IT2013_1069_CH14_v2_P1_7-22

Chapter 14:

Separate Financial Statements of a Subsidiary

Chapter Summary

Intercorporate (or intra-entity) tax allocation (i.e., allocating income taxes to entities within a consolidated tax group) involves related parties and typically results from an expressed or implied agreement among the parties concerning the allocation of taxes currently payable. It is not uncommon for intercorporate tax-allocation agreements to be inconsistent with arrangements that might have been derived on an arm’s-length basis. ASC 850, Related Party Disclosures, and SAS 45/AU 334 recognize that a subsidiary does not independently control its own actions and that most related party transactions, including intercorporate tax allocations, might have been structured differently if the subsidiary had not been a controlled entity.


14.1 Acceptable Methods

ASC 740-10-30-27 through 30-28 require that the consolidated amount of current and deferred tax expense for a group that files a consolidated tax return be allocated among the group members when those members issue separate financial statements. Further, the method adopted must be systematic, rational, and consistent with the broad principles of ASC 740. Typically, the same method should be used to allocate tax expense to each member of the consolidated tax group. However, depending on the individual facts and circumstances, it may be acceptable to use more than one allocation method for different subsidiaries in a consolidated group.

While ASC 740-10-30-27 through 30-28 does not require the use of any single allocation method, it does indicate that the following methods are inconsistent with the broad principles of ASC 740:

A method that allocates only current taxes payable to a member of the group that has taxable temporary differences

A method that allocates deferred taxes to a member of the group using a method fundamentally different from its asset and liability method (the deferred method that was used before 1989 is cited as an example)

A method that allocates 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

14.1.1 Separate Return Method

Under ASC 740-10-30-27, it is acceptable to use a method that allocates current and deferred taxes to members of the group by applying ASC 740 to each member as if it were a separate taxpayer. In SAB Topic 1B, which discusses financial statements included in registrations of initial public offerings, the SEC staff states its belief that the separate return basis is the preferred method for computing the income tax expense of a subsidiary, division, or lesser business component of another entity included in consolidated tax returns. The SEC staff further states: “When the historical income statements in the filing do not reflect the tax provision on the separate return basis, the staff has required a pro forma income statement for the most recent year and interim period reflecting a tax provision calculated on the separate return basis.”

Under this method, the subsidiary is assumed to file a separate return with the taxing authority, thereby reporting its taxable income or loss and paying the applicable tax to or receiving the appropriate refund from the parent. The rules followed by the subsidiary in computing its tax or refund, including the effects of AMT, should be exactly the same as those followed by the subsidiary in filing a separate return with the IRS. Thus, it is possible that the subsidiary could recognize a loss or credit carryforward, even though there is no carryforward on a consolidated basis (i.e., they were used by the parent). Additionally, the subsidiary 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.

When the separate return method is used to allocate the current and deferred tax expense or benefit for a group that files a consolidated return, the subsidiary’s current provision would be the amount of tax payable or refundable based on the subsidiary’s hypothetical, current-year separate return. After computing its current tax payable or refund, the subsidiary should provide deferred taxes on its temporary differences and on any carryforwards that it could claim on its hypothetical return. The subsidiary should also assess the need for a valuation allowance on the basis of its projected separate return results. The assessment should include tax-planning strategies that are prudent and feasible (i.e., within the control of the subsidiary).

ASC 740-10-30-27 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, one member might generate deferred tax assets for which a valuation allowance would be required if that member were a separate taxpayer. However, a valuation allowance may not be needed when the assessment is made from the standpoint of the consolidated group. Similarly, the sum of amounts determined for individual members may not equal the consolidated amount as a result of intercompany transactions.

14.1.2 Benefits-for-Loss

Another type of tax allocation, known as benefits-for-loss, may be considered to comply with the criteria of ASC 740-10-30-27 through 30-28. This 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 even if the subsidiary would not otherwise have realized the 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 financial statements.

However, application of this policy may be complicated when the consolidated group is in an AMT position or requires a valuation allowance on its deferred tax assets. To comply with the criteria in ASC 740, the policy should not be applied in a manner that results in either current or deferred tax benefits being reported in the separate subsidiary financial statements that would not be considered realizable on a consolidated basis unless such benefits are realizable on a stand-alone basis.

While not a pre-requisite, oftentimes the benefits-for-loss policy mirrors the tax-sharing agreement between the parent and the subsidiary. To the extent that the consolidated return group settles cash differently than the amount reported as realized under the benefits-for-loss accounting policy, the difference should be accounted for as either a capital contribution or as a distribution (see TX 14.2 below).

