Comments on proposed statement on financial accounting standards: accounting for income taxes.

The Financial Accounting Standards Boards issued an Exposure Draft of a revised Statement of Accounting for Income Taxes on June 5, 1991. The Exposure Draft, if adopted, would supersede Statement of Financial Accounting Standards 96, Accounting for Income Taxes (hereinafter Statement 96), which was issued in December 1987. Some companied have already adopted the accounting principles of Statement 96 when issuing their financial statements. Other companies, however, have deferred adopting Statement 96 inasmuch as the effective date for mandatory use of Statement 96 has been delayed by Statements of Financial Accounting Standards 100 and 103. The Exposure Draft is proposed to be effective for fiscal years beginning after December 15, 1992, but earlier application is encouraged.

Background

Tax Executives Institute, Inc. (TEI) is the principal organization of corporate tax professionals in North America. The Institute's approximately 4,700 members are employed by nearly 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community and is dedicated to the development of sound tax policy and to promoting the uniform and equitable enforcement of the tax laws. The Institute is proud of its record of working with congressional committees, governmennt agencies, and other policy-making bodies to minimize the cost and burden of tax administration and compliance to the mutual benefit of the government, business, and ultimately the public. TEI is firmly committed to maintaining a tax system that works -- one that is consistent with sound tax policy and one that taxpayers can comply with.

We believe that the diversity, professional training of our members, and our dedication to both an effective national tax policy and the efficient administration of the tax laws qualify us to address issues raised by the Exposure Draft. Our members are the individuals who must contend daily with the practical implications and application of the tax laws and the FASB's requirements concerning accounting for income taxes.

General Comments

TEI commends the Board for undertaking to ameliorate the administrative complexity inherent in Statement 96. A number of thoughtful critical comments directed at Statement 96 have been incorporated by the Board in the Exposure Draft. The changes have been deftly woven into the existing pattern of accounting principles adopted in Statement 96 without chaning the fundamental fabric of the liability approach.

In the comments that follow, TEI sets forth its recommendations on how the Exposure Draft should be revised to further ease the complexity of computing and reporting tax provisions without compromising the accuracy and utility of financial statements. On the whole, TEI is quite pleased with the Board's resolution of a number of difficult issues. Our differences are in the nature of "fine-tuning."

Deferred Tax Asset Recognition

Under Statement 96, a deferred tax asset can be recognized only for the tax benefit of net deductible amounts that can be realized by loss carryback from future years to reduce (1) a current deferred liability and (2) taxes paid in the current or prior years. No asset is recognized for any additional net deductible amounts in future years, and reporting firms are not allowed to anticipate future income sufficient to permit recognition of net future deductible amounts as deferred tax assets.

The Exposure Draft would provide that deferred tax assets may be recognized currently regardless of whether deferred tax liabilities exist. Such assets, however, are to be reduced by a "valuation allowance" if it is "more likely than not" that the asset will not be relized. TEI commends the Board for recognizing that one of the principal sources of complexity in Statement 96 is its assumption that the only taxable or deductible amounts in future years are the reversals of the temporary differences existing at the end of the financial statement period. We concur in the Board's conclusion that the critical recognition event is the event that gives rise to the deductible temporary difference or carryforward. By permitting reporting firms to anticipate (within the bounds of prudent judgment) the prospect of future earnings from operations and future originating temporary differences [Exposure Draft Paragraph 17.], (1) the Exposure Draft would greatly simplify the artificial and complex scheduling of reversing temporary differences. TEI commends the Board for recognizing that a business enterprise is a going concern that depends upon a stream of future operating income for its existence. Earning taxable income subsequent to the date of the statement of financial position confirms the existence of a recognizable tax event at the close of the current year, but it is not a prerequisite event that must occur to recognize a tax benefit. [Paragraph 83.] TEI welcomes the Exposure Draft's shift in emphasis.

The Exposure Draft would provide that in determining whether a valuation allowance is necessary to reduce the carrying value of a deferred tax asset, all available evidence -- both positive and negative -- is to be taken into account. [Paragraph 20.] The examples provided, however, either assume negative evidence outweights positive evidence or manifest a strictly mechanical approach to the determination. (2) Thus, the example at Paragraph 224 assumes a net operating loss in the current year portends net operating losses in all future years. Moreover, the example does not discuss the process of balancing of positive and negative evidence (i.e., the application of prudent accounting judgment) but simply assumes that "available positive evidence" will not overcome the negative evidence of the loss. (3) The intent of the Exposure Draft is presumably to ensure that management will prudently and conservatively evaluate the prospects of continued net operating losses and other negative evidence. TEI recommends that the examples confirm this point and that they be revised to illustrate the qualitative balancing a firm (and its certified public accountants) is to undertake, thereby eliminating any inference that positive and negative evidence is to be weighed in a rigidly mechanical approach.

