This article is the first in a series that will address relevant considerations and provide insights when a change to U.S. corporate income tax laws or rates is anticipated. This first installment covers the financial statement considerations upon a change in tax law or rate. The second installment will address tax planning considerations in connection with an anticipated change in tax law or rate.
In President Obama’s speech to the U.S. Chamber of Commerce on February 7, he urged businesses to support his message delivered to Congress in his State of the Union address, where he encouraged Republicans and Democrats to work together to reform the current tax system. The President asked businesses to join him in an effort to change a “burdensome” corporate tax code, calling for “something smarter, something simpler, something fairer.” “You’ve got too many companies ending up making decisions based on what their tax director says instead of what their engineer designs or what their factories produce,” Obama said. “And that puts our entire economy at a disadvantage.” How high profile our U.S. tax directors have become! The tenet of the President’s reform would center on making the U.S. more competitive by lowering the corporate tax rate. Of course, the President also indicated that doing this without increasing the growing federal budget deficit would require eliminating “various corporate loopholes and carve-outs.”
The call for reform of the corporate tax code is not new to this administration, but given that it appears to be a shared goal of the Executive Office and Republican House, are we closer to it becoming a reality?
The President’s recent call for tax reform comes on the heels of the December 2010 release of the “deficit reduction plan” by the National Commission on Fiscal Responsibility and Reform, which failed to attract enough votes to be formally recommended to Congress. Although the Commission did not secure the votes necessary to make a formal recommendation to Congress, the plan is likely to influence the debate on tax reform efforts in the future. The Commission’s “illustrative” tax reform plan called for a reduction in the corporate income tax rate to 28 percent, which would be offset with a broadening of the tax base by eliminating “tax expenditures” such as general business credits, the Section 199 domestic manufacturing deductions and the availability of the LIFO inventory method. In addition, the plan recommends a “territorial tax system,” in which a U.S. company would not be taxed on its foreign earned income. Specific industries may be in the President’s tax reform sights as well. In a speech at Penn State in early February, the President renewed his call for clean-energy tax incentives that would be offset by the elimination of current tax provisions that benefit oil and gas companies.
Based on the volume of tax reform dialogue in recent months, notwithstanding Treasury Secretary Timothy Geithner’s recent comments that the President’s 2012 budget proposal will not include any plans for corporate tax reform, it is quite possible that broad tax reform may be with us in the near term in the form of a reduction in the corporate income tax rate along with a broadening of the tax base.
Assuming some form of tax reform is in the offing, what would an anticipated change in corporate income tax laws or rates mean to a U.S. corporation’s financial statements?
Let’s briefly review the income tax accounting considerations for when a change in tax law or statutory tax rate occurs:
- The tax effects of a change in tax law or rate should be recognized in the period that includes the enactment date.
- The tax effects of a change in tax law or rate should be recognized in continuing operations.
- The applicable tax rate used to revalue deferred tax assets (DTAs) and deferred tax liabilities (DTLs) should be the enacted rate that’s effective in the period that the reversal of the temporary difference is expected to impact taxes payable (or refundable).
- A change in tax law or rates should be considered in the computation of the annual effective tax rate in the first interim period that includes the enactment date. The effect of the change in rate on DTAs and DTLs is recorded as a discrete event in an interim period.
- All adjustments to DTAs and DTLs resulting from tax law or rate changes should be disclosed. In addition, the rate reconciliation should include an item for the effect of rate changes enacted in the current year.
Mechanically, this calculation should not be overly cumbersome; however, the subjective nature of the calculation could prove more challenging. For example, a company may project that a timing difference will reverse in a future year with a lower enacted statutory rate and, therefore, will revalue the associated deferred tax asset or liability at the lower rate. But what happens if the reversal of the timing difference also creates a net operating loss that may be carried back to a year with a higher tax rate? As this example illustrates, the reversal of timing differences can be difficult to forecast and even more difficult for your financial auditor to audit. A change in tax law or rate can further complicate the income tax provision calculation if the company has certain other attributes — such as valuation allowances, calculations that rely on after-tax benefits such as leveraged leases, or undistributed earnings.
The impact of a change in tax law or rate on a corporation’s valuation allowance is worth exploring a bit more. An enacted tax law or tax rate change entails reconsideration of the realizability of existing deferred tax assets. Any adjustment to an existing deferred tax asset through the creation or adjustment of an existing valuation allowance should be included in income from continuing operations for the period that includes the enactment date. In some instances, tax rate changes may be enacted after year-end but before the financial statements are issued. In those situations, the enacted change would not be recognized until the period that includes the enactment date. Some might argue that any valuation allowance for deferred tax assets should take into consideration the impact of a decrease in tax rates. However, the intent is that the impact of all tax rate or tax law changes be reflected in the period of enactment, regardless of the effect on deferred assets and liabilities in financial statements for earlier periods. Accordingly, the impact on the valuation allowance of a decrease in tax rates enacted after year-end but before the financial statements are issued would not be recorded at year-end. However, when changes in tax laws or rates are enacted subsequent to year-end but before the financial statements are released, the effect on existing deferred tax assets or liabilities should be disclosed.
Interestingly enough, it’s income tax accounting principles such as the one described in the second bullet above concerning the requirement that the tax effects of a change in law or rate are to be recorded in continuing operations (i.e., profit and loss statement — P&L) that can have a significant influence on tax policy. This is evidenced by the success that representatives from a handful of America’s leading manufacturing companies had in 2004 in changing the direction of tax policy by convincing the tax staff of the Committee on Ways and Means of the House of Representatives to enact a tax benefit for American manufacturing companies in the form of a new deduction (the “domestic manufacturing deduction”) rather than a corporate tax rate cut, even though most public companies at the time desired a tax rate cut. As a result of the revaluation of their net DTAs, this group of manufacturers that these representatives were lobbying for would have had an immediate charge to their P&L if the benefit had been provided in the form of a rate cut, which was unacceptable to this influential group of manufacturers. This scenario could conceivably reoccur in the current environment, where many companies that struggled in 2008 and 2009 and recorded significant net operating loss DTAs would have charges in their P&L if the corporate tax rate was reduced.
Alvarez & Marsal Taxand Says:
What should tax directors do at this juncture? It’s clear that our C-suite friends read the Wall Street Journal and see articles such as the one that described multibillion dollar earnings charges for some large U.S. companies resulting from the revaluation of deferred tax assets due to a reduction in the corporate income tax rate. A famous football coach once said, "The best defense is a good offense." If you as a tax director have not warned your fellow C-suite executives of the positive or negative tax consequences of a lower corporate tax rate on your company’s financial statements, it may be time to beef up your modeling capabilities and start analyzing the impact under alternative tax scenarios so that you’re prepared when that inevitable call comes.
Furthermore, if you happen to toil in one of the administration’s targeted industries, or have attributes that would make the revaluation of your deferred tax assets and liabilities more tedious, such as loss carryforwards or carrybacks or unremitted earnings, you may want to enhance your models so that you’re equipped to analyze new proposals as they occur.
Managing Director, New York
Danielle Hutcheson, Senior Director, and Ashley Higgins, Senior Associate, contributed to this article
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