Issues & Trends
March 2013, No. 13-14
Contents
Federal and State Income Tax
Accounting Methods
Transfer Pricing
Accounting for Income Taxes
Taxes Not Based on Income
Other Considerations
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The FASB and IASB (the Boards) project to achieve a converged revenue recognition standard could produce significant changes in how some entities recognize revenue, which could in turn affect both the calculation of and financial reporting for income taxes.
1 This edition of Defining Issues discusses some of the potential tax implications an entity should consider when evaluating the potential implications of the forthcoming standard.
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United States federal income tax law contains specific rules for revenue recognition for certain items such as income from long-term contracts, advance payments for goods and services sold to domestic entities, and informational reporting for foreign subsidiaries. For tax purposes, an entity must determine whether the transaction is a service, sale, license, or lease transaction. The Internal Revenue Code generally treats differently the income derived from each of these transactions. In some circumstances, the Internal Revenue Code requirement coincides with a taxpayer’s financial reporting treatment. If so, the taxpayer simply uses the same revenue recognition method such as recognition on shipment or completed contract for both tax and financial reporting. The effect on taxable income for state tax purposes will generally follow federal tax laws.
The Internal Revenue Code does not require an entity to maintain its accounting records using a specific method of accounting, such as U.S. GAAP, to determine taxable income; rather, adjustments are made to the financial reporting records to calculate income for tax purposes. However, changing an accounting method for financial reporting may result in the current federal tax accounting method no longer being permissible in some instances. In other instances, an entity may choose to voluntarily change its tax accounting method when its financial reporting changes.
The following situations may result in a change in tax accounting methods.
Tax Income Recognition – In General.
For federal tax purposes, an accrual method entity generally recognizes income in the period in which the right to the income becomes fixed and the amount is determinable with reasonable accuracy. For sales of goods, this point in time may be shipment, delivery, acceptance, or title passage; for services, income may be recognized as the services are rendered, or may be deferred until completion and acceptance of discrete deliverables. Changes in financial reporting accounting methods may highlight or generate a need to change tax accounting methods.
1 See KPMG’s Defining Issues publications on the Boards’ redeliberations of their joint revenue recognition project, all available at www.kpmginstitutes.com/financial-reporting-network. Also see the summary of decisions reached on the joint revenue recognition project of the FASB and IASB, available at www.fasb.org.
2 The FASB has tentatively decided to require public entities to adopt the standard in fiscal years, and interim periods within those years, beginning on or after January 1, 2017. The FASB has not yet considered the effective date for nonpublic entities.
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Advance Payments.
If the contract with the customer requires advance payments, tax deferral is generally allowed to the extent that deferral occurs for financial reporting purposes. Therefore, an acceleration of the recognition of revenue for financial reporting purpose could result in acceleration of taxable income.
3 For example, software vendors would no longer be required to have vendor-specific objective evidence (VSOE) for the undelivered items in a software contract to be able to account for the license separate from the undelivered items. Rather, a vendor would need to estimate stand-alone selling prices for all distinct goods or services without regard to a VSOE threshold. This could result in earlier revenue recognition compared to current U.S. GAAP. Upon adoption of the forthcoming standard, the recognition of a portion of the advance payments also would generally be accelerated for tax purposes.
Percentage of Completion.
Certain entities may be required for federal income tax purposes to report taxable income on the basis of percentage of completion, such as construction businesses and long-term contract manufacturers. To the extent that a change in financial reporting accounting methods affects the revenues recognized by entities using percentage of completion, a different tax accounting method may be desirable or potentially necessary. In these situations, a change in the tax accounting method will generally be made on a cut-off basis (i.e., old contracts must be accounted for under the former method and new contracts will be accounted for under the new accounting method for tax purposes).
Change in Tax Accounting Method.
A change in financial reporting accounting method will not generally be deemed to constitute a change in underlying facts for tax procedural purposes. In general, when a new tax accounting method is required or desirable because the financial reporting accounting method changes, an entity must obtain permission from the Internal Revenue Service (IRS) National Office by filing Form 3115, Application for Change in Accounting Method . The filing procedures and timing vary based on whether the change is automatic or subject to advance consent from the IRS.
If an entity is changing to a tax accounting method that is identified in published IRS guidance, the IRS is deemed to automatically approve the change when Form 3115 is received and, at the same time, forgive interest and penalties, if any, if the entity is moving from an impermissible method to a permissible method. The timing of recognition for financial reporting purposes of the effects of a change in tax accounting methods, including the potential forgiveness of interest and penalties, may depend on when the entity determines to make the change, when Form 3115 is filed, and whether the entity is changing from an impermissible method to a permissible method.
