Tax valuation allowance fundamentals

Video Apr 24, 2017

Assessing a valuation allowance on deferred tax assets? Watch now for the basics. PwC’s Scott Allender shares the fundamentals on the model along with his perspectives on what to look out for. This includes topics such as: assessing positive and negative evidence, income in a carryback period, future reversal of temporary differences, projections of future income, tax planning strategies, and more.

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This video is part of The quarter close publication and video perspectives series.

Transcript

Hi, I’m Scott Allender.

While the guidance around deferred tax asset valuation allowances hasn’t changed much in the last 25 years, the extent of judgment required means that it continues to be an area of focus, where a few reminders can always be helpful. In this video, I’ll walk through the model for deferred tax asset valuation allowance assessments, including the consideration of positive and negative evidence in forming a conclusion.

The recognition of a valuation allowance against a company’s deferred tax assets is required when the weight of all available evidence leads you to conclude that it’s “more-likely-than-not” that the deferred tax asset will not be realized. This assessment is subjective and requires significant judgment to evaluate all available positive and negative evidence. It’s important to remember that the assessment needs to be done by jurisdiction, and judgments should be re-assessed each reporting period. It’s difficult to avoid a valuation allowance when there are cumulative losses in recent years. While not a bright line, cumulative pretax losses for the most recent 3 years is a common starting point when evaluating negative evidence. The thought here is that three years is typically long enough to not be overly influenced by one-time events, yet recent enough to support projections of future results.

When evaluating positive evidence, there are four sources of income that can support the realization of deferred tax assets. We have:
● Income in a carryback period,
● the future reversal of taxable temporary differences or DTL’s,
● tax planning strategies, and
● projections of future income.

All four sources must be considered. While the model is an “all available evidence” model, the weight given to positive and negative evidence should be commensurate with the extent to which it can be objectively verified.

Typically, income in a carryback period and the reversal of taxable temporary differences are going to be given the most weight of the four sources of income. Income in a carryback period is already known and is therefore objectively verifiable. Similar, the reversal of DTLs is often very predictable. For example, if the DTL is related to the amortization of an intangible assets, it’s easy to predict the pattern of reversal. That said, not all DTLs can support DTAs. For example, DTLs from indefinite-lived intangibles or goodwill, often referred to as naked credits, aren't recovered in the normal course and cannot be used to support most DTAs. Keep in mind that even DTAs that don't expire need to be supported. When you have an unlimited carryforward period, some may assume that the company will eventually be profitable and as such, no valuation allowance is necessary. But when considering recent and consistent losses, compared to a future potential for profit, it may be difficult to overcome that negative evidence, even with a carryforward period that doesn’t expire.

Tax planning strategies and projections of future income are based on assumptions and estimates, and therefore more subjective. A tax planning strategy is an action an entity might not normally take, but would take solely to prevent an attribute from expiring unrealized. The strategy needs to be both prudent and feasible. In order for a strategy to be prudent, it has to be economical to the Company and provide some level of cash tax savings. For example, it may be feasible to shift income from a zero tax rate jurisdiction to another jurisdiction with a full valuation allowance, meaning that management has the intent and ability to implement the strategy. But such a shift would provide no net benefit, so would not be prudent, and as such cannot be used as a valid tax planning strategy.

Let’s now look at projections of future income. Just because a projection of income is more subjective, doesn’t mean that there can’t be objectively verifiable evidence to support it. For example, if a company plans to extinguish debt, and the removal of that interest expense burden will make an entity profitable, projections that exclude the impact of the interest expense are reasonable and verifiable. A common pitfall in this area is not assessing both the positive and negative impacts of projected events. For example, if a company sold a business, the projections need to reflect both the reduced costs as well as the reduced earnings. Projections can also have some higher levels of assumptions and estimates involved. When that’s the case, assessing the reliability of the information is key. I tend to look to see if the forecasts are consistent with those used in impairment testing, or perhaps those provided to the board. Doing a lookback assessment to see how reliable prior projections were can also be helpful.

Given the level of judgment, it’s important to take your time, gather all the relevant facts and sources of evidence on a jurisdiction by jurisdiction basis, and be sure your evidence is supportable. As in all areas of significant judgment, your thought process and conclusions should be well documented, and related disclosures should be transparent.

For more information on this topic, please refer to chapter 5 of our Income tax accounting guide, available on CFOdirect.com.

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