Tax holidays and other incentives: determining the right accounting model

Tax Accounting Insights
Tax holidays and other incentives:
determining the right accounting
model
October 10, 2013
In brief
To incentivize foreign direct investment and economic development, governments have provided relief
from income taxation in many creative ways. In addition to offering the traditional full tax holiday for a
specified time period, governments now also provide reduced tax rates, exemptions, and similar special
deductions. Some of these benefits are generally available to any enterprise operating in the jurisdiction;
others require application or qualification procedures. Determining whether these government tax
incentives are tax holidays for accounting purposes, or whether they should receive some other income
tax accounting treatment, can be a challenge. In some cases, the incentives may represent government
grants or subsidies that fall outside of income tax accounting. This Tax Accounting Insight provides a
comparison of the potentially relevant accounting models and highlights some of the factors to consider
in determining which model applies.
In detail
Tax Holidays
Neither US Generally Accepted
Accounting Principles (US
GAAP) nor International
Financial Reporting Standards
(IFRS) provide a definition of
‘tax holiday’. There is, however,
guidance on the proper tax
accounting for tax holidays
under US GAAP. Specifically,
the Financial Accounting
Standards Board (FASB)
considered whether a deferred
tax asset should be established
for the future tax savings on the
premise that such savings are
similar to a net operating loss
(NOL) carryforward or other tax
attribute. In analyzing the issue,
the FASB distinguished between
two types of tax holidays: one
that is generally available to any
entity within a class of entities,
and one that is controlled by a
specific entity that qualifies for
it. The first type was likened to a
general exemption from
taxation for a class of entities,
creating nontaxable status for
which a deferred tax asset
should not be recognized. The
second type was perceived to be
a ‘unique’ type of tax holiday
because it was not necessarily
available to any entity within a
class of entities and, as a result,
might conceptually require the
recognition of deferred tax
benefits.
Ultimately, the FASB decided to
prohibit recognition of a
deferred tax asset for any tax
holiday (including those
considered unique), because of
the practical problems
associated with (1)
distinguishing between a
general tax holiday and a unique
tax holiday and (2) measuring
the deferred tax asset associated
with future benefits expected
from tax holidays.
So, although there is no official
definition of a tax holiday, it’s
www.pwc.com
Tax Accounting Insights
clear from the guidance that if the
future anticipated benefit is the result
of a tax holiday, there is no
recognition of a deferred tax asset for
that future benefit.
In general, under ASC 740, Income
Taxes, the effects on existing deferred
income tax balances resulting from
the initial qualification for a tax
holiday or its extension/renewal
should be recognized on the approval
date or on the filing date if approval is
not necessary. There may be
exceptions, for instance, if
government approval is considered
perfunctory because the qualification
requirements can clearly and
objectively be assessed. In those cases,
depending upon a company’s specific
facts and circumstances, the effects of
the holiday may be recorded prior to
the final approval.
Additionally, differences often exist
between the book and tax basis of
assets and liabilities on balance sheet
dates within the holiday period. If
these differences are scheduled to
reverse during the tax holiday,
deferred taxes should be measured for
the differences based on the
conditions of the tax holiday (e.g., full
or partial exemption). If the
differences are scheduled to reverse
after the tax holiday, deferred taxes
should be provided at the enacted rate
that is expected to be in effect after the
tax holiday expires. The expiration of
the holiday is similar to an enacted
change in future tax rates, which must
be recognized in the deferred tax
computation. In some circumstances,
tax planning actions to accelerate
taxable income into the holiday period
or to delay deductions until after the
holiday may be considered.
There is no specific guidance under
IFRS regarding tax holidays, but the
treatment of holidays is typically not
substantially different than under US
GAAP. However, for temporary
2
differences that reverse after the tax
holiday period, deferred taxes should
be measured at the enacted or
‘substantively enacted’ tax rates that
are expected to apply after the tax
holiday period.
Tax carryforward assets or
additional tax basis
Another form of government relief
from taxation is the granting of
additional tax basis, allowances, or
exemption amounts (e.g., a tax credit
carryforward). Tax credits granted at
the outset of a relief or incentive
program typically result from a
company committing to expenditures
or other transactions that will be
incurred. As such, a tax credit may be
a result of some incentivized action
that will take place in the operations
of the company. The amount of the
initial credit, once calculated, results
in an attribute that may be realized as
a benefit in the current period through
a reduction to the current period taxes
due, if sufficient taxable income exists.
If sufficient taxable income does not
exist in the current period, the future
benefit of the attribute may be
reflected as a deferred tax asset, if
carryforward is allowed under the
local law. In other words, if there is an
established and quantifiable future
benefit it may be appropriate to
recognize a deferred tax asset.
The future benefit would be subject to
the traditional analysis for realization
(based upon evidence of sufficient
future taxable income). A similar
framework would apply to a tax
attribute in the form of additional tax
basis.
Special deductions
ASC 740 doesn’t define special
deductions, but does offer several
examples: (1) statutory depletion, (2)
special deductions available for
certain health benefit entities, (3)
special deductions for small life
insurance companies, and (4) IRC
section 199 deductions for qualified
domestic production activities. In
general, the specified special
deductions have tax law requirements
or limitations that are based upon
future performance of specific
activities. This future-performance
requirement or other limitation
generally differentiates the deduction
from being equivalent to a tax-rate
reduction.
The tax benefit of a special deduction
should be recognized no earlier than
the year in which the deduction can be
taken on the tax return, thereby
yielding a permanent benefit in the
period of recognition. As such, the
benefits of a special deduction should
not be anticipated for purposes of
offsetting a deferred tax liability for
taxable temporary differences at the
end of the current year, or as a rate
reduction that is applied in measuring
deferred taxes.
The benefit of special deductions
would impact deferred taxes to the
extent the estimation of future taxable
income, including the special
deduction, affects the graduated rates
expected to apply to the deferred
taxes. If the special deduction causes
taxable income to fall within a lower
graduated rate, then deferred tax
should be measured at the lower rate.
Anticipated benefits should also be
considered in assessing the
realizability of deferred tax assets if
the entity must consider future
taxable income, including the benefits
from special deductions. Even though
there’s no reference to special
deductions within IFRS,
considerations similar to those
described under US GAAP are often
applied.
Government grants and
subsidies
While some benefits provided in the
income tax laws may be claimed on an
income tax return, a number of factors
pwc
Tax Accounting Insights
may require that the benefit not be
reflected within income taxes, but
instead be accounted for in pre-tax
income. Some additional factors may
need to be considered when making
that determination. But generally, a
benefit that’s refundable even when
exceeding tax otherwise due would
not be accounted for within the
income tax accounts. The benefit
would follow a pre-tax income
recognition and measurement model.

