Chapter 8 — Accounting for Income Taxes in Separate Financial Statements

8.3 Allocating Current and Deferred Income Tax Expense in the Income Statement of Separate and Carve-Out Financial Statements

The allocation of current and deferred income tax expense required by ASC 740-10-30-27 to separate financial statements is necessary because, in a consolidated income tax return, the results of operations of the members are combined to determine income tax expense of the consolidated group. Therefore, taxable income of one member of the consolidated return may be offset by losses and credits of another member and vice versa. Because income tax obligations are not determined at a level below the consolidated filing group, it is necessary to make an allocation of the amount of consolidated current and deferred income tax expense into separate or carve-out financial statements.

8.3.1 Acceptable Methods of Allocating Tax to Separate and Carve-Out Financial Statements

ASC 740-10-30-27 does not prescribe a particular method for allocating current and deferred income tax expense to separate financial statements of a member; rather, it requires only the use of a systematic and rational method that is consistent with the broad principles established by ASC 740. Several income tax allocation methods may meet the requirements of ASC 740-10-30-27, including the commonly applied separate-return and parent-company-down approaches, both of which are discussed below. Choosing an income tax allocation method is an accounting policy decision, and the method should be consistently applied. See Section 8.3.2 for considerations specific to entities that file financial statements with the SEC.

8.3.1.1 Separate-Return Method

Under the separate-return method of allocation, a group member issuing separate financial statements determines current and deferred tax expense or benefit for the period by applying the requirements of ASC 740 as if the group member were required to file a separate tax return. This method can lead to inconsistencies between conclusions reached related to the realizability of DTAs (and the related tax expense or benefit) reflected in (1) the consolidated financial statements and (2) the separate or carve-out financial statements. For example, the separate financial statements may include a valuation allowance because of insufficient taxable income on a hypothetical separate-return basis, while in the consolidated financial statements (which include other profitable entities), a valuation allowance may not be required. ASC 740 acknowledges that sometimes the sum of the amounts allocated to the individual group members under the separate-return method may not equal the total current and deferred income tax expense or benefit of the consolidated tax return group.

Example 8-1

Parent P’s two operating subsidiaries, S1 and S2, are members of a consolidated tax return group. The table below illustrates each subsidiary’s taxable income and statutory tax rate for the period. Assume that on a separate-return basis, S1 requires a full valuation allowance against its DTAs and therefore cannot recognize a benefit for its loss of $100. However, on a consolidated basis, the group has sufficient taxable income to realize a benefit from S1’s loss. Income tax expense under the separate-return method would be allocated as follows:

Note that in this example, as a result of the different conclusions related to realizability of the benefit for S1’s loss, the $147 of tax expense representing the “sum of the parts” of income tax expense allocated in the separate financial statements does not equal the $126 of tax expense reflected in P’s consolidated financial statements.

8.3.1.1.1 Modifications to the Separate-Return Method

Depending on the facts and circumstances, certain modifications to the separate-return method may be considered systematic, rational, and consistent with the broad principles of ASC 740. For example, entities often modify the separate-return method to eliminate the effects of inconsistent conclusions related to realizability.

Example 8-2

Assume the same facts as in Example 8-1. Under this modified method, because the consolidated group has sufficient taxable income in the current year to realize the benefit for S1’s loss, S1 would recognize a tax benefit of $21 as follows:

Under this approach, it may be necessary to limit the amount of the benefit recorded by S1 to the amount that is actually realizable on a consolidated basis. For example, if state apportionment factors reduced the amount of state tax benefit the consolidated group could realize from S1’s loss (i.e., on a stand-alone basis, S1 would have recorded — ignoring valuation allowance considerations — more of a benefit than the consolidated group could realize), the state tax benefit recorded by S1, even under this modified approach, may need to be limited.

Other modifications to the separate-return method might also be appropriate. For example, it may be considered systematic, rational, and consistent with the broad principles in ASC 740 to use consolidated state apportionment factors in the allocation of income tax expense in the separate financial statements of a member rather than determine a separate apportionment factor as would be required under a pure separate-return method. However, this modification may not be appropriate when the consolidated apportionment factor would not be considered rational because of significant differences between the operations of the separate or carve-out entity and the consolidated group (e.g., a significantly different geographic or sales footprint). To determine whether a particular modification is systematic, rational, and consistent with the broad principles of ASC 740-10, an entity must evaluate the facts and circumstances and apply judgment. Consultation with the entity’s accounting advisers is suggested when modifications are being contemplated other than for purposes related to realizability.

