25 March 2020 COVID-19 could have implications on income tax accounting Companies affected by COVID-19 need to consider the income tax accounting implications resulting from the current economic environment on their financial performance and projections of future results. Companies receiving benefits under legislation enacted in response to the pandemic also need to account for those benefits. Companies need to allow adequate time in the financial reporting process to evaluate the tax implications of their actual results of operations and forecasts, as well as any legislative, regulatory or administrative developments. Additional time and effort may be needed to determine the estimated annual effective tax rate, assess the realizability of deferred tax assets, determine the tax effect of losses in continuing operations, revisit assertions related to the reinvestment of foreign earnings, and determine the tax effect of any impairments, as well as other changes to estimated components of the tax provision. The following discusses certain tax accounting guidance for these and other related topics that companies affected by COVID-19 may need to consider as part of their financial reporting for income taxes. For a discussion of the financial reporting implications of COVID-19 on other areas of the financial statements, see the following publications: EY Technical line, Accounting and reporting considerations for the effects of the coronavirus outbreak, which provides a broader discussion of accounting and reporting considerations beyond income tax accounting EY Technical Line, Accounting for impairment of goodwill and indefinite-lived intangible assets due to the coronavirus Our EY Tax COVID-19 Response Tracker provides a summary of select global legislative and government responses to COVID-19, and is updated routinely for the latest developments. Throughout this Alert, we reference EY's Financial Reporting Developments Guide to Accounting for Income Taxes, which can be referenced for further information on any topic. Under ASC 740, each interim period is considered an integral part of the annual period, and tax expense is measured using an estimated annual effective rate. A company is required, at the end of each interim reporting period, to make its best estimate of the annual effective tax rate for the full fiscal year and use that rate to provide for income taxes on a current year-to-date basis. The estimated effective tax rate should reflect enacted federal, state and local income tax rates, foreign tax rates and credits, percentage depletion, capital gains rates, other taxes and credits, and available tax-planning alternatives. The rate should be revised, if necessary, as of the end of each successive interim period during the fiscal year to the entity's best current estimate of its annual effective tax rate. The determination of the estimated annual effective tax rate requires an estimate of forecasted income or losses for the year. Companies affected by the coronavirus outbreak may experience a reduction in demand, temporary closures of their operations or supply chain interruptions that may create challenges in preparing reliable estimates. Estimates of the annual effective tax rate are, of necessity, based on evaluations of possible future events and transactions and may be subject to subsequent refinement or revision. ASC 740 addresses the consequences of an entity's inability to reliably estimate some or all the information that is ordinarily required to determine the annual effective tax rate in an interim period financial statement. When an entity is unable to estimate a part of its ordinary income (loss) or the related tax (or benefit) but is otherwise able to make a reliable estimate of its estimated annual effective tax rate, the tax (or benefit) applicable to the item that cannot be estimated should be reported in the interim period in which the item is reported. In some cases, minor changes in estimated ordinary income can have a significant effect on the estimated annual effective rate. A common example of this is when a company is estimating that its operating results will be at or about break even or when permanent differences are significant as compared to estimated income. Companies in situations in which minor changes in estimated annual ordinary income can have significant effects on the estimated annual effective tax rate need to consider whether a reliable estimate of the annual effective tax rate can be made. If a reliable estimate of the estimated effective tax rate cannot be made, the actual effective tax rate for the year to date may be the best estimate of the annual effective tax rate. Additional guidance is given in determining the estimated annual effective tax rate that may be particularly relevant in light of COVID-19. When a company is subject to tax in one or more individual jurisdictions, ASC 740-270-30-36 indicates that one overall estimated annual effective tax rate should be used to determine the interim period tax (benefit) related to the registrant's consolidated ordinary income (loss) for the year-to-date period, except as follows: If, in a separate jurisdiction, the company anticipates an ordinary loss for the fiscal year or incurs an ordinary loss for the year-to-date period for which a tax benefit cannot be realized in accordance with ASC 740, the company should exclude