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Carve-out financial statements refer to financial statements prepared by an entity for a division or other part of its business that is not necessarily a separate legal entity, but is part of the larger consolidated financial reporting group. The preparation of carve-out financial statements can be complex and is often highly judgmental. Preparing the tax provision for carve-out financial statements can likewise be challenging, particularly if separate financial statements (including a tax provision) have not historically been prepared. However, as required by ASC 740-10-30-27 related to separate financial statements, taxable entities must include a tax provision in carve-out financial statements.
The methods for intercorporate tax allocation for a carve-out are the same as the methods described previously for the separate financial statements of a subsidiary that is part of a consolidated tax group. However, preparing a tax provision for carve-out financial statements can present a specific set of reporting considerations. These include the following:
  • Understanding the purpose of the carve-out financial statements and the corresponding pre-tax accounting: Carve-out financial statements are often guided by the legal or strategic form of a business transaction that involves capital formation, or the acquisition or disposal of a portion of a larger entity. Alternatively, the statements may be guided by regulatory requirements for certain industry-specific filings.
Those responsible for preparing a tax provision should coordinate closely with those responsible for the pre-tax aspects of the carve-out financial statements. The tax provision should be based on the financial statement accounts that are included in the carve-out entity. Accordingly, reflecting the appropriate tax effect requires a full understanding of the pre-tax accounts that will be included in the carve-out statements, as well as the impacts of any adjustments to such accounts.
The tax provision can be affected by methodologies being used for revenue or cost allocations that differ from historical practices. Carve-out financial statements should reflect all of the costs of doing business. That typically requires an allocation of corporate overhead expenses (and the related tax effects) to the carve-out entity—even if allocations were not previously made. Similarly, it may be necessary to allocate other expenses, such as stock-based compensation, to the carve-out entity.
Stand-alone financials may also reflect “pushdown” accounting adjustments, which can often relate to debt obligations of the parent or other members of the reporting group. The tax provision would be prepared based upon such pre-tax accounts. Accordingly, the stand-alone entity would be assumed to have tax basis in such debt for purposes of applying ASC 740 and, as a consequence, no temporary difference or deferred tax consequence would arise from the pushdown.
  • Intercompany transactions: Intercompany transactions that were formerly eliminated in the consolidated financial statements (e.g., transactions between the carve-out entity and other entities in the consolidated financial statements) generally would not be eliminated in the carve-out financial statements. For example, sales of inventory to a sister company that are eliminated in the consolidated financial statements would remain in the carve-out statements. Accordingly, the income tax accounting for those transactions would also change. Specifically, ASC 740-10-25-3(e), which prescribes the accounting for the income tax effects of intercompany inventory transactions, would not apply to such transactions in the carve-out financial statements.
In addition, it may be appropriate for carve-out statements to reflect intercompany transaction gains (or losses) that were previously deferred in a consolidated return. It would also be necessary to assess whether the income tax accounting effects of certain intercompany transactions are recognized in equity, as described in ASC 740-20-45-11(c) or (g).
  • Intercompany cash settlement arrangements: When a company is preparing carve-out financial statements, the underlying cash flows related to taxes during the historical period may have no relationship to the actual tax liabilities of the carved-out entity. As such, there could be a series of equity transactions (capital contributions and dividends) that account for the differences between actual cash flow and the taxes that are allocated under the accounting policy chosen for intercorporate tax allocation.
  • Hindsight: ASC 740-10-30-17 refers to the consideration of “all available evidence” and historical information supplemented by “all currently available information about future years” when assessing the need for a valuation allowance. Notwithstanding this guidance, we generally believe that hindsight should not be used to apply ASC 740 when preparing carve-out financial statements for prior years. For example, consider a deferred tax asset that was supportable in Year 1 based on the fact that the entity had been profitable and had no negative evidence. As a result of significant subsequent losses, a valuation allowance was required in Year 2. When preparing carve-out financial statements, we believe that it would continue to be appropriate to reflect the deferred tax asset without a valuation allowance in Year 1 and then to record a valuation allowance in Year 2 based on the subsequent developments.
  • Historical assertions made by management of the consolidated group: At times, management may indicate in a carve-out situation that it would have made different assertions or tax elections if the entity had been a stand-alone entity. However, it is generally not appropriate to revisit historical assertions or elections made by management of the consolidated group because the tax provision for the carve-out entity is an “allocation” of the group tax provision. Similarly, it would generally be inappropriate to reassess the historical recognition and measurement of uncertain tax positions when preparing carve-out financial statements. The preparation of carve-out financial statements, in and of itself, does not constitute new information that would justify recording a change with respect to uncertain tax positions.
For example, some have questioned whether it would be appropriate to revisit the indefinite reinvestment assertion (ASC 740-30-25-17) that the parent reflected in its consolidated financial statements. We do not believe that this would be appropriate. However, if the carve-out entity expects its assertions may change in the near future (e.g., after it has been separated from the consolidated group), it may be appropriate to disclose such expectations and the estimated financial reporting impact of such a change. See additional discussion in TX 14.8.1.

