October 15th is behind us, and many tax professionals are taking a much needed break. It’s time to relax for a day, watch the sun set, or maybe even eat something that did not come in a take-out bag. That sounds amazing…
Then we wake up, shake off the day dream, and realize that October 16th simply means we are officially a day late getting started on the quarterly tax provision! For many companies, September 30th marked the end of third quarter, perhaps the busiest quarter of all. Now is the time that budgets are updated with nine months of actual results; the tax returns are generally complete; and companies are assessing their key tax-related estimates, such as realizability of deferred tax assets and whether to permanently reinvest those foreign earnings. With all of this activity, how does it all get worked into the interim tax provision, and what do tax accountants need to be concerned about?
The general approach: In its most basic form, accounting for income taxes in an interim period seems to be a fairly simple task; yet – for most tax professionals – it has become one of the more complex, ambiguous challenges that we face. The basic premise of accounting for taxes in an interim period is to reflect the best estimate of worldwide taxes for the entire year. Those full-year taxes include the impacts of federal, state, local and foreign income taxes, reflecting any credits and incentives, special deductions, variable tax rates and other amounts impacting the global tax rate. Additionally, for each period, one-time charges and benefits are reflected for items occurring during the period that are unusual or infrequent in nature. Once the basic premise is understood and modeled, there are a few additional wrinkles to iron out before it is ‘pencils down’ and time to go.
Exceptions to the general rule. Beware of exceptions to the general rule of developing a single worldwide estimated annual effective tax rate. These exceptions are not elective, but are required whenever the exception applies.
- Discrete events are accounted for as they occur. One of the more complex areas of interim tax accounting is determining whether an event is discrete or a component of the estimated tax rate. Discrete events generally fall into two main categories. (1) Items clearly defined in accounting literature, such as changes in tax rate or tax law, as amounts required to be presented in the period in which they occur, or that are infrequent or unusual in nature; and (2) gains or losses that are not a component of “ordinary income” (continuing operating income), such as income from discontinued operations or losses reflected as a component of other comprehensive income. The most difficult concept is generally determining whether an item is truly infrequent in occurrence or unusual in nature, based on guidance consistent with determining extraordinary items in ASC 225, Income Statement Extraordinary and Unusual Items.
- One example of a “discrete” item is the provision-to-return adjustment. For many companies, this is reflected in the third quarter as the income tax returns are finally filed. For some companies, this is also a bright yellow caution flag! When the provision to return reflects significant differences between the estimated tax amounts prepared for the prior year’s financial statements and the income tax return amounts as actually filed – as many as nine months later – companies should evaluate whether that difference was a result of an error in the tax provision or truly a change in estimate. For example, if a company projected state tax using the 2011 state tax rate for its 2012 income tax provision and, upon filing the 2011 tax returns, determines that the state rate is significantly different; the change is typically viewed as an error in the tax provision. On the other hand, if the 2011 state tax rate is updated based on 2012 apportionment and state rates, then most differences would be considered a change in estimate as that estimate is refined.
- When determining the interim income benefit tax associated with losses in continuing operations, the tax benefit should consider gains reflected in items other than ordinary income. This limitation can result in unusual and unexpected effective tax rates that fluctuate from quarter to quarter.
- Loss jurisdictions, for an otherwise profitable entity, are removed from the overall annual estimated tax rate unless the tax benefit of the loss can be realized. This exception applies to separate return jurisdictions as well as operating jurisdictions. Note that “no tax benefit” means no tax benefit. If a loss is being carried back to offset income in a prior period, this exception does not apply and the carryback should be considered in determining the overall tax rate.
- Earnings or losses of a particular jurisdiction or revenue stream that cannot be reliably estimated are treated discretely as incurred. This exception is also very narrow in scope and does not apply to seasonal operations or abrupt economic changes. Companies generally cannot rely on this exception even when discrete events cause the effective tax rate to be volatile.
With all of these complexities, and many more, it is no small wonder that interim tax accounting is in the forefront of tax accountant’s thoughts. The good news is – after this is done, we finally do get to take that much needed break and enjoy the sunset!