8.4 Current and Deferred Income Taxes in the Balance Sheet of Separate and Carve-Out Financial Statements
As discussed in detail above, an allocation of current and deferred income tax expense to
separate and carve-out financial statements is often necessary. However, there is no
authoritative guidance in ASC 740-10-30-27 or elsewhere that specifically addresses how
current and deferred taxes should be reflected on the balance sheet of the separate or
carve-out financial statements. ASC 740-10-30-28 does, however, provide examples of
methods of allocating current and deferred tax expense that are not consistent with the
broad principles established by ASC 740. Such examples include allocating only current
taxes payable to a member of the group that has taxable temporary differences and
allocating deferred taxes to a member of that group by using a method fundamentally
different from the asset and liability approach described in ASC 740.
8.4.1 Requirement to Record DTAs and DTLs in Separate or Carve-Out Financial Statements
The recording of DTAs and DTLs in the balance sheet of carve-out financial statements
was discussed at the June 12, 2001, AICPA SEC Regulations Committee joint meeting
with the SEC staff. The following is an excerpt from those meeting minutes that expresses the SEC staff’s view:
Question: Should carveout financial statements (i.e., financial
statements of a business that is not a legal entity, e.g., a division)
reflect income tax expense and deferred tax assets/liabilities if the
reporting entity is a component of a taxable entity?
Background: The accounting literature does not clearly address the
issue of accounting for income taxes by a reporting entity that is not a
legal entity.
Paragraph 1 of SFAS 109 states that it “addresses financial accounting and
reporting for the effects of income taxes that result from an
enterprise’s activities . . . .” Paragraph 40 provides standards for
accounting for income taxes in the “separate financial statements of a
subsidiary.” It states that tax expense “shall be allocated among
the members of the group when those members issue separate
financial statements.” (Emphasis added.) SFAS 109 does not define the term
“enterprise.” However, paragraph 40 seems to apply only to legal
entities.
SAB Topic 1-B is entitled Allocation of Expenses and Related Disclosures in
Financial Statements of Subsidiaries, Divisions, or Lesser Business
Components of Another Entity. In its text, it seems to use the word
“subsidiary” as a surrogate for the larger collection of reporting entities
listed in its title. The response to Question 1 states that “the historical
income statements of a registrant should reflect all of its costs of doing
business.” However, the response then states that “income taxes . . . are
discussed separately below.” Question 3 addresses income tax expense.
Although the SAB seems to use the term “subsidiary” broadly, the discussion
of subsidiary income taxes in the response to Question 3 seems to be written
in the context of legal entities, referring to issues of whether the entity
can be included in a consolidated tax return (this is not an issue for a
component of a legal entity) with its “parent.” The response states the need
to provide a pro forma tax provision if the financial statements do not
reflect income taxes on a separate return basis. Guidance in the Staff
Training Manual (at Topic Three.IV.A.1. and Topic Seven.IV.A.4.) also
focuses on the need for pro forma tax provision information.
Although an allocation of deferred tax assets and liabilities needs to be
made to apply the separate return method, none of this guidance specifically
addresses balance sheet presentation or footnote disclosure issues. The
guidance calling for pro forma information focuses on the need for tax
provision information.
Discussion: Many accountants focus on the concept stated in SAB Topic
1-B that income statements should reflect all costs of doing business. They
present income tax provisions as part of the historical accounts reflected
in carveout financial statements. Others believe that since reporting
entities that are not legal entities do not have legal tax status, they do
not have tax liabilities or expenses. Therefore, they present income tax
information in carveout financial statements only on a pro forma basis.
Although practice does not appear to be uniform, it appears that registrants
present income taxes in carveout financial statements as part of the
historical accounts more frequently than they present them as pro forma
information. This observation is based in part on comments made by the Big 5
accounting firms in communications discussing the question of whether a
single member LLC should present a tax provision in its financial
statements. A single member LLC is treated as a “disregarded entity” for tax
purposes. In other words, it is treated no differently than a division of a
taxpayer. The majority of the firms felt that a single member LLC should
present a tax provision. The other firms did not have strong views.