If an entity is changing its tax accounting method outside the automatic procedures,
IRS approval of the change (and forgiveness of interest and penalties, if any) is not automatic. The entity may need to consider the GAAP requirements on accounting for tax uncertainties to determine whether it is appropriate to account for the change before it receives approval, i.e., the ruling letter.
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3 Reg. §1.451-5 of the income tax regulations is applicable to advance payments for prepaid merchandise and Rev. Proc. 2004-34, modified by Rev. Proc. 2011-18, is applicable to prepaid services and mixed prepayments.
4 FASB ASC Subtopic 740-10, Income Taxes – Overall, available at www.fasb.org.
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If the adoption of the forthcoming standard results in accelerated income, there could be an unfavorable tax accounting method change. That adjustment (i.e., the income inclusion catch-up adjustment that is the difference between the tax accounting on the old method and new method as of the beginning of the year of change) would generally be spread over four years for tax purposes. This would also create an additional temporary difference for the portion of the effect of the tax accounting method change that has not yet been recognized for tax purposes.
The transfer pricing strategy of a multinational entity can have significant tax implications, and can require extensive documentation to demonstrate how its strategy meets the local requirements for intercompany transactions. Changes to the amount and timing of revenue recognition from the forthcoming standard could have a significant effect on transfer pricing specifically as it relates to using revenue or profit-based methods for establishing the transfer pricing. An entity would need to consider whether its transfer pricing strategies and supporting documentation should be revised or updated.
The forthcoming standard could have other implications on the accounting for income taxes, in addition to the implications related to the tax accounting method changes discussed above. Some potential implications include:
Costs of Obtaining a Contract.
Incremental costs that an entity incurs only as a result of obtaining a contract (e.g., sales commissions) would be capitalized for financial reporting purposes under the Boards’ tentative decisions if the entity expects to recover these costs. As a practical expedient, an entity would not be required to capitalize the incremental costs of obtaining a contract if the amortization period would be one year or less. For both cash-basis and accrual-basis taxpayers, the default U.S. federal income tax treatment is to capitalize and amortize the costs of obtaining the contract over the contractual term, but there are several exceptions that may permit a current deduction (e.g., sales commissions to employees would generally fall within one of these exceptions). Thus, the existence and magnitude of differences in the basis for financial reporting and tax amounts of capitalized contract acquisition costs and the related deferred tax assets and liabilities will depend on the specific facts and circumstances.
Collectibility.
The Boards’ tentative decisions do not include collectibility as a recognition threshold, which requires an assessment of the customer’s ability to pay the promised amount of consideration before revenue could be recognized. Instead, an entity would recognize revenue (even when collectibility is not probable or reasonably assured) and separately recognize an allowance for any expected credit impairment loss from contracts with customers. As a result of the potential removal of the collectibility threshold, revenue could be recognized earlier than under current
U.S. GAAP for certain contracts, with a corresponding credit impairment loss for an entity’s estimate of contractual cash flows not expected to be collected. Because tax deductions for bad debts generally occur when a receivable is specifically charged off, a deferred tax asset generally would exist for the financial statement carrying amount of the allowance for doubtful accounts.
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Investments in Foreign Operations.
Adoption of the forthcoming standard would affect the opening balance sheet for many entities, which could affect the outside basis difference in investments in foreign operations on the date of adoption. The outside basis difference is the difference between the basis of an entity’s investment in a subsidiary for financial reporting purposes and the tax basis of the investment. When the financial reporting basis of an investment in a foreign subsidiary exceeds the tax basis, a deferred tax liability should be recognized unless the difference is supported by evidence of specific plans for indefinite reinvestment or the earnings would be remitted in a tax-free liquidation. Changes in the investment in a foreign subsidiary upon adoption of the new standard may impact the amount of the deferred tax liability when the indefinite reinvestment criterion is not applied or may require assessment of the effect of the change on the indefinite reinvestment criterion when it is applied.
An entity that maintains a deferred tax liability on some, but not all, of the outside basis difference in foreign subsidiaries would have additional considerations. For example, if the deferred tax liability established for the excess tax basis over the financial reporting basis is determined based on the amount of basis difference above a specific amount to be indefinitely reinvested, the deferred tax liability could be affected by the adoption of the forthcoming standard. However, if the deferred tax liability was established for a specific amount expected to be repatriated, with the remainder subject to the indefinite reinvestment criteria, the deferred tax liability may not be affected.
