Does tax reform mean tax risk for companies with deferred positions?

Broad expectations of tax reform are prompting tax experts to ponder whether companies should be disclosing new risks to investors, especially companies that might be facing a hit to earnings.

With a Republican-controlled Congress and a new administration in the White House, capital markets are demonstrating a strong expectation of corporate tax reform, including reduced corporate income tax rates. Deloitte’s survey of corporate chief financial officers in the fourth quarter of 2016 says two-third of CFOs expect corporate tax rates to fall, and three-fourths expect some change in rules that will make it more attractive for companies to repatriate any foreign earnings they are holding offshore.

While a reduction in rates might sound like positive news for cash flow, it could also mean a reduction in net income for companies that are carrying big deferred tax assets on their balance sheets, a line item auditors like to scrutinize. At the same time, it could produce an earnings windfall for companies carrying deferred tax liabilities. A recent securities blog called the prospect of tax reform to upend current deferred tax positions a “sleeper issue” for companies to face.

Deferred tax assets and deferred tax liabilities are booked on corporate balance sheets as a result of timing differences between tax rules and accounting rules. Depreciation rules, for example, are different under tax rules than accounting rules, says Jim Hedderman, managing director at tax firm True Partners Consulting. U.S. GAAP might allow a company to depreciate a particular piece of equipment over 10 years, while tax rules might allow depreciation over a much shorter period of time.

“In year one, you’re going to depreciate more for tax purposes than in financial statements,” says Hedderman. “That’s going to generate a timing difference,” which gives rise to a deferred tax liability in financial statements.

Tax rules also allow companies that experience net operating losses to deduct those losses against gains in prior or future tax periods. For financial statement purposes, that means companies can book an asset on their balance sheet representing the net operating loss that can be used at some point in the future to offset taxes that will be due. Tax credits allowed under tax law can be treated similarly, booked as assets to be used in future periods as tax rules permit.

The numbers booked for DTAs and DTLs are revisited in subsequent financial statement periods as companies re-measure the value of those assets and reconsider the extent to which they might be useful. Credits and net operating losses, for example, can expire, so companies must continually assess whether they are holding their value in subsequent periods or must be marked down.

Likewise, companies must re-measure the value of DTAs or DTLs if tax rates change. If a company books a DTA, for example, based on a corporate tax rate of 35 percent, that DTA will be worth much less if the rate is reduced to 20 percent. “These assets can be huge on balance sheets,” says Hedderman. “In general, the more material the deferred tax assets become on balance sheets, the more transparent you want to be with investors.

“In year one, you’re going to depreciate more for tax purposes than in financial statements. That’s going to generate a timing difference.”

Jim Hedderman, Managing Director, True Partners Consulting

Under current U.S. GAAP, companies would not re-measure the value of deferred tax assets or liabilities based on a projection of tax reform, says Al Cappelloni, a tax partner at audit firm RMS. “You don’t account for those until the period in which any law is enacted,” he says. “There’s certainly no basis for any hard accounting, and I don’t expect companies to disclose very much in financials.”

KPMG’s Ashby Corum, partner in charge of the accounting for income taxes group in the national tax practice, concurs on the GAAP requirements. “We wouldn’t expect companies to adjust the amount of their deferred tax assets or liabilities, or the amount of any related valuation allowances, prior to the interim period that any tax reform legislation is signed into law,” he says.

Should tax reform become a reality, companies will have a great deal to re-measure and disclose, says Joe Russo, a tax partner with audit firm BDO USA, and it could begin as early as the first or second quarter of 2017. “Whenever something comes through and is signed into law by the president, you’re going to see significant changes and revaluations to deferred assets and liabilities based on whatever the newly enacted rates are going to be,” he says.

For companies carrying deferred assets, that means an expense to earnings because of lower tax rates, says Russo. “For companies sitting in a deferred tax liability situation, they’re going to see benefits,” he says. “We’re going to see effective income tax rates coming in all over the board.”

