6.2 Method for Allocating Income Taxes to Components of Comprehensive Income and Shareholders’ Equity

ASC 740-20

45-1 This guidance addresses the requirements to allocate total income tax expense or benefit. Subtopic 740-10 defines the requirements for computing total income tax expense or benefit for an entity. As defined by those requirements, total income tax expense or benefit includes current and deferred income taxes. After determining total income tax expense or benefit under those requirements, the intraperiod tax allocation guidance is used to allocate total income tax expense or benefit to different components of comprehensive income and shareholders’ equity.

45-2 Income tax expense or benefit for the year shall be allocated among:

Continuing operations
Discontinued operations
Subparagraph superseded by Accounting Standards Update No. 2015-01.
Other comprehensive income
Items charged or credited directly to shareholders’ equity.

45-3 The tax benefit of an operating loss carryforward or carryback (other than for the exceptions related to the carryforwards identified at the end of this paragraph) shall be reported in the same manner as the source of the income or loss in the current year and not in the same manner as the source of the operating loss carryforward or taxes paid in a prior year or the source of expected future income that will result in realization of a deferred tax asset for an operating loss carryforward from the current year. The only exception is the tax effects of deductible temporary differences and carryforwards that are allocated to shareholders’ equity in accordance with the provisions of paragraph 740-20-45-11(c) through (f).

Subparagraph not used.
Subparagraph not used.

45-4 Paragraph 740-10-45-20 requires that changes in the beginning of the year balance of a valuation allowance caused by changes in judgment about the realization of deferred tax assets in future years are ordinarily allocated to continuing operations. That paragraph also identifies certain exceptions to that allocation guidance related to business combinations and the items specified in paragraph 740-20-45-11(c) through (f). The effect of other changes in the balance of a valuation allowance are allocated among continuing operations and items other than continuing operations using the general allocation methodology presented in this Section.

45-5 See Section 740-20-55 for examples of the allocation of total tax expense or benefit to continuing operations, the effect of a tax credit carryforward, and an allocation to other comprehensive income.

Allocation to Continuing Operations

45-6 This guidance addresses the allocation methodology for allocating total income tax expense or benefit to continuing operations. The amount of income tax expense or benefit allocated to continuing operations may include multiple components. The tax effect of pretax income or loss from current year continuing operations is always one component of the amount allocated to continuing operations.

45-7 The tax effect of pretax income or loss from continuing operations should be determined by a computation that does not consider the tax effects of items that are not included in continuing operations.

45-8 The amount allocated to continuing operations is the tax effect of the pretax income or loss from continuing operations that occurred during the year, plus or minus income tax effects of:

Changes in circumstances that cause a change in judgment about the realization of deferred tax assets in future years (see paragraph 740-10-45-20 for a discussion of exceptions to this allocation for certain items)
Changes in tax laws or rates (see paragraph 740-10-35-4)
Changes in tax status (see paragraphs 740-10-25-32 and 740-10-40-6)
Tax-deductible dividends paid to shareholders.

The remainder is allocated to items other than continuing operations in accordance with the provisions of paragraphs 740-20-45-12 and 740-20-45-14.

45-9 See Example 1 (paragraph 740-20-55-1) for an example of the allocation of total tax expense or benefit to continuing operations.

Allocations to Items Other Than Continuing Operations

45-10 This guidance identifies specific items outside of continuing operations that require an allocation of income tax expense or benefit. It also establishes the methodology for allocation. That methodology differs depending on whether there is only one item other than continuing operations or whether there are multiple items other than continuing operations.

45-11 The tax effects of the following items occurring during the year shall be charged or credited directly to other comprehensive income or to related components of shareholders’ equity:

Adjustments of the opening balance of retained earnings for certain changes in accounting principles or a correction of an error. Paragraph 250-10-45-8 addresses the effects of a change in accounting principle, including any related income tax effects.
Gains and losses included in comprehensive income but excluded from net income (for example, translation adjustments accounted for under the requirements of Topic 830 and changes in the unrealized holding gains and losses of securities classified as available-for-sale as required by Topic 320).
An increase or decrease in contributed capital (for example, deductible expenditures reported as a reduction of the proceeds from issuing capital stock).
Subparagraph superseded by Accounting Standards Update No. 2016-09.
Subparagraph superseded by Accounting Standards Update No. 2016-09.
Deductible temporary differences and carryforwards that existed at the date of a quasi reorganization.
All changes in the tax bases of assets and liabilities caused by transactions among or with shareholders shall be included in equity including the effect of valuation allowances initially required upon recognition of any related deferred tax assets. Changes in valuation allowances occurring in subsequent periods shall be included in the income statement.

Single Item of Allocation Other Than Continuing Operations

45-12 If there is only one item other than continuing operations, the portion of income tax expense or benefit for the year that remains after the allocation to continuing operations shall be allocated to that item.

45-13 See Example 2 (paragraph 740-20-55-8) for an example of the allocation of total tax expense or benefit to continuing operations and one other item.

Multiple Items of Allocation Other Than Continuing Operations

45-14 If there are two or more items other than continuing operations, the amount that remains after the allocation to continuing operations shall be allocated among those other items in proportion to their individual effects on income tax expense or benefit for the year. When there are two or more items other than continuing operations, the sum of the separately calculated, individual effects of each item sometimes may not equal the amount of income tax expense or benefit for the year that remains after the allocation to continuing operations. In those circumstances, the procedures to allocate the remaining amount to items other than continuing operations are as follows:

Determine the effect on income tax expense or benefit for the year of the total net loss for all net loss items.
Apportion the tax benefit determined in (a) ratably to each net loss item.
Determine the amount that remains, that is, the difference between the amount to be allocated to all items other than continuing operations and the amount allocated to all net loss items.
Apportion the tax expense determined in (c) ratably to each net gain item.

Presentation of Deferred Tax Assets Relating to Losses on Available-for-Sale Debt Securities

45-15 An entity that recognizes a deferred tax asset relating to a net unrealized loss on available-for-sale securities may at the same time conclude that it is more likely than not that some or all of that deferred tax asset will not be realized. In that circumstance, the entity shall report the offsetting entry to the valuation allowance in the component of other comprehensive income classified as unrealized gains and losses on certain investments in debt securities because the valuation allowance is directly related to the unrealized holding loss on the available-for-sale securities. The entity shall also report the offsetting entry to the valuation allowance in the component of other comprehensive income classified as unrealized gains and losses on certain investments in debt securities if the entity concludes on the need for a valuation allowance in a later interim period of the same fiscal year in which the deferred tax asset is initially recognized.

