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11.9 Other considerations—outside basis differences
Publication date: 31 Dec 2023
us Income taxes guide
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 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 for which they conclude that they are not the primary beneficiary but are accounted for under the equity method 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.
11.9.2.1 Change from investee to foreign 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.
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).
11.9.2.2 Change from foreign subsidiary to investee
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 in accordance with ASC 740-30-25-15. 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 occurs.
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 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.
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