#740 #ASC

H. State and Local Income Taxes

Excerpt From Accounting Standards Codification

Income Taxes—Overall

Implementation Guidance and Illustrations

740–10–55–25

If deferred tax assets or liabilities for a state or local tax jurisdiction are significant, this Subtopic requires a separate deferred tax computation when there are significant differences between the tax laws of that and other tax jurisdictions that apply to the entity. In the United States, however, many state or local income taxes are based on US federal taxable income, and aggregate computations of deferred tax assets and liabilities for at least some of those state or local tax jurisdictions might be acceptable. In assessing whether an aggregate calculation is appropriate, matters such as differences in tax rates or the loss carryback and carryforward periods in those state or local tax jurisdictions should be considered. Also, the provisions of paragraph 740-10-45-6 about offset of deferred tax liabilities and assets of different tax jurisdictions should be considered. In assessing the significance of deferred tax expense for a state or local tax jurisdiction, it is appropriate to consider the deferred tax consequences that those deferred state or local tax assets or liabilities have on other tax jurisdictions, for example, on deferred federal income taxes.

When deferred tax assets and liabilities attributable to state or local tax jurisdictions are significant, a separate deferred tax computation may be required when there are significant differences between the tax laws of that state or local tax jurisdiction and other tax jurisdictions applicable to the company (i.e., the US federal and other state or local tax jurisdiction). For example, many states have limited carryback and carryforward provisions, which could result in limited asset recognition under the liability method. In assessing whether an aggregate calculation is appropriate, matters such as differences in tax rates or the loss carryback and carryforward periods in those state or local tax jurisdictions should be considered.

1. State Applied vs. Enacted Tax Rates —

ASC 740 requires the use of currently enacted tax rates in computing deferred taxes. However, when considering state and local income taxes, companies must consider the federal tax benefits, if any, related to those state and local taxes and adjust the enacted tax rates by the expected federal benefit. That is, if the enacted income tax rate for a given state is 10% and the company anticipates receiving a federal tax deduction in the period that tax liability becomes payable to the state taxing authority, and the company's federal tax rate is 21%, the company would compute its state deferred taxes using 7.9% (or 10% x (1-0.21)). Despite the computation of the state tax, public entities are required by Regulation S-X to separately disclose the state income tax expense exclusive of the federal tax benefit when disclosing the components of income tax expense. In addition, the guidance for accounting of income taxes in ASC 740 does not permit netting of deferred tax assets and liabilities related to different tax jurisdictions (e.g., federal and state) in the statement of financial position (ASC 740-10-45-6). See section XVIII.A.1.a(1), State and local income taxes and valuation allowance, for further discussion, including when a state deferred tax asset is not more likely than not to be realized.

In addition to the impact of federal tax benefits attributable to state and local income taxes, companies with operations in multiple state and local taxing jurisdictions must also consider the various allocation methodologies under state income tax laws and regulations. See Section V.F.3 Income Apportionment, for additional discussion.

2. Estimating Deferred State Income Taxes (updated September 2020) —

In some jurisdictions, state and local taxes are based on US federal taxable income, and aggregate computations of deferred tax assets and liabilities for at least some of those state or local tax jurisdictions might be acceptable. In assessing whether an aggregate calculation is appropriate, matters such as differences in tax rates or the loss carryback and carryforward periods should be considered. In addition, in assessing the significance of deferred tax expense with respect to state or local taxes, consideration should be given to the deferred tax consequences that those deferred state or local tax assets or liabilities have on other tax jurisdictions, for example, on the computation of deferred federal income taxes. Consideration must also be given to the prohibition against offsetting deferred tax liabilities and assets attributable to different tax jurisdictions under ASC 740-10-45-6. (See Section XVIII Financial Statement Presentation, for further discussion). Companies with a majority of their taxable income allocated to a few states ordinarily should be able to analyze the tax effects in those states, and estimate an overall provision for remaining operations.