45-16 An entity that does not need to recognize a valuation allowance at the same time that it establishes a deferred tax asset relating to a net unrealized loss on available-for-sale securities may, in a subsequent fiscal year, conclude that it is more likely than not that some or all of that deferred tax asset will not be realized. In that circumstance, if an entity initially decided that no valuation allowance was required at the time the unrealized loss was recognized but in a subsequent fiscal year decides that it is more likely than not that the deferred tax asset will not be realized, a valuation allowance shall be recognized. The entity shall include the offsetting entry as an item in determining income from continuing operations. The offsetting entry shall not be included in other comprehensive income.

45-17 An entity that recognizes a deferred tax asset relating to a net unrealized loss on available-for-sale securities may, at the same time, conclude that a valuation allowance is warranted and in a subsequent fiscal year makes a change in judgment about the level of future years’ taxable income such that all or a portion of that valuation allowance is no longer warranted. In that circumstance, the entity shall include any reversals in the valuation allowance due to such a change in judgment in subsequent fiscal years as an item in determining income from continuing operations, even though initial recognition of the valuation allowance affected the component of other comprehensive income classified as unrealized gains and losses on certain investments in debt securities. If, rather than a change in judgment about future years’ taxable income, the entity generates taxable income in the current year (subsequent to the year the related deferred tax asset was recognized) that can use the benefit of the deferred tax asset, the elimination (or reduction) of the valuation allowance is allocated to that taxable income. Paragraph 740-10-45-20 provides additional information.

45-18 An entity that has recognized a deferred tax asset relating to other deductible temporary differences in a previous fiscal year may at the same time have concluded that no valuation allowance was warranted. If in the current year an entity recognizes a deferred tax asset relating to a net unrealized loss on available-for-sale securities that arose in the current year and at the same time concludes that a valuation allowance is warranted, management shall determine the extent to which the valuation allowance is directly related to the unrealized loss and the other deductible temporary differences, such as an accrual for other postemployment benefits. The entity shall report the offsetting entry to the valuation allowance in the component of other comprehensive income classified as unrealized gains and losses on certain investments in debt securities only to the extent the valuation allowance is directly related to the unrealized loss on the available-for-sale securities that arose in the current year.

6.2.1 General “With-and-Without” Rule

ASC 740-20-45-7 states that the “tax effect of pretax income . . . from continuing operations should be determined by a computation that does not consider the tax effects of items that are not included in continuing operations” (in other words, the tax effect allocated to items that are not part of continuing operations is generally their incremental tax effect).

Under a with-and-without approach, total tax expense or benefit for the period (the “with”) is computed by adding the deferred tax expense or benefit for the period (determined by computing the change in DTLs and DTAs during the period) to the current tax expense or benefit for the period and other tax expense (e.g., UTBs). The computation of total tax expense includes (1) the effects of all taxable income or loss items, regardless of the source of the taxable income or loss, and (2) the effect of all changes in the valuation allowance, except those changes required by ASC 740-20-45-3 (listed above), ASC 805-740-45-2 (regarding changes during the measurement period resulting from new information about facts and circumstances that existed as of the acquisition date), or ASC 852-740-45-3 (regarding quasi-reorganizations).

Then, tax expense or benefit related to income or loss from continuing operations (the “without”) is computed as the tax effect of the pretax income or loss from continuing operations (current, deferred, and other tax expense — for example, UTBs) for the period plus or minus the tax effects of the four items identified in ASC 740-20-45-8, as follows:

Changes in circumstances that cause a change in judgment about the realization of deferred tax assets in future years (see paragraph 740-10-45-20 for a discussion of exceptions to this allocation for certain items)
Changes in tax laws or rates (see paragraph 740-10-35-4)
Changes in tax status (see paragraphs 740-10-25-32 and 740-10-40-6)
Tax-deductible dividends paid to shareholders.

The with-and-without approach is illustrated in the example below.

Example 6-1

Company X has $3,000 of income from continuing operations and $1,000 of loss from discontinued operations during the current year. All of the $3,000 of income from continuing operations qualifies for the FDII deduction under IRC Section 250 (considered a special deduction under ASC 740-10-55-27 through 55-30). The IRC Section 250 deduction is calculated as the lesser of 37.5 percent1 of FDII or U.S. taxable income. There are no other differences between book and tax income. The tax rate is 25 percent.

When determining the tax attributable to continuing operations, X should include the effects of the IRC Section 250 FDII special deduction without considering the loss from discontinued operations. Accordingly, X would perform the following “with” and “without” calculations:

While ASC 740-20 does not explicitly state how the intraperiod tax allocation guidance should be applied when there are multiple tax-paying components, 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, by analogy, entities should apply the intraperiod tax allocation guidance to each tax-paying component; that is, they should apply it at the tax-return level within each taxing jurisdiction.

6.2.2 Changes in Valuation Allowances

As discussed in Section 6.2.1, when performing an intraperiod tax allocation, an entity generally must first determine income tax allocated to continuing operations. ASC 740-10-45-20 states, in part, “[t]he effect of a change in the beginning-of-the-year balance of a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years ordinarily shall be included in income from continuing operations” (emphasis added). Causes of changes in valuation allowances could result from, for example, (1) the expiration of a reserved tax attribute carryforward (in which the valuation allowance is reduced in a manner similar to the way in which a write-off of a reserved account receivable reduces the reserve for bad debts), (2) changes in judgment about the realizability of beginning-of-the-year DTAs because of current-year income from continuing operations or income expected in future years regardless of component, or (3) the generation of deductible temporary differences and carryforwards in the current year that are not more likely than not to be realized. While a change in valuation allowance that results from the expiration of a reserved tax attribute carryforward would not affect total tax expense and therefore would not affect intraperiod tax allocation, changes in valuation allowance related to the other categories would.

