This article was updated on January 2, 2024.
Now that 2023 has ended, calendar year taxpayers have several opportunities to proactively prepare for their fourth quarter 2023 income tax provisions and financial statement audits. Below, we’ll highlight recent trends in Accounting Standards Codification (ASC) Topic 740 and some reporting considerations to keep in mind as we approach tax provision season.
Section 174 Capitalization
Internal Revenue Code (IRC) Section 174 continues to be a hot topic as the IRS has issued additional guidance that clarifies the treatment of specified research or experimental expenditures.
Taxpayers who adopted a method using the simplified process for 2022 will need to review their current method for conformity with Notice 2023-63, which was issued in September 2023. Companies may need to consider whether a method change is warranted, would provide audit protection, and if there is need for an uncertain tax position (UTP).
Capitalized IRC Section 174 costs can also create a significant deferred tax asset (DTA), increase current taxable income, and impact the analysis of realizability of DTAs overall. If the DTA is significant, companies may need to revisit their deferred scheduling to determine if a valuation allowance is appropriate.
Valuation Allowance Considerations of TCJA Changes
Beyond IRC Section 174, valuation allowances continue to be an area of focus. As the Tax Cuts and Jobs Act (TCJA) changes to bonus depreciation take effect—reducing the deduction from 100% in 2022 to 80% in 2023, and further 20% reductions each year through 2026—this impacts taxable income and lowers future reversing deferred tax liabilities (DTLs).
As these changes work together in the 2023 tax year, it may impact the realizability of DTAs in future years. For example, companies will want to consider how the effects of IRC Section 174 capitalization and bonus depreciation impact the computation of IRC Section 163(j) interest limitation in the valuation allowance analysis. These changes, along with the evolving business and financing landscape, may require companies to revisit their deferred tax scheduling and valuation allowances for 2023.
In 2022, in an SEC review of a public company filing, the SEC found material misstatements where an indefinite-lived DTL was incorrectly netted, and an additional asset was incorrectly classified as a definite-lived asset in the valuation allowance calculation. Beyond the base analysis of whether a partial or full valuation allowance is warranted, companies also need to take an inventory of assets and liabilities to determine whether they’re properly classified when considering what can be netted for valuation allowance purposes.
New and Expanded Tax Credits under the Inflation Reduction Act and CHIPS Act
The Inflation Reduction Act and Creating Helpful Incentives to Produce Semiconductors for America (CHIPS) Act introduced incentives in the form of new, extended tax credits for expanded clean energy investments, production tax credits, and semiconductor manufacturing investments. Across these credits, additional incentives were added:
- Allowing applicable entities to claim elective refundable cash payments in lieu of certain tax credits through the direct pay program
- Allowing certain credits to be monetized and transferred to third-party purchasers
- Allowing certain credits to be carried back for three years to offset prior year taxes
A company generating, selling, or purchasing these new credits must assess the accounting considerations to determine if they’re within the scope of ASC 740 income taxes or should be accounted for under a government grant accounting model. Given the complexity of these new tax laws, work with your tax advisor and external auditor in assessing the accounting treatment, as well as formulating accounting policy elections relative to these tax credits.
Accounting of Investments in Tax Credit Structures Using Proportional Amortization (ASU 2023-02)
This Accounting Standards Update (ASU), finalized this year, expands the types of tax credits that can qualify for the proportional amortization method. Previously, the proportional amortization method (PAM) typically applied to investments in structures that generated Low Income Housing Tax Credits.
Under this ASU, a tax equity investor reporting entity can make a policy election for a specific project to apply the PAM for income tax credits from a tax credit program. A company should evaluate its tax credit investments to model out the accounting considerations of making a policy election to apply the PAM.
Improvements to Income Tax Disclosures (ASU 2023-09)
The Financial Accounting Standards Board (FASB) finalized changes to income tax disclosures on December 14, 2023. ASU 2023-09 is effective for public business entities (PBEs) for fiscal years beginning after December 15, 2024. Other non-PBEs have an additional year to adopt the ASU.
Key changes to the financial statement disclosures are as follows.
