Essentials of taxation 2016 cengage chapter 03

• While the financial statements show book income before tax of $25 million, the reported Federal tax expense is only $7.7 million.. Book-Tax Differences• Significant differences may ex

Essentials of Taxation

Chapter 3

Taxes on the Financial

Statements

The Big Picture (slide 1 of 2)

• Raymond Jones, the CEO of Arctic Corporation, would like

some help reconciling the income tax expense on Arctic’s

financial statements with the income tax reported on the

company’s corporate income tax return

– Mr Jones doesn’t understand why he can’t simply multiply the

financial statement income by the company’s 35% marginal tax rate to get the financial tax expense.

• While the financial statements show book income before tax

of $25 million, the reported Federal tax expense is only $7.7 million

• In addition, the corporate tax return reports taxable income of

$19 million and Federal income taxes payable of only $6.65 million ($6.65 million X 35%)

The Big Picture (slide 2 of 2)

company’s financial statements, does Arctic’s situation look reasonable?

to $8.75 million ($25 million X 35%)?

between the taxes shown on the financial

statements and the taxes due on the tax return?

Book-Tax Differences

• Significant differences may exist between a corp.'s

Federal income tax liability reported on Form 1120

(tax) and the corp.’s income tax expense on financial

statements (book)

– Differences are caused by any or all of the following:

• Differences in reporting entities included in the calculation

• Different definition of taxes included in the income tax expense

amount

• Different accounting methods

Different Reporting Entities

(slide 1 of 2)

consolidate all U.S and foreign subsidiaries

when the parent corporation has > 50%

ownership

– For 20% to 50% ownership, parent uses the equity

method to account for earnings of sub

– For < 20% ownership, use the cost method to

account for income from these investments

Different Reporting Entities

(slide 2 of 2)

– U.S corporation may elect to include any domestic

subsidiaries that are 80% or more owned in its

consolidated U.S tax return

• The income of foreign subsidiaries and < 80% owned

domestic subsidiaries is not included in consolidated tax return

The Big Picture – Example 1

Different Reporting Entities

• Return to the facts of The Big Picture on p 3-1.

• Arctic Corporation owns the following:

– 100% of Gator, Inc., a domestic corporation;

– 100% of Hurricane, Ltd., a foreign corporation; and

– 40% of Beach, Inc., a domestic corporation

• Arctic’s combined financial statement includes its own net

income and the net income of both Gator and Hurricane

– In addition, Arctic’s financial statement includes its 40% share of

Beach’s net income

• Arctic’s financial statement includes the income of these

subsidiaries regardless of whether Arctic receives any actual profit distributions from its subsidiaries

The Big Picture – Example 2

Different Reporting Entities

• Return to the facts of The Big Picture on p 3-1 and also assume the facts

presented in Example 1

• If Arctic elects to include Gator as part of its consolidated

Federal income tax return, Arctic’s return includes its own

taxable income and the taxable income generated by Gator

– Hurricane’s taxable income is not included in the consolidated return

because it is a non-U.S corporation

– Beach, although a domestic corporation, cannot be consolidated with

Arctic because Arctic owns only 40% of the stock

• Income from Hurricane and Beach will be included in Arctic’s

U.S taxable income only when Arctic receives actual or

constructive dividends

Different Taxes

• For book purposes, income tax expense includes:

– Federal, state, local, and foreign income taxes

– Both current and deferred tax expense amounts

• For tax purposes:

– Amount is based on the U.S corporation’s taxable income

– State income taxes are reported on the Federal tax return,

but as deductions in arriving at taxable income

The Big Picture – Example 3

Different Taxes

• Return to the facts of The Big Picture on p 3-1 and also assume the facts

presented in Example 1

• For book purposes, Arctic, Gator, and Hurricane

combine their income and expenses into a single

financial statement.

– The book tax expense for the year includes all Federal,

state, local, and foreign income taxes paid or accrued by these three corporations

– In addition, the book tax expense amount includes any

future Federal, state, local, or foreign income tax expenses (or tax savings) on income reported in the current income statement

The Big Picture – Example 4

• The tax expense reported on the Form 1120 is only

the U.S Federal income tax expense for the

consolidated taxable income of Arctic and Gator.