Additional state and local income tax considerations as a result of the TCJA and the CARES Act

The TCJA and CARES Act also have state and local tax implications. Most state income tax laws use federal taxable income as a starting point for determining state income tax. While some states automatically adopt federal tax law changes, other states conform their laws with federal law on specific dates. States also may have chosen or will choose to decouple from new federal tax provisions and continue to apply the old tax law. As a result, a company may need to follow one set of rules when determining taxable income for US income tax purposes and multiple sets of rules when determining state and local taxable income. Companies will need to understand the conformity rules and changes to the tax laws in the states in which they operate so they can appropriately account for the effects on their state income taxes. As a result, depending on whether a state adopted or decoupled from federal tax law, additional complexities may result in the computation of deferred state tax liabilities and assets.

3. Income Apportionment —

Many states require apportionment of federal taxable income to the states in which companies operate in based on various factors. Taxable income is typically apportioned based on sales, payroll costs and assets (“three factors”) in each state.

Illustration 5-8: Apportionment of taxable income to the states in which companies operate based on sales, payroll costs and assets
Assume Company LML has $10,000 income before taxes from its operations in Connecticut, New York, Texas, and Virginia. Further assume there are no temporary differences and all state apportionment factors are consistent.

	CT	NY	IL	VA	Total
Apportionment factors:
Sales	$5	$15	$20	$60	$100
Payroll costs	15	5	70	10	100
Tangible assets	5	5	80	10	100
	$25	$25	$170	$80	$300

State taxable income	$10,000	$10,000	$10,000	$10,000	$10,000
State tax rate	× 4%	× 7%	× 10%	× 5%
Apportionment factor	× 25 / 300	× 25 / 300	× 170/300	× 80/300
State income taxes	$33	$58	$567	$133	$791

Federal taxable income					9,209
Federal tax rate					21%
Federal income taxes					1,934
Net Income					$7,275

Because not all state and local taxing authorities require or permit the same allocation methodologies, a portion of the company's income may be taxable in more than one jurisdiction or may not be subject to taxation in any jurisdiction.

ASC 740 does not specifically address the apportionment of income for purposes of determining the state tax rates to apply to temporary differences. However, the apportionment factors utilized to measure deferred tax assets and liabilities generally should be those that are expected to apply when those deferred tax assets and liabilities are settled or realized. One approach would be to estimate future allocations to states based on historical relationships.

A company may expect future changes in its business that will affect its state apportionment factors. For example, a company may expect a shift in operations or employees from one state to another state. Additionally, a company may plan on expanding operations or adding employees in a state (e.g., construction of a new manufacturing facility may result in more employees in that state). We believe the effects of these anticipated changes are generally included in the measurement of deferred tax balances when the company has committed to a sufficiently developed plan to carry out the actions that will result in the change in operations and the remaining steps to complete the plan are within the company's control.

Business Combinations

We often receive questions regarding the effects that a future business combination may have on tax apportionment. A business combination is defined in ASC 805 as “[a] transaction or other event in which an acquirer obtains control of one or more businesses.” We do not believe that a company should anticipate obtaining control of a business for purposes of measuring its deferred taxes. That is, changes in the measurement of an acquirer's deferred taxes as a result of a business combination should be recorded when the business combination occurs. This view is consistent with the fact that a business combination is a nonrecognized subsequent event.¹⁹

¹⁹ ASC 855-10-55-2 provides examples of non-recognized subsequent events and includes a business combination that occurs after the balance sheet date but before financial statements are issued or available to be issued.

If the tax rate (including consideration of income apportionment) applicable to existing deductible or taxable temporary differences of the acquirer changes as a result of a business combination, the effect of the change should be reported in the current operating results and not in acquisition accounting. See Section XI.M.2, Apportioned Tax Rates, for additional discussion of apportioned tax rate considerations in accounting for a business combination.

Change in Apportionment Method

A company's apportionment method for a state might change for various reasons, including those listed below. The accounting for the change will depend on the specific facts and circumstances surrounding that change.

