Indefinite-lived assets in tax provision.
Deferred tax liabilities are a consideration in the analysis of whether to apply a valuation allowance because taxable temporary differences may be used as a source of taxable income to support the realization of deferred tax assets. The taxable temporary differences and future taxable income from operations provide a primary basis for support in determining whether to maintain a full or partial valuation allowance (FAS 109, [paragraph] 21; ASC [paragraph] 740-10-30-18).
Although taxable temporary differences are typically used to support realization of deferred tax assets, an anomaly may occur when the source of the taxable temporary difference is an asset with an indefinite useful life--for example, goodwill, trademarks, logos, and other indefinite-lived intangibles. Unlike temporary taxable differences, indefinite useful life intangible assets have no measurable or defined periods of time in which the asset will expire. At some indefinite future time, these assets will be sold or perhaps written off. Until such an event occurs, the asset remains on the books of the company with a related deferred tax liability resulting from book over tax basis or amortization expense. This is commonly referred to as a "naked credit."
These naked credits create a problem because a primary characteristic of a liability is that it represents a present responsibility to an entity that entails settlement at a specific or determinable date (FASB Statement of Financial Accounting Concepts No. 6, q136). In the case of intangible assets with indefinite lives, although in concept the deferred tax liabilities are a temporary difference, the underlying asset could remain on the balance sheet of the company indefinitely. The result is that deferred tax liabilities created by indefinite-lived assets cannot be used as a source of taxable income to support the realization of deferred tax assets. Thus, if there are no other sources of taxable income to support the realization of deferred tax assets, a valuation allowance would need to be recorded against the deferred tax assets, and a net deferred tax liability or naked credit is presented on the company's balance sheet.
Example 1: Company X is in a breakeven net income position for the current tax year with expiring net operating losses of $1 million or federal deferred tax assets of $350,000 ($1 million x 35% tax rate). X has the following deferred tax liabilities on the balance sheet at year end: installment payment, $150,000; accelerated depreciation, $150,000; and trademark amortization, $200,000. In evaluating whether a valuation allowance applies against the deferred tax asset of $350,000, X determined that $300,000 of the deferred tax liabilities is a source of taxable income to support the partial realization of expiring net operating losses (NOLs). The remaining expiring NOLs cannot be supported by amortization of the trademark deferred tax liability because this is an indefinite-lived asset. The result is as in Exhibit 1.
X records a partial valuation allowance of $50,000 and tax provision expense of $50,000. On X's balance sheet, a $300,000 deferred tax asset is included along with a $500,000 deferred tax liability or alternatively a net $200,000 deferred tax liability (naked credit).
Another anomaly that occurs with indefinite-lived assets is an increase in the effective tax rate when the company has a full valuation allowance. When the indefinite-lived asset is acquired, as in the case of goodwill with book over tax basis or amortization of tax basis, the resulting deferred tax liability is presented on the balance sheet with no deferred tax assets, resulting in a naked credit. With no deferred tax assets to offset this naked credit, a tax provision expense is recorded in the current period, affecting the effective tax rate.
Example 2: Company Y has been in an NOL position for the past two years, accumulating net operating losses of $1 million. In the current year, Y expects to report break-even profit and loss. As a result, a full valuation allowance for the current year was established. In addition, Y acquired a trademark for $1,500,000 and determined it appropriate to amortize over 15 years for tax purposes. Assuming a federal tax rate of 35%, the result is as in Exhibit 2.
Y records a full valuation allowance of $350,000 and a tax provision expense of $350,000. In addition, a tax provision expense of $35,000 is recorded for the amortization of the trademark. The total tax provision expense is $385,000 in the current period. On Y's balance sheet, deferred tax asset is zero and deferred tax liability or naked credit is $35,000. As the company returns to a profitable position and is able to support recognition of deferred tax assets, the tax provision expense for the valuation allowance and naked credit is reversed and recorded as a benefit to the effective tax rate in the period of recognition.
Indefinite-lived assets can cause unexpected results related to the determination of a valuation allowance and its impact on the effective tax rate. As assets are acquired and amortized for tax purposes, an analysis should be performed to determine their nature and useful life. If they are determined to be indefinite-lived assets, tax accounting policies and procedures should be put in place to account for their treatment in the event of a full or partial valuation allowance and their potential impact on the effective tax rate.
From Mario Castellon, CPA, Celera Corporation, Redwood City, CA, and Clara Xu, MS, Form Factor Inc., Livermore, CA (not affiliated with DFK International/USA)
Exhibit 1: Deferred tax liabilities offsetting NOLs in Example 1 Net operating loss $350,000 deferred tax asset Installment payment (150,000) deferred tax liability Accelerated (150,000) depreciation deferred tax liability Unsupported 50,000 deferred tax asset Valuation allowance (50,000) Net unsupported $0 deferred tax asset Exhibit 2: No deferred tax asset leads to naked credit Net operating loss $350,000 deferred tax asset Valuation allowance (350,000) Net deferred 0 tax asset Trademark deferred $(35,000) tax liability
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|Author:||Castellon, Mario; Xu, Celera|
|Publication:||The Tax Adviser|
|Date:||Oct 1, 2009|
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