Key Questions and Answers about Income Tax Accounting Considerations for the CARES Act
On March 27, 2020 President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Some portions of the CARES Act will affect the accounting for income taxes, however some items will not. For example, if a company applies for a small business loan to be used to fund payroll for employees, this loan, and the subsequent forgiveness of the loan may be accounted for as a government grant and do not have an impact on the income tax accounting.
Examples of changes in income tax law that will be accounted for under the accounting guidance for income taxes are:
- Allowing corporations to fully utilize their net operating loss (NOL) carryforwards to offset taxable income from 2018, 2019, and 2020. This temporarily eliminates the 80% of taxable income limitation for the use of NOLs.
- NOLs from 2018, 2019, and 2020 may be carried back for five years.
- The net interest expense deduction limit of 30% is increased to 50% of adjusted taxable income for 2019 and 2020
- Corporate alternative minimum tax (AMT) credits may be claimed as a refund in 2020 rather than being claimed over several years as previously required.
- A fix for the “retail glitch” that permits qualified improvement property to be eligible for 100% bonus depreciation if it was placed in service after Dec. 31, 2017
- The limitation on corporation deductions for cash charitable contributions paid during 2020 is increased from 10% to 25%
These and other tax law changes will be taken into account when preparing the current and deferred income tax provision, as well as evaluating whether it is necessary to have valuation allowance for deferred tax assets. The acceleration of the refund of AMT credits is not expected to impact the amount of income tax benefit or expense. However, entities that had previously included the noncurrent portion of the refundable credits in their net deferred tax asset or liability, or as a noncurrent income tax receivable, will need to consider reclassifying the amount to the current income tax receivable. All of these changes will require careful consideration and evaluation in preparing both income tax provisions during 2020.
When is the Impact of the CARES Act Recorded for Accounting Purposes?
Accounting Standards Codification (ASC) Topic 740, Income Taxes requires the effect of tax law changes and tax rates to be accounted for in the period in which new legislation is enacted. For calendar year companies, that would be during their first quarter of 2020. This is true regardless of whether the tax law change is for the future deductibility of existing tax assets or if the change relates to prior periods. Take the following example:
A company preparing its 2019 tax provision anticipates that only a portion of its interest expense is deductible and the remaining interest expense, which is deferred, requires a valuation allowance. The company would recognize the reduction to that valuation allowance and a discrete income tax gain during the first quarter of 2020. This would be reported the same as if a company determined that a valuation allowance might be reduced for existing NOLs due to the expectation of realization in the future.
ASC Topic 740 is specific regarding the period of recognition for changes in tax laws. In accordance with that guidance, the CARES Act itself may not be considered in evaluating the tax provision as of a date earlier than March 27, 2020. This includes the considering of the need for a valuation allowance against existing tax assets that is based upon changes in the tax law. For those companies that have not yet issued their Dec. 31, 2019 financial statements, the accounting rules therefore require that in preparing the 2019 tax provision, the effect of this change may not be considered. As such, the ability under the CARES Act to make various changes such as to carryback NOLs against income in prior periods should not be considered a source of taxable income.
In a similar manner, a 2019 tax provision should not consider the future negative consequences of the COVID-19 pandemic to a company’s business. This may be confusing for some companies, as ASC 740 requires that the evaluation of the need for a valuation allowance should be based upon both historical evidence and all currently available information about the results of operations. This guidance is intended to be specific to facts and circumstances that existed as of the balance sheet date and how it relates to the business. We believe the nature of the pandemic being a Type II subsequent event in the United States for annual periods ending Dec. 31, 2019 implies that decreases or increases in sales, shutdowns, and other effects triggered by the pandemic should not be factored into projections of taxable income.
In addition, tax planning strategies may also be considered as a source of income to recognize tax assets. However, tax planning strategies require that management must currently have the ability to carry out the strategy. A strategy to utilize a deduction that is not allowed under the tax laws that existed on Dec. 31, 2019, would not be considered prudent.
