If either of the tax bills put forth by House or Senate Republicans passes in its current form, both public-company and private-company financial statements could be significantly impacted. And that impact could come soon, as companies would have to implement the changes the law stipulates during the fiscal quarter in which it was enacted.
CFOs should consider now how tax reform could affect their financial statements and overall effective tax rates (ETR) ahead of its possible enactment in late 2017 or early 2018. There are five major proposals to consider:
- Reduction of corporate tax rate to 20%
- Immediate expensing of capital investments
- Interest deductions limited to 30% of “adjusted taxable income.” Also, the $1 million deduction limitation on certain officers’ compensation is expanded
- In the House bill, un-repatriated foreign earnings taxed at 14% for earnings invested in cash and cash equivalents, and 7% for other earnings (a somewhat different calculation in the Senate bill)
- Introduction of participation exemption system for foreign income
Here are the tax accounting considerations for each of these five proposals.
- Corporate tax rate drops from 35% to 20%
- Re-measure all deferred tax assets (DTAs) and deferred tax liabilities (DTLs). Recognize the impact in the income statement for the period that includes the enactment date. Companies in a net DTA position will recognize a tax expense in the period of enactment; companies in a net DTL position will recognize a tax benefit. All of this will affect the company’s overall ETR. Scheduling of timing differences may be necessary if the rate reduction is scheduled to occur in a future year, as the Senate bill proposes.
- For interim periods, companies generally use a forecasted annual ETR. Companies will need to recalculate estimated annual ETR for future interim tax provisions, considering all of the new law’s provisions. If the law is enacted in a company’s Q2 or Q3, examine the previous quarters’ catch-up.
- Consider the impact of the tax-rate change on previously booked uncertain tax positions.
This company has the indicated DTA and DTL. The rate change will impact as follows:
|DTL||GROSS AMOUNT||TAX RATE||NET AMOUNT||DIFFERENCE|
|Accelerated tax depreciation over book||$(10,000,000)||35%||$(3,500,000)|
|Net operating loss (NOL)||$12,000,000||35%||$4,200,000|
|Total rate change effect||$300,000|
The company will recognize a charge within income tax expense of $300,000 (net DTA drops from $700,000 to $400,000), negatively impacting overall ETR.
- Immediate expensing of capital assets (excluding land and buildings)
- This could create net operating losses. Evaluate whether new or current DTAs are realizable.
- It could also create taxable temporary differences that may be considered an income source for assessing DTA realizability.
Consider state tax conformity rules and whether new deferred taxes are needed for federal and state depreciation differences.
- Interest limitation and other base-broadening measures
- Consider: the impact to annual forecasted ETR from the interest expense limitation; inclusion of performance-based compensation in the $1 million limitation on officer compensation; and repeal of the Section 199 domestic production deduction.
- Determine if a valuation allowance will be required for DTA established for disallowed interest expense carryforward (five-year carryforward under the House proposal and indefinite carryforward under the Senate bill).
- Calculate the impact on DTA realizability from an increase of taxable income.
- Tax on un-repatriated foreign earnings
- Does the company maintain the foreign earnings and profits (E&P) calculations to determine the potential tax (if not previously provided for in the financial statements)?
- Some amount of foreign tax credits may be available to offset the mandatory repatriation tax. Will you need a valuation allowance for part of a company’s foreign tax credit carryforwards?
- What are the impacts on current valuation allowance tax planning strategies and APB 23 permanent reinvestment assertions?
- Can any deferred tax liabilities booked for un-repatriated foreign earnings be reversed into income?
A company has $50,000,000 of un-repatriated non-cash invested E&P that is permanently reinvested offshore. A DTL was not established for the potential tax liability on a repatriation of these earnings. A deemed repatriation of non-cash E&P at a 7% tax rate, payable in eight annual equal installments, is proposed.
The company would incur a $3.5 million federal corporate tax expense, and it would record a short-term liability of $437,500 and a long-term liability of $3,062,500, increasing the company’s overall ETR.
If a company has recorded a DTL on its un-repatriated E&P at a rate exceeding the deemed repatriation rate, then the liability reduction will create a tax benefit and decrease overall ETR.
The company is operating in a foreign jurisdiction that imposes a 20% tax rate and plans to repatriate the E&P. The cumulative E&P is $10 million and potential foreign tax credit is $2 million. If the dollars are repatriated today, the company will incur a $1.5 million federal tax liability ($10 million of income at 35% less the $2 million foreign tax credit), and a DTL has been established for that amount. If the repatriation rate is 7%, the liability would decrease to $700,000 (excluding any foreign tax credit benefits that would be allowed) and the company would recognize an $800,000 benefit in its income tax provision.
- Participation exemption system for foreign income
- Possible decreases to the annual forecasted ETR from having earnings of 10%-owned foreign subsidiaries permanently excluded from U.S. taxation
- Possible increases to ETR from the “foreign high returns” provision, which will tax certain foreign earnings subject to low or no foreign tax, and new interest expense limitation for companies that are members of an “international financial reporting group.”
If and when tax reform similar to what’s in either of the current House bill becomes the law of the land, CFOs may have little time to update their annual or interim tax provision. Take the time now to examine how the proposed changes could affect your financial statements through modeling — by, for example, quantifying foreign E&P — and adjust accordingly.