November 6, 2017 Income Tax Accounting Considerations of House Tax Cuts and Jobs Act On November 2, 2017, House Ways and Means Committee Chairman Kevin Brady (R- TX) released a long-awaited tax reform bill entitled the Tax Cuts and Jobs Act of 2017 (H.R. 1), followed by a Chairman's Mark of H.R. 1 on November 3, 2017 (collectively referred to in this Alert as "the bill"). The Committee will begin considering the bill this week, kicking off formal tax committee action on the first overhaul of the US tax system in over 30 years. Senate Finance Committee Chairman Orrin Hatch (R-UT) announced that he plans to release a Senate Republican version of a tax reform bill after the Ways and Means Committee completes its work. The Senate Finance Committee could consider Hatch's plan while the Ways and Means Committee bill is on the House floor to make as much progress as possible on the legislation before Thanksgiving. For more information on the bill and potential key aspects of tax reform, see Tax Alert 2017-1831. Although ASC740 does not permit US companies to account for changes in US tax law until the President signs the legislation, companies need to understand the proposed legislation now so they can evaluate and prepare for the financial statement income tax accounting implications. This Alert highlights some of the income tax accounting-related issues inherent in the proposed bill. For a more detailed discussion of the income tax accounting implications of potential US tax reform, see Tax Alert 2017-1589. Lower corporate income tax rate The bill proposes to permanently reduce the top corporate federal income tax rate from 35% to 20% for tax years beginning after 2017. Income tax accounting insights 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 of the company will determine how the effects are recorded. Under ASC 740, companies must: (1) record the impact of a rate or law change on income taxes currently payable or refundable for the current year after the effective dates prescribed in the statutes; and (2) reflect the impact of that change in the computation of their annual effective tax rate, beginning in the first interim period that includes the enactment date of the new legislation. If the effective date is later than the enactment date, companies should include the impact of the change on the estimate of the payable or receivable for the current year in the calculation of their estimated annual effective tax rate, beginning on the effective date. 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. A lower corporate income tax rate will require the future benefits of existing deductible temporary differences and carryforwards, such as accruals for pension liabilities and net operating loss (NOL) carryforwards, to be computed at the new tax rate. This would result in lower deferred tax assets and increased income tax expense in the period of enactment. Similarly, taxable temporary differences will result in lower deferred tax liabilities, such as those related to accelerated depreciation on property and equipment, decreasing income tax expense in the period of enactment. As deferred tax assets are measured at the new tax rate, companies will also need to remeasure their valuation allowances against deferred tax assets and also adjust those amounts as part of income tax expense in the period of enactment. 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 before calculating the effects of the rate change. Finally, companies will be required to 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. 100% capital expensing Taxpayers would be able to expense 100% of the cost of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023 (January 1, 2024, for certain qualified property with a longer production period, as well as certain aircraft). Income tax accounting insights In the period of enactment, companies will need to evaluate whether capital expenditures made after September 27, 2017, qualify for immediate expensing and consider the effect on any existing current and deferred tax balances as a result of these accelerated deductions. If, for example, new legislation is enacted during the first quarter of 2018, a calendar-year company would record in the interim period of enactment the catch-up adjustment to current and deferred taxes for additional allowable 2017 deductions at the 35% corporate tax rate (before adjusting deferred taxes to the 20% tax rate). Additionally, companies should consider the implications of accelerated capital expensing on the realizability of deferred tax assets. Accelerated deductions may create NOLs and may also create taxable temporary differences that may be considered a source of income for purposes of assessing deferred tax assets for realizability. Likewise, companies should consider the application of transition rules and the phase-out of the temporary cost recovery regime on December 31, 2022, on the reversal of temporary differences. Broader corporate tax base To pay for the proposed lower corporate income tax rate, the bill includes various base-broadening provisions. Consistent with the Unified Framework, the bill proposes to eliminate the domestic production deduction (Section 199 deduction), various