Income tax implications on financial reporting C_pres(1).pdf · Income tax implications on financial reporting March 2014 . PwC ... • Contingent consideration ... deferred state

Income tax implications on financial reporting

March 2014

www.pwc.com

PwC

Agenda

Why income taxes matter?

Hot topics

• Tax reform

• Corporate inversions

Tax accounting highlights & SEC comment letter trends

• Valuation allowances

• Indefinite reinvestment assertion

• Tax reserves

• Effective tax rate

Business combinations

• APB 23

• IPR&D

• Contingent consideration

• Transaction costs

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March 2014 CBI - Life Sciences Accounting & Reporting Congress

PwC

Why income taxes matter?

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The environment Judgments, estimates and assertions

Making the headlines

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March 2014

“[Company ABC] shares tumbled 12% on Wednesday after the company said it would adjust results for the past four years by $500 million due to a “material weakness” in its tax reporting.”

“[Company XYZ] shares are falling Friday on news that the company will be restating its earnings for the fiscal year ended December 25, 2010, due to the IRS denying its claim to carry back certain tax losses to prior tax years.”

“[ABC Incorporated] today announced that the financial statements for the year ended December 31, 2010, should no longer be relied upon as a result of errors relating to the understatement of net deferred state tax liabilities and an overstatement of valuation allowances related to state net operating losses.”

“[Company XYZ] could make up to $250 million in aggregate net adjustments to correct material weakness errors, and it may delay filing its 2011 10-K for up to 15 days. The weakness is related to its income tax reporting calculations.”

“…as the amount of earnings stashed overseas has reached $1.5 trillion, and the need for financing grows back home, there is a real question whether companies can continue to defend their assertions that they have legitimate plans and the intent to continue to indefinitely reinvest those funds, and billions and billions more, overseas.”

CBI - Life Sciences Accounting & Reporting Congress


The environment Judgments, estimates and assertions

• Income tax is the most frequent accounting area identified as a material weakness by the clients of each of the Big-4 accounting firms

#1 material weakness

• For 10 years, income taxes have ranked among the top 10 restatement issues

Top 10 restatement

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March 2014

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The environment Current regulatory and investor landscape

Income tax accounting focal points

• Areas of SEC and investor focus

- Impairment assessment of deferred tax assets

- Tax reserves

- Indefinite reinvestment of foreign earnings

- Effective tax rate reconciliations

• PCAOB reviews

- Focus on audit evidence, procedures and documentation with respect to the judgments, estimates and assertions relating to the above items

- Focus on internal controls

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The environment Current regulatory and investor landscape (continued)

SEC comment letters issued in 2013 and publicly released through 12/31/2013

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11

114

5 2

90

2 3

34

99

66

0

20

40

60

80

100

120

Bus Com APB 23 Intraperiod Interim Period

Rate Rec Stock Options

Transfer Pricing

UTP V/A Other


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Chairman Camp’s proposal for tax reform

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House Ways and Means Chairman Dave Camp Tax Reform Act of 2014 discussion draft

In brief

• Intended to be revenue neutral during the 10-year window

• Shift from a worldwide to a territorial-based system

• Reduce the top corporate tax rate to 25% over a 5-year period

• Reduce the individual rate structure to three brackets – 10%, 25% & 35%

• Eliminate the majority of corporate and individual tax credits

• Repeal the corporate and individual AMT

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House Ways and Means Chairman Dave Camp Tax Reform Act of 2014 discussion draft (continued)

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March 2014

Largest domestic provisions New rule

Corporate rate/AMT • 25% rate (phased in 2% reduction/year over 5 yrs)

