Shifting from one uncertain position to another, companies are facing a subtle but important change in how they must explain the effects of tax reform to their investors.
When it was signed into law in late December 2017, the Tax Cuts and Jobs Act produced the biggest change in tax rules that companies have seen since the 1980s. A drop in the corporate tax rate from 35 percent to 21 percent coupled with a huge shift in the approach to taxing foreign earnings produced an enormous learning curve for companies.
They had much to learn, and little time to do so. Under GAAP, companies are required to report the expected effect of tax legislation in the period the law is enacted. That gave companies only a handful of business days to absorb the massive change and explain it in their regulatory filings with the Securities and Exchange Commission.
The SEC swooped in with Staff Accounting Bulletin No. 118 to extend preparers some relief on how to report the expected effects to investors in their next filings. SAB 118 created a one-year “measurement period,” giving companies a year to learn the act and digest any regulatory guidance that would follow so they could explain to investors how the company’s financial statements would be affected.
Under SAB 118, companies were required to disclose what they could as they assessed their circumstances and updated their disclosures each quarter. Now that guidance is expiring, and SEC staff members are referring companies to Accounting Standards Codification Topic 740, guidance originally issued as Financial Interpretation No. 48 on reporting uncertain tax positions in financial statements.
At a recent financial reporting conference, SEC Deputy Chief Accountant Sagar Teotia said the staff realizes companies may still face some uncertainties about various significant aspects of the new rules. “We have confidence that ASC 740 will be appropriate for that,” he said.
The shift from SAB 118 to ASC 740 puts a little more onus on companies to say more about how they’ll be affected. Under SAB 118, companies could say they had no idea, if that was true. Under ASC 740, they have to establish some kind of best estimate.
“The biggest thing SAB 118 allowed companies to do last year-end was to say if we just can’t make an estimate, then we’ll disclose we can’t make an estimate,” says Angela Evans, a partner at EY. “The ASC 740 framework says you can’t just ignore the new tax law. Now you can no longer defer. You have to make reasonable estimates.”
Those reasonable estimates will be subject to year-end audit scrutiny, says Mark Winiarski, a shareholder at audit firm Mayer Hoffman McCann. Under SAB 118, companies could change their estimates one quarter to the next as new information became available to them. Under ASC 740, a change in estimate could be evaluated by auditors for whether it’s an update based on new information or a misstatement requiring correction. “If you take a position that’s not reasonable, it could be an error,” he says.
While companies are certainly in a better position at the end of 2018 to understand the effects of tax reform than they were at the end of 2017, there are still plenty of questions, says Evans. The U.S. Treasury is not expected to finalize guidance until the middle of 2019. “There’s still a lot of uncertainty about how to account for the tax reform package and the related regulations going forward,” she says.
Adam Lehmann, tax risk and advisory partner at Grant Thornton, says the “hit list” of the most significant uncertain items includes four major issues: limitations on the deductibility of interest; the rules around global intangible low-taxed income, or GILTI; the base erosion and anti-abuse tax, or BEAT; and the taxation of foreign-derived intangible income, or FDII. Companies have some proposed guidance that at least signals directionally how the rules around interest deductibility and GILTI are going to work, he says.
As for BEAT and FDII: “Those are still in a situation where we have a lot of uncertainty and no proposed regulations,” says Lehmann. Despite that, companies will have to do some conjecture and make their best guess under ASC 740, and then document that to the satisfaction of auditors.
And they’ll need to remeasure their deferred tax assets and deferred tax liabilities accordingly. Those are balance sheet line items that capture timing differences between when companies realize tax benefits or liabilities for book purposes compared with tax purposes. “The need for scheduling out deferred tax assets and deferred tax liabilities has never been more important,” says Lehmann.
The original legislative language also contains what appears to tax professionals to be plain errors, producing requirements that defy logic or the apparent intention of the tax reform measure, says Lehmann. As an example, a provision around leasehold improvements and bonus depreciation leaves companies that should have expected a 100 percent bonus deprecation instead facing 39 years of managing a depreciation schedule.
“That’s one of the worst possible answers for someone planning around tax and capital expenditures,” says Lehmann. “That’s well known as an item that seems like an error or at least an oversight of the original law.”
Still without a technical correction, companies are left to interpret the language of the statute and report under ASC 740 accordingly, says Lehmann. A similar conundrum exists over the extent to which net operating losses can be carried back into prior periods or carried forward into future periods, offsetting tax liability. “We have to interpret the law as written for reporting purposes,” he says. “To the extent it gets changed in subsequent periods, you could correct or true up the provision.”
Preparers should set aside any anxiety over how reporting may look under ASC 740 and simply tell their story, says Jo Anna Fellon, a partner at accounting firm Friedman. Companies fretted a great deal, perhaps unnecessarily, about the effect of the original FIN 48, now ASC 740, when it was issued, she said.
“Everyone was worried about sharing that information, whether it would bring down net income or show additional liability,” says Fellon. “Now that we’ve gotten comfortable with it, it’s typically the last footnote in the 10-K, and nobody reads it.”
Preparers should expect to deal with reporting uncertainty well into 2019, says Michael Williams, a partner and national practice leader on ASC 740 at BDO USA. Treasury and the Internal Revenue Service are expected to issue more guidance, and state tax authorities are likely waiting to see how things resolve at the federal level before taking measures of their own, he says.
“My sense is this is going to be here for a while,” says Williams.