US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 10
Chapter 10: Income Taxes
10-1 Accounting for refundable income tax credits
Background
Company A was awarded a research and development (R&D) tax credit of $1 million that can be used to reduce its income tax liability. If not used, it is fully refundable. Said differently, Company A can be in a taxable loss position and still be eligible to receive the tax credit.
Question: Is the refundable R&D tax credit of $1 million accounted for as part of income taxes within the scope of ASC 740?
Solution
The refundable R&D tax credit of $1 million is not within the scope of the income tax standard (ASC 740), because the ability to realize the credit does not depend on having an income tax liability. Company A should instead account for (and present) the R&D tax credit consistent with how it would account for a government grant.
However, in cases when there are differing economic consequences if Company A choses to monetize the credit via sale or refund versus reducing its income tax liability, an argument may exist that the credit is in the scope of ASC 740. This might be the case, for example, if monetizing the benefit via sale or refund results in different taxation of the benefit (e.g., state income tax consequences).
Relevant guidance
ASC 740-10-15-3: The guidance in the Income Taxes Topic applies to:
a. Domestic federal (national) income taxes (U.S. federal income taxes for U.S. entities) and foreign, state, and local (including franchise) taxes based on income
b. An entity's domestic and foreign operations that are consolidated, combined, or accounted for by the equity method.
10-2 Valuation allowance: Whether a deferred tax liability for an IPR&D asset should be considered a source of income for realizing deferred tax assets
Background
Company A acquires Company B in a nontaxable business combination. Company A recognizes an in-process research and development (IPR&D) asset of $500 million and records an associated deferred tax liability of $125 million. Under ASC 805, Business Combinations, the IPR&D asset is classified as indefinite-lived until the project is either abandoned or completed, at which time a useful life will be determined. Company A plans to file a consolidated tax return with Company B. Company A had a pre-existing deferred tax asset of $100 million for net operating losses (NOLs) that will expire in 10 years (for simplicity, assume this is the Company’s only deferred tax asset). Prior to the acquisition, Company A had a valuation allowance against the deferred tax asset.
Question: Should the deferred tax liability related to the IPR&D asset be considered a source of income for realizing deferred tax assets?
Solution
It depends. Company A must estimate both when the R&D project will be completed and the expected useful life of the resulting IPR&D asset in order to determine whether the deferred tax liability related to the IPR&D asset can be used as a source of taxable income. If Company A expects the R&D project to be completed within two years and expects the useful life of the IPR&D asset to be three years, then the deferred tax liability should be used as a source of income in assessing the realization of the deferred tax asset because the deferred tax liability is expected to reverse (over years three to five) before the NOL carryforward expires. Any benefit recognized if Company A reverses all or a portion of its valuation allowance would be recorded outside of acquisition accounting in continuing operations.
Relevant guidance
ASC 740-10-30-18: Future realization of the tax benefit of an existing deductible temporary difference or carryforward ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback, carryforward period available under the tax law. The following four possible sources of taxable income may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards:
a. Future reversals of existing taxable temporary differences
b. Future taxable income exclusive of reversing temporary differences and carryforwards
c. Taxable income in prior carryback year(s) if carryback is permitted under the tax law
d. Tax-planning strategies (see paragraph 740-10-30-19) that would, if necessary, be implemented to, for example:
- Accelerate taxable amounts to utilize expiring carryforwards
- Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss
- Switch from tax-exempt to taxable investments.
Evidence available about each of those possible sources of taxable income will vary for different tax jurisdictions and, possibly, from year to year. To the extent evidence about one or more sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered. Consideration of each source is required, however, to determine the amount of the valuation allowance that is recognized for deferred tax assets.
10-3 Valuation Allowance: Deferred tax liability related to an IPR&D asset in a jurisdiction with an unlimited loss carryforward period
Background
Company A operates in a jurisdiction with an unlimited NOL carryforward period. Company A has $80 million of NOLs (tax effected). Company A has a deferred tax liability of $100 million for an IPR&D asset. Company A has significant negative evidence as a result of historical losses and is unable to place reliance on projected taxable income or tax-planning strategies. Accordingly, the taxable temporary difference related to the IPR&D asset is the only potential source of income available to support realization of the deferred tax asset related to the NOL carryforward. However, Company A is currently unable to reliably estimate when the R&D project will be completed and therefore considers the related deferred tax liability to have an indefinite or indeterminable reversal period.
Question: Should Company A consider the taxable temporary difference associated with the IPR&D asset as a source of taxable income to support realization of the NOL deferred tax asset?
Solution
Yes. Company A would not record a valuation allowance against the deferred tax asset related to the NOL. While the taxable temporary difference related to the IPR&D asset currently has an indeterminable reversal period, since the NOLs never expire, they will always be available to shield any tax cost that would be incurred when deferred tax liability related to the IPR&D asset ultimately reverses. In addition, both the NOLs and the IPR&D asset are within the same tax jurisdiction and are of the appropriate character. Said another way, the NOL is fully realizable if and when the taxable income that would be generated from recovering the IPR&D asset materializes.