14.8.1 Spin-off transactions—indefinite reversal assertion

In the event of a spin-off transaction, the parent (or spinnor) entity will need to evaluate whether the decision to spin-off the business into a separate entity results in a change to management’s ability and intent to indefinitely prevent the outside basis difference of a foreign subsidiary from reversing with a tax consequence. To the extent the decision to spin-off the business results in a change to the indefinite reinvestment assertion, the consolidated financial statements of the parent should reflect a charge to continuing operations at either the time of the decision to consummate the spin-off (i.e., prior to the spin), or at the time of the spin-off, even though such a charge would not have been required if the spin-off had not occurred.
If a charge is recognized in the consolidated financial statements prior to the spin-off, this charge should also be reflected in the standalone financial statements of the subsidiary (to the extent not already reflected in earlier periods if the subsidiary was accounting for deferred taxes in accordance with the separate return method described in TX 14.2.1).
Example TX 14-10 discusses the alternatives related to the timing of recording the charge in the consolidated financial statements.
EXAMPLE TX 14-10
Accounting for a change in the indefinite reinvestment assertion as a result of a nontaxable spin-off transaction
In 20X1, Company A decided to spin-off Subsidiary B and its controlled foreign corporation (CFC) in a nontaxable transaction. Company A’s management will prepare carve-out financial statements for Subsidiary B in connection with the anticipated transaction.
Historically, Company A asserted indefinite reinvestment under ASC 740-30-25-17 regarding Subsidiary B’s outside basis difference in its investment in CFC (i.e., no deferred tax liability was recorded on the outside book-over-tax basis difference). After the spin-off, Subsidiary B will no longer be able to assert indefinite reinvestment. This is because after the spin-off, Subsidiary B will no longer receive funding from Company A and therefore will need to repatriate CFC’s cash in order to fund its US operations and repay separate company borrowings. Absent the spin-off transaction, Company A would expect to continue to assert indefinite reinvestment (i.e., no other factors exist that would cause Company A to change its indefinite reinvestment assertion).
At what point in time, and on whose books (i.e., spinnor’s or spinnee’s), should the tax effect of a change in the indefinite reinvestment assertion (i.e., the recording of a DTL for the outside basis difference) as a result of the nontaxable spin-off be recorded?
Analysis
We believe that there are two acceptable accounting alternatives.
Alternative 1
Record the DTL on both the spinnor’s and spinnee’s books when the decision to consummate the spin-off transaction is made (i.e., prior to the spin).
This view is supported by ASC 740-30-25-19, which provides that “[i]f circumstances change and it becomes apparent that some or all of the undistributed earnings of a subsidiary will be remitted in the foreseeable future but income taxes have not been recognized by the parent company, it should accrue as an expense of the current period income taxes attributable to that remittance.” In addition, this view is consistent with ASC 740-30-25-10, which indicates that a company should record a DTL for the outside basis difference when it is apparent that the temporary difference will reverse in the foreseeable future (i.e., no later than when the subsidiary qualifies to be reported as discontinued operations).
Proponents of this alternative point to the fact that the temporary difference related to Subsidiary B’s outside basis difference in its investment in the CFC existed prior to the change in assertion, but, by virtue of the indefinite reinvestment exception, Company A was not required to accrue income taxes on the undistributed earnings of the CFC. Consequently, the moment it becomes apparent that some or all of the undistributed earnings of the subsidiary will be remitted in the foreseeable future, Company A should record the DTL on the outside basis difference.
Alternative 2
Record the DTL on both the spinnor’s and spinnee’s books at the time of the spin-off transaction.
Proponents of this alternative point to the fact that absent the spin-off transaction, Company A would continue to assert indefinite reinvestment under ASC 740-30-25-17. Therefore, Company A’s expectations regarding the indefinite reversal of the temporary difference will not change until the consummation of the spin-off.
Refer to TX 12.5.2.2 for discussion of intraperiod allocation of the related tax expense when recording the deferred tax liability.
Example TX 14-11 illustrates the recording of the tax effects of a taxable spin-off.

