Chapter 3 — Book-Versus-Tax Differences and Tax Attributes

3.4 Outside Basis Differences

ASC 740-10

25-1 This Section establishes the recognition requirements necessary to implement the objectives of accounting for income taxes identified in Section 740-10-10. The following paragraph sets forth the basic recognition requirements while paragraph 740-10-25-3 identifies specific, limited exceptions to the basic requirements.

25-2 Other than the exceptions identified in the following paragraph, the following basic requirements are applied in accounting for income taxes at the date of the financial statements:

A tax liability or asset shall be recognized based on the provisions of this Subtopic applicable to tax positions, in paragraphs 740-10-25-5 through 25-17, for the estimated taxes payable or refundable on tax returns for the current and prior years.
A deferred tax liability or asset shall be recognized for the estimated future tax effects attributable to temporary differences and carryforwards.

25-3 The only exceptions in applying those basic requirements are:

Certain exceptions to the requirements for recognition of deferred taxes whereby a deferred tax liability is not recognized for the following types of temporary differences unless it becomes apparent that those temporary differences will reverse in the foreseeable future:
1. An excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration. See paragraphs 740-30-25-18 through 25-19 for the specific requirements related to this exception.
2. Undistributed earnings of a domestic subsidiary or a domestic corporate joint venture that is essentially permanent in duration that arose in fiscal years beginning on or before December 15, 1992. A last-in, first-out (LIFO) pattern determines whether reversals pertain to differences that arose in fiscal years beginning on or before December 15, 1992. See paragraphs 740-30-25-18 through 25-19 for the specific requirements related to this exception.
3. Bad debt reserves for tax purposes of U.S. savings and loan associations (and other qualified thrift lenders) that arose in tax years beginning before December 31, 1987. See paragraphs 942-740-25-1 through 25-3 for the specific requirements related to this exception.
4. Policyholders’ surplus of stock life insurance entities that arose in fiscal years beginning on or before December 15, 1992. See paragraph 944-740-25-2 for the specific requirements related to this exception.
Subparagraph superseded by Accounting Standards Update No. 2017-15.
The pattern of recognition of after-tax income for leveraged leases or the allocation of the purchase price in a purchase business combination to acquired leveraged leases as required by Subtopic 842-50.
A prohibition on recognition of a deferred tax liability related to goodwill (or the portion thereof) for which amortization is not deductible for tax purposes (see paragraph 805-740-25-3).
A prohibition on recognition of a deferred tax asset for the difference between the tax basis of inventory in the buyer’s tax jurisdiction and the carrying value as reported in the consolidated financial statements as a result of an intra-entity transfer of inventory from one tax-paying component to another tax-paying component of the same consolidated group. Income taxes paid on intra-entity profits on inventory remaining within the consolidated group are accounted for under the requirements of Subtopic 810-10.
A prohibition on recognition of a deferred tax liability or asset for differences related to assets and liabilities that, under Subtopic 830-10, are remeasured from the local currency into the functional currency using historical exchange rates and that result from changes in exchange rates or indexing for tax purposes. See Subtopic 830-740 for guidance on foreign currency related income taxes matters.

ASC 740-30

25-1 This Section provides guidance on the accounting for specific temporary differences related to investments in subsidiaries and corporate joint ventures, including differences arising from undistributed earnings. In certain situations, these temporary differences may be accounted for differently from the accounting that otherwise requires comprehensive recognition of deferred income taxes for temporary differences.

25-2 Including undistributed earnings of a subsidiary (which would include the undistributed earnings of a domestic international sales corporation eligible for tax deferral) in the pretax accounting income of a parent entity either through consolidation or accounting for the investment by the equity method results in a temporary difference.

25-3 It shall be presumed that all undistributed earnings of a subsidiary will be transferred to the parent entity. Accordingly, the undistributed earnings of a subsidiary included in consolidated income shall be accounted for as a temporary difference unless the tax law provides a means by which the investment in a domestic subsidiary can be recovered tax free.

25-4 The principles applicable to undistributed earnings of subsidiaries in this Section also apply to tax effects of differences between taxable income and pretax accounting income attributable to earnings of corporate joint ventures that are essentially permanent in duration and are accounted for by the equity method. Certain corporate joint ventures have a life limited by the nature of the venture, project, or other business activity. Therefore, a reasonable assumption is that a part or all of the undistributed earnings of the venture will be transferred to the investor in a taxable distribution. Deferred taxes shall be recorded, in accordance with the requirements of Subtopic 740-10 at the time the earnings (or losses) are included in the investor’s income.

25-5 A deferred tax liability shall be recognized for both of the following types of taxable temporary differences:

An excess of the amount for financial reporting over the tax basis of an investment in a domestic subsidiary that arises in fiscal years beginning after December 15, 1992.
An excess of the amount for financial reporting over the tax basis of an investment in a 50-percent-or-less-owned investee except as provided in paragraph 740-30-25-18 for a corporate joint venture that is essentially permanent in duration.

Paragraphs 740-30-25-9 and 740-30-25-18 identify exceptions to the accounting that otherwise requires comprehensive recognition of deferred income taxes for temporary differences arising from investments in subsidiaries and corporate joint ventures.

25-6 Paragraph 740-30-25-18 provides that a deferred tax liability is not recognized for either of the following:

An excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary that meets the criteria in paragraph 740-30-25-17.
Undistributed earnings of a domestic subsidiary that arose in fiscal years beginning on or before December 15, 1992, and that meet the criteria in paragraph 740-30-25-17. The criteria in that paragraph do not apply to undistributed earnings of domestic subsidiaries that arise in fiscal years beginning after December 15, 1992, and as required by the preceding paragraph, a deferred tax liability shall be recognized if the undistributed earnings are a taxable temporary difference.

Determining Whether a Temporary Difference Is a Taxable Temporary Difference

25-7 Whether an excess of the amount for financial reporting over the tax basis of an investment in a more-than-50-percent-owned domestic subsidiary is a taxable temporary difference shall be assessed. It is not a taxable temporary difference if the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the entity expects that it will ultimately use that means. For example, tax law may provide that:

An entity may elect to determine taxable gain or loss on the liquidation of an 80-percent-or-more-owned subsidiary by reference to the tax basis of the subsidiary’s net assets rather than by reference to the parent entity’s tax basis for the stock of that subsidiary.
An entity may execute a statutory merger whereby a subsidiary is merged into the parent entity, the noncontrolling shareholders receive stock of the parent, the subsidiary’s stock is cancelled, and no taxable gain or loss results if the continuity of ownership, continuity of business entity, and certain other requirements of the tax law are met.

25-8 Some elections for tax purposes are available only if the parent owns a specified percentage of the subsidiary’s stock. The parent sometimes may own less than that specified percentage, and the price per share to acquire a noncontrolling interest may significantly exceed the per-share equivalent of the amount reported as noncontrolling interest in the consolidated financial statements. In those circumstances, the excess of the amount for financial reporting over the tax basis of the parent’s investment in the subsidiary is not a taxable temporary difference if settlement of the noncontrolling interest is expected to occur at the point in time when settlement would not result in a significant cost. That could occur, for example, toward the end of the life of the subsidiary, after it has recovered and settled most of its assets and liabilities, respectively. The fair value of the noncontrolling interest ordinarily will approximately equal its percentage of the subsidiary’s net assets if those net assets consist primarily of cash.

Recognition of Deferred Tax Assets

25-9 A deferred tax asset shall be recognized for an excess of the tax basis over the amount for financial reporting of an investment in a subsidiary or corporate joint venture that is essentially permanent in duration only if it is apparent that the temporary difference will reverse in the foreseeable future.

25-10 For example, if an entity decides to sell a subsidiary that meets the requirements of paragraphs 205-20-45-1A through 45-1D for measurement and display as a discontinued operation and the parent entity’s tax basis in the stock of the subsidiary (outside tax basis) exceeds the financial reporting amount of the investment in the subsidiary, the decision to sell the subsidiary makes it apparent that the deductible temporary difference will reverse in the foreseeable future. Assuming in this example that it is more likely than not that the deferred tax asset will be realized, the tax benefit for the excess of outside tax basis over financial reporting basis shall be recognized when it is apparent that the temporary difference will reverse in the foreseeable future. The same criterion shall apply for the recognition of a deferred tax liability related to an excess of financial reporting basis over outside tax basis of an investment in a subsidiary that was previously not recognized under the provisions of paragraph 740-30-25-18.

25-11 The need for a valuation allowance for the deferred tax asset referred to in paragraph 740-30-25-9 and other related deferred tax assets, such as a deferred tax asset for foreign tax credit carryforwards, shall be assessed.

25-12 Paragraph 740-10-30-18 identifies four sources of taxable income to be considered in determining the need for and amount of a valuation allowance for those and other deferred tax assets. One source is future reversals of temporary differences.

25-13 Future distributions of future earnings of a subsidiary or corporate joint venture, however, shall not be considered except to the extent that a deferred tax liability has been recognized for existing undistributed earnings or earnings have been remitted in the past.

25-14 A tax benefit shall not be recognized, however, for tax deductions or favorable tax rates attributable to future dividends of undistributed earnings for which a deferred tax liability has not been recognized under the requirements of paragraph 740-30-25-18.

Ownership Changes in Investments

25-15 An investment in common stock of a subsidiary may change so that it is no longer a subsidiary because the parent entity sells a portion of the investment, the subsidiary sells additional stock, or other transactions affect the investment. If a parent entity did not recognize income taxes on its equity in undistributed earnings of a subsidiary for the reasons cited in paragraph 740-30-25-17 (and the entity in which the investment is held ceases to be a subsidiary), it shall accrue in the current period income taxes on the temporary difference related to its remaining investment in common stock in accordance with the guidance in Subtopic 740-10.

25-16 Paragraph superseded by Accounting Standards Update No. 2019-12.

An outside basis difference is the difference between the carrying amount of an entity’s investment (e.g., an investment in a consolidated subsidiary) for financial reporting purposes and the underlying tax basis in that investment (e.g., the tax basis in the subsidiary’s stock). From a consolidated financial reporting perspective, an entity’s financial reporting carrying amount in a consolidated subsidiary is eliminated; however, book-to-tax differences in this amount may still result in the need to record deferred taxes.

How an investor should apply the guidance in ASC 740-30 on temporary differences related to investments depends on the type of investment and whether the financial reporting carrying value exceeds the tax basis or vice versa.

The table below summarizes the types of investments and the relevant guidance.

Investment	DTA Considerations	DTL Considerations
Domestic subsidiary Domestic corporate joint venture that is essentially permanent in nature	Under ASC 740-30-25-9, a DTA is recognized for the “excess of the tax basis over the amount for financial reporting . . . only if it is apparent that the temporary difference will reverse in the foreseeable future.”	Under ASC 740-30-25-5, recognition of a DTL depends on when the excess of the financial reporting basis over the tax basis of the investment arose: If the outside basis difference arose in fiscal years beginning on or before December 15, 1992, no DTL should be recorded unless the temporary difference will reverse in the foreseeable future. If the entity is a more-than-50-percent-owned subsidiary and the outside basis difference arose in fiscal years beginning after December 15, 1992, a DTL is recorded under ASC 740-30-25-7 unless the investment can be recovered in a tax-free manner without significant cost and the entity expects to use this means of recovery.
Foreign subsidiary Foreign corporate joint venture that is essentially permanent in nature	Under ASC 740-30-25-9, a DTA is recognized for the “excess of the tax basis over the amount for financial reporting . . . only if it is apparent that the temporary difference will reverse in the foreseeable future.”	Under ASC 740-30-25-18, a DTL should not be recognized on the excess of the financial reporting basis over the tax basis of an investment unless it becomes apparent that the temporary difference will reverse in the foreseeable future (i.e., the indefinite reversal criteria are not met).6
Equity method investee (generally, ownership of less than 50 percent but more than 20 percent) that is not a corporate joint venture	A DTA is recognized for the excess of the tax basis of the investment over the amount for financial reporting and must be assessed for realizability (in most jurisdictions, the loss would be capital in character).	A DTL is recorded on the excess of the financial reporting basis over the tax basis of the investment.
Cost method investee7	Generally, a DTA is recognized for the excess of the tax basis of the investment over the amount for financial reporting (if applicable) and must be assessed for realizability (in most jurisdictions, the loss would be capital in character).	Generally, a DTL is recorded on the excess of the financial reporting basis over the tax basis of the investment (if applicable).

Deferred taxes are always recorded on taxable and deductible temporary differences unless a specific exception applies.

3.4.1 Definition of Foreign and Domestic Investments

ASC 740-10-25-3(a)(1) contains an exception to the requirement to provide a DTL for the “excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint venture” (emphasis added), while ASC 740-30-25-7 contains an exception to the requirement to provide a DTL for the “excess of the amount for financial reporting over the tax basis of an investment in a more-than-50-percent-owned domestic subsidiary” (emphasis added). Accordingly, it is important to determine whether an entity is a foreign or domestic entity.

