To this point, this textbook has not attempted to analyze the income tax implications involved in corporate mergers and acquisitions. Only a comprehensive tax course can provide complete coverage of the numerous complexities inherent in the tax laws in this area. Furthermore, es- sential accounting issues can be overshadowed by intermingling an explanation of the finan- cial reporting process with an in-depth study of related tax consequences.
hoy36628_ch07_293-334.qxd 1/12/10 5:05 PM Page 307
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
Despite the desire to focus attention on basic accounting issues, income taxes can never be ignored. Certain elements of the tax laws have a direct impact on the financial reporting of any business combination. At a minimum, a fair presentation of the consolidated entity’s financial statements requires recognition of current income tax expense figures and deferred income taxes. Therefore, a complete understanding of the financial reporting process requires an in- troduction to the income taxation of a business combination.
Affiliated Groups
A central issue in accounting for the income taxes of a business combination involves the en- tity filing its tax returns. Many combinations require only a single consolidated return; in other cases, some, or even all, of the component corporations prepare separate returns. According to current tax laws, a business combination may elect to file a consolidated return encompassing all companies that compose an affiliated groupas defined by the Internal Revenue Code. The Code automatically requires all other corporations to submit separate income tax returns. Con- sequently, a first step in the taxation process is to delineate the boundaries of an affiliated group. Because of specific requirements outlined in the tax laws, this designation does not necessarily cover the same constituents as a business combination.
According to the Internal Revenue Code, the essential criterion for including a subsidiary within an affiliated group is the parent’s ownership of at least 80 percent of the voting stock and at least 80 percent of each class of nonvoting stock. This ownership may be direct or indi- rect, although the parent must meet these requirements in connection with at least one directly owned subsidiary. As another condition, each company in the affiliated group must be a do- mestic (rather than a foreign) corporation. A company’s options can be described as follows:
• Domestic subsidiary, 80 percent to 100 percent owned:May file as part of consolidated return or may file separately.
• Domestic subsidiary, less than 80 percent owned:Must file separately.
• Foreign subsidiary:Must file separately.
Clearly, a distinction exists between business combinations (identified for financial report- ing) and affiliated groups as defined for tax purposes. Chapter 2 described a business combi- nation as comprising all subsidiaries controlled by a parent company unless control is only temporary. The possession (either directly or indirectly) of a mere majority of voting stock normally supports control. Conversely, the Internal Revenue Code’s 80 percent rule creates a smaller circle of companies qualifying for inclusion in an affiliated group.
For the companies of an affiliated group, filing a consolidated tax return provides several distinct benefits:
• Intra-entity profits are not taxed until realized (through use or sale to an outside party);
similarly, intra-entity losses (which are rare) are not deducted until realized.
• Intra-entity dividends are nontaxable (this exclusion applies to all dividends between mem- bers of an affiliated group regardless of whether a consolidated return is filed).
• Losses incurred by one affiliated company can be used to reduce taxable income earned by other group members.
Deferred Income Taxes
Some deviations between generally accepted accounting principles and income tax laws cre- ate temporary differenceswhereby (1) a variation between an asset or liability’s recorded book value and its tax basis exists and (2) this difference results in taxable or deductible amounts in future years. When a temporary difference is present, financial reporting principles require recognizing a deferred tax asset or liability. The specific amount of this income tax deferral depends somewhat on whether consolidated or separate returns are being filed. Thus, we ana- lyze here the tax consequences of several common transactions to demonstrate a business combination’s income tax expense reporting.
Intra-Entity Dividends
For financial reporting, dividends between the members of a business combination always are eliminated; they represent intra-entity cash transfers. In tax accounting, dividends also are
308 Chapter 7
LO4
List the criteria for being a member of an affiliated group for income tax filing purposes.
