We’re sure many of you are wondering what the Biden tax plan, as well as already-enacted 2021 tax law changes could mean to you or your organization. While others have written detailed volumes on this topic, our goal here is to distill the potential changes into a list of no more than 10 items for both individuals and corporations. Our Top 10 Lists are based upon a combination of President Biden’s campaign tax plan and the American Rescue Plan that was released in January 2021.
If you’d like to discuss these potential changes or other aspects of the Biden tax plan, please contact us to further discuss what these changes might mean for you.
Other 2021 Tax Changes Unrelated to the Biden Tax Plan
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Carol Vachon – email@example.com C: 781-630-0429
Janice Leahy – firstname.lastname@example.org C: 339-223-0245
The 2017 Tax Cut and Jobs Act (the Act) — the largest overhaul of the US tax code in 31 years, will have significant impacts on US taxpayers. One such area of substantial impact is the Act’s effect on corporate treasury activity.
This Alert reviews the most important issues facing the corporate treasury function and strategy following enactment of the Act.
Contact L&V Partners www.l-vpartners.com to review specific items effecting your organization.
The Act has created several opportunities for corporate treasurers. Provisions of the Act lower income tax rates, create domestic incentives, move the United States toward a territorial taxation regime, and make it easier (and cheaper) to repatriate foreign earnings. These measures generate, create access to cash and provide multiple tactical and strategic opportunities regarding cash management and investment.
Several important provisions of the Act have led directly to action items for corporate treasuries. These provisions include:
tax when the cash is repatriated, as part of the transition from a ‘global’ to a ‘territorial’ tax system for the United States;
Impressions: Corporate treasury functions take an important role in how their company prepares for the Act. The significant changes in liquidity positions will require a broader reevaluation of the treasury operating model, including understanding the transition approach, related controversy management, and future state treasury transfer pricing model. Teaming with the tax department will be essential to ensure that cash forecasting investment decisions, and potential changes in legal entity structures & operating models, are being coordinated.
These provisions allow Treasurers to examine:
Optimize the Treasury function.
Treasury activities related to the Act can be divided between tactical (short-term) and strategic (long-term). The tactical steps outlined below are largely cross-functional planning and calculation efforts — strategic decisions will be owned by the treasury department, along with broader stakeholders including the finance, legal, and tax departments.
Tactical: cross-functional tasks spread among various departments:
Strategic: Treasury work to come
Strategic work for corporate treasurers includes defining the company’s future-state global cash
|management strategy and liquidity profile, including the internal-external funding mix; reviewing hedging and investment programs and validating
existing strategies; assessing intercompany funding/netting changes; identifying opportunities for investment in treasury technology (i.e., accelerated capital expenditures or ‘capex’); and assessing the treasury operating model and potential resource shifts.
|understanding, assessing, and addressing key impacts of the Act.
To respond effectively to the Act, corporate treasury should establish regularly scheduled reviews with the tax department to address cross-functional impacts of tax reform.
Regional treasurers need to develop detailed cash profiles and forecasts by legal entity to evaluate the
|impacts of tax reform and determine appropriate balance of global liquidity.
Lastly, treasury may want to develop a strategy to assess and address the Act’s effects on the company’s long-term treasury operating model, such as the possible need for pooling structure changes, investment portfolio changes, and foreign exchange impacts.
The treasury function should work with the tax department on
Let L&V be your partner at the table.
If you would like to discuss the possible impact of the Act on your company’s treasury function, please contact:
Tax Service Team Tax & Treasury Service Team
Charles Hills Janice Leahy Carol Vachon
(978)749-9900 (339) 223-0245 (781) 630 – 0429
Chills@l-vpartners.com Jleahy@l-vpartners.com Cvachon@lvpartners.com
Slide credit: Kristin Jones
Research and development activity receives two types of treatment within the tax code. The first is deduction. The creation of intellectual property by research and development is a capital asset, and is generally be amortized over a period of not less than 60 months; normally a 15-year period. Election under IRC Section 174(a)(2)(A) can be made to expense research and development expenditures in the year they are paid or incurred. The election to expense does not need to be made in a formal manner; the taxpayer expenses its research expenditures on the tax return.
The second benefit offered to research activity within the code is the Research and Development (R&D) Tax Credit(s) offered in IRC Section 41. The calculation of the credit is often an integrated process of gathering proper documentation and collection of project expenses. Be aware, the amount of expenses used to determine the credit cannot also be deducted for the determination of taxable income, unless an election is made according to IRC Section 280C(c)(3)(A). This election allows for the full deduction of expenses used to determine the credit, but also reduces the credit by 35%; the result is the taxpayer receives full deduction of the expenditures and approximately a 5.5% R&D tax credit.
