (A has paid a $1.7 million
premium above book value to acquire the additional interest); essentially A transitions from owning 80
percent of P’s $37.5 million net book value19 to owning 84 percent of P’s $57.5 million net book value after
the contribution. Company A’s basis in P for financial reporting purposes increases by $18.3 million; however,
its basis for income tax reporting purposes increases by the entire $20 million contribution, resulting in a
deductible temporary difference of $1.7 million.

Because there is a difference between the fair value and adjusted tax basis of the property owned by the
partnership at the time of A’s additional contribution, consideration needs to be given to whether, as a
matter of tax law, A will be allocated deductions equal to the fair value of its contribution of $20 million. If the
partnership’s allocation method (the remedial method in this case since the goodwill has no tax basis in the
hands of the partnership) under the applicable income tax regulations will allocate such deductions to A, A
should record a DTA for the deductible temporary difference given that such a difference will close through
normal business operations. Company A’s outside book and tax basis are $48.3 million and $50 million,
respectively. Company B’s and A’s share of inside bases held by the investment would be as follows:

Total B’s Basis A’s Basis

Book Tax Book Tax Book Tax Difference

Cash 47.5 47.5 7.6 7.6 39.9 39.9 —

PP&E 8.0 8.0 1.3 1.3 6.7 6.7 —

Intangibles 12.0 12.0 1.9 1.9 10.1 10.1 —

Goodwill* — — — (1.7) — 1.7 (1.7)

Liabilities (10.0) (10.0) (1.6) (1.6) (8.4) (8.4) —

Total 57.5 57.5 9.2 7.5 48.3 50.0 (1.7)

* Represents notional future income allocable to B in accordance with the remedial allocation method.

Assume a 25 percent tax rate. The resulting entry to record the control-to-control loss in equity would be as
follows:

DTA 425,000
APIC 1,275,000
Noncontrolling interest 1,700,000

18
(80 percent × $80 million [fair value of the company]) + $20 million contribution ÷ ($80 million [fair value of the company] + $20 million
contribution) = 84 percent.
19
$25 million (initial GAAP basis) + $12.5 million (20X9 income) = $37.5 million.

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Example 3-27 (continued)

If the partnership’s allocation method will not allocate A deductions equal to its $20 million contribution (i.e.,
the “traditional method” in this case since the goodwill has no tax basis in the hands of the partnership), such
a deductible temporary difference will reverse only upon P’s sale or taxable liquidation. Company A should
consider the application of ASC 740-30-25-9, by analogy, to such a residual temporary difference. A summary of
A’s outside basis and related look-through temporary differences in its investment in such a case would be as
follows:

Total B’s Basis A’s Basis

Book Tax Book Tax Book Tax Difference

Cash 47.5 47.5 7.6 7.6 39.9 39.9 —

PP&E 8.0 8.0 1.3 1.3 6.7 6.7 —

Intangibles 12.0 12.0 1.9 1.9 10.1 10.1 —

Liabilities (10.0) (10.0) (1.6) (1.6) (8.4) (8.4) —

Residual 1.7 (1.7)

Total 57.5 57.5 9.2 9.2 48.3 50.0 (1.7)

If A applied ASC 740-30-25-9 by analogy, A would record the entry for the control-to-control loss as follows:

APIC 1,700,000
Noncontrolling interest 1,700,000

3.4.17 Other Considerations
3.4.17.1 Consideration of the VIE Model in ASC 810-10 in the Evaluation of
Whether to Recognize a DTL
740-30-25 (Q&A 15)
For VIEs, an analysis of voting rights may not be effective in the determination of control. Under the VIE
model in ASC 810-10, a reporting entity could be determined to have a controlling financial interest in
a VIE, and thus consolidate the VIE, if the reporting entity has (1) the power to direct the activities that
most significantly affect the VIE’s economic performance and (2) the obligation to absorb losses of (or
right to receive benefits from) the VIE that could potentially be significant to the VIE. A reporting entity
that consolidates a VIE is known as the primary beneficiary.

When accounting for a VIE under ASC 740, the reporting entity must consider both inside and outside
basis differences.

When determining whether an exception to recording an outside basis difference applies to the
primary beneficiary’s investment in a VIE, the reporting entity should carefully consider the facts
and circumstances. The primary beneficiary should not assume that its controlling financial interest
(through which it has the power to direct the activities that most significantly affect the VIE’s economic
performance) also gives it the power to direct all of the activities of the VIE that are relevant to the
determination of whether an exception to recording an outside basis difference is applicable (e.g.,
when and if the VIE will distribute earnings, the manner in which the primary beneficiary will recover
its investment, and so forth). Provided that the criteria for an exception are met, a primary beneficiary

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of a VIE may apply the outside basis exceptions.20 However, meeting some of these exceptions may be
challenging. When determining which party has the power to control decisions regarding the distribution
of earnings, for example, an entity should consider how the VIE is controlled (i.e., through contract or
governing documents rather than voting interests) and the rights of other parties to the arrangement.

3.4.17.2 Recognition of a DTA or DTL Related to a Subsidiary Classified as a

Discontinued Operation
740-30-25 (Q&A 10)
ASC 740-30-25-9 states that “[a] deferred tax asset shall be recognized for an excess of the tax basis
over the amount for financial reporting of an investment in a subsidiary or corporate joint venture that
is essentially permanent in duration only if it is apparent that the temporary difference will reverse in
the foreseeable future.” This criterion (i.e., a reversal of a temporary difference in the foreseeable future)
would be met no later than when the “held-for-sale” criteria in ASC 360-10-45-9 are met. The same
criterion should apply to the recognition of a DTL related to an excess of financial reporting basis over
outside tax basis of an investment in a subsidiary. In other words, the deferred tax consequences of
temporary differences related to investments in foreign subsidiaries that were not previously recognized
as a result of application of the exception in ASC 740-30-25-18(a) should be recognized when it becomes
apparent that the temporary difference will reverse in the foreseeable future.

Similarly, the potential tax consequences of basis differences related to investments in domestic
subsidiaries that were not previously recognized because (1) the tax law provides a means to recover
the reported amount of the investment in a tax-free manner, and (2) the entity had previously expected
that it would ultimately use those means, should be accrued when it becomes apparent that the reversal
of those basis differences will have a future tax consequence.

The tax effects of the recognition of DTAs and DTLs for preexisting outside basis differences when
an investee meets the criteria to be classified as held for sale generally will give rise to an “out-of-
period” adjustment in the current period (see Section 6.2.5 for further information on out-of-period
adjustments and Section 6.2.5.1 for guidance on the intraperiod allocation of such adjustments
resulting from the recognition of an outside basis difference associated with a subsidiary classified as a
discontinued operation).

Note that if the unrecognized outside basis difference DTL will close through a GILTI inclusion, entities
that have elected to treat GILTI as a current-period expense, as discussed in Section 3.4.10.1, would
recognize the tax expense in the period in which the tax is incurred. In other words, recognition of the
tax expense may not coincide with the held-for-sale date, as described above.

20
While the exception in ASC 740-30-25-7 refers to a “more-than-50-percent-owned domestic subsidiary,” the exception was written at a time when
the usual condition for control was ownership of a majority (over 50 percent) of the outstanding voting stock. Accordingly, we believe that an entity
is not automatically prohibited from applying that exception simply because it owns less than 50 percent of the VIE.

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3.4.17.3 State Tax Considerations

740-30-25 (Q&A 13)
In recognizing outside basis differences associated with various investments, entities should pay close
attention to certain state tax considerations. ASC 740-30-25-7 and 25-8 provide guidance on assessing
whether the outside basis difference of an investment in a domestic subsidiary is a taxable difference.
This assessment should be performed on a jurisdiction-by-jurisdiction basis. Accordingly, the outside
basis difference of an investment in a domestic subsidiary that is not a taxable difference for federal
purposes would also need to be assessed at the state level.

An entity should consider the following factors in applying the guidance in ASC 740-30-25-7 and 25-8 at
the state level:

• Whether tax-free liquidation is permitted in the applicable state jurisdictions. See Section 3.4.3
for further discussion of tax-free liquidations.

• Whether the parent files a separate, combined, or consolidated return in the state jurisdiction
and whether intra-entity transactions (e.g., dividends) are eliminated when subsidiaries are
combined or consolidated in that state return.

• Whether a dividends received deduction is available in the state jurisdiction or whether

federal taxable income is used as the starting point for the state tax liability calculation and is
unadjusted for dividends received deductions taken on the federal return. A dividends received
deduction is a deduction on an income tax return for dividends paid from a subsidiary to a
parent.

See Section 3.3.4.6 for a discussion of further considerations related to certain state matters, including
optional future tax elections in the measurement of DTAs and DTLs.

Example 3-28

Subsidiary B, a 90 percent owned subsidiary of Entity A, operates in only one state (State C), which does
not permit a tax-free liquidation in accordance with ASC 740-30-25-7. Entity A is taxable in C. Subsidiary B
is consolidated in A’s federal return. The only outside basis difference in B relates to $1,000 of unremitted
earnings, which A expects to be remitted as dividends. For federal income tax purposes, since A holds more
than 80 percent of B, A can deduct 100 percent of the dividends it receives from B (i.e., the dividends received
deduction). State C does not adjust federal taxable income for the dividends received deduction. In this
example, the unremitted earnings of B to A would not create a temporary difference on which A should record
a DTL.

Example 3-29

Assume the same facts as in Example 3-28 above except that State C adjusts federal income for the dividends
received deduction. For federal purposes, Entity A can still deduct 100 percent of the dividends it receives from
Subsidiary B; thus, no temporary difference exists for federal tax purposes. However, because C adjusts federal
income for the dividends received deduction, a temporary difference exists for state income tax purposes on
which A should record a DTL because state tax law does not provide a means by which the reported amount of
the investment can be recovered tax free.

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3.5 Other Considerations and Exceptions

There are other exceptions and special situations that result in additional considerations when an entity
is determining the appropriate amounts of DTAs and DTLs to present in the financial statements. See
Section 3.4 for a discussion of exceptions to recording deferred taxes for outside basis differences.

3.5.1 Changes in Tax Laws and Rates

ASC 740-10

25-47 The effect of a change in tax laws or rates shall be recognized at the date of enactment.

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.

Under ASC 740-10-25-47 and ASC 740-10-35-4, the effect of a change in tax laws or rates on DTAs and
DTLs should be recognized on the date of enactment of the change. A change in tax rate may affect
the measurement of DTAs and DTLs. Those DTAs and DTLs that exist as of the enactment date and are
expected to reverse after the effective date of the change in tax rate should be adjusted on the basis of
the new statutory tax rate. Any DTAs and DTLs expected to reverse before the effective date should not
be adjusted to the new statutory tax rate.

To determine the DTAs and DTLs that exist as of the enactment date, a reporting entity should calculate
temporary differences by comparing the relevant book and tax basis amounts as of the enactment date.
To determine book basis amounts as of the enactment date, the reporting entity should apply U.S. GAAP
on a year-to-date (YTD) basis up to the enactment date. For example:

• Any book basis accounts that must be remeasured at fair value under U.S. GAAP would be
adjusted to fair value as of the enactment date (e.g., certain investments in securities or
derivative assets or liabilities).

• Book balances that are subject to depreciation or amortization would be adjusted to reflect
current period-to-date depreciation or amortization up to the enactment date.

• Book basis account balances such as pension and other postretirement assets and obligations
for which remeasurement is required as of a particular date (and for which no events have
occurred that otherwise would require an interim remeasurement) would not be remeasured
as of the enactment date if the enactment date does not coincide with the remeasurement date
of the account balances (i.e., no separate valuation of the benefit obligation is required as of the
enactment date) for purposes of adjusting the temporary difference that will be measured to the
new statutory tax rate as of the enactment date. For example, assume a calendar-year reporting
entity has a pension plan with an annual measurement date of December 31 and a tax law
change is enacted on December 22. The entity would adjust its balance sheet accounts for the
effects of current-year net periodic pension cost and other contribution and benefit payment
activity through the date of enactment but not for the impact of the remeasurement of pension
plan assets and liabilities.

• Any book basis balances associated with share-based payment awards that are classified as
liabilities would be remeasured (on the basis of fair value, calculated value, or intrinsic value, as
applicable) as of the enactment date. In addition, for those share-based payment awards that
ordinarily would result in future tax deductions, compensation cost would be determined on the
basis of the YTD requisite service rendered up to the enactment date.

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3.5.1.1 Retroactive Changes in Tax Laws or Rates and Expiring Provisions That

May Be Reenacted
740-10-25 (Q&A 46)
If retroactive tax legislation is enacted, the effects are recognized as a component of income tax expense
or benefit from continuing operations in the financial statements for the interim or annual period that
includes the enactment date. The FASB reached this conclusion because it believes that the event to be
recognized is the enactment of new legislation. Therefore, the appropriate period in which to recognize
the retroactive provisions of a new law is the period of enactment.

Further, entities should not anticipate the reenactment of a tax law or rate that is set to expire or
has expired. Rather, under ASC 740-10-30-2, an entity should consider the currently enacted tax law,
including the effects of any expiration, in calculating DTAs and DTLs.

If the provision is subsequently reenacted, the entity would look to ASC 740-10-25-47 and measure the
effect of the change as of the date of reenactment.

3.5.1.2 Enacted Changes in Tax Laws or Rates That Affect Items Recognized in

Equity
740-10-25 (Q&A 47)
Changes in tax law may also affect DTAs and DTLs attributable to items recognized in equity, including
(1) foreign currency translation adjustments under ASC 830, (2) actuarial gains and losses and prior
service cost or credit recognized under ASC 715, (3) unrealized holding gains and losses on certain
available-for-sale (AFS) debt securities under the investment guidance in ASC 320, (4) tax benefits
recognized in a taxable business combination accounted for as a common-control merger, and
(5) certain tax benefits recognized after a quasi-reorganization.

The FASB concluded that the effect of changes in tax law related to items recorded directly in
shareholders’ equity must always be recorded in continuing operations in the period of enactment (see
Chapter 6 for intraperiod allocation guidance). This requirement could produce unusual relationships
between pretax income from continuing operations and income tax expense or benefit, as illustrated in
Example 3-30.

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Example 3-30

Assume the following:

• An entity’s only temporary difference at the end of years 20X2 and 20X3 is the foreign currency
translation adjustment of $500, which arose in year 20X1 and resulted in the recording of a $105 DTL.
• The applicable tax rate at the end of 20X1 and 20X2 is 21 percent. A tax law change is enacted at the
beginning of year 20X3 that changes the applicable tax rate to 25 percent.
• The following tables show the income statements for 20X2 and 20X3 and the balance sheets at the end
of 20X2 and 20X3:

Income Statement (Select

Accounts) 20X2 20X3

Pretax income from continuing

operations $ 1,000 $ 1,000

Income tax expense

Current 210 250

Deferred — 20

Total 210 270

Net income $ 790 $ 730

ETR 21% 27%

December 31

Balance Sheet (Select Accounts) 20X2 20X3

DTL $ 105 $ 125

Equity CTA 500 500

Deferred tax thereon (105) (105)

Net balance $ 395 $ 395

The following is an analysis of the facts in this example:

• Changes in tax laws affect the DTAs and DTLs of items originally recorded directly in shareholders’ equity.
The effect of the change is recognized as an increase or decrease to a DTL or DTA and a corresponding
increase or decrease in income tax expense or benefit from continuing operations in the period of
enactment.
• Tax law changes can significantly affect an entity’s ETR because the effect of the change is computed on
the basis of all cumulative temporary differences and carryforwards on the measurement date. In this
case, the 4 percent tax rate increase related to the CTA amounts to $20 and is reflected as deferred tax
expense in 20X3.
• After a tax rate change, the tax consequence previously recorded in shareholders’ equity no longer
“trues up” given the current tax rate (i.e., because the tax effects are reversed at 25 percent after being
initially recorded in equity at 21 percent, a 4 percent differential is created in equity). This “differential”
may continue to be recorded as a component of OCI until an entire category (e.g., AFS securities,
pension liabilities) that originally gave rise to the difference has been eliminated completely (e.g., if the
entire marketable security portfolio were sold). An exception to this accounting might exist if the entity
specifically tracks its investments for income tax purposes (as discussed in Section 6.2.6.1), identifying
which investments have tax effects reflected in equity at the old rate and which have tax effects reflected
in equity at the new rates. However, because this level of tracking is usually impractical, the applicability
of this alternative would be rare.

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3.5.1.3 Change in Tax Law That Allows an Entity to Monetize an Existing DTA or

Tax Credit in Lieu of Claiming the Benefit in the Future
740-10-35 (Q&A 01)
A tax authority may enact a tax law that allows entities to monetize an existing DTA before the asset
would otherwise be realized as a reduction of taxes payable. For example, a prior law in the United
States allowed entities to claim a refundable credit for their AMT carryforward and research credits
in lieu of claiming a 50 percent bonus depreciation on qualified property placed in service during a
particular period.

ASC 740-10-35-4 states the following regarding an entity’s assessment of a change in tax law that affects
the measurement of DTAs and DTLs and realization of DTAs:

Deferred tax liabilities and assets shall be adjusted for the effect of a change in tax laws or rates. A change in
tax laws or rates may also require a reevaluation of a valuation allowance for deferred tax assets.

Accordingly, the entity must adjust its DTAs and DTLs, along with any related valuation allowances, in the
first period in which the law was enacted if the entity expects to realize the asset by electing the means
provided by the newly enacted tax law.

For example, an entity may have a valuation allowance for a particular DTA because it was not more
likely than not that the asset would have been realizable before the change in tax law occurred.
However, the new tax law provides the entity a means of realizing the DTA. The reduction of the
valuation allowance will affect the income tax provision in the first period in which the law was enacted.
If, however, no valuation allowance is recognized for the entity’s DTA, the reduction in the DTA (a
deferred tax expense) is offset by the cash received from monetizing the credits (a current tax benefit).
Therefore, in this case, the reduction of the DTA does not affect the income tax provision.

See Section 7.3.2 for further guidance on accounting for changes in tax laws or rates in an interim
period.

See Section 2.7 for guidance on whether refundable tax credits are within the scope of ASC 740 and are
accordingly classified within income tax expense/benefit in the financial statements.

For a discussion of the intraperiod tax allocation rules with respect to changes in tax laws or rates, see
Chapter 6.

3.5.2 Changes in Tax Status of an Entity

740-10-25 (Q&A 44)

ASC 740-10

25-32 An entity’s tax status may change from nontaxable to taxable or from taxable to nontaxable. An example
is a change from a partnership to a corporation and vice versa. A deferred tax liability or asset shall be
recognized for temporary differences in accordance with the requirements of this Subtopic at the date that a
nontaxable entity becomes a taxable entity. A decision to classify an entity as tax exempt is a tax position.

25-33 The effect of an election for a voluntary change in tax status is recognized on the approval date or on
the filing date if approval is not necessary and a change in tax status that results from a change in tax law is
recognized on the enactment date.

25-34 For example, if an election to change an entity’s tax status is approved by the taxing authority (or filed,
if approval is not necessary) early in Year 2 and before the financial statements are issued or are available to
be issued (as discussed in Section 855-10-25) for Year 1, the effect of that change in tax status shall not be
recognized in the financial statements for Year 1.

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ASC 740-10 (continued)

Cessation of an Entity’s Taxable Status

40-6 A deferred tax liability or asset shall be eliminated at the date an entity ceases to be a taxable entity. As
indicated in paragraph 740-10-25-33, the effect of an election for a voluntary change in tax status is recognized
on the approval date or on the filing date if approval is not necessary and a change in tax status that results
from a change in tax law is recognized on the enactment date.

ASC 740-10-25-32 states that a DTL or DTA is recognized for temporary differences in existence on
the date a nontaxable entity becomes a taxable entity. Conversely, under ASC 740-10-40-6, DTAs and
DTLs should be eliminated when a taxable entity becomes a nontaxable entity. ASC 740-10-45-19 notes
that the effect of a change in tax status should be recorded in income from continuing operations. This
section provides an overview of considerations when an entity has a change in tax status.

For a discussion of the intraperiod tax allocation rules with respect to a change in tax status, see
Chapter 6.

3.5.2.1 Recognition Date
ASC 740-10-25-33 indicates that the effect of an entity’s election to voluntarily change its tax status is
recognized when the change is approved or, if approval is unnecessary (e.g., approval is perfunctory), on
the filing date. Therefore, the recognition date is either the filing date, if regulatory approval is deemed
perfunctory, or the date regulatory approval is obtained. The recognition date for a change in tax status
that results from a change in tax law, such as the change that occurred in the U.S. federal tax jurisdiction
for Blue Cross/Blue Shield entities as a result of the enactment of the Tax Reform Act of 1986, is the
enactment date.

If an entity voluntarily elects to change its tax status after the entity’s year-end but before the issuance of
its financial statements, that subsequent event should be disclosed but not recognized (a nonrecognized
subsequent event). For example, if an entity filed an election on January 1, 20X9, before the financial
statements for the fiscal year ended December 31, 20X8, are issued, the entity should disclose the
change in tax status and the effects of the change (i.e., pro forma financial information), if material, in the
20X8 financial statements. See Section 14.7.1 for a discussion of the potential disclosure impact when
an entity changes its tax status from nontaxable to taxable.

3.5.2.2 Effective Date
The effective date of an entity’s election to voluntarily change to nontaxable status can differ depending
on the laws of the applicable tax jurisdiction. For example, in the United States, the effective date of a
change in status election from a C corporation to an S corporation can be either of the following:
1. Retroactive to the beginning of the year in which the election is filed if the filing or necessary
approval occurs within the first two and a half months of the fiscal year (i.e., by March 15 for a
calendar-year-end entity).
2. At the beginning of the next fiscal year (i.e., January 1, 20X1, for a calendar-year-end entity).

In scenario 1, the effective date would be January 1 of the current year and would be accounted for no
earlier than when the election is filed; in scenario 2, however, the effective date would be January 1 of
the following year for calendar-year-end entities. Note that for a change to nontaxable status in scenario
2, the effect of the change in status would be recognized on the approval date or filing date, provided
that approval is perfunctory, as illustrated in Example 3-33.

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3.5.2.3 Measurement — Change From Nontaxable to Taxable

When an entity changes its status from nontaxable to taxable, DTAs and DTLs should be recognized for
any temporary differences in existence on the recognition date (unless the entity is subject to one of the
recognition exceptions in ASC 740-10-25-3). The entity should measure those recognizable temporary
differences in accordance with ASC 740-10-30.

3.5.2.4 Measurement — Change From Taxable to Nontaxable

In a change to a nontaxable status, the difference between the net DTA and DTL immediately before the
recognition date and the net DTA and DTL on the recognition date represents the financial statement
effect of a change in tax status. If the recognition date of the change in nontaxable status is before the
effective date, entities will generally need to schedule the reversal of existing temporary differences
to estimate the portion of these differences that is expected to reverse after the recognition date.
Temporary differences that are expected to reverse after the effective date should be derecognized,
while those that are expected to reverse before the effective date should be maintained in the financial
statements. However, some temporary differences may continue even after a change to nontaxable
status, depending on the applicable tax laws (e.g., U.S. built-in gain tax). For further discussion of built-in
gain taxes, see Section 3.5.4.2.

3.5.3 Tax Effects of a Check-the-Box Election

740-10-25 (Q&A 75)
U.S. multinational companies typically conduct business in foreign jurisdictions through entities that
are organized under the laws of the jurisdictions in which they operate. These entities might take the
legal form of a corporation or partnership in their respective jurisdictions. Notwithstanding an entity’s
classification in the foreign jurisdiction, the U.S. Treasury has promulgated entity-classification income
tax regulations, commonly referred to as the check-the-box regulations, under which an eligible foreign
entity21 may separately elect its tax classification, or tax status, for U.S. income tax reporting purposes.
Under the check-the-box regulations, an eligible entity may elect, for U.S. income tax reporting purposes,
to be treated as a corporation, treated as a partnership (if it has more than one owner), or disregarded
(i.e., treated as an entity not separate from its owner if it has only one owner). An eligible entity electing
to be treated as a disregarded entity is considered a branch of its parent for U.S. income tax purposes.

As a result of an eligible entity’s check-the-box election to change its status from a regarded foreign
corporation to a disregarded branch of a U.S. parent, the post-check-the-box operations of the foreign
entity will become taxable when earned for U.S. tax purposes, requiring the parent entity to recognize
U.S. deferred taxes on existing temporary differences and eliminate any outside basis difference (as
opposed to the nonrecognition of an outside basis difference because of the application of an exception).
Similarly, a foreign subsidiary directly owned by a U.S. parent may have previously elected, for U.S. income
tax reporting purposes, to be treated as a disregarded entity. If the entity elects, for U.S. income tax
reporting purposes, to “uncheck the box” and change its status from a disregarded entity to a regarded
foreign corporation, the taxable income or loss of the foreign entity will no longer be immediately
included in taxable income of the U.S. parent, requiring the derecognition of U.S. deferred taxes on the
assets held inside the foreign corporation. Although the guidance in ASC 740-10-25-32 predates the
introduction of the check-the-box regulations, the need to recognize or derecognize DTAs and DTLs as a
result of the election makes the check-the-box election analogous to a change in tax status. Accordingly,
we generally believe that the tax effects of recognizing or derecognizing DTAs and DTLs should be
recorded in continuing operations on the approval date or on the filing date if approval is not necessary.

21
While check-the-box elections are most commonly considered in a foreign context, the same elections can be made for domestic entities.

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Example 3-31

Assume that a U.S. parent owns 100 percent of FS, which operates in Jurisdiction X and is not otherwise taxable
in the United States. The U.S. parent had previously directed FS to check the box and be treated as a branch
for U.S. tax purposes. At year-end 20X1, the U.S. parent states that it plans for FS to uncheck the box in 20X2,
resulting in the derecognition (if nontaxable) or reversal (if taxable) of U.S. deferred taxes on inside basis
differences. If an outside basis difference exists when the box is unchecked, the U.S. parent will need to assess
it for recognition under the exceptions in ASC 740-30-25-18(a) and ASC 740-30-25-9.

The plan to have FS uncheck the box should be accounted for as a change in status, and the tax effects
(including the initial recognition of any outside basis difference DTA or DTL) should be reflected in 20X2.

However, there may be other circumstances in which a check-the-box election may not appear as
analogous to a change in tax status. For example, if the check-the-box election affects only an entity’s
recognition or measurement of the tax effects of its outside basis difference of its investment in the
subsidiary, an alternative view is that the check-the-box election may appear to simply be an election
(rather than a change in status) that could be accounted for at the time the parent intends to make it. In
support of this alternative view, we note that (1) the guidance on change in status in ASC 740-10-25-32
predates the introduction of the check-the-box regulations and (2) the guidance in ASC 740-30-25-18(a)
and ASC 740-30-25-9 is intent focused and forward looking (i.e., it permits the entity to determine
whether the amounts will reverse in the foreseeable future). Accordingly, if a check-the-box election
for a foreign corporation is expected to result in only the avoidance of a reversal of either a taxable or
deductible temporary difference with respect to the outside basis difference in a subsidiary, it would
be appropriate to recognize (and measure) the related deferred tax effects when the entity is internally
committed to making the election and the election is within the entity’s control.

Because the appropriate accounting for a check-the-box election can depend on the facts and
circumstances, consultation with income tax accounting advisers is encouraged.

Example 3-32

Assume that a U.S. parent owns 100 percent of FS1, which operates in Jurisdiction X and is not taxable in the
United States. FS1 owns 100 percent of FS2, which operates in Jurisdiction Y and is also not taxable in the
United States. FS2 is eligible to make a check-the-box election for U.S. income tax reporting purposes. FS1 had
a transaction with FS2 on December 15, 20X1, that gives rise to a type of income that the U.S. parent must
recognize under the Subpart F rules (i.e., a deemed dividend that would result in a current tax payable). For U.S.
income tax-planning purposes, however, the U.S. parent plans to cause FS2 to make a check-the-box election
that will result in FS2’s treatment as a foreign disregarded entity effective on December 1, 20X1, allowing the
U.S. parent to avoid recognizing the deemed dividend in 20X1 (i.e., the transaction will no longer be between
FS1 and FS2 since under U.S. tax law they will be considered a single legal entity).22

As of December 31, 20X1, the check-the-box election had not yet been filed, but the U.S. parent has the intent
and ability to cause FS2 to file the election and will do so by February 13, 20X2, the last day the election can be
made and still be effective as of December 1, 20X1 (generally such elections can be made with retroactive effect
of up to 75 days).

22
The check-the-box election is not part of a larger restructuring transaction.

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Example 3-32

The U.S. parent could record a current tax liability for the deemed dividend between FS1 and FS2 that occurred
in 20X1 and recognize the effects of the check-the-box election (i.e., the reversal of the current tax liability) in
20X2. Alternatively, because the check-the-box election will not change the tax status of FS2 in its local jurisdiction
or from the perspective of FS1 (i.e., there are no other tax effects of the election), the U.S. parent could assert
that (1) the election should be considered relevant only under the guidance on taxable temporary differences
in foreign subsidiaries (generally, no DTL is recognized unless it is foreseeable that the temporary difference will
reverse) and, as a result of the planned election, (2) the outside basis difference related to its investment in FS1
will not reverse. Under this alternative view, the U.S. parent’s intent and ability to direct FS2 to make the election
would be considered in the measurement of the U.S. parent’s deferred and current tax liability related to its
investment in FS1 as of December 31, 20X1 (i.e., no deferred or current tax liability would be recognized).

3.5.4 Real Estate Investment Trust

740-10-25 (Q&A 58)
A corporate entity may elect to be a REIT if it meets certain criteria under the U.S. IRC. As a REIT, an entity
is allowed a tax deduction for dividends paid to shareholders. By paying dividends equal to its annual
taxable income, a REIT can avoid paying income taxes on otherwise taxable income. This in-substance
tax exemption would continue as long as (1) the entity intends to continue to pass all the qualification
tests, (2) there are no indicators of failure to meet the qualifications, and (3) the entity expects to
distribute substantially all of its income to its shareholders.

3.5.4.1 Recognition Date for Conversion to a REIT

The IRS is not required to approve an entity’s election of taxable status as a REIT; nor does the entity
need to file a formal election. Rather, to be eligible for taxable status as a REIT, an entity must meet the
IRC requirements of a REIT. For example, the entity must:

• Establish a legal structure appropriate for a REIT (i.e., corporation, trust, or association that is not
a financial institution or subchapter L insurance company).

• Distribute the accumulated E&P of the corporation to the shareholders before election of REIT
status.

• Adopt a calendar tax year.

• File its tax return as a REIT (Form 1120-REIT) by the normal due date.
Because ASC 740 does not specifically address when the tax effects of a conversion to REIT status
should be recognized, diversity has developed in practice. One view is that the effect of a conversion to
REIT status would be recognized when the entity has committed to a plan to convert its tax status and
has met all the legal requirements to be a REIT under the IRC, including the distribution of accumulated
E&P of the corporation to the shareholders. An entity must use judgment to determine what constitutes
its commitment to conversion (e.g., approval by the board of directors, securing financing to distribute
accumulated E&P, public announcement). The recognition date of conversion to REIT status generally
would not be contingent on the filing of the first tax return as a REIT because this is normally a
perfunctory step.

Alternatively, some entities have analogized an election of REIT status to a change in tax status (i.e.,
taxable to nontaxable) in accordance with ASC 740-10-25-32 (see Section 3.5.4.2). According to this
view, the recognition of REIT status would most likely not be until the election is made with the IRS upon
the entity’s filing of its initial-year tax return (the filing date).

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3.5.4.2 Change in Tax Status to Nontaxable: Built-in Gain Recognition and

Measurement
740-10-25 (Q&A 45)
Upon an entity’s change in tax status from a taxable C corporation to a nontaxable S corporation or REIT,
it may have net unrealized “built-in gains.” A built-in gain arises when the fair market value of an asset is
greater than its adjusted tax basis on the date of the entity’s change in tax status. Under U.S. tax law, if a
built-in gain associated with an asset is realized before the required holding period from the change in
tax status expires (i.e., the recognition period), the entity would be subject to corporate-level tax on the
gain. However, if this gain is realized after the recognition period, the built-in gain would not be subject
to tax.

Whether an entity continues to record a DTL associated with the built-in gain tax on the date of
conversion to nontaxable status depends on whether any of the net unrealized built-in gain is
expected to be recognized and taxable during the recognition period. Any subsequent change in that
determination would result in either recognition or derecognition of a DTL.

An entity should consider the following items in determining when tax associated with an unrealized
built-in gain should be recognized and how the related DTL should be measured, either upon
conversion to nontaxable status or anytime during the recognition period.

3.5.4.2.1 Recognition
An entity must first determine whether it expects that a tax will be due on a net unrealized built-in gain
within the recognition period. ASC 740-10-55-65 provides the following guidance on this topic:

A C corporation that has temporary differences as of the date of change to S corporation status shall determine
its deferred tax liability in accordance with the tax law. Since the timing of realization of a built-in gain can
determine whether it is taxable, and therefore significantly affect the deferred tax liability to be recognized,
actions and elections that are expected to be implemented shall be considered.

The following are examples of items that an entity should consider when evaluating “actions and
elections that are expected to be implemented” under ASC 740-10-55-65:

• Management’s intentions regarding each item with a built-in gain — Whether a DTL is recorded for
a temporary difference depends on management’s intentions for each item with a built-in gain.
That is, an entity should evaluate management’s intent and ability to do what is necessary to
prevent a taxable event (e.g., holding marketable securities for the minimum amount of time)
before determining whether a DTL should be recorded.

• Overall business plans — The conclusion about whether realization of a built-in gain is expected
to trigger a tax liability for the entity should be consistent with management’s current actions
and future plans. That is, the plans for assets should be consistent with, for example, the entity’s
liquidity requirements and plans for expansion. Management’s budgets, forecasts, and analyst
presentations are examples of information that could serve as evidence of management’s
intended plans.

• Past actions — The entity should also consider past actions to determine whether they support
management’s ability to represent that, for example, an asset will be held for the minimum
amount of time necessary to preclude a taxable event.

• Nature of the item — The nature of the item could also affect whether a built-in gain is expected
to result in a taxable event.

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3.5.4.2.2 Measurement
Under ASC 740-10-55-65, if, after considering the “actions and elections that are expected to be
implemented,” an entity expects to be subject to a built-in gain tax through the disposition of an asset
within the recognition period, the entity must recognize the related DTL at the lower of:

• The net unrecognized built-in gain (based on the applicable tax law).
• The existing temporary difference as of the date of the change in tax status.
The DTL recognized should lead to the recognition of DTAs for attribute carryforwards (i.e., net operating
or capital losses) that are expected to be used in the same year in which the built-in gain tax is triggered.

If the potential gain (first bullet above) exceeds the temporary difference (second bullet above), the
related tax should not be recognized earlier than the period in which the pretax financial reporting
income (or gain) is recognized (or is expected to be recognized in the case of amounts that would be
considered “ordinary income,” as that term is used in connection with the AETR).

Further, ASC 740-10-55-169 requires an entity to “remeasure the deferred tax liability for net built-in
gains based on the provisions of the tax law” as of each subsequent financial statement date until the
end of the recognition period. This remeasurement should include a reevaluation of the recognition
considerations noted above and should describe management’s intent and ability to do what is
necessary to prevent a taxable event. Remeasurement of the DTL is generally recorded through
continuing operations under the intraperiod tax guidance.

Example 3-33

Entity X, a C corporation, is a calendar-year-end entity and files an election on June 30, 20X8, to become
a nontaxable S corporation effective January 1, 20X9. In this example, IRS approval is perfunctory for the
voluntary change because the entity meets all the requirements to become an S corporation; therefore, the
effect of the change in tax status should be recognized as of June 30, 20X8 (the recognition date).

Entity X’s change to nontaxable status will result in the elimination of the portion of all DTAs and DTLs related
to temporary differences that are scheduled to reverse after December 31, 20X8, and will not be taxable under
the provisions of the tax law for S corporations. The only remaining DTAs or DTLs in the financial statements as
of June 30, 20X8, will be those associated with temporary differences that existed on the recognition date that
will reverse during the period from July 1, 20X8, to December 31, 20X8, plus the tax effects of any temporary
differences that will reverse after December 31, 20X8, that are taxable under the provisions of the tax law for S
corporations (e.g., built-in gain tax). Entity X should record any effects of eliminating the existing DTAs and DTLs
that will reverse after the effective date of January 1, 20X9, in income from continuing operations.

Entity X will not recognize net deferred tax expense or benefit during the period between the recognition date
and the effective date of January 1, 20X9, in connection with basis differences that arise during this time unless
they are scheduled to reverse before December 31, 20X8, or will be subject to tax under the tax law for S
corporations.

See ASC 740-10-55-168 for an example illustrating the measurement of a DTL associated with
an unrecognized built-in gain resulting from an entity’s change from a taxable C corporation to a
nontaxable S corporation.

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3.5.5 Tax Consequences of Bad-Debt Reserves of Thrift Institutions

942-740-25 (Q&A 01)
Regulatory authorities require U.S. savings and loan associations and other qualified thrift lenders to
appropriate a portion of earnings to general reserves and to retain the reserves as a protection for
depositors. The term “general reserves” is used in the context of a special meaning within regulatory
pronouncements. Provisions of the U.S. federal tax law permit a savings and loan association to deduct
an annual addition to a reserve for bad debts in determining taxable income. This annual addition
generally differs significantly from the bad-debt experience upon which determination of pretax
accounting income is based. Therefore, taxable income and pretax accounting income of an association
usually differ.

ASC 942-740-25-1 precludes recognition of a DTL for the tax consequences of bad-debt reserves “for
tax purposes of U.S. savings and loan associations (and other qualified thrift lenders) that arose in tax
years beginning before December 31, 1987” (i.e., the base-year amount), “unless it becomes apparent
that those temporary differences will reverse in the foreseeable future.” That is, the indefinite reversal
notion of ASC 740-30-25-17 is applied to the entire amount of the base-year bad-debt reserve for
tax purposes. ASC 942-740-25-2 states that a DTL should be recognized for the tax consequences of
bad-debt reserves for “tax purposes . . . that arise in tax years beginning after December 31, 1987.” That
is, the excess of a tax bad-debt reserve over the base-year reserve is a temporary difference for which
deferred taxes must be provided.

Application of the guidance in ASC 942-740-25-2 effectively results in a “two-difference” approach to the
measurement of deferred tax consequences of bad-debt reserves of thrift institutions:

• Difference 1 — A DTL is not recognized for the amount of tax bad-debt reserve that is less than
the tax base-year amount (generally, amounts established at the beginning of the tax year
in 1988). However, a DTL is recognized for any excess of the tax bad-debt reserve over the
base-year amount.

• Difference 2 — A DTA is recognized for the entire allowance of bad debt established for financial
reporting purposes (i.e., the “book” bad-debt reserve). As with any DTA, a valuation allowance is
necessary to reduce the DTA to an amount that is more likely than not to be realized.

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Example 3-34

This example illustrates the application of the two-difference approach for a thrift institution. Assume the
following:

• The tax law froze the tax bad-debt reserve at the end of 1987. This limitation does not apply to use of
future percentage of taxable income (PTI) deductions. However, experience method deductions for
years after 1987 are limited to amounts that increase the tax bad-debt reserve to the base-year amount.
Under this method, a thrift is allowed a tax deduction to replenish its bad-debt reserve to the base-year
amount.
• The thrift elected to adopt ASC 740 retroactively to January 1, 1988.
• An annual election is permitted under the tax law. Bad-debt deductions may be computed on (1) the
experience method or (2) the PTI method. The PTI is 8 percent.
• The association has no temporary differences other than those arising from loan losses.
• The enacted tax rate for all years is 25 percent.

20X1 20X2 20X3 20X4

Activity in Book — Bad-Debt Reserve
Beginning balance $ 500 $ 500 $ 300 $ 600
Loan loss provision 100 100 400 300
Charge-offs (100) (300) (100) (320)
Ending balance $ 500 $ 300 $ 600 $ 580

Activity in Tax — Bad-Debt Reserve

Base year (1987) $ 850
Beginning balance (current) $ 850 $ 910 $ 850 $ 910
PTI deductions 160 160
Charge-offs (100) (300) (100) (320)
Experience method deductions 240 260
Ending balance $ 910 $ 850 $ 910 $ 850

Current Tax Liability

Pretax accounting income before loan
loss provision $ 2,000 $ 2,000 $ 2,000 $ 3,000
Tax bad-debt deduction (160) (240) (160) (260)
Taxable income $ 1,840 $ 1,760 $ 1,840 $ 2,740
Current liability $ 460 $ 440 $ 460 $ 685

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Example 3-34 (continued)

Deferred tax amounts are shown below.

20X0 20X1 20X2 20X3 20X4

Deferred Tax Balance
Deductible temporary difference* $ 500 $ 500 $ 300 $ 600 $ 580
Taxable temporary difference** (60) (60)
Net temporary difference $ 500 $ 440 $ 300 $ 540 $ 580
DTA — net $ 125 $ 110 $ 75 $ 135 $ 145

* The book bad-debt reserve.

** Excess, if any, of the tax bad-debt reserve over the base year (1987) tax bad-debt reserve.

Income statement amounts are shown below (select accounts).

20X1 20X2 20X3 20X4

Income before taxes $ 1,900 $ 1,900 $ 1,600 $ 2,700
Provision (benefit) for income taxes:
Current 460 440 460 685
Deferred 15 35 (60) (10)
475 475 400 675
Net income $ 1,425 $ 1,425 $ 1,200 $ 2,025
ETR 25% 25% 25% 25%

942-740-25 (Q&A 02)

As indicated above, ASC 942-740-25-1 concludes that the indefinite reversal notion of ASC 740-30-25-17
is applied to the entire amount of the tax base-year bad-debt reserve of savings and loan associations
and other qualified thrift lenders. That is, a DTL is not recognized for the amount of tax bad-debt reserve
that is less than the tax base-year reserve.

If the savings and loan association or thrift has the ability to refill the base-year reserve but has elected
not to take the tax deductions to refill the base-year amount, the excess represents a potential tax
deduction for which a DTA is recognized subject to a valuation allowance, if necessary. However, if the
base-year reserve has been reduced because of a reduction in the amount of the qualifying loans, the
exception provided in ASC 942-740-25-1 and 25-2 that applies to the base-year bad-debt reserve under
ASC 740 should apply only to the current remaining base-year amount, as determined in accordance
with IRC Section 585. Future increases in the base-year amount are a form of special deduction, as
described in ASC 740-10-25-37, that should not be anticipated.

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Example 3-35

Assume that Entity B, a bank holding company, acquires a 100 percent interest in a stock savings and loan
association, Entity T, in a 20X0 business combination. In 20X1, B directs T to transfer a substantial portion
of its existing loan portfolio to a sister corporation operating under a bank charter. The transfer was not
contemplated as of the acquisition date. Further, assume that under IRC Section 585, this transfer reduces
the tax base-year bad-debt reserve but the transfer of loans to a sister entity does not result in a current tax
liability for the corresponding reduction in the base-year bad-debt reserve.

If management did not contemplate the transfer before 20X1, the effect of recording an additional DTL for the
tax consequences of the reduction in the base-year bad-debt reserve for tax purposes should be recognized
as a component of income tax expense from continuing operations in 20X1. The decision in 20X1 to transfer
the loans is the event that causes the recognition of the deferred tax consequences of the reduction in the
bad-debt reserve, and the additional expense should be recognized in that period.

3.5.6 Tax Effects of Intra-Entity Profits on Inventory

740-10-25 (Q&A 02)
After an intra-entity sale of inventory or other assets occurs at a profit between affiliated entities that are
included in consolidated financial statements but not in a consolidated tax return, the acquiring entity’s
tax basis of that asset exceeds the reported amount in the consolidated financial statements. This
occurs because, for financial reporting purposes, the effects of gains or losses on transactions between
entities included in the consolidated financial statements are eliminated in consolidation. A DTA is
recorded for the excess of the tax basis over the financial reporting carrying value of assets other than
inventory that results from the intra-entity sale.

With respect to inventory, ASC 740-10-25-3(e) requires that income taxes paid on intra-entity profits
on inventory remaining within the group be accounted for under the consolidation guidance in ASC
810-10 and prohibits recognition of a DTA for the difference between the tax basis of the inventory in
the buyer’s tax jurisdiction and its cost as reported in the consolidated financial statements (i.e., after
elimination of intra-entity profit). Specifically, ASC 810-10-45-8 states, “[i]f income taxes have been
paid on intra-entity profits on inventory remaining within the consolidated group, those taxes shall be
deferred or the intra-entity profits to be eliminated in consolidation shall be appropriately reduced.”

The FASB concluded that in these circumstances, an entity’s income statement should not reflect a
tax consequence for intra-entity sales of inventory that are eliminated in consolidation. Under this
approach, the tax paid or payable from the sale is deferred upon consolidation (as a prepaid income tax
or as an increase in the carrying amount of the related asset) and is not included in tax expense until the
inventory or other asset is sold to an unrelated third party. This prepaid tax is different from deferred
taxes that are recorded in accordance with ASC 740 because it represents a past event whose tax effect
has simply been deferred, rather than the future taxable or deductible differences addressed by ASC
740. Example 3-36 illustrates these conclusions for a situation involving the transfer of inventory.

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Example 3-36

Assume the following:

• A parent entity, P, operates in a jurisdiction, A, where the tax rate is 25 percent. Parent P’s wholly owned
subsidiary, S, operates in a jurisdiction, B, where the tax rate is 35 percent.
• Parent P sells inventory to S at a $100 profit, and the inventory is on hand at year-end. Assume that P
purchased the inventory for $200. Therefore, S’s basis for income tax reporting purposes in Jurisdiction
B is $300.
• Parent P prepares consolidated financial statements and, for financial reporting purposes, gains and
losses on intra-entity transactions are eliminated in consolidation.
The following journal entry shows the income tax impact of this intra-entity transaction on P’s consolidated
financial statements.

Journal Entry

Prepaid income tax 25

Income taxes payable 25

The FASB concluded that although the excess of the buyer’s tax basis over the cost of transferred assets
reported in the consolidated financial statements meets the technical definition of a temporary difference, in
substance an entity accounts for this temporary difference by recognizing income taxes related to intra-entity
gains that are not recognized in consolidated financial statements. The FASB decided to eliminate that conflict
by prohibiting the recognition of deferred taxes in the buyer’s jurisdiction for those differences and deferring
the recognition of expense for the tax paid by the seller.

Assume that in a subsequent period, S sold the inventory that it acquired from P to an unrelated third party
for the exact amount it previously paid P — $300. The following journal entry shows the sales and related tax
consequences that should be reflected in P’s consolidated financial statements.

Journal Entry

Cash for sales 300

Cost of goods sold 200
Sales 300
Inventory 200
Income tax expense 25
Prepaid income tax 25

3.5.6.1 Subsequent Changes in Tax Rates Involving Intra-Entity Transactions

740-10-25 (Q&A 03)
If a jurisdiction changes its tax rates after an intra-entity transaction but before the end product is sold
to a third party, the prepaid tax that was recognized should not be revalued. This prepaid tax is different
from deferred taxes that are recorded in accordance with ASC 740 (which would need to be revalued)
because it represents a past event whose tax effect (i.e., tax payment) has simply been deferred, rather
than the future taxable or deductible difference addressed by ASC 740. Thus, a subsequent change in
the tax rates in either jurisdiction (buyer or seller) does not result in a change in the actual or future tax
benefit to be received. In other words, a future reduction in rates in the seller’s market does not change
the value because the transaction that was taxed has passed and is complete. In the buyer’s market, a
change in rates does not make the previous tax paid in the other jurisdiction any more or less valuable
either. The deferral is simply an income statement matching matter that arises in consolidation whose
aim is recognition of the ultimate tax effects (at the actual rates paid) in the period of the end sale to an
external third party. Hence, prepaid taxes associated with intra-entity profits do not need to be revalued.

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3.5.7 Income Tax Consequences of Debt With a Conversion Feature

Accounted for Separately as a Derivative
740-10-25 (Q&A 56)
Entities that issue convertible debt must assess whether the instrument’s conversion feature should be
accounted for separately (bifurcated) in accordance with relevant U.S. GAAP (e.g., ASC 470-20). Under
U.S. GAAP, the entity must also determine whether a conversion feature that is bifurcated should be
classified as equity or as a derivative.

ASC 740-10-55-51 provides guidance on accounting for tax consequences of convertible debt
instruments that contain a beneficial conversion feature that is bifurcated and accounted for as equity.
In addition, the income tax accounting guidance in ASC 470-20-25-27 addresses situations in which (1) a
convertible debt instrument may be settled in cash upon conversion and (2) the conversion feature is
bifurcated and accounted for as equity.

However, the income tax accounting guidance is not as explicit on situations in which the conversion
feature is bifurcated and accounted for as a separate derivative liability. In such cases, there is typically
a difference between the book and tax basis of both the debt instrument and the conversion feature
accounted for as a derivative liability. These basis differences result because, although the convertible
debt instrument is separated into two units of accounting for financial reporting purposes (the debt
instrument and the conversion feature), typically the debt is not bifurcated for tax purposes. In such
circumstances, deferred taxes should be recorded for the basis differences of both the debt and the
derivative liability.

The tax basis difference associated with a debt conversion feature that is a derivative liability is
considered a deductible temporary difference. ASC 740-10-20 defines a temporary difference as a
difference “that will result in taxable or deductible amounts in future years when the reported amount
of the . . . liability is recovered or settled.” Further, ASC 740-10-20 states that “[e]vents that do not have
tax consequences do not give rise to temporary differences.” This conclusion is also based by analogy
on the income tax accounting guidance on beneficial conversion features and conversion features
bifurcated from convertible debt instruments that may be settled in cash upon conversion.

ASC 740-10-55-51 addresses the income tax accounting for beneficial conversion features and states, in
part:

The issuance of convertible debt with a beneficial conversion feature results in a basis difference for purposes
of applying this Topic. The recognition of a beneficial conversion feature effectively creates two separate
instruments — a debt instrument and an equity instrument — for financial statement purposes while it is
accounted for as a debt instrument, for example, under the U.S. Federal Income Tax Code. Consequently, the
reported amount in the financial statements (book basis) of the debt instrument is different from the tax basis
of the debt instrument. The basis difference that results from the issuance of convertible debt with a beneficial
conversion feature is a temporary difference for purposes of applying this Topic because that difference will
result in a taxable amount when the reported amount of the liability is recovered or settled. That is, the liability
is presumed to be settled at its current carrying amount (reported amount).

The convertible debt guidance in ASC 470-20-25-27 addresses the income tax accounting for conversion
features bifurcated from convertible debt instruments that may be settled in cash upon conversion. This
paragraph states, in part:

Recognizing convertible debt instruments within the scope of the Cash Conversion Subsections as two separate
components — a debt component and an equity component — may result in a basis difference associated with
the liability component that represents a temporary difference for purposes of applying Subtopic 740-10.

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Accordingly, any difference between the financial reporting basis and tax basis of both the convertible
debt instrument and the derivative liability should be accounted for as a temporary difference in
accordance with ASC 740. However, as demonstrated in Example 3-37 below, if the settlement of the
convertible debt and derivative liability at an amount greater than their combined tax basis would not
result in a tax-deductible transaction, a net DTA should not be recorded.

Example 3-37

On January 1, 20X1, Entity A issues 100,000 convertible notes at their par value of $1,000 per note, raising
total proceeds of $100 million. The embedded conversion feature must be accounted for separately from the
convertible notes (i.e., as a derivative instrument under ASC 815). On January 1, 20X1, and December 31, 20X1,
the derivative liability has a fair value of $40 million and $35 million, respectively. The notes bear interest at a
fixed rate of 2 percent per annum, payable annually in arrears on December 31, and mature in 10 years. The
notes do not contain embedded prepayment features other than the conversion option.

The tax basis of the notes is $100 million, and A’s tax rate is 25 percent. Entity A is entitled to tax deductions
based on cash interest payments but will receive no tax deduction if the payment of consideration upon
conversion is in excess of the tax basis of the convertible notes ($100 million), regardless of the form of that
consideration (cash or shares).

Transaction costs are not considered in this example.

Journal Entries: January 1, 20X1

Cash 100,000,000
Debt discount 40,000,000
Debt 100,000,000
Derivative liability 40,000,000
To record the issuance of the convertible debt.

Income tax provision 10,000,000

DTL 10,000,000
To record the DTL for the temporary difference between the financial
reporting basis of the debt ($60 million) and the tax basis of the
debt ($100 million).

DTA 10,000,000
Income tax provision 10,000,000
To record the DTA for the temporary difference between the financial
reporting basis of the derivative liability ($40 million) and the tax
basis of the derivative liability ($0).

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Example 3-37 (continued)

As shown above, the deferred tax balances will typically offset each other at issuance. However, the temporary
differences will not remain equivalent because the derivative liability will typically be marked to fair value on an
ongoing basis while the discount on the debt will accrete toward the principal balance, as shown below.

Journal Entries: December 31, 20X1

Interest expense 5,144,587

Debt discount 3,144,587
Cash 2,000,000
To record the amortization of the debt discount and the payment of
the cash interest for the first year.

Derivative liability 5,000,000

Gain on change in derivative liability fair value 5,000,000
To record the change in the fair value of the derivative liability in the
first year.

DTL 786,147
Income taxes payable 500,000
Income tax provision 1,286,147
To record the tax effects of the interest expense, consisting of
$500,000 of current tax benefits and $1,286,147 of deferred
tax benefits.

Income tax provision 1,250,000

DTA 1,250,000
To record the decrease in the DTA for the change in the financial
reporting carrying value of the derivative liability from $40 million to
$35 million.

Because A presumes that the liabilities will be settled at their current carrying value (reported amount) in the
future and the combined carrying value is less than the combined tax basis, the settlement will result in a
taxable transaction. Accordingly, the basis differences meet the definition of a temporary difference under ASC
740 and a net DTL is recorded. However, if the fair value of the derivative liability would have increased and the
combined carrying value (reported amount) of the convertible debt and derivative liability would have exceeded
the combined tax basis, the basis differences would not meet the definition of a temporary difference under
ASC 740 because the settlement of convertible debt and derivative liability at an amount greater than their
combined basis would not result in a tax-deductible transaction.

Therefore, it is acceptable for A to record deferred taxes for the basis differences but only to the extent that the
combined carrying value of the convertible debt and derivative liability is equal to or less than the combined tax
basis. In other words, at any point, A could have a net DTL related to the combined carrying value but not a net DTA.

3.5.8 Leases
A lease’s classification for accounting purposes does not affect its classification for tax purposes. An
entity will therefore continue to be required to determine the tax classification of a lease under the
applicable tax laws. While the classification may be similar for either purpose, the differences between
tax and accounting principles and guidance often result in book/tax differences. Thus, once an entity
implements ASU 2016-02, it will need to establish a process (or leverage its existing processes) to
account for these differences.

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Connecting the Dots

ASC 842 does not significantly affect the accounting for income taxes under ASC 740. In a
manner consistent with ASC 840, differences between accounting and tax guidance will result in
book/tax differences. Because the lessee will recognize a new right-of-use (ROU) asset and lease
liability for operating leases as a result of adopting ASC 842, there are likely to be more book/
tax differences under ASC 842 than under ASC 840. If there is no tax basis in the ROU asset, a
taxable temporary difference may arise. Similarly, if there is no tax basis in the lease liability, a
deductible temporary difference may arise. The taxable and deductible temporary differences
are separate and give rise to separate and distinct deferred tax amounts and generally should
not be netted in the income tax disclosures. Entities should carefully consider the disclosure
requirements in both ASC 740-10-50-2 and ASC 740-10-50-6 (see Chapter 8 for details
regarding the disclosure requirement of ASC 740).

Because ASC 842 requires entities to reevaluate their leases, they may have the opportunity to reassess
the tax treatment of such leases as well as their data collection and processes. Since the IRS considers
a taxpayer’s tax treatment of leases to be a method of accounting, an entity may need to obtain IRS
consent if it makes any changes to its existing methods. Entities should also consider the potential state
tax issues that may arise as a result of ASC 842, including how the classification of the ROU asset may
affect the apportionment formula in the determination of state taxable income and how the significant
increase in recorded lease assets could affect the determination of franchise tax payable and state DTAs
and DTLs.

3.5.8.1 Deferred Tax Consequences of Synthetic Leases

740-10-25 (Q&A 42)
Entities (lessees) may enter into complex leasing arrangements involving special-purpose entities to
achieve off-balance-sheet financing of real property. One such arrangement is a synthetic lease. The
objective of a synthetic lease is for the lessee to achieve operating lease treatment for financial reporting
purposes while, for income tax purposes, the entity is treated as the owner of the property. Therefore,
the entity recognizes lease cost in its financial statements but capitalizes the property and the related
debt obligation in its income tax return.

In a synthetic lease structure, because the tax bases of the property and related debt differ from
their reported amounts in the financial statements, deferred tax consequences are created and a
temporary difference arises. A temporary difference exists because the recognition and measurement
requirements under the tax law are different from those under the financial accounting standards.

Note that if the special-purpose entity is required to be consolidated by the lessee, there is effectively no
synthetic lease arrangement because the entity is also treated as the owner of the property for financial
reporting purposes.

Upon the adoption of ASC 842, the entity (lessee) will recognize on its statement of financial position
an ROU asset and a lease liability for most operating leases (including those related to synthetic lease
arrangements). For income tax purposes, the entity is still treated as the owner of the property. The
tax bases of the property and related debt for income tax purposes may differ from the ROU asset and
lease liability and cause separate temporary differences for each item. Therefore, the entity may need
to record and track the deferred taxes on each temporary difference separately. For example, if there is
no tax basis in the ROU asset, a taxable temporary difference may arise. Similarly, if there is no tax basis
in the lease liability, a deductible temporary difference may arise. The taxable and deductible temporary
differences are separate and give rise to separate and distinct deferred tax amounts and generally
should not be netted in the income tax disclosures.

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Before the adoption of ASC 842, an entity does not recognize on its statement of financial position an
asset and liability for operating leases, although it is entitled to the future tax benefits (deductions) from
the depreciation of the property and the interest from the debt. Accordingly, the entity should record
a DTA and DTL for the future tax consequences related to the depreciation of the property and the
amortization of the debt, respectively. The initial recording of the DTA and DTL generally offset each
other. Subsequently, a net DTA or DTL usually will result because the methods of depreciating the
property are different from those for amortizing the debt. If the property is held for the full term of the
lease, the DTA and DTL will reverse over time. Regardless of whether the DTA and DTL offset each other,
it is generally expected that entities will disclose their respective DTAs and DTLs gross within the income
tax disclosures. Entities should carefully consider the disclosure requirements in both ASC 740-10-50-2
and ASC 740-10-50-6 (see Chapter 8 for details regarding the disclosure requirement of ASC 740).

3.5.9 Accounting for Temporary Differences Related to ITCs

740-10-25 (Q&A 77)

ASC 740-10

25-45 An investment credit shall be reflected in the financial statements to the extent it has been used as an
offset against income taxes otherwise currently payable or to the extent its benefit is recognizable under the
provisions of this Topic.

25-46 While it shall be considered preferable for the allowable investment credit to be reflected in net income
over the productive life of acquired property (the deferral method), treating the credit as a reduction of federal
income taxes of the year in which the credit arises (the flow-through method) is also acceptable.

The ITC guidance in ASC 740-10-25-46 specifies that an entity can use one of two methods to account
for the receipt of an ITC as an item of income in the financial statements: (1) the deferral method or
(2) the flow-through method.

Under the deferral method, the ITC would result in a reduction to income taxes payable (or an increase
in a DTA if the credit is carried forward to future years, subject to assessment for realization) that
is recognized as either a reduction to the carrying value of the related asset or as a deferred credit
(i.e., credit is treated as deferred income). The benefit of the ITC is either reflected in net income as a
reduction to depreciation expense or recognized as deferred income over the productive life of the
related property (rather than as a reduction to income tax expense).23 Under this method, temporary
differences may be created when either the financial statement carrying amount of the acquired
property is reduced or when a deferred credit is recorded. In some cases, receipt of the credit results
in a statutory reduction in the tax basis of the related asset, which may affect the temporary basis
difference.

Under the flow-through method, the ITC would result in (1) a reduction to income taxes payable for the
year in which the credit arises (or an increase in a DTA if the credit is carried forward to future years,
subject to assessment for realization) and (2) an immediate reduction to income tax expense. Under this
method, temporary differences are generally created only if a statutory reduction in tax basis occurs.

23
We are also aware of an alternative view under which the deferred credit would be reversed through the income tax provision in accordance with
paragraph 3 of APB Opinion 4.

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The following two approaches are acceptable for recording the tax effect of temporary differences
created by ITCs:

• Gross-up approach — Under this approach, there is no immediate income statement recognition
because the DTA or DTL is recorded as an adjustment to the carrying value of the acquired
property (or deferred credit). The simultaneous equations method is used to calculate the final
book basis of the acquired property and the DTA or DTL. (For a discussion and illustration of
the simultaneous equations method, see ASC 740-10-25-51 and ASC 740-10-55-171 through
55-182.)

• Income statement approach — Under this approach, the DTA or DTL is recorded with an offset to
income tax expense.

Both approaches are discussed below in greater detail. Note that the approach an entity selects is an
accounting policy election that should be applied consistently. Note also that this guidance applies only
to the accounting for ITCs. An entity should not analogize to other situations. In circumstances other
than those related to ITCs, consultation with accounting advisers is recommended.

Example 3-38

ITC With No Statutory Reduction to Tax Basis

Assume the following:

• Entity A invests in a qualifying asset for $1,000 that entitles A to an ITC for 25 percent of the purchase
price, and it records the following initial entry:
Entry 1A

PP&E 1,000
Cash 1,000
To record the initial purchase.

• In accordance with the tax law, there is no associated reduction in the tax basis of the related asset.
• Entity A’s applicable tax rate is 21 percent.
Deferral Method
Under the deferral method, A recognizes the reduction in taxes payable and records the offsetting credit as a
reduction in the carrying value of the asset, as shown in the following journal entry:

Entry 1B

Income taxes payable 250

PP&E 250

To record the reduction of income taxes payable and the related

reduction in the carrying value of the qualifying asset under the
deferral method.*
* Instead of reducing the carrying value of the qualifying asset, A could record a “deferred credit,” which would result
in the same deferred tax accounting treatment (i.e., there would be a book-to-tax difference related to the deferred
credit that is recorded for book purposes but not for tax purposes).

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Example 3-38 (continued)

If there is no corresponding adjustment to the tax basis of the qualifying asset (per the tax law), a deductible
temporary difference of $250 arises. The accounting treatment for the DTA depends on whether A has elected
the gross-up approach or the income statement approach.

Gross-Up Approach
Under the gross-up approach, A’s application of a simultaneous equation yields a DTA of $66 (rounded) and a
reduction to the recorded amount of the qualifying asset of $66 (rounded). Thus, the qualifying asset should
be recorded at $684 ($1,000 purchase price less the $250 ITC less the $66 DTA). Entity A will record all of the
entries above as well as the following entry to account for the qualifying asset, the ITC, and the initial basis
difference in the qualifying asset:

Entry 1C

DTA 66

PP&E 66

To record the DTA determined by using the gross-up approach

(initial deductible temporary difference of $250 × 21% tax rate ÷
(1–21% tax rate) = $66 DTA).

Income Statement Approach

Under the income statement approach, A records a DTA of $53 as a component of income tax expense. Entity
A will record Entry 1B above and the following entry to account for the initial basis difference in the qualifying
asset:

Entry 1D

DTA 53
Deferred tax expense 53
To record the DTA under the income statement approach ($250
deductible temporary difference × 21% tax rate = $53 DTA).

Flow-Through Method
Under the flow-through method, A recognizes the reduction in taxes payable and records the offsetting credit
as a current income tax benefit, as shown in the following journal entry:

Entry 1E

Income taxes payable 250

Current income tax expense 250

To record the reduction of income taxes payable and the related

income tax benefit under the flow-through method.

Because there is no adjustment to the book basis of the qualifying asset and it is assumed that there is no
adjustment to the tax basis of the qualifying asset (per the tax law), no deductible temporary difference arises.
Therefore, the gross-up and income statement approaches are not applicable.

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Example 3-39

ITC With Statutory Reduction to Tax Basis

Assume the same facts as in Example 3-38, except that in accordance with the tax law, there is an associated
reduction in the tax basis of the related property equal to 50 percent of the ITC (i.e., $125). Entity A records the
same initial entry as follows:

Entry 2A

PP&E 1,000
Cash 1,000
To record the initial purchase.

Deferral Method
Under the deferral method, A recognizes the reduction in taxes payable and records the offsetting credit as a
reduction in the carrying value of the asset, as shown in the following journal entry:

Entry 2B

Income taxes payable 250

PP&E 250

To record the reduction of income taxes payable and the related

reduction in the carrying value of the qualifying asset under the
deferral method.*
* Instead of reducing the carrying value of the qualifying asset, A could record a “deferred credit,” which would result
in the same deferred tax accounting treatment (i.e., there would be a book-to-tax difference related to the deferred
credit that is recorded for book purposes but not for tax purposes).

Because the corresponding adjustment to the tax basis of the qualifying asset (per the tax law) differs from that
of the adjustment made to the carrying value of the qualifying asset, a deductible temporary difference of $125
arises ($750 book basis vs. $875 tax basis). The accounting treatment for the related DTA depends on whether
A has elected the gross-up approach or the income statement approach.

Gross-Up Approach
Under the gross-up approach, A’s application of a simultaneous equation yields a DTA of $33 (rounded) and a
reduction to the recorded amount of the qualifying asset of $33 (rounded). Thus, the qualifying asset should
be recorded at $717 ($1,000 purchase price less the $250 ITC less the $33 DTA determined herein). Entity A
will record the entries above and the following entry to account for the initial basis difference in the qualifying
asset:

Entry 2C

DTA 33
PP&E 33
To record the DTA determined under the simultaneous equations
method (initial deductible temporary difference of $125 × 21% tax
rate ÷ [1–21% tax rate] = $33 DTA).

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Example 3-39 (continued)

Income Statement Approach

Under the income statement approach, A records a $26 DTA as a component of tax expense. Entity A will
record Entry 2B and the following entry to account for the qualifying asset, the ITC, and the initial basis
difference in the qualifying asset:

Entry 2D

DTA 26

Deferred tax expense 26

To record the DTA under the income statement approach ($125

deductible temporary difference × 21% tax rate = $26 DTA).

Flow-Through Method
Under the flow-through method, A recognizes the reduction in taxes payable and records the offsetting credit
as a current income tax benefit, as shown in the following journal entry:

Entry 2E

Income taxes payable 250

Current income tax expense 250

To record the reduction of income taxes payable and the related

income tax benefit under the flow-through method.

Although there is no adjustment to the book basis of the qualifying asset under this approach, the tax basis of
the qualifying asset (per the tax law) differs from the book basis of the qualifying asset, and an initial taxable
temporary difference of $125 arises ($1,000 book basis vs. $875 tax basis). The accounting treatment for the
related DTL depends on whether A has elected the gross-up approach or the income statement approach.

Gross-Up Approach
Under the gross-up approach, A’s application of a simultaneous equation yields a DTL of $26 (rounded) and an
increase to the recorded amount of the qualifying asset of $26 (rounded). Thus, the qualifying asset should be
recorded at $1,026 ($1,000 purchase price plus the $26 DTL determined herein). Entity A will record Entry 2E
and the following entry to account for the initial basis difference in the qualifying asset:

Entry 2F

PP&E 26

DTL 26

To record the DTL under the income statement approach ($125

taxable temporary difference × 21% tax rate = $26 DTL).

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Example 3-39 (continued)

Income Statement Approach

Under the income statement approach, A would not use the simultaneous equations method. Rather, A would
apply its tax rate of 21 percent to the taxable temporary difference of $125, resulting in the recognition of a
$26 DTL with the offset to deferred tax expense. Entity A will record Entry 2E and the following entry to account
for the qualifying asset, the ITC, and the initial basis difference in the qualifying asset:

Entry 2G

Deferred tax expense 26

DTL 26

To record the DTL under the income statement approach ($125

taxable temporary difference × 21% tax rate = $26 DTL).

3.5.10 Tax Consequences of Securities Classified as HTM, Trading, and AFS

740-20-45 (Q&As 09, 10, and 11)
In January 2016, the FASB issued ASU 2016-01, which amends the guidance in U.S. GAAP on the
classification and measurement of financial instruments. The new guidance requires that entities,
upon the effective date of the ASU (generally after December 15, 2017, for public entities), carry
all investments in equity securities, including other ownership interests such as partnerships,
unincorporated joint ventures, and LLCs, at fair value, with any changes in value recorded through
continuing operations.

The guidance in this section reflects U.S. GAAP before the adoption of ASU 2016-01.

ASC 320-10 addresses the accounting and reporting for (1) investments in equity securities that have
readily determinable fair values and (2) all investments in debt securities. Under ASC 320-10-25-1, an
entity must classify and account for such investments in one of the following three ways:

• Debt securities that the entity has the positive intent and ability to hold until maturity are
classified as HTM and are reported at amortized cost.

• Debt and equity securities that are bought and held principally to be sold in the near term are
classified as trading securities and are reported at fair value, with any unrealized gains and
losses included in earnings.

• Debt and equity securities not classified as either HTM or trading are classified as AFS and are
reported at fair value, with unrealized gains and losses excluded from earnings and reported
in OCI.

3.5.10.1 HTM Securities
Use of the amortized cost method of accounting for debt securities that are HTM often creates taxable
or deductible temporary differences because, for financial reporting purposes, any discount or premium
is amortized to income over the life of the investment. However, the cost method used for tax purposes
does not amortize discounts or premiums. For example, because the amortization of a discount
increases the carrying amount of the debt security for financial reporting purposes, a taxable temporary
difference results when the tax basis in the investment remains unchanged under the applicable tax law.
Accounting for the deferred tax consequences of any resultant temporary differences created by the
use of the amortized cost method is relatively straightforward because both the pretax impact caused
by the amortization of a discount or premium and its related deferred tax consequences are recorded
in the income statement during the same period.

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When the amortized cost method creates a deductible temporary difference, realization of the
resultant DTA must be assessed. A valuation allowance is necessary to reduce the related DTA to an
amount whose realization is more likely than not. The tax consequences of valuation allowances and
any subsequent changes necessary to adjust the DTA to an amount that is more likely than not to be
realized are generally charged or credited directly to income tax expense or benefit from continuing
operations (exceptions to this general rule are discussed in ASC 740-20-45-3). This procedure produces
a normal ETR for income tax expense from continuing operations. Since the preceding discussion
pertains to HTM securities, the resulting income and losses are reported in continuing operations rather
than in OCI.

3.5.10.2 Trading Securities
Trading securities that are reported at fair value create taxable and deductible temporary differences
when the cost method is used for income tax purposes. For example, a temporary difference is created
when the fair value of an investment and its corresponding carrying amount for financial reporting
purposes differ from its cost for income tax purposes. Accounting for the deferred tax consequences
of any temporary differences resulting from marking the securities to market for financial reporting
purposes is charged or credited directly to income tax expense or benefit from continuing operations.

When mark-to-market accounting creates a deductible temporary difference, realization of the

resulting DTA must be assessed. A DTA is reduced by a valuation allowance, if necessary, so that the net
amount represents the tax benefit that is more likely than not to be realized. The tax consequences of
establishing a valuation allowance and any subsequent changes that may be necessary are generally
charged or credited directly to income tax expense or benefit from continuing operations (exceptions to
this general rule are discussed in ASC 740-20-45-3). This procedure produces a normal ETR for income
tax expense from continuing operations in the absence of a valuation allowance.

3.5.10.3 AFS Securities
Securities classified as AFS are marked to market as of the balance sheet date, which creates taxable
and deductible temporary differences whenever the cost method is used for income tax purposes. For
example, a DTL will result from taxable temporary differences whenever the fair value of an AFS security
is in excess of the amount of its cost basis as determined under tax law. ASC 320-10-35-1 indicates that
unrealized holding gains and losses must be excluded from earnings and reported as a net amount in
OCI. In addition, ASC 740-20-45-11 provides guidance on reporting the tax effects of unrealized holding
gains and losses. ASC 740-20-45-11(b) requires that the tax effects of gains and losses that occur during
the year that are included in comprehensive income but excluded from net income (i.e., unrealized gains
and losses on AFS securities) are also charged or credited to OCI. Example 3-40 below illustrates this
concept.

For details on intraperiod tax allocations related to AFS securities, see Section 6.2.4.

Example 3-40

Assume that at the beginning of the current year, 20X1, Entity X has no unrealized gain or loss on an AFS
security. During 20X1, unrealized losses on AFS securities are $1,000 and the tax rate is 25 percent. As a
result of significant negative evidence available at the close of 20X1, X concludes that a 50 percent valuation
allowance is necessary. Therefore, X records a $250 DTA and a $125 valuation allowance. Accordingly, the
carrying amount of the AFS portfolio is reduced by $1,000, OCI is reduced by $875, and a $125 net DTA (a DTA
of $250 less a valuation allowance of $125) is recognized at the end of 20X1.

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4.1 Overview and Scope

As discussed in Chapter 1, an entity’s overall objectives in the accounting for income taxes are to
(1) “recognize the amount of taxes payable or refundable for the current year” and (2) “recognize
deferred tax liabilities and assets for the future tax consequences of events that have been recognized
in an entity’s financial statements or tax returns.” The total tax provision includes current tax expense
(benefit) (i.e., the amount of income taxes paid or payable [or refundable] for a year as determined by
applying the provisions of the enacted tax law to the taxable income or the excess of deductions over
revenues for that year) and deferred tax expense (or benefit) (i.e., change in DTAs and DTLs during the
year). The total tax expense reported in the financial statements should reflect the income tax effects of
tax positions on the basis of the two-step process in ASC 740-10, recognition (step 1) and measurement
(step 2). The recognition and measurement requirements of ASC 740 should be applied only to
uncertainties in income taxes and do not apply to non-income taxes such as sales tax, value-added tax,
and payroll tax.

See Section 11.4 for a discussion of the accounting for uncertainty in income taxes in business
combinations.

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4.1.1 UTB Decision Tree and Assumptions in Recognition and Measurement

740-10-25 (Q&A 19)
The following decision tree provides an overview of the process for recognizing the benefits of a tax
position under ASC 740:
Identify material tax position at appropriate
unit of account.

Is tax
Measure associated tax benefit to position “more
be recorded at the largest amount Yes likely to be No
greater than 50 percent likely to sustained than not” on Record UTB for the full amount.
be realized upon settlement with the basis of
tax authority. its technical
merits?

Calculate interest and penalties if necessary.

Is tax
position
Yes related to No Record discretely in the current
Incorporate into interim AETR.
current-year period.
ordinary
income?

Provide financial statement disclosures.

Yes
Yes

Subsequent Periods

Has the
Yes
tax position been
Yes Account for the resolution of the
effectively settled
tax position and provide financial
or has the statute
statement disclosures.
of limitations
expired?

No

Did the tax

Is new position meet Is new
information Yes the more-likely- No information
available regarding the than-not recognition available regarding the
sustainability of the threshold sustainability of the
tax position? in the prior tax position?
period?

No

No

Is the new No
information There is no change to the tax benefit
available related to previously recorded. Calculate interest and
measurement of the penalties if necessary and provide financial
associated tax statement disclosures.
benefit?

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The following table summarizes the framework an entity uses when applying the two-step process of
recognition and measurement under ASC 740-10:

Step 1 — Recognition Step 2 — Measurement

The position will be examined Same
The examiner will have full knowledge of all relevant Same
information
Offsetting or aggregating tax positions should not be Same
considered
The evaluation should be based solely on the position’s The evaluation should be based on all relevant
technical merits information available on the reporting date
It should be assumed that the position will be resolved The conclusion should be based on the amount the
in a court of last resort taxpayer would ultimately accept in a negotiated
settlement with the tax authority

4.1.2 Consideration of Tax Positions Under ASC 740

740-10-05 (Q&A 02)
ASC 740 applies to all tax positions in a previously filed tax return or tax positions expected to be taken
in a future tax return. A tax position can result in a permanent reduction of income taxes payable,
a deferral of income taxes otherwise currently payable to future years, or a change in the expected
realizability of DTAs.

The definition of “tax position” in ASC 740-10-20 also lists the following examples of tax positions that
are within the scope of ASC 740:

• “A decision not to file a tax return” (e.g., a decision not to file a specific state tax return because
nexus was not established).

• “An allocation or a shift of income between jurisdictions” (e.g., transfer pricing).

• “The characterization of income or a decision to exclude reporting taxable income in a tax
return” (e.g., interest income earned on municipal bonds).

• “A decision to classify a transaction, entity, or other position in a tax return as tax exempt” (e.g., a
decision not to include a foreign entity in the U.S. federal tax return).

• “An entity’s status, including its status as a pass-through entity or a tax-exempt not-for-profit
entity.”

Uncertainties related to tax positions not within the scope of ASC 740, such as taxes based on gross
receipts, revenue, or capital, should be accounted for under other applicable literature (e.g., ASC 450).

4.1.2.1 Tax Positions Related to Entity Classification

740-10-05 (Q&A 07)
Many entities are exempt from paying taxes because they qualify as either a tax-exempt (e.g., not-for-
profit organization) or a pass-through entity (e.g., Subchapter S corporation, partnership), or they
function similarly to a pass-through entity (e.g., REIT, RIC). To qualify for tax-exempt or pass-through
treatment, such entities must meet certain conditions under the relevant tax law.

According to the definition of a tax position in ASC 740-10-20, a decision to classify an entity as tax
exempt or as a pass-through should be evaluated under ASC 740 for recognition and measurement. In
some situations, it may be appropriate for the entity to consider how the administrative practices and
precedents of the relevant tax authority could affect its qualification for tax-exempt or pass-through
treatment.

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For example, a Subchapter S corporation must meet certain conditions to qualify for special tax
treatment. If the Subchapter S corporation violates one of these conditions, it might still qualify for
the special tax treatment under a tax authority’s widely understood administrative practices and
precedents. Sometimes, however, these administrative practices and precedents are available only if
an entity self-reports the violation. In assessing whether self-reporting affects an entity’s ability to avail
itself of administrative practices and precedents, the entity should consider whether relief would still be
as readily available if, before self-reporting, the tax authority contacts the entity for an examination. If
an entity has the ability to pursue relief, and the likelihood of relief is not compromised even if, before
self-reporting, the tax authority makes contact for an examination, then the entity can rely on these
administrative practices and precedents for recognition purposes because such administrative practices
and precedents are not contingent upon self-reporting. However, if relief were no longer available, or
the likelihood of relief were compromised had the tax authority contacted the entity for examination
before self-reporting, then the administrative practice would be contingent upon self-reporting, and
the entity would not be able to rely on these administrative practices and precedents for recognition
purposes until the violation had actually been self-reported.

4.1.2.2 Unit of Account
740-10-25 (Q&A 30) ,740-10-25 (Q&A 32) & 740-10-25 (Q&A 31)
Each individual tax position must be analyzed separately under ASC 740. ASC 740-10-25-13 states that
an entity’s determination of what constitutes a unit of account for its individual tax position “is a matter
of judgment based on the individual facts and circumstances.” To determine the unit of account, the
entity should consider, at a minimum, (1) the manner in which it prepares and supports its income tax
return and (2) the approach it expects the tax authorities will take during an examination. The entity may
also consider:

• The composition of the position — whether the position is made up of multiple transactions that
could be individually challenged by the tax authority.

• Statutory documentation requirements.

• The nature and content of tax opinions.
• The history of the entity (or reliable information about others’ history) with the relevant tax
authority on similar positions.

The determination of the unit of account to which ASC 740 is applied is not an accounting policy choice;
rather, it is a factual determination that is based on the facts and circumstances for the tax position
being considered. Every tax position (e.g., transaction, portion of transaction, election, decision) for
which a tax reporting consequence is reported in the financial statements is within the scope of ASC 740
and is, therefore, a possible unit of account to which ASC 740 applies. The unit of account is determined
by evaluating the facts and circumstances of the tax position.

Once determined, the unit of account for a tax position should be the same for each position and similar
positions from period to period unless changes in facts and circumstances indicate that a different unit
of account is appropriate.

Changes in facts and circumstances that could cause management to reassess its determination of the
unit of account include significant changes in organizational structure (e.g., sale of a subsidiary), recent
experience with tax authorities, a change in tax law, and a change in the regulatory environment within a
jurisdiction.

Although ASC 740-10-55-87 through 55-89 acknowledge that changes in a unit of account may occur,
such changes are expected to be infrequent. Further, if a change in unit of account is caused by

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something other than a change in facts and circumstances, it may be an indication that ASC 740 was
applied incorrectly in prior periods.

A change in judgment regarding the appropriate unit of account that does not result from the correction
of an error should be treated as a change in estimate and applied prospectively.

4.2 Recognition
ASC 740-10

25-5 This Subtopic requires the application of a more-likely-than-not recognition criterion to a tax position
before and separate from the measurement of a tax position. See paragraph 740-10-55-3 for guidance related
to this two-step process.

25-6 An entity shall initially recognize the financial statement effects of a tax position when it is more likely
than not, based on the technical merits, that the position will be sustained upon examination. The term more
likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also
include resolution of the related appeals or litigation processes, if any. For example, if an entity determines that
it is certain that the entire cost of an acquired asset is fully deductible, the more-likely-than-not recognition
threshold has been met. The more-likely-than-not recognition threshold is a positive assertion that an
entity believes it is entitled to the economic benefits associated with a tax position. The determination of
whether or not a tax position has met the more-likely-than-not recognition threshold shall consider the facts,
circumstances, and information available at the reporting date. The level of evidence that is necessary and
appropriate to support an entity’s assessment of the technical merits of a tax position is a matter of judgment
that depends on all available information.

25-7 In making the required assessment of the more-likely-than-not criterion:

a. It shall be presumed that the tax position will be examined by the relevant taxing authority that has full
knowledge of all relevant information.
b. Technical merits of a tax position derive from sources of authorities in the tax law (legislation and
statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and
circumstances of the tax position. When the past administrative practices and precedents of the
taxing authority in its dealings with the entity or similar entities are widely understood, for example, by
preparers, tax practitioners and auditors, those practices and precedents shall be taken into account.
c. Each tax position shall be evaluated without consideration of the possibility of offset or aggregation with
other positions.

25-8 If the more-likely-than-not recognition threshold is not met in the period for which a tax position is taken
or expected to be taken, an entity shall recognize the benefit of the tax position in the first interim period that
meets any one of the following conditions:
a. The more-likely-than-not recognition threshold is met by the reporting date.
b. The tax position is effectively settled through examination, negotiation or litigation.
c. The statute of limitations for the relevant taxing authority to examine and challenge the tax position has
expired.
Accordingly, a change in facts after the reporting date but before the financial statements are issued or are
available to be issued (as discussed in Section 855-10-25) shall be recognized in the period in which the change
in facts occurs.

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ASC 740-10 (continued)

25-9 A tax position could be effectively settled upon examination by a taxing authority. Assessing whether a
tax position is effectively settled is a matter of judgment because examinations occur in a variety of ways. In
determining whether a tax position is effectively settled, an entity shall make the assessment on a position-by-
position basis, but an entity could conclude that all positions in a particular tax year are effectively settled.

25-10 As required by paragraph 740-10-25-8(b) an entity shall recognize the benefit of a tax position when it is
effectively settled. An entity shall evaluate all of the following conditions when determining effective settlement:
a. The taxing authority has completed its examination procedures including all appeals and administrative
reviews that the taxing authority is required and expected to perform for the tax position.
b. The entity does not intend to appeal or litigate any aspect of the tax position included in the completed
examination.
c. It is remote that the taxing authority would examine or reexamine any aspect of the tax position. In
making this assessment management shall consider the taxing authority’s policy on reopening closed
examinations and the specific facts and circumstances of the tax position. Management shall presume
the relevant taxing authority has full knowledge of all relevant information in making the assessment on
whether the taxing authority would reopen a previously closed examination.

25-11 In the tax years under examination, a tax position does not need to be specifically reviewed or examined
by the taxing authority to be considered effectively settled through examination. Effective settlement of a
position subject to an examination does not result in effective settlement of similar or identical tax positions in
periods that have not been examined.

25-12 An entity may obtain information during the examination process that enables that entity to change its
assessment of the technical merits of a tax position or of similar tax positions taken in other periods. However,
the effectively settled conditions in paragraph 740-10-25-10 do not provide any basis for the entity to change
its assessment of the technical merits of any tax position in other periods.

25-13 The appropriate unit of account for determining what constitutes an individual tax position, and whether
the more-likely-than-not recognition threshold is met for a tax position, is a matter of judgment based on the
individual facts and circumstances of that position evaluated in light of all available evidence. The determination
of the unit of account to be used shall consider the manner in which the entity prepares and supports its
income tax return and the approach the entity anticipates the taxing authority will take during an examination.
Because the individual facts and circumstances of a tax position and of an entity taking that position will
determine the appropriate unit of account, a single defined unit of account would not be applicable to all
situations.

25-14 Subsequent recognition shall be based on management’s best judgment given the facts, circumstances,
and information available at the reporting date. A tax position need not be legally extinguished and its
resolution need not be certain to subsequently recognize the position. Subsequent changes in judgment
that lead to changes in recognition shall result from the evaluation of new information and not from a new
evaluation or new interpretation by management of information that was available in a previous financial
reporting period. See Sections 740-10-35 and 740-10-40 for guidance on changes in judgment leading to
derecognition of and measurement changes for a tax position.

25-15 A change in judgment that results in subsequent recognition, derecognition, or change in measurement
of a tax position taken in a prior annual period (including any related interest and penalties) shall be recognized
as a discrete item in the period in which the change occurs. Paragraph 740-270-35-6 addresses the different
accounting required for such changes in a prior interim period within the same fiscal year.

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ASC 740-10 (continued)

25-16 The amount of benefit recognized in the statement of financial position may differ from the amount
taken or expected to be taken in a tax return for the current year. These differences represent unrecognized
tax benefits. A liability is created (or the amount of a net operating loss carryforward or amount refundable is
reduced) for an unrecognized tax benefit because it represents an entity’s potential future obligation to the
taxing authority for a tax position that was not recognized under the requirements of this Subtopic.

25-17 A tax position recognized in the financial statements may also affect the tax bases of assets or liabilities
and thereby change or create temporary differences. A taxable and deductible temporary difference is a
difference between the reported amount of an item in the financial statements and the tax basis of an item as
determined by applying this Subtopic’s recognition threshold and measurement provisions for tax positions.
See paragraph 740-10-30-7 for measurement requirements.

Related Implementation Guidance and Illustrations

• Recognition and Measurement of Tax Positions — a Two-Step Process [ASC 740-10-55-3].
• Example 1: The Unit of Account for a Tax Position [ASC 740-10-55-81].
• Example 2: Administrative Practices — Asset Capitalization [ASC 740-10-55-90].
• Example 3: Administrative Practices — Nexus [ASC 740-10-55-93].
• Example 11: Information Becomes Available Before Issuance of Financial Statements
[ASC 740-10-55-117].
• Example 32: Definition of a Tax Position [ASC 740-10-55-223].
• Example 33: Definition of a Tax Position [ASC 740-10-55-224].
• Example 34: Definition of a Tax Position [ASC 740-10-55-225].
• Example 35: Attribution of Income Taxes to the Entity or Its Owners [ASC 740-10-55-226].
• Example 36: Attribution of Income Taxes to the Entity or Its Owners [ASC 740-10-55-227].
• Example 37: Attribution of Income Taxes to the Entity or Its Owners [ASC 740-10-55-228].
• Example 38: Financial Statements of a Group of Related Entities [ASC 740-10-55-229].

An assessment of whether a tax position meets the more-likely-than-not recognition threshold is based
on the technical merits of the tax position. If that threshold is not met, no benefit can be recognized in
the financial statements for that tax position.

When recognizing a tax position, an entity must assess the position’s technical merits under the tax law
for the relevant jurisdiction. That assessment often requires consultation with tax law experts.

4.2.1 Meaning of the Court of Last Resort and Its Impact on Recognition

740-10-25 (Q&A 25) & 740-10-25 (Q&A 26)
As part of the technical merit assessment, an entity must assess what the outcome of a dispute would
be if the matter was taken to the court of last resort. According to ASC 740-10-55-3, the “recognition
threshold is met when the taxpayer (the reporting entity) concludes that . . . it is more likely than not that
the taxpayer will sustain the benefit taken . . . in a dispute with taxing authorities if the taxpayer takes the
dispute to the court of last resort.”

The court of last resort is the highest court that has discretion to hear a particular case in a particular
jurisdiction. In determining whether a tax position meets the more-likely-than-not recognition threshold,
an entity must consider how the court of last resort would rule. To form a conclusion, an entity must
examine all laws against which the court of last resort would evaluate the tax position.

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In the United States, the U.S. Supreme Court, as the highest judicial body, is the highest court that
has discretion to hear an income-tax-related case. It is thus the ultimate court for deciding the
constitutionality of federal or state law. Many more cases are filed with the U.S. Supreme Court than are
heard; the justices exercise discretion in deciding which cases to hear.

When evaluating the recognition criteria in ASC 740, an entity should not consider the likelihood that the
U.S. Supreme Court will hear a case regarding the constitutionality of the applicable tax law. In assessing
the tax position for recognition, the entity should assume that the case will be heard by the court of last
resort.

The highest courts of jurisdictions outside the United States that hear income-tax-related cases may not
be these jurisdictions’ supreme courts. In addition, in foreign jurisdictions, supreme courts may also not
evaluate a case against laws other than income tax laws. Tax positions should be evaluated against all
laws that apply in each relevant jurisdiction.

4.2.2 Legal Tax Opinions Not Required

740-10-25 (Q&A 24)
An entity is not required to obtain a legal tax opinion to support its conclusion that a tax position meets
the recognition criteria in ASC 740-10-25-6. However, the entity must have sufficient evidence to support
its assertion that a tax benefit should be recognized on the basis of the technical merits of the relevant
law. In addition, the entity should determine whether it has the appropriate expertise to evaluate all
available evidence and the uncertainties associated with the relevant statutes or case law. The entity
must use judgment in determining the amount and type of evidence it needs in addition to, or in lieu of,
a tax opinion to demonstrate whether the more-likely-than-not recognition threshold is met.

4.2.3 Consideration of Widely Understood Administrative Practices and

Precedents
740-10-25 (Q&A 27)
When assessing whether a tax position meets the more-likely-than-not recognition threshold, an entity
is allowed under ASC 740 to consider past administrative practices and precedents only when the tax
position taken by the entity could technically be a violation of tax law but is known to be widely accepted
by the tax authority. An example of this concept is the tax authority’s accepting the immediate deduction
of the cost of acquired fixed assets that are below a reasonable dollar threshold even though this may
be considered a technical violation of the tax law.

Because ASC 740 does not provide guidance on when an administrative practice and precedent is
considered “widely understood,” this assertion depends on the specific facts and circumstances of the
tax position; therefore, an entity must use professional judgment to decide what constitutes “widely
understood.” An entity that asserts that an administrative practice and precedent is widely understood
should document the basis of that assertion, including the evidence to support it. Such evidence may
include reliable knowledge of the tax authority’s past dealings with the entity on the same tax matter
when the facts and circumstances have been similar. The use of administrative practices and precedents
is expected to be infrequent.

With respect to administrative practices and precedents, the SEC has indicated1 that if a tax authority
objects to an entity’s tax position but has previously granted prospective transition by indicating that no
additional taxes would be due for prior periods, the entity should “consider the taxing authority’s
practice of addressing fund industry issues on a prospective basis as part of the administrative
practices and precedents of the taxing authority” (emphasis added) when analyzing the technical
merits of the specific tax position.

1
In a December 22, 2006, letter from SEC Chief Accountant Conrad Hewitt to the Investment Company Institute.

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4.3 Measurement
740-10-30 (Q&A 05), 740-10-30 (Q&A 06) , 740-10-30 (Q&A 08) & 740-10-30 (Q&A 09)

ASC 740-10

30-7 A tax position that meets the more-likely-than-not recognition threshold shall initially and subsequently
be measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon
settlement with a taxing authority that has full knowledge of all relevant information. Measurement of a tax
position that meets the more-likely-than-not recognition threshold shall consider the amounts and probabilities
of the outcomes that could be realized upon settlement using the facts, circumstances, and information
available at the reporting date. As used in this Subtopic, the term reporting date refers to the date of the
entity’s most recent statement of financial position. For further explanation and illustration, see Examples 5
through 10 (paragraphs 740-10-55-99 through 55-116).

4.3.1 Information Affecting Measurement of Tax Positions

In determining the largest amount of tax benefit that is more than 50 percent likely to be realized
upon ultimate settlement with a tax authority, an entity should give more weight to information that is
objectively verifiable than to information that is not. The amount of tax benefit to recognize in financial
statements should be based on reasonable and supportable assumptions. Some information used to
determine the amount of tax benefit to be recognized in financial statements (amounts and probabilities
of the outcomes that could be realized upon ultimate settlement) will be objectively determined, while
other amounts will be determined more subjectively. The weight given to the information should
be commensurate with the extent to which the information can be objectively verified. Examples of
objectively determined information include the amount of deduction reported in an entity’s as-filed tax
return or the amount of deduction for a similar tax position examined by, or sustained in settlement
with, the tax authority in the past.

ASC 740-10-30-7 states, in part:

Measurement of a tax position . . . shall consider the amounts and probabilities of the outcomes that could be
realized upon [ultimate] settlement using the facts, circumstances, and information available at the reporting
date.

Because of the level of uncertainty associated with a tax position, unless the position is considered
“binary” (see additional discussion in Section 4.3.5), an entity will generally need to perform a
cumulative-probability assessment of the possible estimated outcomes when applying the measurement
criterion.

Because ASC 740 does not prescribe how to assign or analyze the probabilities of individual outcomes
of a recognized tax position, this process involves judgment. Ultimately, an entity must consider all
available information about the tax position to form a reasonable, supportable basis for its assigned
probabilities. Factors an entity should consider in forming the basis for its assigned probabilities include,
but are not limited to, the amount reflected (or expected to be reflected) in the tax return, the entity’s
past experience with similar tax positions, information obtained during the examination process,
closing and other agreements, and the advice of experts. The entity should maintain the necessary
documentation to support its assigned probabilities.

In any of the following circumstances, an entity may need to obtain third-party expertise to assist with
measurement:

• The tax position results in a large tax benefit.

• The tax position relies on an interpretation of law in which the entity lacks expertise.
• The tax position arises in connection with an unusual, nonrecurring transaction or event.

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• The range of potential sustainable benefits is widely dispersed.

• The tax position is not addressed specifically in the tax law and requires significant judgment
and interpretation.

4.3.2 Cumulative-Probability Table
It is expected that an entity will perform a cumulative-probability analysis when measuring its uncertain
tax positions that have met the recognition threshold in instances in which there is more than one
possible settlement outcome. Although the use of a cumulative-probability table in the performance of
such an analysis is not required, it is a tool that can help management (1) assess and document the level
of uncertainty related to the outcomes of various tax positions and (2) demonstrate that the amount of
tax benefit recognized is consist with the guidance in ASC 740-10-30-7.

4.3.3 Cumulative-Probability Approach Versus Best Estimate

In the determination of the amount of tax benefit that will ultimately be realized upon settlement with
the tax authority, cumulative probability is not equivalent to best estimate. While the best estimate is
the single expected outcome that is more probable than all other possible outcomes, the cumulative-
probability approach is based on the largest amount of tax benefit with a greater than 50 percent
likelihood of being realized upon ultimate settlement with a tax authority.

The table in Example 4-1 below illustrates this difference by showing the measurement of the benefit of
an uncertain tax position. Under the cumulative-probability approach, the largest amount of tax benefit
with a greater than 50 percent likelihood of being realized is $20, while the best estimate is $25 (the
most probable outcome at 31 percent). An entity must use the cumulative-probability approach when
measuring the amount of tax benefit to record under ASC 740-10-30-7.

Example 4-1

In its 20X7 tax return, an entity takes a $100 tax deduction, which reduces its current tax liability by $25. The
entity concludes that there is a greater than 50 percent chance that, if the tax authority were to examine the
tax position, it would be sustained as filed. Accordingly, the tax deduction meets the more-likely-than-not
recognition threshold.

Although the tax position meets the more-likely-than-not recognition threshold, the entity believes that it
would negotiate a settlement if the tax position were challenged by the tax authority. On the basis of these
assumptions, the entity determines the following possible outcomes and probabilities:

Cumulative
Possible Estimated Individual Probability Probability of
Outcome of Occurring Occurring
$ 25 31% 31%
$ 20 20% 51%
$ 15 20% 71%
$ 10 20% 91%
$ 0 9% 100%

Accordingly, the entity should (1) recognize a tax benefit of $20 because this is the largest benefit that has a
cumulative probability of greater than 50 percent and (2) record a $5 liability for UTBs (provided that the tax
position does not affect a DTA or DTL).

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4.3.4 Use of Aggregation and Offsetting in Measuring a Tax Position

An entity may not employ aggregation or offsetting techniques that specifically apply to multiple
tax positions when measuring the benefit associated with a tax position. Each tax position must be
considered and measured independently, regardless of whether the related benefit is expected to be
negotiated with the tax authority as part of a broader settlement involving multiple tax positions.

4.3.5 Tax Positions That Are Considered Binary

740-10-30 (Q&A 75)
A tax position is considered binary when there are only two possible outcomes (e.g., full deduction or
100 percent disallowance).

Connecting the Dots

Because tax authorities are often permitted — in lieu of litigation — to negotiate a settlement
with taxpayers for positions taken in their income tax returns, very few tax positions are, in
practice, binary.

In certain circumstances, however, it may be acceptable to evaluate the amount of benefit to recognize
as if the position was binary (e.g., when the tax position is so fundamental to the operation of an entity’s
business that the entity is unwilling to compromise). Since such circumstances are expected to be rare,
the entity should use caution in determining whether a tax position should be considered binary with
respect to measuring the amount of tax benefit to recognize.

If a tax position is considered binary and meets the more-likely-than-not threshold for recognition,
it is appropriate to consider only two possible outcomes for measurement purposes: the position is
sustained or the position is lost. ASC 740-10-30-7 states, in part:

A tax position that meets the more-likely-than-not recognition threshold shall initially and subsequently be
measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon
settlement with a taxing authority that has full knowledge of all relevant information. Measurement of a tax
position that meets the more-likely-than-not recognition threshold shall consider the amounts and probabilities
of the outcomes that could be realized upon settlement using the facts, circumstances, and information
available at the reporting date.

While such situations are rare, when a tax position is considered binary and meets the more-likely-
than-not recognition threshold in ASC 740-10-30-7, that tax position should be measured at the largest
amount that is more than 50 percent likely to be realized, which would generally be the as-filed position
(i.e., full benefit).

Connecting the Dots

When a full tax benefit is recognized for a tax position that is considered binary and no UTB
is presented in the tabular UTB reconciliation, the entity should consider disclosing additional
information for such tax positions that could have a significant effect on the entity’s financial
position, operations, or cash flows.

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4.4 Interest (Expense and Income) and Penalties

740-10-25 (Q&A 48) & 740-10-25 (Q&A 52)

ASC 740-10

30-29 Paragraph 740-10-25-56 establishes the requirements under which an entity shall accrue interest on
an underpayment of income taxes. The amount of interest expense to be recognized shall be computed
by applying the applicable statutory rate of interest to the difference between the tax position recognized
in accordance with the requirements of this Subtopic for tax positions and the amount previously taken or
expected to be taken in a tax return.

30-30 Paragraph 740-10-25-57 establishes both when an entity shall record an expense for penalties
attributable to certain tax positions as well as the amount.

4.4.1 Interest Expense
ASC 740-10-30-29 requires that an entity recognize and compute interest expense by applying the
applicable statutory rate of interest to the difference between the tax position recognized in the financial
statements, in accordance with ASC 740, and the as-filed tax position.

Paragraphs B52 and B53 of Interpretation 48, which were not codified, explain that the FASB, during its
redeliberations of the provisions of Interpretation 48, considered whether to require accrual of interest
on (1) management’s best estimate of the amount that would ultimately be paid to the tax authority
upon settlement or (2) the difference between the tax benefit of the as-filed tax position and the amount
recognized in the financial statements. The FASB concluded that accruing interest on the basis of
management’s best estimate would be inconsistent with the approach required in Interpretation 48 for
recognizing tax positions and that the amount of interest and penalties recognized should be consistent
with the amount of tax benefits reported in the financial statements.

4.4.2 Interest Income
ASC 740 does not discuss the recognition and measurement of interest income on UTBs; however, an
entity should recognize and measure interest income to be received on an overpayment of income
taxes in the first period in which the interest would begin accruing according to the provisions of the
relevant tax law.

4.4.3 Penalties
Penalties should be accrued if the position does not meet the minimum statutory threshold necessary
to avoid payment of penalties unless a widely understood administrative practices and precedents
exception (discussed below) is applicable.

In many jurisdictions, penalties may be imposed when a specified threshold of support for a tax position
taken is not met. In the United States, some penalties are transaction specific (i.e., not based on taxable
income) and others, such as penalties for substantial underpayment of taxes, are based on the amount
of additional taxes due upon settlement with the tax authority.

ASC 740-10-25-57 indicates that an entity must recognize, on the basis of the relevant tax law, an
expense for the amount of a statutory penalty in the period in which the tax position that would give rise
to a penalty has been taken or is expected to be taken in the tax return. Penalties required under the
relevant tax law should thus be recorded in the same period in which the liability for UTBs is recognized.
If the penalty was not recorded when the tax position was initially taken because the position met
the minimum statutory threshold, the entity should recognize the expense in the period in which its
judgment about meeting the minimum statutory threshold changes.

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Example 4-2

On December 31, 20X7, a calendar-year-end entity expects to a take a tax position that will reduce its tax
liability in its 20X7 tax return, which will be filed in 20X8. The entity concludes that the tax position lacks the
specified confidence level (e.g., substantial authority) required to avoid the payment of a penalty under the
relevant tax law. In its December 31, 20X7, financial statements, the entity should record a liability for the
penalty amount the tax authority is expected to assess on the basis of the relevant tax law.

An entity should consider a tax authority’s widely understood administrative practices and precedents in
determining whether the minimum statutory threshold to avoid the assessment of penalties has been
met. If the tax authority has a widely understood administrative practice or precedent that modifies the
circumstances under which a penalty is assessed (relative to the statutory criteria), the entity should
consider this administrative practice or precedent in determining whether a penalty should be assessed.
Anecdotal evidence, such as the entity’s historical experience with the tax authority in achieving penalty
abatement, would not be considered an administrative practice.

To take such a widely understood policy into consideration, the entity must conclude that the tax
authority would not assess penalties provided that the tax authority has full knowledge of all the relevant
facts. The use of such a policy is limited to whether the tax authority would assess penalties. It does
not apply to the determination of the amount of penalties that the entity will actually pay once they are
assessed. That is, a tax authority’s historical practice of abating penalties during negotiations with the
entity when the threshold to avoid the assessment of penalties has not been met is not relevant to the
accrual and measurement of penalties. If the entity concludes that penalties are applicable under ASC
740-10-25-56 because there is no widely understood policy, the entity must calculate the penalties to
accrue on the basis of the applicable tax code.

Example 4-3

A U.S. corporate entity applies the provisions of ASC 740 to its tax positions and recognizes a liability for its
UTBs. The entity accrues interest by applying the applicable statutory rate of interest to the difference between
the tax position recognized in the financial statements, in accordance with ASC 740, and the as-filed tax
position. The entity identifies a written policy in the tax authority’s manual that allows its field agents to ignore
the statute and not assess penalties when an entity has a reasonable basis for its return position and the tax
authority has routinely applied the exception in circumstances that are similar to the entity’s specific situation.
The entity should consider that policy when determining whether it must accrue penalties related to its UTBs.

Example 4-4

An entity applies the provisions of ASC 740 to its tax positions and recognizes a liability for its UTBs. The
entity accrues interest by applying the applicable statutory rate of interest to the difference between the tax
position recognized in the financial statements, in accordance with ASC 740, and in the as-filed tax position. The
entity did not meet the minimum statutory threshold to avoid assessment of penalties; however, the entity’s
past experience indicates that it is probable that the tax authority will abate all penalties assessed during
the examination process. The entity may not take its past experience into consideration because it does not
constitute a widely understood administrative practice or precedent relative to whether a penalty would be
assessed under the circumstances. Since the entity did not meet the minimum statutory threshold to avoid the
assessment of penalties, the entity must accrue penalties on the basis of the applicable statutory rate.

See Section 13.3.1 for a discussion related to presentation of interest (expense and income) and
penalties in the financial statements.

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4.5 Subsequent Changes in Recognition and Measurement

740-10-25 (Q&A 28)

ASC 740-10

35-2 Subsequent measurement of a tax position meeting the recognition requirements of paragraph 740-10-
25-6 shall be based on management’s best judgment given the facts, circumstances, and information available
at the reporting date. Paragraph 740-10-30-7 explains that the reporting date is the date of the entity’s most
recent statement of financial position. A tax position need not be legally extinguished and its resolution need
not be certain to subsequently measure the position. Subsequent changes in judgment that lead to changes
in measurement shall result from the evaluation of new information and not from a new evaluation or new
interpretation by management of information that was available in a previous financial reporting period.

35-3 Paragraph 740-10-25-15 requires that a change in judgment that results in a change in measurement of
a tax position taken in a prior annual period (including any related interest and penalties) shall be recognized
as a discrete item in the period in which the change occurs. Paragraph 740-270-35-6 addresses the different
accounting required for such changes in a prior interim period within the same fiscal year.

40-2 An entity shall derecognize a previously recognized tax position in the first period in which it is no longer
more likely than not that the tax position would be sustained upon examination. Use of a valuation allowance
is not a permitted substitute for derecognizing the benefit of a tax position when the more-likely-than-not
recognition threshold is no longer met. Derecognition shall be based on management’s best judgment given
the facts, circumstances, and information available at the reporting date. Paragraph 740-10-30-7 explains that
the reporting date is the date of the entity’s most recent statement of financial position. Subsequent changes
in judgment that lead to derecognition shall result from the evaluation of new information and not from a
new evaluation or new interpretation by management of information that was available in a previous financial
reporting period.

40-3 If an entity that had previously considered a tax position effectively settled becomes aware that the
taxing authority may examine or reexamine the tax position or intends to appeal or litigate any aspect of the
tax position, the tax position is no longer considered effectively settled and the entity shall reevaluate the tax
position in accordance with the requirements of this Subtopic for tax positions.

40-4 Paragraph 740-10-25-15 requires that a change in judgment that results in derecognition of a tax position
taken in a prior annual period (including any related interest and penalties) shall be recognized as a discrete
item in the period in which the change occurs. Paragraph 740-270-35-6 addresses the different accounting
required for such changes in a prior interim period within the same fiscal year.

Management’s assessment of UTBs is an ongoing process. ASC 740-10-25-14, ASC 740-10-35-2, and
ASC 740-10-40-2 stipulate that management, when considering the subsequent recognition and
measurement of the tax benefit associated with a tax position that did not initially meet the recognition
threshold and the subsequent derecognition of one that did, should base such assessments on its “best
judgment given the facts, circumstances, and information available at the reporting date.”

ASC 740-10-25-8 states, in part:

If the more-likely-than-not recognition threshold is not met in the period for which a tax position is taken or
expected to be taken, an entity shall recognize the benefit of the tax position in the first interim period that
meets any one of the following conditions:
a. The more-likely-than-not recognition threshold is met by the reporting date.
b. The tax position is effectively settled through examination, negotiation or litigation.
c. The statute of limitations for the relevant taxing authority to examine and challenge the tax position has
expired.

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An entity that has taken a tax position that previously did not meet the more-likely-than-not recognition
threshold can subsequently recognize the benefit associated with that tax position only if new
information changes the technical merits of the position or the tax position is effectively settled through
examination or expiration of the statute of limitations.

The finality or certainty of a tax position’s outcome through settlement or expiration of the statute of
limitations is not required for the subsequent recognition, derecognition, or measurement of the benefit
associated with a tax position. However, such changes in judgment should be based on management’s
assessment of new information only, not on a new evaluation or interpretation of previously available
information.

See Section 11.4 for a discussion of subsequent changes in recognition and measurement of
uncertainty in income taxes in a business combination.

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4.5.1 Decision Tree for the Subsequent Recognition, Derecognition, and

Measurement of Benefits of a Tax Position
740-10-25 (Q&A 28)

Wait until new information

Did the uncertain tax becomes available, the
Yes tax position is effectively
position originally
meet the recognition settled, or the statute of
threshold? limitations expires before
remeasuring the associated
tax benefit.

No

Has the
statute of Yes Recognize the full tax
limitations benefit.
expired?

No

Wait until the tax position

is effectively settled, the
Wait until the statute of Wait until the statute
statute of limitations
limitations expires or new of limitations expires
Was the expires, or new information
information becomes or new information
tax position becomes available that
available that changes the No becomes available that
in a tax return subject changes the technical
technical merits of the tax changes the technical
to an examination? merits of the tax position
position. merits of the tax position,
before recognizing and
permitting recognition and
measuring the tax benefit.
measurement of the tax
benefit.

Yes
No No

Was the Has new information

Are the tax position Are the about the
three conditions in
No specifically examined
Yes three conditions in
No technical merits or
ASC 740-10-25-10 met? by the tax ASC 740-10-25-10 measurement of the
authority? met? tax position been
obtained during the
exam?

Yes

Yes Yes

Consider the impact of

the new information
on recognition and
The tax position is measurement.
effectively settled.
Recognize the full tax
benefit.

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4.5.2 New Information
740-10-25 (Q&A 34) & 740-10-25 (Q&A 33)
New information (e.g., from a recently completed examination by the tax authority of a tax year that
includes a similar type of tax position) may result in a change to the recognition or measurement of a tax
position. New information may also include, but is not limited to, developments in case law, changes in
tax law and regulations, and rulings by the tax authority.

An entity that has taken a tax position that previously did not meet the more-likely-than-not recognition
threshold can subsequently recognize a benefit associated with the tax position if new information
changes the technical merits of the position. The examination of a tax year by the relevant authority in
a jurisdiction (e.g., the IRS in the United States) does not mean that all tax positions not disputed by the
tax authority meet the more-likely-than-not recognition threshold. An entity cannot assert that a tax
position can be sustained on the basis of its technical merits simply because the tax authority did not
dispute or disallow the position. This lack of dispute or disallowance may be because the tax authority is
overlooking a position.

An entity that has taken a tax position that previously met the more-likely-than-not recognition
threshold can subsequently remeasure the benefit associated with the tax position on the basis of new
information, without the limitation that the new information must change the technical merits of the
position.

Under ASC 740, an entity should not consider new information that is received after the balance sheet
date, but that is not available as of the balance sheet date, when evaluating an uncertain tax position as
of the balance sheet date. Specifically, paragraph B38 in the Basis for Conclusions of Interpretation 48
(not codified in ASC 740), states:

In deliberating changes in judgment in this Interpretation, the Board decided that recognition and
measurement should be based on all information available at the reporting date and that a subsequent change
in facts and circumstances should be recognized in the period in which the change occurs. Accordingly, a
change in facts subsequent to the reporting date but prior to the issuance of the financial statements should
be recognized in the period in which the change in facts occurs.

Note that subsequent events are currently accounted for under ASC 855. The guidance in ASC 740
applies only to situations covered by ASC 740 and is not analogous to other situations covered by
ASC 855. ASC 855 prescribes the accounting requirements for two types of subsequent events:
(1) recognized subsequent events, which constitute additional evidence of conditions that existed as of
the balance sheet date and for which adjustment of previously unissued financial statements is required,
and (2) nonrecognized subsequent events, which constitute evidence of conditions that did not exist as
of the balance sheet date but arose after that date and for which only disclosure is required.

Example 4-5 (below) and Example 4-6 illustrate the consideration of new information concerning an
uncertain tax position that is received after the balance sheet date.

Example 4-5

As of the balance sheet date, an entity believes that it is more likely than not that an uncertain tax position will
be sustained. Before the financial statements are issued or are available to be issued, management becomes
aware of a recent court ruling that occurred after the balance sheet date and that disallowed a similar tax
position taken by another taxpayer. Because the court ruling occurred after the balance sheet date, the entity
should reflect any change in its assessment of recognition and measurement that resulted from the new
information in the interim period that includes the court ruling; however, the entity should consider whether
the court ruling and an estimate of its impact should be disclosed in accordance with ASC 855.

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Example 4-6

Assume that (1) an entity finalizes a tax litigation settlement with the tax authority after the balance sheet date
but before its financial statements are issued or are available to be issued and (2) the events that gave rise to
the litigation had taken place before the balance sheet date. According to ASC 740, the entity should not adjust
its financial statements to reflect the subsequent settlement; however, the entity should disclose, in the notes
to the financial statements, the settlement and its effect on the financial statements.

4.5.3 Effectively Settled Tax Positions

740-10-25 (Q&A 29) & 740-10-25 (Q&A 22)
A tax position that was included in an examination by the tax authority can be considered effectively
settled without being legally extinguished. An entity must use significant judgment in determining
whether a tax position is effectively settled.

A tax position is considered effectively settled when both the entity and the tax authority believe that
the examination is complete and that the likelihood of the tax authority’s reexamining the tax position
is remote (as defined in ASC 450). Although a tax position can be considered effectively settled only if it
was part of a completed examination, a tax position that is part of an examination does not need to be
specifically reviewed by the tax authority to be considered effectively settled; however, the fact that an
issue was not examined will affect the assessment of whether examination or reexamination is remote.

For a tax position to be considered effectively settled, it must meet all of the following conditions in ASC
740-10-25-10:
a. The taxing authority has completed its examination procedures including all appeals and administrative
reviews that the taxing authority is required and expected to perform for the tax position.
b. The entity does not intend to appeal or litigate any aspect of the tax position included in the completed
examination.
c. It is remote that the taxing authority would examine or reexamine any aspect of the tax position. In
making this assessment management shall consider the taxing authority’s policy on reopening closed
examinations and the specific facts and circumstances of the tax position. Management shall presume
the relevant taxing authority has full knowledge of all relevant information in making the assessment on
whether the taxing authority would reopen a previously closed examination.

If the tax authority has specifically examined a tax position during the examination process, an entity
should consider this information in assessing the likelihood that the tax authority would reexamine the
tax position included in the completed examination. Effective settlement of a position subject to an
examination does not result in effective settlement of similar or identical tax positions in periods that
have not been examined.

Accordingly, an entity must first determine whether the tax authority has completed its examination
procedures, including all appeals and administrative reviews that are required and are expected to
be performed for the tax position. For U.S. federal income tax positions, we believe that the condition
that all administrative reviews be complete includes reviews by the Joint Committee on Taxation for
cases that are subject to the committee’s approval. A completed tax examination may be related only
to specific tax positions or to an entire tax year. While it is common for all tax positions for a particular
tax year to be effectively settled at the same time, there may be circumstances in which individual tax
positions are effectively settled at different times.

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The entity must then determine whether it intends to appeal or litigate any aspect of the tax position
associated with the completed examination. If the entity does not intend to appeal or litigate, it must
determine whether the tax authority’s subsequent examination or reexamination of any aspect of the
tax position is remote.

In determining whether to reopen a closed examination, tax authorities follow policies that vary
depending on the type of examination and the agreement entered into between the taxpayer and the
tax authority. For example, a tax authority may be permitted to reexamine a previously examined tax
position (or all tax positions that were part of a closed examination) only if specific conditions exist, such
as fraud or misrepresentation of material fact. An entity must base the likelihood that the tax authority
would examine or reexamine a tax position on individual facts and circumstances, assuming that the tax
authority has all relevant information available to it. The entity may need to use significant judgment to
evaluate whether individual tax positions included in the completed examination meet the conditions of
a tax authority’s policy not to examine or reexamine a tax position. If the likelihood is considered remote
and the other conditions are met, the tax position is effectively settled and the entity recognizes the full
benefit associated with that tax position.

Given the complexities in the determination of whether a tax position has been effectively settled,
consultation with income tax accounting advisers is encouraged.

A tax position that is determined to be effectively settled must be reevaluated if (1) an entity becomes
aware that the tax authority may examine or reexamine that position or (2) the entity changes its intent
to litigate or appeal the tax position. In addition, an entity may obtain information in an examination that
leads it to change its evaluation of the technical merits.

ASC 740-10-25-12 acknowledges that “[a]n entity may obtain information during the examination
process that enables that entity to change its assessment of the technical merits of a tax position or of
similar tax positions taken in other periods.” However, an entity’s conclusion that a position is “effectively
settled,” as described in ASC 740-10-25-8, is not a basis for changing its assessment of the technical
merits of that or a similar tax position.

See Section 7.3.3 for a discussion related to the interim accounting for subsequent change in
recognition and measurement.

4.6 Other Topics
4.6.1 Accounting for the Tax Effects of Tax Positions Expected to Be Taken
in an Amended Tax Return or Refund Claim or to Be Self-Reported Upon
Examination
740-10-25 (Q&A 66)
In certain jurisdictions, an entity may elect to take a certain tax position on its original tax return but
subsequently decide to take an alternative tax position (which is also acceptable) in an amended return.
For example, an entity may amend a previously filed income tax return to retroactively elect a deduction
for foreign taxes paid rather than to claim a credit or vice versa, or to file a refund claim to carry back a
tax operating loss or tax credit to a prior year. Alternatively, an entity under examination may present to
the examiner self-identified adjustments (i.e., affirmative adjustments) to change the amount of income,
deductions, or credits reflected in the previously filed tax return that is under examination.2

2
Presenting affirmative adjustments upon examination, rather than claiming the position on an originally filed income tax return, might be part of
the entity’s strategy to avoid penalties on a particular tax position in a particular tax jurisdiction or to limit the jurisdiction’s ability to make other
changes to the year (i.e., changes that are unrelated to the adjustment being sought by the entity).

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The decision to file an amended tax return or refund claim or to self-report a tax position upon
examination may be made before the end of the reporting period even though the process of actually
preparing the amended tax return/refund claim, or self-reporting the tax position, might not occur until
after the reporting period ends.

An entity should account for the tax effects of its intent to file amended tax returns or refund claims or
to report self-identified audit adjustments (i.e., affirmative adjustments) in its financial statements by
using the guidance in ASC 740-10. ASC 740-10-05-6 states, in part:

This Subtopic provides guidance for recognizing and measuring tax positions taken or expected to be taken
in a tax return that directly or indirectly affect amounts reported in financial statements. [Emphasis added]

In addition, ASC 740-10-25-2 states:

Other than the exceptions identified in the following paragraph, the following basic requirements are applied in
accounting for income taxes at the date of the financial statements:
a. A tax liability or asset shall be recognized based on the provisions of this Subtopic applicable to tax
positions, in paragraphs 740-10-25-5 through 25-17, for the estimated taxes payable or refundable on
tax returns for the current and prior years.
b. A deferred tax liability or asset shall be recognized for the estimated future tax effects attributable to
temporary differences and carryforwards.

While an amended return or refund claim may be filed after the reporting period has ended, an entity
should account for the tax effects in the period in which it concludes that it expects to amend the
return or file the refund claim. Such accounting should be consistent with the general recognition and
measurement principles of ASC 740-10. An entity should determine its intent with respect to the filing of
an amended return or refund claim as of each reporting date. Changes in intent with respect to the filing
of an amended return or refund claim should be supported by a change in facts or circumstances.

In a manner consistent with the above discussion, refund claims that an entity intends to file in
connection with the carryback of tax attributes (e.g., an NOL or a tax credit) should generally be reflected
as an income tax receivable (after the entity considers the recognition and measurement principles of
ASC 740-10) in the reporting period in which the entity concludes that it will file the refund claim.

Affirmative adjustments should be accounted for similarly to tax positions that will be taken on a tax
return (i.e., similarly to an amended return or refund claim). That is, the entity should account for the
tax positions associated with affirmative adjustments in the period in which the entity concludes that it
intends to present the positions to an examiner in a future tax examination. Generally, we would expect
this to be the period in which the position was originally taken. Such accounting should be consistent
with the general recognition and measurement principles of ASC 740-10.

Note that this section does not address the additional considerations that can arise when the filing of
the amended tax return or refund claim, or the decision to self-report a tax position, represents the
correction of an error. See Section 12.6.1 for guidance on those considerations.

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4.6.2 State Tax Positions

740-10-05 (Q&A 05) & 740-10-05 (Q&A 04)
Certain operational activities may be taxable in multiple jurisdictions (e.g., federal and state) or may need
to be allocated between these jurisdictions on the basis of the application of tax rules (e.g., domestic
versus international authorities, state versus state authorities). It is not always certain how these rules
should be applied and therefore, management routinely makes judgments about the application of
various technical rules (e.g., regarding the jurisdictions in which to report tax positions and how to
allocate revenue and expenses among these jurisdictions). In addition to being subject to federal
income taxes, an entity could also be subject to income tax imposed by a state or states. While there are
similarities between the federal and state income tax rules, there are also differences that give rise to
unique state tax positions.

4.6.2.1 Economic Nexus
“Economic nexus” refers to a view, held by some states, that a company deriving income from the
residents of a state should be taxable even when the connection with the state is not physical (i.e., its
only contact with the state is economic). Many states have enacted tax laws that could subject an out-of-
state entity to income taxes in that state in accordance with the economic nexus theory even when the
entity has no physical presence in that state.

An entity should consult all relevant law and authorities to determine whether, for a state in which it
does not file income tax returns, it is more likely than not that it does not have a filing obligation in that
state. While the concept of economic nexus may sometimes be ambiguous and difficult to apply, the
entity must, to comply with the requirements of ASC 740, assess the technical merits of its conclusion
that it does not have economic nexus in a state. An entity should consider engaging specialists for
assistance in performing this assessment.

An entity that concludes that it is more likely than not that it does not have economic nexus in a
particular state has met the recognition threshold for this tax position. Conversely, an entity that has a
reasonable basis for not filing a state income tax return in a particular state but has concluded that it is
more likely than not that it has economic nexus in that state has not met the recognition threshold.

Under ASC 740, if a tax position does not meet the recognition threshold, a liability is recognized for
the total amount of the tax benefit of that tax position (see Section 4.2). That liability should not be
subsequently derecognized unless there is a change in technical merits, the position is effectively settled,
or the statute of limitations expires. In many jurisdictions, it is common for the statute of limitations to
begin to run only when a tax return is filed. Therefore, when an entity does not file a state income tax
return in such a jurisdiction, the entity cannot consider the statute of limitations in determining whether
it has a filing obligation and UTB liability in that state.

Some state tax authorities may have a widely understood administrative practice or precedent under
which the authority would, in the event of an examination and in the absence of a voluntary disclosure
agreement, look back no more than a certain number of years to determine the amount of income tax
deficiency due (i.e., a “lookback period”). If a state tax authority has such a practice, the entity should
consider it when calculating the liability for UTBs that meet certain conditions.

In the absence of a widely understood administrative practice or precedent, however, ASC 740 requires
accrual of the state income tax liability for every year in which it is more likely than not that the entity
had economic nexus with that state, and the state tax liability is determined as if state income tax
returns were prepared in accordance with ASC 740’s recognition and measurement guidance. Interest
and penalties would be accrued under ASC 740 and on the basis of the relevant tax law. Such liabilities
for UTBs would be derecognized only when (1) a change in available information indicates that the

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technical merits of the position subsequently meet the more-likely-than-not recognition threshold or
(2) the position is effectively settled.

For example, assume that an entity has not filed state income tax returns in a particular state and is
aware of a widely understood administrative practice under which only entities that have not historically
filed tax returns with that state must file six years of tax returns. Accordingly, at the end of each year,
the entity is permitted to record a liability for UTBs for the amount of tax due to the state for the most
recent six years as if tax returns, prepared in accordance with ASC 740’s recognition and measurement,
were filed for the most recent six years. Interest and penalties would be accrued on such deficiencies as
required by ASC 740 and on the basis of the relevant tax law.

An entity should be able to demonstrate that it has considered all relevant facts and circumstances
in reaching its conclusion about the maximum number of previous years that the state tax authority
will require the entity to file under its widely understood administrative practices or precedents. The
number of such previous years should not change unless new information becomes available. This
guidance applies only to economic nexus when a statute of limitations does not expire because an
income tax return has not been filed; it should not necessarily be applied to other situations.

An entity may also consider entering into a state’s voluntary disclosure program, which may limit the
number of prior years for which tax returns will be required. The terms and conditions of such programs
vary among states; generally, however, voluntary disclosure programs limit lookback periods to three
or four years. In addition, when assessing its UTB liabilities, an entity should generally not consider
the potential to limit the lookback period until the reporting period in which it enters the particular
state’s voluntary disclosure program.3 Therefore, when the entity has entered into such a program, its
liability for UTBs for that state’s income taxes would be limited by the number of prior years for which
tax returns will be required under the terms and conditions of the program, plus accrued interest and
penalties, if applicable. Entities should consult their tax advisers regarding the effect of entering into a
state’s voluntary disclosure program.

4.6.2.2 Due Process
In addition to considering the application of relevant tax rules in accounting for state tax positions, an
entity should also consider the “due process clause” and the “commerce clause” of the U.S. Constitution,
which limit the states’ rights to tax.

The due process clause of the Fourteenth Amendment requires a definite link between a state and the
person, property, or transaction it seeks to tax; the connection need not include physical presence in
the state. This clause also requires that the income attributed to the state for tax purposes be rationally
related to values connected with the taxing state. The commerce clause of the Constitution gives
Congress the authority to regulate commerce among the states.

No state or federal law is allowed to violate the Constitution. In evaluating all tax positions for recognition
under ASC 740, as well as for technical merits under the tax law as written and enacted, an entity may
need to assess whether the U.S. Supreme Court would overturn that tax law. This analysis is required for
recognition even though the court issues certiorari for tax matters involving the constitutionality of state
income taxes only in rare circumstances. Generally, an entity will conclude that the court would uphold
the tax law. However, in certain situations, an entity may conclude that the applicable tax law violates the
Constitution.

3
Some states require an entity to be accepted into the voluntary disclosure program before being afforded audit protection for previous years.

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For example, with respect to economic nexus, an entity may determine that, under the tax law, it is
more likely than not that it has incurred a tax obligation to the tax authority. However, the entity may
also conclude that the same tax law more likely than not violates the Constitution. In other words, if the
entity were to litigate this position to the U.S. Supreme Court, it is more likely than not that the court,
after evaluating such a law, would deem that law unconstitutional; in such a situation, the entity would
therefore not have a tax obligation to the tax authority.

An entity must have sufficient evidence to support its conclusion about the constitutionality of the
current tax law. This evidence will often be in the form of a legal opinion from competent outside
counsel. The legal opinion would state whether the tax law violates the Constitution and whether it is
more likely than not that the U.S. Supreme Court would overturn the enacted tax law.

4.6.3 Uncertain Tax Positions in Transfer Pricing Arrangements

740-10-30 (Q&A 69)
Transfer pricing relates to the pricing of intra-entity and related-party transactions involving transfers
of tangible property, intangible property, services, or financing between affiliated entities. These
transactions include transfers between domestic or international entities, such as (1) U.S. to foreign,
(2) foreign to foreign, (3) U.S. to U.S., and (4) U.S. state to state.

The general transfer pricing principle is that the pricing of a related-party transaction should be
consistent with the pricing of similar transactions between independent entities under similar
circumstances (i.e., an arm’s-length transaction). Transfer pricing tax regulations are intended to
prevent entities from using intra-entity charges to evade taxes by inflating or deflating the profits of a
particular jurisdiction the larger consolidated group does business in. Even if a parent corporation or
its subsidiaries are in tax jurisdictions with similar tax rates, an entity may have tax positions that are
subject to the recognition and measurement principles in ASC 740-10-25-6 and ASC 740-10-30-7.

An entity’s exposure to transfer pricing primarily occurs when the entity includes in its tax return the
benefit received from a related-party transaction that was not conducted as though it was at arm’s
length. A UTB results when one of the related parties reports either lower revenue or higher costs than
it can sustain (depending on the type of transaction). While a benefit is generally more likely than not
to result from such a transaction (e.g., some amount will be allowed as an interest deduction, royalty
expense, or cost of goods sold), the amount of benefit is often uncertain because of the subjectivity of
valuing the related-party transaction.

An entity must apply the two-step process (i.e., recognition and measurement) under ASC 740-10 to all
uncertain tax positions within its scope. The requirements of ASC 740 in the context of transfer pricing
arrangements, including related considerations and examples, are outlined below.

4.6.3.1 Determination of the Unit of Account

Before applying the recognition and measurement criteria, an entity must identify all material uncertain
tax positions and determine the appropriate unit of account for assessment. Intra-entity and related-
party transactions under transfer pricing arrangements are within the scope of ASC 740 since they
encompass “[a]n allocation or a shift of income between jurisdictions.”

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Further, tax positions related to transfer pricing generally should be evaluated individually, since
two entities and two tax jurisdictions are involved in each transaction. Such an evaluation should be
performed even when the transaction is supported by a transfer pricing study prepared by one of the
entities. Typically, there would be at least two units of account. For example, the price at which one
entity will sell goods to another entity will ultimately be the basis the second entity will use to determine
its cost of goods sold. In addition, some transfer pricing arrangements could be made up of multiple
components that could be challenged individually or in aggregate by a taxing authority. Therefore, there
could be multiple of units of account associated with a particular transfer pricing arrangement. See
Section 4.1.2.2 for more information about determining the unit of account.

4.6.3.2 Recognition
ASC 740-10-25-6 indicates that the threshold for recognition has been met “when it is more likely than
not, based on the technical merits, that the position will be sustained upon examination.” An entity
should apply the recognition threshold and guidance in ASC 740 to each unit of account in a transfer
pricing arrangement. In some cases, a tax position will be determined to have met the recognition
threshold if a transaction has taken place to generate the tax positions and some level of benefit will
therefore be sustained. For example, assume that a U.S. parent entity receives a royalty for the use of
intangibles by a foreign subsidiary that results in taxable income for the parent and a tax deduction for
the foreign subsidiary. The initial tax filing (income in the receiving jurisdiction and expense/deduction in
the paying jurisdiction) may typically meet the more-likely-than-not recognition threshold on the basis of
its technical merits, since a transaction between two parties has occurred. However, because there are
two entities and two tax jurisdictions involved, the tax jurisdictions could question whether the income is
sufficient, whether the deduction is excessive, or both.

4.6.3.3 Measurement
After an entity has assessed the recognition criteria in ASC 740 and has concluded that it is more likely
than not that the tax position taken will be sustained upon examination, the entity should measure the
associated tax benefit. This measurement should take into account all relevant information, including
tax treaties and arrangements between tax authorities. As discussed above, each tax position should
be assessed individually and a minimum of two tax positions should be assessed for recognition and
measurement in each transfer pricing transaction.

For measurement purposes, ASC 740-10-30-7 requires that the tax benefit be based on the amount
that is more than 50 percent likely to be realized upon settlement with a tax jurisdiction “that has full
knowledge of all relevant information.” Intra-entity or transfer pricing assessments present some unique
measurement-related challenges that are based on the existence of tax treaties or other arrangements
(or the lack of such arrangements) between two tax jurisdictions.

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Measurement of uncertain tax positions is typically based on facts and circumstances. The following are
some general considerations (not all-inclusive):

• Transfer pricing studies — An entity will often conduct a transfer pricing study with the objective
of documenting the appropriate arm’s-length pricing for the transactions. The entity should
consider the following when using a transfer pricing study to support the tax positions taken:
o The qualifications and independence of third-party specialists involved (if any).
o The type of study performed (e.g., benchmarking analysis, limited or specified-method
analysis, U.S. documentation report, Organisation for Economic Co-operation and
Development report) and, to avoid incurring penalties, whether it satisfies the particular
jurisdiction’s requirements.
o The specific transactions and tax jurisdictions covered in the study.
o The period covered by the study.
o The reasonableness of the model(s) and the underlying assumptions used in the study (i.e.,
comparability of companies or transactions used, risks borne, any adjustments made to
input data).
o Any changes in the current environment, including new tax laws in effect.

• Historical experience — An entity should consider previous settlement outcomes of similar tax
positions in the same tax jurisdictions. Information about similar tax positions, in the same tax
jurisdictions, that the entity has settled in previous years may serve as a good indicator of the
expected settlement of current positions.

• Applicability of tax treaties or other arrangements — An entity should consider whether a tax treaty
applies to a particular tax position and, if so, how the treaty would affect the negotiation and
settlement with the tax authorities involved.

• Symmetry of positions — Even though each tax position should be evaluated individually for
appropriate measurement, if there is a high likelihood of settlement through “competent-
authority” procedures under the tax treaty or other agreement, an entity should generally
use the same assumptions about such a settlement to measure both positions (i.e., the
measurement assumptions are similar, but the positions are not offset). Under the terms
of certain tax treaties entered into by the United States and foreign jurisdictions, countries
mutually agree to competent-authority procedures to relieve such companies of double taxation
created by transfer pricing adjustments to previously filed returns. If competent-authority
procedures are available, entities should carefully consider whether to pursue relief through
them and whether the particular jurisdictions involved are likely to reach an agreement with
respect to the particular disputed transactions.

An entity should carefully consider whether the tax jurisdictions involved strictly apply the arm’s-length
principle. Some jurisdictions may have a mandated statutory margin that may or may not equate to what
is considered arm’s length by another reciprocal taxing jurisdiction. In these situations, when an entity
measures positions, it may be inappropriate for the entity to assume that they are symmetrical.

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Example 4-7 illustrates the above considerations. See Section 13.2.4 for a discussion of balance sheet
presentation in transfer pricing arrangements under ASC 740.

Example 4-7

Assume that a U.S. entity licenses its name to its foreign subsidiary in exchange for a 2 percent royalty on sales.
This example focuses on the two separate tax positions that the entity has identified in connection with the
royalty transaction. For tax purposes, the U.S. entity recognizes royalty income in its U.S. tax return and the
foreign subsidiary takes a tax deduction for the royalty expense in its local-country tax return. Both positions
are deemed uncertain, since the respective tax authorities may either disallow a portion of the deduction
(deeming it to be excessive) or challenge the royalty rate used in this intra-entity transaction (deeming it to be
insufficient). The entity should evaluate both tax positions under the recognition and measurement criteria of
ASC 740. In this example, the “more-likely-than-not” recognition threshold is considered met since a transaction
has occurred between the two parties and it is therefore more likely than not that the U.S. entity has income
and the foreign subsidiary has a deduction.

The U.S. entity believes that if the IRS examines the tax position, it will more likely than not conclude that the
royalty rate should have been higher to be in line with an arm’s-length transaction. In the absence of any
consideration of relief through an international tax treaty, the lowest royalty rate that the entity believes is
more than 50 percent likely to be accepted by the IRS is 5 percent, on the basis of historical experience and
recent transfer pricing studies. A higher royalty rate would not only trigger an increase in taxable income for
the U.S. entity but would also result in double taxation of the additional royalty for the amount that is in excess
of the deduction claimed by the foreign subsidiary (i.e., 3 percent in this instance — calculated as the 5 percent
estimated arm’s-length amount less the original 2 percent recorded in the transaction). If there is a tax treaty
between the United States and the relevant foreign tax jurisdiction, that treaty will typically include procedures
that provide for competent-authority relief from double taxation. Under such an agreement, the two tax
authorities may agree at their discretion on an acceptable royalty rate in each jurisdiction. One tax authority
would make an adjustment (i.e., increasing revenue and taxable income) that would require a consistent
transfer pricing adjustment (i.e., increasing deduction and reducing taxable income) in the related party’s tax
jurisdiction.

In this example, management determines that it would pursue the competent-authority relief. Accordingly,
it concludes that it is appropriate to recognize relief from double taxation because of the expected outcome
of competent-authority procedures. Also, management has represented that the entity will incur the cost of
pursuing a competent-authority process. Therefore, the U.S. entity records a liability that would result from
resolution of the double taxation of this non-arm’s-length transaction if the original 2 percent royalty rate is
increased through application of the competent-authority process. Management of the U.S. entity believes that a
royalty rate of 3.5 percent is the lowest percentage (i.e., greatest benefit) that is more than 50 percent likely to be
accepted by the two tax jurisdictions under such a treaty on the basis of its historical experience. Because there
is a high likelihood of settlement through the competent-authority process, the foreign subsidiary should also use
this assumption when measuring the tax position to ensure symmetry of the two tax positions under ASC 740.
Note that this example focuses on one tax position in each jurisdiction; there may be other tax positions related
to this transfer pricing arrangement that would have to be similarly analyzed.

4.6.4 Uncertainty in Deduction Timing

740-10-30 (Q&A 10)
A deduction taken on an entity’s tax return may be certain except for the appropriate timing of the
deduction under the tax law in the applicable jurisdiction. In such cases, the recognition threshold is
satisfied and the entity should consider the uncertainty in the appropriate timing of the deduction in
measuring the associated tax benefit in each period.

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Example 4-8

Assume the following:

• An entity purchases equipment for $1,000 in 20X7.

• The entity’s earnings before interest, depreciation, and taxes are $1,200 each year in years 20X7–20Y1.
• For book purposes, the equipment is depreciated ratably over five years.
• For tax purposes, the entity deducts the entire $1,000 in its 20X7 tax return.
• The entity has a 25 percent tax rate and is taxable in only one jurisdiction.
• There is no half-year depreciation rule for accounting or tax purposes.
• For simplicity, interest and penalties on tax deficiencies are ignored.
In applying the recognition provisions of ASC 740-10-25-5, the entity has concluded that it is certain that the
$1,000 equipment acquisition cost is ultimately deductible under the tax law. Thus, the tax deduction of the
tax basis of the acquired asset would satisfy the recognition threshold in ASC 740-10-25-6. In measuring the
benefit associated with the deduction, the entity concludes that the largest amount that is more than 50
percent likely to be realized in a negotiated settlement with the tax authority is $200 per year for five years (the
tax life is the same as the book life).

Exclusive of interest and penalties, the entity’s current-year tax benefit is unaffected because the difference
between the benefit taken in the tax return and the benefit recognized in the financial statements is a
temporary difference.

However, although interest and penalties are ignored in this example for simplicity, ASC 740-10-25-56 requires
an entity to recognize interest and penalties on the basis of the provisions of the relevant tax law. In this case,
the entity would begin accruing interest in 20X8. Therefore, even though this is a timing difference, the accrual
of interest (and penalties, if applicable) will have an impact on profit and loss (P&L).

The 20X7 tax return reflects a $250 reduction in the current tax liability for the $1,000 deduction claimed.
For book purposes, the entity will recognize a balance sheet credit of $200 ([$1,000 – $200] × 25%) for UTBs
associated with the deduction claimed in year 1. The liability for UTBs will be extinguished over the succeeding

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Example 4-8 (continued)

four years at $50 ($200 × 25 percent) per year. The entity would record the following journal entries, excluding
interest and penalties, for the tax effects of the purchased equipment:

20X7 20X8 20X9 20Y0 20Y1 Totals

Pretax book and taxable income
before depreciation and interest $ 1,200 $ 1,200 $ 1,200 $ 1,200 $ 1,200 $ 6,000
Depreciation (200) (200) (200) (200) (200) (1,000)
Pretax book and taxable income on
ASC 740-10 basis $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 5,000
Adjust for tax depreciation as filed (800) 200 200 200 200 —
Taxable income on as-filed basis $ 200 $ 1,200 $ 1,200 $ 1,200 $ 1,200 $ 5,000
Current tax provision 50 300 300 300 300 1,250
Tax provision —
adjusted for uncertainty 200 (50) (50) (50) (50) —
Deferred tax provision — — — — — —
Total tax provision 250 250 250 250 250 1,250
Book income (after tax) $ 750 $ 750 $ 750 $ 750 $ 750 $ 3,750

25% 25% 25% 25% 25% 25%

Taxable income — as filed $ 200 $ 1,200 $ 1,200 $ 1,200 $ 1,200 $ 5,000
Taxable income — adjusted for
uncertainty 1,000 1,000 1,000 1,000 1,000 5,000
Current tax liability — as filed 50 300 300 300 300
Tax liability — adjusted
for uncertainty 250 250 250 250 250
UTB liability 200 150 100 50 0

Journal Entries 20X7 20X8 20X9 20Y0 20Y1

Current tax provision $ 50 $ 300 $ 300 $ 300 $ 300
Current tax liability (50) (300) (300) (300) (300)

Income tax provision 200 — — — —

Current UTB liability (50) — — — —
Long-term UTB liability (150) — — — —

Current UTB liability — 50 50 50 50

Income tax provision — (50) (50) (50) (50)

Long-term UTB liability — 50 50 50 —
Current UTB liability — (50) (50) (50) —

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Example 4-8 (continued)

20X7 20X8 20X9 20Y0 20Y1

Income taxes paid $ 50 $ 300 $ 300 $ 300 $ 300
Beginning of the year — (200) (150) (100) (50)
Gross increases — prior-year positions — — — — —
Gross decreases — prior-year positions — — — — —
Increases in UTBs — current-year positions (200) — — — —
Settlements with tax authorities — 50 50 50 50
Reductions that are due to statute lapse — — — — —
End of year $ (200) $ (150) $ (100) $ (50) $ —

At the end of each year, the entity, if an SEC registrant, would include its total liabilities for UTBs in the tabular
disclosure of contractual obligations required by SEC Regulation S-K, Item 303(a)(5), in “Other Long-Term
Liabilities Reflected on the Registrant’s Balance Sheet Under GAAP.” In that table, allocation of the total liabilities
for UTBs to “Payments due by period” would be based on the scheduled repayments ($50 per year for the next
four years in the above example).

See Section 3.3.5 for a discussion related to the accounting for tax method changes.

4.6.5 Deferred Tax Consequences of UTBs

740-10-25 (Q&A 21)
Recording a liability for a UTB may result in a corresponding temporary difference and DTA. Example 4-9
(below) and Example 4-10 illustrate how a DTA can arise from the accounting for a UTB.

Example 4-9

Company A has taken an uncertain tax position in State B that reduces its taxes payable by $10,000 in that
state. In assessing the uncertain tax position under ASC 740, A determines that it is not more likely than not
that the position, on the basis of its technical merits, will be sustained upon examination. Therefore, A records
a $10,000 liability for the UTB.

Company A will receive an additional federal tax deduction if it is ultimately required to make an additional tax
payment to the state. Therefore, A should record a DTA for the indirect benefit from the potential disallowance
of the uncertain tax position taken on its tax return in State B.

If the federal tax rate is 21 percent, A would record the following journal entries to account for the uncertain
tax position and the indirect tax benefit:

Income tax expense 10,000

Liability for UTBs 10,000

Federal DTA for state UTB liability 2,100

Deferred income tax expense 2,100

Like other DTAs, the DTA created as a result of recording the liability for the UTB should be evaluated for
realizability.

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Example 4-10

Company A has operations in State B but has never filed a tax return in that state. ASC 740-10-20 indicates that
the “decision not to file a tax return” is a tax position. In assessing the tax position under ASC 740, A determines
that it may have nexus in B and that it is not more likely than not that the position, on the basis of its technical
merits, will be sustained upon examination. Therefore, A records a $10,000 liability for the taxes payable to B
for the current and prior years.

However, if A were to file a return in B, it would also have a large deductible temporary difference that would
result in an $8,000 DTA in that state. Therefore, A should record a DTA as a result of potential nexus in B and
evaluate it for realizability.

If the federal tax rate is 21 percent, A would record the following journal entries to account for the uncertain
tax position and the related temporary difference:

Current income tax expense 10,000

Liability for unrecognized state tax benefits 10,000

State DTA for indirect tax benefit 8,000

Deferred income tax expense 8,000

Federal DTA for state UTB liability 2,100

Federal DTL for state DTA 1,680
Deferred income tax expense 420

See Section 14.4.1.7 for further discussion of the presentation of deferred taxes resulting from UTBs.

4.6.6 UTBs and Spin-Off Transactions

740-10-25 (Q&A 74)
In a spin-off transaction, a reporting entity (the “spinnor”) may distribute one or more of its subsidiaries
(“spinnees”) to its shareholders in the form of a dividend. After the spin-off is finalized, complexities can
arise in the accounting for uncertain tax positions in the separate financial statements of the spinnor
and spinnee when, before a spin-off, they file a consolidated tax return as a “consolidated return group.”
Under U.S. federal tax law, members of a consolidated return group are severally liable for all tax
positions taken in the consolidated return. The taxing authority typically seeks collection of the payment
of the consolidated return group’s tax liabilities from the parent of the consolidated return group;
however, if the IRS cannot collect from the parent of the consolidated return group (e.g., the parent is
insolvent), the IRS can seek payment from a subsidiary of the consolidated return group. Example 4-11
below illustrates the accounting for UTBs in a spin-off transaction.

Example 4-11

Company A, in the current reporting period, spins off a portion of its business that was conducted by Company
B. Before the spin-off, A and B were in the same federal consolidated return group and (1) A had recognized
a liability for uncertain tax positions in its consolidated financial statements associated with B’s operations
and (2) B had recognized the liability in its stand-alone financial statements prepared under the separate-
return approach (see Section 8.3.1.1). Under the terms of the separation agreement, A will be responsible for
settlement of the uncertain tax positions in tax returns for periods before the spin-off. Company A is solvent as
of the date of the spin-off and is expected to remain so afterward.

Company A
Upon completion of the spin-off transaction, A should continue to recognize a liability associated with the
uncertain tax position. Because the uncertain tax position was taken in a consolidated return group filed by
A, the primary obligor under the consolidated return regulations was and will continue to be A. Accordingly, A
should continue to recognize the liability for the UTB associated with the uncertain tax position under ASC 740.

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Example 4-11 (continued)

Company B
Each of the following views is acceptable:

• View A — Because A is the primary obligor, B cannot be the primary obligor and therefore should not
continue to recognize the liability for the UTB. In accordance with the consolidated return regulations,
the liability is retained by A, and B is typically liable only if A becomes insolvent. Accordingly, B no longer
has an uncertain tax position under ASC 740 and would remove the liability with an offsetting credit to
capital at the time of the spin-off. Company B would separately assess its contingent liability to the tax
authority if A becomes insolvent under ASC 450.
This view is consistent with the guidance in ASC 405-40 on obligations resulting from joint and several
liability obligations, which can be applied by analogy even though income taxes are not within its scope.
ASC 405-40-30-1 states:
Obligations resulting from joint and several liability arrangements included in the scope of this
Subtopic initially shall be measured as the sum of the following:
a. The amount the reporting entity agreed to pay on the basis of its arrangement among its
co-obligors
b. Any additional amount the reporting entity expects to pay on behalf of its co-obligors. If
some amount within a range of the additional amount the reporting entity expects to pay is a
better estimate than any other amount within the range, that amount shall be the additional
amount included in the measurement of the obligation. If no amount within the range is a
better estimate than any other amount, then the minimum amount in the range shall be the
additional amount included in the measurement of the obligation.

• View B — Because B is still an obligor under the consolidated return regulations, it should continue
to record a liability for the UTB under ASC 740. The uncertain tax position was generated by B and
presented in its separate company financial statements before the spin-off. In addition, although A
insulates B from liability to a degree, B could be required to settle the uncertain tax position. Accordingly,
B should apply ASC 740 in recording and subsequently measuring an uncertain tax benefit. Company B
would also record an indemnification receivable, subject to (1) any contractual limitations on its amount
and (2) management’s assessment of the collectibility of the indemnification asset (by analogy to the
guidance in ASC 805-20-35-4), reflecting the fact that A has agreed to be responsible for settlement of
the uncertain tax positions.
While View A and View B are both acceptable, the selected method would represent an accounting policy that
should be consistently applied and appropriately disclosed.

See Section 11.3.6.6 for additional guidance on indemnification agreements.

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5.1 Introduction
This chapter provides guidance on the amount at which an entity should measure a tax asset in its
financial statements when the recognition criteria for that asset or liability have been met in accordance
with ASC 740. Specifically, this chapter focuses on how to evaluate DTAs for realizability and when
a valuation allowance would be appropriate. As the complexity of an entity’s legal structure and
jurisdictional footprint increases, so do the challenges related to measuring tax assets and liabilities.
However, the guidance in this chapter applies equally to highly complex organizations as well as to
simple entities that operate in a single jurisdiction.

A valuation allowance may be required to be recorded against DTAs so the financial statements reflect
the amount of the net DTA that is expected to be used in the future (i.e., realized). Expected realization
of DTAs must meet the more-likely-than-not standard to be recorded in the financial statements without
a valuation allowance. The more-likely-than-not concept is discussed below.

5.2 Basic Principles of Valuation Allowances

ASC 740-10

30-16 As established in paragraph 740-10-30-2(b), there is a basic requirement to reduce the measurement of
deferred tax assets not expected to be realized. An entity shall evaluate the need for a valuation allowance on
a deferred tax asset related to available-for-sale debt securities in combination with the entity’s other deferred
tax assets.
30-17 All available evidence, both positive and negative, shall be considered to determine whether, based on
the weight of that evidence, a valuation allowance for deferred tax assets is needed. Information about an
entity’s current financial position and its results of operations for the current and preceding years ordinarily is
readily available. That historical information is supplemented by all currently available information about future
years. Sometimes, however, historical information may not be available (for example, start-up operations) or it
may not be as relevant (for example, if there has been a significant, recent change in circumstances) and special
attention is required.

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ASC 740-10 (continued)

30-18 Future realization of the tax benefit of an existing deductible temporary difference or carryforward
ultimately depends on the existence of sufficient taxable income of the appropriate character (for example,
ordinary income or capital gain) within the carryback, carryforward period available under the tax law. The
following four possible sources of taxable income may be available under the tax law to realize a tax benefit for
deductible temporary differences and carryforwards:
a. Future reversals of existing taxable temporary differences
b. Future taxable income exclusive of reversing temporary differences and carryforwards
c. Taxable income in prior carryback year(s) if carryback is permitted under the tax law
d. Tax-planning strategies (see paragraph 740-10-30-19) that would, if necessary, be implemented to, for
example:
1. Accelerate taxable amounts to utilize expiring carryforwards
2. Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or
loss
3. Switch from tax-exempt to taxable investments.
Evidence available about each of those possible sources of taxable income will vary for different tax
jurisdictions and, possibly, from year to year. To the extent evidence about one or more sources of taxable
income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not
be considered. Consideration of each source is required, however, to determine the amount of the valuation
allowance that is recognized for deferred tax assets.

30-19 In some circumstances, there are actions (including elections for tax purposes) that:
a. Are prudent and feasible
b. An entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward
from expiring unused
c. Would result in realization of deferred tax assets.
This Subtopic refers to those actions as tax-planning strategies. An entity shall consider tax-planning
strategies in determining the amount of valuation allowance required. Significant expenses to implement a
tax-planning strategy or any significant losses that would be recognized if that strategy were implemented (net
of any recognizable tax benefits associated with those expenses or losses) shall be included in the valuation
allowance. See paragraphs 740-10-55-39 through 55-48 for additional guidance. Implementation of the
tax-planning strategy shall be primarily within the control of management but need not be within the unilateral
control of management.
30-20 When a tax-planning strategy is contemplated as a source of future taxable income to support the
realizability of a deferred tax asset, the recognition and measurement requirements for tax positions in
paragraphs 740-10-25-6 through 25-7; 740-10-25-13; and 740-10-30-7 shall be applied in determining the
amount of available future taxable income.
30-21 Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence
such as cumulative losses in recent years. Other examples of negative evidence include, but are not limited to,
the following:
a. A history of operating loss or tax credit carryforwards expiring unused
b. Losses expected in early future years (by a presently profitable entity)
c. Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and
profit levels on a continuing basis in future years
d. A carryback, carryforward period that is so brief it would limit realization of tax benefits if a significant
deductible temporary difference is expected to reverse in a single year or the entity operates in a
traditionally cyclical business.

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ASC 740-10 (continued)

30-22 Examples (not prerequisites) of positive evidence that might support a conclusion that a valuation
allowance is not needed when there is negative evidence include, but are not limited to, the following:
a. Existing contracts or firm sales backlog that will produce more than enough taxable income to realize
the deferred tax asset based on existing sales prices and cost structures
b. An excess of appreciated asset value over the tax basis of the entity’s net assets in an amount sufficient
to realize the deferred tax asset
c. A strong earnings history exclusive of the loss that created the future deductible amount (tax loss
carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for
example, an unusual or infrequent item) is an aberration rather than a continuing condition.
30-23 An entity shall use judgment in considering the relative impact of negative and positive evidence. The
weight given to the potential effect of negative and positive evidence shall be commensurate with the extent
to which it can be objectively verified. The more negative evidence that exists, the more positive evidence
is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed for
some portion or all of the deferred tax asset. A cumulative loss in recent years is a significant piece of negative
evidence that is difficult to overcome.
30-24 Future realization of a tax benefit sometimes will be expected for a portion but not all of a deferred tax
asset, and the dividing line between the two portions may be unclear. In those circumstances, application of
judgment based on a careful assessment of all available evidence is required to determine the portion of a
deferred tax asset for which it is more likely than not a tax benefit will not be realized.
30-25 See paragraphs 740-10-55-34 through 55-38 for additional guidance related to carrybacks and
carryforwards.
Related Implementation Guidance and Illustrations
• Recognition of Deferred Tax Assets and Deferred Tax Liabilities [ASC 740-10-55-7].
• Offset of Taxable and Deductible Amounts [ASC 740-10-55-12].
• Pattern of Taxable or Deductible Amounts [ASC 740-10-55-13].
• The Need to Schedule Temporary Difference Reversals [ASC 740-10-55-15].
• Operating Loss and Tax Credit Carryforwards and Carrybacks [ASC 740-10-55-34].
• Tax-Planning Strategies [ASC 740-10-55-39].
• Example 4: Valuation Allowance and Tax-Planning Strategies [ASC 740-10-55-96].
• Example 12: Basic Deferred Tax Recognition [ASC 740-10-55-120].
• Example 13: Valuation Allowance for Deferred Tax Assets [ASC 740-10-55-124].
• Example 19: Recognizing Tax Benefits of Operating Loss [ASC 740-10-55-149].
• Example 20: Interaction of Loss Carryforwards and Temporary Differences [ASC 740-10-55-156].
• Example 21: Tax-Planning Strategy With Significant Implementation Cost [ASC 740-10-55-159].
• Example 22: Multiple Tax-Planning Strategies Available [ASC 740-10-55-163].

5.2.1 The More-Likely-Than-Not Standard

740-10-30 (Q&A 24)
A key concept underlying the measurement of a DTA is that the amount to be recognized is the
amount that is “more likely than not” expected to be realized. ASC 740-10-30-5(e) requires that DTAs
be reduced “by a valuation allowance if, based on the weight of available evidence, it is more likely than
not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be
realized.”

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A more-likely-than-not standard for measuring DTAs could be applied positively or negatively. That
is, an asset could be measured on the basis of a presumption that it would be realized, subject to an
impairment test, or it could be measured on the basis of an affirmative belief about realization. Because
the threshold of the required test is “slightly more than 50 percent,” the results would seem to be
substantially the same under either approach. However, some view an affirmative approach as placing a
burden of proof on the entity to provide evidence to support measurement “based on the weight of the
available evidence.” Regardless of whether an entity views the more-likely-than-not threshold positively
or negatively, the entity should fully assess all of the available evidence and be able to substantiate its
determination.

Further, the more-likely-than-not threshold for recognizing a valuation allowance is a lower threshold
than impairment or loss thresholds found in other sections of the Codification. For example, ASC
450-20-25-2 requires that an estimated loss from a loss contingency be accrued if the loss is probable
and can be reasonably estimated. Further, ASC 360-10-35-17 requires that an impairment loss of
long-lived assets be recognized “only if the carrying amount of a long-lived asset (asset group) is not
recoverable and exceeds its fair value.” In paragraphs A95 and A96 of the Basis for Conclusions of
Statement 109, the FASB rejected the term “probable” with respect to the measurement of DTAs and
believes that the criterion should be “one that produces accounting results that come closest to the
expected outcome, that is, realization or nonrealization of the deferred tax asset in future years.” If the
same assumptions about future operations are used, this difference in recognition criteria could cause
an entity to recognize a valuation allowance against a DTA but not to recognize an asset impairment or a
loss contingency.

5.3 Sources of Taxable Income

740-10-30 (Q&A 28)
To assess whether DTAs meet the more-likely-than-not threshold for realization, an entity needs to
consider its sources of future taxable income. Taxable income of the appropriate character (e.g., capital
or ordinary), within the appropriate time frame, is necessary for the future realization of DTAs.

When determining whether a valuation allowance is needed, an entity must (1) evaluate each of the
four sources of taxable income discussed below in accordance with how objectively verifiable it is and
(2) consider that each may represent positive evidence that future taxable income will be generated. In
addition, the entity may also have to consider negative evidence in its analysis.

ASC 740-10-30-18 lists four sources of taxable income that may enable realization of a DTA, stating, in
part:

The following four possible sources of taxable income may be available under the tax law to realize a tax benefit
for deductible temporary differences and carryforwards:
a. Future reversals of existing taxable temporary differences
b. Future taxable income exclusive of reversing temporary differences and carryforwards
c. Taxable income in prior carryback year(s) if carryback is permitted under the tax law
d. Tax-planning strategies (see paragraph 740-10-30-19) that would, if necessary, be implemented to, for
example:
1. Accelerate taxable amounts to utilize expiring carryforwards
2. Change the character of taxable or deductible amounts from ordinary income or loss to capital gain
or loss
3. Switch from tax-exempt to taxable investments.

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The possible sources listed in ASC 740-10-30-18(a) and (c) above can often be objectively verified.
Because the sources listed in ASC 740-10-30-18(b) and (d) are based on future events, their
determination is more subjective. An entity should first consider the objectively verifiable sources. If,
within the appropriate time frame, those sources will generate sufficient taxable income of the right
character (e.g., capital or ordinary), an entity may not need to assess the likelihood of other future
taxable income.

Objectively verifiable positive evidence is required to offset any objectively verifiable negative evidence
(e.g., cumulative losses in recent periods; see the discussion in Section 5.3.2.1) in the assessment of
whether a valuation allowance is required. Subjectively verifiable positive evidence (e.g., management’s
future income projections, which incorporate future earnings growth) may be sufficient to overcome
certain types of subjective negative evidence (e.g., negative trends in the entity’s industry outlook that
may not be specific to the entity itself). As discussed throughout this chapter, the entity should evaluate
both the positive and negative evidence to determine whether a valuation allowance is required.

The implementation guidance in ASC 740-10-55-16 and 55-17 illustrates that the timing of the
deductions and other benefits associated with a DTA must coincide with the timing of the taxable
income. An entity may devise a qualifying tax-planning strategy (the source listed in ASC 740-10-30-18(d)
above) to change the timing or character of the future taxable income. Such a strategy should be given
more weight (see ASC 740-10-30-23) than a forecast of future taxable income from future events (the
source listed in ASC 740-10-30-18(b) above), since it constitutes more objectively verifiable evidence of
realizability. To help illustrate how to weigh the four sources of future taxable income, we will discuss
each source in more detail below.

5.3.1 Future Reversals of Existing Taxable Temporary Differences

740-10-30 (Q&A 30)
The possible source of future taxable income listed in ASC 740-10-30-18(a) above is “[f]uture reversals
of existing taxable temporary differences.” When evaluating whether an existing taxable temporary
difference is a source of future taxable income, an entity must have a general understanding of
the reversal patterns of temporary differences because such an understanding is relevant to the
measurement of DTAs when the entity is assessing the need for a valuation allowance under ASC
740-10-30-18. Example 5-1 below illustrates the future reversals of existing taxable temporary
differences as a source of taxable income.

Example 5-1

Existing Taxable Temporary Differences That Will Reverse in the Future

Generally, the existence of sufficient taxable temporary differences will enable use of the tax benefit of
operating loss carryforwards, tax credit carryforwards, and deductible temporary differences, irrespective
of future expected income or losses from other sources identified in ASC 740-10-30-18. For example, if an
entity has $300,000 of taxable temporary differences that are expected to reverse over the next 10 years
(which represents objectively verifiable positive evidence) and deductible temporary differences of $25,000
that are expected to reverse within the next several years, realization of the DTA is more likely than not and
no valuation allowance would be necessary even if future losses are expected or a cumulative loss exists as
of the measurement date (the latter of which would represent objectively verifiable negative evidence; see
the discussion in Section 5.3.2.1). Because the reversing future taxable temporary differences are objectively
verifiable positive evidence, they may be used to outweigh the objectively verifiable negative evidence of
cumulative losses.

Another simple example is the temporary difference that is often created by recording of warranty reserves.
In most tax jurisdictions, tax deductions for accrued warranty costs are not permitted until the obligation is
settled. The temporary differences attributable to warranty accruals for financial reporting purposes should be
scheduled to reverse during the years in which the tax deductions are expected to be claimed.

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5.3.1.1 Determining the Pattern of Reversals of Existing Taxable Temporary

Differences
Although ASC 740-10-55-22 states that the “methods used for determining reversal patterns should be
systematic and logical,” ASC 740 does not specify in detail how the reversal patterns for each class of
temporary differences should be treated and indicates that in many situations there might be more than
one logical approach. The amount of scheduling of reversal patterns that might be necessary, if any, will
therefore depend on the specific facts and circumstances. The implementation guidance in ASC 740-10-
55-12 and 55-13 suggests that two concepts are important to determining the reversal patterns for
existing temporary differences:

• The “tax law determines whether future reversals of temporary differences will result in taxable
and deductible amounts that offset each other in future years.”

• The “particular years in which temporary differences result in taxable or deductible amounts
generally are determined by the timing of the recovery of the related asset or settlement of the
related liability.”

Further, ASC 740-10-55-22 states that “[m]inimizing complexity is an appropriate consideration in

selecting a method for determining reversal patterns” and that an entity should use the same method
of reversal when measuring the deferred tax consequences for a “particular category of temporary
differences for a particular tax jurisdiction.” For example, if the loan amortization method and the
present value method are both systematic and logical reversal patterns for temporary differences that
originate as a result of assets and liabilities that are measured at present value, an entity engaged in
leasing activities should consistently use either of those methods for all its temporary differences related
to leases that are recorded as lessor receivables, because those temporary differences are related to
a particular category of items. If that same entity also has temporary differences resulting from loans
receivable, a different method of reversal might be used because those differences are related to
another category of temporary differences.

ASC 740-10-55-22 also states:

If the same temporary difference exists in two tax jurisdictions (for example, U.S. federal and a state tax
jurisdiction), the same method should be used for that temporary difference in both tax jurisdictions. The same
method for a particular category in a particular tax jurisdiction should be used consistently from year to year.

An entity should report any change in the method of reversal as a change in accounting principle in
accordance with ASC 250.

See Section 5.8 for additional examples of existing temporary differences and some common methods
for determining the pattern of their reversal.

5.3.1.2 Realization of a DTA Related to an Investment in a Subsidiary: Deferred

Income Tax Exceptions Not a Source of Income
740-30-25 (Q&A 09)
The future reversal of an existing taxable temporary difference for which a DTL has not been recognized
under the indefinite reversal criteria of ASC 740-30-25-17 should not be considered a source of taxable
income in accordance with the source listed in ASC 740-10-30-18(a) discussed above. ASC 740-30-
25-13 indicates that an entity should not consider future distributions of future earnings of a subsidiary
or corporate joint venture in assessing the need for a valuation allowance unless a DTL has been
recognized for existing undistributed earnings or earnings have been remitted in the past. Similarly,
an entity should not consider future reversals of existing taxable temporary differences as a source of
taxable income unless a DTL has been recognized on the related taxable temporary difference (i.e., an
unrecognized DTL is not a source of future taxable income). Example 5-2 illustrates this concept.

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Example 5-2

An Unrecognized DTL Is Not a Source of Future Taxable Income

Assume that before the enactment of the 2017 Act, Entity X, a U.S. domestic parent entity, has a wholly owned
foreign subsidiary, FS1. The amounts for financial reporting and the tax basis of X’s investment in FS1 are
$2,000 and $1,000, respectively, on December 31, 20X1 (i.e., X has a taxable outside basis difference related to
its investment in FS1). Further assume that X has an NOL DTA of $1,000, with a 20-year carryforward period.1

Entity X has not recorded a DTL related to its investment in FS1 because X asserts that the indefinite
reinvestment criteria have been met for the $1,000 taxable temporary difference, which is attributable to
undistributed earnings. In addition, FS1 has not previously remitted earnings.

Ordinarily, before the enactment of the 2017 Act, an existing taxable temporary difference (e.g., from the
undistributed earnings of FS1) would have been a potential source of taxable income for consideration in the
assessment of the need for a valuation allowance. However, X has not previously accrued a DTL on the earnings
of FS1, and FS1 has not remitted earnings in the past; therefore, X cannot consider the reversal of the outside
basis taxable temporary difference associated with its investment in FS1 as a source of taxable income when
determining whether it is more likely than not that the NOL DTA is realizable.

5.3.1.3 Using the Reversal of a DTL for an Indefinite-Lived Asset as a Source of

Taxable Income After Enactment of the 2017 Act
740-10-30 (Q&A 65)
Enactment of the 2017 Act modified aspects of U.S. federal tax law regarding NOL carryforwards. Under
previous U.S. federal tax law, NOLs generally had a carryback period of 2 years and a carryforward
period of 20 years. For NOLs incurred in years subject to the new federal tax rules, the 2017 Act
eliminates, with certain exceptions, the NOL carryback period and permits an indefinite carryforward
period, with some limitations as discussed below. However, the provision to eliminate the NOL carryback
period was temporarily repealed with the enactment of the CARES Act, which reinstated a five-year
carryback period for certain taxable years (see Section 5.3.3 for further information about the carryback
period).

After implementation of the 2017 Act, in accordance with the source listed in ASC 740-10-30-18(a),
one of the four sources of future taxable income discussed above, a taxable temporary difference
associated with an indefinite-lived asset is generally considered to be a source of taxable income
to support realization of either NOLs with an unlimited carryforward period or disallowed interest
carryforwards with unlimited carryforward periods. This would also generally be true for a deductible
temporary difference that is scheduled to reverse into an NOL with an unlimited carryforward period.
However, because the 2017 Act includes restrictions on the ability to use NOLs and disallowed interest
carryforwards with unlimited carryforward periods (i.e., NOLs arising in years subject to the new rules
are limited in use to 80 percent of taxable income and the amount of net business interest an entity can
deduct is limited to 30 percent of modified taxable income), no more than 80 percent or 30 percent of
the indefinite-lived taxable temporary difference would serve as a source of taxable income with respect
to the NOL or disallowed interest carryforward, respectively.2

1
The conclusion reached in this example would have been the same even if the NOL’s carryforward period had been indefinite.
2
The CARES Act temporarily eliminated the 80 percent limitation for NOLs for taxable years beginning before January 1, 2021. It also temporarily
increased the business interest expense limitation from 30 percent to 50 percent for taxable years beginning after 2019 and 2020 and allows
entities to elect to use their 2019 modified taxable income as their 2020 modified taxable income. As a result, entities will need to consider how
this temporary change affects their previous conclusions about their ability to offset future sources of taxable income from indefinite-lived taxable
temporary differences. For example, a NOL generated in 2019 will not be limited to a PTI and thus an indefinite-lived taxable temporary difference
will not be limited as a source of taxable income with respect to this NOL. For further information about the CARES Act and the subsequent
income tax accounting, see Deloitte’s Heads Up, “Highlights of the CARES Act.”

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However, an entity may sometimes have both NOLs with an unlimited carryforward period and
disallowed interest carryforwards with an unlimited carryforward period, meaning that portions of
the indefinite-lived taxable temporary difference might serve as a source of taxable income for both
because of the limitations provided in the 2017 Act. For example, because the annual interest limitation
is calculated before NOLs are taken into account, the taxable temporary difference associated with an
indefinite-lived asset would first be a source of taxable income for the disallowed interest carryforward
(limited to 30 percent of the taxable temporary difference, as discussed above), but then any remaining
taxable temporary difference on the indefinite lived asset might also be a source of taxable income for
NOLs with an unlimited carryforward period (limited to 80 percent of the remaining taxable temporary
difference, as discussed above).

For existing U.S. federal jurisdiction NOLs created before the effective date of the 2017 Act and in
jurisdictions that have finite-lived NOLs, the reversal of a DTL related to an indefinite-lived asset generally
cannot be used as a source of taxable income to support the realization of such finite-lived DTAs. This
is because a taxable temporary difference related to an indefinite-lived asset (e.g., land, indefinite-lived
intangible assets, and tax-deductible “component 1” goodwill) will reverse only when the indefinite-lived
asset is sold. If a sale of an indefinite-lived asset is not expected in the foreseeable future, the reversal
of the related DTL generally cannot be scheduled, so an entity generally cannot consider the reversal
a source of future taxable income when assessing the realizability of DTAs, other than for indefinite-
lived DTAs. However, there are circumstances such as the following in which it may be appropriate to
consider a DTL related to an indefinite-lived asset as a source of taxable income for a finite-lived NOL:

• If the sale of an indefinite-lived asset is expected in the foreseeable future (e.g., the asset is
classified as held for sale) and the related DTL can therefore be scheduled to reverse.

• If it is anticipated that the indefinite-lived asset will be reclassified as finite-lived. For example, an
R&D asset acquired in a business combination that is initially classified as indefinite-lived will be
reclassified as finite-lived once the project is completed or abandoned.

5.3.1.4 Deemed Repatriation Transition Tax as a Source of Future Taxable Income

See Chapter 3 for a discussion of outside basis differences and the deemed repatriation transition
tax. Under certain circumstances, an entity would record a liability for the transition tax in the
financial statements for the year that included the enactment date but would not include the deemed
repatriation and corresponding tax in that year’s tax return. We believe that it would be appropriate in
these circumstances for the entity to consider the corresponding one-time deemed repatriation income
inclusion to be a source of taxable income when analyzing the realization of DTAs recorded in the
financial statements in the period in which the transition tax liability is recorded. The entity should verify
that the one-time deemed repatriation income inclusion coincides with the timing of the deductions and
other benefits associated with the DTAs.

However, if the entity elects to defer payment of the transition tax liability over a period of up to eight
years, the transition tax liability itself does not represent a source of taxable income in future periods
when analyzing the realization of DTAs that remain after the deemed repatriation has been included in
the entity’s income tax return. This is because settlement of the transition tax liability in a future year or
years will not result in taxable income.

