The Impact of Tax Reform on Financial Accounting
By Katy Daiell, Senior Manager, Tax & Business Services
On December 22, 2017, the Tax Cuts and Jobs Act (the “Act”), was signed into law. The Act will have a significant impact on financial reporting issued for the periods ending on or after that date.
Change of Federal Corporate Rate
The Act provides for a flat corporate tax rate of 21% effective, January 1, 2018. However, corporations are required to report the effect of a change in tax law or rate in the period that includes the enactment date as opposed to the effective date. For calendar year entities, any deferred tax assets or liabilities must be adjusted to reflect the new 21% federal rate as of December 22, 2017. The effect of the change should be presented as a discrete item in the rate reconciliation, including circumstances where a full valuation allowance has been recorded. However, the current tax expense or benefit will not reflect the new rate until the rate change becomes effective in 2018. Entities with fiscal year-ends will be subject to blended rates (see Marcum Tax Flash: The New Corporate Blended Rate for Fiscal Year Entities.)
The Financial Accounting Standards Board (“FASB”) released ASU 2018-02, effective for any organization that is required to apply the provision of Topic 220 (Income Statement-Reporting Comprehensive Income), detailing items for which the tax effects are presented in other comprehensive income (“OCI”) under GAAP. An entity is required to disclose the following items:
- A description of the accounting policy for releasing income tax effects from accumulated OCI;
- Whether the entity elects to reclassify the stranded income tax effects from the Act; and
- A description of other income tax effects that are reclassified.
The amendment is effective for all organizations for fiscal years beginning after December 15, 2018, and interim periods within those years. The amendments should be applied in either the period of adoption or retrospectively to the period(s) in which the effect of the change in corporate tax rates is recognized.
Net Operating Loss
Another significant financial statement reporting change includes the limitations on use of net operating loss (“NOL”) carrybacks and carryovers. For NOLs arising in tax years ending after December 31, 2017, the two-year carryback period is repealed for most losses. The use of these losses in subsequent years is limited to 80% of taxable income. Net operating losses from years after December 31, 2017, can now be carried forward indefinitely. Companies may need to reassess the need for a valuation allowance for deferred tax assets created by net operating losses that may not be realized due to the 80% limitation rule and those that can be recognized due to the indefinite carryforward period.
Alternative Minimum Tax Repeal
Effective for tax years beginning after December 31, 2017, the corporate Alternative Minimum Tax (“AMT”) is repealed. Tax law prior to the Act imposed an AMT if the amount of tax calculated according to the provisions of the AMT was greater than the regular tax calculated in the same year. The excess of AMT over the regular tax liability was deemed to be a credit that could offset future regular tax. This credit could be carried forward indefinitely. Not only is any AMT credit carryforward now available to offset regular tax for the years 2018 through 2020, any amount of the credit that is unused to offset regular tax is eligible for a refund. In most cases, 50% of the credit can be refunded in years 2018 through 2020, and 100% is eligible for refund in 2021. For financial accounting purposes, companies recognized deferred tax assets for AMT credit carryforwards. Since the credit carryforward can be applied against future tax or a refund can be received even if the entity never has taxable income, the AMT credit can be presented as either a deferred tax asset or a receivable, provided there is appropriate disclosure. Certain entities may have recorded an offsetting valuation allowance. Because the credit will be refundable in the future, a valuation allowance against the deferred tax asset for the credit can now be released, and the associated benefit can be recognized. After the valuation allowance is released, an entity can record a receivable.