• Repeals AMT

Depreciation Repeals MACRS and implements ADS type system

R&D expenses • Requires capitalization with 5-year amortization

• Alternative simplified credit made permanent

Advertising expenses Capitalizes 50% with 10-year recovery period

Section 199 Phases out and ultimately repeals 199 deduction for tax years

beginning after 2016

Inventory • Repeals LIFO, LCM, and subnormal goods rules

• Modifies UNICAP to expand small taxpayer exception

NOLs Limits NOL carryforwards and carrybacks to 90% of taxable

income

Like kind exchanges Repeals section 1031


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March 2014

International provisions New rule

DRD/Exemption Territorial System, 95% DRD

Pre-transition E&P Bifurcation - E&P retained as cash and cash equivalents is taxed

at 8.75% with all other E&P taxed at 3.5%

Payment period for deemed

repatriation of pre-transition E&P

Payable over 8 years (8% in years 1-5; 15%,20%,25% in years

6-8, respectively); no interest assessed

Anti-base erosion Modified Option C – intangible income from foreign markets taxed

at a reduced 15% rate once fully phased in, US intangible income

also eligible for reduced rate

Subpart F Only includes low-taxed foreign income. The low-tax threshold

applies differently to different types of income

Interest expense Applies the worldwide affiliated group concept. Interest expense

deduction limited to the lesser of ‘excess domestic indebtedness’

threshold or 40% of ATI

Intangible Definition Section 936(h)(3)(B) is replaced with Section 367(d)(4) which

contains the same definition of intangibles and does not

incorporate the Obama administration’s proposals


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March 2014

• Modified R&D tax credit made permanent

- Credit equal to 15% of qualified research expenses (QREs) that exceed 50% of the average QREs for the previous three tax years plus 15% of the basic research payments that exceed 50% of the average basic research payments for the previous three years.

◦ ASC only method for calculating the credit.

- Amounts paid for the development of computer software and supplies would no longer qualify as qualified research expenses.

- Effective for tax years beginning after 2013.

• Other Notable Provisions

- Tax credit for orphan drugs repealed

- Technical clarification of orphan drug exemption for branded prescription drug fee

- Repeals medical device excise tax


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History of corporate inversions

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March 2014

1983:

McDermott

Through

Mar. 1994 Dec. 1996 – Feb. 2003

Mar. 2003 –

May 2006

Sept 2009 –May

2012

Apr. 1994 –

Nov. 1996

1993:

Helen of Troy (B)

Notice 94-46

(Apr. 1994)

From June

2012

Final Section 367

Regulations (TD 8702)

(Dec. 1996)

Section 7874

(Mar. 2003)

10% Safe Harbor and Facts and

Circumstances Tests for Substantial

Business Activities (“SBA”) Temporary


(June 2006)

Elimination of 10% Safe Harbor

Under SBA Temporary


(June 2009)

25% “Bright Line” for SBA under

Temporary Regulations (TD 9592)

(June 2012)

Inverted Company

Ownership Final and

Temporary Regulations

Following Notice 2009-78

(TD 9654)

(Jan. 2014)

1996:

Triton Energy (C)

1996:

Chicago Bridge & Iron

1997:

Santa Fe Corporation (C)

Tyco (B)

1998:

Fruit of the Loom (C)

Gold Reserve

Playstar

Xoma (B) 1999:

Everest Reinsurance (B)

PXRE (B)

Transocean (C)

Trenwick (B)

White Mountain Insurance (B)

Airtouch/Vodafone

2000:

Applied Power (B)

Foster Wheeler (B)

R&B Falcon (C)

2001:

Accenture (B)

Cooper Industries (B)

Global Marine (C)

Ingersoll Rand (B)

2002:

Nabors Industries (B)

Noble Drilling (C)

Seagate Technology (C)

Weatherford (B)

2005:

Luna Gold

2007:

Fluid Media Networks

Lincoln Gold

Star Maritime Acquisition Group

Western Goldfields

2008:

Arcade Acquisition Group

Ascend Acquisition Corp. (B)

Energy Infrastructure

Patch International

2009:

Tim Hortons

2010:

Global Indemnity

Plastinum Polymer Tech

Valeant/Bioavail

2011:

Alkermes/Elan Drug Tech

Jazz Pharma/Azur Pharma

Pentair/Tyco Flow

Ensco International**

2013:

Actavis/Warner Chilcott

Applied Materials/Tokyo Electron

Omnicom/Publicis Groupe

Perrigo Company/Elan

Liberty Global/Virgin Media**

Endo/Paladin

2009:

Alpha Security Group (B)

Alyst Acquisition

Hungarian Telephone and Cable

Vantage Energy Services (C)

B: Bermuda

C: Cayman ** SBA requirement met

June 2006 –

May 2009

Notice 2009-78

(Sept 2009)

2009:

2020 ChinaCap Acquirco

Ideation Acquisition Group (C)

June

2009 –

Aug

2009

2012:

Aon Corporation**

Eaton/Cooper

Rowan Companies

Sara Lee CoffeeCo**


PwC

Inversions via transactions with non-US corporations

• Basic template transaction is a formation of a new non-US Parent company with the shareholders of the US company and the foreign company contributing their respective shareholdings to the new holding company in exchange for stock and cash as the deal terms require.

- Shareholders of the US company receive less than 80% of the vote and value of the new foreign Parent.

- Different tax consequences to shareholders and the acquired US company apply depending on the level of ownership retained by the US company’s shareholders.

◦ The relevant thresholds are 50% or lower retained ownership, 50+% to less than 60% retained ownership, and 60% to less than 80% retained ownership.

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Corporate inversions – Typical tax synergies

• Immediate benefits captured through:

- Structural tax rate reduction through tax efficient leverage of US operations introduced at the time of the transaction.

- Increased flexibility with cash redeployment of previously constrained cash.

• Longer term benefits achieved through

- New structure provides greater flexibility in integrating the combined businesses

- Access to capital markets outside a US-parented structure facilitates future acquisitions and growth outside the US

- Ability to efficiently align foreign operations reduces potential costs of current and future US Subpart F rules

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Corporate profile – Practical considerations

• Greatest long term tax synergy can be captured for companies through some combination of following attributes.

- Substantial US taxable base and capacity for incremental internal leverage;

- Opportunity for expansion off-shore;

- Pressure on existing rate driven by offshore cash build up and demand for additional capital to be returned to shareholders;

- Foreign competitors with lower cost of capital;

- Substantial exposure to US tax reform.

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Management and director compensation – Section 4985 excise tax

• Section 4985 imposes a 15% excise tax on the value of stock related compensation held by certain “insiders” of an expatriated DC or a related corporation. The tax is imposed on the value of stock options, restricted stock and any other stock based compensation.

- The tax also applies to insiders of the FC since it will be related to the expatriated DC after the deal

- Affected insiders are persons subject to restrictions imposed by Section 16 of the 1934 Exchange Act or persons who would be subject to such restrictions if the DC were an issuer of securities subject to the Act. This population includes certain officers, directors and significant shareholders.

- The excise tax applies to stock compensation grants held on the “expatriation date” (closing), canceled within the 6 months prior to the expatriation date or granted within 6 months after the expatriation

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Tax accounting highlights & SEC comment letter trends

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Valuation allowances

Critical takeaways

• Deferred tax assets are not fair-valued, thus impairment charges can be magnified

• Accounting model differs from other asset impairment models

- Historically weighted analysis vs. forward-looking

• Assessment at jurisdictional level based on tax return filing

- Often differs from management’s strategic/operational view of the business

• Impairment may be necessary in situations even when…

- Company is profitable on a worldwide basis

- Carry-forward period of tax attributes is long or unlimited

- Company expects to return to profitability in the foreseeable future

- Other assets are not impaired

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Valuation allowances (continued)

Future realization

• Future realization depends

- on sufficient taxable income

- of the appropriate character (ordinary v. capital)

- within the carryback or carryforward period (ASC 740-10-30).

• Consider all evidence (both positive and negative) and use judgement --no “magic formula”.

- Historic results carries more weight than future estimates.

- Cumulative losses in recent years is strong negative evidence.

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Valuation allowances (continued)

Releases

• Same rules that apply to establishing valuation allowances apply to the release of valuation allowances, i.e. MLTN threshold, weighing of all available positive and negative evidence, emphasis on what is objectively verifiable, etc.

