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This section discusses other considerations related to the accounting for outside basis differences, including:
  • Variable interest entities
  • Changes from investee to subsidiary and from subsidiary to investee
  • Changes in a parent’s equity in the net assets of a subsidiary resulting from transactions with the noncontrolling shareholders
  • Tax-to-tax (inside versus outside) basis differences

11.9.1 Variable interest entities—outside basis differences

Under US GAAP, a reporting entity must consolidate any entity in which it has a controlling financial interest. Under the voting interest model, generally the investor that has voting control (usually more than 50% of an entity’s voting interests) consolidates the entity. Under the variable interest entity (VIE) model in ASC 810, Consolidation, the party that has the power to direct the entity’s most significant economic activities and the ability to participate in the entity’s economics consolidates the entity. This party could be an equity investor, some other capital provider, or a party with contractual arrangements. A reporting entity that consolidates a VIE is known as the primary beneficiary.
The impact of a consolidated VIE entity on the accounting for income taxes must be evaluated in each individual circumstance. The ASC Master Glossary defines subsidiary as “an entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as its parent, holds a controlling financial interest. (Also, a variable interest entity that is consolidated by a primary beneficiary.).” Hence, the income tax accounting guidance for subsidiaries applies to consolidated VIEs that are taxpaying entities.
In assessing the deferred tax consequences of outside basis differences in a consolidated VIE, we believe that the primary beneficiary’s ability to control reversal of the difference will be a significant factor in the analysis. Even though the implication of being a primary beneficiary in the VIE model is that the primary beneficiary has a controlling financial interest, in the deferred tax context, a more specific assessment of the primary beneficiary’s ability to control distributions or other transactions that would cause a taxable event to occur is necessary. We believe that an entity must be able to prevent distributions or other transactions that would cause a taxable event to occur in order to assert indefinite reversal of an outside basis difference. In many VIE scenarios, the primary beneficiary may control the most important aspects of the entity’s economics but may not have a majority shareholding that is often necessary to approve (or not approve) the payment of dividends or other distributions. Thus, in assessing an investor’s ability and intent to control the timing of the events that cause basis differences to reverse under ASC 740-30-25-17, an entity cannot assume control as it might in the case of a consolidated subsidiary under the voting interest model.
This same logic would apply to the exception to recognizing deferred tax assets in ASC 740-30-25-9. That is, the primary beneficiary must have the ability to control the timing of the events that cause the temporary difference to reverse in a taxable manner.
Entities with interests in VIEs for which they conclude that they are not the primary beneficiary should apply the equity method accounting guidance for equity method investments in TX 11.8.2.

11.9.2 Changes between investee and subsidiary

Deferred tax assets and liabilities must be recorded for outside basis differences in equity method investees. Determining if a change in an investment from an investee to a subsidiary (or vice versa) will give rise to an adjustment to deferred tax assets and liabilities can be impacted by whether the outside basis difference relates to a foreign or domestic entity. The change between investee and subsidiary can result from the investor/parent’s purchase or sale of stock held by other investors, as well as the investee/subsidiary’s transactions in its own shares.
New guidance
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. This guidance removes certain exceptions to the general principles of ASC 740 and simplifies several other areas. ASU 2019-12 is effective for public business entities for annual reporting periods beginning after December 15, 2020, and interim periods within those reporting periods. For all other entities, it is effective for annual periods beginning after December 15, 2021, and interim periods within annual periods beginning after December 15, 2022. Early adoption is permitted in any interim or annual period, with any adjustments reflected as of the beginning of the fiscal year of adoption. If an entity chooses to early adopt, it must adopt all changes as a result of the ASU. The transition provisions vary by amendment.
Two amendments within ASU 2019-12 remove exceptions to the general principles in ASC 740-30 that resulted in “frozen” outside basis differences for foreign equity method investments and subsidiaries. The amendments should be applied through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. See TX 11.9.2.1A and TX 11.9.2.2A for applicable guidance before adoption of ASU 2019-12.

