An enterprise establishes deferred tax assets for deductible temporary differences and tax carryforwards. These items result from past events or transactions that have not yet given the enterprise an actual tax savings, but have the potential for benefit in the future. If the enterprise determines that realization of the future tax benefit is not more likely than not, the enterprise establishes a valuation allowance. The enterprise must determine the likelihood of realizing benefit from tax carryforwards and deductible temporary differences.

Treatment of Tax Carrybacks and Carryforwards

An enterprise recognizes the tax benefit produced by the carryback (or anticipated carryback) of tax losses or credits. A carryback does not present the same difficulties associated with a carryforward. The enterprise need not be concerned with the likelihood of translating a tax carryback into money based on future events. The carryback produces a refund based on events that have already occurred.

An enterprise enters more speculative grounds when establishing deferred tax assets for tax carryforwards. Carryforwards encompass two essential traits: the carryforwards represent the potential for tax savings based on the occurrence of past events and the benefit has been blocked by some limitation, which must be overcome in the future in order for the enterprise to realize the potential benefit. SFAS 109 attempts to reconcile these two conflicting traits. The Statement recognizes that realization of benefit is inherently speculative because realization requires the future occurrence of circumstances that cannot be predicted with certainty. SFAS 109 differs significantly from SFAS 96 in that deferred assets can exceed the combined deferred tax liabilities and those taxes already paid which would be refunded upon the reversal of deductible temporary differences.

Statement 109 allows deferred tax assets for tax carryforwards even though realization of benefit is not assured or even highly probable. The statement assumes benefit from a carryforward, creating an asset for that benefit. The statement then limits that asset by requiring a valuation allowance for the asset if realization is sufficiently in doubt, under the ''more likely than not'' standard.

The statement provides examples of evidence, both positive and negative, that an enterprise considers in judging likelihood of realizing a tax benefit. Examples of negative evidence include a history of expired tax carryforwards, expected losses in early future years by a presently profitable entity, unsettled circumstances that could produce negative results, and a brief carryforward period if the enterprise expects reversal of a significant deductible temporary difference or the enterprise operates in a cyclical industry. Examples of positive evidence include existing contracts or firm commitments that the enterprise expects to return profits, an excess of asset value over the tax basis of the entity's net assets, and evidence that the circumstances producing the loss were an aberration rather than a continuing pattern.

The statement makes an arguable assumption when an enterprise has a recent history of losses. The statement indicates that ''forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years.'' The FASB adopted this guideline in the context of rejecting a more stringent standard for enterprises with cumulative losses. In explaining its reasons for this guideline, the FASB indicated that the ''more likely than not'' standard, ''requires positive evidence of sufficient quality and quantity to counteract negative evidence in order to support a conclusion that, based on the weight of all available evidence, a valuation allowance is not needed. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.'' The FASB did not provide evidence supporting its assertion that an enterprise with cumulative losses will have difficulty establishing that a valuation allowance is not needed. Nor did it address the distinct possibility that an enterprise that is not more likely than not able to use its carryforwards might be in serious jeopardy of losing its status as a going concern.

Considerations for Specific Carryforwards

In determining need for a valuation allowance for a carryforward, the enterprise must consider both the guidelines provided by the FASB and the underlying tax law creating the carryforward. The guidance partially addresses the distinct tax law constraints. Financial statement prepares must then deal with the practical considerations associated with net operating loss, capital loss, minimum tax credit, and foreign tax credit carryovers.

Net Operating Losses

Generally, a corporation must first carry that loss back to the third prior year, then to the second prior year, then to the first prior year, then forward 15 years. IRC Sec. 172(b)3) allows the corporation an election to just carry the net operating loss forward.

IRC Sec. 382, which applies following a change in a corporation's ownership, provides the most important additional limitation on the use of net operating loss carryforwards. When Sec. 382 applies, it imposes an annual limitation on the use of net operating losses equal to the value of the loss corporation multiplied by the long-term tax-exempt rate (currently approximating 6%). Sec. 382 increases that limitation if the corporation has sufficient unrealized built-in gains.

