Eyes on US tax reform: A guide to income tax accounting considerations

29 September 2017

Overview of recent developments

Managing tax risk for companies operating in a continuously evolving global tax environment extends well beyond the actual outlay of tax dollars. US companies are not only facing increasing reputational and operational risk as they adapt to increased transparency and enhanced international co-operation between tax administrations, but also legislative risk both globally from the effects of the Organisation for Economic Co-operation and Development's Base Erosion and Profit Shifting (BEPS) project and domestically as the Trump Administration and the Republican Congress face increased pressure to deliver on their stated legislative priorities.

Congress returned from recess in September facing a daunting legislative agenda dominated by must-pass items. The legislative agenda included funding the federal Government past September 30 and raising the US debt limit. Many believe the three-month extension of the debt ceiling and government funding clears the path for Congress to focus on advancing meaningful tax reform.

This week, the Trump Administration, the House Ways and Means Committee, and the Senate Finance Committee released a "Unified Framework for Fixing our Broken Tax Code" (the framework), which will serve as "a template for the tax-writing committees to develop legislation … and additional reforms to improve the efficiency and effectiveness of tax laws and to effectuate the goals of the framework."

Key elements of the framework include a 20% corporate income tax rate, immediate capital expensing, a broader tax base and a shift from a worldwide tax system to a territorial tax system with a one-time mandatory tax on previously deferred foreign earnings. For more information on the framework and potential key aspects of tax reform, see Tax Alert 2017-1563.

Based on press reports, Congressional Republicans on both the Ways and Means Committee and the Senate Finance Committee hope to complete work on a budget resolution to provide reconciliation instructions for tax reform by mid-October. A vote on the actual legislation could come soon thereafter. While ASC740 dictates that changes in tax law are not accounted for until the period of enactment, which in the US is when the President signs the legislation, as US tax reform unfolds and legislation begins to take shape, it is critical that companies understand the various tax proposals and evaluate and prepare for the financial statement income tax accounting considerations associated with a potentially unprecedented shift in US taxation. Likewise, it will be important for companies to be aware of those US States whose statutes allow for automatic conformity with US Federal legislation to assess the impact on state tax provisions. Finally, companies need to understand the statutory implications of passing tax reform under the budget reconciliation process and whether the changes are permanent or subject to a sunset provision similar to the "Bush Tax Cuts." See Tax Alert 2017-1264 for steps a company should consider taking now to prepare for US tax reform.

What could tax accounting for reform entail?

Lower corporate income tax rate

Globally, the current policy initiatives driving many governments' tax legislation include a low statutory tax rate with a broader income base. The consensus articulated in the framework appears to reflect this approach by proposing to reduce the top corporate income tax rate from 35% to 20%. The manner in which the change in the corporate income tax rate will be effected is of key interest in determining the tax accounting implications of such a change. For example, will a lower corporate income tax rate be immediate, phased in over a period of years, or retroactively applied? Will it be a temporary rate cut or will it be permanent? Lowering the corporate rate can impact both the estimated annual effective tax rate and the tax effects discrete to the period of enactment. Ultimately, the date of enactment and the fiscal year-end date will determine how the effects are recorded.

A lower corporate income tax rate means the future benefits of existing deferred tax assets, such as accruals for pension liabilities and net operating loss carryforwards, need to be computed at the new tax rate, which would result in lower deferred tax assets and increased income tax expense in the period of enactment. A corporate income tax rate reduction will also lower the expected future cost of existing deferred tax liabilities, such as those related to accelerated depreciation on property and equipment, decreasing income tax expense in the period of enactment. Elements of reform such as a phased-in approach or a temporary rate cut will likely result in many companies having to schedule out the reversal of temporary differences in order to apply different income tax rates to different future periods. This scheduling exercise may be cumbersome and time-consuming for many companies. In addition, as ASC740 only requires deferred taxes to be calculated on an annual basis, companies will need to bring their deferred balances forward to the date of enactment prior to calculating any effects of the rate change.

The following are some important tax accounting considerations and references to EY interpretive guidance to assist with accounting for a change in the corporate income tax rate.