the ordinary income (loss) in that jurisdiction and the related tax (benefit) from the overall computations of the estimated annual effective tax rate and interim period tax (benefit). The company must compute a separate estimated annual effective tax rate for this jurisdiction, which would be applied to the ordinary income (loss) in that jurisdiction. If a company is unable to estimate the annual effective tax rate in a foreign jurisdiction in dollars (e.g., depreciation in a foreign jurisdiction may be significant and foreign exchange rates have historically fluctuated) or is otherwise unable to make a reliable estimate of the foreign jurisdiction's ordinary income (loss) or the related tax (benefit) for the fiscal year, the company should exclude the ordinary income (loss) in that jurisdiction and the related tax (benefit) from the overall computations of the estimated annual effective tax rate and interim period tax (benefit). The company must compute separately the interim tax (benefit) for this jurisdiction as the jurisdiction reports ordinary income (loss) in an interim period (ASC 740-270-30-19). See also EY's Financial Reporting Developments guide on Accounting for Income Taxes Sections 20.1 thru 20.4. The first quarter for calendar year-end companies is likely to present increased challenges in the accounting and reporting for income taxes. Companies may need additional time to collect and discuss the inputs needed to project the estimated annual effective tax rate, as well as any discrete items recorded in the period. Information on forecasts of income or losses may be updated frequently. Companies should review the forecast used for tax provision purposes for consistency with other financial accounting estimates used. It will be important for tax calculations to be based on the same estimates and forecasts used for other non-tax areas of financial reporting (e.g., projections used for impairment testing). Companies should also consider whether recent changes in supply chains or operations are reflected in the projected forecast of pre-tax earnings by jurisdiction and that revisions align with transfer pricing policies. In addition, companies that have significant variations in the customary relationship between income tax expense and pretax accounting income in the interim period financial statements should disclose the reasons if they are not otherwise apparent from the financial statements or from the nature of the entity's business. As a result of increased needs for cash or liquidity, companies may be changing their expectations about remitting earnings. The income tax effects of a company changing its indefinite reinvestment assertion for a foreign subsidiary should be recorded in the interim reporting period when the change in assertion occurs. Generally, a change in assertion of indefinite reinvestment during the year should result in the same reporting for the annual period as if the change in assertion occurred at the beginning of the year; that is, despite reporting on an interim basis, the results of a change in an indefinite reinvestment assertion during the year should not be presented any differently in the annual financial statements than if the entity fully reported on an annual basis. The tax effects of undistributed earnings, including translation adjustments related to the current year (i.e., the outside basis difference related to the current reporting year) would be recognized as an adjustment to the estimated annual effective tax rate in the period in which the change in assertion occurs. The deferred tax effects of the translation adjustment related to the current period should be reported in other comprehensive income in accordance with ASC 740-20-45-11. The deferred income tax effects of undistributed earnings related to prior years, including any deferred income tax effects of the beginning-of-the-year cumulative translation adjustment related to the investment (i.e., the outside basis difference on the company's investment in a foreign subsidiary as of the beginning of the year) should be reported in continuing operations as a discrete charge to income tax expense in the period in which the change in assertion occurs. The backward tracing of the tax effects of the beginning-of-the-year cumulative translation adjustment to accumulated other comprehensive income would not be appropriate. Companies should consider whether working-capital needs impact their current or future plans for repatriating cash from foreign operations. Close coordination between Finance, Tax and Treasury is usually needed to determine an apparent change in assertion on the remittance of foreign earnings as of the end of the reporting period. When anticipated remittances are expected to come from previously taxed income for US tax purposes, the tax effects of distribution plans may not result in incremental federal income tax, but there may be foreign withholding taxes associated with repatriation through a chain of entities, local country taxes on dividend distributions, and state and local tax effects. In addition, the tax effects of future distributions will require consideration of the expected tax on foreign currency translation gains and losses and the ability to utilize or realize a future benefit for foreign tax credits generated. As result of COVID-19 and evolving economic conditions, companies