Naked credits and the interest expense limitation.

• Author: Solomon, Murray J.

EXECUTIVE SUMMARY

* A naked credit occurs when a company has a full valuation allowance against its net deferred tax assets (DTAs) but also has deferred tax liabilities (DTLs) that have an indefinite life. Recent final regulations may change the way some companies determine their naked credit.

* In determining a valuation allowance, assumed future income of indefinitelived DTLs may support indefinite-lived DTAs, but statutory limitations may affect this calculation, such as those introduced by the legislation known as the Tax Cuts and Jobs Act, P.L. 115-97, limiting deductions of business interest expense and net operating losses.

* Final and proposed regulations providing guidance on the calculation of adjusted taxable income (ATI) for purposes of the interest expense limitation require ATI to be reduced for gains from sales of assets to the extent those gains derive from depreciation or amortization incurred between 2018 and 2021, which may increase both valuation allowances related to interest DTAs and naked credits.

Final Treasury regulations (1) with guidance on applying the Sec. 163(j) interest expense limitation may change the calculus some companies use in determining the amount of their naked credit.

A deferred tax asset (DTA) is recognized for temporary differences that will result in deductible amounts in future years and for carryforwards. If, based on all available evidence, positive and negative, there is more than a 50% likelihood (i.e., it is more likely than not) that a taxpayer will not realize a portion or all of a DTA, the taxpayer is required to reduce the DTA to its actual value by recognizing a valuation allowance. A taxpayer that has temporary differences that will result in taxable amounts in future years recognizes a deferred tax liability (DTL). DTAs and DTLs can be definite-lived (attributable to assets with a definite useful life) or indefinite-lived (attributable to an indefinite-lived asset, e.g., goodwill).

Definite-lived DTLs can typically be used as a source of future taxable income to support definite-lived DTAs and can be netted against such DTAs. When it is more likely than not that the net DTA will not be realized, a valuation allowance reserve is booked against the net DTA. (2) Indefinite-lived DTLs, however, are left out of this calculation and often left on the balance sheet, creating a "naked credit," where a company has a full valuation allowance against its net DTAs but also has DTLs that have an indefinite life.

Indefinite-lived DTLs are typically attributed to indefinite-lived intangibles that have a book (or GAAP) basis that is higher than the tax basis. This is created either when an indefinitelived intangible is purchased in a stock acquisition and the amount of tax basis in the acquired intangible is less than the GAAP basis booked in purchase accounting, or in an asset acquisition when the intangible has the same beginning basis for GAAP and tax but has an indefinite life for GAAP purposes and is being amortized for tax purposes. Before the legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, alternative minimum tax credits were primarily the only indefinite-lived DTAs in the United...