14.1.3 Other Methods

If another method or a modified method (described above) is used, it must be determined whether that method falls within the parameters of ASC 740-10-30-27 through 30-28. The tax allocation requirements of ASC 740 pertain to the allocation of expense; yet the basic methodology of ASC 740 pertains to the determination of deferred tax liabilities or assets based on temporary differences. Although the allocation method must be consistent with the broad principles of ASC 740, it is not clear whether any correlation is intended between an individual member’s temporary differences and the portion of the consolidated deferred tax liabilities and assets that are reflected in its separate statements.

In most cases, the same allocation method should be applied to all members of the group. However, there may be facts and circumstances that prompt the use of different methods for certain members of a consolidated group.

14.2 Tax Allocation Versus Tax Sharing Arrangements

If a tax-sharing agreement differs from the method of allocation under ASC 740-10-30-27 through 30-28, the difference between the amount paid or received under the tax-sharing agreement and the expected settlement amount based on the method of allocation is treated as a dividend (i.e., when less cash was received or more cash was paid by the subsidiary than would have been expected under the method of tax allocation) or a capital contribution (i.e., when more cash was received or less cash was paid by the subsidiary than would have been expected under the method of tax allocation). For example, a single-member limited liability company (LLC) that presents a tax provision on the separate return basis, but is not required to remit cash to the parent for any amounts payable or is not entitled to receive cash for amounts receivable should recharacterize these amounts payable or receivable as a capital contribution or dividend. A single-member LLC should also recharacterize these amounts payable or receivable as a capital contribution or dividend if the parent decides not to collect or reimburse a subsidiary under a tax-sharing arrangement that would otherwise require settlement.

Example 14-1: Differences between Amounts Expected under a Tax-Allocation Method and Amounts Settled under the Tax-Sharing Arrangement

Background/Facts:

A subsidiary that prepares separate company financial statements is a member included in the consolidated tax return of the parent. The subsidiary uses the separate return method to allocate income taxes to their stand-alone financial statements. Under the tax-sharing arrangement, the subsidiary pays taxes to or receives tax refunds from the parent, based on the separate return method. When the subsidiary generates operating losses that are carried back to offset tax liabilities on the consolidated tax return, the parent establishes an intercompany account to the subsidiary in lieu of remitting cash.

In 2007, the subsidiary generated operating losses that resulted in a $100 million receivable from the parent because the subsidiary reported that, under the separate return method, the operating losses were being carried back to taxable income from prior years. The parent decided that it will not cash-settle the intercompany account with the subsidiary.

Question(s):

How should this decision be recorded in the subsidiary’s separate company financial statements? Should it be considered an operating expense or a capital distribution/dividend to the parent company?

Analysis/Conclusion:

The decision by the parent not to cash-settle the intercompany account should be recorded as a capital distribution/dividend in the separate financial statements of the subsidiary. In essence, the parent has amended the tax-sharing arrangement with the subsidiary. That is, the differences between the expected settlement amount based on the method of allocation under ASC 740-10-30-27 through 30-28 and the actual settlement amount under the tax-sharing arrangement (or amended tax-sharing arrangement as in this fact pattern) should be recorded in equity.

14.3 Change in Method

A change in tax-allocation policy is considered a change in accounting principle, as ASC 740 prescribes criteria that an intra-entity tax-allocation policy must meet to be considered acceptable under U.S. GAAP. Therefore, the change in policy must be justified as preferable given the circumstances, and an SEC registrant must obtain a preferability letter from its auditors. Companies need to follow the guidance in ASC 250, Accounting Changes and Error Corrections, which requires a retrospective application.


14.4 Single-member and Multiple-member Limited Liability Companies

Questions often arise regarding how single-member and multiple-member LLCs should account for income taxes in their separate financial statements. ASC 740 does not specifically mention either type of entity. ASC 272, Limited Liability Entities, however, provides some guidance for accounting for LLCs. ASC 272-10-05-4 indicates that LLCs are similar to partnerships in that members of an LLC (rather than the entity itself) are taxed on their respective shares of the LLC’s earnings. Therefore, multiple-member LLCs generally do not reflect income taxes if they are taxed as partnerships (a partnership tax return is filed and the investors each receive K-1s) and are not otherwise subject to state or local income taxes. (However, if a multiple-member LLC is subject to state or local income taxes (i.e., because certain states impose income taxes on LLCs) the entity would be required to provide for such taxes in accordance with ASC 740.) This is also true if the multiple members are part of the same consolidated group.