may need to reevaluate the recorded amounts of goodwill, equity investments or other assets recorded on their balance sheets. To the extent adjustments are recorded, they could give rise to reductions in deferred tax liabilities or increases in deferred tax assets. In addition, many companies may be using projections of future income to support the realizability of deferred tax assets. Companies need to assess the realizability of deferred tax assets at the end of each reporting period. Under ASC 740-10-45-20, companies must ordinarily include in income from continuing operations the effect of a change in the beginning-of-the-year balance of a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years. The only exceptions are changes to valuation allowances of certain tax benefits that are adjusted within the measurement period as required by paragraph 805-740-45-2d (related to business combinations) and the initial recognition (that is, by elimination of the valuation allowances) of tax benefits related to the items specified in paragraph 740-20-45-11(c) through (f). The effect of other changes in the balance of a valuation allowance are allocated among continuing operations and items other than continuing operations as required by paragraphs 740-20-45-2 and 740-20-45-8. See also EY's Financial Reporting Developments guide on Accounting for Income Taxes Sections 15.2.2.2 and 6.12. The assessment of the realizability of deferred tax assets requires projections of future income and consideration of whether a three-year cumulative loss exists. Companies should update their projections of income for recent events. Tax attribute carryforwards that were otherwise expected to be utilized in the near term should be reviewed to determine if they might expire unutilized. In addition, companies should assess whether changes in expiration periods or limitations on the use of tax attributes have been enacted in jurisdictions in which the attributes reside that would impact management's judgments on the amount of a valuation allowance that is needed. In addition, companies should consider whether they need to provide additional financial statement disclosures to more fully explain the use of estimates or management's judgments in reaching its conclusions on the amount of valuation allowances recorded against deferred tax assets. ASC 740-270-25-5 says "[t]he tax effect of a change in tax laws or rates on taxes currently payable or refundable for the current year shall be recorded after the effective dates prescribed in the statutes and 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." Prior to the adoption of ASU 2019-12, Simplifying the Accounting for Income Taxes, 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 would be included in the calculation of the estimated annual effective tax rate beginning in the interim period including the effective date. The effect of a change in tax rates on deferred tax assets and liabilities is recognized as a component of income tax expense from continuing operations in the period in which the change is enacted. In responding to the COVID-19 crisis, many countries have proposed offering government assistance. Determining whether government assistance should be subject to income tax accounting or another accounting model requires the use of significant judgment. If an entity determines that the governmental assistance does not fall within the scope of ASC 740 (and it is not considered an Investment Tax Credit) or ASC 605, (Revenue Recognition before the adoption of ASC 606) or ASC 606, the entity should consider whether the governmental assistance is a governmental grant, (i.e., a credit received from a government entity without regard to taxable income). While not specifically addressed in US GAAP, the accounting for government grants received has been addressed in International Financial Reporting Standards (IFRS) in International Accounting Standard No. 20, Accounting for Government Grants and Disclosure of Government Assistance (IAS 20) , which we believe is an appropriate model to follow. Companies should closely monitor tax law changes and stimulus packages that could result in immediate tax effects to the financial statements in the period of enactment. Determining whether a benefit is an income tax or above-the-line benefit should be considered for each jurisdiction's benefit. Companies projecting a loss from continuing operations for the current year need to consider the tax accounting rules in this area, some of which were revised under ASU 2019-12. Prior to ASU 2019-12, the exception to the general principle of intraperiod tax allocation described in ASC 740-20-45-7 applies if a company anticipates having an ordinary loss from continuing operations for the full fiscal year. This exception requires that all items (i.e., discontinued operations, other comprehensive income, and so forth) be considered in determining the amount of tax benefit that results from a loss from continuing operations that should be allocated to continuing operations. The exception in ASC 740-20-45-7 applies in all situations in which there is a loss from continuing operations while there is income from other items outside of continuing operations, even if a company has recorded a full valuation allowance at the beginning and end of the reporting period and the overall tax provision for the year is zero (i.e., a benefit would be recognized in continuing operations even though the loss from continuing operations does not provide a current period incremental tax benefit). Provided a loss from continuing operations is anticipated for the full fiscal year, a company should apply the exception in ASC 740-20-45-7 for interim reporting if there is income from other items outside of continuing operations that has been recognized in an interim reporting period. This would include situations in which a company has recorded a full valuation allowance at the beginning and end of the period and the overall tax provision for the year is expected to be zero (i.e., a benefit would be recognized in continuing operations even though the loss from continuing operations does not provide a current period incremental tax benefit). This exception only relates to the allocation of the current period tax provision and does not change a company's overall tax provision. In addition, companies with losses should consider how to treat a tax benefit related to current-year or prior-year operating losses in the estimated annual effective tax rate computation. For operating losses that originated in the current year, the estimated annual effective tax rate computation should include the tax benefit of those losses if the losses are expected to be (1) realized during the current fiscal year or (2) recognizable as a deferred tax asset at the end of the fiscal year. However, the expected benefit would be limited to the estimated net deferred tax asset associated with the current operating losses (i.e., the expected benefit should be reduced by any estimated valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized). That is, if the tax benefit attributable to the company's year-to-date operating loss exceeds the amount that will be offset by anticipated operating income (of sufficient reliability in accordance with the more-likely-than-not standard) in subsequent interim periods in the current year or qualify for recognition as a deferred asset without a valuation allowance at year-end, those excess tax benefits are not recognized in the interim period. Prior to the adoption of ASU 2019-12, the tax benefit associated with the year-to-date ordinary loss, when an ordinary loss is anticipated for the year, is limited to the amount that would be recognized if the year-to-date ordinary loss is the anticipated ordinary loss for the fiscal year. This limitation does not apply to companies that have adopted ASU 2019-12, which eliminates this exception. Companies with forecast losses from continuing operations should evaluate carefully the guidance related to recording the tax effects and consider whether or not they have adopted ASU 2019-12. As part of the annual effective tax rate estimation process, a company is required, at the end of each reporting period, to make its best estimate of pretax ordinary income for the full fiscal year. In estimating pretax ordinary income for the full fiscal year, questions often arise as to how to consider events (specifically, non-recognized subsequent events) that occur after the interim balance sheet date (i.e., events that occur after the most recent quarter end but within the same fiscal year), but before the interim financial statements are issued. As noted in ASC 855, non-recognized subsequent events provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date. Those events are recognized in the financial statements in the period in which they occur. When a company estimates its annual effective tax rate, the estimate of pretax ordinary income includes only items that are expected to be included in pretax ordinary income for the year. ASC 740 and ASC 855 do not address how a company should consider non-recognized subsequent events that would be considered a component of pretax ordinary income but were not included in the estimate of ordinary income for the full fiscal year and occur after an interim balance sheet date when estimating the annual effective tax rate to apply in the interim financial statements. Because the pretax effects of non-recognized subsequent events are recorded in the period in which they occur, we believe that it is most appropriate to exclude those events from the estimate of pretax ordinary income (to the extent they were not previously included in the estimate) prior to the events occurring for purposes of determining the effective tax rate. Companies should monitor the occurrence of subsequent events and understand whether the events are considered in the projections used for other areas of financial statement reporting. Generally, the assumptions inherent in the estimates or projections used for the tax provision should be consistent with those used for other accounting determinations. As a result of operational changes stemming from COVID-19, companies may need to revisit numerous items when determining their projections of the estimated annual effective tax rate. Companies also will need to revisit components that may have remained fairly stable in a more typical year, such as the disallowance of interest under IRC Section 163(j) or the meals and entertainment disallowance. This Alert is not an all-inclusive list of the topics to consider, but rather provides some guidance on areas that may require additional time to consider.
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