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Firms Flag COVID-Related Complexities in Reporting Income Taxes

Posted on Jan. 13, 2021

The coronavirus pandemic has complicated the judgments companies must make in accounting for income taxes for a year unlike any other.

Practitioners speaking on their firms’ recent webcasts alerted businesses to nuanced challenges for year-end financial reporting stemming from the effects of COVID-19 on taxable income and to the implications of legislative relief packages.

In the accounting for income taxes for financial statement purposes, it's important to understand current-year and historical results, along with what those mean for the future, Jennifer Spang of PwC said during a webinar hosted by her firm on December 9, 2020. “COVID-19 has brought a whole new level of difficulty when you’re thinking about those pieces of information.”

The Financial Accounting Standards Board’s guidance on accounting for income taxes requires that business entities recognize taxes payable or refundable for the current year on the income statement and recognize deferred tax liabilities and assets on the balance sheet.

Deferred tax assets include tax attributes, such as net operating loss, foreign tax credits, and disallowed business interest carryovers, that may be used to reduce the amount of tax due in a future period. If a company determines that it is more likely than not that a deferred tax asset’s value won’t be fully realized, a valuation allowance must be determined and disclosed.

The standard requires businesses to consider four sources of taxable income against which NOLs and other tax attributes could be realized unless one or more sources is sufficient to conclude that an allowance isn’t required. The four sources are taxable income in prior years if carryback is permitted; future reversals of existing taxable temporary differences; tax planning strategies; and future taxable income exclusive of reversing temporary differences and carryforwards.

The valuation allowance assessment “is based on whether there is sufficient taxable income of the appropriate character in the period that the deferred tax asset is expected to reverse,” considering the weight of all positive and negative evidence and how objectively verifiable each piece of evidence is, Mary Smith of EY explained during a webcast on December 15, 2020.

“There are no bright lines, no formulas. It’s really an area where a company must use judgment” to determine whether to record a valuation allowance, maintain one, or potentially reverse it, Smith said. That can be challenging in any year, but the continued effects of the COVID-19 pandemic on businesses make 2020 a more daunting year, she said.

As companies evaluate valuation allowances for the recent quarter and wrap up 2020, it’s important to think about any change in estimates and transparent disclosure, Spang advised.

Unusual Fact Patterns

The standard for assessing realizability of deferred tax assets weighs more heavily on recent financial results — either income or loss — because they are more objectively verifiable than a financial projection, which is inherently subjective, Spang said.

If a company has cumulative losses, generally for three years, that is a significant piece of objective negative evidence that “can be difficult to overcome, but it’s not a light switch [indicating] that you automatically need to record or maintain a valuation allowance,” explained Spang.

“Importantly, the flip side is also true,” she said, noting that companies with cumulative income that have been facing a downward trend, or expect to have cumulative losses in the near term, may need a valuation allowance even though they are still in a cumulative income position.

The baseline for the valuation allowance analysis is typically the company’s actual results, but for a year like 2020, starting with that presents difficulties.

Companies that previously had cumulative losses with a valuation allowance but are thriving amid the pandemic have asked whether they should release that allowance, Spang said. She emphasized that those companies should assess whether the income is a result of COVID-19 and is sustainable and therefore constitutes objective evidence when considering future taxable income.

Spang contrasted that situation with companies that have cumulative income but their industry is doing poorly as a result of COVID-19, or they have triggered a cumulative loss position. Those companies need to consider how they performed in the second half of the 2020, their current position, and what is driving their forecasts.

“In any of these situations, it’s difficult to decide what is objectively verifiable,” Spang said.

Smith further suggested that companies consider the extent to which actual results deviated from what was forecast during 2020 and their ability to achieve their projections in the future. If taxpayers have significant deviations from their projections, they might not be able to rely as much on future taxable income as a source for realizing the benefits of their deferred tax assets, she said.

Balancing historical results, the effects of the pandemic, and uncertain forecasts will be more challenging than ever, according to Kathleen Bauman of PwC, who spoke separately December 15, 2020, during a podcast hosted by her firm.

Hopefully, most companies can “put a ring fence around what the COVID impact was,” Bauman said. For the forecast of taxable income, “it’s probably less about what the number is [and more about] understanding the timelines and potential to return to previous levels,” she added.

Companies hurt by the pandemic should assess whether they expect to immediately return to previous profit levels once all restrictions have been lifted, or whether, based on consumer sentiment and government restrictions, it will take more time, advised Bauman. Then the question is whether those companies have that time, she said. Do their tax attributes, like NOLs, expire in several years, or are they indefinitely lived, and therefore any return to profitability is what’s needed? she asked.