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5.3.1.5 Use of Attributes That Result in Replacement or “Substitution” of DTAs

ASC 740-10

55-37 An operating loss or tax credit carryforward from a prior year (for which the deferred tax asset was
offset by a valuation allowance) may sometimes reduce taxable income and taxes payable that are attributable
to certain revenues or gains that the tax law requires be included in taxable income for the year that cash is
received. For financial reporting, however, there may have been no revenue or gain and a liability is recognized
for the cash received. Future sacrifices to settle the liability will result in deductible amounts in future years.
Under those circumstances, the reduction in taxable income and taxes payable from utilization of the operating
loss or tax credit carryforward gives no cause for recognition of a tax benefit because, in effect, the operating
loss or tax credit carryforward has been replaced by temporary differences that will result in deductible
amounts when a nontax liability is settled in future years. The requirements for recognition of a tax benefit
for deductible temporary differences and for operating loss carryforwards are the same, and the manner of
reporting the eventual tax benefit recognized (that is, in income or as required by paragraph 740-20-45-3) is
not affected by the intervening transaction reported for tax purposes. Example 20 (see paragraph 740-10-
55-156) illustrates recognition of the tax benefit of an operating loss in the loss year and in subsequent
carryforward years when a valuation allowance is necessary in the loss year.

ASC 740-10-55-37 describes a situation in which an NOL carryforward from a prior year may be used
to reduce taxable income (and taxes payable) on an entity’s income tax return. In this scenario, the
attribute is used to offset a gain in the current year that must, in accordance with tax law, be included in
taxable income for the year in which cash is received. However, in doing so, the NOL carryforward DTA
may be replaced by another DTA because a liability is recognized for financial reporting purposes under
U.S. GAAP, and future sacrifices to settle the liability will result in deductible amounts in future years.

In situations such as these, in which a DTA for an attribute is replaced by a DTA for a future deduction,
the use of the attribute against the entity’s taxable income (and, thus, the reduction in its income tax
payable) generally would not constitute realization of a tax benefit unless the entity has other sources
of future taxable income that the “replacement” or “substitute” DTA can be used to offset (e.g., if the
NOL carryforward was set to expire and the “refresh” of the attribute (i.e., the use of the attribute and
substitution with a future deduction allowed the company to access sources of future taxable income
that are more likely than not to arise in a period beyond the end of the existing carryforward period
for the attribute). In other words, unless the future deduction that replaced the attribute can also be
realized, the use of the attribute does not constitute realization. If, on the other hand, an economic
benefit will result from the use of the attribute, realization has occurred.

We believe that while ASC 740-10-55-37 does not specifically address such cases, an entity would
apply this principle to assess realization in situations in which (1) the attribute already has a valuation
allowance recorded against it but will be used in a future year or (2) the entity is evaluating planning
strategies that it could execute in a subsequent year.

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The following example from ASC 740-10-55-156 through 55-158 illustrates the guidance in ASC 740-10-
55-37 on the interaction of NOL carryforwards and temporary differences:

ASC 740-10

Example 20: Interaction of Loss Carryforwards and Temporary Differences

55-156 This Example illustrates the guidance in paragraph 740-10-55-37 for the interaction of loss
carryforwards and temporary differences that will result in net deductible amounts in future years. This
Example has the following assumptions:
a. The financial loss and the loss reported on the tax return for an entity’s first year of operations are the
same.
b. In Year 2, a gain of $2,500 from a transaction that is a sale for tax purposes but does not meet the
sale recognition criteria for financial reporting purposes is the only difference between pretax financial
income and taxable income.

55-157 Financial and taxable income in this Example are as follows.

Financial Taxable
Income Income

Year 1: Income (loss) from operations $ (4,000) $ (4,000)

Year 2: Income (loss) from operations $ — $ —

Taxable gain on sale 2,500

Taxable income before loss carryforward 2,500

Loss carryforward from Year 1 (4,000)

Taxable income $ —

55-158 The $4,000 operating loss carryforward at the end of Year 1 is reduced to $1,500 at the end of Year 2
because $2,500 of it is used to reduce taxable income. The $2,500 reduction in the loss carryforward becomes
$2,500 of deductible temporary differences that will reverse and result in future tax deductions when the sale
occurs (that is, control of the asset transfers to the buyer-lessor). The entity has no deferred tax liability to be
offset by those future tax deductions, the future tax deductions cannot be realized by loss carryback because
no taxes have been paid, and the entity has had pretax losses for financial reporting since inception. Unless
positive evidence exists that is sufficient to overcome the negative evidence associated with those losses, a
valuation allowance is recognized at the end of Year 2 for the full amount of the deferred tax asset related to
the $2,500 of deductible temporary differences and the remaining $1,500 of operating loss carryforward.

As illustrated above, in the absence of positive evidence (e.g., projections of future taxable income),
there will ultimately be no realization resulting from use of the operating loss carryforward.

5.3.2 Future Taxable Income

As discussed above, ASC 740-10-30-18 lists four sources of future income that may enable realization
of a DTA, including the source listed in ASC 740-10-30-18(b), “[f]uture taxable income exclusive of
reversing temporary differences and carryforwards.” Management projections are inherently subjective.3
Therefore, future taxable income from the source listed in ASC 740-10-30-18(b) is generally considered
to be subjectively determined as opposed to objectively determined.

3
The projections referred to here are management’s estimates of future income based on metrics and qualitative information used by the entity,
which might include future growth assumptions and other subjective management assertions.

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An entity will consider a number of factors in preparing subjective projections of future taxable income,
including the following:

• The reasonableness of management’s business plan and its impact on future taxable income,
including management’s history of carrying out its stated plans and its ability to carry out its
plans (given contractual commitments, available financing, or debt covenants).

• The reasonableness of financial projections based on historical operating results.

• The consistency of assumptions in relation to prior periods and projections used in other
financial statement estimates (e.g., goodwill impairment analysis).

• Consistency with relevant industry data, including short- and long-term trends in the industry.
• The reasonableness of financial projections when current economic conditions are considered.
Also see Section 5.4 for further considerations related to future events.

In determining whether a valuation allowance is needed, an entity must use judgment and consider the
relative weight of the available negative and positive evidence. Further, ASC 740-10-30-23 states that
the “weight given to the potential effect of negative and positive evidence shall be commensurate with
the extent to which it can be objectively verified.” For example, information about the entity’s current
financial position and income or loss for recent periods may constitute objectively verifiable evidence,
while a long-term forecast of sales and income for a new product may be less objective and verifiable.

In addition, if an entity has no objectively verifiable negative evidence, then it need only determine
whether it is more likely than not that the DTA will be realized. If the more-likely-than-not assertion can
be supported, often by using management’s subjective projections of future income, there is no need
for a valuation allowance. However, if the entity is in a cumulative loss position (which is considered a
piece of objective and verifiable negative evidence), it requires objective and verifiable positive evidence
to overcome this negative evidence, as discussed further below.

5.3.2.1 Cumulative Losses: An Objectively Verifiable Form of Negative Evidence

740-10-30 (Q&A 39)
ASC 740-10-30-21 states that “cumulative losses in recent years” are a type of negative evidence for
entities to consider in evaluating the need for a valuation allowance. However, ASC 740 does not define
“cumulative losses in recent years.” In deliberating whether to define the term, the FASB discussed the
possibility of imposing conditions that would require such losses to be (1) cumulative losses for tax
purposes that were incurred in tax jurisdictions that were significant to an entity for a specified number
of years, (2) cumulative losses for tax purposes that were incurred in all tax jurisdictions in which an
entity operated during a specified number of years, (3) cumulative pretax accounting losses incurred in
the reporting entity’s major markets or its major tax jurisdictions for a specified number of years, and
(4) cumulative consolidated pretax accounting losses for a specified number of years. However, the FASB
ultimately decided not to define the term.

Because there is no authoritative definition of this term, management must use judgment in determining
whether an entity has negative evidence in the form of cumulative losses. In making that determination,
management should generally consider the relevant tax-paying component’s4 results before tax from all
sources (e.g., amounts recognized in discontinued operations and OCI) for the current year and previous
two years, adjusted for recurring permanent differences. Use of a “three-year” convention arose, in
part, as a result of proposed guidance in the exposure draft on FASB Statement 109. This guidance was
omitted in the final standard (codified in ASC 740) because the FASB decided that a bright-line definition
of the term “cumulative losses in recent years” might be problematic. Paragraph 103 of Statement 109’s

4
As described in ASC 740-10-30-5, a tax-paying component is an individual entity or group of entities that is consolidated for tax purposes.

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Basis for Conclusions states that the “Board believes that the more likely than not criterion required by
[ASC 740] is capable of appropriately dealing with all forms of negative evidence, including cumulative
losses in recent years.” The paragraph further indicates that the more-likely-than-not criterion “requires
positive evidence of sufficient quality and quantity to counteract negative evidence in order to support
a conclusion that . . . a valuation allowance is not needed.” A three-year period, however, generally
supports the more-likely-than-not recognition threshold because it typically covers several operating
cycles of the entity and one-time events in a given cycle do not overly skew the entity’s analysis.

Even though there is no bright-line three-year cumulative loss test, the SEC has consistently questioned
registrants that had a three-year cumulative loss about why there was not a valuation allowance and
asked for documentation to support such a determination. In very rare circumstances, it may be
acceptable for entities that have business cycles longer or shorter than three years to use a period
longer or shorter than three years to determine whether they have a cumulative loss. To support this
determination, an entity must demonstrate that it operates in a cyclical industry and that a period other
than three years is more appropriate. For example, a four-year period or a two-year period may be
acceptable if the entity can demonstrate that it operates in a cyclical business and the business cycles
correspond to those respective periods. If a period other than three years is used, the entity should
consult with its income tax accounting advisers and apply the period it selects consistently (i.e., in each
reporting period).

When determining whether cumulative losses in recent years exist, an entity should generally not
exclude nonrecurring items from its results. It may, however, be appropriate for the entity to exclude
nonrecurring items when projecting future income in connection with its determination of the amount
of the valuation allowance needed.

Cumulative losses are one of the most objectively verifiable forms of negative evidence. Thus, an entity
that has suffered cumulative losses in recent years may find it difficult to support an assertion that a DTA
could be realized if such an assertion is based on subjective forecasts of future profitable results rather
than an actual return to profitability. In other words, an entity that has cumulative losses is generally
prohibited from using an estimate of subjectively determined future earnings to support a conclusion
that realization of an existing DTA is more likely than not if such a forecast is not based on objectively
verifiable information. An objectively verifiable estimate of future income is based on operating results
from the reporting entity’s recent history. See Section 5.3.2.3 for further discussion of the development
of objectively verifiable future income estimates.

Examples 5-3 through 5-7 below illustrate different types of negative evidence that an entity should
consider in determining whether a valuation allowance is required.

Example 5-3

Cumulative Losses in Recent Years

• An entity has incurred operating losses for financial reporting and tax purposes over the past two years.
The losses for financial reporting purposes exceed operating income for financial reporting purposes, as
measured cumulatively for the current year and two preceding years.
• A currently profitable entity has a majority ownership interest in a newly formed subsidiary that has
incurred operating and tax losses since its inception. The subsidiary is consolidated for financial
reporting purposes. The tax jurisdiction in which the subsidiary operates prohibits it from filing a
consolidated tax return with its parent. This would be negative evidence for the DTA of the subsidiary in
that jurisdiction.

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Example 5-4

A History of Operating Loss or Tax Credit Carryforwards Expiring Unused

• An entity has generated tax credit carryforwards during the current year. During the past several
years, tax credits, which originated in prior years, expired unused. There are no available tax-planning
strategies that would enable the entity to use the tax benefit of the carryforwards.
• An entity operates in a cyclical industry. During the last business cycle, it incurred significant operating
loss carryforwards, only a portion of which were used to offset taxable income generated during the
carryforward period, while the remainder expired unused. The entity has generated a loss carryforward
during the current year.

Example 5-5

Losses Expected in Early Future Years

• An entity that is currently profitable has a significant investment in a plant that produces its only
product. The entity’s chief competitor has announced a technological breakthrough that has made the
product obsolete. As a result, the entity is anticipating losses over the next three to five years, during
which time it expects to invest in production facilities that will manufacture a completely new, but as yet
unidentified, product.
• An entity operates in an industry that is cyclical in nature. The entity has historically generated income
during the favorable periods of the cycle and has incurred losses during the unfavorable periods. During
the last favorable period, the entity lost market share. Management is predicting a downturn for the
industry during the next two to three years.

Example 5-6

Unsettled Circumstances That if Unfavorably Resolved Would Adversely Affect Profit Levels on a
Continuing Basis in Future Years
• During the past several years, an entity has manufactured and sold devices to the general public. The
entity has discovered, through its own product testing, that the devices may malfunction under certain
conditions. No malfunctions have been reported. However, if malfunctions do occur, the entity will face
significant legal liability.
• In prior years, the entity manufactured certain products that required the use of industrial chemicals.
The entity contracted with a third party, Company X, to dispose of the by-products. Company X is now
out of business, and the entity has learned that the by-products were not disposed of in accordance with
environmental regulations. A governmental agency may propose that the entity pay for clean-up costs.

Example 5-7

A Carryback or Carryforward Period That Is So Brief That It Would Limit Realization of Tax Benefits
if (1) a Significant Deductible Temporary Difference Is Expected in a Single Year or (2) the Entity
Operates in a Traditionally Cyclical Business
An entity operates in a state jurisdiction with a one-year operating loss carryforward period. During the current
year, it implemented a restructuring program and recorded estimated closing costs in its financial statements
that will become deductible for tax purposes next year. The deductible amounts exceed the taxable income
expected to be generated during the next two years.

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5.3.2.2 Positive Evidence Considered in the Determination of Whether a

Valuation Allowance Is Required
740-10-30 (Q&A 47)
When an entity has negative evidence, such as a cumulative loss position, it should also evaluate what
positive evidence exists. ASC 740-10-30-22 gives the following examples of positive evidence that, when
present, may overcome negative evidence in the assessment of whether a valuation allowance is needed
to reduce a DTA to an amount more likely than not to be realized:
a. Existing contracts or firm sales backlog that will produce more than enough taxable income to realize
the deferred tax asset based on existing sales prices and cost structures
b. An excess of appreciated asset value over the tax basis of the entity’s net assets in an amount sufficient
to realize the deferred tax asset
c. A strong earnings history exclusive of the loss that created the future deductible amount (tax loss
carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for
example, an unusual or infrequent item) is an aberration rather than a continuing condition.

Example 5-8 below illustrates situations in which entities have positive evidence that may indicate that a
valuation allowance would not be necessary.

Example 5-8

Scenarios Based on ASC 740-10-30-22(a)

For example:

• An entity enters into a noncancelable long-term contract that requires the customer to purchase
minimum quantities and that therefore will generate sufficient future taxable income to enable use of all
existing operating loss carryforwards.
• During the current year, an entity merges with Company L, which operates in a different industry
that is characterized by stable profit margins. The tax law does not restrict use of preacquisition NOL
carryforwards. Company L’s existing contracts will produce sufficient taxable income to enable use of the
loss carryforwards.
Scenario Based on ASC 740-10-30-22(b)
An entity has invested in land that has appreciated in value, and the land is not integral to the entity’s business
operations. If the land were sold at its current market value, the sale would generate sufficient taxable income
for the entity to use all tax loss carryforwards. The entity would sell the land and realize the gain if the operating
loss carryforward would otherwise expire unused. After considering its tax-planning strategy, the entity
determines that the fair value of the entity’s remaining net assets exceeds its tax and financial reporting basis.

Scenario Based on ASC 740-10-30-22(c)

An entity incurs operating losses that result in a carryforward for tax purposes. The losses resulted from the
disposal of a subsidiary whose operations are not critical to the continuing entity, and the company’s historical
earnings, exclusive of the subsidiary losses, have been strong.

Examples 5-9 through 5-125 illustrate additional situations in which entities that have had negative
evidence have concluded that no valuation allowance is required (or that only a small valuation
allowance is necessary) as a result of available positive evidence.

5
Note that similar examples may not result in a similar conclusion. An entity must use judgment in determining whether a valuation allowance is
necessary.

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Example 5-9

An entity experienced operating losses from continuing operations for the current year and two preceding
years and is expected to return to profitability in the next year. Positive evidence included (1) completed plant
closings and cost restructuring that permanently reduced fixed costs without affecting revenues and that, if
implemented earlier, would have resulted in profitability in prior periods and (2) a long history during which no
tax loss carryforwards expired unused.

Example 5-10

An entity with a limited history incurred cumulative operating losses since inception. The losses were
attributable to the company’s highly leveraged capital structure, which included indebtedness with a relatively
high interest rate. Positive evidence included a strict implementation of cost containment measures, an
increasing revenue base, and a successful infusion of funds from the issuance of equity securities, which were
used, in part, to reduce high-cost debt capital.

Example 5-11

An entity incurred cumulative losses in recent years; the losses were directly attributable to a business
segment that met the criteria in ASC 205-20 for classification as a discontinued operation for financial reporting
purposes. Positive evidence included a history of profitable operations outside the discontinued segment.

Example 5-12

An entity suffered significant losses in its residential real estate loan business. The entity has recently
discontinued the issuance of new residential real estate loans, has disposed of all previously held residential
real estate loans, and has no intention of purchasing real estate loans in the future. Positive evidence included
a history of profitable operations in the entity’s primary business, commercial real estate lending.

5.3.2.3 Effect of Nonrecurring Items on Estimates of Future Income and

Development of Objectively Verifiable Future Income Estimates
When objective and verifiable negative evidence is present (e.g., cumulative losses), an entity may
develop an estimate of future taxable income or loss that is also considered to be objectively verifiable
when determining the amount of the valuation allowance needed to reduce the DTA to an amount that
is more likely than not to be realized. Management’s projections of future income are inherently not
objectively verifiable, and therefore, such projections alone would not be enough to outweigh objectively
verifiable negative evidence such as cumulative losses. However, to the extent that management’s future
income projections are adjusted to be based solely on objectively verifiable evidence (e.g., when an
estimate is based on operating results from the entity’s recent history, no subjective assumptions have
been made, and there is no contrary evidence suggesting that future taxable income would be less than
historical results), entities may give more weight to the positive evidence from such estimates.

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That is, such estimates should be based on objectively verifiable evidence (e.g., an estimate of future
income that does not include reversals of taxable temporary differences and carryforwards and that is
based on operating results from the entity’s recent history without subjective assumptions). An entity
with objective negative evidence may look to its recent operating history to determine how much, if any,
income exclusive of temporary differences is expected in future years. The entity typically begins this
determination by analyzing income or loss for financial reporting purposes during its current year and
two preceding years and adjusts for certain items as discussed below.

When preparing an objectively verifiable estimate of future income or loss by using historical income
or loss for financial reporting purposes in recent years, an entity should generally not consider the
effects of discontinued operations and nonrecurring items. Generally, these items are not relevant to
or indicative of an entity’s ability to generate taxable income in future years. Examples of nonrecurring
items that an entity usually excludes from its historical results when preparing such estimates of future
income include:

• One-time restructuring charges that permanently remove fixed costs from future cash flows.
• Large litigation settlements or awards that are not expected to recur in future years.
• Historical interest expense on debt that has been restructured or refinanced.
• Historical fixed costs that have been reduced or eliminated.
• Large permanent differences that are included in pretax accounting income or loss but are not a
component of taxable income.

• One-time severance payments related to management changes.

When adjusting historical income or loss for financial reporting purposes to develop an estimate
of future income or loss that is generally considered to be objective and verifiable, an entity may
also need to consider items occurring after the balance sheet date but before the issuance of the
financial statements. For example, a debt refinancing that is in process as of the balance sheet date
and consummated before the date of issuance of the financial statements may constitute additional
objective and verifiable evidence when an entity is projecting future taxable income, since the entity’s
normal projections (which would have been used in the absence of the existence of negative evidence
in the form of cumulative losses) would routinely have included this as a forecasted item. An entity must
use judgment and carefully consider the facts and circumstances in such situations.

Notwithstanding the above, the following items should generally not be considered nonrecurring:

• Unusual loss allowances (e.g., large loan loss or bad-debt loss provisions).
• Poor operating results caused by an economic downturn, government intervention, or changes
in regulation.

• Operating losses attributable to a change in the focus or directives of a subsidiary or business

unit.

• Onerous effects on historical operations attributable to prior management decisions when

a new management team is engaged (excluding any direct employment cost reductions
associated with the replacement of the old management team).

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In addition, an entity should consider the effects of the IRC Section 163(j)6 limitation in a manner similar
to nonrecurring items for which the entity makes an adjustment in its historical results. However, the
ability to adjust historical operating results to obtain an objectively verifiable estimate of future taxable
income does not change the fact that the entity would still need to consider such losses as part of
its prior earnings history (i.e., the entity may not exclude such losses in determining whether it has
cumulative losses in recent years) in a manner similar to the nonrecurring items discussed above.

Once the objectively verifiable estimate of future income has been developed, this estimate may be used
to support the realizability of DTAs. Entities often use an average of the current and two prior years of
adjusted historical results as a basis from which to estimate an objective and verifiable annual taxable
income for future periods.

Example 5-13 below illustrates how an entity might develop an estimate of future taxable income
(excluding reversals of temporary differences and carryforwards) that is based on objectively verifiable
historical results when objectively verifiable negative evidence in the form of cumulative losses exists:

Example 5-13

Estimation of Future Taxable Income When Negative Evidence in the Form of Cumulative Losses
Exists
Assume the following:

• Entity X, a calendar-year entity, operates in a single tax jurisdiction in which the tax rate is 25 percent.
• Tax losses and tax credits can be carried forward for a period of four years after the year of origination.
However, carryback of losses or credits to recover taxes paid in prior years is not permitted.
• As of December 31, 20X3, X has a tax loss carryforward of $1,000 and a tax credit carryforward of $600,
both of which expire on December 31, 20X7. Thus, to realize its DTA of $850 ([$1,000 × 25%] + $600) at
the end of 20X3, X must generate $3,400 ($850 ÷ 25%) of future taxable amounts through 20X7 — the
tax loss and tax credit carryforward period.
• There are (1) no tax-planning strategies available to generate additional taxable income and (2) no
taxable temporary differences as of December 31, 20X3.
• Entity X has determined that a three-year period is the appropriate period for which it will assess
whether negative evidence in the form of cumulative losses in recent years exists.

6
IRC Section 163(j) limits the ability of certain corporations to deduct interest paid or accrued on indebtedness. In general, this limit applies to
interest paid or accrued by certain corporations (when no U.S. federal income tax is imposed on the interest income) whose debt-to-equity ratio
exceeds 1.5 to 1.0 and when net interest expense exceeds 50 percent of the adjusted taxable income. The 2017 Act removed the debt-to-equity
safe harbor, expanded interest deductibility limitations, and generally limited the interest deduction on business interest to (1) business interest
income plus (2) 30 percent of the taxpayer’s adjusted taxable income. The CARES Act temporarily increased the 30 percent limitation of adjusted
taxable income to 50 percent for taxable years beginning in 2019 and 2020. It also permitted entities to use their 2019 adjusted taxable income
for the 2020 taxable year. For further information about the CARES Act and the subsequent income tax accounting, see Deloitte’s Heads Up,
“Highlights of the CARES Act.”

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Example 5-13 (continued)

• Historical pretax income (loss) is $100, ($500), and ($1,000) for 20X3, 20X2, and 20X1, respectively.
• The following table shows historical income (loss) adjusted for nonrecurring items during the three-year
period ending on December 31, 20X3, which X considers when estimating future income that does not
include reversals of temporary differences and carryforwards:

Adjusted Historical Results

Three-Year
20X3 20X2 20X1 Total
Pretax income (loss) — as stated $ 100 $ (500) $ (1,000) $ (1,400)
Nonrecurring items not indicative of future
operations:
Litigation settlement 1,600 1,600
Interest expense on debt that
has been extinguished in 20X3 100 200 200 500
Fixed cost reduction as a result
of a completed restructuring 200 300 300 800
Annual adjusted pretax income (loss) $ 400 $ 1,600 $ (500) 1,500

Average annual adjusted pretax income $ 500

Because X has positive average annual adjusted pretax income (i.e., historical earnings when adjusted
for nonrecurring items), it may consider its average annual adjusted pretax income as a starting point for
objectively estimating future taxable income (excluding reversals of temporary differences and carryforwards).
However, the estimation of future income is not simply a “mechanical exercise” in which X would multiply its
average annual adjusted pretax income by the number of years remaining in the loss or credit carryforward
period. Rather, X should consider adjusting its average annual pretax income for certain additional positive and
negative evidence that is present in the historical period to develop an estimate that is based on objectively
verifiable evidence, including, but not limited to:

• Its recent trend in earnings (i.e., the fact that the most recent year’s [20X3’s] earnings are less than the
prior year’s [20X2’s] and the three-year average annual adjusted pretax income, which might suggest
that the use of average annual adjusted pretax income is inappropriate).
• The length and magnitude of pretax losses compared with the length and magnitude of pretax
income (e.g., X has a significant cumulative loss and has only recently returned to a minor amount of
profitability).
• The causes of its annual losses (e.g., X reported a pretax loss in 20X1 even on an adjusted basis) and
cumulative losses.
• Anticipated changes in the business.
The weight given to the positive evidence in the form of X’s estimate of future taxable income should be
commensurate with the extent to which it is based on objectively verifiable historical results. Entity X would
then determine whether a valuation allowance is needed on the basis of all available evidence, both positive
and negative.

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Example 5-13A

Consideration of the Impact of an IRC Section 163(j) Limitation on the Estimation of Future Taxable
Income When Negative Evidence Exists in the Form of Cumulative Losses
Assume the following:

• Entity A has determined that it is appropriate to use a three-year period in assessing whether negative
evidence exists in the form of cumulative losses in recent years.
• As of December 31, 2020, A is in a cumulative-loss position, with a pretax loss of $58, $60, and $52 for
2018, 2019, and 2020 respectively.
• Entity A anticipates being subject to the IRC Section 163(j) limitation for the foreseeable future.
• Because A is in a cumulative-loss position, it uses its recent earnings history, adjusted for nonrecurring
items and recurring permanent differences, to project future taxable income in evaluating the
realizability of its DTAs.
• Entity A has determined that it has (1) recurring permanent differences of $5 in each year of its recent
tax years and (2) an objectively verifiable nonrecurring item of $5 in 2019.
• The following table shows amounts that were included in pretax loss for each of the last three tax years:

2018 2019 2020

Interest expense, net of interest income $ 153.50 $ 158 $ 160

Depreciation and amortization $ 320 $ 322 $ 308

In addition, because interest expense is a component of A’s pretax loss, when A adjusts its recent earnings
history as part of developing objectively verifiable future income projections, it would consider whether the
amount that it can deduct under IRC Section 163(j) is limited and, if so, adjust its estimate of future taxable
income accordingly.

Further, the limitation percentage for allowable interest has been, and is expected to continue to be, 30
percent of adjusted taxable income. For taxable year 2021, adjusted taxable income is equal to pretax
income (or loss), adjusted for nonrecurring items, recurring permanent differences, net interest expense, and
depreciation and amortization. For taxable years after 2021, adjusted taxable income is equal to pretax income
(or loss), adjusted for nonrecurring items, recurring permanent differences, and net interest expense.

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Example 5-13A (continued)

Entity A’s estimate of its future taxable income, including the effects of its IRC Section 163(j) limitation, is shown
below:

Adjusted Historical Results as of 2021 (Rounded for Simplicity)

2018 2019 2020 Average

Pretax income/(loss) $ (58) $ (60) $ (52) $ —

Recurring permanent differences 5 5 5 —

Nonrecurring items — 5 — —

Adjusted pretax income/(loss) before

Section 163(j) adjustment (53) (50) (47) (50)

Net interest expense 153.50 158 160 —

Depreciation and amortization 320 322 308 —

Adjusted taxable income 420.50 430 421 —

Interest allowed — 30% 126.20 129 126.30 —

Disallowed interest — 2021 tax year $ 27.30 $ 29 $ 33.70 30

Adjusted pretax income/(loss) before

Section 163(j) adjustment (per above) (50)

2021 projected income based on

as-adjusted earnings history $ (20)

Adjusted Historical Results Post-2021 (Rounded for Simplicity)

2018 2019 2020 Average

Adjusted pretax income/(loss) before

Section 163(j) adjustment (per above) $ (53) $ (50) $ (47) $ —

Net interest expense 153.50 158 160 —

Depreciation and amortization n/a n/a n/a —

Adjusted taxable income 100.50 108 113 —

Interest allowed — 30% 30.20 32.40 33.90 —

Disallowed interest — post-2021 tax

year $ 123.40 $ 125.60 $ 126.10 125

Adjusted pre-tax income/(loss) before

Section 163(j) adjustment (per above) (50)

Post-2021 projected income based on

as-adjusted earnings history $ 75

The assessment of future taxable income is not a purely mechanical exercise; A must consider all positive and
negative evidence to develop an estimate that is based on objectively verifiable evidence. After considering all
such evidence, including any contrary evidence that might suggest that future taxable income would be less
than the adjusted historical results (i.e., the adjusted pretax loss of $50 adjusted for disallowed interest of $30
and $125 for 2021 and post-2021 tax years, respectively), A may be able to demonstrate that it will have taxable
income after 2021 once it has factored in the impacts of Section 163(j).

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5.3.2.3.1 Time Frame for Projection of Future Taxable Income

An entity should consider as many years as it can to reliably estimate future taxable income on the
basis of its specific facts and circumstances. Although subjectivity may increase as the number of
years increases, it would usually not be appropriate for an entity to limit the number of years it uses to
estimate future taxable income, whether such estimates represent management’s inherently subjective
projections of future income or objectively verifiable estimates of future income based on adjusted
historical results as determined by using the method discussed above. In either case, limiting the period
over which future taxable income is estimated could inappropriately result in a smoothing of the income
statement impact of changes in a valuation allowance. For example, it would not be appropriate to
continue to add a year to the estimate of future taxable income as each year passes so that changes
in a valuation allowance occur annually. Rather, in these situations, it may be reasonable to project
additional years of taxable income on the basis of historical operating results by using the method
discussed above. In some circumstances, however, there may be a limited number of years over which
future taxable income can be estimated because significant changes are expected in the business (e.g.,
probable future withdrawal from the jurisdiction); in such circumstances, the time frame used would be
limited and should not change until a change in facts and circumstances warrants an adjustment.

5.3.3 Taxable Income in Prior Carryback Year(s) if Carryback Is Permitted

Under the Tax Law
As discussed above, ASC 740-10-30-18 lists four sources of future income that may enable realization of
a DTA, including the source listed in ASC 740-10-30-22(c), “[t]axable income in prior carryback year(s) if
carryback is permitted under the tax law.”

The ability to recover taxes paid in the carryback period (the source listed in ASC 740-10-30-22(c)) is
considered to be an objectively verifiable form of positive evidence that can overcome negative evidence
such as the following: (1) cumulative losses; (2) a history of operating losses’ expiring unused; (3) losses
expected in early future years; (4) unsettled circumstances that, if unfavorably resolved, would adversely
affect future operations; and (5) a brief carryforward period, discussed earlier.

Some tax laws (e.g., those in certain U.S. state, local, or foreign tax jurisdictions) permit taxpayers to
carry back operating loss or tax credits to obtain refunds of taxes paid in prior years. The extent to
which the carryback benefit is possible depends on the length of the carryback period and the amounts
and character of taxable income generated during that period.

While the enactment of the 2017 Act eliminated the ability to carry back NOLs originating in years after
December 31, 2017, the CARES Act repealed this provision for certain taxable years. Under the CARES
Act, NOLs that arise in taxable years beginning after December 31, 2017, and before January 1, 2021,
are allowed to be carried back to each of the five taxable years that precede the taxable year of that
loss. Entities that generated taxable income in previous years may now be able to carryback current
year losses to those periods and, as a result, will need to evaluate how this change in tax law affects
their realizability assessment of DTAs. For further information about the CARES Act and the subsequent
income tax accounting, see Deloitte’s Heads Up, “Highlights of the CARES Act.”

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Example 5-14 illustrates taxable income in prior carryback year(s) in situations in which carryback is
permitted under the tax law as a source of taxable income listed in ASC 740-10-30-18(c).

Example 5-14

Refunds Available by Carryback of Losses to Offset Taxable Income in Prior Years

Assume that an entity has a deductible temporary difference of $1,000 at the end of 20X1 and that pretax
income and taxable income are zero. If at least $1,000 of taxable income is available for carryback refund of
taxes paid during the year in which the temporary difference becomes deductible, realization of the DTAs for
the net deductible amount is more likely than not even though tax losses are expected in early future years.

5.3.4 Tax-Planning Strategies
As discussed above, ASC 740-10-30-18 lists four sources of future income that may enable realization
of a DTA, including the source listed in ASC 740-10-30-22(d), “[t]ax-planning strategies (see paragraph
740-10-30-19) that would, if necessary, be implemented to, for example:
1. Accelerate taxable amounts to utilize expiring carryforwards
2. Change the character of taxable or deductible amounts from ordinary income or loss to capital
gain or loss
3. Switch from tax-exempt to taxable investments.”

Because future taxable income from the source listed in ASC 740-10-30-22(d) may be based on future
events, it may be more subjective than that from the sources listed in ASC 740-10-30-22(a) and (c).

The ASC master glossary defines a tax-planning strategy as follows:

An action (including elections for tax purposes) that meets certain criteria (see paragraph 740-10-30-19) and
that would be implemented to realize a tax benefit for an operating loss or tax credit carryforward before
it expires. Tax-planning strategies are considered when assessing the need for and amount of a valuation
allowance for deferred tax assets.

A qualifying tax-planning strategy must meet the criteria in ASC 740-10-30-19. That is, the tax-planning
strategy should be (1) “prudent and feasible”; (2) one that an entity “ordinarily might not take, but would
take to prevent an operating loss or tax credit carryforward from expiring unused”; and (3) one that
“[w]ould result in realization of [DTAs].” ASC 740-10-55-39 clarifies these three criteria:

• For the tax-planning strategy to be prudent and feasible, “[m]anagement must have the ability
to implement the strategy and expect to do so unless the need is eliminated in future years.”
If the action is prudent but not feasible (or vice versa), it would not meet the definition of a
tax-planning strategy. In determining whether an action constitutes a tax-planning strategy,
an entity should consider all internal and external factors, including whether the action is
economically prudent.

• Regarding criterion 2, strategies management would employ in the normal course of business
are considered “implicit in management’s estimate of future taxable income and, therefore, are
not tax-planning strategies.”

• Regarding whether the strategy would result in realization of DTAs (criterion 3 above), ASC
740-10-55-39 states, “The effect of qualifying tax-planning strategies must be recognized in the
determination of . . . a valuation allowance.” Further, the tax-planning strategy should result in
the realization of a DTA, but only if it does not result in another DTA that would not be realized.

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Management should have control over implementation of the tax-planning strategy. However, paragraph
A107 of the Basis for Conclusions in FASB Statement 109 clarifies that this control does not need to be
unilateral. In determining whether a tax-planning strategy is under management’s control, the entity
should consider whether, for example, the action is subject to approval by its board of directors and
whether approval is reasonably ensured.

Finally, to be considered a possible source of future taxable income, a tax-planning strategy (and
any associated taxable income generated from that strategy) must (1) meet the more-likely-than-not
recognition threshold and (2) be measured as the largest amount of benefit that is more likely than not
to be realized.

Because tax-planning strategies are a possible source of taxable income that an entity must consider
when assessing the need for a valuation allowance, an entity must make a reasonable effort to identify
qualifying tax-planning strategies. Question 27 of the FASB Staff Implementation Guide to Statement 109
addresses whether management must “make an extensive effort to identify all tax-planning strategies
that meet the criteria for tax-planning strategies.” The answer, which was codified in ASC 740-10-55-41,
states, in part:

Because the effects of known qualifying tax-planning strategies must be recognized . . . , management should
make a reasonable effort to identify those qualifying tax-planning strategies that are significant. Management’s
obligation to apply qualifying tax-planning strategies in determining the amount of valuation allowance required
is the same as its obligation to apply the requirements of other Topics for financial accounting and reporting.
However, if there is sufficient evidence that taxable income from one of the other sources of taxable income
listed in paragraph 740-10-30-18 will be adequate to eliminate the need for any valuation allowance, a search
for tax-planning strategies is not necessary.

5.3.4.1 Examples of Qualifying Tax-Planning Strategies

740-10-30 (Q&A 70), 740-10-30 (Q&A 34)
The following are some possible examples (not all-inclusive) of qualifying tax-planning strategies:

• Selling and subsequent leaseback of certain operating assets.

• Switching certain investments from tax-exempt to taxable securities.
• Filing a consolidated tax return versus separate stand-alone income tax returns.
• Disposing of obsolete inventory that is reported at net realizable value.
• Changing the method of accounting for inventory for tax purposes.
• Selling loans at an amount that is net of their allowance for doubtful accounts.
• Accelerating the funding of certain liabilities if that funding is deductible for tax purposes.
• Switching from deducting R&D costs to capitalizing and amortizing the costs for tax purposes.
• Electing to deduct foreign taxes paid or accrued rather than treating them as creditable foreign
taxes.

• Accelerating the repatriation of foreign earnings for which deferred taxes were previously
funded.

Example 5-15 and Example 5-16 illustrate additional situations in which entities use tax-planning
strategies to provide evidence of future taxable income to support the conclusion that no valuation
allowance is required or that a valuation allowance is necessary for only a portion of the entity’s DTAs.

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Example 5-15

Acceleration of Taxable Amounts to Use Carryforward

In 20X2, Entity A generates, for tax purposes, a $2,000 operating loss that cannot be used in the current tax
return. Tax law allows for a one-year carryforward. However, after considering (1) future reversals of existing
taxable temporary differences, (2) future taxable income exclusive of reversing taxable temporary differences
and carryforwards, and (3) taxable income in the prior carryback years, A must record a valuation allowance for
the tax consequences of $1,000 of future deductions that are not expected to be realized.

However, A has identified a tax-planning strategy that involves selling at book value, and leasing back, plant and
equipment. This strategy would accelerate $600 of taxable amounts (the excess depreciation in prior years) that
would otherwise reverse in years beyond the carryforward period. For tax purposes, the sale would accelerate
the reversal of the taxable difference (the excess-book-over-tax basis on the date of the sale-leaseback) into
taxable income in the year of the sale. After considering the strategy, A must record a valuation allowance at the
end of 20X2 only for the $400 of the operating loss whose realization is not more likely than not.

When A is considering the sale and leaseback of assets as a tax-planning strategy, it should be reasonable
for A to conclude that the fair value of the assets approximates the book value at the time of the sale. If the
assets have appreciated, the sale and leaseback would create taxable income (typically considered a capital
gain). Conversely, selling the assets at a loss would reduce the taxable income that is created by the strategy. In
addition, for the sale and leaseback of assets to meet the criteria for a qualifying tax-planning strategy, future
taxable income must otherwise be expected (because the sale and leaseback of assets when the fair value
approximates the carrying value does not create additional taxable income). Without future taxable income, the
sale and leaseback only postpones the expiration of the DTA. Further, when measuring the valuation allowance
necessary (i.e., the impact of future lease payments on taxable income), A must incorporate the future
implications of the tax-planning strategy into the determination of the strategy’s effects. (See Section 5.3.4.3 for
more information about measuring the tax benefits of tax-planning strategies.)

Example 5-16

Switch From Tax-Exempt to Taxable Investments

In 20X2, Entity B generates $2,000 of tax credits that cannot be used in the current-year tax return. Tax law
permits a one-year credit carryforward to reduce income taxes in 20X3. After considering (1) future reversals
of existing taxable temporary differences, (2) future taxable income exclusive of taxable temporary differences
and carryforwards, and (3) taxable income in the prior carryback years, B must record a valuation allowance of
$1,000.

However, B has identified a tax-planning strategy in which its investment portfolio of tax-exempt securities
could, if sold and replaced with higher-yielding taxable securities, generate sufficient taxable income during
20X3 to enable the use of $200 of the available tax credit carryforward. Provided that the replacement of
tax-exempt securities is prudent and feasible, a valuation allowance is recognized only for the $800 of tax credit
carryforwards whose realization is not more likely than not. In assessing whether the tax-planning strategy is
prudent and feasible, B should determine whether the replacement securities offer a better pretax yield than
the tax-exempt securities (i.e., if the yield is identical, no benefit is derived from the change in investment and
the tax-planning strategy is therefore not prudent).

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5.3.4.2 Examples of Nonqualifying Tax-Planning Strategies

740-10-30 (Q&A 35)
The following actions would generally not qualify as tax-planning strategies because they would not
meet one or more of the criteria in ASC 740-10-30-19 (as discussed above):

• Actions that are inconsistent with financial statement assertions. For example, to classify an
investment in a debt security as HTM, an entity must positively assert that it has the ability and
intent to hold the investment until maturity. It would be inconsistent with that assertion for the
entity to simultaneously assert as a tax-planning strategy that it would sell securities classified as
HTM to realize a DTA.
However, the absence of a positive financial statement assertion does not necessarily preclude
an action from qualifying as a tax-planning strategy. For example, an entity does not need to
meet all the criteria for held-for-sale classification to assert as a tax-planning strategy that it
would sell an appreciated asset to realize a DTA.

• Selling an entity’s principal line of business or selling certain operating assets (e.g., an indefinite-
lived trade name) that are core to the business. Such an action would not be considered
prudent.

• Selling advanced technology to a foreign government when such a sale is prohibited by statute.
Such an action would not be considered feasible.

• Disposing of an unprofitable subsidiary, which is generally not considered an action that an

entity “might not ordinarily take” and may not be feasible.

• Funding executive deferred compensation before the agreed-upon payment date. Such a
strategy would generally not be considered prudent because, while it would result in reversal of
a DTA, it would also result in an acceleration of income tax for the executive(s).

• Moving income from a nontax jurisdiction to a tax jurisdiction solely to realize operating loss
carryforwards. This action would result in use of the asset in the jurisdiction receiving the
income but not in an overall economic benefit since, irrespective of whether the entity took the
action, it would not have incurred tax on the income.

In addition, changing a parent entity’s tax status generally would not qualify as a tax-planning strategy
because ASC 740-10-25-32 requires that the effect of a change in tax status be recognized as of the
date on which the change in tax status occurs.

Example 5-17 illustrates a situation in which an entity would not be able to use the proposed
tax-planning strategy as positive evidence to support the conclusion that no valuation allowance is
necessary because the tax-planning strategy does not align with positions taken elsewhere within the
financial statements.

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Example 5-17

Tax-Planning Strategy That Is Inconsistent With Financial Statement Assertions

Assume the following:

• An entity is measuring its DTAs and DTLs at the end of 20X2.

• Capital losses of $2 million were incurred in 20X2.
• Capital losses can be used only to offset capital gains; no capital gains occurred in 20X2.
• The capital gains tax rate is 50 percent.
• The entity has an investment portfolio of debt securities that it has classified as HTM in accordance with
ASC 320. The portfolio has the following attributes:

Fair market value $ 2,000,000*

Tax basis 1,200,000
Book basis 2,500,000
* Decline because of interest rate increase, not a credit adjustment.

• An assumption inherent in the preparation of the financial statements is that an other-than-temporary

impairment (OTTI) has not occurred in accordance with ASC 320-10-35-33A though 35-33C7 because
(1) the entity does not have the intent to sell any of the securities in the portfolio, (2) it is not more likely
than not that the entity will be required to sell any of the securities in the portfolio before recovery, and
(3) the entity expects to recover the entire amortized cost basis of the securities in the portfolio.
• Management is considering a tax-planning strategy to sell the debt securities to generate an $800,000
taxable gain to reduce the valuation allowance that would otherwise be necessary. No cost would be
incurred on the sale.
The strategy is inconsistent with the assumptions inherent in the preparation of the financial statements. If the
entity assumed the sale of the debt securities to recognize a tax benefit of $400,000 ($800,000 × 50%), such a
strategy would conflict with ASC 320’s HTM classification. The strategy may also conflict with the entity’s OTTI
assumptions (i.e., intent to sell; see ASC 320-10-35-33A) and potentially other financial statement assertions,
such as the entity’s use of Approach 1, described in Section 5.7.4.1.1, to evaluate DTAs on its debt securities’
unrealized losses. The tax-planning strategy described above would be inconsistent with the assumption
made in the application of Approach 1, which requires the entity to assert its intent and ability to hold the debt
security until recovery.

5.3.4.3 Recognition and Measurement of a Tax-Planning Strategy

740-10-30 (Q&A 33)
ASC 740-10-30-20 states the following about recognition and measurement of a tax-planning strategy:

When a tax-planning strategy is contemplated as a source of future taxable income to support the realizability
of a deferred tax asset, the recognition and measurement requirements for tax positions in paragraphs 740-10-
25-6 through 25-7; 740-10-25-13; and 740-10-30-7 shall be applied in determining the amount of available
future taxable income.

To be contemplated as a possible source of future taxable income, a tax-planning strategy (and its
associated taxable income) must (1) meet the more-likely-than-not recognition threshold and (2) be
measured as the largest amount of benefit that is more likely than not to be realized.

7
ASU 2016-13 was issued in June 2016 and significantly amends the guidance in U.S. GAAP on the measurement of financial instruments. In
November 2019, the FASB issued ASU 2019-10, which established the following effective dates for ASU 2016-13: for public business entities (PBEs)
that meet the U.S. GAAP definition of an SEC filer, ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim
periods therein. For all other entities, the ASU is effective for fiscal years beginning after December 15, 2022, and interim periods therein. Early
adoption is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.

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Further, regarding measurement of the benefits of a tax-planning strategy, ASC 740-10-30-19 states, in
part:

Significant expenses to implement a tax-planning strategy or any significant losses that would be recognized if
that strategy were implemented (net of any recognizable tax benefits associated with those expenses or losses)
shall be included in the valuation allowance.
740-10-30 (Q&A 36)
Examples 5-18 through 5-20 below illustrate the measurement of a valuation allowance in three
different scenarios: (1) when no tax-planning strategy is available, (2) when the cost of implementing
a tax-planning strategy under ASC 740 has an incremental tax benefit, and (3) when the cost of
implementing a tax-planning strategy under ASC 740 has no incremental tax benefit. For all three
examples, assume that “cumulative losses in recent years,” as discussed in ASC 740-10-30-21 and
Section 5.3.2.1, do not exist.

Example 5-18

No Tax-Planning Strategy Is Available

Assume the following:

• The entity operates in a single tax jurisdiction where the applicable tax rate is 25 percent.
• The measurement date for DTAs and DTLs is in 20X1.
• A $10,000 operating loss carryforward will expire on December 31, 20X2. No carryback refunds are
available.
• Taxable temporary differences of $2,000 exist at the end of 20X1, $1,000 of which is expected to reverse
in each of years 20X2 and 20X3.
• No qualifying tax-planning strategies to accelerate taxable income to 20X2 are available.
• The following table illustrates, on the basis of historical results and other available evidence, the
estimated taxable income exclusive of reversing temporary differences and carryforwards expected to
be generated during 20X2:

Estimated taxable income in 20X2 $ 6,000

Existing taxable temporary differences that will
reverse in 20X2 1,000
Estimated taxable income exclusive of reversing
temporary differences and carryforwards $ 5,000

The following table shows the computation of the DTL, DTA, and valuation allowance at the end of 20X1:

Debit (Credit)
DTL ($2,000 × 25%) $ (500)
DTA ($10,000 × 25%) 2,500
Valuation allowance
([$10,000 – $6,000] × 25%) (1,000)

A valuation allowance of $1,000 is necessary because $4,000 of the $10,000 of operating loss carryforward will
expire in 20X2.

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Example 5-19

Cost of Tax-Planning Strategy Has an Incremental Tax Benefit

Assume the following:

• The entity operates in a single tax jurisdiction where the applicable tax rate is 25 percent.
• The measurement date for DTAs and DTLs is in 20X1.
• A $9,000 operating loss carryforward will expire on December 31, 20X2. No carryback refunds are
available.
• Taxable temporary differences of $10,000 exist at the end of 20X1. The temporary differences result
from investments in equipment for which accelerated depreciation is used for tax purposes and straight-
line depreciation is used for financial reporting purposes.
• Taxable temporary differences of $2,000 are expected to reverse in each of years 20X2–20X6.
• The following table illustrates, before any qualifying tax-planning strategies are considered and on
the basis of historical results and other available evidence, the estimated taxable income exclusive of
reversing temporary differences and carryforwards expected to be generated during 20X2:

Estimated taxable income in 20X2 $ 4,000

Reversal of existing taxable temporary differences 2,000
Estimate of taxable income exclusive of reversing temporary
differences $ 2,000

• Management has identified a qualifying tax-planning strategy to sell and lease back the equipment in
20X2, thereby accelerating the reversal of the remaining temporary difference of $8,000 to 20X2.
• The estimated cost attributable to the qualifying strategy is $1,000.
The following table illustrates the computation of the DTAs and valuation allowance at the end of 20X1:

Computation of Anticipated Taxable Income

Operating loss carryforward $ (9,000)
Estimated taxable income (excluding legal costs from
tax-planning strategy) 4,000
Income from tax-planning strategy 8,000
Anticipated taxable income in excess of loss carryforward $ 3,000

Legal and other estimated costs to implement the tax-planning strategy (1,000)
Future tax benefit of those legal and other expenses ($1,000 × 25%) 250
Total valuation allowance $ (750)

DTA ($9,000 × 25%) $ 2,250

Less: valuation allowance (750)
Net DTA $ 1,500

When the effects of the qualifying tax-planning strategy are taken into account, the total estimated taxable
income for 20X2 of $12,000 ($4,000 estimated taxable income plus $8,000 accelerating the reversal of
the taxable temporary difference) exceeds the $9,000 operating loss carryforward. However, in a manner
consistent with the guidance in ASC 740-10-55-44 (and as illustrated in ASC 740-10-55-159), a valuation
allowance for the cost of the tax-planning strategy, net of any related tax benefit, should reduce the tax benefit
recognized. Therefore, a valuation allowance of $750 would be required. The tax benefit of the cost of the
strategy in this example is recognized as a reduction of the valuation allowance because sufficient taxable
income is available to cover the cost in 20X2 after the results of the strategy are considered.

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Example 5-20

Cost of Tax-Planning Strategy Has No Incremental Tax Benefit

Assume the following:

• The entity operates in a single tax jurisdiction where the applicable tax rate is 25 percent.
• The measurement date for DTAs and DTLs is in 20X1.
• A $10,000 operating loss carryforward will expire on December 31, 20X2. No carryback refunds are
available.
• Taxable temporary differences of $3,000 exist at the end of 20X1. The temporary differences result from
investments in equipment for which accelerated depreciation is used for tax purposes and straight-line
depreciation is used for financial reporting purposes.
• Taxable temporary differences of $1,000 are expected to reverse in each of years 20X2–20X4.
• The following table illustrates, before any qualifying tax-planning strategies are considered and on
the basis of historical results and other available evidence, the estimated taxable income exclusive of
reversing temporary differences and carryforwards expected to be generated during 20X2:

Estimate of taxable income in 20X2 $ 6,000

Reversal of existing taxable temporary differences 1,000
Estimate of taxable income exclusive of reversing temporary
differences $ 5,000

• Management has identified a qualifying tax-planning strategy to sell and lease back the equipment in
20X2, thereby accelerating the reversal of $2,000 of taxable income to 20X2.
• Estimated costs attributable to the qualifying tax-planning strategy are $500.
The following table illustrates the computation of the DTAs and valuation allowance at the end of 20X1:

Computation of Anticipated Taxable Income

Operating loss carryforward $ (10,000)
Estimated taxable income 6,000
Income from tax-planning strategy 2,000
Anticipated taxable income deficit $ (2,000)

Valuation allowance on anticipated taxable income deficit ($2,000 × 25%) (500)

Legal and other estimated costs to implement the tax-planning strategy* (500)
Total valuation allowance $ (1,000)

DTA ($10,000 × 25%) $ 2,500

Less: valuation allowance (1,000)
Net DTA $ 1,500

* Future tax benefit for these legal and other expenses is $0 because incurring the costs of $500 will
not provide any incremental tax benefit (i.e., a $500 deduction for legal and other expenses will not be
available to reduce taxes in 20X2).

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5.3.5 Determining of the Need for a Valuation Allowance by Using the Four

Sources of Taxable Income
740-10-30 (Q&A 49)
Example 5-21 below illustrates all the concepts in Section 5.3 and shows how, when positive and
negative evidence is present, an entity uses the four sources of taxable income described in ASC 740-10-
30-18 to determine whether a valuation allowance is required.

Example 5-21

Assume the following:

• Entity A is measuring its DTAs and DTLs as of year 20X2.

• Entity A operates and is subject to tax solely in Jurisdiction X.
• The enacted tax rate is 21 percent for all years.
• The DTA balance at the beginning of 20X2 is $0.
• Tax law permits a two-year carryback and five-year carryforward of operating losses.
• Entity A’s DTL is scheduled to reverse over a period of five years.
Computation of the DTA and DTL
Entity A has identified all temporary differences existing at the end of 20X2. The measurement of DTAs and
DTLs is as follows:

Deferred Tax Consequences

Benefit Before Valuation

Allowance Obligation

Temporary Asset Temporary Liability

Difference at 21% Difference at 21%
Depreciable assets — — $ 35 $ 7

Net operating loss $ 440 $ 93 — —

Total $ 440 $ 93 $ 35 $ 7

Available Evidence
In assessing whether a valuation allowance is required, A has identified the following evidence:

• Negative Evidence
o Entity A has been historically profitable but has incurred a loss in 20X2 as a result of one-time
restructuring of certain operations.
o Entity A operates in a traditionally cyclical business.8
• Positive Evidence
o Tax benefits have never expired unused.9
o Entity A has a strong earnings history at the close of 20X2.10 While it incurred a loss in 20X2, the loss
was an aberration that resulted from one-time charges, and A is expected to return to profitability in
20X3.
o Entity A is not in a cumulative loss position in 20X2 and does not forecast that it will be in a
cumulative loss position in 20X3.
o Entity A has identified certain tax planning strategies that (1) it has determined are prudent, feasible,
and outside of the company’s normal operations and (2) would accelerate taxable amounts so that
the expiring carryforward of the NOL generated in 20X2 could be used.

8
Indicates a source of evidence that can be verified objectively.
9
See footnote 7.
10
See footnote 7.

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Example 5-21 (continued)

Assessment of Realization
On the basis of the available evidence, management has concluded that it is more likely than not that some
portion of the $93 of tax benefits from $440 ($275 + $165) of deductions will not be realized in future tax
returns.

To determine the amount of valuation allowance required, management has considered four sources of
taxable income. As part of this analysis, the company is forecasting taxable income of $25 in each of the
next five tax years (i.e., the carryforward period) and has $55 of taxable income in the carryback period. The
company is forecasting $35 of taxable income from future reversals of existing taxable temporary differences
that will reverse over the carryforward period. Finally, the company has identified a tax-planning strategy in
which its investment portfolio of tax-exempt securities could be sold and replaced with higher-yielding taxable
securities, generating taxable income of $26 and implementation costs of $1 during the carryforward period.
The company’s analysis is as follows:

Amount
1. Estimated future taxable income (during the period
in which the deductible temporary differences will
reverse) exclusive of reversing taxable temporary
differences $ 125
2. Taxable income during the carryback period 55
3. Taxable temporary differences related to
depreciation 35
4. Tax-planning strategy net of implementation cost 25
$ 240

Upon considering the timing, amounts, and character of the four sources of taxable income available for use of
existing tax benefits, management concludes that all such income can be used without limitation. For example,
all of the taxable temporary differences will reverse during the same period as the deductible temporary items.
Therefore, A expects to realize $240 of $440 of deductions and will record a valuation allowance of $42 ($200 ×
21%) on the $200 of deductions that is not expected to be realized.

Entity A would record the following journal entry:

Journal Entry
DTA 93
DTL 7
Valuation allowance 42
Benefit for income taxes 44
To record DTAs and DTLs at the end of fiscal 20X2 and the tax benefit for
the year ended.

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Example 5-21 (continued)

The following is an analysis of the facts in the above example:

• Entity A may need to estimate the amount and timing of future income in determining whether it is more
likely than not that existing tax benefits for deductible temporary differences and carryforwards will be
realized in future tax returns.
• In determining the valuation allowance, A was required to consider (1) the amounts and timing of future
deductions or carryforwards and (2) the four sources of taxable income that enable utilization: future
taxable income exclusive of reversals of temporary differences, taxable income available for carryback
refunds, taxable temporary differences, and tax-planning strategies. If A had been able to conclude that
a valuation allowance was not required on the basis of one or more sources, A would not have needed
to consider the remaining sources. In this case, A needed to consider all four sources, after which it
determined that a valuation allowance was required.
• The assessment is based on all available evidence, both positive and negative.

5.4 Consideration of Future Events When Assessing the Need for a Valuation

Allowance
740-10-30 (Q&A 25)
In general, entities should consider all available information about future events when determining
whether a valuation allowance is needed for DTAs.

Entities must exercise professional judgment when assessing information that is obtained after the
balance sheet date but before the financial statements are issued or are available to be issued. See
Section 5.3.2.3 for further discussion of the effect of nonrecurring items on estimates of future income.

The following are future events that entities should not consider or anticipate when assessing the
realizability of DTAs:

• Changes in tax laws or rates (see ASC 740-10-35-4).

• Changes in tax status (see ASC 740-10-25-32 and 25-33).
• Expected business combinations.
• Expected initial public offerings (IPOs).
• Events that are inconsistent with financial reporting assertions as of the balance sheet date. For
example, anticipating sales of HTM securities would be inconsistent with management’s intent
and with the classification of such securities. Similarly, entities should not anticipate the sale of
indefinite-lived intangible assets that are not classified as held for sale as of the reporting date,
because doing so would be inconsistent with management’s assessment of the useful life of
these assets.

• Events that depend on future market conditions or that are otherwise not within the entity’s
control. For example, an entity should not anticipate income associated with forgiveness of
indebtedness to reduce an otherwise required valuation allowance.

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5.5 Reduction of a Valuation Allowance When Negative Evidence Is No

Longer Present
740-10-30 (Q&A 45)
When an entity concludes that negative evidence (as discussed in ASC 740-10-30-21) exists and that
realization of all or a portion of its DTA as of that date is not more likely than not, the entity would
recognize a valuation allowance to reduce its DTA to an amount that is more likely than not to be
realized. However, circumstances may change over time such that in a subsequent year, the negative
evidence discussed in ASC 740-10-30-21 is no longer present.

If an entity has returned to profitability for a sustained period, the entity should assume, in the absence
of evidence to the contrary, that favorable operations or conditions will continue in the future. Further,
as discussed in Section 5.3.2.3.1, unless the facts and circumstances dictate otherwise, an entity should
not limit the estimate of future income to (1) a specific period (e.g., the period over which it measures
cumulative losses in recent periods) or (2) general uncertainties. For example, it would be inappropriate
to project taxable income for only three years and assume that taxable income beyond three years
would be zero solely on the basis of the uncertainty in projecting taxable income beyond three years
(such a projection would be particularly inappropriate if income is projected in connection with
other financial statement assertions, such as those about impairment tests). Therefore, the valuation
allowance provided in prior years for which negative evidence was present should be eliminated in the
period in which the negative evidence ceases to exist.

See Section 7.3.1 for further discussion of change in valuation allowance in interim periods.

5.6 Going-Concern Opinion as Negative Evidence

740-10-30 (Q&A 46)
PCAOB AS 2415 and AICPA AU-C Section 570 require an explanatory paragraph in the auditor’s
report when the auditor concludes that “substantial doubt about the entity’s ability to continue as a
going concern for a reasonable period of time remains.” In addition, ASC 205-40 requires an entity’s
management to evaluate whether conditions or events raise substantial doubt about the entity’s
ability to continue as a going concern and, if so, “whether its plans that are intended to mitigate those
[relevant] conditions and events, when implemented, will alleviate substantial doubt.” In circumstances
in which management has identified conditions or events that raise substantial doubt that has not been
alleviated by its plans and an explanatory paragraph that has been added to the auditor’s report, a
valuation allowance would generally be recorded for all DTAs whose realization is not assured by either
offsetting existing taxable temporary differences or carryback to open tax years. However, in very limited
circumstances, the immediate cause of the going-concern uncertainty may not be directly related to the
entity’s operations, in which case a full valuation allowance may not be required.

The fact that (1) management has not identified conditions or events that raise substantial doubt,
(2) management has identified conditions or events that raise substantial doubt but has determined its
plans alleviate the substantial doubt, or (3) a going-concern explanatory paragraph is not included in
the auditor’s report does not automatically constitute positive evidence about the realization of DTAs.
Similarly, when an entity concludes that it must record a valuation allowance for all or part of its DTAs,
a going-concern problem may not necessarily exist. For example, an entity that generates sufficient
positive cash flows to service its debt and support the book value of its assets (i.e., the entity’s assets
are not impaired), but that is experiencing financial reporting losses (i.e., recent cumulative losses),
would have negative evidence about the realization of DTAs. In this case, the positive evidence may not
be sufficient to overcome the negative evidence; thus, the entity would provide a valuation allowance
for all or part of its DTAs. However, the auditor may conclude, on the basis of positive cash flows and
other factors, that it is not necessary to provide a going-concern reference in the auditor’s report, and
management may likewise conclude that conditions or events do not raise substantial doubt about the
entity’s ability to continue as a going concern.

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5.7 Exceptions and Special Situations

5.7.1 AMT Valuation Allowances
FRA 18.1 Q&A 7.1
The U.S. federal AMT has been repealed for tax years beginning after December 31, 2017. Taxpayers
with AMT credit carryforwards that have not yet been used may claim a refund in future years for those
credits even though no income tax liability exists.11 As a result of the enactment of the 2017 Act, entities
could continue to use AMT credits to offset any regular income tax liability in years 2018 through 2020,
with 50 percent of remaining AMT credits refunded in each of the 2018, 2019, and 2020 tax years and all
remaining credits refunded in tax year 2021. The CARES Act further accelerated refund of these credits
by amending IRC Section 53(e) so that all prior-year minimum tax credits are potentially available for
refund for an entity’s first taxable year beginning in 2018.

Because the AMT credit will now be fully refundable regardless of whether there is a future income
tax liability before AMT credits, the benefit of the AMT credit will be realized. Therefore, an income tax
benefit should be recognized for all AMT credits. Further, as a result of the CARES Act, entities will need
to adjust the classification of any remaining AMT credits as a result of the AMT credit acceleration. For
further information about the CARES Act and the subsequent income tax accounting, see Deloitte’s
Heads Up, “Highlights of the CARES Act.”

5.7.2 Assessing Realization of a DTA for Regular Tax NOL Carryforwards

When Considering Future GILTI Inclusions
FRA 18-1 Q&A 4.10 and 4.11
Under the GILTI tax regime, foreign taxes paid or accrued in the year of the inclusion may be creditable
against U.S. taxes otherwise payable, subject to certain limitations (e.g., foreign source income, expense
allocations). If not used in the year of inclusion, however, the FTC would be permanently lost. Further,
because IRC Section 250 deductions are limited to 50 percent of taxable income after NOL deductions,
use of NOLs could reduce or eliminate the eligibility for an IRC Section 250 deduction. Therefore, as
a result of expected future GILTI inclusions, a U.S. entity that has historically experienced cumulative
losses may expect that existing NOL carryforwards, for which a valuation allowance has historically been
recorded, will now be used. Use of the NOL carryforwards may, however, result in an actual cash tax
savings that is less than the DTA (before reduction for any valuation allowance) and, in some cases, may
result in no cash tax savings at all because, without the NOL, the entity would have been eligible for an
IRC Section 250 deduction that would have reduced the net taxable income inclusion and would have
been able to use FTCs.

There are two acceptable views regarding how an entity should consider future GILTI inclusions when
assessing the realizability of NOL DTAs. The first is that an entity would consider future GILTI inclusions
on the basis of tax law ordering rules when estimating available sources of future taxable income to
assess the realizability of DTAs. Under a tax law ordering approach, the future reduction or elimination
of the IRC Section 250 deduction and FTCs will not result in the need for a valuation allowance for an
entity’s existing NOL DTAs. Use of a tax law ordering approach is consistent with Example 18 in the ASC
740-10 implementation guidance (see ASC 740-10-55-145 through 55-148). The same conclusion would
apply to DTAs for other tax attributes and deductible temporary differences.

11
Taxpayers should consider whether other limitations (e.g., IRC Section 383) apply to their ability to claim a refund of AMT.

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Alternatively, an entity could assess the realizability of DTAs on the basis of the incremental economic
benefit they would produce. In other words, because future GILTI inclusions are an integrated part of
the regular tax system, an entity would determine how much, if any, benefit is expected to be realized
from an entity’s existing NOL carryforwards on a “with-and-without” basis. That is, a DTA would be
recognized for only the amount of incremental tax savings the DTAs are expected to produce after
the entity considers all facts and circumstances, elements of the tax law, and other factors that would
otherwise limit the availability of the IRC Section 250 deduction and use of the FTCs.

We believe that when measuring U.S. GILTI DTAs and DTLs (more specifically, evaluating whether future
IRC Section 250 deductions should affect the measurement of GILTI DTAs and DTLs), an entity should
apply an approach that is consistent with its assessment of how future IRC Section 250 deductions affect
the realizability of an NOL DTA.

For example, if the entity evaluates the realizability of NOL DTAs on the basis of the incremental
economic benefit the NOLs would produce (i.e., the “with-and-without” approach described above), it
would be appropriate for the entity to factor in the IRC Section 250 deduction that would be available
without the NOL when measuring its GILTI DTAs and DTLs. Alternatively, if the entity evaluates the
realizability of NOL DTAs on the basis of tax law ordering rules, the measurement of GILTI DTAs and
DTLs should take into account only the impact of the IRC Section 250 deduction that will actually be
available after use of the NOL in the year the GILTI DTAs and DTLs reverse, because the ordering
rules would suggest that the maximum amount of GILTI deduction will not be obtained in those
circumstances.

5.7.3 Determination of the Need for a Valuation Allowance Related to FTCs

740-10-30 (Q&A 68)
In their U.S. tax returns, taxpayers are allowed to elect either to deduct direct foreign taxes incurred on
foreign-source earnings or to claim a credit for such taxes. Credits for foreign taxes incurred are subject
to certain limitations (e.g., such credits are limited to the amount calculated by using the U.S. statutory
rate and cannot be used against U.S. taxes imposed on domestic income). Taxpayers are also permitted
to claim a credit for indirect (or deemed-paid) foreign taxes (i.e., taxes included for U.S. tax purposes on
the underlying income of a foreign subsidiary or more-than-10-percent investee when the underlying
income is remitted as dividends). In this situation, pretax income is grossed up for the amount of taxes
credited. If the taxpayer elects not to claim a credit for deemed-paid taxes, the income is not grossed up.

According to the IRC,12 a taxpayer must choose between either deducting or claiming a credit for the
foreign taxes that are paid in a particular tax year. The election to claim the credit or deduction is made
annually and may be changed at any time while the statute of limitations remains open. In the case of
an overpayment as a result of not claiming a credit for foreign taxes, a claim for credit or refund may
be filed within 10 years from the time the return is filed or two years from the time the tax is paid,
whichever is later.13

Creditable foreign taxes paid or deemed paid in a given year give rise to an FTC. An FTC can be either
recorded as a reduction in taxes payable (with a corresponding increase in taxable income with respect
to deemed-paid taxes) or taken as a tax deduction (for direct-paid taxes) in arriving at taxable income.
Any FTC not currently allowed because of various current-year limitations (i.e., an excess FTC) should be
recognized as a DTA. ASC 740-10-30-2(b) states, “The measurement of deferred tax assets is reduced, if
necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be
realized.” An exception to this are FTCs related to GILTI. Excess GILTI FTCs may not be carried forward or
carried back; therefore, a DTA should not be recorded for any excess GILTI FTCs. See Section 3.4.10 for
additional information about FTCs created by GILTI.
12
IRC Section 275(a)(4) and Treas. Reg. 26 CFR Section § 1.901-1(h)(2).
13
Treas. Reg. 26 CFR Section § 301.6511(d)-3.

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Further, ASC 740-10-55-23 states, in part:

Measurements [of deferred tax liabilities and assets] are based on elections (for example, an election for loss
carryforward instead of carryback) that are expected to be made for tax purposes in future years.

Although, given the statute extension, the decision of whether to take a credit or deduct foreign
taxes may not be finalized until subsequent periods, the ability to deduct foreign taxes qualifies as a
tax-planning strategy and should be taken into account in the determination of the minimum DTA that
should be recognized for financial reporting purposes as of any reporting date.

In determining a valuation allowance against the DTA, an entity must compare the annual tax benefit
associated with either deducting foreign taxes or claiming them as credits. In some circumstances in
which an FTC carryover might otherwise have a full valuation allowance, recovery by way of a deduction
may yield some realization through recognition of the federal tax benefit of a deduction. In such
circumstances, it is not appropriate for an entity to assume no realization of the FTC solely on the basis
of a tax credit election (i.e., leading to a full valuation allowance) when the entity is able to change the
election to a deduction in subsequent periods and realize a greater benefit than is provided by claiming
a credit for the year in question.

Since the election to claim foreign taxes as either a deduction or a credit is an annual election, the
calculation of the appropriate valuation allowance should be determined on the basis of the foreign
taxes paid or deemed paid in a given year.

Example 5-22

Deduction Benefit Greater Than Credit Benefit

Entity X, a U.S. entity, paid direct foreign taxes of $100 in 20X9. On the basis of the applicable limitations, X is
permitted to use $10 of FTC against its 20X9 taxes payable; X is allowed to carry back the remaining $90 for one
year and carry it forward for 10 years, which gives rise to a DTA. The U.S. federal income tax rate is 21 percent.

Entity X must evaluate the realizability of the DTA for the FTC. The maximum valuation allowance will be limited
by any benefit that X would realize by amending its 20X9 tax return to take a deduction rather than allowing
the remaining $90 FTC to expire unused. If X has sufficient taxable income to take the deduction in 20X9, the
benefit that can be realized by taking a tax deduction would be $21 (21% tax rate × $100 of foreign taxes paid).
A $10 benefit has already been taken for the FTC through the credit election; therefore, X should at least realize
an additional $11 benefit for the carryforward taxes as a result of the option to take a deduction ($21 available
deduction less the $10 credit taken in 20X9). Therefore, the maximum valuation allowance that X should
consider for the $90 FTC carryforward is $79. Note that the FTC was not created by GILTI.

Example 5-23

Credit Benefit Greater Than Deduction Benefit

Assume the same facts as in Example 5-22, except that X is permitted to use $40 of FTC against its 20X9 taxes
payable. Since the benefit that can be realized by taking a deduction for the $100 creditable taxes is $21 (as
calculated in Example 5-22) and $40 has already been recognized as a benefit in the financial statements, the
entire remaining $60 FTC carryforward may be subject to a valuation allowance if X does not expect to be able
to generate sufficient foreign-source income in the future. Note that the valuation allowance cannot reduce the
DTA below zero.

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Example 5-24

Deemed-Paid Taxes
Entity X, a U.S. entity, receives a distribution of $300 from its foreign subsidiary, Y, on the basis of Y’s underlying
income of $400, taxable at 25 percent in the foreign jurisdiction. The distribution brings with it $100 of
creditable foreign taxes (i.e., $100 in deemed-paid taxes of X) ($400 income × 25% tax rate). For tax year 20X9,
there is a $400 dividend (consisting of the $300 distribution and a $100 gross-up for the deemed-paid taxes
associated with the decision to take a credit for the 20X9 foreign income taxes paid by Y). As a result of the
FTC limitation, X is permitted to use $10 of FTC against its 20X9 taxes payable and is allowed to carry back the
remaining $90 for one year and carry it forward for 10 years, which gives rise to a DTA. Entity X did not have a
sufficient FTC limitation to use the FTC in the prior year. The U.S. federal income tax rate is 21 percent. Total
U.S. federal income tax paid by X in 20X9 would be $74 ([$400 dividend × 21% tax rate] – $10 FTC). If X chose to
“deduct,” rather than credit, the FTC in 20X9, the tax paid would be $63 ($300 distribution × 21% tax rate).

The gross-up under the credit option effectively results in X’s paying an additional $11 in tax in 20X9 related
to the foreign-source income ([$100 deemed-paid taxes × 21% tax rate] – $10 FTC). The remaining $90 of FTC
may be used in a future period; however, there are no additional gross-ups in those periods. In evaluating the
realizability of the DTA for the $90 excess FTC, if X no longer expected to realize the FTC, it could benefit from
amending the 20X9 tax return for a “deduction” (effectively, this is an exclusion of the gross-up from income
and no FTC, rather than a deduction). Electing a deduction would result in a refund of $11 ($74 − $63) because
of the removal of the gross-up. Accordingly, the maximum valuation allowance is $79 ($90 – $11 refund).

Alternatively, if, instead of a $10 credit limitation, $75 of FTC could be used in 20X9, the FTC would have
given rise to a $54 benefit in 20X9 ([$100 × 21%] − $75). In evaluating the realizability of the DTA for the $25
carryforward, X could not benefit from amending the 20X9 tax return for a deduction since the benefit of the
FTC already taken exceeds the tax cost of the gross-up. The deduction would result in a benefit of only $21
($100 × 21%), compared with the credit of $75 in 20X9. Accordingly, the maximum valuation allowance in this
alternative is $25.

Note that the decision to deduct, rather than credit, the FTC in a given year applies to both paid and deemed-
paid taxes. The benefit obtained from amending a return to deduct paid foreign taxes rather than letting the
FTC expire will be offset in part or in full by loss of the benefit on deemed-paid taxes otherwise creditable that
year.

5.7.4 Evaluating a DTA (for Realization) Related to a Debt Security Attributed

to an Unrealized Loss Recognized in OCI
740-10-30 (Q&A 27)
A debt security classified as AFS or HTM may result in the recognition of unrealized holding gains or
losses in OCI as the fair value of the security changes over the contractual term of the investment. A
holding loss would be tax deductible if the debt security was recovered at its carrying value on the
balance sheet date; therefore, the difference between the carrying amount of a debt security and its tax
basis is a deductible temporary difference. In addition, if an entity has the intent and ability to hold the
debt security until recovery of its amortized cost, increases in the security’s fair value up to its amortized
cost basis will reverse out of accumulated other comprehensive income (AOCI) over the contractual life
of the investment, resulting in no cumulative change in the entity’s comprehensive income or future
taxable income. In this respect, the temporary differences associated with unrealized gains and losses
on debt securities are unlike other types of temporary differences because they do not affect the
income statement or the tax return if held until recovery of the debt securities’ amortized cost.

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ASC 320-10-35-1(b) requires an entity to exclude unrealized holding gains and losses for AFS debt
securities from earnings and report them as a net amount in OCI. ASC 320-10-35-18 requires that an entity
assess debt securities classified as either AFS or HTM to determine whether a decline in fair value below
the amortized cost is considered other than temporary. Under ASC 320-10-35-33A through 35-33C, before
the adoption of ASU 2016-13,14 an OTTI is triggered if (1) an entity has the intent to sell the security, (2) it is
more likely than not that it will be required to sell the security before recovery, or (3) it does not expect to
recover the entire amortized cost basis of the security (referred to as a credit loss).

Under step 3 of the impairment test, if an entity concludes that the present value of the cash flows
expected to be collected is less than the amortized cost basis of the security, the impairment is
considered an OTTI. In that situation, the entity records only the credit-related portion of the impairment
loss in earnings (i.e., the difference between the security’s present value of expected cash flows and
amortized cost basis). Accordingly, for AFS and HTM debt securities, the amount recognized in OCI is
the difference between the fair value of the debt security and the amortized cost less the credit loss
component of the OTTI.

ASC 740-20-45-11(b) requires that the tax effects of gains and losses that occur during the year that are
included in comprehensive income but excluded from net income (e.g., unrealized gains and losses on
AFS securities) be charged or credited directly to related components of shareholders’ equity.

The financial statement assertions of ASC 320 regarding the expected recovery of the amortized cost
basis of a debt security differ from the assertions of ASC 740 regarding the evaluation of the realizability
of DTAs generated from unrealized losses of those securities. ASC 320 requires management to
determine whether a decline in the fair value of a debt security below amortized cost is other than
temporary and to recognize any credit loss in earnings. ASC 740 requires an entity to measure the
tax effects of a deductible temporary difference for the same debt security (the DTA) on the basis of
an expected recovery of the carrying value as of the reporting date. In the ASC 740 assessment of
whether a valuation allowance is required, an entity may not be permitted to assume recovery of the
debt security to its amortized cost, whereas ASC 320 would appear to allow for such an assumption
under step 3 of the impairment test, providing an additional source of taxable income to demonstrate
realization of this specific deductible temporary difference. More specifically, under ASC 320, the
presumption for any noncredit losses is that the debt security will recover to its amortized cost basis (as
of the reporting date) (i.e., any unrealized loss recorded in OCI will reverse over the contractual term of
the security without affecting the entity’s cumulative comprehensive income or taxable income).

In January 2016, the FASB issued ASU 2016-01, which amends the guidance in U.S. GAAP on the
classification and measurement of financial instruments. The new guidance clarifies that, upon the
effective date of the ASU, “an entity should evaluate the need for a valuation allowance on a deferred tax
asset related to available-for-sale securities in combination with the entity’s other deferred tax assets.”
For all other entities other than PBEs, including not-for-profit entities and employee benefit plans
within the scope of ASC 960 through ASC 965 on plan accounting, the amendments in ASU 2016-01 are
effective for fiscal years beginning after December 15, 2018, and interim reporting periods within fiscal
years beginning after December 15, 2019.

14
See footnote 13.

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5.7.4.1 Before the Adoption of ASU 2016-01

There are two acceptable approaches (described below) for evaluating a DTA that is recognized as a
result of an unrealized loss on a debt security that is recognized in OCI. Approach 1 is based on the
view that the entity would exclude the DTA attributed to unrealized holding losses of a debt security
recognized in OCI from its other DTAs when evaluating the need for a valuation allowance because this
deductible temporary difference will not require future taxable income for realization on the basis of
the assumption that the debt security will be held until recovery. Approach 2 is based on the view that
the entity must evaluate the reporting entity’s collective DTAs for realization on the basis of all expected
future sources of taxable income. The SEC staff has indicated that it would accept either of the two
approaches. Selection of either alternative is an accounting policy decision that, once made, must be
consistently applied.

5.7.4.1.1 Approach 1
Under this approach, periodic unrealized holding gains and losses do not reflect the economic return on
an investment that will be held until recovery of its amortized cost, which may be maturity. Unrealized
gains and losses recognized in OCI any time before the security’s maturity have no effect on an entity’s
comprehensive income (or taxable income) over the life of the investment. Accordingly, tax effects of
these temporary differences should be excluded from other of the entity’s DTAs being evaluated for
realization because the DTA recognized for unrealized losses of a debt security included in OCI does
not require a source of future taxable income for realization. The recovery is predictable and effectively
guaranteed through the collection of contractual cash flows (provided that collectibility is not a concern).
Likewise, an entity needs to carefully analyze a DTL for unrealized gains on an AFS debt security to
determine whether it can provide a source of taxable income for realizing the benefit of other deductible
temporary differences. The unrealized gains (that give rise to DTLs) may not ultimately provide a source
of taxable income if, for example, the debt instrument is held until maturity. (See Section 5.3.4.1 for
additional discussion of examples of qualifying tax-planning strategies.)

Proponents of Approach 1 believe it is inappropriate to recognize, within reported results of operations,

tax effects of fair value changes in debt securities when those changes will not be included in earnings.
Accordingly, when evaluating whether it is more likely than not that DTAs will be realizable, an entity
should exclude debt security DTAs established in OCI from other DTAs (i.e., those requiring a source
of future taxable income for realization). Given the unique nature of this temporary difference, it is
inappropriate for an entity to apply this approach (by analogy) when evaluating other DTAs, including
DTAs recognized as a result of a credit loss or an OTTI recognized in earnings.

The difference between a debt security’s new amortized cost and its reporting-date fair value does not
require a future source of taxable income to demonstrate realization because the expected manner of
recovery of the investment is based on a decision not to dispose of the investment before recovery.

Accordingly, to apply Approach 1 when assessing the realization of a DTA, an entity must still
demonstrate its intent and ability to hold the debt security until recovery.

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5.7.4.1.2 Approach 2
Under this approach, even if the entity has the intent and ability to hold the debt security until
maturity, the DTAs related to the tax effect of unrealized losses on the debt securities cannot, under
ASC 740, be excluded from the realization assessment of the entity’s other DTAs. Under ASC 740, an
entity determines the total tax provision by (1) identifying temporary differences, (2) recognizing and
measuring DTAs and DTLs, and (3) assessing the overall need for a valuation allowance against DTAs and
reflecting all sources of income. Only then is that total provision allocated in the financial statements as
either net income or AOCI.

Proponents of this approach believe that a debt security DTA should not be excluded from the entity’s
evaluations of overall DTAs for realization. Proponents of Approach 2 observe that, while the ability and
intent to hold a debt security until recovery imply a source of future taxable income, these facts should
not be considered in isolation. Rather, this source of future income must be considered in the context
of all other entity sources of future taxable income and expected losses. If verifiable sources of future
comprehensive income and expected losses do not produce aggregate future taxable income sufficient
for realization of the collective DTAs, a valuation allowance is required.

In addition, proponents of Approach 2 believe that the objectives of ASC 220, which require an entity to
report OCI, are consistent with the objectives of ASC 740, which reflect an asset/liability approach. Under
Approach 2, an entity’s ability to recover a debt security’s amortized cost as of the balance sheet date
would be evaluated. Therefore, management’s assertion about its intent or ability to hold a security with
an unrealized loss until recovery or maturity should not be a factor. Rather, proponents of Approach 2
believe that DTAs related to debt securities should be evaluated with other DTAs.

5.7.4.2 After the Adoption of ASU 2016-01

Historically, some entities have evaluated the need for a valuation allowance on DTAs associated with
AFS debt securities separately from other DTAs (i.e., Approach 1 above). The revised guidance clarifies
that such separate evaluation is not permitted, and upon adoption of ASU 2016-01, Approach 1 will no
longer be acceptable, and an entity will be required to apply Approach 2.

Precluding an entity from evaluating the realizability of unrealized losses on AFS debt securities
separately from all other DTAs may mean that the entity will recognize a valuation allowance on the
unrealized losses on AFS debt securities when other negative evidence in the form of cumulative
losses in recent years is present. This recognition is a result of the entity’s no longer being permitted to
solely rely on the assertion that its intent and ability to hold the debt security until maturity will result
in recovery of the unrealized losses given that the recovery of the unrealized losses may only partially
offset the entity’s potential future losses.

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5.7.5 Assessing Realization of Tax Benefits From Unrealized Losses on AFS

Securities
740-20-45 (Q&A 15)
Future realization of tax benefits, whether tax loss carryforwards or deductible temporary differences,
ultimately depends on the existence of sufficient taxable income of the appropriate character (e.g.,
ordinary or capital gain) within the carryback and carryforward periods prescribed under tax law. For
most entities, the assessment of the realization of tax benefits from unrealized losses on an AFS debt
securities portfolio will often depend on the inherent assumptions used for financial reporting purposes
concerning the ultimate recovery of the carrying amount of the portfolio.

ASC 740-10-25-20 concludes that an “assumption inherent in an entity’s statement of financial position
prepared in accordance with [U.S. GAAP] is that the reported amounts of assets and liabilities will
be recovered and settled, respectively.” Thus, an entity ordinarily assumes that the recovery of the
carrying amount of its AFS debt securities portfolio is the portfolio’s fair value as of each balance sheet
date. Whenever an unrealized holding loss exists, recovery at fair value would result in a capital loss
deduction. Because U.S. federal tax law for most entities requires use of capital losses only through
offset of capital gains, an entity would need to assess whether realization of the loss is more likely
than not on the basis of available evidence. Evidence the entity would consider might include (1) the
available capital loss carryback recovery of taxes paid in prior years and (2) tax-planning strategies to sell
appreciated capital assets that would generate capital gains income. In this situation, the entity should
evaluate such available evidence to determine whether it is more likely than not that it would have, or
could generate, sufficient capital gain income during the carryback and carryforward periods prescribed
under tax law.

Under certain circumstances, however, an entity might assume that recovery of its debt security
investment portfolio classified as AFS will not result in a capital loss. This assumption is based on the fact
that, to avoid sustaining a tax loss, an entity could choose to hold the securities until maturity, provided
that their decline in fair value results from market conditions and not a deterioration of the credit
standing of the issuer. If an entity proposes to rely on such an assumption, the validity of that assertion
should be assessed on the basis of the entity’s ability to hold investments until maturity. Factors that are
often relevant to this assessment include, but are not limited to, the investor’s current financial position,
its recent securities trading activity, its expectations concerning future cash flow or capital requirements,
and the conclusions reached in regulatory reports. The circumstances under which an entity applying
ASC 740 could assume recovery of the carrying amount of a portfolio of debt securities classified as AFS
without incurring a loss are expected to be infrequent.

An assumption that an entity will not incur a tax consequence for unrealized losses on its equity security
investments classified as AFS is not appropriate because market changes in the fair value of equity
securities are not within the unilateral control of an investor entity.

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5.7.6 Application of ASC 740-20-45-7 to Recoveries of Losses in AOCI

740-20-45 (Q&A 36)
A credit or gain may be recognized in OCI on a debt security that is classified as AFS but that remains in
an overall loss position.

Example 5-25

Recoveries of Losses in AOCI

Entity A purchases a debt security on January 1, 20X1, for $1,000. The security is classified as held for sale
for financial reporting purposes. During 20X1, the security declines in value so that its carrying amount for
financial reporting purposes is $800 on December 31, 20X1. The unrealized loss of $200 is recognized in OCI
in accordance with ASC 320. During 20X2, the security increases in value, and an unrealized gain of $150 is
recognized in OCI. As a result, the security’s financial reporting carrying amount increases to $950.

Approach 1 — Make No Distinction Between Credits on Securities in a Net Loss Position and Those in a
Net Gain Position
Under this approach, rather than distinguishing between credits on securities in a net loss position and credits
on securities in a net gain position, A would look only to the total amount of unrealized gains or losses recorded
in OCI during the period when applying ASC 740-20-45-7. This approach is consistent with ASC 740-20-45-7,
which states, in part:
The tax effect of pretax income or loss from continuing operations generally should be determined by a
computation that does not consider the tax effects of items that are not included in continuing operations.
The exception to that incremental approach is that all items (for example, discontinued operations, other
comprehensive income, and so forth) be considered in determining the amount of tax benefit that results
from a loss from continuing operations and that shall be allocated to continuing operations.

Note that Section 6.2.15 discusses how a reporting entity should consider credits in OCI that are the result of
reclassification adjustments when it applies ASC 740-20-45-7. An entity that applies the alternative approach
described in Section 6.2.15 (i.e., an entity that does not distinguish between credits that represent gains and
those that represent reclassification adjustments) generally should apply Approach 1 to determine the effects
of unrealized gains on AFS debt securities when it is applying ASC 740-20-45-7.

Approach 2 — Do Not Include Credits on Securities That Represent Recovery of Previous Net Losses
Under this approach, A would not consider an unrealized gain recognized in OCI in the current year as a
potential source of future income when applying the intraperiod allocation exception if the security remains in
a net loss position. The guidance in ASC 740-20-45-7 that provides the FASB’s rationale for including “all items”
supports this premise, stating, in part:
That modification of the incremental approach is to be consistent with the approach in Subtopic
740-10 to consider the tax consequences of taxable income expected in future years in
assessing the realizability of deferred tax assets. Application of this modification makes it
appropriate to consider a gain on discontinued operations in the current year for purposes of allocating a
tax benefit to a current-year loss from continuing operations. [Emphasis added]

In other words, when a security remains in a net loss position even after a current-year unrealized gain, there
is no taxable income expected in future years that would serve as a source of income for the current-year loss
from continuing operations. This is substantiated by the fact that there is a DTA for a deductible temporary
difference on the security since the tax basis is greater than the book basis. If the security in the example above
is sold at the financial reporting amount of $950, there is a taxable loss and no gain; hence, nothing serves as a
source of income that would benefit the current-year continuing operations loss.

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Example 5-26

Assume the following:

• Entity B:
o Determined, in 20X0, that a valuation allowance is needed to reduce its DTA to an amount that is
more likely than not to be realized, or zero.
o Has a YTD pretax loss and is anticipating a pretax loss for the year for which no tax benefit can be
recognized.
o Has a portfolio of four equity securities that are classified as AFS for financial reporting purposes and,
therefore, the unrealized gains or losses are recognized in OCI in accordance with ASC 320.
o Purchased each equity security on January 1, 20X1, for $1,000.
• During 20X1, a net unrealized gain of $50 on AFS securities is recognized in OCI.
• During 20X2, a net unrealized gain of $150 is recognized in OCI.

Year 1 Gain/ December 31, Year 2 Gain/ December 31,

Cost (Loss) 20X1 (Loss) 20X2

Security 1 $ 1,000 $ 100 $ 1,100 $ 100 $ 1,200

Security 2 1,000 (30) 970 50* 1,020

Security 3 1,000 (100) 900 50** 950

Security 4 1,000 80 1,080 (50) 1,030

Total $ 4,000 $ 50 $ 4,050 $ 150 $ 4,200

* Security 2 year 2 gain includes $30 recovery of unrealized losses from prior year.
** Security 3 year 2 gain Includes $50 recovery of unrealized losses from prior year.

See Section 6.2.15 for additional discussion of the intraperiod tax implications of Examples 5-25 and 5-26.

5.7.7 Realization of a DTA of a Savings and Loan Association: Reversal of a

Thrift’s Base-Year Tax Bad-Debt Reserve
942-740-25 (Q&A 04)
An entity is not permitted to consider the tax consequences of a reversal of a thrift’s base-year tax
bad-debt reserve in assessing whether a valuation allowance is necessary for a DTA recognized for
the tax consequences of a savings and loan association’s bad-debt reserve unless a DTL has been
recognized for that taxable temporary difference. As stated in ASC 942-740-25-1, a DTL for base-year
bad-debt reserves is not recognized “unless it becomes apparent that those temporary differences will
reverse in the foreseeable future.”

See Section 3.5.5 for additional discussion of the guidance in ASC 942-740-25 on a thrift’s bad-debt
reserves.

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5.7.8 Accounting for Valuation Allowances in Separate or Carve-Out Financial

Statements
See Section 8.5 for specific guidance on valuation allowances accounted for in separate or carve-out
financial statements.

5.7.9 Accounting for a Change in a Valuation Allowance in an Interim Period

See Section 7.3.1 for guidance on changes in valuation allowances in an interim period. For a discussion
of intraperiod tax allocations for valuation allowances, see Section 7.4.

5.7.10 Accounting Considerations for Valuation Allowances Related to

Business Combinations
See Section 11.5 for a discussion of (1) recognition of an acquiring entity’s tax benefit not considered
in acquisition accounting, (2) recording a valuation allowance in a business combination, and (3) issues
related to accounting for changes in the acquirer’s and acquiree’s valuation allowance as of and after the
acquisition date.

5.7.11 Accounting Considerations for Valuation Allowances Related to Share-

Based Payment DTAs
See Section 10.6 for guidance on the determination of a valuation allowance for deferred taxes
associated with share-based payment awards.

5.8 Examples Illustrating the Determination of the Pattern of Reversals of

Temporary Differences
740-10-30 (Q&A 31)
The following examples describe several types of temporary differences and provide some common
methods (i.e., for illustrative purposes only) for determining the pattern of their reversal. Other methods
may also be acceptable if they are consistent with the guidance in ASC 740-10-55 on determining
reversal patterns.

5.8.1 State and Local Tax Jurisdictions

In the computation of an entity’s U.S. federal income tax liability, income taxes that are paid to a state or
municipal jurisdiction are deductible. Thus, ASC 740-10-55-20 states, in part:

[A] deferred state [or municipal] income tax liability or asset gives rise to a temporary difference for purposes
of determining a deferred U.S. federal income tax asset or liability, respectively. The pattern of deductible or
taxable amounts in future years for temporary differences related to deferred state [or municipal] income tax
liabilities or assets should be determined by estimates of the amount[s] of those state [and local] income taxes
that are expected to become . . . deductible or taxable for U.S. federal tax purposes in those particular future
years.

5.8.2 Unrecognized Tax Benefits

Under the tax law, an entity may have a basis for deductions (e.g., repair expenses) and may have
accrued a liability for the probable disallowance of those deductions (a UTB). If such deductions are
disallowed, they would be capitalized for tax purposes and would then be deductible in later years.
ASC 740-10-55-21 states that the accrual of the liability in this situation “has the effect of [implicitly]
capitalizing those expenses for tax purposes” and that those “expenses are considered to result in
deductible amounts in the later years” in which, for tax purposes, the deductions are expected to be
allowed. Moreover, this paragraph states that “[i]f the liability for unrecognized tax benefits is based on
an overall evaluation of the technical merits of the tax position, scheduling should reflect the evaluations
made in determining the liability for unrecognized tax benefits that was recognized.”
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The change in the timing of taxable income or loss caused upon the disallowance of expenses may
affect an entity’s realization assessment of a DTA recognized for the tax consequences of deductible
temporary differences, operating loss, and tax credit carryforwards. For example, upon disallowance of
those expenses, taxable income for that year will be higher. Similarly, taxable income for years after the
disallowance will be lower because the deductions are being amortized against taxable income in those
years. An entity should consider the impact of disallowance in determining whether realization of a DTA
meets the more-likely-than-not recognition threshold in ASC 740.

5.8.3 Accrued Interest and Penalties

An entity that takes an aggressive position in a tax return filing often will accrue a liability in its financial
statements for interest and penalties that it would incur if the tax authority successfully challenged that
position. Such an entity should schedule a deductible amount for the accrued interest for the future
year in which that interest is expected to become deductible as a result of settling the underlying issue
with the tax authority.

Because most tax jurisdictions do not permit deductions for penalties, a temporary difference does not
generally result from the accrual of such amounts for financial reporting purposes.

5.8.4 Tax Accounting Method Changes

ASC 740-10-55-59 states that a “change in tax law may require a change in accounting method for
tax purposes, for example, the uniform cost capitalization rules required by the Tax Reform Act of
1986.” Under the uniform capitalization rules, calendar-year entities revalued “inventories on hand
at the beginning of 1987 . . . as though the new rules had been in effect in prior years.” The resulting
adjustment was included in the determination of taxable income or loss over not more than four years.
ASC 740-10-55-58 through 55-62 indicate that the uniform capitalization rules initially gave rise to two
temporary differences.

ASC 740-10-55-60 and 55-61 describe these two temporary differences as follows:

One temporary difference is related to the additional amounts initially capitalized into inventory for tax
purposes. As a result of those additional amounts, the tax basis of the inventory exceeds the amount of the
inventory for financial reporting. That temporary difference is considered to result in a deductible amount when
the inventory is expected to be sold. Therefore, the excess of the tax basis of the inventory over the amount of
the inventory for financial reporting as of December 31, 1986, is considered to result in a deductible amount
in 1987 when the inventory turns over. As of subsequent year-ends, the deductible temporary difference to be
considered would be the amount capitalized for tax purposes and not for financial reporting as of those year-
ends. The expected timing of the deduction for the additional amounts capitalized in this example assumes
that the inventory is not measured on a LIFO basis; temporary differences related to LIFO inventories reverse
when the inventory is sold and not replaced as provided in paragraph 740-10-55-13.

The other temporary difference is related to the deferred income for tax purposes that results from the initial
catch-up adjustment. As stated above, that deferred income likely will be included in taxable income over four
years. Ordinarily, the reversal pattern for this temporary difference should be considered to follow the tax
pattern and would also be four years. This assumes that it is expected that inventory sold will be replaced.
However, under the tax law, if there is a one-third reduction in the amount of inventory for two years running,
any remaining balance of that deferred income is included in taxable income for the second year. If such
inventory reductions are expected, then the reversal pattern will be less than four years.

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5.8.5 LIFO Inventory
ASC 740-10-55-13 states:

The particular years in which temporary differences result in taxable or deductible amounts generally are
determined by the timing of the recovery of the related asset or settlement of the related liability. However,
there are exceptions to that general rule. For example, a temporary difference between the tax basis and the
reported amount of inventory for which cost is determined on a [LIFO] basis does not reverse when present
inventory is sold in future years if it is replaced by purchases or production of inventory in those same future
years. A LIFO inventory temporary difference becomes taxable or deductible in the future year that inventory is
liquidated and not replaced.

For most entities, an assumption that inventory will be replaced through purchases or production does
not ordinarily present difficulty. However, if there is doubt about the ability of an entity to continue
to operate as a going concern, the entity should evaluate available evidence to determine whether it
can make this assumption when measuring DTAs and DTLs under ASC 740. The ability to assume that
inventory can be replaced might affect the recognition of a DTA when realization depends primarily on
the reversal of a taxable temporary difference. For example, if an entity is unable to replace inventory
because of financial or operating difficulties, a taxable temporary difference resulting from LIFO
inventory accounting would reverse at that time and not be available to offset the tax consequences of
future deductions for retirement benefits that have been accrued for financial reporting purposes but
that will become deductible many years in the future when the benefits are paid.

5.8.6 Obsolete Inventory
For financial reporting purposes, inventory may be written down to net realizable value (e.g., when
obsolescence occurs). Generally, for tax purposes, the benefit of such a write-down cannot be realized
through deductions until disposition of the inventory. Thus, in such circumstances, there is a deductible
temporary difference between the reported amount of inventory and its underlying tax basis. This
temporary difference should be assumed to be deductible in the period in which the inventory
deductions are expected to be claimed (i.e., in the period in which the inventory dispositions occur).

5.8.7 Cash Surrender Value of Life Insurance

Under ASC 325-30, an asset is recognized for financial reporting purposes in the amount of the cash
surrender value of life insurance purchased by an entity. ASC 740-10-25-30 cites the “excess of cash
surrender value of life insurance over premiums paid” as an example of a basis difference that “is not a
temporary difference if the [cash surrender value] is expected to be recovered without tax consequence
upon the death of the insured.” If, however, the policy is expected to be surrendered for its cash
value, the entity would include in taxable income any excess cash surrender value over the cumulative
premiums paid (note that the tax basis in the policy is generally equal to cumulative premiums paid). The
resulting taxable temporary difference should be scheduled to reverse in the year in which the entity
expects to surrender the policy.

5.8.8 Land
The financial reporting basis of the value assigned to land may differ from the tax basis. Such a
difference may result from (1) property acquired in a nontaxable business combination, (2) differences
between capitalized costs allowable under accounting standards and those allowable under tax law,
or (3) property recorded at predecessor cost for financial reporting purposes because it was acquired
through a transaction among entities under common control. Regardless of the reason for the
difference, the entity should assume that the temporary difference will reverse in the year in which the
land is expected to be sold to an unrelated third party; otherwise, the timing of the reversal would be
indefinite.

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5.8.9 Nondepreciable Assets
In some jurisdictions, certain office buildings and other real estate cannot be depreciated under local
tax law. The tax authority may permit the tax basis of such property to be routinely increased for the
approximate loss in purchasing power caused by inflation. The tax basis, as adjusted for indexing, is
used to measure the capital gain or loss. For financial reporting purposes, depreciation is recognized on
such assets. The effects of indexing for tax purposes and depreciation for financial reporting purposes
create deductible temporary differences that reverse upon disposition of the associated assets.

5.8.10 Assets Under Construction

For financial reporting purposes, the carrying amount and tax basis of an asset under construction for
an entity’s own use may differ as a result of differences in capitalized costs (e.g., interest capitalized
under ASC 835-20 may differ from the amount to be capitalized for tax purposes). The difference
between the amount reported for construction in progress for financial reporting purposes and its
related tax basis should be scheduled to reverse over the expected depreciable life of the asset, which
should not commence before the date on which the property is expected to be placed into service.

5.8.11 Disposal of Long-Lived Assets by Sale

A deductible temporary difference results when, under ASC 360-10-35-37, a loss is recognized for a
write-down to fair value less costs to sell for assets to be disposed of by sale. Because the deductions for
losses cannot generally be applied to reduce taxable income until they occur, the temporary difference
should be assumed to reverse during the period(s) in which such losses are expected to be deductible
for tax purposes.

5.8.12 Costs Associated With Exit or Disposal Activities

Under ASC 420, the fair value of certain exit or disposal costs (e.g., contract termination) is recorded on
the date the activity is initiated (e.g., contract termination date) and is accreted to its settlement amount
on the basis of the discount rate initially used to measure the liability. Generally, an entity cannot apply
the deductions for exit or disposal activities to reduce taxable income until they occur; therefore, the
resulting deductible temporary differences should be scheduled to reverse during the period(s) in which
such losses are expected to be deductible for tax purposes.

5.8.13 Loss Contingencies
Under ASC 450, the estimated losses on contingencies that are accrued for financial reporting purposes
when it is probable that a liability has been incurred and the amount of the loss can be reasonably
estimated are not deductible for tax purposes until paid. The resulting deductible temporary differences
should be scheduled to reverse during the periods in which the losses are expected to be deductible for
tax purposes.

5.8.14 Organizational Costs
In the U.S. federal tax jurisdiction, an entity generally uses the straight-line method to defer
organizational costs and amortize them to income over five years. Such costs are recognized as an
expense for financial reporting purposes in the period in which they are incurred unless an entity
can clearly demonstrate that the costs are associated with a future economic benefit. If the costs are
reported as an expense in the period in which they are incurred, any deductible temporary differences
should be scheduled to reverse on the basis of the future amortization of the tax basis of the
organizational asset recorded for tax purposes.

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5.8.15 Long-Term Contracts
Before the Tax Reform Act of 1986, use of the completed-contract method for tax purposes resulted in
significant temporary differences for many entities that used the percentage-of-completion method for
financial reporting purposes. The Tax Reform Act of 1986 eliminated this use of the completed-contract
method (except for small contractors that are defined under the law), requiring that an entity determine
taxable income by using the percentage-of-completion method or a hybrid of the completed-contract
and percentage-of-completion methods for contracts entered into after February 1986.

For entities that are permitted to continue using the completed-contract method for tax purposes, a
temporary difference will result in future taxable income in the amount of gross profit recognized for
financial reporting purposes. The reversal of these differences would be assumed to occur on the basis
of the period in which the contract is expected to be completed.

If the percentage-of-completion method is used for both tax and financial reporting purposes,
temporary differences may nevertheless result because the gross profit for tax purposes may be
computed differently from how gross profit is computed for book purposes. To schedule the reversals of
these temporary differences, an entity would generally need to estimate the amount and timing of gross
profit for tax and financial reporting purposes.

If a hybrid method is used for tax purposes and the percentage-of-completion method is used for
financial reporting purposes, the temporary differences might be allocated between the portions of the
contract that are accounted for under the completed-contract method and those accounted for under
the percentage-of-completion method for tax purposes. Under this approach, the amount attributable
to the use of the completed-contract method for tax purposes might be scheduled to reverse, thereby
increasing taxable income, during the year in which the contract is expected to be completed. The
amount of temporary differences attributable to differences in the percentage-of-completion methods
for financial reporting and tax purposes might be allocated and scheduled on the basis of the estimates
of future gross profit for financial reporting and tax purposes.

5.8.16 Pension and Other Postretirement Benefit Obligations

Under ASC 715, an employer generally recognizes the estimated cost of providing defined benefit
pension and other postretirement benefits to its employees over the estimated service period of those
employees. It records an asset or liability representing the amount by which the present value of the
estimated future cost of providing the benefits either exceeds or is less than the fair value of plan assets
at the end of the reporting period.

Under U.S. tax law, however, an employer generally does not receive a deduction until it makes a
contribution to its pension plan or pays its other postretirement benefit obligations (e.g., retiree medical
costs). Because tax law generally precludes an entity from taking deductions for these costs until the
pension contribution is made or the other postretirement benefit obligations are paid, the accounting
required under ASC 715 usually results in significant taxable or deductible temporary differences for
employers that provide such benefits.

ASC 715-30-55-4 and 55-5 explain that a taxable temporary difference related to an overfunded pension
obligation will reverse if (1) the plan is terminated to recapture excess assets or (2) periodic pension cost
exceeds future amounts funded. For an overfunded obligation, we believe that the pattern of taxable
amounts in future years should generally be determined to be consistent with the pattern in scenario
(2). That is, we believe that the pattern of taxable amounts in future years that will result from the
temporary difference should generally be considered the same as the pattern of estimated net periodic
pension cost (as that term is defined in ASC 715-30-20) for financial reporting for the following year

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and succeeding years, if necessary, until future net periodic pension cost, on a cumulative basis, equals
the amount of the temporary difference. Under this approach, additional employer contributions to
the plan, if any, are ignored. It may be estimated, however, that in early years, there will be net periodic
pension income (because the plan is significantly overfunded). If so, the existing overfunded amount will
not be recovered until the later years for which it is estimated that there will be net periodic pension cost.

For an underfunded plan, the pattern of deductible amounts in future years that will result from
the temporary difference could be considered the same as the pattern by which estimated future
tax-deductible contributions are expected to exceed future interest cost on the benefit obligation
existing at the end of the reporting period. This approach is similar to determining the pattern of
reversals for other discounted liabilities (e.g., amortizing a loan). Under this approach, each estimated
tax-deductible contribution to the plan in future years would be allocated initially to (1) estimated future
interest expense on the projected benefit obligation existing at the end of the reporting period and then
to (2) the projected benefit obligation existing at the end of the reporting period.

5.8.17 Deferred Income and Gains

For tax purposes, certain revenue or income is taxed upon receipt of cash (e.g., rental income, loan,
or maintenance fees received in advance). However, for financial reporting purposes, such income is
deferred and recognized in the period in which the fee or income is earned. The amounts deferred in an
entity’s balance sheet will result in a deductible temporary difference because, for tax purposes, no tax
basis in the item exists.

Temporary differences from revenues or gains deferred for financial reporting purposes, but not for tax
purposes, should be assumed to result in deductible amounts when the revenues or gains are expected
to be earned or generated (i.e., when the deferred credit is expected to be settled).

5.8.18 Allowances for Doubtful Accounts

The Tax Reform Act of 1986 requires most taxpayers to use the specific charge-off method to compute
bad-debt deductions for tax purposes. For financial reporting purposes, entities recognize loan losses
in the period in which the loss is estimated to occur. Such recognition creates a deductible temporary
difference in the amount of the allowance for doubtful accounts established for financial reporting
purposes. It is expected that an allowance for doubtful accounts as of the current balance sheet date
will result in deductible amounts in the year(s) in which such accounts (1) are expected to be determined
to be worthless for tax purposes or (2) are planned to be sold (if held for sale).

5.8.19 Property, Plant, and Equipment

An entity might find it necessary to schedule the reversals of temporary differences related to
depreciable assets for two primary reasons: (1) to assess whether it has sufficient taxable income of the
appropriate character, within the carryback/carryforward period available under the tax law, to conclude
that realization of a DTA is more likely than not and (2) to calculate the tax rate used to measure DTAs
and DTLs by determining the enacted tax rates expected to apply to taxable income in the periods in
which the DTLs or DTAs are expected to be settled or realized. In each case, the entity must estimate
the amounts and timing of taxable income or loss expected in future years. Further, ASC 740-10-55-14
states, “For some assets or liabilities, temporary differences may accumulate over several years and then
reverse over several years. That pattern is common for depreciable assets.”

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Example 5-27

The following example illustrates the scheduling of temporary differences for depreciable assets. Assume the
following:

• An entity acquired depreciable assets for $1,000 at the beginning of 20X1.

• For financial reporting purposes, the property is depreciated on a straight-line basis over five years; for
tax purposes, the modified accelerated cost recovery method is used.
• The following table illustrates the depreciation schedules:

Tax Financial Tax Over (Under)

Year Cumulative Reporting Financial Reporting
20X1 $ 350 $ 200 $ 150 $ 150
20X2 260 200 60 210
20X3 156 200 (44) 166
20X4 110 200 (90) 76
20X5 110 200 (90) (14)
20X6 14 — 14 —
$ 1,000 $ 1,000

In December 20X1, the temporary difference of $150 (financial statement carrying amount of $800 less tax
basis of $650) will result in a future net taxable amount. If the originating differences are considered, the
temporary difference of $150 should be scheduled to reverse in the following manner as of the end of 20X1:

(Originating)
Future Reversing
Years Amount
20X2 $ (60)
20X3 44
20X4 90
20X5 90
20X6 (14)
$ 150

If the entity does not consider future originating differences to minimize the complexity of scheduling reversal
patterns, a first-in, first-out pattern would be used and the $150 taxable temporary difference would be
scheduled as follows on December 31, 20X1:

(Originating)
Future Reversing
Years Amount
20X2 $ —
20X3 44
20X4 90
20X5 16
20X6 —
$ 150

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Chapter 6 — Intraperiod Allocation

6.1 Background
ASC 740 requires an entity to allocate its total annual income tax provision among continuing
operations and the other components of its financial statements (e.g., discontinued operations, OCI,
and shareholders’ equity). Although it may appear simple, ASC 740’s model for achieving intraperiod tax
allocation, which is often referred to as the “with-and-without” approach, is one of the more challenging
aspects of income tax accounting.

6.2 Method for Allocating Income Taxes to Components of Comprehensive

Income and Shareholders’ Equity
ASC 740-20

45-1 This guidance addresses the requirements to allocate total income tax expense or benefit. Subtopic
740-10 defines the requirements for computing total income tax expense or benefit for an entity. As defined
by those requirements, total income tax expense or benefit includes current and deferred income taxes. After
determining total income tax expense or benefit under those requirements, the intraperiod tax allocation
guidance is used to allocate total income tax expense or benefit to different components of comprehensive
income and shareholders’ equity.

45-2 Income tax expense or benefit for the year shall be allocated among:
a. Continuing operations
b. Discontinued operations
c. Subparagraph superseded by Accounting Standards Update No. 2015-01
d. Other comprehensive income
e. Items charged or credited directly to shareholders’ equity.

45-3 The tax benefit of an operating loss carryforward or carryback (other than for the exceptions related to
the carryforwards identified at the end of this paragraph) shall be reported in the same manner as the source
of the income or loss in the current year and not in the same manner as the source of the operating loss
carryforward or taxes paid in a prior year or the source of expected future income that will result in realization
of a deferred tax asset for an operating loss carryforward from the current year. The only exception is the tax
effects of deductible temporary differences and carryforwards that are allocated to shareholders’ equity in
accordance with the provisions of paragraph 740-20-45-11(c) through (f).
a. Subparagraph not used
b. Subparagraph not used

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ASC 740-20 (continued)

45-4 Paragraph 740-10-45-20 requires that changes in the beginning of the year balance of a valuation
allowance caused by changes in judgment about the realization of deferred tax assets in future years are
ordinarily allocated to continuing operations. That paragraph also identifies certain exceptions to that allocation
guidance related to business combinations and the items specified in paragraph 740-20-45-11(c) through (f).
The effect of other changes in the balance of a valuation allowance are allocated among continuing operations
and items other than continuing operations using the general allocation methodology presented in this Section.

45-5 See Section 740-20-55 for examples of the allocation of total tax expense or benefit to continuing
operations, the effect of a tax credit carryforward, and an allocation to other comprehensive income.

Allocation to Continuing Operations

45-6 This guidance addresses the allocation methodology for allocating total income tax expense or benefit to
continuing operations. The amount of income tax expense or benefit allocated to continuing operations may
include multiple components. The tax effect of pretax income or loss from current year continuing operations
is always one component of the amount allocated to continuing operations.

45-7 The tax effect of pretax income or loss from continuing operations generally should be determined by
a computation that does not consider the tax effects of items that are not included in continuing operations.
The exception to that incremental approach is that all items (for example, discontinued operations, other
comprehensive income, and so forth) be considered in determining the amount of tax benefit that results
from a loss from continuing operations and that shall be allocated to continuing operations. That modification
of the incremental approach is to be consistent with the approach in Subtopic 740-10 to consider the tax
consequences of taxable income expected in future years in assessing the realizability of deferred tax assets.
Application of this modification makes it appropriate to consider a gain on discontinued operations in the
current year for purposes of allocating a tax benefit to a current-year loss from continuing operations.

Pending Content (Transition Guidance: ASC 740-10-65-8)

45-7 The tax effect of pretax income or loss from continuing operations should be determined by a
computation that does not consider the tax effects of items that are not included in continuing operations.

45-8 The amount allocated to continuing operations is the tax effect of the pretax income or loss from
continuing operations that occurred during the year, plus or minus income tax effects of:
a. Changes in circumstances that cause a change in judgment about the realization of deferred tax assets
in future years (see paragraph 740-10-45-20 for a discussion of exceptions to this allocation for certain
items)
b. Changes in tax laws or rates (see paragraph 740-10-35-4)
c. Changes in tax status (see paragraphs 740-10-25-32 and 740-10-40-6)
d. Tax-deductible dividends paid to shareholders.
The remainder is allocated to items other than continuing operations in accordance with the provisions of
paragraphs 740-20-45-12 and 740-20-45-14.

45-9 See Example 1 (paragraph 740-20-55-1) for an example of the allocation of total tax expense or benefit to
continuing operations.

Allocations to Items Other Than Continuing Operations

45-10 This guidance identifies specific items outside of continuing operations that require an allocation of
income tax expense or benefit. It also establishes the methodology for allocation. That methodology differs
depending on whether there is only one item other than continuing operations or whether there are multiple
items other than continuing operations.

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ASC 740-20 (continued)

45-11 The tax effects of the following items occurring during the year shall be charged or credited directly to
other comprehensive income or to related components of shareholders’ equity:
a. Adjustments of the opening balance of retained earnings for certain changes in accounting principles
or a correction of an error. Paragraph 250-10-45-8 addresses the effects of a change in accounting
principle, including any related income tax effects.
b. Gains and losses included in comprehensive income but excluded from net income (for example,
translation adjustments accounted for under the requirements of Topic 830 and changes in the
unrealized holding gains and losses of securities classified as available-for-sale as required by Topic
320).
c. An increase or decrease in contributed capital (for example, deductible expenditures reported as a
reduction of the proceeds from issuing capital stock).
d. Subparagraph superseded by Accounting Standards Update No. 2016-09.
e. Subparagraph superseded by Accounting Standards Update No. 2016-09.
f. Deductible temporary differences and carryforwards that existed at the date of a quasi reorganization.
g. All changes in the tax bases of assets and liabilities caused by transactions among or with shareholders
shall be included in equity including the effect of valuation allowances initially required upon recognition
of any related deferred tax assets. Changes in valuation allowances occurring in subsequent periods
shall be included in the income statement.

Single Item of Allocation Other Than Continuing Operations

45-12 If there is only one item other than continuing operations, the portion of income tax expense or benefit
for the year that remains after the allocation to continuing operations shall be allocated to that item.

45-13 See Example 2 (paragraph 740-20-55-8) for an example of the allocation of total tax expense or benefit
to continuing operations and one other item.

Multiple Items of Allocation Other Than Continuing Operations

45-14 If there are two or more items other than continuing operations, the amount that remains after the
allocation to continuing operations shall be allocated among those other items in proportion to their individual
effects on income tax expense or benefit for the year. When there are two or more items other than continuing
operations, the sum of the separately calculated, individual effects of each item sometimes may not equal
the amount of income tax expense or benefit for the year that remains after the allocation to continuing
operations. In those circumstances, the procedures to allocate the remaining amount to items other than
continuing operations are as follows:
a. Determine the effect on income tax expense or benefit for the year of the total net loss for all net loss
items.
b. Apportion the tax benefit determined in (a) ratably to each net loss item.
c. Determine the amount that remains, that is, the difference between the amount to be allocated to all
items other than continuing operations and the amount allocated to all net loss items.
d. Apportion the tax expense determined in (c) ratably to each net gain item.

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ASC 740-20 (continued)

Presentation of Deferred Tax Assets Relating to Losses on Available-for-Sale Debt Securities

45-15 An entity that recognizes a deferred tax asset relating to a net unrealized loss on available-for-sale
securities may at the same time conclude that it is more likely than not that some or all of that deferred tax
asset will not be realized. In that circumstance, the entity shall report the offsetting entry to the valuation
allowance in the component of other comprehensive income classified as unrealized gains and losses on
certain investments in debt securities because the valuation allowance is directly related to the unrealized
holding loss on the available-for-sale securities. The entity shall also report the offsetting entry to the valuation
allowance in the component of other comprehensive income classified as unrealized gains and losses on
certain investments in debt securities if the entity concludes on the need for a valuation allowance in a later
interim period of the same fiscal year in which the deferred tax asset is initially recognized.

45-16 An entity that does not need to recognize a valuation allowance at the same time that it establishes a
deferred tax asset relating to a net unrealized loss on available-for-sale securities may, in a subsequent fiscal
year, conclude that it is more likely than not that some or all of that deferred tax asset will not be realized.
In that circumstance, if an entity initially decided that no valuation allowance was required at the time the
unrealized loss was recognized but in a subsequent fiscal year decides that it is more likely than not that the
deferred tax asset will not be realized, a valuation allowance shall be recognized. The entity shall include the
offsetting entry as an item in determining income from continuing operations. The offsetting entry shall not be
included in other comprehensive income.

45-17 An entity that recognizes a deferred tax asset relating to a net unrealized loss on available-for-sale
securities may, at the same time, conclude that a valuation allowance is warranted and in a subsequent fiscal
year makes a change in judgment about the level of future years’ taxable income such that all or a portion of
that valuation allowance is no longer warranted. In that circumstance, the entity shall include any reversals in
the valuation allowance due to such a change in judgment in subsequent fiscal years as an item in determining
income from continuing operations, even though initial recognition of the valuation allowance affected the
component of other comprehensive income classified as unrealized gains and losses on certain investments
in debt securities. If, rather than a change in judgment about future years’ taxable income, the entity generates
taxable income in the current year (subsequent to the year the related deferred tax asset was recognized)
that can use the benefit of the deferred tax asset, the elimination (or reduction) of the valuation allowance is
allocated to that taxable income. Paragraph 740-10-45-20 provides additional information.

45-18 An entity that has recognized a deferred tax asset relating to other deductible temporary differences
in a previous fiscal year may at the same time have concluded that no valuation allowance was warranted. If
in the current year an entity recognizes a deferred tax asset relating to a net unrealized loss on available-for-
sale securities that arose in the current year and at the same time concludes that a valuation allowance is
warranted, management shall determine the extent to which the valuation allowance is directly related to the
unrealized loss and the other deductible temporary differences, such as an accrual for other postemployment
benefits. The entity shall report the offsetting entry to the valuation allowance in the component of other
comprehensive income classified as unrealized gains and losses on certain investments in debt securities only
to the extent the valuation allowance is directly related to the unrealized loss on the available-for-sale securities
that arose in the current year.

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6.2.1 General Rule
6.2.1.1 General “With-and-Without” Rule
740-20-45 (Q&A 01)
ASC 740-20-45-7 states that the “tax effect of pretax income . . . from continuing operations generally
should be determined by a computation that does not consider the tax effects of items that are not
included in continuing operations” (in other words, the tax effect allocated to items that are not part of
continuing operations is generally their incremental tax effect; see Section 6.2.11 for an exception to
this general rule).

Under a with-and-without approach, total tax expense or benefit for the period (the “with”) is computed
by adding the deferred tax expense or benefit for the period (determined by computing the change in
DTLs and DTAs during the period) to the current tax expense or benefit for the period and other tax
expense (e.g., UTBs). The computation of total tax expense includes (1) the effects of all taxable income
or loss items, regardless of the source of the taxable income or loss, and (2) the effect of all changes
in the valuation allowance, except those changes required by ASC 740-20-45-3 (listed above), ASC
805-740-45-2 (regarding changes during the measurement period), or ASC 852-740-45-3 (regarding
quasi-reorganizations).

Then, tax expense or benefit related to income from continuing operations (the “without”) is computed
as the tax effect of the pretax income or loss from continuing operations (current, deferred, and
other tax expense — for example, UTBs) for the period plus or minus the tax effects of the four items
identified in ASC 740-20-45-8, as follows:
a. Changes in circumstances that cause a change in judgment about the realization of deferred tax assets
in future years (see paragraph 740-10-45-20 for a discussion of exceptions to this allocation for certain
items)
b. Changes in tax laws or rates (see paragraph 740-10-35-4)
c. Changes in tax status (see paragraphs 740-10-25-32 and 740-10-40-6)
d. Tax-deductible dividends paid to shareholders.

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The with-and-without approach is illustrated in the example below.

Example 6-1

Company X has $3,000 of income from continuing operations and $1,000 of loss from discontinued operations
during the current year. All of the $3,000 of income from continuing operations qualifies for the FDII deduction
under IRC Section 250 (considered a special deduction under ASC 740-10-55-27 through 55-30). The IRC
Section 250 deduction is calculated as the lesser of 37.5 percent1 of FDII or U.S. taxable income. There are no
other differences between book and tax income. The tax rate is 25 percent.

When determining the tax attributable to continuing operations, X should include the effects of the Section 250
FDII special deduction without considering the loss from discontinued operations. Accordingly, X would perform
the following “with” and “without” calculations:

With Loss From

Without Discontinued
Loss From Operations (in
Discontinued Accordance With
Operations the Tax Return) Difference
Income from continuing operations $ 3,000 $ 2,000
FDII deduction (1,125) (750)
Taxable income 1,875 1,250
Tax rate 25% 25%
Income tax per component $ 469 $ 313 $ (156)*
Tax provision — continuing operations $ 469
Tax provision — discontinued operations (156)
Total income tax expense $ 313
* Difference is due to the lost IRC Section 250 tax benefit, calculated as follows:
Discontinued operations pretax $ (1,000)
Tax rate 25%
Expected income tax benefit $ (250)
IRC Section 250 benefit lost 94
Tax provision – discontinued operations $ (156)

740-20-45 (Q&A 25)

While ASC 740-20 does not explicitly state how the intraperiod tax allocation guidance should be applied
when there are multiple tax-paying components,2 ASC 740-10-30-5 states, in part:

Deferred taxes shall be determined separately for each tax-paying component (an individual entity or group of
entities that is consolidated for tax purposes) in each tax jurisdiction.

Accordingly, by analogy, entities should apply the intraperiod tax allocation guidance to each tax-paying
component; that is, they should apply it at the tax-return level within each taxing jurisdiction.

1
The percentage of income that can be deducted is reduced in taxable years beginning after December 31, 2025.
2
As described in ASC 740-10-30-5, a tax-paying component is an individual entity or group of entities that is consolidated for tax purposes.

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6.2.2 Changes in Valuation Allowances

740-20-45 (Q&A 03)
As discussed in Section 6.2.1.1, when performing an intraperiod tax allocation, an entity generally must
first determine income tax allocated to continuing operations. ASC 740-10-45-20 states, in part, “[t]he effect
of a change in the beginning-of-the-year balance of a valuation allowance that results from a change
in circumstances that causes a change in judgment about the realizability of the related deferred tax
asset in future years ordinarily shall be included in income from continuing operations” (emphasis
added). Causes of changes in valuation allowances could result from, for example, (1) the expiration
of a reserved carryforward (in which the valuation allowance is reduced in a manner similar to the way
in which a write-off of a reserved account receivable reduces the reserve for bad debts), (2) changes
in judgment about the realizability of beginning-of-the-year DTAs because of current-year income
from continuing operations or income expected in future years of any type, or (3) the generation
of deductible temporary differences and carryforwards in the current year that are not more likely
than not to be realized. While a change in valuation allowance that results from the expiration of a
reserved carryforward would not affect total tax expense and therefore would not affect intraperiod tax
allocation, changes in valuation allowance related to the other categories would.

Though the normal rule would suggest that the effect of changes in valuation allowances should be
included in continuing operations, an entity would not allocate changes in valuation allowances related
to items (2) and (3) to income from continuing operations in the following situations:

• If the change in valuation allowance of an acquired entity’s DTA occurs within the measurement
period and results “from new information about facts and circumstances that existed at the
acquisition date,” the change in valuation allowance is recorded as an increase or a decrease in
goodwill in accordance with ASC 805-740-45-2.

• Reductions in the valuation allowance established at the time the deductible temporary
difference or carryforward occurred (resulting in the initial recognition of benefits) that are
related to the following (referred to in ASC 740-20-45-11(c) and (f)) should be allocated directly
to OCI or related components of shareholders’ equity:
o A “decrease in contributed capital (for example, deductible expenditures reported as a
reduction of the proceeds from issuing capital stock).”
o “Deductible temporary differences and carryforwards that existed at the date of a quasi
reorganization,” with limited exceptions.

• Any other change in the valuation allowance recognized solely because of income or losses
recognized in the current year in a category other than income from continuing operations (in
that case, the effect of the change in valuation allowance is allocated to that other category —
for example, a discontinued operation). The exception to this rule exists when there is a loss
from continuing operations. See below for further information regarding the exception to the
general rule.

Regarding the last bullet point, when it is difficult for an entity to determine whether a change in
valuation allowance is solely because of one item, the effect of any change in the valuation allowance
should be allocated to income from continuing operations. This premise is based on the guidance in ASC
740, which requires that income tax allocated to continuing operations be determined first and that the
effects of all changes in valuation allowances (with the exception of the items listed in the first two bullet
points above) that are attributable to changes in judgments about realizability in future years (regardless
of the income category causing the change in judgment) be allocated to income from continuing
operations.

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Example 6-2

At the beginning of 20X1, Entity X, a company operating in a tax jurisdiction with a 25 percent tax rate, has a
$375 tax credit carryforward with no temporary differences. The tax credit carryforward was generated by
operating losses in prior years by Subsidiary A and is reflected as a DTA of $375 less a full valuation allowance.

During 20X1, X disposes of A for a gain of $3,000. Loss from continuing operations is $500. Income from
discontinued operations, including the $3,000 gain, is $2,000. Because the gain on the sale resulted in income
from discontinued operations in the current year, management expects to realize the tax credit carryforward
in the current year solely because of that income. Therefore, the release of the valuation allowance would be
allocated to discontinued operations.

Example 6-3

At the beginning of 20X3, Entity Y, a company operating in a tax jurisdiction with a 25 percent tax rate, has
a $2,000 tax credit carryforward with no temporary differences. The tax credit carryforward was generated
by operating losses in prior years by Subsidiary B and is reflected as a DTA of $2,000 less a full valuation
allowance.

During 20X3, Y’s management enters into a definitive agreement to sell B for an anticipated gain of $8,000.
However, the deal does not close until the first quarter of 20X4; thus, the gain is not recognized until the
transaction is closed. Entity Y had $200 in income from continuing operations. In addition, management
concludes that the DTA is realizable on the basis of the weight of all available evidence, including projections of
future taxable income.

In this example, the release of the entire valuation allowance would be allocated to continuing operations
because there was a change in judgment about the realizability of the related DTA in future years (i.e., because
the gain on the sale would not be recognized until the following year).

6.2.3 Special Situations
6.2.3.1  Quasi-Reorganization Tax Benefits
The tax benefits of deductible temporary differences and carryforwards as of the date of a quasi-
reorganization ordinarily are reported as a direct addition to contributed capital if the tax benefits are
recognized in subsequent years (by reducing or eliminating the valuation allowance). After a quasi-
reorganization, however, an entity may conclude that a valuation allowance should be recognized or
increased for a DTA attributable to pre-quasi-reorganization benefits that were recognized in a prior
period. This charge to establish or increase the valuation allowance is reported as a component of
income tax expense from continuing operations.

6.2.3.2 Fresh-Start Accounting
740-20-45 (Q&A 23)
ASC 852-10 requires an entity emerging from Chapter 11 bankruptcy protection to adopt a new
reporting basis (“fresh-start accounting”) for its assets and liabilities if certain criteria are met. DTAs as
of the fresh-start reporting date are measured in accordance with ASC 740-10-30. The recognition of a
valuation allowance against DTAs as of the fresh-start reporting date generally increases the amount of
reorganization value assigned to goodwill.

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ASC 852-740-45-1 states that a reduction in a valuation allowance for a tax benefit that was not
recognizable as of the plan confirmation date should be reported as a reduction in income tax expense.
Therefore, a subsequent adjustment (increase or decrease) to a valuation allowance established as of
the date of fresh-start reporting should be reported as either an increase or a decrease in income tax
expense.

6.2.4 AFS Debt Securities: Valuation Allowance for Unrealized Losses

740-20-45 (Q&A 13)
In accordance with ASC 740-20-45-11(b), the tax consequences of changes in the amount of unrealized
holding gains or losses from AFS debt securities generally are charged or credited to OCI (see Section
3.5.10.3). An entity will sometimes recognize a valuation allowance to reduce a DTA for an unrealized loss
on AFS debt securities to an amount that is more likely than not to be realized and then subsequently
increase or decrease the valuation allowance related to changes in the DTA associated with subsequent
changes in the fair value of such securities.
740-20-45 (Q&A 14)
Sometimes the effect of an increase or a decrease in a valuation allowance that was initially established
to reduce a DTA for an unrealized loss on an AFS debt security is not allocated to OCI. If changes in
a valuation allowance are caused by a transaction, event, or set of circumstances that is not directly
attributable to either an increase or a decrease in the holding gains or losses on an AFS debt security, an
entity must analyze the cause to determine how the tax consequence of the change should be reported.
This conclusion is based on guidance from ASC 740, as described below.

ASC 740-10-45-20 states, in part:

The effect of a change in the beginning-of-the-year balance of a valuation allowance that results from a
change in circumstances that causes a change in judgment about the realizability of the related deferred tax
asset in future years ordinarily shall be included in income from continuing operations. . . . The effect of other
changes in the balance of a valuation allowance are allocated among continuing operations and items other
than continuing operations as required by paragraphs 740-20-45-2 and 740-20-45-8. [Emphasis added]

In addition, ASC 740-20-45-8 concludes that the “amount allocated to continuing operations is the tax
effect of the pretax income or loss from continuing operations that occurred during the year, plus or
minus income tax effects of . . . [c]hanges in circumstances that cause a change in judgment about the
realization of deferred tax assets in future years.”

Further, ASC 740-20-45-3 requires that the “tax benefit of an operating loss carryforward or carryback . . .
be reported in the same manner as the source of the income or loss in the current year and not in the
same manner as the source of the operating loss carryforward or taxes paid in a prior year or the source
of expected future income that will result in realization of a deferred tax asset for an operating loss
carryforward from the current year.” The only exceptions are identified in ASC 740-20-45-11. Example 6-4
below illustrates this concept.

Example 6-4

Assume that at the beginning of the current year, 20X1, Entity X has no unrealized gain or loss on an AFS debt
security. During 20X1, unrealized losses on AFS debt securities are $1,000 and the tax rate is 25 percent. As a
result of significant negative evidence available at the close of 20X1, X concludes that a 50 percent valuation
allowance is necessary. Therefore, X records a $250 DTA and a $125 valuation allowance. Accordingly, the
carrying amount of the AFS debt portfolio is reduced by $1,000, OCI is reduced by $875, and a $125 net DTA (a
DTA of $250 less a valuation allowance of $125) is recognized at the end of 20X1.

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Example 6-4 (continued)

During 20X2, (1) additional unrealized losses of $2,000 on AFS debt securities are incurred and (2) a change
in circumstances causes a change in judgment about the realizability of tax benefits. Assume that the change
relates to an increase in the fair value of X’s investments in land, which gives rise to a $3,000 source of future
capital gain income, and that X would sell appreciated land if faced with the possibility of having a capital loss
carryforward expire unused. Because a change in circumstances has caused a change in judgment about the
amount of the DTA that will more likely than not be realized, no valuation allowance is necessary at the end of
20X2. Thus, as of the end of 20X2, the carrying amount of the AFS debt portfolio is reduced by a total of $3,000
($1,000 + $2,000), the DTA is increased to a total of $750 ($250 + $500), the valuation allowance is eliminated,
the total unrealized loss (net of tax) on AFS debt securities recorded in AOCI is $2,375 ($875 + $2,000 – [$2,000
× 25%]), and income tax expense from continuing operations for 20X2 is credited (reduced) for the $125
change in judgment related to the beginning-of-the-year valuation allowance.

As a result of the requirement to record the effects of changes in the beginning-of-the-year valuation allowance
in income tax expense from continuing operations, the net-of-tax amount of cumulative unrealized losses
on AFS debt securities included in AOCI at the end of 20X2 does not equal the sum of the cumulative pretax
amount from unrealized losses of $3,000 less the cumulative tax consequences of $750 related to such items
($3,000 × 25%). This situation creates what are commonly referred to as “stranded taxes” or anomalies, which
are discussed in Section 6.2.6. If an entity uses the portfolio approach to account for unrealized gains or losses,
any differential caused by this requirement ($125 in this example) will remain in AOCI until substantially all of
the entity’s securities in the AFS portfolio are sold. If, however, an entity uses the specific identification method,
any differential created by this requirement will diminish over time as the securities that were on hand at the
time the valuation allowance was originally established are sold.

6.2.5 Out-of-Period Items
740-20-45 (Q&A 29)
Generally, an entity will account for the tax effects of a transaction in the same period in which (1) the
related pretax income or loss is included in a component of comprehensive income or (2) equity is
adjusted. Out-of-period adjustments occur when a tax expense or benefit is recognized in an annual
period after the original transaction occurs.

ASC 740-20 and ASC 740-10 provide guidance on the intraperiod tax allocation of certain out-of-period
adjustments. Such adjustments include (1) changes in valuation allowances that are attributable to
changes in judgments about future realization (see ASC 740-20-45-4), (2) changes in tax laws and tax
rates (see ASC 740-10-45-15), and (3) changes in tax status (see ASC 740-10-45-19). In each of these
instances, the related tax effects should be allocated to income from continuing operations, as stated in
ASC 740-20-45-4, ASC 740-10-45-15, and ASC 740-10-45-19, respectively.

ASC 740 does not, however, provide guidance on how to allocate the tax effects of certain other out-of-
period adjustments. The following are examples of circumstances that give rise to out-of-period adjustments
for which ASC 740 does not contain explicit guidance on how to allocate the tax benefit or expense:

• A change in the expected timing of reversal of a DTA or DTL resulting in a change in the
expected benefit or expense (as may be the case when a change in tax rates is phased in over
multiple years).

• Recognition of the benefit of a deduction for an incentive stock option (ISO) that becomes
deductible only because of a disqualifying disposition.

• Recognition of previously unrecognized DTAs or DTLs that are recognized because they are no
longer subject to one of the exceptions in ASC 740-30.

In such cases, it is usually appropriate for an entity to analogize to the guidance in ASC 740-20 on
out-of-period adjustments. Thus, the entity should generally allocate the tax effects of out-of-period
adjustments that are not specifically addressed in ASC 740-20 to income from continuing operations.

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However, other Codification topics may contain guidance that appears, in some cases, to conflict with
an analogy to ASC 740-20. In those situations, it may be acceptable to apply the presentation guidance
from that other topic. See Section 6.2.5.1 for further discussion of certain tax effects associated with
discontinued operations.

6.2.5.1 Intraperiod Allocation of Out-of-Period Items Related to Components

Classified as Discontinued Operations
Guidance on the presentation of discontinued operations is contained in ASC 205. Specifically, ASC
205-20-45-3A through 45-5 state the following:

45-3A The results of all discontinued operations, less applicable income taxes (benefit), shall be reported as a
separate component of income. . . .

45-3B A gain or loss recognized on the disposal (or loss recognized on classification as held for sale) shall be
presented separately on the face of the statement where net income is reported or disclosed in the notes to
financial statements (see paragraph 205-20-50-1(b)).

45-3C A gain or loss recognized on the disposal (or loss recognized on classification as held for sale) of a
discontinued operation shall be calculated in accordance with the guidance in other Subtopics. For example,
if a discontinued operation is within the scope of Topic 360 on property, plant, and equipment, an entity shall
follow the guidance in paragraphs 360-10-35-37 through 35-45 and 360-10-40-5 for calculating the gain or loss
recognized on the disposal (or loss on classification as held for sale) of the discontinued operation.

45-4 Adjustments to amounts previously reported in discontinued operations in a prior period shall be
presented separately in the current period in the discontinued operations section of the statement where net
income is reported.

45-5 Examples of circumstances in which those types of adjustments may arise include the following:
a. The resolution of contingencies that arise pursuant to the terms of the disposal transaction, such as the
resolution of purchase price adjustments and indemnification issues with the purchaser
b. The resolution of contingencies that arise from and that are directly related to the operations of the
discontinued operation before its disposal, such as environmental and product warranty obligations
retained by the seller
c. The settlement of employee benefit plan obligations (pension, postemployment benefits other than
pensions, and other postemployment benefits), provided that the settlement is directly related
to the disposal transaction. A settlement is directly related to the disposal transaction if there is a
demonstrated direct cause-and-effect relationship and the settlement occurs no later than one year
following the disposal transaction, unless it is delayed by events or circumstances beyond an entity’s
control (see paragraph 205-20-45-1G).

ASC 205-20 notes that the income statement should include, as a separate component, the results
of operations of the discontinued operation for the current and prior periods, less applicable income
taxes. Further, ASC 205-20-45-5 does not distinguish between pretax- and income-tax-related effects
of adjustments to amounts previously recorded in discontinued operations, but it does require those
adjustments to be directly related to the discontinued operations (including the disposal transaction).
Accordingly, under ASC 205, an entity may conclude that out-of-period tax effects directly related to the
operations of the discontinued operation (including the disposal transaction) should be allocated to
discontinued operations.

Further, in connection with the implementation of Interpretation 48 (most of which was codified in ASC
740), informal discussions were held with the FASB staff regarding a situation in which the application
of ASC 205 would result in a different presentation than would the application of ASC 740. Specifically,
the FASB staff was asked whether income tax expense or benefit arising from the remeasurement
of a UTB related to a discontinued operation should be reflected in (1) continuing operations in a
manner consistent with the general prohibition on backwards tracing implicit in ASC 740-20-45 or
(2) discontinued operations in a manner consistent with ASC 205. The FASB staff indicated that it was

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aware of both presentations in practice and that an entity should elect one of them as an accounting
policy and apply it consistently.

Accordingly, if an entity concludes that the out-of-period tax benefit (or expense) is directly related to
the operations of the component that is presented in discontinued operations (including the disposal
transaction), there are generally two acceptable views regarding the allocation of such tax effects. Under
one view, the entity may elect to allocate this tax expense or benefit to discontinued operations by
applying ASC 205-20 or, under an alternative view, to income from continuing operations by analogy
to the general intraperiod allocation rules for out-of-period adjustments in ASC 740-20. Under the
alternative view, if the entity concludes that the tax benefit (or expense) is not directly related to the
operations of the component that is presented in discontinued operations (including the disposal
transaction), the entity should allocate the entire tax expense or benefit to income from continuing
operations (by analogy to ASC 740-20).

Out-of-period adjustments are common with respect to discontinued operations (including the disposal
transaction). The following are three situations in which an entity may need to make such adjustments:

• As discussed in Section 3.4.17.2, an out-of-period adjustment may be required when an

unrecognized book-versus-tax difference that is related directly to the operations of a
discontinued operation is no longer subject to one of the exceptions in ASC 740.3

• A domestic corporation may change its legal structure or make elections for tax purposes that
result in a worthless stock deduction that is directly related (either partially or entirely) to the
operations of a discontinued operation.4

• In some tax jurisdictions, when a parent disposes of a component that was included in the
parent’s income tax return, the parent might retain the obligation for UTBs that arose from and
were directly related to the operations of the component while it was still part of the parent’s
tax return (including UTBs related to the disposal transaction itself). The parent may classify
the results of operations of the component in periods before the disposal as discontinued
operations. After the disposal, the parent may need to adjust the amount of the UTB.

Example 6-5

Change in an Indefinite Reinvestment Assertion

Entity X has a profitable foreign subsidiary, Entity A. Entity X has asserted that it intends to indefinitely reinvest
A’s undistributed earnings, and, accordingly, that the indefinite reversal criteria in ASC 740-30-25-17 are met.
Therefore, X has not recorded a DTL in connection with the financial-reporting-over-tax basis difference for the
investment in A (the outside basis difference). Further, A’s functional currency is its local currency; thus, any
resulting translation differences in consolidation by X are accounted for in OCI.

In a subsequent year, X changes its intent and no longer asserts that it intends to indefinitely reinvest the
earnings of A. Thus, X must recognize a DTL for the expected tax consequences of the remittance. The resulting
tax expense is recorded as an expense in the current period. The tax expense related to prior-year earnings
is generally allocated to continuing operations by analogy to the out-of-period guidance in ASC 740-20 and
because “backwards tracing” is not permitted under ASC 740. The tax expense attributable to currency
exchange rate fluctuation related to the current year, however, would be allocated to OCI in accordance with
the general with-and-without rule. For a discussion of the accounting for the deferred tax effects of translation,
see Section 9.2.

3
As discussed in Section 3.4.17.2, an entity may expect an unrecognized outside basis difference DTL to close through a GILTI inclusion, and the
entity may have elected to treat GILTI tax as a current-period expense when it arises. In that case, when the tax effect is ultimately recorded, it will
represent a current-period tax expense and be allocated in accordance with the normal intraperiod tax allocation rules (i.e., not those applicable to
out-of-period adjustments).
4
IRC Section 165(g)(3) specifies that the worthless stock deduction may be taken against the domestic corporation’s ordinary income if the
investee is considered an affiliate. If the investee is not an affiliate, the deduction would be against the domestic corporation’s capital income. This
determination may affect the amount of the deduction the domestic corporation is able to benefit from in the current period.

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Example 6-6

Change in State Apportionment Rate

Entity A, a U.S. entity, operates in multiple state jurisdictions and uses state apportionment factors to allocate
DTAs and DTLs to various states in accordance with the income tax laws of each state. (See Section 3.3.4.6.1
for a further discussion of state apportionment.)

During a subsequent annual period, A experiences a change in its business operations that will affect the
apportionment rate used in the state of X (i.e., there has been a change in the state footprint, but not in the
enacted tax rate). Entity A’s deferred taxes are remeasured by using the different apportionment rate expected
to apply in the period in which the deferred taxes are expected to be recovered or settled. The related tax
effects of the change in DTAs and DTLs would generally be allocated to income from continuing operations in
accordance with the intraperiod allocation guidance in ASC 740-20.

Example 6-7

Tax Benefit From a Worthless Stock Deduction

Entity Y, a U.S. entity, owns 100 percent of H, a foreign holding company that holds three operating companies.
The three operating companies have historically generated losses, resulting in a difference between Y’s book
basis and the U.S. tax basis in the investment in H. This outside basis difference gives rise to a DTA that has
historically not been recognized, since the difference was not expected to reverse in the foreseeable future in
accordance with ASC 740-30-25-9.

In 20X1, H sells one of the operating companies (Company 1) and presents it as a discontinued operation in the
consolidated financial statements in accordance with ASC 205-20-45-1. Concurrently with the sale of Company
1, Y elected to treat H as a disregarded entity for tax purposes (i.e., nontaxable status) by “checking the box.”
For tax purposes, this election is considered a deemed liquidation. The liquidated liabilities of H are in excess
of the liquidated assets; therefore, the investment in H is considered worthless and Y can claim a related
deduction for tax purposes in the U.S. tax jurisdiction. The benefit of that deduction is considered out of period
from Y’s perspective because it represents the recognition of the tax benefit of a loss in a period after the loss
arose.

The benefit recognized in connection with the worthless stock deduction is a result of the historical losses
incurred at the three operating companies. Without these losses in prior years, the deemed liquidation
of H would not have resulted in a tax deduction and a benefit would not have been recognized. The tax
consequence of this benefit could be allocated between the three operating companies, one of which —
Company 1 — is presented in discontinued operations. Accordingly, it would be appropriate for Y to present
the benefit from the losses related to Company 1 in discontinued operations and the benefit from losses
related to Companies 2 and 3 in income from continuing operations.

An acceptable alternative would be for Y to allocate the entire benefit to income from continuing operations.

Example 6-8

Out-of-Period Tax Effects of a UTB That Originated in Discontinued Operations

An entity recorded a UTB classified as a noncurrent liability in connection with a tax position related to the
character (capital vs. ordinary) of the gain from the disposal of a component. The income tax expense for
recording the UTB was reflected in discontinued operations in accordance with the intraperiod tax allocation
guidance in ASC 740-20. In a subsequent year, the statute of limitations expired and the entity recognized a tax
benefit when the UTB was derecognized.

In determining where the benefit should be allocated, the entity could apply the guidance in ASC 740-20-45,
which prohibits backwards tracing of out-of-period adjustments, to record the benefit in continuing operations.
Alternatively, the entity could record the benefit in discontinued operations under ASC 205-20-45-4 even
though this benefit may be the only item in discontinued operations in that reporting period. The approach
chosen is considered an accounting policy election and should be consistently applied.

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6.2.6 Stranded Taxes
Certain circumstances may result in taxes’ being “stranded” in AOCI. Stranded taxes, or anomalies, may
arise on account of:

• Changes in tax rates after the pretax amount was included in OCI.
• Pretax amounts’ not being tax effected because of the presence of a valuation allowance and
the inapplicability of ASC 740-20-45-7.

• The fact that the exception in ASC 740-20-45-7 is applicable in one annual accounting period,
but the pretax amount in OCI reverses in a subsequent annual period.

• A change in tax status.

• A change in indefinite reinvestment assertion.
• Circumstances similar to the above.
For example, assume that an entity has a portfolio of AFS debt securities and that during 20X1, their
fair value has declined to the extent that unrealized holding losses are incurred and reported in OCI.
Available evidence supports a conclusion that a full valuation allowance is necessary as of the end of the
year. In 20X2, the entity’s estimate of future income, excluding temporary differences and carryforwards,
changes. Accordingly, these circumstances have caused a change in judgment about the realizability of
the related DTA in future years and a valuation allowance is no longer necessary at the close of 20X2.
The elimination of the valuation allowance is reported as a reduction in income tax expense from
continuing operations in 20X2 because the change is directly attributable to a change in estimate about
income or loss in future years (see ASC 740-10-45-20). Also, assume that in 20X3, the fair value of the
securities increases to the degree that the unrealized loss previously reported in OCI is eliminated
and the securities are sold at no gain or loss. OCI is increased for the market value increase net of any
related tax consequences. When applying the incremental approach, an entity treats a reduction in a
prior loss as income in the current period.

The FASB staff has informally indicated that, in the situation described above, whether an entity should
eliminate the deferred tax consequences that remain in AOCI (a component of equity) at the end
of 20X3 depends on whether the entity is using the security-by-security approach or the portfolio
approach. The tax consequences reported under the security-by-security approach may sometimes
be different from those reported under the portfolio approach. Under ASC 220-10-50-1, an entity is
required to disclose its policy for releasing income tax effects from AOCI.

6.2.6.1 Security-by-Security Approach
Under the security-by-security approach, the tax consequences of unrealized gains and losses that are
reported in OCI are tracked on a security-by-security basis. In the situation described above, because of
the sale, there is zero cumulative pretax unrealized gain or loss on the AFS debt security at the end of
20X3, and because no tax effect was originally recorded in OCI, the credit to eliminate the gross deferred
tax effect remaining in AOCI at the close of 20X3 is balanced by recognizing an equal amount of income
tax expense from continuing operations during 20X3.

6.2.6.2 Portfolio Approach
The portfolio approach involves a strict period-by-period cumulative incremental allocation of income
taxes to the change in unrealized gains and losses reflected in OCI. Under this approach, the net
cumulative tax effect is ignored. The net change in unrealized gains or losses recorded in AOCI under
this approach would be eliminated only on the date the entire inventory of AFS debt securities is sold or
otherwise disposed of.

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6.2.6.3 ASU 2018-02
As indicated above, another example of a situation in which taxes may be left stranded in AOCI is a
change in tax rate after the pretax amount was included in OCI. In February 2018, the FASB issued ASU
2018-02 to address industry concerns related to the application of ASC 740 to certain provisions of
the 2017 Act. Specifically, some constituents in the banking and insurance industries had expressed
concerns about the requirement in ASC 740 that the effect of a change in tax laws or rates on DTAs
and DTLs be included in income from continuing operations. That guidance applies even in situations in
which the tax effects were initially recognized directly in OCI at the previous rate, resulting in stranded
amounts in AOCI related to the income tax rate differential.

ASU 2018-02 does not affect the application of the intraperiod rules in ASC 740-20; however, the ASU
allows an entity to elect a one-time reclassification from AOCI to retained earnings of stranded tax
effects resulting from the 2017 Act. The amount of the reclassification includes (1) the effect of the
change in the U.S. federal corporate income tax rate on the gross deferred tax amounts and related
valuation allowances, if any, on the date of enactment of the 2017 Act related to items remaining in
AOCI and (2) other income tax effects of the 2017 Act on items remaining in AOCI that an entity elects
to reclassify. The effects of the change in the U.S. federal corporate income tax rate on gross valuation
allowances that were originally charged to income from continuing operations are not included.

For example, assume that before the enactment date of the 2017 Act, an entity recognized a $1,000
loss in OCI in connection with a derivative used in cash flow hedging activities. No further changes in
the fair value of the hedge occur after that date. The forecasted transactions will not occur until after
the enactment date. Because there was no tax basis in the derivative, the entity also recognized a $350
DTA and recorded a corresponding entry to OCI. On the enactment date of the 2017 Act, the entity
reduced the DTA by $140 and recognized a corresponding increase in income tax expense, equal to the
temporary difference of $1,000 multiplied by the 14 percent tax rate change. Upon adopting the ASU
and electing to make the reclassification, the entity would then recognize a one-time reclassification to
move the effect of the rate reduction from AOCI to retained earnings. The entries are summarized in the
table below.

Derivative Net Retained

Liability AOCI DTA Income Earnings

Derivative loss $ (1,000) $ 1,000

Related tax effect (350) $ 350

Reduction in statutory rate (140) $ 140 $ 140

Reclassification under
ASU 2018-02 140 (140)

Final balance $ (1,000) $ 790 $ 210 140 —

For entities electing to reclassify income tax effects of the 2017 Act from AOCI to retained earnings, ASU
2018-02 also addressed “[o]ther income tax effects of the Tax Cuts and Jobs Act.” Items classified as
other income tax effects of the 2017 Act might include, for example, the effect of certain international
tax provisions. In some cases, an entity may not have been indefinitely reinvested in the outside
basis difference in its foreign subsidiary and, accordingly, recorded a DTL related to the outside basis
difference measured in a manner consistent with laws in effect before the deemed repatriation
transition tax. When the DTL was initially recorded, a portion may have been recorded through OCI as
the tax effects related to the translation of the underlying assets and liabilities of the foreign subsidiary.
Because of tax reform, the measurement of the tax effects related to the outside basis difference may

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have changed as a result, in whole or in part, of the deemed inclusion of previously untaxed post-1986
foreign E&P, offset by a deduction designed to generally result in an effective U.S. federal income tax
rate on such E&P of either 15.5 percent or 8 percent depending on the SFC’s aggregate foreign cash
position. The remeasurement of the portion of the DTL that remains in AOCI would be an example of
other income tax effects of the 2017 Act on items remaining in AOCI that an entity may elect to reclassify
in accordance with ASC 220-10-45-12A(b).

ASU 2018-02 must be adopted by all entities; however, certain provisions of the ASU are elective. For
example, a company can elect to reclassify the income tax effects of the 2017 Act on items in AOCI to
retained earnings as described above. Under ASC 220-10-45-12A, as added by ASU 2018-02, if an entity
elects to reclassify the income tax effects of the 2017 Act, the amount of the reclassification includes:
a. The effect of the change in the U.S. federal corporate income tax rate on the gross deferred tax
amounts and related valuation allowances, if any, at the date of enactment of the Tax Cuts and Jobs Act
related to items remaining in accumulated other comprehensive income. . . .
b. Other income tax effects of the Tax Cuts and Jobs Act on items remaining in accumulated other
comprehensive income that an entity elects to reclassify, subject to the disclosures in paragraph
220-10-50-2(b).

Accordingly, if a company elects to make a reclassification entry, it would be required to reclassify

amounts prescribed in ASC 220-10-45-12A(a) but would not be required to reclassify amounts
prescribed in ASC 220-10-45-12A(b).

Regardless of whether an election is made to reclassify income tax effects of the 2017 Act, however, all
companies are required to disclose the following upon adoption of the ASU:

• The company’s accounting policy related to releasing income tax effects from AOCI (e.g., the
portfolio approach or the security-by-security approach), described above. This disclosure
requirement, which is contained in ASC 220-10-50-1, is applicable only to stranded taxes.

• Whether the company has elected to reclassify, to retained earnings in the statement of
stockholders’ equity, the stranded tax effects in AOCI related to the 2017 Act.

• If the company has elected to reclassify to retained earnings the stranded tax effects in AOCI
related to the 2017 Act, what the reclassification encompasses (whether it includes only the
change in the federal corporate tax rate or whether it also includes other changes resulting from
the 2017 Act that affect AOCI).

The existence of a valuation in current or prior periods may affect the reclassification under ASU
2018-02. For example, if a DTA for which the offsetting amount would otherwise be recorded to AOCI
requires a valuation allowance at the time it is recorded, there is no net amount recorded in AOCI
because the valuation allowance is also recorded as an entry to AOCI. Consequently, upon enactment
there would be no stranded tax effect in AOCI related to the item that gave rise to the DTA. Examples
6-9 and 6-10 illustrate the impact of valuation allowances on the reclassification of stranded tax effects
under ASU 2018-02.

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Example 6-9

Valuation Allowance Recorded Before Tax Effects

Assume that in year 1, before the enactment date of the 2017 Act, an entity with a full valuation allowance
against its DTAs recognized a $100 loss in OCI in connection with an AFS security held as a short-term
investment. The entity records a DTA equal to $35 (the $100 unrealized loss on the AFS security multiplied
by the corporate tax rate of 35 percent). Because the entity has a full valuation allowance against its DTAs, it
does not record a net tax benefit in OCI but instead records an increase in the valuation allowance of $35. The
entries for year 1 are as follows:

AFS Valuation Retained Continuing

Security AOCI DTA Allowance Earnings Operations

Unrealized
loss on AFS
security $ (100) $ 100 $ 35 $ (35) $ — $ —

During year 2, the entity determines that the valuation allowance is no longer needed and releases it through
continuing operations by debiting the valuation allowance and crediting tax benefit (i.e., continuing operations)
in the amount of $35. The 2017 Act is enacted in year 3, and the entity remeasures its DTA related to the AFS
security by using the new lower corporate tax rate of 21 percent to credit the DTA and debit tax expense
(i.e., continuing operations) in the amount of $14 ($100 unrealized loss on the AFS security multiplied by the
difference in tax rates of 14 percent [35 percent minus 21 percent]).

The entity adopts ASU 2018-02 as of January 1 of year 4. The amount of tax effects remaining in AOCI related
to the AFS security as of the date of enactment is $0. This is because when the tax effects of the changes in value
of the AFS security occurred, the entity had a full valuation allowance recorded, hence no tax effects were ever
recorded in OCI. Accordingly, no amount is reclassified from AOCI to retained earnings under ASU 2018-02. The
entries for years 2, 3, and 4 are as follows:

AFS Valuation Retained Continuing

Security AOCI DTA Allowance Earnings Operations

Release of the
valuation allowance 35 (35)

Enactment (14) 14

ASU 2018-02 — —

Total (years 1,
2, 3, and 4) $ (100) $ 100 $ 21 $ — $ — $ (21)

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Example 6-10

Valuation Allowance Recorded After Tax Effects

Assume the same facts as in Example 6-9, except that the valuation allowance is not recorded until the
beginning of year 2 and is not released before enactment.

In year 1, the entity records the $35 DTA and corresponding tax benefit in OCI related to the $100 unrealized
loss on the AFS security. The entries for year 1 are as follows:

AFS Valuation Retained Continuing

Security AOCI DTA Allowance Earnings Operations

Unrealized loss on
AFS security $ (100) $ 100 $ — $ —

(35) $ 35

In year 2, the entity determines that a full valuation allowance is needed and accordingly credits the valuation
allowance in the amount of $35 with an offsetting entry to tax expense (i.e., the amount is not “backwards traced”
to AOCI). In year 3, the 2017 Act is enacted, and the entity remeasures its DTA related to the AFS security by using
the new lower corporate tax rate of 21 percent to credit the DTA and debit the valuation allowance in the amount
of $14. The entity adopts ASU 2018-02 as of January 1 of year 4. In doing so, it determines that upon enactment,
the stranded tax effect related to the AFS security is $14. This is because although the entity recorded a valuation
allowance against the DTA related to the AFS security in year 2, the tax effect related to the AFS security that was
recorded in OCI (and thus remained in AOCI as of enactment) was $35. Consequently, a debit of $14 is made to
AOCI, and a credit of $14 is made to retained earnings to reclassify the stranded tax effects remaining in AOCI as
of enactment. The entries for years 2, 3, and 4 are as follows:

AFS Valuation Retained Continuing

Security AOCI DTA Allowance Earnings Operations

Full valuation
allowance recorded $ (35) 35

Enactment (14) 14

ASU 2018-02 14 (14)

Total (years 1,
2, 3, and 4) $ (100) $ 79 $ 21 $ (21) $ (14) $ 35

For entities that adopt ASU 2018-02 prospectively in a period after the enactment date (December 22,
2017), the reclassification adjustment is based on the amount that remains at the time of adoption. For
example, assume that before enactment, an entity holds an AFS security for which an unrealized loss of
$1,000 has been recorded in AOCI, resulting in a corresponding tax effect of $350 that is also recorded
in AOCI. Upon enactment, the entity records an entry in the amount of $140 ($1,000 × [35% – 21%]) to
reduce the DTA related to the unrealized loss with a corresponding debit to tax expense to reflect the
difference between the pre-enactment corporate tax rate of 35 percent and the new corporate tax rate
of 21 percent.

In the first quarter of 2018, after the enactment date, the entity sells the AFS security, resulting in the
reversal of the remaining $210 DTA balance and, before application of either the security-by-security
approach or the portfolio approach, reversal of $210 of tax benefit recorded in OCI. During the second
quarter of 2018 and after the sale of the AFS security, the entity adopts ASU 2018-02 and elects to
reclassify stranded tax effects from AOCI to retained earnings.

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If the entity had made an accounting policy election to use the security-by-security approach to account
for deferred taxes associated with unrealized gains and losses recorded in OCI, the amount of the
reclassification under ASU 2108-02 recorded in the second quarter of 2018 would be $0 because
the entire tax effect associated with the AFS security would have been removed from AOCI when the
security was sold.

Alternatively, if the entity had made an accounting policy election to use the portfolio approach to
account for deferred taxes associated with unrealized gains and losses recorded in OCI and, as a result,
the $140 tax effect associated with the AFS security remained in OCI (e.g., the sale did not liquidate
the entire portfolio of AFS securities), $140 would be reclassified from AOCI to retained earnings upon
adoption of ASU 2018-02. This is because under the portfolio approach, tax effects associated with an
individual security in a portfolio are not removed from AOCI until the disposal of the last security in the
portfolio.

The ASU is effective for all entities for fiscal years beginning after December 15, 2018, including interim
periods therein. Earlier application is permitted in financial statements that have not yet been issued or
made available for issuance. Upon adoption, an entity would apply this guidance to each period in which
the effect of the 2017 Act (or portion thereof) is recorded and may apply it either (1) retrospectively as of
the date of enactment5 or (2) as of the beginning of the period of adoption.

Because both ASU 2018-02 and ASU 2016-01 may affect amounts previously recorded in AOCI, the
impact that the adoption of one ASU has on the adoption of the other will depend on (1) the order
in which the ASUs are adopted, (2) the entity’s existing policies for releasing stranded tax effects, and
(3) the entity’s choice of adoption with respect to ASU 2018-02.

Changing Lanes
In January 2016, the FASB issued ASU 2016-01, which amends the guidance in U.S. GAAP on the
classification and measurement of financial instruments. Although the ASU retains many current
requirements, it significantly revises an entity’s accounting related to (1) the classification and
measurement of investments in equity securities and (2) the presentation of certain fair value
changes for financial liabilities measured at fair value. The ASU also amends certain disclosure
requirements associated with the fair value of financial instruments.

The ASU requires entities to carry all investments in equity securities, including other
ownership interests such as partnerships, unincorporated joint ventures, and LLCs, with
readily determinable fair values (and those without readily determinable fair values upon the
occurrence of certain events), to fair value each period through net income. However, AFS debt
securities will continue to be recorded through OCI. The ASU is effective for PBEs for fiscal years
beginning after December 15, 2017, and interim periods therein. Upon adoption, an entity is
required to record a cumulative-effect adjustment to the balance sheet as of the beginning of
the fiscal year of adoption. Consequently, entities with equity securities that were classified as
AFS before adoption will reclassify amounts from AOCI to retained earnings by means of the
cumulative-effect adjustment recorded upon adoption.

For example, if ASU 2016-01 is adopted before ASU 2018-02 and the entity elects to adopt
ASU 2018-02 prospectively, certain stranded tax effects may have already been reclassified
5
If a registrant elects to apply the guidance retrospectively after it files its annual financial statements in its Form 10-K (e.g., if it elects
retrospective adoption in its Form 10-Q filed for the first quarter of 2019 for a calendar-year entity) and subsequently files a new or amended
registration statement that incorporates by reference those interim financial statements, the registrant must consider the need to retrospectively
revise its annual financial statements that are incorporated by reference in that new or amended registration statement (i.e., the annual financial
statements in its Form 10-K for the year ended December 31, 2018, in this example). This requirement does not apply to a registrant that chooses
to (1) apply the new guidance as of the beginning of the period of adoption or (2) early adopt the new guidance in the annual financial statements
incorporated by reference into the new or amended registration statement.

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into retained earnings because the entity’s existing policy was to release stranded tax effects
by using a security-by-security approach (i.e., those specific effects will not remain in AOCI
when ASU 2018-02 is adopted and, accordingly, will not be affected by ASU 2018-02). However,
an entity may still elect to reclassify other tax effects of the 2017 Act in accordance with ASC
220-10-45-12A(a) (e.g., effect of rate change on deferred tax amounts related to debt securities)
or ASC 220-10-45-12A(b) in addition to those previously reclassified by means of the cumulative-
effect adjustment recorded upon adoption of ASU 2016-01.

Alternatively, if ASU 2018-02 is adopted before ASU 2016-01 (or is adopted after ASU 2016-01, but the
entity elects to adopt ASU 2018-02 on a retrospective basis) and the entity has elected to reclassify
stranded tax effects from AOCI, the tax effects remaining in AOCI that would be reclassified upon
adoption of ASU 2016-01 would generally be limited to the tax effect of the pretax gain or loss on the
equity security at the new 21 percent statutory tax rate.

If the two ASUs are adopted simultaneously, the entity should decide which ASU was adopted first since
that determination will affect the resulting disclosures.

6.2.7 Transactions Among or With Shareholders

6.2.7.1 Tax Consequences of Transactions Among (and With) Shareholders
Certain transactions among shareholders can affect the tax attributes of an entity itself. For example,
if more than 50 percent of a company’s stock changes hands within a certain period, a limitation on the
entity’s ability to use its attribute carryforwards could be triggered. The following are examples of such
transactions:

• Heavy trading in a company’s stock by major shareholders over a period of several years.
• An investor buys 70 percent of a company and consolidates the company but does not use
pushdown accounting.

• An investor buys 100 percent of a company (in a nontaxable business combination) and
consolidates the company but does not use pushdown accounting.

Note that the term “nontaxable business combination,” as used in ASC 740, means a business
combination in which the target company’s tax bases in its assets and liabilities carry over to the
combined entity.

Certain transactions with shareholders (i.e., transactions between a company and its shareholders) can
have the same effect. The following are examples of such transactions:

• An IPO.
• Additional stock offerings.
• Conversion of convertible debt into equity in accordance with the stated terms of the debt
agreement.

• Conversion of debt into equity in a troubled debt restructuring.

• A recapitalization in which preferred stock is exchanged for common stock (i.e., no new equity is
raised, on a net basis).

• A recapitalization in which new debt is incurred and the proceeds are used to purchase treasury
stock.

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Certain transactions among or with shareholders may also change the tax bases of the company’s
assets and liabilities. The following are examples of such transactions:

• An investor buys 100 percent of the outstanding stock of a company (in a business combination)
and consolidates the company but does not use pushdown accounting. The transaction is
treated as the purchase of assets for tax purposes, and assets and liabilities are adjusted to fair
value for tax purposes (which may either increase or decrease the tax basis).

• A parent company sells 100 percent of the stock of a subsidiary in an IPO. For financial reporting
purposes, the carrying amounts of the subsidiary’s assets and liabilities in its separate financial
statements are the historical carrying amounts reflected in the parent company’s consolidated
financial statements. However, the transaction is structured so that, for tax purposes, the
transaction is taxable and the subsidiary adjusts its bases in its assets and liabilities to fair value
(the proceeds from the IPO) for tax purposes. Therefore, the subsidiary now has new temporary
differences that are related to its assets and liabilities.

Changes in valuation allowances, write-offs of DTAs, and the tax consequences of changes in tax
bases of assets and liabilities caused by transactions among or with a company’s shareholders may be
recognized either in the income statement or directly in equity, depending on the nature of the change.

In accordance with ASC 740-10-45-21, the following should be charged to the income statement:

• “Changes in valuation allowances due to changed expectations about the realization of deferred
tax assets caused by transactions among or with shareholders.”

• “A write-off of a preexisting deferred tax asset that an entity can no longer realize as a result of a
transaction among or with its shareholders.”

In addition, in accordance with ASC 740-20-45-11(g), the following should be charged directly to equity:

• The effects of “changes in the tax bases of assets and liabilities caused by transactions among or
with shareholders.”

• The “effect of valuation allowances initially required upon recognition of any related deferred tax
assets” as a result of “changes in the tax bases of assets and liabilities caused by transactions
among or with shareholders.” However, subsequent changes in valuation allowances should be
charged to the income statement.

Because ASC 740-20-45-11(g) applies to all changes in the tax bases of assets and liabilities, this
guidance also applies to tax-deductible goodwill.

6.2.8 Other Special Considerations

6.2.8.1 Holding Gains and Losses Recognized for Both Financial Reporting and
Tax Purposes
740-20-45 (Q&A 16)
Assume that an entity has an AFS portfolio of debt securities that is being accounted for in accordance
with ASC 320-10. Thus, unrealized gains and losses are recorded in OCI, net of any related tax
consequences. For tax purposes, the entity has elected under the tax law to include unrealized gains
and losses on securities portfolios in the determination of taxable income or loss.

When an unrealized loss is incurred and the loss deductions are included in the determination of
taxable income or loss in the tax return, the tax consequences for financial reporting purposes should
be considered (1) in the year the unrealized loss is incurred and (2) in the year the securities are sold.
Example 6-11 below illustrates this concept.

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Example 6-11

Assume the following:

• Company X acquires AFS debt securities for $12 million on January 1, 20X0.
• For financial reporting purposes, unrealized gains and losses on AFS debt securities are recorded in OCI,
net of any tax consequences, in accordance with ASC 740-20-45-11(b).
• Company X elects to include unrealized gains and losses on securities portfolios in the determination of
taxable income or loss (this election is permitted by the tax law).
• At the end of 20X1, the unrealized loss on AFS debt securities is $5 million, all of which was incurred
during the current year.
• The tax rate for 20X1 and 20X2 is 20 percent.
• Pretax income and taxable income, excluding the unrealized loss for 20X1 and 20X2, are $5 million and
zero, respectively.
• The market value of the portfolio, determined at the end of 20X1 (i.e., an unrealized loss of $5 million),
does not change through the end of 20X2.
• Company X sells the AFS debt securities for $7 million and records in income a pretax loss of $5 million
on the sale of the portfolio on the last day of 20X2; taxable income is zero for 20X2.
Company X must record the following journal entries:

Journal Entries Year 1

Unrealized loss on investments (OCI) 5,000,000

Investment portfolio 5,000,000
To record the unrealized loss on AFS securities in OCI.

Income tax expense — continuing operations 1,000,000

Taxes currently payable 1,000,000
To record the taxes payable on $5 million of taxable income exclusive
of losses on the security portfolio, which are reported in OCI (i.e.,
the “without calculation”).

Taxes currently payable 1,000,000

Income tax benefit — OCI 1,000,000
To record the tax consequences of losses on securities portfolio in
20X1 — computed on the basis of mark-to-market accounting as
elected under tax law (i.e., the “with calculation”).

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Example 6-11 (continued)

Journal Entries Year 2

Realized loss on sale of investments (P&L) 5,000,000

Cash 7,000,000
Investment portfolio 7,000,000
Unrealized loss on investment (OCI) 5,000,000
To record the pretax consequences of the sale of the investment
portfolio in 20X2.

Taxes currently payable/NOL DTA 1,000,000

Income tax benefit — continuing operations 1,000,000
To record the tax consequences of the loss on sale of the securities
portfolio in 20X2 (i.e., the “without calculation”).

Income tax expense — OCI 1,000,000

Taxes currently payable/NOL DTA 1,000,000
To record the tax consequences of the reclassification out of AOCI of
the previously unrealized loss on the securities portfolio (i.e., the
“with calculation”).

6.2.8.2 Change in Tax Status to Taxable: Accounting for an Increase in Tax Basis

740-10-25 (Q&A 59)
For a discussion of temporary differences, see Chapter 3.

Upon an entity’s change in tax status, the entity may also recognize a step-up in tax basis in certain
circumstances. For example, in the U.S. federal jurisdiction, upon a change in tax status from a
nontaxable partnership to a taxable C corporation, the entity may recognize a step-up in tax basis for
its assets in an amount equivalent to the taxable gain recognized by the former partners. The former
partners must recognize a taxable gain when the liabilities being assumed by the corporation exceed
the tax basis in the assets being transferred to the corporation.

Generally, the expense or benefit from recognizing the DTLs and DTAs as a result of the change in tax
status should be included in income from continuing operations. ASC 740-10-45-19 states:

When deferred tax accounts are recognized or derecognized as required by paragraphs 740-10-25-32 and
740-10-40-6 due to a change in tax status, the effect of recognizing or derecognizing the deferred tax liability or
asset shall be included in income from continuing operations.

Conversely, any tax benefit attributable to an increase in the tax basis of an entity’s assets resulting from
a transaction with or among shareholders should be allocated to equity. ASC 740-20-45-11(g) states:

All changes in the tax bases of assets and liabilities caused by transactions among or with shareholders shall be
included in equity including the effect of valuation allowances initially required upon recognition of any related
deferred tax assets. Changes in valuation allowances occurring in subsequent periods shall be included in the
income statement.