Best practice companies conduct an R&D tax credit study to account and support its R&D tax credit claim. These studies can be complex depending on the level of activities within and outside of the business. Short cutting R&D documentation for tax purposes can pose a tax risk to an organization already allocating significant funds to its R&D department. If a business invests so much time and money in its R&D processes, why not put a small fraction of that investment towards proper documentation so that the tax credit claim is solid.
Qualifying Research Activities (QREs)
The definition of qualifying research has been defined and redefined by Congress, and interpreted by the IRS and US courts in differently depending on the circumstances. In general, IRC Section 174 defines qualifying research as activities that “eliminate uncertainty either about the capability or method of developing or improving the product or about its appropriate design.” Note that the term ‘product’ also includes components of products. https://www.irs.gov/businesses/audit-techniques-guide-credit-for-increasing-research-activities-i-e-research-tax-credit-irc-41-qualified-research-activities
Few examples exist in instructions or publications to help you determine if your activity is qualifying research. The preamble of the IRS 2003 proposed regulation 1.41-4(c)(10) includes the following two examples of non-qualifying and qualifying activities https://www.irs.gov/irb/2004-06_IRB/ar07.html#d0e395:
The courts have offered a greater range of interpretation; sometimes conflicting, on the definition of qualifying research. Many of these court cases, notably within the software industry, offer in-depth analysis of the standards of research in specific industries.
If the activities qualify, the expenses that can be used for the determination of credit fall into two categories:
In-house research expenses consist of the sum of the following three types of expenses:
An exact determination of which wages and supplies qualify must be made on a case by case basis. In general, wages and supplies expended in the direct performance of research and development qualify; indirect expenses do not.
‘Contract research expense’ equals 65% of any amount paid or incurred to persons who are non-employees for the performance of either (1) qualified research, or (2) services that would constitute qualified services if performed by employees of the taxpayer (IRC Section 41(b)(3)(A)).
Successfully claiming the credit is dependent on appropriate documentation. Due to the highly subjective nature of determining if activities qualify as research, the IRS looks for appropriate documentation. Failure to adequately document research activities may cause the tax credit claim to fail. A majority of IRS court victories against taxpayers have been in cases where the IRS challenged the taxpayer’s lack of documentation.
The most common method of documenting research activities is by R&D departmental project plans, employee surveys and R&D project cost tracking. During a current year, employees involved in R&D research processes and projects may be asked to complete surveys which requires them to estimate the percentage of their time spent on qualifying research activities. If the estimation surveys are the only form of documentation being used to support the calculated salaries as a QREs, this is a weak method, and will risk the credit being reversed in audit or partially reversed in appeals court. First, the hours used to determine the credit are based on approximations, not on actual accumulated data. Second, the surveys are not contemporaneous records (contemporaneous records are created at the time of the event, not after the fact). Non-contemporaneous documentation of activities frequently fail in court. Third, and most importantly, these surveys frequently fail to document the four essential elements that qualify the activity as research.
Many companies collect the data necessary to implement an ideal documentation system for the R&D credit, but continue to use the weaker employee cost survey system. Most companies have cost data collection systems where R&D staff allocate their time to jobs or projects by activity code. One of these activity codes should be tagged for research. Additional steps may be needed to develop an iron-clad system of documenting these research hours.
First, the R&D staff should be educated about which activities qualify as research. Second, according to the frequency of a company’s payroll cycle, employees who report research activity in each pay cycle submit research worksheets accounting for research time performed. Building a research process worksheet is simple drafting in these items:
The total hours reported on all sheets for that employee should equal the total research hours reported for that employee in the payroll data for that period. The total of all employee sheets should equal the total research hours reported at the company level for that period. Many companies require the payroll department to verify the existence of the supporting documentation when preparing the payroll. The records are usually saved electronically with project files and payroll files. The dates the files are originated and saved (metadata) prove that they were created contemporaneously.
Some companies use multiple spreadsheets for accumulation of data to final documentation. Beginning with last year’s R&D actual performance plan to the current year strategy plan, employee wages (which may be tiered in its application as a QRE under the code), contract vendor expenses, supplies and leases. Many companies use various worksheets to support the completion of a separate master file for each R&D project.
The keys to benefiting from the R&D Tax Credit are identifying qualifying research activities, and having effective documentation systems in place to support and defend a tax credit claim. The cost of implementing these steps is well worth it for the sustainability of the credit. L&V Partners can champion the process involved in documenting qualified R&D expenses and calculating the credit for your organization.