Staff Comment: As stated in SAB Topic 1B, the staff believes that
financial statements are more useful to investors if they reflect all costs
of doing business. As the transactions reported in the carveout financial
statements have income tax implications to the taxable entity of which the
reporting entity is a part, the staff believes that carveout financial
statements should reflect income tax expense and deferred tax
assets/liabilities attributable to the reporting entity.
As indicated in the minutes above, the SEC staff believes that financial statements
“are more useful to investors if they reflect all costs of doing business” and that
carve-out financial statements “should reflect income tax expense and deferred tax
assets/liabilities attributable to the reporting entity.” While the staff’s views
were expressed specifically in the context of carve-out financial statements, we
believe that such views would also apply to separate financial statements of members
(i.e., taxable legal entities that are included in a parent’s consolidated tax
return).
Therefore, we generally believe that the balance sheet of separate and carve-out
financial statements should include DTAs and DTLs for temporary differences related
to the separate entity’s operations when such financial statements will be included
in a filing with the SEC. In addition, although it is not clear from the minutes
above, we believe that it is generally appropriate to record DTAs and DTLs in
separate and carve-out financial statements regardless of the method (e.g., the
separate-return method or the parent-company-down method) used to allocate current
and deferred income tax expense to the separate or carve-out financial
statements.
8.4.2 Method for Recording DTAs and DTLs on the Balance Sheet of Separate or Carve-Out Financial Statements
We believe that it is generally appropriate for an entity to begin
its allocation of DTAs and DTLs on the balance sheet of separate or carve-out
financial statements by identifying stand-alone temporary differences related to,
and attributes generated by, the separate or carve-out entity. The temporary
differences would be based on the financial statement carrying amount of the assets
and liabilities included in the separate or carve-out financial statements and the
related tax bases as if the entity were required to file its own tax return.
However, because there is no available guidance on how DTAs should be reflected in
separate and carve-out financial statements, many issues arise in practice. We
discuss some of those issues in the next two sections.
8.4.3 Recognition and Presentation of DTAs Related to Temporary Differences for Which the Separate or Carve-Out Entity Has Been Paid
Under some tax-sharing arrangements, one member of the consolidated
filing group, typically a parent, will pay a separate or carve-out entity for
temporary difference DTAs in each period as they arise. We believe that in these
situations, it would not be appropriate for an entity to remove those temporary
difference DTAs from the separate or carve-out financial statements.
Temporary difference DTAs are tied to the financial reporting and
tax bases of specific assets and liabilities of the separate or carve-out entity.
The fact that the entity receives payment for temporary difference DTAs does not
change the existing basis difference or future benefit that would result from
settlement of the asset or recovery of the liability at its financial reporting
carrying amount. Therefore, derecognition of DTAs related to temporary differences
would generally not be consistent with the broad principles of ASC 740.
8.4.3.1 Recognition and Presentation of DTAs Related to Tax Attributes Under the Separate-Return Method
The operations of a separate or carve-out entity may result in tax credits or
NOLs in a particular year. Had the separate or carve-out entity filed its
own tax return, it may not have been able to use the tax credits in the year
in which they were generated. In these circumstances, NOL and tax credit
carryforwards (tax attributes) could result.
Under the separate-return method (without any modifications for
realizability), the separate or carve-out entity would recognize DTAs
associated with the tax attributes (carryforwards) and evaluate them for
realizability only on the basis of positive and negative evidence related to
the entity’s operations. See Section
8.5 for additional details on the assessment of whether a
valuation allowance should be recorded against the DTAs.
However, these tax attributes may be used in the income tax return of the
consolidated filing group (to offset taxable income from other operations
included in the consolidated filing group) in a period before they would
have been used by the separate or carve-out entity solely on the basis of
the separate or carve-out entity’s operations. Therefore, the tax attributes
generated by the separate or carve-out entity would not be available to
reduce future taxable income in the tax return of the consolidated tax
filing group. In these situations, the tax attribute carryforwards represent
“hypothetical DTAs” in the separate or carve-out financial statements
because they no longer legally exist within the consolidated filing group;
however, if the separate or carve-out entity had filed its own tax return,
the tax attributes would be available.
