Financial Reporting Implications of the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (“the Act”), signed by the President on December 22, 2017, has ushered in sweeping changes to the U.S. tax system. Certain changes in the new legislation will have an immediate impact on the income tax accounting of reporting entities, specifically those with calendar year ends and those with fiscal years that include the enactment date.
Particularly significant changes include a one-time tax on certain foreign earnings in the 2017 tax year (which historically have not been subject to U.S. income tax until being physically repatriated), and the permanently reduced corporate income tax rate of 21%.
Reporting entities will need to reflect these and other legislative changes when accounting for their income taxes in 2017 and beyond. In this article, we address select legislative changes and the impact we believe those changes will have on the income tax accounting of reporting entities subject to U.S. corporate income taxes.
Mandatory Deemed “Repatriation” in 2017
Under the new legislation, undistributed earnings of foreign subsidiaries and corporate joint ventures that were not previously subject to U.S. income taxes will be subject to the one-time tax in the 2017 tax year. This mandatory deemed “repatriation” of the undistributed earnings of foreign subsidiaries and corporate joint ventures will be a component of Subpart F-income in 2017 only. Accordingly, U.S.-based reporting entities will generally be required to include as taxable income their pro rata share of the post-1986 deferred foreign income of each of their foreign subsidiaries that had not been previously subject to U.S. taxation. This one-time tax will be calculated by applying an applicable tax rate1 to the greater of (1) the post-1986 deferred foreign income determined as of November 2, 2017, and (2) the accumulated post-1986 deferred foreign income determined as of December 31, 2017.
Prior to the Act, the United States imposed income taxes on the worldwide income of domestic reporting entities. However, U.S.-based reporting entities could defer taxation on certain foreign earnings if they were permanently reinvested in a foreign jurisdiction. Accordingly, a U.S.-based reporting entity could defer U.S. income taxation on foreign earnings until they were repatriated or brought back into the U.S. For income tax accounting purposes, domestic reporting entities were granted an exception to the recognition of current or deferred taxes on those un-repatriated foreign earnings that were permanently invested abroad2.
Reporting entities subject to this mandatory deemed “repatriation” will be required to recognize current tax expense on foreign income for which current or deferred taxes had not been previously recognized, to the extent the new legislation results in a tax liability on those foreign earnings. This could result in a significant current tax expense in the financial reporting period that includes the enactment date. Further, reporting entities with classified balance sheets will need to determine the appropriate balance sheet classification (i.e. current or noncurrent) of any resulting liabilities recognized for income taxes payable.
Impact on Reporting Entities: This one-time mandatory deemed “repatriation” could have a significant impact on a reporting entity’s current tax expense and liabilities (current or non-current depending on how the entity intends to pay the repatriation tax). In addition, reporting entities will evaluate whether they need to accrue tax expense for the tax implications in foreign jurisdictions associated with any physical repatriation of those foreign earnings (e.g. foreign withholding taxes).
Reporting entities should begin a discussion with their tax advisor to determine whether existing carryforwards (i.e., net operating losses and foreign tax credits) can be used to offset the one-time tax on foreign deferred income and, if so, how to appropriately maximize the benefits associated with those carryforwards. Reporting entities will also need to evaluate how this one-time tax will affect existing book and tax basis differences related to their investments in foreign subsidiaries. Accordingly, reporting entities will be required to determine whether any of the exceptions for recording deferred taxes under ASC 740-302 continue to apply.
New Corporate Income Tax Rate
The corporate income tax rate of 21% will be a flat rate for all corporations. Although this new tax rate will not take effect until 2018, it will have an impact on recognized deferred tax assets and deferred tax liabilities in the period that includes the enactment date of the Act3. In other words, all deferred tax assets and deferred tax liabilities must be re-measured using the enacted tax rate in effect at the time the related temporary differences are expected to reverse.
