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ASC 740-30-25 reflects the general rule that book-over-tax (taxable) outside basis differences, whether attributable to undistributed earnings or other factors, related to a subsidiary or corporate joint venture should be presumed to reverse in the foreseeable future.

ASC 740-30-25-3

It shall be presumed that all undistributed earnings of a subsidiary will be transferred to the parent entity. Accordingly, the undistributed earnings of a subsidiary included in consolidated income shall be accounted for as a temporary difference unless the tax law provides a means by which the investment in a domestic subsidiary can be recovered tax free.

ASC 740-30-25-4

The principles applicable to undistributed earnings of subsidiaries in this Section also apply to tax effects of differences between taxable income and pretax accounting income attributable to earnings of corporate joint ventures that are essentially permanent in duration and are accounted for by the equity method. Certain corporate joint ventures have a life limited by the nature of the venture, project, or other business activity. Therefore, a reasonable assumption is that a part or all of the undistributed earnings of the venture will be transferred to the investor in a taxable distribution. Deferred taxes shall be recorded in accordance with the requirements of Subtopic 740-10 at the time the earnings (or losses) are included in the investor's income.

ASC 740-30-25-18 provides an exception for any book-over-tax basis difference attributable to a domestic subsidiary or to a corporate joint venture that is essentially permanent in duration that arose in fiscal years beginning on or before December 15, 1992. That exception is essentially the same as the “indefinite reversal” exception applicable to outside basis differences in foreign subsidiaries that exists today. The remainder of this chapter assumes any temporary differences in question arose in fiscal years beginning after December 15, 1992.

11.3.1 Book-over-tax outside basis difference—domestic sub/joint venture

ASC 740-30-25-7 states that an excess book-over-tax outside basis difference “is not a taxable temporary difference if the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the entity expects that it will ultimately use that means.” See TX 11.3.2 for discussion of the implications when a reporting entity has the ability to recover an investment in a tax-free manner. The guidance in ASC 740-30-25-5 specific to domestic subsidiaries should also be considered when evaluating whether a reporting entity would be required to record a deferred tax liability on the outside book-over-tax basis difference of a domestic corporate joint venture that is essentially permanent in duration.

11.3.2 Tax-free recovery of investment

In the case of a US subsidiary that is at least 80% owned, US tax law provides several means by which the investment can be recovered tax-free, including liquidating or merging the subsidiary into the parent, spin-offs, split-offs, and other forms of reorganization. As long as the US parent has the ability to use a tax-free means of recovery and expects to ultimately use that means to recover its outside basis difference, it should not record a deferred tax liability for the book-over-tax basis difference.
The ability to recover the investment utilizing one of the tax-free alternatives must be within the control of the reporting entity. For example, assume that a US parent corporation has a wholly-owned US subsidiary that is a regulated entity. A tax-free liquidation or merger of that entity into the parent may not be possible without regulatory approval. If regulatory approval is more than perfunctory, the parent corporation cannot assert that its basis in the subsidiary can be recovered on a tax-free basis.
Other jurisdictions may have similar tax-free liquidation and merger rules that should be considered in assessing whether outside basis in a same-jurisdiction subsidiary can be recovered tax-free. Importantly, the assessment must be performed with respect to each subsidiary to determine if the applicable tax law provides a means of recovering the outside basis difference tax-free.
If a subsidiary is less than 80% owned, but more than 50% owned, the parent may still be able to assert that the basis difference can and is expected to be recovered tax-free if the parent is able to (and expects to) effectuate the acquisition of the additional ownership necessary to avail itself of any tax-free means to recover the outside basis difference. Note that the parent must be able to acquire the additional ownership at no significant additional cost (see TX 11.3.2.1) and must continue to reassess that ability at each reporting date. If, at any point, the parent determines that it is not able to acquire the additional interest without significant cost, a deferred tax liability would be recorded on the outside basis difference in the current period.
Example TX 11-2 illustrates a circumstance when the tax-free recovery of an investment in a domestic subsidiary is not available.
EXAMPLE TX 11-2
Recording an outside basis deferred tax liability when an investment in a domestic subsidiary is impaired for tax purposes
Company A, a Luxembourg company, owns 100% of the stock of Company B, which is also a Luxembourg company. For local statutory and income tax reporting purposes, Company A is required to annually determine the fair value of its investment in Company B and recognize an impairment if the fair value is lower than the statutory carrying value. Company A performs this assessment in the current year and concludes that its investment in Company B is impaired. The resulting write-down is currently deductible for Luxembourg income tax purposes. Based on the underlying net assets of the entity and applicable US GAAP, however, no asset impairments are recognized for book purposes. This write-down represents the only difference between the book and tax basis in Company A’s investment in Company B (i.e., its outside basis).
Ordinarily, under Luxembourg tax law, a parent company may liquidate or dispose of a subsidiary and receive dividends in a tax-free manner. However, the tax deductible write-down is subject to recapture if the value of the investment increases in future periods. That is, to the extent the investment value increases, the write-down must be recaptured into taxable income. Company A has no intention of selling its investment in Company B or liquidating the subsidiary. In fact, Company A will continue to operate Company B and hopes to “turn around” the investment.
Does Company A need to record a deferred tax liability for the excess book-over-tax basis in its investment in Company B?
Analysis
Yes. ASC 740-30-25-5 and ASC 740-30-25-7 require that deferred taxes be provided on a book-over-tax outside basis difference in a domestic subsidiary unless the tax law provides a means by which the reported amount of that investment can be recovered tax-free and the entity expects that it will ultimately use that means. In this situation, Company A is planning to continue operating Company B and, therefore, it does not have the ability to avoid potential recapture of the tax benefit claimed for the tax write-down of the investment in Company B. Accordingly, Company A should record a deferred tax liability on its US GAAP books for the outside basis difference related to its investment in Company B. This is consistent with the assumption in ASC 740-10-25-20 that assets and liabilities are expected to be recovered or settled at their financial statement carrying amount. If the investment in Company B were recovered at its financial statement carrying amount, there would a tax consequence.