LO5
Compute taxable income and deferred tax amounts for an affiliated group based on information presented in a consolidated set of financial statements.
hoy36628_ch07_293-334.qxd 1/6/10 8:04 AM Page 308
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
Consolidated Financial Statements—Ownership Patterns and Income Taxes 309
removed from income but only if at least 80 percent of the subsidiary’s stock is held. Conse- quently, at this ownership level, no difference between financial and tax reporting exists; both eliminate all intra-entity dividends. Income tax expense is not recorded. Deferred tax recogni- tion is also ignored because no temporary difference has been created.
However, if less than 80 percent of a subsidiary’s stock is held, tax recognition becomes necessary. Intra-entity dividends are taxed partially because, at that ownership level, 20 per- cent is taxable. The dividends received deduction on the tax return (the nontaxable portion) is only 80 percent.3Thus, an income tax liability is immediately created for the recipient. In ad- dition, deferred income taxes are required for any of the subsidiary’s income not paid currently as a dividend. A temporary difference is created because tax payments will occur in future years when the subsidiary’s earnings eventually are distributed to the parent. Hence, a current tax liability is recorded based on the dividends collected, and a deferred tax liability is recorded for the taxable portion of any income not paid to the parent during the year.
The Impact of Goodwill
Current law allows, in some cases, the amortization of goodwill and other purchased intangi- bles (referred to as Section 197 property) over a 15-year period. For financial reporting, good- will is written off if it is impaired or if the related business is disposed of in some manner.
Because of the difference in the periods in which taxable income and financial income are reduced, the presence of tax-deductible goodwill creates a temporary difference that necessi- tates recognizing deferred income taxes. The same is true for other purchased intangibles if a life other than 15 years is used for financial reporting.
Unrealized Intra-Entity Gains
Taxes on unrealized gains that result from transfers between related companies within a busi- ness combination create a special accounting problem. On consolidated financial statements, the impact of all such transactions is deferred. The same is true for a consolidated tax return;
the gains are removed until realized. No temporary difference is created.
If separate returns are filed, though, tax laws require the profits to be reported in the period of transfer even though unearned by the business combination. Thus, the income is taxed im- mediately, prior to being earned from a financial reporting perspective. This “prepayment” of the tax creates a deferred income tax asset.4
Consolidated Tax Returns—Illustration
To illustrate accounting effects created by filing a consolidated tax return, assume that Great Company possesses 90 percent of Small Company’s voting and nonvoting stocks. Subsequent to the acquisition, the two companies continue normal operations, which includes significant intra-entity transactions. Each company’s operational and dividend incomes for the current time period are presented below, along with the effects of unrealized gains. No income tax ac- cruals have been recognized within these totals:
Small Great Company Company (90% owned) Operating income (excludes equity or dividend
income from subsidiary) . . . $160,000 $40,000 Net unrealized gains in current year income (included
in operating income above) . . . 30,000 8,000 Dividend income (from Small) . . . 9,000 –0–
Dividends paid . . . 20,000 10,000
3If less than 20 percent of a company’s stock is owned, the dividends received deduction is only 70 percent.
However, this level of ownership is not applicable to a subsidiary within a business combination.
4Deferral is required for the amount of taxes paid on the unrealized gain by the seller. This approach was taken rather than computing the deferral based on the future tax effect caused by the difference between the buyer’s book value and tax basis, a procedure typically followed. This deferral treatment helps eliminate the need for complex cross-currency deferred tax computations when the parties are in separate tax jurisdictions.
hoy36628_ch07_293-334.qxd 1/12/10 5:05 PM Page 309
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
310 Chapter 7
From the perspective of the single economic entity, Great’s individual income for the pe- riod amounts to $130,000: $160,000 in operational earnings less $30,000 in unrealized gains. Using this same approach, Small’s income is $32,000 after removing the effects of the intra-entity transfers ($40,000 operating income less $8,000 in unrealized gains). Thus, the income to report in consolidated financial statements before the reduction for noncontrol- ling interest is $162,000 ($130,000 ⫹ $32,000). For financial reporting, both intra-entity dividends and unrealized gains are omitted in arriving at this total. Income prior to the non- controlling interest is computed here because any allocation to these other owners is not de- ductible for tax purposes.
