Companies affected by the COVID-19 pandemic need to consider the income tax accounting implications resulting from the current economic environment, the recent regulatory updates, and the anticipated bill likely becoming law before March 31st. For companies with the March quarter ends, they will need to act fast in order to incorporate impacts into their tax provisions. The consideration to adopt ASU 2019-12, Simplifying the Accounting for Income Taxes during the period of enactment will become more important and have potentially more impact than previously considered.
The determination of the EAETR requires an estimate of forecasted income or losses for the year. Companies affected by the COVID-19 pandemic may experience significant reductions to operations and could face challenges in preparing reliable forecasts. ASC 740 addresses the consequences of an entity's inability to reliably estimate some or all the information that is ordinarily required to determine the annual effective tax rate in an interim period financial statement.
Companies recognize income tax expense in interim periods based on the view that each interim period is an integral part of the annual period. If a company is unable to reliably estimate its AETR, the actual effective tax rate for the year-to-date period may be the best estimate of the AETR. This may be the case when a small change in estimated ordinary income would result in a large change in the EAETR.
Companies that are experiencing unexpected losses in light of COVID-19 may need to adjust their EAETR, limit year-to-date tax benefits, or both if those losses exceed the ordinary losses expected for the full fiscal year. This can cause departures from ASC 740-270-30-36 which indicates that one overall EAETR should be used to determine the interim period tax (benefit) related to consolidated ordinary income (loss) for the year-to-date period. Exceptions which may become more prevalent in this environment are:
Prior to the adoption of ASU 2019-12, the tax benefit associated with the year-to-date ordinary loss, when an ordinary loss is anticipated for the year, is limited to the amount that would be recognized if the year-to-date ordinary loss is the anticipated ordinary loss for the fiscal year. This limitation does not apply to companies that have adopted ASU 2019-12, which eliminates this exception. Companies with forecasted losses from continuing operations should evaluate carefully the guidance related to recording the tax effects and consider whether or not they have adopted ASU 2019-12.
Global companies may experience losses due to COVID-19 in only certain tax jurisdictions. This may cause those companies needing to estimate a separate EAETR for those loss jurisdictions. Companies must exclude from its overall EAETR the ordinary loss and the related tax benefit for a tax jurisdiction if that jurisdiction (1) experiences a year-to-date loss or (2) anticipates an annual loss and no benefit from those losses are more likely than not to be realized.
The first quarter for calendar year-end companies is likely to present increased challenges in accounting and reporting for income taxes. Companies should review the forecast used for tax provision purposes for consistency with other financial accounting estimates used. It will be important for tax calculations to be based on the same estimates and forecasts used for other non-tax areas of financial reporting (e.g., projections used for impairment testing). Companies should also consider whether recent changes in supply chains or operations are reflected in the projected forecast of pre-tax earnings by jurisdiction and that revisions align with transfer pricing policies.
As of March 26, 2020, the Senate has passed the Phase III COVID-19 relief legislation and will likely become law before March 31st. Global companies must also consider any legislation passed in various other foreign jurisdictions it operates in and the impact on income tax accounting. Companies should recognize the effect of a change in tax law or rate on existing deferred tax assets and liabilities in income from continuing operation in the period that includes the enactment date of the change.
Prior to the adoption of ASU 2019-12, if the effective date is later than the enactment date, the impact of the change on the estimate of the payable or receivable for the current year would be included in the calculation of the estimated annual effective tax rate beginning in the interim period including the effective date. If a company adopts or has adopted ASU 2019-12, it adjusts the EAETR in the period that includes the enactment date.
Companies should closely monitor tax law changes and stimulus packages that could result in immediate tax effects to the financial statements in the period of enactment. Determining whether a benefit is an income tax, or above-the-line benefit should be considered for each jurisdiction's benefit.
Many countries have proposed offering government assistance. Determining whether government assistance should be subject to income tax accounting or another accounting model requires the use of significant judgment. If an entity determines that the government assistance does not fall within the scope of ASC 740, the entity should consider whether the governmental assistance is a governmental grant, (i.e., a credit received from a government entity without regard to taxable income).
Companies may be experiencing U.S. domestic cash shortages due to COVID-19 and as a result, may need to change their assertion regarding foreign earnings. Companies should consider whether working capital needs to impact their current or future plans for repatriating cash from foreign operations. The income tax effects of a company changing its indefinite reinvestment assertion for a foreign subsidiary should be recorded in the interim reporting period when the change in assertion occurs.