• Change in state tax law — A state may change its tax law as to how income is apportioned. For example, a state may no longer require all three factors to determine the amount of income apportioned, but the state may require income be apportioned based on a single factor (e.g., sales). Alternatively, for example, a state may no longer require a single factor (e.g., sales), but the state may require all three factors to determine the amount of income apportioned. Changes in tax laws are recognized at the date of enactment. Refer to Section VIII, An Enacted Change in Tax Laws or Rates, for additional discussion.

• Resolution of income tax uncertainty — The resolution of an income tax uncertainty with respect to a state apportionment method would be accounted for in the period of change under the guidance on uncertainty in income taxes in Section XIX.G, Subsequent Recognition, Derecognition and Measurement.

• Change in state regulations — A new state regulation might result in a change to a state apportionment method. Care should be taken in determining whether the change is akin to change in state tax law (refer to Chapter 8, An enacted change in tax laws or rates) or the resolution of an income tax uncertainty (refer to Section XIX.G, Subsequent Recognition, Derecognition and Measurement).

• Voluntary change in tax accounting method — A company may voluntarily change its state apportionment method by a change in tax accounting method. Refer to Section VIII.G, Changes in Tax Accounting Methods.

4. State Taxes Based on the Greater of Franchise Tax or Income Tax (updated September 2020) —

Standard Setting

In December 2019, as part of its broader simplification initiative, the FASB issued ASU 2019-12 that simplifies the accounting for income taxes by eliminating some exceptions to the general approach in ASC 740 and clarifying certain aspects of the legacy guidance to promote more consistency. The amendments require entities to recognize a franchise tax by (1) accounting for the amount based on income under ASC 740 and (2) accounting for any residual amount as a non-income-based tax.

For PBEs, the guidance is effective for fiscal years beginning after 15 December 2020 and interim periods within those fiscal years. For all other entities, the guidance is effective for fiscal years beginning after 15 December 2021 and interim periods within fiscal years beginning after 15 December 2022.

Early adoption is permitted in interim or annual periods for which PBEs have not yet issued financial statements and all other entities have not made financial statements available for issuance. Entities that elect to early adopt the amendments in an interim period should reflect any adjustments as of the beginning of the annual period that includes that interim period. Additionally, entities that elect to early adopt must adopt all the amendments in the same period.

Entities must apply the amendment related to franchise taxes either retrospectively for all periods presented or using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption.

Before the adoption of ASU 2019-12

Excerpt From Accounting Standards Codification

Income Taxes—Overall

Scope and Scope Exception

Transactions

740–10–15–4

The guidance in this Topic does not apply to the following transactions and activities:

a. A franchise tax to the extent it is based on capital and there is no additional tax based on income. If there is an additional tax based on income, that excess is considered an income tax and is subject to the guidance in this Topic. See Example 17 (paragraph 740-10-55-139) for an example of the determination of whether a franchise tax is an income tax.

b. A withholding tax for the benefit of the recipients of a dividend. A tax that is assessed on an entity based on dividends distributed is, in effect, a withholding tax for the benefit of recipients of the dividend and is not an income tax if both of the following conditions are met:

1. The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does not reduce future income taxes the entity would otherwise pay.

2. Shareholders receiving the dividend are entitled to a tax credit at least equal to the tax paid by the entity and that credit is realizable either as a refund or as a reduction of taxes otherwise due, regardless of the tax status of the shareholders.

See the guidance in paragraphs 740-10-55-72 through 55-74 dealing with determining whether a payment made to a taxing authority based on dividends distributed is an income tax.

Implementation Guidance and Illustrations

740–10–55–139

The guidance in paragraph 740-10-55-26 addressing when a tax is an income tax is illustrated using the following historical example.

740–10–55–140

In August 1991, a state amended its franchise tax statute to include a tax on income apportioned to the state based on the federal tax return. The new tax was effective Jan. 1, 1992. The amount of franchise tax on each corporation was set at the greater of 0.25 percent of the corporation's net taxable capital and 4.5 percent of the corporation's net taxable earned surplus. Net taxable earned surplus was a term defined by the tax statute for federal taxable income.