Single-member LLCs, however, are accounted for differently. The U.S. federal tax law provides an election for single-member LLCs to be taxed as either associations (i.e., corporations) or “disregarded entities.” If the election is made to be taxed as an association, there is no difference between classification as a single-member LLC and a wholly owned C corporation for federal income taxes. If a single-member LLC does not specifically “check the box,” it is automatically treated as a disregarded entity. This means that, for federal income tax purposes, single-member LLCs are accounted for as divisions of the member and do not file separate tax returns. For example, if the member was a C corporation, the earnings and losses of the LLC would automatically roll up into the member’s corporate tax return, where they would be subject to tax at the corporate rate. From a federal income tax perspective, there is no substantive difference between a single-member LLC that is treated as a disregarded entity and a division that is included in the consolidated tax return. Therefore, for LLCs that are included in a public filing and subject to complying with SAB Topic 1B’s “carve-out” accounting, income taxes should be provided. For LLCs not subject to SAB Topic 1B, we believe that presenting a tax provision is the preferred accounting policy election. For those entities that do not present an income tax provision, we would expect disclosures stating why income taxes have not been provided.

Conversely, if the single member was a partnership, the earnings and losses of the LLC would automatically roll up into the member’s partnership return and be passed through to the individual partners. In this case, we believe that the single-member LLC, regardless of whether they are included in a public filing, should not provide income taxes in their separate financial statements. In situations where the LLC is owned by a second single-member LLC, the character of the member of the second LLC (for example, a C corporation or a partnership) should determine the presentation of income taxes in the separate financial statements of the lower-tier LLC.

Disclosure of the entity’s accounting policy should be provided with regard to income taxes in the separate financials of the single-member LLC. The accounting policy should be applied consistently from period to period. For private companies that present a tax provision, disclosures should be consistent with those required by
ASC 740-10-50-17.

Example 14-2: Determining Whether a Wholly Owned, Multi-member LLC Is an In-substance, Single-member LLC

Background/Facts:

An LLC is 50 percent owned by two parties, Company X and Company Y (both C corporations). However, the LLC is a public registrant through the issuance of public debt. Further, Company X is owned by a C corporation, Company Z. The LLC’s separate company financial statements appropriately did not provide for income taxes because it was a multi-member LLC and thus a flow-through entity for tax purposes. In a subsequent purchase transaction, Company Y was acquired by Company Z. After the acquisition of Company Y by Company Z, the LLC is ultimately wholly owned by Company Z.

Question:

After the purchase transaction is completed, should the LLC provide taxes in its separate company financial statements in accordance with SAB topic 1B? The organization structure after the transaction follows below.


Analysis/Conclusion:

No. We believe that the determination of whether taxes should be provided in the LLC’s separate financial statements should focus on whether the tax law considers the entity to be a flow-through entity. In this case, Company X and Company Y continue to retain their respective interests in the LLC. Therefore, the LLC is still considered a partnership for federal income tax purposes, and the separate financial statements of the LLC should not include any provision for income taxes.

14.5 Disclosures

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 items in its separately issued financial statements:

The aggregate amount of current and deferred tax expense for each statement of earnings presented and the amount of any tax-related balances due to or from affiliates as of the date of each statement of financial position presented

The principal provisions of the method by which the consolidated amount of current and deferred tax expense is allocated to members of the group, and the nature and effect of any changes in that method (and in determining related balances to or from affiliates) during the years for which the disclosures are presented

These disclosure requirements are in lieu of, rather than in addition to, the general disclosure requirements discussed in Chapter TX 15 of this monograph. The disclosure requirements are essentially the generic requirements of ASC 850, which are applied to intercorporate tax allocation. We believe that it is generally appropriate in separate company financial statements to include a description of the types, and potentially the amounts, of significant temporary differences. Further, for SEC registrants, disclosures should be as complete as those required for separate return taxpayers (if practicable).

Some intercorporate tax-sharing agreements require the group members to settle currently with the parent the deferred and current tax liability or receivable. This may simply mean that the deferred tax provision is credited or charged to an intercompany account, where it loses any separate identity as tax-related. Thus, the separate statements of the subsidiary will not have deferred tax liabilities and/or assets that are reflective of its temporary differences. In such circumstances, we strongly suggest disclosing, at least in aggregate, the amounts of the taxable and deductible temporary differences and/or carryforwards, in addition to the corresponding amounts included in the intercompany accounts.

When an entity has been included in a consolidated U.S. tax return, it is jointly, with other members of the consolidated group, and severally liable for any additional taxes that may be assessed. There may be circumstances in which it is appropriate to disclose this contingent liability, based on the disclosure requirements for unasserted claims.

14.6 Impact of a Change in Tax Basis on Separate Historical Financial Statements

ASC 740-20-45-11 addresses the way an entity should account for the income tax effects of transactions among or with its shareholders. ASC 740-20-45-11 provides that the tax effects of all changes in tax bases of assets and liabilities caused by transactions among or with shareholders should be included in equity. In addition, if a valuation allowance was initially required for deferred tax assets, as a result of a transaction among or with shareholders, the effect of recording such a valuation allowance should also be recognized in equity. However, changes in the valuation allowance that occur in subsequent periods should be included in the income statement.

