EITF ABSTRACTS. Title: Tax Reform Act of 1986: Issues Related to the Alternative Minimum Tax

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1 EITF ABSTRACTS Issue No Title: Tax Reform Act of 1986: Issues Related to the Alternative Minimum Tax Dates Discussed: April 7, 1987; February 23, 1989 References: FASB Statement No. 13, Accounting for Leases FASB Statement No. 96, Accounting for Income Taxes FASB Statement No. 109, Accounting for Income Taxes FASB Interpretation No. 25, Accounting for an Unused Investment Tax Credit FASB Interpretation No. 32, Application of Percentage Limitations in Recognizing Investment Tax Credit FASB Highlights, Task Force Addresses Accounting for Corporate Alternative Minimum Tax, May 26, 1987 APB Opinion No. 11, Accounting for Income Taxes APB Opinion No. 16, Business Combinations AICPA Accounting Interpretation 10, Amortization of Deferred Taxes, of APB Opinion No. 11 ISSUE The Tax Reform Act of 1986 (Act) replaces the add-on minimum tax with a new alternative minimum tax (AMT) system. Under the Act, a company's federal income tax liability is the greater of the tax computed using the regular tax system (regular tax) or the tax under the AMT system. A credit (AMT credit) may be earned for tax paid on an AMT basis that is in excess of the amount of regular tax that would have otherwise been paid. With certain exceptions, the AMT credit can be carried forward indefinitely and used to reduce regular tax, but not below the AMT for that future year. The issues are: 1. Whether the AMT system should be viewed as a separate but parallel tax system that may generate a credit carryforward, or whether AMT in excess of regular tax should be viewed as a prepayment of future regular tax to the extent that it results in AMT credits 2. How the AMT should affect the amount of deferred taxes provided on originating timing differences 3. How the amount of AMT credit should be determined for financial reporting purposes age 1

2 4. Under what circumstances, if any, the AMT credit in excess of the amount offset in the withand-without computation (excess AMT credit) should be recognized in the financial statements, and how it should be reported 5. If drawdown of existing net deferred tax credits is appropriate, whether consideration should be given to limitations on the amount of excess AMT credit that can be used to reduce regular tax in a future year 6. Whether accounting for the reduction of originating deferred tax credits by AMT credits should be required to conform with the resolution of the issue of recognizing the AMT limitations in reducing existing net deferred tax credits described in Issue 5 7. If AMT credits previously recognized by offset of deferred tax credits are subsequently used in the tax return, how deferred tax credits should be reinstated 8. If upon reversal of a deductible timing difference an enterprise pays AMT, how AMT should affect the amortization of the related deferred tax asset 9. If deferred tax credits have been adjusted by ITC carryforward, whether they should be further adjusted by the AMT credit (assuming it cannot, in the circumstances, be recognized as an asset) and, if so, whether the recomputation should reflect the reduced ITC and the new tax rate 10. Whether the effect of the AMT on cash flows should be considered in leveraged lease computations and, if so, how 11. Under what circumstances, if any, the AMT should be considered in estimating the tax effects for purposes of valuing the assets acquired and liabilities assumed in a business combination accounted for as a purchase. EITF DISCUSSION The Task Force reached the following consensuses relating to accounting for the AMT under Opinion 11: Issue 1. The Task Force reached a consensus that the AMT system should be viewed as a separate but parallel tax system that may generate a credit carryforward. The amount of AMT in excess of regular tax should not be viewed as a prepayment of future regular tax to the extent that it results in AMT credit. Although AMT credit can be carried forward indefinitely, it can be used only to reduce regular tax in excess of AMT in a future year. [Note: See STATUS section.] Issue 2. The Task Force reached a consensus that the effect of the AMT on the amount of deferred taxes provided on originating timing differences should be determined based on a with-and-without computation. Paragraph 36 of Opinion 11 states that "the tax effect of a timing difference should be measured by the differential between income taxes computed with and without inclusion of the age 2