An entity should determine whether an investment is foreign or domestic on the basis of the relationship of the investee to the tax jurisdiction of its immediate parent rather than the relationship of the investee to the ultimate parent of the consolidated group. This determination should be made from the “bottom up” through successive tiers of consolidation. At each level, it is necessary to determine whether the subsidiaries being consolidated are foreign or domestic with respect to the consolidating entity. A subsidiary that is treated as a domestic subsidiary under the applicable tax law of its immediate parent would be considered a domestic subsidiary under ASC 740. The examples below illustrate this concept.

Example 3-17

A U.S. parent entity, P, has a majority-owned domestic subsidiary, S1, which has two investments: (1) a majority ownership interest in a foreign entity, FS1, and (2) an ownership interest in a foreign corporate joint venture, FCJV1. In preparing its consolidated financial statements, S1 consolidates FS1 and applies the equity method of accounting to its investment in FCJV1. Under ASC 740, S1 would consider its investments in FS1 and FCJV1 to be in a foreign subsidiary and foreign corporate joint venture, respectively. Parent P would treat S1 as a domestic subsidiary when consolidating S1.

Example 3-18

A U.S. parent entity, P, has a majority ownership interest in a subsidiary (chartered in a foreign country), FS, which has two investments: (1) a majority ownership interest in another entity, S1, and (2) an ownership interest in another corporate joint venture entity, S2. Both S1 and S2 are located in the same foreign country in which FS is chartered. When preparing the consolidated financial statements, FS would consider S1 and S2 a domestic subsidiary and domestic corporate joint venture, respectively, in determining whether to recognize deferred taxes in the foreign country on the outside basis difference of FS’s investments in S1 and S2. Parent P would consider FS a foreign subsidiary.

Example 3-19

A foreign parent entity, FP, prepares U.S. GAAP financial statements and has two investments: (1) a majority-owned investment in a U.S. entity, US1, and (2) an investment in a corporate joint venture located in the United States, JVUS1. In preparing its consolidated financial statements, FP would consider US1 and JVUS1 a foreign subsidiary and a foreign corporate joint venture, respectively.

Example 3-20

A foreign entity, FP2, prepares U.S. GAAP financial statements and has two investments: (1) a majority-owned investment in another entity, S1, and (2) an investment in a corporate joint venture, JV1. Both S1 and JV1 are located in the same foreign country in which FP2 is chartered. In preparing its consolidated financial statements, FP2 would consider S1 and JV1 a domestic subsidiary and a domestic corporate joint venture, respectively.

Example 3-21

A U.S. parent entity, P, has a majority ownership interest in a subsidiary (chartered in a foreign country), FS, that has two investments: (1) a majority ownership interest in another entity, S1, located in the same foreign country in which FS is chartered, and (2) an investment in a corporate joint venture located in the United States, JVUS1. Before being consolidated by P, FS would treat S1 as a domestic subsidiary and would apply the equity method of accounting to JVUS1, as a foreign corporate joint venture to determine whether to recognize deferred taxes on the outside basis difference of its investments in S1 and JVUS1.

3.4.1.1 Definition of Subsidiary and Corporate Joint Venture

An entity should use the following guidance to determine whether an investment is in either a subsidiary or a corporate joint venture:

ASC 810-10-20 defines a subsidiary as follows:

An entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as its parent, holds a controlling financial interest. (Also, a variable interest entity that is consolidated by a primary beneficiary.)

However, ASC 740-10-20 does not specifically define the term “subsidiary” and does not refer to the definition in ASC 810-10. Rather, in practice, the definition of subsidiary in APB Opinion 18 (codified in ASC 323) has been applied. APB Opinion 18 states that subsidiary refers to “a corporation which is controlled, directly or indirectly, by another corporation. The usual condition for control is ownership of a majority (over 50%) of the outstanding voting stock.” Accordingly, while the definition in ASC 810 includes partnerships and trusts, those entities are not considered subsidiaries under ASC 740 because the earnings of such entities generally pass directly through to their owners. See Section 3.4.15 for further discussion of pass-through entities.

The term corporate joint venture is defined in ASC 740-10-20 as follows:

A corporation owned and operated by a small group of entities (the joint venturers) as a separate and specific business or project for the mutual benefit of the members of the group. A government may also be a member of the group. The purpose of a corporate joint venture frequently is to share risks and rewards in developing a new market, product or technology; to combine complementary technological knowledge; or to pool resources in developing production or other facilities. A corporate joint venture also usually provides an arrangement under which each joint venturer may participate, directly or indirectly, in the overall management of the joint venture. Joint venturers thus have an interest or relationship other than as passive investors. An entity that is a subsidiary of one of the joint venturers is not a corporate joint venture. The ownership of a corporate joint venture seldom changes, and its stock is usually not traded publicly. A noncontrolling interest held by public ownership, however, does not preclude a corporation from being a corporate joint venture.

3.4.1.2 Potential DTA: Foreign and Domestic Subsidiaries and Corporate Joint Ventures

ASC 740-30-25-9 states:

A deferred tax asset shall be recognized for an excess of the tax basis over the amount for financial reporting of an investment in a subsidiary or corporate joint venture that is essentially permanent in duration only if it is apparent that the temporary difference will reverse in the foreseeable future.

As used in ASC 740-30-25-9, the term “foreseeable future” refers to an entity’s ability to reasonably anticipate the reversal of the outside basis difference. Further, we believe that in this context, “reverse” is intended to mean “be realized” (i.e., be taken as a deduction on the parent’s income tax return). Since a deductible outside basis difference in a subsidiary generally results in a deduction on the parent’s income tax return only upon sale or taxable liquidation of the subsidiary, under ASC 740-30-25-9, a DTA would rarely be recognized before the criteria in ASC 360-10-45-9 through 45-11 are met for classification of assets as held for sale. While future earnings of the subsidiary may reduce the deductible outside basis temporary difference, those future earnings do not result in a reversal of the temporary difference, as the term “reverse” is used in ASC 740-30-25-9. In other words, future earnings of the subsidiary do not result in a deduction on the parent’s income tax return. Therefore, anticipated future earnings of the subsidiary should not be relied upon to support a conclusion that “the temporary difference will reverse in the foreseeable future” and that a DTA can be recorded under ASC 740-30-25-9.

At the point at which the criteria in ASC 360-10-45-9 through 45-11 for a measurement date have been satisfied, the deferred tax consequences of the deductible outside basis difference should be recognized as a DTA. 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 it is not more likely than not that all or a portion of the DTA will be realized, a valuation allowance is necessary.

ASC 740-30-25-9 through 25-13 apply to more-than-50-percent-owned subsidiaries (foreign or domestic) but do not apply to 50-percent-or-less-owned foreign or domestic investees. However, an entity will need to use judgment to determine whether a recognition exception applies to a subsidiary that is consolidated by applying the variable interest entity (VIE) guidance when less than 50 percent of the voting interest is owned by the investor. See Section 3.4.17.1 for consideration of the VIE model in ASC 810-10 in the evaluation of whether to recognize a DTL.

3.4.1.3 Potential DTL: Domestic Subsidiary

ASC 740-30-25-7 applies to investments in a more-than-50-percent-owned domestic subsidiary and assumes that the subsidiary would be consolidated under ASC 810 (see Section 3.4.1.1). ASC 740-30-25-7 does not allow for the application of the indefinite reversal exception to the recognition of DTLs for undistributed earnings of a domestic subsidiary or corporate joint venture generated in fiscal years beginning on or after December 15, 1992. Therefore, under ASC 740-30-25-3, DTLs must be recognized “unless the tax law provides a means by which the investment in a domestic subsidiary can be recovered tax free” and the entity expects that it will ultimately use that means. The holder of the investment must meet both criteria to avoid recording the DTL (see Section 3.4.3 for more information).

While ASC 740-30-25-7 states that it applies only to more-than-50-percent-owned domestic subsidiaries, an entity will need to use judgment to determine whether a recognition exception applies to a subsidiary that is consolidated under the VIE guidance when less than 50 percent of the voting interest is owned by the investor. See Section 3.4.17.1 for considerations related to the VIE model in ASC 810-10 in the evaluation of whether to recognize a DTL.

3.4.2 Tax Consequences of a Change in Intent Regarding Remittance of Pre-1993 Undistributed Earnings

It is possible for an entity to change its intent regarding remittance of the portion of unremitted earnings that was generated for fiscal years beginning on or before December 15, 1992, for domestic subsidiaries and domestic corporate joint ventures that were previously deemed indefinitely invested.

An entity should apply the guidance in ASC 740-30-25-17 and ASC 740-30-25-19 to tax consequences of a change in intent regarding unremitted earnings that arose in fiscal years beginning on or before December 15, 1992. This guidance states, in part:

25-17 The presumption in paragraph 740-30-25-3 that all undistributed earnings will be transferred to the parent entity may be overcome, and no income taxes shall be accrued by the parent entity . . . if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation. . . .

25-19 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 entity, it shall accrue as an expense of the current period income taxes attributable to that remittance. If it becomes apparent that some or all of the undistributed earnings of a subsidiary on which income taxes have been accrued will not be remitted in the foreseeable future, the parent entity shall adjust income tax expense of the current period.

Example 3-22

Assume that Entity X had $2,000 of unremitted earnings from its investment in a domestic corporate joint venture that arose in fiscal years beginning on or before December 15, 1992, and that management has determined that all of the pre-1993 corporate joint venture earnings were indefinitely reinvested. Therefore, no DTL has been recorded. In addition, assume that during 20X1, unremitted earnings from the joint venture were $1,000 and that X accrued the related deferred income taxes on these earnings. During 20X2, management of the joint venture changed its intent regarding remitting joint venture earnings, concluding that $1,000 of retained earnings would be distributed (via a dividend) to X on December 31, 20X2, and $1,000 on December 31, 20X3, respectively.

ASC 740-10-25-3(a) states that whether reversals pertain to differences that arose in fiscal years beginning on or before December 15, 1992, is determined on the basis of a LIFO pattern. Therefore, X would accrue, as of the date the change in intent occurred in 20X2, a DTL for an additional $1,000 of taxable income representing the tax consequence of only $1,000 of pre-1993 unremitted earnings; the deferred tax consequences of the other $1,000 are related to income generated in post-1993 years, which was previously accrued in 20X1.

3.4.3 Tax-Free Liquidation or Merger of a Subsidiary

There may be instances in which it is acceptable to treat an outside basis difference in a domestic subsidiary as a nontaxable temporary difference. An analysis to achieve this treatment has quantitative and qualitative thresholds.

In the assessment of whether the outside basis difference of an investment in a domestic subsidiary is a taxable temporary difference in the United States, an 80 percent investment in the subsidiary alone is not sufficient for an entity to conclude that the outside basis difference is not a taxable temporary difference. While U.S. tax law provides a means by which an investment of 80 percent or more in a domestic subsidiary can be liquidated or merged into the parent in a tax-free manner, an entity must also intend to ultimately use that means. Satisfying the tax law requirements alone is not sufficient; the entity should also consider:

Any regulatory approvals that may be required (e.g., in a rate-regulated entity in which a merger would be subject to regulatory approval and that approval is more than perfunctory).
Whether the liquidation or merger is subject to approval by the noncontrolling interest holders.
Whether it would be desirable for the entity to recover its investment in a tax-free manner. For example, if the entity’s outside basis in the subsidiary is significantly higher than the subsidiary’s inside basis, tax-free liquidation may be undesirable.

Some non-U.S. jurisdictions may stipulate similar rules for liquidation or merger of a subsidiary into a parent in a tax-free manner. A similar analysis should be performed on all subsidiaries for which the tax law provides a means by which a reported investment can be recovered in a tax-free manner and the parent intends to use that means.

In some circumstances, the parent may own less than the required percentage under the applicable tax law (i.e., more than 50 percent but less than 80 percent). In such cases, the parent may still be able to assert that it can recover its investment in a tax-free manner (and thus not treat the outside basis difference in the subsidiary as a taxable temporary difference) if it can do so without incurring significant cost. ASC 740-30-25-8 states:

Some elections for tax purposes are available only if the parent owns a specified percentage of the subsidiary's stock. The parent sometimes may own less than that specified percentage, and the price per share to acquire a noncontrolling interest may significantly exceed the per-share equivalent of the amount reported as noncontrolling interest in the consolidated financial statements. In those circumstances, the excess of the amount for financial reporting over the tax basis of the parent’s investment in the subsidiary is not a taxable temporary difference if settlement of the noncontrolling interest is expected to occur at the point in time when settlement would not result in a significant cost. That could occur, for example, toward the end of the life of the subsidiary, after it has recovered and settled most of its assets and liabilities, respectively. The fair value of the noncontrolling interest ordinarily will approximately equal its percentage of the subsidiary’s net assets if those net assets consist primarily of cash. [Emphasis added]

In this context, one interpretation of significant cost could be that the costs (based on fair value) of acquiring the necessary interest in that subsidiary to recover it tax free are significant. In performing this assessment, the parent can consider the cost that would be incurred at the end of the life of the subsidiary (i.e., once the subsidiary’s assets have been converted to cash and all outstanding liabilities have been settled). Under the “end-of-life” scenario, the carrying value of the noncontrolling interest may be equivalent to fair value. If the cost of assuming the noncontrolling interest at the “end of the subsidiary’s life” is practicable, a tax-free liquidation or merger can be assumed and the outside basis difference would not be treated as a taxable temporary difference (as long as the tax law provides a means for a tax-free liquidation or merger and the entity intends to use this means).