Because the parent owns more than 80 percent of Small’s stock, dividends collected from the subsidiary are tax free. Likewise, intra-entity gains are not taxable presently because a con- solidated return is filed. Hence, financial and tax accounting are the same for both items;nei- ther of these figures produces a temporary difference and deferred income taxes are not needed.
The affiliated group pays taxes on $162,000 and, assuming an effective rate of 30 percent, must convey $48,600 ($162,000 ⫻30%) to the government this year. Because no temporary differences exist, deferred income tax recognition is not applicable. Consequently, $48,600 is the only tax expense reported. This amount is recorded for the consolidated entity by means of a worksheet entry or through an individual accrual by each company.
Income Tax Expense Assignment—Consolidated Return
Whenever a firm files a consolidated tax return, it allocates the total expense between the two parties. This figure is especially important to the subsidiary if it must produce separate finan- cial statements for a loan or a future issuance of equity. The subsidiary’s expense also serves as a basis for calculating the noncontrolling interest’s share of consolidated net income.
Several techniques can accomplish this proration. For example, the expense charged to the subsidiary often is based on the percentage of the total taxable income from each company (the percentage allocation method) or on the appropriate taxable income figures if separate re- turns were filed (the separate return method).
To illustrate, we again use the figures from Great and Small in the previous example. Great owned 90 percent of Small’s outstanding stock. Based on filing a consolidated return, total in- come tax expense of $48,600 was recognized. How should these two companies allocate this figure?
Percentage Allocation Method
Total taxable income on this consolidated return was $162,000. Of this amount, $130,000 ap- plied to the parent (operating income after deferral of unrealized gain), and $32,000 came from the subsidiary (computed in the same manner). Thus, 19.753 percent ($32,000/$162,000) of total expense should be assigned to the subsidiary, an amount that equals $9,600 (19.753 percent of $48,600).
Separate Return Method
On separate returns, intra-entity gains are taxable. Therefore, the separate returns of these two companies appear as follows:
Great Small Total
Operating income . . . $160,000 $40,000 Assumed tax rate . . . 30% 30%
Income tax expense—separate returns . . . $ 48,000 $12,000 $60,000
By filing a consolidated return, an expense of only $48,600 is recorded for the business com- bination. Because 20 percent of income tax expense on the separate returns ($12,000/$60,000) came from the subsidiary, $9,720 of the expense ($48,600 ⫻20%) is assigned to Small.
hoy36628_ch07_293-334.qxd 1/23/10 12:54 AM Page 310
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
Consolidated Financial Statements—Ownership Patterns and Income Taxes 311
Under this second approach, the noncontrolling interest’s share of this subsidiary’s income is computed as follows:
Small Company—reported income . . . $40,000 Less: Unrealized intra-entity gains . . . (8,000) Less: Assigned income tax expense . . . (9,720) Small Company—realized income . . . $22,280 Outside ownership . . . 10%
Noncontrolling interest in Small Company’s income . . . $ 2,228
Filing of Separate Tax Returns
Despite the advantages of filing as an affiliated group, a single consolidated return cannot al- ways encompass every member of a business combination. Separate returns are mandatory for foreign subsidiaries and for domestic corporations not meeting the 80 percent ownership rule. Also, a company may still elect to file separately even if it meets the conditions for in- clusion within an affiliated group. If all companies in an affiliated group are profitable and few intra-entity transactions occur, they may prefer separate returns. Filing in this manner gives the various companies more flexibility in their choice of accounting methods and fis- cal tax years.5Tax laws, though, do not allow a company to switch back and forth between consolidated and separate returns. Once a company elects to file a consolidated tax return as part of an affiliated group, obtaining Internal Revenue Service permission to file separately can be difficult.
Filing a separate tax return by a member of a business combination often creates tem- porary differences because of (1) the immediate taxation of unrealized gains (and losses) and (2) the possible future tax effect of any subsidiary income in excess of dividend pay- ments. Because temporary differences can result, recognizing a deferred tax asset or lia- bility can be necessary. For example, as mentioned, intra-entity gains and losses must be included on a separate return at the time of transfer rather than when the earning process is culminated. These gains and losses appear on both sets of records but, if unrealized at year- end, in different time periods. The temporary difference produced between the transferred asset’s book value and tax basis affects future tax computations; thus, deferred taxes must be reported.