Companies have to consider — possibly more than before — their supply chains, customer trends, and whether their industry is expected to rebound, but perhaps not to what it was before COVID-19, Bauman said.

Debt Modifications

The pandemic has also caused many businesses experiencing financial difficulties to revisit their existing debt, which, if modified, could have material tax and tax accounting implications if they trigger cancellation of debt (COD) income, Lauren Jansen of Grant Thornton LLP said during a webcast December 16, 2020.

Jansen noted that COD income can arise when debt is restructured with more favorable terms, which can include not only changes in the principal amount but also changes in the interest rate or other terms.

Under section 108, canceled debt is generally included in gross income unless specific exceptions apply, such as when the debt is discharged in a bankruptcy case or when the taxpayer is insolvent. For those exclusions of COD income, taxpayers must reduce specified tax attributes — including NOLs, capital-loss carryovers, and basis reductions — following prescribed ordering rules. 

If there’s a deemed exchange of debt that is publicly traded, the issue price of the new debt is its fair market value rather than its face amount. That means a debtor can have COD income even though the principal amount of its debt obligation has not been reduced.

Section 382 can be implicated if changes in the debt structure affect the overall equity of the company, which could limit the ability to use some tax attributes like NOLs and credit carryovers, Jansen said.

Jansen also pointed out that if a company’s refinancing is considered a new borrowing, it may be able to deduct previously amortized debt issuance costs.

All those items stemming from a debt modification affect taxable income computations, tax attributes, and potentially valuation allowances for the deferred tax assets, she said.

CARES Considerations

Companies must also consider how the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) might affect the need for a valuation allowance, said Smith, pointing to the NOL carryback provision, which could result in companies being able to realize NOLs that they otherwise couldn’t.

Spang also warned of the potential effects of the CARES Act, noting that some companies carried back an NOL only to free up other attributes — like FTCs or research credits — that may in turn need a valuation allowance.

Companies may be rethinking the CARES Act provisions, which they accounted for in the period of enactment, said Angela Evans of EY, who joined Smith on the webcast. She added that having more information might affect their decisions to carry back NOLs, noting that the companies will have three additional quarters of actual results and updates to forecasts, along with provision-to-return adjustments with 2019 tax returns having been filed.

Evans reminded taxpayers to consider the complicated knock-on effects of carrying back losses, including the interactions with FTCs, foreign-derived intangible income, global intangible low-taxed income, the base erosion and antiabuse tax, and the section 965 transaction tax calculations.

Jennifer Cobb, also of EY, said that “the biggest variable for many [multinational] companies has just been the size of the 2020 loss that they are carrying back.” She explained that with the enactment of the Tax Cuts and Jobs Act, taxpayers have to layer onto the FTC considerations the effects of losing the section 250 deduction — which is limited based on taxable income — and the potential of becoming a BEAT taxpayer if losses are carried back to tax years beginning after December 31, 2017.

Uncertain Tax Positions

Each reporting period, businesses must consider the effects of modifications to tax laws, including changes in tax regimes in their global jurisdictions; new U.S. federal final, temporary, or proposed regulations; or states’ decisions on tax conformity with federal rules.

Companies must also account for uncertain tax positions, which involves a two-step process. The first step is deciding whether it is more likely than not that a tax position will be sustainable on audit and through appeals and litigation based on technical merits under the law. That standard must be met for a company to recognize the tax benefits in its financial statements.

If the recognition threshold is met, the second step of measuring that benefit is based on the largest amount that has a cumulative probability of being sustained above 50 percent upon settlement.

In evaluating uncertain tax positions, there’s a difference between new information and changes in estimates. Developments that further refine the application of law affect the tax position, which differs significantly from a reevaluation of existing information, said Jennifer Schiellack of PwC, who joined Spang on the webcast.

Schiellack pointed out that the proposed regulations don’t carry the weight of final or temporary regulations, but because they provide Treasury’s interpretation of existing law, companies should assess whether they can follow the rules and their intent to apply them. However, once companies regard those proposed regulations as new information in assessing their uncertain tax positions, the outcome isn’t expected to change until there’s new information, like the final regs, she explained.

Several regulation packages allow taxpayers to apply the rules retroactively, but Schiellack warned that any effects of filing amended returns must be part of evaluating an uncertain tax position.

Evans advised that companies making decisions now — versus earlier in the year — to carry back losses to years in which uncertain tax positions have been released — because, for example, the statute of limitations lapsed — might need to reestablish those positions. The IRS can review them, Evans said, adding that “it’s a sleeper” that taxpayers shouldn’t forget about.

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