Income tax accounting considerations	Relevant EY FRD Sections¹
Measurement of current payable and receivable balances and deferred tax liabilities and assets is based on provisions of the enacted tax law, and the effects of future changes in tax laws or rates are not anticipated.	Sections 5.2, 5.1
Changes in tax rates are recognized in the period in which the new legislation is enacted.	Section 8.1
The enactment date in the US is the date the bill becomes law, which is when the President signs the bill.	Section 8.2.1
The impact of a rate change on income taxes currently payable or refundable for the current year are recorded after the effective dates prescribed in the statutes and are reflected 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. If the effective date is later than the enactment date, the impact of the change on the estimate of the payable or receivable for the current year should be included in the calculation of the estimated annual effective tax rate beginning on the effective date.	Sections 8.1, 20.3, 20.8.1.2
The impact of a change in tax rate on deferred tax assets and liabilities is recognized as a component of income tax expense from continuing operations in the period of enactment.	Section 8.1, 20.3, 20.8.1.2
The impact of a phased-in newly enacted tax rate may require scheduling of deferred tax assets and liabilities over the phase-in period.	Section 4.3, 5.1, 8.1, 8.3
The impact of any retroactive changes in enacted tax rates and the effect on current payable/receivable and deferred tax assets and liabilities is determined at the date of enactment using temporary differences and currently taxable income existing as of the date of enactment and tax effect is included in income from continuing operations.	Section 8.4
The impact of a tax law change after the adoption of a new accounting standard, such as ASC 606, is not recognized in the cumulative effect of adopting the standard, but would be recognized in income from continuing operations for the period that includes the enactment date. This would be true regardless of whether the change in tax law or rate was retroactive to the earlier date.	Section 8.5
The impact of a newly enacted tax rate on deferred taxes initially charged or credited directly to shareholders' equity or comprehensive income would be recognized as an adjustment to income tax expense from continuing operations and not as an adjustment to shareholders' equity.	Section 8.6
For interim reporting purposes, the effect of a change in tax rate is recognized in the interim period in which the legislation is enacted even if the change in the tax rates is retroactive.	Section 20.3
Consider the impact of the tax law change on previously recorded uncertain tax positions and related recognition, measurement and disclosure requirements.	Section 19
Disclose the effect of adjustments to deferred tax amounts for enacted changes in tax laws or rates as well as, for interim periods, the effect of the change in the estimated annual effective tax rate.	Section 18.4

Broader tax base

The Congressional Budget Office (CBO) and the Joint Committee on Taxation (JCT) estimated that it will cost approximately $100 billion to reduce the corporate income tax rate by one percentage point over 10 years. To pay for the proposed lower rate, US tax reform proposals have included a wide array of base-broadening provisions. In line with the framework, certain deductions, exclusions and credits could be either eliminated or reduced substantially in order to raise revenue. Many of these proposals will likely come with a series of complex transition rules. The framework "aims to eliminate" the corporate alternative minimum tax (AMT), would "partially limit" the deduction for net interest expense and explicitly preserves the research credit.

The framework specifically provides that, "because of the … substantial rate reduction for all businesses, the current-law domestic production (Section 199) deduction will no longer be necessary. Domestic manufacturers will see the lowest marginal rates in almost 80 years. In addition, numerous other special exclusions and deductions will be repealed or restricted." The framework's adoption of this approach could mean that other business or industry preferences may not be protected. Examples might include the repeal of tax-free like kind exchanges or many of the "tax extenders" currently in effect until 2019.

Examples of other revenue-raising measures could include limitations on the carryback or carryforward of net operating losses or a repeal of the deduction for state income taxes. Any changes to the availability of such tax attributes could be made on a prospective-only basis, or could be retroactive to the beginning of the year of enactment or earlier.

The following are some important tax accounting considerations and references to EY interpretive guidance to assist in evaluating the impact of a potentially broader tax base if such changes are enacted.

