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Practical tip

A tip on applying financial reporting


requirements

No. 2011-03
June 16, 2011

Deferred tax accounting implications of


holding gains from obtaining control of a
foreign investee
When a company obtains control of an entity, or becomes the primary beneficiary of a
variable interest entity, it remeasures its previously held equity interest to fair value and
recognizes a holding gain in income. This holding gain will create an additional outside
basis temporary difference (i.e., the difference between a company's tax basis in the stock
of an investee or subsidiary and its carrying value). Accordingly, a company may have to
record a deferred tax liability (DTL) since the holding gain typically is not recognized for
income tax purposes.
However, when consolidating a previously nonconsolidated foreign equity investee, an
accounting policy election1 is available related to the recognition of a DTL on the
resultant holding gain.

Some key points to consider with respect to investments in foreign entities:


Deferred taxes should be recorded for outside basis temporary differences in foreign
equity method investments unless the expected manner of recovery of the equity
investment (e.g., dividends or capital gain income from a disposition) has no tax
consequences. For example, in some jurisdictions dividends do not have tax
consequences to an investor but capital gain income does trigger tax. Evidence based
on all facts and circumstances should determine whether an investor's liability for tax
consequences of temporary differences related to its equity in earnings of an investee
should be measured using tax rates applicable to a capital gain or a dividend.
Therefore, a realistic and reasonable expectation as to the time and manner in which
such difference is expected to be recovered must be determined.

This policy election does not apply to foreign corporate joint ventures that are permanent in duration, foreign
branches, or domestic entities.
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Practical tip

When a company acquires a controlling interest in, or otherwise obtains control of, a
foreign equity investee, the DTL previously recorded for the equity in earnings of the
foreign investee is required2 to be "frozen" until: (1) dividends from the subsidiary
exceed the parents share of the subsidiarys earnings after the date on which the
equity investee became a subsidiary or (2) the parent disposes of its interest in the
subsidiary. This amount would be "frozen" even if the parent has an intent and ability
to indefinitely reinvest the foreign subsidiary's earnings and, therefore, does not plan
to provide for income taxes on future earnings.
If the company expects to make an indefinite reinvestment assertion with respect to
the foreign subsidiary, the additional taxable temporary difference arising from a
holding gain would require a company to either:
1. Record a DTL on the holding gain and "freeze" the DTL related to the entire
outside basis difference, or
2. Not record a DTL on the holding gain and only "freeze" the DTL that relates to
unremitted earnings of the investee as of the date control is obtained (i.e., the
preexisting DTL as of the date the equity interest is remeasured to fair value) 3.
The approach selected is an accounting policy election that should be consistently
applied to all acquisitions.
If the company does not expect to make an indefinite reinvestment assertion with
respect to the foreign subsidiary, the deferred tax effect of the entire outside basis
difference should be recorded. This is because it is implied that upon recovery of the
investment (e.g., through dividend distributions), the entire outside basis taxable
temporary difference will reverse in a manner that will have tax consequences.
On occasion, the expected manner of recovery prior to obtaining control does not
have tax consequences to the investor company, so no DTL is provided for the taxable
temporary difference in the foreign equity investee. Therefore, when the investor
company obtains control over the investee there is no DTL to "freeze." In such
circumstances, if the company expects to maintain an indefinite reinvestment
assertion after the foreign equity investee becomes a foreign subsidiary, no DTL
would be recorded.

A practical example
Scenario 1
Facts:
Company X is a US corporation which owns 40% of Company A (a foreign corporation)
and accounts for its investment using the equity method. Company X's applicable federal
and state tax rate is 40%, and it has recorded a DTL of $16 million for its 40% equity in
the undistributed earnings of Company A because any recovery method (e.g., dividends
or capital gain income from a disposition) would be taxable to Company X. The

The applicable guidance is included in ASC 740-30-25-16.


The theory behind freezing the previously recorded liability is that once a tax liability is provided it would not
be appropriate to derecognize it until the related obligation is settled. A remeasurement of an equity interest
does not result in settlement of the inherent tax obligation. The policy election to include the holding gain in the
frozen amount is based on the notion that the previously held interest is deemed to be sold and reacquired at
fair value. Therefore, the deemed sale increases the taxable temporary difference and the inherent tax
obligation.
3

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Practical tip

measurement of the US DTL does not reflect any foreign tax credits or withholding taxes
since Company A is domiciled in a zero rate jurisdiction.
In the current period, Company X acquires the remaining 60% equity of Company A for
an amount significantly in excess of book value, resulting in a holding gain of $100
million. Company X expects to make an indefinite reinvestment assertion when
Company A becomes a foreign subsidiary.
Analysis:
Company X is required to "freeze" the $16 million DTL which relates to its equity in the
undistributed earnings of a foreign equity investee. Additionally, Company X can adopt
an accounting policy to either "freeze" the entire outside basis difference and thus record
an additional DTL of $40 million (40% of the additional $100 million taxable temporary
difference arising from the holding gain), or alternatively not record an additional DTL
and only "freeze" the preexisting $16 million DTL.
The recorded DTL would remain "frozen" until Company A either distributes the related
earnings or until Company X disposes of its interest in Company A.
Scenario 2
Facts:
Assume the same fact pattern as Scenario 1, except Company X does not expect to
maintain an indefinite reinvestment assertion after Company A becomes a foreign
subsidiary.
Analysis:
Company X would recognize an additional DTL of $40 million (40% of the additional
$100 million taxable temporary difference arising from the holding gain). The total DTL
recognized on the balance sheet for the entire outside basis difference in Company A
would be $56 million ($16 million preexisting DTL plus $40 million additional DTL).

Questions
PwC clients that have questions about this Practical tip should contact their engagement
partner. Engagement teams that have questions should contact a member of the Tax
team in the National Professional Services Group (1-973-236-7806).

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Practical tip

Authored by:
Brett Cohen
Partner
Phone: 1-973-236-7201
Email: brett.cohen@us.pwc.com

Yosef Barbut
Director
Phone: 1-973-236-7305

Email: yosef.barbut@us.pwc.com
Trent Horsfall
Senior Manager
Phone: 1-973-236-5376
Email: trent.r.horsfall@us.pwc.com

Practical tips offer tips on applying financial reporting requirements and are prepared by the National Professional Services Group of PwC. This
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