Naked Credits and the Interest Limitation
October 28, 2021
By Tanya Korzhova
Assessing the valuation allowances for deferred tax assets (DTAs) is a very involved and lengthy process. Since the passage of the Tax Cuts and Jobs Act (“TCJA”), many companies have had to change the way they compute valuation allowances. There has been an increased focus on the need to schedule the reversals of existing temporary differences due to the limitations on the utilization of interest expense and net operating loss (NOL) carryforwards. In scheduling out these reversals, companies must consider the ways that changes in tax laws have impacted the analysis.
Recently, our own Murray Solomon, a tax partner, wrote an article published in the Tax Adviser that addressed the implications of TCJA and the final regulations issued under IRC Sec. 163(j) on valuation allowance assessment when there are indefinite-lived intangibles (i.e., naked credits) in the entity’s deferred inventory.
In his article, Murray addressed in detail (with examples) the following:
- Generally, taxable temporary differences (DTLs) constitute a source of income to support the realization of DTAs and should reduce the valuation allowance amount that is otherwise required. However, the reversal of DTLs related to indefinite-lived intangible assets cannot be determined or scheduled. Before TCJA, the indefinite-lived DTLs could not be considered a source of income for valuation allowance purposes, because there were no significant indefinite-lived DTAs generated under United States tax law. This accounting resulted in a valuation allowance in excess of net DTAs and a net credit balance, or a “naked credit” DTL.
- The concept of indefinite-lived DTAs, related to tax attributes with indefinite carryforward periods, was created as a result of TCJA changes. Therefore, a valuation allowance assessment now requires that the definite-lived DTLs are measured against the definite-lived DTAs and the indefinite-lived DTLs (i.e., naked credits) are measured against the indefinite-lived DTAs.
- The indefinite-lived DTLs constitute a source of taxable income to support the realization of the indefinite-lived DTAs, but the following two statutory limitations on the use of such tax attributes must be taken into account:
- Future interest expense deductions can only be taken to the extent of 30% of adjusted taxable income (ATI).
- NOLs incurred after 2017 can be carried forward indefinitely but limited to offset 80% of taxable income.
- The final IRC Sec.163(j) regulations clarified how taxpayers determine their ATI. In order to avoid a double benefit in ATI with respect to the sale or disposition of property, the final regulations require a subtraction to tentative taxable income by the lesser of: 1) the gain recognized on the sale or disposition of property, or 2) the amount of depreciation or amortization taken during EBIDTA period. This additional factor in calculating the interest expense limitation may result in a larger naked credit and valuation allowance.