• Cumulative pre-tax book income is not a prerequisite for release

• Consider indefinite carryforward jurisdictions

- Even where utilization will be over a number of years

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SEC comment letters on taxes


“The reversal of an $XXX million valuation allowance against certain of your United States deferred tax assets represents a significant component of your net earnings for the six months ended June 30, 2010.

Please enhance your disclosures in future filings to explain in further detail your consideration of FASB ASC 740-10-30-17 through 740-10-30-24 in determining during the three months ended June 30, 2010 that it is more likely than not that these deferred tax assets are realizable.

Please discuss and disclose in future filings the specific factors in 2010 that led you to determine the reversal was appropriate at this time; Please discuss how you determined the amount of valuation allowance to reverse; and Please disclose in future filings the amount of pre-tax income that you need to generate to realize these deferred tax assets. Please show us in your supplemental response what the revisions will look like. ”

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SEC comment letters on taxes (continued)


“Your response indicates that you have concluded that your deferred tax assets are recoverable based on projections of future results. In support of those projections, you identify various factors, including cost reduction measures to improve gross profit and reduce operating expenses, and the potential sale of your Membership Plus product line. Paragraph 25 of SFAS 109 indicates that the weight given to positive and negative evidence should be commensurate with the extent to which it can be objectively verified. Because projections and forecasts are inherently uncertain, tell us more about how you were able to use these to overcome the objectively verifiable negative evidence. As part of your response, show us how reliable your projections and forecasts had been in the past by describing to us how accurate your past budgets have been when compared to actual results.”

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Form 10K – 12/31/10

Notes to the Financial Statements

The Company conducted an analysis to assess the need of a valuation allowance at December 31, 2010. As part of this assessment, all available evidence, including both positive and negative, was considered to determine whether based on the weight of such evidence, a valuation allowance for deferred tax assets was needed. In accordance with ASC Topic 740-10, Income Taxes (ASC 740), a valuation allowance is deemed to be needed when, based on the weight of the available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or all of a deferred tax asset will not be realized. The future realization of the tax benefit depends on the existence of sufficient taxable income within the carryback and carryforward periods.

Form 10K – 12/31/11

Notes to the Financial Statements

In the Company’s consideration of the weight of the available evidence, the Company provided more weight to evidence that was more objectively verifiable. In 2010 and 2011, the most significant weight was given to the cumulative income/loss position. In 2010 when the Company was in a cumulative loss position, the Company recorded a valuation allowance of $15.6 million. The remaining deferred tax assets, for which a valuation allowance was not established, related to amounts that could be realized through future reversals of existing taxable temporary differences and through available tax planning strategies. The Company’s estimates of future taxable income in 2010 were limited to tax planning strategies and no weight was placed on future taxable income expected to be generated through management’s approved business plans.

At December 31, 2011, the Company gave significant weight to the fact that the Company had returned to a cumulative income position in the fourth quarter of 2011. The Company had availability in its carryback years, current deferred income tax liabilities that are expected to absorb a portion of the deferred tax asset balance and sufficient projected future taxable income. As such, the Company determined that a valuation allowance was not required at December 31, 2011 and the Company reversed the deferred tax valuation allowance of $15.6 million during the fourth quarter of 2011.

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CBI - Life Sciences Accounting & Reporting Congress March 2014

PwC

Indefinite reinvestment assertion

Critical takeaways

• Ability to assert indefinite reinvestment is driven by a company’s overall business strategy, financial plans and structure of investments

- Cross-functional collaboration is imperative

• Disclosure of the unrecorded tax liability is required, unless determined “impracticable”

- Financial statement assertion that an estimate is impracticable requires appropriate company-specific support

- Recent trending towards either recording or disclosing the estimated liability

• Calculation of the liability can be highly judgmental and subject to continual re-measurement

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Indefinite reinvestment assertion (continued)

• Specific plans for indefinite reinvestment assertions must be documented and maintained by management

• In evaluating specific plans, consider the following:

- Forecasts and budgets of parent and subsidiary for both long & short term

- Financial requirements of both parent and subsidiary for long & short term

- Past history of dividend actions

- Planned acquisitions

- Tax consequences of a decision to remit or reinvest

- Remittance restrictions in a loan agreement of a subsidiary

- Remittance restrictions imposed by foreign governments that result in forced reinvestment in the country

- Any U.S. government programs designed to influence remittances

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• Current economic environment may impact a company’s ability to continue to assert indefinite reinvestment

- Are significant payments due in the near-term, such as debt or pension funding?