8.3.1.1.2 Application of the Separate-Return Method in Separate or Carve-Out Financial Statements That Combine Multiple Legal Entities, Multiple Divisions, or Both

When multiple members are presented in separate financial statements on a combined basis, questions have arisen regarding the application of the separate-return method about whether (1) a “member” refers to a single legal entity, in which case an income tax provision would be allocated to each distinct legal entity and then combined, or (2) the group of members that is combined in the separate financial statements can be viewed collectively as a single member, in which case a single tax provision would be allocated to the combined members as a whole.

In these circumstances, we believe that there are two acceptable approaches for applying the separate-return method to determine the amount of income taxes to be allocated to the separate financial statements of the combined members.

The first approach is to calculate the tax provision as if all the members combined in the separate financial statements had been combined in such statements in all periods presented and had historically filed a consolidated tax return. This approach is supported by the guidance in ASC 810-10-45-10, which states:

If combined financial statements are prepared for a group of related entities, such as a group of commonly controlled entities, intra-entity transactions and profits or losses shall be eliminated, and noncontrolling interests, foreign operations, different fiscal periods, or income taxes shall be treated in the same manner as in consolidated financial statements. [Emphasis added]

Accordingly, calculation of an income tax provision under the separate-return method as if all of the members were part of a consolidated return during all periods presented (in accordance with the same principles) would appear to be an acceptable interpretation of this guidance.

Alternatively, because most tax jurisdictions require that there be a common parent for a consolidated tax return to be filed and no common parent is actually included in the separate, combined financial statements, we believe that a second acceptable approach is to calculate the tax provision by applying the separate-return method to each member separately.1 In other words, application of the tax law to the individual members appearing in the separate financial statements would result in a separate tax provision calculation for each member that lacks a common parent in the separate financial statements. These individual tax provisions would then be combined to determine the total amount of taxes to be allocated to the combined, separate financial statements. This approach is consistent with the guidance in ASC 740-10-30-5, which 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. [Emphasis added]

In selecting which approach to apply, an entity should consider the purpose for the separate financial statements. For example, if they are being prepared in connection with a spin-off or sale transaction and will be part of a consolidated tax return prospectively, a historical presentation that conforms to that prospective treatment may be more meaningful to financial statement users.

We believe that both approaches would also be acceptable for a combination of disregarded entities (e.g., certain single-member LLCs) since they have separate legal existence that would allow for application of a separate-return approach to each individual entity but are treated as divisions for tax purposes, allowing for the application of a single-return approach. We recommend that entities consult their professional accounting advisers in these circumstances. See Section 8.2.3 for additional discussion of single-member LLCs.

8.3.1.1.3 Application of the Separate-Return Method in Separate or Carve-Out Financial Statements When Tax Amounts Are Calculated on a Consolidated Tax Return Basis (e.g., the Deemed Repatriation Transition Tax, GILTI, BEAT)

The member should record income taxes as if it had not been a member of the U.S. consolidated tax return group. However, depending on the facts and circumstances, it may be appropriate for an entity to apply related-party and affiliated group tax rules that are relevant regardless of whether it makes an election to file a consolidated tax return.

8.3.1.2 Parent-Company-Down Method

Under the parent-company-down method, total current and deferred income tax expense, as determined at the consolidated level, is allocated to separate or carve-out financial statements by using a pro rata allocation. The pro rata portion of consolidated tax expense allocated to the separate or carve-out financial statements might be determined by, for example:

Calculating the member’s or carve-out entity’s pretax income as a percentage of the total consolidated pretax income.
Calculating the member’s or carve-out entity’s pretax income adjusted for permanent items as a percentage of the total consolidated pretax income adjusted for permanent items.

Example 8-3

This example illustrates how the parent-company-down method would be applied when consolidated tax expense is allocated to group members on the basis of each group member’s relative proportion of (1) consolidated pretax income or loss or (2) consolidated pretax income or loss adjusted for permanent items.