– This tax expense does not include the income taxes that

Arctic and its subsidiaries paid to state, local, or foreign governments

Different Methods

(slide 1 of 4)

accounting methods

– Some are temporary differences

• Income and expenses appear in both the financial

statement and tax return, but in different periods

– Others are permanent differences

• Items appear in financial statement or tax return, but not

both

Different Methods

(slide 2 of 4)

– Depreciation on fixed assets

• MACRS used for tax, straight-line for book

– Compensation-related expenses where, under

GAAP, corps must accrue future expenses related

to certain postretirement benefits

• Only deductible for tax purposes when paid

– Accrued income and expenses such as warranty

expenses

• Accrued for book purposes, but are not deductible for

tax purposes until incurred

Different Methods

(slide 3 of 4)

(cont’d):

– Net operating losses incurred in one year for book

purposes may be used as a deduction for tax

purposes in a different year

– Certain intangible assets such as goodwill are not

amortizable for book purposes, but for tax

purposes, intangibles are amortized over 15 years

Different Methods

(slide 4 of 4)

• Examples of permanent differences include:

– Nontaxable income such as municipal bond interest, which

is income for book purposes but is not taxable

– Nondeductible expenses such as 50% of meals &

entertainment expense and certain penalties that are not

deductible for tax purposes but are expensed in arriving at

book income

– Tax credits such as the research activities credit which

reduce the Federal income tax liability but have no

corresponding book treatment

Schedule M–1

(slide 1 of 2)

• Used to reconcile book income to taxable income

– Contains positive and negative adjustments for both

temporary and permanent differences

• Schedule M–3 is required for a consolidated tax group with total

year-end assets ≥ $10 million

– Income tax note of the financial statements also contains a

tax reconciliation, but the purpose and content of this

reconciliation are quite different

• Schedule M-1 or M-3 is typically the starting point

for IRS audits of corporations

– Identifies large differences between book and taxable

income which may offer the IRS auditor insights into tax

saving strategies

Schedule M–1

(slide 2 of 2)

Uncertain Tax Positions (slide 1 of 2)

return positions they have taken that may not

be fully supported by the law

– Schedule UTP (“uncertain tax positions”) is added

to the Form 1120 for all corporations with assets of

at least $10 million

Uncertain Tax Positions (slide 2 of 2)

• Disclosures on the Schedule UTP include tax return

positions for the current and prior tax years where the

taxpayer or a related party

– Recorded a reserve against the Federal income tax expense

on its audited financial statements, and

– Did not record a tax reserve based on its analysis of

expected litigation

• This means that in the taxpayer’s view, the probability of settling

the item with the IRS < 50%, and

• The taxpayer determines that it is more likely than not ( > 50%

likelihood) to prevail on the merits of the issue in litigation

GAAP Principles (slide 1 of 5)

109) is made up of both current and deferred

components

– Current tax expense theoretically represents the

taxes actually payable to (or refund receivable

from) the government

– Deferred tax expense or deferred tax benefit

represents the future tax cost (or savings)

connected with income reported in the

current-period financial statement

• Created as a result of temporary differences

GAAP Principles (slide 2 of 5)

approach to measuring deferred taxes

– Under this approach, the deferred tax expense or

benefit is the change from one year to the next in

the net deferred tax liability or deferred tax asset

tax liability related to current income

(measured using enacted tax rates and rules)

GAAP Principles (slide 3 of 5)

following situations:

– An expense is deductible for tax in the current

period but is not deductible for book until some

future period

– Income is includible currently for book purposes

but is not includible in taxable income until a

future period

GAAP Principles (slide 4 of 5)

benefit related to current book income

(measured using enacted tax rates and rules)

– A deferred tax asset is created in the following

situations:

• An expense is deductible for book in the current period

but is not deductible for tax until some future period

• Income is includible in taxable income currently but is

not includible in book income until a future period

GAAP Principles (slide 5 of 5)

on the balance sheet

– Deferred tax liabilities represent an amount that

may be paid to the government in the future

• In essence, an interest-free loan from the govt with a

due date perhaps many years in the future

– Deferred tax assets are future tax benefits

• Similar to a receivable from the government that may

not be received until many years in the future

Deferred Tax Asset Example

(slide 1 of 3)

• MollCo, Inc., earns net income before warranty

expense of $400,000 in 2014 and $450,000 in 2015.

• In 2014, MollCo deducts $30,000 in warranty

expense for book purposes related to expected

warranty repairs

– This warranty expense is not deductible for tax purposes

until actually incurred

• Assume that the $30,000 warranty expense is paid in

2015 and that this is MollCo’s only temporary

difference.