Though the general rule would suggest that the effect of changes in valuation allowances should be included in continuing operations, an entity would not allocate changes in valuation allowances related to items (2) and (3) to income or loss from continuing operations in the following situations:

If the change in valuation allowance of an acquired entity’s DTA occurs within the measurement period and results “from new information about facts and circumstances that existed at the acquisition date,” the change in valuation allowance is recorded as an increase or a decrease in goodwill in accordance with ASC 805-740-45-2.
Reductions in the valuation allowance established at the time the deductible temporary difference or carryforward occurred (resulting in the initial recognition of benefits) that are related to the following (referred to in ASC 740-20-45-11(c) and (f)) should be allocated directly to OCI or related components of shareholders’ equity:
- A “decrease in contributed capital (for example, deductible expenditures reported as a reduction of the proceeds from issuing capital stock).”
- “Deductible temporary differences and carryforwards that existed at the date of a quasi reorganization,” with limited exceptions.
Any other change in the valuation allowance recognized solely because of income or losses recognized in the current year in a category other than income or loss from continuing operations (in that case, the effect of the change in valuation allowance is allocated to that other category — for example, a discontinued operation).

Regarding the last bullet point, when it is difficult for an entity to determine whether a change in valuation allowance is solely because of one item, the effect of any change in the valuation allowance should be allocated to income or loss from continuing operations. This premise is based on the guidance in ASC 740, which requires that income tax allocated to continuing operations be determined first and that the effects of all changes in valuation allowances (with the exception of the items listed in the first two bullet points above) that are attributable to changes in judgments about realizability in future years (regardless of the income category causing the change in judgment) be allocated to income or loss from continuing operations.

Example 6-2

At the beginning of 20X1, Entity X, a company operating in a tax jurisdiction with a 25 percent tax rate, has a $375 DTA for a tax credit carryforward generated by Subsidiary A. The DTA is offset by a full valuation allowance. During 20X1, X disposes of A for a gain of $3,000. Loss from continuing operations is $500. Income from discontinued operations, including the $3,000 gain, is $2,000. Because the gain on the sale resulted in income from discontinued operations in the current year, management expects to realize the tax credit carryforward in the current year solely because of that income. Therefore, the release of the valuation allowance would be allocated to discontinued operations.

Example 6-3

At the beginning of 20X3, Entity Y, a company operating in a tax jurisdiction with a 25 percent tax rate, has a $2,000 tax credit carryforward generated by Subsidiary B. The DTA is offset by a full valuation allowance.

During 20X3, Y’s management enters into a definitive agreement to sell B for an anticipated gain of $8,000. However, the deal does not close until the first quarter of 20X4; thus, the gain is not recognized until the transaction is closed. Entity Y has income from continuing operations. In addition, management concludes that the DTA is realizable on the basis of the weight of all available evidence, including projections of future taxable income.

In this example, the release of the entire valuation allowance would be allocated to continuing operations because there was a change in judgment about the realizability of the related DTA in future years (i.e., because the gain on the sale would not be recognized until the following year).

6.2.3 Special Situations

6.2.3.1 Quasi-Reorganization Tax Benefits

The tax benefits of deductible temporary differences and carryforwards as of the date of a quasi-reorganization ordinarily are reported as a direct addition to contributed capital if the tax benefits are recognized in subsequent years (by reducing or eliminating the valuation allowance). After a quasi-reorganization, however, an entity may conclude that a valuation allowance should be recognized or increased for a DTA attributable to pre-quasi-reorganization benefits that were recognized in a prior period. This charge to establish or increase the valuation allowance is reported as a component of income tax expense from continuing operations.

6.2.3.2 Fresh-Start Accounting

ASC 852-10 requires an entity emerging from Chapter 11 bankruptcy protection to adopt a new reporting basis (“fresh-start accounting”) for its assets and liabilities if certain criteria are met. In accordance with ASC 852-10-45-21, “the effects of the adjustments on the reported amounts of individual assets and liabilities resulting from the adoption of fresh-start reporting [and related income tax effects] and the effects of the forgiveness of debt shall be reflected in the predecessor entity’s final statement of operations.” The successor’s deferred taxes as of the fresh-start reporting date are measured in accordance with ASC 740-10-30. The recognition of a valuation allowance against DTAs as of the fresh-start reporting date generally increases the amount of reorganization value assigned to goodwill.

ASC 852-740-45-1 states that a reduction in a valuation allowance for a tax benefit that was not recognizable as of the plan confirmation date should be reported as a reduction in income tax expense. Therefore, a subsequent adjustment (increase or decrease) to a valuation allowance established as of the date of fresh-start reporting should be reported as either an increase or a decrease in income tax expense.

6.2.4 Out-of-Period Items

Generally, an entity will account for the tax effects of a transaction in the same period in which (1) the related pretax income or loss is included in a component of comprehensive income or (2) equity is adjusted. Out-of-period adjustments occur when a tax expense or benefit is recognized in an annual period after the pretax effects of the original transaction were recognized.

ASC 740-20 and ASC 740-10 provide guidance on the intraperiod tax allocation of certain out-of-period adjustments. Such adjustments include (1) changes in valuation allowances that are attributable to changes in judgments about future realization (see ASC 740-20-45-4), (2) changes in tax laws and tax rates (see ASC 740-10-45-15), and (3) changes in tax status (see ASC 740-10-45-19). In each of these instances, the related tax effects should be allocated to income or loss from continuing operations, as stated in ASC 740-20-45-4, ASC 740-10-45-15, and ASC 740-10-45-19, respectively.

ASC 740 does not, however, provide guidance on how to allocate the tax effects of certain other out-of-period adjustments. The following are examples of circumstances that give rise to out-of-period adjustments for which ASC 740 does not contain explicit guidance on how to allocate the tax benefit or expense:

A change in the expected timing of reversal of a DTA or DTL resulting in a change in the expected benefit or expense (as may be the case when a change in tax rates is phased in over multiple years).
Recognition of the benefit of a deduction for an incentive stock option (ISO) that becomes deductible only because of a disqualifying disposition.
Recognition of previously unrecognized DTAs or DTLs because the outside basis differences are no longer subject to one of the exceptions in ASC 740-30.

