Chapter 12 — Other Investments and Special Situations

12.3 Equity Method Investee Considerations

When an investor owns less than 50 percent of the voting capital, but is able to exercise significant influence, it generally applies the equity method of accounting unless an exception applies (i.e., the investor elects the fair value option under ASC 825-10, or specialized industry accounting requires carrying the investment at fair value).

In general, under the equity method of accounting, an investor initially recognizes its investment in an investee (including a joint venture) at cost in accordance with ASC 805-50-30. In addition, an investor that applies the equity method of accounting should comply with the requirements of ASC 323-10-35-4, which states, in part:

Under the equity method, an investor shall recognize its share of the earnings or losses of an investee in the periods for which they are reported by the investee in its financial statements rather than in the period in which an investee declares a dividend. An investor shall adjust the carrying amount of an investment for its share of the earnings or losses of the investee after the date of investment and shall report the recognized earnings or losses in income. An investor’s share of the earnings or losses of an investee shall be based on the shares of common stock and in-substance common stock held by that investor.

12.3.1 Deferred Tax Consequences of an Investment in an Equity Method Investment

When accounting for income taxes, investors in an equity method investment should generally recognize the deferred tax consequences for an outside basis difference unless an exception applies. An entity may need to use judgment, however, if it applies the equity method to a more-than-50-percent-owned investment (e.g., because the entity is a VIE and the investor is not the primary beneficiary or because of other participating rights held by other shareholders) given that the guidance in ASC 740-30-25-5(b) specifically refers to an investment in a 50-percent-or-less owned investee. In such a case, other guidance might also be relevant if, for example, the equity method investor could unilaterally determine whether dividends are granted by the equity method investee or could unilaterally execute steps that would allow the investment to be recovered in a tax-free manner.

See Section 3.4 for guidance on the definition of an outside basis difference. See Section 3.4.1 for guidance on the definition of foreign and domestic investments. Also see Section 3.4.17.1 for considerations related to VIEs.

12.3.1.1 Potential DTL: Domestic Investee

Equity investors that hold less than a majority of the voting capital of an investee do not possess majority voting power and, therefore, generally cannot control the timing and amounts of dividends, in-kind distributions, taxable liquidations, or other transactions and events that may result in tax consequences for investors. Therefore, for a 50 percent-or-less-owned investee, whenever the carrying amount of the equity investment for financial reporting purposes exceeds the tax basis in the stock or equity units of a domestic investee, a DTL is generally recognized in the balance sheet of the investor (in the absence of the exception in ASC 740-30-25-18(b)). An entity should consider the guidance in ASC 740-10-55-24 when measuring the DTL. The DTL is measured by reference to the expected means of recovery. For example, if recovery is expected through a sale or other disposition, the capital gain rate may be appropriate. Conversely, if recovery is expected through dividend distributions, the ordinary tax rate may be appropriate.

12.3.1.2 Potential DTL: Foreign Investee

ASC 740-30-25-5(b) requires equity investors that hold less than a majority of the voting capital of a foreign investee to recognize a DTL for the excess amount for financial reporting purposes over the tax basis of a foreign equity method investee that is not a corporate joint venture that is essentially permanent in duration. The indefinite reversal criterion in ASC 740-30-25-17 applies only to a consolidated foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration. A related topic is discussed in Section 3.4.4.

12.3.1.3 Potential DTA: Foreign and Domestic Investee

ASC 740-30-25-9 does not apply to 50-percent-or-less-owned foreign or domestic investees that are not corporate joint ventures that are permanent in duration. Therefore, equity investors that hold a noncontrolling interest in an investment that is not a corporate joint venture that is essentially permanent in duration should generally record a DTA for the excess tax basis of an equity investee over the amount for financial reporting purposes. As with all DTAs, in accordance with ASC 740-10-30-18, realization of the related DTA “depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback, carryforward period available under the tax law.” If realization of all or a portion of the DTA is not more likely than not, a valuation allowance is necessary.