Business Combinations

The Exposure Draft would require the recognition of deferred tax assets and liabilities in connection with the difference between assigned book values and tax bases of assets that arise in certain purchase business combinations. As with deferred tax assets arising from operations, the Exposure Draft would require the consideration of a valuation allowance at the date of the business combination. [Paragraph 29 and 240.] If a valuation allowance exists at the time of the business combination, subsequent realization of the deferred tax asset is to be applied first to reduce goodwill, second to reduce other non-current intangible assets, and only then to reduce income tax expense for the period of recognition. TEI objects to this rule.

The rationale offered by the Board for the proposal is that, "some . . . were concerned that the opportunity to reduce income tax expense in future years for a portion of acquired tax benefits might sometimes influence purchase price allocations for business combinations." [Paragraph 126.] Purchase price allocations in business transactions are a result of arm's-length negotiations and are often subject to close Internal Revenue Service scrutiny. A financial accounting standard is not required to police the tax implications of such allocations. (4)

More important, since it is the current business activity that gives rise to the realization of the deferred tax asset arising from business combinations, we believe that current income tax expense should be reduced. For example, if a profit is earned enabling the use of deferred tax assets carried forward (but reduced by a valuation allowance) on a separate return limitation year (SRLY) basis, the use of those deferred tax assets should be recognized in the current year's income statement. Similarly, if events arise that result in a reduction of the valuation allowance, those events will have arisen in the current period and the effect of the valuation allowance reduction should also be recognized in the current period.

Considering the obverse situation, if a valuation allowance is first required in a period subsequent to the business combination, the reduction of the deferred tax asset (through an increase to the valuation allowance) is presumably to be reflected in current income taxes. TEI believes that recognition of the use of deferred tax assets should also be included in current period tax expense. The lack of symmetry of accounting treatment in the Board's position is troubling to TEI.

As a less desirable alternative to the income statement approach advocated above, the Board should consider a rule pursuant to which the loss of the deferred tax asset (as a result of a subsequently required valuation allowance) will be reflected as an adjustment to goodwill or other balance sheet amount. Symmetrical treatment should prevail regardless of whether the focus of the subsequent adjustment is the income statement or statement of financial position.

Disclosure of Valuation

Allowance

The Exposure Draft requires disclosure of the valuation allowance, whether established as a result of operations or in connection with a business combination. [Paragraphs 40 and 45.] In addition, the change in the valuation allowance must be disclosed annually.

We do not believe disclosure will always be salutary. If the valuation allowance increases, it may be erroneously interpreted as a signal that the firm is about to experience financial difficulties, and that the firm or its auditors believe that these future difficulties are to be reflected in the valuation allowance. This interpretation might be false, for example, where the increase in the valuation allowance is the result of a change in tax laws or regulations. Use of alternatie, and potentially misleading, forms of disclosure such as the amount of valuation allowance and changes in valuation may serve only to confuse investors, creditors, customers, and suppliers. TEI favors that the net asset be disclosed. If separate disclosure is retained in the final statement, TEI recommends that the disclosure of changes in the valuation allowance should be limited to material changes in the allowance account.

Foreign Tax Credits

The Exposure Draft would allow foreign tax credit carryforward to be recognized only to the extent that credits reduce the defererd tax liability recognized for undistributed foreign earnings and other foreign source income. [Paragraph 32.] The Exposure Draft would continue the treatment of undistributed foreign earnings prescribed by Opinion 23 of the Accounting Principles Board (APB). Under APB 23, deferred tax liabilities are not required to reflect the impact of future distributions of earnings of foreign subsidiaries, but foreign tax credit carrryovers may not be recognized as deferred tax assets.

The Board's position may be based on an unstated assumption that most U.S. corporations are generally in an excess foreign tax credit position -- either as a result of the lower U.S. tax rates or because of the operation of the expense sourcing rules in determining foreign source taxable income. We agree that it would be difficult for most firms to project the hypothetical calculations with sufficient certainty that a deferred tax asset should be realized for foreign tax credit carryforwards. Some companies, however, do not have excess foreign tax credits and, thus, TEI takes exception to a total prohibition of recognition of deferred tax assets for foreign tax credit carryovers.

