IT2013_1069_CH11_v2_P1_7-22

Chapter 11:

Outside Basis Differences and Other Special Areas

Chapter Summary

ASC 740-30 provides guidance on a number of complex issues, including (1) the accounting for an entity’s investments in subsidiaries, joint ventures, and certain other less-than-50-percent-owned investees, and (2) several industry-specific temporary differences. This chapter focuses largely on the accounting for foreign and domestic outside basis differences. It also addresses unique challenges associated with flow-through structures, including partnerships, foreign branch operations, and foreign corporations that generate U.S. subpart F income. Finally, it addresses the tax accounting issues associated with foreign currency translation and hedging of investments in foreign subsidiaries.




11.1 Accounting for the Outside Basis of Investments

11.1.1 Difference Between Outside and Inside Bases

Tax practitioners refer to a parent’s basis in the stock of its subsidiary as the “outside basis” and the subsidiary’s basis in its various assets and liabilities as the “inside basis.” Specifically, a parent’s outside basis difference in a subsidiary is the difference between the parent’s tax basis in the stock of the subsidiary and the book basis in its investment. In considering the parent’s outside basis in the subsidiary, it is important to note that “parent” does not necessarily mean the ultimate parent. The “parent” could, in fact, be a subsidiary that owns another subsidiary. Outside basis differences need to be considered at every level of an organization’s legal entity structure.

An outside basis difference most frequently exists as a result of unremitted earnings. The parent’s book basis in the subsidiary is increased by the subsidiary’s earnings that have been included in consolidated net income, but have not been remitted to the parent. There is no corresponding increase in the parent’s tax basis in the subsidiary’s stock if the subsidiary is not consolidated for tax purposes. The resulting excess-book-over-tax basis is a temporary difference if it will result in taxable income upon its reversal. Typically, reversal of the outside basis difference will occur through dividends from the subsidiary, sale of the subsidiary’s stock by the parent, liquidation of the subsidiary, or a merger of the subsidiary into the parent.

However, it should be noted that unremitted earnings represent only one component of the outside basis difference. Other components of the outside basis difference may include, but are not limited to, cumulative translation adjustments (CTA), changes in a parent’s equity in the net assets of a subsidiary resulting from transactions with noncontrolling shareholders (i.e., the subsidiary’s capital transactions and transactions between parent and noncontrolling shareholders), and other comprehensive income (OCI) items such as unrealized gains or losses on available-for-sale securities. Frequently, there are changes in the outside tax basis that arise in business combinations and reorganizations for which there is no corresponding change in the outside book basis. Basis differences that, upon ultimate sale or liquidation, result in taxable income or deductions are considered temporary differences. For consolidated subsidiaries, the parent’s book basis in its investment does not appear as a separate asset in the consolidated balance sheet. However, for the purposes of applying ASC 740, any outside basis difference must still be considered.

11.1.2 Domestic Versus Foreign Subsidiaries

11.1.2.1 Classification as Domestic or Foreign

Although the indefinite reversal exception applies to the outside basis differences in foreign subsidiaries, it does not apply to domestic subsidiaries, except for certain temporary differences that arose before December 15, 1992 (see ASC 740-30-25-18(b)). Therefore, the classification of a subsidiary as either foreign or domestic can have a significant impact on the accounting for the outside basis difference of a subsidiary or corporate joint venture. For example, ASC 740-30-25-5 and ASC 740-30-25-7 require that deferred taxes be provided on a book-over-tax outside basis difference in a domestic subsidiary unless “the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the entity expects that it will ultimately use that means.” However, deferred taxes on a book-over-tax outside basis difference in a foreign subsidiary must be recorded unless the entity can make a positive assertion that this basis difference will not reverse in the foreseeable future (see ASC 740-3-25-17 through 25-18).

In making this determination, we believe that companies should look to the relevant tax law in the jurisdiction of the parent that holds the investment to determine whether the investment should be classified as foreign or domestic. For example, if a subsidiary of a U.S. parent is treated as a domestic subsidiary under U.S. tax law, it should be accounted for under ASC 740 as a domestic subsidiary.

In general, under U.S. tax law, a U.S. corporation that owns or controls (directly or indirectly) 100 percent of the capital stock of a corporation organized under the laws of a contiguous foreign country may elect to treat the foreign corporation as a domestic corporation for the purposes of filing a U.S. consolidated tax return, provided that the foreign corporation’s sole purpose is to comply with the laws of the foreign country as to the title and operation of property. Thus, if a U.S. entity elects to treat a Canadian or Mexican subsidiary as a domestic subsidiary for U.S. federal tax-return purposes, we believe that under ASC 740 the Canadian or Mexican subsidiary should be accounted for as a U.S. domestic subsidiary.

11.1.2.2 Tiered Foreign Subsidiaries

Whether a subsidiary is domestic or foreign is determined at each level in the corporate structure. Accordingly, a second-tier foreign subsidiary owned by a first-tier foreign subsidiary in the same country would be a domestic subsidiary for purposes of applying the recognition provisions in ASC 740-30. Thus, a first-tier foreign subsidiary would have to provide deferred foreign taxes for the outside basis difference of a second-tier subsidiary domiciled in the same country, if it does not meet any of the exceptions applicable to a domestic subsidiary that permit it to not record a deferred tax liability or a deferred tax asset.

In determining whether an exception applicable to a domestic subsidiary is available, an entity with tiers of subsidiaries in the same foreign country must determine whether the tax laws of the particular foreign country permit the following:

Consolidation for tax purposes and the elimination in the consolidated tax return of intercompany dividends.

Exclusion of a parent’s taxable income of dividends from its domestic subsidiaries, if tax consolidation is not permitted.

Tax-free liquidation or statutory merger of a subsidiary into its parent.

Example 11-1: Third-Tier Subsidiary in a Foreign Jurisdiction Classified as Domestic under ASC 740-30

Assume that U.S. Parent P1 owns 100 percent of U.K. subsidiary S1, that U.K. subsidiary S1 owns 100 percent of U.K. subsidiary S2 and Swiss subsidiary S3 and that, under U.K. tax law, S2 is a domestic subsidiary of S1.


In preparing P1’s U.S. GAAP consolidated financial statements, any outside basis difference related to S1’s investment in S2 represents an outside basis in a domestic subsidiary. Therefore, S1’s investment in S2 should be evaluated using the exceptions to comprehensive recognition available to outside basis differences related to domestic subsidiaries to determine whether a temporary difference exists. Any outside basis difference related to S1’s investment in S3 represents an outside basis in a foreign subsidiary and should be evaluated using the exceptions to comprehensive recognition available to outside basis differences related to foreign subsidiaries (e.g., ASC 740-30-25-17).

11.1.3 Overview of Potential Deferred Tax Assets and Liabilities Related to Outside Basis Differences

The determination as to whether a temporary difference should be recorded for outside basis differences depends on a number of factors. These include the form of the entity, whether it is domestic or foreign, and management’s intentions for the entity. The recording of deferred taxes on outside basis differences is summarized in the table below.




1 Investments of 20% or less are generally accounted for at fair value (in accordance with ASC 320, Investments—Debt and Equity Securities) or by using the cost method. Differences between the carrying amount and the tax basis of the investment represent normal temporary differences for which deferred taxes should be provided.



11.1.4 Potential Deferred Tax Liabilities, Domestic Subsidiaries, and Domestic Corporate Joint Ventures

11.1.4.1 In General

ASC 740 extends the scope of the indefinite reversal exception in ASC 740-30-25-17 for foreign unremitted earnings to include any excess outside book basis in a foreign subsidiary or foreign corporate joint venture that is essentially permanent in duration. For purposes of applying the indefinite reversal exception, a corporate joint venture is defined in ASC 323-10-20 as follows:

A corporation owned and operated by a small group of entities (the joint venturers) as a separate and specific business or project for the mutual benefit of the members of the group. The purpose of a corporate joint venture frequently is to share risks and rewards in developing a new market, product or technology; to combine complimentary technological knowledge; or to pool resources in developing production or other facilities. A corporate joint venture also usually provides an arrangement that each joint venturer may participate, directly or indirectly, in the overall management of the joint venture. Joint venturers thus have an interest or relationship other than as passive investors. An entity that is a subsidiary of one of the joint venturers is not a corporate joint venture. The ownership of a corporate joint venture seldom changes, and its stock is usually not traded publicly. A minority public ownership, however, does not preclude a corporation from being a corporate joint venture.

Further, to qualify for the indefinite reversal exception, a corporate joint venture must be essentially permanent in duration (i.e., it cannot have a life limited by the nature of the venture or other business activity).

In contrast, the grandfathering of the indefinite reversal exception for a domestic subsidiary or domestic corporate joint venture extends only to undistributed earnings earned in fiscal years beginning prior to December 15, 1992 (see ASC 740-30-25-18(b)). This means that a company will need to consider whether a deferred tax liability should be established on the excess outside book basis difference of a domestic subsidiary or domestic corporate joint venture for undistributed earnings for fiscal years beginning after December 15, 1992. If it is anticipated that ultimate receipt by the U.S. parent will occur in a tax-free manner, the unremitted earnings are not considered to be a taxable temporary difference. The same is true for other outside basis differences. However, U.S. subsidiaries that are stock life insurers or savings and loans associations may require special consideration. The rules for whether excess book-over-tax outside basis differences should be recognized as taxable temporary differences depend on when those differences arose.


11.1.4.2 Domestic Subsidiaries and Domestic Corporate Joint Ventures: Excess Book-Over-Tax Outside Basis Differences That Arose in Fiscal Years Beginning on or before December 15, 1992

A deferred tax liability on unremitted earnings of a domestic subsidiary or domestic joint venture that arose in fiscal years beginning on or before December 15, 1992 should not be recognized unless it is apparent that the temporary difference will reverse in the foreseeable future (ASC 740-30-25-18(b)).

A last-in, first-out (LIFO) assumption is used to determine whether- reversals relate to unremitted earnings for fiscal years beginning on or before December 15, 1992, or whether they relate to later years. Assume, for example, that a calendar-year entity has not recognized a deferred tax liability on $2,000,000 of undistributed earnings of a domestic subsidiary that arose in 1992 and earlier years. The entity has another $1,000,000 of undistributed earnings from the same subsidiary that arose in 1993 and later years for which a deferred tax liability is provided. The subsidiary pays a dividend of $50,000, which the entity elects, for tax purposes, to distribute from the larger carryforward earnings that underlie the $2,000,000 unrecorded deferred tax liability. For financial reporting purposes, however, because of the LIFO assumption, this reversal would be applied to reduce the $1,000,000 amount, leaving the base-year amount intact. Because the temporary difference, on which deferred taxes were provided, was reduced to $950,000, the related deferred tax liability must also be reduced.

However, deferred taxes should be recorded for unremitted earnings of a domestic subsidiary or a domestic corporate joint venture that arose in fiscal years beginning on or before December 15, 1992, if it becomes apparent that the temporary difference will reverse in the foreseeable future (i.e., if indefinite reversal can no longer be asserted).

11.1.4.3 Domestic Subsidiaries: Excess Book-Over-Tax Outside Basis Differences That Arose in Fiscal Years Beginning after December 15, 1992

ASC 740-30-25-5 states that a deferred tax liability should be recognized for certain types of taxable temporary differences, including the “excess of the amount for financial reporting over the tax basis of an investment in a domestic subsidiary that arises in fiscal years beginning after December 15, 1992.” However, an assessment of whether differences between book and tax outside bases are, in fact, taxable temporary differences also must be made (under ASC 740-30-25-7, an excess book outside basis difference “is not a taxable temporary difference if the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the entity expects that it will ultimately use that means”).

11.1.4.4 Domestic, 50 Percent-or-Less-Owned Investees: Excess Book-Over-Tax Outside Basis Differences That Arose in Fiscal Years Beginning after December 15, 1992

ASC 740-30-25-5(b) requires recognition of a deferred tax liability for the excess book-over-tax basis of an investment in a 50-percent-or-less-owned investee except as provided in ASC 740-30-25-18 for a corporate joint venture (as defined in ASC 323) that is essentially permanent in duration. In addition, it should be noted that the exception under ASC 740-30-25-7 for recording a deferred tax liability (described in Section TX 11.1.4.5 below) is not applicable. In providing deferred taxes, understanding the expected form of realization by the investor—dividends vs. capital gains—is often critical (see Section TX 11.1.8).

11.1.4.5 Exception for Domestic Subsidiaries under ASC 740-30-25-7

11.1.4.5.1 Ability and Intent to Recover Tax-free the Investment in the Domestic Subsidiary

ASC 740-30-25-7 states that a book-over-tax outside basis difference in an investment in a more-than-50-percent-owned domestic subsidiary is not a temporary difference if “the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the entity expects that it will ultimately use that means.”

In the case of a U.S. subsidiary that is at least 80 percent owned, U.S. tax law provides a means by which the subsidiary can be liquidated or merged into the parent on a tax-free basis. Accordingly, a U.S. parent corporation may be able to use these means to recover its outside basis difference in the subsidiary in a tax-free manner. As long as the U.S. parent has the ability to use one of these tax-free means of recovery and expects to ultimately use that means to recover its outside basis difference, it should not record a deferred tax liability for this difference.

Note, however, that satisfaction of the relevant tax requirements alone is not sufficient to support this assertion. For example, assume that a U.S. parent corporation has a wholly-owned U.S. subsidiary that is a regulated entity. A tax-free liquidation or merger of that entity into the parent may not be possible without regulatory approval. If regulatory approval is more than perfunctory, the parent corporation cannot assert that its basis in the subsidiary can be recovered on a tax-free basis.

Similar tax-free liquidation and merger rules apply in various foreign jurisdictions. Accordingly, an analysis of whether the exception set forth in ASC 740-30-25-7 may be asserted must be performed with respect to each subsidiary to determine if the applicable tax law provides a means of recovering the outside basis difference tax-free.

If a subsidiary is less than 80 percent owned, but more than 50 percent owned, the parent may still be able to assert that the basis difference can and is expected to be recovered tax-free. Such a position would be based on the parent’s assertion that it is able to effectuate and expects to effectuate the acquisition of the additional ownership necessary to avail itself of any tax-free means to recover the outside basis difference. (Note that the additional ownership must be acquired at no significant additional cost (see Section TX 11.1.4.5.2)). However, if the parent later determines that it is no longer able to or no longer expects to acquire the additional interest necessary to avail itself of a tax-free recovery of the outside basis difference, it must record a deferred tax liability on the outside basis difference.

Example 11-2: Application of ASC 740-3-25-7 to a Change in Assertion to Effectuate a Tax-free Liquidation

Background/Facts:

Company A owns 60 percent of Company B. Appropriately, Company A has not recorded a deferred tax liability on the outside basis in Company B. The decision not to record the deferred tax liability was based on Company A’s assertion that it would be able to effectuate a purchase of an additional 20 percent in Company B, without significant cost, to avail itself of a tax-free liquidation (as per the guidance in ASC 740-30-25-7).

Since Company A first reached that conclusion, circumstances have changed. Company A no longer expects to acquire the 20 percent necessary to avail itself of the tax-free liquidation provisions.

Question:

How should the tax consequences of the change in assertion be reported?

Analysis/Conclusion:

Once Company A’s expectations change (i.e., once it no longer expects to acquire the noncontrolling interest in Company B that is necessary to effectuate a tax-free liquidation), the assertion that allowed A not to record deferred taxes on the outside basis difference is no longer applicable. This is analogous to ASC 740-30-25-19, which states, “If circumstances change and it becomes apparent that some or all of the undistributed earnings of a subsidiary will be remitted in the foreseeable future but income taxes have not been recognized by the parent company, it shall accrue as an expense of the current period income taxes attributable to that remittance.” The original outside basis difference for which deferred taxes were not provided due to this assertion (and therefore for which charges were not taken) should be multiplied by the applicable tax rate and should be recorded as a deferred tax liability. A corresponding charge should also be recorded through the income statement.