11.3.2.1 Tax-free recovery of basis—meaning of “significant cost”

Under ASC 740-30-25-8, if a parent corporation does not own the requisite percentage of a domestic subsidiary’s stock to effectuate a tax-free recovery of the outside basis, the parent may still be able to assert that it expects to recover its outside basis difference in the subsidiary tax-free, as long as it can do so without incurring “significant cost.”

ASC 740-30-25-8

Some elections for tax purposes are available only if the parent owns a specified percentage of the subsidiary’s stock. The parent sometimes may own less than that specified percentage, and the price per share to acquire a noncontrolling interest may significantly exceed the per-share equivalent of the amount reported as noncontrolling interest in the consolidated financial statements. In those circumstances, the excess of the amount for financial reporting over the tax basis of the parent’s investment in the subsidiary is not a taxable temporary difference if settlement of the noncontrolling interest is expected to occur at the point in time when settlement would not result in a significant cost. That could occur, for example, toward the end of the life of the subsidiary, after it has recovered and settled most of its assets and liabilities, respectively. The fair value of the noncontrolling interest ordinarily will approximately equal its percentage of the subsidiary’s net assets if those net assets consist primarily of cash.

A cost to purchase a noncontrolling interest that significantly exceeds its book value would represent a significant cost. Essentially “significant cost” means any significant fair value premium over book value to acquire the noncontrolling interest. In an “end of life” scenario, once the subsidiary’s net assets have been converted to cash and it has no significant unrecorded intangible assets or contingent liabilities, the cost to acquire the noncontrolling interest in the subsidiary would generally approximate its book value. At that time, acquisition of the noncontrolling interest would not involve a significant cost. As a result, when making the assessment, even in a period prior to the period in which “end of life” is reached, the parent corporation could likely conclude that it could acquire the requisite noncontrolling interest without significant cost and avail itself of a tax-free liquidation or merger. As such, the parent would not need to record the tax impact of any book-over-tax outside basis difference. If a parent has not provided deferred taxes based on such an “end of life” scenario, the entity would need to monitor for changes in facts and expectations and consider whether it must provide deferred taxes on its outside basis difference as a result of those changes.

11.3.2.2 Potential state tax considerations—outside basis differences

It is possible that the outside basis difference of a US subsidiary may constitute a temporary difference for state tax purposes, even if it is not a temporary difference for federal tax purposes. However, if the US parent is able to project that the outside basis difference will ultimately be recovered in a liquidation that is tax-free for federal purposes, it may be able to avoid a provision for state taxes.
Note that while this section refers specifically to state taxes in a US context, the principles would be applicable for similar sub-jurisdiction (e.g., provincial, cantonal, local) taxes in other countries.
In some cases, a tax-free liquidation may not be available in all states in which the parent files returns. Nevertheless, the outside basis may not be a temporary difference for certain states. For example, a temporary difference does not arise if the unremitted earnings are eventually expected to be remitted as dividends in a jurisdiction where there is a dividends-received deduction or where the parent and subsidiary file on a combined or consolidated basis and intercompany dividends are eliminated.
If it is expected that unremitted earnings will be received through a sale of the subsidiary’s shares, state tax will generally be avoided if the parent’s tax basis for state tax purposes has been increased by the subsidiary’s taxable income (i.e., no difference between inside and outside tax bases). This would be the case in states in which the parent files a combined or consolidated return with the subsidiary in which the federal consolidated return rules are followed.
The measurement of the deferred tax liability for unremitted earnings in a particular state would need to consider (1) whether the state permits or requires a combined method of reporting (and, if so, whether the subsidiary is engaged in a unitary business); (2) whether the dividends or gain on sale or liquidation will be treated as business or nonbusiness income; (3) which expected apportionment factor should be applied; and (4) whether a dividends-received deduction is available.

11.3.2.3 Consideration of lower-tier foreign subsidiaries

TX 11.3.2 discusses a scenario in which a parent can assume an ultimate tax-free liquidation of a domestic subsidiary that is less than 80% owned. However, if the domestic subsidiary owns a lower-tier foreign subsidiary, the parent must additionally consider whether its domestic subsidiary has asserted the indefinite reversal exception with respect to the lower-tier foreign subsidiary. If the domestic subsidiary has asserted indefinite reversal with respect to its foreign subsidiary, the parent would not be able to recover its investment in the domestic subsidiary without triggering the tax on the foreign subsidiary’s undistributed earnings or other outside basis differences.
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