5.9 Income Taxes
An IPO typically increases the complexity of accounting for income taxes. For
example, in an IPO involving a carved-out portion of a larger entity, the tax
provision may be prepared for the first time for multiple periods, in which case an
entity may be required to use significant judgment in assessing the accounting and
presentation of income taxes. Irrespective of whether the registrant is a carve-out
or an existing business, however, changes in tax status, predecessor/successor
issues, and other transactions with shareholders in connection with an IPO result in
complexities in the calculation and presentation of the income tax provision for the
pre- and post-IPO periods. In addition, for interim reporting, possible limitations
on future deductions may need to be assessed as well as additional disclosure
requirements.
The income tax accounting and reporting requirements can be complex
for entities that are preparing an initial registration statement. For more detailed
considerations related to accounting for income taxes, see Deloitte’s Roadmap
Income
Taxes.
In addition to the accounting and reporting issues addressed in these sections,
management should consider working with tax advisers to determine the income tax
implications of an IPO. Tax advisers often add value to the IPO process by
identifying income tax or transaction tax matters that may be material to the
IPO.
5.9.1 Separate or Carve-Out Financial Statements
One of the major activities associated with an IPO is
preparation of the financial statements that will be included in the
registration statement. Financial statements often need to include assets and
operations of some subcomponent of a larger consolidated reporting entity. Such
financial statements are commonly referred to as “separate” or “carve-out”
financial statements.
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. 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.”
Current and deferred income taxes must be allocated to separate and carve-out
financial statements prepared in contemplation of an IPO. The allocation of
income taxes in carve-out financial statements included in an SEC filing 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 in accordance with Rule
3-05).
Deloitte’s Roadmap Carve-Out Financial Statements discusses general
accounting issues that often arise in connection with the preparation of
separate or carve-out financial statements, and Chapter 8 of Deloitte’s Roadmap Income Taxes
discusses the methods used in practice to allocate income taxes into separate or
carve-out financial statements and common issues that occur.
5.9.2 Change in Tax Status
5.9.2.1 General
For general income tax accounting guidance on accounting for
the effects of a change in tax status of a reporting entity, see Section 3.5.2 of Deloitte’s Roadmap
Income
Taxes. Also see Section 5.9.6.3 of this Roadmap for
more information regarding pro forma reporting disclosures that may be
triggered by a change in status.
5.9.2.2 Nontaxable to Taxable
In connection with an IPO, it is common for a preexisting entity to be converted
from a nontaxable entity (e.g., a partnership) to a taxable entity (e.g., a
taxable C corporation). While this conversion may seem straightforward, the
change in status is often effected through a series of complex transactions.
One mechanism for doing this conversion is referred to informally as an
“Up-C” transaction. In Up-C transactions, the historical partners in a
partnership (the “founders”) establish a C corporation (the “Up-C”) to serve
as the IPO vehicle. The Up-C is the entity that will ultimately issue its
shares to the public and become the SEC registrant. In addition, the Up-C
often uses the IPO proceeds to acquire an incremental ownership interest in
the partnership from current owners.
Depending on the nature of the predecessor and successor entities and the
resulting structure, it is common under U.S. tax law for a step-up in tax
basis to occur, in which case an entity would be required to recognize DTAs
and deferred tax liabilities (DTLs) that net to an amount equivalent to the
tax effect of a gain recognized by the former partners.
Sections 3.5.2.3,
6.2.7.2,
and 11.7.4.1 of
Deloitte’s Roadmap Income Taxes provide detailed guidance on a
successor entity’s accounting for the recognition of income taxes when the
predecessor entity is nontaxable.
