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11.8 Measuring the tax effects of outside basis differences
Publication date: 31 Dec 2023
us Income taxes guide
ASC 740-10-55-23 to ASC 740-10-55-24 provide guidance with respect to measuring the tax effect of an outside basis difference.
The tax rate or rates that are used to measure deferred tax liabilities and deferred tax assets are the enacted tax rates expected to apply to taxable income in the years that the liability is expected to be settled or the asset recovered. Measurements are based on elections (for example, an election for loss carryforward instead of carryback) that are expected to be made for tax purposes in future years. Presently enacted changes in tax laws and rates that become effective for a particular future year or years must be considered when determining the tax rate to apply to temporary differences reversing in that year or years. Tax laws and rates for the current year are used if no changes have been enacted for future years. An asset for deductible temporary differences that are expected to be realized in future years through carryback of a future loss to the current or a prior year (or a liability for taxable temporary differences that are expected to reduce the refund claimed for the carryback of a future loss to the current or a prior year) is measured using tax laws and rates for the current or a prior year, that is, the year for which a refund is expected to be realized based on loss carryback provisions of the tax law. See Examples 14 through 16 (paragraphs 740-10-55-129 through 55-138) for illustrations of this guidance.
Deferred tax liabilities and assets are measured using enacted tax rates applicable to capital gains, ordinary income, and so forth, based on the expected type of taxable or deductible amounts in future years. For example, evidence based on all facts and circumstances should determine whether an investor’s liability for the tax consequences of temporary differences related to its equity in the earnings of an investee should be measured using enacted tax rates applicable to a capital gain or a dividend. Computation of a deferred tax liability for undistributed earnings based on dividends should also reflect any related dividends received deductions or foreign tax credits, and taxes that would be withheld from the dividend.
All facts and circumstances should be considered when determining whether temporary differences should be measured using the enacted tax rates applicable to a capital gain or a dividend. This is not an accounting policy election. The assumed manner of recovery and related tax consequences should be determined / re-assessed each reporting period. Among other factors, consideration should generally be given to:
- History of paying dividends (from accumulated earnings)
- Ability to control or influence dividend payments
- Intentions for the investment and any history of disposing of comparable investments
- Other significant shareholders with ability or influence to either force a disposal of the investment or dividend payments
- Entity’s liquidity and capital requirements
- Legal considerations and the availability of market disposal options
- Tax planning opportunities that would influence the disposal structure/consequences
- Whether the investment represents an integral component of the overall business or long-term strategic plans
To calculate or measure the tax effect of an outside basis difference, a realistic and reasonable expectation as to the time and manner in which such a difference is expected to be recovered must be determined. Taxes provided should reflect the expected form of repatriation (e.g., dividend, sale or liquidation, or loan to the parent), the character of taxable income that the repatriation will generate (e.g., ordinary versus capital gain), and the effect of any foreign tax credits that the repatriation would generate.
11.8.1 Considerations for domestic and foreign outside basis differences
When outside basis differences of domestic subsidiaries, foreign subsidiaries, and corporate joint ventures do not qualify for any of the exceptions for recording deferred taxes in ASC 740 (e.g., tax-free recovery of investment, indefinite reversal criteria), all tax effects of reversal should be included in the parent company’s deferred tax computations. The deferred tax liability for the outside basis difference should be based on the tax treatment resulting from the expected manner of recovery. Therefore, if the company expects to recover all or a portion of the outside basis difference through distributions, the company must consider the applicable provisions in the tax law (e.g., a dividend received deduction, state taxes, withholding taxes, FTCs) in the calculation of the deferred tax liability. The US federal and state outside basis differences may also include foreign currency gains/losses on previously taxed income (PTI) or other currency translation that could be taxable (collectively, “taxable foreign currency gains/losses”) which also need to be considered.
Some jurisdictions apply a different tax rate to earnings based on whether the earnings are retained or distributed. The guidance related to these dual-rate jurisdictions should be considered and applied consistently when measuring deferred taxes related to the foreign entity’s inside basis differences and the parent’s outside basis difference (see TX 4.3.3.6). Additionally, if the outside basis difference is expected to be recovered through sale, the applicable tax law that applies to sale transactions (e.g., capital gains tax treatment) should be considered in the calculation of the deferred tax liability.
As previously mentioned, withholding taxes and realizable FTCs should generally be considered when measuring the deferred tax liability on outside basis differences. That is, a net amount should be presented, instead of reflecting both a deferred tax liability for withholding taxes and a deferred tax asset for future FTCs on the withholding taxes. Conversely, reporting entities that do not expect to be able to realize any tax benefit from FTCs that are created as a result of paying withholding tax in the future should not include them in measuring the deferred tax liability. Refer to TX 13.3.1 for discussion of taxes on foreign currency transaction gains and losses.
