Does tax reform mean tax risk for companies with deferred positions?
That's the question Tammy Whitehouse of Compliance Week asked TPC Managing Director James T. Hedderman in her January 18th article. An excerpt of the article is below. You can read the entire article HERE with a subscription.
Broad expectations of tax reform are prompting tax experts to ponder whether companies should be disclosing new risks to investors, especially companies that might be facing a hit to earnings.
With a Republican-controlled Congress and a new administration in the White House, capital markets are demonstrating a strong expectation of corporate tax reform, including reduced corporate income tax rates. Deloitte’s survey of corporate chief financial officers in the fourth quarter of 2016 says two-third of CFOs expect corporate tax rates to fall, and three-fourths expect some change in rules that will make it more attractive for companies to repatriate any foreign earnings they are holding offshore.
While a reduction in rates might sound like positive news for cash flow, it could also mean a reduction in net income for companies that are carrying big deferred tax assets on their balance sheets, a line item auditors like to scrutinize. At the same time, it could produce an earnings windfall for companies carrying deferred tax liabilities. A recent securities blog called the prospect of tax reform to upend current deferred tax positions a “sleeper issue” for companies to face.
Deferred tax assets and deferred tax liabilities are booked on corporate balance sheets as a result of timing differences between tax rules and accounting rules. Depreciation rules, for example, are different under tax rules than accounting rules, says Jim Hedderman, managing director at tax firm True Partners Consulting. U.S. GAAP might allow a company to depreciate a particular piece of equipment over 10 years, while tax rules might allow depreciation over a much shorter period of time.
“In year one, you’re going to depreciate more for tax purposes than in financial statements,” says Hedderman. “That’s going to generate a timing difference,” which gives rise to a deferred tax liability in financial statements.
Tax rules also allow companies that experience net operating losses to deduct those losses against gains in prior or future tax periods. For financial statement purposes, that means companies can book an asset on their balance sheet representing the net operating loss that can be used at some point in the future to offset taxes that will be due. Tax credits allowed under tax law can be treated similarly, booked as assets to be used in future periods as tax rules permit.
The numbers booked for DTAs and DTLs are revisited in subsequent financial statement periods as companies re-measure the value of those assets and reconsider the extent to which they might be useful. Credits and net operating losses, for example, can expire, so companies must continually assess whether they are holding their value in subsequent periods or must be marked down.
Likewise, companies must re-measure the value of DTAs or DTLs if tax rates change. If a company books a DTA, for example, based on a corporate tax rate of 35 percent, that DTA will be worth much less if the rate is reduced to 20 percent. “These assets can be huge on balance sheets,” says Hedderman. “In general, the more material the deferred tax assets become on balance sheets, the more transparent you want to be with investors.
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