740–10–55–141

In this Example, the total computed tax is an income tax only to the extent that the tax exceeds the capital-based tax in a given year.

740–10–55–142

A deferred tax liability is required to be recognized under this Subtopic for the amount by which the income-based tax payable on net reversing temporary differences in each future year exceeds the capital-based tax computed for each future year based on the level of capital that exists as of the end of the year for which deferred taxes are being computed.

740–10–55–143

The portion of the current tax liability based on income is required to be accrued with a charge to income during the period in which the income is earned. The portion of the deferred tax liability related to temporary differences is required to be recognized as of the date of the statement of financial position for temporary differences that exist as of the date of the statement of financial position.

740–10–55–144

Because the state tax is an income tax only to the extent that the tax exceeds the capital-based tax in a given year, under the requirements of this Subtopic, deferred taxes are recognized for temporary differences that will reverse in future years for which annual taxable income is expected to exceed 5.5% (.25% of net taxable capital/4.5% of taxable income) of expected net taxable capital. In measuring deferred taxes, see paragraph 740-10-55-138 to determine whether a detailed analysis of the net reversals of temporary differences in each future year is warranted. While the tax statutes of states differ, the accounting described above would be appropriate if the tax structure of another state was essentially the same as in this Example.

Franchise taxes are often referred to as “privilege” taxes because the tax is levied on all entities granted authority by the state to conduct business within its jurisdiction (i.e., the state allows the company to have the privilege of operating within the state). An example of a state franchise tax is included in ASC 740-10-55-139 through ASC 740-10-55-144. In this example, the amount of franchise tax owed by a corporation was the greater of 0.25 percent of the corporation's net taxable capital, as defined, or 4.5 percent of the corporation's net taxable earned surplus. Net taxable earned surplus was a term defined by the tax statute and is based on federal taxable income. Additionally, the total computed tax is an income tax only to the extent that the tax exceeds the capital-based tax in a given year (ASC 740-10-55-141).

We believe a franchise tax with essentially the same tax structure as the example above comprises of two elements under ASC 740, that is, a franchise tax and an income tax. To the extent the tax is based on net taxable capital, it is a franchise tax that should be accrued in the year to which the privilege relates. If there is additional tax due based on income, that excess is considered to be an income tax that should be accrued in the year the income was earned. The income-based franchise tax should be included in a company's estimated annual effective tax rate for purposes of applying ASC 740-270 to interim financial statements.

Illustration 5-9: State taxes based on the greater of franchise tax or income tax
Assume net taxable capital at December 31, 20X0 is $10.0 million and net taxable earned surplus is $1.0 million for the year ended December 31, 20X0. Also, assume that the privilege period to which the franchise tax relates is 20X1 franchise taxes for 20X0 and would be computed as follows:

Net taxable capital at December 31, 20X0	$10,000,000
Tax rate	0.25%
Franchise tax based on capital	$25,000	A

Net taxable earned surplus—20X0	$1,000,000
Tax rate	4.5%
Franchise tax based on income	$45,000	B
Additional tax based on income	$20,000	B − A

The company would recognize $20,000 of the tax as income tax expense in 20X0 ($45,000 franchise tax based on income less $25,000 based on capital). Because the tax on net earned surplus is based on income reported in the 20X0 financial statements, the $20,000 franchise tax based on this amount should also be accrued and reported in the 20X0 financial statements. The remaining franchise tax due of $25,000 for the taxpayer's privilege of doing business in the taxing jurisdiction in 20X1, which is calculated on capital, would be recognized as an operating expense in the 20X1 financial statements. That is, the $25,000 is not a tax based on current-year income. If the $25,000 franchise tax based on capital had exceeded the $45,000 franchise tax based on earnings, no amount would be recognized in 20X0.

