11.7 Other Considerations

Deferred taxes associated with the stock of the component being sold (the outside basis differences7) should not be presented as held for sale in either an asset sale or a stock sale since the acquirer will not assume the outside basis difference.

An entity can either record the amounts in its subsidiary’s books (i.e., actual pushdown accounting) or maintain the records necessary to adjust the consolidated amounts to what they would have been had the amounts been recorded on the subsidiary’s books (i.e., notional pushdown accounting). The latter method can often make recordkeeping more complex.

Further, to the extent the reporting entity’s functional currency differs from the currency in which an acquiree files its tax return, an entity must convert the entire amount recorded under the acquisition method for a particular asset or liability to the currency in which the tax-paying component files its tax return (the “tax currency”) to properly determine the (1) temporary difference associated with the particular asset or liability and (2) the corresponding DTA or DTL (i.e., deferred taxes are calculated in the tax currency and then translated or remeasured in accordance with ASC 830).

The legacy partners typically control the C corporation even after the IPO (i.e., the legacy partners sell an economic interest to the public while retaining shares with voting control but no economic interest). The C corporation uses the IPO proceeds to purchase an economic interest in the partnership along with a controlling voting interest. Accordingly, the C corporation consolidates the partnership for book purposes. Because the C corporation is taxable, it will need to recognize deferred taxes related to its investment in the partnership. This outside basis difference is created because the C corporation (1) receives a tax basis in the partnership units that is equal to the amount paid for the units (i.e., fair value) but (2) has carryover basis in the assets of the partnership for U.S. GAAP reporting (because the transaction is a transaction among entities under common control). See Appendix B of Deloitte’s Roadmap Business Combinations for further discussion of the accounting for common-control transactions.

Typically, the original partnership is the C corporation’s predecessor entity and the C corporation is the successor entity (and the registrant). After the transaction becomes effective, the registrant’s initial financial statements reflect the predecessor entity’s operations through the effective date and the successor entity’s post-effective operations in a single set of financial statements (i.e., the predecessor and successor financial statements are presented on a contiguous basis). Since no step-up in basis occurs for financial statement purposes because of the common-control nature of the transaction, the income statement and balance sheet are presented without use of a “black line.” The equity statement, however, reflects the recognition of a noncontrolling interest as of the effective date and prospectively in the registrant’s post-effective financial statements. In addition, the C corporation must recognize deferred taxes upon investing in the partnership, which occurs on the effective date.

In such situations, questions often arise about whether (1) the predecessor entity’s tax status has changed in such a way that the deferred tax benefit or expense related to the recognition of the deferred tax accounts would be accounted for in the income statement or (2) there has been a contribution of assets among entities under common control, in which case the recognition of the corresponding deferred tax accounts would be accounted for in equity.

While the formation of the new C corporation has resulted in a change in the reporting entity, we do not believe that the predecessor entity’s tax status has changed. In fact, in the situation described above, the predecessor entity was formerly structured as a partnership and continues to exist as a partnership after the effective date (i.e., the legacy partners continue to own an interest in the same entity, which remains a “flow-through” entity to them both before and after the effective date) even though the successor entity’s financial statements are presented on a contiguous basis with the predecessor entity’s financial statements, albeit with the introduction of a noncontrolling interest.

Accordingly, we believe that the recognition of taxes on the C corporation’s investment in the partnership should be recorded as a direct adjustment to equity, as if the former partners in that partnership contributed their investments (along with the corresponding tax basis) to the C corporation (see Section 12.4.1 for a discussion of why these adjustments are recorded as equity transactions). The additional step-up in tax basis received by the C corporation upon its investment in the partnership (and in the flow-through tax basis of the underlying assets and liabilities of the partnership) after the effective date would similarly be reflected in equity in accordance with ASC 740-20-45-11(g), which states:

Typically, the division or disregarded entity is determined to be the newco’s predecessor entity and the newco is determined to be the successor entity. After the transaction is effective, the successor’s initial financial statements reflect the predecessor entity’s operations through the effective date and the successor entity’s operations after the effective date in a single set of financial statements (i.e., the predecessor and successor financial statements are presented on a contiguous basis). Since no step-up in basis occurs for financial statement purposes because of the common-control nature of the transaction, the income statement and balance sheet are typically presented without the use of a “black line.”

