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Impact of Tax Reform on Financial Statements & Tax Rates

Impact of Tax Reform on Financial Statements & Tax Rates
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The House Ways and Means Committee has released the House Republican’s version of a tax reform bill which would be called “The Tax Cut and Jobs Act” and, along with the recent passing of the budget by both the Senate and the House, the prospects for tax reform are becoming ever closer to reality. Congressional leaders had promised passage before the end of the year, or very early next year.

This tax reform could have significant impacts on public-company financial statements and companies must account for these changes in the fiscal quarter that a new law is signed by the President.

There is a high possibility this legislation could be enacted in Q4 of 2017, or in the first quarter of 2018. Therefore, companies should begin to consider how tax reform could affect their financial statements and overall effective tax rates (“ETR”). If your company has not started considering the tax accounting implications of tax reform, now is the time so that management and boards know what to expect.

The Ways and Means Committee legislation includes six major proposals that could have a significant impact on corporations and their financial statements. Although the final bill may have many differences from this initial draft, analyzing the tax accounting impacts of the following provisions is a good start.

  1. The corporate tax rate would be reduced to 20%.
  2. There would be immediate expensing of capital investments.
  3. Interest deductions would be limited to 30% of “adjusted taxable income”1 with a five-year carryforward for disallowed interest,2 and the $1 million limitation on certain officer’s compensation would be expanded.
  4. Net operating losses carried forward will be limited to 90% of taxable income starting in 2018. No carrybacks allowed.3
  5. Un-repatriated foreign earnings would be taxed (12% for earnings invested in cash and cash equivalents and 5% for other earnings).
  6. Introduction of participation exemption system for foreign income.

Following are each the six major changes listed above followed by tax accounting considerations for each proposal and some examples.

1) A flat 20% corporate tax rate (reduced from 35%) is proposed

  • A company will need to re-measure all of their deferred tax assets (“DTA”) and deferred tax liabilities (“DTL”). This impact will be recognized in the income statement in the interim period that includes date of enactment. Companies in a net deferred tax asset position will recognize a tax expense in the quarter of passage while companies in a net deferred tax liability position will recognize a tax benefit — all affecting the overall ETR of the company.
  • For interim periods, companies are generally required to use a forecasted annual ETR. Companies will need to recalculate their estimated annual ETR for future interim tax provisions taking into account all of the provisions of the new law. If the law is enacted in a company’s second or third quarter, special attention will have to be paid to the catch-up from the previous quarters.
  • Consider the impact of the tax rate change on any previously booked uncertain tax provisions.

Example A

A company has the following deferred tax asset and liability. The impact of the rate change will be computed as follows.

DEFERRED TAX LIABILITY

GROSS AMOUNT

TAX RATE

NET AMOUNT

DIFFERENCE

Accelerated tax depreciation over book

(10,000,000)

35%

$(3,500,000)

New rate

20%

$(2,000,000)

$(1,500,000)

DEFERRED TAX ASSET

Net operating loss (“NOL”)

12,0000,000

35%

$4,200,000

New rate

20%

$2,400,000

$1,800,000

Total rate change effect

$300,000

The company will recognize a charge within corporate income tax expense of $300,000 (reduction in the net deferred tax asset from $700,000 to $400,000), which will have a negative effect on the overall ETR.

2) Immediate expensing of capital assets (excluding land & buildings)

  • Immediate expensing of capital assets could create net operating losses. Companies may need to evaluate whether new or current deferred tax assets are realizable.
  • Immediate expensing may also create taxable temporary differences which may be considered a source of income for purposes of assessing realizability of deferred tax assets.
  • Consider state tax conformity rules and whether new deferred taxes will be required for federal and state depreciation differences.

3) Interest limitation and other base broadening measures

  • Consider impact to annual forecasted ETR from items such as:
  • Unfavorable impact from limitation of interest expense, from the inclusion of performance-based compensation in the $1 million limitation on officer’s compensation, and from repeal of Section 199 domestic production deduction.
  • Favorable impacts for exempt foreign dividends received.
  • Consider whether a valuation allowance will be required for deferred tax asset established for disallowed interest expense carryforward.
  • Consider impact on realizability of deferred tax assets from an increase of taxable income.