After the adoption of ASU 2019-12

Excerpt From Accounting Standards Codification

Income Taxes—Overall

Scope and Scope Exception

Transactions

Pending Content:

Transition Date: (P) December 16, 2020; (N) December 16, 2021 | Transition Guidance: 740-10-65-8

740–10–15–4

The guidance in this Topic does not apply to the following transactions and activities:

a. A franchise tax (or similar tax) to the extent it is based on capital or a non-income-based amount and there is no portion of the tax based on income. If a franchise tax (or similar tax) is partially based on income (for example, an entity pays the greater of an income-based tax and a non-income-based tax), deferred tax assets and liabilities shall be recognized and accounted for in accordance with this Topic. Deferred tax assets and liabilities shall be measured using the applicable statutory income tax rate. An entity shall not consider the effect of potentially paying a non-income-based tax in future years when evaluating the realizability of its deferred tax assets. The amount of current tax expense equal to the amount that is based on income shall be accounted for in accordance with this Topic, with any incremental amount incurred accounted for as a non-income-based tax. See Example 17 (paragraph 740-10-55-139) for an example of how to apply this guidance.

1. The tax is payable by the entity if and only if a dividend is distributed to shareholders. The tax does not reduce future income taxes the entity would otherwise pay.

See the guidance in paragraphs 740-10-55-72 through 55-74 dealing with determining whether a payment made to a taxing authority based on dividends distributed is an income tax.

Implementation Guidance and Illustrations

740–10–55–139

The guidance in paragraph 740-10-55-26 addressing when a tax is an income tax is illustrated using the following historical example.

Pending Content

Transition Date: (P) December 16, 2020; (N) December 16, 2021 | Transition Guidance: 740-10-65-8

740–10–55–140

A state's franchise tax on each corporation is set at the greater of 0.25 percent of the corporation's net taxable capital and 4.5 percent of the corporation's net taxable earned surplus. Net taxable earned surplus is a term defined by the tax statute for federal taxable income.

740–10–55–141

In this Example, the amount of franchise tax equal to the tax on the corporation's net taxable earned surplus is an income tax.

740–10–55–142

Deferred tax assets and liabilities are required to be recognized under this Subtopic for the temporary differences that exist as of the date of the statement of financial position using the tax rate to be applied to the corporation's net taxable earned surplus (4.5 percent).

740–10–55–143

The portion of the total computed franchise tax that exceeds the amount equal to the tax on the corporation's net taxable earned surplus should not be presented as a component of income tax expense during any period in which the total computed franchise tax exceeds the amount equal to the tax on the corporation's net taxable earned surplus.

740–10–55–144

While the tax statutes of states or other jurisdictions differ, the accounting described in paragraphs 740-10-55-140 through 55-143 would be appropriate if the tax structure of another state or jurisdiction was essentially the same as in this Example.

Franchise taxes are often referred to as “privilege” taxes because the tax is levied on all entities granted authority by the state to conduct business in its jurisdiction. Certain jurisdictions impose franchise taxes (or other similar taxes) that are calculated using the greater of two tax computations, one based on income and one based on items other than income. ASC 740-10-15-4(a) requires entities to recognize the franchise tax by (1) accounting for the amount based on income under ASC 740 and (2) accounting for any residual amount as a non-income-based tax.

ASC 740-10-15-4(a) provides guidance on the measurement of deferred tax assets and liabilities when the entity is subject to a franchise tax that is partially based on income, stating that deferred tax assets and liabilities should be measured using the applicable statutory income tax rate.

An example of a state franchise tax is included in ASC 740-10-55-139 through ASC 740-10-55-144. In this example, the amount of franchise tax owed by a corporation is the greater of 0.25% of the corporation's net taxable capital or 4.5% of the corporation's net taxable earned surplus. Net taxable earned surplus is a term defined by the tax statute and is based on federal taxable income. Therefore, the amount of franchise tax equal to the tax on the corporation's net taxable earned surplus is an income tax (ASC 740-10-55-141).

