Essentials of taxation 2016 cengage chapter 03

Chapter Taxes on the Financial Statements Essentials of Taxation © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Big Picture (slide of 2) • Raymond Jones, the CEO of Arctic Corporation, would like some help reconciling the income tax expense on Arctic’s financial statements with the income tax reported on the company’s corporate income tax return – Mr Jones doesn’t understand why he can’t simply multiply the financial statement income by the company’s 35% marginal tax rate to get the financial tax expense • While the financial statements show book income before tax of $25 million, the reported Federal tax expense is only $7.7 million • In addition, the corporate tax return reports taxable income of $19 million and Federal income taxes payable of only $6.65 million ($6.65 million X 35%) The Big Picture (slide of 2) • Without knowing the specifics of the company’s financial statements, does Arctic’s situation look reasonable? • Why is Arctic’s financial tax expense not equal to $8.75 million ($25 million X 35%)? • What causes the $1.05 million difference between the taxes shown on the financial statements and the taxes due on the tax return? • Read the chapter and formulate your response Book-Tax Differences • Significant differences may exist between a corp.'s Federal income tax liability reported on Form 1120 (tax) and the corp.’s income tax expense on financial statements (book) – Differences are caused by any or all of the following: • Differences in reporting entities included in the calculation • Different definition of taxes included in the income tax expense amount • Different accounting methods Different Reporting Entities (slide of 2) • For book purposes, a corporate group must consolidate all U.S and foreign subsidiaries when the parent corporation has > 50% ownership – For 20% to 50% ownership, parent uses the equity method to account for earnings of sub – For < 20% ownership, use the cost method to account for income from these investments Different Reporting Entities (slide of 2) • For tax purposes: – U.S corporation may elect to include any domestic subsidiaries that are 80% or more owned in its consolidated U.S tax return • The income of foreign subsidiaries and < 80% owned domestic subsidiaries is not included in consolidated tax return The Big Picture – Example Different Reporting Entities • Return to the facts of The Big Picture on p 3-1 • Arctic Corporation owns the following: – 100% of Gator, Inc., a domestic corporation; – 100% of Hurricane, Ltd., a foreign corporation; and – 40% of Beach, Inc., a domestic corporation • Arctic’s combined financial statement includes its own net income and the net income of both Gator and Hurricane – In addition, Arctic’s financial statement includes its 40% share of Beach’s net income • Arctic’s financial statement includes the income of these subsidiaries regardless of whether Arctic receives any actual profit distributions from its subsidiaries The Big Picture – Example Different Reporting Entities • Return to the facts of The Big Picture on p 3-1 and also assume the facts presented in Example • If Arctic elects to include Gator as part of its consolidated Federal income tax return, Arctic’s return includes its own taxable income and the taxable income generated by Gator – Hurricane’s taxable income is not included in the consolidated return because it is a non-U.S corporation – Beach, although a domestic corporation, cannot be consolidated with Arctic because Arctic owns only 40% of the stock • Income from Hurricane and Beach will be included in Arctic’s U.S taxable income only when Arctic receives actual or constructive dividends Different Taxes • For book purposes, income tax expense includes: – Federal, state, local, and foreign income taxes – Both current and deferred tax expense amounts • For tax purposes: – Amount is based on the U.S corporation’s taxable income – State income taxes are reported on the Federal tax return, but as deductions in arriving at taxable income The Big Picture – Example Different Taxes • Return to the facts of The Big Picture on p 3-1 and also assume the facts presented in Example • For book purposes, Arctic, Gator, and Hurricane combine their income and expenses into a single financial statement – The book tax expense for the year includes all Federal, state, local, and foreign income taxes paid or accrued by these three corporations – In addition, the book tax expense amount includes any future Federal, state, local, or foreign income tax expenses (or tax savings) on income reported in the current income statement Calculating Corporate Income Tax Expense 38 Financial Accounting for Tax Uncertainties (slide of 4) • Companies sometimes take positions in their tax returns that may not ultimately survive IRS scrutiny – Companies may book a reserve (or “cushion”) for these uncertain tax positions • That is, rather than book the entire tax benefit (and thus reduce tax expense in the current year), the company may book only a portion (or none) of the tax benefit 39 Financial Accounting for Tax Uncertainties (slide of 4) • If the company later loses the actual tax benefit upon audit, the additional tax imposed is charged against the reserve (or “cushion”) – The additional tax does not affect the future-year tax expense • If the company’s tax position is not challenged in the future (or the company successfully defends any challenge), the reserve can be released 40 Financial Accounting for Tax Uncertainties (slide of 4) • The FASB was concerned that companies too freely used the tax reserve as a “cookie jar” to shift earnings from one period to another – To add more structure to the accounting for tax reserves, the FASB released ASC 740-10 (FIN 48), “Accounting for Uncertainty in Income Taxes” – FIN 48 results in