12.3.2 Tax Effects of Investor Basis Differences Related to Equity Method Investments

In certain situations, there may be a difference between the cost of an equity method investment and the investor’s share of the investee’s individual assets and liabilities. ASC 323-10-35-13 requires entities to account for the “difference between the cost of an [equity method] investment and the amount of underlying equity in net assets of an investee . . . as if the investee were a consolidated subsidiary.” Entities therefore determine any difference between the cost of an equity method investment and the investor’s share of the fair values of the investee’s individual assets and liabilities by using the acquisition method of accounting in accordance with ASC 805. Differences of this nature are known as “investor basis differences” and result from the requirement that investors allocate the cost of the equity method investment to the individual assets and liabilities of the investee. Like business combinations, investor basis differences may give rise to deferred tax effects. To accurately account for its equity method investment, an investor would consider these inside basis differences in addition to any outside basis difference in its investment.

In accordance with ASC 323-10-45-1, equity method investments are presented as a single consolidated amount. Accordingly, tax effects attributable to the investor basis differences become a component of this single consolidated amount and are not presented separately in the investor’s financial statements as individual current assets and liabilities or DTAs and DTLs. The example below illustrates this concept.

Further, the investor’s share of investee income or loss needs to be adjusted for investor basis differences, including those associated with income taxes.

Example 12-3

Investor Y purchases a 40 percent interest in Investee Z for $2 million cash and applies the equity method of accounting. The book value of Z’s net assets is $3.5 million. The table below shows the book values and fair values of Z’s net assets (along with Y’s proportionate share) as of the investment acquisition date. Investee Z did not record any DTAs or DTLs in its own financial statements.

The statutory tax rate of Y and Z is 25 percent.

Since equity method goodwill is treated as if it were goodwill acquired in a business combination, there is no DTL associated with this basis difference. Because the total amount of the basis difference between the cost of Y’s investment ($2 million) and its proportionate share of the book value of Z’s net assets ($1.4 million) has not changed, the DTL recognized in the memo accounts increases the basis difference attributable to equity method goodwill in an amount equal to the DTL.

See Example 4-10 in Section 4.5 of Deloitte’s Roadmap Equity Method Investments and Joint Ventures for the above example’s predecessor, which illustrates the initial recognition of basis differences. See Example 5-13 in Section 5.1.5.2 of Deloitte’s Roadmap Equity Method Investments and Joint Ventures for an expanded version of the above example that illustrates the subsequent measurement of basis differences.

12.3.3 Change in Investment From a Subsidiary to an Equity Method Investee

ASC 740-30-25-15 provides guidance on situations in which an investment in common stock of a subsidiary changes in such a manner that it is no longer considered a subsidiary (e.g., the extent of ownership in the investment changes so that it becomes an equity method investment). In these cases, an entity must recognize a deferred tax expense in the current period to recognize a DTL related to the equity method investment when the subsidiary becomes an equity method investment. The example below illustrates this concept.

Example 12-4

Assume that Entity X had $1,000 of unremitted earnings from its investment in a foreign subsidiary, FI, and that management has determined that all earnings were indefinitely reinvested and that the related temporary difference would not reverse in the foreseeable future. Therefore, no DTL has been recorded. Further assume that at the beginning of 20X1, FI sold previously owned capital stock to an unrelated third-party investor such that X no longer has a controlling financial interest in Fl. However, because of its equity share of FI, X was required to use the equity method of accounting in accordance with ASC 323. During 20X1, X’s equity in earnings of FI was $2,000 and no dividends were paid or payable. In addition, X can no longer control the dividend policy of FI because it no longer controls a majority of the seats on the board of directors, and FI has announced a change in dividend policy beginning with 20X2 in which 20 percent of retained earnings, as of December 31, 20X2, will be paid to shareholders of record as of that date.

During 20X1, X would accrue as a current charge to income tax expense from continuing operations the tax effect of establishing (1) a DTL for the tax consequences of $2,000 of taxable income attributable to its share of equity in earnings of FI during 20X1, and (2) a DTL for its portion of the 20 percent equity in retained earnings to be distributed in 20X2 in accordance with FI’s new policy of remitting earnings in the future (calculated on the basis of the retained earnings balance at the end of 20X1).

