The financial difficulties a reporting entity may experience prior to a bankruptcy filing may have certain income tax accounting consequences, particularly with respect to management’s assertions regarding indefinite reinvestment of foreign subsidiaries, long-term investment nature of intercompany loans, recoverability of investments in domestic subsidiaries, and realizability of deferred tax assets. Such income tax considerations are further discussed in the following sections.

2.7.1 Foreign subsidiaries (pre-bankruptcy)

Reporting entities may assert that book-over-tax outside basis differences attributable to a foreign subsidiary will be indefinitely reinvested and, thus, not provide for parent-level deferred taxes on such earnings under the guidance of ASC 740, Income Taxes. In advance of a bankruptcy filing, however, it may be difficult to continue to support this assertion if the financial condition of a parent is such that at least some of the outside basis difference might need to be repatriated to fund the domestic cash flow needs of the parent. In this instance, a deferred tax liability may need to be established for all or a portion of the foreign subsidiary's outside basis difference.
Additionally, reporting entities may assert that intercompany loans with foreign subsidiaries are of a long-term investment nature (i.e., settlement is not planned or anticipated in the foreseeable future), which allows for gains and losses on the related foreign currency translations to be excluded from net income. Reporting entities that treat such loans as long-term may assert indefinite reinvestment and not provide for deferred taxes on these gains and losses, which are recognized in other comprehensive income. Similar to the indefinite reinvestment assertion, reporting entities may find it challenging to continue to assert that intercompany foreign currency loans will not be settled in the foreseeable future and may need to recognize gains and losses prospectively in net income and establish deferred taxes on the accumulated foreign currency translation through an adjustment to income tax expense.

2.7.2 Domestic subsidiaries (pre-bankruptcy)

Under the guidance of ASC 740, reporting entities are not required to provide for deferred taxes on outside basis differences in domestic subsidiaries based on an assertion that they have the ability and intent to recover the amount of their investment in a tax-free manner. In advance of a bankruptcy filing, it may be difficult to continue to support this assertion if, for instance, a disposal of the subsidiary may be required to fund cash flow needs.

2.7.3 Valuation allowance considerations (pre-bankruptcy)

Reporting entities should consider the need for valuation allowances against deferred tax assets in advance of a bankruptcy filing. Given the nature of events that typically precede a bankruptcy filing, including ongoing operating losses, deteriorating credit conditions, etc., it may be more likely than not that the tax benefits from deferred tax assets will not be realized and that a valuation allowance should be recorded. Careful consideration should be given to the reporting entity's history of operating losses and the impact that a bankruptcy filing could have on the reporting entity's ability to utilize deferred tax assets in the future. The assumptions, such as earnings projections, used in assessing the realizability of deferred tax assets should be consistent with assumptions used in impairment testing and consideration of the reporting entity's ability to continue as a going concern. This assessment will often lead to a conclusion that a valuation allowance is required prior to a bankruptcy filing.
The impact on net income from certain changes may be amplified when a full valuation allowance is recorded. For example, charges for items such as long-lived asset impairments that typically give rise to a deferred tax asset will not be reduced by a tax benefit when a reporting entity has recorded a full valuation allowance. For further discussion on valuation allowance assessments see TX 5.
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