3 transaction creating the difference between taxable income and pretax accounting income." Examples 1 and 2 in Exhibit 87-8A illustrate the effect of the AMT on the with-and-without computation. [Note: This consensus has been nullified by Statements 96 and 109. See STATUS section.] Issue 3. The Task Force reached a consensus that for financial reporting purposes the AMT credit is the amount by which the AMT computed on financial income exceeds the regular tax computed on financial income. The FASB staff pointed out that this computation could result in an enterprise's providing taxes on an AMT basis in a year in which it pays tax on a regular tax basis. Task Force members agreed that this accounting was appropriate under the deferred method and that the "book AMT credit" resulting from this computation should be accounted for as described under Issue 4 below. Example 3 in Exhibit 87-8A illustrates the computation of the amount of AMT credit for financial reporting purposes. [Note: This consensus has been nullified by Statements 96 and 109. See STATUS section.] Issue 4. The Task Force reached a consensus that, if the realization of the AMT credit is assured beyond any reasonable doubt, the excess credit should be recognized as an asset prior to realization in the tax return. If, however, realization is not assured beyond any reasonable doubt, the credit should be used to offset existing deferred tax credits. This accounting is consistent with the accounting under Opinion 11 for a net operating loss carryforward. [Note: This consensus has been nullified by Statements 96 and 109. See STATUS section.] Issue 5. The Task Force reached a consensus that the amount of excess AMT credit offset against existing net deferred tax credits should be limited to the difference between the regular tax provided on the timing difference when it originated and the AMT that will have to be paid when it reverses. This accounting is analogous to the percentage limitations on the drawdown of deferred tax credits by ITC carryforward. Example 4 in Exhibit 87-8A illustrates how to determine the age 3

4 amount of existing deferred tax credits that could be offset by AMT credits. [Note: This consensus has been nullified by Statements 96 and 109. See STATUS section.] Issue 6. The Task Force reached a consensus that limitations on originating timing differences should be based on a with-and-without computation. [Note: This consensus has been nullified by Statements 96 and 109. See STATUS section.] Issue 7. The Task Force reached a consensus that, when AMT credits previously recognized by offset of deferred tax credits are subsequently used in the tax return, deferred tax credits should be reinstated in an amount equivalent to the AMT credits realized as a reduction of federal income taxes payable. [Note: This consensus has been nullified by Statements 96 and 109. See STATUS section.] Issue 8. The Task Force reached a consensus that under the net change method, pursuant to AICPA Interpretation 10, deferred taxes are provided or amortized based on the difference between income tax on taxable income and income tax on taxable income plus or minus the aggregate timing differences (both originating and reversing). Example 5 in Exhibit 87-8A illustrates this approach. [Note: This consensus has been nullified by Statements 96 and 109. See STATUS section.] Issue 9. The Task Force reached a consensus that, to the extent that the AMT could be used to reduce taxes on existing timing differences to an amount less than the amount of deferred tax credits after the previous drawdown for ITC carryforwards, existing deferred tax credits should be further reduced by the AMT credit. The tax law provides that the AMT credit can be used to reduce regular tax in future years to the extent that the regular tax liability (net of all other nonrefundable credits) exceeds the AMT in that future year. Example 6 in Exhibit 87-8A illustrates this consensus. [Note: This consensus has been nullified by Statements 96 and 109. See STATUS section.] age 4

5 Issue 10. The Task Force reached a consensus that an enterprise should include assumptions regarding the effect of the AMT, considering its consolidated tax position, in leveraged lease computations. In accordance with paragraph 46 of Statement 13, those assumptions should be reviewed at least annually. If a change to the tax assumptions changes total estimated after-tax net income, the rate of return on the leveraged lease should be recalculated from inception, the accounts constituting the lessor's net investment should be adjusted, and a gain or loss recognized in the year in which the assumption is changed. An enterprise whose tax position frequently varies between AMT and regular tax would not be required to recompute each year unless there was an indication that the original assumptions regarding total after-tax net income from the lease were no longer valid. In that circumstance, the enterprise would be required to revise the leveraged lease computations in any period in which total net income from the leveraged lease changes due to the effect of the AMT on cash flows for the lease. Paragraph 44 of Statement 13 requires income from a leveraged lease to be allocated among years in which the lessor's net investment in the leveraged lease is positive, based on the after-tax cash flows projected at the inception of the leveraged lease. The lessor's income tax rate and the amount of taxes paid or tax benefits received are important assumptions in a leveraged lease calculation. Any difference between AMT depreciation and the tax depreciation assumed in the leveraged lease or between income recognition for financial reporting purposes and AMT income could, depending on the lessor's overall tax situation, result in AMT or the utilization of AMT credits. In the circumstances in which AMT is paid or an AMT credit is utilized, the total cash flows from the leveraged lease could be changed, and the lessor's net investment in the leveraged lease and income recognition would be affected. The Issue Summary that was distributed to Task Force members contains an example illustrating an approach to implementing the consensus. [Note: See STATUS section.] Issue 11. The Task Force reached a consensus that an enterprise should consider its potential tax position during the life of the related assets and liabilities in determining the effects of the AMT in age 5