11.9.2.1 Change from investee to foreign subsidiary (after adoption of ASU 2019-12)

When an investee becomes a foreign subsidiary in a business combination achieved in stages, the acquirer’s previously held equity interest is remeasured to fair value at the date the controlling interest is acquired and a gain or loss is recognized in the income statement (see BCG 5.3). The requirement to record the previously held equity interest at fair value may increase the outside basis difference.
When an investee becomes a foreign subsidiary through a business combination achieved in stages and a deferred tax liability can be released (based on the ability to assert the indefinite reversal exception as discussed in TX 11.4.1), the corresponding income tax benefit should be reflected in continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation).
If the acquirer does not assert the indefinite reversal exception, the deferred tax liability for an excess book outside basis difference in its investment in a foreign subsidiary acquired through a business combination achieved in stages cannot be released. In such cases, the tax effect of the corresponding change in outside basis difference caused by the requirement to record the pre-existing equity interest at fair value should also be recorded in income from continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation).
If a deferred tax asset has been established for the excess outside tax basis of an investee and the investee subsequently becomes a foreign subsidiary through a business combination achieved in stages, it is likely that the deferred tax asset will no longer qualify for recognition (i.e., if the temporary difference will not reverse in the foreseeable future as required in ASC 740-30-25-9). In this case, the deferred tax asset should be derecognized with the charge reflected in continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation).

11.9.2.1A Change from investee to foreign subsidiary (before adoption of ASU 2019-12)

In general, ASC 740-30-25-16 requires that the deferred tax liability provided for unremitted earnings of a prior investee that becomes a foreign subsidiary be frozen, regardless of whether the investment currently meets the indefinite reversal criteria. The frozen deferred tax liability would not be reversed until (1) dividends from the subsidiary exceed the parent’s share of the subsidiary’s earnings subsequent to the date on which it became a subsidiary or (2) the parent disposes of its interest in the subsidiary.

ASC 740-30-25-16

An investment in common stock of an investee (other than a subsidiary or corporate joint venture) may change so that the investee becomes a subsidiary because the investor acquires additional common stock, the investee acquires or retires common stock, or other transactions affect the investment. A temporary difference for the investor’s share of the undistributed earnings of the investee prior to the date it becomes a subsidiary shall continue to be treated as a temporary difference for which a deferred tax liability shall continue to be recognized to the extent that dividends from the subsidiary do not exceed the parent entity’s share of the subsidiary’s earnings subsequent to the date it became a subsidiary.

When an investee becomes a foreign subsidiary in a business combination achieved in stages, the acquirer’s previously held equity interest is remeasured to fair value at the date the controlling interest is acquired and a gain or loss is recognized in the income statement (see BCG 5.3). The requirement to record the previously held equity interest at fair value may increase the outside basis difference. A question arises about whether the additional temporary difference also needs to be frozen. Because of the lack of clarity in the guidance, we believe there is more than one acceptable view. One view is that the deferred tax liability for the entire outside basis difference (refer to TX 11.4.1 for meaning of “entire outside basis difference”) should be frozen until the temporary difference reverses. Alternatively, the parent investor may elect to freeze only the portion of the deferred tax liability that relates to undistributed earnings of the investee as of the date control is obtained.
When a deferred tax asset was previously recognized for an equity method investment, we believe the deferred tax asset should be written off unless the temporary difference is expected to reverse in the foreseeable future. If the deferred tax asset is written off, the charge should be recorded in income from continuing operations, except for any portion related to current year activity that is required to be recorded in other comprehensive income.
New guidance
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. The new guidance removes two exceptions to the general principles in ASC 740-30 that resulted in “frozen” outside basis differences for foreign equity method investments and subsidiaries. See TX 11.9.2 and TX 11.9.2.1 for additional information on ASU 2019-12, including effective dates, transition requirements, and post-adoption guidance.

11.9.2.2 Change from foreign subsidiary to investee (after adoption of ASU 2019-12)

If deferred taxes were not provided on the taxable outside basis difference of a foreign subsidiary because of the indefinite reversal exception provided in ASC 740-30-25-17, deferred taxes generally would need to be provided on the taxable outside basis difference upon the subsidiary’s change in status to investee. We believe that the charge to recognize the deferred tax liability in these cases would be recorded in income from continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation). The charge should be recorded when the entity’s intentions change and it no longer anticipates that it can assert indefinite reinvestment. An entity may determine this prior to the period in which the change in status from subsidiary to investee actually occurs.

11.9.2.2A Change from foreign subsidiary to investee (before adoption of ASU 2019-12)

If a foreign subsidiary becomes an investee, ASC 740-30-25-15 indicates that the amount of outside basis difference of the foreign subsidiary for which deferred taxes were not provided on the basis of the indefinite reversal exception is effectively frozen until it becomes apparent that any of those undistributed earnings (prior to the change in status) will be remitted. However, given the need to be able to control the timing and manner of reversal of any such basis difference, it may be difficult to continue to assert the indefinite reversal criteria are met once an entity no longer controls the investee.

