Seven principles to consider when preparing a tax provision for subsidiary or carve-out financial statements.

AuthorAbahoonie, Edward J.

Businesses that prepare consolidated (or group) financial statements also often prepare separate financial statements for one or more divisions, business units or subsidiaries. Such statements (hereinafter referred to as "carve-out" or "stand alone" financial statements) can be neccessitated by a pending transaction such as an initial public offering, spin-off, or business combination. Alternatively, they may be required for certain statutory or regulatory filings on an ongoing periodic basis. Carve-out financial reporting is even more common outside the United States.

The preparation of carve-out financial statements can be complex and is often highly judgmental. There are limited specific accounting rules or guidance that govern the composition of the carve-out entity and resulting application of U.S. Generally Accepted Accounting Principles (GAAP). 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. For taxable entities, the exclusion of a tax provision in such financial statements is not an option because a tax provision is required for the carve-out financial statements to be in accordance with FASB Statement No. 109, Accounting for Income Taxes (FAS 109).

While not exhaustive, this article reviews several key principles that, if kept in mind, will enable preparers to manage the carve-out tax provision process more smoothly.

  1. 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 and in aligning the application of the chosen allocation method to the pre-tax accounts.

    Tax provision preparers 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, one must fully understand the pre-tax accounts that will be included in the carve-out financial statements, as well as the effects of any adjustments to such accounts, in order to reflect the appropriate income tax effects.

    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 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. An appropriate methodology for determining the pool of "windfall benefits" applicable to the carve-out entity will then need to be adopted in accordance with FASB Statement No. 123(R), Share-Based Payment.

    Stand-alone financials may also reflect "push-down" 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 standalone entity would be assumed to have tax basis in such debt for purposes of applying FAS 109 and, as a consequence, no temporary difference or deferred tax consquences arising from the push-down.

    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. Thus, sales of inventory to a sister company that are eliminated in the consolidated financial statements generally would remain in the carve-out financial statements. Accordingly, the income tax accounting for those transactions would also change. Specifically, paragraph 9(e) of FAS 109 (which prescribes the accounting for the income tax effects of intercompany transactions) would not apply to such transactions in the carve-out financial statements.

    Similarly, it may be appropriate to reflect in carve-out statements intercompany...

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