ASC 740 UPDATE CASE STUDIES

Transcription

1 ASC 740 UPDATE CASE STUDIES Tax Executives Institute Detroit Chapter June 14, 2017 BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms.

2 Case Study 1 Question: Fulham Corporation, U.S. Corporation and a public business entity, adopted ASU , improvements to Employee Share based payments, on January 1, Fulham is in a full valuation allowance position with respect to its deferred tax asset position. At the date of adoption Fulham had excess tax benefits from exercises of stock options and vesting of RSUs embedded in its net operating loss carryovers. At the date of adoption no cumulative effect adjustment was recorded in retained earnings since the increase in the deferred tax asset was offset by a valuation allowance. During the third quarter of 2017 Fulham determined that based on positive evidence that it was able to release its valuation allowance including the amount with respect to its excess tax benefits. Fulham management has suggested that retained earnings as of January 1, 2017 should be adjusted for the impact of the release of the valuation allowance with respect to excess tax benefits. How would you respond to Fulham s suggested accounting? Answer: In this situation the proper response would be that the release of the valuation allowance with respect to the excess tax benefits should be released through earnings (continuing operations or other elements) and that opening retained earnings should not be adjusted. The objective of the modified retrospective adjustment to retained earnings is meant to recast a company s accounting for a particular item where it would have been at the beginning of the year as if it had always been on the revised method.

3 Case Study 2 Question: Company M holds a 40% interest in a partnership that is accounted for under the equity method Book basis is $4 million, Tax basis is $5 million M has a DTA on the outside basis difference in the investment in partnership of $400 (40% tax rate) No valuation allowance M decides to buy out the other partner for $30 million and ultimately owns 100% afterwards M s initial investment in the partnership is stepped up to fair value of $20 million Assets acquired and liabilities assumed are: Purchase price $50,000,000 Liabilities assumed 100,000 Purchase price plus liabilities assumed $50,100,000 Less: FV of assets acquired Cash and investments 700,000 Inventory 400,000 Fixed assets 500,000 IPR&D 10,700,000 Intangible Assets 14,300,000 Total $26,600,000 Goodwill $23,500,000 What are the deferred tax entries and tax consequences required as a result of the acquisition of the remaining interest in the partnership? Also, what amount, if any, is considered tax deductible goodwill? Answer: Total 60% 40% 1060 Allocation Purchase price $50,000,000 $30,000,000 $20,000,000 Liabilities assumed 100,000 60,000 40,000 40,000 Purchase price plus liabilities assumed $50,100,000 $30,060,000 $20,040,000 40,000 Less: FV of assets acquired Cash and investments 700, , , ,000 Inventory 400, , , ,000 Fixed assets 500, , , ,000 IPR&D 10,700,000 6,420,000 4,280,000 1,883,200 Intangible Assets 14,300,000 8,580,000 5,720,000 2,516,800 Total $26,600,000 $15,960,000 $10,640,000 $5,040,000 Goodwill $23,500,000 $14,100,000 $9,400,000 Tax basis $30,000,000 $5,000,000 5,000,000 Full tax basis Partial tax basis

4 Entry 1: Reverse DTA on outside basis as no longer necessary DR: Deferred Tax Expense $400,000 CR: DTA $400,000 In addition, a gain of $16,000,000 ($20M stepped up basis less book basis of $4M) will be recorded for financial statement purposes with no corresponding deferred tax accounting since it is assumed that the DTL which would be set up on the outside basis difference will reverse through P&L with the net deferred on the inside basis difference recorded in acquisition accounting. Entry 2: Record deferred taxes through purchase accounting for inside basis differences DR: Goodwill $2,240,000 CR: DTL $2,240,000 Calculated: Total book basis of intangibles attributable to the 40% interest: $10,000,000 Total tax basis of intangibles allocated under 1060* $ 4,400,000 Taxable temporary difference $ 5,600,000 DTL at 40% tax rate $ 2,240,000 *(see Reg b(8) partial non recognition exchanges) Goodwill: Book Tax Component 1 $14,100,000 $14,100,000 Lesser of tax deductible GW or book GW Component 2 $11,600,000 Excess non deductible book goodwill Total $25,700,000 $14,100,000 $14,100,000 of goodwill is deductible for income tax purposes. As there was no purchase price remaining to allocate to goodwill under 1060 when allocating the tax basis of the equity method investment, zero goodwill for tax purposes is attributable to the 40%. There is an alternate view with respect to the recognition of a DTL with respect to the gain recognized on the previously owned 40% interest. Pursuant to this view deferred tax expense would be recorded with respect to the gain recognized with the inherent DTL morphed into the inside DTL with any residual deferred tax recorded in acquisition accounting.

