Recent Changes in Accounting for Income Taxes

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Recent Changes in Accounting for Income Taxes
TAXATION COMMITTEE MEETING

• Michael Reno
• Deloitte Tax LLP
• June 27, 2005

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Recent Changes in Accounting for Income Taxes

• Agenda
• Tax Deduction for Qualified Production Activities
• Foreign Earnings Repatriation Provision
• Federal Subsidies for Prescription Drug Plans
• Employee options and warrants
• Uncertain Tax Positions

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Tax Deduction for Qualified Production Activities

• FASB Staff Position No. FAS 109-1
• 4. The FASB staff believes that the qualified
  production activities deductions characteristics
  are similar to special deductions illustrated in
  paragraph 231 of Statement 109 because the
  qualified production activities deduction is
  contingent upon the future performance of
  specific activities, including the level of
  wages. Accordingly, the FASB staff believes that
  the deduction should be accounted for as a
  special deduction in accordance with Statement
  109.

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Foreign Earnings Repatriation Provision

• FASB Staff Position No. FAS 109-2
• 6. The FASB staff believes that the lack of
  clarification of certain provisions within the
  Act and the timing of the enactment necessitate a
  practical exception to the Statement 109
  requirement to reflect in the period of enactment
  the effect of a new tax law.
• 10. The following information shall be provided
  in an enterprises financial statements for the
  period in which it completes its evaluation of
  the repatriation provision
• The total effect on income tax expense (or
  benefit) for amounts that have been recognized
  under the repatriation provision. For annual
  financial statements, any effect should be shown
  separately in the same place (either on the face
  of the income statement or in the footnotes) that
  the amounts of current and deferred taxes are
  disclosed for the period.

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Federal Subsidies for Prescription Drug Plans

• Code Section 139A
• Gross income shall not include any special
  subsidy payment received under section 1860D-22
  of the Social Security Act. This section shall
  not be taken into account for purposes of
  determining whether any deduction is allowable
  with respect to any cost taken into account in
  determining such payment.
• FSP 106-2
• 19. In the periods in which the subsidy affects
  the employers accounting for the plan, it shall
  have not effect on any plan-related temporary
  difference accounted for under Statement 109
  because the subsidy is exempt from federal
  taxation. That is, the measure of any temporary
  difference shall continue to be determined as if
  the subsidy did not exist.

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Employee Options and Warrants

• FAS 123 was issued in 1995.
• Background
• FAS The statement provides rules for applying a
  fair value method to account for stock based
  compensation.
• Entities could either adopt FAS 123 or they could
  choose to continue accounting for stock based
  compensation using APB 25 a statement that
  allows the use of intrinsic value at grant date
  as the measure of compensation.
• Entities choosing to remain on APB 25 were (and
  continue to be) required to disclose the pro
  forma net income effect of FAS 123 (as if it was
  adopted) including additional tax effects (FAS
  123 par. 45).
• Pro forma disclosures apply FAS 123 to options
  granted in fiscal years beginning after December
  15, 1994 (FAS 123 par. regarding Effective Date
  and Transition).
• FASB 123R effective for first interim or annual
  reporting period that begins after June 15, 2005.

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Employee Options and Warrants

• FAS 123, Par. 44
•  
• If a deduction reported on a tax return for a
  stock-based award exceeds the cumulative
  compensation cost for that award recognized for
  financial reporting, the tax benefit for that
  excess deduction shall be recognized as
  additional paid-in capital. If the deduction
  reported on a tax return is less than the
  cumulative compensation cost recognized for
  financial reporting, the write-off of a related
  deferred tax asset in excess of the benefits of
  the tax deduction, net of the related valuation
  allowance, if any, shall be recognized in the
  income statement except to the extent that there
  is remaining additional paid-in capital from
  excess tax deductions from previous stock-based
  employee compensation awards accounted for in
  accordance with the fair value based method in
  this Statement. In that situation, the amount of
  the write-off shall be charged against that
  additional paid-in capital.

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Employee Options and Warrants

• FAS 123, Par. 227
•  
• The temporary difference related to a
  stock-based award is measured by the cumulative
  compensation cost recognized rather than the
  expected future tax deduction based on the
  present intrinsic value of the award. Therefore,
  a deferred tax asset recognized for that
  temporary difference should be reduced by a
  valuation allowance only if, based on the weight
  of the available evidence, the entity expects
  future taxable income will be insufficient to
  recover the deferred tax asset in the periods the
  tax deduction for the stock-based award will be
  recognized or in an applicable carry-back or
  carry-forward period.

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Employee Options and Warrants

• FAS 123, Par. 224
•  
• The Board believes that recognition of deferred
  tax benefits related to stock-based awards for
  financial reporting should be based on provisions
  in the tax law that govern the deductibility of
  stock-based compensation. Some stock-based
  compensation plans result in tax deductions.
  Examples under existing U.S. tax law are
  so-called nonstatutory stock options (which are
  options that do not qualify for preferential tax
  treatment as incentive stock options) and
  nonvested stock. However, under existing U.S.
  tax law, an entity does not receive tax
  deductions for so-called incentive stock options
  (provided that employees comply with the
  requisite holding periods).