3.4.4 Potential DTL: Foreign Subsidiary and Foreign Corporate Joint Venture

ASC 740-30

Exceptions to Comprehensive Recognition of Deferred Income Taxes

25-17 The presumption in paragraph 740-30-25-3 that all undistributed earnings will be transferred to the parent entity may be overcome, and no income taxes shall be accrued by the parent entity, for entities and periods identified in the following paragraph if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation. A parent entity shall have evidence of specific plans for reinvestment of undistributed earnings of a subsidiary which demonstrate that remittance of the earnings will be postponed indefinitely. These criteria required to overcome the presumption are sometimes referred to as the indefinite reversal criteria. Experience of the entities and definite future programs of operations and remittances are examples of the types of evidence required to substantiate the parent entity’s representation of indefinite postponement of remittances from a subsidiary. The indefinite reversal criteria shall not be applied to the inside basis differences of foreign subsidiaries.

25-18 As indicated in paragraph 740-10-25-3, a deferred tax liability shall not be recognized for either of the following types of temporary differences unless it becomes apparent that those temporary differences will reverse in the foreseeable future:

An excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration.
Undistributed earnings of a domestic subsidiary or a domestic corporate joint venture that is essentially permanent in duration that arose in fiscal years beginning on or before December 15, 1992. A last-in, first-out (LIFO) pattern determines whether reversals pertain to differences that arose in fiscal years beginning on or before December 15, 1992.

Outside basis differences in foreign entities (i.e., the holder of the investment is taxable in a jurisdiction different from the investee’s) are taxable temporary differences. DTLs should be recorded for these taxable temporary differences unless the exception in ASC 740-30-25-18(a) applies.

ASC 740-30-25-18(a) states that a DTL is not recognized for an “excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary” unless it becomes apparent that the temporary difference will reverse in the foreseeable future. See Section 3.3.1 for a discussion of inside and outside basis differences.

3.4.5 DTL for a Portion of an Outside Basis Difference

As noted above, ASC 740-30-25-18(a) states that a DTL is not required for an “excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration” unless “it becomes apparent that those temporary differences will reverse in the foreseeable future.” In certain circumstances, an entity may require its foreign subsidiary or foreign corporate joint venture to remit only a portion of undistributed earnings.

An entity is permitted to recognize a DTL only for the portion of the undistributed earnings to be remitted in the future (remittances are not limited to dividends or distributions). ASC 740-30-25-18 is not an all-or-nothing requirement.

Example 3-23

Entity A has one subsidiary, B, a wholly owned subsidiary in foreign jurisdiction X. Subsidiary B has $500,000 in undistributed earnings, which represents the entire outside basis difference in B (there has been no fluctuation in the exchange rates). On the basis of available evidence, A has historically concluded that no part of this basis difference was expected to reverse in the foreseeable future and that, therefore, the indefinite reversal criteria in ASC 740-30-25-17 and 25-18 were met in accordance with management’s intent and the associated facts and circumstances. Consequently, A has not historically recorded a DTL on its book-over-tax basis difference in its investment in B.

In the current year, B has net income of $300,000 and declares a one-time dividend for the full $300,000. Subsidiary B has no plans to declare or pay future dividends, and there are no other changes in facts or circumstances to suggest that the indefinite reversal assertion on the existing $500,000 outside basis difference would be inappropriate. Further, the one-time circumstances that led to the distribution of the $300,000 are not expected to reoccur. In this example, A could continue to assert the indefinite reinvestment of B’s earnings in the future. Entity A should document its intent and ability to indefinitely reinvest the undistributed earnings; see the next section for further discussion.

Example 3-24

Assume the same facts as in the example above, except that the dividend was declared as a result of projected shortfalls in Entity A’s working capital requirements during the coming year. The ongoing short-term capital needs of A may suggest that A can no longer indefinitely reinvest the earnings of Entity B. In this example, the indefinite reinvestment assertion may no longer be appropriate and, if not, A should record a DTL on its entire $500,000 outside basis difference.

3.4.5.1 Evidence Needed to Support the Indefinite Reinvestment Assertion

ASC 740-30-25-3 states, in part, that it “shall be presumed that all undistributed earnings of a subsidiary will be transferred to the parent entity.” ASC 740-30-25-17 states that this presumption “may be overcome, and no income taxes shall be accrued by the parent entity . . . if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely.”

An entity’s documented plan for reinvestment of foreign earnings would enable it to overcome the presumption that all undistributed earnings of a foreign subsidiary will be transferred to the parent entity. To support its assertion that the undistributed earnings of a subsidiary will be indefinitely reinvested, an entity should demonstrate that the foreign subsidiary has both the intent and ability to indefinitely reinvest undistributed earnings. Past experience with the entity, in and of itself, would not be sufficient for an entity to overcome the presumption in ASC 740-30-25-3. In documenting its written plan for reinvestment of foreign earnings, an entity should consider such factors as:

Operating plans (for both the parent company and the subsidiary).
Budgets and forecasts.
Long-term and short-term financial requirements of the parent company and the subsidiary (i.e., working capital requirements and capital expenditures).
Restrictions on distributing earnings (i.e., requirements of foreign governments, debt agreements, or operating agreements).
History of dividends.
Tax-planning strategies an entity intends to rely on to demonstrate the recoverability of DTAs.

This analysis is performed for each foreign subsidiary as of each balance sheet date (see above for guidance on determining whether a specific investment of a consolidated parent company is a foreign or domestic subsidiary). This analysis should be performed on a subsidiary-by-subsidiary basis and determined by using a bottom-up approach. An entity could reach different conclusions for two subsidiaries within the same jurisdiction.

Further, in a business combination, this analysis should be performed by the acquirer as of the acquisition date, regardless of any previous position taken by the acquiree or historical practice by the subsidiary. As a result of the analysis, market participants could reach different conclusions regarding the same acquiree.

3.4.5.2 Ability to Overcome the Presumption in ASC 740-30-25-3 After a Change in Management’s Plans for Reinvestment or Repatriation of Foreign Earnings

In some circumstances, an entity’s reinvestment or repatriation plan may change because of different factors, such as the parent’s liquidity requirements or changes in tax ramifications of repatriation.

An entity may have asserted previously that it had a plan to indefinitely reinvest foreign earnings overseas to overcome the presumption described in ASC 740-30-25-3 that undistributed foreign earnings will be transferred to the parent entity. As a result of various factors, the same entity may later decide to repatriate some or all of its undistributed foreign earnings.

A change in management’s intent regarding repatriation of earnings may taint management’s future ability to assert that earnings are indefinitely reinvested. However, it depends on the reason(s) for the change. The following are a few questions an entity could consider in determining whether management’s ability is tainted in this situation:

Did management have sufficient evidence of a specific plan for reinvestment or repatriation of foreign earnings in the past?
Is it clear that this change is a result of a temporary and identifiable event (e.g., a change in tax law available for a specified period)?
Can management provide evidence that supports what has changed from its previous plans?
Does management have a plan for reinvestment of future earnings?

Generally, if the conditions were met, management would be able to assert indefinite reinvestment of foreign earnings in the future.

However, if management’s current actions indicate that its previous plan was not supported by actual business needs (e.g., stated foreign capital requirements were over what proved to be necessary), the change in intent may call into question management’s ability to assert that future foreign earnings are indefinitely reinvested.

3.4.5.3 Change in Indefinite Reinvestment Assertion — Recognized or Nonrecognized Subsequent Event

In some circumstances, an entity’s reinvestment or repatriation plan may change because of various factors, such as the parent’s liquidity requirements or changes in the tax ramifications of repatriation.

ASC 740-30-25-19 indicates that the impact of the change in plans would be accounted for in the period in which management’s plans change (e.g., when management no longer can assert that all, or a portion, of its foreign earnings are indefinitely reinvested). However, an entity may need to use judgment to identify the period in which management’s decision to change its plans occurred, especially if this decision occurs soon after the balance sheet date.

An entity should consider the nature and timing of the factors that influenced management’s decision to change its plans when evaluating whether a change in management’s plans for reinvestment or repatriation is a recognized or nonrecognized subsequent event under ASC 855. Specifically, if identifiable events occurred after the balance sheet date that caused the facts or conditions that existed as of the balance sheet date to change significantly, and management changed its intent regarding indefinite reinvestment because of the new facts, the change in intent may be a nonrecognized subsequent event.

In contrast, if the change in intent after the balance sheet date is due to factors other than responding to the occurrence of an identifiable event, the facts or conditions that existed at the end of the period are unlikely to have changed significantly. Therefore, if prior-period financial statements have not been issued or are not yet available to be issued (as these terms are defined in the subsequent-event guidance in ASC 855-10-20), the entity would generally be required to record the effect of the change in management’s plan in these financial statements (i.e., a recognized subsequent event).

Example 3-25

Assume that an identifiable event (e.g., a change in tax rates associated with repatriation of foreign earnings) occurs in period 2 and that this event causes management to reconsider and change its plans in that period. The change in tax rates is an identifiable event that caused the facts or conditions that existed at the end of period 1 to change significantly. In this case, the effect of the change in plans, which is attributable specifically to the change in tax rate, should be recorded in period 2 (i.e., a nonrecognized subsequent event).

In contrast, an entity may change its repatriation plans because of operating factors or liquidity needs and, shortly after a reporting period, may not be able to assert that its foreign earnings are indefinitely reinvested. In this case, an entity must perform a careful analysis to determine whether the conditions causing the changes in management’s plans existed at the end of the reporting period. The results of this analysis will affect whether the accounting effect of the change in plans should be recorded as a recognized or nonrecognized subsequent event under ASC 855.

3.4.6 Measuring Deferred Taxes on Outside Basis Differences in Foreign Investments

As discussed above, analysis of deferred taxes on outside basis differences requires a bottom-up approach whereby an entity must consider its outside basis difference at each level in the organization chart. The entity should start with the lowest entity in the organization structure and determine whether such entity’s direct parent’s financial reporting carrying amount is greater or less than its tax basis. When performing this analysis, the entity should consider the expected manner of recovery (e.g., sale, liquidation, dividend). ASC 740-10-55-24 states, in part, that the “[c]omputation of a deferred tax liability for undistributed earnings based on dividends should also reflect any related dividends received deductions or foreign tax credits, and taxes that would be withheld from the dividend.” Thus, the parent entity should consider withholding taxes, FTCs, and participation exemptions (i.e., a dividends received deduction) when determining the amount of DTL to be recognized.

Many jurisdictions tax earnings of foreign subsidiaries and foreign corporate joint ventures that are essentially permanent in duration (collectively, “foreign investments”) upon distribution of such earnings. Where the immediate parent entity’s outside basis taxable temporary difference in a foreign investment would close upon remittance of foreign earnings and is not indefinitely reinvested, the parent entity would need to recognize a DTL for the additional tax to be imposed in its jurisdiction upon receipt of the earnings. The parent entity may be able to avail itself of a participation exemption and, as stated above, should factor such an exemption into the amount of DTL to be recognized.

For example, in the United States, companies may be entitled to a 100 percent dividends received deduction on the repatriation of earnings that have not previously been taxed. Further, any foreign taxes properly attributable to the earnings that are subject to the 100-percent-dividends-received deduction are not available as an FTC since those earnings are not subject to U.S. federal income tax. The repatriation of earnings to which the 100-percent-dividends-received deduction applies generally should reduce the outside basis difference because the distribution reduces the financial reporting carrying value of the investment but does not reduce the U.S. tax basis in the investment. While there may be no U.S. federal income tax implications of the distribution, there can nonetheless be additional foreign withholding tax and state taxes.

In other instances, however, an outside basis difference may be expected to reverse in a taxable manner, irrespective of whether there is a distribution (e.g., through future Subpart F or GILTI inclusions). To the extent that earnings have been previously taxed (situations involving Subpart F, GILTI, or IRC Section 965 are discussed further below), for example, a U.S. company would receive a basis increase for U.S. income tax purposes. Upon distribution, such earnings are not taxed again; rather, the U.S. tax basis in the investment is reduced by the amount of the previously taxed earnings distributed. In a manner similar to earnings subject to the 100-percent-dividends-received deduction, there can still be additional withholding taxes and state taxes incurred on a repatriation of earnings to the U.S. company; see Section 3.4.13 for a discussion of withholding taxes. In addition, there may be foreign exchange gains or losses that are taxable/deductible upon repatriation, capital gains upon sale of an investment, or foreign income taxes. If a U.S. company is not indefinitely reinvested in the outside basis difference in its investment in a foreign subsidiary or foreign corporate joint venture that is essentially permanent in duration, it may need to recognize a DTL with respect to its investment.

3.4.7 [Reserved]

3.4.8 Outside Basis Difference in a Foreign Subsidiary — Subpart F Income

Under ASC 740-30-25-18, unless it becomes clear that this type of temporary difference will reverse in the foreseeable future, a DTL should not be recognized for an “excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration.” Further, there is a rebuttable presumption under ASC 740-30-25-3 that all undistributed earnings will be transferred by a subsidiary to its parent. This rebuttable presumption may be overcome if the criteria of ASC 740-30-25-17 are met (i.e., sufficient evidence shows the subsidiary has invested or will invest the undistributed earnings indefinitely).

