In the wake of COVID-19, on March 27, 2020, Congress passed and the President signed into law the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) which included significant changes to U.S. federal income tax law. Corporations subject to U.S. federal income tax should give consideration to how these aspects of the CARES Act may impact their provision for income taxes reported in interim and annual financial statements. Following are some key considerations which should be evaluated when measuring deferred tax accounts and determining income tax expense.
Accounting Standards Codification 740, Income Taxes (ASC 740) requires the effect of changes in income tax laws (or rates) on deferred tax assets and liabilities to be recorded in continuing operations in the period which includes the date of enactment (i.e., March 27, 2020 in the case of the CARES Act). For interim financial reporting purposes, the tax effects would be recognized during the period of enactment (e.g., the first quarter of 2020 for calendar year-end companies) and not allocated to subsequent interim periods through adjustments to the estimated annual effective tax rate.
As a result, the tax effect of these changes should not be recognized in the December 31, 2019 financial statements of calendar year-end companies. However, if the effects are expected to be material, companies should consider whether they require subsequent event disclosure under ASC 855.
The following discusses certain changes in the CARES Act with potential to impact companies:
Net operating losses
- The CARES Act has temporarily restored the ability to carryback net operating losses (NOL) originating in 2018, 2019 and 2020 to offset taxable income in the five preceding years. This creates the opportunity to recognize a current benefit for losses that would otherwise have been carried forward.
- If the company intends to elect out of the carryback or there is no historical taxable income to offset, companies should continue to record any NOLs generated as a deferred tax asset. Consistent with the Tax Cuts and Jobs Act (TCJA), losses continue to be carried forward indefinitely.
- The CARES Act included the elimination of the 80% taxable income NOL limitation for the 2018, 2019 and 2020 tax years. The limitation will be reinstated for tax years beginning in 2021. For companies that limited the utilization of 2018 NOLs on their 2019 financial statements, there may be a balance sheet reclassification between deferred taxes and taxes receivable required in the interim period that includes the enactment date.
- Carryback claims should consider impacts to Alternative Minimum Tax (AMT), domestic production activities deduction, foreign tax credits, uncertain tax positions, etc. in the tax years to which NOLs are carried back.
- Calendar year taxpayers with NOLs originating in 2018 and 2019 which were initially measured at the current corporate income tax rate of 21% may now be carried back to offset taxable income that was taxed at pre-TCJA tax rates of up to 35%. Taxpayers that expect to carryback these NOLs should record the benefit expected to be received as an increase to income taxes income taxes receivable (or a reduction of income taxes payable). Any benefit received at a rate other than 21% will have an impact on the company’s effective tax rate.
- The CARES Act provided a technical correction for fiscal year taxpayers where the TCJA intended to prohibit NOL carrybacks and apply the 80% limitation on offsets to taxable income to tax years beginning after December 31, 2017, however the TCJA statutory language applied to taxable years ending after December 31, 2017. The technical correction in the CARES Act allows for a two year carryback with no taxable income limitation. Carryback claims or an election to waive the carryback for affected years can be made within 120 days of enactment. Consideration should be given to any need for balance sheet reclassification between deferred tax assets and income taxes receivable.
- For taxpayers with international operations, carrying back NOLs to any repatriation (Sec. 965) year may introduce further complexities in determining the net benefit to be realized from the carryback. Consideration should be given to the impact on the company’s prior Sec. 965 calculations and the availability of election to exclude Sec. 965 years from the carryback period. In addition, companies that are paying a Sec. 965 liability in annual installments may be limited in their ability to receive a refund resulting from a carryback claim until their transition tax installment payments have been made. Consideration should be given as to the current versus noncurrent balance sheet classification for any anticipated income tax receivable.
Interest expense limitation
- The CARES Act increases the 30% adjusted taxable income net interest expense deduction limitation to 50% for tax years beginning January 1, 2019 and 2020, although taxpayers may elect not to apply this increased limitation. Taxpayers have the option to make an election in 2020 to use 2019 adjusted taxable income increasing the eligible interest expense deduction in 2020. The 2020 interest expense deduction will be included in the current year provision. For interim tax provisions, the 2019 interest expense will be a discrete item in the period of enactment. For taxpayers that reported an interest limitation on their 2019 financial statements, a balance sheet reclassification between deferred taxes and taxes payable may be required in the interim period that includes in the enactment date.
- The IRS has subsequently issued guidance pertaining to the CARES Act to allow taxpayers to revoke a previous election under Sec. 163(j)(7) real property trade or business election for a 2018, 2019, or 2020 taxable year by filing an amended Federal income tax return. Under Sec. 163(j)(7)(B), a real property trade or business may elect out of the Sec. 163(j) business interest expense deduction limitation. The tradeoff is that the taxpayer must use the alternative depreciation system (ADS) for nonresidential real property, residential real property, and qualified improvement property (QIP). Consideration should be given to any remeasurement of deferred tax balance sheet accounts relating to fixed assets resulting from these depreciation changes.