incentive credits particularly in the energy industry, and the work opportunity tax credit (WOTC). The bill would repeal existing limitations on the deductibility of interest expense under Section 163(j) and replace them with a more broadly applicable limitation that would disallow a deduction for net business interest expense above 30% of the business's adjusted taxable income for the year. An additional limitation would also be imposed on the deductibility of net interest expense of a US corporation that is a member of an international financial reporting group to the extent the US corporation's share of the group's net interest expense exceeds 110 percent of the US corporation's share of the group's global earnings before interest, taxes, depreciation and amortization (EBITDA). US corporations that are subject to both limitations would have to apply the limitation that disallows the greater amount of net interest expense deduction. Interest disallowed under either provision could be carried forward for up to five years. The limitations on deductibility of net interest expense would apply to tax years beginning after December 31, 2017. The bill would repeal the alternative minimum tax (AMT), and would allow indefinite carry forward of NOLs arising in tax years beginning after December 31, 2017. The bill also would repeal all carrybacks for losses generated in tax years beginning after December 31, 2017. The bill would limit the amount of all NOLs that a taxpayer could use to offset taxable income to 90% of the taxpayer's taxable income (computed without taking into account the NOL deduction) for tax years beginning after December 31, 2017. In addition, the provision would permit NOLs arising in tax years beginning after 2017 and carried forward to be increased by an interest factor to preserve the NOL value. Income tax accounting insights In the period in which tax reform is enacted, companies will need to adjust their estimated annual effective tax rate to eliminate a number of tax benefits repealed, including the Section 199 deduction, WOTC and other incentive credits. In addition, the tax effect of current year interest disallowed as a result of the limitations on net interest deductibility should be included in the estimated annual effective tax rate, including determination of the realizability of any excess interest carryforwards. The bill includes significant additional computations for companies in determining allowable interest, which may present challenges in determining the estimated annual effective tax rate. In addition, companies will need to reassess the realizability of their tax attribute carryforwards (e.g., AMT credits and NOL carryforwards) under the new proposals and record a valuation allowance in the period of enactment if it is more likely than not that all or a portion of these deferred tax assets will not be realized. New international tax system The bill would modify the current US worldwide system of taxation and adopt a territorial system that would provide a 100% deduction for the foreign-source portion of dividends received by a domestic corporation from a "specified 10%-owned foreign corporation." Credits and deductions for foreign taxes (including withholding taxes) paid or accrued with respect to any dividend that benefits from the 100% deduction would be disallowed. The 100% deduction would not apply to either foreign income directly earned by a domestic corporation through foreign branches or to capital gains recognized from the sale or exchange of stock in a specified 10%-owned foreign corporation. To the extent that Section 1248 treats any capital gain from the sale or exchange of stock in a controlled foreign corporation as a dividend, however, the 100% deduction should apply. The proposed move to a participation exemption system for the foreign-source portion of dividends from certain foreign corporations would also eliminate the application of existing Section 956. The proposed adoption of a territorial tax system includes a one-time mandatory transition tax of 12% on deferred foreign earnings held in cash and cash equivalents and 5% on all other deferred foreign earnings. The foreign earnings subject to the transition tax would be deemed to be repatriated by increasing the Subpart F income of a specified foreign corporation that generally includes controlled foreign corporations and foreign corporations with a 10% or greater domestic corporation shareholder in its last tax year beginning before January 1, 2018. The foreign earnings subject to the transition tax would be measured at two set points in time: November 2, 2017 and December 31, 2017. These dates are the required measurement dates, irrespective of the foreign corporation's tax year or its financial accounting period. The amount of foreign earnings subject to the transition tax would be the greater of the two amounts — measured using earnings and profits (E&P) accumulated after 1986. Taxpayers would be able to elect to pay the transition tax over eight years in eight equal installments. Existing foreign tax credit carryforwards of the US shareholder could be used to offset the transition tax. Similarly, any net operating losses of the US shareholder