ASC 740 and federal accounting methods update18 November 2016

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► This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer’s facts and circumstances.

► These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.

► The views expressed by the presenters are not necessarily those ofErnst & Young LLP.

► This presentation is © 2016 Ernst & Young LLP. All Rights Reserved.

EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms, of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com.Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US.

Disclaimer

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Today’s presenters

Brendan CoxPartner, Business Tax AdvisoryErnst & Young LLP +1 908 415 6357 brendan.cox@ey.com

Brian LiocePartner, Global Compliance & ReportingErnst & Young LLP +1 732 516 4605brian.lioce@ey.com

George WongPartner, Global Compliance & ReportingErnst & Young LLP +1 212 773 6432george.wong@ey.com

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Today’s agenda

► Accounting Standard Codification (ASC) 740 update:► Accounting Standards Update (ASU) 2015-17: Balance Sheet

Classification of Deferred Taxes► ASU 2016-09: Improvements to Employee Share-Based Payment

Accounting► ASU 2016-16: Intra-Entity Transfers of Assets Other Than

Inventory

► Federal accounting methods update

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ASC 740 update

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ASU 2015-17: Balance Sheet Classification of Deferred Taxes

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ASU 2015-17: Balance Sheet Classification of Deferred Taxes

► Requires classification of all deferred tax assets (DTAs)/deferred tax liabilities (DTLs) as noncurrent

► No longer allocate valuation adjustment (V/A) between current and noncurrent

► No change to jurisdictional offsetting requirements► For public business entities, standard effective for annual periods,

and interim periods within those annual periods, beginning after 15 December 2016

► For nonpublic business entities, standard effective for annual periods beginning after 15 December 2017 and interim periods in annual periods beginning after 15 December 2018

► Early adoption permitted ► Prospective or retrospective transition approach permitted

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ASU 2016-09: Improvements to Employee Share-Based Payment Accounting

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► Financial Accounting Standards Board (FASB) issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting

► Recognize all excess tax benefits and tax deficiencies in the income statement when awards vest or are settled: ► Accounted for as discrete items in the interim period in

which they occur ► Prospective transition from the beginning of the fiscal year of

adoption

Improvements to employee share-based payment accounting – final standard

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► Eliminates requirement that excess tax benefits not be recognized until they are realized (i.e., through a reduction in income taxes payable):► Modified retrospective transition with a cumulative catch-up

adjustment to retained earnings as of the beginning of the year of adoption for excess tax benefits not previously recognized

► Any V/A recorded against those DTAs also recorded in transition in retained earnings

► Present excess tax benefits as an operating activity on the statement of cash flows rather than as a financing activity:► Retrospective or prospective transition

Improvements to employee share-based payment accounting – final standard (continued)

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► For public business entities, standard effective for annual periods, and interim periods within those annual periods, beginning after 15 December 2016

► For nonpublic business entities, standard effective for annual periods after 15 December 2017 and interim periods in annual periods beginning after 15 December 2018

Improvements to employee share-based payment accounting – final standard (continued)

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► Early adoption is permitted in any period for which financial statements have not yet been issued or made available: ► All guidance must be adopted in the same period.► Adjustments are reflected as of beginning of fiscal year.► For adoption in an interim period, prior interim periods are updated

next time presented.

Example of adoption in Q2 Q1 2016 Q2 2016 YTD

Net income before change in accounting principle

100 120 220

Effect on each quarter 20 30 50

Net income after change in accounting principle

120 150 270

Update Q1 2016 financial statements next time presented

Improvements to employee share-based payment accounting – final standard (continued)

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ASU 2016-16: Intra-Entity Transfers of Assets Other Than Inventory

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► Assets (e.g., inventory) are sometimes sold at a profit or loss among entities that are part of a consolidated financial reporting entity but file separate income tax returns.

► Examples of separate income tax returns include: ► Unconsolidated returns within the same tax jurisdiction► Cross-border affiliates

► Seller’s separate financial statements:► Generally reflect profit or loss on the sale and related income tax

effect of that profit or loss

Intercompany transactions refreshAccounting background

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► Buyer’s separate financial statements:► Generally reflect the assets at the intercompany transfer price

(including the seller’s profit or loss), and the buyer’s tax basis equals the transfer price

► In consolidation:► The seller’s pretax profit is reversed, the assets are carried at

historical cost, and the income taxes paid are “deferred” (i.e., prepaid).

► ASC 740-10-25-3(e) prohibits recognition of deferred taxes for the buyer’s tax basis in excess of the consolidated book basis. Income taxes paid on intra-entity profits on assets remaining within the group are accounted for under ASC 810-10.

Intercompany transactions refreshAccounting background (continued)

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► Consolidation entries eliminating intercompany profit also “defer” income taxes paid by the seller (prepaid tax) (ASC 810-10-45-8):► Prepaid tax is not a temporary difference.► It requires companies to track (in the period of the intercompany

sale and subsequent periods) intercompany activity and related income taxes to avoid misstatement of deferred taxes in consolidated financial statements.

