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:
- 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.
How are deferred tax asset valuation allowances calculated?
The process for identifying deferred tax assets and determining whether a valuation allowance is required has five steps:
- Identify basis differences between GAAP (Generally Accepted Accounting Practices) and tax balance sheets with future tax implications.
- Categorize differences into future taxable and future deductible amounts to determine whether the difference is a deferred tax liability or a deferred tax asset.
- Determine the correct tax rate. The rate to use is the enacted rate applicable when the difference is anticipated to reverse.
- Calculate the deferred tax assets, using the rate from step 3.
- Consider whether a valuation allowance is required. If it is more likely than not (a greater than 50% chance) that the assets will not be fully recoverable, ASC 740 requires a valuation allowance. The assets should be reduced to the amount that more likely than not can be recovered—meaning there is a greater than 50% chance that the remaining assets are recoverable.
Obviously, assessing whether or not a valuation allowance is required, as well as the amount of such adjustment, necessitates considerable judgment. Accurate future forecasts are dependent on making the necessary assumptions; if any of those assumptions are erroneous, the forecast may differ dramatically from reality in terms of how the future unfolds.
Ultimately, ASC 740 valuation allowance guidance has the same intent as goodwill impairment testing: to bring the assets on the balance sheet into alignment with fair market value. ASC 740’s “more likely than not” standard for determining whether a valuation allowance is required is intended to offset wishful thinking that otherwise might keep deferred tax assets on the balance sheet indefinitely, creating a widening gap between the value reflected in the balance sheet and the actual fair market value of the business.
Need help determining the fair market value of your business assets?
Our valuation and transfer pricing experts at Taqeem have decades of combined experience in providing accurate, defensible values and services. Please contact us to learn more about how we can assist your organization with all of its valuation and transfer pricing requirements.