White paper www,l-vpartners.com September 2017
What constitutes intellectual property (“IP”) generally includes intangible assets as wide-ranging as patents, copyrights, secret processes and formulas, goodwill, trademarks, and trade brands. IP is extremely valuable as a tax asset because it often takes years to develop, which allows a Company to incur losses and expenses, which can offset a Company’s U.S. source income. In addition, intangible assets are highly portable, making it easy for a Company to transfer them to lower-tax jurisdictions when they become income-producing assets.
Several foreign jurisdictions offer “patent regimes” or “innovation boxes”  that offer preferential tax treatment on income attributable to IP. These incentives were first implemented in Ireland and have since been adopted by other European countries including Belgium, France, Luxembourg, Spain and the U.K. This proliferation of favorable IP regimes abroad has led U.S. Companies to seek ways to transfer IP to these jurisdictions.
The U.S. has not adopted an innovation box of its own to compete with those offered by European countries. U.S. final Treasury regulations under Internal Revenue Code1Section (TD 9803) (the Final Regulations), published December 16, 2016, eliminate the exception under Treas. Reg. Section 1.367(d)-1T(b) for outbound transfers of foreign goodwill and going concern value (FGGCV) and limit application of the active foreign trade or business (ATB) exception under Section 367(a)(3) to certain specified property (not including FGGV). For FGGCV, the Final Regulations require the US transferor to either recognize gain currently under Section 367(a) or elect into the deemed royalty regime of Section 367(d), thus subjecting to US taxation transfers that have not generally been subject to income or gain recognition
under Section 367. The Final Regulations apply on a retroactive basis to transfers occurring on or after 14 September 2015, and to transfers occurring before that date resulting from entity classification elections filed on or after 14 September 2015. These rules make it increasingly difficult for a U.S. Company to transfer existing IP to a foreign jurisdiction in a tax efficient manner.
Active trade/business exception
Section 367 of the 1986 Internal Revenue Code, as amended, (the “Code”)  taxes the outbound transfer of U.S. assets by disallowing “nonrecognition,” or tax-free treatment, in otherwise tax-free transactions, such as contributions to capital of a corporation, the liquidation of a corporation’s subsidiaries, and corporate reorganizations. Section 367 essentially “turns off” the gain nonrecognition rules granting tax-free treatment under Sections 332, 351, 354, 356, and 361 when the transferee corporation is foreign.
Deemed royalty provisions
U.S. transferors apply Section 367(d)’s deemed royalty regime to certain property that would otherwise be subject to gain recognition under Section 367(a) (including FGGCV). Require generally deemed royalties under Section 367(d) to be included during the entire useful life of the transferred property (including any property for which the US transferor elects to apply Section 367(d)), but permit the US transferor to elect to instead include such amounts during the 20-year period beginning in the first tax year in which an inclusion is required.
While the transfer of patents, formulas, franchises, trade names, and customer lists would be considered a sale that the seller would be required to report as foreign-source ordinary-income each year equal to an arm’s length royalty over the asset’s useful life, a transfer of FGGCV was previously not subject to such a regime.
Changes concerning the useful life of intangible property.
The Final Regulations define the “useful life” of transferred intangible property during which deemed royalties must be included under Reg. Section 1.367(d)-1T(c)(1) as “the entire period during which exploitation of the intangible property is reasonably anticipated to affect the determination of taxable income, as of the time of transfer.” For this purpose, the Final Regulations provide that exploitation of the transferred property “includes any direct or indirect use or transfer of the intangible property, including … use in the further development of the intangible property itself … and … in the development [and exploitation] of other intangible property… “
Section 482 standards for inter-company sale/purchase of IP
Section 482 sets out detailed transfer pricing rules associated with the way that a company prices goods, services, and intangibles transferred to, or used between, affiliates domiciled in different taxing jurisdictions. These rules generally require that prices reflect the “arm’s length principle” as if the parties were not related. To determine what would be “arm’s length” values, detailed transaction-based and profit-based methods are set forth in the applicable regulations.
Placement of IP in Low-Tax Foreign Subsidiaries
Profits earned by foreign subsidiaries of U.S. Companies are generally not taxable until repatriated. In addition, stock sales of foreign subsidiaries are generally exempt from capital gains tax in the foreign country.
Why is this important from a IP value and tax strategy perspective? This means that the Company should plan for a foreign subsidiary to be the developer or owner – and eventual seller – of the IP. The choice of foreign jurisdiction should consider the tax rate, local incentives, as well as tax treaties that may provide additional tax efficiencies.
For illustrative purposes only, the Cayman Islands imposes no corporate tax. A Cayman Islands subsidiary’s sale of its assets would not be taxable to the Cayman subsidiary. Adversely, the Cayman Islands does not have tax treaties that eliminate “withholding taxes” which could be imposed on payments from the Cayman Islands to the U.S. These payments could occur, for example, when the Cayman Islands subsidiary pays royalties to the U.S. affiliate.
