Current Developments New GAAP Requirements and Effect on Accounting for Income Taxes

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1 Current Developments New GAAP Requirements and Effect on Accounting for Income Taxes Greg Pfahl/John Monahan December 8, 2016

2 New Revenue Recognition Standard Replacing industry-specific guidance, the ASU focuses on a new five-step analysis to be applied to all contracts with customers to transfer goods or services. These steps include: 1. Identify the contract(s) with a customer 2. Identify the performance obligations in the contract 3. Determine the transaction price 4. Allocate the transaction price to the performance obligations in the contract 5. Recognize revenue when (or as) the entity satisfies a performance obligation.

3 New Revenue Recognition Standard The model indicates that revenue should be recognized when (or as) an entity transfers control of goods or services to a customer at the amount to which the entity expects to be entitled. Depending on whether certain criteria are met, revenue is recognized either over time, in a manner that demonstrates the entity's performance, or at a point when control of the goods or services is transferred to the customer.

4 New Revenue Recognition Standard Practically all companies will be affected to some extent Change in timing of recognizing revenue Significant increase in required disclosures Impact will vary depending on industry and current accounting practices Companies will need to consider changes that might be necessary to information technology systems, processes, and internal controls to capture new data and address changes in financial reporting

5 Effective Dates New Revenue Recognition Standard Public annual reporting periods beginning after December 15, 2017 All other annual reporting periods beginning after December 15, 2018 Early adoption only permitted as of the original effective date for public companies Transition methods Full retrospective or modified retrospective

6 New Revenue Recognition Tax Considerations Standard Companies will need to asses if new book standard of revenue recognition is allowed for tax purposes. Will likely affect temporary difference related to deferred revenue For tax purposes, can be on a cash method of deferred revenue recognition or defer revenue recognition up to one year under Regs. Sec or Rev. Proc One year deferral cannot exceed the financial accounting deferral

7 New Revenue Recognition Tax Considerations Standard Companies will need to consider the impact that an acceleration of book revenue may have on their cash taxes The IRS considers a change in the underlying book method to be a method change for which consent is required However, for taxpayers using Rev. Proc , consent may be obtained automatically under Rev. Proc

8 New Revenue Recognition Tax Considerations Standard It is important to understand that if a company s tax method has been following financial accounting and the company changes its book method, it cannot simply change its tax method to follow the new book method. Rather, it needs to evaluate whether applying the tax rules would result in the same answer as the new book method, and if so, the company will have to file a Form 3115 to change it tax method to implement it on its tax return

9 New Lease Standard The new standard does not fundamentally change lease accounting from the lessor s perspective From a lessee s perspective, the most significant change from prior lease guidance is that lessees are required to recognize the rights and obligations resulting from most operating leases as assets and liabilities on the balance sheet

10 New Lease Standard Prior to the new standard, a lessee did not recognize assets and liabilities arising from most operating leases While recognizing assets the related expense in the income statement, the lease obligations were offbalance sheet liabilities under previous GAAP As a result of recognizing the rights and obligations arising from most leases on the balance sheet, the new standard will dramatically impact the balance sheet of lessee

11 New Lease Standard Effective Dates Public fiscal years beginning after December 15, 2018, including interim periods within those fiscal years All other Fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 2020annual reporting periods Early adoption permitted Transition method Modified retrospective as of the beginning of the earliest period presented

12 New Lease Standard Tax Considerations The new standard does not change the treatment of leases for income tax purposes A lessee that is not otherwise required to capitalize the lease for income tax purposes will not have any tax basis in the right-of-use asset and related lease liability recorded for tax purposes

13 New Lease Standard Tax Considerations Differences are temporary in nature Must recognize a deferred tax liability for excess GAAP basis in the right-of-use asset Must recognize a deferred tax asset for the excess GAAP basis in the related lease liability Other tax considerations State apportionment State definition of property Effect on rent expense Franchise/Net Worth taxes

14 Balance Sheet Classification of Deferred Taxes ASU , Simplifying the Balance Sheet Classification of Deferred Taxes New guidance requires all deferred tax assets and liabilities to be classified as noncurrent on the balance sheet Any related valuation allowances are also to be classified as noncurrent Netting of deferred tax assets and liabilities from different jurisdictions is still prohibited Effective Dates Effective after December 15, 2016 for public companies and after December 15, 2017 (interim periods in the following year) for private companies Earlier application is permitted for all entities as of the beginning of any interim or annual reporting period

15 Balance Sheet Classification of Deferred Taxes ASU , Simplifying the Balance Sheet Classification of Deferred Taxes Adoption guidance New guidance may be applied prospectively or retrospectively Required disclosures for first interim and first annual period of change: The nature and reason for the change in accounting principle Prospective change: a statement that prior periods were not retrospectively adjusted Retrospective change: quantitative information about the effects of the accounting change on prior periods

16 Intra-entity transactions under ASC (e) The FASB decided the following regarding the exception to recognizing tax effects in intra-entity asset transfers: To eliminate the exception for all intra-entity transfers except for transfers of inventory The FASB decided not to provide specific guidance on the treatment of the tax effects of intra-entity transfers in the determination of interim tax provision (e.g., inclusion in the annual effective tax rate versus discrete reporting) The Board decided to issue a final standard with an effective date for annual periods beginning after December 15, 2017 for public companies and December 15, 2018 (one year later for interim) for private companies Early adoption will be permitted although the specifics of when early adoption may be available were unclear from the Board s discussion

17 Overview of Purchase Accounting Treatment of Goodwill and Other Intangibles John Monahan December 8, 2016

18 ASC 740 Basic Principles A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year (current provision). A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards (deferred provision). The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted law. 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 (valuation allowance).

19 ASC 805 Business Combinations - Basics Requires that all business combinations be recorded using the acquisition method of accounting The acquisition method requires: Identification of the acquirer Determination of the acquisition date Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, and Recognizing and measuring goodwill or a gain from a bargain purchase Determine the acquirer. Business combination is defined as A transaction or other event in which an acquirer obtains control of one or more businesses. (Control defined under ASC requirements)

20 ASC 805 Business Combinations - Basics Determine the acquisition date Date on which the acquirer obtains control of the acquiree, usually on the date of the legal transfer of consideration (i.e., closing date) On the acquisition date, acquirer shall recognize and measure all consideration transferred (including equity consideration), assets acquired and liabilities assumed Recognize identifiable assets acquired and liabilities assumed To qualify for recognition, identifiable assets and liabilities assumed must meet the definitions under FASB Concepts Statement 6 (para 12) The recognition standard may cause the acquirer to recognize assets (i.e., brand names, etc.) that were not recorded by the acquirer Assets recognized using the measurement principle by looking to fair value as of the acquisition date. (ASC )

21 ASC 805 Business Combinations - Basics Goodwill defined in ASC as the excess of cost of: Consideration transferred as measured based on fair value, plus the fair value of non-controlling interests and the fair value of previously acquired equity interests, over The net of the acquisition date amounts of the identifiable assets acquired and liabilities assumed as measured under ASC 805 (fair value approach) ASC requires that the acquirer recognize gain in earnings on the acquisition date to the extent of the measured bargain purchase Total consideration is less than the fair market value of assets acquired and liabilities assumed The term Negative Goodwill from old FAS 141 no longer applies

22 ASC 805 Business Combination - Intangibles Provides for the recognition of intangible assets, apart from goodwill, where the intangible asset meets one of two criteria: Recorded separately if it is either separable or transferable (e.g., sold, rented, licensed, transferred or exchanged), or Recorded separately if it arises from contractual or other legal right (regardless of whether rights are separable or transferable) Identified Intangible defined as an asset that lacks physical substance and specifically excludes goodwill

23 ASC 805 Business Combination - Intangibles Illustrative list of identifiable intangibles acquired: Marketing-related intangibles (trademarks, tradenames, trade dress, internet domain names, non-compete agreements) Customer-related intangibles (customer lists, customer contracts, noncontractual customer relationships, order backlog) Artistic-related intangibles (plays, movies, books, music, newspapers, photos, video) Contract-based intangibles (royalty agreements, supply contracts, employment agreements, broadcast rights) Technology-based intangibles (software, patents, databases, trade secrets, formulas)

24 ASC 805 Business Combinations Other Issues Noncontrolling Interest in Acquiree acquirer shall measure a noncontrolling interest of an acquiree based on fair value at the acquisition date Contingent Consideration acquirer shall include the fair value of contingent consideration as a component of the total consideration transferred at the acquisition Contingent consideration as ultimately settled may increase or decrease acquired goodwill or intangibles and thus impact deferreds Step Acquisition acquirer shall recognize 100% of the assets and liabilities when control is acquired, with a gain or loss recorded to P&L for previously acquired interests Often results in a book gain of previously acquired interests if there were prior impairments

25 ASC 805 and ASC 740 Tax Accounting and Business Combinations In a business combination, the consideration transferred (i.e., cash, other assets, liabilities assumed, contingent consideration, equity interests) is considered the appropriate fair value of the enterprise. The acquiring entity shall assign the fair value to the assets acquired and liabilities assumed based on their estimated fair values, with any excess assigned to goodwill. Deferred taxes should be recognized on the acquisition date for the future tax consequences of the differences between the assigned values and tax bases of the assets acquired and liabilities assumed (ASC ). The deferred tax adjustment ordinarily will increase or decrease acquired goodwill or intangible assets. Compute opening balance sheet deferred taxes based on the applicable tax rate for the jurisdiction that has the basis difference (U.S. federal/ U.S. State/ Foreign).