How Are CARES Act Tax Changes Reflected in Accounting for Interim Periods?
For companies preparing for the interim quarterly reporting, the company will have to estimate the full-year taxable income to determine the annual effective tax rate. That rate is then applied to the pre-tax income or loss earned year to date in order to compute the estimated year-to-date income tax expense. ASC Topic 740 includes a provision that if a reliable estimate of the annual taxable income cannot be made, the actual effective tax rate for the year to date may be utilized as the best estimate of the annual effective tax rate. However, when making this determination, companies should consider if forecasts have been utilized in other areas of the financial statements such as impairment and going concern. The ability to forecast for other purposes may call into question a conclusion that the company is unable to reasonable estimate the annual effective tax rate. In addition, publicly traded companies should consider the potential implications on the company’s internal controls over financial reporting if management is unable to prepare a reliable estimate of taxable income for the year.
For the interim period provision, gains or losses from unusual or infrequently occurring items would be excluded from the estimated annual effective tax rate calculation. Rather, these items should be recorded on a discrete basis in the period in which the item occurs. Judgment will have to be applied in determining whether an item is unusual or infrequent.
How Do Impairments Impact Accounting for Income Taxes?
When goodwill is impaired, the difference between the reporting unit’s fair value and its financial statement carrying amount is recorded as an expense with an equal reduction in the value of the goodwill asset. If the goodwill impaired is nondeductible for tax purposes, the impairment will result in a permanent difference between book and tax with no change to deferred income tax assets or liabilities. However, if a portion of this goodwill is deductible for tax purposes, the impairment will affect the deferred tax balance as tax deductible goodwill is a temporary difference. Therefore, the impairment will result in a change to the carrying amount of the reporting unit being valued. This change would affect the impairment charge itself and results in a simultaneous equation. When this occurs, the company should utilize the simultaneous equation described in the guidance for business combinations.
In some instances, the simultaneous calculation may be avoided if the impairment indicated in the impairment test is in excess of the amount of goodwill recorded. This may occur because of the loss in value of other assets below their carrying values for which an impairment charge cannot be recorded. A common cause of this may be due to fixed assets that have declined in value, but have passed the Step 1 undiscounted cash flow test for their asset group and therefore will not be impaired. In addition, if only a portion of the goodwill is impaired and management elects to allocate that portion of the impairment loss to non-deductible goodwill, there would be no need for the simultaneous equation.
Will the CARES Act Tax Changes Affect Re-investment Assertions?
Many companies have a history of asserting their intentions to indefinitely re-invest income from foreign operations rather than repatriating the cash earned back into the U.S. This assertion can have a material impact on the overall income tax provision, especially when significant profits are being earned overseas. However, during times of financial uncertainty, the need to challenge and re-evaluate these assertions is even more important. Moreover, companies should ensure their plans and intentions for indefinite re-investment are consistent with the company’s plans on meeting its existing obligations.
For example, if a company has debt obligations held by the parent company coming due over the next 12 months, the company’s plans regarding their going concern risk may involve utilizing cash on hand to meet those obligations. However, if that cash were located overseas in jurisdictions in which the company has previously asserted indefinite re-investment, the intention to repatriate those funds in order to meet existing obligations would be inconsistent with that indefinite re-investment assertion. Therefore, while the company may have a history and tax planning strategy that supports indefinite re-investment, liquidity needs and other factors also must be considered. If a company determines that the previous indefinite re-investment assertion is no longer appropriate, the tax effect of that change should be recorded at that time, even if the repatriation will occur at some point in the future.
As organizations work through the tax changes ushered in as part of the CARES Act and other coronavirus stimulus legislation, it will be important to check in with the effect these updates will have on financial reporting and accounting. Our team is here to help. For more information on the accounting impact of the coronavirus pandemic, visit our COVID-19 Resource Center or contact a member of our team. Published on April 27, 2020