5 Case Study 3 Question: Alpha Corp. forms a partnership (Beta) with Omega Corp. with the ownership of 80% and 20%, respectively. Alpha contributes $1,000 and Omega contributes $250 to Beta. Beta then acquires the outstanding stock of a foreign corporation for $1,250. That year, the foreign corporation earns $500 of net income, which is not distributed to its owner. Beta earns $500 of net income (earnings from foreign corporation), which is also not distributed. At the end of the year, Alpha s investment in the partnership is equal to $1,400 ($1,000 original investment and 80% * $500 of partnership earnings). Alpha s tax basis of its investment in the partnership is $1,000. The $400 basis difference is entirely due to the undistributed earnings of the partnership s investment in the foreign corporation. Should Alpha record a deferred tax liability for the excess book basis over tax basis of its investment in the partnership? Answer: It depends. A deferred tax liability would not need to be recognized for the basis difference if Alpha is able to demonstrate that the ASC (APB 23) exception applies to the partnership s investment in the foreign corporation.

6 Case Study 4 Question: Tax rate is 30%. XYZ Company owns a 70% interest in ABC partnership which is consolidated for book purposes. The partnership s consolidated pre tax operating results for 20X7 are: Revenue $140,000 Less: Expenses (40,000) Income before income tax expense $100,000 Prepare the income statement for XYZ for 20X7, assuming that the partnership is its only business unit. Answer: Revenue $140,000 Less: Expenses (40,000) Income before income tax expense 100,000 Income tax expense (21,000) Net income 79,000 Less net income attributable to non-controlling interest (30,000) 1 Net income attributable to controlling interest $49,000 Since the partnership is not a taxable entity, XYZ would only include the tax expense associated with its portion of the partnership operating results in the tax calculation. This creates a variance between the expected and actual tax expense reported. 1 ($100,000 X 30%) $0 income tax expense

7 Case Study 5 Question: Delta Co., a U.S. C corporation, has a calendar year end. Delta is very profitable and pays federal tax at a 35% rate. During 2017 the federal rate changes from 35% to 20% on 6/30/17 effective for tax years beginning on or after 1/1/2018. As of December 31, 2016 Delta s deferred tax position was as follows: Gross Net Depreciation (500)@35% (175) Bad Debts 70 Available for sale securities 35 Delta is projecting income for financial reporting purposes of $4,000 for 2017 and assume it is earned ratably over each quarter. Delta has projected its ending deferred tax balance as of to be as follows: Gross Net Depreciation $(140) Bad Debts 60 In addition the amounts in OCI are as follows (note OCI is always calculated discretely, Q3 & Q4 are presented as actual to demonstrate the accounting for OCI: Gross Rate Net DTA 12/31/16 3/31/17 6/30/17 9/30/17 12/31/17 $100 $100 $150 $200 $200 X35% X35% X20% X20% X20% $35 $35 $30 $40 $40 Based on the above calculate the tax provisions for Q1, Q2, Q3 and year end (assume for yearend that projected equals actual)

8 Answer: When determining the effect of a tax law change entities must consider the tax law changes effect on the deferred tax balances at the date of enactment. In this example we are assuming that the income is earned ratably and that the related deferred items increase ratably. The following would be a reasonable methodology for determining the tax provisions at each quarter end. 3/31/17 6/30/17 9/30/17 12/31/17 Q1 Q2 Q3 Q4 Pre tax $4000 $4,000 $4000 $4000 Temporary diffs (100) (100) (100) (100) Taxable income X 35% 35% 35% 35% Estimated current tax $1,365 $1,365 $1,365 $1,365 Projected Deferred tax expense $1,400 $1,385 $1,385 $1,385 Rate 35% 34.6% 34.6% 34.6% Q1 Pretax $1000. $2,000 $3,000 $4,000 Rate X35% X34.6% X34.6% X34.6% rate $350 $692 $1,038 $1,384 Discrete Change in rate 2 (45) (45) (45) Rate change in OCI Total tax expense Continuing operations $350 $662 $1008 $1,354 Quarterly Tax Continuing operations $350 $312 $346 $346 OCI (10) (10) Total Expense $350 $302 $336 $346

