Chapter 8 — Accounting for Income Taxes in Separate Financial Statements
Chapter 8 — Accounting for Income Taxes in Separate Financial Statements
8.1 Introduction
Financial statements that include assets and operations of some
subcomponent of a larger consolidated reporting entity are commonly referred to as
“separate” or “carve-out” financial statements, and they are routinely required in
connection with an IPO, a spin-off, a sale, or debt covenant compliance.
When used broadly, “separate” and “carve-out” describe financial statements that are
derived from the financial statements of a larger parent company. In this context, the
words are often used interchangeably. A narrower use of the term “carve-out financial
statements” refers specifically to financial statements that are not the separate
financial statements of a legal entity subsidiary but rather of certain operations
(e.g., unincorporated divisions, branches, disregarded entities, or lesser components of
the parent reporting entity) that have been “carved out” of the parent entity or one or
more legal entity subsidiaries. In this chapter, we use “separate financial statements”
to refer to financial statements of one or more legal entity subsidiaries and “carve-out
financial statements” to refer to financial statements that are composed of the assets
and operations of divisions, branches, disregarded entities, or lesser components of the
parent entity or one of its subsidiaries.
Even though carve-out financial statements are not those of a legal
entity (i.e., they are composed of portions of a legal entity or entities that have been
“carved out”), they are commonly referred to as the financial statements of the
carve-out “entity.” See Deloitte’s Roadmap Carve-Out Financial Statements for further
discussion of carve-out financial statements.
8.2 Determining Whether an Allocation of Income Taxes Is Required in Separate or Carve-Out Financial Statements
ASC 740-10
Allocation of Consolidated Tax Expense to Separate Financial
Statements of Members
30-27 The consolidated amount of
current and deferred tax expense for a group that files a
consolidated tax return shall be allocated among the members of
the group when those members issue separate financial
statements. This Subtopic does not require a single allocation
method. The method adopted, however, shall be systematic,
rational, and consistent with the broad principles established
by this Subtopic. A method that allocates current and deferred
taxes to members of the group by applying this Topic to each
member as if it were a separate taxpayer meets those criteria.
In that situation, the sum of the amounts allocated to
individual members of the group may not equal the consolidated
amount. That may also be the result when there are intra-entity
transactions between members of the group. The criteria are
satisfied, nevertheless, after giving effect to the type of
adjustments (including eliminations) normally present in
preparing consolidated financial statements.
30-27A An entity is not required to
allocate the consolidated amount of current and deferred tax
expense to legal entities that are not subject to tax. However,
an entity may elect to allocate the consolidated amount of
current and deferred tax expense to legal entities that are both
not subject to tax and disregarded by the taxing authority (for
example, disregarded entities such as single-member limited
liability companies). The election is not required for all
members of a group that files a consolidated tax return; that
is, the election may be made for individual members of the group
that files a consolidated tax return. An entity shall not make
the election to allocate the consolidated amount of current and
deferred tax expense for legal entities that are partnerships or
are other pass-through entities that are not wholly owned.
30-28 Examples of
methods that are not consistent with the broad principles
established by this Subtopic include the following:
- A method that allocates only current taxes payable to a member of the group that has taxable temporary differences
- A method that allocates deferred taxes to a member of the group using a method fundamentally different from the asset and liability method described in this Subtopic (for example, the deferred method that was used before 1989)
- A method that allocates no current or deferred tax expense to a member of the group that has taxable income because the consolidated group has no current or deferred tax expense.
Question 3 of SAB Topic 1.B.1 (codified in ASC 220-10-S99-3) states:
ASC 220-10 — SEC Materials
SAB Topic 1.B, Allocation of Expenses and Related Disclosure
in Financial Statements of Subsidiaries, Divisions or Lesser
Business Components of Another Entity
S99-3 The following is the text of SAB Topic 1.B.1, Costs
Reflected in Historical Income Statements . . .
Question 3: What are the staff’s views with respect to the
accounting for and disclosure of the subsidiary’s income tax
expense?
