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The conglomerate may be able to take advantage of tax benefits because "there is room for judgment" with respect to a deferred tax liability ripening into an actual liability.
Robert Willens, CFO.com | US
November 8, 2010
Weyerhaeuser Co. recently reported third-quarter earnings of $1.116 billion. However, substantially all of those earnings can be traced to an "income tax adjustment" in the amount of $1.035 billion. In light of Weyerhaeuser's conversion from C corporation status to a real estate investment trust (REIT) status, the company "reversed" its deferred tax liabilities that had accrued while it was a C corporation. The reversal of deferred tax liabilities produces a corresponding "deferred tax benefit" that is reflected in income from continuing operations.
An assumption implicit in an enterprise's statement of financial position is that the reported amounts of assets and liabilities will be recovered or settled, respectively. Thus, a difference between the tax basis of an asset and its reported amount will result in taxable or deductible amounts in some future year, when the reported amounts are recovered or settled. For example, the cost of an asset may have been deducted for tax purposes more rapidly than it was depreciated for financial reporting purposes.
Amounts received upon full recovery of the amount of the asset will exceed the remaining tax basis of the asset, and the excess will be taxable when the asset is recovered. This type of difference (between the reported amount of an asset and its tax basis) is referred to as a "temporary" difference. Temporary differences that will result in taxable amounts in future years when the asset is recovered are referred to as "taxable temporary differences."
Further, companies recognize a deferred tax liability for all taxable temporary differences. Indeed, Weyerhaeuser recorded a deferred tax liability to reflect the fact that the cost of its assets were deducted for tax purposes at a more rapid rate than such assets were depreciated for "book" purposes.
The accounting rules recognize that a company's tax status may change from nontaxable to taxable, or from taxable to nontaxable. In the latter instance, Paragraph 28 of FAS 109, Accounting for Income Taxes, provides that ". . .a deferred tax liability shall be eliminated at the date an enterprise ceases to be a taxable enterprise. . .the effect of eliminating the deferred tax liability shall be included in income from continuing
operations. . . ."
Weyerhaeuser has successfully converted to REIT status and, apparently, is taking the position that such conversion means it has ceased to be a taxable enterprise. However, the tax rules (specifically Regulation Section 1.337(d)-7) state that if property owned by a C corporation becomes the property of a REIT in a "conversion transaction," which is the case with Weyerhaeuser, then Section 1374 treatment will apply — unless the C corporation elects deemed sale treatment.
Under Section 1374, the REIT will be subject to tax on the "net built-in gain" in the converted property. That section imposes a corporate-level tax on a REIT's "net recognized built-in gain" during the "recognition period" (the 10-year period beginning on the first day of the first taxable year for which REIT status became effective). Recognized built-in gain, in turn, includes any gain recognized on the disposition of an asset during the recognition period.
In 2001 the Internal Revenue Service ruled that a REIT's income on the sale of wood products emanating from timber properties owned on the date of conversion is not considered recognized built-in gain (see Revenue Ruling 2001-50, 2001-2 C.B. 343). However, a disposal of the timber properties themselves within the recognition period would give rise to a recognized built-in gain, to which the provisions of Section 1374 would apply. Arguably, the Weyerhaeuser transformation from taxable status to nontaxable status will not be perfected until the recognition period expires some 10 years hence and, therefore, the elimination of the deferred tax liabilities could be seen as premature.
However, we would argue that Weyerhaeuser's actions were entirely appropriate. The company must have determined that the possibility of disposing its timber properties (as opposed to the wood products) is exceedingly remote. Therefore, in Weyerhaeuser's judgment, the possibility of its being subjected to the built-in gains tax is so negligible that it was disregarded. We believe there is room for judgment in determining whether a deferred tax liability will ripen into an actual liability, and endorse the action taken by Weyerhaeuser with respect to the write-off of its deferred tax liability.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.