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A change in tax status, in and of itself, will generally not cause an increase in the tax basis of assets.
However, when the liabilities exceed the tax basis in the assets, under U.S. tax law, the partner is
treated as having entered into a taxable exchange with the newly formed corporation, receiving taxable
consideration (in the form of the corporation’s assumption of the partner’s liabilities) in exchange for the
assets being transferred to the corporation. When the liabilities assumed exceed the tax basis of the
assets being transferred, the partner both realizes and recognizes a gain for U.S. income tax purposes.

The corporation determines its initial tax basis in the assets by using the partnership’s historical tax
basis plus an amount equal to the gain recognized by the former partners (now shareholders) on
account of the taxable exchange with the corporation. In the absence of the taxable exchange with the
shareholder, the tax basis would have been strictly the historical basis of the assets in the hands of the
partnership. Therefore, an entity should use that historical tax basis when determining the amount of
deferred taxes required that are directly related to the change in status. The adjustment of that initial
amount of deferred taxes on account of the increase in tax basis corresponding to the gain recognized
by the partners (now shareholders) should be recognized in equity since it is directly on account of a
transaction with or among the shareholders. See Section 6.2.7.1 for further discussion and examples of
tax consequences involving transactions with or among shareholders.

We are aware of an alternative approach in practice under which all of the tax effects arising in
connection with a change in tax status (including the deferred tax effect of any incremental step-up in
tax basis related to the shareholder gain) would be allocated to income from continuing operations in
accordance with ASC 740-10-45-19. This approach is based on the previous discussion in EITF Issue
94-10, which noted that the guidance contained therein did not address shareholder transactions that
involve a change in the tax status of a company (such as a change from nontaxable S-corporation status
to taxable C-corporation status). While it is not clear whether this statement was intended to address
any incremental step-up afforded the partnership as a result of income being recognized by its partners,
we would also accept this approach.

6.2.8.3 Income Tax Accounting Considerations Related to When a Subsidiary Is

Deconsolidated
740-20-45 (Q&A 28)
The deconsolidation of a subsidiary may result from a variety of circumstances, including a sale of 100
percent of an entity’s interest in the subsidiary. The sale may be structured as either a “stock sale” or an
“asset sale.”

A stock sale occurs when a parent sells to a third party enough shares in a subsidiary to lose control of
the subsidiary, and the subsidiary’s assets and liabilities are effectively transferred to the buyer.

An asset sale occurs when a parent sells individual assets (and liabilities) to the buyer and retains
ownership of the original legal entity. In addition, by election, certain stock sales can be treated for tax
purposes as if the subsidiary sold its assets and was subsequently liquidated.

Upon a sale of a subsidiary, the parent entity should consider the income tax accounting implications for
its income statement and balance sheet.

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6.2.8.3.1 Income Statement Considerations

ASC 810-10-40-5 provides a formula for calculating a parent entity’s gain or loss on deconsolidation of a
subsidiary, which is measured as the difference between:
a. The aggregate of all of the following:
1. The fair value of any consideration received
2. The fair value of any retained noncontrolling investment in the former subsidiary or group of assets
at the date the subsidiary is deconsolidated or the group of assets is derecognized
3. The carrying amount of any noncontrolling interest in the former subsidiary (including any
accumulated other comprehensive income attributable to the noncontrolling interest) at the date
the subsidiary is deconsolidated.
b. The carrying amount of the former subsidiary’s assets and liabilities or the carrying amount of the group
of assets.

6.2.8.3.1.1 Asset Sale
When the net assets of a subsidiary are sold, the parent will present the gain or loss on the net assets
(excluding deferred taxes) in pretax income and will present the reversal of any DTAs or DTLs associated
with the assets sold (the inside basis differences6) and any tax associated with the gain or loss on sale in
income tax expense (or benefit).

6.2.8.3.1.2 Stock Sale
As with an asset sale, when the shares of a subsidiary are sold, the parent will present the gain or
loss on the net assets in pretax income. One acceptable approach to accounting for the deferred tax
effects (the inside basis differences7) is to include the elimination of such amounts as part of the overall
computation of the pretax gain or loss on the sale of the subsidiary; under this approach, the only
amount that would be included in income tax expense (or benefit) would be the tax associated with the
gain or loss on the sale of the shares (the outside basis difference8). The rationale for this view is that
any future tax benefits (or obligations) of the subsidiary are part of the assets acquired and liabilities
assumed by the acquirer with the transfer of shares in the subsidiary and the carryover tax basis in the
assets and liabilities. Other approaches may be acceptable depending on the facts and circumstances.

If the subsidiary being deconsolidated meets the requirements in ASC 205 for classification as
a discontinued operation, the entity would also need to consider the intraperiod guidance on
discontinued operations in addition to this guidance. For a discussion of outside basis differences in
situations in which the subsidiary is presented as a discontinued operation, see Section 3.4.17.2.

6.2.8.3.2 Balance Sheet Considerations

Entities with a subsidiary (or component) that meets the held-for-sale criteria in ASC 360 should classify
the assets and liabilities associated with that component separately on the balance sheet as “held
for sale.” The presentation of deferred tax balances associated with the assets and liabilities of the
subsidiary or component classified as held for sale is determined on the basis of the method of the
expected sale (i.e., asset sale or stock sale) and whether the entity presenting the assets as held for sale
is transferring the basis difference to the buyer.

6
See Section 3.3.1 for the meaning of “inside” and “outside” basis differences.
7
See footnote 6.
8
See footnote 6.

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Deferred taxes associated with the stock of the component being sold (the outside basis difference9)
should not be presented as held for sale in either an asset sale or a stock sale since the acquirer will not
assume the outside basis difference.

6.2.8.3.2.1 Asset Sale
In an asset sale, the tax bases of the assets and liabilities being sold will not be transferred to the
buyer. Therefore, the deferred taxes related to the assets and liabilities (the inside basis differences10)
being sold should not be presented as held for sale; rather, they should be presented along with the
consolidated entity’s other deferred taxes.

6.2.8.3.2.2 Stock Sale
In a stock sale, the tax bases of the assets and liabilities being sold generally are carried over to the
buyer. Therefore, the deferred taxes related to the assets and liabilities (the inside basis differences11)
being sold should be presented as held for sale and not with the consolidated entity’s other deferred
taxes.

6.2.9 Tax Benefits for Dividends Paid to Shareholders: Recognition

740-20-45 (Q&A 05)
In certain tax jurisdictions, an entity may receive a tax deduction for dividend payments made to
shareholders. ASC 740-20-45-8 specifies that tax benefits received for these deductions should be
recognized as a reduction of income tax expense at the time of the dividend distribution. The rationale
for this conclusion is based on the belief that, in substance, a tax deduction for the payment of those
dividends represents an exemption from taxation of an equivalent amount of earnings. However, an
exception to this accounting treatment is discussed below.

6.2.10 Treatment of Tax Benefit for Dividends Paid on Shares Held by an ESOP

740-20-45 (Q&A 17) & 718-740-45 (Q&A 02)
In March 2016, the FASB issued ASU 2016-09, which simplifies several aspects of the accounting for
employee share-based payment transactions for both public and nonpublic entities, including the
accounting for income taxes.

After the adoption of ASU 2016-09, the tax benefit of tax-deductible dividends on allocated and
unallocated shares paid to the employee stock ownership plan (ESOP) should be recorded in the income
statement. ASC 718-740-45-7 states, “[t]he tax benefit of tax-deductible dividends on allocated and
unallocated employee stock ownership plan shares shall be recognized in the income statement.”

Changing Lanes

In December 2019, the FASB issued ASU 2019-12, which modifies ASC 740 to simplify the
accounting for income taxes (as part of the FASB’s Simplification Initiative), including by making
minor improvements to the Codification topics on income taxes related to ESOPs. The ASU
amends the guidance in ASC 718-740-45-7 to clarify where the tax benefit of tax-deductible
dividends should be shown in the income statement. That is, the tax benefit should be
recognized in income taxes allocated to continuing operations.

For further information about ASU 2019-12, see Appendix B.

9
See footnote 6.
10
See footnote 6.
11
See footnote 6.

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6.2.11 Exception to the General Rule

6.2.11.1 Intraperiod Tax Allocation When There Is a Loss From Continuing
Operations in the Current Period
740-20-45 (Q&A 08)
ASC 740-20-45-7 provides an exception to the general intraperiod allocation guidance under ASC
740-20 for an entity that has a current-year loss from continuing operations.

ASC 740-20-45-7 states:

The tax effect of pretax income or loss from continuing operations generally should be determined by a
computation that does not consider the tax effects of items that are not included in continuing operations.
The exception to that incremental approach is that all items (for example, discontinued operations,
other comprehensive income, and so forth) be considered in determining the amount of tax benefit
that results from a loss from continuing operations and that shall be allocated to continuing
operations. That modification of the incremental approach is to be consistent with the approach in Subtopic
740-10 to consider the tax consequences of taxable income expected in future years in assessing the
realizability of deferred tax assets. Application of this modification makes it appropriate to consider a gain on
discontinued operations in the current year for purposes of allocating a tax benefit to a current-year loss from
continuing operations. [Emphasis added]

The benefit to be allocated to continuing operations is generally computed as the lesser of (1) the tax
expense associated with the income in discontinued operations or (2) the tax benefit associated with the
loss in continuing operations.

The exception to the general rule applies to a situation in which (1) an entity has a loss from continuing
operations and income related to other items such as discontinued operations and (2) the entity would
not have otherwise recognized a benefit for the loss from continuing operations under the with-and-
without approach described in ASC 740-20-45 (e.g., because the entity has a valuation allowance against
its net DTAs). Below is an illustration of the exception to the general intraperiod tax allocation rule.

Example 6-12

Assume the following:

• Company A has a $10,000 NOL DTA at the beginning of the year with a full valuation allowance recorded
against it.
• During the current year, A disposes its wholly owned subsidiary, Company B, and has determined that
the disposal will be presented as discontinued operations in accordance with ASC 205.
• Company A generated a loss of $6,000 during the year, and B generated income of $5,000 during the
year.
• There are no permanent differences.
• Company A concludes that it will still need a full valuation allowance for its DTAs.

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Example 6-12 (continued)

As a result of the exception to the general rule above, the pretax income/(loss), tax expense/(benefit), and net
income/(loss) would be as follows:

Continuing Discontinued
Operations Operations

Current year income/(loss) $ (6,000) $ 5,000

Income tax expense/(benefit) (1,250)* 1,250

Net income/(loss) $ (4,750) $ 3,750

* The benefit allocated to continuing operations is limited to the tax expense associated
with discontinued operations income of $5,000 × 25% = $1,250.

Note that the table above is for illustrative purposes only, given that discontinued operations are presented net
of tax in the financial statements.

When applying the exception in ASC 740-20-45-7, an entity is not required to combine pretax income or
loss from all sources other than continuing operations. ASC 740-20-45-7 indicates that the purpose of
this exception is to achieve consistency with the approach in ASC 740-10, under which entities consider
the tax consequences of taxable income expected in future years in assessing the realizability of DTAs.
However, ASC 740-20 does not provide any further implementation guidance on the manner in which
items of comprehensive income other than income from continuing operations should be taken into
consideration when there is more than one such component. Accordingly, we believe that there are two
acceptable approaches, which are discussed below. The approach an entity selects is an accounting
policy election that should be applied consistently.

6.2.11.1.1 The Individual-Component Approach

Under this approach, when an entity applies the guidance in ASC 740-20-45-7, it can allocate an income
tax benefit to the loss from continuing operations if any individual component of comprehensive
income or loss (other than the loss from continuing operations) is positive after factoring in jurisdiction,
character, and the amount that is subject to tax (see additional discussion below). Under this approach,
the individual component would be defined as a category other than continuing operations (e.g., a gain
from discontinued operations or OCI). The total current-year tax expense or benefit from all current-year
sources of income or loss (which may be zero) is then allocated between continuing operations and only
those individual components of current-year comprehensive income other than continuing operations
that are sources of income.

6.2.11.1.2 The Net Approach

Under the net approach, an entity allocates a tax benefit to a loss from continuing operations only
when the net of all components of comprehensive income or loss other than the loss from continuing
operations is positive (i.e., results in income). This approach is consistent with the general guidance in
ASC 740-20-45-8, which requires that, after determining the amount allocable to continuing operations,
the entity allocate the “remainder” (which implies that those items should be aggregated) to items other
than continuing operations in accordance with ASC 740-20-45-12 and ASC 740-20-45-14. In addition, as
noted in ASC 740-20-45-7, the purpose of this exception is to achieve consistency with the approach in
ASC 740-10, under which entities consider the tax consequences of all taxable income that is expected
in future years in assessing the realizability of DTAs.

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6.2.11.1.3 Considerations
Regardless of the approach selected, an entity should also determine whether the component of
income other than continuing operations represents a source of income under ASC 740-20-45-7. For
example, the entity should consider:

• The character (capital vs. ordinary) of both the loss from continuing operations and the
components of comprehensive income other than continuing operations (see Section 6.2.16).

• Whether a gain in OCI related to foreign currency translation is a source of income under ASC
740-20-45-7. A foreign currency gain would not be a source of income if the entity applies the
indefinite reversal exception in ASC 740-30 to its investment in the foreign subsidiary.

• Its policy regarding adjustments to reclassify losses out of AOCI or loss into net income or loss
(see Section 6.2.14).

An entity should apply its selected approach consistently to all periods and tax-paying components.

Example 6-13

Assume the following:

• An entity has incurred losses for financial and income tax reporting purposes in recent years and,
accordingly, has recognized significant NOL carryforwards for which the DTA, net of its valuation
allowance, is zero at the beginning of the year.
• The entity does not have positive verifiable evidence to support a valuation allowance release at the end
of each year presented.
• The entity reflects a zero total income tax provision for the year because of the need to establish a full
valuation allowance against all of its DTAs at the end of the year.
• The applicable jurisdiction tax rate for all items is 25 percent.
The scenarios below are based on the above assumptions and illustrate application of the individual-
component approach and the net approach.

Scenario A

Individual-Component Approach Net Approach

Allocated Allocated
Tax Benefit Tax Benefit
Pretax (Expense) Net of Tax Pretax (Expense) Net of Tax
Net loss from continuing
operations $ (1,000) $ 250 $ (750) $ (1,000) $ — $ (1,000)
Net loss from discontinued
operations (1,000) (1,000) (1,000) — (1,000)
OCI 1,000 (250) 750 1,000 — 1,000

Comprehensive loss $ (1,000) $ — $ (1,000) $ (1,000) $ — $ (1,000)

Scenario A illustrates that under the individual-component approach, even though there is no incremental
tax effect from discontinued operations and other comprehensive loss (because of the entity’s NOL and full
valuation allowance established against its DTAs), income tax benefit is allocated to continuing operations,
income tax expense is correspondingly allocated to OCI (which is the only other “intraperiod allocation”
component in the current year), and no income tax expense or benefit is allocated to discontinued operations.
There is no incremental tax effect, regardless of whether there are multiple items of income or loss, or there
is a single item of income other than a continuing-operations loss, because the financial statement reporting
effect of applying the ASC 740-20-45-7 exception is simply a mechanical intraperiod allocation of the entity’s
total current-year income tax provision of zero.

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Example 6-13 (continued)

Scenario B

Possible Methods of
Allocating Income Tax Benefit
(Expense) When Applying the
Individual-Component Approach Net Approach

Allocated Allocated Allocated

Tax Tax Benefit Tax Benefit
Benefit (Expense) (Expense)
Pretax (Expense) Net of Tax Option 1 Option 2
Net loss from continuing
operations $ (1,000) $ 250 $ (750) $ 150 $ 150
Net loss from discontinued
operations (400) — (400) — 100
OCI 1,000 (250) 750 (150) (250)
Comprehensive loss $ (400) $ — $ (400) $ — $ —

Scenario B illustrates that there may be multiple possible methods of allocating income tax benefit and
expense when the net approach is applied.

Changing Lanes
In December 2019, the FASB issued ASU 2019-12, which modifies ASC 740 to simplify the
accounting for income taxes (as part of the FASB’s Simplification Initiative).

Under the Simplification Initiative, stakeholders provided feedback on the difficulty of applying
the exception in ASC 740-20-45-7, which they noted (1) is often overlooked, (2) provides little
perceived benefit to users of financial statements, and (3) is applied inconsistently in practice.
On the basis of this feedback, ASU 2019-12 removes the exception in ASC 740-20-45-7. The
FASB notes that removal of this exception “will reduce the cost of applying Topic 740, while not
significantly altering the information provided to users of financial statements.” In addition, the
ASU provides related amendments to the illustrative example in ASC 740-20-55-10 through
55-14 to conform with the removal of the exception.

These amendments should be applied prospectively. For further information about ASU
2019-12, see Appendix B.

6.2.12 Application of ASC 740-20-45-7 to Amounts Credited Directly to APIC

740-20-45 (Q&A 34)
Certain debt instruments are bifurcated into debt and equity for financial reporting purposes (e.g., those
containing a beneficial conversion feature). Generally, the equity component is recognized as a credit
to APIC with a corresponding debit to debt discount. When the debt instruments are not bifurcated
for income tax purposes, the tax basis of these debt instruments would be higher than the financial
reporting basis. If the difference is determined to be a taxable temporary difference, a DTL is recognized
for the difference. The expense related to recognizing the DTL would generally be allocated to APIC
under the intraperiod tax allocation rules. However, when an entity has a valuation allowance against its
DTAs, and the taxable temporary difference on the debt instruments is considered a source of taxable
income of the appropriate character and timing, the recognition of the DTL would lead to a reversal of
the valuation allowance, resulting in no net tax expense or benefit. This outcome is consistent with the
application of the “with” and “without” rules discussed in Section 6.2.1.1.

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However, as discussed in Section 6.2.11, because the entity has a valuation allowance against its DTAs
and would not otherwise recognize a tax benefit for a loss from continuing operations, the exception
in ASC 740-20-45-7 to the general intraperiod tax allocation rule requires that “all items (for example,
discontinued operations, other comprehensive income, and so forth) be considered in determining the
amount of tax benefit that results from a loss from continuing operations and that shall be allocated to
continuing operations.”

In applying the exception, entities have had questions about what the term “all items” includes. The
words “and so forth” would seem to indicate that the Board intended “all items” to include items in
addition to discontinued operations and OCI. However, it is unclear whether “all items” refers to all items
discussed in ASC 740-20-45-2 or whether the exception should be limited to those items that affect
comprehensive income (i.e., items recognized directly in equity to the extent that a net incremental
income tax benefit is included in comprehensive income).

We believe that there are two acceptable approaches to applying the exception in ASC 740-20-45-7 and
the question of whether “all items” includes APIC items.

• Approach 1 — “All items” should include APIC items. Since the guidance in ASC 740-20-45-7
is an exception to the general intraperiod tax allocation rule in ASC 740-20, the exception
should apply to all financial statement components to which the general rule applies, including
continuing operations, discontinued operations, OCI, and items charged or credited directly to
shareholders’ equity, as outlined in ASC 740-20-45-2.

• Approach 2 — “All items” should not include APIC items. ASC 740-20-45-7 indicates that the
exception is consistent with the approach in ASC 740-10 under which an entity considers the tax
consequences of taxable income expected in future years in assessing the realizability of DTAs.
When determining income sources available outside continuing operations to absorb a tax loss
from continuing operations, the entity should consider only amounts included in comprehensive
income. The ASC master glossary defines comprehensive income, in part, as follows:

The change in equity (net assets) of a business entity during a period from transactions and other events
and circumstances from nonowner sources. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners. [Emphasis added]

When a debt instrument is bifurcated into debt and equity for financial reporting purposes, the amount
recognized in APIC for the equity component is treated as a transaction with the owners and is therefore
excluded from comprehensive income. Applying the exception to items not included in comprehensive
income would result in the recognition of a net incremental income tax benefit in comprehensive
income.

6.2.13 Application of ASC 740-20-45-7 to Foreign Currency Exchange Gains

740-20-45 (Q&A 35)
Foreign currency exchange gains and losses recorded in OCI represent foreign currency translation
adjustments of an entity’s foreign operations as well as transaction gains and losses on intercompany
loans that are considered long term (“translation adjustments”). Translation adjustments are recognized
for operations of foreign subsidiaries and foreign branches when the functional currency differs from
the reporting currency. The translation adjustments may be related to capital, earnings that have not
been taxed by the U.S. parent’s tax jurisdiction, or earnings that have been previously taxed by the U.S.
parent’s tax jurisdiction. While translation adjustments do not typically enter into the measure of taxable
income in the foreign jurisdiction (e.g., when the tax return is prepared in the functional currency of
the foreign subsidiary or branch), if they are related to foreign subsidiaries, they affect the financial
reporting carrying value (“outside book basis”) in the investment in the foreign subsidiary. In accordance
with ASC 830-30-45-21, deferred taxes are not recognized for translation adjustments related to foreign
subsidiaries to which the indefinite reversal exception applies.

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Foreign currency exchange gains recorded in OCI should not be included in the measure of income
outside continuing operations under the intraperiod allocation exception in ASC 740-20-45-7 if the
translation adjustments result in an outside basis difference in a foreign subsidiary or foreign corporate
joint venture (that is essentially permanent in nature) whose earnings are asserted to be indefinitely
reinvested.12

As discussed in Section 9.4.1, ASC 830-30-45-21 states that if “deferred taxes are not provided for
unremitted earnings of a subsidiary, in those instances, deferred taxes shall not be provided on
translation adjustments.” Accordingly, under the intraperiod allocation exception, a foreign currency
exchange gain that is part of an outside taxable temporary difference that would not normally result in a
recognition of tax should not result in an allocation of tax to that item.

These requirements are similar to the guidance in ASC 740-30-25-13, which indicates that in assessing
the need for a valuation allowance for a DTA, an entity should not consider future taxable income
related to an investment in a foreign subsidiary for which the entity does not recognize a DTL related to
a taxable outside basis difference because of the exception in ASC 740-30-25-18.

6.2.14 Consideration of Credit Entries for Reclassification Adjustments That

Are Recorded in OCI During the Reporting Period When the Exception to the
General Intraperiod Tax Allocation Rule Is Applied
740-20-45 (Q&A 31)
Generally, an entity should exclude credit entries for reclassification adjustments that are recorded in
OCI during the reporting period when applying ASC 740-20-45-7 to determine income within OCI. The
guidance in ASC 740-20-45-7 supports this premise, stating, in part:

That modification of the incremental approach is to be consistent with the approach in Subtopic 740-10
to consider the tax consequences of taxable income expected in future years in assessing the
realizability of deferred tax assets. Application of this modification makes it appropriate to consider a gain
on discontinued operations in the current year for purposes of allocating a tax benefit to a current-year loss
from continuing operations. [Emphasis added]

In other words, regarding the determination of the amount of income tax benefit that should be
allocated to continuing operations when there is a loss from continuing operations, ASC 740-20-45-7
requires a reporting entity to consider whether there are other sources of taxable income outside of
continuing operations in the current year. This approach is consistent with the general approach in
ASC 740-10 that an entity would apply to determine whether a valuation allowance is required against
DTAs (i.e., the reporting entity would consider the tax consequences of taxable income expected in
future years in assessing the realizability of DTAs). A credit in OCI created by the reclassification of a
realized loss to continuing operations does not represent potential future taxable income; therefore, the
exception is not applicable in such circumstances. Under this premise, an entity should similarly exclude
debit entries for reclassification adjustments that are recorded in OCI that would otherwise reduce
other gains in OCI that would provide a source of income.

We are aware of an alternative approach in practice under which an entity does not distinguish between
credits resulting from reclassification adjustments and other gains in OCI. Using this approach, an entity
would look to the total amount of the adjustment recorded in OCI during the period when applying ASC
740-20-45-7, as discussed in Section 6.2.11.1.1.

Further, ASC 220 indicates that the purpose of reclassification adjustments is to properly state
comprehensive income for a period. Therefore, because reclassification adjustments are a component
of book comprehensive income (a gain in OCI that offsets the loss in continuing operations), an entity

12
The CTA related to an entity’s long-term intra-entity loans to foreign subsidiaries is generally not eligible for the indefinite reinvestment assertion
and, therefore, any loan-related pretax foreign exchange gain or loss should be included in the measure of income outside of continuing
operations; see Section 9.7 for additional discussion.

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would consider these adjustments along with other components of OCI when applying ASC 740-20-45-7
under the alternative approach described above. Entities should consult with their accounting advisers
before applying this alternative approach.

6.2.15 Application of ASC 740-20-45-7 to Recoveries of Losses in AOCI

740-20-45 (Q&A 36)
A credit or gain may be recognized in OCI on a debt security that is classified as AFS but that remains in
an overall loss position.

Example 6-14

Entity A purchases a debt security on January 1, 20X1, for $1,000. The security is classified as held for sale
for financial reporting purposes. During 20X1, the security declines in value so that its carrying amount for
financial reporting purposes is $800 on December 31, 20X1. The unrealized loss of $200 is recognized in OCI
in accordance with ASC 320. During 20X2, the security increases in value, and an unrealized gain of $150 is
recognized in OCI. As a result, the security’s financial reporting carrying amount increases to $950.

If the $150 unrealized gain recognized in OCI in 20X2 is not taxed currently, there are two acceptable
approaches on whether A should include it in the measure of income outside of continuing operations when
applying the intraperiod allocation exception given that the security is still in a net loss position of $50. The
approach an entity selects is an accounting policy election that should be applied consistently.

Approach 1 — Make No Distinction Between Credits on Securities in a Net Loss Position and Those
in a Net Gain Position
Under this approach, rather than distinguishing between credits on securities in a net loss position and credits
on securities in a net gain position, A would look only to the total amount of unrealized gains or losses recorded
in OCI during the period when applying ASC 740-20-45-7. This approach is consistent with ASC 740-20-45-7,
which states, in part:
The tax effect of pretax income or loss from continuing operations generally should be
determined by a computation that does not consider the tax effects of items that are not
included in continuing operations. The exception to that incremental approach is that all items
(for example, discontinued operations, other comprehensive income, and so forth) be considered
in determining the amount of tax benefit that results from a loss from continuing operations and
that shall be allocated to continuing operations.

Note that Section 6.2.15 discusses how a reporting entity should consider credits in OCI that are the result of
reclassification adjustments when it applies ASC 740-20-45-7. An entity that applies the alternative approach
described in Section 6.2.15 (i.e., an entity that does not distinguish between credits that represent gains and
those that represent reclassification adjustments) generally should apply Approach 1 to determine the effects
of unrealized gains on AFS debt securities when it is applying ASC 740-20-45-7.

Approach 2 — Do Not Include Credits on Securities That Represent Recovery of Previous Net Losses
Under this approach, A would not consider an unrealized gain recognized in OCI in the current year as a
potential source of future income when applying the intraperiod allocation exception if the security remains in
a net loss position. The guidance in ASC 740-20-45-7 that provides the FASB’s rationale for including “all items”
supports this premise, stating, in part:
That modification of the incremental approach is to be consistent with the approach in
Subtopic 740-10 to consider the tax consequences of taxable income expected in future
years in assessing the realizability of deferred tax assets. Application of this modification
makes it appropriate to consider a gain on discontinued operations in the current year for
purposes of allocating a tax benefit to a current-year loss from continuing operations. [Emphasis
added]

In other words, when a security remains in a net loss position even after a current-year unrealized gain, there
is no taxable income expected in future years that would serve as a source of income for the current-year loss
from continuing operations. This is substantiated by the fact that there is a DTA for a deductible temporary
difference on the security since the tax basis is greater than the book basis. If the security in the example above
is sold at the financial reporting amount of $950, there is a taxable loss and no gain; hence, nothing serves as a
source of income that would benefit the current-year continuing operations loss.

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Example 6-15

Assume the following:

• Entity B:
o Determined, in 20X0, that a valuation allowance is needed to reduce its DTA to an amount that is
more likely than not to be realized, or zero.
o Has a YTD pretax loss and is anticipating a pretax loss for the year for which no tax benefit can be
recognized.
o Has a portfolio of four debt securities that are classified as AFS for financial reporting purposes and,
therefore, the unrealized gains or losses are recognized in OCI in accordance with ASC 320.
o Purchased each debt security on January 1, 20X1, for $1,000.
• During 20X1, a net unrealized gain of $50 on AFS securities is recognized in OCI.
• During 20X2, a net unrealized gain of $150 is recognized in OCI.

Year 1 Gain/ December 31, Year 2 Gain/ December 31,

Cost (Loss) 20X1 (Loss) 20X2

Security 1 $ 1,000 $ 100 $ 1,100 $ 100 $ 1,200

Security 2 1,000 (30) 970 50* 1,020

Security 3 1,000 (100) 900 50** 950

Security 4 1,000 80 1,080 (50) 1,030

Total $ 4,000 $ 50 $ 4,050 $ 150 $ 4,200

* Security 2 year 2 gain includes $30 recovery of unrealized losses from prior year.
** Security 3 year 2 gain Includes $50 recovery of unrealized losses from prior year.

If B selects Approach 1, the amount of gain it should include in the measure of income outside of continuing
operations when applying the intraperiod allocation exception in ASC 740-20-45-7 for the two years would be
determined on the basis of the following amounts:

Year 1 Gain/(Loss) Year 2 Gain/(Loss)

$ 50 $ 150

If B selects Approach 2, the amount of gain it should include in the measure of income outside of continuing
operations when applying the intraperiod allocation exception in ASC 740-20-45-7 for the two years would be
determined on the basis of the following amounts:

Year 1 Gain/(Loss) Year 2 Gain/(Loss)

$ 50 $ 70

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6.2.16 Implications of the Character of Income (or Loss) When the Exception

to the General Intraperiod Tax Allocation Rule Is Applied
740-20-45 (Q&A 32)
Intraperiod allocation is required for each tax-paying component (see Section 6.2.11.1). ASC 740-20-
45-7 specifies that an entity should apply the exception to determine the amount of tax benefit that
should be allocated to a loss from continuing operations. It does not specify that the entity must
consider the character of the income or loss. Therefore, if an entity has overall income from continuing
operations in a particular tax-paying component, it is not required to apply ASC 740-20-45-7 to a capital
loss in that tax-paying component as if the capital loss were a separate tax-paying component.

However, in certain instances, it would be acceptable for an entity to establish an accounting policy
under which the ordinary income and capital loss within continuing operations are treated as separate
tax-paying components. For example, this policy election might be appropriate in a taxing jurisdiction in
which an entity cannot offset capital losses against ordinary income. In this circumstance, the ordinary
income and capital losses may be considered, in essence, separate tax-paying components — as if
separate tax returns were filed for ordinary and capital items. Thus, the ASC 740-20-45-7 exception
would be applied separately to the ordinary income and capital loss even though they aggregate to
overall income from continuing operations.

In any case, an entity that applies ASC 740-20-45-7 must always take into consideration the character of
income outside of continuing operations when determining the amount of tax benefit to be allocated
to a loss within continuing operations (either an overall loss or a capital loss being evaluated under the
policy election described above). For example, in a jurisdiction in which an entity cannot offset capital
losses against ordinary income, ordinary income outside of continuing operations should not be used as
a basis for recognizing a tax benefit for a capital loss within continuing operations.

Example 6-16

In a tax jurisdiction that has a 25 percent tax rate and does not allow the offset of capital losses against
ordinary income, an entity had $300 of income from continuing operations, which consisted of $1,000 of
ordinary income offset by a $700 capital loss. The entity also had a gain of $600 on AFS debt securities
recorded as a component of OCI. The following table illustrates the separate application of the approaches
described above:

If Character Is If Character Is
Not Considered Considered
Income from continuing operations $ 300 $ 300
Tax expense (250) (100)*
Net income 50 200

Capital gain (AFS securities) 600 600

Tax expense 0 (150)
OCI (net of tax) 600 450
Total comprehensive income $ 650 $ 650

* (1,000 × 25%) – (600 × 25%).

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Chapter 7 — Interim Reporting

7.1 Overview
ASC 740-270

05-1 This Subtopic addresses the accounting and disclosure for income taxes in interim periods. The
accounting requirements established in this Subtopic build upon the general requirements for accounting for
income taxes established in Subtopic 740-10 as well as the intraperiod tax allocation process established in
Subtopic 740-20.

05-2 Subtopic 740-10 addresses the computation of total tax expense for an entity. Subtopic 740-20 addresses
the process of allocating total income tax expense (or benefit) for a period to different components of
comprehensive income and shareholders’ equity.

05-3 Because an interim period is a subset of a longer period, typically a year, incremental requirements for
recognition and measurement are established by this Subtopic.

05-4 This Subtopic describes:

a. The general computation of interim period income taxes (see paragraphs 740-270-30-1 through 30-9)
b. The application of the general computation to specific situations (see paragraphs 740-270-30-22
through 30-28)
c. The interim period income taxes requirements applicable to significant unusual or infrequently
occurring items and discontinued operations (see Section 740-270-45)
d. Special computations applicable to operations taxable in multiple jurisdictions (see paragraph 740-270-
30-36)
e. Guidelines for reflecting the effects of new tax legislation in interim period income tax provisions (see
paragraphs 740-270-25-5 through 25-6)
f. Disclosure requirements (see paragraph 740-270-50-1).
This Subtopic also provides Examples and illustrations in Section 740-270-55.

Overall Guidance
15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic, see
Subtopic 740-10-15.

General Recognition Approach

25-1 This guidance addresses the issue of how and when income tax expense (or benefit) is recognized in
interim periods and distinguishes between elements that are recognized through the use of an estimated
annual effective tax rate applied to measures of year-to-date operating results, referred to as ordinary income
(or loss), and specific events that are discretely recognized as they occur.

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ASC 740-270 (continued)

25-2 The tax (or benefit) related to ordinary income (or loss) shall be computed at an estimated annual effective
tax rate and the tax (or benefit) related to all other items shall be individually computed and recognized when
the items occur.

25-3 If an entity is unable to estimate a part of its ordinary income (or loss) or the related tax (or benefit) but is
otherwise able to make a reliable estimate, the tax (or benefit) applicable to the item that cannot be estimated
shall be reported in the interim period in which the item is reported.

25-4 The tax benefit of an operating loss carryforward from prior years shall be included in the effective tax
rate computation if the tax benefit is expected to be realized as a result of ordinary income in the current
year. Otherwise, the tax benefit shall be recognized in the manner described in paragraph 740-270-45-4 in
each interim period to the extent that income in the period and for the year to date is available to offset the
operating loss carryforward or, in the case of a change in judgment about realizability of the related deferred
tax asset in future years, the effect shall be recognized in the interim period in which the change occurs.

25-5 The effects of new tax legislation shall not be recognized prior to enactment. The tax effect of a change
in tax laws or rates on taxes currently payable or refundable for the current year shall be recorded after the
effective dates prescribed in the statutes and reflected in the computation of the annual effective tax rate
beginning no earlier than the first interim period that includes the enactment date of the new legislation.
The effect of a change in tax laws or rates on a deferred tax liability or asset shall not be apportioned among
interim periods through an adjustment of the annual effective tax rate.

Pending Content (Transition Guidance: ASC 740-10-65-8)

25-5 The effects of new tax legislation shall not be recognized prior to enactment. The tax effect of a
change in tax laws or rates on taxes currently payable or refundable for the current year shall be reflected
in the computation of the annual effective tax rate beginning in the first interim period that includes the
enactment date of the new legislation. The effect of a change in tax laws or rates on a deferred tax liability
or asset shall not be apportioned among interim periods through an adjustment of the annual effective
tax rate.

25-6 The tax effect of a change in tax laws or rates on taxes payable or refundable for a prior year shall be
recognized as of the enactment date of the change as tax expense (benefit) for the current year. See Example 6
(paragraph 740-270-55-44) for illustrations of accounting for changes caused by new tax legislation.

25-7 The effect of a change in the beginning-of-the-year balance of a valuation allowance as a result of a change
in judgment about the realizability of the related deferred tax asset in future years shall not be apportioned
among interim periods through an adjustment of the effective tax rate but shall be recognized in the interim
period in which the change occurs.

Recognition of the Tax Benefit of a Loss in Interim Periods

25-8 This guidance establishes requirements for considering whether the amount of income tax benefit
recognized in an interim period shall be limited due to interim period losses.

25-9 The tax effects of losses that arise in the early portion of a fiscal year shall be recognized only when the
tax benefits are expected to be either:
a. Realized during the year
b. Recognizable as a deferred tax asset at the end of the year in accordance with the provisions of
Subtopic 740-10.

25-10 An established seasonal pattern of loss in early interim periods offset by income in later interim periods
shall constitute evidence that realization is more likely than not, unless other evidence indicates the established
seasonal pattern will not prevail.

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ASC 740-270 (continued)

25-11 The tax effects of losses incurred in early interim periods may be recognized in a later interim period of
a fiscal year if their realization, although initially uncertain, later becomes more likely than not. When the tax
effects of losses that arise in the early portions of a fiscal year are not recognized in that interim period, no
tax provision shall be made for income that arises in later interim periods until the tax effects of the previous
interim losses are utilized.

25-12 If an entity has a significant unusual or infrequently occurring loss or a loss from discontinued
operations, the tax benefit of that loss shall be recognized in an interim period when the tax benefit of the loss
is expected to be either:
a. Realized during the year
b. Recognizable as a deferred tax asset at the end of the year in accordance with the provisions of
Subtopic 740-10.
Realization would appear to be more likely than not if future taxable income from (ordinary) income during
the current year is expected based on an established seasonal pattern of loss in early interim periods offset
by income in later interim periods. The guidance in this paragraph also applies to a tax benefit resulting from
an employee share-based payment award within the scope of Topic 718 on stock compensation when the
deduction for the award for tax purposes is greater than the cumulative cost of the award recognized for
financial reporting purposes.

25-13 See Example 3, Cases A and B (paragraphs 740-270-55-26 through 55-28) for example computations
involving unusual or infrequently occurring losses.

25-14 If recognition of a deferred tax asset at the end of the fiscal year for all or a portion of the tax benefit
of the loss depends on taxable income from the reversal of existing taxable temporary differences, see
paragraphs 740-270-30-32 through 30-33 for guidance. If all or a part of the tax benefit is not realized and
future realization is not more likely than not in the interim period of occurrence but becomes more likely than
not in a subsequent interim period of the same fiscal year, the previously unrecognized tax benefit shall be
reported that subsequent interim period in the same manner that it would have been reported if realization
had been more likely than not in the interim period of occurrence, that is, as a tax benefit relating to continuing
operations or discontinued operations. See Subtopic 740-20 for the requirements to allocate total income tax
expense (or benefit).

General Methodology and Use of Estimated Annual Effective Tax Rate

30-1 This guidance establishes the methodology, including the use of an estimated annual effective tax rate, to
determine income tax expense (or benefit) in interim financial information.

30-2 In reporting interim financial information, income tax provisions shall be determined under the general
requirements for accounting for income taxes set forth in Subtopic 740-10.

30-3 Income tax expense (or benefit) for an interim period is based on income taxes computed for ordinary
income or loss and income taxes computed for items or events that are not part of ordinary income or loss.

30-4 Paragraph 740-270-25-2 requires that the tax (or benefit) related to ordinary income (or loss) be
computed at an estimated annual effective tax rate and the tax (or benefit) related to all other items be
individually computed and recognized when the items occur (for example, the tax effects resulting from an
employee share-based payment award within the scope of Topic 718 when the deduction for the award for tax
purposes does not equal the cumulative compensation costs of the award recognized for financial reporting
purposes).

30-5 The estimated annual effective tax rate, described in paragraphs 740-270-30-6 through 30-8, shall be
applied to the year-to-date ordinary income (or loss) at the end of each interim period to compute the year-to-
date tax (or benefit) applicable to ordinary income (or loss).

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ASC 740-270 (continued)

30-6 At the end of each interim period the entity shall make its best estimate of the effective tax rate expected
to be applicable for the full fiscal year. In some cases, the estimated annual effective tax rate will be the
statutory rate modified as may be appropriate in particular circumstances. In other cases, the rate will be
the entity’s estimate of the tax (or benefit) that will be provided for the fiscal year, stated as a percentage of
its estimated ordinary income (or loss) for the fiscal year (see paragraphs 740-270-30-30 through 30-34 if an
ordinary loss is anticipated for the fiscal year).

30-7 The tax effect of a valuation allowance expected to be necessary for a deferred tax asset at the end of the
year for originating deductible temporary differences and carryforwards during the year shall be included in the
effective tax rate.

30-8 The estimated effective tax rate also shall reflect anticipated investment tax credits, foreign tax rates,
percentage depletion, capital gains rates, and other available tax planning alternatives. However, in arriving
at this estimated effective tax rate, no effect shall be included for the tax related to an employee share-based
payment award within the scope of Topic 718 when the deduction for the award for tax purposes does not
equal the cumulative compensation costs of the award recognized for financial reporting purposes, significant
unusual or infrequently occurring items that will be reported separately, or for items that will be reported net
of their related tax effect in reports for the interim period or for the fiscal year. The rate so determined shall be
used in providing for income taxes on a current year-to-date basis.

30-9 Examples 1 through 2 (see paragraphs 740-270-55-2 through 55-23) contain illustrations of the
computation of estimated annual effective tax rates beginning in paragraphs 740-270-55-3; 740-270-55-12;
and 740-270-55-19 through 55-20.

Related Implementation Guidance and Illustrations

• Example 1: Accounting for Income Taxes Applicable to Ordinary Income (or Loss) at an Interim Date
if Ordinary Income Is Anticipated for the Fiscal Year [ASC 740-270-55-2].
• Example 2: Accounting for Income Taxes Applicable to Ordinary Income (or Loss) at an Interim Date
if an Ordinary Loss Is Anticipated for the Fiscal Year [ASC 740-270-55-11].
• Example 3: Accounting for Income Taxes Applicable to Unusual or Infrequently Occurring Items [ASC
740-270-55-24].
• Example 4: Accounting for Income Taxes Applicable to Income (or Loss) From Discontinued
Operations at an Interim Date [ASC 740-270-55-29].

740-270-25 (Q&A 01)

The core principle of ASC 740-270 is that the interim period is integral to the entire financial reporting
year. Thus, this chapter describes the general process for allocating an entity’s annual tax provision to
its interim financial statements. A major part of that process is estimating the entity’s AETR, which is
determined and updated in each interim reporting period.

An entity faces various challenges when estimating its AETR. For example, when estimating this rate, an
entity must also estimate its income by jurisdiction, impact of operating losses, changes to valuation
allowances, and use of tax credits. These estimates are further complicated when a change in tax law
or income tax rates occurs within a particular interim period. An entity must also consider taxable
transactions outside of ordinary income when calculating discrete tax consequences (or benefits)
and recognize them in the interim period in which they occur and in the appropriate components of
the financial statements. This chapter discusses considerations and complexities when an entity is
accounting for income taxes in interim periods.

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7.1.1 The Basic Interim Provision Model

ASC 740-270-25-2 requires entities to compute tax (or benefit) related to ordinary income (or loss)
by using an estimated AETR for each interim period. To calculate its estimated AETR, an entity must
estimate its ordinary income and the related tax expense or benefit for the full fiscal year. The formula
to compute the estimated AETR is as follows:

Estimated Annual Tax on Ordinary Income/Loss

AETR =
Estimated Annual Pretax on Ordinary Income/Loss

The estimated AETR is then applied to YTD ordinary income or loss to compute the YTD tax (or benefit)
applicable to ordinary income or loss as follows:

YTD Tax Expense/Benefit = AETR × YTD Ordinary Income/Loss

The interim tax expense (or benefit) is the difference between current YTD tax (or benefit) and prior YTD
tax (or benefit):

Interim Tax Expense/Benefit = YTD Tax Expense/Benefit – Prior-Period YTD Tax Expense/Benefit

The AETR should also include anticipated ITCs (see ASC 740-270-30-14 and 30-15 for certain exclusions),
FTCs, percentage depletion, capital gains rates, and other available tax-planning alternatives.

Example 7-1 below illustrates a typical computation of the AETR and interim tax expense as determined
under ASC 740-270.

Example 7-1

Assume the following:

• The entity anticipates ordinary income of $100,000 for the full fiscal year.
• All income is taxable in the United States at a 21 percent rate. The income is not taxable in any other
jurisdiction.
• Estimated tax credits for the fiscal year total $4,000.
• No events that do not have tax consequences are anticipated.
• No changes in estimated ordinary income, tax rates, or tax credits occur during the year.
Computation of the estimated AETR is as follows:

Tax on estimated annual ordinary income at

statutory rate ($100,000 at 21%) $ 21,000

Less estimated tax credits (4,000)

Estimated annual tax on ordinary income $ 17,000

Estimated AETR (17,000 ÷ 100,000) 17%

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Example 7-1 (continued)

Assuming that ordinary income before tax is $20,000 in each of the first three quarters and $40,000 in the
fourth quarter, the entity computes quarterly taxes as follows:

Ordinary Income Tax

Less
Previously Reporting
Reporting Period YTD AETR YTD Provided Period

First quarter $ 20,000 $ 20,000 17% $ 3,400 $ — $ 3,400

Second quarter 20,000 40,000 17% 6,800 3,400 3,400

Third quarter 20,000 60,000 17% 10,200 6,800 3,400

Fourth quarter 40,000 100,000 17% 17,000 10,200 6,800

Fiscal year $ 100,000 $ 17,000

7.2 Items Accounted for Separately From the AETR

ASC 740-270

Exclusion of Items From Estimated Annual Effective Tax Rate

30-10 This guidance identifies items that are always excluded from the determination of the estimated annual
effective tax rate. This guidance also specifies the alternatives for including or excluding certain investment tax
credits in the estimated annual effective tax rate.

Items Always Excluded From Estimated Annual Effective Tax Rate

30-11 The effects of changes in judgment about beginning-of-year valuation allowances and effects of changes
in tax laws or rates shall be excluded from the estimated annual effective tax rate calculation. See paragraph
740-270-25-5 for requirements related to when the estimated annual effective tax rate shall be adjusted to
reflect changes in tax laws and rates that affect current year taxes payable or refundable.

Pending Content (Transition Guidance: ASC 740-10-65-8)

30-11 The effects of changes in judgment about beginning-of-year valuation allowances and effects of
changes in tax laws or rates on deferred tax assets or liabilities and taxes payable or refundable for prior
years (in the case of a retroactive change) shall be excluded from the estimated annual effective tax rate
calculation.

30-12 Taxes related to an employee share-based payment award within the scope of Topic 718 when the
deduction for the award for tax purposes does not equal the cumulative compensation costs of the award
recognized for financial reporting purposes, significant unusual or infrequently occurring items that will be
reported separately or items that will be reported net of their related tax effect shall be excluded from the
estimated annual effective tax rate calculation.

30-13 As these items are excluded from the estimated annual effective tax rate, Section 740-270-25 requires
that the related tax effect be recognized in the interim period in which they occur. See Example 3 (paragraph
740-270-55-24) for illustrations of accounting for these items in the interim period which they occur.

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ASC 740-270 (continued)

Certain Tax Credits

30-14 Certain investment tax credits may be excluded from the estimated annual effective tax rate. If an entity
includes allowable investment tax credits as part of its provision for income taxes over the productive life
of acquired property and not entirely in the year the property is placed in service, amortization of deferred
investment tax credits need not be taken into account in estimating the annual effective tax rate; however, if
the investment tax credits are taken into account in the estimated annual effective tax rate, the amount taken
into account shall be the amount of amortization that is anticipated to be included in income in the current
year (see paragraphs 740-10-25-46 and 740-10-45-28).

30-15 Further, paragraphs 840-30-30-14 and 840-30-35-34 through 35-35 require that investment tax credits
related to leases that are accounted for as leveraged leases shall be deferred and accounted for as return on
the net investment in the leveraged leases in the years in which the net investment is positive and explains
that the use of the term years is not intended to preclude application of the accounting described to shorter
periods. If an entity accounts for investment tax credits related to leveraged leases in accordance with those
paragraphs for interim periods, those investment tax credits shall not be taken into account in estimating the
annual effective tax rate.

Pending Content (Transition Guidance: ASC 842-10-65-1)

30-15 Further, paragraphs 842-50-30-1 and 842-50-35-3 through 35-4 require that investment tax credits
related to leases that are accounted for as leveraged leases shall be deferred and accounted for as
return on the net investment in the leveraged leases in the years in which the net investment is positive
and explains that the use of the term years is not intended to preclude application of the accounting
described to shorter periods. If an entity accounts for investment tax credits related to leveraged leases in
accordance with those paragraphs for interim periods, those investment tax credits shall not be taken into
account in estimating the annual effective tax rate.

Ability to Make Estimates

30-16 This guidance addresses the consequences of an entity’s inability to reliably estimate some or all of
the information which is ordinarily required to determine the annual effective tax rate in interim financial
information.

30-17 Paragraph 740-270-25-3 requires that if an entity is unable to estimate a part of its ordinary income
(or loss) or the related tax (or benefit) but is otherwise able to make a reliable estimate, the tax (or benefit)
applicable to the item that cannot be estimated be reported in the interim period in which the item is reported.

30-18 Estimates of the annual effective tax rate at the end of interim periods are, of necessity, based on
evaluations of possible future events and transactions and may be subject to subsequent refinement or
revision. If a reliable estimate cannot be made, the actual effective tax rate for the year to date may be the best
estimate of the annual effective tax rate.

30-19 The effect of translating foreign currency financial statements may make it difficult to estimate an annual
effective foreign currency tax rate in dollars. For example, in some cases depreciation is translated at historical
exchange rates, whereas many transactions included in income are translated at current period average
exchange rates. If depreciation is large in relation to earnings, a change in the estimated ordinary income that
does not change the effective foreign currency tax rate can change the effective tax rate in the dollar financial
statements. This result can occur with no change in exchange rates during the current year if there have been
exchange rate changes in past years. If the entity is unable to estimate its annual effective tax rate in dollars or
is otherwise unable to make a reliable estimate of its ordinary income (or loss) or of the related tax (or benefit)
for the fiscal year in a jurisdiction, the tax (or benefit) applicable to ordinary income (or loss) in that jurisdiction
shall be recognized in the interim period in which the ordinary income (or loss) is reported.

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ASC 740-270 (continued)

Effect of Operating Losses

30-20 This guidance addresses changes to the general methodology to determine income tax expense (or
benefit) in interim financial information as set forth in paragraph 740-270-30-5 when an entity has experienced
or expects to experience operating losses.

30-21 An entity may have experienced year-to-date ordinary income (or loss) at the end of any interim period.
These year-to-date actual results of either ordinary income (or loss) may differ from the results expected
by the entity for either ordinary income (or loss) for the full fiscal year. This guidance identifies the required
methodology for recording interim period income taxes for each of the four possible relationships of year-to-
date ordinary income (or loss) and expected full fiscal year ordinary income (or loss).See Examples 1 through
2 (paragraphs 740-270-55-2 through 55-23 ) for example computations in these different situations. This
guidance also establishes income tax benefit limitations when ordinary losses exist.

Year-to-Date Ordinary Income; Anticipated Ordinary Income for the Year

30-22 If an entity has ordinary income for the year to date at the end of an interim period and anticipates
ordinary income for the fiscal year, the interim period tax shall be computed in accordance with paragraph
740-270-30-5.

30-23 See Example 1, Cases A and B1 (paragraphs 740-270-55-4 through 55-6) for illustrations of the
application of these requirements.

Year-to-Date Ordinary Loss; Anticipated Ordinary Income for the Year

30-24 If an entity has an ordinary loss for the year to date at the end of an interim period and anticipates
ordinary income for the fiscal year, the interim period tax benefit shall be computed in accordance with
paragraph 740-270-30-5, except that the year-to-date tax benefit recognized shall be limited to the amount
determined in accordance with paragraphs 740-270-30-30 through 30-33.

30-25 See Example 1, Cases B2 and B3 (paragraphs 740-270-55-7 through 55-8) for illustrations of the
application of these requirements.

Year-to-Date Ordinary Income; Anticipated Ordinary Loss for the Year

30-26 If an entity has ordinary income for the year to date at the end of an interim period and anticipates
an ordinary loss for the fiscal year, the interim period tax shall be computed in accordance with paragraph
740-270-30-5. The estimated tax benefit for the fiscal year, used to determine the estimated annual effective
tax rate described in paragraphs 740-270-30-6 through 30-8, shall not exceed the tax benefit determined in
accordance with paragraphs 740-270-30-30 through 30-33.

30-27 See Example 2, Cases A2 and C2 (paragraphs 740-270-55-16 and 740-270-55-20) for illustrations of the
application of these requirements.

Year-to-Date Ordinary Loss; Anticipated Ordinary Loss for the Year

30-28 If an entity has an ordinary loss for the year to date at the end of an interim period and anticipates an
ordinary loss for the fiscal year, the interim period tax benefit shall be computed in accordance with paragraph
740-270-30-5. The estimated tax benefit for the fiscal year, used to determine the estimated annual effective
tax rate described in paragraphs 740-270-30-6 through 30-8, shall not exceed the tax benefit determined in
accordance with paragraphs 740-270-30-30 through 30-33. In addition to that limitation in the effective rate
computation, if the year-to-date ordinary loss exceeds the anticipated ordinary loss for the fiscal year, the tax
benefit recognized for the year to date shall not exceed the tax benefit determined, based on the year-to-date
ordinary loss, in accordance with paragraphs 740-270-30-30 through 30-33.

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ASC 740-270 (continued)

Pending Content (Transition Guidance: ASC 740-10-65-8)

30-28 If an entity has an ordinary loss for the year to date at the end of an interim period and anticipates
an ordinary loss for the fiscal year, the interim period tax benefit shall be computed in accordance with
paragraph 740-270-30-5. The estimated tax benefit for the fiscal year, used to determine the estimated
annual effective tax rate described in paragraphs 740-270-30-6 through 30-8, shall not exceed the tax
benefit determined in accordance with paragraphs 740-270-30-30 through 30-33.

30-29 See Example 2, Cases A1, B, and C1 (paragraphs 740-270-55-15, 740-270-55-17, and 740-270-55-19) for
illustrations of the application of these requirements.

Determining Income Tax Benefit Limitations

30-30 Paragraph 740-270-25-9 provides that a tax benefit shall be recognized for a loss that arises early in a
fiscal year if the tax benefits are expected to be either of the following:
a. Realized during the year
b. Recognizable as a deferred tax asset at the end of the year in accordance with the requirements
established in Subtopic 740-10. Paragraph 740-10-30-5(e) requires that a valuation allowance be
recognized if it is more likely than not that the tax benefit of some portion or all of a deferred tax asset
will not be realized.

30-31 The limitations described in the preceding paragraph shall be applied in determining the estimated tax
benefit of an ordinary loss for the fiscal year, used to determine the estimated annual effective tax rate and the
year-to-date tax benefit of a loss.

30-32 The reversal of existing taxable temporary differences may be a source of evidence in determining
whether a tax benefit requires limitation. A deferred tax liability related to existing taxable temporary
differences is a source of evidence for recognition of a tax benefit when all of the following conditions exist:
a. An entity anticipates an ordinary loss for the fiscal year or has a year-to-date ordinary loss in excess of
the anticipated ordinary loss for the fiscal year.
b. The tax benefit of that loss is not expected to be realized during the year.
c. Recognition of a deferred tax asset for that loss at the end of the fiscal year is expected to depend on
taxable income from the reversal of existing taxable temporary differences (that is, a higher deferred tax
asset valuation allowance would be necessary absent the existing taxable temporary differences).
The requirement to consider the reversal of existing taxable temporary differences is illustrated in Example 2,
Case D (see paragraph 740-270-55-21).

30-33 If the tax benefit relates to an estimated ordinary loss for the fiscal year, it shall be considered in
determining the estimated annual effective tax rate described in paragraphs 740-270-30-6 through 30-8. If the
tax benefit relates to a year-to-date ordinary loss, it shall be considered in computing the maximum tax benefit
that shall be recognized for the year to date.

30-34 See Example 2, Cases A1; B, C1; and C2 (paragraphs 740-270-55-15; 740-270-55-17; and 740-270-55-19
through 55-20) for illustrations of computations involving operating losses, and Example 1, Cases B2 and B3
(see paragraphs 740-270-55-7 through 55-8), and Example 2, Case A2 (see paragraph 740-270-55-16) for
illustrations of special year-to-date limitation computations.

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ASC 740-270 (continued)

Pending Content (Transition Guidance: ASC 740-10-65-8)

30-34 See Example 2, Cases A1 and A2; B; and C1 and C2 (paragraphs 740-270-55-15 through 55-17 and
740-270-55-19 through 55-20) for illustrations of computations involving operating losses, and Example
1, Cases B2 and B3 (see paragraphs 740-270-55-7 through 55-8) for illustrations of special year-to-date
limitation computations.

Multiple Tax Jurisdictions

30-35 This guidance addresses possible changes to the general interim period income tax expense
methodology when an entity is subject to tax in multiple jurisdictions.

30-36 If an entity that is subject to tax in multiple jurisdictions pays taxes based on identified income in one or
more individual jurisdictions, interim period tax (or benefit) related to consolidated ordinary income (or loss)
for the year to date shall be computed in accordance with the requirements of this Subtopic using one overall
estimated annual effective tax rate with the following exceptions:
a. If in a separate jurisdiction an entity anticipates an ordinary loss for the fiscal year or has an ordinary
loss for the year to date for which, in accordance with paragraphs 740-270-30-30 through 30-33, no
tax benefit can be recognized, the entity shall exclude ordinary income (or loss) in that jurisdiction and
the related tax (or benefit) from the overall computations of the estimated annual effective tax rate
and interim period tax (or benefit). A separate estimated annual effective tax rate shall be computed
for that jurisdiction and applied to ordinary income (or loss) in that jurisdiction in accordance with the
methodology otherwise required by this Subtopic.
b. If an entity is unable to estimate an annual effective tax rate in a foreign jurisdiction in dollars or is
otherwise unable to make a reliable estimate of its ordinary income (or loss) or of the related tax (or
benefit) for the fiscal year in a jurisdiction, the entity shall exclude ordinary income (or loss) in that
jurisdiction and the related tax (or benefit) from the overall computations of the estimated annual
effective tax rate and interim period tax (or benefit). The tax (or benefit) related to ordinary income (or
loss) in that jurisdiction shall be recognized in the interim period in which the ordinary income (or loss) is
reported. The tax (or benefit) related to ordinary income (or loss) in a jurisdiction may not be limited to
tax (or benefit) in that jurisdiction. It might also include tax (or benefit) in another jurisdiction that results
from providing taxes on unremitted earnings, foreign tax credits, and so forth.
See Example 5, Cases A; B; and C (paragraphs 740-270-55-39 through 55-43) for illustrations of accounting for
income taxes applicable to ordinary income if an entity is subject to tax in multiple jurisdictions.

Accounting for Income Taxes Applicable to the Cumulative Effect of a Change in Accounting
Principle
30-37 Topic 250 establishes the accounting requirements related to recording the effect of a change in
accounting principle. The guidance in this Subtopic addresses issues related to the measurement of the tax
effect in interim periods associated with those changes.

30-38 The tax (or benefit) applicable to the cumulative effect of the change on retained earnings at the
beginning of the fiscal year shall be computed the same as for the annual financial statements.

30-39 When an entity makes an accounting change in other than the first interim period of the entity’s fiscal
year, paragraph 250-10-45-14, requires that financial information for the prechange interim periods of the
fiscal year shall be reported by retrospectively applying the newly adopted accounting principle to those
prechange interim periods. The tax (or benefit) applicable to those prechange interim periods shall be
recomputed. The revised tax (or benefit) shall reflect the year-to-date amounts and annual estimates originally
used for the prechange interim periods, modified only for the effect of the change in accounting principle on
those year-to-date and estimated annual amounts.

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ASC 740-270 (continued)

Subsequent Measurement
35-1 This guidance addresses the accounting for interim period income tax expense (or benefit) in periods
subsequent to an entity’s first interim period within a fiscal year. See Section 740-270-30 for a description of
and requirements related to the determination of the estimated annual effective tax rate.

35-2 The estimated annual effective tax rate is described in paragraphs 740-270-30-6 through 30-8. As
indicated in paragraph 740-270-30-18, estimates of the annual effective tax rate at the end of interim periods
are, of necessity, based on evaluations of possible future events and transactions and may be subject to
subsequent refinement or revision. If a reliable estimate cannot be made, the actual effective tax rate for the
year to date may be the best estimate of the annual effective tax rate.

35-3 As indicated in paragraph 740-270-30-6, at the end of each successive interim period the entity shall
make its best estimate of the effective tax rate expected to be applicable for the full fiscal year. As indicated in
paragraph 740-270-30-8, the rate so determined shall be used in providing for income taxes on a current year-
to-date basis. The rate shall be revised, if necessary, as of the end of each successive interim period during the
fiscal year to the entity’s best current estimate of its annual effective tax rate.

35-4 As indicated in paragraph 740-270-30-5, the estimated annual effective tax rate shall be applied to the
year-to-date ordinary income (or loss) at the end of each interim period to compute the year-to-date tax (or
benefit) applicable to ordinary income (or loss). The interim period tax (or benefit) related to ordinary income
(or loss) shall be the difference between the amount so computed and the amounts reported for previous
interim periods of the fiscal year.

35-5 One result of the year-to-date computation is that, if the tax benefit of an ordinary loss that occurs in the
early portions of the fiscal year is not recognized because it is more likely than not that the tax benefit will not
be realized, tax is not provided for subsequent ordinary income until the unrecognized tax benefit of the earlier
ordinary loss is offset (see paragraphs 740-270-25-9 through 25-11). As indicated in paragraph 740-270-30-31,
the limitations described in paragraph 740-270-25-9 shall be applied in determining the estimated tax benefit
of an ordinary loss for the fiscal year, used to determine the estimated annual effective tax rate, and the year-
to-date tax benefit of a loss. As indicated in paragraph 740-270-30-33, if the tax benefit relates to an estimated
ordinary loss for the fiscal year, it shall be considered in determining the estimated annual effective tax rate
described in paragraphs 740-270-30-6 through 30-8. If the tax benefit relates to a year-to-date ordinary loss, it
shall be considered in computing the maximum tax benefit that shall be recognized for the year to date.

35-6 A change in judgment that results in subsequent recognition, derecognition, or change in measurement
of a tax position taken in a prior interim period within the same fiscal year is an integral part of an annual
period and, consequently, shall be reflected as such under the requirements of this Subtopic. This requirement
differs from the requirement in paragraph 740-10-25-15 applicable to a change in judgment that results in
subsequent recognition, derecognition, or a change in measurement of a tax position taken in a prior annual
period, which requires that the change (including any related interest and penalties) be recognized as a
discrete item in the period in which the change occurs.

35-7 See Example 1, Case C (paragraph 740-270-55-9) for an illustration of how changes in estimates impact
quarterly income tax computations.

Related Implementation Guidance and Illustrations

• Example 1: Accounting for Income Taxes Applicable to Ordinary Income (or Loss) at an Interim Date
if Ordinary Income Is Anticipated for the Fiscal Year [ASC 740-270-55-2].
• Example 2: Accounting for Income Taxes Applicable to Ordinary Income (or Loss) at an Interim Date
if an Ordinary Loss Is Anticipated for the Fiscal Year [ASC 740-270-55-11].
• Example 5: Accounting for Income Taxes Applicable to Ordinary Income if an Entity Is Subject to Tax
in Multiple Jurisdictions [ASC 740-270-55-37].
• Example 6: Effect of New Tax Legislation [ASC 740-270-55-44].

740-20-45 (Q&A 30)

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ASC 740-270-25-2 states:

The tax (or benefit) related to ordinary income (or loss) shall be computed at an estimated annual effective tax
rate and the tax (or benefit) related to all other items shall be individually computed and recognized when
the items occur. [Emphasis added]

The ASC master glossary defines ordinary income (or loss) as follows:
Ordinary income (or loss) refers to income (or loss) from continuing operations before income taxes (or
benefits) excluding significant unusual or infrequently occurring items. Discontinued operations and cumulative
effects of changes in accounting principles are also excluded from this term. The term is not used in the income
tax context of ordinary income versus capital gain. The meaning of unusual or infrequently occurring items is
consistent with their use in the definitions of the terms unusual nature and infrequency of occurrence.[1]

Ordinary income does not include items of comprehensive income outside of continuing operations
(discontinued operations and OCI). Therefore, the tax effects of such items are excluded from the AETR.
Other tax effects of items reported in equity are also excluded from the AETR.

Certain items or events related to continuing operations are specifically excluded from the estimated
AETR, and their related tax effects are recognized discretely (i.e., numerator excludes tax effect and
denominator excludes any pretax book income or loss), including:

• Significant unusual or infrequent items (ASC 740-270-30-8).

• Components of pretax income that are not estimable (ASC 740-270-30-17).
• Exclusion of a jurisdiction from the AETR (ASC 740-270-30-36(a) and (b)).
• Excess tax benefits and tax deficiencies from share-based payment awards (ASC 740-270-30-4).
• Tax-exempt interest.
• Interest expense when interest is classified as income tax expense.
7.2.1 Significant Unusual or Infrequent Items
740-270-25 (Q&A 09)
In accordance with ASC 740-270-30-8, significant unusual or infrequently occurring items that are
separately reported are specifically excluded from the definition of ordinary income and are therefore
excluded from the AETR. To qualify for exclusion from the AETR, the item must be:

• Significant.
• Unusual or infrequently occurring:
o Unusual nature — “The underlying event or transaction should possess a high degree of
abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary
and typical activities of the entity, taking into account the environment in which the entity
operates” (ASC master glossary).
o Infrequency of occurrence — “The underlying event or transaction should be of a type that
would not reasonably be expected to recur in the foreseeable future, taking into account the
environment in which the entity operates” (ASC master glossary).

• Separately reported.
An entity records the tax effects of significant unusual or infrequently occurring items in the period
in which the items occur and excludes those tax effects from the calculation of the estimated AETR.
Example 7-2 below illustrates an interim tax provision that includes a significant unusual or infrequently
occurring item.

1
Although use of the term “unusual or infrequently occurring items” is consistent with the accounting definition of extraordinary items in ASC 225, it
is related to items that are not classified as a separate component of the financial statement, as prescribed in that Codification topic.

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Example 7-2

Assume the following:

• The entity computes its AETR for each quarter of 20X1 on the basis of estimated results expected for the
full fiscal year ending December 31, 20X1.
• The statutory tax rate and AETR in 20X1 is 25 percent.
• In the third quarter, a significant unusual or infrequent loss was realized in the amount of $15,000, and
only $10,000 of the loss is deductible for tax purposes.

Ordinary Income Income Tax — Ordinary Income

Reporting Previously Reporting

Quarter Period YTD AETR YTD Reported Period
First $ 10,000 $ 10,000 25% $ 2,500 $ 2,500
Second 20,000 30,000 25% 7,500 $ 2,500 5,000
Third 15,000 45,000 25% 11,250 7,500 3,750
Fourth 35,000 80,000 25% 20,000 11,250 8,750
Annual $ 80,000 $ 20,000

Significant Unusual or Income Tax — Significant Unusual or

Infrequent Loss Infrequent Loss

Reporting Tax Previously Reporting

Quarter Period YTD Rate YTD Reported Period
First
Second
Third $ (15,000) $ (15,000) 25% $ (2,500)* $ (2,500)
Fourth — (15,000) (2,500) —
Annual $ (15,000) $ (2,500)
* The $2,500 tax benefit relates to the tax effect of the $10,000 deductible loss. The remaining $5,000 is not tax
deductible as stated in the facts of this example.

Total Income Total Income Tax

Reporting Previously Reporting

Quarter Period YTD YTD Reported Period
First $ 10,000 $ 10,000 $ 2,500 $ 2,500
Second 20,000 30,000 7,500 $ 2,500 5,000
Third — 30,000 8,750 7,500 1,250
Fourth 35,000 65,000 17,500 8,750 8,750
Annual $ 65,000 $ 17,500

The AETR estimate of 25 percent applied to ordinary income is not affected by the significant unusual or
infrequent item. See ASC 740-270-55-24 through 55-36 for other examples.

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7.2.2 Components of Pretax Income That Are Not Estimable

740-270-25 (Q&A 08)
Generally, an entity can reliably estimate ordinary income (or loss); however, there may be instances
in which the entity is unable to estimate part of its ordinary income (or loss). In situations in which an
entity is unable to estimate a portion of its ordinary income (or loss), the guidance in ASC 740-270-25-3
applies:

If an entity is unable to estimate a part of its ordinary income (or loss) or the related tax (or benefit) but is
otherwise able to make a reliable estimate, the tax (or benefit) applicable to the item that cannot be estimated
shall be reported in the interim period in which the item is reported.

Accordingly, the pretax amount of ordinary income (or loss) that cannot be reliably estimated and the
related tax effects should be excluded from the entity’s estimate of its AETR in all periods, and the tax
effects of the item that cannot be estimated should be recorded discretely in the interim period in which
that item is reported.

Examples of such items may include (but are not limited to) impairment losses and foreign exchange
gains or losses that would not already be excluded from the entity’s estimate of its AETR (e.g., because
they are significant unusual or infrequently occurring items).

7.2.3 Exclusion of a Jurisdiction From the AETR

740-270-30 (Q&A 01)
ASC 740-270-30-36 states that for entities subject to tax in multiple jurisdictions, the “interim period tax
(or benefit) related to consolidated ordinary income (or loss) for the year to date shall be computed . . .
using one overall estimated annual effective tax rate.” However, ASC 740-270-30-36 contains exceptions
to this general guidance, which can lead to the exclusion of a jurisdiction from the AETR.

7.2.3.1 Loss Jurisdiction for Which No Tax Benefit Can Be Recognized

740-270-30 (Q&A 01)
ASC 740-270-30-36(a) states:

If in a separate jurisdiction an entity anticipates an ordinary loss for the fiscal year or has an ordinary loss for
the year to date for which, in accordance with paragraphs 740-270-30-30 through 30-33, no tax benefit can be
recognized, the entity shall exclude ordinary income (or loss) in that jurisdiction and the related tax (or benefit)
from the overall computations of the estimated annual effective tax rate and interim period tax (or benefit).
A separate estimated annual effective tax rate shall be computed for that jurisdiction and applied to ordinary
income (or loss) in that jurisdiction in accordance with the methodology otherwise required by this Subtopic.

An entity must use judgment in determining whether a tax benefit can be recognized. ASC 740-270-
30-30 states that “a tax benefit shall be recognized for a loss that arises early in a fiscal year if the tax
benefits are expected to be either” (1) “[r]ealized during the year” or (2) “[r]ecognizable as a deferred tax
asset at the end of the year in accordance with the requirements established in Subtopic 740-10.” See
ASC 740-270-30-32 and Example 2, Case D, in ASC 740-270-55-21 for guidance on situations in which,
as ASC 740-270-30-32 states, the “reversal of existing taxable temporary differences may be a source of
evidence in determining whether a tax benefit requires limitation.”

The examples below illustrate the guidance in ASC 740-270-30-36(a) with respect to an entity subject to
tax in multiple jurisdictions, one of which anticipates an ordinary loss for the year. In Example 7-3, no
amount of tax benefit can be recognized for the forecasted loss; in Example 7-4, however, a tax benefit
can be recognized for a portion of the forecasted loss.

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Example 7-3

Assume the following:

• An entity operates through separate corporate entities in three countries: A, B, and C.

• The entity has no unusual or infrequently occurring items during the fiscal year and anticipates no tax
credits or events that do not have tax consequences.
• The full year’s forecasted pretax income (loss) and anticipated tax expense (benefit) for the three
countries are shown below.
• The entity can reliably estimate its ordinary income (loss) and tax (in dollars) in the three countries for
the fiscal year.
• An ordinary loss is anticipated for the current year in Country C. Under ASC 740-270-30-30 through 30-33,
no tax benefit can be recognized for this loss. Accordingly, in accordance with ASC 740-270-30-36(a), the
corporate entity in Country C is excluded from the computation of the overall AETR.
Computation of the overall estimated AETR is as follows:

Combined —
Excluding
Country A Country B Country C Total Country C
Forecasted income (loss) for the year 80,000 40,000 (20,000) 100,000 120,000
Anticipated tax expense (benefit) for the
year 32,000 8,000 — 40,000 40,000
AETR 33%

Quarterly tax computations are as follows:

Ordinary Income (Loss) Tax Expense (Benefit)

Combined — YTD — Less

Reporting Country Country Country Excluding Excluding Previously Reporting
Period A B C Total Country C Country C AETR YTD Reported Period
First quarter 20,000 10,000 (15,000) 15,000 30,000 30,000 33% 10,000 10,000
Second quarter 20,000 10,000 5,000 35,000 30,000 60,000 33% 20,000 10,000 10,000
Third quarter 20,000 10,000 (10,000) 20,000 30,000 90,000 33% 30,000 20,000 10,000
Fourth quarter 20,000 10,000 — 30,000 30,000 120,000 33% 40,000 30,000 10,000
Fiscal year 80,000 40,000 (20,000) 100,000 120,000 40,000

This example is consistent with Example 5, Case B, in ASC 740-270-55-41.

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If an entity is able to recognize any benefit (even a relatively small one) attributable to the anticipated
ordinary loss in a separate jurisdiction, the entity cannot exclude ordinary income (or loss) in that
jurisdiction and the related tax expense from the overall computation of the estimated AETR. When
recognizing a tax benefit for any of the anticipated ordinary loss for the fiscal year or the ordinary loss
for the YTD, an entity must include the ordinary loss in the separate jurisdiction and the related tax in
the computations of the estimated AETR and interim-period tax (or benefit). When determining whether
any tax benefit can be recognized for an ordinary loss in a separate jurisdiction, an entity must consider
local tax laws and whether a tax benefit can be recognized for the ordinary loss (e.g., whether the entity
can use the losses in a consolidated tax return, can employ income/loss sharing or group relief with
other entities in the same jurisdiction, can carry back current-year losses to offset prior-year income, or
can recognize a benefit in a different jurisdiction attributable to the loss jurisdiction).

Example 7-4

Assume the same facts as in Example 7-3 except that the entity will be able to recognize a small tax benefit
of $1,000 related to the ordinary loss in Country C as a result of a carryback claim. Because the entity can
recognize some benefit related to the current-year loss, the income (loss) in Country C should not be removed
from the computation of the overall AETR.

Computation of the overall estimated AETR is as follows:

Country A Country B Country C Total

Forecasted income (loss) for the year 80,000 40,000 (20,000) 100,000
Anticipated tax expense (benefit) for the year 32,000 8,000 (1,000) 39,000
AETR 39%

Quarterly tax computations are as follows:

Ordinary Income (Loss) Tax Expense (Benefit)

Less
Reporting Country Country Country Previously Reporting
Period A B C Total YTD AETR YTD Reported Period
First quarter 20,000 10,000 (15,000) 15,000 15,000 39% 5,850 5,850
Second quarter 20,000 10,000 5,000 35,000 50,000 39% 19,500 5,850 13,650
Third quarter 20,000 10,000 (10,000) 20,000 70,000 39% 27,300 19,500 7,800
Fourth quarter 20,000 10,000 — 30,000 100,000 39% 39,000 27,300 11,700
Fiscal year 80,000 40,000 (20,000) 100,000 39,000

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7.2.3.1.1 Foreign Losses Providing a Tax Benefit by Reducing a GILTI Inclusion

Questions arise about whether an entity should exclude ordinary losses in foreign subsidiaries from the
estimation of its AETR under ASC 740-270-30-36(a) if the entity concludes that it is not more likely than
not that the entity will realize the tax benefits of losses in those foreign jurisdictions, but those losses will
provide tax benefits for U.S. tax purposes by reducing the entity’s GILTI inclusion.

We believe that there are two acceptable views.

Under one view, both the loss from the foreign subsidiary and the corresponding U.S. tax benefit
related to the reduction in the GILTI inclusion would be contemplated in the estimation of the AETR. ASC
740-270-30-36(b) states, in part:

The tax (or benefit) related to ordinary income (or loss) in a jurisdiction may not be limited to tax (or benefit) in
that jurisdiction. It might also include tax (or benefit) in another jurisdiction that results from providing taxes on
unremitted earnings, foreign tax credits, and so forth.

Accordingly, because there is a benefit in the U.S. jurisdiction, ordinary losses and the related U.S.
benefit derived by reduced GILTI inclusion would be included in the overall AETR.

Under the alternative view, however, the U.S. tax benefit related to the reduction in GILTI inclusion would
be included in the estimation of the AETR, but the ordinary loss from the foreign subsidiary would not.
ASC 740-270-30-36(a) states:

If in a separate jurisdiction an entity anticipates an ordinary loss for the fiscal year or has an ordinary loss for
the year to date for which, in accordance with paragraphs 740-270-30-30 through 30-33, no tax benefit can be
recognized, the entity shall exclude ordinary income (or loss) in that jurisdiction and the related tax (or benefit)
from the overall computations of the estimated annual effective tax rate and interim period tax (or benefit).
A separate estimated annual effective tax rate shall be computed for that jurisdiction and applied to ordinary
income (or loss) in that jurisdiction in accordance with the methodology otherwise required by this Subtopic
[ASC 740-270].

Under this second view, because the guidance in ASC 740-270-30-36 appears to suggest application
on a jurisdiction-by-jurisdiction basis, the ordinary loss from the loss jurisdiction and the related tax (or
benefit) in that separate jurisdiction would be excluded. However, the U.S. tax benefit related to the
reduction in GILTI inclusion would be included in the estimation of the AETR unless the U.S. jurisdiction
is also a loss jurisdiction.

7.2.3.1.2 Zero-Tax-Rate Jurisdictions and Nontaxable Entities

740-270-30 (Q&A 02)
ASC 740 does not provide explicit guidance on how to adjust a parent entity’s consolidated estimated
AETR (if at all) when a portion of its business is conducted by entities that either are operating in a zero-
tax-rate jurisdiction or are nontaxable.

The exception in ASC 740-270-30-36(a) should not be extended to exclude nontaxable entities or
entities that are operating in a zero-tax-rate jurisdiction from the overall computation of the AETR. We
do not believe that the exception in ASC 740-270-30-36(a) (discussed in Section 7.2.3.1) is applicable
in such circumstances because this paragraph contains a cross-reference to the discussion on
realizability of a benefit for current-year losses in ASC 740-270-30-30 through 30-33 and does not focus
on nontaxable entities or entities operating in a zero-tax-rate jurisdiction for which no benefit would
inherently be recorded. Accordingly, such entities should generally be reflected in the computation of an
entity’s AETR regardless of whether they have a profit or loss for the year.

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Example 7-5

Entity P is a nontaxable flow-through entity that has a wholly owned subsidiary, S, a taxable C corporation that
operates in a jurisdiction in which the tax rate is 25 percent. Estimated annual pretax income for P and S is
$900 and $100, respectively. Estimated annual consolidated pretax income and tax expense are $1,000 and
$25, respectively, resulting in an estimated AETR of 2.5 percent. The YTD pretax income of P and S is $370 and
$30, respectively. The YTD interim tax expense is $10 ($400 YTD consolidated pretax income multiplied by 2.5
percent).

Example 7-6

Entity P operates in a jurisdiction in which the tax rate is 25 percent and has a wholly owned subsidiary, S, that
operates in a jurisdiction in which the tax rate is 0 percent. Estimated annual pretax income (loss) for P and S
is $1,100 and ($100), respectively. Estimated annual consolidated pretax income and tax expense are $1,000
and $275, respectively, resulting in an annual estimated AETR of 27.5 percent. The YTD pretax income (loss)
for P and S is $430 and ($30), respectively. The YTD interim tax expense is $110 ($400 YTD consolidated pretax
income multiplied by 27.5 percent).

7.2.3.2 Inability to Estimate AETR in Dollars or Unreliable Estimate of Ordinary

Income (or Loss) or Related Tax Expense (or Benefit)
ASC 740-270-30-36(b) states:

If an entity is unable to estimate an annual effective tax rate in a foreign jurisdiction in dollars or is otherwise
unable to make a reliable estimate of its ordinary income (or loss) or of the related tax (or benefit) for the fiscal
year in a jurisdiction, the entity shall exclude ordinary income (or loss) in that jurisdiction and the related tax
(or benefit) from the overall computations of the estimated annual effective tax rate and interim period tax (or
benefit). The tax (or benefit) related to ordinary income (or loss) in that jurisdiction shall be recognized in the
interim period in which the ordinary income (or loss) is reported. The tax (or benefit) related to ordinary income
(or loss) in a jurisdiction may not be limited to tax (or benefit) in that jurisdiction. It might also include tax (or
benefit) in another jurisdiction that results from providing taxes on unremitted earnings, foreign tax credits, and
so forth.

ASC 740-270-30-36(b) provides additional exceptions to the general rule that the interim period tax
(or benefit) related to consolidated ordinary income (or loss) for the YTD should be computed by using
one overall estimated AETR. It indicates that if an entity is (1) unable to estimate an AETR in a foreign
jurisdiction in dollars or (2) unable to make a reliable estimate of (a) its ordinary income (or loss) or (b)
the related tax (or benefit) for the fiscal year, the entity should exclude that jurisdiction from the overall
AETR.

An entity may not be able to reliably estimate an AETR in a foreign jurisdiction in dollars2 if the relevant
foreign exchange rate is highly volatile. The determination of what constitutes a “reliable estimate” is a
matter of judgment.

2
Although the standard refers to “dollars,” we believe that this concept would apply to any reporting entity that has difficulty estimating an AETR in a
foreign jurisdiction in its reporting currency.

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7.2.4 Excess Tax Benefits and Deficiencies Related to Share-Based Payment

Awards
718-740-35 (Q&A 13)
When a share-based payment award is granted to an employee, the fair value of the award is generally
recognized over the vesting period, and a corresponding DTA is recognized to the extent that the award
is tax deductible. The tax deduction is generally based on the intrinsic value at the time of exercise
(for an option) or on the fair value upon vesting of the award (for restricted stock), and it can be either
greater (excess tax benefit) or less (tax deficiency) than the compensation cost recognized in the
financial statements.

ASC 740-270-30-4, ASC 740-270-30-8, and ASC 740-270-30-12 require entities to account for excess
tax benefits and tax deficiencies as discrete items in the period in which they occur (i.e., entities should
exclude them from the AETR). Therefore, the effects of expected future excesses and deficiencies should
not be anticipated. The tax effects of the expected compensation expense should be included in the AETR.

Example 7-7

If, in the first quarter, an exercise of stock options results in a tax deficiency, but it is anticipated that in the
second quarter a large excess tax benefit will result, an entity should still record an income tax expense related
to the tax deficiency in the first quarter. In the second quarter, if an excess tax benefit does result, the income
tax expense recorded in the first quarter resulting from the deficiency can be reversed as income tax benefit.

7.2.4.1 Interim Tax Effects of Awards Expected to Expire Unexercised During

the Year
718-740-35 (Q&A 13)
When estimating the AETR for the current interim period, an entity should not include the estimated
effects of the expiration of awards expected to occur in a future interim period. For example, if share-
based payment awards are expected to expire unexercised in the second quarter because they are
“deep out of the money,” the entity should not consider the anticipated income tax expense as a result
of the write-off of the related DTAs when estimating the AETR to compute the tax provision for the first
quarter. Instead, the entity should record the income tax expense related to the write-off of the DTA
upon expiration of an award in the period in which the awards expire unexercised. See Chapter 10
for general guidance on the accounting for income taxes associated with share-based payments and
Section 10.2.4.2 for guidance related to the accounting for awards that expire unexercised.

7.2.4.2 Measuring the Excess Tax Benefit or Tax Deficiency Associated With

Share-Based Compensation: Tax Credits and Other Items That Affect the ETR
718-740-35 (Q&A 07)
Entities may receive tax credits or deductions for qualifying expenditures, which often include employee
share-based compensation costs (e.g., the research and experimentation credit and the FDII deduction)
that lower the entity’s ETR and can affect the determination of the excess tax benefit or tax deficiency
that must be (1) accounted for under ASC 718-740-35-2 and (2) treated as a discrete item in the period
in which the excess tax benefit or tax deficiency occurs. Accordingly, the excess tax benefit or deficiency
of a share-based compensation deduction may differ from the amount computed on the basis of the
applicable jurisdiction’s statutory tax rate multiplied by the excess or deficiency of the tax compensation
deduction over an award’s corresponding compensation costs recognized for financial reporting
purposes (e.g., “direct tax effects”).

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Under U.S. GAAP, there are several acceptable approaches to determining the excess tax benefits or
deficiencies that must be accounted for discretely under ASC 718-740-35-2. One acceptable approach is
to consider only the direct tax effects of the share-based compensation deduction. Under this approach,
an entity would multiply its applicable income tax rate, as described in ASC 740-10-30-8, by the amount
of cumulative share-based compensation cost and the deduction reported on a tax return to determine
the amount of the DTA and the actual tax benefit, respectively. The income tax rate for each award
should be computed on the basis of the rates applicable in each tax jurisdiction, as appropriate.

Under this approach, the indirect effects of the deduction are not considered. The actual tax benefit
is computed by multiplying the tax deduction by the applicable income tax rate in effect in the period
in which the award is settled, which, in the absence of a change in enacted tax rate or tax law, would
generally equal the rate used when the associated DTA was recognized (e.g., the jurisdiction’s statutory
tax rate).

A second acceptable approach would be to perform a full ASC 740 “with-and-without” computation.
Under this approach, the entire incremental tax effect of the actual tax deduction would be compared
with the entire incremental tax effect of the cumulative amount of compensation cost recognized for
book purposes as if it were the actual tax deduction. The difference would be the amount of excess tax
benefit or tax deficiency.

A third acceptable alternative would be to compare the entire incremental tax effect of the actual tax
deduction with the DTA recognized to determine the excess tax benefit or tax deficiency.

Use of one of the approaches described above to measure the excess tax benefit or tax deficiency
constitutes an accounting policy that should be applied consistently to all awards and related tax effects.

7.2.5 Tax-Exempt Interest
740-270-25 (Q&A 10)
It is acceptable for an entity to either include or exclude tax-exempt interest income when computing its
estimated AETR. However, if tax-exempt interest income is included in ordinary income, we believe that
the resulting tax benefit (permanent difference) should be included in the calculation of the estimated
AETR. Whichever method is elected should be consistently applied.

As described in paragraph 80 of Interpretation 18, the FASB did not provide explicit guidance requiring
a specific approach and instead stated, “the accounting practice . . . for tax-exempt interest income
in interim periods appears to be uniform.” Comments received from respondents suggest that the
common practice at the time among financial institutions was to exclude tax-exempt interest income
from the estimated tax rate calculation.

7.2.6 Interest Expense When Interest Is Classified as Income Tax Expense

740-10-25 (Q&A 50)
ASC 740-10-45-25 indicates that interest recognized for the underpayment of income taxes can be
classified in the statement of operations as either income tax or interest expense, depending on the
entity’s accounting policy election.

An entity that has adopted an accounting policy to include interest expense for the underpayment of
income taxes as a component of income taxes in accordance with ASC 740-270 should not recognize
interest expense through the estimated AETR for interim reporting purposes. This is because the
interest expense relates to prior-year UTBs and is not based on taxes for current-year income and
expense amounts. This conclusion was confirmed with the SEC staff.

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7.3 Items Excluded in Part From the AETR

Certain items that may affect the AETR can also result in amounts recorded separately from the AETR,
such as certain changes in:

• Valuation allowances (ASC 740-270-30-7, ASC 740-270-30-11, and ASC 740-270-25-4).

• Tax laws and rates (ASC 740-270-25-5 and ASC 740-270-30-11).
• Changes in recognition and measurement of UTBs.
• Assertions related to outside basis difference exceptions.
These events often affect both beginning-of-the-year tax balances as well as taxes related to current-
year activities.

7.3.1 Valuation Allowances
740-270-25 (Q&A 02)
ASC 740-270-30-7 states that “[t]he tax effect of a valuation allowance expected to be necessary” at the
end of the year for a DTA originating in the current year should be included in the AETR.

A valuation allowance on beginning-of-the-year DTAs may increase or decrease during the year. ASC
740-270-30-11 states that “[t]he effects of changes in judgment about beginning-of-year valuation
allowances . . . shall be excluded from the estimated annual effective tax rate calculation.” However, ASC
740-270-25-4 indicates that “[t]he tax benefit of an operating loss carryforward from prior years shall be
included in the effective tax rate computation if the tax benefit is expected to be realized as a result of
ordinary income in the current year” (emphasis added).

Examples 7-8 through 7-10 below illustrate this concept.

Example 7-8

Valuation Allowance on Originating DTA

Assume that during the first quarter of fiscal year 20X1, Entity A, operating in a tax jurisdiction with a 50 percent
tax rate, generates a tax credit of $3,000 that, under tax law, will expire at the end of 20X2. At the end of the
first quarter of 20X1, available evidence about the future indicates that taxable income of $1,000 and $3,000
will be generated during 20X1 and 20X2, respectively. Therefore, a valuation allowance of $1,000 ($3,000 tax
credit – [$4,000 combined forecasted taxable income of 20X1 and 20X2 × 50%]) will be necessary at the end of
20X1. The estimated pretax book income for the full fiscal year is $10,000. The $9,000 difference between book
income and taxable income is attributable to tax-exempt income.

Because the valuation allowance relates to the tax attribute originating during the current year, the tax
consequences of the $1,000 valuation allowance on the credits are included in the AETR.

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Example 7-8 (continued)

The AETR and first-quarter tax expense are computed as follows:

Estimated pretax book income for 20X1 $ 10,000

Estimated tax-exempt income during 20X1 (9,000)
Estimated pretax book income subject to tax
for 20X1 $ 1,000
Statutory tax rate 50%
Estimated tax before credits $ 500
Generated credits (3,000)
Valuation allowance on credits generated in
the current year 1,000
Total estimated annual tax expense/(benefit) $ (1,500)
Estimated AETR $1,500 benefit ÷ $10,000
pretax income –15%
Income earned in first quarter of 20X1 $ 5,000
Tax expense/(benefit) for first quarter of
20X1 ($5,000 × [–15%]) $ (750)

Thus, if pretax accounting income is $5,000 during the first quarter of 20X1, a benefit for income taxes of $750
($5,000 × [–15%]) would be recognized and net income of $5,750 would be reported for that interim period.

Example 7-9

Decrease in Valuation Allowance on Beginning-of-the-Year DTAs

Assume the following:

• At the beginning of fiscal year 20X1, Entity X has a DTA of $4,000 that relates to $20,000 of NOLs that all
expire in 20X5. A full valuation allowance is recorded against the DTA because X believes, on the basis of
the weight of available evidence, that it is more likely than not that the DTA will not be realized.
• Entity X has no other DTAs or DTLs.
• Entity X’s tax rate is 20 percent.
• At the beginning of the year, X estimates that it will earn $1,000 of income before tax in each of the
quarters in 20X1.
• Income before tax for the first quarter of 20X1 totals $1,000.
• Income before tax for the second quarter of 20X1 totals $1,000.
• At the end of the second quarter, X estimates, on the basis of new evidence, that it will earn $30,000 of
taxable income in 20X2–20X4. Accordingly, X concludes that it is more likely than not that all of its DTAs
will be realized.
• The AETR is 0% ($0 projected tax expense ÷ $4,000 forecasted income).

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Example 7-9 (continued)

The following table illustrates X’s tax expense (or benefit) in each of the four quarters of 20X1:

Quarter Quarter Quarter Quarter Year

Ended Ended Ended Ended Ended
March June September December December
31, 20X1 30,20X1 30, 20X1 31, 20X1 31, 20X1
Income before income taxes $ 1,000 $ 1,000 $ 1,000* $ 1,000* $ 4,000*
Income tax expense (benefit):**
Reduction in gross DTAs as a result of
application of NOLs to reduce
current period’s taxable income*** 200 200 200 200 800
Reduction in valuation allowance as a
result of reduction in gross DTAs† (200) (200) (200) (200) (800)
Reduction in valuation allowance as a
result of changes in judgment over
the future years — (3,200) — — (3,200)
Total income tax expense — (3,200) — — (3,200)
Net income $ 1,000 $ 4,200 $ 1,000 $ 1,000 $ 7,200
* Income for the third and fourth quarters are estimates as of the end of the second quarter.
** The components of income tax expense (benefit) have been shown separately for illustrative purposes only.
*** As income is earned, X’s NOLs will be applied to reduce taxable income to zero. Accordingly, the application of NOLs to
reduce taxable income will reduce X’s gross DTAs.
† The reduction of X’s gross DTAs as a result of the application of NOLs to reduce taxable income will cause a
corresponding decrease in the valuation allowance.

Because X estimated that it will earn income of $1,000 in each quarter in the current year, $800 of valuation
allowance will be reduced through the AETR ($4,000 projected annual income × 20% tax rate) in accordance
with ASC 740-270-25-4. Also in accordance with ASC 740-270-25-4, the remaining valuation allowance of $3,200
will be reduced discretely in the second quarter because the reduction is resulting from changes in judgment
over the realizability of the DTA in future years.

Example 7-10

Increase in Valuation Allowance on Beginning-of-the-Year DTAs

Assume that Entity B operates in a tax jurisdiction with a 50 percent tax rate and is computing its ETR for fiscal
year 20X2 at the end of its first quarter. At the end of the previous year, 20X1, B recorded a DTA of $4,000 for
a tax credit carryforward generated in that year that, according to tax law, expires in 20X3, and B reduced that
DTA by a valuation allowance of $1,000 on the basis of an estimate of taxable income of $3,000 in 20X2 and
$3,000 in 20X3.

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Example 7-10 (continued)

At the end of the first quarter of 20X2, assume that B’s estimate of future taxable income expected in 20X3 is
revised from $3,000 to $2,000, and B’s estimate of taxable income expected in 20X2 continues to be $3,000.
Pretax book income and taxable income for 20X2 are expected to be the same, and no new tax credits are
expected during the year. Because the additional valuation allowance of $500 ($1,000 reduction in estimated
20X3 taxable income × 50%) relates to a change in judgment about the realizability of the related DTA in future
years, the entire effect is recognized during the first quarter of 20X2. Thus, if B had pretax accounting income
of $2,000 in the first quarter of 20X2 and its AETR for the full fiscal year is 50 percent, it would record income
tax expense of $1,500, as computed below, and net income of $500 for the first quarter of 20X2.

YTD ordinary income $ 2,000

AETR 50%
YTD tax expense on ordinary income $ 1,000
Increase in valuation allowance as a result of change in judgment
about realizability in future years 500
Total tax expense in first quarter of 20X2 $ 1,500
ETR in first quarter of 20X2 ($1,500 ÷ $2,000) 75%

7.3.1.1 Recognition of the Tax Benefit of a Loss in an Interim Period

740-270-25 (Q&A 04)
Under ASC 740-270-25-9, the “tax effects of losses that arise in the early portion of a fiscal year shall be
recognized only when the tax benefits are expected to be . . . [r]ealized” either during the current year
or “as a deferred tax asset at the end of the year.” ASC 740-270-25-10 indicates that an “established
seasonal pattern of loss in early interim periods offset by income in later interim periods” is generally
sufficient to support a conclusion that realization of the tax benefit from the early losses is more likely
than not. In addition, in accordance with ASC 740-270-30-31, limitations on the recognition of a DTA are
“applied in determining the estimated tax benefit of an ordinary loss for the fiscal year.” This benefit is
“used to determine the estimated annual effective tax rate and the year-to-date tax benefit of a loss.”
The term “ordinary loss” in this context excludes significant unusual or infrequently occurring items that
will be separately reported or reported net of their related tax effects. The tax benefit of losses incurred
in early interim periods would not be recognized in those interim periods if available evidence indicates
that the income is not expected in later interim periods.

If the tax benefits of losses that are incurred in early interim periods of a fiscal year are not recognized
in those interim periods, an entity should not provide income tax expense on income generated in later
interim periods until the tax effects of the previous losses are offset. In accordance with ASC 740-270-
30-7, the “tax effect of a valuation allowance expected to be necessary for a deferred tax asset” at the
end of a fiscal year for deductible temporary differences and carryforwards that originate during the
current fiscal year should be spread throughout the fiscal year by an adjustment to the AETR.

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7.3.1.2 YTD Pretax Loss Exceeds the Anticipated Pretax Loss for the Full Year
Under current U.S. GAAP and the interim period income tax model, an entity is generally required to
calculate its best estimate of the AETR for the full fiscal year at the end of each interim reporting period
and to use that rate to calculate income taxes on a YTD basis. ASC 740-270-30-28 provides additional
guidance for situations in which an entity incurs a loss on a YTD basis that exceeds the anticipated loss
for the year. In these situations, the income tax benefit is limited to the income tax benefit that would
exist on the basis of the YTD loss.

Changing Lanes
In December 2019, the FASB issued ASU 2019-12, which modifies ASC 740 to simplify the
accounting for income taxes (as part of the FASB’s Simplification Initiative). The ASU amends the
exception to the general guidance in ASC 740-270-30-28 described above.

Stakeholders provided mixed feedback on the usefulness of the exception and the outcomes
it yields. However, stakeholders acknowledged that application of this exception is complex
and prone to errors. The FASB decided that removing the exception in ASC 740-270-30-28
would reduce the cost and complexity of applying ASC 740. The FASB also decided that removal
of the exception would not significantly affect the information provided to users of financial
statements. In paragraph BC42 of the ASU, the Board acknowledges that removal of the
exception could result in recognition of tax benefits in an interim period that exceed the tax
benefits that would be received on the basis of the actual YTD loss. However, the FASB further
notes that the informational benefit to financial statement users of limiting the tax benefits in
the interim period would not outweigh the costs to preparers.

These amendments should be applied prospectively. For further information about ASU
2019-12, see Appendix B.

7.3.2 Changes in Tax Laws and Rates Occurring in Interim Periods

740-270-25 (Q&A 05)
Under ASC 740-270-25-5, the effects of new legislation are recognized upon enactment, which in the
U.S. federal jurisdiction is the date the president signs a tax bill into law. The tax effects of a change
in tax laws or rates on taxes currently payable or refundable for the current year are reflected in the
computation of the AETR after the effective dates prescribed in the statutes or after the new legislation
becomes administratively effective, beginning no earlier than the first interim period that includes the
enactment date of the new legislation. The effect of a change in tax laws or rates on a DTL or DTA is
recognized as a discrete item in the interim period that includes the enactment date and accordingly
is not allocated among interim periods remaining in the fiscal year by an adjustment of the AETR. If
the effective date of a change in tax law differs from the enactment date, affected DTAs or DTLs are
remeasured in the interim period that includes enactment; however, the remeasurement should
include only the effects of the change on items that are expected to reverse after the effective date.
For example, if an entity has two temporary differences that may be affected by a tax law change and
expects one to reverse before the effective date of the change and the other to reverse after the
effective date, the one that reverses after the effective date would be remeasured for the change in tax
law in the interim period of enactment.

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Changing Lanes
In December 2019, the FASB issued ASU 2019-12, which modifies ASC 740 to simplify the
accounting for income taxes (as part of the FASB’s Simplification Initiative). The ASU amends
the guidance in ASC 740-270-25-5 to address feedback from stakeholders that the guidance
on recognizing the income tax effects of an enacted change in tax law in an interim period is
unclear. More specifically, ASC 740-10 requires that the tax effect of a change in tax law or rates
on deferred tax accounts and taxes payable or refundable for prior years be recognized in the
period that includes the enactment date. ASC 740-270-25-5, however, states that the effect of
a change in tax law or rates on taxes currently payable or refundable for the current year is
recorded after the effective date and no earlier than the enactment date. Because the guidance
in ASC 740-270-25-5 appears inconsistent with that in ASC 740-10, diversity in practice has
developed.

As a result, to reduce the cost and complexity of applying ASC 740, the FASB amended ASC
740-270-25-5 to require that the effects of an enacted change in tax law be reflected in the
computation of the AETR in the first interim period that includes the enactment date of the new
legislation. In addition, the example in ASC 740-270-55-44 through 55-49 will also be amended
to reflect the change.

These amendments should be applied prospectively. For further information about ASU
2019-12, see Appendix B.

7.3.2.1 Retroactive Changes in Tax Laws

Certain changes in tax laws are applied retroactively. When provisions of a new tax law are effective
retroactively, they can affect both the current-year measure of tax expense or benefit (either current or
deferred) and the tax expense or benefit attributable to income recognized in prior annual periods that
ended after the effective date of the retroactive legislation. The effect (if any) on the prior annual period
is recognized in the interim period (and annual period) that includes the date of enactment. Such an
effect might be reflected as a change to current tax accounts, deferred tax accounts, or both. Amounts
pertaining to the prior annual accounting period must be recognized entirely in the period that includes
the enactment date and should not be reflected in the current-period AETR.

When retroactive legislation is enacted in an interim period before the fourth quarter of the annual
accounting period, the effect on the current annual accounting period is generally recognized by
updating the AETR in the period of enactment for the effect of the retrospective legislation. That updated
AETR is then applied to the YTD ordinary income through the end of the interim period that includes the
enactment date. The cumulative amount of tax expense or benefit for the current year is then adjusted
to this amount, which effectively “catches up” the prior interim periods for the change in law. The impact
on the entity’s balance sheet should be consistent with its normal policy for adjusting the balance sheet
accounts (current and deferred) on an interim basis. For further discussion, see Section 7.5.3.

In certain circumstances, an entity might not use the AETR approach to account for its interim income
tax provision (generally because the entity cannot make a reliable estimate; for more information,
see Section 7.2.2). In these situations, an entity would be required to determine the actual effect of
retrospective legislation on income tax expense (or benefit) and balance sheet income tax accounts.

An entity that has not yet issued its report for the interim or annual period that ended before enactment
cannot consider the enactment in preparing that report; however, the effect that the retroactive
legislation will have on the period being reported should still be disclosed. To determine the amount
to disclose in such circumstances, the entity generally must perform computations similar to those
described above.

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Example 7-11 below illustrates the accounting for a change in tax rate retroactive to interim periods of
the current year.

Example 7-11

Entity C, operating in a tax jurisdiction with a 35 percent tax rate, is computing its AETR for each quarter of
20X2. Entity C’s estimated annual ordinary pretax income is $8,000, which it earns in equal amounts during
each quarter of fiscal year 20X2. At the end of the previous year, C recorded a DTA of $350 for a $1,000 liability
on the financial statements that is deductible on the tax return when paid. As the payments are made, they
reduce the liability throughout the year, as shown in the following table:

Item January 1 March 31 June 30 September 30 December 31

Balance sheet liability $ (1,000) $ (950) $ (850) $ (800) $ (200)

Entity C has another temporary difference related to an accumulated hedging loss in the statement of OCI. The
following table summarizes the gain (loss) activity during each quarter of 20X2:

Item January 1 March 31 June 30 September 30 December 31

Accumulated hedging
(loss) gain $ (300) $ (600) $ (400) $ (200) $ 100

The table below illustrates C’s estimated AETR calculation for fiscal year 20X2 at the end of the first quarter. As
discussed in Section 7.2, the changes in OCI are excluded from the AETR calculation.

Estimated AETR Calculation on March 31, 20X2

Estimated annual ordinary

income $ 8,000
Temporary difference (800)
Estimated taxable income 7,200
Tax rate 35%
Current tax expense 2,520
Deferred tax expense 280
Estimated annual tax
expense $ 2,800
Estimated AETR 35%

Estimated Change in DTA on March 31, 20X2

Deductible
Temporary
Difference Tax Rate DTA
January 1, 20X2 $ 1,000 35% $ 350
December 31, 20X2 200 35% 70

Change = deferred tax expense $ 280

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Example 7-11 (continued)

At the end of May, legislation was enacted that increased the tax rate for 20X2 and years thereafter to 40
percent. The effect of the change in the tax rate related to the DTA is recognized on the enactment date as a
discrete item, and the effect of the change on taxes currently payable is recognized by adjusting the AETR in the
interim period of the change.

On the enactment date, the balance sheet liability was $900 and the cumulative loss in OCI was $500. The
following table illustrates the calculation of the deferred tax expense that is recorded as a discrete amount and
the amount that is recognized through the AETR:

Estimated Change in DTA on June 30, 20X2

Deductible
Temporary
Difference Tax Rate DTA
January 1, 20X2 $ 1,000 35% $ 350
December 31, 20X2 200 40% 80
Change = deferred tax expense $ 270
Less: discrete tax benefit ($900 liability
× 5% rate increase) (45)

Deferred tax expense included in AETR $ 315

Estimated AETR Calculation

Estimated annual ordinary income $ 8,000

Temporary difference (800)
Estimated taxable income 7,200
Tax rate 40%
Current tax expense 2,880
Deferred tax expense 315*
Estimated annual tax expense $ 3,195
Estimated AETR 39.9%
* Computed in table above.

Because of the enacted tax rate increase, the DTA related to the cumulative $500 loss in OCI for hedging
activity on the enactment date must also be adjusted. The $25 tax benefit ($500 cumulative loss × 5% change
in tax rate) related to the adjustment to the DTA for the tax rate increase is a discrete item that is part of
continuing operations and therefore affects the tax expense in the quarter of enactment.

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Example 7-11 (continued)

The following table summarizes the quarterly income tax on the basis of the above calculations:

Quarterly ETR Calculation

Q1 Q2 Q3 Q4

YTD ordinary income $ 2,000 $ 4,000 $ 6,000 $ 8,000

AETR 35.0% 39.9% 39.9% 39.9%

YTD income tax expense attributable

to ordinary income 700 1,598 2,396 3,195

YTD discrete income tax expense — (70)* (70) (70)

YTD total income tax expense 700 1,528 2,326 3,125

Previously recorded — 700 1,528 2,326

Interim tax expense $ 700 $ 828 $ 798 $ 799

ETR 35.0% 41.4% 39.9% 39.9%

Quarterly OCI Changes

Q1 Q2 Q3 Q4
OCI (pretax) $ (300) $ 200 $ 200 $ 300
Tax 105 (75)** (80) (120)
OCI (net) $ (195) $ 125 $ 120 $ 180

* $70 = $45 (balance sheet liability) + $25 (OCI).

** $75 = ($100 [before enactment] × 35%) + ($100 [after enactment] × 40%).

The effect of the change in tax rates should be (1) reported as a separate line item in income tax expense from
continuing operations or (2) disclosed in the footnotes. For further discussion, see Chapter 14.

7.3.2.2 Administratively Effective Date of New Legislation

ASC 740-270-55-49 indicates that “[t]he effect of the new legislation shall not be reflected [in an AETR]
until it is effective or administratively effective.” Further, ASC 740-270-55-50 states:

Legislation generally becomes effective on the date prescribed in the statutes. However, tax legislation may
prescribe changes that become effective during an entity’s fiscal year that are administratively implemented
by applying a portion of the change to the full fiscal year. For example, if the statutory tax rate applicable to
calendar-year corporations were increased from 48 to 52 percent, effective January 1, the increased statutory
rate might be administratively applied to a corporation with a fiscal year ending at June 30 in the year of the
change by applying a 50 percent rate to its taxable income for the fiscal year, rather than 48 percent for the
first 6 months and 52 percent for the last 6 months. In that case the legislation becomes effective for that entity
at the beginning of the entity’s fiscal year.

An example is the tax rate change under the 2017 Act, which reduced the corporate tax rate to 21
percent, effective January 1, 2018, for all corporations. IRC Section 15 required fiscal year-end taxpayers
to determine a blended tax rate on the basis of the applicable rates before and after the change and the
number of days in the period within the taxable year before and after the effective date of the change
in tax rate. The “blended rate” was applied to taxable income for the entire taxable year. As illustrated in
the table below, the domestic federal statutory tax rate (blended tax rate) for all non-calendar-year-end

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entities with the same fiscal year-end was the same, regardless of income (or projected income used for
interim reporting). It is assumed in the table that the entities’ fiscal year-end is March 31, 2018, and the
effective date of the new tax rate is January 1, 2018.

Days Under Tentative

Tax Rate Tax Rate Tax Ratio Tax Rate

Effective rate before enactment (April

1, 2017, to December 31, 2017) 35% 275 75.34% 26.37%

Effective rate after enactment

(January 1, 2018, to March 31, 2018) 21% 90 24.66% 5.18%

Domestic federal statutory tax rate

(blended tax rate) 365 31.55%

Given the mechanics of IRC Section 15, we believe that the change in tax rate was administratively
effective for a fiscal-year-end entity at the beginning of the entity’s fiscal year that included January 1,
2018 (in this case, April 1, 2017), and that the “blended rate” should have been reflected in the entity’s
third-quarter AETR — i.e., as of the later of the enactment date or the administratively effective date.

In addition, because ASC 740-10-25-47 requires the effect of a change in tax laws or rates to be
recognized as of the date of enactment, all corporations, regardless of their year-end, were required
to adjust their DTAs and DTLs as of December 22, 2017. Accordingly, in a manner consistent with the
guidance in ASC 740-270-55-50 and 55-51, the applicable tax rates for deferred tax balances were as
follows:

• For balances expected to reverse after the enactment date and within the fiscal year including
the effective date, the applicable rate was the “blended tax rate.”

• For balances not expected to reverse in the fiscal year including the effective date, the applicable
rate was the new statutory tax rate of 21 percent.

7.3.3 Changes in Judgment Related to UTBs

740-10-25 (Q&A 35)
An entity may change its judgment regarding (1) the validity of a tax position based on the more-likely-
than-not recognition threshold or (2) the measurement of the greatest amount of benefit that is more
likely than not to be realized in a negotiated settlement with the taxing authority.

For interim financial reporting purposes, the accounting for a change in judgment about a tax position
taken or to be taken in the current year is different from the accounting for a change in judgment about
a tax position taken in a prior fiscal year. To maintain consistency with the existing requirements of ASC
740-270 for interim reporting, ASC 270, ASC 740-10-25-15, and ASC 740-270-35-6 require the following
accounting:

• The effect of a change in judgment regarding a tax position taken in a prior fiscal year is
recorded entirely in the interim period in which the judgment changes (similarly to taxes on a
significant, unusual, or infrequently occurring item).

• The effect of a change in judgment regarding a tax position taken in a prior interim period in the
same fiscal year is allocated to the current and subsequent interim periods by inclusion in the
revised AETR.

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7.3.3.1 Changes in Judgment Regarding a Tax Position Taken in the Current Year

740-10-25 (Q&A 36)
Example 7-12 below demonstrates changes in judgment regarding a tax position taken in the current year.

Example 7-12

In the first quarter of 20X7, an entity:

• Estimates that its ordinary income for fiscal year 20X7 will be $4,000 ($1,000 per quarter). Assume a tax
rate of 25 percent.
• Enters into a transaction that is expected to permanently reduce its 20X7 taxable income by $1,000;
thus, its total tax expense for the year is expected to be $750 ([$4,000 - $1,000] × 25%). Assume that the
transaction meets the recognition threshold and that the full $250 will be recognized under ASC 740.

Estimated pretax book income for 20X7 $ 4,000

Estimated income tax expense for 20X7 (includes the $250 tax benefit) $ 750
Estimated AETR 18.8%

Accordingly, for each quarter in 20X7 (provided that earnings are ratable), ordinary income and income tax
expense are expected to be $1,000 and $188, respectively.

During the second quarter of 20X7, the entity receives new information indicating that the tax position related
to the $1,000 deduction no longer meets the more-likely-than-not recognition threshold but does meet the
minimum threshold required to avoid penalties if the position is taken on the tax return; thus, the company
intends to still take the uncertain tax position on the 20X7 tax return. Therefore, in preparing its second-
quarter financial statements, the entity updates its estimate of the AETR as follows:

Estimated pretax net income for 20X7 ($1,000 per quarter) $ 4,000
Estimated income tax expense for 20X7 (excludes the $250 benefit) $ 1,000
Estimated AETR 25%

On the basis of the new information received in the second quarter, the entity should report the following
ordinary income and income tax expense for each quarter during 20X7:

Q1 Q2 Q3 Q4

YTD ordinary income $ 1,000 $ 2,000 $ 3,000 $ 4,000

Estimated AETR 18.8% 25% 25% 25%

YTD income tax expense 188 500 750 1,000

Less previously recorded — 188 500 750

Interim tax expense $ 188 $ 312 $ 250 $ 250

ETR 18.8% 31.2% 25% 25%

The effect of the change in judgment over a tax position taken in the current fiscal year is recognized by
changing the estimated AETR to 25 percent, which does not reflect any benefit for the tax position. Of the $250
total change representing the loss of the tax benefit previously thought to be more likely than not, a $125
UTB is recognized in the second quarter and the remaining UTB of $125 is recognized in the third and fourth
quarters.

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7.3.3.2 Changes in Judgment Regarding a Tax Position Taken in the Prior Year

740-10-25 (Q&A 37)
Example 7-13 below demonstrates changes in judgment regarding a tax position taken in the prior year.

Example 7-13

In the first quarter of 20X7, an entity estimates that its AETR for the year will be 30 percent.

In the second quarter of 20X7, the entity receives new information indicating that a tax position taken in 20X6
no longer meets the more-likely-than-not recognition threshold. The benefit recognized for that tax position
in the 20X6 financial statements was $400. No similar tax positions were taken or are expected to be taken in
20X7.

Assuming that ordinary income for each of the quarters is $1,000, the entity determines income tax expense in
each of the quarters in 20X7 as follows:

Q1 Q2 Q3 Q4

YTD ordinary income $ 1,000 $ 2,000 $ 3,000 $ 4,000

Estimated AETR 30% 30% 30% 30%

YTD income tax expense attributable

to ordinary income 300 600 900 1,200

YTD discrete income tax expense — 400 400 400

YTD total income tax 300 1,000 1,300 1,600

Less previously recorded — 300 1,000 1,300

Interim tax expense $ 300 $ 700 $ 300 $ 300

ETR 30% 70% 30% 30%

The effect of the change in judgment regarding the tax position taken in 20X6 is recorded as a discrete item
in the second quarter of 20X7, the period in which the judgment changed, and does not affect the AETR to be
applied to 20X7 ordinary income.

7.3.4 Changes in an Indefinite Reinvestment Assertion

740-30-25 (Q&A 14)
An entity may change its indefinite reinvestment assertion related to an investment in a foreign
subsidiary or foreign corporate joint venture that is essentially permanent in duration. For interim
income tax reporting purposes, the DTL related to the beginning-of-the-year outside basis difference
that is expected to reverse in the foreseeable future is recorded as a discrete item in the period of the
change in assertion. However, the amounts pertaining to the current year (e.g., current-year earnings)
will be captured within the estimated AETR in accordance with ASC 740-270-35-6. For the same reasons
discussed in Section 6.2.5.1, the adjustment for the beginning-of-the-year outside basis difference is
(1) generally allocated to continuing operations and (2) calculated by using the exchange rate at the
beginning of the year.

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7.4 Intraperiod Tax Allocation in Interim Periods

ASC 740-270

45-1 Subtopic 740-20 establishes requirements to allocate total income tax expense (or benefit) of an entity for
a period to different components of comprehensive income and shareholders’ equity. That process is referred
to as intraperiod tax allocation. This Section addresses that required allocation of income tax expense (or
benefit) in interim periods.

45-2 Section 740-20-45 describes the method of applying tax allocation within a period. The tax allocation
computation shall be made using the estimated fiscal year ordinary income together with unusual items,
infrequently occurring items, and discontinued operations for the year-to-date period.

45-3 Discontinued operations that will be presented net of related tax effects in the financial statements
for the fiscal year shall be presented net of related tax effects in interim financial statements. Unusual or
infrequently occurring items that will be separately disclosed in the financial statements for the fiscal year shall
be separately disclosed as a component of pretax income from continuing operations, and the tax (or benefit)
related to those items shall be included in the tax (or benefit) related to continuing operations. See paragraphs
740-270-25-12 through 25-14 for interim period recognition guidance when an entity has a significant unusual
or infrequently occurring loss or a loss from discontinued operations. See paragraphs 740-270-45-7 through
45-8 for the application of interim period allocation requirements to recognized income tax expense (or
benefit) and discontinued operations. See Example 7 (paragraph 740-270-55-52) for an illustration of the
income statement display of these items.

45-4 Paragraph 740-20-45-3 requires that the manner of reporting the tax benefit of an operating loss
carryforward recognized in a subsequent year generally is determined by the source of the income in that year
and not by the source of the operating loss carryforward or the source of expected future income that will
result in realization of a deferred tax asset for the operating loss carryforward. The tax benefit is allocated first
to reduce tax expense from continuing operations to zero with any excess allocated to the other source(s) of
income that provides the means of realization, for example, discontinued operations, other comprehensive
income, and so forth. That requirement also pertains to reporting the tax benefit of an operating loss
carryforward in interim periods.

45-5 Paragraph 740-270-25-11 establishes the requirement that when the tax effects of losses that arise in
the early portions of a fiscal year are not recognized in that interim period, no tax provision shall be made for
income that arises in later interim periods until the tax effects of the previous interim losses are utilized.

Specific Requirements Applicable to Discontinued Operations

45-6 This guidance addresses specific requirements for the intraperiod allocation of income taxes in interim
periods when there are discontinued operations.

45-7 When an entity reports discontinued operations, the computations described in paragraphs 740-270-
25-12 through 25-14, 740-270-30-11 through 30-13, and 740-270-45-2 through 45-3 shall be the basis for the
tax (or benefit) related to the income (or loss) from operations of the discontinued operation before the date
on which the criteria in paragraph 205-20-45-1E are met.

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ASC 740-270 (continued)

45-8 Income (or loss) from operations of the discontinued operation, prior to the interim period in which the
date on which the criteria in paragraph 205-20-45-1E are met occurs, will have been included in ordinary
income (or loss) of prior periods and thus will have been included in the estimated annual effective tax rate and
tax (or benefit) calculations described in Sections 740-270-30 and 740-270-35 applicable to ordinary income.
The total tax (or benefit) provided in the prior interim periods shall not be recomputed but shall be divided
into two components, applicable to the remaining ordinary income (or loss) and to the income (or loss) from
operations of the discontinued operation as follows. A revised estimated annual effective tax rate and resulting
tax (or benefit) shall be computed, in accordance with Sections 740-270-30 and 740-270-35 applicable to
ordinary income, for the remaining ordinary income (or loss), on the basis of the estimates applicable to such
operations used in the original calculations for each prior interim period. The tax (or benefit) related to the
operations of the discontinued operation shall be the total of:
a. The difference between the tax (or benefit) originally computed for ordinary income (or loss) and the
recomputed amount for the remaining ordinary income (or loss)
b. The tax computed in accordance with paragraphs 740-270-25-12 through 25-14; 740-270-30-11
through 30-13; and 740-270-45-2 through 45-3 for any unusual or infrequently occurring items of the
discontinued operation.
See Example 4 (paragraph 740-270-55-29) for an illustration of accounting for income taxes applicable to
income (or loss) from discontinued operations at an interim date.

740-20-45 (Q&A 04)

The requirements within ASC 740-20 to allocate the total income tax expense (or benefit) of an entity
to different components of comprehensive income and shareholder’s equity are applicable to interim
periods (the “with-and-without” intraperiod allocation model; see Chapter 6). ASC 740-270-45-2 states
that “[t]he tax allocation computation shall be made using the estimated fiscal year ordinary income
together with unusual items, infrequently occurring items, and discontinued operations for the year-to-
date period.”

The intraperiod allocation of tax effects in an earlier quarter may be revised in a later quarter. For
example, a tax effect may be allocated to an item other than income from continuing operations during
the first quarter of the fiscal year. However, as a result of the occurrence of unanticipated events in a
later quarter of the same fiscal year, the allocation of the tax effect to that item could change (e.g., a
component classified as a discontinued operation might be sold in the current year, whereas the entity’s
initial expectation was that it would not be sold until the subsequent year). The change in tax effect
should be reflected as an adjustment of the original allocation. The objective should be to properly
reflect the intraperiod allocation of tax expense for the annual period. The intraperiod tax allocation
should be adjusted at each interim date, if necessary, to achieve that goal.

This approach is consistent with the example in ASC 740-270-55-28, which illustrates the accounting in
interim periods for income taxes applicable to unusual or infrequently occurring items. However, this
conclusion does not apply to the interim-period effects of changes in tax law or rates. As discussed in
ASC 740-10-45-17, the effects of changes in tax law or rates on prior interim periods should be included
in the current interim period as part of income from continuing operations.

Example 7-14

In the first and second quarters of 20X1, an entity generates tax benefits from unrealized losses on an AFS debt
security, which results in the recognition of a DTA. In accordance with ASC 740-20-45-11(b), the expense related
to the unrealized losses is recorded net of tax through OCI. On the basis of the entity’s expected future earnings,
no valuation allowance on the DTA is deemed necessary. No further tax benefits are generated in the third and
fourth quarters.

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Example 7-14 (continued)

Beginning in the third quarter and through the end of the fiscal year, unanticipated events result in continued
operating losses for the entity; by year-end, a full valuation allowance on the DTA is necessary. Although the
recognition of the benefit of the DTA in OCI was appropriate in the first and second quarters, the application of
the intraperiod allocation approach to the YTD income in the third quarter would result in there being no tax
benefit allocated to OCI, and a valuation allowance should be recognized through OCI in the fourth quarter.

For the annual period, there is no impact on the intraperiod tax allocation because the need for a valuation
allowance occurred in the same annual period in which the DTA was generated. If the valuation allowance was
not required until the subsequent year, the change in the valuation allowance would be allocated to income
from continuing operations, in accordance with ASC 740-20-45-4.

Example 7-15

In the first quarter of 20X0, an entity is evaluating whether to release a valuation allowance against an NOL DTA
on the basis of an expected gain on a sale of a discontinued operation (assume that the income from the sale
is of the appropriate character for the entity to realize the DTA and is the only source of income during the year).

When there is uncertainty about the timing of the sale, the entity should determine, by using its best estimate,
the period in which the sale will be finalized. If management expects to sell the component in the current
year, the entity should follow Approach 1 below. If management does not expect to sell the component in the
current year, the entity should follow Approach 2 below. Whichever approach is applied on the basis of an
entity’s facts and circumstances, the objective to properly reflect the intraperiod allocation of tax expense for
the annual period should be met.

• Approach 1 — Allocate the anticipated benefit to discontinued operations in the quarter and YTD period
in which income is available to offset the DTA (which would generally be the period in which the sale
occurs in this example). If management’s expectation regarding the timing of the sale of the component
changes in a subsequent interim period such that the sale is now expected to occur in the subsequent
year, any benefit previously recognized in discontinued operations during the year and any benefit not
yet recognized during a previous interim period should be recognized in continuing operations in the
quarter in which it becomes apparent, on the basis of the entity’s best estimate, that the transaction will
not occur in the current year.
• Approach 2 — Allocate the anticipated benefit to income from continuing operations in the first quarter
and, if income from discontinued operations becomes available in a subsequent quarter and YTD period
and is sufficient to offset the DTA (which would generally be the period in which the sale occurs in this
example), reclassify the benefit to income from discontinued operations.
See Section 6.2.2 for further guidance on accounting for changes in valuation allowances resulting from items
other than continuing operations.

7.4.1 Recognition of the Tax Benefit of an Operating Loss Carryforward in an

Interim Period
740-270-25 (Q&A 06)
The method of intraperiod tax allocation for annual periods also applies to reporting the tax benefit of
an operating loss carryforward in interim periods. ASC 740-20-45-3 indicates that an entity determines
the tax benefit of an operating loss carryforward recognized in a subsequent year under ASC 740 in
the same way that it determines the source of the income in that year and not in the same way that it
determines the source of (1) the operating loss carryforward or (2) the “expected future income that
will result in realization of a deferred tax asset” for the operating loss carryforward. The tax benefit is
allocated first to reduce income tax expense from continuing operations to zero with any excess benefit
allocated to other sources of income that provide a means of realization (e.g., gains from extraordinary
items and from discontinued operations).

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7.4.2 Intraperiod Tax Allocation When There Is a Loss From Continuing

Operations and Income in Discontinued Operations
740-20-45 (Q&A 30)
The tax effect of discontinued operations should be recognized in the period in which the pretax
amounts are recognized. Such amounts should be consistent with the intraperiod tax allocation (i.e., the
tax related to the discontinued operations is the incremental tax effect of those pretax amounts).

ASC 740-20-45-7 contains the following exception to the income tax accounting treatment of a loss from
continuing operations:

The tax effect of pretax income or loss from continuing operations generally should be determined by a
computation that does not consider the tax effects of items that are not included in continuing operations.
The exception to that incremental approach is that all items (for example, discontinued operations,
other comprehensive income, and so forth) be considered in determining the amount of tax benefit
that results from a loss from continuing operations and that shall be allocated to continuing
operations. That modification of the incremental approach is to be consistent with the approach in Subtopic
740-10 to consider the tax consequences of taxable income expected in future years in assessing the
realizability of deferred tax assets. Application of this modification makes it appropriate to consider a gain on
discontinued operations in the current year for purposes of allocating a tax benefit to a current-year loss from
continuing operations. [Emphasis added]

There are three acceptable alternatives related to how an entity should record an interim tax provision
containing discontinued operations (or other items recorded separately from continuing operations)
in interim periods when there is a loss from continuing operations. Each alternative is illustrated in
Example 7-16 below.

Example 7-16

Assume the following:

• Entity T has an NOL carryforward of $1 million. The DTA of $250,000 (at a 25 percent tax rate) is fully
offset by a valuation allowance (i.e., realization is not more likely than not).
• Pretax income from continuing operations for fiscal year 20X2 is estimated to be a loss of $400,000
realized evenly over each quarter.
• At the end of the first quarter, T sells a component of its operations, resulting in a pretax gain of
$300,000 in discontinued operations.
• There are no changes in T’s assertion that realization of the DTA is not more likely than not; thus, T
continues to record a valuation allowance against current-year losses, resulting in zero income tax
expense or benefit for the current period.
Because of the exception in ASC 740-20-45-7, T must allocate a tax benefit to continuing operations as a result of
the $300,000 gain in discontinued operations and loss in continuing operations. The allocation of the tax benefit
(to continuing operations) and tax expense (to the gain on discontinued operations) is calculated as follows:

Gain from discontinued operations $ 300,000

Statutory tax rate 25%
Income tax expense allocated to
discontinued operations $ 75,000
Income tax (benefit) allocated to continuing
operations $ (75,000)

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Example 7-16 (continued)

On the basis of the above computation, the estimated AETR for continuing operations is 18.8 percent,
calculated as follows:

Estimated annual tax benefit $ (75,000)

Estimated annual pretax loss $ (400,000) = 18.8%

Given the above facts, the paragraphs below illustrate the three acceptable alternatives on how an entity
should record its tax provision in interim periods when there is a loss from continuing operations. As with other
accounting policies, the method selected must be disclosed and should be applied consistently.

Alternative 1

Balance
Continuing Operations Discontinued Operations Sheet

Tax
Income/ Income/ Tax Receivable
Quarter (Loss) AETR Tax (Loss) Rate Tax (Payable)
First $ (100,000) 18.8% $ 18,750 $ 300,000 25% $ (75,000) $ (56,250)
Second (100,000) 18.8% 18,750 (37,500)
Third (100,000) 18.8% 18,750 (18,750)
Fourth (100,000) 18.8% 18,750 — — —
$ (400,000) $ 75,000 $ 300,000 $ (75,000) $ —

In this alternative, T would apply the concepts of the AETR during each period for continuing operations
and would recognize discontinued operations as a discrete item in the period in which it occurs. However,
ASC 740-20-45-7 requires an equal amount of continuing operations tax benefit and “other component”
tax expense (i.e., financial statement component neutral). While the above approach complies with the
requirements of an AETR for continuing operations and a discrete item for other components by year-end,
the resulting effect does not maintain the financial statement component neutrality (i.e., equal amounts of tax
expense and benefit that are not related to changes in the tax balance sheet accounts).

Alternative 2

Discontinued Balance
Continuing Operations Operations Sheet

Tax
Income/ Income/ Receivable
Quarter (Loss) AETR Tax (Loss) Tax (Payable)
First $ (100,000) $ 75,000 $ 300,000 $ (75,000) $ —
Second (100,000) —
Third (100,000) —
Fourth (100,000) —
$ (400,000) $ 75,000 $ 300,000 $ (75,000) $ —

This alternative maintains the financial statement component neutrality of ASC 740-20-45-7. It also meets the
requirement to recognize the tax effect of other components on a discrete basis that is consistent with what
the intraperiod tax allocation amount will be for the full year. However, these requirements are met only if the
entity does not comply with the requirement to use an AETR for continuing operations.

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Example 7-16 (continued)

Alternative 3

Discontinued Balance
Continuing Operations Operations Sheet

Tax
Income/ Income/ Receivable
Quarter (Loss) AETR Tax (Loss) Tax (Payable)
First $ (100,000) 18.8% $ 18,750 $ 300,000 $ (18,750) $ —
Second (100,000) 18.8% 18,750 (18,750) —
Third (100,000) 18.8% 18,750 (18,750) —
Fourth (100,000) 18.8% 18,750 (18,750) —
$ (400,000) $ 75,000 $ 300,000 $ (75,000) $ —

This alternative similarly maintains financial statement component neutrality as of each interim date as well
as at year-end. Further, the tax benefit recognized in continuing operations is based on the use of an AETR.
However, the tax related to discontinued operations has not been recognized entirely in the period in which
the gain was recognized.

7.5 Other Considerations
Other complexities can arise when entities are determining the appropriate amount of income tax to
recognize in an interim period. ASC 740-270 addresses some of these complexities.

7.5.1 Inability to Make a Reliable Estimate of the AETR

740-270-30 (Q&A 03) and 740-270-25 (Q&A 01)
ASC 740-270-30-18 states:

Estimates of the annual effective tax rate at the end of interim periods are, of necessity, based on evaluations of
possible future events and transactions and may be subject to subsequent refinement or revision. If a reliable
estimate cannot be made, the actual effective tax rate for the year to date may be the best estimate of the
annual effective tax rate.

If a company’s AETR is highly sensitive to changes in estimates of total ordinary income (or loss), the
AETR may not be considered reliable. This may occur when, for example, an entity is expecting marginal
ordinary income (or loss) and relatively significant permanent differences or tax credits.

In certain situations, a negative AETR may be projected (e.g., nondeductible expenses exceed pretax
loss). Often these estimates are sensitive to ordinary income and may be an indicator that reasonable
estimates cannot be made. If a reliable estimate of the AETR cannot be made, the best estimate of the
AETR may be the actual ETR for the YTD.

7.5.2 Nonrecognized Subsequent Events

740-270-25 (Q&A 07)
ASC 740-270-35-3 indicates that at the end of each successive interim period during the fiscal year, an
entity should revise its estimated AETR, if necessary, to reflect its current best estimate.

Questions have arisen regarding whether an entity’s current best estimate of its AETR should include
events that occurred after the interim balance sheet date but before its financial statements are issued
or are available to be issued (i.e., a nonrecognized subsequent event as contemplated in ASC 855).

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Generally, a nonrecognized subsequent event should not be reflected in the AETR (but should be
disclosed if significant). This approach is based on ASC 855-10-25-3, which states that nonrecognized
subsequent events should not result in the adjustment of the financial statements.

We are aware of an alternative approach in practice under which an entity’s current best estimate of its
AETR is based on information available up to the date on which its financial statements are issued or are
available to be issued, even though that might include information that did not exist or was not relevant
until after the interim balance sheet date. Even under this approach, an entity would still be required
to exclude items for which the tax effects must be recognized in the period in which they occur (e.g.,
changes in UTBs, changes in tax laws or rates, a change in tax status, an IPO, or a business combination).
Entities should consult with their accounting advisers before applying this alternative approach.

7.5.3 Balance Sheet Effects of the Interim Provision for Income Taxes

740-270-25 (Q&A 12)
In accordance with ASC 740-10, entities use a balance sheet approach to determine the annual
provision for income taxes. However, for interim financial statements, ASC 740-270 requires entities
to determine the YTD income tax expense or benefit by applying an estimated AETR to YTD ordinary
income. Because of the inherent disconnect between the year-end balance sheet approach of ASC
740-10 and the interim income statement approach of ASC 740-270, questions have arisen about how
to reflect the YTD expense or benefit on the balance sheet. That is, the YTD tax expense or benefit that
an entity determines under ASC 740-270 will typically not reconcile to the balance sheet adjustments
that would be required if the year-end balance sheet approach of ASC 740-10 were applied to the
current and deferred tax accounts on an interim basis. ASC 740-270 neither addresses this disconnect
nor provides guidance on how to record the balance sheet effects of recording the interim provision for
income taxes.

An entity should generally adjust its income tax balance sheet accounts as of interim reporting periods
in a manner that is representationally faithful to either the balance sheet approach of ASC 740-10 (with
respect to the measurement of current and deferred taxes) or the income statement approach of ASC
740-270. For example, adjusting current and deferred taxes by developing a “split” AETR that consists
of current and deferred components would appear to be representationally faithful to the income
statement approach of ASC 740-270. Alternatively, calculating the actual deferred YTD tax expense
(or benefit) and deriving the adjustment to current taxes (or calculating current taxes and deriving
the adjustment to deferred taxes) would appear to be representationally faithful to the balance sheet
approach of ASC 740-10 (at least with respect to one of the balance sheet components).

Other methods may also be acceptable depending on an entity’s specific facts and circumstances,
including materiality considerations.

Because the method applied to adjust the income tax balance sheet accounts for interim reporting
periods would not be disclosed in the annual financial statements, entities should consider disclosing
the method applied in their interim financial statements.

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Example 7-17

Company A is preparing interim financial statements and calculates an estimated AETR of 25 percent that,
when applied to YTD ordinary income of $100, results in an interim expense for income taxes of $25.

To adjust its income tax balance sheet accounts for interim reporting purposes, A might apply one of the
following methods:

• Split estimated AETR — On a forecasted basis, A estimates an 80/20 split between the current and
deferred portions of the annual provision for income taxes and applies this split to the interim provision
to allocate the adjustment between current and deferred balance sheet accounts.
• Calculate current taxes — Company A calculates its current taxes payable in accordance with tax law
applied to YTD income and records a $40 liability. On the basis of the required AETR provision of $25, A
adjusts the deferred taxes for the beginning of the year by $15 (a debit entry to the balance sheet).
• Calculate deferred taxes — Company A calculates its deferred taxes as of the interim balance sheet date
and adjusts its deferred taxes for the beginning of the year by $10 (a credit entry to the balance sheet).
On the basis of the required AETR provision of $25, A recognizes a current liability of $15.

Balance Sheet

Income
Current Deferred Statement
Debits (Credits) Taxes Taxes Provision
1. Split AETR 20 5 25
2. Calculate current taxes 40 (15) 25
3. Calculate deferred taxes 15 10 25

Note that in most cases, none of the methods above produce the same balance sheet and related expense or
benefit that would arise if the balance sheet approach of ASC 740-10 were applied.

7.5.4 Required Interim Disclosures

ASC 740-270-50-1 notes that application of the interim-period requirements for reporting income taxes
may result in “significant variations in the customary relationship between income tax expense and
pretax accounting income.” Entities must disclose the reasons behind such variations in their interim-
period financial statements if the differences are not readily apparent from the financial statements
themselves or from the nature of the business of the entity.

In addition, for entities that are subject to SEC reporting requirements, management should consider
the requirements in SEC Regulation S-X, Rule 10.01(a)(5), which state, in part:

The interim financial information shall include disclosures either on the face of the financial statements or in
accompanying footnotes sufficient so as to make the interim information presented not misleading. Registrants
may presume that users of the interim financial information have read or have access to the audited financial
statements for the preceding fiscal year and that the adequacy of additional disclosure needed for a fair
presentation may be determined in that context.

Accordingly, if any annual disclosures have significantly changed since the most recently completed fiscal
year, management should update them in a manner sufficient to ensure that the interim information
presented is not misleading. See Sections 14.4.1.6 and 14.4.3.3 for examples of situations in which
management should consider updating an entity’s annual disclosures during an interim period.

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Taxes in Separate Financial Statements

8.1 Introduction
Financial statements that include assets and operations of some subcomponent of a larger consolidated
reporting entity are commonly referred to as “separate” or “carve-out” financial statements, and they are
routinely required in connection with an IPO, a spin-off, a sale, or debt covenant compliance.

When used broadly, “separate” and “carve-out” describe financial statements that are derived from
the financial statements of a larger parent company. In this context, the words are often used
interchangeably. A narrower use of the term “carve-out financial statements” refers specifically to
financial statements that are not the separate financial statements of a legal entity subsidiary but
rather of certain operations (e.g., unincorporated divisions, branches, disregarded entities, or lesser
components of the parent reporting entity) that have been “carved out” of the parent entity or one or
more legal entity subsidiaries. In this chapter, we use “separate financial statements” to refer to financial
statements of one or more legal entity subsidiaries and “carve-out financial statements” to refer to
financial statements that are composed of the assets and operations of divisions, branches, disregarded
entities, or lesser components of the parent entity or one of its subsidiaries.

Even though carve-out financial statements are not those of a legal entity (i.e., they are composed of
portions of a legal entity or entities that have been “carved out”), they are commonly referred to as the
financial statements of the carve-out “entity.” See Deloitte’s A Roadmap to Accounting and Financial
Reporting for Carve-Out Transactions for further discussion of carve-out financial statements.

8.2 Determining Whether an Allocation of Income Taxes Is Required in

Separate or Carve-Out Financial Statements
ASC 740-10

Allocation of Consolidated Tax Expense to Separate Financial Statements of Members

30-27 The consolidated amount of current and deferred tax expense for a group that files a consolidated tax
return shall be allocated among the members of the group when those members issue separate financial
statements. This Subtopic does not require a single allocation method. The method adopted, however, shall
be systematic, rational, and consistent with the broad principles established by this Subtopic. A method that
allocates current and deferred taxes to members of the group by applying this Topic to each member as if it
were a separate taxpayer meets those criteria. In that situation, the sum of the amounts allocated to individual
members of the group may not equal the consolidated amount. That may also be the result when there are
intra-entity transactions between members of the group. The criteria are satisfied, nevertheless, after giving
effect to the type of adjustments (including eliminations) normally present in preparing consolidated financial
statements.

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ASC 740-10 (continued)

Pending Content (Transition Guidance: ASC 740-10-65-8)

30-27A An entity is not required to allocate the consolidated amount of current and deferred tax expense
to legal entities that are not subject to tax. However, an entity may elect to allocate the consolidated
amount of current and deferred tax expense to legal entities that are both not subject to tax and
disregarded by the taxing authority (for example, disregarded entities such as single-member limited
liability companies). The election is not required for all members of a group that files a consolidated tax
return; that is, the election may be made for individual members of the group that files a consolidated tax
return. An entity shall not make the election to allocate the consolidated amount of current and deferred
tax expense for legal entities that are partnerships or are other pass-through entities that are not wholly
owned.

30-28 Examples of methods that are not consistent with the broad principles established by this Subtopic
include the following:
a. A method that allocates only current taxes payable to a member of the group that has taxable
temporary differences
b. A method that allocates deferred taxes to a member of the group using a method fundamentally
different from the asset and liability method described in this Subtopic (for example, the deferred
method that was used before 1989)
c. A method that allocates no current or deferred tax expense to a member of the group that has taxable
income because the consolidated group has no current or deferred tax expense.

Question 3 of SAB Topic 1.B.1 (codified in ASC 220-10-S99-3) states:

SEC Staff Accounting Bulletins

SAB Topic 1.B, Allocation of Expenses and Related Disclosure in Financial Statements of Subsidiaries,
Divisions or Lesser Business Components of Another Entity
S99-3 The following is the text of SAB Topic 1.B.1, Costs Reflected in Historical Income Statements . . .

Question 3: What are the staff’s views with respect to the accounting for and disclosure of the subsidiary’s
income tax expense?

Interpretive Response: Recently, a number of parent companies have sold interests in subsidiaries, but have
retained sufficient ownership interests to permit continued inclusion of the subsidiaries in their consolidated
tax returns. The staff believes that it is material to investors to know what the effect on income would have
been if the registrant had not been eligible to be included in a consolidated income tax return with its parent.

Some of these subsidiaries have calculated their tax provision on the separate return basis, which the staff
believes is the preferable method. Others, however, have used different allocation methods.

When the historical income statements in the filing do not reflect the tax provision on the separate return
basis, the staff has required a pro forma income statement for the most recent year and interim period
reflecting a tax provision calculated on the separate return basis.1

1
Paragraph 40 of Statement 109 [paragraph 740-10-30-27] states: “The consolidated amount of current and deferred tax
expense for a group that files a consolidated tax return shall be allocated among the members of the group when those
members issue separate financial statements. . . . The method adopted . . . shall be systematic, rational, and consistent
with the broad principles established by [Statement 109] [Subtopic 740-10]. A method that allocates current and
deferred taxes to members of the group by applying [Statement 109] [Subtopic 740-10] to each member as if it were a
separate taxpayer meets those criteria.”

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To understand the accounting for income taxes in separate or carve-out financial statements,
management and practitioners must understand the legal structure of the operations to be included in
such statements. The remainder of this section discusses some of the considerations related to whether
separate or carve-out financial statements would require an allocation of income taxes.

8.2.1 Separate Financial Statements Composed of One or More Taxable Legal

Entities
The primary source of guidance applicable to the accounting for income taxes in separate financial
statements is ASC 740-10-30-27, which requires a group of entities that files a consolidated tax return
to allocate the “consolidated amount of current and deferred tax expense . . . among the members
of the group when those members issue separate financial statements.” For income tax accounting
purposes, a “member” is generally a taxable legal entity (i.e., a corporation or an LLC that has elected
to be taxed as a corporation) that is included in the parent’s consolidated tax return. Thus, if separate
financial statements are being prepared that are composed of one or more taxable legal entities that
are included in the parent’s consolidated tax return (as might be the case if the separate financial
statements are being prepared in connection with a spin-off of a subsidiary), an allocation of current and
deferred income tax expense is explicitly required under ASC 740-10-30-27.

8.2.2 Separate Financial Statements of Nontaxable Legal Entities or “Pass-

Through” Entities
Separate financial statements may be composed of one or more nontaxable entities (e.g., “pass-
through” entities such as partnerships and multiple member LLCs that have elected to be taxed
as pass- throughs). Such nontaxable or pass-through entities are not members of their parent’s
consolidated income tax return. Therefore, allocation of income tax expense is not appropriate in the
separate financial statements of a pass-through entity for jurisdictions in which the entity is considered
a nontaxable pass-through entity. This is true irrespective of whether the separate financial statements
will be included in a filing with the SEC. See Section 14.5 for the disclosure requirements that apply in
this circumstance.

8.2.3 Carve-Out Financial Statements (i.e., Statements Composed of One

or More Unincorporated Divisions, Branches, Disregarded Entities, or Lesser
Components of the Parent Reporting Entity)
Because ASC 740-10-30-27 discusses only the allocation of current and deferred income taxes to the
separate financial statements of a member (i.e., a taxable legal entity subsidiary that is included in a
parent’s consolidated income tax return), it does not explicitly address the allocation of income taxes
in carve-out financial statements. Whether an allocation of the consolidated amounts of current and
deferred income taxes is required in carve-out financial statements depends on the ultimate use of the
financial statements.

If the carve-out financial statements will be included in a filing with the SEC, an allocation of taxes is
generally required under the guidance in SAB Topic 1.B.1 (codified in ASC 220-10-S99-3). Question 3 of
SAB Topic 1.B.1 specifically addresses income taxes and states, in part:

The staff believes that it is material to investors to know what the effect on income would have been if the
registrant had not been eligible to be included in a consolidated income tax return with its parent.

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In this context, “the registrant” has been interpreted in practice to include a carve-out “entity,” either
because the carve-out entity will ultimately become a registrant or because the carve-out entity
represents the predecessor of the registrant.

The allocation of income taxes in carve-out financial statements that will be included in a filing with the
SEC is required regardless of whether the carved-out operations will be subsumed into a taxable or
nontaxable entity upon consummation of the transaction for which the carve-out financial statements
are being prepared. Only in limited circumstances has the SEC allowed the omission of a tax provision
(e.g., if the carve-out entity prepares abbreviated financial statements — see Section 8.2.5).

If the carve-out financial statements will not be included in a filing with the SEC, the parent entity is
generally not required to allocate income taxes to the carve-out financial statements, although doing so
is usually preferable because it yields more useful information.

8.2.4 Separate Financial Statements of Single-Member LLCs

740-10-30 (Q&A 60)
An LLC with only one member (a “single-member LLC”) is a unique legal entity structure that can,
under certain circumstances, be classified for U.S. federal income tax purposes as a regarded entity
(i.e., similar to a corporation) or can be disregarded (i.e., not respected as an entity separate from its
owner but rather treated like a division of a corporation). However, unlike a division of a corporation,
a disregarded single-member LLC generally is not severally liable for the current and deferred income
taxes of its taxable owner provided that it maintains its separate and distinct legal existence. An entity’s
determination of whether an allocation of current and deferred income taxes is required in the separate
financial statements of a single-member LLC therefore depends, in part, on how the single-member LLC
elects to treat itself for U.S. federal income tax purposes.

A regarded single-member LLC that is subject to federal, foreign, state, or local taxes based on income
should account for such taxes in its separate financial statements in accordance with ASC 740 (see
Section 8.2.1).

A disregarded single-member LLC would follow the guidance discussed in Section 8.2.3 to allocate
current and deferred taxes in its financial statements. Accordingly, while it would certainly be acceptable
by analogy to ASC 740-10-30-27 (and would generally be preferable) for the disregarded single-member
LLC to recognize an allocation of current and deferred income taxes in its separate financial statements,
we do not believe that it is required unless the disregarded single-member LLC (1) will include the
separate financial statements in a filing with the SEC or (2) is in the situation described in the paragraph
below.

Because a single-member LLC is a legal entity and not a division, it is possible for the single-member LLC
to enter into a tax-sharing agreement with its owner. If a contractual tax-sharing agreement exists
between the single-member LLC and its taxable owner, the existence of that contractual agreement
would generally suggest that the single-member LLC should be treated no differently than a corporate
member of the consolidated tax return (i.e., the single-member LLC is now contractually liable for
a portion of its owner’s tax obligations). Accordingly, the single-member LLC should recognize an
allocation of income taxes in its separate financial statements in accordance with ASC 740-10-30-27. The
allocation method used must be appropriate for financial reporting purposes regardless of the manner
in which the contractual tax-sharing agreement allocates taxes to the single-member LLC. See Section
8.3.1 for further discussion of acceptable allocation methods and Section 8.3.4 for further discussion of
tax-sharing arrangements that are inconsistent with the broad principles established by ASC 740.

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If income taxes are not allocated, practitioners should ensure that they have a complete understanding
of the business purpose of the structure and of the user(s) of the financial statements. See Section
8.7.2 for disclosure considerations for financial statements of a single-member LLC that do not include
an allocation of income taxes. An entity’s conclusion about whether to allocate income taxes to the
separate financial statements of a single-member LLC is not an assessment of whether income taxes are
attributable to that single-member LLC. Rather, such a conclusion would be consistent with an entity’s
application of the presentation guidance in ASC 740-10-30-27.

Changing Lanes
Because stakeholders indicated that the previous guidance was unclear, the FASB issued
ASU 2019-12 in December 2019. The ASU added the guidance in ASC 740-10-30-27A
to clarify that legal entities that are not subject to tax (e.g., certain partnerships and
disregarded single-member LLCs) are not required to have an allocation of consolidated
current and deferred taxes in their separate financial statements. An allocation of
current and deferred income tax expense is permitted, however, in the separate financial
statements of legal entities that are not subject to tax and are disregarded by the taxing
authority. In addition, ASC 740-10-50-17A requires an entity that is not subject to tax and
is disregarded by the taxing authority to disclose that it has elected to allocate amounts of
consolidated current and deferred taxes in its separate financial statements.

The policy election to allocate taxes to legal entities that are not subject to tax and are
disregarded by the taxing authority allows the inclusion of a tax provision in the separate
financial statements of a single-member LLC (a disregarded entity for tax purposes) but not in
the financial statements of a partnership (a regarded entity for tax purposes).

These amendments should be applied retrospectively.

The addition of ASC 740-10-30-27A means that current and deferred income tax expense are
no longer required to be allocated to the financial statements of a single-member LLC being
prepared for inclusion in an SEC filing (regardless of whether a tax-sharing agreement exists
between the single-member LLC and its taxable parent). That is, such financial statements are
treated the same as those of a partnership in the accounting for income taxes in the separate
financial statements.

For more information on ASU 2019-12, see Appendix B.

An entity’s conclusion about whether to allocate income taxes to the separate financial statements
of a single-member LLC is not an assessment of whether income taxes are attributable to that
single-member LLC in accordance with ASC 740-10-55-226 through 55-229. Rather, such a
conclusion constitutes the application of the presentation guidance in ASC 740-10-30-27.

8.2.5 Abbreviated Financial Statements

SEC Regulation S-X, Rule 3-05, requires registrants to furnish financial statements of certain businesses
acquired or to be acquired. In certain circumstances, it may not be practicable to prepare full separate
financial statements or carve-out financial statements, such as when the acquiree is a small portion or
product line of a much larger business and separate financial records were not maintained. In such
circumstances, abbreviated financial information of certain businesses acquired or to be acquired
typically may be acceptable and would consist only of (1) a statement of revenues and direct expenses
(in lieu of a full statement of operations) and (2) a statement of assets acquired and liabilities assumed
(in lieu of a full balance sheet). In addition, it may be appropriate not to include an allocation of income
taxes in the acquired business’s abbreviated financial statements.

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See Section 5.2.4 of Deloitte’s A Roadmap to Accounting and Financial Reporting for Carve-Out
Transactions and Section 1.5 of Deloitte’s A Roadmap to SEC Reporting Considerations for Business
Combinations for further discussion of abbreviated financial statements. Also see Section 8.7.3 of
this Roadmap for disclosures required when income taxes are not allocated in abbreviated financial
statements.

8.3 Allocating Current and Deferred Income Tax Expense in the Income

Statement of Separate and Carve-Out Financial Statements
The allocation of current and deferred income tax expense required by ASC 740-10-30-27 to separate
financial statements is necessary because, in a consolidated income tax return, the results of operations
of the members are combined to determine income tax expense of the consolidated group. Therefore,
taxable income of one member of the consolidated return may be offset by losses and credits of
another member and vice versa. Because income tax obligations are not determined at a level below
the consolidated filing group, it is necessary to make an allocation of the amount of consolidated current
and deferred income tax expense into separate or carve-out financial statements.

8.3.1 Acceptable Methods of Allocating Tax to Separate and Carve-Out

Financial Statements
740-10-30 (Q&A 51)
ASC 740-10-30-27 does not prescribe a particular method for allocating current and deferred income
tax expense to separate financial statements of a member; rather, it requires only the use of a
systematic and rational method that is consistent with the broad principles established by ASC 740.
Several income tax allocation methods may meet the requirements of ASC 740-10-30-27, including the
commonly applied separate-return and parent-company-down approaches, both of which are discussed
below. Choosing an income tax allocation method is an accounting policy decision, and the method
should be consistently applied. See Section 8.3.2 for considerations specific to entities that file financial
statements with the SEC.

8.3.1.1 Separate-Return Method
Under the separate-return method of allocation, a group member issuing separate financial statements
determines current and deferred tax expense or benefit for the period by applying the requirements
of ASC 740 as if the group member were required to file a separate tax return. This method can lead
to inconsistencies between conclusions reached related to the realizability of DTAs (and the related
tax expense or benefit) reflected in (1) the consolidated financial statements and (2) the separate or
carve-out financial statements. For example, the separate financial statements may include a valuation
allowance because of insufficient taxable income on a hypothetical separate-return basis, while in the
consolidated financial statements (which include other profitable entities), a valuation allowance may not
be required. ASC 740 acknowledges that sometimes the sum of the amounts allocated to the individual
group members under the separate-return method may not equal the total current and deferred
income tax expense or benefit of the consolidated group.

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Example 8-1

Parent P has two operating subsidiaries, S1 and S2, both of which are members of the consolidated group. The
table below illustrates each subsidiary’s taxable income and statutory tax rate for the period. Assume that on a
separate-return basis, S1 requires a full valuation allowance against its DTAs and therefore cannot recognize a
benefit for its loss of $100. However, on a consolidated basis, the group has sufficient taxable income to realize
a benefit from S1’s loss. Income tax expense under the separate-return method would be allocated as follows:

Separate-Return Approach Consolidated

Sum of
P Separate-
(Stand- Return Tax
Description Alone) S1 S2 Expense P Difference
Taxable income $ 300 $ (100) $ 400 $ 600
Tax rate 21% 21% 21% 21%
Current tax expense
(benefit) 63 0 84 $ 147 126 $ (21)

Deferred tax
expense (benefit) 0 0 0 0 0 0
Total tax expense
(benefit) $ 63 $ 0 $ 84 $ 147 $ 126 $ (21)

Note that in this example, as a result of the different conclusions related to realizability of the benefit for S1’s
loss, the $147 of tax expense representing the “sum of the parts” of income tax expense allocated in the
separate financial statements does not equal the $126 of tax expense reflected in P’s consolidated financial
statements.

8.3.1.1.1 Modifications to the Separate-Return Method

Depending on the facts and circumstances, certain modifications to the separate-return method
may also be considered systematic, rational, and consistent with the broad principles of ASC 740. For
example, entities often modify the separate-return method to eliminate the effects of inconsistent
conclusions related to realizability.

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Example 8-2

Assume the same facts as in Example 8-1. Under this modified method, because the consolidated group has
sufficient taxable income in the current year to realize the benefit for S1’s loss, S1 would recognize a tax benefit
of $21 as follows:

Separate-Return Approach — Modified Consolidated

Sum of
Separate-
Return Tax
Description P S1 S2 Expense P Difference
Taxable income $ 300 $ (100) $ 400 $ 600
Tax rate 21% 21% 21% 21%

Current tax expense

(benefit)* 63 (21) 84 $ 126 126 $ 0
Total tax expense
(benefit) $ 63 $ (21) $ 84 $ 126 $ 126 $ 0

* If the consolidated group did not have sufficient taxable income in the current year to realize the benefit for S1’s loss
but concluded that it would have sufficient taxable income in future years, S1 would have recorded a deferred tax
benefit (rather than a current tax benefit) of $21 in the current year.

Under this approach, it may be necessary to limit the amount of the benefit recorded by S1 to the amount that
is actually realizable on a consolidated basis. For example, if state apportionment factors reduced the amount
of state tax benefit the consolidated group could realize from S1’s loss (i.e., on a stand-alone basis, S1 would
have recorded — ignoring valuation allowance considerations — more of a benefit than the consolidated group
could realize), the state tax benefit recorded by S1, even under this modified approach, may need to be limited.

Other modifications to the separate-return method might also be appropriate. For example, it
may be considered systematic, rational, and consistent with the broad principles in ASC 740 to use
consolidated state apportionment factors in the allocation of income tax expense in the separate
financial statements of a member rather than determine a separate apportionment factor as would be
required under a pure separate-return method. However, this modification may not be appropriate
when the consolidated apportionment factor would not be considered rational because of significant
differences between the operations of the separate or carve-out entity and the consolidated group (e.g.,
a significantly different geographic or sales footprint). To determine whether a particular modification
is systematic, rational, and consistent with the broad principles of ASC 740-10, an entity must evaluate
the facts and circumstances and apply judgment. Consultation with the entity’s accounting advisers is
suggested when modifications are being contemplated other than for purposes related to realizability.

8.3.1.1.2 Application of the Separate-Return Method in Separate or Carve-Out

Financial Statements That Combine Multiple Legal Entities, Multiple Divisions,
or Both
740-10-30 (Q&A 73)
When multiple members are presented in separate financial statements on a combined basis, questions
have arisen regarding the application of the separate-return method about whether (1) a “member”
refers to a single legal entity, in which case an income tax provision would be allocated to each distinct
legal entity and then combined, or (2) the group of members that is combined in the separate financial
statements can be viewed collectively as a single member, in which case a single tax provision would be
allocated to the combined members as a whole.

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In these circumstances, we believe that there are two acceptable approaches for applying the separate-
return method to determine the amount of income taxes to be allocated to the separate financial
statements of the combined members.

The first approach is to calculate the tax provision as if all the members combined in the separate
financial statements had been combined in such statements in all periods presented and had historically
filed a consolidated tax return. This approach is supported by the guidance in ASC 810-10-45-10, which
states:

If combined financial statements are prepared for a group of related entities, such as a group of commonly
controlled entities, intra-entity transactions and profits or losses shall be eliminated, and noncontrolling
interests, foreign operations, different fiscal periods, or income taxes shall be treated in the same manner
as in consolidated financial statements. [Emphasis added]

Accordingly, calculation of an income tax provision under the separate-return method as if all of the
members were part of a consolidated return during all periods presented (in accordance with the same
principles) would appear to be an acceptable interpretation of this guidance.

Alternatively, because most tax jurisdictions require that there be a common parent for a consolidated
tax return to be filed and no common parent is actually included in the separate, combined financial
statements, we believe that a second acceptable approach is to calculate the tax provision by applying
the separate-return method to each member separately.1 In other words, application of the tax law to
the individual members appearing in the separate financial statements would result in a separate tax
provision calculation for each member that lacks a common parent in the separate financial statements.
These individual tax provisions would then be combined to determine the total amount of taxes to be
allocated to the combined, separate financial statements. This approach is consistent with the guidance
in ASC 740-10-30-5, which states, in part:

Deferred taxes shall be determined separately for each tax-paying component (an individual entity or
group of entities that is consolidated for tax purposes) in each tax jurisdiction. [Emphasis added]

In selecting which approach to apply, an entity should consider the purpose for the separate financial
statements. For example, if they are being prepared in connection with a spin-off or sale transaction and
will be part of a consolidated tax return prospectively, a historical presentation that conforms to that
prospective treatment may be more meaningful to financial statement users.

We believe that both approaches would also be acceptable for a combination of disregarded entities
(e.g., certain single-member LLCs) since they have separate legal existence that would allow for
application of a separate-return approach to each individual entity but are treated as divisions for
tax purposes, allowing for the application of a single-return approach. We recommend that entities
consult their professional accounting advisers in these circumstances. See Section 8.2.3 for additional
discussion of single-member LLCs.

8.3.1.1.3 Application of the Separate-Return Method in Separate or Carve-Out

Financial Statements When Tax Amounts Are Calculated on a Consolidated Tax
Return Basis (e.g., the Deemed Repatriation Transition Tax, GILTI, BEAT)
The member should record income taxes as if it had not been a member of the U.S. consolidated tax
return group. However, depending on the facts and circumstances, it may be appropriate for an entity
to apply related-party and affiliated group tax rules that are relevant regardless of whether it makes an
election to file a consolidated tax return.

1
Under this approach, if a division or group of divisions is included in the separate or carve-out financial statements, the separate-return method
would generally be applied to those divisions in aggregate and then combined with the tax provisions of the members.

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8.3.1.2 Parent-Company-Down Method
740-10-30 (Q&A 51)
Under the parent-company-down method, total current and deferred income tax expense, as
determined at the consolidated level, is allocated to separate or carve-out financial statements by using
a pro rata allocation. The pro rata portion of consolidated tax expense allocated to the separate or
carve-out financial statements might be determined by, for example:

• Calculating the member’s or carve-out entity’s pretax income as a percentage of the total
consolidated pretax income.

• Calculating the member’s or carve-out entity’s pretax income adjusted for permanent items as a
percentage of the total consolidated pretax income adjusted for permanent items.

Example 8-3

This example illustrates how the parent-company-down method would be applied when consolidated
tax expense is allocated to group members on the basis of each group member’s relative proportion of
(1) consolidated pretax income or loss or (2) consolidated pretax income or loss adjusted for permanent items.

Parent P, a holding company, has two consolidated subsidiaries, S1 and S2. Parent P, S1, and S2 all operate in a
tax jurisdiction with a 20 percent tax rate. On a consolidated basis, P has current and deferred tax expense of
$110 for 20X1 that is based on $600 of pretax book income. The stand-alone results for P, S1, and S2 for 20X1
are as follows:

Parent S1 S2

Relative Relative Relative

Amount Percentage Amount Percentage Amount Percentage Total
Pretax income (loss) $ 300 50% $ (100) (17)% $ 400 67% $ 600
Permanent items $ 100 $ 50 $ (200) $ (50)
Pretax income (loss)
adjusted for
permanent items $ 400 73% $ (50) (9)% $ 200 36% $ 550
Tax rate 20% 20% 20% 20%
Consolidated tax $ 110

On the basis of the assumptions above, the group members would record the following tax expense in
accordance with the allocation method chosen:

Parent S1 S2

Tax Relative Tax Relative Tax Relative

Allocated Percentage Allocated Percentage Allocated Percentage Total
Income tax allocated
on the basis of
pretax income (loss) $ 55 50% $ (18.7) (17)% $ 73.7 67% $ 110
Income tax allocated
on the basis of
pretax income (loss)
adjusted for
permanent items $ 80.3 73% $ (9.9) (9)% $ 39.6 36% $ 110

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Example 8-3 (continued)

As depicted above, total current and deferred tax expense or benefit for the period, as determined at the
consolidated level, should equal the sum of the current and deferred income tax expense or benefit allocated
to all members of the group for the period ($110 in this example).

8.3.2 Preferable Allocation Method for Financial Statements Filed With

the SEC
740-10-30 (Q&A 52)
Question 3 of SAB Topic 1.B.1 (codified in ASC 220-10-S99-3) states, in part:

Some of these subsidiaries have calculated their tax provision on the separate return basis, which the staff
believes is the preferable method. . . . When the historical income statements in the filing do not reflect the
tax provision on the separate return basis, the staff has required a pro forma income statement for the most
recent year and interim period reflecting a tax provision calculated on the separate return basis.

For entities that file financial statements with the SEC, the separate-return method for allocating taxes
among members of a group that file a consolidated tax return is preferable to other methods and, if the
separate-return method is not used (including, as discussed in Section 8.3.1.1.1, when the separate-
return method is modified), a pro forma income statement is required for the most recent annual
and interim periods, including a tax provision determined by using the separate-return method. The
acceptable methods for allocating current and deferred income taxes in carve-out financial statements
are generally the same as those for allocating income taxes in separate financial statements of a
member. It would also, therefore, be considered preferable to allocate income taxes to carve-out
financial statements by using the separate-return method if such an allocation is required (e.g., because
the carve-out financial statements will be included in a public filing).

Most entities preparing separate and carve-out financial statements to which an allocation of current
and deferred income taxes is required will use the separate-return method because to use a different
method would require entities to maintain a separate set of financial statements to meet the SEC’s
expectation of a pro forma income statement when the allocation is not determined on the separate-
return basis.

8.3.3 Change in Application of Tax Allocation Methods

740-10-30 (Q&A 53)
An entity should report the change from one acceptable allocation method to another as a change
in accounting principle under ASC 250. However, in accordance with ASC 250-10-45-12, a change in
accounting principle is permitted only if the entity “justifies the use of an allowable alternative . . . on the
basis that it is preferable.”

Under ASC 250-10-45-5, an entity should “report a change . . . through retrospective application of the
new accounting principle to all prior periods, unless it is impracticable to do so.” A change in accounting
principle would affect only the separate or carve-out financial statements. No change would be reflected
in the consolidated financial statements of the parent company. SEC registrants that are reporting a
change in accounting principle must provide a preferability letter from their independent accountants.

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8.3.4 Tax-Sharing Agreements
740-10-30 (Q&A 55)

8.3.4.1 General
A tax-sharing agreement is a legal agreement between the members of a consolidated group (e.g.,
a parent and corporate subsidiary) that typically governs the cash payment responsibility of each
party related to income taxes of the consolidated filing group. Tax-sharing agreements should be
formally documented, and the documentation should indicate how a member of a consolidated filing
group will pay or be compensated for income tax expense or benefit attributed to its operations. This
would generally include documentation of, for example, (1) the manner in which a member’s cash
payment responsibility will be calculated (e.g., on a consolidated or separate-return basis) and (2) how
the member will be compensated for the benefit to the consolidated group of NOLs and tax credits
attributable to its operations.

Such documentation is important because it provides information about the risks and rewards of the
parties to a legally enforceable contract. In addition, a well-documented tax-sharing agreement helps an
entity prepare separate or carve-out financial statements (e.g., a basis for the amounts due to or from
the parent).

8.3.4.2 Tax-Sharing Agreements That Are Not Acceptable for Financial Reporting

Purposes
When the legal tax-sharing agreement that governs the cash payments and receipts between a parent
entity and the members of its consolidated filing group is not in line with the “systematic, rational,
and consistent” requirements in ASC 740-10-30-27 for allocating taxes among members of a group
that file a consolidated return, the tax-sharing agreement need not be amended to conform to those
requirements. Instead, for financial reporting purposes, an entity should apply an acceptable method
of allocating income tax expense or benefit to a member of the consolidated filing group that prepares
separate financial statements. Any difference between (1) the income-tax-related cash flows that are
to be paid or received by a member under the legal tax-sharing agreement and (2) the income-tax-
related cash flows of the member implied by the allocation of current and deferred income taxes by
using a systematic and rational method of allocation for financial reporting purposes is reported in the
separate financial statements of the group member as either a charge to retained earnings (i.e., in a
manner consistent with accounting for dividends generally) or a credit to paid-in capital (i.e., in a manner
consistent with accounting for contributions from shareholders generally).

Example 8-4

Assume that a parent company, Entity P, a holding company operating in a tax jurisdiction with a 21 percent tax
rate, has two operating subsidiaries, S1 and S2, and that the legal tax-sharing agreement states that S1 and S2
will not make a payment to or receive a payment from P with regard to the subsidiaries’ taxable income or loss
for a given year when the consolidated group has no tax liability (expense) or refund (benefit) for that year.

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Example 8-4 (continued)

Further assume that in 20X1, P has no taxable income or loss, S1 has generated taxable income of $1,000,
and S2 has incurred a taxable loss of $1,000. An allocation of income tax expense in a manner consistent with
the cash obligations of P, S1, and S2 under the tax-sharing agreement generally would not conform with the
“systematic, rational, and consistent” requirements of ASC 740-10-30-27. Therefore, assume that for financial
reporting purposes, the group has chosen to allocate income taxes to the separate financial statements of S1
and S2 by using the separate-return method and that the NOL resulting from the $1,000 loss incurred by S2
in 20X1 does not require a valuation allowance. Entity P records the following journal entries in the separate
financial statements of S1 and S2 for 20X1:

Journal Entry — Consolidated Group Member S1

Income tax expense — income from continuing

operations 210
Income taxes payable 210
Income taxes payable 210
Paid-in capital 210
To record income tax expense and payable in the separate financial
statements of S1 on a separate-return basis and then reclassify
the payable to paid-in capital to reflect the fact that S1 will not
have to make a payment with regard to such taxes under the
tax-sharing agreement. In effect, the taxes were paid on its behalf
by P, representing a contribution by S1’s shareholders to S1’s
capital ($1,000 × 21%).
Journal Entry — Consolidated Group Member S2
NOL carryforward* 210
Income tax benefit — loss from continuing
operations 210
Retained earnings* 210
NOL carryforward 210
To record income tax benefit in the separate financial statements
of S2 on a separate-return basis and reflect the fact that S2 will
not receive a payment with regard to the reduction in taxes
resulting from its loss. In effect, S2 distributed the benefit of the
loss to P as a dividend against retained earnings ($1,000 × 21%).
* See the discussion in Section 8.4.3 of alternative approaches for accounting for hypothetical DTAs in separate
financial statements prepared by using the separate-return method. This example assumes that S2 has elected not
to record the hypothetical DTA (it is hypothetical because no NOL exists on a consolidated basis; P had no taxable
income, and S2’s loss was offset by S1’s income). Under this approach, if S2 did not have retained earnings, the
amount could also be recorded as a return of capital.

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8.3.5 Allocating Benefits to a Subsidiary for Parent’s Interest Expense

740-10-30 (Q&A 56)

Example 8-5

Assume that Entity P is the parent of a wholly owned subsidiary, Company S, and that S is a member of P’s
consolidated tax return. Further assume that P issued term debt upon acquiring S and that P deducts the
interest paid on the debt for income tax purposes. The legal tax-sharing agreement between P and S specifies
that S will receive payments from P to the extent of the benefit to P of the interest deductions taken by P in the
consolidated tax return related to the term debt.

Company S prepares separate financial statements, and P does not allocate the debt and corresponding
interest expense to S for financial reporting purposes. Company S does pay dividends to P, in part to provide
cash flows for P’s debt service obligation.

The FASB staff has informally indicated that in circumstances such as those in Example 8-5 above, the
tax benefit of the interest expense determined in accordance with the legal tax-sharing agreement
and paid by P to S should be allocated to equity in the separate financial statements of S. Income tax
expense from continuing operations should not be credited in this situation. This view is based on the
belief that allocating the tax consequences attributable to interest expense, the pretax amounts for
which neither principal nor interest has been recognized in S’s financial statements, is inconsistent with
the broad principles established by ASC 740.

8.3.6 “Return-to-Provision” Adjustments in Separate or Carve-Out Financial

Statements
When preparing an income tax provision for financial reporting purposes, an entity will often find it
necessary to make estimates of amounts that will ultimately be included in the filed income tax return
because the financial statements must be issued before the date on which the income tax return is
due. This can result in “return-to-provision” adjustments (also known as return-to-accrual adjustments),
which occur when estimates used for the provision in the consolidated financial statements differ from
the amounts reported on the consolidated income tax return. Any resulting differences between the
consolidated tax return and consolidated tax provision should be carefully evaluated to determine
whether such variances represent changes in estimates or a correction of an error.

The income tax effects of return-to-provision adjustments that are considered changes in estimates
in the consolidated financial statements are generally recorded in separate or carve-out financial
statements in the same period in which the changes in estimates were identified in the consolidated
financial statements. The income tax effects of return-to-provision adjustments that are not considered
changes in estimates in the consolidated financial statements, however, generally should be recorded
in the historical separate or carve-out financial statements in the periods to which they relate and not
in the period identified (i.e., irrespective of the period in which they were accounted for in the parent’s
consolidated financial statements). Differences between the periods in which return-to-provision
adjustments are recorded in consolidated financial statements versus when they are recorded in
separate or carve-out statements could stem, for example, from differences in materiality between the
separate or carve-out financial statements and the consolidated financial statements.

