Taxing Situations Two Cases on Income Taxes and Financial Reporting

Document Sample
Taxing Situations Two Cases on Income Taxes and Financial Reporting Powered By Docstoc
               U.S. Income
Appendix 3B   Taxes: Domestic


    W       hen a domestic parent-subsidiary relationship exists, knowledge of certain tax rules and elec-
            tions peculiar to such situations is needed to determine how the domestic group is taxed.
    Furthermore, because various ownership levels are taxed differently, these tax rules are a factor to
    consider when a parent decides to change its ownership level in a subsidiary.
        In this appendix, we discuss the issue of taxation of a subsidiary’s earnings at the parent level
    as well as taxation at the subsidiary level. This area cannot be meaningfully discussed without also
    briefly describing (1) the nature of consolidated income tax returns, (2) the conditions to be met
    for filing such a return, and (3) the advantages and disadvantages of filing such a return. We also
    present a Practitioner Perspective of a tax accountant.

    Manner of Taxing Subsidiaries versus Branches
    When a subsidiary distributes its earnings to its parent, the parent has dividend income for tax-
    reporting purposes. Thus an element of “double corporate taxation”1 appears to exist when an en-
    tity has a subsidiary instead of a branch. Recall from Chapter 1 that a branch’s earnings are in-
    cluded with the home office’s earnings for tax reporting. Thus branch earnings are taxed only
    once—when the earnings occur—not a second time when branch earnings are remitted to the home

    The Intent of Congress
    The intent of Congress, however, is to tax a subsidiary’s earnings only once (in the United States)
    at the corporate level. Accordingly, if a subsidiary has paid U.S. income taxes at the subsidiary level
    (as only domestic subsidiaries do), its earnings (net of the taxes paid) will not be taxed again in
    the form of dividend income at the parent level. Special provisions in the tax code (discussed
    shortly) exist so that such dividend income is not taxed at the parent level. However, 20% of the
    dividend income from less than 80%-owned subsidiaries is taxed at the parent level.

    Domestic versus Foreign Subsidiaries
    As stated above, only a domestic subsidiary can pay U.S. income taxes at the subsidiary level. In
    contrast, a foreign subsidiary pays income taxes to the foreign government. Because a foreign sub-
    sidiary pays no U.S. income taxes at the subsidiary level, a parent’s dividend income from a for-
    eign subsidiary is assessed a parent-level tax in the United States. The manner of calculating the
    U.S. income taxes on this foreign income (which requires a pro forma tax calculation to which al-
    lowable foreign tax credits can be applied) is discussed in the Appendix of Chapter 16.

    The Result of This Manner of Taxation
    The result of this manner of taxation is that subsidiaries and branches are taxed the same—only
    once in the United States. Accordingly, whether the subsidiary or branch form of organization is
    used for an outlying location does not matter insofar as U.S. income taxes are concerned (except
    for the timing factor of reporting the income as earned versus when distributed).

      Double corporate taxation differs from the more familiar term double taxation, which refers to the fact that income is taxed both
    at the corporate level and at the individual level when that income is distributed as dividends.

   The Special Provisions in the U.S. Tax
   Law Regarding a Parent’s Dividend Income
   The special provisions of the Internal Revenue Code that allow dividend income from domestic
   subsidiaries not to be taxed at the parent level pertain to (1) the election to file a consolidated in-
   come tax return and (2) the dividend received deduction, which is a factor only when a parent and
   its domestic subsidiary file separate income tax returns. We now discuss each of these provisions.