6 estimating the tax effects to be used in determining the amounts to be assigned to assets acquired and liabilities assumed in a current business combination accounted for as a purchase. Amounts assigned in business combinations consummated previously would not normally be revised, as was concluded in Issue No , "Effect of a Change in Tax Rates on Assets and Liabilities Recorded Net-of-Tax in a Purchase Business Combination," unless a significant change occurs during the allocation period, the remaining asset is impaired, or the liability is understated. [Note: This consensus has been nullified by Statements 96 and 109. See STATUS section.] STATUS The accounting for AMT under Opinion 11 was also addressed in the May 1987 Highlights, which was published in Status Report No In December 1987, the FASB issued Statement 96, which supersedes Opinion 11. Statement 96 affected the above issues as summarized below. Issue 1. Paragraph 47 of Statement 96 notes that a tax law may require that more than one comprehensive method or system be used to determine an enterprise's potential tax liability. The paragraph cites as an example the fact that the U.S. Internal Revenue Code for 1987 requires a corporation to calculate its potential federal income tax liability using both the regular tax system and the AMT system, with the corporation's actual income tax liability for the year being the greater of the two. Under Statement 96, if alternative systems exist, they should be used to measure an enterprise's deferred tax asset or liability in a manner consistent with the tax law. Issue 2. The concept of originating timing differences under Opinion 11 is no longer applicable under Statement 96. Paragraph 47 of Statement 96 indicates that, after giving consideration to any interaction between the separate tax systems, an enterprise's deferred tax asset or liability is recognized based on the age 6

7 results of two calculations for each future year. Accordingly, under existing U.S. tax law, a U.S. enterprise uses both the regular tax system and the AMT system for each future period to determine the deferred tax consequences of its current and past activities. Issue 3. Provisions in the tax law that limit utilization of tax credits are applied in determining the amount by which a deferred tax liability is reduced. Under Statement 96, the tax benefit of a tax credit carryforward that cannot be recognized as a reduction of a deferred tax liability is not recognized as an asset regardless of the probability that the enterprise will generate taxable financial income in future years. Following paragraph 48, Statement 96 presents an example that illustrates the measurement of the amount of deferred taxes payable for an enterprise when two comprehensive tax systems must be used to determine the enterprise's tax liability. That example includes an illustration of how to determine the amount of the AMT credit. Issue 4. The with-and-without computation is no longer applicable under Statement 96. See Issue 3 regarding the recognition of AMT credits. Issue 5. The drawdown of existing net deferred tax credits is no longer applicable under Statement 96. See Issue 3 regarding the treatment of AMT credits. Issue 6. This issue is no longer applicable under Statement 96. See Issue 5. Issues 7-9. These issues are no longer applicable under Statement 96. Issue 10. Statement 96 does not amend the accounting for leveraged leases required by Statement 13. See paragraph 127 of Statement 96. Issue 11. The net-of-tax approach to assigning values to the assets and liabilities of the acquired enterprise is no longer applicable under Statement 96. Under Statement 96, a liability or asset is recognized for the deferred tax consequences of differences between the financial reporting and tax age 7