9 The key point in the above example is to demonstrate that the deferred impact of the rate change is recorded in continuing operations in the period of enactment. This also includes the rate change ascribed to items recorded in other comprehensive income. In the above example the $45 is calculated as the BOY 20% which is the amount of the rate change. The rate change with respect to the current year increase in deferred is recorded via the rate applied to Y T D income. Footnotes: 1. Projected deferred tax expense: Q1 BOY $105 (net DTL $400x35%) EOY 140 Projected Expense $35 Q2, Q3, Q4 BOY $ 60 (net DTL $300x20%) EOY 80 Projected Expense $20 2. Discrete change in rate: BOY net deferreds ($300x20%) $105=$45 3. OCI rate change discrete: BOY $100x35% = $35 Q1 100x20% = 20 Rate Change $15

10 Case study 6 Question: Tottenham, Inc. a U.S. publicly traded C Corporation has been in losses for the past several years and has only recorded deferred tax assets to the extent of its reversing taxable temporary differences. Its deferred tax profile at 12/31/17 is as follows: Gross Rate Net Net Operating loss carryover $5,000 35% $1,750 Temporary differences $2,000 35% 700 Intangible assets ($6,100) 35% ($2,100) Goodwill ($1,000) 35% ($350) Val Allowance ($350) Net deferred tax liability ($350) The net operating loss carryovers have a remaining life of 20 years and the intangible assets will reverse pro rata over the next four years. The bad debt differential will reverse in On January 1, 2018 federal tax legislation is passed which designates all existing net operating losses as well as any future carryovers to have an unlimited carryover period and eliminates any carryback period that existed. The legislation also provided that the NOL can only offset 90% of taxable income in any given year. Based on the above determine what adjustment, if any, Tottenham would need to record with respect to the change in tax law. Answer: In this fact pattern Tottenham would need to schedule the reversal of its existing deferred taxes in order to determine what adjustment, if any, would be needed due to the recently passed legislation. The following table summarizes the computation of the deferred tax assets after the application of the loss limitation and the extension of the net operating loss carryforward period:

11 Account Reversal Reversal Reversal Reversal Reversal 1/1/ Infinite Bad debts $2,000 (2,000) Intangible assets (6,000) 1,500 1,500 1,500 1,500 Goodwill (1,000) 1,000 Taxable income (500) 1,500 1,500 1,500 1,000 NOL loss limitation (1,350) (1,350) (1,350) (900) NOL remaining 5,000 5,500 4, , Rate X35% Val Allowance $193 As can be seen from this simple example scheduling can be quite complex. Although ASC 740 does not require an entity to perform detailed scheduling in this situation it would be required in order to determine the pattern and the timing of the reversal of temporary differences in order to ascertain the need and amount of the valuation allowance. Although the carryforward period has been extended the fact that the NOL is limited to 90% of taxable income still necessitates that a valuation allowance be recorded.

12 Case Study 7 Question: Delta Company which is a U.S. C Corporation operates a branch in country X. The U.S. tax rate is 40% while the branch rate in country X is 20%. During 20x1 the years operating results of the parent and the branch are as follows (U.S. results include branch results): U.S. Country X Branch Elim Total Pre tax income $300 $200 $(200) $300 The country X branch has tax depreciation in excess of book depreciation of $100. There are no temporary differences or nondeductible/non includible amounts in the U.S. Based on the above how would Delta record its tax provision for 20x1. Assume that Delta is able to avail itself of foreign tax credits. Answer: U.S. Country X Branch Elim Total Pre tax income $300 $200 $(200) $300 Temporary difference (100) Taxable Income Tax Rate 40% 20% Foreign tax credit (20) Total current tax expense $100 $20 $120 Total Tax: U.S. Country X Branch Total Current tax $100 $20 $120 Deferred tax Def. tax for potential FTC (20) (20) Total tax $80 $40 $120

13 Because the branch is taxable in both the U.S. and country X a taxable temporary difference needs to be recorded in order to avoid double counting. In the case of Delta Company foreign taxes will be increased when the DTL is settled in the county X branch. Since Delta is able to benefit from foreign tax credits an offsetting DTA is recorded to reflect the potential benefit.

