Is a Valuation Allowance an Uncertain Tax Position?

April 16, 2024
Is a Valuation Allowance an Uncertain Tax Position?

From time to time, the analytical framework for evaluating uncertain income tax positions interacts with the ASC 740 income tax provision literature and rules concerning the recording and valuation of deferred tax assets. A deferred tax asset is an asset that reflects the deferred tax consequences of a deductible temporary difference or carryforwards. These deferred tax consequences amount to reductions in tax liabilities in future tax years.

Unrecognized tax benefits vs. uncertain tax positions

A deferred tax asset is recognized only if the underlying tax position that would create it meets the recognition threshold under ASC 740 and thus is not an uncertain tax position. Even though the tax position underlying the deferred tax asset meets the recognition threshold, the asset is subject to a valuation allowance if the future tax benefits associated with it might not materialize. For example, a deferred tax asset based on a net operating loss (NOL) carryforward might not be realized if there will not be sufficient future taxable income to absorb the NOL carryforward before it expires.

What if the realization of a deferred tax asset is based on an uncertain tax position the entity plans to take in the future? Does the uncertainty of the future tax position need to be reflected through the deferred tax asset’s valuation allowance, or through a reserve for uncertain tax positions if it doesn’t meet the more-likely-than-not recognition standard? This type of uncertainty should be reflected through a reserve for uncertain tax positions.

How do I know if I need a valuation allowance for a deferred tax asset?

The measurement of a deferred tax asset must be reduced by the amount not expected to be realized. An entity must also evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale debt securities in combination with the entity’s other deferred tax asset. The term “realization” generally refers to the additional benefit one may achieve via the reduction in future taxes payable or an increase in future taxes refundable from deferred tax assets, assuming that the underlying deductible difference and carryforwards are the last items to enter into the determination of future taxable income.

ASC 740 guidance further provides that corporate entities should weigh all available evidence to determine the need for a valuation allowance. Depending on the weight of the evidence, deferred tax assets should be reduced by a valuation allowance only when it is more likely than not (50% or more likelihood) that some or all of the deferred tax assets won’t be realized. The valuation allowance should be sufficient to reduce the determined tax asset to the amount that is more likely than not to be realized.

Thus, if a deferred tax asset is based on a deductible temporary difference, whether the asset will ever be realized depends on the existence of sufficient taxable income in the taxable years the deductible temporary difference is likely to reverse. Similarly, if a deferred tax asset is based on a carryforward, whether the asset will ever be realized depends on the existence of taxable income in the carryforward years sufficient to absorb the carryforward amount. Potential sources of future taxable income include future reversals of existing taxable temporary differences and available future tax planning strategies.

Comparing valuation allowances and uncertain tax position requirements

There is a distinction between an uncertain tax position and its impact on deferred taxes as compared to the assessment of the need for a valuation allowance for a deferred tax asset. The likelihood of a tax position being sustained on the technical merits depends on whether the deferred tax asset or liability exists. By contrast, valuation allowances depend on whether there is adequate taxable income to absorb the attribute so the deferred tax asset may be realized. Therefore, a valuation allowance isn’t an appropriate substitute for derecognizing a tax position and shouldn’t be used to record reserves for uncertain tax positions.

A tax position should be derecognized in the first reporting period in which it is no longer more likely than not that the tax position would be sustained upon examination. Use of a valuation allowance is not a permitted substitute for derecognizing a benefit of a tax position where the more-likely-than-not recognition standard is no longer met.

This means that uncertain tax positions not yet taken on a filed return should be accounted for as uncertain tax positions under ASC 740 rather than in the valuation allowance of a deferred tax asset. In situations where the uncertainty concerns the ability to access a deferred tax asset due to technical tax uncertainty about a future tax position to be taken, the uncertain tax position constructs are the ones to apply. The valuation allowance construct gets at a different issue: the value of the deferred tax asset as opposed to whether it is there to begin with.

Authoritative analysis on ASC 740 income tax provision

From recognizing uncertain tax positions to accounting for net operating losses and tax credits, calculating your company’s provision for income taxes under ASC 740 requires a nuanced understanding of a multitude of factors. Take control of your tax provision process with our Essential Guide to ASC 740. This guide breaks down the steps and helps you navigate the biggest hurdles with background, details, and examples of how ASC 740 interacts with various tax laws and corporate facts.

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