5.9.2.2.1 Tax Receivable Agreements
In connection with an IPO, many Up-Cs enter into tax
receivable agreements (TRAs) related to certain tax attributes (e.g., a
net operating loss carryforward) or certain tax effects of the IPO
transaction (e.g., a step-up in tax basis of the assets and liabilities
of the IPO company). TRAs are often entered into between the Up-C and
its previous owners to compensate the previous owners for these
attributes and tax effects. Such tax attributes and tax effects may be
realized by the public company after the IPO, resulting in a required
payment under the TRA. Entities that encounter TRAs or similar
agreements should consult with their tax and accounting advisers to
determine the appropriate accounting treatment.
5.9.2.3 Taxable to Nontaxable
In connection with an IPO, a parent may plan to contribute
“unincorporated” assets, liabilities, and operations of a division or
disregarded entity to a new company (i.e., a “newco”) at or around the time
of the transaction. The newco is typically established to serve as the IPO
vehicle (i.e., it is the entity that will ultimately issue its shares to the
public) and, therefore, ultimately becomes an SEC registrant. In some
instances, income taxes will be allocated in the financial statements of the
predecessor division or disregarded entity in periods before the IPO but the
successor newco will be a nontaxable entity after the IPO. In that case, the
successor newco will not include deferred taxes in its financial statements
after the IPO. For detailed guidance on the accounting for the elimination
of income taxes allocated to a predecessor entity when the successor entity
is nontaxable, see Sections 3.5.2.4 and 11.7.4.2 of Deloitte’s Roadmap
Income
Taxes.
5.9.3 Tax Consequences of Transactions Among or With Shareholders
Certain transactions between an entity and its shareholders that occur during an
IPO may affect an entity’s tax attributes and may also change the tax bases of
its assets and liabilities. For example, an IPO may significantly change the
composition of shareholders, which can trigger tax consequences for the entity
undertaking the IPO.
For detailed guidance on the accounting for tax consequences of
transactions among or with shareholders, see Section 6.2.6 of Deloitte’s Roadmap
Income
Taxes.
5.9.4 Interim Reporting
Before an IPO, an entity may not have been subject to interim reporting
requirements and therefore may be unfamiliar with the guidance in ASC 740-270.
The core principle of ASC 740-270 is that the interim period is integral to the
entire financial reporting year. Thus, annual income tax expense must be
allocated to an entity’s interim financial statements. A major part of the
allocation process is estimating the annual effective tax rate (AETR), which
will need to be updated in each interim reporting period.
The AETR is based on estimates of income by jurisdiction, the
impact of operating losses, changes in valuation allowances, and utilization of
tax credits. These estimates are further complicated when a change in tax law or
income tax rates occurs in an interim period. Taxable transactions that are
accounted for outside of ordinary income must also be considered when an entity
estimates discrete tax consequences or benefits. Such transactions must be
recognized in the interim period in which they occur and be presented in the
appropriate components of the financial statements.
For detailed guidance on interim reporting requirements, see Chapter 7 of Deloitte’s Roadmap Income Taxes.
5.9.5 Tax Effects of Executive and Employee Compensation
5.9.5.1 Limitations on Future Compensation Deductions
IRC Section 162(m) limits the deductibility of cash and share-based payment
awards issued by an entity that is a “publicly held corporation” for Section
162(m) purposes. The definition of a publicly held corporation includes
entities subject to registration of securities under Section 12 or entities
required to file reports under Section 15(d) of the Exchange Act. The
statute specifically limits the deductibility of compensation paid to a
company’s CEO and CFO as well as its three other highest paid officers
(referred to collectively as the “covered employees”). Under IRC Section
162(m), only the first $1 million in compensation (whether cash or
share-based remuneration) paid to a covered employee is deductible for tax
purposes in any given year. Once an individual becomes a covered employee,
the individual remains a covered employee each year during the period of
employment and thereafter, including after termination and death. Before the
enactment of the Tax Cuts and Jobs Act of 2017 (the “Tax Act”),
performance-based compensation was generally not subject to this limitation.
For detailed guidance on determining the deductibility of share-based payment
awards under IRC Section 162(m), see Section
10.2.3 of Deloitte’s Roadmap Income Taxes.