Example 11-3: Recording an Outside Basis Deferred Tax Liability When an Investment in a Domestic Subsidiary Is Impaired for Tax Purposes

Background/Facts:

Company A, a Luxembourg parent company, owns 100 percent of the stock of Company B, a Luxembourg subsidiary. For statutory and income tax reporting purposes, Company A is required to annually determine the fair value of its investment in Company B and recognize an impairment if the fair value is lower than the statutory carrying value. Company A performs this assessment in the current year and concludes that its investment is impaired. The resulting write-down is currently deductible for Luxembourg income tax purposes. However, the tax benefit is also subject to recapture if the value of the investment increases in future periods. That is, to the extent the investment value increases, the write-down must be recaptured into taxable income. A potential increase in fair value may be attributable to future earnings as well as other exogenous factors that may affect the value of Company B. This write-down represents the only difference between the book and tax basis in Company A’s investment in Company B and, therefore, Company A’s book basis in Company B (i.e., its outside basis) is greater than its tax basis for Luxembourg income tax purposes.

Under Luxembourg law, a parent company may liquidate or dispose of a subsidiary and receive dividends in a tax-free manner. Company A has no intention of selling its investment in Company B or liquidating the subsidiary. In fact, Company A will continue to operate Company B and hopes to “turn around” the investment.

Question:

Does Company A need to record a deferred tax liability for the excess book-over-tax basis in its investment in Company B?

Analysis/Conclusion:

Yes. ASC 740-30-25-5 and ASC 740-30-25-7 require that deferred taxes be provided on a book-over-tax outside basis difference in a domestic subsidiary unless the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the entity expects that it will ultimately use that means. In this situation, Company A is planning to continue operating Company B and, therefore, it does not have the ability to avoid potential recapture of the tax benefit claimed for the tax write-down of the investment in Company B. Accordingly, Company A should record a deferred tax liability for the outside basis difference related to its investment in Company B.

11.1.4.5.2 Meaning of “Significant Cost” under ASC 740-30-25-8

If a parent corporation does not own the requisite percentage of a domestic subsidiary’s stock to effectuate a tax-free recovery of the outside basis, the parent may still be able to assert that it expects to recover its outside basis difference in the subsidiary tax-free, as long as it can do so without incurring “significant cost.” Specifically, ASC 740-30-25-8 states the following:

Some elections for tax purposes are available only if the parent owns a specified percentage of the subsidiary’s stock. The parent sometimes may own less than that specified percentage, and the price per share to acquire a noncontrolling interest may significantly exceed the per share equivalent of the amount reported as noncontrolling interest in the consolidated financial statements. In those circumstances, the excess of the amount for financial reporting over the tax basis of the parent’s investment in the subsidiary is not a taxable temporary difference if settlement of the noncontrolling interest is expected to occur at the point in time when settlement would not result in a significant cost. That could occur, for example, toward the end of the life of the subsidiary, after it has recovered and settled most of its assets and liabilities, respectively. The fair value of the noncontrolling interest ordinarily will approximately equal its percentage of the subsidiary’s net assets if those net assets consist primarily of cash.

Furthermore, as indicated above, “significant cost” occurs if the cost to purchase a noncontrolling interest would exceed its book value. However, under the “end of time” scenario, once the subsidiary’s net assets have been converted to cash and it has no significant unrecorded intangible assets or contingent liabilities, the noncontrolling interest in the subsidiary would be worth approximately its book value. A subsequent purchase of this noncontrolling interest by the parent would be deemed a settlement of a liability at its book value and would not involve a “significant cost.” As a result, a tax-free liquidation or merger would be available, and the parent would never expect the unremitted earnings—any book-over-tax outside basis difference—to result in taxable income. While it is true that this scenario is only hypothetical, it is important to recognize that, in many circumstances, it may be just as difficult to assume (1) that the parent will receive the unremitted earnings in cash as opposed to reinvesting them in the subsidiary and (2) that the cash will be received by the parent in a taxable transaction.

If a parent has not provided deferred taxes based on the “end of time” scenario, the entity would need to consider whether it must provide deferred taxes on its outside basis difference when a change in facts/expectations occurs. Under the FASB staff’s view, once the parent decides to acquire the noncontrolling interest for a premium over book value, the entity cannot continue to assert its ability to use the “end of time” scenario. Accordingly, it must provide a deferred tax liability on the outside basis difference (or, if lower, the significant cost) with a related charge to income. Subsequently, in accounting for the acquisition of the noncontrolling interest, the release of the deferred tax liability would be recorded either in equity or income, depending on whether the tax effect would be considered a “direct” or “indirect” tax effect from a transaction with a noncontrolling shareholder (Chapter TX 10 provides additional guidance on transactions with noncontrolling shareholders).

However, we believe that one must consider the entity’s reasons behind the acquisition. If the acquisition is driven by substantive business reasons (e.g., the parent’s belief that the noncontrolling interest is significantly undervalued or the parent’s desire to fully integrate the subsidiary’s operations into its own operations), and not primarily or largely by the desire to effect a tax-free merger or liquidation, we do not believe that the related costs should be considered incremental significant costs to effectuate the tax-free recovery of the outside basis. For this reason, the parent may be able to continue to assert its ability to recover the outside basis difference in the subsidiary tax-free and, as a consequence, may not need to provide deferred taxes on the outside basis difference in the subsidiary.

An entity with less than 50 percent ownership in an investment cannot avoid recording a deferred tax liability, even if it intends to purchase stock so that it owns more than 50 percent. Before it can use the exception, an entity must have control of the subsidiary. Permitting use of a tax-planning action to gain control would mean that the action could be used by more than one entity for the same investee, and two entities cannot control the same investee.

11.1.4.5.3 Potential State Tax Considerations

On occasion, the outside basis difference of a U.S. subsidiary may constitute a temporary difference for deferred state tax computations, even if it is not a temporary difference for federal deferred tax computations. However, if the U.S. parent is able to project that the unremitted earnings will ultimately be received in a liquidation that is tax-free for federal purposes, it will often be able to avoid a provision for state taxes.

Even if a tax-free liquidation is not available in all states in which the parent files returns or is not projected by the parent for other reasons, the unremitted earnings may still not be considered a temporary difference for certain states. For example, if the unremitted earnings are eventually expected to be remitted as dividends, there will be no deferred state tax if either one of the following two circumstances is true:

The parent is operating only in states in which it files on a combined or consolidated basis with the subsidiary, and intercompany dividends can be eliminated 100 percent in those returns.

The subsidiary is consolidated in the parent’s federal return, and the parent is operating only in states that do not adjust federal taxable income (the typical starting point for determining state taxable income) for the federal 100 percent dividends-received deduction.

If it is expected that unremitted earnings will be received through a sale of stock, state tax will generally be avoided if the parent’s tax basis for state tax purposes has been increased by the subsidiary’s taxable income (for those subsidiaries that have no difference between inside and outside tax bases). This would be the case in states where the parent files with the subsidiary a combined or consolidated return in which the federal consolidated return rules are followed.

When the unremitted earnings are a temporary difference for a particular state, the deferred state tax provision would need to consider (1) whether the state permits or requires a combined method of reporting (and, if so, whether the subsidiary is engaged in a unitary business); (2) whether the dividend or gain on sale or liquidation will be treated as business or nonbusiness income; (3) which expected apportionment factor should be applied; and (4) whether a dividends-received deduction is available in lieu of the 100 percent federal dividends-received deduction.

11.1.4.5.4 Consideration of Lower-Tier Foreign Subsidiaries Owned by a Domestic Subsidiary

As discussed in Section TX 11.1.4.5.2 above, ASC 740-30-25-8 discusses an excess book-over-tax outside basis difference related to a domestic subsidiary. It presents a scenario that would permit a parent to assume an ultimate tax-free liquidation of a domestic subsidiary that is less than 80 percent owned. After the subsidiary has recovered all of its assets and has settled all of its liabilities, the parent would be able to buy the noncontrolling interest for its book value.

But suppose the domestic subsidiary owns a lower-tier foreign subsidiary for which the indefinite reversal exception is used. The domestic subsidiary would not be able to recover its investment in the lower-tier foreign subsidiary without triggering the tax on the foreign subsidiary’s undistributed earnings or other outside basis differences.

However, if the parent anticipates that the domestic subsidiary would recover all its assets except its investment in the lower-tier foreign subsidiary and that the foreign subsidiary would also recover all of its assets and settle all of its liabilities, the net book value of the domestic subsidiary would exceed its fair value because of the potential tax on the foreign subsidiary’s outside basis difference. This would enable the parent to buy the noncontrolling interest of the domestic subsidiary without incurring significant cost (the purchase would be at a discount to book value). The parent could then proceed with a tax-free liquidation of the domestic subsidiary without triggering the tax on the outside basis of the foreign subsidiary.

11.1.4.6 Special Considerations for Savings & Loan Associations and Stock Life Insurance Companies

ASC 740-10-25-3(a)(3) and (a)(4), allow the indefinite reversal criteria to be applied to the inside basis differences resulting from pre-1988 tax bad debt reserves of U.S. savings and loan associations (S&Ls) and from policyholders’ surplus of stock life insurance companies that arose in fiscal years ending on or before December 15, 1992.

When such institutions are subsidiaries included in a consolidated U.S. tax return, outside basis differences will result from these items. ASC 740-10-25-3 also discusses the indefinite reversal criteria for outside basis differences of domestic subsidiaries arising from pre-1993 undistributed earnings, as well as outside basis differences arising from pre-1988 tax bad debt reserves of an S&L subsidiary or policyholders’ surplus of a stock life insurance subsidiary that arose before 1993. These outside differences mirror the related inside differences; they will reverse when the inside differences reverse and therefore do not require separate consideration.

As for outside basis differences that are not covered by the exception under ASC 740-30-25-18, one must consider the method by which the book investment in the S&L subsidiary or the stock life insurance subsidiary will be recovered. ASC 740-20-25-7 indicates that it may be unnecessary to provide deferred taxes on an outside basis difference of a domestic subsidiary if the subsidiary can be liquidated tax-free. An S&L or a stock life insurance company could be liquidated into its parent tax-free. However, such liquidation would trigger tax on the inside differences to which indefinite reversal has been asserted for the pre-1988 tax bad debts reserve of the S&L or the pre-1993 policyholders’ surplus of the life insurer. Accordingly, if a tax-free liquidation of the subsidiary is contemplated to avoid deferred taxes on an outside basis difference of an S&L or life insurance subsidiary, deferred taxes would need to be provided on the inside differences.

At times, certain domestic subsidiaries cannot be liquidated under the applicable tax law in a tax-free manner. For example, in the United States, a wholly owned life insurance company cannot be liquidated tax-free into a noninsurance company. In these instances, should a deferred tax liability be recognized for an outside basis difference that results from an inside basis temporary difference? The answer depends on several factors as discussed in the following example.

Example 11-4: Application of the Tax-free Liquidation Assertion under ASC 740-30-25-7 to an Investment in a Wholly Owned Life Insurance Company

Background/Facts:

Company B, a life insurance company, is a wholly owned subsidiary of Company A. The companies file a consolidated tax return. The tax rate for all years is 40 percent. Prior to a change in the tax law, Company B added amounts to policyholders’ surplus accounts, which permitted tax deductions totaling $100. After 1984, the tax law changed and the deduction was no longer allowed. Under ASC 740-10-25-3(a)(4), deferred taxes have not been provided on the temporary difference related to the policyholders’ surplus accounts. During the current year, a $200 difference between pretax book and tax income arose as a result of originating taxable temporary differences. Company B has provided deferred taxes on these temporary differences.

Company A’s outside basis in its investment in Company B is as follows:


The following calculation is used to determine whether Company A should recognize deferred taxes on its outside basis difference at year-end (the calculation assumes that the sale of the stock of the subsidiary would be at a price equal to the pretax book investment in the subsidiary):


Question:

Should Company A recognize a deferred tax liability for an outside basis difference that results from an inside basis temporary difference?

Analysis/Conclusion:

In this example, Company A would not recognize deferred taxes on the outside basis difference because the tax consequences of the items creating the outside basis difference have already been reflected by Company B and recovery of the net assets of Company B at recorded amount would eliminate the outside basis difference. However, if Company A decides to sell the stock of Company B, causing the temporary difference to reverse in the foreseeable future, the outside basis difference related to the temporary difference under ASC 740-10-25-3(a)(4) would then have tax consequences. Accordingly, Company A would recognize deferred taxes of $40, unless it could develop an alternative scenario that would cause the subsidiary’s outside basis difference to reverse without resulting in taxable income and without triggering tax on the inside basis difference.

One possible scenario that could be considered would involve a downstream merger of Company A into Company B. Such a merger would need to occur at an indefinite future date after Company A has recovered all of its assets, except for its investment in Company B, and has settled all of its liabilities. (This scenario would require a reasonable expectation that Company A’s assets, excluding its investment in Company B, will exceed its liabilities.) The downstream merger would require the approval of the appropriate regulatory authorities. Presumably, the regulators would not object to an additional cash infusion into the regulated entity. It would also be necessary to consider whether conversion of Company A’s net assets to cash could be achieved without triggering tax on exempt undistributed earnings or other differences in the outside basis of any other subsidiaries. Further, ASC 740-30-25-8, requires that the contemplated tax-free reversal of the outside temporary difference should be effected without significant cost. Accordingly, the portion of the outside basis difference attributable to pre-1993 policyholders’ surplus would not be a taxable temporary difference, provided that (1) this scenario reflects Company A’s expectation of the ultimate disposition of the outside basis temporary difference in Company B, (2) it is extremely unlikely that regulators would preclude the downstream merger, and (3) the scenario would not result in a significant cost.

11.1.5 Potential Deferred Tax Liabilities, Foreign Subsidiaries, and Foreign Corporate Joint Ventures

11.1.5.1 Outside Basis Differences: Undistributed Earnings and Other Differences

Under U.S. tax laws, when earnings of a foreign subsidiary enter into the taxable income of the U.S. parent, a foreign tax credit may be available to eliminate or at least mitigate the effect of double taxation of the subsidiary’s earnings (i.e., taxation both by the foreign country in which the subsidiary operates and by the United States). The tax laws of most foreign countries include a mechanism that provides similar relief.

U.S. law with respect to taxation of foreign operations is extremely complex. For this reason, the FASB concluded that calculating the parent’s taxes payable on repatriation would be too difficult relative to their assessment of the related benefit. The Board instead decided to preserve the indefinite reversal exception, which does not require the recognition of a deferred tax liability for the excess of the amount of financial reporting over the tax basis of an investment in a foreign subsidiary or foreign corporate joint venture that is essentially permanent in duration, unless it becomes apparent that the basis difference will reverse in the foreseeable future.

Accordingly, ASC 740-30-25-18(a) provides that a deferred tax liability is not recognized for “an excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or foreign corporate joint venture (as defined in ASC 323-10-15-3) that is essentially permanent in duration.” This outside basis difference may be the result of undistributed earnings or other differences. ASC 740-30-25-3 states, “it shall be presumed that all undistributed earnings of a subsidiary will be transferred to the parent company. Accordingly, the undistributed earnings of a subsidiary included in consolidated income shall be accounted for as a temporary difference unless the tax law provides a means by which the investment in a domestic subsidiary can be recovered tax free.” These excerpts from ASC 740-30-25 reflect the general rule that book-over-tax basis differences attributable to undistributed earnings of a subsidiary should be presumed to reverse in the foreseeable future. Therefore, the establishment of deferred taxes is generally required with respect to book-over-tax outside basis differences attributable to undistributed earnings of a foreign subsidiary, unless the indefinite reversal criteria of ASC 740-30-25-17 are met.

In addition, ASC 740-30-25-18(a) extends the indefinite reversal exception to the entire excess book-over-tax outside basis difference in a foreign subsidiary or foreign corporate joint venture that is essentially permanent in duration. While the largest portion of the outside basis difference typically arises from unremitted earnings, other changes in the parent’s outside basis may result from other comprehensive income, including cumulative translation adjustments, and other changes in the subsidiary’s equity. We believe that the difference between the book and tax basis in the investment represents a single outside basis difference. Accordingly, it would be inappropriate to separate the outside basis difference into multiple temporary differences. For example, an entity should not record a deferred tax asset for one portion of the outside basis difference while not recording a deferred tax liability for another portion of the difference based on an indefinite reversal exception. However, this discussion is not meant to limit an entity’s ability to assert that only a portion of the single outside basis difference is subject to the indefinite reversal exception. See discussion at Section TX 11.1.5.3.