A predecessor entity’s financial statements that have been filed publicly often include an income tax provision. SAB Topic 1.B.1 requires that members (i.e., corporate subsidiaries) and certain nonmembers10 (i.e., divisions or lesser business components of another entity) of a group that are part of a consolidated tax return include an allocation of taxes when those members or nonmembers issue separate financial statements11 In addition, an entity may have a policy to allocate taxes to the separate financial statements of legal entities that are not subject to tax and are disregarded by the taxing authority (e.g., single-member LLCs or disregarded entities).12 When the successor entity is nontaxable (e.g., a master limited partnership), however, the successor entity will need to eliminate (upon effectiveness) any deferred taxes that were previously allocated to the predecessor entity.13

In situations in which deferred income taxes that were allocated to the predecessor entity are eliminated in the successor entity’s financial statements when the successor entity is nontaxable, questions often arise about whether (1) the predecessor entity’s tax status has changed in the manner discussed in ASC 740-10-25-32 such that the deferred tax benefit/expense from the elimination of the deferred tax accounts would be accounted for in the income statement, as prescribed by ASC 740-10-45-19, or (2) the deferred taxes were effectively retained by the contributing entity, suggesting that the deferred taxes should be eliminated through equity.

As noted above, while the predecessor entity has received an allocation of the parent’s consolidated income tax expense, the predecessor entity typically comprises unincorporated or disregarded entities that are not individually considered to be taxpayers under U.S. tax law (i.e., the historical owner was, and continues to be, the taxpayer). Accordingly, we do not believe that the predecessor entity’s tax status has changed in the manner discussed in ASC 740-10-25-32. Rather, we believe that the parent has retained the previously allocated deferred taxes (which is consistent with removing the deferred taxes through equity). Alternatively, the removal of the net deferred tax accounts, particularly in the case of a net DTL, might be analogous to the extinguishment (by forgiveness) of intra-entity debt. ASC 470-50-40-2 provides guidance on such situations, noting that “extinguishment transactions between related entities may be in essence capital transactions.” Accordingly, we believe that it is appropriate to reflect the elimination of deferred income taxes that were allocated to the predecessor entity as a direct adjustment to the successor entity’s equity on the effective date of the transaction.

The elimination of deferred taxes via an adjustment to equity is also consistent with an SEC staff speech by Associate Chief Accountant Leslie Overton in the SEC’s Division of Corporation Finance at the 2001 AICPA Conference on Current SEC Developments. Ms. Overton discussed a fact pattern in which the staff believed that certain operations that would be left behind upon a spin-off (i.e., retained by the parent) still needed to be included in the historical carve-out financial statements of the predecessor entity to best illustrate management’s track record with respect to the business operations being spun. However, Ms. Overton concluded her speech by noting that “[a]ssets and operations that are included in the carve-out financial statements, but not transferred to Newco should be reflected as a distribution to the Parent at the date Newco is formed.”

Although the transaction was between parties under common control, the combined financial statements should not be adjusted to include income taxes of the S corporation before the date of the common-control merger. ASC 740-10-25-32 states that DTAs and DTLs should be recognized “at the date that a nontaxable entity becomes a taxable entity.” Therefore, any periods presented in the combined financial statements before the common-control merger should not be adjusted for income taxes of the S corporation.

However, it may be appropriate for an entity to present pro forma financial information, including the income tax effects of the S corporation (as if it had been a C corporation), in the historical combined financial statements for all periods presented. For more information on financial reporting considerations, see Section 14.7.1.