For dividend payments, deferred taxes are not required when ownership equals or exceeds 80 percent. Because the tax law provides a 100 percent dividends received deduction, the transfer is nontaxable even on a separate return; no expense recognition is required.
If the amount distributed by a subsidiary that is less than 80 percent owned equals current earnings, 20 percent of the collection is taxed immediately, but no temporary difference is cre- ated because no future tax effect is produced. Hence, again, deferred income tax recognition is not appropriate.
Conceptually, questions about the recognition of deferred taxes arise when a less than 80 percent owned subsidiary pays less in dividends than its current income. If a subsidiary earns $100,000, for example, but pays dividends of only $60,000, will the parent’s share of the
$40,000 remainder ever become taxable income? Do these undistributed earnings represent temporary differences? If so, immediate recognition of the associated tax effect is required even though payment of this $40,000 is not anticipated for the foreseeable future.
The FASB ASC (para. 740-30-25-4) addresses this issue as follows, “A deferred tax liabil- ity shall be recognized for . . . an excess of the amount for financial reporting over the tax ba- sis of an investment in a domestic subsidiary.” Therefore, other than one exception noted later in this chapter, any portion of the subsidiary’s income not distributed in the form of dividends creates a temporary difference but is not taxed until a later date; thus, a deferred tax liability is created. Because many companies retain a substantial portion of their income to finance growth, an expense recognized here may never be paid.
LO6
Compute taxable income and deferred tax amounts to be recognized when separate tax returns are filed by any of the affiliates of a business combination.
5At one time, the filing of separate returns was especially popular to take advantage of reduced tax rates on lower income levels. However, Congress eliminated the availability of this tax savings.
hoy36628_ch07_293-334.qxd 1/12/10 5:05 PM Page 311
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
Deferred Tax on Undistributed Earnings—Illustrated
Assume that Parent Company owns 70 percent of Child Company. Because ownership is less than 80 percent, filing separate tax returns for the two companies is mandatory. In the current year, Parent’s operational earnings (excluding taxes and any income from this investment) amount to $200,000, and Child reports a pretax net income of $100,000. During the period, the subsidiary paid a total of $20,000 in cash dividends, $14,000 (70 percent) to Parent, and the remainder to the other owners. To avoid complications in this initial example, we assume that no unrealized intra-entity gains and losses are present.
The reporting of Child’s income taxes does not provide a significant difficulty because it involves no temporary differences. Using an assumed tax rate of 30 percent, the subsidiary ac- crues income tax expense of $30,000 ($100,000 30%), leaving an after-tax profit of
$70,000. Because it paid only $20,000 in dividends, undistributed earnings for the period amount to $50,000.
For Parent, Child’s undistributed earnings represent a temporary tax difference. The fol- lowing schedules have been developed to calculate Parent’s current tax liability and deferred tax liability.
Income Tax Currently Payable—Parent Company
Reported operating income—Parent Company . . . $200,000 Dividends received . . . $ 14,000
Less: Dividend deduction (80%) . . . (11,200) 2,800 Taxable income—current year . . . $202,800 Tax rate . . . 30%
Income tax payable—current period (Parent) . . . $ 60,840
Deferred Income Tax Payable—Parent Company
Undistributed earnings of Child Company . . . $ 50,000 Parent Company’s ownership . . . 70%
Undistributed earnings accruing to Parent . . . $ 35,000 Dividends received deduction upon eventual distribution (80%) . . . (28,000)
Income to be taxed—subsequent dividend payments . . . $ 7,000 Tax rate . . . 30%
Deferred income tax payable . . . $ 2,100 These computations show a total income tax expense of $62,940: a current liability of
$60,840 and a deferred liability of $2,100. The deferred balance results entirely from Child’s undistributed earnings. Although the subsidiary has a $70,000 after-tax income, it distributes only $20,000 in the form of dividends. The $50,000 that Child retains represents a temporary tax difference to the stockholders. Thus, it recognizes the deferred income tax associated with these undistributed earnings. The income is earned now; therefore, the liability is recorded in the current period.