The Act allows for increased Section 179 expensing and accelerated depreciation. Under revised Section 179, an entity may expense up to $1 million of the cost of assets, with a phase-out threshold of $2.5 million for qualifying property placed in service in tax years beginning after December 31, 2017. A 100% first-year deduction (bonus depreciation) for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023, is now available. (For years 2023 through 2025, there are reduced bonus rates planned, and the provision is scheduled to expire on January 1, 2026). Companies that can benefit from these new allowances should consider the impact of accelerated depreciation and increased 179 expensing on realizing deferred tax assets. Recognizing these deductions could generate net operating losses. On the flip side, accelerated deductions could create taxable temporary differences in future periods, providing a source of future income that should be considered when assessing possible realization of deferred tax assets. Management should understand which state jurisdictions may be decoupling from these federal provisions and take into consideration possible effects on both current and deferred state taxes.
For tax years beginning after December 31, 2017, all business are subject to a general disallowance of deduction for net interest expense in excess of 30% of a business’s adjusted taxable income. Adjusted taxable income, for purposes of the interest deduction, is computed as taxable income before deductions related to interest, depreciation, amortization, or depletion. Any interest that is disallowed in a given year is treated as interest paid or accrued in the next tax year. The disallowed interest can be carried forward indefinitely (similar to a net operating loss carryover). Taxpayers with three-year average annual gross receipts under $25 million are exempted from this rule. Companies will have to assess the possible need for a valuation allowance on any deferred tax balances resulting from interest that has been limited in a given year.
Toll Charge to U.S. Shareholders of Non-U.S. Corporations
One of the more significant impacts of the new tax law is the one-time transition tax now levied on U.S. shareholders of controlled foreign corporations. This “toll charge” will be levied on shareholders with a 10% or greater ownership interest in a controlled foreign corporation. The charged is based on the accumulated foreign earnings not previously distributed to the U.S. owner. The corporate rate of tax applicable to this deemed dividend will depend on the asset make-up of the foreign corporation and will be either 15.5% (on cash and equivalents) or 8% (on illiquid assets). Shareholders will be required to calculate and report the tax on their 2017 tax returns. The Act permits a company to pay this tax over eight years, interest-free. If a corporation elects to pay on installments, 8% of the tax liability is due from years 1 to 5; 15% in year 6; 20% in year 7; and the remaining 25% is due in year 8. An entity should recognize the effect of this one-time transition tax as a component of operating expense from continuing operations for the period that includes the enactment date.
U.S. Payments to Foreign-Related Parties
The Act imposes a Base Erosion Anti-Abuse Tax (“BEAT”) on U.S. corporations making base erosion payments to foreign-related parties. The BEAT is similar to the AMT in that it is required to be paid if it is greater than the regular tax liability. The BEAT is calculated with modifications for payments to foreign-related parties. A rate of tax lower than that of regular tax is applied to BEAT income.
The Act requires a 10% or greater shareholder of a controlled foreign corporation (“CFC”) to include in gross income its share of the CFC’s Global Intangible Low-Taxed Income (“GILTI”). The GILTI tax is a new category of Subpart F income for years beginning after December 31, 2017. In general, the GILTI is calculated by taking 10% of the U.S. shareholder’s foreign qualified business property (essentially its tangible personal property), less interest expense, and subtracting this amount from its total foreign net profits. A loss in a given year cannot offset future income. In general, corporate shareholders are allowed a GILTI deduction of 50%. However, this deduction is limited to taxable income. A corporation is also allowed to offset its federal income tax liability attributable to the GILTI by 80% of the foreign tax paid or accrued, attributable to the underlying CFC. Any unused foreign tax credit cannot be carried forward. Both the BEAT and GILTI taxes should be considered for quarterly and annual tax provisions for periods beginning after December 31, 2017.
The Tax Cut and Jobs Act will create sweeping changes for almost all businesses. The effects of the new law will also extend to those required to provide financial statement reporting. The above analysis includes a summary of some of the more significant changes that can affect business financials. Almost all financial reporting will be affected either by rate changes or deferred tax recalculations. While most of the changes contained in the Act will not need to be considered until 2018, certain changes will need to be disclosed in current 2017 financial statements.
Should you have inquiries on how your company’s financial reporting may be impacted by the Act, contact your Marcum tax professional.