Income tax indemnifications are contractual arrangements established between two parties whereby one party will reimburse the other for income taxes paid to a taxing authority related to tax positions that arose (typically) prior to a transaction. Income tax indemnifications can arise from a number of circumstances, including business combinations, spin-offs and IPOs. Common scenarios, including the general direction of indemnification arrangements, are summarized below:
Sale of a subsidiary that previously filed a separate tax return
Sale of a subsidiary that previously filed as part of a consolidated tax return
Spin-off, IPO or carve-out of an entity that previously filed a separate tax return
Previous owner
New entity or shareholders
Spin-off, IPO or carve-out of an entity that previously filed as part of a consolidated tax return
Previous owner
New entity or shareholders
The accounting for indemnification arrangements described in the next sections differs from the accounting that would result if the entity purchased insurance coverage from a third party to mitigate its exposure. In that situation, the entity should consider the guidance in ASC 720-20, Insurance Costs. Indemnification arrangements may also arise in a number of commercial or financing transactions such as leases; however, the accounting for such arrangements is not addressed in this section.

15.8.1 Accounting for tax indemnification by indemnifying party

When determining how to account for an indemnification, entities should consider the relationship with the taxing authority and the relationship between the parties to the arrangement.
The indemnifying party must determine whether it is a primary obligor to the taxing authority. In situations in which an entity that previously filed a separate tax return is sold to a third party or spun-off to shareholders, the determination may be clear. For example, when a US company sells its interest in a foreign subsidiary, the consolidated entity generally has no legal obligation to pay back taxes in the foreign jurisdiction subsequent to the sale. Therefore, even if the US company indemnified the buyer, it would likely not be the primary obligor.
In situations in which the transferred entity was previously included as part of a consolidated return, the determination may be less clear and more than one party may be considered a primary obligor. If a company is a primary obligor to the taxing authority, it should account for any tax exposure pursuant to the uncertain tax provision guidance of ASC 740. If the tax is determined to be a non-income based tax, a similar analysis will need to be performed; however, the guidance in ASC 740 should not be followed. Rather, accounting guidance such as ASC 450 may need to be applied.
If an indemnifying party is not a primary obligor to the taxing authority, it should account for the tax risk pursuant to ASC 460, Guarantees (ASC 460), which requires the use of fair value based upon the guidance in ASC 820, Fair Value Measurements and Disclosures (ASC 820). The scope of ASC 460 does not apply to an indemnification issued between a parent and its subsidiary or between companies under common control. However, if a parent indemnifies a subsidiary prior to a spin-off or sale, a decision to retain the guarantee post transaction is the same as issuing a new guarantee at the date of the transaction. As a result, ASC 460 would apply subsequent to the transaction.
If the ASC 460 parent-subsidiary scope exception applies, a company should account for the indemnification pursuant to ASC 450, Contingencies. ASC 450 requires a company to accrue a liability when it is probable that the liability has been incurred and the amount of loss can be reasonably estimated.
Figure TX 15-1 illustrates considerations related to determining the applicable guidance for an indemnification.
Figure TX 15-1
Determining applicable guidance for an indemnification
A change in circumstances causing a change in the applicable principle may result in adjusting or recognizing (and possibly reclassifying) a liability. For example, a company that was previously a primary obligor may have recorded a liability for unrecognized tax benefits pursuant to ASC 740. Following a disposition, the company is no longer a primary obligor to the taxing authority but may agree to indemnify the buyer. The company would need to adjust its liability to reflect an ASC 460 approach. Entities previously filed as part of consolidated return

When a wholly-owned subsidiary that was previously included as a member of a consolidated federal income tax return is spun off from its parent, the subsidiary may agree to indemnify the parent for any income taxes that the parent may be assessed related to the resolution of the subsidiary’s pre-spin uncertain tax positions. Further, because the entities were previously included as part of a consolidated return, both the parent and the spun-off entity may be considered a primary obligor under current US tax law.
In general, when considering the former subsidiary’s indemnification of the parent, we do not believe it would be appropriate for the subsidiary to record a liability for the income taxes related to the parent’s operations. Although the subsidiary may be legally liable for the parent’s taxes (because the taxing authority may consider all entities in the original consolidated filing as jointly liable for the taxes of the entire pre-spin consolidated group), the convention under US GAAP is that each entity should recognize income taxes related to its own operations. However, if the parent becomes insolvent (and, therefore, the taxing authority’s only recourse is to seek recovery from the subsidiary), it may be appropriate for the subsidiary to account for the potential liability related to the parent’s tax uncertainties as a contingent liability in accordance with ASC 450.