Impact on Reporting Entities: The re-measurement of deferred tax assets and deferred tax liabilities will be required as of the balance sheet date for the period that includes the enactment date (i.e., as of December 31, 2017 for calendar year reporting periods)4. For example, if a reporting entity expects to have a lower U.S. corporate income tax once this rate change takes effect, it would do the following as of December 31, 2017:
- Re-measure the deferred tax assets (DTA), including those related to NOL carryforwards. All else being equal, a lower rate would result in a lower gross DTA balance and a corresponding charge to income tax expense for the current period.
- Re-assess its valuation allowance against DTAs. This reassessment would result in a change in valuation allowances and a corresponding adjustment through income tax expense for the current period.
- Re-measure its deferred tax liabilities (DTLs). All else being equal, a lower rate would result in a lower DTL balance and a corresponding offset to income tax expense for the current period.
The above is an example and has been provided purely for illustrative purposes. It is not intended to encompass the accounting treatment for the full scope of possible temporary differences, nor does it address all considerations required when re-measuring deferred tax assets and deferred tax liabilities.
Financial Reporting Considerations for Public Business Entities
There may be situations in which an SEC filer is unable to obtain, prepare, or analyze information in reasonable detail to complete its income tax accounting under ASC 740 for certain income tax effects of the Act in time to meet SEC filing deadlines. The SEC staff has issued Staff Accounting Bulletin No. 118 (“SAB 118” or “SAB Topic 5EE”), expressing its views on how SEC filers should approach such situations.
The SEC staff has indicated that SEC filers should apply the guidance in ASC 740 regarding the income tax accounting for changes in enacted tax rates and laws3 to the legislative changes of the Act. However, the SEC acknowledged in SAB 118 that certain aspects of SEC filers’ income tax accounting may be incomplete when the financial statements for reporting periods that include the enactment date5 are issued. Specifically, the SEC staff views expressed in SAB 118 apply to situations where an SEC filer “does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete”6 its income tax accounting for certain income tax effects of the Act. The following is a brief summary of the “measurement period approach” expressed in SAB 118, which provides that a measurement period would effectively begin on the enactment date5 and would not extend beyond one year therefrom:
- The specific income tax effects of the Act for which accounting has been complete should be reflected in an SEC filer’s financial statements and would not be provisional.
- The specific income tax effects of the Act for which accounting is incomplete should be included at provisional amounts in an SEC filer’s financial statements, but only if a reasonable estimate of those effects can be made.
Impact on Reporting Entities: Adjustments to provisional amounts will be required in subsequent reporting periods. For example, adjustments would be made upon obtaining, preparing, or analyzing additional information about facts and circumstances that existed as of the enactment date that, if had been known, would have affected the income tax effects initially reported as provisional amounts7.
- The specific income tax effects of the Act for which accounting is incomplete and a reasonable estimate cannot be determined would not be reported at provisional amounts in an SEC filer’s financial statements. For such effects, SEC filers will continue to apply their income tax accounting based on the tax law in effect immediately prior to the enactment of the Act.
Impact on Reporting Entities: Provisional amounts would initially be recognized and reported in the first reporting period in which reasonable estimates thereof can be made. Such provisional amounts would subsequently be subject to adjustment during the measurement period.
In addition, SEC filers will need to consider the level of disclosure required in their SEC filings with respect to the Act. For example, in addition to required footnote disclosures, an SEC filer must evaluate whether and to what extent they should discuss the effect of the Act in Item 7 of their Form 10-K (Management’s Discussion and Analysis or “MD&A”). The one-time tax on deferred foreign income could have an impact on the liquidity of an SEC Filer that should be discussed within the Liquidity and Capital Resources section of the MD&A. SEC filers should also consider whether it is appropriate to discuss the current tax effects of the one-time tax on deferred foreign income, as well as the future impact of the new corporate tax rate on their blended effective tax rates, in the Results of Operations section of their MD&As.
US Territorial Tax System
Prior to the Act, the United States imposed income taxes on worldwide income. However, U.S.-based reporting entities could defer taxation on certain foreign earnings if they were permanently reinvested in that foreign jurisdiction. Subsequent to the one-time tax on foreign deferred income discussed above, the U.S. tax system will be territorial. In other words, certain foreign income will not be subject to U.S. income taxation even if it is repatriated to the US. The Act provides for a dividend exemption that applies to dividends paid by certain foreign corporations to a U.S. corporation, which would result in 100% of such dividend being exempt from U.S. federal income taxation.
