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12.5 Intraperiod allocation—other areas for consideration
Publication date: 31 Oct 2021
us Income taxes guide 12.5
Other transactions and activities that may require special consideration in the intraperiod allocation process include shareholders equity transactions, discontinued operations, unrecognized tax benefits, common control transactions and sales of a subsidiary.
12.5.1 Intraperiod allocation for dividends
ASC 740-20-45-8(d) requires that the benefit of tax-deductible dividends be reflected in continuing operations. This general rule includes the tax effects of tax-deductible dividends on unallocated ESOP shares that are accounted for under ASC 718, as such dividends are not charged to retained earnings (per ASC 718-740-45-7). In addition, ASC 718-740-45-8 through ASC 718-740-45-12 concludes that, when an income tax benefit is realized from dividends or dividend equivalents that are paid to employees on equity-classified nonvested equity shares, nonvested equity share units, or outstanding equity share options, even when those dividends are charged to retained earnings, the tax benefit should be recognized within income tax expense or benefit in the income statement.
12.5.2 Intraperiod allocation related to discontinued operations
US GAAP requires presentation of discontinued operations in financial statements in certain circumstances. The objective of the requirement is to provide users with information about the portion of a reporting entity’s operations that will not continue and to provide historical financial results comparable with a company’s continuing operations. A reporting entity with a component that meets the conditions for discontinued operations should report the results of operations of the component, less applicable income taxes (benefit), as a separate component of income. This requires that companies consider the intraperiod allocation rules for all periods presented in the financial statements.
12.5.2.1 Intraperiod allocation for restating discontinued operations
In the period when operations that meet the criteria in ASC 205-20 for discontinued operations are disposed of or classified as held-for-sale, prior years’ results are segregated retrospectively between continuing and discontinued operations in accordance with ASC 205-20-45-3 through ASC 205-20-45-5. When this occurs, a new allocation of tax expense or benefit to continuing operations must be determined for the prior years.
ASC 740-270-45-8 specifies that the amount of tax to be allocated to discontinued operations should be the difference between the tax originally allocated to continuing operations and the tax allocated to the restated amount of continuing operations. Amounts of tax allocated to components of income (loss) other than continuing operations recognized in prior years should not be adjusted in recasting the financial statements for the discontinued operation. This prescribed “with-and-without” allocation approach will often result in a different amount than would result from a complete reapplication of the intraperiod allocation rules.
The reallocation between continuing and discontinued operations of the tax expense originally allocated to continuing operations should be based entirely on estimates that were made in preparing the prior years' financial statements and should not reflect any hindsight. While ASC 740-270-45-8 specifically applies to interim financial reporting, we believe its provisions apply to restating prior annual periods as well. See Example FSP 16-1 for the accounting when a change in tax law occurred in the prior period being restated for discontinued operations.
When the prior years include changes in the valuation allowance for beginning-of-year DTAs, however, a question arises as to whether any of the change should be attributed to the discontinued operations. To the extent the discontinued operations were included in a consolidated tax return along with the remaining continuing operations, the change in valuation allowance resulting from the change in judgment about the realizability of DTAs in future years should be recorded entirely in continuing operations consistent with the "general rule" set forth in ASC 740-10-45-20.
This would be the case even if the change in judgment (at the time) related to beginning-of-year DTAs that arose in operations that are now classified as discontinued or as a result of income that was expected from those now discontinued operations. As provided in TX 12.3.2.4, if the benefit of a loss is not recognized in the year in which the loss is incurred, it will not, when recognized in a subsequent year, be classified on the basis of the source of the loss. Thus, the fact that a loss carryforward or deductible difference arose from operations in a prior year that subsequently were classified as discontinued would not be relevant in classifying the tax benefit initially recognized in the current year.
There is one situation, however, where departure from the general rule may be appropriate. If the discontinued operations filed a separate tax return, it may be appropriate to record in discontinued operations the change in assessment of the realizability of DTAs in future years. However, in situations where a valuation allowance is required in a spin-off transaction, the recognition of a valuation allowance may be required to be reflected through continuing operations. Refer to TX 14.8.1.
A question also could arise when the disposal results in a different realization, or estimate of future realization, of DTAs from that reflected in the beginning-of-year valuation allowance. DTAs (or DTLs) that relate to a subsidiary's inside basis temporary differences may simply disappear, perhaps indirectly realized in the pre-tax gain or loss on sale of the subsidiary's stock. These tax effects should be reflected as the tax effects of the gain or loss on disposal, even though implicitly they may reflect a change in the valuation allowance related to beginning-of-year DTAs.
In the event that there is a change to the reporting entity's estimated tax rate (e.g., change in blended state tax rate) within a particular jurisdiction as a direct result of the sale of discontinued operations, a question may arise as to whether the adjustment should be reflected in continuing operations or discontinued operations. Although the need to adjust the estimated tax rate arose because of discontinued operations, the remaining temporary differences are part of continuing operations. Therefore, the impact of revaluing the reporting entity's DTAs and DTLs should be reflected in continuing operations.