Example TX 11-4 discusses the recognition of a deferred tax liability for withholding taxes when an entity does not assert indefinite reinvestment.
EXAMPLE TX 11-4
Accounting for a deferred tax liability related to withholding taxes
Accounting for a deferred tax liability related to withholding taxes
On January 1, 20X1, Company A, a US corporation, acquired 100% of Subsidiary B, a foreign corporation, for $100 million. On the date of acquisition, the outside book and tax basis of the investment were equal at $100 million. During 20X1, Subsidiary B generated $10 million of financial reporting income for US GAAP purposes. During 20X1, Subsidiary B has $8 million in earnings for both local statutory purposes and US tax purposes (i.e., US earnings and profits or E&P). The difference in the US GAAP and statutory income is attributable to a timing difference. On December 31, 20X1, Company A has a $110 million outside GAAP basis in Subsidiary B and $100 million in tax basis resulting in a gross outside basis temporary difference of $10 million.
Company A does not assert indefinite reinvestment in Subsidiary B. Company A’s expected manner of recovery of the basis difference in Subsidiary B is through dividend distributions.
The foreign jurisdiction assesses a 10% withholding tax on dividend distributions from Subsidiary B to Company A based on the amount of dividends distributed. In the foreign jurisdiction, dividend distributions cannot be made if the distribution is in excess of distributable reserves (e.g., local statutory basis). Due to this limitation, the company’s intent is to repatriate $10 million in the future only after the $2 million temporary difference reverses. No additional US tax will be incurred by Company A upon dividend distribution. For simplicity, this example assumes Company A is not able to realize the benefit from any foreign tax credits. Company A accounts for GILTI as a period cost.
How should Company A measure the outside basis difference in Subsidiary B?
Analysis
We believe Company A should recognize a deferred tax liability of $1 million ($10 million x 10%) for withholding taxes.
Company A's financial statements are prepared under US GAAP and Company A's expected recovery of the basis difference in Subsidiary B is through dividend distributions. In future periods, local retained earnings will "catch up" to US GAAP retained earnings. ASC 740-10-25-20 provides that the deferred tax accounting model is predicated on the assumption that assets will be recovered at their carrying amounts. Since the earnings subject to withholding taxes have already been recognized on a US GAAP basis, the measurement of the outside basis difference of Subsidiary B should also include those earnings.
11.8.2 Considerations for equity method investments
Deferred taxes should be provided with respect to the entire outside basis difference, including unremitted earnings, of investments accounted for under the equity method. Refer to TX 11.6 for further discussion. For the unremitted earnings of an equity method investee, the assumed pattern and type of future taxable income should be based on the expected method of recovery (i.e., dividends or sale). If the payment of dividends is unlikely, the investor may have to assume recovery through sale of the investment. Accordingly, the investor would need to consider whether the gain or loss on disposal would be capital or ordinary in nature. This may result in deductible temporary differences and/or capital loss carryforwards that would be realizable only if sufficient capital gains can be expected.
If an equity investee has paid dividends in excess of current year earnings in the past and that practice is expected to continue in the future, it may be appropriate to assume that the basis difference will reverse through dividend distributions. Accordingly, if an investor is in a jurisdiction where dividends are not taxable due to a dividend received deduction or are, in effect, a return of capital not subject to tax, it may be appropriate not to record a deferred tax liability. However, if the investee has not paid dividends, or has always paid dividends only from current year earnings, and there is no indication that the practice will change in the future, it may be appropriate to assume that the basis difference will reverse through a disposal. In that case, the investor would measure the deferred tax liability at the capital gains rate, even if it has no intention of disposing of the equity investment in the foreseeable future.
Calculating the deferred taxes using the tax rate applicable to dividends would typically be appropriate only in relation to the underlying earnings and profits of the investee (this could include E&P accumulated prior to the investor’s purchase), adjusted for anticipated changes in E&P that will result from reversals of the investee’s temporary differences prior to the distributions.
Any difference (positive or negative) between the investor’s cost and the value of the underlying net assets of the investee would be amortized by the investor as part of its equity method accounting. To the extent that such amortization represents eventual capital gain or loss, investor taxes should be provided, assuming capital treatment. When assessing realizability, recognition of the benefits of capital loss is appropriate only if sufficient positive evidence exists to indicate that necessary future capital gains to support realization will be generated.
As facts and expectations change, evidence may accumulate over time supporting a shift from a dividend to disposal assumption or vice versa. Disclosure of the reversal assumption along with the possibility of near-term changes that could have a significant accounting or liquidity impact may be appropriate.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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