Does utilization of the benefit
depend solely on the existence of
taxable income, or do other
limiting factors need to be
considered?

Is the benefit transferable in the
context of a change in ownership?

How does the government
describe the program and what do
the documents and negotiation
procedures suggest as to the
nature of the program?
A careful analysis

Is there an application and/or
qualification process?
Given these fine distinctions and
limited accounting guidance, a variety
of factors should be analyzed to
conclude on the appropriate
accounting treatment of tax law
incentives. Answers to the following
questions can help the analysis:

Is the incentive refundable, either
optionally or in the absence of
income tax otherwise due?
Similarly, can the benefit be
applied to reduce taxes that are
not based on income (e.g., excise,
VAT, gross receipts, or property
tax)?

Is the benefit a fixed and certain
amount? If it’s a fixed amount, is
it anticipated that the full amount
of the benefit can be realized?

Does the sustainability of the
benefit depend on future events
(e.g., maintaining expenditures
related to payroll or fixed assets)?

3
Is the benefit revocable by the
applicable government authority?
Be mindful that no one factor is
necessarily determinative and an
analysis of all facts and circumstances
should be performed with respect to
each particular law or program. If the
benefits offered under a particular
government incentive regime vary,
and are subject to negotiation and
agreement with the local authorities,
it’s possible that different accounting
models may apply to different
companies under the same
jurisdiction’s incentive regime.
Disclosure is required with respect to
tax holidays and should be considered
with respect to the effects of all
significant incentives.
The takeaway
Determining whether an incentive
falls within the scope of income taxes
and identifying the proper income tax
accounting treatment for the various
new and creative incentive regimes
that governments are offering can be
challenging. Careful analysis of the
specific aspects of the incentive
regime is needed to determine its
accounting effects. If it’s concluded
that the government incentive
constitutes a tax holiday, a deferred
tax asset should not be recorded for
the future anticipated benefits.
However, the applicable rate utilized
to determine deferred taxes should be
assessed so that deferred taxes that
are expected to reverse within and
after the holiday period are taxeffected appropriately. If it’s
determined that the government
incentive is effectively a tax
carryforward asset or additional tax
basis, then a deferred tax asset should
be recorded. This deferred tax asset
would be subject to an assessment of
realizability performed for all deferred
tax assets. An incentive that’s
considered a special deduction would
be recognized in the year in which the
benefit is reported in the tax return. If
the incentive is more equivalent to a
grant or a subsidy, it would be
accounted for as part of pre-tax
income.
To learn more about tax incentives
and financial reporting, refer to
Patent box and technology incentives:
Tax and Financial reporting
considerations and Understanding
financial reporting for green and
stimulus incentives.
pwc
Tax Accounting Insights
Let’s talk
For a deeper discussion of how this issue might affect your business, please contact your local PwC partner or one of the
individuals listed below :
Tax Accounting Services
Ken Kuykendall
Global & US Tax Accounting Services
Leader
+1 (312) 298-2546
[email protected]
Marjorie Dhunjishah
Latin America & US Tax Accounting
Services Partner
+51 (1) 211-6500
[email protected]
David Wiseman
Global & US Tax Accounting Services
Partner
+1 (617) 530-7274
[email protected]
Janet Anderson
EMEA Tax Accounting Services Leader
+32 (2) 710-4323
[email protected]
Terry SY Tam
Asia Tax Accounting Services Leader
+86 (21) 2323-1555
[email protected]
Tim Hale
Asia Tax Accounting Services
+852 2289 3783
[email protected]
SOLICITATION.
This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
© 2013 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a Delaware limited liability partnership),
which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.
4
pwc