Under Subpart F of the Internal Revenue Code, a U.S. parent may be taxed on specified income of a foreign subsidiary (commonly referred to as Subpart F income) when earned by the foreign subsidiary (e.g., certain types of passive income are treated as Subpart F income). When recognized for tax-reporting purposes by the U.S. parent, Subpart F income increases the outside tax basis in a foreign subsidiary. Likewise, when recognized for financial reporting purposes by the foreign subsidiary (and thus in the U.S. parent’s consolidated financial statements), such income increases the U.S. parent’s book basis in the foreign subsidiary.

Subpart F income may result in taxable income for the U.S. parent in the same amount and same period as that in which the income is recognized by the foreign subsidiary for financial reporting purposes. In such cases, current taxable income would be recognized in the period in which the income is recognized for financial reporting purposes, and there would generally be no change in the U.S. parent’s outside basis difference in the foreign subsidiary (i.e., because the book basis and tax basis both generally increase by an equal amount). However, Subpart F income may be taxed in a later period than the period in which the income is recognized for financial reporting purposes. In these cases, there will be an increase in the parent’s book basis in the subsidiary attributable to Subpart F income recognized for financial reporting purposes with no change in the corresponding tax basis. This section does not apply to situations involving Subpart F income that will not be immediately taxable as a result of other circumstances (e.g., a situation in which the Subpart F income is deferred when there is a deficit in E&P but will become includable when the foreign subsidiary in question has positive earnings).

A U.S. parent that, according to ASC 740-30-25-18(a), does not recognize a DTL on its outside basis taxable temporary difference in a foreign subsidiary should generally recognize a DTL for the portion of the outside basis difference that corresponds to amounts already recognized for financial reporting purposes by the foreign subsidiary that will be treated as Subpart F income when considered to be earned for tax reporting purposes (i.e., amounts within the foreign subsidiary that would give rise to taxable temporary differences under U.S. tax law).

The portion of the outside basis taxable temporary difference that corresponds to an inside Subpart F temporary difference should be treated as though it is apparent that it will reverse “in the foreseeable future” and will thus require the recognition of a DTL. Since Subpart F income is often related to passive types of income, in most cases neither the U.S. parent nor the foreign subsidiary can control when it will become taxable to the U.S. parent. Therefore, a deferred tax expense and outside basis DTL should be recognized in the period in which the income is recognized for financial reporting purposes. This is true even if the U.S. parent does not intend to distribute the associated earnings of the foreign subsidiary and irrespective of whether the U.S. parent has elected to treat GILTI as a period cost. See Section 3.4.10 for a discussion of GILTI deferred taxes.

Example 3-26

Entity P, a U.S. parent, owns Entity F, a foreign subsidiary that, in turn, owns an equity method investment that does not meet the ASC master glossary’s definition of a corporate joint venture. Entity P’s tax basis was not affected by undistributed earnings of the equity investee. In addition, its investment (book basis) in F increases by the amount of equity method income recognized by the subsidiary, which increases the outside basis difference in the investment in F (since P’s tax basis was not affected by the undistributed earnings of the equity investee). When F sells or receives a distribution from the equity method investee, the gain or distribution will be treated as Subpart F income that P must recognize immediately. Further, as an equity investor, F has no control over when it might receive a dividend from the equity investee, nor can it assert indefinite reinvestment in the equity method investee because it is not a subsidiary or corporate joint venture that is essentially permanent in duration; therefore, P should not consider the outside basis difference in F that is attributable to the unremitted earnings of the equity method investee to be eligible for treatment as indefinitely reinvested. Accordingly, P should recognize a DTL for that portion of the outside basis difference that will reverse when the investment in the equity investee is recovered, which would trigger recognition of Subpart F income and increase P’s tax basis in F (which has the effect of reversing the corresponding outside basis difference).

3.4.9 Outside Basis Difference in a Foreign Subsidiary — Deferred Subpart F Income

The previous section discusses Subpart F income that will be immediately taxable when considered earned for tax reporting purposes. However, sometimes Subpart F income will actually be deferred, even after it has been earned for tax reporting purposes (“deferred Subpart F income”) because of certain U.S. tax limitations. For example, the amount of currently taxable Subpart F income of any CFC for any taxable year may not exceed such CFC’s E&P for the year. Accordingly, while such amounts may be deferred and recaptured in a future year, current-year Subpart F income is limited to actual E&P earnings.

Assume, for example, that Company Y, a CFC, earns $100 of Subpart F income and generates a non-Subpart F loss of $40 in year 1. Company Y earns $200 of Subpart F income in each of years 2 and 3, $10 of non-Subpart F income in year 2, and $100 of non-Subpart F income in year 3. Because Y’s E&P is $60 in year 1, the amount of Subpart F income attributable to Y in year 1 that Y’s U.S. shareholder must include in its year 1 taxable income is limited to $60. However, in year 2, Y’s U.S. shareholder must include $10 of Y’s deferred Subpart F income from year 1. Likewise, in year 3, the U.S. shareholder must include the remaining $30 of Company Y’s deferred Subpart F income from year 1 that was not taxed in years 1 and 2. Thus, all the deferred Subpart F income from year 1 is recaptured.

If the existence of deferred Subpart F income suggests that some part of the outside basis difference will reverse in the foreseeable future, a DTL should be recorded. However, the mere existence of deferred Subpart F earnings does not automatically suggest that a part of the outside basis difference will reverse in the foreseeable future. Rather, all the facts and circumstances must be assessed. For example, if a recovery and settlement of the subsidiary’s assets and liabilities were to give rise to the taxation of the deferred Subpart F income, a DTL would be recognized provided that the amount of the deferred Subpart F income does not exceed the outside basis difference in the foreign subsidiary.

If an entity uses the financial reporting carrying amounts of the assets and liabilities to determine whether some part of the outside basis difference would be expected to reverse in the foreseeable future, the DTL recognized would take into account only the tax consequences associated with events that already have occurred and been reported in the financial statements. When additional events, such as future earnings, must occur (e.g., when the recovery of assets and settlement of liabilities alone does not result in the E&P needed to make all the deferred Subpart F income taxable to the U.S. parent), no DTL would be recognized until the financial statements include such future earnings. To assess the effect of recovering assets and settling liabilities, the entity might need to schedule the recovery or settlement. For example, the recovery of certain assets would result in E&P and the settlement of certain liabilities would result in reductions in E&P; however, it could become apparent that the outside basis difference will reverse in the foreseeable future when the entity expects assets to be recovered before the liabilities are settled.

3.4.10 Global Intangible Low-Taxed Income

The 2017 Act created a new requirement that certain income (i.e., GILTI) earned by a CFC must be included currently in the gross income of the CFC’s U.S. shareholder. GILTI is the excess of the shareholder’s “net CFC tested income” over the net deemed tangible income return (the “routine return”), which is defined as the excess of (1) 10 percent of the aggregate of the U.S. shareholder’s pro rata share of the qualified business asset investment (QBAI) of each CFC with respect to which it is a U.S. shareholder over (2) the amount of certain interest expense taken into account in the determination of net CFC-tested income.

A domestic corporation is permitted a deduction of up to 50 percent of the sum of the GILTI inclusion and the amount treated as a dividend in accordance with IRC Section 78 (“IRC Section 78 gross-up”). If the sum of the GILTI inclusion (and related IRC Section 78 gross-up) and the corporation’s FDII (see Section 3.2.1.4) exceeds the corporation’s taxable income, the deductions for GILTI and for FDII are reduced by the excess. As a result, the GILTI deduction can be no more than 50 percent of the corporation’s taxable income (and will be less if the corporation is also entitled to an FDII deduction). The maximum GILTI deduction is reduced to 37.5 percent for taxable years beginning after December 31, 2025.

3.4.10.1 GILTI Accounting Policy Election

There may be situations in which a U.S. investor in a CFC has a financial reporting carrying value (i.e., book basis) that does not equal its outside tax basis for U.S. tax purposes in its foreign investment, resulting in an outside basis difference in the foreign investment. In addition, the U.S. investor would have a U.S. tax basis in the CFC’s underlying assets and liabilities held that will be used for calculating GILTI inclusions. Accordingly, a U.S. investor may have book/U.S. tax inside basis differences that, upon reversal, will increase or decrease the GILTI inclusion and, because GILTI inclusions increase the U.S. tax basis in the foreign investment, will also affect the outside basis difference in the foreign investment.

In January 2018, the FASB staff issued a Q&A document, which states that a company may elect, as an accounting policy, to either (1) treat taxes due on future U.S. inclusions in taxable income under the GILTI provision as a current-period expense when incurred or (2) factor such amounts into the company’s measurement of its deferred taxes (the “GILTI deferred method”).

The decision tree below illustrates the approach for determining the deferred tax accounting for outside basis differences in foreign investments that are expected to reverse as a result of the GILTI provision.

3.4.10.2 GILTI Deferred Method — Overview

We believe that in a manner consistent with the mechanics of the GILTI computation, GILTI DTAs and DTLs should generally be computed on a U.S.-shareholder-by-U.S.-shareholder basis if the GILTI deferred method is elected. Further, when multiple U.S. shareholders are includable in a U.S. consolidated income tax return, the aggregation rules applicable to such consolidated tax filings should be considered. Multiple CFCs within the same U.S. consolidated tax return group would be analyzed in the aggregate. If a U.S. shareholder has a mixture of profitable and unprofitable CFCs that, in the aggregate, are not profitable to the extent that future GILTI inclusions are not expected at the U.S. shareholder level, no GILTI DTAs and DTLs would be recorded. Conversely, if a U.S. shareholder has a mixture of profitable and unprofitable CFCs that, in the aggregate, are profitable to the extent that future GILTI inclusions are expected, that U.S. shareholder should measure GILTI DTAs and DTLs as discussed below.

3.4.10.3 GILTI Deferred Method — Measurement of Deferred Taxes

In determining the amount of U.S.-investor-level deferred taxes necessary for foreign investments under this model, companies should “look through” the outside basis of the CFC to determine how the book/U.S. tax inside basis differences will reverse and how such reversals will affect future GILTI inclusions and the outside basis difference.

Unlike other situations involving outside basis differences in foreign subsidiaries, this “look through” approach (see Section 3.4.15) would be employed even if no overall outside basis difference in the CFC exists, or if only an overall deductible outside basis difference in the CFC exists.

In addition, in assessing the GILTI impact of the CFC’s underlying assets and liabilities, a company would, in a fashion similar to branch accounting, recognize U.S. DTAs or DTLs to account for the U.S. income tax effects of the future reversal of any in-country DTAs and DTLs (also referred to as “anticipatory foreign tax credit/deduction” or “anticipatory” DTAs and DTLs). When determining the amount of a U.S. anticipatory DTA or DTL, an entity must carefully consider all applicable provisions in the tax law, since the amount of the incremental foreign taxes that will be creditable and realizable, or forgone, because of the future reversal of the local in-country DTAs and DTLs may be difficult to assess and subject to limitations (e.g., an 80 percent limitation, limitations as a result of expense allocations, and a limitation on utilization as a result of the absence of a carryforward or carryback period, as well as tax rate differences). For example, a local-country DTL that will reverse in the same year(s) in which a GILTI inclusion is expected may be creditable against the U.S. tax in that year, subject to the 80 percent limitation. In addition, U.S. DTAs that reverse in the same year as the local in-country deferred might further limit the FTC. Future FTCs directly related to future book income and future expense allocation limitations directly related to future book expense generally should not be included in the measurement of the anticipatory DTA or DTL until such income or expense, or both, are recognized (i.e., such FTCs and expense allocation limitations should be limited to those directly tied to existing temporary differences). See also Section 3.3.6.3.1, which discusses the measurement of anticipatory DTAs and DTLs.

While many “branch-like” principles are employed in the look-through model described above, unlike a branch, a CFC that will have substantially all of its income taxable in the United States as a result of a GILTI inclusion may still have a residual outside basis difference that is not related to the CFC’s underlying assets or liabilities (i.e., inside/outside tax basis disparities). An entity should then analyze that residual outside basis difference to determine whether it would result in a taxable or deductible amount when the investment is recovered and whether an ASC 740 outside basis exception (i.e., ASC 740-30-25-18(a) or ASC 740-30-25-9) applies. For more information about accounting for foreign branch operations, see Section 3.3.6.3.

In summary, recorded GILTI DTAs and DTLs under the look-through model will consist of the following three items:

DTAs and DTLs related to inside book/U.S. tax basis differences that will affect future GILTI inclusions, identified by “looking through” the CFC’s outside basis to the CFC’s underlying assets and liabilities.
DTAs and DTLs related to the U.S. tax consequences of settling the CFC’s in-country DTAs or DTLs (i.e., anticipatory DTAs and DTLs).
Any DTA or DTL related to a residual outside basis temporary difference for which an exception has not been applied.

There have been a number of discussions with the FASB and SEC staffs about the more significant aspects of the guidance on measuring GILTI-related deferred taxes. Accordingly, while other acceptable accounting approaches may exist, entities that plan to apply methods that are inconsistent with those discussed herein are strongly encouraged to consult with their income tax accounting advisers.