In certain jurisdictions, the use of NOLs is limited to a percentage (e.g., 80%) of taxable income, in any given year. Companies should consider tax law limitations on the utilization of NOLs, and in certain instances may need to record a partial valuation allowance.
Relevant guidance
ASC 740-10-30-18: Future realization of the tax benefit of an existing deductible temporary difference or carryforward ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback, carryforward period available under the tax law. The following four possible sources of taxable income may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards:
a. Future reversals of existing taxable temporary differences
b. Future taxable income exclusive of reversing temporary differences and carryforwards
c. Taxable income in prior carryback year(s) if carryback is permitted under the tax law
d. Tax-planning strategies (see paragraph 740-10-30-19) that would, if necessary, be implemented to, for example:
- Accelerate taxable amounts to utilize expiring carryforwards
- Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss
- Switch from tax-exempt to taxable investments.
Evidence available about each of those possible sources of taxable income will vary for different tax jurisdictions and, possibly, from year to year. To the extent evidence about one or more sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered. Consideration of each source is required, however, to determine the amount of the valuation allowance that is recognized for deferred tax assets.
10-4 Tax impact of acquired IPR&D in an asset acquisition
Background
On January 1, 20X1, Company A acquires the intellectual property (IP) of Drug A from Company B for $200 million. The payment was expensed as IPR&D because there is no alternative future use for the IP and the acquired asset does not constitute a business. Because of the manner in which the IP was acquired, the tax basis in the IP is zero.
Question: Should Company A recognize a deferred tax liability for the initial difference between the financial statement reporting amount ($200 million) and the underlying tax basis ($0)?
Solution
No. We believe the write off of amounts assigned for financial statement reporting purposes to IPR&D expense occurs prior to the measurement of deferred taxes. Accordingly, deferred taxes are not provided on the initial differences between amounts assigned for financial reporting and tax purposes. As a result, the IPR&D expense is reflected without any offsetting tax benefit (i.e., as a permanent difference).
Relevant guidance
Emerging Issues Task Force (EITF) 96-7, Accounting for Deferred Taxes on In-Process Research and Development Activities Acquired in a Purchase Business Combination: The Task Force reached a consensus that the write-off of amounts assigned for financial reporting purposes to in-process R&D occurs prior to the measurement of deferred taxes in a purchase business combination… Accordingly, deferred taxes are not provided on the initial differences between the amounts assigned for financial reporting and tax purposes, and in-process R&D is charged to expense on a gross basis at acquisition. [Note: EITF 96-7 was nullified by FASB Statement 141(R) (codified in ASC 805); however, this issue still applies to IPR&D acquired outside a business combination.]
10-5 Effects of IPR&D expense on estimated annual effective tax rate
Background
Company A records an impairment charge of $100M related to its IPR&D asset in the third quarter of 20X1.
Question: Should the impairment charge be included in measuring Company A’s estimated annual effective tax rate (AETR) or should the tax effect of the charge be treated discretely in the third quarter?
Solution
Judgment is necessary to determine whether an IPR&D impairment charge should be considered an unusual or infrequent item and therefore reflected entirely in the third quarter. In circumstances in which there has been no history of IPR&D impairments and there is no reasonable expectation of significant IPR&D impairments in the future, the tax effect of the impairment might be able to be accounted for discretely in the period in which the impairment is recorded. However, depending on facts and circumstances, a history of IPR&D impairments or a reasonable expectation that there will be impairments in the future might indicate that the impairment is not unusual and should therefore be included in the estimated AETR.
Relevant guidance
ASC 740-270-25-1: This guidance addresses the issue of how and when income tax expense (or benefit) is recognized in interim periods and distinguishes between elements that are recognized through the use of an estimated annual effective tax rate applied to measures of year-to-date operating results, referred to as ordinary income (or loss), and specific events that are discretely recognized as they occur.
ASC 740-270-25-2: The tax (or benefit) related to ordinary income (or loss) shall be computed at an estimated annual effective tax rate and the tax (or benefit) related to all other items shall be individually computed and recognized when the items occur.
ASC 740-270-30-8: The estimated effective tax rate also shall reflect anticipated investment tax credits, foreign tax rates, percentage depletion, capital gains rates, and other available tax planning alternatives. However, in arriving at this estimated effective tax rate, no effect shall be included for the tax related to an employee share-based payment award within the scope of Topic 718 when the deduction for the award for tax purposes does not equal the cumulative compensation costs of the award recognized for financial reporting purposes, significant unusual or infrequently occurring items that will be reported separately, or for items that will be reported net of their related tax effect in reports for the interim period or for the fiscal year. The rate so determined shall be used in providing for income taxes on a current year-to-date basis.