With respect to discontinued operations, we believe the net effect of the change in estimated tax rate generally should be reflected in the period in which the subsidiary is classified as held for sale.
12.5.2.2 Intraperiod allocation for unrecognized deferred taxes
A question arises as to the intraperiod allocation of a deferred tax expense/benefit when an entity’s discontinued operation is in a subsidiary with an outside basis difference and has not previously recorded a DTL or DTA for the outside basis difference, for one of three possible reasons:
- An excess outside book-over-tax basis difference related to an investment in a foreign subsidiary was not recorded as a DTL because of the “indefinite reversal” criteria of ASC 740-30-25-17.
- An excess outside book-over-tax basis difference related to an investment in a domestic subsidiary was not considered a taxable temporary difference because the entity expected that the difference would reverse without tax effect (ASC 740-30-25-7).
- A DTA was not recognized for a deductible temporary difference because it was not apparent that the excess outside tax basis would reverse in the foreseeable future (ASC 740-30-25-9).
In this circumstance, consistent with ASC 740-30-25-10, the entity should record a DTA or DTL for the outside basis difference when its expectation has changed and, in any event, no later than the date on which the component of the entity is classified as held-for-sale. There are precedents in practice that support intraperiod allocation of the related tax benefit or expense to either discontinued operations or continuing operations. Support for discontinued operations would be that the temporary difference was generated from the operations (e.g., operating losses) of the subsidiary and that the disposition triggers the recognition of the outside basis difference. Support for continuing operations would be that the temporary difference is related to the tax consequences of the investor's interest in the entity. We would not object to allocation to either component, provided that appropriate disclosures were made.
12.5.3 Unrecognized tax benefits
See TX 15.7 for a discussion on intraperiod allocation of the tax provision impacts of liabilities for unrecognized tax benefits.
12.5.4 Tax effect of changes in accounting principle
The cumulative effect adjustment from an accounting change generally will be included as an adjustment to beginning retained earnings. ASC 740-20-45-11(a) requires that the tax effect of the cumulative effect adjustment should also be recorded as an adjustment to beginning retained earnings, but the tax effects to be recorded are the effects that would have been recorded if the newly adopted accounting method had been used in prior years. Presumably, hindsight would not be used in this determination.
We believe that the tax effect of a cumulative effect of a change in accounting principle that is reported as an adjustment to beginning retained earnings is an adjustment of cumulative income tax expense from prior periods and not an allocation of the current period’s tax expense. For example, assume that an entity has a change in accounting principle that results in a cumulative increase in prior-year financial reporting income that is to be reported as a cumulative effect adjustment to beginning retained earnings. Such an increase also would have resulted in an increase in taxable temporary differences as of that date. The resulting DTL should be established by taking into account the deferred tax balances at the beginning of the year and the enacted tax rates expected to be in effect when those temporary differences reverse (as determined under ASC 740-10-30-8). Accordingly, if the taxable temporary differences would have allowed for a lesser valuation allowance at the beginning of the year on previously recorded DTAs, the valuation allowance release also would be included in the cumulative effect. Although a change in accounting principle also may yield a revised estimate of future pre-tax book income, generally there will be no impact on taxable income.
If the cumulative effect is required to be reported as a component of net income, it would be subject to the intraperiod allocation rules. In calculating such cumulative effect, the intraperiod allocation rules would be applied to each prior period.
This guidance applies to the general manner in which changes in accounting principle are reported. However, any new accounting standard may specify different methods not specifically addressed here. For example, a standard could be adopted during an interim period or at the end of the year. It also might require a change in accounting to be reported in net income, as opposed to retained earnings, or other components of equity or net assets. Thus, it is important to consider the specific manner in which a change in accounting will be reported in order to determine the appropriate reporting of the related tax effects.
12.5.5 Intraperiod allocation for convertible debt issuance
See TX 9.4 for a discussion of the income tax impacts from issuing convertible debt instruments, including situations which may require a pre-tax component of the issuance to be recorded through APIC.
12.5.6 Taxable exchange between entities under common control
See TX 10.10 for a discussion of the income tax impacts of changes in tax basis resulting from a taxable exchange between entities under common control.
12.5.7 Tax effects of the sale of stock of a subsidiary
If the sale of a subsidiary is structured as an asset sale (e.g., an asset acquisition or a share acquisition treated as an asset acquisition), the seller will reflect a gain or loss on the sale of the assets in pre-tax income and will recognize any current taxes, as well as the reversal of any deferred taxes related to the business, in the tax provision.
