About a month ago one of my colleagues wrote a blog post “COVID-19: Top 5 Accounting Issues and Resources”. He included impairment of non-financial assets, impairment of financial assets, fair value measurements, contingencies, and restructuring as his top 5 issues. While I thought this was a worthy endeavor and I respect his choices, I must admit I was a bit disappointed by the post. You see, he had not included my favorite accounting topic, accounting for income taxes under ASC 740! I realize it was a tall order to pick only five out of the numerous accounting and financial reporting considerations resulting from the pandemic. I also realize that maybe talking about COVID-19 and income taxes in the same post might not be a crowd pleaser, but somebody has to do it! And I guess that somebody is me. So, here we go, let’s talk a little bit about the impact that COVID-19 is having on the accounting for income taxes and the considerations that should be made.

Realizability of deferred tax assets

ASC 740 requires deferred tax assets to be reduced by a valuation allowance for any portion not expected to be realized. Realization of deferred tax assets requires sufficient taxable income of the appropriate character within the carryback and/or carryforward period available under the tax law. The standard sites four possible sources of taxable income.

In addition to the sources, ASC 740 goes on to state that all available evidence, both positive and negative, must be considered in determining whether a valuation allowance is needed. Information about the current year and prior years is supplemented by currently available information about future years. However, sometimes current and historical information may not be as relevant, for example, if there has been a significant, recent change in circumstances. The economic effect that the COVID-19 pandemic is having on many companies may cause historical and even current information to not be as relevant, thus requiring additional analysis and consideration of (revised) future forecasts. Be aware that the guidance also states that “forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence…”  It provides the following examples of negative evidence:

1. Cumulative losses in recent years
2. A history of operating loss of tax credit carryforwards expiring unused
3. Losses expected in early future years (by a presently profitable entity)
4. Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years
5. Brief carryback or carryforward period(s)

Unfortunately, many currently profitable entities are beginning to expect future losses due to the economic impacts of the pandemic. It is important to note that the “weight” of this piece of negative evidence is the same as cumulative losses in recent years. Any piece of negative evidence can be difficult to overcome and often results in a valuation allowance being recognized.

Indefinite reinvestment of foreign earnings

One of the few exceptions to deferred tax recognition outlined in ASC 740 is for an excess of the financial reporting basis over the tax basis of an investment in a foreign subsidiary that is essentially permanent in duration. In order to be “essentially permanent in duration” an entity must have sufficient evidence that the subsidiary has invested or will invest the undistributed earnings indefinitely, meaning that the remittance of the earnings to the parent will be postponed indefinitely.

It is important for entities to continually reassess the evidence they have to support the assertion that the earnings are reinvested indefinitely. The current and future economic outlook, along with the specific liquidity needs of the entity should be considered, among other items. The rapid changes as a result of the pandemic will likely require companies to reassess whether they continue to have sufficient evidence to continue to support the assertion. If they find that they no long have sufficient evidence, appropriate adjustments must be made to record the income tax effects.

Effects of tax law changes

The CARES Act, enacted on March 27, 2020, included many provisions to assist companies and individuals during the pandemic. A lot of attention has been given to the stimulus aspects of the Act, but it also made some temporary changes to the income tax code:

So, what are the accounting impacts from these changes? ASC 740 requires that the effects from any changes in tax laws or rates be recorded in the period of enactment. For calendar year end companies, that was the quarter ended March 31, 2020 since the legislation was enacted on March 27. Also, it is important to remember that all effects from the changes are recorded as current tax expense or benefit for the year, regardless of how or where the affected balances were originally recorded. No backwards tracing is allowed!

In addition to recording the effects of the changes in the income tax code, there may be other considerations that need to be made. For example, these changes may have an impact on an entity’s assessment of the need for a valuation allowance on deferred tax assets.

Summary

This post highlights some of the impacts that the COVID-19 pandemic may have on the accounting for income taxes. There are others, such as numerous interim reporting considerations. For more information on income tax considerations, as well as other accounting issues resulting from the pandemic, check out EY’s Technical Line: Accounting and reporting considerations for the effects of the coronavirus outbreak.

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