For example, ASC 740-20-45-11 would apply in the separate financial statements of an acquired entity that does not apply push-down accounting to a transaction in which an investor entity acquires 100 percent of the stock (i.e., a non-taxable transaction) of the acquired entity. If, for tax purposes, this transaction is accounted for as a purchase of assets (e.g., under IRC Section 338(h)(10)), there would be a change in the tax bases of the assets and liabilities. However, because the purchase accounting impacts are not pushed-down to the separate financial statements of the acquired entity for book purposes, there would be no change in the carrying value of the acquired entity’s assets and liabilities. In this situation, both the impacts of the change in tax basis and any changes in the valuation allowance that result from the transaction with shareholders would be recognized in equity. However, changes in the valuation allowance that occur in subsequent periods should be included in the income statement.

Example 14-3: Interaction of Push-down Accounting and Deferred Taxes on a Subsidiary’s Separate Financial Statements

Background/Facts:

Company A (a public company) purchased Company B’s stock (a privately-held company) in a transaction accounted for as a taxable business combination (i.e., an asset purchase for tax purposes), as a result of an election under IRC Section 338(h)(10). Company B is required to issue separate company financial statements that will not be filed with the SEC. Company B uses the separate return method in recording taxes in the separate financial statements.

Question:

Should Company B record deferred taxes related to goodwill (which is equal for book and tax purposes on a consolidated basis at the time of the business combination) in its separate financial statements if Company B (1) applies push-down accounting, or (2) does not apply push-down accounting?

Analysis/Conclusion:

As a private company, Company B has the choice of whether or not to apply push-down accounting in accordance with ASC 805-50-25-3. However, regardless of whether or not push down accounting is applied, the tax basis in goodwill is stepped up as a result of the asset purchase. Thus, Company B will enjoy the benefit of the amortization of the tax basis in goodwill.

Scenario 1—Push-Down Accounting:

No. Deferred taxes related to goodwill are not recognized at the date of acquisition. Company B would reflect book goodwill at the amount that is pushed down. In this example, the book push-down amount equals tax goodwill and, thus all goodwill is classified as component 1 as described in ASC 805-740-25-8 through 25-9. As goodwill is amortized and deducted for tax purposes, a book over tax difference on the component 1 goodwill is created (assuming the book goodwill has not been impaired) for which a deferred tax liability would be recorded.

Scenario 2—No Push-Down Accounting:

Yes. Deferred taxes related to goodwill are recognized at the date of acquisition. Company B would not record book goodwill in its separate financial statements. However, the tax basis (in this case tax-deductible goodwill) created, as a result of the election to treat the business combination as an asset purchase, is attributable to Company B and should be reflected in Company B’s separate financial statements. ASC 740-20-45-11(g) indicates that the effects of “all changes in the tax bases of assets and liabilities caused by transactions among or with shareholders shall be included within equity.” Accordingly, Company B would report an increase to contributed capital by the amount of the DTA initially recorded. Subsequently, changes to the DTA resulting from amortization of the goodwill for tax purposes would be reported as a component of deferred tax expense in the income statement and will offset the current tax benefit attributable to the amortization of goodwill, resulting in no impact on the effective tax rate subsequent to the combination.

Example 14-4: Accounting for the Income Tax Effect of a Taxable Distribution by a Subsidiary to Its Parent on the Subsidiary’s Separate Financial Statements

Background/Facts:

Company A owns 100 percent of Company B. Company B makes a taxable distribution of appreciated property to Company A. Separate financial statements must be issued at the level of Company B. In Company B’s financial statements, the distribution is recorded for GAAP purposes at book value and reflected as a distribution to Company A; as such, no gain is recognized for book purposes. However, Company B is taxed in its jurisdiction on the excess of the distributed property’s fair value over its tax basis.

Question:

How should the tax effect of this transaction be reflected in the separate financial statements of Company B?

Analysis/Conclusion:

ASC 740-20-45-11(g) states that tax effects of all changes in the tax bases of assets and liabilities caused by transactions among or with shareholders should be included in equity. Furthermore, ASC 740-20-45-11(c) states that the tax effects of an increase or decrease in contributed capital shall be charged or credited to shareholders’ equity. Accordingly, in the example above, Company B should reflect the tax effects of the transaction as a reduction of paid-in capital. The application of ASC 740-20-45-11 should be made with respect to the reporting entity.

Note: The analysis/conclusion discussed above is applicable to the separate financial statements of Company B. The accounting would be different for the consolidated statements of Company A. Specifically, Company A would need to consider ASC 740-10-25-3(e), which prescribes the accounting for the income tax effects of intercompany transactions rather than ASC 740-20-45-11(g).