3.4.10.4 GILTI Deferred Method — Other Considerations

3.4.10.4.1 Net Deemed Tangible Income Return

Given that the CFC’s routine return is excluded from the GILTI inclusion, we believe that there is more than one acceptable approach to accounting for the routine return in the measurement of GILTI DTAs and DTLs, including the following:

Special deduction — The routine return could be treated akin to a special deduction, with the benefit recognized when the GILTI inclusion is reduced by the routine return. Under this approach, the routine return is viewed as dependent on future events, including future investments in QBAI and interest expense deductions, and it therefore would not be factored into the tax rate expected to apply to the temporary differences.
Graduated tax rate — Under this approach, the amount of taxable income equal to the routine return would be considered income taxed at a zero rate. Accordingly, if the routine return represents a significant factor, companies would measure GILTI DTAs and DTLs by using the average graduated tax rate applicable to the amount of estimated annual taxable income in the periods in which the aforementioned deferred taxes are estimated to be settled or realized. Companies will need to use judgment in determining the periods in which GILTI DTAs and DTLs will reverse and the estimated annual taxable income in each of those periods. See Section 3.3.4.1.

Other models may also be acceptable in certain situations (e.g., a portion of the book/U.S. tax basis difference that will reverse and represent a routine return might not be considered a taxable temporary difference for which a deferred tax would be recorded in accordance with ASC 740-10-25-30).

The approach an entity selects would be an accounting policy election that, like all other such elections, must be applied consistently.

3.4.10.4.2 IRC Section 250 Deduction (the “GILTI Deduction”)

The GILTI deduction is intended to lower the GILTI income inclusion (with the intent of lowering the ETR on the included income) and, in many cases, will immediately apply when a company has a GILTI inclusion. Accordingly, we believe that if a company generally expects to be able to apply the full GILTI deduction in the period in which the GILTI DTAs and DTLs reverse, it should consider the deduction in the measurement of the GILTI DTAs and DTLs in accordance with ASC 740-10-55-24 (see guidance in Appendix A). As noted above, however, the GILTI deduction is “up to,” rather than “guaranteed” to be, 50 percent and could be reduced by the taxable income limitation, which is applied in combination with the FDII deduction. An entity should carefully consider this limitation when factoring the GILTI deduction into the measurement of U.S. GILTI DTAs and DTLs. For example, when the taxable income limitation and expense allocation limitations are expected to apply and be significant (e.g., in situations in which the U.S. operations generate significant losses or an entity expects to forgo the GILTI deduction because it expects to use existing NOL carryforwards), entities may conclude that factoring the GILTI deduction into the rate is not appropriate. See additional discussion in Section 5.7.2.

3.4.11 Deemed Repatriation Transition Tax (IRC Section 965)

Under the 2017 Act, a U.S. shareholder of a specified foreign corporation (SFC)8 was required to include in gross income, at the end of the SFC’s last tax year beginning before January 1, 2018, the U.S. shareholder’s pro rata share of certain of the SFC’s undistributed and previously untaxed post-1986 foreign E&P. The inclusion generally was reduced by foreign E&P deficits that were properly allocable to the U.S. shareholder. In addition, the mandatory inclusion was reduced by the pro rata share of deficits of another U.S. shareholder that is a member of the same affiliated group. A foreign corporation’s E&P were taken into account only to the extent that they were accumulated during periods in which the corporation was an SFC (referred to below as a “foreign subsidiary”). The amount of E&P taken into account was the greater of the amount determined as of November 2, 2017, or December 31, 2017, unreduced by dividends (other than dividends to other SFCs) during the SFC’s last taxable year beginning before January 1, 2018.

The U.S. shareholder’s income inclusion was offset by a deduction designed to generally result in an effective U.S. federal income tax rate of either 15.5 percent or 8 percent. The 15.5 percent rate applied to the extent that the SFCs held cash and certain other assets (the U.S. shareholder’s “aggregate foreign cash position”), and the 8 percent rate applied to the extent that the income inclusion exceeded the aggregate foreign cash position.

The 2017 Act permits a U.S. shareholder to elect to pay the net tax liability9 interest free over a period of up to eight years.

3.4.11.1 Classification of the Transition Tax Liability

The transition liability should be recorded as a current/noncurrent income tax payable. ASC 210 provides general guidance on the classification of accounts in statements of financial position. An entity should classify as a current liability only those cash transition tax payments that management expects to make within the next 12 months. The installments that the entity expects to settle beyond the next 12 months should be classified as a noncurrent income tax payable.

3.4.11.1.1 Classification of Transition Tax Obligation in Periods Before Inclusion in the Income Tax Return

In certain circumstances, the transition tax was not reported in an entity’s tax return for the year that included the enactment date. On the basis of the unique nature of tax reform and the mandatory one-time deemed repatriation income inclusion, we believe that it would be appropriate, in those circumstances, to classify the deemed repatriation transition tax liability as a current/noncurrent income tax payable in the period that includes the enactment date.

3.4.11.2 Measurement of Transition Tax Obligation in Periods Before Inclusion in the Income Tax Return

Although we generally believe that the recognition of a DTL related to a foreign subsidiary would be limited to the amount that corresponds to the entity’s outside basis difference in the foreign subsidiary, we also believe that, given the unique circumstances presented in Section 3.4.11, it would be appropriate to record the entire amount of the deemed repatriation transition tax in the period of enactment even if it exceeds the outside basis difference in the foreign subsidiary. Under these circumstances, the E&P subject to taxation related to past events and transactions are simply payable in a subsequent year.

3.4.11.3 Measurement of the Transition Tax Obligation — Discounting

Although ASC 740-10-30-8 clearly prohibits discounting of DTAs and DTLs, it does not address income tax liabilities payable over an extended period. In January 2018, the FASB staff issued a Q&A document, which states that the deemed repatriation transition tax liability should not be discounted. The FASB staff stated in the Q&A that “paragraph 740-10-30-8 prohibits the discounting of deferred tax amounts. Due to the unique nature of the tax on the deemed repatriation of foreign earnings, the staff believes that the guidance in paragraph 740-10-30-8 should be applied by analogy to the payable recognized for this tax.” The FASB staff also noted the following in the Q&A:

ASC 835-30 applies to the accounting for business transactions conducted at arm’s length and the interest rate “should represent fair and adequate compensation to the supplier.”
“[T]he transition tax liability is not the result of a bargained” arm’s length transaction.
The scope exception in ASC 835-30-15-3(e) that indicates that ASC 835-30 does not apply to “transactions where interest rates are affected by tax attributes or legal restrictions prescribed by a governmental agency (such as, income tax settlements)” would apply to the transition tax obligation.
Because the amount of the deemed repatriation transition tax is inherently subject to uncertain tax positions, measurement of the ultimate amount to be paid is potentially subject to future adjustment. Since uncertain tax positions are not discounted, it would not be appropriate to discount the transition tax liability “when the uncertain tax position is undiscounted.”

3.4.12 “Unborn” FTCs — Before the 2017 Act

When a U.S. company has concluded that the earnings of one or more of its foreign subsidiaries will not be indefinitely reinvested, the U.S. parent must recognize a DTL related to the portion of the outside basis difference for which reversal is foreseeable. Under U.S. federal tax law, when the U.S. parent receives a dividend from a foreign subsidiary, the parent is permitted to treat itself as having paid the foreign taxes that were paid by the foreign subsidiary. The parent does this by grossing up the taxable amount of the dividend by an amount equal to the related taxes. An FTC is allowed in an amount equal to this gross-up; such a credit is commonly referred to as a “deemed paid” credit. In certain circumstances, a deemed-paid FTC may exceed the U.S. taxes on the grossed-up dividend and, when the dividend is actually paid, such an excess FTC (commonly referred to as a “hyped credit”) will be available to offset U.S. taxes otherwise payable on unrelated foreign source income in the year of the dividend (or to offset U.S. taxes on foreign source income in prior or subsequent tax years by carryback or carryforward of the excess FTCs). Alternatively, instead of claiming an FTC, the U.S. parent can choose to deduct the foreign taxes by not grossing up the taxable amount of the dividend on its U.S. federal tax return.

A DTA should not be recognized for the anticipated excess FTCs that will arise in a future year when the foreign subsidiary pays the dividend. The anticipated excess FTC that will arise in a future period when the dividend is paid is considered to be “unborn.” The example below illustrates the circumstances that can lead to an unborn FTC.

Example 3-27

Terms Used

FC — Functional currency (in this example, the local currency is the functional currency).
E&P — Earnings and profits (similar to retained earnings but generally measured by using a tax concept of profit).
Tax pool — The cumulative taxes paid in connection with the E&P. The pool is (1) measured in U.S. dollars (USDs) by translating the amount payable each year at the average exchange rate for the year and (2) reduced by the amounts lifted (i.e., considered to be “born”) with prior dividends.

When Sub A distributes 100 FC in a future period, the U.S. parent will receive $110 (based on the reporting-date exchange rate). If the U.S. parent deducted foreign taxes in the year of the distribution, it would simply report the $110 as taxable income and determine the related tax liability — that is, it would not separately claim a deduction for deemed-paid foreign taxes. However, in this example, the U.S. parent has determined that it will claim an FTC for the foreign taxes paid by Sub A. Under U.S. tax law, the dividend received will be grossed up for the taxes paid by Sub A in connection with its earnings. In this example, Sub A has cumulative E&P of 400 LC. Because it is distributing 100 LC, it is distributing 25 percent of its total E&P. Therefore, 25 percent of the cumulative tax pool is treated as associated with the 100 LC being distributed. To be entitled to claim the $250 as an FTC, the U.S. parent must gross up the $110 received for the related taxes (25 percent of the tax pool of $1,000, or $250). As noted in Section 3.4.10, such gross-ups are required by IRC Section 78 and are often referred to as “IRC Section 78 gross-ups” for this reason. Since the U.S. parent is now paying tax on an amount that corresponds to Sub A’s pretax income that is being distributed, the U.S. parent is entitled to claim the IRC Section 78 gross-up amount as an FTC. In this example, the resulting $250 of FTC is greater than the U.S. tax on Sub A’s pretax income of $126. The excess amount is an unborn hyped FTC related to Sub A. The U.S. parent did not actually pay the $250 of foreign taxes but is deemed to have paid those taxes, and the first moment it is deemed to have paid those taxes is when the dividend is received from Sub A.

ASC 740-10-55-24 states, in part, that the “[c]omputation of a deferred tax liability for undistributed earnings based on dividends should also reflect any related dividends received deductions or foreign tax credits, and taxes that would be withheld from the dividend.” Thus, it requires a U.S. parent to consider available FTCs when determining the DTL related to a distribution of unremitted earnings from a foreign subsidiary.

We do not believe that in Example 3-27 a DTA should be established for the $124 of unborn FTC, since the unborn FTC does not meet the definition of a DTA. ASC 740-10-20 defines deferred tax asset as the “deferred tax consequences attributable to deductible temporary differences and carryforwards.”

Further, ASC 740-10-20 defines carryforwards, in part, as follows:

Deductions or credits that cannot be utilized on the tax return during a year that may be carried forward to reduce taxable income or taxes payable in a future year. An operating loss carryforward is an excess of tax deductions over gross income in a year; a tax credit carryforward is the amount by which tax credits available for utilization exceed statutory limitations.

The unborn FTC cannot be recognized as a DTA related to a carryforward since such an amount is not a tax credit “available for utilization” on a tax return that is carried forward for use on subsequent tax returns because it exceeds statutory limitations. In other words, for an FTC to be recognized as a “carryforward” DTA, the tax return must first show FTCs as being carried forward. The $124 in this example has the potential to become a carryforward if it is not fully used in the year in which Sub A pays the dividend. However, as of the current reporting date, there is only a plan to remit from Sub A in the foreseeable future (it is therefore necessary to measure the DTL related to the taxable temporary difference in Sub A). Until the period that includes the remittance causing the excess FTC to be born, no DTA should be recognized, but the DTL related to the investment in Sub A could be reduced to zero after taking the expected FTC into consideration.

Connecting the Dots

Since enactment of the 2017 Act, the relevance of unborn FTCs has greatly diminished because almost all of the foreign earnings are taxed in the United States in the period in which they are earned in the form of Subpart F, GILTI, or branch income. Therefore, FTCs are available to the U.S. parent in the same period in which the income is earned.

3.4.12A Foreign Exchange Gain (or Loss) on Distributions From a Foreign Subsidiary When There Is No Overall Taxable (or Deductible) Outside Basis Difference

Before the issuance of FASB Statement 109, APB Opinion 23 provided guidance on the establishment of a liability for unremitted foreign earnings. That guidance stated that such earnings were presumed to be repatriated, and a liability should be recorded for the tax consequences of the remittance, unless a company could demonstrate specific plans for reinvestment. As a result of the adoption of the balance sheet approach in Statement 109, the concept of a liability for unremitted earnings evolved into the recognition of a DTL for an outside basis difference in a company’s investment in a foreign subsidiary. This is because unremitted earnings typically resulted in an increase in the book basis of the investment and no corresponding increase in its tax basis. Further, it was generally presumed under this approach that no income tax related to earnings of a foreign corporate subsidiary would be incurred in the parent’s tax jurisdiction until a repatriation occurred. The concepts in APB Opinion 23 and Statement 109 were codified in ASC 740-30-25-18(a), which states that an entity should recognize a DTL for an “excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary or a foreign corporate joint venture that is essentially permanent in duration” if the temporary difference will reverse in the foreseeable future. In this context, it is still presumed that the unremitted earnings in a foreign subsidiary or foreign corporate joint venture will be distributed to its parent and that the outside basis temporary difference will reverse unless the indefinite reversal criteria of ASC 740-30-25-17 are met.

