Businesses that prepare consolidated (or group) financial statements also often prepare separate financial statements for one or more divisions, business units and/or subsidiaries. Such statements (herein referred to as "carve-out" or "stand-alone" financial statements) can be necessitated by a pending transaction such as an initial public offering, spin-off or business combination. Alternatively, they may be required for certain statutory or regulatory filings on an ongoing periodic basis. Carve-out financial reporting is even more common outside the United States.
The preparation of carve-out financial statements can be complex and is often highly judgmental; there are limited specific accounting rules or guidance governing the composition of the carve-out entity and resulting application of U.S. Generally Accepted Accounting Principles. Preparing the tax provision for carve-out financial statements can likewise be challenging, particularly if separate financial statements (including a tax provision) have not historically been prepared. For taxable entities, the exclusion of a tax provision in such financial statements is not an option because a tax provision is required for the carve-out financial statements to be in compliance with Financial Accounting Standards Board (FASB) Accounting Standards Codification 740, Income Taxes (ASC 740). While not all inclusive, seven principles which will enable preparers to manage a carve-out tax provision process more smoothly are discussed herein.Carve-out financial statements are often guided by the legal or strategic form of a business transaction that involves capital formation, or the acquisition or disposal of a portion of a larger entity. Alternatively, the statements may be guided by regulatory requirements for certain industry-specific filings. Understanding the overall context and intended use of the statements is important in deciding which tax provision allocation "method" to apply and in aligning the application of the chosen allocation method to the pre-tax accounts.
Tax provision preparers should coordinate closely with those responsible for the pre-tax aspects of the carve-out financial statements. The tax provision should be based on the financial statement accounts that are included in the carve-out entity. Accordingly, one must fully understand the pre-tax accounts that will be included in the carve-out statements, as well as the impacts of any adjustments to such accounts, in order to reflect the appropriate income tax effects.
The tax provision can be affected by methodologies being used for revenue or cost allocations that differ from historical practices. Carve-out financial statements should reflect all the costs of doing business. That typically requires an allocation of corporate overhead expenses (and the related tax effects) to the carve-out entity—even if allocations were not previously made. Similarly, it may be necessary to allocate other expenses, such as stock-based compensation, to the carve-out entity. An appropriate methodology for determining the pool of "windfall benefits" applicable to the carve-out entity will then also need to be adopted, in accordance with ASC 718, Stock Compensation.
Stand-alone financials may also reflect "push-down" accounting adjustments, which can often relate to debt obligations of the parent or other members of the reporting group. The tax provision would be prepared based upon such pre-tax accounts. Accordingly, the stand-alone entity would be assumed to have tax basis in such debt for purposes of applying ASC 740 and, as a consequence, no temporary difference or deferred tax consequence arising from the push-down.
Intercompany transactions that were formerly eliminated in the consolidated financial statements (for example, transactions between the carve-out entity and other entities in the consolidated financial statements) generally would not be eliminated in the carve-out financial statements. For example, sales of inventory to a sister company that are eliminated in the consolidated financial statements generally would remain in the carve-out statements. Consequently, additional attention may need to be given to the measurement of revenues and costs (i.e. transfer pricing) from a stand-alone perspective.
The income tax accounting for certain intercompany transactions may also change. Specifically, ASC 740-10-25-3(e) which prescribes the accounting for the income tax effects of intercompany transactions) would not apply to such transactions in the carve-out financial statements.
Similarly, it may be appropriate to reflect in carve-out statements intercompany transaction gains (or losses) that were previously deferred in a consolidated tax return. It would be necessary to assess whether the respective income tax accounting effects are recognized in equity, in accordance with ASC 740-20-45-11(c).
ASC 740-10-30-27 requires that the current and deferred tax expense for a group that files a consolidated return be allocated among the group members when those members issue separate financial statements. While ASC 740 does not require the use of any particular allocation method, it does require that the method be systematic, rational and consistent with the broad principles of ASC 740. It goes on to indicate that the separate return method meets those criteria. In addition, the SEC staff has stated that it believes the separate return method is the preferred method.
Under the separate return method, the carve-out entity would calculate its tax provision as if it were filing its own separate tax return based on the pre-tax accounts included in the carve-out entity. This can result in perceived inconsistencies between the tax provision of the carve-out entity and the tax provision of the consolidated group. This is acceptable, however, under ASC 740, which acknowledges that if the separate return method is used the sum of the amounts allocated to individual members of the group may not equal the consolidated amount.