EXAMPLE TX 14-11
Measurement of the tax effects of a taxable spin-off of a majority-owned investment
Company A agrees to acquire Company B in a business combination. As a condition precedent to the purchase transaction stemming from its need for regulatory approval, Company A requires Company B to spin-off one of Company B's majority-owned subsidiaries ("Spinnee"). This transaction will be treated as a taxable transaction under the Internal Revenue Code. Prior to this transaction, Company B asserted that its outside basis difference in Spinnee (due to undistributed earnings) was indefinitely reinvested and therefore deferred taxes were not historically provided. At the date of the spin-off, Company B's investment in Spinnee was $500 and its tax basis was $400. As of the date of the spin-off, Spinnee's fair value was $800.
How should Company B account for the tax consequences of the taxable spin-off?
Analysis
The tax effects of this transaction can be separated into two distinct parts:
Part 1: The book/tax difference for which no deferred tax liability has previously been provided ($500 - $400 = $100)
Part 2: The additional taxable income resulting from the fair value of Spinnee over its current book basis ($800 - $500 = $300)
A tax liability should be provided on each, but the intraperiod allocation of the tax expense is different.
Consistent with the accounting for a change in assertion for Part 1, a deferred tax liability should be recognized for the outside basis difference of $100 multiplied by the applicable tax rate with a corresponding charge to tax expense in the income statement no later than the time of the spin-off.
ASC 740-20-45-11 states that "the tax effects of all changes in the tax bases of assets and liabilities caused by transactions among or with shareholders should be included within equity." Thus, for Part 2, the tax consequence of the $300 increase in the fair value of Spinnee would be a change in the tax basis caused by a transaction with shareholders (the spin-off). Therefore, upon spin-off, the tax expense arising from the increase in the value of Spinnee that will be borne by Company B should be charged to equity.

14.8.2 Recording a valuation allowance upon spin-off

In certain cases, deferred tax assets exist related to the subsidiary that are supportable in consolidation, but will, upon spin-off, require a valuation allowance. An issue arises as to whether this impairment should be recognized in the consolidated financial statements prior to the spin-off. In such cases, the consolidated financial statements of the parent should reflect a charge to continuing operations at the time of the spin-off. The rationale for that treatment is that the parent is not transferring the deferred tax assets at the value at which those assets were recorded in consolidation. Rather, the deferred tax assets have been impaired by the decision to spin off the business into a separate entity that will be unable, at least at a more-likely-than-not confidence level, to realize the value of those deferred tax assets.
The recognition of the valuation allowance would also be reflected in the standalone financial statements of the subsidiary if it had not already been reflected in earlier periods under the separate return method described in TX 14.2.1. In limited situations, specifically when the discontinued operations have filed a separate tax return, it may be appropriate to present the charge for the recognition of the valuation allowance as part of discontinued operations. Refer to TX 12.5.2.1 for further discussion.
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