However, the 2017 Act greatly increased the likelihood that a foreign subsidiary may have positive cumulative unremitted foreign earnings even though the book basis of the parent’s investment in the foreign subsidiary may not be greater than its tax basis (e.g., the U.S. parent’s tax basis in the foreign subsidiary may have increased as a result of taxable income inclusions related to the transition tax under IRC Section 965 or GILTI). Sometimes, a distribution of the unremitted earnings may even result in a reduction in the book basis of the parent’s investment in the foreign subsidiary that exceeds the reduction in the tax basis (i.e., the distribution could create or increase a deductible temporary difference rather than result in the reversal of a taxable outside basis difference) even though the distribution results in taxable income (i.e., for the currency gain) in the parent’s jurisdiction.

For example, the U.S. taxable income or loss of a U.S. parent as a result of the remittance of earnings by a foreign corporate subsidiary is now typically limited to any foreign currency gain or loss calculated for tax purposes. Such amounts, however, would already have increased or decreased the book basis but generally would not have affected the tax basis before distribution.

In these situations, a questions may arise about whether a U.S. parent should record a DTL when (1) there is no overall outside basis difference on its investment in a foreign subsidiary or the overall outside basis difference is deductible, (2) the U.S parent intends to repatriate the foreign subsidiary’s earnings, and (3) the entity expects that there will be a foreign exchange gain in the parent’s jurisdiction upon distribution.

We believe that there are two acceptable approaches:

View A — A DTL should not be recognized when no overall outside basis taxable temporary difference exists as of the reporting date (i.e., the financial reporting basis does not exceed the tax basis) even if the entity would incur an income tax liability if the unremitted earnings were repatriated. This is because the recovery of the entire financial reporting carrying amount of the investment would result in either (1) no taxable gain (when there is no outside basis difference) or (2) a loss (when the basis difference is deductible) for tax purposes.
View B — If, in a prior period, a company has undistributed earnings that have been recognized in the financial statements that would trigger an investor-level tax upon distribution, and the company is not asserting that such earnings are indefinitely reinvested, the investor would disaggregate the outside basis difference into multiple components, such as (1) a temporary difference related to unremitted earnings, (2) a temporary difference related to financial statement gain or loss reported in OCI related to the unremitted earnings, and (3) other temporary differences that will not reverse as a result of a distribution of unremitted earnings (e.g., cumulative translation adjustment [CTA] reported in OCI related to the foreign subsidiary’s capital accounts or residual outside basis differences).10 The recognition of a DTL in this instance would be acceptable, irrespective of the overall outside basis difference in the investment in the subsidiary (i.e., disaggregation would be acceptable). This approach is consistent with the accounting discussed in Section 3.4.11.2 for the transition tax obligation and the guidance in ASC 740-30-25-19, which states, in part:

If . . . 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 entity, it shall accrue as an expense of the current period income taxes attributable to that remittance.

Generally, the same two views would also apply to the reverse scenario (i.e., there is no overall outside basis difference in a foreign subsidiary or the overall outside basis difference is taxable, the entity intends to remit the foreign earnings, and the entity expects that there will be a tax benefit associated with a foreign exchange loss in the parent’s jurisdiction upon distribution). However, additional considerations are necessary when a DTA (as opposed to a DTL) is recorded because of the requirements in ASC 740-30-25-9, which only allow for the recording of a deferred tax asset related to a temporary difference in an investment that is expected to reverse in the “foreseeable future.” We believe that a reporting entity that meets this criterion may record a DTA even when no overall deductible outside basis difference exists if it has definitive plans to repatriate earnings in the foreseeable future. For additional details regarding how to interpret the “foreseeable future” criteria related to recording a DTA, see Section 3.4.1.2.

The application of either view described above would be considered an accounting policy that should be consistently applied.

Example 3-28

Entity X, a U.S. entity, has a wholly owned subsidiary, Entity Y, located in foreign jurisdiction Z. As of December 31, 20X9, Y has the following balances and outside basis difference, and it anticipates a distribution of its accumulated unremitted earnings to X in the foreseeable future:

Under View A described above, X would not record a DTL related to its investment in Y, notwithstanding the fact that it will incur a tax liability related to a financial statement gain of 5 USD on the planned 200 FC remittance, since X has an overall deductible outside basis difference in Y. Further, under the exception in ASC 740-30-25-9, X would not recognize a DTA for its overall deductible temporary difference in Y unless it becomes apparent that the deductible temporary difference will reverse in the foreseeable future. Under this approach, a current-year tax expense will result from the distribution in the year it is made (without an offset by any reversal of deferred tax). Such expense can be viewed as attributable to X’s inability to record a DTA on the incremental 5 USD deductible outside basis difference (i.e., that increase in the deductible temporary difference is subject to the exception under ASC 740-30-25-9) rather than to the lack of establishing a DTL in a prior period.

Under View B, X would record a DTL for the future tax effects of the financial statement gain of 5 USD that would be triggered upon the distribution of 200 FC. The remaining deductible temporary difference that is a component of the overall deductible outside basis difference would be recorded when it becomes apparent that the deductible temporary difference will reverse in the foreseeable future, in a manner consistent with ASC 740-30-25-9.

See Section 3.4.11.2 for a discussion of the measurement of the transition tax obligation in periods before its inclusion in the tax return.

3.4.13 Withholding Taxes Imposed on Distributions From Disregarded Entities and Foreign Subsidiaries

Multinational companies generally operate globally through entities organized under the laws of the respective foreign jurisdiction that govern the formation of legally recognized entities. These foreign entities might be considered partnerships or corporations under local law; however, sometimes no legal entity exists, and the assets and liabilities are simply viewed as an extension of the parent entity doing business in the jurisdiction (i.e., a “true branch” or “division”).

In the case of a legal entity, under U.S. Treasury Regulation Sec. 301.7701-3 (the check-the-box regulations), certain eligible foreign entities may elect to be disregarded as entities separate from their parents (hereafter referred to as foreign disregarded entities). As a result of the check-the-box election, the earnings of a foreign disregarded entity that is owned directly by a U.S. entity will, like those of a branch, be taxable in the United States as earned.

In many foreign jurisdictions, a resident corporation must pay a withholding tax upon a distribution of earnings to its nonresident shareholder(s). Since disregarded entities are often corporations under local law, the applicability of withholding tax on distributions will generally depend on whether the entity is regarded or disregarded for U.S. tax purposes. Although the distributing entity remits the withholding tax to the local tax authority (reducing the amount received by the parent), under the local tax statutes, the tax is generally assessed on the recipient of the distribution.

In the case of a foreign disregarded entity, no outside basis exists (from the perspective of U.S. tax law) because the foreign entity is viewed as a division of the parent as a result of the U.S. check-the-box election. In the case of a foreign regarded entity, its parent might still have no taxable temporary difference in its investment in the foreign entity because (1) all the unremitted earnings have already been taxed in the parent’s tax jurisdiction (e.g., 100 percent of the unremitted earnings of a foreign subsidiary were taxable to its U.S. parent as Subpart F income or GILTI in such a way that the financial reporting carrying amount and the tax basis are equal) or (2) CTA losses have reduced the financial reporting carrying value without a corresponding reduction in its tax basis.

Even when no taxable temporary difference exists (either in the assets of a disregarded entity or in the shares of a regarded entity), the foreign entity may have earnings that could be distributed to its parent, at which time withholding taxes would be imposed by the local tax authority.

We believe that there are two acceptable views on determining whether a parent should recognize a DTL for withholding taxes that are within the scope of ASC 740 and that would be imposed by the local tax authority on a distribution from a disregarded entity or foreign subsidiary: (1) the parent jurisdiction view and (2) the foreign jurisdiction view.

3.4.13.1 View 1 — Parent Jurisdiction Perspective

ASC 740-10-25-2 states, in part:

Other than the exceptions identified in the following paragraph, the following basic requirements are applied in accounting for income taxes at the date of the financial statements: . . .

b. A deferred tax liability or asset shall be recognized for the estimated future tax effects attributable to temporary differences and carryforwards. [Emphasis added]

Further, ASC 740-10-55-24 states:

Deferred tax liabilities and assets are measured using enacted tax rates applicable to capital gains, ordinary income, and so forth, based on the expected type of taxable or deductible amounts in future years. For example, evidence based on all facts and circumstances should determine whether an investor’s liability for the tax consequences of temporary differences related to its equity in the earnings of an investee should be measured using enacted tax rates applicable to a capital gain or a dividend. Computation of a deferred tax liability for undistributed earnings based on dividends should also reflect any related dividends received deductions or foreign tax credits, and taxes that would be withheld from the dividend. [Emphasis added]

Under the parent jurisdiction view, a parent would apply ASC 740-10-55-24 by considering the withholding tax as a tax that the parent would incur upon the reversal of a U.S. jurisdiction taxable temporary difference that is attributable to unremitted earnings.

In the case of a disregarded entity, since (1) no outside basis difference exists (because the foreign entity is viewed as a division of the parent as a result of the U.S. check-the-box election) and (2) the earnings of the foreign disregarded entity are taxed in the parent’s jurisdiction as they are generated, there is generally no taxable temporary difference related to the net assets of the disregarded entity (i.e., the net assets that arose on account of unremitted earnings have a tax basis since the income of the disregarded entity was recognized for U.S. tax purposes as earned). In the absence of a U.S. taxable temporary difference for which a DTL can be recognized, a DTL cannot be recognized for the future withholding tax. Under this view, the withholding tax would be recognized in the period in which the actual withholding tax arises (as a current tax expense).

Similarly, a regarded foreign subsidiary would be unable to recognize a DTL when (1) all of its unremitted earnings have already been taxed by the United States (e.g., 100 percent of the unremitted earnings were taxable as Subpart F income or GILTI in such a way that the financial reporting carrying amount and the tax basis are equal) or (2) CTA losses have reduced the financial reporting carrying value without a corresponding reduction in its tax basis. Without a U.S. taxable temporary difference, the requirement under ASC 740-10-55-24 for an entity to consider withholding taxes (when recording a DTL for a basis difference related to unremitted earnings expected to be reduced by remittances) would appear not to be applicable.

However, if an outside basis difference does exist in the parent’s investment in the foreign subsidiary, the parent would apply ASC 740-10-55-24 when measuring the DTL to be recognized (i.e., it would include a DTL for the withholding tax).

3.4.13.2 View 2 — Foreign Jurisdiction Perspective

ASC 740-10-30-5 states, in part:

Deferred taxes shall be determined separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction.

Accordingly, from the perspective of the local jurisdiction (i.e., the disregarded entity or subsidiary), two separate and distinct taxpayers exist: (1) the distributing entity (which is generally viewed as a taxable legal entity in the local jurisdiction) and (2) the parent. Under the foreign jurisdiction view, the local jurisdiction taxes the distributing entity on its earnings as they occur, and it taxes the parent entity only when those “already net of tax” earnings are distributed. An entity that applies this view evaluates each jurisdiction and considers the perspective of the jurisdiction that is actually taxing the recipient (i.e., the local jurisdiction imposing the withholding tax) when determining whether the parent has a taxable temporary difference. From the perspective of the local jurisdiction, the parent has a financial reporting carrying amount in its investment in the distributing entity that is greater than its local tax basis (i.e., from the perspective of the local jurisdiction, the entities have a “parent-corporate subsidiary” relationship since the election to disregard the entity is applicable only in the parent’s jurisdiction and is not relevant in the local jurisdiction). Therefore, from a local jurisdiction perspective, an “outside” taxable temporary difference equal to the amount of such unremitted earnings that would be subject to withholding tax exists and, in accordance with ASC 740-10-55-24, the measurement of the DTL should reflect withholding taxes to be incurred when that taxable temporary difference reverses.

Under this view, even in the case of a disregarded entity, the indefinite reversal criteria would be considered and, if the reversal of the taxable temporary difference is not foreseeable, no deferred taxes should be recognized.

3.4.13.3 Determining the Income Tax Effects of Distributions of Previously Taxed Earnings and Profits in a Single-Tier or Multi-Tier Legal Entity Structure

In some cases, a remittance of foreign earnings to the parent may trigger tax consequences in multiple jurisdictions. For example, a U.S. parent may have an investment in a foreign subsidiary that has unremitted earnings that, upon remittance, may give rise to a withholding tax in the foreign jurisdiction (a DTL) and an FTC or deduction for the withholding taxes in the U.S. parent’s federal jurisdiction (a DTA). In addition, a consolidated group may have a multi-tiered structure that includes intermediate legal entities or “HoldCos” in between a parent and its foreign subsidiaries.

