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Defining Issues®

January 2015, No. 15-3

FASB Proposes Changes to

Accounting for Income Taxes on

Intercompany Transfers and

Deferred Tax Classification

The FASB recently issued proposed Accounting Standards Updates

(ASUs) that would require entities to recognize the income tax

consequences of intercompany asset transfers and classify all

deferred tax assets and liabilities as noncurrent in a classified

statement of financial position.1

Key Facts

The first proposal would require both the seller and the buyer in an

intercompany asset transfer to immediately recognize the current and

deferred income tax consequences of the transaction.

A second proposal would require the net deferred tax asset or liability in each

tax jurisdiction to be presented as noncurrent on a classified balance sheet.

Comments on the proposed ASUs are due by May 29, 2015.

Key Impacts

Requiring entities to immediately recognize the tax consequences of

intercompany transfers could significantly affect reported tax rates and

increase the volatility in earnings, particularly for companies that transfer

intangible assets.

Classifying all deferred taxes as noncurrent may simplify an entity’s processes

because it would eliminate the need to separately identify the net current and

net noncurrent deferred tax asset or liability for each tax jurisdiction (including

allocating valuation allowances into current and noncurrent amounts).

The proposals, if finalized, would result in convergence with International

Financial Reporting Standards on these topics.2

1 FASB Proposed Accounting Standards Updates, Income Taxes (Topic 740): Intra-Entity Asset

Transfers, and Balance Sheet Classification of Deferred Taxes, January 22, 2015, available at

www.fasb.org.

2 IAS No. 12, Income Taxes, and IAS No. 1, Presentation of Financial Statements.

Contents

Intercompany Asset Transfers ...... 2

Presentation of Deferred Taxes ..... 3

Proposed Transition and Effective

Dates .......................................... 4

©2001–2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative, a Swiss entity.

Defining Issues® — January 2015, No. 15-3

2

Intercompany Asset Transfers

In consolidation, intercompany balances, transactions, and profit or loss on

transfers of assets (if they remain within the group) are eliminated and no

immediate gain or loss is recognized.3 However, intercompany transfers of

assets, such as the sale of inventory, depreciable assets, or intellectual property

between tax jurisdictions, have cash tax effects because generally those are

taxable events for the seller (typically resulting in taxable gain) and the buyer

(typically resulting in a new tax basis in the buyer’s tax jurisdiction).

Current GAAP prohibits recognition of the income tax consequences of

intercompany asset transfers.4 The seller defers any net tax effect and the buyer

is prohibited from recognizing a deferred tax asset on the difference between

the newly created tax basis of the asset in its tax jurisdiction and its existing

financial statement carrying amount as reported in the consolidated financial

statements. The proposal would instead require entities to recognize these tax

consequences in the period of transfer. If tax rates differ in the seller’s and

buyer’s tax jurisdictions, there would be an immediate impact in earnings.

Example – Intercompany Asset Transfer

ABC Corp. and DEF Corp. are wholly owned subsidiaries of Parent Z. ABC

and DEF file separate tax returns in different tax jurisdictions. ABC sells

inventory with a book and tax basis of $100 to DEF for $150. The tax rate is

20% in ABC’s tax jurisdiction and 40% in DEF’s tax jurisdiction. Under the

new proposal, ABC would recognize current tax expense of $10 ($50 gross

profit multiplied by the 20% tax rate) for the intercompany profit on the sale

(but in this case, no reversal of existing deferred taxes because the book

basis equals the tax basis).

The tax basis of the inventory for DEF is $150. In the consolidated financial

statements, the inventory has a carrying amount of $100 after elimination of

intercompany profit. Assuming no valuation allowance, a tax benefit of $20

(temporary difference of $50 multiplied by the 40% tax rate) would be

recognized by DEF for this temporary difference. In the consolidated financial

statements, the intercompany sale of inventory would result in net income of

$10 (deferred tax benefit of $20 less current tax expense of $10).

The Board believes the proposal will eliminate the current diversity in practice

and result in a more faithful depiction of the tax consequences of an

intercompany asset transfer. The Board indicated recognizing current tax

expense in the period the transfer occurs would assist financial statement users

when comparing current tax expense and the effective tax rate to cash paid for

income taxes.5

3 FASB ASC Topic 810, Consolidation, available at www.fasb.org.

4 FASB ASC paragraphs 810-10-45-8 and 740-10-25-3(e), available at www.fasb.org.

5 FASB Proposed Accounting Standards Update, Income Taxes (Topic 740): Intra-Entity Asset

Transfers, paragraph BC7, available at www.fasb.org.

Enhanced discussion in

MD&A and earnings releases

may be necessary to:

Explain the volatility in the

effective tax rate and

earnings per share;

More clearly explain the

business purpose for

intercompany transfers

that would be more

visible to financial

statement users.

