GAAP Working Group Submits Comments on FASB Exposure Draft to Expand the Proportional Amortization Method to All Tax Credits
Improving the accounting treatment for investments in tax credits is of vital importance to ensure the relevant and faithfully representative financial reporting for investments such as those made in not just the low-income housing tax credit (LIHTC), but all tax credits. As such, the exposure draft issued Aug. 22 by the Financial Accounting Standards Board (FASB) that would allow reporting entities to elect to use the proportional amortization method for all eligible tax equity investments that meet five specific conditions is a positive step forward as it would simplify the accounting treatment for various tax credits.
The comment period for the exposure draft, titled, “Investments—Equity Method and Joint Ventures (Topic 323) Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method” ended today. The GAAP Accounting for Tax Credits Working Group (GAAP Working Group) hosted by Novogradac submitted comments on the exposure draft , some of which will be discussed in this blog post.
How We Got Here
In the original accounting standards update (ASU 2014-01) FASB introduced the option to apply the proportional amortization method to account for investments made primarily for the purpose of receiving income tax credits and other income tax benefits. However, the guidance limited the proportional amortization method to investments in LIHTC structures.
The proportional amortization method results in the cost of the investment being amortized in proportion to the income tax credits and other income tax benefits received with the investment gains and losses and tax credits being presented net in the income statement as a component of income tax expense (benefit), according to the Aug. 22 update. On the other hand, investments in other similar tax credit structures are typically accounted for using variations of the equity or cost methods. The difference with the equity or cost method is it often results in investment gains and losses and tax credits being presented gross on the income statement in their respective line items, creating an uneven playing field when compared to LIHTC investments accounting for using the proportional amortization method.
Stakeholders have asserted that economically similar investments that are made primarily for the purpose of receiving income tax credits and other income tax benefits should also have the same election to apply the proportional amortization method as LIHTC structures, according to the GAAP Working Group. This is because the proportional amortization method provides a better understanding of the returns from such investments than the equity or cost method. As a result, stakeholders asked that FASB allow reporting entities to elect to apply the proportional amortization method on a tax credit program-by-program basis to account for tax equity investments that generate tax credits through other programs. This would apply for the LIHTC, the new markets tax credit (NMTC), the historic tax credit (HTC) and renewable energy tax credits (RETCs). It would also be available for any new tax credit programs created by Congress in the future.
GAAP Working Group Comments
In its comment letter, the GAAP Working Group made several recommendations including a request that FASB also consider reviewing and making changes to the current conditions as part of a new project after the current proposed update is implemented. If FASB opens a new project to evaluate the five conditions included in the update and make changes as recommended by the GAAP Working Group, it would allow the guidance to be applied more broadly for various tax credit structures, especially renewable energy transactions.
The working group’s comments correspond with FASB’s 14 questions for respondents in the exposure draft of its Proposed Accounting Standards Update. This blog will go into detail on a couple of those responses.
Beginning with question one, the working group agrees that a reporting entity that makes tax equity investments primarily for the benefit of tax credits and other tax benefits through limited liability entities may elect to account for those investments using the proportional amortization method.
However, the working group requests that FASB remove the addition of “income” before tax credits in the amended language throughout the update. The word “income” unnecessarily limits tax credit investments to tax credits that reduce income tax liabilities. Some tax credits, especially certain state tax credits and potentially future tax credits, allow the reporting entity to offset tax liabilities that aren’t related to income taxes, like a premium tax liability. The update’s intention is to expand the guidance to all tax credit investments. Therefore, limiting it to only income tax credits would be counterproductive and may also impact the current application to certain state LIHTCs.
Question 1 goes on to recommend that FASB consider taking on a new accounting update project to make changes to three of the five conditions that need to be met in order for reporting entities to use the proportional amortization method for all community development tax credit incentives.
But first, here are the five conditions as amended in the update (amended updates are strikethrough and underlined below):
a. It is probable that the income tax credits allocable to the investor will be available.
aa. The investor does not have the ability to exercise significant influence over the operating and financial policies of the
limited liability entity underlying project.
aaa. Substantially all of the projected benefits are from income tax credits and other income tax benefits (for example, tax benefits generated from the operating losses of the investment). Projected benefits include, but are not limited to, income tax credits, other income tax benefits, and other non-income-tax-related benefits, including refundable tax credits (that is, those tax credits not dependent upon an investor’s income tax liability). Tax credits that would be accounted for outside of the scope of Topic 740 (for example, refundable tax credits) shall be included in total projected benefits, but not in income tax credits and other income tax benefits when evaluating this condition. This condition shall be determined on a discounted basis using a discount rate that is consistent with the cash flow assumptions utilized by the tax equity investor for the purpose of making a decision to invest in the project.
b. The investor’s projected yield based solely on the cash flows from the income tax credits and other income tax benefits is positive.
c. The investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the investor’s liability is limited to its capital investment.
The working group letter requests to re-evaluate conditions aa, aaa and b, commonly referred to as the significant influence, substantially all, and positive yield conditions, respectively. Without any changes, many renewable energy tax credit transactions will have a difficult time satisfying the five conditions as amended in the update.
Another important issue discussed in the working group’s comment letter is highlighted in question 6 where the working group agrees that the accounting policy election should be made on a tax-credit-program-by-tax-credit-program basis. Due to the diversity in types of tax credits as well as the possibility of future, unknown tax credits, the working group believes it is most practical to allow preparers to apply the election to use the proportional amortization method on a tax-credit-program-by-tax-credit-program basis. The working group agrees “…because it allows companies flexibility to evaluate the cost of applying the proportional amortization method for tax credit programs in which they may not have a high volume of transactions in comparison to the benefits of improved financial reporting.”
The working group further supports the previous staff comment that an election on a tax-credit-program-by-tax-credit-program basis “…allows for an appropriate level of flexibility for entities to manage the costs associated with evaluating whether an investment is eligible to apply the proportional amortization method and the benefits of the resulting financial reporting in the income tax line item depending on the number and size of investments within that tax credit program.” It is difficult to expand the existing conditions to all investments and assume that one size fits all, the comment letter stated. Having an election in place on a tax-credit-program-by-tax-credit-program basis allows investors the flexibility needed to address the diversity of investments in their portfolio and make the accounting policy election that will provide the most relevant information for each portfolio. It would be much more costly if an investor is required to determine eligibility for all of its tax credit investments and may impact its decision to make certain tax credit investments.
The working group discussed how critical it is that early adoption of the proportional amortization method be available. They noted that when ASU 2014-01 was released that many investors utilized early adoption because the accounting treatment under the proportional amortization method was so much better. Many entities have indicated, as noted by the working group, that they similarly plan to elect to use the proportional amortization method for their qualifying tax equity investments (such as NMTCs, HTCS and RETCs) as soon as they’re allowed.
How Can Novogradac Help?
This blog serves as a snapshot of the working group’s comments on FASB’s Proposed Accounting Standards Update. To read the GAAP Working Group comment letter in its entirety, click here. To join the GAAP Working Group and its efforts to get FASB to take on a subsequent project to discuss changes to the five conditions noted above, please contact Brad Elphick.