14.6 Disclosure of the Components of Income (or Loss) Before Income Tax Expense (or Benefit) as Either Foreign or Domestic

SEC Regulation S-X, Rule 4-08(h), requires public companies to include in their financial statements a disclosure of the domestic and foreign components of income (or loss) before income tax expense (or benefit).

SEC Regulation S-X, Rule 4-08(h), defines foreign income or loss as income or loss generated from a registrant’s “foreign operations, i.e., that are located outside the registrant’s home country.” Conversely, domestic income or loss is income or loss generated from a registrant’s operations located inside the registrant’s home country.

While providing this disclosure is often straightforward, it may be difficult in certain circumstances to determine (1) the source of the income or loss (i.e., foreign or domestic) or (2) the period or manner in which to reflect the income or loss in the disclosure. In particular, it can be challenging to classify income as foreign or domestic when a portion of a registrant’s pretax income or loss is generated by a branch or when intra-entity transactions occur between different tax-paying components2 within the consolidated group.

14.6.1 Branches

A U.S. parent may create an entity in a foreign jurisdiction that is regarded (e.g., as a corporation) in its foreign jurisdiction but then cause that foreign corporation to elect to be disregarded for U.S. federal income tax purposes (commonly referred to as a branch). Because the foreign corporation is disregarded for U.S. federal income tax purposes, the U.S. parent includes the foreign entity’s taxable income or loss in its U.S. federal taxable income. The foreign corporation’s profits are taxed simultaneously in the foreign jurisdiction in which it operates (i.e., the foreign corporation will file a tax return in the foreign jurisdiction in which it operates) and in the United States (because the entity’s taxable income or loss will be included in the U.S. parent’s U.S. federal taxable income). Taxes paid by the foreign corporation in the foreign jurisdiction may be deducted on the U.S. parent’s return or claimed as an FTC, subject to certain limitations.

The foreign corporation is treated like a branch of its U.S. parent for U.S. income tax purposes, which does not change the fact that the profits of the foreign entity are generated from operations located outside the United States. The profits and losses of the foreign entity are considered foreign income or loss in the disclosure of domestic and foreign components of pretax income or loss in the U.S. parent’s financial statements.

14.6.2 Intra-Entity Transactions

Intra-entity transactions between different tax-paying components within the consolidated group often result in tax consequences in each member’s respective taxing jurisdiction in the period in which the transaction occurs. However, the pretax effects of these transactions are eliminated in consolidation for accounting purposes. Accounting for the tax consequences of an intra-entity transaction depends on the nature of the transaction.

14.6.2.1 Intra-Entity Transactions Not Subject to ASC 740-10-25-3(e)

We believe that the primary purpose of the disclosure of the components of pretax income or loss as either domestic or foreign is to give the users of financial statements an ability to relate the domestic and foreign tax provisions to their respective pretax amounts. Therefore, when an intra-entity transaction results in taxable income in one component and deductible losses in another component, and those pretax amounts are eliminated in consolidation, we believe that the disclosure of the foreign and domestic components of pretax income or loss is generally more meaningful if the components are “grossed up” since the grossed-up amounts correspond more closely to the actual amounts of domestic and foreign tax expense and benefit.

However, because SEC Regulation S-X, Rule 4-08(h), is not explicit and simply requires disclosure of “the components of income (loss) before income tax expense (benefit),” we believe that “net” presentation, with appropriate disclosure in the income tax rate reconciliation, would also be acceptable.

Consider the example below.

Example 14-11

Assume the following facts:

Company P is an SEC registrant and is domiciled and operates in the United States, which has a 21 percent tax rate.
Company S is a wholly owned foreign subsidiary of P and is domiciled and operating in Jurisdiction B, which has a 50 percent tax rate.
Company P’s consolidated financial statements are prepared under U.S. GAAP and include S.
Companies P and S enter into a cost-sharing arrangement under which S reimburses P for 50 percent of certain costs incurred by P to further the development of Product X, which S licenses to third parties.
None of the amounts paid qualify for capitalization.
For the year 20X5, P records $200 of development expense before reimbursement by S. Company S reimburses P for 50 percent of the costs. Accordingly, P recognizes a net development expense of $100 under the cost-sharing arrangement, and S records $100 of development expense.
Company P increases its income tax expense by $21 for the cost-sharing expense reimbursement in 20X5, and S receives an income tax benefit of $50 from the development expense it incurs.

The cost-sharing payment is eliminated in P’s 20X5 consolidated financial statements. However, the income tax expense incurred by P and the income tax benefit received by S are recognized in P’s consolidated financial statements in 20X5. Therefore, provided that P discloses the grossed-up amounts of the domestic and foreign components of pretax income or loss, P’s pretax income would reflect the $100 net development cost expense in the disclosure of domestic income or loss and would similarly include $100 of development expense in the disclosure of foreign income or loss. That is, the cost-sharing arrangement has the effect of moving $100 of expense from domestic to foreign. This disclosure corresponds to an applicable amount of domestic and foreign tax expense and benefit, respectively, which is also recognized and disclosed in 20X5.

14.6.2.2 Intra-Entity Transactions Subject to ASC 740-10-25-3(e)

ASC 740-10-25-3(e) and ASC 810-10-45-8 require deferral of the recognition of income taxes paid on intra-entity profits from the sale of inventory for which intra-entity profits are eliminated in consolidation. For these types of transactions, we believe that it is appropriate to include an allocation of the consolidated pretax income or loss to the foreign and domestic components in the year in which the inventory is sold outside the consolidated group.

Consider the example below.

Example 14-12

Assume the same facts as in Example 14-11, but instead of entering into a cost-sharing agreement:

During 20X5, Company P sells inventory with a historical cost basis for both book and tax purposes of $200 to Company S for $300, and the inventory is on hand at year-end.
Company P pays tax of $21 in the United States on this intra-entity profit of $100.
The inventory is sold outside the consolidated group at a price of $350 in the following year (20X6).

In 20X5 the $100 gain on the intra-entity sale is eliminated in consolidation, and the related tax is deferred under ASC 740-10-25-3(e) and ASC 810-10-45-8. The intra-entity gain of $100 that is eliminated in 20X5 should not be included in the disclosure of the 20X5 pretax domestic and foreign income or loss.

In 20X6, when the inventory is sold outside the consolidated group, a profit before income taxes of $150 is recorded in the consolidated financial statements ($100 of which is related to profits previously taxed in the United States, and $50 of which is related to profits taxed in Jurisdiction B). In 20X6, $100 of income from the sale should be reported as domestic income, and $50 of income from the sale should be reported as foreign income. This corresponds to an applicable amount of domestic and foreign tax expense, which is also recognized and disclosed in 20X6.

Footnotes

As described in ASC 740-10-30-5, a tax-paying component is “an individual entity or group of entities that is consolidated for tax purposes.”

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.