For PBEs, changes to the tabular rate reconciliation include:
- Specific categories of disclosure, including state and local tax net of federal tax effect, foreign tax effects, effects of changes in tax laws or rates enacted in the current period, effect of cross-border tax laws, tax credits, changes in valuation allowance, nontaxable or nondeductible items, changes in unrecognized tax benefits, and others
- Required equal to or greater than 5% threshold for further disaggregation of other reconciling items not included above as specific disclosure categories
- Separate disclosures for cross-border tax laws, tax credits, and permanent items disaggregated by nature, are required if equal to or greater than 5%
- The tax effect of global intangible low-taxed income (GILTI), considered a cross-border tax law, is allowed to be disclosed on a net basis, after the effects of related foreign tax credits
- Disaggregation by jurisdiction and by nature for foreign tax effects categories
- Reporting using both percentage and reporting currency amounts
- Qualitative description of the state and local jurisdictions that make up the majority—(greater than 50%)—of the effect of the state and local income tax category
- Required to provide explanation, if not otherwise evident, of the individual reconciling items disclosed, such as the nature, effect, and underlying causes of the reconciling items and the judgment used in categorizing the reconciling items
Non-PBEs require qualitative disclosure about specific categories of reconciling items and individual jurisdictions that result in significant differences between the statutory and effective tax rate, but a numerical reconciliation, isn’t required.
The following disclosures are applicable to all entities:
- Disaggregation of pre-tax income or loss from continuing operations between domestic and foreign
- Disaggregation of income tax expense or benefit from continuing operation between federal, state, and foreign tax
- Annual disclosure of income taxes paid and net of refunds received disaggregated by federal, state, and foreign tax
- Annual disclosure of the amount of income taxes paid, disaggregated by individual jurisdiction in which income taxes paid is equal to or greater than 5% of total income taxes paid – all amounts net of refunds received
- Elimination of the requirement to disclose the cumulative amount of each type of temporary difference where a deferred tax liability isn’t recognized due to exceptions to recognition, such as for permanently reinvested unrepatriated earnings related to subsidiaries and corporate joint ventures
- Elimination of the requirement to disclose the nature and estimate the range of the reasonably possible change in the unrecognized tax benefits balance over the next 12 months
Companies have the option to early adopt the ASU and all entities may apply the amendments on a prospective basis, with a retrospective option.
Annual Reminders
Below are annual reminders related to income tax and relevant guidance.
Return-to-Provision Reconciliation
If not completed in an earlier interim period, begin evaluating the return-to-provision (RTP) reconciliation internally, book any impacts to the 2023 financials, and document any changes in estimates or corrections of errors that may have occurred to discuss with your external audit team. Corrections of errors must be separately evaluated to determine whether they are material and whether there may be an internal control deficiency.
An RTP difference on a permanent item may result in an impact to the overall tax expense, while temporary items generally don’t impact tax expense and are treated as a reclass between the tax payable or receivable and the deferred tax asset or liability.
Performing this work ahead of the provision can help to smooth the year-end provision process and allows time to implement any changes in process that may be necessary for the 2023 provision to avoid the need for a similar correction going forward.
Accounting for Effects of Changes in Tax Laws
For any tax law changes during the year, both the impact on the income taxes receivable or payable and the impact on the existing DTAs and DTLs are recognized in income tax expense or benefit for continuing operations for the interim period that includes the enactment date—not the effective date. The impact of these changes is based on the temporary differences as of the enactment date and should include any reevaluation of the valuation allowance related to the tax law change.
Deferred Tax Rate Updates
The end of the year is also the time to evaluate any changes to your deferred tax rate for 2023—whether you’re utilizing a jurisdiction-by-jurisdiction or blended rate analysis. If there were significant changes in apportionment between prior year provision and return, recent state tax law changes resulting in changes in state tax rates, apportionment factor methodology changes, or nexus determinations during the year, this can impact the appropriate deferred rate to utilize on your 2023 provision and result in effective tax rate adjustments for the current year.
UTPs
Now is also a good time to revisit income tax positions for all jurisdictions to evaluate the need for any adjustments for reserves for UTPs. This may include a roll-forward of reserves for UTPs that existed at the beginning of the year for additional tax, interest and applicable penalty accruals, reversals for settled positions or expiration of statute of limitations, as well as any new positions arising in the current year. For example, it’s common to see a company earn a new type of tax credit enacted into current year law, but there may be still uncertainties on the application of the new law which necessitates an evaluation for a new UTP.
We’re Here to Help
If you have questions or need help applying any of this new guidance to your 2023 financials, contact your Moss Adams professional.