Parent P, a holding company, has two consolidated subsidiaries, S1 and S2. Parent P, S1, and S2 all operate in a tax jurisdiction with a 20 percent tax rate. On a consolidated basis, P has current and deferred tax expense of $110 for 20X1 that is based on $600 of pretax book income. The stand-alone results for P, S1, and S2 for 20X1 are as follows:

On the basis of the assumptions above, the group members would record the following tax expense in accordance with the allocation method chosen:

As depicted above, total current and deferred tax expense or benefit for the period, as determined at the consolidated level, should equal the sum of the current and deferred income tax expense or benefit allocated to all members of the group for the period ($110 in this example).

8.3.2 Preferable Allocation Method for Financial Statements Filed With the SEC

Question 3 of SAB Topic 1.B.1 (codified in ASC 220-10-S99-3) states, in part:

Some of these subsidiaries have calculated their tax provision on the separate return basis, which the staff believes is the preferable method. . . . When the historical income statements in the filing do not reflect the tax provision on the separate return basis, the staff has required a pro forma income statement for the most recent year and interim period reflecting a tax provision calculated on the separate return basis.

For entities that file financial statements with the SEC, the separate-return method for allocating taxes among members of a group that file a consolidated tax return is preferable to other methods and, if the separate-return method is not used (including, as discussed in Section 8.3.1.1.1, when the separate-return method is modified), a pro forma income statement is required for the most recent annual and interim periods, including a tax provision determined by using the separate-return method. The acceptable methods for allocating current and deferred income taxes in carve-out financial statements are generally the same as those for allocating income taxes in separate financial statements of a member. It would also, therefore, be considered preferable to allocate income taxes to carve-out financial statements by using the separate-return method if such an allocation is required (e.g., because the carve-out financial statements will be included in a public filing).

Most entities preparing separate and carve-out financial statements to which an allocation of current and deferred income taxes is required will use the separate-return method because to use a different method would require entities to maintain a separate set of financial statements to meet the SEC’s expectation of a pro forma income statement when the allocation is not determined on the separate-return basis.

8.3.3 Change in Application of Tax Allocation Methods

An entity should report the change from one acceptable allocation method to another as a change in accounting principle under ASC 250. However, in accordance with ASC 250-10-45-12, a change in accounting principle is permitted only if the entity “justifies the use of an allowable alternative . . . on the basis that it is preferable.”

Under ASC 250-10-45-5, an entity should “report a change . . . through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so.” A change in accounting principle would affect only the separate or carve-out financial statements. No change would be reflected in the consolidated financial statements of the parent company. SEC registrants that are reporting a change in accounting principle must provide a preferability letter from their independent accountants.

8.3.4 Tax-Sharing Agreements

8.3.4.1 General

A tax-sharing agreement is a legal agreement between the members of a consolidated group (e.g., a parent and corporate subsidiary) that typically governs the cash payment responsibility of each party related to income taxes of the consolidated filing group. Tax-sharing agreements should be formally documented, and the documentation should indicate how a member of a consolidated filing group will pay or be compensated for income tax expense or benefit attributed to its operations. This would generally include documentation of, for example, (1) the manner in which a member’s cash payment responsibility will be calculated (e.g., on a consolidated or separate-return basis) and (2) how the member will be compensated for the benefit to the consolidated group of NOLs and tax credits attributable to its operations.

Such documentation is important because it provides information about the risks and rewards of the parties to a legally enforceable contract. In addition, a well-documented tax-sharing agreement helps an entity prepare separate or carve-out financial statements (e.g., a basis for the amounts due to or from the parent).

8.3.4.2 Tax-Sharing Agreements That Differ From the Tax Allocation Method for Financial Reporting Purposes

When the legal tax-sharing agreement that governs the cash payments and receipts between a parent entity and the members of its consolidated filing group is not in line with the “systematic, rational, and consistent” requirements in ASC 740-10-30-27 for allocating taxes among members of a group that file a consolidated return, the tax-sharing agreement need not be amended to conform to those requirements. Instead, for financial reporting purposes, an entity should apply an acceptable method of allocating income tax expense or benefit to a member of the consolidated filing group that prepares separate financial statements. Any difference between (1) the income-tax-related cash flows that are to be paid or received by a member under the legal tax-sharing agreement and (2) the income-tax-related cash flows of the member implied by the allocation of current and deferred income taxes by using a systematic and rational method of allocation for financial reporting purposes is reported in the separate financial statements of the group member as either a charge to retained earnings (i.e., in a manner consistent with accounting for dividends generally) or a credit to paid-in capital (i.e., in a manner consistent with accounting for contributions from shareholders generally).