Another alternative is Ireland, which offers a “Knowledge Development Box” regime where business profits from patents are taxed at a low 12.5%. In addition, unlike the Cayman Islands, Ireland has a wide tax treaty network that makes 0% withholding tax rates available for royalty payments.
Common tax efficient structures for U.S. tax purposes include executing contracts for a foreign affiliate to:
(1) conduct R&D and the licensing of IP;
(2) share costs related to IP R&D and the licensing with a U.S. entity; or
(3) form a partnership with a U.S. entity to conduct R&D and the licensing of IP.
A contract R&D and licensing arrangement is a structure in which the foreign affiliate funds the costs of all R&D performed by other affiliates and owns all interests in the resulting intangibles. For example, if it is preferable to keep the R&D in the U.S.; the foreign subsidiary can contract the R&D of the IP to the U.S. operations, but remain the owner of the IP. However, because the U.S. entity and foreign affiliate are related parties, the IRS may scrutinize the contract under the Sec. 482 rules discussed before. The U.S. entity will generally be required to compensate the foreign affiliate through arm’s length royalty payments that are “commensurate with income.” 
Alternatively, a cost sharing arrangement is a structure in which all affiliates share the costs of R&D as well as the ownership of the interests in the resulting intangibles. The payments between the affiliates are generally not royalties and hence do not need to satisfy the “commensurate with income” standard, but rather must comply with other transfer pricing rules under Section 482. These rules would generally determine the “appropriate” transfer price under one of six prescribed methods including: comparable uncontrolled services price, the gross services margin method, the cost of services plus method, the comparable profits method, the simplified cost-based method, and the profits split method. 
A partnership is an arrangement between two or more parties that share the income from the partnership, but may or may not share the costs of development – thus distinguishing itself from a cost sharing arrangement. A joint venture is an example of a typical partnership.
Subpart F income
To choose the appropriate structural arrangement with a foreign affiliate, a Company must consider each arrangement’s “subpart F” consequences. U.S. income earned by foreign subsidiaries is generally not taxable until repatriated to the U.S. U.S. tax authorities are concerned with any U.S. Company “abusively” using foreign corporations to shelter income abroad and defer U.S. taxes by accumulating income in foreign “base” companies located in low-tax jurisdictions. They look at deferral of two particular types of income perceived as manipulatable: passive investment income and income derived from transactions between related corporations.
If these types of income are earned by “controlled foreign corporations” (“CFC”), that income will be immediately taxable to the “U.S. shareholders” of the CFC. A CFC is a foreign corporation whose “U.S. shareholders” hold more than 50 percent of the corporation’s interests, by vote or by value. A “U.S. shareholder” is a U.S. person owning at least 10 percent or more of the total combined voting power” of that foreign corporation. The use of a foreign affiliate corporation risks creating a CFC and incurring the associated subpart F income tax inclusions.
To avoid immediate taxation on subpart F income, check-the-box elections can be used to treat eligible foreign affiliates as pass-through entities and ownership interests can be minimized to avoid CFC classification. To illustrate; if the foreign subsidiary makes a check-the-box election to be taxed as a partnership, it is no longer a foreign “corporation” for purposes of subpart F income.  In addition, proper planning can ensure that 50% of the ownership of the foreign subsidiary is held by a non-U.S. person, or that all U.S. persons own 10% or less of the ownership in the CFC.
Each of the above arrangements that include a foreign affiliate would also have different subpart F consequences. A contract R&D and licensing arrangement generally leads to royalty income received by a foreign affiliate from a related party. This could cause the foreign affiliate to earn subpart F income immediately taxable to its U.S. parent. However, a cost-sharing arrangement, where the foreign affiliate itself performs some portion of the R&D, would generally cause the foreign affiliate to earn its income in the form of sales income, which may not be treated as subpart F income.  Sales income and royalty income are subject to different rules under the subpart F regime. In general, sales income from the sale of IP is not subpart F income if the IP is used by the seller in a trade or business as defined in Section 162, and royalty income from the licensing of IP is not subpart F income if received from related parties for use in the same country as the CFC, or if received from unrelated parties for use in an active trade/business by the CFC. 
A partnership arrangement generally avoids subpart F income if it is formed as a partnership and not a corporation. However, partnerships are generally not tax-efficient because they generally lead to a U.S. taxable presence for the foreign partner, or a foreign taxable presence for the U.S. affiliate. But such an arrangement is not entirely without tax benefits: the partners would generally be entitled to claim tax deductions for each partner’s share of R&D expenses. 