14 Case Study 8 Question: The facts are the same as the previous example except that Delta is not able to credit foreign taxes but rather claims them as deductions. How would Delta record its 20x1 for provision based on the above. Answer: U.S. Country X Branch Elim Total Pre tax income $300 $200 $(200) $300 Temporary difference _ (100) Foreign tax deduction (20) Taxable income Tax Rate 40% 20% Current Tax $ $132 Total tax: U.S. Country X Branch Total Current Tax $112 $20 $132 Deferred tax U.S. benefit of Deduction $20x40% (8) (8) Total tax expense $104 $40 $144 In the above fact pattern the U.S. DTA for impact of the foreign tax is only benefited for the tax effect of the deduction. Due to this Delta s overall tax expense is increased as compared to the prior example.

15 Case Study 9 Question: Celtic Inc., a U.S. C Corporation, is doing business in the U.K. in branch form. The operating results for 20x1 are as follows: U.S. U.K Elim Total PBT $300 $(100) $100 $300 The tax rate in the U.S. is 35% and in the U.K. 20%. There are no other temporary or permanent differences and no attributes being carried over from the previous years. In the past the U.K. has been profitable but the U.S. has only been able to deduct the foreign tax paid by the U.K. as opposed to claiming the credit. What is the tax accounting for the combined operations? Answer: In this particular fact pattern we have seen two different positions taken. The first is as follows: U.S. U.K. Elim Total Pre tax income $300 $100 $100 $300 Tax Rate 35% 20% Tax $105 $(20) U.S. DTL on U.K. carryover 20 Total tax expense $125 $125 $105 Generally when the branch has attributes (DTA s included) the U.S. Company records a DTL when the branch is in an overall DTA position under the theory that it is improper to recognize a double benefit for the foreign attribute since it would have been used in the U.S. return. When it subsequently reverses there will be no foreign tax credit or deductions to offset the inclusion of the foreign income in the U.S. group. An alternative view is as follows: U.S. U.K Elim Total Pre tax income $300 $(100) $100 $300 Tax rate 35% 20% Tax $105 (20) DTL for U.K. carryover 7 Total tax expenses $112 $(20) $92

16 Under this construction the U.S. DTL is only recorded at the expected cost of the deduction which in this case will be $20x35%. When this eventually unwinds the overall tax rate will increase since there will be no foreign tax credit or deduction to offset the inclusion of income in the U.S. tax accounts.

17 Case study 10 Question: Blarney Co., a U.S. public Company purchases all of the outstanding stock of Kinsale Ltd located in the country of Moronika (MK). The purchase price paid by Blarney was $1,000,000 of which $250,000 was allocated to amortizable intangibles and $300,000 was allocated to goodwill. The intangibles are amortizable for book purposes over a five year period and there is no tax basis in either the intangibles or goodwill. At the time of the acquisition the exchange rate between the U.S. and MK was 1.0 to 1.5. The following were the exchange rates at the end of each subsequent year: Year Average Rate Spot Rate At the acquisition date Blarney did not record the acquisition accounting entries on the books of Kinsale but rather recorded them as a separate company in its general ledger system. The tax rate in MK is 20% and U.S. is 40%. Blarney s accounting for the goodwill and intangibles in its separate company books was as follows: Int. & G.W DTL Equity P&L Ret. earnings Acq Date 550,000 (50,000) (500,000) Yr 1 500,000 (40,000) (500,000) (40,000) Yr 2 450,000 (30,000) (500,000) (40,000) (40,000) Yr 3 400,000 (20,000) (500,000) (40,000) (80,000) Yr 4 350,000 (10,000) (500,000) (40,000) (120,000) Based on the above what recommendation would you have made with respect to the above accounting?

18 Answer: In the instant situation we believe that the above accounting is not correct since it fails to take into account the impact of F/X movements on the reported balances. The following would be what we perceive to be the appropriate accounting: At Acquisition Accounting Date FC F/X Rate US $ Intangibles 825, ,000 Deferred tax liability (DTL) (75,000) 1.5 (50,000) Equity 750, ,000 Year 1 FC F/X Rate US $ Intangibles 750, ,000 DTL (60,000) 2.0 (30,000) 690, ,000 Amort exp. 75, ,860 Def. tax (15,000) 1.75 (8,575) benefit R.E. Equity 750, ,000 CTA 120,715 (750,000) (345,000)