Example 8-4

Assume that a parent company, Entity P, a holding company operating in a tax jurisdiction with a 21 percent tax rate, has two operating subsidiaries, S1 and S2, and that the legal tax-sharing agreement states that S1 and S2 will not make a payment to or receive a payment from P with regard to the subsidiaries’ taxable income or loss for a given year when the consolidated group has no tax liability (expense) or refund (benefit) for that year.

Further assume that in 20X1, P has no taxable income or loss, S1 has generated taxable income of $1,000, and S2 has incurred a taxable loss of $1,000. An allocation of income tax expense in a manner consistent with the cash obligations of P, S1, and S2 under the tax-sharing agreement generally would not conform with the “systematic, rational, and consistent” requirements of ASC 740-10-30-27. Therefore, assume that for financial reporting purposes, the group has chosen to allocate income taxes to the separate financial statements of S1 and S2 by using the separate-return method and that the NOL resulting from the $1,000 loss incurred by S2 in 20X1 does not require a valuation allowance. Entity P records the following journal entries in the separate financial statements of S1 and S2 for 20X1:

Journal Entries — Consolidated Group Member S1

Journal Entries — Consolidated Group Member S2

8.3.4.3 Allocating Benefits to a Subsidiary for Parent’s Interest Expense

There may be instances in which a tax-sharing agreement specifies certain arrangements between the parent entity and the members of its consolidated filing group related to the tax effects of items that may not be included in the group members’ separate financial statements. Consider the example below.

Example 8-5

Assume that Entity P is the parent of a wholly owned subsidiary, Company S, and that S is a member of P’s consolidated tax return. Further assume that P issued term debt upon acquiring S and that P deducts the interest paid on the debt for income tax purposes. The legal tax-sharing agreement between P and S specifies that S will receive payments from P to the extent of the benefit to P of the interest deductions taken by P in the consolidated tax return related to the term debt.

Company S prepares separate financial statements, and P does not allocate the debt and corresponding interest expense to S for financial reporting purposes. Company S does pay dividends to P, in part to provide cash flows for P’s debt service obligation.

In accordance with informal discussions with the FASB staff, the tax benefit of the interest expense determined under the legal tax-sharing agreement and paid by P to S should be allocated to equity in S’s separate financial statements. Income tax expense from continuing operations should not be credited in this situation. This conclusion is based on the view that allocating the tax consequences attributable to interest expense is inconsistent with the broad principles established by ASC 740 because neither principal nor interest for the pretax amounts has been recognized in S’s financial statements.

8.3.5 “Return-to-Provision” Adjustments in Separate or Carve-Out Financial Statements

When preparing an income tax provision for financial reporting purposes, an entity will often find it necessary to make estimates of amounts that will ultimately be included in the filed income tax return because the financial statements must be issued before the date on which the income tax return is due. This can result in “return-to-provision” adjustments (also known as return-to-accrual adjustments), which occur when estimates used for the provision in the consolidated financial statements differ from the amounts reported on the consolidated income tax return. An entity should carefully evaluate any resulting differences between the consolidated tax return and consolidated tax provision to determine whether those differences represent changes in estimates or a correction of an error. See Section 12.6.1 for a discussion of how to distinguish between the two.

The income tax effects of return-to-provision adjustments that are considered changes in estimates in the consolidated financial statements are generally recorded in separate or carve-out financial statements in the same period in which the changes in estimates were identified in the consolidated financial statements. The income tax effects of return-to-provision adjustments that are not considered changes in estimates in the consolidated financial statements, however, generally should be recorded in the historical separate or carve-out financial statements in the periods to which they relate and not in the period identified (i.e., irrespective of the period in which they were accounted for in the parent’s consolidated financial statements). Differences between the periods in which return-to-provision adjustments are recorded in consolidated financial statements versus when they are recorded in separate or carve-out statements could stem, for example, from differences in materiality between the separate or carve-out financial statements and the consolidated financial statements.

Footnotes

Under this approach, if a division or group of divisions is included in the separate or carve-out financial statements, the separate-return method would generally be applied to those divisions in aggregate and then combined with the tax provisions of the members.

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.