Rather, a rule of prudent business judgment should be applied in the case of foreign tax credits in the same fashion as for other loss or credit carryforwards, thereby allowing recognition of the deferred tax asset subject to a valuation allowance determined under the "more likely than not" standard. For example, if continuing operations produce a consistent stream of foreign source royalties and other evidence suggests there will be taxable income at least equal to the royalty income in future periods, one could conclude that it is more likely than not that the foreign tax credits will be used and the deferred tax asset realized.

We urged the Board to temper its position that foreign tax credit carryforwards be offset by deferred tax liabilities on undistributed foreign earnings before recognition of the deferred tax asset. The uncertainty of projecting future hypothetical foreign source taxable income will be a major factor inhibiting the recognition of such assets for many firms under the "more likely than not" standard.

ESOP Dividend Deductions

As a means of encouraging employee ownership of business enterprises, Congress has afforded corporations a tax deduction for dividends paid on shares held by an Employee Stock Ownership Plan (ESOP). Statement 96 allows the tax benefit arising from such dividend payments to be reflected as a reduction in current income tax expense, but the Exposure Draft would provide that tax benefits related to dividends that are paid on unallocated shares held by an ESOP are to be credited to shareholders' equity. [Paragraph 34f.]

By not allowing the tax benefit to be reflected in current earnings, the Exposure Draft would undermine the tax incentive for establishing an ESOP. More important, TEI concurs with the Board's reasoning in paragraph 141 of Statement 96 that the deduction actually amounts to an exemption of a portion of the firm's current year income and, thus, should be reflected in income tax expense. For these reasons, we believe that the rule set forth in Statement 96 should be retained.

Foreign Currenty Translation

for Hyperinflationary Non-monetary

Assets and Liabilities

The Exposure Draft states that temporary differences arise when accounting for results of foreign subsidiaries in the U.S. dollar rather than the functional currency (i.e., when the reporting currency is used as the functional currency) and a change in exchange rate occurs. [Paragraph 11g.] Under Statement of Financial Accounting Standards 52, this will likely occur when reporting the results of operations in a country with a hyperinflationary currency, such as Brazil or Argentina. An example illustrates how to compute the deferred tax consequences of exchange rate changes. [Paragraph 111.] The example in this Exposure Draft is more clear than the example published in Statement 96.

TEI believes the Exposure Draft gives inadequate consideration to the adjustments to the tax basis of assets that many countries with hyperinflationary currencies allow when computing taxable income. Under the Exposure Draft, adjustments to the foreign country tax basis would be taken into account when determining taxes currently payable. This would produce a mismatch for tax reporting purposes because the increased deferred tax liability that arises as a currency devalues against the dollar will likely be offset by a future reduction in taxes currently payable. We therefore believe that, if the Board wishes to recognize deferred taxes when the foreign currency value of assets reported at fixed, historical dollar values inflates, then it should also recognize the likely effect of tax basis adjustments and eliminate the requirement of establishing the deferred tax liability. (5)

Transition Rules/Business

Combinations

Transition rules are provided for those reporting firms that have not yet adopted Statement 96. The transition rules address the reporting of prior business combinations. [Paragraph 50, et seq.] No transition rules are provided, however, for reporting firms that have already adopted Statement 96, but would recognize a deferred tax asset under the Exposure Draft. (Firms that established deferred tax liabilities as a result of business combinations governed by Statement 96 are unaffected.) If a deferred tax asset was not recognized at the time of adoption of Statement 96, but would be recognized under the Exposure Draft (using the "more likely than not" standard), transitional rules should be established to permit recognition of the asset.

Deferred Intercompany Profit

The gross profit realized on intercompany sales of products that remain in the inventory of a consolidated financial reporting group gives rise to a deductible temporary difference when the buying and selling companies do not join in filing a consolidated tax return. [Paragraph 112-114.] The Exposure Draft would continue the Statement 96 perscription to treat the temporary difference as the buyer's temporary difference. When products are shipped from low-tax rate jurisdictions to high-tax jurisdictions, a deferred tax asset (and an income statement benefit) arises. Conversely, if product is shipped from a high-tax to a low-tax jurisdiction, a deferred tax liability (and tax expense) is generated.

TEI believes that the tax effects of an intercompany sale should not be recognized until the related revenue is recognized in the consolidated financial statements. We believe such a result is attained by treating the deferred gross profit element of the selling company as a temporary difference of the seller. Thus, notwithstanding the internal consistency and the theoretical position of the Exposure Draft provision, TEI questions the wisdom of a policy that allows mismatching of reported revenues and expenses.