Notwithstanding the FASB's language used to explain its actions, an enterprise's essential inquiry in determining deferred tax assets for net operating loss carryforwards is the likelihood of realizing a future tax benefit. Unless the enterprise elected to forego the carryback, a carryforward can only result if the enterprise's loss is so large as to exceed cumulative taxable income for the last three years. But the enterprise has fifteen years to realize the benefit from the carryforward and need not (for now) discount the benefit expected many years hence. Fifteen years seem like a virtual eternity in current business practice.

As a practical matter, the enterprise might be forced to reconcile a determination that it is a going concern with its determination that it does not expect sufficient total taxable income over the next 15 years to utilize the net operating loss carryforward. Particular circumstances could provide that reconciliation. For example, if Sec. 382 applies due to an ownership change, the enterprise's potential use of the net operating loss could be significantly reduced notwithstanding substantial taxable income in the future. A substantial loss in conjunction with a significant contraction of business could lead an enterprise to conclude that while it will eventually regain profitability, taxable income will be insufficient to utilize past losses. Also, the enterprise must consider the possibility that it is able to generate sufficient cashflow to continue in existence, but has only minimal taxable income.

Example: Loss Corp. pays tax at a 34% rate. Loss Corp. has Pre-NOL deduction taxable incomes (losses) for years 1990 through 1993 as follows:

1990, $1,000,000; 1991, $1,000,000; 1992, $1,000,000; 1993, $(10,000,000). The shareholders of Loss Corp. sell their stock for $5,000,000 at the end of 1993, triggering application of Sec. 382. The long-term tax-exempt rate is 6%. Loss's assets have bases equal to their values.

Loss Corp. establishes a deferred tax asset of $2,380,000, 34% x (10,000,000-3,000,000) and a valuation allowance of at least $850,000 at the end of 1993. The $10,000,000 loss gives rise to a carryback of $1,000,000 to each of years 1990 through 1992, leaving $7,000,000 for carryforward. Loss Corp. reflects refunds expected from the carryback as current receivables. Due to Loss's change of ownership, Sec. 382 limits the amount of loss carryforward that Loss Corp. may use each year. That annual limitation is $300,000, 6% (long-term tax-exempt rate) x $5,000,000 (value of Loss Corp.). Over 15 years, Loss Corp. could use no more than $4,500,000 of its loss carryforward, with any remainder expiring worthless. Loss Corp. will therefore lose the benefit of at least $2,500,000 of the carryforward, a benefit of $850,000 (34% x 2,500,000). If other circumstances make realization of some part of the $4,500,000 not more likely than not, Loss Corp. would have to increase its valuation allowance.

Capital Loss Carryovers. A corporation has a capital loss carryback/carryover when that corporation's capital losses exceed capital gains for the year. This excess of capital losses first creates a capital loss carryback to the third prior year, then to the second prior year, then to the first prior year and then carried forward for a maximum period of five years. Availability of capital gains is the primary limitation on the use of the carryback/carryover of capital losses. A corporation can deduct capital losses only to the extent of capital gains. A corporation can deduct capital loss carrybacks/carryovers only to the extent of capital gain net income in the year carried to.

IRC Sec. 383 provides the other major limitation on the use of capital loss carryovers. Sec. 383 applies when the Loss Corporation undergoes an ownership change. In this case, Sec. 383 provides that use of several attributes, including capital loss and net operating loss carryovers, must not exceed the Sec. 382 limitation (discussed above). In utilizing the "unified" Sec. 382 limitation, the corporation absorbs capital losses before net operating loss carryovers or other attributes.

The FASB recognizes that the use of a carryover depends on sufficient income of the appropriate character within the carryover period, and specifically mentions capital gains as an example of a particular type of income. The FASB also includes techniques converting ordinary income into capital gains as examples of tax planning techniques, a factor used in determining the need for a valuation allowance. Beyond these references, the enterprise must rely on SFAS 109's general principles to determine the need for a valuation allowance.