► No income tax effect should be recognized in earnings due to sale of assets among members of a consolidated group.

Intercompany transactions exception

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► Transaction must involve a sale or transfer of an asset:► It is applicable to tangible and intangible assets.► Intercompany financing, leasing and licensing arrangements would

not be eligible.► Careful consideration of the revenue recognition guidance in ASC

605 is needed to determine whether an arrangement qualifies for the exception in ASC 810-10-45-8:► Determining whether intangible assets such as intellectual property

have been sold (i.e., revenue has been recognized) can present unique challenges.

► Taxes paid under an intercompany license of intellectual property (IP) would not typically be eligible for the ASC 810-10-45-8 exception.

When does the intercompany transaction exception apply?

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► The prepaid amount includes the incremental taxes paid by the seller and any deferred taxes related to temporary differences in the seller’s tax jurisdiction before the transaction.

► Incremental taxes paid – “with and without” approach:► Equal to the difference between:

► Seller’s tax payable (receivable) with the intercompany profit► Seller’s tax payable (receivable) without the intercompany profit

► Existing deferred tax balances may be affected by the intercompany sale.

Measurement of prepaid tax on intercompany transactions

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Seller’s subsequent amortization of prepaid tax

► Amortize the prepaid (accrued) asset based on how the asset leaves the consolidated group: ► Sale to a third party► Depreciation or amortization by the buyer

► Amortized over the asset’s remaining tax life (to the extent related to sale of indefinite-lived intangible assets)

► Asset impairment or abandonment

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Classification of prepaid tax on intercompany transactions

► Record tax paid/payable as a prepaid (accrued) asset ► Prepaid tax is not:

► A temporary difference or deferred tax balance► Subject to remeasurement due to changes in laws or tax rates

(represents the tax effect of a past event)► Subject to need for valuation allowance (V/A)

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Intercompany transactions and net operating loss considerations

► Tax in the seller’s jurisdiction that arises as a result of an intercompany transaction may be “paid” in cash or settled with existing tax attributes (i.e., existing net operating losses (NOL(s)):► Method of payment may not have an effect on the measurement of

the associated prepaid tax

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Intercompany transactions – other considerations

► When a deferred tax asset (DTA) (i.e., NOL) with a corresponding V/A is used to “pay” the tax in the seller’s jurisdiction, determining whether the intercompany transaction results in a change in judgement about the realizability of the existing DTA requires careful consideration of the facts and circumstances and consolidated economics of the intercompany transaction.

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Intra-entity transfers of assets other than inventory — final standard

► FASB issued ASU 2016-16, Intra-Entity Transfers of Assets Other Than Inventory.

► Income tax effects of intercompany transfers of assets other than inventory (e.g., intangible assets) are accounted for when the transfer occurs.

► Companies will still be required to defer the income tax effects of intercompany inventory transactions in an exception to the income tax accounting guidance.

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Intra-entity transfers of assets other than inventory — final standard

► Transition:► For public business entities (PBEs), the new guidance is effective

for annual periods, and interim periods within those annual periods, beginning after 15 December 2017.

► For nonpublic business entities, the new guidance is effective for annual periods beginning after 15 December 2018 and interim periods in annual periods beginning after 15 December 2019.

► Early adoption is permitted as of the beginning of an annual period.

► The final standard uses a modified retrospective transition approach.

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Federal accounting methods update

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Revenue recognitionNew book rules, old tax rules

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Revenue recognition: New FASB/International Accounting Standards Board (IASB) model

► ASU 2014-09, Revenue from Contracts with Customers (FASB Topic 606 and International Financial Reporting Standards (IFRS) 15), issued 28 May 2014

► The model addresses revenue arising from contracts with customers:► The new standard is one comprehensive revenue

recognition model for all contracts across virtually all entities and sectors.

► New standard replaces virtually all existing US generally accepted accounting principles (GAAP) and IFRS guidance on revenue recognition.

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Revenue recognition: New FASB/IASB model(continued)

► The new revenue model requires companies to make more estimates and use more judgment than under current practice and make more disclosures about these judgments and estimates.

► Virtually all entities deriving revenue under contractual agreements with customers must evaluate the impact of the new model.

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Core principle: Recognize income at the earlier of when all events have occurred to earn the revenue or when the company is entitled to the revenue

Core principle: Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be

entitled in exchange for those goods or services

Book

Tax

Identify the contract(s) with

a customer

Identify the separate

performance obligations in the

contract

Determine the transaction price

Allocate transaction price to the separate performance

obligations in the contract

Recognize revenue when or

as entity satisfies a

performance obligation

Confirm the amount of

income that can be determined

with reasonable accuracy

Determine when the company

has a fixed right to the income –

either when earned, due or

received

Consider special rules that

change the timing of income

recognition

Identify income streams and underlying contracts

Step 1 Step 2 Step 3 Step 4 Step 5

Comparison of book/tax revenue recognition models

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Relevance of the new revenue recognition standard to tax

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Implementation – tax diagnostic

Integration

Understandfinancial

statement (F/S) changes

Assess taximplications

Assess required

effort

Developtimeline

Project management

Connect with accounting and finance.Ensure the tax department has a seat at the table.