11.1.5.2 Indefinite Reversal Exception


This exception to ASC 740’s comprehensive model for recognition of temporary differences essentially requires a positive assertion of management’s intent to indefinitely reinvest its foreign undistributed earnings. That is, management must have the ability and the intent to indefinitely prevent the outside basis difference of a foreign subsidiary from reversing with a tax consequence.

When the indefinite reversal exception is used to avoid a provision for deferred taxes on outside basis differences, a new judgment regarding the indefinite reversal criteria is required as of each balance sheet date with respect to each subsidiary. Generally, the total outside basis difference of a foreign subsidiary (i.e., the excess of net assets of the subsidiary reflected in consolidation over the parent’s tax basis in the stock of the subsidiary) and the pre-1993 undistributed earnings of a domestic subsidiary will need to be considered. However, the prospect of a tax-free liquidation may make it possible to conclude that the entire outside basis difference of a domestic subsidiary, including unremitted earnings, is not a taxable temporary difference. Similar judgment will be required for the excess book-over-tax basis of a foreign corporate joint venture that is permanent in duration.

11.1.5.3 Partial Reinvestment Assertion

ASC 740 extends the indefinite reversal exception for foreign unremitted earnings to include any excess outside book-over-tax basis in a foreign subsidiary or in a foreign corporate joint venture that is essentially permanent in duration. A number of questions arise. For example, can an entity have a deferred tax liability that reflects an intention to remit a portion, but not all, of the unremitted earnings? Furthermore, can an entity have a deferred tax liability that reflects an intention to remit unremitted earnings, but no amount corresponding to other factors underlying an outside basis difference?

The answer is this: An entity can maintain a deferred tax liability on some, but not all, of the outside basis difference (whether or not such difference is caused by unremitted earnings or other factors) if its assertion is justified by the “evidence” and “plans” described in ASC 740-30-25-17. However, it should be clear that, if an entity makes a partial reinvestment assertion, the entity cannot change its assertion from year-to-year in a manner that would suggest that the entity is managing its income. If partial deferred taxes are provided, the amount should be based on the tax liability that would be triggered by repatriation of the amount that is not invested indefinitely.

11.1.5.4 Evidence Required

ASC 740-30-25-17 requires management to compile evidence to support its assertion that the foreign unremitted earnings are indefinitely reinvested in order to qualify for the indefinite reversal exception. A mere history of not distributing foreign earnings does not serve as a replacement for specific reinvestment plans. The following matters, among others, should be considered in evaluating specific plans:

The forecasts and budgets of the parent and subsidiary for both the long and short term.

The financial requirements of both the parent and subsidiary for the long and short term, including:

1. Projected working capital and other capital needs in locations where the earnings are generated; and

2. Reasons why any excess earnings are not needed by the parent or another subsidiary somewhere else in the chain.

Past history of dividend actions.

Tax consequences of a decision to remit or reinvest.

Remittance restrictions in a loan agreement of a subsidiary.

Remittance restrictions imposed by foreign governments that result in forced reinvestment in the country.

Any U.S. government programs designed to influence remittances.

The specific plans for reinvestment must be documented and maintained. They must support the assertion that the reversal of the outside basis difference can and will be postponed indefinitely.

Section TX 11.1.5.9 discusses the National Professional Services Group consultation requirement when engagement teams have performed extended going concern procedures (regardless of whether a going concern opinion is ultimately rendered) and management asserts indefinite reinvestment.

11.1.5.5 Effect of Distributions Out of Current-Year Earnings on an Indefinite Reversal Assertion

An entity can make a distribution from current-year GAAP earnings and still not have a change in assertion about undistributed earnings existing as of the end of its prior fiscal year.

Example 11-5: Effect of Current-Year Distributions on a Company’s Assertion Regarding Indefinite Reversal of Undistributed Earnings

Background/Facts:

Assume that, based on asserting and meeting the ASC 740-30-25-18 indefinite reversal criteria, a company has not historically recognized a deferred tax liability on its excess book-over-tax basis for its investment in a foreign subsidiary. This outside basis results from undistributed earnings of the foreign subsidiary totaling $400,000. The company anticipates that its foreign subsidiary will generate earnings in excess of $100,000 per year for the foreseeable future. As a result, management decides to initiate future annual dividend payments of $100,000 from the foreign subsidiary. These dividends would be limited to future earnings, and therefore would be reduced to the extent that the level of future earnings is not met.

Question:

Does management’s plan call into question the indefinite reversal assertion, which would require the company to record a deferred tax liability with respect to the higher outside book basis?

Analysis/Conclusion:

Not necessarily. In the above situation, management intends to include only future earnings in distributions and to reduce or eliminate the dividend in the event of any shortfall. Therefore, the indefinite reversal assertion remains sustainable with respect to the existing outside basis difference, although management must still be able to provide sufficient evidence that the outside basis will continue to meet the indefinite reversal criteria, including specific plans for reinvesting the funds.

If, however, management’s intentions were to repatriate $100,000 a year, regardless of the foreign subsidiary’s earnings, a change in circumstances would be deemed to have occurred with respect to its prior assertion. Recognition of a deferred tax liability and a corresponding charge to continuing operations in the period of change would be required. This is consistent with ASC 740-30-25-19, which indicates that the tax effect of undistributed earnings of a subsidiary should be charged to expense in the period during which the circumstances change. The tax effect of undistributed earnings of a subsidiary should not be classified as an extraordinary item.

11.1.5.6 Effect of Change in an Indefinite Reversal Assertion


If it becomes apparent that some or all of the unremitted earnings of the foreign subsidiary will be remitted in the foreseeable future and if the entity has not provided deferred taxes on that amount, the parent entity should adjust income tax expense of the current period and make the disclosures required by ASC 740-10-50-2.

The impact of current-year movement in the cumulative translation adjustments (CTA) account on the expected tax liability on the repatriation should generally be allocated to CTA, consistent with the intraperiod allocation provisions of ASC 740-20-45-11(b). See Section TX 11.5.3 and Section TX 12.2.3.2.2.1. ASC 740-20-45-11(b) states that the tax effects of gains and losses included in comprehensive income, but excluded from net income, that occur during the year are charged or credited directly to related components of shareholders’ equity. Thus, the tax expense or benefit for the related current-year CTA movement would be recorded through other comprehensive income. However, because the beginning-of-year CTA account balance did not arise during the year, but rather in prior years, ASC 740-10-45-11(b) does not apply and the tax effects associated with the beginning-of-year balance should be recorded to continuing operations, and not backwards traced to CTA, when there is a change in the indefinite reversal assertion.

11.1.5.7 Inside Basis Differences That Meet the Indefinite Reversal Criteria

A question arises as to whether the indefinite reversal exception can be used so that an entity does not need to recognize temporary differences that exist within foreign subsidiaries (i.e., inside basis temporary differences) that may not reverse in the foreseeable future. ASC 740-30-25-17 specifically prohibits an extension of the outside-basis indefinite reversal exception to inside basis temporary differences of a foreign subsidiary.

For example, consider inside basis differences of an Italian subsidiary of a U.S. parent where the local currency is the functional currency. Under an Italian law that is no longer applicable, fixed assets were occasionally restated for tax purposes to compensate for the effects of inflation. The amount that offsets the increase in the tax basis of fixed assets was described as a credit to revaluation surplus, which some viewed as a component of equity for tax purposes. That amount became taxable in certain situations, such as in the event of a liquidation of the Italian subsidiary or if the earnings associated with the revaluation surplus were distributed. Under this former Italian law, no mechanisms were available to avoid eventual treatment of the revaluation surplus as taxable income. Faced with a similar tax law, a parent company of a foreign subsidiary should not apply the indefinite reversal criteria to inside basis differences of a foreign subsidiary such as a revaluation surplus (ASC 740-30-25-17).

Therefore, the indefinite reversal criteria of ASC 740-30-25-17 should not be applied to inside basis differences of foreign subsidiaries and a deferred tax liability should be provided on the amount of the inside basis difference (e.g., a revaluation surplus temporary difference), even though such amounts may not be expected to reverse in the foreseeable future.


11.1.5.8 Indefinite Reversal Exception and Purchase Accounting

In a business combination, the acquirer must make its own determination regarding indefinite reversal (or lack thereof) in connection with outside basis differences of the target. If the acquirer does not meet or does not assert the indefinite reversal criteria at the time of the acquisition with respect to the outside basis difference related to an acquired foreign subsidiary or joint venture that is permanent in nature, deferred taxes should be recognized in purchase accounting, regardless of the prior owner’s assertion (see Section TX 10.4.3 for more details).


An acquisition may also impact the acquirer’s intention and ability to delay reversal of taxable temporary difference related to subsidiaries it owned prior to the acquisition. As discussed in Section TX 10.4.3, the tax effects of the change in assertion related to the acquirer’s previously owned subsidiaries would generally be recorded in the income statement.

11.1.5.9 Going-Concern Uncertainty

The existence of a going-concern uncertainty may suggest that management is no longer able to control the decision to indefinite reinvest unremitted foreign earnings. In fact, the financial uncertainty that often exists in these cases may create a presumption that unremitted foreign earnings will be needed to meet existing obligations and keep the business afloat. In this regard, the facts and circumstances of each individual going-concern situation should be evaluated to understand whether maintaining an indefinite reinvestment assertion is still possible or whether a deferred tax liability is needed.

When we have performed extended going concern procedures (regardless of whether a going concern opinion is ultimately rendered) and the company continues to assert indefinite reinvestment for its outside basis difference in a foreign subsidiary under ASC 740-30-25, PwC engagement teams are required to consult with the Accounting Services Group within PwC’s National Professional Services Group.

11.1.6 Foreign Corporate Joint Ventures That Are Not Permanent in Duration

Most investments in corporate joint ventures are accounted for by the equity method for financial reporting purposes and by the cost method for tax purposes. The book and tax carrying amounts of any investment may differ due to undistributed earnings, translation adjustments, changes in interest, and differences between the book and tax bases of the assets and liabilities contributed. The difference between the book basis and tax basis of the investment in a foreign joint venture that is not permanent in duration is a temporary difference for which a deferred tax liability or asset should be recorded.

11.1.7 Measuring the Tax Effect of Outside Basis Differences on Subsidiaries and Equity Investees (Domestic and Foreign)

With respect to measuring the tax effect of a book-over-tax outside basis difference, ASC 740-10-55-23 provides:

The tax rate that is used to measure deferred tax liabilities and deferred tax assets is the enacted tax rate(s) expected to apply to taxable income in the years that the liability is expected to be settled or the asset recovered. Measurements are based on elections (for example, an election for loss carryforward instead of carryback) that are expected to be made for tax purposes in future years. Presently enacted changes in tax laws and rates that become effective for a particular future year or years must be considered when determining the tax rate to apply to temporary differences reversing in that year or years. Tax laws and rates for the current year are used if no changes have been enacted for future years. An asset for deductible temporary differences that are expected to be realized in future years through carryback of a future loss to the current or a prior year (or a liability for taxable temporary differences that are expected to reduce the refund claimed for the carryback of a future loss to the current or a prior year) is measured using tax laws and rates for the current or a prior year, that is, the year for which a refund is expected to be realized based on loss carryback provisions of the tax law.

ASC 740-10-55-24 provides:

Deferred tax liabilities and assets are measured using enacted tax rates applicable to capital gains, ordinary income, and so forth, based on the expected type of taxable or deductible amounts in future years. For example, evidence based on all facts and circumstances should determine whether an investor’s liability for the tax consequences of temporary differences related to its equity in the earnings of an investee should be measured using enacted tax rates applicable to a capital gain or a dividend. Computation of a deferred tax liability for undistributed earnings based on dividends should also reflect any related dividends received, deductions or foreign tax credits, and taxes that would be withheld from the dividend.

Thus, in order to calculate or measure the tax effects of a book-over-tax outside basis difference, a realistic and reasonable expectation as to the time and manner in which such a difference is expected to be recovered must be determined.

The appropriate amount of tax that should be recorded for the outside basis differences of domestic subsidiaries will need to be identified if the tax-free recovery assertion in ASC 740-30-25-7 cannot be made.

When unremitted earnings of foreign subsidiaries do not meet the indefinite reversal criteria and when foreign equity investees exist, the effects of reversal on the parent company’s deferred tax computations include the potential gross-up and related credit for foreign taxes that are deemed paid. The effects of reversal also include any foreign withholding taxes and the related parent company’s tax deduction or credit when repatriation is expected by dividends. Differences between tax accumulated earnings and profits (E&P) and U.S. GAAP unremitted earnings may merit consideration, as these differences would affect the measurement of taxes due upon remittance. For example, E&P may include earnings of a purchased subsidiary prior to its acquisition, and would therefore affect the amount of any potential distribution that would be considered a taxable dividend (as opposed to a return of capital or a distribution in excess of the parent’s tax basis in the subsidiary).

Moreover, in estimating whether foreign taxes will be deducted or credited in the reversal years, it may be necessary to project the following: (1) foreign taxes that will be paid on branch income or subpart F income, resulting either from reversals or from future taxable income other than reversals; (2) dividends that will be received from future earnings of the same or other foreign subsidiaries; (3) the related deemed-paid credits that would be available; (4) the source of the income (i.e., whether it is sourced in the United States or a foreign country) and its effects on the foreign tax credit computations; and (5) whether the proximate years available for carryback and carryforward will be “excess credit” or “excess limitation” years.

In addition, some jurisdictions apply a different tax rate to distributed earnings than they do to undistributed earnings. As a result, the applicable tax rate will depend on whether the indefinite reversal criteria have been asserted and met and whether it will affect the related foreign tax credit calculations. (See ASC 740-10-25-39 through 25-41 and Section TX 4.2.4.2.)

Foreign tax credit calculations can be extremely complex. Taxes provided must reflect the expected form of repatriation (e.g., dividend, sale or liquidation, or loan to the parent), the particular tax characterization that the expected form of repatriation will attract (ordinary versus capital gain), and the extent to which deemed-paid foreign tax credits are available. As a result, the amount of the deferred tax liability can vary considerably, depending on the repatriation scenario. Considerations similar to those discussed in the final paragraphs of this section may be appropriate with respect to nonsubsidiary investees. All estimates and calculations must be reflected in the applicable rate that is applied to the taxable temporary difference.

In addition, deferred taxes must be provided with respect to unremitted earnings of nonsubsidiary and non-joint venture investees that are carried on the equity method (for further discussion on equity method investees, see Section TX 11.1.10.5). In fact, the entire outside basis difference in such an investee is included in the deferred tax computation. The deferred tax, when provided for such reversals, is generally the estimated incremental effect on future taxes payable (except when graduated rates are a significant factor). For the unremitted earnings of an equity-method investee, the pattern and type of future taxable income should be based on the expected method of realization (i.e., dividends or sale). If the dividend assumption is inappropriate, the investor may have to assume ultimate realization through sale of the investment. When measuring the related deferred taxes, consideration will need to be given to the expected character of the gain or loss on disposal. This may result in deductible temporary differences and loss carryforwards of a capital nature that are not realizable without sufficient sources of capital gain income. For further discussion regarding the factors to be considered in assessing the expected method of realization, refer to Example 11-6.

Whether the investor has control of the investee must also be considered. For example, a tax-planning action may exist that could be employed to achieve a lower tax. However, such an action may be limited because the investor does not control the investee.