Deferred Tax Asset Example

(slide 2 of 3)

Deferred Tax Asset Example

(slide 3 of 3)

Valuation Allowance

(slide 1 of 2)

assets are recognized only when it is probable

that the future tax benefits will be realized

– When the more likely than not threshold is not

met, a valuation allowance (a contra-asset account) must be created to offset all or a portion of the

deferred tax asset

Valuation Allowance

(slide 2 of 2)

• To determine if a valuation allowance is required,

both positive and negative evidence must be evaluated

– Examples of negative evidence include:

• History of losses

• Expected future losses

• Short carryback/carryforward periods

• History of tax credits expiring unused– Examples of positive evidence include:

• Strong earnings history

• Existing contracts

• Unrealized appreciation in assets

• Sales backlog of profitable orders

The Big Picture – Example 13

Releasing Valuation Allowance (slide 1 of 2)

• Return to the facts of The Big Picture on p 3-1

asset for an NOL carryforward is offset by a $1 million valuation allowance, due to doubts

over the levels of future sales and profitability

The Big Picture – Example 13

Releasing Valuation Allowance (slide 2 of 2)

• But this year, Arctic completed improvements to its

inventory management system

– This is likely to increase contribution margins of every

product it sells

• Two of Arctic’s largest customers have secured

financing that will relieve the financial difficulties

that have restricted them

– Arctic just received purchase orders from those customers

that will increase unit sales by 20% over the next 18

months

• As a result, Arctic’s auditors now support a release of

$200,000 of the valuation allowance in the current

quarter.

Tax Disclosures in the Financial Statements

(slide 1 of 5)

– Temporary differences create deferred tax

liabilities or deferred tax assets

• These amounts appear in the corporation’s balance

• If not related to any asset, then the classification is

based on the expected reversal period

Tax Disclosures in the Financial Statements

(slide 2 of 5)

– A corporation may have both deferred tax assets

and liabilities, current and noncurrent

• The corporation reports the net current deferred tax

assets or liabilities and the net noncurrent deferred tax

assets or liabilities

The Big Picture – Example 15

Balance Sheet Reporting

• Return to the facts of The Big Picture on p 3-1

• Arctic Corporation holds the following deferred tax asset and liability accounts for the current year.

Noncurrent deferred tax liabilities 28,000

• On its balance sheet, Arctic reports:

– A $22,000 current net deferred tax liability

• $72,000 - $50,000, and – A $65,000 noncurrent net deferred tax asset

• $93,000 - $28,000.

Tax Disclosures in the Financial Statements

– Tax expense must be allocated to:

• Income from continuing ops

• Discontinued ops

• Extraordinary items

• Prior-period adjustments, and

• The cumulative effect of accounting changes

– Additional disclosures are required for some of these items

Tax Disclosures in the Financial Statements

(slide 4 of 5)

• Financial Statement Footnotes – the income tax note

contains the following info:

– Breakdown of income between domestic and foreign

– Detailed analysis of provision for income tax expense

– Detailed analysis of deferred tax assets and liabilities

– Effective tax rate reconciliation (dollar amount or

percentage)

– Information on use of ASC 740-30 (APB 23) for the

earnings of foreign subsidiaries

– Discussion of significant tax matters

Tax Disclosures in the Financial Statements

(slide 5 of 5)

– Demonstrates how a corporation’s actual book

effective tax rate relates to its “hypothetical tax

rate” as if the book income were taxed at a rate of

35%

– Similar to Schedule M–1 or M–3, but only reports

differences triggered by permanent differences

• Can provide substantial clues as to tax planning

strategies adopted (or not adopted) by a company

Calculating Corporate

Income Tax Expense

Financial Accounting for Tax Uncertainties

(slide 1 of 4)

tax returns that may not ultimately survive IRS scrutiny

– Companies may book a reserve (or “cushion”) for

these uncertain tax positions

• That is, rather than book the entire tax benefit (and thus

reduce tax expense in the current year), the company may book only a portion (or none) of the tax benefit

Financial Accounting for Tax Uncertainties

(slide 2 of 4)

upon audit, the additional tax imposed is

charged against the reserve (or “cushion”)

– The additional tax does not affect the future-year

tax expense

in the future (or the company successfully

defends any challenge), the reserve can be

released

Financial Accounting for Tax Uncertainties

(slide 3 of 4)

freely used the tax reserve as a “cookie jar” to

shift earnings from one period to another

– To add more structure to the accounting for tax

reserves, the FASB released ASC 740-10 (FIN 48),

“Accounting for Uncertainty in Income Taxes”

– FIN 48 results in significantly more disclosure

about uncertain tax positions by companies