Avoiding PFIC status
The immediate taxation of subpart F income only results for “U.S. shareholders.” To tax those U.S. persons who own less than 10 percent in foreign corporations, Congress enacted an additional set of rules for passive foreign investment companies (“PFICs”).
A PFIC is generally defined as a foreign corporation, where at least 75 percent of the corporation’s income is passive income, or where at least 50 percent of the corporation’s assets are held for the production of passive income. Passive income is defined by the same definitions in Section 954 that define subpart F income for CFC purposes with a few notable exceptions that pertain only to PFICs. These exceptions include a 25- percent subsidiary look-through rule as well as a related party look-through rule where otherwise passive income is excepted from PFIC calculations if it is earned as “active” income by the affiliate.  Additional rules regarding whether royalty income is earned in the “active” conduct of a trade or business also applies for these purposes.
Proper planning to ensure qualification for these exceptions is important to managing tax risks associated with these structures. L&V Partners can champion your directives. Contact us set up an initial discussion of IP strategies at +1-978-749-9900.
 “Innovation Boxes and Their Potential Role in International Tax Reform,” Checkpoint Daily Newsstand, March 16, 2016
 “An Innovation Box would be a Bad Innovation for American Tax Policy,” Assistant Secretary of Tax Policy Mark Mazur, March 11, 2016. https://www.treasury.gov/connect/blog/Pages/-An-Innovation-Box-Would-be-a-Bad-Innovation-for-American-Tax-Policy.aspx
 Unless otherwise provided, all references to Section herein are to the U.S. Internal Revenue Code of 1986, as amended.
 Treas. Reg. sec. 1.482-4(e)(3)(i). Treas. Reg. sec. 1.482-2(f)(11), Ex. 6, 57 Fed. Reg. 3571 (Jan. 30, 1992).
 See generally, Sec. 1.482-7.
 However, for U.S. tax purposes, all income and losses would flow-through the foreign subsidiary to its U.S. owners.
 Treas. Reg. sec. 1.954-2(d).
 See, Sec. 954(c)(2)(A), Sec. 954(c)(3)(A)(ii), Sec. 954(c)(1)(A). https://www.law.cornell.edu/uscode/text/26/954
 See generally, Sec. 721. https://www.irs.gov/pub/irs-drop/rr-99-5.pdf
 The related party look thru rule states that otherwise passive income received by a related party allocable to non-passive activity of that related party is not passive income to the recipient for the purposes of calculating whether the recipient is a PFIC. Royalty payments from a related party that derives the income to make that payment through an active licensing business would not be considered passive income. See Sec. 954(d)(3).
White paper September 2017
FASB’s New Directive on Stock Compensation Impacts Tax Accounting and Related Disclosures – C Hills
As part of its Simplification Project, last year the FASB issued Accounting Standards Updates (“ASU”) 2016-09 and 2016 – 16, addressing the tax accounting for stock compensation and intra-group asset transfers. ASU 2016-09 is currently effective for public entities (2018 for nonpublic). ASU 2016-16 is effective beginning is 2018.
The changes carve off the extra steps previously meant to eliminate, in the case of stock compensation, or minimize in the case of asset transfers, their immediate impact on reported earnings. Now the tax effects of those transactions go directly to the tax provisions in the periods they occur. Commentaries see ASU 2016-09 and 2016-16 bringing new volatility to tax rates when there is limited ability to predict or moderate these transactions.
ASU 2016-09 mandates treating the tax benefits or shortfalls from stock compensation as discrete, period adjustments. The annual effective tax rate, the expected answer to “What’s the tax rate?”, excludes period adjustments. This falls into the same basket as reversals of valuation allowances, Fin 48 reserves recoveries, or new tax rate adjustments on deferred balances. Yes – they get into that reported GAAP number for quarter and year-to-date, but they’re wholly ignored in talking about future expectations. Who pays attention to the GAAP number?
Over the past several years the SEC and FASB have stressed a desire for better and more useful disclosure in company reports. But does this change the way companies will talk about their tax rates? ASU 2016-09 simplifies how companies will account for the tax effect, but probably doesn’t change the usual emphasis.
Disclosure of the material effect seems to answer the volatility concern. Check out the language highlighting the matter in Q2 2017 10-Qs for Waters and PAREXEL, for example[i], quantifying in their interim reports the impact of adopting the new accounting.