4) Net operating loss carryforward limitation

  • Consider the impact of the 90% taxable income limitation on valuation allowance measurements of NOL deferred tax assets.

5) Tax on un-repatriated foreign earnings

  • Does the company have the earnings and profits (“E&P”) of foreign subsidiaries properly calculated in order to determine the potential tax (if not already previously provided for in the financial statements)?
  • Some amount of foreign tax credits will be available to offset the mandatory repatriation tax. Will a valuation allowance be required for a portion of a company’s foreign tax credits carryforwards?
  • Consider the impact on valuation allowance tax planning strategies that are currently in place.
  • Consider the impact on current APB 23 permanent reinvestment assertions.
  • Consider impact on deferred tax liabilities booked for un-repatriated foreign earnings. Can some part of these deferred tax liabilities be reversed into income?

Example B

A company has $50,000,000 of un-repatriated non-cash invested E&P that is permanently reinvested offshore. Accordingly, a deferred tax liability was not established for the potential tax liability on a repatriation of these earnings. The proposed law includes a deemed repatriation of non-cash E&P at a 5% tax rate, payable in eight annual equal installments.

The Company would incur a $2,500,000 Corporate Tax Expense and it will record a short-term liability of $312,500 and a long-term liability of $2,187,500. Obviously, this will increase the company’s overall ETR.

A note of caution is necessary. Since many companies have avoided the recognition of this potential liability by asserting a policy of permanent reinvestment of their foreign earnings, they may not have the proper documentation to support this tax computation.

Example C

Some companies may recognize a benefit from this change. If a company has recorded a deferred tax liability on its un-repatriated E&P at a rate that is in excess of the deemed repatriation rate, then the reduction in this liability will create a tax benefit and a decrease in overall ETR.

A company is operating in a foreign jurisdiction that imposes a 20% tax rate and plans to repatriate the E&P. The cumulative E&P is $10,000,000 and the potential foreign tax credit is $2,000,000. If the dollars are repatriated today, the company will incur a $1,500,000 U.S. tax liability ($10,000,000 of income at 35% less the $2,000,000 foreign tax credit) and a deferred tax liability has been established for that amount. If the deemed repatriation rate is set at 5%, the liability would decrease to $500,0004 and the company would recognize a $1,000,000 benefit in its corporate income tax expense line.

6) Participation exemption system for foreign income

  • Consider possible decreases to the annual forecasted ETR from having earnings of 10%-owned foreign subsidiaries permanently excluded from U.S. taxation.
  • Consider possible increases to ETR from “foreign high returns” provision which, taken very simplistically, will tax certain foreign earnings that are subject to low or no foreign tax.
  • Consider possible increases to ETR from new excise tax on certain payments to related foreign corporations.
  • Consider possible increases to ETR from new net interest expense limitation of companies that are members of an “international financial reporting group.”

Summary

The ultimate impact that the law will have on a company’s tax provision, overall ETR and disclosures will probably have to wait until the law is passed. However, once the law is passed, companies may not have much time to incorporate these changes into their annual or interim tax provision. Currently companies should be anticipating how the changes will affect their financial statements through modeling and preparing for certain changes such as quantifying foreign E&P. Planning ahead is critical.

1 Adjusted taxable income is taxable income without regard to business interest expense, business interest income, net operating losses, depreciation, amortization, and depletion.

2 Businesses with average gross receipts of less than $25 million would be exempt from this interest disallowance (i.e., small businesses will still be allowed an interest deduction).

3 NOL carryforwards will be increased by an interest factor. Small businesses will be allowed a one-year carryback.

4 For the sake of simplicity, this amount excludes any benefit from foreign tax credits. However, it is expected that some proportionate amount of foreign tax credits will be available to offset a portion of the un-repatriated earnings tax.

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