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The U.S. Tax Code seems to encourage the exercise of judgment when it comes to the accrual of deferred taxes.
Robert Willens, CFO.com | US
April 19, 2011
CFOs working for companies investing in joint ventures and other investments employing the equity method of accounting would do well to take a look at how their company accrues taxes for the purposes of reporting such investments. Are taxes accruing at too high a rate?
If they are, the company's earnings are penalized, and CFOs may want to rethink their policy. In fact, they may want to adopt the approach Southern Union employed, according to its February 25 10-K.
SU, a gas company, has an equity-method investment in Citrus Corp., owning 50% of Citrus's outstanding stock. SU's partner in the venture, El Paso Corp., owns the remaining 50% of Citrus's stock.
The equity method of accounting is generally used by corporations that invest in other corporations and have an investment of 20% or more of the voting stock of the corporation; the original investment is recorded at the investor's cost. That original investment is then adjusted periodically to recognize the investor's proportionate share of the corporation's earnings or losses. Dividends received by the investor reduce the basis of its investment.
In SU's case, as in others, the equity-method investment produces taxable temporary differences for which deferred tax liabilities must be recorded. But SU did not accrue such taxes at the maximum statutory 35% rate. Instead, it accrued taxes at a lower rate that is imposed on intercorporate dividends.
SU provides the following reasoning for its position: ". . .due to the anticipated increase in dividends from Citrus. . .the company [SU] expects the entire deferred tax liability related to its investment in Citrus will be realized at the company's statutory income tax rate less the dividends received deduction. . . ." (The italics are mine.)
Thus it appears that, stemming from the intercorporate dividends-received deduction, SU accrued deferred taxes on its investment in Citrus at only a 7% rate. The reason is that Section 243 of the Internal Revenue Code states that such companies will get a deduction of 80% of the amount received as dividends from a 20% or more owned corporation. Thus the effective tax rate imposed on SU's dividend income is 7%, since 20% of the dividend was taxed at the 35% rate.
The SU case is just another example of the role judgment can play in accounting for income taxes. SU is predicting that it will "realize" its investment in Citrus primarily through the extraction of dividends, and this prediction informs the amount of its deferred tax accruals. Other enterprises might adopt a more conservative approach and accrue deferred taxes on their investments at the statutory rate. It seems that either is allowed by the tax code, which appears to encourage the exercise of judgment when it comes to the accrual of deferred taxes.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.