[i] “…The Company adopted this standard as of January 1, 2017 and recognized an excess tax benefit related to stock-based compensation which decreased income tax expense for the three and six months ended July 1, 2017 by $4 million and $12 million, respectively, and added $0.05 and $0.14 to net income per diluted share, respectively.” 2017 Q2 Form 10-Q, p.20, Waters Corporation
“…For the nine months ended March 31, 2017 and 2016, we had effective income tax rates of 32.1% and 27.7%, respectively… The tax rate for the nine months ended March 31, 2017, benefited 3.0% from the adoption of ASU 2016-09 as discussed in Note 1…” 2017 Q3 Form 10-Q, p.14, PAREXEL International Corporation
This white paper relates to public companies and private companies with relatively mature documented financial reporting. Start-ups and any company where the books are suspect have to be handled with a special set of considerations.
There are similarities between manufacturers and software companies (and others) but there are also specific differences that require their own set of particular analysis. Regardless of company, always ask for the three statement financials and if non-public and they have it, the accompanying financial disclosure statements, or at least an MD&A. There are a lot of good starting points, but I prefer to look at MD&A and proceed to the balance sheet. Cash is the first category on a balance sheet for good reason. I’ll look at MD&A and see what they have to say about the cash position of the company. Try to calculate the burn rate by comparing as many quarters of beginning and ending cash balances as possible. I also like to take a quick peek at cumulative retained earnings. I have worked for many tech companies that have negative accumulated earnings – meaning they have not made a profit over their lifetime, or they fluctuate from profit to loss often. In either case this means a major change in their planned performance must require a major change in how the business operates, or a change in the markets they participate in. So this is one of the first notes to self I make when a plan looks different than recent history.
Next, again to get a sense of where the company has been financially, a quick look at the revenue trend, including quarterly cycles, gross margins and operating profit or EBITDA is useful to project where the company would wind up given current state operations. If there was a recent growth spurt it’s important to understand what drove the growth and is it sustainable at the same pace (or better?) going forward.
At this point having a good sense of what the company’s general prospects are it is time to get into more detailed analysis.
Cash – In addition to the above review, bank statements should be reconciled monthly and tie to the ledger accounts.
Receivables – DSO and a look at customers with balances over 90 days. A conversation with the receivable supervisor regarding overdue balances provides insight and a reminder to that person to get back to problem customers. It also makes sense to check how fast cash is being applied internally. If the company is experiencing rapid growth it’s important to factor that into future financing requirements. Slower growth than desired could mean it is time to look at loosening credit.
Inventory – After making sure the perpetual inventory system is working well and cycle counts are in place (showing few errors), Turns and an ABC analysis to see what is moving (and isn’t) are the basics. “Just in time”, “PAR” and “KanBan” are a few of the techniques to consider, even if only for portions of the inventory. Quality and broader supply chain issues all come into play when doing a deep dive regarding inventory, a topic in itself.
Prepaids, Other Receivables, “Other” – make sure there is a current account analysis available for each account updated monthly with explanations for changes.
Fixed Assets / Intangibles – These don’t change often, but there should be a register that lists all assets, depreciation/amortization, and ties to the GL.
Accounts Payable – Ideally the payables should be to terms and days payable should be comparable to days receivable keeping any financing relatively stable. Interesting to note the MRO balance v the material balance in the account, and the material balance should bare a relationship as a percentage of revenue to the material COS percentage to same. A scan of the top 10-20 percent of the largest vendor payables will most likely be consistent over time and provides some insight to that aspect of the business.
Accrued Expenses – usually encompasses a variety of accounts of a different nature. Most importantly as with prepaids above, a current account analysis available for each account updated monthly with explanations for changes is essential.
Equity Accounts – These accounts tend to be fairly static, though are subject to change with any financing and are updated yearly with accumulated earnings/loss for the year. Prior year role-through and applicable cap tables are primary tools used for analysis.
Banking – Usually found as loan accounts after Accounts Payable on the balance sheet are worth a special look if they exist (if the company required financing along the way).
Revolver and term loan accounts are standard financing arrangements and it’s important to understand the banking relationships the company has. If they have a revolver, there is a history associated with the borrowings and repayments directly and/or through various assets valuations. I like to see and review or if necessary – create a cash flow analysis based on this data including the calculations used by the bank relative to meeting the established bank covenants agreed to by the company. If the company is outside of the agreed covenants a meeting with the CEO with supporting analysis is in order.
The income statement is fairly straight forward and is best compared to plan and current forecast as well as previous quarter and year. In addition to the revenue analysis previously discussed a detailed analysis of the components of Cost of Sales provides insight to the current cost structure of the company. A margin analysis by customer or project should be compiled breaking out material, labor and any variable overhead applied to COS. With this data a focus on problem areas can be further examined, with or without a budget/plan by virtue of honing in on substandard margins.
Department overheads and SG&A can be compared to budget and significant variations examined and discussed with appropriate managers.
Another interesting pass at the income statements is a top down listing of expenses monthly and year to date. The 80-20 rule typically applies so the list can be quickly shortened to the top ten or so items for further discussion, and almost invariably salaries and wages will make the top of the list.