Interpretive Response: Recently, a number of parent
companies have sold interests in subsidiaries, but have retained
sufficient ownership interests to permit continued inclusion of
the subsidiaries in their consolidated tax returns. The staff
believes that it is material to investors to know what the
effect on income would have been if the registrant had not been
eligible to be included in a consolidated income tax return with
its parent.
Some of these subsidiaries have calculated their tax provision on
the separate return basis, which the staff believes is the
preferable method. Others, however, have used different
allocation methods.
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.1
____________________
1 Paragraph 40 of Statement 109 [paragraph
740-10-30-27] states: “The consolidated amount of current and
deferred tax expense for a group that files a consolidated tax
return shall be allocated among the members of the group when
those members issue separate financial statements. . . . The
method adopted . . . shall be systematic, rational, and
consistent with the broad principles established by [Statement
109] [Subtopic 740-10]. A method that allocates current and
deferred taxes to members of the group by applying [Statement
109] [Subtopic 740-10] to each member as if it were a separate
taxpayer meets those criteria.”
To understand the accounting for income taxes in separate or carve-out
financial statements, management and practitioners must understand the legal structure
of the operations to be included in such statements. The remainder of this section
discusses some of the considerations related to whether an allocation of income taxes
would be required in separate or carve-out financial statements and, if so, which
allocation methods may be used, including considerations related to the application of
each method.
8.2.1 Separate Financial Statements Composed of One or More Taxable Legal Entities
The primary source of guidance applicable to the accounting for income taxes in
separate financial statements is ASC 740-10-30-27, which requires a group of
entities that files a consolidated tax return to allocate the “consolidated amount
of current and deferred tax expense . . . among the members of the group when those
members issue separate financial statements.” For income tax accounting purposes, a
“member” is generally a taxable legal entity (i.e., a corporation or an LLC that has
elected to be taxed as a corporation) that is included in the parent’s consolidated
tax return. Thus, if separate financial statements are being prepared that are
composed of one or more taxable legal entities that are included in the parent’s
consolidated tax return (as might be the case if the separate financial statements
are being prepared in connection with a spin-off of a subsidiary), an allocation of
current and deferred income tax expense is explicitly required under ASC
740-10-30-27.
8.2.2 Separate Financial Statements of Nontaxable Legal Entities or “Pass-Through” Entities
Separate financial statements may be composed of one or more
nontaxable entities (e.g., “pass-through” entities such as partnerships and multiple
member LLCs that have elected to be taxed as pass- throughs). Such nontaxable or
pass-through entities are not members of their parent’s consolidated income tax
return. Therefore, allocation of income tax expense is not appropriate in the
separate financial statements of a pass-through entity for jurisdictions in which
the entity is considered a nontaxable pass-through entity. This is true irrespective
of whether the separate financial statements will be included in a filing with the
SEC. See Section 14.5 for the disclosure
requirements that apply in this circumstance.
8.2.3 Separate Financial Statements of Single-Member LLCs
An LLC with only one member (a “single member LLC”) is a unique
legal entity structure that can, under certain circumstances, be classified for U.S.
federal income tax purposes as a regarded entity (i.e., similar to a corporation) or
can be disregarded (i.e., not respected as an entity separate from its owner but
rather treated like a division of a corporation). However, unlike a division of a
corporation, a disregarded single-member LLC generally is not severally liable for
the current and deferred income taxes of its taxable owner provided that it
maintains its separate and distinct legal existence. An entity’s determination of
whether an allocation of current and deferred income taxes is required in the
separate financial statements of a single-member LLC therefore depends, in part, on
how the single-member LLC elects to treat itself for U.S. federal income tax
purposes.
A regarded single-member LLC that is subject to federal, foreign,
state, or local taxes based on income should account for such taxes in its separate
financial statements in accordance with ASC 740 (see Section 8.2.1).