   Special Provision 1: Filing a
   Consolidated Income Tax Return
   A parent company and its subsidiaries may file a consolidated federal income tax return—as op-
   posed to the parent and the subsidiaries each filing separate income tax returns—if the parent owns
   directly or indirectly at least 80% of both (1) the voting power of all classes of stock and (2) the
   value of all classes of stock included in the consolidated return. (The 80% requirement must be
   satisfied by direct ownership for at least one subsidiary included in the consolidated return.2)

   The Nature of a Consolidated Return
   A consolidated income tax return is the tax equivalent of a consolidated income statement for fi-
   nancial reporting purposes. Thus all intercompany transactions—including intercompany divi-
   dends—are eliminated for income tax–reporting purposes. A consolidated income tax return can
   be prepared in two ways. The easier way is to start with the consolidated income statement for fi-
   nancial reporting purposes and merely make necessary adjustments on a worksheet to obtain con-
   solidated taxable income. The second way is to make tax adjustments for each separate company
   to arrive at separate company taxable income amounts and then prepare a consolidating tax work-

   The Major Restriction on Filing a Consolidated Return
   The restriction of major significance is that consolidated income tax returns may be filed only with
   domestic subsidiaries, and then only if certain ownership conditions are met. Foreign subsidiaries
   are automatically excluded because they must always file separate income tax returns in the for-
   eign country in which they are incorporated.

   Other Advantages of Filing a Consolidated Return
   Filing a consolidated return has several other distinct advantages beyond the freedom from paying
   income taxes on dividends received from a subsidiary. These other advantages are as follows:

   1. Offsetting operating losses against operating profits. Operating losses of companies within the
      consolidated group that do not generate profits can offset operating profits of the other mem-
      bers of the consolidated group.
   2. Offsetting capital losses against capital gains. Capital losses of one company can offset capital
      gains of other members of the consolidated group.
   3. Deferring profits on intercompany transactions. Intercompany profits recorded on the sale of
      assets between entities are deferred until such assets are sold (for inventory transfers) or depre-
      ciation occurs (for depreciable asset transfers).
   4. Avoiding Section 482 problems. As noted previously, Section 482 of the Internal Revenue Code
      (discussed more fully in Chapter 8) requires supportable fair transfer pricing between affiliated
      entities. Section 482 permits the IRS to allocate income and deductions among affiliated enti-
      ties. Because all intercompany transactions are undone in preparing a consolidated return, there

       The detailed requirements are set forth in the U.S. Internal Revenue Code of 1954, Sec. 1504(a).

                 is never any Section 482 problem. Thus the Section 482 problem primarily affects parents and
                 their foreign subsidiaries.
              5. Using certain tax credits. If a foreign branch of a domestic subsidiary has “excess foreign tax
                 credits” (discussed in the Appendix of Chapter 16), the group may be able to use it.

              Disadvantages of Filing a Consolidated Return
              The following are some of the disadvantages of consolidated returns:

              1. Losses on intercompany transactions must be deferred.
              2. The IRS rules for determining consolidated income are quite complex.

              Allocating Consolidated Income Tax
              Expense: A Financial Reporting Issue
              When a company files a consolidated income tax return, a financial reporting issue arises if either
              the parent or the subsidiary issues separate financial statements (possibly for loan covenant agree-
              ments). In such cases, the total consolidated income tax expense must be allocated among the com-
              panies included in the consolidated income tax return. We discuss possible manners of making this
              allocation in Chapter 8. Even in consolidated statements, companies often disclose how the allo-
              cation is made.


    Chevron Corporation’s Tax Allocation Disclosure (2003 annual report)
    It is the company’s policy for subsidiaries included      with the parent recording the adjustment to income
    in the U.S. consolidated tax return to record in-         tax expense for the effects of consolidation.
    come tax expense as though they filed separately,

              Impact of Filing a Consolidated Tax Return
              on the Parent’s Tax Basis of Its Investment
              When a consolidated tax return is filed, the tax basis of the parent’s investment in the subsidiary
              (1) increases for the subsidiary’s earnings and (2) decreases for (a) the subsidiary’s losses and (b)
              dividends paid. Essentially, this treatment is the same as if the equity method of accounting were
              applied for tax-reporting purposes.

