Valuation allowances for deferred tax assets are anticipated to become a problem for many businesses in the aftermath of the COVID-19 outbreak. Shutdowns and other disruptions to corporate operations have had a severe financial impact on numerous organizations, and many more are expected to lose money in 2020. (and perhaps for 2021 as well).

This is expected to have an impact on enterprises who had deferred tax assets on their books as of 2020. (and potentially many that did not but still suffered severe revenue impacts from the pandemic). Given the unknowns surrounding the post-pandemic recovery, this will almost certainly need a valuation allowance to lower the deferred tax assets.

In this article, we’ll define what deferred tax assets and valuation allowances are—and when it is appropriate to apply a valuation allowance.

What is a deferred tax asset?

A deferred tax asset (DTA) is the result of an overpayment or advance payment of taxes. It can be caused by a misalignment of tax and accounting laws, as well as a rollover of tax losses. DTAs are represented as assets on the balance sheet since they represent a previous expense that may be recouped in the future. Deferred tax assets (DTAs) can be “redeemed” to lower tax responsibilities in a future time of profitability—the tax paid will be reduced by the value of the DTAs, which were basically a prepayment of the present tax due. As a result, when DTAs are redeemed, they result in an increase in revenue.

Prior to the Tax Cut and Jobs Act of 2017 (TCJA), DTAs could only be carried forward for a limited period of time to offset a current tax liability. Because the TCJA removed the time limit, DTAs now have an indefinite lifespan—at least in theory. In actuality, it’s quite improbable that a DTA issued in 2018, just after the TCJA was enacted, would still be on the books in 2028 to redeem—not only because tax policy may change in the interim, but also for the reasons discussed in the following sections.

When is it appropriate to apply a valuation allowance for deferred tax assets?

Deferred tax assets must be reduced by a valuation allowance for any component of the assets that is not expected to be realized, according to FASB ASC 740. To realize the DTAs, the company must generate enough revenue over the carryforward period to reclaim the assets. As previously stated, the TCJA’s modifications have made the carryforward period indefinite. But that doesn’t imply deferred tax assets can’t be carried on the balance sheet indefinitely if they’re unlikely to be realized.

When the preponderance of evidence—both positive and negative—indicates that some or all of the DTAs will not be realized, ASC 740 mandates a valuation allowance. “Forming a determination that a valuation allowance is not warranted is difficult when there is negative evidence,” according to FASB regulation.

Negative evidence examples include:

• How should such a loss be allocated between the Licensor and Licensee?
• Past history of tax credit carryforwards expiring unused
• Expected losses in years in the near future by a currently profitable company
• Issues or circumstances that if unfavorably resolved will adversely impact future operations and profits on a continuing basis

As a result, most organizations are unlikely to be able to use the infinite carryforward term for DTAs. Events like the COVID-19 pandemic can make previous or current data less relevant, necessitating more in-depth research and revisions to future estimates. The consequences of the epidemic constitute a piece of negative data with just as much weight as cumulative historical losses, regardless of past firm performance and profitability. Even firms that were successful before to the pandemic may be subject to a value allowance since any unfavorable evidence is difficult to overcome. The valuation allowance can be overturned if it is later discovered that the DTAs will be realized.

Allocating Income To Non-routine Contributions

In most cases, residual profits are allocated using the RPSM based on a measure of each party’s intangible investments or particular contributions to value drivers. Profits during COVID-19, on the other hand, are more likely to represent specific risk events—both positive and bad—than past intangible investments.

Practitioners will need to think about how to deal with the possibility of a residual loss in 2020. For the standard Licensor/Licensee scenario stated above, this position poses a number of problems, the answers to which are up for debate:

• How should such a loss be allocated between the Licensor and Licensee?
• Would a Licensor accept a negative royalty in such a situation? Is this situation addressed in the intercompany contracts between the Licensor and Licensee?
• How much of the expected residual profit or loss should the Licensee bear for taking on the market risks inherent with being the Principal in transactions with customers, versus the provider of intangible assets (i.e. the Licensor)?
• Is no royalty the correct answer for the transfer price in a situation where there is a residual loss? If so, can the loss be “carried-forward” so that future royalties will be lower once the economy has recovered?

A clothing business is an interesting example of the influence the COVID-19 economic crisis might have on an existing RPSM. A clothes store could be made up of one business doing product design, another doing internet distribution, and a third doing brick-and-mortar sales. The demand and attraction of apparel designs may be essentially unaffected in the present COVID-19 climate, with internet retailers selling at increasing volumes and brick and mortar retailers seeing considerable sales declines. Should these companies continue to distribute profits and losses in the same way they did before the COVID-19 financial crisis? Should the internet merchant’s earnings rise while the brick and mortar retailer loses money? Taxpayers will have to judge if an existing RPSM effectively accounts for risk and produces a reasonable result.

Taxpayers will need to give serious consideration to the reliability of the selection of the RPSM as the most appropriate method in the COVID-19 economic crisis. While the first sentence in 1.482-6 of the U.S. transfer pricing regulations indicates that the PSM “evaluates whether the allocation of the combined operating profit or loss (emphasis added)” is consistent with an arm’s length outcome, the issues associated with applying the RPSM in a loss situation are such that some taxpayers may choose to temporarily (or permanently) choose an alternative method to govern these intercompany transactions that would provide a more reasonable and reliable outcome.