26 ASC 805 and ASC 740 Tax Accounting and Business Combinations Acquiring entity 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 arise as a result of the acquisition. Acquiring entity shall not record deferred taxes for book goodwill in excess of tax deductible goodwill Deferred tax assets are recorded at the acquisition date for tax deductible goodwill that exceeds book goodwill Record deferred tax assets for acquired attributes (i.e., NOLs, general business credits, foreign tax credits, capital losses, etc.) ASC 805 maintains the basic concepts for recording deferred tax assets and liabilities related to all book/tax basis differences

27 ASC 805- Accounting for Income Taxes in a Business Combination ASC805/740 requires the recognition of a deferred tax liability in the opening balance sheet for identified intangibles recorded for books that have no tax basis Occurs primarily in transactions involving tax-free reorganizations or the acquisition of the stock of a target corporation (no asset step-up for tax) ASC 805/740 requires the recognition of a deferred tax asset in the opening balance sheet for tax deductible goodwill or intangibles that have a smaller book basis

28 ASC 805- Accounting for Income Taxes in a Business Combination Ex: Deferred Tax Liability recorded in purchase accounting The stock of Target, a consumer brand manufacturer, is acquired by Corporation X on 03/31/2013 for $1,500. Market-related and customer-related intangibles are identified and recorded for book purposes in the amount of $600. Assume no section 338 election, a 40% effective tax rate, and $0 tax basis in the intangibles held by Target. ASC Book Tax Difference DTL Identified Intangibles $ 600 $ - $ 600 Tax Rate 40% $ 240 Journal Entry: Dr. Goodwill $ 240 Cr. Deferred Tax Liability $ 240

29 ASC 805- Accounting for Income Taxes in a Business Combination Ex: Deferred Tax Asset recorded in purchase accounting The stock of Target, a consumer brand manufacturer is acquired by Corporation Y on 03/31/2013 for $950. Market-related and customer-related intangibles are identified and recorded for book purposes in the amount of $300. Assume no section 338 election, a 40% effective tax rate and historic tax basis of intangibles held by Target from prior acquisition of $500. ASC Book Tax Difference DTA Identified Intangibles $ 300 $ 500 $ 200 Tax Rate 40% $ 80 Journal Entry: Dr. Deferred Tax Asset $ 80 Cr. Goodwill $ 80

30 ASC 350 Goodwill and Intangible Assets Excess of purchase price over the value of identified tangible and intangible assets is treated as goodwill Goodwill will not be amortized for book purposes (exception provided for private companies who can elect to amortize) Goodwill is tested for impairment at least annually for amounts recorded in the reporting units. Generally, look to segments as defined under ASC 280 to determine the reporting unit Goodwill impairment loss is recorded as a component of income from operations (i.e., pre-tax income) or to discontinued operations if the business unit is sold

31 ASC 350 Goodwill and Intangibles Intangible assets identified under ASC 805 determine the useful life of the intangible asset: Intangibles with an indefinite useful life no amortization Intangibles with a useful life amortize over the useful life Amortize based on residual value of intangible with an useful life

32 Illustration of How Recognition of Tax Benefits on Acquisition Date Affect Deferred Taxes Company A, newly formed HoCo, acquires 100% of Company B stock in a taxable purchase on 01/01/2016 for $600,000 plus assumed liabilities. Company B has an NOL carryforward of $10,000 with fair value and tax basis information as follows: FAIR VALUE TAX BASIS TEMPORARY DIFFERENCE DEFERRED TAX LIABILITY/(ASSET) ACCOUNTS RECEIVABLE $ 70,000 $ 75,000 $ (5,000) $ (1,750) INVENTORY $ 90,000 $ 80,000 $ 10,000 $ 3,500 FIXED ASSETS $ 200,000 $ 100,000 $ 100,000 $ 35,000 INTANGIBLE ASSETS $ 100,000 $ 50,000 $ 50,000 $ 17,500 ACCOUNTS PAYABLE $ 35,000 $ 35,000 $ - $ - LONG-TERM DEBT $ 185,000 $ 180,000 $ (5,000) $ (1,750) TENTATIVE DEFERRED TAX LIABILITY $ 52,500 NOL CARRYFORWARD $ (3,500) NET DEFERRED TAX LIABILITY $ 49,000 Note: the NOL carryforward is a future deductible amount and decreases the deferred tax liability otherwise recognized. Assumes a 35% tax rate.

33 Company A Opening Balance Sheet Accounts Receivable 70,000 Inventory 90,000 Fixed Assets 200,000 Intangible Assets 100,000 Deferred Tax Asset 7,000 Goodwill 409,000 Total Assets $ 876,000 Accounts Payable 35,000 Deferred Tax Liability 56,000 Long Term Debt 185,000 Equity 600,000 Total Liabilities and Equity $ 876,000

34 Accounting for Tax Deductible Goodwill ASC 740 and ASC 805 provide an exception to comprehensive recognition of deferred taxes for nondeductible goodwill Prior to enactment of IRC Section 197, in August 1993, acquired goodwill was never tax deductible Accordingly goodwill amortization for financial reporting was a permanent difference IRC Section 197 permits companies to deduct acquired goodwill over a 15-year period Applies only to asset acquisitions and stock acquisitions in which a Section 338 election is made

35 Tax Deductible Goodwill Accounting rules are complex (ASC ) First, divide goodwill into two components: Component 1 = Financial reporting goodwill equal to tax goodwill Generally will create a deferred tax liability in subsequent reporting periods when tax benefits are realized for tax deductible goodwill Component 2 = Financial reporting goodwill in excess of tax goodwill or tax goodwill in excess of book goodwill Existing rules apply to excess book goodwill (i.e., no deferred tax recorded for book goodwill in excess of tax goodwill) Goodwill impairment charge for financial reporting treated as a permanent difference

36 Tax Deductible Goodwill

37 Illustration of Excess Financial Assumptions: Reporting Goodwill Company A acquires Company B in an asset acquisition The carrying and fair values of Target s assets and liabilities (for both financial reporting and tax purposes) are as follows: HISTORIC BOOK VALUE BOOK FAIR VALUE TAX BASIS TAX FAIR VALUE ACCOUNTS RECEIVABLE $ 70,000 $ 70,000 $ 75,000 $ 70,000 INVENTORY $ 80,000 $ 90,000 $ 80,000 $ 90,000 FIXED ASSETS $ 100,000 $ 200,000 $ 100,000 $ 200,000 ACCOUNTS PAYABLE $ (35,000) $ (35,000) $ (35,000) $ (35,000) ACCRUED LIABILITIES $ (180,000) $ (185,000) $ (180,000) $ (180,000) NET WORTH $ 35,000 $ 140,000 $ 40,000 $ 145,000 The difference in fair values between financial reporting and tax relates to certain liabilities that are recognized for financial reporting but not for income tax purposes (e.g., OPEB liabilities, restructuring costs, etc.) The purchase price and tax rates are as follows: Purchase price: $500,000 plus assumed liabilities Assumed Tax Rate: 35%

38 Illustration of Excess Financial Reporting Goodwill The calculation of goodwill is as follows: BOOK TAX PURCHASE PRICE $ 720,000 $ 715,000 FAIR VALUE OF NET ASSETS $ (360,000) $ (360,000) GOODWILL $ 360,000 $ 355,000 LESS: TAX DEDUCTIBLE AMOUNT $ 355,000 EXCESS BOOK GOODWILL $ 5,000 Component 1 goodwill equal to $355,000 Component 2 goodwill (excess book goodwill over tax goodwill) of $5,000 represents a "permanent difference" Consider the impact of opening balance sheet DTA/DTL when measuring component 1 and component 2 goodwill

39 Illustration of Excess Financial Reporting Goodwill The calculation of deferred taxes is as follows: DEFERRED TAX CARRYING VALUE TAX BASIS TEMPORARY (ASSET)/ LIABILITY ACCOUNTS RECEIVABLE $ 70,000 $ 70,000 $ - $ - INVENTORY $ 90,000 $ 90,000 $ - $ - FIXED ASSETS $ 200,000 $ 200,000 $ - $ - TOTAL LIABILITIES $ 220,000 $ 215,000 $ (5,000) $ (1,750) TOTAL DEFERRED ASSETS $ (1,750) ADJUSTED EXCESS FINANCIAL REPORTING GOODWILL $ 3,250 Component 2 goodwill (excess of book goodwill over tax goodwill) is thus reduced from $5,000 to $3,250

40 Tax Deductible Goodwill Tax deductible goodwill in excess of financial reporting goodwill Under ASC 805, a deferred tax asset is created at the acquisition date for tax goodwill that exceeds book goodwill (Component 2) The iterative process resulting from the deferred tax asset requires an adjustment to book goodwill in the opening balance sheet Formula to measure the DTA for excess tax goodwill; Tax Rate / (1 Tax Rate) x Preliminary Temp Diff = DTA Keep in mind that transaction costs are not considered a portion of the Component 2 tax deductible goodwill to measure the required deferred tax asset

41 ASC 350 Accounting for Income Taxes for Goodwill and Intangible Assets Unusual results of ASC 805/350 and ASC 740: Since goodwill is not amortized for book purposes, tax deductions for goodwill create deferred tax liabilities over time Tax deductions for long-lived intangible assets acquired (no book amortization) create deferred tax liabilities over time Deferred tax liabilities recorded due to acquired intangibles that have zero or low tax basis may substantially increase book goodwill. Impairment issues may be magnified for post-deal impairment testing.