Establishing a deferred tax asset without the need for a valuation allowance should generally prove much more difficult for capital loss carryovers than for net operating loss carryovers. An enterprise with excess capital losses does not face the same fine line between being a going concern and yet not expecting sufficient taxable income to absorb net operating loss carryovers. An otherwise profitable operation can have excess capital losses. Unless the enterprise has a history of generating capital gains or can identify specific circumstances that will likely give rise to capital gains (e.g., tax-planning strategies), satisfaction of the more likely than not standard is doubtful.

Example: Capital Corp. has consistently earned taxable income of over $1,000,000 for the last several years and expects to continue that trend. Capital Corp. had a capital gain of $100,000 in 1990, no capital gain or loss in 1991 or 1992, and a capital loss of $1,000,000 in 1993. Capital presently intends to dispose of a major asset in 1994, estimated to produce a capital gain of $250,000. Capital Corp. also intends to implement tax-planning strategies converting ordinary income into capital gains of $500,000. Capital has not been able to identify any other likely sources of capital gains over the next 5 years.

Capital Corp. would carry the remaining $900,000 forward, resulting in the deferred tax asset of $306,000 (34% x 900,000). Because the company can identify circumstances that will give rise to only $750,000 of capital gains (250,000 + 500,000), the remaining $150,000 will likely expire worthless, thus requiring a valuation allowance of $51,000 (34% x 150,000).

Minimum Tax Credit

The minimum tax credit is a mechanism linking the alternative minimum tax system with the regular tax system. Taxpayers must each year compute a regular tax and a tentative minimum tax. A large corporate taxpayer determines its tentative minimum tax (before credits), by multiplying alternative minimum taxable income by the alternative minimum tax rate of 20%. That corporate taxpayer computes its regular tax (before credits) by multiplying its taxable income by the regular tax rate of 34%. If the taxpayer has a tentative minimum tax in excess of a regular tax in any year, the taxpayer pays both the regular tax and an additional tax--the alternative minimum tax. A corporation's payment of alternative minimum tax creates a minimum tax credit carryover, available to reduce regular tax liabilities in future years.

Consistent with the approach that every taxpayer pays a minimum amount of tax, as measured by the taxpayer's tentative minimum tax, the credit against regular tax for any year cannot reduce the regular tax below the taxpayer's tentative minimum tax for that year. Any minimum tax credit carryover in excess of this limitation carries over to future years. While the tax law does not allow a carryback of the minimum tax credit, the tax law does not limit the number years for carryover.

Sec. 383, applicable upon a change of a corporation's ownership, limits the use of the corporation's attributes, including the minimum tax credit, to an amount determined by reference to Sec. 382. The taxpayer determines the Sec. 382 limitation for credits by multiplying any unused Sec. 382 limitation by the corporate tax rate. The minimum tax credit is the last attribute available for use against the "unified" Sec. 382 limitation.

The FASB discusses the minimum tax credit in the context of the tax rate an enterprise uses in computing deferred tax assets or liabilities. SFAS 109 requires use of the regular tax rate in all cases rather than allowing use of the alternative minimum tax rate for those taxpayers that expect to pay alternative minimum taxes in the future. These enterprises establish deferred taxes based on the regular tax rate, establish deferred tax assets for any minimum tax credit carryforwards, and if realization of benefit from the minimum tax credit is not more likely than not, establish a valuation allowance for that deferred tax asset.

The FASB recognizes that no valuation allowance is needed for deferred tax assets from minimum tax credit carryforwards if the benefit can be realized by--

* Deferred tax liability based on regular tax rates to the extent that liability exceeds the amount of tentative alternative minimum tax that would result from alternative minimum taxable temporary differences;

* The amount by which regular tax on expected future taxable income will exceed the tentative minimum tax on expected future alternative minimum taxable income;

* By loss carryback; and

* Tax-planning strategies, such as switching from investments free from regular tax but not alternative minimum tax to fully taxable investments offering a higher rate of return.