significantly more disclosure about uncertain tax positions by companies 41 Financial Accounting for Tax Uncertainties (slide of 4) • ASC 740-10 (FIN 48) uses a two-step process of recognition and measurement – First, a tax benefit from an uncertain tax position may be recognized only if it is more likely than not (> 50% likelihood) that the position would be sustained on its technical merits • Audit or detection risk cannot be considered • This first step determines whether any of the tax benefit is recognized – If the uncertain tax position meets this threshold, the second step is to determine the amount of the tax benefit to report • Measurement is based on the probabilities associated with the position not being challenged or being challenged with a negotiated settlement or litigation 42 Earnings Of Foreign Subsidiaries (slide of 2) • Corporate group’s financial stmts include both domestic and foreign controlled subsidiaries – Foreign corps controlled by U.S shareholders, are not part of a U.S consolidated tax return • May achieve deferral of current U.S taxes on foreign income if earned through foreign subsidiary corps in jurisdictions with lower tax rates than the U.S • Effective tax rate for financial stmt purposes may not reflect this deferral – ASC 740 (SFAS 109) requires that a corporate group report both current and deferred income tax expense 43 Earnings Of Foreign Subsidiaries (slide of 2) • ASC 740-30 (APB 23) provides a special exception to ASC 740 (SFAS 109) for income from foreign subs – If a corp documents it is permanently reinvesting earnings of its foreign subs outside the U.S., the corp does not record as an expense any future U.S income tax that the corp may pay on such earnings • ASC 740-30 (APB 23) can be adopted in some years and not others – Even within a year it may be used for only a portion of foreign subsidiary earnings 44 The Big Picture – Example 21 ASC 740-30(APB 23) • Return to the facts of The Big Picture on p 3-1 • Recall from Example that Arctic Corporation has a wholly owned foreign subsidiary, Hurricane, Ltd – Assume that Arctic also owns 100% of another foreign corporation, Typhoon, Ltd • Arctic can choose to apply ASC 740-30(APB 23) to: – Both of its foreign subsidiaries in year 1, and – To only Hurricane in year • In year 3, Arctic can choose to use ASC 740-30 (APB 23) for: – 40% of Hurricane’s earnings, and – 80% of Typhoon’s earnings Benchmarking • Reported income tax expense is a valuable source of information – Provides clues about a company’s operational and tax planning strategies – Companies may benchmark their tax situation to other years’ results or to other companies within the same industry • The starting point is data from the income tax note rate reconciliation 46 Refocus On The Big Picture (slide of 5) • Raymond Jones should understand that tax expense reported on the company’s financial statements and tax payable on the company’s income tax returns are often different as a result of: – Differences in reporting entities used in the calculation, and – The different accounting methods used for book and tax purposes Refocus On The Big Picture (slide of 5) • The use of different accounting methods may result in both temporary and permanent differences in financial statement income and taxable income – Examples of permanent differences include nontaxable income like municipal bond interest and tax credits – Temporary differences include depreciation differences and other amounts that are affected by the timing of a deduction or inclusion but ultimately will result in the same amount being reflected in the financial statements and income tax returns Refocus On The Big Picture (slide of 5) • Permanent differences such as municipal bond interest cause Arctic’s book income to be greater than its taxable income • In calculating the tax expense shown on the financial statements, Arctic’s book income must be adjusted for these permanent differences – This results in an effective tax rate for financial statement purposes (30.8%) that is below the top U.S statutory corporate income tax rate of 35% Refocus On The Big Picture (slide of 5) • In this case, Arctic’s income tax expense of $7.7 million is higher than the current Federal income tax payable – This results from timing differences and creates a $1.05 million deferred tax liability that is reported on the company’s balance sheet • Unlike other liabilities, deferred tax liabilities are ‘‘good’’ in the sense that they represent an amount that may be paid to the government in the future rather than today Refocus On The Big Picture (slide of 5) What If? • Mr Jones is concerned about a newspaper article that said that companies reporting less tax on their tax returns than on their financial statements were cheating the IRS – Is this an accurate assessment? • While differences in income taxes payable to the IRS and financial tax expense can result from aggressive and illegal tax shelters, differences also result from different methods of accounting that are required for financial statement reporting using GAAP and tax laws as enacted by Congress If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr Donald R Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 52 ... evaluated – Examples of negative evidence include: • • • • History of losses Expected future losses Short carryback/carryforward periods History of tax credits expiring unused – Examples of positive evidence... appreciation in assets Sales backlog of profitable orders 29 The Big Picture – Example 13 Releasing Valuation Allowance (slide of 2) • Return to the facts of The Big Picture on p 3-1 • Arctic... carryforward is offset by a $1 million valuation allowance, due to doubts over the levels of future sales and profitability The Big Picture – Example 13 Releasing Valuation Allowance (slide of 2) •