8 bases of the assets and liabilities of the acquired enterprise. Under paragraph 47 of Statement 96, if alternative systems exist, they should be used to measure an enterprise's deferred tax asset or liability in a manner consistent with the tax law. After giving consideration to any interaction between the two systems, such as the U.S. alternative minimum tax credit, that enterprise's deferred tax asset or liability is recognized based on the results of the two calculations for each future year. Accordingly, under existing U.S. tax law, a U.S. enterprise uses both the regular tax system and the alternative minimum tax system for each future period to determine the deferred tax consequences of its current and past activities. At the February 23, 1989 meeting, an FASB staff member reported that the FASB had received an inquiry about whether the tax benefit resulting from an AMT credit carryforward that is recognized for financial reporting purposes in a subsequent year should be reported as an extraordinary item under Opinion 11. The FASB staff believes that the tax benefit should be reported as a reduction of income tax expense and not as an extraordinary credit unless recognition is the direct result of an extraordinary item. In February 1992, the FASB issued Statement 109, which supersedes Opinion 11 and Statement 96. Statement 109 requires that an enterprise recognize a deferred tax liability or asset for all temporary differences and operating loss and tax credit carryforwards. Paragraph 18 of Statement 109 indicates that the objective is to measure a deferred tax liability or asset using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized. With respect to Issues 1-3, paragraph 19 indicates that in the U.S. federal tax jurisdiction, the applicable tax rate is the regular tax rate, and a deferred tax asset is recognized for alternative minimum tax credit carryforwards, reduced by a valuation allowance if applicable. Issues 4-9 addressed in Issue 87-8 are no longer applicable under Statement 109. Regarding Issue 10, Statement 109 does not amend the accounting for leveraged leases required by Statement 13. age 8

9 Regarding Issue 11, the net-of-tax approach to valuing assets and liabilities acquired in a purchase business combination is no longer applicable under Statement 109. Paragraph 30 of Statement 109 indicates that a deferred tax liability or asset shall be recognized in accordance with the requirements of the Statement for differences between the assigned values and tax bases of the assets and liabilities (except the portion of goodwill for which amortization is not deductible for tax purposes, unallocated "negative goodwill," leveraged leases, and acquired Opinion 23 differences) recognized in a purchased business combination. No further EITF discussion is planned. age 9

10 Exhibit 87-8A Examples of Application of the EITF Consensus on Issue 87-8 Example 1 Effect of AMT on the With and Without Computation Financial Reporting Tax Regular tax: Pretax book income $1,000 $1,000 Timing differences 700 Taxable income 1, Tax rate 40% 40% Tax expense $ 400 $ 120 AMT: Taxable income $1,000 $ 300 Book income adjustment 350 AMT income 1, Tax rate 20% 20% Tax liability $ 200 $ 130 Tax provision: Tax expense $ 400 Taxes currently payable 130 Deferred taxes $ 270 In this example, taxes will be paid and current taxes will be provided based on the AMT system; however, for financial reporting purposes, the tax provision for regular tax is greater than the AMT because of timing differences. Therefore, income tax is determined using the regular tax system, and deferred taxes are provided based on the difference between the AMT on tax basis income and the regular tax on financial statement income. This result is consistent with the objective of Opinion 11 to make the income statement appear as it would have appeared had a tax return been filed on the basis of financial statement income. [Note: The consensus illustrated by this example has been nullified by Statements 96 and 109. See STATUS section.] age 10

11 EXAMPLE 2 EFFECT OF AMT ON THE WITH AND WITHOUT COMPUTATION Assumptions: All tax-exempt bond income is created by pre-august 1986 bond issues Accelerated depreciation methods are 200 percent declining balance for tax, 150 percent declining balance for AMT, and straight-line for financial reporting. Computations: Financial Reporting Tax Regular tax: Pretax income $1,000 $1,000 Tax-exempt bond income (700) (700) Accelerated depreciation: Tax over AMT (140) AMT over book (60) Taxable income Tax rate 40% 40% Tax expense $ 120 $ 40 AMT: Taxable income $ 300 $ 100 Depreciation adjustment (tax over AMT) 140 AMT income, before adjustment Book income adjustment* AMT income Tax rate 20% 20% Tax liability $ 130 $ AMT provision: Current $ 124 Deferred 6 Total $ 130 * Computed as ½ of ($1,000 - AMT income, before adjustment). + This is Company A's tax that is payable for age 11

12 In this example, taxes will be paid and current taxes will be provided based on the AMT system. Because the AMT is higher than the regular tax on financial income, income tax expense is also determined using the AMT system, and deferred taxes are provided based on the difference between the AMT on tax basis income and AMT on financial income. In this circumstance, the AMT will result in a higher tax expense because the AMT tax is higher on a financial reporting basis than the regular tax. [Note: The consensus illustrated by this example has been nullified by Statements 96 and 109. See STATUS section.] EXAMPLE 3 DETERMINING THE AMT CREDIT FOR FINANCIAL REPORTING Applying the consensus for Issue 3 to Example 1, there would be no AMT credit for financial reporting purposes because the regular tax computed on financial income exceeds the AMT computed on financial income. That is, the AMT credits generated on a tax basis of $10 ($ = $10) are entirely offset in the with-and-without computation ($ = $10). Applying the consensus for Issue 3 to Example 2, the AMT credit for financial reporting purposes would be $10 ($ = $10). This is reconciled to the amount of AMT generated on a tax basis as follows: AMT credit for tax purposes ($124 40) $84 Amount of AMT offset in with-and-without computation ($80 6) 74 AMT credit for financial reporting purposes $10 [Note: The consensus illustrated by this example has been nullified by Statements 96 and 109. See STATUS section.] age 12