The FASB ASC Topic 740, Income Taxes, provides one important exception to the recognition of deferred income taxes on a subsidiary’s undistributed income. Paragraph 740-30-25-18 states that a deferred tax liability is not recognized for the excess amount for financial reporting over the tax basis of an investment in a foreignsubsidiary that is essen- tially permanent in duration. Thus, in the previous example, if the subsidiary is foreign and the retention of these excess earnings seems to be permanent, the $2,100 deferred tax liability is omitted, reducing the total reported expense to $60,840.
Separate Tax Returns Illustrated
A complete example best demonstrates the full accounting impact created by filing separate tax returns. As a basis for this illustration, assume that Lion Corporation reported the follow- ing data with its 60 percent owned subsidiary, Cub Company (a domestic corporation), for the current year:
312 Chapter 7
hoy36628_ch07_293-334.qxd 1/12/10 5:05 PM Page 312
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
Consolidated Financial Statements—Ownership Patterns and Income Taxes 313
Cub Company
Lion (60% owned
Corporation by Lion) Operating income . . . $500,000 $200,000 Unrealized intra-entity inventory gains
(included in operating income) . . . 40,000 30,000 Dividend income from Cub Company . . . 24,000 Not applicable Dividends paid . . . Not applicable 40,000 Applicable tax rate . . . 30% 30%
Subsidiary’s Income Tax Expense Because the companies must file separate tax returns, they do not defer the unrealized gains but leave them in both companies’ operating incomes.
Thus, Cub’s taxable income is $200,000, an amount that creates a current payable of $60,000 ($200,000 30%). The unrealized gain is a temporary difference for financial reporting pur- poses, creating a deferred income tax asset (payment of the tax comes before the income ac- tually is earned) of $9,000 ($30,000 30%). Therefore, the subsidiary recognizes only
$51,000 as the period’s appropriate expense.
Income Tax Expense—Cub
Income currently taxable . . . $200,000
Tax rate . . . 30% $60,000 Temporary difference (unrealized gain is taxed
before being earned) . . . $ (30,000)
Tax rate . . . 30% (9,000) Income tax expense—Cub . . . $51,000 Consequently, Cub reports after-tax income of $119,000 ($200,000 operating income less
$30,000 unrealized gain less $51,000 in income tax expense). This profit figure is the basis for recognizing $47,600 ($119,000 40% outside ownership) as the noncontrolling interest’s share of consolidated income.
Parent’s Income Tax Expense On Lion’s separate return, its own unrealized gains remain within income. The taxable portion of the dividends received from Cub also must be included.
Hence, the parent’s taxable earnings total $504,800, a balance that creates a $151,440 current tax liability for the company.
Income Tax Currently Payable—Lion
Operating income—Lion Corporation
(includes $40,000 unrealized gains) . . . $500,000 Dividends received from Cub Company (60%) . . . $24,000
Less: 80% dividends received deduction . . . (19,200) 4,800 Taxable income . . . $504,800 Tax rate . . . 30%
Income tax payable—current (Lion) . . . $151,440 Although we present Lion’s tax return information here, Lion determines its total tax ex- pense for the period only by accounting for the impact of the two temporary differences: the parent’s $40,000 in unrealized gains and the undistributed earnings of the subsidiary. The undistributed earnings amount to $47,400, computed as follows:
After-tax income of Cub (above) . . . $119,000 Dividends paid . . . (40,000)
Undistributed earnings . . . $ 79,000 Lion’s ownership . . . 60%
Lion’s portion of undistributed earnings . . . $ 47,400 Now the parent can derive its deferred income tax effects for financial reporting.
hoy36628_ch07_293-334.qxd 1/12/10 5:05 PM Page 313
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com