- Have there been any recent remittances?

- Will a US investment or acquisition necessitate financing by redeployment of foreign subsidiary funds?

- Have there been any defaults or debt covenant violations?

- Is there substantial doubt about the ability to continue as a going concern?

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Foreign subsidiaries

• If not permanently reinvested, need a provision for incremental taxes to be incurred upon distribution, including but not limited to:

- US tax, after foreign tax credits (if elected & fits US tax profile)

- Withholding taxes in local country/throughout the ownership tier(s)

- Foreign taxes, if applicable

- Previously taxed income:

◦ Exchange rate gains and losses for foreign withholding tax liability affects tax expense

• Reevaluate position quarterly or when significant restructuring occurs

• Can you record a tax benefit? (e.g. excess FTCs are generated)

• Change in repatriation plans for undistributed earnings

- Change in accounting estimate

- Discrete item for interim financial statements

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Indefinite reinvestment

“Tell us your consideration of providing liquidity disclosures to discuss the potential tax impact associated with the repatriation of undistributed earnings of foreign subsidiaries. In this regard, consider disclosing the amount of investments that are currently held by your foreign subsidiaries and disclose the impact of repatriating the undistributed earnings of foreign subsidiaries. We refer you to Item 303(a)(1) of Regulation S-K and Section IV of SEC Release 33-8350.”

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“We note your determination during the first quarter of 2010 to indefinitely reinvest offshore the earnings of your foreign subsidiaries, which resulted in the reversal of the net U.S. deferred tax liability on the undistributed earnings of all foreign subsidiaries.

Given the significant impact such determination had on net income, please tell us and disclose in future filings the amount of cash actually distributed by these foreign subsidiaries over the last three years.

Also please name your foreign subsidiaries, the country in which each is domiciled, and provide the "indefinite reversal criteria" discussed in ASC Topic 740-35-25-17 to 740-35-25-18 that is required to overcome the presumption that all undistributed earnings will be transferred to the parent entity. ”

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“We note your footnote disclosure states that you intend to utilize the undistributed earnings of your foreign subsidiaries in your foreign operations for an indefinite period of time except as it relates to the recently repatriated earnings from your Canadian and Japanese subsidiaries. Considering that you have repatriated earnings from your Canadian subsidiaries in each of the past three fiscal years and from your Japanese subsidiaries in each of the past two fiscal years, please tell us the factors considered by management in its conclusion that the undistributed earnings of your foreign subsidiaries will not be repatriated, especially in relation to your Canadian and Japanese subsidiaries. Your response should also outline your plans for the permanent reinvestment of the undistributed earnings of your foreign subsidiaries.”

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“We note that you repatriated $1.1 billion of current year earnings from certain foreign subsidiaries during the fourth quarter of 2010.

In this regard, we have the following comments: Please tell us and revise your disclosure to fully explain the reasons you repatriated $1.1 billion of current year earnings from certain foreign subsidiaries; Please tell us and revise your disclosure to address how you concluded, in light of your repatriation in the fourth quarter of 2010, that you have the ability and intent to invest $8.9 billion of accumulated foreign unremitted earnings indefinitely as of December 31, 2010.

Please refer to ASC 740-30- 25-17 though 19; and Please clarify why the repatriation of $1.1 billion of current year earnings from certain foreign subsidiaries resulted in a $265 million tax benefit for excess foreign tax credits.”

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SEC comment letters on taxes Indefinite reinvestment

Form 10Q – 9/30/2011

Management Discussion and Analysis

In the quarter ended March 31, 2010, XXX included in the computation of its estimated annual effective tax rate a tax benefit of $265 million related to an expected fourth quarter repatriation of $1.1 billion of 2010 foreign earnings. The repatriated earnings represented a portion of the current year earnings of certain foreign subsidiaries and affiliates located in Asia and thus were not previously permanently reinvested.