It goes without saying that in multi-plant operations the balance sheet and income statement need to be reviewed at each location. Once comfortable with those operations that are at plan, more time can be spent on those operations that are under-performing.
Cash Flow Statement:
The cash flow statement is a useful summary of the inflows and outflows of cash in the business and should tie to the changes in the Balance Sheet for the timeframe that it represents. Depreciation and amortization are typically taken from the Income Statement. As it is summary data, I focus my attention on the detailed cash flow analysis that is typically constructed by major sources and uses of cash constructed in the same basic breakout of the cash flow statement, with material and labor costs broken out by project or customer if possible.
WHAT IS YOUR RISK?
Your team is the foundation anchor of the financial reporting production function. You have strict deadlines to meet with voluminous deliverables, but that isn’t anything unusual for the team. You have a routine to run key critical processes, and you are fairly confident internal controls in place are adequate. Yet, as another reporting cycle is upon you something is different in the report production process. There is an unanticipated failure and data integrity critical to the reporting cycle is suspect. You discover that the impediment affects more than one process because financial functions are intertwined. Checks and balances? Not likely to save a catastrophic failure. What happened? You’ve fallen victim to Financial Reporting Fatigue™.
Financial Reporting Fatigue™ refers to a condition when a weak link(s) in the chain of the financial production process places stress on other stages within the reporting cycle that are reliant upon the other. If a bridge has weakened stress points in critical areas of its structure propagate could result causing catastrophic failure ultimately ending in bridge collapse. Financial Reporting Fatigue™ (FRF) risk is akin to bridge support erosion because of the interconnection of data and process. Left unattended, this condition will fester throughout your production reporting cycle.
What causes FRF? The investigation can potentially drill to the lowest denomination covering both skill and automation.
Our survey touched upon this subject matter. The financial professional respondents displayed a common theme worth exploring. The extracted data displayed below is pertinent to the subject at hand:
These responses provide an interesting interpretation of what is occurring within financial departments. Departments operating under pressure and stress are more likely to create a rush to close, not quality to close. The use of an automated system to record business transactions provides the level of comfort and security needed to support the financial close process. It is what happens beyond the financial database extraction that poses the most risk and uncertainty. Responses 3 & 4 tie together. Human participation in the best thought out process is not air tight. As 100% of respondents use spreadsheets to disclose and report financial results, statistical odds work against you that an internal reporting error will rise up in the financial production close process.
I had the opportunity to sit with a financial head of a mid-market sized organization and witnessed why real automation, not automated spreadsheets, need to take hold of the production reporting cycle. This visit entailed a review of a V3-spreadsheet statement of cash flow that was not calculating properly. When the spreadsheet was put up on a projector for review; tracing through the data, a number of cells within the spreadsheet had errors. Reference points appeared to hold the majority of misfired calculations, though we did discover other mathematical formula errors. When the data was dumped from the big data system to workable spreadsheet files something got lost in translation. A simple question came to light. ‘”How can one be sure nothing has been manipulated through the spreadsheet, that the raw data extracted from your database is the reflection you are viewing now?” This was the third file version. After a few hmmms…it was decided the best course of action was to trash the spreadsheet and start again. It takes several hours to check and correct reference point mistakes and mathematical errors in large complex workbook files. This tedious and time-consuming forensic work is what eats away at reporting deadlines. How does your team determine the internal process causing variation? Ask yourself these thought provoking questions:
What causes defects and/or errors?
What are the ways to address the defects?
What needs to be developed to measure changes made in the process?
Get the hmmm out of the financial report production process. Look at what needs to be brought in to change the process. A financial reporting team reports; they should not hold positions of ‘in-house software developers’ creating home-grown external reports. Bad idea.
What’s the risk? That’s a bit of a loaded question. Sitting through an audit committee review of financial data is not a pleasurable experience. What would occur if your external auditor discovered the financial reporting error? That is, at the very least, a 1/2 day discussion of vetting the root cause. The majority of survey respondents deemed a breakdown within the financial reporting production led to audit risk.
This brings us to the last item pulled from the survey. Though 100% of the respondents use spreadsheets to disclose and report their financial reports, 42% of the same respondents were concerned about FRF. How does the other 58% reconcile the disparity? Are you that certain? What is the limit of risk you can live with?
How often do spreadsheets used in the financial report production process change hands? Do you allow spreadsheet modifications to be performed by new staff? How would you even know if that happened?