5.9.5.2 Share-Based Compensation
Private companies looking to go public often use share-based compensation
arrangements to attract and retain key employees, and the tax treatment of
those arrangements can have substantial tax effects on an entity and its
employees. Therefore, stakeholders should be aware of certain SEC focus
areas with respect to IPOs, including “cheap stock” issues resulting from
the issuance of equity instruments preceding an IPO, as well as a company’s
compliance with the requirements in IRC Section 409A. In some cases, issuing
cheap stock may result in unintended tax consequences for the grantor and
grantee of the share-based payment award. Therefore, it is important for an
entity to consult with tax advisers regarding the tax effects of both
existing and planned share-based compensation plans to determine whether the
requirements in IRC Section 409A or other IRC sections may apply.
See Sections 4.12.1
and 4.12.2 of
Deloitte’s Roadmap Share-Based Payment Awards for additional
discussion of cheap stock and IRC Section 409A, respectively.
5.9.6 Additional Disclosure Requirements
5.9.6.1 Disclosures in the Financial Statements
An entity that becomes a public registrant may be required to provide additional
disclosures about its income taxes that were not required in prior financial
statements. In addition to providing the disclosures described below, public
entities must present, under Regulation S-X, Rule 12-09, a “[l]ist, by major
classes, [of] all valuation and qualifying accounts and reserves not
included in specific schedules,” including valuation allowances related to
DTAs. This list may be included as a supplemental schedule in an entity’s
annual filings or may be included in the financial statement footnotes, and
the schedule must contain a rollforward of such accounts, showing additions
and deductions throughout the year.
Other possible income-tax-related disclosure requirements for public entities
include the following:12
- Change in status.
- Unrecognized tax benefits.
- Deferred taxes.
- Rate reconciliation.
- Income tax expense.
See Chapter 14 and Appendix D of Deloitte’s Roadmap
Income
Taxes for further discussion of the financial reporting
matters listed above, including sample disclosures provided in accordance
with the accounting and disclosure requirements of Regulation S-K and
Regulation S-X.
Changing Lanes
In December 2023, the FASB issued ASU 2023-09, which establishes
new income tax disclosure requirements in addition to modifying and
eliminating certain existing requirements. The ASU is intended to
improve the usefulness of information provided to financial
statement users about an entity’s income taxes and addresses
investors’ requests for greater transparency by enhancing the
disclosure requirements related to the rate reconciliation and
income taxes paid. Some of the disclosure requirements already
existed in Regulation S-X, while others are new requirements that
the FASB staff believes will improve the effectiveness of financial
reporting. Many of the new disclosure requirements apply only to
PBEs. The ASU’s amendments are effective for PBEs for fiscal years
beginning after December 15, 2024 (2025 for calendar-year-end PBEs),
and early adoption is permitted. Entities other than PBEs have an
additional year to adopt the guidance. Accordingly, preparers
anticipating an IPO in the near future should consider the ASU’s
impact on the disclosure requirements for PBEs.
5.9.6.2 Disclosures Outside the Financial Statements — MD&A
As described in more detail in Section 4.3, public entities are also
required to include MD&A in their public filings. Discussion and
analysis of income taxes is an important part of an entity’s MD&A since
income taxes can be a significant factor in the entity’s operating results.
Such discussion should address the following (if material):
- CAEs — The determination of income tax expense, DTAs and DTLs, and unrecognized tax benefits inherently involves several CAEs of current and future taxes to be paid. Management should provide information about the nature of these estimates in MD&A.
- Liquidity and capital resources — The SEC staff expects registrants to disclose (1) the amount of cash and short-term investments held by foreign subsidiaries that would not be available to fund domestic operations unless the funds were repatriated and (2) whether additional tax expense would need to be recognized if the funds are repatriated. Although we expect this issue to be less prevalent than it was historically, an entity may still be subject to income tax on its foreign investments (e.g., foreign exchange gains or losses on distributions and withholding taxes).