In these instances, questions generally arise about how to measure the deferred taxes related to a distribution. We believe that if a company’s policy prohibits disaggregation of the U.S. parent’s outside basis in the investee into multiple components to book a DTA or DTL (see Section 3.4.13), two different approaches can be used to measure (1) the withholding tax liability at the foreign subsidiary level and (2) the corresponding foreign tax deduction or credit at the U.S. parent level.

One approach is to consider the various tax consequences of a distribution, regardless of jurisdiction. This view is consistent with the guidance in ASC 740-10-55-24, which states, in part, that the “[c]omputation of a deferred tax liability for undistributed earnings . . . should also reflect any related dividends received[,] deductions or foreign tax credits, and taxes that would be withheld from the [distribution].” Under this approach, an entity aggregates all tax consequences of the distribution, regardless of the jurisdiction in which they are recognized, when assessing whether there is an overall DTA or DTL with respect to the U.S. parent’s outside basis difference (i.e., whether there is an overall net DTL to record). In situations in which the U.S. parent has a taxable outside basis difference with respect to its investment in the foreign subsidiary, and there is an overall DTL, the tax impact would be recorded (for single-tier entities).11 While there would be an added level of complexity for multi-tier entities, we believe that this view would still be acceptable if the U.S. parent can represent that such earnings will move all the way “up the chain” (i.e., from the second-tier subsidiary, to the HoldCos in between, to the U.S. parent) in the same period so that the U.S. parent cannot be left with a “naked” DTA (e.g., a DTA for an unborn FTC) related to an overall taxable outside basis temporary difference in its investment in HoldCo as of the end of the year.

A second approach would be to consider the tax consequences of the distribution on a jurisdiction-by-jurisdiction basis. Under this approach, a foreign tax deduction or credit would not be considered as part of the measurement of the withholding tax liability because they exist in different jurisdictions. Rather, in the case of withholding tax obligations at a second-tier or lower foreign subsidiary jurisdiction, a foreign tax deduction or credit could only be recorded if the U.S. parent, in fact, had a deductible temporary difference in its investments in the first-tier foreign subsidiary12 or, in the case of a withholding tax obligation at a first-tier foreign subsidiary jurisdiction, if the foreign tax deduction or credit is a direct consequence of the withholding tax liability itself (e.g., the “state/federal” effect in a single-tier entity).

3.4.14 Withholding Taxes — Foreign Currency Considerations

While foreign withholding taxes are generally considered a liability of the investor rather than the investee (i.e., are attributable to the investor’s outside basis difference), such taxes will ultimately be payable to the foreign government in local currency and, provided that the investor’s functional currency is different from the investee’s local currency, represent foreign-currency-denominated liabilities of the investor.

When the investor is a U.S. entity, the amount of a non-USD-denominated, foreign withholding tax liability will change as a result of fluctuations in the corresponding exchange rate between the U.S. parent (i.e., the USD) and the applicable local currency of the first-tier foreign subsidiary. Because the U.S. parent is the primary obligor, such a liability is not recorded by the first-tier foreign subsidiary and is therefore not subject to translation. Accordingly, the impact of fluctuations between the reporting currency of the U.S. parent and the functional currency of the first-tier foreign subsidiary should be recorded through continuing operations of the U.S. parent as the related liability is remeasured in each reporting period in accordance with ASC 830-20.

Questions have arisen related to how a first-tier foreign subsidiary (or foreign corporate joint venture that is essentially permanent in duration) should account for fluctuations in the value of a foreign withholding tax liability related to earnings of a second-tier foreign subsidiary (or foreign corporate joint venture that is essentially permanent in duration) (the “second-tier foreign subsidiary”) that are not indefinitely reinvested when the first-tier foreign subsidiary has the same local and functional currency as that of the second-tier foreign subsidiary, which is not the reporting currency.

Because the withholding tax liability is denominated in the same currency as the first-tier foreign subsidiary’s functional currency, the amount of the withholding tax liability on the functional currency books of the first-tier foreign subsidiary will not change as a result of exchange rate fluctuations. Accordingly, the related liability would not be remeasured in each reporting period, and the first-tier foreign subsidiary would not record transaction gain or loss in accordance with ASC 830-20. However, because the first-tier foreign subsidiary is the primary obligor, such a liability is recorded by the first-tier foreign subsidiary and is therefore subject to translation. Accordingly, the impact of fluctuations between the reporting currency of the U.S. parent and the functional currency of the first-tier foreign subsidiary should be recorded as a CTA through other comprehensive income (OCI).

If the first-tier foreign subsidiary has a functional currency that is different from (1) the local currency of the second-tier foreign subsidiary or (2) the reporting currency, the reporting entity needs to account for the fluctuations in the value of a foreign withholding tax liability related to the earnings of a second-tier foreign subsidiary. The amount of a foreign withholding tax liability denominated in the local currency of the second-tier foreign subsidiary will change as a result of fluctuations in the corresponding exchange rate between the applicable local currencies of the first-tier foreign subsidiary and the second-tier foreign subsidiary. Accordingly, the impact of fluctuations between the functional currencies of the first-tier foreign subsidiary and the second-tier foreign subsidiary should be recorded through continuing operations of the first-tier foreign subsidiary as the related liability is remeasured in each reporting period in accordance with ASC 830-20. In addition, because the first-tier foreign subsidiary is the primary obligor, such a liability is recorded by the first-tier foreign subsidiary and is therefore subject to translation. Accordingly, the impact of fluctuations between the reporting currency of the parent and the functional currency of the first-tier foreign subsidiary should be recorded as a CTA through OCI.

3.4.15 Tax Consequences of Investments in Pass-Through or Flow-Through Entities

Generally, “pass-through” or “flow-through” entities (e.g., partnerships and LLCs that have not elected to be taxed as corporations) are not taxable. Rather, the earnings of such entities pass through or flow through to the entities’ owners and are therefore reported by the owners in accordance with the governing tax laws and regulations. See ASC 740-10-55-226 through 55-228 for examples illustrating when income taxes are attributed to a pass-through entity or its owners.

Further, while ASC 740 does provide for certain exceptions to the recognition of deferred taxes for basis differences related to investments in certain subsidiaries, those exceptions historically have not been applied to pass-through or flow-through entities since those types of entities were not subsidiaries as defined before the issuance of ASU 2010-08. Rather, at the time FASB Statement 109 (codified in ASC 740) was issued, APB Opinion 18 (codified in ASC 323) defined a subsidiary as “a corporation which is controlled, directly or indirectly, by another corporation.”

An investor in a pass-through or flow-through entity should determine the deferred tax consequences of its investment. Because pass-through or flow-through entities are not subject to tax, an investor should not recognize deferred taxes on the book and tax basis differences associated with the underlying assets and liabilities of the entity (i.e., “inside basis differences”) regardless of how the investor accounts for its interest in the entity (e.g., consolidation, equity method, or cost method13). Rather, because any taxable income or tax losses resulting from the recovery of the financial reporting carrying amount of the investment will be recognized and reported by the investor, the investor’s temporary difference should be determined by reference to the investor’s tax basis in the investment itself.

Often, this outside basis difference will fully reverse as the underlying assets and liabilities are recovered and settled, respectively. However, differences can exist between the investor’s share of inside tax basis and the investor’s outside tax basis in the investment, leading to a temporary difference that will generally not reverse as a result of the operations of the entity (a “residual” temporary difference). Nonetheless, because that residual temporary difference will still ultimately be recognized as additional taxable income or loss upon the dissolution of the partnership (if the dissolution is taxable) or will be attached to the assets distributed in liquidation of the investor’s interest (if the dissolution is nontaxable), the recognition of deferred taxes related to an investment in a pass-through or flow-through entity should always take into account (and reconcile back to) the entirety of the outside basis difference.

Two acceptable approaches have developed in practice for measuring the DTA or DTL to be recognized for an outside basis difference related to an investor’s investment in a consolidated pass-through or flow-through entity: (1) the outside basis approach and (2) the look-through approach.

Under the outside basis approach, measurement of the DTA or DTL is based on the entirety of the investor’s outside basis difference in the pass-through or flow-through entity investment without regard to any of the underlying assets or liabilities. While it is easy to perform this computation, application of the outside basis approach can result in certain additional practice issues. For example, an outside basis difference would generally be considered capital in character under a “pure” outside basis approach because such an approach assumes that (1) the investment will be recovered when it is disposed of in its entirety and (2) the interest in a pass-through or flow-through entity is capital in nature. However, as discussed above, the recovery and settlement of the pass-through or flow-through entity’s individual assets and liabilities through normal operations of the entity will result in (1) reversal of the temporary difference before the investor disposes of the investment, (2) the pass-through of income or loss to the owner that is ordinary rather than capital in character, or (3) both. Among other things, the assumed timing of reversal and the character of the resulting income or loss may have an effect on the investor’s conclusions about the tax rate to be applied to the temporary difference and whether a valuation allowance against the investor’s DTAs is needed. Accordingly, for the reasons noted above, even those investors applying an outside basis approach for measurement should generally consider the recovery and settlement of the pass-through or flow-through entity’s underlying assets and liabilities, respectively, when assessing character and scheduling.

Under the look-through approach, the investor would “look through” and notionally match up its outside temporary difference with its share of inside temporary differences for purposes of (1) applying ASC 740’s exceptions to deferred tax accounting and (2) determining the character (capital versus ordinary) and resulting reversal patterns used for assessing the applicable tax rate or realizability of DTAs. Only the residual difference (if any) would take its character and reversal pattern exclusively from the investment itself. For example, under this approach, the portion of the investor’s outside basis temporary difference that is notionally attributed to “inside” nondeductible goodwill or the pass-through entity’s own investment in a foreign corporate subsidiary (with unremitted earnings that are indefinitely reinvested) would be identified and the applicable exception in ASC 740 would be applied (i.e., no DTL would be recorded for that portion of the investor’s outside basis temporary difference).

The look-through approach recognizes that because the pass-through or flow-through entity is consolidated, (1) the assets and liabilities of the pass-through or flow-through entity are actually being reported by the investor in the investor’s financial statements and (2) the investor is the actual taxpayer when the pass-through or flow-through entity’s underlying assets and liabilities are recovered and settled, respectively. Accordingly, measuring the outside basis difference under the look-through approach results in the recognition of deferred taxes in a manner consistent with the characteristics of the underlying assets and liabilities that will be individually recovered and settled, respectively.

When the look-through approach is applied, however, any residual difference between the total of the investor’s share of the pass-through or flow-through entity’s inside tax basis and the investor’s outside tax basis related to the investment would still need to be taken into account. As noted above, while this component of the outside basis difference often would not become taxable or deductible until sale or liquidation of the entity, a DTA or DTL would generally be recorded because there is no available exception to apply. In some instances, however, it may be appropriate to apply, by analogy, the exception to recognizing a DTA in ASC 740-30-25-9. While it is more difficult to perform computations under the look-through approach than under the outside basis approach, application of the look-through approach can potentially alleviate some of the aforementioned practice issues regarding character and scheduling that result from applying the outside basis approach.

The approach selected to measure the deferred tax consequences of an investment in a pass-through or flow-through entity would be considered an accounting policy that should be consistently applied to all similar investments. In addition, given the complexities associated with applying either alternative, consultation with appropriate accounting advisers is encouraged in these situations.

3.4.16 Accounting for the Tax Effects of Contributions to Pass-Through Entities in Control-to-Control Transactions

ASC 810-10-45-22 provides examples of transactions in which a parent’s ownership in a subsidiary changes but the parent retains control of the subsidiary. Specifically:

A “parent purchases additional ownership interests in its subsidiary.”
A “parent sells some of its ownership interests in its subsidiary.”
A “subsidiary reacquires some of its ownership interests” held by a nonaffiliated entity.
A “subsidiary issues additional ownership interests” to a nonaffiliated entity.

When the parent maintains control over the subsidiary, the parent accounts for changes in its ownership interest as equity transactions. See Section 12.4.1.

When there are subsequent contributions by either the controlling interest or the noncontrolling interest to the pass-through entity, recognition of a gain or loss in equity by the controlling shareholder will typically create an additional basis difference that will need to be addressed (i.e., the controlling interest’s basis for financial and income tax reporting purposes may change by different amounts). Further, under the look-through approach, additional complexities can arise because of the applicable income tax regulations governing the allocation to partners of items of income, gain, loss, or deduction for U.S. tax purposes.14 For example, such transactions can often result in residual outside basis differences (i.e., the investor’s outside tax basis will not equal its share of the inside tax basis) that will usually not be deductible or taxable until a sale or taxable liquidation of the partnership (e.g., distribution of cash following a sale of the partnership’s assets).

Typically, an investor accounts for changes in the measurement of deferred taxes on its investment in a pass-through entity that result from a control-to-control transaction in equity in accordance with the intraperiod tax allocation guidance in ASC 740-20-45-11. If the investor uses the look-through approach in measuring deferred taxes on its investment in the pass-through entity, such changes would include the impact of any residual outside basis difference. If the residual outside basis difference represents future deductible amounts, the investor must consider its policy on applying ASC 740-30-25-9, by analogy, to its investment in the pass-through entity.