There were two factors influencing XXX’s decision to consider repatriating these 2010 earnings. One was XXX;s decision, as announced early in 2010, to pursue acquisitions that were expected to require cash to be available in the U.S. in excess of amounts expected to be generated from domestic sources. The second factor was proposed federal tax legislation which, if enacted, could significantly increase the tax cost of repatriation after 2010. Because there had been no change in our longer term international capital expansion plans as of the first quarter, our intent to indefinitely reinvest foreign earnings accumulated through the year ended December 31, 2009 was not changed by these factors. As of the year ended December 31, 2010, XXX had $8.9 billion of foreign unremitted earnings that it intends to keep indefinitely reinvested. It is not practical to calculate the unrecognized deferred tax liability on those earnings with reasonable accuracy. Of this amount, nearly 70% consists of:

Non-liquid operating assets or short term liquidity required to meet current international working capital needs; and SCP or other joint venture unremitted earnings that require a joint determination with our partners to remove any indefinitely reinvested representation.

Additionally, in the third quarter of 2010, XXX announced a significant multi-year investment plan that was expected to result in 2011 capital investment of $2.4 billion to $2.7 billion, the substantial majority of which would be spent internationally and would include over the term of the plan: $800 million for additional LCD capacity in China; capacity expansion for Eagle XG LCD glass and XXX Gorilla Glass in Asia; expansion of automotive substrate facilities in China and Germany; and a new manufacturing and distribution center in China for our Life Sciences businesses. These factors in addition to the fact that XXX has sufficient access to funds in the U.S. to fund currently anticipated domestic needs result in our ability and intent to indefinitely reinvest our foreign unremitted earnings of $8.9 billion as of December 31, 2010.

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Form 10K – 12/31/10


We currently provide income taxes on the earnings of foreign subsidiaries and affiliated companies to the extent these earnings are currently taxable or expected to be remitted. As of December 31, 2010, taxes have not been provided on approximately $8.9 billion of accumulated foreign unremitted earnings that are expected to remain invested indefinitely. It is not practical to calculate the unrecognized deferred tax liability on those earnings.

Certain foreign subsidiaries in China and Taiwan are operating under tax holiday arrangements. The nature and extent of such arrangements vary, and the benefits of such arrangements phase out through 2014 according to the specific terms and schedules of the relevant taxing jurisdictions. The impact of the tax holidays on our effective rate is a reduction in the rate of 3.1, 7.3 and 5.3 percentage points for 2010, 2009 and 2008, respectively.

While we expect the amount of unrecognized tax benefits to change in the next 12 months, we do not expect the change to have a significant impact on the results of operations or our financial position.


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Tax reserves

The basics

• Recognition Threshold

- More likely than not based solely on technical merit

• Measurement

- The largest amount greater than 50 percent likely of being realized upon settlement with taxing authority that has full knowledge of all relevant information (so-called “cumulative probability” approach).

• Change in judgment

- Should be based on new information instead of re-assessing old information.

• Interest/Penalties

- Accounting policy to be applied consistently.

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Tax reserves (continued)

The basics

• Balance Sheet Classification

- Long-term liability unless cash payment/receipt is expected within the next 12 months or operating cycle.

• Disclosures

- Accounting policy classification of interest and penalties;

- Tabular reconciliation of the UTPs on an aggregated worldwide basis;

- The amount of UTPs, if recognized, would affect the effective tax rate;

- Interest/penalties accrued during the year and cumulative balances;

- Reasonably possible change to the UTPs within next 12 months;

- Tax years subject to examination by major tax jurisdictions.

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Subsequent recognition and measurement

• Key areas of judgement and challenges

- Evaluating “new information” that leads to changes in recognition and measurement

- Applying the concept of “effective settlement”

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Subsequent recognition and measurement

• Recognition and measurement should be reassessed (using ASC 740-10 model) at each reporting date.