For example, it is possible that the carve-out entity could recognize a deferred tax asset for a loss or credit carryforward, even if there is no carryforward on a consolidated basis (e.g., the attribute was used in a consolidated tax return). In other cases, the carve-out entity could reflect a current-year loss as being carried back against its taxable income in the carryback period, even though the consolidated group was in a loss carryforward position. In another common scenario, a valuation allowance might be necessary for the carve-out entity (because it cannot rely on the taxable income of the group) even though no valuation allowance is needed for the consolidated group. This might be the case if the carve-out entity has been generating losses while the other members of the group are profitable. Alternatively, the converse may be true: a profitable carve-out entity may require a tax provision even though the remaining members of the group are generating losses. As a result, a valuation allowance may not be needed for the carve-out entity, even though a valuation allowance is required for the consolidated group.
Because the separate return method requires the carve-out entity to prepare its tax provision as if it were filing its own separate tax return, it may be appropriate to consider whether calculations performed for the consolidated financial statements should be adjusted. For example, the state tax apportionment factors may be different for the carve-out entity than for the consolidated group. Items such as research and foreign tax credits may also be calculated differently for the carve-out entity than for the consolidated group.
The separate return method, however, is nonetheless an "allocation" of the group tax provision. Accordingly, certain aspects of historical tax provision accounting should not be changed. For example, it is generally not appropriate to revisit historical assertions made by management of the consolidated group on the basis that the assertions would have been different if made by the stand-alone entity. Thus, it would generally not be appropriate for the carve-out financial statements to reflect a different assertion with respect to indefinite reversal of investment basis in a foreign subsidiary pursuant to ASC 740-30-25-17. Nor, as explained later, would it be appropriate to reassess the application of Accounting for Uncertainty in Income Taxes on a stand-alone basis. Elections made in a consolidated tax return should also generally be followed in the carve-out tax provision. If the carve-out entity expects its assertions or tax elections may change in the near future (e.g., after it has been separated from the consolidated group), it may be appropriate to disclose such expectations and the estimated financial reporting impact of such a change.
Similarly, the historical legal entity structure should generally not be recasted for purposes of the carve-out tax provision. For example, if the carve-out entity includes either newly created corporations (heretofore corporate divisions or business units) or businesses whose stock is not owned directly by an entity in the carve-out group, the historic legal entities would be considered as remaining intact for purposes of the carve-out tax provision.
Although the separate return method is the preferred method, ASC 740 does not require the use of any particular allocation method. Therefore, if a company has not previously adopted the separate return method another method may be acceptable as long as it is systematic, rational and consistent with the broad principles of ASC 740. One such method is the "benefits-for-loss" approach.
The benefits-for-loss approach modifies the separate return method so that net operating losses (or other current or deferred tax attributes) are characterized as realized (or realizable) by the subsidiary when those tax attributes are realized (or realizable) by the consolidated group. This would be the case even if the subsidiary would not otherwise have realized those tax attributes on a stand-alone basis. Thus, when the benefit of the net operating loss (or other tax attribute) is recognized in the consolidated financial statements, the subsidiary would generally reflect a benefit in its separate financial statements. This may not be the case, however, if the consolidated group requires a valuation allowance on its deferred tax assets. The benefits for-loss approach may eliminate some of the perceived inconsistencies that would arise from applying the separate return method.
Because the separate return method is the preferred method for allocating income taxes to carve-out financial statements, companies should carefully evaluate whether the use of another method is appropriate. Consideration should be given to any tax sharing agreements and to whether another method provides more useful information to the users of the financial statements. Depending upon the overall circumstances, the use of another method may provide more useful information to those users.
If, however, carve-out financial statements will be included in an initial public offering with the SEC using a method other than the separate return method (for example, the "benefits-for-loss" approach), a pro forma income statement for the most recent year and interim period reflecting a tax provision calculated using the separate return method will be required.
Companies that file consolidated tax returns often have tax sharing agreements which govern the intercompany settlement of tax obligations. Although a tax sharing agreement could be a factor in determining what method the company will use to allocate its tax provision, the tax sharing agreement does not dictate the choice of a tax provision allocation policy. In fact, it may be inappropriate to allocate an income tax provision based on a tax sharing agreement because the agreement may not satisfy the requirements of ASC 740. If a tax sharing agreement differs from the chosen method of tax allocation under ASC 740, the difference between the amount paid or received under the tax sharing agreement and the expected settlement amount based on the tax allocation method is treated as a dividend or capital contribution (i.e., recorded in equity).
Notwithstanding ASC 740-10-30-17, we generally believe that hindsight should not be used when restating interim or annual periods. This guidance also applies to the preparation of carve-out financial statements; carve-out statements for multiple years are often prepared simultaneously. Accordingly, if an assertion or measurement that existed in one year changed in the succeeding year as a result of economic events, hindsight should not be used to apply the new assertion to the prior year. For example, assume that a company is preparing carve-out financial statements for the current and prior years. If a deferred tax asset was supportable in Year 1 based on evidence that existed at that time, but as a result of subsequent losses required a valuation allowance in Year 2, it would not be appropriate to use hindsight and record a valuation allowance in Year 1. Instead, the company would record the deferred tax asset with no valuation allowance in Year 1 and then record a valuation allowance in Year 2 based on subsequent developments.