10-6 Intra-entity transfer of IP with a contingent payment
Background
On January 1, 20X1, Company A transferred IP for Drug A, a commercial product, from the US parent company to a wholly-owned subsidiary in Jurisdiction X. No consideration was exchanged; however, for US tax purposes, Company A will report a deemed distribution equal to 10% on revenues generated in the future. Upon transfer, the initial tax basis in the IP in Jurisdiction X was $250 million. The IP was internally developed and therefore has a book carrying amount of zero in the consolidated financial statements.
Question: How should Company A account for this intra-entity transfer of the IPR&D asset?
Solution
A deferred tax asset (subject to valuation allowance considerations) would be recorded in Jurisdiction X because the buyer’s tax basis of $250 million is different than the consolidated book basis of zero. However, no deferred tax liability would be recorded for the future tax effects of the deemed or actual royalties that will arise from the intercompany transaction.
For US tax purposes, the sale of IP would be considered a “367(d) transaction.”For US tax purposes, the transaction is deemed to be a sale of property in exchange for payments (annual royalties of 10%) that are contingent upon the future revenues generated from the IP.
For 367(d) transactions, the prevailing view is that since no temporary difference exists for purposes of the consolidated balance sheet, no deferred tax liability would be recorded. As a result, no US tax expense would be recognized at the time of transfer; rather, the current tax provision would reflect the effects of the deemed (or actual) royalties in future periods as they are included in taxable income (i.e., as permanent differences).
We understand that the SEC staff would accept not recognizing a deferred tax liability in the US. A registrant that is considering recognizing a deferred tax liability is encouraged to consult with the SEC staff prior to electing this approach.
Relevant guidance
ASC 740-10-25-2: Other than the exceptions identified in the following paragraph, the following basic requirements are applied in accounting for income taxes at the date of the financial statements:
a. A tax liability or asset shall be recognized based on the provisions of this Subtopic applicable to tax positions, in paragraphs 740-10-25-5 through 25-17, for the estimated taxes payable or refundable on tax returns for the current and prior years.
b. A deferred tax liability or asset shall be recognized for the estimated future tax effects attributable to temporary differences and carryforwards.
ASC 740-10-25-3: The only exceptions in applying those basic requirements are: ...
e. A prohibition on recognition of a deferred tax asset for the difference between the tax basis of inventory in the buyer's tax jurisdiction and the carrying value as reported in the consolidated financial statements as a result of an intra-entity transfer of inventory from one tax-paying component to another tax-paying component of the same consolidated group. Income taxes paid on intra-entity profits on inventory remaining within the consolidated group are accounted for under the requirements of Subtopic 810-10...
10-7 Timing of the recognition of a tax holiday
Background
Company A operates in Jurisdiction X. On November 1, 20X1, (i.e., Q4 20X1), Company A filed its initial application for a specific tax holiday in Jurisdiction X. The holiday lasts for five years and applies to corporations that meet certain objectively determinable, statutory requirements with respect to the company's management, ownership, and foreign sales as a percentage of total sales. The statute that sets forth the requirements provides no discretion to the taxing authority or government officials to deny the application if the taxpayer meets the requirements set forth in the statute. On January 30, 20X2 (i.e., Q1 20X2), Company A receives a letter from the taxing authority in Jurisdiction X acknowledging receipt of Company A’s application.
Question: In which period should Company A account for the effects of the tax holiday: (1) the period in which the Company A filed its application (i.e., Q4 20X1), or (2) the period in which the letter of acknowledgment was received (i.e., Q1 20X2)?
Solution
In general, we believe the tax effects resulting from the initial qualification for a tax holiday should be treated in a manner similar to a change in tax status. Accordingly, Company A should record the effects of the holiday in the period in which the application was filed, rather than in the period in which the acknowledgement letter was received. In this instance, Q4 20X1 is the point in time that Company A had both met all the requirements set forth in the applicable statute and formally filed its application. As such, there was no basis for the taxing authority to deny the application. Receipt of the acknowledgement letter was merely confirmation of Company A's entitlement to the holiday rather than formal approval of it.
It should be noted, however, that if there is discretion on the part of the taxing authority or any government official to deny the application or alter its terms, the effects of the holiday should not be reflected in the financial statements until the formal government approval date.
Relevant guidance
ASC 740-10-25-33: The effect of an election for a voluntary change in tax status is recognized on the approval date or on the filing date if approval is not necessary and a change in tax status that results from a change in tax law is recognized on the enactment date.
ASC 740-10-25-35: There are tax jurisdictions that may grant an entity a holiday from income taxes for a specified period. These are commonly referred to as tax holidays. An entity may have an expected future reduction in taxes payable during a tax holiday.
ASC 740-10-25-36: Recognition of a deferred tax asset for any tax holiday is prohibited because of the practical problems in distinguishing unique tax holidays (if any exist) for which recognition of a deferred tax asset might be appropriate from generally available tax holidays and measuring the deferred tax asset.
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