Example 14-5: Accounting in Separate Company Financial Statements for the Tax Consequences of a Transfer of Shares That Results in an IRC Section 311(b) Gain on a Consolidated Tax Basis

Background/Facts:

Parent A owns 100 percent of the stock of Subsidiary B, which in turn owns 100 percent of Subsidiary M. A domestic subsidiary, Subsidiary M falls within the same tax jurisdiction as Subsidiary B. To determine income taxes, Subsidiary B prepares separate company financial statements using the separate return method. Parent A files a U.S. consolidated tax return that includes Subsidiaries B and M.

Subsidiary B distributes the stock of Subsidiary M to Parent A through a nonreciprocal transfer of the stock to Parent A at book value. The book basis that Subsidiary B has in Subsidiary M’s stock exceeds the tax basis of its investment, but is less than the fair value of the shares. The transfer of Subsidiary M by Subsidiary B triggers an Internal Revenue Code (IRC) Section 311(b) tax gain, which is deferred for tax return purposes because the transfer occurs within the consolidated tax group. Based on its facts and circumstances, Parent A does not expect to recover the related Section 311(b) gain tax-free. On a consolidated basis, the gain will be recognized upon the dissolution of the consolidated group (e.g., when the distributing company, Subsidiary B, is no longer considered part of the consolidated group) or the sale of Subsidiary M to a third party. A diagram of the organization and transfer follows:


Question:

Should Subsidiary B record the tax effects of this transaction in its separate company financial statements, even though the Section 311(b) gain is a deferred intercompany transaction on a consolidated tax basis?

Analysis/Conclusion:

Yes. Under the separate return method, Subsidiary B must calculate the income tax effects of this transaction in accordance with ASC 740-10-30-27 through 30-28 as if it were a stand-alone entity. However, because the transaction involves a shareholder (i.e., parent), ASC 740-20-45-11 must also be considered. The transfer of Subsidiary M to Parent A should be characterized as a transfer that would trigger recognition of the 311(b) gain on a separate return basis. Accordingly, Subsidiary B should recognize the tax effects of this transfer, as a tax liability would have been triggered if Subsidiary B had been a stand-alone company (the accounting required under a separate return method). The income tax consequence generated from this distribution is based on the difference between the fair value of the shares distributed and the tax basis of such shares.

The income tax consequence should be accounted for as follows:

1. Difference between the outside book basis in Subsidiary M and the tax basis (i.e., outside basis difference)

Typically, Subsidiary B would assert that Subsidiary M would be divested in a tax-free manner. This is because Subsidiary M is a domestic subsidiary, and therefore a deferred tax liability would not have been previously recorded for the outside basis difference (ASC 740-30-25-7). Because Subsidiary M was divested in a manner that was not tax-free, Subsidiary B must record the tax effects of any previously unrecognized outside basis difference through the income statement, with a corresponding liability recorded in the balance sheet. This tax consequence is the result of a change in Subsidiary B’s expectations about the amount of time or the method ultimately used to recover its investment in the subsidiary. The effect of this change should be recognized in the income statement in the period during which the expectation changes.

This conclusion would be the same for a domestic subsidiary (as described in the fact pattern above) or a foreign subsidiary for which a deferred tax liability was not provided due to the provisions of ASC 740-30-25-17.

If a deferred tax liability had been previously recorded for the difference between the book basis and the tax basis related to Subsidiary B’s investment in Subsidiary M, and if that deferred tax liability represented the actual tax consequence for the outside basis difference, no incremental tax consequence should be recognized in the income statement of Subsidiary B. For example, the tax rates used to measure the deferred tax liability (i.e., capital gains rate) would need to be consistent with the actual tax rate applied to the transfer (i.e., capital gains rate). However, any differences between the deferred tax liability previously recorded on the outside basis difference and the actual tax rate applied to the outside basis difference would need to be recognized through the income statement in the period during which the expectation changes.

2. Difference between the fair value and book basis of the stock

To the extent that a tax liability is generated from Subsidiary B’s transfer of Subsidiary M’s shares to Parent A, the portion of the tax liability related to the excess of fair value over book value should be accounted for as a direct charge to equity by analogy to ASC 740-20-45-11, which provides that “the tax effects of all changes in the tax bases of assets and liabilities caused by transactions among or with shareholders should be included in equity.” This portion of the tax liability is not related to a previously unrecognized outside basis difference, but rather is considered an incremental tax effect of an equity restructuring between the company (Subsidiary B) and its shareholder (Parent A).