42 ASC 350 Accounting for Income Taxes for Goodwill and Intangible Assets Unusual results of ASC 805/350 and ASC 740 (cont.): Deferred tax liabilities recorded for acquired long-lived intangibles in the opening balance sheet may not be viewed as a source of future taxable income for purposes of measuring valuation allowances (e.g., naked credits ) Tax benefits are not recognized to tax expense (P&L) in post-acquisition periods for the use of acquired NOLs or the tax benefits form tax deductible goodwill amortization

43 Goodwill Impairment When goodwill is subsequently impaired for book purposes the deferred tax impact will be as follows: If no tax-deductible goodwill exists, no deferred tax implications arise If tax-deductible goodwill exists, and book goodwill exceeds tax goodwill, the impairment must be allocated pro rata to the two components of book goodwill to determine the deferred tax effect The impairment is allocated pro rata to the two components based on the book carrying amounts If tax-deductible goodwill exceeds book goodwill, no allocation is necessary and the impairment will increase the DTA or reduce the DTL

44 Goodwill Impairment An Example Assumptions: Goodwill for reporting unit X suffers and impairment loss of $400 four years after the acquisition data Tax related goodwill is deductible over 15 years Applicable tax rate of 40% COMPONENT COMPONENET DEFERRED 1 GOODWILL 2 GOODWILL BOOK BASIS TAX BASIS TAXES BALANCE AT ACQUISITION DATE $ 900 $ 300 $ 1,200 $ 900 $ - TAX AMORTIZATION $ - $ - $ - $ (240) $ (96) BALANCE BEFORE IMPAIRMENT TEST $ 900 $ 300 $ 1,200 $ 660 $ (96) IMPAIRMENT LOSS $ (300) $ (100) $ (400) $ - $ 120 ENDING BALANCE $ 600 $ 200 $ 800 $ 660 $ 24 $300 of the impairment loss represents a "temporary difference" $100 of the impairment loss represents a "permanent difference"

45 Basic Asset vs. Stock Acquisition

46 Section 338 Elections IRC 338 provides that if elected, a stock deal is treated as an asset deal for federal income tax purposes For all other purposes (i.e., legal, GAAP, regulatory), the transaction is a stock deal IRC 338(h)(10) election is generally available only for the sale of a subsidiary out of a U.S. consolidated tax group or an S corporation Sellers are generally subject to only one level of tax (versus two in the typical asset sale), but incremental taxes may still be incurred Requires a joint election to be filed between Buyer and Seller, among other statutory requirements (e.g., corporate purchaser, QSP, etc.) IRC 338(g) election is a unilateral election that may be filed by a corporate purchaser, which is often utilized in connection with foreign acquisitions

47 Section 338(h)(10) Elections

48 GAAP & Tax Accounting Differences Domestic Stock vs. Asset Deal

49 GAAP & Tax Accounting Differences Domestic Stock vs. Asset Deal

50 Identifying Acquired Tax Benefits Realization test for acquired tax benefits An acquirer should consider the tax attributes and future taxable income of the combined business when assessing whether acquired deferred tax assets are realizable. Deductible differences or carryforwards of the acquiree can be realized because the acquirer has sufficient taxable temporary differences that will generate future taxable income These new sources of future taxable income from the perspective of the combined business may make it possible to recognize deferred tax assets for the combined business at the date of acquisition. However, depending on the specific tax jurisdiction, there may be various limitations on the use of acquired tax benefits (Ex. Section 382 limitation). Any resulting DTA would be recorded through acquisition accounting

51 Identifying Acquired Tax Benefits Realization test for acquired tax benefits Combined tax attributes or income may also provide evidence as to the realizability of the acquirer s own deferred tax assets at the date of acquisition. However, changes in the assessment of realizability of the acquiring company s deferred tax assets are not included in acquisition accounting

52 Identifying Acquired Tax Benefits Changes to the acquired deferred tax assets after the business combination The release of a valuation allowance that does not qualify as a measurement period adjustment is reflected in income tax expense The release of a valuation allowance within the measurement period resulting from new information about facts and circumstances that existed at the acquisition date is reflected first as an adjustment to goodwill, then as a bargain purchase Changes resulting from discrete events or circumstances that arise within the measurement period and did not exist at the acquisition date generally would not be recorded in acquisition accounting

53 Identifying Acquired Tax Benefits Changes in the acquirer s deferred tax balances related to acquisition accounting The impact on the acquiring company s deferred tax assets and liabilities caused by an acquisition is recorded in the acquiring company s financial statements outside of acquisition accounting. Such impact is not a part of the fair value of the assets acquired and liabilities assumed. For example, for a company using a composite state tax rate, the expected post-combination results of the company may cause a change in the tax rate expected to be applicable when the deferred tax assets and liabilities reverse.

54 Business Combinations Tax Uncertainties Recording tax uncertainties In a taxable business combination, positions may be taken in allocating the acquisition price and in filing subsequent tax returns, which are expected to be challenged by the taxing authority In nontaxable business combinations there may be uncertainties about the tax basis of individual assets or the pre-acquisition tax returns of the acquired business. Same recognition and measurement criteria with corresponding fair value of liability recorded to goodwill Treatment of indemnified items

55 Business Combinations Tax Uncertainties Subsequent resolution of tax uncertainties in a business combination Adjustments to uncertain tax positions made subsequent to the acquisition date are recognized in earnings, unless they qualify as measurement period adjustments. Measurement period adjustments are recorded first as an adjustment to goodwill, then as a bargain purchase. Need to evaluate whether an adjustment within the measurement period relates to circumstances that were included in the acquirer s assessment at the date of the acquisition

56 ASC 805 Business Combinations Acquisition Costs Acquirer Acquisition Costs acquirer shall not include acquisition costs (professional fees, IB fees, registrations costs, etc.) as part of the consideration transferred Acquirer shall record transaction costs as an expense in measuring pre-tax income from operations Potential for permanent differences for stock acquisitions Potential for uncertain tax positions for transaction costs treated as a current section 162(a) ordinary and necessary business expense Look to Treas. Reg (a)-5 to determine what portion of transaction costs may be deductible for income tax purposes

57 General Background Treas. Reg (a)-5 A taxpayer must capitalize amounts paid to facilitate the following transactions: Acquisition of assets that constitute a trade or business Acquisition where the two parties are related within the meaning of 267(b) or 707(b) immediately after the transaction Acquisition of an ownership interest of the taxpayer (other than an acquisition by the taxpayer) Restructuring, recapitalization, or reorganization of the capital structure Transfers as described in 351 or 721 Formation of organization of a disregarded entity Acquisition of capital Borrowing Writing an option

58 General Background (continued) Covered transactions include: A taxable acquisition by the taxpayer of assets that constitute a trade or business A taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of the Sections 267(b) or 707(b) A reorganization described in Section 368(a)(1)(A), or or a reorganization described in Section 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under Section 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization).

59 General Background (continued) Bright-line test for certain acquisitive transactions- Capitalize any inherently facilitative amount Capitalize any amount related to activities performed after the earlier of: The date on which a letter of intent or exclusivity agreement is executed by representatives of the acquirer and the target; or The date on which the material terms of the transaction are authorized or approved by the taxpayer s board of directors. Comment: A letter of intent or exclusivity agreement could pre-date board approval by months while the due diligence is underway

60 General Background (continued) Documentation of success-based fees: Regulations provide that the following documentation requirements must be met: Identify activities provided by the service provider The amount of fee (or percentage of time) allocable to each activity The amount of fee (or percentage of time) allocable to the performance of activities before and after the decision date Name, address and phone number of the service provider Historically, area of controversy with IRS-exam agents want detailed timesheets Documentation must be completed on or before due date of tax return (incl. extensions) for year during which transaction closes

61 General Background (continued) Documentation of success-based fees safe harbor election Rev. Proc Creates a safe-harbor election for taxpayers seeking to allocate success-based fees between facilitative and non-facilitative amounts In lieu of requiring documentation specified under regulations, safe harbor allows use of a simplified, percentage-based allocation Elect to treat 70% of all success-based fees incurred as non-facilitative and remaining 30% is considered facilitative and must be capitalized Statement required in originally filed return

62 Recovery of Previously Capitalized Costs Professional fees incurred by target corporation provide a long-term future benefit in the form of synergistic and resource benefits that are indefinite in nature and therefore must be capitalized Generally capitalized into a floating intangible In INDOPCO, the Supreme Court observed that capitalized costs could later be recovered by amortization or depreciation deductions over the life of the asset, or where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. What event might allow for capitalized transaction costs to be recovered? Termination of relationship giving rise to the benefits (i.e., sale of the company, IPO, etc.) may be an identifiable event Losses must be evidenced by a closed and completed transaction that is fixed by identifiable events Treas. Reg. Sec (b)

63 Contact Information John Monahan Tax Partner (303) Hein & Associates LLP.

64 Tax Accounting for Equity Compensation Brian Parmelee December 8, 2016

65 Agenda Introduction Overview ASC 718 Specific Equity Arrangements Accounting Treatment Specific Equity Arrangements Income Tax Treatment

66 Introduction ASC 718, Stock Compensation Establishes deferred tax asset on cumulative book expense which is expected to result in future tax benefit Reverse deferred tax asset as award is settled for income tax purpose Complex and Audit risk Many granting jurisdictions Many types of awards, large amount of awards, and many grant dates Tax rules 2015 Hein & Associates LLP.