In such cases, it is usually appropriate for an entity to analogize to the guidance in ASC 740-20 and ASC 740-10 on out-of-period adjustments. Thus, the entity should generally allocate the tax effects of out-of-period adjustments that are not specifically addressed to income or loss from continuing operations. The example below illustrates the treatment of the tax effects of out-of-period adjustments.

Example 6-4

Change in State Apportionment Rate

Entity A, a U.S. entity, operates in multiple state jurisdictions and uses state apportionment factors to allocate DTAs and DTLs to various states in accordance with the income tax laws of each state. (See Section 3.3.4.6.1 for a further discussion of state apportionment.)

During a subsequent annual period, A experiences a change in its business operations that will affect the apportionment rate used in the state of X (i.e., there has been a change in the state footprint, but not in the enacted tax rate). Entity A’s deferred taxes are remeasured by using the different apportionment rate expected to apply in the period in which the deferred taxes are expected to be recovered or settled. The related tax effects of the change in DTAs and DTLs would generally be allocated to income from continuing operations in accordance with the intraperiod allocation guidance in ASC 740-20.

However, other Codification topics may contain guidance that appears, in some cases, to conflict with an analogy to ASC 740-20. In those situations, it may be acceptable to apply the presentation guidance from that other topic. See the next section for further discussion of certain tax effects associated with discontinued operations.

6.2.4.1 Intraperiod Allocation of Out-of-Period Items Related to Components Classified as Discontinued Operations

Guidance on the presentation of discontinued operations is contained in ASC 205. Specifically, ASC 205-20-45-3A through 45-5 state the following:

ASC 205-20

45-3A The results of all discontinued operations, less applicable income taxes (benefit), shall be reported as a separate component of income. . . .

45-3B A gain or loss recognized on the disposal (or loss recognized on classification as held for sale) shall be presented separately on the face of the statement where net income is reported or disclosed in the notes to financial statements (see paragraph 205-20-50-1(b)).

45-3C A gain or loss recognized on the disposal (or loss recognized on classification as held for sale) of a discontinued operation shall be calculated in accordance with the guidance in other Subtopics. For example, if a discontinued operation is within the scope of Topic 360 on property, plant, and equipment, an entity shall follow the guidance in paragraphs 360-10-35-37 through 35-45 and 360-10-40-5 for calculating the gain or loss recognized on the disposal (or loss on classification as held for sale) of the discontinued operation.

45-4 Adjustments to amounts previously reported in discontinued operations in a prior period shall be presented separately in the current period in the discontinued operations section of the statement where net income is reported.

45-5 Examples of circumstances in which those types of adjustments may arise include the following:

The resolution of contingencies that arise pursuant to the terms of the disposal transaction, such as the resolution of purchase price adjustments and indemnification issues with the purchaser
The resolution of contingencies that arise from and that are directly related to the operations of the discontinued operation before its disposal, such as environmental and product warranty obligations retained by the seller
The settlement of employee benefit plan obligations (pension, postemployment benefits other than pensions, and other postemployment benefits), provided that the settlement is directly related to the disposal transaction. A settlement is directly related to the disposal transaction if there is a demonstrated direct cause-and-effect relationship and the settlement occurs no later than one year following the disposal transaction, unless it is delayed by events or circumstances beyond an entity’s control (see paragraph 205-20-45-1G).

ASC 205-20 notes that the income statement should include, as a separate component, the results of operations of the discontinued operation for the current and prior periods, less applicable income taxes. Further, ASC 205-20-45-4 does not distinguish between pretax- and income-tax-related effects of adjustments to amounts previously recorded in discontinued operations, but it does require those adjustments to be directly related to the discontinued operations (including the disposal transaction). Accordingly, under ASC 205-20, an entity may conclude that out-of-period tax effects directly related to the operations of the discontinued operation (including the disposal transaction) should be allocated to discontinued operations.

Further, in connection with the implementation of Interpretation 48 (most of which was codified in ASC 740), informal discussions were held with the FASB staff regarding a situation in which the application of ASC 205 would result in a different presentation than would the application of ASC 740. Specifically, the FASB staff was asked whether income tax expense or benefit arising from the remeasurement of a UTB related to a discontinued operation should be reflected in (1) continuing operations in a manner consistent with the general prohibition on backwards tracing implicit in ASC 740-20-45 or (2) discontinued operations in a manner consistent with ASC 205-20. The FASB staff indicated that it was aware of both presentations in practice and that an entity should elect one of them as an accounting policy and apply it consistently.

Accordingly, if an entity concludes that the out-of-period tax benefit (or expense) is directly related to the operations of the component that is presented in discontinued operations (including the disposal transaction), there are generally two acceptable views regarding the allocation of such tax effects. Under one view, the entity may elect to allocate this tax expense or benefit to discontinued operations by applying ASC 205-20 or, under an alternative view, to income or loss from continuing operations by analogy to the general intraperiod allocation rules for out-of-period adjustments in ASC 740-20. Under the alternative view, if the entity concludes that the tax benefit (or expense) is not directly related to the operations of the component that is presented in discontinued operations (including the disposal transaction), the entity should allocate the entire tax expense or benefit to income or loss from continuing operations (by analogy to ASC 740-20).

Out-of-period adjustments are common with respect to discontinued operations (including the disposal transaction). The following are three situations in which an entity may need to make such adjustments:

As discussed in Section 3.4.17.2, an out-of-period adjustment may be required when an unrecognized book-versus-tax difference that is related directly to the operations of a discontinued operation is no longer subject to one of the exceptions in ASC 740.2
A domestic corporation may change its legal structure or make elections for tax purposes that result in a worthless stock deduction that is directly related (either partially or entirely) to the operations of a discontinued operation.3
In some tax jurisdictions, when a parent disposes of a component that was included in the parent’s income tax return, the parent might retain the obligation for UTBs that arose from and were directly related to the operations of the component while it was still part of the parent’s tax return (including UTBs related to the disposal transaction itself). The parent may classify the results of operations of the component in periods before the disposal as discontinued operations. After the disposal, the parent may need to adjust the amount of the UTB.

For each of these situations, the treatment of the tax effects of out-of-period adjustments is discussed in the examples below. Any current-year tax effects would still be allocated by using the with-and-without approach described in Section 6.2.1.