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8.4 Current and Deferred Income Taxes in the Balance Sheet of Separate and
Carve-Out Financial Statements
As discussed in detail above, an allocation of current and deferred income tax expense to separate
and carve-out financial statements is often necessary. However, there is no authoritative guidance in
ASC 740-10-30-27 or elsewhere that specifically addresses how current and deferred taxes should be
reflected in the balance sheet of the separate or carve-out financial statements.

8.4.1 Requirement to Record DTAs and DTLs in Separate or Carve-Out

Financial Statements
The recording of DTAs and DTLs in the balance sheet of carve-out financial statements was discussed at
the June 12, 2001, AICPA SEC Regulations Committee joint meeting with the SEC staff. The following is an
excerpt from those meeting minutes that expresses the SEC staff’s view:

Question: Should carveout financial statements (i.e., financial statements of a business that is not a legal
entity, e.g., a division) reflect income tax expense and deferred tax assets/liabilities if the reporting entity is a
component of a taxable entity?

Background: The accounting literature does not clearly address the issue of accounting for income taxes by a
reporting entity that is not a legal entity.

Paragraph 1 of SFAS 109 states that it “addresses financial accounting and reporting for the effects of income
taxes that result from an enterprise’s activities . . . .” Paragraph 40 provides standards for accounting for income
taxes in the “separate financial statements of a subsidiary.” It states that tax expense “shall be allocated among
the members of the group when those members issue separate financial statements.” (Emphasis added.) SFAS
109 does not define the term “enterprise.” However, paragraph 40 seems to apply only to legal entities.

SAB Topic 1-B is entitled Allocation of Expenses and Related Disclosures in Financial Statements of Subsidiaries,
Divisions, or Lesser Business Components of Another Entity. In its text, it seems to use the word “subsidiary”
as a surrogate for the larger collection of reporting entities listed in its title. The response to Question 1 states
that “the historical income statements of a registrant should reflect all of its costs of doing business.” However,
the response then states that “income taxes . . . are discussed separately below.” Question 3 addresses income
tax expense. Although the SAB seems to use the term “subsidiary” broadly, the discussion of subsidiary income
taxes in the response to Question 3 seems to be written in the context of legal entities, referring to issues
of whether the entity can be included in a consolidated tax return (this is not an issue for a component of a
legal entity) with its “parent.” The response states the need to provide a pro forma tax provision if the financial
statements do not reflect income taxes on a separate return basis. Guidance in the Staff Training Manual (at
Topic Three.IV.A.1. and Topic Seven.IV.A.4.) also focuses on the need for pro forma tax provision information.

Although an allocation of deferred tax assets and liabilities needs to be made to apply the separate return
method, none of this guidance specifically addresses balance sheet presentation or footnote disclosure issues.
The guidance calling for pro forma information focuses on the need for tax provision information.

Discussion: Many accountants focus on the concept stated in SAB Topic 1-B that income statements should
reflect all costs of doing business. They present income tax provisions as part of the historical accounts
reflected in carveout financial statements. Others believe that since reporting entities that are not legal entities
do not have legal tax status, they do not have tax liabilities or expenses. Therefore, they present income tax
information in carveout financial statements only on a pro forma basis. Although practice does not appear to
be uniform, it appears that registrants present income taxes in carveout financial statements as part of the
historical accounts more frequently than they present them as pro forma information. This observation is
based in part on comments made by the Big 5 accounting firms in communications discussing the question of
whether a single member LLC should present a tax provision in its financial statements. A single member LLC is
treated as a “disregarded entity” for tax purposes. In other words, it is treated no differently than a division of a
taxpayer. The majority of the firms felt that a single member LLC should present a tax provision. The other firms
did not have strong views.

Staff Comment: As stated in SAB Topic 1B, the staff believes that financial statements are more useful to
investors if they reflect all costs of doing business. As the transactions reported in the carveout financial
statements have income tax implications to the taxable entity of which the reporting entity is a part, the staff
believes that carveout financial statements should reflect income tax expense and deferred tax assets/liabilities
attributable to the reporting entity.

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As indicated in the minutes above, the SEC staff believes that financial statements “are more useful
to investors if they reflect all costs of doing business” and that carve-out financial statements “should
reflect income tax expense and deferred tax assets/liabilities attributable to the reporting entity.” While
the staff’s views were expressed specifically in the context of carve-out financial statements, we believe
that such views would also apply to separate financial statements of members (i.e., taxable legal entities
that are included in a parent’s consolidated tax return).

Therefore, we generally believe that the balance sheet of separate and carve-out financial statements
should include DTAs and DTLs for temporary differences related to the separate entity’s operations
when such financial statements will be included in a filing with the SEC. In addition, although it is not
clear from the minutes above, we believe that it is generally appropriate to record DTAs and DTLs in
separate and carve-out financial statements regardless of the method (e.g., the separate-return method
or the parent-company-down method) used to allocate current and deferred income tax expense to the
separate or carve-out financial statements.

8.4.2 Method for Recording DTAs and DTLs in the Balance Sheet of Separate
or Carve-Out Financial Statements
We believe that it is generally appropriate for an entity to begin its allocation of DTAs and DTLs in the
balance sheet of separate or carve-out financial statements by identifying stand-alone temporary
differences and attributes of the separate or carve-out entity. Those differences and attributes would be
based on the financial statement carrying amount of the assets and liabilities included in the separate or
carve-out financial statements as if the entity were required to file its own tax return. However, because
there is no available guidance on how DTAs should be reflected in separate and carve-out financial
statements, many issues arise in practice. We discuss some of those issues in Section 8.4.3 (below) and
Section 8.4.4.

8.4.3 Recognition of DTAs Related to Temporary Differences for Which

the Separate or Carve-Out Entity Has Been Paid by Another Member of the
Consolidated Filing Group
Under some tax-sharing arrangements, one member of the consolidated filing group, typically a parent,
will pay a separate or carve-out entity for temporary difference DTAs each period as they arise. Once
the separate or carve-out entity has been paid for the DTAs, questions arise about whether such DTAs
should be removed from the separate or carve-out entity’s balance sheet.

Careful consideration should be given to the facts and circumstances of each individual tax-sharing
agreement. We believe that it would generally not be appropriate for an entity to remove DTAs related
to temporary differences from the separate or carve-out financial statements when a parent pays
a separate or carve-out entity for temporary difference DTAs each period as they arise. Temporary
difference DTAs are tied to the financial reporting and tax bases of specific assets and liabilities of the
separate or carve-out entity. The fact that the entity receives payment for associated DTAs does not
change whether a basis difference exists or whether a future benefit would result from settlement of
the asset or recovery of the liability at its financial reporting carrying amount. Therefore, derecognition
of DTAs related to temporary differences would generally not be consistent with the broad principles of
ASC 740.

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8.4.4 Recording Deferred Income Taxes in the Balance Sheet Under the

Separate-Return Method
8.4.4.1 Taxable Temporary Differences Resulting From Investments in Foreign
Subsidiaries and Foreign Corporate Joint Ventures in Separate Financial
Statements Prepared by Using the Separate-Return Method
740-10-30 (Q&A 80)
ASC 740-30-25-18 indicates that a DTL should not be recognized for an “excess of the amount for
financial reporting over the tax basis [i.e., ‘outside basis difference’] of an investment in a foreign
subsidiary or a foreign corporate joint venture that is essentially permanent in duration” unless “it
becomes apparent that those temporary differences will reverse in the foreseeable future”
(emphasis added). There is, however, also a rebuttable presumption under ASC 740-30-25-3 that all
undistributed earnings will be transferred by a subsidiary to its parent. This rebuttable presumption
may be overcome if the criteria of ASC 740-30-25-17 are met (i.e., sufficient evidence shows that the
subsidiary has invested or will invest the undistributed earnings indefinitely).

The determination of whether a DTL should be recognized (e.g., whether the rebuttable presumption
is or is not overcome) for an excess of the amount for financial reporting over the tax basis of an
investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent
in duration is first made at the parent’s level on a consolidated basis and takes into account all of the
consolidated entity’s relevant facts and circumstances.

When the investment in the foreign subsidiary or corporate joint venture is owned by the separate
reporting entity and is included in the separate financial statements of that entity, the separate financial
statements prepared by using the separate-return method2 must also include an assertion with respect
to whether the temporary difference will reverse in the foreseeable future. Questions often arise about
whether the assertion in the separate financial statements prepared by using the separate-return
method should be the same as the assertion made in the consolidated financial statements related to
that same investment or whether, instead, the separate reporting entity must perform an independent
analysis that takes into account only the separate reporting entity’s operations, facts, and circumstances.

Preparing an independent analysis that takes into account only the facts and circumstances of the
separate reporting entity is consistent with the separate-return method. However, we believe that
because the separate reporting entity is controlled by its parent, if the parent considers the separate
reporting entity’s facts and circumstances, the parent is inherently required to also consider the
consolidated filing group’s plans for reinvestment, cash needs, and so forth when determining whether
the outside basis taxable temporary difference will reverse in the foreseeable future. Therefore, in
most cases, if a separate analysis is performed, the separate reporting entity would reach the same
conclusion in both the current and historical periods presented in the separate financial statements
as that reached by the parent regarding the corresponding periods in the consolidated financial
statements. Thus It would generally be unnecessary for the separate reporting entity to perform a
separate analysis. Example 8-6 illustrates this concept.

2
It may be appropriate in some circumstances to modify the separate-return method (see Section 8.3.1.1.1). We would not generally expect the
types of modifications to the separate-return method that are described in Section 8.3.1.1.1 to affect the applicability of the guidance in this
section to separate financial statements.

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Example 8-6

Assume that U.S. Parent (USP) owns 100 percent of U.S. Subsidiary (USS, a member of USP’s consolidated U.S.
tax return), and USS is preparing separate financial statements by using the separate-return method. Assume
further that USS owns an investment in Foreign Corporation A and A has undistributed earnings. USP has
significant cash needs on a consolidated basis and therefore cannot assert that the undistributed earnings of
A will be indefinitely reinvested, so it records a DTL in its consolidated financial statements. Even if USS could
demonstrate that, on its own, it did not (and does not) have significant cash needs in the United States, it would
record a DTL in its separate financial statements because a decision by USP to repatriate A’s undistributed
earnings to meet USP’s consolidated cash needs would result in USS’s incurring U.S. income tax (i.e., it would be
difficult to support a conclusion that USS’s outside basis taxable temporary difference on its investment in A will
not reverse in the foreseeable future given USP’s cash needs and its control over USS’s operations).

Alternatively, assume that USP has demonstrated (and continues to demonstrate) on a consolidated basis
that it does not have significant cash needs and therefore has asserted that the undistributed earnings of A
will be indefinitely reinvested. USS, on its own, did not and does not generate sufficient cash flows to meet
its debt obligations without contributions from USP. USP has historically provided and has the ability and
intent to continue providing the necessary contributions for the foreseeable future. Because USP had (and
continues to have) the ability and intent to provide funding to USS, USS would not have to record a DTL related
to its investment in A in its separate financial statements. However, USS must carefully consider the facts and
circumstances and use significant professional judgment to determine the appropriate period, if any, in which
to record the DTL in the separate financial statements.

If management believes that the facts and circumstances suggest that it is appropriate for the separate
or carve-out financial statements and the consolidated financial statements to contain different
conclusions, consultation with the company’s accounting advisers is strongly encouraged.

Regardless of the conclusions reached, disclosure would be required in the separate or carve-out
financial statements of the company’s accounting for outside basis deferred taxes on investments in
foreign corporations and joint ventures.

8.4.4.2 Current Taxes Payable or Receivable and UTBs Liability Under the

Separate-Return Method
740-10-30 (Q&A 81)
When income tax expense is allocated to the separate reporting entity under the separate-return
method and (1) such allocation results in a current income tax payable or receivable or (2) the allocation
includes an expense related to a UTB, questions can arise about whether and, if so, how such a current
payable or receivable and the UTB liability should be reflected in the balance sheet.3

A separate reporting entity to which income tax expense was allocated under the separate-return
method should initially reflect current income taxes payable and UTB liabilities in the balance sheet
in the same manner as if it had prepared a separate return. This view is premised on the facts that
(1) under U.S. federal tax law, members (corporate subsidiaries) of a consolidated filing group are
severally liable for all tax positions taken in the consolidated return and (2) while nonmembers
(unincorporated divisions, branches, or disregarded entities included in the entity’s consolidated income
tax return) are not severally liable for the current tax liability or tax positions taken in the consolidated
return because they are not regarded as separate entities for income tax purposes, the presentation
of current tax payables and UTB liabilities in the separate financial statements of nonmembers is
consistent with the separate-return method. The separate reporting entity would then derecognize
the payable or UTB liability (1) once it makes a payment (presumably to its parent under the terms of
the tax-sharing arrangement) to settle the current tax payable or UTB liability or (2) once the current

3
The concepts in this section are equally applicable to income taxes payable and receivable. However, for ease of discussion throughout the
remainder of this section, we refer only to income taxes payable.

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tax payable or UTB liability is settled by the parent directly with the taxing authority. If the current tax
payable or UTB liability is settled by the parent directly with the taxing authority, the separate reporting
entity would derecognize the liability with a corresponding entry to equity. Adjustments to the current
tax payable or UTB liability because of changes in facts and circumstances (i.e., unrelated to payment of
the obligations) would generally be accounted for in the income tax provision.

However, in circumstances in which a tax-sharing agreement exists between the separate reporting
entity and its parent or other members of the consolidated filing group (or both), we believe that it
would also be acceptable for the separate reporting entity to immediately adjust, through equity, the
recorded amount of current income taxes payable or UTB liabilities to reflect only the amount the
separate reporting entity would be required to pay (presumably to its parent). For example, a tax-sharing
agreement between a parent and a separate reporting entity that is a member (corporate subsidiary)
of the consolidated return group may specify that the member is not liable for the tax consequences of
tax positions taken in the consolidated return related to its business. The tax-sharing agreement might
also specify that the separate reporting member must reimburse the parent for income taxes paid for
an amount different from that determined by using the separate-return method. We believe that in each
scenario it would be acceptable to adjust the UTB and current taxes payable to an amount consistent
with what the separate reporting entity would ultimately have to pay (presumably to its parent) under
the tax-sharing agreement. Any such adjustment would be recorded through equity.

8.4.4.3 DTAs Related to Tax Attributes Under the Separate-Return Method

740-10-30 (Q&A 78)
The operations of a separate or carve-out entity may result in tax credits or NOLs in a particular
year. Had the separate or carve-out entity filed its own tax return, it may not have been able to use
the tax credits in the year in which they were generated. In these circumstances, NOL and tax credit
carryforwards (tax attributes) could result.

Under the separate-return method, the separate or carve-out entity would recognize DTAs associated
with the tax attributes (carryforwards) and evaluate them for realizability. The DTA would be assessed for
realizability on the basis of positive and negative evidence related to the operations of only the separate
or carve-out entity.

These tax attributes may be realized in the income tax return of the consolidated filing group (to offset
taxable income from other operations included in the consolidated filing group) in a period before
they would have been used by the separate or carve-out entity solely on the basis of the separate or
carve-out entity’s operations. Therefore, the tax attributes generated by the separate or carve-out
entity would no longer be available to reduce future taxable income of either the consolidated filing
group or the separate or carve-out entity. In these situations, the tax attribute carryforwards represent
“hypothetical DTAs” in the separate or carve-out financial statements because they no longer legally exist
within the consolidated filing group; however, if the separate or carve-out entity had filed its own tax
return, the tax attributes would be available.

Generally, two approaches exist for accounting for hypothetical DTAs related to tax attribute
carryforwards, but an entity should choose and apply one consistently.

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Under the first approach, the balance sheet of the separate or carve-out financial statements would
reflect the “tax return reality” that, since the tax attribute does not legally exist, it cannot be used in
future periods to offset taxable income (i.e., it has been, in effect, distributed to and used by the parent
and, accordingly, should be reversed through equity). Under this approach, the deferred tax benefit
associated with the tax attributes would still be recognized in the income statement of the separate
or carve-out financial statements (as long as no valuation allowance was needed in the separate or
carve-out financial statements).

In subsequent years, the entity must continue assessing its ability to realize the benefit of the
hypothetical DTA on the basis of the positive and negative evidence associated with its stand-alone
operations (even though it does not continue to record the hypothetical DTA in the balance sheet).
Changes in the measurement of the hypothetical DTA would be effected through an entry to deferred
tax expense (or benefit) in the income statement of the separate or carve-out financial statements with
an offsetting entry in APIC. Subsequent accounting is also an accounting policy election that should be
applied consistently.

In addition, the separate company would be required to disclose the following:

• The reasons why the hypothetical DTA was not recorded.

• The possible effects on future tax provisions related to future changes in the realizability of the
unrecorded hypothetical DTA.

Under the second approach, we believe that it would be acceptable to present the hypothetical DTA in
the balance sheet of the separate financial statements. This view is premised on the fact that, under the
separate-return method, income taxes are allocated to the separate financial statements in accordance
with ASC 740 as if the separate reporting entity had filed a separate tax return. If it had, the hypothetical
DTA could not have been used by any other entity and thus would be presumed to continue to exist.

However, this second approach would not be appropriate if the separate or carve-out entity would not
have been able to recognize the benefit of the tax attribute on a separate-return basis but has recorded
a DTA and corresponding benefit after modifying the separate-return method to take into consideration
realizability of the attribute within the consolidated filing group (see Section 8.3.1.1.1 for further
discussion of modifying the separate-return method for realizability). In that situation, once the parent
has used the tax attribute, realization has occurred in a manner consistent with the initial conclusion
about the recognition of the attribute in the separate financial statements (i.e., it was recognized only
because it could be used by the consolidated filing group), and the DTA should be derecognized.

If a hypothetical DTA is recorded in the separate or carve-out financial statements, the separate or
carve-out entity should disclose the fact that the DTA does not legally exist and would be derecognized if
the entity were to leave the consolidated tax return filing group.

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Example 8-7

Technology Co., an SEC registrant, is a U.S. software company with a March 31 year-end. Technology Co. has
a software services division (“the Division”) for which it is preparing separate financial statements that will be
included in a registration statement. The operations of the Division are included in the U.S. federal consolidated
income tax return of Technology Co. Technology Co. will apply the separate-return method to allocate income
taxes to the separate financial statements of the Division.

The Division has been in operation for one year and was profitable on a stand-alone pretax basis, but it
generated a tax loss because of accelerated depreciation. The loss was used by Technology Co. to reduce
consolidated taxable income in the year in which it was generated.

In applying the separate-return method, management has determined that the tax loss of the Division would
have resulted in an NOL carryforward of $5 million. Therefore, the NOL carryforward represents a hypothetical
DTA because it exists under the separate-return method, but it does not legally exist since it has already been
used by Technology Co. in its consolidated income tax return. Management also evaluated the positive and
negative evidence associated with the Division’s operations and concluded that it is more likely than not that
the Division will have sufficient future taxable income (on a stand-alone basis) to realize the benefit of the
hypothetical DTA. Because the separate-return method is used for allocation of income taxes to the Division,
Technology Co. may choose whether to record the hypothetical DTA in the Division’s separate balance sheet.
If Technology Co. elects to record the hypothetical DTA, it would record the following entry in the Division’s
separate financial statements:

NOL DTA 1.1 million

Deferred tax benefit 1.1 million
[5 million NOL carryforward × 21% tax rate]
If it elects not to record the hypothetical DTA, it would record the following entries:
NOL DTA 1.1 million
Deferred tax benefit 1.1 million
Retained earnings 1.1 million
NOL DTA 1.1 million

In either case, management is still required to evaluate in subsequent years whether the benefit associated
with the hypothetical DTA continues to be realizable. If, in a future year, management determines that the
hypothetical DTA is no longer realizable, it must record a deferred tax expense and a credit to a valuation
allowance (if the hypothetical DTA was recorded) or to equity (if the hypothetical DTA was not recorded).

8.5 Valuation Allowance in Separate or Carve-Out Financial Statements

740-10-30 (Q&A 54)
See Chapter 5 for a general discussion of valuation allowances under ASC 740. The manner in which
valuation allowances are accounted for in separate or carve-out financial statements depends on
whether income taxes are allocated by using the separate-return or the parent-company-down method
(see Section 8.3 for further discussion of each method):

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8.5.1 Separate-Return Method
If the separate-return method is used to allocate taxes in separate or carve-out financial statements, the
separate or carve-out entity’s DTAs should be assessed for realizability on the basis of available evidence
related to only the operations of the separate or carve-out entity. Therefore, if that entity has negative
evidence (e.g., cumulative losses in recent years), it would be difficult to support a conclusion that a
valuation allowance is not necessary, irrespective of the available evidence at the consolidated group
level (e.g., a history of profitable operations of the consolidated filing group level).

8.5.2 Parent-Company-Down Method
If the parent-company-down method is used to allocate taxes in separate or carve-out financial
statements, the determination of the need for a valuation allowance in the separate or carve-out
financial statements depends on whether a valuation allowance was recognized in the consolidated
financial statements. In other words, if a valuation allowance is required at the parent-company level,
a valuation allowance is also required in the financial statements of the stand-alone group member.
If no valuation allowance is necessary at the parent-company level, no valuation allowance should be
provided in the separate or carve-out financial statements.

8.6 Change in Status of the Separate Reporting Entity

Many circumstances can arise that result in the initial recognition or derecognition of current and
deferred income taxes in separate or carve-out financial statements. See Section 3.5.2 for a general
discussion of an entity’s accounting for a change in status and Sections 11.2.2 and 11.7.4.2 for a
discussion of recognition and derecognition of income taxes in predecessor and successor financial
statements (which may be separate or carve-out financial statements) and separate financial statements
of an acquiree.

8.7 Disclosures Required in the Separate Financial Statements of a Member

of a Consolidated Tax Return
740-10-50 (Q&A 27)

ASC 740-10

50-17 An entity that is a member of a group that files a consolidated tax return shall disclose in its separately
issued financial statements:
a. The aggregate amount of current and deferred tax expense for each statement of earnings presented
and the amount of any tax-related balances due to or from affiliates as of the date of each statement of
financial position presented
b. The principal provisions of the method by which the consolidated amount of current and deferred
tax expense is allocated to members of the group and the nature and effect of any changes in that
method (and in determining related balances to or from affiliates) during the years for which the above
disclosures are presented.

Pending Content (Transition Guidance: ASC 740-10-65-8)

50-17A An entity that is both not subject to tax and disregarded by the taxing authority that elects to
include the allocated amount of current and deferred tax expense in its separately issued financial
statements in accordance with paragraph 740-10-30-27A shall disclose that fact and provide the
disclosures required by paragraph 740-10-50-17.

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For general disclosure requirements related to the accounting for income taxes, see Chapter 14.
ASC 740-10-50-17 contains disclosure requirements specific to separate financial statements of a
member of a consolidated filing group.

Changing Lanes
The Board issued ASU 2019-12 in December 2019 (discussed in Section 8.2.4), adding ASC
740-10-50-17A, which requires an entity that is not subject to tax and is disregarded by the
taxing authority to disclose that an allocation of income taxes has been made in the separate
financial statements.

For more information on ASU 2019-12, see Appendix B.

8.7.1 Disclosures in Separate or Carve-out Financial Statements to Be

Included in a Filing With the SEC
The disclosures required by ASC 740-10-50-17 help financial statement users understand how current
and deferred income taxes were allocated, as required by ASC 740-10-30-27, to a member in its
separate financial statements. The disclosures also help inform users about how that allocation method
differs, if at all, from the terms of any tax-sharing agreements of the member, its parent, and its affiliates.

However, as SAB Topic 1.B.1 states, the disclosures do not provide information needed to help financial
statement users understand “what the effect on income would have been if the registrant had not been
eligible to be included in a consolidated income tax return with its parent.” For example, the disclosures
required by ASC 740-10-50-17 do not describe either the (1) nature of DTAs and DTLs, NOLs, and tax
credit carryforwards or (2) uncertain tax positions of the consolidated return group that are attributable
to the assets, liabilities, operations, and tax positions of the member.

Therefore, while it is not clear in ASC 740-10-50-17, we believe that the separate financial statements
of a member that will be included in a filing with the SEC should generally provide the disclosures
required by ASC 740-10-50-17 in addition to the disclosures required by ASC 740-10-50-2 through 50-16,
particularly in situations in which a method other than the parent-company-down approach is used to
compute the tax allocation included in the financial statements. We believe that the same is true for
carve-out financial statements that will be included in a filing with the SEC.

In addition, as discussed in Section 8.3.2, a pro forma income statement reflecting a tax provision
calculated on a separate-return basis is required if the separate or carve-out financial statements
include an allocation of current and deferred income taxes that uses a method other than the separate-
return method.

8.7.2 Disclosures in Separate or Carve-Out Financial Statements That Will

Not Be Included in a Filing With the SEC
If a member’s separate or carve-out financial statements will not be included in a filing with the SEC, the
disclosures required by ASC 740-10-50-17 may be provided in lieu of those required by ASC 740-10-
50-2 through 50-16. However, we do not believe that this is preferable for the reasons discussed
above. Further, such financial statements may need to provide income tax disclosures other than those
specifically required by ASC 740-10-50-17 when, for example, income tax matters affecting a member or
carve-out entity are critical to users’ understanding of the financial statements. The circumstances under
which additional disclosures should be provided in such financial statements are a matter of judgment,
and consultation with accounting advisers is recommended.

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If the separate financial statements are those of a single-member LLC and no allocation of income taxes
has been made, the single-member LLC should disclose that fact in the notes to the separate financial
statements and the reasons why.

8.7.3 Disclosures in Abbreviated Separate or Carve-Out Financial Statements

See Section 8.2.5 of this Roadmap, Section 5.2.4 of Deloitte’s A Roadmap to Accounting and Financial
Reporting for Carve-Out Transactions, and Section 1.5 of Deloitte’s A Roadmap to SEC Reporting
Considerations for Business Combinations for further discussion of when abbreviated financial
statements may be appropriate.

When abbreviated separate or carve-out financial statements of a business acquired or to be acquired

are prepared with no income tax allocation, an entity should disclose in the footnotes to the historical
abbreviated statements that no allocation of income tax has been made. It may also be appropriate
to include an explanatory paragraph in the independent accountant’s report that (1) indicates that no
income tax expense or benefit has been recognized in the statement of revenues and expenses and
(2) provides a reference to the appropriate footnote that further discusses the matter.

8.7.4 Disclosures Associated With Attributes (i.e., NOL or Tax Credit

Carryforwards) in Separate or Carve-Out Financial Statements
See Section 8.4.4.3 for a discussion of appropriate disclosures in separate or carve-out financial
statements associated with attributes (i.e., NOL or tax credit carryforwards) that result from the
operations of the separate or carve-out entity.

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9.1 Overview
The primary objective of ASC 830, which provides guidance on foreign currency matters, is for reporting
entities to present their consolidated financial statements as though they are the financial statements of
a single entity. Therefore, if a reporting entity operates in more than one currency environment, it must
translate the financial results of those operations into a single currency (referred to as the reporting
currency). However, this process should not affect the financial results and relationships that were
created in the economic environment of those operations.

In accordance with the primary objective of ASC 830, a reporting entity must use a “functional currency
approach” in which all transactions are first measured in the currency of the primary economic
environment in which the reporting entity operates (i.e., the functional currency) and then translated
into the reporting currency.

In preparing consolidated financial statements as though they are the financial statements of a single
entity, an entity has essentially three currencies to consider:

• Local currency (abbreviated in examples below as “LC” in references to specific currency amounts) —
Generally the currency of the country in which the entity operates, it is also the currency in
which the financial statements are maintained for local reporting purposes and is commonly,
but not always, the currency in which an entity files its tax returns.

• Functional currency (abbreviated in examples below as “FC” in references to specific currency

amounts) — The ASC master glossary states that “[a]n entity’s functional currency is the currency
of the primary economic environment in which the entity operates; normally, that is the currency
of the environment in which an entity primarily generates and expends cash” from its activities. It
is also commonly, but not necessarily, the local currency.

• Reporting currency (abbreviated in examples below as “RC” in references to specific currency

amounts) — This is the currency in which the financial statements of the reporting group are
prepared for consolidated financial reporting purposes.

Local currency amounts are remeasured into functional currency, and functional currency amounts are
translated into the reporting currency in accordance with the guidance in ASC 830, as discussed in more
detail below.

See Deloitte’s A Roadmap to Foreign Currency Transactions and Translations for a detailed discussion of
foreign currency matters.

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ASC 830-740

05-1 Topic 740 addresses the majority of differences between the financial reporting (or book) basis and tax
basis of assets and liabilities (basis differences).

05-2 This Subtopic addresses the accounting for specific types of basis differences for entities operating in
foreign countries. The accounting addressed in this Subtopic is limited to the deferred tax accounting for
changes in tax or financial reporting bases due to their restatement under the requirements of tax laws or
generally accepted accounting principles (GAAP) in the United States. These changes arise from tax or financial
reporting basis changes caused by any of the following:
a. Changes in an entity’s functional currency
b. Price-level related changes
c. A foreign entity’s functional currency being different from its local currency.
This Subtopic addresses whether these changes, which can affect the amount of basis differences, result in
recognition of changes to deferred tax assets or liabilities.

Overall Guidance
15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic, see
Section 830-10-15, with specific qualifications noted below.

Entities
15-2 The guidance in this Subtopic applies to all entities operating in foreign countries.

Transactions
15-3 The guidance in this Subtopic applies to certain specified deferred tax accounting matters, specifically to
the income tax consequences of changes to tax or financial reporting bases from their restatements caused by:
a. Changes in an entity’s functional currency
b. Price-level related changes
c. A foreign entity’s functional currency being different from its local currency.

Remeasurement Changes Causing Deferred Tax Recognition

25-1 This Section addresses basis differences that result from remeasurement of assets and liabilities due to
changes in functional currency and price levels. These remeasurement changes will often affect the amount of
temporary differences for which deferred taxes are recognized.

Functional Currency Related Changes

25-2 Subtopic 830-30 requires that a change in functional currency from the reporting currency to the local
currency when an economy ceases to be considered highly inflationary shall be accounted for by establishing
new functional currency bases for nonmonetary items. Those bases are computed by translating the historical
reporting currency amounts of nonmonetary items into the local currency at current exchange rates.

Pending Content (Transition Guidance: ASC 105-10-65-6)

25-2 Subtopic 830-10 requires that a change in functional currency from the reporting currency to the
local currency when an economy ceases to be considered highly inflationary shall be accounted for
by establishing new functional currency bases for nonmonetary items. Those bases are computed by
translating the historical reporting currency amounts of nonmonetary items into the local currency at
current exchange rates.

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ASC 830-740 (continued)

25-3 As a result of applying those requirements, the functional currency bases generally will exceed the local
currency tax bases of nonmonetary items. The differences between the new functional currency bases and
the tax bases represent temporary differences under Subtopic 740-10, for which deferred taxes shall be
recognized. Paragraph 830-740-45-2 addresses the presentation of the effect of recognizing these deferred
taxes.

Price-Level Related Changes

25-4 Entities located in countries with highly inflationary economies may prepare financial statements restated
for general price-level changes in accordance with generally accepted accounting principles (GAAP) in the
United States. The tax bases of assets and liabilities of those entities are often restated for the effects of
inflation.

25-5 When preparing financial statements restated for general price-level changes using end-of-current-year
purchasing power units, temporary differences are determined based on the difference between the indexed
tax basis amount of the asset or liability and the related price-level restated amount reported in the financial
statements. Example 1 (see paragraph 830-740-55-1) illustrates the application of this guidance.

Inside Basis Differences Within Foreign Subsidiaries That Meet the Indefinite Reversal Criterion
25-6 Temporary differences within an entity’s foreign subsidiaries are referred to as inside basis differences.
Differences between the tax basis and the financial reporting basis of an investment in a foreign subsidiary are
referred to as outside basis differences.

25-7 Inside basis differences of a foreign subsidiary of a U.S. parent where the local currency is the functional
currency may result from foreign laws that provide for the occasional restatement of fixed assets for tax
purposes to compensate for the effects of inflation. The amount that offsets the increase in the tax basis of
fixed assets is sometimes described as a credit to revaluation surplus, which some view as a component of
equity for tax purposes. That amount becomes taxable in certain situations, such as in the event of a liquidation
of the foreign subsidiary or if the earnings associated with the revaluation surplus are distributed. In this
situation, it is assumed that no mechanisms are available under the tax law to avoid eventual treatment of the
revaluation surplus as taxable income. The indefinite reversal criteria of Subtopic 740-30 shall not be applied
to inside basis differences of a foreign subsidiary, as indicated in paragraph 740-30-25-17, and a deferred tax
liability shall be provided on the amount of the revaluation surplus.

25-8 Paragraph 740-10-25-24 indicates that some temporary differences are deferred taxable income and
have balances only on the income tax balance sheet. Therefore, these differences cannot be identified with a
particular asset or liability for financial reporting purposes. Because the inside basis difference related to the
revaluation surplus results in taxable amounts in future years based on the provisions of the foreign tax law,
it qualifies as a temporary difference even though it may be characterized as a component of equity for tax
purposes. Subtopic 740-30 clearly limits the indefinite reversal criterion to the temporary differences described
in paragraph 740-10-25-3(a) and shall not be applied to analogous types of temporary differences.

Remeasurement Changes Not Resulting in Deferred Tax Recognition

25-9 Some remeasurement-caused changes in basis differences do not result in recognition of deferred taxes.

25-10 As indicated in paragraph 740-10-25-3(f), recognition is prohibited for a deferred tax liability or asset for
differences related to assets and liabilities that, under the requirements of Subtopic 830-10, are remeasured
from the local currency into the functional currency using historical exchange rates and that result from
changes in exchange rates or indexing for tax purposes.

25-11 Paragraph 830-10-45-16 provides additional guidance on accounting for the eventual recognition of
indexing related deferred tax benefits after an entity’s functional currency changes from the foreign currency to
the reporting currency because the foreign economy becomes highly inflationary.

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ASC 830-740 (continued)

Foreign Financial Statements Restated for General Price Level Changes

30-1 In foreign financial statements that are restated for general price-level changes, the deferred tax expense
or benefit shall be calculated as the difference between the following two measures:
a. Deferred tax assets and liabilities reported at the end of the current year, determined in accordance
with paragraph 830-740-25-5
b. Deferred tax assets and liabilities reported at the end of the prior year, remeasured to units of current
general purchasing power at the end of the current year.

30-2 The remeasurement of deferred tax assets and liabilities at the end of the prior year is reported together
with the remeasurement of all other assets and liabilities as a restatement of beginning equity.

30-3 Example 1 (see paragraph 830-740-55-1) illustrates the application of this guidance.

45-1 As indicated in paragraph 830-20-45-3, when the reporting currency (not the foreign currency) is the
functional currency, remeasurement of an entity’s deferred foreign tax liability or asset after a change in the
exchange rate will result in a transaction gain or loss that is recognized currently in determining net income.
Paragraph 830-20-45-1 requires disclosure of the aggregate transaction gain or loss included in determining
net income but does not specify how to display that transaction gain or loss or its components for financial
reporting. Accordingly, a transaction gain or loss that results from remeasuring a deferred foreign tax liability
or asset may be included in the reported amount of deferred tax benefit or expense if that presentation is
considered to be more useful. If reported in that manner, that transaction gain or loss is still included in the
aggregate transaction gain or loss for the period to be disclosed as required by that paragraph.

45-2 The deferred taxes associated with the temporary differences that arise from a change in functional
currency discussed in paragraph 830-740-25-3 when an economy ceases to be considered highly inflationary
shall be presented as an adjustment to the cumulative translation adjustments component of shareholders’
equity and therefore shall be recognized in other comprehensive income.

Related Implementation Guidance and Illustrations

• Example 1: Illustration of Foreign Financial Statements Restated for General Price-Level Changes
[ASC 830-740-55-1].

9.2 Remeasurement
An entity’s functional currency is determined by considering each of the economic factors in ASC 830-10-55.
After considering these factors, management may determine that an entity’s functional currency is the
currency of the jurisdiction in which the entity operates (i.e., the local currency). Management may also
conclude, on the basis of the facts and circumstances, that the functional currency is that of another
jurisdiction (e.g., a U.K. subsidiary of a U.S. parent might have a local currency of pounds sterling, a
functional currency of euros, and a reporting currency of U.S. dollars).

Each balance sheet and income statement account must be measured in an entity’s functional currency
for financial reporting purposes. Therefore, if an asset or liability or transaction is denominated in a
currency other than the functional currency (e.g., local currency), it must be remeasured from that
currency into the functional currency. In addition, if an entity’s books and records are not maintained in
the functional currency, the entity must remeasure each balance sheet and income statement account
into the functional currency. Therefore, an entity’s book basis in an asset or liability is also established in
its functional currency.

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ASC 830 provides the following guidance on the rate to be used in remeasuring local currency balance
sheet and income statement amounts:

Description Exchange Rate

Monetary assets and liabilities Current exchange rate

Nonmonetary assets and liabilities Historical exchange rate

Revenue and expense items Weighted-average or historical exchange rate

Remeasurement of various balance sheet and income statement items by using different exchange
rates will generally cause the balance sheet to not balance; unlike the translation adjustment, the
adjustment required to bring the balance sheet into balance is usually recorded through the income
statement as a remeasurement gain or loss, or often referred to as a transaction gain or loss.

Regardless of an entity’s functional currency for financial reporting purposes, its tax return is generally
prepared in the local currency. Therefore, an entity’s tax basis in an asset or liability is also typically
established in the local currency. As a result, the remeasurement gains and losses noted above generally
never enter into the tax computation in the local jurisdiction and, hence, represent a permanent
difference, as discussed in more detail below.

Example 9-1

Remeasurement — Monetary
Entity S is a foreign subsidiary of Entity X. The functional currency (FC) of S is the euro, which is not the local
currency (LC). Assume the following:

• On January 1, 20X1, S obtains a 500,000 LC loan from a third party (i.e., monetary liability) when the
exchange rate is 1 LC to 1 FC.
• Entity S’s tax basis in the loan is 500,000 LC on January 1, 20X1.
• On December 31, 20X2, the exchange rate is 1 LC to 2 FC.
• For simplicity, assume that the liability balance has not changed.
On December 31, 20X2, S remeasures the liability from its local-currency-denominated value of 500,000 LC
to 1 million FC. The remeasured value results in an unrealized pretax remeasurement loss of 500,000 FC
for financial reporting purposes. However, there is no change in book/tax basis difference since the amount
required to settle the liability (500,000 LC = 1 million FC ÷ 2) and the tax basis (500,000 LC) has not changed.
Therefore, although the fluctuations in the exchange rate resulted in a pretax loss for financial reporting
purposes, S would not record any deferred taxes (i.e., remeasurement loss represents a permanent item since
it is not deductible for income tax reporting purposes).

Connecting the Dots

Because the tax return is generally prepared in the local currency (and taxable income therefore
is determined in the local currency), an entity must also calculate the temporary differences in
the local currency to determine the amount that will ultimately result in an increase or decrease
to taxes payable in future years.

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The inherent assumption in ASC 740 regarding the accounting for temporary differences is that assets
will be recovered and liabilities will be settled at their respective book basis, which is determined in the
entity’s functional currency. Therefore, if the functional currency is different from the local currency,
changes in the exchange rate will also change the amount of local currency revenues necessary to
recover or settle the book basis of an asset or liability; however, the local currency tax basis will not have
changed. In addition, because temporary differences (i.e., the deductible/taxable difference between the
book basis and tax basis) must be determined in the local currency, fluctuations in exchanges will affect
the book basis of an asset or liability when calculated in the local currency.

The income tax accounting for nonmonetary and monetary assets and liabilities is discussed in further
detail in the sections below.

9.2.1 Nonmonetary Assets and Liabilities

740-10-25 (Q&A 06)
When the functional currency is not the local currency, an entity is required to remeasure nonmonetary
assets and liabilities (e.g., PP&E) from the local currency into the functional currency by using the
historical exchange rate (i.e., the exchange rate that was in effect when the transaction was executed).
By using the historical exchange rate to remeasure nonmonetary assets and liabilities, the entity
achieves the same result it would have achieved had it entered into the related transactions in its
functional currency. Therefore, fluctuations in exchange rates will neither increase nor decrease the
carrying amount of nonmonetary assets and liabilities (and will not give rise to remeasurement gains
and losses for financial reporting purposes).

Under ASC 740, it is assumed that assets will be recovered and liabilities will be settled at their
respective financial reporting carrying amounts. Therefore, if the exchange rate changes after a
nonmonetary asset or liability is acquired or incurred, respectively, the amount of local currency needed
to recover the asset or settle the liability will also change. However, the tax basis of the asset or liability
will not change because it would have been established when the asset was acquired or the liability was
incurred (in the local currency). Therefore, changes in the exchange rate result in a difference between
the amount of local currency needed to recover the functional-currency-denominated carrying value
and the local currency tax basis.

ASC 740-10-25-3(f) prohibits “recognition of a deferred tax liability or asset for differences related to
assets and liabilities that, under Subtopic 830-10, are remeasured from the local currency into the
functional currency using historical exchange rates and that result from changes in exchange rates or
indexing for tax purposes.” In other words, deferred taxes are not recorded for basis differences related
to nonmonetary assets and liabilities that result from changes in exchange rates.

Although this basis difference technically meets the definition of a temporary difference under ASC 740,
the FASB concluded that accounting for it as a temporary difference would result in the recognition of
deferred taxes on exchange gains and losses that are not recognized in the income statement under
ASC 830. For this reason, the FASB decided to prohibit recognition of the deferred tax consequences for
those differences.

However, entities are still required to record deferred taxes for differences between the local currency
tax basis and the local currency book basis that do not arise from changes in exchange rates or indexing
for tax purposes (e.g., when a nonmonetary asset is depreciated over different periods or at different
rates for book and tax purposes). The deferred taxes for these types of basis differences are determined
in the local currency and then remeasured into the functional currency at the spot rate. See Example
9-3 for an illustration of this concept.

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Example 9-2

Temporary Differences Not Recognized Under ASC 740

Entity S is a foreign subsidiary of Entity P. The FC of S is USD, which is not the LC. Assume the following:

• On January 1, 20X1, S purchases a piece of equipment for 500,000 LC when the exchange rate is 1 USD
to 1.25 LC (i.e., FC book basis is 400,000 USD).
• The equipment is depreciable on a straight-line basis over 10 years for both financial reporting and tax
purposes.
• The foreign tax basis and book basis in the asset is 500,000 LC (the amount paid to acquire the asset).
Therefore, no temporary difference exists at the time of purchase.
• The exchange rate on December 31, 20X1, is 1 USD to 1.5 LC.
• The tax rate in S’s jurisdiction is 30 percent.
In this example, if S were to sell the equipment for its functional currency book basis of $360,000 ($400,000
historical cost less $40,000 of accumulated depreciation) as of December 31, 20X1, S would not recognize any
book gain or loss in its functional currency financial statements. However, S would realize a taxable gain of
90,000 LC in its local tax return, as illustrated in the following table:

Financial-reporting carrying value of the

equipment 360,000 USD

Spot rate on December 31, 20X1 1.5

Hypothetical sale proceeds 540,000 LC

Tax basis 450,000 LC*

Taxable gain (loss) 90,000 LC

* $500,000 of tax basis less $50,000 of accumulated depreciation
($500,000 ÷ 10 years).

The difference between the local-currency-denominated hypothetical sale proceeds and the tax basis meets
the definition of a temporary difference. However, because ASC 740-10-25-3(f) prohibits the recognition of
deferred taxes associated with differences related to nonmonetary assets and liabilities that are caused by
changes in the exchange rate, S should not record deferred taxes for the 90,000 LC basis difference.

In this example, there are no other differences between the local currency book basis and the local currency
tax basis of the equipment that would give rise to deferred taxes.

Example 9-3

Temporary Differences Recognized Under ASC 740

Assume the same facts as in Example 9-2 above, except:

• The equipment is depreciated over five years for tax purposes.

• The weighted-average exchange rate during 20X1 is 1 USD to 1.35 LC.

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Example 9-3 (continued)

As of December 31, 20X1, Entity S measures the deferred taxes related to the equipment, as illustrated in the
following table (all amounts are in local currency):

Temporary
Book Tax Difference DTA (DTL)
Basis as of January 1, 20X1 500,000 500,000 — —
20X1 depreciation expense 50,000 100,000
Basis as of December 31, 20X1 450,000 400,000 (50,000) (15,000)

As indicated above, S recognizes a DTL of 15,000 LC (30% of 50,000 LC) as of December 31, 20X1, related to the
equipment for the difference between the local currency book basis and local currency tax basis caused by the
difference in depreciation methods. The DTL is then remeasured into the functional currency at the reporting-
date spot rate. In addition, S recognizes a deferred tax expense of 15,000 LC in 20X1 as a result of the increase
in the DTL, which is then remeasured into the functional currency at the weighted-average exchange rate in
effect during 20X1. The difference between these two amounts results in a foreign currency transaction gain
during 20X1, as illustrated in the following table:

Exchange Transaction
LC Rate FC Gain
Beginning-of-year DTL at beginning-of-year
rate — 1.25 —
Beginning-of-year DTL at end-of-year rate — 1.5 —
Foreign currency transaction gain (loss) —

Deferred tax expense at weighted-average

rate (15,000) 1.35 (11,111)
Deferred tax expense at end-of-year rate (15,000) 1.5 (10,000)
Foreign currency transaction gain (loss) 1,111

Total foreign currency transaction gain

(loss) 1,111

In accordance with ASC 830-740-45-1, S may present the transaction gain as a deferred tax benefit (as opposed
to a transaction gain above the line) if that presentation is considered more useful. If the transaction gain is
reported in that manner, it would still be included in the aggregate transaction gain or loss for the period to be
disclosed as required by ASC 830-20-45-1.

9.2.2 Indexing of the Tax Basis

740-10-25 (Q&A 04)
In addition to fluctuations in the exchange rate, basis differences may arise for nonmonetary assets and
liabilities as a result of indexing that is permitted or required under the local tax law. Specifically, certain
countries (especially those with economies that are considered highly inflationary) may permit or require
taxpayers to adjust the tax basis of an asset or liability to take into account the effects of inflation. The
inflation-adjusted tax basis of an asset or liability would be used to determine the future taxable or
deductible amounts.

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ASC 740-10-25-3(f) prohibits the recognition of a DTL or DTA for tax consequences of “differences
related to assets and liabilities that, under the requirements of Subtopic 830-10, are remeasured from
the local currency into the functional currency using historical exchange rates and that result from
changes in exchange rates or indexing for tax purposes” (emphasis added).

As discussed in Section 9.2, under ASC 830, assets and liabilities are remeasured when the local
currency and the functional currency are not the same. The exception in ASC 740-10-25-3(f) applies
only with respect to nonmonetary assets and liabilities when the parent remeasures the foreign
entity’s financial statements from the local currency into the functional currency (i.e., by using historical
exchange rates). DTAs and DTLs are considered to be monetary assets and liabilities,1 and therefore, the
prohibition in ASC 740-10-25-3(f) would not apply to the indexation of NOL carryforwards, if permitted.
If the foreign entity’s local currency is the functional currency (i.e., subject to translation rather than
remeasurement), the guidance in ASC 740-10-25-3(f) does not apply. The foreign entity would recognize
the deferred tax effects of any indexing, and the parent would then translate the resulting deferred
taxes into the reporting currency. Example 9-4 below illustrates this concept.

Example 9-4

Assume that X, an entity reporting under U.S. GAAP in USD, has operations in a foreign country in which the
local currency is the functional currency. At the beginning of 20X2, the foreign jurisdiction enacts tax legislation
that increases the tax basis of depreciable assets by 10 percent. That increase will permit X to deduct additional
depreciation in current and future years. Further assume that X is subject to the guidance in ASC 740 and that,
at the end of 20X1, the basis of depreciable assets is 1,000 FC units for tax and financial reporting purposes;
the foreign tax rate is 50 percent; and the current exchange rate between the foreign currency and the USD is
2 FC to $1.

Under ASC 740, X would establish a DTA on the enactment date. The DTA is measured in accordance with
foreign tax law and is determined on the basis of the deductible temporary difference between the financial
reporting basis of the asset (1,000 FC) and the indexed tax basis (1,100 FC). Thus, at the beginning of 20X2, X
would record a DTA of 50 FC ([1,100 – 1,000] × 50%) in the foreign currency books of record. That DTA would
be translated as $25 (50 FC × 0.5) on the basis of the current exchange rate.

9.2.3 Monetary Assets and Liabilities When the Reporting Currency Is the

Functional Currency
740-10-25 (Q&A 71)
As stated above, the exception in ASC 740-10-25-3(f) does not apply to assets and liabilities that are
remeasured by using current exchange rates (referred to as “monetary assets and liabilities”). However,
when a foreign entity’s functional currency is different from the local currency (e.g., the functional
currency is the reporting currency of its parent), the foreign entity’s deferred tax accounting for
monetary assets and liabilities depends on whether the asset or liability is denominated in the local
currency or the reporting currency.

9.2.3.1 Local-Currency-Denominated Monetary Assets and Liabilities

When a monetary asset or liability is denominated in an entity’s local currency, it must be remeasured
into the entity’s functional currency each period by using the current exchange rate for financial
reporting purposes. Therefore, when the reporting currency is the functional currency, monetary assets
and liabilities denominated in the local currency must be remeasured into the reporting currency at
the then-current exchange rate. Fluctuations in the exchange rate between the local currency and the
reporting currency will result in (1) changes in the financial-reporting carrying value of the monetary
asset or liability and (2) transaction gains and losses for financial reporting purposes.

1
Paragraph 54 of FASB Statement 52 (not codified).

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However, although a pretax gain or loss is recognized for financial reporting purposes, there will be no
current or deferred tax expense or benefit. This is because the exchange rate fluctuations will not result
in taxable income or loss when the asset is recovered or the liability is settled since the local currency
is used to determine taxable income (i.e., those gains and losses exist only when the asset or liability
is measured in the reporting currency). Further, these exchange rate fluctuations do not contribute to
any difference between the book and tax basis of the asset or liability when the book basis is measured
in the local currency. Therefore, there are no current or deferred tax consequences related to the
transaction gains and losses. Thus, such gains or losses will be permanent items that affect the ETR (i.e.,
pretax income or loss with no related tax expense or benefit).

Example 9-5

Local-Currency-Denominated Debt
Entity A, a foreign entity located in Canada, has a U.S. parent that uses the USD as its reporting currency. In
accordance with ASC 830, A determines that its functional currency is the reporting currency of its parent (USD)
and not the local currency, the Canadian dollar (CAD). On September 30, 20X5, A obtains a loan for CAD 100
million from its U.S. parent when the exchange rate is USD 1 to CAD 1.25. The exchange rate on December 31,
20X5, is USD 1 to CAD 1.33.

On September 30, 20X5, the date of the borrowing, A records the loan at its USD-equivalent value of USD 80
million (CAD 100 million ÷ 1.25). Entity A’s tax basis in the borrowing is the initial amount borrowed of CAD 100
million (i.e., the tax basis is the local-currency-denominated amount).

On December 31, 20X5, A remeasures the liability from its local-currency-denominated value of CAD 100 million
into USD by using the exchange rate in effect on that date. The remeasured value of USD 75 million (CAD 100
million ÷ 1.33) results in an unrealized pretax transaction gain of USD 5 million for financial reporting purposes,
which is the difference between the financial-statement carrying value (in USD) on September 30, 20X5, and
that on December 31, 20X5.

However, on December 31, 20X5, there is no unrealized gain for tax purposes because there is no difference
between the amount required to settle the liability (CAD 100 million) and the tax basis of the liability (CAD 100
million). Since taxable income is determined by using CAD and the loan is denominated in CAD, the balance is
unchanged from its original tax basis of CAD 100 million and there is no unrealized gain for tax corresponding
to the gain for financial reporting. Therefore, although the fluctuation in the exchange rate resulted in a pretax
gain for financial reporting purposes, A would not record any deferred taxes.

Observation
As discussed above, A will have pretax gain or loss on a separate-company basis but will not have any
corresponding tax expense or benefit. On a consolidated basis, because the loan is denominated in CAD,
there will be an equal and offsetting pretax gain or loss for the U.S. parent. So, on a consolidated basis, there
will be no net pretax gain or loss. While such a pretax gain or loss will not have any tax effects for A (since A’s
tax return is filed in CAD), there will be a tax effect related to the U.S. parent’s pretax amount since the parent
uses USD in filing its tax return. The U.S. parent will have a deferred tax effect related to the CAD-denominated
loan since the USD amount required to settle the loan fluctuates from the tax basis of the liability (the USD
equivalent of the CAD 100 million when the loan is entered into). In summary, there will be no pretax gain or
loss on a consolidated basis (there are equal and offsetting pretax amounts) and no Canadian tax effect for A;
however, there will be a tax effect for the U.S. parent, which will affect the ETR.

9.2.3.2 Reporting-Currency-Denominated Monetary Assets and Liabilities

Unlike the local-currency-denominated monetary assets and liabilities discussed above, monetary assets
or liabilities denominated in an entity’s reporting currency do not need to be remeasured for financial
reporting purposes since they are already denominated in the functional currency. Therefore, in such
cases, currency fluctuations do not give rise to pretax transaction gains or losses for financial reporting
purposes.

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However, fluctuations in the exchange rates will create a difference between the book and tax basis
of the asset or liability when the local-currency equivalent of the reporting-currency book basis is
compared with the local-currency tax basis. Therefore, although no pretax gain or loss is recognized for
financial reporting purposes, current or deferred taxes may be required. Whether a current or deferred
tax is required in this situation depends on whether the entity will be taxed on a realized or unrealized
basis, as explained below:

• Realized basis (or “settlement approach”) — The gain or loss is included in taxable income only
on the date the asset is recovered or the liability is settled. The amount of gain or loss is
calculated by comparing the initial tax basis of the asset or liability with its tax basis when the
asset or liability is recovered or settled, respectively. The initial tax basis of the asset or liability is
generally the local-currency equivalent of the reporting-currency carrying value, determined by
using the spot rate on the transaction date. The tax basis of the asset or liability upon settlement
is generally the local-currency equivalent of the reporting-currency carrying value, determined
by using the spot rate on the settlement/recovery date.

• Unrealized basis (or “mark-to-spot approach”) — The unrealized gain or loss is included in taxable
income each year. The amount of unrealized gain or loss is calculated by comparing the initial
tax basis of the asset or liability with its tax basis at the end of each year. The initial tax basis
is determined in the same manner as the initial tax basis determined under the settlement
approach described above. The tax basis of the asset or liability at the end of each year is
generally the local-currency equivalent of the reporting-currency carrying value, determined by
using the spot rate in effect at the end of the year.

If a foreign entity is taxed under the settlement approach, it is necessary to calculate a temporary
difference and related DTL or DTA as of the end of each reporting period. The amount of deferred taxes
required is equal to the difference between the initial tax basis of the asset or liability (in local currency)
and the local-currency equivalent of the financial-statement carrying value, determined by using the
exchange rate in effect at the end of the year and multiplied by the enacted tax rate expected to apply.

Conversely, for jurisdictions that tax unrealized foreign exchange gains or losses under the mark-to-
spot approach, there will generally be no temporary difference since the entire unrealized amount will
be included in taxable income as it arises and a corresponding current tax expense or benefit will be
recognized.

Because any tax expense or benefit (whether current or deferred) will not have a corresponding
pretax book amount, the related tax expense or benefit will generally affect the ETR that should be
appropriately disclosed in the footnotes to the financial statements.

Example 9-6

Reporting-Currency-Denominated Debt
Assume the same facts as in Example 9-5 except that the loan is denominated in USD and Entity A’s tax rate is
30 percent.

On September 30, 20X5, the date of the borrowing, A records the loan at its USD-equivalent value of USD 100
million. Entity A’s initial tax basis in the loan is CAD 125 million, the local-currency equivalent of the amount
borrowed, which is calculated by using the exchange rate in effect on the date of the borrowing (USD 100
million × 1.25).

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Example 9-6 (continued)

On December 31, 20X5, the financial-reporting carrying value of the loan is still USD 100 million since the
loan is denominated in the functional currency. However, the local-currency-equivalent value of the loan has
changed to CAD 133 million as a result of the fluctuation in the exchange rate. Therefore, the change in the
exchange rate has created an unrealized tax loss of CAD 8 million (equal to the difference between the book
and tax basis of the loan when converted into the local currency).

If A is taxed under the settlement approach, it would record a DTA of CAD 2.4 million, which is equal to the tax
effect of the difference between the tax basis of the loan and the local-currency-equivalent value on December
31, 20X5 ([CAD 125 million – CAD 133 million] × 30%). The DTA would be recognized at the average exchange
rate (to determine the amount to recognize as an income tax benefit) and would then be remeasured at the
exchange rate in effect on December 31, 20X5; any difference between the two amounts would be included in
the income statement. Under ASC 830-740-45-1, A may present the transaction gain or loss that results from
remeasuring the DTA as deferred tax expense or benefit (as opposed to foreign-currency transaction gain or
loss) if such presentation is considered more useful. If reported in that manner, that transaction gain or loss is
still included in the aggregate transaction gain or loss for the period, which is disclosed in accordance with ASC
830-20-45-1.

Conversely, if A is taxed under the mark-to-spot approach, it would recognize a taxable loss of CAD 8 million
and should record a CAD 2.4 million reduction in current tax payable and a CAD 2.4 million income tax benefit.

Observation
In this example, there will be no pretax income for either A or the U.S. parent, nor will there be such income
in consolidation (since A, the U.S. parent, and the consolidated financial statements use USD). Further, the
U.S. parent in this example (unlike the U.S. parent in Example 9-5) will have no tax effect since the loan is
denominated in USD and the U.S. parent files its tax return in USD. However, A will have a tax effect (either
current or deferred, depending on Canadian tax law) related to the loan, since it files its tax return in CAD but
the loan is denominated in USD.

In summary, in both examples, there is no consolidated pretax gain or loss. (In Example 9-5, there are equal
and offsetting pretax amounts; in this example [Example 9-6], because the loan is denominated in USD, there
is no pretax gain or loss in either A or the U.S. parent.) In each example, there is a tax effect in the consolidated
financial statements (and that tax effect affects the ETR, since there is a tax effect with no corresponding pretax
amount; however, see Section 9.7 for a possible exception). In Example 9-5, the loan is denominated in CAD
so the tax effect is in the U.S. parent; in this example (Example 9-6), the loan is denominated in USD so the tax
effect is in A.

9.3 Price-Level-Adjusted Financial Statements

740-10-25 (Q&A 05)
Entities located in countries with highly inflationary economies may prepare financial statements
restated for general price-level changes in accordance with U.S. GAAP. The tax bases of those entities’
assets and liabilities are often restated for the effects of inflation.

When a foreign entity prepares domestic price-level-adjusted financial statements in accordance with
U.S. GAAP, the recognition exception in ASC 740-10-25-3(f) does not apply. ASC 830-740-25-5 concludes
that “[w]hen preparing financial statements restated for general price-level changes using end-of-
current-year purchasing power units, temporary differences [under ASC 740] are determined based on
the difference between the indexed tax basis amount of the asset or liability and the related price-level
restated amount reported in the financial statements.”

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In addition, ASC 830-740-30-1 concludes that the deferred tax expense or benefit should be calculated
as the difference between (1) “[d]eferred tax assets and liabilities reported at the end of the current
year, determined in accordance with paragraph 830-740-25-5,” and (2) “[d]eferred tax assets and
liabilities reported at the end of the prior year, remeasured to units of current general purchasing power
at the end of the current year.” Further, ASC 830-740-30-2 states, the “remeasurement of deferred tax
assets and liabilities at the end of the prior year is reported together with the remeasurement of all
other assets and liabilities as a restatement of beginning equity.”

The following graphic illustrates the calculation of deferred tax expense or benefit:

Remeasured
Deferred tax End-of-year
beginning-of-year
expense (benefit) DTAs and DTLs
DTAs and DTLs

9.4 Cumulative Translation Account Overview

Under ASC 830-30, all financial statement elements must be translated from the functional currency to
the reporting currency by using a current exchange rate, which ASC 830-30-45-4 defines as “the rate as
of the end of the period covered by the financial statements or as of the dates of recognition in those
statements in the case of revenues, expenses, gains, and losses.” For practical reasons, ASC 830 permits
the use of weighted-average exchange rates or other methods that provide a reasonable approximation
of the rates in effect on the date of recognition.

The following is a summary of the exchange rates used in the translation process:

Current Historical Weighted Average

• Assets • Common stock • Revenues
• Liabilities • Preferred stock • Expenses
• APIC • Gains
• Dividends • Losses
• Beginning retained • Change in retained
earnings earnings from net
income

9.4.1 Recognition of Deferred Taxes for Temporary Differences Related to

the CTA
740-10-25 (Q&A 14)
As stated above, under foreign currency guidance in ASC 830, assets, liabilities, revenues, expenses,
gains, and losses of a foreign subsidiary whose functional currency is the local currency are translated
from that foreign currency into the reporting currency by using current exchange rates. Translation
adjustments recognized as part of this process are not included in the determination of net income but
are reported as a separate component of shareholders’ equity (the CTA). After a change in exchange
rates, the translation process often creates basis differences in amounts equal to the parent entity’s
translation adjustment because it changes the parent’s financial reporting amount of the investment in
the foreign entity but the parent’s tax basis in that entity generally does not change.

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A DTA or DTL may be required when an entity recognizes translation adjustments as a result of an
exchange rate change if the parent entity is accruing income taxes on its outside basis difference in a
particular investment (note that a CTA can be recorded on both the capital and undistributed earnings
of the investment, as illustrated in Example 9-7 below). However, ASC 830-30-45-21 states that if
“deferred taxes are not provided for unremitted earnings of a subsidiary, in those instances, deferred
taxes shall not be provided on translation adjustments.” In other words, if all or a portion of the earnings
are not indefinitely reinvested and the related temporary differences will reverse within the foreseeable
future (i.e., the earnings will be repatriated to the parent), translation adjustments associated with
such unremitted earnings will affect the deferred taxes to be recorded. Conversely, if the earnings
are indefinitely reinvested and the requirements in ASC 740-30 for not recording deferred taxes on
unremitted earnings of a subsidiary have been met, deferred taxes on the translation adjustments are
similarly not recorded.

Example 9-7

Assume that Entity X, a calendar-year U.S. entity whose reporting currency is USD, has a majority-owned
subsidiary, S, located in the United Kingdom, and that S’s functional currency is the British pound. In addition,
assume that as of December 31, 20X1, S’s net assets subject to translation under ASC 830 are 1,100 British
pounds, the exchange rate between USD and the British pound is 1 to 1, X’s tax basis in S’s common stock is
$1,000, and S had $100 in unremitted earnings for 20X1. Further assume that, in a manner consistent with
ASC 830-10-55-10 and 55-11, the calculation of $100 in unremitted earnings was based on “an appropriately
weighted average exchange rate for the period,” which was also 1 to 1.

Moreover, assume that on December 31, 20X2, S’s common stock subject to translation is unchanged at 1,000
British pounds, S’s undistributed earnings for 20X2 are 200 British pounds (the total undistributed earnings
as of December 31, 20X2, are 300 British pounds), and the weighted-average exchange rate during the year
between USD and the British pound remained at 1 to 1. As of December 31, 20X2, however, the exchange rate
is 2 to 1. Thus, X’s investment in S is translated at $2,600, and the CTA account reflects a $1,300 pretax gain.
Entity X has the intent and ability to indefinitely reinvest undistributed earnings of S (inclusive of the CTA). Thus,
in accordance with ASC 740-10-25-3(a)(1), no DTL is recognized on the portion of the outside basis difference
related to the undistributed earnings of S (inclusive of the CTA). Further, in accordance with ASC 830-30-45-21,
no deferred taxes are provided on the translation adjustments related to the common stock.

However, if X does not have the intent and ability to indefinitely reinvest S’s earnings (although X believes
that its original investment in S is considered indefinite under ASC 740-30), a DTL should be recorded for
the portion of the outside basis difference related to unremitted earnings, including the $300 translation
adjustment on the earnings (on the basis of a weighted average of exchange rates for the period). However, X
would not have to record a DTL for the $1,000 of CTA related to the 1,000 British pounds of common stock.

Note that after the enactment date of the 2017 Act, undistributed earnings may not give rise to a taxable
outside basis difference because such earnings are/were immediately includable in an entity’s U.S. taxable
income (whether as a result of (1) the entity’s deemed repatriation tax (IRC Section 965) or (2) deemed
repatriation as a GILTI inclusion or Subpart F inclusion in the year earned) or are eligible for the IRC Section
245A dividends received deduction when the entity is measuring the U.S. DTL.

740-10-25 (Q&A 15)

When a DTL or DTA related to a parent entity’s cumulative foreign currency translation adjustments is
recognized, the tax consequences of foreign currency exchange translations are generally in accordance
with the intraperiod allocation rules, reported as a component of the CTA account in accordance with
ASC 740-20-45-11(b).

See Chapter 6 for a detailed discussion of intraperiod allocation.

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9.5 Hedge of a Net Investment in a Foreign Subsidiary

740-10-25 (Q&A 16)
Entities sometimes enter into transactions to hedge their net investment in a foreign subsidiary (e.g.,
through the use of a forward contract). Under the derivatives and hedging guidance in ASC 815, such a
transaction would be designated as a hedge of the foreign currency exposure of a net investment in a
foreign operation. Gains and losses on the effective portion of such hedging transactions are credited or
charged directly to OCI through the CTA in accordance with ASC 815-35-35-1.

If such a hedging transaction creates a temporary difference but the parent does not provide for
deferred taxes related to translation adjustments, the deferred taxes should nonetheless be recognized
for the temporary difference created by the hedging transaction. The tax consequences of hedging
gains or losses that are attributable to assets and liabilities of a foreign subsidiary or foreign corporate
joint venture are not indefinitely postponed, as contemplated in ASC 740-10-25-3(a)(1), because the
tax consequences are generally recognized upon settlement (e.g., settlement at the end of a contract
period or repayment of a loan). Therefore, usually a DTL or DTA will result from hedging gains and
losses, irrespective of whether a parent entity’s investment in a foreign subsidiary or foreign corporate
joint venture is considered indefinite. In accordance with the intraperiod allocation rules, specifically ASC
740-20-45-11(b), the tax consequences of establishing a DTA or DTL in hedging transactions are typically
reported as a component of the CTA.

9.6 Changes in an Entity’s Functional Currency

An entity may determine that it needs to change its functional currency as a result of significant
changes in economic facts and circumstances. For example, changes in functional currency may result
from one-time transactions, such as a merger or acquisition, or from a longer-term shift in an entity’s
operations.

In addition, when the economy in the country in which a foreign entity operates becomes highly
inflationary, the entity must change its functional currency to its immediate parent’s reporting currency
(e.g., USD). Likewise, when the economy in the country in which a foreign entity operates ceases to be
highly inflationary, the entity should discontinue using its immediate parent’s reporting currency as
its functional currency, provided that the entity’s facts and circumstances have not changed in such
a way that its functional currency should now be the same as the reporting currency used for highly
inflationary accounting (e.g., analysis of the economic indicators described in ASC 830-10 results in
the determination that the entity’s functional currency should be that of its parent regardless of the
inflationary status of its local economy).

Regardless of the reason, ASC 830 requires entities to account for the effects of a change in the
functional currency by remeasuring the carrying value of their assets and liabilities into the new
functional currency. ASC 830-740 addresses the accounting for the income tax effects related to a
change in the functional currency, which differs depending on whether the functional currency changed
to or from the reporting currency.

9.6.1 Changes From the Local Currency to the Reporting Currency

740-10-25 (Q&A 69)
When the reporting currency is the functional currency, ASC 830-10-45-18 requires that historical
exchange rates be used to remeasure nonmonetary assets and liabilities from the local currency into
the reporting currency, and therefore the exception in ASC 740-10-25-3(f), as discussed in Section 9.2.1,
applies.

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ASC 830-10-45-10 states that “[i]f the functional currency changes from a foreign currency to the
reporting currency, translation adjustments for prior periods shall not be removed from equity and the
translated amounts for nonmonetary assets at the end of the prior period become the accounting basis
for those assets in the period of the change and subsequent periods.”

In this case, because the pretax carrying amounts of the subsidiary’s assets and liabilities do not change
when the functional currency changes, temporary differences also do not change. Therefore, the
subsidiary’s DTAs and DTLs should not be adjusted on the date the functional currency changes.

However, the guidance in ASC 740-10-25-3(f) would be applied prospectively from the date of the
change. Therefore, after the functional currency is changed to the reporting currency, the exception
applies and the local-currency-equivalent amount of the financial reporting carrying value (for use in
determining the temporary difference) is measured by using the historical exchange rates as of the date
of the change in the functional currency (even though the resulting local-currency amount differs from
the amount that an entity needs to recover the reporting-currency carrying value of the asset or liability).

In addition, an entity would continue to recognize deferred taxes for (1) differences related to the effects
of exchange rate changes associated with reporting-currency-denominated monetary assets and
liabilities and (2) other differences between the local-currency financial reporting carrying value and
local-currency tax basis of nonmonetary assets (e.g., differences arising when a nonmonetary asset
is depreciated over different periods for book and tax purposes), excluding the effects of indexing. As
discussed in Section 9.2.2, certain countries (especially those that are considered highly inflationary)
permit the tax basis of assets to be indexed. ASC 830-10-45-16 states, in part:

[D]eferred tax benefits attributable to any such indexing that occurs after the change in functional currency
to the reporting currency shall be recognized when realized on the tax return and not before. Deferred tax
benefits that were recognized for indexing before the change in functional currency to the reporting currency
are eliminated when the related indexed amounts shall be realized as deductions for tax purposes.

Therefore, deferred tax effects (either a lesser DTL or a DTA) that were recognized as a result of indexing
before the change in functional currency to the reporting currency are not derecognized. Rather, such
effects reverse over time as those benefits are realized on the tax return (i.e., previously recognized
DTAs should not be reversed when the functional currency is changed to the reporting currency). Going
forward, no new DTAs should be recognized for the effects of indexing that occur after the change in the
functional currency.

Because the effects of indexing are ignored for deferred tax accounting purposes when the reporting
currency is the functional currency, the current-year tax depreciation of indexation not recognized
under ASC 740 (i.e., any indexation after the reporting currency became the functional currency) will
result in a current-period tax benefit and a favorable permanent difference. Therefore, the excess
tax depreciation (because of unrecognized indexing) will result in a lower ETR in the year in which it is
realized on the entity’s tax return. The prohibition in ASC 740-10-25-3(f) causes the timing of recognition
of the tax benefit related to indexing to shift from the period in which the indexing occurs to the period
in which the additional tax basis is depreciated or amortized (even when the resulting deduction
increases an NOL carryforward).

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Example 9-8

Entity A, a foreign entity, uses the LC as its functional currency. Entity A’s parent is a U.S. entity that uses USD
as its reporting currency. On January 1, 20X5, A acquires a piece of equipment for 1 million LC. The equipment
is depreciated on a straight-line basis over four years for both book and tax purposes. The tax laws of the
foreign country in which A operates allow for a 15 percent increase in the tax basis at the end of each year
(i.e., the depreciable tax basis includes the additional tax basis from indexation), which is depreciated over the
remaining tax life of the equipment. Assume that A’s tax rate is 40 percent.

Entity A’s deferred taxes on the temporary difference associated with the equipment are calculated as follows
(all amounts are in local currency):

Temporary
Tax Basis Book Basis Difference DTA / (DTL)
Basis on January 1, 20X5 1,000,000 1,000,000 — —
20X5 depreciation expense 250,000 250,000 — —
750,000 750,000 — —
20X5 indexing 112,500 — 112,500 45,000
Basis on December 31, 20X5 862,500 750,000 112,500 45,000

Assume that on January 1, 20X6, the country in which A operates becomes highly inflationary (or that A
otherwise determines that its functional currency has changed to the reporting currency). The exchange
rate on January 1, 20X6, is 1 USD to 5 FC, the average exchange rate for 20X6 is 1 USD to 12.5 FC, and the
exchange rate on December 31, 20X6, is 1 USD to 20 FC. Under ASC 830, A’s functional currency would change
to the reporting currency of its parent (USD) in the period in which A determines that the jurisdiction is highly
inflationary (or otherwise determines that its functional currency should be the reporting currency). The
USD-translated amount for the equipment at the end of the prior period (December 31, 20X5) becomes the
accounting basis in the current period and in subsequent periods. The following table illustrates the tax effects
when A changes its functional currency from the local currency to the reporting currency (all amounts are in
local currency):

Tax Basis

Not
Recognized Recognized
Under Under Book Temporary DTA /
ASC 740 ASC 740 Basis Difference (DTL)
Basis on January 1, 20X6 — 862,500 750,000 112,500 45,000
20X6 depreciation expense — 287,500 250,000 37,500 (15,000)
— 575,000 500,000 75,000 30,000
20X6 indexing 86,250 — — N/A N/A
Basis on December 31, 20X6 86,250 575,000 500,000 75,000 30,000

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Example 9-8 (continued)

On December 31, 20X6, A would recognize a DTA of 30,000 LC (temporary difference of 75,000 LC × 40% tax
rate). The change in the local currency DTA from the beginning of the year to the end of the year would be
recognized at the average exchange rate (to determine the amount to recognize as an income tax expense)
(45,000 LC − 30,000 LC = 15,000 LC ÷ 12.5 = $1,200), and the end-of-year local currency DTA would then be
converted at the exchange rate in effect on December 31, 20X6; any difference between the change in the USD
beginning-of-the-year DTA ($9,000 = 45,000 LC ÷ 5) and the USD end-of-year DTA ($1,500 = 30,000 LC ÷ 20)
and the amount recognized as an income tax expense ($1,200) would be included in the income statement
($6,300 = [$9,000 − $1,500] − $1,200). Under ASC 830-740-45-1, A may present the transaction gain or loss that
results from remeasuring the DTA (i.e., $6,300) as deferred tax expense or benefit (rather than as a transaction
gain or loss) if such presentation is considered more useful. If reported in that manner, the transaction gain or
loss would still be included in the aggregate transaction gain or loss for the period, which would be disclosed in
accordance with ASC 830-20-45-1.

Because A’s functional currency changed to USD (i.e., the reporting currency of its parent) in 20X6, it would not
recognize any deferred taxes related to the additional indexing that occurred in 20X6 since that adjustment
was made after the functional currency changed. Further, A would not immediately reverse the DTA that it
previously recorded in connection with the 20X5 indexing adjustments before its functional currency changed.
Rather, the DTA would be reversed over time as those benefits (in the form of increased tax depreciation
expense) are realized on A’s tax return. In 20X6, A claimed 37,500 LC more tax depreciation than book
depreciation. Because this additional depreciation was realized on the return, A reverses the DTA by the
corresponding, tax-effected amount (37,500 LC × 40% = 15,000).

In addition, when determining the local-currency-equivalent amount of the USD carrying value of the
equipment (for use in measuring the temporary difference related to the equipment), A must use the exchange
rate in effect at the time the functional currency changed (i.e., the historical exchange rate).2 The fact that the
presumed recovery of the equipment for its USD carrying amount implies a different local-currency-equivalent
amount as the exchange rate fluctuates is not considered because the equipment is remeasured from the
local currency into the functional currency by using historical exchange rates (which is the exception in ASC
740-10-25-3(f)).

Further assume that throughout 20X7, the country in which A operates continues to be highly inflationary and
that its functional currency therefore continues to be the reporting currency. The following table illustrates A’s
tax effects in 20X7 (all amounts are in local currency):

Tax Basis

Not
Recognized Recognized
Under Under Book Temporary DTA /
ASC 740 ASC 740 Basis Difference (DTL)
Basis on January 1, 20X7 86,250 575,000 500,000 75,000 30,000
20X7 depreciation expense 43,125 287,500 250,000 37,500 (15,000)
43,125 287,500 250,000 37,500 15,000
20X7 indexing 49,594 — — N/A N/A
Basis on December 31, 20X7 92,719 287,500 250,000 37,500 15,000

2
With respect to assets held at the time the functional currency is changed to the reporting currency, the “historical exchange rate” means the rate
in effect on the date of change in the functional currency. With respect to assets acquired after the change in functional currency, the “historical
exchange rate” means the rate used to remeasure the local-currency cost of the asset into the reporting-currency amount (generally, the rate in
effect when the asset was acquired).

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Example 9-8 (continued)

In 20X7, A realizes total tax depreciation of 330,625 LC on its tax return (the total of the first and second
columns in the table above). However, of the total tax depreciation realized, 43,125 LC is related to the effects
of the indexing that occurred in 20X6.3 Because the indexing occurred after the functional currency changed to
the reporting currency, the excess depreciation realized in 20X7 has no impact on the DTA. However, since this
amount is realized on the entity’s return, it creates a permanent difference in 20X7, which would lower A’s ETR
and current payable (provided that A reported taxable income).

The remainder of the tax depreciation realized in 20X7 (287,500 LC) is related to the tax basis that existed
before the functional currency changed to the reporting currency. The amount is the same as the amount
calculated in 20X6 and would remain the same in 20X8 (the last year of the asset’s useful life for tax purposes).
Because this amount is 37,500 LC higher than the depreciation expense realized for book purposes, A reverses
the DTA by the corresponding, tax-effected amount (37,500 LC × 40% = 15,000). The remaining temporary
difference of 37,500 LC at the end of 20X7 would be reversed in 20X8.

Lastly, A does not recognize a DTA for the additional indexing that occurred at the end of 20X7 since that
adjustment occurred after the functional currency was changed.

9.6.2 Change in the Functional Currency When an Economy Ceases to Be

Considered Highly Inflationary
740-10-25 (Q&A 07)
As discussed above, when an entity has a foreign subsidiary operating in an economy that is considered
highly inflationary under ASC 830, the reporting currency will be used as the subsidiary’s functional
currency to measure foreign nonmonetary assets and liabilities, such as inventory, land, and depreciable
assets. If the rate of inflation for the local currency significantly declines, the economy will no longer
be considered highly inflationary and the entity will need to account for the change in its subsidiary’s
functional currency from the reporting currency to the local currency.

Deferred taxes should be recognized when the new local currency accounting bases are established
for the foreign nonmonetary assets and liabilities. ASC 830-740-25-3 concludes that any resulting
difference between the new functional currency basis and the tax basis is a temporary difference for
which intraperiod tax allocation is required under ASC 740. Since the functional currency book basis
generally will exceed the local currency tax basis in this situation, a DTL will be recognized at the time the
change occurs. In addition, under ASC 830-740-45-2, the deferred taxes associated with the temporary
difference that arises should be reflected as an adjustment to the cumulative translation component of
OCI rather than as a charge to income. Example 9-9 below illustrates this concept.

Example 9-9

A foreign subsidiary of a U.S. entity operating in a highly inflationary economy purchases equipment with a
10-year useful life for 100,000 LC on January 1, 20X1. The exchange rate on the purchase date is 10 LC to $1,
so USD-equivalent cost was $10,000. On December 31, 20X5, the equipment has a net book value on the
subsidiary’s local books of 50,000 LC (the original cost of 100,000 LC less accumulated depreciation of 50,000
LC) and the current exchange rate is 75 LC to 1 USD. In the U.S. parent’s consolidated financial statements,
annual depreciation expense of $1,000 has been reported for each of the last five years, and on December
31, 20X5, a $5,000 amount is reported for the equipment (foreign currency basis measured at the historical
exchange rate between USD and the foreign currency on the date of purchase).

3
The amount of depreciation expense related specifically to the 20X6 indexing is calculated by dividing the amount of tax basis created as a result
of the indexing (86,250 LC) by the number of years remaining on the asset’s useful life for tax purposes at the time the basis increased (two years).
This amount can also be calculated by comparing the amounts of tax depreciation expense before and after the change in functional currency.

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Example 9-9 (continued)

At the beginning of 20X6, the economy in which the subsidiary operates ceases to be considered highly
inflationary. Accordingly, assuming the functional currency and local currency are now the same, the foreign
subsidiary would establish a new functional currency accounting basis for the equipment as of January 1, 20X6,
by translating the reporting currency amount of $5,000 into the functional currency at the current exchange
rate of 75 LC to 1 USD. The new functional currency accounting basis on the date of change would be 375,000
LC (5,000 × 75).4

A DTL, as measured under the tax laws of the foreign jurisdiction, is recorded in the subsidiary’s local books
on January 1, 20X6. This measurement is based on the temporary difference between the new reporting
basis of the asset of 375,000 LC and its underlying tax basis, 50,000 LC, on that date. Thus, if a tax rate of 50
percent in the foreign jurisdiction is assumed, a DTL of 162,500 LC (325,000 LC × 50%) would be recorded
on the local books of record. That DTL would then be translated at the current exchange rate between USD
and the local currency and reported as $2,167 in the consolidated financial statements (162,500 LC ÷ 75) with
a corresponding charge to the cumulative translation account. The foreign subsidiary would compare the
functional currency book basis with the tax basis prospectively to determine the temporary difference and
change in the DTL recognized.

9.7 Long-Term Intra-Entity Loans to Foreign Subsidiaries

In accordance with ASC 830-20-35-4, intra-entity loans to foreign subsidiaries that are of a long-term-
investment nature and whose repayment is not foreseeable are treated as part of the overall net
investment in the foreign subsidiary. If either the parent or the subsidiary has a different functional
currency than the currency in which the loan is denominated, it will have foreign currency exposure
for financial reporting purposes related to fluctuations in the exchange rate. In a manner consistent
with the loan’s “part of the net investment” characterization, ASC 830-20-35-3(b) requires that any
loan-related pretax foreign exchange gain or loss that would have been classified as a foreign currency
transaction gain or loss in the income statement be recognized in the CTA account within OCI.

If the loan is denominated in the subsidiary’s functional currency, any gain or loss related to fluctuations
in the exchange rate will reside with the parent. If the loan is denominated in the parent’s functional
currency, any gain or loss related to fluctuations in the exchange rate will reside with the foreign
subsidiary. In either case, as noted above, the gain or loss is recognized as part of the CTA account
within OCI rather than as a foreign exchange gain or loss in the period in which the gain or loss arises.

Because the loan is characterized as part of the overall net investment, questions can arise regarding
the recognition of deferred taxes. The sections below discuss in further detail the income tax accounting
for a loan that is of a long-term investment nature.

9.7.1 Deferred Tax Considerations When Intra-Entity Loans That Are of

a Long-Term-Investment Nature Are Denominated in the Subsidiary’s
Functional Currency
740-30-25 (Q&A 16)
When a loan that is of a long-term-investment nature is denominated in the subsidiary’s functional
currency and the parent will have an exchange-related gain or loss, the parent should not automatically
apply the exception to the recognition of a DTL under ASC 740-30-25-18 (related to a taxable basis
difference in a foreign subsidiary whose reversal is not foreseeable) or the exception to the recognition
of a DTA under ASC 740-30-25-9 (related to a deductible temporary difference in any subsidiary that is
not expected to reverse in the foreseeable future). Rather, an entity must consider applicable tax law
and, if the taxable or deductible temporary difference related to the loan is expected to reverse in the

4
Note that the redetermination of the new functional currency occurs only in the year in which the economy ceases to be highly inflationary.

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foreseeable future, the entity should generally recognize deferred taxes (i.e., either a DTL or a DTA),
setting aside “unit of account” considerations (see additional discussion in Section 9.7.1.1 below).

For example, when the loan has a fixed term but it is asserted that repayment is not foreseeable, a
representation is being made that the loan either will be extended when it would otherwise mature or
will be contributed to the equity of the subsidiary. If either of those actions will result in the recognition
of an unrealized foreign-exchange-related gain or loss for tax purposes, an entity should generally
recognize a DTL or DTA (setting aside “unit of account” considerations). In other words, since both the
loan’s maturity date and the date on which the related temporary difference will reverse are known,
it appears that the related temporary difference (whether taxable or deductible) will reverse in the
foreseeable future. Since the temporary difference is certain to reverse on a known date, the exceptions
that might apply when the reversal of the temporary difference is not foreseeable should not be applied.

9.7.1.1 Unit of Account
The fact that the loan is considered under ASC 830 as part of the overall net investment in the foreign
subsidiary raises an interesting question about the identification of the appropriate “unit of account.”
For example, if the U.S. parent has a foreign-exchange-related gain or loss (the loan is denominated in
the functional currency of the subsidiary) and there is a taxable temporary difference related to the loan
but a deductible temporary difference related to the parent’s investment in the subsidiary’s shares (as a
result of losses in the subsidiary), the overall basis difference (viewed as a single unit of account) might
net to a deductible temporary difference (i.e., the subsidiary’s losses exceed the loan-related exchange
gain). The reverse can also occur, in which case a taxable temporary difference related to the shares
and a deductible temporary difference related to the loan would net to an overall taxable temporary
difference for the single unit of account.

We believe that, in such instances, an entity should establish an accounting policy to address the
“opposite direction” circumstances described above. One acceptable alternative would be for the entity
to consider the loan and share temporary differences as distinct units of account, allowing a deferred
tax to be recognized for the loan-related temporary difference irrespective of the overall temporary
difference. According to this alternative, two distinct assets are recognized as existing under the tax law
(the loan and the shares), each with its own separate and distinct basis difference. The other acceptable
alternative would be to consider the overall temporary difference as a single unit of account for which
deferred tax would be recognized for the loan-related temporary difference only if it is (1) in the same
direction as the overall temporary difference and (2) limited to the greater of the overall temporary
difference or the loan-related temporary difference. According to this alternative, the loan is considered
part of the net investment in the subsidiary under ASC 830 (i.e., there is only one investment balance for
book purposes).

Note that the “unit of account” question primarily arises when the temporary difference related to the
loan is in the opposite direction of the overall temporary difference (including the loan). This question
can also arise when the loan-related temporary difference exceeds the overall temporary difference
(including the loan). When the temporary difference related to the loan and the overall temporary
difference are in the same direction and the overall temporary difference exceeds the loan-related
amount, the DTL or DTA would be recognized under either accounting policy.

In accordance with the intraperiod allocation rules, specifically ASC 740-20-45-11(b), deferred income
tax expense or benefit related to an unrealized exchange gain or loss with respect to the loan would
generally be allocated to the CTA account within OCI.

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9.7.2 Deferred Tax Considerations When Intra-Entity Loans That Are of a

Long-Term-Investment Nature Are Denominated in the Parent’s Functional
Currency
740-10-25 (Q&A 68)
When a loan is denominated in the parent’s currency, the treatment of the loan as part of the overall net
investment might raise the question of whether the loan should be treated as equity. Also, a question
might arise regarding whether the subsidiary should consider any of the exceptions that might apply to
a parent’s investment in a foreign subsidiary (generally, ASC 740-30-25-17 and ASC 740-30-25-9 prohibit
the recognition of deferred taxes when it is not foreseeable that the related taxable or deductible
temporary difference will reverse).

When an intra-entity loan that is of a long-term-investment nature is denominated in the parent’s

functional currency, the foreign subsidiary should generally record deferred taxes related to the pretax
foreign exchange gain or loss unless the foreign subsidiary’s jurisdiction will not tax the foreign exchange
gain or loss at any point in time. In such cases, the foreign subsidiary should neither analogize to ASC
740-30-25-17 or ASC 740-30-25-9 nor consider the loan a component of its equity that is therefore not
subject to evaluation as a temporary difference.

It would not be appropriate for the foreign subsidiary to apply the exceptions in ASC 740-30-25-17 and
ASC 740-30-25-9 because those exceptions apply to a parent’s outside basis difference in an investment
in a foreign subsidiary (i.e., the exceptions apply to the parent as the “investor” in a foreign subsidiary
and are not relevant to the foreign subsidiary “investee”).

In addition, although an intra-entity loan that is of a long-term-investment nature is treated as part of

the parent’s net investment in the foreign subsidiary in the accounting for foreign currency fluctuations,
it is still a loan, albeit one that has an indefinite duration. While an intra-entity loan that is of a long-
term-investment nature might ultimately be contributed to the equity of the foreign subsidiary, in the
intervening periods, an intra-entity loan that is of a long-term-investment nature is reflected in the books
of the parent and subsidiary as an intra-entity receivable and payable (subject to the assessment of any
uncertain tax positions). Therefore, the foreign subsidiary should not treat the liability as a component of
its equity.

Accordingly, the temporary difference related to the foreign subsidiary’s liability will need to be
determined as of each reporting date by comparing the tax basis, which is generally equal to the original
amount borrowed (in terms of the local currency that is used to measure taxable income), with the book
basis in the liability, which is equal to the amount required to repay the loan (again, determined in terms
of the local currency and the exchange rate as of the reporting date). The difference, which represents
a transaction gain or loss for tax purposes, will generally be included in the local tax return on either a
realized basis or an unrealized basis as discussed in Section 9.2.3.

Because the actual mechanics may vary by jurisdiction (i.e., some jurisdictions might limit the
deductibility of losses but require that all gains be taxed), an entity must consider the actual local tax law
related to whether the foreign currency transaction gain or loss is taxable or deductible as well as the
timing of recognition of any gain or loss.

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Since it is not foreseeable that the loan will be repaid, it is expected that the loan would be extended
upon its scheduled maturity or contributed to equity. If those events are not considered taxable
transactions in the foreign subsidiary’s jurisdiction, it would be appropriate to apply the exception in ASC
740-10-25-30, which states that basis differences that do “not result in taxable or deductible amounts in
future years when the related asset or liability for financial reporting is recovered or settled . . . may not
be temporary differences for which a deferred tax liability or asset is recognized” (e.g., corporate-owned
life insurance that can be recovered tax free upon the death of the insured in accordance with the intent
of the policy owner).

While the preceding discussion focuses on a foreign subsidiary (i.e., a foreign corporation that is
controlled and consolidated by the parent), the same potential for tax consequences would apply to
loans made to a disregarded entity (i.e., an entity that is treated as a branch of the parent) or to loans
between brother-sister entities. However, in the case of a loan made to a disregarded entity, the parent
should also consider the FTC consequences of any current or deferred tax recognized by the foreign
subsidiary.

A U.S. parent should also be aware that any gain or loss recognized by a foreign subsidiary might be
treated as Subpart F income under the IRC.

9.8  Changes in U.S. Deferred Income Taxes Related to a Foreign Branch CTA
740-10-25 (Q&A 76)
As discussed in Section 3.3.6.3, a branch is subject to taxation in two countries; therefore, it will
generally have in-country temporary differences and U.S. temporary differences. Further, because a
foreign branch of a U.S. parent operates in a foreign country, its functional currency as determined
under ASC 830 may be, and often is, different from the U.S. parent’s functional currency. For example,
the branch’s functional currency may be the local currency, while the U.S. parent’s functional currency
is USD. When the U.S. parent uses the 1991 proposed regulations under IRC Section 987,5 the branch’s
taxable income or loss is calculated in the branch’s functional currency and then translated into USD
by using the average exchange rate for the taxable year. Because the U.S. tax bases of the branch’s
assets and liabilities are maintained in the branch’s functional currency, the U.S. temporary differences
and DTAs and DTLs related to such assets and liabilities must be calculated in the functional currency;
then, the appropriate exchange rate must be used to translate the DTAs and DTLs into USD. Therefore,
exchange rate changes will cause the financial reporting carrying value of the U.S. parent’s DTAs or DTLs
related to the U.S. temporary differences to fluctuate.

When exchange rate fluctuations cause fluctuations in the carrying value of DTAs or DTLs related to U.S.
temporary differences, each of the following views is acceptable for recording the offsetting entry:

• View A — The offsetting adjustment should be recognized in the CTA account. The exchange rate
fluctuation’s effect on the carrying value of the assets, including the change in the DTA or DTL,
would be captured in CTA as part of the translation of the investment in the branch. Therefore,
the foreign currency exchange rate effect on the DTA or DTL would be part of the tax effect of
such translation adjustment, which should be recorded in CTA in accordance with ASC 740-20-
45-11(b) and ASC 830-20-45-5.

• View B — The offsetting adjustment should be recognized in the U.S. parent’s income statement.
Although the branch is considered a foreign entity under ASC 830, the DTAs or DTLs related to
the U.S. temporary differences represent assets and liabilities of the parent entity rather than

5
On December 7, 2016, the IRS and the U.S. Treasury issued new final and temporary regulations under IRC Section 987 (the “2016 Regulations”)
with a prospective effective date. The IRS subsequently issued additional guidance that further deferred the prospective effective date of the
regulations and withdrew a portion of the temporary regulations. For reporting periods including and after the issuance of the 2016 Regulations,
entities will generally need to adjust their computation of deferred taxes related to IRC Section 987.

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those of the branch being translated. Accordingly, the DTAs or DTLs represent the U.S. parent’s
assets or liabilities that are denominated in a currency other than its functional currency.
Exchange rate fluctuations will increase or decrease the amount of the parent’s functional
currency cash flows upon recovery or settlement of the DTA or DTL; therefore, in accordance
with ASC 830-20-35-1, such fluctuations would be reported as foreign currency transaction gains
or losses in the determination of net income. Alternatively, under ASC 830-740-45-1, the U.S.
parent may classify the transaction gain or loss in deferred tax benefit or expense rather than in
pretax income if that presentation is considered more useful.

The selected method should be applied consistently to all DTAs and DTLs related to U.S. temporary
differences denominated in a foreign currency.

Example 9-10

Assume that a U.S. parent company (Parent Co.) establishes a branch (Branch Co.) in the United Kingdom. In
accordance with ASC 830, management determines that the functional currency of Parent Co. is USD, and that
of Branch Co. is the British pound. Parent Co. is subject to tax in the United States at 21 percent, and Branch
Co. is subject to tax in the United Kingdom at 20 percent. In addition, the taxes paid by Branch Co. in the
United Kingdom are fully creditable in the United States without limitation, and Parent Co. intends to elect to
claim FTCs in the year in which the foreign temporary difference reverses.

Assume the following:

• In 20X6, Branch Co. had pretax book income of £200,000.

• For U.S. and U.K. income tax reporting purposes, Branch Co. has a taxable temporary difference of
£100,000 because of accelerated depreciation.
• Branch Co. had no other U.K. or U.S. temporary differences.
• The exchange rates in effect during 20X6 were as follows:
o January 1 £1 = $1.5
o December 31 £1 = $1.2
o Weighted average £1 = $1.3
Parent Co. uses the 1991 proposed regulations to determine its IRC Section 987 gain/loss.

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Example 9-10 (continued)

Parent Co. calculates the currency adjustment for the DTAs and DTLs associated with the U.S. temporary
differences as follows:

Beginning
U.S. Temporary Difference of Year Calendar Year End of Year
Fixed assets — (£100,000) (£100,000)

Tax rate 21% 21% 21%

DTL — (£21,000) (£21,000)

Branch taxes — anticipatory FTCs (DTA) — £20,000 £20,000

Net DTL — (£1,000) (£1,000)

Year-end spot exchange rate 1.2

U.S. DTA (DTL) required on December 31, 20X6 ($1,200)

U.S. beginning-of-year DTA (DTL) plus change in

U.S. DTA/DTL recognized at weighted average
during 20X6 (£1 = $1.3) ($1,300)

Adjustment required $100

To record the currency adjustment of $100, Parent Co. would make the following journal entries:

Journal Entry 1: View A and B

Deferred tax expense 1,300

DTA (anticipatory FTCs) (£20,000 × 1.3) 26,000

DTL (fixed assets) (£21,000 × 1.3) 27,300

Journal Entry 2: View A

DTL 100

CTA 100

Journal Entry 2: View B

DTL 100

Transaction gain or deferred tax benefit 100

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10.1 Background and Scope

ASC 718-740

Overview and Background

05-1 Topic 740 addresses the majority of tax accounting issues and differences between the financial reporting
(or book) basis and tax basis of assets and liabilities (basis differences).

05-2 This Subtopic addresses the accounting for current and deferred income taxes that results from share-
based payment arrangements, including employee stock ownership plans.

05-3 This Subtopic specifically addresses the accounting requirements that apply to the following:
a. The determination of the basis differences which result from tax deductions arising in different amounts
and in different periods from compensation cost recognized in financial statements
b. The recognition of tax benefits when tax deductions differ from recognized compensation cost
c. The presentation required for income tax benefits from share-based payment arrangements.

05-4 Income tax regulations specify allowable tax deductions for instruments issued under share-based payment
arrangements in determining an entity’s income tax liability. For example, under tax law, allowable tax deductions
may be measured as the intrinsic value of an instrument on a specified date. The time value component, if any,
of the fair value of an instrument generally may not be tax deductible. Therefore, tax deductions may arise in
different amounts and in different periods from compensation cost recognized in financial statements. Similarly,
the amount of expense reported for an employee stock ownership plan during a period may differ from the
amount of the related income tax deduction prescribed by income tax rules and regulations.

Scope and Scope Exceptions

15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic, see
Section 718-10-15, with specific transaction qualifications noted below.

15-2 The guidance in this Subtopic applies to share-based payment transactions with both employees and
nonemployees.

Pending Content (Transition Guidance: ASC 718-10-65-11)

15-2 The guidance in this Subtopic applies to share-based payment transactions.

Understanding the tax law relevant to share-based payment awards is critical to understanding the
proper accounting for the income tax effects of such awards. An entity must carefully consider the
specific facts and circumstances of its share-based payment awards to determine the appropriate
income tax treatment for them, and consultation with the entity’s tax advisers is encouraged. Taxation
of transfers of property (including shares) to employees and vendors in connection with performance of

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services and delivery of goods is generally governed by IRC Section 83. This chapter summarizes U.S. tax
law related to share-based payment awards under IRC Section 83.

10.1.1 Nonvested Shares
Under IRC Section 83, the grantee of a nonvested share award is generally taxed on the date the
grantee becomes substantially vested in the share for income tax purposes (which may be different
from the vesting date for accounting purposes). The fair market value of the share on the income tax
vesting date is treated as ordinary income for the grantee, and the employer generally will receive a
corresponding tax deduction.

10.1.2 Share Options
For share options, taxation depends on whether the transfer of shares resulting from exercise of the
option is considered a qualifying transfer under IRC Sections 421 and 422.

For the transfer of shares resulting from the exercise of an option to be considered a qualifying transfer,
the following must be true of the option and option plan:

• The option plan is approved by the stockholders of the company.

• The option is granted within 10 years of adoption of the plan or, if earlier, the date on which the
stockholders approve the plan.

• The maximum term of the option is 10 years from the grant date. For employees who own
more than 10 percent of the total combined voting power of the employer or of its parent or
subsidiary corporation, the maximum term is 5 years.

• The option price is not less than the fair market value of the stock at the time the option is
granted. For employees who own more than 10 percent of the total combined voting power of
the employer or of its parent or subsidiary, the option price must not be less than 110 percent
of the fair market value.

• The option is transferable only in the event of death.

• The employee is employed by the employer (or its parent or subsidiary) for the entire period up
to three months before the exercise date of the option.

Share options that meet these criteria are commonly referred to as ISOs or statutory stock options, and
shares transferred or issued in connection with the exercise of such options are referred to as statutory
option stock. Options that do not meet these criteria are commonly referred to as nonqualified options
(NQSOs). ISOs may be issued only to employees, whereas NQSOs may be issued to nonemployees.

To continue being considered as a qualifying transfer, the transfer of shares resulting from the exercise
of an option must meet the criteria above, and the individual acquiring statutory option stock may
not dispose of it within two years of the grant date or within one year of the exercise date. If these
requirements are violated, a disqualifying disposition occurs, and the transfer is no longer considered
a qualifying transfer. Also, the maximum amount of ISOs that may first become exercisable by an
employee in a calendar year is $100,000. That maximum is determined by reference to the fair market
value of the shares underlying the option on the grant date (i.e., the fair value of the shares, not the
fair value of the option, on the grant date). Generally, options to acquire shares that exceed the annual
maximum should be treated as NQSOs.

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10.1.2.1 Qualifying Transfers
Qualifying transfers receive favorable tax treatment from the perspective of the employee. These
transfers are not taxable to the employee (or former employee) for “regular” tax purposes until the
statutory option stock has been disposed of (although there may be AMT consequences — see the next
paragraph). Upon disposition of the stock, the employee will be subject to long-term capital gains tax
for the difference between the proceeds received upon disposal and the exercise price, as long as the
employee has held the stock for the required periods. If the employee holds the stock for the required
periods, the employer does not receive a tax deduction related to the ISO.

Under the tax law, an individual must recognize a “tax preference” item upon exercise of an ISO that is
equal to the difference between the exercise price and the fair market value of the underlying shares
on the exercise date. This tax preference item may cause the individual to owe AMT. Generally, the
AMT may be avoided by selling the ISO shares in the same calendar year in which they were purchased
(a disqualifying disposition; the tax consequences are noted below). An employer does not receive a
deduction corresponding with an employee’s AMT liability upon exercise of an ISO.

10.1.2.2 Nonqualifying Transfers
If the transfer is considered nonqualifying because the terms of the award preclude it from being
considered an ISO, the intrinsic value of the option on the date of exercise is included in the employee’s
ordinary income and the employer receives a corresponding deduction.

If the transfer is considered nonqualifying because of a disqualifying disposition, the lesser of (1) the
excess of the fair market value of the stock on the exercise date over the strike price or (2) the
actual gain on sale is included in the employee’s ordinary income as compensation in the year of the
disqualifying disposition. The employer receives a tax deduction for the amount of income included by
the employee.

10.1.3 Restricted Share Units and SARs

Share-settled RSUs and share appreciation rights (SARs) are both generally taxed when the shares are
transferred in settlement of the award. Taxation of share-settled RSUs is the same as that for deferred
compensation, resulting in ordinary income for the employee equal to the value of shares when
distributed and a corresponding deduction for the employer. RSUs are not considered legally issued
shares and therefore do not represent actual property interests (e.g., equity in the company). Unlike
nonvested shares, RSUs can be structured to defer income beyond the vesting date.

Taxation of SARs is similar to that of NQSOs. Like NQSOs, SARs result in income on “exercise” or
settlement. The employee has ordinary income on the basis of the fair value of the cash or shares
transferred at settlement, and the employer receives a corresponding deduction.

10.1.4 Employee Stock Purchase Plans

Employees may also have the option to acquire stock of their employer in accordance with an employee
stock purchase plan (ESPP). In a manner similar to ISOs, the acquisition of stock in connection with an
ESPP that meets the criteria in IRC Section 423 also generally does not result in income to the employee
at the time the stock is purchased. Therefore, the employer would not ordinarily receive a deduction
related to shares purchased under an ESPP unless a disqualifying disposition occurs. The maximum
amount of stock that can be purchased under an ESPP is $25,000 per year.

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10.2 Deferred Tax Effects of Share-Based Payments

ASC 718-740

Determination of Temporary Differences

25-1 This guidance addresses how temporary differences are recognized for share-based payment
arrangement awards that are classified either as equity or as liabilities under the requirements of paragraphs
718-10-25-7 through 25-19. Incremental guidance is also provided for issues related to employee stock
ownership plans.

Pending Content (Transition Guidance: ASC 718-10-65-11)

25-1 This guidance addresses how temporary differences are recognized for share-based payment
arrangement awards that are classified either as equity or as liabilities under the requirements of
paragraphs 718-10-25-7 through 25-19A. Incremental guidance is also provided for issues related to
employee stock ownership plans.

Instruments Classified as Equity

25-2 The cumulative amount of compensation cost recognized for instruments classified as equity that
ordinarily would result in a future tax deduction under existing tax law shall be considered to be a deductible
temporary difference in applying the requirements of Subtopic 740-10. The deductible temporary difference
shall be based on the compensation cost recognized for financial reporting purposes. Compensation cost that
is capitalized as part of the cost of an asset, such as inventory, shall be considered to be part of the tax basis of
that asset for financial reporting purposes.

25-3 Recognition of compensation cost for instruments that ordinarily do not result in tax deductions under
existing tax law shall not be considered to result in a deductible temporary difference. 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. An example of a future event that would be recognized only
when it occurs is an employee’s sale of shares obtained from an award before meeting a tax law’s holding
period requirement, sometimes referred to as a disqualifying disposition, which results in a tax deduction not
ordinarily available for such an award.

Instruments Classified as Liabilities

25-4 The cumulative amount of compensation cost recognized for instruments classified as liabilities that
ordinarily would result in a future tax deduction under existing tax law also shall be considered to be a
deductible temporary difference. The deductible temporary difference shall be based on the compensation
cost recognized for financial reporting purposes.

Initial Measurement
30-1 The deferred tax benefit (or expense) that results from increases (or decreases) in the recognized share-
based payment temporary difference, for example, an increase that results as additional service is rendered
and the related cost is recognized or a decrease that results from forfeiture of an award, shall be recognized in
the income statement.

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10.2.1 Equity-Classified Awards That Ordinarily Result in a Deduction

ASC 718-740-25-2 indicates that the “cumulative amount of compensation cost recognized for
instruments classified as equity that ordinarily would result in a future tax deduction under
existing tax law shall be considered to be a deductible temporary difference in applying
[ASC 740]” (emphasis added). This represents the first of two key exceptions to ASC 740’s balance
sheet model contained in ASC 718 (see Section 10.2.10 for discussion of the second). Because the
accounting for an equity award under ASC 718 does not result in a difference in the basis of an asset
or liability recognized for income tax or financial reporting purposes (i.e., because the offsetting entry
to compensation cost is equity of the issuer), no temporary basis difference would exist, and therefore
no deferred taxes would be recorded for such an award. ASC 718-740-25-2, however, requires that
the cumulative amount of compensation cost itself be considered a deductible temporary difference
for which a DTA is recorded. Likewise, recognition of compensation cost for share-based payments
that “ordinarily do not result in tax deductions” do not give rise to deferred taxes, as indicated in
ASC 718-740-25-3, but the recognition of a DTA may be required if a future event gives rise to a tax
deduction that ordinarily would not be available for such instruments. See Section 10.2.7 for additional
information.

As described in Section 10.1, examples of awards that ordinarily would result in a future tax deduction
under U.S. tax law include nonvested shares, SARs, RSUs, and NQSOs.

Example 10-1 below illustrates the basic deferred income tax effects of deductible, equity-classified
share-based payment awards in situations in which the amount of cumulative compensation cost and
the ultimate amount of the associated deduction are equal.

Example 10-1

Assume the following:

• Company A grants 100 equity-classified NQSOs on its $0.01 par value common stock to its employees in
20X1.
• The strike price of the options is equal to the fair value of A’s common stock of $5 on the grant date. The
fair value of the options on the grant date is $4.
• The options vest at the end of the fourth year of service (cliff-vesting).
• The options are exercised immediately after the completion of the four-year vesting period, when the
share price is $9, and A receives a deduction when the options are exercised.
• Company A has a 21 percent tax rate in all years.
Because the $400 of compensation cost (100 awards × $4 fair-value-based measure) that will result in a future
deduction is recognized over the requisite service period, a temporary difference arises, and A records a DTA
in accordance with ASC 718-740. This DTA is equal to the book compensation cost multiplied by A’s applicable
tax rate. The effect of forfeitures is ignored for simplicity in this example. Therefore, the following journal entries
are made at the end of each service year to recognize the compensation cost and tax benefits associated with
the options:

Journal Entries (Years 1–4)

Compensation cost 100

APIC 100

To recognize compensation cost ($400 ÷ 4 years).

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Example 10-1 (continued)

DTA 21
Deferred tax benefit 21
To recognize the DTA for the temporary difference related to
compensation cost (100 × 21% = 21).

Upon exercise of the options, the fair value of the company’s stock is $9, resulting in a deduction1 of $400 for
income tax purposes (($9 – $5) × 100 option awards).

Journal Entry: Pretax Entries Upon Exercise of Options

Cash ($5 × 100) 500

APIC 499
Common stock (100 × $0.01) 1
To record the receipt of cash for the exercise price and recognize the
issuance of common stock.

Journal Entries: Tax Effects of Exercise of Options

Current tax payable ($400 × 21%) 84

Current tax benefit 84
Deferred tax expense 84
DTA 84
To reverse the DTA and adjust the income tax payable.
Because the cumulative compensation cost and the amount of the deduction upon exercise of the options are
equal, there is no net impact to income tax expense or benefit as a result of the exercise.

10.2.2 Liability-Classified Awards That Ordinarily Result in a Deduction

As indicated in ASC 718-740-25-4, the accounting for liability-classified awards that would ordinarily
result in a deduction is the same as that for equity-classified awards. That is, the cumulative amount
of compensation cost recognized for financial reporting purposes represents a deductible temporary
difference for which a DTA is recorded. While ASC 718-740 does not make a distinction between
equity- and liability-classified awards (e.g., a SAR that requires settlement in cash) for this purpose, the
deferred tax accounting for liability awards does not represent an exception to the balance sheet model
under ASC 740 because the cumulative amount of compensation cost recorded for financial reporting
purposes under ASC 718 does result in a temporary difference (i.e., a liability recorded for financial
reporting purposes with no corresponding liability for tax purposes).

1
The tax deduction represents the difference between the company’s share price on the date of exercise and the exercise price stated in the award
multiplied by the number of options awarded.

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10.2.3 Determining Deductibility of Awards Under IRC Section 162(m)

IRC Section 162(m) may limit the deductibility of an ordinarily deductible share-based payment award
issued by an entity that is a “publicly held corporation” under that section’s requirements. The definition
of a publicly held corporation includes entities that must register securities or file reports under Sections
12 or 15(d), respectively, of the Securities Exchange Act of 1934. IRC Section 162(m) specifically limits
the deductibility of compensation paid to a company’s CEO and CFO as well as its three other highest
paid officers (referred to collectively as “covered employees”). Under IRC Section 162(m), only the first
$1 million in compensation (whether cash or share based renumeration) paid to a covered employee is
deductible for tax purposes in any given year. Once an individual becomes a covered employee, he or
she remains a covered employee in each taxable year during the period of employment and thereafter,
including after termination and death. Before the enactment of the 2017 Act, compensation that was
performance based was generally not subject to this limitation, which lessened the impact of IRC Section
162(m) on the deductibility of executive compensation given that performance-based compensation is
common for covered employees.

In addition, IRC Section 162(m) applies differently to (1) compensation arrangements entered into before
November 2, 2017 (that have not been materially modified on or after that date2), and (2) compensation
arrangements entered into on or after November 2, 2017. That is, only compensation stemming from
a written, binding contract entered into after November 2, 2017 (or a preexisting contract modified on
or after this date), is subject to the revised terms of IRC Section 162(m) as amended by the 2017 Act.
Compensation arrangements that were in place before this date are effectively “grandfathered,” and
the legacy requirements apply. Therefore, it is important for an entity to consult with its tax advisers
regarding the deductibility of executive compensation for covered employees to determine how the
limitations in IRC Section 162(m) apply.

Because IRC Section 162(m) applies to all types of compensation issued to covered employees, it may
be difficult to determine the extent to which the share-based component of the covered employees’
compensation is limited by IRC Section 162(m). We are aware of three approaches that have been
commonly applied in practice both before and since enactment of the 2017 Act regarding the
accounting for deferred taxes in cases in which compensation is expected to be limited by IRC Section
162(m). These approaches are as follows:

• Deductible compensation is allocated to cash compensation first — A DTA would not be recorded
for share-based compensation if cash compensation is expected to exceed the limit.

• Deductible compensation is allocated to earliest compensation recognized for financial statement

purposes — Because stock-based compensation is typically expensed over a multiple-year
vesting period but deductible when fully vested or exercised, and cash-based compensation
is generally deductible in the period in which it is expensed for financial statement purposes,
stock-based compensation is generally considered the earliest compensation recognized for
financial statement purposes, and a DTA for share-based compensation would be recorded up
to the deductible limit.

• Limitation is allocated pro rata between stock-based compensation and cash compensation — A
partial DTA may result on the basis of the expected ratio of share-based compensation to cash
compensation.

The choice of which approach to apply is a policy election that should be applied consistently.

2
The 2017 Act contains explicit wording indicating that material modifications made to a compensation agreement on or after November 2, 2017,
will cause the agreement to become subject to the updated requirements of IRC Section 162(m). An analysis of applicable laws is necessary
in order to assess whether an arrangement constitutes a written binding contract as of November 2, 2017. Judgment may be required in the
determination of whether a modification is material. Further, if a modified compensation agreement is related to a share-based payment award,
companies will need to consider whether the modification guidance in ASC 718-20 should be applied.

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See Section 10.3 for guidance on the accounting for an award subject to IRC Section 162(m) that is
determined not to be deductible.

10.2.4 Excess Tax Benefits and Tax Deficiencies

ASC 718-740

Treatment of Tax Consequences When Actual Deductions Differ From Recognized Compensation Cost
35-2 This Section addresses the accounting required in a period when actual tax deductions for compensation
expense taken by an entity on its tax return for share-based payment arrangements differ in amounts and
timing from those recorded in the financial statements. The tax effect of the difference, if any, between the
cumulative compensation cost of an award recognized for financial reporting purposes and the deduction for
an award for tax purposes shall be recognized as income tax expense or benefit in the income statement. The
tax effect shall be recognized in the period in which the tax deduction arises or, in the case of an expiration
of an award, in the period in which the expiration occurs. The appropriate period depends on the type of
award and the incremental guidance under the requirements of Subtopic 740-270 on income taxes — interim
reporting.

Pending Content (Transition Guidance: ASC 105-10-65-4)

35-2 This Section addresses the accounting required in a period when the deduction for compensation
expense to be recognized in a tax return for share-based payment arrangements differs in amounts and
timing from the compensation cost recorded in the financial statements. The tax effect of the difference, if
any, between the cumulative compensation cost of an award recognized for financial reporting purposes
and the deduction for an award for tax purposes shall be recognized as income tax expense or benefit in
the income statement. The tax effect shall be recognized in the income statement in the period in which
the amount of the deduction is determined, which typically is when an award is exercised or expires, in the
case of share options, or vests, in the case of nonvested stock awards. The appropriate period depends on
the type of award and the incremental guidance under the requirements of Subtopic 740-270 on income
taxes — interim reporting.

35-3 Paragraph superseded by Accounting Standards Update No. 2016-09.

35-4 See Examples 1, Case A (paragraph 718-20-55-10); 8 (paragraph 718-20-55-71); 15, Case A (paragraph
718-20-55-123); and Example 1 (paragraph 718-30-55-1), which provide illustrations of accounting for the
income tax effects of various awards.

The tax deduction that arises for an equity-classified share-based payment award will frequently
differ from the amount of compensation cost recorded for financial reporting purposes. Such a
difference is referred to as an excess tax benefit (when the amount of the deduction is greater than the
compensation cost recognized for financial reporting purposes) or as a tax deficiency (when the amount
of the deduction is less than the compensation cost recognized for financial reporting purposes). In
accordance with ASC 718-740-35-2, the excess tax benefits and tax deficiencies are recognized as
decreases or increases to current tax expense in the income statement in the period in which the
excess tax benefits or tax deficiencies arise. This results in a permanent difference between the amount
of cumulative compensation for financial reporting purposes and the deduction taken for income tax
purposes and has an impact on an entity’s ETR in the period in which the excess or deficiency arises.
Example 10-2 illustrates an excess tax benefit and a tax deficiency for a deductible equity-classified
award. See Section 10.3 for further discussion of permanent differences associated with share-based
payments.

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Example 10-2

Assume the following:

• Company A grants 100 NQSOs on its $0.01 par value common stock to its employees in 20X1.
• The strike price of the options is equal to the fair value of A’s common stock of $5 on the grant date. The
fair value of the options on the grant date is $4.
• The options vest at the end of the fourth year of service (cliff vesting).
• The options are exercised immediately after the completion of the four-year vesting period, when the
share price is $10, and A receives a deduction when the options are exercised.
• Company A has a 25 percent tax rate in all years.

Because the $400 of compensation cost (100 awards × $4 fair-value-based measure) that will result in a future
deduction is recognized over the requisite service period, a temporary difference arises, and A records a DTA
in accordance with ASC 740. This DTA is equal to the book compensation cost multiplied by A’s applicable tax
rate. The effect of forfeitures is ignored for simplicity in this example. Therefore, the following journal entries
are made at the end of each service year to recognize the compensation cost and tax benefits associated with
the options:

Journal Entries (Years 1–4)

Compensation cost 100

APIC 100

To recognize compensation cost ($400 ÷ 4 years).

DTA 25
Deferred tax benefit 25
To recognize the DTA for the temporary difference related to
compensation cost (100 × 25% = 25).

Upon exercise of the options, the fair value of the company’s stock is $10, resulting in a deduction3 of $500 for
income tax purposes ([$10 – $5] × 100 option awards).

Journal Entry: Pretax Entries Upon Exercise of Options

Cash ($5 × 100) 500

APIC 499
Common stock (100 × $0.01) 1
To record the receipt of cash for the exercise price and recognize the
issuance of common stock.

3
See footnote 1.

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Example 10-2 (continued)

Journal Entry: Tax Effects of Exercise of Options

Current tax payable 125

Deferred tax expense 100
DTA 100
Current tax benefit 125
To reverse the DTA and record the current tax effect
([$10 – $5] × 100 option awards × 25%). Because the amount of
the deduction upon exercise of the options is greater than the
cumulative compensation cost, there is a $25 net excess tax benefit
impact to the income statement ($125 – $100).

If the share price at the time of exercise was instead $8, a tax deficiency would be recognized as follows:

Journal Entry: Upon Exercise of Options

Current tax payable 75

Deferred tax expense 100
DTA 100
Current tax expense 75
To reverse DTA and record the current tax effect ([$8 – $5] × 100
option awards × 25%). Because the amount of the deduction upon
exercise of the options is less than the cumulative compensation
cost, there is a $25 net tax deficiency in the income statement
($75 – $100).

10.2.4.1 Excess Tax Benefits and Tax Deficiencies in Interim Financial Statements

ASC 740-270-30-4, ASC 740-270-30-8, and ASC 740-270-30-12 require entities to account for excess
tax benefits and tax deficiencies as discrete items in the period in which they occur (i.e., entities should
exclude them from the AETR). Therefore, the effects of expected future excesses and deficiencies should
not be anticipated. However, the tax effects of the expected compensation expense should be included
in the AETR. See Chapter 7 for further guidance on the accounting for income taxes associated with
share-based payments in interim financial statements.

10.2.4.2 Tax Deficiency Resulting From Expiration of an Award

When a fully vested NQSO award has expired unexercised, the tax effects are accounted for as if the tax
deduction taken is zero. Thus, the DTA recorded in the financial statements would be reduced to zero
through a charge to deferred income tax expense. See ASC 718-20-55-23.

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Example 10-3

A company grants 1,000 “at-the-money” fully vested NQSOs, each of which has a grant-date fair-value-based
measure of $4. The company’s applicable tax rate is 25 percent. Further assume that no valuation allowance
has been established for the DTA and that the awards subsequently expire unexercised. The company would
record the following journal entries:

Journal Entries: Upon Grant

Compensation cost 4,000

APIC 4,000

To record compensation cost upon the grant of the award

(1,000 × $4).
DTA 1,000
Deferred tax expense 1,000
To record the tax effects upon the grant of the award ($4,000 × 25%).

Journal Entry: Upon Expiration

Deferred tax expense 1,000

DTA 1,000
To reverse the tax effects of unexercised options.

10.2.5 Deferred Tax Effects of a Change in Share Price on Equity-Classified

Awards
The DTA associated with stock-based compensation is computed on the basis of the cumulative
amount of stock-based compensation cost recorded in the financial statements and is not affected
by the grantor’s current stock price. Such DTAs should not be remeasured or written off because of a
decline in the grantor’s stock price, even if it has declined so significantly that (1) an award’s exercise is
unlikely to occur or (2) the intrinsic value on the exercise date will most likely be less than the cumulative
compensation cost recorded in the financial statements (i.e., a tax deficiency exists).

10.2.6 Deferred Tax Effects of a Change in Share Price on Liability-Classified

Awards
The primary difference between the deferred income tax accounting for equity-classified awards
and that for liability-classified awards under ASC 718 is that the measurement of the DTA associated
with liability-classified awards inherently takes into account the grantor’s current stock price in each
period. This is because liability-classified awards are remeasured to their fair-value-based amount each
period until settlement. The DTA (and corresponding deferred income tax benefit) is recognized in the
same manner as the compensation cost (i.e., either immediately or over the remaining service period,
depending on the vested status of the award). Because the DTA and the associated compensation
cost are remeasured in each reporting period, the tax benefit of the liability-classified award will, upon
settlement, equal the DTA. Accordingly, the settlement of a liability-classified award generally will not
result in an excess tax benefit or a tax deficiency as described in Section 10.2.4 for equity-classified
awards.

Example 10-4 illustrates the differences between the income tax accounting for deductible equity-
classified versus liability-classified awards issued in the form of SARs (including an excess tax benefit).

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Example 10-4

On January 1, 20X1, Company A grants 1,000 SARs to one employee. The SARs vest at the end of the second
year of service (cliff vesting). The fair-value-based measures of the SARs are as follows:

• $10 on January 1, 20X1.

• $15 on December 31, 20X1.
• $14 on December 31, 20X2.
• $18 on December 31, 20X3.
For simplicity, the effects of forfeitures have been ignored. Company A’s applicable tax rate is 21 percent. There
are no interim reporting requirements. In Scenario 1 (see table below), A is required to settle the SARs with
shares (equity-classified award). Note that the income tax accounting for an equity-classified SAR is the same
as the accounting for an equity-classified NQSO. In Scenario 2 (see table below), A is required to settle the SARs
with cash (liability-classified award). The award is settled on May 15, 20X4, and the value of the shares (Scenario
1) and cash (Scenario 2) delivered upon settlement is $16.

Scenario 1 — Equity-Classified SARs

Compensation DTA Increase/

Year Ended Cost (Decrease) Comments

December 31, 20X1 $ 5,000 $ 1,050 Compensation cost is based on the number of
SARs granted, the grant-date fair-value-based
measure of the equity-classified SARs, and the
amount of services rendered in the period
(1,000 SARs × $10 grant-date fair-value-based
measure × 50%* services rendered). The DTA
is based on the compensation cost recognized
and A’s income tax rate ($5,000 compensation
cost × 21% income tax rate).

December 31, 20X2 $ 5,000 $ 1,050 Compensation cost is based on the number of
SARs granted, the grant-date fair-value-based
measure of the equity-classified SARs, and
the amount of services rendered (1,000 SARs
× $10 grant-date fair-value-based measure ×
50% services rendered). The DTA is based on
compensation cost recognized and A’s income
tax rate ($5,000 compensation cost × 21%
income tax rate).

December 31, 20X3 — — Remeasurement of equity-classified awards is

not required.

Period from
January 1, 20X4, Remeasurement of equity-classified awards is
to May 15, 20X4 — — not required.

Total $ 10,000 $ 2,100

* In this calculation, 50 percent indicates that the employee is providing one of two years of service.

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Example 10-4 (continued)

Compensation
Cost Comments

May 15, 20X4 $ — Remeasurement of the equity award on settlement is not required. The
tax accounting will be based on the tax deduction A receives.

Tax entries Journal Entries:

on final
Taxes payable 3,360
settlement
Current tax benefit 3,360

To adjust current tax expense and

taxes payable for the SAR deduction
($16 × 1,000 awards × 21%).

Deferred tax expense 2,100

DTA 2,100

To reverse the DTA.

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Example 10-4 (continued)

Scenario 2 — Liability-Classified SARs

Compensation DTA Increase/

Year Ended Cost (Decrease) Comments

December 31, 20X1 $ 7,500 $ 1,575 Compensation cost is based on the number
of SARs granted, the fair-value-based measure
of the liability-classified SARs on the reporting
date, and the amount of services rendered
(1,000 SARs × $15 fair-value-based measure ×
50% services rendered). The DTA is based on
compensation cost recognized and A’s income
tax rate ($7,500 compensation cost × 21%
income tax rate).

December 31, 20X2 6,500 1,365 Compensation cost is based on the number
of SARs granted, the fair-value-based
measure of the liability-classified SARs on the
reporting date, and the amount of services
rendered, less compensation costs previously
recognized ([1,000 SARs × $14 fair-value-based
measure × 100% services rendered] – $7,500
compensation cost previously recognized).
The DTA is based on the compensation cost
recognized and A’s income tax rate ($6,500
compensation cost × 21% income tax rate).

December 31, 20X3 4,000 840 Once all services have been provided, the
liability-classified SAR is remeasured on each
reporting date until the SARs are settled.
Remeasurement is based on the number of
SARs vested and the fair-value-based measure
of the liability-classified SARs on the reporting
date, less compensation cost previously
recognized ([1,000 SARs × $18 fair-value-
based measure] – $14,000 compensation cost
previously recognized). Adjustment to the DTA
is based on the change in the compensation
cost recognized and A’s income tax rate ($4,000
compensation cost × 21% income tax rate).

May 15, 20X4 (2,000) (420) Once all services have been provided, the
liability is remeasured each reporting date until
the award is settled. Remeasurement is based
on the number of awards vested and the fair
value of the liability award on the reporting date,
less amounts previously recognized ([1,000
awards × $16] – 18,000). Adjustment to the DTA
is based on the change in the compensation
cost recognized and A’s income tax rate ($2,000
decrease in compensation cost × 21% income
tax rate).

Total $ 16,000 $ 3,360

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Example 10-4 (continued)

Comments

Tax entries Journal Entries:

on final
settlement Taxes payable 3,360
Current tax benefit 3,360
To record the current tax benefit of
the SAR deduction.

Deferred tax expense 3,360

DTA 3,360
To reverse the DTA.

10.2.7 Deferred Tax Effects of a Change in Tax Status of an Award

If an entity has non-tax-deductible awards (e.g., ISOs) that are expected to be subject to disqualifying
dispositions, it should follow the guidance under ASC 718-740-25-3, which explains that an entity cannot
record a tax benefit in the income statement until the disqualifying disposition of an award occurs.
Therefore, no DTA and related tax benefit can be recognized in connection with such an award until a
disqualifying disposition occurs.

When a disqualifying disposition occurs, a deduction is available to be taken in the employer’s tax return.
The benefit of any tax deduction resulting from the disqualifying disposition would be recorded as a
reduction of current-period tax expense in the income statement.

Example 10-5

A company grants a fully vested ISO with a grant-date fair-value-based measure of $100, which is recorded in
the income statement as compensation cost. Since the award is an ISO, no corresponding DTA or tax benefit is
recorded because the award does not ordinarily result in a tax deduction for the company.

Assume that a disqualifying disposition occurs and results in the company’s taking a deduction of $120 in its tax
return. If the company’s applicable tax rate is 25 percent, the company would record a $30 current income tax
benefit in the income statement ($120 deduction taken on the income tax return × 25% tax rate).

Example 10-6

Assume the same facts as in Example 10-5 above except that the disqualifying disposition results in a
deduction of only $80. If the company’s applicable tax rate is 25 percent, the company would record a tax
benefit of $20 as a reduction of current income tax expense in the income statement ($80 deduction taken on
the income tax return × 25% tax rate).

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10.2.8 Deferred Tax Effects of Changes in Tax Rates

When enacted changes occur in the tax law that cause a change in an entity’s tax rate, a DTA related to
temporary differences arising from tax-deductible share-based payment awards should be adjusted in
the period in which the change in the applicable tax rate is enacted into law. To determine the amount
of the new DTA, an entity should multiply the new tax rate by the existing temporary difference for
outstanding tax-deductible share-based payment awards measured as of the enactment date of the rate
change. The difference between the new DTA and the existing DTA should be recorded as a deferred tax
benefit or expense and allocated to income from continuing operations discretely. See Section 3.5.1 for
a broader discussion of the accounting for deferred tax effects of changes in rates.

10.2.9 Deferred Tax Effects of IRC Section 83(b) Elections and “Early”

Exercises of NQSOs
The grantee of a nonvested share may, within 30 days of that grant, make an election under IRC
Section 83(b) to be taxed when the award is granted (i.e., when the property is transferred for IRC Section
83 purposes) rather than when it vests for tax purposes (commonly referred to as an 83(b) election).
In that case, the grantee will have ordinary income equal to the fair market value of the stock on the
date the award is granted and the employer will receive a corresponding deduction. Any subsequent
appreciation realized by the employee upon sale of those shares is taxed at capital gains rates.4

Similarly, a grantee of an NQSO may be permitted to exercise the option before it is vested (commonly
referred to as an “early exercise”). The stock received upon an early exercise represents a nonvested
share for which the grantee may make an 83(b) election. In this scenario, the grantee will have ordinary
income equal to the fair market value of the option on the date of the early exercise (which, for options
issued at the money, will be zero if early exercised on the grant date) and the employer will receive a
corresponding deduction. Such awards often include an employer call feature that allows the issuer to
repurchase the option share if the employee leaves before the end of the requisite service period.

When an employee makes an 83(b) election upon receipt of a nonvested share, a DTL should be
recorded for the amount of the tax benefit on the basis of the tax deduction that the employer receives.
For example, if an employee receives an equity-classified nonvested share with a grant-date fair value
of $10 and makes an 83(b) election, the employee will be taxed on ordinary income of $10 and the
employer will receive a tax deduction of $10. Assuming a tax rate of 21 percent, the employer would
record a current tax benefit (and reduced income tax payable) of $2.10 to account for the deduction.
The employer would also record a DTL and deferred tax expense of $2.10 in the period of the grant. The
DTL will then be reversed in proportion to the amount of expense recorded over the requisite service
period, resulting in a normal rate.

10.2.10 Deferred Tax Effects When Compensation Cost Is Capitalized

Under U.S. GAAP, compensation cost may be capitalized for employees who spend time on production
of inventory or construction of fixed assets. This results in an asset for financial reporting purposes
with no corresponding tax basis and, under ASC 740, would ordinarily represent a taxable temporary
difference and corresponding DTL. However, in accordance with ASC 718-740- 25-2 (for instruments
classified as equity) and ASC 718-740-25-4 (for instruments classified as liabilities), the “cumulative
amount of compensation cost recognized for instruments . . . that ordinarily would result in a future
tax deduction under existing tax law shall be considered to be a deductible temporary difference.” If
the cost of an award that will ordinarily result in a deduction for tax purposes is capitalized (e.g., as part
of inventory or a fixed asset), the capitalized cost also becomes part of the tax basis of the asset. This

4
Because RSUs do not represent actual property interests (e.g., equity in the company), an employee receiving RSUs does not have an opportunity
to make an IRC Section 83(b) election on the grant date.

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represents the second of two key exceptions to ASC 740’s balance sheet model contained in ASC 718
(see Section 10.2.1 for a discussion of the first). As a result of this exception, the book and tax basis
of the capitalized compensation cost initially are considered to be equal and no DTL is recorded. If
depreciation is taken for financial reporting purposes before a deduction (or capitalization) for income
tax purposes, a temporary difference will arise. Upon generating a deduction (or upon capitalization) for
income tax purposes, an entity should recognize any excess tax benefit or tax deficiency in the income
statement. Any capitalized cost of an award that would not ordinarily result in a future deduction would
not be treated as part of the tax basis of the asset in accordance with ASC 718-740-25-3.

Example 10-7

In year 1, Company A grants fully vested NQSOs to the employees involved in the construction of a fixed
asset, resulting in the capitalization of $1,500 of share-based compensation cost. Other key facts include the
following:

• The asset is placed into service at the beginning of year 2 and has a 10-year life.
• Awards are fully vested on the grant date.
• Company A will receive a tax deduction for the intrinsic value of the option when it is exercised.
• Company A’s tax rate is 25 percent.
• The employees exercise the options with an intrinsic value of $4,000 at the end of year 3.
• None of the compensation cost is capitalized for income tax purposes upon exercise.

Journal Entry: Grant Date in Year 1

On the grant date, the share-based compensation cost related to the NQSOs increases the carrying amount of
A’s fixed asset under construction by $1,500. The offsetting entry is a credit to APIC.

Fixed asset 1,500

APIC 1,500

In year 2, A records $150 of depreciation expense and has a $1,350 remaining book basis in the portion of the
equipment’s carrying amount related to the share-based compensation cost. In accordance with ASC 718-740-
25-2, A’s corresponding tax basis is presumed to be $1,500, which is not depreciated for tax-return purposes.
As a result, A recognizes a $37.50 DTA: ([$1,500 tax basis – $1,350 book basis] × 25% tax rate).

Journal Entries: Year 2

Depreciation expense ($1,500 ÷ 10) 150

Accumulated depreciation 150
DTA 37.50
Deferred tax benefit 37.50

Journal Entries: Year 3

Record Depreciation and DTA (Same as Year 2)

Depreciation expense 150

Accumulated depreciation 150
DTA 37.50
Deferred tax expense 37.50

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Example 10-7 (continued)

Record Exercise of Options

When accounting for the impact of exercising the options, A must (1) record a reduction in income taxes
payable and corresponding reduction of current tax expense of $1,000 resulting from the exercise ($4,000
× 25%), (2) reverse the $75 DTA generated in years 2 and 3, and (3) establish a DTL for the basis difference
resulting from the exercise ([$1,200 remaining book basis − $0 remaining tax basis] × 25% tax rate = $300 DTL).
Note that this results in the entire excess tax benefit’s being recorded immediately in the income statement
upon exercise.

Income taxes payable 1,000

Current tax benefit 1,000
Deferred tax expense 375
DTA (year 2 + year 3) 75
DTL 300

In years 4 through 11, A would continue to record depreciation expense. In addition, A would reduce the DTL
and record a corresponding deduction in the deferred tax expense over the same period.

Journal Entries: Years 4 Through 11

Depreciation expense 150

Accumulated depreciation 150
DTL 37.50
Deferred tax benefit 37.50

10.3 Permanent Differences Resulting From Share-Based Payment Awards

As indicated in ASC 718-740-25-3, recognition of compensation cost for share-based payments that
“ordinarily do not result in tax deductions” do not give rise to deferred taxes for financial accounting
purposes. In addition, excess tax benefits and tax deficiencies result in permanent differences between
the amount of cumulative compensation cost recorded for equity-classified share-based payments and
the amount of the corresponding deduction taken for tax purposes as discussed in Section 10.2.4.1.
Other circumstances that result in permanent differences are discussed in the sections below.

10.3.1 Equity- and Liability-Classified Awards That Do Not Ordinarily Result

in a Deduction
ASC 718-740-25-3 indicates that the cumulative amount of compensation cost for awards that would not
ordinarily result in a future deduction under existing tax law does not represent a deductible temporary
difference. No deferred taxes would be recorded for these awards unless a change in circumstances
occurs. A common example of this type of an award is an ISO (see Section 10.1). When an entity issues
an ISO, it will record compensation cost as the award is earned but will not receive a tax deduction upon
the holder’s exercise of the award (i.e., a deduction will result only if the holder subsequently disposes
of the shares in a disqualifying disposition). Thus, the resulting book expense is considered a permanent
book-to-tax difference and will have the effect of increasing the issuing entity’s ETR.

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10.3.2 Tax Benefits of Dividends on Share-Based Payment Awards

ASC 718-740

Tax Benefits of Dividends on Share-Based Payment Awards to Employees

45-8 An income tax benefit from dividends or dividend equivalents that are charged to retained earnings
and are paid to employees for any of the following equity classified awards shall be recognized as income tax
expense or benefit in the income statement:
a. Nonvested equity shares
b. Nonvested equity share units
c. Outstanding equity share options.

Pending Content (Transition Guidance: ASC 718-10-65-11)

Tax Benefits of Dividends on Share-Based Payment Awards

45-8 An income tax benefit from dividends or dividend equivalents that are charged to retained earnings
and are paid to grantees for any of the following equity classified awards shall be recognized as income tax
expense or benefit in the income statement:
a. Nonvested equity shares
b. Nonvested equity share units
c. Outstanding equity share options.

As discussed further in Section 3.10 of Deloitte’s A Roadmap to Accounting for Share-Based Payment
Awards, the terms of some share-based payment awards permit holders to receive a dividend during
the vesting period and, in some instances, to retain the dividend even if the award fails to vest. Such
awards are commonly referred to as “dividend-protected awards.” Dividend payments made to grantees
for dividend-protected awards should be charged to retained earnings to the extent that the awards
are expected to vest. If an employee is entitled to retain dividends paid on shares that fail to vest, the
dividend payment for dividend-protected awards that are not expected to vest should be charged to
compensation cost.

For income tax purposes, dividends paid on such awards may result in a deduction and corresponding
income tax benefit. The income tax benefit resulting from payment of dividends on (1) nonvested equity
shares, (2) nonvested equity share units, and (3) outstanding equity share options should be recorded as
an income tax benefit in the income statement. If the dividend is charged against retained earnings for
pretax accounting purposes, a permanent difference will result.

10.4 “Recharge Payments” Made by Foreign Subsidiaries

Generally, a U.S. parent company is not entitled to a share-based compensation tax deduction (in the
United States) for awards granted by the parent to employees of a foreign subsidiary. Likewise, in most
jurisdictions, the foreign subsidiary that does not bear the cost of the compensation (i.e., because the
foreign parent who issued the award to the foreign subsidiary’s employees is bearing the cost) will not
be able to deduct the award in the foreign jurisdiction. Accordingly, some arrangements may specify
that a foreign subsidiary will make a “recharge payment” to the U.S. parent company that is equal to the
intrinsic value of the stock option upon its exercise so that the foreign subsidiary is entitled to take a
local tax deduction equal to the amount of the recharge payment. Under such an arrangement, the U.S.
parent company is not taxed on the payment made by the foreign subsidiary with respect to the parent
company’s stock.

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At its July 21, 2005, meeting, the FASB Statement 123(R) Resource Group agreed that in this case, the
direct tax effects of share-based compensation awards should be accounted for under the ASC 718
income tax accounting model. Because the U.S. parent company does not receive a deduction on
its U.S. tax return for awards granted to employees of the foreign subsidiary, the foreign subsidiary’s
applicable tax rate is used to measure (1) DTAs and (2) excess tax benefits and tax deficiencies recorded
by the foreign subsidiary in accordance with ASC 718. Any indirect effects of the recharge payment are
not accounted for under ASC 718. For example, if payment of the recharge results in an increase in an
outside basis deductible temporary difference or a reduction in an outside basis taxable temporary
difference, the corresponding deferred tax benefit will be recognized in the income statement at
the time the recharge payment is made and the deduction actually occurs for income tax reporting
purposes.

10.5 Cost-Sharing Arrangements
Related entities in different tax jurisdictions may enter into cost-sharing agreements under which
one party is reimbursed for a portion of certain costs it incurred in undertaking shared development
activities associated with intangible property. A jurisdiction may permit or require the resident entity to
include stock-based compensation cost in the joint cost pool that is reimbursed (commonly referred to
as the all costs rule).

The guidance in this section is applicable for entities that are allocating stock-based compensation
to related parties under a qualified cost-sharing arrangement. See Section 4.6.3 for a discussion of
uncertain tax positions associated with transfer pricing.

The issue of accounting for income taxes related to cost-sharing arrangements in the U.S. federal tax
jurisdiction was discussed at the FASB Statement 123(R) Resource Group’s July 21, 2005, meeting. The
discussion document for the meeting states, in part:

Related companies that plan to share the cost of developing intangible property may choose to enter into
what is called a cost-sharing agreement whereby one company bears certain expenses on behalf of another
company and is reimbursed for those expenses. U.S. tax regulations specify the expenses that must be
included in a pool of shared costs; such expenses include costs related to stock-based compensation awards
granted in tax years beginning after August 26, 2003.

The tax regulations provide two methods for determining the amount and timing of share-based compensation
that is to be included in the pool of shared costs: the “exercise method” and the “grant method.” Under the
exercise method, the timing and amount of the allocated expense is based on the intrinsic value that the award
has on the exercise date. Companies that elect to follow the grant method use grant-date fair values that
are determined based on the amount of U.S. GAAP compensation costs that are to be included in a pool of
shared costs. Companies must include such costs in U.S. taxable income regardless of whether the options are
ultimately exercised by the holder and result in an actual U.S. tax deduction.

The example below, adapted5 from the discussion document, illustrates the accounting for income taxes
associated with the allocation of share-based payment awards under a cost-sharing arrangement in the
U.S. federal tax jurisdiction.

5
The original example included in the discussion document for the FASB Statement 123(R) Resource Group’s July 21, 2005, meeting was developed
before the issuance of ASU 2016-09. The example has been modified herein to reflect the guidance in ASC 718-740-35-2, as amended by ASU
2016-09, which indicates that all excess tax benefits and tax deficiencies should be recorded in the income statement.

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Example 10-8

Company A, which is located in the United States, enters into a cost-sharing arrangement with its subsidiary,
Company B, which is located in Switzerland. Under the arrangement, the two companies share costs associated
with the R&D of certain technology. Company B reimburses Company A for 30 percent of the R&D costs
incurred by Company A. The U.S. tax rate is 25 percent. Cumulative book compensation for a fully vested option
is $100 for the year ending on December 31, 20X6. The award is exercised during 20X7, when the intrinsic
value of the option is $150.

The tax accounting impact is as follows:

Exercise Method
On December 31, 20X6, Company A records $18 as the DTA related to the option (rounded for $100 book
compensation expense × 70% not subject to reimbursement × 25% tax rate). When, in 20X7, the option is
exercised, any net tax benefit that exceeds the DTA is an excess tax benefit and is recorded in the income
statement. The company is entitled to a U.S. deduction resulting in a benefit (net of the inclusion) of $26
(rounded for $150 intrinsic value when the option is exercised × 70% not reimbursed × 25%). Accordingly, $8
($26 – $18) would be recorded in the income statement as an excess tax benefit.

Grant Method
The cost-sharing impact is an increase of currently payable U.S. taxes each period; however, in contrast to the
exercise method, the cost-sharing method should have no direct impact on the carrying amount of the U.S.
DTA related to share-based compensation. If there was $100 of stock-based compensation during 20X6, the
impact on the December 31, 20X6, current tax provision would be $8 (rounded for $100 book compensation
expense × 30% reimbursed × 25%). If the stock-based charge under ASC 718 is considered a deductible
temporary difference, a DTA also should be recorded in 20X6 for the financial statement expense, in the
amount of $25 ($100 book compensation expense × 25%). The net impact on the 20X6 income statement is a
tax benefit of $17 ($25 – $8). At settlement, the excess tax deduction of $13 would be recorded in the income
statement.

An entity should consider the impact of cost-sharing arrangements when measuring, on the basis of
the tax election it has made or plans to make, the initial and subsequent deferred tax effects associated
with its stock compensation costs. If regulations in a particular jurisdiction vary significantly from those
in the U.S. federal tax jurisdiction described above, the entity should consult with its accounting advisers
regarding the appropriate accounting treatment.

10.6 Accounting Considerations for Valuation Allowances Related to Share-

Based Payment DTAs
ASC 718-740

30-2 Subtopic 740-10 requires a deferred tax asset to be evaluated for future realization and to be reduced
by a valuation allowance if, based on the weight of the available evidence, it is more likely than not that some
portion or all of the deferred tax asset will not be realized. Differences between the deductible temporary
difference computed pursuant to paragraphs 718-740-25-2 through 25-3 and the tax deduction that would
result based on the current fair value of the entity’s shares shall not be considered in measuring the gross
deferred tax asset or determining the need for a valuation allowance for a deferred tax asset recognized under
these requirements.

In assessing whether a valuation allowance should be provided on DTAs related to stock-based

compensation cost, an entity should not consider the current price of the grantor’s stock. ASC 718-740-
30-2 prohibits an entity from considering the current price of the grantor’s stock and adjusting the gross
amount of the DTA.

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When an entity is evaluating the need for a valuation allowance, it should apply the guidance in
ASC 740-10-30-17 through 30-23. That is, whether the entity needs to record a valuation allowance
depends on whether it is more likely than not that there will be sufficient taxable income to realize
the DTA.

Therefore, even if the award is deep out-of-the-money to a degree that its exercise is unlikely or the
award’s intrinsic value on the exercise date is most likely to be less than its grant-date fair value, the
entity should not record a valuation allowance unless and until it is more likely than not that
future taxable income will not be sufficient to realize the related DTAs. See Chapter 5 for a
broader discussion of valuation allowance considerations.

Example 10-9

On January 1, 20X6, an entity grants 1,000 “at-the-money” employee share options, each with a grant-date
fair-value-based measure of $7. The awards vest at the end of the third year of service (cliff vesting), have an
exercise price of $23, and expire after the fifth year from the grant date. The entity’s applicable tax rate is 25
percent. On December 31, 20Y0, the entity’s share price is $5. The entity has generated taxable income in the
past and expects to continue to do so in the future.

In each reporting period, the entity would record compensation cost on the basis of the number of awards
expected to vest, the grant-date fair-value-based measure of the award, and the amount of services rendered.
Contemporaneously, a DTA would be recorded on the basis of the amount of compensation cost recorded
and the entity’s applicable tax rate. On December 31, 20Y0, even though the likelihood that the employee
will exercise the award is remote (i.e., the award is “deep out-of-the-money”) and the DTA therefore will not
be realized, the entity would not be allowed to write off any part of the gross DTA or to provide a valuation
allowance against the DTA until the award expires unexercised (January 1, 20Y1) assuming there is sufficient
future taxable income to realize that DTA on December 31, 20Y0. The entity would be able to record a valuation
allowance against the DTA only when it is more likely than not that the entity will not generate sufficient taxable
income to realize the DTA.

10.7 Deferred Tax Effects of Replacement Awards Issued in a Business

Combination
ASC 805-740

Replacement Awards Classified as Equity

25-10 Paragraph 805-30-30-9 identifies the types of awards that are referred to as replacement awards in
the Business Combinations Topic. For a replacement award classified as equity that ordinarily would result in
postcombination tax deductions under current tax law, an acquirer shall recognize a deferred tax asset for
the deductible temporary difference that relates to the portion of the fair-value-based measure attributed
to precombination employee service and therefore included in consideration transferred in the business
combination.

Pending Content (Transition Guidance: ASC 718-10-65-11)

25-10 Paragraph 805-30-30-9 identifies the types of awards that are referred to as replacement awards
in the Business Combinations Topic. For a replacement award classified as equity that ordinarily would
result in postcombination tax deductions under current tax law, an acquirer shall recognize a deferred tax
asset for the deductible temporary difference that relates to the portion of the fair-value-based measure
attributed to a precombination exchange of goods or services and therefore included in consideration
transferred in the business combination.

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ASC 805-740 (continued)

25-11 For a replacement award classified as equity that ordinarily would not result in tax deductions under
current tax law, an acquirer shall recognize no deferred tax asset for the portion of the fair-value-based
measure attributed to precombination service and thus included in consideration transferred in the business
combination. A future event, such as an employee’s disqualifying disposition of shares under a tax law, may 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.

Pending Content (Transition Guidance: ASC 718-10-65-11)

25-11 For a replacement award classified as equity that ordinarily would not result in tax deductions
under current tax law, an acquirer shall recognize no deferred tax asset for the portion of the fair-value-
based measure attributed to precombination vesting and thus included in consideration transferred in
the business combination. A future event, such as an employee’s disqualifying disposition of shares under
a tax law, may 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.

Tax Deductions for Replacement Awards

45-5 Paragraph 805-30-30-9 identifies the types of awards that are referred to as replacement awards in this
Topic. After the acquisition date, the deduction reported on a tax return for a replacement award classified as
equity may be different from the fair-value-based measure of the award. The tax effect of that difference shall
be recognized as income tax expense or benefit in the income statement of the acquirer.

In a business combination, share-based payment awards held by grantees of the acquiree are often
exchanged for share-based payment awards of the acquirer. ASC 805 refers to the new awards as
“replacement awards.”

10.7.1 Tax Effects of Replacement Awards Issued in a Business Combination

That Ordinarily Would Result in a Deduction
10.7.1.1 Income Tax Accounting as of the Acquisition Date
For share-based payment awards that (1) are exchanged in a business combination and (2) ordinarily
result in a tax deduction under current tax law (e.g., NQSOs), an acquirer should record a DTA as of
the acquisition date for the tax benefit of the fair-value-based measure of the acquirer’s replacement
awards included in the consideration transferred, generally with a corresponding reduction of goodwill.
For guidance on calculating the amount of the fair-value-based measure to include in the consideration
transferred, see Section 10.2 of Deloitte’s A Roadmap to Accounting for Share-Based Payment Awards.

10.7.1.2 Income Tax Accounting After the Acquisition Date

For the portion of the fair-value-based measure of the acquirer’s replacement awards that is attributed
to postcombination vesting and therefore included in postcombination compensation cost, a DTA
is recorded over the remaining vesting period (i.e., as the postcombination compensation cost is
recorded).

In accordance with ASC 718, the DTA for replacement awards classified as equity is not subsequently
adjusted to reflect changes in the entity’s share price. By contrast, for replacement awards classified
as a liability, the DTA is remeasured, along with the compensation cost, in every reporting period until
settlement.

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10.7.1.3 Income Tax Accounting Upon Vesting or Exercise of the Share-Based

Payment Awards
ASC 805-740-45-5 states that “the deduction reported on a tax return for a replacement award
classified as equity may be different from the fair-value-based measure of the award. The tax effect of
that difference shall be recognized as income tax expense or benefit in the income statement of the
acquirer.”

The examples below, adapted from ASC 805-30-55, illustrate the income tax accounting for tax benefits
associated with equity-classified replacement awards that are issued in a business combination.

Example 10-10

Assume the following:

• Entity A acquired Entity B in a business combination on June 30, 20X1.

• Entity A was obligated to issue replacement awards to B’s employees under the acquisition agreement’s
terms.
• The replacement awards are stock options that would typically result in a tax deduction (e.g., NQSOs).
• Entity A’s applicable tax rate is 20 percent.
For simplicity, the par value of the common stock issued and the cash received for the option’s exercise price
are not considered.

Entity A issues replacement awards of $110 (fair-value-based measure) on the acquisition date in exchange for
B’s awards of $100 (fair-value-based measure) on the acquisition date. The exercise price of the replacement
awards issued by A is $15. No postcombination services are required for the replacement awards, and B’s
employees rendered all of the required service for the replaced awards as of the acquisition date.

The amount attributable to precombination service is the fair-value-based measure of B’s awards ($100) on
the acquisition date; that amount is included in the consideration transferred in the business combination. The
amount attributable to postcombination service is $10, which is the difference between the total fair-value-
based measure of the replacement awards ($110) and the portion attributable to precombination service
($100). Because no postcombination service is required for the replacement awards, A immediately recognizes
$10 as compensation cost in its postcombination financial statements.

Journal Entries: June 30, 20X1

Goodwill 100
Compensation cost 10
APIC 110
To record the portions of the fair-value-based measure of the
replacement awards that are attributable to precombination service
(i.e., consideration transferred) and postcombination service (i.e.,
postcombination compensation cost).
DTA 22
Goodwill 20
Income tax provision 2
To record the associated income tax effects of the fair-value-based
measure of the portions of the replacement award that are
attributable to precombination service (i.e., consideration
transferred) and postcombination service (i.e., postcombination
compensation cost).

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Example 10-10 (continued)

On September 30, 20X1, all replacement awards issued by A are exercised when the market price of A’s shares
is $150. Given the exercise of the replacement awards, A will realize a tax deduction of $135 ($150 market price
of A’s shares less the $15 exercise price). The tax benefit of the tax deduction is $27 ($135 × 20% tax rate).
Therefore, an excess tax benefit of $5 (tax benefit of the tax deduction of $27 less the previously recorded DTA
of $22) is recorded to the current income tax expense.

Journal Entry: September 30, 20X1

Taxes payable 27
Income tax provision 5
DTA 22
To record the income tax effects of the awards upon exercise.

Example 10-11

Assume the following:

• Entity A acquired Entity B in a business combination on June 30, 20X1.

• Entity A was obligated to issue replacement awards to B’s employees under the acquisition agreement’s
terms.
• The replacement awards are stock options that would typically result in a tax deduction (e.g., NQSOs).
• Entity A’s applicable tax rate is 20 percent.
For simplicity, the par value of the common stock issued and the cash received for the options’ exercise price
are not considered.

Entity A exchanges replacement awards that require one year of postcombination service for B’s share-based
payment awards for which employees had completed the requisite service period before the business
combination. The fair-value-based measure of both awards is $100 on the acquisition date. The exercise price of
the replacement awards is $15. When originally granted, B’s awards had a requisite service period of four years.
As of the acquisition date, B’s employees holding unexercised awards had rendered a total of seven years of
service since the grant date. Even though B’s employees had already rendered the requisite service for the original
awards, A attributes a portion of the replacement awards to postcombination compensation cost in accordance
with ASC 805-30-30-12 because the replacement awards require one year of postcombination service. The total
service period is five years — the requisite service period for the original acquiree awards completed before the
acquisition date (four years) plus the requisite service period for the replacement awards (one year).

The portion attributable to precombination service equals the fair-value-based measure of the replaced awards
($100) multiplied by the ratio of the precombination service period (four years) to the total service period (five
years). Thus, $80 ($100 × [4 years/5 years]) is attributed to the precombination service period and therefore
is included in the consideration transferred in the business combination. The remaining $20 is attributed to
the postcombination service period and therefore is recognized as compensation cost in A’s postcombination
financial statements, in accordance with ASC 718.

Journal Entries: June 30, 20X1

Goodwill 80
APIC 80
DTA 16
Goodwill 16
To record the portion of the fair-value-based measure of the
replacement awards attributable to precombination service (i.e.,
consideration transferred) and the associated income tax effects.

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Example 10-11 (continued)

Journal Entries: December 31, 20X1

Compensation cost 10
APIC 10
DTA 2
Income tax provision 2
To record the compensation cost and the associated income tax
effects for the six-month period from the date of the acquisition
until December 31, 20X1.

Journal Entries: June 30, 20X2

Compensation cost 10
APIC 10
DTA 2
Income tax provision 2
To record the compensation cost and the associated income tax
effects for the six-month period ended June 30, 20X2.

On June 30, 20X2, all replacement awards issued by A vest and are exercised when the market price of A’s
shares is $150. Given the exercise of the replacement awards, A will realize a tax deduction of $135 ($150
market price of A’s shares less the $15 exercise price). The tax benefit of the tax deduction is $27 ($135 × 20%
tax rate). Therefore, an excess tax benefit of $7 (tax benefit of the tax deduction of $27 less the previously
recorded DTA of $20 [$16 + $2 + $2]) is recorded to the current income tax provision.

Journal Entry: June 30, 20X2

Taxes payable 27
Deferred tax expense 20
DTA 20
Current tax expense 27
To record the income tax effects of the award upon exercise.

10.7.2 Tax Effects of Replacement Awards Issued in a Business Combination

That Would Not Ordinarily Result in Tax Deductions
Under ASC 805-740-25-11, an acquirer should not record a DTA as of the acquisition date for the tax
benefits of the fair-value-based measure of its replacement share-based payment awards included in
the consideration transferred that do not ordinarily result in a tax deduction (e.g., ISOs).

10.7.2.1 Tax Effects of a Disqualifying Disposition in a Business Combination

The acquirer may receive a tax deduction associated with replacement awards that would not ordinarily
result in deductions as a result of events that occur after the acquisition date (e.g., a disqualifying
disposition). The tax effects of such events are recognized only when they occur and would be recorded
in the income tax provision.

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10.7.3 Exchange of Vested Acquiree Employee Awards for Unvested Share

Awards of Acquirer in a Business Combination
To incentivize a key employee of an acquiree to remain with the combined entity after the transaction
is completed, an acquirer may permit or require that employee to surrender fully vested shares of the
acquiree for nonvested shares of the acquirer. In this situation, the original restricted stock award would
have resulted in a tax liability for the employee and a tax deduction for the acquiree on the original
vesting date. The employee may make an IRC Section 83(b) election upon receipt of the nonvested
acquirer share. Typically, the exchange on the date of the business combination is for equal value;
therefore, the employee making the 83(b) election would not owe any additional tax on the exchange
and would pay more favorable capital gains tax on any appreciation when the acquirer shares vest and
are ultimately sold. Similarly, the employer would not get a tax deduction for the new award.

For financial reporting purposes, the acquirer would account for the exchange and the grant of the new
unvested stock in accordance with ASC 718. Therefore, compensation cost would be measured on the
basis of the fair-value-based measure of the new restricted stock award on the grant date and would
be recognized over the vesting period. Thus, the recognition of the compensation cost for financial
reporting purposes would result in a permanent difference that would affect the entity’s ETR.

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11.1 Introduction
ASC 805-740

05-1 This Subtopic provides incremental guidance on accounting for income taxes related to business
combinations and to acquisitions by not-for-profit entities. This Subtopic requires recognition of deferred
tax liabilities and deferred tax assets (and related valuation allowances, if necessary) for the deferred tax
consequences of differences between the tax bases and the recognized values of assets acquired and liabilities
assumed in a business combination or in an acquisition by a not-for-profit entity.

05-2 The recognition and measurement requirements related to accounting for income taxes in this Subtopic
are exceptions to the recognition and measurement principles that are otherwise required for business
combinations and acquisitions by not-for-profit entities, as established in Sections 805-20-25 and 805-20-30.

Overall Guidance
15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic, see
Section 805-10-15.

25-1 This Section provides general guidance on the recognition of deferred tax assets and liabilities in
connection with a business combination. It also addresses certain business-combination-specific matters
relating to goodwill, replacement awards, and the allocation of consolidated tax expense after an acquisition.

25-2 An acquirer shall recognize a deferred tax asset or deferred tax liability arising from the assets acquired
and liabilities assumed in a business combination and shall account for the potential tax effects of temporary
differences, carryforwards, and any income tax uncertainties of an acquiree that exist at the acquisition date, or
that arise as a result of the acquisition, in accordance with the guidance in Subtopic 740-10 together with the
incremental guidance provided in this Subtopic.

25-3 As of the acquisition date, a deferred tax liability or asset shall be recognized for an acquired entity’s
taxable or deductible temporary differences or operating loss or tax credit carryforwards except for differences
relating to the portion of goodwill for which amortization is not deductible for tax purposes, leveraged leases,
and the specific acquired temporary differences identified in paragraph 740-10-25-3(a). Taxable or deductible
temporary differences arise from differences between the tax bases and the recognized values of assets
acquired and liabilities assumed in a business combination. Example 1 (see paragraph 805-740-55-2) illustrates
this guidance. An acquirer shall assess the need for a valuation allowance as of the acquisition date for an
acquired entity’s deferred tax asset in accordance with Subtopic 740-10.

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ASC 805-740 (continued)

25-4 Guidance on tax-related matters related to the portion of goodwill for which amortization is not deductible
for tax purposes is in paragraphs 805-740-25-8 through 25-9; guidance on accounting for the acquisition
of leveraged leases in a business combination is in paragraph 840-30-30-15; and guidance on the specific
acquired temporary differences identified in paragraph 740-10-25-3(a) is referred to in that paragraph.

Pending Content (Transition Guidance: ASC 842-10-65-1)

25-4 Guidance on tax-related matters related to the portion of goodwill for which amortization is not
deductible for tax purposes is in paragraphs 805-740-25-8 through 25-9; guidance on accounting for
the acquisition of leveraged leases in a business combination is in Subtopic 842-50; and guidance on
the specific acquired temporary differences identified in paragraph 740-10-25-3(a) is referred to in that
paragraph.

25-5 The tax bases used in the calculation of deferred tax assets and liabilities as well as amounts due to or
receivable from taxing authorities related to prior tax positions at the date of a business combination shall be
calculated in accordance with Subtopic 740-10.

25-6 In a taxable business combination, the consideration paid is assigned to the assets acquired and liabilities
assumed for financial reporting and tax purposes. However, the amounts recognized for particular assets and
liabilities may differ for financial reporting and tax purposes. As required by paragraph 805-740-25-3, deferred
tax liabilities and assets are recognized for the deferred tax consequences of those temporary differences. For
example, a portion of the amount of goodwill for financial reporting may be allocated to some other asset for
tax purposes, and amortization of that other asset may be deductible for tax purposes. If a valuation allowance
is recognized for that deferred tax asset at the acquisition date, recognized benefits for those tax deductions
after the acquisition date shall be applied in accordance with paragraph 805-740-45-2.

25-7 See Examples 1 through 3 (paragraphs 805-740-55-2 through 55-8) for illustrations of the recognition of
deferred tax assets and related valuation allowances at the date of a nontaxable business combination.

A business combination occurs when one substantive legal entity obtains control of a group of assets
that meets the ASC master glossary’s definition of a business. A business combination can be legally
structured in a variety of ways and as discussed further below, the determination of whether a legal
entity (or group of assets) being acquired meets the definition of a business is often a conclusion that
requires significant judgment as well as a good understanding of the components of the transaction.

The main difference between the accounting for an acquisition of a business (i.e., a business
combination) and that for an acquisition of a group of assets that is not a business (i.e., an asset
acquisition) is the existence of goodwill. As discussed further in Section 11.8, the accounting for income
tax consequences differs between an asset acquisition and a business combination as well.

The underlying premise of accounting for a business combination (which is addressed by ASC 805) is
that when an entity obtains a controlling financial interest in a business, it becomes accountable for all
of the acquiree’s assets and liabilities. This results in an accounting recognition event for which the entity
should recognize the assets acquired and liabilities assumed at their fair values on the acquisition date.
This is true regardless of whether the acquirer obtains 100 percent or lesser controlling financial interest
in a business. That is, the acquisition method of accounting, whereby acquired assets and liabilities are
recorded at fair value by the acquirer, is applied whenever an entity obtains control of a business.

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ASC 805 has two key principles, known as the “recognition principle” and the “measurement
principle.” According to the recognition principle, for financial reporting purposes, an acquirer must
“recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree.” Under the measurement principle, for financial reporting
purposes, the acquirer must then measure “the identifiable assets acquired, the liabilities assumed,
and any noncontrolling interest in the acquiree at their acquisition-date fair values.”1 The application of
these principles will have an impact on the accounting for income taxes since, depending on how the
transaction is structured for tax purposes, deductible and taxable temporary differences might need to
be recorded in connection with the accounting for the business combination or asset acquisition.

Before an entity can apply the acquisition method, it must determine whether a transaction meets the
definition of a business combination. The ASC master glossary defines a business combination as “[a]
transaction or other event in which an acquirer obtains control of one or more businesses.” Typically, a
business combination occurs when an entity purchases the equity interests or the net assets of one or
more businesses in exchange for cash, equity interests of the acquirer, or other consideration. However,
the definition of a business combination applies to more than just purchase transactions: It incorporates
all transactions or events in which an entity or individual obtains control of a business.

Control has the same meaning as “controlling financial interest,” and an entity applies the guidance in
ASC 810-10 to determine whether it has obtained a controlling financial interest in a business. Under
ASC 810-10, an entity determines whether it has obtained a controlling financial interest by applying the
VIE model or the voting interest entity model.

In January 2017, the FASB issued ASU 2017-01 to clarify the definition of a business because the
previous definition in ASC 805 was often applied so broadly that transactions that were more akin to
asset acquisitions were being accounted for as business combinations. The ASU introduces a screen
for determining when a set of activities and assets is not a business. An entity uses the screen to assess
whether substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated
in a single identifiable asset or group of similar identifiable assets. If so, the set is not a business.
The screen is intended to reduce the number of transactions that an entity must further evaluate to
determine whether they are business combinations or asset acquisitions.

To be considered a business, an acquired group of assets must (1) pass the screen and (2) include an
input and a substantive process that together significantly contribute to the ability to create outputs.
Under the previous definition of a business, it was not always clear whether an element was an input or
a process or whether a process had to be substantive to affect the determination. Therefore, the ASU
provides a framework to help entities evaluate whether both an input and a substantive process are
present.

ASU 2017-01 is effective for PBEs for annual periods beginning after December 15, 2017, including
interim periods therein. For all other entities, the ASU is effective for annual periods beginning after
December 15, 2018, and interim periods within annual periods beginning after December 15, 2019. The
ASU must be applied prospectively, but early adoption is permitted for transactions that have not been
reported.

It is expected that fewer acquisitions will be business combinations for entities that have adopted ASU
2017-01. See Chapter 1 of Deloitte’s A Roadmap to Accounting for Business Combinations for additional
guidance on the determination of whether an acquired group of assets meets the definition of a
business.

1
As discussed further in this chapter, there are certain exceptions to the measurement principle.

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Once it has been concluded that a business combination has occurred and the amount of consideration
to acquire the business has been determined, the next step in applying the acquisition method is
recognizing and measuring the identifiable assets, liabilities, and any noncontrolling interest in the
acquiree. Acquired assets and liabilities are generally initially measured at their acquisition-date fair
value. However, certain assets or liabilities are exceptions to the recognition principle, the measurement
principle, or both, and are measured in accordance with other U.S. GAAP. These would include income
taxes that are recognized and measured in accordance with ASC 740, which is discussed throughout this
chapter.

11.1.1 Measurement Period
Because it may take time for an entity to obtain the information necessary to recognize and measure all
the items exchanged in a business combination, the acquirer is allowed a period in which to complete
its accounting for the acquisition. That period — referred to as the measurement period — ends as
soon as the acquirer (1) receives the information it had been seeking about facts and circumstances that
existed as of the acquisition date or (2) learns that it cannot obtain further information. However, the
measurement period cannot be more than one year after the acquisition date. During the measurement
period, the acquirer recognizes provisional amounts for the items for which the accounting is
incomplete, including income taxes. Adjustments to any of these items will affect the amount of goodwill
recognized or bargain purchase gain.

ASC 805 originally required that if a measurement-period adjustment was identified, the acquirer
retrospectively revised comparative information for prior periods, including making any change in
depreciation, amortization, or other income effects as if the accounting for the business combination
had been completed as of the acquisition date. However, revising prior periods to reflect measurement-
period adjustments added cost and complexity to financial reporting, and many believed that it did not
significantly improve the usefulness of the information provided to users. To address those concerns,
the FASB issued ASU 2015-16 in September 2015. Under the ASU, an acquirer must recognize
adjustments to provisional amounts that are identified during the measurement period in the reporting
period in which the adjustment amounts are determined rather than retrospectively, including the effect
on earnings of changes in depreciation or amortization, or other income effects (if any) as a result of
the change to the provisional amounts, calculated as if the accounting had been completed as of the
acquisition date.

Measurement-period adjustments (i.e., those that result in an adjustment to goodwill or bargain gain) do
not result from new information that was not available as of the acquisition date (e.g., new information
that might affect the assessment of realization of uncertain tax benefits). Adjustments to acquired assets
and liabilities related to events or occurrences after the acquisition date would be recorded immediately
to income even if the new information was obtained within the measurement period. See Section 11.4
for additional information.

11.1.2 Asset Acquisitions
An asset acquisition is an acquisition of an asset, or a group of assets, that does not meet the definition
of a business; such an acquisition therefore does not meet the definition of a business combination.
The accounting for these transactions is addressed in the “Acquisition of Assets Rather Than a Business”
subsections of ASC 805-50 but has many of the same considerations related to the accounting for
income taxes as a business combination.

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For financial reporting purposes, asset acquisitions are accounted for by using a cost accumulation
model (i.e., the cost of the acquisition, including certain transaction costs, is allocated to the assets
acquired on the basis of relative fair values, with some exceptions). By contrast, a business combination
is accounted for by using a fair value model (i.e., the assets and liabilities are generally recognized at
their fair values, and the difference between the consideration paid, excluding transaction costs, and
the fair values of the assets and liabilities is recognized as goodwill). As a result, there are differences
between the accounting for an asset acquisition and the accounting for a business combination.

A significant difference in an asset acquisition is that there is no goodwill recorded. That is, the cost paid
to acquire the assets and liabilities is allocated entirely to the assets and liabilities acquired. This includes
acquired DTLs and DTAs that result from an asset acquisition. This adds complexities to the calculation
of acquired DTAs and DTLs in asset acquisitions since there is no goodwill to record as an offset to
acquired DTAs and DTLs (resulting in the need to perform a simultaneous calculation to determine the
DTAs or DTLs). As noted in Section 11.1, ASU 2017-01 narrows the definition of a business, which could
result in fewer acquisitions’ being accounted for as business combinations but rather being accounted
for as asset acquisitions. See Section 11.8 for additional discussion about the accounting for income tax
consequences of asset acquisitions.

11.1.3 Taxable Versus Nontaxable Business Combination

805-740-25 (Q&A 02)
Once recognition and measurement of the identifiable assets, liabilities, and any noncontrolling
interest in the acquiree has occurred (for financial reporting purposes under the principles of U.S.
GAAP), ASC 805-740 requires recognition of a DTL or DTA as of the acquisition date for the taxable and
deductible temporary differences between (1) the financial reporting values of assets acquired and
liabilities assumed and (2) the tax bases of those assets and liabilities. Determining the appropriate tax
bases of those assets and liabilities depends in part on whether the transaction is treated as taxable or
nontaxable.

Generally, the difference between a taxable business combination and a nontaxable business
combination is that the assets acquired and liabilities assumed in a taxable business combination are
typically recorded at fair value for both income tax and financial reporting purposes; however, in a
nontaxable business combination, the predecessor’s tax bases are carried forward for assets acquired and
liabilities assumed.

A taxable business combination will usually occur when the purchase transaction is structured as
an asset purchase wherein the acquirer purchases the specific assets and liabilities of the acquiree
but does not assume ownership of the target’s stock. This type of transaction allows the acquirer to
step up the tax basis of the assets and liabilities to their fair value. By contrast, a nontaxable business
combination will typically be the result in a stock purchase wherein the acquirer will assume the
acquiree’s tax basis of the assets and liabilities. However, certain elections under the tax code related to
the establishment of the tax bases of assets and liabilities acquired may be available that will allow an
acquirer to treat a stock purchase in a manner similar to an asset purchase.

Connecting the Dots

Asset acquisitions or business combinations under U.S. GAAP could be asset purchases or stock
purchases for tax purposes. It is critical that an entity understand the structure and accounting
for a given transaction under ASC 805 and the tax code, including what tax elections may apply,
when determining the deferred tax consequences of the transaction.

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In both taxable and nontaxable business combinations, the amounts assigned to the individual assets
acquired and liabilities assumed for financial statement purposes may differ from the amounts assigned
or carried forward for tax purposes. A DTL or DTA is recognized for each of these temporary differences
with certain exceptions (e.g., recognition of deferred taxes on goodwill), as described throughout
this Roadmap. An entity would apply the recognition and measurement criteria of ASC 740 (or other
authoritative literature) to record acquired DTAs and DTLs instead of the general measurement
principles of ASC 805.

11.1.4 Other General Considerations

Some key accounting requirements outside ASC 805 that an entity should consider when applying ASC
740 to the accounting for business combinations include, but are not limited to, the following:

• Tax benefits arising from the excess of tax-deductible goodwill over goodwill for financial
reporting purposes must be recognized as of the acquisition date as a DTA. Conversely, ASC
805-740-25-9 prohibits the recognition of a DTL for financial reporting goodwill in excess of the
amount that is amortizable for tax (see Section 11.3.2).