We believe a franchise tax with essentially the same tax structure as the example above comprises two elements under ASC 740, that is, a tax based on income and a tax based on net taxable capital. To the extent the tax is based on income, deferred tax assets and liabilities are required to be recognized for the temporary differences that exist as of the date of the financial statements by applying the applicable income tax rate (e.g., 4.5%). The income-based franchise tax is an income tax and should be included in a company's estimated annual effective tax rate for purposes of applying ASC 740-270 to interim financial statements. If there is any portion of the total franchise tax that exceeds the tax on income, that excess is not recognized as a component of income tax expense.

Illustration 5-9A: State taxes based on the greater of franchise tax or income tax
• The Company operates in a jurisdiction that assesses a franchise tax based on the greater of tax based on net taxable capital or net taxable earned surplus.
• The Company's net taxable earned surplus for the year ended December 31, 20X0 is $1 million.
• The Company's net taxable capital at December 31, 20X0 is $15 million.
• The privilege period to which the franchise tax relates is 20X1.
• The franchise tax for 20X0 is computed as the greater of 0.40% of net taxable capital or 4.5% of net taxable earned surplus. The franchise tax for 20X0 is computed as the greater of 0.40% of net taxable capital or 4.5% of net taxable earned surplus.
Analysis

Net taxable earned surplus for 20X0	$1,000,000
Tax rate	4.5%
Franchise tax based on income	$45,000	A
Net Taxable capital at December 21, 20X0	$15,000
Tax rate	0.40%
Franchise tax based on capital	$60,000	B
Additional non-income tax	$15,000	B — A

After the adoption of ASU 2019-12, the Company would recognize $45,000 as current income tax expense in 20X0. Because the tax on net earned surplus is based on income reported in the 20X0 financial statements, the $45,000 franchise tax based on this amount should also be accrued and reported in the 20X0 financial statements. The remaining franchise tax due of $15,000 for the taxpayer's privilege of doing business in the taxing jurisdiction in 20X1, which is calculated on capital, would be recognized as an operating expense in the 20X1 financial statements. That is, the $15,000 is not a tax based on current-year income.

Deferred tax assets and liabilities are required to be recognized for the temporary differences that exist as of the date of the 20X0 financial statements by applying the applicable income tax rate (in this example, 4.5%).

a. Texas Franchise Tax (Updated November 2018) —

The Texas franchise tax is a tax based on “taxable margin.” Taxable margin is defined as the entity's “total revenues” less (at the election of the taxpayer) the greater of “cost of goods sold” or “compensation” (compensation would include wages and cash compensation as well as benefits). However, the entity's taxable margin would be capped at 70 percent of the entity's total revenues. The Texas franchise tax also provides for the carryforward of prior tax credits, subject to limitations, as well as a temporary tax credit.

We believe the Texas franchise tax, while based on an entity's margins (as discussed above), is nonetheless, a tax based substantially on income, and as such is subject to the provisions of ASC 740. Companies with qualifying tax credit carryforwards would continue to analyze the realizability of those credits to determine the need for a valuation allowance as required by ASC 740. Shortly after the Texas franchise tax was enacted, the FASB declined to add to its agenda a project to provide guidance relating to the accounting implications of the Revised Tax— principally whether or not it should be accounted for under ASC 740. In their deliberations, the FASB staff noted that the tax is based substantially on a measure of income and as a result believes it is subject to ASC 740.

b. Franchise Tax Effect on Deferred State Income Taxes —

ASC 740 does not require specific accounting for deferred state income taxes. The guidance for the accounting of income taxes in ASC 740 requires recognition of a current tax asset or liability for the estimated taxes payable or refundable on tax returns for the current year and a deferred tax asset or liability for the estimated future tax effects attributable to temporary differences and carryforwards that are measured at the enacted tax rates.

Accordingly, under ASC 740 before the adoption of ASU 2019-12, deferred taxes are recognized for temporary differences that will reverse in future years for which annual taxable income is expected to exceed the capital-based tax computation based on the level of existing capital at year-end.

