Recent tax legislation, generally referred to as the Tax Cuts and Jobs Act (the “Act”), will have a significant impact on financial statement reporting. The Act was signed into law on December 22, 2017, and the financial impact of the Act’s changes must generally be reflected on a company’s financial statements as of that date.
In the context of an M&A transaction, a target company’s financial statements often provide substantial insight to a purchaser as it undertakes due diligence with respect to the target’s tax attributes and exposure. The impact of the Act will generally be reflected in the target’s financial statement presentation of balance sheet items and will also have an impact on reported earnings. In addition, the changes made by the Act may require a target to assess the impact on its operations and any attendant tax risk or required restructuring may be reflected in the risk disclosure section.
For financial reporting purposes, virtually all companies will be required to revalue deferred tax assets (DTAs) and deferred tax liabilities (DTLs) using the new lower corporate tax rate. Other changes in the Act that may impact a target’s financial statements include:
- Changes to net operating loss (NOL) and alternative minimum tax (AMT) provisions.
The Act limits the use of NOL carryforwards to an amount equal to 80% of taxable income, but also allows NOLs to be carried forward indefinitely. The Act also repealed the AMT and allows AMT credit carryforwards to either offset regular tax liability or be refunded over a period beginning after 2017 and before 2022. These changes will impact the determination of the value and reserve against DTAs that are established for NOL and AMT carryforwards on the target’s financial statements, and may reflect assets for which the seller would expect to be compensated.
- Changes to the taxation of international operations.
The Act contains extensive changes impacting the U.S. income taxation of companies with international operations, including (i) the “deemed repatriation” provisions that impose a one-time tax on previously deferred foreign earnings, (ii) a territorial taxing regime that allows the repatriation of certain future foreign earnings without the imposition of U.S. income tax, (iii) provisions intended to limit base erosion of U.S. income subject to taxation, and (iv) provisions subjecting certain global intangible income to current U.S. taxation.
The tax due on deemed repatriated foreign earnings must be recorded as a liability (and a component of income tax expense) on financial statements as of the date of enactment. This liability is generally not discounted if a company elects to pay the tax over a period of eight years, as permitted by the Act. To the extent a target’s financial statement reflects a liability with respect to the deemed repatriation provisions, such liability should be taken into account as the transaction is priced and structured.
As a result of the more territorial tax regime, a company’s position with respect to foreign earnings being permanently reinvested may no longer have a significant impact on its accrual of U.S. income tax liability associated with such earnings. However, there may still be other impacts on a company’s financial statements arising out of its policy with respect to foreign earnings, such as accruals for foreign withholding taxes.
The base erosion anti-abuse tax (BEAT) provisions limit deductions for certain payments made to foreign affiliates and impose a separate base erosion minimum tax, raising questions of whether the tax is separately accounted for or is a component of regular income tax expense. The global intangible low-taxed income (GILTI) provisions, which imposes a minimum tax on certain foreign earnings, raises similar issues. The effects of these provisions should be taken into account both in considering the target’s tax exposure and in determining the best approach to integrate the target into the purchaser’s existing structure post-closing.
- Changes that limit or disallow certain deductions.
There are a number of provisions in the Act limiting or disallowing companies’ deductions for certain expenses. For instance, the Act generally limits net business interest expense to 30% of adjusted taxable income, with an indefinite carryforward of disallowed interest expense. In addition, the disallowance of compensation expense over $1 million to certain “covered employees” was expanded to apply to more companies, and the exception for performance-based compensation was eliminated. Other changes in the Act limiting deductions include the elimination of the deduction for domestic production activities, the non-deductibility of certain local “lobbying” expenses, and additional limitations on deductions for entertainment expenses and fringe benefits.
The limitation on or disallowance of various deductions under the Act will increase a company’s permanent U.S. income tax expense reflected on its financial statements. In addition, the carryforward of disallowed business interest expenses will generate temporary differences and could give rise to reserves with respect to carryovers that are not likely to be utilized in the future.
The discussion presented above only covers a limited number of changes made by the Act and their impact on financial accounting and reporting. The SEC staff’s views regarding application of U.S. GAAP in accounting for the income tax effects of the Act are reflected in Staff Accounting Bulletin (SAB) No. 118.