• A net DTA is recognized in a business combination if it is more likely than not that the
tax benefits for deductible temporary differences and carryforwards will be realized (see
Section 11.5).

• If separate tax returns are expected to be filed in future years (e.g., when a domestic entity
acquires a foreign entity), only the available evidence of the acquired entity should be
considered in the determination of whether it is more likely than not that the acquired tax
benefits will be realized (see Section 11.5).

• Discounting of the income tax consequences of temporary differences and carryforwards to

their present values is prohibited.

The remaining sections of this chapter will discuss these considerations and others in greater detail.

11.2 General Principles of Income Tax Accounting for a Business

Combination
Understanding the details of a business combination transaction is important to understanding the
related impacts on income tax accounting. For example, depending on the nature of the transaction,
certain elements may be accounted for as part of purchase accounting or as separate transactions in
the postcombination financial statements of the acquirer or in the precombination financial statements
of the acquiree.

11.2.1 Identifying Parts of the Business Combination

805-740-25 (Q&A 23)
ASC 805-20-25-6 states:

At the acquisition date, the acquirer shall classify or designate the identifiable assets acquired and liabilities
assumed as necessary to subsequently apply other GAAP. The acquirer shall make those classifications or
designations on the basis of the contractual terms, economic conditions, its operating or accounting policies,
and other pertinent conditions as they exist at the acquisition date.

Under ASC 805-20-25-6, DTAs and DTLs recognized in a business combination should reflect the
tax attributes of the acquired entity as well as the structure of the combined entity as it exists on
the acquisition date. Accordingly, the tax effects of income tax elections, changes in tax status, tax
planning, and subsequent business integration steps that occur post-closing are generally accounted
for separately and apart from the business combination (i.e., on “day 2”). However, some income tax

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elections, changes in tax status, tax planning, and subsequent business integration steps may be so
integral to the business combination transaction that they should be included in the application of the
acquisition method of accounting to the business combination.

While ASC 805-10-25-20 through 25-22 provide general guidance an entity should consider when
determining whether a transaction is part of the business combination (see Section 1.1.9 of Deloitte’s
A Roadmap to Accounting for Business Combinations), there is no direct guidance addressing whether
the tax effects of income tax elections, tax planning, and subsequent business integration steps that
occur post-closing are so integral to the business combination transaction that they should be included
in the acquisition accounting.

Accordingly, an entity must apply significant judgment on the basis of its facts and circumstances and
should consider the following questions, which are neither mutually exclusive nor individually conclusive,
when determining whether to include income tax elections, changes in tax status, tax planning, or
other subsequent business integration steps that occur post-closing in its application of the acquisition
method of accounting to the business combination.

• Was the income tax election, change in tax status, tax planning, or subsequent business
integration step a factor in the negotiations of the business combination (e.g., were any
adjustments to the purchase price considered during negotiations with the previous owners
in contemplation of, or as consideration for, any of the income tax elections, tax planning,
or subsequent business integration steps), or was the income tax election, tax planning, or
subsequent business integration step identified post-closing?

• Was the effective date of the income tax election, tax planning, or subsequent business
integration step concurrent with or retroactive to the acquisition date, or will it only become
effective post-closing?

• Was the income tax election, tax planning, or subsequent business integration step primarily
within the control of the acquirer or seller, or were there uncertainties or regulatory hurdles
related to the income tax election, tax planning, or business integration step as of the closing?

• Would the income tax election, tax planning, or subsequent business integration step be
expected of every market participant, or would it be based on the acquirer’s specific facts and
circumstances?

• Were the tax benefits of the income tax election, tax planning, or subsequent business
integration step obtained without interaction with the government, or was the acquirer required
to (1) make a separate payment directly to the governmental taxing authority or (2) forego tax
attributes to obtain the tax benefits?

11.2.2  Change in Tax Status as a Result of Acquisition

740-10-25 (Q&A 57)
An entity’s taxable status may change as a result of a business combination. For example, an S
corporation could lose its nontaxable status when acquired by a C corporation. When an entity’s
status changes from nontaxable to taxable, DTAs and DTLs should be recognized for any temporary
differences in existence on the recognition date (unless one of the recognition exceptions in ASC
740-10-25-3 is applicable). Entities should initially measure such recognizable temporary differences in
accordance with ASC 740-10-30. See Section 3.5.2 for further discussion of recognizing and measuring
changes in tax status.

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If the loss of the acquiree’s nontaxable status directly results from an acquisition, temporary differences
in existence on the acquisition date should be recognized as part of the business combination
acquisition accounting (i.e., through goodwill during the measurement period) under ASC 805-740-
25-3 and 25-4. If, because of the acquisition, the acquired entity no longer meets the requirements
to be considered a nontaxable entity, all the basis differences in the entity that would be considered
taxable or deductible temporary differences would be recognized on the acquisition date. If a valuation
allowance is established, all subsequent changes (i.e., after the measurement period) are recorded in
accordance with ASC 740, typically in income from continuing operations. See Section 11.5.1 for more
information. Also see Section 3.5.2 for additional financial reporting considerations related to a change
in tax status.

However, if the business combination is deemed a transaction “among or with shareholders,” the initial
tax effects of changes in the tax bases of assets or liabilities should be charged or credited directly
to shareholders’ equity, as discussed in ASC 740-20-45-11(g). Any subsequent changes in valuation
allowances should be recorded in accordance with ASC 740, typically in income from continuing
operations. See Section 6.2.7 for further discussion and examples of transactions “among or with
shareholders.”

See Section 8.3.1 for a discussion of accounting for change in status in the separate or carve-out
financial statements of the acquiree resulting from a business combination.

11.2.3 The Applicable Tax Rate

805-740-30 (Q&A 01)
Another question that arises when an entity is accounting for the tax impacts of a business combination
is what tax rate should be used to establish initial DTAs and DTLs as a result of the acquisition. The
combined entity may have different tax characteristics than the predecessor and successor entities.

ASC 740-10-30-5 states that “[d]eferred taxes shall be determined separately for each tax-paying
component (an individual entity or group of entities that is consolidated for tax purposes) in each
tax jurisdiction.” In addition, under ASC 740-10-30-8, an acquired entity’s deferred taxes should be
measured by “using the enacted tax rate(s) expected to apply to taxable income in the periods in which
the deferred tax liability or asset is expected to be settled or realized.”

If, in periods after the business combination, the combined entity expects to file a consolidated tax
return, the enacted tax rates for the combined entity should be used in measuring the deferred taxes of
the acquirer and the acquiree. The effect of tax law or rate changes that occur after the acquisition date
should be reflected in income from continuing operations in the period in which the change in tax law or
rate occurs (e.g., not as part of the business combination).

In some cases, the process of establishing the enacted rate(s) expected to apply is not straightforward.
Among other situations, complexities arise during tax holidays and when an entity adds state
jurisdictions to the acquirer’s state tax profile as a result of the acquisition.

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11.2.3.1 Tax Holidays
Deferred taxes are not recognized for the expected taxable or deductible amounts of temporary
differences that are related to assets or liabilities that are expected to be recovered or settled during a
tax holiday. Paragraph 183 in the Basis for Conclusions of FASB Statement 109 states:

The Board considered whether a deferred tax asset ever should be recognized for the expected future
reduction in taxes payable during a tax holiday. In most jurisdictions that have tax holidays, the tax holiday is
“generally available” to any enterprise (within a class of enterprises) that chooses to avail itself of the holiday.
The Board views that sort of exemption from taxation for a class of enterprises as creating a nontaxable status
(somewhat analogous to S-corporation status under U.S. federal tax law) for which a deferred tax asset should
not be recognized.

Therefore, deferred taxes are recognized for the expected taxable or deductible amounts of temporary
differences that are expected to reverse outside of the tax holiday. In some situations, a temporary
difference associated with a particular asset or liability may reverse during both the tax holiday and
periods in which the entity is taxed at the enacted rates. Accordingly, it may be necessary to use
scheduling to determine the appropriate deferred taxes to record in connection with the business
combination.

For additional information on the effect of tax holidays on the applicable tax rate, see Section 3.3.4.5.

11.2.3.2 State Tax Footprint

The acquirer’s state tax footprint for an entity can change because of a business combination. For
example, an acquirer that is operating in Nevada with no deferred state taxes but substantial temporary
differences acquires a target company in California. As a result of this acquisition, the acquirer is now
required to file a combined California tax return with the target company. Therefore, the acquirer must
record deferred taxes for California state tax when no state taxes were previously recognized. When
calculating the impact of this change on the state tax footprint, an entity must account for the income
tax effects of its assets and liabilities before the combination separately from those that were acquired
as part of the business combination.

Any change in the measurement of existing deferred tax items of the acquirer as a result of this acquisition
are recorded “outside” of the acquisition accounting as a component of income tax expense. The initial
recognition of deferred tax items of the target company by the acquirer is accounted for as part of the
business combination. (Note that the target company’s deferred taxes are measured in accordance with
ASC 740, since this is one of the exceptions to the fair value measurement principles in ASC 805.)

11.3 Recognition and Measurement of Temporary Differences Related to

Identifiable Assets Acquired and Liabilities Assumed
As noted in Section 11.1, the recognition principle and the measurement principle of ASC 805 require
an entity to “recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed,
and any noncontrolling interest in the acquiree” and to measure “the identifiable assets acquired, the
liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values.”
These recognition and measurement principles may differ for financial reporting and tax purposes (i.e.,
an asset may be recorded at fair value for book purposes versus at carryover basis for tax purposes). As
a result, deductible and taxable temporary differences (i.e., basis differences) might need to be recorded
in connection with the accounting for the business combination or asset acquisition. For example, the
recognition and measurement principles for acquired goodwill may be different for financial reporting
and tax purposes, resulting in the potential need to record deferred taxes for the basis difference.
This section discusses how to account for basis differences resulting from a business combination and
provides examples of common scenarios that require additional consideration.
805-740-25 (Q&A 19)

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11.3.1 Basis Differences
A basis difference arises when there is a difference between the financial reporting amount of an asset
or liability and its tax basis, as determined by reference to the relevant tax laws in each tax jurisdiction.
There are two categories of basis differences: “inside” basis differences and “outside” basis differences.
(For more information about inside and outside basis differences, see Section 3.3.1.)

The paragraphs below describe the accounting for inside and outside basis differences that arise in a
business combination.

11.3.1.1 Inside Basis Difference

An inside basis difference is a temporary difference between the carrying amount, for financial reporting
purposes, of individual assets and liabilities and their tax bases that will give rise to a tax deduction
or taxable income when the related asset is recovered or liability is settled. Deferred taxes are always
recorded on taxable and deductible temporary differences unless one of the exceptions in ASC 740-10-
25-3 applies.

11.3.1.2 Outside Basis Difference

An outside basis difference is the difference between the carrying amount of an entity’s investment (e.g.,
an investment in a consolidated subsidiary) for financial reporting purposes and the underlying tax basis
in that investment (e.g., the tax basis in the subsidiary’s stock).

Deferred taxes are always recorded for taxable and deductible temporary differences unless a specific
exception applies. The exception that may apply under ASC 740 depends on whether the outside
basis difference results in a DTL or a DTA. DTLs are recorded on all outside basis differences that are
taxable temporary differences unless one of the exceptions described in Section 3.3.2 is applicable. ASC
740-30-25-9 states that no DTAs should be recorded on the excess of tax over financial reporting basis
in subsidiaries and corporate joint ventures unless it is “apparent that the temporary difference will
reverse in the foreseeable future” (e.g., generally within the next 12 months).

Example 11-1

Inside Basis Difference

Assume the following:

• Acquiring Company (AC) purchases Target Company’s (TC’s) stock for $1,000 in cash in a nontaxable
business combination. TC meets the definition of a business under ASC 805.
• TC has two subsidiaries (S1 and S2), each of which was acquired in a previous taxable stock acquisition.
• S1’s and S2’s assets consist of buildings and equipment, which have fair values of $750 and $250,
respectively.
• All of the entities are domestic corporations with respect to AC.
• The tax rate is 21 percent.
TC’s only assets are its shares of S1 and S2, as illustrated in the following table:

Identifiable Assets TC’s Stock S1 S2

Fair value $ 1,000 $ 750 $ 250

TC’s tax basis in S1’s and S2’s stock N/A 600 200

S1’s and S2’s tax bases in their underlying

identifiable assets (assume no tax goodwill) N/A 300 100

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Example 11-1 (continued)

The journal entries recording the accounting for the initial acquisition are as follows:

To record AC’s investment in TC:

AC
Investment in TC 1,000
Cash 1,000

To record TC’s investment in S1 and S2:

TC
Investment in S1 750
Investment in S2 250
Equity 1,000

To record deferred taxes on the temporary differences inside S1 and S2:

S1
Assets 750
Goodwill 94.5*
DTL 94.5**
Equity 750
* No DTL is recorded for the amount of goodwill for financial reporting in excess of the tax basis of goodwill.
** (750 – 300) × 21%.

S2
Assets 250
Goodwill 31.5*
DTL 31.5**
Equity 250
* No DTL is recorded for the amount of goodwill for financial reporting in excess of the tax basis of goodwill.
** (250 – 100) × 21%.

Note that while pushdown accounting is not required by ASC 805, journal entries have been recorded (i.e.,
pushed down) to the subsidiaries’ books because, in accordance with ASC 740-10-30-5, “[d]eferred taxes shall
be determined separately for each tax-paying component . . . in each tax jurisdiction.” See Section 11.7.3 for
further discussion.

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Example 11-2

Outside Basis Difference

Assume the same facts as in Example 11-1. AC must determine whether there is a basis difference in its
investment in TC and TC’s subsidiaries and whether that difference (if any) is a taxable temporary difference.
The initial outside basis differences are as follows:

TC’s Stock S1’s Stock S2’s Stock

Initial book basis $ 1,000 $ 750 $ 250
Tax basis 1,000 600 200
Difference — 150 50
DTL (if recognized) — 31.5 10.5

As illustrated in the table above, there is no difference between AC’s book and tax basis in its investment in
TC for AC to assess as of the acquisition date. AC does, however, have differences to assess with respect to
TC’s investment in S1 and S2. The following are two potential conclusions that AC could reach in assessing the
outside basis difference:

• AC could determine that it would liquidate S1 and S2 into TC to eliminate the outside basis differences
in a tax-free manner. Accordingly, in applying the provisions of ASC 740-30-25-7, AC could conclude that
the outside basis differences in S1’s and S2’s stock are not temporary differences. See Section 3.4.3 for
further discussion of a tax-free liquidation or merger of a subsidiary.
• AC could determine that to dispose of S1 and S2, AC would choose to have TC sell their stock rather than
sell their assets to maximize after-tax proceeds. Accordingly, the outside basis differences in S1’s and
S2’s stock would both be taxable temporary differences and the DTLs would be recorded in the business
combination accounting.

11.3.2 Goodwill
As previously noted, the acquisition method of accounting requires the acquirer to recognize and
measure all separately identifiable assets and liabilities acquired or assumed in connection with a
business combination. As discussed further in Section 11.3.4, deferred taxes may need to be recorded
as part of purchase accounting for these acquired assets and liabilities. For financial reporting purposes,
the difference between the acquisition price and the fair value of the acquired assets and liabilities will
be recorded as goodwill (or on rare occasions as a bargain purchase gain). A business combination may
also result in an entity’s acquiring goodwill for tax purposes. Special accounting consideration (discussed
further below) is required when an entity is determining how to account for the tax effects of acquired
goodwill.

ASC 805-740

25-1 This Section provides general guidance on the recognition of deferred tax assets and liabilities in
connection with a business combination. It also addresses certain business-combination-specific matters
relating to goodwill, replacement awards, and the allocation of consolidated tax expense after an acquisition.

25-2 An acquirer shall recognize a deferred tax asset or deferred tax liability arising from the assets acquired
and liabilities assumed in a business combination and shall account for the potential tax effects of temporary
differences, carryforwards, and any income tax uncertainties of an acquiree that exist at the acquisition date, or
that arise as a result of the acquisition, in accordance with the guidance in Subtopic 740-10 together with the
incremental guidance provided in this Subtopic.

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ASC 805-740 (continued)

25-3 As of the acquisition date, a deferred tax liability or asset shall be recognized for an acquired entity’s
taxable or deductible temporary differences or operating loss or tax credit carryforwards except for differences
relating to the portion of goodwill for which amortization is not deductible for tax purposes, leveraged leases,
and the specific acquired temporary differences identified in paragraph 740-10-25-3(a). Taxable or deductible
temporary differences arise from differences between the tax bases and the recognized values of assets
acquired and liabilities assumed in a business combination. Example 1 (see paragraph 805-740-55-2) illustrates
this guidance. An acquirer shall assess the need for a valuation allowance as of the acquisition date for an
acquired entity’s deferred tax asset in accordance with Subtopic 740-10.

25-4 Guidance on tax-related matters related to the portion of goodwill for which amortization is not deductible
for tax purposes is in paragraphs 805-740-25-8 through 25-9; guidance on accounting for the acquisition
of leveraged leases in a business combination is in paragraph 840-30-30-15; and guidance on the specific
acquired temporary differences identified in paragraph 740-10-25-3(a) is referred to in that paragraph.

Pending Content (Transition Guidance: ASC 842-10-65-1)

25-4 Guidance on tax-related matters related to the portion of goodwill for which amortization is not
deductible for tax purposes is in paragraphs 805-740-25-8 through 25-9; guidance on accounting for
the acquisition of leveraged leases in a business combination is in Subtopic 842-50; and guidance on
the specific acquired temporary differences identified in paragraph 740-10-25-3(a) is referred to in that
paragraph.

Goodwill
25-8 Guidance on the financial accounting for goodwill is provided in Subtopic 350-20. For tax purposes,
amortization of goodwill is deductible in some tax jurisdictions. In those tax jurisdictions, the reported amount
of goodwill and the tax basis of goodwill are each separated into two components as of the acquisition date for
purposes of deferred tax calculations. The first component of each equals the lesser of goodwill for financial
reporting or tax-deductible goodwill. The second component of each equals the remainder of each, that is, the
remainder, if any, of goodwill for financial reporting or the remainder, if any, of tax-deductible goodwill.

25-9 Any difference that arises between the book and tax basis of that first component of goodwill in
future years is a temporary difference for which a deferred tax liability or asset is recognized based on the
requirements of Subtopic 740-10. If that second component is an excess of tax-deductible goodwill over the
reported amount of goodwill, the tax benefit for that excess is a temporary difference for which a deferred
tax asset is recognized based on the requirements of that Subtopic (see Example 4 [paragraph 805-740-55-9]).
However, if that second component is an excess of goodwill for financial reporting over the tax-deductible
amount of goodwill, no deferred taxes are recognized either at the acquisition date or in future years.

Related Implementation Guidance and Illustrations

• Example 1: Nontaxable Business Combination [ASC 805-740-55-2].
• Example 4: Tax Deductible Goodwill Exceeds Financial Reporting Goodwill [ASC 805-740-55-9].

805-740-25 (Q&A 10)

ASC 805-740-25-3 indicates that recognition of deferred taxes on differences between the financial
reporting and the tax basis of goodwill depends on whether goodwill amortization is deductible for tax
purposes. More specifically, for financial reporting purposes, deferred taxes generally should not be
recognized for book and tax basis differences related to the portion of goodwill for which deductions
are not allowed for the amortization or impairment of goodwill (e.g., goodwill subject to antichurning
rules in the United States). We are aware of an alternative view in practice, however, that allows for
recognition of deferred taxes even if the goodwill amortization is not deductible for tax purposes as long
as the tax basis in the goodwill would be deductible upon cessation or sale of a business with which it
is associated. This alternative view is based on ASC 740-10-25-50, which addresses the tax basis of an
asset used in the determination of temporary differences.

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In tax jurisdictions where goodwill is deductible, goodwill for financial reporting purposes and
tax-deductible goodwill must be separated as of the acquisition date into two components, in
accordance with ASC 805-740-25-8 and 25-9 (see illustration below).

Book greater than tax Tax greater than book

Component 2 Component 2

Component 1 Component 1

Book Tax Book Tax

Goodwill Goodwill Goodwill Goodwill

The first component of goodwill (“component 1 goodwill”) equals the lesser of (1) goodwill for financial
reporting purposes or (2) tax-deductible goodwill. Any difference that arises between the book and tax
basis of component 1 goodwill in future periods is a temporary difference for which a DTA or DTL is
recognized.

The second component of goodwill (“component 2 goodwill”) equals (1) total goodwill (the greater of
financial reporting goodwill or tax-deductible goodwill) less (2) the calculated amount of component 1
goodwill.

If component 2 goodwill is an excess of tax-deductible goodwill over financial reporting goodwill, an

entity must recognize a DTA related to the excess as of the acquisition date in accordance with ASC
740. The entity should use an iterative calculation to determine this DTA because goodwill and the DTA
are established simultaneously as of the acquisition date. ASC 805-740-55-9 through 55-13 provide
the “simultaneous equations method” for this purpose. Using this method, an entity simultaneously
determines the amount of goodwill to record for financial reporting purposes and the amount of the
DTA. Example 11-3 below illustrates the application of the simultaneous equations method.

However, in accordance with ASC 805-740-25-9, if component 2 goodwill is an excess of financial

reporting goodwill over tax-deductible goodwill, no DTL should be recorded.

Further, in certain business combinations, the acquired entity may have tax-deductible goodwill from a
prior acquisition for which it received carry-over tax basis. The acquired tax-deductible goodwill should
be included in the acquisition date allocation between component 1 goodwill and component 2 goodwill.

Example 11-3

Assume the following:

• Acquisition date of January 1, 20X9.

• Financial reporting goodwill of $800, before initial tax adjustments.
• Tax goodwill of $1,000.
• Annual tax amortization of $500 per year.
• No other temporary differences.
• Tax rate of 25 percent.
• Income before taxes in year 1 is $10,000, in year 2 is $11,000, and in year 3 is $12,000.

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Example 11-3 (continued)

On Acquisition Date:
1. Preliminary calculation of goodwill components:

Book Tax
Component 1 goodwill $ 800 $ 800
Component 2 goodwill — 200
Total goodwill $ 800 $ 1,000

2. Calculation of the DTA:

• DTA = (0.25 ÷ [1 – 0.25]) × $200.
• DTA = $67.
3. Journal entry to record the DTA:

DTA 67
Goodwill 67

(Note that “final” financial reporting goodwill is $733.)

Accounting in Years 1–3:
1. Calculation of taxes payable:

Year 1 Year 2 Year 3

Book income (pretax) $ 10,000 $ 11,000 $ 12,000
Tax amortization 500 500 —
Taxable income $ 9,500 $ 10,500 $ 12,000
Taxes payable (25%) $ 2,375 $ 2,625 $ 3,000

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Example 11-3 (continued)

2. Calculation of deferred taxes:2

Goodwill is not amortized for financial reporting purposes. Each year, a DTL must be calculated and
recognized for the difference between component 1 financial reporting goodwill and component 1 tax
goodwill. This DTL will reverse when the company impairs, sells, or disposes of the related assets.

January End of End of End of

1, 20X9 Year 1 Year 2 Year 3
Financial reporting basis — goodwill $ 733 $ 733 $ 733 $ 733
Tax basis — component 1 goodwill 733 367 — —
Tax basis — component 2 goodwill 267 133 — —
Total tax basis in goodwill 1,000 500 —
Temporary difference —
component 1 goodwill — 367 733 733
Temporary difference —
component 2 goodwill 267 133 — —
DTL — component 1 goodwill — 92 183 183
DTA — component 2 goodwill $ 67 $ 33* $ — $ —
Deferred income tax expense $ 125 $ 125 $ —
Current income tax benefit $ (125) $ (125)
* Although the deferred tax allocation seemingly creates a DTL for component 1 goodwill and a DTA for
component 2 goodwill, both components should be viewed as a net DTL in the assessment of the need for a
valuation allowance (i.e., no valuation allowance would be needed on the DTA of $33).

3. Realization of the tax benefit:

A tax benefit will be realized for the tax deduction associated with goodwill.

Journal Entries for Years 1 and 2:

Income tax expense 125

DTL 92

DTA 33*

* Represents deferred taxes associated with the component 2 goodwill temporary difference amortized
over two years ([$267 ÷ 2] × 25%).

2
In the calculation of deferred taxes in this example, it is assumed that allocation is consistent with Approach 2 described in Section 11.3.2.2.

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Example 11-3 (continued)

4. P&L snapshot:

Year 1 Year 2 Year 3

Book income (pretax) $ 10,000 $ 11,000 $ 12,000
Tax amortization
Current 2,375 2,625 3,000
Deferred 125 125 —
Total income tax expense 2,500 2,750 3,000
Net income $ 7,500 $ 8,250 $ 9,000

11.3.2.1 Pre-FASB Statement 141(R) Transactions

805-740-25 (Q&A 16)
Given the long-term nature of goodwill balances, some goodwill may have been generated in connection
with business combinations that were accounted for under FASB Statement 141 before the issuance
of FASB Statement 141(R) (codified in ASC 805), which amended paragraph 262 of FASB Statement
109 to require that the tax benefit associated with component 2 tax-deductible goodwill (an excess
of tax-deductible goodwill over financial reporting goodwill) be recognized as of the acquisition date.
Before the amendments made by Statement 141(R), the tax benefit associated with component 2
tax-deductible goodwill was recognized only when realized on the tax return. This tax benefit was
applied first to reduce goodwill related to the acquisition to zero, then to reduce other noncurrent
intangible assets related to the acquisition to zero, and lastly to reduce income tax expense.

After the effective date of Statement 141(R) (codified in ASC 805), the tax benefit associated with
component 2 tax-deductible goodwill should continue to be recognized for business combinations
previously accounted for in accordance with FASB Statement 141 (i.e., business combinations
consummated in periods before the effective date of Statement 141(R)).

Paragraph 77 of Statement 141(R) states, “[f]or business combinations in which the acquisition date
was before the effective date of this Statement, the acquirer shall apply the requirements of Statement
109, as amended by this Statement, prospectively” (emphasis added). Therefore, an entity would still
need to apply the guidance in paragraphs 262 and 263 of Statement 109 (before the Statement 141(R)
amendments) to any component 2 tax-deductible goodwill from business combinations accounted
for under Statement 141. That is, for business combinations consummated before the effective date
of ASC 805 (Statement 141(R)), goodwill would continue to be adjusted as the tax benefit associated
with component 2 goodwill is realized on the tax return. Paragraph 262 of Statement 109, before being
amended by Statement 141(R), stated:

Amortization of goodwill is deductible for tax purposes in some tax jurisdictions. In those tax jurisdictions,
the reported amount of goodwill and the tax basis of goodwill are each separated into two components as
of the combination date for purposes of deferred tax calculations. The first component of each equals the
lesser of (a) goodwill for financial reporting or (b) tax-deductible goodwill. The second component of each
equals the remainder of each, that is, (1) the remainder, if any, of goodwill for financial reporting or (2) the
remainder, if any, of tax-deductible goodwill. Any difference that arises between the book and tax basis of that
first component of goodwill in future years is a temporary difference for which a deferred tax liability or asset
is recognized based on the requirements of this Statement. No deferred taxes are recognized for the second
component of goodwill. If that second component is an excess of tax-deductible goodwill over the reported
amount of goodwill, the tax benefit for that excess is recognized when realized on the tax return, and that tax
benefit is applied first to reduce to zero the goodwill related to that acquisition, second to reduce to zero other
noncurrent intangible assets related to that acquisition, and third to reduce income tax expense.

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Paragraph 263 of Statement 109, before being amended by Statement 141(R), included an example
that illustrated the accounting for the tax consequences of goodwill when amortization of goodwill is
deductible for tax purposes. Example 11-4 below has been adapted from paragraph 263 of Statement
109 (as published before the amendments of Statement 141(R)) and illustrates the accounting that
a reporting entity should apply to tax benefits associated with component 2 tax-deductible goodwill
from business combinations originally accounted for under Statement 141. As described above, this
accounting method applies even after the effective date of Statement 141(R).

Example 11-4

Assume the following:

• As of the acquisition date (i.e., January 1, 20X8), the financial reporting amount and tax basis amount of
goodwill are $600 and $800, respectively.
• For tax purposes, amortization of goodwill will result in tax deductions of $400 in each of years 1 and 2.
Those deductions result in current tax benefits in years 20X8 and 20X9.
• For simplicity, the consequences of other temporary differences are ignored for years 20X8–2X11.
• The entity has a calendar year-end and will adopt FASB Statement 141(R) on January 1, 20X9.
• Income before income taxes is $1,000 in each of years 20X8–2X11.
• The tax rate is 25 percent for all years.
Income taxes payable for years 20X8–2X11 are:

20X8 20X9 2X10 2X11

Income before amortization of
goodwill $ 1,000 $ 1,000 $ 1,000 $ 1,000
Tax amortization of goodwill 400 400 — —
Taxable income 600 600 1,000 1,000
Income tax payable $ 150 $ 150 $ 250 $ 250

As of the combination date, goodwill is separated into two components as follows:

Reported Tax
Amount Basis
First component $ 600 $ 600
Second component — 200
Total goodwill $ 600 $ 800

A DTL is recognized for the tax amortization of goodwill for years 20X8 and 20X9 for the excess of the financial
reporting amount over the tax basis of the first component of goodwill. Although there is no difference
between the book and tax basis of component 1 goodwill as of the business combination date (both $600), a
difference does arise as of the reporting date. This difference results from (1) the reduction of book goodwill by
the realized benefits on component 2 goodwill (the calculation is explained below) and (2) the tax amortization
of the component 1 tax-deductible goodwill. When the second component of goodwill is realized on the tax
return for years 20X8 and 20X9, the tax benefit is allocated to reduce financial reporting goodwill.

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Example 11-4 (continued)

The second component of goodwill is deductible at $100 per year in years 20X8 and 20X9. Those tax
deductions provide $25 ($100 at 25 percent) of tax benefits that are realized in years 20X8 and 20X9. The
realized benefits reduce the first component of goodwill and produce a deferred tax benefit by reducing the
taxable temporary difference related to that component of goodwill. Thus, the total tax benefit (TTB) allocated
to reduce the first component of goodwill in years 20X8 and 20X9 is the sum of (1) the $25 realized tax benefit
allocated to reduce goodwill and (2) the deferred tax benefit from reducing the DTL related to goodwill. The TTB
is determined as follows:

TTB = realized tax benefit plus (tax rate times TTB)

TTB = $25 + (0.25 × TTB)

TTB = $33

Goodwill for financial reporting purposes for years 20X8–2X11 is:

20X8 20X9 2X10 2X11

Balance at beginning of year $ 600 $ 567 $ 534 $ 534
TTB allocated to reduce goodwill 33 33 — —
Balance at end of year $ 567 $ 534 $ 534 $ 534

The DTL for the first component of goodwill and the related amount of deferred tax expense (benefit) for years
20X8–2X11 are:

20X8 20X9 2X10 2X11

Reported goodwill at end of year $ 567 $ 534 $ 534 $ 534
Tax basis of goodwill (first component) 300 — — —
Taxable temporary difference $ 267 $ 534 $ 534 $ 534
DTL:
At end of year (25 percent) 67 134 134 134
At beginning of year — 67 134 134
Deferred tax expense for the year $ 67 $ 67 $ — $ —

Income for financial reporting for years 20X8–2X11 is:

20X8 20X9 2X10 2X11

Income before income tax $ 1,000 $ 1,000 $ 1,000 $ 1,000
Income tax expense:
Current 150 150 250 250
Deferred 67 67 — —
Benefit applied to reduce goodwill 33 33 — —
Income tax expense 250 250 250 250
Net income $ 750 $ 750 $ 750 $ 750

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11.3.2.2 Amortization of Goodwill
805-740-25 (Q&A 22)
As discussed in Section 11.3.2, in jurisdictions in which goodwill is deductible under the tax law, goodwill
for financial reporting purposes and tax-deductible goodwill should be separated as of the acquisition
date into two components in accordance with ASC 805-740-25-8 and 25-9. The first component of
goodwill (“component 1 goodwill”) equals the lesser of (1) goodwill for financial reporting purposes or
(2) tax-deductible goodwill. The second component of goodwill (“component 2 goodwill”) equals (1) total
goodwill (the greater of financial reporting goodwill or tax-deductible goodwill) less (2) the calculated
amount of component 1 goodwill.

When tax-deductible goodwill exceeds goodwill for financial reporting purposes, entities have
alternatives for allocating tax amortization between component 1 goodwill and component 2 goodwill.
However, these alternatives will have the same net effect on the consolidated financial statements.

The following two approaches are acceptable for allocating tax amortization between component 1
goodwill and component 2 goodwill:

• Approach 1 — Allocate the tax amortization first to any amount of tax-deductible goodwill
greater than goodwill for financial reporting purposes (i.e., allocate first to component 2
goodwill). Under this approach, the entity will first reduce any DTA recognized in the acquisition
accounting before recognizing a DTL.

• Approach 2 — Allocate the tax amortization on a pro rata basis between component 1 goodwill
and component 2 goodwill. Under this approach, the entity will reduce the DTA recognized in
the acquisition accounting for the tax amortization allocated to component 2 goodwill and at the
same time recognize a DTL for the tax amortization allocated to component 1 goodwill.

Example 11-5 below demonstrates the two approaches and their similar effects on the financial
statements.

Example 11-5

Assume that Entity X acquires Entity Y in a taxable business combination. The acquisition results in goodwill for
financial reporting purposes of $1 million and tax-deductible goodwill of $1.3 million. Entity X’s tax rate is 25
percent. Because tax-deductible goodwill exceeds goodwill for financial reporting purposes, X recognizes a DTA
of $100,000 as part of the business combination accounting (see Section 11.3.2 for guidance on calculating
this amount), with an offset to goodwill for financial reporting purposes (i.e., final goodwill for financial reporting
purposes is $900,000 on the acquisition date). Assume for tax purposes that the tax-deductible goodwill is
amortized over 10 years and that X has not recognized any goodwill impairments. In this example, component
1 goodwill would be $900,000 (i.e., the lesser of goodwill for financial reporting purposes and tax-deductible
goodwill) and component 2 goodwill would be $400,000 (i.e., the difference between total tax-deductible
goodwill of $1.3 million and component 1 goodwill of $900,000).

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Example 11-5 (continued)

The following journal entries would be recorded to recognize the first year of tax amortization:

• Approach 1 — The tax amortization of $130,000 ($1,300,000 ÷ 10 years) would be allocated to the
component 2 goodwill. Therefore, component 2 goodwill would be reduced to $270,000 ($400,000 –
$130,000) and the DTA recognized as of the acquisition date would be reduced by $32,500 ($130,000 ×
25%).

Income taxes payable 32,500

Income tax expense 32,500
To record the income tax benefit of the tax amortization.

Income tax expense 32,500

DTA 32,500

To allocate the tax amortization between component 1 and

component 2 goodwill under Approach 1.

• Approach 2 — The tax amortization of $130,000 ($1,300,000 ÷ 10 years) would be allocated on a pro
rata basis between the component 1 goodwill and the component 2 goodwill. Component 2 goodwill
would be reduced to $360,000 ($400,000 – [$400,000 ÷ $1,300,000 × $130,000]) and the DTA associated
with component 2 goodwill would be reduced by $10,000 ([$400,000 ÷ $1,300,000 × $130,000] × 25%).
Component 1 goodwill would be reduced to $810,000 ($900,000 – [$900,000 ÷ $1,300,000 × $130,000]),
which would create a DTL of $22,500 ([$900,000 ÷ $1,300,000 × $130,000] × 25%) for the taxable
temporary difference between goodwill for financial reporting purposes and tax-deductible goodwill.

Income taxes payable 32,500

Income tax expense 32,500
To record the income tax benefit of the tax amortization.

Income tax expense 32,500

DTL 22,500
DTA 10,000

To allocate the tax amortization between component 1 and

component 2 goodwill under Approach 2.

While amortization of the goodwill is reflected in both approaches, Approach 2 seemingly creates a DTL with
the allocation. However, the goodwill remains one asset for financial reporting purposes and, correspondingly,
the related deferred taxes should be considered on a net basis in the assessment of the need for a valuation
allowance (i.e., the ending DTA in year 1 would be $67,500).

11.3.2.3 Private Company Alternative

740-10-25 (Q&A 62)
The accounting for goodwill by a private company may differ from the accounting for goodwill by a
public company. Under ASC 350-20-15-4, a private company may elect a simplified, alternative approach
to subsequently account for goodwill (the “goodwill accounting alternative”). Under this approach, the
company can amortize financial reporting goodwill related to each business combination on a straight-
line basis, generally over a period of 10 years.

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A private company that elects the goodwill accounting alternative should consider several things when
preparing its provision for income taxes. Those considerations vary, in part, depending on whether the
goodwill is deductible for tax purposes:

• Non-tax-deductible goodwill — The accounting alternative does not change the prohibition on
the recognition of a DTL for goodwill that is not deductible for tax purposes. The amortization of
goodwill for financial reporting purposes will typically create a reconciling item related to the ETR
(i.e., an unfavorable permanent difference).

• Tax-deductible goodwill — The amortization of financial reporting goodwill will result in either an
increase or a decrease to deferred taxes depending on how it compares with the related tax
amortization in the period.

When both tax-deductible and non-tax-deductible goodwill are present, an entity must determine the
amount of financial reporting goodwill amortization attributable to the components of goodwill that
were originally determined in acquisition accounting. (See Section 11.3.2 for more information about the
recognition of deferred taxes on the basis of the components of goodwill.) When an entity is determining
the amount of financial reporting goodwill amortization attributable to the components of goodwill, it
should consider whether it has already established a policy for such attribution in connection with a
past impairment and, if so, should apply that policy consistently. One method that is commonly used
in such circumstances is a pro rata allocation. (See Section 11.3.2.4 below for an example illustrating
a pro rata allocation.) Under a pro rata allocation approach for goodwill amortization, an entity would
proportionally allocate the amortization to tax-deductible and nondeductible goodwill on the basis of
the proportion of each. Other approaches may also be acceptable. Further complexities arise when the
goodwill in a reporting unit is associated with multiple acquisitions or spans multiple taxing jurisdictions.

In addition, an entity’s postacquisition tax amortization of component 1 goodwill (see Section 11.3.2)
may have created DTLs. Because these DTLs were previously associated with an indefinite-lived
intangible asset, they generally would not have been considered a source of income for the realization
of DTAs. However, because of the recharacterization of goodwill as a finite-lived asset, the DTL could
potentially be a source of taxable income supporting the recoverability of a DTA.

11.3.2.4 Impairment Testing
350-20-35 (Q&A 40)
ASC 350-20 requires that goodwill be tested for impairment either annually or between annual tests if
certain events or circumstances occur. Goodwill is tested for impairment at the reporting unit level. The
ASC master glossary defines a reporting unit as “[t]he level of reporting at which goodwill is tested for
impairment. A reporting unit is an operating segment or one level below an operating segment (also
known as a component).”

The current guidance in ASC 350 includes a goodwill impairment test that consists of two steps.
Under that guidance, an entity may perform the two-step goodwill impairment test if it (1) qualitatively
determines the fair value of the reporting unit is more likely than not less than the carrying amount or
(2) chooses not to perform the qualitative assessment outlined in ASC 350-20-35-3 through 35-3G.

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ASC 350-20-35-4 through 35-17 outline the two steps as follows on the basis of the fair value
determined for each reporting unit:

• Step 1:
o Quantitatively determine whether the fair value of the reporting unit is less than its carrying
amount, including goodwill. If so, proceed to step 2.
o If the fair value of the reporting unit is not less, further testing of goodwill for impairment is
not performed.
o If the carrying amount of the reporting unit is zero or negative, proceed to step 2 if, on the
basis of qualitative considerations, it is more likely than not that a goodwill impairment exists.

• Step 2:
o Determine the implied fair value of the goodwill of the reporting unit by assigning the fair
value of the reporting unit used in step 1 to all the assets and liabilities of that reporting unit
(including any recognized and unrecognized intangible assets) as if the reporting unit had
been acquired in a business combination.
o Compare the implied fair value of goodwill with the carrying amount of goodwill to determine
whether goodwill is impaired.

In January 2017, the FASB issued ASU 2017-04, which eliminates step 2 from the goodwill impairment
test (i.e., the measurement of the amount of impairment loss when the carrying amount of a reporting
unit is greater than its fair value). Instead, when an entity performs a quantitative goodwill impairment
test, it compares the fair value of a reporting unit with the reporting unit’s carrying amount (i.e.,
performs what was previously step 1 of the two-step goodwill impairment test) to determine whether
the reporting unit is impaired and, if so, the amount of impairment loss.

Further, in accordance with ASU 2017-04:

If a reporting unit has tax deductible goodwill, recognizing a goodwill impairment loss may cause a change
in deferred taxes that results in the carrying amount of the reporting unit immediately exceeding its fair
value upon recognition of the loss. In those circumstances, the entity shall calculate the impairment loss and
associated deferred tax effect in a manner similar to that used in a business combination in accordance with
the guidance in paragraphs 805-740-55-9 through 55-13. The total loss recognized shall not exceed the total
amount of goodwill allocated to the reporting unit.

ASU 2017-04 is effective for a PBE that is an SEC filer for any annual or interim goodwill impairment tests
in fiscal years beginning after December 15, 2019. The ASU is effective for a business entity that is not an
SEC filer for any annual interim goodwill impairment tests in fiscal years beginning after December 15,
2020, and is effective for all other entities for any annual or interim goodwill impairment tests in fiscal
years beginning after December 15, 2021. Early adoption is permitted for interim or annual goodwill
impairment tests performed on testing dates after January 1, 2017.

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11.3.2.4.1 Assumptions Related to a Reporting Unit Bought or Sold in a Taxable or

Nontaxable Business Combination
Determining the fair value of a reporting unit requires some assumptions about the sale of the
reporting unit to a market participant. ASC 350-20-35-25 states that an entity’s assumption about
whether a reporting unit would be bought or sold in a taxable or nontaxable business combination in
its step 1 analysis of the goodwill impairment test3 is a matter of judgment and will depend on facts and
circumstances.

ASC 350-20-35-26 provides the following considerations to help entities make this determination:
a. Whether the assumption is consistent with those that marketplace participants would incorporate into
their estimates of fair value
b. The feasibility of the assumed structure
c. Whether the assumed structure results in the highest and best use and would provide maximum value
to the seller for the reporting unit, including consideration of related tax implications.

In addition, under ASC 350-20-35-27, an entity must also consider the following factors (not all-inclusive)
when assessing whether it is appropriate to assume a nontaxable transaction:
a. Whether the reporting unit could be sold in a nontaxable transaction
b. Whether there are any income tax laws and regulations or other corporate governance requirements
that could limit an entity’s ability to treat a sale of the unit as a nontaxable transaction.

11.3.2.4.2 Assigning Deferred Taxes and Related Valuation Allowances to a

Reporting Unit
When determining a reporting unit’s carrying value in step 1 of the goodwill impairment test,4 an entity
should assign deferred taxes and any related valuation allowances to its reporting units.

ASC 350-20-35-7 states that the deferred taxes and any related valuation allowances related to the
assets and liabilities of the reporting unit should be included in the carrying value of the reporting
unit. This is true regardless of whether the entity assumes, in its determination of the fair value of the
reporting unit, that the reporting unit would be bought or sold in a taxable or nontaxable business
combination. In determining whether to assign DTAs associated with NOL and tax credit carryforwards
to a reporting unit, an entity should consider the following guidance from ASC 350-20-35-39 and 35-40:

35-39 For the purpose of testing goodwill for impairment, acquired assets and assumed liabilities shall be
assigned to a reporting unit as of the acquisition date if both of the following criteria are met:
a. The asset will be employed in or the liability relates to the operations of a reporting unit.
b. The asset or liability will be considered in determining the fair value of the reporting unit.

Assets or liabilities that an entity considers part of its corporate assets or liabilities shall also be assigned
to a reporting unit if both of the preceding criteria are met. Examples of corporate items that may meet
those criteria and therefore would be assigned to a reporting unit are environmental liabilities that relate
to an existing operating facility of the reporting unit and a pension obligation that would be included in the
determination of the fair value of the reporting unit. This provision applies to assets acquired and liabilities
assumed in a business combination and to those acquired or assumed individually or with a group of other
assets.

3
Upon the adoption of ASU 2017-04, when an entity performs a quantitative goodwill impairment test (i.e., performs what was previously step 1
of the two-step goodwill impairment test), it compares the fair value of a reporting unit with the reporting unit’s carrying amount to determine
whether the reporting unit is impaired and, if so, the amount of impairment loss.
4
See footnote 2.

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35-40 Some assets or liabilities may be employed in or relate to the operations of multiple reporting units.
The methodology used to determine the amount of those assets or liabilities to assign to a reporting unit
shall be reasonable and supportable and shall be applied in a consistent manner. For example, assets and
liabilities not directly related to a specific reporting unit, but from which the reporting unit benefits, could
be assigned according to the benefit received by the different reporting units (or based on the relative fair
values of the different reporting units). In the case of pension items, for example, a pro rata assignment based
on payroll expense might be used. A reasonable allocation method may be very general. For use in making
those assignments, the basis for and method of determining the fair value of the acquiree and other related
factors (such as the underlying reasons for the acquisition and management’s expectations related to dilution,
synergies, and other financial measurements) shall be documented at the acquisition date.

If an entity has recorded a valuation allowance at the consolidated level and files a consolidated return,
it should allocate the valuation allowance on the basis of the DTAs and DTLs assigned to each reporting
unit.

11.3.2.4.3 Tax Bases Used to Determine Implied Fair Value of a Reporting Unit’s

Goodwill
When an entity is determining the implied fair value of a reporting unit’s goodwill in step 2 of the
goodwill impairment test (i.e., before the adoption of ASU 2017-04), ASC 350-20-35-20 states that the
entity should use the tax bases of a reporting unit’s assets and liabilities implicit in the assumed tax
structure (i.e., taxable or nontaxable) in performing step 1 of the goodwill impairment test. If the entity
assumed a nontaxable transaction, it should use its existing tax bases. If the entity assumed a taxable
transaction, new tax bases are established on the basis of the fair value (i.e., fair value according to
applicable tax law) of the reporting unit’s assets and liabilities.

After the adoption of ASU 2017-04, consideration of the implied fair value of a reporting unit’s goodwill is
no longer necessary. While impairments will still occur, this specific step is not required when an entity is
measuring a required impairment (if any) after it has adopted ASU 2017-04.
350-20-35 (Q&A 39)

11.3.2.4.4 Determining the Deferred Tax Effects of a Goodwill Impairment

The initial accounting for an acquisition of a business is affected by whether the transaction is structured
as a taxable or nontaxable transaction and whether the acquisition results in tax-deductible and
nondeductible goodwill. (See Sections 11.1.3 and 11.3.2 for further discussion of the initial accounting
in a business combination.) ASC 350-20-35-41 states that, for financial reporting purposes, “goodwill
acquired in a business combination shall be assigned to one or more reporting units as of the
acquisition date.”

ASC 350-20-35-15 states that “goodwill shall be tested for impairment at a level of reporting referred to
as a reporting unit” (emphasis added). Under U.S. GAAP, a reporting unit is defined as “an operating
segment or one level below an operating segment.”

However, ASC 740-10-30-5 states that “[d]eferred taxes shall be determined separately for each
tax-paying component . . . in each tax jurisdiction.”

A reporting unit’s goodwill balance subject to impairment testing may comprise both tax-deductible
and nondeductible goodwill. One common method used to allocate the goodwill impairment among
the legal entities that constitute the reporting unit is pro rata allocation. Under this approach, an entity
proportionately allocates the impairment to tax-deductible and nondeductible goodwill on the basis of
the proportion of each in the reporting unit. Other approaches may also be acceptable; however, the

5
Once effective, ASU 2017-04 amends ASC 350-20-35-1 to state that “goodwill shall be tested at least annually for impairment at a level of
reporting referred to as a reporting unit” (emphasis added). While ASC 350-20-35-1 is amended, as described above, the requirement under ASC
350-20-35-28 to test goodwill at least annually did not change.

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approach an entity selects is an accounting policy election that, like all such elections, should be applied
consistently.

Example 11-6 below demonstrates the application of the pro rata allocation approach. Note that this
approach involves consolidated financial statements. When one or more of the legal entities within a
reporting unit prepare separate-company financial statements, the allocations may differ between the
separate and consolidated financial statements. Entities are encouraged to consult with their income tax
accounting advisers when determining an appropriate approach.

Example 11-6

Entity X has one reporting unit, R, that consists of two legal entities, Y and Z. Entities Y and Z operate in different
tax jurisdictions and have tax rates of 30 percent and 40 percent, respectively. Entity X’s annual goodwill
impairment test coincides with its December 31 fiscal year-end. Assume the following with respect to R:

Legal Entity Y

Component 1 Component 2 Total Book

Goodwill Goodwill Tax Basis Basis
January 1, 20X9 $ 1,000,000 $ 500,000 $ 1,000,000 $ 1,500,000
Tax amortization — — 100,000 —
December 31, 20X9, before impairment $ 1,000,000 $ 500,000 $ 900,000 $ 1,500,000

Legal Entity Z

Component 1 Component 2 Total Book

Goodwill Goodwill Tax Basis Basis
January 1, 20X9 $ 4,000,000 $ 500,000 $ 4,000,000 $ 4,500,000
Tax amortization — — 400,000 —
December 31, 20X9, before impairment $ 4,000,000 $ 500,000 $ 3,600,000 $ 4,500,000

On December 31, 20X9, before its annual goodwill impairment test:

• Unit R has total goodwill of $6 million ($1.5 million + $4.5 million) for financial reporting purposes.
• Unit R has remaining tax-deductible goodwill of $4.5 million ($0.9 million + $3.6 million).
• Entity Y has a DTL of $30,000 ([$1,000,000 – $900,000] × 30%) related to the taxable temporary
difference of its component 1 goodwill.
• Entity Z has a DTL of $160,000 ([$4,000,000 – $3,600,000] × 40%) related to the taxable temporary
difference of its component 1 goodwill.
In accordance with ASC 805-740-25-9, neither legal entity has recognized deferred taxes for component 2
goodwill because component 2 goodwill comprises an excess of goodwill for financial reporting purposes over
tax-deductible goodwill.

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Example 11-6 (continued)

Entity X performs its annual goodwill impairment test on December 31, 20X9, and concludes that a goodwill
impairment of $2 million exists for R. In accordance with its accounting policy election, for tax purposes, X
allocates the $2 million impairment proportionately between Y and Z on the basis of the carrying amount of
goodwill. Thus, $500,000 ([$1,500,000 ÷ $6,000,000] × $2,000,000) of the impairment is allocated to Y and
$1,500,000 ([$4,500,000 ÷ $6,000,000] × $2,000,000) of the impairment is allocated to Z. Entities Y and Z then
allocate their portions of the impairment proportionately between component 1 and component 2 goodwill on
the basis of the relative carrying amount of each component, as shown below.

Legal Entity Y

Component 1 Component 2
Goodwill Goodwill Tax Basis Book Basis
December 31, 20X9, before impairment $ 1,000,000 $ 500,000 $ 900,000 $ 1,500,000
Impairment 333,333* 166,667** — 500,000
December 31, 20X9 $ 666,667 $ 333,333 $ 900,000 $ 1,000,000
* ($1,000,000 ÷ $1,500,000) × $500,000.
** ($500,000 ÷ $1,500,000) × $500,000.

Legal Entity Z

Component 1 Component 2
Goodwill Goodwill Tax Basis Book Basis
December 31, 20X9, before impairment $ 4,000,000 $ 500,000 $ 3,600,000 $ 4,500,000
Impairment 1,333,333* 166,667** — 1,500,000
December 31, 20X9 $ 2,666,667 $ 333,333 $ 3,600,000 $ 3,000,000
* ($4,000,000 ÷ $4,500,000) × $1,500,000.
** ($500,000 ÷ $4,500,000) × $1,500,000.

On the basis of the allocations in the above tables, Y and Z would record the following journal entries for the
goodwill impairment:

Legal Entity Y

Impairment loss 500,000

Goodwill 500,000
DTL 30,000*
DTA 70,000**
Income tax expense 100,000

* Represents the DTL that was originally recognized from the tax amortization.
** ($900,000 – $666,667) × 30%.

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Example 11-6 (continued)

Legal Entity Z

Impairment loss 1,500,000

Goodwill 1,500,000
DTL 160,000*
DTA 373,333**
Income tax expense 533,333

* Represents the DTL that was originally recognized from the tax amortization.
** ($3,600,000 – $2,666,667) × 40%.

11.3.2.5 Disposal of Goodwill
In accordance with ASC 350-20, when all or a portion of a reporting unit that constitutes a business is
disposed of, all or a portion of the goodwill allocated to that reporting unit needs to be included in the
carrying amount of the reporting unit (or disposal group) when an entity is determining the gain or loss
on disposal. Given the intricacies involved with determining the deferred tax accounting for goodwill
(e.g., calculating component 1 and component 2 goodwill), additional complexities may arise when a
reporting unit (or portion thereof) that has goodwill is disposed of.
350-20-40 (Q&A 03)
An acquired business that generates goodwill will often be integrated into an existing reporting unit
(or reporting units) of the acquirer. The reporting unit to which the assets and liabilities of the acquiree
are assigned may be composed of multiple legal entities that were either acquired in previous business
combinations or formed by the acquirer. Although the goodwill generated in the business combination
will continue to be associated with the reporting unit to which it is allocated, the goodwill may not be
specifically associated with the assets and liabilities from the business combination that generated the
goodwill. For example, if an acquired business is significantly integrated with other subsidiaries of a
reporting unit and a subsidiary within the reporting unit is subsequently disposed of, the acquirer may
need to allocate a portion of the total goodwill of the reporting unit to the disposal group regardless of
how the goodwill was generated.

Under ASC 350-20-40-3, an entity determines the amount of goodwill that must be deconsolidated
by allocating goodwill from the larger reporting unit to the part of the reporting unit being sold on the
basis of relative fair value. However, for a reporting unit that contains goodwill that is tax deductible,
ASC 350-20-40 does not provide guidance on how to determine what portion of the goodwill being
disposed of represents component 1 goodwill and what portion represents component 2 goodwill.
Further, because the allocation is made at the reporting unit level, the character of the goodwill to be
deconsolidated (i.e., component 1 or component 2) will not always be determinable from the character
of the goodwill recognized in the financial statements of the specific entity to be deconsolidated.
Accordingly, several methods have developed in practice for determining the deferred tax consequences
in these types of situations.

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One such approach is the pro rata method, under which the character of the deconsolidated goodwill is
determined on a pro rata basis by reference to the character of goodwill within the larger reporting unit.

A second approach is to determine the character of the goodwill to be retained by reference to the
character of the goodwill of the component being deconsolidated, even though ASC 350-20-40-1
through 40-76 suggest that acquired goodwill loses its entity-specific character when an entity is
performing an impairment test or determining the amount of goodwill to be deconsolidated when part
of a reporting unit is sold.

A third approach is to interpret ASC 350-20-40-1 through 40-77 as simply requiring the reporting entity
to retain a portion of its investment in the disposed-of subsidiary within the reporting unit and then
classify that portion as goodwill in its consolidated financial statements until the goodwill is recovered in
accordance with ASC 350. Under this alternative, a DTL would be recorded because the residual outside
basis difference would represent a taxable temporary difference for which no exception exists. The
recognition of a DTL for the residual outside basis is also consistent with the fact that the corresponding
tax basis in the “investment” is deducted upon the sale of the disposed-of entity’s stock for income tax
purposes.

A fourth approach is to treat any goodwill retained by the reporting unit as a permanent difference
(i.e., not a temporary difference). Under this approach, any goodwill remaining in the reporting unit
is effectively characterized as internally generated goodwill that must be capitalized. Accordingly,
ASC 740-10-25-3(d) would preclude the reporting entity from recognizing a DTL on goodwill retained
for financial reporting purposes but not deductible for tax purposes. ASC 740-10-25-3(d) prohibits
“recognition of a deferred tax liability [or asset] related to goodwill (or the portion thereof) for which
amortization is not deductible for tax purposes.”

All of the approaches described above may be considered acceptable when a portion of the goodwill
originally related to the component to be deconsolidated is retained. Regardless of the method selected,
an entity should consistently apply its chosen approach to all dispositions of businesses within a
reporting unit and provide adequate footnote disclosures that describe the accounting method used
and the effects of applying that method.

While complexities are likely to be encountered when any of the approaches described above are
applied, the second approach, in particular, will need to be supplemented by additional policies when
the amount being deconsolidated exceeds the amount recognized on the books of that specific
component. Entities are encouraged to consult with their accounting advisers in these situations.

Note that each approach described above assumes that a subsidiary has been fully integrated into a
reporting unit before deconsolidation. If a subsidiary has not been previously integrated into a reporting
unit, entities should apply ASC 350-20-40-4, which requires that the current carrying amount of the
acquired goodwill (i.e., the actual subsidiary-specific goodwill) be included in the carrying amount of the
subsidiary to be disposed of. In these types of situations, which are expected to be infrequent, entities
are encouraged to consult with their accounting advisers.

6
Once effective, ASU 2017-04 amends ASC 350-20-40-7 to refer to ASC 350-20-35-3A through 35-13 rather than ASC 350-20-35-3A through 35-19.
ASU 2017-04, which eliminates step 2 from the goodwill impairment test, supersedes ASC 350-20-35-14 through 35-19. Entities that have early
adopted the amendments in ASU 2017-04 should refer to the updated guidance.
7
See footnote 5.

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Example 11-7 below illustrates the methods described above applied to the disposal of goodwill.

Example 11-7

Company P acquires 100 percent of the voting common stock of Subsidiary S1 for $1,000 in an acquisition
accounted for as a business combination. Accordingly, P’s outside tax basis in the stock of S1 is $1,000.
Company P recognizes $100 of goodwill in the acquisition of S1. Since the transaction results in carryover tax
basis, there is no corresponding tax basis in the goodwill (i.e., all goodwill is component 2 goodwill). Company P
assigns all the assets and liabilities of S1, including goodwill, to Reporting Unit 1.

As of the acquisition date of S1, Reporting Unit 1 consists of multiple legal entities, some of which were
acquired and others of which were formed by P. The goodwill recognized in these acquisitions and assigned
to Reporting Unit 1 consists of a combination of tax-deductible and non-tax-deductible goodwill. When
tax-deductible goodwill has been acquired, it has been amortized in accordance with tax law after the
acquisition.

After S1 is integrated into Reporting Unit 1, P decides to sell S1 for consideration of $800. Assume that no
goodwill impairments have been recognized under ASC 350 between the date of the acquisition of S1 and its
disposition. Further assume that, in accordance with ASC 350-20-40-1 through 40-7,8 $70 of Reporting Unit 1
goodwill will be deconsolidated upon the sale of S1 and will affect the determination of the gain or loss on
disposal for financial reporting purposes. Accordingly, upon the disposition of S1, only $70 of the goodwill
recognized in connection with the acquisition of S1 will be deconsolidated, while $30 of the total goodwill
recognized in connection with the acquisition of S1 will be retained as continuing goodwill of Reporting Unit 1.

For tax purposes, assume that the stock basis continues to be the original $1,000 paid for S1. Accordingly,
when P sells S1 for $800, it will have a capital loss of $200 and a related $42 tax benefit (assume a 21 percent
tax rate and that P can realize a tax benefit for a capital loss).

If P uses the pro rata method to determine the deferred tax consequences, it would begin its analysis by
assessing the characteristics of the $70 of goodwill that is being deconsolidated. For example, if any part
of the $70 being deconsolidated is considered component 1 goodwill, a DTL would be recorded as part of
the disposed-of assets and liabilities of S1 (since the related tax basis to be deconsolidated is zero in this
example). Further, the temporary difference associated with the goodwill retained by Reporting Unit 1 would
be similarly adjusted. This adjustment would either reduce the retained DTL or give rise to a DTA, with the
total change in the temporary difference directly corresponding to the amount of component 1 goodwill that
is considered deconsolidated. If the facts had been different and some (or all) of the goodwill recorded in
connection with the acquisition of S1 had been tax deductible, a DTA, or a reduced DTL, would be included with
the assets and liabilities of S1 to be deconsolidated (as a result of removing the related tax basis). Further, the
retained temporary difference would be adjusted to reflect the retained component 1 book basis without the
corresponding tax basis, resulting in the recognition of an additional DTL related to the goodwill being retained
by Reporting Unit 1.

If P uses the second approach to determine the deferred tax consequences, all of the goodwill recorded on
S1’s books would have been considered component 2; therefore, the remaining $30 would be considered to
still represent component 2 goodwill, resulting in no recorded DTL.

Under the third approach, P would retain a portion of its investment in S1 within the reporting unit and then
classify that portion as goodwill in its consolidated financial statements until the goodwill is recovered in
accordance with ASC 350. Under this alternative, a DTL would be recorded because the residual outside basis
difference would represent a taxable temporary difference for which no exception exists. The recognition
of a DTL for the residual outside basis is also consistent with the fact that the corresponding tax basis in the
“investment” was deducted upon the sale of the S1 stock for income tax purposes.

If P uses the fourth method described above to determine the deferred tax consequences, the $30 of goodwill
remaining in Reporting Unit 1 is effectively characterized as internally generated goodwill that P must capitalize.
Accordingly, ASC 740-10-25-3(d) would preclude P from recognizing a DTL on goodwill retained for financial
reporting purposes that is not deductible for tax purposes.

8
See footnote 5.

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11.3.3 Bargain Purchase
805-30-25 (Q&A 05)
In some limited situations, the fair value of assets acquired (net of assumed liabilities) exceeds the
consideration paid to acquire the business. A bargain purchase occurs when the net of the fair value of
the identifiable assets acquired and liabilities assumed exceeds the sum of:

• The acquisition-date fair value of the consideration transferred, including the fair value of the
acquirer’s previously held interest (if any) in the acquiree (i.e., a business combination achieved
in stages).

• The fair value of any noncontrolling interest in the acquiree.

These instances are expected to be infrequent and require an acquirer to reconsider whether all
acquired assets have been separately recognized and properly measured. However, after the acquirer
confirms that the fair value of acquired net assets exceeds the consideration paid, the acquirer
recognizes the excess (i.e., the bargain purchase element) as a gain on the acquisition date.

When an entity has been acquired, the acquirer calculates the gain on the bargain purchase after
the deferred taxes on the inside basis differences (see Section 11.3.1 for more information about
inside and outside basis differences) are recorded on the acquired entity’s assets and liabilities. This
recognized gain increases the acquirer’s investment in the acquired entity and causes a corresponding
increase in the acquired entity’s equity for financial reporting purposes. However, for tax purposes,
the bargain purchase gain is generally not included in the tax basis of the investment in the acquiree.
Therefore, a difference arises between the investment in the acquiree for financial reporting purposes
and the investment in the acquiree for tax purposes. If deferred taxes are recorded on the outside
basis difference caused by the bargain purchase gain, the tax effects would be recorded outside of the
business combination as a component of income tax expense.

Example 11-8

Taxable Business Combination — Bargain Purchase

AC pays $800 to acquire TC in a taxable business combination. The fair value of the identifiable assets is $1,000.
AC recognizes a $158 gain on the bargain purchase. Assume a 21 percent tax rate.

For the inside basis difference, a DTL of $42 is recorded on the difference between the book basis ($1,000) and
tax basis ($800) of the acquired assets.

The journal entries for the acquisition, gain on the bargain purchase, and resulting deferred taxes are as follows:

TC’s journal entry

Assets 1,000
DTL 42
Equity 958*

* $800 consideration plus $158 gain on bargain purchase.

AC’s journal entry

Investment in TC 958
Cash 800
Gain on bargain purchase 158

Regarding the outside basis difference, the carrying amount of AC’s investment in TC for financial reporting
purposes will increase by $158 and there will be a corresponding increase in TC’s equity as a result of the
recognition of the $158 gain.

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Example 11-8 (continued)

The following table illustrates AC’s investment in TC:

Book
Basis New Tax Basis
TC stock $ 800 $ 800
Gain on bargain purchase 158 —
Total $ 958 $ 800

In accordance with ASC 740-30-25-7, AC could determine that the outside basis difference in TC’s stock is not a
taxable temporary difference because (1) the tax law provides a means by which the reported amount of that
investment can be recovered tax free and (2) AC expects it will ultimately use that means. See Section 3.4.3 for
further discussion of tax-free liquidation or merger of a subsidiary.

Example 11-9

Nontaxable Business Combination — No Bargain Purchase Gain Recognized as a Result of the DTL
AC pays $900 to acquire the stock of TC in a nontaxable business combination. The fair value of the identifiable
assets is $1,000. Assume that the tax bases of the identifiable assets are $400 and that the tax rate is 21
percent.

The following are TC’s and AC’s journal entries recording the acquisition and resulting deferred taxes:

TC’s journal entry

Assets 1,000
Goodwill 26
DTL 126
Equity 900

AC’s journal entry

Investment in TC 900
Cash 900

The gain on the bargain purchase is calculated after deferred taxes are recorded. AC does not recognize a gain
on the bargain purchase because the fair value of the identifiable assets acquired and liabilities assumed (net
amount of $874) does not exceed the consideration transferred. There is no bargain purchase after the DTL is
recorded for the difference between the book basis of $1,000 and tax basis of $400 for the assets acquired.

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Example 11-10

Nontaxable Business Combination — Bargain Purchase

Assume the same facts as in Example 11-9 except that the tax bases of the identifiable assets are $700 rather
than $400.

A DTL of $63 is recorded for the difference between the book basis of $1,000 and tax basis of $700 for the
assets acquired. The journal entries recording the acquisition gain on the bargain purchase and resulting
deferred taxes are as follows:

TC’s journal entry

Assets 1,000
DTL 63
Equity 937

AC’s journal entry

Investment in TC 937
Cash 900
Gain on bargain purchase 37

These journal entries show that AC recognizes a $37 gain on the bargain purchase. As a result of AC’s
recognition of a $37 gain, AC’s investment in TC will increase by $37, with a corresponding increase in TC’s
equity. Thus, an outside basis difference will arise between the book basis of $937 and tax basis of $900 for
TC’s stock. AC determines that the outside basis difference in TC’s stock is a taxable temporary difference and
records a DTL.

AC’s journal entry

Deferred tax expense 8

DTL 8

The DTL represents a $37 basis difference at a tax rate of 21 percent. Goodwill is not affected because the
outside basis difference is related to the bargain purchase gain recognized and therefore is unrelated to the
business combination accounting.

11.3.4 Other Assets Acquired

Although recognition and measurement of income taxes related to goodwill acquired in a business
combination are considered among the most significant exceptions to the basic principles of acquisition
accounting, special consideration must also be made for other types of assets acquired.

11.3.4.1 Other Intangibles
805-740-25 (Q&A 11)
Deferred taxes are not recognized for differences between goodwill for financial statement purposes
and nondeductible goodwill for tax purposes. However, deferred income taxes are always recognized
for differences between the carrying amounts and tax bases of all acquired identifiable intangible assets
(e.g., customer lists, trademarks, and core deposit intangibles of financial institutions), regardless of
whether they are indefinite-lived or finite-lived. The FASB concluded that goodwill is a residual asset
that is uniquely different from other types of long-term intangible assets that may not be deductible in
certain tax jurisdictions. Therefore, the exception to recording deferred taxes on nondeductible goodwill
is not carried over to indefinite-lived intangible assets.

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11.3.4.2 Reacquired Rights
805-20-30 (Q&A 07)
In a business combination, the acquirer may reacquire a right that it previously granted to the acquiree
(e.g., a license or franchise). ASC 805-20-30-20 stipulates that reacquired rights are intangible assets that
the acquirer must recognize apart from goodwill.

An acquirer measures the value of the reacquired right in a business combination in accordance with
the fair value measurement guidance in ASC 820, with one exception: The value of the intangible asset
is limited to its remaining contractual term (i.e., the contractual term that remains until the next renewal
date), regardless of whether market participants would assume renewal or extension of the existing
terms of the arrangement. Because renewals are not taken into consideration in the determination of
the fair value, the reacquired right’s tax basis and its financial reporting basis as of the acquisition date
will generally differ and a DTA should be recognized for the difference between the assigned value for
financial reporting and tax purposes.

Subsequently, for financial reporting purposes, an entity must amortize the intangible assets related to
reacquired rights on the basis of their remaining contractual terms. See Example 11-11 below.

An acquiring entity must also determine whether the terms of the contract give rise to a reacquired right
that is favorable or unfavorable in relation to similar market transactions for similar rights. If the terms
of the contract do give rise to such a reacquired right, the acquirer recognizes a settlement gain or loss.
ASC 805-10-55-21(b) provides guidance on calculating the settlement gain or loss, stating that it should
be recorded as the lesser of:
1. The amount by which the contract is favorable or unfavorable from the perspective of the acquirer
when compared with pricing for current market transactions for the same or similar items. . . .
2. The amount of any stated settlement provisions in the contract available to the counterparty to whom
the contract is unfavorable . . . . [See Example 11-12.]

An acquirer may subsequently sell a reacquired right to a third party. The carrying amount of the
recognized intangible asset (i.e., reacquired right) would then be included in the gain or loss on sale.

Example 11-11

Company B sells products in Europe under a license agreement with Company A. Company A acquires B
for $100 million in a taxable business combination. As of the acquisition date, the license agreement has a
remaining contractual term of three years and can be renewed at the end of the current term and indefinitely
every five years thereafter. Assume that the pricing of the license agreement is at-market and that the
agreement does not have explicit settlement provisions. The tax rate is 21 percent. Company A has calculated
the following values for the license agreement:

• $7.5 million — Value of the license for the remaining three-year contractual term.
• $20 million — Fair value of the license agreement, calculated in accordance with the principles of ASC
820, which takes into account future renewals by market participants.
• $60 million — Other tangible assets.

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Example 11-11 (continued)

The following illustrates the book and tax bases of the assets:

New Tax
Book Basis Basis
Other tangible assets $ 60,000,000 $ 60,000,000
License agreement 7,500,000 20,000,000
Goodwill 32,500,000* 20,000,000
$ 100,000,000 $ 100,000,000
* Before the impact of deferred taxes is considered.

Company A will record the following journal entry on the acquisition date:

Other tangible assets 60,000,000

License agreement 7,500,000
Goodwill 29,875,000*
DTA 2,625,000
Cash 100,000,000

* ($32,500,000 – $2,625,000).

In this example, A would recognize an intangible asset for $7.5 million and would amortize this amount over the
remaining three-year contractual term for financial reporting purposes. Company A recognizes a DTA related to
the license agreement’s tax-over-book basis of $2.625 million ([$20 million – $7.5 million] × 21%). In accordance
with ASC 805-740-25-3 and ASC 805-740-25-9, no DTL is recorded for the book-over-tax-basis goodwill of
$9.875 million ($29.875 million – $20 million).

Example 11-12

Assume the same facts as in Example 11-11, except that under the terms of the license agreement, B pays
a license fee that is below-market in relation to that of its competitors with similar licensing agreements.
In addition, A now calculates the value of the license, for the remaining three-year contractual term, to be
$10 million. (Note that this amount is greater than the $7.5 million value calculated in Example 11-11 for an
at-market contract, because the expense related to the license is less than the market rate.)

Company A would record an intangible asset of $7.5 million for the reacquired license (the at-market value for
similar agreements) and would recognize a $2.5 million settlement loss in the income statement. In effect, the
settlement loss represents additional consideration A would be required to give B to terminate the existing
agreement, which was unfavorable to A.

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Example 11-12 (continued)

The following illustrates the book and tax bases of the assets:

Book Basis New Tax Basis

Other tangible assets $ 60,000,000 $ 60,000,000
License agreement 7,500,000 20,000,000
Goodwill 32,500,000* 20,000,000
$ 100,000,000 $ 100,000,000
* Before the loss on the unfavorable license agreement and the impact of deferred taxes are considered.

Company A will record the following journal entry on the acquisition date:

Other tangible assets 60,000,000

License agreement 7,500,000
Goodwill 30,000,000*
Loss on unfavorable license agreement 2,500,000
Cash 100,000,000

* Before the impact of deferred taxes is considered.

DTA 2,625,000
Goodwill 2,100,000
Income tax expense 525,000

Company A recognizes a DTA related to the license agreement’s tax-over-book basis of $2.625 million ([$20
million – $7.5 million] × 21%), of which $2.1 million is a DTA recorded in the acquisition accounting (as a
reduction to goodwill). The remaining component of the DTA of $525,000 is associated with the $2.5 million
financial reporting loss ($2.5 million × 21%) that was recognized in the statement of operations by the acquirer
(i.e., separately and apart from acquisition accounting). Therefore, in evaluating the DTA for realizability after
the acquisition date, an entity should remember that the character of the DTA originated in part from a finite-
lived intangible asset and in part from an expense recorded in the statement of operations.

In addition, ASC 805-740-25-3 and ASC 805-740-25-9 prohibit the recognition of a DTL for the book-over-tax-
basis goodwill.

11.3.4.3 R&D Assets
350-30-35 (Q&A 20)
Under ASC 350-30-35-17A, acquired R&D assets will be separately recognized and measured at their
acquisition-date fair values. ASC 350-30-35-17A states that an R&D asset acquired in a business
combination must be considered an indefinite-lived intangible asset until completion or abandonment
of the associated R&D efforts. Once the R&D efforts are complete or abandoned, an entity should apply
the guidance in ASC 350 to determine the useful life of the R&D assets and should amortize these assets
accordingly in the financial statements. If the project is abandoned, the asset would be written off if it
has no alternative use.

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In accordance with ASC 740, deferred taxes should be recorded for temporary differences related to
acquired R&D assets as of the business combination’s acquisition date. As with all acquired assets and
assumed liabilities, an entity must compare the amount recorded for an R&D intangible asset with its
tax basis to determine whether a temporary difference exists. If the tax basis of the R&D intangible asset
is zero, as it will be in a typical nontaxable business combination, a DTL will be recorded for that basis
difference. (See Section 5.3.1.3 for guidance on using these DTLs to evaluate DTAs for realization.)

11.3.4.4 Leveraged Leases Acquired

840-30-30 (Q&A 02)
ASC 840-10-25-43(c) defines a leveraged lease as having all of the following characteristics:
1. It meets the criteria . . . for a direct financing lease.
2. It involves at least three parties . . . .
3. The financing provided by the long-term creditor is nonrecourse as to the general credit of the lessor . . . .
4. The lessor’s net investment . . . declines during the early years once the investment has been completed
and rises during the later years of the lease before its final elimination.

As indicated in ASC 840-30, the initial recognition of a leveraged lease is based on projected after-tax
cash flows. However, in a business combination, an acquired entity’s individual assets and liabilities are
generally assigned fair values before taxes are considered.

In accordance with ASC 840-30-30-15, the acquiring entity should record an acquired leveraged lease
on the basis of the remaining future cash flows while giving appropriate recognition to the estimated
future tax effects of those cash flows. Therefore, the fair value assigned to an acquired leveraged lease
is determined on an after-tax basis (e.g., net of tax) and deferred taxes should not be established for
temporary differences related to acquired leveraged leases as of the acquisition date.

See ASC 840-30-55-50 for an example of the accounting for a leveraged lease acquired in a business
combination.

The guidance above is applicable for entities that have not yet adopted ASC 842.

In February 2016, the FASB issued ASU 2016-02, its new leasing standard (codified as ASC 842). ASC
842 introduces a lessee model that brings most leases onto the balance sheet; aligns certain of the
underlying principles of the lessor model with those in ASC 606, the FASB’s new revenue recognition
standard; and addresses other concerns related to the leasing model from the previous guidance
under ASC 840. The new guidance is effective for PBEs for annual periods beginning after December
15, 2018 (i.e., calendar periods beginning on January 1, 2019), and interim periods therein. For all other
entities, the ASU is effective for annual periods beginning after December 15, 2020 (i.e., calendar periods
beginning on January 1, 2021), and interim periods within fiscal years beginning after December 15,
2021. Early adoption is permitted for all entities.

Under ASC 842-50-30-2, the initial recognition of a leveraged lease acquired in a business combination
is unchanged from the guidance in ASC 840. That is, the acquiring entity should record an acquired
leveraged lease on the basis of the remaining future cash flows while giving appropriate recognition to
the estimated future tax effects of those cash flows.

Example 4 in ASC 842-50-55-27 through 55-33 illustrates the accounting for a leveraged lease acquired
in a business combination.

For additional information about ASC 842, see Deloitte’s A Roadmap to Applying the New Leasing
Standard.

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11.3.4.5 Obtaining Tax Basis Step-Up of Acquired Assets Through Direct

Transaction With Governmental Taxing Authority
805-740-25 (Q&A 20)
In some tax jurisdictions, an acquirer may pay the taxing authority to obtain a step-up in the tax basis
of the net assets of the acquired business. Such a transaction is not with the acquiree and is not in
exchange for the business acquired. Accordingly, the resulting step-up in tax basis should not be
accounted for as part of the recording of deferred taxes under the acquisition method of accounting.

Rather, the acquisition of tax basis from the tax authority should be accounted for as a transaction
that is separate and apart from the business combination in accordance with ASC 740-10-25-53. That
guidance indicates that the deferred tax effects of a payment to a taxing authority to obtain a step-up
in tax basis are generally accounted for directly in income (net of the amount of the payment). See ASC
740-10-55-202 through 55-204 for an example of such a transaction.

Further, ASC 740-10-25-54 states that if the step-up in tax basis relates to previously non-deductible
goodwill that will become deductible, no DTA would be recorded, except for instances in which the
deductible goodwill amount established by the step-up transaction with the taxing authority exceeds
goodwill recorded for book purposes.

Changing Lanes
In December 2019, the FASB issued ASU 2019-12, which modifies ASC 740 to simplify the
accounting for income taxes (as part of the FASB’s Simplification Initiative). The ASU amends
the guidance in ASC 740-10-25-54 that prohibits recognition of a DTA for a step-up in tax
basis “except to the extent that the newly deductible goodwill amount exceeds the remaining
balance of book goodwill.” Stakeholders noted that applying the guidance in U.S. GAAP did not
necessarily result in outcomes that reflected the economics of the underlying transactions.
For example, an entity may have sacrificed an NOL carryforward in exchange for tax basis in
goodwill. In that case, economically, the entity would have exchanged one asset for another and
yet may have been precluded from recognizing the asset received.

As a result of stakeholder feedback, the FASB removed the guidance in ASC 740-10-25-54 that
prohibited recognition of a DTA for a step-up in tax basis “except to the extent that the newly
deductible goodwill amount exceeds the remaining balance of book goodwill.” Instead, the
FASB provided a list of factors to assist an entity in determining whether the step-up in tax basis
is related to the business combination that caused the initial recognition of goodwill or to a
separate transaction. If the step-up is related to the business combination in which the book
goodwill was originally recognized, the entity would not record a DTA for the step-up in basis
except to the extent that the newly deductible goodwill amount exceeds the remaining balance
of book goodwill. If the step-up is related to a subsequent transaction, however, the entity would
record a DTA.

The Board noted in paragraph BC19 of the ASU that entities still need to apply judgment in this
area, and the factors provided in the ASU are intended to assist entities in doing so.

These amendments should be applied prospectively. For further information about ASU
2019-12, see Appendix B.

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11.3.5 Liabilities Assumed
Recognition and measurement principles of certain liabilities assumed in a business combination may
differ for financial reporting and tax purposes, resulting in deferred taxes. In addition, certain liabilities
may be accounted for under exceptions to the general principles of ASC 805, requiring additional
consideration when an entity is determining the appropriate tax accounting consequences.

11.3.5.1 Contingencies
805-20-25 (Q&A 25)
Under ASC 805-20-25-19, a contingency should be recognized at its acquisition-date fair value if the
acquisition-date fair value can be determined during the measurement period.

ASC 805-20-35-3 does not prescribe a specific method for measuring and accounting for contingencies
after the acquisition date for financial reporting purposes; rather, it states that the acquirer should
“develop a systematic and rational basis for subsequently measuring and accounting for . . .
contingencies depending on their nature.” A contingency could result in a temporary difference on the
acquisition date.

For tax purposes, the acquirer is generally precluded from recognizing a contingency until the
contingency has become fixed and determinable with reasonable accuracy, or in some jurisdictions, until
it has been settled. This could result in a basis difference between the assets and liabilities recognized
for financial reporting and tax purposes on the acquisition date.

When assessing whether a DTA or DTL should be recognized on the acquisition date, the acquirer
should determine the expected tax consequences that would result if the contingency was settled at its
initial reported amount in the financial statements. In other words, the acquirer should determine the
tax consequences as if the contingency was settled at the amount reported in the financial statements
as of the acquisition date. The tax consequences will, in part, depend on how the business combination
is structured for tax purposes (i.e., taxable or nontaxable business combination).

After the acquisition, the acquirer should account for the tax consequences resulting from a change in
the fair value of an acquired contingency and recognize the deferred tax consequences of such change
as a component of income tax expense (i.e., outside of the business combination), unless the change
qualifies as a measurement-period adjustment under ASC 805-10-25-13.

11.3.5.1.1 Taxable Business Combination

11.3.5.1.1.1 Recognition and Initial Measurement
In a taxable business combination, the settlement of a contingency will generally affect the tax basis of
goodwill. Therefore, the acquirer should assume that the contingency will be settled at its acquisition-date
fair value and should include this amount in the calculation of tax-deductible goodwill when performing the
acquisition-date comparison of tax-deductible goodwill with financial reporting goodwill. If the amount of
the hypothetical tax-deductible goodwill (i.e., tax-deductible goodwill that includes the amount associated
with the contingency) exceeds the amount of financial reporting goodwill, a DTA should be recorded.
However, if the financial reporting goodwill continues to exceed the hypothetical tax-deductible goodwill,
no DTL is recorded for the excess (because of the exception in ASC 805-740-25-9). See Section 11.3.2 for
further discussion of the acquisition-date comparison of financial reporting goodwill with tax-deductible
goodwill.

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11.3.5.1.1.2 Subsequent Measurement
In a taxable business combination, a subsequent increase or decrease in the value of the contingency
will result in an adjustment to the tax bases of the acquired assets. A DTA or DTL would be recorded
through the tax provision for the expected tax consequences.

If the revised fair value exceeds the amount recorded as a liability, a DTA will be recorded in connection
with expected additional tax-deductible goodwill. For financial reporting purposes, the additional
tax-deductible goodwill is treated as unrelated to the acquisition (i.e., it is attributed to the expense
recognized); therefore, a DTA results in the recording of a benefit to the continuing operation’s income
tax provision rather than a reduction in financial reporting goodwill.

If the contingency is settled for an amount less than the liability recorded on the books, there is a
favorable adjustment to pretax book income. This pretax book income is eliminated from taxable
income (e.g., by a Schedule M adjustment for U.S. federal tax). This adjustment to pretax book income
is treated, in substance, as an accelerated deduction of component 1 amortizable goodwill (see Section
11.3.2 for a discussion of goodwill components). In this case, a DTL is recognized and the related income
tax expense is recorded (see Example 11-13 below).

11.3.5.1.2 Nontaxable Business Combination

11.3.5.1.2.1 Recognition and Initial Measurement
In a nontaxable business combination, the settlement of a contingency may result in a tax deduction or
taxable income (e.g., a legal dispute between an acquired entity and a third party is settled, resulting in
a payment from the third party to the acquired entity). If the settlement of the contingency will result in
either a tax deduction or taxable income, deferred taxes should be recorded as part of the acquisition
accounting.

11.3.5.1.2.2 Subsequent Measurement
In a nontaxable business combination, if it was determined that the settlement of the contingency would
result in either a tax deduction or taxable income, a subsequent change in the value of the contingency
would result in a corresponding change to the previously recorded DTA or DTL. Any change recorded to
either the DTA or DTL would be recognized as a component of income tax expense (i.e., outside of the
business combination). See Example 11-13 below.

Example 11-13

Taxable Business Combination

AC acquires the stock of TC for $45 million in a taxable business combination on June 30, 20X9 (e.g., a stock
acquisition with a taxable election under IRC Section 338). In connection with the acquisition, AC recognizes a
contingent liability at a fair value of $650,000. AC’s applicable tax rate is 25 percent.

The goodwill for financial reporting purposes is $4 million (including the fair value of the contingent liability).
Tax-deductible goodwill is $3.5 million, excluding the fair value of the contingent liability.

For tax purposes, AC has determined that once the contingency is settled, it will be added to tax-deductible
goodwill. Therefore, AC includes the acquisition-date fair value of the contingent liability in tax-deductible
goodwill when comparing acquisition-date tax-deductible goodwill with financial reporting goodwill.

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Example 11-13 (continued)

Tax-deductible goodwill is compared with financial reporting goodwill as follows:

Tax-deductible goodwill $ 3,500,000

Acquisition-date fair value of the contingent liability 650,000
Hypothetical tax-deductible goodwill 4,150,000
Financial reporting goodwill 4,000,000
Excess of hypothetical tax-deductible goodwill over financial
reporting goodwill $ 150,000

Because hypothetical tax-deductible goodwill exceeds financial reporting goodwill, AC records a DTA by using
the following iterative calculation, as described in Section 11.3.2:

DTA = (0.25 ÷ [1 – 0.25]) × $150,000

DTA = $50,000

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

AC

Investment in TC 45,000,000
Cash 45,000,000

TC (to reflect “push-down” of the journal entries to TC’s books)

Identifiable assets 41,650,000

DTA 50,000
Goodwill ($4,000,000 – $50,000) 3,950,000
Contingent liability 650,000
Equity 45,000,000

September 30, 20X9

On September 30, 20X9, AC remeasures the contingent liability and determines its fair value to be $300,000, a
decrease of $350,000 ($650,000 – $300,000). AC has determined that the adjustment to the contingent liability
will decrease tax-deductible goodwill if settled at its adjusted financial reporting basis. Therefore, AC reduces
the DTA recorded on the acquisition date and records a DTL. The acquisition-date comparison of financial
reporting goodwill with tax-deductible goodwill should not be reperformed after the acquisition date.

The following journal entry is recorded on September 30, 20X9 (for simplicity, the effects of tax-deductible
goodwill amortization are excluded from this example):

TC (to reflect “push-down” of the journal entries to TC’s books)

Contingent liability 350,000

Deferred tax expense 87,500*
Gain on remeasurement — contingent liability 350,000
DTA 50,000
DTL 37,500

* $350,000 × 25%.

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Example 11-13 (continued)

December 31, 20X9

On December 31, 20X9, AC settles the contingent liability for $1 million. The $700,000 increase in the obligation
gives rise to an operating expense for financial reporting purposes and a deferred tax benefit of $175,000
($700,000 × 25% tax rate). At settlement, AC adjusts its tax-deductible goodwill for the $1 million amount.
Deferred taxes are adjusted accordingly.

The following journal entry is recorded on December 31, 20X9 (for simplicity, the effects of tax-deductible
goodwill amortization are excluded from this example):

TC (to reflect “push-down” of the journal entries to TC’s books)

Contingent liability 300,000

Expense on remeasurement — contingent liability 700,000
DTA 137,500
DTL 37,500
Cash 1,000,000
Deferred tax benefit 175,000

Example 11-14

Nontaxable Business Combinations

AC acquires the stock of TC for $45 million in a nontaxable business combination on June 30, 20X9. In
connection with the acquisition, AC recognizes a contingent liability at a fair value of $650,000. The tax basis of
the contingent liability is zero. For this example, assume that there are no differences between the carryover
tax basis and book basis of the identifiable assets acquired. AC has determined that it will receive a tax
deduction when the contingency is settled. AC’s applicable tax rate is 25 percent.

Because AC has determined that the contingent liability has a tax basis of zero and will result in a tax deduction
when settled, a temporary difference exists.

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

AC

Investment in TC 45,000,000
Cash 45,000,000

TC (to reflect “push-down” of the journal entries to TC’s books)

Identifiable assets 41,650,000

DTA 162,500
Goodwill ($4,000,000 – $162,500) 3,837,500
Contingent liability 650,000
Equity 45,000,000

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Example 11-14 (continued)

September 30, 20X9

On September 30, 20X9, AC remeasures the contingent liability and determines its fair value to be $300,000, a
decrease of $350,000 ($650,000 – $300,000). AC has determined that the adjustment to the contingent liability
will decrease the tax deduction allowed at settlement.

The following journal entry is recorded on September 30, 20X9:

TC (to reflect “push-down” of the journal entries to TC’s books)

Contingent liability 350,000

Deferred tax expense 87,500*
Gain on remeasurement — contingent liability 350,000
DTA 87,500

* $350,000 × 25%.

December 31, 20X9

On December 31, 20X9, AC settles the contingent liability for $1 million. The $700,000 increase in the obligation
gives rise to an operating expense for financial reporting purposes. AC is entitled to a tax deduction at
settlement.

The following journal entry is recorded on December 31, 20X9:

TC (to reflect “push-down” of the journal entries to TC’s books)

Contingent liability 300,000

Expense on remeasurement — contingent liability 700,000
Deferred tax expense 75,000
Income taxes payable 250,000
Cash 1,000,000
DTA 75,000
Current tax benefit 250,000

11.3.5.2 Environmental Liabilities
805-20-25 (Q&A 26)
A specific type of contingency that can be encountered as part of a business combination is an
environmental remediation liability. There are unique tax considerations related to situations in which
an acquirer purchases the assets of an entity that has preexisting contingent environmental liabilities.
Presumably, the acquirer has factored the costs of any known remediation requirements into the
amount that it would pay for the property when determining the property’s fair value in a business
combination.

For financial reporting purposes, the asset requiring environmental remediation is recorded at fair value,
full remediation is assumed, and a liability is recorded to recognize the estimated costs of remediation.
However, for tax purposes, the asset is recorded at its unremediated value. Therefore, the acquirer will
record a DTL for the taxable temporary difference between the amount recorded for financial reporting
purposes and the tax basis of the asset.

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Further, U.S. Treasury Regulation Section 1.338–5(b)(2)(iii) gives the following example illustrating when
to adjust the tax basis for the contingent environmental liability:

T, an accrual basis taxpayer, is a chemical manufacturer. In Year 1, T is obligated to remediate environmental

contamination at the site of one of its plants. Assume that all the events have occurred that establish the
fact of the liability and the amount of the liability can be determined with reasonable accuracy but economic
performance has not occurred with respect to the liability within the meaning of section 461(h). P acquires all
of the stock of T in Year 1 and makes a section 338 election for T. Assume that, if a corporation unrelated to T
had actually purchased T’s assets and assumed T’s obligation to remediate the contamination, the corporation
would not satisfy the economic performance requirements until Year 5. . . . The incurrence of the liability in Year
5 under the economic performance rules is an increase in the amount of liabilities properly taken into account
in the basis and results in the redetermination of AGUB [adjusted grossed-up basis].

Therefore, in a taxable business combination, the settlement of a contingent environmental liability will
generally increase tax-deductible goodwill. Therefore, as described in Section 11.3.5.1, the acquirer
should assume that the contingent environmental liability will be settled at its acquisition-date fair
value and should include this amount in the calculation of tax-deductible goodwill when performing
the acquisition-date comparison with financial reporting goodwill. If the amount of the hypothetical
tax-deductible goodwill (i.e., tax-deductible goodwill that includes the amount associated with the
contingency) exceeds the amount of financial reporting goodwill, a DTA should be recorded. However,
if the financial reporting goodwill continues to exceed the hypothetical tax-deductible goodwill, no
DTL is recorded for the excess (because of the exception in ASC 805-740-25-9). See Section 11.3.2 for
further discussion of the acquisition-date comparison of financial reporting goodwill with tax-deductible
goodwill.

Example 11-15

AC acquires the stock of TC for $45 million in a taxable business combination on June 30, 20X9 (e.g., a stock
acquisition with a taxable election under IRC Section 338). As part of the acquisition, AC recognizes a contingent
environmental liability with a fair value of $1 million in connection with contaminated land. For financial
reporting purposes, the land is recognized at its fair value (full remediation is assumed) of $5 million; however,
for tax purposes, the land is recognized at only $4 million (i.e., the tax basis is based on unremediated fair
value). The remaining assets of TC have a fair value of $37 million with an equal tax basis. AC’s applicable tax
rate is 25 percent.

Goodwill for both financial reporting and tax purposes is calculated below:

Book Basis Tax Basis

Land $ 5,000,000 $ 4,000,000
All other assets 37,000,000 37,000,000
Contingent environmental liability (1,000,000) —
Consideration transferred (45,000,000) (45,000,000)
Goodwill $ 4,000,000* $ 4,000,000
* Before the impact of deferred taxes is considered.

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Example 11-15 (continued)

AC will recognize a DTL of $250,000 for the taxable temporary difference between the tax basis of the land and
the amount recorded for financial reporting purposes ([$5,000,000 – $4,000,000] × 25%).

For tax purposes, AC has determined that once the contingent environmental liability is settled, it will be
added to tax-deductible goodwill. Therefore, AC includes the acquisition-date fair value of the contingent
environmental liability in tax-deductible goodwill when comparing acquisition-date tax-deductible goodwill with
financial reporting goodwill.

Tax-deductible goodwill is compared with financial reporting goodwill as follows:

Tax-deductible goodwill $ 4,000,000

Acquisition-date fair value of the contingent environmental liability 1,000,000
Hypothetical tax-deductible goodwill $ 5,000,000
Financial reporting goodwill ($4,000,000 + $250,000) 4,250,000
Excess of hypothetical tax-deductible goodwill over financial
reporting goodwill $ 750,000

Because hypothetical tax-deductible goodwill exceeds financial reporting goodwill, AC records a DTA by using
the following iterative calculation, as further described in Section 11.3.2:

DTA = (0.25 ÷ [1 – 0.25]) × $750,000

DTA = $250,000

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

AC

Investment in TC 45,000,000
Cash 45,000,000

TC (to reflect “push-down” of the journal entries to TC’s books)

All other identifiable assets 37,000,000

Land 5,000,000
DTA 250,000
Goodwill 4,000,000*
Contingent environmental liability 1,000,000
DTL 250,000**
Equity 45,000,000

* ([$4,000,000 + $250,000 DTL] – $250,000 DTA).

** DTL recognized for the taxable temporary difference in the land acquired ([$5,000,000 – $4,000,000] × 25%).

11.3.6 Other Considerations
Other special considerations in connection with the recognition, measurement, and subsequent
measurement of income taxes related to a business combination include those regarding transaction
costs incurred, the settlement of preexisting relationships, assets that were previously subject to intra-
entity sale guidance, and indemnification assets. As previously noted, it is important to fully understand
the components of a business combination to appropriately apply the guidance.

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11.3.6.1 Transaction Costs
Significant acquisition-related costs are often incurred in connection with a business combination, and
the accounting for such costs may differ for financial and tax reporting purposes. To determine the
appropriate accounting for acquisition-related costs, entities may need to also consider (among other
factors) the timing of the expenditures (i.e., before or after the business combination is consummated)
and which entity incurs the costs (i.e., the acquiree or the acquirer).
805-10-25 (Q&A 19)

11.3.6.1.1 Transaction Costs Incurred by the Acquirer

In accordance with ASC 805-10, acquisition-related costs incurred by the acquirer in connection with
a business combination (e.g., deal fees for attorneys, accountants, investment bankers, and valuation
experts) must be expensed as incurred for financial reporting purposes unless they are subject to other
U.S. GAAP (e.g., costs related to the issuance of debt or equity securities).

When acquisition-related costs are incurred, it may not be clear whether they will ultimately be
deductible for income tax reporting purposes. For example, certain acquisition-related costs may have
to be capitalized for income tax reporting purposes when incurred and become immediately deductible
if the business combination is not consummated. If the business combination is consummated, the
capitalized costs may be added (1) to the basis of the assets acquired in a taxable asset acquisition or
(2) to the basis in the stock of the acquired entity in a nontaxable stock acquisition. Because acquisition-
related costs are not considered part of the acquisition and are expensed as incurred for financial
reporting purposes, the related deferred taxes (if any) will be recorded as a component of income tax
expense (i.e., outside of the business combination).

When acquisition-related costs are incurred in a period before a business combination is consummated
and those costs are capitalized for tax purposes, a book/tax basis difference results. The acquirer will
need to assess whether that basis difference represents a deductible temporary difference for which a
DTA should be recorded. In making this determination, the acquirer may use either of the following two
approaches.9

• Approach 1 — If the costs that were capitalized for tax purposes will become deductible in the
event the business combination does not occur, a deductible temporary difference exists, and
a DTA should be recorded when the expense is recognized for financial reporting purposes.
If the business combination is ultimately consummated, the acquirer would need to reassess
the DTA to determine whether recognition continues to be appropriate. For example, if the
business combination occurs and is a taxable asset acquisition, the capitalized costs would be
added to the basis of the net assets acquired, and a DTA would generally result. Alternatively, if
the business combination is consummated and is a nontaxable stock acquisition, the capitalized
costs would be added to the basis of the stock acquired, and an outside basis deductible
temporary difference would typically be created. However, the entity would need to evaluate
whether an exception to recognition of the outside basis DTA is applicable (i.e., the entity would
need to evaluate ASC 740-30-25-9). If recognition is no longer appropriate, the DTA should be
reversed to the income statement.

9
The approach an entity selects is an accounting policy election that, like all such elections, should be applied consistently.

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• Approach 2 — The acquirer can record a DTA if, on the basis of (1) the probability that the
business combination will be consummated and (2) the expected tax structure of the business
combination, the acquisition-related expenses would result in a future tax deduction. Approach
2 requires the acquirer, in determining whether to record all or a portion of the DTA for the
acquisition expenses, to make assumptions about how the transaction would be structured
from a tax perspective and about the probability that the business combination would be
consummated. As a result of this approach, the entity would conform its financial reporting to
its “expectation” as of each reporting date (i.e., the DTA may be recognized and subsequently
derecognized if expectations change from one reporting period to the next).

11.3.6.1.2 Transaction Costs Incurred by the Target

Like acquisition-related costs incurred by the acquirer, precombination transaction costs incurred by
the target are generally expensed as incurred for financial reporting purposes. It may not be clear at
the time the costs are incurred whether they will ultimately be deductible for income tax reporting
purposes. In some jurisdictions, capitalized transaction costs incurred by the target may result in a
tax deduction (1) if the business combination is not consummated or (2) if the business combination
is consummated and is treated as a taxable asset sale. However, if the business combination is
consummated in the form of a nontaxable stock sale, the target’s capitalized transaction costs may not
be deductible or amortizable.

When the target incurs precombination transaction costs and those costs are capitalized for tax
purposes, the target will also need to assess whether that temporary difference is a deductible
temporary difference for which a DTA should be recorded. We believe that the target may use either of
the aforementioned approaches available to the acquirer to account for the expected tax consequences
of the precombination transaction costs.10
805-10-25 (Q&A 18)

Example 11-16

Taxable Business Combination

AC acquires TC in a taxable business combination for $1,000 and incurs $200 of costs related to the
acquisition. The identifiable assets have a fair value of $700. For financial reporting purposes, AC expenses the
$200 acquisition-related costs. For income tax reporting purposes, AC adds the $200 acquisition-related costs
to the total amount that is allocated to assets, resulting in tax-deductible goodwill of $500. Assume that the tax
rate is 21 percent.

AC would record the following journal entries on the acquisition date:

Assets 700
Goodwill 300
Cash 1,000

Acquisition expense 200

Cash 200

DTA 42*
Income tax expense 42

* $200 (acquisition-related costs that are capitalized as amortizable goodwill for tax purpose) × 21%.

10
See footnote 8.

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Example 11-16 (continued)

The tax impact of the acquisition costs is reflected in the income statement because the excess amount
of tax-deductible goodwill over financial reporting goodwill relates solely to the acquisition costs that are
expensed for financial reporting purposes. As a result, neither (1) the acquisition-date comparison of
tax-deductible goodwill with financial reporting goodwill nor (2) the iterative calculation described in ASC
805-740-25-8 and 25-9 and Section 11.3.2 is required.

Example 11-17

Nontaxable Business Combination

AC acquires TC in a nontaxable business combination for $1,000 and incurs $200 of costs related to the
acquisition. The identifiable assets have a fair value of $700 and a tax basis of $250. For financial reporting
purposes, AC expenses the $200 of acquisition-related costs. For tax purposes, AC adds the $200 of
acquisition-related costs to the basis of TC’s stock. Assume a 21 percent tax rate.

AC would record the following journal entries on the acquisition date:

Assets 700
Goodwill 394.5
DTL 94.5*
Cash 1,000
* ($700 fair value – $250 tax basis) × 21%.

Acquisition expense 200

Cash 200

Unlike the acquisition expenses in the taxable business combination in Example 11-7, the acquisition expenses
may not be tax-affected in a nontaxable business combination. The acquisition-related costs are included in
the outside tax basis of AC’s investment in TC. Therefore, the DTA would have to be assessed in accordance
with ASC 740-30-25-9. As long as it is not apparent that the temporary difference will reverse in the foreseeable
future, no DTA is recorded.

11.3.6.2 Contingent Consideration
Many business combinations include contingent consideration features whereby the amount of
consideration the buyer ultimately pays for the business will depend on the outcome of future events
(for example, the earnings generated by the business for a period after the acquisition). ASC 805
requires the buyer to initially measure the contingent consideration at fair value and include the
incurred liability as part of the purchase price for the acquired business. However, as discussed further
below, there can be complexities regarding the initial and subsequent accounting for the tax impacts of
contingent consideration.
805-30-25 (Q&A 12)

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11.3.6.2.1 The Income Tax Measurement Consequences of Contingent

Consideration in a Business Combination
Differences exist between the accounting for contingent consideration in a business combination under
U.S. GAAP and that accounting under the tax code. For financial reporting purposes, the acquirer is
required to recognize contingent consideration as part of the consideration transferred in the business
combination. The obligation is recorded at its acquisition-date fair value and classified as a liability or as
equity depending on the nature of the consideration. The accounting consequences of the classification
of contingent consideration are as follows:

• Contingent consideration classified as equity is not remeasured. Generally, any deferred tax
consequences resulting from the resolution of the contingency are charged or credited directly
to equity.

• Contingent consideration classified as a liability is remeasured at fair value on each reporting

date. All post-measurement-period adjustments are recorded through earnings.

• If the contingent consideration is considered a hedging instrument under ASC 815, the changes
in fair value are initially recognized in OCI (see ASC 805-30-35-1).

For tax purposes, the acquirer is generally precluded from recognizing contingent consideration as
part of the consideration transferred until the contingency has become fixed and determinable with
reasonable accuracy, or in some jurisdictions, until it has been settled. This could result in a difference in
the total consideration recognized for financial reporting and tax purposes on the acquisition date. As a
result, a book-to-tax basis difference may arise.

To determine whether a DTA or DTL should be recognized on the acquisition date, the acquirer
should determine the expected tax consequences that would result if the contingent consideration
was settled at its initial reported amount in the financial statements as of the acquisition date. The tax
consequences will, in part, depend on how the business combination is structured for tax purposes (i.e.,
as a taxable or nontaxable business combination).

11.3.6.2.1.1 Taxable Business Combination — Initial Measurement

In a taxable business combination, the settlement of contingent consideration will generally increase the
tax basis of goodwill. The acquirer should assume that the contingency will be settled at its acquisition-
date fair value and should include this amount in the calculation of tax-deductible goodwill when
performing the acquisition-date comparison of tax-deductible goodwill with financial reporting goodwill.
If the amount of the hypothetical tax-deductible goodwill (i.e., tax-deductible goodwill that includes
the amount associated with the contingent consideration) exceeds the amount of financial reporting
goodwill, a DTA should be recorded. However, if the financial reporting goodwill continues to exceed the
hypothetical tax-deductible goodwill, no DTL is recorded for the excess (because of the exception in ASC
805-740-25-9). See Section 11.3.2 for further discussion of the acquisition-date comparison of financial
reporting goodwill with tax-deductible goodwill.

11.3.6.2.1.2 Taxable Business Combination — Subsequent Measurement

In a taxable business combination, a subsequent increase or decrease in the fair value of the contingent
consideration will result in an adjustment to the tax bases of the acquired assets. A DTA or DTL would be
recorded through the tax provision for the expected tax consequences.

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If the revised fair value exceeds the amount originally recorded as a liability, a DTA will be recorded
in connection with expected additional tax-deductible goodwill. For financial reporting purposes, this
additional tax-deductible goodwill is treated as unrelated to the acquisition (i.e., it is attributed to the
expense recognized); therefore, the DTA results in recognition of a tax provision benefit to continuing
operations rather than a reduction in financial reporting goodwill.

If the contingent consideration is adjusted to an amount that is less than the liability originally recorded
on the books, a gain is recognized for financial reporting purposes. This gain is eliminated from taxable
income (e.g., by a Schedule M adjustment for U.S. federal tax). This adjustment to pretax book income
is treated, in substance, as an accelerated deduction of component 1 amortizable goodwill (see Section
11.3.2 for a discussion of goodwill components). In this case, a DTL is recognized and the related income
tax expense is recorded (see Example 11-18 below).

11.3.6.2.1.3 Nontaxable Business Combination — Initial Measurement

In a nontaxable business combination, the settlement of contingent consideration will generally increase
the tax basis in the stock of the acquired company (i.e., it increases the outside tax basis; for more
information about “inside” and “outside” basis differences, see Section 3.3.1). If the hypothetical tax
basis in the shares (i.e., tax basis that includes the amount associated with the contingent consideration)
exceeds the financial reporting basis of the shares acquired, the acquirer should consider the provisions
of ASC 740-30-25-9 regarding the possible limitations on recognizing a DTA. However, if the financial
reporting basis of the shares acquired exceeds the hypothetical tax basis, the acquirer should consider
the provisions of ASC 740-10-25-3(a) and ASC 740-30-25-7 regarding the possible exceptions to
recognizing a DTL. See Section 11.3.1.2 for further discussion of recognizing DTAs and DTLs related to
outside basis differences.

11.3.6.2.1.4 Nontaxable Business Combination — Subsequent Measurement

In a nontaxable business combination, an increase or a decrease in the fair value of the contingent
consideration for financial reporting purposes would result in an adjustment to the original hypothetical
tax basis of the acquired company’s stock. In many cases, an exception to recording deferred taxes on
outside basis differences will apply (e.g., see ASC 740-10-25-3(a) and ASC 740-30-25-7 and 25-8 for DTLs
and ASC 740-30-25-9 for DTAs). See Example 11-19.

Example 11-18

Taxable Business Combination

AC acquires the stock of TC for $45 million and a contingent payment (classified as a liability) with a fair value of
$5 million in a taxable business combination on June 30, 20X9 (e.g., a stock acquisition with a taxable election
under IRC Section 338). The identifiable assets have a fair value of $45 million and an initial tax basis of $45
million. AC’s applicable tax rate is 21 percent.

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

AC

Investment in TC 50,000,000
Cash 45,000,000
Contingent consideration liability 5,000,000

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Example 11-18 (continued)

TC (to reflect “push-down” of the journal entries to TC’s books)

Identifiable assets 45,000,000

Goodwill 5,000,000
Equity 50,000,000

AC determines that the expected tax consequences of settling the $5 million contingent consideration liability
would be to increase the tax basis of its identifiable assets and goodwill to equal the book amounts. Therefore,
no deferred taxes are recorded on the acquisition date because AC identifies no difference when performing
the acquisition-date comparison of hypothetical tax-deductible goodwill with financial reporting goodwill.

September 30, 20X9

On September 30, 20X9, subsequent facts and circumstances indicate that the contingent consideration has a
fair value of $3 million.

AC

Contingent consideration liability 2,000,000

Gain on remeasurement — contingent 2,000,000
Deferred tax expense 420,000
DTL 420,000

The $2 million decrease would reduce the hypothetical tax-deductible component 1 goodwill by $2 million.
Accordingly, a $420,000 DTL is recognized ($2 million × 21%), with an offsetting journal entry to deferred tax
expense.

December 31, 20X9

On December 31, 20X9, AC settles the contingent consideration for $11 million (fair value).

AC

Expense on remeasurement — contingent

consideration 8,000,000
Contingent consideration liability 3,000,000
Cash 11,000,000
DTA 1,260,000
DTL 420,000
Deferred tax expense 1,680,000

The $8 million increase gives rise to an equal amount of tax-deductible goodwill that corresponds to the
$8 million pretax book expense. Accordingly, a $1.26 million DTA is recognized along with a decrease of the
$420,000 DTL that was recognized on September 30, 20X9. The offsetting journal entry is to recognize deferred
tax expense of $1.68 million.

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Example 11-19

Nontaxable Business Combination

AC acquires the stock of TC for $45 million and a contingent payment (classified as a liability) with a fair value of
$5 million in a nontaxable business combination on June 30, 20X9. The identifiable assets have a fair value of
$45 million and a carryover tax basis of $45 million. AC’s applicable tax rate is 21 percent.

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

AC

Investment in TC 50,000,000
Cash 45,000,000
Contingent consideration liability 5,000,000

TC (to reflect “push-down” of the journal entries to TC’s books)

Identifiable assets 45,000,000

Goodwill 5,000,000
Equity 50,000,000

AC determines that the expected tax consequences of settling the $5 million contingent liability would be
to increase the tax basis of its investment in TC. As demonstrated below, after considering the future tax
consequences of settling the contingent consideration liability, there is no difference between the book basis
and the hypothetical tax basis of its investment in TC, so no deferred taxes are recorded on the acquisition
date.

Tax basis of AC’s investment in TC $ 45,000,000

Contingent consideration 5,000,000
Hypothetical tax basis 50,000,000
AC’s investment in TC for financial reporting 50,000,000
Difference $ —

However, if, after the contingent liability is considered, the hypothetical tax basis had exceeded the book basis,
AC would have needed to consider ASC 740-30-25-9 before recognizing a DTA on the outside basis difference.
If, after the contingent consideration liability is considered, the hypothetical tax basis had still been less than
the book basis, AC would have needed to consider ASC 740-10-25-3(a) and ASC 740-30-25-7 before recognizing
a DTL on the outside basis difference.

September 30, 20X9

On September 30, 20X9, subsequent facts and circumstances indicate that the contingent consideration has a
fair value of $3 million.

AC

Contingent consideration liability 2,000,000

Gain on remeasurement — contingent consideration 2,000,000

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Example 11-19 (continued)

Because the future settlement of the contingent consideration will affect the outside tax basis of the shares, AC
considers ASC 740-10-25-3(a) and ASC 740-30-25-7 and concludes that no associated DTL should be recorded.
Therefore, there is book income without a corresponding tax expense, resulting in an impact to the ETR.

December 31, 20X9

On December 31, 20X9, AC settles the contingent consideration for $11 million (fair value).

AC

Expense on remeasurement — contingent consideration 8,000,000

Contingent consideration liability 3,000,000
Cash 11,000,000

Because the settlement of the contingent consideration affects the outside tax basis of the shares, AC
considers ASC 740-30-25-9 and concludes that no associated DTA should be recorded. Therefore, there is book
expense without a corresponding tax benefit, resulting in an impact to the ETR.

11.3.6.3 Business Combinations Achieved in Stages

805-10-25 (Q&A 20)
A business combination is achieved in stages when an acquirer holds a noncontrolling interest in an
investment (e.g., an equity method investment) in the acquired entity (the “original investment”) before
obtaining control of the acquired entity. When the acquirer obtains control of the acquired entity,
it remeasures the original investment at fair value. The acquirer adds the fair value of the original
investment to the total amount of consideration transferred in the business combination (along with
the fair value of any noncontrolling interest still held by third parties) to determine the target’s opening
equity (which in turn affects the measurement of goodwill). The gain or loss resulting from the fair value
remeasurement is reported in the statement of operations (separately and apart from the acquisition
accounting). Any gains or losses previously recognized in OCI that are associated with the original
investment are reclassified and included in the calculation of the gain or loss.

For the acquirer, the remeasurement of the original investment in a business combination achieved
in stages at fair value will result in an increase or a decrease in the financial reporting basis of the
investment. Generally, the tax basis of the investment will not be affected, and an outside basis
difference will therefore be created. (For further guidance on outside basis differences, see Section
3.3.1.)
805-10-25 (Q&A 21)

11.3.6.3.1 DTLs for Domestic Subsidiaries Acquired in Stages

If the acquiree is a domestic subsidiary, the acquirer may not be required to recognize a DTL for an
outside basis difference once the acquirer obtains control of the acquiree. ASC 740-30-25-7 states
that the acquirer should assess whether the outside basis difference of an investment in a domestic
subsidiary is a taxable temporary difference. If the tax law provides a means by which the tax basis of
the investment can be recovered in a tax-free transaction and the acquirer expects that it will ultimately
use that means to recover its investment, a DTL should not be recognized for the outside basis
difference. Therefore, under these circumstances, the acquiring entity should reverse any DTL previously
recognized for the outside basis difference, including any DTL associated with the remeasurement of
the original investment. This reversal of the DTL should be recognized in the acquirer’s statement of
operations in the same period that includes the business combination.

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The gain or loss resulting from the remeasurement of the original investment at fair value is reported in
the statement of operations (separately and apart from the acquisition accounting). The corresponding
tax effect of the remeasurement should also be recorded as a component of the income tax provision
unless an exception applies (e.g., ASC 740-30-25-9, ASC 740-10-25-3, or ASC 740-30-25-7). See Example
11-20 below.

Example 11-20

In year 1, AC purchased 20 percent of TC, a domestic investee, for $100. In year 2, AC records $100 of equity
method earnings. Accordingly, at the end of year 2, AC has a $200 book basis and $100 tax basis in its equity
method investment and records a DTL of $21 on the outside basis difference. Assume that the tax rate is 21
percent.

AC’s journal entries are as follows:

Year 1

Investment in TC 100
Cash 100

Year 2

Investment in TC 100
Deferred tax expense 21
DTL 21
Equity in earnings of TC 100

In a nontaxable business combination, AC purchases the remaining 80 percent of TC for $2,000. The fair value
of all the identifiable assets is $2,000, and their tax basis is $500.

AC remeasures its 20 percent investment in TC as $500 (for simplicity, any control premium is ignored) and
recognizes $300 of gain.

AC records the following journal entries for the remeasurement of its original investment in TC:

Investment in TC 300
Deferred tax expense 63
Gain on remeasurement — original investment 300
DTL 63*
* Tax effects of the increase in the outside-basis difference ($300 × 21%).

AC records a DTL on the remeasurement gain because it determines that the outside basis difference is a
taxable temporary difference (i.e., the exception in ASC 740-30-25-7 does not apply).

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Example 11-20 (continued)

AC records the following journal entries for the acquisition and resulting deferred taxes:

AC

Investment in TC 2,000
Cash 2,000

TC (to reflect “push-down” of the journal entries to TC’s books)

Identifiable assets 2,000

Goodwill 815
DTL 315
Equity 2,500

A DTL of $315 is recorded on the inside basis difference attributable to the asset acquired, since the book basis
of the assets acquired is greater than the tax basis ($2,000 – $500). No DTL is recorded on the book-greater-
than-tax basis ($815 – $0) in goodwill, in accordance with ASC 805-740-25-9.

If, at any time after the acquisition, AC (1) reassesses the outside basis difference in its investment in TC and
concludes that the tax law provides a means by which the reported amount of its investment can be recovered
tax free, and (2) expects that it will ultimately use that means, the DTL on the outside basis difference would be
reversed as an adjustment to income tax expense.

As discussed in Section 11.3.6.3.2, if TC were a foreign entity, AC would be required to continue recording
a DTL for the taxable temporary difference related to its share of the undistributed earnings of the acquiree
before the date it became a subsidiary to the extent that dividends from the subsidiary do not exceed the
acquirer’s share of the subsidiary’s earnings after the date it became a subsidiary.

Example 11-21

Assume the same facts as in Example 11-20, except that in applying ASC 740-30-25-7, AC determines that its
outside basis difference in TC is not a taxable temporary difference and therefore records no deferred taxes.

AC records the following journal entries for the remeasurement of its original investment in TC:

Investment in TC 300
DTL 21
Gain on remeasurement — original investment 300
Deferred tax benefit 21

Because AC determines that its outside basis difference in TC (a domestic investee) is not a taxable temporary
difference under ASC 740-30-25-7, AC reverses the previously recorded DTL for the outside basis difference
([$200 book basis – $100 tax basis] × 21% tax rate) and records no DTL for the outside basis difference created
from the remeasurement gain.

AC records the following journal entries for the acquisition and resulting deferred taxes:

AC

Investment in TC 2,000
Cash 2,000

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Example 11-21 (continued)

TC (to reflect “push-down” of the journal entries to TC’s books)

Identifiable assets 2,000

Goodwill 815
DTL 315
Equity 2,500

A DTL of $315 ([$2,000 – $500] × 21%) is still recorded on the inside basis difference of the assets acquired,
since the exception in ASC 740-30-25-7 is related only to the outside basis differences.

As discussed in Section 11.3.6.3.2 below, if TC were a foreign entity, AC would be required to continue
recording a DTL for the taxable temporary difference related to its share of the undistributed earnings of the
acquiree before the date it became a subsidiary to the extent that dividends from the subsidiary do not exceed
the acquirer’s share of the subsidiary’s earnings after the date it became a subsidiary. Therefore, the reversal
of the DTL and the related deferred tax benefit of $21 shown in the first journal entry above would not be
applicable. In addition, a DTL resulting from the remeasurement of AC’s original investment in TC may also be
required (see the discussion in Section 11.3.6.3.2 below).

If TC were a partnership for U.S. tax purposes and AC purchased its interest via a separate subsidiary so
that TC’s partnership status postacquisition was preserved, the exception in ASC 740-30-25-7 would generally
not apply because an investor in a flow-through entity typically cannot recover its investment in a tax-free
manner. Rather, the outside basis difference would reverse through normal operations and would therefore
be a taxable temporary difference. In addition, deferred taxes would not be recorded on the underlying assets
inside TC since TC is a nontaxable entity.

11.3.6.3.2 DTLs for Foreign Subsidiaries Acquired in Stages

Under ASC 740-30-25-16, an acquiring entity that acquires a foreign entity must continue to treat a
temporary difference for its share of the undistributed earnings of the acquiree before the date it becomes
a subsidiary as a taxable temporary difference. Therefore, in accordance with ASC 740-30-25-16, the
acquiring entity should continue to recognize a DTL to the extent that the foreign subsidiary’s dividends do
not exceed the acquirer’s share of the subsidiary’s earnings after the date it becomes a subsidiary.

Questions have arisen about whether, in a step acquisition, a DTL resulting from a remeasurement of
the original investment should also be retained in accordance with ASC 740-30-25-16. There are two
acceptable approaches:

• The DTL associated with the entire outside basis difference, including any DTL associated with
the remeasurement of the original investment, should be retained.

• Only the DTL associated with the undistributed earnings of the acquiree before control is
obtained should be retained.

The approach an entity selects is an accounting policy election that, like all such elections, should be
applied consistently.

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Changing Lanes
In December 2019, the FASB issued ASU 2019-12, which modifies ASC 740 to simplify the
accounting for income taxes (as part of the FASB’s Simplification Initiative). The ASU amends
the guidance in ASC 740-30-25-16 on situations in which a foreign equity method investment
becomes a subsidiary. The previous guidance stated that the DTL previously recognized for
a foreign investment could not be derecognized when the investment became a subsidiary
unless dividends received from the subsidiary exceeded earnings from the subsidiary after
the date it became a subsidiary. This was this case regardless of whether an exception under
ASC 740-30-25-18(a) applied.

The FASB noted that this requirement increased the cost and complexity of applying ASC 740
because it essentially required an entity to bifurcate its outside basis difference in the subsidiary
and account for the components separately. This complicated the accounting for investments
and foreign subsidiaries and reduced comparability across entities (i.e., some of a reporting
entity’s subsidiaries may not have been eligible to apply the exception simply because of the
nature of the investment before it became a subsidiary).

To decrease the complexity of applying ASC 740 and increase the usefulness of information for
financial statement users, the FASB removed the exception in ASC 740-30-25-16 that freezes
the DTL on the outside basis difference that existed before the investment became a subsidiary.
Accordingly, an entity may need to reverse a DTL and recognize a tax benefit if it asserts
indefinite reinvestment of earnings of the subsidiary. This treatment results in consistency
among all the entity’s subsidiaries for which indefinite reinvestment is asserted.

Entities should apply these amendments by using a modified retrospective approach, which
would require removing deferred liabilities as of the beginning of the period of adoption, with a
cumulative-effect adjustment to retained earnings. For further information about ASU 2019-12,
see Appendix B.

11.3.6.4 Accounting for the Settlement of a Preexisting Relationship

805-10-25 (Q&A 13)
If a business combination effectively results in the settlement of a preexisting relationship between an
acquirer and an acquiree, the acquirer would recognize a gain or loss. ASC 805-10-55-21 indicates how
such a gain or loss should be measured:
a. For a preexisting noncontractual relationship, such as a lawsuit, fair value
b. For a preexisting contractual relationship, the lesser of the following:
1. The amount by which the contract is favorable or unfavorable from the perspective of the acquirer
when compared with pricing for current market transactions for the same or similar items. An
unfavorable contract is a contract that is unfavorable in terms of current market terms. It is not
necessarily a loss contract in which the unavoidable costs of meeting the obligations under the
contract exceed the economic benefits expected to be received under it.
2. The amount of any stated settlement provisions in the contract available to the counterparty to
whom the contract is unfavorable. If this amount is less than the amount in (b)(1), the difference is
included as part of the business combination accounting.

Note that if a preexisting contract is otherwise cancelable without penalty, no settlement gain or loss
would be recognized. The acquirer’s recognition of an asset or liability related to the relationship before
the business combination will affect the calculation of the settlement (see Example 11-22).

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When a business combination results in the settlement of a noncontractual relationship, such as a

lawsuit or threatened litigation, the gain or loss should be recognized and measured at fair value.
This settlement gain or loss may differ from any amount previously recorded under the contingency
guidance in ASC 450.

Example 11-22 (below) and Example 11-23 have been adapted from ASC 805-10-55-30 through 55-32
to illustrate the tax effects of a preexisting relationship between parties to a business combination.

Example 11-22

AC acquires TC in a taxable business combination. The acquisition includes a supply contract under which AC
purchases electronic components from TC at fixed rates over a five-year period. Currently, the fixed rates are
higher than the rates at which AC could purchase similar electronic components from another supplier. The
supply contract allows AC to terminate the contract before the end of the initial five-year term only by paying
a $6 million penalty. With three years remaining under the supply contract, AC pays $50 million to acquire TC.
This amount is the fair value of TC and is based on what other market participants would be willing to pay for
the entity (inclusive of the above-market contract).

The total fair value of TC includes $8 million related to the fair value of the supply contract with AC. The $8
million represents a $3 million component that is “at-market” because the pricing is comparable to pricing
for current market transactions for the same or similar items (e.g., selling effort, customer relationships) and
a $5 million component for pricing that is unfavorable to AC because it exceeds the price of current market
transactions for similar items. TC has no other identifiable assets or liabilities that are related to the supply
contract, and AC has not recognized any assets or liabilities in connection with the supply contract before the
business combination. The remaining fair value of $42 million relates to machine equipment. The tax rate is 21
percent. Assume a taxable transaction in a jurisdiction that allows for tax-deductible goodwill.

AC will record the following journal entries on the acquisition date:

Machine equipment 42,000,000

Goodwill 3,000,000
Loss on unfavorable supply contract 5,000,000
Cash 50,000,000

In applying ASC 805-10-55-21(b), AC recognizes a loss of $5 million (the lesser of the $6 million stated
settlement amount in the supply contract or the amount by which the contract is unfavorable to the acquirer)
separately from the business combination. The $3 million at-market component of the contract is part of
goodwill.

DTA 1,050,000
Income tax expense 1,050,000

The $5 million loss on the supply contract is recognized as an expense in the statement of operations for
financial reporting purposes (e.g., separately and apart from the acquisition accounting). Typically, the supply
contract will not be viewed as a separate transaction for tax purposes and will be included in tax-deductible
goodwill, resulting in a temporary difference. This will give rise to a DTA and a tax provision credit as a result of
tax affecting the $5 million loss recognized in the statement of operations. The resulting DTA would be reversed
when the goodwill is deducted on the tax return (as long as there are no realization concerns).

Note that if this transaction was structured as a nontaxable business combination (i.e., AC acquires the stock
of TC), the basis difference that arises related to the $5 million loss would not give rise to a DTA as discussed in
the preceding paragraph (i.e., because it would now be related to an excess tax over financial reporting basis in
a subsidiary and be subject to the exception in ASC 740-30-25-9).

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Example 11-23

Assume the same facts as in Example 11-22 (e.g., a taxable business combination and tax-deductible
goodwill), except that AC had recorded a $6 million liability and a $1.26 million DTA related to the supply
contract with TC before the business combination.

AC will record the following journal entries on the acquisition date:

Machine equipment 42,000,000

Goodwill 3,000,000
Liability — unfavorable supply contract 6,000,000
Cash 50,000,000
Gain 1,000,000
Income tax expense 1,260,000
DTA 1,260,000

In applying ASC 805-10-55-21(b), AC recognizes a $1 million settlement gain on the contract (the $5 million
measured loss on the contract less the $6 million loss previously recognized), along with the corresponding tax
effects, separately from the business combination. The $3 million at-market component of the contract is part
of goodwill.

DTA 1,050,000
Income tax expense 1,050,000

Because the transaction is structured as a taxable business combination, the tax impact on the total $5 million
loss related to the supply contract is treated the same as in Example 11-22 (i.e., the supply contract will not be
viewed as a separate transaction for tax purposes and will be included in tax-deductible goodwill, resulting in a
temporary difference and corresponding DTA and tax provision credit).

11.3.6.5 Accounting for Assets Acquired in a Business Combination That Were

Subject to an Intra-Entity Sale
805-740-25 (Q&A 21)
Changing Lanes
In October 2016, the FASB issued ASU 2016-16, which removes the prohibition in ASC 740
against the immediate recognition of the current and deferred income tax effects of intra-entity
transfers of assets other than inventory (i.e., the current accounting for inventory transfers will
remain unchanged). The ASU, which is part of the Board’s Simplification Initiative, is intended to
reduce the complexity of U.S. GAAP and diversity in practice related to the tax consequences
of certain types of intra-entity asset transfers, particularly those involving intellectual property.
The guidance below related to assets other than inventory applies before the adoption of
ASU 2016-16. After adoption, the guidance below will apply only to inventory.

As discussed in Section 3.5.6, when an intra-entity sale of inventory or other assets occurs at a
profit between affiliated entities that are included in consolidated financial statements but not in a
consolidated tax return, the purchasing entity’s tax basis of that asset exceeds the reported amount in
the consolidated financial statements. This occurs because, for financial reporting purposes, the effects
of gains or losses on transactions between entities included in the consolidated financial statements are
eliminated in consolidation. ASC 740-10-25-3(e) requires that income taxes paid on intra-entity profits
on assets remaining within the group be accounted for under ASC 810-10 and prohibits recognition of
a DTA for the difference between the tax basis of the assets in the buyers’ tax jurisdiction and their cost
as reported in the consolidated financial statements. Specifically, ASC 810-10-45-8 states, “If income

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taxes have been paid on intra-entity profits on inventory remaining within the consolidated group, those
taxes shall be deferred or the intra-entity profits to be eliminated in consolidation shall be appropriately
reduced.”

However, ASC 805-740-25-3 requires that, in a business combination, a DTA be recognized when the tax
basis of an acquiree’s asset exceeds the reported amount of the asset in the financial statements.

A DTA or DTL should be recognized for the difference between the acquisition-date fair value assigned
to the asset and the buyer’s actual tax basis (i.e., the tax basis after the intra-entity sale). When the
inventory is sold to a party outside the consolidated group or depreciation of the fixed asset occurs, the
DTA or DTL should be reversed. The intra-entity sales of inventory or other assets after the business
combination should be accounted for under the normal guidance in ASC 740-10-25-3(e).

11.3.6.6 Recognition of Changes in Indemnification Assets Under a Tax

Indemnification Arrangement
740-10-45 (Q&A 02)
Business combinations commonly involve tax indemnification arrangements between the former parent
and the acquirer of a subsidiary in which the parent partly or fully indemnifies the acquirer for tax
uncertainties related to uncertain tax positions taken by the subsidiary in periods before the sale of the
subsidiary.

ASC 805 addresses the accounting for indemnifications in a business combination. Specifically, ASC
805-20-25-27 states that the “acquirer shall recognize an indemnification asset at the same time that
it recognizes the indemnified item, measured on the same basis as the indemnified item, subject to
the need for a valuation allowance for uncollectible amounts.” ASC 805-20-30-19 further elaborates on
indemnifications provided for uncertain tax positions:

[A]n indemnification may relate to an asset or a liability, for example, one that results from an uncertain tax
position that is measured on a basis other than acquisition-date fair value. [I]n those circumstances, the
indemnification asset shall be recognized and measured using assumptions consistent with those used to
measure the indemnified item, subject to management’s assessment of the collectibility of the indemnification
asset and any contractual limitations on the indemnified amount.

Therefore, if the subsidiary (after the acquisition) has UTBs determined in accordance with ASC 740,
and if the related tax positions are indemnified by the former parent, the subsidiary could recognize an
indemnification asset on the basis of the indemnification agreement and the guidance in ASC 805-20-
25-27 and ASC 805-20-30-19. ASC 805-20-35-4 also provides guidance on subsequent measurement of
indemnification assets.

Example 11-2411

Company P sells its subsidiary (Company S) to an unrelated party in January 20X9. Before the sale, P and S
were separate companies and filed separate income tax returns. In connection with the sale, P and S enter
into an indemnification agreement in which P will partially indemnify S for the settlement of S’s uncertain tax
positions related to periods before the sale (i.e., P and S will share 40 percent and 60 percent of the settlement,
respectively). Specifically, if S settles an uncertain tax position with the tax authority for $100, S would be
reimbursed $40 by P. However, S remains the primary obligor for its tax positions since it filed separate returns
before the sale.

11
Entities should not use this example as a basis for recording an indemnification receivable since they would need additional facts to reach such a
conclusion. Rather, entities must evaluate their own facts and circumstances and use significant judgment when determining the appropriateness
of such a receivable. Any receivable recorded should be adjusted to reflect collection risk as appropriate.

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Example 11-24 (continued)

Assume that, upon the sale, S has recorded a liability of $100 for UTBs. On the basis of its specific facts and
circumstances, S determines that recording a receivable (i.e., an indemnification asset) for the indemnification
agreement is appropriate in accordance with ASC 805. At the time of the acquisition and subsequently, S
concluded that, in the absence of collectibility concerns, the indemnification receivable should be accounted
for under the same accounting model as that used for the related liability and subsequently adjusted for any
changes in the liability. Company S also concluded that the indemnification receivable should not be recorded
net of the related UTBs because it does not meet the criteria for offsetting in ASC 210-20. (See Section 2.8 for
an example illustrating the accounting for the guarantor side of the indemnification agreement.) Therefore, at
the time of the acquisition, S recorded an indemnification receivable (an “indemnification asset”) of $40, which
equals the amount that it expects to recover from P as a result of the indemnification agreement.

The potential payments to be received under the indemnification agreement are not income-tax-related items
because the amounts are not due to or from a tax jurisdiction. Rather, they constitute a contractual agreement
between the two parties regarding each party’s ultimate tax obligations. If S settled its uncertain tax positions
with the tax authority, and P was unable to pay S the amount due under the indemnification agreement, S’s
liability to the tax authority would not be altered or removed.

SEC Regulation S-X, Rule 5-03(b)(11), notes that a company should include “only taxes based on income” in
the income statement line item under the caption “income tax expense.” Accordingly, any adjustment to the
indemnification asset should be included in an “above the line” income statement line item. If S determined
that P was unable to pay its $40 obligation, S would impair the indemnification asset and record the associated
expense outside of “income tax expense.”

Similar issues may arise when a subsidiary is spun off from its parent. See Section 4.6.6 for considerations
involving UTBs in a spin-off transaction.

For additional considerations related to income tax indemnifications upon the sale of a subsidiary that
previously filed a separate tax return, meaning that the acquiring entity may not be directly liable for the
acquiree’s tax obligations upon acquisition, see Section 2.8.

11.3.6.7 Acquired Current Taxes Payable

In general, acquired liabilities are recorded at fair value on the acquisition date as prescribed under
ASC 805-20-25-1. However, this requirement only applies to liabilities that exist as of the acquisition date.

In some business combinations, income taxes are due as a result of a requirement to prepare a stub-
period tax return for the acquired entity. Those income taxes payable would be included as a liability
acquired by the acquirer and recorded in purchase accounting. After the acquisition, any tax on income
generated would not be included as a liability assumed by the acquirer and would be recorded as a
component of postacquisition income tax expense.

11.4 Accounting for Uncertainty in Income Taxes in Business Combinations

Uncertain tax positions related to a business combination and subsequent changes to those positions
require special consideration under ASC 805 during the initial measurement period and after a business
combination.

ASC 805-740

Other Presentation Matters

45-1 This Section addresses how an acquirer recognizes changes in valuation allowances and tax positions
related to an acquisition and the accounting for tax deductions for replacement awards.

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ASC 805-740 (continued)

Changes in Tax Positions

45-4 The effect of a change to an acquired tax position, or those that arise as a result of the acquisition, shall be
recognized as follows:
a. Changes within the measurement period that result from new information about facts and
circumstances that existed as of the acquisition date shall be recognized through a corresponding
adjustment to goodwill. However, once goodwill is reduced to zero, the remaining portion of that
adjustment shall be recognized as a gain on a bargain purchase in accordance with paragraphs 805-30-
25-2 through 25-4.
b. All other changes in acquired income tax positions shall be accounted for in accordance with the
accounting requirements for tax positions established in Subtopic 740-10.

805-740-25 (Q&A 13)

The recognition and measurement guidance in ASC 740 is applicable to a business combination
accounted for in accordance with ASC 805. ASC 805-740-25-5 states, “The tax bases used in the
calculation of deferred tax assets and liabilities as well as amounts due to or receivable from taxing
authorities related to prior tax positions at the date of a business combination shall be calculated in
accordance with Subtopic 740-10.” In addition, the effect of subsequent changes to acquired uncertain
tax positions established in the business combination should be recorded in accordance with the
presentation and classification guidance in ASC 740 unless that change relates to new information about
facts and circumstances that existed as of the acquisition date and occurs within the measurement
period (as described in ASC 805-10-25-13 through 25-19).

The measurement period applies to the potential tax effects of (1) uncertainties associated with
temporary differences and carryforwards of an acquired entity that exist as of the acquisition date
in a business combination or (2) income tax uncertainties related to a business combination (e.g., an
uncertainty related to the tax basis of an acquired asset that will ultimately be agreed to by the tax
authority) acquired or arising in a business combination.

ASC 805-740-45-4(a) states that if the change occurs in the measurement period and relates to “new
information about facts and circumstances that existed as of the acquisition date,” it is reflected with a
“corresponding adjustment to goodwill.” However, if goodwill is reduced to zero, the remaining portion
will be reflected as a bargain purchase gain.

If the adjustment to the acquired tax position balance directly results from an event that occurred after
the business combination’s acquisition date, regardless of whether the adjustment is identified during
or after the measurement period, the entire adjustment is recognized as an adjustment to income tax
expense in accordance with ASC 740 and is not an adjustment to goodwill.

After the measurement period, changes in the acquired tax position balances because of additional
information about facts and circumstances that existed as of the acquisition date would need to be
assessed to determine whether the adjustment is a correction of an error.
805-740-45 (Q&A 01)

11.4.1 Changes in Uncertain Income Tax Positions Acquired in a Business

Combination
Before ASC 805 (formerly FASB Statement 141(R)), the acquirer generally recorded subsequent
adjustments to uncertain tax positions arising from a business combination through goodwill, in
accordance with EITF Issue 93-7, regardless of whether such adjustments occurred during the allocation
period or thereafter. If goodwill attributable to the acquisition was reduced to zero, the acquirer then

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reduced other noncurrent intangible assets related to that acquisition to zero and recorded any
remaining credit as a reduction of income tax expense.

An acquirer must record all changes to acquired uncertain tax positions arising from a business
combination consummated before the adoption of Statement 141(R) in accordance with ASC 805-740-
45-4, which requires that changes to an acquired tax position, or those that arise as a result of the
acquisition (other than changes occurring during the measurement period that are related to facts and
circumstances as of the acquisition date), be accounted for in accordance with ASC 740-10 (generally as
an adjustment to income tax expense).

Under the transition guidance in ASC 805-10-65-1 (since removed from the Codification), the
requirement to record subsequent adjustments to an acquired entity’s uncertain tax position balance
in accordance with ASC 740 is not limited to business combinations occurring after the effective
date of Statement 141(R). Rather, ASC 805’s income tax transitional provisions apply to all business
combinations, regardless of the acquisition date (i.e., even business combinations that were initially
accounted for in accordance with FASB Statement 141). Therefore, this requirement affects the
subsequent accounting for all acquired uncertain tax positions, unless the change occurs in the
measurement period and results from additional information about facts and circumstances that
existed as of the acquisition date. (See Section 11.4 for additional guidance.)

Example 11-25

Company X, a calendar-year-end company, acquired 100 percent of Company Y on July 1, 20X7, in a transaction
accounted for as a business combination under FASB Statement 141. As part of the transaction, X recorded
(1) goodwill of $500 and (2) a liability for an uncertain tax position of $100 related to a position taken by Y on its
previous tax returns.

On September 30, 20X8, after the allocation period, X changed its estimate of the liability for the uncertain tax
position to $75. Under Statement 141, X adjusted its business combination accounting by crediting goodwill
for $25.

Company X adopted FASB Statement 141(R) on January 1, 20X9. On March 31, 20X9, as a result of new
information, X again changed its estimate of the liability for the uncertain tax position, this time to $30. Under
ASC 805-740, X recorded the entire adjustment of $45 ($75 – $30) as a credit to income tax expense.

Example 11-26

Company X, a calendar-year-end company, acquired 100 percent of Company Y on October 1, 20X8, in a

transaction accounted for as a business combination under FASB Statement 141. For the fiscal year ended
December 31, 20X8, X disclosed that it recorded provisional amounts for goodwill and an uncertain tax position
(liability) of $200 and $80, respectively.

Company X adopted FASB Statement 141(R) on January 1, 20X9. On March 31, 20X9, X disclosed in its interim
financial statements that it had finalized its accounting for the business combination and, on the basis of
additional information about facts that existed as of the acquisition date, determined the liability for the
uncertain tax position to be $70. Because X’s adjustment was (1) made during the allocation period and
(2) a result of information about facts and circumstances that existed as of the acquisition date, X recorded
the offsetting credit of $10 ($80 – $70) to goodwill.

On November 30, 20X9, X obtained new information about the uncertain tax position, which indicated that the
appropriate balance should be $100. Therefore, X adjusted the liability for the uncertain tax position upward by
$30, with the offsetting debit recorded to income tax expense. Company X must account for all such changes
under ASC 805-740, which results in accounting for such effects through income tax expense.

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11.5 Valuation Allowances
In accordance with the guidance in ASC 740-10 and ASC 805-740, an acquirer recognizes DTAs and DTLs
associated with the assets acquired and the liabilities assumed in a business combination. The acquirer
also assesses whether a valuation allowance is required against some or all of the acquired DTAs when
it is not more likely than not that such DTAs will be realized. This is generally done as part of purchase
accounting. The business combination may also cause a change in judgment about the realizability of
the acquirer’s DTAs.

Special consideration is required of a reporting entity when it is accounting for changes in a valuation
allowance as of or after a business combination under ASC 805-740. The reporting entity should
carefully consider the reason for the change in the valuation allowance, the DTAs to which the change
in valuation allowance relates (i.e., whether they are the acquiree’s or the acquirer’s), and whether the
information that caused the change in judgment existed before the acquisition date.

ASC 805-740

30-1 An acquirer shall measure a deferred tax asset or deferred tax liability arising from the assets acquired
and liabilities assumed in a business combination in accordance with Subtopic 740-10. Discounting deferred
tax assets or liabilities is prohibited for temporary differences (except for leveraged leases, see Subtopic
840-30) related to business combinations as it is for other temporary differences.

Pending Content (Transition Guidance: ASC 842-10-65-1)

30-1 An acquirer shall measure a deferred tax asset or deferred tax liability arising from the assets
acquired and liabilities assumed in a business combination in accordance with Subtopic 740-10.
Discounting deferred tax assets or liabilities is prohibited for temporary differences (except for leveraged
leases, see Subtopic 842-50) related to business combinations as it is for other temporary differences.

30-2 See Example 1 (paragraph 805-740-55-2) for an illustration of the measurement of deferred tax assets
and a related valuation allowance at the date of a nontaxable business combination.

30-3 The tax law in some tax jurisdictions may permit the future use of either of the combining entities’
deductible temporary differences or carryforwards to reduce taxable income or taxes payable attributable
to the other entity after the business combination. If the combined entity expects to file a consolidated tax
return, an acquirer may determine that as a result of the business combination its valuation for its deferred
tax assets should be changed. For example, the acquirer may be able to utilize the benefit of its tax operating
loss carryforwards against the future taxable profit of the acquiree. In such cases, the acquirer reduces its
valuation allowance based on the weight of available evidence. However, that reduction does not enter into
the accounting for the business combination but is recognized as an income tax benefit (or credited directly to
contributed capital [see paragraph 740-10-45-20]).

35-1 An acquirer may have a valuation allowance for its own deferred tax assets at the time of a business
combination. The guidance in this Section addresses measurement of that valuation allowance and the
potential need to distinguish the separate pasts of the acquirer and the acquired entity in the measurement
of valuation allowances together with expected future results of operations. Guidance on the subsequent
measurement of deferred tax assets or liabilities arising from the assets acquired and liabilities assumed in a
business combination, and any income tax uncertainties of an acquiree that exist at the acquisition date, or
that arise as a result of the acquisition, is provided in Subtopic 740-10.

35-2 Changes in the acquirer’s valuation allowance, if any, that result from the business combination shall
reflect any provisions in the tax law that restrict the future use of either of the combining entities’ deductible
temporary differences or carryforwards to reduce taxable income or taxes payable attributable to the other
entity after the business combination.

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ASC 805-740 (continued)

35-3 Any changes in the acquirer’s valuation allowance shall be accounted for in accordance with paragraph
805-740-30-3. For example, the tax law may limit the use of the acquired entity’s deductible temporary
differences and carryforwards to subsequent taxable income of the acquired entity included in a consolidated
tax return for the combined entity. In that circumstance, or if the acquired entity will file a separate tax return,
the need for a valuation allowance for some portion or all of the acquired entity’s deferred tax assets for
deductible temporary differences and carryforwards is assessed based on the acquired entity’s separate past
and expected future results of operations.

Other Presentation Matters

45-1 This Section addresses how an acquirer recognizes changes in valuation allowances and tax positions
related to an acquisition and the accounting for tax deductions for replacement awards.

Changes in Valuation Allowances

45-2 The effect of a change in a valuation allowance for an acquired entity’s deferred tax asset shall be
recognized as follows:
a. Changes within the measurement period that result from new information about facts and
circumstances that existed at the acquisition date shall be recognized through a corresponding
adjustment to goodwill. However, once goodwill is reduced to zero, an acquirer shall recognize any
additional decrease in the valuation allowance as a bargain purchase in accordance with paragraphs
805-30-25-2 through 25-4. See paragraphs 805-10-25-13 through 25-19 and 805-10-30-2 through 30-3
for a discussion of the measurement period in the context of a business combination.
b. All other changes shall be reported as a reduction or increase to income tax expense (or a direct
adjustment to contributed capital as required by paragraphs 740-10-45-20 through 45-21).

45-3 Example 2 (see paragraph 805-740-55-4) illustrates this guidance relating to accounting for a change in an
acquired entity’s valuation allowance.

Change in Acquirer’s Valuation Allowance as a Result of a Business Combination

50-1 Paragraph 805-740-30-3 describes a situation where an acquirer reduces its valuation allowance for
deferred tax assets as a result of a business combination. Paragraph 740-10-50-9(h) requires disclosure
of adjustments of the beginning-of-the-year balance of a valuation allowance because of a change in
circumstances that causes a change in judgment about the realizability of the related deferred tax asset in
future years. That would include, for example, any acquisition-date income tax benefits or expenses recognized
from changes in the acquirer’s valuation allowance for its previously existing deferred tax assets as a result of a
business combination.

Related Implementation Guidance and Illustrations

• Example 2: Valuation Allowance at Acquisition Date Subsequently Reduced [ASC 805-740-55-4].
• Example 3: Acquirer’s Taxable Temporary Differences Eliminate Need for Acquiree Valuation
Allowance [ASC 805-740-55-7].

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11.5.1 Accounting for Changes in the Acquirer’s and Acquiree’s Valuation

Allowances as of and After the Acquisition Date
805-740-25 (Q&A 04)
The following table summarizes the differences between accounting for changes in the acquiring entity’s
valuation allowance and accounting for the acquired entity’s valuation allowances as of and after the
acquisition date:

Changes in Valuation Allowance as a Result of Facts and Circumstances

That:

Existed as of the Acquisition Date Occurred After the Acquisition Date

Valuation allowance on the Generally, ASC 805-740-35-3 requires that changes in assumptions about
acquiring entity’s DTAs that the realizability of an acquirer’s valuation allowance as a result of a business
existed as of the acquisition combination be recorded separately from business combination accounting.
date Accordingly, all changes to an acquirer’s valuation allowance as the result of
a business combination, whether as of the acquisition date or subsequently,
should be recognized in income tax expense (or credited directly to contributed
capital [see ASC 740-10-45-20]).

Valuation allowance on the Record as part of the business Generally, record as an adjustment
acquired entity’s DTAs that combination (adjustment to goodwill) to income tax expense (see ASC
existed as of the acquisition only if the change occurred in the 805-740-45-2).
date measurement period and resulted
from new information about facts and
circumstances that existed as of the
acquisition date. If, as a result of the
adjustment, goodwill is reduced to
zero, any additional amounts should
be recognized as a bargain purchase
in accordance with ASC 805-30-25-2
through 25-4. All other changes
should generally be recorded as an
adjustment to income tax expense (see
ASC 805-740-45-2).

805-740-25 (Q&A 06)

Under ASC 805, a valuation allowance established against acquired DTAs is recorded as part of
acquisition accounting (i.e., establishing the valuation allowance would generally result in an increase to
goodwill). By contrast, under ASC 805-740-30-3, a change in the acquirer’s valuation allowance as a result
of the business combination is recognized as a component of income tax expense (i.e., it is accounted for
separately from the business combination). In addition, the impact of a change in a valuation allowance
related to acquired DTAs as a result of facts and circumstances that occurred after the acquisition date is
recognized as a component of income tax expense separately from the business combination.

Although a change in judgment related to an acquiring entity’s valuation allowance may appear to be
inextricably linked to the business combination (e.g., the addition of an extra source of income to support
realizability of DTAs), the impact should generally be recorded to income tax expense or benefit in the
period of the change in judgment. For example, in some tax jurisdictions, tax law permits the use of
deductible temporary differences or carryforwards of an acquiring entity to reduce future taxable income if
consolidated tax returns are filed after the acquisition. Assume that as a result of a business combination,
it becomes more likely than not that an acquiring entity’s preacquisition tax benefits will be realized. ASC
805-740-30-3 requires that changes in assumptions about the realizability of an acquirer’s valuation
allowance, as a result of the business combination, be recorded separately from the business combination
accounting. If, as of the acquisition date, realization of the acquiring entity’s tax benefits becomes more
likely than not, reductions in the acquiring entity’s valuation allowance should be recognized as an income
tax benefit (or credited directly to contributed capital — see ASC 740-10-45-20 and related guidance

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in Sections 6.2.2 through 6.2.4). Similarly, any subsequent changes to the acquiring entity’s valuation
allowance will not be recorded as part of acquisition accounting (i.e., no adjustments to goodwill).

11.5.2 Assessing the Need for a Valuation Allowance as of and After the

Acquisition Date
805-740-25 (Q&A 25)
It may be complex for a reporting entity to determine whether DTAs — whether those of the acquiree
or those of the acquirer — are more likely than not to be realized when the entity undertakes
an acquisition. ASC 740-10-30-18 indicates that the future reversal of existing taxable temporary
differences is one of four possible sources of taxable income that may be available to an entity for
realizing a tax benefit for deductible temporary differences and carryforwards under the tax law. In
some cases, acquired DTLs may represent a source of taxable income that supports the realizability of
some or all of the benefit of either (1) the acquired DTAs or (2) the acquirer’s DTAs but is not sufficient to
support both. In this circumstance, the guidance in ASC 805 and ASC 740 is not clear about whether the
acquired DTLs should be first considered a source of taxable income in the evaluation of realizability of
the acquired DTAs or the acquirer’s existing DTAs.

There are two acceptable methods that entities can use to determine how the source of taxable income
from the future reversal of acquired DTLs should be allocated in the evaluation of the realizability of the
acquired DTAs and the acquirer’s existing DTAs. The method an acquirer selects is an accounting policy
decision that should be applied consistently. The acquirer should also provide appropriate disclosures,
including information about benefits or expenses recognized for changes in its valuation allowance
made in accordance with ASC 805-740-50-1.

• Method 1: Assess acquired DTAs first — The acquirer first considers the acquired DTLs to be a
source of taxable income for realization of the acquired DTAs. ASC 805-20-30-1 states that
the “acquirer shall measure the identifiable assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree at their acquisition-date fair values.” Allocating the source
of taxable income from the acquiree’s DTLs first to the realization of the acquiree’s DTAs is
consistent with this principle. Any net residual source of taxable income from the acquiree’s
DTLs remaining after the acquiree’s DTAs are taken into account would be considered a
potential source of taxable income for the realization of the benefit of the acquirer’s existing
DTAs. Any change in the acquirer’s valuation allowance is recognized in income tax expense.

• Method 2: Assess on the basis of tax law ordering — Allocation of the source of taxable income
from the acquiree’s DTLs is based on the tax law in the given jurisdiction. To determine whether
the acquiree’s DTAs or the acquirer’s DTAs will be used to reduce taxable income that results
from the reversal of the DTLs, the acquirer schedules the reversal of all temporary differences
of both the acquirer and the acquiree on the basis of the applicable tax law. If such scheduling
does not result in a determination, the acquirer should develop a systematic, rational, and
consistent method for scheduling the reversal of the temporary differences. Under this method,
a net DTL could be recorded through purchase accounting, and the entity could simultaneously
recognize an income tax benefit for the release of the acquirer’s valuation allowance. The net
DTL that is reflected in the acquisition accounting will commonly result in an increase of an asset
(generally goodwill).

Under this method, it is assumed that the fair value measurement principle is not applied to
DTAs and DTLs and that scheduling of the combined group’s DTLs and DTAs is a normal part
of that valuation analysis by an acquirer. It is also assumed that immediately after the business
combination, the valuation allowance determination is performed by using the combined
group’s postacquisition positive and negative evidence (i.e., not solely the acquiree’s positive and
negative evidence).

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Example 11-27

This example illustrates the application of each method in a valuation allowance assessment.

Assume the following:

• AC purchased TC in a nontaxable transaction.

• AC will file a consolidated tax return that will include TC.
• Before the acquisition, AC has a $1,000 NOL DTA with a $1,000 valuation allowance.
• After the application of acquisition accounting, TC has a $600 NOL DTA and a $600 DTL.
• Other than the $600 DTL, there are no other sources of taxable income for realizing the benefit of the
consolidated group’s DTAs.
• In accordance with tax law, the oldest available NOLs must be used first. There are no other limitations
on the use of attributes.
The following table shows the years when the NOL carryforwards will expire:

Total 20X1 20X2 20X3 20X4

AC 1,000 400 600

TC 600 300 300

The following table shows the years when the DTL will reverse:

Total 20X1 20X2 20X3 20X4

TC (600) (150) (150) (150) (150)

Application of Method 1
TC records a DTA of $600 and a DTL of $600 as part of the acquisition accounting. There is no impact on AC’s
deferred tax balances. AC’s final consolidated financial statements will reflect a $1,600 DTA, a $600 DTL, and a
$1,000 valuation allowance.

Application of Method 2
Per tax law, AC’s older NOL DTAs must be used first; however, a portion of AC’s NOL DTAs will expire in 20X1
and 20X2 before the full reversal of the DTL. The $300 of taxable income that will result from reversal of the
acquired DTL in 20X1 and 20X2 will be allocated as a source of income to support the realizability of AC’s NOL
DTA. The $300 of taxable income that will result from reversal of the acquired DTL in 20X3 and 20X4 will be
allocated as a source of income to support the realizability of TC’s NOL DTA.

The purchase price allocation for TC will therefore include a $600 DTA, a $600 DTL, and a $300 valuation
allowance as part of the acquisition accounting. AC will reverse $300 of valuation allowance and record a
corresponding income tax benefit of $300. AC’s final consolidated financial statements will reflect a $1,600 DTA,
a $600 DTL, and a $1,000 valuation allowance.

11.6 Share-Based Payments
Changing Lanes
In March 2016, the FASB issued ASU 2016-09, which simplifies several aspects of the
accounting for employee share-based payment transactions for both public and nonpublic
entities, including the accounting for income taxes, forfeitures, and statutory tax withholding
requirements, as well as classification in the statement of cash flows. The new guidance also
contains two practical expedients under which nonpublic entities can use the simplified method
to estimate the expected term of an award and make a one-time election to switch from fair
value measurement to intrinsic value measurement for liability-classified awards. For PBEs,

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the ASU is effective for annual reporting periods beginning after December 15, 2016, including
interim periods therein. For all other entities, the ASU is effective for annual reporting periods
beginning after December 15, 2017, and interim periods within annual reporting periods
beginning after December 15, 2018.

Because ASU 2016-09 is effective for all entities, the guidance in this Roadmap is written as
if adoption has occurred. For guidance before the adoption of ASU 2016-09, see Deloitte’s
A Roadmap to Accounting for Share-Based Payment Awards.

In a business combination, share-based payment awards held by employees of the acquiree are often
exchanged for share-based payment awards of the acquirer. ASC 805 refers to the new awards as
“replacement awards.” This exchange may or not be required as part of the acquisition or as part of
the acquiree’s stock compensation plan. When the exchange is required as part of the acquisition, the
acquirer must analyze the terms of both the preexisting and the replacement awards to determine what
portion of the replacement awards is related to past service and therefore part of the consideration
transferred in the business combination. The portion of replacement awards that is related to future
services should be recognized as compensation cost in the postcombination period. Additional
complexities arise when the terms of the replacement awards are different from those of the original
rewards. See Deloitte’s A Roadmap to Accounting for Share-Based Payment Awards for additional
discussion about the accounting for equity awards issued in connection with a business combination.

Similarly, ASC 805-740 includes specific income tax accounting guidance related to these types of
awards. Because a portion of the fair value of the replacement award may be considered part of the
consideration transferred in the business combination, initial and subsequent accounting for the income
tax effects of the awards may be complex.

ASC 805-740

Replacement Awards Classified as Equity

25-10 Paragraph 805-30-30-9 identifies the types of awards that are referred to as replacement awards in
the Business Combinations Topic. For a replacement award classified as equity that ordinarily would result in
postcombination tax deductions under current tax law, an acquirer shall recognize a deferred tax asset for
the deductible temporary difference that relates to the portion of the fair-value-based measure attributed
to precombination employee service and therefore included in consideration transferred in the business
combination.

Pending Content (Transition Guidance: ASC 718-10-65-11)

25-10 Paragraph 805-30-30-9 identifies the types of awards that are referred to as replacement awards
in the Business Combinations Topic. For a replacement award classified as equity that ordinarily would
result in postcombination tax deductions under current tax law, an acquirer shall recognize a deferred tax
asset for the deductible temporary difference that relates to the portion of the fair-value-based measure
attributed to a precombination exchange of goods or services and therefore included in consideration
transferred in the business combination.

25-11 For a replacement award classified as equity that ordinarily would not result in tax deductions under
current tax law, an acquirer shall recognize no deferred tax asset for the portion of the fair-value-based
measure attributed to precombination service and thus included in consideration transferred in the business
combination. A future event, such as an employee’s disqualifying disposition of shares under a tax law, may 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.

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ASC 805-740 (continued)

Pending Content (Transition Guidance: ASC 718-10-65-11)

25-11 For a replacement award classified as equity that ordinarily would not result in tax deductions
under current tax law, an acquirer shall recognize no deferred tax asset for the portion of the fair-value-
based measure attributed to precombination vesting and thus included in consideration transferred in
the business combination. A future event, such as an employee’s disqualifying disposition of shares under
a tax law, may 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.

Tax Deductions for Replacement Awards

45-5 Paragraph 805-30-30-9 identifies the types of awards that are referred to as replacement awards in this
Topic. After the acquisition date, the deduction reported on a tax return for a replacement award classified as
equity may be different from the fair-value-based measure of the award. The tax effect of that difference shall
be recognized as income tax expense or benefit in the income statement of the acquirer.

45-6 Paragraph superseded by Accounting Standards Update No. 2016-09.

11.6.1 Tax Benefits of Tax-Deductible Share-Based Payment Awards

Exchanged in a Business Combination
805-740-25 (Q&A 17)
The appropriate income tax accounting for tax-deductible share-based payment awards exchanged in a
business combination depends on the timing of the exchange relative to the acquisition date.

11.6.1.1 Income Tax Accounting as of the Acquisition Date

For share-based payment awards that (1) are exchanged in a business combination and (2) ordinarily
result in a tax deduction under current tax law (e.g., NQSOs), an acquirer should record a DTA as of
the acquisition date for the tax benefit of the fair-value-based measure12 of the acquirer’s replacement
award included in the consideration transferred.

11.6.1.2 Income Tax Accounting After the Acquisition Date

For the portion of the fair-value-based measure of the acquirer’s replacement award that is attributed
to postcombination service and therefore included in postcombination compensation cost, a DTA is
recorded over the remaining service period (i.e., as the postcombination compensation cost is recorded)
for the tax benefit of the postcombination compensation cost.

In accordance with ASC 718, the DTA for awards classified as equity is not subsequently adjusted to
reflect changes in the entity’s share price. In contrast, for awards classified as a liability, the DTA is
remeasured, along with the compensation cost, in every reporting period until settlement.

11.6.1.3 Income Tax Accounting Upon Exercise of the Share-Based Payment

Awards
ASC 805-740-45-5 states, in part, that “the deduction reported on a tax return for a replacement award
classified as equity may be different from the fair-value-based measure of the award. The tax effect of
that difference shall be recognized as income tax expense or benefit in the income statement of the
acquirer.”

12
This guidance uses the term “fair-value-based measure”; however, ASC 718 also permits the use of “calculated value” or “intrinsic value” in specified
circumstances. This guidance would also apply in situations in which calculated value or intrinsic value is permitted.

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Example 11-28 (below) and Example 11-29, adapted from ASC 805-30-55, illustrate the income
tax accounting for tax benefits received from tax-deductible share-based payment awards that are
exchanged in a business combination after the effective date of FASB Statement 141(R).

Example 11-28

The par value of the common stock issued and cash received for the option’s exercise price are not considered
in this example.

Assume the following:

• Company A has a calendar year-end and therefore adopted FASB Statement 141(R) on January 1, 20X1.
• The acquisition date of the business combination is June 30, 20X1.
• Company A was obligated to issue the replacement awards under the terms of the acquisition
agreement.
• The replacement awards in this example are awards that would typically result in a tax deduction (e.g.,
NQSOs).
• Company A’s applicable tax rate is 25 percent.
Company A issues replacement awards of $110 (fair-value-based measure) on the acquisition date in exchange
for Company B’s awards of $100 (fair-value-based measure) on the acquisition date. The exercise price of the
replacement awards issued by A is $15. No postcombination services are required for the replacement awards,
and B’s employees had rendered all of the required service for the acquiree awards as of the acquisition date.

The amount attributable to precombination service is the fair-value-based measure of B’s awards ($100) on
the acquisition date; that amount is included in the consideration transferred in the business combination.
The amount attributable to postcombination service is $10, which is the difference between the total value
of the replacement awards ($110) and the portion attributable to precombination service ($100). Because
no postcombination service is required for the replacement awards, A immediately recognizes $10 as
compensation cost in its postcombination financial statements. See the following journal entries.

Journal Entry: June 30, 20X1

Goodwill 100
Compensation cost 10
APIC 110
To record the portions of the fair-value-based measure of the
replacement award that are attributable to precombination service
(i.e., consideration transferred) and postcombination service
(i.e., postcombination compensation cost).

Journal Entry: June 30, 20X1

DTA 27.5
Goodwill 25
Income tax provision 2.5
To record the associated income tax effects of the
fair-value-based measure of the portions of the replacement
award that are attributable to precombination service
(i.e., consideration transferred) and postcombination service
(i.e., postcombination compensation cost).

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Example 11-28 (continued)

On September 30, 20X1, all replacement awards issued by A are exercised when the market price of A’s shares
is $150. Given the exercise of the replacement awards, A will realize a tax deduction of $135 ($150 market
price of A’s shares less the $15 exercise price). The tax benefit of the tax deduction is $33.75 ($135 × 25% tax
rate). Therefore, an excess tax benefit of $6.25 (tax benefit of the tax deduction of $33.75 less the previously
recorded DTA of $27.5) is recorded to current income tax expense. See the following journal entry.

Journal Entry: September 30, 20X1

Taxes payable 33.75

Deferred tax expense 27.5
Current tax expense 33.75
DTA 27.5
To record the income tax effects of the award upon exercise.

Example 11-29

The par value of the common stock issued and cash received for the option’s exercise price are not considered
in this example.

Assume the following:

• Company A has a calendar year-end and therefore adopted FASB Statement 141(R) on January 1, 20X1.
• The acquisition date of the business combination is June 30, 20X1.
• Company A was obligated to issue the replacement awards under the terms of the acquisition
agreement.
• The replacement awards in this example are awards that would typically result in a tax deduction (e.g.,
NQSOs).
• Company A’s applicable tax rate is 25 percent.
Company A exchanges replacement awards that require one year of postcombination service for share-based
payment awards of Company B for which employees had completed the requisite service period before the
business combination. The fair-value-based measure of both awards is $100 on the acquisition date. The
exercise price of the replacement awards is $15. When originally granted, B’s awards had a requisite service
period of four years. As of the acquisition date, B’s employees holding unexercised awards had rendered a
total of seven years of service since the grant date. Even though B’s employees had already rendered the
requisite service for the original awards, A attributes a portion of the replacement award to postcombination
compensation cost in accordance with ASC 805-30-30-12 because the replacement awards require one year
of postcombination service. The total service period is five years — the requisite service period for the original
acquiree award completed before the acquisition date (four years) plus the requisite service period for the
replacement award (one year).

The portion attributable to precombination service equals the fair-value-based measure of the acquiree award
($100) multiplied by the ratio of the precombination service period (four years) to the total service period (five
years). Thus, $80 ($100 × [4 years/5 years]) is attributed to the precombination service period and therefore
is included in the consideration transferred in the business combination. The remaining $20 is attributed to
the postcombination service period and therefore is recognized as compensation cost in A’s postcombination
financial statements, in accordance with ASC 718. See the following journal entries.

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Example 11-29 (continued)

Journal Entries: December 31, 20X1

Compensation cost 10
APIC 10
DTA 2.5
Income tax provision 2.5
To record the compensation cost and the associated income tax
effects for the six-month period from the date of the acquisition
until December 31, 20X1.

Journal Entries: June 30, 20X1

Goodwill 80
APIC 80
DTA 20
Goodwill 20
To record the portion of the fair-value-based measure of the
replacement award attributable to precombination services (i.e.,
consideration transferred) and the associated income tax effects.

On June 30, 20X2, all replacement awards issued by A vest and are exercised when the market price of A’s
shares is $150. Given the exercise of the replacement awards, A will realize a tax deduction of $135 ($150
market price of A’s shares less the $15 exercise price). The tax benefit of the tax deduction is $33.75 ($135
× 25% tax rate). Therefore, an excess tax benefit of $8.75 (tax benefit of the tax deduction of $33.75 less
the previously recorded DTA of $25 [$20 + $2.5 + $2.5]) is recorded to current income tax expense. See the
following journal entries.

Journal Entries: June 30, 20X2

Compensation cost 10
APIC 10
DTA 2.5
Income tax provision 2.5
To record the compensation cost and the associated income tax
effects for the six-month period ended June 30, 20X2.

Journal Entry: June 30, 20X2

Taxes payable 33.75

Deferred tax expense 25
Current tax expense 33.75
DTA 25
To record the income tax effects of the award upon exercise.

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11.6.2 Settlement of Share-Based Payment Awards Held by the Acquiree’s

Employees
As described above, in a business combination, the acquiring company often issues replacement
share-based payment awards to the acquiree’s employees. In other situations, however, the acquiring
company may choose to cash-settle the awards instead. If the awards are unvested at the time of the
business combination, the acquiring company’s discretionary decision to cash-settle the awards will
typically result in its recognition of an accounting cost for the unvested portion in the postacquisition
period (see ASC 805-30-55-23 and 55-24). However, since the tax deduction may be included in the
acquiree’s final tax return, an entity may have questions about when and how to account for the
corresponding tax benefit in the acquirer’s financial statements. Consider the following example:

Example 11-30

On December 1, 20X1, Company A enters into an agreement to acquire Company B, in which A offers to
purchase all issued and outstanding shares of B. Under the terms of the purchase agreement, A is required
to cash-settle all outstanding employee awards held by B’s employees. Company A agrees to pay each holder
of the awards, through B’s payroll system, a cash payment due on settlement no later than five business days
after the closing of the purchase agreement. As a result, vesting will be accelerated for all of B’s unvested
employee awards that A will cash-settle.

During negotiations of the purchase agreement, A agrees to the cash-settlement provision because it wants
to (1) compensate B’s employees and (2) establish postacquisition compensation arrangements that would be
consistent with A’s existing compensation arrangements. Because no postcombination services are required
by holders of B’s awards that will be cash-settled, and because the decision to accelerate the awards is made at
A’s discretion, the accelerated unrecognized compensation cost of B’s awards will be accounted for as if A had
decided to accelerate the vesting of B’s awards immediately after the purchase-agreement closing. Therefore, A
will allocate the fair value of these awards to postcombination compensation cost because all the awards that
were outstanding and cash-settled were unvested before the close of the acquisition.

Company B will file a short-period income tax return for the period of January 1, 20X1, through December 1,
20X1, because it was purchased by A. Under the agreement, on December 6, 20X1, B cash-settles all awards
outstanding. The settlement of B’s awards is tax deductible in B’s short-period tax return for the period ended
December 1, 20X1, because B cash-settles the awards within two-and-a-half months of the end of B’s taxable
period ending December 1, 20X1. The income tax deduction for the cash-settled awards reduces taxable
income and creates an NOL carryforward in B’s income tax return for the short period ended December 1,
20X1. This NOL carryforward is available to reduce A’s postcombination taxable income.

Because the cash settlement of B’s awards is deductible for tax purposes in B’s precombination consolidated
tax return and payment does not occur until December 6, 20X1, A’s tax-basis acquisition accounting balance
sheet will reflect not only the NOL but also an employee compensation liability as of the close of the acquisition
on December 1, 20X1. Company A is accounting for the compensation cost associated with the cash-
settled awards attributable to postcombination services as a transaction that is separate from the business
combination. As a result, A will have postcombination compensation cost for which the related tax deduction
will be claimed on B’s precombination tax return.

Each of the following alternatives is acceptable in accounting for the tax consequences (deduction claimed by
B) of the postcombination compensation expense that is recognized separately and apart from the business
combination:

• Alternative 1 — Recognize all tax consequences in purchase accounting — Recognizing the tax consequences
of the postcombination compensation cost in purchase accounting is consistent with B’s deduction
of the compensation cost on its income tax return for the precombination short period. Company A’s
acquisition tax-basis balance sheet reflects the tax consequences related to the deduction claimed by
B. As a result, the acquisition balance sheet includes a DTA related to the NOL carryforward created by
the deduction claimed on B’s tax return. In addition, the acquisition balance sheet will also include a DTL
representing the taxable temporary difference related to A’s assumed obligation to settle B’s awards,
which is included in A’s tax return but is not recognized for book purposes until after the combination.

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Example 11-30 (continued)

• Alternative 2 — Recognize tax consequences separately from purchase accounting — Under this alternative,
because ASC 805 requires entities to recognize the compensation cost in the postcombination financial
statements, it is assumed that the tax effects of the postcombination compensation cost also arise
separately from the business combination in A’s postcombination financial statements. Accordingly,
there is no DTA or DTL established in B’s acquisition balance sheet. Rather, it is assumed that A receives
a tax deduction that creates a DTA (to the extent that such deduction increased an NOL carryforward)
or reduction in taxes payable (to the extent that such deduction reduced taxes payable) separately
from the business combination, which results in a tax benefit for A in the postcombination financial
statements.
Although the balance sheet presentation of each alternative would differ, the same amount of goodwill and tax
effects would be reflected in the postcombination income statement.

11.7 Other Considerations
Entities should be mindful of other tax considerations that are not directly related to or within the scope
of the accounting literature on business combinations, including those that address deconsolidation,
a planned sale or disposal of a business (either of which would trigger discontinued operations
presentation in the financial statements), the election of an acquiree to apply pushdown accounting, and
other reorganizations or mergers in contemplation of an IPO or related transaction.

11.7.1 Deconsolidation
740-20-45 (Q&A 28)
Although this chapter focuses on business combinations, entities must also evaluate special
considerations when accounting for transactions that cause deconsolidation of subsidiaries. The
deconsolidation of a subsidiary may result from a variety of circumstances, including a sale of 100
percent of an entity’s interest in the subsidiary. The sale may be structured as either a “stock sale” or an
“asset sale.” A stock sale occurs when a parent sells all of its shares in a subsidiary to a third party and
the subsidiary’s assets and liabilities are transferred to the buyer.

An asset sale occurs when a parent sells individual assets (and liabilities) to the buyer and retains
ownership of the original legal entity. In addition, by election, certain stock sales can be treated for tax
purposes as if the subsidiary sold its assets and was subsequently liquidated.

Upon a sale of a subsidiary, the parent entity should consider the income tax accounting implications for
its income statement and balance sheet.

