Tax indemnification arrangements: navigating the financial reporting standards.

• Author: Abahoonie, Edward J.

Income tax indemnifications are established in a variety of transactions, including business acquisitions, corporate spin-offs, and initial public offerings (IPOs). Accounting for an income tax indemnification arrangement depends upon whether the company is obligated to the taxing authority, the relationship between the parties and the type of transaction. This article provides a framework to apply in determining the appropriate accounting. (1)

Background

Income tax indemnifications are contractual arrangements 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, before the transaction in which the indemnification was established. Common scenarios in which an indemnification is provided, and the general direction of the arrangements, are illustrated in the nearby table.

While the income tax accounting principles (ASC 740) do not apply to taxes other than income taxes, the other elements of this framework may be applied with respect to indemnifications for such taxes.

Accounting by the indemnifying party

Determining the applicable accounting model

The applicable model will determine the initial accounting, as well as subsequent changes in the recognition and measurement of the liability throughout the term of the arrangement. To determine the appropriate accounting, consideration should be given to whether there is an obligation to the taxing authority, the attribution of any such obligation and the relationship between the parties to the arrangement.

The indemnifying party should determine whether it is a primary obligor to the taxing authority. If 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 U.S. company sells its interest in a foreign subsidiary, the consolidated enterprise generally has no legal obligation to pay back taxes in the foreign jurisdiction subsequent to the sale. The determination may be less clear, and more than one party may be considered a primary obligor, in situations when the transferred entity was previously included as part of a consolidated return.

If a company is a primary obligor to the taxing authority, it should account for the indemnification pursuant to the provisions within ASC 740, Income Taxes (ASC 740), dealing with accounting for uncertain tax positions. These provisions set out a two-step recognition and measurement approach. A liability is recorded for the full amount of a position that is not considered more-likely-than-not to be sustained upon examination based on its technical merits. For positions more-likely-than-not to be sustained, a liability is recorded for the difference between the tax benefit claimed and the largest amount of benefit that is greater than 50 percent likely of being sustained. The possibility of offset with other positions should not be considered when assessing an individual tax position. Further, an entity should assume that the taxing authority will examine the position with access to all relevant facts and information. The resulting liability for unrecognized benefits is recorded on an undiscounted basis. The same principles apply when the unrecognized benefits reduce a tax asset (e.g., loss carryforward), rather than being recorded as a liability.

If an indemnifying party is not a primary obligor to the taxing authority, it should account for the indemnification pursuant to ASC 460, Guarantees (ASC 460), which requires the use of fair value based upon...