Changes in Tax Law: Accounting

for the Effective Date

The Exposure Draft would provide that firms recognize the effect of tax law changes upon enactment of changes. [Paragraph 26.] The approval process for tax law changes, however, differs among jurisdictions and it might be appropriate to recognize tax law and rate changes in some countries from the proposed implementation date. For example, in Canada tax return filings often incorporate tax law and rate changes proposed in budget speeches, premised on the high degree of probability that measures will be (and almost always are) enacted without change in either substance or implementation date. (This is a by-product of Canada's parliamentary system.) If a firm is at liberty to file tax returns based on the proposed changes (hence, making judgments directly affecting a firm's cash flows), firms should also be allowed to exercise judgment on the probability of final enactment in preparing financial statements. Thus, TEI suggests that firms should be permitted to show tax provisions incorporating judgments regarding proposed tax law changes.

Miscellaneous Remarks

The Exposure Draft rejects the concept of discounting deferred tax assets and liabilities in connection with business combinations. [Paragraph 120.] This conclusion is to be commended, particularly for its avoidance of complexity. The Board, however, would still appear to be considering adoption of discounting of tax liabilities in connection with its study of Present-Value-Based Measurements in Accounting. [Paragraph 5b.] TEI reiterates its opposition to the application of discounting to deferred tax liabilities. Discounting would involve complex considerations, including the determination of the appropriate discount rate and assumptions concerning the timing of reversals of tax assets and liabilities. Some of the salutary changes to alleviate complexity in the Exposure Draft would be eliminated if discounting were required. TEI submits that the Final Statement should explicitly reject discounting of income tax assets and liabilities.

TEI approves of the change to the treatment of goodwill arising in business combinations in jurisdictions where goodwill is deductible for tax purposes. Developing events in the U.S. Congress suggest that the Board's precedent in establishing a rule for foreign business combinations may prove prescient and useful in accounting for future U.S. business combinations. (6)

Finally, the Board has greatly simplified the computation of deferred taxes by no longer requiring computations under alternative methods of taxation. [Paragraph 19.] As tax practitioners intimately involved with the preparation of tax provisions, this change in the treatment of the alternative minimum tax for financial statements is welcome relief.

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the Board's Exposure Draft on the Accounting For Income Taxes. If you should have any questions about our comments, please do not hesitate to call David F. Nitschke, chair of TEI's Federal Tax Committee or Paul Cherecwich, Jr., chair of TEI's Tax Accounting and Financial Reporting Subcommittee, at [phone] or [phone], respectively, or Jeffery P. Rasmussen of the Institute's professional tax staff at [phone].

(1) Unless otherwise noted, references to paragraphs are to the Exposure Draft.

(2) Paragraph 25 indicates that a firm should exercise judgment in determining when negative evidence outweighs positive evidence. Examples should avoid the inference that negative evidence always outweighs the positive evidence.

(3) The example states as an assumption that management concludes negative evidence outweighs positive evidence. Based on the facts of the example, one might infer that losses of sufficient magnitude to create a deficit in retained earnings at the end of year 5 is the evidence that requires the entire deferred asset to be subject to the valuation allowance. We do not quarrel with such a rule.

(4) In addition, the requirement is at odds with the treatment of revised valuations of other assets and liabilities acquired in a business combination. Such revisions in valuation are established by charges and credits to subsequent period income statements.

(5) If the Exposure Draft is adopted, the deferred tax liabilities required by this rule would never result in a tax payment to a foreign government (though, concededly, the liability may ultimately reverse.) If the assets giving rise to the deferred tax liabilities are continually replaced or the U.S. dollar equivalent amounts consistent grow, the deferred tax liabilities will also consistently grow. One criticism of APB 11 (and one rationale cited to change APB 11) is that it produced an accumulation of deferred tax credits that bore no relationship to the amounts that would ultimately be paid or settled. Unless an affected company's fortunes suffer a serious downturn or its assets are liquidated, the deferred tax liabilities required by the Exposure Draft would not reverse.

(6) See H.R. 3035 (102nd Cong., 1st Sess.), a bill relating to the Simplification of the Tax Treatment of Intangibles; U.S. General Accounting Office, Issues and Policy Proposals Regarding Tax Treatment of Intangible Assets (Report to the Joint Committee on Taxation) (GAO/GGD-91-88)(August 9, 1991).