19 Year 2 F/X FC Rate US $ Intangibles 675, ,000 DTL (45,000) 2.5 (18,000) 630, ,000 Amort exp. 75, ,500 Def. tax (15,000) 2.0 (7,500) benefit R.E. 60,000 34,285 Equity (750,000) 1.5 (500,000) CTA 183,715 (630,000) (252,000) Year 3 FC F/X Rate US $ Intangibles 600, ,000 (DTL) (30,000) 3.0 (10,000) 570, ,000 Amort exp. 75, ,780 Def. tax (15,000) 2.7 (5,555) benefit R.E. 120,000 64,285 Equity (750,000) 1.5 (500,000) CTA 223,490 (570,000) (190,000)

20 Year 4 F/X FC Rate US $ Intangibles 525, ,000 (DTL) (15,000) 2.5 (6,000) 510, ,000 Amort exp. 75, ,850 Def. tax (15,000) 2.6 (5,770) benefit R.E. 180,000 86,510 Equity (750,000) 1.5 (500,000) CTA 186,410 (510,000) (204,000)

21 Case Study 11 Question: Assume the following with respect to Arsenal Corporation as of its year ended December 31, 20X7: Dr (Cr) Beginning NOL carryforward $1,000 Current year pre tax book income 500 Current year temporary difference tax depreciation greater than book depreciation (700) State only tax credits generated in the current year 500 Arsenal files in one state only. The book and tax depreciation and net operating loss carryovers are the same for state and federal purposes. Arsenal has determined that it will be able to recognize its deferred tax assets the federal rate is 35% and the state rate is 8%. Based on the above which of the following would be considered the appropriate footnote presentation. A. Net operating loss carryover 482 State credit carryover 325 Fixed Assets (282) B. Net operating loss carryover 482 State credits 500 Federal effect of state temporary differences (175) Fixed assets (282) C. Net operating loss carryover 516 State tax credit carryovers 500 Federal effect of state (190) temporary differences Fixed assets (301) D. B & C E. All of the above Answer: C ASC states:

22 State income taxes are deductible for U.S. federal income tax purposes and therefore, a deferred state income tax liability or asset gives rise to a temporary difference for purposes of determining a deferred U.S. federal income tax asset or liability, respectively. The pattern of deductible or taxable amounts in future years for temporary differences related to deferred state income tax liabilities or assets should be determined by estimates of the amount of those state income taxes that are expected to become payable or recoverable for particular future years and, therefore, deductible or taxable for U.S. federal tax purposes in those particular future years. ASC 740 generally requires separate identification of temporary differences and related deferred taxes for each tax paying component of an entity in each tax jurisdiction, including U.S. federal, state, local and foreign tax jurisdictions. ASC states the following regarding the offsetting of DTAs and DTLs: For a particular tax paying component of an entity and within a particular tax jurisdiction, all current deferred tax liabilities and assets shall be offset and presented as a single amount and all noncurrent deferred tax liabilities and assets shall be offset and presented as a single amount. However, an entity shall not offset deferred tax liabilities and assets attributable to different tax paying components of the entity or to different tax jurisdictions. Answer A nets the federal benefit against the state deferred item. Calculation is as follows: NOL carryover ((.08 x.65) +.35) x 1,200 =$482 Fixed assets ((.08 x.65) +.35 x (700) = ($282) State only credits (.65 x 50) = $325 The concern with this type of presentation is that in certain situations an entity might improperly assess whether a valuation allowance is needed, could lead to improper balance sheet presentation and could lead to improper footnote disclosures related to DTAs. Although we do see this in practice companies should assess whether it causes any issues with respect to what was discussed above (in certain cases there won t be an issue). Answer B discloses a separate deferred tax item for the state only tax credits. The deferred taxes are calculated as follows: NOL carryover ((8% x 1,200) + ((35% x (1 8%) x 1,200) = $482 State credits since a state only deferred would record the full $500 credit Federal impact of state only deferred tax items $500 x 35% = ($175) Fixed assets (8% x $700) + ((35% x (1 8%) x $300) = ($282)

23 Under this construction the state benefit/detriment is netted versus the deferreds that are identical for both federal and state purposes while the federal detriment (DTL) for the state only credit is recorded as a separate deferred item. It appears that this would be an acceptable approach for those items where the state and federal deferred tax items are the same. We believe it would be a rare situation whereby federal and state NOLs are the same and would expect in most situations that the state NOLs would be treated as a separate item. Answer C records both the federal and state tax effected DTAs and DTLs without factoring in any state tax effect. The state tax impact is reported as a separate deferred item. The calculations are as follows: NOL carryover (8% x $1200) + (35% x $1,200) = $516 State credits since a state only deferred would record the full $500 credit Federal effect of state temporary differences: NOL (8% x $1,200) x 35% = ($34) State credit (35% x $1,200) = ($175) Fixed assets (8% x $700) x 35% = $19 ($190) Fixed assets (8% x $700) + (35% x $700) = ($301) The presentation in C is one that at least one firm will only accept. We believe it is also acceptable since it clearly reflects an entity s deferred tax position.