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Employee Options and Warrants

• FAS 123, Par. 42
•   The cumulative amount of compensation cost
  recognized for a stock-based award that
  ordinarily results in a future tax deduction
  under existing tax law shall be considered to be
  a deductible temporary difference in applying
  FASB Statement No. 109, Accounting for Income
  Taxes. The deferred tax benefit (or expense)
  that results from increases (or decreases) in
  that temporary difference, for example, as
  additional service is rendered and the related
  cost is recognized, shall be recognized in the
  income statement. Recognition of compensation
  cost for an award that ordinarily does not result
  in tax deductions under existing tax law shall
  not be considered to result in a deductible
  temporary difference in applying Statement 109.
  A future event, such as an employee's
  disqualifying disposition of stock under existing
  U.S. tax law, can give rise to a tax deduction
  for an award that ordinarily does not result in a
  tax deduction. The tax effects of such an event
  shall be recognized only when it occurs.

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Employee Options and Warrants

• Tax Effects of FAS 123
• Some temporary differences do not relate to a
  book/tax basis difference but rather relate to a
  financial statement event for which a future tax
  deduction can be expected and a deferred tax
  asset (or DTA) should be recorded (FAS 123 par.
  225 citing par. 15 of FAS 109).
• Future deductions can be expected for NQSOs but
  not for ISOs (FAS 123 par 225).
• This temporary difference is measured by the
  compensation expense recorded for books (FAS 123
  par. 226).
• The book expense is measured by the fair value at
  grant and the tax deduction is measured by the
  intrinsic value at exercise. These amounts are
  almost certain to be different. The DTA, once
  recorded, is not re-measured or valued due to
  stock price fluctuations but is considered in
  applying normal valuation considerations -
  regarding adequacy of future income to recover
  all DTAs (FAS 123 par. 227).

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Employee Options and Warrants

• Tax Effects of FAS 123 - continued
• Any excess tax benefits are recorded as equity
  pursuant to par. 36e of FAS 109 (FAS 123 par.
  228).
• A FAS 123 related DTA might not be fully
  recovered (i.e., the tax deduction - based on
  spread at exercise - turns out to be less than
  the book expense - based on fair value at
  grant). When a DTA is not fully recovered, the
  amount not recovered is written off to APIC to
  the extent that prior accounting for FAS 123
  options created APIC on account of excess tax
  benefits. Any remaining DTA is written off to
  tax expense (FAS 123 par. 229).
• In the event that a tax benefit is realized for
  an ISO (due to a disqualification) the related
  tax benefit is recorded as a provision benefit
  for not more than the tax benefit attributable to
  the book compensation expense. Any excess tax
  benefit is recorded as equity (FAS 123 par. 231).

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Employee Options and Warrants

• Process requirements - FAS 123 disclosure
• Identify and track options granted 1995 and later
  (assuming calendar year company).
• Determine fair value of options pursuant to FAS
  123
• Determine tax effect of book compensation expense
  as recorded to PL.
• Re-measure tax effect for subsequent adjustments
  to book compensation expense required by FAS 123.
• Determine the DTA associated with each option
  grant as of the date of the exercise or
  expiration of the option.
• Determine with respect to each DTA (step 5)
  whether it was under recovered or over recovered.
  If over recovered, credit APIC. If under
  recovered, write-off under recovery to APIC to
  extent of APIC pool, expense remainder.
• For each disqualifying disposition of an ISO
  granted 1995 or later, record a provision benefit
  limited to the tax effect of the original book
  expense and record APIC for any excess (no DTA
  can be under recovered since none was recorded).

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Uncertain Tax Positions

• Through its deliberations, the Board decided
• An entity shall recognize the benefit of tax
  positions when it is probable, in the context of
  FASB Statement No. 5, Accounting for
  Contingencies, that the position will be
  sustained when challenged by taxing authorities.
  
• An entity shall presume that a taxing authority
  will review a tax position when evaluating
  whether the position is probable of being
  sustained. Therefore, consideration of the risk
  of detection is inappropriate.
• The benefit of tax positions shall be
  derecognized when it is more likely than not that
  the position will not be sustained.

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Uncertain Tax Positions

• A taxpayer shall record the financial statement
  benefit of an uncertain tax position based on the
  best estimate of the amount that will be
  ultimately sustained upon resolution of the
  litigation or appeals process.
• If a tax return is filed with a tax position that
  does not meet the probable criterion, a liability
  shall be calculated on the difference between the
  probable tax basis and the as-filed tax basis.
  
• The liability that results from the difference
  between the probable tax basis in the financial
  statements and the as-filed tax basis shall be
  classified based on the expected timing of cash
  flows to settle underpayment controversies with
  taxing authorities.
• Changes in judgment about sustainability of a tax
  benefit or in the amount to be sustained shall be
  recognized in the current interim period and not
  spread over future interim periods.

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Uncertain Tax Positions

• An interest expense accrual for the settlement of
  underpayment controversies shall be recognized
  based on the amounts reflected on the tax return
  for which a benefit has not been recognized in
  the financial statements.
• Disclosures shall continue to be made in
  accordance with Statement 5.
• The impact of adopting the new pronouncement
  shall be accounted for as a cumulative effect of
  a change in accounting principle.
• The proposed Interpretation shall be effective
  for all companies for the first annual period
  ending after December 15, 2005. Early adoption
  is encouraged.
• The comment period for the proposed
  Interpretation will be 60 days.

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Recent Changes in Accounting for Income Taxes

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