The tax effects of undistributed earnings, including translation adjustments related to the current year (e.g., the outside basis difference related to the current reporting year) would be recognized as an adjustment to the estimated annual effective tax rate in the period in which the change in assertion occurs. The deferred tax effects of the translation adjustment related to the current period should be reported in other comprehensive income in accordance with ASC 740-20-45-11.
When anticipated remittances are expected to come from previously taxed income for U.S. tax purposes, the tax effects of distribution plans may not result in incremental federal income tax, but there may be foreign withholding taxes associated with repatriation through a chain of entities, local country taxes on dividend distributions, and state and local tax effects. In addition, the tax effects of future distributions will require consideration of the expected tax on foreign currency translation gains and losses and the ability to utilize or realize a future benefit for foreign tax credits generated.
Companies may be experiencing unexpected losses due to COVID-19 or capital losses due to directly connected economic conditions. A valuation allowance is required for deferred tax assets if it is more likely than not all or some of the assets will not be realized. In assessing realization, a company considers whether it will be able to generate sufficient taxable income in the period and of the character necessary to use the benefit. In addition, many companies may be using projections of future income to support the realizability of deferred tax assets. Companies must assess the realizability of deferred tax assets at the end of each reporting period.
The assessment of the realizability of deferred tax assets requires projections of future income and consideration of whether a three-year cumulative loss exists. Companies should update their projections of income for recent events. Tax attribute carryforwards that were otherwise expected to be utilized in the near term should be reviewed to determine if they might expire unutilized. In addition, companies should assess whether changes in expiration periods or limitations on the use of tax attributes have been enacted in jurisdictions in which the attributes reside that would impact management's judgments on the amount of a valuation allowance that is needed.
Prior to the adoption of ASU 2019-12, the tax benefit associated with the year-to-date ordinary loss, when an ordinary loss is anticipated for the year, is limited to the amount that would be recognized if the year-to-date ordinary loss is the anticipated ordinary loss for the fiscal year. This limitation does not apply to companies that have adopted ASU 2019-12, which eliminates this exception. Companies with forecasted losses from continuing operations should evaluate carefully the guidance related to recording the tax effects and consider whether or not they have adopted ASU 2019-12.
As part of the annual effective tax rate estimation process, a company is required, at the end of each reporting period to make its best estimate of pretax ordinary income for the full fiscal year. In estimating pretax ordinary income for the full fiscal year, questions often arise as to how to consider events (specifically, non-recognized subsequent events) that occur after the interim balance sheet date (i.e., events that occur after the most recent quarter-end but within the same fiscal year), but before the interim financial statements are issued. As noted in ASC 855, non-recognized subsequent events provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date. Those events are recognized in the financial statements in the period in which they occur.
Generally, COVID-19 would be a Q1 event for calendar year taxpayers. Not all subsequent events should factor into determining the need for a current period valuation allowance. For example, items that clearly represent subsequent-period events (e.g., the tax effects of a natural disaster or catastrophe, such as an earthquake or a fire) should be recognized in the period in which they occur, because that is when the pretax effect, if any, will be recorded.
As a result of operational changes stemming from COVID-19, companies may need to revisit numerous items when accounting for income taxes.
As mentioned above, ASC 740 requires that the tax effects of changes in tax laws or rates be recorded discretely as a component of the income tax provision related to continuing operations in the period of enactment. For US federal tax purposes, the enactment date is the date the president signs the bill into law. Among other considerations, the CARES Act allows for federal NOLs generated in certain years to be carried back for five years and temporarily removes the federal 80% of taxable income limitation, allowing an NOL to fully offset taxable income. Further, temporary increases to the Section §163(j) interest expense limitation will be available for 2019 and 2020.
To ensure regulatory compliance, companies should consider the impacts of these changes on the realizability of deferred tax assets, particularly where carrybacks of NOLs were previously not allowed under federal tax law and therefore carryback was not available as a source of taxable income. Further, when carrying back an NOL to a prior year, companies should consider the impact of utilization at a higher rate (generally 35%, or blended rate for fiscal year taxpayers) than the rate used to record the deferred tax asset currently. The tax rate applied to NOLs generated in the current year should reflect the applicable tax rate for the year in which the NOL is expected to be utilized.
