Financial reporting for tax complexity in divestitures

Editor: Alexander J. Brosseau, CPA

In today’s dynamic business environment, entities are continually seeking opportunities to enhance their business, including strategic acquisitions, restructurings, and divestitures. Each type of transaction carries its own tax consequences and may present nuanced financial reporting challenges for tax accounting. The nonrecurring nature of these transactions may present challenges and risks within an organization. In fact, nonrecurring transactions are a common theme of material weaknesses attributable to income tax. This item highlights important considerations related to financial reporting for taxes that tax and accounting professionals should be familiar with when contemplating a divestiture.

Separate or carve-out financial statements

Divestitures can take many forms, including sales, spinoffs, and split–offs. When an entity is divesting one or more legal entities, separate financial statements may be required. Similarly, when an entity disposes of assets and liabilities or components of an entity within the consolidated financial statements, carve–out financial statements may be required.

Income statement considerations: Entities should understand the legal structure of the business that will be included in separate and carve–out statements to determine the appropriate amount of income tax expense or benefit (collectively referred to here as “income tax expense”) to allocate to the separate or carve–out financial statements. FASB ASC Paragraph 740–10–30–27 does not require a single method for allocating current and deferred income tax expense to the separate financial statements of a member or members of a consolidated tax return group. However, the method adopted must be systematic, rational, and consistent with the broad principles established by FASB ASC Topic 740, Income Taxes.

The most common allocation method is the separate–return method. Under this method, current and deferred taxes are allocated to each member of the consolidated tax return group as if it were a separate taxpayer. The SEC has indicated that calculating the tax provision on the separate–return basis is preferable (SEC Staff Accounting Bulletin No. 114, Topic 1.B.1, Question 3). When registrants have not used the separate–return method, the SEC has required pro forma information for the most recent annual and interim periods, reflecting a tax provision calculated on a separate–return basis.

In certain situations, the income tax expense allocated to the separate or carve–out financial statements may not reflect the amount of tax included in the consolidated financial statements related to the operations of the separate or carve–out group. For example, an entity may conclude that it can recognize the benefit of deferred tax assets (DTAs) in the consolidated financial statements because the consolidated tax return group has sufficient sources of taxable income. However, when applying the separate–return method, an entity may only consider the positive and negative evidence specific to the separate or carve–out group and may determine that the benefit it can recognize in the separate or carve–out financial statements is different than the benefit recognized in the consolidated financial statements.

Balance sheet presentation: While there is no authoritative guidance in Topic 740 that specifically addresses how current and deferred taxes should be reflected in the balance sheet of separate or carve–out financial statements, it is generally appropriate to record DTAs and deferred tax liabilities (DTLs) for temporary differences related to the assets and liabilities of the separate or carve–out group, regardless of the method used to allocate income tax expense to such financial statements. These temporary differences should be based on the difference between carrying amounts of the assets and liabilities included in the separate or carve–out financial statements and the related tax bases.

The operations of a separate or carve–out entity may result in tax credits or a net operating loss (NOL) in a particular year. Had the separate or carve–out entity filed its own tax return, it may not have been able to use the tax credits in the year in which they were generated. In these circumstances, NOL and tax credit carryforwards (tax attributes) could result. Under the separate–return method, DTAs and related valuation allowances associated with the tax attributes are determined as if the separate or carve–out entity had filed its own tax return.

Additionally, under the separate–return method, the balance sheet should also reflect current income taxes receivable/payable and unrecognized tax benefit liabilities in the same manner as if the separate or carve–out entity had prepared a separate income tax return. Determining the amount of these assets and liabilities to recognize in separate or carve–out financial statements can be complicated and may require additional consideration of the entity’s obligations to the taxing authority under the relevant tax law and the entity’s obligations due to the parent under a tax–sharing agreement with the parent entity.

Held-for-sale classification

When an entity classifies assets and liabilities as held for sale (HFS) in the consolidated financial statements, it is important not to overlook the potential Topic 740 implications. For example, the conditions leading to HFS classification may also indicate that an entity should recognize a DTA or DTL related to the difference between the book and tax basis of the stock of the entities being divested if a DTA or DTL had not previously been recognized. Additionally, the change in facts that resulted in HFS classification may affect the positive and negative evidence related to realizability of the entity’s DTAs, potentially resulting in a change in valuation allowance. Careful analysis of the facts and circumstances is necessary to determine the appropriate timing and manner of recognizing such changes in the consolidated financial statements.