15.8.2 Accounting for tax indemnification by indemnified party

The indemnified party must also determine if they are a primary obligor to the taxing authority and, if so, recognize and measure a liability in accordance with ASC 740. If the indemnifying and indemnified parties are both liable for the exposure, both parties should apply the guidance in ASC 740. The indemnified party must then determine the amount to recognize for the indemnification receivable.
The relevant accounting guidance for the indemnified party may differ depending on whether the transaction is accounted for as a business combination (see TX 10.7 for discussion of indemnification uncertainties in a business combination). Regardless of the recognition and measurement model followed for the indemnified asset, the indemnified party should not offset the indemnification receivable against the tax liability because those amounts are receivable from and payable to two different parties and so do not qualify for off-set.
The guidance in ASC 805 is limited to business combinations and, therefore, does not apply to transactions such as spin-offs or asset acquisitions. Accordingly, the question arises whether "mirror image" accounting should be applied to transactions other than business combinations. In “mirror image” accounting, the indemnified party recognizes an indemnification asset (as it relates to the uncertain tax position) at the same time that it recognizes the indemnified item and measures the asset on the same basis as the indemnified item.
Question TX 15-3 addresses the tax accounting related to indemnification receivables.
Question TX 15-3
Company B used to be the parent of Company A. However, the two companies are no longer related. Company B has indemnified Company A for any uncertain tax position liabilities ultimately payable by Company A related to periods when Company B was Company A’s parent. Therefore, Company A has recorded an indemnification receivable equivalent to its uncertain tax position liabilities from that time period. Should deferred income taxes be recorded related to the indemnification receivable?
PwC response
No. From a US tax perspective, there are typically no consequences from indemnification payments. The amount paid to the taxing authority and the amount collected from the seller would generally offset, with no net impact on taxable earnings. As a result, in most cases the indemnification receivable recorded would not be expected to have a deferred tax effect.

Question TX 15-4 addresses intraperiod considerations related to tax consequences of an indemnification.
Question TX 15-4
Company A spins off Company B but retains a partial interest. The spinnor (Company A) may indemnify the spinnee (Company B) for a legal claim. When the legal claim is settled, any necessary indemnification payments from the spinnor to the spinnee would constitute taxable income to the spinnee. How should the tax consequences of the indemnification payment be recorded?
PwC response
In this case, the tax consequences of the indemnification payment should generally be recorded in the same manner as the indemnification payment. For example, if the indemnification payment is recorded as a capital contribution due to an ownership relationship between the two parties, the tax consequences should also be recorded in accumulated paid-in-capital.

In certain situations, in an effort to neutralize the impact of a tax exposure to a fund’s net asset value (NAV), a fund manager is willing to indemnify the fund for its tax exposure. In connection with the implementation of ASC 740’s guidance related to uncertain tax positions, certain investment funds approached the SEC staff for guidance on how to measure an indemnification receivable. In a letter to the funds, the SEC staff noted that “an advisor’s (or other relevant party’s) contractual obligation to indemnify uncertain tax positions generally would be sufficient in demonstrating that the likelihood of recovery is probable. The process of obtaining a contractual obligation to indemnify uncertain tax positions may occur simultaneously while the fund is gathering the relevant information to assess whether a liability should be recorded to NAV. In these circumstances, recognition of an indemnification receivable, to the extent of recovery of the tax accrual, generally would be acceptable practice.” The SEC’s letter provides support for recognizing the indemnification receivable at the same amount as the recorded liability absent any collectability or contractual limitations on the indemnified amount.
A more common indemnification scenario, outside of a business combination, is when a parent spins off a subsidiary. Following the spin-off, the parent may indemnify the new entity for income tax exposures related to the spun-off entity’s prior operations. Assuming that the indemnification fully covers the exposure, we believe that it would be reasonable for the spun-off entity to record an indemnification receivable at the same amount as the tax liability. This view is consistent with the SEC’s letter to the funds.
When a parent retains a controlling interest after a transaction like an IPO or spin-off, the parent-subsidiary relationship survives the transaction. If the parent indemnifies the subsidiary, consideration should be given to whether the indemnification asset and subsequent changes should be recorded in equity.

15.8.3 Presentation and disclosure—indemnified arrangements

An indemnification asset should not be netted against the related liability. Adjustments to the indemnification asset should be recorded in pre-tax income, not as part of income tax expense. The income tax line item is reserved for only those amounts expected to be paid to (or received from) the taxing authorities. Therefore, although dollar-for-dollar changes in an income tax liability and a related indemnification asset will offset on an after-tax basis, pre-tax income measures and a company’s effective tax rate will be impacted.
Companies should ensure that liabilities for unrecognized tax benefits, regardless of whether covered by an indemnification agreement, are included in the company’s annual disclosures. That is, the disclosures required by ASC 740-10-50-15 would reflect the unrecognized tax benefits with no offset or netting for an indemnification. For example, the company would need to include the tax position in its disclosure of gross amounts of increases and decreases in unrecognized tax benefits and amounts that, if recognized, would affect the effective tax rate. However, it may often be necessary to provide additional disclosure in regard to the terms of any indemnification arrangements so that financial statement readers can appropriately assess the net economic exposure to the entity.

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