In the separate financial statements of legal entities that are not subject to tax
and are disregarded by the taxing authority, there is no requirement to
allocate current and deferred taxes. However, a disregarded single-member LLC may
elect to apply the guidance discussed in Section
8.2 and allocate current and deferred taxes in its financial
statements. If an entity that is not subject to tax and is disregarded by the taxing
authority has elected to allocate amounts of consolidated current and deferred taxes
in its separate financial statements ASC 740-10-50-17A requires to disclose that
election.
The policy election to allocate taxes to legal entities that are not
subject to tax and are disregarded by the taxing authority is made on an
entity-by-entity basis and allows the inclusion of a tax provision in the separate
financial statements of a single-member LLC (a disregarded entity for tax purposes)
but not in the financial statements of a partnership (a regarded entity for tax
purposes).
The policy election applies to a single-member LLC being prepared for inclusion in an
SEC filing (regardless of whether a tax-sharing agreement exists between the
single-member LLC and its taxable parent). That is, such financial statements are
treated the same as those of a partnership in the accounting for income taxes in the
separate financial statements.
If an entity maintains a tax-sharing agreement and chooses to allocate income taxes,
the allocation method used must be appropriate for financial reporting purposes
regardless of the manner in which the contractual tax-sharing agreement allocates
taxes to the single-member LLC. See Section 8.3.1 for further discussion of
acceptable allocation methods and Section 8.3.4 for further discussion of tax-sharing arrangements
that are inconsistent with the broad principles established by ASC 740.
If income taxes are not allocated, practitioners should ensure that
they have a complete understanding of the business purpose of the structure and of
the user(s) of the financial statements. See Section 8.7.2 for disclosure considerations
for financial statements of a single-member LLC that do not include an allocation of
income taxes.
8.2.4 Carve-Out Financial Statements (i.e., Statements Composed of One or More Unincorporated Divisions, Branches, Disregarded Entities, or Lesser Components of the Parent Reporting Entity)
Because ASC 740-10-30-27 discusses only the allocation of current
and deferred income taxes to the separate financial statements of a member (i.e., a
taxable legal entity subsidiary that is included in a parent’s consolidated income
tax return), it does not explicitly address the allocation of income taxes in
carve-out financial statements. Whether an allocation of the consolidated amounts of
current and deferred income taxes is required in carve-out financial statements
depends on the ultimate use of the financial statements.
If the carve-out financial statements will be included in a filing
with the SEC, an allocation of taxes is generally required under the guidance in SAB
Topic 1.B.1 (reproduced in ASC 220-10-S99-3). Question 3 of SAB Topic 1.B.1
specifically addresses income taxes and states, in part:
The
staff believes that it is material to investors to know what the effect on
income would have been if the registrant had not been eligible to be included in
a consolidated income tax return with its parent.
In this context, “the registrant” has been interpreted in practice
to include a carve-out “entity” either because the carve-out entity will ultimately
become a registrant or because the carve-out entity represents the predecessor of
the registrant.
The allocation of income taxes in carve-out financial statements
that will be included in a filing with the SEC is required regardless of whether the
carved-out operations will be subsumed into a taxable or nontaxable entity upon
consummation of the transaction for which the carve-out financial statements are
being prepared. Only in limited circumstances has the SEC allowed the omission of a
tax provision (e.g., if the carve-out entity prepares abbreviated financial
statements — see Section
8.2.5).
If the carve-out financial statements will not be included in a
filing with the SEC, the parent entity is generally not required to allocate income
taxes to such statements, although doing so is usually preferable because it yields
more useful information.
8.2.5 Abbreviated Financial Statements
SEC Regulation S-X, Rule 3-05, requires registrants to file separate preacquisition
historical financial statements for an acquired or to be acquired business that is
significant (acquiree). Similarly, under Regulation S-X, Rule 3-14, registrants may
be required to provide preacquisition financial statements for a significant
acquired or to be acquired real estate operation (real estate acquiree).