Alternative Minimum Credits
- The CARES Act allows AMT credits to be refunded in their entirety beginning in 2019 instead of over a period of future years. The TCJA previously didn’t allow the credits to be fully refundable until 2021. Remaining credits should be included in the current year income tax receivable and reclassified from noncurrent balance sheet accounts. Taxpayers may elect to make the credits fully refundable for tax years beginning in 2018.
- NOL carrybacks and other amendments to prior tax returns may result in changes to the AMT liability in such prior years. Consideration should be given to this impact as well as to any correlative impacts to AMT credit refunds.
- For cash contributions made during the 2020 tax year, the CARES Act temporarily increases limitation on deductions from 10% to 25% of income. Similarly, for qualified contributions of food inventory made during 2020, the limitation on deductions is increased from 15% to 25% of income. Companies should consider these increased limitations when determining the deductibility of current-year charitable contributions.
Qualified improvement property
- The CARES Act included the long awaited technical correction to classify qualified improvement property as having a 15-year recovery period that is eligible for bonus depreciation. This change is retroactive to 2018. Taxpayers may amend their 2018 tax return or file an automatic change of accounting method to include the bonus depreciation on their 2019 income tax returns.
- Companies electing to change their method of accounting or amend prior tax returns should record the financial statement impact as a discrete item in the interim period in which the CARES Act was enacted. These impacts could include changes to deferred tax liabilities for fixed assets, deferred tax assets for NOLs and other items that result from limitations based on taxable income.
Paycheck Protection Program (PPP)
- The CARES Act authorizes loans to small businesses via the Small Business Administration (SBA) to provide short-term cash flow for payroll and other operating expenses. If program requirements are met some or all of the loan may be forgiven. The forgiveness of debt is excluded from income for tax purposes. As of the writing of this article, it is not clear whether the GAAP treatment of this forgiveness will be to record income to the income statement or treat as a capital contribution (i.e., treating the forgiveness as a government grant). Careful attention should be paid to the GAAP treatment to determine whether a permanent book-tax difference should be shown when calculating the tax provision. It is also unclear for tax purposes, whether expenses paid with PPP loan funds that are forgiven will be deductible for federal income tax purposes.
Payroll tax deferral
- The CARES Act permits some companies, particularly those that are not receiving loan forgiveness under the PPP, to defer paying certain 2020 federal payroll taxes to 2021 and 2022 (50% deferral to each year). In that economic performance with respect to these payroll taxes will not occur until later years, the resulting accrued liabilities will not be deductible until such later year. Companies should consider this item as a temporary difference and record a deferred tax asset.
- ASC 740 requires companies to assess all evidence, both positive and negative, when evaluating the realizability of deferred tax assets. A valuation allowance must be established for deferred tax assets if it is “more-likely-than-not” that all or a portion of the deferred tax assets will not be realized. ASC 740 provides four sources of taxable income to consider when determining if the benefit should be realized for deferred tax assets:
– taxable income in prior carryback year(s) if carryback is permitted under the tax law;
– future reversal of existing taxable temporary differences;
– future taxable income exclusive of reversing temporary differences and carryforwards;
– tax planning strategies.
- With changes under the CARES Act for utilization of NOLs, increased interest expense limitation, etc. companies should review the necessary tax law changes and the ability to realize deferred tax assets ultimately resulting in a recording or release of a valuation allowance. Companies should evaluate all available positive and negative evidence that impact each of the four sources of income, noting that enhanced financial modeling may be required in some instances. (However, if sufficient positive evidence of income arising from one source exists, it may not be necessary to evaluate other sources.)
- In addition to considering changes arising in law (e.g., availability of NOL carrybacks and changes to interest limitations), companies should reevaluate future income forecasts, particularly in light of current economic conditions.
- Changes in judgment of valuation allowance with respect to future income is recorded as a discrete item in the interim quarter.
Non U.S. federal income tax law changes
- Various taxing authorities (e.g., state, local and foreign) may have made or may be considering modifications to their laws that don’t necessarily correlate to U.S. federal tax law changes. Companies will need to monitor and take into account changes in each relevant jurisdiction and make appropriate adjustments to their deferred taxes in the period of enactment, as well as consider impact to current and future tax provision calculations.
- The company should give consideration to changes to their projected annual effective tax rate for the current year used in calculating interim tax provisions, including the impact of changes to forecasted income/loss and the ability of the company to recognize the benefit of any losses forecasted for the current year.
- The company should be cautious in situations where year to date losses exceeds forecasted losses for the year.
In evaluating the potential impacts of the CARES Act, including the availability of elections, carryback claims, amended returns, etc., companies should be certain to consider all available information when recording changes to deferred taxes and their provision for income taxes. While changes in estimates can generally be recorded in the tax provisions of subsequent periods, errors resulting from incorrect or incomplete analyses introduce a risk of financial statement errors.