The FASB recognizes that alternative minimum taxes can result from temporary differences or from preferences, and to the extent of temporary differences, the taxpayer should eventually get back the alternative minimum taxes through the minimum tax credit. While preferences do not reverse, the alternative minimum tax rate of 20% is significantly lower than the maximum regular tax rate of 34%. A taxpayer must usually have substantial preferences over its life to be subject to a net alternative minimum tax over time (i.e., alternative minimum taxes paid exceed minimum tax credits taken).

While tax law restrictions on use of net operating losses are less than the limitations placed on use of minimum tax credits, realization of benefit from minimum tax credits is usually more likely than any other attribute, including net operating losses. Unlike companies with net operating losses, companies with minimum tax credits generate those credits from profitable operations. The tax law does not confine use of minimum tax credits to any particular carryforward period. Unless a company faces a Sec. 383 limitation, or reasonably expects a continued generation of substantial preferences, it should be able to use the minimum tax credits at some point in its life. Even a company that expects substantial preferences should be able to employ tax-planning strategies to utilize the credits. The enterprise should determine that use of minimum tax credits is more likely than not unless the company identifies distinct reasons to refute that assumption.

Foreign Tax Credits

The foreign tax credit carryback/carryover allows taxpayers a limited opportunity to offset U.S. tax liability with foreign taxes from other years. United States taxpayers may offset their U.S. federal tax liability with a credit for taxes paid or accrued to foreign countries. This credit is limited to an amount equivalent to the pre-credit U.S. tax liability on the taxpayer's foreign source income. The taxpayer must also segregate its foreign source income into several baskets (categories), with the foreign tax credit for each basket limited to the equivalent pre-credit U.S. tax liability on that basket of income. The taxpayer's foreign tax credit for any one year cannot exceed the lesser of the overall limitation or the sum of the limitations on the various baskets of foreign source income. Foreign taxes paid or accrued in excess of those limitations gives rise to foreign tax credit carrybacks or carryovers. The taxpayer first carries those credits back to the second preceding year, then the first preceding year then forward for five years. The amount of foreign tax credits carried to any year equals the excess of the limitations described above over the foreign taxes paid or accrued in that year, with foreign tax credit carrybacks/carryovers used chronologically.

Following a change of ownership, IRC Sec. 383(c) subjects use of pre- change foreign tax credits to the "unified" Sec. 382 limitation, similar to the limitations imposed on capital loss carryovers and minimum tax credit carryovers.

Deferred tax assets for foreign tax credits depend on the same "more likely than not" standard applicable to other carryforwards. A company does not establish deferred taxes for the difference between the financial statement carrying amount and tax basis in an investment in a foreign subsidiary that is essentially permanent in nature unless the company expects the difference to reverse in the future.

Taxpayers with foreign tax credit carryovers usually continue to have foreign taxes in subsequent years in amounts comparable to the amounts generated in the years that had credits. This factor combined with the relatively short life given the foreign tax credit carryover suggest difficulty in using the carryover. The need to allocate credit carryovers to the particular baskets of income that generated the taxes compounds the difficulty. Taxpayers are, however, sometimes able to overcome these difficulties. Tax advisers expend considerable efforts developing tax planning strategies to utilize these credits. So, while an enterprise may struggle to justify a deferred tax asset for foreign tax credits, particular circumstances, plans, or tax planning strategies may adequately satisfy the more likely than not requirement.

Satisfying the Standards

Satisfying the "more likely than not" standard for carryforwards varies depending on the carryforward and the particular enterprise. Taxpayers should usually satisfy this standard for net operating loss and minimum tax credit carryovers, while experiencing difficulties in satisfying the standard for capital loss and foreign tax credit carryovers. Taxpayers have 15 years to generate any kind of taxable income to absorb net operating loss carryovers, but only five years to generate capital gains to absorb capital loss carryovers. Because minimum tax credits have an indefinite carryover, taxpayers will likely use those carryovers upon reversal of the temporary differences that likely caused the minimum tax. Taxpayers have five years to generate the particular type of foreign source income needed to utilize foreign tax credit carryovers, a task usually complicated by businesses that continue to generate excess foreign taxes.