Example 3-29

On January 1, 20X9, Company A contributes a recently acquired business (net assets including cash, subject to debt) with a fair value and financial reporting and income tax bases of $20 million to Partnership P for an 80 percent interest in P, and Company B contributes cash of $5 million for a 20 percent interest in P. Partnership P is a pass-through entity and is not subject to income taxes in any jurisdiction in which it operates. Company A uses the look-through approach in measuring deferred taxes with respect to investments in consolidated pass-through entities. At the time of the contribution, A’s outside basis for financial and income tax reporting purposes are $20 million and $20 million, respectively. Company B’s and A’s share of inside bases held by the investment upon formation were as follows:

During 20X9, P generates $12.5 million of income through normal operations for both financial and income tax reporting purposes and makes no distributions. Company A’s outside basis for financial and income tax reporting purposes are $30 million and $30 million, respectively. Company B’s and A’s share of inside bases held by the investment are as follows:

As of December 31, 20X9, P has appreciated in value to $80 million; assume such appreciation is attributable entirely to P’s goodwill. Further assume that on December 31, 20X9, B contributes an additional $20 million to P. The contribution decreases A’s ownership to 64 percent,15 which results in A’s having a financial reporting basis of $36.8 million16 in its investment in P. As a result of the contribution, A must recognize a control-to-control gain of $6.8 million ($36.8 million – $30 million) for financial statement reporting purposes; essentially A transitions from owning 80 percent of P’s $37.5 million net book value17 to owning 64 percent of P’s $57.5 million net book value after the contribution.

Immediately after the $20 million contribution by the noncontrolling interest holders, B’s and A’s shares of inside bases held by the investment would be as follows:

However, the contribution does not affect A’s tax basis in its investment in P, which creates a taxable temporary difference of $6.8 million and a DTL of $1.7 million. In this case, the allocation method chosen in accordance with the applicable income tax regulations will affect only whether the $6.8 million becomes taxable over time through certain partnership allocations18 or not until the ultimate sale or taxable liquidation of the partnership; in either case, a DTL is required.

Assume a 25 percent tax rate. Company A will make the following consolidated journal entry to recognize the contribution made by the noncontrolling interest holders:

Example 3-30

Assume the same facts as in the example above except that on December 31, 20X9, Company A (not Company B) contributes an additional $20 million to Partnership P. The contribution increases A’s ownership to 84 percent.19 As a result of the contribution, A must recognize a control-to-control loss of $1.7 million (A has paid a $1.7 million premium above book value to acquire the additional interest); essentially A transitions from owning 80 percent of P’s $37.5 million net book value20 to owning 84 percent of P’s $57.5 million net book value after the contribution. Company A’s basis in P for financial reporting purposes increases by $18.3 million; however, its basis for income tax reporting purposes increases by the entire $20 million contribution, resulting in a deductible temporary difference of $1.7 million.

Because there is a difference between the fair value and adjusted tax basis of the property owned by the partnership at the time of A’s additional contribution, consideration needs to be given to whether, as a matter of tax law, A will be allocated deductions equal to the fair value of its contribution of $20 million. If the partnership’s allocation method (the remedial method in this case since the goodwill has no tax basis in the hands of the partnership) under the applicable income tax regulations will allocate such deductions to A, A should record a DTA for the deductible temporary difference given that such a difference will close through normal business operations. Company A’s outside book and tax basis are $48.3 million and $50 million, respectively. Company B’s and A’s share of inside bases held by the investment would be as follows:

Assume a 25 percent tax rate. The resulting entry to record the control-to-control loss in equity would be as follows:

If the partnership’s allocation method will not allocate A deductions equal to its $20 million contribution (i.e., the “traditional method” in this case since the goodwill has no tax basis in the hands of the partnership), such a deductible temporary difference will reverse only upon P’s sale or taxable liquidation. Company A should consider the application of ASC 740-30-25-9, by analogy, to such a residual temporary difference. A summary of A’s outside basis and related look-through temporary differences in its investment in such a case would be as follows:

If A applied ASC 740-30-25-9 by analogy, A would record the entry for the control-to-control loss as follows:

3.4.17 Other Considerations

3.4.17.1 Consideration of the VIE Model in ASC 810-10 in the Evaluation of Whether to Recognize a DTL

For VIEs, an analysis of voting rights may not be effective in the determination of control. Under the VIE model in ASC 810-10, a reporting entity could be determined to have a controlling financial interest in a VIE, and thus consolidate the VIE, if the reporting entity has (1) the power to direct the activities that most significantly affect the VIE’s economic performance and (2) the obligation to absorb losses of (or right to receive benefits from) the VIE that could potentially be significant to the VIE. A reporting entity that consolidates a VIE is known as the primary beneficiary.

When accounting for a VIE under ASC 740, the reporting entity must consider both inside and outside basis differences.

When determining whether an exception to recording an outside basis difference applies to the primary beneficiary’s investment in a VIE, the reporting entity should carefully consider the facts and circumstances. The primary beneficiary should not assume that its controlling financial interest (through which it has the power to direct the activities that most significantly affect the VIE’s economic performance) also gives it the power to direct all of the activities of the VIE that are relevant to the determination of whether an exception to recording an outside basis difference is applicable (e.g., when and if the VIE will distribute earnings, the manner in which the primary beneficiary will recover its investment, and so forth). Provided that the criteria for an exception are met, a primary beneficiary of a VIE may apply the outside basis exceptions.21 However, meeting some of these exceptions may be challenging. When determining which party has the power to control decisions regarding the distribution of earnings, for example, an entity should consider how the VIE is controlled (i.e., through contract or governing documents rather than voting interests) and the rights of other parties to the arrangement.

3.4.17.2 Recognition of a DTA or DTL Related to a Subsidiary Classified as a Discontinued Operation

ASC 740-30-25-9 states that “[a] deferred tax asset shall be recognized for an excess of the tax basis over the amount for financial reporting of an investment in a subsidiary or corporate joint venture that is essentially permanent in duration only if it is apparent that the temporary difference will reverse in the foreseeable future.” This criterion (i.e., a reversal of a temporary difference in the foreseeable future) would be met no later than when the “held-for-sale” criteria in ASC 360-10-45-9 are met. The same criterion should apply to the recognition of a DTL related to an excess of financial reporting basis over outside tax basis of an investment in a subsidiary. In other words, the deferred tax consequences of temporary differences related to investments in foreign subsidiaries that were not previously recognized as a result of application of the exception in ASC 740-30-25-18(a) should be recognized when it becomes apparent that the temporary difference will reverse in the foreseeable future.

Similarly, the potential tax consequences of basis differences related to investments in domestic subsidiaries that were not previously recognized because (1) the tax law provides a means to recover the reported amount of the investment in a tax-free manner, and (2) the entity had previously expected that it would ultimately use those means, should be accrued when it becomes apparent that the reversal of those basis differences will have a future tax consequence.

The tax effects of the recognition of DTAs and DTLs for preexisting outside basis differences when an investee meets the criteria to be classified as held for sale generally will give rise to an “out-of-period” adjustment in the current period (see Section 6.2.4 for further information on out-of-period adjustments and Section 6.2.4.1 for guidance on the intraperiod allocation of such adjustments resulting from the recognition of an outside basis difference associated with a subsidiary classified as a discontinued operation).

Note that if the unrecognized outside basis difference DTL will close through a GILTI inclusion, entities that have elected to treat GILTI as a current-period expense, as discussed in Section 3.4.10.1, would recognize the tax expense in the period in which the tax is incurred. In other words, recognition of the tax expense may not coincide with the held-for-sale date, as described above.

3.4.17.3 State Tax Considerations

In recognizing outside basis differences associated with various investments, entities should pay close attention to certain state tax considerations. ASC 740-30-25-7 and 25-8 provide guidance on assessing whether the outside basis difference of an investment in a domestic subsidiary is a taxable difference. This assessment should be performed on a jurisdiction-by-jurisdiction basis. Accordingly, the outside basis difference of an investment in a domestic subsidiary that is not a taxable difference for federal purposes would also need to be assessed at the state level.

An entity should consider the following factors in applying the guidance in ASC 740-30-25-7 and 25-8 at the state level:

Whether tax-free liquidation is permitted in the applicable state jurisdictions. See Section 3.4.3 for further discussion of tax-free liquidations.
Whether the parent files a separate, combined, or consolidated return in the state jurisdiction and whether intra-entity transactions (e.g., dividends) are eliminated when subsidiaries are combined or consolidated in that state return.
Whether a dividends received deduction is available in the state jurisdiction or whether federal taxable income is used as the starting point for the state tax liability calculation and is unadjusted for dividends received deductions taken on the federal return. A dividends received deduction is a deduction on an income tax return for dividends paid from a subsidiary to a parent.

See Section 3.3.4.6 for a discussion of further considerations related to certain state matters, including optional future tax elections in the measurement of DTAs and DTLs.

Example 3-31

Subsidiary B, a 90 percent owned subsidiary of Entity A, operates in only one state (State C), which does not permit a tax-free liquidation in accordance with ASC 740-30-25-7. Entity A is taxable in C. Subsidiary B is consolidated in A’s federal return. The only outside basis difference in B relates to $1,000 of unremitted earnings, which A expects to be remitted as dividends. For federal income tax purposes, since A holds more than 80 percent of B, A can deduct 100 percent of the dividends it receives from B (i.e., the dividends received deduction). State C does not adjust federal taxable income for the dividends received deduction. In this example, the unremitted earnings of B to A would not create a temporary difference on which A should record a DTL.

Example 3-32

Assume the same facts as in the example above except that State C adjusts federal income for the dividends received deduction. For federal purposes, Entity A can still deduct 100 percent of the dividends it receives from Subsidiary B; thus, no temporary difference exists for federal tax purposes. However, because C adjusts federal income for the dividends received deduction, a temporary difference exists for state income tax purposes on which A should record a DTL because state tax law does not provide a means by which the reported amount of the investment can be recovered tax free.

Footnotes

There may be situations in which the reversal of the excess of financial reporting over tax basis is apparent because of future global intangible low-taxed income (GILTI) inclusions (e.g., excess of financial reporting over tax basis inside the controlled foreign corporation [CFC]); see Section 3.4.10.

With certain exceptions, ASU 2016-01 eliminated the cost method. Exceptions include (1) qualified affordable housing projects that are not eligible for the equity method and elect not to use the proportional amortization method and (2) investments in Federal Home Loan Bank and Federal Reserve Bank stock issued to member financial institutions.

An SFC includes all CFCs and all other foreign corporations (other than passive foreign investment companies) in which at least one domestic corporation is a U.S. shareholder.

Net tax liability under IRC Section 965 is the excess, if any, of the taxpayer’s net income tax for the taxable year in which the IRC Section 965 inclusion amount is included over such taxpayer’s net income tax for the taxable year, excluding (1) the IRC Section 965 amount and (2) any income or deduction properly attributable to a dividend received by such U.S. shareholder from any deferred foreign income corporation.

Additional disaggregation may be appropriate in situations in which a portion of the outside basis difference is related to intra-entity loans (see Section 9.7), basis differences that will reverse because of Subpart F inclusions (see Section 3.4.8), or GILTI inclusions (see Section 3.4.10).

Presentation of the component parts would still be disaggregated (i.e., a DTA in the United States would not be net on the balance sheet against a foreign withholding tax DTL).

In the case of an unborn FTC, the U.S. parent would also need to represent that the associated earnings will move all the way “up the chain” in a manner similar to the example above.

With certain exceptions, ASU 2016-01 eliminated the cost method. Exceptions include (1) QAHPs that are not eligible for the equity method and elect not to use the proportional amortization method and (2) investments in Federal Home Loan Bank and Federal Reserve Bank stock issued to member financial institutions.

Treasury regulations promulgated under IRC Section 704(c) account for the difference between the fair value and the adjusted tax basis in property at the time they are contributed to the partnership. In addition, such regulations can result in adjustments in certain other situations, including when the fair value of property owned by the partnership is in excess of its adjusted tax basis at the time of a contribution to the partnership.

(80 percent × $80 million [fair value of the company]) ÷ ($80 million [fair value of the company] + $20 million contribution) = 64 percent.

($37.5 million + $20 million) × 64 percent = $36.8 million.

$25 million (initial GAAP basis) + $12.5 million (20X9 income) = $37.5 million.

IRC Section 704(c), as noted in footnote 14, applies to reverse IRC Section 704(c) layers created as a result of a revaluation. Upon the contribution of $20 million by B, the partners revalued the partnership property. Under IRC Section 704(c), use of the “remedial method” will generally result in the $6.8 million’s becoming taxable over time, whereas use of the “traditional method” will generally result in the $6.8 million’s becoming taxable upon the ultimate sale or taxable liquidation of the partnership since the goodwill has no tax basis in the hands of the partnership.

(80 percent × $80 million [fair value of the company]) + $20 million contribution ÷ ($80 million [fair value of the company] + $20 million contribution) = 84 percent.

$25 million (initial GAAP basis) + $12.5 million (20X9 income) = $37.5 million.

While the exception in ASC 740-30-25-7 refers to a “more-than-50-percent-owned domestic subsidiary,” the exception was written at a time when the usual condition for control was ownership of a majority (over 50 percent) of the outstanding voting stock. Accordingly, we believe that an entity is not automatically prohibited from applying that exception simply because it owns less than 50 percent of the VIE.

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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.