To further illustrate, a multi-national company uses a traditional financial database in which a download is performed to extract the entire trial balance to a spreadsheet. Upon extraction, in-house finance personnel create spreadsheet pivots to format the data for management reporting. Note to self; a pivot table is only as good as the data you put into it. The values were off as lines were not picked up. In addition, when a pivot recipient further extracts data by some defined parameter out of the pivot table, those values are easily overwritten. Who corrects that? Does something along the way get ‘forced to fix’ the delta? Hmmm… there’s an OMG moment.
Automating the financial report production process will improve efficiency, integrity and reduce FRF risk. Automate as much as possible in reporting, planning, cash flow and working capital performance measures. Close faster and smarter.
You’ve come full circle. Between budgetary and time constraints how can you view opportunity for improvement? The answer is a simple one. Either you make time to research innovative solutions to improve, enhance, speed-up and secure by automation the financial report production process, or maintain the status quo and wait for the hammer to fall. In the meantime, the internal clock ticks away with Financial Reporting Fatigue™ silently percolating.
Smart selection; our value proposition-
OIKOS Software offers secure, permission based access to our suite of cloud-based applications for financial reporting and analytics. Unlike traditional financial software systems, OIKOS Software applications are accessed via a computer and the internet. There are no servers to buy, no capital expenditure investment, no upfront costs, and no additional IT staff needed. We provide training, support and if needed, custom implementations so your financial team can immediately increase productivity, reduce cycle time to close, view critical data in real time, and, by harnessing the power of proprietary analytics, lower company risk from inaccurate measurement of working capital, cash flow, financial planning and reporting. Use OIKOS Software in‐house, or our OIKOS Software consultants can manage the applications for you.
Your business has accumulated net operating losses (NOLs) and tax credits. Is there a need to perform an IRC §382 and §383 study?
What? I’ll worry about that when the business starts making money!!!
With new equity infusions, business development, etc., fortunes have turned for the better. You’re thinking ‘Let’s start getting some benefit for the tough economic years we endured. We just carry NOLs and tax credits forward for later use, right?’
Then, someone down the table says, “Wait a minute. I’ve got a few questions…”
· When can we use the losses?
· How much of them can we use?
· What are they worth on my books?
· Can there be more than one Change of Control (CoC) event to deal with?
· Where, when and what is the value to disclose in our financials? In our tax return? For a transaction; to value NOLs and credits during due diligence?
· Should we provide for the protection of tax attributes by adopting a Rights Agreement/Sec. 382 NOL Plan?
While it is true under current US federal tax rules allow business utilization of tax credits and NOLs up to twenty years, restrictions apply when ownership increases among one or more 5-percent shareholders, in aggregate, by more than 50 percentage points over the lowest percentage of stock owned by such shareholders at any time during the “testing period” (generally three years).
Section 382 of the Code and accompanying Treasury Regulations require that a loss corporation calculate increases in the percentage of stock ownership of 5-percent shareholders to determine whether an ownership change occurred.
Internal Revenue Codes §382 and §383 provide the measures for determining when a limitation arises, and the allowable amounts, but sighting the targets “When” and “What” requires sifting through the myriad of business events. An outright acquisition of controlling equity interest is an obvious flag, but other significant occurrences might not be as apparent. Plus, there are considerations of asset valuations, etc. that can impact the final answers.
What are some ownership change triggers?
· Section 382 measures shareholders’ ownership percentage based on value of shares, not the number of shares issued;
· Schedules 13D and 13G that are filed by a public corporation’s direct 5-percent shareholders;
· The term 5 percent shareholder can include multiple groups of shareholders that individually own less than 5 percent;
· Acquisition or IPO event; and
· Large R&D investments in technology requiring several rounds of financing.
Corporations undergoing a Section 382 ownership change should devote attention to understanding the substance of the transactions causing the change.
New owners can’t simply buy unhindered benefits accrued previously. This could give rise to financial accounting concerns under GAAP and tax when these asset carryforwards are valued on the balance sheet as ASC 740 requires. Everyone dislikes surprises, don’t be caught off-guard dealing with multiple CoC events.
The rules provided in Section 382 are very complex. A company with NOLs or other tax attributes that may be subject to Section 382 must understand the potential impact of a limitation, regardless if these NOLs or tax credits will be used on a tax return in the future. Using proprietary and patented tools designed for this process, L&V conducts comprehensive analyses of Sections 382 & 383 so you can strategically plan for the utilization of these NOLs and tax credits.
L&V is an advisory firm specializing in the fields of domestic and international taxation, treasury, finance, and international trade matters for public and privately held businesses. Our seasoned financial professionals and practical approaches will help you define and focus on the critical success factors affecting your business.
Contact Charles Hills @ +1-978-749-9900 www.l-vpartners.com
250 Commercial Street, STE 3012, Manchester, NH 03101
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