See Section 11.3.6.3 for further discussion of the tax consequences of business combinations achieved in stages.

12.3.4 Accounting for an ITC Received From an Investment in a Partnership Accounted for Under the Equity Method

The accounting for ITCs was originally addressed in APB Opinion 2 (codified in ASC 740-10-25-46), which discusses direct investments in acquired depreciable property that generate ITCs. Since that guidance was introduced, however, the types of vehicles through which entities take advantage of ITCs have evolved. For example, entities often invest in partnerships whose operations include investments in assets that qualify for ITCs, which can then be passed through directly to the investors.

While ASC 740 addresses the accounting by an entity that directly owns an asset that generates an ITC, it does not explicitly address the accounting by a reporting entity that is an investor in a flow-through entity that owns the asset that generates the credit that is then passed through to the investor. In the latter case, the reporting entity must first consider whether it is required under ASC 810 (including the VIE subsections of ASC 810-10) to consolidate the flow-through entity in which it has invested. If consolidation of the investee is not required, the reporting entity would most often account for the investment by using the equity method.

There are two acceptable approaches (“Approach 1” and “Approach 2”) on how a reporting entity that accounts for its investment in a flow-through entity under the equity method should account for the tax benefits received in the form of ITCs. The approach an entity selects is an accounting policy election that should be applied consistently. (See Section 12.2 for a discussion of the accounting for temporary differences related to ITCs.)

12.3.4.1 Approach 1 — Account for ITCs as an Income Tax Benefit

Under Approach 1, the investor would account for the tax benefits received in the form of ITCs as an income tax benefit. This method is consistent with accounting for the tax benefits under the flow-through method. It is also consistent with ASC 323-740-55-8 (formerly Exhibit 94-1A of EITF Issue 94-1), which contains an example of the application of the equity method to a QAHP investment that does not qualify for the proportional amortization method. In that example, the tax credits are recorded in the income tax provision in the year that they are received.

12.3.4.2 Approach 2 — Apply a Model Similar to the Deferral Method

Approach 2 is premised on the guidance originally contained in paragraph 3 of APB Opinion 4 on an ITC that was passed through to a lessee under an operating lease for leased property. More specifically, paragraph 3 of APB Opinion 4 provided an example in which the asset generating the ITC was not carried on the lessee’s balance sheet; rather, the ITC was passed through to the lessee in a manner similar to the way it would be passed through to an investor in a flow-through entity.3 In the example, the Interpretation indicated that the “lessee should account for the credit by whichever method is used for purchased property” and then provided clarification on how to apply the deferral method if that method is selected, suggesting that the lessee could use either the deferral method or the flow-through method even in a situation in which the underlying asset that generated the credit was not actually reflected in the reporting entity’s financial statements.

Under Approach 2, the tax benefits from the ITCs would be deferred and amortized over the useful life of the related assets, resulting in a cost reduction that would be reflected as an adjustment in the equity method earnings (i.e., “above the line”). That is, the deferral method would yield an increase in the equity method earnings because less depreciation would flow through to the investor.4

Changing Lanes

ASC 740-10-25-46, as amended by ASU 2023-02, requires an entity to use a different policy for investments accounted for under the proportional amortization method even if the deferral method is used for other investments. That is, if an investor in a flow-through entity generates ITCs and uses the proportional amortization method to account for that investment, the investor must use the flow-through method to account for the ITCs generated by the investee. If the investor has other investments that are not accounted for under the proportionate amortization method and previously used the deferral method to account for ITCs, it should continue to use that method for such investments.

12.3.5 Presentation of Tax Effects of Equity in Earnings of an Equity Method Investee

The investor’s income tax provision equals the sum of current and deferred tax expense, including any tax consequences of the investor’s equity in earnings and temporary differences attributable to its investment in an equity method investee.

Because it is the investor’s tax provision, not the investee’s, the tax consequences of the investor’s equity in earnings and temporary differences attributable to its investment in the investee should be recognized in income tax expense and not be offset against the investor’s equity in earnings.