Note: The cash settlement of this liability depends on the terms of the intercompany tax-sharing agreement. If Subsidiary B will not be responsible for the tax due either currently or at some future date, the extinguishment of that liability is considered a capital contribution by Parent A to Subsidiary B and should be recorded as a credit to equity.

14.7 Uncertain Tax Positions and Separate Financial Statements of a Subsidiary

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.

Questions have arisen regarding the appropriate disclosures related to unrecognized tax benefits for separate statements of a member of a group that files as part of a consolidated tax return. The following example illustrates the correlation between the intercorporate allocation accounting policy under ASC 740-10-30-27 through 30-28 and its related impact on the disclosure requirements for unrecognized tax benefits.

Example 14-6: Disclosures in Separate Company Financial Statements

Background/Facts:

Subsidiary B is wholly owned by Company A and is included as a member of the Company A consolidated federal income tax return. Subsidiary B is included in the consolidated financial statements of Company A and also prepares its own separate company financial statements.

Question:

Should Subsidiary B include all of the disclosures related to unrecognized tax benefits required by ASC 740-10-50-15 and 50-15A in its separate company financial statements?

Analysis/Conclusion:

If practicable, separate company financial statements should be prepared so that they are as similar as possible to a complete set of GAAP financial statements. However, ASC 740-10-50-17 requires specific disclosures for an entity that is a member of a group that files a consolidated tax return. We believe that these disclosure requirements are offered in lieu of, rather than in addition to, the disclosure requirements for consolidated financial statements. Consistent with the general principles of separate company financial statements, we believe that the decision to include the disclosures required by ASC 740-10-50-15 and 50-15A in separate company financial statements depends primarily on the level of other income tax footnote disclosures presented in the separate company financial statements. Common methods of allocating income taxes in separate company financial statements and related disclosures are provided below:

1. Separate return method (i.e., no modifications)

Under the separate return method for allocating consolidated income tax expense, a subsidiary is allocated income tax expense as if it were a separate taxpayer. In SAB Topic 1(B), the SEC staff stated its belief that this is the preferred method for allocating income taxes in separate company financial statements, as this allocation method is intended to reflect all tax consequences on a stand-alone basis. Because it is common practice for entities applying the separate return method to provide all disclosures required by ASC 740-10-50, users of this method should include all applicable disclosures required by ASC 740-10-50-15 and 50-15A.

2. Modified separate return method (i.e., settlement of uncertain tax position)

This method of allocating consolidated income tax expense is identical to the separate return method, with one noteworthy exception: Any subsequent changes in assessment about the sustainability of tax positions should be allocated to the parent. Thus, under the tax-sharing agreement, the subsidiary bears no risk associated with any subsequent change in the sustainability of uncertain tax positions. For example, assume that a subsidiary takes a position in its tax return that does not meet the recognition threshold of ASC 740-10-25. In this case, the subsidiary records tax expense as if the position provided no benefit. For the fact pattern presented above, we do not believe that all of the applicable disclosures required by ASC 740-10-50-15 and 50-15A are required because the tax-allocation method stipulates that the effects of changes in recognition and measurement of uncertain tax positions are allocated to the parent. However, we do believe that the company should provide transparent disclosures of the company’s intercorporate tax-allocation policy and the manner in which the benefits from uncertain tax positions are allocated (both in the year in which the position is taken and the year in which subsequent changes to recognition and measurement occur).

3. Any other acceptable allocation policy

If a company employs an intercorporate tax-allocation accounting policy, other than the separate return method or the separate return method with a modification for tax uncertainties, that is consistent with the provisions of ASC 740-10-30-27 through 30-28, we believe that the level of disclosures related to unrecognized tax benefits should be based on the current level of disclosure related to income taxes in general. If the financial statements contain disclosures that are consistent with those of a complete set of GAAP financial statements (i.e., all ASC 740 disclosures), all of the applicable disclosures required by ASC 740-10-50-15 and 50-15A should be included. However, if the financial statements do not include all other disclosures required by ASC 740, but include only those disclosures required by ASC 740-10-50-17, we do not believe that inclusion of all disclosures related to unrecognized tax benefits is required.

14.8 Carve-out Financial Statements

Carve-out financial statements refer to financial statements prepared by an entity for a division or other part of its business that is not necessarily a separate legal entity, but is part of the larger consolidated financial reporting group. The preparation of carve-out financial statements can be complex and is often highly judgmental. 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. However, 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 ASC 740.

The methods for intercorporate tax allocation for a carve-out are the same as the methods described previously for the separate financial statements of a subsidiary that is part of a consolidated tax group. However, preparing a tax provision for carve-out financial statements can present a unique set of financial reporting issues. These include the following:

Understanding the purpose of the carve-out financial statements and the corresponding pre-tax accounting: 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.