Generally, the following two approaches exist for presenting hypothetical
DTAs related to tax attribute carryforwards in the balance sheet when the
separate-return method is used; however, an entity should choose one
approach and apply it consistently:
-
Approach 1 — Under this approach, the balance sheet of the separate or carve-out financial statements would reflect the “tax return reality” that, since the tax attribute does not legally exist, it cannot be used in future periods to offset taxable income (i.e., it has been, in effect, distributed to and used by the parent and, accordingly, should be reversed through equity). Under this approach, the deferred tax benefit associated with the tax attributes would still be recognized in the income statement of the separate or carve-out financial statements (as long as no valuation allowance was needed in the separate or carve-out financial statements).In subsequent years, the entity must continue to assess its ability to realize the benefit of the hypothetical DTA on the basis of the positive and negative evidence associated with its stand-alone operations (even though it does not continue to record the hypothetical DTA in the balance sheet). Changes in the measurement of the hypothetical DTA would be effected through an entry to deferred tax expense (or benefit) in the income statement of the separate or carve-out financial statements with an offsetting entry in APIC. Subsequent accounting is also an accounting policy election that should be applied consistently.In addition, the separate company would be required to disclose the following:
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The reasons why the hypothetical DTA was not recorded.
-
The possible effects on future tax provisions related to future changes in the realizability of the unrecorded hypothetical DTA.
-
-
Approach 2 — Under this approach, the hypothetical DTA would be presented in the balance sheet of the separate or carve-out financial statements. This view is premised on the fact that, under the separate-return method, income taxes are allocated to the separate financial statements in accordance with ASC 740 as if the separate reporting entity had filed a separate tax return. If it had, the hypothetical DTA could not have been used by any other entity and thus would be presumed to continue to exist.If a hypothetical DTA is recorded in the separate or carve-out financial statements, the separate or carve-out entity should disclose the fact that the DTA does not legally exist and would be derecognized if the entity were to leave the consolidated tax return filing group. The example below illustrates this concept.
We believe that both approaches are acceptable regardless of whether the
separate or carve-out entity receives payment for the NOL or tax credit
carryforward or whether the tax attributes have been used in the income tax
return of the consolidated filing group.
Example 8-6
Technology Co., an SEC registrant, is a U.S. software
company with a March 31 year-end. Technology Co. has
a software services division (“the Division”) for
which it is preparing separate financial statements
that will be included in a registration statement.
The operations of the Division are included in the
U.S. federal consolidated income tax return of
Technology Co. Technology Co. will apply the
separate-return method to allocate income taxes to
the separate financial statements of the
Division.
The Division has been in operation for one year and
was profitable on a stand-alone pretax basis, but it
generated a tax loss because of accelerated
depreciation. The loss was used by Technology Co. to
reduce consolidated taxable income in the year in
which it was generated.
In applying the
separate-return method, management has determined
that the tax loss of the Division would have
resulted in an NOL carryforward of $5 million.
Therefore, the NOL carryforward represents a
hypothetical DTA because it exists under the
separate-return method, but it does not legally
exist since it has already been used by Technology
Co. in its consolidated income tax return.
Management also evaluated the positive and negative
evidence associated with the Division’s operations
and concluded that it is more likely than not that
the Division will have sufficient future taxable
income (on a stand-alone basis) to realize the
benefit of the hypothetical DTA. Because the
separate-return method is used for allocation of
income taxes to the Division, Technology Co. may
choose whether to record the hypothetical DTA in the
Division’s separate balance sheet. If Technology Co.
elects to record the hypothetical DTA, it would
record the following entry in the Division’s
separate financial statements:
If it elects not to
record the hypothetical DTA, it would record the
following entries:
In either case, management is still required to
evaluate in subsequent years whether the benefit
associated with the hypothetical DTA continues to be
realizable. If, in a future year, management
determines that the hypothetical DTA is no longer
realizable, it must record a deferred tax expense
and a credit to a valuation allowance (if the
hypothetical DTA was recorded) or to equity (if the
hypothetical DTA was not recorded).