In certain circumstances, it may not be practicable for management to prepare full
carve-out financial statements of an acquiree, such as when the acquiree is a small
portion or product line of a much larger business and separate financial records
were not maintained. In such circumstances and as long as certain qualifying
conditions and presentation and disclosure requirements in Rule 3-05(e) are met,
abbreviated financial statements of an acquiree may be acceptable and would consist
only of (1) a statement of revenues and direct expenses (in lieu of a full statement
of operations), (2) a statement of assets acquired and liabilities assumed (in lieu
of a full balance sheet), and (3) certain footnote disclosures required by Rules
3-05(e)(2)(iii) and 3-14(c)(2). In a manner consistent with the presentation and
disclosure requirements in Rule 3-05(e), a registrant may omit an allocation of
income taxes in the acquiree’s abbreviated financial statements.
See Sections 2.6.4 and 3.5 of Deloitte’s Roadmap SEC Reporting Considerations for Business Acquisitions
for further discussions of requirements related to abbreviated financial statements
under Rules 3-05 and 3-14, respectively. Also see Section 8.7.3 of this Roadmap for a discussion
of disclosures required when income taxes are not allocated in abbreviated 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:
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
1
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.
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:
-
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.
8.5 Valuation Allowance in Separate or Carve-Out Financial Statements
See Chapter
5 for a general discussion of valuation allowances under ASC 740. The
manner in which valuation allowances are accounted for in separate or carve-out
financial statements depends on whether income taxes are allocated by using the
separate-return or the parent-company-down method (see Section 8.3 for further discussion of each method):
8.5.1 Separate-Return Method
If the separate-return method is used to allocate taxes in separate or carve-out
financial statements, the separate or carve-out entity’s DTAs should be assessed for
realizability on the basis of available evidence related to only the
operations of the separate or carve-out entity. Therefore, if that entity has
negative evidence (e.g., cumulative losses in recent years), it would be difficult
to support a conclusion that a valuation allowance is not necessary, irrespective of
the available evidence at the consolidated group level (e.g., a history of
profitable operations of the consolidated filing group level).
If, however, an entity has modified the separate-return method for
realizability of its DTAs (as discussed in Section 8.3.1.1.1), the entity may consider
evidence at the consolidated group level when determining whether a valuation
allowance is needed. An entity that files separate or carve-out financial statements
with the SEC and modifies the separate-return method (in this manner or another way)
that is also required to provide pro forma financial statements would be required to
include, in its pro forma income statement, a tax provision (and valuation allowance
assessment) determined by using the separate-return method. See Section 4.4 of Deloitte’s
Roadmap Initial Public
Offerings for more information about pro forma financial
information and when it must be presented.
8.5.2 Parent-Company-Down Method
If the parent-company-down method is used to allocate taxes in separate or carve-out
financial statements, the determination of the need for a valuation allowance in the
separate or carve-out financial statements depends on whether a valuation allowance
was recognized in the consolidated financial statements. In other words, if a
valuation allowance is required at the parent-company level, a valuation allowance
is also required in the financial statements of the stand-alone group member. If no
valuation allowance is necessary at the parent-company level, no valuation allowance
should be provided in the separate or carve-out financial statements.
8.6 Change in Status of the Separate Reporting Entity
Many circumstances can arise that result in the initial recognition or derecognition of
current and deferred income taxes in separate or carve-out financial statements. See
Section 3.5.2 for a general discussion of an entity’s
accounting for a change in status and Sections 11.2.2 and
11.7.4.2 for a discussion of recognition and derecognition of
income taxes in predecessor and successor financial statements (which may be separate or
carve-out financial statements) and separate financial statements of an acquiree.
8.7 Disclosures Required in the Separate Financial Statements of a Member of a Consolidated Tax Return
ASC 740-10
50-17 An entity
that is a member of a group that files a consolidated tax return
shall disclose in its separately issued financial statements:
- The aggregate amount of current and deferred tax expense for each statement of earnings presented and the amount of any tax-related balances due to or from affiliates as of the date of each statement of financial position presented
- The principal provisions of the method by which the consolidated amount of current and deferred tax expense is allocated to members of the group and the nature and effect of any changes in that method (and in determining related balances to or from affiliates) during the years for which the above disclosures are presented.