Example 6-5

Change in an Indefinite Reinvestment Assertion

Entity X has a profitable foreign subsidiary, Entity A. Entity X has asserted that it intends to indefinitely reinvest A’s undistributed earnings, and, accordingly, that the indefinite reversal criteria in ASC 740-30-25-17 are met. Therefore, X has not recorded a DTL in connection with the financial-reporting-over-tax basis difference for the investment in A (the outside basis difference). Further, A’s functional currency is its local currency; thus, any resulting translation differences in consolidation by X are accounted for in OCI.

In a subsequent year, X changes its intent and no longer asserts that it intends to indefinitely reinvest the earnings of A. Thus, X must recognize a DTL for the expected tax consequences of the remittance. The resulting tax expense is recorded as an expense in the current period. The tax expense related to prior-year earnings is generally allocated to continuing operations by analogy to the out-of-period guidance in ASC 740-20 and because “backwards tracing” is not permitted under ASC 740. The tax expense attributable to currency exchange rate fluctuation related to the current year, however, would be allocated to OCI in accordance with the general with-and-without rule. For a discussion of the accounting for the deferred tax effects of translation, see Section 9.2.

Example 6-6

Tax Benefit From a Worthless Stock Deduction

Entity Y, a U.S. entity, owns 100 percent of H, a foreign holding company that holds three operating companies. The three operating companies have historically generated losses, resulting in a difference between Y’s book basis and the U.S. tax basis in the investment in H. This outside basis difference gives rise to a DTA that has historically not been recognized, since the difference was not expected to reverse in the foreseeable future in accordance with ASC 740-30-25-9.

In 20X1, H sells one of the operating companies (Company 1) and presents it as a discontinued operation in the consolidated financial statements in accordance with ASC 205-20-45-1. Concurrently with the sale of Company 1, Y elected to treat H as a disregarded entity for tax purposes (i.e., nontaxable status) by “checking the box.” For tax purposes, this election is considered a deemed liquidation. The liabilities of H are in excess of the assets; therefore, the investment in H is considered worthless and Y can claim a related deduction for tax purposes in the U.S. tax jurisdiction. The benefit of that deduction is considered out of period from Y’s perspective because it represents the recognition of the tax benefit of a loss in a period after the loss arose.

The benefit recognized in connection with the worthless stock deduction is a result of the historical losses incurred at the three operating companies. Without these losses in prior years, the deemed liquidation of H would not have resulted in a tax deduction and a benefit would not have been recognized. The tax consequence of this benefit could be allocated between the three operating companies, one of which — Company 1 — is presented in discontinued operations. Accordingly, it would be appropriate for Y to present the benefit from the losses related to Company 1 in discontinued operations and the benefit from losses related to Companies 2 and 3 in income from continuing operations.

An acceptable alternative would be for Y to allocate the entire benefit to income from continuing operations.

Example 6-7

Out-of-Period Tax Effects of a UTB That Originated in Discontinued Operations

An entity recorded a UTB classified as a noncurrent liability in connection with a tax position related to the character (capital vs. ordinary) of the gain from the disposal of a component. The income tax expense for recording the UTB was reflected in discontinued operations in accordance with the intraperiod tax allocation guidance in ASC 740-20. In a subsequent year, the statute of limitations expired and the entity recognized a tax benefit when the UTB was derecognized.

In determining where the benefit should be allocated, the entity could apply the guidance in ASC 740-20-45, which prohibits backwards tracing of out-of-period adjustments, to record the benefit in continuing operations. Alternatively, the entity could record the benefit in discontinued operations under ASC 205-20-45-4 even though this benefit may be the only item in discontinued operations in that reporting period. The approach chosen is considered an accounting policy election and should be consistently applied.

6.2.4.2 Intraperiod Allocation of Out-of-Period Items Related to Changes in UTBs

In some instances, the income tax expense for recording uncertain tax positions may have been initially allocated to OCI. For example, a UTB related to the deductibility of costs reported as a reduction to the proceeds from issuing capital stock may have been recorded directly to equity under ASC 740-20-45-11(c). We believe that subsequent changes related to all UTBs initially allocated to OCI should be recorded as a component of continuing operations, including items described in ASC 740-20-45-11(c)–(f). However, we are aware of other views related to the items described in ASC 740-20-45-11(c)–(f); accordingly, entities are encouraged to consult with their accounting advisers in these situations.

6.2.5 Stranded Taxes

As a result of certain circumstances, taxes may be “stranded” in AOCI. Stranded taxes, or anomalies, may arise on account of:

Changes in tax rates after the pretax amount was included in OCI.
Pretax amounts that are not tax effected because of the presence of a valuation allowance.
A subsequent change in the valuation allowance as a result of a change in judgment about the realizability of a DTA when the initial recognition of deferred taxes and related valuation allowance were associated with a pretax amount originally recorded to OCI.
A change in tax status.
A change in indefinite reinvestment assertion.

Example 6-8

Entity E has a portfolio of AFS debt securities. During 20X1, the fair value of such securities declines to the extent that E incurs unrealized holding losses, which it reports in OCI in accordance with ASC 740-20-45-11(b) (see Section 3.5.9.3). On the basis of available evidence, E concludes that a full valuation allowance is needed to reduce the DTA for the unrealized loss on AFS debt securities to an amount that is more likely than not to be realized as of the end of the year. Accordingly, there is no income tax benefit recognized in OCI related to the unrealized holding losses recognized in 20X1.

In 20X2, E’s estimate of future income, excluding temporary differences and carryforwards, changes. As a result, E revises its conclusion about the realizability of the related DTA in future years and determines that a valuation allowance is no longer necessary at the close of 20X2.

If changes in a valuation allowance are caused by a transaction, event, or set of circumstances that is not directly attributable to either an increase or a decrease in the holding of gains or losses on an AFS debt security, an entity must analyze the cause to determine how the tax consequence of the change should be reported. This conclusion is based on guidance from ASC 740, as described below.