In any analysis of the form of realization, consideration should be given to whether the investor’s recorded share of investee earnings represents accumulated earnings and profits of the investee for tax purposes (and which, if remitted, would be treated as dividends for tax purposes) or amortization of the investor’s cost difference. The dividend rate would be appropriate only in relation to the underlying E&P of the investee (this could include E&P accumulated prior to the investor’s purchase), adjusted to accommodate investee timing differences for changes in E&P that will result from reversals of the timing differences prior to the distributions. If there is a difference between investor’s cost and underlying equity, this difference will be amortized by the investor. To the extent that such amortization represents eventual capital gain, investor taxes should be provided, assuming capital gain treatment. To the extent that amortization represents an ultimate reduction in capital gain or an increase in capital loss, it is possible that a benefit should be recognized. If investor taxes are being provided on underlying earnings, assuming capital gain treatment, reduction of such taxes to reflect accumulated amortization of excess investor cost would be appropriate. Recognition of the benefits of capital loss is appropriate only if offset against capital gains meets the more-likely-than-not criterion. Circumstances could arise in which it is appropriate to apply the dividend rate to the entire amount of underlying earnings, without recognizing any tax benefit on amortization of excess investor cost, because application of the dividend rate would result in capital loss, the tax benefit of which is more-likely-than-not to expire unused.

Example 11-6: Measurement of a Deferred Tax Liability Related to the Excess Book-Over-Tax Outside Basis in an Equity Method Investment

Background/Facts:

Company A owns 30 percent of the outstanding stock of Company B and accounts for the investment under the equity method. Company A and B are in the same country. Company A’s investment in Company B has an excess book-over-tax basis that is attributable to unremitted earnings.

In the jurisdiction in which Company A and B operate, dividends can be distributed tax-free to a corporate investor that has more than 25 percent ownership. However, a capital gains tax is levied upon disposal of stock investments.

Because Company B is an integral part of Company A’s overall business by supporting its supply chain, Company A has no plan to sell its stock investment in Company B in the foreseeable future. Although Company A has the ability to exercise significant influence over operating and financial policies of Company B, it does not have the ability to require Company B to pay dividends.

Question:

Should Company A measure the deferred tax liability related to the excess book-over-tax outside basis in Company B based on a disposal or a dividend assumption? Can the assumption change as circumstances change?

Analysis/Conclusion:

ASC 740-10-55-24 states that deferred taxes should be measured using the enacted tax rates applicable to capital gains, ordinary income, and so forth, based on the expected type of taxable or deductible amounts in future years. It also indicates that all facts and circumstances should determine whether an investor’s liability for the tax consequences of temporary differences related to its equity in the earnings of an investee should be measured using enacted tax rates applicable to a capital gain or a dividend. That is, the temporary difference reversal assumption should be based upon a neutral assessment of the relevant facts and expectations rather than on an accounting policy presumption. The assumption should be based upon the most likely manner of recovery at each reporting period and may change (with resulting remeasurement of current or deferred taxes) as circumstances change.

In addition to other situation-specific factors, in assessing the facts and expectations, consideration should generally be given to:

Investee’s history of paying dividends (from accumulated earnings)

Investor’s (and/or investee’s) ability to control or influence dividend payments

Investor’s intentions for the investment and any history of disposing of comparable investments

Other significant shareholders with an ability or influence to either force a disposal of the investment or dividend payments

Investee’s (and/or investor’s) liquidity and capital requirements

Legal considerations and the availability of market disposal options

Tax planning opportunities that would influence the disposal structure/consequences

Whether the investment represents an integral component of the investor’s overall business or long-term strategic plans

For example, if Company B has paid dividends in excess of current year earnings in the past and that practice is expected to continue in the future, it may be appropriate to assume that the basis difference will reverse through dividend distributions. Accordingly, it may be appropriate for Company A not to record a deferred tax liability as dividends would be tax-free in the jurisdiction in which it operates.

However, if Company B has not paid dividends, or has always paid dividends only from current year earnings, and there is no indication that the practice will change in the future, it may be appropriate to assume that the basis difference will reverse through a disposal. In that case, Company A would measure the deferred tax liability at the capital gains rate even though it has no intention of disposing the Company B stock in the foreseeable future.

As facts and expectations change, evidence may accumulate over time supporting a shift from a dividend to disposal assumption or vice-versa. Disclosure of the reversal assumption along with the possibility of near-term changes which could have a significant accounting or liquidity impact may be appropriate.

11.1.8 Potential Deferred Tax Assets on Subsidiaries, Corporate Joint Ventures, and Equity Investees (Foreign and Domestic)

11.1.8.1 In General

Where outside tax basis exceeds outside book basis in an investment in a subsidiary or corporate joint venture that is essentially permanent in duration, there may be a deductible temporary difference that justifies the recognition of a deferred tax asset. Under ASC 740-30-25-9, the future tax benefit is recognized “only if it is apparent that the temporary difference will reverse in the foreseeable future.” The “foreseeable future” as used in ASC 740-30-25-9, contradicts the indefinite reversal criteria of ASC 740-30-25-17, because the reversal of the excess outside tax basis would be definitely planned, and not indefinitely deferred.

Note that ASC 740-30-25-9 does not apply to foreign or domestic unconsolidated investees (except for corporate joint ventures). Therefore, the outside tax-over-book basis for such an investment should generally result in a deferred tax asset (which is subject to a valuation allowance assessment). Based on ASC 740-10-55-24, measurement would depend on expectations of how the investment will ultimately be realized (e.g., through sale or liquidation). If an entity expects to ultimately realize the investment through sale at a loss, the deferred tax asset should be measured based on capital loss rates. If, however, an entity expects to recognize the investment through sale at a gain (but a higher book than tax gain because of the excess outside tax basis), measurement at ordinary rates is appropriate. The expectation must be reasonable and supportable.

Realization of the excess outside tax basis may be predicated upon sale of the subsidiary. But, as confirmed by ASC 740-30-25-10, there could be circumstances in which the tax benefit can be recognized prior to meeting the criteria of ASC 360-10-45-9 as “held for sale.” The held-for-sale date is the date on which the pretax gain or loss from disposal should be estimated and a component should be reclassified as a discontinued operation. We believe that, in most cases, the held-for-sale date will be the date on which it becomes apparent that disposition will occur in the foreseeable future. Certain assets to be disposed of do not qualify as a component under ASC 360. If the disposal of such assets involves the realization of a higher outside tax basis, we believe that, in most cases, the tax benefit of the higher outside basis should be recognized when the “held for sale” conditions of ASC 360-10-45-9, are met.


If there is a change in intention or fact that would cause a deferred tax asset to be recorded under ASC 740-30-25-9, such an asset should be treated as a discrete item in the interim period during which the change in intention or circumstances occurs.

It should be noted that the generation of future profits does not constitute “reversal” of an excess tax outside basis difference. ASC 740-1-25-20 defines a deductible temporary difference as a temporary difference that results in deductible amounts in future years when the related asset or liability is recovered or settled, respectively. Thus, “reversal” of a deductible temporary difference provides a tax deduction when the related asset is recovered. Future earnings will neither recover the related asset (i.e., the investment in the subsidiary or corporate joint venture that is essentially permanent in duration) nor result in a tax deduction or benefit in the parent’s tax return; rather, the book basis of parent’s investment in the subsidiary or corporate joint venture will increase and the tax basis in the investment will remain unchanged.

Example 11-7: When to Recognize a Tax Benefit for a Worthless Stock Deduction

Background/Facts:

Company A, a U.S. corporation, has a wholly-owned foreign subsidiary (FS). At December 31, 20X1, Company A had zero book basis in FS due to significant prior year losses and $100 million tax basis in the FS stock. During Q4 of 20X1, there have been ongoing discussions about the viability of FS’s continued business plans leading to a decision to cease operations and liquidate FS. It was expected that the liquidation of FS would be consummated within the next year. In Q1 20X2, Company A made a “Check-the-Box” (CTB) election to treat FS as a disregarded entity retroactively effective on the last day of its 20X1 tax return. The CTB election resulted in a deemed liquidation of FS for U.S. federal income tax purposes, leading Company A to claim its $100 million tax basis in FS as a worthless stock deduction on the 20X1 tax return. The CTB election has no other U.S. or foreign tax implications and FS has no inside basis temporary differences. At December 31, 20X1, management concluded that without the CTB election (or other process of liquidation), Company A would not have met the more-likely-than-not recognition threshold to record the tax benefit from the worthless stock deduction.

Question:

When should Company A recognize the tax benefit from the worthless stock deduction (i.e., Q4 20X1 or Q1 20X2)?

Analysis/Conclusion:

The tax effects of an excess tax-over-book basis in the stock of a subsidiary should be recognized when it becomes apparent that the temporary difference will reverse in the foreseeable future. In the context of a worthless stock deduction, this criterion would generally be met in the earliest period in which the investment is considered “worthless” for federal income tax purposes. There are various measures used to make this determination and there are certain identifying events that confirm stock worthlessness including a bankruptcy, court-appointed receiver, and liquidation. As a result, if such an identifiable event is required in order to recognize a tax benefit under ASC 740-10-25-6, the ability of the company to control the occurrence of that event must be considered. The relevant question is therefore whether Company A would have concluded that, based on available information as of December 31, 20X1, the FS stock was otherwise considered worthless and they could presume completion of the “confirming” event. If the stock was otherwise considered worthless as of December 31, 20X1, the mere fact that the CTB election was filed in a subsequent period should not change the timing of when the benefit is recognized. Absent regulatory or/and contractual restrictions, the liquidation of FS via a CTB election would be considered primarily within Company A’s control.

The filing date of the CTB election and the selected effective date are not determinative if the stock was otherwise considered worthless as of December 31, 20X1, and the company expected to complete all relevant administrative procedures shortly thereafter. If the company had selected an effective date in 20X2, it would still not change the fact that as of December 31, 20X1, it was apparent that the excess tax basis would reverse (i.e., become deductible) within the next year.

Note: The tax effect of a worthless stock deduction should be accounted for discretely in the interim reporting period when it becomes apparent that the temporary difference will reverse in the foreseeable future. There might also be other accounting consequences in these circumstances, such as deferred tax effects resulting from the change in tax status.

11.1.8.2 Recognition of Deferred Tax Assets on Foreign Tax Credits Prior to Meeting the Establishing Criteria under Tax Law

In general, we believe that ASC 740 supports recognition of foreign tax credits (FTCs) as deferred tax assets only when such tax attributes have been generated and can be claimed on a U.S. tax return (i.e., the related carryforward provisions have begun). In other words, a deferred tax asset should not be recognized for FTCs that currently do not exist, but will be generated by the reversal of a taxable temporary difference (often referred to as “unborn FTCs”). One exception to this concept is with regard to FTCs that can be recognized as deferred tax assets if all of the conditions except for the actual repatriation of cash have been met to create the credits. Even in this case, we believe that an entity must be able to assert that it has met the condition for apparent reversal in the foreseeable future prior to its recognition, as stipulated in ASC 740-30-25-9 (e.g., the entity is committed to making the repatriation in the near term). Only then should an entity record and analyze for realizability the deferred tax asset related to the entire FTC, including any portion of the FTC that has been carried forward and could be utilized in future years, as long as its future realization is not dependent on past or future items (e.g., undistributed earnings) for which a deferred tax liability has not been or will not be recorded.

In certain jurisdictions such as the United States, a dividend from a foreign subsidiary may carry with it a deemed-paid foreign tax credit that, in general, is only available if the subsidiary has accumulated earnings and profits from which it can pay a dividend. This leads to a common question: Can a deferred tax asset be recorded by the parent company for foreign taxes that have already been paid by the foreign subsidiary but, because of a current deficit in accumulated earnings and profits, would not give rise to a deemed-paid foreign tax credit unless (or until) the foreign subsidiary generates future earnings and profits in excess of the current deficit and makes a distribution? In this circumstance, we believe that a deferred tax asset should not be recorded until a distribution from the subsidiary would represent the repatriation of accumulated E&P (i.e., the point at which a distribution, if made, would qualify for the deemed-paid credit).

Example 11-8: Recognition of Deferred Tax Assets on Foreign Tax Credits Before the Establishing Criteria under Tax Law Have Been Met

Background/Facts:

At the end of year 1, a recently acquired subsidiary has taxable profits for local tax purposes, but a deficit in earnings and profits (E&P) for U.S. income tax purposes. This deficit is due primarily to amortizable goodwill for U.S. tax purposes; however, no such goodwill exists for local tax purposes and the subsidiary has paid foreign taxes. The parent believes that the subsidiary will most likely continue to be profitable on a local tax basis and that, over the next few years, the E&P will turn positive and foreign tax credits (FTCs) will be able to be generated in the parent company’s U.S. tax return. However, thus far, the cash distributions from the subsidiary to the parent have been deemed a return of capital, and not dividends, because of the deficit in E&P.

Assume that the following facts are true:


Question:

Can a deferred tax asset be recorded at the end of year 1 for future FTCs ($600 in this example) if it is probable that the deficit in E&P will reverse and that the FTCs will eventually be generated when future dividends are paid?

Analysis/Conclusion:

No. The deferred tax asset should not be recorded until at least one dollar of potential cash distributions represents repatriation of cumulative E&P (i.e., until potential cash distributions are dividends and not return of capital). Because the U.S. tax benefit from the foreign taxes is predicated on future events (i.e., the creation of positive E&P from future profits), it does not meet the general criteria of an asset under CON 6, par. 25 and 26.

Rather, in this example, the U.S. tax benefit related to the foreign tax paid can be reflected in year 2 once the subsidiary has generated positive E&P and the parent plans to repatriate the excess cash from the subsidiary. Assuming that there is no other foreign-source income in year 2, the FTC calculation in the U.S. tax return will result in excess FTCs, which can be used to offset U.S. tax on other foreign-source income in future years. The piece of the FTC that has been carried forward should be calculated as follows:


The excess FTC benefit would constitute a deferred tax asset at the end of year 2 and would be evaluated for realization under ASC 740 at that time.

11.1.9 Partnerships and Other Flow-Through Entities

We believe that deferred taxes related to an investment in a foreign or domestic partnership (and other flow-through entities that are taxed as partnerships, such as multi-member LLCs) should be measured based on the difference between the financial statement amount of the investment and its tax basis (i.e., its outside basis difference). Deferred taxes are not based on book/tax-basis differences within the partnership because those differences are inherent in the outside basis difference. This is the case regardless of whether the book investment in the partnership is accounted for using the cost, or equity method, consolidated or pro-rata consolidated. The deferred taxes should be based on the tax consequences associated with the partner’s expected method of recovering its book investment in the partnership. Furthermore, if an entity is treated as a partnership or other pass-through entity by its parent for tax purposes, the parent cannot utilize the indefinite reversal exception in ASC 740-30-25-17 to avoid recording a deferred tax liability on the outside basis difference. (As discussed in Section TX 11.6.1, however, the parent can have an accounting policy that permits an indefinite reversal assertion to be made with respect to a foreign branch CTA account in cases where taxation of foreign currency gains or losses occur only upon repatriation).

We are aware, however, that certain exceptions to the general guidance have been made in practice. Specifically, different views exist regarding if and when deferred taxes should be provided on the portion of an outside basis difference attributable to nondeductible goodwill. For example, assume that an entity contributes to a partnership the net assets of one of its subsidiaries and that those assets include nondeductible goodwill. Some believe that deferred taxes should be recognized on the entire outside basis difference, including the portion attributable to nondeductible goodwill inherent to the underlying investment, while others believe that the portion of the outside basis attributable to nondeductible goodwill should be excluded from the outside basis difference for which a deferred tax liability is recorded. Still others believe that the exception should be limited to situations in which the investment in a partnership is controlled and therefore consolidated by the investor entity. We would not object to any of these practices provided that, whichever one is chosen, the entity follows it consistently for all partnership investments.

Moreover, an examination of outside basis through its component parts should not be limited to nondeductible goodwill alone. There are other exceptions to the comprehensive model of recognition such as the indefinite reversal exception in ASC 740-30-25-17 that might be applied with regard to a foreign subsidiary owned by the partnership. We believe that an entity must adopt a consistent policy to (1) look through the outside basis of the partnership and exclude it from the computation of deferred taxes on all underlying items for which ASC 740 provides an exception to its comprehensive model of recognition or (2) not look through the outside basis of the partnership and record deferred taxes based on the entire difference between the book and tax bases of its investment. As noted above, we do not object to either practice. However, we expect entities to choose one practice and apply that practice consistently to all flow-through entities.

