Question

P 16-13 Multiple differences; uncertain tax position CL016–2, 2016–5, Q.1016–9 * Tru Developers, Inc., sells plots of land for industrial development. Tru recognizes income for financial reporting purposes in the year it sells the plots. For some of the plots sold this year, Tru took the position that it could recognize the income for tax purposes when the installments are collected. Income that Tru recognized for financial reporting purposes in 2021 for plots in this category was $60 million. The company expected to collect 60% of each sale in 2022 and 40% in 2023. This amount over the next two years is as follows: 2022 $36 million 2023 24 million $60 million Tru's pretax accounting income for 2021 was $88 million. In its income statement, Tru reported interest income of $16 million, unrelated to the land sales, for which the company's position is that the interest is not taxable. Accordingly, the interest was not reported on the tax return. There are no differences between accounting income and taxable income other than those described above. The enacted tax rate is 25%. Management believes the tax position taken on the land sales has a greater than 50% chance of being upheld based on its technical merits, but the position taken on the interest has a less than 50% chance of being upheld. It is further believed that the following likelihood percentages apply to the tax treatment of the land sales ($ in millions):

Answer 1

Requirement 1

In the tax return, taxable income is reduced by the $15 million interest, reducing taxes currently payable by the entire tax benefit:                              $15 million x 40% = $6 million.

Requirement 2

In the financial statements, none of the tax benefit is recognized because it is not “more likely than not” that Tru’s position that the interest is not taxable could be sustained upon examination. Thus, Tru should record a $15 million x 40% = $6 million liability for the potential additional tax. This represents the potential payment to the taxing authorities in the event the tax position is ultimately not upheld. It likely will be reported as a long-term liability because that determination probably will not be made within the coming year.

Requirement 3

The tax benefit from the tax treatment of the plot sales is the ability to defer paying the tax. Tru is reducing taxable income by the entire $60 million, effectively deferring the $60 million x 40% = $24 million tax. How much of that deferral can Tru show as a deferred tax liability (DTL) as opposed to a liability associated with an uncertain tax position? It is “more likely than not” that Tru’s position could be sustained upon examination, so Tru needs to determine the largest amount that has a greater than 50% likelihood of sustainability. As shown below, that amount is $40 million, so Tru will recognize a DTL for $40 million x 40% = $16 million.

Amount Qualifying                 Percentage Likelihood                 Cumulative Likelihood

for Installment                          of Tax Treatment                         of Tax Treatment

Sales Treatment                           Being Sustained                            Being Sustained

         $60                                                 20%                                               20%

           50                                                 20%                                               40%

           40                                                 20%                                              60%

           30                                                 20%                                               80%

           20                                                 20%                                             100%

The other $8 million isn’t shown as a DTL, but rather is shown as a liability associated with an uncertain tax position. The timing of the payment of that liability depends on the resolution of the uncertainty in the tax position. It likely will be reported as a long-term liability because that resolution probably will not be made within the coming year.

Requirement 4

($ in millions)

                                                             Current                    Future            Future
                                                               Year                     Taxable         Taxable
                                                               2013                     Amounts        Amounts
                                                                                        2014      2015       [total]  

Accounting income                                  90
Nontemporary difference:
   Interest income                                    (15)                                                    
Temporary difference:
   Plot sales                                              (60)                   36           24            60

Taxable income                                       15                                  
Enacted tax rate                                       40%                                             40%
   Tax payable currently                              6
   Deferred tax liability                                                                                    24

                                                                                                                         ¯

                                    Deferred tax liability:

Ending balance                                                                                           $ 24
Less: beginning balance                                                                                (0)
   Change in balance                                                                                     $24

                                                                                                                                           

         Journal entry

         Income tax expense (to balance)                           30
               Deferred tax liability (determined above)                  24
               Income tax payable (determined above)                    6

Requirement 5

        

                                                                                                                               ($ in millions)

         Income tax expense (to balance)                                                                   36
               Deferred tax liability ($40 x 40%)                                                                       16
               Income tax payable (determined in req. 4)                                                          6

               Liability—Potential projected tax ($6 + 8, calculated below)                              14         

               Projected additional tax for interest:                                $15   x 40% = $6

               Projected additional tax for installment income: $20* x 40% = $8

                  *$60 installment sales less $40, the largest amount
                      with greater than 50% likelihood of sustainability.

Now consider what happens later, when uncertainty about the tax position is resolved.

Interest income (permanent difference):

What if it is completely disallowed? (worst case)

            Liability—Projected additional tax                                         6           

                  Cash (or income tax payable)                                                      6

What if it is completely upheld? (best case)

            Liability—Projected additional tax                                         6           

                  Tax expense (benefit)                                                                  6

Installment income (temporary difference):

What if it is completely disallowed? (worst case)

            Liability—Projected additional tax                                         8

            Deferred tax liability (removing it, because tax paid)          16                       

                  Cash (or income tax payable)                                                    24

What if it is completely upheld? (best case)

            Liability—Projected additional tax                                         8           

                  Deferred tax liability (setting up additional DTL,

                  because tax can be deferred until paid in the future)                   8

So, in general, when uncertainty resolves, the Liability—Cash (or income tax payable additional tax is reduced to zero and the plug is to tax expense (with respect to permanent differences) or to deferred taxes (with respect to temporary differences).