11.7.1.1 Income Statement Considerations

ASC 810-10-40-5 provides a formula for calculating a parent entity’s gain or loss on deconsolidation of a
subsidiary, which is measured as the difference between:
a. The aggregate of all of the following:
1. The fair value of any consideration received
2. The fair value of any retained noncontrolling investment in the former subsidiary or group of assets
at the date the subsidiary is deconsolidated or the group of assets is derecognized
3. The carrying amount of any noncontrolling interest in the former subsidiary (including any
accumulated other comprehensive income attributable to the noncontrolling interest) at the date
the subsidiary is deconsolidated.
b. The carrying amount of the former subsidiary’s assets and liabilities or the carrying amount of the group
of assets.

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11.7.1.1.1 Asset Sale
When the net assets of a subsidiary are sold, the parent will present the gain or loss on the net assets
(excluding deferred taxes) in pretax income and will present the reversal of any DTAs or DTLs associated
with the assets sold (the inside basis differences13) and any tax associated with the gain or loss on sale in
income tax expense (or benefit).

11.7.1.1.2 Stock Sale
As with an asset sale, when the shares of a subsidiary are sold, the parent will present the gain or loss
on the net assets in pretax income. One acceptable approach to accounting for the reversal of deferred
taxes (the inside basis differences14) is to include the reversal in the computation of the pretax gain
or loss on the sale of the subsidiary; under this approach, the only amount that would be included in
income tax expense (or benefit) would be the tax associated with the gain or loss on the sale of the
shares (the outside basis difference15). The rationale for this view is that any future tax benefits (or
obligations) of the subsidiary are part of the assets acquired and liabilities assumed by the acquirer with
the transfer of shares in the subsidiary and the carryover tax basis in the assets and liabilities. Other
approaches may be acceptable depending on the facts and circumstances.

If the subsidiary being deconsolidated meets the requirements in ASC 205-20 for classification as a
discontinued operation, the entity would need to consider the intraperiod guidance on discontinued
operations in addition to this guidance. In addition, see Section 3.4.17.2 for a discussion of outside basis
differences in situations in which the subsidiary is presented as a discontinued operation.

11.7.1.2 Balance Sheet Considerations

Entities with a subsidiary (or component) that meets the held-for-sale criteria in ASC 360 should classify
the assets and liabilities associated with that component separately on the balance sheet as “held
for sale.” The presentation of deferred tax balances associated with the assets and liabilities of the
subsidiary or component classified as held for sale is determined on the basis of the method of the
expected sale (i.e., asset sale or stock sale) and whether the entity presenting the assets as held for sale
is transferring the basis difference to the buyer.

Deferred taxes associated with the stock of the component being sold (the outside basis differences16)
should not be presented as held for sale in either an asset sale or a stock sale since the acquirer will not
assume the outside basis difference.

11.7.1.2.1 Asset Sale
In an asset sale, the tax bases of the assets and liabilities being sold will not be transferred to the
buyer. Therefore, the deferred taxes related to the assets and liabilities (the inside basis differences17)
being sold should not be presented as held for sale; rather, they should be presented along with the
consolidated entity’s other deferred taxes.

13
See Section 11.3.1 for the meaning of “inside” and “outside” basis differences.
14
See footnote 12.
15
See footnote 12.
16
See footnote 12.
17
See footnote 12.

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11.7.1.2.2 Stock Sale
In a stock sale, the tax bases of the assets and liabilities being sold generally are carried over to the
buyer. Therefore, the deferred taxes related to the assets and liabilities (the inside basis differences18)
being sold should be presented as held for sale and not with the consolidated entity’s other deferred
taxes.

11.7.2 Discontinued Operations
When an entity contemplates sale or disposition of a portion of its business, this might cause the
portion of the business to be presented as discontinued operations. In this scenario, specific accounting
considerations apply. Guidance on discontinued operations is presented in other sections of this
Roadmap:

• See Section 3.4.17.2 for a discussion of recognition of a DTA related to a subsidiary presented
as a discontinued operation.

• See Section 7.2 for interim reporting implications of intraperiod tax allocation for discontinued
operations.

11.7.3 Pushdown Accounting Considerations

As previously noted, when an entity obtains control of a business, a new basis of accounting is
established in the acquirer’s financial statements for the assets acquired and liabilities assumed.
Sometimes the acquiree will prepare separate financial statements after its acquisition. Use of the
acquirer’s basis of accounting in the preparation of an acquiree’s separate financial statements is called
pushdown accounting.

In November 2014, the FASB issued ASU 2014-17, which became effective upon issuance. This ASU
gives an acquiree the option to apply pushdown accounting in its separate financial statements when it
has undergone a change in control. See Appendix A of Deloitte’s A Roadmap to Accounting for Business
Combinations for additional discussion regarding pushdown accounting.

11.7.3.1 Applicability of Pushdown Accounting to Income Taxes and Foreign

Currency Translation Adjustments
805-50-25 (Q&A 15)
ASC 740-10-30-5 indicates that deferred taxes must be “determined separately for each tax-paying
component . . . in each tax jurisdiction.” ASC 805-50 does not require an entity to apply pushdown
accounting for separate financial statement reporting purposes. However, to properly determine the
temporary differences and to apply ASC 740 accurately, an entity must push down, to each tax-paying
component, the amounts assigned to the individual assets and liabilities for financial reporting purposes.
That is, because the cash inflows from assets acquired or cash outflows from liabilities assumed will
be reflected on the tax return of the respective tax-paying component, the acquirer has a taxable or
deductible temporary difference related to the entire amount recorded under the acquisition method
(compared with its tax basis), regardless of whether such fair value adjustments are actually pushed
down and reflected in the acquiree’s statutory or separate financial statements.

An entity can either record the amounts in its subsidiary’s books (i.e., actual pushdown accounting) or
maintain the records necessary to adjust the consolidated amounts to what they would have been had
the amounts been recorded on the subsidiary’s books (i.e., notional pushdown accounting). The latter
method can often make recordkeeping more complex.

18
See footnote 12.

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Further, to the extent the reporting entity’s functional currency differs from the currency in which an
acquiree files its tax return, an entity must convert the entire amount recorded under the acquisition
method for a particular asset or liability to the currency in which the tax-paying component files its
tax return (the “tax currency”) to properly determine the (1) temporary difference associated with the
particular asset or liability and (2) the corresponding DTA or DTL (i.e., deferred taxes are calculated in the
tax currency and then translated or remeasured in accordance with ASC 830).

Example 11-31

Assume the following:

• A U.S. parent acquires the stock of U.S. Target (UST), which owns Entity A, a foreign corporation
operating in Jurisdiction X, in which the income tax rate is 25 percent.
• Entity A must file statutory financial statements with X that are prepared in accordance with A’s local
GAAP; the acquisition does not affect these financial statements or A’s tax basis in its assets and liabilities
in X.
• As a result of the acquisition, A will record a fair value adjustment of $10 million related to its intangible
assets, which will be amortized for U.S. GAAP purposes over 10 years, the estimated useful life of the
intangible assets, which was not recognized for statutory purposes.
• Entity A’s functional currency and local currency is the euro. As of the date of acquisition, the conversion
rate from USD to the euro was 1 USD = 1 euro. At the end of year 1, the conversion rate was 1.20 USD =
1 euro.
Entity A will record its intangible assets as part of its statutory-to-U.S.-GAAP adjustments (“stat-to-GAAP
adjustments”) and will not be entitled to any amortization deduction for local income tax reporting purposes.
However, the cash flows related to such intangible assets will be reported on A’s local income tax return
prospectively, and such cash flows will be taxable in X. Thus, A must recognize a $2.5 million DTL as part of
its stat-to-GAAP adjustments related to the excess of the intangible assets’ U.S. GAAP reporting basis over its
income tax basis. This DTL will reverse as the intangible assets are amortized for U.S. GAAP financial statement
reporting purposes. The year-end stat-to-GAAP adjustments and related currency conversions (in thousands)
are as follows:

Conversion Rate
Conversion Rate as of Date of Acquisition: at End of Year 1:
1 euro = 1 USD 1 euro = 1.20 USD

Statutory
Financial Stat-to- GAAP — GAAP — GAAP — GAAP —
Statements — GAAP Local Reporting Local Reporting
Description Local GAAP Adjustment Currency Currency Currency Currency
Intangibles — € 10,000 € 10,000 $ 10,000 € 9,000* $ 10,800
Goodwill — € 2,500 € 2,500 $ 2,500 € 2,500 $ 3,000

DTL — € (2,500) € (2,500)** $ (2,500) € (2,250) (2,700)

* The carrying value after amortization of €1,000.
** ASC 805-740-25-9 prohibits the recognition of a DTL for the financial reporting goodwill in excess of the amount that
is amortizable for tax.

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Example 11-32

Assume the same facts as in Example 11-31 above, except that A has NOL carryforwards and, on the reporting
date, has significant objectively verifiable negative evidence. Entity A has determined that the only available
source of future taxable income is the reversal of existing DTLs.

Entity A’s statutory books at the end of year 1 (in thousands) are as follows:

GAAP — Tax —
Local Local
Description Currency Currency Difference DTA/(DTL)
NOL carryforward — € 10,000 € 10,000 € 2,500 [a]

Parent’s books, for A’s original business combination journal entries, at the end of year 1 (in thousands) are as
follows:

GAAP — Tax — DTA/(DTL)

Local Local — Local
Description Currency Currency Difference Currency
Intangibles € 9,000* — € 9,000 € (2,250) [b]
Goodwill € 2,500 — € 2,500 —
* The carrying value after amortization of €1,000.

Entity A’s DTL that is recorded on the parent’s books represents an available future source of income in the
assessment of the realization of A’s DTAs. Accordingly, A’s net DTA (before valuation allowance) at the end of
year 2 is €250 ([a] + [b] in the tables above) or $300 (€250 × 1.2); therefore, on the basis of the evidence, a full
valuation allowance will be needed. Regardless of whether the journal entries are actually or notionally pushed
down, A’s net DTA to be assessed for realizability should be the same.

11.7.4 Other Forms of Mergers

740-10-25 (Q&A 70)

11.7.4.1 Successor Entity’s Accounting for the Recognition of Income Taxes When

the Predecessor Entity Is Nontaxable
In connection with a transaction such as an IPO, the historical partners in a partnership (the “legacy
partners”) may establish a C corporation that will invest in the partnership at the time of the transaction.
In the case of an IPO, the C corporation is typically established to serve as the IPO vehicle (i.e., it is
the entity that will ultimately issue its shares to the public) and therefore ultimately becomes an
SEC registrant. These transactions have informally been referred to in the marketplace as “Up-C”
transactions.

The legacy partners typically control the C corporation even after the IPO (i.e., the legacy partners sell
an economic interest to the public while retaining shares with voting control but no economic interest).
The C corporation uses the IPO proceeds to purchase an economic interest in the partnership along
with a controlling voting interest. Accordingly, the C corporation consolidates the partnership for book
purposes. Because the C corporation is taxable, it will need to recognize deferred taxes related to
its investment in the partnership. This outside basis difference is created because the C corporation
(1) receives a tax basis in the partnership units that is equal to the amount paid for the units (i.e., fair
value) but (2) has carryover basis in the assets of the partnership for U.S. GAAP reporting (because
the transaction is a transaction among entities under common control). See Appendix B of Deloitte’s
A Roadmap to Accounting for Business Combinations for further discussion of the accounting for
common-control transactions.

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Typically, the original partnership is the C corporation’s predecessor entity and the C corporation is
the successor entity (and the registrant). After the transaction becomes effective, the registrant’s initial
financial statements reflect the predecessor entity’s operations through the effective date and the
successor entity’s post-effective operations in a single set of financial statements (i.e., the predecessor
and successor financial statements are presented on a contiguous basis). Since no step-up in basis
occurs for financial statement purposes because of the common-control nature of the transaction, the
income statement and balance sheet are presented without use of a “black line.” The equity statement,
however, reflects the recognition of a noncontrolling interest as of the effective date and prospectively
in the registrant’s post-effective financial statements. In addition, the C corporation must recognize
deferred taxes upon investing in the partnership, which occurs on the effective date.

In such situations, questions often arise about whether (1) the predecessor entity’s tax status has
changed in such a way that the deferred tax benefit or expense related to the recognition of the
deferred tax accounts would be accounted for in the income statement or (2) there has been a
contribution of assets among entities under common control, in which case the recognition of the
corresponding deferred tax accounts would be accounted for in equity.

While the formation of the new C corporation has resulted in a change in the reporting entity, we do not
believe that the predecessor entity’s tax status has changed. In fact, in the situation described above,
the predecessor entity was formerly structured as a partnership and continues to exist as a partnership
after the effective date (i.e., the legacy partners continue to own an interest in the same entity, which
remains a “flow-through” entity to them both before and after the effective date) even though the
successor entity’s financial statements are presented on a contiguous basis with the predecessor entity’s
financial statements, albeit with the introduction of a noncontrolling interest.

Accordingly, we believe that the recognition of taxes on the C corporation’s investment in the
partnership should be recorded as a direct adjustment to equity, as if the former partners in that
partnership contributed their investments (along with the corresponding tax basis) to the C corporation.
The additional step-up in tax basis received by the C corporation upon its investment in the partnership
(and in the flow-through tax basis of the underlying assets and liabilities of the partnership) after the
effective date would similarly be reflected in equity in accordance with ASC 740-20-45-11(g), which
states:

All changes in the tax bases of assets and liabilities caused by transactions among or with shareholders
shall be included in equity including the effect of valuation allowances initially required upon recognition of any
related deferred tax assets. Changes in valuation allowances occurring in subsequent periods shall be included
in the income statement. [Emphasis added]

Example 11-33

F1 and F2 own LP, a partnership with net assets whose book basis is $2,000 and fair value is $20,000. F1 and
F2 have a collective tax basis of $1,000 in their units of the partnership and a collective DTL of $210. (Assume
that the tax rate is 21 percent and that the outside basis temporary difference will reverse through LP’s normal
operating activities.)

F1 and F2 form Newco, a C corporation, which sells nonvoting shares to the public in exchange for IPO
proceeds of $12,000. Newco records the following journal entry:

Cash 12,000
Equity 12,000

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Example 11-33 (continued)

Newco then uses the IPO proceeds to purchase 60 percent of the units of LP from F1 and F2. Because Newco
and LP are entities under common control, Newco records a $2,000 investment in LP’s assets (at F1’s and
F2’s historical book basis as if the net assets were contributed) along with a noncontrolling interest of $800
(representing the units of LP still held by F1 and F2) and a corresponding reduction in equity of $10,800 for the
deemed distribution to F1 and F2. This leaves $1,200 that is attributable to the controlling interest (which also
reflects the book basis of Newco’s investment in the assets of LP). Newco records the following journal entry:

Investment in the assets of LP 2,000

Equity 10,800
Noncontrolling interest in LP 800
Cash 12,000

If it is assumed that Newco is subject to a 21 percent tax rate and that Newco’s tax basis in the units has
remained consistent with F1’s and F2’s historical tax basis in LP, Newco will also record a DTL of $126 ([$1,200
book basis – $600 tax basis] × 21%), with an offset to equity, as follows:

Equity 126
DTL 126

In other words, F1 and F2 have effectively contributed their 60 percent investment in LP (along with 60 percent
of their corresponding DTL related to LP) to Newco.

Because the sale of units of LP to Newco is a taxable transaction, F1 and F2 would have taxable income of
$11,400 ($12,000 proceeds less tax basis of the interest sold [60% of $1,000]), resulting in taxes payable of
$2,280 ($11,400 × 20% capital gains rate). F1 and F2 would also eliminate the portion of their collective DTL
that was effectively contributed to Newco ([$2,000 book basis – $1,000 tax basis] × 60% × 20%). Newco would
receive a tax basis in the units of LP that is equal to its purchase price of $12,000 and would record a DTA of
$2,268 ([$12,000 tax basis – $1,200 book basis] × 21%), ignoring realizability considerations.

In accordance with ASC 740-20-45-11(g), Newco’s change in deferred taxes as a result of a change in its tax
basis in its investment in LP would be recorded directly in equity as follows:

DTA 2,268
DTL 126
Equity 2,394

11.7.4.2 Accounting for the Elimination of Income Taxes Allocated to a

Predecessor Entity When the Successor Entity Is Nontaxable
740-10-25 (Q&A 67)
In connection with certain transactions such as an IPO, a parent may plan to contribute the
“unincorporated” assets, liabilities, and operations of a division or disregarded entity to a new company
(i.e., a “newco”) at or around the time of the transaction. The newco is typically established to serve
as the IPO vehicle (i.e., it is the entity that will ultimately issue its shares to the public) and therefore
ultimately becomes an SEC registrant. In some instances, income taxes will be allocated in the financial
statements of the predecessor division or disregarded entity in periods before the IPO, but the
successor newco will be a nontaxable entity after the IPO.

Typically, the division or disregarded entity is determined to be the newco’s predecessor entity and
the newco is determined to be the successor entity. After the transaction is effective, the successor’s
initial financial statements reflect the predecessor entity’s operations through the effective date and
the successor entity’s operations after the effective date in a single set of financial statements (i.e., the
predecessor and successor financial statements are presented on a contiguous basis). Since no step-up in

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basis occurs for financial statement purposes because of the common-control nature of the transaction,
the income statement and balance sheet are typically presented without the use of a “black line.”

If the predecessor entity’s financial statements have been filed publicly, those financial statements
would generally include an income tax provision because SAB Topic 1.B.1 requires that both members
(i.e., corporate subsidiaries) and nonmembers (i.e., divisions or disregarded entities) of a group that are
part of a consolidated tax return include an allocation of taxes when those members or nonmembers
issue separate financial statements.19 When the successor entity is nontaxable (e.g., a master limited
partnership), however, the successor entity will need to eliminate (upon effectiveness) any deferred
taxes that were previously allocated to the predecessor entity.20

In situations in which deferred income taxes that were allocated to the predecessor entity are eliminated
in the successor entity’s financial statements when the successor entity is nontaxable, questions often
arise about whether (1) the predecessor entity’s tax status has changed in the manner discussed in
ASC 740-10-25-32 such that the deferred tax benefit/expense from the elimination of the deferred
tax accounts would be accounted for in the income statement, as prescribed by ASC 740-10-45-19, or
(2) the deferred taxes were effectively retained by the contributing entity, suggesting that the deferred
taxes should be eliminated through equity.

As noted above, while the predecessor entity has received an allocation of the parent’s consolidated
income tax expense, the predecessor entity typically comprises unincorporated or disregarded entities
that are not individually considered to be taxpayers under U.S. tax law (i.e., the historical owner was,
and continues to be, the taxpayer). Accordingly, we do not believe that the predecessor entity’s tax
status has changed in the manner discussed in ASC 740-10-25-32. Rather, we believe that the parent
has retained the previously allocated deferred taxes (which is consistent with removing the deferred
taxes through equity). Alternatively, the removal of the net deferred tax accounts, particularly in the
case of a net DTL, might be analogous to the extinguishment (by forgiveness) of intra-entity debt. ASC
470-50-40-2 provides guidance on such situations, noting that “extinguishment transactions between
related entities may be in essence capital transactions.” Accordingly, we believe that it is appropriate to
reflect the elimination of deferred income taxes that were allocated to the predecessor entity as a direct
adjustment to the successor entity’s equity on the effective date of the transaction.

The elimination of deferred taxes via an adjustment to equity is also consistent with an SEC staff speech
by Leslie Overton, associate chief accountant in the SEC’s Division of Corporation Finance, at the 2001
AICPA Conference on Current SEC Developments. Ms. Overton discussed a fact pattern in which the
staff believed that certain operations that would be left behind upon a spin-off (i.e., retained by the
parent) still needed to be included in the historical carve-out financial statements of the predecessor
entity to best illustrate management’s track record with respect to the business operations being spun.
However, Ms. Overton concluded her speech by noting that “[a]ssets and operations that are included in
the carve-out financial statements, but not transferred to Newco should be reflected as a distribution to
the Parent at the date Newco is formed.”

19
See Section 8.3 for guidance on acceptable methods of allocating income taxes to members of a group and Section 8.2.4 for a discussion of the
allocation of income taxes to single member LLCs.
20
If the parent actually contributes a member (corporate subsidiary) to a nontaxable successor entity and the successor entity will continue to
own that C corporation, previously allocated deferred taxes would not be eliminated and this guidance would not be applicable. However, such
situations are rare.

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11.7.4.3 Change in Tax Status as a Result of a Common-Control Merger

740-10-25 (Q&A 55)
A common-control merger occurs when two legal entities that are controlled by the same parent
company are merged into a single entity. Such a transaction is not a business combination because
there was not a change in control of the entities involved (i.e., they are controlled by the same entity
before and after the merger). The accounting for a change in an entity’s taxable status through a
common-control merger may differ from the method described in Section 11.7.4.2. For example,
an S corporation could lose its nontaxable status when acquired by a C corporation in a transaction
accounted for as a merger of entities under common control. When an entity’s status changes from
nontaxable to taxable, the entity should recognize DTAs and DTLs for any temporary differences that
exist as of the recognition date (unless these temporary differences are subject to one of the recognition
exceptions in ASC 740-10-25-3). The entity should initially measure those recognizable temporary
differences in accordance with ASC 740-10-30. Such a measurement would be consistent with the
method described in Section 11.7.4.2.

Although the transaction was between parties under common control, the combined financial
statements should not be adjusted to include income taxes of the S corporation before the date of
the common-control merger. ASC 740-10-25-32 states that DTAs and DTLs should be recognized “at
the date that a nontaxable entity becomes a taxable entity.” Therefore, any periods presented in the
combined financial statements before the common-control merger should not be adjusted for income
taxes of the S corporation.

However, it may be appropriate for an entity to present pro forma financial information, including
the income tax effects of the S corporation (as if it had been a C corporation), in the historical
combined financial statements for all periods presented. For more information on financial reporting
considerations, see Section 14.7.1.

11.8 Asset Acquisitions
As described in Section 11.1, an entity may acquire a group of assets that do not meet the definition
of a business under ASC 805. Acquisitions of this nature are considered “asset acquisitions” and do not
follow the measurement principles of a business combination under ASC 805. For financial reporting
purposes, such transactions are generally recognized under a cost accumulation model. However, the
tax bases of assets acquired could be different from the cost bases for a variety of reasons. As a result,
temporary differences arise. The accounting for these differences differs from the accounting for a
business combination described throughout this chapter. The primary difference is that no goodwill
is recorded in an asset acquisition. Instead, the cost basis of an asset may be adjusted to account for
recognition of deferred taxes.

ASC 740-10-25-51 prohibits immediate income statement recognition when the amount paid for
an asset accounted for as an asset acquisition differs from the tax basis in that asset. Instead, a
simultaneous equations method is used to determine the measurement of the asset and a related
DTL or DTA in such a manner that there is no income statement impact (i.e., the financial reporting
measurement of the asset and the DTA or DTL taken together equal the consideration transferred for
the asset in such a way that there is an effect on earnings).

ASC 740-10-55-171 through 55-182 provide illustrative examples of how an entity can apply the
simultaneous equations method when accounting for asset acquisitions that are not accounted for as
business combinations.

See Example 25 in ASC 740-10-55-170 through 55-182 in Appendix A.

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ASC 740-10

25-49 The following guidance addresses the accounting when an asset is acquired outside of a business
combination and the tax basis of the asset differs from the amount paid.

25-50 The tax basis of an asset is the amount used for tax purposes and is a question of fact under the tax
law. An asset’s tax basis is not determined simply by the amount that is depreciable for tax purposes. For
example, in certain circumstances, an asset’s tax basis may not be fully depreciable for tax purposes but would
nevertheless be deductible upon sale or liquidation of the asset. In other cases, an asset may be depreciated at
amounts in excess of tax basis; however, such excess deductions are subject to recapture in the event of sale.

25-51 The tax effect of asset purchases that are not business combinations in which the amount paid differs
from the tax basis of the asset shall not result in immediate income statement recognition. The simultaneous
equations method shall be used to record the assigned value of the asset and the related deferred tax asset
or liability. (See Example 25, Cases A and B [paragraphs 740-10-55-171 through 55-182] for illustrations of the
simultaneous equations method.) For purposes of applying this requirement, the following applies:
a. An acquired financial asset shall be recorded at fair value, an acquired asset held for disposal shall be
recorded at fair value less cost to sell, and deferred tax assets shall be recorded at the amount required
by this Topic.
b. An excess of the amounts assigned to the acquired assets over the consideration paid shall be allocated
pro rata to reduce the values assigned to noncurrent assets acquired (except financial assets, assets
held for disposal, and deferred tax assets). If the allocation reduces the noncurrent assets to zero, the
remainder shall be classified as a deferred credit. (See Example 25, Cases C and D [paragraphs 740-10-
55-183 through 55-191] for illustrations of transactions that result in a deferred credit.) The deferred
credit is not a temporary difference under this Subtopic.
c. A reduction in the valuation allowance of the acquiring entity that is directly attributable to the asset
acquisition shall be accounted for in accordance with paragraph 805-740-30-3. Subsequent accounting
for an acquired valuation allowance (for example, the subsequent recognition of an acquired deferred
tax asset by elimination of a valuation allowance established at the date of acquisition of the asset)
would be in accordance with paragraphs 805-740-25-3 and 805-740-45-2.

25-52 The net tax benefit (that is, the difference between the amount paid and the deferred tax asset recognized)
resulting from the purchase of future tax benefits from a third party which is not a government acting in its
capacity as a taxing authority shall be recorded using the same model described in the preceding paragraph. (See
Example 25, Case F [paragraph 740-10-55-199] for an illustration of a purchase of future tax benefits.)

25-53 Transactions directly between a taxpayer and a government (in its capacity as a taxing authority) shall
be recorded directly in income (in a manner similar to the way in which an entity accounts for changes in tax
laws, rates, or other tax elections under this Subtopic). (See Example 26 [paragraph 740-10-55-202] for an
illustration of a transaction directly with a governmental taxing authority.)

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ASC 740-10 (continued)

25-54 In situations in which the tax basis step up relates to goodwill that was previously not deductible, no
deferred tax asset would be recorded for the increase in basis except to the extent that the newly deductible
goodwill amount exceeds the remaining balance of book goodwill.

Pending Content (Transition Guidance: ASC 740-10-65-8)

25-54 An entity shall determine whether a step up in the tax basis of goodwill relates to the business combination
in which the book goodwill was originally recognized or whether it relates to a separate transaction. In
situations in which the tax basis step up relates to the business combination in which the book goodwill was
originally recognized, no deferred tax asset would be recorded for the increase in basis except to the extent
that the newly deductible goodwill amount exceeds the remaining balance of book goodwill. In situations in
which the tax basis step up relates to a separate transaction, a deferred tax asset would be recorded for the entire
amount of the newly created tax goodwill in accordance with this Subtopic. Factors that may indicate that the
step up in tax basis relates to a separate transaction include, but are not limited to, the following:
a. A significant lapse in time between the transactions has occurred.
b. The tax basis in the newly created goodwill is not the direct result of settlement of liabilities recorded
in connection with the acquisition.
c. The step up in tax basis is based on a valuation of the goodwill or the business that was performed
as of a date after the business combination.
d. The transaction resulting in the step up in tax basis requires more than a simple tax election.
e. The entity incurs a cash tax cost or sacrifices existing tax attributes to achieve the step up in tax basis.
f. The transaction resulting in the step up in tax basis was not contemplated at the time of the
business combination.

25-55 In the event that an entity purchases tax benefits that result from intra-entity transactions between
members of a consolidated entity, paragraph 740-10-25-3(e), which prohibits recognition of a deferred tax
asset for the difference between the tax basis of assets in the buyer’s tax jurisdiction and the cost of those
assets as reported in the consolidated financial statements, shall be applied.

Pending Content (Transition Guidance: ASC 740-10-65-7)

25-55 Paragraph superseded by Accounting Standards Update No. 2018-09.

Related Implementation Guidance and Illustrations

• Example 25: Purchase Transactions That Are Not Accounted for as Business Combinations
[ASC 740-10-55-170].
• Example 26: Direct Transaction With Governmental Taxing Authority [ASC 740-10-55-202].

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ASC 740-10 — SEC Materials — SEC Staff Guidance

S25-1 See paragraph 740-10-S99-3, SEC Observer Comment: Accounting for Acquired Temporary Difference
in Certain Purchase Transactions that Are Not Accounted for as Business Combinations, for SEC Staff views on
accounting for such transactions.

S99-3 The following is the text of SEC Observer Comment: Accounting for Acquired Temporary Differences in
Certain Purchase Transactions that Are Not Accounted for as Business Combinations.
Paragraph 740-10-25-50 provides guidance on the accounting for acquired temporary differences
in purchase transactions that are not business combinations. The SEC staff would object to broadly
extending this guidance to adjust the basis in an asset acquisition to situations different from those
illustrated in Examples 25 through 26 (see paragraphs 740-10-55-170 through 55-204) without first having
a clear and complete understanding of those specific fact patterns.

ASC 740-10

35-5 A deferred credit may arise under the accounting required by paragraph 740-10-25-51 when an asset
is acquired outside of a business combination. Any deferred credit arising from the application of such
accounting requirements shall be amortized to income tax expense in proportion to the realization of the tax
benefits that gave rise to the deferred credit.

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Special Situations

12.1 Introduction
This chapter provides income tax accounting and disclosure guidance related to noncontrolling
interests, equity method investments (including specific exceptions in ASC 740 related to corporate
joint ventures and changes in ownership of investees), QAHP investments, regulated entities, and
distinguishing a change in estimate from a correction of an error. The book-versus-tax-differences
chapter of this Roadmap (Chapter 3) provides helpful guidance on the respective definitions of inside
and outside basis differences (see Section 3.3.1) and the recognition criteria for deferred taxes.

12.2 Noncontrolling Interests
ASC 810-10-20 defines a noncontrolling interest as the “portion of equity (net assets) in a subsidiary not
attributable, directly or indirectly, to a parent.” Consequently, noncontrolling interests are presented
only in the consolidated financial statements of a parent whose holdings include a controlling interest
in one or more subsidiaries it partially owns. The objective of accounting for noncontrolling interests
is to present users of the consolidated financial statements with a clear depiction of the portion of a
subsidiary’s net assets, net income, and net comprehensive income that is attributable to equity holders
other than the parent.

12.2.1 Accounting for the Tax Effects of Transactions With Noncontrolling

Shareholders
810-10-45 (Q&A 18)
A parent accounts for changes in its ownership interest in a subsidiary over which it maintains control
(“control-to-control” transactions) as equity transactions. The parent cannot recognize a gain or loss in
consolidated net income or comprehensive income for such transactions and is not permitted to step
up a portion of the subsidiary’s net assets to fair value to the extent of any additional interests acquired
(i.e., no additional acquisition method accounting). As part of the equity transaction accounting, the
entity must also reallocate the subsidiary’s AOCI between the parent and the noncontrolling interest.

The tax accounting consequences related to stock transactions associated with a subsidiary are
addressed under ASC 740-20-45-11. The direct tax effect of a change in ownership interest in a
subsidiary when a parent maintains control is generally recorded in shareholders’ equity. Some
transactions with noncontrolling shareholders may create both a direct and an indirect tax effect. It
is important to properly distinguish between the direct and indirect tax effects of a transaction since
the accounting for each may be different. For example, an entity records as income tax expense in
continuing operations rather than in shareholders’ equity the indirect tax effect of a parent’s change in
its assumptions associated with undistributed earnings of a foreign subsidiary resulting from a sale of its
ownership interest in that subsidiary.

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Example 12-1

Parent Entity A owns 80 percent of its foreign subsidiary, which operates in a zero-rate tax jurisdiction. The
subsidiary has a net book value of $100 million as of December 31, 20X9. Entity A’s tax basis of its 80 percent
investment is $70 million. Assume that the carrying amounts of the interest of the parent (A) and noncontrolling
interest holder (Entity B) in the subsidiary are $80 million and $20 million, respectively. The $10 million
difference between A’s book basis and tax basis in the subsidiary is attributable to undistributed earnings of the
foreign subsidiary. In accordance with ASC 740-30-25-17, A has not historically recorded a DTL for the taxable
temporary difference associated with undistributed earnings of the foreign subsidiary because A has specific
plans to reinvest such earnings in the subsidiary indefinitely and the reversal of the temporary difference is
therefore indefinite.

On January 1, 20Y0, A sells 12.5 percent of its interest in the foreign subsidiary to a nonaffiliated entity, Entity
C, for total proceeds of $20 million. As summarized in the table below, this transaction (1) dilutes A’s interest
in the subsidiary to 70 percent and decreases its carrying amount by $10 million (12.5% × $80 million) to $70
million, and (2) increases the total carrying amount of the noncontrolling interest holders (B and C) by $10
million to $30 million.

Original Carrying Ownership

Original Carrying Ownership Amount Interest
Entity Amount Interest January 1, 20Y0 January 1, 20Y0
A $ 80,000,000 80% $ 70,000,000 70%
B 20,000,000 20 20,000,000 20
C — — 10,000,000 10
Total $ 100,000,000 100% $ 100,000,000 100%

Below is A’s journal entry on January 1, 20Y0, before consideration of income tax accounting:

Cash 20,000,000
Noncontrolling interest 10,000,000
APIC 10,000,000

Entity A’s current tax payable and tax expense from its taxable gain on the sale of its investment in the
subsidiary is $2,812,500, which is computed as follows: ($20 million selling price – [$70 million tax basis × 12.5%
portion sold]) × 25% tax rate. The amount consists of the following direct and indirect tax effects:
1. The direct tax effect of the sale is $2.5 million. This amount is associated with the difference between
the selling price and book basis of the interest sold by A (i.e., the gain on the sale) and is computed as
follows: ($20 million selling price – [$80 million book basis × 12.5% portion sold]) × 25% tax rate. The
gain on the sale of A’s interest is recorded in shareholders’ equity; therefore, the direct tax effect is
recognized in shareholders’ equity.
2. The indirect tax effect of the sale is $312,500. This amount is associated with the preexisting taxable
temporary difference (i.e., the undistributed earnings of the subsidiary) of the interest sold for which a
DTL was not recognized because of A’s assertion regarding the undistributed earnings of the subsidiary
and is computed as follows: ([$80 million book basis – $70 million tax basis] × 12.5% portion sold) × 25%
tax rate. The partial sale of the subsidiary results in a change in A’s assertion regarding the indefinite
reinvestment of the subsidiary’s earnings associated with the interest sold by A. This is considered an
indirect tax effect and recognized as income tax expense in continuing operations.
Below is A’s journal entry on January 1, 20Y0, to account for the income tax effects of the sale of its interest in
the foreign subsidiary:

Current tax expense 312,500

APIC 2,500,000
Current tax payable 2,812,500

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Example 12-1 (continued)

In addition, as a result of the sale, A should reassess its intent and ability to indefinitely reinvest the earnings of
the foreign subsidiary associated with its remaining 70 percent ownership interest. A DTL should be recognized
if circumstances have changed and A concludes that the temporary difference is now expected to reverse in
the foreseeable future. This reassessment and the recording of any DTL may occur in a period preceding the
actual sale of its ownership interest, since a liability should be recorded when A’s assertion regarding indefinite
reinvestment changes.

12.2.2 Noncontrolling Interests in Pass-Through Entities: Income Tax

Financial Reporting Considerations
810-10-45 (Q&A 48)
ASC 810-10-45-18 through 45-21 require consolidating entities to report earnings attributed to
noncontrolling interests as part of consolidated earnings and not as a separate component of income
or expense. Thus, the income tax expense recognized by the consolidating entity will include the
total income tax expense of the consolidated entity. When there is a noncontrolling interest in a
consolidated entity, the amount of income tax expense that is consolidated will depend on whether
the noncontrolling interest is a pass-through (i.e., a U.S. partnership) or taxable entity (e.g., a U.S.
C corporation).

ASC 810 does not affect how entities determine income tax expense under ASC 740. Typically, no
income tax expense is attributable to a pass-through entity; rather, such expense is attributable to its
owners. Therefore, a consolidating entity with an interest in a pass-through entity should recognize
income taxes only on its controlling interest in the pass-through entity’s pretax income. The income
taxes on the pass-through entity’s pretax income attributed to the noncontrolling interest holders
should not be included in the consolidated income tax expense.

Example 12-2

Entity X has a 90 percent controlling interest in Partnership Y (an LLC). Partnership Y is a pass-through entity
and is not subject to income taxes in any jurisdiction in which it operates. Entity X’s pretax income for 20X9
is $100,000. Partnership Y has pretax income of $50,000 for the same period. Entity X has a tax rate of 25
percent. For simplicity, this example assumes that there are no temporary differences.

Given the facts above, X would report the following in its consolidated income statement for 20X9:

Income before income tax expense ($100,000 + $50,000) $ 150,000

Income tax expense ([$100,000 + ($50,000 × 90%)] × 25%) (36,250)
Consolidated net income 113,750
Less: net income attributable to noncontrolling interests ($50,000 × 10%) (5,000)
Net income attributable to controlling interest $ 108,750

In this example, ASC 810 does not affect how X determines income tax expense under ASC 740, since X
recognizes income tax expense only for its controlling interest in the income of Y. However, ASC 810 does
affect the ETR of X. Given the impact of ASC 810, X’s ETR is 24.2 percent ($36,250/$150,000). Provided that X
is a public entity and that the reconciling item is significant, X should disclose the tax effect of the amount of
income from Y attributed to the noncontrolling interest in its numerical reconciliation from expected to actual
income tax expense.

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12.3 Equity Method Investee Considerations

When an investor owns less than 50 percent of the voting capital but is able to exercise significant
influence, it generally applies the equity method of accounting unless an exception applies (i.e., the
investor elects the fair value option under ASC 825-10, or specialized industry accounting requires
carrying the investment at fair value).

In general, under the equity method of accounting, an investor initially recognizes its investment in an
investee (including a joint venture) at cost, in accordance with ASC 805-50-30. In addition, an investor
that applies the equity method of accounting should comply with the requirements of ASC 323-10-35-4,
which states, in part:

Under the equity method, an investor shall recognize its share of the earnings or losses of an investee in the
periods for which they are reported by the investee in its financial statements rather than in the period in which
an investee declares a dividend. An investor shall adjust the carrying amount of an investment for its share of
the earnings or losses of the investee after the date of investment and shall report the recognized earnings or
losses in income. An investor’s share of the earnings or losses of an investee shall be based on the shares of
common stock and in-substance common stock held by that investor.

12.3.1 Deferred Tax Consequences of an Investment in an Equity Method

Investment (a 50-Percent-or-Less-Owned Investee)
740-30-25 (Q&A 03)
For income tax accounting purposes, investors in an equity method investment should recognize the
deferred tax consequences for an outside basis difference unless an exception applies.

See Section 3.4 for guidance on the definition of an outside basis difference. See Section 3.4.1
for guidance on the definition of foreign and domestic investments. Also see Section 3.4.17.1 for
considerations related to VIEs.

12.3.1.1 Potential DTL: Domestic Investee

Equity investors that hold less than a majority of the voting capital of an investee do not possess
majority voting power and, therefore, generally cannot control the timing and amounts of dividends,
in-kind distributions, taxable liquidations, or other transactions and events that may result in tax
consequences for investors. Therefore, for a 50 percent-or-less-owned investee, whenever the carrying
amount of the equity investment for financial reporting purposes exceeds the tax basis in the stock
or equity units of a domestic investee, a DTL is recognized in the balance sheet of the investor (in
the absence of the exception in ASC 740-30-25-18(b)). An entity should consider the guidance in ASC
740-10-55-24 when measuring the DTL. The DTL is measured by reference to the expected means of
recovery. For example, if recovery is expected through a sale or other disposition, the capital gain rate
may be appropriate. Conversely, if recovery is expected through dividend distributions, the ordinary tax
rate may be appropriate.

12.3.1.2 Potential DTL: Foreign Investee

ASC 740-30-25-5(b) requires equity investors that hold less than a majority of the voting capital of a
foreign investee to recognize a DTL for the excess amount for financial reporting purposes over the
tax basis of a foreign equity method investee that is not a corporate joint venture that is essentially
permanent in duration. The indefinite reversal criterion in ASC 740-30-25-17 applies only to a
consolidated foreign subsidiary or a foreign corporate joint venture that is essentially permanent in
duration. A related topic is discussed in Section 3.4.4.

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12.3.1.3 Potential DTA: Foreign and Domestic Investee

ASC 740-30-25-9 does not apply to 50-percent-or-less-owned foreign or domestic investees that are
not corporate joint ventures that are permanent in duration. Therefore, equity investors that hold
a noncontrolling interest in an investment that is not a corporate joint venture that is essentially
permanent in duration always recognize a DTA for the excess tax basis of an equity investee over
the amount for financial reporting purposes. As with all DTAs, in accordance with ASC 740-10-30-18,
realization of the related DTA “depends on the existence of sufficient taxable income of the appropriate
character (for example, ordinary income or capital gain) within the carryback, carryforward period
available under the tax law.” If realization of all or a portion of the DTA is not more likely than not, a
valuation allowance is necessary.

12.3.2 Tax Effects of Investor Basis Differences Related to Equity Method

Investments
323-10-45 (Q&A 03)
In certain situations, there may be a difference between the cost of an equity method investment and
the investor’s share of the investee’s individual assets and liabilities. ASC 323-10-35-13 requires entities
to account for the “difference between the cost of an [equity method] investment and the amount of
underlying equity in net assets of an investee . . . as if the investee were a consolidated subsidiary.”
Entities therefore determine any difference between the cost of an equity method investment and the
investor’s share of the fair values of the investee’s individual assets and liabilities by using the acquisition
method of accounting in accordance with ASC 805. Differences of this nature are known as “investor
basis differences” and result from the requirement that investors allocate the cost of the equity method
investment to the individual assets and liabilities of the investee. Like business combinations, investor
basis differences may give rise to deferred tax effects. To accurately account for its equity method
investment, an investor would consider these inside basis differences in addition to any outside basis
difference in its investment.

In accordance with ASC 323-10-45-1, equity method investments are presented as a single consolidated
amount. Accordingly, tax effects attributable to the investor basis differences become a component of
this single consolidated amount and are not presented separately in the investor’s financial statements
as individual current assets and liabilities or DTAs and DTLs. Example 12-3 below illustrates this concept.

Further, the investor’s share of investee income or loss needs to be adjusted for investor basis
differences, including those associated with income taxes.

Example 12-3

Investor Y purchases a 40 percent interest in Investee Z for $2 million cash and applies the equity method of
accounting. The book value of Z’s net assets is $3.5 million. The table below shows the book values and fair
values of Z’s net assets (along with Y’s proportionate share) as of the investment acquisition date. Investee Z has
no liabilities and Z did not record any DTAs or DTLs in its own financial statements.

The effective tax rate of Y and Z is 25 percent.

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Example 12-3 (continued)

Y's share
of Z’s Net
Y's 40% Assets
Share of Z's Y's 40% (Fair Value)
Book Value Fair Value Net Assets Share of Z's Adjusted
of Z's Net of Z's Net (Book Net Assets Y's Basis for Tax
Assets Assets Value) (Fair Value) Differences** Effects

A B C = A × 40% D = B × 40% D–C

Current assets $ 1,000,000 $ 1,000,000 $ 400,000 $ 400,000 $ — $ 400,000
Fixed assets 3,000,000 4,000,000 1,200,000 1,600,000 400,000 1,600,000

Current liabilities (500,000) (500,000) (200,000) (200,000) — (200,000)

Intangible assets — 300,000 — 120,000 120,000 120,000
Goodwill — — — 80,000* 210,000*** 210,000

DTL — — — — (130,000)*** (130,000)

$ 3,500,000 $ 4,800,000 $ 1,400,000 $ 2,000,000 $ 600,000 $ 2,000,000

* The $600,000 difference between the cost of Y’s investment ($2 million) and its proportionate share of the book value
of Z’s net assets ($1.4 million) is attributable to Z’s fixed assets ($400,000), Z’s patented technology ($120,000), and
equity method goodwill ($80,000). The $80,000 of equity method goodwill represents the excess of Y’s purchase price
over Y’s equity in Z’s net assets that is not attributable to Z’s identifiable net assets.
** The basis differences, including equity method goodwill, are presented as part of Y’s overall investment in Z and
subsequently tracked in memo accounts. That is, Y would not present the $120,000 and $210,000 separately as
“intangible assets” and “goodwill,” respectively, in its balance sheet.
*** Investor Y’s basis differences in fixed assets and intangible assets multiplied by the effect tax rate: (400,000 + 120,000) ×
25%.

Since equity method goodwill is treated as if it were goodwill acquired in a business combination, there is no
DTL associated with this basis difference. Because the total amount of the basis difference between the cost
of Y’s investment ($2 million) and its proportionate share of the book value of Z’s net assets ($1.4 million) has
not changed, the DTL recognized in the memo accounts increases the basis difference attributable to equity
method goodwill in an amount equal to the DTL.

12.3.3 Change in Investment From a Subsidiary to an Equity Method Investee

740-30-25 (Q&A 05)
If, in accordance with ASC 323, a parent divests of a portion of a subsidiary and the equity method is
used to account for the remaining investment in common stock, the investor should recognize income
taxes on its share of the prospective current earnings of the investee entity.

ASC 740-30-25-15 states that “[i]f a parent entity did not recognize income taxes on its equity in
undistributed earnings of a subsidiary” because the temporary difference is related to an investment
in a foreign subsidiary that is essentially permanent in duration, it should “accrue as a current period
expense income taxes on undistributed earnings in the period that it becomes apparent that any of
those undistributed earnings (prior to the change in status) will be remitted.” ASC 740-30-25-15 clarifies
the meaning of the term “apparent” as used in this context, stating that the “change in the status of an
investment would not by itself mean that remittance of these undistributed earnings shall be considered
apparent.” If a parent entity recognized income taxes on its equity in undistributed earnings of a
subsidiary, the amount of deferred income taxes of the parent attributable to undistributed earnings
of the subsidiary should be considered when the parent accounts for a disposition through a sale or
another transaction that reduces the investment. Example 12-4 below illustrates this concept.

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Example 12-4

Assume that Entity X had $1,000 of unremitted earnings from its investment in a foreign subsidiary, FI, and
that management has determined that all earnings were indefinitely reinvested and that the related temporary
difference would not reverse in the foreseeable future. Therefore, no DTL has been recorded. Further assume
that at the beginning of 20X1, FI sold previously owned capital stock to an unrelated third-party investor such
that X no longer controlled most of its voting common shares. However, because of its equity share of FI, X
was required to use the equity method of accounting in accordance with ASC 323. During 20X1, X’s equity
in earnings of FI was $2,000 and no dividends were paid or payable. In addition, X can no longer control the
dividend policy of FI because it no longer controls most of the seats on the board of directors, and FI has
announced a change in dividend policy beginning with 20X2 in which 20 percent of retained earnings, as of
December 31, 20X2, will be paid to shareholders of record as of that date.

Case 1
During 20X1, X would accrue as a current charge to income tax expense from continuing operations the tax
effect of establishing (1) a DTL for the tax consequences of $2,000 of taxable income attributable to its share of
equity in earnings of FI during 20X1 and (2) a DTL for its portion of the 20 percent equity in retained earnings to
be distributed in 20X2 in accordance with FI’s new policy of remitting earnings in the future (calculated on the
basis of the retained earnings balance at the end of 20X1).

Case 2
Assume the same facts as in Case 1, except that FI’s dividend policy regarding undistributed earnings did
not change as a result of the change in ownership in 20X1 and that the new majority investor’s policy is to
indefinitely reinvest all earnings. Entity X would accrue a DTL only for the tax consequences of the $2,000
related to its share in equity in earnings of FI. No additional accrual for the deferred tax consequences of
remitting X’s share of undistributed earnings is necessary because no facts have come to the attention of X that
would lead it to conclude that previously undistributed earnings will be remitted currently or in the future.

Case 3
Assume the same facts as in Case 2, except that X’s management concludes during 20X1 that it will dispose of
its remaining investment in FI through a sale within the foreseeable future. During 20X1, X would accrue, as a
current charge to income tax expense from continuing operations, the tax effect of establishing (1) a DTL for
the tax consequences of $2,000 of taxable income attributable to its share of equity in earnings of FI during
20X1 and (2) a DTL for 100 percent of the remaining outside basis difference, which is assumed to enter into
the determination of taxable income (i.e., recovery of the recorded amount of the investment) in the future
when the sale is consummated and the investment is realized.

See Section 11.3.6.3 for further discussion of the tax consequences of business combinations achieved
in stages.

Changing Lanes
In December 2019, the FASB issued ASU 2019-12, which modifies ASC 740 to simplify the
accounting for income taxes (as part of the FASB’s Simplification Initiative). The ASU amends
the guidance in ASC 740-30-25-15 on situations in which an investment in common stock of a
subsidiary changes so that it is no longer considered a subsidiary (e.g., the extent of ownership
in the investment changes so that it becomes an equity method investment). If the parent
entity did not previously recognize income taxes on its undistributed earnings because of the
exception in ASC 740-30-25-18(a) (i.e., because of an assertion of indefinite reinvestment), the
previous requirement under U.S. GAAP that no deferred taxes be recognized on that portion of
the basis difference until it becomes apparent that such undistributed earnings will be remitted
(i.e., deferred taxes are not automatically recognized) applied. This represented an exception to
the general principle for accounting for outside basis differences of equity method investments.

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The FASB noted that “this exception increases the cost and complexity of applying Topic
740” because it essentially required an entity to bifurcate its outside basis difference in the
investment and account for the components separately. The original outside basis difference
that existed when the subsidiary became an equity method investment was “frozen”; however,
subsequent changes in the outside basis difference would be recognized separately. The FASB
removed the exception in ASC 740-30-25-15 that restricted recognition of a DTL on the portion
of the outside basis difference that existed before the subsidiary became an equity method
investment. Accordingly, an entity will need to recognize current tax expense to recognize a
DTL related to the equity method investment when the subsidiary becomes an equity method
investment. This guidance creates consistency with current U.S. GAAP, under which an equity
method investor cannot assert indefinite reinvestment of earnings to avoid recording deferred
taxes on its outside basis differences.

Entities should apply these amendments by using a modified retrospective approach, which
would require recognizing deferred taxes as of the beginning of the period of adoption, with a
cumulative-effect adjustment to retained earnings. For further information about ASU 2019-12,
see Appendix B.

12.3.4 Accounting for an ITC Received From an Investment in a Partnership

Accounted for Under the Equity Method
740-10-25 (Q&A 78)
The ITC guidance in ASC 740-10-25-46 specifies that an entity can use one of two methods to account
for the receipt of an ITC as an item of income in the financial statements: (1) the deferral method or (2)
the flow-through method.

Under the deferral method, the ITC would result in (1) a reduction to income taxes payable (or an
increase in a DTA if the credit is carried forward to future years, subject to assessment for realization)
and (2) either a reduction to the carrying value of the related asset or a deferred credit. The tax benefit
of the ITC is reflected in net income as a reduction to depreciation expense over the productive life of
the related property.1

Under the flow-through method, the ITC would result in (1) a reduction to income taxes payable for the
year in which the credit arises (or an increase in a DTA if the credit is carried forward to future years,
subject to assessment for realization) and (2) a reduction to income tax expense.

The accounting for ITCs was originally addressed in APB Opinion 2 (codified in ASC 740-10-25-46), which
discusses direct investments in acquired depreciable property that generate ITCs. Since that guidance
was introduced, however, the types of vehicles through which entities take advantage of ITCs have
evolved. For example, entities often invest in partnerships whose operations include investments in
assets that qualify for ITCs, which can then be passed through directly to the investors.

While ASC 740 addresses the accounting by an entity that directly owns an asset that generates an ITC,
it does not explicitly address the accounting by a reporting entity that is an investor in a flow-through
entity that owns the asset that generates the credit that is then passed through to the investor. In the
latter case, the reporting entity must first consider whether it is required under ASC 810 (including
the VIE subsections of ASC 810-10) to consolidate the flow-through entity in which it has invested. If
consolidation of the investee is not required, the reporting entity would most often account for the
investment by using the equity method.

1
Note that there is an alternative view under which the benefit would be recorded in the income tax provision in accordance with paragraph 3 of
APB Opinion 4.

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There are two acceptable approaches (“Approach 1” and “Approach 2”) on how a reporting entity that
accounts for its investment in a flow-through entity under the equity method should account for the
tax benefits received in the form of ITCs. The approach an entity selects is an accounting policy election
that should be applied consistently. (See Section 3.5.9 for a discussion of the accounting for temporary
differences related to ITCs.)

12.3.4.1 Approach 1 — Account for ITCs as an Income Tax Benefit

Under Approach 1, the investor would account for the tax benefits received in the form of ITCs as
an income tax benefit. This method is consistent with accounting for the tax benefits under the flow-
through method. It is also consistent with ASC 323-740-55-8 (formerly Exhibit 94-1A of EITF Issue 94-1),
which contains an example of the application of the equity method to a QAHP investment that does not
qualify for the proportional amortization method. In that example, the tax credits are recorded in the
income tax provision in the year that they are received.

12.3.4.2 Approach 2 — Apply a Model Similar to the Deferral Method

Approach 2 is premised on the guidance originally contained in paragraph 3 of APB Opinion 4 on an
ITC that was passed through to a lessee under an operating lease for leased property. More specifically,
paragraph 3 of APB Opinion 4 provided an example in which the asset generating the ITC was not
carried on the lessee’s balance sheet; rather, the ITC was passed through to the lessee in a manner
similar to the way it would be passed through to an investor in a flow-through entity.2 In the example,
the Interpretation indicated that the “lessee should account for the credit by whichever method is used
for purchased property” and then provided clarification on how to apply the deferral method if that
method is selected, suggesting that the lessee could use either the deferral method or the flow-through
method even in a situation in which the underlying asset that generated the credit was not actually
reflected in the reporting entity’s financial statements.

Under Approach 2, the tax benefits from the ITCs would be deferred and amortized over the useful life
of the related assets, resulting in a cost reduction that would be reflected as an adjustment in the equity
method earnings (i.e., “above the line”). That is, the deferral method would yield an increase in the equity
method earnings because less depreciation would flow through to the investor.3

12.3.5 Presentation of Tax Effects of Equity in Earnings of an Equity Method

Investee
323-10-45 (Q&A 01)
The investor’s income tax provision equals the sum of current and deferred tax expense, including
any tax consequences of the investor’s equity in earnings and temporary differences attributable to its
investment in an equity method investee.

Because it is the investor’s tax provision, not the investee’s, the tax consequences of the investor’s
equity in earnings and temporary differences attributable to its investment in the investee should be
recognized in income tax expense and not be offset against the investor’s equity in earnings.

2
See also paragraph 11 of APB Opinion 2.
3
Alternatively, under the deferral method, instead of reducing the cost basis of the qualifying asset or assets, an entity could recognize a deferred
credit. In this scenario, the recovery of the deferred credit would result in a reduction to the income tax provision over the life of the qualifying
asset or assets.

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12.4 QAHP Investments
ASC 323-740

05-1 This Subtopic contains standalone Qualified Affordable Housing Project Investments Subsections, which
provide income tax accounting guidance on a specific type of investment in real estate. Income tax accounting
guidance on other types of equity method investments and joint ventures is contained in Subtopics 740-10 and
740-30.

05-2 The Qualified Affordable Housing Project Investments Subsections provide income tax accounting
guidance on a specific type of investment in real estate. This guidance applies to investments in limited liability
entities that manage or invest in qualified affordable housing projects and are flow-through entities for tax
purposes.

05-3 The following discussion refers to and describes a provision within the Revenue Reconciliation Act of 1993;
however, it shall not be considered a definitive interpretation of any provision of the Act for any purpose. The
Revenue Reconciliation Act of 1993, enacted in August 1993, retroactively extended and made permanent the
affordable housing credit. Investors in entities that manage or invest in qualified affordable housing projects
receive tax benefits in the form of tax deductions from operating losses and tax credits. The tax credits are
allowable on the tax return each year over a 10-year period as a result of renting a sufficient number of units
to qualifying tenants and are subject to restrictions on gross rentals paid by those tenants. These credits
are subject to recapture over a 15-year period starting with the first year tax credits are earned. Corporate
investors generally purchase an interest in a limited liability entity that manages or invests in the qualified
affordable housing projects.

Scope and Scope Exceptions

Overall Guidance
15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic, see
Section 323-10-15, with specific transaction qualifications noted in the other Subsections of this Section.

15-2 The Qualified Affordable Housing Project Investments Subsections follow the same Scope and Scope
Exceptions as outlined in the General Subsection of this Subtopic, see Section 323-10-15, with specific
transaction qualifications noted below.

Transactions
15-3 The guidance in the Qualified Affordable Housing Project Investments Subsections applies to reporting
entities that are investors in qualified affordable housing projects through limited liability entities that are flow-
through entities for tax purposes.

Recognition
25-1 A reporting entity that invests in qualified affordable housing projects through limited liability entities
(that is, the investor) may elect to account for those investments using the proportional amortization method
(described in paragraphs 323-740-35-2 and 323-740-45-2) provided all of the following conditions are met:
a. It is probable that the tax credits allocable to the investor will be available.
aa. The investor does not have the ability to exercise significant influence over the operating and financial
policies of the limited liability entity.
aaa. Substantially all of the projected benefits are from tax credits and other tax benefits (for example, tax
benefits generated from the operating losses of the investment).
b. The investor’s projected yield based solely on the cash flows from the tax credits and other tax benefits
is positive.
c. The investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and
the investor’s liability is limited to its capital investment.

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ASC 323-740 (continued)

25-1A In determining whether an investor has the ability to exercise significant influence over the operating
and financial policies of the limited liability entity, a reporting entity shall consider the indicators of significant
influence in paragraphs 323-10-15-6 through 15-7.

25-1B Other transactions between the investor and the limited liability entity (for example, bank loans) shall not
be considered when determining whether the conditions in paragraph 323-740-25-1 are met, provided that all
three of the following conditions are met:
a. The reporting entity is in the business of entering into those other transactions (for example, a financial
institution that regularly extends loans to other projects).
b. The terms of those other transactions are consistent with the terms of arm’s-length transactions.
c. The reporting entity does not acquire the ability to exercise significant influence over the operating and
financial policies of the limited liability entity as a result of those other transactions.

25-1C At the time of the initial investment, a reporting entity shall evaluate whether the conditions in
paragraphs 323-740-25-1 through 25-1B have been met to elect to apply the proportional amortization
method on the basis of facts and circumstances that exist at that time. A reporting entity shall subsequently
reevaluate the conditions upon the occurrence of either of the following:
a. A change in the nature of the investment (for example, if the investment is no longer in a flow-through
entity for tax purposes)
b. A change in the relationship with the limited liability entity that could result in the reporting entity no
longer meeting the conditions in paragraphs 323-740-25-1 through 25-1B.

25-2 For an investment in a qualified affordable housing project through a limited liability entity not accounted
for using the proportional amortization method, the investment shall be accounted for in accordance with
Subtopic 970-323. In accounting for such an investment under that Subtopic, the requirements in paragraphs
323-740-25-3 through 25-5 and paragraphs 323-740-50-1 through 50-2 of this Subsection that are not related
to the proportional amortization method, shall be applied.

25-2A Accounting for an investment in a qualified affordable housing project using the cost method may be
appropriate. In accounting for such an investment using the cost method, the requirements in paragraphs
323-740-25-3 through 25-5 and paragraphs 323-740-50-1 through 50-2 of this Subsection that are not related
to the proportional amortization method shall be applied.

25-3 A liability shall be recognized for delayed equity contributions that are unconditional and legally binding.
A liability also shall be recognized for equity contributions that are contingent upon a future event when that
contingent event becomes probable. Topic 450 and paragraph 840-30-55-15 provide additional guidance on
the accounting for delayed equity contributions.

Pending Content (Transition Guidance: ASC 842-10-65-1)

25-3 A liability shall be recognized for delayed equity contributions that are unconditional and legally
binding. A liability also shall be recognized for equity contributions that are contingent upon a future event
when that contingent event becomes probable. Topic 450 and paragraph 842-50-55-2 provide additional
guidance on the accounting for delayed equity contributions.

25-4 The decision to apply the proportional amortization method of accounting is an accounting policy decision
to be applied consistently to all investments in qualified affordable housing projects that meet the conditions
in paragraph 323-740-25-1 rather than a decision to be applied to individual investments that qualify for use of
the proportional amortization method.

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ASC 323-740 (continued)

25-5 At the time of initial investment, immediate recognition of the entire benefit of the tax credits to be
received during the term of an investment in a qualified affordable housing project is not appropriate (that
is, affordable housing credits shall not be recognized in the financial statements before their inclusion in the
investor’s tax return).

25-6 Example 1 (see paragraph 323-740-55-2) illustrates the application of accounting guidance to a limited
partnership investment in a qualified affordable housing project using the cost, equity, and proportional
amortization methods.

Initial Measurement
30-1 Paragraph 323-740-25-5 prohibits immediate recognition of tax credits, at the time of initial investment,
for the entire benefit of tax credits to be received during the term of an investment in a qualified affordable
housing project. See paragraph 323-740-35-2 for the required subsequent measurement calculation
methodology when an entity uses the proportional amortization method of accounting for an investment in a
qualified affordable housing project through a limited liability entity.

30-2 Example 1 (see paragraph 323-740-55-2) illustrates the application of accounting guidance to a limited
partnership investment in a qualified affordable housing project using the cost, equity, and proportional
amortization methods.

Subsequent Measurement
35-1 This guidance addresses the methodology for measuring an investment in a qualified affordable housing
project through a limited liability entity that is accounted for using the proportional amortization method.

35-2 Under the proportional amortization method, the investor amortizes the initial cost of the investment in
proportion to the tax credits and other tax benefits allocated to the investor. The amortization amount shall be
calculated as follows:
a. The initial investment balance less any expected residual value of the investment, multiplied by
b. The percentage of actual tax credits and other tax benefits allocated to the investor in the current
period divided by the total estimated tax credits and other tax benefits expected to be received by the
investor over the life of the investment.

35-3 Example 1 (see paragraph 323-740-55-2) illustrates the application of accounting guidance to a
limited liability investment in a qualified affordable housing project using the cost, equity, and proportional
amortization methods.

35-4 As a practical expedient, an investor is permitted to amortize the initial cost of the investment in
proportion to only the tax credits allocated to the investor if the investor reasonably expects that doing so
would produce a measurement that is substantially similar to the measurement that would result from applying
the requirement in paragraph 323-740-35-2.

35-5 Any expected residual value of the investment shall be excluded from the proportional amortization
calculation. Cash received from operations of the limited liability entity shall be included in earnings when
realized or realizable. Gains or losses on the sale of the investment, if any, shall be included in earnings at the
time of sale.

35-6 An investment in a qualified affordable housing project through a limited liability entity shall be tested for
impairment when events or changes in circumstances indicate that it is more likely than not that the carrying
amount of the investment will not be realized. An impairment loss shall be measured as the amount by which
the carrying amount of an investment exceeds its fair value. A previously recognized impairment loss shall not
be reversed.

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ASC 323-740 (continued)

Other Presentation Matters

45-1 This guidance addresses the income statement presentation of the affordable housing tax credit when an
investment in a qualified affordable housing project through a limited liability entity is accounted for using the
proportional amortization method.

45-2 Under the proportional amortization method, the amortization of the investment in the limited liability
entity is recognized in the income statement as a component of income tax expense (or benefit). The current
tax expense (or benefit) shall be accounted for pursuant to the general requirements of Topic 740.

45-3 Example 1 (see paragraph 323-740-55-2) illustrates the application of accounting guidance to a limited
partnership investment in a qualified affordable housing project using the cost, equity, and proportional
amortization methods.

Disclosure
50-1 A reporting entity that invests in a qualified affordable housing project shall disclose information that
enables users of its financial statements to understand the following:
a. The nature of its investments in qualified affordable housing projects
b. The effect of the measurement of its investments in qualified affordable housing projects and the
related tax credits on its financial position and results of operations.

50-2 To meet the objectives in the preceding paragraph, a reporting entity may consider disclosing the
following:
a. The amount of affordable housing tax credits and other tax benefits recognized during the year
b. The balance of the investment recognized in the statement of financial position
c. For qualified affordable housing project investments accounted for using the proportional amortization
method, the amount recognized as a component of income tax expense (benefit)
d. For qualified affordable housing project investments accounted for using the equity method, the
amount of investment income or loss included in pretax income
e. Any commitments or contingent commitments (for example, guarantees or commitments to provide
additional capital contributions), including the amount of equity contributions that are contingent
commitments related to qualified affordable housing project investments and the year or years in which
contingent commitments are expected to be paid
f. The amount and nature of impairment losses during the year resulting from the forfeiture or ineligibility
of tax credits or other circumstances. For example, those impairment losses may be based on actual
property-level foreclosures, loss of qualification due to occupancy levels, compliance issues with tax
code provisions, or other issues.

Related Implementation Guidance and Illustrations

• Example 1: Application of Accounting Guidance to a Limited Partnership Investment in a Qualified
Affordable Housing Project [ASC 323-740-55-2].

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ASC 323-740 — SEC Materials — SEC Staff Guidance

S25 Recognition
Qualified Affordable Housing Project Investments
S25-1 See paragraph 323-740-S99-2, SEC Observer Comment: Accounting for Tax Benefits Resulting From
Investments in Affordable Housing Projects, for SEC Staff views on extending the application of the effective
yield method policy election used in affordable housing project investment to analogous situations.

S99 SEC Materials

SEC Observer Comment: Accounting for Tax Benefits Resulting From Investments in Qualified Affordable
Housing Projects
S99-2 The following is the text of SEC Observer Comment: Accounting for Tax Benefits Resulting from
Investments in Qualified Affordable Housing Projects. [The SEC Staff conformed this Comment to the
guidance issued in Accounting Standards Update No. 2014-01, Investments — Equity Method and Joint
Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects.]
It has been observed that the decision to apply the proportional amortization method of accounting is
an accounting policy decision to be applied consistently to all investments in qualified affordable housing
projects that meet the conditions in paragraph 323-740-25-1 rather than a decision to be applied
to individual investments that qualify for use of the proportional amortization method. The SEC staff
believes that it would be inappropriate to extend the proportional amortization method of accounting to
situations analogous to those described in paragraph 323-740-05-3.

ASC 323-740 permits entities to elect, as an accounting policy, to account for QAHP investments that
meet certain criteria by using a proportional amortization method.4 Such method, however, applies only
to investments in QAHPs through limited liability entities and should not be analogized to investments in
other projects for which substantially all of the benefits come from tax benefits. This restriction is similar
to the SEC staff’s view described in ASC 323-740-S99-2 that it would be inappropriate to extend the
prior-effective-yield method of accounting to analogous situations (i.e., investments involving other types
of analogous credits).

12.4.1 Tax Benefits Resulting From Investments in Affordable Housing

Projects
740-10-30 (Q&A 02)
Before applying the guidance in ASC 323-740, a reporting entity must first consider whether it is
required under ASC 810 (including the VIE subsections of ASC 810-10) to consolidate a QAHP investee. If
consolidation of the QAHP investee is required, the proportional amortization method cannot be used.

4
An entity that used the effective yield method to account for its QAHP investments before adopting ASU 2014-01 may continue to apply that
method for those prior investments.

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12.4.1.1 The Proportional Amortization Method

If the QAHP investee is not consolidated, ASC 323-740-25-1 permits a “reporting entity that invests in
qualified affordable housing projects through limited liability entities (that is, the investor) [to] elect to
account for those investments using the proportional amortization method (described in paragraphs
323-740-35-2 and 323-740-45-2)” as long as all of the following criteria are met:
a. It is probable that the tax credits allocable to the investor will be available.
aa. The investor does not have the ability to exercise significant influence over the operating and financial
policies of the limited liability entity.[5]
aaa. Substantially all of the projected benefits are from tax credits and other tax benefits (for example, tax
benefits generated from the operating losses of the investment).
b. The investor’s projected yield based solely on the cash flows from the tax credits and other tax benefits
is positive.
c. The investor is a limited liability investor in the limited liability entity for both legal and tax purposes,
and the investor’s liability is limited to its capital investment.

Under the proportional amortization method as described in ASC 323-740-35-2, an investor amortizes
the initial cost of the investment in proportion to the tax credits and other tax benefits received. As a
practical expedient, an investor applying the proportional amortization method may choose to amortize
the initial cost of the investment in proportion to only the tax credits allocated to the investor if the
investor reasonably expects that doing so would produce a measurement that is substantially similar to
the measurement that would result from applying the full proportional amortization method described
in ASC 323-740-35-2.

12.4.1.1.1 Changes in Circumstances After Initial Measurement

12.4.1.1.1.1 Changes in Laws or Rates
Questions have arisen regarding whether a company needs to reevaluate whether the project yields an
overall benefit (the criterion in ASC 323-740-25-1(b) above) when a change in tax rate is enacted (e.g.,
the corporate rate reduction signed into U.S. tax law on December 22, 2017). Although a change in tax
rates may affect whether the criteria in ASC 323-740-25-1 are met after the initial investment, we do
not believe that the change in tax rate represents either a change in the nature of the investment or a
change in the relationship with the investee, as those terms are contemplated in ASC 323-740-25-1C.
Therefore, an entity is not required to reassess whether it is still appropriate to apply the proportional
amortization method solely because of the change in tax rates.

However, when the total expected tax benefit (tax credits and other tax benefits received) changes,
amortization of the investment must be revised to ensure that cumulative amortization over the life of
the investment equals the initial carrying amount (less any residual value). The change in corporate tax
rate mentioned above will generally reduce the benefit of “other” tax benefits (i.e., tax benefits other
than credits) to be allocated to a QAHP investor in the future (i.e., the pass-through losses in the future
will now benefit the investor at a 21 percent, instead of a 35 percent, tax rate). If an investor has not
elected to use the practical expedient, the proportion of benefits already allocated to the investor will
increase in relation to the total expected tax credits and other tax benefits. As a result, we believe that
there are two acceptable approaches for adjusting amortization.

Under the first approach, the investor would record a cumulative catch-up adjustment to the carrying
amount of the investment on the basis of the amount of tax credits and other tax benefits that have

5
For information regarding the determination of whether an investor has the ability to exercise significant influence over an entity that invests in
QAHPs, see Section 3.4.2 of Deloitte’s A Roadmap to Accounting for Equity Method Investments and Joint Ventures.

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been allocated to the investor in relation to the revised amount of total expected tax benefits. This
approach is consistent with the guidance in ASC 323-740, which requires that the initial cost of the
investment be amortized in proportion to the tax credits and other benefits that have been allocated to
the investor.

Under the second approach, the investor would adjust amortization prospectively. This treatment is
consistent with accounting for a change in estimate that does not affect the carrying amount of an asset
or liability but alters the subsequent accounting for existing or future assets or liabilities under ASC 250.

An investor should consider whether it has, in effect, made a policy election in prior periods when
adjusting amortization to take into account changes in expected tax benefits that are due to factors
other than changes in tax rates. If so, using a different approach to account for the change in tax rate
would be a change in accounting principle that would need to be assessed for preferability.

12.4.1.1.1.2 Impairments
QAHP investors are required to assess their investment for impairment when the occurrence of an
event or a change in circumstances indicates that it is more likely than not that the carrying amount
of the investment will not be realized. ASC 323-740-35-6 states that the “impairment loss shall be
measured as the amount by which the carrying amount of an investment exceeds its fair value.” Fair
value should take into account discounting of the future tax benefits expected to be received. Therefore,
if a significant portion of the investor’s yield was tied to such benefits, the investor may have needed to
test its investment for impairment. More specifically, the investor would have needed to compare the
carrying amount of the investment, after any cumulative catch-up is considered, with the undiscounted
amount of the remaining expected tax credits and other tax benefits in the evaluation of whether it is
more likely than not that the carrying amount will not be realized.

ASC 323-740 does not specify where in the income statement an impairment charge related to a QAHP
investment should be recorded. Under the proportional amortization method, the amortization of the
cost of the investment is netted against the tax benefits received within the income tax expense line.
An impairment is a recognition of the fact that the unamortized cost of acquiring the benefits exceeds
the remaining expected benefits, but it does not change the nature of the initial investment as an
investment in tax credits and other tax benefits. Accordingly, we believe that the impairment would be
recorded as a component of income tax expense.

12.4.1.2 Other Methods
As for a limited liability investment in a QAHP that is not accounted for under the proportional
amortization method, ASC 323-740-25-2 provides that “the investment shall be accounted for in
accordance with Subtopic 970-323.”

ASC 970-323-25-6 generally requires use of the equity method of accounting for limited partnership
real estate investments unless the limited partner’s interest is “so minor [(generally considered to be
no more than 3 to 5 percent)] that the limited partner may have virtually no influence over partnership
operating and financial policies.” ASC 323-740-55-8 includes an example of the application of the equity
method to an investment in a QAHP that does not qualify for the proportional amortization method.
For additional information on the accounting for ITCs as an income tax benefit (when received from an
investment in a partnership accounted for under the equity method), see Section 12.3.4. A related issue
was discussed in an SEC staff announcement addressing the SEC staff’s position on the application of
the equity method to all types of investments in limited partnerships. See ASC 323-30-S99-1 for more
information. If the equity method is not required, the investment should be accounted for in accordance
with ASC 321.

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Changing Lanes
In December 2019, the FASB issued ASU 2019-12, which modifies ASC 740 to simplify the
accounting for income taxes (as part of the FASB’s Simplification Initiative). The ASU makes
improvements to the Codification topics on income taxes related to investments in QAHPs
accounted for under the equity method.

ASC 323-740-55-8 includes an illustrative example of the accounting for an investment in a

QAHP under the equity method. The example previously indicated that the investment became
impaired in year 9 and that impairment was measured on the basis of the remaining tax credits
allocable to the investor; however, the impairment assessment (specifically, the year in which
the impairment occurs) was incorrect on the basis of the revised facts that were used when
the example was amended in ASU 2014-01. ASU 2019-12 corrects the error in the illustrative
example. For further information about ASU 2019-12, see Appendix B.

In addition, although ASU 2016-01 removed the reference to the cost method in ASC 970-323 and
superseded ASC 325-20, ASC 323-740-25-2A (added by the ASU) states that “[a]ccounting for an
investment in a qualified affordable housing project using the cost method may be appropriate. In
accounting for such an investment using the cost method, the requirements in paragraphs 323-740-
25-3 through 25-5 and paragraphs 323-740-50-1 through 50-2 of this Subsection that are not related to
the proportional amortization method shall be applied.”

12.4.2 Applicability of the Proportional Amortization Method to a QAHP

Investment That Generates Other Tax Credits in Addition to Affordable
Housing Credits
323-740-15 (Q&A 01)
Another criterion in ASC 323-740-25-1 for applying the proportional amortization method is that
substantially all of the projected benefits of the QAHP investment must be derived from the QAHP
tax credits and other tax benefits (such as tax benefits generated from the operating losses of the
investment). ASC 323-740-15-3 limits the scope of ASC 323-740 and states:

The guidance in the Qualified Affordable Housing Project Investments Subsections applies to reporting entities
that are investors in qualified affordable housing projects through limited liability entities that are flow-through
entities for tax purposes.

Further, paragraph BC10 of ASU 2014-01 states, in part:

The Task Force also discussed whether the scope of the amendments in this Update should be extended to tax
credit investments other than investments in qualified affordable housing projects. . . . The Task Force reached
a consensus to limit the scope of the amendments in this Update to only investments in qualified affordable
housing projects because it will more quickly address the concerns in practice about the income statement
presentation of those investments.

In some situations, the QAHP generates other tax credits (e.g., alternative energy credits and credits
from restoring and rehabilitating historic buildings), which are also allocated to investors in the QAHP.
Because the scope of ASC 323-740 is limited to QAHP investments, it is unclear whether a QAHP
investment that generates other credits in addition to QAHP credits would be automatically excluded
from the scope of ASC 323-740. While we believe that an entity needs to carefully consider the nature
of the investment, we do not think that a QAHP investment that generates tax benefits other than QAHP
credits would automatically be excluded from the scope of ASC 323-740.

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This is not a bright-line determination; however, as the significance of the other tax credits increases in
relation to the significance of the QAHP credits and tax benefits from operating losses of the investment,
it becomes more difficult to conclude that the investment is within the scope of ASC 323-740. For
example, we believe that if 45 percent of the projected benefits of a QAHP investment are attributable
to QAHP credits and tax benefits from operating losses of the investment and the remaining 55 percent
are associated with other tax credits, it would be difficult to conclude that the investment is within the
scope of ASC 323-740. Alternatively, we believe that if 90 percent of the projected benefits of a QAHP
investment are related to QAHP credits and tax benefits from operating losses of the investment and
the remaining 10 percent are associated with other tax credits, it would generally be appropriate to
conclude that the investment is within the scope of ASC 323-740.

12.4.3 Recognizing Deferred Taxes When the Proportional Amortization

Method Is Used to Account for an Investment in a QAHP
323-740-25 (Q&A 01)
For an investment accounted for under the proportional amortization method, an entity generally
should not record deferred taxes for the temporary difference between the investment’s carrying
amount for financial reporting purposes and its tax basis. The proportional amortization method reflects
the view that an investment in a QAHP through a limited liability entity is in substance the purchase of
tax benefits. Accordingly, the initial investment is amortized in proportion to the affordable housing tax
credits and other tax benefits allocated to the investor, as described in ASC 323-740-35-2. This approach
is similar to the accounting for purchased tax benefits described in ASC 740-10-25-52, which requires
that future tax benefits (net of the amount paid) purchased from a party other than a tax authority
be initially recognized as a deferred credit and then recognized in tax expense when the related tax
attributes are realized.

Further, while ASC 323-740 does not explicitly state that an entity is not required to recognize deferred
taxes for the temporary difference related to its investment in a QAHP, ASU 2014-01 amended the
example in ASC 323-740-55-2 through 55-9 so that it no longer addresses the recognition of deferred
taxes for the temporary difference.

In the Background Information and Basis for Conclusions of ASU 2014-01, the EITF expressed the view
that the proportional amortization method better reflects the investment’s economics than the equity
or cost methods of accounting for such an investment and thus should help users better understand
an entity’s investment in QAHPs. As shown in column K of Example 12-5, if an entity does not record
deferred taxes when using the proportional amortization method, there will be a return in all periods
that is positive and in proportion to the investment amortization in each respective period. Column O
of Example 12-5, on the other hand, shows that when deferred taxes are recorded on the investment, a
net decrease in income tax expense (or increase in benefit) occurs in the early years and a net increase
in income tax expense (or reduction of benefit) occurs in later years. We believe that result is less
indicative of the overall economics, is more difficult for financial statement users to understand, and is
therefore generally inconsistent with the EITF’s overall objectives in ASU 2014-01.

Nonetheless, we are aware that others believe that since the asset is an investment, an entity would not
be precluded from accruing deferred taxes on the related temporary difference. Entities that take this
view are encouraged to consult with their income tax accounting advisers.

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Conversely, we believe that when an entity uses the practical expedient described in ASC 323-740-35-4,
it should recognize deferred taxes on the investment. Under the practical expedient, the entire cost
of the QAHP investment is amortized over only the period during which the QAHP credits are received
(generally 10 years). The period over which “other tax benefits” such as depreciation will be received may
be longer (e.g., depreciation deductions would normally be taken over a period of 15 years or longer).

When deferred taxes are recognized for the temporary difference, the current tax benefit for the “other
tax benefits” received after the amortization of the investment’s cost is offset by deferred tax expense
resulting from the reversal of the DTA recognized for the remaining tax basis. As demonstrated in
column O of Example 12-6, we believe that when using the practical expedient, an entity should record
deferred taxes since this results in a better reflection of the investment’s performance and thus should
provide users with a better understanding of an entity’s QAHP investment.

If the practical expedient is used and deferred taxes are not recorded (see column K of Example 12-6),
a reporting entity will recognize “other tax benefits” in years after the cost of the investment has been
amortized and those “other tax benefits” will not be reduced by the cost of obtaining them in the period
in which they are recognized. As can also be seen in column K, incremental expense may result from the
investment in early years and incremental benefit may result in later years. We believe that these results
are less reflective of the overall economics of the investment and, again, inconsistent with the overall
objectives of ASU 2014-01.

12.4.3.1 Illustrative Examples
In each of the illustrative examples below, assume that Company A makes a $200,000 investment in a
QAHP in exchange for a 10 percent limited partnership interest. Further assume that:

• The partnership is financed entirely with equity.

• Annual tax credits equal 9 percent of the original cost of the property each year for 10 years.
• Tax depreciation is determined by using a straight-line method over 25 years.
• Company A’s ETR is 25 percent.

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 Example 12-5

Book Basis Tax Basis Net Benefit — Excluding Deferred Taxes Net Benefit — Including Deferred Taxes
Total
Other Tax Credits
Benefits and Deductible Deferred
(Taxed Other Tax Less: Net Temporary DTA at Tax Benefit Net Benefit
Beginning Amortization Ending Beginning Depreciation Ending Tax Credits at 25%) Benefits Amortization Benefit Difference 25% (Expense) (Expense)
Year (A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N) (O)
1 $ 200,000 $ 17,391 $ 182,609 $ 200,000 $ 8,000 $ 192,000 $ 18,000 $ 2,000 $ 20,000 $ 17,391 $ 2,609 $ 9,391 $ 2,348 $ 2,348 $ 4,957
2 182,609 17,391 165,217 192,000 8,000 184,000 18,000 2,000 20,000 17,391 2,609 18,783 4,696 2,348 4,957
3 165,217 17,391 147,826 184,000 8,000 176,000 18,000 2,000 20,000 17,391 2,609 28,174 7,043 2,348 4,957
4 147,826 17,391 130,435 176,000 8,000 168,000 18,000 2,000 20,000 17,391 2,609 37,565 9,391 2,348 4,957
5 130,435 17,391 113,043 168,000 8,000 160,000 18,000 2,000 20,000 17,391 2,609 46,957 11,739 2,348 4,957
6 113,043 17,391 95,652 160,000 8,000 152,000 18,000 2,000 20,000 17,391 2,609 56,348 14,087 2,348 4,957
7 95,652 17,391 78,261 152,000 8,000 144,000 18,000 2,000 20,000 17,391 2,609 65,739 16,435 2,348 4,957
8 78,261 17,391 60,870 144,000 8,000 136,000 18,000 2,000 20,000 17,391 2,609 75,130 18,783 2,348 4,957
9 60,870 17,391 43,478 136,000 8,000 128,000 18,000 2,000 20,000 17,391 2,609 84,522 21,130 2,348 4,957
10 43,478 17,391 26,087 128,000 8,000 120,000 18,000 2,000 20,000 17,391 2,609 93,913 23,478 2,348 4,957
11 26,087 1,739 24,348 120,000 8,000 112,000 — 2,000 2,000 1,739 261 87,652 21,913 (1,565) (1,304)
12 24,348 1,739 22,609 112,000 8,000 104,000 — 2,000 2,000 1,739 261 81,391 20,348 (1,565) (1,304)
13 22,609 1,739 20,870 104,000 8,000 96,000 — 2,000 2,000 1,739 261 75,130 18,783 (1,565) (1,304)
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14 20,870 1,739 19,130 96,000 8,000 88,000 — 2,000 2,000 1,739 261 68,870 17,217 (1,565) (1,304)
15 19,130 1,739 17,391 88,000 8,000 80,000 — 2,000 2,000 1,739 261 62,609 15,652 (1,565) (1,304)
16 17,391 1,739 15,652 80,000 8,000 72,000 — 2,000 2,000 1,739 261 56,348 14,087 (1,565) (1,304)
17 15,652 1,739 13,913 72,000 8,000 64,000 — 2,000 2,000 1,739 261 50,087 12,522 (1,565) (1,304)
18 13,913 1,739 12,174 64,000 8,000 56,000 — 2,000 2,000 1,739 261 43,826 10,957 (1,565) (1,304)
19 12,174 1,739 10,435 56,000 8,000 48,000 — 2,000 2,000 1,739 261 37,565 9,391 (1,565) (1,304)
20 10,435 1,739 8,696 48,000 8,000 40,000 — 2,000 2,000 1,739 261 31,304 7,826 (1,565) (1,304)
21 8,696 1,739 6,957 40,000 8,000 32,000 — 2,000 2,000 1,739 261 25,043 6,261 (1,565) (1,304)
22 6,957 1,739 5,217 32,000 8,000 24,000 — 2,000 2,000 1,739 261 18,783 4,696 (1,565) (1,304)
23 5,217 1,739 3,478 24,000 8,000 16,000 — 2,000 2,000 1,739 261 12,522 3,130 (1,565) (1,304)
24 3,478 1,739 1,739 16,000 8,000 8,000 — 2,000 2,000 1,739 261 6,261 1,565 (1,565) (1,304)
25 1,739 1,739 — 8,000 8,000 — — 2,000 2,000 1,739 261 — — (1,565) (1,304)
$ 200,000 $ 200,000 $ 180,000 $ 50,000 $ 230,000 $ 200,000 $ 30,000 $ 30,000

A = Beginning book basis each year, representing initial $200,000 investment in year 1 and prior-year G = 8.5 percent annual tax credit on $200,000 tax basis of underlying initial investment.
ending balance in Column C for remaining years. H = Column E × 25 percent tax rate.
B = Initial investment of $200,000 × (total tax benefits received during the year in Column I ÷ total I = Column G + Column H.
anticipated tax benefits over the life of the investment of $230,000 shown as the total of Column I). J = Column B.
C = End-of-year book basis of investment, net of amortization in Column B. K = Column I – Column J.
D = Beginning tax basis each year, representing initial $200,000 investment in year 1 and prior-year ending L = Column F − Column C.
balance in Column F for remaining years. M = Column L × 25 percent tax rate.
E = Tax depreciation (on $200,000 initial investment) by using straight-line method over 25 years. N = Change in DTA in Column M for the year.
F = End-of-year tax basis of investment, net of tax depreciation in Column E. O = Column N + Column K.
 Example 12-6

Book Basis Tax Basis Net Benefit — Excluding Deferred Taxes Net Benefit — Including Deferred Taxes
Total
Other Tax Credits
Benefits and Deductible Deferred
(Taxed Other Tax Less: Net Temporary DTA at Tax Benefit Net Benefit
Beginning Amortization Ending Beginning Depreciation Ending Tax Credits at 25%) Benefits Amortization Benefit Difference 25% (Expense) (Expense)
Year (A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N) (O)
1 $ 200,000 $ 20,000 $ 180,000 $ 200,000 $ 8,000 $ 192,000 $ 18,000 $ 2,000 $ 20,000 $ 20,000 $ — $ 12,000 $ 3,000 $ 3,000 $ 3,000
2 180,000 20,000 160,000 192,000 8,000 184,000 18,000 2,000 20,000 20,000 — 24,000 6,000 3,000 3,000
3 160,000 20,000 140,000 184,000 8,000 176,000 18,000 2,000 20,000 20,000 — 36,000 9,000 3,000 3,000
4 140,000 20,000 120,000 176,000 8,000 168,000 18,000 2,000 20,000 20,000 — 48,000 12,000 3,000 3,000
5 120,000 20,000 100,000 168,000 8,000 160,000 18,000 2,000 20,000 20,000 — 60,000 15,000 3,000 3,000
6 100,000 20,000 80,000 160,000 8,000 152,000 18,000 2,000 20,000 20,000 — 72,000 18,000 3,000 3,000
7 80,000 20,000 60,000 152,000 8,000 144,000 18,000 2,000 20,000 20,000 — 84,000 21,000 3,000 3,000
8 60,000 20,000 40,000 144,000 8,000 136,000 18,000 2,000 20,000 20,000 — 96,000 24,000 3,000 3,000
9 40,000 20,000 20,000 136,000 8,000 128,000 18,000 2,000 20,000 20,000 — 108,000 27,000 3,000 3,000
10 20,000 20,000 — 128,000 8,000 120,000 18,000 2,000 20,000 20,000 — 120,000 30,000 3,000 3,000
11 — — — 120,000 8,000 112,000 — 2,000 2,000 — 2,000 112,000 28,000 (2,000) —
12 — — — 112,000 8,000 104,000 — 2,000 2,000 — 2,000 104,000 26,000 (2,000) —
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13 — — — 104,000 8,000 96,000 — 2,000 2,000 — 2,000 96,000 24,000 (2,000) —

14 — — — 96,000 8,000 88,000 — 2,000 2,000 — 2,000 88,000 22,000 (2,000) —
15 — — — 88,000 8,000 80,000 — 2,000 2,000 — 2,000 80,000 20,000 (2,000) —
16 — — — 80,000 8,000 72,000 — 2,000 2,000 — 2,000 72,000 18,000 (2,000) —
17 — — — 72,000 8,000 64,000 — 2,000 2,000 — 2,000 64,000 16,000 (2,000) —
18 — — — 64,000 8,000 56,000 — 2,000 2,000 — 2,000 56,000 14,000 (2,000) —
19 — — — 56,000 8,000 48,000 — 2,000 2,000 — 2,000 48,000 12,000 (2,000) —
20 — — — 48,000 8,000 40,000 — 2,000 2,000 — 2,000 40,000 10,000 (2,000) —
21 — — — 40,000 8,000 32,000 — 2,000 2,000 — 2,000 32,000 8,000 (2,000) —
22 — — — 32,000 8,000 24,000 — 2,000 2,000 — 2,000 24,000 6,000 (2,000) —
23 — — — 24,000 8,000 16,000 — 2,000 2,000 — 2,000 16,000 4,000 (2,000) —
24 — — — 16,000 8,000 8,000 — 2,000 2,000 — 2,000 8,000 2,000 (2,000) —
25 — — — 8,000 8,000 — — 2,000 2,000 — 2,000 — — (2,000) —
$ 200,000 $ 200,000 $ 180,000 $ 50,000 $ 230,000 $ 200,000 $ 30,000 $ 30,000

A = Beginning book basis each year, representing initial $200,000 investment in year 1 and prior-year G = 8.5 percent annual tax credit on $200,000 tax basis of underlying initial investment.
ending balance in Column C for remaining years. H = Column E × 25 percent tax rate.
B = Initial investment of $200,000 × (total tax benefits received during the year in Column G ÷ total I = Column G + Column H.
anticipated tax benefits over the life of the investment of $180,000 shown as the total of Column G). J = Column B.
C = End-of-year book basis of investment, net of amortization in Column B. K = Column I – Column J.
D = Beginning tax basis each year, representing initial $200,000 investment in year 1 and prior-year ending L = Column F − Column C.
balance in Column F for remaining years. M = Column L × 25 percent tax rate.
E = Tax depreciation (on $200,000 initial investment) by using straight-line method over 25 years. N = Change in DTA in Column M for the year.
F = End-of-year tax basis of investment, net of tax depreciation in Column E. O = Column N + Column K.
 Chapter 12 — Other Investments and Special Situations

12.5 Regulated Entities
ASC 980-740

Income Taxes Applicable to Regulated Entities

25-1 For regulated entities that meet the criteria for application of paragraph 980-10-15-2, this Subtopic
specifically:
a. Prohibits net-of-tax accounting and reporting
b. Requires recognition of a deferred tax liability for tax benefits that are flowed through to customers
when temporary differences originate and for the equity component of the allowance for funds used
during construction
c. Requires adjustment of a deferred tax liability or asset for an enacted change in tax laws or rates.

25-2 If, as a result of an action by a regulator, it is probable that the future increase or decrease in taxes
payable for (b) and (c) in the preceding paragraph will be recovered from or returned to customers through
future rates, an asset or liability shall be recognized for that probable future revenue or reduction in future
revenue pursuant to paragraphs 980-340-25-1 and 980-405-25-1. That asset or liability also shall be a
temporary difference for which a deferred tax liability or asset shall be recognized.

25-3 Example 1 (see paragraph 980-740-55-8) illustrates recognition of an asset for the probable revenue to
recover future income taxes.

25-4 Example 2 (see paragraph 980-740-55-13) illustrates adjustment of a deferred tax liability when the
liability represents amounts already collected from customers.

12.5.1 Regulated Entities Subject to ASC 980

980-740-25 (Q&A 01)
Regulated entities preparing financial statements under U.S. GAAP would apply ASC 740 when
determining the tax amounts to record. In addition, ASC 980-740 relies on the general standards of
accounting for the effects of regulation in ASC 980 and, in a manner consistent with those standards,
requires recognition of (1) an asset when a DTL is recognized if it is probable that future revenue will be
provided for the payment of those DTLs and (2) a liability when a DTA is recognized if it is probable that a
future reduction in revenue will result when that DTA is realized.
980-740-25 (Q&A 02)
ASC 980-740-25-1 prohibits net-of-tax accounting on the basis that commingling assets and liabilities
with their related tax effects confuses the relationship among the various classifications in financial
statements. Therefore, in accordance with ASC 980-740-25-1, regulated entities should adjust the
reported net-of-tax amount of construction in progress and plant in service to the pretax amount.

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12.6 Special Situations
12.6.1 Distinguishing a Change in Estimate From a Correction of an Error
740-10-25 (Q&A 60)
A change in a prior-year tax provision can arise from either a change in accounting estimate or the
correction of an error.

The primary source of guidance on accounting changes and error corrections is ASC 250. ASC
250-10-20 defines a change in accounting estimate as a “change that has the effect of adjusting the
carrying amount of an existing asset or liability . . . . Changes in accounting estimates result from new
information.” A change in a prior-year tax provision is a change in accounting estimate if it results from
new information, a change in facts and circumstances, or later identification of information that was
not reasonably knowable or readily accessible as of the prior reporting period. In addition, ASC 740-10-
25-14 and ASC 740-10-35-2 state that the subsequent recognition and measurement of a tax position
should “be based on management’s best judgment given the facts, circumstances, and information
available at the reporting date” and that subsequent changes in management’s judgment should
“result from the evaluation of new information and not from a new evaluation or new interpretation by
management of information that was available in a previous financial reporting period.”

In contrast, ASC 250-10-20 defines an error in previously issued financial statements (an “error”) as an
“error in recognition, measurement, presentation, or disclosure in financial statements resulting from
mathematical mistakes, mistakes in the application of [GAAP], or oversight or misuse of facts that existed
at the time the financial statements were prepared. A change from an accounting principle that is not
generally accepted to one that is generally accepted is a correction of an error.” In determining whether
the change is a correction of an error, an entity should consider whether the information was or should
have been “reasonably knowable” or “readily accessible” from the entity’s books and records in a prior
reporting period and whether the application of information at that time would have resulted in different
reporting. The determination of when information was or should have been reasonably knowable or
readily accessible will depend on the entity’s particular facts and circumstances.

Distinguishing between a change in accounting estimate and a correction of an error is important

because they are accounted for and reported differently. In accordance with ASC 250-10-45-23, an
error correction is typically accounted for by restating prior-period financial statements. However,
ASC 250-10-45-17 specifies that a change in accounting estimate is accounted for prospectively “in the
period of change if the change affects that period only or in the period of change and future periods
if the change affects both.” Under ASC 250-10-50-4, if the change in estimate affects several future
periods, an entity must disclose the “effect on income from continuing operations, net income (or other
appropriate captions of changes in the applicable net assets or performance indicator), and any related
per-share amounts of the current period.”

If the change to the prior-period tax provision is determined to be an error, the entity should look to ASC
250 for guidance on how to report the correction of the error. Additional guidance is also provided by
SAB Topics 1.M (SAB 99) and 1.N (SAB 108).

An entity must often use judgment in discerning whether a change in a prior-year tax provision results
from a correction of an error or a change in estimate. The sections below list examples of changes in
accounting estimate and error corrections.

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The following are examples of changes that should be accounted for as changes in accounting estimate:

• A change in judgment (as a result of a change in facts or circumstances or the occurrence of an

event) regarding the sustainability of a tax position or the need for a valuation allowance.

• The issuance of a new administrative ruling.

• Obtaining additional information on the basis of the experience of other taxpayers with similar
circumstances.

• Adjusting an amount for new information that would not have been readily accessible from the
entity’s books and records as of the prior reporting date. For example, to close its books on a
timely basis, an entity may estimate certain amounts that are not readily accessible. In this case,
as long as the entity had a reasonable basis for its original estimate, the subsequent adjustment
is most likely a change in estimate.

• Developing, with the assistance of tax experts, additional technical insight into the application
of the tax law with respect to prior tax return positions involving very complex or technical tax
issues. Because both tax professionals and the tax authorities are continually changing and
improving their understanding of complex tax laws, such circumstances typically constitute a
change in estimate rather than an error.

• Making a retroactive tax election that affects positions taken on prior tax returns if the primary
factors motivating such a change can be tied to events that occurred after the balance sheet
date.

• Deciding to pursue a tax credit or deduction retroactively that was previously considered not to
be economical but that becomes prudent because of a change in facts and circumstances. Such
a decision is a change in estimate if the entity evaluated the acceptability of the tax position as
of the balance sheet date and analyzed whether the tax position was economical but concluded
that it was not prudent to pursue this benefit. The decision would not be considered a change in
estimate if the entity did not consider or otherwise evaluate the acceptability of the tax position
as of the balance sheet date.

The following are examples of changes that should be accounted for as error corrections:

• Intentionally misstating a tax accrual.

• Discovering a mathematical error in a prior-year income tax provision.
• Oversight or misuse of facts or failure to use information that was reasonably knowable and
readily accessible as of the balance sheet date.

• Misapplying a rule or requirement or the provisions of U.S. GAAP. One example is a situation in
which an entity fails to record a DTA, a DTL, a tax benefit, or a liability for UTBs that should have
been recognized in accordance with ASC 740 on the basis of the facts and circumstances that
existed as of the reporting date that were reasonably knowable when the financial statements
were issued.

• Adjusting an amount for new information that would have been readily accessible from the
entity’s books and records as of the prior reporting period. In assessing whether information
was or should have been “readily accessible,” an entity should consider the nature, complexity,
relevance, and frequency of occurrence of the item.

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Taxes

13.1 Background
This chapter provides interpretive guidance on presentation matters discussed in ASC 740-10-45, the
Other Presentation Matters section of the Income Taxes: Overall subtopic. Matters discussed in the Other
Presentation sections of other subtopics in ASC 740 are included in other chapters within this Roadmap.
The ASC 200 topics of the Codification also comprise several presentation-related topics; however,
those topics are not discussed in this chapter because, although they provide general guidance on
presentation that may apply to income tax accounting, they do not provide specific guidance on the
classification and presentation of income tax accounts.

13.2 Statement of Financial Position Classification of Income Tax Accounts

ASC 740-10

45-1 This Section provides guidance on statement of financial position, income statement and statement of
shareholder equity classification, and presentation matters applicable to all the following:
a. Statement of financial position classification of income tax accounts
b. Income statement presentation of certain measurement changes to income tax accounts
c. Income statement classification of interest and penalties
d. Presentation matters related to investment tax credits under the deferral method.
e. Statement of shareholder equity reclassification of certain income tax effects from accumulated other
comprehensive income.

45-2 See Subtopic 740-20 for guidance on the intraperiod allocation of total income tax expense (or benefit).

Statement of Financial Position Classification of Income Tax Accounts

45-3 Topic 210 provides general guidance for classification of accounts in statements of financial position. The
following guidance addresses classification matters applicable to income tax accounts and is incremental to the
general guidance.

Deferred Tax Accounts

45-4 In a classified statement of financial position, an entity shall classify deferred tax liabilities and assets as
noncurrent amounts.

45-5 Paragraph superseded by Accounting Standards Update No. 2015-17.

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ASC 740-10 (continued)

45-6 For a particular tax-paying component of an entity and within a particular tax jurisdiction, all deferred
tax liabilities and assets, as well as any related valuation allowance, shall be offset and presented as a single
noncurrent amount. However, an entity shall not offset deferred tax liabilities and assets attributable to
different tax-paying components of the entity or to different tax jurisdictions.

45-7 Paragraph superseded by Accounting Standards Update No. 2015-17.

45-8 Paragraph superseded by Accounting Standards Update No. 2015-17.

45-9 Paragraph superseded by Accounting Standards Update No. 2015-17.

45-10 Paragraph superseded by Accounting Standards Update No. 2015-17.

Tax Accounts, Other Than Deferred

Unrecognized Tax Benefits
45-10A Except as indicated in paragraphs 740-10-45-10B and 740-10-45-12, an unrecognized tax benefit, or
a portion of an unrecognized tax benefit, shall be presented in the financial statements as a reduction to a
deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward.

45-10B To the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not
available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income
taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does
not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose,
the unrecognized tax benefit shall be presented in the financial statements as a liability and shall not be
combined with deferred tax assets. The assessment of whether a deferred tax asset is available is based on the
unrecognized tax benefit and deferred tax asset that exist at the reporting date and shall be made presuming
disallowance of the tax position at the reporting date.

45-11 An entity that presents a classified statement of financial position shall classify an unrecognized tax
benefit that is presented as a liability in accordance with paragraphs 740-10-45-10A through 45-10B as a
current liability to the extent the entity anticipates payment (or receipt) of cash within one year or the operating
cycle, if longer.

45-12 An unrecognized tax benefit presented as a liability shall not be classified as a deferred tax liability
unless it arises from a taxable temporary difference. Paragraph 740-10-25-17 explains how the recognition and
measurement of a tax position may affect the calculation of a temporary difference.

Offsetting
45-13 The offset of cash or other assets against the tax liability or other amounts owing to governmental
bodies is not acceptable except as noted in paragraphs 210-20-45-6 and 740-10-45-10A through 45-10B.

In November 2015, the FASB issued ASU 2015-17, which requires entities to present DTAs and DTLs as
noncurrent in a classified balance sheet. The ASU simplifies the old guidance, which required entities to
separately present DTAs and DTLs as current and noncurrent in a classified balance sheet. The ASU is
currently effective for all entities.

For other balance sheet items, such as income taxes payable/receivable, ASC 210-10 provides guidance
on the classification in the statement of financial position. Typically, income taxes payable would be
presented as a current liability because it would be expected to be settled within a relatively short
period, usually 12 months (ASC 210-10-45-9).

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For public companies, ASC 210-10-S99-1(20) and ASC 210-10-S99-1(26) indicate that the SEC prescribed
certain balance sheet captions in SEC Regulation S-X, Rule 5-02, related to income taxes, as follows:

• “Other current liabilities. State separately, in the balance sheet or in a note thereto, any item
in excess of 5 percent of total current liabilities. Such items may include, but are not limited
to, accrued payrolls, accrued interest, taxes, indicating the current portion of deferred income
taxes, and the current portion of long-term debt. Remaining items may be shown in one
amount.”

• “Deferred credits. State separately in the balance sheet amounts for (a) deferred income taxes,
(b) deferred tax credits, and (c) material items of deferred income.”

On the basis of informal discussions with the SEC staff, a liability for UTBs should be classified as an
“other current liability” or “other long-term liability” to comply with SEC Regulation S-X, Rule 5-02.

Because the SEC staff does not consider this liability a “contingent liability,” disclosures for contingencies
would not be required. However, an entity must follow the disclosure requirements outlined in ASC
740-10-50. See Chapter 14 for more information.

See below for further guidance on circumstances in which a UTB liability should be recorded as a
current liability.

13.2.1 Presentation of Deferred Federal Income Taxes Associated With

Deferred State Income Taxes
740-10-45 (Q&A 13)
ASC 740-10-55-20 states:

State income taxes are deductible for U.S. federal income tax purposes and therefore a deferred state income
tax liability or asset gives rise to a temporary difference for purposes of determining a deferred U.S. federal
income tax asset or liability, respectively. The pattern of deductible or taxable amounts in future years for
temporary differences related to deferred state income tax liabilities or assets should be determined by
estimates of the amount of those state income taxes that are expected to become payable or recoverable for
particular future years and, therefore, deductible or taxable for U.S. federal tax purposes in those particular
future years.

It is not appropriate to net the federal effect of a state DTL or DTA against the state deferred tax. ASC
740 generally requires separate identification of temporary differences and related deferred taxes for
each tax-paying component of an entity in each tax jurisdiction, including U.S. federal, state, local, and
foreign tax jurisdictions. ASC 740-10-45-6 states the following regarding the offsetting of DTAs and DTLs:

For a particular tax-paying component of an entity and within a particular tax jurisdiction, all deferred tax
liabilities and assets, as well as any related valuation allowance, shall be offset and presented as a single
noncurrent amount. However, an entity shall not offset deferred tax liabilities and assets attributable
to different tax-paying components of the entity or to different tax jurisdictions. [Emphasis added]

For example, assume that Company A has a state DTL of $100 related to a fixed asset and that this DTL
represents taxes that will need to be paid when the fixed asset is recovered at its financial reporting
carrying amount. The future state taxes will result in a $100 deduction on the U.S. federal income
tax return, and a DTA of $21 ($100 deduction × 21% tax rate) should be recognized for that future
deduction. In this example, A should report a $100 state DTL and separately report a $21 federal DTA. It
would not be appropriate to report a “net of federal tax benefit” state DTL of $79.

In addition to improper presentation of DTAs and DTLs in the balance sheet, improperly netting the
federal effect of state deferred taxes against the state deferred taxes themselves can result in, among
other things, (1) an improper assessment of whether a valuation allowance is necessary in a particular
jurisdiction or (2) improper disclosures related to DTAs and DTLs.

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13.2.2 Balance Sheet Classification of the Liability for UTBs

740-10-45 (Q&A 05)
ASC 740-10-45-11 states that an entity should “classify an unrecognized tax benefit that is presented
as a liability in accordance with paragraphs 740-10-45-10A through 45-10B as a current liability to
the extent the entity anticipates payment (or receipt) of cash within one year or the operating cycle, if
longer.” ASC 740-10-45-12 states that an “unrecognized tax benefit presented as a liability shall not be
classified as a deferred tax liability unless it arises from a taxable temporary difference.”

On the basis of this guidance, an entity will generally classify a liability associated with a UTB as a
noncurrent liability because the period between the filing of the tax return and the final resolution of an
uncertain tax position with the tax authority will generally extend over several years. An entity should
classify as a current liability only those cash payments that management expects to make within the next
12 months to settle liabilities for UTBs.

In addition, an entity should reclassify a liability from noncurrent to current only when a change in the
balance of the liability is expected to result from a payment of cash within one year or the operating
cycle, if longer. For example, the portion of the liability for a UTB that is expected to reverse because
of the expiration of the statute of limitations within the next 12 months would not be reclassified as a
current liability. See Section 14.4.1 for more information on the disclosure requirements related to UTBs.

13.2.3 Interaction of UTBs and Tax Attributes

740-10-45 (Q&A 07)
U.S. tax law requires that an entity’s taxable income be reduced by any available NOL carryforwards and
carrybacks in the absence of an affirmative election to forgo the NOL carryback provisions. The Internal
Revenue Service cannot require a taxpayer to cash-settle a disallowed uncertain tax position if sufficient
NOLs or other tax carryforwards are available to eliminate the additional taxable income. Similarly, a
taxpayer may not choose when to use its NOL carryforwards; rather, the taxpayer must apply NOL
carryforwards and carrybacks in the first year in which taxable income arises. NOLs that are available but
not used to reduce taxable income may not be carried to another period.

Assume that an entity takes, or expects to take, a $200 deduction in the U.S. federal tax jurisdiction
related to a UTB in its current-year tax return and for which the entity records a UTB of $40 (20 percent
tax rate × $200) in its financial statements. This UTB would be settled as of the reporting date without
the payment of cash because of the application of available tax NOL carryforwards of $1,000 in the U.S.
federal tax jurisdiction for which the entity has recognized a $200 DTA.

As discussed in ASC 740-10-45-10A and 45-10B, the entity’s balance sheet should reflect the UTB as
a reduction of the entity’s NOL carryforward DTAs. Under ASC 740-10-45-10A, an entity must present
a UTB, or a portion of a UTB, in its balance sheet “as a reduction to a deferred tax asset for [an NOL]
carryforward, a similar tax loss, or a tax credit carryforward” except when:

• An NOL or other carryforward is not available under the governing tax law to settle taxes that
would result from the disallowance of the tax position.

• The entity does not intend to use the DTA for this purpose (provided that the tax law permits a
choice).

If either of these conditions exists, an entity should present a UTB as a liability and not net the UTB with
a DTA.

The assessment of whether to net the UTB with a DTA should be performed as of the reporting date (i.e.,
on a hypothetical-return basis). The entity should not evaluate whether the DTA will expire or be used
before the UTB is settled. However, the entity must consider whether there are any limitations on the
use of the DTA in the relevant tax jurisdiction.

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Therefore, if the uncertain tax position of $200 is not sustained, the entity may use its $1,000 NOL
carryforward to offset such a position, thus resulting in a $40 reduction to the existing NOL carryforward
DTA of $200. That is, the entity would present a net DTA of $160.

13.2.4 Balance Sheet Presentation of UTBs Resulting From Transfer Pricing

Arrangements
740-10-25 (Q&A 38)
Another common example of a UTB that may affect two separate jurisdictions is related to transfer
pricing. See Section 4.6.3 for a detailed discussion of the application of transfer pricing arrangements
under ASC 740.

In some cases, if two governments follow the Organisation for Economic Co-operation and
Development’s transfer pricing guidelines to resolve substantive issues related to transfer pricing
transactions between units of the same entity, an asset could be recognized in one jurisdiction because
of the application of competent-authority procedures and a liability could be recognized for UTBs from
another tax jurisdiction that arose because of transactions between the entity’s affiliates that were not
being considered at arm’s length.

In this case, an entity should present the liability for UTBs and the tax benefit on a gross basis in its
balance sheet. In addition, a public entity would include only the gross liability for UTBs in the tabular
reconciliation disclosure. However, in the disclosure required by ASC 740-10-50-15A(b), the public entity
would include the liability for UTBs and the tax benefit on a net basis in the amount of UTBs that, if
recognized, would affect the ETR.

For more information on UTBs related to transfer pricing arrangements, see Section 4.6.3.

13.3 Income Statement
13.3.1 Classification of Interest and Penalties in the Financial Statements
740-10-45 (Q&A 08)
ASC 740-10-45-25 permits an entity, on the basis of its accounting policy election, to classify interest
in the financial statements as either income taxes or interest expense and to classify penalties in the
financial statements as either income taxes or another expense classification. The election must be
consistently applied. An entity’s accounting policy for classification of interest may be different from its
policy for classification of penalties. For example, interest expense may be recorded above the line as
part of interest expense and penalties may be recorded below the line as part of income tax expense.

An SEC registrant that changes its financial statement classification of interest and penalties should
provide the disclosures specified by ASC 250-10-50-1 through 50-3. Such a change in accounting
principle should be retrospectively applied beginning with the first interim period in the year of
adoption. In addition, the SEC staff has indicated that a preferability letter is required for classification
changes.

An entity’s balance sheet classification related to the accruals for interest and penalties (as part of
accrued liabilities or as part of the liability for UTBs) must be consistent with the income statement
classification (above the line or below the line). For example, an entity that classifies interest as a
component of interest expense should classify the related accrual for interest as a component of
accrued expenses. Likewise, an entity that classifies interest as a component of income tax expense
should classify the related accrual for interest as a component of the liability for UTBs; however the
amounts are classified, they should be presented separately from the UTB in the tabular rollforward
required by ASC 740-10-50-15A.

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13.3.2 Capitalization of Interest Expense

740-10-25 (Q&A 51)
Interest expense recognized on the underpayment of income tax is not eligible for capitalization under
ASC 835-20. ASC 835-20-30-2 indicates that the amount of interest cost to be capitalized is the amount
that theoretically could have been avoided if expenditures for the asset had not been made. An entity
has two alternatives: (1) repay existing borrowings or (2) invest in an asset. The entity could avoid
interest cost by choosing to repay a borrowing instead of investing in an asset. Once the decision to
invest in the asset is made, the relationship between the investment in the asset and the incurrence of
interest cost makes the interest cost analogous to a direct cost in the asset (i.e., the two alternatives are
linked).

The liability for UTBs recognized under ASC 740 is not a result of the investment alternatives above;
rather, it is a result of a difference in the amount of benefit recognized in the financial statements
compared with the amount taken, or expected to be taken, in a tax return. The liability for UTBs is not a
borrowing, as contemplated in ASC 835-20, and should not be considered a financing activity. Therefore,
the related interest expense should not be capitalized but should be expensed as incurred.

13.3.3 Interest Income on UTBs

740-10-25 (Q&A 49)
ASC 740 does not discuss the recognition and measurement of interest income on UTBs; however, an
entity should recognize and measure interest income to be received on an overpayment of income
taxes in the first period in which the interest would begin accruing according to the provisions of the
relevant tax law.

It is preferable for a public entity to present interest income attributable to an overpayment of income
taxes as an element of nonoperating income, separately stated in the income statement or in a note to
the financial statements as interest on refund claims due from tax authorities. This presentation is
consistent with SEC Regulation S-X, Rule 5-03(b)(7).

On the basis of informal discussions with the SEC staff, we understand that the staff currently does
not have a view on this matter and may not object to an entity’s including interest income attributable
to overpayment of income taxes as an element of its provision for income taxes. Accordingly, the SEC
staff has advised us that if an entity’s accounting policy is to include interest income attributable to
overpayment of income taxes within the provision for income taxes, this policy must be prominently
disclosed and transparent to financial statement users. The SEC staff has also indicated that it
believes that a public entity that has an accounting policy to include interest income or expense on
overpayments and underpayments of income taxes should consistently display such amounts as income
tax in the balance sheets, statements of operations, statements of cash flows, and other supplemental
disclosures. Further, we believe that companies should present interest income in a manner consistent
with the policy election related to interest expense on UTBs. See Section 14.4.4.1 for more information
regarding disclosures related to interest income.

13.3.4 Presentation of Professional Fees

740-10-45 (Q&A 12)
Entities often incur costs for professional services (e.g., attorney and accountant fees) related to the
implementation of tax strategies,1 the resolution of tax contingencies, assistance with the preparation of
the income tax provision in accordance with ASC 740, or other tax-related matters.

It is not appropriate for an entity to include such costs as income tax expense or benefit in the financial
statements. ASC 740 defines income tax expense (or benefit) as the sum of current tax expense

1
If a tax-planning strategy is identified to support realization of DTAs, the entity should consider the cost of implementing the strategy (inclusive of
professional fees) when measuring the incremental benefit such a strategy would provide.

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(benefit) and deferred tax expense (benefit), neither of which would include fees paid to professionals in
connection with tax matters.

Further, SEC Regulation S-X, Rule 5-03(b)(11), specifies that an entity should include only taxes based on
income within the income tax expense caption in the income statement. Therefore, it is inappropriate to
include professional fees within the income tax caption.

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14.1 Overview
This chapter outlines the income tax accounting disclosures that entities are required to provide in the
notes to, and on the face of, the financial statements. Appendix E provides disclosure examples that
may be helpful as the requirements outlined in this chapter are considered. Disclosure requirements
related to certain special areas are addressed in other chapters of this Roadmap as follows:

• Chapter 7 — interim tax reporting.

• Chapter 8 — separate or carve-out financial statements (including abbreviated separate or
carve-out financial statements).

• Chapter 11 — the effects of a business combination on an entity’s valuation allowance.

• Chapter 12 — noncontrolling interests, equity method investments, and QAHP investments,
including specific exceptions in ASC 740 related to corporate joint ventures and changes in
ownership of investees.

14.2 Balance Sheet
ASC 740-10

50-2 The components of the net deferred tax liability or asset recognized in an entity’s statement of financial
position shall be disclosed as follows:
a. The total of all deferred tax liabilities measured in paragraph 740-10-30-5(b)
b. The total of all deferred tax assets measured in paragraph 740-10-30-5(c) through (d)
c. The total valuation allowance recognized for deferred tax assets determined in paragraph 740-10-30-5(e).
The net change during the year in the total valuation allowance also shall be disclosed.

50-3 An entity shall disclose both of the following:

a. The amounts and expiration dates of operating loss and tax credit carryforwards for tax purposes
b. Any portion of the valuation allowance for deferred tax assets for which subsequently recognized tax
benefits will be credited directly to contributed capital (see paragraph 740-20-45-11).

50-4 In the event that a change in an entity’s tax status becomes effective after year-end in Year 2 but before
the financial statements for Year 1 are issued or are available to be issued (as discussed in Section 855-10-25),
the entity’s financial statements for Year 1 shall disclose the change in the entity’s tax status for Year 2 and the
effects of that change, if material.

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ASC 740-10 (continued)

50-5 An entity’s temporary difference and carryforward information requires additional disclosure. The
additional disclosure differs for public and nonpublic entities.

Public Entities
50-6 A public entity shall disclose the approximate tax effect of each type of temporary difference and
carryforward that gives rise to a significant portion of deferred tax liabilities and deferred tax assets (before
allocation of valuation allowances).

50-7 See paragraph 740-10-50-16 for disclosure requirements applicable to a public entity that is not subject
to income taxes.

Nonpublic Entities
50-8 A nonpublic entity shall disclose the types of significant temporary differences and carryforwards but may
omit disclosure of the tax effects of each type.

Changing Lanes
In March 2019, the FASB issued a proposed ASU that would modify or eliminate certain
requirements related to income tax disclosures as well as establish new disclosure
requirements. If it is approved, PBEs would be required to disclose the tax-effected amounts of
federal or national, state, and foreign NOL and tax credit carryforwards along with the valuation
allowance associated with such amounts. It would also require PBEs to explain any valuation
allowance recognized or released during the year, along with the corresponding amount. Board
members believed that these requirements would provide decision-useful information.

While the Board believed that PBEs should be required to provide the tax-effected amounts
of federal or national, state, and foreign DTAs related to NOL and tax credit carryforwards, on
the basis of feedback received from nonpublic entities, the Board proposed that nonpublic
entities disclose the total amounts of federal or national, state, and FTCs and other federal or
national, state, and foreign carryforwards (on a not-tax-effected basis) separately for (1) those
carryforwards that expire, along with their expiration dates (or range of expiration dates) and
(2) those that do not.

The proposed ASU would require the guidance to be applied prospectively, and the Board will
determine an effective date and whether to permit early adoption after it considers feedback
from stakeholders. For further information about the status of this project, see Appendix C.

14.2.1 Deferred Taxes
740-10-50 (Q&A 02)
ASC 740-10-50-6 requires that a public entity disclose “the approximate tax effect of each type of
temporary difference and carryforward that gives rise to a significant portion of deferred tax liabilities
and deferred tax assets (before allocation of valuation allowances).”

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14.2.1.1 Required Level of Detail

740-10-50 (Q&A 01)
When disclosing the tax effect of each type of temporary difference or carryforward as required by
ASC 740-10-50-6, an entity should separately disclose deductible and taxable temporary differences. An
entity can determine individual disclosure items by looking at financial statement captions (e.g., PP&E) or
by subgroup (e.g., tractors, trailers, and terminals for a trucking company) or individual asset. An entity
should look to the level of detail in its general accounting records (e.g., by property subgroup) but is not
required to quantify temporary differences by individual asset. The level of detail used should not affect
an entity’s net deferred tax position but will affect its footnote disclosure of gross DTAs and DTLs.

14.2.1.2 Definition of “Significant” With Respect to Disclosing the Tax Effect of

Each Type of Temporary Difference and Carryforward That Gives Rise to DTAs
and DTLs
740-10-50 (Q&A 02)
Neither the ASC master glossary nor SEC Regulation S-X defines “significant,” as used in ASC 740-10-
50-6. However, the SEC staff has indicated that to meet this requirement, public entities should disclose
all components that equal or exceed 5 percent of the gross DTA or DTL.

14.2.2 Other Balance Sheet Disclosure Considerations

14.2.2.1 Disclosure of Temporary Difference or Carryforward That Clearly Will
Never Be Realized
740-10-50 (Q&A 03)
ASC 740-10-50-6 requires that a public entity disclose “the approximate tax effect of each type of
temporary difference and carryforward that gives rise to a significant portion of deferred tax liabilities
and deferred tax assets (before allocation of valuation allowances).” Questions have arisen about
whether it is appropriate to write off a DTA and its related valuation allowance when an entity believes
that realization is not possible in future tax returns (e.g., situations in which an entity with a foreign loss
carryforward discontinues operations in a foreign jurisdiction in which the applicable tax law does not
impose an expiration period for loss carryforward benefits).

Paragraph 156 of the Basis for Conclusions of FASB Statement 109 states:

Some respondents to the Exposure Draft stated that disclosure of the amount of an enterprise’s total deferred
tax liabilities, deferred tax assets, and valuation allowances is of little value and potentially misleading. It might
be misleading, for example, to continue to disclose a deferred tax asset and valuation allowance of equal
amounts for a loss carryforward after operations are permanently terminated in a particular tax jurisdiction.
The Board believes that it need not and should not develop detailed guidance for when to cease disclosure of
the existence of a worthless asset. Some financial statement users, on the other hand, stated that disclosure
of the total liability, asset, and valuation allowance as proposed in the Exposure Draft is essential for gaining
some insight regarding management’s decisions and changes in decisions about recognition of deferred tax
assets. Other respondents recommended significant additional disclosures such as the extent to which net
deferred tax assets are dependent on (a) future taxable income exclusive of reversing temporary differences
or even (b) each of the four sources of taxable income cited in paragraph 21. After reconsideration, the Board
concluded that disclosure of the total amounts as proposed in the Exposure Draft is an appropriate level of
disclosure.

Therefore, while an entity is generally required to disclose the total amount of its DTLs, DTAs, and
valuation allowances, there is no detailed guidance for when to cease disclosure of the existence of a
worthless tax benefit, and the entity needs to use judgment. In the above example, it is appropriate to
write off the DTA if the entity will not continue operations in that jurisdiction. However, if operations
are to continue, it is not appropriate to write off the DTA and valuation allowance regardless of
management’s assessment about future realization.

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14.2.2.2 Disclosure of Outside Basis Differences

740-30-50 (Q&A 01)
If an entity has two foreign subsidiaries operating in different tax jurisdictions and has a “taxable”
outside basis difference (i.e., an outside basis difference for which, in the absence of the exception in
ASC 740-30-25-1 through 25-6, the accrual of a DTL would be required) related to one subsidiary and
a “deductible” outside basis difference related to the other, it is not acceptable for the entity to net the
outside basis differences to meet the disclosure requirements of ASC 740-30-50-2. The disclosures
required by ASC 740-30-50-2(b) for the cumulative amount of the temporary difference and by ASC
740-30-50-2(c) for unrecognized DTLs related to foreign subsidiaries should include only subsidiaries
with “taxable” outside basis differences.

Changing Lanes
As discussed in Section 14.2, the FASB issued a proposed ASU that would modify or eliminate
certain requirements related to income tax disclosures as well as establish new disclosure
requirements. If approved, the proposed ASU would remove the existing requirement in ASC
740-30-50-2(b) to disclose the “cumulative amount of each type of temporary difference” when a
“deferred tax liability is not recognized because of the exceptions to comprehensive recognition
of deferred taxes related to subsidiaries and corporate joint ventures.”

For more information about the status of this project, including the proposed ASU’s transition
and effective dates, see Appendix C.

14.3 Income Statement
ASC 740-10

50-9 The significant components of income tax expense attributable to continuing operations for each year
presented shall be disclosed in the financial statements or notes thereto. Those components would include, for
example:
a. Current tax expense (or benefit)
b. Deferred tax expense (or benefit) (exclusive of the effects of other components listed below)
c. Investment tax credits
d. Government grants (to the extent recognized as a reduction of income tax expense)
e. The benefits of operating loss carryforwards
f. Tax expense that results from allocating certain tax benefits directly to contributed capital
g. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in
the tax status of the entity
h. Adjustments of the beginning-of-the-year balance of a valuation allowance because of a change in
circumstances that causes a change in judgment about the realizability of the related deferred tax asset
in future years. For example, any acquisition-date income tax benefits or expenses recognized from
changes in the acquirer’s valuation allowance for its previously existing deferred tax assets as a result of
a business combination (see paragraph 805-740-30-3).

50-10 The amount of income tax expense (or benefit) allocated to continuing operations and the amounts
separately allocated to other items (in accordance with the intraperiod tax allocation provisions of paragraphs
740-20-45-2 through 45-14 and 852-740-45-3) shall be disclosed for each year for which those items are
presented.

50-11 The reported amount of income tax expense may differ from an expected amount based on statutory
rates. The following guidance establishes the disclosure requirements for such situations and differs for public
and nonpublic entities.

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ASC 740-10 (continued)

Public Entities
50-12 A public entity shall disclose a reconciliation using percentages or dollar amounts of the reported
amount of income tax expense attributable to continuing operations for the year to the amount of income tax
expense that would result from applying domestic federal statutory tax rates to pretax income from continuing
operations. The statutory tax rates shall be the regular tax rates if there are alternative tax systems. The
estimated amount and the nature of each significant reconciling item shall be disclosed.

Nonpublic Entities
50-13 A nonpublic entity shall disclose the nature of significant reconciling items but may omit a numerical
reconciliation.

All Entities
50-14 If not otherwise evident from the disclosures required by this Section, all entities shall disclose the nature
and effect of any other significant matters affecting comparability of information for all periods presented.

Related Implementation Guidance and Illustrations

• Income-Tax-Related Disclosures [ASC 740-10-55-79].
• Example 29: Disclosure Related to Components of Income Taxes Attributable to Continuing
Operations [ASC 740-10-55-212].

14.3.1 Rate Reconciliation
740-10-50 (Q&A 05)
Reporting entities often pay income taxes in multiple jurisdictions other than the domestic federal
jurisdiction (e.g., domestic state and local jurisdictions, foreign federal and foreign local or provincial
jurisdictions), and the applicable income tax rates vary in each jurisdiction. Further, tax laws often differ
from financial accounting standards; therefore, permanent differences can arise between pretax income
for financial reporting purposes and taxable income.

Thus, a reporting entity’s income tax expense cannot generally be determined for a period by simply
applying the domestic federal statutory tax rate to the reporting entity’s pretax income from continuing
operations for financial reporting purposes. See ASC 740-10-50-12 and 50-13 above.

The disclosure requirement addressed by ASC 740-10-50-12 and 50-13 is often referred to as the “rate
reconciliation” disclosure requirement. ASC 740 does not require a reporting entity to include a specific
number or type of reconciling items in the rate reconciliation. Reconciling items will vary depending on
the reporting entity’s facts and circumstances. However, the SEC staff frequently comments on rate
reconciliation disclosures that are not clear and transparent. A reporting entity should evaluate its
reconciling items to ensure that they clearly communicate to financial statement users the events and
circumstances affecting the reporting entity’s ETR.

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Changing Lanes
As discussed in Section 14.2, the FASB has issued a proposed ASU that would amend ASC
740-10-50-12 in a manner consistent with SEC Regulation S-X, Rule 4-08(h), to require a PBE to
“disclose a reconciliation . . . of reported total income tax expense (or benefit) from continuing
operations” to the amount of income tax expense (or benefit) that would result from multiplying
the pretax income (or loss) from continuing operations by the statutory federal or national
income tax rate. However, the amendment would modify the requirement to disaggregate and
separately present components in the rate reconciliation that are greater than or equal to 5
percent of the tax at the statutory rate in a manner consistent with the requirement in SEC
Regulation S-X, Rule 4-08(h).

During deliberations of the proposed ASU, some Board members questioned whether 5 percent
was an appropriate threshold given the decrease in the U.S. statutory rate as a result of the
2017 Act. Thus, the Board has asked stakeholders for feedback on an appropriate threshold.

For more information about the status of this project, including the proposed ASU’s transition
and effective dates, see Appendix C.

14.3.1.1 Evaluating Significance of Reconciling Items in the Rate Reconciliation

740-10-50 (Q&A 05)
ASC 740-10-50 does not define the term “significant.” However, SEC Regulation S-X, Rule 4-08(h), states
that as part of the reconciliation, public entities should disclose all reconciling items that individually
make up 5 percent or more of the computed amount (i.e., income before tax multiplied by the
applicable domestic federal statutory tax rate).

Reconciling items may be aggregated in the disclosure if they are individually less than 5 percent of
the computed amount. Reconciling items that are individually equal to or greater than 5 percent of the
computed amount should not be netted against other offsetting reconciling items into a single line item
that is itself less than 5 percent.

SEC Regulation S-X, Rule 4-08(h)(2), states that public entities can omit this reconciliation in the following
circumstances:

[When] no individual reconciling item amounts to more than five percent of the amount computed by
multiplying the income before tax by the applicable statutory Federal income tax rate, and the total difference
to be reconciled is less than five percent of such computed amount, no reconciliation need be provided unless
it would be significant in appraising the trend of earnings.

Because SEC Regulation S-X, Rule 4-08(h), does not apply to nonpublic entities, such entities must often
use judgment in determining whether they need to disclose the nature of a particular reconciling item or
items.

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14.3.1.2 Appropriate Federal Statutory Rate for Use in the Rate Reconciliation of

a Foreign Reporting Entity
740-10-50 (Q&A 31)
ASC 740-10-50-12 indicates that the federal statutory income tax rate a foreign reporting entity (i.e., the
parent of the consolidated group that is not domiciled in the United States) should use when preparing
the rate reconciliation disclosure should be based on application of “domestic federal statutory tax rates
to pretax income from continuing operations.” SEC Regulation S-X, Rule 4-08(h)(2), states, in part:

Where the reporting person is a foreign entity, the income tax rate in that person’s country of domicile should
normally be used in making the above computation, but different rates should not be used for subsidiaries or
other segments of a reporting entity.

As noted, the appropriate rate for public entities is normally the federal rate in the reporting entity’s
jurisdiction of domicile. That rate should be applied to pretax income from continuing operations of
all subsidiaries or other segments of the reporting entity, even if most of the operations are located
outside that jurisdiction.1 SEC Regulation S-X, Rule 4-08(h)(2), also notes that if the rate used differs from
the U.S. federal corporate income tax rate (e.g., because the reporting entity is domiciled in a foreign
jurisdiction), “the rate used and the basis for using such rate shall be disclosed.”

Question 1 in paragraph 5 of SAB Topic 6.I (codified in ASC 740-10-S99-1(5)) provides an exception to
the general rule and states:

Question 1: Occasionally, reporting foreign persons may not operate under a normal income tax base rate
such as the current U.S. Federal corporate income tax rate. What form of disclosure is acceptable in these
circumstances?

Interpretive Response: In such instances, reconciliations between year-to-year effective rates or between
a weighted average effective rate and the current effective rate of total tax expense may be appropriate in
meeting the requirements of Rule 4-08(h)(2). A brief description of how such a rate was determined would
be required in addition to other required disclosures. Such an approach would not be acceptable for a U.S.
registrant with foreign operations. Foreign registrants with unusual tax situations may find that these guidelines
are not fully responsive to their needs. In such instances, registrants should discuss the matter with the staff.

The use of a rate other than the federal rate in the reporting entity’s jurisdiction of domicile could be
subject to challenge and, accordingly, consultation is encouraged in these situations.

While SEC Regulation S-X, Rule 4-08(h), does not apply to nonpublic entities, we believe that it would
generally be appropriate for a nonpublic entity to determine the domestic federal statutory rate in a
manner consistent with how a public reporting entity determines it.

14.3.1.3 Computing the “Foreign Rate Differential” in the Rate Reconciliation

740-10-50 (Q&A 33)
The unit of account for various reconciling items is not always clear. For example, an entity with foreign
operations will commonly include a reconciling item referred to as a “foreign rate differential.” Because
it is often unclear what the foreign rate differential reconciling line should include, diversity in practice
exists.

We believe that a line in the rate reconciliation described as the foreign rate differential should generally
include only the effects on an entity’s ETR of differences between the domestic federal statutory tax rate
and the statutory income tax rate in the applicable foreign jurisdiction(s), multiplied by pretax income
from continuing operations in each respective foreign jurisdiction.

1
This would apply to (or include) a tax inversion.

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14.3.2 Other Income Statement Disclosure Considerations

740-10-50 (Q&A 28) and 740-10-50 (Q&A 04)
ASC 740-10-50-9 requires an entity to disclose significant components of income tax expense or benefit
that are attributable to continuing operations for each year presented in the financial statements.

14.3.2.1 Disclosure of the Components of Deferred Tax Expense

740-10-50 (Q&A 28)
One of the components required to be disclosed in ASC 740-10-50-9 is deferred tax expense (or
benefit). In many circumstances, certain changes between the beginning-of-year and end-of-year
deferred tax balances do not affect the total deferred tax expense or benefit. Examples of such
circumstances include, but are not limited to, the following:

• If a business combination has occurred during the year, DTLs and DTAs, net of any related
valuation allowance, are recorded as of the acquisition date as part of acquisition accounting.
There would be no offsetting effect to the income tax provision.

• If a single asset is purchased (other than as part of a business combination) and the amount
paid is different from the tax basis attributable to the asset, the tax effect should be recorded as
an adjustment to the carrying amount of the related asset in accordance with ASC 740-10-25-51.

• For consolidated subsidiaries in foreign jurisdictions for which the functional currency is the
same as the parent’s reporting currency but income taxes are assessed in the local currency,
deferred tax balances should be remeasured in the functional currency as transaction gains or
losses or, if considered more useful, as deferred tax benefit or expense, as described in ASC
830-740-45-1.

• For consolidated subsidiaries in foreign jurisdictions for which the local currency is the functional
currency and income taxes are assessed in the local currency, deferred tax balances should be
translated into the parent’s reporting currency through the CTA account. The revaluations of
the deferred tax balances are not identified separately from revaluations of other assets and
liabilities.

In addition, other changes in deferred tax balances might result in an increase or a decrease in the total
tax provision but are allocated to a component of current-year activity other than continuing operations
(e.g., discontinued operations and the items in ASC 740-20-45-11 such as OCI).

14.3.2.2 Disclosure of the Tax Effect of a Change in Tax Law, Rate, or Tax Status
740-10-50 (Q&A 04)
ASC 740-10-50-9(g) requires an entity to disclose the tax consequences of adjustments to a DTL or DTA
for enacted changes in tax laws or rates or a change in the entity’s tax status. An entity may provide such
disclosures on the face of its income statement as a separate line item component (e.g., a subtotal) that,
in the aggregate, equals the total amount of income tax expense (benefit) allocated to income (loss) from
continuing operations for each period presented. However, the entity should not present the effects of
these changes on the face of the income statement or in the footnotes in terms of per-share earnings
(loss) amounts available to common shareholders because such disclosure would imply that the normal
earnings per share (EPS) disclosures required by ASC 260 are not informative or are misleading.

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14.4 UTB-Related Disclosures
ASC 740-10

[All Entities]
50-15 All entities shall disclose all of the following at the end of each annual reporting period presented: . . .
c. The total amounts of interest and penalties recognized in the statement of operations and the total
amounts of interest and penalties recognized in the statement of financial position
d. For positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will
significantly increase or decrease within 12 months of the reporting date:
1. The nature of the uncertainty
2. The nature of the event that could occur in the next 12 months that would cause the change
3. An estimate of the range of the reasonably possible change or a statement that an estimate of the
range cannot be made.
e. A description of tax years that remain subject to examination by major tax jurisdictions.

[Public Entities]
50-15A Public entities shall disclose both of the following at the end of each annual reporting period presented:
a. A tabular reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of
the period, which shall include at a minimum:
1. The gross amounts of the increases and decreases in unrecognized tax benefits as a result of tax
positions taken during a prior period
2. The gross amounts of increases and decreases in unrecognized tax benefits as a result of tax
positions taken during the current period
3. The amounts of decreases in the unrecognized tax benefits relating to settlements with taxing
authorities
4. Reductions to unrecognized tax benefits as a result of a lapse of the applicable statute of limitations.
b. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate.
See Example 30 (paragraph 740-10-55-217) for an illustration of disclosures about uncertainty in income taxes.

Related Implementation Guidance and Illustrations

• Example 30: Disclosure Relating to Uncertainty in Income Taxes [ASC 740-10-55-217].

14.4.1 The Tabular Reconciliation of UTBs

740-10-50 (Q&A 09) and 740-10-50 (Q&A 15)
ASC 740-10-50-15A(a) requires public entities to disclose a “tabular reconciliation of the total amounts
of unrecognized tax benefits at the beginning and end of the period.” In some cases, the beginning
and ending amounts in the tabular disclosure equal the amount recorded as a liability for the UTBs
in the balance sheet. However, that is not always the case, since the reconciliation must include, on
a comprehensive basis, all UTBs that are recorded in the balance sheet, not just the amount that is
classified as a liability. In other words, the reconciliation should include an amount recorded as a liability
for UTBs and amounts that are recorded as a reduction in a DTA, a current receivable, or an increase in
a DTL. (See Section 13.2.3 for an example of a UTB recorded as a reduction in a DTA.)

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Changing Lanes
As discussed in Section 14.2, the FASB issued a proposed ASU that would modify or eliminate
certain requirements related to income tax disclosures as well as establish new disclosure
requirements. If approved, the proposed ASU would require PBEs to provide a breakdown (i.e.,
a mapping) of the amount of total UTBs shown in the reconciliation of the total amounts of UTBs
by the respective balance-sheet lines on which such UTBs are recorded.

For more information about the status of this project, including the proposed ASU’s transition
and effective dates, see Appendix C.

An entity’s policy election for interest and penalties under ASC 740-10-45-25 does not affect the
disclosures under ASC 740-10-50-15A.

Interest and penalties that are classified as part of income tax expense in the statement of operations,
and that are therefore classified as a component of the liability for UTBs in the statement of financial
position, should not be included by public entities in the tabular reconciliation of UTBs under ASC
740-10-50-15A(a).

14.4.1.1 Items Included in the Tabular Disclosure of UTBs From Uncertain Tax

Positions May Also Be Included in Other Disclosures
740-10-50 (Q&A 11)
ASC 740-10-50-15A(a) indicates that the tabular reconciliation of the total amounts of UTBs should
include the “gross amounts of the increases and decreases in unrecognized tax benefits as a result of
tax positions taken during a prior period” or a current period. Increases and decreases in the estimate
that occur in the same year can be reflected on a net basis in the tabular reconciliation. However,
if these changes in estimate are significant, it may be appropriate to disclose them on a gross basis
elsewhere in the footnotes to the financial statements. For example, if a public entity does not recognize
any tax benefit for a significant position taken in the second quarter (and therefore recognizes a liability
for the full benefit) but subsequently recognizes the full benefit in the fourth quarter (and therefore
derecognizes the previously recorded liability), the entity would be expected to disclose the significant
change in estimate in the footnotes to the financial statements.

[Example 14-1 has been renamed as Example 14-3A and moved to Section 14.4.1.7.]

14.4.1.2 Periodic Disclosures of UTBs

740-10-50 (Q&A 24)
Both ASC 740-10-50-15 and 50-15A appear to require entities to provide disclosures at the end of each
annual reporting period presented. Accordingly, entities should present the information required by
ASC 740-10-50-15 and 50-15A for each applicable period. For example, if a public entity were to present
three years of income statements and two years of balance sheets, the disclosures listed in ASC 740-10-
50-15 and 50-15A would be required for each year in which an income statement is presented.

14.4.1.3 Presentation of Changes Related to Exchange Rate Fluctuations in the

Tabular Reconciliation
740-10-50 (Q&A 19)
Exchange rate fluctuations are not changes in judgment regarding recognition or measurement and
are not considered as part of the settlement when a tax position is settled. Therefore, in the tabular
reconciliation, increases or decreases in UTBs caused by exchange rate fluctuations should not be
combined with other types of changes; rather, they should be presented as a separate line item (a single
line item is appropriate).

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14.4.1.4 Disclosure of Fully Reserved DTAs in the Reconciliation of UTBs

740-10-50 (Q&A 12)
Public entities with NOLs and a full valuation allowance are required to include in their tabular disclosure
amounts for positions that, if recognized, would manifest themselves as DTAs that would be reduced by
a valuation allowance because it is more likely than not that some portion or all of the DTAs will not be
realized. The general recognition and measurement provisions should be applied first; the remaining
balance should then be evaluated for realizability in accordance with ASC 740-10-30-5(e).

Example 14-2

A public entity has a $1 million NOL carryforward. Assume a 25 percent tax rate. The entity records a $250,000
DTA, for which management applies a $250,000 valuation allowance because it does not believe it is more
likely than not that the entity will have income of the appropriate character to realize the NOL. Management
concludes that the tax position that gave rise to the NOL will more likely than not be realized on the basis of
its technical merits. The entity concludes that the benefit should be measured at 90 percent. The entity would
need to reduce the DTA for the NOL and the related valuation allowance to $225,000, which represents 90
percent of the benefit. In addition, the entity would include a UTB of $25,000 in the tabular disclosure under
ASC 740-10-50-15A(a).

14.4.1.5 Disclosure of the Settlement of a Tax Position When the Settlement

Amount Differs From the UTB
740-10-50 (Q&A 13)
In some cases, cash that will be paid as part of the settlement of a tax position differs from the UTB
related to that position. The difference between the UTB and the settlement amount should be
disclosed in line 1 of the reconciliation, which includes the gross amounts of increases and decreases in
the total amount of UTBs related to positions taken in prior periods. The cash that will be paid to the tax
authority to settle the tax position would then be disclosed in line 2 of the reconciliation, which contains
amounts of decreases in UTBs related to settlements with tax authorities.

Example 14-3

Entity A has recorded a UTB of $1,000 as of December 31, 20X7 (the end of its fiscal year). During the fourth
quarter of fiscal year 20X8, Entity A settles the tax position with the tax authority and makes a settlement
payment of $800 (recognizing a $200 benefit related to the $1,000 tax position). Entity A’s tabular reconciliation
disclosure as of December 31, 20X8, would show a decrease of $200 in UTBs from prior periods (line 1) and a
decrease of $800 in UTBs related to settlements (line 2). A “current taxes payable” for the settlement amount of
$800 should be recorded until that amount is paid to the tax authority.

14.4.1.6 Consideration of Tabular Disclosure of UTBs in an Interim Period

740-10-50 (Q&A 10)
ASC 740-10-50-15A(a) requires public entities to provide a “tabular reconciliation of the total amounts of
unrecognized tax benefits at the beginning and end of the period.”

Although such disclosure is not specifically required in an interim period, if a significant change from
the prior annual disclosure occurs, management should consider whether a tabular reconciliation or
other qualitative disclosures would inform financial statement users about the occurrence of significant
changes or events that have had a material impact since the end of the most recently completed fiscal
year. Management should consider whether to provide such disclosure in the notes to the financial
statements if it chooses not to provide a tabular reconciliation.

Management of entities subject to SEC reporting requirements should consider Form 10-Q’s disclosure
requirements, which include providing disclosures about significant changes from the most recent fiscal
year in estimates used in preparation of the financial statements.

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14.4.1.7 Presentation in the Tabular Reconciliation of a Federal Benefit

Associated With Unrecognized State and Local Income Tax Positions
740-10-50 (Q&A 14)
The recognition of a UTB may indirectly affect deferred taxes. For example, a DTA for a federal benefit
may be created if the UTB is related to a state tax position. If an evaluation of the tax position results in
an entity’s increasing its state tax liability, the entity should record a DTA for the corresponding federal
benefit. However, the UTB related to a state or local income tax position should be presented by a
public entity on a gross basis in the tabular reconciliation required by ASC 740-10-50-15A(a).

Example 14-3A

Entity P, a public entity, records a liability for a $1,000 UTB related to a position taken in a state tax return. Its
federal tax rate is 21 percent. The additional state income tax liability associated with the unrecognized state
tax deduction results in a state income tax deduction on the federal tax return, creating a federal benefit of
$210 ($1,000 × 21%). Entity P would include only the gross $1,000 unrecognized state tax benefit in the tabular
reconciliation. However, in accordance with ASC 740-10-50-15A(b), P would include $790 in the amount of UTBs
that, if recognized, would affect the ETR.

14.4.2 Disclosure of UTBs That, if Recognized, Would Affect the ETR

740-10-50 (Q&A 06)
ASC 740-10-50-15A(b) requires public entities to disclose the “total amount of unrecognized tax benefits
that, if recognized, would affect the effective tax rate.”

The disclosure under ASC 740-10-50-15A(b) is required if recognition of the tax benefit would affect
the ETR from “continuing operations” determined in accordance with ASC 740. However, the SEC staff
expects public entities to provide supplemental disclosure of amounts that significantly affect other
items outside continuing operations (e.g., goodwill or discontinued operations).

14.4.2.1 Example of UTBs That, if Recognized, Would Not Affect the ETR

740-10-50 (Q&A 07)
Certain UTBs, if recognized, would not affect the ETR and would be excluded from the ASC 740-10-50-15A(b)
disclosure requirements. Example 14-4 below illustrates a situation involving such UTBs.

Example 14-4

An entity expenses $10,000 of repair and maintenance costs for book and tax purposes. Upon analyzing
the tax position, the entity believes, on the basis of the technical merits, that the IRS will more likely than not
require the entity to capitalize and depreciate the cost over 10 years. The entity has a 25 percent applicable tax
rate. The entity would recognize a $2,250 ($9,000 × 25%) DTA for repair cost not allowable in the current period
($1,000 would be allowable in the current period for depreciation expense) and a liability for the UTB. Because
of the impact of deferred tax accounting, the disallowance of the shorter deductibility period would not affect
the ETR but would accelerate the payment of cash to the tax authority to an earlier period. Therefore, the entity
recognizes a liability for a UTB and a DTA, both affecting the balance sheet, with no net impact on overall tax
expense.

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14.4.3 Disclosure of UTBs That Could Significantly Change Within 12 Months

of the Reporting Date
740-10-50 (Q&A 20) and 740-10-50 (Q&A 23)
ASC 740-10-50-15(d) requires an entity to disclose information “[f]or positions for which it is reasonably
possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within
12 months of the reporting date.”

Sometimes, the total amount of a UTB will change without affecting the income statement (e.g., a UTB
may be expected to be settled in an amount equal to its carrying value). In other cases, a change in the
total amount of a UTB will affect the income statement (e.g., the tax benefit will be recognized because
the applicable statute of limitations has expired). Further, UTBs may be attributable to either permanent
differences, which generally affect the income statement if adjusted, or temporary differences, which
generally do not affect the income statement if adjusted.

The ASC 740-10-50-15(d) disclosure is intended to provide financial statement users with information
about future events (such as settlements with the tax authority or the expiration of the applicable
statute of limitations) that may result in significant changes to the entity’s total UTBs within 12 months of
the reporting date. “Total UTBs” would be those reflected in the tabular reconciliation required by ASC
740-10-50-15A. The disclosure should not be limited to UTBs for which it is reasonably possible that the
significant changes will affect the income statement or to UTBs associated with permanent differences.

While ASC 740-10-50-15(d) does not require disclosure of whether a reasonably possible change in UTB
will affect tax expense, an entity may consider disclosing the amounts of the expected change that will
affect tax expense and the amounts that will not.

Example 14-5

An entity identifies an uncertain tax position and measures the UTB at $40 million as of the reporting date of
year 1. The tax authorities are aware of the uncertain tax position, and the entity expects that it is reasonably
possible to settle the amount in the fourth quarter of year 2 for between $20 million and $60 million and
that the potential change in UTB would be significant. In this example, the entity’s ASC 740-10-50-15(d)
financial statement disclosure for year 1 should report that because of an anticipated settlement with the tax
authorities, it is reasonably possible that the amount of UTBs may increase or decrease by $20 million.

Example 14-6

An entity identifies an uncertain tax position and measures the UTB at $40 million as of the reporting date of
year 1. The tax authorities are aware of the uncertain tax position, and while the entity expects to settle the
amount for $40 million in the fourth quarter of year 2, it is reasonably possible that the entity could sustain the
position. The uncertain tax position is a binary position with only zero or $40 million as potential outcomes. In
this example, provided that the change in UTB would be significant, the entity’s ASC 740-10-50-15(d) financial
statement disclosure for year 1 should state that it is reasonably possible that a decrease of $40 million in its
UTB obligations could occur within 12 months of the reporting date because of an anticipated settlement with
the tax authorities.

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Example 14-7

On January 1 of year 1, an entity (1) incurs $10 million of costs related to maintaining equipment and (2) claims
a deduction for repairs and maintenance for the entire amount of the costs incurred in its tax return filed
for year 1. It is more likely than not that the tax law requires the costs to be capitalized and depreciated
over a five-year period. As of the reporting date in year 1, the entity recognizes an $8 million liability for
a UTB associated with the deductions taken for tax purposes in year 1. Management believes that the
$8 million liability will be reduced by $2 million per year over the next four years as the entity forgoes claiming
depreciation for the asset previously deducted. In this example, provided that the change in UTB would be
significant, the entity’s ASC 740-10-50-15(d) financial statement disclosure for year 1 should state that it is
reasonably possible that a decrease of $2 million will occur within 12 months of the reporting date. The entity
should continue to disclose such information in subsequent years until the liability balance is reduced to zero
(provided that the entity does not believe that it is reasonably possible that a more accelerated reversal of the
UTB will result from an audit of the year of deduction).

While ASC 740-10-50-15(d) does not require disclosure of whether a reasonably possible change in UTB will
affect tax expense, an entity may consider disclosing the amounts of the expected change that will affect tax
expense and the amounts that will not.

Changing Lanes
As discussed in Section 14.2, the FASB issued a proposed ASU that would modify or eliminate
certain requirements related to income tax disclosures as well as establish new disclosure
requirements. The proposed ASU would also remove the existing requirement in ASC 740-10-
50-15(d) to disclose the details of tax “positions for which it is reasonably possible that the total
amounts of unrecognized tax benefits will significantly increase or decrease” in the next 12
months.

For more information about the status of this project, including the proposed ASU’s transition
and effective dates, see Appendix C.

14.4.3.1 Disclosure of Expiration of Statute of Limitations

740-10-50 (Q&A 20)
A scheduled expiration of the statute of limitations within 12 months of the reporting date is subject to
the disclosure requirements in ASC 740-10-50-15(d). If the statute of limitations is scheduled to expire
within 12 months of the date of the financial statements and management believes that it is reasonably
possible that the expiration of the statute will cause the total amounts of UTBs to significantly decrease,
the entity should disclose the required information.

14.4.3.2 Disclosure Requirements for Effectively Settled Tax Positions

740-10-50 (Q&A 21)
There are no specific disclosure requirements for tax positions determined to be effectively settled
as described in ASC 740-10-25-10. However, for positions expected to be effectively settled, an entity
should not overlook the requirements in ASC 740-10-50-15(d). Under those requirements, the entity
must disclose tax positions for which it is reasonably possible that the total amounts of UTBs will
significantly increase or decrease within 12 months of the reporting date.

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Example 14-8

A calendar-year-end entity is undergoing an audit of its 20X4 tax year. The 20X4 tax year includes tax positions
that did not meet the more-likely-than-not recognition threshold. Therefore, the entity recognizes a liability for
the UTBs associated with those tax positions. The entity believes that the tax authority will complete its audit
of the 20X4 tax year during 20X8. It also believes that it is reasonably possible that the tax positions within that
tax year will meet the conditions to be considered effectively settled. When preparing its ASC 740-10-50-15(d)
disclosure as of December 31, 20X7, the entity should include the estimated decrease of its UTBs for the tax
positions taken in 20X4 that it believes will be effectively settled.

14.4.3.3 Interim Disclosure Considerations Related to UTBs That Will Significantly

Change Within 12 Months
740-10-50 (Q&A 22)
The ASC 740-10-50-15(d) disclosure is required as of the end of each annual reporting period presented.
However, material changes since the end of the most recent fiscal year-end should be disclosed in the
interim financial statements in a manner consistent with SEC Regulation S-X, Article 10.

Therefore, in updating the ASC 740-10-50-15(d) disclosure for interim financial reporting, an entity must
consider changes in expectations from year-end as well as any events not previously considered at
year-end that may occur within 12 months of the current interim reporting date and that could have a
material effect on the entity. This effectively results in a “rolling” 12-month disclosure. For example, an
entity that is preparing its second-quarter disclosure for fiscal year 20X7 should consider any events
that may occur in the period from the beginning of the third quarter of fiscal year 20X7 to the end of
the second quarter of fiscal year 20X8 to determine the total amounts of UTBs for which a significant
increase or decrease is reasonably possible within 12 months of the reporting date.

14.4.4 Separate Disclosure of Interest Income, Interest Expense, and

Penalties
740-10-50 (Q&A 16)

ASC 740-10

Interest and Penalty Recognition Policies

50-19 An entity shall disclose its policy on classification of interest and penalties in accordance with the
alternatives permitted in paragraph 740-10-45-25 in the notes to the financial statements.

ASC 740-10-50-15(c) states that entities must disclose “[t]he total amounts of interest and penalties
recognized in the statement of operations and the total amounts of interest and penalties recognized in
the statement of financial position.” Interest income, interest expense, and penalties should be disclosed
separately. Accordingly, an entity should disclose interest income, interest expense, and penalties gross
without considering any tax effects. In accordance with ASC 740-10-50-19, an entity should also disclose
its policy for classification of interest and penalties.

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14.4.4.1 Interest Income on UTBs

740-10-25 (Q&A 49)
The SEC staff has advised us that if an entity’s accounting policy is to include interest income attributable
to overpayment of income taxes within the provision for income taxes, this policy must be prominently
disclosed and transparent to financial statement users. Public entities should consider presenting the
following disclosure of the components of the income tax provision, either on the face of the statements
of operations or in a note to the financial statements:

Current tax expense (benefit) $ XXX

Tax expense (benefit) recognized for UTBs in the XXX

income statement

Interest expense related to income taxes XXX

Interest income related to income taxes XXX

Penalties, gross of related tax effects XXX

Deferred tax expense (benefit) XXX

Tax benefits charged or credited to APIC XXX

Total tax provision $ XXX

Interest expense and interest income in the table above should not include any related tax effects since
those amounts should be included in the deferred tax expense (benefit) line.

This disclosure is also recommended for nonpublic entities, since it may help financial statement users
understand the effect of interest expense and income.

14.4.5 Disclosure of Liabilities for UTBs in the Contractual Obligations Table

740-10-50 (Q&A 08)
SEC Regulation S-K, Item 303(a)(5), requires registrants to include in the MD&A section a tabular
disclosure of all known contractual obligations, such as long-term debt, capital and operating lease
obligations, purchase obligations, and other liabilities recorded in accordance with U.S. GAAP. A
registrant should include the liability for UTBs in the tabular disclosure of contractual obligations in
MD&A if it can make reasonably reliable estimates about the period of cash settlement of the liabilities.
For example, if any liabilities for UTBs are classified as a current liability in a registrant’s balance sheet,
the registrant should include that amount in the “Less than 1 year” column of its contractual obligations
table. Similarly, the contractual obligations table should include any noncurrent liabilities for UTBs for
which the registrant can make a reasonably reliable estimate of the amount and period of related future
payments (e.g., uncertain tax positions subject to an ongoing examination by the respective tax authority
for which settlement is expected to occur after the next operating cycle).

Often, however, the timing of future cash outflows associated with some liabilities for UTBs is highly
uncertain. In such cases, a registrant (1) might be unable to make reasonably reliable estimates of the
period of cash settlement with the respective tax authority (e.g., UTBs for which the statute of limitations
might expire without examination by the respective tax authority) and (2) could exclude liabilities for
UTBs from the contractual obligations table or disclose such amounts within an “other” column added
to the table. If any liabilities for UTBs are excluded from the contractual obligations table or included in
an “other” column, a footnote to the table should disclose the amounts excluded and the reason for the
exclusion.

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14.4.6 Disclosing the Effects of Income Tax Uncertainties in a Leveraged

Lease Entered Into Before the Adoption of ASC 842
740-10-50 (Q&A 18)
On the effective date of ASC 842, leases previously classified as leveraged leases under ASC 840 will be
subject to the guidance in ASC 842-50. The legacy accounting requirements are grandfathered in for
leases that were entered into and accounted for as leveraged leases before the effective date of ASC
842. A leveraged lease modified on or after the effective date of ASC 842 would be accounted for as
a new lease under the lessor model in ASC 842. Entities are not permitted to account for any new or
subsequently amended lease arrangements as leveraged leases after the effective date of ASC 842. For
additional information on the impact of ASC 842 on leveraged lease accounting, see Section 9.5.2 of
Deloitte’s A Roadmap to Applying the New Leasing Standard.

ASC 840-30-35-42 indicates that a change or projected change in the timing of cash flows related to
income taxes generated by a leveraged lease is a change in an important assumption that affects
the periodic income recognized by the lessor for that lease. Accordingly, the lessor should apply the
guidance in ASC 840-30-35-38 through 35-41 and ASC 840-30-35-45 through 35-47 whenever events
or changes in circumstances indicate that a change in timing of cash flows related to income taxes
generated by a leveraged lease has occurred or is projected to occur.

In addition, ASC 840-30-35-44 states, “Tax positions shall be reflected in the lessor’s initial calculation
or subsequent recalculation based on the recognition, derecognition, and measurement criteria in
paragraphs 740-10-25-6, 740-10-30-7, and 740-10-40-2.”

The tax effects of leveraged leases are within the scope of ASC 740. Accordingly, a lessor in a leveraged
lease should apply the disclosure provisions of ASC 740-10-50 that would be relevant to the income tax
effects for leveraged leases, including associated uncertainties and effects of those uncertainties.

Lessors in a leveraged lease should also be mindful of the SEC observer’s comment in EITF Issue 86-43
(codified in ASC 840-30), which indicates that when an entity applies the leveraged lease guidance in ASC
840-30-35-38 through 35-41 because the after-tax cash flows of the leveraged lease have changed as a
result of a change in tax law, the cumulative effect on pretax income and income tax expense, if material,
should be reported as separate line items in the income statement. Because ASC 840-30-35-42 through
35-44 clarify that the timing of the cash flows related to income taxes generated by a leveraged lease is
an important assumption — just as a change in tax rates had always been — this guidance should be
applied by analogy.

14.5 Public Entities Not Subject to Income Taxes

ASC 740-10

50-16 A public entity that is not subject to income taxes because its income is taxed directly to its owners shall
disclose that fact and the net difference between the tax bases and the reported amounts of the entity’s assets
and liabilities.

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14.5.1 Tax Bases in Assets

740-10-50 (Q&A 25) and 740-10-50 (Q&A 26)
The disclosure requirement described in ASC 740-10-50-16 above applies to any public entity for which
income is taxed directly to its owners, including regulated investment companies (mutual funds), public
partnerships, and Subchapter S corporations with public debt.

The reference to “tax bases” in ASC 740-10-50-16 is meant to include the partnership’s or other entity’s
tax basis in its (net) assets. The FASB’s rationale for this information is based on the belief that financial
statement users would benefit from knowing the approximate tax consequence in the event the flow-
through entity changes its tax status and becomes a taxable entity in the future.

14.6 Disclosure of the Components of Income (or Loss) Before Income Tax

Expense (or Benefit) as Either Foreign or Domestic
740-10-50 (Q&A 30)
SEC Regulation S-X, Rule 4-08(h), requires public companies to include in their financial statements a
disclosure of the domestic and foreign components of income (or loss) before income tax expense (or
benefit).

SEC Regulation S-X, Rule 4-08(h), defines foreign income or loss as income or loss generated from a
registrant’s “foreign operations, i.e., that are located outside the registrant’s home country.” Conversely,
domestic income or loss is income or loss generated from a registrant’s operations located inside the
registrant’s home country.

While providing this disclosure is often straightforward, it may be difficult in certain circumstances to
determine (1) the source of the income or loss (i.e., foreign or domestic) or (2) the period or manner in
which to reflect the income or loss in the disclosure. In particular, it can be challenging to classify income
as foreign or domestic when a portion of a registrant’s pretax income or loss is generated by a branch or
when intra-entity transactions occur between different tax-paying components2 within the consolidated
group.

Changing Lanes
As discussed in Section 14.2, the FASB issued a proposed ASU that would modify or eliminate
certain requirements related to income tax disclosures as well as establish new disclosure
requirements. If approved, it would require all entities to disclose (1) the pretax “[i]ncome (or
loss) from continuing operations . . . disaggregated between domestic and foreign” amounts,3
(2) the “[i]ncome tax expense (or benefit) from continuing operations disaggregated between
federal, state, and foreign” amounts,4 and (3) the “[i]ncome taxes paid disaggregated between
federal, state, and foreign” amounts.

2
As described in ASC 740-10-30-5, a tax-paying component is “an individual entity or group of entities that is consolidated for tax purposes.”
3
Represents an existing disclosure requirement for PBEs under SEC Regulation S-X, Rule 4-08(h).
4
See footnote 3.

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The proposed ASU also contains clarifications related to the following:

• Jurisdiction of domicile income tax on foreign earnings — Such income tax should be
classified as income tax for the jurisdiction of domicile (e.g., U.S. federal tax on GILTI
resulting from foreign earnings is classified as domestic for a U.S.-domiciled company).

• Preconsolidation basis — The amount of pretax income (or loss) from continuing
operations indicated in the disaggregation should be presented “before intra-entity
eliminations.” When deliberating the proposed guidance, some Board members
expressed concern that diversity in practice could result because “before intra-entity
eliminations” is not defined in U.S. GAAP. Accordingly, the FASB included Question 4 in the
proposed ASU’s questions for respondents to determine whether clarification is needed.

For more information about the status of this project, including the proposed ASU’s transition
and effective dates, see Appendix C.

14.6.1 Branches
A U.S. parent may create an entity in a foreign jurisdiction that is regarded (e.g., as a corporation)
in its foreign jurisdiction but then cause that foreign corporation to elect to be disregarded for U.S.
federal income tax purposes (commonly referred to as a branch). Because the foreign corporation
is disregarded for U.S. federal income tax purposes, the U.S. parent includes the foreign entity’s
taxable income or loss in its U.S. federal taxable income. The foreign corporation’s profits are taxed
simultaneously in the foreign jurisdiction in which it operates (i.e., the foreign corporation will file a tax
return in the foreign jurisdiction in which it operates) and in the United States (because the entity’s
taxable income or loss will be included in the U.S. parent’s U.S. federal taxable income). Taxes paid
by the foreign corporation in the foreign jurisdiction may be deducted on the U.S. parent’s return or
claimed as an FTC, subject to certain limitations.

The foreign corporation is treated like a branch of its U.S. parent for U.S. income tax purposes, which
does not change the fact that the profits of the foreign entity are generated from operations located
outside the United States. The profits and losses of the foreign entity are considered foreign income or
loss in the disclosure of domestic and foreign components of pretax income or loss in the U.S. parent’s
financial statements.

14.6.2 Intra-Entity Transactions
Intra-entity transactions between different tax-paying components within the consolidated group often
result in tax consequences in each member’s respective taxing jurisdiction in the period in which the
transaction occurs. However, the pretax effects of these transactions are eliminated in consolidation for
accounting purposes. Accounting for the tax consequences of an intra-entity transaction depends on
the nature of the transaction.

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14.6.2.1 Intra-Entity Transactions Not Subject to ASC 740-10-25-3(e)

We believe that the primary purpose of the disclosure of the components of pretax income or loss as
either domestic or foreign is to give the users of financial statements an ability to relate the domestic
and foreign tax provisions to their respective pretax amounts. Therefore, when an intra-entity
transaction results in taxable income in one component and deductible losses in another component,
and those pretax amounts are eliminated in consolidation, we believe that the disclosure of the foreign
and domestic components of pretax income or loss is generally more meaningful if the components are
“grossed up” since the grossed-up amounts correspond more closely to the actual amounts of domestic
and foreign tax expense and benefit.

However, because SEC Regulation S-X, Rule 4-08(h), is not explicit and simply requires disclosure of “the
components of income (loss) before income tax expense (benefit),” we believe that “net” presentation,
with appropriate disclosure in the income tax rate reconciliation, would also be acceptable.

Consider the following example:

Example 14-9

Assume the following facts:

• Company P is an SEC registrant and is domiciled and operates in the United States, which has a
21 percent tax rate.
• Company S is a wholly owned foreign subsidiary of P and is domiciled and operating in Jurisdiction B,
which has a 50 percent tax rate.
• Company P’s consolidated financial statements are prepared under U.S. GAAP and include S.
• Companies P and S enter into a cost-sharing arrangement under which S reimburses P for 50 percent of
certain costs incurred by P to further the development of Product X, which S licenses to third parties.
• None of the amounts paid qualify for capitalization.
• For the year 20X5, P records $200 of development expense before reimbursement by S. Company S
reimburses P for 50 percent of the costs. Accordingly, P recognizes a net development expense of $100
under the cost-sharing arrangement, and S records $100 of development expense.
• Company P increases its income tax expense by $21 for the cost-sharing expense reimbursement in
20X5, and S receives an income tax benefit of $50 from the development expense it incurs.
The cost-sharing payment is eliminated in P’s 20X5 consolidated financial statements. However, the income tax
expense incurred by P and the income tax benefit received by S are recognized in P’s consolidated financial
statements in 20X5. Therefore, provided that P discloses the grossed-up amounts of the domestic and foreign
components of pretax income or loss, P’s pretax income would reflect the $100 net development cost expense
in the disclosure of domestic income or loss and would similarly include $100 of development expense in
the disclosure of foreign income or loss. That is, the cost-sharing arrangement has the effect of moving $100
of expense from domestic to foreign. This disclosure corresponds to an applicable amount of domestic and
foreign tax expense and benefit, respectively, which is also recognized and disclosed in 20X5.

14.6.2.2 Intra-Entity Transactions Subject to ASC 740-10-25-3(e)

ASC 740-10-25-3(e) and ASC 810-10-45-8 require deferral of the recognition of income taxes paid on
intra-entity profits from the sale of inventory for which intra-entity profits are eliminated in consolidation.
For these types of transactions, we believe that it is appropriate to include an allocation of the
consolidated pretax income or loss to the foreign and domestic components in the year in which the
inventory is sold outside the consolidated group.

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Consider the following example:

Example 14-10

Assume the same facts as those in Example 14-9, but instead of entering into a cost-sharing agreement:

• During 20X5, P sells inventory with a historical cost basis for both book and tax purposes of $200 to S for
$300, and the inventory is on hand at year-end.
• Company P pays tax of $21 in the United States on this intra-entity profit of $100.
• The inventory is sold outside the consolidated group at a price of $350 in the following year (20X6).
In 20X5 the $100 gain on the intra-entity sale is eliminated in consolidation, and the related tax is deferred
under ASC 740-10-25-3(e) and ASC 810-10-45-8. The intra-entity gain of $100 that is eliminated in 20X5 should
not be included in the disclosure of the 20X5 pretax domestic and foreign income or loss.

In 20X6, when the inventory is sold outside the consolidated group, a profit before income taxes of $150 is
recorded in the consolidated financial statements ($100 of which is related to profits previously taxed in the
United States, and $50 of which is related to profits taxed in Jurisdiction B). In 20X6, $100 of income from
the sale should be reported as domestic income, and $50 of income from the sale should be reported as
foreign income. This corresponds to an applicable amount of domestic and foreign tax expense, which is also
recognized and disclosed in 20X6.

14.7 Pro Forma Financial Statements

14.7.1 Change in Tax Status to Taxable: Pro Forma Financial Reporting
Considerations
740-10-50 (Q&A 29)
In certain situations, an entity may be required to disclose, in the financial statements included in an SEC
filing, pro forma information regarding a change in tax status. One example would be an entity (e.g., an
S corporation) that changes its tax status in connection with an IPO. The financial statements presented
in the registration statement on Form S-1 for the periods in which the entity was a nontaxable entity
are not restated for the effect of income tax. Rather, the entity must provide pro forma disclosures to
illustrate the effect of income tax on those years.

Therefore, certain income tax reporting considerations may arise when an SEC registrant changes its
status from nontaxable to taxable. Paragraph 3410.1 of the SEC Financial Reporting Manual (FRM)
states:

If the issuer was formerly a Sub-Chapter S corporation (“Sub-S”), partnership or similar tax exempt enterprise,
pro forma tax and EPS data should be presented on the face of historical statements for the periods identified
below:
a. If necessary adjustments include more than adjustments for taxes, limit pro forma presentation to latest
fiscal year and interim period
b. If necessary adjustments include only taxes, pro forma presentation for all periods presented is
encouraged, but not required.

The pro forma information should be prepared in accordance with SEC Regulation S-X, Rule 11-02. The
tax rate used for the pro forma calculations should normally equal the “statutory rate in effect during
the periods for which the pro forma income statements are presented,” as stated in Section 3270 of the
FRM. However, Section 3270 of the FRM also indicates that “[c]ompanies are allowed to use different
rates if they are factually supportable and disclosed.”

If an entity chooses to provide pro forma information for all periods presented under the option in
paragraph 3410.1(b) of the FRM above, the entity should continue to present this information in periods
after the entity becomes taxable to the extent that the earlier comparable periods are presented.

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With respect to the pro forma financial information, any undistributed earnings or losses of an S
corporation are viewed as distributions to the owners immediately followed by a contribution of capital
to the new taxable entity. ASC 505-10-S99-3 states that these earnings or losses should therefore be
reclassified to paid-in capital.

14.8 Statement of Cash Flows

Under ASC 230-10-50-2, the supplemental cash flow information for income taxes paid is required when
an indirect method is used. Such disclosure can be included in the company’s statement of cash flows or
in a footnote. See Appendix E for a sample of this required disclosure.

Changing Lanes
As discussed in Section 14.2, the FASB issued a proposed ASU that would modify or eliminate
certain requirements related to income tax disclosures as well as establish new disclosure
requirements. If approved, the proposed ASU would amend ASC 230-10-50-2 to add an interim
requirement to disclose income taxes paid for all interim periods presented.

For more information about the status of this project, including the proposed ASU’s transition
and effective dates, see Appendix C.

14.9 Additional Disclosure Requirements

An entity that becomes a public registrant may be required to provide additional disclosures about
its income taxes that were not required in prior financial statements. In addition to providing the
disclosures described below, public entities must present, under SEC Regulation S-X, Rule 12-09, a
“[l]ist, by major classes, [of] all valuation and qualifying accounts and reserves not included in specific
schedules,” including valuation allowances related to DTAs. This list must be included as a supplemental
schedule in an entity’s annual filings, and the schedule must contain a rollforward of such accounts,
showing additions charged to costs and expenses, additions charged to other accounts, and deductions
throughout the year.

14.10 Disclosures Outside the Financial Statements — MD&A

The filings of public entities must include MD&A. Discussion and analysis of income taxes is an important
part of an entity’s MD&A since income taxes can be a significant factor in the entity’s operating results.
Such discussion should address the following (if material):

• Critical accounting estimates — The determination of income tax expense, DTAs and DTLs, and
UTBs inherently involves several critical accounting estimates of current and future taxes to be
paid. Management should provide information about the nature of these estimates in MD&A.

• Liquidity and capital resources — The SEC staff expects registrants to disclose (1) the amount of
cash and short-term investments held by foreign subsidiaries that would not be available to fund
domestic operations unless the funds were repatriated and (2) whether additional tax expense
would need to be recognized if the funds are repatriated. Although we expect scenarios such
as these to be less prevalent than they have been historically, an entity may still be subject to
income tax on its foreign investments (e.g., foreign exchange gains or losses on distributions and
withholding taxes).