Example 11-9: Establishing Deferred Taxes on a Partnership Investment for Which Part of the Outside Basis Difference Is Attributable to Nondeductible Goodwill

Background/Facts:

Suppose Company X effectively owns 100 percent of a domestic partnership, Partnership P, which is a flow-through entity for tax purposes. Partnership P is also a reporting unit to which the company allocated nondeductible goodwill pursuant to ASC 350, Intangibles-Goodwill and Other. The allocation of nondeductible goodwill increases Company X’s investment in Partnership P for book but not for tax purposes and creates an outside basis difference.

It is Company X’s policy not to provide deferred taxes on the portion of outside basis difference attributable to nondeductible goodwill. Company X intends to dispose of its investment in Partnership P and classifies it as held for sale. Company X anticipates that the sale will result in a taxable gain in excess of the book gain, due largely to the nondeductible goodwill that is inherent in the outside basis difference.

Question:

Should Company X provide deferred taxes on the outside basis difference attributable to the nondeductible goodwill when it first decides to dispose of Partnership P, or should Company X allow the disproportionate tax effect of not recording the deferred taxes on the full outside basis to be reflected at the time of the actual disposition?

Analysis/Conclusion:

We believe that, because Company X adopted a policy to look through its outside basis difference in a partnership and not provide deferred taxes on the portion related to nondeductible goodwill, Company X should not provide taxes on the outside basis difference and should reflect a disproportionate tax effect in the period of the actual disposal. It should be noted that, if deferred taxes had not been recorded on portions of the outside basis difference of Partnership P for other reasons (e.g., the indefinite reversal exception under ASC 740-30-25-17 related to the partnership’s investment in a foreign subsidiary), Company X would be required to provide deferred taxes once the relevant assertion could no longer be relied upon (e.g., at the held-for-sale date).

With respect to potential deferred tax assets in outside basis differences associated with a partnership, questions will arise as to whether the guidance in ASC 740-30-25-9, should be applied. This guidance prohibits the recognition of a deferred tax asset for an investment in a subsidiary or corporate joint venture, unless it is apparent that the temporary difference will reverse in the foreseeable future.

Because partnerships are not taxable entities and their tax consequences “flow-through” to the investors, the guidance in ASC 740-30-25-9 does not directly apply. However, in situations where the investor entity has control, it may be appropriate to consider this guidance by analogy.

For example, if all or a portion of the outside excess tax basis in the partnership is expected to be realized only through sale of the investment, it may not be appropriate to recognize the related deferred tax asset until a sale is contemplated in the foreseeable future. In addition, when assessing the realizability of a deferred tax asset related to an investment in a partnership, it is important to remember that the deferred tax asset represents a tax loss that is often capital in nature. Under existing U.S. tax law, future taxable income of a similar nature (i.e., capital gains) will be necessary to realize the capital loss that underlies the deferred tax asset.

11.1.10 Other Issues Related to Accounting for Outside Basis Differences

11.1.10.1 Considerations Related to Variable Interest Entities

The impact of a consolidated variable interest entity (VIE) under ASC 810 on the accounting for income taxes must be evaluated in each individual circumstance. The ASC Master Glossary defines subsidiary as “an entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as its parent, holds a controlling financial interest. (Also, a variable interest entity that is consolidated by a primary beneficiary.) [ARB 51, paragraph B1].” Hence, we believe that the income tax accounting guidance for subsidiaries applies to consolidated VIEs.

In assessing the accounting for outside basis differences of a consolidated VIE, we believe that control will be a significant factor in the analysis. Control as used in this context implies the right to control distributions or other transactions that would otherwise cause a taxable event to occur. When considering whether a deferred tax liability is required under either ASC 740-30-25-18 or ASC 740-30-25-7, we believe that an entity must be able to control distributions or other transactions that would otherwise cause a taxable event to occur in order to assert indefinite reversal. This is based on our belief that the underlying rationale for the indefinite reversal exception in ASC 740-30-25-17 is an entity’s ability and intent to control the timing of the events that cause basis differences to reverse and result in taxable amounts in fu-ture years.

Further, we understand that the restriction in ASC 740-30-25-9 regarding the recognition of deferred tax assets was included to bring some form of parity to the exceptions provided in ASC 740-30-25-18(a) and ASC 740-30-25-7 for recognition of deferred tax liabilities. Therefore, we believe it is appropriate to apply a similar thought process when considering whether the exception to recognizing deferred tax assets in ASC 740-30-25-9 applies (i.e., the entity must have the ability to control the timing of the events that cause the temporary difference to reverse in a taxable manner).

11.1.10.2 Changes from Investee to Subsidiary and from Subsidiary to Investee


Because deferred tax assets and liabilities must be recorded for outside basis differences of investees and often will not be provided for outside basis differences of subsidiaries, determining whether a change in an investment from an investee to a subsidiary (or vice versa) will give rise to an adjustment to deferred tax assets and liabilities generally depends on whether the outside basis difference relates to a foreign or domestic entity. The change from investee to subsidiary (or vice versa) can result from the investor/parent’s purchase or sale of stock held by other investors, as well as the investee/subsidiary’s transactions in its own shares.

Guidance for investments in foreign entities is provided in ASC 740-30-25-15 through 25-16.

Change from investee to foreign subsidiary

In general, ASC 740-30-25-16 requires that the deferred tax liability provided for unremitted earnings of a prior investee that becomes a foreign subsidiary is frozen, regardless of whether the investment currently meets the indefinite reversal criteria. The frozen deferred tax liability would not be reversed until (1) dividends from the subsidiary exceed the parent’s share of the subsidiary’s earnings subsequent to the date on which it became a subsidiary or (2) the parent disposed of its interest in the subsidiary.

When an investee becomes a foreign subsidiary in a business combination achieved in stages, the acquirer’s previously held equity interest is remeasured to fair value at the date the controlling interest is acquired and a gain or loss is recognized in the income statement (ASC 805-10-25-10). The requirement to record the previously held equity interest at fair value may increase the outside basis difference. A question arises whether the additional temporary difference need also be frozen, consistent with ASC 740-30-25-16. Because of the lack of clarity in the guidance, we believe there is more than one acceptable view. One view is that the deferred tax liability for the entire outside basis difference (refer to Section TX 11.1.5.1 for meaning of “entire outside basis difference”) should be frozen until the temporary difference reverses. Alternatively, the parent investor may elect to freeze only the portion of the deferred tax liability that relates to undistributed earnings of the investee as of the date control is obtained. The approach selected is an accounting policy election that should be applied consistently from acquisition to acquisition (for further discussion, see Section TX 10.5.7).

When a deferred tax asset was previously recognized for an equity method investment, we believe the deferred tax asset should be written off unless the temporary difference is expected to reverse in the foreseeable future. If the deferred tax asset is written off, the charge should be recorded in income from continuing operations, except for any portion related to current year activity that is recorded in other comprehensive income.

Change from foreign subsidiary to investee

If a foreign subsidiary becomes an investee, ASC 740-30-25-15 indicates that the amount of outside basis difference of the foreign subsidiary for which deferred taxes were not provided on the basis of the indefinite reversal exception is effectively frozen until the indefinite reversal criteria are no longer met.

Change from domestic subsidiary to investee

We believe that ASC 740-30-25-16 is applicable only to outside basis differences to which the indefinite reversal exception applies and, therefore, is generally not available to outside basis differences in domestic entities. Thus, if deferred taxes were not provided on the taxable outside basis difference of a prior domestic subsidiary on the basis of the scenario suggested by ASC 740-30-25-7, deferred taxes generally would need to be provided on the subsidiary’s change in status to investee. We believe that the charge to recognize the deferred tax liability in these cases would be recorded in income from continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation). It is also important to remember that the charge would occur when the entity’s intentions changed and it no longer anticipated that it would be able to recover the investment tax-free. An entity may determine this well before the change in status from subsidiary to investee actually occurs.

Change from investee to domestic subsidiary

The requirement to record a pre-existing interest at fair value also applies when an investee becomes a domestic subsidiary. The effect of reversing a deferred tax asset or liability recorded by the acquirer prior to the investee becoming a domestic subsidiary of the acquirer should be reflected in income from continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation). Therefore, when an investee becomes a domestic subsidiary through a combination achieved in stages and a deferred tax liability can be released (based on the ability to recover the investment in a tax-free manner (see Section TX 11.1.4.5.1)), the corresponding credit should go to income from continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation).

If a deferred tax asset has been established for the excess outside tax basis of an investee and the investee subsequently becomes a domestic subsidiary through a combination achieved in stages, it is likely that the deferred tax asset will no longer qualify for recognition (i.e., if the temporary difference will not reverse in the foreseeable future as required in ASC 740-30-25-9). In this case, the deferred tax asset should be derecognized with the charge recorded in income from continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation).

Sometimes the scenario suggested in ASC 740-30-25-7 does not apply and the acquirer cannot release a deferred tax liability for an excess book outside basis difference in its investment in a domestic subsidiary acquired through a combination achieved in stages. In such cases, the tax effect of the corresponding change in outside-basis difference caused by the requirement to record the pre-existing equity interest at fair value should also be recorded in income from continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation).

11.1.10.3 Changes in a Parent’s Equity in the Net Assets of a Subsidiary Resulting from Transactions with the Non-Controlling Shareholders

A parent’s ownership interest in a subsidiary can change while its controlling financial interest in the subsidiary is retained. For example, the parent might buy additional interests or sell interests in the subsidiary and/or the subsidiary might reacquire some of its ownership interest or issue additional ownership interest. Under ASC 810-10-65-1, these events are considered equity transactions. Accordingly, the difference between the fair value of the consideration received or paid and the amount by which the noncontrolling interest is adjusted is recognized in equity attributable to the parent. A further discussion on these transactions and the tax accounting consequences is included in Section TX 10.8.

11.1.10.4 Tax-to-Tax (Inside Versus Outside) Tax Basis Differences

In addition to the outside basis differences and inside basis differences discussed above, differences may exist between the tax basis of the capital stock of a subsidiary (i.e., the parent’s tax basis in the shares of the subsidiary) and the subsidiary’s tax basis in the underlying individual net assets. These differences are generally referred to as “tax-to-tax differences” or “inside versus outside tax-basis differences.” Such differences are not discussed in ASC 740.1 Temporary differences are differences between an asset or liability’s tax basis and the reported amount in the financial statements. Consequently, tax-to-tax differences are not temporary differences as defined by ASC 740, and recognition of a deferred tax asset for an outside tax-basis difference over an inside tax-basis difference is prohibited.

1 The FASB staff addressed tax-to-tax differences in an announcement at the March 1993 EITF meeting. The staff indicated that recognition of deferred tax assets is only permitted for deductible temporary differences and carryforward amounts.

11.1.10.5 Equity Method Investees

Investments accounted for under the equity method for financial reporting purposes, pursuant to ASC 323, The Equity Method of Accounting for Investments in Common Stock, are generally accounted for under the cost method for tax purposes. As a result, a temporary difference arises related to the outside basis difference in the investment. Deferred taxes should be provided for this outside basis temporary difference as discussed in Section TX 11.1.4.4, Section 11.1.7 and Section TX 11.1.8.

The outside basis difference is calculated by comparing the tax basis of the stock to the book basis of the investment. While determining the tax basis (i.e., cost) of the stock is generally straightforward, complexities often arise when applying the equity method to determine the book basis. Under the equity method, the investor is required to allocate its cost of the investment to the individual assets and liabilities of the investee, similar to the purchase price allocation process required for business combinations. This allocation process includes consideration of incremental deferred tax assets and liabilities (on the investee’s books) for differences between the allocated values (that reflect the investor’s cost) and the carrying amounts in the investee’s financial statements. ARM 1163.441 provides further guidance on this allocation process and determining the underlying equity in the net assets of the investee.

11.2 Certain Bad Debt Reserves for U.S. S&L Associations



Prior to ASC 740, a deferred tax liability was not recognized for bad debt reserves for U.S. S&L associations (and other qualified thrift lenders) that arose in tax years beginning before December 31, 1987 (i.e., the base-year amount). ASC 740 continues the exception for this taxable temporary difference (ASC 740-10-25-3(a)(3)), but prospectively requires a deferred tax liability for amounts arising in tax years beginning after December 31, 1987 (ASC 942-740-25-1 through 25-3).

There are two key tax-related questions on this topic: (1) What is the base-year bad debt reserve of U.S. S&L associations (and other qualified thrift lenders)? (2) How are deferred taxes calculated for amounts that are in excess of the base-year amount?

The base-year tax reserve is the bad debt reserve for income tax purposes that arose in tax years beginning before 1988. The base-year tax reserve includes the balances of the nonqualifying, qualifying, and supplemental bad debt reserves as of the end of the tax year beginning before 1988. The excess at the balance sheet date of a tax bad debt reserve over the base-year reserve is a taxable temporary difference for which a deferred tax liability must be provided. If the tax bad debt reserve falls below the base-year reserve, the amount of that reduction constitutes taxable income, and the entity would need to increase its current taxes payable for the tax effect of that amount. Subsequent increases in the reserve, up to the base-year amount, are not taxable temporary differences (to the extent that such restorations of the base-year amount are permitted under the tax law).

The entire balance of the bad debt reserves for financial reporting purposes are considered future deductible temporary differences for which deferred tax assets are recognized, subject to an assessment of the need for a valuation allowance. The tax benefit of the deductible temporary difference (i.e., the entire book bad debt reserve) would be subject to a realization test, as would any other deferred tax asset.


Example 11-10: Accounting for Income Tax Benefits from Bad Debts of a Savings and Loan Association

Assume that the following information is true as of December 31, 20X7:


At December 31, 20X7, the taxable temporary difference would be $1,000 (a tax bad debt reserve of $3,000 less a base-year reserve of $2,000).

If, as of December 31, 20X8, the tax bad debt reserve were to fall to $2,000, there would be no remaining taxable temporary difference because the tax bad debt reserve would equal the base-year reserve.

If, as of December 31, 20X9, the tax bad debt reserve were to fall further to $1,500, the current tax liability (payable) would increase, but there would be no deferred tax liability because the tax bad debt reserve would be less than the base-year reserve.

11.3 Policyholders’ Surplus Account of Stock Life Insurance Companies


The Life Insurance Company Tax Act of 1959 allowed stock life insurance companies to defer a portion of their income in a tax-memorandum account called the Policyholders’ Surplus Account (PSA). The accumulated deferred income was subject to tax only if the amounts were deemed to be distributed from the PSA or if certain stipulated maximums were exceeded. The Deficit Reduction Act of 1984 repealed the provisions that allowed the deferral of income, but left intact the provisions that subjected deductions from the PSA to income tax.

In general, amounts in the PSA are subject to income tax in the following circumstances:

Distributions to shareholders are deemed to come from the PSA.

Amounts are subtracted from the PSA pursuant to a special election by the taxpayer.

The balance in the PSA exceeds a prescribed limit.

The entity ceases activity as an insurance entity for one year or as a life insurance entity for two consecutive years.

The American Jobs Creation Act of 2004 suspended the rules imposing tax on distributions to shareholders from the PSA. The Act also changed the order in which distributions are deemed to have occurred: Distributions are first paid out from the PSA, then from the shareholders’ surplus account (SSA), and finally from other accounts. These changes apply to tax years beginning in 2005 and 2006 only.

Pursuant to ASC 740-10-25-3(a)(4), deferred taxes do not need to be provided on the PSA balance unless it becomes apparent that those temporary differences will reverse in the foreseeable future.

11.4 Deposits in Statutory Reserve Funds by U.S. Steamship Entities

ASC 995-740 provides that specific taxable temporary differences related to U.S. steamship entities may be exempted from the requirement for recognition of deferred income taxes on all temporary differences. Specifically, ASC 995-740-25-2 prescribes the treatment under ASC 740 of temporary differences related to deposits in statutory reserve funds of U.S. steamship entities that were not previously tax-effected. ASC 995-740-25-2 states, “The tax effects of temporary differences related to deposits in statutory reserve funds by U.S. steamship entities that arose in fiscal years beginning on or before December 15, 1992 and that were not previously recognized shall be recognized when those temporary differences reverse.”