              Special Provision 2: Using the Dividend Received
              Deduction (Separate Tax Returns Filed)
              80%-or More Owned Domestic Subsidiaries
              When both a parent and an 80%-or more owned domestic subsidiary file separate income tax re-
              turns, the Internal Revenue Code permits a “dividend received deduction” of 100% of the divi-
              dend received from the domestic subsidiary. Thus none of the intercompany dividend is taxed on
              the parent’s separate tax return. Without such a provision, triple taxation of a subsidiary’s earn-
              ings results (first at the subsidiary level, second at the parent level, and third at the individual level
              when dividends are paid).
                  Consequently, because the dividend received deduction is not allowed for dividends received
              from foreign subsidiaries and because foreign subsidiaries cannot be consolidated for income tax–re-
              porting purposes, the taxation of subsidiary dividends at the parent level is usually a problem almost
              exclusively for foreign subsidiaries (the taxation of which is discussed in the Appendix of Chapter
              16). It is also a problem for less-than-80%-owned domestic subsidiaries, as discussed below.
                  Note that this 80%-ownership level is the same percentage required for filing a consolidated
              tax return. Thus no parent-level tax is recorded for all 80%-or more owned domestic sub-
      APPENDIX 3B         CONSOLIDATED U.S. INCOME TAXES: DOMESTIC SUBSIDIARIES ONLY                                                         5

          sidiaries—regardless of whether they file separate tax returns or are included in a consolidated tax

          Less-Than-80%-Owned Domestic Subsidiaries
          If a domestic subsidiary is less than 80% owned, the dividend received deduction allowed is
          only 80% of the dividend received: 3 Thus a parent-level tax is incurred. To avoid incurring any
          parent-level tax, companies must carefully control their ownership levels in partially owned


Note from the earlier Case in Point that when                       the parent-level tax the percentage of shares sold
Sears, Roebuck and Company had a partial dis-                       was not more than 20%.
posal of its Allstate Insurance subsidiary, to avoid

          When to Record the Parent-Level Tax
          Under APB Opinion No. 23, “Accounting for Income Taxes—Special Areas,” this parent-level tax
          must be recorded for financial reporting purposes in the year in which the domestic subsidiary re-
          ports the income—not when it pays dividends. Furthermore, for undistributed earnings that arise
          in fiscal years beginning after December 15, 1992, FASB Statement No. 109, “Accounting for In-
          come Taxes,” requires recording the parent-level income taxes on those undistributed earnings—
          regardless of whether the intent is to reinvest them for the indefinite future. For undistributed earn-
          ings that arose in fiscal years prior to December 15, 1992, the parent-level tax is recorded only if
          those undistributed earnings are not being reinvested indefinitely.

          Assessing Whether Taxable Temporary Differences Exist
          When a subsidiary has undistributed earnings and files a separate tax return and when the parent
          uses the equity method, the parent’s Investment in Subsidiary account will have an excess of book
          basis over tax basis. This excess may or may not be a taxable temporary difference as that term is
          used in FAS 109. Recall from intermediate accounting that FAS 109 requires deferred income taxes
          to be provided on taxable temporary differences. Accordingly, an assessment must first be made as
          to whether the excess is a taxable temporary difference.
              The excess is not a taxable temporary difference if (1) the parent can recover the investment
          excess tax free and (2) the parent intends to do so. Two ways exist for the parent to recover the
          excess tax free:

          1. Realization through dividends when the ownership level is 80% or more. The first way exists
             when realization is expected through dividends and the parent’s ownership level is 80% or
             more. In this case, the parent will be able to use the 100% dividend received deduction in the
             future and thus avoid paying any parent-level taxes.
          2. Tax-free liquidation into a division. The second way exists when the parent can liquidate the
             subsidiary into a division in a tax-free manner (usually under Section 332 of the Internal Rev-
             enue Code, which can be applied only to domestic subsidiaries). When done, no taxes are
             payable to the IRS (the tax basis of the Investment “disappears,” and the tax basis of the sub-
             sidiary’s assets survive in the enlarged entity’s books).

              When the parent is unable to use either of the preceding two options (such as when its owner-
          ship level is below 80% or when it is unlikely that the parent can liquidate the subsidiary in a tax-
          free manner), the excess is a taxable temporary difference.

            This 80% dividend received deduction for intercorporate investments extends down to the 20% ownership level. For less than 20%
          intercorporate investments, the dividend received deduction is only 70%.