Persons responsible for preparing a tax provision 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 (see Section TX 18.12.1).

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 would arise from the push-down.

Intercompany transactions: Intercompany transactions that were formerly eliminated in the consolidated financial statements (e.g., 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. Accordingly, the income tax accounting for those transactions would 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) or (g).

Intercompany cash settlement arrangements: When a company is preparing carve-out financial statements, the underlying cash flows related to taxes during the historical period may have no relationship to the actual tax liabilities of the carved-out entity. As such, there could be a series of equity transactions (capital contributions and dividends) that account for the differences between actual cash flow and the taxes that are allocated under the accounting policy chosen for intercorporate tax allocation.

Hindsight: ASC 740-10-30-17 states that “all available evidence . . . shall be considered . . .” and that “historical information is supplemented by all currently available information about future years.” Notwithstanding ASC 740-10-30-17, we generally believe that hindsight should not be used to apply ASC 740 when preparing carve-out financial statements for prior years. Accordingly, if an assumption 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 assumption to the prior year. For example, consider this scenario: A deferred tax asset was supportable in Year 1 based on the fact that the entity had been profitable and had no negative evidence, but, as a result of significant subsequent losses, a valuation allowance was required in Year 2. Without using hindsight, we believe that it would be appropriate to set up a deferred tax asset without a valuation allowance in Year 1 and then to record a valuation allowance in Year 2 based on the subsequent developments.

Historical assertions made by management of the consolidated group: At times, management may indicate in a carve-out situation that it would have made different assertions or tax elections if the entity had been a stand-alone entity. However, it is generally not appropriate to revisit historical assertions or elections made by management of the consolidated group because the tax provision for the carve-out entity is an “allocation” of the group tax provision. Similarly, it would generally be inappropriate to reassess the historical recognition and measurement of uncertain tax positions when preparing carve-out 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.

For example, some carved-out entities have questioned whether it would be appropriate to revisit the indefinite reinvestment assertion (ASC 740-30-25-17) that the parent reflected in its consolidated financial statements. We do not believe that this would be appropriate. However, if the carve-out entity expects its assertions 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.

In certain limited situations, it may be appropriate for a stand-alone entity’s carve-out financial statements to deviate from the assertion or election made by management of the consolidated group as illustrated below in Example 14-7. In this narrow fact pattern, the federal tax regulations provide for a choice in the treatment of foreign taxes paid. Companies are allowed to deduct foreign taxes paid or may find it more beneficial to claim a credit for those payments.

Example 14-7: Consideration of Foreign Taxes Paid in Separate Company Financial Statements of Subsidiary

Background/Facts:

Company A is a multinational company that generates U.S. foreign tax credits (FTCs) as a result of taxes paid which could alternatively be elected to be claimed as U.S. federal tax deductions. In 20X1, Company A generated FTCs in the amount of $100. Despite a current year loss at Company A, the FTCs were fully utilized in the U.S. consolidated tax return filed by Company A’s parent. Although Company A is included in its parent’s consolidated financial statements, it also prepares separate company financial statements using the separate return method for the allocation of income taxes. Since Company A does not expect to have sufficient foreign source income to utilize the FTCs, if it were filing a separate return, Company A would deduct the foreign taxes paid rather than claiming them as a credit.

Question(s):

Under the separate return method for allocating income taxes, how should Company A record the tax effects of its foreign taxes paid?1

1 Eligibility to claim a U.S. federal tax deduction does not extend to foreign taxes “deemed paid” under IRC Sec. 902. To the extent a company elects to deduct foreign taxes, it would forgo any deemed paid credits for the years in which deductions are taken.

Analysis/Conclusion:

ASC 740-10-20-37 requires the consolidated amount of current and deferred tax expense for a group that files a consolidated income tax return to be allocated among the group members when those members issue separate financial statements.2

2 The same principle would apply to combined, unitary or other similar tax returns, including non-U.S. jurisdictions.

Under the separate return method, a subsidiary is assumed to file its own stand-alone tax returns. Thus, it is possible that a subsidiary could recognize a hypothetical loss or credit carryforward in its separate company accounts even if no carryforward exists on a consolidated basis. The subsidiary must then assess the need for a valuation allowance against any such credits or loss carryforwards on the basis of its separate evidence in accordance with ASC 740-10-30-19.

In this case, Company A would recognize a $100 FTC carryforward deferred tax asset in its stand-alone accounts, even though there is no FTC carryforward reflected in its parent’s consolidated balance sheet accounts. Company A would then need to assess the credit carryforward for realization.

To the extent Company A determines that it cannot realize the FTC on a separate return basis and would need to record a valuation allowance, it would be able to deduct foreign taxes paid (rather than treating them as creditable) as an option available under U.S. tax law. Thus, Company A would record a valuation allowance of $65 (assuming a 35 percent tax rate), which represents the excess benefit of claiming a credit over a deduction.