11.5 Tax Effects of Changes in Foreign Exchange Rate

11.5.1 Translation of Foreign Deferred Taxes

Deferred foreign income taxes are translated at current rates under ASC 830, Foreign Currency Matters, regardless of an entity’s functional currency.

11.5.2 Transaction Gains and Losses

Gains and losses from foreign currency transactions will generally be taxable (deductible), either in the U.S. or in a foreign country. If these gains and losses are included in taxable income in a period that differs from the one in which they are included in income for financial reporting purposes, ASC 830-20-05-3, requires deferred tax accounting in accordance with ASC 740.

11.5.3 Translation Adjustments on Outside Basis Differences

Translation adjustments for subsidiaries are part of the outside basis temporary difference related to the parent’s investment in the subsidiary. These adjustments, in general, reflect the gains and losses associated with the translation of a foreign subsidiary’s financial statements from its functional currency into the reporting currency. ASC 830-30-45-21, states that deferred taxes shall not be provided on translation adjustments when deferred taxes are not provided on unremitted earnings under the indefinite reversal exception discussed in ASC 740-30-25-17. However, if deferred taxes are not provided on unremitted earnings because it is expected that their repatriation will result in no additional U.S. tax because of foreign tax credits, it may still be necessary to provide for deferred tax on translation adjustments if the indefinite reversal criteria are not met and if realization would not constitute foreign source income or would not generate foreign tax credits.

When determining whether to tax effect translation adjustments, the following points should be considered:

1. The need for tax-effecting is first determined on a foreign-operation-by-foreign-operation basis. Hence, it may be appropriate to tax-effect translation adjustments of only certain foreign operations. (Note that while the need is determined on an operation-by-operation basis, operations will often be aggregated by tax jurisdiction for tax-planning and computational purposes.)

2. Even though all local currency net assets (represented by total capital and retained earnings) affect the translation adjustment, the portion of the translation adjustment tax-effected within an operation identified in consideration 1 above should be directly related to the portion of equity (including capital and retained earnings) that is expected to be remitted. For example, if return of capital is not expected, but all retained earnings will be remitted, it may be appropriate to tax-effect only the portion of the translation adjustment related to retained earnings. If a return of both capital and retained earnings is contemplated, it may be appropriate to consider whether the capital portion is likely to be taxed as a capital gain and will not trigger any foreign tax credits as no local taxes would typically have been paid with respect to the currency effects.

3. It is necessary to consider whether the translation adjustments will result in ordinary or capital gain or loss. Different tax rates may apply, and the assessment of whether realization is more-likely-than-not may be affected. Further, the extent to which foreign tax credits can be applied in the calculation will need to be considered.

4. For a discussion on the treatment of translation adjustments related to branches see Section TX 11.6.1.

11.5.4 Hedging

11.5.4.1 Hedging an Investment in a Foreign Subsidiary

A parent company may enter into a transaction that qualifies as a hedge of its net investment in a foreign subsidiary. Any gains or losses associated with this hedge are recognized in the cumulative translation adjustments (CTA) account. Consistent with the treatment of gains and losses associated with the hedging transaction, the tax effects of temporary differences created by this hedging transaction generally are credited or charged to CTA under ASC 830-30-45-21 and ASC 740-20-45-11(b). If the indefinite reversal exception in ASC 740-30-25-17 applies, the parent would not need to provide for deferred taxes related to CTA. However, in such instances, the entity should provide for the tax effects of any temporary differences resulting from the hedging transaction because the associated tax consequences are not indefinitely deferred (i.e., the instrument used to hedge will have tax consequences upon its settlement). In such situations, a deferred tax asset or liability would be recognized on any gains or losses associated with the hedge, with corresponding entries for CTA. Upon settlement of the hedge, the deferred taxes would be reversed to offset the current taxes associated with the settlement. The net tax effects of the hedge would remain in CTA until the investment in the foreign entity was sold or completely, or substantially, liquidated.

11.5.4.2 Hedging a Deferred Tax Balance

An entity may have a foreign subsidiary that hedges the foreign currency risks associated with a deferred tax asset or liability and whose functional currency is the reporting currency. Since gains and losses on the remeasurement of the deferred tax asset or liability are recorded in the income statement, gains or losses from the hedging instrument designated as a fair value hedge of foreign currency should also be recorded in the income statement. (See ASC 815, Derivatives and Hedging, for entities that designate these hedges as cash flow hedges of foreign currency.) Within the income statement, the hedging gains or losses should be reported on the same line as the foreign currency gains or losses so that the gains or losses on the hedged item are offset by the losses or gains on the hedging instrument.

11.5.5 U.S. Dollar Functional Currency

11.5.5.1 Nonmonetary Assets and Liabilities

ASC 740’s asset and liability method determines the deferred taxes that are implicit in the balance sheet based on the assumption that assets will be recovered and liabilities will be settled at their carrying amounts. When a foreign operation uses the U.S. dollar as its functional currency, the carrying amounts of nonmonetary assets and liabilities (e.g., fixed assets) are based on U.S. dollar amounts that are derived by using historical exchange rates.

The foreign tax basis of the asset would have been initially established when the asset was acquired. That tax basis equaled the amount of foreign currency paid to acquire the asset, which was the same amount translated at the exchange rate then in effect when the asset was acquired (i.e., the historical rate) and used to arrive at the U.S. dollar carrying amount before depreciation. The foreign tax basis, especially in hyperinflationary countries, may be subject to indexing under the foreign tax law.

For any nonmonetary asset, the temporary difference for foreign tax purposes includes the following three components:

1. The difference between the foreign tax basis before any adjustment for indexing and the carrying amount in the pre-remeasurement, foreign-currency financial statements (i.e., after adjustment to U.S. accounting principles and before remeasurement into U.S. dollars)

2. The changes in tax basis, if any, resulting from indexing provisions of the foreign tax law

3. The difference arising in remeasurement (i.e., the difference between the historical-rate and current-rate translations of the U.S. dollar carrying amount)

Typically, in hyperinflationary countries, the second component listed above would partially offset the impact of the third component.

A strict application of ASC 740’s asset and liability method would require that deferred foreign taxes be provided for all three components, but ASC 740-10-25-3(f) precludes deferred taxes for the second and third components. While the effects of indexing on the tax bases are recognized in computing deferred taxes in situations where the foreign currency is the functional currency, they are not recognized for differences related to assets and liabilities that under, ASC 830-10, are remeasured from the local currency into the functional currency using historical exchange rates.

Thus, for fixed assets, when the U.S. dollar is the functional currency, deferred taxes should be computed in the foreign currency by comparing the historical book and tax bases in the foreign currency after the respective depreciation, but before any indexing for book or tax purposes. The foreign currency deferred tax is then remeasured into U.S. dollars using the current exchange rate. Any additional tax depreciation on the current return that results from indexing will reduce the current tax provision.

Example 11-11: Foreign Subsidiary with a U.S. Dollar Functional Currency

Background/Facts:

A foreign subsidiary with a U.S. dollar functional currency purchased an item of plant and equipment for 5,000 foreign currency (FC) at the start of year 1, when the exchange rate was FC5 to $1. The asset is depreciated on the straight-line basis over ten years for financial reporting purposes and over five years for tax purposes. The foreign tax law does not include indexing. The exchange rate increases to FC7 to $1 in year 3.

Question:

What portion of the temporary difference gives rise to deferred taxes?

Analysis/Conclusion:

Deferred taxes should only be provided on the difference between the FC tax basis and the FC equivalent of the U.S. dollar book basis (i.e., the FC carrying amount in U.S. GAAP before remeasurement) translated at the historical exchange rate. Consistent with ASC 740-10-25-3(f), deferred taxes should not be provided on the remaining difference that is attributable to changes in the exchange rate since the time of the asset’s acquisition (i.e., the difference between the current spot rate and the historical exchange rate at the date of the asset’s acquisition). The calculation of these temporary differences and the portion of the temporary difference that gives rise to deferred taxes is shown below:


The temporary differences recognized under ASC 740 would be tax-effected at the applicable foreign tax rate and remeasured into the functional currency at the current exchange rate.

In year 3 above, there is a total temporary difference of FC2,900. This is the difference between the tax basis of the asset and the future foreign currency revenues at the current exchange rate, which is needed to recover the functional currency book basis. The temporary difference has arisen from two sources:

The difference between U.S. GAAP depreciation in the foreign currency before remeasurement and tax depreciation. This element, which is a temporary difference of FC1,500, is recognized under ASC 740.

The change in the exchange rate that changes the foreign currency equivalent of the functional currency book basis, using the current exchange rate. In this example, it increases the temporary difference by FC1,400, (FC4,900 vs. FC3,500). This element is not recognized in the financial statements under ASC 740-10-25-3(f).

It is important to note, however, that foreign private issuers located in countries with highly inflationary economies that prepare financial statements restated for general price-level changes would record deferred taxes for temporary differences between the indexed tax-basis amount of the asset or liability and the related price-level restated amount reported in the financial statements (ASC 830-740-25-5 and ASC 830-740-30-1).

11.5.5.2 Monetary Assets and Liabilities

An entity, located and taxed in a foreign jurisdiction, and having the U.S. dollar as its functional currency, may have monetary assets and liabilities denominated in the local currency, which would likely be the currency used to prepare the income tax return in the foreign jurisdiction. While the effects of changes in the exchange rate would give rise to transaction gains or losses in the functional currency financial statements under ASC 830, the resulting change in the functional currency financial statement carrying amounts, however, generally will not result in the recognition of either current or deferred taxes in the foreign jurisdiction. This is because in such circumstances, changes in foreign exchange rates do not have tax consequences in the foreign jurisdiction and do not create basis differences between the local currency financial statement carrying amounts and the local currency tax basis.

However, such entity may have monetary assets and liabilities that are denominated in currencies other than the local currency. Perhaps the most common example would be a foreign subsidiary’s intercompany payables, denominated in U.S. dollars. If the entity will be taxed on the difference between the foreign currency amount at which the asset or liability is originally incurred and the amount at which it is ultimately settled, the temporary difference for the monetary asset or liability would be computed by comparing the book basis in the currency of the country of domicile—the carrying amount in U.S. dollars in the remeasured financial statements translated at the current exchange rate—with the tax basis in that currency. After application of the applicable rate to the temporary difference, the deferred tax so computed in the foreign currency would be translated at the current exchange rate into U.S. dollars for inclusion in the remeasured financial statements. (A deferred tax asset would, of course, be assessed as to the need for a valuation allowance.)

This procedure will cause a deferred tax asset or liability to be recognized as the exchange rate changes. When the monetary asset or liability is denominated in U.S. dollars, changes in the exchange rate between the U.S. dollar and the foreign currency will give rise to a deferred tax effect, even though there is no pretax exchange-rate gain or loss in the remeasured financial statements. In some jurisdictions, changes in the exchange rate would have current tax consequences, as illustrated in the following example.

Example 11-12: Foreign Subsidiary with a U.S. Dollar Functional Currency and Unrealized Foreign Exchange Gains/Losses on Intercompany Loans

Background/Facts:

Company P is a multinational company domiciled in the U.S. with a wholly owned subsidiary (“Sub”) in Country B. Company P prepares U.S. GAAP consolidated financial statements. The reporting currency (RC) is the U.S. dollar (“USD”). Sub has concluded that its functional currency (FC) is also the USD, pursuant to ASC 830, Foreign Currency Matters. Since Sub maintains its books and records in USD, there is no remeasurement from local currency into USD for financial statement purposes. Under the provisions of the tax law in Country B, Sub must file its tax return in local currency (LC), the Euro. Sub has a USD-denominated intercompany payable to P in the amount of $30.0 million.

The tax law of Country B requires that Sub’s unrealized foreign exchange (“FX”) gains/losses be included in taxable income in the period in which they arise. It is determined that this law applies with respect to the intercompany loan. Since the intercompany loan is denominated in USD, there is no pre-tax accounting under ASC 830 for unrealized translation gains/losses at each reporting date. However, for purposes of Sub’s tax filing in LC, unrealized FX gains/losses are reported on the tax return as they occur.

Question:

Do the unrealized FX gains/losses, which are currently taxable and created upon translation of the USD-denominated intercompany loan to local currency for tax reporting purposes, result in a temporary difference under ASC 740?

Analysis/Conclusion:

No. In this fact pattern, the unrealized FX gains/losses that are currently taxable will not reverse either on a future tax return or when the liability is settled. Therefore, unrealized FX gains/losses that arise upon translation of the intercompany loan to local currency for tax reporting purposes should not be treated as a temporary difference. Rather, the effects on taxable income should be accounted for in the periods in which they arise. In addition, such tax effects should generally be included within income tax expense in continuing operations, and not as part of the cumulative translation adjustments (CTA) account in other comprehensive income (OCI). To the extent the tax effects resulting from unrealized FX gains/losses are significant, additional explanation may be needed in connection with the company’s tax rate reconciliation disclosures.

A careful understanding of the applicable tax law in the relevant jurisdiction is important in determining the accounting for the income tax effects of the unrealized FX gains/losses. In this particular fact pattern, the tax law of Country B requires that unrealized FX gains/losses be included in taxable income in the period in which they arise. In many jurisdictions, however, the law instead would require taxation of the unrealized FX gains/losses when the liability is settled. In those circumstances, a temporary difference would exist and a deferred tax asset/liability would be required for the future tax consequence of the accumulated unrealized FX effects as of each balance sheet.

11.5.6 Indexed NOLs in Highly Inflationary Economies

11.5.6.1 Switching to a Highly Inflationary Economy

In accordance with ASC 830-10-45-16, when the functional currency is the reporting currency, ASC 740-10-25-3(f) prohibits recognition of deferred tax benefits that result from indexing for tax purposes assets and liabilities that are remeasured into the reporting currency using historical exchange rates. Thus, deferred tax benefits attributable to any such indexing that occurs after the change in functional currency to the reporting currency are recognized when realized on the tax return and not before. Deferred tax benefits that were recognized for indexing before the change in functional currency to the reporting currency are eliminated when the related indexed amounts shall be realized as deductions for tax purposes. Prospectively, deferred tax assets should not be recorded for future indexation consistent with the prohibition in ASC 740-10-25-3(f).

In many instances, net operating loss (NOL) carryforwards in these jurisdictions are also indexed for inflation. The staff announcement did not explicitly address how such indexed NOLs should be treated. Should the tax benefit resulting from the indexation of existing NOLs be recorded or should it be precluded from recognition in accordance with ASC 740-10-25-3(f)? This leads to another question: Because a foreign entity’s tax return will use indexed tax bases for nonmonetary assets to calculate tax deductions that may increase the NOL upon which a deferred tax asset is reported, should the portion of the current-period loss attributable to indexing be segregated and not recognized in accordance with ASC 740-10-25-3(f)?

ASC 830-10-45-18 no longer regards deferred tax assets and liabilities as items that must be translated using historical exchange rates. Accordingly, we believe that the prohibition in ASC 740-10-25-3(f) which relates solely to assets and liabilities translated using historical exchange rates, does not apply and that the impact of indexing the NOL amount should be recognized. Further, the tax loss reported on the tax return should be used to calculate the NOL upon which a deferred tax asset is reported because the prohibition in ASC 740-10-25-3(f) relates to the direct book/tax differences, and not to the impact of indexing on the deductions used in the tax return. Also, we do not believe that it is practicable to determine the portion of prior tax losses that are attributable to indexing nonmonetary assets.

Thus, the entire amount of the indexed foreign currency NOL should be recognized as a deferred tax asset and translated using current exchange rates. Such deferred tax assets should then be evaluated for realization as required by ASC 740.

11.5.6.2 Economies That Are No Longer Highly Inflationary

When the reporting currency is the functional currency, ASC 740 does not permit the recording of deferred taxes for portions of the temporary differences that result from the remeasurement of nonmonetary items and from tax indexing. However, once ASC 830-10-45-15 has been applied, these portions become part of the temporary differences between the new functional currency book bases of nonmonetary items and their tax bases adjusted for any indexing. The temporary differences for nonmonetary items are not changed, but the ASC 740 exception for portions of the differences no longer applies. Thus, while there is no effect of the change in functional currency on the consolidated carrying amount of nonmonetary items, there is likely to be an effect on deferred taxes. ASC 830-740-45-2 requires that deferred taxes be reflected in the cumulative translation adjustments component of other comprehensive income in shareholders’ equity.