67 Recognition of Compensation Cost Compensation cost recognized for financial statement purposes under one of two methods: Equity classified Liability classified

68 Equity Classified Method Fair value of equity award determined at grant date Options/Stock appreciation rights Black-Scholes or binomial model Restricted stock/ Restricted stock unit fair market value of stock Recognize compensation cost over requisite service period (generally vesting period) Debit to compensation cost Credit to additional paid in capital Settlement Forfeiture Expiration Exercise

69 Liability Classified Method Fair value of equity award determined at grant date Fair value remeasured at end of each reporting period until award settled True-up compensation cost for changes in fair value pro-rated for portion of requisite service period rendered After end of requisite service period, recognize change in compensation cost based on change in fair value Liability account credited instead of APIC Financial statement and tax compensation cost the same

70 Income Tax Deduction Tax deduction recorded when settlement occurs Nonqualified stock options exercise date Incentive stock options date of disqualifying disposition Stock appreciation rights exercise Restricted stock vesting date Restricted stock units date stock is transferred

71 Reconciling Timing Difference Use principles of ASC 740 Grant date and requisite service period Recognize deferred tax asset (DTA) as book compensation cost recorded for awards expected to provide future tax deduction No DTA for incentive stock options No DTA for employee stock purchase plans Deferred tax benefit recorded in income statement based on book compensation cost for the reporting period Deferred tax liability (DTL) recorded when tax deduction occurs prior to recognizing book compensation cost (Section 83(b) election made)

72 Reconciling Timing Difference Tax Settlement Deferred tax asset reversed with off setting entry to deferred tax benefit Difference between deferred tax asset and actual tax benefit results in a windfall or shortfall Current rules: Windfalls add to APIC pool and shortfalls reduce APIC pool, if any Excess shortfalls recorded as additional tax expense in current period May only recognize windfall benefit if there is a reduction in taxes payable New rules: Windfalls and shortfalls recognized in income statement in period realized Discrete item Effective for periods beginning after December 15, 2016 May adopt earlier

73 Incentive Stock Options No DTA Recorded Tax benefit recorded only if there is a disqualifying disposition Windfalls reflected in period of disqualifying disposition No shortfall recorded $100,000 limitation ISOs exceeding $100,000 annual limitation (determined at date of grant) treated as nonqualified stock options Accelerating future vesting may cause ISOs to be treated as nonqualified stock options resulting in the need to establish DTA at that time

74 Income Tax Limitations Section 162(M) Applies only to publicly held corporations Limitation does not apply to performance-based compensation Methodologies for allocating limitation: Equity first DTA established on equity compensation up to $1Million limitation before other compensation taken into account Salary first DTA established on equity compensation only if available limit exists after taking into account cash compensation Pro Rata Allocate $1Million to all compensation Future change in cash compensation could result in reduction to DTA and increase to tax expense

75 Modification of Awards Exchange of original award for a new award Additional compensation cost if fair value of new award greater than fair value of original award Record additional DTA if necessary on vested awards If there is a modification that causes equity classified award to become a liability classified award, DTA needs to be adjusted If modification to ISO results in loss of ISO status, then establish DTA as of modification date

76 Pool of Windfall Tax Benefits- Prior to 2017 Pool of realized windfall tax benefits available to offset shortfalls Hypothetical account in APIC Windfalls recorded only when associated tax deduction reduces taxes payable Reduce APIC pool by shortfalls but not below zero No tax benefit recorded if excess tax deduction part of net operating loss carryforward Business combinations may result in allocation of APIC pool

77 Windfall/ Shortfall Tax Benefits After 2016 Windfalls and Shortfalls Reflected in income statement at the time award is settled for tax purposes No more APIC pool Included in net operating loss DTA, may need a valuation allowance on the NOL Effective for public business entities for annual reporting period beginning after December 15, 2016 and interim periods included in such period (other business entities 12 months later) although early adoption is permitted

78 Business Combination Exchange of target awards for acquiring company awards Record DTA on Acquisition date for precombination portion of the fair value of vested awards acquirer is obligated to replace Fair value of replaced unvested awards expensed over requisite service period Fair value of awards acquirer not obligated to replace are expensed post-combination Windfalls and shortfalls recorded at time replacement awards settled

79 Business Combination - Example Exercise Price $ FMV of stock on acquisition date $ FMV of option on acquisition date (Black-Scholes) $ Outstanding options exchanged 10,000,000 Fair value of options exchanged ($21 x 10,000,000) $ 210,000,000 Deferred tax asset established at acquisition (40% tax rat $ 84,000,000 Total deemed consideration paid for stock options $ 294,000,000 Actual tax benefit (exercise at $35 FMV -40% tax rate) $ 100,000,000 Excess tax benefit ($100,000,000 - $84,000,000) $ 16,000,000 Actual tax benefit (Exercise price $25 FMV - 40% tax rate) $ 60,000,000 Deficit tax benefits (60,000,000 - $84,000,000) $ (24,000,000)

80 Specific Equity Arrangements Accounting Treatment

81 Nonqualified Stock Option Equity Classified Event Action Grant Date Measure fair value of option (Black-Scholes, binomial model) During Requisite Service Period Settlement Date, (exercise, cancel, lapse) Recognize Compensation cost and related DTA on options that vest and for which future tax deduction is expected Reverse entry for options forfeited Reflect changes in tax rates Record valuation allowance Reverse prior tax entry and reconcile DTA If tax deduction exceeds cumulative book expense, additional tax benefit is a windfall If tax deduction is less than cumulative book expense, a shortfall occurs

82 Nonqualified Stock Option Equity Facts Classified Windfall Example 10,000 options granted at $10 Fair value is $3 per option One year vesting and all options vest Recognition of expense and DTA Dr. Compensation Cost $30,000 Cr. APIC $30,000 Dr. Deferred Tax Asset $12,000 Cr. Deferred Tax Benefit $12,000 Exercise Dr. Deferred Tax Benefit $12,000 Cr. Deferred Tax Asset $12,000 Dr. Current Taxes Payable $60,000 Cr. Current Tax Benefit $12,000 Cr. APIC $48,000 Exercise when stock value is $25 Combined tax rate of 40% Recognize compensation expense (10,000 x $3) Recognize deferred tax asset ($30,000 x 40%) Reverse prior tax entry Calculate tax deduction/benefit (10,000 x $15 x 40%) and windfall ($60,000 -$12,000)

83 Nonqualified Stock Option Equity Facts Classified Shortfall Example 10,000 options granted at $10 Fair value is $3 per option One year vesting and all options vest Recognition of expense and DTA Dr. Compensation Cost $30,000 Cr. APIC $30,000 Dr. Deferred Tax Asset $12,000 Cr. Deferred Tax Benefit $12,000 Exercise Dr. Deferred Tax Benefit $12,000 Cr. Deferred Tax Asset $12,000 Dr. Current Taxes Payable $8,000 Dr. APIC or Current Tax Benefit $4,000 Cr. Current Tax Benefit $12,000 Exercise when stock value is $12 Combined tax rate of 40% Recognize compensation expense (10,000 x $3) Recognize deferred tax asset ($30,000 x 40%) Reverse prior tax entry Calculate tax deduction/benefit (10,000 x $2 x 40%) and shortfall ($8,000 -$12,000)

84 Stock Appreciation Right Equity Classified Event Action Grant Date Measure fair value of SAR (Black-Scholes, binomial model) During Requisite Service Period Settlement Date, (exercise, cancel, lapse) Recognize Compensation cost and related DTA on SARs that vest and for which future tax deduction is expected Reverse entry for SARs forfeited Reflect changes in tax rates Record valuation allowance Reverse prior tax entry and reconcile DTA If tax deduction exceeds cumulative book expense, additional tax benefit is a windfall If tax deduction is less than cumulative book expense, a shortfall occurs

85 Facts Stock Appreciation Right Equity Classified Windfall Example 10,000 SARs granted at $10 Fair value is $3 per SAR One year vesting and all SARs vest Recognition of expense and DTA Dr. Compensation Cost $30,000 Cr. APIC $30,000 Dr. Deferred Tax Asset $12,000 Cr. Deferred Tax Benefit $12,000 Exercise Dr. Deferred Tax Benefit $12,000 Cr. Deferred Tax Asset $12,000 Dr. Current Taxes Payable $60,000 Cr. Current Tax Benefit $12,000 Cr. APIC $48,000 Exercise when stock value is $25 Combined tax rate of 40% Recognize compensation expense (10,000 x $3) Recognize deferred tax asset ($30,000 x 40%) Reverse prior tax entry Calculate tax deduction/benefit (10,000 x $15 x 40%) and windfall ($60,000 -$12,000)

86 Facts Stock Appreciation Right Equity Classified Shortfall Example 10,000 options granted at $10 Fair value is $3 per SAR One year vesting and all SARs vest Recognition of expense and DTA Dr. Compensation Cost $30,000 Cr. APIC $30,000 Dr. Deferred Tax Asset $12,000 Cr. Deferred Tax Benefit $12,000 Exercise Dr. Deferred Tax Benefit $12,000 Cr. Deferred Tax Asset $12,000 Dr. Current Taxes Payable $8,000 Dr. APIC or Current Tax Benefit $4,000 Cr. Current Tax Benefit $12,000 Exercise when stock value is $12 Combined tax rate of 40% Recognize compensation expense (10,000 x $3) Recognize deferred tax asset ($30,000 x 40%) Reverse prior tax entry Calculate tax deduction/benefit (10,000 x $2 x 40%) and shortfall ($8,000 -$12,000)

87 Incentive Stock Option Equity Classified- Qualifying Disposition Event Action Grant Date Measure fair value of Option (Black-Scholes, binomial model) During Requisite Service Period Settlement Date, (exercise, cancel, lapse) Qualifying Disposition Dispose after 1-year and 2- year Holding Periods Recognize Compensation cost (no related DTA recorded) on options that vest Reverse entry for options forfeited Reflect changes in tax rates No impact No Impact