8.4.3.2 DTAs Related to Tax Attributes Under the Modified Separate-Return Method
As discussed in the previous section, the operations of a separate or
carve-out entity may result in the generation of tax credits or NOLs in a
particular year for which the entity would not have been able to recognize
the associated tax benefit on a separate-return basis but hasrecorded a DTA
and corresponding benefit after modifying the separate-return method to take
into consideration realizability of the attribute within the consolidated
filing group (see Section 8.3.1.1.1
for further discussion of modifying the separate-return method for
realizability). In such a case, once the parent has used the tax attribute,
realization has occurred in a manner consistent with the initial conclusion
about the recognition of the attribute in the separate financial statements
(i.e., it was recognized only because it could be used by the consolidated
filing group), and the DTA should be derecognized.
8.4.4 Taxable Temporary Differences Resulting From Investments in Foreign Subsidiaries and Foreign Corporate Joint Ventures in Separate Financial Statements Prepared by Using the Separate-Return Method
ASC 740-30-25-18 indicates that a DTL should not be recognized for
an “excess of the amount for financial reporting over the tax basis [i.e., ‘outside
basis difference’] 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” (emphasis added). There is, however, also 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 that the subsidiary has invested or will invest the undistributed earnings
indefinitely).
The determination of whether a DTL should be recognized (e.g.,
whether the rebuttable presumption is or is not overcome) 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 is first made at the parent’s level on a consolidated basis and takes into
account all of the consolidated entity’s relevant facts and circumstances.
When the investment in the foreign subsidiary or corporate joint
venture is owned by the separate reporting entity and is included in the separate
financial statements of that entity, the separate financial statements prepared by
using the separate-return method2 must also include an assertion with respect to whether the temporary
difference will reverse in the foreseeable future. Questions often arise about
whether the assertion in the separate financial statements prepared by using the
separate-return method should be the same as the assertion made in the consolidated
financial statements related to that same investment or whether, instead, the
separate reporting entity must perform an independent analysis that takes into
account only the separate reporting entity’s operations, facts, and
circumstances.
Preparing an independent analysis that takes into account only the
facts and circumstances of the separate reporting entity is consistent with the
separate-return method. However, we believe that because the separate reporting
entity is controlled by its parent, if the parent considers the separate reporting
entity’s facts and circumstances, the parent is inherently required to also consider
the consolidated filing group’s plans for reinvestment, cash needs, and so forth
when determining whether the outside basis taxable temporary difference will reverse
in the foreseeable future. Therefore, in most cases, if a separate analysis is
performed, the separate reporting entity would reach the same conclusion in both the
current and historical periods presented in the separate financial statements as
that reached by the parent regarding the corresponding periods in the consolidated
financial statements. Thus, it would generally be unnecessary for the separate
reporting entity to perform a separate analysis. The example below illustrates this
concept.
Example 8-7
Assume that U.S. Parent (USP) owns 100
percent of U.S. Subsidiary (USS, a member of USP’s
consolidated U.S. tax return), and USS is preparing separate
financial statements by using the separate-return method.
Assume further that USS owns an investment in Foreign
Corporation A and A has undistributed earnings. USP has
significant cash needs on a consolidated basis and therefore
cannot assert that the undistributed earnings of A will be
indefinitely reinvested, so it records a DTL in its
consolidated financial statements. Even if USS could
demonstrate that, on its own, it did not (and does not) have
significant cash needs in the United States, it would record
a DTL in its separate financial statements because a
decision by USP to repatriate A’s undistributed earnings to
meet USP’s consolidated cash needs would result in USS’s
incurring U.S. income tax (i.e., it would be difficult to
support a conclusion that USS’s outside basis taxable
temporary difference on its investment in A will not reverse
in the foreseeable future given USP’s cash needs and its
control over USS’s operations).
Alternatively, assume that USP has
demonstrated (and continues to demonstrate) on a
consolidated basis that it does not have significant cash
needs and therefore has asserted that the undistributed
earnings of A will be indefinitely reinvested. USS, on its
own, did not (and does not) generate sufficient cash flows
to meet its debt obligations without contributions from USP.