DEFERRED TAXES UNDER TRUMP

Below is an excerpt from the Securities Law Exchange blog by Jay Knight: “Sleeper Issue? Deferred Tax Assets under a Trump Administration.”
Yogi Berra is often attributed with saying, “It’s difficult to make predictions, especially about the future.” This is especially true with predictions about revisions to the tax code.  However, many observers now believe a reduction in the corporate tax rate is a realistic possibility as a result of the combination of a new Trump administration and a Republican-controlled Congress. According to www.donaldjtrump.com, “The Trump Plan will lower the business tax rate from 35 percent to 15 percent, and eliminate the corporate alternative minimum tax.” In light of these dynamics, a potential sleeper issue for many companies, especially those carrying sizeable deferred tax assets on the balance sheet, is a potential charge to earnings resulting from the remeasuring of deferred tax assets due to a change in the corporate income tax rate.
At a high level, deferred tax assets are reported as assets on the balance sheet and represent the decrease in taxes expected to be paid in the future because of net operating loss (NOL) and tax credit carryforwards and because of future reversals of temporary differences in the bases of assets and liabilities as measured by enacted tax laws and their bases as reported in the financial statements. NOL and tax credit carryforwards result in reductions to future tax liabilities, and many of these attributes can expire if not utilized within certain periods. If a company believes it is more likely than not that some portion or all of the deferred tax asset will not be realized, a valuation allowance must be recognized. By way of example of the charge that can result from a reduction in corporate income tax rates, the disclosure below is from the earnings release of a large financial institution when the U.K. enacted reduced corporate income tax rates in 2013:
“Income tax expense for the third quarter of 2013 was $2.3 billion on $4.8 billion of pretax income. This includes a charge of $1.1 billion for remeasuring certain deferred tax assets due to the U.K. corporate income tax rate reduction of 3 percent enacted in July 2013. In the year-ago quarter, the company reported income tax expense of $770 million on $1.1 billion of pretax income. This included a $0.8 billion charge for remeasuring certain deferred tax assets due to the enacted U.K. corporate income tax rate reduction of 2 percent.”
Therefore, companies with sizeable deferred tax assets should consider analyzing the potential impact that could result if corporate income tax rates are reduced, including discussing these potential impacts with tax and independent auditors.  If the potential impacts are significant, management should consider bringing these issues to its audit committee so that they are fully informed of the possible financial statement impacts of any corporate income tax reduction, as well as revisit their SEC disclosures to ensure the risks are adequately disclosed.
Source: Securities Law Exchange

Ahead of any actual change in tax law, companies should be taking a hard look at their deferred tax positions and considering whether perhaps disclosures are warranted in management discussion and analysis or in their discussion of risk factors, says Dean Jorgensen, national partner-in-charge in the tax area at Grant Thornton. Many companies already provide somewhat boilerplate disclosures about tax risk, but if the expectation of tax reform is so great and the potential impact to a given company is significant, maybe something more specific is in order, he says.

“The Securities and Exchange Commission would want companies to disclose if it is a material risk to financial statements,” says Jorgensen. “If it’s a downward adjustment, as a best practice, those companies would want to disclose that in MD&A.”

Jorgensen also advises profitable companies to follow conventional wisdom from a tax planning standpoint, accelerating deductions and deferring income to the extent possible to increase the benefit that might arise from a reduced tax rate. That opportunity, however, depends on how a company’s fiscal year-end aligns with tax reporting.

Companies that might consider disclosures about tax risk should look beyond the prospect of reduced rates as well, tax experts advise. The potential for repatriation relief, for example, might incentivize companies to revisit their investment strategy with respect to foreign earnings. The SEC has signaled it will be watching those disclosures for consistency. Any income tax credits companies might be banking on might also be at play in tax reform, carrying further implications for the effect on deferred assets or liabilities.

“You can’t record the effects of pending legislation, but we’re advising companies to be aware of it and to look at tax planning or what can be done in the meantime,” says Jorgensen.