Question

Delta Catfish Company has taken a position in its tax return to claim a tax credit of $18 million (direct reduction in taxes payable) and has determined that its sustainability is “more likely than not,” based on its technical merits. Delta has developed the probability table shown below of all possible material outcomes:

Probability Table ($ in millions)
Amount of the tax benefit that management expects to receive	$	18			$	14.4			$	10.8			$	7.2			$	3.6
Percentage likelihood that the tax benefit will be sustained at this level		10	%			20	%			25	%			20	%			25	%

Delta’s taxable income is $93 million for the year. Its effective tax rate is 40%. The tax credit would be a direct reduction in current taxes payable.

Required:
1. At what amount would Delta measure the tax benefit in its income statement?
2. Prepare the appropriate journal entry for Delta to record its income taxes for the year.

Answer 1

The chances of tax deduction of $18 mn being sustained is “more likely than not” which means more than 50% probability of the tax position being upheld.

As per ASC 740, the threshold for recognizing the benefits of uncertain tax returns positions as “more likely than not”,i.e., 50%. So, in this case, threshold is met. Further, as per ASC 740, the benefit to be recognized should be measured based on the largest benefit that is more than 50% likely to be realized.

To determine the tax benefit that should be recognized by the Co., a cumulative probability table of the likely tax benefit amounts needs to be constructed as below:

Amount of tax benefit the management expects to receive (in $mn)	Probability	Cumulative probability
$18	10%	10%
$14.40	20%	30%
$10.80	25%	55%
$7.20	20%	75%
$3.60	25%	100%

So, here, $10.80 mn benefit should be recognized by the company since it is the largest amount having cumulative probability more than 50%.

Further, journal entry as below will be recorded. The difference between the tax benefit recognized based on probability and the maximum tax benefit that could have been obtained ($18mn - $10.80 mn = $7.2 mn) is credited to tax contingency reserve since Income tax payable was originally recorded at the liability estimated at $93 mn * 40% tax rate, i.e., $37.2 mn. The excess to be paid $7.2 mn will be credited to tax contingency reserve which is a liability account. Income tax expense will be $37.2 mn + $7.2 mn excess estimated to be paid.

Journal entry	Debit amount (in $mn)	Credit amount(in $mn)
Income tax expense	44.4
Income tax payable		37.2
Tax contingency reserve		7.2