88 Incentive Stock Option- Equity Classified- Qualifying Disposition Facts 10,000 ISOs granted at $10 Fair value is $3 per option One year vesting and all ISOs vest Recognition of expense and DTA Dr. Compensation Cost $30,000 Cr. APIC $30,000 Exercise No tax entry Exercise when stock value is $25 Qualifying disposition at $30 Combined tax rate of 40% Recognize compensation expense (10,000 x $3) Disposition No tax entry

89 Incentive Stock Option Equity Classified-Disqualifying Disposition Event Action Grant Date Measure fair value of Option (Black-Scholes, binomial model) During Requisite Service Period Recognize Compensation cost (no related DTA recorded) on options that vest Reverse entry for options forfeited Reflect changes in tax rates Settlement Date, (exercise, cancel, lapse) Disqualifying Disposition Dispose within 1- year and 2-year Holding Periods No impact Record income tax benefit of compensation cost If tax deduction greater than cumulative book compensation cost, then tax benefit associated with excess tax deduction treated as a windfall If tax deduction less than cumulative book compensation cost, then credit to income tax expense limited to actual tax benefit

90 Incentive Stock Option - Equity Classified- Disqualifying Disposition (Windfall) Facts 10,000 ISOs granted at $10 Fair value is $3 per Option One year vesting and all ISOs vest Recognition of expense and DTA Dr. Compensation Cost $30,000 Cr. APIC $30,000 Exercise No tax entry Disposition Dr. Current Taxes Payable $60,000 Cr. Current Tax Benefit $12,000 Cr. APIC $48,000 Exercise when stock value is $25 Disqualifying disposition at $30 Combined tax rate of 40% Recognize compensation expense (10,000 x $3) Calculate tax deduction/benefit (10,000 x ($25 - $10) x 40% and windfall ($60,000 - $12,000)

91 Incentive Stock Option- Equity Classified- Disqualifying Disposition (No Windfall) Facts 10,000 ISOs granted at $10 Fair value is $3 per Option One year vesting and all ISOs vest Recognition of expense and DTA Dr. Compensation Cost $30,000 Cr. APIC $30,000 Exercise No tax entry Disposition Dr. Current Taxes Payable $8,000 Cr. Current Tax Benefit $8,000 Exercise when stock value is $25 Disqualifying disposition at $12 Combined tax rate of 40% Recognize compensation expense (10,000 x $3) Calculate tax deduction/benefit (10,000 x ($12 - $10) x 40% - no windfall or shortfall

92 Restricted Stock Equity Classified No Section 83(b) Election Event Grant Date Measure fair value of stock Action During Requisite Service Period Recognize Compensation cost and related DTA shares that vest and are expected to result in future tax deduction Reverse entry for restricted stock forfeited Reflect changes in tax rates Record valuation allowance Vesting Date Reverse DTA If tax deduction is greater than cumulative book compensation cost, additional tax benefit is a windfall If tax deduction less than cumulative book compensation cost, a shortfall occurs

93 Restricted Stock Equity Classified No Section 83(b) Election With Windfall Facts 10,000 restricted stock granted Fair value of stock is $10 One year vesting and all shares vest Recognition of expense and DTA Dr. Compensation Cost $100,000 Cr. APIC $100,000 Dr. Deferred Tax Asset $40,000 Cr. Deferred Tax Benefit $40,000 Vesting Dr. Deferred Tax Benefit $40,000 Cr. Deferred Tax Asset $40,000 Dr. Current Taxes Payable $100,000 Cr. Current Tax Benefit $40,000 Cr. APIC $60,000 Fair value of stock is $25 at vesting Combined tax rate of 40% Recognize compensation expense (10,000 x $10) Recognize deferred tax asset ($100,000 x 40%) Reverse prior tax entry Calculate tax deduction/ benefit (10,000 x $25 x 40%) and windfall ($100,000 - $40,000)

94 Restricted Stock Equity Classified No Section 83(b) Election With Shortfall Facts 10,000 restricted stock granted Fair value of stock is $10 One year vesting and all shares vest Recognition of expense and DTA Dr. Compensation Cost $100,000 Cr. APIC $100,000 Dr. Deferred Tax Asset $40,000 Cr. Deferred Tax Benefit $40,000 Vesting Dr. Deferred Tax Benefit $40,000 Cr. Deferred Tax Asset $40,000 Dr. Current Taxes Payable $32,000 Dr. APIC or Current Tax Benefit $8,000 Cr. Current Tax Benefit $40,000 Fair value of stock is $8 at vesting Combined tax rate of 40% Recognize compensation expense (10,000 x $10) Recognize deferred tax asset ($100,000 x 40%) Reverse prior tax entry Calculate tax deduction/ benefit (10,000 x $8 x 40%) and shortfall ($32,000 - $40,000)

95 Restricted Stock Equity Classified Event Section 83(b) Election Action Grant Date Measure fair value of stock Record DTL with respect to income tax deduction During Requisite Service Period Recognize Compensation cost Reflect book tax benefit as a debit to DTL Vesting Date No further adjustment No windfall or shortfall as book and tax deductions are the same

96 Restricted Stock Equity Classified Section 83(b) Election Facts 10,000 restricted stock granted Fair value of stock is $10 One year vesting and all shares vest Recognition of expense and DTA Dr. Current Taxes Payable $40,000 Cr. Current Tax Benefit $40,000 Dr. Deferred Tax Benefit $40,000 Cr. Deferred Tax Liability $40,000 Dr. Compensation Cost $100,000 Cr. APIC $100,000 Dr. Deferred Tax Liability $40,000 Cr. Deferred Tax Benefit $40,000 Vesting No Tax Entry Combined tax rate of 40% Recognize tax benefit of tax deduction (10,000 x $10 x 40%) Recognize Compensation Expense (10,000 x $10) Write down of deferred tax liability recorded ($100,000 x 40%)

97 Restricted Stock Unit Equity Classified Event Grant Date Measure fair value of stock Action During Requisite Service Period Vesting Date No impact Recognize Compensation cost and related DTA on shares that vest and expected to result in future tax deduction Reverse entry for restricted stock units forfeited Reflect changes in tax rates Record valuation allowance Transfer Date Reverse DTA If tax deduction greater than cumulative book compensation cost, additional tax benefit is a windfall If tax deduction less than cumulative book compensation cost, a shortfall occurs

98 Restricted Stock Unit Equity Classified Windfall Facts 10,000 restricted stock units granted Fair value of stock is $10 One year vesting and all shares vest Recognition of expense and DTA Dr. Compensation Cost $100,000 Cr. APIC $100,000 Dr. Deferred Tax Asset $40,000 Cr. Deferred Tax Benefit $40,000 Fair value of stock is $25 at vesting Combined tax rate of 40% Recognize Compensation Expense (10,000 x $10) Recognize deferred tax asset ($100,000 x 40%) Vesting Dr. Deferred Tax Benefit $40,000 Cr. Deferred Tax Asset $40,000 Dr. Current Taxes Payable $100,000 Cr. Current Tax Benefit $40,000 Cr. APIC $60,000 Reverse prior tax entry Calculate tax deduction/benefit (10,000 x $25 x 40%) and windfall ($100,000 - $40,000)

99 Restricted Stock Unit Equity Classified Shortfall Facts 10,000 restricted stock units granted Fair value of stock is $10 One year vesting and all shares vest Recognition of expense and DTA Dr. Compensation Cost $100,000 Cr. APIC $100,000 Dr. Deferred Tax Asset $40,000 Cr. Deferred Tax Benefit $40,000 Fair value of stock is $8 at vesting Combined tax rate of 40% Recognize Compensation Expense (10,000 x $10) Recognize deferred tax asset ($100,000 x 40%) Vesting Dr. Deferred Tax Benefit $40,000 Cr. Deferred Tax Asset $40,000 Dr. Current Taxes Payable $32,000 Dr. APIC or Current Tax Benefit $8,000 Cr. Current Tax Benefit $40,000 Reverse prior tax entry Calculate tax deduction/benefit (10,000 x $8 x 40%) and shortfall ($32,000 - $40,000)

100 Specific Equity Arrangements Income Tax Treatment

101 Nonqualified Stock Option Generally, exercise price equal to or greater than FMV as of date of grant to avoid deferred compensation rules under section 409A and deduction limit under section 162(m) Shareholder approval not required other than for section 162(m) purposes Income Tax deduction None at time of grant None at the time of vesting as long as issued at FMV At date of exercise, deduction equal to amount included in service provider s gross income (FMV less exercise price)

102 Nonqualified Stock Option Included in income means Service provider filed income tax return and included the amount on such income tax return Deemed to have included in income if employer timely files information return (Form W-2 and/or Form 1099MISC) Timing of deduction Employer s tax year which includes last day of service provider s tax year in which amount included in gross income Special rule- If stock is substantially vested upon transfer, then under the company s normal method of accounting

103 Nonqualified Stock Option Withholding and reporting requirements with respect to employee Report compensation in Boxes 1, 3, and 5 of form W-2 Compensation subject to income tax and FICA withholdings Compensation also reflected in Box 12 of Form W-2 with code V For non-employee, report on form 1099MISC in box 7, non-employee compensation

104 Facts Nonqualified Stock Option - Example 10,000 restricted stock granted with $10 exercise price (FMV) on June 10, 2015 FMV of stock on date of exercise (September 12, 2016) is $25 Results Employee recognizes $150,000 of compensation (10,000 x [$25 - $10]) Employer must withhold income taxes, Medicare taxes, social security taxes Employer reports $150,000 of compensation income on employee s 2016 Form W-2 Since stock was fully vested upon transfer, employer entitled to an income tax deduction under its normal method of accounting