USP has historically provided and has the ability and intent
to continue providing the necessary contributions for the
foreseeable future. Because USP had (and continues to have)
the ability and intent to provide funding to USS, USS would
not have to record a DTL related to its investment in A in
its separate financial statements. However, USS must
carefully consider the facts and circumstances and use
significant professional judgment to determine the
appropriate period, if any, in which to record the DTL in
the separate financial statements.
If management believes that the facts and circumstances suggest that
it is appropriate for the separate or carve-out financial statements and the
consolidated financial statements to contain different conclusions, consultation
with the company’s accounting advisers is strongly encouraged.
Regardless of the conclusions reached, disclosure would be required
in the separate or carve-out financial statements of the company’s accounting for
outside basis deferred taxes on investments in foreign corporations and joint
ventures.
8.4.5 Current Taxes Payable or Receivable and UTB Liability Under the Separate-Return Method
When income tax expense is allocated to the separate reporting
entity under the separate-return method and (1) such allocation results in a current
income tax payable or receivable or (2) the allocation includes an expense related
to a UTB, questions can arise about whether and, if so, how such a current payable
or receivable and the UTB liability should be reflected in the balance sheet.3
A separate reporting entity to which income tax expense was
allocated under the separate-return method should initially reflect current income
taxes payable and UTB liabilities in the balance sheet in the same manner as if it
had prepared a separate return. This view is premised on the facts that (1) under
U.S. federal tax law, members (corporate subsidiaries) of a consolidated filing
group are severally liable for all tax positions taken in the consolidated return
and (2) while nonmembers (unincorporated divisions, branches, or disregarded
entities included in the entity’s consolidated income tax return) are not severally
liable for the current tax liability or tax positions taken in the consolidated
return because they are not regarded as separate entities for income tax purposes,
the presentation of current tax payables and UTB liabilities in the separate
financial statements of nonmembers is consistent with the separate-return method.
The separate reporting entity would then derecognize the payable or UTB liability
(1) once it makes a payment (presumably to its parent under the terms of the
tax-sharing arrangement) to settle the current tax payable or UTB liability or (2)
once the current tax payable or UTB liability is settled by the parent directly with
the taxing authority. If the current tax payable or UTB liability is settled by the
parent directly with the taxing authority, the separate reporting entity would
derecognize the liability with a corresponding entry to equity. Adjustments to the
current tax payable or UTB liability because of changes in facts and circumstances
(i.e., unrelated to payment of the obligations) would generally be accounted for in
the income tax provision.
However, in circumstances in which a tax-sharing agreement exists
between the separate reporting entity and its parent or other members of the
consolidated filing group (or both), we believe that it would also be acceptable for
the separate reporting entity to immediately adjust, through equity, the recorded
amount of current income taxes payable or UTB liabilities to reflect only the amount
the separate reporting entity would be required to pay (presumably to its parent).
For example, a tax-sharing agreement between a parent and a separate reporting
entity that is a member (corporate subsidiary) of the consolidated return group may
specify that the member is not liable for the tax consequences of tax positions
taken in the consolidated return related to its business. The tax-sharing agreement
might also specify that the separate reporting member must reimburse the parent for
income taxes paid for an amount different from that determined by using the
separate-return method. We believe that in each scenario it would be acceptable to
adjust the UTB and current taxes payable to an amount consistent with what the
separate reporting entity would ultimately have to pay (presumably to its parent)
under the tax-sharing agreement. Any such adjustment would be recorded through
equity. This view cannot be applied by analogy to temporary differences in the
separate financial statements.
Footnotes
2
It may be appropriate in some circumstances to modify the
separate-return method (see Section 8.3.1.1.1). We would not
generally expect the types of modifications to the separate-return method
that are described in that section to affect the applicability of the
guidance in this section to separate financial statements.
3
The concepts in this section are equally applicable to
income taxes payable and receivable. However, for ease of discussion
throughout the remainder of this section, we refer only to income taxes
payable.