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ASC 740-10-45-19 requires that the deferred tax effects of a change in tax status be included in income from continuing operations at the date the change in tax status occurs. Deferred tax assets and liabilities should be recognized for existing temporary differences when an entity changes its tax status to become subject to income taxes. Similarly, deferred tax assets and liabilities should be eliminated when a taxable entity ceases to be taxable. In both cases, the resulting adjustment is included in income from continuing operations even if the temporary difference relates to another category of earnings (e.g., discontinued operations).
ASC 740-10-25-32 and ASC 740-10-25-34 require that an election for a voluntary change in tax status be recognized in the financial statements on the approval date, or on the filing date if approval is not necessary. Alternatively, a change in tax status that results from a change in tax law is recognized on the enactment date, similar to other tax law changes.
Example TX 8-1 illustrates accounting for deferred taxes on an available-for-sale debt security when a change in tax status occurs.
EXAMPLE TX 8-1
Accounting for deferred taxes on an available-for-sale debt security when a change in tax status occurs
Company A, a US entity with a December 31 fiscal year-end, filed a “check-the-box” election to convert Company B, its foreign subsidiary, into a US branch operation. The election is effective beginning on July 1, 20X2. During the first half of 20X2, Company B experienced an unrealized loss on an available-for-sale (AFS) debt security it held in the local country. The unrealized loss was recognized in other comprehensive income (OCI). The unrealized loss has no impact on Company B’s local country taxes as Company B is located in a zero-rate jurisdiction, but will result in a tax deduction in the US when the loss is ultimately realized since Company B is now a branch of Company A. Should the tax benefit associated with establishing the US deferred tax asset related to the unrealized loss on the security on July 1, 20X2 be recorded in OCI or income from continuing operations?
Analysis
The tax benefit should be recognized in income from continuing operations. In this situation, even though the pretax event (i.e., the unrealized loss) was recognized in OCI, the initial tax effect from the unrealized loss was the direct result of the election made by Company A to convert Company B to a US branch operation and thereby change its tax status. In accordance with ASC 740-10-45-19, when deferred tax accounts are adjusted as a result of a change in tax status, the effect of recognizing or eliminating the deferred tax liability or asset is included in income from continuing operations.
Once the deferred tax asset is established upon the change in tax status, the tax effect of any subsequent changes in the value of the AFS debt security would be subject to normal intraperiod allocation rules. This may result in a disproportionate effect being lodged in OCI (since the establishment of the deferred tax asset was reflected in continuing operations). See TX 12.3.3.3 for a discussion on the disproportionate tax effects lodged in OCI.
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