105 Stock Appreciation Right Generally, exercise price equal to or greater than FMV as of date of grant to avoid deferred compensation rules under section 409A and deduction limit under section 162(m) Shareholder approval not required other than for section 162(m) purposes Income Tax Deduction None at time of grant None at time of vesting as long as issued at FMV At date of exercise, deduction equal to amount included in service provider s gross income (FMV less exercise price)

106 Stock Appreciation Right Included in income means Service provider filed income tax return and included the amount on such income tax return Deemed to have included in income if employer timely files information return (Form W-2 and/or Form 1099MISC) Timing of deduction Stock Issued Employer s tax year which includes last day of service provider s tax year in which amount included in gross income Special rule- if stock is substantially vested upon transfer, then under company s normal method of accounting

107 Stock Appreciation Right Timing of deduction Cash Payment If exercised in same year as vesting, then deduct under normal method of accounting If exercised in year after vesting, then treated as deferred compensation and deduct in tax year which includes last day of service provider s tax year in which amount included in gross income Withholding and reporting requirements with respect to employee Report compensation in Boxes 1, 3, and 5 of Form W-2 Compensation subject to income tax and FICA withholdings For non-employee, report on form 1099MISC in box 7, non-employee compensation

108 Stock Appreciation Right- Example Facts 10,000 SARs granted on June 10, 2015 when FMV is $10 FMV of stock on date of exercise (September 12, 2016) is $25 and stock transferred Results Employee recognizes $150,000 of compensation (10,000 x [$25 - $10]) Employer must withhold income taxes, Medicare taxes, social security taxes Employer reports $150,000 of compensation income on employee s 2016 Form W-2 Since stock was fully vested upon transfer, employer entitled to an income tax deduction under its normal method of accounting If cash were paid Vesting in year of exercise deduction under normal method of accounting Vesting in prior year treated as deferred compensation

109 Incentive Stock Option Must satisfy the rules under section 422 Available only to employees of parent corporation or any 50% controlled corporation Option price must not be less than FMV of stock on date of grant Option must be granted within 10 years of plan s effective date and exercised within 10 years of grant 10% shareholder option price 110% of FMV and exercise period is 5 years Option not transferable other than by will

110 Incentive Stock Option Shareholder approval of plan required $100,000 limit on total value of options that may become exercisable for the first time in any calendar year Provide employee with form 3921 for year of exercise Income tax impact No employer income tax deduction upon grant, vesting or exercise Income tax deduction available only at time of disqualifying disposition Stock disposed within 1 year of exercise, or Stock disposed within 2 years of grant

111 Incentive Stock Option Income tax deduction Amount of ordinary income recognized by employee which is the lesser of Spread at time of exercise, or Spread at time of disqualifying disposition Obtain deduction if amount included in the income of the employee Included in income means Employee filed income tax return and included the amount on such income tax return Deemed to have included in income if employer files Form W-2 or Form W-2c before the employer files tax return on which it is claiming deduction Deduction available to employer for its tax year which includes the date of the disqualifying disposition

112 Incentive Stock Option Compensation income reported on form W-2, but not subject to withholding Disqualifying disposition includes any disposition except in the case of Transfer due to death Stock for stock acquisition Mere pledge or hypothecation Transfer to joint ownership with rights of survivorship Transfer to spouse incident to divorce

113 Incentive Stock Option Qualifying Facts Disposition - Example 10,000 options granted with $10 exercise price (FMV) on June 10, 2014 FMV of stock on date of exercise (July 15, 2015) is $25 FMV of stock on date of disposition (September 12, 2016) is $28 Results Employer required to file 3921 for calendar year 2015 Employee does not recognize compensation income for regular tax purposes since the stock was disposed after the expiration of the two holding periods Employer is not entitled to an income tax deduction

114 Incentive Stock Option Disqualifying Disposition - Example Facts 10,000 options granted with $10 exercise price (FMV) on June 10, 2014 FMV of stock on date of exercise (July 15, 2015) is $25 FMV of stock on date of disposition (April 12, 2016) is $28 Results Employer required to file 3921 for calendar year 2015 Employee recognizes $150,000 of compensation in 2016 since the stock was disposed within both the 1-year/2-year holding periods (10,000 x [$25 - $10]) Employer not required to withhold income taxes, Medicare taxes, or social security taxes, but must report the income on a Form W-2 Employer is entitled to an income tax deduction in the amount of $150,000 for tax year that includes April 12, 2016

115 Restricted Stock Stock issued at date of grant subject to substantial risk of forfeiture Forfeiture provision not satisfied, individual must return shares to company Shareholder approval not required other than for section 162(m) purposes Not subject to deferred compensation rules under 409A

116 Restricted Stock Income tax deduction None at the time of grant (unless Section 83(b) election made) At time of vesting, tax deduction equal to amount included in service provider s gross income (FMV at time of vesting) Included in Income means Service provider filed income tax return and included the amount on such income tax return Deemed to have included in income if employer timely files information return (W-2 and/or 1099MISC) Employer entitled to deduction for its tax year which includes last day of service provider s tax year in which amount included in income.

117 Restricted Stock Withholding and reporting requirements Employee Report compensation in boxes 1, 3, and 5 of Form W-2 Compensation subject to income tax and FICA withholdings For non-employees, report on form 1099MISC in box 7, non-employee compensation Section 83(b) election made by service provider Deduction equal to FMV of stock on date of transfer which is included in service provider s income Deduction in employer s tax year which includes last day of service provider s tax year in which the amount is include in gross income Reverse deduction if stock is forfeited

118 Restricted Stock- Example Facts 4,000 restricted stock transferred on June 10, 2015 when FMV is $10 FMV of stock on date of vesting (September 12, 2016) is $25 No Section 83(b) election is made Results Employee recognize $100,000 of compensation in 2016 (4,000 x $25) which is required to be reported on Form W-2 Employer must withhold income taxes, Medicare taxes, and social security taxes Since the stock was not fully vested upon transfer, employer entitled to income tax deduction for its tax year that includes the last day of the employee s tax year (December 31, 2016) in which the amount is included in income

119 Facts Restricted Stock- Section 83(b) Example 4,000 restricted stock transferred on June 10, 2015 when FMV is $10 FMV of stock on date of vesting (September 12, 2016) is $25 No Section 83(b) election is made Results Employee recognize $40,000 of compensation in 2016 (4,000 x $10) which is required to be reported on Form W-2 Employer must withhold income taxes, Medicare taxes, and social security taxes Since the stock was not fully vested upon transfer, employer entitled to income tax deduction for its tax year that includes the last day of the employee s tax year (December 31, 2015) in which the amount is included in income No income tax impact on September 12, 2016 when the stock vests

120 Restricted Stock Unit Promise to issue stock at a future date after risk of forfeiture lapses Forfeiture provision not satisfied, individual does not receive the stock Shareholder approval not required other than for section 162(m) purposes Subject to deferred compensation rules under section 409A if stock is transferred more than 2 ½ months after the calendar year in which the service provider vests

121 Restricted Stock Unit Income Tax deduction None at the time of grant and none at the time of vesting At time of transfer, tax deduction equal to amount included in service provider s gross income (FMV at time of transfer) Included in income means Service provider filed income tax return and included the amount on such income tax return Deemed to have included in income if employer timely files information return (Form W-2 and/or Form 1099MISC) Since shares are substantially vested upon transfer, employer entitled to an income tax deduction under its normal method of accounting

122 Restricted Stock Unit Withholding and reporting requirements Employee Report compensation in Boxes 1, 3, and 5 of Form W-2 Compensation subject to income tax and FICA withholdings For non-employees, report on Form 1099MISC in Box 7, non-employee compensation

123 Restricted Stock Unit - Example Facts Promise made on June 10, 2015 to transfer 4,000 shares of stock within 45 days of vesting date Vesting Date (September 12, 2016) Transfer shares on September 24, 2016 when FMV is $25 Results Employee recognize $100,000 of compensation in 2016 (4,000 x $25) which is required to be reported on Form W-2 Employer must withhold income taxes, Medicare taxes, and social security taxes Since the stock was fully vested upon transfer, employer entitled to income tax deduction in accordance with its normal method of accounting

124 Contact Information Brian Parmelee Tax Director (303) Hein & Associates LLP.

125 International Operations Stu Myhill December 8, 2016

126 Three Components of Consolidated US Multinational Tax Provision Tax Provision of U.S. parent and other domestic subsidiaries Tax Provision for the foreign business Entities, branches, or other foreign activities Impact on U.S. tax provision of foreign entities, foreign branches, or other foreign activities

127 Components of International Tax Provision (continued) Tax Provision of foreign business Inside Basis Current and deferred tax calculation Differences between U.S. GAAP and foreign tax law U.S. GAAP income to statutory book income Statutory book income to local taxable income

128 Components of International Tax Provision - Items of foreign activity potentially impacting U.S. tax provision Foreign branch activity flowing into U.S. Dividends from foreign subsidiaries Retained earnings of foreign subsidiaries Subpart F inclusions Foreign withholding tax on dividends, royalties, interest Foreign tax credits or deductions Foreign currency issues

129 Foreign Branch Operations U.S. Foreign Branch Operations A branch represents the portion of U.S. operations located and taxed in a foreign jurisdiction Can be wholly owned foreign corporation electing to be treated as disregarded entity for U.S. tax purposes Branch operations subject to tax in two jurisdictions 129

130 Foreign Branch Activity Foreign Branch Deferred Taxes Two sets of temporary differences that give rise to deferred tax assets and liabilities Adjust home country deferred taxes for the effects of foreign deferred tax assets and liabilities 130

131 Foreign Branch Deferred Taxes When a deferred foreign liability is settled, it increases taxes paid, decreasing the home country taxes paid because of additional foreign tax credits or deductions. When a foreign tax asset is recovered, it reduces taxes paid, increasing the home country taxes because of lower foreign tax credits or deductions. 131