Income tax accounting considerations	Relevant EY FRD Sections
Consider the impact of a change in law on the realizability of deferred tax assets and evaluate the impact of a change in law on the four sources of taxable income (e.g., taxable income in carryback years (if permitted), future reversals of existing taxable temporary differences, tax-planning strategies, and future taxable income exclusive of the reversal of temporary differences). Re-assess whether deferred tax assets such as net operating losses are more likely than not to be utilized before expiration. If not, consider whether a valuation allowance related to the deferred tax asset is needed.	Sections 6.1 through 6.6
Consider whether a deferred tax asset is currently recognized in connection with an AMT credit carryforward. If so, consider the need for derecognition of the deferred tax asset to the extent the AMT carryforward will no longer be creditable against future regular income tax.	Sections 5.5, 5.5.1, 5.5.2, 5.5.3, 3.1
Consider changes to special deductions, such as the domestic manufacturing deduction, and determine whether it continues to be appropriate to recognize a benefit in the estimated annual effective tax rate for such deductions.	Sections 5.7, 5.7.1, 20.1, 20.3
Assess: (1) the ability to deduct interest expense under the new rules, (2) whether interest on existing debt is grandfathered, (3) the need to compute net interest expense or computations, such as leverage ratios, that may be necessary to apply new limitations, and (4) the impact on the estimated annual effective tax rate, current payables/receivables and deferred tax assets and liabilities. Evaluate deferred tax assets related to interest expense carryforwards for realizability.	Section 4.1, 6.1, 6.2, 20.3
Evaluate the impact of a loss of state tax deductions on the estimated annual effective tax rate. Identify indirect US federal tax effects associated with a loss of state tax deduction, if any. Examples of indirect tax effects of state taxes include: current federal tax effects of state current income taxes refundable (payable), deferred federal tax effects of state deferred income tax balances and/or unrecognized state income tax benefits, etc.	Section 4.2.4, 5.6, 8.1, 20.3

Changes to cost recovery

For GOP lawmakers, US economic growth is a key goal of tax reform, and proposals to accelerate cost recovery of capital investments are largely viewed as pro-growth. The Republican Blueprint for tax reform allowed for the immediate expensing of business investment in tangible property (such as equipment and buildings, but not land) and intangible assets, but denied a deduction for net interest expense, fueling a debate on whether immediate capital expensing is worth losing interest deductions. Based on the framework, accelerating the deductibility of capital expenditures remains a key priority.

The following are some important tax accounting considerations and references to EY interpretive guidance to assist in evaluating the impact of changes to cost recovery for tangible and intangible assets if such changes are enacted.

Income tax accounting considerations	Relevant EY FRD Sections
Evaluate whether capital expenditures made in the year of enactment and/or beginning September 27, 2017, qualify for immediate expensing or accelerated depreciation deductions and consider the impact to prior deferred tax balances and current income tax benefits associated with these accelerated deductions.	Section 3.1, 4.2
Consider the implications of accelerated capital expensing on prior assessments made with respect to the realizability of deferred tax assets (e.g., net operating loss carryforwards or interest expense carryforwards). The accelerated deductions may create net operating losses and may also create taxable temporary differences that may be considered a source of income for purposes of assessing deferred tax assets for realizability.	Section 6.3
Consider the change in enacted tax rates (potentially phased in and sunsetting after a period of years) discussed above and the application of the transition rules for the new cost recovery regime.	Sections 4.1,4.2, 4.3, 8.1
Identify which states will automatically conform by statute to the new federal cost recovery system for capital expenditures and consider the impact on current payable or receivable and deferred state tax liabilities.	Sections 4.2.4, 5.6

New international tax system

International reform has been a significant element of tax reform proposals, with lawmakers citing the US system as uncompetitive compared to other countries in the global competition for capital and investment. The US policy of taxing US-based businesses on their global earnings (rather than a territorial approach) leaves the US as the only G7 country with this system. The framework outlines a move to a territorial system from a worldwide system, which would allow companies to repatriate future profits without incurring additional taxes and level the playing field for American companies. Under the framework, offshore profits previously deferred will be subject to a "one-time tax" payable over several years with a bifurcated rate that could potentially be achieved by allowing a lower dividends received deduction (resulting in a higher effective tax rate) for cash and cash equivalents versus other illiquid assets, similar to previous proposals.

A territorial regime would likely include a new foreign dividend exemption system for dividends received from certain foreign subsidiaries, with a possible reduction in the deduction for future losses on the disposition of foreign subsidiaries. While the transition tax proposals would generally permit the use of foreign tax credits, it is unclear whether existing tax attributes, such as foreign tax credit carryforwards and net operating loss carryforwards, will be available to offset the transition tax. Negotiators will be looking for other ways to raise revenue to offset proposed tax rate reductions and prevent erosion of the US tax base. In that respect, there could be modifications to the existing foreign tax credit system (e.g., expansion of the passive basket) and substantial reforms to the existing subpart F anti-deferral regime resulting in a minimum tax on certain foreign earnings. It is also likely that inbound investors won't be immune to the anti-base erosion measures given the potential for final legislation to tighten earnings stripping rules or include any number of other previous revenue-raising proposals affecting foreign investors in the US.