11.5.7 Intraperiod Allocation as It Applies to the CTA Account

Some transaction gains and losses (ASC 830-20-35-3) and all translation adjustments are recorded directly in the cumulative translation adjustments (CTA) account. ASC 830-30-45-21 requires the tax effects of these items to be allocated to the CTA account.

Allocation to the CTA account is clearly required for current and deferred taxes on transaction gains and losses recorded in the CTA account and for deferred taxes on translation adjustments. With respect to deferred taxes provided by a parent or investor for the outside basis temporary difference, the method of allocating deferred taxes between continuing operations and other items must be considered. (As indicated in ASC 740-20-45-14, the allocation of tax effects to two or more items other than continuing operations must follow certain procedures under ASC 740.) Although several alternatives exist, one logical method of allocation is set forth below. For simplicity of discussion, it should be assumed that (1) the only sources of change in the outside basis difference during the year are continuing operations and translation adjustments for the year, and (2) no remittance or other recovery of the parent’s investment has occurred during the year.

1. Compute the total deferred tax provision for the year. This would be the difference between (a) the required year-end deferred tax liability at enacted tax rates and current exchange rates, utilizing available credits and tax-planning alternatives, and (b) the beginning-of-year deferred tax liability.

2. Compute the charge to continuing operations. This consists of the following components:

a. The deferred taxes related to the current year’s continuing operations at average translation rates for the year (i.e., the rate used in translating the income statement).

b. The change in the deferred tax liability resulting from changes in tax rates, tax-planning actions, and the portion of a change in the valuation allowance that results from a change in judgment about the realizability of the related deferred tax asset in future years. Note that in absence of a basis for allocation, it may be appropriate to prorate the effects of changes in tax-planning actions between continuing operations and the CTA account.

3. The differential (1 less 2 above) represents (in the absence of any other items except continuing operations) the charge (or credit) to the CTA account, which should include the following components:

a. The capital gain or loss effect of revaluation of contributed capital.

b. The effect of exchange rate changes on beginning-of-year deferred taxes provided on unremitted earnings.

c. The effect of exchange-rate changes on the deferred tax liability provided on current-year continuing operations (2 above) at year-end, and not average, exchange rates.

d. The effects of changes in the valuation allowance and changes in tax-planning actions that are not appropriately allocated to continuing operations.

This computation will require appropriate consideration of foreign withholding taxes and limitations on utilization of foreign tax credits.

Chapter TX 12 offers a comprehensive discussion of intraperiod allocation.

11.5.8 Deferred Taxes on Intercompany Loans with Foreign Subsidiaries

Often, parent entities have intercompany loans with their foreign subsidiaries that are of a long-term-investment nature (that is, settlement is not planned or anticipated in the foreseeable future as discussed in ASC 830-20-35-3(b)). Typically, these loans are either denominated in the functional currency of the parent or the functional currency of the subsidiary. Because of the difference between the functional currencies and the denomination of the loan, foreign currency translation adjustments arise. As a result, one needs to consider whether deferred taxes should be recorded on these translation adjustments, particularly in light of any assertion of indefinite reversal under ASC 740-30-25-17. Consider the following example:

Example 11-13: Whether Deferred Taxes Should Be Provided on the Foreign Currency Gains and Losses Reported in OCI

Background/Facts:

Company X is a U.S. multinational corporation and has several outstanding intercompany loans with one of its wholly owned foreign subsidiaries, Subsidiary Y. The functional currency of Subsidiary Y is the local currency. Company X has asserted that the loans are of a long-term investment nature. Therefore, gains and losses are reported in other comprehensive income (“OCI”) under ASC 830-30-45-21.

The intercompany loans can be divided into the following two categories:

Loans denominated in the functional currency of the parent for which Subsidiary Y bears the currency risk.

Loans denominated in the functional currency of Subsidiary Y for which the parent bears the currency risk.

Company X asserts and meets the indefinite reversal criteria under ASC 740-30-25-17 for its investment in Subsidiary Y.

Question:

Should deferred taxes be provided on the foreign currency gains and losses reported in OCI?

Analysis/Conclusion:

ASC 830-30-45-21 states that translation adjustments should be accounted for in the same way that temporary differences are accounted for under the provisions of ASC 740, except for translation adjustments related to foreign subsidiaries where deferred taxes are not provided on unremitted earnings under the indefinite reversal exception in ASC 740-30-25-17.

Loans denominated in the functional currency of Subsidiary Y

The intercompany loans and the related gains and losses on the loans denominated in the functional currency of Subsidiary Y should be viewed as a part of Company X’s net investment in Subsidiary Y (i.e., outside basis difference). The tax effects should be evaluated under the governing principles of the indefinite reversal criteria in ASC 740-30-25-17. Accordingly, a deferred tax liability should be recorded for a book-over-tax-outside basis difference unless an assertion of indefinite reversal is made under ASC 740-30-25-17.

Loans denominated in the functional currency of the parent

The gains and losses on intercompany loans denominated in the functional currency of the parent create a difference between the book basis and tax basis of the intercompany payable or receivable on Subsidiary Y’s books (i.e., inside basis difference). Deferred taxes should generally be provided on these types of temporary differences, and the tax benefit or expense should generally be recorded in other comprehensive income, subject to the intraperiod allocation rules of ASC 740-20. However, if the parent is asserting indefinite reversal of its outside basis difference in Subsidiary Y under ASC 740-30-25-17, it may be appropriate to extend the principles of the indefinite reversal exception to the temporary differences related to the intercompany loans. This latter approach would only be appropriate if the ultimate taxation of the foreign currency effects of a loan only occur upon repayment and if settlement is not planned or anticipated in the foreseeable future.

In cases where the indefinite reversal criteria is asserted and met, we believe that a second assessment must also be performed with respect to the intercompany loans to determine whether a deferred tax liability should be provided. If events other than a cash remittance or repatriation event could cause that portion of the temporary difference to become taxable, Company X would need to consider whether the taxable event can, in fact, be deferred indefinitely. For example, under the IRS’s “significant modification” rules, many common business decisions (e.g., changing the interest rate on a loan, recapitalizing a portion of the loan, etc.) could result in a significant modification to the terms of the loan and cause a taxable event, even if repayment or settlement does not occur. In other words, even though Company X asserts the loans are of a long-term investment nature and asserts that it will indefinitely reinvest the earnings of Subsidiary Y, if Company X is unwilling or unable to assert that a taxable event can be deferred indefinitely because certain business decisions may cause a taxable event, a deferred tax liability should be established, with the related tax expense recorded in OCI.

In addition to the second evaluation above, any temporary difference resulting from an excess of tax-over-book outside basis difference would need to be evaluated under ASC 740-30-25-9. Under that guidance, a deferred tax asset is recorded only if it is apparent that the temporary difference will reverse in the foreseeable future.

In evaluating the appropriate foreign currency and deferred tax implications of intercompany loans, it is also important to ensure that management’s assertions used to determine the appropriate book accounting under GAAP are consistent with management’s assertions submitted to the relevant taxing authorities, which form the basis for determining the appropriate tax return treatment.

11.6 Accounting for Branch Operations and Subpart F Income

11.6.1 Branch Operations

A branch operation generally represents the operations of an entity conducted in a country that is different from the country in which the entity is incorporated. Accordingly, for a U.S. entity, a branch represents the portion of the U.S. entity’s operations that are located in and taxed by a foreign jurisdiction. For U.S. entities, a branch can also take the form of a wholly-owned foreign corporation that has elected for tax purposes to be treated as a disregarded entity of its immediate parent corporation.

Branch operations are often subject to tax in two jurisdictions: the foreign country in which the branch operates and the entity’s home country. Accordingly, we would expect the entity to have two sets of temporary differences that give rise to deferred tax assets and liabilities: one for the foreign jurisdiction in which the branch operates and one for the entity’s home jurisdiction. The temporary differences in the foreign jurisdiction will be based on the differences between the book basis and the related foreign tax basis of each related asset and liability. The temporary differences in the home country jurisdiction will be based on differences between the book basis and the home country tax basis in each related asset and liability.

In addition, the entity should record deferred taxes in its home country for the tax effects of foreign deferred tax assets and liabilities because each would be expected to constitute a temporary difference in the home country deferred tax computation. Specifically, when a deferred foreign tax liability is settled, it increases foreign taxes paid, which decreases the home country taxes paid as a result of additional foreign tax credits or deductions for the additional foreign taxes paid. Conversely, when a deferred foreign tax asset in the foreign jurisdiction is recovered, it reduces foreign taxes paid, which increases the home country taxes as a result of lower foreign tax credits or deductions for foreign taxes paid. (See ASC 740-10-55-20 which describes a similar concept within the context of deductible state income taxes.)

In considering the amount of deferred taxes to record in the home country as they relate to the foreign deferred tax assets and liabilities recorded, an entity must consider how those foreign deferred taxes, when paid, will interact with the tax computations in the home country tax return. In the United States, for example, a taxpayer makes an annual election to deduct foreign taxes paid or to take them as a credit against its U.S. tax liability. (Although the deduction of foreign taxes paid is obviously less beneficial than claiming a credit, there are limitations on the use of foreign tax credits, and unutilized foreign tax credits have a limited carryforward period.) Also, in deciding whether to deduct or credit foreign taxes paid, a taxpayer will need to consider the interaction of the income and taxes of the foreign branch with the income and taxes of the entity’s other branches and foreign corporations, which, in turn, will affect the decision to take a deduction or a credit for foreign tax.

If the taxpayer expects to take a credit for the foreign taxes to be paid, it should record, before considering any related credit limitations, a home country deferred tax asset (liability) for each related foreign deferred tax liability (asset) at a rate of 100 percent for the amount of the foreign deferred taxes that are expected to be creditable. If the foreign taxes that will be paid as the deferred taxes reverse are not expected to be fully creditable (e.g., in situations where the foreign tax rate exceeds the home country tax rate), unique considerations will arise. As a result, it may be appropriate to record home country deferred taxes on foreign country deferred taxes at a rate of less than 100 percent of the foreign deferred tax asset or liability, or it may be appropriate to record such taxes at a rate of 100 percent with a valuation allowance for the portion of any net foreign deferred taxes that, when paid, are expected to expire unutilized.

If the entity expects to deduct (rather than take a credit for) foreign taxes paid, it should establish in the home country jurisdiction deferred taxes on the foreign deferred tax assets and liabilities at the home country enacted rate that is expected to apply in the period during which the foreign deferred taxes reverse.

If there is no net deferred tax asset in the foreign jurisdiction due to a full valuation allowance, a corresponding deferred tax liability in the home country jurisdiction would generally be inappropriate.

While deferred taxes must be recorded for branch earnings, another area that must be considered when looking at the accounting for branches is the accounting for any cumulative translation adjustments (“CTA”) account for the operations of the branch. In circumstances when the temporary differences associated with the CTA of the foreign branch will not be taxed in the U.S. until there is a remittance of cash, a question arises as to whether or not a company can apply an indefinite reversal assertion to the CTA of the foreign branch.

We believe the answer depends upon which of two acceptable views the Company applies in its interpretation of the accounting literature. View 1 is that an indefinite reversal assertion is not available for a branch and View 2 allows for the application of an indefinite reversal assertion (when facts and circumstances permit). The views are summarized as follows:

View 1—ACS 740-30-25-17, which is an exception to comprehensive recognition of deferred taxes, only applies to outside basis taxable temporary differences related to investments in foreign subsidiaries and certain foreign corporate joint ventures. Because branch income is directly taxable to the owner or parent, there is technically no outside basis difference in the branch and therefore the exception in ASC 740-30-25-17 is not applicable. Furthermore, ASC 740-30-15-4 prohibits applying the indefinite reversal criterion to analogous types of temporary differences.

View 2—In deliberating ASC 740, the FASB indicated that the underlying rationale for the exception in ASC 740-30-25-17 is based on the inherent complexity and hypothetical nature of the calculation. However, application of the exception depends on a company’s ability and intent to control the timing of the events that cause temporary differences to reverse and result in taxable amounts in future years. In particular, the exception focuses on the expectation of owner or parent taxation in the home jurisdiction. If taxation of the CTA occurs only upon a remittance of cash from the branch, the timing of taxation can be controlled by the owner or parent. On that basis, an indefinite reversal assertion could be applied to the CTA of a foreign branch (even though the assertion could not apply to the periodic earnings of the branch since they pass through to the parent). This is not an “analogous” temporary difference which would be prohibited by ASC 740-30-15-4; rather, it is in the scope of ASC 740-30-25-17. That is because such amount relates to a foreign operation and carries with it the same measurement complexities as any other foreign outside basis difference.

The view taken is an accounting policy which should be applied consistently. Accordingly, if View 1 is adopted, it would be applied to all of the Company’s foreign branches. If View 2 is adopted, indefinite reversal could be asserted for any branch for which the criteria are supportable by specific plans relating to the unremitted branch earnings. As a result, under View 2, an indefinite reversal assertion could be made and supported for one branch while not being make for another.

For a company applying View 2, other points to note are as follows:

Note that View 2 is analogous to the conclusion reached in Section TX 11.6.2.3 with respect to previously taxed income of a foreign subsidiary. As noted in Section TX 11.6.2.3, the fact that earnings have already been taxed can make the assertion difficult when there is a possibility of repatriation from foreign operations.

When an overall translation loss exists in the CTA, it is necessary to demonstrate that the temporary difference will reverse in the foreseeable future before recognizing a deferred tax asset under ASC 740-30-25-9.

In the event that an indefinite reversal assertion changes, the deferred taxes attributable to current year CTA movement are recorded to other comprehensive income in accordance with ASC 740-20-45-11(b). However, because the beginning-of-year CTA balance did not arise during the year, but rather in prior years, ASC 740-20-45-11(b) does not apply and the tax effects associated with these prior-year cumulative balances should be recorded to continuing operations.

The effects of translating the home country’s temporary differences related to the foreign branch should be recorded in CTA (for further discussion, see Example 11-14).

Example 11-14: Recording Foreign Currency Fluctuation Impacts on Deferred Income Taxes Related to Foreign Branches

Background/Facts:

Company A is a U.S. corporation with a wholly owned subsidiary in Germany. The subsidiary is treated as a branch for U.S. tax purposes (i.e., a “check-the-box” election has been made). The functional currency of the German subsidiary is the local currency, the euro. In the current year, the subsidiary records an operating expense of €1 million and a corresponding accrual for an obligation payable in euros. The expense is deductible in the U.S. only when paid; therefore, a U.S. deferred tax asset is recorded on the deductible temporary difference. At that time, the exchange rate is 1.5 to 1, resulting in a deductible temporary difference of $1.5 million. At the end of the subsequent reporting period, the exchange rate is to 2 to 1. Assuming no other change in the operating expense accrual, the U.S. deductible temporary difference would increase from $1.5 million to $2 million.

Question:

How should Company A record the income tax benefit related to the $.5 million increase in the deductible temporary difference?

Analysis/Conclusion:

The benefit should be recorded as part of the cumulative translation adjustment (CTA) in other comprehensive income (OCI). ASC 740-20-45-11(b) states that tax effects of gains and losses included in comprehensive income but excluded from net income shall also be charged or credited to OCI. In this case, the increase in the deductible temporary difference is caused by the change in the exchange rate. The effect of translating the accrual from euros to dollars in consolidation would be recorded in CTA, and the related tax effect should therefore also be recorded in CTA.

The example above is based on a simple fact pattern meant to highlight the requirement to allocate tax effects from translation adjustments to CTA. In most circumstances, changes in deferred tax assets and liabilities are caused by a number of reasons in addition to exchange rate changes (e.g., actual movements in the underlying accounts, changes in tax rates or laws, valuation allowance, etc.). In those circumstances, it may be more challenging to determine proper intraperiod allocation of the overall tax provision among the various components of comprehensive income.