ASC 740-10-45-20 states, in part:

The effect of a change in the beginning-of-the-year balance of a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years ordinarily shall be included in income from continuing operations. . . . The effect of other changes in the balance of a valuation allowance are allocated among continuing operations and items other than continuing operations as required by paragraphs 740-20-45-2 and 740-20-45-8. [Emphasis added]

In addition, ASC 740-20-45-8 specifies that the “amount allocated to continuing operations is the tax effect of the pretax income or loss from continuing operations that occurred during the year, plus or minus income tax effects of . . . [c]hanges in circumstances that cause a change in judgment about the realization of deferred tax assets in future years.”

Further, ASC 740-20-45-3 requires that the “tax benefit of an operating loss carryforward or carryback . . . be reported in the same manner as the source of the income or loss in the current year and not in the same manner as the source of the operating loss carryforward or taxes paid in a prior year or the source of expected future income that will result in realization of a deferred tax asset for an operating loss carryforward from the current year.” The only exceptions are identified in ASC 740-20-45-11.

Accordingly, E reports the elimination of the valuation allowance as a reduction in income tax expense from continuing operations in 20X2 because the change is directly attributable to a change in estimate about income or loss in future years. Hence, there is still no income tax benefit in OCI related to the unrealized holding losses recognized in 20X1.

In 20X3, the fair value of the securities increases to the degree that the unrealized loss previously reported in OCI is eliminated and the securities are sold at no gain or loss. OCI is increased for the market value increase net of any related tax consequences. When the incremental approach is applied, the gain in OCI would result in a tax expense recognized in OCI. However, after the securities are sold, no amounts remain in AOCI for previously unrealized holding gains or losses because the increase in the fair value in 20X3 equals the decrease in fair value in 20X1. The tax expense recognized in OCI in 20X3 becomes stranded. To eliminate the stranded tax, E would use, in accordance with its accounting policy election, one of the approaches discussed below.

The FASB staff has informally indicated that, in the situation described above, whether an entity should eliminate the deferred tax consequences that remain in AOCI (a component of equity) at the end of 20X3 depends on whether the entity is using the security-by-security approach or the portfolio approach. The tax consequences reported under the security-by-security approach may sometimes be different from those reported under the portfolio approach. Under ASC 220-10-50-1, an entity is required to disclose its policy for releasing income tax effects from AOCI.

6.2.5.1 Security-by-Security Approach

Under the security-by-security approach, the tax consequences of unrealized gains and losses that are reported in OCI are tracked on a security-by-security basis. Upon the sale of the security, such tax consequences are removed from OCI and reported in continuing operations.

6.2.5.2 Portfolio Approach

The portfolio approach involves a strict period-by-period cumulative incremental allocation of income taxes to the change in unrealized gains and losses reflected in OCI. Under this approach, the net cumulative tax effect is ignored. The net change in unrealized gains or losses recorded in AOCI under this approach would be eliminated only on the date the entire inventory of AFS debt securities is sold or otherwise disposed of.

Example 6-9

Assume the same facts as in Example 6-8. At the time of the sale in 20X3, there is zero cumulative pretax unrealized gain or loss on the AFS debt securities. However, there is a stranded tax in AOCI related to the securities sold in 20X3 because no tax effect was originally recorded in OCI for the write-down of such securities in 20X1 but a tax expense was recognized in OCI for the securities’ write-up in 20X3. The security-by-security approach and portfolio approach are applied as follows:

Security-by-Security Approach

The stranded tax expense would be removed from AOCI and recorded in continuing operations upon sale of the securities in 20X3. Cumulatively, there is no tax expense or benefit recorded in continuing operations for these securities because the tax expense cleared from AOCI and recognized in continuing operations in 20X3 offsets the 20X2 tax benefit recorded in continuing operations related to the release of the valuation allowance on the DTA associated with the same securities.

Portfolio Approach

If it is assumed that Entity E still holds other AFS debt securities in its portfolio, the stranded tax expense in AOCI related to the securities sold would not be removed from AOCI and recorded in continuing operations upon the sale of such securities in 20X3. Cumulatively, through the end of 20X3, there is a tax benefit recorded in continuing operations (attributable to the release of the valuation allowance in 20X2) and a tax expense recorded in OCI (attributable to the write-up of the AFS debt securities during 20X3) even though the specific securities that gave rise to such tax effects have been disposed of.

6.2.6 Transactions Among or With Shareholders

6.2.6.1 Tax Consequences of Transactions Among (and With) Shareholders

Certain transactions among shareholders can affect the tax attributes of an entity itself. For example, if more than 50 percent of a company’s stock changes hands within a certain period, a limitation on the entity’s ability to use its attribute carryforwards could be triggered. The following are examples of such transactions:

Heavy trading in a company’s stock by major shareholders over a period of several years.
An investor buys 70 percent of a company and consolidates the company but does not use pushdown accounting.
An investor buys 100 percent of a company (in a nontaxable business combination) and consolidates the company but does not use pushdown accounting.

Note that the term “nontaxable business combination,” as used in ASC 805-740, means a business combination in which the target company’s tax bases in its assets and liabilities carry over to the combined entity.

Certain transactions with shareholders (i.e., transactions between a company and its shareholders) can have the same effect. The following are examples of such transactions:

An IPO.
Additional stock offerings.
Conversion of convertible debt into equity in accordance with the stated terms of the debt agreement.
Conversion of debt into equity in a troubled debt restructuring.
A recapitalization in which preferred stock is exchanged for common stock (i.e., no new equity is raised, on a net basis).
A recapitalization in which new debt is incurred and the proceeds are used to purchase treasury stock.

Certain transactions among or with shareholders may also change the tax bases of the company’s assets and liabilities. The following are examples of such transactions:

An investor buys 100 percent of the outstanding stock of a company (in a business combination) and consolidates the company but does not use pushdown accounting. The transaction is treated as the purchase of assets for tax purposes, and assets and liabilities are adjusted to fair value for tax purposes (which may either increase or decrease the tax basis).
A parent company sells 100 percent of the stock of a subsidiary in an IPO. For financial reporting purposes, the carrying amounts of the subsidiary’s assets and liabilities in its separate financial statements are the historical carrying amounts reflected in the parent company’s consolidated financial statements. However, the transaction is structured so that, for tax purposes, the transaction is taxable and the subsidiary adjusts its bases in its assets and liabilities to fair value (the proceeds from the IPO) for tax purposes. Therefore, the subsidiary now has new temporary differences that are related to its assets and liabilities.