Impact on Reporting Entities: While this change is significant, its impact will be generally small for those entities that elected to not record deferred income taxes because the earnings of the foreign corporation were deemed permanently reinvested. The shift to a modified territorial system of taxation may significantly alter the components of the effective tax rate due to the shift in how, and at what rates, earnings are taxed in foreign countries. Further, some reporting entities may experience a one-time increase in their effective tax rates in the 2017 tax year as the result of the mandatory deemed repatriation and the potential foreign tax impact of physically repatriating earnings from foreign jurisdictions.
Changes Impacting Net Operating Losses
Under the Act, NOL carrybacks have generally been eliminated. However, NOLs can be carried forward indefinitely. These changes apply to NOLs generated after December 31, 2017. In addition, the NOL deduction in any given tax year cannot exceed 80% of that year’s taxable income.
Impact on Reporting Entities: Reporting entities will need to assess how these changes to NOL tax rules will impact their valuation allowances. We do not believe that the introduction of an indefinite NOL carryforward will eliminate the potential need for a valuation allowance against a deferred tax asset for an NOL carryforward. When assessing whether such a valuation allowance is required, reporting entities will continue to be required to determine whether they will be able to utilize their NOL carryforwards. We believe that recurring U.S. GAAP net losses will continue to be the primary threshold when performing such an evaluation.
The following is a list of some additional items reporting entities should consider. This list is comprised of income tax accounting considerations, as well as additional legislative changes.
- The Act includes provisions that broaden the tax base by eliminating or reducing certain deductions, exclusions and credits. For example, the number of individuals to which the $1 million compensation deduction cap applies has been expanded.
- The corporate alternative minimum tax has been eliminated.
- There is a new tax on certain intangible foreign income (a “minimum tax”) and a new base erosion anti-abuse tax (BEAT) that subjects certain payments made by a U.S. company to a related foreign company to additional taxes.
- Foreign tax credits will continue to be allowed to offset taxes paid by overseas branches to a foreign tax jurisdiction. However, foreign tax credits and deductions have been eliminated for taxes paid or accrued, including withholding taxes, for amounts to which the new 100% exemption for the foreign source portion of dividends applies.
- There is a limit on the amount that may be deducted for net interest expense.
- Businesses can immediately deduct the cost of new investments in certain qualified depreciable assets made after September 27, 2017. This provision will begin to phase out in 2023.
- There are recently issued FASB staff Q&As and a proposed FASB Accounting Standards Update.
1 Post-1986 deferred foreign income held in the form of cash or cash equivalents will be subject to tax at a rate of 15.5%. All other forms of post-1986 deferred foreign income will be subject to tax at a rate of 8%.
2 Refer to ASC 740-30-25 regarding the treatment of the permanently reinvested undistributed earnings of subsidiaries and corporate joint ventures and the treatment of outside basis differences for foreign subsidiaries and corporate joint ventures.
3Under ASC 740-10-35, deferred tax assets and liabilities must be adjusted for changes in tax laws and/or rates at the time such changes are enacted. As a consequence of this, valuation allowances on deferred tax assets must also be reevaluated at the time such changes are enacted.
4 See ASC 740-10-35.
5 The enactment date of the Act was December 22, 2017.
7 Excerpted from SAB 118
For further guidance in adopting the changes explained above, please contact Robert Hilbert, Managing Partner – Assurance, at 646-601-7843, or email@example.com, or Matthew Derba, Senior Manager, at 646-601-7828 or firstname.lastname@example.org.
For a detailed summary of the Tax Cuts and Jobs Act and the latest developments related to the new legislation, click here. To learn more about CohnReznick’s Accounting and Assurance practice, visit our webpage.
This has been prepared for informational purposes, is general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without first obtaining professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
Visit Our Tax Reform Resource Center
On Demand Webinar: Financial Reporting Implications of the Tax Cuts and Jobs Act