4 Critical Tax Areas for Fintechs

The need for a comprehensive evaluation of valuation allowances against deferred tax assets becomes critical in an uncertain economic environment. A valuation allowance serves as a reserve against deferred tax assets when it is more likely than not that these assets will not be realized. Determining the need for a valuation allowance requires accumulating all positive and negative evidence, consideration of the objective verifiability of that evidence, and an overall evaluation of weight of that evidence.

Objectively verifiable evidence, such as recent cumulative losses over a specified period, carries substantial weight in the evaluation process. Understandably, objectively verifiable evidence is more heavily weighted than subjective evidence, such as forecasted future income. While there is no definitive guidance on the time frame for assessing cumulative losses, a three-year period is commonly used as a practical benchmark. However, it is essential to consider whether other periods or nonrecurring items should be factored into the analysis.

Assessing positive evidence, such as existing contracts that will generate future taxable income or a strong history of earnings with a recent aberration, can provide counterbalancing arguments. However, a company generally will not overcome objectively verifiable negative evidence with subjective positive evidence.

It is also essential to consider sources of future taxable income, including future reversals of existing temporary differences (objective), forecasted future taxable income (subjective), carryback potential (objective), and tax planning strategies (could be a mix of both objective and subjective). 

Operating across multiple states and countries presents fintechs with a complex web of tax considerations. As these companies expand their geographic footprints, they must keep up with varying tax rates, regulations, and reporting requirements in each jurisdiction in which they operate. Failure to properly navigate this intricate landscape can lead to costly missteps, legal issues, and reputational damage. Broad-brushing is simply not an option.

It is important to note that valuation allowances are to be considered on a jurisdictional basis. Thus, while a U.S.-reporting corporation might have considerable losses at the U.S. federal and state level, it is quite possible for that company’s foreign subsidiaries to be taxable in their respective foreign jurisdictions due to transfer pricing agreements that compensate those foreign subsidiaries for arm’s-length services. Additionally, there are state jurisdictions in which the company might still have a GAAP-basis, current income tax liability that is not dependent on standard taxable income calculations, such as the Texas Franchise Tax or the Oregon Corporate Activity Tax.

To effectively manage their multijurisdictional tax profiles, fintechs must model various scenarios to understand the tax implications of their business decisions across all relevant jurisdictions. By proactively identifying potential tax risks and opportunities, fintechs can make informed choices that optimize their tax positions while maintaining full compliance.

Moreover, fintechs should explore opportunities to optimize tax processes through automation. Implementing robust, centralized tax data management systems can enhance visibility, improve accuracy, and facilitate seamless reporting across multiple jurisdictions. This approach can reduce administrative burdens and minimize the risk of costly errors or oversights.

By staying ahead of regulatory changes, relying on tax planning strategies, and optimizing their processes, fintechs can navigate the complex tax terrain with confidence and agility. 

In a fintech company’s growth phase, it is often generating net operating loss (NOL) and credit (particularly research tax credit) carryforward assets. These are critical elements of tax strategy, especially when it comes to bolstering cash flows. However, as the company earns out of those carryforward assets, the Tax Cut and Jobs Act of 2017 (TCJA) brings the likelihood of cash-basis taxes before full realization of the carryforwards.

This sweeping legislation ushered in significant changes to the NOL regime, including limiting the deductibility of NOLs to 80% of taxable income in any given year. Failing to account for this limitation could result in unexpected cash tax liabilities, even when substantial NOLs are available. Furthermore, the TCJA eliminated the ability to carry back NOLs to recover taxes paid in prior years in most instances.

In addition to NOLs, many fintechs have accumulated tax credits, such as research and development (R&D) credits. There is a limitation on the use of certain business credits, capping them at 75% of the taxpayer’s federal income tax liability for the year. This limitation applies to general business credits, including the R&D credit, but excludes certain other credits, such as the low-income housing credit and renewable electricity production credit. Thus, even if a company has more than enough NOL carryforwards and general business credit carryforwards to offset its entire taxable income and tax liability, there will still be a portion that is left exposed to these rules.

Accurately projecting cash tax obligations is crucial for effective financial planning and cash flow management. However, the interplay between NOLs, tax credits, and the various limitations introduced by the TCJA can make this task complex.

By incorporating these intricate rules and limitations into their tax modeling, savvy fintech chief financial officers, tax directors, and other decision-makers can gain a clear understanding of their projected cash tax obligations, which can help them make informed decisions and optimize their tax positions accordingly.