132 International Operations Foreign Branch Deferred Taxes Example Company A has a branch in Country X where the statutory tax rate is 25% In current year, branch has pretax income of $10,000 For both Country X and US tax purposes, branch has excess tax-over-book depreciation of $5,000 and nondeductible inventory reserves of $3,000 For U.S. tax purposes, the branch is taxed at 40% Taxes paid to Country X will be claimed as a foreign tax credit How and in what jurisdiction should deferred taxes be recorded? 132

133 International Operations Foreign Branch Deferred Taxes Example Country X Nondeductible reserves $ 750 ($3,000 x 25%) Depreciation (1,250) (($5,000) x 25%) Branch DTL, Net $ (500) U.S. Nondeductible reserves $ 1,200 ($3,000 x 40%) Depreciation (2,000) (($5,000) x 40%) DTA on Branch DTL, Net 500 ($500 x 100%)* U.S. DTL, Net $ (300) Total DTA/(DTL) $ (800) * Assumes when paid will be fully creditable 133

134 Dividends from Foreign Subsidiaries Gross amount of dividend included in taxable income of US recipient Also include Section 78 Gross-Up if taking foreign tax credits Withholding tax on dividend included in US recipient s tax provision Portion of foreign taxes paid by foreign subsidiary deductible or creditable to US recipient Reduces current tax if utilized in current year Deferred tax asset if results in loss ( NOL ) or tax credit ( FTC ) carry-forward 134

135 Dividends from Foreign Subsidiaries Example Assume: Earnings of UK Sub $200 Taxes $ 40 Cash $160 Dividend to U.S. parent $ 80 Withholding tax on dividend $ 8 Result: Cash Dividend $ 80 Section 78 Gross Up $ 20 U.S. Taxable Income $100 U.S. Tax at 35% plus withholding tax of $8 $ 43 Foreign Tax Credit ($ 28) Net U.S. Tax (Incremental Tax from Dividend) $

136 Retained Earnings of Foreign Subsidiaries Treatment in consolidated tax provision differs depending upon if earnings are permanently reinvested Permanently reinvested no impact on US tax provision Not permanently reinvested tax effects of outside book-tax basis difference in subsidiary must be accounted for in U.S. tax provision

137 Indefinite Reversal Assertion (APB 23) ASC (a) A deferred tax liability is not recognized for an excess of an amount of financial reporting over tax basis of an investment in a foreign subsidiary that is essentially permanent in duration Basis differences usually a result of: Undistributed earnings Changes in foreign exchange Indefinite reversal criteria must be met 137

138 Indefinite Reversal Assertion Positive assertion of management s intent to indefinitely reinvest its foreign undistributed earnings Management s ability and intent to indefinitely prevent the outside basis difference of a foreign subsidiary from reversing with a tax consequence 138

139 Indefinite Reversal Assertion Evidence Required History of not distributing foreign earnings does not replace specific reinvestment plans Document and maintain specific reinvestment plans 139

140 Indefinite Reversal Assertion Evidence Required (cont.) Forecasts and budgets for parent and subsidiary Financial requirements of parent and subsidiary Remittance restrictions in a loan agreement of the subsidiary Remittance restrictions imposed by foreign government 140

141 Indefinite Reversal Assertion Positive Evidence No need of cashflow from foreign subs to support U.S. operations Specific plans to reinvest foreign cash in capital projects or acquisitions Foreign debt service requirements

142 Indefinite Reversal Assertion Negative Evidence U.S. debt service requirements Subpart F

143 Indefinite Reversal Assertion Q: Can a company make a partial reinvestment assertion? A: Yes, a deferred tax liability can be maintained on some, but not all, of the outside basis difference if the assertion is justified by the evidence. 143

144 Indefinite Reversal Assertion Effect of Change in an Indefinite Reversal Assertion Some or all of undistributed subsidiary earnings will be remitted in foreseeable future Parent adjustment to income tax expense and deferred tax liability in the current period and make ASC disclosure 144

145 Foreign Currency Issues Functional currency - Currency of the primary economic environment of the entity Reporting currency Currency used to report financial statements 145

146 Foreign Currency Issues Translation gains and losses Deferred foreign income taxes are translated at current rates if reporting currency is not functional currency Translation adjustments are part of the outside basis temporary difference on investment in foreign subsidiary 146

147 Foreign Currency Issues Transaction gains and losses Usually recognized in income for financial reporting Gains and losses from foreign currency transactions recognized for tax purposes Deferred tax accounting required if tax gains or losses included in period different than for financial reporting purposes 147

148 Foreign Currency Issues Best Practices Prepare base calculations of foreign provisions in the functional currency, not in U.S.$! Book all related provision entries on the foreign books in functional currency, not topside in U.S.$! Be mindful of period issues Let the ERP software do the f/x translation Translate into U.S.$ in consolidated tax provision workpapers using same f/x rates as ERP system 148

149 QUESTIONS? 149

150 State and Local Tax Provision Common Elements and Errors Bill Mueldener December 8, 2016

151 Common Elements Single biggest element for state tax purposes: Effective Tax Rate Broken into two components: Current Rate Deferred Rate

152 State Tax Provision Considerations Differences between the current and deferred rates: Deferred should be booked at the tax rate in effect at the time the deferred item is expected to turn. All legislative changes to tax rates must be considered (increases or decreases). Legislative changes impacting filing methodology in future years should be considered. Does the state file on a combined, consolidated, or separate company basis? Factors calculating the rate should represent the most accurate business information and changes known.

153 Calculation of the State Rate One method of computing the current state tax expense: blended effective rate computation Company X Company X Company X Total California Georgia Pre-Tax Book Income $10,000,000 (A) $10,000,000 $10,000,000 State Apportionment 40% 20% State Tax Rate 8.84% 6% Current Blended Rate 4.74% (B) 3.54% 1.20% Current State Provision $474,000 (A*B) Key Components: Income, Apportionment and Tax Rate

154 Common Provision Apportionment Issues Apportionment Property difference on current and deferred rate. Property apportionment factor is typically the average of BOY and EOY property. Sourcing of Sales Sales of Goods vs. Services (current trend to move towards market based sourcing of services) Sourcing of intangible income Inclusion of activity from ownership in a partnership Consideration of the definition of sales in a specific state Economic nexus and sourcing rules Other property and payroll sourcing issues

155 Concerns with a Simple Blended Rate Calculation Blended effective rate computation Company X&Y Company X&Y Company Y Total California (Unitary) Georgia (Separate) Pre-Tax Book Income $10,000,000 (A) $10,000,000 ($1,000,000) State Apportionment 40% 20% State Tax Rate 8.84% 6% Current Blended Rate 4.74% (B) 3.54% 1.20% Current State Provision $474,000

156 State by State Computation Example Computation Company X&Y Company X&Y Company Y Total California (Unitary) Georgia (Separate) Pre-Tax Book Income $10,000,000 $10,000,000 $3,000,000 Perm. Differences 2,000,000 1,000,000 Temp. Differences 50,000 50,000 State Modifications 300, ,000 Apportionable Income 12,350,000 4,150,000 State Apportionment 40% 20% Pre-NOL State Income 4,940, ,000 State NOLs 500,000 0 State Taxable Income 4,440, ,000 State Tax Rate 8.84% 6% Current State Tax Provision $441,800 (A+B) $ 392,000 (A) $ 49,800 (B)

157 State by State Computation Requires consideration of state level computation issues Items impacting individual state computation: State filing methodology (separate, combined, consolidated) State modifications and conformity to federal law Top Side accounting or tax adjustments State deferred tax items should be accounted for individually. State NOLs State tax credits

158 Valuation Allowance DTA is reduced by a valuation allowance if it is more likely than not (i.e., >50%) that some portion, or all, of the DTA will not be realized. For example: NOL carryover provides no tax benefit if there is no taxable income during carryover period.

159 Forecasting the Effective Tax Rate and Interim Reporting John Monahan December 8, 2016

160 Interim Reporting Basic Principles ASC APB 28, Interim Financial Reporting, 19 states that At the end of each interim period the company should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year. The rate so determined should be used in providing for income taxes on a current year-to-date basis. The effective tax rate should reflect anticipated investment tax credits, foreign tax rates, percentage deletion, capital gains rates, and other available tax planning alternatives. However, in arriving at this effective tax rate no effect should be included for the tax related to significant unusual, or extraordinary items that will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year.

161 Interim Reporting Basic Principles ASC (APB 28, Interim Financial Reporting, 29) states that The tax effects of losses that arise in the early portion of a fiscal year should be recognized only when the tax benefits are expected to be (a) realized during the year or (b) recognizable as a deferred tax asset at the end of the year in accordance with the provisions of [ASC 740]. 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 after the effective dates prescribed in the statutes 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.

162 Interim Reporting Basic Principles ASC (FIN 18, Accounting for Income Taxes in Interim Periods, 6), clarifies that: The tax (or benefit) related to ordinary income is to be computed using an estimated annual effective tax rate, and The tax (or benefit) related to all other items is to be individually computed and recognized when the event occurs ( discrete period items )

163 Interim Reporting Basic Principles Examples of Other Items: Closing of prior years audits Expiration of the statute of limitations for prior tax years Subsequent recognition of uncertain tax position Change in tax law Change in tax status Certain changes in realizability of deferred tax assets Change in judgment about unremitted foreign earnings and other outside basis differences A significant, unusual or infrequent item

164 Interim Reporting Discrete Items Change related to: Prior year uncertain tax position Current year uncertain tax position (related to ordinary income included in ETR) Current year uncertain tax position (related to income excluded from ETR) Interim Accounting Treatment Discrete Included in ETR Discrete

165 Interim Reporting Discrete Items Interest and penalties recognized on uncertain tax positions ASC requires that interest be accrued in the first period in which the interest would begin accruing according to the provisions of the relevant tax law. Therefore, interest would be excluded from ETR calculation. ASC indicates that a penalty should be recorded when a position giving rise to a penalty is taken or anticipated to be taken on the current year s tax return.