13 EXAMPLE 4 DETERMINING THE AMOUNT OF DEFERRED TAX CREDITS THAT CAN BE OFFSET BY AMT CREDITS Under the consensus for Issue 5, the amount of excess AMT credit offset against existing net deferred tax credits (that is, the amount of drawdown of existing net deferred tax credits) should be limited to the difference between the regular tax provided on the timing difference when it originated and the AMT that will have to be paid when it reverses. Using the facts in Example 2 and assuming existing deferred tax credits at January 1, 1987 of $16 ($35 of timing differences 46%), the drawdown in 1987 would be limited to $9 because the $16 of existing deferred tax credits could not be drawn down below $7 ($35 timing differences 20% AMT rate). (For simplicity, differences between regular tax depreciation and AMT depreciation have been ignored.) Therefore, the tax provision after drawdown would be as follows: Debit Credit Income tax expense $121 Deferred taxes payable 3 Income taxes payable $124 [Note: The consensus illustrated by this example has been nullified by Statements 96 and 109. See STATUS section.] age 13

14 Example 5 Effect of AMT on Amortization of Deferred Tax Credits under the Net Change Method This example illustrates the application of the consensus to Issue 8. Under the net change method, deferred taxes are provided or amortized based on the difference between income tax on taxable income and income tax on taxable income plus or minus the aggregate timing differences (both originating and reversing). Assume deferred tax debits at the beginning of the year are $920 ($2,000 of deductible timing differences 46%). Financial Reporting Tax Regular tax: Pretax book income $1,000 $1,000 Reversing timing differences 1,000 Taxable income 1,000 0 Tax rate 40% 40% Tax expense $ 400 $ 0 AMT: Taxable income $1,000 $ 0 Book income adjustment 500 AMT income 1, Tax rate 20% 20% Tax liability $ 200 $ 100 Tax provision: Tax expense $ 400 Taxes currently payable (100) Reduction of deferred tax debits $ 300 At year-end, deferred tax debits would be $620 on $1,000 of deductible timing differences. [Note: The consensus illustrated by this example has been nullified by Statements 96 and 109. See STATUS section.] age 14

15 Example 6 Effect of AMT Credit on Deferred Tax Credits That Have Previously Been Adjusted by ITC Carryforward Assumptions: Cumulative amount of timing differences at 1/1/X1 $10,000 AMT credit available 700 Deferred tax balance at 1/1/X1 after reduction for ITC carryforward of $2,100 2,500 The limitation on the reduction of deferred taxes by AMT credits is computed as follows: Cumulative timing differences* $10,000 Tax rate for AMT 20% AMT on cumulative timing differences $ 2,000 Deferred tax balance at 1/1/X1 $ 2,500 AMT on cumulative timing differences 2,000 Amount deferred taxes can be reduced by AMT credits $ 500 *This computation assumes no differences between timing differences for the regular tax system and the AMT system; however, to the extent differences exist, they should be taken into consideration in computing the AMT that will be payable when the existing timing differences reverse. The enterprise in this example would reduce its deferred tax credit balance by $500. Paragraph 21 of Interpretation 32 illustrates a computation of existing deferred tax credits available to be offset by unrecognized ITC. The computation applies an average tax rate to the amount of timing differences to determine the amount of deferred tax credits that are available to be offset by the ITC. A similar approach could be used in computing the amount of existing deferred tax credits that may be offset by AMT credits. The rate used to compute the regular tax liability could be an average of the rates in effect when the timing differences originated. The ITC limitation should be the same limitation used at the time the ITC was originally used to draw down the deferred tax credits. age 15

16 [Note: The consensus illustrated by this example has been nullified by Statements 96 and 109. See STATUS section.] age 16