50-17A An entity that is both not
subject to tax and disregarded by the taxing authority that
elects to include the allocated amount of current and deferred
tax expense in its separately issued financial statements in
accordance with paragraph 740-10-30-27A shall disclose that fact
and provide the disclosures required by paragraph
740-10-50-17.
For general disclosure requirements related to the accounting for income
taxes, see Chapter 14. ASC
740-10-50-17 contains disclosure requirements specific to separate financial statements
of a member of a consolidated filing group. Further, ASC 740-10-50-17A requires an
entity that is not subject to tax and is disregarded by the taxing authority to disclose
that an allocation of income taxes has been made in the separate financial
statements.
8.7.1 Disclosures in Separate or Carve-Out Financial Statements to Be Included in a Filing With the SEC
The disclosures required by ASC 740-10-50-17 help financial
statement users understand how current and deferred income taxes were allocated, as
required by ASC 740-10-30-27, to a member in its separate financial statements. The
disclosures also help inform users about how that allocation method differs, if at
all, from the terms of any tax-sharing agreements of the member, its parent, and its
affiliates.
However, as SAB Topic 1.B.1 states, the disclosures do not provide information needed
to help financial statement users understand “what the effect on income would have
been if the registrant had not been eligible to be included in a consolidated income
tax return with its parent.” For example, the disclosures required by ASC
740-10-50-17 do not describe either the (1) nature of DTAs and DTLs, NOLs, and tax
credit carryforwards or (2) uncertain tax positions of the consolidated return group
that are attributable to the assets, liabilities, operations, and tax positions of
the member.
Therefore, while it is not clear in ASC 740-10-50-17, we believe
that the separate financial statements of a member that will be included in a filing
with the SEC should generally provide the disclosures required by ASC 740-10-50-17
in addition to the disclosures required by ASC 740-10-50-2 through 50-16,
particularly in situations in which a method other than the parent-company-down
approach is used to compute the tax allocation included in the financial statements.
We believe that the same is true for carve-out financial statements that will be
included in a filing with the SEC.
In addition, as discussed in Section 8.3.2, a
pro forma income statement reflecting a tax provision calculated on a
separate-return basis is required if the separate or carve-out financial statements
include an allocation of current and deferred income taxes that uses a method other
than the separate-return method.
8.7.2 Disclosures in Separate or Carve-Out Financial Statements That Will Not Be Included in a Filing With the SEC
If a member’s separate or carve-out financial statements will not be included in a
filing with the SEC, the disclosures required by ASC 740-10-50-17 may be provided
in lieu of those required by ASC 740-10-50-2 through 50-16. However, we
do not believe that this is preferable for the reasons discussed above. Further,
such financial statements may need to provide income tax disclosures other than
those specifically required by ASC 740-10-50-17 when, for example, income tax
matters affecting a member or carve-out entity are critical to users’ understanding
of the financial statements. The circumstances under which additional disclosures
should be provided in such financial statements are a matter of judgment, and
consultation with accounting advisers is recommended.
If the separate financial statements are those of a single-member
LLC and no allocation of income taxes has been made, the single-member LLC should
disclose that fact in the notes to the separate financial statements and the reasons
why.
8.7.3 Disclosures in Abbreviated Separate or Carve-Out Financial Statements
See Section
8.2.5 of this Roadmap, Section 5.2.4 of Deloitte’s Roadmap Carve-Out Financial
Statements, and Section 1.5 of Deloitte’s Roadmap SEC Reporting Considerations for Business
Acquisitions for further discussion of when abbreviated
financial statements may be appropriate.
When abbreviated separate or carve-out financial statements of a business acquired or
to be acquired are prepared with no income tax allocation, an entity should disclose
in the footnotes to the historical abbreviated statements that no allocation of
income tax has been made. It may also be appropriate to include an explanatory
paragraph in the independent accountant’s report that (1) indicates that no income
tax expense or benefit has been recognized in the statement of revenues and expenses
and (2) provides a reference to the appropriate footnote that further discusses the
matter.