Example 11-15: Deferred Tax Accounting on Inside Basis Difference in a Foreign Branch

Background/Facts:

Company P has a branch in Country X where the statutory tax rate is 25 percent.

In the current year, the branch has pretax income of $10,000. For Country X and U.S. tax purposes, the branch has excess tax-over-book depreciation of $5,000 and nondeductible inventory reserves of $3,000.

For U.S. purposes, the branch is taxed at 40 percent.

Taxes paid to Country X will be claimed as a foreign tax credit.

Question:

How and in which jurisdictions should deferred taxes be recorded on the depreciation and nondeductible reserves temporary differences?

Analysis/Conclusion:

Because the branch is taxed in both Country X and the United States, the taxable and deductible temporary differences in each jurisdiction must be computed. A net deferred tax asset (DTA) for the U.S. tax effects of the foreign deferred tax liability (DTL) associated with the depreciable property, as well as a DTL for the U.S. tax effects of the foreign DTA associated with the reserves, would be included in the deferred tax balance because both the foreign DTL and DTA have a book basis but no tax basis. For U.S. tax purposes, this will reduce foreign taxes paid when the foreign DTA is recovered, and will increase foreign taxes paid when the foreign DTL is settled. Consequently, the effect of these foreign deferred taxes on the foreign taxes paid will, in turn, affect the U.S. tax liability as a result of the impact on future U.S. credits or deductions for foreign taxes paid.

This concept is illustrated below:


When the foreign branch incurs a loss, a deferred tax asset would arise in the foreign jurisdiction for that loss if it can be carried forward to offset future foreign taxable income and no valuation allowance is required. Generally, a foreign-branch loss would also be deductible under current U.S. tax law. If that were the case, should a “double” tax benefit (i.e., current U.S. deduction and foreign deferred tax asset) be recognized?

No, we believe that a deferred tax liability should be reported in the U.S. jurisdiction because the future foreign taxable income necessary for the realization of the foreign deferred tax asset will also be reported as U.S. income in future years, with no foreign tax credits available to offset the U.S. tax in the year during which the foreign income is earned. As discussed above, the tax liability for this taxable temporary difference would generally be based on the foregone foreign tax credits that would otherwise have been available to the company had cash taxes been paid.

Example 11-16: Foreign Branches

Single Branch

Assume that a U.S. entity has a foreign branch that incurs a $100 loss and records a deferred tax asset (DTA) of $20 related to a foreign NOL carryover (20 percent foreign tax rate) with no valuation allowance. Assuming that the U.S. entity is profitable, the $100 foreign loss that is included in the U.S. tax return would reduce the current U.S. taxes payable by $40.

To realize the foreign DTA of $20, the foreign branch will need $100 of foreign taxable income in the future, and this $100 will also need to be reported in future U.S. tax returns. As a result, a $20 U.S. deferred tax liability (DTL) should be recognized for the foreign DTA.

When the foreign branch earns $100 of income in the future, the $20 foreign DTA that is related to the foreign NOL will be utilized. Additionally, the $100 will be included in the U.S. tax return, creating $40 in current U.S. taxes payable and causing the $20 in deferred U.S. tax liability to reverse. The net effect will be a $40 tax provision for the $100 of branch income that is reported in the U.S. tax jurisdiction.

Multiple Branches

If more than one branch in more than one jurisdiction exists, the accounting increases in complexity. Assume that there are no temporary differences in a given year, that the tax rate is 40 percent in both the United States and foreign jurisdiction A, and that the tax rate is 20 percent in foreign jurisdiction B. The company takes U.S. foreign tax credits for its foreign taxes paid. There is no carryback potential, but both loss and credit carryforwards are allowed in each jurisdiction.


The following illustrates the calculation of FTC availability:


In this example, although $120 of foreign taxes were paid, only $80 can be claimed as a tax credit in the current year’s return. The remaining $40 would be carried forward. Given that excess foreign tax credits have limited carryforward potential in the United States, these carryovers need to be assessed for realizability. If, for example, losses are anticipated in jurisdiction B through the U.S. foreign tax credit carryforward period, a valuation allowance may be appropriate on the $40 of excess foreign tax credits.

Also, with respect to the DTA of $20 that is related to the $100 of NOL generated in jurisdiction B, the company will need to consider whether a valuation allowance should be established. If a valuation allowance is not recorded, a corresponding DTL of $20 should be recorded in the United States. On the other hand, if a valuation allowance is recorded against the NOL-related DTA in jurisdiction B, a corresponding DTL in the U.S. jurisdiction would be inappropriate because there is no net DTA in the foreign jurisdiction.

11.6.2 U.S. Subpart F Income: Income from Foreign Subsidiaries That Cannot Be Deferred

11.6.2.1 In General

If a U.S. corporation conducts business through a foreign subsidiary that has not elected to be taxed as a disregarded entity or partnership, there is normally no U.S. taxation unless earnings are distributed to the subsidiary’s parent. The exceptions to this general deferral rule are contained within subpart F of the Internal Revenue Code. Subpart F was enacted to discourage U.S. companies from forming a foreign subsidiary to defer the U.S. taxation of certain types of foreign earnings. Under the subpart F regime, certain types of income are currently taxable to the extent of the foreign subsidiary’s current earnings and profits (current E&P). Subpart F income, when taxable, is treated as a deemed dividend, followed by an immediate recontribution of the deemed dividend to the foreign subsidiary. This recontribution increases the U.S. parent’s tax basis in the foreign subsidiary. If a subsequent distribution is actually made from the foreign subsidiary, the amounts that have already been subjected to subpart F can be repatriated without further taxation (other than potential withholding taxes and any tax consequences applicable to foreign currency gains or losses). However, the distribution would serve to reduce the U.S. parent’s tax basis in the subsidiary.

In some circumstances the entire income of the foreign subsidiary may be subject to subpart F. Foreign subsidiaries whose subpart F income represents more than 70 percent of the entity’s gross income are considered “full inclusion” subsidiaries (meaning, their entire income is considered subpart F income). There are also instances where foreign subsidiaries engaged in certain financing activities may be subject to current U.S. taxation on their entire income in the absence of a statutory exception for “active” financing activities. In those circumstances, recognition of U.S. deferred taxes would be required for temporary differences of that subsidiary since it is effectively the tax equivalent of a branch.

Similar to the discussion in Section TX 11.6.1 for foreign branches, foreign entities subject to subpart F may have U.S. tax consequences that arise upon the reversal of temporary differences which, upon reversal, will represent subpart F income. Foreign temporary differences, both deductible and taxable, that will impact subpart F income (and thus U.S. taxes) when they reverse may give rise to U.S. deferred taxes (in a manner that is similar to that discussed in Section TX 11.6.1 for a foreign branch).

Additionally, subpart F income may sometimes be deferred for U.S. tax purposes because the foreign subsidiary has no current E&P. Deferred subpart F income is recognized in taxable income when the foreign subsidiary generates current E&P. We believe the accounting consequences from subpart F income, whether the income is (1) unrealized or (2) realized but deferred for U.S. tax purposes, should follow either one of the following acceptable views:

View A (an inside-basis unit of account): Under this view, deferred taxes would be recorded regardless of whether an outside basis difference exists and regardless of whether the outside basis is in a book-over-tax- or tax-over-book position. Unrealized income recognized in book earnings will create subpart F income when the underlying asset is recovered. Therefore, the equivalent of an inside basis U.S. taxable temporary difference exists for which a U.S. deferred tax liability is recognized. Similarly, even deferred subpart F income would create the equivalent of an inside basis U.S. taxable temporary difference. This is because deferred subpart F income is comparable to other book income permitted by U.S. tax law to be deferred (but not permanently avoided). Therefore, under ASC 740-10-55-63, a temporary difference exists for deferred subpart F income as it would for other deferred taxable income. While anticipation of future losses at the foreign subsidiary could further delay the taxation of subpart F income, the concepts underpinning ASC 740 do not allow the recognition of a deferred tax liability to be avoided by consideration of anticipated future losses.

View B (an outside-basis unit of account): Subpart F income (both unrealized and realized but deferred for U.S. tax purposes), as a component of the subsidiary’s book earnings, is encompassed in the outside basis of the parent’s investment. Therefore, outside basis would be the unit of account for purposes of determining the relevant temporary difference. However, unlike other portions of the outside basis difference for which the U.S. parent may be able to control the timing of taxation simply by avoiding repatriations of cash, as it relates to subpart F income there may not be an ability to delay taxation. Therefore, under this view, deferred taxes are recorded when subpart F income is recognized in book income (both unrealized and realized but deferred for U.S. tax purposes), but only with respect to the amount of subpart F income that does not exceed the parent’s book-tax outside basis difference. If the U.S. parent asserts indefinite reinvestment, deferred taxes recorded are limited to the hypothetical deferred tax amount that cannot be avoided as a result of its indefinite reinvestment assertion.

The selection of one of these views is an accounting policy choice that must be consistently applied. Further, it should be noted that neither view is applicable in a case where the company already recognizes deferred taxes on its outside basis difference. This is because such amounts are inherent in the outside basis difference and thus already reflected in the deferred taxes recorded on the balance sheet.

Example 11-17: Foreign Temporary Differences That Give Rise to Subpart F Income in the Future

Background/Facts:

Assume that a foreign subsidiary holds an appreciated available-for-sale security that is accounted for under ASC 320, Investments—Debt and Equity Securities. When sold, the gain on the sale of this security would constitute subpart F income in the United States. The U.S. parent company has a significant book-over-tax outside basis difference in the foreign subsidiary; however, it has asserted indefinite reversal as it does not intend to repatriate any of the subsidiary’s undistributed earnings.

Question:

Should U.S. deferred taxes be recorded on the potential subpart F income resulting from the appreciated equity security?

Analysis/Conclusion:

Yes. To the extent that the company is not able to avoid the triggering of subpart F income on the reversal of the temporary difference associated with this investment, U.S. deferred taxes should be provided in a circumstance where the company has otherwise made an assertion of indefinite reversal related to its overall outside basis difference under ASC 740-30-25-17. This would be the case whether the company was following a recognition and measurement approach consistent with either View A, an inside-basis unit of account, or View B, an outside-basis unit of account.

11.6.2.2 Indefinite Reversal Exception and Potential Future Subpart F Income

To utilize the indefinite reversal exception in ASC 740-30-25-17, the immediate parent must have the ability and intent to indefinitely defer the reversal of the temporary difference with a tax consequence. To the extent that activities occurring at the controlled foreign corporation (CFC) level or below will cause the recognition of subpart F income by the CFC’s U.S. parent, the underlying facts and circumstances must be examined to determine whether recording U.S. deferred taxes can be avoided for the item that may become subject to U.S. tax. The following example discusses the indefinite reinvestment consequence from a CFC’s equity method investment:

Example 11-18: Subpart F Income and Indefinite Reversal

Background/Facts:

Company A operates in the United States and owns 100 percent of U.K. Subsidiary B, which is a CFC. Subsidiary B owns 30 percent of the outstanding stock of Irish Investee C, but does not have the ability to exercise control over Investee C. Accordingly, Subsidiary B carries Investee C on its books using the equity method of accounting.


The following assumptions are true for this example:

Dividends remitted by Investee C to Subsidiary B will be taxable to Company A under U.S. subpart F rules. In other words, even if the cash from the dividend payment were to remain with Subsidiary B, the income would be immediately taxable in the United States.3

Company A has asserted its intention to indefinitely reinvest all of the accumulated unremitted earnings of Subsidiary B.

The entire difference between Company A’s book and tax bases in Subsidiary B relates to unremitted earnings.

Investee C has not had a history of making distributions.

Question:

As Company A intends to indefinitely reinvest all of Subsidiary B’s accumulated unremitted earnings, can Company A rely on the indefinite reversal exception in ASC 740-30-25-17 to not record deferred taxes on the portion of Subsidiary B’s unremitted earnings that relate to Investee C?

Analysis/Conclusion:

No. For Company A to invoke the exception in ASC 740-30-25-17, it must not only have the intent, but also the ability to control the reversal of the portion of the outside basis difference for which deferred taxes are not recorded. To the extent that activities of a CFC constitute subpart F income for tax purposes, the subpart F includable amounts are treated as a deemed distribution, followed by a subsequent reinvestment of the proceeds back to the CFC. This reinvestment of proceeds results in an increase in the U.S. parent’s tax basis in the CFC and a consequential reduction in the outside basis difference at a tax cost. This result is squarely inconsistent with an indefinite reversal assertion under ASC 740-30-25-17.

Because Subsidiary B does not control Investee C, and because a dividend or certain other transactions involving Investee C will be taxable in the United States to Company A as subpart F income, Company A does not have the ability to assert the exception in ASC 740-30-25-17 on the portion of Subsidiary B’s unremitted earnings that relate to Investee C. In effect, the existence of the subpart F provisions makes Company A’s indirect ownership in the Investee C (through Subsidiary B) analogous to Company A having direct ownership in Investee C. Accordingly, ownership of Investee C indirectly through Subsidiary B does not change the accounting—even if Investee C does not have a history of making distributions.

11.6.2.3 Subpart F Qualified Deficit

When the subsidiary has a current-year E&P deficit (i.e., a loss measured under applicable tax law), subpart F taxation is deferred until it has current-year E&P (Section TX 11.6.2.1). A qualified subpart F deficit is the amount of a current-year E&P deficit attributable to activities which, when profitable, give rise to certain types of subpart F income. The qualified deficit is available to reduce income from sales activities in the future that would otherwise be taxable under the subpart F rules. The question is, should a U.S. deferred tax asset be recorded for the subpart F qualified deficit?

Consistent with our view on the accounting for subpart F gains (Section TX 11.6.2.1), we believe a policy choice, applied on a consistent basis, should be made to determine whether deferred taxes relating to subpart F taxation are recognized and measured on an inside- or outside-basis unit of account. Depending on a company’s accounting policy, as discussed below, it may be appropriate to recognize a deferred tax asset for a subpart F qualified deficit:

View A (inside-basis unit of account): Under this view, a qualified deficit creates an inside basis difference for which a deferred tax asset would be recorded. This view considers a qualified deficit to be a tax attribute akin to a carryforward or a deferred stream of tax deductions which can reduce income of the same category in the future that would otherwise be taxable under the subpart F rules.

View B (outside-basis unit of account): Under this view, a qualified deficit is considered a component of the subsidiary’s book earnings, and therefore inherent in the outside basis of the parent’s investment. Accordingly, the recognition requirement applicable to a deductible outside basis difference would apply. A deferred tax asset is recorded only if it is apparent that reversal of the qualified deficit is anticipated to occur in the foreseeable future (ASC 740-30-25-9) and only to the extent of the parent’s tax-over-book outside basis difference. If subpart F income is anticipated in future periods and the qualified deficit is expected to eliminate the associated U.S. tax cost (cash or utilization of a loss or credit carryforward), a deferred tax asset would be recognized based upon the amount of subpart F loss that does not exceed the parent’s tax-over-book outside basis difference.

Importantly, under either View A or View B, a valuation allowance may be required if it is more-likely-than-not that some portion or all of the recognized deferred tax asset will not be realized.

11.6.2.4 Indefinite Reversal and Subpart F’s Previously Taxed Income

This question is often asked: How should previously taxed income (PTI) be considered when applying the indefinite reversal criteria?

A U.S. parent can generally distribute PTI without subjecting itself to further U.S. income tax except for the tax consequences applicable to any foreign currency gain or loss as well as the tax costs associated with foreign withholding taxes that may be offset by a U.S. foreign tax credit. Therefore, management must still declare its intentions as to whether that PTI is indefinitely reinvested if that repatriation will result in additional taxes (such as foreign withholding taxes net of U.S. foreign tax credits or U.S. taxes on foreign currency gains or losses associated with remittances). Section TX 11.6.1 on branch operations discusses the rationale for an indefinite reversal assertion related to PTI. When a company analyzes its intentions under ASC 740-30-25-17, which will often include the tax consequences of remitting undistributed earnings, it may be more difficult to overcome the presumption that the undistributed earnings that underlies the PTI are indefinitely reinvested because the earnings have already been taxed and the incremental tax may be relatively minimal (e.g., foreign withholding taxes and translation effects).