Stimulus Bill Could Impact First Quarter Financial Accounting for Income Taxes

Two business tax provisions of the recently enacted Coronavirus Aid, Relief and Economic Security (“CARES”) Act may have significant financial statement impacts as early as the first quarter of 2020. The legislation, intended to provide emergency assistance for individuals, families, and businesses affected by the 2020 coronavirus pandemic, includes changes to the net operating loss and interest expense limitation rules. Both of these changes could cause some companies to reevaluate and make changes to their valuation allowance assessments and might also require the recording of current tax benefits in the first quarter of 2020 financial statements.

Net Operating Loss (“NOL”) Changes

Under the Tax Cuts and Jobs Act (“TCJA”), passed on December 22, 2017, corporate NOLs generated beginning in 2018 cannot be carried back but are carried forward indefinitely. These NOLs could offset only up to 80% of taxable income in future years (pre-2018 NOLs could continue to offset taxable income with no limitation).

Under the CARES Act, corporations with NOLs earned in 2018, 2019, or 2020 can carry back those losses five years. The NOL limit of 80%of taxable income is also suspended through 2020, so companies may use NOLs to fully offset taxable income in pre-2021 years. In 2021, the 80% limitation returns for post-2017 NOLs.

Interest Expense Limitation Changes

The TCJA placed significant limitations on interest expense tax deductions. Interest expense deductions are currently limited to 30% of “adjusted taxable income” which is taxable income calculated without regard to net interest expense, NOLs, depreciation, and amortization (“EBITDA”). Beginning in 2022, adjusted taxable income will be calculated without regard to net interest expense or NOLs but leaving depreciation and amortization in the calculation to create an even larger limitation. Disallowed interest expense is carried forward indefinitely.

The CARES Act increases the interest deduction limitation to 50%of EBITDA in 2019 and 2020. In addition, companies may elect in 2020 to use the 2019 adjusted taxable income amount in the 50% calculation.

Financial Statement Tax Accounting Implications

Under ASC 740, companies account for the tax effects of legislation in the quarter a law is enacted. As the President signed the CARES Act into law on March 27, 2020, companies will account for the tax impacts of the changes caused by the new law as discrete period adjustments in their quarterly financials that include this date.^[1]

The changes to both NOL and interest expense rules can significantly change the assessments of valuation allowance made at the time when financial statements were filed merely days or weeks ago. In measuring the realizability of deferred tax assets (such as for NOLs and disallowed interest expense) companies must consider four possible sources of taxable income.^[2] The first, and least subjective, of the four tests for deferred tax asset realization is met when a company has taxable income in prior years to which a carryback is permitted under the tax law. Expanding the carryback period to five years may provide a source of taxable income to realize NOLs that were fully reserved with a valuation allowance. Companies may be able to release valuation allowance on 2018 or 2019 NOLs that were not previously realizable with a one-year carryback but which can now be carried back up to five years.

The removal of the 80% limitation on utilization of NOLs could favorably impact valuation allowance scheduling exercises where 2020 taxable income previously only supported the 80% utilization of NOL carryforwards.

The relaxed interest limitation rules could also allow for a reduction of valuation allowances against interest expense previously disallowed in 2018 or 2019. For example, the increased 2019 interest limitation could, in some cases, provide additional capacity to deduct interest expense that was limited in 2018.

In addition, some companies may have anticipated the need for a valuation allowance against any disallowed 2020 interest expense when calculating their estimated annual effective tax rate for 2020. This may now change if the company had significant taxable income in 2019 and elects to use 2019 adjusted taxable income to measure the 2020 interest limitation.

Other Tax Accounting Considerations

Valuation Allowance Changes

Changes to a valuation allowance may be either a discrete adjustment to the quarter or included as part of the estimated annual effective tax rate.

A company recognizes a change in the valuation allowance in an interim period through its estimated annual effective tax rate if the change relates to: 1) deferred tax assets originating during the year; or 2) deferred tax assets existing at the beginning of the year that are expected to be realized as a result of current year ordinary income.

A company recognizes a change in the valuation allowance entirely in the interim period if the change relates to deferred tax assets existing at the beginning of the year that are expected to be realized in future years.

Example 1 - Discrete Period Adjustment: A company is releasing valuation allowance in the first quarter of 2020 for a 2018 NOL deferred tax asset that can now be carried back to 2016, or earlier. In this case, a discrete benefit would be recognized in the first quarter of 2020.

Example 2 – Adjustment to Estimated Annual Effective Tax Rate: A company is projecting a taxable loss in 2020 which it expects can be carried back against 2017 taxable income. This company would include the tax benefit of the 2020 taxable loss as part of its estimated annual effective tax rate. 

State Impacts

Companies will need to monitor whether states adopt the federal law changes. States may have automatic conformity or may need to pass their own laws that affect NOLs or interest expense deductions. In addition, companies that file a consolidated federal tax return but file separately in some states may also have different interest limitations for federal and state purposes.

[1] If ASU 2019-12 has been early adopted, the impact of the new law would be spread over the remaining three quarters. ASU 2019-12 Simplifying the Accounting for Income Taxes, is effective in 2021 for calendar year-end public companies. ASU 2019-12 allows early adoption, including in an interim period. 

[2] The four sources of taxable income to be considered in determining whether a valuation allowance is required (from least to most subjective) are: 1) taxable income in prior carryback years, if carryback is permitted under the tax law; 2) future reversals of existing taxable temporary differences; 3) tax planning strategies; and 4) future taxable income exclusive of reversing temporary differences.