Changes in valuation allowances, write-offs of DTAs, and the tax consequences of changes in tax bases of assets and liabilities caused by transactions among or with a company’s shareholders may be recognized either in the income statement or directly in equity, depending on the nature of the change.

In accordance with ASC 740-10-45-21, the following should be charged to the income statement:

“Changes in valuation allowances due to changed expectations about the realization of deferred tax assets caused by transactions among or with shareholders.”
“A write-off of a preexisting deferred tax asset that an entity can no longer realize as a result of a transaction among or with its shareholders.”

In addition, in accordance with ASC 740-20-45-11(g), the following should be charged directly to equity:

The effects of “changes in the tax bases of assets and liabilities caused by transactions among or with shareholders.”
The “effect of valuation allowances initially required upon recognition of any related deferred tax assets” as a result of “changes in the tax bases of assets and liabilities caused by transactions among or with shareholders.” However, subsequent changes in valuation allowances should be charged to the income statement.

ASC 740-20-45-11(g) applies to all changes in the tax bases of assets and liabilities, including tax-deductible goodwill.

6.2.7 Other Special Considerations

6.2.7.1 Holding Gains and Losses Recognized for Both Financial Reporting and Tax Purposes

Assume that an entity has an AFS portfolio of debt securities that is being accounted for in accordance with ASC 320-10. Thus, unrealized gains and losses are recorded in OCI, net of any related tax consequences. For tax purposes, the entity has elected under the tax law to include unrealized gains and losses on securities portfolios in the determination of taxable income or loss.

When an unrealized loss is incurred and the loss deductions are included in the determination of taxable income or loss in the tax return, the tax consequences for financial reporting purposes should be considered (1) in the year the unrealized loss is incurred and (2) in the year the securities are sold. The example below illustrates this concept.

Example 6-10

Assume the following:

Company X acquires AFS debt securities for $12 million on January 1, 20X0.
For financial reporting purposes, unrealized gains and losses on AFS debt securities are recorded in OCI, net of any tax consequences, in accordance with ASC 740-20-45-11(b).
Company X elects to include unrealized gains and losses on securities portfolios in the determination of taxable income or loss (this election is permitted by the tax law).
At the end of 20X1, the unrealized loss on AFS debt securities is $5 million, all of which was incurred during the current year.
The tax rate for 20X1 and 20X2 is 20 percent.
Pretax income and taxable income, excluding the unrealized loss for 20X1 and 20X2, are $5 million and zero, respectively.
The market value of the portfolio, determined at the end of 20X1 (i.e., an unrealized loss of $5 million), does not change through the end of 20X2.
Company X sells the AFS debt securities for $7 million and records in income a pretax loss of $5 million on the sale of the portfolio on the last day of 20X2; taxable income is zero for 20X2.

Company X must record the following journal entries:

Journal Entries Year 1

Journal Entries Year 2

6.2.7.2 Change in Tax Status to Taxable: Accounting for an Increase in Tax Basis

Upon an entity’s change in tax status, the entity may also recognize a step-up in tax basis in certain circumstances. For example, in the U.S. federal jurisdiction, upon a change in tax status from a nontaxable partnership to a taxable C corporation, the entity may recognize a step-up in tax basis for its assets in an amount equivalent to the taxable gain recognized by the former partners. The former partners must recognize a taxable gain when the liabilities being assumed by the corporation exceed the tax basis in the assets being transferred to the corporation.

Generally, the expense or benefit from recognizing the DTLs and DTAs as a result of the change in tax status should be included in income or loss from continuing operations. ASC 740-10-45-19 states:

When deferred tax accounts are recognized or derecognized as required by paragraphs 740-10-25-32 and 740-10-40-6 due to a change in tax status, the effect of recognizing or derecognizing the deferred tax liability or asset shall be included in income from continuing operations.

Conversely, any tax benefit attributable to an increase in the tax basis of an entity’s assets resulting from a transaction with or among shareholders should be allocated to equity. ASC 740-20-45-11(g) states:

All changes in the tax bases of assets and liabilities caused by transactions among or with shareholders shall be included in equity including the effect of valuation allowances initially required upon recognition of any related deferred tax assets. Changes in valuation allowances occurring in subsequent periods shall be included in the income statement.

A change in tax status, in and of itself, will generally not cause an increase in the tax basis of assets. However, when the liabilities exceed the tax basis in the assets, under U.S. tax law, the partner is treated as having entered into a taxable exchange with the newly formed corporation, receiving taxable consideration (in the form of the corporation’s assumption of the partner’s liabilities) in exchange for the assets being transferred to the corporation. When the liabilities assumed exceed the tax basis of the assets being transferred, the partner both realizes and recognizes a gain for U.S. income tax purposes.

The corporation determines its initial tax basis in the assets by using the partnership’s historical tax basis plus an amount equal to the gain recognized by the former partners (now shareholders) on account of the taxable exchange with the corporation. In the absence of the taxable exchange with the shareholder, the tax basis would have been strictly the historical basis of the assets in the hands of the partnership. Therefore, an entity should use that historical tax basis when determining the amount of deferred taxes required that are directly related to the change in status. The adjustment of that initial amount of deferred taxes on account of the increase in tax basis corresponding to the gain recognized by the partners (now shareholders) should be recognized in equity since it is directly on account of a transaction with or among the shareholders. See Section 6.2.6.1 for further discussion and examples of tax consequences involving transactions with or among shareholders.

An acceptable alternative approach also exists under which all of the tax effects arising in connection with a change in tax status (including the deferred tax effect of any incremental step-up in tax basis related to the shareholder gain) would be allocated to income or loss from continuing operations in accordance with ASC 740-10-45-19. This approach is based on the previous discussion in EITF Issue 94-10, which noted that the guidance contained therein did not address shareholder transactions that involve a change in the tax status of a company (such as a change from nontaxable S-corporation status to taxable C-corporation status).

6.2.7.3 Income Tax Accounting Considerations Related to When a Subsidiary Is Deconsolidated

The deconsolidation of a subsidiary may result from a variety of circumstances, including a sale of 100 percent of an entity’s interest in the subsidiary. The sale may be structured as either a “stock sale” or an “asset sale.”