    Which Tax Rates to Use When the
    Excess Is a Taxable Temporary Difference
    If the parent expects to realize the excess through dividends, ordinary tax rates are used. On the
    other hand, if the parent expects to realize the excess through the sale of its investment (at a price
    at least equal to its book value), capital gain tax rates are used.
        Note that even if the parent’s ownership level is 100%, deferred income taxes would still have
    to be provided if the parent expects to sell the subsidiary.

            SUMMARY                OF     APPENDIX 3B KEY POINTS
    1. For 80%-or more owned domestic subsidiaries, no parent-level tax exists because of the use of
       (1) consolidated tax returns or (2) the dividend received deduction allowed for dividends re-
       ceived from domestic subsidiaries.
    2. Consolidated tax returns have several advantages over separate company tax returns, such as
       the ability to offset losses of one entity against the profits of another entity. Another big advan-
       tage is the elimination of Section 482 transfer pricing problems.
    3. A subsidiary’s earnings may be taxed at the parent level if the subsidiary is (1) a foreign sub-
       sidiary or (2) a less-than-80%-owned domestic subsidiary.
    4. For less-than-80%-owned domestic subsidiaries, parent-level taxes (for financial reporting pur-
       poses) on undistributed earnings are recorded in the year the subsidiary earns the income—not
       when the dividends are paid. No “indefinite investment” exemption is available (as exists for
       foreign subsidiaries).

       GLOSSARY               OF     NEW TERMS                   FOR       APPENDIX 3B
    Consolidated tax return A tax return in which the combined income of a parent and one or more
       of its domestic subsidiaries that meet certain ownership conditions is reported.
    Dividend received deduction The deduction the IRS allows to parent companies reporting as in-
       come the dividends received from their domestic subsidiaries (80–100%, depending on the par-
       ent’s ownership level).
    Parent-level tax Income tax that a parent company records based on a subsidiary’s earnings.

          SELF-STUDY QUESTIONS                                FOR       APPENDIX 3B
    (Answers are at the end of these questions.)
    1. Which of the following is not an advantage unique to filing a consolidated tax return?
       a. The nontaxability of intercompany dividends.
       b. The deferral of intercompany profits on the intercompany transactions.
       c. The offsetting of loss operations against profitable operations.
       d. The avoidance of Section 482 problems.
    2. The parent-level tax is essentially an issue for which of the following?
       a. All domestic subsidiaries.
       b. 100%-owned domestic subsidiaries.
       c. Less-than-100%-owned domestic subsidiaries.
       d. Less-than-80%-owned domestic subsidiaries.

           3. Sax is a 75%-owned domestic subsidiary of Pax. For 2004, Sax had $500,000 of pretax income
              and $300,000 of net income. At the end of 2004, Sax paid a $160,000 dividend. The remain-
              ing $140,000 of net income is expected to be invested indefinitely. The tax rate is 40%. What
              parent-level tax does Pax record for 2004?
              a. $ –0–
              b. $9,600
              c. $18,000
              d. $24,000

           Answers to Self-Study Questions for Appendix
           1. a     2. d       3. c

           (Interactive Quizzes containing these questions and answers can be found at the website:

                     REVIEW QUESTIONS                         FOR      APPENDIX 3B
            1. When does a parent report on its tax return the earnings of its subsidiary?
            2. What is the purpose of the parent-level tax on a subsidiary’s earnings?
            3. What are two ways to avoid the parent-level tax when domestic subsidiaries exist?
            4. What is the nature of a consolidated income tax return?
            5. Which subsidiaries can be included in a consolidated return?
            6. What are four advantages of a consolidated return? Two disadvantages?
            7. What financial reporting issue exists when a consolidated income tax return is filed?
            8. When is the dividend received deduction allowed?
            9. Is the dividend received deduction used in preparing a consolidated return?
           10. When and to what extent does APBO No. 23 require recording the parent-level taxes on a do-
               mestic subsidiary’s earnings?