- ASC 740-10 assessment (recognition and measurement) subject to change based on new information

◦ Changes to prior year tax positions would be treated as discrete items in the period the change occurs

◦ Changes to current year tax positions would be accounted for under ASC 740-270-35-6

- May occur prior to final resolution of matter

- “Subsequent event” disclosure considerations

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Effective settlement

• Taxing authority has completed examination procedures, including appeals and administrative reviews required

- Consideration should be given to the existence of NOLs and the taxing authority’s ability to examine/re-examine positions when the benefit is utilized on a subsequent return regardless of whether the statute of limitations has expired

• Taxpayer does not intend to appeal or litigate any aspect of the tax position included in the completed examination

• It is remote that the taxing authority would examine/reexamine any aspect of a tax position

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Effective Tax Rate

Critical takeaways

• The effective tax rate (ETR) reconciliation is a primary area of focus in the current regulatory and political environment

• Provides valuable insight into the business

• Increased scrutiny of certain reconciling items:

- Foreign operations

- 5 percent consideration

- Aggregation considerations

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Rate reconciliations

“Please consider providing disclosures to explain in greater detail the impact on your effective income tax rates and obligations of having proportionally higher earnings in countries where you have lower statutory tax rates. You should consider explaining the relationship between the foreign and domestic effective tax rates in greater detail. It appears as though separately discussing the foreign effective income tax rates is important information necessary to understanding your results of operations. We refer you to Item 303(a)(3)(i) of Regulation S-K and Section III.B of SEC Release 33-8350.”

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“We note the caption in your effective income tax rate reconciliation for foreign rate differentials. Please clarify what the foreign rate differential represents in each of the three years presented. As part of your response, explain how the foreign rate differential is determined in each fiscal year and identify the significant components of this item.”

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Form 10K – 4/27/2008


The effective income tax rate (taxes as a percentage of income (loss) before income taxes) was a benefit of 11.2% and 56.1% in fiscal 2008 and 2007, respectively. The income tax benefit of 11.2% in fiscal 2008 primarily reflects pre-tax losses from the company's U.S. operations (which are taxed at higher income tax rates), lower income tax expense from foreign sources due to foreign currency fluctuations and taxable income subject to lower income tax rates, research and development credits with regards to the company's Canadian subsidiary of $593,000, and income tax incentives granted by the Chinese government of $592,000. The income tax benefit of 56.1% in fiscal 2007 primarily reflects pre-tax losses from the company's U.S. operations (which are taxed at higher income tax rates) due to restructuring activities in its U.S. upholstery fabric operations, and taxable income from foreign sources taxed at lower income tax rates, offset by non-deductible stock option expenses.

Form 10K – 5/1/2011


We recorded an income tax benefit of $1.1 million, or 7.3% of income before income tax expense in fiscal 2011 compared with income tax expense of $1.1 million, or 7.9% of income before income tax expense, in fiscal 2010. The income tax benefit for fiscal 2011 is different from the amount obtained by applying our statutory rate of 34% to income before income taxes for the following reasons:

The income tax rate was reduced by 42% or an income tax benefit of $6.4 million was recorded for the reduction in the valuation allowance recorded against our net deferred tax assets associated with our U.S. and China operations. This income tax benefit of $6.4 million represents a $2.8 million realization of U.S. loss carryforwards associated with fiscal 2011 pre-tax income from our U.S. operations, a $2.3 million adjustment pertaining to a change in judgment about the future realization of our U.S. net deferred tax assets, and a $1.3 million adjustment pertaining to a change in judgment about the future realization of our China net deferred tax assets.

The income tax rate was reduced by 7% for taxable income subject to lower statutory income rates in foreign jurisdictions (Canada and China) compared with the statutory income tax rate of 34% for the United States.

The income tax rate was reduced by 2% for adjustments made to our Canadian deferred tax liabilities associated with our election to file our Canadian income tax returns in U.S. dollars commencing with our fiscal 2011 tax year. Our Canadian income tax returns were filed in Canadian dollars for fiscal years prior to fiscal 2011. This adjustment totaled $315,000 and represented a discrete event in which the full tax effects were recorded in the first quarter and the full year of fiscal 2011

The income tax rate increased 9% for an increase in unrecognized tax benefits.