After ASU 2019-12 is adopted, if a franchise tax (or similar tax) is partially based on income (for example, an entity pays the greater of an income-based tax and a non-income-based tax), deferred tax assets and liabilities are recognized and accounted for in accordance with ASC 740 and measured using the applicable statutory income tax rate. An entity should not consider the effect of potentially paying a non-income-based tax in future years when evaluating the realizability of its deferred tax assets.

ASC 740-10-55-138 and its discussion of graduated tax rates, should be considered when determining whether a detailed analysis of the net reversals of temporary differences in each future year (i.e., scheduling) is warranted. In most cases, ASC 740 does not require temporary difference to be scheduled. See Section IV.C Scheduling the Reversal of Temporary Differences, for further discussion.

5. State Taxes Based on Items Other Than Income —

Some state/local taxing authorities compute taxes due from business operations based on income plus or minus payroll, capital expenditures, net capital, and/or other items. Based on a company's actual operating results, the income tax component of the state/local taxation scheme may not be applicable (e.g., when the company is in a loss position) or may be the most significant component of the total state/local tax liability. In determining whether these taxation schemes are income taxes or other taxes (e.g., payroll, sales/use, franchise), companies should consider the current and future impact of the various components of the state/local tax scheme. In addition, companies should note that the ASC Master Glossary defines income tax expense (or benefit) as the sum of current tax expense (or benefit)(that is, the amount of income taxes paid or payable (or refundable) for a year as determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year) and deferred tax expense (or benefit) (that is, the change during the year (or since the acquisition date for acquired temporary differences) in an entity's deferred tax liabilities and assets). Further, public companies should consider Rule 5-03(b)(11) of Regulation S-X, which requires public companies to include only taxes based on income under the caption income tax expense.

In other words, taxes based on net capital are generally regarded as franchise taxes and recognized in the period the company has the privilege to operate in the taxing authority's jurisdiction. Likewise, taxes based on payroll or capital expenditures are generally regarded as payroll or use taxes and recognized in the period those costs are incurred. Conversely, taxes based on income should be recognized in the period in which the income is reported for financial reporting purposes (including the recognition of deferred tax assets and liabilities). Before adoption of ASU 2019-12, deferred taxes are recognized based on the incremental effect caused by reversals of temporary differences in future years for which annual taxable income is expected to exceed the other components (based on the existing relative significance) of the taxation scheme. After the adoption of ASU 2019-12, if a franchise tax (or similar tax) is partially based on income (for example, an entity pays the greater of an income-based tax and a non-income-based tax), deferred taxes are recognized and accounted for in accordance with ASC 740 and calculated using the applicable statutory income tax rate.

Illustration 5-10: State taxes based on items other than income (before the adoption of ASU 2019-12)

Jurisdiction M's business tax is based on income for the period plus payroll costs less construction expenditures. In many situations, the payroll and construction expenditures components may be more significant than the income component. Although Jurisdiction M's tax law clearly states the tax is not an income tax, the starting point for the tax is income for the period and therefore meets ASC 740’s definition of a “tax on income.”

Some diversity in practice arises because companies may have losses for both financial reporting and US federal income tax purposes and still have a tax liability for Jurisdiction M's business tax due to the payroll component of the base computation. Thus, some companies may consider classifying this tax (1) as income tax expense, (2) partially as income tax expense and partially as general expense, or (3) as general expense. We believe tax allocation is appropriate for the Jurisdiction M business tax — that is, the income tax portion of the tax should be reported as a component of income tax expense, while the payroll cost and construction expenditures are treated as payroll taxes and use taxes, respectively, and typically reported as general expenses.

Note: Subsequent to the adoption of ASU 2019-12, companies subject to the Jurisdiction M business tax would first compute the tax for the component based on income and account for it under ASC 740. Any excess above the tax for the income-based component would be accounted for as a non-income tax, outside the scope of ASC 740.

H. State and Local Income Taxes