would also be available to reduce the taxable income resulting from the mandatory Subpart F inclusion. Any foreign tax credits generated with the mandatory inclusion would be subject to a partial disallowance, but any that remain unused after the imposition of the transition tax could be carried forward 20 years as opposed to the 10-year period currently applicable. Going forward, foreign corporations would have large amounts of previously taxed E&P, an attribute that could potentially impact tax basis in stock and foreign exchange exposure for US tax purposes. The move to a territorial tax system includes anti-base erosion provisions targeting both US-based and foreign-based multinational companies. Significantly, the bill includes: (1) a new foreign high return amount included in gross income of US shareholders (as a Subpart F inclusion) that would effectively establish a minimum tax on certain income; and (2) a new non-deductible 20% excise tax on otherwise deductible payments from a US corporation to a related foreign corporation unless the foreign corporation elects to treat the payments as income that is effectively connected with a US trade or business (ECI). If the foreign corporation elected to treat the payments as taxable in the US, its income would be taxed on a net basis. The proposed excise tax would apply to amounts paid or incurred by domestic corporations to related foreign corporations after December 31, 2018. For more information on proposed international aspects of the bill, see Tax Alert 2017-1845. Income tax accounting insights If enacted, companies will need to calculate the transition tax and determine the income tax accounting effects by validating US tax attributes such as earnings and profits accumulated after 1986, previously taxed income and foreign tax credit pools. Additionally, because a US shareholder could elect to pay the transition tax over a period of eight years, companies should consider the impact on the balance sheet classification between current and non-current taxes payable. Companies should also evaluate the impact of the transition tax and the change to a territorial tax system on indefinite reinvestment assertions. Given the mandatory US taxation of previously deferred foreign earnings and the 100% dividends received deduction for certain distributions of foreign earnings made after December 31, 2017, companies will need to evaluate whether earnings will be distributed and accruals are needed for withholding taxes. Companies contemplating a sale of their subsidiaries should consider that there is still no capital gain exemption on sales of stock of foreign subsidiaries and consequently may need to record deferred taxes on all or a portion of their outside basis differences. Additionally, companies will need to evaluate changes to the Subpart F regime, which could, if enacted, also affect the computation of the estimated annual effective tax rate. The bill would allow companies to utilize existing foreign tax credit carryforwards to offset the transition tax on previously deferred foreign earnings and to continue to carry forward unused foreign tax credits already generated. If the bill is enacted, however, companies will need to evaluate the realizability of unused foreign tax credit carryforwards and whether a valuation allowance may be needed, especially in light of the impact of the changes to the international tax system. As mentioned, companies should determine whether they plan to actually repatriate earnings in light of the proposed deemed repatriation under the transition tax and evaluate the need to accrue foreign withholding taxes associated with those earnings. Companies should consider eligibility for reduced withholding rates under applicable tax treaties. Finally, ASC 740 applies to all federal, foreign, state and local (including franchise) taxes that are based on income. Foreign corporations may elect to be taxed on related-party payments from US corporations as ECI. With the availability of an ECI election, the proposed excise tax includes characteristics of both an income tax and a non-income based tax. Corporations should consider whether they plan to make the election to treat payments as ECI and consider how to account for this tax if effective in 2019. State and local tax implications of federal tax reform Many of the proposed federal tax reform measures, if enacted, will affect the income taxes imposed by state and local governments (collectively hereinafter referred to as "state" or "states"). Generally, most state income tax systems use federal taxable income as a starting point for state income tax computations, but do not automatically conform to federal tax rate changes. Thus, state taxes would rise (immediately or in the near term) as the federal tax base expands, unless states align their tax rates with federal tax rate reductions. States generally conform to the Internal Revenue Code (IRC) in one of several ways: (1) they automatically tie to the federal tax law as it changes (known as "rolling" conformity states); (2) they tie to the federal tax law as of a specific date (known as "fixed" conformity states); or (3) they pick and choose different federal tax law provisions and