Changes in Accounting for Income Taxes as a Result of the CARES Act
March 31, 2020
On Friday, March 27, 2020, the President signed the Coronavirus Aid, Relief, and Economic Security (CARES Act) into law. It contains certain Federal income tax provisions that offer relief to corporate taxpayers, and those changes will have an impact on accounting for income taxes for annual as well as interim financial reporting.
SC&H’s Key Takeaways
- Companies carrying back an NOL from tax years 2018-2020 to a pre-2018 tax year should expect to record a tax benefit for financial reporting purposes to recognize the recovery of taxes at a higher rate than the rate at which the NOL was generated
- Carryover AMT credits should be classified as current taxes receivable; they are fully refundable in 2019
- When a 2018-2020 NOL is carried back to a year in which AMT credits are used to offset the company’s regular tax liability, the AMT credit becomes refundable
- The 50% IRC §163(j) business interest limitation can give rise to an NOL in 2019 or 2020, and if carried back against pre-2018 taxable income, a tax benefit is recorded for financial reporting purposes
- Consider making use of the special election to use 2019 adjusted taxable income for purposes of the 2020 IRC §163(j) business interest limitation
- For companies scheduling out their deferred tax liabilities and assets while analyzing the need for a valuation allowance, the provisions of the CARES Act should be incorporated and likely will result in a more favorable fact pattern with fewer deferred tax assets available (e.g., NOL’s are carried back and IRC §163(j) business interest limitation is smaller)
- The impact is recorded in income from continuing operations for the period that includes the enactment date, Q1, for most publicly traded companies. Private companies will disclose as a subsequent event in financial statements with a period ending before the Act was enacted and reflect a return to provision adjustment in the following period’s financial statements.
Accounting for Income Taxes is governed by ASC 740, which provides specific direction regarding changes in tax law and tax rates, which is applied to each of the CARES Act provisions as applicable. With respect to understanding the correct measurement of deferred tax assets and liabilities, we have the following guidance:
ASC 740-10-30-2 tells us that “The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated.”
Additionally, ASC 740-10-35-4 indicates that “Deferred tax liabilities and assets shall be adjusted for the effect of a change in tax laws or rates. A change in tax laws or rates may also require a reevaluation of a valuation allowance for deferred tax assets.”
Finally, ASC 740-10-45-15 tells us that “When deferred tax accounts are adjusted as required by paragraph 740-10-35-4 for the effect of a change in tax laws or rates, the effect shall be included in income from continuing operations for the period that includes the enactment date.”
Net Operating Losses
The CARES Act of 2020 allows net operating losses (NOL’s) generated in tax years beginning after December 31, 2017, and before January 1, 2021, to be carried back five years. There is no limitation involved (whereas previously under the TCJA of 2017, only 80% of taxable income could be offset by NOL), so the full amount of NOL can be utilized to offset prior year taxable income. As referenced above, deferred tax liabilities and assets are adjusted to reflect the effects of the changes in tax laws as of the date of enactment, with the related impact of any such adjustment reflected in income from continuing operations during the interim period that includes the enactment date.
It is therefore expected that if a taxpayer has determined that NOL’s arising in tax years 2018 – 2020 will be carried back to a pre-2018 tax year, the company will recognize a tax benefit in its financial statements. This is a result of recognizing a tax refund receivable related to the pre-2018 year at a higher rate (e.g., 35%), while the NOL it is carrying back is reversing at a lower rate of 21%. The benefit would be recorded in the period in which the enacted date of the CARES Act of 2020 falls, which for most taxpayers will be the first quarter of 2020. For those taxpayers who have not yet reported their financial statements for a period that ends before the enactment date of the CARES Act, we would anticipate disclosure of Management’s evaluation of the effects of the CARES Act as a subsequent event.
Alternative Minimum Tax
The corporate alternative minimum tax (AMT) was repealed as part of the TCJA of 2017, and 50% of any remaining credit carryover available that was not used to offset regular tax became refundable in the years 2018-2020; in 2021 100% of the remaining credit was to become refundable. The CARES Act permits any available AMT credits to become refundable in full in 2019. The impact to the financial statements would be a reclassification of the remaining deferred tax asset to current taxes receivable.
Taxpayers who offset their regular tax liability with AMT credits in tax years beginning after December 31, 2017, might have an opportunity to claim a tax refund by carrying back 2019 NOL to offset earlier taxable income and reduce or eliminate their regular tax liability.
IRC §163(j) Limitation on Deductible Business Interest Expense
One of the very impactful provisions of the TCJA of 2017 was the limitation of net business interest expense to 30% of adjusted taxable income. The CARES Act of 2020 temporarily raises the 30% limitation to a more favorable 50% limitation for tax years beginning in 2019 and 2020. This may have a current impact on taxable income not just by reducing the taxpayer’s current tax liability but also by potentially generating a current NOL that can be carried back to a pre-2018 tax year, thereby benefiting from the financial statement tax benefit referenced above.
Additionally, an election is available under the CARES Act for taxpayers to use their adjusted taxable income in 2019 to compute their net business interest expense limitation in 2020 (short tax years would be pro-rated). With the expectation that many businesses will likely experience a decline in 2020, the use of the company’s 2019 adjusted taxable income allows taxpayers to use the higher income base from 2019 that would provide a greater interest expense deduction.
ASC 740-10-30-18 identifies four sources of taxable income that may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards. The first and most significant is “Taxable income in prior carryback years if carryback is permitted under the relevant tax law.” Since the CARES Act of 2020 temporarily reinstates the ability of corporate taxpayers to carry back NOL’s, this source of taxable income has become vital once again when weighing positive and negative evidence in consideration of the need for a valuation allowance.
In addition, taxpayers who have scheduled out the reversal of their deferred tax assets and liabilities should recognize the impact of the CARES Act, specifically with respect to the carryback utilization of NOL and the reduced amount of IRC §163(j) business interest. This will likely leave the taxpayer with fewer deferred tax assets, making this Act favorable from a valuation allowance perspective.
As indicated above, due to the fact that the law was not enacted until March 27, 2020, financial statements for the periods ending before that date would not be impacted with the exception of subsequent event disclosure. For private companies, we would anticipate any changes to be reflected as return to provision adjustments in the following period’s financial statements. For publicly traded companies, we would expect the financial statements, including the date of enactment, to contain the impact of the Act, which for most taxpayers is the first quarter of 2020.
SC&H Group’s Tax team continues to keep a close watch on updates as they take place. If you have any questions on how these provisions apply to your organization, please Contact Us, or to your third party administrator on your qualified plan.