If the transaction is structured as a stock sale (e.g., a third party purchases 100% of the parent’s stock in the subsidiary), the tax effects of the parent include the realization of any basis difference that exists on the parent’s investment in subsidiaries being sold. In addition, the historical tax bases of the subsidiary’s individual assets and liabilities generally transfer to the buyer (and do not impact the seller’s tax on the transaction) resulting in the need to eliminate the subsidiary’s inside basis differences on parent’s consolidated financial statements. We believe that calculating the pre-tax book gain or loss based on the parent’s carrying value of the subsidiary, including the DTAs and DTLs of the entity being sold, is an acceptable method of accounting for the elimination of deferred taxes on the inside basis differences of the subsidiary sold. This view reflects the fact that the acquirer, by agreeing to buy the stock of the entity (and receiving the tax carryover basis), also is buying the future deductions or future taxable income inherent in the entity.
Example TX 12-19 illustrates this method for calculating the pre-tax gain or loss of a subsidiary which is inclusive of deferred taxes.
EXAMPLE TX 12-19
Calculation of pre-tax gain or loss of a subsidiary inclusive of deferred taxes
Calculation of pre-tax gain or loss of a subsidiary inclusive of deferred taxes
- A subsidiary holds one asset, with a carrying amount of $1,000 for book purposes and a tax basis of zero.
- The tax rate for both the parent and subsidiary is 25%.
- The subsidiary has recorded a $250 DTL related to that temporary difference.
- The parent has a GAAP basis investment in the subsidiary of $750 ($1,000 pre-tax, less the $250 DTL recorded by the subsidiary) and a tax basis in the shares of the subsidiary of zero. The parent has not previously recorded a DTL on this book-over-tax outside basis difference. It is assumed that there was no held-for-sale accounting in an earlier period and, therefore, the guidance in TX 11.5 (which requires recognition of an outside-basis deferred tax no later than the held-for-sale date) does not apply.
- The parent sells 100% of the stock of the subsidiary for $1,200.
How is the pre-tax gain or loss computed of a subsidiary “inclusive of deferred taxes”?
Analysis
The pre-tax gain would be calculated as follows:
Pre-tax GAAP gain |
$450 |
($1,200 proceeds – $750 carrying amount of investment) |
Current tax provision |
300 |
($1,200 proceeds – zero tax basis × 25%) |
Net income |
$150 |
($450 pre-tax gain less $300 tax provision) |
There may be other acceptable methods depending on the facts and circumstances. We would expect that an entity would consider how it treated deferred taxes in its disposal group previously classified as held for sale (see TX 12.5.7.1) and whether there have been any changes to the facts.
12.5.7.1 Deferred income taxes in a disposal group (held for sale)
A reporting entity should determine whether deferred taxes need to be included in the carrying amount of a disposal group classified as held for sale. According to ASC 360-10-15-4, a disposal group represents assets to be disposed of together as a group in a single transaction and liabilities directly associated with those assets that will be transferred in the transaction. A determination of whether deferred tax assets and liabilities should be included in the disposal group depends on whether the buyer will acquire any of the tax attributes and succeed to the tax basis of assets and liabilities. If the buyer will be acquiring tax benefits or assuming tax liabilities (otherwise known as “inside” basis difference), deferred taxes should be included in the disposal group. While the determination ultimately depends on the terms of the sale and the provisions of the relevant tax law in the applicable jurisdiction, in general sales of asset groups in the form of the sale of the shares of a corporation would result in the tax bases of assets and liabilities and tax attributes carrying over to the buyer. Conversely, a sale of an asset group that is structured as the sale of assets and liabilities will result in the buyer establishing a new tax basis in those assets and liabilities.
If the sale is structured as a sale of stock, deferred taxes associated with any book-tax basis differences in the assets and liabilities of the disposal group will usually be assumed by the buyer. Therefore, these deferred taxes should be included in the carrying amount of the disposal group because the deferred taxes meet the definition of assets to be disposed of or liabilities to be transferred (included in the definition of a disposal group in ASC 360-10-15-4).
A decision to sell the shares of a subsidiary could require the recognition of additional deferred taxes associated with the difference between the seller’s carrying amount of the subsidiary’s net assets in the financial statements and its basis in the shares of the subsidiary (otherwise known as “outside” basis difference). Because those deferred taxes will remain with, and be settled by the seller, they should not be included in the disposal group. Refer to ASC 740-30-25-10 and TX 11.1 for further guidance regarding the recognition of any temporary difference related to the outside basis difference.
If the sale is structured as an asset sale, the seller will usually retain and settle or recover the deferred tax assets and liabilities (i.e., any inside basis differences will reverse in the period of sale and become currently deductible by or taxable to the seller). Therefore, in an asset sale, deferred taxes should usually not be included in the carrying amount of the assets and liabilities that are held for sale because they will not be transferred to the buyer (i.e., they are not part of the disposal group as defined in ASC 360-10-15-4).
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