dates to which they will conform (known as "selective" conformity states). Most states generally define "state taxable income" as federal taxable income plus or minus certain additions or subtractions (such as adding back federal depreciation and substituting their own methods of depreciation). A handful of states, however, select sections of the IRC to which they will conform and then modify the actual provision (Arkansas, California and Mississippi are examples of states whose tax laws work in this selective manner). Income tax accounting insights Twenty-two states1 currently adopt a "rolling" IRC conformity date and, as such, automatically conform to the IRC as enacted. Accordingly, if federal tax reform were to occur, these states generally would automatically adopt the federal tax changes unless the state chooses to decouple from the new federal provisions (for example, when facing significant IRC changes in the past, states have often enacted special provisions to decouple from some of the federal measures they sensed would be too costly, such as accelerated depreciation). Absent any change in state conformity or the state tax rate, taxpayers generally would see an immediate impact on their state effective tax rate. In contrast, another 20 states2 currently adopt a "fixed" IRC conformity date and thus generally would only incorporate changes to the IRC if they changed their conformity date to a date on or after the effective dates of federal tax reform provisions. Accordingly, for the federal changes to apply, these states generally would have to update their IRC conformity date.3 As such, taxpayers in these states generally will continue using the pre-federal tax reform version of the IRC to determine their state effective tax rate unless the state takes specific action to update its conformity date. The remaining five states4 with an income tax use a "selective" approach and adopt only specific provisions of the IRC, typically as of a specific fixed date. In these states, taxpayers generally could see a hybrid of the approaches used in the "rolling" and "fixed" conformity states that would affect their state effective tax rates. Regardless of which method a state uses, federal tax reform could have an assortment of effects at the state level depending not only on how states conform but also how each state responds to these federal tax law changes. Companies should be prepared to monitor and assess the effects of federal tax reform on their state tax profile across multiple financial reporting periods because the state approaches could be very different than what occurs for federal income tax purposes. Finally, companies should pay particular attention to the potential state income tax accounting effects of the proposed transition tax on deferred foreign earnings. The bill proposes to characterize the income subject to the transition tax as Subpart F income. Currently, states approach Subpart F income (and foreign dividends, for that matter) in a variety of ways. In the period of enactment, companies will need to carefully model the federal and state tax impact of the transition tax, and be prepared to compute and report the state tax accounting impact. For additional discussion of the state income tax impact of federal tax reform, please see Tax Alert 2017-1850. Summary The income tax accounting and related disclosures for the proposed tax reform bill will undoubtedly be complex. Companies should begin to model the impact of various proposals and be prepared to record and disclose the financial reporting effects if reform is enacted. ———————————————
——————————————— 1 States that currently use a "rolling" IRC conformity date are: Alabama, Alaska, Colorado, Connecticut, Delaware, District of Columbia, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Oregon, Rhode Island, Tennessee and Utah. 2 States that currently use a "fixed" (or static) IRC conformity date are: Arizona, Florida, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Michigan (note: taxpayers can make an election to use the current IRC date), Minnesota, New Hampshire, North Carolina, Ohio (personal income tax), South Carolina, Texas, Vermont, Virginia, West Virginia and Wisconsin. 3 A majority of fixed conformity states annually update their date of conformity to the IRC and usually do so within the first few months of each year. These states generally conform to the IRC on either the last day of the prior year or the first day of the current year, with a couple of states opting to conform to the date the state bill updating the IRC conformity date was enacted. Though it is likely that most of the fixed conformity states will update their date of conformity in order to couple to the proposed federal tax reform changes, especially those changes broadening the tax base, it is equally likely that some, if not most, of these states will decouple from certain provisions, such as immediate expensing of new equipment, as these states may not be able to afford to conform. 4 States that currently use a "selective" IRC conformity approach are: Arkansas, California, Mississippi, New Jersey and Pennsylvania. | |||||||||||||||||||||||||
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