166 Interim Reporting Discrete Items Change in tax law Adjustments to deferred tax assets and liabilities as a result of a change in tax law or rates should be accounted for discretely in continuing operations at the date of enactment. The effects of a retroactive change in tax rates should also be accounted for discretely in continuing operations in the interim period in which the law is enacted. Prospective effects of a change in tax law or rates on tax expense in the year of enactment should be reflected in the estimated annual effective tax rate calculation.

167 Interim Reporting Discrete Items Change in tax status The effect of a voluntary change in tax status should be recognized discretely on 1. the date that approval is granted by the taxing authority or 2. the filing date, if approval is unnecessary.

168 Interim Reporting Discrete Items Certain changes in the assessment of the realizability of deferred tax assets The tax effect of a change in the beginning-of-the year balance of a valuation allowance caused by a change in judgment about the realizability of the related deferred tax asset that results from changes in the projection of income expected to be available in future years should be recognized discretely in the interim period in which the change in judgment occurs. A change in judgment about the realizability of deferred tax assets resulting from changes in estimates of current-year ordinary income and/or deductible temporary differences and carryforwards that is expected to originate in ordinary income in the current year should be considered in determining the estimated annual effective tax rate.

169 Interim Reporting Discrete Items Certain changes in the assessment of the realizability of deferred tax assets - Example The company has a $2.5M NOL carryfoward available at the beginning of the year. A valuation allowance was recorded for the full amount of the related deferred tax asset for $875,000 (35% rate). During Q2 of the current year, the full year forecast of pre-tax book income increased from $0 to $500,000 causing partial utilization of the NOL carryforward. Adjusted future year income forecasts have caused reversal of the remaining amount of the valuation allowance. Estimated full year pre-tax income $ 500,000 Tax expense: Tax on current-year income at 35% 175,000 Reversal of valuation allowance related to current-year income (175,000) Total current tax based on ETR $ - Reversal of valuation allowance based on future-years income (700,000) Total tax provision (700,000) Net income $ 1,200,000 Estimated ETR at end of second quarter [($0) / $500,000] (0)%

170 Interim Reporting Discrete Items Change in judgment regarding unremitted foreign earnings and other outside-basis differences The tax effect of the change in judgment for the establishment/reversal of the deferred tax liability related to the outside basis difference that had accumulated as of the beginning of the year should be recorded in continuing operations in the interim period during which the intentions changed. The tax effect of the change in intentions on unremitted earnings of the current year should be reflected in the determination of the company s ETR.

171 Interim Reporting Discrete Items Change in estimate related to a prior-year tax provision The language in ASC , makes it clear that the estimated annual effective tax rate approach should only be used to record the tax effect of current-year ordinary income. A change in estimate in the current year that is related to a prior-year tax provision does not constitute a tax effect on current-year income therefore, change should be recorded discretely in period that change in estimate occurs.

172 Interim Reporting Discrete Items Change in estimate vs. error Examples of errors A mechanical error is made when calculating the income tax provision Misapplications of ASC 740 and related accounting principles and interpretations are made. The company chose to estimate rather than obtain an amount for tax provision purposes at the balance sheet date that was readily accessible in the company s books and records, and the actual amount differs from the estimate.

173 Interim Reporting Discrete Items Change in estimate vs. error Examples of changes in estimate An adjustment of a prior-period tax accrual that results either from new information (including a change in facts and circumstances) or later identification of information that was not reasonably knowable at the original balance sheet date and that results in improved judgment would lead to a change in estimate. An event occurs that results in a changed judgment with respect to the sustainability of an uncertain tax position

174 Interim Reporting - Definitions Tax (or benefit) is defined to be the total income tax expense (or benefit), including the provision (or benefit) for income taxes both currently payable and deferred. ASC (FIN 18, 5) Ordinary income (or loss) refers to income (or loss) from continuing operations before income taxes (or benefits) excluding significant unusual or infrequently occurring items. Extraordinary items, discontinued operations, and cumulative effects of changes in accounting principles are also excluded from this term. ASC (FIN 18, 5)

175 Interim Reporting - Computation Steps to compute the interim tax provision using the annual effective tax rate 1. Determine projected income, permanent differences, credits and carryforwards for the entire year. 2. Calculate the projected total provision for the year (excluding discrete items). 3. Calculate the effective tax rate (ETR) for the year. 4. Apply the ETR to the year to date earnings (i.e. Ordinary Income. 5. Adjust interim provision for discrete period items, if any.

176 Interim Reporting- Computation Computing the Annual ETR: Example (Q3) Q1-3 (Actual) Q4 (Estimate) Total (Estimate) Pre-Tax Book Income 25,000 15,000 40,000 Permanent Items 3,000 Book Taxable Income 43,000 Statutory Tax Rate 28% Extimated Annual Tax divided by 12,000 Pre-Tax Book Income 40,000 Estimated Annual effective Tax Rate 30%

177 Interim Reporting- Computation Computing the Annual ETR: Example (Q3) Total (Estimate) Pre-Tax Book Income 25,000 Estimated Annual ETR 30% "Ordinary" Tax 7,500 Audit Settlement (Q1) (1,000) FIN 48 Interest (Q1) 100 Account Balance Correction (Q2) (500) FIN 48 Interest (Q2) 100 Impairment (Permanent) (Q3) 3,000 FIN 48 Interest (Q3) 100 Total Tax Expense 9,300 Q3 Effective Tax Rate 37%

178 Interim Reporting Limitation on benefits of losses in loss periods The ETR approach is modified by ASC through 30-34, which limit the tax benefit recognized for a loss in interim periods to the amount that is expected to be (a) realized during the year or (b) recognizable as a deferred tax asset at the end of the year.

179 Interim Reporting Limitation on benefits of losses in loss periods Example For the year, an entity anticipates an ordinary loss of $(200,000). A total of $15,000 in R&D credits will be generated during the year. The entity operates in one jurisdiction where the statutory tax rate is 30%. The entity has the following year-to-date ordinary income and losses for the following interim periods: First Quarter Second Quarter Third Quarter Fourth Quarter Year-to-date ordinary income/(loss) $ 40,000 $ (120,000) $ (280,000) $ (200,000) Annual Effective Rate Tax benefit at statutory rate ($200,000 at 30%) $ (60,000) Tax Credits (15,000) Net tax benefit $ (75,000) Estimated annual effective rate %

180 Interim Reporting Limitation on benefits of losses in loss periods Example (cont.) Reporting period Quarterly income/(loss) Year-to-date income/(loss) Estimated annual effective tax rate Computed Limited to Less previously provided Reporting period amount Q1 $ 40,000 $ 40, % $ 15,000 $ - $ 15,000 Q2 (160,000) (120,000) 37.50% (45,000) 15,000 (60,000) Q3 (160,000) (280,000) 37.50% (105,000) (99,000) (45,000) (54,000) Q4 80,000 (200,000) 37.50% (75,000) (99,000) 24,000 Y/E $ (200,000) $ (75,000)

181 Interim Reporting Limitation on benefits of losses in loss periods Example (cont.) Because the Q3 year-to-date ordinary loss exceeds the anticipated ordinary loss for the fiscal year, the tax benefit recognized for the year-to-date loss 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: Tax benefit at statutory rate ($280,000 at 30%) $ (84,000) Tax Credits (15,000) Net tax benefit $ (99,000) Estimated annual effective rate %

182 Interim Reporting Exceptions to the use of the ETR approach Jurisdictions with pretax losses for which no tax benefit can be recognized When a company operates in a jurisdiction that has generated ordinary losses on a year-to-date basis or on the basis of the results anticipated for the full fiscal year and no benefit can be recognized on those losses, ASC (a) requires the company to exclude that jurisdiction s income (or loss) from the overall ETR calculation. A separate ETR should be computed and applied to ordinary income (or loss) in that jurisdiction. Assuming the reason for no benefit is a full valuation allowance, the separate ETR for that jurisdiction would be zero.

183 Interim Reporting Multiple Jurisdictions Ordinary Loss in a Jurisdiction with no realized tax benefit

184 Interim Reporting Reliability of estimates When a company operates in a jurisdiction where a reliable estimate of the translated effective tax rate cannot be made, ASC (FIN 18, paragraph 22b) requires the company to exclude the ordinary income (or loss) in that jurisdiction and the related tax (or benefit) attributable to ordinary income in that jurisdiction from the overall estimate of the ETR and interim period tax (or benefit).

185 Interim Reporting Reliability of estimates ASC (FIN 18, paragraph 8, footnote 7) states that if a reliable estimate of the ETR cannot be made, the actual tax rate for the year-to-date may represent the most appropriate estimate of the annual rate. The footnote continues: If an enterprise 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. This footnote makes it clear that the effective rate approach must be used to the extent that, but only to the extent that, a reliable estimate can be made.

186 Current Developments Involving Interim Reporting Impact of Accounting Standard Developments ASU : Recognize windfall and shortfall tax benefits in tax expense Change will likely result in greater effective tax rate volatility Discrete interim reporting required to record the tax effect in the period in which they occur. Change: Recognition of tax consequences of intra-entity transfers (except transfers of inventory) in tax expense even though the pre-tax profits are eliminated in consolidation Companies should consider the impact on forecasting effective tax rate