Understand treatment under the new standard for impacted revenue streams.

Identify all areas of tax which will be affected by implementation of ASU 2014-09.

Assess the level of effort/ complexity for the tax department to transition.

Determine an implementation timeline for the tax department to analyze and make required changes.O

bjec

tive

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Tax implications of FASB leasing rules

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New leases standardTax considerations

► Recognition of lease-related assets and liabilities that are not on the balance sheet today would affect many aspects of accounting for income taxes, such as:

► Recognition and measurement of deferred tax assets and liabilities► Assessment of the recoverability of DTAs (i.e., the need for and

measurement of a V/A)► Uncertainty around whether the right-of-use asset would be:► State and local tax: included in the property factor for apportionment

of income► Sales and use tax: subject to sales tax► Property tax: included in property tax base

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New leases standardTax considerations (continued)

► Federal income tax review:► There is no effect on current classification for federal income

tax purposes.► Many taxpayers follow book and may use this opportunity to

review classification for federal income tax purposes:► Method change issues

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New leases standardSystems considerations

► Do companies need to update tax processes and internal controls?

► Will information and data currently available be sufficient under the new standard?

► How will new data and systems impact the current tax process?

► What additional data points are necessary to identify and track existing and new leases?

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Uniform capitalization (UNICAP): negative Section 263A regulations (Proposed)

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Negative Section 263A regulations

► Address the treatment of “negative amounts”:► Negative amounts are generally when taxpayer capitalizes a cost as a

Section 471 cost that is greater than amount required to be capitalized for tax, including:► Costs that do not have to be capitalized (e.g., warranty, 174)► Book/tax differences (e.g., meals and entertainment (M&E), bonus, pension,

depreciation)► Proposed regulations generally prohibit inclusion of negative amounts as

additional Section 263A costs when simplified production method (SPM) is used► Must use modified simplified production method (MSPM), simplified resale

method (SRM), other reasonable allocation method► SPM taxpayers must account for negative amounts by reducing Section

471 costs using a method that approximates the manner in which the taxpayer originally capitalized the costs.

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Modified simplified production method (MSPM)

► Proposed regulations introduce a new MSPM:► Two absorption ratios, rather than one as in SPM

► Pre-production absorption ratio:► Purchasing, raw material shipping and handling (S&H), etc.► Applied to raw material and raw material content of work in progress (WIP)

and finished goods ending inventory► Production absorption ratio:

► Production and post production costs like finished goods S&H► Applied to costs that include production labor and overhead costs only

► Potentially third ratio for post-production

► Historic absorption ratio (HAR) considerations

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Capitalization update

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IRS tangible property regulation audit technique guide (ATG)

► The ATG provides comprehensive insights into how the Internal Revenue Service (IRS) plans to examine taxpayers.

► Significant provisions also include a focus throughout the ATG on compliance with Section 263A, including with regard to self-constructed assets such as those relating to building property.

► Compliance with Section 263A for self-constructed assets (e.g., leasehold improvements owned by the taxpayer) should be an area of focus in light of the ATG.

► Taxpayers also should consider their ability to maintain methods established, generally for 2014.

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Accounting for tax method changes

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Accounting effects — method changes

► Financial statement effect should generally be recognized when the Form 3115 is filed with the IRS National Office.

► For a nonautomatic change from one proper tax accounting method to another proper tax accounting, the financial statement effect should be recognized in the period in which the company receives notification of the IRS National Office’s approval of the change (i.e., when all procedures necessary to effect the change have been completed).

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Accounting effects — method changes (continued)

► There are alternative views in practice► Unfavorable 481(a):

► Gives rise to two temporary differences:► Initial basis difference from “catch up” adjustment► Deferred liability for four-year spread into taxable income

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Section 199 update

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Proposed and temporary Section 199 regulations

► The proposed and temporary regulations provide guidance on the following topics: ► Contract manufacturing► Cost of goods sold► W-2 wages for acquisitions, dispositions and short years► What activities are qualifying activities► Defining the "item“► Oil-related qualified production activities income► Qualified films► Treatment of activities in Puerto Rico► Hedging transactions► Agricultural and horticultural cooperative payments

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Proposed and temporary Section 199 regulations (continued)

► Rules relating to W-2 wages for acquisitions, dispositions and short tax years are the only provisions of the published rules that are temporary regulations.

► The proposed regulations are expected to be finalized late this year/early 2017.

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Questions?

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EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com.

Ernst & Young LLP is a client-serving member firm ofErnst & Young Global Limited operating in the US.

© 2016 Ernst & Young LLP.All Rights Reserved.

1610-2086733ED None

This material has been prepared for general informational purposesonly and is not intended to be relied upon as accounting, tax or otherprofessional advice. Please refer to your advisors for specific advice.

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