A stock sale occurs when a parent sells to a third party enough shares in a subsidiary to lose control of the subsidiary, and the subsidiary’s assets and liabilities are effectively transferred to the buyer.

An asset sale occurs when a parent sells individual assets (and liabilities) to the buyer and retains ownership of the original legal entity. In addition, by election, certain stock sales can be treated for tax purposes as if the subsidiary sold its assets and was subsequently liquidated.

Upon a sale of a subsidiary, the parent entity should consider the income tax accounting implications for its income statement and balance sheet.

6.2.7.3.1 Income Statement Considerations

ASC 810-10-40-5 provides a formula for calculating a parent entity’s gain or loss on deconsolidation of a subsidiary, which is measured as the difference between:

The aggregate of all of the following:
1. The fair value of any consideration received
2. The fair value of any retained noncontrolling investment in the former subsidiary or group of assets at the date the subsidiary is deconsolidated or the group of assets is derecognized
3. The carrying amount of any noncontrolling interest in the former subsidiary (including any accumulated other comprehensive income attributable to the noncontrolling interest) at the date the subsidiary is deconsolidated.
The carrying amount of the former subsidiary’s assets and liabilities or the carrying amount of the group of assets.

6.2.7.3.1.1 Asset Sale

When the net assets of a subsidiary are sold, the parent will present the gain or loss on the net assets (excluding deferred taxes) in pretax income and will present the reversal of any DTAs or DTLs associated with the assets sold (the inside basis differences4) and any tax associated with the gain or loss on sale in income tax expense (or benefit).

6.2.7.3.1.2 Stock Sale

As with an asset sale, when the shares of a subsidiary are sold, the parent will present the gain or loss on the net assets in pretax income. One acceptable approach to accounting for the deferred tax effects (the inside basis differences5) is to include the elimination of such amounts as part of the overall computation of the pretax gain or loss on the sale of the subsidiary; under this approach, the only amount that would be included in income tax expense (or benefit) would be the tax associated with the gain or loss on the sale of the shares (the outside basis difference6). The rationale for this view is that any future tax benefits (or obligations) of the subsidiary are part of the assets acquired and liabilities assumed by the acquirer with the transfer of shares in the subsidiary and the carryover tax basis in the assets and liabilities. Other approaches may be acceptable depending on the facts and circumstances.

If the subsidiary being deconsolidated meets the requirements in ASC 205 for classification as a discontinued operation, the entity would also need to consider the intraperiod guidance on discontinued operations in addition to this guidance. For a discussion of outside basis differences in situations in which the subsidiary is presented as a discontinued operation, see Section 3.4.17.2.

Example 6-11

Assume the following:

U.S. Parent consolidates U.S. Sub for financial reporting purposes.
The statutory tax rate of U.S. Parent and U.S. Sub is 25 percent.
U.S. Sub’s only temporary difference is $500 related to an intangible asset (book basis is greater than tax basis).
In 20X1, U.S. Parent sells U.S. Sub for $1,000 in a stock sale.
U.S. Sub’s operations are presented as a discontinued operation in the consolidated financial statements in accordance with ASC 205-20-45-1 for the year ended December 31, 20X1.

The carrying values of U.S. Sub’s assets and liabilities on the date of sale are as follows:

U.S. Parent computes its pretax gain or loss from the sale of U.S. Sub as follows:

U.S. Parent would then need to assess taxes due on the sale of its investment in U.S. Sub. See Section 3.4.17.2 for additional guidance.

6.2.7.3.2 Balance Sheet Considerations

Entities with a subsidiary (or component) that meets the held-for-sale criteria in ASC 360 should classify the assets and liabilities associated with that component separately on the balance sheet as “held for sale.” The presentation of deferred tax balances associated with the assets and liabilities of the subsidiary or component classified as held for sale is determined on the basis of the method of the expected sale (i.e., asset sale or stock sale) and whether the entity presenting the assets as held for sale is transferring the basis difference to the buyer.

Deferred taxes associated with the stock of the component being sold (the outside basis difference7) should not be presented as held for sale in either an asset sale or a stock sale since the acquirer will not assume the outside basis difference.

6.2.7.3.2.1 Asset Sale

In an asset sale, the tax bases of the assets and liabilities being sold will not be transferred to the buyer. Therefore, the deferred taxes related to the assets and liabilities (the inside basis differences8) being sold should not be presented as held for sale; rather, they should be presented along with the consolidated entity’s other deferred taxes.

6.2.7.3.2.2 Stock Sale

In a stock sale, the tax bases of the assets and liabilities being sold generally are carried over to the buyer. Therefore, the deferred taxes related to the assets and liabilities (the inside basis differences9) being sold should be presented as held for sale and not with the consolidated entity’s other deferred taxes.

6.2.8 Tax Benefits for Dividends Paid to Shareholders or on Shares Held by an ESOP: Recognition

In certain tax jurisdictions, an entity may receive a tax deduction for dividend payments made to shareholders or dividends on allocated and unallocated shares paid to the employee stock ownership plan (ESOP). ASC 740-20-45-8 specifies that tax benefits received for these deductions should be recognized as a reduction of income tax expense at the time of the dividend distribution. The rationale for this conclusion is based on the belief that, in substance, a tax deduction for the payment of those dividends represents an exemption from taxation of an equivalent amount of earnings.

Footnotes

The percentage of income that can be deducted is reduced in taxable years beginning after December 31, 2025.

As discussed in Section 3.4.17.2, an entity may expect an unrecognized outside basis difference DTL to close through a GILTI inclusion, and the entity may have elected to treat GILTI tax as a current-period expense when it arises. In that case, when the tax effect is ultimately recorded, it will represent a current-period tax expense and be allocated in accordance with the normal intraperiod tax allocation rules (i.e., not those applicable to out-of-period adjustments).

IRC Section 165(g)(3) specifies that the worthless stock deduction may be taken against the domestic corporation’s ordinary income if the investee is considered an affiliate. If the investee is not an affiliate, the deduction would be against the domestic corporation’s capital income. This determination may affect the amount of the deduction the domestic corporation is able to benefit from in the current period.

See Section 3.3.1 for the meaning of “inside” and “outside” basis differences.

See footnote 4.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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