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, 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 unique set of financial reporting issues. 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. Understanding the overall context and intended use of the statements is important in deciding which tax provision allocation method to apply.

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, as described in ASC 740-20-45-11(c) or (g), are recognized in equity.

  • 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.

In certain limited situations it may be appropriate for a stand-alone entity’s carve-out financial statements to deviate from the assertion or election made by management of the consolidated group. See Example TX 14-9.

EXAMPLE TX 14-9
Accounting for a change in the indefinite reinvestment assertion as a result of a nontaxable spin-off transaction

In 20X8, Company A made a decision 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.

In the event of an increase in valuation allowance as a result of a spin-off, the financial statements of the parent should reflect a charge to continuing operations at the time of the spin-off even though such a charge would not have been required if the spin off had not occurred. See TX 14.8.1 for additional information on this interpretation.

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.

When recording the DTL on Company A’s books (due to the change in indefinite reinvestment assertion), we would not object to intraperiod allocation of the related tax expense to either discontinued operations or continuing operations, provided that appropriate disclosures were made and the chosen accounting method was consistently applied (See TX 12.5.4 for further discussion).

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