• Contractual obligations — See Section 14.4.5.

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In addition to discussion of the results of operations, SEC Regulation S-K, Item 303(a), requires entities
to provide certain forward-looking information related to “material events and uncertainties known to
management that would cause reported financial information not to be necessarily indicative of future
operating results or of future financial condition.”

Many tax-related events and uncertainties may need to be elaborated on in MD&A. For instance, before
the enactment of tax law proposals or changes to existing tax rules, an SEC registrant should consider
whether the potential changes represent an uncertainty that management reasonably expects could
have a material effect on the registrant’s results of operations, financial position, liquidity, or capital
resources. If so, the registrant should consider disclosing information about the scope and nature of any
potential material effects of the changes.

After the enactment of a new tax law, registrants should consider disclosing, when material, the
anticipated current and future impact of the law on their results of operations, financial position,
liquidity, and capital resources. In addition, registrants should consider providing disclosures in the
critical accounting estimates section of MD&A to the extent that the changes could materially affect
existing assumptions used in estimating tax-related balances.

The SEC staff also expects registrants to provide early-warning disclosures to help users understand
various risks and how those risks potentially affect the financial statements. Examples of such risks
include situations in which (1) the registrant may have to repatriate foreign earnings to meet current
liquidity demands, resulting in a tax payment (e.g., withholding taxes) that may not be accrued for; (2) the
historical effective tax rate is not sustainable and may change materially; (3) the valuation allowance
on net DTAs may change materially; and (4) tax positions taken during the preparation of returns
may ultimately not be sustained. Early-warning disclosures give investors insight into management’s
underlying assumptions as well as the conditions and risks an entity faces before a material change or
decline in performance is reported.

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Appendix A — Implementation Guidance
and Illustrations
This Roadmap contains the implementation guidance and illustrative examples from ASC 740-10, ASC
740-20, ASC 740-270, ASC 805-740, ASC 830-740, and ASC 323-740, as included in the FASB Accounting
Standards Codification. This guidance is not all-inclusive; an entity should also consider its specific facts and
circumstances.

ASC 740-10 — Implementation Guidance and Illustrations

General
55-1 This Section is an integral part of the requirements of this Subtopic. This Section provides additional
guidance and illustrations that address the application of accounting requirements to specific aspects of
accounting for income taxes, including disclosures. The guidance and illustrations that follow, unless stated
otherwise, assume that the tax law requires offsetting net deductions in a particular year against net taxable
amounts in the 3 preceding years and then in the 15 succeeding years. These assumptions about the tax law
are for illustrative purposes only. This Subtopic requires that the enacted tax law for a particular tax jurisdiction
be used for recognition and measurement of deferred tax liabilities and assets.

Implementation Guidance
55-2 The guidance is organized as follows:
a. Application of accounting requirements for income taxes to specific situations
b. Subparagraph superseded by Accounting Standards Update No. 2015-17
c. Income tax related disclosures.

Application of Accounting Requirements for Income Taxes to Specific Situations

Recognition and Measurement of Tax Positions — a Two-Step Process
55-3 The application of the requirements of this Subtopic related to tax positions requires a two-step process
that separates recognition from measurement. The first step is determining whether a tax position has met
the recognition threshold; the second step is measuring a tax position that meets the recognition threshold.
The recognition threshold is met when the taxpayer (the reporting entity) concludes that, consistent with
paragraphs 740-10-25-6 through 25-7 and 740-10-25-13, it is more likely than not that the taxpayer will sustain
the benefit taken or expected to be taken in the tax return in a dispute with taxing authorities if the taxpayer
takes the dispute to the court of last resort.

55-4 Relatively few disputes are resolved through litigation, and very few are taken to the court of last resort.
Generally, the taxpayer and the taxing authority negotiate a settlement to avoid the costs and hazards of
litigation. As a result, the measurement of the tax position is based on management’s best judgment of the
amount the taxpayer would ultimately accept in a settlement with taxing authorities.

55-5 The recognition and measurement requirements of this Subtopic related to tax positions require that
the entity recognize the largest amount of benefit that is greater than 50 percent likely of being realized upon
settlement.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-6 See Examples 1 through 12 (paragraphs 740-10-55-81 through 55-123) for illustrations of this guidance.

Recognition of Deferred Tax Assets and Deferred Tax Liabilities

55-7 Subject to certain specific exceptions identified in paragraph 740-10-25-3, a deferred tax liability is
recognized for all taxable temporary differences, and a deferred tax asset is recognized for all deductible
temporary differences and operating loss and tax credit carryforwards. A valuation allowance is recognized if
it is more likely than not that some portion or all of the deferred tax asset will not be realized. See Example 12
(paragraph 740-10-55-120) for an illustration of this guidance.

55-8 To the extent that evidence about one or more sources of taxable income is sufficient to eliminate any
need for a valuation allowance, other sources need not be considered. Detailed forecasts, projections, or other
types of analyses are unnecessary if expected future taxable income is more than sufficient to realize a tax
benefit.

55-9 The terms forecast and projection refer to any process by which available evidence is accumulated and
evaluated for purposes of estimating whether future taxable income will be sufficient to realize a deferred
tax asset. Judgment is necessary to determine how detailed or formalized that evaluation process should
be. Furthermore, information about expected future taxable income is necessary only to the extent positive
evidence available from other sources (see paragraph 740-10-30-18) is not sufficient to support a conclusion
that a valuation allowance is not needed. The requirements of this Subtopic do not require either a financial
forecast or a financial projection within the meaning of those terms in the Statements on Standards for
Attestation Engagements and Related Attest Engagements Interpretations [AT], AT section 301, Financial
Forecasts and Projections issued by the American Institute of Certified Public Accountants.

55-10 See Example 12 (paragraph 740-10-55-120) for an illustration of a situation where detailed analyses are
not necessary.

55-11 See Example 13 (paragraph 740-10-55-124) for an illustration of determining a valuation allowance for
deferred tax assets.

Offset of Taxable and Deductible Amounts

55-12 The tax law determines whether future reversals of temporary differences will result in taxable and
deductible amounts that offset each other in future years. The tax law also determines the extent to which
deductible temporary differences and carryforwards will offset the tax consequences of income that is
expected to be earned in future years. For example, the tax law may provide that capital losses are deductible
only to the extent of capital gains. In that case, a tax benefit is not recognized for temporary differences that will
result in future deductions in the form of capital losses unless those deductions will offset any of the following:
a. Other existing temporary differences that will result in future capital gains
b. Capital gains that are expected to occur in future years
c. Capital gains of the current year or prior years if carryback (of those capital loss deductions from the
future reversal years) is expected.

Pattern of Taxable or Deductible Amounts

55-13 The particular years in which temporary differences result in taxable or deductible amounts generally
are determined by the timing of the recovery of the related asset or settlement of the related liability. However,
there are exceptions to that general rule. For example, a temporary difference between the tax basis and the
reported amount of inventory for which cost is determined on a last-in, first-out (LIFO) basis does not reverse
when present inventory is sold in future years if it is replaced by purchases or production of inventory in those
same future years. A LIFO inventory temporary difference becomes taxable or deductible in the future year that
inventory is liquidated and not replaced.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-14 For some assets or liabilities, temporary differences may accumulate over several years and then reverse
over several years. That pattern is common for depreciable assets. Future originating differences for existing
depreciable assets and their subsequent reversals are a factor to be considered when assessing the likelihood
of future taxable income (see paragraph 740-10-30-18(b)) for realization of a tax benefit for existing deductible
temporary differences and carryforwards.

The Need to Schedule Temporary Difference Reversals

55-15 Reversal patterns of existing temporary differences may need to be scheduled under the requirements
of this Subtopic as follows:
a. Subparagraph superseded by Accounting Standards Update No. 2015-17.
b. Deferred tax assets are recognized without reference to offsetting, and then an assessment is made
about the need for a valuation allowance. Paragraph 740-10-30-18 lists four possible sources of taxable
income that may be available to realize such deferred tax assets. In many cases it may be possible to
determine without scheduling that expected future taxable income (see paragraph 740-10-30-18(b)) will
be adequate to eliminate the need for a valuation allowance. Disclosure of the amounts and expiration
dates (or a reasonable aggregation of expiration dates) of operating loss and tax credit carryforwards is
required only on a tax basis and does not require scheduling.
c. The adoption of a tax rate convention for measuring deferred taxes when graduated tax rates are
a significant factor will, in many cases, eliminate the need for the scheduling. In addition, alternative
minimum tax rates and laws are a factor only in considering the need for a valuation allowance for a
deferred tax asset for alternative minimum tax credit carryforwards. When there is a phased-in change
in tax rates, however, scheduling will often be necessary. See paragraphs 740-10-55-24; 740-10-55-31
through 55-33; and Examples 14 through 16 (paragraphs 740-10-55-129 through 55-138).

55-16 Paragraph 740-10-30-18 lists four possible sources of taxable income that may be available to realize a
future tax benefit for deductible temporary differences and carryforwards. One source is future taxable income
exclusive of reversing temporary differences and carryforwards. Future originating temporary differences
and their subsequent reversal are implicit in estimates of future taxable income. Where it can be easily
demonstrated that future taxable income will more likely than not be adequate to realize future tax benefits
of existing deferred tax assets, scheduling of reversals of existing taxable temporary differences would be
unnecessary.

55-17 In other cases it may be easier to demonstrate that no valuation allowance is needed by considering
the reversal of existing taxable temporary differences. Even in that case, the extent of scheduling will depend
on the relative magnitudes involved. For example, if existing taxable temporary differences that will reverse
over a long number of future years greatly exceed deductible differences that are expected to reverse
over a short number of future years, it may be appropriate to conclude, in view of a long (for example, 15
years) carryforward period for net operating losses, that realization of future tax benefits for the deductible
differences is thereby more likely than not without the need for scheduling.

55-18 A general understanding of reversal patterns is, in many cases, relevant in assessing the need for a
valuation allowance. Judgment is crucial in making that assessment. The amount of scheduling, if any, that will
be required will depend on the facts and circumstances of each situation.

55-19 The following concepts however, underlie the determination of reversal patterns for existing temporary
differences:
a. The particular years in which temporary differences result in taxable or deductible amounts generally
are determined by the timing of the recovery of the related asset or settlement of the related liability
(see paragraph 740-10-55-13).
b. The tax law determines whether future reversals of temporary differences will result in taxable and
deductible amounts that offset each other in future years (see paragraph 740-10-55-14).

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-20 State income taxes are deductible for U.S. federal income tax purposes and therefore a deferred state
income tax liability or asset gives rise to a temporary difference for purposes of determining a deferred U.S.
federal income tax asset or liability, respectively. The pattern of deductible or taxable amounts in future years
for temporary differences related to deferred state income tax liabilities or assets should be determined by
estimates of the amount of those state income taxes that are expected to become payable or recoverable for
particular future years and, therefore, deductible or taxable for U.S. federal tax purposes in those particular
future years.

55-21 An entity may have claimed certain deductions, such as repair expenses, on its income tax returns.
However, the entity may have recognized a liability (including interest) for the unrecognized tax benefit
of those tax positions. If scheduling of future taxable or deductible differences is necessary, liabilities for
unrecognized tax benefits should be considered. Accrual of a liability for unrecognized tax benefits of expenses,
such as repairs, has the effect of capitalizing those expenses for tax purposes. Those capitalized expenses
are considered to result in deductible amounts in the later years, for example, as depreciation expense. If
the liability for unrecognized tax benefits is based on an overall evaluation of the technical merits of the tax
position, scheduling should reflect the evaluations made in determining the liability for unrecognized tax
benefits that was recognized. The effect of those evaluations may indicate a source of taxable income (see
paragraph 740-10-30-18(c)) for purposes of assessing the need for a valuation allowance for deductible
temporary differences. Those evaluations may also indicate lower amounts of taxable income in other years. A
deductible amount for any accrued interest related to unrecognized tax benefits would be scheduled for the
future year in which that interest is expected to become deductible.

55-22 Minimizing complexity is an appropriate consideration in selecting a method for determining reversal
patterns. The methods used for determining reversal patterns should be systematic and logical. The same
method should be used for all temporary differences within a particular category of temporary differences for
a particular tax jurisdiction. Different methods may be used for different categories of temporary differences.
If the same temporary difference exists in two tax jurisdictions (for example, U.S. federal and a state tax
jurisdiction), the same method should be used for that temporary difference in both tax jurisdictions. The same
method for a particular category in a particular tax jurisdiction should be used consistently from year to year. A
change in method is a change in accounting principle under the requirements of Topic 250. Two examples of a
category of temporary differences are those related to liabilities for deferred compensation and investments in
direct financing and sales-type leases.

Measurement of Deferred Tax Liabilities and Assets

55-23 The tax rate or rates that are used to measure deferred tax liabilities and deferred tax assets are the
enacted tax rates expected to apply to taxable income in the years that the liability is expected to be settled
or the asset recovered. Measurements are based on elections (for example, an election for loss carryforward
instead of carryback) that are expected to be made for tax purposes in future years. Presently enacted
changes in tax laws and rates that become effective for a particular future year or years must be considered
when determining the tax rate to apply to temporary differences reversing in that year or years. Tax laws and
rates for the current year are used if no changes have been enacted for future years. An asset for deductible
temporary differences that are expected to be realized in future years through carryback of a future loss to the
current or a prior year (or a liability for taxable temporary differences that are expected to reduce the refund
claimed for the carryback of a future loss to the current or a prior year) is measured using tax laws and rates
for the current or a prior year, that is, the year for which a refund is expected to be realized based on loss
carryback provisions of the tax law. See Examples 14 through 16 (paragraphs 740-10-55-129 through 55-138)
for illustrations of this guidance.

55-24 Deferred tax liabilities and assets are measured using enacted tax rates applicable to capital gains,
ordinary income, and so forth, based on the expected type of taxable or deductible amounts in future years.
For example, evidence based on all facts and circumstances should determine whether an investor’s liability
for the tax consequences of temporary differences related to its equity in the earnings of an investee should
be measured using enacted tax rates applicable to a capital gain or a dividend. Computation of a deferred
tax liability for undistributed earnings based on dividends should also reflect any related dividends received
deductions or foreign tax credits, and taxes that would be withheld from the dividend.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

State and Local Income Taxes

55-25 If deferred tax assets or liabilities for a state or local tax jurisdiction are significant, this Subtopic requires
a separate deferred tax computation when there are significant differences between the tax laws of that and
other tax jurisdictions that apply to the entity. In the United States, however, many state or local income taxes
are based on U.S. federal taxable income, and aggregate computations of deferred tax assets and liabilities for
at least some of those state or local tax jurisdictions might be acceptable. In assessing whether an aggregate
calculation is appropriate, matters such as differences in tax rates or the loss carryback and carryforward
periods in those state or local tax jurisdictions should be considered. Also, the provisions of paragraph 740-10-
45-6 about offset of deferred tax liabilities and assets of different tax jurisdictions should be considered.
In assessing the significance of deferred tax expense for a state or local tax jurisdiction, it is appropriate to
consider the deferred tax consequences that those deferred state or local tax assets or liabilities have on other
tax jurisdictions, for example, on deferred federal income taxes.

55-26 Local (including franchise) taxes based on income are within the scope of this Topic. A tax, to the extent
it is based on capital, is a franchise tax. As indicated in paragraph 740-10-15-4(a), if there is an additional tax
based on income, that excess is considered an income tax. A historical example that illustrates this guidance is
presented in Example 17 (see paragraph 740-10-55-139).

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-26 Local (including franchise) taxes based on income are within the scope of this Topic. A tax, to the
extent it is based on capital, is a non-income-based tax. As indicated in paragraph 740-10-15-4(a), if there
is an amount of a franchise tax based on income, that amount is considered an income tax. Any additional
amount incurred is considered a non-income-based tax. An example that illustrates this guidance is
presented in Example 17 (see paragraph 740-10-55-139).

Special Deductions — Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation
Act of 2004
55-27 The following discussion and Example 18 (see paragraph 740-10-55-145) refer to and describe a
provision within the American Jobs Creation Act of 2004; however, they shall not be considered a definitive
interpretation of any provision of the Act for any purpose.

55-28 On October 22, 2004, the Act was signed into law by the president. This Act includes a tax deduction of
up to 9 percent (when fully phased-in) of the lesser of qualified production activities income, as defined in the
Act, or taxable income (after the deduction for the utilization of any net operating loss carryforwards). This tax
deduction is limited to 50 percent of W-2 wages paid by the taxpayer.

55-29 The qualified production activities deduction’s characteristics are similar to special deductions discussed
in paragraph 740-10-25-37 because the qualified production activities deduction is contingent upon the future
performance of specific activities, including the level of wages. Accordingly, the deduction should be accounted
for as a special deduction in accordance with that paragraph.

55-30 The special deduction should be considered by an entity in measuring deferred taxes when graduated
tax rates are a significant factor and assessing whether a valuation allowance is necessary as required
by paragraph 740-10-25-37. Example 18 (see paragraph 740-10-55-145) illustrates the application of the
requirements of this Subtopic for the impact of the qualified production activities deduction upon enactment of
the Act in 2004.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

Alternative Minimum Tax

55-31 Temporary differences such as depreciation differences are one reason why tentative minimum tax
may exceed regular tax. Temporary differences, however, ultimately reverse and, absent a significant amount
of preference items, total taxes paid over the entire life of the entity will be based on the regular tax system.
Preference items are another reason why tentative minimum tax may exceed regular tax. If preference items
are large enough, an entity could be subject, over its lifetime, to the alternative minimum tax system; and the
cumulative amount of alternative minimum tax credit carryforwards would expire unused. No one can know
beforehand which scenario will prevail because that determination can only be made after the fact. In the
meantime, this Subtopic requires procedures that provide a practical solution to that problem.

55-32 Under the requirements of this Subtopic, an entity shall:

a. Measure the total deferred tax liability and asset for regular tax temporary differences and
carryforwards using the regular tax rate
b. Measure the total deferred tax asset for all alternative minimum tax credit carryforward
c. Reduce the deferred tax asset for alternative minimum tax credit carryforward by a valuation allowance
if, based on the weight of available evidence, it is more likely than not that some portion or all of that
deferred tax asset will not be realized.

55-33 Paragraph 740-10-30-18 identifies four sources of taxable income that shall be considered in
determining the need for and amount of a valuation allowance. No valuation allowance is necessary if the
deferred tax asset for alternative minimum tax credit carryforward can be realized in any of the following ways:
a. Under paragraph 740-10-30-18(a), by reducing a deferred tax liability from the amount of regular tax on
regular tax temporary differences to not less than the amount of tentative minimum tax on alternative
minimum taxable temporary differences
b. Under paragraph 740-10-30-18(b), by reducing taxes on future income from the amount of regular
tax on regular taxable income to not less than the amount of tentative minimum tax on alternative
minimum taxable income
c. Under paragraph 740-10-30-18(c), by loss carryback
d. Under paragraph 740-10-30-18(d), by a tax-planning strategy such as switching from tax-exempt to
taxable interest income.

Operating Loss and Tax Credit Carryforwards and Carrybacks

Recognition of a Tax Benefit for Carrybacks
55-34 An operating loss, certain deductible items that are subject to limitations, and some tax credits
arising but not utilized in the current year may be carried back for refund of taxes paid in prior years or
carried forward to reduce taxes payable in future years. A receivable, to the extent it meets the recognition
requirements of this Subtopic for tax positions, is recognized for the amount of taxes paid in prior years that is
refundable by carryback of an operating loss or unused tax credits of the current year.

Recognition of a Tax Benefit for Carryforwards

55-35 A deferred tax asset, to the extent it meets the recognition requirements of this Subtopic for tax
positions, is recognized for an operating loss or tax credit carryforward. This requirement pertains to all
investment tax credit carryforwards regardless of whether the flow-through or deferral method is used to
account for investment tax credits.

55-36 In assessing the need for a valuation allowance, provisions in the tax law that limit utilization of an
operating loss or tax credit carryforward are applied in determining whether it is more likely than not that some
portion or all of the deferred tax asset will not be realized by reduction of taxes payable on taxable income
during the carryforward period. Example 19 (see paragraph 740-10-55-149) illustrates recognition of the tax
benefit of an operating loss in the loss year and in subsequent carryforward years when a valuation allowance
is necessary in the loss year.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-37 An operating loss or tax credit carryforward from a prior year (for which the deferred tax asset was
offset by a valuation allowance) may sometimes reduce taxable income and taxes payable that are attributable
to certain revenues or gains that the tax law requires be included in taxable income for the year that cash is
received. For financial reporting, however, there may have been no revenue or gain and a liability is recognized
for the cash received. Future sacrifices to settle the liability will result in deductible amounts in future years.
Under those circumstances, the reduction in taxable income and taxes payable from utilization of the operating
loss or tax credit carryforward gives no cause for recognition of a tax benefit because, in effect, the operating
loss or tax credit carryforward has been replaced by temporary differences that will result in deductible
amounts when a nontax liability is settled in future years. The requirements for recognition of a tax benefit
for deductible temporary differences and for operating loss carryforwards are the same, and the manner of
reporting the eventual tax benefit recognized (that is, in income or as required by paragraph 740-20-45-3) is
not affected by the intervening transaction reported for tax purposes. Example 20 (see paragraph 740-10-
55-156) illustrates recognition of the tax benefit of an operating loss in the loss year and in subsequent
carryforward years when a valuation allowance is necessary in the loss year.

Reporting the Tax Benefit of Operating Loss Carryforwards or Carrybacks

55-38 Except as noted in paragraph 740-20-45-3, the manner of reporting the tax benefit of an operating loss
carryforward or carryback is determined by the source of the income or loss in the current year and not by the
source of the operating loss carryforward or taxes paid in a prior year or the source of expected future income
that will result in realization of a deferred tax asset for an operating loss carryforward from the current year.
Deferred tax expense (or benefit) that results because a change in circumstances causes a change in judgment
about the future realization of the tax benefit of an operating loss carryforward is allocated to continuing
operations (see paragraph 740-10-45-20). Thus, for example:
a. The tax benefit of an operating loss carryforward that resulted from a loss on discontinued operations in
a prior year and that is first recognized in the financial statements for the current year:
1. Is allocated to continuing operations if it offsets the current or deferred tax consequences of income
from continuing operations
2. Is allocated to a gain on discontinued operations if it offsets the current or deferred tax
consequences of that gain
3. Is allocated to continuing operations if it results from a change in circumstances that causes a
change in judgment about future realization of a tax benefit.
b. The current or deferred tax benefit of a loss from continuing operations in the current year is
allocated to continuing operations regardless of whether that loss offsets the current or deferred tax
consequences of a gain on discontinued operations that:
1. Occurred in the current year
2. Occurred in a prior year (that is, if realization of the tax benefit will be by carryback refund)
3. Is expected to occur in a future year.

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 Appendix A — Implementation Guidance and Illustrations

ASC 740-10 — Implementation Guidance and Illustrations (continued)

Tax-Planning Strategies
55-39 Expectations about future taxable income incorporate numerous assumptions about actions, elections,
and strategies to minimize income taxes in future years. For example, an entity may have a practice of deferring
taxable income whenever possible by structuring sales to qualify as installment sales for tax purposes. Actions
such as that are not tax-planning strategies, as that term is used in this Topic because they are actions that
management takes in the normal course of business. For purposes of applying the requirements of this
Subtopic, a tax-planning strategy is an action that management ordinarily might not take but would take, if
necessary, to realize a tax benefit for a carryforward before it expires. For example, a strategy to sell property
and lease it back for the expressed purpose of generating taxable income to utilize a carryforward before it
expires is not an action that management takes in the normal course of business. A qualifying tax-planning
strategy is an action that:
a. Is prudent and feasible. Management must have the ability to implement the strategy and expect to do
so unless the need is eliminated in future years. For example, management would not have to apply the
strategy if income earned in a later year uses the entire amount of carryforward from the current year.
b. An entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward
from expiring unused. All of the various strategies that are expected to be employed for business or tax
purposes other than utilization of carryforwards that would otherwise expire unused are, for purposes
of this Subtopic, implicit in management’s estimate of future taxable income and, therefore, are not tax-
planning strategies as that term is used in this Topic.
c. Would result in realization of deferred tax assets. The effect of qualifying tax-planning strategies must be
recognized in the determination of the amount of a valuation allowance. Tax-planning strategies need
not be considered, however, if positive evidence available from other sources (see paragraph 740-10-30-
18) is sufficient to support a conclusion that a valuation allowance is not necessary.

55-40 Paragraph 740-10-30-19 indicates that tax-planning strategies include elections for tax purposes. The
following are some examples of elections under current U.S. federal tax law that, if they meet the criteria
for tax-planning strategies, should be considered in determining the amount, if any, of valuation allowance
required for deferred tax assets:
a. The election to file a consolidated tax return
b. The election to claim either a deduction or a tax credit for foreign taxes paid
c. The election to forgo carryback and only carry forward a net operating loss.

55-41 Because the effects of known qualifying tax-planning strategies must be recognized (see Example
22 [paragraph 740-10-55-163]), management should make a reasonable effort to identify those qualifying
tax-planning strategies that are significant. Management’s obligation to apply qualifying tax-planning
strategies in determining the amount of valuation allowance required is the same as its obligation to apply the
requirements of other Topics for financial accounting and reporting. However, if there is sufficient evidence
that taxable income from one of the other sources of taxable income listed in paragraph 740-10-30-18 will
be adequate to eliminate the need for any valuation allowance, a search for tax-planning strategies is not
necessary.

55-42 Tax-planning strategies may shift estimated future taxable income between future years. For example,
assume that an entity has a $1,500 operating loss carryforward that expires at the end of next year and that its
estimate of taxable income exclusive of the future reversal of existing temporary differences and carryforwards
is approximately $1,000 per year for each of the next several years. That estimate is based, in part, on the
entity’s present practice of making sales on the installment basis and on provisions in the tax law that result in
temporary deferral of gains on installment sales. A tax-planning strategy to increase taxable income next year
and realize the full tax benefit of that operating loss carryforward might be to structure next year’s sales in a
manner that does not meet the tax rules to qualify as installment sales. Another strategy might be to change
next year’s depreciation procedures for tax purposes.

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55-43 Tax-planning strategies also may shift the estimated pattern and timing of future reversals of temporary
differences. For example, if an operating loss carryforward otherwise would expire unused at the end of
next year, a tax-planning strategy to sell the entity’s installment sale receivables next year would accelerate
the future reversal of taxable temporary differences for the gains on those installment sales. In other
circumstances, a tax-planning strategy to accelerate the future reversal of deductible temporary differences
in time to offset taxable income that is expected in an early future year might be the only means to realize
a tax benefit for those deductible temporary differences if they otherwise would reverse and provide no tax
benefit in some later future year(s). Examples of actions that would accelerate the future reversal of deductible
temporary differences include the following:
a. An annual payment that is larger than an entity’s usual annual payment to reduce a long-term pension
obligation (recognized as a liability in the financial statements) might accelerate a tax deduction for
pension expense to an earlier year than would otherwise have occurred.
b. Disposal of obsolete inventory that is reported at net realizable value in the financial statements would
accelerate a tax deduction for the amount by which the tax basis exceeds the net realizable value of the
inventory.
c. Sale of loans at their reported amount (that is, net of an allowance for bad debts) would accelerate a tax
deduction for the allowance for bad debts.

55-44 A significant expense might need to be incurred to implement a particular tax-planning strategy, or a
significant loss might need to be recognized as a result of implementing a particular tax-planning strategy. In
either case, that expense or loss (net of any future tax benefit that would result from that expense or loss)
reduces the amount of tax benefit that is recognized for the expected effect of a qualifying tax-planning
strategy. For that purpose, the future effect of a differential in interest rates (for example, between the rate
that would be earned on installment sale receivables and the rate that could be earned on an alternative
investment if the tax-planning strategy is to sell those receivables to accelerate the future reversal of related
taxable temporary differences) is not considered.

55-45 Example 21 (see paragraph 740-10-55-159) illustrates recognition of a deferred tax asset based on
the expected effect of a qualifying tax-planning strategy when a significant expense would be incurred to
implement the strategy.

55-46 Under this Subtopic, the requirements for consideration of tax-planning strategies pertain only to the
determination of a valuation allowance for a deferred tax asset. A deferred tax liability ordinarily is recognized
for all taxable temporary differences. The only exceptions are identified in paragraph 740-10-25-3. Certain
seemingly taxable temporary differences, however, may or may not result in taxable amounts when those
differences reverse in future years. One example is an excess of cash surrender value of life insurance over
premiums paid (see paragraph 740-10-25-30). Another example is an excess of the book over the tax basis
of an investment in a domestic subsidiary (see paragraph 740-30-25-7). The determination of whether those
differences are taxable temporary differences does not involve a tax-planning strategy as that term is used in
this Topic.

55-47 Example 22 (see paragraph 740-10-55-163) provides an example where an entity has identified multiple
tax-planning strategies.

55-48 Under current U.S. federal tax law, approval of an entity’s change from taxable C corporation status to
nontaxable S corporation status is automatic if the criteria for S corporation status are met. If an entity meets
those criteria but has not changed to S corporation status, a strategy to change to nontaxable S corporation
status would not permit an entity to not recognize deferred taxes because a change in tax status is a discrete
event. Paragraph 740-10-25-32 requires that the effect of a change in tax status be recognized at the date
that the change in tax status occurs, that is, at the date that the change is approved by the taxing authority (or
on the date of filing the change if approval is not necessary). For example, as required by paragraph 740-10-
25-34, if an election to change an entity’s tax status is approved by the taxing authority (or filed, if approval is
not necessary) early in Year 2 and before the financial statements are issued or are available to be issued (as
discussed in Section 855-10-25) for Year 1, the effect of that change in tax status shall not be recognized in the
financial statements for Year 1.

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Examples of Temporary Differences

55-49 The following guidance presents examples of temporary differences. These examples are intended
to be illustrative and not all-inclusive. Any references to various tax laws shall not be considered definitive
interpretations of such laws for any purpose.

Premiums and Discounts

55-50 Differences between the recognition for financial accounting purposes and income tax purposes
of discount or premium resulting from determination of the present value of a note should be treated as
temporary differences in accordance with this Topic.

Beneficial Conversion Features

55-51 The issuance of convertible debt with a beneficial conversion feature results in a basis difference for
purposes of applying this Topic. The recognition of a beneficial conversion feature effectively creates two
separate instruments-a debt instrument and an equity instrument-for financial statement purposes while it is
accounted for as a debt instrument, for example, under the U.S. Federal Income Tax Code. Consequently, the
reported amount in the financial statements (book basis) of the debt instrument is different from the tax basis
of the debt instrument. The basis difference that results from the issuance of convertible debt with a beneficial
conversion feature is a temporary difference for purposes of applying this Topic because that difference will
result in a taxable amount when the reported amount of the liability is recovered or settled. That is, the liability
is presumed to be settled at its current carrying amount (reported amount). The recognition of deferred taxes
for the temporary difference of the convertible debt with a beneficial conversion feature should be recorded
as an adjustment to additional paid-in capital. Because the beneficial conversion feature (an allocation to
additional paid-in capital) created the basis difference in the debt instrument, the provisions of paragraph
740-20-45-11(c) apply and therefore the establishment of the deferred tax liability for the basis difference
should result in an adjustment to the related components of shareholders’ equity.

Pending Content (Transition Guidance: ASC 815-40-65-1)

Editor’s Note: Paragraph 740-10-55-51 will be superseded upon transition, together with its heading:
Beneficial Conversion Features
55-51 Paragraph superseded by Accounting Standards Update No. 2020-06.

LIFO Inventory of Subsidiary

55-52 An entity may use the LIFO method to value inventories for tax purposes which may result in LIFO
inventory temporary differences, that is, for the excess of the amount of LIFO inventory for financial reporting
over its tax basis.

55-53 Even though a deferred tax liability for the LIFO inventory of a subsidiary will not be settled if that
subsidiary is sold before the LIFO inventory temporary difference reverses, recognition of a deferred tax liability
is required regardless of whether the LIFO inventory happens to belong to the parent entity or one of its
subsidiaries.

Accrued Postretirement Benefit Cost and the Effect of the Nontaxable Subsidy Arising From the Medicare
Prescription Drug, Improvement, and Modernization Act of 2003
55-54 The following guidance and Example 23 (see paragraph 740-10-55-165) refer to provisions of the
Medicare Prescription Drug, Improvement, and Modernization Act of 2003; however, they shall not be
considered definitive interpretations of the Act for any purpose. That Example provides a simple illustration of
this guidance.

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55-55 As indicated in paragraph 715-60-05-9, on December 8, 2003, the president signed the Medicare
Prescription Drug, Improvement, and Modernization Act of 2003 into law. The Act introduces a prescription
drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care
benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. An employer’s
eligibility for the 28 percent subsidy depends on whether the prescription drug benefit available under its plan
is at least actuarially equivalent to the Medicare Part D benefit.

55-56 The Act excludes receipt of the subsidy from the taxable income of the employer for federal income tax
purposes. That provision affects the accounting for the temporary difference related to the employer’s accrued
postretirement benefit cost under the requirements of this Topic.

55-57 In the periods in which the subsidy affects the employer’s accounting for the plan, it shall have no effect
on any plan-related temporary difference accounted for under this Topic because the subsidy is exempt from
federal taxation. That is, the measure of any temporary difference shall continue to be determined as if the
subsidy did not exist. Example 23 (see paragraph 740-10-55-165) provides a simple illustration of this guidance.

Changes in Accounting Methods for Tax Purposes

55-58 The following guidance refers to provisions of the Tax Reform Act of 1986 and the Omnibus Budget
Reconciliation Act of 1987; however, it shall not be considered a definitive interpretation of the Acts for any
purpose.

55-59 A change in tax law may require a change in accounting method for tax purposes, for example, the
uniform cost capitalization rules required by the Tax Reform Act of 1986. For calendar-year taxpayers,
inventories on hand at the beginning of 1987 are revalued as though the new rules had been in effect in prior
years. That initial catch-up adjustment is deferred and taken into taxable income over not more than four years.
This deferral of the initial catch-up adjustment for a change in accounting method for tax purposes gives rise to
two temporary differences.

55-60 One temporary difference is related to the additional amounts initially capitalized into inventory for tax
purposes. As a result of those additional amounts, the tax basis of the inventory exceeds the amount of the
inventory for financial reporting. That temporary difference is considered to result in a deductible amount when
the inventory is expected to be sold. Therefore, the excess of the tax basis of the inventory over the amount of
the inventory for financial reporting as of December 31, 1986, is considered to result in a deductible amount
in 1987 when the inventory turns over. As of subsequent year-ends, the deductible temporary difference to be
considered would be the amount capitalized for tax purposes and not for financial reporting as of those year-
ends. The expected timing of the deduction for the additional amounts capitalized in this example assumes
that the inventory is not measured on a LIFO basis; temporary differences related to LIFO inventories reverse
when the inventory is sold and not replaced as provided in paragraph 740-10-55-13.

55-61 The other temporary difference is related to the deferred income for tax purposes that results from the
initial catch-up adjustment. As stated above, that deferred income likely will be included in taxable income over
four years. Ordinarily, the reversal pattern for this temporary difference should be considered to follow the
tax pattern and would also be four years. This assumes that it is expected that inventory sold will be replaced.
However, under the tax law, if there is a one-third reduction in the amount of inventory for two years running,
any remaining balance of that deferred income is included in taxable income for the second year. If such
inventory reductions are expected, then the reversal pattern will be less than four years.

55-62 Paragraph 740-10-35-4 requires recognition of the effect of a change in tax law or rate in the period that
includes the enactment date. For example, the Tax Reform Act of 1986 was enacted in 1986. Therefore, the
effects are recognized in a calendar-year entity’s 1986 financial statements.

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55-63 The Omnibus Budget Reconciliation Act of 1987 requires family-owned farming businesses to use the
accrual method of accounting for tax purposes. The initial catch-up adjustment to change from the cash to the
accrual method of accounting is deferred. It is included in taxable income if the business ceases to be family-
owned (for example, it goes public). It also is included in taxable income if gross receipts from farming activities
in future years drop below certain 1987 levels as set forth in the tax law. The deferral of the initial catch-up
adjustment for that change in accounting method for tax purposes gives rise to a temporary difference
because an assumption inherent in an entity’s statement of financial position is that the reported amounts of
assets and liabilities will be recovered and settled. Under the requirements of this Topic, deferred tax liabilities
may not be eliminated or reduced because an entity may be able to delay the settlement of those liabilities
by delaying the events that would cause taxable temporary differences to reverse. Accordingly, the deferred
tax liability is recognized. If the events that trigger the payment of the tax are not expected in the foreseeable
future, the reversal pattern of the related temporary difference is indefinite.

Built-in Gains of Nontaxable S Corporations

55-64 An entity may change from taxable C corporation status to nontaxable S corporation status. An entity
that makes that status change shall continue to recognize a deferred tax liability to the extent that the entity
would be subject to a corporate-level tax on net unrecognized built-in gains.

55-65 A C corporation that has temporary differences as of the date of change to S corporation status shall
determine its deferred tax liability in accordance with the tax law. Since the timing of realization of a built-in gain
can determine whether it is taxable, and therefore significantly affect the deferred tax liability to be recognized,
actions and elections that are expected to be implemented shall be considered. For purposes of determining
that deferred tax liability, the lesser of an unrecognized built-in gain (as defined by the tax law) or an existing
temporary difference is used in the computations described in the tax law to determine the amount of the tax
on built-in gains. Example 24 (see paragraph 740-10-55-168) illustrates this guidance.

Unrecognized Gains or Losses From Involuntary Conversions

55-66 Gain or loss resulting from an involuntary conversion of a nonmonetary asset to monetary assets that is
not recognized for income tax reporting purposes in the same period in which the gain or loss is recognized for
financial reporting purposes is a temporary difference for which comprehensive interperiod tax allocation, as
required by this Subtopic, is required.

Treatment of Certain Payments to Taxing Authorities

55-67 An entity may make payments to taxing authorities for different reasons. The following guidance
addresses certain of these payments.

Payment Made to Taxing Authority to Retain Fiscal Year

55-68 The following guidance refers to provisions of the Tax Reform Act of 1986 and the Revenue Act of 1987;
however, it shall not be considered a definitive interpretation of the Acts for any purpose.

55-69 The guidance addresses how a payment should be recorded in the financial statements of an entity for a
payment to a taxing authority to retain their fiscal year.

55-70 On December 22, 1987, the Revenue Act of 1987 was enacted, which allowed partnerships and S
corporations to elect to retain their fiscal year rather than adopt a calendar year for tax purposes as previously
required by the Tax Reform Act of 1986. Entities that elected to retain a fiscal year are required to make an
annual payment in a single installment each year that approximates the income tax that the partners-owners
would have paid on the short-period income had the entity switched to a calendar year. The payment is made
by the entity and is not identified with individual partners-owners. Additionally the amount is not adjusted if a
partner-owner leaves the entity.

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55-71 In this fact pattern, partnerships and S corporations should account for the payment as an asset since
the payment is viewed as a deposit that is adjusted annually and will be realized when the entity liquidates, its
income declines to zero, or it converts to a calendar year-end.

Payment Made Based on Dividends Distributed

55-72 The following guidance refers to provisions which may be present in the French tax structure; however,
it shall not be considered a definitive interpretation of the historical or current French tax structure for any
purpose.

55-73 The French income tax structure is based on the concept of an integrated tax system. The system utilizes
a tax credit at the shareholder level to eliminate or mitigate the double taxation that would otherwise apply
to a dividend. The tax credit is automatically available to a French shareholder receiving a dividend from a
French corporation. The precompte mobilier (or precompte) is a mechanism that provides for the integration
of the tax credit to the shareholder with the taxes paid by the corporation. The precompte is a tax paid by the
corporation at the time of a dividend distribution that is equal to the difference between a tax based on the
regular corporation tax rate applied to the amount of the declared dividend and taxes previously paid by the
corporation on the income being distributed. In addition, if a corporation pays a dividend from earnings that
have been retained for more than five years, the corporation loses the benefit of any taxes previously paid in
the computation of the precompte.

55-74 Paragraph 740-10-15-4(b) sets forth criteria for determining whether a tax that is assessed on an entity
based on dividends distributed is, in effect, a withholding tax for the benefit of recipients of the dividend to be
recorded in equity as part of the dividend distribution in that entity’s separate financial statements. A tax that
is assessed on a corporation based on dividends distributed that meets the criteria in that paragraph, such
as the French precompte tax, should be considered to be in effect a withholding of tax for the recipient of the
dividend and recorded in equity as part of the dividend paid to shareholders.

Excise Tax on Withdrawal of Excess Pension Plan Assets

55-75 An employer that withdraws excess plan assets from its pension plan may be subject to an excise tax.
If the excise tax is independent of taxable income, that is, it is a tax due on a specific transaction regardless of
whether there is any taxable income for the period in which the transaction occurs, it is not an income tax and
the employer should recognize it as an expense (not classified as income taxes) in the period of the withdrawal.

Other Direct Payments to Taxing Authorities

55-76 Example 26 (see paragraph 740-10-55-202) illustrates a transaction directly with a governmental taxing
authority.

55-77 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-78 Paragraph superseded by Accounting Standards Update No. 2015-17.

Income Tax Related Disclosures

55-79 Paragraph 740-10-50-9 requires disclosure of the significant components of income tax expense
attributable to continuing operations. The sum of the amounts disclosed for the components of tax expense
should equal the amount of tax expense that is reported in the statement of earnings for continuing
operations. Insignificant components that are not separately disclosed should be combined and disclosed as
a single amount so that the sum of the amounts disclosed will equal total income tax expense attributable to
continuing operations. Separate disclosure of the tax benefit of operating loss carryforwards and tax credits
and tax credit carryforwards that have been recognized as a reduction of current tax expense and deferred
tax expense is required. There are a number of ways to satisfy that disclosure requirement. Three acceptable
approaches, referred to as the gross method, the net method, and the statutory tax rate reconciliation method,
are illustrated in Example 29 (see paragraph 740-10-55-212).

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55-80 Income tax expense is defined as the sum of current and deferred tax expense, and the amount to be
disclosed under any of the above approaches is only the amount by which total income tax expense from
continuing operations has been reduced by tax credits or an operating loss carryforward. For example, assume
that a tax benefit is recognized for an operating loss or tax credit carryforward by recognizing a deferred tax
asset in Year 1, with no valuation allowance required because of an existing deferred tax liability. Further,
assume that the carryforward is realized on the tax return in Year 2. For financial reporting in Year 2:
a. Current tax expense will be reduced for the tax benefit of the operating loss or tax credit carryforward
realized on the tax return.
b. Deferred tax expense will be larger (or a deferred tax benefit will be smaller) by the same amount.
In those circumstances, the operating loss or tax credit carryforward affects only income tax expense (the sum
of current and deferred tax expense) in Year 1 when a tax asset (with no valuation allowance) is recognized.
There is no effect on income tax expense in Year 2 because the separate effects on current and deferred tax
expense offset each other. Accordingly, the requirement for separate disclosure of the effects of tax credits or
an operating loss carryforward is not applicable for Year 2. However, that disclosure requirement applies to
financial statements for Year 1 that are presented for comparative purposes.

Illustrations
Example 1: The Unit of Account for a Tax Position
55-81 This Example illustrates the initial and subsequent determination by an entity of the unit of account for
a tax position. Paragraph 740-10-25-13 requires an entity to determine an appropriate unit of account for an
individual tax position. The following Cases illustrate:
a. The determination of the unit of account (Case A)
b. A change in the unit of account (Case B).

55-82 Cases A and B share all of the following assumptions.

55-83 An entity anticipates claiming a $1 million research and experimentation credit on its tax return for the
current fiscal year. The credit comprises equal spending on 4 separate projects (that is, $250,000 of tax credit
per project). The entity expects to have sufficient taxable income in the current year to fully utilize the $1
million credit. Upon review of the supporting documentation, management believes it is more likely than not
that the entity will ultimately sustain a benefit of approximately $650,000. The anticipated benefit consists of
approximately $200,000 per project for the first 3 projects and $50,000 for the fourth project.

Case A: Determining the Unit of Account — A Prerequisite to Recognition Assessment

55-84 This Case illustrates an entity’s initial determination of the unit of account for a tax position.

55-85 In its evaluation of the appropriate amount to recognize, management first determines the appropriate
unit of account for the tax position. Because of the magnitude of expenditures in each project, management
concludes that the appropriate unit of account is each individual research project. In reaching this conclusion,
management considers both the level at which it accumulates information to support the tax return and the
level at which it anticipates addressing the issue with taxing authorities. In this Case, upon review of the four
projects including the magnitude of expenditures, management determines that it accumulates information
at the project level. Management also anticipates the taxing authority will address the issues during an
examination at the level of individual projects.

55-86 In evaluating the projects for recognition, management determines that three projects meet the more-
likely-than-not recognition threshold. However, due to the nature of the activities that constitute the fourth
project, it is uncertain that the tax benefit related to this project will be allowed. Because the tax benefit related
to that fourth project does not meet the more-likely-than-not recognition threshold, it should not be recognized
in the financial statements, even though tax positions associated with that project will be included in the tax
return. The entity would recognize a $600,000 financial statement benefit related to the first 3 projects but
would not recognize a financial statement benefit related to the fourth project.

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Case B: Change in the Unit of Account

55-87 This Case illustrates a change in an entity’s initial determination of the unit of account for a tax position.

55-88 In Year 2, the entity increases its spending on research and experimentation projects and anticipates
claiming significantly larger research credits in its Year 2 tax return. In light of the significant increase in
expenditures, management reconsiders the appropriateness of the unit of account and concludes that the
project level is no longer the appropriate unit of account for research credits. This conclusion is based on the
magnitude of spending and anticipated claimed credits and on previous experience and is consistent with the
advice of external tax advisors. Management anticipates the taxing authority will focus the examination on
functional expenditures when examining the Year 2 return and thus needs to evaluate whether it can change
the unit of account in subsequent years’ tax returns.

55-89 Determining the unit of account requires evaluation of the entity’s facts and circumstances. In making
that determination, management evaluates the manner in which it prepares and supports its income tax
return and the manner in which it anticipates addressing issues with taxing authorities during an examination.
The unit of account should be consistently applied to similar positions from period to period unless a change
in facts and circumstances indicates that a different unit of account is more appropriate. Because of the
significant change in the tax position in Year 2, management’s conclusion that the taxing authority will likely
examine tax credits in the Year 2 tax return at a more detailed level than the individual project is reasonable
and appropriate. Accordingly, the entity should reevaluate the unit of account for the Year 2 financial
statements based on the new facts and circumstances.

Example 2: Administrative Practices — Asset Capitalization

55-90 The guidance in paragraph 740-10-25-7(b) on evaluating a taxing authority’s widely understood
administrative practices and precedents shall be taken into account when assessing the more-likely-than-not
recognition threshold established in paragraph 740-10-25-6. This Example illustrates such consideration.

55-91 An entity has established a capitalization threshold of $2,000 for its tax return for routine property and
equipment purchases. Assets purchased for less than $2,000 are claimed as expenses on the tax return in
the period they are purchased. The tax law does not prescribe a capitalization threshold for individual assets,
and there is no materiality provision in the tax law. The entity has not been previously examined. Management
believes that based on previous experience at a similar entity and current discussions with its external tax
advisors, the taxing authority will not disallow tax positions based on that capitalization policy and the taxing
authority’s historical administrative practices and precedents.

55-92 Some might deem the entity’s capitalization policy a technical violation of the tax law, since that law
does not prescribe capitalization thresholds. However, in this situation the entity has concluded that the
capitalization policy is consistent with the demonstrated administrative practices and precedents of the taxing
authority and the practices of other entities that are regularly examined by the taxing authority. Based on its
previous experience with other entities and consultation with its external tax advisors, management believes
the administrative practice is widely understood. Accordingly, because management expects the taxing authority
to allow this position when and if examined, the more-likely-than-not recognition threshold has been met.

Example 3: Administrative Practices — Nexus

55-93 The guidance in paragraph 740-10-25-7(b) on evaluating a taxing authority’s widely understood
administrative practices and precedents shall be taken into account when assessing the more-likely-than-not
recognition threshold established in paragraph 740-10-25-6. This Example illustrates such consideration.

55-94 An entity has been incorporated in Jurisdiction A for 50 years; it has filed a tax return in Jurisdiction A in
each of those 50 years. The entity has been doing business in Jurisdiction B for approximately 20 years and has
filed a tax return in Jurisdiction B for each of those 20 years. However, the entity is not certain of the exact date
it began doing business, or the date it first had nexus, in Jurisdiction B.

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55-95 The entity understands that if a tax return is not filed, the statute of limitations never begins to run;
accordingly, failure to file a tax return effectively means there is no statute of limitations. The entity has become
familiar with the administrative practices and precedents of Jurisdiction B and understands that Jurisdiction B
will look back only six years in determining if there is a tax return due and a deficiency owed. Because of the
administrative practices of the taxing authority and the facts and circumstances, the entity believes it is more
likely than not that a tax return is not required to be filed in Jurisdiction B at an earlier date and that a liability
for tax exposures for those periods is not required.

Example 4: Valuation Allowance and Tax-Planning Strategies

55-96 Paragraph 740-10-30-20 requires that entities determine the amount of available future taxable income
from a tax-planning strategy based on the application of the recognition and measurement requirements of
this Subtopic for tax positions. This Example illustrates the recognition aspect of that requirement.

55-97 An entity has a wholly owned subsidiary with certain deferred tax assets as a result of several years
of losses from operations. Management has determined that it is more likely than not that sufficient future
taxable income will not be available to realize those deferred tax assets. Therefore, management recognizes a
full valuation allowance for those deferred tax assets both in the separate financial statements of the subsidiary
and in the consolidated financial statements of the entity.

55-98 Management has identified certain tax-planning strategies that might enable the realization of those
deferred tax assets. Management has determined that the strategies will meet the minimum statutory
threshold to avoid penalties and that it is not more likely than not that the strategies would be sustained
upon examination based on the technical merits. Accordingly, those strategies may not be used to reduce the
valuation allowance on the deferred tax assets. Only a tax-planning strategy that meets the more-likely-than-not
recognition threshold would be considered in evaluating the sufficiency of future taxable income for realization
of deferred tax assets.

Example 5: Highly Certain Tax Positions

55-99 This Example illustrates the recognition and measurement criteria of this Subtopic to tax positions
where the tax law is unambiguous. The recognition and measurement criteria of this Subtopic applicable to tax
positions begin in paragraph 740-10-25-5 for recognition and paragraph 740-10-30-7 for measurement.

55-100 An entity has taken a tax position that it believes is based on clear and unambiguous tax law for the
payment of salaries and benefits to employees. The class of salaries being evaluated in this tax position is not
subject to any limitations on deductibility (for example, executive salaries are not included), and none of the
expenditures are required to be capitalized (for example, the expenditures do not pertain to the production of
inventories); all amounts accrued at year-end were paid within the statutorily required time frame subsequent
to the reporting date. Management concludes that the salaries are fully deductible.

55-101 All tax positions are subject to the requirements of this Subtopic. However, because the deduction is
based on clear and unambiguous tax law, management has a high confidence level in the technical merits of
this position. Accordingly, the tax position clearly meets the recognition criterion and should be evaluated for
measurement. In determining the amount to measure, management is highly confident that the full amount
of the deduction will be allowed and it is clear that it is greater than 50 percent likely that the full amount of
the tax position will be ultimately realized. Accordingly, the entity would recognize the full amount of the tax
position in the financial statements.

Example 6: Measurement With Information About the Approach to Settlement

55-102 This Example demonstrates an application of the measurement requirements of paragraph 740-10-
30-7 for a tax position that meets the paragraph 740-10-25-6 requirements for recognition. Measurement in
this Example is based on identified information about settlement.

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55-103 In applying the recognition criterion of this Subtopic for tax positions, an entity has determined that
a tax position resulting in a benefit of $100 qualifies for recognition and should be measured. The entity has
considered the amounts and probabilities of the possible estimated outcomes as follows.

Individual Cumulative
Possible Estimated Probability of Probability of
Outcome Occurring (%) Occurring (%)
$ 100 5 5
80 25 30
60 25 55
50 20 75
40 10 85
20 10 95
— 5 100

55-104 Because $60 is the largest amount of benefit that is greater than 50 percent likely of being realized
upon settlement, the entity would recognize a tax benefit of $60 in the financial statements.

Example 7: Measurement With More Limited Information About the Approach to Settlement
55-105 As in the preceding Example, this Example also demonstrates an application of the measurement
requirements of paragraph 740-10-30-7 for a tax position determined to meet recognition requirements. While
measurement in this Example is also based on identified information about settlement, the information is more
limited than in the preceding Example.

55-106 In applying the recognition criterion of this Subtopic for tax positions an entity has determined that a
tax position resulting in a benefit of $100 qualifies for recognition and should be measured. There is limited
information about how a taxing authority will view the position. After considering all relevant information,
management’s confidence in the technical merits of the tax position exceeds the more-likely-than-not
recognition threshold, but management also believes it is likely it would settle for less than the full amount of
the entire position when examined. Management has considered the amounts and the probabilities of the
possible estimated outcomes.

Individual Cumulative
Possible Estimated Probability of Probability of
Outcome Occurring (%) Occurring (%)
$ 100 25 25
75 50 75
50 25 100

55-107 Because $75 is the largest amount of benefit that is greater than 50 percent likely of being realized
upon settlement, the entity would recognize a tax benefit of $75 in the financial statements.

Example 8: Measurement of a Tax Position After Settlement of a Similar Position

55-108 This Example demonstrates an application of the measurement requirements of paragraph 740-10-
30-7 for a tax position that meets the paragraph 740-10-25-6 requirements for recognition. Measurement in
this Example is based on settlement of a similar tax position with the taxing authority.

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55-109 In applying the recognition criterion of this Subtopic for tax positions, an entity has determined that
a tax position resulting in a benefit of $100 qualifies for recognition and should be measured. In a recent
settlement with the taxing authority, the entity has agreed to the treatment for that position for current and
future years. There are no recently issued relevant sources of tax law that would affect the entity’s assessment.
The entity has not changed any assumptions or computations, and the current tax position is consistent with
the position that was recently settled. In this case, the entity would have a very high confidence level about the
amount that will be ultimately realized and little information about other possible outcomes. Management will
not need to evaluate other possible outcomes because it can be confident of the largest amount of benefit that
is greater than 50 percent likely of being realized upon settlement without that evaluation.

Example 9: Differences Relating to Timing of Deductibility

55-110 This Example demonstrates an application of the measurement requirements of paragraph 740-10-
30-7 for a tax position that meets the paragraph 740-10-25-6 requirements for recognition. Measurement in
this Example is based on the timing of the deduction.

55-111 In Year 1, an entity acquired a separately identifiable intangible asset for $15 million that has an
indefinite life for financial statement purposes and is, therefore, not subject to amortization. Based on some
uncertainty in the tax code, the entity decides for tax purposes to deduct the entire cost of the asset in Year
1. While the entity is certain that the full amount of the intangible is ultimately deductible for tax purposes, the
timing of deductibility is uncertain under the tax code. In applying the recognition criterion of this Subtopic for
tax positions, the entity has determined that the tax position qualifies for recognition and should be measured.
The entity believes it is 25 percent likely it would be able to realize immediate deduction upon settlement,
and it is certain it could sustain a 15-year amortization for tax purposes. Thus, the largest Year 1 benefit that
is greater than 50 percent likely of being realized upon settlement is the tax effect of $1 million (the Year 1
deduction from straight-line amortization of the asset over 15 years).

55-112 At the end of Year 1, the entity should reflect a deferred tax liability for the tax effect of the temporary
difference created by the difference between the financial statement basis of the asset ($15 million) and the
tax basis of the asset computed in accordance with the guidance in this Subtopic for tax positions ($14 million,
the cost of the asset reduced by $1 million of amortization). The entity also should reflect a tax liability for
the tax-effected difference between the as-filed tax position ($15 million deduction) and the amount of the
deduction that is considered more likely than not of being sustained ($1 million). The entity should evaluate
the tax position for accrual of statutory penalties as well as interest expense on the difference between the
amounts reported in the financial statements and the tax position taken in the tax return.

Example 10: Change in Timing of Deductibility

55-113 This Example demonstrates an application of the measurement requirements of paragraph 740-10-
30-7 for a tax position that meets the paragraph 740-10-25-6 requirements for recognition. Measurement in
this Example is based on a change in timing of deductibility.

55-114 In 20X1 an entity took a tax position in which it amortizes the cost of an acquired asset on a straight-line
basis over three years, while the amortization period for financial reporting purposes is seven years. After one
year, the entity has deducted one-third of the cost of the asset in its income tax return and one-seventh of the
cost in the financial statements and, consequently, has a deferred tax liability for the difference between the
financial reporting and tax bases of the asset.

55-115 In accordance with the requirements of this Subtopic, the entity evaluates the tax position as of the
reporting date of the financial statements. In 20X2, the entity determines that it is still certain that the entire
cost of the acquired asset is fully deductible, so the more-likely-than-not recognition threshold has been met
according to paragraph 740-10-25-6. However, in 20X2, the entity now believes based on new information
that the largest benefit that is greater than 50 percent likely of being realized upon settlement is straight-line
amortization over 7 years.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-116 In this Example, the entity would recognize a liability for unrecognized tax benefits based on the
difference between the three- and seven-year amortization. In 20X2, no deferred tax liability should be
recognized, as there is no longer a temporary difference between the financial statement carrying value of the
asset and the tax basis of the asset based on this Subtopic’s measurement requirements for tax positions.
Additionally, the entity should evaluate the need to accrue interest and penalties, if applicable under the tax law.

Example 11: Information Becomes Available Before Issuance of Financial Statements

55-117 Paragraphs 740-10-25-6 and 740-10-25-8 require that tax positions be recognized and measured
based on information available at the reporting date. This Example demonstrates the effect of information
becoming available after the reporting date but before the financial statements are issued or are available to be
issued (as discussed in Section 855-10-25).

55-118 Entity A has evaluated a tax position at its most recent reporting date and has concluded that the
position meets the more-likely-than-not recognition threshold. In evaluating the tax position for recognition,
Entity A considered all relevant sources of tax law, including a court case in which the taxing authority has
fully disallowed a similar tax position with an unrelated entity (Entity B). The taxing authority and Entity B are
aggressively litigating the matter. Although Entity A was aware of that court case at the recent reporting date,
management determined that the more-likely-than-not recognition threshold had been met. After the reporting
date, but before the financial statements are issued or are available to be issued (as discussed in Section
855-10-25), the taxing authority prevailed in its litigation with Entity B, and Entity A concludes that it is no longer
more likely than not that it will sustain the position.

55-119 Paragraph 740-10-40-2 provides the guidance that an entity shall derecognize a previously recognized
tax position in the first period in which it is no longer more likely than not that the tax position would be
sustained upon examination, and paragraphs 740-10-25-14; 740-10-35-2; and 740-10-40-2 establish that
subsequent recognition, derecognition, and measurement shall be based on management’s best judgment
given the facts, circumstances, and information available at the reporting date. Because the resolution of Entity
B’s litigation with the taxing authority is the information that caused Entity A to change its judgment about
the sustainability of the position and that information was not available at the reporting date, the change in
judgment would be recognized in the first quarter of the current fiscal year.

Example 12: Basic Deferred Tax Recognition

55-120 This Example illustrates the guidance in paragraphs 740-10-55-7 through 55-9 relating to recognition of
deferred tax assets and liabilities, including when a detailed analysis of sources of taxable income may not be
necessary in considering the need for a valuation allowance for deferred tax assets. In this Example, an entity
has $2,400 of deductible temporary differences and $1,500 of taxable temporary differences at the end of Year
3 (the current year).

55-121 A deferred tax liability is recognized at the end of Year 3 for the $1,500 of taxable temporary
differences, and deferred tax asset is recognized for the $2,400 of deductible temporary differences. All
available evidence, both positive and negative, is considered to determine whether, based on the weight of that
evidence, a valuation allowance is needed for some portion or all of the deferred tax asset. If evidence about
one or more sources of taxable income (see paragraph 740-10-30-18) is sufficient to support a conclusion that
a valuation allowance is not needed, other sources of taxable income need not be considered. For example,
if the weight of available evidence indicates that taxable income will exceed $2,400 in each future year, a
conclusion that no valuation allowance is needed can be reached without considering the pattern and timing of
the reversal of the temporary differences, the existence of qualifying tax-planning strategies, and so forth.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-122 Similarly, if the deductible temporary differences will reverse within the next 3 years and taxable income
in the current year exceeds $2,400, nothing needs to be known about future taxable income exclusive of
reversing temporary differences because the deferred tax asset could be realized by carryback to the current
year. A valuation allowance is needed, however, if the weight of available evidence indicates that some portion
or all of the $2,400 of tax deductions from future reversals of the deductible temporary differences will not be
realized by offsetting any of the following:
a. The $1,500 of taxable temporary differences and $900 of future taxable income exclusive of reversing
temporary differences
b. $2,400 of future taxable income exclusive of reversing temporary differences
c. $2,400 of taxable income in the current or prior years by loss carryback to those years
d. $2,400 of taxable income in one or more of the circumstances described above and as a result of a
qualifying tax-planning strategy (see paragraphs 740-10-55-39 through 55-48).
Paragraph 740-10-55-8 provides guidance on when a detailed analysis of sources of taxable income may not be
necessary in considering the need for a valuation allowance for deferred tax assets.

55-123 Detailed analyses are not necessary, for example, if the entity earned $500 of taxable income in each
of Years 1–3 and there is no evidence to suggest it will not continue to earn that level of taxable income in
future years. That level of future taxable income is more than sufficient to realize the tax benefit of $2,400
of tax deductions over a period of at least 19 years (the year(s) of the deductions, 3 carryback years, and 15
carryforward years) in the U.S. federal tax jurisdiction.

Example 13: Valuation Allowance for Deferred Tax Assets

55-124 This Example illustrates the guidance in paragraphs 740-10-55-7 through 55-9 relating to recognition
of a valuation allowance for a portion of a deferred tax asset in one year and a subsequent change in
circumstances that requires adjustment of the valuation allowance at the end of the following year. This
Example has the following assumptions:
a. At the end of the current year (Year 3), an entity’s only temporary differences are deductible temporary
differences in the amount of $900.
b. Pretax financial income, taxable income, and taxes paid for each of Years 1-3 are all positive, but
relatively negligible, amounts.
c. The enacted tax rate is 40 percent for all years.

55-125 A deferred tax asset in the amount of $360 ($900 at 40 percent) is recognized at the end of Year 3. If
management concludes, based on an assessment of all available evidence (see guidance in paragraphs 740-10-
30-17 through 30-24), that it is more likely than not that future taxable income will not be sufficient to realize
a tax benefit for $400 of the $900 of deductible temporary differences at the end of the current year, a $160
valuation allowance ($400 at 40 percent) is recognized at the end of Year 3.
55-126 Assume that pretax financial income and taxable income for Year 4 turn out to be as follows.

Pretax financial loss $ (50)

Reversing deductible temporary

differences (300)
Loss carryforward for tax purposes $ (350)

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-127 The $50 pretax loss in Year 4 is additional negative evidence that must be weighed against available
positive evidence to determine the amount of valuation allowance necessary at the end of Year 4. Deductible
temporary differences and carryforwards at the end of Year 4 are as follows.

Loss carryforward from Year 4 for tax purposes

(see above) $ 350
Unreversed deductible temporary differences
($900 – $300) 600
$ 950

55-128 The $360 deferred tax asset recognized at the end of Year 3 is increased to $380 ($950 at 40 percent)
at the end of Year 4. Based on an assessment of all evidence available at the end of Year 4, management
concludes that it is more likely than not that $240 of the deferred tax asset will not be realized and, therefore,
that a $240 valuation allowance is necessary. The $160 valuation allowance recognized at the end of Year 3
is increased to $240 at the end of Year 4. The $60 net effect of those 2 adjustments (the $80 increase in the
valuation allowance less the $20 increase in the deferred tax asset) results in $60 of deferred tax expense that
is recognized in Year 4.

Example 14: Phased-In Change in Tax Rates

55-129 This Example illustrates the guidance in paragraph 740-10-55-23 for determination of the tax rate for
measurement of a deferred tax liability for taxable temporary differences when there is a phased-in change in
tax rates. At the end of Year 3 (the current year), an entity has $2,400 of taxable temporary differences, which
are expected to result in taxable amounts of approximately $800 on the future tax returns for each of Years
4–6. Enacted tax rates are 35 percent for Years 1–3, 40 percent for Years 4–6, and 45 percent for Year 7 and
thereafter.

55-130 The tax rate that is used to measure the deferred tax liability for the $2,400 of taxable temporary
differences differs depending on whether the tax effect of future reversals of those temporary differences is on
taxes payable for Years 1–3, Years 4–6, or Year 7 and thereafter. The tax rate for measurement of the deferred
tax liability is 40 percent whenever taxable income is expected in Years 4–6. If tax losses are expected in Years
4–6, however, the tax rate is:
a. 35 percent if realization of a tax benefit for those tax losses in Years 4–6 will be by loss carryback to
Years 1–3
b. 45 percent if realization of a tax benefit for those tax losses in Years 4–6 will be by loss carryforward to
Year 7 and thereafter.

Example 15: Change in Tax Rates

55-131 This Example illustrates the guidance in paragraph 740-10-55-23 for determination of the tax rate for
measurement of a deferred tax asset for deductible temporary differences when there is a change in tax rates.
This Example has the following assumptions:
a. Enacted tax rates are 30 percent for Years 1–3 and 40 percent for Year 4 and thereafter.
b. At the end of Year 3 (the current year), an entity has $900 of deductible temporary differences, which are
expected to result in tax deductions of approximately $300 on the future tax returns for each of Years 4–6.

55-132 The tax rate is 40 percent if the entity expects to realize a tax benefit for the deductible temporary
differences by offsetting taxable income earned in future years. Alternatively, the tax rate is 30 percent if the
entity expects to realize a tax benefit for the deductible temporary differences by loss carryback refund.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-133 Further assume for this Example both of the following:

a. The entity recognizes a $360 ($900 at 40 percent) deferred tax asset to be realized by offsetting taxable
income in future years.
b. Taxable income and taxes payable in each of Years 1–3 were $300 and $90, respectively.

55-134 Realization of a tax benefit of at least $270 ($900 at 30 percent) is assured because carryback refunds
totaling $270 may be realized even if no taxable income is earned in future years. Recognition of a valuation
allowance for the other $90 ($360 – $270) of the deferred tax asset depends on management’s assessment of
whether, based on the weight of available evidence, a portion or all of the tax benefit of the $900 of deductible
temporary differences will not be realized at 40 percent tax rates in future years.

55-135 Alternatively, if enacted tax rates are 40 percent for Years 1–3 and 30 percent for Year 4 and thereafter,
measurement of the deferred tax asset at a 40 percent tax rate could only occur if tax losses are expected in
future Years 4–6.

Example 16: Graduated Tax Rates

55-136 This Example illustrates the guidance in paragraph 740-10-55-23 for determination of the average
graduated tax rate for measurement of deferred tax liabilities and assets by an entity for which graduated tax
rates ordinarily are a significant factor. At the end of Year 3 (the current year), an entity has $1,500 of taxable
temporary differences and $900 of deductible temporary differences, which are expected to result in net taxable
amounts of approximately $200 on the future tax returns for each of Years 4–6. Enacted tax rates are 15 percent
for the first $500 of taxable income, 25 percent for the next $500, and 40 percent for taxable income over $1,000.
This Example assumes that there is no income (for example, capital gains) subject to special tax rates.

55-137 The deferred tax liability and asset for those reversing taxable and deductible temporary differences
in Years 4–6 are measured using the average graduated tax rate for the estimated amount of annual taxable
income in future years. Thus, the average graduated tax rate will differ depending on the expected level of
annual taxable income (including reversing temporary differences) in Years 4–6. The average tax rate will be:
a. 15 percent if the estimated annual level of taxable income in Years 4–6 is $500 or less
b. 20 percent if the estimated annual level of taxable income in Years 4–6 is $1,000
c. 30 percent if the estimated annual level of taxable income in Years 4–6 is $2,000.

55-138 Temporary differences usually do not reverse in equal annual amounts as in the Example above, and
a different average graduated tax rate might apply to reversals in different future years. However, a detailed
analysis to determine the net reversals of temporary differences in each future year usually is not warranted. It
is not warranted because the other variable (that is, taxable income or losses exclusive of reversing temporary
differences in each of those future years) for determination of the average graduated tax rate in each future
year is no more than an estimate. For that reason, an aggregate calculation using a single estimated average
graduated tax rate based on estimated average annual taxable income in future years is sufficient. Judgment
is permitted, however, to deal with unusual situations, for example, an abnormally large temporary difference
that will reverse in a single future year, or an abnormal level of taxable income that is expected for a single
future year. The lowest graduated tax rate should be used whenever the estimated average graduated tax rate
otherwise would be zero.

Example 17: Determining Whether a Tax Is an Income Tax

55-139 The guidance in paragraph 740-10-55-26 addressing when a tax is an income tax is illustrated using the
following historical example.

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-139 The guidance in paragraph 740-10-55-26 addressing when a tax is an income tax is illustrated
using the following example.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-140 In August 1991, a state amended its franchise tax statute to include a tax on income apportioned to
the state based on the federal tax return. The new tax was effective January 1, 1992. The amount of franchise
tax on each corporation was set at the greater of 0.25 percent of the corporation’s net taxable capital and 4.5
percent of the corporation’s net taxable earned surplus. Net taxable earned surplus was a term defined by the
tax statute for federal taxable income.

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-140 A state’s franchise tax on each corporation is set at the greater of 0.25 percent of the corporation’s
net taxable capital and 4.5 percent of the corporation’s net taxable earned surplus. Net taxable earned
surplus is a term defined by the tax statute for federal taxable income.

55-141 In this Example, the total computed tax is an income tax only to the extent that the tax exceeds the
capital-based tax in a given year.

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-141 In this Example, the amount of franchise tax equal to the tax on the corporation’s net taxable
earned surplus is an income tax.

55-142 A deferred tax liability is required to be recognized under this Subtopic for the amount by which the
income-based tax payable on net reversing temporary differences in each future year exceeds the capital-
based tax computed for each future year based on the level of capital that exists as of the end of the year for
which deferred taxes are being computed.

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-142 Deferred tax assets and liabilities are required to be recognized under this Subtopic for the
temporary differences that exist as of the date of the statement of financial position using the tax rate to
be applied to the corporation’s net taxable earned surplus (4.5 percent).

55-143 The portion of the current tax liability based on income is required to be accrued with a charge to
income during the period in which the income is earned. The portion of the deferred tax liability related to
temporary differences is required to be recognized as of the date of the statement of financial position for
temporary differences that exist as of the date of the statement of financial position.

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-143 The portion of the total computed franchise tax that exceeds the amount equal to the tax on the
corporation’s net taxable earned surplus should not be presented as a component of income tax expense
during any period in which the total computed franchise tax exceeds the amount equal to the tax on the
corporation’s net taxable earned surplus.

55-144 Because the state tax is an income tax only to the extent that the tax exceeds the capital-based
tax in a given year, under the requirements of this Subtopic, deferred taxes are recognized for temporary
differences that will reverse in future years for which annual taxable income is expected to exceed 5.5% (.25%
of net taxable capital/4.5% of taxable income) of expected net taxable capital. In measuring deferred taxes,
see paragraph 740-10-55-138 to determine whether a detailed analysis of the net reversals of temporary
differences in each future year is warranted. While the tax statutes of states differ, the accounting described
above would be appropriate if the tax structure of another state was essentially the same as in this Example.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-144 While the tax statutes of states or other jurisdictions differ, the accounting described in paragraphs
740-10-55-140 through 55-143 would be appropriate if the tax structure of another state or jurisdiction
was essentially the same as in this Example.

Example 18: Special Deductions

55-145 Paragraph 740-10-55-27 introduces guidance relating to a special deduction for qualified production
activities that may be available to an entity under the American Jobs Creation Act of 2004.

55-146 This Example illustrates how an entity with a calendar year-end would apply paragraphs 740-10-25-37
and 740-10-35-4 to the qualified production activities deduction at December 31, 2004. In particular, this
Example illustrates the methodology used to evaluate the qualified production activities deduction’s effect on
determining the need for a valuation allowance on an entity’s existing net deferred tax assets. This Example
intentionally is not comprehensive (for example, it excludes state and local taxes).

55-147 This Example has the following assumptions:

a. Expected taxable income (excluding the qualified production activities deduction and net operating loss
carryforwards) for 2005: $21,000
b. Expected qualified production activities income for 2005: $50,000
c. Net operating loss carryforwards at December 31, 2004, which expire in 2005: $20,000
d. Expected W-2 wages for 2005: $10,000
e. Assumed statutory income tax rate: 35%
f. Qualified production activities deduction: 3% of the lesser of qualified production activities income or
taxable income (after deducting the net operating loss carryforwards); limited to 50% of W-2 wages: $30.

55-148 Based on these assumptions, the entity would not recognize a valuation allowance for the net operating
loss carryforwards at December 31, 2004, because expected taxable income in 2005 (after deducting the
qualified production activities deduction) exceeds the net operating loss carryforwards, as follows.

Analysis to compute the qualified production activities deduction

Expected taxable income (excluding the qualified production activities
deduction and net operating loss carryforwards) for the year 2005 $ 21,000
Less net operating loss carryforwards(a) 20,000
Expected taxable income (after deducting the net operating loss
carryforwards) $ 1,000
Qualified production activities deduction $ 30
The Act requires that net operating loss carryforwards be deducted from the taxable income in determining the
(a)

qualified production activities deduction. Therefore, the qualified production activities deduction will not result in
a need for a valuation allowance for an entity’s deferred tax asset for net operating loss carryforwards. However,
certain types of tax credit carryforwards are not deducted in determining the qualified production activities
deduction and, therefore, could require a valuation allowance.

Analysis to determine the effect of the qualified production activities deduction on the need for a
valuation allowance for deferred tax assets for the net operating loss carryforwards
Expected taxable income after deducting the qualified production
activities deduction $ 20,970
Net operating loss carryforwards 20,000
Expected taxable income exceeds the net operating loss carryforwards $ 970

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

Example 19: Recognizing Tax Benefits of Operating Loss

55-149 This Example illustrates the guidance in paragraphs 740-10-55-35 through 55-36 for recognition of
the tax benefit of an operating loss in the loss year and in subsequent carryforward years when a valuation
allowance is necessary in the loss year. This Example has the following assumptions:
a. The enacted tax rate is 40 percent for all years.
b. An operating loss occurs in Year 5.
c. The only difference between financial and taxable income results from use of accelerated depreciation for
tax purposes. Differences that arise between the reported amount and the tax basis of depreciable assets
in Years 1–7 will result in taxable amounts before the end of the loss carryforward period from Year 5.
d. Financial income, taxable income, and taxes currently payable or refundable are as follows.
Year 1 Years 2–4 Year 5 Year 6 Year 7
Pretax financial
income (loss) $ 2,000 $ 5,000 $ (8,000) $ 2,200 $ 7,000
Depreciation
differences (800) (2,200) (800) (700) (600)
Loss carryback — — 2,800 — —
Loss carryforward — — — (6,000) (4,500)
Taxable income
(loss) $ 1,200 $ 2,800 $ (6,000) $ (4,500) $ 1,900
Taxes payable
(refundable) $ 480 $ 1,120 $ (1,120) $ — $ 760

e. At the end of Year 5, profits are not expected in Years 6 and 7 and later years, and it is concluded that a
valuation allowance is necessary to the extent realization of the deferred tax asset for the operating loss
carryforward depends on taxable income (exclusive of reversing temporary differences) in future years.

55-150 The deferred tax liability for the taxable temporary differences is calculated at the end of each year as
follows.

Year 1 Years 2–4 Year 5 Year 6 Year 7

Unreversed differences:
Beginning amount $ — $ 800 $ 3,000 $ 3,800 $ 4,500
Additional amount 800 2,200 800 700 600
Total $ 800 $ 3,000 $ 3,800 $ 4,500 $ 5,100
Deferred tax liability
(40 percent) $ 320 $ 1,200 $ 1,520 $ 1,180 $ 2,040

55-151 The deferred tax asset and related valuation allowance for the loss carryforward are calculated at the
end of each year as follows.

Year 1 Years 2–4 Year 5 Year 6 Year 7

Loss carryforward for
tax purposes $ — $ — $ 6,000 $ 4,500 $ —
Deferred tax asset
(40 percent) $ — $ — $ 2,400 $ 1,800 $ —
Valuation allowance equal
to the amount by which the
deferred tax asset exceeds
the deferred tax liability — — (880) — —
Net deferred tax asset $ — $ — $ 1,520 $ 1,800 $ —

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-152 Total tax expense for each period is as follows.

Year 1 Years 2–4 Year 5 Year 6 Year 7

Deferred tax expense
(benefit):
Increase in deferred tax
liability $ 320 $ 880 $ 320 $ 280 $ 240
(Increase) decrease in net
deferred tax asset — — (1,520) (280) 1,800
320 880 (1,200) — 2,040
Currently payable
(refundable) 480 1,120 (1,120) — 760
Total tax expense (benefit) $ 800 $ 2,000 $ (2,320) $ — $ 2,800

55-153 In Year 5, $2,800 of the loss is carried back to reduce taxable income in Years 2–4, and $1,120 of
taxes paid for those years is refunded. In addition, a $1,520 deferred tax liability is recognized for $3,800 of
taxable temporary differences, and a $2,400 deferred tax asset is recognized for the $6,000 loss carryforward.
However, based on the conclusion described in paragraph 740-10-55-149(e), a valuation allowance is
recognized for the amount by which that deferred tax asset exceeds the deferred tax liability.

55-154 In Year 6, a portion of the deferred tax asset for the loss carryforward is realized because taxable
income is earned in that year. The remaining balance of the deferred tax asset for the loss carryforward at the
end of Year 6 equals the deferred tax liability for the taxable temporary differences. A valuation allowance is not
needed.

55-155 In Year 7, the remaining balance of the loss carryforward is realized, and $760 of taxes are payable on
net taxable income of $1,900. A $2,040 deferred tax liability is recognized for the $5,100 of taxable temporary
differences.

Example 20: Interaction of Loss Carryforwards and Temporary Differences

55-156 This Example illustrates the guidance in paragraph 740-10-55-37 for the interaction of loss
carryforwards and temporary differences that will result in net deductible amounts in future years. This
Example has the following assumptions:
a. The financial loss and the loss reported on the tax return for an entity’s first year of operations are the
same.
b. In Year 2, a gain of $2,500 from a transaction that is a sale for tax purposes but a sale and leaseback for
financial reporting is the only difference between pretax financial income and taxable income.

Pending Content (Transition Guidance: ASC 842-10-65-1)

55-156 This Example illustrates the guidance in paragraph 740-10-55-37 for the interaction of loss
carryforwards and temporary differences that will result in net deductible amounts in future years. This
Example has the following assumptions:
a. The financial loss and the loss reported on the tax return for an entity’s first year of operations are
the same.
b. In Year 2, a gain of $2,500 from a transaction that is a sale for tax purposes but does not meet
the sale recognition criteria for financial reporting purposes is the only difference between pretax
financial income and taxable income.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-157 Financial and taxable income in this Example are as follows.

Financial Taxable
Income Income
Year 1: Income (loss) from operations $ (4,000) $ (4,000)
Year 2: Income (loss) from operations $ — $ —
Taxable gain on sale 2,500
Taxable income before loss carryforward 2,500
Loss carryforward from Year 1 (4,000)

Taxable income $ —

55-158 The $4,000 operating loss carryforward at the end of Year 1 is reduced to $1,500 at the end of Year 2
because $2,500 of it is used to reduce taxable income. The $2,500 reduction in the loss carryforward becomes
$2,500 of deductible temporary differences that will reverse and result in future tax deductions when lease
payments are made. The entity has no deferred tax liability to be offset by those future tax deductions, the
future tax deductions cannot be realized by loss carryback because no taxes have been paid, and the entity
has had pretax losses for financial reporting since inception. Unless positive evidence exists that is sufficient to
overcome the negative evidence associated with those losses, a valuation allowance is recognized at the end of
Year 2 for the full amount of the deferred tax asset related to the $2,500 of deductible temporary differences
and the remaining $1,500 of operating loss carryforward.

Pending Content (Transition Guidance: ASC 842-10-65-1)

55-158 The $4,000 operating loss carryforward at the end of Year 1 is reduced to $1,500 at the end
of Year 2 because $2,500 of it is used to reduce taxable income. The $2,500 reduction in the loss
carryforward becomes $2,500 of deductible temporary differences that will reverse and result in future
tax deductions when the sale occurs (that is, control of the asset transfers to the buyer-lessor). The entity
has no deferred tax liability to be offset by those future tax deductions, the future tax deductions cannot
be realized by loss carryback because no taxes have been paid, and the entity has had pretax losses
for financial reporting since inception. Unless positive evidence exists that is sufficient to overcome the
negative evidence associated with those losses, a valuation allowance is recognized at the end of Year 2
for the full amount of the deferred tax asset related to the $2,500 of deductible temporary differences
and the remaining $1,500 of operating loss carryforward.

Example 21: Tax-Planning Strategy With Significant Implementation Cost

55-159 This Example illustrates the guidance in paragraph 740-10-55-44 for recognition of a deferred tax asset
based on the expected effect of a qualifying tax-planning strategy when a significant expense would be incurred
to implement the strategy. This Example has the following assumptions:
a. A $900 operating loss carryforward expires at the end of next year.
b. Based on historical results and the weight of other available evidence, the estimated level of taxable
income exclusive of the future reversal of existing temporary differences and the operating loss
carryforward next year is $100.
c. Taxable temporary differences in the amount of $1,200 ordinarily would result in taxable amounts of
approximately $400 in each of the next 3 years.
d. There is a qualifying tax-planning strategy to accelerate the future reversal of all $1,200 of taxable
temporary differences to next year.
e. Estimated legal and other expenses to implement that tax-planning strategy are $150.
f. The enacted tax rate is 40 percent for all years.

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55-160 Without the tax-planning strategy, only $500 of the $900 operating loss carryforward could be realized
next year by offsetting $100 of taxable income exclusive of reversing temporary differences and $400 of
reversing taxable temporary differences. The other $400 of operating loss carryforward would expire unused
at the end of next year. Therefore, the $360 deferred tax asset ($900 at 40 percent) would be offset by a $160
valuation allowance ($400 at 40 percent), and a $200 net deferred tax asset would be recognized for the
operating loss carryforward.

55-161 With the tax-planning strategy, the $900 operating loss carryforward could be applied against $1,300 of
taxable income next year ($100 of taxable income exclusive of reversing temporary differences and $1,200 of
reversing taxable temporary differences). The $360 deferred tax asset is reduced by a $90 valuation allowance
recognized for the net-of-tax expenses necessary to implement the tax-planning strategy. The amount of that
valuation allowance is determined as follows.

Legal and other expenses to implement the tax-planning

strategy $ 150
Future tax benefit of those legal and other expenses — $150
at 40 percent 60
$ 90

55-162 In summary, a $480 deferred tax liability is recognized for the $1,200 of taxable temporary differences,
a $360 deferred tax asset is recognized for the $900 operating loss carryforward, and a $90 valuation
allowance is recognized for the net-of-tax expenses of implementing the tax-planning strategy.

Example 22: Multiple Tax-Planning Strategies Available

55-163 This Example illustrates the guidance in paragraphs 740-10-55-39 through 55-48 relating to
tax-planning strategies. An entity might identify several qualifying tax-planning strategies that would either
reduce or eliminate the need for a valuation allowance for a deferred tax asset. For example, assume that an
entity’s required valuation allowance would be reduced $5,000 based on Strategy A, $7,000 based on Strategy
B, and $12,000 based on both strategies. The entity may not recognize the effect of one of those strategies in
the current year and postpone recognition of the effect of the other strategy to a later year.

55-164 The entity should recognize the effect of both tax-planning strategies and reduce the valuation
allowance by $12,000 at the end of the current year. Paragraph 740-10-30-19 provides guidance on
tax-planning strategies and establishes the requirement that strategies meeting the criteria set forth in that
paragraph shall be considered in determining the required valuation allowance.

Example 23: Effects of Subsidy on Temporary Difference

55-165 Paragraph 740-10-55-54 introduces guidance relating to a nontaxable subsidy that may be available to
an entity under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. This Example
illustrates that guidance.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-166 Before the accounting for the effects of the Act, an employer’s carrying amount of accrued
postretirement benefit cost (the amount recognized in the statement of financial position) is $100 for a
noncontributory, unfunded prescription drug benefit plan with only inactive participants who are not yet
eligible to collect benefits. Assuming a tax rate of 35 percent and no corresponding tax basis for the accrued
postretirement benefit cost, the employer would report a $35 deferred tax asset related to that $100
deductible temporary difference. Because the employer has a policy of amortizing gains and losses under
paragraph 715-60-35-29, upon recognition of a $28 actuarial gain resulting from the estimate of the expected
subsidy, neither the carrying amount of accrued postretirement benefit cost nor the deferred tax asset would
change. Subsequently, ignoring interest on the accumulated postretirement benefit obligation (which includes
interest on the subsidy), as the actuarial gain related to the subsidy is amortized as a component of net periodic
postretirement benefit cost, the carrying amount of accrued postretirement cost would be reduced. However,
the associated temporary difference and deferred tax asset would remain unchanged. That is, after the gain
related to the subsidy is amortized in its entirety, the carrying amount of accrued postretirement benefit cost
would be $72, and the deferred tax asset would remain at $35.

55-167 For purposes of simplicity, this Example ignores complexities regarding the amount and timing of
the subsidies reflected in the carrying amount of accrued postretirement benefit cost arising from any of the
following:
a. Netting gains and losses and application of the corridor amortization approach described in paragraph
715-60-35-29
b. Recognition of additional subsidies through amortization of prior service costs that include effects of the
subsidy
c. Reduction in future service and interest costs.
Those complexities must be considered in determining the temporary difference on which the deferred tax
effects under this Topic will be based.

Example 24: Built-In Gains of S Corporation

55-168 This Example illustrates an entity’s change from taxable C corporation status to nontaxable S
corporation status, in accordance with the guidance provided in paragraph 740-10-55-65. This Example has the
following assumptions:
a. An entity’s S corporation election is effective for calendar-year 1990 and that at the conversion date its
assets comprise marketable securities, finished goods inventory, and depreciable assets as follows.

Topic 740
Fair Market Reported Temporary Built-In
Value Tax Basis Amount Differences Gain (Loss)
Marketable securities $ 90 $ 100 $ 80 $ (20) $ (10)
Inventory, (first-in
first-out [FIFO]) 100 50 100 50 50
Depreciable assets 95 80 90 10 10
$ 285 $ 230 $ 270 $ 40 $ 50

b. The entity has no tax loss or credit carryforwards available to offset the built-in gains.
c. The depreciable assets will be recovered by use in operations (and, therefore, will not result in a taxable
amount pursuant to the tax law applied to built-in gains).
d. The marketable securities will be sold in the same year that the inventory is sold, the $50 built-in gain on
the inventory is reduced by the $10 built-in loss on the marketable securities, and $40 would be taxed in
the year that the inventory turns over and the securities are sold. Accordingly, the entity should continue
to display in its statement of financial position a deferred tax liability for that $40 net taxable amount.

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Pending Content (Transition Guidance: ASC 740-10-65-7)

55-168 This Example illustrates an entity’s change from taxable C corporation status to nontaxable S
corporation status, in accordance with the guidance provided in paragraph 740-10-55-65. This Example
has the following assumptions:
a. An entity’s S corporation election is effective for calendar-year 1990 and that at the conversion
date its assets comprise marketable securities, finished goods inventory, and depreciable assets as
follows.

Topic 740
Fair Market Reported Temporary Built-In
Value Tax Basis Amount Differences Gain (Loss)
Marketable
securities $ 90 $ 100 $ 80 $ (20) $ (10)
Inventory, (first-in
first-out [FIFO]) 100 50 100 50 50
Depreciable assets 95 80 90 10 10
$ 285 $ 230 $ 270 $ 40 $ 50

b. The entity has no tax loss or credit carryforwards available to offset the built-in gains.
c. The depreciable assets will be recovered by use in operations (and, therefore, will not result in a
taxable amount pursuant to the tax law applied to built-in gains).
d. The marketable securities will be sold in the same year that the inventory is sold, the $50 built-in
gain on the inventory is reduced by the $10 built-in loss on the marketable securities, and $40
would be taxed in the year that the inventory turns over and the securities are sold. Accordingly,
the entity should continue to display in its statement of financial position a deferred tax liability for
that $40 net taxable amount.

55-169 At subsequent financial statement dates until the end of the 10 years following the conversion date, the
entity should remeasure the deferred tax liability for net built-in gains based on the provisions of the tax law.
Deferred tax expense (or benefit) should be recognized for any change in that deferred tax liability.

Example 25: Purchase Transactions That Are Not Accounted for as Business Combinations
55-170 Paragraph 740-10-25-51 addresses the accounting when an asset is acquired outside of a business
combination and the tax basis of the asset differs from the amount paid. The following Cases illustrate the
required accounting for purchase transactions that are not accounted for as business combinations in the
following circumstances:
a. The amount paid is less than the tax basis of the asset (Case A).
b. The amount paid is more than the tax basis of the asset (Case B).
c. The transaction results in a deferred credit (Case C).
d. A deferred credit is created by a financial asset (Case D).
e. Subparagraph not used.
f. The result is a purchase of future tax benefits (Case F).

Case A: Amount Paid Is Less Than Tax Basis of Asset

55-171 This Case illustrates an asset purchase that is not a business combination in which the amount paid
differs from the tax basis of the asset (tax basis is greater).

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-172 As an incentive for acquiring specific types of equipment in certain sectors, a foreign jurisdiction permits
a deduction, for tax purposes, of an amount in excess of the cost of the acquired asset. To illustrate, assume
that Entity A purchases a machine for $100 and its tax basis is automatically increased to $150. Upon sale of
the asset, there is no recapture of the extra tax deduction. The tax rate is 35 percent.

55-173 In accordance with paragraph 740-10-25-51, the amounts assigned to the equipment and the related
deferred tax asset should be determined using the simultaneous equations method as follows (where FBB is
Final Book Basis; CPP is Cash Purchase Price; and DTA is Deferred Tax Asset):

Equation A (determine the final book basis of the equipment):

FBB – [Tax Rate × (FBB – Tax Basis)] = CPP

Equation B (determine the amount assigned to the deferred tax asset):

(Tax Basis – FBB) × Tax Rate = DTA.

55-174 In this Case, the following variables are known:

a. Tax Basis = $150
b. Tax Rate = 35 percent
c. CPP = $100.

55-175 The unknown variables (FBB and DTA) are solved as follows:

Equation A: FBB = $73

Equation B: DTA = $27.

55-176 Accordingly, the entity would record the following journal entry.

Equipment $73
Deferred tax asset 27
Cash $100

Case B: Amount Paid Is More Than Tax Basis of Asset

55-177 This Case illustrates an asset purchase that is not a business combination in which the amount paid
differs from the tax basis of the asset (tax basis is less).

55-178 Assume that an entity pays $1,000,000 for the stock of an entity in a nontaxable acquisition (that is,
carryover basis for tax purposes). The acquired entity’s sole asset is a Federal Communications Commission
(FCC) license that has a tax basis of zero. Since the acquisition of the entity is in substance the acquisition of
an FCC license, no goodwill is recognized. A deferred tax liability would need to be recorded for the temporary
difference (in this Case, the entire $1,000,000 plus the tax-on-tax effect from increasing the carrying amount of
the FCC license acquired) related to the FCC license. The tax rate is 35 percent.

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55-179 In accordance with paragraph 740-10-25-51, the amounts assigned to the FCC license and the related
deferred tax liability should be determined using the simultaneous equations method as follows (where FBB is
Final Book Basis; CPP is Cash Purchase Price; and DTL is Deferred Tax Liability):

Equation A (determine the FBB of the FCC license):

FBB – [Tax Rate × (FBB – Tax Basis)] = CPP

Equation B (determine the amount assigned to the DTL):

(FBB – Tax Basis) × Tax Rate = DTL.

55-180 In this Case, the following variables are known:

a. Tax Basis = $0
b. Tax Rate = 35 percent
c. CPP = $1,000,000.

55-181 The unknown variables (FBB and DTL) are solved as follows:

Equation A: FBB = $1,538,462

Equation B: DTL = $538,462.

55-182 Accordingly, the entity would record the following journal entry.

FCC license $1,538,462

Deferred tax liability $538,462
Cash $1,000,000

Case C: Transaction Results In Deferred Credit

55-183 This Case provides an illustration of a transaction that results in a deferred credit.

55-184 Entity A buys a machine for $50 with a tax basis of $200. The tax rate is 35 percent.

55-185 In accordance with paragraph 740-10-25-51, the amounts assigned to the machine and the deferred
tax asset should be determined using the simultaneous equations method as follows (where FBB is Final Book
Basis; CPP is Cash Purchase Price; and DTA is Deferred Tax Asset):

Equation A (determine the FBB of the machine):

FBB – [Tax Rate × (FBB – Tax Basis)] = CPP

Equation B (determine the amount assigned to the DTA):

(Tax Basis – FBB) × Tax Rate = DTA.

55-186 In this Case, the following variables are known:

a. Tax Basis = $200
b. Tax Rate = 35 percent
c. CPP = $50.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-187 The unknown variables (FBB and DTA) are solved as follows:

Equation A: FBB = $(31). However, because the FBB cannot be less than zero, the FBB is recorded at zero.

Equation B: DTA = $70.

55-188 The excess of the amount assigned to the deferred tax asset over the cash purchase price paid for the
machine is recorded as a deferred credit. Accordingly, the entity would record the following journal entry.
Machine $—
Deferred tax asset 70
Deferred credit $20
Cash $50

Case D: Deferred Credit Created by Financial Asset

55-189 This Case provides an illustration of a deferred credit created by the acquisition of a financial asset.

55-190 Entity A acquires the stock of another corporation for $250. The principal asset of the corporation is a
marketable equity security with a readily determinable fair value of $200 and a tax basis of $500. The tax rate is
35 percent. The acquired entity has no operations and so the acquisition is accounted for as an asset purchase
and not as a business combination.

55-191 In accordance with paragraph 740-10-25-51, the acquired financial asset should be recognized at fair
value, and a deferred tax asset should be recorded at the amount required by this Subtopic. The excess of the
fair value of the financial asset and the deferred tax asset recorded over the cash purchase price should be
recorded as a deferred credit. Accordingly, the entity would record the following journal entry.

Marketable equity security $200

Deferred tax asset (300 × .35) 105
Deferred credit $55
Cash $250

Case E: Simultaneous Equations Method and Reduction in Preexisting Valuation Allowance

55-192 Paragraph not used.

55-193 Paragraph not used.

55-194 Paragraph not used.

55-195 Paragraph not used.

55-196 Paragraph not used.

55-197 Paragraph not used.

55-198 Paragraph not used.

Case F: Purchase of Future Tax Benefits

55-199 This Case provides an illustration of the purchase of future tax benefits.

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55-200 A foreign entity that has nominal assets other than its net operating loss carryforwards is acquired by
a foreign subsidiary of a U.S. entity for the specific purpose of utilizing the net operating loss carryforwards
(this type of transaction is often referred to as a tax loss acquisition). It is presumed that this transaction
does not constitute a business combination, since the acquired entity has no operations and is merely a shell
entity. As a result of the time value of money and because the target entity is in financial difficulty and has
ceased operations, the foreign subsidiary is able to acquire the shell entity at a discount from the amount
corresponding to the gross deferred tax asset for the net operating loss carryforwards. Assume, for example,
that $2,000,000 is paid for net operating loss carryforwards having a deferred tax benefit of $5,000,000 for
which it is more likely than not that the full benefit will be realized. The tax rate is 35 percent.

55-201 In accordance with paragraph 740-10-25-51, the amount assigned to the deferred tax asset should be
recorded at its gross amount (in accordance with this Subtopic) and the excess of the amount assigned to the
deferred tax asset over the purchase price should be recorded as a deferred credit as follows.

Deferred tax asset $5,000,000

Deferred credit $3,000,000
Cash $2,000,000

Example 26: Direct Transaction With Governmental Taxing Authority

55-202 Guidance is provided on various types of payments made to taxing authorities in paragraphs 740-10-
55-67 through 55-75. This Example illustrates one possible payment situation.

55-203 In this Example, tax laws in a foreign country enable corporate taxpayers to elect to step up the tax
basis for certain fixed assets ($1,000,000) to fair value ($2,000,000) in exchange for a current payment to the
government of 3 percent of the step-up ($30,000). An entity would be expected to avail itself of this election
(and make the upfront payment) as long as it believed that it was likely that it would be able to utilize the
additional deductions (at a tax rate of 35 percent) that were created as a result of the step-up to reduce
future taxable income and that the timing and amount of the resulting future tax savings justified the current
payment. (For purposes of this Example, it is assumed that the transaction that accomplishes this step-up for
tax purposes does not create a taxable temporary difference and is not an intra-entity transfer of inventory
as discussed in paragraph 740-10-25-3(e). A taxable temporary difference would exist, for example, if the tax
benefit associated with the transaction with the governmental taxing authority becomes taxable in certain
situations, such as those described in paragraph 830-740-25-7).

Pending Content (Transition Guidance: ASC 740-10-65-7)

55-203 In this Example, tax laws in a foreign country enable corporate taxpayers to elect to step up the
tax basis for certain fixed assets ($1,000,000) to fair value ($2,000,000) in exchange for a current payment
to the government of 3 percent of the step-up ($30,000). An entity would be expected to avail itself of this
election (and make the upfront payment) as long as it believed that it was likely that it would be able to
utilize the additional deductions (at a tax rate of 35 percent) that were created as a result of the step-up to
reduce future taxable income and that the timing and amount of the resulting future tax savings justified
the current payment. (For purposes of this Example, it is assumed that the transaction that accomplishes
this step-up for tax purposes does not create a taxable temporary difference. A taxable temporary
difference would exist, for example, if the tax benefit associated with the transaction with the governmental
taxing authority becomes taxable in certain situations, such as those described in paragraph 830-740-25-7.)

55-204 In this Example, the tax effects of transactions directly with a taxing authority are recorded directly in
income as follows.

Deferred tax asset $350,000

Deferred tax benefit $320,000
Cash $30,000

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

55-205 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-206 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-207 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-208 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-209 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-210 Paragraph superseded by Accounting Standards Update No. 2015-17.

55-211 Paragraph superseded by Accounting Standards Update No. 2015-17.

Example 29: Disclosure Related to Components of Income Taxes Attributable to Continuing Operations
55-212 Paragraph 740-10-55-79 provides guidance on satisfying the required disclosure of the significant
components of income taxes and identifies three acceptable approaches illustrated in this Example:
a. The gross method (Case A)
b. The net method (Case B)
c. The statutory tax rate reconciliation method (Case C).

55-213 Cases A, B, and C share the following assumptions:

a. An entity has $1,588 of taxable income and $100 of investment tax credits for the current year. The
$100 deferred tax asset for $295 of operating loss carryforwards was fully reserved at the beginning of
the current year.
b. Pretax financial income from continuing operations is $5,000.
c. Income tax expense from continuing operations is $1,500.
d. Effective tax rate is 30%.
e. Statutory tax rate is 34%.

Case A: Gross Method

55-214 The first acceptable approach, illustrated as follows, to disclosure of components of income tax
expense from continuing operations is referred to as the gross method.

Current Deferred
Tax expense before application of
investment tax credits and operating
loss carryforwards $ 540 $ 1,160
Investment tax credits (100) —
Tax benefit of operating loss
carryforwards (100) —
Tax expense from continuing
operations $ 340 $ 1,160

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

Case B: Net Method

55-215 The second acceptable approach, illustrated as follows, to disclosure of components of income tax
expense from continuing operations is referred to as the net method.

Current tax expense (net of $100

investment tax credits and $100 tax
benefit of operating loss
carryforwards) $ 340
Deferred tax expense 1,160
Tax expense from continuing
operations $ 1,500

Case C: Statutory Tax Rate Reconciliation Method

55-216 The third acceptable approach, illustrated as follows, to disclosure of components of income tax
expense from continuing operations is referred to as the statutory tax rate reconciliation method.

Current tax expense $ 340

Deferred tax expense 1,160
Tax expense from continuing
operations $ 1,500

Tax expense at statutory rate $ 1,700

Benefit of investment tax credits (100)
Benefit of operating loss
carryforwards (100)
Tax expense from continuing
operations $ 1,500

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

Example 30: Disclosure Relating to Uncertainty in Income Taxes

55-217 This Example illustrates the guidance in paragraph 740-10-50-15 for disclosures about uncertainty in
income taxes.
The Company or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction, and
various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S.
federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 20X1.
The Internal Revenue Service (IRS) commenced an examination of the Company’s U.S. income tax returns
for 20X2 through 20X4 in the first quarter of 20X7 that is anticipated to be completed by the end of
20X8. As of December 31, 20X7, the IRS has proposed certain significant adjustments to the Company’s
transfer pricing and research credits tax positions. Management is currently evaluating those proposed
adjustments to determine if it agrees, but if accepted, the Company does not anticipate the adjustments
would result in a material change to its financial position. However, the Company anticipates that it is
reasonably possible that an additional payment in the range of $80 to $100 million will be made by the end
of 20X8. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows.

20X7 20X6 20X5

(in thousands)
Balance at January 1 $ 370,000 $ 380,000 $ 415,000
Additions based on tax positions
related to the current year 10,000 5,000 10,000
Additions for tax positions of prior years 30,000 10,000 5,000
Reductions for tax positions of prior years (60,000) (20,000) (30,000)
Settlements (40,000) (5,000) (20,000)
Balance at December 31 $ 310,000 $ 370,000 $ 380,000

At December 31, 20X7, 20X6, and 20X5, there are $60, $55, and $40 million of unrecognized tax benefits
that if recognized would affect the annual effective tax rate.
The Company recognizes interest accrued related to unrecognized tax benefits in interest expense
and penalties in operating expenses. During the years ended December 31, 20X7, 20X6, and 20X5, the
Company recognized approximately $10, $11, and $12 million in interest and penalties. The Company
had approximately $60 and $50 million for the payment of interest and penalties accrued at December
31, 20X7, and 20X6, respectively.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

Example 31: Disclosure Relating to Realizability Estimates of Deferred Tax Asset

55-218 This Example illustrates the guidance in paragraph 275-10-50-8 for disclosure relating to the realizability
estimates of a deferred tax asset.

55-219 In this Example, Entity A develops, manufactures, and markets limited-use vaccines. The entity has a
dominant share of the narrow market it serves. As of December 31, 19X4, the entity has no temporary differences
and has aggregate loss carryforwards of $12 million that originated in prior years and that expire in varying
amounts between 19X5 and 19X7. As of December 31, 19X4, the entity has a deferred tax asset of $4.8 million
that represents the benefit of the remaining $12 million in loss carryforwards, and it has concluded at that date
that a valuation allowance is unnecessary. The loss carryforwards arose during the entity’s development stage
when it incurred high levels of research and development expenses prior to commencing sales. While the entity
has earned, on average, $6 million income before tax (taxable income before carryforwards) in each of the last 5
years, future profitability in this competitive industry depends on continually developing new products. The entity
has a number of promising new vaccines under development, but it is aware that other entities recently began
testing vaccines that would compete with the vaccines being developed by the entity as well as products that
will compete with the vaccines that are currently generating the entity’s profits. Rapid introduction of competing
products or failure of the entity’s development efforts could reduce estimates of future profitability in the near
term, which could affect the entity’s ability to fully utilize its loss carryforward.

55-220 Illustrative disclosure for the entity follows.

The entity has recorded a deferred tax asset of $4.8 million reflecting the benefit of $12 million in loss
carryforwards, which expire in varying amounts between 19X5 and 19X7. Realization is dependent on
generating sufficient taxable income prior to expiration of the loss carryforwards. Although realization
is not assured, management believes it is more likely than not that all of the deferred tax asset will be
realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the
near term if estimates of future taxable income during the carryforward period are reduced.

55-221 In addition to other disclosures, information as to the amount of loss carryforwards and their expiration
dates and the amount of any valuation allowance with respect to the recorded deferred tax asset is required
under This Subtopic.

55-222 The disclosure in this Example informs users that:

a. Realization of the deferred tax asset depends on achieving a certain minimum level of future taxable
income within the next three years.
b. Although management currently believes that achievement of the required future taxable income is
more likely than not, it is at least reasonably possible that this belief could change in the near term,
resulting in establishment of a valuation allowance.

Example 32: Definition of a Tax Position

55-223 Entity A has sales in Jurisdiction S but no physical presence. Management has reviewed the nexus rules
for filing a return in Jurisdiction S and must determine whether filing a tax return in Jurisdiction S is required. In
evaluating the tax position to file a tax return, management should consider all relevant sources of tax law. The
evaluation of nexus has to be made for all jurisdictions where Entity A might be subject to income taxes. Each
of these evaluations is a separate tax position that is subject to the recognition, measurement, and disclosure
requirements of this Subtopic.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

Example 33: Definition of a Tax Position

55-224 Entity S converted to an S Corporation from a C Corporation effective January 1, 20X0. In 20X7, Entity S
disposed of assets subject to built-in gains and reported a tax liability on its 20X7 tax returns. Tax positions to
consider related to the built-in gains tax include, but are not limited to:
a. Whether other assets were sold subject to the built-in gains tax
b. Whether the income associated with the calculation of the taxable amount of the built-in gains is correct
c. Whether the basis associated with the built-in gains calculation is correct.
It should be noted that whether or not Entity S is subject to the built-in gains tax also is a tax position subject to
the provisions of this Subtopic.

Example 34: Definition of a Tax Position

55-225 Entity N, a tax-exempt not-for-profit entity, enters into transactions that may be subject to income tax
on unrelated business income. Tax positions to consider include but are not limited to:
a. Entity N’s characterization of its activities as related or unrelated to its exempt purpose
b. Entity N’s allocation of revenue between activities that relate to its exempt purpose and those that are
allocated to unrelated business income
c. The allocation of Entity N’s expenses between activities that relate to its exempt purpose and those that
are allocated to unrelated business activities.
Even if Entity N were not subject to income taxes on unrelated business income, it still has a tax position of
whether it qualifies as a tax-exempt not-for-profit entity.

Example 35: Attribution of Income Taxes to the Entity or Its Owners

55-226 Entity A, a partnership with two partners—Partner 1 and Partner 2—has nexus in Jurisdiction J.
Jurisdiction J assesses an income tax on Entity A and allows Partners 1 and 2 to file a tax return and use their
pro rata share of Entity A’s income tax payment as a credit (that is, payment against the tax liability of the
owners). Because the owners may file a tax return and utilize Entity A’s payment as a payment against their
personal income tax, the income tax would be attributed to the owners by Jurisdiction J’s laws whether or not
the owners file an income tax return. Because the income tax has been attributed to the owners, payments to
Jurisdiction J for income taxes should be treated as a transaction with the owners. The result would not change
even if there were an agreement between Entity A and its two partners requiring Entity A to reimburse Partners
1 and 2 for any taxes the partners may owe to Jurisdiction J. This is because attribution is based on the laws and
regulations of the taxing authority rather than on obligations imposed by agreements between an entity and its
owners.

Example 36: Attribution of Income Taxes to the Entity or Its Owners

55-227 If the fact pattern in paragraph 740-10-55-226 changed such that Jurisdiction J has no provision for the
owners to file tax returns and the laws and regulations of Jurisdiction J do not indicate that the payments are
made on behalf of Partners 1 and 2, income taxes are attributed to Entity A on the basis of Jurisdiction J’s laws
and are accounted for based on the guidance in this Subtopic.

Example 37: Attribution of Income Taxes to the Entity or Its Owners

55-228 Entity S, an S Corporation, files a tax return in Jurisdiction J. An analysis of the laws and regulations
of Jurisdiction J indicates that Jurisdiction J can hold Entity S and its owners jointly and severally liable for
payment of income taxes. The laws and regulations also indicate that if payment is made by Entity S, the
payments are made on behalf of the owners. Because the laws and regulations attribute the income tax to the
owners regardless of who pays the tax, any payments to Jurisdiction J for income taxes should be treated as a
transaction with its owners.

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ASC 740-10 — Implementation Guidance and Illustrations (continued)

Example 38: Financial Statements of a Group of Related Entities

55-229 Entity A, a partnership with 2 partners, owns a 100 percent interest in Entity B and is required to issue
consolidated financial statements. Entity B is a taxable entity that has unrecognized tax positions and a related
liability for unrecognized tax benefits. Because entities within a consolidated or combined group should
consider the tax positions of all entities within the group regardless of the tax status of the reporting entity,
Entity A should include in its financial statements the assets, liabilities, income, and expenses of both Entity A
and Entity B, including those relating to the implementation of this Subtopic to Entity B. This is required even
though Entity A is a pass-through entity.

ASC 740-20 — Implementation Guidance and Illustrations

Illustrations
Example 1: Allocation to Continuing Operations
55-1 Paragraph 740-20-45-8 states that the amount of income tax expense or benefit allocated to continuing
operations is the tax effect of pretax income or loss from continuing operations that occurred during the year
plus or minus certain adjustments.

55-2 The adjustments include the tax effects of:

a. Changes in circumstances that cause a change in judgment about the realization of deferred tax assets
in future years
b. Changes in tax laws or rates
c. Changes in tax status
d. Tax-deductible dividends paid to shareholders.

55-3 The allocation of income tax expense between pretax income from continuing operations and other items
shall include deferred taxes.

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ASC 740-20 — Implementation Guidance and Illustrations (continued)

55-4 This Example illustrates allocation of current and deferred tax expense. The assumptions are as follows:
a. Tax rates are 40 percent for Years 1, 2, and 3 and 30 percent for Year 4 and subsequent years. No
valuation allowances are required for deferred tax assets.
b. At the end of Year 1, there is a $500 taxable temporary difference relating to the entity’s contracting
operations and a $200 deductible temporary difference related to its other operations. Determination of
the entity’s deferred tax assets and liabilities at the end of Year 1 is as follows.

Future Years
Temporary Differences Year 2 Year 3 Year 4 Total
Contracting operations $ — $ — $ 500 $ 500

Other operations (100) (100) — (200)

$ (100) $ (100) $ 500 $ 300
Enacted tax rate for future years 40% 40% 30%
Deferred tax liability (asset) $ (40) $ (40) $ 150 $ 70

c. During Year 2, the entity decides that it will sell its contracting operations in Year 3. As a result, all
temporary differences related to the contracting operations (the $500 taxable temporary difference that
existed at the end of Year 1, plus an additional $200 taxable temporary difference that arose during Year
2) are now considered to result in taxable amounts in Year 3 because the contracting operations will be
sold in Year 3.
d. At the end of Year 2, the entity also has $300 of deductible temporary differences ($100 of the
temporary difference that existed at the end of Year 1, plus an additional $200 that arose during Year 2)
from continuing operations.
e. For Year 2, the entity has $50 of pretax reported income from continuing operations and $200 of pretax
reported income from discontinued operations.
f. Determination of the entity’s deferred tax asset and liability at the end of Year 2 is as follows.

Future Years
Temporary Differences Year 3 Year 4 Total
Discontinued operations $ 700 $ — $ 700
Continuing operations (200) (100) (300)
$ 500 $ (100) $ 400
Enacted tax rate for future years 40% 30%
Deferred tax liability (asset)
— net $ 200 $ (30) $ 170

55-5 Total deferred tax expense for Year 2 is $100 ($170 – $70). The deferred tax benefit of the deductible
temporary differences related to the entity’s continuing operations during Year 2 is determined as follows.

Deferred tax asset related to the entity’s continuing operations at the

end of Year 2 (40 percent of $200 and 30 percent of $100) $ (110)
Deferred tax asset related to the entity’s continuing operations at the
beginning of Year 2 (40 percent of $200) (80)
Deferred tax benefit for Year 2 $ (30)

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ASC 740-20 — Implementation Guidance and Illustrations (continued)

55-6 The deferred tax expense for taxable temporary differences related to the entity’s discontinued operations
during Year 2 is determined as follows.

Deferred tax liability at the end of Year 2 (40 percent of $700) $ 280
Deferred tax liability at the end of Year 1 (30 percent of $500) (150)
Deferred tax expense for Year 2 $ 130

55-7 Total tax expense and tax expense allocated to continuing and discontinued operations for Year 2 are
determined as follows.

Discontinued Continuing
Operations Operations Total
Pretax reported income $ 200 $ 50 $ 250
Originating and reversing temporary differences, net (200) 100 (100)
Taxable income $ — $ 150 $ 150
Current tax expense (40 percent) $ — $ 60 $ 60
Deferred tax expense (benefit) as determined
above 130 (30) 100
Income tax expense $ 130 $ 30 $ 160

Example 2: Allocations of Income Taxes to Continuing Operations and One Other Item
55-8 If there is only one item other than continuing operations, the portion of income tax expense or benefit
for the year that remains after the allocation to continuing operations is allocated to that item. If there are two
or more items other than continuing operations, the amount that remains after the allocation to continuing
operations is allocated among those other items in proportion to their individual effects on income tax expense
or benefit for the year.

55-9 The following Cases both present allocations of income tax to continuing operations when there is only
one item other than income from continuing operations:
a. Loss from continuing operations with an extraordinary gain (Case A)
b. Income from continuing operations with a loss from discontinued operations (Case B).

Case A: Loss From Continuing Operations With a Gain on Discontinued Operations

55-10 This Case illustrates allocation of income tax expense if there is only one item other than income from
continuing operations. The assumptions are as follows:
a. The entity’s pretax financial income and taxable income are the same.
b. The entity’s ordinary loss from continuing operations is $500.
c. The entity also has a gain on discontinued operations of $900 that is a capital gain for tax purposes.
d. The tax rate is 40 percent on ordinary income and 30 percent on capital gains. Income taxes currently
payable are $120 ($400 at 30 percent).

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ASC 740-20 — Implementation Guidance and Illustrations (continued)

Pending Content (Transition Guidance: ASC 740-10-65-8)

Editor’s Note: Paragraph 740-20-55-10 will be amended upon transition, together with its heading:

Case A: Loss From Continuing Operations With a Gain on Discontinued Operations (Tax Benefit Realizable)
55-10 This Case illustrates allocation of income tax expense if there is only one item other than income from
continuing operations. The assumptions are as follows:
a. The entity’s pretax financial income and taxable income are the same.
b. The entity’s ordinary loss from continuing operations is $500.
c. The entity also has a gain on discontinued operations of $900 that is a capital gain for tax purposes.
d. The tax rate is 40 percent on ordinary income and 30 percent on capital gains. Income taxes
currently payable are $120 ($400 at 30 percent).
e. The entity has determined that the deferred tax asset that would have resulted from the loss from
continuing operations if the gain on discontinued operations had not occurred would be expected to
be realized (that is, a valuation allowance would not have been needed).

55-11 Income tax expense is allocated between the pretax loss from operations and the gain on discontinued
operations as follows.

Total income tax expense $ 120

Tax benefit allocated to the loss from operations (150)
Incremental tax expense allocated to the gain on discontinued operations $ 270

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-11 Income tax expense is allocated between the pretax loss from operations and the gain on
discontinued operations as follows.

Total income tax expense $ 120

Tax benefit allocated to the loss from operations (200)
Incremental tax expense allocated to the gain on discontinued operations $ 320

55-12 The effect of the $500 loss from continuing operations was to offset an equal amount of capital gains that
otherwise would be taxed at a 30 percent tax rate. Thus, $150 ($500 at 30 percent) of tax benefit is allocated
to continuing operations. The $270 incremental effect of the gain on discontinued operations is the difference
between $120 of total tax expense and the $150 tax benefit from continuing operations.

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-12 The effect of the $500 loss from continuing operations was to offset an equal amount of capital
gains that otherwise would be taxed at a 30 percent tax rate. However, the guidance in paragraph 740-20-
45-7 requires that an entity determine the tax effects of pretax income from continuing operations by a
computation that does not consider the tax effects of items that are not included in continuing operations.
The entity has determined that, absent the capital gain from discontinued operations, a valuation
allowance would not have been needed on the deferred tax asset resulting from the $500 loss from
continuing operations. Thus, $200 ($500 at 40 percent) of tax benefit is allocated to continuing operations.
The $320 incremental effect of the gain on discontinued operations is the difference between $120 of
total tax expense and the $200 tax benefit allocated to continuing operations.

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ASC 740-20 — Implementation Guidance and Illustrations (continued)

Case A1: Loss From Continuing Operations With a Gain on Discontinued Operations (Tax Benefit Not
Realizable)

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-12A This Case illustrates allocation of income tax expense if there is only one item other than income
from continuing operations. The assumptions are the same as in Case A except that the entity has
determined that the deferred tax asset that would have resulted from the loss from continuing operations
if the gain on discontinued operations had not occurred would not be expected to be realized (that is, a
valuation allowance would have been needed).

55-12B Income tax expense is allocated between the pretax loss from operations and the gain on
discontinued operations as follows.

Total income tax expense $ 120

Tax benefit allocated to the loss from operations —
Incremental tax expense allocated to the gain on discontinued
operations $ 120

55-12C The effect of the $500 loss from continuing operations was to offset an equal amount of capital
gains that otherwise would be taxed at a 30 percent tax rate. However, the guidance in paragraph 740-20-
45-7 requires that an entity determine the tax effects of pretax income from continuing operations
by a computation that does not consider the tax effects of items that are not included in continuing
operations. The entity has determined that, absent the capital gain from discontinued operations, a
valuation allowance would have been needed on the deferred tax asset resulting from the $500 loss from
continuing operations. Thus, zero tax benefit is allocated to continuing operations. The $120 incremental
income tax expense related to the gain on discontinued operations is the difference between $120 of total
tax expense and the zero tax benefit allocated to continuing operations.

Case B: Income From Continuing Operations With a Loss From Discontinued Operations
55-13 This Case further illustrates the general requirement to determine the tax effects of pretax income from
continuing operations by a computation that does not consider the tax effects of items that are not included in
continuing operations.

55-14 To illustrate, assume that in the current year an entity has $1,000 of income from continuing operations
and a $1,000 loss from discontinued operations. At the beginning of the year, the entity has a $2,000 net
operating loss carryforward for which the deferred tax asset, net of its valuation allowance, is zero, and the
entity did not reduce that valuation allowance during the year. No tax expense should be allocated to income
from continuing operations because the $2,000 loss carryforward is sufficient to offset that income. Thus, no
tax benefit is allocated to the loss from discontinued operations. See paragraph 740-20-45-7 for the exception
to the general requirement when an entity has a loss from continuing operations.

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-14 To illustrate, assume that in the current year an entity has $1,000 of income from continuing
operations and a $1,000 loss from discontinued operations. At the beginning of the year, the entity has
a $2,000 net operating loss carryforward for which the deferred tax asset, net of its valuation allowance,
is zero, and the entity did not reduce that valuation allowance during the year. No tax expense should be
allocated to income from continuing operations because the $2,000 loss carryforward is sufficient to offset
that income. Thus, no tax benefit is allocated to the loss from discontinued operations.

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ASC 740-20 — Implementation Guidance and Illustrations (continued)

Example 3: Allocation of the Benefit of a Tax Credit Carryforward

55-15 This Example illustrates the guidance in paragraphs 740-20-45-7 through 45-8 for allocation of the
tax benefit of a tax credit carryforward that is recognized as a deferred tax asset in the current year. The
assumptions are as follows:
a. The entity’s pretax financial income and taxable income are the same.
b. Pretax financial income for the year comprises $300 from continuing operations and $400 from a gain
on discontinued operations.
c. The tax rate is 40 percent. Taxes payable for the year are zero because $330 of tax credits that arose in
the current year more than offset the $280 of tax otherwise payable on $700 of taxable income.
d. A $50 deferred tax asset is recognized for the $50 ($330 – $280) tax credit carryforward. Based on the
weight of available evidence, management concludes that no valuation allowance is necessary.

55-16 Income tax expense or benefit is allocated between pretax income from continuing operations and the
gain on discontinued operations as follows.

Total income tax benefit $ (50)

Tax expense (benefit) allocated to income from continuing
operations:
Tax (before tax credits) on $300 of taxable income at 40
percent $ 120
Tax credits (330) (210)
Tax expense allocated to the gain on discontinued operations $ 160

55-17 Absent the gain on discontinued operations and assuming it was not the deciding factor in reaching a
conclusion that a valuation allowance is not needed, the entire tax benefit of the $330 of tax credits would be
allocated to continuing operations. The presence of the gain on discontinued operations does not change that
allocation.

Example 4: Allocation to Other Comprehensive Income

55-18 Income taxes are sometimes allocated directly to shareholders’ equity or to other comprehensive
income. This Example illustrates the allocation of income taxes for translation adjustments under the
requirements of Subtopic 830-30 to other comprehensive income. In this Example, FC represents units of
foreign currency.

55-19 A foreign subsidiary has earnings of FC 600 for Year 2. Its net assets (and unremitted earnings) are FC
1,000 and FC 1,600 at the end of Years 1 and 2, respectively.

55-20 The foreign currency is the functional currency. For Year 2, translated amounts are as follows.

Foreign
Currency Exchange Rate Dollars
Unremitted earnings, beginning of year 1,000 FC1 = $1.20 $ 1,200
Earnings for the year 600 FC1 = $1.10 660
Unremitted earnings, end of year 1,600 FC1 = $1.00 $ 1,600

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ASC 740-20 — Implementation Guidance and Illustrations (continued)

55-21 A $260 translation adjustment ($1,200 + $660 - $1,600) is reported in other comprehensive income and
accumulated in shareholders’ equity for Year 2.

55-22 The U.S. parent expects that all of the foreign subsidiary’s unremitted earnings will be remitted in the
foreseeable future, and under the requirements of Subtopic 740-30, a deferred U.S. tax liability is recognized
for those unremitted earnings.

55-23 The U.S. parent accrues the deferred tax liability at a 20 percent tax rate (that is, net of foreign tax
credits, foreign tax credit carryforwards, and so forth). An analysis of the net investment in the foreign
subsidiary and the related deferred tax liability for Year 2 is as follows.

Net Deferred Tax

Investment Liability
Balances, beginning of year $ 1,200 $ 240

Earnings and related taxes 660 132

Transaction adjustment and related
taxes (260) (52)
Balances, end of year $ 1,600 $ 320

55-24 For Year 2, $132 of deferred taxes are charged against earnings, and $52 of deferred taxes are reported
in other comprehensive income and accumulated in shareholders’ equity.

ASC 740-270 — Implementation Guidance and Illustrations

General
55-1 This Section, which is an integral part of the requirements of this Subtopic, provides Examples of applying
the required accounting for interim period income taxes to some specific situations. In general, the Examples
illustrate matters unique to accounting for income taxes at interim dates. The Examples do not include
consideration of the nature of tax credits and events that do not have tax consequences or illustrate all
possible combinations of circumstances.

Illustrations
Example 1: Accounting for Income Taxes Applicable to Ordinary Income (or Loss) at an Interim Date if
Ordinary Income Is Anticipated for the Fiscal Year
55-2 The following Cases illustrate the guidance in Sections 740-270-30 and 740-270-35 for accounting for
income taxes applicable to ordinary income (or loss) at an interim date if ordinary income is anticipated for the
fiscal year:
a. Ordinary income in all interim periods (Case A)
b. Ordinary income and losses in interim periods (Case B)
c. Changes in estimates (Case C).

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

55-3 Cases A and B share all of the following assumptions:

a. For the full fiscal year, an entity anticipates ordinary income of $100,000. All income is taxable in one
jurisdiction at a 50 percent rate. Anticipated tax credits for the fiscal year total $10,000. No events that
do not have tax consequences are anticipated. No changes in estimated ordinary income, tax rates, or
tax credits occur during the year.
b. Computation of the estimated annual effective tax rate applicable to ordinary income is as follows.
Tax at statutory rate ($100,000 at 50%) $ 50,000
Less anticipated tax credits (10,000)
Net tax to be provided $ 40,000
Estimated annual effective tax rate
($40,000 ÷ $100,000) 40%

c. Tax credits are generally subject to limitations, usually based on the amount of tax payable before the
credits. In computing the estimated annual effective tax rate, anticipated tax credits are limited to the
amounts that are expected to be realized or are expected to be recognizable at the end of the current
year in accordance with the provisions of Subtopic 740-10. If an entity is unable to estimate the amount
of its tax credits for the year, see paragraphs 740-270-30-17 through 30-18.

Case A: Ordinary Income in All Interim Periods

55-4 The entity has ordinary income in all interim periods. Quarterly tax computations are as follows.

Ordinary Income Tax

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ 20,000 $ 20,000 40% $ 8,000 $ — $ 8,000
Second quarter 20,000 40,000 40% 16,000 8,000 8,000
Third quarter 20,000 60,000 40% 24,000 16,000 8,000
Fourth quarter 40,000 100,000 40% 40,000 24,000 16,000
Fiscal year $ 100,000 $ 40,000

Case B: Ordinary Income and Losses in Interim Periods

55-5 The following Cases illustrate ordinary income and losses in interim periods:
a. Year-to-date ordinary income (Case B1)
b. Year-to-date ordinary losses, realization more likely than not (Case B2)
c. Year-to-date ordinary losses, realization not more likely than not (Case B3).

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Case B1: Year-to-Date Ordinary Income

55-6 The entity has ordinary income and losses in interim periods; there is not an ordinary loss for the fiscal
year to date at the end of any interim period. Quarterly tax computations are as follows.

Ordinary Income (Loss) Tax (or Benefit)

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ 40,000 $ 40,000 40% $ 16,000 $ — $ 16,000
Second quarter 40,000 80,000 40% 32,000 16,000 16,000
Third quarter (20,000) 60,000 40% 24,000 32,000 (8,000)
Fourth quarter 40,000 100,000 40% 40,000 24,000 16,000
Fiscal year $ 100,000 $ 40,000

Case B2: Year-to-Date Ordinary Losses, Realization More Likely Than Not
55-7 The entity has ordinary income and losses in interim periods, and there is an ordinary loss for the year
to date at the end of an interim period. Established seasonal patterns provide evidence that realization in the
current year of the tax benefit of the year-to-date loss and of anticipated tax credits is more likely than not.
Quarterly tax computations are as follows.

Ordinary Income (Loss) Tax (or Benefit)

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ (20,000) $ (20,000) 40% $ (8,000) $ — $ (8,000)
Second quarter 10,000 (10,000) 40% (4,000) (8,000) 4,000
Third quarter 15,000 5,000 40% 2,000 (4,000) 6,000
Fourth quarter 95,000 100,000 40% 40,000 2,000 38,000
Fiscal year $ 100,000 $ 40,000

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Case B3: Year-to-Date Ordinary Losses, Realization Not More Likely Than Not
55-8 The entity has ordinary income and losses in interim periods, and there is a year-to-date ordinary loss
during the year. There is no established seasonal pattern and it is more likely than not that the tax benefit of
the year-to-date loss and the anticipated tax credits will not be realized in the current or future years. Quarterly
tax computations are as follows.

Ordinary Income (Loss) Tax

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ (20,000) $ (20,000) — (a) $ — $ — $ —
Second quarter 10,000 (10,000) — (a) — — —
Third quarter 15,000 5,000 40% 2,000 — 2,000
Fourth quarter 95,000 100,000 40% 40,000 2,000 38,000
Fiscal year $ 100,000 $ 40,000
(a)
No benefit is recognized because the tax benefit of the year-to-date loss is not expected to be realized during the
current year or recognizable as a deferred tax asset at the end of the current year in accordance with the provisions
of Subtopic 740-10.

Case C: Changes in Estimates

55-9 During the fiscal year, all of an entity’s operations are taxable in one jurisdiction at a 50 percent rate. No
events that do not have tax consequences are anticipated. Estimates of ordinary income for the year and of
anticipated credits at the end of each interim period are as shown below. Changes in the estimated annual
effective tax rate result from changes in the ratio of anticipated tax credits to tax computed at the statutory
rate. Changes consist of an unanticipated strike that reduced income in the second quarter, an increase in
the capital budget resulting in an increase in anticipated investment tax credit in the third quarter, and better
than anticipated sales and income in the fourth quarter. The entity has ordinary income in all interim periods.
Computations of the estimated annual effective tax rate based on the estimate made at the end of each
quarter are as follows.

Estimated, end of
First Second Third Actual
Quarter Quarter Quarter Fiscal Year
Estimated ordinary income
for the fiscal year $ 100,000 $ 80,000 $ 80,000 $ 100,000

Tax at 50% statutory rate $ 50,000 $ 40,000 $ 40,000 $ 50,000

Less anticipated credits (5,000) (5,000) (10,000) (10,000)

Net tax to be provided $ 45,000 $ 35,000 $ 30,000 $ 40,000

Estimated annual effective
tax rate 45% 43.75% 37.5% 40%

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

55-10 Quarterly tax computations are as follows.

Ordinary Income Tax

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ 25,000 $ 25,000 45% $ 11,250 $ — $ 11,250
Second quarter 5,000 30,000 43.75% 13,125 11,250 1,875
Third quarter 25,000 55,000 37.5% 20,625 13,125 7,500
Fourth quarter 45,000 100,000 40% 40,000 20,625 19,375
Fiscal year $ 100,000 $ 40,000

Example 2: Accounting for Income Taxes Applicable to Ordinary Income (or Loss) at an Interim Date if an
Ordinary Loss Is Anticipated for the Fiscal Year
55-11 The following Cases illustrate the guidance in Section 740-270-30 for accounting for income taxes
applicable to ordinary income (or loss) at an interim date if an ordinary loss is anticipated for the fiscal year:
a. Realization of the tax benefit of the loss is more likely than not (Case A)
b. Realization of the tax benefit of the loss is not more likely than not (Case B)
c. Partial realization of the tax benefit of the loss is more likely than not (Case C)
d. Reversal of net deferred tax credits (Case D).

55-12 Cases A, B, and C share the following assumptions.

a. For the full fiscal year, an entity anticipates an ordinary loss of $100,000. The entity operates entirely in
one jurisdiction where the tax rate is 50 percent. Anticipated tax credits for the fiscal year total $10,000.
No events that do not have tax consequences are anticipated.
b. If there is a recognizable tax benefit for the loss and the tax credits pursuant to the requirements of
Subtopic 740-10, computation of the estimated annual effective tax rate applicable to the ordinary loss
would be as follows.

Tax benefit at statutory rate ($100,000 at 50%) $ (50,000)

Tax credits (10,000)
Net tax benefit $ (60,000)
Estimated annual effective tax rate ($60,000 ÷ $100,000) 60%

55-13 Cases A, B, and C state varying assumptions with respect to assurance of realization of the components
of the net tax benefit. When the realization of a component of the benefit is not expected to be realized during
the current year or recognizable as a deferred tax asset at the end of the current year in accordance with the
provisions of Subtopic 740-10, that component is not included in the computation of the estimated annual
effective tax rate.

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Case A: Realization of the Tax Benefit of the Loss Is More Likely Than Not
55-14 The following Cases illustrate when realization of the tax benefit of the loss is more likely than not:
a. Ordinary losses in all interim periods (Case A1)
b. Ordinary income and losses in interim periods (Case A2).

Case A1: Ordinary Losses in All Interim Periods

55-15 The entity has ordinary losses in all interim periods. The full tax benefit of the anticipated ordinary loss
and the anticipated tax credits will be realized by carryback. Quarterly tax computations are as follows.

Ordinary Loss Tax Benefit

Estimated
Annual Less
Reporting Year-to- Effective Previously Reporting
Reporting Period Period Date Tax Rate Year-to-Date Provided Period
First quarter $ (20,000) $ (20,000) 60% $ (12,000) $ — $ (12,000)
Second quarter (20,000) (40,000) 60% (24,000) (12,000) (12,000)
Third quarter (20,000) (60,000) 60% (36,000) (24,000) (12,000)
Fourth quarter (40,000) (100,000) 60% (60,000) (36,000) (24,000)
Fiscal year $ (100,000) $ (60,000)

Case A2: Ordinary Income and Losses in Interim Periods

55-16 The entity has ordinary income and losses in interim periods and for the year to date. The full tax benefit
of the anticipated ordinary loss and the anticipated tax credits will be realized by carryback. The full tax benefit
of the maximum year-to-date ordinary loss can also be realized by carryback. Quarterly tax computations are
as follows.

Ordinary Income (Loss) Tax (or Benefit)

Year-to-Date
Estimated
Annual Less
Reporting Reporting Year-to- Effective Limited Previously Reporting
Period Period Date Tax Rate Computed to Provided Period
First quarter $ 20,000 $ 20,000 60% $ 12,000 $ — $ 12,000
Second quarter (80,000) (60,000) 60% (36,000) 12,000 (48,000)
Third quarter (80,000) (140,000) 60% (84,000) $ (80,000)
(a)
(36,000) (44,000)
Fourth quarter 40,000 (100,000) 60% (60,000) (80,000) 20,000
Fiscal year $ (100,000) $ (60,000)
Because the year-to-date ordinary loss exceeds the anticipated ordinary loss for the fiscal year, the tax benefit
(a)

recognized for the year-to-date is limited to the amount that would be recognized if the year-to-date ordinary loss
were the anticipated ordinary loss for the fiscal year. The limitation is computed as follows:
Year-to-date ordinary loss times the statutory rate
($140,000 at 50%) $ (70,000)
Estimated tax credits for the year (10,000)
Year-to-date benefit limited to $ (80,000)

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-16 The entity has ordinary income and losses in interim periods and for the year to date. The full tax
benefit of the anticipated ordinary loss and the anticipated tax credits will be realized by carryback. The
full tax benefit of the maximum year-to-date ordinary loss can also be realized by carryback. Quarterly tax
computations are as follows.

Ordinary Income (Loss) Tax (or Benefit)

Estimated
Annual Less
Reporting Reporting Year-to- Effective Tax Previously Reporting
Period Period Date Rate Year-to-Date Provided Period
First quarter $ 20,000 $ 20,000 60% $ 12,000 $ — $ 12,000
Second
quarter (80,000) (60,000) 60% (36,000) 12,000 (48,000)
Third quarter (80,000) (140,000) 60% (84,000) (36,000) (48,000)
Fourth
quarter 40,000 (100,000) 60% (60,000) (84,000) 24,000
Fiscal year $ (100,000) $ (60,000)
(a) Footnote superseded by Accounting Standards Update No. 2019-12.

Case B: Realization of the Tax Benefit of the Loss Is Not More Likely Than Not
55-17 In Cases A1 and A2, if neither the tax benefit of the anticipated loss for the fiscal year nor anticipated tax
credits were recognizable pursuant to Subtopic 740-10, the estimated annual effective tax rate for the year would
be zero and no tax (or benefit) would be recognized in any quarter. That conclusion is not affected by changes in
the mix of income and loss in interim periods during a fiscal year. However, see paragraph 740-270-30-18.

Case C: Partial Realization of the Tax Benefit of the Loss Is More Likely Than Not
55-18 The following Cases illustrate when partial realization of the tax benefit of the loss is more likely than not:
a. Ordinary losses in all interim periods (Case C1)
b. Ordinary income and losses in interim periods (Case C2).

Case C1: Ordinary Losses in All Interim Periods

55-19 The entity has an ordinary loss in all interim periods. It is more likely than not that the tax benefit of the loss in
excess of $40,000 of prior income available to be offset by carryback ($20,000 of tax at the 50 percent statutory rate)
will not be realized. Therefore the estimated annual effective tax rate is 20 percent ($20,000 benefit more likely than
not to be realized divided by $100,000 estimated fiscal year ordinary loss). Quarterly tax computations are as follows.

Ordinary Loss Tax Benefit

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ (20,000) $ (20,000) 20% $ (4,000) $ — $ (4,000)
Second quarter (20,000) (40,000) 20% (8,000) (4,000) (4,000)
Third quarter (20,000) (60,000) 20% (12,000) (8,000) (4,000)
Fourth quarter (40,000) (100,000) 20% (20,000) (12,000) (8,000)
Fiscal year $ (100,000) $ (20,000)

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Case C2: Ordinary Income and Losses in Interim Periods

55-20 The entity has ordinary income and losses in interim periods and for the year to date. It is more likely
than not that the tax benefit of the anticipated ordinary loss in excess of $40,000 of prior income available to be
offset by carryback ($20,000 of tax at the 50 percent statutory rate) will not be realized. Therefore the estimated
annual effective tax rate is 20 percent ($20,000 benefit more likely than not to be realized divided by $100,000
estimated fiscal year ordinary loss), and the benefit that can be recognized for the year to date is limited to
$20,000 (the benefit that is more likely than not to be realized). Quarterly tax computations are as follows.

Ordinary Income Tax

(Loss) (or Benefit)
Year-to-Date
Estimated
Ordinary Annual Less
Reporting Income Year-to- Effective Previously Reporting
Period (Loss) Date Tax Rate Computed Limited to Provided Period
First
quarter $ 20,000 $ 20,000 20% $ 4,000 $ — $ 4,000
Second
quarter (80,000) (60,000) 20% (12,000) 4,000 (16,000)
Third
quarter (80,000) (140,000) 20% (28,000) $ (20,000) (12,000) (8,000)
Fourth
quarter 40,000 (100,000) 20% (20,000) (20,000) —
Fiscal year $ (100,000) $ (20,000)

Case D: Reversal of Net Deferred Tax Credits

55-21 The entity anticipates a fiscal year ordinary loss. The loss cannot be carried back, and future profits
exclusive of reversing temporary differences are unlikely. Net deferred tax liabilities arising from existing net
taxable temporary differences are present. A portion of the existing net taxable temporary differences relating
to those liabilities will reverse within the loss carryforward period. Computation of the estimated annual
effective tax rate to be used (see paragraphs 740-270-30-32 through 30-33) is as follows.

Estimated fiscal year ordinary loss $ (100,000)

The tax benefit to be recognized is the lesser of:
Tax effect of the loss carryforward ($100,000 at 50% statutory
rate) $ 50,000
Amount of the net deferred tax liabilities that would otherwise
have been settled during the carry-forward period $ 24,000
Estimated annual effective tax rate ($24,000 ÷ $100,000) 24%

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

55-22 Quarterly tax computations are as follows.

Ordinary Loss Tax Benefit

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ (20,000) $ (20,000) 24% $ (4,800) $ — $ (4,800)
Second quarter (20,000) (40,000) 24% (9,600) (4,800) (4,800)
Third quarter (20,000) (60,000) 24% (14,400) (9,600) (4,800)
Fourth quarter (40,000) (100,000) 24% (24,000) (14,400) (9,600)
Fiscal year $ (100,000) $ (24,000)

55-23 Note that changes in the timing of the loss by quarter would not change this computation.

Example 3: Accounting for Income Taxes Applicable to Unusual or Infrequently Occurring Items
55-24 The following Cases illustrate accounting for income taxes applicable to unusual or infrequently occurring
items when ordinary income is expected for the fiscal year:
a. Realization of the tax benefit is more likely than not at date of occurrence (Case A)
b. Realization of the tax benefit not more likely than not at date of occurrence (Case B).

55-25 Cases A and B illustrate the computation of the tax (or benefit) applicable to unusual or infrequently
occurring items when ordinary income is anticipated for the fiscal year. These Cases are based on the
assumptions and computations presented in paragraph 740-270-55-3 and Example 1, Cases A and B (see
paragraphs 740-270-55-4 through 55-8), plus additional information supplied in Cases A and B of this Example.
The computation of the tax (or benefit) applicable to the ordinary income is not affected by the occurrence
of an unusual or infrequently occurring item; therefore, each Case refers to one or more of the illustrations
of that computation in Example 1, Cases A and B (see paragraphs 740-270-55-4 through 55-8), and does not
reproduce the computation and the assumptions. The income statement display for tax (or benefit) applicable
to unusual or infrequently occurring items is illustrated in Example 7 (see paragraph 740-270-55-52).

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Case A: Realization of the Tax Benefit Is More Likely Than Not at Date of Occurrence
55-26 As explained in paragraph 740-270-55-25, this Case is based on the computations of tax applicable
to ordinary income that are illustrated in Example 1, Case A (see paragraph 740-270-55-4). In addition, the
entity experiences a tax-deductible unusual or infrequently occurring loss of $50,000 (tax benefit $25,000) in
the second quarter. Because the loss can be carried back, it is more likely than not that the tax benefit will be
realized at the time of occurrence. Quarterly tax provisions are as follows.

Tax (or Benefit)

Applicable to
Unusual or Unusual or
Ordinary Infrequently Ordinary Infrequently
Reporting Period Income Occurring Income Occurring
First quarter $ 20,000 $ 8,000
Second quarter 20,000 $ (50,000) 8,000 $ (25,000)
Third quarter 20,000 8,000
Fourth quarter 40,000 16,000
Fiscal year $ 100,000 $ (50,000) $ 40,000 $ (25,000)

55-27 Note that changes in assumptions would not change the timing of the recognition of the tax benefit
applicable to the unusual or infrequently occurring item as long as realization is more likely than not.

558
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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Case B: Realization of the Tax Benefit Not More Likely Than Not at Date of Occurrence
55-28 As explained in paragraph 740-270-55-25, this Case is based on the computations of tax applicable to
ordinary income that are illustrated in Example 1, Cases A and B1 (see paragraphs 740-270-55-4 through 55-6).
In addition, the entity experiences a tax-deductible unusual or infrequently occurring loss of $50,000 (potential
benefit $25,000) in the second quarter. The loss cannot be carried back, and available evidence indicates that
a valuation allowance is needed for all of the deferred tax asset. As a result, the tax benefit of the unusual or
infrequently occurring loss is recognized only to the extent of offsetting ordinary income for the year to date.
Quarterly tax provisions under two different assumptions for the occurrence of ordinary income are as follows.

Tax (or Benefit) Applicable to

Ordinary Income Unusual or Infrequently
(Loss) Occurring Loss
Unusual or
Assumptions Ordinary Infrequently Less
and Reporting Income Occurring Reporting Year-to- Year-to- Previously Reporting
Period (Loss) Loss Period Date Date Provided Period
Income in all
quarters:
First quarter $ 20,000 $ 8,000 $ 8,000
Second
quarter 20,000 $ (50,000) 8,000 16,000 $ (16,000) $ — $ (16,000)
Third quarter 20,000 8,000 24,000 (24,000) (16,000) (8,000)
Fourth
quarter 40,000 16,000 40,000 (25,000) (24,000) (1,000)
Fiscal year $ 100,000 $ (50,000) $ 40,000 $ (25,000)

Income and
loss quarters:
First quarter $ 40,000 $ 16,000 $ 16,000
Second
quarter 40,000 $ (50,000) 16,000 32,000 $ (25,000) $ — $ (25,000)
Third quarter (20,000) (8,000) 24,000 (24,000) (25,000) 1,000
Fourth
quarter 40,000 16,000 40,000 (25,000) (24,000) (1,000)
Fiscal year $ 100,000 $ (50,000) $ 40,000 $ (25,000)

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Example 4: Accounting for Income Taxes Applicable to Income (or Loss) From Discontinued Operations at
an Interim Date
55-29 This Example illustrates the guidance in paragraph 740-270-45-7. An entity anticipates ordinary income
for the year of $100,000 and tax credits of $10,000. The entity has ordinary income in all interim periods. The
estimated annual effective tax rate is 40 percent, computed as follows.

Estimate pretax income $ 100,000

Tax at 50% statutory rate $ 50,000
Less anticipated credit (10,000)
Net tax to be provided $ 40,000
Estimated annual effective
tax rate 40%

55-30 Quarterly tax computations for the first two quarters are as follows.

Ordinary Income Tax

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ 20,000 $ 20,000 40% $ 8,000 $ — $ 8,000
Second quarter 25,000 45,000 40% 18,000 8,000 10,000

55-31 In the third quarter a decision is made to discontinue the operations of Division X, a segment of the
business that has recently operated at a loss (before income taxes). The pretax income (and losses) of the
continuing operations of the entity and of Division X through the third quarter and the estimated fourth quarter
results are as follows.

Division X
Revised
Ordinary
Income
From Provision
Continuing Loss From for Loss on
Reporting Period Operations Operations Disposal
First quarter $ 25,000 $ (5,000)
Second quarter 35,000 (10,000)
Third quarter 50,000 (10,000) $ (55,000)
Fourth quarter 50,000 (a)
— —
Fiscal year $ 160,000 $ (25,000) $ (55,000)

Estimated.
(a)

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

55-32 No changes have occurred in continuing operations that would affect the estimated annual effective tax
rate. Anticipated annual tax credits of $10,000 included $2,000 of credits related to the operations of Division X.
The revised estimated annual effective tax rate applicable to ordinary income from continuing operations is 45
percent, computed as follows.

Estimated ordinary income from continuing operations $ 160,000

Tax at 50% statutory rate $ 80,000
Less anticipated tax credits applicable to continuing operations (8,000)
Net tax to be provided $ 72,000
Estimated annual effective tax rate 45%

55-33 Quarterly computations of tax applicable to ordinary income from continuing operations are as follows.

Ordinary Income Tax

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ 25,000 $ 25,000 45% $ 11,250 $ — $ 11,250
Second quarter 35,000 60,000 45% 27,000 11,250 15,750
Third quarter 50,000 110,000 45% 49,500 27,000 22,500
Fourth quarter 50,000 160,000 45% 72,000 49,500 22,500
Fiscal year $ 160,000 $ 72,000

55-34 Tax benefit applicable to Division X for the first two quarters is computed as follows.

Tax Applicable to
Ordinary Income
Tax Benefit
Applicable
Previously Recomputed to Division
Reported (Above) X
Reporting Period (A) (B) (A–B)
First quarter $ 8,000 $ 11,250 $ (3,250)
Second quarter 10,000 15,750 (5,750)
$ (9,000)

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

55-35 The third quarter tax benefits applicable to both the loss from operations and the provision for loss on
disposal of Division X are computed based on estimated annual income with and without the effects of the
Division X losses. Current year tax credits related to the operations of Division X have not been recognized. It
is assumed that the tax benefit of those credits will not be realized because of the discontinuance of Division X
operations. Any reduction in tax benefits resulting from recapture of previously recognized tax credits resulting
from discontinuance or current year tax credits applicable to the discontinued operations would be reflected in
the tax benefit recognized for the loss on disposal or loss from operations as appropriate. If, because of capital
gains and losses, and so forth, the individually computed tax effects of the items do not equal the aggregate tax
effects of the items, the aggregate tax effects are allocated to the individual items in the same manner that they
will be allocated in the annual financial statements. The computations are as follows.

Loss From Provision

Operations for Loss on
Division X Disposal
Estimated annual income from continuing operations $ 160,000 $ 160,000
Loss from Division X operations (25,000)
Provision for loss on disposal of Division X (55,000)
Total $ 135,000 $ 105,000
Tax at 50% statutory rate $ 67,500 $ 52,500
Anticipated credits from continuing operations (8,000) (8,000)
Tax credits of Division X and recapture of previously recognized
tax credits resulting from discontinuance — —
Taxes on income after effect of Division X losses 59,500 44,500
Taxes on income before effect of Division X losses — see
computation above 72,000 72,000
Tax benefit applicable to the losses of Division X (12,500) (27,500)
Amounts previously recognized — see computation above (9,000) —
Tax benefit recognized in third quarter $ (3,500) $ (27,500)

55-36 The resulting revised quarterly tax provisions are summarized as follows.

Pretax Income (Loss) Tax (or Benefit) Applicable to

Provisions Operations Provisions
Continuing Operations for Loss on Continuing of Division for Loss on
Reporting Period Operations of Division X Disposal Operations X Disposal
First quarter $ 25,000 $ (5,000) $ 11,250 $ (3,250)
Second quarter 35,000 (10,000) 15,750 (5,750)
Third quarter 50,000 (10,000) $ (55,000) 22,500 (3,500) $ (27,500)
Fourth quarter 50,000 22,500
Fiscal year $ 160,000 $ (25,000) $ (55,000) $ 72,000 $ (12,500) $ (27,500)

562
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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Example 5: Accounting for Income Taxes Applicable to Ordinary Income if an Entity Is Subject to Tax in
Multiple Jurisdictions
55-37 The following Cases illustrate the guidance in paragraph 740-270-30-36 for accounting for income taxes
applicable to ordinary income if an entity is subject to tax in multiple jurisdictions:
a. Ordinary income in all jurisdictions (Case A)
b. Ordinary loss in a jurisdiction; realization of the tax benefit not more likely than not (Case B)
c. Ordinary income or tax cannot be estimated in one jurisdiction (Case C).
55-38 Cases A, B, and C assume that an entity operates through separate corporate entities in two countries.
Applicable tax rates are 50 percent in the United States and 20 percent in Country A. The entity has no unusual
or infrequently occurring items during the fiscal year and anticipates no tax credits or events that do not have
tax consequences. (The effect of foreign tax credits and the necessity of providing tax on undistributed earnings
are ignored because of the wide range of tax planning alternatives available.) For the full fiscal year the entity
anticipates ordinary income of $60,000 in the United States and $40,000 in Country A. The entity is able to
make a reliable estimate of its Country A ordinary income and tax for the fiscal year in dollars. Computation of
the overall estimated annual effective tax rate in Cases B and C is based on additional assumptions stated in
those Cases.

Case A: Ordinary Income in All Jurisdictions

55-39 Computation of the overall estimated annual effective tax rate is as follows.

Anticipated ordinary income for the fiscal year:

In the United States $ 60,000
In Country A 40,000
Total $ 100,000
Anticipated tax for the fiscal year:
In the United States ($60,000 at 50% statutory rate) $ 30,000
In Country A ($40,000 at 20% statutory rate) 8,000
Total $ 38,000
Overall estimated annual effective tax rate
($38,000 ÷ $100,000) 38%

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

55-40 Quarterly tax computations are as follows.

Ordinary Income Tax

Overall
Estimated
Annual Less
Reporting United Country Year- Effective Year-to- Previously Reporting
Period States A Total to-Date Tax Rate Date Reported Period
First quarter $ 5,000 $ 15,000 $ 20,000 $ 20,000 38% $ 7,600 $ — $ 7,600
Second
quarter 10,000 10,000 20,000 40,000 38% 15,200 7,600 7,600
Third quarter 10,000 10,000 20,000 60,000 38% 22,800 15,200 7,600
Fourth
quarter 35,000 5,000 40,000 100,000 38% 38,000 22,800 15,200
Fiscal year $ 60,000 $ 40,000 $ 100,000 $ 38,000

Case B: Ordinary Loss in a Jurisdiction; Realization of the Tax Benefit Not More Likely Than Not
55-41 In this Case, the entity operates through a separate corporate entity in Country B. Applicable tax rates
in Country B are 40 percent. Operations in Country B have resulted in losses in recent years and an ordinary
loss is anticipated for the current fiscal year in Country B. It is expected that the tax benefit of those losses
will not be recognizable as a deferred tax asset at the end of the current year pursuant to Subtopic 740-10;
accordingly, no tax benefit is recognized for losses in Country B, and interim period tax (or benefit) is separately
computed for the ordinary loss in Country B and for the overall ordinary income in the United States and
Country A. The tax applicable to the overall ordinary income in the United States and Country A is computed as
in Case A of this Example. Quarterly tax provisions are as follows.

Ordinary Income (or Loss) Tax (or Benefit)

Combined Combined
Reporting United Country Excluding Country Excluding Country
Period States A Country B B Total Country B B Total
First quarter $ 5,000 $ 15,000 $ 20,000 $ (5,000) $ 15,000 $ 7,600 $ — $ 7,600
Second quarter 10,000 10,000 20,000 (25,000) (5,000) 7,600 — 7,600
Third quarter 10,000 10,000 20,000 (5,000) 15,000 7,600 — 7,600
Fourth quarter 35,000 5,000 40,000 (5,000) 35,000 15,200 — 15,200
Fiscal year $ 60,000 $ 40,000 $ 100,000 $ (40,000) $ 60,000 $ 38,000 $ — $ 38,000

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Case C: Ordinary Income or Tax Cannot Be Estimated in One Jurisdiction

55-42 In this Case, the entity operates through a separate corporate entity in Country C. Applicable tax rates
in Country C are 40 percent in foreign currency. Depreciation in that country is large and exchange rates have
changed in prior years. The entity is unable to make a reasonable estimate of its ordinary income for the year
in Country C and thus is unable to reasonably estimate its annual effective tax rate in Country C in dollars.
Accordingly, tax (or benefit) in Country C is separately computed as ordinary income (or loss) occurs in Country
C. The tax applicable to the overall ordinary income in the United States and Country A is computed as in Case
A of this Example. Quarterly computations of tax applicable to Country C are as follows.

Foreign Currency (FC) Translated Amounts in

Amounts Dollars
Ordinary Ordinary
Income in Income in
Reporting Tax Reporting
Reporting Period Period (at 40% rate) Period Tax
First quarter FC 10,000 FC 4,000 $ 12,500 $ 3,000
Second quarter 5,000 2,000 8,750 1,500
Third quarter 30,000 12,000 27,500 9,000
Fourth quarter 15,000 6,000 16,250 4,500
Fiscal year FC 60,000 FC 24,000 $ 65,000 $ 18,000

55-43 Quarterly tax provisions are as follows.

Ordinary Income Tax

Combined Combined
Reporting United Country Excluding Country Excluding Country
Period States A Country C C Total Country C C Total
First
quarter $ 5,000 $ 15,000 $ 20,000 $ 12,500 $ 32,500 $ 7,600 $ 3,000 $ 10,600
Second
quarter 10,000 10,000 20,000 8,750 28,750 7,600 1,500 9,100
Third
quarter 10,000 10,000 20,000 27,500 47,500 7,600 9,000 16,600
Fourth quarter 35,000 5,000 40,000 16,250 56,250 15,200 4,500 19,700
Fiscal year $ 60,000 $ 40,000 $ 100,000 $ 65,000 $ 165,000 $ 38,000 $ 18,000 $ 56,000

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

Example 6: Effect of New Tax Legislation

55-44 The following Cases illustrate the guidance in paragraphs 740-270-25-5 through 25-6 for accounting in
interim periods for the effect of new tax legislation on income taxes:
a. Legislation effective in a future interim period (Case A)
b. Effective date of new legislation (Case B).

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-44 The following Example illustrates the guidance in paragraphs 740-270-25-5 through 25-6 for
accounting in interim periods for the effect of new tax legislation on income taxes when legislation is
effective in a future interim period.
a. Subparagraph superseded by Accounting Standards Update No. 2019-12.
b. Subparagraph superseded by Accounting Standards Update No. 2019-12.

Case A: Legislation Effective in a Future Interim Period

55-45 The assumed facts applicable to this Case follow.

Pending Content (Transition Guidance: ASC 740-10-65-8)

Editor’s Note: Paragraph 740-270-55-45 will be amended upon transition, together with its heading:

Legislation Effective in a Future Interim Period

55-45 The assumed facts applicable to this Example follow.

55-46 For the full fiscal year, an entity anticipates ordinary income of $100,000. All income is taxable in one
jurisdiction at a 50 percent rate. Anticipated tax credits for the fiscal year total $10,000. No events that do not
have tax consequences are anticipated.

55-47 Computation of the estimated annual effective tax rate applicable to ordinary income is as follows.

Tax at statutory rate ($100,000 at 50%) $ 50,000

Less anticipated tax credits (10,000)
Net tax to be provided $ 40,000
Estimated annual effective tax rate ($40,000 ÷ $100,000) 40%

55-48 Further, assume that new legislation creating additional tax credits is enacted during the second quarter
of the entity’s fiscal year. The new legislation is effective on the first day of the third quarter. As a result of
the estimated effect of the new legislation, the entity revises its estimate of its annual effective tax rate to the
following.

Tax at statutory rate ($100,000 at 50%) $ 50,000

Less anticipated tax credits (12,000)
Net tax to be provided $ 38,000
Estimated annual effective tax rate ($38,000 ÷ $100,000) 38%

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

55-49 The effect of the new legislation shall not be reflected until it is effective or administratively effective.
Accordingly, quarterly tax computations are as follows.

Ordinary Income Tax

Estimated
Annual Less
Reporting Year-to- Effective Year-to- Previously Reporting
Reporting Period Period Date Tax Rate Date Provided Period
First quarter $ 20,000 $ 20,000 40% $ 8,000 $ — $ 8,000
Second quarter 20,000 40,000 40% 16,000 8,000 8,000
Third quarter 20,000 60,000 38% 22,800 16,000 6,800
Fourth quarter 40,000 100,000 38% 38,000 22,800 15,200
Fiscal year $ 100,000 $ 38,000

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-49 The effect of the new legislation shall be reflected in the computation of the annual effective tax rate
beginning in the first interim period that includes the enactment date of the new legislation. Accordingly,
quarterly tax computations are as follows.

Ordinary Income Tax

Estimated
Annual Less
Reporting Reporting Year-to- Effective Tax Previously Reporting
Period Period Date Rate Year-to-Date Provided Period
First quarter $ 20,000 $ 20,000 40% $ 8,000 $ — $ 8,000
Second quarter 20,000 40,000 38% 15,200 8,000 7,200
Third quarter 20,000 60,000 38% 22,800 15,200 7,600
Fourth quarter 40,000 100,000 38% 38,000 22,800 15,200
Fiscal year $ (100,000) $ 38,000

Case B: Effective Date of New Legislation

55-50 Legislation generally becomes effective on the date prescribed in the statutes. However, tax legislation
may prescribe changes that become effective during an entity’s fiscal year that are administratively
implemented by applying a portion of the change to the full fiscal year. For example, if the statutory tax rate
applicable to calendar-year corporations were increased from 48 to 52 percent, effective January 1, the
increased statutory rate might be administratively applied to a corporation with a fiscal year ending at June
30 in the year of the change by applying a 50 percent rate to its taxable income for the fiscal year, rather than
48 percent for the first 6 months and 52 percent for the last 6 months. In that case the legislation becomes
effective for that entity at the beginning of the entity’s fiscal year.

Pending Content (Transition Guidance: ASC 740-10-65-8)

Editor’s note: Paragraph 740-270-55-50 will be superseded upon transition, together with its heading:

Case B: Effective Date of New Legislation

55-50 Paragraph superseded by Accounting Standards Update No. 2019-12.

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ASC 740-270 — Implementation Guidance and Illustrations (continued)

55-51 Applying this to specific legislation, an entity with a fiscal year other than a calendar year would account
during interim periods for the reduction in the corporate tax rate resulting from the Revenue Act of 1978
through a revised annual effective tax rate calculation in the same way that the change will be applied to the
entity’s taxable income for the year. The revised annual effective tax rate would then be applied to pretax
income for the year to date at the end of the current interim period.

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-51 Paragraph superseded by Accounting Standards Update No. 2019-12.

Example 7: Illustration of Income Taxes in Income Statement Display

55-52 The following illustrates the location in an income statement display of the various tax amounts
computed under this Subtopic.

Net sales(a) $ XXXX

Other income (a)
XXX
XXXX
Costs and expenses
Cost of sales(a) $ XXXX
Selling, general, and administrative expenses (a)
XXXX
Interest expense (a)
XXX
Other deductions(a) XX
Unusual items XXX
Infrequently occurring items XXX XXXX
Income (loss) from continuing operations before income taxes and
other items listed below XXXX
Provision for income taxes (benefit) (b)
XXXX

Income (loss) from continuing operations before other items listed

below XXXX
Discontinued operations:
Income (loss) from operations of discontinued Component X
(less applicable income taxes of $XXXX) XXXX
XXXX

Net income (loss) $ XXXX

(a)
Components of ordinary income (loss).
(b)
Consists of the total income taxes (or benefit) applicable to ordinary income, unusual items, and infrequently
occurring items.

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 Appendix A — Implementation Guidance and Illustrations

ASC 805-740 — Implementation Guidance and Illustrations

General
55-1 This Section is an integral part of the requirements of this Subtopic. This Section provides illustrations
that address the application of accounting requirements to specific aspects of accounting for income taxes in
connection with business combinations. The illustrations that follow make various assumptions about the tax
law. These assumptions about the tax law are for illustrative purposes only.
Illustrations
Example 1: Nontaxable Business Combination
55-2 This Example illustrates the guidance in paragraphs 805-740-25-2 through 25-3 and 805-740-30-1 relating
to the recognition and measurement of a deferred tax liability and deferred tax asset in a nontaxable business
combination. The assumptions are as follows:
a. The enacted tax rate is 40 percent for all future years, and amortization of goodwill is not deductible for
tax purposes.
b. A wholly owned entity is acquired for $20,000, and the entity has no leveraged leases.
c. The tax basis of the net assets acquired (other than goodwill) is $5,000, and the recognized value is
$12,000. Future recovery of the assets and settlement of the liabilities at their assigned values will result
in $20,000 of taxable amounts and $13,000 of deductible amounts that can be offset against each other.
Therefore, no valuation allowance is necessary.

55-3 The amounts recorded to account for the business combination transaction are as follows.

Recognized value of the net assets (other than goodwill) acquired $ 12,000
Deferred tax liability for $20,000 of taxable temporary differences (8,000)
Deferred tax asset for $13,000 of deductible temporary differences 5,200
Goodwill 10,800
Consideration paid for the acquiree $ 20,000

Example 2: Valuation Allowance at Acquisition Date Subsequently Reduced

55-4 This Example illustrates the guidance in paragraphs 805-740-25-3 and 805-740-45-2 relating to the
recognition of a deferred tax asset and the related valuation allowance for acquired deductible temporary
differences at the date of a nontaxable business combination and in subsequent periods when the tax law
limits the use of an acquired entity’s deductible temporary differences and carryforwards to subsequent
taxable income of the acquired entity in a consolidated tax return. The assumptions are as follows:
a. The enacted tax rate is 40 percent for all future years.
b. The purchase price is $20,000, and the assigned value of the net assets acquired is also $20,000.
c. The tax basis of the net assets acquired is $60,000. The $40,000 ($60,000 – $20,000) of deductible
temporary differences at the combination date is primarily attributable to an allowance for loan losses.
Provisions in the tax law limit the use of those future tax deductions to subsequent taxable income of
the acquired entity.
d. The acquired entity’s actual pretax results for the two preceding years and the expected results for the
year of the business combination are as follows.

Year 1 $ (15,000)
Year 2 (10,000)
Year 3 to the combination date (5,000)
Expected results for the remainder of Year 3 (5,000)

e. Based on assessments of all evidence available at the date of the business combination in Year 3 and
at the end of Year 3, management concludes that a valuation allowance is needed at both dates for the
entire amount of the deferred tax asset related to the acquired deductible temporary differences.

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ASC 805-740 — Implementation Guidance and Illustrations (continued)

55-5 The acquired entity’s pretax financial income and taxable income for Year 3 (after the business
combination) and Year 4 are as follows.

Year 3 Year 4
Pretax financial income $ 15,000 $ 10,000
Reversals of acquired deductible temporary
differences (15,000) (10,000)
Taxable income $ — $ —

55-6 At the end of Year 4, the remaining balance of acquired deductible temporary differences is $15,000
($40,000 – $25,000). The deferred tax asset is $6,000 ($15,000 at 40 percent). Based on an assessment of all
available evidence at the end of Year 4, management concludes that no valuation allowance is needed for that
$6,000 deferred tax asset. Elimination of the $6,000 valuation allowance results in a $6,000 deferred tax benefit
that is reported as a reduction of deferred income tax expense because the reversal of the valuation allowance
occurred after the measurement period (see paragraph 805-740-45-2). Tax benefits realized in Years 3 and 4
attributable to reversals of acquired deductible temporary differences are reported as a zero current income
tax expense. The consolidated statement of earnings would include the following amounts attributable to the
acquired entity for Year 3 (after the business combination) and Year 4.

Year 3 Year 4
Pretax financial income $ 15,000 $ 10,000
Income tax expense (benefit):
Current — —
Deferred — (6,000)
Net income $ 15,000 $ 16,000

Example 3: Acquirer’s Taxable Temporary Differences Eliminate Need for Acquiree Valuation Allowance
55-7 This Example illustrates the guidance in paragraph 805-740-25-3 if there is an elimination of the need for a
valuation allowance for the deferred tax asset for an acquired loss carryforward based on offset against taxable
temporary differences of the acquiring entity in a nontaxable business combination. This Example assumes that
the tax law permits use of an acquired entity’s deductible temporary differences and carryforwards to reduce
taxable income or taxes payable attributable to the acquiring entity in a consolidated tax return. The other
assumptions are as follows:
a. The enacted tax rate is 40 percent for all future years.
b. The purchase price is $20,000. The tax basis of the identified net assets acquired is $5,000, and the
assigned value is $12,000, that is, there are $7,000 of taxable temporary differences. The acquired entity
also has a $16,000 operating loss carryforward, which, under the tax law, may be used by the acquiring
entity in the consolidated tax return.
c. The acquiring entity has temporary differences that will result in $30,000 of net taxable amounts in
future years.
d. All temporary differences of the acquired and acquiring entities will result in taxable amounts before the
end of the acquired entity’s loss carryforward period.

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 Appendix A — Implementation Guidance and Illustrations

ASC 805-740 — Implementation Guidance and Illustrations (continued)

55-8 In assessing the need for a valuation allowance, future taxable income exclusive of reversing temporary
differences and carryforwards (see paragraph 740-10-30-18(b)) need not be considered because the $16,000
operating loss carryforward will offset the acquired entity’s $7,000 of taxable temporary differences and
another $9,000 of the acquiring entity’s taxable temporary differences. The amounts recorded to account for
the purchase transaction are as follows.

Assigned value of the identified net assets acquired $ 12,000

Deferred tax liability recognized for the acquired entity’s taxable temporary differences
($7,000 at 40 percent) (2,800)
Deferred tax asset recognized for the acquired loss carryforward based on offset against the
acquired company’s taxable temporary differences ($7,000 at 40 percent) 2,800
Deferred tax asset recognized for the acquired loss carryforward based on offset against the
acquiring entity’s taxable temporary differences ($9,000 at 40 percent) 3,600
Goodwill 4,400
Purchase price of the acquired entity $ 20,000

Example 4: Tax Deductible Goodwill Exceeds Financial Reporting Goodwill

55-9 This Example illustrates the guidance in paragraphs 805-740-25-8 through 25-9 on accounting for the tax
consequences of goodwill when tax-deductible goodwill exceeds the goodwill recorded for financial reporting
at the acquisition date. The assumptions are as follows:
a. At the acquisition date, the reported amount of goodwill for financial reporting purposes is $600 before
taking into consideration the tax benefit associated with goodwill and the tax basis of goodwill is $900.
b. The tax rate is 40 percent for all years.

55-10 As of the acquisition date, the goodwill for financial reporting purposes is adjusted for the tax benefit
associated with goodwill by using the following simultaneous equations method. In the following equation, the
Preliminary Temporary Difference variable is the excess of tax goodwill over book goodwill, before taking into
consideration the tax benefit associated with goodwill, and the Deferred Tax Asset variable is the resulting
deferred tax asset.
(Tax Rate ÷ [1-Tax Rate]) × Preliminary Temporary Difference = Deferred Tax Asset

55-11 In this Example, the following variables are known:

Tax rate = 40 percent
Preliminary Temporary Difference = $300 ($900 − $600)

55-12 The unknown variable (Deferred Tax Asset) equals $200, and the goodwill for financial reporting
purposes would be adjusted with the following entry.
Deferred tax asset 200
Goodwill 200

55-13 Goodwill for financial reporting would be established at the acquisition date at $400 ($600 less the $200
credit adjustment).

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ASC 830-740 — Implementation Guidance and Illustrations

Example 1: Illustration of Foreign Financial Statements Restated for General Price-Level Changes
55-1 This Example illustrates the guidance in paragraphs 830-740-25-5 and 830-740-30-1 through 30-2. An
entity has one asset, a nonmonetary asset that is not depreciated for financial reporting or tax purposes.
The local currency is FC. Units of current purchasing power are referred to as CFC. The enacted tax rate is 40
percent. The asset had a price-level-adjusted financial reporting amount of CFC 350 and an indexed basis for
tax purposes of CFC 100 at December 31, 19X2, both measured using CFC at December 31, 19X2. The entity
has a taxable temporary difference of CFC 250 (CFC 350 – CFC 100) and a related deferred tax liability of CFC
100 (CFC 250 × 40 percent) using CFC at December 31, 19X2.

55-2 General price levels increase by 50 percent in 19X3, and indexing allowed for 19X3 for tax purposes is
25 percent. At December 31, 19X3, the asset has a price-level-adjusted financial reporting amount of CFC 525
(CFC 350 × 150 percent) and an indexed basis for tax purposes of CFC 125 (CFC 100 × 125 percent), using CFC
at December 31, 19X3. The entity has a taxable temporary difference of CFC 400 (CFC 525 – CFC 125) and a
related deferred tax liability of CFC 160 (CFC 400 × 40 percent) at December 31, 19X3, using CFC at December
31, 19X3. The deferred tax liability at December 31, 19X2 is restated to units of current general purchasing
power as of December 31, 19X3. The restated December 31, 19X2 deferred tax liability is CFC 150 (CFC 100 ×
150 percent). For 19X3, the difference between CFC 160 and CFC 150 is reported as deferred tax expense in
income from continuing operations. The difference between the deferred tax liability of CFC 100 at December
31, 19X2 and the restated December 31, 19X2 deferred tax liability of CFC 150 is reported in 19X3 as a
restatement of beginning equity.

55-3 The following is a tabular presentation of this Example.

19X2 19X3
Financial reporting basis CFC 350 × 1.5 CFC 525
Tax basis CFC 100 × 1.25 CFC 125
Temporary difference CFC 250 CFC 400
Tax rate × .40 × .40
Deferred tax liability, end of year CFC 100 CFC 160
Deferred tax liability (restated), beginning of year CFC 100 × 1.5 CFC 150
Deferred tax expense CFC 10

ASC 323-740 — Implementation Guidance and Illustrations

55-1 This Section is an integral part of the requirements of this Subtopic.

Illustrations

Example 1: Application of Accounting Guidance to a Limited Partnership Investment in a Qualified

Affordable Housing Project

55-2 This Example illustrates the application of the cost, equity, and proportional amortization methods of
accounting for a limited liability investment in a qualified affordable housing project.

55-3 The following are the terms for this Example.

