What Calendar Year Filers Need to Know About ASC 740-270 in Q1

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With the first quarter of 2024 closed, calendar year filers are preparing for their first quarter income tax provision and financial statement interim reviews by their auditors. Below we will highlight reporting considerations to keep in mind.

Applying the Estimated Annual Effective Tax Rate (EAETR)

Each quarter, taxpayers calculate their expected annual income tax rate using their annual forecasted pre-tax book income or loss from continuing operations and applying expected permanent tax adjustments and expected temporary differences in determining expected annual taxable income.

The EAETR is then applied to the year-to-date pre-tax book income or loss from continuing operations in determining tax expense for the interim period before discrete items.

Where the EAETR computation includes expected temporary differences, the taxpayer may compute both a current EAETR and deferred EAETR applied to year-to-date pre-tax book income or loss for computing current and deferred tax expense or benefit for the interim period in rolling its current and deferred tax balance sheet accounts from prior year-end to the close of the interim period. Any tax-effected discrete items would be incorporated to calculate the total tax expense and effective tax rate for the period.

What Qualifies as Tax-Effected Discrete Item?

Taxpayers are required to evaluate discrete items each quarterly reporting period and incorporate them into the total tax expense for the period. Discrete items are defined as significant unusual or infrequently occurring items, which may require analysis of the facts and circumstances, as well as the company’s history of similar transactions.

Examples of discrete items include, but are not limited to:

  • Certain changes in valuation allowance
  • Statute of limitations expirations
  • Uncertain tax positions
  • Tax rate changes
  • Windfalls or shortfalls related to share-based compensation

To the extent there is a change in the valuation allowance on deferred tax assets (DTA) that existed at the prior year-end, the impact would be incorporated in the current period as a discrete item.

If there is a change to a valuation allowance related to temporary differences created in the current year, it would be included in the EAETR.

If a statute of limitations expired in a particular jurisdiction, the impact to the associated ASC 740-10 Accounting for Uncertainty in Income Taxes reserve would run through the current period as a discrete item.

Changes in tax, interest or penalty related to an uncertain tax position for a prior period are posted in the current period as a discrete item.

The effect of jurisdictional tax rate changes on deferred tax assets or liabilities are included as a discrete item in the quarter of enactment.

Net windfall or shortfall on certain share-based compensation is treated as a discrete item in the quarter the vesting or exercise event occurs. To the extent the ultimate tax deduction exceeded the deduction for financial statement purposes, a windfall is recorded in the period the compensation became deductible for tax as a discrete item. Conversely, if the tax-deductible compensation was less than the deduction for financial statement purposes, a shortfall would be recorded in the period as a discrete item.

Tax Law Changes

Some changes are taking effect and some potential changes are in the works.

Tax Relief for American Families and Workers Act

House of Representatives (HR) Bill 7024, the Tax Relief Act of 2024, passed the House of Representatives January 31, 2024, by a margin of 357–70. The bill is currently before the Senate.

The Senate Finance Committee Chair, Ron Wyden of Oregon, previously set a deadline to pass by April 15, 2024, the end of the tax filing season, however it remains uncertain whether the Senate will meet this deadline.

If it passes, the changes will impact corporate taxpayers. It would delay the capitalization requirements of domestic research and experimentation (R&E) costs to 2026. The current proposal is retroactive, and costs capitalized in 2022 could be recovered in one of the following ways:

  • Amend 2022 income tax returns to reverse the capitalization of domestic R&E costs
  • Take a balloon deduction of unamortized 2022 capitalized domestic R&E costs on 2023 income tax returns
  • Allow the 2022 costs to amortize over the remaining 5-year amortization period and deduct, rather than capitalize, R&E costs incurred in 2023 through 2025

Additionally, HR 7024 includes provisions to revert the 30% interest expense limitation to be calculated on taxable income before interest, depreciation, and amortization rather than taxable income before interest, effective through 2025, and extends 100% bonus depreciation to 2025. Current law allows for 80% bonus depreciation on assets placed in service in 2023, 60% in 2024, and 40% in 2025.

The impacts of a tax law change are reflected in the income tax provision of the quarter in which enacted.

However, HR 7024 may still impact Q1 income tax provisions if the bill is enacted after the quarter ends, but before the quarter’s financial statements are issued, as companies must consider any impacts to valuation allowances in their quarterly financial statements issued after enactment as well as disclose any expected material impacts of the legislation.

Changes to Limits on Executive Compensation

The American Rescue Plan Act (ARPA), passed in 2021, expanded the number of covered employees under Internal Revenue Code (IRC) Section 162(m) to include the CEO, CFO, and the next eight highest-paid employees, an increase from the CEO, CFO and next three highest paid. The number of covered employees may exceed 10 individuals due to the once-covered-always-covered rule added by the Tax Cuts and Jobs Act, but that rule doesn’t extend to the additional five covered employees added under ARPA.

This expanded rule is generally effective for compensation paid after 2026 including deferred compensation that was earned by the employee prior to 2027.

As 2027 approaches, companies will need to consider monitoring stock-based compensation DTA balances to determine whether amounts should be limited where the ultimate deduction of these amounts is likely to be limited. The impacts of Section 162(m) on DTAs create a rate impact and may need to be considered in calculating the company’s EAETR during the interim provision if material.

Factors which may impact the timing of consideration include the length of vesting and cancellation periods, types of stock-based compensation issue, and a company’s accounting policy in applying the Section 162(m) limit to cash or stock compensation first.

We’re Here to Help

If you have questions or need help applying any of this new guidance to your Q1 2024 financials, contact your Moss Adams professional.

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