Example 14-8: Undistributed Foreign Earnings

Background/Facts:

A spin-off entity plans to avail itself of the indefinite reinvestment exemption (ASC 740-30-25-17) for providing income taxes on foreign undistributed earnings and other outside basis differences in the years following the spin-off. However, the parent group of the spinnee did not make this assertion and, in fact, actually repatriated earnings. Management contends that if the spin-off entity had been a separate stand-alone entity, it would not have repatriated earnings and would have asserted indefinite reinvestment.

Question(s):

Can the spin-off entity’s separate historical financial statements reflect assertions regarding the indefinite reinvestment of foreign earnings that differ from historical events? Can the spin-off entity therefore avail itself of the indefinite reinvestment exemption for the carve-out years?

Analysis/Conclusion:

No, it would be inappropriate for the spin-off entity’s separate historical financial statements to reflect a different indefinite reinvestment assertion than existed historically. Specifically, the tax consequences of foreign income should be reflected on a stand-alone basis in the periods the income was earned (i.e., the ASC 740-30-25-17 exemption should not be used). However, the entity would not be precluded from changing its indefinite reinvestment assertion for future periods (i.e., post spin-off). If such a change is made, the effects should be reflected in the period the assertion changes.

Example 14-9: Accounting for a Change in Indefinite Reinvestment Assertion as a Result of a Nontaxable Spin-off Transaction

Background/Facts:

In 20X8, Company A made a decision to spin-off Subsidiary B (“Sub B”) and its controlled foreign corporation (“CFC”), in a nontaxable transaction. Company A’s management will prepare carve-out financial statements for Sub B in connection with the anticipated transaction.

Historically, Company A asserted indefinite reinvestment under ASC 740-30-25-17, regarding Sub B’s outside basis difference in its investment in CFC (i.e., no deferred tax liability (“DTL”) was recorded on the outside book-over-tax basis difference). After the spin-off, however, Sub B will no longer be able to assert indefinite reinvestment. This is because after the spin-off, Sub B will no longer receive funding from Company A and therefore will need to repatriate CFC’s cash in order to fund its U.S. operations and repay separate company borrowings. Absent the spin-off transaction, Company A would expect to continue to assert indefinite reinvestment (i.e., no other factors exist that would cause Company A to change its indefinite reinvestment assertion).


Question:

At what point in time, and on whose books (i.e., spinnor’s or spinnee’s), should the tax effect of a change in the indefinite reinvestment assertion (i.e., the recording of a DTL for the outside basis difference) as a result of the nontaxable spin-off be recorded?

Analysis/Conclusion:

We believe that there are two acceptable accounting alternatives to consider:

Alternative #1: Record the DTL on both the spinnor’s and spinee’s books when the decision to consummate the spin-off transaction is made (i.e., prior to the spin).

This view is supported by ASC 740-30-25-19, which provides that “… 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 should accrue as an expense of the current period income taxes attributable to that remittance.” In addition, this view is consistent with ASC 740-30-25-10, which indicates that a company should record a DTL for the outside basis difference when it is apparent that the temporary difference will reverse in the foreseeable future (i.e., no later than when the subsidiary qualifies to be reported as discontinued operations).

Proponents of this alternative point to the fact that the temporary difference related to Sub B’s outside basis difference in its investment in the CFC existed prior to the change in assertion, but, by virtue of the indefinite reinvestment exception, Company A was not required to accrue income taxes on the undistributed earnings of the CFC. Consequently, the moment it becomes apparent that some or all of the undistributed earnings of the subsidiary will be remitted in the foreseeable future, Company A should record the DTL on the outside basis difference.

Alternative #2: Record the DTL on both the spinnor’s and spinee’s books at the time of the spin-off transaction.

This view is supported by analogy to Section TX 6.2.5.2, which indicates that in the event of an increase in valuation allowance as a result of a spin-off, the financial statements of the parent should reflect a charge to continuing operations at the time of the spin-off even though such a charge would not have been required if the spin off had not occurred.

Proponents of this alternative point to the fact that absent the spin-off transaction, Company A would continue to assert indefinite reinvestment under ASC 740-30-25-17, therefore Company A’s expectations regarding the indefinite reversal of the temporary difference will not change until the consummation of the spin-off.

Note: As it relates to the charge to establish the DTL on Company A’s books (i.e., due to the change in indefinite reinvestment assertion), we would not object to intraperiod allocation of the related tax expense to either discontinued operations or continuing operations, provided that appropriate disclosures were made and the chosen accounting method was consistently applied (See Section TX 12.2.3.2.4.2 for further discussion).