Deferred tax assets generally are not recognized for deductible outside basis differences in investments in subsidiaries that will not be realized in the foreseeable future, which is generally interpreted in practice to be within one year. If an entity does expect to realize the deferred tax asset within the foreseeable future, it will also need to consider what effect the forthcoming standard will have on the temporary difference and related deferred taxes.
The Boards’ tentative decisions also could affect non-income based taxes with respect to income statement presentation and contracting practices.
Income Statement Presentation.
The forthcoming standard would supersede accounting guidance on how taxes collected from customers and remitted to governmental authorities should be presented in the income statement (i.e., gross versus net presentation).
5 Current accounting guidance allows a policy election, but the proposed standard would require an entity to determine whether taxes collected from customers and remitted to governmental authorities should be recognized on a gross or net basis based on principal versus agent considerations.
The proposed standard says that sales taxes are a common example of an agency relationship. When an entity sells a product, sales taxes collected on behalf of a government body should be excluded from the recognized revenue. These taxes are remitted in full to the government and do not increase equity. Therefore, revenue should be presented net of sales taxes.
5 FASB ASC Subtopic 605-45, Revenue Recognition – Principal Agent Considerations, available at www.fasb.org.
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The treatment of sales taxes differs from production taxes, which are treated as a cost of sales. It could be necessary to analyze for each jurisdiction in which the entity operates whether certain taxes are sales taxes or production taxes to determine the accounting treatment. For example, excise duty paid by tobacco and alcohol manufacturers is a sales tax in some jurisdictions and a production tax in others. In some jurisdictions, it may be difficult to determine the exact nature of the tax, requiring the exercise of judgment to determine its character. When determining whether revenue should be presented gross or net of excise tax, the key consideration is whether the entity is acting as a principal or as an agent on behalf of the government. Other taxes that would need to be evaluated include, but are not limited to, value-added taxes, use tax, withholding taxes, and gross receipts taxes.
Contracting Practices.
Generally, direct taxes, such as sales taxes, are determined based on stated contractual amounts for a specific good or a service. Any changes in contracting practices may affect the amount of tax assessed because there may be different tax rates assessed for the sale of goods versus the sale of services. Where goods and services are sold as a bundle, an entity might have a contracting practice of reflecting these goods and services as a single price offering. In those cases, an entity would need to evaluate and determine the amount allocable to the goods versus services to determine sales taxes. If an entity uses the amounts recognized in its financial statements to support the amounts allocable to the goods or services for tax purposes, the forthcoming standard could have an impact on sales taxes if there are any significant changes in the amounts allocable to goods or services.
In preparing for the adoption of the forthcoming revenue recognition requirements, an entity should evaluate how it may affect other aspects in addition to those discussed above. Management should consider:
 Training needs;
 Contract practices and potential changes that would affect financial reporting if an entity chooses to make revisions to contracts;
 Potential changes to the tax accounting methods for foreign income taxes;
 Specific contractual terms that could result in a difference between the allocation for tax and financial reporting purposes when accounting for multipleelement contracts;
 Inconsistencies between financial and tax reporting that would require dual accounting records;
 New data or information system requirements resulting from different tax and financial accounting methods;
 Effects on income tax reporting, compliance, and planning (e.g., financial reporting for new tax-basis differences, the need to capitalize contract costs for financial reporting purposes, the effect of contract modifications, and the effect on an entity’s assessment of whether it is more likely than not that deferred tax assets will be realized for purposes of considering a valuation allowance);
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 Potential effects on determining revenue-based apportionment factors used for calculating state income taxes and used for determining the applicable rate used to measure state deferred income taxes; and
 Other tax implications, such as net worth or capital-based taxes, if any.
Contact us:
This is a publication of KPMG’s
Department of Professional Practice
212-909-5600
Contributing authors:
Darryl S. Briley
Prasadh Cadambi
Ashby T. Corum
Kevin P. Slama
Earlier editions are available at: http://www.kpmginstitutes.com/financial-reporting-network
The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the proposed standard or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors.
Defining Issues® is a registered trademark of KPMG LLP.
©2001-2013 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the
KPMG network of independent member firms affiliated with KPMG International Cooperative
(“KPMG International”), a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative (“KPMG International”), a Swiss entity.