©2001–2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative, a Swiss entity.

Defining Issues® — January 2015, No. 15-3

3

KPMG Observations

Because general consolidation principles prohibit entities from including in

the consolidated financial statements gains or losses on intercompany

transactions, requiring entities to currently recognize the income tax effects

of intercompany asset transfers, while eliminating an exception in the income

tax guidance, would create an exception to the consolidation guidance. The

FASB’s current proposal is consistent with the requirements in Statement 96

that was issued by the FASB in 1987. However, in 1992 the FASB issued

Statement 109, which amended parts of Statement 96, including the

guidance on intercompany transfers.6 In Statement 109, the FASB concluded

that although the excess of the buyer’s tax basis of an asset over its reported

amount in the consolidated financial statements meets the definition of a

temporary difference, treating that excess as a temporary difference would

result in recognizing income taxes related to intercompany gains that are not

recognized under the consolidation guidance on eliminating the effects of

intercompany transactions.

Presentation of Deferred Taxes

The proposed ASU would require entities to offset all deferred tax assets and

liabilities (and any valuation allowance) for each tax-paying jurisdiction within

each tax-paying component and present that net deferred tax as a single

noncurrent amount.

Currently, entities that present a classified statement of financial position

present a net current deferred tax asset or liability, and a net noncurrent deferred

tax asset or liability, for each tax jurisdiction. Classification as current or

noncurrent generally is based on the underlying asset or liability for financial

reporting. Deferred tax assets and liabilities not related to GAAP assets or

liabilities are classified based on the expected reversal date of the temporary

difference. Valuation allowances are allocated by tax-paying jurisdiction between

current and noncurrent deferred tax assets on a pro-rata basis.

Preparers have indicated to the FASB that complying with the current

requirement is costly and the resulting information provides little benefit to

users, because the classification of deferred taxes may not be consistent with

when the deferred tax amounts are expected to be recovered or settled. The

Board concurred and developed the proposed model to eliminate the cost and

complexity.7 The Board discussed an alternative that would have required

entities to classify deferred tax assets and liabilities based on when they are

expected to become deductible, but rejected it as complex, costly, and not

aligned with the Board’s simplification initiatives.

The Board has acknowledged that the proposed noncurrent classification for all

deferred tax assets and liabilities is not conceptually pure, but believes it would

6 FASB Statement No. 96, Accounting for Income Taxes, replaced by FASB Statement No. 109,

Accounting for Income Taxes, both available at www.fasb.org.

7 FASB Proposed Accounting Standards Update, Income Taxes (Topic 740): Balance Sheet

Classification of Deferred Taxes, paragraph BC4, available at www.fasb.org.

The proposed standard is

expected to reduce the cost

of tracking deferred tax items

based on the nature of the

underlying account and

reduce complexity by

eliminating the requirement

to allocate the valuation

allowance on a pro-rata basis.

©2001–2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative, a Swiss entity.

Defining Issues® — January 2015, No. 15-3

4

reduce cost and complexity without decreasing the usefulness of information

provided to users of financial statements. During deliberations prior to the

issuance of the Statement 109 guidance in current U.S. GAAP, the Board also

contemplated classifying all deferred taxes as noncurrent.8 The FASB did not

adopt this alternative at that time because it believed noncurrent presentation

would be confusing for financial statement users and result in inappropriate

current ratios. If the current proposal is finalized, the Board plans to consider

whether additional disclosure may be necessary.9

Proposed Transition and Effective Dates

The change in accounting for intercompany transfers would be applied on a

modified retrospective basis at the beginning of the period of adoption with a

cumulative effect adjustment to beginning retained earnings. The change in

classification of deferred tax balances on the balance sheet would be applied

prospectively.

The proposed ASUs are expected to be effective for public business entities for

annual and interim periods in fiscal years beginning after December 15, 2016,

with no early adoption allowed. For other entities, the guidance would be

effective for annual periods in fiscal years beginning after December 15, 2017,

and interim periods in fiscal years beginning after December 15, 2018. Early

adoption would be allowed for entities other than public business entities, but

not before December 15, 2016, and only if both ASUs are adopted at the same

time.

Contact us: This is a publication of KPMG’s Department of Professional Practice 212-909-5600

Contributing authors: Kayreen M. Handley, Angela B. Storm and Jonathan C. Ridgway

Earlier editions are available at: http://www.kpmg-institutes.com

Legal–The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the proposed standards or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues® is a registered trademark of KPMG LLP.

8 FASB Statement No. 109, Accounting for Income Taxes, available at www.fasb.org.

9 FASB Proposed Accounting Standards Update, Income Taxes (Topic 740): Balance Sheet

Classification of Deferred Taxes, paragraph BC6, available at www.fasb.org.