As we discussed in last week’s post, companies have been utilizing the indefinite reversal criteria within ASC 740 to avoid paying U.S. taxes on approximately $2.4 trillion of foreign earnings. Otherwise known as the “APB 23 exception,” ASC 740-30 let’s companies overcome the presumption that all undistributed earnings will be transferred to the parent entity, and no income taxes accrued, if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation.

A parent entity must have evidence of specific plans for reinvestment of undistributed earnings. This means that being “undecided” is not good enough! Companies must have specific plans that are proven by evidence. If circumstances change and it becomes apparent that some or all of the undistributed earnings of a subsidiary will be remitted in the foreseeable future but income taxes have not been recognized by the parent entity, it shall accrue as an expense of the current period income taxes attributable to the remittance.

Let’s take a look at an example.

Example

Charlotte Insurance is located in the U.S. and has a subsidiary in Bermuda (0% tax rate). In prior years, Charlotte’s management did not record a deferred tax liability on the $50 million outside basis difference on its Bermudian subsidiary as they applied (correctly) the exception related to undistributed earnings of foreign subsidiaries that were “permanently reinvested.”

During the 4^th quarter of 20X1, management decided to sell the subsidiary. This sale has to be approved by the Board of Directors, which is granted during the 1^st quarter 20X2. The subsidiary is sold for a gain of $70 million during the 3^rd quarter 20X2. The applicable tax rate is 35%.

Does Charlotte Insurance qualify for the indefinite reversal criteria within ASC 740 to avoid deferred tax recognition at December 31, 20X1?

Solution

No. Charlotte Insurance does not meet the exception at December 31, 20X1 and must record the deferred tax liability on all basis differences related to the Bermudian subsidiary when management decides to sell the subsidiary (i.e. during the 4^th quarter of 20X1) which is different than the period of the gain recorded for book purposes (i.e. during the 3^rd quarter of 20X2).

During the 4^th quarter of 20X1, circumstances changed and it became apparent that some or all of the undistributed earnings of the Bermudian subsidiary would be remitted in the foreseeable future but income taxes had not previously been recognized by Charlotte Insurance; therefore, the company should accrue as an expense of the current period income taxes attributable to that remittance.

Note: The current taxes associated with the gain should be reflected when the gain is recorded in the financial statements during the 3^rd quarter of 20X2 (at which point the deferred liability would also reverse).

Final Thoughts

Remember the indefinite reversal criteria within ASC 740 are a privilege, not a right. Companies need to substantiate their assertion regarding permanent reinvestment with evidence, and external auditors are required to substantiate the evidence and document this evidence in their working papers. Companies should be careful before making public statements regarding their intention to reinvest or repatriate undistributed foreign earnings as doing so may have a negative financial impact. If the indefinite reversal criteria are no longer met, companies may be required to record an immediate expense in their financial statements in the period of the change and this expense may be significant. Be sure to consult our external auditors if your plans for the undistributed earnings have changed.

This is just one of the “hot topics” we discuss in our course, The Essential Accounting and Auditing Update (2016). We have limited availability during the remainder of the year to facilitate the course at your locations, so schedule your course today! 

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