Income Tax Accounting (ASC 740) Implications of the CARES Act

The Coronavirus Aid, Relief and Economic Security (CARES) Act was signed into law on March 27, 2020. The CARES Act includes a number of tax provisions designed to support businesses impacted by the Coronavirus pandemic. ASC 740 requires changes in tax law to be accounted for in the period of enactment. Many of the provisions of the CARES Act will have an immediate impact on the accounting for income taxes of various filers, especially those about to complete interim reporting for the period ending March 31, 2020.

The tax years used in this article assume a calendar-year filer. Fiscal year filers may have a variety of divergent treatments for various provisions. The language in this article generally references accounting for the Q1 2020 interim period, as that is the period that generally includes the date of enactment. However, for companies that have not yet issued their 2019 financial statements, the passage of the CARES Act may represent a material subsequent event that warrants accounting or disclosure in the 2019 financial statements. Additionally, absent a determination of a material subsequent event, companies that have not yet issued their 2019 financial statements should not take the provisions of the CARES Act into account, particularly regarding their deferred tax asset realizability analysis. Beyond the scope of this article, there can be some interplay between accounting for the effects of the CARES Act and the decision on whether to early adopt ASU 2019-12.

Use of Net Operating Losses

The CARES Act makes two significant changes to the treatment of Net Operating Losses (NOLs). First, the act provides for a five-year carryback period for NOLs generated in 2018 and 2019. For companies with positive taxable income in the relevant carryback years and losses in 2018 or 2019, this provides the opportunity for an immediate cash refund. For taxpayers having the ability and intent to file a NOL carryback claim, this could result in a discrete benefit for the Q1 2020 interim period as an NOL currently carried at a 21 percent tax rate will be carried back to a tax year with a 35 percent rate. This 14 percent rate differential will have a permanent, favorable rate impact for the interim period.

Secondly, the Cares Act removes the 80 percent limitation on the utilization of NOLs generated after 2017. For companies that showed limited utilization of 2018 NOLs on their 2019 financial statements, there may be a balance sheet reclassification required at Q1 2020. This reclassification would likely be between deferred taxes and taxes payable. Furthermore, there can be valuation allowance nuances to consider as this could represent a decrease in an indefinite-lived deferred tax asset that may have been used to offset an indefinite-lived deferred tax liability.

Interest Expense Limitation

The CARES Act makes two changes to the limitations on the deduction of interest expense under IRC §163(j). First, the 30 percent of Alternative Taxable Income (ATI) limit for 2019 and 2020 is increased to 50 percent of ATI. Second, for the 2020 tax year, taxpayers may use the higher of 2019 ATI or 2020 ATI for purposes of calculating the interest limit for tax year 2020. For companies that reported an interest limitation on their 2019 financial statements, there may be a balance sheet reclassification required at Q1 2020. This reclassification would likely be between deferred taxes and taxes payable. However, for companies with both an NOL carryforward and a §163(j) carryforward, the reclassification could involve several line items.

This item carries with it several valuation allowance nuances to consider. Some profitable companies have recorded valuation allowances against their §163(j) carryforwards on the basis that their future taxable income will not be of the appropriate character to offset the interest limitation. This is generally a scenario applicable to highly leveraged companies. For companies in this position, the §163(j) provisions of the CARES Act may result in a discrete favorable adjustment for Q1 2020 as some portion of the valuation allowance on existing §163(j) carryforwards could be released.

Qualified Improvement Property Depreciation

This provision provides a technical correction to the Tax Cuts and Jobs Acts (TCJA) signed into law in December of 2017. The TCJA intended to provide for immediate expensing for certain improvements to real property, known as Qualified Improvement Property (QIP), through bonus depreciation. Due to an acknowledged drafting error in the TCJA, depreciation on QIP was restricted to 39-year straight line depreciation. The CARES Act retroactively corrects this error, allowing for a 15-year recovery period and bonus depreciation beginning in 2018 on QIP.

For affected companies that choose to amend their 2018 return or adjust their 2019 returns before filing, there may be a balance sheet reclassification required at Q1 2020. For companies in taxable income, this would be a reclassification between deferred taxes and taxes payable. For companies in an NOL position, this would be a reclassification between deferred taxes for fixed assets and the NOL carryforward. Note that there can be valuation allowance nuances to consider as this could represent an exchange of a finite-lived deferred tax item for an indefinite-lived deferred tax asset.

Corporate AMT Credits

The CARES Act provides for the immediate refunding of AMT Credits that were previously carried over from 2018 to 2019 under the provisions of the TCJA. Applicable companies may have a balance sheet reclassification required at Q1 2020. To the extent that the AMT credit carryforward was recorded as a non-current receivable or as a deferred tax asset, the balance for companies making the refund claim should be reclassified as a current receivable.

Charitable Contribution Limitations

The CARES Act increases the corporate limitation for the deduction of charitable contributions for 2020 from 10 percent up to 25 percent. Companies that anticipate significant charitable contributions for 2020 should consider this increase when evaluating current tax expense vs. deferred tax expense during interim periods of 2020. This provision may also interplay with various other taxable income sensitive items in the income tax provision, such as estimates of NOL utilization, the interest expense deduction, and the FDII deduction.

Expansion of SBA 7(a) Loan Program

The CARES Act provides for the expansion of the SBA 7(a) loan program between February 15, 2020, and June 30, 2020. While this provision is limited to smaller filers (fewer than 500 employees), it also provides potential conversion to grant funding for all or a portion of the loan through forgiveness of debt provisions. If the debt is forgiven in a future period, the forgiveness may result in income for financial statement purposes that is non-taxable for income tax purposes. This could give rise to a permanent favorable tax rate impact for the period of forgiveness.

State Conformity

Filers should note that there will be a variety of state conformity issues related to the above federal provisions of the CARES Act. These items will need to be monitored and evaluated as more state guidance is issued.

For more information regarding the impacts of the CARES Act on the accounting for income taxes, please contact us at taxCARES@dhg.com.

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