24 Case Study 12 Question: Assume a 40 percent tax rate: Dr.(Cr.) Beginning NOL carry-forward $3,000 Beginning of year unrealized loss on for sale securities $3,000 Deferred tax asset $2,400 Valuation allowance ($2,400) Current Year Activity: Loss from continuing operations $1,000 * Unrealized gain on for sale securities ($800) * Unrealized loss that was reclassified to continuing operations ($200) Ending NOL carry forward $4,200 Ending unrealized loss on available for sale securities $2,000 Deferred tax asset $2,480 Valuation allowance ($2,480) * Amount does not include $200 of unrealized loss (reclassification entry) on available for sale securities that was both earned and recorded in continuing operations during the current year Determine the total tax expense and its allocation between continuing operations and other comprehensive income. A. Continuing operations $0 Other comprehensive income $0 B. Continuing operations ($320) Other comprehensive income $320 C. Continuing operations ($400) Other comprehensive income $400 D. (B) or (C) Answer D Total tax expense generally is allocated using a step-by-step approach. Under this approach, an enterprise first determines the amount of tax expense or benefit allocated to continuing operations and then proportionally allocates the remainder to items other than continuing operations. In the question above, the total tax benefit is $0, because the increase in the deferred tax assets was offset by an increase in the valuation allowance.

25 Generally, the tax effect of income from continuing operations should be determined without considering the tax effect of items that are not included in continuing operations. ASC paragraph provides an exception to this general approach by requiring all components, including discontinued operations, extraordinary items, and items charged or credited directly to equity, be considered when determining the tax benefit from a loss from continuing operations. For example, there may be situations in which an enterprise has a loss from continuing operations for which a valuation allowance would be required absent income being generated from another component outside continuing operations, for example discontinued operations. In the question above, the company would record an income tax benefit in continuing operations of $320 ($800 x 40%) and an income tax expense in OCI of $320($800 x 40%). The entity should consider the $800 of unrealized gains on available for sale securities earned during the current year when determining the tax benefit from a loss from continuing operations. Some practitioners might advocate and thus there is diversity in practice that the reclassification of the unrealized loss to continuing operations should be treated as part of the gain on the for sale securities and thus would yield a benefit of $400 in continuing operations and an expense in OCI which would make C the Answer.

26 Case Study 13 Question: As of 12/31/X7 Charlton, Inc., a US C Corporation, had a net operating loss carryover of $ 35,000 on which it had maintained a full valuation allowance. During the fourth quarter Charlton sold subsidiary X and recognized a book tax gain of $70,000, there were no permanent nor temporary differences except for the net operating loss carry overs. The operating results of subsidiary X which Charlton sold will be classified as discontinued operations in its 20X7 financial statements. Charlton generated a year to date loss in continuing operations of ($10,000) and a loss from operations for subsidiary X of ($10,000). Charlton is unable to project that it will have income from the remaining business. Charlton proposed to record the following tax amounts in continuing operations and discontinued operations. Exp./(Benefit) Continuing Operations $(15,750) Discontinued Operations 21,000 Total tax expense $5,250 Carlton derived the above based upon the following: Calculation of total tax expenses: Loss continuing operations $(10,000) Loss discontinued operations (10,000) Gain on Sale 70,000 Utilization of NOL (Fully Valued) (35,000) Total taxable income 15,000 Rate 35% Total Tax $5,250 Charlton next took the results from discontinued operations of: Loss from operations $(10,000) Gain on Sale 70,000 Total Income 60,000 Rate 35% Expense allocated disc.ops. 21,000 Residual to continuing ops. (15,750) Total Tax Expense $5,250 Based on the above what recommendations would you make to Charlton with respect its proposed accounting? Answer:

27 Based on the above fact pattern we believe it would be appropriate for Charlton to change its accounting for 20X7 to the following Exp. (Benefit) Continuing Operations $(3,500) Discontinued Operations 8,750 Total tax expense $5,250 The logic that Charlton should have used in the current situation was to prepare a with and without calculation. Charlton did consider the with calculation and determined total tax expense. However, in calculating on a without basis Charlton used a bottoms up approach of calculating the impact on discontinued operations without considering the guidance in ASC , 13 & 14 which would have required Charlton to allocate expense/benefit to continuing operations prior to allocating to items other than continuing operations. Had Charlton followed the above it would have first analyzed whether a benefit should be recognized for the ($10,000) loss in continuing operations and would have determined that pursuant to ASC that the income from discontinued operations be considered a source of income in order to recognize the benefit. The next step in the analysis would have been to determine whether the release of the beginning of the year valuation allowance ($12,250 ($35,00 x 35%)) could be allocated to continuing operations based on projections of future year(s) income. In the above facts it was stated that Charlton could not project future income from the continuing business and thus the release of the BOY valuation allowance would not be allocated to continuing operations but would in effect be allocated to discontinued operation since the expense in discontinued operations would be the residual amount after the allocation to continuing operations.

28 Case Study 14 Question: Patriot Corp, a U.S. headquarter company, has a wholly owned foreign subsidiary in Australia which it charges a yearly royalty of $100,000,000 which is based on 5% of Australia s sales. The U.S. rate is 40% while the Australian rate is 30%. Patriot has yearly transfer pricing studies performed but it believes if audited that the I.R.S. would assert that the royalty should be based on 8% of sales ($160,000,000) and believes that this rate is greater than 50% likely of being accepted by the Internal Revenue Service. In addition, Patriot believes that Australia will assert that the royalty amount is overstated and feels at a more likely than not level that Australia will assert a 4% royalty rate. The U.S. Australian treaty allows for the remediation of double taxation via the competent authority process. Patriot s prior experience has been that generally there will be a split at the CA level. Based on the above what should Patriot record for the current year with respect to the royalty arrangement. Answer: Based on the facts Patriot should record the following Dr. Taxes receivable Australia 6,000,000 Cr. Taxes payable U.S. 8,000,000 Dr. Provision for income taxes 2,000,000 The above takes into account that an expected split of a proposed adjustment at the CA level would yield a 1% change in the royalty rate. The reason that there is an overall expense is due to the arbitrage between the U.S. and Australian tax rates. In addition, Patriot would disclose in its tabular roll forward of uncertain tax positions the $8,000,000 U.S. liability and disclose that the net impact would be $2,000,000 if settled in its disclosures.

29 Case Study 15 Question: Assume a 40 percent tax rate Fulham Corporation acquires the stock of Wigan Corporation on December 31, 2012 in a nontaxable transaction. Both entities are U.S. Corporations and will join in filing consolidated income tax returns subsequent to the acquisition date with Fulham being the parent of the group. At the date of acquisition Fulham has federal net operating loss carryovers of $10,000 and Wigan has federal net operating loss carryovers (state loss carryovers are ignored for this example) of $5,000. The net operating loss carryovers of both entities were generated as follows: Fulham Wigan December 31, 2008 $2,000 December 31, ,000 December 31, ,000 December 31, 2011 $2,000 December 31, ,000 3,000 Total $10,000 $5,000 As part of the acquisition, Wigan has a gross deferred tax liability of $7,000 which will reverse over the next seven years and the combined group cannot rely on future taxable income to support the realization of its deferred tax assets. Based on the above set of facts record the journal entries for the purchase of Wigan. Also note that Wigan would set up a valuation allowance of $1,600 with respect to its deferred tax assets. Answer: In the fact pattern described above there are two alternative views as to how the acquisition should be recorded. Under the first view the DTLs would be considered a source of income first with respect to Wigan s net operating losses and second with regard to Fulham s net operating losses. Based on this view the following would be recorded: Dr. DTA $2,000 Dr. Valuation allowance $800 DR. Goodwill $800 Cr. Deferred tax benefit $800 Cr. DTL $2,800

30 Under the second view, realization of the deferred tax asset would be based solely on tax law ordering and therefore in this situation, the earliest NOL s are used first against the reversing taxable temporary differences. The journal entry under this view would be as follows: Dr. DTA $400 Dr. Valuation allowance $2,400 Dr. Goodwill $2,400 Cr. Deferred tax benefit $2,400 Cr. DTL $2,800 There is diversity in practice with some firms that accept only the first view while others accept only the second view. Additionally, there are other firms that state it is a policy choice which once elected needs to be applied consistently on a go forward basis.

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