                              EXERCISES             FOR      APPENDIX 3B
 E 3B-1    Income Taxes: Parent Level Sunco is a 75%-owned domestic subsidiary of Punco. Sunco was cre-
           ated on 1/1/06, when it issued $4 million of common stock for cash ($3 million of which was Par-
           rco). For 2006, Sunco had $500,000 of pretax income and $300,000 of net income. At the end of
           2006, Sunco paid a $100,000 dividend. The remaining $200,000 of net income is expected to be
           invested indefinitely. The tax rate is 40%.

Required   1. What parent-level tax does Punco record for 2006?
           2. Calculate the financial reporting basis and the tax reporting basis of Punco’s investment at
              12/31/06. Then calculate the deferred tax liability.
           3. Repeat requirement 1, assuming that Sunco is 80% owned.

 E 3B-2    Income Taxes: Parent Level Sorr is a 60%-owned domestic subsidiary of Porr. For 2006, Sorr had
           $2,500,000 of pretax income and $1,500,000 of net income. At the end of 2006, Sorr paid a
           $750,000 dividend. The remaining $750,000 of net income is expected to be invested indefinitely.
           The tax rate is 40%.

    Required   1. What parent-level tax does Porr record for 2006?
               2. Repeat requirement 1, assuming that Sorr is 80% owned.

                                          THINKING CRITICALLY
               Case for Appendix 3B
      C 3B-1   Single versus Double Corporate Taxation: Why Interest Expense Is Tax-Deductible For 2006,
               Pankco reported interest expense of $100,000, all of which pertained to a bank loan from Bankco.
               Assume that (1) both entities reported $500,000 of income before interest and taxes (EBIT) for
               2006, (2) the corporate income tax rate is 40%, (3) the individual income tax rate is 30%, and (4)
               each entity distributed all its net income as dividends in 2006.

    Required   1. Calculate the total federal taxes that would be paid at all levels (corporate and individual) as-
                  suming that the interest expense is tax-deductible.
               2. Repeat requirement 1 assuming that interest expense is not tax-deductible.
               3. What is the effective result when interest is not tax-deductible? Is it fair to allow interest to be
               4. What result would occur if Pankco had borrowed the money from an individual instead of a

               Financial Analysis Problem for Appendix 3B
    FAP 3B-1   The Time Value of Money: Why 28% Is Not 28%! You are preparing your employer’s consoli-
               dated tax return in which the $500,000 capital gain on land that the parent had held for 20 years
               fully offsets the subsidiary’s capital loss of $100,000. Your supervisor, Kelly Ganes, mentions to
               you that (1) the effective tax rate on capital gains is lower than the statutory tax rate because of
               the time value of money factor and (2) the longer the capital asset is held, the lower the effective
               capital gain tax rate.
                   You are perplexed and ask for further explanation. Kelly asks you to suppose that (1) you in-
               vest $1,000 and earn a 10% pretax dividend each year (taxable at ordinary rates), (2) the ordinary
               income tax rate is 28%, and (3) the after-tax income is reinvested at the same 10% rate of return.
               Using a pocket calculator, Kelly shows that you would accumulate $4,017 after 20 years.
                   If instead you had invested in a common stock that paid no dividend but had increased in value
               each year by 10%, the common stock would be worth $6,728 after 20 years. If you then sold the
               stock, you would report a realized capital gain of $5,728 ($6,728 – $1,000). If the capital gain tax
               rate were 28%, you would pay taxes of $1,604 ($5,718 X 28%), leaving you with $5,124 ($6,728
               – $1,604). This $5,124 amount is $1,107 more ($5,124 – $4,017) than the annual dividend situ-
                   To have accumulated this additional $1,107, the effective tax rate had to be 15%—not 28%.
               In other words, if you had paid taxes at 15% each year on the 10% increase in value (and then
               reinvested the remaining 85% each year), you would have accumulated $5,124. Therefore, the ef-
               fective capital gain tax rate was 15%—not 28%.

    Required   What is the effective tax rate if the common stock investment were held for only 10 years?

Description: Taxing Situations Two Cases on Income Taxes and Financial Reporting document sample