A tabular disclosure of contractual obligations and
disclosures about off-balance-sheet arrangements are no longer required.
Regulation S-K, Item 303(b), does require a registrant to include an
analysis of “material cash requirements from known contractual and other
obligations” in the discussion of liquidity and capital resources. This
discussion should take into account the entity’s unrecognized tax
benefits.
In addition to discussion concerning the current-year
operations, Regulation S-K, Item 303(a), requires entities to provide
certain forward-looking information related to “material events and
uncertainties known to management that are reasonably likely to cause
reported financial information not to be necessarily indicative of future
operating results or of future financial condition.”
Many tax-related events and uncertainties may need to be
clarified in MD&A. For instance, before the enactment of tax law
proposals or changes to existing tax rules, an SEC registrant should
consider whether the potential changes represent an uncertainty that
management reasonably expects could have a material effect on the
registrant’s results of operations, financial position, liquidity, or
capital resources. If so, the registrant should consider disclosing
information about the scope and nature of any potential material effects of
the changes.
After the enactment of a new tax law (e.g., the Organisation
for Economic Co-operation and Development’s [OECD’s] Pillar Two global
minimum tax), registrants should consider disclosing, when material, the
anticipated current and future impact of the law on their results of
operations, financial position, liquidity, and capital resources. In
addition, registrants should consider providing disclosures in the CAEs
section of MD&A to the extent that the changes could materially affect
existing assumptions used in estimating tax-related balances.
The SEC staff also expects registrants to provide
early-warning disclosures to help users understand various risks and how
these risks potentially affect the financial statements. Examples of such
risks include situations in which (1) the registrant may have to repatriate
foreign earnings to meet current liquidity demands, resulting in a tax
payment (e.g., withholding taxes) that may not be accrued for; (2) the
historical effective tax rate is not sustainable and may change materially;
(3) the valuation allowance on net DTAs may change materially; and (4) tax
positions taken during the preparation of returns may ultimately not be
sustained. Early-warning disclosures give investors insight into
management’s underlying assumptions as well as the conditions and risks an
entity faces before a material change or decline in performance is
reported.
Appendix
D of Deloitte’s Roadmap Income Taxes contains sample
disclosures provided in accordance with the accounting and disclosure
requirements of Regulation S-K and Regulation S-X.
5.9.6.3 Pro Forma Disclosures
In connection with an IPO, certain income-tax-related events or transactions
may occur for which disclosure of pro forma financial information would be
required in the registrant’s filing under Regulation S-X, Article 11. Such
events or transactions may include termination or revision of tax or other
cost-sharing agreements or a change in a registrant’s tax status (e.g., an
issuer was formerly a partnership or similar pass-through entity for tax
purposes). A registrant may be required to provide pro forma financial
information in such circumstances if the transaction is material to the
registrant’s financial statements. See Section
4.4 for additional discussion of pro forma financial
information.
5.9.7 Resource Considerations
An IPO can cause substantial changes to an entity’s income taxes. To
appropriately address the income tax accounting implications of going public, it
is critical for an entity to obtain sufficient resources and establish
appropriate accounting processes and internal controls well in advance of the
IPO.
Specifically, entities should consider the resources they need to address the following:
- Tax department participation in preparation of initial and ongoing SEC filings.
- Availability, accuracy, and timeliness of income-tax-related information used for financial reporting.
- Accumulation of income-tax-related information for required historical audited financial statements.
- Income-tax-related disclosure requirements that specifically apply to public companies.
- Augmenting or revisiting current internal controls and preparation for certification in connection with the effectiveness of income-tax-related internal controls. See Sections 6.11 and 7.5 for considerations and requirements related to ICFR.
- An entity undergoing an IPO will also encounter many tax issues beyond accounting for income taxes (e.g., issues associated with tax planning and the IRS requirements for public companies).
Footnotes
12
Note that other tax-related disclosure requirements
may apply to particular transactions.