Date of investment January 1, 20X1

Purchase Price of Investment $100,000

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ASC 323-740 — Implementation Guidance and Illustrations (continued)

55-4 This Example has the following assumptions:

a. All cash flows (except initial investment) occur at the end of each year.
b. Depreciation expense is computed, for book and tax purposes, using the straight-line method with a
27.5 year life (the same method is used for simplicity).
c. The investor made a $100,000 investment for a 5 percent limited partnership interest in the project at
the beginning of the first year of eligibility for the tax credit.
d. The partnership finances the project cost of $4,000,000 with 50 percent equity and 50 percent debt.
e. The annual tax credit allocation (equal to 4 percent of the project’s original cost) will be received for a
period of 10 years.
f. The investor’s tax rate is 40 percent.
g. The project will operate with break-even pretax cash flows including debt service during the first 15
years of operations.
h. The project’s taxable loss will be equal to depreciation expense. The cumulative book loss (and thus the
cumulative depreciation expense) recognized by the investor is limited to the $100,000 investment.
i. Subparagraph superseded by Accounting Standards Update No. 2014-01.
j. It is assumed that all requirements are met to retain allocable tax credits so there will be no recapture of
tax credits.
k. The investor expects that the estimated residual value of the investment will be zero.
l. All of the conditions described in paragraph 323-740-25-1 are met to qualify the investment for the use
of the proportional amortization method.

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ASC 323-740 — Implementation Guidance and Illustrations (continued)

55-5 An analysis of the proportional amortization method follows.

Tax Credits
Other Tax Tax Credits and Other
Amortization Net Benefits and Tax Benefits,
Net of Tax Losses/Tax From Tax Other Tax Net of
Investment Investment Credits Depreciation Depreciation Benefits Amortization
Year (1) (2) (3) (4) (5) (6) (7)
1 $ 90,909 $ 9,091 $ 8,000 $ 7,273 $ 2,909 $ 10,909 $ 1,818
2 81,818 9,091 8,000 7,273 2,909 10,909 1,818
3 72,727 9,091 8,000 7,273 2,909 10,909 1,818
4 63,636 9,091 8,000 7,273 2,909 10,909 1,818
5 54,545 9,091 8,000 7,273 2,909 10,909 1,818
6 45,454 9,091 8,000 7,273 2,909 10,909 1,818
7 36,363 9,091 8,000 7,273 2,909 10,909 1,818
8 27,272 9,091 8,000 7,273 2,909 10,909 1,818
9 18,181 9,091 8,000 7,273 2,909 10,909 1,818
10 9,090 9,091 8,000 7,273 2,909 10,909 1,818
11 6,666 2,424 — 7,273 2,909 2,909 485
12 4,242 2,424 — 7,273 2,909 2,909 485
13 1,818 2,424 — 7,273 2,909 2,909 485
14 — 1,818 — 5,451 2,183 2,183 365
15 — — — — — — —
Total $ 100,000 $ 80,000 $ 100,000 $ 40,000 $ 120,000 $ 20,000

(1) End-of-year investment for a 5% limited liability interest in the project net of amortization in Column (2).
(2) Initial investment of $100,000 × (total tax benefits received during the year in Column (6) / total
anticipated tax benefits over the life of the investment of $120,000).
(3) 4 percent tax credit on $200,000 tax basis of underlying assets.
(4) Depreciation (on $200,000 tax basis of the underlying assets) using the straight-line method over 27.5
years up to the amount of the initial investment of $100,000.
(5) Column (4) × 40% tax rate.
(6) Column (3) + Column (5).
(7) Column (6) – Column (2).

55-6 Paragraph superseded by Accounting Standards Update No. 2014-01.

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 Appendix A — Implementation Guidance and Illustrations

ASC 323-740 — Implementation Guidance and Illustrations (continued)

55-7 A detailed analysis of the cost method with amortization follows.

Amortization Deferred
Net of Tax Current Tax Tax Benefit Impact on
Investment Investment Depreciation Tax Credits Benefit (Expense) Net Income
Year (1) (2) (3) (4) (5) (6) (7)
1 $ 90,000 $ 10,000 $ 7,273 $ 8,000 $ 10,909 $ 1,091 $ 2,000
2 80,000 10,000 7,273 8,000 10,909 1,091 2,000
3 70,000 10,000 7,273 8,000 10,909 1,091 2,000
4 60,000 10,000 7,273 8,000 10,909 1,091 2,000
5 50,000 10,000 7,273 8,000 10,909 1,091 2,000
6 40,000 10,000 7,273 8,000 10,909 1,091 2,000
7 30,000 10,000 7,273 8,000 10,909 1,091 2,000
8 20,000 10,000 7,273 8,000 10,909 1,091 2,000
9 10,000 10,000 7,273 8,000 10,909 1,091 2,000
10 10,000 7,273 8,000 10,909 1,091 2,000
11 7,273 2,909 (2,909)
12 7,273 2,909 (2,909)
13 7,273 2,909 (2,909)
14 5,451 2,183 (2,183)
15
Total $ 100,000 $ 100,000 $ 80,000 $ 120,000 $ — $ 20,000

(1) End-of-year investment for a 5 percent limited liability interest in the project net of amortization in column (2).
(2) Investment in excess of estimated residual value (zero in this case) amortized in proportion to tax credits received in the
current year to total estimated tax credits.
(3) Depreciation (on $200,000 tax basis of the underlying assets) using the straight-line method over 27.5 years up to the
amount of the initial investment of $100,000.
(4) 4 percent tax credit on $200,000 tax basis of the underlying assets.
(5) (Column [3] × 40% tax rate) + column (4).
(6) The change in deferred taxes resulting from the difference between the book and tax bases of the investment. In this
Example, that amount can be determined as follows: (column [2] – column [3]) × 40% tax rate.
(7) Column (5) + column (6) – column (2).

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ASC 323-740 — Implementation Guidance and Illustrations (continued)

55-8 A detailed analysis of the equity method follows.

Deferred
Net Tax Loss Current Tax Tax Benefit Impact on
Investment Book Loss (Depreciation) Tax Credits Benefit (Expense) Net Income
Year (1) (2) (3) (4) (5) (6) (7)
1 $ 92,727 $ 7,273 $ 7,273 $ 8,000 $ 10,909 $ 3,636
2 85,454 7,273 7,273 8,000 10,909 3,636
3 78,181 7,273 7,273 8,000 10,909 3,636
4 70,908 7,273 7,273 8,000 10,909 3,636
5 63,635 7,273 7,273 8,000 10,909 3,636
6 56,362 7,273 7,273 8,000 10,909 3,636
7 49,089 7,273 7,273 8,000 10,909 3,636
8 41,816 7,273 7,273 8,000 10,909 3,636
9 (a)
16,000 25,816 7,273 8,000 10,909 $ 7,418 (7,489)
10 16,000 7,273 8,000 10,909 3,492 (1,599)
11 7,273 2,909 (2,909)
12 7,273 2,909 (2,909)
13 7,273 2,909 (2,909)
14 5,451 2,183 (2,183)
15 — — —
Total $ 100,000 $ 100,000 $ 80,000 $ 120,000 $ 0 $ 20,000

(1) End-of-year investment for a 5 percent limited liability interest in the project less the investor’s share of losses.
(2) The investor’s share of book losses recognized under the equity method. The cumulative losses recognized are limited to
the investment of $100,000. (See also (a) below)
(3) Depreciation (on $200,000 tax basis of the underlying assets) using the straight-line method over 27.5 years up to the
amount of the initial investment of $100,000.
(4) 4 percent tax credit on $200,000 tax basis of the underlying assets.
(5) (Column [3] × 40% tax rate) + column (4).
(6) The change in deferred taxes resulting from differences between the book and tax bases of the investment and tax losses in
excess of the at-risk investment. In this Example, that amount can be determined as follows: (column [2] – column [3]) × 40%
tax rate.
(7) Column (5) + column (6) – column (2).

(a) Projections of future operating results at the end of Year 9 indicate that a net loss will be recognized over the remaining
term of the investment indicating a need to assess the investment for impairment. For purposes of this Example,
impairment is measured based on the remaining tax credits allocable to the investor, although an alternative measure
could include other tax benefits to be generated by the investment. The impairment loss recognized in this Example
($18,543) is derived as follows: Investment at the end of Year 8 ($41,816) less the loss recognized in Year 9 ($7,273), the
remaining tax credits allocable to the investor ($16,000), and the estimated residual value ($0).

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ASC 323-740 — Implementation Guidance and Illustrations (continued)

Pending Content (Transition Guidance: ASC 740-10-65-8)

55-8 A detailed analysis of the equity method follows.

Deferred
Net Tax Loss Current Tax Tax Benefit Impact on
Investment Book Loss (Depreciation) Tax Credits Benefit (Expense) Net Income
Year (1) (2) (3) (4) (5) (6) (7)
1 $ 92,727 $ 7,273 $ 7,273 $ 8,000 $ 10,909 $ 3,636
2 85,454 7,273 7,273 8,000 10,909 3,636
3 78,181 7,273 7,273 8,000 10,909 3,636
4 70,908 7,273 7,273 8,000 10,909 3,636
5 63,635 7,273 7,273 8,000 10,909 3,636
6 (a)
32,000 31,635 7,273 8,000 10,909 $ 9,746 (10,980)
7 24,000 8,000 7,273 8,000 10,909 291 3,200
8 16,000 8,000 7,273 8,000 10,909 291 3,200
9 8,000 8,000 7,273 8,000 10,909 291 3,200
10 8,000 7,273 8,000 10,909 291 3,200
11 7,273 2,909 (2,909)
12 7,273 2,909 (2,909)
13 7,273 2,909 (2,909)
14 5,451 2,183 (2,183)
15 — — —
Total $ 100,000 $ 100,000 $ 80,000 $ 120,000 $ 0 $ 20,000
(1) End-of-year investment for a 5 percent limited liability interest in the project less the investor’s share of losses.
(2) The investor’s share of book losses recognized under the equity method. The cumulative losses recognized are
limited to the investment of $100,000. (See also (a) below)
(3) Depreciation (on $200,000 tax basis of the underlying assets) using the straight-line method over 27.5 years up to
the amount of the initial investment of $100,000.
(4) 4 percent tax credit on $200,000 tax basis of the underlying assets.
(5) (Column [3] × 40% tax rate) + column (4).
(6) The change in deferred taxes resulting from differences between the book and tax bases of the investment and
tax losses in excess of the at-risk investment. In this Example, that amount can be determined as follows: (column
[2] – column [3]) × 40% tax rate.
(7) Column (5) + column (6) – column (2).
(a) Projections of the total future tax benefits at the end of Year 6 indicate that a net loss will be recognized over the
remaining term of the investment indicating an other-than-temporary impairment. For purposes of this Example,
in Year 6, impairment is measured as the excess of the carrying amount of the net investment over the remaining
tax credits allocable to the investor, although an alternative measure could include other tax benefits to be
generated by the investment. The impairment loss recognized in this Example in Year 6 ($24,362) is derived as
follows: Investment at the end of Year 5 ($63,635) less the loss recognized in Year 6 ($7,273) before recognizing the
impairment, the remaining tax credits allocable to the investor ($32,000), and the estimated residual value ($0).

55-9 This Example is but one method for recognition and measurement of impairment of an investment
accounted for by the equity method. Inclusion of this method in this Example does not indicate that it is a
preferred method.

55-10 Paragraph superseded by Accounting Standards Update No. 2014-01.

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Appendix B — Changes Under ASU
2019-12: Simplifying the Accounting for
Income Taxes

B.1 Overview
While the guidance in ASU 2019-12 is reflected throughout this Roadmap, the ASU’s key provisions and
transition guidance, including its effective dates, are summarized in the sections below.

B.2 Background and Key Provisions of the ASU

B.2.1 Hybrid Tax Regimes
In December 2019, the FASB issued ASU 2019-12, which modifies ASC 740 to simplify the accounting
for income taxes. The changes were originally submitted by stakeholders in connection with the FASB’s
initiative to reduce complexity in accounting standards (the Simplification Initiative). As the Board states
in the ASU, “[t]he objective of the Simplification Initiative is to identify, evaluate, and improve areas of
generally accepted accounting principles (GAAP) for which cost and complexity can be reduced while
maintaining or improving the usefulness of the information provided to users of financial statements.”

ASU 2019-12 amends the requirements related to the accounting for hybrid tax regimes. Such regimes
are tax jurisdictions that impose the greater of two taxes — one based on income or one based on
items other than income. Although ASC 740 does not apply to taxes based on items other than income,
ASC 740-10-15-4(a) originally specified that if there is a tax based on income that is greater than a
franchise tax based on capital, only that excess is subject to the guidance in ASC 740. In feedback to the
FASB, stakeholders indicated that the guidance on hybrid tax regimes increased the cost and complexity
of applying ASC 740, particularly when the tax amount deemed to be a non-income tax was insignificant.
Further, such guidance made it more difficult for entities to determine the appropriate tax rate to use
when recording deferred taxes.

Accordingly, the FASB amended ASC 740-10-15-4(a) to state that an entity should include the amount
of tax based on income in the tax provision and should record any incremental amount recorded as a
tax not based on income. This amendment effectively reverses the order in which an entity determines
the type of tax under current U.S. GAAP. In addition, the ASU amends the illustrative examples referred
to and included in ASC 740-10-55-26 and ASC 740-10-55-139 through 55-144. The FASB notes that
such amendments are consistent with the accounting for other incremental taxes, such as the BEAT.
Moreover, in paragraph BC12 of the ASU, the FASB concluded that subjecting these taxes to the
disclosure requirements in ASC 740 will result in greater transparency of franchise tax amounts.

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B.2.2 Tax Basis Step-Up in Goodwill Obtained in a Transaction That Is Not a

Business Combination
In a business combination that results in the recognition of goodwill in accordance with ASC 805,
amounts assigned to goodwill may be different, for income tax purposes, from the amounts used for
financial reporting. Under U.S. GAAP, a DTA is recognized when the tax basis of goodwill exceeds the
book basis of goodwill. When the book basis of goodwill exceeds the tax basis of goodwill, however, ASC
805 prohibits recognition of a DTL.

After a business combination, certain transactions or events may increase the tax basis of the entity’s
assets, including goodwill. The previous guidance in ASC 740-10-25-4 prohibited recognition of a DTA for
a subsequent step-up in the tax basis of goodwill that is related to the portion of goodwill from a prior
business combination for which a DTL was not initially recognized, except when “the newly deductible
goodwill amount exceeds the remaining balance of book goodwill.”

Stakeholders noted that applying the guidance in U.S. GAAP did not necessarily result in outcomes that
reflected the economics of the underlying transactions. For example, an entity may have sacrificed an
NOL carryforward in exchange for tax basis in goodwill. From an economic perspective, such an entity
would have exchanged one asset for another and yet may have been precluded from recognizing the
asset received.

In response to stakeholder feedback, the FASB removed the previous guidance in ASC 740-10-25-54 that
prohibited recognition of a DTA for a step-up in tax basis “except to the extent that the newly deductible
goodwill amount exceeds the remaining balance of book goodwill.” Instead, the amended guidance
contains a model under which an entity can consider a list of factors in determining whether the step-up
in tax basis is related to the business combination that caused the initial recognition of goodwill or to a
separate transaction. If the step-up is related to the business combination in which the book goodwill
was originally recognized, the entity would not record a DTA for the step-up in basis except to the
extent that the newly deductible goodwill amount exceeds the remaining balance of book goodwill. If
the step-up is related to a subsequent transaction, however, the entity would record a DTA. The Board
decided that this revised guidance “better reflects the economic consequences of separate transactions
because it results in the recognition of an asset instead of expense when the step up in tax basis results
in a future tax benefit.”

In paragraph BC19 of ASU 2019-12, the Board acknowledged that entities will still need to apply
judgment in making this determination.

B.2.3 Separate Financial Statements of Legal Entities Not Subject to Tax

ASC 740-10-30-27 requires that “[t]he consolidated amount of current and deferred tax expense for
a group that files a consolidated tax return . . . be allocated among the members of the group when
those members issue separate [company] financial statements.” However, ASC 740-10-30-27 does not
state which entities would be considered “members” of the group in the determination of whether taxes
should be allocated to a given entity. For example, the guidance does not specify whether taxes should
be allocated to nontaxable entities (e.g., a disregarded single-member LLC that passes income through
to the owner of the entity for tax purposes and is not severally liable for the related taxes of its owner).

Because stakeholders had indicated that the original guidance was unclear, the FASB added ASC
740-10-30-27A, which clarifies that legal entities that are not subject to tax (e.g., certain partnerships
and disregarded single-member LLCs) are not required to include, in their separate financial statements,
amounts of consolidated current and deferred taxes. An entity, however, may elect to allocate current
and deferred tax expense from its consolidated parent entity in its stand-alone financial statements, as

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long as the legal entity is not subject to tax and is disregarded by the taxing authority. In addition, the
Board added ASC 740-10-50-17A, which requires that when a legal entity that is both not subject to tax
and disregarded by the taxing authority elects to include the allocated amount of current and deferred
tax expense in its separately issued financial statements in accordance with ASC 740-10-30-27A, it must
disclose that fact and provide the disclosures required by ASC 740-10-50-17.

Paragraph BC22 of ASU 2019-12 notes that one reason to allow such a policy election is that some
entities (e.g., certain rate-regulated entities or entities with cost-plus revenue arrangements) may, for
business reasons, want to include in their separate financial statements an allocation of the tax amounts
incurred by the consolidating parent entity as a result of transactions generated by the entity not subject
to tax.

Connecting the Dots

Under the aforementioned policy election, a single-member LLC (a disregarded entity for tax)
is permitted to include a tax provision in its separate financial statements, but a partnership (a
regarded entity for tax) is not.

B.2.4 Intraperiod Tax Allocation Exception to Incremental Approach

Under U.S. GAAP, an entity should determine the tax effect of income from continuing operations
without considering the tax effect of items that are not included in continuing operations, such as
discontinued operations or OCI. Prior U.S. GAAP included an exception to this approach, as described in
ASC 740-20-45-7 (before ASU 2019-12), which required that “all items . . . be considered in determining
the amount of tax benefit that results from a loss from continuing operations.” This exception applied
only when there was a current-period loss from continuing operations.

Stakeholders provided feedback on the difficulty of applying this exception, which they noted (1) was
often overlooked, (2) provided little perceived benefit to users of financial statements, (3) was applied
inconsistently in practice, and (4) often yielded counterintuitive results. On the basis of this feedback, the
FASB removed the exception in ASC 740-20-45-7. While some respondents disagreed with the removal
of this exception and believed that its removal may indeed increase costs for certain entities, the FASB
noted that “overall, the scenarios in which removing the exception would decrease the cost of applying
Topic 740 are likely more common than those scenarios in which removing the exception would
increase costs.” In addition, the ASU amends the illustrative example in ASC 740-20-55-10 through 55-14
to conform with the removal of the exception in ASC 740-20-45-7.

B.2.5 Ownership Changes in Investments — Changes From a Subsidiary to an

Equity Method Investment
ASC 740-30-25-15 previously provided guidance on situations in which an investment in common stock
of a subsidiary changes so that it is no longer considered a subsidiary (e.g., the extent of ownership in
the investment changes so that it becomes an equity method investment). Under prior U.S. GAAP, if the
parent entity did not previously recognize income taxes on its undistributed earnings because of the
exception in ASC 740-30-25-18(a) (i.e., because of an assertion of indefinite reinvestment), no deferred
taxes were recognized on that portion of the basis difference until it became apparent that such
undistributed earnings would be remitted (i.e., deferred taxes were not automatically recognized). This
requirement represented an exception to the general principle related to the accounting for outside
basis differences of equity method investments.

In paragraph BC31 of ASU 2019-12, the FASB states that the exception in ASC 740-30-25-15 increases
“the cost and complexity of applying Topic 740” because it essentially required an entity to bifurcate
its outside basis difference in the investment and account for the components separately. The original

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outside basis difference that existed when the subsidiary became an equity method investment was
“frozen”; however, subsequent changes in the outside basis difference were recognized separately. The
FASB removed the exception in ASC 740-30-25-15, which restricted recognition of a DTL on the portion
of the outside basis difference that existed before the subsidiary became an equity method investment.
Under the new guidance, an entity will need to recognize a DTL related to the outside basis difference of
an equity method investment when the subsidiary becomes an equity method investment. Accordingly,
an entity “shall accrue in the current period income taxes on the temporary difference related to its
remaining investment in common stock.” This guidance is now consistent with current U.S. GAAP, under
which an equity method investor is prohibited from asserting indefinite reinvestment of earnings to
avoid recording deferred taxes on its outside basis differences.

B.2.6 Ownership Changes in Investments — Changes From an Investment to

a Subsidiary
ASC 740-30-25-16 provides guidance on situations in which a foreign equity method investment
becomes a subsidiary. Prior guidance stated that the DTL previously recognized for a foreign investment
could not be derecognized when the investment became a subsidiary unless dividends received from
the subsidiary exceeded earnings from the subsidiary after the date it became a subsidiary. This was the
case regardless of whether an exception under ASC 740-30-25-18(a) applied.

In a manner similar to its observations related to ASC 740-30-25-15 above, the FASB noted that this
historical requirement increased the cost and complexity of applying ASC 740 because an entity
essentially needed to bifurcate its outside basis difference in the subsidiary and account for the
components separately. This complicated the accounting for investments and foreign subsidiaries and
reduced comparability among entities (i.e., some of a reporting entity’s subsidiaries may not have been
eligible to apply the exception simply because of the nature of the investment before they became
subsidiaries).

To decrease the complexity of applying ASC 740 and increase the usefulness of information for financial
statement users, the FASB removed the exception in ASC 740-30-25-16 that “froze” the DTL on the
outside basis difference that existed before the investment became a subsidiary. Accordingly, an entity
may need to reverse a DTL if it asserts indefinite reinvestment of earnings of the subsidiary at the time
of the ownership change. This treatment results in consistency among all of the entity’s subsidiaries for
which indefinite reinvestment is asserted.

B.2.7 Interim-Period Accounting for Enacted Changes in Tax Law

Stakeholder feedback indicated that the guidance on recognizing the income tax effects of an enacted
change in tax law in an interim period was unclear. More specifically, the previous guidance in ASC
740-10 required that the tax effect of a change in tax law or rates on deferred tax accounts and taxes
payable or refundable for prior years be recognized in the period that includes the enactment date.
ASC 740-270-25-5, however, previously stated that the effect of a change in tax law or rates on taxes
currently payable or refundable for the current year is recorded after the effective date and no earlier
than the enactment date. Because the prior guidance in ASC 740-270-25-5 appeared inconsistent with
that in ASC 740-10, diversity in practice developed.

As a result, to reduce the cost and complexity of applying ASC 740, the FASB amended ASC 740-270-
25-5 to require that the effects of an enacted change in tax law on taxes currently payable or refundable
for the current year be reflected in the computation of the AETR in the first interim period that includes
the enactment date of the new legislation. In addition, the example in ASC 740-270-55-44 through 55-49
was also amended to reflect the change. This amendment superseded the example in ASC 740-270-
55-50 and 55-51.

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B.2.8 YTD Loss Limitation in Interim-Period Tax Accounting

Under the interim-period income tax model, an entity is generally required to calculate its best estimate
of the AETR for the full fiscal year at the end of each interim reporting period and to use that rate to
calculate income taxes on a YTD basis. ASC 740-270-30-28 provides additional guidance on situations
in which an entity incurs a loss on a YTD basis that exceeds the anticipated loss for the year. In these
situations, previous U.S. GAAP stipulated that the income tax benefit was limited to the income tax
benefit that would exist on the basis of the YTD loss. This represented an exception to the general
guidance in ASC 740-270. Stakeholders provided mixed feedback on the usefulness of the exception
and the outcomes it yielded. However, the Board noted that application of this exception is complex and
prone to errors.

The FASB determined that the elimination of this exception would reduce the time and cost associated
with remediating errors while not adversely altering the information provided to stakeholders on an
interim basis within an entity’s quarterly financial statements. Thus, the FASB removed the exception in
ASC 740-270-30-28. In paragraph BC42 of ASU 2019-12, the Board acknowledges that removal of the
exception may result in recognition of tax benefits in an interim period that exceed the tax benefits that
would be received on the basis of the YTD loss. However, the FASB decided that the benefit to financial
statement users of limiting the tax benefits would not outweigh the costs of the limitation.

B.3 Codification Improvements
ASU 2019-12 makes two minor improvements to the Codification topics discussed below.

B.3.1 Income Statement Presentation of Tax Benefits of Tax-Deductible

Dividends
Once effective for a reporting entity, ASU 2016-09 will amend ASC 718-740-45-7 to state that “[t]he tax
benefit of tax-deductible dividends on allocated and unallocated employee stock ownership plan shares
shall be recognized in the income statement” (emphasis added). Paragraph BC44 of ASU 2019-12 notes
that before the adoption of ASU 2016-09, ASC 718-740-45-7 stated that the relevant tax benefit “should
be recognized in income taxes allocated to continuing operations” (emphasis added). Other Codification
topics that address this issue use the language in ASC 718-740-45-7 before the adoption of ASU
2016-09. The FASB decided to change the phrase “recognized in the income statement” to “recognized
in income taxes allocated to continuing operations” (i.e., the phrase that was used before the adoption
of ASU 2016-09) to clarify where income tax benefits related to tax-deductible dividends should be
presented in the income statement.

B.3.2 Impairment of Investment in QAHPs Accounted for Under the Equity

Method
ASC 323-740-55-8 includes an example illustrating the accounting for an investment in a QAHP under
the equity method. The example previously indicated that the investment becomes impaired in year
9 and that impairment is measured on the basis of the remaining tax credits allocable to the investor;
however, the impairment assessment (specifically, the year in which the impairment occurs) is incorrect
on the basis of the revised facts that were used when the example was amended in ASU 2014-01.
The FASB initially suggested deleting ASC 323-740-55-8, noting that the example was not necessary
because a more relevant and useful example already exists in this Codification topic. However, during
the comment period, the FASB received feedback indicating that the example is used in the accounting
for subsequent measurement of qualified affordable housing property investments under the equity
method. Accordingly, the FASB reversed its initial decision and instead corrected the error in the
calculation.

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B.4 Transition and Effective Date

B.4.1 Transition and Related Disclosure
The transition method related to the amendments made by ASU 2019-12 depends on the nature of the
guidance as follows:

• Guidance on the separate financial statements of legal entities that are not subject to tax should
be applied on a retrospective basis for all periods presented.

• Guidance on ownership changes of foreign equity method investments or foreign subsidiaries

should be applied on a modified retrospective basis, with a cumulative-effect adjustment
recorded through retained earnings as of the beginning of the period of adoption.

• Guidance on hybrid tax regimes (i.e., franchise taxes that are partially based on income) can be
adopted by using either a full retrospective approach for all periods presented or a modified
retrospective approach, with a cumulative-effect adjustment recorded through retained
earnings as of the beginning of the period of adoption.

• All amendments for which there is no specific application guidance should be applied on a
prospective basis.

Upon transition, entities are required to disclose (1) the nature of and reason for the change in
accounting principle, (2) the transition method selected for each topic applicable to the entity, and (3) a
description of the impact of the adoption on the specific financial statement line items affected by the
change in accounting principle. In paragraph BC57 of the ASU, the Board states that it would not be
cost-beneficial “to require quantitative disclosures that would effectively require an entity to maintain
two sets of accounting records solely to meet disclosure requirements that would not be required
when preparing the entity’s basic financial statements.” Accordingly, no such quantitative disclosure
requirement exists.

B.4.2 Effective Date
The amendments in ASU 2019-12 are effective for PBEs for fiscal years beginning after December 15,
2020, including interim periods therein. Early adoption of the standard is permitted, including adoption
in interim or annual periods for which financial statements have not yet been issued.

For all other entities, the guidance is effective for fiscal years beginning after December 15, 2021, and for
interim periods beginning after December 15, 2022. Early adoption for these entities is also permitted,
including adoption in interim or annual periods for which financial statements have not yet been made
available for issuance.

If an entity early adopts these amendments in an interim period, it should reflect any adjustments as of
the beginning of the annual period that includes that interim period. In addition, an entity that elects to
early adopt the standard is required to adopt all of the amendments in the same period (i.e., an entity
cannot select which amendments to early adopt).

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Income Tax Disclosure Requirements

C.1 Background
In March 2019, the FASB issued a proposed ASU that would modify or eliminate certain requirements
related to income tax disclosures as well as establish new disclosure requirements. The proposed
guidance, which is part of the Board’s disclosure framework project, is intended to increase the
relevance of income tax disclosures for financial statement users. Comments on the proposal were due
by May 31, 2019.

The proposed ASU is a revised version of the FASB’s July 2016 exposure draft (the “initial ED”) on
changes to the income tax disclosure requirements. The Board discussed stakeholder feedback on the
initial ED in January 2017, again in November 2018 (when it also assessed whether updates would be
needed as a result of the 2017 Act), and again at its February 2020 meeting, at which it asked the staff to
perform additional research and outreach. For more information about the initial ED, see Deloitte’s July
29, 2016, Heads Up.

This appendix compares the requirements in the initial ED with those in the proposed ASU. The proposed
ASU’s questions for respondents are reproduced in Section C.5 for reference, and certain of its sample
disclosures related to operating loss and tax credit carryforwards are reproduced in Section C.6.

C.2 Key Changes Outlined in the Proposed ASU

C.2.1 Disaggregation
The initial ED would have required all entities to disclose the following disaggregated amounts:

• The amount of pretax income (or loss) “from continuing operations . . . disaggregated between
domestic and foreign.” 1

• The amount of “income tax expense (or benefit) from continuing operations disaggregated
between domestic and foreign.” 2

• The amount of income taxes paid, disaggregated by foreign and domestic amounts. A further
disaggregation would be required for “any country that is significant to total income taxes paid.”

The proposed ASU retains the disaggregated presentation of the amount of income (or loss) from
continuing operations, the amount of income tax expense (or benefit) from continuing operations, and
the amount of income taxes paid, disaggregated by foreign and domestic amounts, but it removes the
by-significant-country disaggregation requirement related to income taxes paid.

1
Represents an existing disclosure requirement for PBEs under SEC Regulation S-X, Rule 4-08(h).
2
See footnote 1.

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On the basis of stakeholder feedback regarding concerns about (1) potential diversity with respect to
the classification of U.S. federal income tax on foreign earnings (e.g., U.S. tax on GILTI) and (2) current
diversity in practice related to reporting income or loss from continuing operations disaggregated
between foreign and domestic amounts, the proposed ASU also contains clarifications related to the
following:

• Jurisdiction of domicile income tax on foreign earnings — Such income tax should be classified as
income tax for the jurisdiction of domicile (e.g., U.S. federal tax on GILTI resulting from foreign
earnings is classified as domestic for a U.S. domiciled company).

• Preconsolidation basis — The amount of pretax income (or loss) from continuing operations
indicated in the disaggregation should be presented “before intra-entity eliminations.” When
deliberating the proposed guidance, some Board members expressed concern that diversity
in practice could result because “before intra-entity eliminations” is not defined in U.S. GAAP.
Accordingly, the FASB included Question 4 in the proposed ASU’s questions for respondents to
determine whether clarification is needed.

Connecting the Dots

In practice, some entities disaggregate elimination entries made in arriving at consolidated
pretax income (loss) and push them back to the respective components, while others disregard
such elimination entries and report the components before elimination entries. For more
information, see Chapter 8.

C.2.2 Indefinitely Reinvested Foreign Earnings

The 2017 Act introduced the concept of the “transition tax,” which requires U.S. shareholders to pay
a tax on certain post-1986 undistributed and previously untaxed foreign E&P. The transition tax has
significantly reduced the amount of untaxed foreign earnings held by entities with foreign operations
because taxes have been (or will be) paid on most, if not all, post-1986 earnings. As a result, the
proposed ASU removes the initial ED’s proposed requirement in ASC 740-30-50-3 that any change
to an indefinite reinvestment assertion made during the year must be disclosed, including the
circumstances that caused such a change and the amount of earnings to which the change in assertion
was related.

Similarly, the proposed ASU would remove the existing requirement in ASC 740-30-50-2(b) to
disclose the “cumulative amount of each type of temporary difference” when a “deferred tax liability is
not recognized because of the exceptions to comprehensive recognition of deferred taxes related to
subsidiaries and corporate joint ventures.”

Connecting the Dots

Note that the proposed ASU would not eliminate the existing requirements in ASC 740-30-
50-2(c) to (1) disclose the amount of unrecognized DTL related to investments in foreign
subsidiaries and corporate joint ventures that are essentially permanent in duration or
(2) provide a statement that determination of such DTL is not practicable.

Likewise, the proposed ASU removes the initial ED’s proposed requirement that entities disclose
the aggregate of cash, cash equivalents, and marketable securities held by their foreign subsidiaries

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to help financial statement users predict the likelihood of future repatriations and the associated tax
consequences related to foreign indefinitely reinvested earnings.

C.2.3 UTBs
The proposed ASU removes the initial ED’s proposed requirement that entities disclose, in the tabular
reconciliation of the total amount of UTBs required by proposed ASC 740-10-50-15A(a), settlements
disaggregated by those that have been (or will be) settled in cash and those that have been (or will be)
settled by using existing DTAs (e.g., settlement by using existing NOL or tax credit carryforwards). But
the proposed ASU retains the initial ED’s proposed requirement that PBEs provide a breakdown (i.e., a
mapping) of the amount of total UTBs shown in the reconciliation of the total amounts of UTBs by the
respective balance-sheet lines on which such UTBs are recorded. However, the proposed ASU removes
the initial ED’s proposed requirement to disclose a UTB that is not included in a balance-sheet line
separately since it was unclear to which UTB the requirement would now be relevant.

The proposed ASU also retains the proposal to remove the existing requirement in ASC 740-10-50-15(d)
to disclose the details of tax positions for which it is reasonably possible that the total amount of UTBs
will significantly increase or decrease in the next 12 months.

C.2.4 Valuation Allowances
The proposed ASU retains the initial ED’s proposed requirement that PBEs explain any valuation
allowance recognized or released during the year, along with the corresponding amount.

C.2.5 Rate Reconciliation
The proposed ASU affirms the initial ED’s proposed amendment to the requirement in ASC 740-10-
50-12 that a PBE disclose the income tax rate reconciliation in a manner consistent with SEC Regulation
S-X, Rule 4-08(h). If amended, ASC 740-10-50-12 would continue to require a PBE to disclose a
reconciliation of the reported amount of income tax expense (or benefit) from continuing operations
to the amount of income tax expense (or benefit) that would result from multiplying the pretax income
(or loss) from continuing operations by the statutory federal or national income tax rate. However, the
amendment would modify the requirement to disaggregate and separately present components in the
rate reconciliation that are greater than or equal to 5 percent of the tax at the statutory rate in a manner
consistent with the requirement in SEC Regulation S-X, Rule 4-08(h).

During deliberations of the proposed ASU, some Board members questioned whether 5 percent was an
appropriate threshold given the decrease to the U.S. statutory rate as a result of the 2017 Act. Thus, the
FASB included Question 6 in the proposed ASU’s questions for respondents.

C.2.6 Operating Loss and Tax Credit Carryforwards

Currently, entities are required to disclose, for tax purposes, the amount and expiration dates of
operating losses and tax credit carryforwards. Historically, there has been diversity in practice related to
this disclosure requirement, which the initial ED sought to reduce by requiring a PBE to disclose the total
amount of:

• “[F]ederal, state, and foreign [gross NOL and tax credit] carryforwards (not tax effected) by time
period of expiration for each of the first five years after the reporting date and a total for any
remaining years.”

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• “[D]eferred tax assets for federal, state, and foreign [NOL and tax credit] carryforwards (tax
effected) before the valuation allowance.”

However, the proposed ASU removed the proposed requirement in the initial ED to report not-tax-
effected amounts because the Board determined that disclosing such amounts of federal or national,
state, and foreign gross NOL and tax credit carryforwards does not provide decision-useful information.
The Board also concluded that disclosure of the tax-effected amounts of federal or national, state, and
foreign NOL and tax credit carryforwards is useful, so it retained the initial ED’s proposed requirement
for such disclosure, with a modification to also disclose the valuation allowance associated with such
amounts.

While the FASB voted to require PBEs to provide the tax-effected amounts of federal or national, state,
and foreign DTAs related to NOL and tax credit carryforwards, on the basis of feedback received from
nonpublic entities, the Board retained the initial ED’s proposed requirement in ASC 740-10-50-8A
that nonpublic entities disclose the total amounts of federal or national, state, and FTCs and other
federal or national, state, and foreign carryforwards (on a not-tax-effected basis) separately for (1) those
carryforwards that expire and (2) those that do not, along with their expiration dates (or range of
expiration dates).

Section C.6 contains illustrations of the above disclosure requirements from the proposed ASU.

C.2.7 Interim Disclosure Requirements

The initial ED did not propose changes to interim disclosure requirements. However, the proposed ASU
would amend ASC 230-10-50-2 to add an interim requirement to disclose income taxes paid for all
interim periods presented.

C.3 Other Changes
C.3.1 Change in Tax Law
The initial ED would have required an entity to disclose an enacted tax law change if it was probable that
such a change would affect the entity in the future. Stakeholders expressed concerns that this language
was potentially too broad, and the Board discussed the possibility of modifying the requirement to
provide such disclosure if that change would have a “significant effect [on the entity] in a future period.” 3  

However, the Board ultimately determined that the disclosure requirement was unnecessary and
removed it (ASC 740-10-50-22 in the initial ED) from the proposed ASU.

C.3.2 Government Assistance
The initial ED would have required an entity to disclose certain information related to assistance
received from a governmental unit that reduces the entity’s income taxes. However, this proposed
disclosure was removed from the proposed ASU.

C.4 Transition and Effective Date

The proposed ASU would require the guidance to be applied prospectively, and the Board will
determine an effective date and whether to permit early adoption after it performs additional research
and outreach.

3
Quoted text is from the handout for the November 14, 2018, FASB meeting.

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C.5 Questions for Respondents

The proposed ASU’s questions for respondents are reproduced below.

Question 1: Would the amendments in this proposed Update that add or modify disclosure
requirements result in more effective, decision-useful information about income taxes? Please
explain why or why not. Would the proposed amendments result in the elimination of decision-useful
information about income taxes? If yes, please explain why.

Question 2: Are the proposed disclosure requirements operable and auditable? If not, which
aspects pose operability or auditability issues and why?

Question 3: Would any of the proposed disclosures impose significant incremental costs? If so,
please describe the nature and extent of the additional costs.

Question 4: One of the proposed amendments would require entities to disclose pretax income (or
loss) from continuing operations before intra-entity eliminations disaggregated between domestic
and foreign, which initial feedback indicated would reduce diversity in practice. Would this proposed
amendment be operable? Should the Board specify whether the disclosed amounts should be
before or after intra-entity eliminations? Why or why not?

Question 5: Would a proposed amendment to require disaggregation of income tax expense (or
benefit) from continuing operations by major tax jurisdiction be operable? Would such a proposed
amendment result in decision-useful information about income taxes? Why or why not?

Question 6: The proposed amendments would modify the existing rate reconciliation requirement
for public business entities to be consistent with SEC Regulation S-X 210.4-08(h). That regulation
requires separate disclosure for any reconciling item that amounts to more than 5 percent of the
amount computed by multiplying the income before tax by the applicable statutory federal income
tax rate. Should the Board consider a threshold that is different than 5 percent? If so, please
recommend a different threshold and give the basis for your recommendation.

Question 7: Are there any other disclosures that should be required by Topic 740 on the basis of
the concepts in Chapter 8 of Concepts Statement 8, as a result of the Tax Cuts and Jobs Act, or for
other reasons? Please explain why.

Question 8: Are there any disclosure requirements that should be removed on the basis of the
concepts in Chapter 8, as a result of the Tax Cuts and Jobs Act, or for other reasons? Please explain
why.

Question 9: The proposed amendments would replace the term public entity in Topic 740 with the
term public business entity as defined in the Master Glossary of the Codification. Do you agree with
the change in scope? If not, please describe why.

Question 10: Should the proposed disclosures be required only for the reporting year in which the
requirements are effective and thereafter or should prior periods be restated in the year in which
the requirements are effective? Please explain why.

Question 11: How much time would be needed to implement the proposed amendments? Should
the amount of time needed to implement the proposed amendments by entities other than public
business entities be different from the amount of time needed by public business entities? Should
early adoption be permitted? Please explain why.

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C.6 Illustrative Examples of Disclosures Related to Operating Loss and Tax

Credit Carryforwards
The illustrative examples below are reproduced from the proposed ASU.

ASC 740-10 (Amended and Added Guidance Suggested by Proposed ASU 2019-500)

55-220 If Entity A is a public business entity, illustrative disclosure for the entity follows.

Deferred Tax Asset for Carryforwards Before Valuation Allowance

Expires During Fiscal Year Federal State Foreign Total

20X2 $ 415 $ 155 $ 270 $ 840

20X3 380 125 330 835

20X4 300 80 270 650

20X5 320 85 165 570

20X6 210 90 120 420

Thereafter 560 245 210 1,015

Indefinite carryforwards 370 100 — 470

Totals 4,800

Unrecognized tax benefits at

December 31, 20X1 (2,000)

Total tax effect of carryforwards

after unrecognized tax benefits 2,800

Valuation allowance — — — —
Total tax effect of carryforwards
after valuation allowance $ 2,800

Realization of the deferred tax asset is dependent on generating sufficient taxable income to utilize
the carryforwards. Although realization is not assured, management believes it is more likely than not
that all of the deferred tax asset will be realized. The amount of the deferred tax asset considered
realizable, however, could be reduced in the near term if estimates of future taxable income during the
carryforward period are reduced.

55-220A If Entity A is an entity other than a public business entity, illustrative disclosure for the entity follows.
The entity has $6.6 million, $6.0 million, and $5.4 million in federal, state, and foreign loss carryforwards
(not tax effected), respectively, of which $1.8 million and $1.6 million in federal and state loss
carryforwards, respectively, do not expire. The remaining loss carryforwards expire at various points
between 20X2 and 20X9. The entity also has deferred tax assets of $1.2 million, $0.4 million, and $0.5
million for federal, state, and foreign credit carryforwards, respectively, which expire at various points
between 20X2 and 20X7.
Realization of the deferred tax asset is dependent on generating sufficient taxable income to utilize
the carryforwards. Although realization is not assured, management believes that it is more likely than
not that all of the deferred tax asset will be realized. The amount of the deferred tax asset considered
realizable, however, could be reduced in the near term if estimates of future taxable income during the
carryforward period are reduced.

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Appendix D — Glossary of Terms in the
ASC 740 Topic and Subtopics
This appendix includes certain defined terms from the glossaries of ASC 740-10-20, ASC 740-20-20, ASC
740-30-20, ASC 740-270-20, ASC 718-740-20, ASC 805-740-20, ASC 830-740-20, ASC 323-740-20, and
the ASC master glossary.

ASC 740 Topics and Subtopics — Glossary

Acquiree
The business or businesses that the acquirer obtains control of in a business combination. This term also
includes a nonprofit activity or business that a not-for-profit acquirer obtains control of in an acquisition by a
not-for-profit entity.

Acquirer
The entity that obtains control of the acquiree. However, in a business combination in which a variable interest
entity (VIE) is acquired, the primary beneficiary of that entity always is the acquirer.

Acquisition by a Not-for-Profit Entity

A transaction or other event in which a not-for-profit acquirer obtains control of one or more nonprofit
activities or businesses and initially recognizes their assets and liabilities in the acquirer’s financial statements.
When applicable guidance in Topic 805 is applied by a not-for-profit entity, the term business combination has
the same meaning as this term has for a for-profit entity. Likewise, a reference to business combinations in
guidance that links to Topic 805 has the same meaning as a reference to acquisitions by not-for-profit entities.

Acquisition Date
The date on which the acquirer obtains control of the acquiree.

Alternative Minimum Tax

A tax that results from the use of an alternate determination of a corporation’s federal income tax liability under
provisions of the U.S. Internal Revenue Code.

Asset Group
An asset group is the unit of accounting for a long-lived asset or assets to be held and used, which represents
the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of
assets and liabilities.

Award
The collective noun for multiple instruments with the same terms and conditions granted at the same time
either to a single employee or to a group of employees. An award may specify multiple vesting dates, referred
to as graded vesting, and different parts of an award may have different expected terms. References to an
award also apply to a portion of an award.

Note: The following definition is Pending Content; see Transition Guidance in 718-10-65-11.

The collective noun for multiple instruments with the same terms and conditions granted at the same time
either to a single grantee or to a group of grantees. An award may specify multiple vesting dates, referred to
as graded vesting, and different parts of an award may have different expected terms. References to an award
also apply to a portion of an award.

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ASC 740 Topics and Subtopics — Glossary (continued)

Benefit
See Tax (or Benefit).

Business
Definition 1
Paragraphs 805-10-55-3A through 55-6 and 805-10-55-8 through 55-9 define what is considered a business.

Business Combination
A transaction or other event in which an acquirer obtains control of one or more businesses. Transactions
sometimes referred to as true mergers or mergers of equals also are business combinations. See also
Acquisition by a Not-for-Profit Entity.
Carrybacks
Deductions or credits that cannot be utilized on the tax return during a year that may be carried back to reduce
taxable income or taxes payable in a prior year. An operating loss carryback is an excess of tax deductions over
gross income in a year; a tax credit carryback is the amount by which tax credits available for utilization exceed
statutory limitations. Different tax jurisdictions have different rules about whether excess deductions or credits
may be carried back and the length of the carryback period.

Carryforwards
Deductions or credits that cannot be utilized on the tax return during a year that may be carried forward to
reduce taxable income or taxes payable in a future year. An operating loss carryforward is an excess of tax
deductions over gross income in a year; a tax credit carryforward is the amount by which tax credits available
for utilization exceed statutory limitations. Different tax jurisdictions have different rules about whether
excess deductions or credits may be carried forward and the length of the carryforward period. The terms
carryforward, operating loss carryforward, and tax credit carryforward refer to the amounts of those items, if
any, reported in the tax return for the current year.

Commencement Date of the Lease (Commencement Date)

Note: The following definition is Pending Content; see Transition Guidance in 842-10-65-1.

The date on which a lessor makes an underlying asset available for use by a lessee. See paragraphs 842-10-
55-19 through 55-21 for implementation guidance on the commencement date.

Component of an Entity
A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally
and for financial reporting purposes, from the rest of the entity. A component of an entity may be a reportable
segment or an operating segment, a reporting unit, a subsidiary, or an asset group.

Conduit Debt Securities

Certain limited-obligation revenue bonds, certificates of participation, or similar debt instruments issued by a
state or local governmental entity for the express purpose of providing financing for a specific third party (the
conduit bond obligor) that is not a part of the state or local government’s financial reporting entity. Although
conduit debt securities bear the name of the governmental entity that issues them, the governmental entity
often has no obligation for such debt beyond the resources provided by a lease or loan agreement with the
third party on whose behalf the securities are issued. Further, the conduit bond obligor is responsible for any
future financial reporting requirements.

Consolidated Financial Statements

The financial statements of a consolidated group of entities that include a parent and all its subsidiaries
presented as those of a single economic entity.

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ASC 740 Topics and Subtopics — Glossary (continued)

Contract
Note: The following definition is Pending Content; see Transition Guidance in 606-10-65-1.

An agreement between two or more parties that creates enforceable rights and obligations.

Contract Asset
Note: The following definition is Pending Content; see Transition Guidance in 606-10-65-1.

An entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer
when that right is conditioned on something other than the passage of time (for example, the entity’s future
performance).

Corporate Joint Venture

A corporation owned and operated by a small group of entities (the joint venturers) as a separate and specific
business or project for the mutual benefit of the members of the group. A government may also be a member
of the group. The purpose of a corporate joint venture frequently is to share risks and rewards in developing a
new market, product or technology; to combine complementary technological knowledge; or to pool resources
in developing production or other facilities. A corporate joint venture also usually provides an arrangement
under which each joint venturer may participate, directly or indirectly, in the overall management of the joint
venture. Joint venturers thus have an interest or relationship other than as passive investors. An entity that is
a subsidiary of one of the joint venturers is not a corporate joint venture. The ownership of a corporate joint
venture seldom changes, and its stock is usually not traded publicly. A noncontrolling interest held by public
ownership, however, does not preclude a corporation from being a corporate joint venture.

Current Tax Expense (or Benefit)

The amount of income taxes paid or payable (or refundable) for a year as determined by applying the
provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year.

Customer
A user or reseller.

Note: The following definition is Pending Content; see Transition Guidance in 606-10-65-1.

A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary
activities in exchange for consideration.

Deductible Temporary Difference

Temporary differences that result in deductible amounts in future years when the related asset or liability is
recovered or settled, respectively. See Temporary Difference.

Deferred Tax Asset

The deferred tax consequences attributable to deductible temporary differences and carryforwards. A deferred
tax asset is measured using the applicable enacted tax rate and provisions of the enacted tax law. A deferred
tax asset is reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than
not that some portion or all of a deferred tax asset will not be realized.

Deferred Tax Consequences

The future effects on income taxes as measured by the applicable enacted tax rate and provisions of the
enacted tax law resulting from temporary differences and carryforwards at the end of the current year.

Deferred Tax Expense (or Benefit)

The change during the year in an entity’s deferred tax liabilities and assets. For deferred tax liabilities and assets
acquired in a purchase business combination during the year, it is the change since the combination date.
Income tax expense (or benefit) for the year is allocated among continuing operations, discontinued operations,
and items charged or credited directly to shareholders’ equity.

Deferred Tax Liability

The deferred tax consequences attributable to taxable temporary differences. A deferred tax liability is
measured using the applicable enacted tax rate and provisions of the enacted tax law.

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ASC 740 Topics and Subtopics — Glossary (continued)

Employee
An individual over whom the grantor of a share-based compensation award exercises or has the right to
exercise sufficient control to establish an employer-employee relationship based on common law as illustrated
in case law and currently under U.S. Internal Revenue Service (IRS) Revenue Ruling 87-41. A reporting entity
based in a foreign jurisdiction would determine whether an employee-employer relationship exists based on
the pertinent laws of that jurisdiction. Accordingly, a grantee meets the definition of an employee if the grantor
consistently represents that individual to be an employee under common law. The definition of an employee
for payroll tax purposes under the U.S. Internal Revenue Code includes common law employees. Accordingly,
a grantor that classifies a grantee potentially subject to U.S. payroll taxes as an employee also must represent
that individual as an employee for payroll tax purposes (unless the grantee is a leased employee as described
below). A grantee does not meet the definition of an employee solely because the grantor represents that
individual as an employee for some, but not all, purposes. For example, a requirement or decision to classify
a grantee as an employee for U.S. payroll tax purposes does not, by itself, indicate that the grantee is an
employee because the grantee also must be an employee of the grantor under common law.

A leased individual is deemed to be an employee of the lessee if all of the following requirements are met:
a. The leased individual qualifies as a common law employee of the lessee, and the lessor is contractually
required to remit payroll taxes on the compensation paid to the leased individual for the services
provided to the lessee.
b. The lessor and lessee agree in writing to all of the following conditions related to the leased individual:
1. The lessee has the exclusive right to grant stock compensation to the individual for the employee
service to the lessee.
2. The lessee has a right to hire, fire, and control the activities of the individual. (The lessor also may
have that right.)
3. The lessee has the exclusive right to determine the economic value of the services performed by the
individual (including wages and the number of units and value of stock compensation granted).
4. The individual has the ability to participate in the lessee’s employee benefit plans, if any, on the same
basis as other comparable employees of the lessee.
5. The lessee agrees to and remits to the lessor funds sufficient to cover the complete compensation,
including all payroll taxes, of the individual on or before a contractually agreed upon date or dates.
A nonemployee director does not satisfy this definition of employee. Nevertheless, nonemployee directors
acting in their role as members of a board of directors are treated as employees if those directors were elected
by the employer’s shareholders or appointed to a board position that will be filled by shareholder election when
the existing term expires. However, that requirement applies only to awards granted to nonemployee directors
for their services as directors. Awards granted to those individuals for other services shall be accounted for as
awards to nonemployees.

Employee Stock Ownership Plan

An employee stock ownership plan is an employee benefit plan that is described by the Employee Retirement
Income Security Act of 1974 and the Internal Revenue Code of 1986 as a stock bonus plan, or combination
stock bonus and money purchase pension plan, designed to invest primarily in employer stock. Also called an
employee share ownership plan.

Event
A happening of consequence to an entity. The term encompasses both transactions and other events affecting
an entity.

Exchange Rate
The ratio between a unit of one currency and the amount of another currency for which that unit can be
exchanged at a particular time.

Fair Value
Definition 1
The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current
transaction between willing parties, that is, other than in a forced or liquidation sale.

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ASC 740 Topics and Subtopics — Glossary (continued)

Definition 2
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date.

Foreign Currency
A currency other than the functional currency of the entity being referred to (for example, the dollar could be a
foreign currency for a foreign entity). Composites of currencies, such as the Special Drawing Rights, used to set
prices or denominate amounts of loans, and so forth, have the characteristics of foreign currency.

Foreign Entity
An operation (for example, subsidiary, division, branch, joint venture, and so forth) whose financial statements
are both:
a. Prepared in a currency other than the reporting currency of the reporting entity
b. Combined or consolidated with or accounted for on the equity basis in the financial statements of the
reporting entity.
Functional Currency
An entity’s functional currency is the currency of the primary economic environment in which the entity operates;
normally, that is the currency of the environment in which an entity primarily generates and expends cash. (See
paragraphs 830-10-45-2 through 830-10-45-6 and 830-10-55-3 through 830-10-55-7.)

Gains and Losses Included in Comprehensive Income but Excluded From Net Income
Gains and losses included in comprehensive income but excluded from net income include certain changes
in fair values of investments in marketable equity securities classified as noncurrent assets, certain changes
in fair values of investments in industries having specialized accounting practices for marketable securities,
adjustments related to pension liabilities or assets recognized within other comprehensive income, and foreign
currency translation adjustments. Future changes to generally accepted accounting principles (GAAP) may
change what is included in this category.

Goodwill
An asset representing the future economic benefits arising from other assets acquired in a business
combination or an acquisition by a not-for-profit entity that are not individually identified and separately
recognized. For ease of reference, this term also includes the immediate charge recognized by not-for-profit
entities in accordance with paragraph 958-805-25-29.

Income Taxes
Domestic and foreign federal (national), state, and local (including franchise) taxes based on income.

Income Taxes Currently Payable (Refundable)

See Current Tax Expense (or Benefit).

Income Tax Expense (or Benefit)

The sum of current tax expense (or benefit) and deferred tax expense (or benefit).

Infrequency of Occurrence
The underlying event or transaction should be of a type that would not reasonably be expected to recur in
the foreseeable future, taking into account the environment in which the entity operates (see paragraph
220-20-60-1).

Intrinsic Value
The amount by which the fair value of the underlying stock exceeds the exercise price of an option. For
example, an option with an exercise price of $20 on a stock whose current market price is $25 has an intrinsic
value of $5. (A nonvested share may be described as an option on that share with an exercise price of zero.
Thus, the fair value of a share is the same as the intrinsic value of such an option on that share.)

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ASC 740 Topics and Subtopics — Glossary (continued)

Inventory
The aggregate of those items of tangible personal property that have any of the following characteristics:
a. Held for sale in the ordinary course of business
b. In process of production for such sale
c. To be currently consumed in the production of goods or services to be available for sale.
The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished
goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed
directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term
assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact
that a depreciable asset is retired from regular use and held for sale does not indicate that the item should
be classified as part of the inventory. Raw materials and supplies purchased for production may be used or
consumed for the construction of long-term assets or other purposes not related to production, but the fact
that inventory items representing a small portion of the total may not be absorbed ultimately in the production
process does not require separate classification. By trade practice, operating materials and supplies of certain
types of entities such as oil producers are usually treated as inventory.

Investor
A business entity that holds an investment in voting stock of another entity.

Lease
An agreement conveying the right to use property, plant, or equipment (land and/or depreciable assets) usually
for a stated period of time.

Note: The following definition is Pending Content; see Transition Guidance in 842-10-65-1.

A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or
equipment (an identified asset) for a period of time in exchange for consideration.

Legal Entity
Any legal structure used to conduct activities or to hold assets. Some examples of such structures are
corporations, partnerships, limited liability companies, grantor trusts, and other trusts.

Lessee
Note: The following definition is Pending Content; see Transition Guidance in 842-10-65-1.

An entity that enters into a contract to obtain the right to use an underlying asset for a period of time in
exchange for consideration.

Lessor
Note: The following definition is Pending Content; see Transition Guidance in 842-10-65-1.

An entity that enters into a contract to provide the right to use an underlying asset for a period of time in
exchange for consideration.

Leveraged Lease
From the perspective of a lessor, a lease that meets all of the conditions in paragraph 840-10-25-43(c).

Note: The following definition is Pending Content; see Transition Guidance in 842-10-65-1.

From the perspective of a lessor, a lease that was classified as a leveraged lease in accordance with the leases
guidance in effect before the effective date and for which the commencement date is before the effective date.

Local Currency
The currency of a particular country being referred to.

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ASC 740 Topics and Subtopics — Glossary (continued)

Market Participants
Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the
following characteristics:
a. They are independent of each other, that is, they are not related parties, although the price in a related-
party transaction may be used as an input to a fair value measurement if the reporting entity has evidence
that the transaction was entered into at market terms
b. They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction
using all available information, including information that might be obtained through due diligence efforts
that are usual and customary
c. They are able to enter into a transaction for the asset or liability
d. They are willing to enter into a transaction for the asset or liability, that is, they are motivated but not
forced or otherwise compelled to do so.
Measurement Date
The date at which the equity share price and other pertinent factors, such as expected volatility, that enter into
measurement of the total recognized amount of compensation cost for an award of share-based payment are
fixed.

Merger of Not-for-Profit Entities

A transaction or other event in which the governing bodies of two or more not-for-profit entities cede control of
those entities to create a new not-for-profit entity.

Noncontrolling Interest
The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A
noncontrolling interest is sometimes called a minority interest.

Nonpublic Entity
Definition 5
An entity that does not meet any of the following criteria:
a. Its debt or equity securities are traded in a public market, including those traded on a stock exchange or
in the over-the-counter market (including securities quoted only locally or regionally).
b. It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or
foreign stock exchange or an over-the-counter market, including local or regional markets).
c. Its financial statements are filed with a regulatory agency in preparation for the sale of any class of securities.
Not-for-Profit Entity
An entity that possesses the following characteristics, in varying degrees, that distinguish it from a business entity:
a. Contributions of significant amounts of resources from resource providers who do not expect
commensurate or proportionate pecuniary return
b. Operating purposes other than to provide goods or services at a profit
c. Absence of ownership interests like those of business entities.
Entities that clearly fall outside this definition include the following:
a. All investor-owned entities
b. Entities that provide dividends, lower costs, or other economic benefits directly and proportionately to
their owners, members, or participants, such as mutual insurance entities, credit unions, farm and rural
electric cooperatives, and employee benefit plans.
Operating Segment
A component of a public entity. See Section 280-10-50 for additional guidance on the definition of an operating segment.

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ASC 740 Topics and Subtopics — Glossary (continued)

Orderly Transaction
A transaction that assumes exposure to the market for a period before the measurement date to allow for
marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a
forced transaction (for example, a forced liquidation or distress sale).

Ordinary Income (or Loss)

Ordinary income (or loss) refers to income (or loss) from continuing operations before income taxes (or
benefits) excluding significant unusual or infrequently occurring items. Discontinued operations and cumulative
effects of changes in accounting principles are also excluded from this term. The term is not used in the income
tax context of ordinary income versus capital gain. The meaning of unusual or infrequently occurring items is
consistent with their use in the definitions of the terms unusual nature and infrequency of occurrence.

Parent
An entity that has a controlling financial interest in one or more subsidiaries. (Also, an entity that is the primary
beneficiary of a variable interest entity.)

Probable
The future event or events are likely to occur.

Public Business Entity

A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity
nor an employee benefit plan is a business entity.
a. It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial
statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including
other entities whose financial statements or financial information are required to be or are included in a
filing).
b. It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations
promulgated under the Act, to file or furnish financial statements with a regulatory agency other than
the SEC.
c. It is required to file or furnish financial statements with a foreign or domestic regulatory agency in
preparation for the sale of or for purposes of issuing securities that are not subject to contractual
restrictions on transfer.
d. It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an
exchange or an over-the-counter market.
e. It has one or more securities that are not subject to contractual restrictions on transfer, and it is
required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and
make them publicly available on a periodic basis (for example, interim or annual periods). An entity must
meet both of these conditions to meet this criterion.
An entity may meet the definition of a public business entity solely because its financial statements or financial
information is included in another entity’s filing with the SEC. In that case, the entity is only a public business
entity for purposes of financial statements that are filed or furnished with the SEC.

Public Entity
Definition 1
An entity that meets any of the following criteria:
a. Its debt or equity securities are traded in a public market, including those traded on a stock exchange or
in the over-the-counter market (including securities quoted only locally or regionally).
b. It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or
foreign stock exchange or an over-the-counter market, including local or regional markets).
c. Its financial statements are filed with a regulatory agency in preparation for the sale of any class of securities.

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ASC 740 Topics and Subtopics — Glossary (continued)

Related Parties
Related parties include:
a. Affiliates of the entity
b. Entities for which investments in their equity securities would be required, absent the election of the fair
value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the
equity method by the investing entity
c. Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or
under the trusteeship of management
d. Principal owners of the entity and members of their immediate families
e. Management of the entity and members of their immediate families
f. Other parties with which the entity may deal if one party controls or can significantly influence the
management or operating policies of the other to an extent that one of the transacting parties might be
prevented from fully pursuing its own separate interests
g. Other parties that can significantly influence the management or operating policies of the transacting
parties or that have an ownership interest in one of the transacting parties and can significantly
influence the other to an extent that one or more of the transacting parties might be prevented from
fully pursuing its own separate interests.
Reporting Currency
The currency in which a reporting entity prepares its financial statements.

Reporting Unit
The level of reporting at which goodwill is tested for impairment. A reporting unit is an operating segment or
one level below an operating segment (also known as a component).

Revenue
Definition 1
Revenue earned by an entity from its direct distribution, exploitation, or licensing of a film, before deduction
for any of the entity’s direct costs of distribution. For markets and territories in which an entity’s fully or jointly-
owned films are distributed by third parties, revenue is the net amounts payable to the entity by third party
distributors. Revenue is reduced by appropriate allowances, estimated returns, price concessions, or similar
adjustments, as applicable.

Note: The following definition is Pending Content; see Transition Guidance in 606-10-65-1.

Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both)
from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing
major or central operations.

Security
Definition 2
A share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer
that has all of the following characteristics:
a. It is either represented by an instrument issued in bearer or registered form or, if not represented by an
instrument, is registered in books maintained to record transfers by or on behalf of the issuer.
b. It is of a type commonly dealt in on securities exchanges or markets or, when represented by an
instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for
investment.
c. It either is one of a class or series or by its terms is divisible into a class or series of shares, participations,
interests, or obligations.

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ASC 740 Topics and Subtopics — Glossary (continued)

Share-Based Payment Arrangements

An arrangement under which either of the following conditions is met:
a. One or more suppliers of goods or services (including employees) receive awards of equity shares,
equity share options, or other equity instruments.
b. The entity incurs liabilities to suppliers that meet either of the following conditions:
1. The amounts are based, at least in part, on the price of the entity’s shares or other equity
instruments. (The phrase at least in part is used because an award may be indexed to both the price
of the entity’s shares and something other than either the price of the entity’s shares or a market,
performance, or service condition.)
2. The awards require or may require settlement by issuance of the entity’s shares.
The term shares includes various forms of ownership interest that may not take the legal form of securities (for
example, partnership interests), as well as other interests, including those that are liabilities in substance but
not in form. Equity shares refers only to shares that are accounted for as equity.

Also called share-based compensation arrangements.

Share-Based Payment Transactions

A transaction under a share-based payment arrangement, including a transaction in which an entity acquires
goods or services because related parties or other holders of economic interests in that entity awards a share-
based payment to an employee or other supplier of goods or services for the entity’s benefit. Also called share-
based compensation transactions.

Share Option
A contract that gives the holder the right, but not the obligation, either to purchase (to call) or to sell (to put) a
certain number of shares at a predetermined price for a specified period of time. Most share options granted
to employees under share-based compensation arrangements are call options, but some may be put options.

Note: The following definition is Pending Content; see Transition Guidance in 718-10-65-11.

A contract that gives the holder the right, but not the obligation, either to purchase (to call) or to sell (to put) a
certain number of shares at a predetermined price for a specified period of time.

Significant Influence
Paragraphs 323-10-15-6 through 15-11 define significant influence.

Special Drawing Rights

Special Drawing Rights on the International Monetary Fund are international reserve assets whose value is
based on a basket of key international currencies.

Subsidiary
An entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as
its parent, holds a controlling financial interest. (Also, a variable interest entity that is consolidated by a primary
beneficiary.)

Taxable Income
The excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the
governmental taxing authority.

Taxable Temporary Difference

Temporary differences that result in taxable amounts in future years when the related asset is recovered or the
related liability is settled. See Temporary Difference.

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ASC 740 Topics and Subtopics — Glossary (continued)

Tax Consequences
The effects on income taxes — current or deferred — of an event.

Tax (or Benefit)

Tax (or benefit) is the total income tax expense (or benefit), including the provision (or benefit) for income taxes
both currently payable and deferred.

Tax-Planning Strategy
An action (including elections for tax purposes) that meets certain criteria (see paragraph 740-10-30-19) and
that would be implemented to realize a tax benefit for an operating loss or tax credit carryforward before
it expires. Tax-planning strategies are considered when assessing the need for and amount of a valuation
allowance for deferred tax assets.

Tax Position
A position in a previously filed tax return or a position expected to be taken in a future tax return that is
reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods. A tax
position can result in a permanent reduction of income taxes payable, a deferral of income taxes otherwise
currently payable to future years, or a change in the expected realizability of deferred tax assets. The term tax
position also encompasses, but is not limited to:
a. A decision not to file a tax return
b. An allocation or a shift of income between jurisdictions
c. The characterization of income or a decision to exclude reporting taxable income in a tax return
d. A decision to classify a transaction, entity, or other position in a tax return as tax exempt
e. An entity’s status, including its status as a pass-through entity or a tax-exempt not-for-profit entity.
Temporary Difference
A difference between the tax basis of an asset or liability computed pursuant to the requirements in Subtopic
740-10 for tax positions, and its reported amount in the financial statements that will result in taxable or
deductible amounts in future years when the reported amount of the asset or liability is recovered or settled,
respectively. Paragraph 740-10-25-20 cites examples of temporary differences. Some temporary differences
cannot be identified with a particular asset or liability for financial reporting (see paragraphs 740-10-05-10 and
740-10-25-24 through 25-25), but those temporary differences do meet both of the following conditions:
a. Result from events that have been recognized in the financial statements
b. Will result in taxable or deductible amounts in future years based on provisions of the tax law.
Some events recognized in financial statements do not have tax consequences. Certain revenues are exempt
from taxation and certain expenses are not deductible. Events that do not have tax consequences do not give
rise to temporary differences.

Tentative Minimum Tax

An intermediate calculation used in the determination of a corporation’s federal income tax liability under the
alternative minimum tax system in the United States. See Alternative Minimum Tax.

Time Value
The portion of the fair value of an option that exceeds its intrinsic value. For example, a call option with an
exercise price of $20 on a stock whose current market price is $25 has intrinsic value of $5. If the fair value of
that option is $7, the time value of the option is $2 ($7 – $5).

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 Appendix D — Glossary of Terms in the ASC 740 Topic and Subtopics

ASC 740 Topics and Subtopics — Glossary (continued)

Transaction Gain or Loss

Transaction gains or losses result from a change in exchange rates between the functional currency and the
currency in which a foreign currency transaction is denominated. They represent an increase or decrease in
both of the following:
a. The actual functional currency cash flows realized upon settlement of foreign currency transactions
b. The expected functional currency cash flows on unsettled foreign currency transactions.
Translation Adjustments
Translation adjustments result from the process of translating financial statements from the entity’s functional
currency into the reporting currency.

Underlying Asset
Note: The following definition is Pending Content; see Transition Guidance in 842-10-65-1.

An asset that is the subject of a lease for which a right to use that asset has been conveyed to a lessee. The
underlying asset could be a physically distinct portion of a single asset.

Unrecognized Tax Benefit

The difference between a tax position taken or expected to be taken in a tax return and the benefit recognized
and measured pursuant to Subtopic 740-10.

Unusual Nature
The underlying event or transaction should possess a high degree of abnormality and be of a type clearly
unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account
the environment in which the entity operates (see paragraph 220-20-60-1).

Valuation Allowance
The portion of a deferred tax asset for which it is more likely than not that a tax benefit will not be realized.

Variable Interest Entity

A legal entity subject to consolidation according to the provisions of the Variable Interest Entities Subsections of
Subtopic 810-10.

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Appendix E — Sample Disclosures of
Income Taxes

E.1 Background
This appendix is adapted and updated from Deloitte’s February 2015 Sample Disclosures: Accounting for
Income Taxes.

The sample disclosures in this document reflect accounting and disclosure requirements outlined in
SEC Regulation S-K, SEC Regulation S-X, and ASC 740 that are effective as of October 31, 2016. SEC
registrants should also consider pronouncements that were issued or effective subsequently that may
be applicable to the financial statements, as well as other professional literature such as AICPA audit and
accounting guides.

In March 2019, the FASB issued a proposed ASU that would modify or eliminate certain requirements
related to income tax disclosures as well as establish new disclosure requirements. Comments on the
proposed ASU were due by May 31, 2019. The FASB is reviewing the comments and is redeliberating.
Because this ASU has not been finalized, we have included details related to the changes it will mandate
in Chapter 14 and Appendix C but have not updated the disclosure samples below.

E.2 Use of These Sample Disclosures

Portions of certain sample disclosures in this document are based on actual disclosures from public
filings. Details that would identify the registrants have been removed, including dollar amounts and
specific references to the business.

The sample disclosures are intended to provide general information only. While entities may use
them to help assess whether they are compliant with U.S. GAAP and SEC requirements, they are not
all-inclusive and additional disclosures may be deemed necessary by entities or their auditors. Further,
the sample disclosures are not a substitute for understanding reporting requirements or for the
exercise of judgment. Entities are presumed to have a thorough understanding of the requirements and
should refer to accounting literature and SEC regulations as necessary.

[Section E.3 has been deleted.]

E.4 MD&A — General
Before the enactment of tax law proposals or changes to existing tax rules, SEC registrants should
consider whether the potential changes represent an uncertainty that management reasonably expects
could have a material effect on the results of operations, financial position, liquidity, or capital resources.
If so, registrants should consider disclosing information about the scope and nature of any potential
material effects of the changes.

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After the enactment of a new tax law, registrants should consider disclosing, when material, the
anticipated current and future impact of the law on their results of operations, financial position,
liquidity, and capital resources. In addition, registrants should consider disclosures in the critical
accounting estimates section of MD&A to the extent that the changes could materially affect existing
assumptions used in estimating tax-related balances.

The SEC staff expects registrants to provide early-warning disclosures to help users understand various
risks and how these risks potentially affect the financial statements. Examples of such risks include
situations in which (1) the registrant may have to repatriate foreign earnings to meet current liquidity
demands, resulting in a tax payment that may not be accrued for; (2) the historical ETR is not sustainable
and may change materially; (3) the valuation allowance on net DTAs may change materially; and (4) tax
positions taken during the preparation of returns may ultimately not be sustained. Early-warning
disclosures give investors insight into the underlying assumptions made by management and conditions
and risks facing an entity before a material change or decline in performance is reported.

E.5 MD&A — Results of Operations

Sample Disclosure

Results of Operations
Our ETR for fiscal years 20X3, 20X2, and 20X1 was XX percent, XX percent, and XX percent, respectively. Our tax
rate is affected by recurring items, such as tax rates in foreign jurisdictions and the relative amounts of income
we earn in those jurisdictions, which we expect to be fairly consistent in the near term. It is also affected by
discrete items that may occur in any given year but are not consistent from year to year. In addition to state
income taxes, the following items had the most significant impact on the difference between our statutory U.S.
federal income tax rate of XX percent and our ETR:
20X3
1. A $XXX (XX percent) reduction resulting from changes in UTBs for tax positions taken in prior periods,
related primarily to favorable developments in an IRS position. Note that a detailed explanation of the
change and the amount previously recorded as a UTB would be expected.
2. A $XXX (XX percent) increase resulting from multiple unfavorable foreign audit assessments. Note that a
detailed explanation of the change and the amount previously recorded as a UTB would be expected.
3. A $XXX (XX percent) reduction resulting from rate differences between U.S. and non-U.S. jurisdictions. No
U.S. taxes were provided for those undistributed foreign earnings that are indefinitely reinvested outside
the United States. Note that a discussion of the countries significantly affecting the overall effective rate
would be expected.
4. A $XXX (XX percent) increase from noncash impairment charges for goodwill that is nondeductible for
tax purposes.
20X2
The notes accompanying the 20X3 items above also apply to the 20X2 items listed below.
1. A $XXX (XX percent) increase resulting from the resolution of U.S. state audits.
2. A $XXX (XX percent) increase resulting from a European Commission penalty, which was not tax
deductible.
3. A $XXX (XX percent) reduction resulting from rate differences between U.S. and non-U.S. jurisdictions.

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Sample Disclosure (continued)

20X1
The notes accompanying the 20X3 items above also apply to the 20X1 items listed below.
1. A $XXX (XX percent) reduction resulting from the reversal of previously accrued taxes from an IRS
settlement.
2. A $XXX (XX percent) reduction resulting from rate differences between U.S. and non-U.S. jurisdictions.

For more information, see SEC Regulation S-K, Item 303.

SEC Regulation S-K, Item 303(a)(3)(ii), requires registrants to “[d]escribe any known trends or
uncertainties that have had or that the registrant reasonably expects will have a material favorable
or unfavorable impact on net sales or revenues or income from continuing operations.” The sample
disclosures below present various descriptions registrants might provide under this requirement.

Sample Disclosure

Early Warning of Possible Valuation Allowance Recognition in Future Periods

As of December 31, 20X1, we had approximately $XX million in net DTAs. These DTAs include approximately
$XX million related to NOL carryforwards that can be used to offset taxable income in future periods and
reduce our income taxes payable in those future periods. Many of these NOL carryforwards will expire if they
are not used within certain periods. At this time, we consider it more likely than not that we will have sufficient
taxable income in the future that will allow us to realize these DTAs. However, it is possible that some or all of
these NOL carryforwards could ultimately expire unused, especially if our Component X restructuring initiative
is not successful. Therefore, unless we are able to generate sufficient taxable income from our Component Y
operations, a substantial valuation allowance to reduce our U.S. DTAs may be required, which would materially
increase our expenses in the period the allowance is recognized and materially adversely affect our results of
operations and statement of financial condition.

Sample Disclosure

Early Warning of Possible Valuation Allowance Reversal in Future Periods

We recorded a valuation allowance against all of our DTAs as of both December 31, 20X2, and December 31,
20X1. We intend to continue maintaining a full valuation allowance on our DTAs until there is sufficient evidence
to support the reversal of all or some portion of these allowances. However, given our current earnings and
anticipated future earnings, we believe that there is a reasonable possibility that within the next 12 months,
sufficient positive evidence may become available to allow us to reach a conclusion that a significant portion
of the valuation allowance will no longer be needed. Release of the valuation allowance would result in the
recognition of certain DTAs and a decrease to income tax expense for the period the release is recorded.
However, the exact timing and amount of the valuation allowance release are subject to change on the basis of
the level of profitability that we are able to actually achieve.

Connecting the Dots

Companies should specify the positive and negative evidence they evaluated, the jurisdiction,
and the potential amount of valuation allowance that may be recorded or reversed.

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Sample Disclosure

Change in Tax Laws Affecting Future Periods

Changes in tax laws and rates may affect recorded DTAs and DTLs and our ETR in the future. In January 20X4,
Country X made significant changes to its tax laws, including certain changes that were retroactive to our
20X3 tax year. Because a change in tax law is accounted for in the period of enactment, the retroactive effects
cannot be recognized in our 20X3 financial results and instead will be reflected in our 20X4 financial results. We
estimate that a benefit of approximately $XXX will be accounted for as a discrete item in our tax provision for
the first quarter of 20X4. In addition, we expect this tax law change to favorably affect our estimated AETR for
20X4 by approximately X percentage points as compared to 20X3.

E.6 MD&A — Critical Accounting Estimates1

Sample Disclosure

Our income tax expense, DTAs and DTLs, and liabilities for UTBs reflect management’s best estimate of current
and future taxes to be paid. We are subject to income taxes in the United States and numerous foreign
jurisdictions. Significant judgments and estimates are required in the determination of the consolidated income
tax expense.

Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and
their reported amounts in the financial statements, which will result in taxable or deductible amounts in the
future. In evaluating our ability to recover our DTAs in the jurisdiction from which they arise, we consider
all available positive and negative evidence, including scheduled reversals of DTLs, projected future taxable
income, tax-planning strategies, and results of recent operations. In projecting future taxable income, we begin
with historical results adjusted for the results of discontinued operations and incorporate assumptions about
the amount of future state, federal, and foreign pretax operating income adjusted for items that do not have
tax consequences. The assumptions about future taxable income require the use of significant judgment and
are consistent with the plans and estimates we are using to manage the underlying businesses. In evaluating
the objective evidence that historical results provide, we consider three years of cumulative operating income
(loss).

As of December 31, 20X3, we have federal and state income tax NOL carryforwards of $XXX and $XXX, which
will expire on various dates from 20X4 through 20Y8 as follows:

20X4–20X8 $ XXX

20X9–20Y3 XXX

20Y4–20Y8 XXX

$ XXX

We believe that it is more likely than not that the benefit from certain state NOL carryforwards will not be
realized. In recognition of this risk, we have provided a valuation allowance of $XX on the DTAs related to these
state NOL carryforwards. If our assumptions change and we determine that we will be able to realize these
NOLs, the tax benefits related to any reversal of the valuation allowance on DTAs as of December 31, 20X3, will
be accounted for as follows: Approximately $XXX will be recognized as a reduction of income tax expense and
$XXX will be recorded as an increase in equity.

1
At the 2013 AICPA Conference on Current SEC and PCAOB Developments (the “AICPA Conference”), in remarks related to disclosures about
valuation allowances on DTAs, the SEC staff discouraged registrants from providing “boilerplate” information and instead recommended that they
discuss registrant-specific factors (e.g., limitations on their ability to use NOLs and FTCs). The SEC staff also stated that it has asked registrants
to disclose the effect of each source of taxable income on their ability to realize a DTA, including the relative magnitude of each source of
taxable income. In addition, the staff recommended that registrants consider disclosing the material negative evidence they evaluated, since
such disclosures could provide investors with information about uncertainties related to a registrant’s ability to recover a DTA. For additional
information, see Deloitte’s December 16, 2013, Heads Up on the AICPA Conference.

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Sample Disclosure (continued)

The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws
and regulations in a multitude of jurisdictions across our global operations. ASC 740 states that a tax benefit
from an uncertain tax position may be recognized when it is more likely than not that the position will be
sustained upon examination, including resolutions of any related appeals or litigation processes, on the basis of
the technical merits.

We (1) record UTBs as liabilities in accordance with ASC 740 and (2) adjust these liabilities when our judgment
changes as a result of the evaluation of new information not previously available. Because of the complexity of
some of these uncertainties, the ultimate resolution may result in a payment that is materially different from
our current estimate of the UTB liabilities. These differences will be reflected as increases or decreases to
income tax expense in the period in which new information is available.

We believe that it is reasonably possible that an increase of up to $XX in UTBs related to state exposures may
be necessary within the coming year. In addition, we believe that it is reasonably possible that approximately
$XX of our currently remaining UTBs, each of which is individually insignificant, may be recognized by the end of
20X4 as a result of a lapse of the statute of limitations.

We consider the earnings of certain non-U.S. subsidiaries to be indefinitely invested outside the United States
on the basis of estimates that future domestic cash generation will be sufficient to meet future domestic
cash needs and our specific plans for reinvestment of those subsidiary earnings. We have not recorded a
DTL related to the U.S. federal and state income taxes and foreign withholding taxes on approximately $XX of
undistributed earnings of foreign subsidiaries indefinitely invested outside the United States. If we decide to
repatriate the foreign earnings, we would need to adjust our income tax provision in the period we determined
that the earnings will no longer be indefinitely invested outside the United States.

For more information, see SEC Interpretation Release Nos. 33-8350, 34-48960, FR-72.

E.7 MD&A — Liquidity and Capital Resources2

Sample Disclosure

As of December 31, 2018, the company has accumulated undistributed earnings of approximately $XXX million
generated by foreign subsidiaries. Because $XXX million of such earnings have previously been subject to the
one-time transition tax on foreign earnings required by the 2017 Act, any additional taxes due with respect to
such earnings or the excess of the amount for financial reporting over the tax basis of our foreign investments
would generally be limited to foreign and state taxes. We intend, however, to indefinitely reinvest these
earnings and expect future U.S. cash generation to be sufficient to meet future U.S. cash needs.

For more information, see SEC Regulation S-K, Item 303.

Connecting the Dots

The SEC staff expects registrants to disclose the amount of cash and short-term investments
held by foreign subsidiaries that would not be available to fund domestic operations unless the
funds were repatriated. A registrant may disclose this information in the Cash and Investments
section of its MD&A.
2
At the 2011 AICPA Conference, Nili Shah, deputy chief accountant in the SEC’s Division of Corporation Finance, and Mark Shannon, associate
chief accountant in the SEC’s Division of Corporation Finance, discussed certain income tax matters in relation to registrants’ significant foreign
operations. Ms. Shah indicated that when a registrant with significant amounts of cash and short-term investments overseas has asserted that
such amounts are indefinitely reinvested in its foreign operations, the SEC staff would expect the registrant to provide the following disclosures in
an MD&A liquidity analysis: (1) the amount of cash and short-term investments held by foreign subsidiaries that is not available to fund domestic
operations unless the funds were repatriated; (2) a statement that the company would need to accrue and pay taxes if repatriated; and (3) if true,
a statement that the company does not intend to repatriate those funds.

At the 2013 AICPA Conference, the SEC staff also reminded registrants when making the assertion of indefinitely reinvested foreign earnings,
companies are required to disclose (1) the amount of the unrecognized DTL or (2) a statement that estimating an unrecognized tax liability is
not practicable. In addition, the staff indicated that it evaluates the indefinite reinvestment assertion in taking into account registrants’ potential
liquidity needs and the availability of funds in U.S. and foreign jurisdictions.

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E.8 MD&A — Contractual Obligations

Sample Disclosure

The table below contains information about our contractual obligations that affect our short- and long-term
liquidity and capital needs. The table also includes information about payments due under specified
contractual obligations and is aggregated by type of contractual obligation. It includes the maturity profile of
our consolidated long-term debt, operating leases, and other long-term liabilities.

Contractual Obligations
(in millions)

Less Than 1–3 3–5 More Than

Total 1 Year Years Years 5 Years
Long-term debt obligations $ XXX $ XXX $ XXX $ XXX $ XXX
Interest payments on
long-term debt XXX XXX XXX XXX XXX
Operating lease obligations XXX XXX XXX XXX XXX
Capital lease obligations XXX XXX XXX XXX XXX
UTBs, including interest and
penalties XXX XXX XXX XXX XXX
Other liabilities reflected on
consolidated balance
sheet XXX XXX XXX XXX XXX
Total $ XXX $ XXX $ XXX $ XXX $ XXX

In the table above, the UTBs, including interest and penalties, are related to temporary differences. The years
for which the temporary differences related to the UTBs will reverse have been estimated in the schedule
of obligations above. In addition, approximately $XX of UTBs have been recorded as liabilities, and we are
uncertain about whether or, if so, when such amounts may be settled. We also recorded a liability for potential
penalties of $XX and interest of $XX for the UTBs not included in the table above.

Sample Disclosure

The following table presents certain payments due under contractual obligations with minimum firm
commitments as of December 31, 20X3:

Payments Due In
(in millions)

Less Than 1–3 3–5 More Than

Total 1 Year Years Years 5 Years
Operating lease obligations $ XXX $ XXX $ XXX $ XXX $ XXX
Purchase obligations XXX XXX XXX XXX XXX
Other obligations XXX XXX XXX XXX XXX
Total $ XXX $ XXX $ XXX $ XXX $ XXX

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Sample Disclosure (continued)

Our other noncurrent liabilities in the consolidated balance sheet include UTBs and related interest and
penalties. As of December 31, 20X3, we had gross UTBs of $XX and an additional $XX for interest and penalties
classified as noncurrent liabilities. At this time, we are unable to make a reasonably reliable estimate of the
timing of payments in individual years in connection with these tax liabilities; therefore, such amounts are not
included in the above contractual obligation table.

For more information, see SEC Regulation S-K, Item 303.

Connecting the Dots

Entities may disclose in either a footnote to the table or an “other” column added to the table a
liability for UTBs for which reasonable estimates about the timing of payment cannot be made.

E.9 Notes to Consolidated Financial Statements

E.9.1 Note A — Summary of Significant Accounting Policies
E.9.1.1 Income Taxes
Sample Disclosure

We account for income taxes under the asset and liability method, which requires the recognition of DTAs and
DTLs for the expected future tax consequences of events that have been included in the financial statements.
Under this method, we determine DTAs and DTLs on the basis of the differences between the financial
statement and tax bases of assets and liabilities by using enacted tax rates in effect for the year in which the
differences are expected to reverse. The effect of a change in tax rates on DTAs and DTLs is recognized in
income in the period that includes the enactment date.

We recognize DTAs to the extent that we believe that these assets are more likely than not to be realized.
In making such a determination, we consider all available positive and negative evidence, including future
reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies,
carryback potential if permitted under the tax law, and results of recent operations. If we determine that we
would be able to realize our DTAs in the future in excess of their net recorded amount, we would make an
adjustment to the DTA valuation allowance, which would reduce the provision for income taxes.

We record uncertain tax positions in accordance with ASC 740 on the basis of a two-step process in which
(1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the
technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition
threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized
upon ultimate settlement with the related tax authority.

E.9.1.2 Classification of Interest and Penalties

Sample Disclosure

We recognize interest and penalties related to UTBs on the income tax expense line in the accompanying
consolidated statement of operations. Accrued interest and penalties are included on the related tax liability
line in the consolidated balance sheet.

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 Appendix E — Sample Disclosures of Income Taxes

Sample Disclosure

We recognize interest and penalties related to UTBs on the interest expense line and other expense line,
respectively, in the accompanying consolidated statement of operations. Accrued interest and penalties are
included on the related liability lines in the consolidated balance sheet.

For more information, see ASC 740-10-50-19.

E.9.1.3 ITC Recognition Policy

Sample Disclosure

We earn ITCs from the state of X’s economic development program. We use the deferral method of accounting
for ITCs.

Sample Disclosure

We use the flow-through method to account for ITCs earned on eligible scientific R&D expenditures. Under this
method, the ITCs are recognized as a reduction to income tax expense in the year they are earned.

For more information, see ASC 740-10-50-20.

E.9.2 Note B — Statement of Cash Flows

Sample Disclosure

Supplemental cash flows and noncash investing and financing activities are as follows:

Years Ended December 31

(in millions)

20X3 20X2 20X1

Noncash Investing and Financing Activities
Acquisition of property and equipment on account $ XXX $ XXX $ XXX
Acquisition of property and equipment through long-term
financing XXX XXX XXX
Supplemental Cash Flow Information
Income taxes paid, net of refunds XXX XXX XXX
Interest paid XXX XXX XXX

Connecting the Dots

Under ASC 230-10-50-2, the supplemental cash flow information for income taxes paid is
required when an indirect method is used. Such disclosure can be included in the company’s
statement of cash flows or in a footnote.

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E.9.3 Note C — Acquisitions
Sample Disclosure

The preliminary purchase price allocation resulted in goodwill of $XX million, which is not deductible for income
tax purposes. Goodwill consists of the excess of the purchase price over the fair value of the acquired assets
and represents the estimated economic value attributable to future operations.

The purchase price allocation is preliminary and subject to revision. At this time, except for the items noted
below, we do not expect material changes to the value of the assets acquired or liabilities assumed in
conjunction with the transaction. Specifically, the following assets and liabilities are subject to change:

• Intangible customer contracts.

• Payments due from and to related parties.
• Deferred income tax assets and liabilities.
As management receives additional information during the measurement period, these assets and liabilities
may be adjusted.

Under the acquisition method of accounting for business combinations, if we identify changes to acquired DTA
valuation allowances or liabilities related to uncertain tax positions during the measurement period, and they
are related to new information obtained about facts and circumstances that existed as of the acquisition date,
those changes are considered a measurement-period adjustment, and we record the offset to goodwill. We
record all other changes to DTA valuation allowances and liabilities related to uncertain tax positions in current-
period income tax expense. This accounting applies to all of our acquisitions, regardless of acquisition date.

Sample Disclosure

Goodwill of $XX million was assigned to the X and Y segments in the amounts of $XX million and $XX million,
respectively, and is deductible for tax purposes. The amounts of intangible assets and goodwill have been
assigned to the X and Y segments on the basis of the respective profit margins of the acquired customer
contracts. The transaction was taxable for income tax purposes, and all assets and liabilities have been
recorded at fair value for both book and income tax purposes. Therefore, no deferred taxes have been
recorded.

See ASC 805-10-50-5 for more information on financial effects of adjustments related to business
combinations that occurred in the current or previous reporting periods, and see ASC 805-30-50-1(d) for
total amount of goodwill that is expected to be deductible for tax purposes.

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E.9.4 Note D — Income Taxes3

Sample Disclosure

For financial reporting purposes, income before income taxes includes the following components:

Years Ended December 31

(in millions)

20X3 20X2 20X1

United States $ XXX $ XXX $ XXX
Foreign XXX XXX XXX
Total $ XXX $ XXX $ XXX

The expense (benefit) for income taxes consists of:

Years Ended December 31

(in millions)

20X3 20X2 20X1

Current:
Federal $ XXX $ XXX $ XXX
State XXX XXX XXX
Foreign XXX XXX XXX
$ XXX $ XXX $ XXX
Deferred and other:
Federal $ XXX $ XXX $ XXX
State XXX XXX XXX
Foreign XXX XXX XXX
$ XXX $ XXX $ XXX
Total tax expense $ XXX $ XXX $ XXX

3
At the 2010 AICPA Conference, Jill Davis, associate chief accountant in the SEC’s Division of Corporation Finance, stated that one of the
requirements in SEC Regulation S-X, Rule 4-08(h), is to disclose the components of income (loss) before income tax expense (benefit) as either
domestic or foreign. Ms. Davis indicated that some registrants’ disclosures about these components have been limited in circumstances in which
the registrants had a very low income tax expense because a substantial amount of profits were derived from countries with little or no tax. She
explained that the disclosures provided should allow an investor to easily determine the ETR for net income attributable to domestic operations
and foreign operations and stated that the lack of such disclosure may result in SEC staff comments. For additional information, see SEC
Regulation S-X, Rule 4-08(h), “General Notes to Financial Statements: Income Tax Expense.”

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Sample Disclosure

For financial reporting purposes, income before income taxes includes the following components:

Years Ended December 31

(in millions)

20X3 20X2 20X1

United States $ XXX $ XXX $ XXX
Foreign XXX XXX XXX
Total $ XXX $ XXX $ XXX

The provision for income taxes for 20X3, 20X2, and 20X1 consists of the following:

Years Ended December 31

(in millions)

20X3 20X2 20X1

U.S. Federal:
Current $ XXX $ XXX $ XXX
Deferred XXX XXX XXX
$ XXX $ XXX $ XXX
U.S. State:
Current $ XXX $ XXX $ XXX
Deferred XXX XXX XXX
$ XXX $ XXX $ XXX
Foreign:
Current $ XXX $ XXX $ XXX
Deferred XXX XXX XXX
$ XXX $ XXX $ XXX

Provision for income taxes $ XXX $ XXX $ XXX

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 Appendix E — Sample Disclosures of Income Taxes

E.9.4.1 Components of Income Tax Expense or Benefit

Sample Disclosure

Years Ended December 31

(in millions)

20X3 20X2 20X1

Current tax expense (benefit) $ XXX $ XXX $ XXX
Deferred tax expense (benefit) XXX XXX XXX
Tax expense (benefit) related to an increase (decrease)
in UTBs XXX XXX XXX
Interest expense — gross of related tax effects XXX XXX XXX
Penalties — gross of related tax effects XXX XXX XXX
Tax expense recorded as an increase of paid-in capital XXX XXX XXX
Total tax expense $ XXX $ XXX $ XXX

For more information, see ASC 740-10-50-9, which requires disclosure of other items, such as the
effects of changes in tax law or in valuation allowances, that may be disclosed elsewhere (i.e., in the
reconciliation of the ETR).

Sample Disclosure

Years Ended December 31

(in millions)

20X3 20X2 20X1

Current tax expense (benefit) $ XXX $ XXX $ XXX
Deferred tax expense (benefit) XXX XXX XXX
Other tax expense (benefit) XXX XXX XXX
Total tax expense $ XXX $ XXX $ XXX

If presented, the other tax expense (benefit) line above would include items affecting the expense that
neither meet the definition of a deferred tax item (see ASC 740-10-30-4) nor the definition of a current
tax item (see ASC 740-10-20). If material, the components of the other tax expense (benefit) should be
separately described below the table. For additional information, see ASC 740-10-50-9.

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E.9.4.2 Rate Reconciliation
Sample Disclosure

Reconciliation between the ETR on income from continuing operations and the statutory tax rate is as follows:

Years Ended December 31

(in millions)

20X3 20X2 20X1

Income tax expense (benefit) at federal statutory rate $ XXX $ XXX $ XXX
State and local income taxes net of federal tax benefit XXX XXX XXX
Foreign tax rate differential* XXX XXX XXX
Change in valuation allowance XXX XXX XXX
Effect of flow-through entity XXX XXX XXX
Effect of double taxation net of dividends received deduction XXX XXX XXX
Noncontrolling interest XXX XXX XXX
Nondeductible/nontaxable items XXX XXX XXX
Share-based compensation XXX XXX XXX
Tax audit settlements XXX XXX XXX
Other — net XXX XXX XXX
Income tax expense (benefit) $ XXX $ XXX $ XXX

* At the 2013 AICPA Conference, the SEC staff noted the following issues with registrants’ tax rate reconciliation
disclosures:
• Labels related to reconciling items were unclear, and disclosures about material reconciling items did not
adequately describe the underlying nature of these items.
• For material reconciling items related to foreign tax jurisdictions, registrants did not disclose in MD&A (1) each
material foreign jurisdiction and its tax rate and (2) how each jurisdiction affects the amount in the tax rate
reconciliation.
• Registrants have inappropriately aggregated material reconciling items. The SEC staff reminded registrants that
Regulation S-X requires separate-line-item disclosure for reconciling items whose amount is greater than 5 percent
of the amount calculated by multiplying the pretax income by the statutory tax rate.
• Amounts reflected in the tax rate reconciliation were inconsistent with related amounts disclosed elsewhere in a
registrant’s filing.
• Corrections of errors were inappropriately reflected as changes in estimates.
For additional information, see Deloitte’s December 16, 2013, Heads Up on the AICPA Conference.

For more information, see ASC 740-10-50-12 through 50-14.

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Connecting the Dots

SEC Regulation S-X, Rule 4-08(h)(2), indicates that for public entities, the reconciliation should
disclose all components of the income tax expense or benefit that constitute 5 percent or more
of income tax expense or benefit from continuing operations, determined by using the statutory
tax rate. Nonpublic entities are permitted to omit this reconciliation but are required to disclose
the nature of significant reconciling items.

Sample Disclosure

The differences between income taxes expected at the U.S. federal statutory income tax rate of 35 percent and
the reported income tax (benefit) expense are summarized as follows:

Years Ended December 31

(in millions)

20X3 20X2 20X1

Expected income tax (benefit) expense at federal statutory
rate $ XXX $ XXX $ XXX
Valuation allowance for DTAs XXX XXX XXX
Fair value of preferred stock equity conversion feature XXX XXX
Residual tax on foreign earnings XXX XXX XXX
Foreign rate differential* XXX XXX XXX
Bargain purchase gain XXX
Gain on contingent purchase price reduction XXX
Meals and entertainment XXX XXX XXX
Exempt foreign income XXX XXX XXX
UTBs XXX XXX XXX
State and local income taxes XXX XXX XXX
Dividends received deduction XXX
Capitalized transaction costs XXX XXX
Other XXX XXX XXX
Reported income tax (benefit) expense $ XXX $ XXX $ XXX
ETR XX% XX% XX%
* See footnote 3.

E.9.4.3 Unrecognized DTL Related to Investments in Foreign Subsidiaries4

Sample Disclosure

As of December 31, 2018, the company has accumulated undistributed earnings generated by foreign
subsidiaries of approximately $XXX million. Because $XXX million of such earnings have previously been subject
to the one-time transition tax on foreign earnings required by the 2017 Act, any additional taxes due with
respect to such earnings or the excess of the amount for financial reporting over the tax basis of our foreign
investments would generally be limited to foreign and state taxes. We intend, however, to indefinitely reinvest
these earnings and expect future U.S. cash generation to be sufficient to meet future U.S. cash needs.

4
See footnote 1.

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E.9.4.4 Components of the Net DTA or DTL

Sample Disclosure

December 31
(in millions)

20X3 20X2
Receivable allowances $ XXX $ XXX
Reserves and accruals not currently deductible for tax purposes XXX XXX
Share-based compensation XXX XXX
R&D costs XXX XXX
NOL and tax credit carryforwards XXX XXX
Restructuring and settlement reserves XXX XXX
Other XXX XXX
Subtotal $ XXX $ XXX
Less: valuation allowance XXX XXX
Total net DTAs $ XXX $ XXX

Inventory valuation and other assets $ XXX $ XXX

Fixed assets XXX XXX
Other XXX XXX
Total DTLs $ XXX $ XXX
Net DTL $ XXX $ XXX

For more information, see ASC 740-10-50-2, ASC 740-10-50-6, ASC 740-10-50-8, and ASC 740-10-50-16.

E.9.4.5 Operating Loss and Tax Credit Carryforwards

Sample Disclosure

We have income tax NOL carryforwards related to our international operations of approximately $XXX. We have
recorded a DTA of $XXX reflecting the benefit of $XXX in loss carryforwards. Such DTAs expire as follows:

20X4–20X8 $ XXX

20X9–20Y3 XXX

20Y4–20Y8 XXX

$ XXX

For more information, see ASC 740-10-50-3.

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E.9.4.6 Valuation Allowance5 and Risks and Uncertainties

Sample Disclosure

Management assesses the available positive and negative evidence to estimate whether sufficient future
taxable income will be generated to permit use of the existing DTAs. A significant piece of objective negative
evidence evaluated was the cumulative loss incurred over the three-year period ended December 31, 20X3.
Such objective evidence limits the ability to consider other subjective evidence, such as our projections for
future growth.

On the basis of this evaluation, as of December 31, 20X3, a valuation allowance of $XXX has been recorded
to recognize only the portion of the DTA that is more likely than not to be realized. The amount of the DTA
considered realizable, however, could be adjusted if estimates of future taxable income during the carryforward
period are reduced or increased or if objective negative evidence in the form of cumulative losses is no longer
present and additional weight is given to subjective evidence such as our projections for growth.

For more information, see ASC 275-10-50-8.

Sample Disclosure

We have federal and state income tax NOL carryforwards of $XXX and $XXX, which will expire on various dates
in the next 15 years as follows:

20X4–20X8 $ XXX

20X9–20Y3 XXX

20Y4–20Y8 XXX

$ XXX

We believe that it is more likely than not that the benefit from certain state NOL carryforwards will not be
realized. In recognition of this risk, we have provided a valuation allowance of $XXX on the DTAs related to
these state NOL carryforwards. If or when recognized, the tax benefits related to any reversal of the valuation
allowance on DTAs as of December 31, 20X3, will be accounted for as follows: Approximately $XXX will be
recognized as a reduction of income tax expense and $XXX will be recorded as an increase in equity.

The federal, state, and foreign NOL carryforwards in the income tax returns filed included UTBs. The DTAs
recognized for those NOLs are presented net of these UTBs.

Because of the change of ownership provisions of the Tax Reform Act of 1986, use of a portion of our domestic
NOL and tax credit carryforwards may be limited in future periods. Further, a portion of the carryforwards may
expire before being applied to reduce future income tax liabilities.

5
At the 2011 AICPA Conference, Mark Shannon advised that entities must consider all available evidence, both positive and negative, in determining
whether a valuation allowance is needed to reduce a DTA to an amount that is more likely than not to be realized. Mr. Shannon said that some
registrants are placing less weight on recent losses when weighing the positive and negative evidence because they view the current economic
downturn as an aberration, as given in an example in ASC 740-10-30-22. He stated that while each company’s facts and circumstances could differ,
in general it would be difficult to conclude the economic downturn is an aberration. He also reminded participants that overcoming such negative
evidence would require significant objective positive evidence. At the 2012 AICPA Conference, Mr. Shannon reiterated these comments. He also
emphasized the importance of evidence that is objectively verifiable and noted that it carries more weight than evidence that is not.

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E.9.4.7 Valuation Allowance Reversal6

Sample Disclosure

As of December 31, 20X3, our DTAs were primarily the result of U.S. NOL, capital loss, and tax credit
carryforwards. A valuation allowance of $XXX and $XXX was recorded against our gross DTA balance as of
December 31, 20X3, and December 31, 20X2, respectively. For the years ended December 31, 20X3, and
December 31, 20X2, we recorded a net valuation allowance release of $XXX (comprising a full-year valuation
release of $XXX related to the X segment, partially offset by an increase to the valuation allowance of $XXX
related to the Y segment) and $XXX, respectively, on the basis of management’s reassessment of the amount of
its DTAs that are more likely than not to be realized.

As of each reporting date, management considers new evidence, both positive and negative, that could affect
its view of the future realization of DTAs. As of December 31, 20X3, in part because in the current year we
achieved three years of cumulative pretax income in the U.S. federal tax jurisdiction, management determined
that there is sufficient positive evidence to conclude that it is more likely than not that additional deferred taxes
of $XXX are realizable. It therefore reduced the valuation allowance accordingly.

As of December 31, 20X3, and December 31, 20X2, we have NOL carryforwards of $XXX and $XXX, respectively,
which, if unused, will expire in years 20Y6 through 20Z2. We have capital loss carryforwards totaling $XXX and
$XXX as of December 31, 20X3, and December 31, 20X2, respectively, which, if unused, will expire in years 20X4
through 20X8. In addition, as of December 31, 20X3, and December 31, 20X2, we have qualified affordable
housing tax credit carryforwards totaling $XXX and $XXX, respectively, which, if unused, will expire in years
20X8 through 20Z3, and alternative minimum tax credits of $XXX and $XXX, respectively, that may be carried
forward indefinitely. Certain tax attributes are subject to an annual limitation as a result of the acquisition of
our Subsidiary A, which constitutes a change of ownership as defined under IRC Section 382.

[Section E.9.4.8 has been deleted.]

E.9.4.9 Tax Holidays
Sample Disclosure

We operate under tax holidays in other countries, which are effective through December 31, 20X3, and may be
extended if certain additional requirements are satisfied. The tax holidays are conditional upon our meeting
certain employment and investment thresholds. The impact of these tax holidays decreased foreign taxes by
$XXX, $XXX, and $XXX for 20X3, 20X2, and 20X1, respectively. The benefit of the tax holidays on net income per
share (diluted) was $.XX, $.XX, and $.XX for 20X3, 20X2, and 20X1, respectively.

For more information, see SAB Topic 11.C.

6
At the 2012 AICPA Conference, Mark Shannon noted that registrants who have returned to profitability may be considering whether they should
reverse a previously recognized valuation allowance. He indicated that factors to consider in making this determination include (1) the magnitude
and duration of past losses and (2) the magnitude and duration of current profitability as well as changes in the factors that drove losses in the
past and those currently driving profitability. Nili Shah further noted that registrants should assess the sustainability of current profits as well as
their track record of accurately forecasting future financial results. She pointed out that registrants’ disclosures should include a discussion of the
factors or reasons that led to a reversal of a valuation allowance that effectively answers the question “why now.” Such disclosures would include
a comprehensive analysis of all available positive and negative evidence and how the entity weighed each piece of evidence in its assessment. She
also reminded registrants that the same disclosures would be expected when there is significant negative evidence and a registrant concludes
that a valuation allowance is necessary.

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E.9.4.10 Unrecognized Tax Benefits

E.9.4.10.1 Tabular Reconciliation of UTBs
Sample Disclosure

Below is a tabular reconciliation of the total amounts of UTBs; this tabular reconciliation disclosure is not
required for nonpublic entities.

20X3 20X2 20X1

(in millions)
UTBs — January 1 $ XXX $ XXX $ XXX
Gross increases — tax positions in prior period XXX XXX XXX
Gross decreases — tax positions in prior period XXX XXX
Gross increases — tax positions in current period XXX XXX XXX
Settlement XXX XXX XXX
Lapse of statute of limitations XXX XXX XXX
UTBs — December 31 $ XXX $ XXX $ XXX

Sample Disclosure

The table below illustrates a selection of reconciling items that may be reported separately or aggregated
on the basis of the specific facts and circumstances. The list is not intended to be all-inclusive. If reported
separately, the descriptions should be appropriately titled so that the user of the financial statements will
understand the nature of the reconciling item being reported.

20X3 20X2 20X1

(in millions)
UTBs — January 1 $ XXX $ XXX $ XXX
Current year — increase XXX XXX XXX
Prior year — increase XXX XXX XXX
Claims XXX XXX XXX
Prior year — decrease XXX XXX XXX
Accrual to return changes XXX XXX XXX
Settlements XXX XXX XXX
Statute expiration XXX XXX XXX
Current year acquisitions XXX XXX XXX
Divestitures XXX XXX XXX
Currency XXX XXX XXX

UTBs — December 31 $ XXX $ XXX $ XXX

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E.9.4.10.2 UTBs That, if Recognized, Would Affect the ETR

Sample Disclosure

Included in the balance of UTBs as of December 31, 20X3; December 31; 20X2; and December 31, 20X1, are
$XXX, $XXX, and $XXX, respectively, of tax benefits that, if recognized, would affect the ETR. Also included in
the balance of UTBs as of December 31, 20X3; December 31, 20X2; and December 31, 20X1, are $XXX, $XXX,
and $XXX, respectively, of tax benefits that, if recognized, would result in adjustments to other tax accounts,
primarily deferred taxes.

For more information, see ASC 740-10-50-15A(b).

E.9.4.10.3 Total Amounts of Interest and Penalties Recognized in the Statement

of Operations and Total Amounts of Interest and Penalties Recognized in the
Statements of Financial Position
Sample Disclosure

We recognize interest accrued related to UTBs and penalties as income tax expense. We accrued penalties
of $XX and interest of $XX during 20X3 and in total, as of December 31, 20X3, recognized a liability related to
the UTBs noted above for penalties of $XX and interest of $XX. During 20X2, we accrued penalties of $XX and
interest of $XX and in total, as of December 31, 20X2, recognized a liability for penalties of $XX and interest of
$XX. During 20X1, we accrued penalties of $XX and interest of $XX.

For more information, see ASC 740-10-50-15(c).

E.9.4.10.4 Tax Positions for Which It Is Reasonably Possible That the Total

Amounts of UTBs Will Significantly Increase or Decrease Within 12 Months of the
Reporting Date
Sample Disclosure

We believe that it is reasonably possible that a decrease of up to $XX in UTBs related to state exposures may
be necessary within the coming year. In addition, we believe that it is reasonably possible that approximately
$XX of current other remaining UTBs, each of which is individually insignificant, may be recognized by the end
of 20X4 as a result of a lapse of the statute of limitations. As of December 31, 20X2, we believed that it was
reasonably possible that a decrease of up to $XX in UTBs related to state tax exposures would have occurred
during the year ended December 31, 20X3. During the year ended December 31, 20X3, UTBs related to those
state exposures actually decreased by $XX as illustrated in the table above.

For more information, see ASC 740-10-50-15(d).

E.9.4.10.5 Description of Tax Years That Remain Subject to Examination by Major

Tax Jurisdictions
Sample Disclosure

We are subject to taxation in the United States and various states and foreign jurisdictions. As of December 31,
20X3, tax years for 20X0, 20X1, and 20X2 are subject to examination by the tax authorities. With few exceptions,
as of December 31, 20X3, we are no longer subject to U.S. federal, state, local, or foreign examinations by tax
authorities for years before 20X0. Tax year 20W9 was open as of December 31, 20X2.

For more information, see ASC 740-10-50-15(e).

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E.9.4.11 Subsequent-Events Disclosure
Sample Disclosure

In January 20X4, we received notice of a tax incentive award of $XX that will allow us to monetize approximately
$XX of state R&D tax credits. In exchange for this award, we pledged to hire more employees and maintain the
additional head count through at least December 31, 20X8. Failure to do so could result in our being required
to repay some or all of these incentives.

For more information, see ASC 855-10-50-2.

Connecting the Dots

Disclosure of a nonrecognized subsequent event is required only when the financial statements
would be considered misleading without such disclosure.

E.10 Schedule II — Valuation and Qualifying Accounts

The schedule and accompanying footnote below are reproduced from SEC Regulation S-X, Rule 12-09.

SEC Regulation S-X, Rule 12-09, “Valuation and Qualifying Accounts”

Column C — Additions

Column B — (1) — Charged (2) — Charged

Balance at to Costs and to Other Column D — Column E —
Column A — Beginning of Expenses Accounts — Deductions — Balance at
Description1 Period Describe Describe End of Period

1
List, by major classes, all valuation and qualifying accounts and reserves not included in specific schedules. Identify
each class of valuation and qualifying accounts and reserves by descriptive title. Group (a) those valuation and
qualifying accounts that are deducted in the balance sheet from the assets to which they apply and (b) those reserves
[that] support the balance sheet caption, Reserves. Valuation and qualifying accounts and reserves as to which [of] the
additions, deductions, and balances were not individually significant may be grouped in one total and in such a case the
information called for under columns C and D need not be given.

Connecting the Dots

A liability for UTBs is not a valuation or qualifying account, whereas a valuation allowance on a
DTA is a valuation account.

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E.11 Interim Disclosures
Sample Disclosure

Our ETR from continuing operations was XX percent and XX percent for the quarter and nine months ended
September 30, 20X2, respectively, and XX percent and XX percent for the quarter and nine months ended
September 30, 20X1, respectively. The following items caused the quarterly or YTD ETR to be significantly
different from our historical annual ETR:

• During the third quarter and nine months ended September 30, 20X2, we recorded an income tax
benefit of approximately $XX million as a result of a favorable settlement of uncertain tax positions in
Jurisdiction X, which reduced the ETR by XX percent and XX percent, respectively.
• During the nine months ended September 30, 20X1, we recorded an income tax benefit of
approximately $XX million related to an increase in tax rates in Country X enacted in the third quarter,
which increased the ETR by XX percent.

Sample Disclosure

When calculating the annual estimated effective income tax rate for the three months ended March 31,
20X1, we were subject to a loss limitation rule because the YTD ordinary loss exceeded the full-year expected
ordinary loss. The tax benefit for that YTD ordinary loss was limited to the amount that would be recognized if
the YTD ordinary loss were the anticipated ordinary loss for the full year.

Sample Disclosure

We have historically calculated the provision for income taxes during interim reporting periods by applying an
estimate of the AETR for the full fiscal year to “ordinary” income or loss (pretax income or loss excluding unusual
or infrequently occurring discrete items) for the reporting period. We have used a discrete ETR method to
calculate taxes for the fiscal three- and six-month periods ended June 30, 20X2. We determined that since small
changes in estimated “ordinary” income would result in significant changes in the estimated AETR, the historical
method would not provide a reliable estimate for the fiscal three- and six-month periods ended June 30, 20X2.

For more information on variations in customary income tax expense relationships, see ASC 740-270-50-1.

E.12 Separate Company Financial Statements

Sample Disclosure

Our company is included in the consolidated tax return of Parent P. We calculate the provision for income
taxes by using a separate-return method. Under this method, we are assumed to file a separate return with
the tax authority, thereby reporting our taxable income or loss and paying the applicable tax to or receiving the
appropriate refund from P. Our current provision is the amount of tax payable or refundable on the basis of
a hypothetical, current-year separate return. We provide deferred taxes on temporary differences and on any
carryforwards that we could claim on our hypothetical return and assess the need for a valuation allowance on
the basis of our projected separate-return results.

Any difference between the tax provision (or benefit) allocated to us under the separate-return method
and payments to be made to (or received from) P for tax expense is treated as either dividends or capital
contributions. Accordingly, the amount by which our tax liability under the separate-return method exceeds the
amount of tax liability ultimately settled as a result of using incremental expenses of P is periodically settled as
a capital contribution from P to us.

For more information on entities with separately issued financial statements that are members of a
consolidated tax return, see ASC 740-10-50-17(b).

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Appendix F — Differences Between U.S.
GAAP and IFRS Standards

F.1 Background
ASC 740 is the primary source of guidance on the accounting for income taxes under U.S. GAAP, and IAS
12 is the primary source of such guidance under IFRS Standards.1

In general, the income tax accounting frameworks in both U.S. GAAP and IFRS Standards require the
application of a balance sheet model, and share the same basic objectives related to the recognition of
(1) the amount of taxes payable or refundable for the current year and (2) DTAs and DTLs for future tax
consequences of events that have been recognized in an entity’s financial statements or tax returns.

However, differences remain between the accounting for income taxes under U.S. GAAP and that under
IFRS Standards. The table below summarizes some of the significant differences and is followed by more
detailed explanations of each difference as well as cross-references to other sections of the Roadmap.2
Note that this appendix should be used in conjunction with the Roadmap’s detailed interpretive
guidance and with A13 of Deloitte’s iGAAP publication.

Subject U.S. GAAP IFRS Standards

Initial recognition No “initial recognition” exception under “Initial recognition” exception applies.
exception U.S. GAAP. Deferred tax is not recognized for taxable
or deductible temporary differences
that arise from the initial recognition
of an asset or a liability in a transaction
that (1) is not a business combination
and (2) does not affect accounting profit
or taxable profit when the transaction
occurs. Changes in this unrecognized
DTA or DTL are not subsequently
recognized.

1
The IASB issued the IFRS for SMEs® Standard (the “SMEs Standard”) in July 2009. The SMEs Standard is a stand-alone standard and does not
require preparers of private-entity financial statements to explicitly refer to full IFRS Standards. Section 29 of the SMEs Standard is the primary
source of guidance on accounting for income taxes for entities applying the SMEs Standard. This appendix does not address the differences
between Section 29 and IAS 12 and, therefore, the differences in the accounting for income taxes that might exist between U.S. GAAP and the
SMEs Standard.
2
Differences are based on comparison of authoritative literature under U.S. GAAP and IFRS Standards and do not necessarily include
interpretations of such literature.

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(Table continued)

Subject U.S. GAAP IFRS Standards

Recognition of DTAs DTAs are recognized in full and reduced DTAs are recognized at the amount that
by a valuation allowance if it is more likely is probable (generally interpreted to
than not that some or all of the DTAs will mean more likely than not3) to be realized
not be realized. on a net basis (i.e., the DTA is written
down, and an allowance is not recorded).

Tax laws and rates used Enacted tax laws and rates are used. Enacted or “substantively” enacted tax
for measuring DTAs laws or rates are used.
and DTLs

Uncertain tax positions ASC 740 prescribes a two-step IFRIC Interpretation 23 was issued by
recognition and measurement approach the International Accounting Standards
under which an entity calculates the Board (IASB®) in June 2017 and is
amount of tax benefit to recognize in effective for annual periods beginning
the financial statements by (1) assessing on or after January 1, 2019, with earlier
whether it is more likely than not that application permitted. The standard
a tax position will be sustained upon clarified how uncertainty over income
examination and (2) measuring a tax tax treatment should be recognized and
position that reaches the more-likely- measured under IAS 12.
than-not recognition threshold to
determine the amount of benefit to Before the adoption of IFRIC
recognize in the financial statements. The Interpretation 23:
tax position is measured at the largest IAS 12 does not specifically address the
amount of benefit that is greater than accounting for tax uncertainties. The
50 percent likely to be realized upon recognition and measurement provisions
settlement. of IAS 37 are relevant because an
uncertain tax position may give rise to a
liability of uncertain timing and amount.
Recognition is based on whether it is
probable that an outflow of economic
resources will occur. “Probable” is defined
as “more likely than not.” Measurement is
based on the entity’s best estimate of the
amount of the tax benefit.

After the adoption of IFRIC

Interpretation 23:
If an entity concludes that it is probable
that the taxing authority will accept an
uncertain tax treatment (including both
the technical merit of the treatment and
the amounts included in the tax return),
recognition and measurement are
consistent with the positions as taken in
the tax filings. If the entity concludes that
it is not probable that the taxing authority
will accept the tax treatment as filed, the
entity is required to reflect the uncertainty
by using (1) the most likely amount or (2)
the expected value. “Probable” is defined
as “more likely than not.”

3
While IAS 12 is silent with regard to the meaning of “probable” in the context of paragraph 24 of IAS 12, IAS 37 defines the term as “more likely
than not.” The footnote to paragraph 23 of IAS 37 acknowledges that this definition is not necessarily applicable to other IFRS Standards. However,
in the absence of any other guidance, the term probable should be considered to mean more likely than not. In March 2009, the IASB issued
an exposure draft containing proposals for an IFRS Standard that would replace IAS 12. Although a replacement standard was not finalized, the
exposure draft provided useful guidance on the meaning of “probable” because it used the term “more likely than not” and noted in the Basis for
Conclusions that it was consistent with the term “probable” as used in IAS 37 and IFRS 3.

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 Appendix F — Differences Between U.S. GAAP and IFRS Standards

(Table continued)

Subject U.S. GAAP IFRS Standards

Tax consequences of Tax effects of intra-entity transfers of No such exception for intra-entity
intra-entity sales inventory are deferred until the related transfers of inventory exists. Any current
inventory is sold or disposed of, and no and deferred tax expense from intra-
deferred taxes are recognized for the entity transfers (inventory or otherwise)
difference between the carrying value of is recognized at the time of the transfer.
the inventory in the consolidated financial Deferred taxes are recognized for the
statements and the tax basis of the difference between the carrying value of
inventory in the buyer’s tax jurisdiction. the transferred asset in the consolidated
financial statements and the tax basis
of the transferred asset in the buyer’s
tax jurisdiction, measured by using the
statutory tax rate of the buyer’s tax
jurisdiction (subject to realization criteria
in IAS 12 if a DTA is recognized on the
basis difference) .

Foreign nonmonetary No deferred tax is recognized on basis No similar guidance in IAS 12.
assets or liabilities for differences resulting from (1) changes
which the functional in exchange rates (i.e., the difference
currency is not the local between the carrying amount for financial
currency reporting purposes, which is determined
by using the historical rate of exchange,
and the tax basis, which is determined by
using the exchange rate on the balance
sheet date) or (2) the indexing of basis for
income tax purposes.

Special deductions An entity is not permitted to anticipate No similar guidance in IAS 12.
(e.g., tax benefits for tax benefits for special deductions
statutory depletion or when measuring the DTL for taxable
special deductions for temporary differences at the end of
certain health benefit the current year. Instead, the entity
entities, small life should recognize such tax benefits
insurance companies, for financial reporting purposes no
or domestic production earlier than the year in which they are
activities) available to reduce taxable income on
the entity’s tax returns. In addition, the
future tax effects of special deductions
may nevertheless affect (1) the average
graduated tax rate to be used for
measuring DTAs and DTLs when
graduated tax rates are a significant
factor and (2) the need for a valuation
allowance for DTAs.

Share-based For awards that ordinarily give rise to For awards that ordinarily give rise
compensation a tax deduction under existing tax law, to a tax deduction, deferred taxes
deferred taxes are computed on the are computed on the basis of the
basis of compensation expense that hypothetical tax deduction for the
is recognized for financial reporting share-based payment corresponding
purposes. Tax benefits in excess of or to the percentage earned to date
less than the related DTA are recognized (i.e., the intrinsic value of the award
in the income statement in the period on the reporting date multiplied by
in which the amount of the deduction the percentage vested). Recognition
is determined (typically when an award of deferred taxes could be recorded
vests or, in the case of options, is through either profit or loss or equity.
exercised or expires).

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(Table continued)

Subject U.S. GAAP IFRS Standards

Subsequent changes Generally allocated to continuing IAS 12 requires that the income tax
in deferred taxes (e.g., operations with limited exceptions (i.e., expense or benefit is recognized in
because of changes in backward tracing is generally prohibited, the same manner in which the asset
tax laws, rates, status regardless of whether the associated or liability was originally recorded. That
or valuation allowance) tax expense or benefit was originally is, if the deferred taxes were originally
recognized outside of continuing recorded outside of profit or loss (e.g.,
operations [e.g., in equity]). in equity), subsequent changes to the
beginning balance will be recorded in the
same manner (i.e., backward tracing is
permitted).

Deferred taxes A DTL is generally not recognized for A DTL is generally recognized for financial
for outside basis financial reporting basis in excess of reporting basis in excess of tax basis of
differences — tax basis in foreign subsidiaries and any form of investee (foreign or domestic,
investment in a corporate joint ventures that are subsidiaries, branches, associates, and
subsidiary or a essentially permanent in duration unless interests in joint arrangements) unless
corporate joint venture the difference is expected to reverse both of the following conditions are
that is essentially in the foreseeable future. For financial satisfied: (1) the parent is able to control
permanent in duration reporting basis in excess of tax basis the timing of the temporary difference’s
in domestic subsidiaries or corporate reversal and (2) it is probable that the
joint ventures, a DTL is generally not temporary difference will not reverse in
recognized if the basis difference arose the foreseeable future.
in fiscal years on or before December 15,
1992, unless the temporary difference A DTA is generally recognized for tax
will reverse in the foreseeable future. basis in excess of financial reporting basis
However, a DTL must be recognized if of any form of investee to the extent that
the basis difference arose in fiscal years it is probable (generally interpreted to
after December 15, 1992, “unless the mean more-likely-than-not) that (1) the
tax law provides a means by which the temporary difference will reverse in
investment in a domestic subsidiary can the foreseeable future and (2) taxable
be recovered tax free” and the entity profit will be available against which the
expects that it will ultimately use that temporary difference can be used.
means. Note that there is no similar prohibition
A DTA is recorded with respect to on applying the guidance to partnerships,
investments in a subsidiary or corporate although meeting the criteria may be
joint venture (domestic or foreign) that difficult because of the flow-through
is essentially permanent in duration nature of partnerships.
only if it is apparent that the temporary
difference will reverse in the foreseeable
future.

Note that according to paragraph

64 of ASU 2015-10, “[t]his exception
to recognizing deferred taxes is not
applicable for partnerships (or other
pass-through entities).”

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(Table continued)

Subject U.S. GAAP IFRS Standards

Deferred taxes A DTL is recognized on the excess of A DTL is recognized on excess book over
for outside basis the financial reporting basis over the tax tax basis unless both of the following
differences — equity basis of the investment. conditions are satisfied: (1) the holder
method investee that of the investment can control the timing
is not a corporate A DTA is recognized for the excess of of the reversal and (2) it is probable that
joint venture (foreign the tax basis of the investment over the the difference will not reverse in the
and domestic) that is amount for financial reporting and must foreseeable future.
essentially permanent be assessed for realizability (in most
in duration jurisdictions, the loss would be capital in A DTA is recognized only to the extent
character). that (1) it is probable that the temporary
difference will reverse in the foreseeable
future and (2) there will be taxable profit
against which the temporary difference
can be used.

Other exceptions to For a leveraged lease (commencing IFRS Standards do not address leveraged
the basic principle before the adoption of ASU 2016-02) leases, thus there is no similar exception.
that deferred tax is exemption, no deferred tax is recognized
recognized for all under ASC 740. See ASC 840-30 for
temporary differences information about the tax consequences
— leveraged leases of leveraged leases.

ASC 842 does not include guidance

on leveraged leases. Entities are not
permitted to account for any new
or subsequently amended lease
arrangements as leveraged leases after
the effective date of ASC 842.

Reconciliation of actual Required for public companies only; Required for all entities applying IFRS
and expected tax rate expected tax expense is computed by Standards. Entities compute expected
applying the domestic federal statutory tax expense by applying the applicable
rates to pretax income from continuing tax rate(s) to accounting profit and
operations. must disclose the basis on which any
applicable tax rate is computed.
Nonpublic companies must disclose the
nature of the reconciling items but are
not required to provide the amounts.

Interim reporting Entities are generally required to To the extent practicable, a separate
compute tax (or benefit) for each interim estimated average annual effective
period by using one overall estimated income tax rate is determined for each
AETR. The estimated AETR is computed tax jurisdiction and applied individually to
by dividing the estimated annual tax (or the interim-period pretax income of each
benefit) into the estimated annual pretax jurisdiction. Similarly, if different income
ordinary income (or loss). tax rates apply to different categories of
income (such as capital gains or income
Entities then apply the estimated AETR earned in particular industries), to the
to YTD pretax ordinary income or loss extent practicable, a separate rate is
to compute the YTD tax (or benefit). applied to each individual category of
The interim tax expense (or benefit) is interim period pretax income.
the difference between the YTD tax (or
benefit) and prior YTD tax (or benefit).

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F.1A Initial Recognition
Under IFRS Standards, deferred taxes are not provided on temporary differences that arise from the
initial recognition of an asset or a liability in a transaction that (1) is not a business combination and
(2) does not affect accounting profit or taxable profit. Changes in the temporary differences also are
not recognized. One example given in IAS 12 is that of an asset for which there is no deduction against
taxable profits for depreciation. If the entity intends to recover the value of the asset through use, the
tax base of the asset is nil. Therefore, a taxable temporary difference equal to the cost of the asset
arises on initial recognition. However, IAS 12 does not permit a DTL to be recognized, because the initial
recognition of the asset is not part of a business combination and does not affect either accounting
profit or taxable profit. Further, no deferred tax is recognized as a result of depreciating the asset.

The prohibition against recognition is based on the argument that if a DTL were recognized, the
equivalent amount would have to be (1) added to the asset’s carrying amount in the statement of
financial position or (2) recognized in profit or loss on the date of initial recognition, which would make
the financial statements “less transparent.” The exception is based on pragmatism and the desire to
avoid such financial statement effects rather than on any particular concepts. Note that the exception
has a particular effect in jurisdictions where some or all of the initial expenditure on assets is disallowed
for tax purposes.

Unlike IFRS Standards, U.S. GAAP do not contain an “initial recognition” exception. Accordingly, unless
an exception applies, deferred taxes are recognized for temporary differences on assets and liabilities.
However, under U.S. GAAP, there is guidance on temporary differences for assets and liabilities not
acquired in a business combination. See Section 3.3.

F.2 Recognition of DTAs
Under U.S. GAAP, ASC 740-10-30-5(e) states that DTAs are recognized in full and then reduced “by a
valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood
of more than 50 percent) that some portion or all of the deferred tax assets will not be realized.” The
valuation allowance will “reduce the deferred tax asset to the amount that is more likely than not to be
realized.” See Section 3.3.4 for additional guidance.

Under IFRS Standards, DTAs are recognized only to the extent that it is probable that they will be
realized.

Therefore, under both sets of standards, DTAs are recognized at an amount that is determined to be
realizable on a more-likely-than-not basis. The only difference is presentation (i.e., a valuation allowance
is used under U.S. GAAP but not under IFRS Standards).

F.3 Tax Laws or Rates for Measuring DTAs and DTLs

Under U.S. GAAP, DTAs and DTLs are measured by using the enacted tax laws or rates only. ASC
740-10-25-47 states that “[t]he effect of a change in tax laws or rates shall be recognized at the date
of enactment.” Accordingly, the effect of a change in tax laws or rates on DTAs and DTLs should be
recognized on the date on which the change is enacted. See Section 3.5.1 for additional guidance.

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Under IFRS Standards, DTAs and DTLs should be measured on the basis of tax laws or rates that have
been enacted or substantively enacted by the balance sheet date at the amount that is expected to apply
when the liability is settled or the asset is realized,. Paragraph 48 of IAS 12 states:

Current and deferred tax assets and liabilities are usually measured using the tax rates (and tax laws) that have
been enacted. However, in some jurisdictions, announcements of tax rates (and tax laws) by the government have
the substantive effect of actual enactment, which may follow the announcement by a period of several months. In
these circumstances, tax assets and liabilities are measured using the announced tax rate (and tax laws).

F.4 Uncertain Tax Positions

Under U.S. GAAP, an entity cannot recognize a tax benefit for a tax position in its financial statements
unless it is more likely than not that the position will be sustained upon examination solely on the basis
of technical merits. In making this determination, an entity must assume that (1) the position will be
examined by a taxing authority that has full knowledge of all relevant information and (2) any dispute will
be taken to the court of last resort. If the recognition threshold is not met, no benefit can be recognized
in the financial statements.

If the recognition threshold is met, the tax benefit recognized is measured at the largest amount of such
benefit that is more than 50 percent likely to be realized upon settlement with the taxing authority that
has full knowledge of all relevant information. The analysis should be based on the amount the taxpayer
would ultimately accept in a negotiated settlement with the taxing authority. Because of the level of
uncertainty associated with a tax position, an entity that applies the measurement criteria may need to
perform a cumulative-probability assessment of the possible estimated outcomes. The assignment of
probabilities associated with the measurement of a recognized tax position requires a high degree of
judgment and should be based on all relevant facts, circumstances, and information.

See Section 4.2 for additional guidance.

F.4.1 Before the Adoption of IFRIC Interpretation 23

No formal guidance existed concerning uncertain tax positions. Since IAS 12 did not specifically address
accounting uncertainties, the recognition and measurement criteria of IAS 37 were considered relevant
because an uncertain tax position may give rise to a liability of uncertain timing and amount. Under IAS
37, recognition is based on whether it is probable that an outflow of economic resources will occur.
“Probable” is defined as “more likely than not.” Measurement is based on the entity’s best estimate of the
amount of the tax benefit.

F.4.2 After the Adoption of IFRIC Interpretation 23

Entities should no longer analogize to IAS 37. Paragraphs 9 and 10 of IFRIC Interpretation 23 state:

An entity shall consider whether it is probable that a taxation authority will accept an uncertain tax treatment.

If an entity concludes it is probable that the taxation authority will accept an uncertain tax treatment, the
entity shall determine the taxable profit (tax loss), tax bases, unused tax losses, unused tax credits or tax rates
consistently with the tax treatment used or planned to be used in its income tax filings.

The entity assesses whether it is probable that a taxing authority will accept an uncertain tax treatment.
The assessment is based on the tax position as filed on the tax return and therefore must include
consideration of both the technical merits of the position and the amount included on the return. While
IFRIC Interpretation 23 is silent on the definition of “probable,” the word is defined in IAS 37 as “more
likely than not.”

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Paragraph 11 of IFRIC Interpretation 23 states:

If an entity concludes it is not probable that the taxation authority will accept an uncertain tax treatment, the
entity shall reflect the effect of uncertainty in determining the related taxable profit (tax loss), tax bases, unused
tax losses, unused tax credits or tax rates. An entity shall reflect the effect of uncertainty for each uncertain tax
treatment by using either of the following methods, depending on which method the entity expects to better
predict the resolution of the uncertainty:
a. the most likely amount — the single most likely amount in a range of possible outcomes. The most likely
amount may better predict the resolution of the uncertainty if the possible outcomes are binary or are
concentrated on one value.
b. the expected value — the sum of the probability-weighted amounts in a range of possible outcomes.
The expected value may better predict the resolution of the uncertainty if there is a range of possible
outcomes that are neither binary nor concentrated on one value.

The determination of whether to use the most likely amount method or the expected value method is
not an accounting policy decision but is based on facts and circumstances.

In general, although the principles of IFRIC Interpretation 23 are similar to those in ASC 740 and IAS
37, the methods introduced by IFRIC Interpretation 23 to reflect uncertainty may create measurement
differences in comparison with the cumulative probability assessment requirement under U.S. GAAP.
Other differences between IFRIC Interpretation 23 and ASC 740 may include recognition of interest and
penalties, classification, presentation, and disclosure related to uncertainty in income taxes.

Example F-1

Assume that an entity takes a deduction of $1,000 that is not a timing item (resulting in a $250 reduction in the
income tax payable on the basis of a tax rate of 25 percent) on its tax return.

Under ASC 740, the entity concludes solely on the basis of the technical merits of the tax position that it is
more likely than not that the position will be sustained if the taxpayer takes the dispute to the court of last
resort. Under IAS 37, the entity concludes that loss is probable upon examination by and settlement with the
taxing authority. Under IFRIC Interpretation 23, the entity concludes that it is not probable that the taxing
authority will accept the tax treatment used in the tax return. This conclusion includes consideration of how the
taxing authority will evaluate both the technical merits of the position and the amount shown on the return.

The entity estimates the probabilities of the possible tax benefit amounts that may be sustained upon
examination by the taxing authority as indicated in the table below.

Possible Estimated Individual Probability Cumulative Probability Estimate of

Outcome of Occurring of Occurring Expected Value
(A) (B) (C) (D) = (A) × (B)

$ 250 22% 22% $ 55

200 30% 52% 60

150 20% 72% 30

100 20% 92% 20

0 8% 100% 0

$ 165

Under ASC 740, the entity would measure the associated tax benefit at the largest amount of benefit that is
more than 50 percent likely to be realized upon settlement. Therefore, the entity should recognize a tax benefit
of $200 because this represents the largest benefit with a cumulative probability of more than 50 percent.
Accordingly, the entity should record a $50 income tax liability.

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Example F-1 (continued)

Under IAS 37, an income tax liability is required because the entity has determined that loss is probable upon
examination by and settlement with the taxing authority. IAS 37 does not provide explicit guidance on which
of the many acceptable methods the entity should use in determining the best estimate of the liability to
recognize. One such method is a weighted-average method (i.e., the expected value method), which would
result in an income tax liability of $85 ($250 maximum less the $165 weighted average) in accordance with the
example above since the weighted average of all possible outcomes is a benefit of $165.

Under IFRIC Interpretation 23, the entity must recognize the effect of uncertainty because it is not probable
that the full deduction taken on its tax return will be accepted by the taxing authority. To measure the required
liability, the entity should select the measurement method that best predicts the resolution of uncertainty.
By applying the most likely amount method, the entity would initially calculate a $50 income tax liability on
the basis of a $200 benefit with a 30 percent likelihood. However, the entity would observe that there was a
range of possible outcomes that were neither binary nor concentrated on one value. Consequently, the entity
would conclude that the expected value method, which results in recognition of an $85 income tax liability on
the basis of a $165 sustained benefit, would best predict the resolution of uncertainty in view of the facts and
circumstances surrounding this tax position.

F.4.3 Presentation
Under U.S. GAAP, ASC 740-10-45-11 states that an entity should “classify an unrecognized tax benefit
that is presented as a liability in accordance with paragraphs 740-10-45-10A through 45-10B as a
current liability to the extent the entity anticipates payment (or receipt) of cash within one year or
the operating cycle, if longer.” ASC 740-10-45-12 states that an “unrecognized tax benefit presented
as a liability shall not be classified as a deferred tax liability unless it arises from a taxable temporary
difference.” See Section 13.2.2 for additional guidance.

Under IFRS Standards, IAS 12 generally requires an entity to present all current tax for current and prior
periods, to the extent unpaid, as a current tax liability. Similarly, IAS 1 generally requires an entity to classify
a liability as current when the entity does not have the unconditional right to defer settlement of the liability
for at least 12 months after the reporting period (which is similar to the treatment for a demand payable).

F.4.4 Classification of Interest Expense and Penalties

Under U.S. GAAP, ASC 740-10-45-25 permits an entity, on the basis of its accounting policy election,
to classify (1) interest in the financial statements as either income taxes or interest expense and
(2) penalties in the financial statements as either income taxes or another expense classification. The
election must be consistently applied. An entity’s accounting policy for classification of interest may be
different from its policy for classification of penalties. For example, interest expense may be recorded
above the line as part of interest expense, and penalties may be recorded below the line as part of
income tax expense. See Section 13.3.1 for additional guidance.

Classification of interest and penalties was discussed by the IFRS Interpretations Committee, which, as
reported in the September 2017 IFRIC Update, concluded that entities do not have an accounting policy
choice between applying IAS 12 and applying IAS 37 to such amounts. Instead, they must use judgment
to determine whether a particular amount payable or receivable for interest and penalties is an income tax.

When there is no significant uncertainty with respect to the overall amount of income tax payable, but
an entity deliberately delays payment of the amount, the resulting interest and penalties can be clearly
distinguished from the assessed income tax. Accordingly, in such circumstances, instead of presenting
the interest and penalties as income tax in the financial statements, the entity should present them
separately on the basis of their nature (i.e., either as a finance cost [interest] or operating expense
[penalties]).

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However, an entity risks incurring interest and penalties if there is significant uncertainty regarding the
amount of income tax to be paid and the entity has, on the basis of discussions with the tax authorities,
withheld payment for the full amount of tax possibly payable (to avoid, for example, prejudicing a future
appeal against the amount claimed as due by the tax authorities). In such circumstances, since possible
interest and penalties can be seen as being part of the overall uncertain tax position, it is appropriate to
consider them as part of tax expense (income).

F.4.5 Subsequent Events
Under U.S. GAAP, changes in recognition and measurement of an uncertain tax position should be
based on changes in facts and circumstances (i.e., new information) and accounted for in the period in
which the new information arises. Therefore, all new information would be considered nonrecognized
subsequent events under ASC 855. See Section 4.5.2 for additional guidance.

Under IFRS Standards, changes should also be based on changes in facts and circumstances (i.e., new
information). However, an entity applies IAS 10 to determine whether a change that occurs after the
reporting period is an adjusting or nonadjusting event.

F.5 Tax Consequences of Intra-Entity Sales

Under U.S. GAAP, ASC 740-10-25-3(e) requires entities to use the consolidation guidance in ASC 810-10
to account for income taxes paid on intra-entity profits on inventory remaining within the group, and it
prohibits the recognition of a DTA for the difference between the tax basis of the inventory in the buyer’s
tax jurisdiction and its cost as reported in the consolidated financial statements (i.e., after elimination of
intra-entity profit). Specifically, ASC 810-10-45-8 states that “[i]f income taxes have been paid on intra-
entity profits on inventory remaining within the consolidated group, those taxes shall be deferred or the
intra-entity profits to be eliminated in consolidation shall be appropriately reduced.”

The FASB has concluded that an entity’s income statement should not reflect a tax consequence for
intra-entity sales of inventory in situations in which any profit (loss) is eliminated in consolidation. The
current tax expense from the sale of inventory is deferred upon consolidation (as a prepaid income
tax) and is not recorded until the inventory is sold to an unrelated party. In addition, under U.S. GAAP,
the buyer is prohibited from recognizing deferred taxes for the temporary difference between the
carrying amount of the inventory in the consolidated financial statement and its tax base. Other than
for inventory, there are no differences between U.S. GAAP and IFRS Standards related to the income tax
accounting of the tax consequences of intra-entity sales of other assets. See Section 3.5.6 for additional
guidance.

Under IFRS Standards, there is no exception related to intra-entity transfers of inventory. Accordingly,
current and deferred tax effects must be recognized for intra-entity sales in accordance with the general
principles of IAS 12. For example, an intra-entity sale creates a temporary difference between the book
carrying amount of the asset and its tax base. When intra-entity transactions occur between entities
that are operating in different tax jurisdictions (e.g., foreign or state tax jurisdictions) or are subject
to different tax rates, the rate applied to the temporary difference is the rate at which the difference
is expected to reverse, which generally is that of the buyer’s tax jurisdiction. If the buyer’s tax rate is
different from the seller’s tax rate, the deferred tax recognized may not entirely offset the current tax
expense resulting from the intra-entity sale.

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F.6 Recognizing Deferred Taxes on Foreign Nonmonetary Assets or Liabilities

When the Functional Currency Is Not the Local Currency
Under U.S. GAAP, ASC 740 prohibits recognition of deferred tax consequences for differences that arise
from either (1) changes in exchange rates or (2) indexing for tax purposes for foreign subsidiaries that
are required to use historical exchange rates to remeasure nonmonetary assets and liabilities from the
local currency into the functional currency. In other words, deferred taxes are not recorded for basis
differences related to nonmonetary assets and liabilities that result from changes in exchange rates
or indexing. Although these basis differences technically meet the definition of a temporary difference
under ASC 740, the FASB has concluded that to account for them as a temporary difference is to
effectively recognize deferred taxes on exchange gains and losses that are not recognized in the income
statement under ASC 830. See Section 9.2.1 for additional guidance.

Under IFRS Standards, deferred taxes are recognized. Paragraph 41 of IAS 12 states:

The non-monetary assets and liabilities of an entity are measured in its functional currency (see IAS 21 The
Effects of Changes in Foreign Exchange Rates). If the entity’s taxable profit or tax loss (and, hence, the tax base of
its non-monetary assets and liabilities) is determined in a different currency, changes in the exchange rate give
rise to temporary differences that result in a recognised deferred tax liability or (subject to paragraph 24) asset.
The resulting deferred tax is charged or credited to profit or loss (see paragraph 58).

[The guidance in Section F.7 has been moved to Sections F.1A and F.12A.]

F.8 Special Deductions
Under U.S. GAAP, tax benefits of special deductions for financial reporting purposes are recognized no
earlier than the year in which they are available to reduce taxable income on the tax return.

ASC 740-10-25-37 includes guidance on the recognition of tax benefits from transactions that result
in special tax deductions. The term “special deduction” is not defined, but ASC 740-10-25-37 and ASC
740-10-55-27 through 55-30 offer four examples: (1) tax benefits for statutory depletion, (2) special
deductions for certain health benefit entities (e.g., Blue Cross/Blue Shield providers), (3) special
deductions for small life insurance companies, and (4) a deduction for domestic production activities.
In addition, the deduction for FDII qualifies as a special deduction. See Section 3.2.1 for additional
guidance.

Although entities are not permitted to anticipate future special deductions when they measure deferred
liabilities, the future tax effects of special deductions may nevertheless affect (1) the average graduated
tax rate used for measuring DTAs and DTLs when graduated tax rates are a significant factor and (2)
the need for a valuation allowance for DTAs. In those circumstances, implicit recognition is unavoidable
because those special deductions are one of the determinants of future taxable income, and future
taxable income is used to determine the average graduated tax rate and may affect the need for a
valuation allowance.

There is no guidance on special deductions under IFRS Standards.

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F.9 Share-Based Compensation
Under U.S. GAAP, the deferred tax recorded on share-based compensation is computed on the basis
of the expense recognized in the financial statements for awards that ordinarily give rise to a tax
deduction. Therefore, changes in an entity’s share price during the vesting period do not affect the DTA
recorded on the entity’s financial statements.

All excess tax benefits (e.g., tax deduction on the award is in excess of cumulative compensation
for financial reporting) and tax deficiencies (e.g., tax deduction on the award is less than cumulative
compensation for financial reporting) are recognized as income tax expense or benefit in the income
statement in the period in which the amount of the deduction is determined (typically when an award
vests or, in the case of options, is exercised or expires).

See Chapter 10 for additional guidance on the ASC 740 accounting for deferred taxes resulting from
share-based payment awards.

Under IFRS Standards, for awards that ordinarily give rise to a tax deduction, the deferred tax is
computed on the basis of the expected tax deduction for the share-based payments corresponding to
the percentage earned to date (i.e., the intrinsic value of the award on the reporting date multiplied by
the percentage vested). Therefore, changes in share price do affect the DTA at period-end and result
in adjustments to the DTA. If the amount of the estimated future tax deduction for awards exceeds
the amount of the tax effect of the related cumulative compensation expense for financial reporting
purposes, a portion of the tax deduction is deemed to be related to an equity item. The excess of the
associated deferred tax is therefore recognized directly in equity. If the tax deduction received is less
than the compensation expense, the DTA is reversed to profit or loss. If, on the other hand, no tax
deduction is anticipated (e.g., because the share price has declined), the DTA is reversed to profit or loss
or equity, or both, as appropriate, depending on how the deferred tax benefit was originally recorded.

F.10 Subsequent Changes in Deferred Taxes That Were Originally Charged or

Credited to Equity (Backward Tracing)
Under U.S. GAAP, subsequent-period changes in deferred tax items that were originally charged or
credited to shareholders’ equity or OCI are allocated to the income tax provision related to continuing
operations (i.e., no backward tracing). For example, the effect of a change in the subsequent tax rate on
recorded deferred tax would be recognized in continuing operations even if the tax expense or benefit
was originally recorded in OCI. (Note that ASC 740-10-45-20 and ASC 740-20-45-11(c)–(f) provide limited
exceptions to the above guidance.) See Section 6.2.5 for additional guidance.

Under IFRS Standards, however, subsequent-period changes in deferred taxes that were originally
charged or credited to shareholders’ equity are also allocated to shareholders’ equity. Paragraph 61A of
IAS 12 states, “Current tax and deferred tax shall be recognised outside profit or loss if the tax relates
to items that are recognised, in the same or a different period, outside profit or loss.” For example,
a deferred tax item originally recognized by a charge or credit to shareholders’ equity may change
either because of changes in assessments of recovery of DTAs or changes in tax rates, laws, or other
measurement attributes. In a manner consistent with the original treatment, IFRS Standards require that
the resulting subsequent change in deferred taxes be charged or credited directly to equity as well.

[The guidance in Section F.11 has been moved to Section F.12B.]

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F.12 Deferred Taxes for Outside Basis Differences

F.12.1  Investment in a Subsidiary or a Corporate Joint Venture That Is
Essentially Permanent in Duration
Under U.S. GAAP, a DTL is not recognized when the excess of financial reporting basis over tax basis in
a domestic subsidiary or a domestic corporate joint venture that is essentially permanent in duration
arose in fiscal years on or before December 15, 1992, unless the temporary difference will reverse in the
foreseeable future. If the temporary difference arose after fiscal years after December 15, 1992, a DTL
must be recognized for the excess book over tax basis “unless the tax law provides a means by which
the investment in a domestic subsidiary can be recovered tax free” and the entity expects that it will
ultimately use that means in accordance with ASC 740-30-25-3.

In accordance with ASC 740-30-25-18(a), a DTL is generally not recognized for financial reporting basis
in excess of tax basis in a foreign subsidiary or a foreign corporate joint venture that is essentially
permanent in duration unless the difference is expected to reverse in the foreseeable future.

ASC 740-30-25-9 states that a DTA “shall be recognized for an excess of the tax basis over the amount
for financial reporting of an investment in a subsidiary or corporate joint venture that is essentially
permanent in duration [domestic or foreign] only if it is apparent that the temporary difference will
reverse in the foreseeable future.” The need for a valuation allowance must also be assessed.

Note that in accordance with paragraph 64 of ASU 2015-10, the above exception to recognizing
deferred taxes does not apply to partnerships (or other pass-through entities).

See Section 3.4 for detailed guidance on the accounting under ASC 740 for outside basis differences.

Under IFRS Standards, IAS paragraph 39 of IAS 12 requires recognition of a DTL for all taxable temporary
differences associated with any form of investee (domestic or foreign) unless (1) “the parent . . . is able to
control the timing of the reversal of the temporary difference” and (2) “it is probable that the temporary
difference will not reverse in the foreseeable future.”

In addition, paragraph 44 of IAS 12 states that a DTA is recognized for all deductible temporary
differences associated with any form of investee (domestic or foreign) “to the extent that, and only to the
extent that it is probable that . . . the temporary difference will reverse in the foreseeable future [and]
taxable profit will be available against which the temporary difference can be [used].”

F.12.2  Equity Method Investee (That Is Not a Corporate Joint Venture)

Under U.S. GAAP, a DTL is recognized on the excess of the financial reporting basis over the tax basis
of the investment. ASC 740-30-25-5 states, in part, that “[a] deferred tax liability shall be recognized for
[an] excess of the amount for financial reporting over the tax basis of an investment in a 50-percent-or-
less-owned investee except as provided in paragraph 740-30-25-18 for a corporate joint venture that is
essentially permanent in duration.”

Similarly, an investor that holds a noncontrolling interest (in general, less than 50 percent ownership)
in an investment that is not a corporate joint venture that is essentially permanent in duration (foreign
or domestic) always recognizes a DTA for the excess tax basis of an equity investee over the amount for
financial reporting purposes. As with all DTAs, in accordance with ASC 740-10-30-18, realization of the
related DTA “depends on the existence of sufficient taxable income of the appropriate character (for
example, ordinary income or capital gain) within the carryback, carryforward period available under the
tax law.” If all or a portion of the DTA is not more likely than not to be realized, a valuation allowance is
necessary.

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See Section 12.3.1 for additional guidance on deferred tax consequences of an investment in an equity
method investment.

Under IFRS Standards, the guidance in paragraph 39 of IAS 12 on taxable temporary differences, and
in paragraph 44 of IAS 12 on deductible temporary differences (see Section F.12.1), applies to the
accounting for all outside basis differences associated with investments, regardless the form of the
investee (i.e., subsidiary, branch, associate, or interests in joint arrangements).

F.12A Other Exceptions to the Basic Principle That Deferred Tax Is

Recognized for All Temporary Differences
F.12A.1 Leveraged Leases — Commencing Before the Adoption of ASU 2016-02
Under U.S. GAAP, there is an exception to the basic principles in ASC 740 that apply to leveraged leases.
In accordance with ASC 840-30, the tax consequences of leveraged leases are incorporated directly into
the lease accounting measurements; therefore, no temporary differences are recognized.

No leases are accounted for as leveraged leases under ASC 842, and entities are not permitted to
account for any new lease arrangements as leveraged leases after the effective date of ASC 842. This
guidance eliminates the difference between U.S. GAAP and IFRS Standards on leveraged leases as
well as the related income tax accounting differences. See Section 11.3.4.4 for detailed guidance on
accounting for leveraged leases.

IFRS Standards do not include the concept of leveraged leases.

F.12B Reconciliation of Actual and Expected Tax Rate

Under U.S. GAAP, all public entities must disclose in percentages or dollars a reconciliation between
(1) the reported amount of income tax expense attributable to continuing operations and (2) the
amount of income tax expense that would have resulted from applying domestic federal statutory rates
to pretax income from continuing operations. In addition, they should disclose the amount and nature
of each significant reconciling item. For nonpublic entities, a numerical reconciliation is not required;
however, the nature of all significant reconciling items related to (1) and (2) above should be disclosed.
See Section 14.3.1 for additional guidance.

Under IFRS Standards, paragraph 81(c) of IAS 12 states that all entities must disclose a numerical
reconciliation in either or both of the following forms:

• The reported “tax expense (income) and the product of accounting profit multiplied by the
applicable tax rate(s), disclosing also the basis on which [any] applicable tax [rate is] computed.”

• The “average effective tax rate and the applicable tax rate, disclosing also the basis on which the
applicable tax rate is computed.”

F.13 Interim Reporting
Under U.S. GAAP, an entity must estimate its ordinary income and the related tax expense or benefit
for the full fiscal year (total of expected current and deferred provisions) to calculate its estimated
AETR. Ordinary income or loss is income from continuing operations, excluding significant unusual
or infrequently occurring items. There are other limited exceptions in which the AETR is not used
to compute the income tax provision for the interim period. Amounts and related tax effects, if any,
excluded from the overall forecasted AETR are generally accounted for either discretely or through a
separate forecasted tax rate. See Chapter 7 for additional guidance.

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 Appendix F — Differences Between U.S. GAAP and IFRS Standards

Under IFRS Standards, a separate estimated average annual effective income tax rate is determined for
each taxing jurisdiction and applied individually to the interim-period pretax income of each jurisdiction.
The interim-period tax charge is the sum of each entity’s interim tax charge. IAS 12 does not address
interim tax reporting. Paragraphs B12 through B22 of IAS 34 provide examples of the application of the
recognition and measurement principles of IAS 34 to interim income tax expense.

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Appendix G — Titles of Standards and
Other Literature

AICPA Literature
Audit Section
AU-C Section 570, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern

Statements on Standards for Attestation Engagement

AT Section 301, Financial Forecasts and Projections

FASB Literature
ASC Topics
ASC 105, Generally Accepted Accounting Principles

ASC 205, Presentation of Financial Statements

ASC 210, Balance Sheet

ASC 220, Comprehensive Income

ASC 225, Income Statement

ASC 230, Statement of Cash Flows

ASC 250, Accounting Changes and Error Corrections

ASC 260, Earnings per Share

ASC 270, Interim Reporting

ASC 275, Risks and Uncertainties

ASC 320, Investments — Debt and Equity Securities

ASC 321, Investments — Equity Securities

ASC 323, Investments — Equity Method and Joint Ventures

ASC 325, Investments — Other

ASC 326, Financial Instruments — Credit Losses

ASC 350, Intangibles — Goodwill and Other

ASC 360, Property, Plant, and Equipment

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 Appendix G — Titles of Standards and Other Literature

ASC 405, Liabilities

ASC 420, Exit or Disposal Cost Obligations

ASC 450, Contingencies

ASC 460, Guarantees

ASC 470, Debt

ASC 505, Equity

ASC 606, Revenue From Contracts With Customers

ASC 715, Compensation — Retirement Benefits

ASC 718, Compensation — Stock Compensation

ASC 740, Income Taxes

ASC 805, Business Combinations

ASC 810, Consolidation

ASC 815, Derivatives and Hedging

ASC 820, Fair Value Measurement

ASC 825, Financial Instruments

ASC 830, Foreign Currency Matters

ASC 835, Interest

ASC 840, Leases

ASC 842, Leases

ASC 852, Reorganizations

ASC 855, Subsequent Events

ASC 942, Financial Services — Depository and Lending

ASC 944, Financial Services — Insurance

ASC 946, Financial Services — Investment Companies

ASC 958, Not-for-Profit Entities

ASC 960, Plan Accounting — Defined Benefit Pension Plans

ASC 962, Plan Accounting — Defined Contribution Pension Plans

ASC 965, Plan Accounting — Health and Welfare Benefit Plans

ASC 970, Real Estate — General

ASC 980, Regulated Operations

ASC 995, U.S. Steamship Entities

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ASUs
ASU 2010-08, Technical Corrections to Various Topics

ASU 2014-01, Investments — Equity Method and Joint Ventures (Topic 323): Accounting for Investments in
Qualified Affordable Housing Projects — a consensus of the FASB Emerging Issues Task Force

ASU 2014-17, Business Combinations (Topic 805): Pushdown Accounting — a consensus of the FASB
Emerging Issues Task Force

ASU 2015-10, Technical Corrections and Improvements

ASU 2015-16, Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period
Adjustments

ASU 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes

ASU 2016-01, Financial Instruments — Overall (Subtopic 825-10): Recognition and Measurement of Financial
Assets and Financial Liabilities

ASU 2016-02, Leases (Topic 842)

ASU 2016-09, Compensation — Stock Compensation (Topic 718): Improvements to Employee Share-Based
Payment Accounting

ASU 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial
Instruments

ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory

ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business

ASU 2017-04, Intangibles — Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment

ASU 2017-15, Codification Improvements to Topic 995, U.S. Steamship Entities: Elimination of Topic 995

ASU 2018-02, Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification of Certain
Tax Effects From Accumulated Other Comprehensive Income

ASU 2019-10, Financial Instruments — Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and
Leases (Topic 842): Effective Dates

ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes

Proposed ASUs
2016-270, Income Taxes (Topic 740): Disclosure Framework — Changes to the Disclosure Requirements for
Income Taxes

2019-500 (Revised), Income Taxes (Topic 740): Disclosure Framework — Changes to the Disclosure
Requirements for Income Taxes (Revision of Exposure Draft Issued July 26, 2016)

2019-700, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes

Staff Q&As
Topic 740, No. 2, “Whether to Discount the Tax Liability on the Deemed Repatriation”

Topic 740, No. 4, “Accounting for the Base Erosion Anti-Abuse Tax”

Topic 740, No. 5, “Accounting for Global Intangible Low-Taxed Income”

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 Appendix G — Titles of Standards and Other Literature

Federal Regulations
CFR
Treas. Reg. 26, “Internal Revenue”
• Section § 1.901-1, “Allowance of Credit for Taxes”
• Section § 301.6511(d)-3, “Special Rules Applicable to Credit Against Income Tax for Foreign
Taxes”

IRC (U.S. Code)

Section 15, “Effect of Changes”

Section 53, “Credit for Prior Year Minimum Tax Liability”

Section 78, “Gross Up for Deemed Paid Foreign Tax Credit”

Section 83, “Property Transferred in Connection With Performance of Services”

Section 103, “Interest on State and Local Bonds”

Section 162, “Trade or Business Expenses”

Section 163, “Interest”

Section 165, “Losses”

Section 171, “Amortizable Bond Premium”

Section 245A, “Deduction for Foreign Source-Portion of Dividends Received by Domestic Corporations
From Specified 10-Percent Owned Foreign Corporations”

Section 250, “Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income”

Section 265, “Expenses and Interest Relating to Tax-Exempt Income”

Section 271, “Debts Owed by Political Parties, Etc.”

Section 274, “Disallowance of Certain Entertainment, Etc., Expenses”

Section 275, “Certain Taxes”

Section 338, “Certain Stock Purchases Treated as Asset Acquisitions”

Section 382, “Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following
Ownership Change”

Section 383, “Special Limitations on Certain Excess Credits, Etc.”

Section 421, “General Rules”

Section 422, “Incentive Stock Options”

Section 423, “Employee Stock Purchase Plans”

Section 481, “Adjustments Required by Changes in Method of Accounting”

Section 585, “Reserves for Losses on Loans of Banks”

Section 611, “Allowance of Deduction for Depletion”

Section 612, “Basis for Cost Depletion”

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Section 613, “Percentage Depletion”

Section 704, “Partner’s Distributive Share”
Section 806, “Small Life Insurance Company Deduction”
Section 833, “Treatment of Blue Cross and Blue Shield Organizations, Etc.”
Section 931, “Income From Sources Within Guam, American Samoa, or the Northern Mariana Islands”
Section 965, “Temporary Dividends Received Deduction”
Section 987, “Branch Transactions”
Section 1016, “Adjustments to Basis”

IRC Treas. Reg.

Section 1.1502-36, “Unified Loss Rule”
Section 1.162-20, “Expenditures Attributable to Lobbying, Political Campaigns, Attempts to Influence
Legislation, etc., and Certain Advertising”

IFRS Literature
IFRS 3, Business Combinations
IAS 1, Presentation of Financial Statements
IAS 10, Events After the Reporting Period
IAS 12, Income Taxes
IAS 20, Accounting for Government Grants and Disclosure of Government Assistance
IAS 21, The Effects of Changes in Foreign Exchange Rates
IAS 34, Interim Financial Reporting
IAS 37, Provisions, Contingent Liabilities and Contingent Assets
IFRIC Interpretation 23, Uncertainty Over Income Tax Treatments

PCAOB Literature
AS 2415, Consideration of an Entity’s Ability to Continue as a Going Concern

SEC Literature
FRM
Topic 3, “Pro Forma Financial Information”

Regulation S-K
Item 303, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”
Item 303(a), “Full Fiscal Years”

Regulation S-X
Rule 3-05, “Financial Statements of Businesses Acquired or to Be Acquired”
Rule 4-08, “General Notes to Financial Statements”

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 Appendix G — Titles of Standards and Other Literature

Rule 5-02, “Balance Sheets”

Rule 5-03, “Statements of Comprehensive Income”
Article 10, “Interim Financial Statements”
Rule 10-01(a), “Condensed Statements”
Rule 11-02, “Preparation Requirements”
Rule 12-09, “Valuation and Qualifying Accounts”

SAB Topics
No. 1.B, “Allocation of Expenses and Related Disclosure in Financial Statements of Subsidiaries, Divisions
or Lesser Business Components of Another Entity”
No. 1.B.1, “Costs Reflected in Historical Financial Statements”
No. 1.M, “Materiality” (SAB 99)
No. 1.N, “Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in
Current Year Financial Statements” (SAB 108)
No. 6.I, “Accounting Series Release 149 — Improved Disclosure of Income Tax Expense (Adopted
November 28, 1973 and Modified by ASR 280 Adopted on September 2, 1980)”
No. 11.C, “Tax Holidays”

Superseded Literature
APB Opinions
No. 2, Accounting for the “Investment Credit”
No. 4, Accounting for the “Investment Credit”
No. 11, Accounting for Income Taxes
No. 18, The Equity Method of Accounting for Investments in Common Stock

EITF Issues
86-43, “Effect of a Change in Tax Law or Rates on Leveraged Leases”
93-7, “Uncertainties Related to Income Taxes in a Purchase Business Combination”
94-1, “Accounting for Tax Benefits Resulting From Investments in Affordable Housing Projects”
94-10, “Accounting by a Company for the Income Tax Effects of Transactions Among or With Its
Shareholders Under FASB Statement No. 109”

FASB Interpretations
No. 18, Accounting for Income Taxes in Interim Periods — an interpretation of APB Opinion No. 28

No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109

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FASB Statements
No. 52, Financial Reporting by Cable Television Companies

No. 109, Accounting for Income Taxes

No. 123(R), Share-Based Payment

No. 141, Business Combinations

No. 141(R), Business Combinations

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Appendix H — Abbreviations
Abbreviation Description Abbreviation Description

AC acquiring company ESPP employee stock purchase plan

AETR annual effective tax rate ETR effective tax rate

AFS available for sale FASB Financial Accounting Standards

Board
AGUB adjusted grossed-up basis
FBB final book basis
AICPA American Institute of Certified
Public Accountants FCC Federal Communications
Commission
AMT alternative minimum tax
FDII foreign-derived intangible income
AOCI accumulated other comprehensive
income FRM SEC Division of Corporation
Finance’s Financial Reporting
APB Accounting Principles Board Manual
APIC additional paid-in capital FTC foreign tax credit
ASC FASB Accounting Standards GAAP generally accepted accounting
Codification principles
ASU FASB Accounting Standards Update GILTI global intangible low-taxed income
BEAT base erosion anti-abuse tax HTM held to maturity
BEMTA base erosion minimum tax amount IAS International Accounting Standard
CAD Canadian dollar IASB International Accounting Standards
CFC controlled foreign corporation Board

CFR Code of Federal Regulations IFRIC IFRS Interpretations Committee

CNIT corporate net income tax IFRS International Financial Reporting

Standard
CPP cash purchase price
IPO initial public offering
CTA cumulative translation adjustment
IRC Internal Revenue Code
DTA deferred tax asset
IRS Internal Revenue Service
DTL deferred tax liability
ISO incentive stock option
E&P earnings and profits
ITC investment tax credit
ED exposure draft
LC local currency
EITF FASB’s Emerging Issues Task Force
LICTI life insurance company taxable
EPS earnings per share income

ESOP employee stock ownership plan LIFO last in, first out

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Abbreviation Description Abbreviation Description

LLC limited liability company REIT real estate investment trust

MD&A Management’s Discussion and RIC regulated investment company

Analysis
ROU right of use
NFP not-for-profit entity
SAB SEC Staff Accounting Bulletin
NOL net operating loss
SAR share appreciation right
NQSO nonqualified option
SEC U.S. Securities and Exchange
OCI other comprehensive income Commission

OTTI other-than-temporary impairment SFAS Statement of Financial Accounting

Standards
PBE public business entity
SFC specified foreign corporation
PCAOB Public Company Accounting
Oversight Board TC target company

PP&E property, plant, and equipment TTB total tax benefit

PTI percentage of taxable income USD U.S. dollar

QAHP qualified affordable housing project UTB unrecognized tax benefit

Q&A question and answer VIE variable interest entity

QBAI qualified business asset investment YTD year to date

R&D research and development

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Appendix I — Changes Made in
the November 2020 Edition of This
Publication
The table below summarizes the substantive changes made since issuance of the April 2020 edition of
this Roadmap.

Section Title Description

2.5 Hybrid Taxes Added example to the Changing Lanes
discussion illustrating the impact of ASU
2019-12 on the scope of hybrid taxes.
2.7.1 Selling Income Tax Credits to Monetize Them Added discussion of scope considerations
related to monetizable tax credits.
3.2 Permanent Differences Updated discussion of tax-to-tax differences
under ASC 740-10-25-31.
3.3.3.3 Tax Basis That Adjusts in Accordance With or Added discussion of situations in which an
Depends on a Variable item’s tax basis may be adjusted on the basis
of an outside factor or a variable that may or
may not be within the entity’s control.
3.3.4.1.2 Anticipation of Future Special Deductions in a Relocated measurement guidance on future
Graduated Tax Rate Structure special deductions from Section 3.2.1 and
renamed Example 3-1 as Example 3-3A.
3.3.4.6.1 State Apportionment Added discussion of two exceptions (sale of
long-lived assets classified as held for sale
and planned restructuring activities) to the
general principal in ASC 740 that expected
changes are not reflected in apportionment
factors until they are recognized in the
financial statements.
3.3.4.9 Deferred Tax Treatment of Hybrid Taxes Updated Changing Lanes discussion to reflect
the impact of ASU 2019-12 on measuring
deferred taxes in a hybrid regime.
3.3.4.10 Consideration of U.S. AMT Credit Amended discussion of AMT credit
Carryforwards carryforwards to reflect recently enacted tax
law under the CARES Act.
3.3.6.3.1 Measurement Complexities Attributable to Added discussion of the measurement of a
Jurisdictional Rate Differences DTL for “forgone” FTCs in situations in which
the U.S. tax rate is lower than the in-country
tax rate.
3.4.7 Unremitted Earnings of a Foreign Subsidiary Removed accounting guidance that applied
When There Is an Overall Deductible Outside before the 2017 Act.
Basis Difference — Pre-Act

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(Table continued)

Section Title Description

3.4.12 “Unborn” FTCs — Before the 2017 Act Added Connecting the Dots discussion of
the relevance of “unborn” FTCs after the
enactment of the 2017 Act.
3.4.12A Foreign Exchange Gain (or Loss) on Updated discussion and added Example
Distributions From a Foreign Subsidiary When 3-25A to address questions about whether
There Is No Overall Taxable (or Deductible) a U.S. parent should record a DTL when
Outside Basis Difference (1) there is no overall outside basis difference
on its investment in a foreign subsidiary
or the overall outside basis difference is
deductible, (2) the U.S. parent intends to
repatriate the foreign subsidiary’s earnings,
or (3) the entity expects that there will be
a foreign exchange gain in the parent’s
jurisdiction upon distribution.
3.4.13.3 Determining the Income Tax Effects of Added discussion of FTCs or deductions
Distributions of Previously Taxed Earnings in a U.S. parent’s federal jurisdiction and
and Profits in a Single-Tier or Multi-Tier Legal withholding taxes in the foreign jurisdiction
Entity Structure on remittances of foreign earnings to the U.S.
parent.
3.5.3 Tax Effects of a Check-the-Box Election Clarified discussion of when a check-the-box
election is analogous to a change in status
and when it’s an election (i.e., not a change in
status).
4.5.1 Decision Tree for the Subsequent Modified decision tree to note that new
Recognition, Derecognition, and information obtained during an examination
Measurement of Benefits of a Tax Position should be considered in the determination
of the measurement and recognition of a tax
position.
5.3.1.3 Using the Reversal of a DTL for an Indefinite- Updated discussion of discussion of the
Lived Asset as a Source of Taxable Income effects of the CARES Act on indefinite-lived
After Enactment of the 2017 Act taxable temporary differences as a source of
future taxable income.
5.3.1.5 Use of Attributes That Result in Replacement Added discussion of the interaction of loss
or “Substitution” of DTAs carryforwards and temporary differences that
will result in net deductible amounts in future
years.
5.3.2.3 Effect of Nonrecurring Items on Estimates Updated discussion of the effects of the
of Future Income and Development of CARES Act on Section 163(j) limitations.
Objectively Verifiable Future Income Includes new Example 5-13A, which illustrates
Estimates the impact of a Section 163(j) limitation on
an entity’s estimate of future taxable income
when negative evidence in the form of
cumulative losses exists.
5.3.3 Taxable Income in Prior Carryback Year(s) if Updated discussion of the effects of the
Carryback Is Permitted Under the Tax Law CARES Act on the carryback rules for NOLs
generated in certain tax years.
5.3.5 Determining the Need for a Valuation Revised Example 5-21 to reflect an entity’s
Allowance by Using the Four Sources of consideration of all four sources of taxable
Taxable Income income as part of its valuation allowance
assessment.

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(Table continued)

Section Title Description

5.7.1 AMT Valuation Allowances Updated discussion of the effects of the
CARES Act on an entity’s ability to realize AMT
credit carryforwards.
10.2.10 Deferred Tax Effects When Compensation Amended discussion to clarify that it applies
Cost Is Capitalized (1) equally to equity and liability classified
awards and (2) only to awards that ordinarily
would result in a deduction.
11.3.2 Goodwill Added discussion of goodwill subject to anti-
churning rules in the United States.
12.3.2 Tax Effects of Investor Basis Differences Redrafted Example 12-3 to illustrate the tax
Related to Equity Method Investments effects of investor basis differences related to
a new equity method investment.
12.4 QAHP Investments Updated discussion to reflect ASU 2016-01.
14.4.1.1 Items Included in the Tabular Disclosure of Renamed Example 14-1 as Example 14-3A
UTBs From Uncertain Tax Positions May Also and relocated it to Section 14.4.1.7.
Be Included in Other Disclosures
14.9 Additional Disclosure Requirements Added discussion of the disclosure
requirements under SEC Regulation S-X,
Rule 12-09.
14.10 Disclosures Outside the Financial Added discussion of MD&A disclosure
Statements — MD&A considerations for material events and
impacts related to income taxes.
E.3 Recent ASUs Not Reflected in This Guidance Deleted section because ASU 2016-09 is now
effective for all companies.
E.9.4.8 DTA Attributable to Excess Stock Option Deleted section because ASU 2016-09 is now
Deductions — Before the Adoption of ASU effective for all companies.
2016-09
F.7.1 Leveraged Leases — Commencing Before the Moved guidance to Section F.12A.
Adoption of ASU 2016-02
F.7.2 Initial Recognition Moved guidance to Section F.1A.
F.11 Reconciliation of Actual and Expected Tax Moved guidance to Section F.12B.
Rate

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