The following are some important tax accounting considerations and references to EY interpretive guidance to assist in evaluating the impact of changes to the international components of US tax provisions if enacted.

Income tax accounting considerations	Relevant EY FRD Sections
Assess the ability to determine the income tax accounting effects of a one-time tax on previously deferred foreign earnings on the current tax provision by validating US tax attributes such as current and accumulated earnings and profits, previously taxed income, foreign tax credit pools and overall foreign losses. Consider the impact if the dividends received deduction is different for cash, cash equivalents, and other short-term assets than it is for illiquid assets. Consider the impact on the balance sheet classification between current and non-current tax payable if the transition tax is payable over a period of years.	Sections 3.1, 14.6.2, 18.1, 19.9
Consider the impact on indefinite reinvestment assertions of a one-time mandatory tax on previously deferred foreign earnings given the inability to control earnings currently subject to US tax. Validate an investee's book and tax basis for each foreign investment and consider what portion of the outside basis difference is subject to tax in the current year as a result of the one-time mandatory tax on previously deferred foreign earnings. Consider the impact of anti-base erosion measures, such as a minimum tax on certain foreign earnings, and also whether plans to actually repatriate foreign cash will change and the need to accrue foreign withholding taxes associated with distributions to the US through a chain of entities. If actual repatriation is planned, consider reduced withholding rates under applicable tax treaties.	Sections 14.2.7.4, 14.2.3, 14.2.3.1, Chapter 19
Consider the impact on US deferred tax liabilities on outside basis differences of foreign investees under the new law if there is a territorial regime. Consider whether the dividends received deduction is 100% or a lesser percentage and whether an exemption also applies to capital gains. Consider whether the exemption under the territorial regime is applicable to all foreign investments or just certain investments meeting certain ownership and other requirements. If asserting indefinite reinvestment on a portion of the outside basis difference not related to earnings, clearly document assertion or any changes to assertion. Consider the impact of a potential phase-in of the new territorial system on assertions and related documentation.	Section 14.2.3
Consider the impact of a change in law on income tax accounting for foreign branches and whether changes in law impact current and deferred tax accounting (for example, if the final legislation deems foreign branches to be reincorporated as foreign corporations).	Section 14.2.7.1
If existing excess onshore foreign tax credits are not able to be utilized to offset the one-time mandatory tax on previously deferred foreign earnings, determine whether a valuation allowance may be needed. Consider the impact of a move to a territorial regime, as well as changes to the existing Subpart F regime on future sources of income and tax-planning strategies.	Section 6.1
If a deferred tax asset exists related to excess interest carryforwards, consider the impact of any changes to the earnings stripping rules and other changes in law that could impact the realizability of this asset.	Section 6.1

Summary

The framework is intended to reflect a consensus among Congressional tax-writers and the Trump Administration with respect to core elements of tax reform. A new tax law will likely represent an unprecedented shift in US taxation, which will likely bring with it a series of complex transition rules and certain provisions that could be phased in or phased out over a specified period of years. The income tax accounting and related disclosures for such a law change will undoubtedly be complex. Companies should begin to model the impact of various proposals and be prepared for the financial reporting implications if reform is enacted. As developments continue to unfold, we will revise and provide further updates to this publication.

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Contact Information
For additional information concerning this Alert, please contact:

Tax Accounting and Risk Advisory Services
• Angela Evans	(404) 817-5130
• Joan Schumaker	(212) 773-8569
• David Northcut	(214) 969-8488
• George Wong	(212) 773-6432
• John M. Wright	(212) 773-1042
• Jason Zenk	(703) 747-1636
International Tax Services
• Jennifer Cobb	(713) 750-1334

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ENDNOTES

¹ EY Financial Reporting Developments, interpretative guidance on Accounting Standards Codification (ASC) 740 revised as of October 2016.

Document ID: 2017-1589