When assets and liabilities are classified as HFS, entities should consider the appropriate balance sheet presentation of DTAs and DTLs associated with such assets and liabilities, taking into account the expected manner of disposal. For example, in certain stock sales, the DTAs and DTLs related to the assets and liabilities classified as HFS are transferred to the buyer. In this case, it would be appropriate to classify these DTAs and DTLs as HFS in the balance sheet of the consolidated financial statements. However, when assets and liabilities (as opposed to the stock) are sold directly to a buyer, the DTAs and DTLs are generally not transferred to the buyer. Rather, the future tax effects of the DTAs and DTLs may affect the seller’s income taxes payable (or tax attribute carryforwards) upon sale. Therefore, such DTAs and DTLs should not be presented as HFS in the consolidated financial statements. Similarly, DTAs and DTLs associated with a parent’s investment in the stock of an entity being sold should not be presented as HFS in the consolidated financial statements.

Discontinued operations

An entity must present both the results of operations and the gain or loss recognized on the disposal as discontinued operations if the criteria in FASB ASC Section 205–20–45 are met. In such cases, an entity should carefully consider the amount of income tax expense that should be allocated to discontinued operations in the consolidated financial statements. It is important to note that not all entities that meet the HFS criteria will also meet the discontinued–operations criteria.

FASB ASC Paragraph 740–20–45–7 requires an entity to allocate its total annual income tax expense among continuing operations and other components of its financial statements (e.g., discontinued operations) by applying a “with and without” approach. Specifically, Paragraph 740–20–45–7 states that the “tax effect of pretax income … from continuing operations should be determined by a computation that does not consider the tax effects of items that are not included in continuing operations [emphasis added]” (i.e., the “without” calculation). This amount is compared to the total income tax expense for the period (i.e., the “with” calculation). The difference between the income tax expense calculated on a “with” basis and the income tax expense calculated on a “without” basis is allocated to items that are not part of continuing operations. In other words, the tax effect allocated to discontinued operations is generally the incremental tax effect of the discontinued operations.

As mentioned previously, an entity may be required to recognize a DTA or DTL related to the difference between the book and tax basis of the stock of the entities being divested. Such basis difference may have arisen in whole or in part in a prior period (an out–of–period adjustment). In other words, some portion of the DTA or DTL may not relate to the entity’s operations in the current period, and the tax effect of the out–of–period adjustment would be addressed separately, as opposed to being allocated as part of the with–and–without calculation. If the DTA or DTL is directly related to the operations of an entity or component that is presented in discontinued operations, there are generally two acceptable views regarding the allocation of an out–of–period adjustment. The out–of–period adjustment may be allocated to discontinued operations by applying FASB ASC Subtopic 205–20. Alternatively, the out–of–period adjustment may be allocated to income or loss from continuing operations by analogy to the general intraperiod allocation rules for other out–of–period adjustments in Section 740–20–45.

Interim reporting considerations

There are additional considerations when a component of the business is classified as discontinued operations in an interim reporting period. Income tax expense related to ordinary income is determined by applying the worldwide estimated annual effective tax rate (AETR) to year–to–date ordinary income. Ordinary income does not include items of comprehensive income that are reported outside continuing operations, including those in discontinued operations. Income tax expense allocated to items reported outside continuing operations is generally recognized in the quarter it arises.

Additionally, out–of–period adjustments allocated to continuing operations are generally recognized in the period the adjustment arises and not included in the AETR. Additionally, in accordance with FASB ASC Paragraph 740–270–30–8, significant, unusual, or infrequently occurring items that are separately reported are excluded from the definition of ordinary income and are therefore excluded from the AETR. Judgment should be applied in determining whether any aspects of a divestiture transaction reported in continuing operations are significant, unusual, or infrequently and separately reported.

Early collaboration encouraged

Accounting for the income tax effects of a divestiture can be complex and may be affected by the divestiture structure, facts and circumstances surrounding the transaction, and the tax accounting policies established. Early collaboration with other stakeholders within the business to proactively identify potential financial reporting and tax complexities is a leading practice. Additionally, discussions with trusted professional advisers may be advised.

Editor

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.

For more information about these items, contact Brosseau at abrosseau@deloitte.com.

Contributors are members of or associated with Deloitte Tax LLP.

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