The recognition and measurement provisions of ASC 740 are applicable to the uncertain tax positions in the separate financial statements of a member of a consolidated tax group to the same extent that they are applicable to the consolidated group. Accordingly, the assumptions used for determining the unrecognized tax benefits in the separate financial statements of the group member should be consistent with those used in the consolidated financial statements.
The preparation of carve-out financial statements, in and of itself, should not be considered to constitute new information that would justify recording a change with respect to uncertain tax positions. Therefore, management should generally not change the historical amounts of uncertain tax position liabilities (or other unrecognized tax benefits) when preparing carve-out financial statements—even if it believes that it would have applied different assumptions for the carve-out entity on a stand-alone basis.
If the carve-out entity uses the separate return method, any changes with respect to the carve-out entity's uncertain tax positions would be allocated to the carve-out entity as if it were a separate taxpayer. If a company chooses another method, the outcome may be different. For example, in circumstances where the tax sharing agreement allocates changes relating to uncertain tax positions to the parent company, it may be acceptable to apply a modified separate return method that is more closely aligned with the tax sharing agreement. This method may in other respects be identical to the separate return method except that any subsequent changes relating to uncertain tax positions are allocated to the parent.
The selection of an appropriate tax provision allocation method requires significant judgment. Accordingly, disclosures regarding the chosen policy should be sufficiently transparent to enable users of the financial statements to make informed decisions.
ASC 740-10-50-17 requires an entity that is a member of a group that files a consolidated tax return to disclose the following in its separate financial statements:Although these disclosure requirements are in lieu of, rather than in addition to, the general disclosure requirements of ASC 740, it is generally advisable to include a description of the types (and potentially the amounts) of significant temporary differences. In addition, if the carve-out financial statements will be filed with the SEC, the disclosures should generally be as comprehensive as if the carve-out entity were a separate taxpayer.
Similarly, disclosures regarding uncertain tax positions of the carve-out entity would generally be appropriate. The level of uncertain tax position disclosures, however, may vary depending on the tax allocation method chosen as well as the other ASC 740 disclosures provided. For example, if income taxes are allocated to a carve-out entity using a method that provides that subsequent changes relating to uncertain tax positions are allocated to the parent company, the carve-out entity may not need to provide all the required ASC 740 disclosures. On the other hand, if the carve-out entity is allocated income taxes using the separate return method, it should generally provide all the required ASC 740 disclosures.
It is also generally appropriate to disclose any tax attributes that have been allocated to the carve-out entity that will not remain with the carve-out entity upon separation from the consolidated group. For example, there may be a separate return method deferred tax asset for a loss or credit carryforward that has been used in a consolidated tax return. Any such carryforwards or other attributes should be identified with appropriate disclosures to enable the users of the carve-out financial statements to make informed decisions.
Preparation of an income tax provision for carve-out financial statements can be complex. The selection of an appropriate tax allocation method requires significant judgment and many issues can arise when applying the chosen allocation method. Consideration of the key principles discussed in this paper will enable preparers to establish a solid foundation from which to build an appropriate tax provision for the carve-out entity.
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Edward Abahoonie
Tax Accounting Services Technical Leader
Phone: 973.236.4448
Email: edward.abahoonie@us.pwc.com
The contribution of Jonathan Linville, Senior Manager, to the original edition of this publication is gratefully acknowledged.
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US Tax Accounting Services & Tax IFRS Leader
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If the carve-out entity includes multiple subsidiaries that would qualify as a consolidated (or unitary) tax group, it would be appropriate to calculate the tax provision as if the carve-out entity were filing a consolidated (or unitary) tax return for such group.
A change in tax allocation method is considered a change in accounting principle. Therefore, a change from the preferred method (i.e., the separate return method) to another method would not be appropriate. Companies should consider whether they have previously adopted a tax allocation method for other subsidiaries or carve-out entities. Generally, the same allocation method should be applied to all members of the consolidated reporting group. However, there may be instances, depending on the facts and circumstances, in which it is acceptable to apply different tax allocation methods to different members of the group.
ASC 740 specifies that methods not consistent with its principles include methods that a) allocate only current taxes payable to a member of a group that has taxable temporary differences, b) allocate deferred taxes using a method that is fundamentally different than the asset and liability method prescribed by ASC 740, or c) allocate no current or deferred tax expense to a member of the group that has taxable income because the consolidated group has no current or deferred tax expense.