ASC 740-30-25-15

An investment in common stock of a subsidiary may change so that it is no longer a subsidiary because the parent entity sells a portion of the investment, the subsidiary sells additional stock, or other transactions affect the investment. If the remaining investment in common stock shall be accounted for by the equity method, the investor shall recognize income taxes on its share of current earnings of the investee entity in accordance with the provisions of Subtopic 740-10. If a parent entity did not recognize income taxes on its equity in undistributed earnings of a subsidiary for the reasons cited in paragraph 740-30-25-17 (and the entity in which the investment is held ceases to be a subsidiary), it shall accrue as a current period expense income taxes on undistributed earnings in the period that it becomes apparent that any of those undistributed earnings (prior to the change in status) will be remitted. The change in the status of an investment would not by itself mean that remittance of these undistributed earnings shall be considered apparent. If a parent entity recognizes a deferred tax liability for the temporary difference arising from its equity in undistributed earnings of a subsidiary and subsequently reduces its investment in the subsidiary through a taxable sale or other transaction, the amount of the temporary difference and the related deferred tax liability will change.

New guidance
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. The new guidance removes two exceptions to the general principles in ASC 740-30 that resulted in “frozen” outside basis differences for foreign equity method investments and subsidiaries. See TX 11.9.2 and TX 11.9.2.2 for additional information on ASU 2019-12, including effective dates, transition requirements, and post-adoption guidance.

11.9.2.3 Change from domestic subsidiary to investee

If deferred taxes were not provided on the taxable outside basis difference of a prior domestic subsidiary on the basis of the scenario suggested by ASC 740-30-25-7, deferred taxes generally would need to be provided on the subsidiary’s change in status to investee. We believe that the charge to recognize the deferred tax liability in these cases would be recorded in income from continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation). It is also important to remember that the charge would occur when the entity’s intentions changed and it no longer anticipated that it would be able to recover the investment tax-free. An entity may determine this prior to the period in which the change in status from subsidiary to investee actually occurs.

11.9.2.4 Change from investee to domestic subsidiary

The requirement to record a pre-existing interest at fair value also applies when an investee becomes a domestic subsidiary. When an investee becomes a domestic subsidiary through a business combination achieved in stages and a deferred tax liability can be released (based on the ability to recover the investment in a tax-free manner, see TX 11.3.2), the corresponding income tax benefit should be reflected in continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation).
Sometimes the scenario suggested in ASC 740-30-25-7 does not apply and the acquirer cannot release a deferred tax liability for an excess book outside basis difference in its investment in a domestic subsidiary acquired through a combination achieved in stages. In such cases, the tax effect of the corresponding change in outside basis difference caused by the requirement to record the pre-existing equity interest at fair value should also be recorded in income from continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation).
If a deferred tax asset has been established for the excess outside tax basis of an investee and the investee subsequently becomes a domestic subsidiary through a business combination achieved in stages, it is likely that the deferred tax asset will no longer qualify for recognition (i.e., if the temporary difference will not reverse in the foreseeable future as required in ASC 740-30-25-9). In this case, the deferred tax asset should be derecognized with the charge reflected in continuing operations (except for the portion related to current year activity, which is subject to intraperiod allocation).

11.9.3 Changes in a parent's ownership interest in a subsidiary

A parent’s ownership interest in a subsidiary can change while its controlling financial interest in the subsidiary is retained. For example, the parent might buy additional interests or sell interests in the subsidiary and/or the subsidiary might reacquire some of its ownership interest or issue additional ownership interests. Under ASC 810-10-65-1, these events are considered equity transactions that have no effect on consolidated net income of the parent/investor. Accordingly, the difference between the fair value of the consideration received or paid and the amount by which the noncontrolling interest is adjusted is recognized in equity. A further discussion of these transactions and their tax accounting consequences is included in TX 10.9.

11.9.4 Tax-to-tax (inside versus outside) basis differences

In addition to the outside basis differences and inside basis differences discussed in TX 11.2.1, differences may exist between the tax basis of the capital stock of a subsidiary (i.e., the parent’s tax basis in the shares of the subsidiary) and the subsidiary’s tax basis in the underlying net assets. These differences are generally referred to as “tax-to-tax differences” or “inside versus outside tax basis differences.” Temporary differences are differences between an asset or liability’s tax basis and the reported amount in the financial statements. Consequently, tax-to-tax differences are not temporary differences as defined by ASC 740, and recognition of a deferred tax asset for an outside tax basis difference over an inside tax basis difference is prohibited.
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