The income tax rate increased 0.7% for non-deductible stock-based compensation expense and other miscellaneous items.

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SEC comment letters on taxes – Summary


• Greater detail in explaining the impact of the ETR reconciliation and obligations of having proportionately higher earnings in countries with lower statutory tax rates.

• Explanation of the relationship between the foreign and domestic ETRs in greater detail.

• Clarification of what the foreign rate differential represents in each of the three years presented.

• Expansion of the disclosure for federal tax credits that have had a material impact on tax expense to include the nature and estimated amount of each significant component in the material reconciling item.

• Request for additional information on why a discussion of the material terms of an Advanced Pricing Agreement entered into with the IRS was not considered to be material for disclosure.

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Critical takeaways

• Acquired business is recorded at fair value, with the exception of income taxes

• Subsequent changes to acquired deferred taxes may need to be recorded through the income statement, even if the change falls within the measurement period

• Whether tax effects of post-acquisition elections and restructurings are recorded in acquisition accounting (adjusting goodwill) is highly judgmental

- Pre-tax accounting has clear boundaries, whereas the tax accounting model is based on expectations

- Recorded tax effects can be out of sync with pre-tax accounts

- Since tax accounts are not fair-valued impact on goodwill magnified


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March 2014

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Business combinations (continued)

Overview

• ASC 805 (formerly FAS 141(R)) and ASC 810 (includes former FAS 160)

• Fundamental underlying principle is that the acquired business should be recorded at fair value (although income taxes are not)

• Increased number of transactions or events that are deemed business combinations

• Subsequent changes to acquired deferred taxes may need to be recorded through the income statement, even if the change falls within the measurement period

• Acquired tax attributes and limitation by tax law

• Business combination achieved in stages

• Deferred tax related to goodwill


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Outside basis differences

• A business combination may include the acquisition of certain temporary differences for which ASC 740 provides an exception for recording deferred taxes

• The acquirer must make its own determination regarding indefinite reversal (or lack thereof) in connection with outside basis differences of the target

- Acquirer cannot rely on prior assertions made by the seller

• No DTL is required for the outside basis difference in acquisition accounting if the parent can establish the intent and ability to indefinitely delay reversal of the difference

• If management intends to repatriate post acquisition earnings vs. indefinite investment of acquired earnings, then they should fully document the plan for the acquired earnings to support the assertion

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In Process Research and Development

• A business combination may include the acquisition of certain temporary differences for which ASC 740 provides an exception for recording deferred taxes

• Acquired in process R&D (“IPR&D”) activities are accounted for as indefinite-lived intangible assets, subject to impairment testing until completion or abandonment

• Recognition of indefinite–lived intangible creates a DTL in acquisition accounting

• Upon completion of an IPR&D activity, a determination of the useful life of the asset is made

• “Naked credit” issues related to IPR&D should be considered when evaluating the related DTL as a source of income to realize a benefit from DTAs

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Contingent consideration

• Recorded at fair value on the acquisition date, regardless of the likelihood of payment

• Contingent consideration is remeasured at fair value in subsequent periods, unless consideration is accounted for as equity under GAAP

• For tax purposes, contingent consideration is generally not recognized until it becomes fixed and determinable, or in some jurisdictions, until it is paid

• Depending on the type of transaction, deferred taxes may need to be provided at the acquisition date and adjusted in subsequent periods as the contingent consideration is adjusted for book purposes

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Transaction Costs

• Transaction costs are required to be expensed for book purposes

• Depending on the type of transaction and nature of the costs, for tax purposes, transaction costs could be expensed as incurred, capitalized as a separate intangible asset, included in the basis of the stock acquired, included in the basis of other assets, or included in tax-deductible goodwill

• Need to consider any potential tax consequence before the transaction has been consummated (i.e., in a pre-combination period)

• If the transaction costs are not immediately deductible for tax purposes, then a temporary difference may arise

• Potential disproportionate ETR impact for stock transactions

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